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When an Airline Buys an Oil Refinery

EconMatters's picture




 

 

By EconMatters


The biggest news in the airline sector of late is probably the announcement by Delta Airlines to buy a Phillips 66 refinery in Trainer, PA.  Delta will pay $150 million for the 180,000 barrels per day (bpd) facility, spend an additional $100 million to upgrade the plant, and get $30 million in state subsidies for infrastructure and to create jobs. 

 

Under the proposal, JP Morgan is reportedly part of the package as well.  Delta would purchase the refinery and JP Morgan's commodities team would finance the refining process, including buying and shipping crude oil from overseas. Delta would then buy the jet fuel from JP Morgan at a wholesale rate, and the bank would sell the other products made by the refinery into the market.

 

The reason behind this unprecedented move is to use the refinery as the ultimate fuel hedge by saving Delta about $300 million a year in jet fuel costs. In our view, despite the optimistic savings projection, there are pros and cons of this deal for Delta.

 

Pros:

 

(1) Fuel represents the single biggest expense component of the airline industry.  Delta's planes guzzled down 3.9 billion gallons of fuel last year, costing the airline $11.8 billion, or 36% of its operating expenses.  So having an East Coast refinery asset could conceivably give Delta better planning and budgeting, and most importantly, pricing power and a cost advantage, particularly in the very competitive North Atlantic market, over its competitors such as American, British Airways 

 

 

Chart Source: IATA

 

 

(2) With JP Morgan bankrolling the whole thing, Delta could benefit from JPM's expertise in the energy trading market, as well as financing, thus reducing the risk of taking on the refinery operation alone.

 

(3) Regardless of the outcome, Delta management at least took a bold and novel approach using physical asset to hedge fuel, instead of the industry standard paper-based hedging program pioneered by Southwest Airlines.

 

Cons:


(1) The biggest cost component of jet fuel is crude oil, which means any savings Delta seeks is driven by the crack spread--the difference between the price of a barrel of oil, and sale price of refined product.  Trainer plant is one of the older refineries that relies on the most expensive grades of crude oil as feedstock.  Even with JPM's backing, what are the odds of an airline and a banker succeeding where Phillips 66 failed?

 

(2)  Refining is not Delta's core expertise.  Refinery operation is quite complex, which both Delta and JPM have little experience.  Integrating a refinery into Delta's business will be a major challenge distracting Delta's focus.  Assuming Delta and JPM can immediately put together an appropriate management team, smooth running will still take at least 2 to 3 years.

 

(3) We also question if the projected $300 million a year savings includes the cost of running the refinery?  Theoretically, if Delta is getting cheaper fuel price from Trainer, that would suggest the refinery most likely is not making money from the transaction.

 

(4) Furthermore, the jet fuel market on the East Coast has tightened up quite a bit due to the closure the Trainer Plant which accounts for one third of the jet-kerosene capacity in the region. So, re-opening the now idled Trainer refinery could actually increase the jet fuel supply benefiting even Delta's competitors.

 

(5) Delta seems to have entered this deal out of desperation during the oil price spike from Iran nuclear controversy.  If oil price stabilizes or weakens as some of the forecasts seem to suggest, this could well end up being a wasted investment.  

 

With almost every US-based airline in bankruptcy at one time or another, the airline industry in general has not had a very good track record of competent management.  On that note, we have to wonder if the money and resource invested in this deal could be better utilized in areas such as customer service and flight safety.  After all, price and quality is what matters the most in any business, including airlines.  

 

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Mon, 05/14/2012 - 20:53 | 2425393 roadhazard
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Delta cuts out one middle man for another.

Mon, 05/14/2012 - 20:01 | 2425291 QQQBall
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Next - Delta buys Boeing to save on acquisition costs... errr!

Mon, 05/14/2012 - 18:01 | 2425096 Bubba's gettin ...
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I realize the execution risks involved, but the risk reward ratio seems to be in Delta's favor.  For a fixed cost of $300 million, plus operating costs Delta now controls 1/3 the jet fuel capcity on the east coast.  Given the regulatory burden /near impossibility of opening new refineries in this country perhaps we should consider this a preemptive grab of a limited commodity namely refinery capacity.  Oil is not the limiting factor- the facilities to produce the jet fuel are.  Think of  refineries as airport slotting rights- a limited piece of real estate.  Delta is buying the Trainer facility at a fire sale price.   Also given the oilly, liquid rich nature of the preliminary results from the Western portion of the Utica shale formation(Ohio), the Trainer, PA refinery could be the beneficiary of cheap oil  relative to the price of Brent Grades in the near future.  Look at the discount of Bakken oil at the well head or even at Cushing relative to Brent.  Trainer, PA  is a  short few hundred miles from this oil rich Utica formations.  The rail infrastructure is already in place to ship oil east from Ohio for immediate uptake at Trainer.  Alternatively this is a short distance for the building of west to east flowing pipelines.  How much more will Trainer be worth as a standalone facility once the cheaper Utica oil starts flowing east, and will this not potentially benefit Delta the most.  Capacity beyond Delta's needs could be sold on spot to capture the differential between a world jet fuel market driven by Brent grade pricing.  With the expansion of the Panama Canal to accomadate Pemax tankers being complete next year, the Asian markets demand will make all North American refined  distillates more valuable.   The marginal buyer for  excess capacity is not Delta's North american competitors but the rapidly growing airlines of the far East.  Remember too, that the overabundance of natural gas from the horizontal drilling in the eastern portion of the Utica formation means that the additional input cost of energy for oil distilation will remain cheap relative to world costs for the forseeable future.  

Mon, 05/14/2012 - 18:04 | 2425088 Broccoli
Broccoli's picture

I hope they accounted for abandonment costs and made Phillips 66 liable for the majority of the costs. Refineries are never officially shutdown because the abandonment and cleanup would destroy the company. Especially an old refinery like this one; once a refiner, always a refiner. Delta will learn this quick.

What is funny is even the Integrated Oil Companies aren't actually vertically integrated. They sell the crude they produce on the open market and buy the crude for the refineries on the open market. Chevron crude doesn't go to chevron refineries. Even funnier, Chevron gas is just an additive package that is put in whatever gas is locally available. It could be valero in your tank.

That way one division isn't cannibalizing the profits of another division through internal deals. The reason they are vertical through exploration through refining is that when crude is low refining normally has more profits, so you are leveling out your earnings throughout all stages of oil prices.

Mon, 05/14/2012 - 17:18 | 2424994 FrankDrakman
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At first blush, i thought "Hey, good for Delta - at least they're trying something other than cutting jobs". But the more I thought about it, the more the traditional arguments against vertical integration came to mind.

Assume Painter becomes a low-cost producer of jet fuel (big assumption, since Phillips gave up on it, but bear with me..). Presumably, Delta would want to buy the fuel at a lower than market price from Painter (i.e. Painter forgoes profit amount "X" that it would make selling that fuel in the open market). Now, the question is: can Delta, having price advantage "X" over its competitors on fuel, make a final profit "Y" that is greater than "X" plus whatever amount Delta would have made if it paid full price for fuel? (Wags contending 'Delta doesn't make a profit in any case' will be ignored.) If not, isn't the corporation as a whole better off selling Painter's product at market prices?

If controlling input costs were a sure-fire key to riches, why isn't McDonald's buying beef and egg farms? Could it be because the guys at Hamburger U know that they don't much about raising cattle and poultry? As the article points out, Delta has zero experience as a refiner.

The traditional argument for vertical integration is that it reduces agency and transaction costs. 150 years ago, with much slower transportation, communication, and information systems, this may well have been true. You might have paid Farmer Brown in Iowa $2/bushel for corn, unaware that Farmer Jones in Nebraska was offering it for $1/bushel. But cheap and reliable transport, the intertube, and $300 PC's have reduced these costs and risks to minimal levels.

For these reasons, I believe this deal has very little upside for Delta and lots of downside.

Plus, as many noted above, any deal where JPM is your "partner" needs to be accompanied by massive applications of K-Y.

Mon, 05/14/2012 - 20:58 | 2425385 Omen IV
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the winner is JPM not Delta - they probably got a take or pay contract for X output from delta at some benchmark price with a spread -with the output committed for 50-65% of the capacity - the guarantees (if any) and equity contributed was probably low from JPM probably equal to the fees received on the financing and the deal itself - "all" support for the debt was the take or pay contract from Delta for the LBO -  so from a deal situation looks interesting for JPM unless the Capex is substantial in the near future or environmental blowback in the future - cant see the assets as collateral value given potential environmentals must be a cash flow deal for the lenders entirely - but phillips left - not rookies - many others long crude in the immediate area and overseas  - so why? 

Mon, 05/14/2012 - 16:05 | 2424765 Roland99
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But think of the Frequent Fueler Miles!!

Mon, 05/14/2012 - 16:01 | 2424760 surf0766
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What about the cash the taxpayers had to put up?  Pro or Con. Will we ever see any of that back? A shit deal  !!

Mon, 05/14/2012 - 18:03 | 2425102 NotApplicable
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Sure, we'll get paid back every penny. Nominally.

Mon, 05/14/2012 - 16:02 | 2424758 Paul451
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The companies that are EXPERTS in the refining business have tiny operating margins, yet an airline with a bank that loses $2B on casino investments as a partner thinks they can handle it? Oh man. I dont know if I should laugh or cry. Stick with losing money hand over foot in a business that you know, fer cryin out loud!

(Anyone old enough to remember when Exxon ventured into the office equipment market?)

 

Mon, 05/14/2012 - 15:58 | 2424750 SmittyinLA
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In a purely competitive capitalist state ..........

I doubt if the JPM/Delta guys could run the refinery more profitably than 66, they're playing the "we're less greedy and more efficient and knowlegable in refining than 66 angle".

HOWEVER with the Creep/banker alliance anything is possible, when creep bankers buy any business they have the potential to use their political clout to kill off the competition, refineries get a whole lot more profitable when the existing competing refining capacity is removed with political clout.  

Mon, 05/14/2012 - 15:45 | 2424701 walküre
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Everyone is getting out of the downstream business and a failing airline and a TBTF bank are entering?

What could possibly go wrong?

Now if Delta and JP had invested into their own oilfields, their own exploration and pipeline equipment in addition to the refinery the deal would make sense.

Mind you, $150 million purchase price and $100 million refurbishment is only a quarter of a billion or just ONE EIGHTH of what JPM lost in the last quarter. Quite possibly even less when the true size of their losses becomes disclosed.

Mon, 05/14/2012 - 15:28 | 2424645 metastar
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They should have invested in a good food services company, or peanut farm.

Mon, 05/14/2012 - 16:30 | 2424852 Papasmurf
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They'll buy the peanut farm next.  Those complementary peanuts sell for $2 a bag now.

Mon, 05/14/2012 - 15:26 | 2424616 Joe Sixpack
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Isn't this the Southwest Airline model? I know a few years back at least they were big players in the heating oil business, and swapped for jet fuel (http://www.sba.pdx.edu/faculty/danr/danraccess/courses/fin562/hedging_ca...).

Mon, 05/14/2012 - 12:32 | 2424048 mijev
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Interesting that 95%+ of comments were negative. Negative in the cynical sense of the word too (i.e. not accompanied by any constructive suggestions - just mindless ignorant negativity. Way to go). I'm not a huge fan of Delta but they are obviously trying to think outside the box, unlike 99.99999% of companies in the US, so lighten up. I'll bet you also said that Apple shouldn't get into the music retail business, or phone business. I wouldn't like to try and find a way to run a profitable airline. Kudos to Delta for trying. And please don't have children.

Mon, 05/14/2012 - 18:03 | 2425095 NotApplicable
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As opposed to the mindless ignorant positivity of "thinking outside the box?"

Sorry, most all of the negative comments here include reasoning, while the positive ones are like yours, giving them credit for trying without regard to the possible disastrous outcome.

Mon, 05/14/2012 - 07:45 | 2423078 carlnpa
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It could be they know a nice little war is brewing in the middle east that will send fuel prices to the stratosphere. 

The bigger issue for delta would be assuring availablity.

Mon, 05/14/2012 - 17:58 | 2425089 NotApplicable
NotApplicable's picture

Well, except for the fact they bought a refinery (not a driller) your logic is spot on.

War would only help if it drove up the crack-spread. It would not help them get more fuel, as they're still buying crude from "over there."

Mon, 05/14/2012 - 07:42 | 2423073 Shibumi2
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I think Delta's hidden play is that they want to get into the driveway resurfacing business. They can undercut the hispanics by controlling the asphalt input costs.

 

"We love to Fly, refine and resurface, adn ti shows"

Mon, 05/14/2012 - 07:39 | 2423053 Red Heeler
Red Heeler's picture

It's not diversification, it's di-worse-ification.

Mon, 05/14/2012 - 06:39 | 2423002 lamont cranston
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This reminds me of when Exxon bought Reliance Electric back in the early 80s at the height of crude prices. The Tiger saw "synergy" in buying a company with cutting edge electric motor technology. 

It proved to be a huge bust, costing them north of $1B when that was real money. Plus ca change...

Mon, 05/14/2012 - 06:31 | 2422997 Sutton
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It will be a disaster.

marrying two impossible industries, no way.

Mon, 05/14/2012 - 07:38 | 2423065 monkeyshine
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I tend to agree. Unless they see something in the NE corridor that will result in Jet Fuel rationing and price spikes that will hurt their competitors. With then recent mergers of, what is it, American plus USAir and Southwest plus AirTran, Eastern Seaboard travel will get less competitive (or more fiercelY competitive if you will) and ticket prices will rise. That gives Delta margin to move tcket prices and gain passengers There must be some arbitrage gains here, eg they want to fill more seats, expand flights from PA, compete on fare, curtail deliveries to competitors and those sorts of things. It makes little sense to buy an operation only to sell yourself product at a loss. The refinery business washes away it's profits on Delta's P&L.

One thing that might make a wee bit of sense is the interest rates being so darn low. In sme crazy flight of fancy the folks at JP Morgan might be so flush with cash that they figure the kerosene and auto fuel crack profits net after all operations will earn them a better return than other investments, and or the long term difficulties in building and licensing refineries in our regulatory environment makes this a longer term potential winner. As I understand it - and I don't very much - the refining business is somewhat capacity strained and fuel supplies susceptible to disruptions if more than a few go offline. That, plus some state regulations (lke California requiring special blends of fuel that ot all refineries can easily produce ) might make specialty fuel production a more lucrative business than general refining, assuming this facility has some type of expertise. Not sure if PA has similar CA style fuel regulation, or maybe NY or NJ does, or will soon thanks to JPMorgan lobbying lol.

Mon, 05/14/2012 - 06:27 | 2422995 orangegeek
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Another sign of a top in the market - when ridiculous moves like this occur.

 

Bearish WTI oil according to the elliott wave principle.

 

http://bullandbearmash.com/chart/spot-wtic-oil-daily-11-2012/

Mon, 05/14/2012 - 06:13 | 2422989 Sathington Willougby
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There's Cons, which you outlined very nicely, then there's The Con.  

Look for the gun in the picture.  That is, where does govt come into play in this deal?  I bet the taxpayer ends up funding Delta on this TBTF folly.  Trim the mark.

Mon, 05/14/2012 - 17:18 | 2425000 NotApplicable
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And it's the only reason this deal ever happened. Vertical integration is one thing, but to do it in mature, highly "regulated" markets?

Mal-mutha-fucking-investment, FTW!

Mon, 05/14/2012 - 04:18 | 2422917 MiniCooper
MiniCooper's picture

The value of any refinery is in the 'real' crack spread option embedded in it.

If the crack spread collapses then the refinery can be closed and the jet fuel bought in the market. If it widens, then run the refinery and produce jet fuel. The big question is who has the 'option' to decide whether the refinery runs? Is it the airline that decides or is it JP Morgan?

Mon, 05/14/2012 - 17:10 | 2424969 chunkylover42
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refineries aren't turned on and off with the flip of a switch, it takes an enormous amout of time, money, and effort to get them online.  A refiner that sits idle still needs maintenence CapEx, etc. so you're carrying the cost of owning it - might as well fire up the burners and make some product.

Delta is going to get hosed here, I am convinced.

Mon, 05/14/2012 - 03:07 | 2422862 El Gordo
El Gordo's picture

In earlier times, this would be an Enron deal, but I suppose that with them out of the picture, someone has to step up and do the shitty deals.

Mon, 05/14/2012 - 02:40 | 2422846 Dr Bob
Dr Bob's picture

I refuse to fly Delta, i think they flat out suck ass. They treat people like cattle. Heck, sounds like a great marriage with JPM. 

Mon, 05/14/2012 - 01:53 | 2422817 Walt D.
Walt D.'s picture

Very good article.

One other unpredictable cost is the cost of compliance with new EPA regulations. You not only have the crack spread to contend with, but also the crackpot spread.

Mon, 05/14/2012 - 01:51 | 2422809 Walt D.
Walt D.'s picture

"Delta could benefit from JPM's expertise in the energy trading market"

The London Whale gets reassigned?

Mon, 05/14/2012 - 01:33 | 2422801 Freddie
Freddie's picture

Who wants  to fly anywhere?  You get groped or worse by TSA.  Then they give you cancer with the scanners.  Hope and Change.

Mon, 05/14/2012 - 15:23 | 2424628 LetThemEatRand
LetThemEatRand's picture

Not that I disagree with your basic point, but your last sentence suggests that you believe this to be a Blue Team issue.  The TSA and the scanners themselves were conceived of by the Red Team.   Hank Paulson -- ex-Goldman CEO and Red Team Treasury Secretary -- made huge profit from them.  The Blue Team picked up the ball and ran with it.  The new Red Team will no doubt do the same if it gets the ball back in November.  

Mon, 05/14/2012 - 01:25 | 2422798 tony bonn
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delta is proving once again that it has more money than brains...with management like this, the buffoons will be in bankruptcy court again....

Mon, 05/14/2012 - 01:58 | 2422818 Augustus
Augustus's picture

That is about the way I see it also.  Why not learn something about trading the crack spread and leave the oil business to the ones that operate in that every day?  Phillips did not decide to shut down and write off something that was generating high profits.

Mon, 05/14/2012 - 01:10 | 2422780 kedi
kedi's picture

If they really want vertical integration, carry on further and sell a majority share to Saudi Arabia. Take the oil from underground all the way to 40,000 feet.

Mon, 05/14/2012 - 01:08 | 2422777 utgolfer
utgolfer's picture

This is pure idiocy.  It has to be based upon the assumption that refiners are making so much money in the jet fuel business that Delta has to jump into it.  I think thats a very poor assumption.

My guess is this was pitched to them by JPM who will be getting nice fees out of it, while Delta is stuck operating a refinery that a refiner decided wasn't economical.

Mon, 05/14/2012 - 00:41 | 2422766 palmereldritch
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+1 for thinking and ACTING outside the box.

More 'independent' refineries = greater price discovery

Mon, 05/14/2012 - 17:07 | 2424958 chunkylover42
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agree that Delta deserves some credit for a novel approach to the problem, but it's not like refinieries are minting money - it's a pretty dreadful business with volatile earnings and tiny margins (sub 5% operating margins are not uncommon).  It's not even that great from a cash flow perspective since regulations and general wear and tear demand a ton of maintenence CapEx. 

More independent refineries won't make much difference in price discovery, the market pretty much is what it is.  Frankly, the industry is trending towards consolidation because of the scale required to even come close to making money, so with no scale, Delta is likely to have some major struggles.  The marginal cost of producing a barrel of oil globaly is over $90, so this deal seems to me like Chevron found a sucker in Delta to take this "asset" off their hands.  I have a hard time seeing how Delta doesn't get their ass handed to them on this deal.

Maybe it's just a place to hide losses and debt off balance sheet?

Mon, 05/14/2012 - 20:31 | 2425340 palmereldritch
palmereldritch's picture

Costs and hedges are getting defined in more and more creative ways...perhaps making price discovery a "market of one" in this case.

Mon, 05/14/2012 - 00:32 | 2422760 OldPhart
OldPhart's picture

Con (6) Partnering with JPMorgan in any business is guaranteed to result in financial rape via fraud.

 

Mon, 05/14/2012 - 00:28 | 2422759 ebworthen
ebworthen's picture

Just think of the insurance and liability costs...

Mon, 05/14/2012 - 18:35 | 2425146 DosZap
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(4) Furthermore, the jet fuel market on the East Coast has tightened up quite a bit due to the closure the Trainer Plant which accounts for one third of the jet-kerosene capacity in the region. So, re-opening the now idled Trainer refinery could actually increase the jet fuel supply benefiting even Delta's competitors.

NOT if Delta says they can't sell to anyone except them.................Unless they can do so at a substantial markup, but under current prices their comps pay, this could be a DOUBLE play Win /Win for Delta.

And I would not do the deal, unless DELTA has control over the excess.

Mon, 05/14/2012 - 05:05 | 2422955 falak pema
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JPM will CDS it to hell and back.

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