Delta’s Oil Refinery Purchase is Either Brilliant or Insane (or Both)

With fuel being an airline’s biggest expense, we all know that the airline and oil industries are tied together. But that tie got even closer this week when Delta announced that it would buy an oil refinery to start making its own fuel, or at least some of it. Now, I don’t understand the oil industry very well, but I’ve learned a lot more over the last couple of days. What I know now is that this move is brilliant . . . or completely insane. In other words, I really don’t know at all but it sure is interesting.

Delta Oil - Diesel and Jet A

I’ve spent time on the phone with people at Delta, I’ve read investor presentations, and I’ve even had beers with a couple of folks who work for big oil companies. In other words, I tried to really get my head around what this all means. Here’s how I understand it.

How This Works
Delta has set up a subsidiary to buy the Phillips 66 refinery in Trainer, Pennsylvania which is in the southeast corner of the state on the Delaware River right near the Delaware border, for $180 million. The actual outlay is only $150 million because the state chips in $30 million for a variety of reasons. This is really cheap.

The subsidiary, which is awesomely named Monroe Energy LLC after, I assume, Delta’s original hometown of Monroe, Louisiana, will then invest $100 million to convert the refinery so that it can make as much jet fuel as possible. From here on, I’ll just refer to the subsidiary as Delta to make things easier.

Delta has set up an agreement with BP to provide the crude oil to the refinery and then Delta will refine it, so the airline doesn’t have to source its crude needs. As part of this deal, Delta is going to own a pipeline that sends the oil up near New York City to a deepwater port. Delta can then use its existing fuel network to transport fuel to its New York hubs and via ship and truck elsewhere around the Northeast.

The problem with jet fuel, however, is that you can’t just turn crude oil into it and nothing else. The process ends up with a lot of byproducts in the form of things like gasoline, diesel, etc. In fact, after optimizing the refinery to produce as much jet fuel as possible, Delta will still only see a third of the total output come in that form. So what Delta has done is agreed with both Phillips 66 and BP to have them take all the non-jet fuel product and exchange it for jet fuel. BP and Phillips 66 will sell the gasoline, diesel, etc through their channels and then they will provide Delta with jet fuel at locations around the US for Delta’s other operations outside the northeast.

By the time everything is up and running, Delta thinks it will be able to provide 80 percent of its domestic jet fuel needs from this project. This year alone, Delta expects to save $100 million in fuel costs and that should increase to around $300 million at today’s prices.

Sounds great, right? Well sure. But where I’m still fuzzy is on how the savings will actually occur.

The Dreaded Crack Spread
Last year, Delta paid around $12 billion for fuel, so that $300 million savings is around 2.5 percent of the total. That’s not bad. Of that $12 billion, $2 billion came from the crack spread.

The Real Crack Spread

The refining process is known as “cracking.” And the crack spread is the cost of the refining process that gets baked into the price of jet fuel. (It’s not really the cost but rather market driven.) So as you can see above from this, ahem, slightly-modified Bloomberg chart, that cost can swing pretty insanely from down around $5 a barrel at its low to almost $40 a barrel. That’s big money. Last year, Delta paid just over 15 percent of its total fuel bill to pay for the cracking process. Put another way, the crack spread accounts for about ten percent of the airline’s total unit costs so it’s a massive expense.

Of course, Delta still has to operate a refinery, so it’s not like it can completely save the cost of the crack spread. But it’s brought in an industry veteran and has come to a tentative agreement with the refinery workers to put it back into production. Delta thinks this works well no matter what happens.

How This Doesn’t Work Well
To me, the obvious downside is if the crack spread on jet fuel in the market drops. What if it goes down to $5? Wouldn’t Delta lose a bunch of money because it could just get fuel cheaper elsewhere? It certainly seems that way to me, but the crack spread seems to travel with the price of oil, at least over the last few years. So if the crack spread drops a lot, that means oil dropped a lot as well. That’s why over the last five years this would have been a money-losing proposition only at the end of 2008, when fuel prices crashed. Every other year, it would have saved the airline money.

Delta's New Refinery

If that kind of crash happens again, Delta will end up paying more for fuel than it would if it bought it on the market, but jet fuel will have dropped so much that the impact will be acceptable in theory. Does this sound familiar? That’s because it’s really just another type of fuel hedge. You may lose money if fuel price drops but you win if it doesn’t.

Dwindling Supply
Part of this isn’t about price at all but rather about supply. Apparently, about half of the jet fuel refining capacity has been shuttered in the northeast over the last few years. With this, Delta can guarantee its supply. Delta shows that the Trainer refinery makes money, so why would it have been idled by its previous owner?

I have to assume that it wasn’t making money, especially on the gasoline by-product which has slim to no margins. We do know that the price of refining in the northeast is more expensive than in the south, and for some types of gas, it’s even cheaper to just buy it from Europe or Asia. So is Delta going to be paying a premium to refine in this area? Maybe.

But there is a big benefit to being in the northeast, because Delta has a lot of thirsty airplanes in the region. Some of the higher costs are offset by lower transportation costs since this is right near Delta’s New York operation. That direct pipeline that goes near the New York airports is one reason that Delta thinks this is a unique opportunity. Having that network significantly lowers transportation costs, and it dumps the fuel out right near two of Delta’s hubs.

I suppose we’ll look back on this in a few years one of two ways; it’s either an incredible move or it’s colossally stupid. Delta seems to have thought through all the different scenarios, so on paper it makes sense. But will it be the same in practice? This one is definitely way outside my knowledge, but it kind of sounds like it might be a great move. Then again, what do I know?

[Original photos via Flickr users Simon_sees, pedrosimoes7, and Wikimedia Commons user Walter Siegmund/CC 2.0]

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56 Comments on "Delta’s Oil Refinery Purchase is Either Brilliant or Insane (or Both)"

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David
Guest

What happens to flights that start in Atlanta, Minneapolis, Detroit, etc.. as well as long haul flights to countries outside the USA ?
Tankering for a short flight (sub 2 hrs out of NYC) might work, but fuel for anything more than about 2 hours from NYC *has* to be supplied locally.

How much fuel does Delta really source from the area around the refinery / NY compared to the rest of the annual airline-wide fuel bill ?

Nick Barnard
Member

Well thats taken care of by Delta’s trading the non-jetfule product with Phillips 66 and BP for jet fuel elsewhere..

Southeasterner
Guest
” Apparently, about half of the jet fuel refining capacity has been shuttered in the northeast over the last few years. With this, Delta can guarantee its supply.” This is a non-issue. The US still exports kerosene type jet fuel at volumes just as high as before Conoco and Sunoco shut down assets. Any extra jet fuel production coming from the Delta refinery will either A) drive down jet fuel prices in the US which means jet fuel refining margins will decline but Delta airlines will have decreased purchase costs or B) mean that somewhere else capacity will have to… Read more »
Jason H
Guest
If I remember correctly the rules around diesel is more strict here in the US than it is in Europe. That is part of the reason diesel cars have been slower to gain traction here. I like that Delta is thinking a bit outside the box on this one. Given that the purchase is paid off with savings in such a short timeframe is an added bonus. Also, if the Dakota crude can be brought to Trainer the upside is even better as the Dakota crude is cheaper to purchase. You have admire Delta’s management for this one, even if… Read more »
Southeasterner
Guest

Except that Dakota crude would require a $400+ million upgrade and a new cross regional pipeline. There are over 400 varieties of crude oil and depending on the complexity of the refinery you can only economically use specific ones. Putting Dakota crude in Trainer would be like throwing diesel in your gasoline engine.

EU sulfur standard (Euro V) – 10ppm
US sulfur standard (ULSD) – 15ppm

Jason H
Guest

I am aware there is a difference in crude. I was stating what was publicly stated by Richard Anderson, but didn’t attribute it as I was called away for a meeting.

http://video.cnbc.com/gallery/?video=3000087462

Bill from DC
Guest
Very interesting. Couple of follow-up questions. Why is this the “marginal” refinery? Assuming that local operating costs and the size of the facility have a lot to do with it, do those numbers change by incorporating reduced transit expense of the jet fuel to DL’s use in the NY / northeast area (as compared to bringing it from the gulf coast)? Also, as I mentioned below, do we not have to know the contractual terms of the agreements DL has with BP and Phillips in order to exchange the 2/3 of the refinery’s output that constitutes byproducts for jet fuel… Read more »
Dan
Guest

The amateur in me doesn’t think this a colossally stupid move, but I don’t have enough background to argue with the likes of Southeasterner.

DesertGhost
Guest

If this works for Delta, I can see other airlines and other transportation companies forming joint ventures of some sort to do the same thing. The diesel can be sold to railroads and truckers. The lubricant grade product can be used by the owners, too. The gasoline, etc. can be sold to others as is being done here.

Getting into a business with which one is unfamiliar is risky. But I have to give Delta an “A” for having guts.

Sanjeev M
Guest

+1 Unbelieveable guts on the part of DL. For a 70,000 employee organization to be this nimble and fast-thinking is commendable. Lets hope it stays this way without impacting the consumer.

Bill from DC
Guest
Great analysis Brett, I thought you were just an airline guy! But you should really be congratulated on, despite researching and creating this analysis, knowing that you still don’t know enough to draw a conclusion. Southeasterner’s points are very interesting. My thought is that a lot of the success/fail of the enterprise will be tied up in the contractual agreements that DL has with BP and Phillips regarding the 2/3 of the total refinery outputs that are not jet fuel and exchange for jet fuel in other parts of the country. As a corporate tax expert, the only thing I… Read more »
Renewed Pilot
Guest

Thanks Brett… That is much more detailed analysis than anything in the media.

ScottC
Guest
As I understand it, part of the problem with Northeast refineries is that they are set up to process light sweet crude, most of which was coming from the North Sea (aka Brent Crude) and parts of Africa. The price of this type of crude is currently running $20-30 a barrel higher than heavier oils (such as Bakken ND crude). Further, the east coast refineries are designed to maximize gasoline production. The refineries are struggling because the cost of their imput oil is much higher and the demand for gasoline has dropped. I read somewhere that Delta was looking at… Read more »
jboekhoud
Member

“Fungible” is my new word for today. Thanks Scott!

Eric S. Morris
Guest

I always wanted to be able to the point when Brett would crack under the pressure of being so publicly cranky. I guess seeing his crack will suffice.

CP
Guest
Fascinating analysis! It is way better than anything I’ve seen in other sources. Nice job, Cranky. It’s a gusty move on Delta’s part. Given that oil seems to be *the* issue in airline profitability, it’s encouraging to see an airline innovating in this area. I guess time will tell if the move pays off. Cranky, a future topic I’d love to see you cover: every so often, you see an item about an airline (including some US airlines) operating a flight on alternative fuel. I’d be interested in knowing more about the potential of that technology. If it is possible… Read more »
CP
Guest

That is, “NOT some new-fangled substance.” CP needs his coffee.

Joe
Guest

Shortly after Alaska Airlines did an alternative fuel demo flight, an article appeared noting that the fuel cost something like $17/gal, three to four times the going rate for Jet-A.

J Bird
Member
I’m skeptical of Delta’s ability to make more money at this venture than just buying the fuel from other. I suspect that the real motivation of this purchase is not in the stockholders interest, but in the interest of management. With the conclusion of Northwest’s integration, Delta has a lot of attorneys, regulatory experts, and integration specialists looking for new projects. They na├»vely think they can take their airline integration skills and turn these skills into refinery integration skills. Also, they assume the airlines are one of the most regulated businesses in the world, so the refining business can’t be… Read more »
CP
Guest

I find this (1) highly cynical and (2) not very likely. The integration with NWA has been complete for a couple of years. If this were really Delta’s motivation, we would have seen an action like this sooner.

Also, I speculate that a decision like this would have involved the board. I doubt that the board — which does represent the shareholders — would have approved the venture if Delta’s rationale (stated or otherwise) was “we have people in need of a new project.”

J Bird
Member

Your totally right. Corporate boards always do what is in the best interest of shareholders. :)

Sean S.
Guest

I can’t speak to specifics of Delta’s board, but simply because Delta’s board approved it doesn’t mean its in the best interest of the shareholders. I think the past couple years in regards to institutional investors and others having fits about board selection amongst others things is a testament to the lack of responsiveness amongst board’s to shareholders wishes.

fredd
Guest

Delta’s competitors are probably thrilled. Delta takes all the risk, maybe helps itself in the process, and drops prices for everyone else by removing a big chunk of its $12 billion of consumption from the open jet fuel market. When demand drops like that, prices usually follow. For Delta, it’s a risky move. For everyone else in the jet fuel market, nothing but upside.

SAN Greg
Guest

Great job explaining the business side of this issue. I think the biggest downside risk is not financial, but public image if something goes wrong such as a major mishap (i.e. refinery accident that involves worker casualties, or a major spill that goes into the Delaware River). If it is discovered that there are safety issues would that have people wondering if Delta has safety issues with airplane maintenance? Look at the damaged corporate image of Exxon and BP after being associated with major spills, and BP with refinery accidents in Texas.

Joe
Guest

Basically they’re just going to take profits from the refining division to fund unprofitable air routes. Questionable at best.

Nick Barnard
Member

But if you can fly those routes for cheaper you can make your competitors hurt. This was WN’s strategy for quite some time.

paultlaf
Member

There’s an interesting article in Aviation Week that lays out the competitive advantage that Delta may get – and some of the risks.

lenniefalcon
Member
Let’s see, first you buy a refinery that had been mothballed for being old inefficient and needing huge improvements to meet the EPA restrictions. Chase takes it off their books and adds the capital cost, costs of future operations (it was previously shut down for not being a profitable entity) and gives a an interested 3rd party a seeming bargain on their future major costs in return for a whole lot of liability. What makes one think Delta which has no experience than Tilton had at United trying to hedge. Tilton came from Texaco. I want whatever Delta’s drinking!
Jim
Guest

Great analysis, Brett. I have a few thoughts:

1. Why couldn’t Phillips, which is part of one of the largest oil companies in the world, make this refinery profitable? If they could, they wouldn’t be selling it. And if they couldn’t, I seriously doubt Delta can.

2. WHY are taxpayers paying $30 million to subsidize the purchase of this refinery for Delta? Which side greased the government’s hands, the airline or the oil company?

3. I never knew that Delta started out in Louisiana, that is pretty cool.

theAVclub
Guest

Firstly, Phillips66 is only 3 days old so it isn’t one of the most profitable companies, yet. It’s former company, ConocoPhillips may have been. In any case, Trainer was idled before Delta came in and that is probably why it was so cheap. This article may shed some light: http://www.tulsaworld.com/business/article.aspx?subjectid=49&articleid=20120429_49_E1_CUTLIN480302

Air Enthusiast
Guest

Sounds like a plan straight out of out of Airline Tycoon – man that game was addictive!

David SF eastbay
Member

I’m sure the other major airlines in the world will be watching to see what will happen. Who knows, it might work. Then again, why hasn’t an airline tried this before?

Airlines buying hotels and car rental company’s of years past didn’t work out so hot, so who knows about this.

kcasper
Member

If their profit will be based on the wide crack spread, the could simply sell the spread in the futures market to alleviate the risk of it falling.

Wayne Rutman
Guest
Well, I know a fair bit about the airline industry and I know a fair bit about the oil market, so I should be able to offer an “expert opinion” about whether Delta’s move makes sense. Unfortunately, I can’t. Frankly, the oil market tends to defy rational analysis as so many things having nothing to do with supply and demand tend to impact price — and therefore the outcome of any investment in the industry. My gut feeling on this though (and my gut tends to be right about 75% on the oil market) is that this move will not… Read more »
Southeasterner
Guest

I think your spot on.

By increasing jet fuel production in a long market Delta will decrease prices and their fuel costs but all that savings in fuel costs will now decrease revenue for their refining business. This clearly gives the advantage to United, AA and others who get the benefit of lower market rates for jet fuel while not having to deal with selling off gasoline, heating oil and fuel oil at a loss in an over-supplied market.

In a sense Delta is cross subsidizing their direct competitors.

Bill from DC
Guest

Now THAT is an interesting point (indirect subsidy of competitors via increasing supply and therefore lowering price of Jet-A).

Southeasterner
Guest

I’ll try to be optimistic and give it 3 years before it is shut down (again).

I honestly don’t think it’s an overly crazy idea…it’s just the wrong asset. If they want to invest in an industry invest in an asset with positive earnings potential. They should have gone after a more complex refinery in the gulf coast that is actually making money processing cheaper crude.

Should make for a very interesting Harvard case study in the failures of vertical integration (not that we don’t have enough already).

Sharon (Trini Catering)
Guest

This is a great article and analysis of the purchase by Delta….I personally think they have made a great move buying this refinery. Guaranteeing fuel for a big airline is a major factor in success. I wonder if more airlines will follow them.

maggie
Guest

Quite an interesting discussion.
Two thing I can add-
Delta does own two hotels-both overseas-NWA owned them before the merger.
The merger wasn’t completed until just this past May 1 when, at last, DAL and NWA flight attendants began flying together system-wide as one group. NOW it’s done:)

Bill from DC
Guest

FYI – a thorough crunching of the numbers (and they aren’t favorable for DL) from the travel insider:

http://blog.thetravelinsider.info/2012/05/deltas-oil-refinery-purchase-now-confirmed-and-even-stranger-than-earlier-expected.html

Wayne Rutman
Guest
Thanks for that link. It certainly confirms my suspicion that Delta is very unlikely to make money actually operating a Philadelphia oil refinery. That said, I do believe (as I argue above) that the operation of this refinery — especially with its focus on producing jet fuel which will be sent to the New York market — is likely to depress jet fuel prices. This will benefit Delta — perhaps enough to offset any losses they sustain at the refinery. But the big winners will be the airlines that operate out of NYC and don’t have to own a marginal… Read more »
joelbader3
Member

I wonder if anyone at Delta ever read Tom Peters’ classic In Search of Excellence, which contained the lesson “Stick to the knitting”–that is, stay with the business you know. I don’t that is the case at Delta.

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