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.
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 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.
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.
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?