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Why 95% of Traders Fail

When an Airline Buys an Oil Refinery

Companies / Corporate News May 14, 2012 - 05:42 AM GMT

By: EconMatters

Companies

Best Financial Markets Analysis ArticleThe 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.


Disclosure: No Positions

By EconMatters

http://www.econmatters.com/

The theory of quantum mechanics and Einstein’s theory of relativity (E=mc2) have taught us that matter (yin) and energy (yang) are inter-related and interdependent. This interconnectness of all things is the essense of the concept “yin-yang”, and Einstein’s fundamental equation: matter equals energy. The same theories may be applied to equities and commodity markets.

All things within the markets and macro-economy undergo constant change and transformation, and everything is interconnected. That’s why here at Economic Forecasts & Opinions, we focus on identifying the fundamental theories of cause and effect in the markets to help you achieve a great continuum of portfolio yin-yang equilibrium.

That's why, with a team of analysts, we at EconMatters focus on identifying the fundamental theories of cause and effect in the financial markets that matters to your portfolio.

© 2012 Copyright EconMatters - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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