Why Delta’s Oil Refinery May Not Have Wings

by Susan J. Aluise | May 8, 2012 10:00 am

Delta’s (NYSE:DAL[1]) decision to lower its out-of-control jet fuel costs by purchasing an idled ConocoPhillips (NYSE:COP[2]) refinery in Pennsylvania is a tricky one. It could be the kind of out-of-the-box thinking that earns CEO Richard Anderson his recent 10% bump in compensation. Or it could backfire and hobble the competitive position of the nation’s second-largest airline for years.

DAL has formed a new energy subsidiary, Monroe Energy, and is buying ConocoPhillips’ Trainer, Penn., refinery[3] for $150 million; the state of Pennsylvania will kick in another $30 million. “Acquiring the Trainer refinery is an innovative approach to managing our largest expense,” Anderson said in announcing the deal on April 30.

Delta will invest another $100 million to boost the facility’s jet fuel production, hoping to save $100 million on fuel this year, with savings eventually rising to $300 million a year.

Delta also has penned marketing and sourcing agreements with Phillips 66 and BP (NYSE:BP[4]). Anderson noted that Delta’s new strategy would solve its fuel-cost problems for less than the price of a single Boeing (NYSE:BA[5]) 777.

Before weighing how good or bad this move is for Delta, let’s take a closer look at how fuel costs make or break an airline.

In this regard, Delta has plenty of company. Like all airlines, its earnings and margins are being ravaged by the cost of jet fuel, which accounts for 35% of Delta’s operating costs — about average for the industry. Last year, Delta’s fuel bill rose by more than $3 billion. Although the carrier’s fuel hedges reduced the pain of rising oil prices by $450 million, hedges can’t really overcome the impact of increasing “crack spreads.”

The crack spread is the difference between the price of a barrel of crude oil and the jet fuel, gasoline or other petroleum products that are extracted from it in the refining process. When oil prices spiked to $147 a barrel in July 2008 — then fell 60% over the next six months — airlines still didn’t catch a break.

The crack spread contributed to deeper suffering in the sector. In 2008, the average price of crude oil was $99.67, but with a crack spread of $24.82, U.S. airlines paid $124.49 for the same amount of jet petrol (JP), according to data compiled[6] by the trade association Airlines 4 America (A4A).

But last year, with crude oil prices averaging nearly $5 a barrel lower, a crack spread of more than $31 cost airlines a record $125.96 for a barrel of JP. Those numbers have trended even higher this year.

So, it’s easy to see why Delta is looking for relief from fuel pressures in unconventional places. And on the face of it, the value of locking up a reliable — and cheaper — source of East Coast JP seems clear, but the financial details appear murkier, as InvestorPlace contributor Keith Fitz-Gerald discussed in “Is JPMorgan Setting Delta Up for a Crash?” [7]

Fuel-price pain is common to all airlines. The largest U.S. carriers earned a combined $390 million last year — less than half a cent on every dollar of revenue. Fuel costs jumped 36% and were the biggest reasons the U.S. industry saw 86% of its combined 2010 profit evaporate one year later.

Faced with the same fuel cost pressures as Delta, will other U.S. airlines like United Continental (NYSE:UAL[8]), US Airways (NYSE:LCC)[9], American Airlines (PINK:AAMRQ[10]), Southwest (NYSE:LUV[11]), JetBlue (NASDAQ:JBLU[12]) or Alaska (NYSE:ALK[13]) follow suit and buy their own refineries? That’s highly doubtful.

Here are four reasons why buying an oil refinery may not be the best way for DAL to lower fuel prices:

1. Competitors are buying new, fuel-efficient planes. Aircraft manufacturers are building exciting new aircraft that will reduce fuel consumption by as much as 20% over previous models, and major airlines are investing in the future now. United Continental reportedly[14] is on the verge of cutting a deal for between 100 and 200 of Boeing’s new fuel-efficient 737 MAX jets. Last December, Southwest announced it would be the launch customer for the 737 MAX, buying150 of the jets as part of a $19 billion, 208-plane order.

Before entering Chapter 11 last November, American inked deals with Boeing and Airbus for 460 fuel-efficient narrow-body aircraft — including the 737 MAX and Airbus’s A320neo. US Airways, an ardent suitor[15] to acquire American out of bankruptcy, has a dozen A320s on order.

2. Delta still needs newer planes. At an average age of 15.9 years, Delta has the industry’s oldest fleet — including 183 Boeing 757s that average18 years. Although it ordered 100 Boeing 737s last year, it didn’t convert the 737-900 order to the new MAX version. That means competitors like United and American will have bigger fuel savings on their new jets than will Delta.

3. Boosting jet fuel supplies could have unintended consequences. The value proposition of Delta’s venture into the oil refining business is to boost its JP supply at lower cost. But if it isn’t buying fuel from commercial sources and instead is meeting 80% of its needs from a refinery that was due to be shut down, that should mean more fuel would be available for other purchasers — likely at a tighter crack spread. And once airlines start replacing fuel-guzzlers with newer models that need 20% less JP, demand could fall further.

4. Now, Delta is in two risky businesses instead of one. Commercial airlines are a notoriously tough to run profitably. So is the oil refining business, which is why Delta got such a great deal on this facility. Both businesses can be expensive, risky and heavily regulated, but the costs, risks and regulations for refiners are very different from those of airlines. Sure, Delta can hire people to run the oil business, but managing both operations effectively is no snap.

Bottom Line: I think Delta’s foray into oil refining is more bold than brilliant. Granted, DAL’s fundamentals make the stock look like a value buy right now. Trading at around $11 a share, it has a forward price-earnings ratio just above 4 and an ultra-low price-to-earnings growth (PEG) ratio of less than o.3 (where 1 would be fairly valued).

But before you get tempted to buy any airline stock, you need to look at two things: fuel prices and business strategy — and DAL’s outlook is hazy on both fronts. I give Delta an “A” for innovation, but a “D” on every other metric — because the devil will be in the details of this very complex deal.

As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.

Endnotes:
  1. DAL: http://studio-5.financialcontent.com/investplace/quote?Symbol=DAL
  2. COP: http://studio-5.financialcontent.com/investplace/quote?Symbol=COP
  3. buying ConocoPhillips’ Trainer, Penn., refinery: http://investorplace.com/2012/05/delta-to-cut-costs-with-refinery-buy./
  4. BP: http://studio-5.financialcontent.com/investplace/quote?Symbol=BP
  5. BA: http://studio-5.financialcontent.com/investplace/quote?Symbol=BA
  6. data compiled: http://www.airlines.org/Pages/Annual-Crude-Oil-and-Jet-Fuel-Prices.aspx
  7. “Is JPMorgan Setting Delta Up for a Crash?” : http://investorplace.com/2012/04/is-jpmorgan-setting-delta-airlines-up-for-a-crash-jpm-dal-ual-dlaky-sun-hes/
  8. UAL: http://studio-5.financialcontent.com/investplace/quote?Symbol=UAL
  9. LCC): http://studio-5.financialcontent.com/investplace/quote?Symbol=LCC)
  10. AAMRQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAMRQ
  11. LUV: http://studio-5.financialcontent.com/investplace/quote?Symbol=LUV
  12. JBLU: http://studio-5.financialcontent.com/investplace/quote?Symbol=JBLU
  13. ALK: http://studio-5.financialcontent.com/investplace/quote?Symbol=ALK
  14. United Continental reportedly: http://www.reuters.com/article/2012/05/04/uk-ual-boeing-idUSLNE84300P20120504
  15. US Airways, an ardent suitor: http://investorplace.com/2012/04/us-airways-parker-a-smart-bid-for-american/

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