A plan by Delta Air Lines to buy a Pennsylvania refinery and save itself $300 million a year in jet fuel costs is an audacious move that may prompt its competitors to follow suit in a bid to control their biggest single expense, analysts said.
But the airline may also face bigger bills than it expects for restarting the currently idle plant and more than doubling its previous output of jet fuel.
The Atlanta-based carrier said on Monday that its Monroe Energy unit will buy the currently shuttered Trainer, Pennsylvania refinery complex near Philadelphia from ConocoPhillips for $180 million, including a $30 million grant from the state of Pennsylvania, and invest another $100 million in equipping the plant to maximize jet-fuel production.
Delta Air Lines will also swap the refinery’s non jet fuel products including gasoline with BP and Phillips 66. BP will supply crude oil to the refinery, which is expected to begin jet fuel production in the third quarter of this year.
At a time when fuel accounts for a growing proportion of airline costs, the purchase – a first for the US airline industry, analysts said – looks like a brave and creative bid to control both the absolute level of fuel costs, and their volatility.
“This is a groundbreaking move, and it’s a big story,” said Vaughn Cordle, managing partner and chief equity strategist at Airlineforecasts.com, which advises on investment in the airline industry.
Cordle predicted that if Delta succeeds in its goal of saving $300 million a year in fuel costs, its share price will surge by at least 15%, leading other airlines to look at owning their own refineries.
“That’s why the other main carriers will follow if this works,” Cordle said.
Very Creative Hedging
The Trainer plant is one of three in the Philadelphia area have recently closed or are under threat of closure because of their dependence on more costly grades of crude, making them unable to compete with more versatile refineries on the U.S. Gulf Coast.
Robert Mann, an airline analyst with RW Mann & Co., a consulting firm on Long Island, NY, called Delta’s move “very creative hedging” of its fuel costs, and said its estimate of saving $300 million a year in fuel costs is “a credible number.”
The move will remove the airline from conventional hedging strategies designed to protect them from rising and volatile prices but which sometimes backfire. Mann cited Southwest Airlines which appeared to be “bulletproof” when it hedged against rising fuel prices from 2002 to 2007 but then lost heavily when fuel prices plunged in the recession of 2008/09.
Mann said it won’t be clear for a whole business cycle whether Delta’s purchase has been a success but that won’t stop some of its competitors “kicking themselves for not being quite so creative” in the meantime.
The Twelve Billion Dollar Question
Ben Brockwell, Director of Data Pricing and Information Services at the Oil Price Information Service (OPIS), said he had been skeptical about the purchase when it was first announced.
But he said Delta had done a good job justifying it in terms of the soaring hedging costs – which totaled $2.2 billion in 2011, against a $12 billion total fuel bill – and in arguing that it had got a bargain in paying only $150 million for the refinery – just a fraction of what its market value three or four years ago.
Still, Delta appears to have sharply underestimated how much it will cost to meet its target of doubling jet fuel production at Trainer to 52,000 barrels a day, and the cost of restarting a refinery that’s been idle for almost a year.
And if the price of gasoline drops while that of jet fuel rises, as predicted, Delta is going to end of with less jet fuel in its swap agreement with BP and Phillips 66, Brockwell said.
