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Delta Airlines Got An Oil Refinery: The Math Does Not Work

 February 05, 2013 10:55 AM
 


Exxon Mobil Corp. (XOM), the world's biggest energy company by market cap, reported its 4Q profit at a five-year high boosted by its refining arm from growing supplies of cheap U.S. oil.  However, Delta Airlines (DAL) can't tell a similar success story with its newly acquired refinery. 

Delta paid $150 million for a Phillips 66 refinery in Trainer PA last May aiming to save $300 million a year in future fuel costs.  At the time, many analysts see this acquisition as a smart fuel hedge move by Delta.  However, as I previously discussed, the actual implementation of this potential fuel cost savings could be quite problematic.  
Chart Source: IATA

[Related -Delta Air Lines, Inc. (NYSE: DAL): Can Airlines Continue Capacity Cuts To Improve Yields?]

During a time when most refiners are reporting good earning numbers as price gain of petroleum  products have outpaced stagnant WTI crude prices, Delta reported loss of $63 million at the Trainer refinery in 4Q, and expects more losses of up to $100 million in 1Q 2013. Delta chalked it up to Sandy, the super storm.  However, as Platts reported that in a Dec. 2012 investor call, Delta executives said Trainer plant relies on crudes at about $4/b above Brent (The plant is old and relies on expensive imported crude feedstock mostly from Nigeria.)

[Related -Chevron (CVX): The Second Biggest Oil Seeker Joins The Dividend Yield Passive Income Portfolio]

Platts concluded that Delta is most likely selling gasoline and fuel oil (distillate) at a loss based on the current crack spread (to Brent).  Gasoline and fuel oil accounts for more than half of Trainer's production.

Furthermore, according to Platts, 

"Refining experts who have done computer simulations tell JFI that Trainer economics theoretically only work using a crude slate of distillate-rich crudes such as Nigerian Forcados, which typically trade at a large premium to Brent crude."

Also, there seems to be another indication of troubles in Delta's vertical-integration strategy of purchasing a refinery as a fuel hedge.  The ex-oil-trader-turned-Delta-VP-of-Fuel, Jon Ruggles, left the company quite abruptly late last year.  Ruggles, a key person behind the Trainer refinery deal, was hired away from Merrill Lynch less than a year ago to head Delta's trading operation.  Rumor has it that Ruggles' exit from Delta was somehow related to losses at the Trainer plant. 

The latest from Delta executives is that they now expected Trainer to have $280 million in savings in 2013 and refine 80% if the airline's domestic jet fuel requirement.  And there could still be hope for Trainer yet as Delta indicated in a recent SEC filing that the company is considering getting the cheaper Bakken crude by railcar.  Given that transporting crude by railcar adds about $22 a barrel to the cost of oil, it is hard to imagine the economics could improve much at Trainer with the current Brent premium  over WTI at only around $19 a barrel. 

To put it another way, if it were as easy as shipping Bakken oil via railcars, wouldn't you think ConocoPhillips, who's only been in the oil business dating back to 1875, would have figured it out long before dumping the Trainer asset?  

Now thinking the worst is over after extensive restructuring and consolidation in the airline sector, most Wall Street analysts have turned optimistic towards the airline industry.  Delta Airlines stock has climbed 25% in the past year outperforming the broader Bloomberg United States Airline Index, which includes Delta Airlines.  Investment houses like J.P. Morgan already raised Delta's 1Q 2013 profit estimate, citing lower fuel prices and strong travel demand.

Chart Source: Bloomberg
However, the fact remains that flying is a commodity, and crude oil prices are expected to remain flat at least in the next two years due to subdued economic growth and demand.  That means the same major factors that have been negatively impacting the airline sector -- weak world GDP, high fuel prices and fierce competition– will still be there, at least in 2013 and 2014, with many down side risks such as the euro zone, and Iran.   So in general, any increase in airline profitability would be hard-earned from things like efficiency gain and capacity reduction. 
Chart Source: IATA

On top of the tough macroeconomics, Delta has one more down side risk than peers – Trainer Refinery.  And as if that's not bad enough already, Delta management projects nonfuel unit costs will increase 6% to 8% for the March quarter and 4% to 6% for fiscal 2013 due to salary increases and Capex.    

IATA, which represents about 80% of global carriers, forecast the average global airline industry profit margins will improve but remain thin at 2.9% in 2013.  So it is hard for me to share the same optimism as JPM regarding Delta or even the airline sector as a whole.
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