This article first appeared in the July issue of
It's said that politics begets strange bedfellows, but politics
ain't got nuthin' on the oil bidness.
Case in point: Delta Airlines (
) is hooking up with Phillips 66 (
), the downstream operation recently spun off from oil giant
). More specifically, the Atlanta-based air carrier's wholly owned
Monroe Energy subsidiary bought an idled Trainer, Pa. refinery from
Phillips as a hedge against rising jet fuel costs. By Delta's
reckoning, the purchase could end up saving the company $300
million a year.
To be sure, fuel is the single biggest expense in the airline
industry. Delta burned 3.9 billion gallons of the stuff last year,
at an average cost of $3.03 a gallon. That $11.8 billion
represented 36 percent of the carrier's operating expenses. But,
while fuel costs have spiked nearly 90 percent over the past three
years, go-juice is actually cheaper than it was a year ago. In this
environment, you have to wonder why Delta doesn't just hedge with
more conventional forward contracting when necessary. Does Delta
know something other airlines don't?
To answer that, we first need to know more about Delta's deal.
The carrier is paying $150 million for the 185,000 barrel-per-day
refinery plus another $100 million for equipment upgrades. As an
offset, Delta gets $30 million in state infrastructure and job
creation subsidies, reducing its net investment to $220 million.
The refinery purchase, according to Delta officials, approximates
the cost of a single wide-bodied jet. Seemingly, the airline could
recoup its costs in just one full year of refinery operations.
But how? After all, jet fuel isn't a refinery's primary output.
More gasoline is typically produced by these facilities than any
other distillate. Indeed, before operations were suspended last
fall, the Trainer refinery's output was 52 percent gasoline. Only
14 percent of daily production was jet fuel, with the balance
coming out as a mix of diesel, heating oil and other products. Not
surprising, then, that the plant was struggling under its previous
ownership as gasoline consumption dipped and costs for light oil
grades-favored for gasoline production-spiked.
After Delta's upgrades, the refinery will more than double its
jet fuel productivity to 32 percent and cut back its output of
gasoline to 43 percent. Stepping up jet fuel production alone won't
give the airline a free fuel ride, though. Delta's struck a
three-year agreement with BP (
) for input crude but the airline will be obliged to buy its oil at
world market (read: notoriously volatile) prices.
Delta's thirst for jet fuel won't be slaked directly by its own
refining either. The company will exchange its gasoline, diesel and
other refining outputs for additional jet fuel from BP,
ConocoPhillips and other sources. Officials claim this
refining/swap combo should cover 80 percent of the carrier's
domestic fuel needs.
Delta points to the steep trajectory of jet fuel costs-versus that
of crude oil-as justification for its refinery purchase. But the
airline's argument only holds water, er, fuel, if it benchmarks the
light, sweet crude known as West Texas Intermediate, or WTI, in its
calculation. Over the last three years, WTI spot prices have risen
by 51 percent-a modest increase compared to the hike in Brent
crude-the grade most often sourced by East Coast refineries like
the Trainer facility. Brent's prices have, in fact, moved in
lockstep with jet fuel. (Chart 1 depicts the recent price trends of
refined products and crude inputs.) If BP supplies crude to the
Delta operation, input prices will likely be pegged at or very near
Brent, so it's hard to see where the savings arise.
But here's the real hitch: Jet fuel is typically more expensive
than most other refined products. Delta's construct of fast-paced
increases in jet fuel prices translates into the trading of
lower-priced products for a higher-priced commodity. Buying high
and selling low is not a recipe for savings, either.
The savings Delta hopes to realize will ultimately be driven by
what's known as the "crack spread"-the difference between the
barrel price of crude and the sale proceeds of refined products.
Crack spreads vacillate for a number of reasons. First, there's
seasonality. Heating oil, for example, tends to move to a premium
over gasoline in winter and early spring, but generally loses
ground to trade at a discount in the summer driving season. More
importantly, spreads are predicated upon a refinery's equipment,
product mix and target market.
It's the crack spread that determines an operator's gross
refining margin ((GRM)). Oddly, GRMs have actually been on an
uptrend recently, albeit raggedly. Throughout 2009 and 2010, gross
margins averaged less than 15 percent, but the numbers
significantly improved in 2011 and 2012. Margins are now on the
better side of 28 percent. (See Chart 2.)
Why, then, have so many refiners had such a hard time? To answer
that, we have to first appreciate that margins are greatly
dependent upon a refiner's product mix.
The gross profit of refineries geared to crank out greater
volumes of light distillates like gasoline can be roughly
approximated by a "3-2-1 crack," a refining scheme in which three
barrels of crude oil yield two barrels of gasoline and one barrel
of heating oil. (Motor and heating fuels are used as pricing
benchmarks because they're the most transparently priced and
actively traded refined products.)
The proxy for refiners leaning toward middle distillates such as
jet fuel, diesel and heating oil is a "2-1-1 crack" where two
barrels of crude oil produce one barrel each of gasoline and
heating oil. (Heating oil, diesel and jet fuel are chemically
similar and are likewise comparably priced.)
Over the past year, refiners who tilted toward middle
distillates earned 1.25 percent more on average than gasoline-heavy
operations. That's a telltale. Peaks and valleys in the margin
differential often confirm broad economic trends.
3-2-1 runs tend to move to a premium over 2-1-1 operations in
boom times and reverse to a
discount in downturns. When the economy's perking along, gasoline
prices, reflecting consumer demand, rise faster than those of
diesel and heating oil. Petrol consumption, in contrast, declines
in bad times. (Corollary: Jet fuel pricing is most closely
correlated to heating oil's, so when heating oil is soft, an
airline's costs go down. It's then that a carrier will want to
stock up on fuel through forward contracting, even though demand
for air travel may be relatively slack.)
GRMs can tell us how much profit potential there is in a barrel
of crude, but can't be looked upon in isolation. To get a more
complete picture of a refiner's earning power, you have to compare
its margin to the cost of goods sold, or COGS. The COGS is
determined by dividing the refiner's crack spread by its product
sales proceeds. The more daylight between the GRM and the COGS, the
better. A refiner becomes truly flush-all else held equal-when its
margin exceeds the COGS by five percentage points or more. Chart 3
tracks the spread between the industry's GRM and COGS. Also
depicted is the premium/discount of 3-2-1 operations vs. 2-1-1
cracks. Higher percentage values for both metrics signal better
Obviously, operating costs have to be factored in to get a clear
picture of a refiner's ability to turn a profit. Given the age of
America's refining infrastructure, that expense can reduce margins
significantly. The Trainer plant, in particular, is one of the
older and least efficient refineries-a circumstance that obliged
its former owner to rely upon the most expensive grades of
feedstock crude. Thus, Delta is compelled to retool the facility to
accommodate its new product mix.
The refinery's profitability might be enhanced if cheap crude
oil from North Dakota's Bakken shale field or WTI banked in
Cushing, Okla., could be shipped in. Both grades are currently
selling at a discount to Brent because they're essentially
landlocked. Without a pipeline to transport crude to Delta's
refinery, though, an expensive combination of barges, trains and
trucks would need to be marshaled.
So does this refinery purchase really make Delta smarter than
the other airlines? Well, there seems some desperation in Delta's
move. The airline negotiated the deal as oil prices spiked amid a
flare-up of Iran nuclear controversy. If oil prices weaken, Delta's
money could be wasted.
Still, the airline picked the right time to shop for assets.
Integrated energy firms have been anxious to unload their
downstream businesses, even at fire sale prices. Delta, too, may be
watching those telltale spreads as bellwethers of better economic
times to come.
Investors apparently appreciate Delta's chutzpah. The airline's
share price jumped 9 percent in the month after word of the
refinery deal got out. Since then, the stock's risen further,
despite the overall market's weakness. Two months after the
purchase was publicized, Delta shares had risen 15 percent. On a
year-to-date basis, the stock's up 30 percent, far ahead of direct
competitors United Continental Holdings (
) and Southwest Airlines (LUV).
That ought to make index followers green with envy. The Guggenheim
Airline ETF (NYSEArca: FAA), a portfolio of 26 global carriers'
stocks, is up just 14 percent on the year. Even more envious are
those tracking the processing of black gold. Collectively, the
value of the 60+ stocks held by the iShares Dow Jones U.S. Oil
& Gas Exploration & Production Fund (NYSEArca: IEO) have
dipped 11 percent since the top of the year (see Chart 4).
Almost every U.S.-based airline has flown into bankruptcy at one
time or another. When management isn't blaming poor performance on
high labor costs or weak business demand, fingers are pointed at
rising fuel costs. Delta's purchase just might stop some of that
Insiders Are Bullish About This Construction