Questions linger in Delta's purchase of Trainer refinery

When Delta Air Lines decided to buy the idled Trainer refinery outside Philadelphia to keep itself supplied with jet fuel, the announcement was met with a mix of skepticism, outright disbelief, and nods of approval from experts who follow the airline industry and oil and energy markets.

Delta's move was smart, risky, insane, stupid, even brilliant — or all of those.

"Is there a better investment than a refinery? Maybe not," wrote airline analyst Helane Becker in a client note.

Jet fuel accounts for 37 percent of Delta's operating costs. The fuel tab for the world's second-largest airline was $12 billion last year, including a $2.2 billion premium paid to refiners for jet fuel, a payment known as the crack spread.

"If you go through the reasons why an airline would buy a refinery, it's purely selfish," said Becker, of Dahlman Rose & Co. "It's to maintain access to jet fuel, and it's really to eliminate the exposure to the crack spread."

Airlines can "hedge" the cost of oil by entering into long-term future contracts. But they cannot hedge the crack spread, or the refiners' profit margin, which fluctuates based on supply, demand, and market trends. In the Northeast, refinery shutdowns have resulted in "significantly higher jet-fuel crack spreads" than in the rest of the country, Delta CEO Richard Anderson said in a phone briefing with reporters in April.

Many in finance scoff at the suggestion that Delta thinks it can run a refinery more efficiently than ConocoPhillips, a major oil company that in October idled the Trainer plant and put it up for sale.

"I heard from everyone in the oil business who had anything to do with jet fuel, whether they be a refiner or a buyer, and they said, 'This is the most ridiculous thing,'?" said Tom Kloza, chief oil analyst for the Oil Price Information Service, which tracks wholesale and retail prices.

Kloza said he sees it differently: "I've seen many cases where new operators come in and take an asset that was marginal when managed by a major oil company and make it work. There are lots of examples."

"Big oil companies get excited about finding new crude reserves. They don't tend to get excited about refining or marketing," Kloza said.

Oil and gas analyst Philip Weiss, with Argus Research Corp., understands Delta's pitch but says he doesn't think it makes financial sense. "I don't see why an airline would want to vertically integrate its business that way because the refining business is very volatile," he said. "It's a return on capital business.

"Why are refineries closing? Because it's not a good business," Weiss said. And two-thirds of what the Trainer refinery will produce — gasoline and diesel fuel — will not be used by Delta.

Under the deal announced April 30, Delta has multiyear contracts with British Petroleum to supply the crude to Trainer, and Phillips 66 and BP will swap the gasoline and diesel for jet fuel to serve Delta at airports around the country.

When the Trainer plant is up and running in September, production will be 165,000 to 185,000 barrels a day, including 52,000 barrels a day of jet fuel, which will go by pipeline and barge to Delta's hub operations at New York's LaGuardia and John F. Kennedy airports.

"We've had this matter under study for the better part of a year," Anderson said in a call with reporters. "What we're tackling here today is the jet crack spread," the fastest-growing portion of all Delta's expenses, he said.

The idled Trainer facility came cheap — an asset probably worth a $1 billion, he said. Delta bought it for $150 million, plus $100 million the airline will invest to modify the plant to maximize jet fuel production. (Pennsylvania kicked in $30 million for job creation and infrastructure improvement.)

Delta said that $250 million investment — a little less than the list price of a new wide-body airplane — would pay off in the first 12 months in lower annual fuel costs of $300 million. The jet fuel from Trainer, and the swaps with BP and Phillips 66, will cover 80 percent of Delta's domestic fuel needs, the company said.

"It looks like it's a good thing; I don't know why all the oil guys tell me it's a bad thing," said airline analyst Bob McAdoo, with Imperial Capital L.L.C. "I am a little skeptical that the people who are the loudest negative are also people who haven't seen the details of this transaction."

"When you look at how much Delta spends on oil, and how much they spend on everything, this is not a big risk financially. These guys do their homework," McAdoo said. "I would expect that it's going to work for them. Even if it doesn't, it's not a big number relative to the overall size of Delta."

Airline analyst Ray Neidl, of Maxim Group L.L.C. said, "If it works out, it will make them look very smart and help them in a small to medium way control the price of the fuel they pay for. It's not a save-all situation as far as the volatility of fuel prices, but it will help them have a better insight into the market and actually be part of the market. "

The critics say that "from an economic perspective it doesn't make sense," said Craig Pirrong, professor of finance and energy markets at the University of Houston. The real cost is what they could sell the jet fuel for in the market. "If they buy that jet fuel from somebody else, or they produce it and consume it themselves, they are giving up the opportunity to sell the barrel to somebody else," he said. "The cost is pretty much the same."

In the 1980s, plenty of companies integrated vertically — a steel company bought an oil company, DuPont Co. bought Conoco Inc. "New management came in later and said, 'Hey, this isn't making any economic sense, so we'll spin it off,'?" Pirrong recalled. "The fact that Delta seems to be going in the opposite direction of everybody else suggests that they are ignoring some key economic costs."

Monroe Energy L.L.C., a wholly owned subsidiary of Delta, took control of the refinery June 22. Union workers in operations and maintenance returned the next week to begin the process of getting the plant up and running. The refinery, when fully operational, will employ 400, including 220 members of United Steelworkers Local 10-234, the same number employed by ConocoPhillips.

The Trainer facility will not aim to be a traditional refiner, like PBF, Sunoco, or predecessor ConocoPhillips. "We don't have a marketing department. We are totally exchanging everything to get jet fuel," said Jeffrey Warmann, Monroe's CEO and plant manager. "That's our whole purpose: to maximize jet fuel availability to our parent company."

Wharton School management professor Larry Hrebiniak said that while some people, especially in energy and finance, don't like the deal, "I'm going to go the other way. I think it makes some sense," but it is not without risks.

The risks include what happens when the contracts with BP and Phillips run out. If there's no more swap, where will Delta sell the by-products, gasoline and diesel, in return for more jet fuel? he asked.

Another risk: If crude and jet fuel prices were to plummet, Delta could be stuck with a refinery that's more expensive to operate than the cost of buying jet fuel in the open market. "I don't think that's going to occur any time soon," Hrebiniak added. On the other hand, if the economy picks up, and more people fly, jet fuel prices will rise, "and their decision is going to look pretty good."

CrankyFlier.com author Brett Snyder, who formerly worked for America West and United Airlines, says the deal seems good if Delta does not have to spend more than $100 million to get the refinery running, and there are no unforeseen big expenses, such as a safety problem.

"The swap is crucial as part of this because gas and diesel are just terrible to sell, especially the gas," Snyder said. "With the swap in place, it seems like it sets this up to work at least for a few years. By then, Delta has made its money back. Maybe it doesn't work a few years down the line, maybe it does," Snyder said. "They'll know more at that point. Then they can make that judgment. And they still should have made money."