COLUMN-Benefits remain elusive from Delta's U.S. oil refinery: Kemp
LONDON, Jan 22 (Reuters) - When Delta Air Lines announced it was buying the Trainer oil refinery from Phillips 66, in April 2012, the U.S. carrier hailed the transaction as "an innovative approach to managing our largest expense". Since then, the company says vertical integration has lowered jet fuel prices in the U.S. Northeast, its home region, and will eventually provide company-specific benefits as the refinery processes more cheap domestic crudes and returns to profitability. But the jury is still out on Delta's strategy. The refinery remained in the red in 2013, reporting a loss of $116 million. On Tuesday, the airline said the refinery lost $46 million in the fourth quarter. No other airline has copied Delta in buying a refinery, even though plenty of other refineries are up for sale in Western Europe and on the U.S. East Coast. It remains unclear whether vertical integration is a more effective solution to the problem of managing airline fuel costs than traditional hedging using futures, options and swap contracts.
RISING FUEL BILLS Fuel costs are increasingly critical to the profitability of airlines. In 2013, Delta spent nearly $11.5 billion - a third of its operating costs - to buy almost 4 billion gallons of jet fuel. Jet fuel prices have risen almost five-fold since 2002, becoming the largest operating expense for airlines such as Delta (Table 1). Demand for jet is growing significantly faster than other refined products. But for refiners, jet is only one relatively minor co-product from plants designed to maximise production of more important fuels like gasoline and diesel. So as refiners have closed plants on the U.S. East Coast and in Northwest Europe to eliminate excess gasoline output and improve their margins, the squeeze on jet supplies has grown intense, and the fuel is becoming relatively more expensive. "Because global demand for jet fuel and related products is increasing at the same time that jet fuel refining capacity is decreasing in the U.S. (particularly in the Northeast), the refining margin reflected in the prices we pay for jet fuel has increased," Delta complained in its 2012 annual filing with the Securities and Exchange Commission. Trainer's closure would have threatened to push jet costs even higher by tightening fuel supplies in the greater New York region. Delta therefore "acquired the Trainer refinery and related assets located near Philadelphia, Pennsylvania in June 2012 as part of our strategy to mitigate the increasing cost of the refining margin we are paying", it explained.
RISK MANAGEMENT With fuel bills accounting for such a high share of the airline's cost base, managing price risks has become ever more essential. Like other airlines, Delta has sought to protect itself through active hedging using futures, options, collars and swaps. The costs of hedging have been large at times, reaching $1.4 billion in 2009, when oil prices unexpectedly collapsed, though of course most of the costs of true hedges should have been offset by reduced operating expenses elsewhere (Table 2). The question is whether buying Trainer was a cheaper and more effective way of hedging price risks and guaranteeing fuel supplies than relying on traditional hedging programmes and importing fuel from other regions if needed. Delta paid just $150 million to acquire the refinery and agreed to invest a further $100 million in modernising the plant to maximise jet fuel production. In addition, the Commonwealth of Pennsylvania and Delaware County have provided additional financial assistance to support job retention, investment and economic development. Delta's investment was "modest" and "equivalent to the list price of (just one) new widebody aircraft," the airline's chief executive noted at the time. Owning the refinery would allow Delta to reduce its annual fuel expense by $300 million and ensure jet fuel availability in the Northeast. "We expect the Trainer acquisition to be accretive to Delta's earnings, expand our margins, and to fully recover our investment in the first year of operations," the company promised in April 2012.
JET MAXIMISATION In practice, Trainer has struggled to meet expectations. The refinery has reported losses in four of the last five quarters, according to the company's records. Trainer was badly hit by Superstorm Sandy in October 2012. Even so, the company has repeatedly promised it is about to return to profit, only to record more losses (Table 3). The company has been reconfiguring the refinery to maximise production of jet fuel and other high-margin distillates. The process should be completed in the first quarter of 2014, when the combined yield of jet and distillates will hit 40 percent of total output. Delta says its acquisition and reconfiguration of Trainer have already helped lower jet fuel prices by 5 to 10 cents per gallon when compared with heating oil (see page 18 of its investor presentation in December 2013). Those benefits accrue to all airlines operating out of New York and the rest of the Northeast. But Delta hopes to secure company-specific gains by making Trainer itself profitable. The company makes much of its plans to buy more domestic crude, which is cheaper than imports, as well as making further operational improvements. Delta wants to capture the cost advantage of processing cheap Bakken crude, trapped in the United States by logistics constraints and a ban on crude oil exports, for itself. Trainer will supply nearly all of Delta's jet fuel needs. Delta's management insists that buying Trainer has been a success, despite doubts expressed "We continue to get questions as to how do we feel about Trainer," Delta president Edward Bastian said at a presentation to investors on Dec. 11. "Let me be very clear. Trainer has been a great success for Delta. And we are pleased that we made that acquisition." "When we entered the market with Trainer, 40 percent of the jet fuel supply was returned to New York Harbor, and it had an immediate impact on jet fuel prices," he added. "Every cent we save on fuel saved us $40 million a year," Bastian said. "It's well worth the $150 million capital investment we've made in this refinery."
INTEGRATION VS HEDGING Buying Trainer has not yielded all the benefits that Delta originally expected. It remains an open question whether vertical integration or using derivatives will be more cost-effective in the long term. But it is notable that no other airline has chosen to follow Delta's lead in this area. In fact, structural changes in the industry may be reducing the overall need for fuel-price hedging. Delta observes structural changes in aviation have produced a much closer correlation between ticket revenues and fuel costs. Fuel surcharges, the elimination of excess capacity and a disciplined approach to expansion are keeping costs and revenues aligned more closely. Airlines use hedging to mitigate the impact of short-term rather than long-term changes in fuel prices. Since tickets are only sold up to a year in advance (and most are sold with much shorter maturities), airlines need only to manage price changes lasting for a few months up to a year (the difference between fixed-price ticket sales and variable-price fuel purchases). Virtually all airline hedging is concentrated in a 12-month window. Airlines assume that if a rise in fuel costs lasts beyond that time frame, it will affect all airlines, and everyone will raise ticket prices. If fuel charges and the elimination of spare capacity are forcing a closer alignment between fuel prices and ticket prices within the 12-month window, even short-term hedging may be becoming somewhat less critical than before. Perhaps the best way of thinking about Delta's investment is that the company paid $150 million, and is shouldering some ongoing losses, to keep plenty of jet-making capacity in the Northeast. But Delta has yet to show that buying Trainer has yielded a competitive advantage that it could not have obtained through more conventional hedging and supply agreements. It may not have cost the company much, but the benefits have been elusive.
Table 1: Fuel prices and costs
Fuel consumption Average price Cost Share of op. costs (million gallons) (U.S.$/gal) ($ million) (percent) 2013 3,828 3.07 11,464 33 2012 3,769 3.25 12,251 36 2011 3,853 3.06 11,783 36 2010 3,823 2.33 8,901 30 2009 3,853 2.15 8,291 29 2008 2,740 3.16 8,686 38 2007 2,534 2.24 5,250 31 2006 2,480 2.12 5,250 30 2005 2,492 1.79 4,466 24 2004 2,527 1.16 2,924 16 2003 2,370 0.82 1,938 13 2002 2,514 0.67 2001 2,694 0.69 2000 2,922 0.67
Source: Delta Air Lines, 10-K
Table 2: Hedging gains and losses
Gain or (loss)
2012 (66) 2011 420 2010 (89) 2009 (1,400) 2008 (65) 2007 51 2006 (108) 2005 No hedges 2004 105 2003 152
Source: Delta Air Lines, 10-K
Table 3: Refinery profits and losses
Gain or (loss) U.S.$ million
Q4 2013 (46) Q3 2013 3 Q2 2013 (51) Q1 2013 (22) Q4 2012 (63)
Source: Delta Air Lines, quarterly earnings reports