DERIVATIVES/OTC

Refinery Ownership the Key to Airline Fuel Woes?

By Transportation FOXBusiness

With the cost of fuel weighing heavily on airlines, perhaps the best way to get rid of the burden is to just buy an oil refinery.

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That’s what some people think Delta Air Lines (DAL) is trying to do by reportedly bidding up to $150 million to take over a ConocoPhillips (COP) refinery on the East Coast.

Conoco, which has been shedding unprofitable assets in an effort to streamline its business and improve margins, announced plans last year to either sell or permanently shut the Trainer, Pa.-based facility.

It has become a theme among East Coast refineries, as their dependence on expensive high-quality crude has clamped down on profit margins in recent years. Two of the three biggest Philadelphia refineries were shut in September, and Sunoco (SUN) says it is prepared to shut the third, and biggest, in July if it can’t find a buyer.  

“Oil companies are closing/selling refineries, they’ve been losing money on them for years,” said Larry Weaver Sr., CEO of aviation fuel consulting company Dellem. “If Delta or anyone else thinks they can make money on them, it’s questionable.”

Yet, Atlanta-based Delta has been pondering the refinery buy for months and is even competing against other bidders for the property, sources close to the matter told The Wall Street Journal. They say a deal could be reached as soon as the end of the month.

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A Delta spokesman said the carrier would not comment on rumors or speculation.  

The temptation is jarring as fuel, which makes up more than half of airline costs, digs deeper into carrier profits. Delta last year paid $3 billion more for fuel than it did in 2010, and the International Air Transport Association projects that the industry’s fuel bill will grow by $40 billion in 2012, from $166 billion last year.

“Assuming away the complexity … it is easy to see the interest in seeing whether refinery ownership can be a good hedge,” said airline consultant Bob Mann.

However, if refineries around the nation are shutting down because oil companies can’t manage to turn a profit, analysts are questioning how a less experienced and financially strapped airline could afford to foot the bill for such a pricey venture.

“Part of the problem is crude is expensive, what’s coming out on the other side is not being sold for enough money to cover it,” Weaver said.

It still remains to be seen how much Delta would save by offsetting some of its dependence on third-party oil and refinery companies, especially since the extremely volatile price of crude causes refining margins to vary widely.

“If they think that by refining their own fuel they’ll be able to lower their own volatility, I think they’re sadly mistaken,” said Phil Flynn, energy analyst at PFGBest and a FOX Business contributor.

At the same time, refineries can’t produce just one type of oil. One barrel gives birth to a wide consortium of fuel, from gasoline and heating oil to jet fuel and diesel, with some squeezing out more gasoline or diesel over others. Jet fuel almost always makes up the smallest percentage.

“Jet fuel is a very small portion of the total barrel of oil, and because of its use, has very stringent quality control requirements that run the costs up on it,” Weaver. “Delta likely could get the jet fuel at a lower cost, but the other products would likely offset any possibly gain to the point   they’d be losing money on the deal.”

So, if Delta owned a refinery, what would it do with the byproducts?

Delta, the world's second-biggest airline by traffic, reportedly would plan to partner with refiners and trading houses to swap the excess diesel, oil, tar and gas that are produced with each barrel of oil in exchange for jet fuel. It would also invest in higher-quality crude so that it could extract a larger percentage of jet fuel from each barrel, the sources said.

The carrier would have to figure out the logistics, such as how to transport the jet fuel to its largest hubs in New York and Atlanta, or sell the oil at a profit to rivals like U.S. Airways (LCC), which has a nearby hub in Philadelphia.

“Delta would have to get into the business of selling the excess product, or giving it away,” Flynn said. “The problem is the realities of the refining business have been pretty boom and bust, it’s not a very profitable end of the business in the long-run.”

If the company could efficiently ship the fuel to its local hubs at La Guardia Airport and John F. Kennedy International Airport in New York, or to nearby competitors, it would be able to cut down on the transportation costs it currently pays third parties to deliver fuel to its fleet.

“From that viewpoint, the transportation to get it to their hub isn’t that high, so maybe there is a method to their madness,” Flynn said. “I think it looks pretty risky, but if they think they can get a reliable amount of crude oil, maybe they can make it make sense.”

Especially since, Flynn noted, Delta might be able to acquire the refinery for “practically nothing,” given Conoco’s desire to remove the dilapidate facility from its balance sheet. However, Delta is reportedly competing against other bidders for the Trainer refinery, which could push up the price, and even if it does score the refinery for cheap, it is due for a major upgrade.

“If Delta can make a go of this and position themselves as a more stable source for jet fuel, other airlines my want to look into this,” Flynn said.

However, the business is risky, and Weaver said airlines should stick to what it knows.

“They’ve got enough business to work on,” he said.

Airline analyst Bob Herbst said the carriers should instead focus on gradually reducing their fuel bill by acquiring fuel-efficient jets like the Boeing (BA) 787 Dreamliner.

“Sunoco and Conoco have exited the East Coast refining business after incurring significant recurring losses,” Mann said. “So how do Delta and partners plan to do better?”

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