Why did Delta buy an oil refinery?

Delta Airlines agreed to purchase an oil refinery outside Philadelphia from ConocoPhillips for $180 million. The refinery was just one month away from being shut down as it was not producing enough profit for ConocoPhillips to justify keeping it open. Delta estimates that the purchase will save the company as much as $300 million a year because of the economic benefits of “vertical integration.” Critics are skeptical that Delta will have the managerial expertise to operate a refinery better than a bonafide oil company. 

that’s a complicated way of saying: Delta Airlines purchased an oil refinery in an attempt to control their fuel costs. Traditionally air carriers purchase jet fuel on the open market and employ “hedges” to limit the cost of jet fuel. In the past few years the price of oil has increased rapidly and undermined the profits of airline companies. Last year fuel purchases accounted for 36 percent of Delta’s operating costs! When you consider the amount of labor it takes to run an airline and the expense of acquiring and maintaining a large fleet of aircraft, 36% is quite a staggering number. Delta’s purchase of the refinery is an attempt to remove jet fuel price volatility and stabilize their profits.

What are the potential benefits of owning a refinery? Delta will be able to easily supply fuel to their hubs in JFK and LaGuardia and throughout the northeast. Eventually the company hopes it will cover approximately 80% of its fuel needs in North America. Receiving fuel from one source will make it easier for Delta to monitor fuel quality. Furthermore, Delta will have effectively cut out one middleman in their supply chain.

This purchase can also be seen as introducing more competition to the refining space. Delta is potentially showing the airline industry an innovative way for them to stabilize costs. Other oil refiners may be forced to lower their prices, improve fuel quality or provide fuel in a more efficient way in order to prevent other airlines from following Delta’s lead.

Removing parts of the supply chain is known as vertical integration. Remember the steel companies and railroad companies of the late 19th century? They started buying up coal and coke mines, successfully driving down the costs of the inputs they needed to produce their primary products. Delta, by refining its own fuel, is expecting to create economic efficiencies to control the cost of their most expensive input and improve their bottom line.

Further, Delta argues that paying $180 million ($30 million of which is funding provided by the State of Pennsylvania) is such a cheap price that even if the venture fails it will not harm their primary business.

What are the potential problems of owning a refinery? Delta Airlines does not have the technological experience or expertise to run an oil refinery. Their skill is in transporting passengers and cargo in airplanes.  Why do they think they would be able to do a better job of operating the refinery than ConocoPhillips? Better than a company whose business model is based on producing and distributing fuel from oil? One of the side-effects of an effective, free market, in my opinion, is the specialization of firms. Vertical integration does not lead to higher profits because the savings to the company of lower prices and smoother distribution will be outweighed by the lost production to be expected due to the foreign business. Delta’s purchase looks to prove this tenet wrong.

Second, while Delta has cut out the middleman of the refiner, they will still need to purchase oil, needed to refine into jet fuel, on the open market. The price of oil is the commodity that fluctuates in price. Refined fuel and gas usually follow the same direction as oil. Undoubtedly there is some markup after refining which will be saved. But if the goal is to shield the company from surges in the price of oil, the purchase of the refinery will not achieve that result.

Delta’s rebuttal: Delta will argue that they do not need to refine fuel in a “profitable” manner. Rather, they need to simply refine fuel so it is cheaper than if they had to purchase it on the open market. Any time they can remove a middleman from their supply chain, they are reducing markups and saving money.

Regarding expertise and experience, Delta will say that they are hiring the same people who were operating the refinery before. They will already come with the necessary knowledge to operate the facility in a cost effective way.

My thought: This seems like an unnecessary risk for Delta. Especially since fuel prices appear to be declining a bit. In my opinion they should continue to employ their strategy of hedging fuel costs and buying on the open market from the refining experts. If Delta can operate the plant smoothly and efficiently, it will certainly be a boon for the company. However, I think the chances of Delta making the refinery work better than ConocoPhillips are not good. As a Delta shareholder I am now looking for a good exit point of the stock.

There are plenty of other compelling reasons to own the company, particularly if you agree that fuel costs are going to decline. Time will tell if this was a smart move, but I predict it will end up being a mistake.