Does Delta know more than the oil specialists?

By acquiring the oil refining facility from ConocoPhillips, Delta is replacing its fuel hedging strategy with backward integration but at the same time entering a particularly challenging market.

The refining business once was dominated by integrated oil companies, which both produced the oil and refined and sold the final product. But as refining and marketing became less profitable than production of crude oil, some big oil companies began spinning off and selling or shutting down refineries.

In 2011, Delta spent $11.7 billion on fuel, which accounted to 36% of its operating costs. In 2010 fuel accounted for 30% of Delta’s expenses. In a written statement, Richard Anderson, Delta Chief Executive said: “This modest investment, the equivalent of the list price of a new wide-body aircraft, will allow Delta to reduce its fuel expense by $300 million annually and ensure jet fuel availability in the Northeast.”

Since the amount of Jet fuel produced in this refinery is not large enough to cover its needs, Delta will exchange gasoline and other refined products from the complex for jet fuel from Phillips 66 and BP through multi-year agreements.

Two questions come to mind after reading all that has been said recently about Delta’s new business adventure.

• Is the profit margin of a crude oil producer so much higher than the margin of an airline that a refinery can be interesting to an airline while the oil company wants to shut it down? If this is true what can we conclude about the price structure of crude oil?

• Is there a synergetic value between a jet fuel producer and an airline company like Delta?

I must say that I don’t see it. I do not see how a specialized company with years of experience in the industry can be less profitable than a newbie. Can Delta utilize some of their underutilized assets or increase the efficiency of the supply chain to decrease the overall expenses of Jet Fuel production? Even if it does reduce the costs of refinement, Delta still has only a part of the Jet fuel production value chain under control. Volatility of crude oil price is still a significant factor that is out of their control since the refinement process only accounts for 12-18 percent of the Jet Fuel price. The focus should be on the total costs of ownership and the level of fuel supply control.

On the other hand investors seem to support Delta’s decision – the company’s shares went up by 10% since the rumor about the acquisition of the refinery started to spread.

I guess we will soon find out if this was the right decision but I am sure that other airline companies are very interested to see the outcome of this venture.