Strange Tales of Delta Air Buying an Oil Refinery

♠ Posted by Emmanuel in ,, at 5/02/2012 02:32:00 PM

With airlines being almost universally unprofitable these days--even Thai Airways is reportedly going to have an unprofitable 2012 or only its second unprofitable year in 51 years of operation--saying that costly aviation fuel is having negative effects on the airline industry is an understatement. From the Land of Smiles' flag carrier, let's turn our attention to the Land of Fats' largest carrier, Delta. A few weeks ago, I noticed an interesting feature about this perennial money loser considering the purchase of a refinery to deal with sky-high fuel costs. Now it's almost a fact: Delta nears completion of a deal to buy a refinery that ConocoPhillips is offloading:
 Delta Air Lines Inc. (DAL) is bringing some jet-fuel production in house, breaking with U.S. carriers’ reliance on outside providers, by acquiring a refinery that Phillips 66 had targeted for shutdown. The world’s second-biggest airline will pay $180 million for the complex in suburban Philadelphia, according to a statement yesterday. Pennsylvania’s state government is putting up $30 million in assistance to defray the expense.

An airline-owned refinery is an experiment in the U.S. industry, said Ray Neidl, an airline analyst at Maxim Group LLC in New York. Atlanta-based Delta estimated the accord will save $300 million on its annual fuel bill, which was $11.8 billion last year, or about $32 million a day. “Nothing ventured, nothing gained,” said Neidl, who has a buy rating on Delta shares. “Delta likes to try new things and I’m sure they studied this for months and ran the calculations. Nobody has done something quite like this before.”
Well that's one optimistic take on the Delta purchase. However, more analysts are skeptical about the costs savings available here, instead focusing on Delta's expansion of non-core functions and its implications for its flight operations. It goes back to time-tested debates about supply chain management and when the vertical integration or "make" decision outweighs the "buy" decision. To be sure, what we have here is a supremely commodified product, so there's no novelty factor involved which usually points in the direction of a "make" decision. Delta's counterargument though would be that these are extraordinary times during which it's better to make certain things in-house. At Bloomberg, Virginia Postrel outlines the sensible case against Delta's plan:
“If markets work well, you’re always better off using the market. Let somebody specialize in what they do and trade with them,” says Richard N. Langlois, an economist at the University of Connecticut whose work on what he calls the “vanishing hand” looks at why corporations have become less vertically integrated in recent decades. “If there are markets that are well functioning for your inputs and there aren’t high transaction costs or other problems, you’re generally better off buying things in markets than owning them yourself.” The vertical integration that Alfred Chandler chronicled in his influential 1977 book “The Visible Hand,” Langlois argues, was “an adaptation to particular historical circumstances” -- specifically, underdeveloped input markets...

In Delta’s case, that means flying airplanes, not refining oil. Delta doesn’t need its own refinery to obtain jet fuel, which is traded in a thick worldwide market, any more than it needs to own a peanut farm to supply in-air snacks. And it seems unlikely that Delta would be noticeably better at running a refinery than any other potential buyer--or, for that matter, ConocoPhillips, which plans to close down the refinery if it can’t make a deal.

The proposed purchase “doesn’t make a huge amount of economic sense -- in fact quite the opposite,” says Craig Pirrong, a finance professor and director of the Global Energy Management Institute at the University of Houston’s Bauer College of Business. You might think that owning a refinery would at least protect the airline from price fluctuations. But, Pirrong notes, crude oil prices affect the profits of airlines and oil refineries exactly the same way. When oil prices go up, their profits go down. Owning a refinery would simply magnify the effect. “If anything,” he says, “it increases the risk exposure that has bedeviled the airline industry for years.” 
I believe these arguments make sense: it's the price of crude oil, not refining it, that is primarily behind costly aviation fuel. Moreover, if a dedicated energy concern alike ConocoPhillips couldn't make ends meet, what better chance does an energy industry neophyte like Delta? Still, you can't deny Delta's chutzpah. For its next act, I'd like to see it buy an inflatable woman doll maker to produce floatation devices. Delta may be losing lots of money, but it might as well have fun doing so.