3 Big Myths About Delta Air Lines, Inc. (DAL)’s Refinery

Page 1 of 2

Delta Air Lines, Inc. (NYSE:DAL) took Wall Street by surprise when it decided to purchase an oil refinery in Trainer, Penn., from Phillips 66 (NYSE:PSX) last year. Since then, many observers have criticized the deal, arguing that Delta’s refinery strategy is doomed to failure. However, much of the criticism is based around three big myths. The truth is that Delta’s refinery gambit will probably succeed.

Myth No. 1: If Phillips 66 couldn’t make it work, Delta can’t either
Perhaps the most common criticism of Delta’s refinery purchase is that the company should not expand beyond its core airline business. Phillips 66 had idled the Trainer refinery prior to selling it and was unwilling to make the necessary investments to keep the refinery running. As the largest independent refiner in the U.S., Phillips 66 clearly has significant expertise in refinery operations. Thus, many industry observers believe that if the Trainer refinery would have been a bad investment for Phillips 66, it will be an even worse investment for Delta.

Delta Air Lines, Inc. (NYSE:DAL)This overlooks a key insight from modern portfolio theory. Investors should demand a higher return for accepting less diversification, and thereby taking on more risk. For Phillips 66, which already owns 15 refineries, owning a “marginal” refinery adds risk that cannot be justified by the expected returns. If the refining crack spread (the price difference between a barrel of crude oil and a barrel of refined products) were to drop, the Trainer refinery would likely become unprofitable. Instead of investing money in the Trainer refinery, it made sense for Phillips 66 to sell it for $180 million and use the cash to fund capital expenditures at other refineries, and to return money to shareholders.

By contrast, for Delta, owning a refinery allows the company to hedge against an increase in the market crack spread. While the refinery subsidiary (Monroe Energy) could lose money if the crack spread decreases, Delta would still benefit in that scenario, because a lower crack spread translates to lower jet fuel prices (holding crude oil prices constant). Thus, owning a refinery could potentially reduce Delta’s risk through diversification, which explains why Delta is willing to operate an asset that Phillips 66 wanted to divest.

The only remaining risk for Delta is that operating costs for the refinery come in higher than projected.  However, barring unexpected maintenance issues, I assume that the long-term costs of operating the refinery can be projected fairly accurately. If Delta did its due diligence before acquiring the refinery, this should not pose a problem. The refinery is being overseen by a 25-year refining industry veteran, so the plant is likely to be managed competently.

Myth No. 2: Delta should just “hedge” instead of owning a refinery
Some people have responded to the diversification argument by claiming that Delta could just “hedge” using financial derivatives. However, this argument is based upon a fundamental misunderstanding of the problem. Delta already hedges against changes in the price of crude oil. By contrast, the Trainer refinery acquisition was designed to help Delta hedge against changes in the crack spread.

It is much more difficult to hedge against changes in the jet fuel crack spread. Jet fuel swaps are the only way to fully eliminate the risk of fuel price changes, but these instruments are expensive, illiquid, and not typically available in sufficient quantity for an airline of Delta’s size. Instead, airlines often use derivatives tied to New York heating oil, which is an exchange-traded commodity. However, the correlation between jet fuel and heating oil is far from perfect. For example, the premium of Gulf Coast jet fuel over New York heating oil dropped from $0.109 per gallon to $0.018 per gallon from 2008 to 2009. More recently, the premium has been around $0.05. These fluctuations show why hedging with heating oil derivatives is not fully satisfactory. The best way to minimize volatility in the jet fuel crack spread is to own a refinery.

Page 1 of 2

Biotech Insider Alert - $6 Stock To Hit $40

$200 Million Dollar Healthcare Hedge Fund's #1 Best Idea Right Now

The best healthcare hedge fund out there right now is one of the largest shareholders in this biotech stock. The fund returned more than 20% in each of the last 2 years with a virtually fully hedged portfolio, and it's sending out a BUY signal on this biotech stock. Get your FREE REPORT today (retail value of $300)

This is a FREE report from Insider Monkey. Credit Card is NOT required.
Comments
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months. Our beta is only 1.2 (don't click this link if beating the market isn't important to you).

Lists

The Best Romance Movies of all Time

The Most Wanted Drug Lords

The Oldest Money Managers

The Greatest Directors in the World

Largest Animals in the World

World’s Most Expensive Desserts

Best Selling Comic Books of All Time

A-list Actors who Sabotaged Their Career

Rappers With a College Degree

The Best Jazz Albums of all Time

The Most Influential Jazz Musicians

The World’s Most Famous Photographers

The Best Oscar-Winning Songs

Most Influential Choreographers Ever

Most Expensive Department Stores in the World

The Most Expensive Stolen Paintings in the World

The World’s Most Expensive Teas

Top Oscar Record Holders

The Most Expensive Flowers in the World

Countries With a Booming Film Industry

Most Expensive Cupcakes in the World

Uncommon European Escapes

The Most Stolen Artists in History

Best Travel Destinations in Australia

World’s Most Expensive Musical Instruments

World’s Most Famous Animals

Most Expensive Cakes in the World

Most Expensive Kosher Champagne in the World

Most Expensive Kosher Wine in the World

The Most Surprisingly Dark Fairy Tales

Most Popular Travel Destinations in Asia

The 10 Most Expensive Dresses Ever Worn to the Oscars

World’s Most Visited Art Museums

Best Countries for Photographers to Work in

Best Paid Jobs in the Film Industry

The Most Renowned Recovered Paintings Ever

Child Stars That Turned out Just Fine

Books That Were Banned in the Past Century

World’s Richest Dancers

Best Remedies against Bad Breath

Foods That Improve Your Skin Texture

Best-Selling Children’s Books of all Time

Foods That Boost Your Libido

Best-Selling Books of all Time

The Most Expensive Academy Awards Jewelry in History

Most Expensive Japanese Restaurant In New York City

The Best B-Boy Movies

Most Awesome Hip Hop Documentaries

Foods That Stain Your Teeth

Richest Doctors in the World

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 129% in 2.5 years!! Wondering How?

Download a complete edition of our newsletter for free!