Delta Tries to Close the Crack Spread

Delta Air Lines (NYS: DAL) recently decided to buy an idled Trainer, Pa., refinery from ConocoPhillips (NYS: COP) . It's an interesting -- and unique -- attempt to try and get a handle on one of the biggest and most volatile expenses in the airline business: jet fuel.

The big problem with Delta's thinking, though, is that a huge part of the cost of jet fuel is driven by the price of oil. As a result, the only savings Delta can possibly get from the deal are driven by something called the crack spread -- the difference between the price of a barrel of oil and the price of the products refined from it.

Why are they doing this?
Delta thinks there's an estimated $300 million in annual fuel savings from the deal. To get at that potential, it's planning to invest $150 million of its own cash -- joined by $30 million in Pennsylvania taxpayers' money -- to buy the refinery. It's spending an additional $100 million of its own money to upgrade the plant to be more focused on producing jet fuel.

That's $280 million total up front ($250 million from the company, the rest from Pennsylvania), for a potential $300 million a year in savings. That's good money, if they can get it. The only problem is that the savings will likely be tougher to actually pocket than the airline would like.

Where are the risks?
For one thing, if there's really $300 million a year in potential value based on a mere $100 million in refinery upgrade investments, why didn't ConocoPhillips make that sort of upgrade investment itself? A greater-than-200% rate of return like that would seem to be a no-brainer for any smart oil company. Instead, the refinery had been idled and slated to be closed, due in large part to continuing losses driven by the fact that it relies on some of the most expensive grades of crude oil as input.

While Delta will be getting its crude oil from BP (NYS: BP) for the project, that change of supplier doesn't change the refinery's reliance on those high-cost grades of fuel. In other words, even with the investment in facility upgrades, Delta's raw material costs for its refinery will still be on the high end. That's a structural cost disadvantage that won't be going away, no matter what.

For another, refining is a notoriously difficult business in which to consistently do well. Valero Energy (NYS: VLO) is a large independent refiner whose strategy is to focus on low-cost input crude to keep its total costs down. Even with that low-cost strategy, Valero lost money in the most recent quarter, eking out a mere 2.6% gross margin. Why should we believe that Delta, a company with no refining experience, no scale in refining, and high refining input costs, can operate its refinery more cost effectively than Valero?

For yet another, assume for a minute that Delta is successful in its quest to operate the refinery efficiently and turn it into its own private supply of cost-effective jet fuel. Think about that from an economics 101 perspective. By servicing its own demand privately with new capacity brought in from the now idle plant, it'd effectively be increasing the supply of jet fuel available on the market from other refineries.

The refinery capacity that's currently slated for Delta simply becomes available to service the other airlines, whose demand isn't changing. In other words, if this works out for Delta, all the airlines benefit from a tighter crack spread, but only Delta has to cover the purchase, investment, financing, and operating costs of running a refinery. It seems like the best case for Delta is an even better case for competition like United Continental (NYS: UAL) that still gets its fuel the old-fashioned way.

Where's the upside?
Whether you look at it from the perspective of the facility itself, the economics of the refining industry, or the market implications if the plan is successful, there doesn't seem to be a clear win for Delta. Running an airline is an incredibly difficult business where small fortunes are often made by starting with large fortunes. An investment like this with no clear path to a sustainable competitive advantage seems like yet another airline pathway to make a small fortune by starting with a large one.

Take this capital allocation decision and mix it with the airline industry's history of financial challenges leading to bankruptcies, and now looks like the right time to make an underperform CAPScall on Delta. Indeed, I've done just that and put my All-Star rating on the line at Motley Fool CAPS with that call.

At the time this article was published At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article, but his wife owned shares of Valero Energy. Click here to see his holdings and a short bio. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story