Backward or forward integration frequently appears very attractive, but bucks the current trend in business to outsource non-core operations. Was Delta smart or dumb to acquire an oil refinery?
The Trainer refinery was being shut down so the net price of $150 million was low, especially since Pennsylvania threw in $30 million for job creation. Oil refineries, for technical reasons, make a mix of oil products out of crude oil and have some ability to vary that mix. That is why Delta, through subsidiary Monroe Energy LLC, will invest another $100 million to maximize the percent of output going to jet fuel. Delta signed three year agreements with BP and CononoPhillips’ Philips 66 for crude oil and to trade the other refined products for jet fuel from other refineries. Delta announced that the move will supply 80% of the company’s domestic jet fuel needs and save the company $300 million annually.
Critics argue that Delta knows nothing about how to operate an oil refinery and there were good reasons that Phillips 66 was mothballing the facility. On the other hand, many airline industry observers complain that airline industry executives know nothing about how to run airlines either.
Savings of $300 million pale in comparison to Delta’s total jet fuel expense of $11.8 billion in 2011, but look good in relationship to profits of $854 million in 2011, the best year in the last four at Delta.
The airline industry is notorious for poor profits and non-existent ROI while the refinery business is significantly better (RMA net profit = 4.8% for 07-08) although nowhere near the lofty levels of oil exploration and development firms. So while ConocoPhillips sought to improve its 2.0% net profit margin for its refining and marketing segment (2011) by closing less profitable facilities, Delta can help raise its margin from 2.43% in 2011 by acquiring the refinery. Due to tax loss carry-forwards, Delta’s savings of $300 million will flow to the bottom line and would have increased Delta’s profits by 35% if the refinery had been owned in 2011.
Will this move improve Delta’s position against competitors? Not really, two Sunoco owned refineries on the east coast and one in the Virgin Islands are also available so other airlines can copy the move if they want. Delta’s buy should be thought of as part of its hedging operation and guaranteeing its supply of fuel. When oil prices become more volatile, hedging by airlines increases. But hedging is expensive and few airlines have the internal expertise to maximize the effectiveness of hedging operations. The refinery is an attempt to diversify its hedging, not an operational change for Delta.
Remember this is an industry where checked luggage fees are a substantial contributor to net profits. Delta earned $957 million in checked baggage fees in 2010 vs. $595 million in net income after special items. Historically, transporting people in airplanes is unprofitable. They might as well buy refineries to lower costs.