Delta Airlines' Oil Refinery: The Math Doesn't Work

[WorldTraveler]

Except DL didn't say the entire state of the universe was rosy. You are the one that wanted to leave no room for the possibility that anything else could have gone wrong and tried to crucify them for complications way beyond their control.
Others get it.

Apparently, you've never heard a doctor tell you or a family member that the problems they found were worse than expected.
Apparently, you've never accepted that government leaders are telling the truth when they say the economy did respond to the interventions that previously worked.

Welcome to the human race - where life doesn't always go as expected - where people tell the truth as they know it and the healthy ones accept that there really are a lot of things out of there control so they figure out how to adapt and move on despite what they encounter.

DL told the truth as they knew it at the time. It's the way the human race works. It's all most of us expect any one to do.

 

[townpete]

I think people are forgetting that the purpose was to reduce fuel costs, not making a profit via traditional refinery. Fuel costs are a net operating loss. With the refinery there is still an operating loss, just not as much as before.

 

[FWAAA]

I think people are forgetting that the purpose was to reduce fuel costs, not making a profit via traditional refinery. Fuel costs are a net operating loss. With the refinery there is still an operating loss, just not as much as before.

No, that's not correct. Fuel costs are not a "net operating loss." Fuel costs are a cost of doing business, just like labor, airplanes, maintenance, terminal rent, landing fees, insurance, utilities and catering expenses. Net operating losses result when your expenses exceed your revenue.

That said, the refinery must operate at a profit in order for it to benefit DL, as operating at a loss means that its expenses exceed the value of its output. For the fourth quarter, that loss was about $63 million. Along with the purchase price ($150 million) plus the improvements ($100 million), DL now has at least $313 million wrapped up in Trainer.

On a somewhat related note, an interesting article appeared yesterday:

Gasoline in New York Harbor weakened versus futures on speculation that Delta Air Lines Inc. (DAL) will restart a fluid catalytic cracker in Pennsylvania this week.

The catalytic cracker, which was initially expected to be offline for 10 days to 14 days, has been shut since December to address issues with a slurry oil circuit, said Trebor Banstetter, a spokesman for Delta in Atlanta. Slurry oil is a byproduct of a catalytic cracker, heavy gasoil is broken down into lighter products. Slurry can be used as feedstock for cokers and hydrocrackers and blended into residual fuel.

http://www.bloomberg.com/news/2013-02-05/new-york-gasoline-weakens-on-restart-of-delta-trainer-fcc.html?cmpid=yhoo

 

[WorldTraveler]

It isn't at all certain that profit for the refinery will mean the same thing for C-P as an oil company as it will for DL.
First, you perhaps can comment but DL is the sole user of jet fuel from the refinery. There have been suggestions - and I am not certain if they are correct or not - that DL will avoid some fuel taxes they would have otherwise paid on purchased jet fuel by using products from its own refinery. There are abundant examples where vertical integration of production works... I don't know the oil industry well enough to know where it makes sense, but I still bristle at the notion that DL - or any other company that would have made just a purchase - didn't investigate those issues.
In fact, the refinery only has to break even or lose less than what DL would pay in higher costs in order for the whole project to be profitable.

Second, the primary reason why DL bought the refinery is because the supply of jet fuel in the US continues to decline because the US is using less and less gasoline. Jet fuel is a byproduct of most refineries... it is the primary intent of this refinery. If refineries in the US continue to close or if they do not produce as high of a percentage of jet fuel as Trainer on smaller total supplies, the crack fuel - which reflects the value of jet fuel as a percent of total production - will continue to rise. No other oil company has said that they intend to focus production on jet fuel - which completely skews the value

Third, the byproducts that DL doesn't use are based on trades; the NE has had above average gasoline costs compared to the rest of the US, a significant part of which is due to the reduced supply of refining capacity in the US. Trainer has the potential to create better trades for jet fuel because of its location in the NE than would occur if it were in other parts of the US.

Fourth, DL's refinery losses were offset by hedging gains. I still don't know if DL will quit hedging when the refinery is totally up and running but hedging gains actually reduced DL's fuel losses by 20%. In fact, part of the motivation why DL wants the refinery is to eliminate about $1B in cash that is tied up continually to buy jet fuel. The interest on that $1B is easily $50M per year and probably more.

Fifth, DL never said that the refinery would be profitable in the first quarter of operation; they did expect it to be profitable within the first year and they have not changed that forecast despite what happened with Sandy. It is worth noting that despite having the refinery loss and having a large operation in the NE that was impacted, DL still managed to generate better financials than any other airline w/ a heavy NE presence.
just as with DL's network, they have the financial resources to try some things and to invest in strategies that don't pay off right away. DL doesn't have to report immediate positive results for the refinery. But if they are right that the refinery ultimately results in the benefits promised, DL could end up with a 2-3% cost advantage just because of the refinery. Right now, no other airline has the financial resources to take such a risk.

I'm still comfortable to believe that DL knows a whole lot more than the online analysts who torpedoed the idea when it began to leak out... and given that DL execs continue to affirm that it was the right financial decision, I think they know full well the repercussions if they cannot deliver.

 

[WorldTraveler]

one more thought....
there were an analyst or two who recognized when the Trainer deal was announced that the airline industry may be one of the few that is lower margin than the refining industry. Oil companies want out of the refining business because it is a drag on much higher margin operations for them. But for an airline, the risk of running a refinery looks relatively tame compared to some of the risks airlines regularly face.

And, again, even if Trainer's 4Q loss is annualized (ie if DL lost the same amount of money for the whole year), the loss still amounts to a fraction of DL's total costs. DL's losses due to Trainer still did not stop DL from reporting a pretty impressive quarter compared to its peers - and DL's fuel costs which were indeed higher than AA's - did not prevent DL from having one of the best CASM's among network carriers. Industry segment low costs - long a DL philosophy - combined with the ability to generate revenues as good as or better than their network airline peers has the potential to change the way the airline industry in the US operates. For years, DL succeeded at keeping costs down but couldn't get revenues up. Now they are succeeded at both - and the refinery presents a decent possibility they could push costs even lower while pushing revenues even higher as the concentrate their position in the NE.
That is probably why Richard Anderson is more and more comfortable saying that the distance between DL and its competitors will only grow in the years ahead.

 

[FWAAA]

In contrast to the SeekingAlpha article linked in the OP, here's a contrary view by a writer for Motley Fool:

http://www.fool.com/investing/general/2013/02/08/3-big-myths-about-deltas-refinery.aspx

I don't think it matters for purposes of this discussion, but before someone else points it out, the writer does own stock in Delta.

 

[jimntx]

The petroleum industry has changed over the past few years. When I was at Texaco, being a vertically-integrated oil company was like a license to print money. I once did a computer project for the Producing Accounting department, and was told not to spend too much time on it because "it's only the entry point to the company books for about $120 million/month." Only $120 million a month????

The underlying reason why the oil companies want out of the refining business is that most of their refining plants are an environmental nightmare that, sooner or later, someone is going to expect them to clean up. Does anyone think that it is just a coincidence that the Beaumont-Port Arthur area of Texas which has the highest concentration of refinery operations in the U.S. also has the highest incidence of cancer in the U.S.?

 

[WorldTraveler]

Jim,
As someone who (also) grew up in Houston, I know full well how un human friendly refineries are. There is a reason why the upper TX coast and LA have very few decent tourist areas and why FL and AL want as little industry along their coasts as possible – at least the polluting kind.

But the real question is whether DL knew about the environmental issues behind Trainer before buying and made sure they are are not going to be on the hook for them and I would strongly bet they have protected themselves. Supposedly part of the reason why NW shut down its ATL maintenance facility and DL wants nothing to do w/ it is because of serious environmental issues that would have to be addressed. I don’t know but environmental concerns for companies have been around long enough that is hard to think they weren’t addressed in the acquisition. And at times, just like w/ the NW ATL maintenance base, problems don’t have to be fully corrected as long as the facility is not used and there is no threat to the environment just from allowing the facility to sit there.

Your other point completely confirms one of the issues which I and others have said all along re: the refinery and which the article FWA linked confirms: the economics of Trainer for DL are completely different than they were for an oil company. A couple hundred million dollars – which may take a lot of risk to obtain – is not worth it for an oil company but is very much worth it for an airline.

The article also notes that hedging doesn’t solve the problem because the problem DL sought to address is the crack spread and the only way to address it is to produce more jet fuel relative to other refined products in a region of the country where refining capacity continues to decline. Add in that hedges tie up cash that could be used for other purposes including paying down debt and what DL is attempting to do financially is very different from what oil companies are interested in doing.

The third point of the article confirms that the refinery was in fact damaged as a result of having to shut down after Sandy because of the inability to distribute products. DL made a point before Sandy that they intended to keep the refinery running because it was in startup phase even though other refineries in the NE were shutting down. No one else has suggested it – and I can only ask the question – if the reason Ruggles, former DL exec who was recruited to manage DL’s fuel operations including the refinery – was so quickly dismissed was because he made the decision to keep the refinery operating against conventional wisdom that it was not safe to do so in that type of forecast storm. Several people have published articles suggesting that Ruggles was fired because DL’s fuel strategy isn’t working even though Anderson has consistently said the refinery buy still makes sense.

Is it possible that Ruggles, a finance/exec type person, overruled others who had more operational experience, including perhaps some of the operational people at Trainer who DL specifically recruited because of their refinery experience, only to have the refinery suffer damage that was far more costly than if DL had shut the refinery down slowly and had to bear the extra cost of restarting it again after the storm?

In the interest of keeping a good discussion going and not leaving me looking like I have to get the last word in (which I don’t), feel free to contribute……

 

[jimntx]

Shutting down a refinery safely is a slow, expensive process. Bringing it back on line is also a slow, and even more expensive process. Refineries, like steel mills, do best when they can operate 24/7/365. Along the Gulf Coast, however, they have had long experience to know that shutting it down in the face of a hurricane is the more prudent and least expensive option in the long run.

And, in the economics of the oil bidness, the advisability of the Trainer purchase will not be known for sure for several years. One hurrricane or one snow storm is not going to stamp final on that discussion--unless, of course, the hurricane wiped the refinery off the map. Any conversation at this point is just as much speculation as how well the AA/US merger is going to work, or even that the merger is going to take place.

 

[700UW]

[size="-1"]Trainer loses an additional $22 million.[/size]

 

[metopower]

Just think what the profits would have been. Time will tell. E for effort and thinking outside the box.

 

[jimntx]

Trainer loses an additional $22 million.

For what? The quarter? The month? The day? Given the size of DL overall, unless that loss is for yesterday only, $22 million is not even pocket change. It's a lot of money to you and me, but when it represents less than 1% of the overall DL financial picture, it probably doesn't matter or "prove" anything.

 

[700UW]

First quarter

 

[LD3]

Time will tell. E for effort and thinking outside the box.

That's what some of the financial boys are saying...

 

[southwind]

Trainer loses an additional $22 million.

Can you show me just one post, where your "NOT" critical of the company that employee's you?