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Delta Airlines (DAL) Buys an Oil Refinery as the “Ultimate Fuel Hedge”

By: , dated May 15th, 2012

Delta Airlines (DAL: Charts, News), the largest airline in terms of fleet size and passenger traffic, surprised the market this month with the acquisition of a Phillips 66 (PSX: Charts, News) oil refinery in Trainer, Philadelphia. The unusual $150 million acquisition is intended to be the “ultimate” fuel hedge by cutting costs by $300 million annually. Using fuel-based investments as hedges against rising fuel costs is not unusual; Southwestern Airlines’ (LUV: Charts, News) strategy of using paper fuel-based assets is well known and often mimicked across the industry. Buying an actual refinery, however, is an industry first. Delta will be assisted by $30 million in state subsidies for creating jobs for Philadelphia residents.

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Fuel costs have traditionally been the largest weight on airlines’ bottom lines. However, Delta must first spend an additional $100 million to upgrade the refinery. JP Morgan (JPM: Charts, News) is also participating in the deal, using its commodities team to finance the refining process and control crude oil sales and purchases from overseas markets. In exchange, JP Morgan agrees to sell the oil to Delta at a wholesale rate, increasing the airline’s pricing power over its competitors. As part of the deal, JP Morgan will claim all the refining byproducts as its own.

Analysts believe that handing over the complicated inner workings of the refinery over to JP Morgan, which has experience in energy investments, is a shrewd and calculated move that will leave Delta free to reap the benefits more quickly.

Delta’s new refinery will provide the airline with 180,000 barrels of oil per day. Last year, Delta spent $11.9 billion, or 36% of its operating expenses, on 3.9 billion gallons of fuel. Constrained by uniform fuel costs, Delta was unable to competitively price its tickets to fend off competitors such as American Airlines, British Airways or United Continental (UAL: Charts, News). With a refinery on the Eastern seaboard, analysts believe that Delta will be able to undercut its competitors’ pricing power, which should lead to wider margins and higher sales volume.

Some analysts aren’t convinced that Delta’s acquisition will help cut costs. They point out that Trainer plant is an outdated refinery which must rely on the most expensive grades of crude oil as feedstock. Hence the costly upgrades, which Delta has already announced. Other analysts also believe that JP Morgan and Delta will have difficulties staffing the refinery with qualified staff in a timely manner.

The Trainer facility, which had been idle over the past year, once accounted for over a third of the Eastern seaboard’s jet fuel supply. Analysts believe that reopening the plant could actually decrease jet fuel prices across the industry, due to the increased supply, inadvertently aiding Delta’s competitors with lower fuel costs. Other analysts have noted that Delta’s yearly cost reduction of $300 million does not account for annual operating costs at the refinery. Since the fuel is being sold to Delta at wholesale, the refinery is unlikely to generate sufficient profits to match operating costs.

Lastly, some believe that Delta entered the deal as a knee-jerk reaction to the spike in oil prices caused by the nuclear crisis in Iran. If this threat fades, and the slowdown in China and Europe depresses oil prices further, then the refinery could become a liability instead of an asset. The bankruptcy of American Airlines’ parent company AMR Corp. may also have triggered the sudden acquisition.

Fundamentally, Delta stock is undervalued, trading at a mere 4.5 times forward earnings. Its 5-year PEG ratio of 0.28 also suggests that the stock has room to grow. For now, however, Delta remains stagnant in an out-of-favor sector that may fall further as the Greece crisis rears its ugly head once more during the dog days of summer.

Other News About DAL
Delta: When An Airline Buys An Oil Refinery
A look at Delta’s unusual acquisition.
Attack of the zombie refineries
Will other companies follow Delta’s example to hedge against rising fuel prices?
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Wendy’s Lags, Estimates Fall
Wendy’s disappoints the market as it trails its competitors.
KFC targets Africa’s middle class with expansion
Yum Brands expands into Africa.

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Leo Sun Leo Sun is a freelance finance writer and position trader. He focuses on a combination of value and momentum investing, with a strong interest in the trading philosophies of Warren Buffett and Peter Lynch. Leo also has experience writing articles to help small business owners acquire loans and manage their finances. He regularly contributes to the Stock of the Day analysis.

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