Delta Deal a Lesson for Integrated Oils
While the deal has received mixed reviews in the market, the fact is that integrated oils are looking to rationalize their output...and this may be the wave of the future, writes Peter Staas of The Energy Strategist.
Delta Air Lines (DAL), the world’s second-largest air carrier, raised eyebrows on April 30, when management confirmed speculation and announced that the airline had inked a deal to purchase the Philadelphia-area Trainer refinery from Phillips 66 (PSX).
The landmark deal marks the first time an airline has acquired a refinery. Delta will pay $180 million for the downstream facility and associated pipeline and transportation assets, while Pennsylvania will kick in $30 million in assistance to ensure that the idled facility isn’t permanently closed. An additional $100 million in capital expenditures will enable the airline to maximize the refinery’s jet fuel production.
In a press release, Delta CEO Richard Anderson highlighted the rationale behind the acquisition: “This modest investment, the equivalent of the list price of a new wide-body aircraft, will allow Delta to reduce its fuel expense by $300 million annually and ensure jet fuel availability in the Northeast.”
Quick-witted critics have panned the deal as a marriage between two money-losing concerns. Aggressive hedging hasn’t prevented rising fuel costs, which consumed about 35% of the major North American airlines’ 2011 revenue, from being a constant threat to the industry’s profit margins.
Meanwhile, integrated oil companies have sought to rationalize their downstream (i.e., refining and marketing) operations, divesting less-profitable refineries in the US in favor of facilities in the Middle East and Asian emerging markets, two regions that offer superior margins and growth prospects.
- BP (BP) in early 2011 announced plans to roughly halve its US refining capacity, and has placed its Texas City and Carson, Calif. facilities on the sales block. The company expects to complete these sales by the end of 2012, reducing its US refinery operations by 50%.
- Chevron Corp (CVX) is in the midst of a three-year plan to rationalize its downstream operations. Last year, Chevron announced the sale of its Pembroke refinery and associated marketing assets in the UK and Ireland.
- ConocoPhillips (COP) spun off its refinery and marketing assets as Phillips 66. The company plans to reduce its downstream exposure to 15 to 20% of overall revenue from 20 to 25% of revenue.
- Marathon Oil Corp (MRO) in 2011 spun off its downstream operations as Marathon Petroleum Corp (MPC).
- Royal Dutch Shell (RDS.B) has been restructuring its downstream operations since 2009 to divest smaller facilities and focus on Asia-Pacific and other markets with high growth potential. By 2012, management expects to reduce its downstream portfolio by a further 700,000 barrels per day.
- Total (TOT) plans to lower its gasoline output by 60%, and has placed its UK Lindsey refinery, which accounts for 20% of its overall capacity, on the sales block.
Independent US refiners have also moved to reduce capacity, selling or closing smaller (and therefore less-efficient) plants on the East Coast—a highly competitive region that lacks access to cheaper, domestically produced crude oil from the Bakken Shale and other unconventional plays. The majority of oil refined at East Coast facilities arrives via tanker from Nigeria, Angola, Algeria, the North Sea, and other international locations.
In light of these challenges, Valero Energy Corp (VLO), the largest US independent, last year sold its Delaware City and Paulsboro, NJ refineries. Meanwhile, Sunoco (SUN) in 2009 shuttered its Eagle Point refinery in Westville, NJ.
The latter company last year moved to exit its legacy refining operations on the East Coast, shuttering a Pennsylvania facility capable of processing 175,000 barrels per day and entering negotiations to shift operation of another refinery in Philadelphia to the Carlyle Group. If this joint venture falls through, Sunoco would idle this facility by August 2012.
At first blush, the factors motivating Delta's purchase of the Trainer refinery makes a great deal of strategic sense for both sides involved. Phillips 66 monetizes a money-losing asset, while the air carrier’s acquisition of the refinery potentially lowers the company’s fuel expense by $300 million and could provide 80% of the company’s jet fuel needs. (In 2011, Delta spent $11.8 billion on 3.86 billion gallons of jet fuel.)
In addition to obtaining the jet fuel produced at Trainer, the air carrier inked three-year deals with BP and Phillips 66 to exchange gasoline and other refined products processed at the refinery.
Equally important, the acquisition prevents the planned closure of the Trainer refinery, a move that would have reduced the supply of jet fuel on the East Coast by more than 20%. With a substantial presence at LaGuardia Airport in New York, and plans to expand its facilities at JFK, Delta fuel costs could have ballooned further if Phillips 66 had shuttered the refinery.
Although reduced refining capacity on the East Coast should help bolster margins at the remaining facilities, the acquisition still exposes Delta to feedstock costs. To address this challenge, management highlighted the potential to transport cost-advantaged crude oil from the Midcontinent region via train and barge.
Much of the scuttlebutt around this deal has focused on whether the transaction makes Delta a more attractive investment. While shares of US Airways (LCC) can serve as a useful hedge against lower oil prices, investors should steer clear of domestic airline stocks outside of this special situation.
That being said, Delta's acquisition of the Trainer refinery highlights two investable trends that we track. First, the deal serves as a reminder that the dramatic increase in US oil and gas output from the nation’s shale fields is reconfiguring the energy landscape, and leading to unforeseen price imbalances as midstream operators bring new takeaway capacity onstream.
At the same time, Delta's unconventional approach to addressing rising fuel costs underscores the challenge of managing these expenses—a trend on which World Fuel Services (INT) seeks to capitalize. The company isn’t involved in oil and natural gas production; rather, the company serves as a middleman to customers looking to reduce fuel costs.
World Fuel Services purchase aviation and marine fuels in bulk, passing on a portion of the savings to its global customer base. The firm’s global energy distribution network also shields its clients from the expense associated with building and maintaining an in-house energy logistics solution.
As a middleman, the outfit earns a spread between the price it pays for buying fuel in bulk and the price it charges customers for fuel and ancillary logistical services. In general, rising or falling energy prices don’t have a significant impact on the company’s margins, as these price fluctuations are reflected in the rates charged to customers. However, extreme shifts in energy prices can stimulate or destroy demand, which would affect the company’s business.
Volatile oil prices make it tougher for firms in energy-intensive businesses to manage fuel-related expenses. In this environment, World Fuel Services’ promise of consistent fuel supplies and cost savings is an easy sell.