I was reading a trade journal one morning on my way to work and saw an article buried on Page 14 that Delta Air Lines was contemplating buying a refinery.
As a financial analyst, part of my job is to figure out what on Page 14 will be “Page 1” news in a week or two, and this seemed like it could work its way forward.
I thought about the idea of an airline owning a refinery and, in fact, discussed it at some length with a colleague of mine, the analyst responsible for refinery companies, just as I am responsible for airline companies.
We couldn’t decide which business was worse: airlines or refiners. We still can’t decide, but the airlines are trying very hard to focus on return on invested capital as a measure of success.
Initially, I thought of it as Delta owning a refinery; however, now I think of it as another way to source jet fuel. It is no secret that refining capacity in the Northeast is down and jet fuel costs for airlines is up. Jet fuel costs are being affected by the “crack spread,” or refining margin, and the airlines cannot hedge this away. In its acquisition of the refinery, Delta’s plan is to have it max out on jet fuel, so Delta can capture that cost.
Delta currently pays the equivalent of $3.25 a gallon for jet fuel. When it owns the refinery, it will pay the equivalent of $3.06 a gallon, saving about 19 cents a gallon.
This equals approximately $300 million per year based on how much jet fuel Delta uses in its operations, and after the costs of owning the refinery.
As an analyst, I look at the bottom-line impact, which is 33 cents a share, and theoretically should add about $3 to the stock price based on a reasonable earnings multiple. Another way to look at this is the savings more than pays for the refinery ($150 million). Or even, the refinery is approximately the cost of one Boeing 777.
This is an interesting experiment, and, as noted, I don’t think of it as Delta in the refining business; I don’t expect to see this in the numbers. Delta will report a net fuel expense and may have a few cents cost advantage over its peer group that is permanent, in a way hedging is not. Airlines hedge jet fuel, but the hedges eventually roll off.
Delta is in an interesting position in that it is free cash- flow positive and isn’t really getting credit in the market for deleveraging its balance sheet. Indeed, the company has seen annual interest expense decline from $1.6 billion in 2010 to $1 billion in 2012, and yet the difference has been eaten up by higher fuel costs, which are up by more than $2 billion in the past two years.
Fuel costs are still going to be tied to the price of oil, but at least Delta eliminates the middleman and maybe sees an earnings benefit that gets reflected in a higher stock price.
Helane Becker is director at Dahlman Rose & Co.
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