Tuesday, May 1, 2012

Delta refinery may mean competitive advantage

In a move that is the first of its kind for an airline, Atlanta-based Delta Air Lines is buying its own refinery in an effort to control fuel costs. Along with labor and aircraft, jet fuel is one the highest cost factors for airlines. High fuel costs over the past few months have put pressure on airline profits and led to reduced schedules and higher fares.

The refinery purchased by Delta is outside Philadelphia and was previously owned by Phillips 66 according to the Atlanta Business Chronicle. A subsidiary of Delta, Monroe Energy LLC, will pay $150 million for the plant and then spend another $100 million for retooling to maximize production of jet fuel. Delta expects production to start in the third quarter of 2012 and forecasts a savings of $100 million this year and $300 million per year thereafter. This means that the investment could pay for itself in less than two years. According to the Wall St. Journal, the deal will supply 80 percent of Delta’s fuel needs in the United States. The refinery had been slated to close if no buyer was found.

The purchase of the refinery is no panacea for fuel costs. A major factor in the cost of fuel is the cost of crude oil. This price is largely fixed by OPEC and varies with changes in demand, interruptions in supply, and international tensions. Delta will still have to purchase oil at market prices to refine. The Wall St. Journal notes that Delta has contracted with BP to provide oil for the refinery for three years.

The company may also find problems with distribution of the jet fuel once it is produced since Delta needs fuel at airports around the country. If the fuel is produced in Philadelphia, it must be transported to where the airplanes are, notably to Delta’s hubs in Atlanta, New York, Cincinnati, Minneapolis, Detroit, Memphis and Salt Lake City.

A partial solution to this problem lies in Delta’s deal with BP. When oil is refined, it produces a variety of fuels, not one specific type. Even though Delta is primarily interested in jet fuel, its refinery will also produce other fuels such as gasoline. The Wall St. Journal notes that Delta has agreed to trade these by-products to BP in exchange for jet fuel at other locations. This eliminates the need to transport at least a portion of the jet fuel across the country.

The purchase makes sense from a standpoint of controlling costs, but there are risks as well. Delta has no experience in the oil industry. Running a refinery is radically different from running an airline. However, as noted in the Wall St. Journal, Delta spent $11.7 billion on fuel in 2011. The $150 million purchase represents less than two percent of that total. Given the estimated savings of $300 million per year, the risk is an attractive one.

Cheaper jet fuel may change the economics of many routes that Delta flies. Smaller destinations may become more profitable under the new cost structure. Destinations that saw flights reduced or eliminated as fuel prices rose may see a return of Delta service. Delta’s competitive advantage in fuel costs may translate to lower fares on some routes.

If the move works, other airlines are likely to follow suit in purchasing their own refineries. Delta might even consider additional purchases in other parts of the world given the airline’s role as a major international carrier. Fuel costs are even more expensive in other countries due to higher taxes and labor costs so the potential savings could be even more attractive.

An additional factor for consumers is the question of the impact of the conversion of the Philadelphia refinery on gasoline prices. In the past few months, refinery closures have caused increases in the price of gasoline, sending the price at the pump near its 2008 highs. As the Philadelphia facility retools to produce more jet fuel, it will necessarily produce less gasoline. This may lead to an increase in the price of gas for drivers.


Read this article on Examiner.com:


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