May 022012
 

Did Delta just buy a $5 billion asset for $250 million? Or was it just taken for the $250 million?

We wrote a month ago about Delta being rumored to buy a closed down loss making oil refinery in the Philadelphia area.  Although we had no exact data on the claimed benefits to Delta or clear reasons why it might consider such a strange diversification, we were still able to reach a clear conclusion – it would make no sense at all for Delta to buy the refinery.

The rumors have now been proven true, with Delta’s purchase of the Trainer refinery now publicly confirmed, for $180 million (less a $30 million package of assistance from PA state).  Delta will also spend an additional $100 million to enhance the refinery’s ability to get more jet fuel from its refining operations, making a total net cost to Delta of about $250 million, and a total net receipt to ConocoPhillips (the seller) of $180 million.

The usual talking heads (as opposed to talking brains) are ecstatic about Delta’s decision, probably based on uncritical acceptance of Delta’s claim that buying a loss-making refinery will somehow enable the airline to now save $300 million a year.

Some of the other claims in support of Delta’s purchase are technical in nature and require complicated consideration to analyze.  So let’s concentrate on this biggest claim of all – Delta stands to save $300 million a year by buying the refinery.

No Logical Sense

This would only make sense if the refinery was previously making a $300 million a year profit.  But it wasn’t.  It was almost certainly losing money.  Its previous owners – an oil company, not an airline – closed it down because it was unprofitable.

In other words, the refinery was unprofitable because it was selling its products for below cost.

How can a non-oil company with no competencies or synergies in the oil industry magically transform a loss making refinery into a $300 million a year profit center?

Folks – this just isn’t possible.  If there was a way the refinery could have switched from most years losing an uncertain amount of money (but probably in the tens or hundreds of millions of dollars) to making $300 million a year in profit, don’t you think it would have already done so?

This simple piece of logical analysis should be all that is needed to clearly and vividly explain the nonsense in this purchase.

To put it another way, it is as likely that an airline could make an oil refinery profitable as it is than an oil company could make an airline profitable.

No Financial Sense

But enough of logic alone.  Let’s also take a look into the details of the numbers.  Delta says its $250+ million investment will bring it immediate savings of $300 million a year because it won’t have to pay the refinery’s ‘profit margin’ on its jet fuel purchases.  If we are to accept this, we’d have to ignore the fact that the refinery’s ‘profit margin’ is not $300 million a year, but rather has been some substantial loss, consistently for just about every year over the last decade or more.

Nonetheless, and putting that thought to one side, let’s look at the possibility of a $300 million a year saving.

Let’s express this as what the alleged profit margin on the price of each gallon of jet fuel from the Trainer refinery would have to be, which in the last year, after a 28% increase over the year before, averaged Delta $3.06/gallon.

We earlier estimated that, based on its daily capacity of 185,000 gallons of crude, the Trainer refinery is capable of producing about 700,000 gallons of jet fuel a day.  We’d also said it makes no sense that Delta should consume all this, due to the extra costs of tankering the fuel to far away locations where it would be needed (Delta’s minimal operations out of Philadelphia would consume only a tiny fraction of this).  But let’s assume Delta takes the entire production of the refinery.

Let’s also say that the $100 million investment that Delta will make in the refinery will increase the jet fuel share of the output of the refinery by 20%, up to 840,000 gallons a day.  In a year, assuming say 350 days of production, that would be 294 million gallons of jet fuel.

Now if we round that guesstimate figure up to 300 million, there is an interesting coincidence.  The refinery can produce about 300 million gallons of jet fuel and Delta is saying it will save $300 million.  Do you think someone did the same calculation we just did, and decided to pick on a nice round $1/gallon saving.

How realistic is it that there is a $1 profit in the $3.06 per gallon that Delta has been paying for jet fuel?  Which oil company do you know of that reports a 33% profit margin?

Although the oil companies have an undeserved reputation for making unfair profits, the reality is very different.  For the first quarter of 2012, ConocoPhillips itself reported $58.3 billion in gross income and $2.94 billion in net income ($2.6 billion before onetime items).  This is either a 5% or a 4.5% net profit across their entire operations, not a 33% profit as Delta’s calculation implies.

It is difficult to see exactly how much profit ConocoPhillips makes from its refineries.  Its most recent annual report, the 2011 report, lumps together refining and marketing, and refers only to the profit contribution from such activities, without disclosing what sort of gross income and net profits and percentages the activities generate.  It did however say that it had idled the Trainer refinery as part of their policy of divesting low-returning assets, which is a polite way of confirming that Delta didn’t exactly pick out the crown jewel from ConocoPhillips’ holdings.

But there is a clue to what we need.  For 2011, their refining and marketing operation made a net profit of $2.617 billion, and they were selling 3.128 million barrels of product a day.  This means they were making an average of $2.30 on each barrel of product sold.

A barrel of petroleum products is 42 gallons.  So ConocoPhillips, in 2011, was averaging a profit of just under 5.5 cents on each gallon of product it sold.

Now, this is an average of 5.5c, and for sure some products would sell more profitably and some would sell less profitably.  Let’s just say that jet fuel is twice as profitable as gasoline and diesel, which represents the largest component of the refinery’s production (although there’s no real reason to believe this is so).

How can we reconcile these two figures, then :

(a)  On average ConocoPhillips makes in the order of 11c/gallon profit for the jetfuel it sells (and probably less from the Trainer facility)

(b)  Delta expects to save $1.00/gallon by owning the refinery itself – nearly ten times as much

What About the Rest of the Refinery’s Production

We’ve been viewing this narrowly through the lens of the jet fuel component of the Trainer refinery’s production.  This will probably be only about 12% of the refinery’s total production.  We can’t just ignore everything else the refinery produces – or can we?

To explain the irrelevance of the rest of the refinery’s products produced, we circle back to the fact that the refinery has not been making money, and has been so chronically unprofitable that if ConocoPhillips didn’t sell it to Delta, it would have happily just left the plant idle and inoperative.

Furthermore, think about this :  Delta is saying there is $300 million in potential profit from the jet fuel side of the refinery’s operations.  If we force ourselves to accept this as truth for a minute, and if we also accept the refinery as a whole lost money, what does that tell us about everything else the refinery produced and sold?  Yes, rather than presenting as additional profits, everything else was losing huge amounts of money for the refinery.

If this is the case, the losses from the sale of everything else the refinery produces will remain in place the same as before, and Delta will have to fund such losses.  Poof!  There goes its $300 million profit.

So, we suggest two things :

(a)  There’s no way that the jet fuel produced at Trainer represents a $300 million a year profit opportunity for anyone

(b)  Everything else produced by Trainer would seem to represent offsetting losses

The more we look at the overall picture, the worse it seems.

Another Perspective On This Impossibility

Most of the enthusiasm expressed by industry commentators starts off from passively accepting Delta’s claim it will make $300 million a year net profit from its refinery purchase.

These commentators managed to suspend their disbelief at the implication that this would make it the only established industry in the world that has a P/E ratio of 0.83.  To compare this with the real world, the Dow Jones utility index currently has a P/E of 16.7.  In other words, if there is $300 million a year in profit represented by the Trainer facility, its valuation should be more like $5 billion, not $250 million ($180 million purchase, less $30 subsidy, plus $100 investment).

Did Delta really manage to snatch up a $5 billion asset (which, ahem, no-one else seems to want to buy at any price) for only $250 million?

To ask a similar question, would ConocoPhillips have closed this refinery down if it had such a huge profit potential and capital value?  And, if there was anything like this value present, why was no-one else expressing any interest in buying it (or the other closed down refineries alongside it)?

Still More Nonsense

There is another line of specious reasoning though which some commentators have tripped themselves up with.  For example, the first Q/A in this article says

By owning a refinery, Delta is ensuring itself a steady supply of fuel and possibly more control over sudden price swings

That is nonsense.  The largest factor in price swings is the underlying cost of the crude oil.

One more thing.  Let’s look at the reason that ConocoPhillips (and other oil companies) are closing down their refineries around Philadelphia.  This is because they can’t compete with lower priced products (ie jet fuel) that have been refined offshore and shipped in.

A good analogy for this is a retail store buying a shoemaker in the US so as to get more margin on shoe sales, but failing to realize that its problem isn’t the shoemaker it has now bought taking too much of the profit; its real problem are the offshore shoe makers in Asia that are producing shoes for below the cost of the US shoemaker.

All the retailer has done is lock in a suppler and pricing at the above market levels.  They would have been better advised to contract directly with offshore shoemakers or to buy an offshore company.

Why didn’t Delta do the same?  The question is important, but a sensible answer seems impossible to obtain.

Is Delta now seeking to trade in crude oil, or in snake oil?

  12 Responses to “Delta’s Oil Refinery Purchase Now Confirmed, And Even Stranger than Earlier Expected”

  1. Great article, I sometimes wonder if you are in the wrong business..a Wall Street analyst earning millions is more like it ! Michael

  2. I think you are dead on. An airline has no business running a refinery of which only a portion of its output will result in producing jet fuel. This will put the airline in the marketing of other refinery products, which is not its core business. Your analysis was accurate. I was formerly in the oil business.

    It is no doubt the price of the refinery is a bargain. But a refinery run by the airline is a financial disaster waiting to happen. They have no idea the regulatory and environmental issues they will be involved with.

    I think one of the biggest drawbacks is that they have no upstream capability or assets. i.e. They will have to buy all their crude oil at market prices which is the biggest part of the cost of fuel!!

    Bob

  3. My money is on Delta – of all the airlines they are in the best position to make a go of it. I don’t believe they ever indicated it was a $300M profit center either. And finally, when was the last oil refinery built in this country? The environmental-wackos have all but stopped those from being built – many oil refineries are consolidating what they have.

  4. Hi, Richard

    You should have read the article before commenting on it.

    To respond in sequence to your comments :

    1. Delta is the best airline to make a go of a refinery? Why do you say that? What special oil industry skills does Delta have that other airlines don’t? Seems to me they all score zero on that point. Yes, DL is bringing in some industry people, of course, but it started off with no more understanding of the oil industry than any other airline.

    2. Almost every article quotes Delta’s claim about the $300 million profit. Why don’t you believe the articles? How much do you believe Delta will make as profit, and why do you prefer that number to Delta’s own claim? For example, and pulled purely at random, http://money.cnn.com/2012/05/01/news/companies/delta-refinery/index.htm.

    3. The main reason oil refineries are being closed down rather than built is explained in my article. Imported refined petroleum products are often cheaper than domestically produced ones. That’s hardly a shocking or unique situation, is it. Think of just about any other manufactured item; the hollowing out of US industry has been going on for years/decades.

    4. Consolidating what they have : That’s another way of saying ‘closing down chronically unprofitable refineries’, I think. Refineries such as, hmmm, the Trainer refinery which was closed down last year.

    Rather than empty statements, why don’t you share with us exactly how Delta will take a perennially loss making refinery that its previous owners would rather close down and walk away from than continue to operate, and make this into a hugely profitable operation, something neither ConocoPhillips or any other company actually in the refining business believes to be possible.

    • Did read the article and others and no where did it say that Delta was looking at earning a “300 million dollar profit” on this venture. They all reported that Delta is expecting a 300 million dollar savings! Don’t profits come after subtracting expenses from your income? Delta has been a well run airline for years. They won’t be making gasoline, diesel fuel for cars, trucks, etc. They will be making one product – jet fuel! The will not even hire airline people to run a refinery. I believe Delta will prove you wrong and I trust you admit as much 2-3 years in this same article!

      • Hi, Richard

        A $300 million net cost saving is synonymous with a $300 million net profit (before tax). The two are opposite sides of the same coin.

        I’ll certainly admit I’m wrong if that is what happens. I’m all for the lowest cost base possible for the airlines – who knows, perhaps the other commentator’s ridiculous assertion that the $300 million saving would flow through to lower airfares might be right. That would sure be a win-win.

        As for your assertion that the Trainer refinery will be only making jet fuel, that is chemically impossible and utter nonsense.

        With all due respect, where do you get such information from?

  5. Let’s face it! The real winner here is Conoco-Phillips. They are getting rid of a dog. A number of the lesser oil companies have been buying old refineries for 10 cents on the dollar and making a go of it. Looks like they all passed on this one. Historically the refining end of the business has always been the least profitable part of the business. Most of the “big” oil companies have concentrated their investments in the other parts of the business as being more profitable. Mostly off shore oil and gas development.

  6. Well,
    As much as everyone thinks he is an expert on the airline business I think Delta probably did their homework knows more about what is workable for them than any of the self proclaimed experts. I imagine they have looked at it from several angles and have concluded that they can find some savings there. Even if the deal is only 20% as good as promised it is still a good investment for them. I wish them luck.
    I can only comment that as a long time customer I can definitely see the improvements in their product in the past couple of years and especially the international business class. In my opinion they are the best of the big US carriers and are competing well worldwide.

  7. Your analysis leaves out a couple of points:

    1) The refinery will produce other products as well, yes, and those products will be purchased by Phillips 66 and BP in exchange for jet fuel in other areas of the country. It is expected to cover approximately 80% of Delta’s jet fuel needs in the US.

    2) The refinery will not be operated by Delta, but a subsidary (Monroe Energy) that will be comprised of experienced refinery operators.

    The $300 million a year in expected savings Delta expects to obtain will come from the difference in price the carrier is paying in what it terms as “crack spreads”. To argue a $300 million profit and a $300 million savings to the airline are different arguements, in my opinion.

    • Hi, James

      1. Actually, I specifically covered the refinery’s other production. See that big heading ‘What About the Rest of the Refinery’s Production’?

      Yes, the other refinery products will be sold on. That’s hardly a surprising statement or a massive bit of innovative marketing by Delta. And saying they will be exchanged for jet fuel is a statement with zero financial meaning. Presumably what they’ll do is they’ll say ‘the market value of your petrol is this much, the market value of our jet fuel is that much, so we’ll swap on this basis’.

      That’s not exactly unlocking any hidden value in the other refinery products, it is merely selling them at market or slightly worse than market rates.

      2. Monroe Energy is a newly created wholly owned subsidiary of Delta. It is a part of the overall Delta empire. It is playing with semantics to suggest that just because it has a different name it is not a part of Delta. Of course it is just as much Delta as are any of Delta’s other subsidiary companies.

      3. There is a lot of misunderstanding about ‘crack spreads’, because they are in truth hard to exactly understand and match to the underlying reality of who profits from what, when, and how. I deliberately ignored that complex topic in my article because it is a red herring and not essential to appreciating the simple reality that a refinery which lost money when owned by ConocoPhillips will not magically start making money now that Delta (or, if you prefer, Monroe Energy) has purchased it.

      Certainly crack spreads exist, and some aspects of the refining industry are very profitable. But we’re not talking about the industry as a whole, and neither are we talking about the very profitable tiny components thereof. We’re talking about one specific refinery, a refinery which has been steadily losing money – even after allowing for crack spreads – for many years and which no-one else wanted.

      That is the bottom line. Talking about vague crack spreads in general has nothing to do with the gritty reality of the unwanted unprofitable Trainer refinery.

      4. There is no difference – all other things being equal – between a reduction in costs and an increase in profits. The two are identical ways of describing the same thing. Here’s a very simple example of a profit and loss statement.

      Sales $100
      - Cost of Sales $60
      = Gross Profit $40
      - Expenses $30
      = Net Profit $10

      (Sorry about the formatting)

      Now, what happens if you reduce the cost of sales by $15. You now have Net profit = $100 – $45 = $55 for Gross Profit and Net Profit = $55 – $30 = $25.

      What just happened? You reduced your costs by $15. And – look at that. Your profit also increased by $15.

      The two are identical.

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