Wednesday, May 2, 2012

Why Delta's Foray into the Crude Refining Business is a BAD Move?

When my mentor/guide and company president Sanjay Poonen threw this open challenge on Twitter:

For all u MBAs, what do u think of Delta buying an oil refinery for $150M (formerly $1B) for top-grade jet fuel. Would Michael Porter frown?

how could I have passed on this challenge PLUS I have been lately descending deep into the technology roots (most of my blogs are technical with lots of code snippets for all intentional purposes - AllThingsR.)  So I decided to spend some time sleuthing and analyzing hard facts before replying to @spoonen, and (may be) counter @gkm1 (George Mathew's) arguments.  This way I get back into analyzing business topics for some time.  (After all, A in MBA stands for analysis right? Masters in Business Analytics?)

The original news on WSJ covering Delta decision to buy a refinery from ConocoPhillips is here.

I spent quite sometime researching so I can educate myself on this deal.  I started with a prior belief that this is a BAD deal.  After all, the crude refining business is a boom and bust business, has razor thin margins and is notoriously competitive.  Here is a quote from Bloomberg supporting my argument: "Refiners in the northeastern U.S. are struggling to turn a profit because of the narrow margin between the cost of imported crude and fuel prices." (Source: Bloomberg)

Moreover, not a single new refinery has sprung up in the US for at least 35 years (Source) because no one wants to invest in this business.  In addition, ConocoPhillips, had idled this refinery for few months now and Sunoco, another refiner in that area, is in the process of shutting down two more refineries in that region. (Source: Bloomberg)  "Sunoco...said its refining businesses has been losing $1 million dollars a day for three years running." (Source)

So why is Delta buying this refinery? Vertical integration, fuel hedging, cost-savings, political, EPS improvements etc?  Actually all of the above.

Delta's planes burned 3.9B gallons of jet fuel last year.  At an avg. 2011 price of $2.86 per gallon, Delta spent $11.8B, which is 40% of its operating expenses. (Source: NYTimes)  If the cost of jet fuel was 40% of your company's operating expense, you will also be thinking about taking such dramatic decisions but may not execute on it if it is outside your realm, but Delta did.

Delta will pay $150M in cash (it has $3B in cash on its balance sheet, so there is no liquidity issue) and will invest another $100M in retooling this refinery.  Also you should note that PA government is chipping in with additional $30M (Thank you tax payers!).  Retooling is required for reason self-evident in this table (Mainly to crank-up the jet-fuel production):

Now, looking at this table why would anyone believe that Delta can earn $300M every year from this. Also remember, Delta is not bringing down its fuel cost from ~$12B by a whole lot, it is merely trying to save few cents on the dollar. A little bit of shift in the numbers above and Delta will be in red trouble.

Delta said that this is a good deal for the investors, really?  Valero had margins of less than 3% in its last quarter and it is a pure play refinery company. Can Delta beat Valero on margins?  I have my serious doubts.  This could be a gain but just for the Delta's management as it attempts to boost EPS in the near-term.

Also, can you believe that Delta can really retool the refinery and produce more jet-fuel than it is possible? The bio-chemistry doesn't support it.  From one barrel of crude, only 19.5 gallons of gasoline and 4.1 gallons of  jet-fuel can be produced.  How is Delta going to produce more jet-fuel per barrel of crude?

Also, FYI, this refinery can only process light sweet crude (with low sulfur) not that heavy Saudi oil that has high sulfur and is gaining more prominence due to global oil issues. (Source: ConocoPhillips)

Net net, this is a bad move, Delta will burn itself and get out in a year or two.  And when they sell, it will be a fire, sale since many other refineries in that area are already struggling to make a profit as I mentioned above. Delta's thinking that future of refineries is brighter is quite puzzling for me.

Happy Analyzing!


  1. Thank you for the info. It sounds pretty user friendly. I guess I’ll pick one up for fun. thank u.

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