BY THOMAS MULHOLLAND
Delta Airlines announced today that it is buying ConocoPhillips’ Trainer, PA refinery in an effort to control fuel costs through vertical integration. The move adds a new dimension to its fuel hedging program. It is a bold risk management move. Now that Delta has taken this step, did it go far enough?
Delta expects the acquisition to add to earnings, allowing Delta to recoup its investment within a year. But operating losses have doomed several refineries in that region to closure. ConocoPhillips idled Trainer months ago and planned to close it by the end of May. In an unrelated announcement, Energy Transfer Partners agreed to buy Sunoco in a $3.5 billion transaction including Sunoco’s Philadelphia refinery. ETP disclosed the refinery will remain open only if it can successfully negotiate a joint venture with the private equity firm Carlyle Group to operate it. Delta and ETP will have to turn the refineries around. Delta must manage Trainer’s operational and crack spread risks better than ConocoPhillips, ranked No. 5 of the world’s top six “super-major” vertically integrated oil companies.
It is not clear the strategy will reduce Delta’s costs or hedge its risks. For vertical integration to work as part of its risk management program, Delta must: 1) reposition Trainer to process domestic crude and 2) develop or control domestic crude supplies. In 1997, American Refining Group (ARG) did just that when it purchased the Bradford, PA refinery from Kendall for $1 plus commitments to invest in upgrades. ARG’s domestic oil wells became the source of crude for Bradford. That was the key to Bradford’s success. To be successful, Delta must use a similarly comprehensive risk management approach.
Poor performance at the start of a vertically integrated supply chain is an insidious problem. Through the acquisition, Delta guaranteed purchases of jet fuel from Trainer. It now must guard against subsidizing its early stage supply chain operations (if they produce poor quality or costly products) by those in later stages. This problem is especially acute because of Trainer’s poor economic condition.
Delta faces another problem. Energy markets in the U.S. are going through major changes. Oversupply of natural gas is forcing drillers to shift to more crude- and liquids-rich plays. Producers and shippers are working to ease crude transportation bottlenecks (see ETP’s announcement regarding possibly converting Trunkline from natural gas to crude). Changes like these could significantly alter spreads that existed at the time of the acquisition in ways that could be costly to Delta.
Risk managers must remain nimble to adapt to changing circumstances. Because it broadened its exposures and committed to invest $350 million over five years, Delta’s acquisition could make that task much more difficult.
At first, it seems logical on the surface to engage assets that will help shore up the risk in the airline fuels marketplace, however, upon further inspection has the asset mitigated your risk? Will this acquired asset function to provide a reliable hedge against immediate and future risk?