Analysts still sceptical of Delta Air Lines refinery acquisition

This week, Delta Air Lines confirmed rumours that it was purchasing a refinery on the US east coast, a first-of-its-kind transaction. As details of the deal have emerged, some observers have warmed up to the idea that Delta can better manage its fuel price risk by acquiring the Trainer refinery outside of Philadelphia. But analysts warn that it will be challenging to make the arrangement work

"It's slightly more intriguing and understandable than it was a week ago, but they're swapping one risk for another," says Mike Corley, president of Mercatus Energy Advisors, a Houston-based consultancy that advises companies on fuel hedging.

Delta Air Lines said on Monday that it would buy the Trainer refinery for $150 million from Phillips 66, the newly formed refining spin-off of ConocoPhillips, and that it would spend an additional $100 million to upgrade the 185,000 barrel-per-day facility to maximise production of jet fuel. Delta also announced that it had entered a three-year agreement with BP to supply the refinery with crude oil, and that it had entered separate agreements with BP and Phillips 66 to swap the gasoline and other non-jet fuel products from the Trainer facility for jet fuel elsewhere in the country.

Ultimately, the jet fuel that Delta gets from the arrangement will account for 80% of Delta's jet fuel needs in the US, according to the airline. The deal is relatively cheap for Delta, said the airline's chief executive, Richard Anderson, calling it "the equivalent of the list price for a new widebody aircraft".

William Brown, president of WHB Energy Research, was among the analysts whose opinion of the deal improved when further details became clear. "Our first analysis of the deal suggested it might make some sense depending on a number of factors, but as rumours of the details emerged, it struck us as having an even better chance of success since Delta could lay off risk to other participants in the deal," he wrote in a report this week. If Delta's partners in the deal absorb the non-jet fuel output, "Delta could in fact end up saving much money compared to its likely hedging costs which, as we pointed out, have included considerable bank fee and basis risk components," he added.

But for the economics of the deal to make sense, analysts say the refinery will need to find a cheaper source of crude. A major reason behind ConocoPhillips's decision to idle the Trainer facility last year and put it up for sale was that it relied on seaborne crude oil, with prices linked to Brent North Sea crude, as opposed to cheaper oil from the middle of North America, where the boom in shale production has created excessive supply. According to Barclays, US east coast refineries had an average gross margin of $4.80 per barrel in 2011 – which became a loss once operating costs were included – while Midwest refineries enjoyed near-record margins of $22.25/bbl and US Gulf Coast refineries saw margins of just below $19/bbl.

Media reports have suggested that Delta and BP will seek to bring crude oil by rail or barge from places such as the Bakken Shale in North Dakota. But that will be a significant logistical challenge for the refinery's new owners, and it raises the question of why ConocoPhillips didn't attempt the same thing, says Walter Zimmerman, vice-president and chief technical analyst of United-Icap. "There isn't a crude oil pipeline running from the mid-continent to Philadelphia. If there was, ConocoPhillips wouldn't have sold its refinery," he says.

Moreover, analysts note that Delta Air Lines will now be taking on the operational risk of running a refinery, which can be quite substantial. "There are physical as well as financial risks in operating a refinery such as accidents and environmental issues," Brown wrote.