By GREGORY J. MILLMAN
A Dow Jones Column
NEW YORK -- Note to investment bankers: start working on
your pitchbook for Delta Air Lines to divest its refinery
operations. Before long, that pitch will have plenty of support
from Delta shareholders.
decided it could minimize jet fuel costs by investing in a
failed refinery, so on April 30 announced the purchase (through
a newly formed, wholly-owned subsidiary called Monroe Energy)
of the Phillips 66 Trainer refinery complex south of
The Commonwealth of Pennsylvania provided $30 million in
assistance, so Delta's out-of-pocket investment to acquire the
refinery is $150 million, and it plans to spend another $100
million to maximize jet fuel production there.
The $250 million that Delta says it is investing is 19% of
its last 12 months earnings (and 29% of 2011's bottom line), so
it's a material number for shareholders.
There are three problems here. First, Delta won't manage the
capital invested in the refinery for optimal return. Second,
even if Delta were to do so, the refinery is one of the least
economical in the US so that its potential returns are low at
best. Third, the refinery will probably require much more
capital than Delta's public presentations suggest.
Once shareholders see the consequences of this deal unfold,
they'll demand that Delta divest the refinery operations and
redeploy the capital in more productive investments - or give
it back to shareholders so they can redeploy it themselves.
Let's take return on capital first. Refiners usually try to
optimize returns by producing more of the more profitable
products and less of the less profitable. In the case of
refiners, this is difficult because crack spreads, the most
important part of their gross margin, are volatile. The crack
spread is the difference between the price of crude and the
price of such refined products as gasoline, jet fuel, diesel,
heating oil, etc.
The product prices vary seasonally and over time, so
refiners try to adjust production accordingly, for example by
making more gasoline during the summer driving season and more
heating oil during the winter.
There are limits to how much production can vary, though,
the most important factor being the crude oil the refinery can
process. Different products boil off of crudes at different
temperatures, and various crudes have various compositions of
those products. Some refineries, such as Trainer, can only
process light, low-sulfur crudes; some can use heavier, cheaper
crudes from Canadian tar sands.
Moreover, some refineries have access to high quality crudes
from the Mid Continent, which are cheap because there are no
pipelines to carry them to world markets, and therefore they
are in superabundant supply. Since the product price is a world
market price, and refineries have access to export markets,
those that can use cheaper crudes enjoy fatter margins and are
more profitable than those who cannot.
Delta's plans to boost jet fuel production to over 30% of
its slate could lock it in to an even more difficult cost
structure, since refining that much jet fuel without
significant new capital investment will mandate the use of
crudes with relatively higher compositions of middle
distillates. The airline's own demand for crudes specifically
in this range could move the price up.
Delta won't try to vary Trainer's production slate in the
same way that other refineries do, and so far it has announced
no plans to make the hefty capital investments necessary to
process cheaper, heavier crudes.
What it has stated, unambiguously and explicitly, is that it
will manage the refinery to maximize jet fuel production. In
fact, Delta will devote a higher proportion - 32% - of
Trainer's production slate to jet fuel than any other refinery
in the US, more than quadruple the jet fuel proportion of other
East Coast refineries.
Delta's planned production slate would only optimize return
on capital if jet fuel always provided a better return than any
other product. But if that were the case, more refineries would
be optimizing their returns on capital by producing a lot more
jet fuel than they do. Delta will not be optimizing returns on
capital, but instead will be optimizing jet fuel availability
for airline operations.
Why is this a problem? Optimizing for refinery returns is
better for shareholders than optimizing for airline returns. US
refiners produced a return on capital of about 25% over the
last 12 months, according to S&P Capital IQ, while US
commercial airlines earned only a 11% return on capital.
(Delta, by the way, produced a 12% return on capital.)
That brings us to the economics of the Trainer refinery. Delta won't improve its
own returns on capital by owning Trainer, notwithstanding CEO
Richard Anderson's statement that Delta can create value "by
capturing the jet crack spread margin that the refiners
The plant will have to refine the entire barrel of oil, and
even under its ambitious targets for jet fuel production, 70%
of a barrel of oil will be refined into non-jet fuel
Delta says it will swap the non-jet fuel production for jet
fuel from its counterparties BP and Phillips 66, according to a
price index. Delta has not revealed any details about the
specifics of the swap, but essentially Delta will be using its
gasoline, diesel and other production as currency to buy jet
fuel from these counterparties.
We have to suppose that prices will approximate the
prevailing market prices, since BP and Phillips 66 are unlikely
to sell jet fuel to Delta for less than they could get from
another customer. (Even if Phillips 66 included a "sweetener"
in its exchange ratio to induce Delta to buy Trainer, it hasn't
been made public, and would probably be temporary.)
So if jet fuel is selling for $135/bbl, and gasoline for
$130/bbl, Delta will probably swap at a ratio of about 1.04 bbl
of gasoline per bbl of jet fuel. This means that Delta will
still be paying the jet fuel crack spread - it will just be
using gasoline or other refined products to make the
And Delta will pay dearly to create this "swap currency" of
refined products. Trainer, originally built in 1925, is one of
the highest-cost refineries in the US. That's why two previous
owners have shut it down rather than make new capital
Technology and geography combine to
make Trainer uneconomical: the technology is not complex enough to
process lower quality crude oils, and the geography prevents
access to cheaper high-quality crudes from the mid-Continent of
the North Amerca. Those crudes are cheap precisely because
there are transportation bottlenecks that prevent them from
When pipelines are built, they will sell at world market
prices. Eventually, shale oil may be available from the
Marcellus and Utica shales, but those regions are richer in gas
than oil. Transportation is also a problem there, as pipelines
have not yet been built to take the newly discovered oil to
Philadelphia. Marathon Oil, for example, has built truck
terminals to haul its Utica shale oil to barges, then to
Kentucky for refining.
coast refineries like Trainer must rely on Brent crude, which
has been running about $116/bbl lately. Add to that cost about
$2.00/bbl to transport the crude to the refinery. Trainer's
production slate would give it about $125/bbl in revenue, for a
gross margin of about $7.0/bbl.
But fixed and variable refinery operating costs take about
$5.2/bbl, leaving a net cash margin of only $1.75/bbl Moreover,
all refineries have to make sustaining capital investments to
address environmental and other issues.
These run from $1.00-2.00/bbl for a refinery on the Trainer
model. So there's no excess return on capital left.
It's easy to see why ConocoPhillips shut Trainer down. But
ConocoPhillips chief financial officer Jeff Sheets made it
explicit in the company's third-quarter earnings call last
year. "The Trainer refinery was not producing net income," he
explained. "The cash generation was also not very strong. We
were at a point where we were having to decide about timing on
turnaround costs and future capital expenditures, which had a
lot to do with the timing of the decision to shut it down in
Finally, Delta shareholders should expect Trainer to be a
capital sink requiring more investment than Delta has indicated
in its public presentations. Delta does seem to have included
in its presentation the "turnaround" investment that
ConocoPhillips was unwilling to make.
Such "turnarounds" are periodically necessary to refurbish
and revamp refineries. Tosco, which re-opened the refinery in
1996 after a shutdown by BP, its previous owner, invested $60
million in a "turnaround". Inflation-adjusted, the $60 million
Tosco spent on a turnaround in 1996 would come to about $89
million today. Add $15 million to $20 million for a new
catalyst that will probably be necessary to support the higher
volumes of jet fuel production planned by Delta, and you have a
capital investment only slightly above the $100 million that
Delta has announced it will be investing in Trainer beyond the
However, refinery experts who spoke to DJBI all pointed to
one missing piece of the picture: working capital. A refinery of Trainer's scale, about
185,000 bpd, would typically require $100 million to $200
million of working capital. Supporting this estimate is the
fact that, after shutting down Trainer, ConocoPhillips told
analysts that its refining margins had benefited from
the liquidation of $180 million in inventory, mainly from
Where is the working capital in Delta's outline of the
Trainer adventure? A spokesman for Delta told DJBI: "We
anticipate that all of our working capital requirements will be
satisfied through payment terms with suppliers."
BP will be sourcing and delivering Delta's crude, and Delta
has not revealed the details of that contract. However, unless
BP has failed to sharpen its pencil on this deal, the payment
terms referenced will surely compensate it for financing
Delta's inventory. So it's reasonable to expect that the
present value of those payment terms will approximate $100
million to $200 million.
Using the $180 million inventory figure from ConocoPhillips
as a rough approximation for the working capital requirements
of Trainer, we can expect working capital will increase Delta's
real investment in Trainer by 72% - over and above the
airline's announced $250 million investment. That's $430
million, half of Delta's 2011 bottom line.
It won't be long before shareholders start asking what they
are getting for that money. The answer won't be
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