Delta Airlines to Buy
an Oil Refinery???
A very puzzling possibility with no
apparent justification or benefit
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Oil refineries are
unsightly and unprofitable. Why would an airline want
to saddle itself with another loss making venture? |
No, it isn't a late April Fools
Day Joke. Two different sources, dated April 4 and 5, both
report that Delta Airlines might be buying a currently closed
and definitely unprofitable oil refinery not far from
Philadelphia.
Why would an airline do something
like this? Some obvious answers leap to mind, but read on
below to find out the invalid aspects of such answers.
There seems no good reason at all
for Delta to enter the oil business. Which probably makes it
a sure thing that this is exactly what the airline will do.
UPDATE MAY 2012
When this article was first written in March, we were responding
only to mere rumors about Delta possibly buying this refinery.
Now, in May, the rumors have been confirmed. Delta is buying
the refinery. By all means, please still read the article
below, which can now be tested by the reality of what subsequently
happened. We stand by all we said.
Please also click on to read our subsequent
commentary and analysis on the specifics of Delta's justification
for buying the Trainer refinery.
Corporate Empire Building - Out of Fashion
Don't get me wrong. I'm all in favor of diversification;
indeed my own career and experience is a crazy example of
diversification every which way.
But note the use of the word 'crazy'. Some types of
diversification make sense, and others do not.
There was a
time when the business ethos was very much focused on building up
huge multi-national conglomerates comprising a broad mix of
diversified interests and activities - perhaps the rationale was
that doing so would spread the risk of the overall holding company
over different industries, different companies, and different
countries.
Any one company, any one industry, any one country could have
major economic problems but the conglomerate as a whole would be
only slightly affected.
(Another rationale was that businesses could borrow cheap money
and were keen to invest cheap money any which way they could.)
Those times - the 1960s and the 1970s - seem to have now been
replaced by the new business paradigm of focusing on one's core
business, and rather than growing mindlessly and without limit, of
'right sizing' a business at some ideal size (whatever that may
vaguely perceived to be). The huge multi-national
conglomerates of several decades ago have evolved and downsized
(do you remember ITT, for example?).
This occurred in the airline industry too - most notably (and most
recently) with United growing to own Hertz, Hilton and Westin, and
even renaming itself as Allegis before selling these other
businesses off and returning, suitably chastened, to its airline routes.
The airlines have of course become ardent practitioners of right
sizing. They happily cut services and reduce their schedules
any which way they can.
They're also familiar with the
concept of outsourcing aspects of their business - ranging from
code sharing flights where they don't do anything at all, to
outsourcing catering or maintenance or call centers or airport
services or just about any other part of their operation (although
they've yet to outsource their senior executives).
Delta's Proposal to Buy an Oil Refinery - Why?
So, with this as background, how can we now understand the
persuasive rumors that
Delta is looking at buying an oil refinery? See also
this
NY Times article which quotes 'a person familiar with the
deal'.
Let's look at this concept first from possible reasons why it
might be a good idea. Fuel and labor are any airline's two
biggest costs, and anything an airline can do to control or reduce
these critical cost elements surely makes sense, right?
And if the refinery can 'cut out the middle man' and simply sell
all its product to one in-house customer, that makes things much
more efficient for the refinery too, right?
Well, the first of these rhetorical questions - that controlling
costs is a good thing - is correct, but we're going to have to
think some more about whether owning one's own refinery actually
would reduce the cost of the jet fuel Delta burns. As for
the second - direct selling all one's product also seems like a
good thing, but....
How Much of the Refinery's Output Would Delta Consume?
Indeed, this second question is the easier matter to look at
first.
The thing is that when a refinery 'refines' a barrel of crude oil,
it doesn't only get jet fuel. It gets a broad mix of
different petro-chemicals, and while the refinery can slightly
alter the percentage of each different type of product it gets, it
can only modestly change the mix of products, and even then,
changing the mix of products may require massively costly capital
investments into new refining equipment.
Here's a chart showing the typical mix of products created from
crude oil.
As you can see, only a very small percentage of each barrel of oil
ends up as jet fuel (about 9%), and no matter what Delta might do
if it ends up owning its own refinery, it will never be able to
substantially change this small percentage.
So the suggestion that there are any efficiencies from the
refinery perspective by having a single customer for all their
products is clearly inapplicable. Whether the concept is
true or not, the reality is that maybe Delta would take all
its jet fuel, but that leaves over 90% of the refinery's output
still needing to be sold through normal channels.
Refinery Location and Convenience for Delta
Now let's think about the next
issue. The refinery is located in Trainer, PA, which is
conveniently close to Philadelphia airport (little more than 10
miles southwest and right off I-95). It can process 185,000
barrels of oil a day, which would provide about 700,000 gallons of
jet fuel a day.
But the PHL airport isn't a
major Delta hub. Although Delta consumes about 10 million
gallons of jet fuel (worldwide) every day, it is unlikely that it could use
the full capacity of the Trainer refinery (which represents almost
7% of its worldwide consumption) for its PHL operations
only, even if every plane it flew in and out of PHL landed perilously
empty and then filled its tanks right to the top before taking off
again.
Neither are nearby airports
such as Baltimore or Newark major Delta hubs either. You
have to go all the way to JFK, 125 miles away, to find a
reasonably substantial sized Delta operation.
The best location for a
refinery, for Delta, might be somewhere close to Atlanta airport,
or one of its other major hubs, where it could readily consume all
the jet fuel produced by the refinery.
But even that isn't as simple
as it seems. Choosing a location based on convenience for
one client that would buy only 9% of the finished product makes no
sense at all. What about the other 91% of clients - and
also, what about the sources, types and costs of crude oil -
something that also varies to a great extent across the country.
Tankering Fuel to Where it Can be
Used
Which leads to the next issue.
There are regional variations in the cost of jet fuel, based on a
number of complex factors such as the availability of crude oil,
the type of crude oil, the location of refineries, and of course,
supply and demand.
Airlines manage their fuel
purchases very carefully, and will sometimes 'tanker' fuel by way
of deliberately filling a plane's tanks more than is necessary for
the next flight, so as to have some less expensive fuel in the
plane for the next journey it then makes on somewhere else.
But it isn't quite as simple
as that - an airplane burns 3%, every hour, of the weight of everything it is
carrying in the form of extra jet fuel consumed to fly that
weight, so the 'tankering' of fuel has an appreciable cost penalty associated
with it.
It may also have additional
hidden costs - flying extra fuel might limit the amount of revenue
earning cargo the flight can carry.
The best case scenario - for
Delta - would be if it was able to get such a huge cost saving
from having its own refinery as to justify tankering the fuel from
PHL and secondarily from BWI, LGA and JFK so as to be able to use
the entire jet fuel production from the Trainer refinery (okay, so
that still leaves Delta with the challenge of needing to sell the
other 91% or so of products created by the refinery, but at least
it now has the 9% of jet fuel taken care of).
Of course, even this is not as
easy as it seems. How does the jet fuel (and everything
else) get from the Trainer refinery to anywhere else? Will
Delta now have to establish a fleet of tanker trucks? Or
will it pay a third party to transport the fuel for it, and of
course, paying them an extra 'profit' amount as well.
Let's next examine a major
underlying assumption - that there's a substantial profit slice in
the selling price of jet fuel that refineries get to keep for
themselves.
Refineries Are Not Automatically
Profitable
Now for the next 'gotcha'
point. Sure, we all perceive the oil industry as making
enormous and outrageous profits, right? We read about major
oil companies making billions of dollars a year in profit, and so
it is understandable that any struggling airline would love a
chance to get a slice of these profits.
But. First, the 'oil
industry' profits are not at all outrageous when viewed as a
percentage of gross revenue or capital employed. And
secondly, the term 'oil industry' covers a lot of different
elements - exploration, drilling, distributing, refining,
marketing and retailing.
The perhaps surprising truth
is that refineries are not very profitable at all (at least in the
US). As
followers of the airline industry, we're familiar with the chronic
unprofitability of airlines, but did you know that refineries are
little better?
With the brief exception of
the period 2004 - 2008, refining has been an across-the-board
unprofitable business, which is the largest reason why there have
been no new refineries built in the US for decades.
The Trainer Refinery is So
Unprofitable it is Closed
Indeed, the refinery
that Delta is looking at buying, currently owned by
ConocoPhillips, has been closed and not working at all since last
September, apparently due to its inability to operate profitably. So too
has another nearby refinery, owned by Sunoco and located almost
immediately next to the Trainer refinery (at Marcus Hook, PA).
It seems significant that, apart from Delta, no-one else is interested in buying the refinery.
In simple terms, the problem
with the Trainer refinery is that it is set up to use the 'wrong'
sort of crude oil.
Crude oil is not a generic
product that is the same anywhere, any more than free flowing
mineral water or any other raw material is identical everywhere.
It has a different mix of components and contaminants, and has
different properties, and of course, comes from different places
with different transportation costs.
The type of crude that the
Trainer refinery was built to work with is a 'light sweet
Atlantic' type of crude, and at present that is the most expensive
type of crude oil out there.
So there is no profit that
Delta is likely to extract from the refinery. Quite the
opposite, it seems that in its past and now failed/discontinued
efforts to sell its refined products on the open market, the
refinery was generating a loss. Translation for Delta :
Every gallon of jet fuel you purchased from the Trainer refinery
in the past had a built in price subsidy - the refinery was
selling it to you for below their cost.
In such a case, why on earth
would Delta now want to buy the refinery? What possible benefit
could there be?
The Lack of Any Economy of Scale
There is another issue/problem as
well if Delta were to buy a refinery - one of 'economy of scale'.
To put this into airline
terms, imagine a startup airline, that starts with one plane, and
a requirement that this plane be based at a single, secondary
airport. Whatever the plane does during the day, it has to
be back at the home airport that night, and it can't fly more than
(say) 1000 miles away from the airport during its daily flight
operations.
If the market for this startup
airline's services grows, it can't take advantage of it, because
it only has one plane. If the market changes or shrinks, it
can't respond, because it only has one plane and one base, and it
can't swap to a smaller plane or shift the plane to another
location.
That is hardly a winning
formula for a new airline, is it.
This is analogous to what Delta would be
doing with one refinery. The major oil companies have
multiple refineries, and more refining is done off shore with
finished product being shipped to the US rather than raw crude.
But Delta would have one only refinery, in one only location.
Unlike its competitors, it would be unable to respond to regional
variations and cyclical shifts in either supply or demand.
Not a Core Competency? No
Synergy?
The key issue these days for
corporations considering adding new elements to their operation is
whether it makes use of or leverages a core competency of the
existing operation. Does the new operation reinforce and
augment the existing operation? Is there, to use a buzz
word, a 'synergy' between the current and the new business.
In the case of Delta buying a
refinery, there seems no underlying benefit at all; and about the
only shared core 'competency' is the ability to lose money -
refineries are chronically unprofitable, as are airlines too.
In other words, this would be
a ridiculous move on Delta's part.
UPDATE MAY 2012
When this article was first written in March, we were responding
only to mere rumors about Delta possibly buying this refinery.
Now, in May, the rumors have been confirmed. Delta is buying
the refinery. By all means, please still read the article
below, which can now be tested by the reality of what subsequently
happened. We stand by all we said.
Please also click on to read our subsequent
commentary and analysis on the specifics of Delta's justification
for buying the Trainer refinery.
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Originally published
6 Apr 2012, last update
30 May 2021
You may freely reproduce or distribute this article for noncommercial purposes as long as you give credit to me as original writer.
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