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Just because a gallon of gas costs us way more than we wish it should at the pump does not mean that the oil refineries are making too much profit.

While some aspects of the oil industry are profitable, refining (at least in the US) does not seem to be one of them.

 
 
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Delta Airlines to Buy an Oil Refinery???

A very puzzling possibility with no apparent justification or benefit
 

An Oil Refinery closeup

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.

Crude Oil Yield

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 02 Jul 2017

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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