Delta Air Lines announced officially yesterday that the company will buy an oil refinery from ConocoPhillips for $180 million. With this audacious bid to save money on fuel costs by investing in a sector shunned by many of the biggest oil firms, the world's second-largest air carrier is becoming the first air carrier to make its own fuel. Atlanta-based Delta said the purchase of the Conoco refinery located in Trainer, Pennsylvania would allow it to cut $300 million annually from jet fuel costs, which reached $12 billion last year and that production at the refinery along with other agreements to exchange refined products for jet fuel would provide 80 % of its fuel needs in the United States. While Delta will still remain hostage to fluctuating crude oil costs, the facility would enable it to save on the cost of refining a barrel of jet fuel, which is currently more than $2 billion a year for Delta and has been rising in the wake of U.S. refinery shutdowns, said Delta Chief Executive Richard Anderson.

And while the initial investment is no more than a wide-body jet liner, even including an additional $100 million to upgrade the plant to maximize jet fuel production, it will put Delta in the unique position of hoping that the recent rebound in refinery profit margins -- normally an indication of added costs for a fuel consumer -- doesn't prove too fleeting. "What we're tackling here today is the jet crack spread, which you cannot hedge in the marketplace effectively," Anderson told reporters during a phone briefing. "It's the fastest single growing cost in our book of expense at Delta."

As expected, Delta will effectively outsource all the oil trading requirements for the refinery, an increasingly frequent arrangement for smaller or less-experienced operators. But instead of JP Morgan, which had been initially named as the trader last month, oil major BP will supply crude oil to be refined at the plant under a three-year agreement. And BP and former refinery owner Phillips 66 will get a share of the gasoline, diesel and refined fuel to sell, in exchange for supplying Delta with jet fuel in other locations.

It will be a familiar role for BP, which owned the plant in the 1990s before selling it to independent refiner Tosco in 1996 for $59 million, coupled with some additional assets. Tosco later merged with Phillips, which then merged with Conoco. The refinery is expected to resume operations in the third quarter, Delta said, about a year after ConocoPhillips idled the plant as rising imported crude oil costs, a collapse in demand and tough competition from foreign refiners crushed margins.

Delta said the deal will include pipelines and other assets that will provide access to the delivery network for jet fuel reaching its Northeast operations, including its increasingly important hubs at New York's LaGuardia and JFK airports.

Fuel costs pushed major U.S. airlines into the red for the first quarter, although oil prices have since eased from March peaks. U.S. crude traded around $105 a barrel on Monday, while Brent crude was about $119 a barrel.

Cautious response

The deal offers a reprieve to one of two key refineries that had been earmarked for permanent closure this year unless buyers were found. Delta will pay ConocoPhillips $180 million for the refinery, but will receive $30 million in state government assistance on the deal, reducing its cost to $150 million.
"This announcement means the preservation of more than 5,000 jobs at the Trainer facility and in related industries," Pennsylvania Gov. Tom Corbett said in a statement. But at the same time it will raise questions among oil sector analysts about whether the rush to revive one of the half-dozen East Coast facilities that has been shut in recent years may be premature given lingering questions over whether these plants can compete without access to cheap crude.

Profit margins in April rose to their highest since 2008, according to a Credit Suisse analysis, and are up more than 60 percent from the average of last year as the planned closure of some 1.5 million bpd, including two refineries in the Caribbean, threatened to cut East Coast capacity to just a third of its peak in 2008. The cuts are deeper when factoring in Europe.

But in addition to Trainer, private equity fund The Carlyle Group is in talks to buy the biggest refinery in Philadelphia, potentially pulling another plant back from the brink. The analysts at Credit Suisse say another 2.6 million bpd of refining capacity across the globe must be shut "to hit the "sweet spot" utilization level of 87 percent". The Delta refinery would be run by a leadership team headed by Jeffrey Warmann, who last ran Murphy Oil USA's Meraux, Louisiana, refinery.

East Coast refineries, among the oldest and least advanced in the country, have been hammered by a series of bad turns: the 2008 recession that cut demand; the rapid injection of ethanol into the U.S. gasoline mix; tougher environmental norms; and the rise of new, more sophisticated plants in India and elsewhere.

The final blow for many has been the surge in cheap shale oil production from North Dakota and West Texas, which has handed a bounty of cut-priced crude to Midwest and Gulf rivals who are now running their plants flat-out.

Will it work?

Robert Mann, an airline consultant in Port Washington, New York, said Delta's statement did not address how it will handle exposure to fluctuations in energy prices or refined product costs or the actual refining process costs. "It's clearly a very innovative approach, but I think it will be a number of years before we know whether it actually works out," Mann said.

Delta expects the purchase to add to its earnings in the first year of operations. Delta's Monroe Energy LLC unit expects to close the purchase in the first half. JP Morgan Chase advised it in the purchase, Delta said.