Monday, September 10, 2018

Delta Belatedly Is Facing Up To Its One Big Mistake: Investing In An Oil Refinery

This Thursday, April 19, 2012 file photo shows the ConocoPhillips refinery in Trainer, Pa., near Philadelphia.  Delta Air Lines Inc. bought the refinery as part of an unprecedented deal that it hopes will cut its jet fuel bill. A Delta subsidiary paid $150 million, including $30 million in job-creation assistance it is getting from the state of Pennsylvania. (AP Photo/Alex Brandon)
This Thursday, April 19, 2012 file photo shows the ConocoPhillips refinery in Trainer, Pa., near Philadelphia. Delta Air Lines Inc. bought the refinery as part of an unprecedented deal that it hopes will cut its jet fuel bill. A Delta subsidiary paid $150 million, including $30 million in job-creation assistance it is getting from the state of Pennsylvania. (AP Photo/Alex Brandon)

Delta Airlines has done a lot of things right since its 2008 acquisition of, and merger with Northwest Airlines, but buying a mothballed, dilapidated, small-ish and costly-to-operate oil refinery outside Philadelphia in 2012 most definitely is not one of them.

Plenty of experts in both the airline and the oil industries said at the time that Delta’s purchase from ConocoPhillips of what is now known as the Monroe Energy refinery in Trainer, PA, was a bad idea, and have continued to say so ever since. But only now are Delta’s own executives, who steadfastly have kept on defending the six-year-old mistake, beginning to admit it. And they’re only doing it now in a grudging, indirect way. But that can’t obscure the fact that Delta, the nation’s most profitable airline thanks mostly to its leaders over the last decade, likely would be even more profitable had they just stuck to their airline knitting instead of wading into the murky swamp of the oil business.

Last week Delta officials said publicly that they’ve hired Barclays Investment Bank and Jefferies Financial Group to look for a joint venture partner to buy a presumably large share of the airline’s Monroe Energy subsidiary. That – also presumably – is because Delta’s leaders know full well that they’ve got no realistic hope of finding a sucker crazy enough to take the whole thing off their hands.

In fact, University of Houston energy economics professor Ed Hirs, a long-time critic of Delta’s foray into the oil business, last week told Reuters that Delta’ quest to sell some of Monroe Energy could come up empty. That would put the Atlanta-based carrier - the world’s second-largest in passengers, capacity and revenue behind the less-profitable American Airlines - in a difficult position. It would have to decide between continuing to sustain large (but far from fatal) losses on its refinery or shutting it down entirely, much to their great embarrassment.

“It was a boneheaded decision” six years ago to buy it, Hirs said. “And they are still paying for it. It is going to be tough to sell a refinery that has faced closure several times due to bad economics.”


Delta, then led by now-retired CEO Richard Anderson, bought the Trainer refinery for just $150 million. But the plant, which had been dormant for a while before the purchase, needed about $120 million in immediate investment at the time to bring it back online in a way that would meet new, tougher environmental rules. But Anderson, with the strong backing of his top lieutenants, including his eventual successor Ed Bastian, broadly proclaimed that the refinery soon would be producing $300 million annually in pre-tax profits.

But just as both airline and oil industry experts said at the time would be the case, Delta’s refinery, which initially produced mostly jet fuel – essentially kerosene – only came close to achieving such results one time.

Monroe Energy lost $63 million in the less than one quarter of 2012 in which it was owned by Delta. It then lost another $115 in 2013 as Delta struggled through the oil industry learning curve.
The refinery operation turned modestly profitable in 2014, earning $96 million before taxes, then reached its high water mark of $291 in profits in 2015. But as the price of oil and – more importantly refined fuels – fell sharply in 2016 so did Monroe Energy’s performance. The refinery had to quit producing about 40% of its product as jet fuel, on which profits were non-existent, and to increase its production of gasoline and diesel fuel, better-selling products that allowed it to lose less money per barrel of production and to collect on government incentives paid to refineries that mix corn-based ethanol into auto fuels. Thanks to a yawning imbalance between the supply – and the price - of crude reaching the plant and the price for its finished products Monroe Energy lost about $125 million that year.

In 2016 Delta called in consultants to help it sort out its oil refinery’s economic issues. They’re the ones who convinced Delta management to have the refinery shift production toward more gasoline and diesel and away from jet fuel. That helped slow the losses, but only a bit. The refinery’s financial results from 2017 and thus far in 2018 (which Delta has not made public) certainly have not been good enough to stop management from seeking a partner – preferably one with real oil industry investing and operational savvy – who might be able to solve the refinery’s problems (or at least provide Delta with some cushion against the refinery’s losses).

Luckily for Delta, their up-front investment in the refinery was relatively low. And compared with the airline’s $40.5 billion in 2017 revenues and $6.1 billion in profits, its Monroe Energy predicament remains something of a bothersome sideshow.

Still, Delta’s foray into the oil industry serves as another sobering lesson to airlines, which historically have done quite poorly whenever they’ve tried various types of vertical integration strategies.

Pan Am, TWA, Northwest, United and American are big U.S. airlines that did not do so well as owners and operators of big hotel chains. American in the 1980s, apparently thinking its base in Texas somehow gave it special insight into the oil business, also wasted time, and a little money, on an oil trading subsidiary. Most carriers also used to own at least a portion of the computerized reservations systems used to sell their tickets via travel agencies in the days before online selling. Those drew lots of attention from regulators but never created the kind of profits that they likely would have made had they been independent companies instead of captives providing their services to their owner-airlines at deeply discounted prices.

The biggest, ugliest example of failed airline efforts at vertical integration was the attempt in 1969 and 1970s of former United Chairman Richard Ferris to create a one-stop shop travel company called Allegis. It included not only United but also the Hilton and Westin hotel chains, Hertz rental cars and other, smaller travel companies. Ferris’ plan was so unpopular with employees and investors alike that it got him booted out of the company less than six months after he unveiled the Allegis mega-brand. All the Allegis subsidiaries except United then were sold off within a year. And United escaped being forced into bankruptcy only by agreeing to be acquired in an union-sponsored Employee Stock Ownership Plan deal that hamstrung the company for years thereafter.

In Delta’s case, despite Anderson’s hyped prediction of $300 million in annual pre-tax profits from the refinery business, the real reason Delta wanted to own a refinery was to use it as a physical hedge against fluctuating and potentially devastatingly high oil prices. The airline’s thinking was that by producing itself a sizeable percentage of the jet fuel the airline would be buying on the market, it could shield itself from the violent up and down swings in the per gallon price and from the periodic kerosene supply shortages that tended to drive big price spikes.

But, as many academics have argued over the years, when a commoditized business like the airline business buys other commoditized businesses like hotels and oil companies – companies whose products are highly sensitive to swings in demand and low price competition – the discounts at which one of those companies is forced to sell its products or services to its sister company typically fails to increase total corporate profits. Instead, researchers have argued effectively it usually has just the opposite of the intend impact by retarding total corporate profit growth.

In Delta’s case not only was that true,  its ownership of Monroe Energy actually helped bring down the price of jet fuel for ALL airlines even though only Delta committed corporate capital and management time to producing those savings.

As a result, Delta never has been able to close the gap between its unit cost for fuel and the price its primary competitors, American, United and Delta, pay per unit of capacity. In 2011 Delta paid, on average $3.10 per gallon of fuel vs. American’s price of $2.93, and United’s $2.87. Even Southwest managed to pay slightly less than Delta, $3.09 a gallon, that year even as its fabled fuel hedging position collapsed amidst an unpredicted big drop in the market price of fuel.
More to the point, it cost Delta 4.8 cents for the fuel it required to fly one seat one mile in 2011. American paid 4.6 cents while United and Southwest paid 4.5 cents each.  The purchase of Monroe Energy was supposed to push Delta from the bottom to the top of that list, but last year it still ranked fourth among that quartet of carriers in price paid for the fuel required to fly one seat one mile: 2.5 cents vs. 2.4 for all three of its big rivals. That tiny, one-tenth of a penny difference actually means a lot given that Delta flew 228.4 billion available seat miles in 2017. Had it simply paid the same price for fuel per available seat mile as its competitors paid last year Delta would have saved about $228.4 million in total fuel expense.

In short, Delta’s purchase of, and continued investment of capital in the Trainer refinery has produced none of the desired results for the airline.  Thus last year’s switch from heavy production of jet fuel to producing more gasoline and diesel was a quiet but clear – and painfully delayed - recognition of reality. So is this year’s decision to find another company on which Delta potentially can lay off some of the risk and responsibility for that refinery.

Thus Delta, which has done many, many things rights over the last 10 years, is facing up, however reluctantly and belatedly, to its one big mistake. And in the big picture, even that mistake isn’t all that big. Still, it is a black mark on Delta managements’ reputation, and one that investors don’t like. Right now they’ll put up with it, given the other, overwhelmingly positive results coming from Delta. But will they be so indulgent if Delta can’t find a partner with which it can share ownership of that old, struggling refinery in Pennsylvania?


Dan Reed

I write about airlines, the travel biz, and related industries
I wrote my first airline-related news story in May 1982 – about the first bankruptcy filing of Braniff International Airways. That led to 26 years covering airlines and related subjects at the Fort Worth Star-Telegram and USA TODAY. I followed the industry through the entire arch of deregulation: expansion, disruption, and consolidation. I’ve also written two books on the subject: American Eagle: The Ascent of Bob Crandall and American Airlines, published in 1993, and (with co-author Ted Reed) American Airlines, US Airways and the Creation of the World’s Largest Airline, published in 2014. Today, I operate my own consulting firm and work as a freelance journalist covering aviation, faith, travel, business, IT, education, and sports. I’m a graduate of the University of Arkansas (Woo Pig Sooie!) and Southwestern Baptist Theological Seminary.

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