Delta Air Lines to buy a US East Coast oil refinery from ConocoPhillips. A good investment but definitely not a hedge against jet fuel crack spreads.

In order to discuss the implications of this move by Delta, we first need to acknowledge the main drivers to the deal. If we exclude short-term shifts and look only at mid-term macro developments, we can observe the following:

a) Heating oil crack spreads, a proxy for jet fuel cracks, have tripled compared to 2009 and now stand at about $30 per barrel. Volatility from Q1 2007 to Q1 2012 has been very high, with spreads fluctuating 40-50% on average, from one quarter to the next. This has subsided over the last year and it seems that spreads will remain at current levels for the rest of 2012. The main driver for high spreads is the much greater overseas demand for distilled fuel, compared to domestic US.

b) Refinery capacity in the US has been shrinking, with some refineries becoming inactive and many being on sale since early 2011. Whereas in 2009-10, a similar mid-sized refinery with 185,000bpd capacity would be priced at $500-600M, refinery prices are now depressed. From Conoco’s perspective, which has been looking to sell its Pennsylvania facility since 2011 and was about to close it down, a $150M price tag is better than nothing. Delta acknowledged the opportunity and acted quickly.

c) Similarly, with greater overseas demand and shrinking domestic US supply, crack spreads should remain at historic highs for the foreseeable future.

Delta’s fuel managing team is experienced in similar situations, as this is not the first time the airline has been proactive in managing costs: Going into 2011 the crude oil WTI-Brent spread increased substantially. With WTI been the benchmark for US airlines in setting fuel hedging contracts, it was no longer considered reliable. Delta was among the first to shift its fuel hedging contracts to Brent, in March 2011.

We could be quick to judge Delta’s move as both proactive and positive, if this were an investment. But it is not an investment, as the airline mentioned it was driven to buy the refinery by the inability to hedge against jet fuel cracks.

Nonetheless, buying the Conoco refinery does not remove risk, unlike hedging. By acquiring this facility, Delta essentially goes long the jet fuel crack spread. They are betting that spreads will either remain at current levels or keep on rising. So, effectively, Delta is adding risk. Should spreads decline, while there is still refinery overcapacity in the US, Delta will incur much lower returns and possibly a write-down on its refinery assets. If the end objective is to manage risk, then Delta would have been better off going to the derivatives market (by selling an underlying heating oil / jet fuel futures contract and buying an underlying crude oil contract, so as to hedge against jet fuel cracks).

As with everything else in the airline industry, we should not expect this deal to be a first of many. Even if refinery valuations are at an all time low and jet fuel crack spreads at an all time high, airlines will not rush to buy similar assets. Delta’s competitors will adopt a “wait-and-see” approach. When Air France merged with KLM in 2003, industry experts were quick to predict a surge in airline mergers. But it was not until 2007 when the industry witnessed a second mega- merger; that between Delta and Northwest.