Back in September, I wrote that Delta's (DAL) decision to purchase an oil refinery from Philips 66 (PSX) was looking like a very smart decision in hindsight. As I noted in the previous article, initial sentiment about the refinery purchase varied widely. Airline analysts were generally positive about the move, agreeing that it would help Delta hedge against refining margins (and in the near term lower refining margins on an absolute basis). Executives elsewhere in the airline industry were cautiously optimistic; United Continental (UAL) CEO Jeff Smisek stated that his company would consider replicating the move if Delta's strategy works. By contrast, oil industry executives and analysts were perplexed, arguing that if the refinery was not economical for Philips 66, it was certain to be unprofitable for Delta.
Since I wrote the initial article, the Trainer refinery has re-started and reached full production rates. Delta is still in the midst of a project to increase the mix of jet fuel to a target of 52,000 bpd (out of 185,000 bpd total capacity). In the company's Q3 earnings report, released last month, Delta's management projected that the Trainer refinery will have a Q4 contribution to profit of breakeven-$25 million. Obviously, this is well below the $300 million annual savings run-rate that Delta projected when it announced the deal. However, as noted above, the refinery did not reach full output until November, as some units were still undergoing maintenance. Additionally, Delta has not yet optimized the mix of jet fuel.
Soon after the refinery restarted, it seemed that Mother Nature was going to take it out of service again. Hurricane Sandy forced most refineries in the Northeast to shut down or operate at reduced rates. Hess (HES) is just now restarting production at its Port Reading, NJ refinery, while Philips 66's Bayway refinery is still shut. Although the Trainer refinery is less than 100 miles from these hard hit sites, Delta was able to maintain power throughout the storm and continue running at normal rates.
As a result, while Delta's primary airline business lost $20 million in October profit due to Hurricane Sandy, Delta's refinery business will actually be a significant beneficiary of this tragedy. The shutdown of various refineries in the Northeast led to tight supplies and created a premium for oil products in the Northeast, compared to the rest of the country. Delta has off-take agreements with BP (BP) and Philips 66, whereby it trades refined products other than jet fuel in Pennsylvania for jet fuel elsewhere in the U.S. A major criticism of the deal was that Delta would not be getting a barrel of jet fuel for every barrel of oil it refines, because other petroleum products (such as gasoline) are not worth as much as jet fuel. However, the recent shortage of gasoline, heating oil and other refined products in the Northeast has significantly increased the value of the products Delta is supplying there.
As a result, Delta is probably realizing much better-than-projected trading rates for its refined products, and will continue to do so until Northeast supplies come back into balance (probably around the end of this month). For example, according to EIA data, Gulf Coast jet fuel traded at an average premium to NY gasoline of 27.7 cents/gallon in the two weeks prior to Hurricane Sandy's arrival. That premium narrowed to 22.1 cents for the week ended 11/2, and then to 10.4 cents in the week ended 11/9. As of Wednesday (the most recent day for which data is available), the premium was a mere 3.2 cents. Indeed, Gulf Coast jet fuel was actually trading at a discount to NY gasoline for several days last week!
The story has been similar for Gulf Coast jet fuel vs. NY heating oil. This is a particularly important comparison, because many airlines use NY heating oil as a hedge instrument, since it is the best proxy for jet fuel among regularly traded petroleum products. Over the past week, Gulf Coast jet fuel has traded at a discount of 4-6 cents to NY heating oil. In the first week after the storm, the discount stood at 10 cents. Yet for the rest of the year, Gulf Coast jet fuel has traded at a premium of 5-10 cents above NY heating oil.
On balance, I am conservatively estimating that Delta's refinery subsidiary will realize an extra $6 of revenue per barrel of oil (or 14 cents/gallon) it processes for the thirty days after Hurricane Sandy, due to the higher margins for Northeast refined products. This works out to a $33.3 million gain. I thus expect Delta to easily beat the high end of its $25 million target for the refinery's profit contribution. Moreover, with jet fuel spot prices on a steady downtrend over the past several weeks, Delta is likely to see quarterly fuel costs come in below the company's most recent projection of $3.15-$3.20/gallon.
As a result, there is upside to the average analyst estimate for EPS of 28 cents in Q4. On the basis of Delta's recent share price decline and the company's rock-bottom valuation, I think a catalyst of this sort could cause the stock price to rally by 10-20% over the next two months.
Disclosure: I am long DAL.