Let's Buy A Refinery

| About: Delta Air (DAL)

Things that are often challenging: to keep-on winning during a casino visit, finding a typewriter repairman, or producing an airline-executive decision as inane as buying a refinery.

Delta Airlines' (NYSE:DAL) decision to buy a 185,000 barrel-per-day facility along the historic Delaware outside Philadelphia is as misguided of a business decision as you ever fear to find. First and foremost, just the most primal of sniff tests born form 50,000-years of human evolution: you're buying this from a refiner (NYSE:COP) who is shedding the asset because it admits, as a deeply-professional, well-seasoned refiner, that it can't turn a profit with the asset. Full stop. Right there.

Baring that failing to fend off fiscal catastrophe, simply announcing to your stakeholders, like creditors, that you're intending to acquire an asset with a total investment, including upgrades, that amounts to 75% of your first-year's earnings (I have no idea how else to read "Delta estimates the deal will cut its fuel bill by $300 million in a year" as you don't offset fuel costs with revenues-before-expenses at your nifty refining arm) should raise some questions. In other words, proposing a transaction with a 0.73 PE multiple, only so high because you'd have to agree to blow the asset off the map in its 13th month, should nurture some questions from those charged with paying attention.

Here's the thing, shifting your exposure to fuel one notch to the left on the "Crude-Refine-Buy" supply chain does exactly nothing for your fuel-cost outcomes unless the difference between the price of finished jet fuel and its feedstock widens, i.e. jet fuel price increases/decreases outpace/trail crude oil price increases/decreases. And that's making the horribly-distortive assumption that their 87-year old refinery, Sinclair originally built the Trainer refinery in 1925, produces exclusively jet fuel. In fact, JET A will be, following the $100mm upgrade, well under 20% of the refinery's total output.

No fear, DAL will exchange the vast majority of co-products for JET A. Never mind the rather sizeable complexities that govern gasoline cracks, or heating oil cracks, or kerosene (where jet fuel lives) cracks, or naptha cracks, all of which will drive their ability to trade out for JET-A with, at times, stunning volatility.

All DAL has done is insert themselves between the crude-oil seller and the jet-fuel buyer, and in so doing adopted catalogs of fancy idiosyncrasies that come with refining hydrocarbons. This isn't a trivial business; painfully far from it. Meanwhile, they still have full exposure to the lion's share of their fuel-cost problem, crude oil. Buying a crude-oil field would have been significantly more sensible - which is why that option isn't available for $150 million.

Perhaps most frustrating of all, is how simple this type of hedge is to facilitate using financial instruments like futures. Buying a refinery is very likely the absolute least-efficient way to offset your fuel-cost risks as an airline, if only for the bevy of operational/regulatory/environmental risks worn by refiners, if to say nothing of the distinct liquidity risk you inherit when tying capital up in a refinery - they are very, very difficult to sell. Engaging in a jet-fuel crack hedge takes at most, literally, 3 separate futures transactions: 1) Buy the Crude Oil Future, 2) Sell the Heating Oil Future, 3) Buy the Heat Oil-Jet Fuel Basis Swap. There you go, you've got your very own virtual jet-fuel refinery, all without the nasty unpleasantries of, you know, owning and operating a refinery. I'd love to be a fly-on-the-wall for their first meeting with the property-insurance underwriters…

I don't think there's a stretch to lambast in suggesting that in 5 years, this will be understood to be one of the most regrettable decisions a private-enterprise airline could make. I cannot fathom how the leadership at DAL made it. Likely, neither can COP.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.