Why Delta's Purchase Of An Oil Refinery Makes Sense

| About: Delta Air (DAL)

Delta's (NYSE:DAL) recent purchase of the Trainer oil refinery from Phillips 66 (PSXWI), a spinoff of ConocoPhillips (NYSE:COP) may seem unusual given the apparent disparity in business models but from a cost perspective the acquisition makes complete sense.

As a comparable and case study I would like to offer up Barrick Gold's (NYSE:ABX) purchase of oil and gas producer Cadence Energy, which was transformed into Barrick Energy back in 2008.

Cadence was a small energy producer operating in Canada producing crude oil and natural gas. Production was small, almost 3,500 boe per day but fit the needs of Barrick who sought to take better control over their rising energy costs. The acquisition allowed Barrick to hedge their energy needs through Cadence's light crude oil production and reserves providing a better way to manage costs in an inflationary environment. By combining the production of Cadence with their hedging strategy Barrick was able to free up working capital that could be put to use in exploration and building out major projects. As of today the production hedge provided by Barrick Energy along with some hedging has assisted in decreasing the energy cost volatility where a $10 change in WTIC will now affect cash costs by just $1.

Delta is in a bit of a different quandary as they have been passing rising fuel costs onto consumers (unlike Barrick) and cutting capacity but those measures can only go so far.

In order to maximize the jet fuel output Delta will spend $100 million dollars to retool the refinery with the hopes of starting production in the third quarter of this year. British Petroleum (NYSE:BP) will supply the crude and the hope is that when the refinery is up and running Delta will free up precious working capital while covering 80% of their yearly US fuel needs, and gain greater control over their largest and most volatile cost.

The market will question the purchase as Delta is stepping outside their comfort zone. Managing a refinery is a much different business than managing an airline but if this purchase can provide the much needed cost certainty then the benefits will be both tangible and intangible. Tangible in that Delta can more effectively hedge their jet fuel costs similar to how Barrick has hedged their energy costs. Intangible in that working capital now tied up can be put to more constructive use.

Almost a month ago Sunoco (NYSE:SUN) announced that they were closing two refineries outside of Philadelphia. Success by Delta would give a new value to these refineries as more energy intensive businesses look to mitigate rising fuel costs.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ABX over the next 72 hours.