Delta Air Lines Is Bakken Business

Includes: BP, CNI, DAL, OIL, USO
by: Matt Smith

For this latest meandering down the path of energy, we are going to take a look at a couple of interesting tales intertwined, with the first anecdote beginning with the incongruous line, 'an airline walks into a refinery'. This is because airlines and railroads are contributing to the domestic energy boom in a fascinating fashion, and this post takes a look why.

In a move from somewhere out in left field, Delta Air Lines (NYSE:DAL) decided in late April to tackle energy risk management head-on by taking a rather unorthodox step of managing its fuel cost exposure by…purchasing a refinery. $150 million later (after a $30 million subsidy from the Commonwealth of Pennsylvania), Delta bought the Trainer refinery just south of Philadelphia, which produces 185,000 barrels a day. In addition to the purchase, it is now retrofitting the refinery (to the tune of $100 million) to maximize its jet fuel output.

Although a seemingly peculiar purchase, jet fuel accounts for 37% of the company's costs - ringing in at a whopping $12 billion for 2011 (up a third on the previous year) - making this less perplexing than it may first appear. The refinery is tweaking jet fuel to become 32% of its output, up from the usual 14%, while gasoline output will drop from 52% to 43%.

Further, the company has entered into a three-year deal with BP (NYSE:BP) to swap out the volumes of these other products for jet fuel. The two deals combined mean that Delta will cover 80% of its jet fuel needs: out-of-the-box risk management, but it may prove to be astute. On the flip side, it could prove to be a very costly mistake should it go wrong.

Our tale takes a detour here, however, as our focus shifts from air to rail via the domestic oil (NYSEARCA:OIL) boom. The US was 83% energy independent in the first half of this year - the highest level in decades - and this is due in part to rapidly expanding oil production following hot on the heels of the shale gas revolution.

The Bakken shale in North Dakota is leading the charge on this front, as production ramps up to 674,000 barrels a day (NYSEARCA:USO) in July - up 59% on the prior year. And this increasing supply comes at a fascinating time as there is a shortfall in East Coast refining capacity due to the lack of profitability.

If these refineries can get their hands on the Bakken oil, which is closer to the price of Oklahoma-based WTI (currently $91) rather than imported Brent crude (currently at $111), it suddenly makes refining considerably more profitable. So refiners are looking to get their hands on this oil by any means possible; hence, a surge in oil shipments by rail:

Bringing this tale of air and rail together is this fascinating article published last week. It is chock full of facts about oil and rail shipments, and here are some of the key points:

--Shipments of oil by rail in the US jumped by 41% to 367,729 barrels a day in Q2 versus Q1
--PBF energy is receiving 40,000 barrels a day to its Delaware plant by rail, which will reach 110,000 barrels by January
--The cost to ship by rail to the East Coast is estimated at $18.75 a barrel (not including gathering / trucking)
--This compares to $2.23 a barrel for a Suezmax-class tanker from West Africa to the East Coast
--Burlington Northern Santa Fe will carry 89 million barrels of oil out of the Bakken region this year, up from 1.3 million in 2008
--Canadian National Railway Co. (NYSE:CNI) expects to ship more than 30,000 carloads from zero two years ago
--At least six Northeast rail terminals are, or will be, operating by the middle of next year, able to unload a total of 620,000 barrels a day

Given both the reduced refinery capacity on the East Coast and ever increasing volume of domestic oil production, there should be greater reliance on cheaper-priced oil from domestic shale plays, in turn meaning less need for higher-priced imports. Oil shipments by rail from the Bakken region have now accordingly risen to 25% of the total volume, while 62% is shipped out by pipeline (while the remaining 13% goes by truck).

As shipments by rail continue to ramp up, the price of Bakken oil has rallied by 32% this quarter, versus 7% for WTI and 14% for Brent. All this has done, however, is bring prices back in line with WTI crude oil:

This leaves us with two fascinating dynamics of the US domestic oil market to watch; that of growing production and that of changing regional oil flows. The potential for the Bakken shale to solve the East Coast refinery capacity problem is a compelling one indeed. Meanwhile, Delta's delving into the refining business will remain riveting. But that is all from this latest installment of pun-based posts on Bakken (which 'Bakken to Basics' kicked off). But given the ongoing revolution, there's plenty more Bakken-based pun posts to come, don't you worry. In the meantime, thanks for playing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.