This Airline Is Controlling Fuel Costs By Buying Its Own Refinery

| About: Delta Air (DAL)

By Renee O'Farrell

Have rising fuel prices ever caused you to worry? What if you could find away around that and literally be able to set your own price of fuel? One airline has found a way to do just that. Delta Air Lines (NYSE:DAL) announced on April 30, that it had agreed to buy a refinery from ConocoPhillips (NYSE:COP) for $150 million. The refinery, which is located near Philadelphia, has been closed for six months. Delta is planning to spend $100 million to refurbish the refinery and develop its jet fuel production.

To put the investment amount in perspective, it is roughly equivalent to the listing price of a Boeing 777 and is expected to reduce Delta's fuel costs by $300 million annually.

To supply the refinery, Delta made an arrangement with BP. While the terms of the deal have not been released, it is known that there is a three-year agreement in place between the two companies that would allow Delta to exchange other fuel products like gasoline and diesel for jet fuel.

According to theNew York Times, "Delta said these deals would provide 80 percent of its fuel needs in the United States." The paper also quoted Delta CEO Richard H. Anderson as saying that the purchase "is an innovative approach to managing our largest expense." The deal appears to have been made just in time. Fuel costs make up more than 40% of Delta's operating costs - a percentage that was poised to increase significantly this year. According to the International Air Transport Association, the global airline industry's fuel costs are expected to rise over 22% this year, or $40 billion, up from $177 billion in 2011.

This level of cost savings is likely to be a huge boon for Delta - or at least it will be as soon as it demonstrates that it is capable of running a refinery, which is a difficult job for even the most experienced. Delta is currently trading at $11 a share. The company earned just $1.41 a share last year but analysts are bullish going forward, estimating that Delta will earn $2.28 a share this year and $2.56 a share next year, making the company's forward P/E ratio under 4.30 times its future earnings. That figure is low for any company, but especially in the airline industry, which has an average forward P/E of almost 15, making Delta a great buy right now. Plus, I highly doubt analyst expectations include the gains that are expected to come from Delta's refinery business.

Some big names in the hedge fund industry seem to agree. Ken Heebner had $146.51 million invested in Delta at the end of the fourth quarter (check out Heebner's top picks for his fund Capital Growth Management). Paul Reeder and Ed Shapiro's PAR Capital Management and John Griffin's Blue Ridge Capital also own significant stakes in Delta.

Competitors like United (NYSE:UAL) and US Airway (LCC) don't stand a chance against Delta's new cost savings. United recently traded for just under $22 a share and has a forward P/E on par with Delta at around 4 times its future earnings, but United doesn't have the same cost savings to look forward to. US Airways is in a similar position. The company recently traded at just over $10 a share and has a forward price-to-earnings ratio of 3.82, but, again, it doesn't have nearly the cost savings Delta is likely to enjoy.

All three are good investments - people will start traveling more as the economy improves and these companies are priced so low that they will go up eventually - but I am recommending Delta over its rivals. The company's strategy, if it works, is utterly brilliant. Granted, the airline could fail in its refinery business but the cost to try it was very low given its potential gains and, given the low cost, the company should at least be able to make its money back. For investors buying in now, why not take a gamble on Delta when the gains could be astronomical. I, for one, think it is worth the risk.

Disclosure: I am long COP.

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