Fitch: Opportunity, Risk In Delta's Refinery Purchase

Delta Air Lines' acquisition of the Trainer refinery near Philadelphia represents an innovative but unproven approach to the long-term management of the airline's jet fuel costs.

Although Delta has outlined the potential for high returns on the Trainer investment, Fitch Ratings expects the purchase to expose the carrier to ongoing operational risk in a global refining industry that remains highly volatile and capital-intensive.

Delta's purchase of the idled refinery from Phillips 66, together with agreements to exchange other refined products for jet fuel, creates an opportunity for Delta to meet as much as 80 percent of its domestic jet fuel requirements from a captive source, limiting the impact of big swings in jet fuel refining margins or crack spreads that have been difficult for Delta and its major airline competitors to hedge in recent years. As global demand for refined products has shifted away from gasoline toward distillates such as diesel and jet fuel, the jet fuel crack spread has become an increasingly unmanageable component of airline operating costs.

Once approximately $100 million in capital improvements (beyond initial net cash capex of $150 million) have been completed by the third quarter, Delta forecasts annual jet fuel savings of as much as $300 million. Crude oil supplies and additional jet fuel needs will be met through sourcing and off-take agreements with BP and Phillips 66 under three-year agreements.

We recognize that the economics of the acquisition are attractive if forecast savings are reached following the boost in jet fuel capacity at Trainer to approximately 52,000 barrels of jet fuel per day.

Should all-in 2012 project capex of approximately $250 million deliver annual operating savings near forecast levels (about 2.5 percent of Delta's $12 billion total consolidated fuel bill in 2011), returns on the Trainer investment would justify the investment, which is modest relative to Delta's operating cash flow of almost $3 billion and total unrestricted liquidity of $5.7 billion (16 percent of revenues) at March 31.

Still, ongoing capex requirements and operational issues linked to potential refinery outages in a single-asset business pose risks that could likely drive periodic cash flow volatility linked to Trainer's operation. Changes in the regulatory environment, potentially involving new government rules related to gasoline sulfur content or other mandates, could also affect the refinery's economics in unanticipated ways. Despite these potential risks, overall fuel costs that Delta currently faces will likely be reduced over time, and importantly this initiative gives Delta more control over its supply chain for its largest expense item.

Jet fuel reflected 29 percent of Delta's 2011 operating expenses, and the carrier estimates that the crack spread alone represented 10 percent of unit costs last year versus 3 percent two years ago, highlighting the urgency of alternative approaches to jet fuel cost management.

Given the size of the acquisition relative to total liquidity and the potential for significant near-term cost savings, the Trainer purchase is not a rating driver. However, we will remain focused on Delta's early operating performance at Trainer and the impact of the deal on relative jet fuel costs, which should become clearer as early as the third quarter. Delta's issuer default rating of 'B-' remains on Positive Outlook as the airline consistently outperforms its peers in key traffic performance, operating earnings and cash flow, and overall debt reduction.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at fitchratings.com. All opinions expressed are those of Fitch Ratings.

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