2012 May 4

The Master Resource Report  2012-05-04

So should I buy a refinery too?

NEW YORK (CNNMoney) — Delta Air Lines announced plans Monday to purchase an oil refinery outside of Philadelphia, a novel approach to reducing its fuel costs.

If it is a good idea for Delta would it be a good idea for me?

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Consider the possibility of hedging my gasoline fuel costs by owning an oil refinery. The EIA graphic on the left illustrates the components that make up the price of the average gallon of gasoline in the U.S. Notice that in 2011 the most significant cost was crude oil at 68%. This is up substantially from the 54% average since 2000 also illustrated in the graphic.

During the last decade costs other than crude oil went from an average of $1.04/g to $1.13/g up $0.09/g or 8%. Crude on the other hand went from being $1.23/g of the cost to $2.39/g up $1.16/g or 85%. So of the total gasoline price increase shown by this data 93% of the $1.25/g increase was crude oil.

So if I had owned my own refinery in 2011 I could have protected myself from less than 7% of the price increase. Of course this assumes I was successful at running my refinery profitably and given the industry’s history that would have been a major accomplishment itself.

The Jet Fuel and Crude Oil Price graph is from the IATA web page which further illustrates the tight relationship between jet fuel prices and crude oil prices. Owning a refinery won’t change that graph. Therefore it appears that owning a refinery would not protect me or Delta Airlines from the biggest driver of fuel prices, crude oil.

Delta indicated that they would optimize the refinery for jet fuel production. If optimizing that refinery to make the maximum jet fuel stream was such a great idea why wouldn’t an experienced operator like ConocoPhillips have already made those changes?

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An airlines biggest expense is fuel and that means oil. To think there is a simple way to eliminate the realities surrounding future price increases is fundamentally flawed. This leads to an alternative conclusion why Delta may have done the deal for the refinery. It is actually the supply risks they are looking at, not just price.

“Production at the refinery combined with multi-year agreements to exchange gasoline, diesel, and other refined products from the refinery for jet fuel will provide 80 percent of Delta’s jet fuel needs in the United States.” Securing 80% of its fuel needs may have been the true priority. While everyone was looking at price Delta was taking an even more fundamental view that reflects their concerns over supply and  not just price.

Now consider another tactic being used in the airline industry. The trick is to raise the amount the passenger pays without raising the price. What??

“Passengers using Spirit Airlines Inc. for a return flight spent an average of more than $100 on extras such as checked bags and boarding passes during the first quarter, in what the U.S. low-cost specialist claimed was an industry first.”

That is right passengers spent more than $100 extra on their trip so they could get a cheaper ticket.

“Spirit’s average nonticket revenue rose 21% to $51.68 for each flight segment. Mr Baldanza said he believed no one else in the industry had broken the $50 barrier. The carrier’s average fare actually fell in the quarter by 6.9% to $76.65, in contrast to network rivals that have been pushing up ticket prices to cover higher fuel costs.”

So in Spirit Airlines case the ticket price went down by $5.68 while the non-ticket revenue went up over $11 for each flight segment. The unwitting passenger is paying more for the flight while thinking the ticket was cheap. Marketing over reality, a common theme American consumers never seems to quite grasp.

So the secret to Spirit Airlines success was being able raise the total revenue collected to balance fuel price increases without letting the passenger know it.

On your next flight look around and consider what services you aren’t being charged for yet and prepare to pay for them soon. Toilets???

Note: Clients and Advisors of Ravenna Capital Management do not hold positions in Delta or Spirit Airlines at this time.