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Delta Air Lines (NYSE: DAL ) seems to be going the extra mile to deal with the headaches caused by rising fuel costs. The company is bidding to buy an oil refinery from ConocoPhillips (NYSE: COP ) in an attempt to curtail soaring fuel expenses at nearby airports in the New York area. The company is also hoping that owning the refinery will enable it to take advantage of fuel-related discounts in the country.
Although this unusual idea has received a mixed response from industry watchers, I think the deal has the potential to give Delta the winning edge over its competitors.
With fuel costs accounting for nearly one-third of total operational expenses incurred by airlines, things certainly don't look good for the industry when this large cost burden grows at a steady rate year after year.
Delta has an incentive to make a move considering its fuel costs accounted for a staggering $11.7 billion in 2011, about $2.8 billion more than what it spent in 2010. Add to this the International Air Transport Association's expectation of a 23% surge in fuel expenses for the airline industry worldwide, and you can perhaps understand Delta's concern. Clearly, this problem is huge and demands immediate attention.
What's the plan?
Delta's plans to purchase the 185,000-barrel-per-day oil refinery from ConocoPhillips could cost the company as much as $150 million. While buying a refinery wouldn't shield Delta against volatile crude oil prices, the company should be able to improve its margins as well as its supply chain.
According to the Energy Information Administration, the total production of jet kerosene fuel on the East Coast is 73,300 bpd and the ConocoPhillips refinery under question, which is located in Trainer, Pa., accounts for nearly one-third of it at 23,300 bpd. With the purchase of this refinery, Delta is expected to save fuel costs up to $25 per barrel, which is nearly 18% of what the company pays as of now. At the same time, owning a refinery may prove tricky for Delta in more ways than one.
A dull refining industry has led to thin margins, which is why ConocoPhillips is eager to sell its refinery. Apart from the fact that its expertise in managing the refinery is being questioned, the fact that Delta plans to operate in two turbulent industries (airline and refinery) at the same time is another major point of concern for analysts.
There is also uncertainty about what Delta plans to do with the residual non-jet kerosene fuel byproducts that will be generated at the refinery. However, this may be more of a boon than a bane. The byproducts such as diesel and gasoline can be further sold or exchanged with jet kerosene. What the company might eventually do is something you need to watch out for.
The Foolish takeaway
Delta Air's unusual idea for cutting costs is interesting. With $3.6 billion cash in hand at the end of 2011, coupled with sound financials as evidenced by its purchase of Northwest Airlines, the company certainly has the capacity to go for the deal. If implemented properly, this acquisition could change the mind-set of the entire airline industry. The most important thing to do at this point is to keep a close eye by adding Delta Air Lines to your Watchlist.
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