In the airline industry, the largest cost of services rendered is the cost of aviation fuel followed by direct labor costs. Profitability and overall business financial results are therefore highly dependent on a predictable cost of fuel.
In May of 2012, Delta Airlines made what Supply Chain Matters viewed as a bold initiative in practicing supply chain vertical integration. At that time, Delta purchased a previously idled Trainer Pennsylvania refinery from Conoco Phillips for $150 million. Plans called for an additional $100 million to retrofit the refinery to optimize its ability to refine jet fuel and Delta would subsequently enter into marketing and sourcing agreements with both Phillips 66 and BP PLC to exchange gasoline, diesel and other refined products additionally produced at this refinery for distribution in other retail markets. Delta’s plan was to eventually reduce its annual jet fuel costs by $300 million, along with having the ability to plan on a reliable source of supply for eastern U.S. operational needs. Airline competitors and industry analysts were very skeptical of this effort and Supply Chain Matters committed to continue to monitor subsequent developments and financial results that concerned this refinery’s contribution to its stated business goal.
Last week, Delta indicated to its investors that lower fuel prices would increase its profitability next year but could force the airline to write-off $1.2 billion as a result of prior fuel hedging contracts. The airline expects pre-tax income to jump 11 percent to $5 billion next year, including a net gain of $1.7 billion in cost savings from lower fuel costs. Since June, the cost of jet fuel has dropped by about a third. However, according to reporting from The Wall Street Journal (paid subscription), those savings could have been 70 percent larger without the hedging. Fuel hedging is a common but controversial procurement practice for the airline industry. Even though Delta owns a refinery, it also exercised fuel hedging contracts to protect from being impacted by high spikes in fuel prices.
Delta indicated that in its fiscal fourth quarter, profit of $75 million at its Trainer refinery would offset a roughly $150 million hedging loss in the period. Delta’s CFO indicated that in a period of stable fuel prices, the refinery, hedges and efficient operations allow Delta to save 8 to 10 cents a gallon on fuel. But, partly because of hedges, “during periods of dramatic price swings… our goal is to drive industry parity” on fuel prices. Delta’s president further indicated that its hedges save it 65 cents for every dollar decrease in the price of fuel.
Thus, at this point, Delta’s investment in a refinery continues to contribute short-term financial benefits, but coupled with a longer-term fuel hedging strategy, and current period of dramatically lower cost of jet fuel costs in 2015, whether or not the refinery serves a strategic advantage. Time will tell, along with subsequent financial reporting from other competing airlines.
Supply Chain Matters will continue to monitor these developments.