Delta Air Lines is getting into fuel business

Delta Air Lines is doing what anybody with a huge gas bill dreams of doing – buying an oil refinery to make its own fuel.

Delta said Monday that it will pay $150 million for a refinery near Philadelphia that is being sold by division of ConocoPhillips. It’s aiming to slice $300 million a year from its jet fuel bill.

Jet fuel is the refinery product that garners the fattest profit margin, “and they’re taking it from airlines,” Delta CEO Richard Anderson said.

It’s the first time that an airline has taken such a bold step to control escalating fuel costs. But it doesn’t come without risks. Fuel refining is volatile and expensive business.

“If this works, you’re going to see everybody doing it,” said Ray Neidl, an airline analyst with the Maxim Group.

Delta can’t just buy the refinery and pump out nothing but jet fuel. Refining crude oil yields different products – including diesel fuel, gasoline, and jet fuel – at different points in the process.

But Delta did say it plans to spend $100 million to modify the refinery in Trainer, Pa., to maximize the amount of jet fuel it produces. Jet fuel is currently 14 percent of the refinery’s output, according to Delta. It plans to boost that to 32 percent.

Here’s how it will work: Delta subsidiary Monroe Energy LLC will buy and run the refinery and will get crude oil from BP PLC. The refinery has access to pipelines that can take jet fuel to New York, where Delta has hubs at LaGuardia and John F. Kennedy airports.

The gasoline, diesel fuel and other products the refinery makes will be swapped with BP and the ConocoPhillips division, Phillips 66, for jet fuel to be delivered to Delta elsewhere in the U.S. Delta aims to fill 80 percent of its U.S. fuel needs this way.

But refining, the practice of taking crude oil and turning it into fuels, is notorious for boom-and-bust cycles. ConocoPhillips and other oil giants are getting out of the business because it hasn’t been consistently profitable.

Refineries are paying high prices for oil, particularly on the East Coast, where they import a lot of more-expensive oil. At the same time, demand for gasoline has fallen because of the weak economy and cars getting more miles per gallon.

As a refinery owner, Delta will still need that more-expensive crude oil to make jet fuel.

“This business is not without risk,” said Ben Brockwell, pricing director at the Oil Price Information Service. “But they thought this is a risk they’re willing to take.”

Delta said environmental cleanup risks previous to its ownership stay with the refinery’s previous operator.

Airlines have been trying to combat rising fuels cost by purchasing more fuel-efficient airplanes and experimenting with different types of fuels. But neither is an immediate solution; it can take a decade to modernize an entire fleet and biofuels, which are made from plants, are not economically feasible.

Airlines also try to limit their exposure to big price spikes through a process known as hedging. The catch: if prices fall dramatically, they end up losing a lot of money.

The price of crude oil itself can be hedged through financial bets. But the price of refining it into jet fuel can’t be hedged, noted Anderson, Delta’s CEO.

But considering that airlines have struggled to be profitable, “I actually think this is a lot less risky than buying 50 new airplanes and spending $2.5 billion in new capital” to expand the fleet, he said. The returns will be better this way – Delta is getting an asset that he estimated to be worth $1 billion.

Fuel has become the largest and most volatile expense for most airlines, including Delta. Its planes burned 3.9 billion gallons of fuel last year, costing it $11.8 billion – 36 percent of its operating expenses.

With a capacity to refine 185,000 barrels per day of oil, the Trainer refinery is the third-biggest of 12 East Coast refineries, according to the Energy Information Administration. Two were idled in 2010, and two more, including Trainer, were idled late last year. Conoco said it would close it for good if it didn’t find a buyer.

That loss of refining capacity has hurt drivers at the pump, and it has worried Delta executives who need to keep the jet fuel flowing.

However, even if Delta makes money from the refinery, airfares are unlikely to drop as a direct result. Route-by-route competition is the main factor in setting airfares.

Delta Air Lines Inc., which is based in Atlanta, said it expects the deal to close by the end of June, with jet fuel production beginning during the third quarter. Changes to expand jet fuel production should be done by the end of the third quarter. Delta said it expects the refinery to pay for itself by the end of the first year of operation.

The state of Pennsylvania is kicking in an expected $30 million in job-creation assistance. The money represents an “opportunity” grant contingent on Monroe Energy investing at least $350 million at the site, including the cost to buy it, and maintaining at least 402 full-time workers there for at least five years, according to Steve Kratz, a spokesman for the state’s Department of Community and Economic Development.

AP