At first blush, it appeared to be an April Fool’s Day prank. A satirical, mock corporate announcement, one that couldn’t possibly be true.
What was the announcement? It was a statement, supposedly issued by “people familiar with the matter” at Delta Airlines, that the firm was “seriously thinking” about an opportunity to enter the oil business by purchasing a 185,000 barrel per day oil refinery from Conoco Phillips. Although the facility has been idle since October 2011, the mysterious statement asserted that Delta believes it can somehow succeed where Conoco Phillips has failed.
But the announcement was no prank. Shortly after the initial rumor hit the press, both Reuters and CNBC confirmed that Delta was, in fact, considering the acquisition. Financial analysts across the globe weren’t impressed; they reacted with skepticism, with criticism, and even with ridicule.
At first blush, of course, most of us would agree that it makes no sense for an airline to diversify into the oil business. But if we take a moment to reflect on Delta’s competitive position, we may start to understand why the airline believes the gambit may be worthwhile. The acquisition strategy, though unconventional in nature, is actually more reflective of the state of the commodity markets than of the state of the airline industry itself.
Method To The Madness
In order to understand Delta’s strategy, it is necessary to appreciate the impact that is wielded by fuel prices on the profitability of the airline industry. Generally speaking, the industry operates on very thin profit margins, with fuel alone representing almost one third of all operating expenses. Over the years, entire airlines have gone bankrupt because of aging fleets of airplanes that consume huge amounts of fuel, rendering flights unprofitable at virtually any level of passenger fares.
The challenge of high fuel prices is worsened by the impact of extreme price volatility. When American automobile drivers wince at double digit percentage increases in the retail prices of gasoline fuel, airline executives experience similar inflationary wallops and wince as well. In fact, such increases inflict far more damage on airlines than on automobile drivers, given that airlines must sign fuel purchase contracts well in advance, long before they know how many passengers will actually purchase tickets to board the scheduled flights.
If the fuel commodity markets were patronized exclusively by producers and users of gasoline, any such price swings would be determined by the economic market forces of supply and demand. But the commodity markets are also open to speculators who buy and sell huge quantities of the commodity, thereby causing wild swings in prices that can wreak havoc on the bottom lines of the low profit margin airlines.
So Delta has decided that it may be worthwhile to find a way to avoid the extreme volatility caused by speculator driven commodity markets. In essence, Delta is willing to bet that the cost burden of operating an unprofitable refinery — one that may nevertheless provide airplanes with fuel at prices equal to or below the cost of production — may be less onerous than the cost burden of purchasing energy from a wildly volatile global market. In other words, even though Delta’s strategy may appear to be madness, there is indeed a rational method to its underlying logic.
The $100 Million Man
Ironically, if Delta does proceed with the acquisition, the extent of its success will likely be determined by the conditions of the fuel markets that it intends to avoid. If those markets are relatively calm and rational, the airline will likely regret its assumption of the burdens of operating an oil refinery. But if those markets are relatively volatile and unpredictable, Delta will likely celebrate its decision to produce its own fuel.
In Delta’s defense, every week appears to produce a new story about the volatility of the global investment markets. Last week, for instance, a bizarre story about a “London Whale” spread throughout the financial press. The story involved a mysterious trader, working for JP Morgan, who was affecting market values around the world by investing heavily in derivative products called credit default swaps.
The trader, Bruno Iksil, reportedly earns $100 million per year by placing massive bets on the future movements of corporate bond prices. But because the placements of such large bets can themselves affect market prices, the very presence of traders like Mr. Iksil can affect what firms like Delta Airlines must pay to borrow money, to raise equity capital, and to purchase commodities for use in running their operations.
In other words, although our global debt, equity, and commodity markets were originally formed to help firms like Delta operate their businesses, they are now serving as vehicles for the highly speculative short term trading strategies of firms like JP Morgan. Apparently, Delta must now decide whether it would prefer to purchase fuel from a market that it doesn’t trust, or whether it would prefer to operate a refinery in a business it doesn’t understand.