Delta Air Lines’ acquisition of an oil refinery in Trainer, Pa., could give it a fuel cost advantage of at least 20 cents a gallon over competitors on transatlantic services from New York and ultimately market dominance across the Atlantic.

According to Philip Verleger, Jr., an economic consultant on energy and commodity markets and publisher of Petroleum Economics Monthly for more than 25 years, simply reducing the refining margin on jet fuel will provide much of these savings for Delta. This so-called “crack spread,” according to Verleger, currently stands at about 15 cents a gallon.

An additional five to 10 cents in savings, says Verleger, will come from the reduced supply for jet fuel on the U.S. East Coast for Delta’s competitors in the New York market, and their growing reliance on more expensive imported stocks. This benefit alone could give Delta a $4,000-5,000 advantage on every flight from John F. Kennedy International Airport to London Heathrow Airport, based on a Boeing 777’s hourly fuel burn, Verleger calculates, and could grow even higher should the small number of refineries located on the East Coast use increased demand to raise prices.

“I fully expect to see five years from now that a much larger share of the international flights from JFK will be Delta’s,” says Verleger, who three decades ago focused on the air transport sector for his PhD thesis at the Massachusetts Institute of Technology. “To really build New York and make it work, you need a cost advantage, and this gives them the cost advantage.”

Verleger also foresees competitive problems for United Airlines on transatlantic flying out of nearby Newark Liberty International Airport.

Cost Advantage

According to Verleger, Delta’s potential competitive advantage compares to Southwest Airlines’ hedging policy before the spike in fuel costs that gave it a distinct cost advantage for several years over the many U.S. airlines that did not hedge. “By acquiring the Trainer refinery, Delta may pull off the same feat as Southwest,” Verleger says in a “Notes at the Margin” report he prepared for Platts just before Delta announced its deal. Platts, like Aviation Week, is owned by the McGraw-Hill Companies.

“Delta will be able to cover a large portion of its jet fuel needs at the major New York airports at a cost substantially below that of its competitors,” adds Verleger. “This advantage would be particularly useful in the very competitive North Atlantic market, where Delta goes up against American [Airlines], British Airways (BA), Lufthansa, Air France, United and Virgin Atlantic, among others.

“With Trainer, Delta could match the competition’s prices and pocket profits from lower-cost fuel. Alternatively, it could follow Southwest’s example and initially pass the cost savings on to consumers. This would force larger losses on other airlines or cause them to exit the market. We bet that Delta chooses the latter option,” notes Verleger.

American Airlines, which is currently restructuring under Chapter 11 protection, is “in no position to fight a price war,” and could be particularly susceptible to pressure and vulnerable on its New York-London route, believes Verleger. BA, which has a joint venture with American on transatlantic services, also could pay a price.

But Verleger notes that Delta is taking some risks. It is expecting the refinery to be profitable, which Verleger thinks is possible but is a broad assumption given the economic difficulties affecting refineries in the past years. Environmental regulations also could create problems, especially if the Environmental Protection Agency tightens rules on sulfur levels in fuel, Verleger says. Boosting jet fuel production—Delta plans to more than double it at Trainer—will create more sulfur, he notes.

Spending to comply with such regulations “can easily be the cost of one or two [Boeing] 777s,” adds Verleger.

Refineries also have to be shut down every year or so for maintenance and, Verleger notes, accidents often occur when refineries come back online. Refinery owners usually build inventories of the refined products ahead of time to carry them through the shutdowns—or strike deals with other refiners to cover each other during their respective maintenance periods—but Delta still will face the risk of an unexpected shutdown.

Healthy Returns

Refineries also pay interest on that extra inventory, and Delta may find that cost rising in the coming years as interest rates rise.

In spite of the risks, Verleger believes Delta is making the right move. The airline, for its part, believes it has mitigated its risks. The carrier, for example, says it has environmental indemnities for anything that occurs prior to its ownership of the refinery. Delta also notes that it already has a three-year agreement with BP to supply the crude oil to be refined at the facility, and multi-year agreements with BP and Phillips 66 to exchange the refinery’s gas, diesel and other products for jet fuel supplies across its network.

The airline also has employed Jeffrey Warmann, a 25-year industry veteran and former manager for Murphy Oil USA’s Meraux, La., refinery, to run its facility.

Delta CEO Richard Anderson also notes that the airline is acquiring the refinery at what he considers a bargain price of $150 million, net of the $30 million that Pennsylvania is putting toward the deal. Even with Delta’s planned investment of $100 million to boost the refinery’s jet fuel output, Anderson says the amount Delta is spending equals the list price of one 777. For its investment, it expects to save about $300 million a year on fuel costs. “I actually think this is a lot less risky than buying 60 new airplanes and spending $2.5 billion in capital,” which is what Delta calculates it would need to do to achieve the same amount of cost savings by flying more fuel-efficient aircraft, Anderson says.