Delta to Buy Refinery - Such a Deal?

Conclusion

It is my opinion that Delta’s acquisition of the Phillips 66 Trainer refinery is a risky bet.

• Domestic gasoline demand has declined leaving the industry with surplus capacity
• The locus of demand is shifting to developing Asia.
• The policy of many OPEC producers has been to refine more of their own crude oil
• Domestic margins for gasoline are being squeezed in part due to the US exporting rather than importing the product (Exports increase transportation cost and therefore decrease refinery net back).  The short term exception is for those who have access to WTI and Bakken crude oil (more on this later)
• Slow economic growth will continue to hamper refinery profitability
• Simpler sweet crude refineries (like Trainer) are competing with more sophisticated Gulf Coast plants and from imports from Europe

In the longer term, demand for gasoline in the US will be restrained by stricter CAFÉ standards, a natural shift to more fuel efficient vehicles (both conventional gasoline and hybrids).  To a lesser degree electric vehicles and biofuels such as E85 may restrain the demand for gasoline

In the final analysis, the survival of a refinery is predicated its ability to convert low quality, low price crude oil into high value products.  Although the Trainer refinery produces an adequate amount of gasoline and distillate, and is capable of destroying resid (a low quality, money losing by product), it is incapable of processing low quality, heavy, high sulfur crude oil.  The rationalization of the industry began years ago.  On the East Coast alone, several sweet crude oil plants have been shut down or have plans to shut down including:

• Sunoco, Marcus Hook Pa. – 178,000 bpd
• Sunoco Philadelphia, Pa. – 355,000 bpd (currently in talks with a potential partner)
• Western Refining, Va. 64,000 bpd
• Valero, Delaware City, De.- 210,000 bpd

Of course, not all sweet crude, plants are at risk.  Some serve relatively isolated markets and process indigenous crude oil (not the case with Trainer).  Some reside in centrally planned economies like China who may consider these plants in their strategic interest regardless of their economic viability.

Could I be wrong about Trainer?  Of course I could be wrong.  Refining is a cyclical and complex business.  As with any business it is subject to the fundamentals of supply and demand.  An economic boom would tax the refining industry and improve margins.  Fracking (of some other new technology) both in the US and worldwide could produce extremely large amounts of sweet crude.   This would shrink the sweet/sour crude differential.  This in turn would help some sweet crude refineries to become more competitive.

Also, some have voiced positive views regarding the deal.  An economist and old acquaintance, Philip Verleger seems to like the concept.  He points to large spread between crude and jet fuel, especially on the East Coast.  Platts reported that Phil wrote "Capturing the refinery premium would provide a(n)...economic advantage to Delta. The firm will also be able to pick up the 'extra refining premium' that has been in the market for the last year or so. For jet fuel, refining margins have increased from around $12 to $18 per barrel. The difference amounts to roughly 15 cts per gallon. The combined savings for Delta could be 20 cts/gal. This would give it a $4000 to $5000 advantage on every flight from JFK to Heathrow, assuming no change to East Coast competitive conditions."

Structure of the Deal

Delta Airlines, through its wholly-owned subsidiary, Monroe Energy LLC has agreed to acquire the Trainer refinery from Phillips 66.  Monroe will pay a net price of $150 million for the plant (after receipt of $30 million in Pennsylvania state government assistance for job creation and infrastructure improvement).  In its press release, Delta stated that the refinery will be upgraded to maximize jet production at a cost of $100 million.  The press release goes on to say that multi-year exchange agreements will exchange gasoline, and other refined production for jet fuel.  In total, production and exchange volumes will provide 80% of Delta’s jet fuel needs in the U.S.  The deal is expected to close by mid-year 2012.

Refinery Trends

In 2000, 158 refineries operated in the US and its territories.  In 2010 the number has dropped to 137 (including lube refineries).  Yet the operable capacity over the same period increased from 16.5 million bpd to 18 million bpd

Booz & Company wrote a paper entitled “Refining Trends: The Golden Age or The Eye of the Storm” Some of their conclusions are as follows

o       Refiners do not see a clear path forward so they may be hesitant to make long term investments

o       Domestic product demand is declining

o       World product demand is growing

o       Penetration of electric vehicles and biofuels

o       Growing economies in developing nations encourage new gasoline powered vehicles

o       New Refineries have been planned but cancellations have been announced as well (due to high construction costs)

o       Gasoline consumption is highly correlated to personal disposable income

o       Slow growth or recession leads to demand destruction and lower refining margins

o       Refining capacity worldwide increased between 2003 and 2007

o       3-4 million bpd crude distillation

o       9 million bpd in other processes

o       If U.S. refiners begin exporting gasoline (which they have – my note), net margins will suffer due to product transportation costs

o       Their prediction was that going from importing gasoline in the US to exporting gasoline in the US could decrease domestic “crack spreads” (a measure of refining margin) by  $4-6/bbl

o       The Middle East is adding refining capacity in excess of local demand.  Many of these countries have made it clear that refining investments are part of their long term plan

In a study entitled “World Refining Western Decline and Eastern Growth”, the author indicates that:

• Falling consumption in the US and Europe has led to a significant surplus in distillation capacity
• There have been several refinery closures and more announcements of sales
• Most of those offered are unlikely to survive as refineries
• Rising consumption in the Middle East and Asia are creating demand for additional refining capacity in these regions

Here are my thoughts.  East Coast refineries were designed to process relatively sweet crude oil.  In an era of recession or slow domestic economic growth they are being squeezed by poor margins.  Products may be shipped to the East Coast from sophisticated refineries in the Gulf Coast or from Europe.  Over the past several years we have seen a rationalization of marginal plants even though total domestic refining capacity has remained constant.  The domestic crude slate is getting heavier and higher in sulfur.  What has happened in the U.S. is that as marginal plants have closed, others have made modest investments to debottleneck or expand their existing plant.  I believe that this trend will continue.

Trainer Refinery

The Trainer Refinery is a sweet crude, cracking refinery with bottoms destruction.  Data from the EIA reports the following configuration.

• Crude Unit – 190,000  Barrels/stream day
• Catalytic Cracking 53,000 Barrels/stream day
• Catalytic Hydrocracking of resid  23,000 Barrels/stream day
• Catalytic Reforming – 50,000 Barrels/stream day
• Desulfurization
• Diesel Fuel – 27,300 Barrels/stream day
• Heavy Gas Oil – 40,000 Barrels/stream day
• Kerosene and Jet fuel – 23,300 Barrels/stream day
• Naphtha – 77,100 Barrels/stream day
• Other Distillate – 4,200 Barrels/stream day

Platts reported that “Looking at company-by-company import data from the past, Trainer appears to have run heavily on Angolan and Nigerian crudes”.  Jeffery Warmann, the head of Trainer’s leadership team indicated the crude slate would be altered to include more North Sea barrels, and crude from Bakken.  The shift to North Sea barrels might have a small impact on profitability.  The wild card is Bakken (see figure 1).  Both WTI and Bakken are selling at a huge discount to Brent.  Bloomberg reported on 4/29/12 that WTI was selling at a discount to Brent by $15.16/bbl and Bakken was $6.50 below WTI (See figure 2 below).  The problem is that logistics are complex and costly to move Bakken to the East Coast.  The crude must be sent via rail to Albany, New York and then barged to the plant.  Estimates of rail costs alone range from $7-12/bbl.  Scheduling could also result in problems.  Even so, at current differentials Bakken is quite attractive.

Figure 1

Figure 2

The differentials have in part been caused by new fracking technology.  Production of Bakken crude has increased from about 33,000 bpd in 2007 to 546,000 bpd in January 2012.  The wide differential is a logistics issue but help is on the way.  Near the end of May, the Seaway Pipeline reversal project will carry about 150,000 bpd to the Gulf Coast.  This project will be expanded to carry about 400,000 bpd by 2013.  There are several other projects that would help reduce the differential including the southern leg of the Keystone XL pipeline, the ONEOK Partners project to transport 200,000 bpd from the Bakken fields to Cushing, Oklahoma and many others.  I believe that enough of these planned projects will be built to bring both WTI and Bakken in line with the historical Brent/WTI differential.  The economic incentives are just too great.  In addition, I believe that moving both Canadian and Bakken crude to the huge and complex refining center in the Gulf Coast makes much more sense than moving it to the East Coast.  In summary, Trainer might be able to take advantage of the discount on Bakken but I believe the anomaly will be short lived.  I also believe that under the best of circumstances, Bakken volumes delivered to the refinery will not exceed 10-20% of its needs at most (but I could be wrong).

BloombergBusinessweek quoted Sun spokesman who said “Sunoco’s Northeast refining business has lost nearly $1 billion over the last three years”.  Applying that same margin to the Trainer plant would indicate a loss of about $350 million over the same period.  The Trainer plant is more sophisticated than either of the Sun plants (although Sun’s Philly plant appears to have excess cat cracking capacity which might have mitigated its losses to some extent) so I would expect the Trainer losses to be somewhat less.  It is nearly impossible to determine the profitability of a particular refinery with public information.  Refining profitability data is almost always aggregated and sometimes combined with marketing.  Full disclosure – I have no insider information on the financial performance of the Trainer refinery so my estimate is nothing more than an educated guess.

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