Airline stocks have been flying high in 2014 after notching up robust gains in 2013. Year-to-date the Dow Jones U.S. Airline Index (^DJUSAR) is higher by 14% after returning 85% in 2013.
The strong performance comes despite rising fuel costs, which can make up approximately 30% of an airline’s operating cost. Many airlines hedge their fuel costs by taking counter positions in the oil futures market, which help offset any rise in jet fuel prices. Delta Air Lines Inc. (NYSE: DAL) has gone a step further and purchased a refinery that supplies its aircrafts directly with jet fuel. But has this nontraditional approach to decrease volatile fuel prices paid off? More importantly, will it pay out for you?
Delta’s Hedging Alternative
In 2012, Delta purchased the Trainer refinery from ConocoPhillips (NYSE: COP) for $180 million, which included a $30 million subsidy from the Pennsylvania government. The company viewed the purchase as a way to hedge jet fuel prices, which have more than doubled during the past decade.
Delta decided to purchase a refinery as opposed to continuing its hedging program because of the difficulty airlines have in hedging the crack spread, or the difference between prices of jet fuel and crude oil. Many airlines hedge their fuel exposure by purchasing crude oil or heating oil futures to offset any rise in jet fuel prices.
In 2013 Delta was disappointed with the performance of its refinery as numerous production challenges generated a loss of approximately $116 million at the facility. The company has been telling investors that the refinery will benefit from sourcing lower-cost Bakken crude from North Dakota as a way of generating future profits.
Refinery vs. Hedging
The issue that most airlines face is that the most liquid hedging instruments do not create a perfect hedge and therefore can generate unwanted volatility for the bottom line as fuel prices gyrate.
Despite becoming a price influencer by purchasing an oil refinery, Delta is now subject to earnings volatility from a business that is highly cyclical. Its hedges are more precise than its competitors, but it is exposed to declining demand for gasoline and warm winters, which can erode the airline’s refinery profit margins.
Given the difficulties Delta has had in producing profits in the refinery business, and the unwanted volatility associated with it, its competitors are likely better served by using conventional derivatives hedging techniques as opposed to purchasing a refinery.
Delta might have discovered a hedging technique that mitigates the volatility of jet fuel costs, but running a refinery is a cyclical business that could hamper the company’s returns at the least desirable time.
The cold weather this winter has increased the demand for petroleum which in turn has driven up fuel prices, but airlines such as Southwest Airlines (NYSE: LUV) and Spirit Airlines (Nasdaq: SAVE), which have hedge fuel costs with futures, have mitigated their exposure to rising jet fuel prices.
While Delta may be a gamble until its earnings stabilize, its competitors that have stuck to the more traditional hedging methods have managed mitigated some volatility to the rising jet fuel prices. Due to rising fuel prices and hedging recent positive outcome for Southwest and Spirit, don’t expect other airlines (or investors) to jump on the refinery ownership bandwagon just yet.
View original at: Investment U
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