Thursday, April 12, 2012

Delta ups the ante in war against Wall Street

I have discussed manipulation of the commodities space many times in this Blog, enjoy the latest addition. Aivars Lode

April 12, 2012: 9:04 AM ET

Delta is hoping to beat Wall Street at its own game by getting into the jet fuel trading business. If successful, one bank stands to lose the most.

By Cyrus Sanati, contributor

deltaFORTUNE -- Delta Air Lines is upping the ante in its war with Wall Street over jet fuel prices. The airline is hiring away oil traders from the Street and is now angling to buy a refinery on the east coast in an effort to cut costs and bypass speculators. If successful, Delta could encourage other airlines to follow suit, delivering a blow to the trading floors at some of the big banks.

The airline industry has lobbied Congress for years to rein in the explosion in financial speculation in the commodity markets. They believe that too much speculation in the physical and futures markets for oil products by Wall Street has led to artificially high jet fuel prices, crushing their profit margins. But while Congress has entertained hearings on the subject on several occasions, the airlines' calls have fallen mostly on deaf ears as they were pitted up against the financial services lobby, which has far greater pull in Washington.

Now Delta is looking to beat Wall Street at its own game by getting into trading. Its merger with Northwest Airlines in 2008 has given Delta the heft and enough cash on hand to start buying and selling jet fuel for its own account. Before the merger, Delta procured jet fuel in much the same way it bought snacks and napkins for its inflight service -- a refiner, broker or bank would quote them a price for fuel and they would take it or risk not flying that day.

In the last year Delta (DAL) has started to look at jet fuel as more of a financial product as opposed to just another line item of expense, a person with knowledge of the situation told Fortune. It has moved its jet fuel procurement division into its treasury services department and started to hire traders away from Wall Street, this person said. Delta recently hired oil trader Jon Ruggles away from Merrill Lynch to build out its trading operations in Atlanta. Ruggles has extensive experience trading oil products with stints at ConocoPhillips (COP), Trafigura and later at Merrill. Delta did not respond to requests for comment.

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Delta wants to move from being a price taker to a market maker. To do that, the airline is moving to buy or control some of the physical assets associated with jet fuel production and distribution, like a refinery. Owning physical assets is a tactic big banks like Goldman Sachs (GS) and Morgan Stanley (MS) have used for years to gain an informational advantage over their competition. Morgan Stanley owns crude and refined product storage tanks and pipelines to track the flow of oil products throughout the U.S., while Goldman bought power plants to give its electricity traders an edge.

Morgan Stanley continues to be a large player in energy trading, especially in jet fuel, where it is by far the largest financial player, according to independent brokers in the space. Morgan Stanley does not break out revenues from its jet fuel trading business, but it is believed to be substantial given the amount of volume it trades. Citigroup (C), Macquarie, JP Morgan (JPM) and Barclays (BCS) all have a sizable presence in trading jet fuel, but to a much smaller degree than Morgan Stanley. Meanwhile, Goldman has largely exited the jet fuel market as it scales down its trading operations, brokers say.

It is unclear what Delta is going to do with a refinery just yet, but it may be trying to emulate Macquarie, the Australian investment bank, in its arrangement with the Come-by-Chance refinery in Canada. The bank has what is known as a physical off-take agreement with the refiner, according to a person with knowledge of the contract. That means it agrees to buy most of the products the refinery pumps out. Macquarie would then take that physical supply and try to broker it out to end users, like the airlines. This agreement makes sense for Delta, as it could gain an informational edge in trading and a physical edge in flying without burdening itself with the cost and headache of owning a refinery.

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But to gain real pricing power over other airlines and to cut Wall Street out at the same time, Delta may choose to buy a refinery outright. The company is reportedly looking to buy the Trainer refinery in New Jersey, which is located near its hub at JFK Airport in New York City. The Trainer refinery is currently owned by ConocoPhillips, where Delta's new fuel chief cut his teeth trading oil a few years back.

The Trainer refinery could possibly be retooled to pump out more jet fuel, but that would require significant capital expenditures. The cost savings, though, may be worth the initial cash outlay. The price differential between a barrel of crude and a barrel of jet fuel in the last year on the east coast has ranged from as low as $16 a barrel this winter to as high as $45 barrel last summer. Built into this differential are refining and trading costs associated with the supply and demand of jet fuel relative to that of crude. Delta could significantly tighten that price differential buy using its own jet fuel and by swapping it directly with other refiners that could supply fuel to Delta's other hubs.

Delta's success could encourage other airlines to trade and own physical assets associated with jet fuel production, essentially squeezing Wall Street traders and brokers out of the game. But Delta's success isn't guaranteed. Trading is a dangerous game where losses can pile up quickly. While the airline stands on much firmer financial ground than in the past, it still doesn't have a strong enough balance sheet to withstand considerable trading losses, especially with a refinery on its books.

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