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May 01, 2012

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I think you're understanding incorrectly what Delta is doing by buying this refinery. It is not going to buy a bunch of crude and then refine a bunch of jet and keep it. Rather, this is a way of hedging fuel prices.

This article explains the strategy pretty well. http://www.platts.com/weblog/oilblog/2012/05/01/an_airline_buys.html

I think you were taking literally people's oversimplifications.

You can't get the socratic method out of me, not after so long at HBS ...

There're two hidden assumptions here.

Delta has two strategies after buying the refinery. Delta thinks that it can earn about $5,000 per flight-equivalent of jet fuel. So for this deal to make sense at all, the capital cost of the refinery purchase has to come to less than $5000 per flight-equivalent of production. E.g., the first assumption is that other potential buyers are capital constrained or unwilling to buy: otherwise they'd just bid up the price until it wasn't worth Delta's while.

Once Delta buy the refinery, it then has two strategies open to it. The first is simply to earn the crack spread by selling the fuel on the open market. The second is to use the fuel itself. In theory, these are equivalent from Delta's point of view.

Why then choose to use the fuel yourself instead of selling it and pocketing the gains? That brings us to the second assumption: that the transaction costs of marketing the oil and then cross-subsidizing the airline operation are higher than the transaction costs of just shipping the stuff to yourself.

In other words, two things need to be true: (a) other buyers have to be unable or unwilling to buy the thing at the going price; and (b) it has to be cheaper for Delta to sell product to itself rather than market it.

Going full circle, I can imagine that these two things would hold true for the Chinese government.

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