Vertical integration as an input price hedge: The case of Delta Air Lines and trainer refinery

• Published date: 01 March 2020
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/fima.12260

DOI: 10.1111/fima.12260

ORIGINAL ARTICLE

Vertical integration as an input price hedge: The

case of Delta Air Lines and trainer refinery

Abdullah Mohammed Almansur1William L. Megginson1,2

Leonid V. Pugachev2,3

1College of Industrial Management, King Fahd

University of Petroleumand Minerals, Dhahran,

Saudi Arabia

2University of Oklahoma, Norman, Oklahoma

3Oklahoma State University, Stillwater,

Oklahoma

Correspondence

WilliamMegginson, College of Industrial Man-

agement,King Fahd University of Petroleum and

Minerals,Dhahran, Saudi Arabia and University of

Oklahoma,Norman, Oklahoma.

Email:wmegginson@ou.edu

PresentAddress

LeonidV. Pugachev,Saunders College of Business,

RochesterInstitute of Technology,Max Lowen-

thalBuilding, Room 3342 107 Lomb Memorial

DriveRochester, NY.

Abstract

In April 2012, Delta Air Lines (Delta) purchased a mothballed oil

refinery. We use this case to illustrate when, how,and why vertical

integration (VI) can hedge input price risk. First, we show that stock-

holders and creditors expected the move to create wealth. Consis-

tent with their predictions, Delta's exposureto refining margins, cash

flow volatility, cost of debt, and default probability all decreased,

relative to peers, postacquisition. Our evidence is consistent with

the refinery influencing Delta's operating strategies, especially in its

most affected markets. The case demonstrates how asset specificity

and financial hedging frictions can justify VI.

1INTRODUCTION

Why would an airline everpurchase and operate a petroleum refinery? Even though jet fuel is an airline's largest single

expense, modern economic and management thought stresses that corporations should focus on their core business

activities and purchase key inputs from efficient specialist suppliers. Delta Air Lines’ (Delta) April 2012 purchase of a

mothballedrefinery in Trainer,Pennsylvania, launched a large-scale, real-world test of the costs and benefits of hedging

input prices through vertical integration (VI). Our study assesses whether this strategy has been successful and why.

The Trainerrefinery (Trainer) created value for Delta by effectively hedging fuel price risk, when financial derivatives

could not. The refinery lowered overallrisk, reduced financing costs, and likely affected product market strategies. This

unique case provides rare, direct evidenceon how input price hedging through VI can create firm value.

The deal's announcement drew overwhelmingly negative reactions from the press. Industry analysts and academic

commentators derided it on industrial organization grounds (e.g., Postrel, 2012; Schaefer, 2012). How can an airline

competently run a refinery when seasoned oil refiners could not? Moody's Bond Rating Agency issued a statement

calling the acquisition “negative for Delta's credit profile” because of the airline's inexperience in refining. Academic

literatures on VI and risk management, however,seem to rationalize Delta's move. VI has been shown to add value in

[Correctionadded on 3 October 2019, after first online publication: the present affiliation of Leonid V. Pugachev has been added.]

c

2019 Financial Management Association International

Financial Management. 2020;49:179–206. wileyonlinelibrary.com/journal/fima 179

180 ALMANSUR ET AL.

cases of asset specificity,especially amid market uncertainty (Fan, 2000; Lafontaine & Slade, 2007). Around the time of

the acquisition, East Coast jet fuel markets faced unprecedented uncertainty as refinery closures threatened to halve

East Coast fuel supply (US Energy Information Administration [EIA], 2012). Given Delta's two New YorkCity hubs, it

stood to lose most from a supply shortage and gain most from avoiding it.1Thus, asset specificity made Trainerpar-

ticularly valuable to Delta. But why could Delta not hedge the looming supply cuts with financial derivatives? Among

several reasons discussed in the nextsection, one key obstacle is extreme illiquidity in the jet fuel derivatives market.

Airlines typically hedge fuel prices using related commodity contracts, usually crude oil and diesel, but as the risk man-

agement literature shows, basis risk may render such contracts ineffective (Gilje & Taillard, 2017; Haushalter,2000).

Thus, Traineroffered Delta a hedge that derivatives could not. Indeed, stakeholders expected the deal to create value.

Event studies estimate $500 million ($100 million) in stockholder (bondholder) wealth generated.

We test whether stakeholderexpectations proved valid by examining Delta's performance postacquisition. We find

that in the postacquisition period, Delta's stock becomes less exposed to refining margins, relative to other airlines.

Bond yields increase by 1.2 percentage points less than peers’ yields, and loan yields follow suit. Lower cost of debt

could reflect lower default probability, consistent with successful hedging (Froot,Scharfstein, & Stein, 1993; Smith &

Stulz, 1985), or higher expectedrecovery in default states, consistent with Delta purchasing an undervalued asset. We

find that Delta's cash flow volatility falls and distance to default rises, which suggest that positive bondholder returns

and lower spreads at least partially reflect a successful hedge.

Guided by studies that relate hedging to firm value, we test for operational changes around the acquisition. Wefind

no consistent evidence that Delta's investmentor debt levels changed more or less than its peer's did. Previous studies

argue the keybenefit to hedging is reduced underinvestment costs; however, our findings suggest that this was not the

primary source of value for Delta's hedge. We do find that postacquisition, Delta shifted toward a lower output, higher

price strategy,especially in its New York City hubs connected to Trainer.

Our paper provides new evidence about the motive, scope, and limitations to corporate risk management. With

incomplete and imperfect derivatives markets, companies may look elsewhere to manage input price exposure. We

present real-world evidence that VI can operationally hedge what illiquid financial derivativescannot. Although many

have shown that derivatives hedging can reduce default probability (e.g., Smith & Stulz, 1985), the Delta case demon-

strates that VI can do the same. Finally,we highlight two features crucial for Trainer's success. First, Trainerpresented

an opportunity to hedge a risk that Delta otherwise could not—refining margins. Second, location made the refinery

especially synergistic.

We proceed as follows. Section 2 provides background on the case and surveys related literature. Section 3 inves-

tigates stakeholder reactions around the acquisition announcement. Section 4 studies Trainer'seffect on Delta'srisk

exposure. Section 5 tests for operational changes. Section 6 summarizes our findings and reviews the implications for

corporate finance research.

2BACKGROUND AND MOTIVATION

Jet fuel constitutes a large portion of airline expenses; at the time of the acquisition, it was 30% of Delta'stotal

expenses. Fuel costs can be decomposed into the cost to obtain crude oil and the cost to refine it. Therefore, jet fuel

price risk reflects dynamics in the crude oil marketand refining industry. The refining margin, or difference between jet

fueland crude oil prices, i s known as a crackspread (what it costs refiners to “crack open” a barrel of crude oil). Although

owning a refinery cannot mitigate crude oil price risk, it can absorb crack spreads. Figure 1, which plots crude oil and

jet fuel prices since 1990, shows that crack spreads vary over time and that they approached record highs around

Delta's acquisition decision. With nearly 4 billion gallons consumed in 2011 at an average price of $2.05 per gallon,

Delta wrote a $2 billion check just for the jet fuel–crude oil crack spread to its refiners that year,nearly one tenth of

operating expenses.

1Accordingto the Bureau of Transportation Statistics market share data for John F.Kennedy and LaGuardia airports, Delta held the largest share of all flights

inand out of New York in 2012 and 2018, approximately one quarter each period.