Delta Airlines vs. Big Gas (No, not Big Oil) [137*3]

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INTRODUCTION

DELTA AIRLINES BOUGHT AN OIL REFINERY TODAY! They bought it to combat the high price of aviation fuel, 40% of their operating costs, they believe is driven primarily by speculation. This hub isn't about the wisdom of their action, although it is absolutely novel, and, in my opinion, certainly called for. Instead, it is about the possible economic effect of their decision, for it puts the oil and refinery industry in a potential bind in the future, depending on Delta's success.

The reason for taking this track is my belief it is important to understand, in today's political debate, a little, from a practical point-of-view, a little of how supply and demand works, the interrelationship of related industries, and how speculation actually works.

WHAT SPECULATION IS ALL ABOUT!

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WHAT IS SPECULATION, REALLY

THE REASON DELTA AIRLINES bought a refinery, something way out of their business comfort zone, was to get control of their fuel costs, the single most expensive part of their operating costs, to eliminate, as they said, the "middle-man". Part of this "middle-man" effect is a specialized term called the "Jet Crack Spread", which is the difference between the price of a barrel of crude oil and the price of a barrel of jet fuel. That difference is more-or-less the cost of refinery plus the cost of trading in the fuel.

For example,

  • in the summer of 2011, the spread between oil and jet fuel was $45 per barrel, while in the winter of 2010 and 2011, it was around $16 -$18 per barrel.
  • In the same period of time, the price of oil stayed around $101 per barrel, except for a brief drop down to about $80 in the fall of 2011.
  • Further, the change in demand for aviation fuel during that time. was a 29% increase in passenger travel from winter of 2010 to summer of 2011, and 14% decrease to winter of 2011.
  • Finally, actual refining costs, excluding the cost of purchasing crude, per barrel of oil, simply would change like that, no business could plan or survive such swings in production costs.
  • Clearly, there is something out of sync between the changing price of oil, the changing price of jet fuel, and the changes in demand for fuel.

Many believe the cause of this anomaly, this huge spike, is the effects of speculation in the trading market. The reason this is thought is there is no good supply/demand based reason for the crack spread, the cost to trade and refine jet fuel, to change so dramatically given there was no particularly good reason why the cost of production should change so dramatically. Therefore, if there wasn't a good supply and demand or a production cost reason, all you have left to blame are major fluctuations in trading, i.e., speculation.

What is speculation, really. It is the betting by non-end users of a security or commodity that the future price is going to change in a certain direction. They place either buy or sell orders to make their bets. Sometime later, they reverse what they did, i, e,. buying what they sold or selling what they bought. If they ended up paying less than what they sold it for, then they win, otherwise they lose. You will notice that in this whole process, it didn't make any difference what we were talking about, the speculators don't really care because they have no vested interest in the particular commodity or security other than how they think the price will move.

All of this is well and good and legal and, in the commodities market, mostly UNREGULATED! Even so, when speculators make up a small portion of total trades then it doesn't matter much because they don't have enough wallop to drive prices to a large degree. Today however, in the commodities market, speculators, in other words, institutions who have no actual use for the commodity they are trading in, have become an unbelievable 70% of all traders, according to Gary Gensler, head of the Commodity Futures Trading Commission. Obviously, when speculators are that much of the market, they can easily drive market prices, regardless of what ideas to the contrary those on the Right-side of the aisle try to convince you.

Speculative swings in prices normally start with some kind of major event or expectation, and those who simply are trying to make a quick buck pounce on it. Let's say in February of 2011, market anaysts predicted a sharp up swing in demand for airline passenger-miles. then you can easily have the following sequence of events:

  1. More demand often means higher prices
  2. Corporations who depend on the fuel, buy some at current prices to "hedge" against expected future price increases.
  3. This action, if large enough, will begin to push fuel prices
  4. Speculators see an opportunity to make money by betting on the price of fuel gong up and begin to make purchases, driving prices a bit higher.
  5. This encourages more speculators to get into the market, and they start buying, which, in turn, drives prices still higher, and so it goes.
  6. At some point, the companies who use the fuel stop buying because they feel they are protected enough.
  7. If these kinds of companies far exceed the speculative traders in the market, this is where price increases often stop and start coming down again as speculators unload their purchases to reap their profits, if they bought early enough.
  8. IF, HOWEVER, SPECULATORS far exceed the user-trader, as they do in the commodities market, the trading does not stop here but keeps on going, driving prices up well beyond their market based value.
  9. At some point, prices get so high, even the speculators start getting cold feet and begin selling, sometimes leading to a crash in prices and sometimes stabilizing out if the world situation is unstable enough.

That is often how speculation works and it is only because speculators control the market.

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ENTER DELTA INTO THE REFINING INDUSTRY

DELTA AIRLINES AS WELL AS the rest of the airline industry cannot live with wild swings in the price of their #1 expense item. Consequently, Delta came up with an innovative solution, they bought their own refinery to produce most of what they need in the way of jet fuel. One of the points of this, of course, is to eliminate the market fuel broker and separate themselves from the speculation driven pricing structure currently in vogue today. They can't do much about the speculation in oil prices, which is a basic raw material for any refinery, but they certainly can mitigate or eliminate the price swings caused by the trading cost portion of the "crack spread".

What might be the implications of this move? If Delta were a small company, not much; but, they aren't, they are #2 in America and they spend somewhere in the neighborhood of $12 billion annually on jet fuel; that is about 9% of the total spent world-wide. What Delta implicitly is doing is reducing demand for fuel on the world market by up to 9% by simply taking themselves out of the game. And, what happens when demand goes down? Prices often follow.

SCENARIO #1 - FUEL PRICES CRASH

BECAUSE THE COMMODITIES market consists of mainly speculators, made worse obviously by the withdrawal of Delta from the trading market, then this sudden drop in demand may set of a speculative run in the other direction, forcing prices down, very quickly. It is easy to make money regardless of which way prices move, they just need to move in the direction and somewhat to the degree you expected them to is all. So, speculators sill start doing what they need to do to make their money and end-users may actually "unhedged" as it were, getting rid of any expensive fuel they may have purchased in the hopes of buying more at lower prices. This mechanism can feed on itself and result in a fuel price crash.

In that event, other airlines and transportation companies who depend on large quantities of refined oil, may be happy just the way things are, and do nothing.

SCENARIO #2 - OTHER AIRLINES BUY THEIR OWN REFINERIES

ON THE OTHER HAND, if prices don't change much because 5 - 9% wasn't enough to set the speculators off, but Delta is successful in obtaining large savings from their venture, then other airlines or other major users of oil products may follow. If they do, you will see a fundamental shift in this sector of the commodities market and, I would suspect, some rather interesting changes in the prices of all things made from oil.

Unless you are a glutton for punishment, you can stop here and start your comments. Otherwise, push on as I discuss how that last sentence may come about.

FINDING THE RIGHT ANSWER

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PUSHING ON

ONE OF THE FIRST CONSEQUENCES may be the death of speculation in the fuels market. This might happen because there is nothing substantial left to speculate in, if most of the major buyers of fuel stop buying and start producing their own. But, another, more basic change may be in the other oil derivatives.

Only being a little bit tongue-in-cheek, this may result from a once obscure area of mathematics called linear algebra and linear programming. I say this because most refineries use calculation methods derived from these fields to figure out how much of various products to produce and sell at what price. So, let's take a quick look at how this works.

Many, many products can be refined from oil: gasoline, diesel, jet fuel, kerosene, and naphtha, to name a few. I don't know if any refineries produce all of these products but they will produce several of them with each refinery determining its specific product mix. What has resulted from all of this is great overlap in refineries that produce some of, if not the same products as other refineries; it sort of ends up like being that "six-degrees of freedom" concept of interconnectedness. I point this out to show that changes in one refineries mix, output, and pricing will ultimately cause changes in many other refinery's mix, output, and pricing.

Those three elements, product mix, output, and pricing end up being a function of supply/demand, production costs, and production capacity; each of the latter set being a system constraint. When any one or more of these constraints changes for a given company, potentially they can change for all interconnected companies, primarily because the products from this industry are traded in the commodities marketplace.

Here is how. Suppose Company A produces products X, Y, and Z while Company B makes products W, X, and Y. Products X and Y obviously are part of the Supply equation that helps set price in the commodities exchange. Enter mathematics.

There are many different algorithms that have been developed that companies use to determining the optimal mix of products to produce and sell at certain prices; one such algorithm is called the Simplex Method. Inputs to the algorithms are such things as supply. demand, cost, and capacity information and the output for Company A is to produce x amount of Product X and sell it price 'a', produce 'y' amount of Product Y and sell it at price 'b', and produce 'z' amount of Product Z and sell it at price 'c'. Company B goes through a similar procedure for its products as do all other refineries. For all of those refineries that make Product X, for example, the sum of the quantities produced equals the Supply of X; let's call X, jet fuel and Y, gasoline, why don't we.

This jet fuel is sold on the commodities market where the price is actually set. So long as the markets are stable, the refineries are happy producing at what their algorithms tell them to and selling it near the optimal price. If prices change, then refineries start rerunning their mathematics and come up with new mixes and prices. Now, here comes Delta Airlines buying their own refinery and making their own jet fuel, as well as other products with they trade for more jet fuel or sell in the marketplace. What happens?

The first thing is a large reduction in demand for the jet fuel that they use to buy on the commodities exchange with no real change in Supply since they aren't putting their product up for sale, at least the jet fuel anyway. What does this reduction accomplish relative to the rest of the refineries? Let us look at the following table to get some insight.

EXAMPLE OF SUPPLY AND DEMAND

 
AGGREGATE DEMAND -->
Demand for Jet Fuel at $20/bbl
Demand for Jet Fuel at $30/bbl
Demand for Jet Fuel at $40/bbl
Demand for Gasoline at $3.00/gal
Demand for Gasoline at $3.50/gal
Demand for Gasoline at $4.00/gal
 
AGGREGATE SUPPLY
100.000
80,000
50,000
1,000,000
700,000
300,000
Supply for Jet Fuel at $20/bbl
70,000
 
 
 
 
 
 
Supply for Jet Fuel at $30/bbl
80,000
 
X
 
 
 
 
Supply for Jet Fuel at $40/bbl
150,000
 
 
 
 
 
 
Supply for Gasoline at $3.00/gal
500,000
 
 
 
 
 
 
Supply for Gasoline at $3.50/gal
700,000
 
 
 
 
X
 
Supply for Gasoline at $4.00/gal
1,500,000
 
 
 
 
 
 

YOU MIGHT NEED TO SCROLL the table from left to right to see it all. As you do, note where the two 'X's are.

THIS IS AN AGGREGATE SUPPLY AND DEMAND table (normally you would see curves, but this is easier to portray). The 'X's are the prices where, for each product, the suppliers are willing to provide enough product at the price the consumer is willing to pay; in this case, 80,000 bbl of jet fuel and 700,000 gal of gasoline. Each refinery which produces jet fuel and gasoline will have found the right amount of each to produce, along with any other product they may make, based on the price the market is paying. It should be easy to see that as price goes up, the amount of product people are willing to buy goes down and the more of the product the supplier is willing to produce. If the supplier produces too much, they will sit on inventory, which costs money; consequently, they will cut production and cut prices to get rid of the inventory. Once things settle down and equilibrium is reached, at least for a short while, you might see something like the table above.

Here comes Delta (and maybe others) and takes a large chunk of demand out of the jet fuel market. The first thing that happens, of course, is the Demand Curve shifts, there is simply less demand at each price level because Delta took $13 billion of the table; a lot less jet fuel is needed now and suppliers face the prospect of sitting on growing inventories and must drop their price and production accordingly; a new equilibrium point must be found as suggested in the table below.

SUPPLY AND DEMAND - TAKE 2, NOT LONG AFTER DELTA LEAVES THE MARKET

 
AGGREGATE DEMAND -->
Demand for Jet Fuel at $20/bbl
Demand for Jet Fuel at $30/bbl
Demand for Jet Fuel at $40/bbl
Demand for gasoline at $3.00/gal
Demand for gasoline at $3.50/gal
Demand for gasoline at $4.00/gal
 
AGGREGATE SUPPLY
70,000
60,000
10,000
1,000,000
700,000
300,000
Supply for Jet Fuel at $20/bbl
70,000
X
 
 
 
 
 
Supply for Jet Fuel at $30/bbl
80,000
 
 
 
 
 
 
Supply for Jet Fuel at $40/bb
100,000
 
 
 
 
 
 
Supply for Gasoline at $3.00/gal
500,000
 
 
 
 
 
 
Supply for Gasoline at $3.50/gal
700,000
 
 
 
 
X
 
Supply for Gasoline at $4.00/gal
1,500,000
 
 
 
 
 
 

NOTICE THAT nothing really changed for gasoline, all of the activity has centered around the jet fuel, but, that is about to change. The reason is the interconnectedness between products and producers of those products. Behind it all are the linear programming algorithms which help companies to decide what product mix they need to maximize their profits.

Just prior to the moment when Delta took demand out of the market, each supplier in the market of gasoline had figured out just how much gasoline and jet fuel to produce (along with any other product they may sell). The moment after Delta does its thing, these suppliers no longer can produce as much jet fuel as that once had; if they do, income will fall and costs will increase for maintaining excess inventory, don't you see.

As a consequence, they rerun their algorithms with new inputs and new constraints, primarily, less demand for jet fuel. Out of this process will come a new quantity of gasoline and jet fuel to produce which will maximize their particular profit picture. The problem is, $13 billion was taken out of circulation by Delta, so that is $13 billion the suppliers of jet fuel are going to lose out of the gross sales.

In order to make up for these lost sales, they will need to produce and sell more of their other products, including gasoline. But, what happens when they increase supply with demand remaining constant? They must reduce their price of gasoline to increase demand. This leads us to the next table you see below.

SUPPLY AND DEMAND AFTER SOME TIME HAS GONE BY

 
AGGREGATE DEMAND -->
Demand for Jet Fuel at $20/bbl
Demand for Jet Fuel at $30/bbl
Demand for Jet Fuel at $40/bbl
Demand for gasoline at $3.00/gal
Demand for gasoline at $3.50/gal
Demand for gasoline at $4.00/gal
 
AGGREGATE SUPPLY
70,000
60,000
10,000
1,000,000
700,000
500,000
Supply of Jet Fuel at $20/bbl
70,000
X
 
 
 
 
 
Supply of Jet Fuel at $30/bbl
80,000
 
 
 
 
 
 
Supply of Jet Fuel at $40/bbl
100,000
 
 
 
 
 
 
Supply of gasoline at $3.00/gal
1,000,000
 
 
 
X
 
 
Supply of gasoline at $3.50/gal
1,500,000
 
 
 
 
 
 
Supply of gasoline at $4.00/gal
1,750,000
 
 
 
 
 
 

OBVIOUSLY, no one will ever see price changes like these simply because Delta left the marketplace, but, if others followed, you certainly; even more dramatic one. I hope, without confusing or boring you too much, I was able to give you a little technical insight to what goes on in supply and demand and that it is not such a simple process as the politicians would have you believe. Instead, it is an amazingly complex set of interactions between countless variables, just as the whole economy is.

Hopefully it is more clear now that if you make simple "fixes" here, you may end up with terrible consequences "there". If I might digress a bit into another arena, the Balanced Budget Amendment, which has been proposed, is such a simple "fix" to America's debt problems. If enacted, it would devastate the economy of the United States because it, in effect, throws glue into the intricate mechanism that drives the American economy without regard to the consequences that may result because weren't seen with one's head is stuck in sand of one's philosophical dogmatism. It would, in practice, take away the "algorithms" the government uses to react to changing domestic and world events and only offers them a single solution to all problems. It is like saying to the suppliers of oil by-products that they aren't allowed to recompute their product mix because of the loss of jet fuel demand, but must stay with the mix the founders of the company originally proposed.

OK, back on task. At the outset, I said I wanted to show the possible economic outcomes resulting from Delta's decision to produce their own jet fuel. I think you can see now that it does cause a deterministic, albeit a small one probably, change in pricing of, not only jet fuel, but of related products like gasoline as well. It was certainly a bold move, but a necessary one that could herald in a new day of how commodities, at least those made from oil, are bought and sold. I only see an upside to what Delta has done and hope it works.

WHAT DO YOU THINK, INTELLIGENT MINDS WANT TO KNOW

Do you believe Gary Gensler, head of the CFTC, when he says Speculators now make up 70% of the commodities market?

  • YES
  • NO
  • NOT SURE/DON'T KNOW
  • DON"T KNOW WHO GARY GENSLER OR THE CFTC ARE
See results without voting

Do you think that Speculation has a significant impact on oil and gas prices?

  • YES
  • NO
  • DON'T KNOW/NOT SURE
See results without voting

Do you think Delta Airlines did the right thing in buy a refinery in order to side-step the commodities market?

  • YES
  • NO
  • NOT SURE/DON'T KNOW
See results without voting

Do you think that with Delta Airlines producing its own jet fuel, it will lower the price of jet fuel on the open market?

  • YES
  • NO
  • NOT SURE/DON'T KNOW
See results without voting

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Comments 4 comments

HSchneider 4 years ago from Parsippany, New Jersey

Great analysis of the jet fuel market and all markets. Speculation is always high and they now resemble casinos rather than stable markets. I still believe that at their core they represent supply and demand in that market but speculators take it up and down to make their profits. The Delta move is a very interesting and innovative one. I hope it takes a healthy bite out of the speculators game.


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My Esoteric 4 years ago from Keystone Heights, FL Author

Thanks HS, I will be following this with great interest.


Kathleen Cochran profile image

Kathleen Cochran 4 years ago from Atlanta, Georgia

This hub could be the text for a college course on the subject. Great work - thanks for the effort you put into this for the rest of us inquiring minds.


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My Esoteric 4 years ago from Keystone Heights, FL Author

Thank you for your very nice comment, Kathleen; I figured I needed to put my nerdism to good use, lol.

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