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Delta's Oil Refinery & Getting Paid in Risk
We start with a look at how volatile oil prices affect airlines and Delta's unique approach to trying to hedge against price shocks. Next, we cover some exotic bonus and payment structures Credit Suisse designed to help align company and employee incentives.
Delta’s Oil Refinery (2 min)
Getting Paid with Risk (1 min)
Why did Delta spend $270 million to buy an oil refinery?
In 2012 Delta spent ~$270 million to buy and retrofit an oil refinery. To understand why it's important to see just how much the price of fuel matters to Delta. Airlines are an industry whose profits are notoriously sensitive to oil prices because they make up such a large portion of their cost structure. In 2010, Delta spent $8.9 billion on fuel. In 2011, that number was up to a staggering $11.8 billion. In 2012, even after reducing the amount of jet fuel it was using, the carrier’s fuel bill totaled $12.2 billion– or 36% of the airline’s total operating expense.
Traditionally some airlines have attempted to hedge their exposure to price swings by locking in guaranteed prices for the year instead of purchasing jet fuel on the open market. In 2008, Southwest hedged 70% of its fuel costs with oil at $51/barrel (meaning that they locked in that price for the duration of the hedge). Oil peaked in the summer of 2008 at $147/barrel and, while other carriers were focused on sizing down their operations, Southwest was able to expand into new markets thanks to its lower fuel costs.
Airline hedging strategies have changed over the last decade as fuel costs have gone up and down but in 2011 Delta paid, on average $3.10 per gallon of fuel vs. American’s price of $2.93, and United’s $2.87. Southwest's fuel hedging strategy backfired amidst a downturn in oil prices that year but it still managed to pay slightly less than Delta: $3.09 a gallon. It was amidst this backdrop that $270 million ($120 million to purchase the site and an addition to $150 million on retrofits and upgrades) to buy a mothballed oil refinery in Pennsylvania.
Delta wanted to use the refinery "as a physical hedge against fluctuating and potentially devastatingly high oil prices. The airline’s thinking was that by producing itself a sizeable percentage of the jet fuel the airline would be buying on the market, it could shield itself from the violent up and down swings in the per gallon price and from the periodic supply shortages [for kerosene jet fuel] that tended to drive big price spikes." And while it did offer some modest cost savings for Delta it also resulted in lower fuel prices across the entire industry, meaning that other airlines benefited from Delta's investment as well.
Ultimately the refinery ended up being a cost center instead of a cost saver for the company and in 2016 Delta had to switch to producing normal fuel products instead of jet fuel in order to cut costs and keep the refinery from losing even more money than it was (~$100 million a year). They've been trying to divest the refinery since 2018 but haven't yet found a partner willing to buy or operate the plant.
In Other Words
Fuel is the largest variable cost that airlines have, often comprising 20-30% of their total operating expenses. Some airlines (particularly Southwest in the US) hedge oil price volatility by purchasing options to stabilize the price of fuel for the year. Delta decided to go one step further and buy a refinery in order to produce its own jet fuel and not be reliant on the whims of producers in the market. Unfortunately, this ultimately proved unprofitable for them and they are now seeking to get rid of the refinery.
Why does Credit Suisse pay its executives in risk?
In 2008 amidst the panic of the financial crisis Credit Suisse decided to pay their senior executives bonuses in the form of junk grade loans and commercial mortgage-backed bonds. This allowed them to maintain bonus levels at a time other banks were slashing theirs (bonuses often comprise 40%+ of a bankers total compensation for the year) while simultaneously offloading over $5 billion of their riskiest assets off the bank's books. By 2012 those assets had gone up 75% making the idea of the toxic asset bonus pool a success.
In 2011 Credit Suisse announced that a portion of bonuses would be paid in a similar manner (bonds backed by derivatives linked to the performance of assets that the bank held). In the words of then CEO Brady Dougan, "We are trying to strike the right balance and align employees with shareholders. It’s a risk transfer from the firm to employees." By structuring bonuses in this way Credit Suisse made it so that a portion of its bankers compensation was tied directly to the long term performance of the assets the bankers were putting onto Credit Suisse's balance sheet. Because the bonuses were in the form of bonds linked to the performance of the bank’s assets that paid out over time, bankers had a much stronger incentive to choose assets that would perform well over the long term instead of riskier assets that just did well in the short term. Thus this facilitated an alignment between the bank’s interests and its employees and this innovative bonus structure has been copied by other banks who are keen to align incentives in a similar way.
In Other Words
During the 2008 financial crisis Credit Suisse needed cash to pay bonus and also needed to quickly offload risky toxic assets from its books. It came up with a scheme whereby it paid senior executive bonuses with the returns from those toxic assets and it proved to be very successful. in 2011 they implemented a similar program where bonuses were paid partially on the performance of the assets on the banks books, which served to incentivize bankers to ensure that the assets performed well over the long term and weren't unduly risky (since their bonus payouts would be affected negatively if the underlying assets defaulted).
That’s all for this week. Thanks for making it this far and I hope you found these answers as interesting to read as I found them interesting to write. If you liked what you read feel free to share it with someone who you think will enjoy this type of content.
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