Southwest Airlines 2011 Annual Report Download - page 76

and/or pledged aircraft are required to be posted whenever the net fair value of derivatives associated with those
counterparties exceeds specific thresholds—cash is either posted by the counterparty if the value of derivatives is
an asset to the Company, or cash and/or aircraft could be posted by the Company if the value of derivatives is a
liability to the Company. Refer to the counterparty credit risk and collateral table provided in Note 10 to the
Consolidated Financial Statements for the fair values of fuel derivatives, amounts posted as collateral, and
applicable collateral posting threshold amounts as of December 31, 2011, at which such postings are triggered.
At December 31, 2011, of the entire $226 million in cash collateral deposits posted with counterparties
under the Company’s bilateral collateral provisions, $41 million in cash collateral deposits has been netted
against noncurrent fuel derivative instruments within Other noncurrent liabilities and $185 million in cash
collateral deposits has been netted against current fuel derivative instruments within Accrued liabilities in the
Consolidated Balance Sheet. No aircraft were pledged as collateral at December 31, 2011. Due to the terms of the
Company’s current fuel hedging agreements with counterparties and the types of derivatives held, in the
Company’s judgment, it does not have significant additional exposure to future cash collateral requirements. As
an example, if market prices for the commodities used in the Company’s fuel hedging activities were to decrease
by one-third from market prices as of December 31, 2011, given the Company’s fuel derivative portfolio, its
aircraft collateral facilities, and its investment grade credit rating, it would likely provide an additional $700
million in cash and/or aircraft collateral to its current counterparties. However, the Company would expect to
also benefit from lower market prices paid for fuel used in its operations.
The Company is also subject to the risk that the fuel derivatives it uses to hedge against fuel price volatility
do not provide adequate protection. The majority of fuel derivatives in the Company’s hedge portfolio are based
on the market price of West Texas intermediate crude oil (WTI). During early 2011, the spread between WTI and
jet fuel widened beyond historic norms, which led to more ineffectiveness when measuring the Company’s
hedges. During that time, jet fuel prices more closely correlated with changes in the price of Brent crude oil
(Brent). During fourth quarter 2011, the spread between WTI and jet fuel narrowed from its 2011 high, but still
remains higher than historic norms; however, there is no assurance that this spread will not expand again in the
future. Although the Company has some fuel derivatives based on the price of Brent, to the extent the spread
between jet fuel and WTI stays at current levels or widens from current levels, the Company’s hedges could
continue to be ineffective and not provide adequate protection against jet fuel price volatility.
The Company also has agreements with each of its counterparties associated with its outstanding interest
rate swap agreements in which cash collateral may be required based on the fair value of outstanding derivative
instruments, as well as the Company’s and its counterparty’s credit ratings. As of December 31, 2011, $64
million had been provided to one counterparty associated with interest rate derivatives based on the Company’s
outstanding net liability derivative position with that counterparty. In addition, in connection with interest rate
swaps entered into by AirTran, a total of $32 million in cash collateral had been provided to two counterparties at
December 31, 2011, as a result of net liability derivative positions with those counterparties. The outstanding
interest rate net derivative positions with all other counterparties at December 31, 2011, were assets to the
Company.
Due to the significance of the Company’s fuel hedging program and the emphasis that the Company places
on utilizing fuel derivatives to reduce its fuel price risk, the Company has created a system of governance and
management oversight and has put in place a number of internal controls designed so that procedures are
properly followed and accountability is present at the appropriate levels. For example, the Company has put in
place controls designed to: (i) create and maintain a comprehensive risk management policy; (ii) provide for
proper authorization by the appropriate levels of management; (iii) provide for proper segregation of duties;
(iv) maintain an appropriate level of knowledge regarding the execution of and the accounting for derivative
instruments; and (v) have key performance indicators in place in order to adequately measure the performance of
its hedging activities. The Company believes the governance structure that it has in place is adequate given the
size and sophistication of its hedging program.
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