Southwest Airlines 2002 Annual Report Download - page 63

44 | SOUTHWEST AIRLINES CO. 2002 10-K
9. Derivative and Financial Instruments
Airline operators are inherently dependent
upon energy to operate and, therefore, are
impacted by changes in jet fuel prices. Jet fuel
and oil consumed in 2002, 2001, and 2000
represented approximately 14.9 percent,
15.6 percent, and 17.4 percent of Southwest’s
operating expenses, respectively. The
Company endeavors to acquire jet fuel at the
lowest possible cost. Because jet fuel is not
traded on an organized futures exchange,
liquidity for hedging is limited. However, the
Company has found that both crude oil and
heating oil contracts are effective com-
modities for hedging jet fuel. The Company
has financial derivative instruments in the
form of the types of hedges it utilizes to
decrease its exposure to jet fuel price
increases. The Company does not purchase or
hold any derivative financial instruments for
trading purposes.
The Company utilizes financial derivative
instruments for both short-term and long-term
time frames when it appears the Company
can take advantage of market conditions. As
of January 22, 2003, the Company had a
mixture of purchased call options, collar
structures, and fixed price swap agreements
in place to hedge approximately 83 percent of
its 2003 total anticipated jet fuel require-
ments, approximately 80 percent of its 2004
total anticipated jet fuel requirements, and
portions of its 2005–2008 total anticipated jet
fuel requirements. As of December 31, 2002,
the majority of the Company’s first quarter
2003 hedges are effectively heating oil based
positions in the form of option contracts. The
majority of the remaining hedge positions are
crude oil based positions.
During 2002, 2001, and 2000, the
Company recognized gains in “Fuel and oil”
expense of $44.5 million, $79.9 million, and
$113.5 million, respectively, from hedging
activities. At December 31, 2002 and 2001,
approximately $13.1 million and $8.2 million,
respectively, due from third parties from
expired derivative contracts, is included in
“Accounts and other receivables” in the
accompanying Consolidated Balance Sheet.
The Company accounts for its fuel hedge
derivative instruments as cash flow hedges,
as defined. Therefore, all changes in fair value
that are considered to be effective are
recorded in “Accumulated other comprehen-
sive income (loss)” until the underlying jet fuel
is consumed. The fair value of the Company’s
financial derivative instruments at
December 31, 2002, was a net asset of
approximately $157.2 million. The current
portion of these financial derivative
instruments is classified as “Fuel hedge
contracts” and the long-term portion is
classified as “Other assets” in the
Consolidated Balance Sheet. The fair value of
the derivative instruments, depending on the
type of instrument, was determined by the use
of present value methods or standard option
value models with assumptions about
commodity prices based on those observed in
underlying markets.
As of December 31, 2002, the Company
had approximately $56.2 million in unrealized
gains, net of tax, in “Accumulated other
comprehensive income (loss)” related to fuel
hedges. Included in this total are
approximately $49.4 million in net unrealized
gains that are expected to be realized in
earnings during 2003.
Outstanding financial derivative instru-
ments expose the Company to credit loss i n
the event of nonperformance by the
counterparties to the agreements. However,
the Company does not expect any of the
counterparties to fail to meet their obligations.
The credit exposure related to these financial
instruments is represented by the fair value of
contracts with a positive fair value at the
reporting date. To manage credit risk, the
Company selects and periodically reviews
counterparties based on credit ratings, limits
its exposure to a single counterparty, and
monitors the market position of the program
and its relative market position with each