Southwest Airlines 2003 Annual Report Download - page 46

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Fuel hedging. The Company utilizes its fuel hedges as a form of insurance against significant increases in
fuel prices. The Company believes there is significant risk in not hedging against the possibility of such fuel
price increases. The Company expects to consume 1.2 billion gallons of jet fuel in 2004. Based on this
usage, a change in jet fuel prices of just one cent per gallon would impact the Company’s “Fuel and oil
expense” by approximately $12 million per year.
The fair values of outstanding financial derivative instruments related to the Company’s jet fuel market price
risk at December 31, 2003, were net assets of $251 million. The current portion of these financial derivative
instruments, or $164 million, is classified as “Fuel hedge contracts” in the Consolidated Balance Sheet. The
long-term portion of these financial derivative instruments, or $87 million, is included in “Other assets.” The
fair values of the derivative instruments, depending on the type of instrument, were determined by use of
present value methods or standard option value models with assumptions about commodity prices based on
those observed in underlying markets. An immediate ten percent increase or decrease in underlying fuel-
related commodity prices from the December 31, 2003, prices would correspondingly change the fair value
of the commodity derivative instruments in place by approximately $125 million. Changes in the related
commodity derivative instrument cash flows may change by more or less than this amount based upon
further fluctuations in futures prices as well as related income tax effects. This sensitivity analysis uses
industry standard valuation models and holds all inputs constant at December 31, 2003, levels, except
underlying futures prices.
Financial market risk. Airline operators are inherently capital intensive as the vast majority of the
Company’s assets are expensive aircraft, which are long-lived. The Company’s strategy is to capitalize
conservatively and grow capacity steadily and profitably. While the Company uses financial leverage, it has
maintained a strong balance sheet and an "A" credit rating on its senior unsecured fixed-rate debt with
Standard & Poor’s and Fitch ratings agencies, and a "Baa1" credit rating with Moody's rating agency. The
Company's Aircraft Secured Notes and French Credit Agreements do not give rise to significant fair value
risk but do give rise to interest rate risk because these borrowings are floating-rate debt. In addition, as
disclosed in Note 10 to the Consolidated Financial Statements, during 2003, the Company entered into
interest rate swap agreements relating to its $385 million 6.5% senior unsecured notes due March 1, 2012,
and $375 million 5.496% Class A-2 pass-through certificates due November 1, 2006. Due to these
transactions, the Company considers these debts to also be at floating rates. Although there is interest rate
risk associated with these floating rate borrowings, the risk for the Aircraft Secured Notes and French Credit
Agreements is somewhat mitigated by the fact that the Company may prepay this debt on any of the semi-
annual principal and interest payment dates. See Notes 6 and 7 to the Consolidated Financial Statements for
more information on the material terms of the Company’s short-term and long-term debt.
Excluding the $385 million 6.5% senior unsecured notes that were converted to a floating rate as previously
noted, the Company had outstanding senior unsecured notes totaling $300 million at December 31, 2003.
These senior unsecured notes currently have a weighted-average maturity of 9.3 years at fixed rates
averaging 7.75 percent at December 31, 2003, which is comparable to average rates prevailing for similar
debt instruments over the last ten years. The fixed-rate portion of the Company’s pass-through certificates
consists of its Class A certificates and Class B certificates, which totaled $193 million at December 31, 2003.
These Class A and Class B certificates had a weighted-average maturity of 2.3 years at fixed rates averaging
5.58 percent at December 31, 2003. The carrying value of the Company’s floating rate debt totaled $964
million, and this debt had a weighted-average maturity of 4.6 years at floating rates averaging 1.47 percent at
December 31, 2003. In total, the Company's fixed rate debt and floating rate debt represented 6.5 percent
and 13.0 percent, respectively, of total noncurrent assets at December 31, 2003.
The Company also has some risk associated with changing interest rates due to the short-term nature of its
invested cash, which totaled $1.9 billion at December 31, 2003. The Company invests available cash in
certificates of deposit, highly rated money markets, investment grade commercial paper, and other highly
rated financial instruments. Because of the short-term nature of these investments, the returns earned parallel
closely with short-term floating interest rates. The Company has not undertaken any additional actions to
cover interest rate market risk and is not a party to any other material market interest rate risk management
activities.
A hypothetical ten percent change in market interest rates as of December 31, 2003, would not have a
material effect on the fair value of the Company's fixed rate debt instruments. See Note 10 to the
Consolidated Financial Statements for further information on the fair value of the Company's financial
instruments. A change in market interest rates could, however, have a corresponding effect on the
Company's earnings and cash flows associated with its floating rate debt, invested cash, and short-term
investments because of the floating-rate nature of these items. Assuming floating market rates in effect as of
December 31, 2003, were held constant throughout a 12-month period, a hypothetical ten percent change in