Southwest Airlines 2004 Annual Report Download - page 41

reported based on other reasonable assumptions or prices are estimated through the observation of similar
conditions suggested by actual historical experience and commodity futures prices (such as crude oil, heating oil,
other data available at the time estimates were made. and unleaded gasoline) and adjusted based on historical
variations to those like commodities.
Financial Derivative Instruments Fair values for Ñnancial derivative instruments and
forward jet fuel prices are both estimated prior to the
The Company utilizes Ñnancial derivative instru-
time that the Ñnancial derivative instruments settle, and
ments primarily to manage its risk associated with
the time that jet fuel is purchased and consumed,
changing jet fuel prices, and accounts for them under
respectively. However, once settlement of the Ñnancial
Statement of Financial Accounting Standards No. 133,
derivative instruments occurs and the hedged jet fuel is
""Accounting for Derivative Instruments and Hedging
purchased and consumed, all values and prices are
Activities'' (SFAS 133). See ""Qualitative and Quantita-
known and are recognized in the Ñnancial statements.
tive Disclosures about Market Risk'' for more informa-
Based on these actual results once all values and prices
tion on these risk management activities and see
become known, the Company's estimates have proved
Note 10 to the Consolidated Financial Statements for
to be materially accurate.
more information on SFAS 133, the Company's fuel
hedging program, and Ñnancial derivative instruments. Estimating the fair value of these fuel hedging
derivatives and forward prices for jet fuel will also result
SFAS 133 requires that all derivatives be marked in changes in their values from period to period and thus
to market (fair value) and recorded on the Consolidated determine how they are accounted for under SFAS 133.
Balance Sheet. At December 31, 2004, the Company To the extent that the change in the estimated fair value
was a party to over 300 Ñnancial derivative instruments, of a fuel hedging instrument diÅers from the change in
related to fuel hedging, for the years 2005 through the estimated price of the associated jet fuel to be
2009. The fair value of the Company's fuel hedging purchased, both on a cumulative and a period-to-period
Ñnancial derivative instruments recorded on the Com- basis, ineÅectiveness of the fuel hedge can result, as
pany's Consolidated Balance Sheet as of December 31, deÑned by SFAS 133. This could result in the immedi-
2004, was $796 million, compared to $251 million at ate recording of charges or income, even though the
December 31, 2003. The large increase in fair value derivative instrument may not expire until a future
primarily was due to the dramatic increase in energy period. Historically, the Company has not experienced
prices throughout 2004, and the Company's addition of signiÑcant ineÅectiveness in its fuel hedges accounted
derivative instruments to increase its hedge positions in for under SFAS 133, in relation to the fair value of the
future years. Changes in the fair values of these instru- underlying Ñnancial derivative instruments.
ments can vary dramatically, as was evident during
2004, based on changes in the underlying commodity SFAS 133 is a complex accounting standard with
prices. The Ñnancial derivative instruments utilized by stringent requirements including the documentation of a
the Company primarily are a combination of collars, Company hedging strategy, statistical analysis to qualify
purchased call options, and Ñxed price swap agreements. a commodity for hedge accounting both on a historical
The Company does not purchase or hold any derivative and a prospective basis, and strict contemporaneous
instruments for trading purposes. documentation that is required at the time each hedge is
executed by the Company. As required by SFAS 133,
The Company enters into Ñnancial derivative in- the Company assesses the eÅectiveness of each of its
struments with third party institutions in ""over-the- individual hedges on a quarterly basis. The Company
counter'' markets. Since the majority of the Company's also examines the eÅectiveness of its entire hedging
Ñnancial derivative instruments are not traded on a program on a quarterly basis utilizing statistical analysis.
market exchange, the Company estimates their fair This analysis involves utilizing regression and other
values. Depending on the type of instrument, the values statistical analyses that compare changes in the price of
are determined by the use of present value methods or jet fuel to changes in the prices of the commodities used
standard option value models with assumptions about for hedging purposes (crude oil, heating oil, and un-
commodity prices based on those observed in underlying leaded gasoline).
markets. Also, since there is not a reliable forward
market for jet fuel, the Company must estimate the The Company also utilizes Ñnancial derivative in-
future prices of jet fuel in order to measure the eÅective- struments in the form of interest rate swap agreements.
ness of the hedging instruments in oÅsetting changes to The primary objective for the Company's use of interest
those prices, as required by SFAS 133. Forward jet fuel rate hedges is to reduce the volatility of net interest
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