Southwest Airlines 2005 Annual Report Download - page 43

to be purchased, both on a cumulative and a period-to- ences in the correlation of crude oil-related products are
period basis, ineffectiveness of the fuel hedge can result, leveraged over large dollar volumes.
as defined by SFAS 133. This could result in the SFAS 133 is a complex accounting standard with
immediate recording of noncash charges or income, stringent requirements, including the documentation of
even though the derivative instrument may not expire a Company hedging strategy, statistical analysis to qual-
until a future period. Likewise, if a cash flow hedge ify a commodity for hedge accounting both on a
ceases to qualify for hedge accounting, those periodic historical and a prospective basis, and strict contempo-
changes in the fair value of derivative instruments are raneous documentation that is required at the time each
recorded to ""Other gains and losses'' in the income hedge is executed by the Company. As required by
statement in the period of the change. SFAS 133, the Company assesses the effectiveness of
each of its individual hedges on a quarterly basis. The
Ineffectiveness is inherent in hedging jet fuel with Company also examines the effectiveness of its entire
derivative positions based in other crude oil-related hedging program on a quarterly basis utilizing statistical
commodities, especially considering the recent volatility analysis. This analysis involves utilizing regression and
in the prices of refined products. In addition, given the other statistical analyses that compare changes in the
magnitude of the Company's fuel hedge portfolio total price of jet fuel to changes in the prices of the commod-
market value, ineffectiveness can be highly material to ities used for hedging purposes (crude oil, heating oil,
financial results. Due to the volatility in markets for and unleaded gasoline).
crude oil and related products, the Company is unable
to predict the amount of ineffectiveness each period, The Company continually looks for better and
including the loss of hedge accounting, which could be more accurate methodologies in forecasting future cash
determined on a derivative by derivative basis or in the flows relating to its jet fuel hedging program. These
aggregate. This may result in increased volatility in the estimates are used in the measurement of effectiveness
Company's results. Prior to 2005, the Company had not for the Company's fuel hedges, as required by
experienced significant ineffectiveness in its fuel hedges SFAS 133. Any changes to the Company's methodol-
accounted for under SFAS 133, in relation to the fair ogy for estimating future cash flows (i.e., jet fuel prices)
value of the underlying financial derivative instruments. will be applied prospectively, in accordance with
The significant increase in the amount of hedge ineffec- SFAS 133. While the Company would expect that a
tiveness and unrealized gains on derivative contracts change in the methodology for estimating future cash
settling in future periods recorded during 2005 was due flows would result in more effective hedges over the
to a number of factors. These factors included: the long-term, such a change could result in more ineffec-
recent significant increase in energy prices, the number tiveness, as defined, in the short-term, due to the
of derivative positions the Company holds, significant prospective nature of enacting the change.
weather events that have affected refinery capacity and
the production of refined products, and the volatility of The Company also utilizes financial derivative
the different types of products the Company uses in instruments in the form of interest rate swap agree-
hedging. The number of instances in which the Com- ments. The primary objective for the Company's use of
pany has discontinued hedge accounting for specific interest rate hedges is to reduce the volatility of net
hedges has increased recently, primarily due to the interest income by better matching the repricing of its
foregoing reasons. In these cases, the Company has assets and liabilities. Concurrently, the Company's in-
determined that the hedges will not regain effectiveness terest rate hedges are also intended to take advantage of
in the time period remaining until settlement and market conditions in which short-term rates are signifi-
therefore must discontinue special hedge accounting, as cantly lower than the fixed longer term rates on the
defined by SFAS 133. When this happens, any changes Company's long-term debt. During 2003, the Company
in fair value of the derivative instruments are marked to entered into interest rate swap agreements relating to its
market through earnings in the period of change. As the $385 million 6.5% senior unsecured notes due 2012,
fair value of the Company's hedge positions increases in and $375 million 5.496% Class A-2 pass-through cer-
amount, there is a higher degree of probability that tificates due 2006. The floating rate paid under each
there will be continued and correspondingly higher agreement sets in arrears. Under the first agreement, the
variability recorded in the income statement and that Company pays the London InterBank Offered Rate
the amount of hedge ineffectiveness and unrealized (LIBOR) plus a margin every six months and receives
gains or losses recorded in future periods will be mate- 6.5% every six months on a notional amount of
rial. This is primarily due to the fact that small differ- $385 million until 2012. The average floating rate paid
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