Southwest Airlines 2005 Annual Report Download - page 60

SOUTHWEST AIRLINES CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued)
frames. In addition to the significant hedging positions refined products. Due to the volatility in markets for
the Company had in place during 2005, the Company crude oil and related products, the Company is unable
also has significant future hedging positions. The Com- to predict the amount of ineffectiveness each period,
pany currently has a mixture of purchased call options, including the loss of hedge accounting, which could be
collar structures, and fixed price swap agreements in determined on a derivative by derivative basis or in the
place to hedge over 70 percent of its 2006 total aggregate. This may result in increased volatility in the
anticipated jet fuel requirements at average crude oil Company's results. The significant increase in the
equivalent prices of approximately $36 per barrel, and amount of hedge ineffectiveness and unrealized gains on
has also hedged the refinery margins on most of those derivative contracts settling in future periods recorded
positions. The Company is also over 60 percent hedged during the Company's most recent five fiscal quarters
for 2007 at approximately $39 per barrel, over 35 per- was due to a number of factors. These factors included:
cent hedged for 2008 at approximately $38 per barrel, the recent significant fluctuation in energy prices, the
and approximately 30 percent hedged for 2009 at number of derivative positions the Company holds,
approximately $39 per barrel. significant weather events that have affected refinery
capacity and the production of refined products, and the
The Company accounts for its fuel hedge deriva- volatility of the different types of products the Company
tive instruments as cash flow hedges, as defined in uses in hedging. The number of instances in which the
Statement of Financial Accounting Standards No. 133, Company has discontinued hedge accounting for spe-
Accounting for Derivative Instruments and Hedging cific hedges has increased recently, primarily due to
Activities, as amended (SFAS 133). Under SFAS 133, these reasons. In these cases, the Company has deter-
all derivatives designated as hedges that meet certain mined that the hedges will not regain effectiveness in
requirements are granted special hedge accounting the time period remaining until settlement and therefore
treatment. Generally, utilizing the special hedge ac- must discontinue special hedge accounting, as defined
counting, all periodic changes in fair value of the by SFAS 133. When this happens, any changes in fair
derivatives designated as hedges that are considered to value of the derivative instruments are marked to market
be effective, as defined, are recorded in ""Accumulated through earnings in the period of change. As the fair
other comprehensive income'' until the underlying jet value of the Company's hedge positions increases in
fuel is consumed. See Note 11 for further information amount, there is a higher degree of probability that
on Accumulated other comprehensive income. The there will be continued variability recorded in the
Company is exposed to the risk that periodic changes income statement and that the amount of hedge ineffec-
will not be effective, as defined, or that the derivatives tiveness and unrealized gains or losses recorded in future
will no longer qualify for special hedge accounting. periods will be material. This is primarily due to the fact
Ineffectiveness, as defined, results when the change in that small differences in the correlation of crude oil
the total fair value of the derivative instrument does not related products are leveraged over large dollar volumes.
exactly equal the change in the value of the Company's
During 2005, the Company recognized approxi-
expected future cash outlay to purchase jet fuel. To the
mately $110 million of additional income in ""Other
extent that the periodic changes in the fair value of the
(gains) losses, net,'' related to the ineffectiveness of its
derivatives are not effective, that ineffectiveness is re-
hedges and the loss of hedge accounting for certain
corded to ""Other gains and losses'' in the income
hedges. Of this amount, approximately $77 million of
statement. Likewise, if a hedge ceases to qualify for
the additional income was unrealized, mark-to-market
hedge accounting, those periodic changes in the fair
changes in the fair value of derivatives due to the
value of derivative instruments are recorded to ""Other
discontinuation of hedge accounting for certain con-
gains and losses'' in the income statement in the period
tracts that will settle in future periods, approximately
of the change.
$9 million was ineffectiveness associated with hedges
Ineffectiveness is inherent in hedging jet fuel with designated for future periods, and $24 million was
derivative positions based in other crude oil related ineffectiveness and mark-to-market gains related to
commodities, especially given the magnitude of the hedges that settled during 2005. During 2004, the
current fair market value of the Company's fuel hedge Company recognized approximately $13 million of ad-
derivatives and the recent volatility in the prices of ditional expense in ""Other (gains) losses, net,'' related
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