Southwest Airlines 2006 Annual Report Download - page 46

Likewise, if a derivative contract ceases to qualify for
hedge accounting, the changes in the fair value of the
derivative instrument is recorded every period to “Other
gains and losses” in the income statement in the period of
the change.
Ineffectiveness is inherent in hedging jet fuel with
derivative positions based in other crude oil related com-
modities, especially given the magnitude of the current
fair market value of the Company’s fuel derivatives and
the recent volatility in the prices of refined products. Due
to the volatility in markets for crude oil and related
products, the Company is unable to predict the amount
of ineffectiveness each period, including the loss of hedge
accounting, which could be determined on a derivative by
derivative basis or in the aggregate. This may result, and
has resulted, in increased volatility in the Company’s
financial statements. The significant increase in the
amount of hedge ineffectiveness and unrealized gains
and losses on the change in value of derivative contracts
settling in future periods recorded during recent periods
has been due to a number of factors. These factors
include: the significant fluctuation in energy prices, the
number of derivative positions the Company holds, sig-
nificant weather events that have affected refinery capac-
ity and the production of refined products, and the
volatility of the different types of products the Company
uses for protection. The number of instances in which the
Company has discontinued hedge accounting for specific
hedges and for specific refined products, such as unleaded
gasoline, has increased recently, primarily due to these
reasons. In these cases, the Company has determined that
the hedges will not regain effectiveness in the time period
remaining until settlement and therefore must discon-
tinue special hedge accounting, as defined by SFAS 133.
When this happens, any changes in fair value of the
derivative instruments are marked to market through
earnings in the period of change. As the fair value of
the Company’s hedge positions increases in amount,
there is a higher degree of probability that there will
be continued variability recorded in the income statement
and that the amount of hedge ineffectiveness and unre-
alized gains or losses recorded in future periods will be
material. This is primarily due to the fact that small
differences in the correlation of crude oil related products
are leveraged over large dollar volumes.
SFAS 133 is a complex accounting standard with
stringent requirements, including the documentation of a
Company hedging strategy, statistical analysis to qualify a
commodity for hedge accounting both on a historical and
a prospective basis, and strict contemporaneous docu-
mentation that is required at the time each hedge is
designated by the Company. As required by SFAS 133,
the Company assesses the effectiveness of each of its
individual hedges on a quarterly basis. The Company also
examines the effectiveness of its entire hedging program
on a quarterly basis utilizing statistical analysis. This
analysis involves utilizing regression and other statistical
analyses that compare changes in the price of jet fuel to
changes in the prices of the commodities used for hedging
purposes.
The Company continually looks for better and more
accurate methodologies in forecasting future cash flows
relating to its jet fuel hedging program. These estimates
are used in the measurement of effectiveness for the
Company’s fuel hedges, as required by SFAS 133. During
first quarter 2006, the Company did revise its method for
forecasting future cash flows. Previously, the Company
had estimated future cash flows using actual market
forward prices of like commodities and adjusting for
historical differences from the Company’s actual jet fuel
purchase prices. The Company’s new methodology uti-
lizes a statistical-based regression equation with data from
market forward prices of like commodities. This equation
is then adjusted for certain items, such as transportation
costs, that are stated in the Company’s fuel purchasing
contracts with its vendors. This change to the Company’s
methodology for estimating future cash flows (i.e., jet
fuel prices) was applied prospectively, in accordance with
the Company’s interpretation of SFAS 133. The Com-
pany believes that this change for estimating future cash
flows will result in more effective hedges over the long-
term.
The Company also utilizes financial derivative
instruments in the form of interest rate swap agreements.
The primary objective for the Company’s use of interest
rate hedges is to reduce the volatility of net interest
income by better matching the repricing of its assets
and liabilities. During 2003, the Company entered into
interest rate swap agreements relating to its $385 million
6.5% senior unsecured notes due 2012, and $375 million
5.496% Class A-2 pass-through certificates due 2006.
The interest rate swap associated with the $375 million
5.496% Class A-2 pass-through certificates expired on
the date the certificates were repaid in fourth quarter
2006. The floating rate paid under the swap associated
with the $385 million 6.5% senior unsecured notes due
2012 sets in arrears. The Company pays the London
InterBank Offered Rate (LIBOR) plus a margin every six
months and receives 6.5% every six months on a notional
amount of $385 million until 2012. The average floating
rate paid under this agreement during 2006 is estimated
to be 7.63 percent based on actual and forward rates at
December 31, 2006.
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