Southwest Airlines 2006 Annual Report Download - page 49

whether as a result of new information, future events, or
otherwise.
Item 7A. Qualitative and Quantitative Disclosures
About Market Risk
Southwest has interest rate risk in its floating rate
debt obligations and interest rate swaps, and has com-
modity price risk in jet fuel required to operate its aircraft
fleet. The Company purchases jet fuel at prevailing mar-
ket prices, but seeks to manage market risk through
execution of a documented hedging strategy. Southwest
has market sensitive instruments in the form of fixed rate
debt instruments and financial derivative instruments
used to hedge its exposure to jet fuel price increases.
The Company also operates 93 aircraft under operating
and capital leases. However, leases are not considered
market sensitive financial instruments and, therefore, are
not included in the interest rate sensitivity analysis below.
Commitments related to leases are disclosed in Note 8 to
the Consolidated Financial Statements. The Company
does not purchase or hold any derivative financial instru-
ments for trading purposes. See Note 10 to the Consol-
idated Financial Statements for information on the
Company’s accounting for its hedging program and for
further details on the Company’s financial derivative
instruments.
Fuel Hedging
The Company utilizes financial derivative instru-
ments, on both a short-term and a long-term basis, 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 approxi-
mately 1.5 billion gallons of jet fuel in 2007. 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 $15 million per year, excluding any impact
of the Company’s derivative instruments.
The fair values of outstanding financial derivative
instruments related to the Company’s jet fuel market
price risk at December 31, 2006, were net assets of
$999 million. The current portion of these financial
derivative instruments, or $369 million, is classified as
“Fuel derivative contracts” in the Consolidated Balance
Sheet. The long-term portion of these financial derivative
instruments, or $630 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,
2006, prices would correspondingly change the fair value
of the commodity derivative instruments in place by up to
$480 million. Changes in the related commodity deriv-
ative 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 mod-
els and holds all inputs constant at December 31, 2006,
levels, except underlying futures prices.
Outstanding financial derivative instruments expose
the Company to credit loss in the event of nonperfor-
mance by the counterparties to the agreements. However,
the Company does not expect any of the counterparties to
fail to meet their obligations. The credit exposure related
to these financial instruments is represented by the fair
value of contracts with a positive fair value at the report-
ing date. To manage credit risk, the Company selects and
will periodically review counterparties based on credit
ratings, limits its exposure to a single counterparty, and
monitors the market position of the program and its
relative market position with each counterparty. At
December 31, 2006, the Company had agreements with
eight counterparties containing early termination rights
and/or bilateral collateral provisions whereby security is
required if market risk exposure exceeds a specified
threshold amount or credit ratings fall below certain
levels. At December 31, 2006, the Company held
$540 million in cash collateral deposits under these
bilateral collateral provisions. These collateral deposits
serve to decrease, but not totally eliminate, the credit risk
associated with the Company’s hedging program. The
deposits are included in “Accrued liabilities” on the
Consolidated Balance Sheet. See also Note 10 to the
Consolidated Financial Statements.
Financial Market Risk
The vast majority of the Company’s assets are air-
craft, which are long-lived. The Company’s strategy is to
maintain a conservative balance sheet 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 1999 and 2004 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, the Company has
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