Southwest Airlines 2006 Annual Report Download - page 63

operating expenses” in the Consolidated Statement of
Income. The total remaining amount accrued (not yet
paid) was immaterial at December 31, 2006.
10. Derivative and Financial Instruments
Fuel Contracts
Airline operators are inherently dependent upon
energy to operate and, therefore, are impacted by changes
in jet fuel prices. Jet fuel and oil consumed during 2006,
2005, and 2004 represented approximately 26.2 percent,
19.6 percent, and 16.3 percent of Southwest’s operating
expenses, respectively. The reason that fuel and oil has
become an increasingly large portion of the Company’s
operating expenses has been due to the dramatic increase
in all energy prices over this period. The Company
endeavors to acquire jet fuel at the lowest possible cost.
Because jet fuel is not traded on an organized futures
exchange, there are limited opportunities to hedge
directly in jet fuel. However, the Company has found
that financial derivative instruments in other commodi-
ties, such as crude oil, and refined products such as
heating oil and unleaded gasoline, can be useful in
decreasing its exposure to jet fuel price increases. The
Company does not purchase or hold any derivative finan-
cial instruments for trading purposes.
The Company has utilized financial derivative
instruments for both short-term and long-term time
frames. In addition to the significant protective fuel
derivative positions the Company had in place during
2006, the Company also has significant future positions.
The Company currently has a mixture of purchased call
options, collar structures, and fixed price swap agree-
ments in place to protect against nearly 95 percent of its
2007 total anticipated jet fuel requirements at average
crude oil equivalent prices of approximately $50 per
barrel, and has also added refinery margins on most of
those positions. Based on current growth plans, the
Company also has fuel derivative contracts in place for
65 percent of its expected fuel consumption for 2008 at
approximately $49 per barrel, over 50 percent for 2009 at
approximately $51 per barrel, over 25 percent for 2010 at
$63 per barrel, approximately 15 percent in 2011 at $64
per barrel, and 15 percent in 2012 at $63 per barrel.
Upon proper qualification, the Company endeavors
to account for its fuel derivative instruments as cash flow
hedges, as defined in Statement of Financial Accounting
Standards No. 133, Accounting for Derivative Instru-
ments and Hedging Activities, as amended (SFAS 133).
Under SFAS 133, all derivatives designated as hedges that
meet certain requirements are granted special hedge
accounting treatment. Generally, utilizing the special
hedge accounting, all periodic changes in fair value of
the derivatives designated as hedges that are considered to
be effective, as defined, are recorded in “Accumulated
other comprehensive income” until the underlying jet
fuel is consumed. See Note 11 for further information on
Accumulated other comprehensive income. The Com-
pany is exposed to the risk that periodic changes will not
be effective, as defined, or that the derivatives will no
longer qualify for special hedge accounting. Ineffective-
ness, as defined, results when the change in the fair value
of the derivative instrument exceeds the change in the
value of the Company’s expected future cash outlay to
purchase and consume jet fuel. To the extent that the
periodic changes in the fair value of the derivatives are not
effective, that ineffectiveness is recorded to Other gains
and losses in the income statement. Likewise, if a hedge
ceases to qualify for hedge accounting, any change in the
fair value of derivative instruments since the last period is
recorded to Other gains and losses in the income state-
ment 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
results. The significant increase in the amount of hedge
ineffectiveness and unrealized gains and losses on deriv-
ative contracts settling in future periods recorded during
2005 and 2006 has been due to a number of factors.
These factors included: the significant fluctuation in
energy prices, the number of derivative positions the
Company holds, significant weather events that have
affected refinery capacity 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 discontinue special hedge
44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)