Southwest Airlines 2007 Annual Report Download - page 49

because of increased volatility in energy markets, the
Company’s estimates of the presumed effectiveness of
its hedges made at the time the hedges were initially
designated have materially differed from actual results,
resulting in increased volatility in the Company’s periodic
financial results. For example, historical data had been
utilized in qualifying unleaded gasoline for SFAS 133
hedge accounting under the presumption that derivatives
of such commodity would result in effective hedges, as
defined. This historical data is updated every quarterly
reporting period to ascertain whether SFAS 133 hedge
accounting is allowed for every commodity the Company
uses in its hedging program. During 2006, based on these
updates, the Company in fact lost SFAS 133 hedge
accounting for all unleaded gasoline derivative instru-
ments, and thus has marked all such derivatives to market
value in each subsequent quarterly period since that time,
with all changes in value reflected as a component of
Other gains/losses in the Consolidated Statement of
Income. Although commodities such as crude oil and
heating oil have continued to qualify for hedge account-
ing in most cases, there have been instances in which the
Company has also lost hedge accounting in specific
geographic locations for these commodities. In these
instances, the Company has also marked such derivatives
to market value with changes reflected in the income
statement each reporting period. Although the Compa-
ny’s prospective assessment has been utilized to ensure
that crude oil and heating oil in most cases still qualify for
SFAS 133 hedge accounting in specific locations where
the Company hedges, there are no assurances that these
commodities will continue to qualify in the future. This is
due to the fact that future price changes in these refined
products may not be consistent with historical price
changes. If recent volatility in these commodity markets
continues for an extended period of time or worsens in the
near future, the Company could lose hedge accounting
altogether for all crude oil and heating oil derivatives,
which would create further volatility in the Company’s
financial results.
Estimating the fair value of these fuel derivative
instruments and forward prices for jet fuel will also result
in changes in their values from period to period and thus
determine how they are accounted for under SFAS 133.
To the extent that the change in the estimated fair value
of a fuel derivative instrument differs from the change in
the estimated price of the associated jet fuel to be pur-
chased, both on a cumulative and a period-to-period
basis, ineffectiveness of the fuel hedge can result, as
defined by SFAS 133. This could result in the immediate
recording of noncash charges or income, representing the
change in the fair value of the derivative, even though the
derivative instrument may not expire/settle until a future
period. 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 for a specific com-
modity. This may result, and has resulted, in increased
volatility in the Company’s financial statements. The
significant increase in the amount of hedge ineffective-
ness 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 fluctu-
ation 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 the hedges will not regain
effectiveness in the time period remaining until settle-
ment and therefore must discontinue 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 posi-
tions can fluctuate significantly in amount from period to
period, it is probable there will be continued variability
recorded in the income statement and that the amount of
hedge ineffectiveness and unrealized gains or losses
recorded in future periods will be material. This is pri-
marily because 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
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