Southwest Airlines 2007 Annual Report Download - page 67

other initiatives is to help the Company reduce future
operating costs.
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 2007,
2006, and 2005 represented approximately 28.0 percent,
26.2 percent, and 19.6 percent of Southwest’s operating
expenses, respectively. The primary reason that fuel and
oil has become an increasingly large portion of the
Company’s operating expenses has been due to the dra-
matic 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 orga-
nized futures exchange, there are limited opportunities to
hedge directly in jet fuel. However, the Company has
found that financial derivative instruments in other com-
modities, 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
2007, 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 over 70 percent of its
2008 total anticipated jet fuel requirements at average
crude oil equivalent prices of approximately $51 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
over 55 percent of its expected fuel consumption for 2009
at approximately $51 per barrel, nearly 30 percent for
2010 at approximately $63 per barrel, over 15 percent for
2011 at $64 per barrel, and over 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; however, in accordance
with SFAS 133, any amounts previously recorded to
Accumulated other comprehensive income would remain
there until such time as the original forecasted transaction
occurs, then would be reclassified to Fuel and oil expense.
In a situation where it becomes probable that a hedged
forecasted transaction will not occur, any gains and/or
losses that have been recorded to Accumulated other
comprehensive income would be required to be immedi-
ately reclassified into earnings. The Company did not
have any such situations occur in 2005, 2006, or 2007.
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 results. The significant
increase in the amount of hedge ineffectiveness and
unrealized gains and losses on derivative contracts settling
in future periods recorded during the past few years 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
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)