Southwest Airlines 2008 Annual Report Download - page 39

Item 7. Management’s Discussion And Analysis
Of Financial Condition And Results Of
Operations
Year in Review
For the 36th consecutive year, the Company
reported a net profit, earning $178 million ($.24 per
share, diluted) in 2008. In addition, the Company
recorded operating profits in all four quarters of
2008, as it has now done in 71 consecutive quarters
dating back to the second quarter of 1991. Given the
significance of events that took place during 2008,
the Company’s challenge to continue these streaks
was unprecedented in recent history.
Demand for air travel, especially for the low
fares offered by the Company, was strong during the
first half of 2008 and through the summer months.
However, demand for air travel waned, especially
during fourth quarter 2008, which the Company
believes was a result of the crisis experienced in
worldwide credit markets and the domestic
recessionary environment that became evident during
the year. The Company was able to gradually raise
fares throughout most of the year to combat an
enormous increase in fuel prices; however, during the
fourth quarter, the Company offered more discounted
fares in order to stimulate demand as the number of
people choosing to travel by air declined versus the
prior year. The Company’s ability to raise fares
during 2008 (as well as to keep prior fare increases in
place) was due in part to competitor capacity
reductions in certain of the Company’s markets —
especially beginning in September 2008, but was also
aided by several Company initiatives including: a
slowing of internal capacity growth at times during
2008; optimizing the flight schedule to eliminate
unproductive and less popular flights and reallocating
capacity to fund market growth opportunities such as
Denver, and the upcoming addition of the Company’s
newest city, Minneapolis-St. Paul (beginning service
in March 2009); enhancement of revenue
management technologies, processes, and techniques;
and aggressive promotion of the Company’s No
Hidden Fees, Low Fare brand.
In addition to having a significant impact on the
entire U.S. economy, energy and fuel prices were
again a major story for airlines during 2008. After
beginning the year at approximately $100 per barrel,
the price of crude oil skyrocketed to over $145 in
July 2008. This caused the Company, as well as all
major U.S. airlines, to reconsider growth and
capacity plans for the near future, as the devastating
impact of these fuel prices was evident in the
financial results of all domestic airlines. The summer
spike in oil prices, as well as other clearly evident
deteriorating economic conditions that followed,
caused the Company to modify its growth and to plan
for an expected decrease in demand for air travel.
Even with fuel derivative instruments in place for
approximately 78 percent of the Company’s fuel
consumption during 2008, the Company’s fuel and oil
expense increased $1.0 billion versus 2007. The fuel
derivative instruments the Company had in place for
2008 resulted in settlement gains of $1.3 billion (on a
cash basis, before profitsharing and income taxes),
which was an increase of $566 million compared to
the fuel derivative cash settlement gains the Company
received during 2007. As a result of the rapid collapse
in energy prices during fourth quarter 2008, the
Company has effectively reduced its net fuel hedge
position in place for the years from 2009 through 2013
to approximately ten percent of its anticipated fuel
consumption in each of those years. Due to the manner
in which the Company reduced its fuel hedge for these
future years (primarily by selling swap instruments,
which in most cases were sold at lower prices than the
positions that were previously purchased), and
disregarding any future potential activity involving
fuel derivative instruments, the Company has fixed
some losses associated with these instruments and
expects to pay higher than market prices for fuel for
these periods. The market value (as of December 31,
2008) of the Company’s net fuel derivative contracts
for 2009 through 2013 reflects a net liability of
approximately $992 million. Based on this liability at
December 31, 2008 (and assuming no change to the
fuel hedge portfolio), the Company’s jet fuel costs per
gallon would exceed market (or unhedged) prices by
approximately $.16 to $.17 in each year from 2009 to
2011, $.10 in 2012, and $.08 in 2013. These estimates
are based on expected future cash settlements from
fuel derivatives, but exclude any Statement of
Financial Accounting Standards No. 133, Accounting
for Derivative Instruments and Hedging Activities,as
amended (SFAS 133) impact associated with the
ineffectiveness of fuel hedges or fuel derivatives that
are marked to market value because they do not
qualify for special hedge accounting. See Note 10 to
the Consolidated Financial Statements for further
information.
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