Southwest Airlines 2008 Annual Report Download - page 54

under Statement of Financial Accounting Standards
No. 133, “Accounting for Derivative Instruments and
Hedging Activities,” as amended (SFAS 133). See
“Quantitative and Qualitative Disclosures about
Market Risk” for more information on these risk
management activities and see Note 10 to the
Consolidated Financial Statements for more
information on SFAS 133, the Company’s fuel
hedging program, and financial derivative
instruments.
SFAS 133 requires that all derivatives be
reflected at market (fair value) and recorded on the
Consolidated Balance Sheet. At December 31, 2008,
the Company was a party to over 536 financial
derivative instruments, related to its fuel hedging
program, for the years from 2009 through 2013. The
fair value of the Company’s fuel hedging financial
derivative instruments recorded on the Company’s
Consolidated Balance Sheet as of December 31,
2008, was a net liability of $992 million, compared to
an asset of $2.4 billion at December 31, 2007. The
large decrease in fair value primarily was due to the
significant decrease in energy prices in the fourth
quarter of 2008, net of the expiration (i.e., settlement
in which the Company received cash proceeds) of
approximately $1.3 billion in fuel derivative
instruments that related to 2008 and net of new
derivative instruments the Company added for future
years. Of the $992 million liability in fair value of
fuel hedging financial derivative instruments at
December 31, 2008, approximately $246 million is
expected to settle, or expire during 2009. Changes in
the fair values of these instruments can vary
dramatically, as was evident during 2008, based on
changes in the underlying commodity prices. During
2008, market “spot” prices for crude oil peaked at a
high of over $147 per barrel and hit a low price of
under $35 per barrel—both within a period of
approximately five months. Market price changes can
be driven by factors such as supply and demand,
inventory levels, weather events, refinery capacity,
political agendas, and general economic conditions,
among other items. The financial derivative
instruments utilized by the Company primarily are a
combination of collars, purchased call options, and
fixed price swap agreements. The Company does not
purchase or hold any derivative instruments for
trading purposes.
The Company enters into financial derivative
instruments with third party institutions in
“over-the-counter” markets. Since the majority of the
Company’s financial derivative instruments are not
traded on a market exchange, the Company estimates
their fair values. Depending on the type of
instrument, the values are determined by the use of
present value methods or standard option value
models with assumptions about commodity prices
based on those observed in underlying markets. Also,
since there is not a reliable forward market for jet
fuel, the Company must estimate the future prices of
jet fuel in order to measure the effectiveness of the
hedging instruments in offsetting changes to those
prices, as required by SFAS 133. Forward jet fuel
prices are estimated through the observation of
similar commodity futures prices (such as crude oil,
heating oil, and unleaded gasoline) and adjusted
based on variations of those like commodities to the
Company’s ultimate expected price to be paid for jet
fuel at the specific locations in which the Company
hedges.
Fair values for financial derivative instruments
and forward jet fuel prices are both estimated prior to
the time that the financial derivative instruments
settle, and the time that jet fuel is purchased and
consumed, respectively. However, once settlement of
the financial derivative instruments occurs and the
hedged jet fuel is purchased and consumed, all values
and prices are known and are recognized in the
financial statements. In recent years, 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. Based on these updates, in certain prior
periods, the Company has in fact lost SFAS 133
hedge accounting for all unleaded gasoline derivative
instruments. At such times, the Company has marked
all such derivatives to market value in each quarterly
period, with all changes in value reflected as a
component of “Other (gains) losses, net” in the
Consolidated Statement of Income. Although
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