Southwest Airlines 2008 Annual Report Download - page 55

commodities such as crude oil and heating oil have
continued to qualify for hedge accounting 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 Company’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 purchased, 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 commodities, especially given 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 commodity. This may result, and has
resulted, in increased volatility in the Company’s
financial statements. The significant increase in the
amount of hedge ineffectiveness 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 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 in recent years, primarily due
to these reasons. Depending on the level at which the
Company is hedged at any point in time, as the fair
value of the Company’s hedge positions fluctuate in
amount from period to period, there could be
continued variability recorded in the income
statement, and furthermore, the amount of hedge
ineffectiveness and unrealized gains or losses
recorded in earnings may be material. This is
primarily because small differences in the correlation
of crude oil related products could be leveraged over
large dollar volumes.
The Company continually looks for better and
more accurate methodologies in forecasting future cash
flows relating to its jet fuel hedging program. These
estimates are an important component used in the
measurement of effectiveness for the Company’s fuel
hedges, as required by SFAS 133. The current
methodology used by the Company in forecasting
forward jet fuel prices is primarily based on the idea that
different types of commodities are statistically better
predictors of forward jet fuel prices, depending on
specific geographic locations in which the Company
hedges. In accordance with SFAS 133, the Company
then adjusts for certain items, such as transportation
costs, that are stated in fuel purchasing contracts with its
vendors, in order to estimate the actual price paid for jet
fuel associated with each hedge. This methodology for
estimating future cash flows (i.e., jet fuel prices) has
been consistently applied during 2008, 2007, and 2006,
in accordance with the Company’s interpretation of
SFAS 133. The Company also has not changed its
method for either assessing or measuring hedge
ineffectiveness during these periods.
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