Southwest Airlines 2008 Annual Report Download - page 59

The Company expects to consume approximately 1.5
billion gallons of jet fuel in 2009. Based on this
usage, a change in jet fuel prices of just one cent per
gallon would impact the Company’s “Fuel and oil
expense” by approximately $15 million per year,
excluding any impact of the Company’s derivative
instruments.
As of December 31, 2008, the Company held a
net position of fuel derivative instruments that
effectively represented a hedge of approximately ten
percent of its anticipated jet fuel purchases for each
year from 2009 through 2013. Prior to fourth quarter
2008, the Company had held fuel derivative
instruments for a much larger portion of its
anticipated fuel purchases for these years; however,
due to the recent precipitous decline in fuel prices,
the Company significantly reduced its hedge in order
to minimize fuel hedging losses related to further oil
price declines and to minimize the potential for the
Company to provide additional cash collateral
deposits to counterparties. The Company
accomplished this reduced hedge by entering into
additional derivative contracts—through selling
primarily fixed-price swap derivatives. The Company
believes this strategy enables it to participate in
further price declines via the sold derivatives, which
should materially offset further declines in value of
the Company’s previously purchased derivatives. The
total net fair value of outstanding financial derivative
instruments related to the Company’s jet fuel market
price risk at December 31, 2008, was a net liability of
$992 million. The current portion of these financial
derivative instruments, or $246 million, is classified
as a component of “Accrued liabilities” in the
Consolidated Balance Sheet. The long-term portion
of these financial derivative instruments, or $746
million, is included in “Other deferred liabilities.”
The fair values of the derivative instruments,
depending on the type of instrument, were
determined by use of present value methods or
standard option value models with assumptions about
commodity prices based on those observed in
underlying markets. An immediate ten-percent
increase or decrease in underlying fuel-related
commodity prices from the December 31, 2008 (for
all years from 2009 through 2013), prices would
correspondingly change the fair value of the
commodity derivative instruments in place by up to
approximately $90 million. Changes in the related
commodity derivative instrument cash flows may
change by more or less than this amount based upon
further fluctuations in futures prices as well as related
income tax effects. This sensitivity analysis uses
industry standard valuation models and holds all
inputs constant at December 31, 2008, levels, except
underlying futures prices.
The Company’s credit exposure related to fuel
derivative instruments is represented by the fair value
of contracts with a net positive fair value to the
Company at the reporting date. At such times, these
outstanding instruments expose the Company to
credit loss in the event of nonperformance by the
counterparties to the agreements. However, in such
cases, the Company does not expect any of the
counterparties to fail to meet their obligations and
has not experienced any significant credit loss as a
result of counterparty nonperformance in the past. To
manage credit risk, the Company selects and will
periodically review counterparties based on credit
ratings, limits its exposure to a single counterparty,
and monitors the market position of the program and
its relative market position with each counterparty.
However, if one or more of these counterparties were
in a liability position to the Company and were
unable to meet their obligations, any open derivative
contracts with the counterparty could be subject to
early termination, which could result in substantial
losses for the Company. At December 31, 2008, the
Company had agreements with eight counterparties
containing early termination rights and/or bilateral
collateral provisions whereby security is required if
market risk exposure exceeds a specified threshold
amount or credit ratings fall below certain levels. As
of December 31, 2008, the Company had active
portfolios with three of these counterparties. Based
on the Company’s current investment grade credit
rating, for one counterparty, these collateral
provisions require cash deposits to be posted
whenever the net fair value of derivatives associated
with that counterparty exceed a specific threshold—
cash is either posted by the counterparty if the value
of derivatives is an asset to the Company, or posted
by the Company if the value of derivatives is a
liability to the Company.
During fourth quarter 2008, the modification of
the Company’s fuel hedge portfolio, in combination
with the amendment to one of the Company’s
counterparty agreements that became effective in
January 2009, significantly reduced the Company’s
current exposure to cash collateral requirements.
Prior to the amendment, if the Company became
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