Southwest Airlines 2008 Annual Report Download - page 78

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
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 (loss)”
until the underlying jet fuel is consumed. See Note 12
for further information on “Accumulated other
comprehensive income (loss).” The Company 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.
Ineffectiveness, 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) losses,
net” 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) losses, net” in the
income statement in the period of the change;
however, in accordance with SFAS 133, any amounts
previously recorded to “Accumulated other
comprehensive income (loss)” 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 (loss)”
would be required to be immediately reclassified into
earnings. The Company did not have any such
situations occur in 2008, 2007, or 2006.
Ineffectiveness is inherent in hedging jet fuel
with derivative positions based in other crude oil
related commodities, especially given the magnitude
of the changes in 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 commodity.
This may result, and has resulted, in increased
volatility in the Company’s financial 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 the production of refined products, and the
volatility of the different types of products the
Company uses in hedging. 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 recently, primarily due to these reasons.
However, even though these derivatives may not
qualify for SFAS 133 special hedge accounting, the
Company continues to hold the instruments as it
believes they continue to represent good “economic
hedges” in its goal to minimize jet fuel costs.
SFAS 133 is a complex accounting standard
with stringent requirements, including the
documentation of a Company hedging strategy,
statistical analysis to qualify a commodity for hedge
accounting both on a historical and a prospective
basis, and strict contemporaneous documentation that
is required at the time each hedge is designated by
the Company. As required by SFAS 133, the
Company assesses the effectiveness of each of its
individual hedges on a quarterly basis. The Company
also examines the effectiveness of its entire hedging
program on a quarterly basis utilizing statistical
analysis. This analysis involves utilizing regression
and other statistical analyses that compare changes in
the price of jet fuel to changes in the prices of the
commodities used for hedging purposes.
59