Southwest Airlines 2009 Annual Report Download - page 49

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 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 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 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 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 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 their accounting treatment. 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. 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. 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.
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