Southwest Airlines 2010 Annual Report Download - page 61

risk management activities, and see Note 10 to the Consolidated Financial Statements for more information on
the Company’s fuel hedging program and financial derivative instruments.
All derivatives are required to be reflected at fair value and recorded on the Consolidated Balance Sheet. At
December 31, 2010, the Company was a party to over 600 financial derivative instruments, related to its fuel
hedging program, for the years 2011 through 2014. The fair value of the Company’s fuel hedging financial
derivative instruments recorded on the Company’s Consolidated Balance Sheet as of December 31, 2010, not
considering the impact of cash collateral deposits provided to counterparties, was a net asset of $142 million,
compared to a net liability of $477 million at December 31, 2009. The change in fair value primarily was due to
an increase in energy prices throughout most of 2010, the expiration (i.e., settlement in which the Company paid
cash to counterparties) of approximately $153 million in fuel derivative instruments that related to 2010, and the
purchase of new derivative positions that will settle in future periods. Although the Company’s fuel derivative
portfolio was in a net asset position at December 31, 2010, the positions that are expected to settle or expire
during 2011 currently consist of a net liability of approximately $62 million. Changes in the fair values of these
instruments can vary dramatically based on changes in the underlying commodity prices, as has been evident in
recent years. For example, 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. During
2010, market spot prices ranged from a low of $68 per barrel to a high of $91 per barrel. Market price changes
can be driven by factors such as supply and demand, inventory levels, weather events, refinery capacity, political
agendas, value of the U.S. dollar, and general economic conditions, among other items. The financial derivative
instruments utilized by the Company primarily are a combination of collars, purchased call options, call spreads,
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. 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 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 some historical
periods, because of increased volatility in energy markets, 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 fair
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. However, the Company did not lose hedge accounting for any entire
commodities during 2010, 2009, or 2008. Although commodities such as crude oil and heating oil have
historically 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 fair value with changes reflected in the Consolidated
Statement of Income each reporting period. Although the Company’s prospective assessment has been utilized to
ensure that the commodities used 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. Increased volatility in these commodity markets for an extended period of time, especially if such
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