Southwest Airlines 2010 Annual Report Download - page 88

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The Company has used financial derivative instruments for both short-term and long-term time frames, and
typically uses a mixture of purchased call options, collar structures (which include both a purchased call option
and a sold put option), call spreads (which include a purchased call option and a sold call option), and fixed price
swap agreements in its portfolio. Generally, when the Company perceives that prices are lower than historical or
expected future levels, the Company prefers to use fixed price swap agreements and purchased call options.
However, at times when the Company perceives that purchased call options have become too expensive, it may
use more collar structures and call spreads. Although the use of collar structures and swap agreements can reduce
the overall cost of hedging, these instruments carry more risk than purchased call options in that the Company
could end up in a liability position when the collar structure or swap agreement settles. With the use of purchased
call options and call spreads, the Company cannot be in a liability position at settlement.
The Company evaluates its hedge volumes strictly from an “economic” standpoint and does not consider
whether the hedges qualified or will qualify for hedge accounting. The Company defines its “economic” hedge as
the net volume of fuel derivative contracts held, including the impact of positions that have been offset through
sold positions, regardless of whether those contracts qualify for hedge accounting. For 2010, the Company had
fuel derivatives in place related to approximately 40 percent of its fuel consumption. As of December 31, 2010,
the Company had fuel derivative instruments in place to provide coverage on a large portion of its 2011
estimated fuel consumption, excluding the impact of the AirTran acquisition, at varying price levels. The
following table provides information about the Company’s volume of fuel hedging for the years 2011 through
2014 on an “economic” basis.
Period (by year)
Fuel hedged as of
December 31, 2010
(gallons in millions)
2011 ...................................... 778
2012 ...................................... 887
2013 ...................................... 750
2014 ...................................... 700
Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges.
All derivatives designated as hedges that meet certain requirements are granted hedge accounting treatment.
Generally, utilizing the hedge accounting, all periodic changes in fair value of the derivatives designated as
hedges that are considered to be effective, are recorded in AOCI until the underlying jet fuel is consumed. See
Note 13 for further information on AOCI. 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 hedge accounting. Ineffectiveness 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 ineffective, the ineffective portion is recorded to Other (gains) losses, net in the
Consolidated Statement of Income. 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
Consolidated Statement of Income in the period of the change; however, any amounts previously recorded to
AOCI would remain there until such time as the original forecasted transaction occurs, at which time these
amounts would be reclassified to Fuel and oil expense. When the Company has sold derivative positions in order
to effectively “close” or offset a derivative already held as part of its fuel derivative instrument portfolio, any
subsequent changes in fair value of those positions are marked to market through earnings. Likewise, any
changes in fair value of those positions that were offset by entering into the sold positions are concurrently
marked to market through earnings. However, any changes in value related to hedges that were deferred as part
of AOCI while designated as a hedge, would remain until the originally forecasted transaction occurs. 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 AOCI would be required to be immediately reclassified into earnings. The Company
did not have any such situations occur during 2010, 2009, or 2008.
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