Southwest Airlines 2011 Annual Report Download - page 71

of the fuel hedge can result. This could result in the immediate recording of non-cash 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, net in the
Consolidated Statement of Income 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 past 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 historically resulted, in increased volatility in the
Company’s financial statements. The amount of hedge ineffectiveness and unrealized gains and losses on the
change in fair value of derivative contracts settling in future periods recorded during historical 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
mitigation of fuel price volatility. The discontinuation of hedge accounting for specific hedges and for specific
refined products, such as unleaded gasoline, can also be a result of these factors. 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 Consolidated Statement of
Income, 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 volumes.
The Company continually looks for better and more accurate methodologies in forecasting expected 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. The Company then adjusts for certain items, such as transportation costs, that are stated in fuel
purchasing contracts with its vendors, in order to estimate the actual price paid for jet fuel associated with each
hedge. This methodology for estimating expected future cash flows (i.e., jet fuel prices) has been consistently
applied during 2011, 2010, and 2009, and has not changed for either assessing or measuring hedge
ineffectiveness during these periods.
The Company believes it is unlikely that materially different estimates for the fair value of financial
derivative instruments and forward jet fuel prices would be made or reported based on other reasonable
assumptions or conditions suggested by actual historical experience and other data available at the time estimates
were made.
Fair value measurements
The Company utilizes unobservable (Level 3) inputs in determining the fair value of certain assets and
liabilities. At December 31, 2011, these included auction rate security investments, valued at $67 million, a
portion of its fuel derivative option contracts, which were a net asset of $417 million, and $5 million in other
investments.
All of the Company’s auction rate security instruments are reflected at estimated fair value in the
Consolidated Balance Sheet. In prior periods, due to the auction process which took place every 30-35 days for
most securities, quoted market prices were readily available, which would have qualified as Level 1. However,
due to events in credit markets beginning during first quarter 2008, the auctions for most of these instruments
failed, and, therefore, the Company has determined the estimated fair values of these securities utilizing a
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