Southwest Airlines 2012 Annual Report Download - page 74

Financial derivative instruments
The Company utilizes financial derivative instruments primarily to manage its risk associated with changing
jet fuel prices. See “Quantitative and Qualitative Disclosures about Market Risk” for more information on these
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, 2012, the Company was a party to over 1,100 separate financial derivative instruments, related to
its fuel hedging program, for the years 2013 through 2017. 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 2011, market “spot” prices for West Texas Intermediate crude oil peaked at a high of
approximately $114 per barrel and hit a low price of approximately $76 per barrel. During 2012, market spot
prices ranged from a high of $110 per barrel to a low of $78 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, geopolitical events, 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 a
certain type of commodity, such as all unleaded gasoline derivative instruments. There have also been instances
in which the Company has lost hedge accounting in specific geographic locations for certain types of
commodities used in hedging. 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. The Company did not lose hedge accounting for an entire commodity during
2012, 2011, or 2010. 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 volatility were
to worsen, could cause the Company to lose hedge accounting altogether for the commodities used in its fuel
hedging program, 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 fair 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
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