Southwest Airlines 2012 Annual Report Download - page 79

Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company has interest rate risk in its floating-rate debt obligations and interest rate swaps, commodity
price risk in jet fuel required to operate its aircraft fleet, and market risk in the derivatives used to manage its fuel
hedging program and in the form of fixed-rate debt instruments. As of December 31, 2012, Southwest and
AirTran operated a total of 189 aircraft under operating and capital leases. However, except for a small number
of aircraft that have lease payments that fluctuate based in part on changes in market interest rates, the remainder
of the leases are not considered market sensitive financial instruments and, therefore, are not included in the
interest rate sensitivity analysis below. Commitments related to leases are disclosed in Note 8 to the Consolidated
Financial Statements. The Company does not purchase or hold any derivative financial instruments for trading
purposes. See Note 10 to the Consolidated Financial Statements for information on the Company’s accounting
for its hedging program and for further details on the Company’s financial derivative instruments.
Hedging
The Company purchases jet fuel at prevailing market prices, but seeks to manage market risk through
execution of a documented hedging strategy. The Company utilizes financial derivative instruments, on both a
short-term and a long-term basis, as a form of insurance against the potential for significant increases in fuel prices.
The Company believes there is significant risk in not hedging against the possibility of such fuel price increases.
The Company expects to consume approximately 1.8 billion gallons of jet fuel in 2013. Based on this anticipated
usage, a change in jet fuel prices of just one cent per gallon would impact the Company’s Fuel and oil expense by
approximately $18 million for 2013, excluding any impact associated with fuel derivative instruments held.
As of December 31, 2012, the Company held a net position of fuel derivative instruments that represented a
hedge for a portion of its anticipated jet fuel purchases for each year from 2013 through 2017. See Note 10 to the
Consolidated Financial Statements for further information. The Company may increase or decrease the size of its
fuel hedge based on its expectation of future market prices, as well as its perceived exposure to cash collateral
requirements contained in the agreements it has signed with various counterparties. The gross fair value of
outstanding financial derivative instruments related to the Company’s jet fuel market price risk at December 31,
2012, was a net asset of $219 million. In addition, no cash collateral deposits were provided by or held by the
Company in connection with these instruments based on their fair value as of December 31, 2012. The fair values
of the derivative instruments, depending on the type of instrument, were determined by use of present value
methods or standard option value models with assumptions about commodity prices based on those observed in
underlying markets. An immediate 10 percent increase or decrease in underlying fuel-related commodity prices
from the December 31, 2012 (for all years from 2013 through 2017) prices would correspondingly change the
fair value of the commodity derivative instruments in place by approximately $340 million. Fluctuations in the
related commodity derivative instrument cash flows may change by more or less than this amount based upon
further fluctuations in futures prices as well as related income tax effects. In addition, this does not consider
changes in cash collateral provided to or by counterparties, which would fluctuate in an amount equal to or less
than this amount, depending on the type of collateral arrangement in place with each counterparty. This
sensitivity analysis uses industry standard valuation models and holds all inputs constant at December 31, 2012
levels, except underlying futures prices.
The Company’s credit exposure related to fuel derivative instruments is represented by the fair value of
contracts with a net positive fair value to the Company. At such times, these outstanding instruments expose the
Company to credit loss in the event of nonperformance by the counterparties to the agreements. As of
December 31, 2012, the Company had eight counterparties in which the derivatives held were a net asset, totaling
$230 million. To manage credit risk, the Company selects and will periodically review counterparties based on
credit ratings, limits its exposure to a single counterparty with collateral support agreements, and monitors the
market position of the program and its relative market position with each counterparty. However, if one or more
of these counterparties were in a liability position to the Company and were unable to meet their obligations, any
open derivative contracts with the counterparty could be subject to early termination, which could result in
substantial losses for the Company. At December 31, 2012, the Company had agreements with all of its
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