Southwest Airlines 2012 Annual Report Download - page 80

counterparties containing early termination rights triggered by credit rating thresholds and/or bilateral collateral
provisions whereby security is required if market risk exposure exceeds a specified threshold amount based on
the counterparty’s credit rating. The Company also had agreements with counterparties in which cash deposits,
lines of credit, and/or pledged aircraft are required to be posted whenever the net fair value of derivatives
associated with those counterparties exceeds specific thresholds—cash is either posted by the counterparty if the
value of derivatives is an asset to the Company, or cash, lines or credit, and/or aircraft could be posted by the
Company if the value of derivatives is a liability to the Company. Refer to the counterparty credit risk and
collateral table provided in Note 10 to the Consolidated Financial Statements for the fair values of fuel
derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of December 31,
2012, at which such postings are triggered.
At December 31, 2012, no cash deposits, letters of credit, and/or aircraft collateral were provided by or held
by the Company based on its outstanding fuel derivative instrument portfolio. Due to the terms of the Company’s
current fuel hedging agreements with counterparties and the types of derivatives held, in the Company’s
judgment, it does not have significant additional exposure to future cash collateral requirements. As an example,
if market prices for the commodities used in the Company’s fuel hedging activities were to decrease by
25 percent from market prices as of December 31, 2012, given the Company’s fuel derivative portfolio, its
aircraft collateral facilities, and its investment grade credit rating, it would likely provide an additional
$669 million in cash, letters of credit, and/or aircraft collateral to its current counterparties. However, the
Company would expect to also benefit from lower market prices paid for fuel used in its operations.
The Company is also subject to the risk that the fuel derivatives it uses to hedge against fuel price volatility
do not provide adequate protection. A portion of the fuel derivatives in the Company’s hedge portfolio are based
on the market price of West Texas intermediate crude oil (WTI). In some periods, the spread between WTI and
jet fuel has widened beyond historic norms, which has led to more ineffectiveness when measuring the
Company’s hedges. During those time periods, jet fuel prices have more closely correlated with changes in the
price of Brent crude oil (Brent). The Company has attempted to mitigate some of this risk by entering into more
fuel hedges based on Brent crude. Although the Company has some fuel derivatives based on the price of Brent,
to the extent the spread between jet fuel and WTI continues to fluctuate, a portion of the change in fair value of
the Company’s hedges could continue to experience ineffectiveness and not provide complete protection against
jet fuel price volatility.
The Company also has agreements with each of its counterparties associated with its outstanding interest rate
swap agreements in which cash collateral may be required based on the fair value of outstanding derivative
instruments, as well as the Company’s and its counterparty’s credit ratings. As of December 31, 2012, $66 million
had been provided to one counterparty associated with interest rate derivatives based on the Company’s outstanding
net liability derivative position with that counterparty. In addition, in connection with interest rate swaps entered
into by AirTran, a total of $23 million in cash collateral had been provided to one counterparty at December 31,
2012, as a result of a net liability derivative position with that counterparty. The outstanding interest rate net
derivative positions with all other counterparties at December 31, 2012, were assets to the Company.
Due to the significance of the Company’s fuel hedging program and the emphasis that the Company places
on utilizing fuel derivatives to reduce its fuel price risk, the Company has created a system of governance and
management oversight and has put in place a number of internal controls designed so that procedures are
properly followed and accountability is present at the appropriate levels. For example, the Company has put in
place controls designed to: (i) create and maintain a comprehensive risk management policy; (ii) provide for
proper authorization by the appropriate levels of management; (iii) provide for proper segregation of duties;
(iv) maintain an appropriate level of knowledge regarding the execution of and the accounting for derivative
instruments; and (v) have key performance indicators in place in order to adequately measure the performance of
its hedging activities. The Company believes the governance structure that it has in place is adequate given the
size and sophistication of its hedging program.
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