Southwest Airlines 2013 Annual Report Download - page 107

there are limited opportunities to hedge directly in jet fuel for time horizons longer than approximately 6 to 12
months into the future. However, the Company has found that financial derivative instruments in other
commodities, such as West Texas Intermediate (“WTI”) crude oil, Brent crude oil, and refined products, such as
heating oil and unleaded gasoline, can be useful in decreasing its exposure to jet fuel price volatility. The
Company does not purchase or hold any financial derivative instruments for trading or speculative purposes.
The Company has used financial derivative instruments for both short-term and long-term time frames, and
primarily 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. 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, but may be exposed to price
changes beyond a certain market price.
The Company evaluates its hedge volumes strictly from an “economic” standpoint and thus does not
consider whether the hedges have 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. The level
at which the Company is hedged for a particular period is also dependent on current market prices for that period
as well as the types of derivative instruments held and the strike prices of those instruments. For example, the
Company may enter into “out-of-the-money” option contracts (including catastrophic protection), which may not
generate intrinsic gains at settlement if market prices do not rise above the option strike price. Therefore, even
though the Company may have an “economic” hedge in place for a particular period, that hedge may not produce
any hedging gains and may even produce hedging losses depending on market prices, the types of instruments
held, and the strike prices of those instruments.
For 2013, the Company had fuel derivative instruments in place for 51 percent of its fuel consumption. As
of December 31, 2013, the Company also had fuel derivative instruments in place to provide coverage for 43
percent of its 2014 estimated fuel consumption, depending on where market prices settle. The following table
provides information about the Company’s volume of fuel hedging for the years 2014 through 2017 on an
“economic” basis considering current market prices:
Period (by year)
Fuel hedged as of
December 31, 2013
(gallons in millions)(a)
Derivative underlying
commodity type
as of December 31, 2013
2014 ............................. 764 WTIcrude, Brent crude oil, GC Jet Fuel
2015 ............................. 1,156 WTI crude and Brent crude oil
2016 ............................. 977 Brent crude oil
2017 ............................. 933 WTIcrude and Brent crude oil
(a) The Company determines gallons hedged based on market prices and forward curves as of December 31,
2013. Due to the types of derivatives utilized by the Company, these volumes may vary significantly as
market prices fluctuate.
Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges.
Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges
that are considered to be effective are recorded in Accumulated Other Comprehensive Income (Loss) (“AOCI”)
until the underlying jet fuel is consumed. See Note 12. The Company’s results are subject to the possibility 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
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