Southwest Airlines 2013 Annual Report Download - page 108

extent that the periodic changes in the fair value of the derivatives are ineffective, the ineffective portion is
recorded to Other (gains) losses, net in the Consolidated Statement of Income. Likewise, if a hedge ceases to
qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period
is recorded to Other (gains) losses, net, in the Consolidated Statement of Income in the period of the change;
however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted
transaction occurs, at which time these amounts would be reclassified to Fuel and oil expense. When the
Company has sold derivative positions in order to effectively “close” or offset a derivative already held as part of
its fuel derivative instrument portfolio, any subsequent changes in fair value of those positions are marked to
market through earnings. Likewise, any changes in fair value of those positions that were offset by entering into
the sold positions are concurrently marked to market through earnings. However, any changes in value related to
hedges that were deferred as part of AOCI while designated as a hedge would remain until the originally
forecasted transaction occurs. In a situation where it becomes probable that a fuel hedged forecasted transaction
will not occur, any gains and/or losses that have been recorded to AOCI would be required to be immediately
reclassified into earnings. The Company did not have any such situations occur during 2011, 2012, or during the
year ended December 31, 2013.
In some situations, an entire commodity type used in hedging may cease to qualify for special hedge
accounting treatment. As an example, during 2013, the Company’s routine statistical analysis performed to
determine which commodities qualify for special hedge accounting treatment on a prospective basis dictated that
WTI crude oil based derivatives no longer qualify for hedge accounting. This is primarily due to the fact that the
correlation between WTI crude oil prices and jet fuel prices during recent periods has not been as strong as in the
past, and therefore the Company can no longer demonstrate that derivatives based on WTI crude oil prices will
result in effective hedges on a prospective basis. As such, the change in fair value of all of the Company’s
derivatives based in WTI have been recorded to Other (gains) losses for the second half of 2013, and all future
changes in the fair value of such instruments will continue to be recorded directly to earnings in future periods.
The change in fair value of the Company’s WTI derivative contracts during the second half of 2013 was an
increase of $15 million, which resulted in a gain in the Consolidated Statement of Income. Any amounts
previously recorded to AOCI will remain there until such time as the original forecasted transaction occurs in
accordance with hedge accounting requirements. The Company will continue to evaluate whether it can qualify
for hedge accounting for WTI derivative contracts in future periods.
Ineffectiveness is inherent in hedging jet fuel with derivative positions based in other crude oil related
commodities. 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 resulted, in
increased volatility in the Company’s financial results. Factors that have and may continue to lead to
ineffectiveness and unrealized gains and losses on derivative contracts include: significant fluctuation in energy
prices, the number of derivative positions the Company holds, significant weather events affecting refinery
capacity and the production of refined products, and the volatility of the different types of products the Company
uses in hedging. However, even though derivatives may not qualify for hedge accounting, the Company
continues to hold the instruments as management believes derivative instruments continue to afford the Company
the opportunity to stabilize jet fuel costs.
Accounting pronouncements pertaining to derivative instruments and hedging are complex with stringent
requirements, including the documentation of a Company hedging strategy, statistical analysis to qualify a
commodity for hedge accounting both on a historical and a prospective basis, and strict contemporaneous
documentation that is required at the time each hedge is designated by the Company. The Company also
examines the effectiveness of each individual hedge and its entire hedging program on a quarterly basis utilizing
statistical analysis. This analysis involves utilizing regression and other statistical analyses that compare changes
in the price of jet fuel to changes in the prices of the commodities used for hedging purposes.
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