Southwest Airlines 2013 Annual Report Download - page 34

fares in reaction to fuel price increases; however, fare increases can be difficult to implement in difficult
economic environments when low fares are often used to stimulate traffic. The ability to increase fares can also
be limited by factors such as the historical low-fare reputation of both Southwest and AirTran, the portion of
their Customer base that purchases travel for leisure purposes, the competitive nature of the airline industry
generally, and the risk that higher fares will drive a decrease in demand.
Jet fuel and oil consumed for 2013 and 2012 represented approximately 35 percent and 37 percent of the
Company’s operating expenses, respectively, and constituted the largest expense incurred by the Company in
both years. As a result, the price of fuel has impacted, and could continue to impact, the timing and nature of the
Company’s growth plans and many of the Company’s strategic initiatives.
The Company purchases jet fuel at prevailing market prices, but often seeks to protect against significant
increases in fuel costs by entering into over-the-counter financial fuel derivative contracts. In addition, the
Company enters into some of these fuel derivative contracts in an effort to reduce volatility in its operating
expenses. Although the Company may periodically enter into jet fuel derivatives for short-term timeframes,
because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge
directly in jet fuel for time horizons longer than approximately six 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. As discussed in detail in Note 10 to the Consolidated Financial
Statements, derivatives that are designated as hedges and deemed “effective” (i.e., that meet certain requirements
under applicable accounting standards) are granted hedge accounting treatment, which can reduce volatility in
the Company’s operating expenses. Nevertheless, because energy prices can fluctuate significantly in a relatively
short amount of time and due to the fact that the Company uses a variety of different derivative instruments and
at different price points, the Company is subject to the risk that the fuel derivatives it uses will not provide
adequate protection against significant increases in fuel prices.
In addition, the Company is subject to the risk that its fuel derivatives will not be effective or that they will no
longer qualify for hedge accounting under applicable accounting standards. In some situations, an entire commodity
type used in hedging may cease to qualify for special hedge accounting treatment. As an example, during third
quarter 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
a result, the changes in fair value of all of the Company’s derivatives based in WTI have been recorded to Other
(gains) losses, and all future changes in the fair value of such instruments will continue to be recorded directly to
earnings in future periods. Adjustments in the Company’s overall fuel hedging strategy, as well as the ability of the
commodities used in fuel hedging (principally crude oil, heating oil, and unleaded gasoline) to qualify for special
hedge accounting, are likely to continue to affect the Company’s results of operations. In addition, there can be no
assurance that the Company will be able to cost-effectively hedge against increases in fuel prices. The Company’s
fuel hedging arrangements and the impact of hedge accounting on the Company’s results of operations are
discussed in more detail under “Management’s Discussion and Analysis of Financial Condition and Results of
Operations” and in Note 10 to the Consolidated Financial Statements.
The Company has used financial derivative instruments for both shortterm and longterm 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.
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