Southwest Airlines 2013 Annual Report Download - page 75

derivative instruments utilized by the Company primarily are a combination of collars, purchased call options,
call spreads, and fixed price swap agreements. The Company does not purchase or hold any derivative
instruments for trading purposes.
The Company enters into financial derivative instruments with third party institutions in “over-the-counter”
markets. Since the majority of the Company’s financial derivative instruments are not traded on a market
exchange, the Company estimates their fair values. Depending on the type of instrument, the values are
determined by the use of present value methods or standard option value models with assumptions about
commodity prices based on those observed in underlying markets. Also, since there is not a reliable forward
market for jet fuel, the Company must estimate the future prices of jet fuel in order to measure the effectiveness
of the hedging instruments in offsetting changes to those prices. Forward jet fuel prices are estimated through the
observation of similar commodity futures prices (such as crude oil, heating oil, and unleaded gasoline) and
adjusted based on variations of those like commodities to the Company’s ultimate expected price to be paid for
jet fuel at the specific locations in which the Company hedges.
Fair values for financial derivative instruments and forward jet fuel prices are estimated prior to the time
that the financial derivative instruments settle and the time that jet fuel is purchased and consumed, respectively.
However, once settlement of the financial derivative instruments occurs and the hedged jet fuel is purchased and
consumed, all values and prices are known and are recognized in the financial statements. In some historical
periods, because of increased volatility in energy markets, the Company has in fact lost hedge accounting for
certain types of commodities. In the third quarter of 2013, because of increased volatility in energy markets, the
Company lost hedge accounting for West Texas Intermediate crude oil instruments. At this time, the Company
marks all such derivatives to fair value in each quarterly period, with all changes in value reflected as a
component of Other (gains) losses, net in the Consolidated Statement of Income. The Company did not lose
hedge accounting for an entire commodity during 2012 or 2011. Although the Company’s prospective
assessment has been utilized to ensure that the commodities used in most cases still qualify for hedge accounting
in specific locations where the Company hedges, there are no assurances that these commodities will continue to
qualify in the future. This is due to the fact that future price changes in these refined products may not be
consistent with historical price changes. Increased volatility in these commodity markets for an extended period
of time, especially if such volatility were to worsen, could cause the Company to lose hedge accounting
altogether for the commodities used in its fuel hedging program, which would create further volatility in the
Company’s financial results.
Estimating the fair value of these fuel derivative instruments and forward prices for jet fuel will also result
in changes in their fair values from period to period and thus determine their accounting treatment. To the extent
that the change in the estimated fair value of a fuel derivative instrument differs from the change in the estimated
price of the associated jet fuel to be purchased, both on a cumulative and a period-to-period basis, ineffectiveness
of the fuel hedge can result. This could result in the immediate recording of non-cash charges or income,
representing the change in the fair value of the derivative, even though the derivative instrument may not expire/
settle until a future period. Likewise, if a derivative contract ceases to qualify for hedge accounting, the change in
the fair value of the derivative instrument is recorded every period to Other (gains) and losses, net in the
Consolidated Statement of Income in the period of the change.
Ineffectiveness is inherent in hedging jet fuel with derivative positions based in other crude oil related
commodities, especially given the past volatility in the prices of refined products. 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 historically resulted, in increased volatility in the
Company’s financial statements. The amount of hedge ineffectiveness and unrealized gains and losses on the
change in fair value of derivative contracts settling in future periods recorded during historical periods has been
due to a number of factors. These factors include: the significant fluctuation in energy prices, the number of
derivative positions the Company holds, significant weather events that have affected refinery capacity and the
production of refined products, and the volatility of the different types of products the Company uses for
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