Southwest Airlines 2013 Annual Report Download - page 76

Download and view the complete annual report

Please find page 76 of the 2013 Southwest Airlines annual report below. You can navigate through the pages in the report by either clicking on the pages listed below, or by using the keyword search tool below to find specific information within the annual report.

Page out of 140

  • 1
  • 2
  • 3
  • 4
  • 5
  • 6
  • 7
  • 8
  • 9
  • 10
  • 11
  • 12
  • 13
  • 14
  • 15
  • 16
  • 17
  • 18
  • 19
  • 20
  • 21
  • 22
  • 23
  • 24
  • 25
  • 26
  • 27
  • 28
  • 29
  • 30
  • 31
  • 32
  • 33
  • 34
  • 35
  • 36
  • 37
  • 38
  • 39
  • 40
  • 41
  • 42
  • 43
  • 44
  • 45
  • 46
  • 47
  • 48
  • 49
  • 50
  • 51
  • 52
  • 53
  • 54
  • 55
  • 56
  • 57
  • 58
  • 59
  • 60
  • 61
  • 62
  • 63
  • 64
  • 65
  • 66
  • 67
  • 68
  • 69
  • 70
  • 71
  • 72
  • 73
  • 74
  • 75
  • 76
  • 77
  • 78
  • 79
  • 80
  • 81
  • 82
  • 83
  • 84
  • 85
  • 86
  • 87
  • 88
  • 89
  • 90
  • 91
  • 92
  • 93
  • 94
  • 95
  • 96
  • 97
  • 98
  • 99
  • 100
  • 101
  • 102
  • 103
  • 104
  • 105
  • 106
  • 107
  • 108
  • 109
  • 110
  • 111
  • 112
  • 113
  • 114
  • 115
  • 116
  • 117
  • 118
  • 119
  • 120
  • 121
  • 122
  • 123
  • 124
  • 125
  • 126
  • 127
  • 128
  • 129
  • 130
  • 131
  • 132
  • 133
  • 134
  • 135
  • 136
  • 137
  • 138
  • 139
  • 140

mitigation of fuel price volatility. The discontinuation of hedge accounting for specific hedges and for specific
refined products, such as unleaded gasoline, can also be a result of these factors. Depending on the level at which
the Company is hedged at any point in time, as the fair value of the Company’s hedge positions fluctuate in
amount from period to period, there could be continued variability recorded in the Consolidated Statement of
Income, and furthermore, the amount of hedge ineffectiveness and unrealized gains or losses recorded in
earnings may be material. This is primarily because small differences in the correlation of crude oil related
products could be leveraged over large volumes.
The Company continually looks for better and more accurate methodologies in forecasting expected future
cash flows relating to its jet fuel hedging program. These estimates are an important component used in the
measurement of effectiveness for the Company’s fuel hedges. The current methodology used by the Company in
forecasting forward jet fuel prices is primarily based on the idea that different types of commodities are
statistically better predictors of forward jet fuel prices, depending on specific geographic locations in which the
Company hedges. The Company then adjusts for certain items, such as transportation costs, that are stated in fuel
purchasing contracts with its vendors, in order to estimate the actual price paid for jet fuel associated with each
hedge. This methodology for estimating expected future cash flows (i.e., jet fuel prices) has been consistently
applied during 2013, 2012, and 2011, and has not changed for either assessing or measuring hedge
ineffectiveness during these periods.
The Company believes it is unlikely that materially different estimates for the fair value of financial
derivative instruments and forward jet fuel prices would be made or reported based on other reasonable
assumptions or conditions suggested by actual historical experience and other data available at the time estimates
were made.
Fair value measurements
The Company utilizes unobservable (Level 3) inputs in determining the fair value of certain assets and
liabilities. At December 31, 2013, these included auction rate security investments, valued at $39 million, a
portion of its fuel derivative option contracts, which were a net asset of $172 million, and $5 million in other
investments.
All of the Company’s auction rate security instruments are reflected at estimated fair value in the
Consolidated Balance Sheet. The Company has determined the estimated fair values of these securities utilizing a
discounted cash flow analysis or other type of valuation model, which qualify the instruments as Level 3. The
Company’s analyses consider, among other items, the collateralization underlying the security investments, the
expected future cash flows, including the final maturity, associated with the securities, estimates of the next time
the security is expected to have a successful auction or return to full par value, forecasted reset rates based on the
London Interbank Offered Rate (“LIBOR”) or the issuer’s net loan rate, and a counterparty credit spread.
The Company determines the fair value of fuel derivative option contracts utilizing an option pricing
model based on inputs that are either readily available in public markets, can be derived from information
available in publicly quoted markets, or are quoted by its counterparties. In situations where the Company
obtains inputs via quotes from its counterparties, it verifies the reasonableness of these quotes via similar quotes
from another counterparty as of each date for which financial statements are prepared. The Company has
consistently applied these valuation techniques in all periods presented and believes it has obtained the most
accurate information available for the types of derivative contracts it holds. Due to the fact that certain inputs
used in determining estimated fair value of its option contracts are considered unobservable (primarily implied
volatility), the Company has categorized these option contracts as Level 3.
As discussed in Note 10 to the Consolidated Financial Statements, any changes in fair value of cash flow
hedges that are considered to be effective, as defined, are offset within AOCI until the period in which the
expected future cash flow impacts earnings. Any changes in the fair value of fuel derivatives that are ineffective,
as defined, or that do not qualify for hedge accounting, are reflected in earnings within Other (gains) losses, net,
in the period of the change. Because the Company has extensive historical experience in valuing the derivative
68