Southwest Airlines 2014 Annual Report Download - page 81

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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 beyond approximately 24 months, 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 periods, because of increased volatility in energy markets, the
Company has lost hedge accounting for certain types of commodities, including in the third quarter of
2013, when 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 any other periods
presented. Although the Company continues to use a prospective assessment to determine that other
commodities continue to 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
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