Southwest Airlines 2014 Annual Report Download - page 82

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 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 2014, 2013, and 2012, 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, 2014, these included auction rate security investments, valued at
$27 million, a portion of its fuel derivative option contracts, which were a net liability of $1.1 billion,
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.
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