Southwest Airlines 2015 Annual Report Download - page 74

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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
GAAP 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 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
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