Southwest Airlines 2015 Annual Report Download - page 81

has the ability to manage or reduce its derivative positions by entering into offsetting positions, as it
did during 2015, for a portion of its future hedge portfolio.
The Company is also subject to the risk that the fuel derivatives it uses to hedge against fuel price
volatility do not provide adequate protection. A portion of the fuel derivatives in the Company’s hedge
portfolio are based on the market price of West Texas intermediate crude oil (“WTI”). In recent years,
jet fuel prices have been more closely correlated with changes in the price of Brent crude oil (“Brent”).
The Company has attempted to mitigate some of this risk by entering into more fuel hedges based on
Brent crude. Although the Company has some fuel derivatives based on the price of Brent, to the
extent the Company holds WTI-based derivatives, changes in the fair value of these positions will
continue to create income statement volatility and may not provide complete protection against jet fuel
price volatility. In addition, to add further protection, the Company may periodically enter into jet fuel
derivatives for short-term timeframes. Jet fuel is not widely traded on an organized futures exchange
and, therefore, there are limited opportunities to hedge directly in jet fuel for time horizons longer than
approximately 24 months into the future.
The Company also has agreements with each of its counterparties associated with its outstanding
interest rate swap agreements in which cash collateral may be required based on the fair value of
outstanding derivative instruments, as well as the Company’s and its counterparty’s credit ratings. As
of December 31, 2015, no cash collateral deposits were provided by or held by the Company based on
its outstanding interest rate swap agreements.
Due to the significance of the Company’s fuel hedging program and the emphasis that the Company
places on utilizing fuel derivatives to reduce its fuel price risk, the Company has created a system of
governance and management oversight and has put in place a number of internal controls designed so
that procedures are properly followed and accountability is present at the appropriate levels. For
example, the Company has put in place controls designed to: (i) create and maintain a comprehensive
risk management policy; (ii) provide for proper authorization by the appropriate levels of management;
(iii) provide for proper segregation of duties; (iv) maintain an appropriate level of knowledge regarding
the execution of and the accounting for derivative instruments; and (v) have key performance
indicators in place in order to adequately measure the performance of its hedging activities. The
Company believes the governance structure that it has in place is adequate given the size and
sophistication of its hedging program.
Financial Market Risk
The vast majority of the Company’s tangible assets are aircraft, which are long-lived. The Company’s
strategy is to maintain a conservative balance sheet and grow capacity steadily and profitably under the
right conditions. While the Company uses financial leverage, it strives to maintain a strong balance
sheet and has a “BBB+” rating with Fitch, a “BBB” rating with Standard & Poor’s, and a “Baa1” credit
rating with Moody’s as of December 31, 2015, all of which are considered “investment grade.” The
Company’s French Credit Agreements due 2018 do not give rise to significant fair value risk but do
give rise to interest rate risk because this borrowing was originally issued as floating-rate debt. In
addition, as disclosed in Note 10 to the Consolidated Financial Statements, the Company has converted
certain of its long-term debt to floating rate debt by entering into an interest rate swap agreement.
Although there is interest rate risk associated with these floating rate borrowings, the risk of the French
Credit Agreements due 2018 is somewhat mitigated by the fact that the Company may prepay this debt
under certain conditions. See Note 6 to the Consolidated Financial Statements for more information on
the material terms of the Company’s short-term and long-term debt.
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