Southwest Airlines Case

Southwest Airlines, one of the world's largest airlines and "America's largest domestic airline," (2011 Annual Report) has been able to deliver 39 years of consecutive annual profits to its shareholders in spite of significant headwinds in the form of a recession, tightening credit and a dramatic rise in energy prices. Southwest Airlines has been able to navigate through these challenges while many of its competitors were "either ceasing operations or reorganizing through bankruptcy" (2011 Annual Report). We believe that Southwest's focus on delivering value through operational excellence via effective risk management practices has been a key contributor to its success while allowing it to consistently fly above its competition.

Airline industry profits continue to be threatened by the rising cost of fuel to historically high levels. The airline industry is largely dependent upon fuel to operate with oil and jet fuel consistently representing one of the largest operating expenses for airline companies and even the smallest volatility in the market price for fuel can have a significant impact on airline industry profitability. However, effectively managing fuel prices comes with significant challenges to the airline industry as the price of fuel remains unpredictable due to numerous external factors such as foreign dependency, capacity constraints, the increased worldwide demand for fuel, the impacts of certain governmental policies and movements in exchange rates.

Southwest Airlines currently employs several risk management tools such as fuel hedges, agreements with its counterparties to manage credit risk and interest rate swaps; however, fuel remains one of the single largest challenges for the organization. "Jet fuel and oil consumed for 2011 and 2010 represented approximately 38 percent and 33 percent of the Company's operating expenses, respectively, and constituted the largest expense incurred by the Company in 2011 and the second largest expense in 2010. As a result, the price of fuel has impacted, and could continue to impact, the timing and nature of the Company's growth plans and strategic initiatives" (2011 Annual Report). Fuel and oil also represent Southwest's single largest expense as its "2011 economic jet fuel cost averaged a record $3.19 per gallon, a 33.5 percent increase relative to 2010" and "total economic fuel and oil expense" in 2011 was "approximately $5.6 billion, a 63.7 percent year-over-year increase" (2011 One Report). As a result, the ability for Southwest Airlines to continue delivering value to its shareholders is largely dependent upon its ability to successfully mitigate the impact of rising energy prices on its operations. This risk management report will primarily focus on Southwest's use of fuel hedges to manage its exposure to unfavorable movements in the price of fuel through its fuel hedging program, which since 2000, has resulted in a decrease in fuel costs of $3.3 billion.

To put the company's jet fuel exposure in perspective, Southwest estimates that a $0.01 increase in jet fuel corresponds to an additional $19 million of expense based on forecasted usage for FY 2012 (2011 Annual Report). Unfortunately for Southwest, there are no "jet fuel" derivatives to use in order to hedge against price increases. Instead, the company relies on "like commodities" such as crude oil, heating oil and unleaded gasoline to hedge its exposure to jet fuel prices (2011 Annual Report). These commodities are positively correlated to jet fuel prices so that if the price of crude oil, heating oil or unleaded gasoline increases, the price of jet fuel should also increase. The correlation has been strong enough in past/current markets for Southwest to be able to use hedge accounting treatment for its derivatives. This is important because it reduces the volatility in the company's income statement from price movements of the company's hedges. Under hedge accounting, the gain/loss on the financial hedge is realized when the commodity is actually purchased versus normal accounting which includes the corresponding gains/losses from the mark to markets of the derivatives in each period (2011 Annual Report).

Many of Southwest's fuel hedges are based on the price of West Texas intermediate crude oil (WTI). The company uses a variety of different instruments in its hedging program, including fixed price swap agreements, purchased call options, collars and call spreads (2011 Annual Report). These are "over-the-counter" contracts which are less liquid than generic contracts traded on market exchanges. This also means Southwest has to monitor its counterparty credit exposure carefully (to make sure it does not get trapped with a counterparty that is unable to pay its obligations). In the company's annual report it cautions that collar and swap agreements can be more risky since they can result in a liability for the company, where as purchased call spreads and options cannot end up as a liability for the company (excluding the premium paid for such contracts). The benefits of collar and swap agreements is that they can result in cheaper hedging as part of the premium is offset by the premium collected from selling the other side of the hedge. Given the large exposure and limited options on hedging jet fuel, Southwest's approach to mitigating risk has been logical and effective.

Southwest reported a net income of $178 million in 2011, which decreased 61.2 percent ($281 million) compared to net income of $459 million