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.