Southwest Feeling the Pinch of Fuel Hedge Reversal

(MoneyWatch)  Although average passenger revenue yield per mile increased 16.5% year-on-year to $14.70, Southwest Airlines announced its first quarterly loss in 17 years (of $120 million) -- not because of negative operating income -- but due to unrealized losses associated with the required mark down in the value of some derivative fuel hedges (used to protect the airline against rising jet fuel costs). The reversal in commodity prices forced the company to record $247 million in net pre-tax charges in the third-quarter ended September 30.

Although Southwest's fuel hedging program wiped-out operating income of $86 million in the third-quarter 2008, fuel derivative instruments have historically provided economic benefit to the company, according to the 10-Q filed with the SEC on Monday:

• "The Company's hedging program resulted in the realization of approximately $448 million in cash settlements for third quarter 2008 compared to $189 million in cash settlements for third quarter 2007. The majority of the $448 million in third quarter 2008 cash settlements were reflected as a reduction to fuel and oil expense."

Even including the strong third quarter 2008 fuel derivative cash settlements, jet fuel cost increased to $2.60 per gallon, up 53.8 percent from last year. Ergo, despite the recent decline in energy prices and related market value of its fuel portfolio, management believes it best to retain a strong fuel hedge position. The net fair value of the Company's remaining unsettled fuel derivative instruments as of September 30, was $2.5 billion.

Whether the hedging program that has boosted fuel economy at Southwest this year will prove to be a drag on earnings next year will depend entirely on the future direction of fuel prices.

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This post first appeared in BNET's 10-Q Detective.