SOUTHWEST AIRLINES CO

10. FINANCIAL DERIVATIVE INSTRUMENTS

Fuel Contracts

Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. Furthermore, jet fuel and oil typically represents one of the largest operating expenses for airlines. The Company has historically aimed to reduce volatility in operating expenses through its fuel hedging program. However, based on higher fuel hedging premium costs over time and other factors, the Company has discontinued its fuel hedging program in 2025 and does not intend to add additional fuel derivatives at this time.

For the purpose of evaluating its net cash spend for jet fuel and for forecasting its future estimated jet fuel expense, the Company has historically evaluated its hedge volumes strictly from an "economic" standpoint and thus did not consider whether the hedges had qualified or would qualify for hedge accounting. The Company defined its "economic" hedge as the net volume of fuel derivative contracts held, including the impact of positions that were offset through sold positions, regardless of whether those contracts qualified for hedge accounting.

During second quarter 2025, the Company terminated its remaining portfolio of fuel hedging contracts, which were scheduled to settle through 2027, to effectively close its fuel hedging portfolio and program. This resulted in the derecognition of all remaining related hedge assets in the Consolidated Balance Sheet. The cash proceeds from this transaction totaled approximately $40 million, which will reduce future premium costs. Subsequent to this termination, approximately $96 million that was previously expended on hedge positions in prior periods was reclassified from AOCI and recognized as an increase to Fuel and oil expense within the Consolidated Statement of Income during 2025, all of which is characterized as premium expense from terminated fuel hedging positions. As of December 31, 2025, approximately $137 million remained in AOCI related to these closed positions. This balance in AOCI, which does not include any tax impact, will also be characterized as premium expense and similarly reclassified as an increase to Fuel and oil expense in future periods when the originally forecasted transactions occur (through the end of 2027), and is net of the impact of the cash proceeds from the hedge terminations. See Note 12 for additional information on AOCI.

Historically, upon proper qualification, the Company accounted for its fuel derivative instruments as cash flow hedges. Qualification was re-evaluated quarterly, and all periodic changes in fair value of the derivatives designated as hedges were recorded in AOCI until the underlying jet fuel was consumed. See Note 12.

If a derivative initially did not qualify or ceased to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period was recorded in Other (gains) losses, net in the Consolidated Statement of Income in the period of the change; however, any amounts previously recorded to AOCI remained there until such time as the original forecasted transaction occurred, at which time these amounts were reclassified to Fuel and oil expense.

During third quarter 2024, the routine statistical analysis performed by the Company to determine which commodities qualify for special hedge accounting treatment on a prospective basis indicated that WTI crude oil-based derivatives no longer qualified for hedge accounting. This change was primarily due to the fact that the correlation between WTI crude oil prices and jet fuel prices during recent periods had not been as strong as in the past, and therefore the Company could no longer demonstrate that derivatives based on WTI crude oil prices would result in effective hedges on a prospective basis. As such, all WTI-based instruments were de-designated from their hedging relationships and the change in fair value of all of the Company's derivatives based in WTI was recorded to Other (gains) losses for third and fourth quarter 2024. All WTI crude oil based derivatives in the Company's portfolio have settled as of December 31, 2024. The change in fair value of the Company's WTI derivative contracts during the second half of 2024 was a decrease of $37 million, which resulted in a corresponding loss in the Consolidated Statement of Income. Any amounts previously recorded to AOCI remained there until the original forecasted transaction occurred in accordance with hedge accounting requirements.

All cash flows associated with purchasing and selling fuel derivatives (including terminations) are classified as Other operating cash flows in the Consolidated Statement of Cash Flows. The following table presents the location of all assets and liabilities associated with the Company’s derivative instruments within the Consolidated Balance Sheet:

(a) Represents the position of each trade before consideration of offsetting positions with each counterparty and does not include the impact of cash collateral deposits provided to or received from counterparties.

In addition, the Company had the following amounts associated with fuel derivative instruments and hedging activities in its Consolidated Balance Sheet:

All of the Company's prior period fuel derivative instruments and current period interest rate swaps are subject to agreements that follow the netting guidance in the applicable accounting standards for derivatives and hedging. The types of derivative instruments the Company determined were subject to netting requirements in the accompanying Consolidated Balance Sheet are those in which the Company paid or received cash for transactions with the same counterparty and in the same currency via one net payment or receipt. For cash collateral held by the Company or provided to counterparties, the Company netted such amounts against the fair value of the Company's derivative portfolio by each counterparty. The Company elected to utilize netting for its prior period fuel derivative instruments and also classified such amounts as either current or noncurrent, based on the net fair value position with each of the Company's counterparties in the Consolidated Balance Sheet.

The Company had the following recognized financial assets and financial liabilities resulting from those transactions that meet the scope of the disclosure requirements as necessitated by applicable accounting guidance for balance sheet offsetting:

(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the Consolidated Balance Sheet in Note 15.

(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the Consolidated Balance Sheet in Note 15.

The following tables present the impact of derivative instruments, including terminations, within the Consolidated Statement of Income for the years ended December 31, 2025 and 2024:

(a) Includes amounts reclassified from Accumulated Other Comprehensive Income associated with hedges previously terminated.

The Company also recorded expenses associated with net premiums paid for fuel derivative contracts that settled/expired and/or terminated during 2025, 2024, and 2023. Gains and/or losses associated with fuel derivatives that qualified for hedge accounting were ultimately recorded to Fuel and oil expense. Gains and/or losses associated with fuel derivatives that did not qualify for hedge accounting were recorded to Other (gains) losses, net. The following table presents the expense impacts and their location within the Consolidated Statement of Income during the period the contracts settled or were scheduled to settle:

Interest Rate Derivatives

The Company is at times party to certain interest rate swap agreements that are accounted for as either fair value hedges or cash flow hedges, as defined in the applicable accounting guidance for derivative instruments and hedging. The Company did not have any interest rate swap agreements designated as cash flow hedges during the periods presented. During the periods presented, the Company's interest rate swap agreements qualify for the "shortcut" or "critical terms match" methods of accounting for hedges, which dictate that the hedges were assumed to be perfectly effective at origination and, thus, there was no ineffectiveness to be recorded in the Consolidated Statement of Income.

During fourth quarter 2025, the Company entered into interest rate swap agreements as a hedge related to its $750 million 5.25% Notes due 2035. See Note 6. The primary objective for the Company's use of this interest rate hedge was to hedge against changes in the fair value of the debt instrument caused by changes in market interest rates, specifically SOFR. The hedge strategy is to eliminate the changes in fair value of the debt by converting the fixed rate interest of the debt to a floating rate. Under these interest rate swap agreements, the Company pays SOFR plus a margin every six months on the notional amount of the debt, and receives payments based on the fixed stated rate of the notes every six months until the date the notes become due. These interest rate swap agreements collectively qualify as a fair value hedge. As a result of the fixed-to-floating interest rate swap agreements in place, the average floating rate recognized during 2025 was approximately 5.44 percent, based on actual and forward rates as of December 31, 2025.

The fair values of the interest rate swap agreements, which are adjusted regularly, have been aggregated by counterparty for classification in the Consolidated Balance Sheet. Agreements totaling a net liability of $16 million, are fair value hedges, and are classified as components of Other noncurrent liabilities. The corresponding offsetting adjustment related to the net asset (or liability) associated with the Company’s fair value hedges is to Long-term debt less current maturities.

During fourth quarter 2023, the Company terminated $150 million notional value of forward-starting interest rate swap agreements associated with the Company's forecasted issuance of debt. These swap agreements had been classified as cash flow hedges, and all fair market value changes were recorded to AOCI prior to their termination. Following the issuance of the Company's $750 million 5.25% Notes due 2035 in fourth quarter 2025, the deferred gain of $23 million associated with these terminated swaps is now being amortized to Interest expense over the life of the notes.

Credit Risk and Collateral

The Company had no cash collateral posted or received as of December 31, 2025.