American Airlines 2006 Annual Report Download - page 69

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65
7. Financial Instruments and Risk Management
As part of the Company's risk management program, AMR uses a variety of financial instruments, primarily fuel
option and collar contracts. The Company does not hold or issue derivative financial instruments for trading
purposes.
The Company is exposed to credit losses in the event of non-performance by counterparties to these financial
instruments, but it does not expect any of the counterparties to fail to meet its obligations. The credit exposure
related to these financial instruments is represented by the fair value of contracts with a positive fair value at the
reporting date, reduced by the effects of master netting agreements. To manage credit risks, the Company
selects counterparties based on credit ratings, limits its exposure to a single counterparty under defined
guidelines, and monitors the market position of the program and its relative market position with each
counterparty. The Company also maintains industry-standard security agreements with a number of its
counterparties which may require the Company or the counterparty to post collateral if the value of selected
instruments exceed specified mark-to-market thresholds or upon certain changes in credit ratings. The
Company’s outstanding posted collateral as of December 31, 2006 is included in restricted cash and short-term
investments and is not material. A deterioration of the Company’s liquidity position may negatively affect the
Company’s ability to hedge fuel in the future.
Fuel Price Risk Management
American enters into jet fuel, heating oil and crude oil hedging contracts to dampen the impact of the volatility in
jet fuel prices. These instruments generally have maturities of up to 24 months. The Company accounts for its
fuel derivative contracts as cash flow hedges and records the fair value of its fuel hedging contracts in Other
current assets and Accumulated other comprehensive loss on the accompanying consolidated balance sheets.
The Company determines the ineffective portion of its fuel hedge contracts by comparing the cumulative change
in the total value of the fuel hedge contract, or group of fuel hedge contracts, to the cumulative change in a
hypothetical jet fuel hedge. If the total cumulative change in value of the fuel hedge contract more than offsets
the total cumulative change in a hypothetical jet fuel hedge, the difference is considered ineffective and is
immediately recognized as a component of Aircraft fuel expense. Effective gains or losses on fuel hedging
contracts are deferred in Accumulated other comprehensive loss and are recognized in earnings as a component
of Aircraft fuel expense when the underlying jet fuel being hedged is used.
Ineffectiveness is inherent in hedging jet fuel with derivative positions based in crude oil or other crude oil related
commodities. As required by Statement of Financial Accounting Standard No. 133, “Accounting for Derivative
Instruments and Hedging Activities”, the Company assesses, both at the inception of each hedge and on an on-
going basis, whether the derivatives that are used in its hedging transactions are highly effective in offsetting
changes in cash flows of the hedged items. In doing so, the Company uses a regression model to determine the
correlation of the change in prices of the commodities used to hedge jet fuel (e.g. WTI Crude oil and NYMEX
Heating oil) to the change in the price of jet fuel. The Company also monitors the actual dollar offset of the
hedges’ market values as compared to hypothetical jet fuel hedges. The fuel hedge contracts are generally
deemed to be “highly effective” if the R-squared is greater than 80 percent and the dollar offset correlation is
within 80 percent to 125 percent. The Company discontinues hedge accounting prospectively if it determines that
a derivative is no longer expected to be highly effective as a hedge or if it decides to discontinue the hedging
relationship. During 2006, the Company determined that certain of its derivatives settling during the remainder of
2006 and in 2007 were no longer expected to be highly effective in offsetting changes in forecasted jet fuel
purchased. As a result of the ineffectiveness assessment on these derivatives, changes in market value were
recognized directly in earnings, while previously deferred gains in Other comprehensive loss were deferred and
recognized as a component of fuel expense when the originally hedged jet fuel was used in operations. All of
these derivatives settling after December 31, 2006, were re-designated as hedges on October 26, 2006. Hedge
accounting continues to be applied to derivatives used to hedge forecasted jet fuel purchases that are expected
to remain highly effective.