Southwest Airlines (NYSE:LUV) reported earnings today - and for the 69th straight quarter, the airline turned a profit. Its quarterly net income increased 15% from a year ago, to $321 million. These results are worth a closer look, considering the rest of the major airlines lost a combined $6 billion in the second quarter. How does Southwest stay in the black as the rest of its peers bleed red? The secret - it hedges its fuel prices better than anyone in the business

A hedge, at its most basic level, is when a company locks in a price for the raw materials that it will need to run its business in the future. In Southwest’s case, these futures contracts are for oil - more specifically, the jet fuel it needs to power its planes - and no matter what happens to the price of oil in the ensuing months, when the due date comes the company pays the contracted price. Using this strategy, Southwest has saved $3.5 billion in fuel costs since 1998 - which translates to about 80% of the company’s profits in that time period.

But there are risks involved with hedging - if oil prices go down rather than up, Southwest could suddenly end up paying much more than market price for its fuel. But lately oil has just kept on climbing (as you’ve probably noticed at the gas pump as the meter clicks away at a $4.00 a gallon clip), and Southwest’s strategy has been wildly successful. For the rest of 2008, Southwest has 65% of its fuel hedged at $49 a barrel - while competitor American Airlines (NYSE:AMR), for example, has just 34% of its fuel needs hedged, and will pay $82 a barrel for these contracts. In 2009, Southwest will pay $51 a barrel for 50% of the oil it needs to run on schedule.

So what’s the catch? Well, eventually futures contracts expire, and you’ve got to sign new ones. That’s not so easy with oil well over $100 a barrel - and although futures contracts for the black gold fell $20 over the past two weeks to $124, that’s still too much for the company to remain profitable. In fact, Southwest hasn’t signed a new hedging contract in 15 months, and a shrinking percentage of its fuel needs are covered over the next four years. Check out this table - by 2012 the company will have just 15% of its fuel needs under hedging contracts, and if oil prices stay near their current levels ($135 a barrel) the company will be paying an average of $124 a barrel for its fuel.

That’s simply too much for the company to stay profitable, especially in a cutthroat industry where Southwest has made a reputation as a discount carrier. For now, Southwest may be sitting pretty, but how long until it must start raising its fares, charging for checked bags, and canceling flights, as so many of its industry peers have done in recent weeks? Or can LUV keep up its remarkable string of profits and continue to hold out as a cheap alternative for getaway vacations? The market is skeptical - see the 6% dive in stock price on the day the second quarter profits were announced - and investors should be cautious when evaluating this apparent diamond in the rough.