The Economics 101 of the Fuel Subsidy Debate in Nigeria

By

Dr. Emmanuel Ojameruaye

emmaojameruaye@yahoo.com

 

In the first part of this article, I looked at the politics of the fuel subsidy debate. In this second part, I will take a look at the “pure” economics of fuel subsidy. Some of the misunderstandings about the fuel subsidy issue would have been clarified or resolved if most of the proponents and opponents had put on the “economic thinking” hat in making their case for or against the fuel subsidy, and if they had a clear understanding of the concept of subsidy. The economic approach to discussing the fuel subsidy issue requires  a clear understanding of the concept of subsidy, an examination of the benefits and costs of  fuel subsidy, an evaluation of different options for addressing the issue, adopting the “economic way of thinking”, and choosing  an “optimal” option based on the maximization of an appropriate social welfare. 

1 The Concept of Subsidy

Put simply, a subsidy (or subvention) is an amount of money paid by government to suppliers (providers or producers) of a product or service to enable them to sell their products or services to final consumers at a price determined by the government, which is less than the true supply cost[1]. For instance, the federal government (FG) provides subvention (subsidy) to federal universities so that they can charge tuition (demand price of university education paid by students) that is less than the true cost of providing university education (i.e., supply cost). Thus, if a federal university has 10,000 registered students and if its total budget is N5 billion, its cost of providing education (supply cost) will be N500,000 per student a year (N5billion/10,000). However, if the FG decides peg tuition fees at N200,000 per student, then it must provide a subsidy (subvention) of N300,000 per student (i.e. N3 billion for all 10,000 students) to the university to enable it to provide its services (education) to the students.  The government also subsidizes imported petroleum products such as petrol otherwise known as gasoline or motor premium spirit (or PMS), diesel (automotive gas oil or AGO), household kerosene (HHK) and liquefied petroleum gas (LPG) because it has decided to fix the prices of these products at levels lower that the cost of importation and delivery to final consumers at the filling stations. For instance, if the cost of importation (landing cost) of petrol is N120 per litre and distribution/marketing cost[2] is N20 per litre, then the supply cost  will be N140 per litre[3]. If the government decides to fix the pump price of petrol at N65 per litre, then it must pay a subsidy of N75 per litre (i.e. N140 – N65) to the suppliers of imported petrol (i.e. importers) so that they can deliver the imported petrol to distributors at N45 per litre instead of the true landing cost of N120 per litre. The distributors and retailers will then add a cost of N20 per litre for their services and sell the product at N65 per litre (pump price) to consumers at the filling stations. If the suppliers import 16 million litres of gasoline a day (i.e. approximately 100,000 barrels a day), then the government will have to pay 16 million x N75 = N1.2 billion a day or N438 billion a year to importers of petrol as price subsidy in order to keep the pump price at N65 per litre.

In addition to subsidizing imported petroleum products, the government may also subsidize petroleum products produced by the local refineries if the supply cost is also less than government-fixed pump price. For instance, if the cost of producing petrol by the local refineries is N80 per litre and the distribution/marketing cost is also N20 per litre, then the supply cost will be N100 per litre, and the subsidy will be N35 per litre (N100 - N65). Thus, if the refineries are delivering an average of 24 million litres of petrol (about 150,000 barrels) a day to distributors at N45 per litre, then the government must provide 24 m x N35 = N840 million a day or N307 billion a year to the refineries as subsidy or subvention. However, if the production cost of petrol by the local refineries is N45 per litre, then the government will not have to pay subsidy or subvention to the refineries. We do not have adequate data on the actual production cost of petroleum products by the local refineries to determine the amount of subsidy government is providing to the local refineries. However, the unit production cost depends largely on the price at which crude oil is delivered to the local refineries, i.e. the price local refineries pay for the crude oil they use. It can be argued that NNPC can afford to deliver crude oil to the refineries at less than N45 per litre given the low cost of producing crude oil in Nigeria vis-ŕ-vis the export (spot market) price of Nigerian crude oil. Assuming the unit production cost of crude oil is $10 per barrel (compared to spot market price of about $100 per barrel) which translates to about 6.2 cents or about N10 per litre, one can assume that the true cost of producing petrol after allowing for refining cost cannot be more than N20 per litre[4]. If NNPC is delivering crude oil to the refineries at  less than the international or export (spot market) price of crude oil of $100 per barrel ( = 62 cents or N100 per litre), then there is an implicit subsidy in terms of income forgone (i.e. the opportunity cost or shadow price of locally refined crude oil). If the local refineries are required to pay the spot market price (N100 per litre) for the crude oil they receive from NNPC, then their unit production cost of petrol will be anywhere from about N105 to N120 per litre depending on their refining cost, and this amount will be close to the unit cost of imported petrol. In this case, the FG will therefore have to pay the difference between their unit cost and the fixed pump price as subsidy to the refineries. Therefore, the existence and level of subsidy on locally produced petroleum products depends on the price at which crude oil is delivered to the local refineries[5]

The government’s claim that it is subsidizing imported fuel cannot be disputed given the fact that the spot market price of petroleum products is far higher than the pump price at Nigeria’s filling stations. For instance, the spot market price (North European/Rotterdam, f.o.b.) for regular petrol unleaded was $92.7 per barrel[6] or about N93 per litre in October 2011, which was much higher than the pump price of N65 per litre in Nigeria. According to the PPPRA’s pricing template in October 2011, the import price (c.i.f.) for petrol was N117.78 per litre and the total cost was N142.13 per litre, thus the subsidy was N77.13 per litre (N142.13 – N65). The main dispute is over the total amount of subsidy that the government says it has paid out to importers of petroleum products. The problem is complicated by the different figures provided by different agencies of government including the PPPRA, NNPC and the Federal Ministry of Finance. For instance, the PPPRA claims that the federal government has spend a whopping sum of N3.655 trillion on subsidy between 2006 and October 2011 including N1.54 trillion (i.e., 42%) during the 10 months of 2011 alone! In fact, while the budget for subsidy for 2011 is N245 billion, the Federal Ministry of Finance (FMOF) has stated that the government has paid N1.54trillion or about N1.3 trillion in excess of the budgeted amount as subsidy to importers between January and October 2011.  At the same time, NNPC claims that the excess amount paid as subsidy is N192.5 billion which is a very far cry from the N1.3 claimed by the FMOF.  In fact, the Executive Director of PPPRA, Reginald Stanley, told the Senate Committee that the gross amount spent on fuel subsidy from 2006 to September this year stood at N3.655trillion which contradicted the N1.426 trillion submitted by the NNPC as subsidy on the products as at August 2011. He also debunked the alleged N450 billion kerosene subsidies owed the NNPC by the FG (Umoru, H. Vanguard, and December 4, 2011).

Whatever the case, the excess amount paid as subsidy cannot be justified on the basis of the quantity of petroleum products imported, the import price of the imported products and prevailing exchange rate. There are strong indications that grand corruption accounted for the astronomical increase in subsidies paid out in 2011.    According to a recent fact sheet presented at a meeting between the President and leaders of some political parties, the Minister of Finance stated that: "The large increase observed in 2011 is as a result of (i) increased crude oil price from US $81.25 per barrel(pb) to $US 113.98pb; (b) exchange rate movements; (c) larger volumes consume(about 35m litres per day); and (iv) N150billion of kerosene carried over from 2009 and 2010” (Yusuf Alli, The Nation, December 5, 2011). She did not provide the calculations to justify this. However, the dubious list of importers who received the subsidies[7] clearly indicates that “corruption” accounts for a substantial part of the increase in the amount of fuel subsidy. Critics of government also point out that the pricing template which PPPRA uses in computing the amount of subsidy is biased in favor of importers and overstates the level of subsidy because: a) the import prices used in the template are generally higher than the international (spot) market prices (after adjusting for the difference between “fob” and “cif”); b) the template provides for excessive financing charges, port and storage charges and margins for importers, transporters, dealers, distributors and retailers; and c) the pricing is not competitive.[8] Thus, if the subsidy is removed, consumers will be unduly penalized and the prices of petroleum products determined through the PPPRA template will most likely be higher than “free market” prices.

2. Effects of Subsidy

What is the impact of subsidy on the demand for and supply of petroleum products?  To answer this question, we will use the demand and supply analysis is economics 101 (Fig. 1) Let the line Do represent the demand curve while the line So represents the supply curve for petrol.  Do is negatively sloped meaning that the higher the price of petrol, the more the quantity of petrol that will be demanded or consumed. On the other hand, the supply curve is positively sloped which means that the higher the price of petrol, the more quantity will be supplied, either by the local refineries or importers. Assuming there is no subsidy paid by government to suppliers, the market will be cleared (i.e. be at equilibrium) at point Eo where Po = N100 per litre, and Qo = 300k barrels a day. If government decides to fix the price of petrol at N65 per litre (P1), the quantity demanded will increase to Q1 = 400k barrels a day. To supply this quantity of petrol, suppliers will require a unit price of P1 = N140 per litre. Therefore the government must pay the difference between the fixed price (N65) and the price suppliers want (N140). This difference N140 – N65 = N75 per litre is the subsidy on each litre of petrol supplied to the market and purchased/consumed by motorists and other users of petrol. Thus, the effect of subsidy is to make the selling price of petrol (and any product that is subsidized) to consumers lower than the true supply cost (market equilibrium price). This means a shift of the supply curve (So) downward by the amount of the subsidy to S1 which means an effective increase in supply. A subsidy is therefore the equivalent of a negative tax, since consumption tax has the opposite effect.

Text Box: S₀
 
Text Box: S₁
 
Text Box: D₀
 
Text Box: E₁
 
Text Box: E₂
 
Text Box: E₀
 
Text Box: Quantity of Petrol
 
Text Box: Q₂=200
 
 
 
1
200
 
Text Box: Q₁=400
 
Text Box:   Q₀=300
 
Text Box: A
 
Text Box: B
 
Text Box: P₁ = 65
 
Text Box: P₀ =100
 
Text Box: P₂ = 140
 
Text Box: Price

 

 

 

 

 

 

 

 

 


 

                                    Fig. 1: Chart showing the effect of subsidy on petrol

In the above chart, P1 = 65 is the price paid by consumers after the subsidy is created. P2 = 140 is the price received by the suppliers which is the price paid by consumers (65) plus the subsidy (75). Note that before the introduction of subsidy, the equilibrium price was Po = 100. Thus, the effects of the subsidy are to lower the price consumers pay and increase the price received by suppliers. The benefit of the subsidy is shared by the consumers and suppliers in a proportion that depends upon the relative slopes (elasticity) of the demand and supply functions. The chart shows that both consumers and suppliers benefit as a result of the subsidy, but the government incurs the cost. How does the benefit received by consumers and suppliers compare with the cost incurred by government? In the chart, the cost of the subsidy to the government is represented by area of the rectangle P2E2E1P1 (= 75 x 400 = 30,000 units); the benefit received by consumers is represented by the area of the trapezoid PoEoE1P1 (=35 x300 + 0.5x35x100 = 12,250 units); and the benefits received by suppliers is represented by the area of the trapezoid P2E2EoPo (= 40x300 + 0.5x40x100 = 14,000 units). The chart shows that the area of the rectangle P2E2E1P1 (30,000 units) representing the cost of subsidy is greater than the sum of the areas of the two trapezoid (12,250 + 14,000 = 26,250 units) meaning that the net cost is positive which is the same as net benefit being negative or the benefit/cost ratio being less than one. Thus, theoretically, economists say that subsidies are Pareto inefficient because they cost more than they deliver in benefits. In this example, the suppliers benefit more than the consumers but this need not be the case always. What is clear is that the sum of the benefits is always lower than the cost incurred by government. The difference between the cost and benefits is called deadweight loss. In this example it is 30,000 – 26,250 = 3,750 units.[9]

The fact that subsidies are Pareto inefficient does not necessarily justify their removal or reduction. As long as a government imposes consumption tax (such as value added tax or sales tax on some commodities), it can be argued that the government should also subsidize certain commodities, especially those that are “critical” to the economy and those that benefit the poor more than the rich. Therefore, how do economists justify subsidies? As a practical matter, the economist must come out of his economic shell to embrace some political and social factors to justify subsidies on some products and services.

3. The Case for Subsidies

The following are some of the economic, social and political reasons why the governments provide subsidies or subventions to producers, suppliers or providers of certain products and services:

a)     To control price inflation and thereby prevent a decline in the real income and living standards of consumers, especially lower income households. This is one of the reasons for subsidizing petroleum products in Nigeria. Removal or reduction of subsidy will not only increase the prices of petroleum products but also the prices of most other products and services in the economy. This in turn may lead to galloping inflation and further pauperization of the poor in a country where over 60% of the people are already living below the poverty line. In fact, a look at the components Nigeria’s consumer price index easily shows that the price of energy is one of the key drivers of inflation in the country because the “accommodation, fuel and light” price index has generally been the higher than the composite price index and those of other components except “household goods and other purchases” (See tables in part 3 of this paper).    

b)     To reduce the cost of production and help to stimulate economic growth by increasing long-run aggregate supply. Since energy cost accounts for a significant part of the cost of production, especially in the industrial sector, a significant increase in the price of petroleum products arising from the removal or reduction in fuel subsidy, will lead to an escalation of the prices of commodities in the economy, which will lead to a reduction in local demand and make exports less competitive. This could lead to a reduction in production, reduction in the demand for labor, increase in unemployment, and, consequently, economic recession. Thus, in order to stimulate economic growth, governments are very cautious in eliminating or reducing existing subsidies. In fact, subsidies are sometimes retained because of the need to prevent massive lay-offs or to boost employment, especially during times of high unemployment.

c)      To smoothen the process of long term structural change or transformation in certain industries and prevent a decline in the production of some agricultural crops such as cotton. Elimination or significant reduction of subsidies can led to a rapid decline or collapse of some ailing industries or those going through structural changes and adaptation. Thus, in order to prevent such as rapid decline, subsidies may be retained or reduced gradually.

d)     To encourage the provision and consumption of “merit” goods and services which generate positive externalities (increased social benefits). Merit goods and services  are those that are provided free or at a subsidized rate by government for the benefit of the entire society because they would be under-provided if left to the market forces or private enterprise. Examples of merit goods are healthcare, education, security and museum. On the other hand, demerit goods and services are those that harm the consumer and have negative externalities. Examples include cigarettes, alcohol, drugs and prostitution. Under-consumption of merit goods can lead to market failure which can lead to a reduction in social welfare. Thus, it is necessary to subsidize some merit goods or services to prevent under-consumption or weak demand. Although petroleum products are not merit goods, they do have some of the qualities of merit goods. For instance, the removal of subsidy on kerosene may force the poor to resort to greater use of firewood for cooking which will in turn increase deforestation and greenhouse gases. Therefore, the elimination or reduction of fuel subsidy must be approached with caution to avoid negative externalities.

e)     To prevent industrial action, protests and riots that can lead to political instability. Labor unions, non-governmental organizations and the poor generally try to resist any attempt to reduce or eliminate subsidies. In some cases, it can lead to uncontrolled strikes, protests and unrests that can lead to political instability and changes in government. In some less developed countries, there have been several cases of “food riots” due to the removal of subsidies on some food items, especially imported food items, which has resulted in high prices of such food items. Thus, the government must weigh the risks of political instability that could arise from the removal or reduction of fuel subsidy.   

4. The Case against Subsidies

In spite of the arguments in favor of subsidies as outlined above, there are also several counter arguments against subsidies, especially on the grounds of economic efficiency and equity. It is necessary to evaluate who gains from a subsidy and who pays as well as the opportunity cost of retaining a subsidy. As shown previously, the fact that subsidies are Pareto inefficient[10] is the theoretical case against subsidies, but it does not necessarily mean that all subsidies must be eliminated. Other arguments against subsidies include the following:

a)      Market distortions: Free market economists argue that subsidies distort the free market mechanism and can worsen the distribution or allocation of resources. For instance, subsidy on some  agricultural commodities like cotton in industrialized countries distort free trade in those commodities and severely curtail exports from less developed countries (LDC). Similarly, import subsidy on petrol by in a LDC may discourage domestic production of petrol and lead to misallocation of an increasing amount of scarce foreign exchange for importation of petrol.

b)      Subjective decision: The decision to subsidize a commodity and which groups of suppliers to receive a subsidy can be arbitrary and subjective. It can also be prone to corruption. More often than not, there are no objective standards to determine which commodities should be subsidized, the level of subsidy and which suppliers should receive the subsidy. Why subsidize petrol instead of electricity, or fertilizers instead of rice, or education instead of health, etc? Why should subsidy be paid to suppliers of imported petrol and not to local refineries (local producers)? Are the suppliers selected through a competitive process or are they “friends” and “supporters” of the government and decision-makers? Is the amount of subsidy paid determined through a competitive process that ensures value-for-money, or do the suppliers influence the amount of subsidy they receive and pay “kick-backs” to decision makers? For instance, it has been alleged that that petroleum pricing template which the PPPRA uses in determining the subsidy on imported fuel is biased in favor of the suppliers because it allows for very “generous” charges and margins and that some of the cost elements can be reduced through competition[11]. For instance, the pricing template for petrol (PMS) for November 2011 includes a financing charge of N2.49 per litre and storage cost of N3 per litre in the landing cost, as well as a bridging fund charge N5.85 per litre, retailers margin of N4.60 per litre, transporters margin of N2.99 per litre, dealers margin N1.75 per litre, Marine Transport Average (MTA) cost of N0.15 per litre) and Administrative charge N0.15 per litre, all of which appear too generous.

c)      Risk of fraud and corruption: Subsidies are susceptible to corruption and the ever-present risk of fraud, especially when allocating subsidy payments. For instance, the delay in the reimbursement of subsidies to importers of fuel has created incentives for the importers to induce payment.[12] There are several reports of high-profit rackets and “round-tripping” of imported fuel and fuel produced by local refineries.[13]  

d)      Cost of subsidies: The cost of subsidy can grow rapidly and become unsustainable in the face of increasing demand for the subsidized product. If not brought under control, subsidies on a few products can crowd out expenditures or investments in other vital sectors such as roads, electricity, public water supply, electricity, education and health. The federal government is arguing that Nigeria is close to such a point in the sense that it paid a whopping sum of N1.3 trillion between January and October 2011 to suppliers of petroleum products[14]. This is the equivalent of giving every Nigerian about N8,000 a year or N40,000 to a family of five to buy whatever they want in place of the subsidy! However, the government cannot pay out N8,000 to each Nigerian as we do not yet have a system to ensure that such payments get to all citizens.

e)      Promotes inefficiency: Subsidies on locally-produced goods can artificially protect inefficient firms who need to restructure. Thus, subsidies tend delay much needed economic reforms. For example, the payment of subsidies to inefficient fertilizer companies or steel companies or local refineries may protect them and thereby prevent them from making necessary changes to become more efficient. While this does not apply to the subsidy paid to importers of fuel, it could apply to subsidies paid to local refineries.

f)       Increase in demand: Subsidies increase demand for (and consumption) of subsidized products which could discourage the demand for (and consumption) of alternatives or substitutes. For example, the existence of subsidies on petroleum products has led to an exponential increase in the demand for (and consumption of) petroleum products. This has discouraged or reduced the demand for, and investment in, alternative energy (or substitutes) such as coal, solar, wind, biomass, etc. If subsidy is reduced or removed from petroleum products, it could spur investment in alternative energy resources, especially renewable or green energy, which will in turn increase the consumption of renewable energy and conserve crude oil which is non-renewable. This is why some advanced countries impose heavy taxes on petroleum products in order to encourage invest in, and consumption of, renewable energy such as solar, wind, geothermal and hydro.[15]

g)      Uneven playing field: Paying subsidy to importers of petroleum products while local refineries do not receive an equal amount of subsidy creates distortions in the petroleum products market and uneven playing field between the local refineries and foreign refineries represented by the importers. This makes local refineries to sell their products at artificially low prices, and the refineries are therefore unable to generate adequate revenues to maintain their plants and expand their production capacities. Thus, the local refineries are not able carry out required turn-around maintenance (TAM) of their plants as at when due, and this has resulted in frequent breakdowns and persistent underutilization of their installed capacities. In fact, over the past 30 years, the local refineries have operated at less than 40% of their combined installed capacity most of the time. If all the refineries are able to operate at 90% of their capacities, they would probably produce enough petroleum products for domestic consumption, thereby eliminating or reducing the importation of petroleum products. It is argued that if fuel subsidy is reduced and the prices of petroleum products are allowed to increase to reflect international market prices, the local refineries will be able to generate enough revenues not only to maintain their plants to ensure over 90% capacity utilization but also to invest in the expansion of their production capacity and produce for exports. Thus, it can be argued that government should pay commensurate subsidy to the local refineries similar to what it pays to suppliers of imported petroleum products.

h)      Private investment: Paying subsidy to importers of petroleum products while local refineries do not receive commensurate subsidy discourages private investors in the downstream sector because the low price of petroleum products makes it unprofitable for private investors to establish new refineries at huge cost only to sell their refined at low prices that cannot guarantee adequate returns on investment. If the private refineries are to buy crude oil from NNPC or other upstream oil companies at international (spot) prices and refine the crude locally into petroleum products they cannot afford to sell the products at the “controlled” price because they will not break even or generate adequate income for maintenance and dividends. It is not surprising therefore that of the 26 companies that have been granted licenses to establish and operate local refineries in Nigeria since 2002, only one has recently managed to establish a small (mini-diesel) refinery (referred to as a topping plant) in Rivers State.[16] All the other companies are still “waiting and watching” and some of them have become importers of fuel in order to benefit from the more lucrative subsidy windfall.

i)        Illegal activities: Fuel subsidy in Nigeria has also encouraged illegal activities such as smuggling of petroleum products out of the country to neighboring countries, adulteration of petroleum products, round-tripping of petroleum products, emergence of illegal small/cottage refineries in the creeks in the Niger Delta region and poor quality of petroleum products which damage of engines/machines and increase environmental pollution.

j)        Shortages: Fuel subsidy has led to sporadic shortages of petroleum products as evidenced by frequent long queues at filling stations, signs of “no fuel” at filling stations, selling of petroleum products at inflated prices along the highways and street corners. This happens when government is unable to provide subsidy to cover the importation of adequate volume of petroleum products to supplement the quantity produced by local refineries. Frequent shortages of petroleum products lead to increases in the cost of transportation and cost of production as well as interruptions in production and frustration of motorists and other users of petroleum products. For instance, there is currently an acute shortage of kerosene in the Lagos area, and a litre of kerosene is selling for N150 per litre outside the filling stations which have none to sell!

 

5. Preliminary Conclusions and Recommendations:

From the above analysis, it is clear that the decision to remove or reduce or retain the current level of subsidy on petroleum products is not an easy one, and it is one that needs to be approached with caution after all the factors stated above have been taken into consideration. In part 3 of this paper, I will take a more rigorous look at the issue from a global perspective, and using published data in Nigeria as well as  some tools of welfare economics. Meanwhile, based on the analysis so far, we can make the following preliminary conclusions and recommendations:

a)      The debate on the removal of fuel subsidy in Nigeria has tended to be more political than economic. The proponents and opponents of fuel subsidy have tended to adopt a “war” approach in their arguments and have used very little theory or established knowledge, data and evidence   to justify their positions.

b)      The testimonies and presentations of government departments (NNPC, PPPRA, FMOF, FMPR) at the hearings in the National Assembly Committees looking into the issue as well as some of the utterances and claims by the President have not only left much to be desired but have also painted a picture of either insincerity or poor grasp of the issue.

c)      The hearings at the National Assembly clearly show that the management of fuel subsidy in Nigeria has been very poor, ineffective and inefficient. There are strong indications of corrupt practices and poor data management. Therefore, an independent audit of the fuel subsidy system should be undertaken immediately. This audit should be conducted by a reliable and reputable audit company, preferably a foreign one, and should include verification of the amounts paid to importers and local refineries, evidence of quantity of petroleum products imported and supplied, cost of producing petroleum products by local refineries, the crude for product swaps, etc.  There is also an urgent need to conduct an independent audit of NNPC and all its subsidiaries with focus on its revenues and expenditures as there are strong indications inefficiency and profligacy within the organization.

d)      Removing the existing fuel subsidy (= increasing the pump price of petroleum product) under the current situation will amount to a transfer of the cost of government inefficiency and the burden official corruption to consumers of petroleum products  and the poor will likely be the hardest hit because they have limited real income loss compensation mechanisms.

e)      The Senate and House of Representatives should go on record by rejecting the proposed removal of subsidy until the Presidency comes up with a credible plan to reduce corruption associated with fuel subsidy and improve the current system. The National Assembly should also demand the resignation of some government officials who have demonstrated gross incompetence in their testimonies during the fuel subsidy hearings. This will serve as a wake-up call for officials to be on top of their jobs and work for the interest of the people rather than special interests.

f)       The federal government must resist any temptation to go ahead to remove the subsidy until it has secured approval of the National Assembly and other key stakeholders and organizations, including the labor unions.  To this end, the federal government must first demonstrate sincerity on the issue and win the confidence of the people by putting in place a plan to improve the fuel subsidy system. The plan should include revitalizing the local refineries to operate at a minimum of 80% of their installed capacity within a period of one year, ensuring that at least three private refineries with at least a combined capacity of 150,000 barrels a day are established and operational within one year, gradual reduction in the volume of imported petroleum products, abolishing the current PPPRA pricing template and establishing a more competitive way of determining the level of subsidy. Once this is done, the federal government can come up with a plan to gradually phase out (reduce) the subsidy in a stepwise fashion over a period of two years( see item m below).

g)      The federal government should revoke all the import licenses granted to private importers of petroleum products with immediate effect and appoint the Products and Pipelines Marketing Company (PPMC), an NNPC’s subsidiary, as the sole importer of petroleum products into the country. The activities of PPMC should be closely monitored by the National Assembly and other watch-dog groups. The PPMC should adopt proven techniques to determine the monthly demands for the various types of petroleum products, domestic production, and the required level of imports to bridge the gap between demand and domestic production. For instance, if the projected demand for petrol in March 2012 is 200,000 barrels a day (= 32 million litres a day) or 6.2 million barrels for that month (= 992 million litres), and if local refineries will produce 80,000 barrels a day or 2.48 million barrels for that month, then PPMC can place order for 120,000 barrels a day or 3.72 million barrels (or 591 million litres) for that month. If the projected landing cost is $100 per barrel (about N100 per litre), then PPMC will need about $380 million to import petrol for that month.

h)      The federal government should direct NNPC to stop the “crude for products swap arrangements” - the practice of swapping crude oil for refined petroleum products from foreign refineries- with immediate effect. Under these “cashless” deals, NNPC provides crude oil to refineries located outside the country to refine and the refineries then ship the refined products to Nigeria. It is like modern-day trade by barter. It is inefficient and prone to corruption and cheating. It is one of the sources of “round tripping” of crude and petroleum products. In fact, during the hearing at the Senate Committee, the NNPC Group Managing Director (GMD) could not account for 65,000 barrels a day that was allegedly swapped.[17] However, a day after that event, the NNPC’s spokesman, Dr. Levi Ajuonuma, denied that the corporation could not account 65,000 barrels a day. He stated that: "NNPC buys 445,000 barrels per day from government at prevailing international market price. Out of this figure, Port Harcourt Refinery gets 90,000 barrels per day, Warri Refinery receives 80,000 barrels.  Also under the Crude for Product Swap arrangements, Societe Ivoirienne De Refinnage (SIR), receives 60,000 barrels, Duke Oil, a wholly owned subsidiary of the NNPC receives 90,000 barrels and Trafigura gets 60,000 barrels per day. The balance of 65,000 barrels meant for Kaduna Refinery is sold to meet up with commitments since Kaduna Refinery has since been shut down due to vandalization of crude supply pipeline at Egwa village in Warri South-West Local Government Area of Delta State…"If you take time to do the simple arithmetic, you will discover that nothing is actually missing or unaccounted for." Notwithstanding, this denial which also raises some issues, the swap arrangement is clearly not an efficient one.  Of the 445,000 barrel a day of crude oil allocated to NNPC, any quantity that cannot be refined locally should be exported, that is, it should be sold at the international market rate, and the proceeds (cash) should be used to fund the subsidy on petroleum products imported by PPMC. For instance, of the 445,000 barrels a day allocated to NNPC, if the local refineries can only refine 170,000 barrels a day, NNPC can sell the balance 275,000 barrels a day at the spot market rate, say $95 per barrel, to make about $26 million a day or about $800 million a month which is more than enough to pay for over 250,000 barrels a day of imported products by PPMC, and which may be adequate to bridge the gap between demand and domestic production. In fact, when this is done, the federal government may not have to pay subsidy to PPMC directly to import petroleum products or it may pay a minimal amount if demand exceeds the quantity of petroleum products that can be produced from 445,000 barrels per day of crude oil allocated to NNPC.

i)        Given that Nigeria produces about 2,400,000 barrels of crude oil a day, of which at least 1,200,000 barrels a day is allocated directly to the federal government (NNPC) as its share in the Joint Venture (JV) upstream oil companies (Shell, Mobil, Chevron, Agip, Elf, etc) that produce the crude oil, I think the federal government can afford to allocate 500,000 barrels a day to NNPC to deliver to local refineries to refine locally, and then give the quantity that cannot be refined locally to PPMC to sell in the spot market and use the proceeds to import petroleum products to bridge the gap between demand and domestic production. If consumers pay 50% of the supply cost of the 500,000 barrels a day[18], the federal government still has over 700,000 million barrels a day to sell (and make at least $66.5 million a day or $2 billion a month or about $25 billion a year) in addition to petroleum profit tax (85%) it will collect from the 1.2 million barrels a day of crude oil that the JV partners and other oil companies operating under production sharing contracts (PSC) will sell and which can bring in at least another $15 billion in oil revenue net of JV cash calls.

j)        The federal government should revoke the licenses to operate local refineries granted to companies that are yet to start construction activities. We do not need additional 26 local refineries in the country. The economies of scale dictate that we certainly do not need “mini-refineries” that can refine less than 20,000 barrels of crude a day. Given the fact that the current four NNPC-owned refineries have a combined installed capacity of 445,000 barrels of crude a day, and Nigeria’s requirements (demand) for petroleum products can be meet by refining about 500,000 barrels of crude a day, we do not need more than five new medium to large scale private refineries with a combined capacity of 200,000 day (average of 40,000 barrels a day). Therefore, the federal government should grant new licenses to at most five companies that will be required to start construction activities within 12 months and start production with 24 months. If they fail to meet this condition, their licenses will expire without a renewal option.

k)      Crude oil should be delivered to all local refineries (NNPC-owned and private) at international market (spot) prices and an agreed amount of subsidy or subvention that is evidence-based should be paid to the refineries by the federal government provided they are able to meet certain performance and cost benchmarks. Ultimately, the subsidy will be reduced gradually as the market becomes fully deregulated.         

l)        The variation in the prices of petroleum products in Nigeria should be minimal, and similar to the variation in the spot market prices, in order to avoid sharp practices such as products adulteration and eliminate or minimize cross-subsidization. 

m)    The subsidy on petroleum products should be reduced gradually in a stepwise fashion to zero over a period of two years. At the end of the two year period, the prices of petroleum products will be completely deregulated and the refineries will supply petroleum products to distributors at their different supply costs plus their margins. Distributors will also supply products to retailers at different prices depending on their cost, location of retailers and their margins. Similarly, retailers will sell products at different prices in different cities or locations and within the same location. However, because of competition, the price variations will be small and inefficient refineries, distributors and retailers will be forced to close or become more efficient.

n)      Finally, the federal government must live up to its responsibility of securing the country’s borders and prevent the smuggling of petroleum products out of the country or into the country. To this end, special border (and maritime) guards or patrol units should be established to patrol our borders and the coasts to prevent smuggling of petroleum products. These units should be well armed and equipped with modern telecommunication equipment, fast vehicles, boats, helicopters, and drones to intercept smugglers and illegal bunkerers. They should also be closely monitored to prevent their officers from being involved in corrupt practices and from aiding and abetting  smuggling.  

 

In the final part of this paper, I will take a more sophisticated analysis of the fuel subsidy debate and propose additional solutions to the issue based on welfare economists. Stay tuned.

 

Dr. Emmanuel Ojameruaye

Phoenix, AZ, USA.

December 14, 2011

 

 

 

Endnotes


 

[1] In the third part of the paper, I will present and discuss a more sophisticated definition of subsidy which the IMF uses in cross-country studies of fuel subsidies. See, Coady, D. et al (2010). Petroleum product subsidies: Costly, inequitable and rising.   IMF. Fiscal Affairs Department. February 25, 2010.

[2]  As per the PPPRA pricing template, importation or landing cost includes import price plus freight and port charges while distribution/marketing cost (the cost of delivery from the port to the filling station) includes local transportation cost and margin, dealers’ margin, retailer’s margin and administrative charges.

[3] The numbers used here are not the actual published numbers. They are illustrative but they have been carefully chosen to be close to actual published numbers.

[4] In fact, the Group Managing Director of NNPC has revealed to the Senate Committee investigating the fuel subsidy issue that it cost “between $4 and $5, depending on the exchange rate to refine a barrel of crude oil which is about 159 litres”. This translates to about N5 per litre to refine a litre of crude oil into petrol and other products. At the Senate hearing, the GMD also indicated that there is subsidy on locally produced petroleum products. According the reports, he said:  "We collect subsidy on locally refined products but it is less than what we collect on imported product. But since we do not include trade marking and other charges on imported products, it costs N11.87 less on locally refined products and N11.87 more on imported ones. An indication that NNPC makes more money on imported products than from the locally produced ones." (Umoru, H. Vanguard, December 4, 2011)

[5] In 2002, the selling price of crude oil to the local refineries by NNPC was increased from $9.50 per barrel to $18.00 per barrel. If the price has not been increased since then, it means that crude oil is still being delivered to local refineries at $18 per barrel which is almost N18 per litre ($18 XN160/159 litre).

[6] See OPEC Bulletin, 11/2011, p. 80.

[7] At a recent session of the Joint Senate Committee on Petroleum Downstream, Finance and Appropriation, a list about 100 companies that shared about N3.655 trillion meant for petroleum subsidy in the country since 2006 was revealed. The list include Oando Nigeria Plc  that received N228.506billion, Integrated Oil and Gas Plc - N30billion,  MRS-N224.818 billion, ConOil- N37.96billion, Enak Oil & Gas- N19.684billion, Bovas & Co. Nig Ltd, N5.685billion, Obat- N85billion and AP- N104.5billion, Folawiyo Oil- N113.3b, IPMAN Investment Limited- N10.9billion, ACON- N24.1billion, Atio Oil- N64.4billion, AMP- N11.4billion, HoneyWell- N12.2billion, Emac Oil- N19.2billion, D.Jones Oil- N14.8billion, Capital Oil - N22.4billion,  A-Z Oil - N18.613billion, Eternal Oil- N5.57billion; Dozil Oil- N3.375 billion; Fort Oil- N8.582 billion. The list included some construction companies   that "have no business importing petroleum products" and which “shut down their web sites since the commencement of the probe” (Umoru, H. Vanguard, December 4, 2011).

[8] For instance, the November 2011 PPPRA’s template for petrol provides N0.64 per litre for NPA charges, N3.0 per litre for storage charge, N0.8 per litre for Jetty Depot through-put charge, N2.5 per litre for financing charge, N4.6 per litre for retailers’ margin, N2.99 litre for transporters, N1.75 per litre for dealers’ margin, N5.85 per litre for bridging fund, N0.15 per litre for marine transport average and N0.15 for administrative charges.  In fact, the business of importing petroleum products is almost risk-free and seems to have a guaranteed excessive rate of return, and the importers have been milking the government dry.

[9] In this analysis, we have lumped all consumers (industrial, rich people, middle income people and poor people together). For practical and policy purposes, it is necessary to disaggregate the benefits enjoyed by each group of consumers in order to study the effect of removal of subsidy on each group. For instance, the Minister of Finance has recently argued that the current fuel subsidy benefit rich people who own many cars more than the poor. However, while this may be true in absolute terms, it may not be true in relative terms if the share of share of cost of petroleum products in the budget of poor families is higher than those of the rich, which may well be the case, and if the rich can easily compensate for the loss of income due to inflation arising from the removal of subsidy while the poor can hardly do so. 

[10] Put simply, a situation or an allocation is said to be Pareto inefficient if at least one person can be made better off without making anyone else worse off or if someone can be made better off even after compensating those made worse off. It is like situation where "we could be doing a better job," as opposed to where there is no way to do a better job, all other things being equal or held constant. As it applies to subsidies, it means, theoretically, that eliminating subsidies can make government better off after compensating for the losses of consumers and suppliers, i.e. allowing for demand and supply to determine the price is better than government imposing a price and paying subsidy to suppliers.

[11] For a detailed critic of the PPPRA pricing template see Makwe, I.A. (2006) A Critique of the Nigerian Petroleum Products Pricing Regulatory Agency (PPPRA) Pricing Template and Cost Recovery Analysis. Oil, Gas and Energy Law (OGEL), Vol. 3, September 2006.

[12] Reforming corruption out of Nigerian oil. U4Brief No. 2, February, 2009. U4 AntiCorruption Resource Centre. www.u4.no/themes/nrm 

[13] Ibid. See also, Nuhu-Koko, A. Fuel subsidy scandal and the impending subsidy removal. In Nigeria Energy Intelligence. 10 November 2008.

[14]  Fuel subsidy in Nigeria increased from $261.1 billion ($2.3b) in 2006 to N633.2 billion ($5.37b) in 2008 (See Adenikinju, A (2009),. Energy pricing and subsidy reform in Nigeria. A presentation at the Global Forum on Trade and Climate Change. OECD Centre, 9-10 June 2009. http://www.oecd.org/dataoecd/58/61/42987402.pdf     

[15] Renewable energy is energy which comes from natural resources such as sunlight (solar), wind, rain, tides, water (hydro) and geothermal heat which are renewable (naturally replenished). About 16% of global final energy consumption currently comes from renewables.

[16] Eighteen licenses were granted to private investors in 2002 to establish private refineries in the country. In 2004, another eight licenses were granted, bringing the total to 26.   The construction of the mini-diesel refinery, owned by the Niger Delta Petroleum Resources (NDPR), started in January 2010 and was completed in December 2010. It is currently undergoing test-run. It can only refine 1,000 barrels a day of crude oil and produce 120,000 litres of diesel a day using crude oil from the nearby Ogbelle Flowstation (Alike, E. ThisDay, November 18, 2011)

[17] At the Senate hearing the CMD revealed that under the Crude for Products Swap arrangement, out of the 445,000 barrels a day of crude oil allocated to NNPC to refine for domestic consumption, it allocates 170 barrels a day to local refineries (Warri -80,000, Port Harcourt – 90,000) and 210,000  barrels to refineries located outside the country (Duke Oil -90,000 barrels per day, Transfigura UK – 60,000 barrels a day; and Societe Ivorien Refineries (SIR). an Ivorian refinery - 60,000 barrels per day ) which left a a balance of 65, 000 barrels  a day unaccounted for.  According to the GMD “When you take the crude, you sell on the market at official price and use the money to import products but in a swap arrangement, there’s flexibility in the products that you get. In a swap arrangement, the transaction is cashless.” (Adetula, F. Daily Sun, December 13, 2011)

[18] The other 50% is more than enough to cover NNPC’s operations.