Containing Domestic Fuel Scarcity via Higher Profit Margins

Oil & Gas
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Friday, March 16, 2018 /8:35 AM /FDC 

Global oil prices have surged in the current year to $70 per barrel (pb), largely due to the combination of rising demand and the output-cut led by the Organization of the Petroleum Exporting Countries (OPEC) and its allies. Given Nigeria’s endowment in oil, this bullish trend in oil prices should translate to a stronger macroeconomic performance.

However, it presents a conundrum to policy makers in Nigeria, largely due to the fact that the country imports a majority of its refined petroleum products. This has placed the nation’s economy in a precarious position whereby it oscillates between periods of acute fuel shortage and steady supply.

Changes in Prevailing Macroeconomic Fundamentals
In December 2017, the Nigerian economy saw a reemergence of fuel queues after 18 months of steady supply. Petroleum authorities have accused petroleum marketers of hoarding to create artificial scarcity and incentives to divert products to the black market. Fuel marketers say that scarcity is a result of a reduction in the importation of refined petroleum products due to declining profit margins. 

Clearly, macroeconomic variables have changed, since the pump price cap was set at N145 per liter in April 2016. For example, the average price of oil (Brent) has risen by 59.77% to an average of $68.99pb in January 2018, from an average of $43.18pb in April 2016. Similarly, the aver-age official exchange rate has depreciated by 53.9% to N305.78/$ from an average of N198.69/$ in April 2016.

These changes in macroeconomic fundamentals have ultimately led to higher costs of importation (landing costs). Given the existing cap in pump price, this has greatly reduced profitability. Hence, independent oil marketers are reluctant to import. In an effort to ease the lingering fuel scarcity, the federal government has directed the Nigeria National Petroleum Corporation (NNPC) to increase its fuel import. The NNPC claims to have spent $5.8bn on fuel importation in Q4’17.

However, fuel scarcity persisted partly due to the existence of arbitrage opportunities. For example, the naira equivalent of petrol pump price in the neighboring Benin Republic and Ghana is N225 per litre and N350 per litre respectively. The disparity in price has encouraged cross border smuggling of petroleum products and highlights the fundamental problem in the existing pricing mechanism in Nigeria.

Means to an end
To address this recurring problem, the federal government could either employ a short term or a long term approach. For example, the federal government could grant a temporary tax holiday as an incentive for independent fuel marketers. This could potentially lower the weighted average cost (landing cost) of petroleum imports and thus raise profit margins in the near term. 

Similarly, the subsidy system could also be employed in light of the political risk associated with increasing pump price at this period. The proposed subsidy could be in terms of lower exchange rates for fuel marketers or a direct subsidy payment system. The downside of a direct payment is the effect on government revenue, ultimately widening the fiscal deficit.

A long-term approach is to construct new refineries, pass the petroleum industry bill and effectively deregulate the downstream oil and gas sector by removing the price cap. The sole responsibility of the government is to create an enabling environment for market forces to thrive. The government can attain this by establishing a pricing framework that factor in the effects of changes in the exchange rate and global price of oil and increasing domestic refining capacity by constructing new refineries.

A typical example of such a pricing mechanism is the one used in the United Kingdom. In the UK, four major variables determine the pump price of fuel: government duty and tax; cost of product (crude) in the international market; retail spread; and, to a lesser extent, the ex-change rate. The exchange rate has a subtle weighting due to the adequacy of the UK’s domestic refining capacity; the country does not have to import refined petroleum products. Nigeria can draw inference from this, in order to establish a dynamic pump pricing sys-tem. Given Nigerian’s current dependence on the importation of re-fined product, the Nigerian mechanism needs to put a higher weighting on exchange rate and crude cost. With this system in place, market factors will come into play in pump price. For example, a depreciating exchange rate will result in a relatively higher pump price, to help mitigate the foreign exchange loss, while a stronger currency will translate to lower pump prices.

However, it is unlikely that the current government will institute such a major reform in the build up to the 2019 general election as it will be considered politically risky. Similarly, reverting to the subsidy system could mean a return to the abuses that marred the system before its abolition -another risky proposition.

In the meantime, the NNPC will continue to bear the burden of higher landing costs which will weigh on its finances. This remains a questionable use of scarce resources for the cash-strapped government and is likely to continue to lead to disruptions in fuel supplies in the country

Proshare Nigeria Pvt. Ltd.

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