Oil Prices Recover, But May Not Be Sustainable – FDC

Oil & Gas
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Thursday, March 10, 2016 05:21 PM / FDC

The global oil prices are among the top five most talked about economic events in the world, and oil the most discussed commodity. Recently, the two largest oil producers globally (Saudi Arabia and Russia) agreed to an output freeze at their January levels. This is the first synchronized move to try to reduce the ongoing supply glut and stop the free fall in oil prices; a feat many analysts deemed nearly impossible to achieve.

However, Iran has refused to give up market share and may act as a snag to the success of this move. Saudi Arabia has also stated that there would be no oil production cuts. Since January levels were at record high for Saudi and Russia, the implication is that the freeze on output will have a limited effect.

In the last one month, oil prices have increased by 14% to $40pb on news of the meeting between the two key oil countries. This is the first time this year that oil prices would trade above the Nigerian budget benchmark. Whilst this is good news for oil producing countries, there is still cause for concern for Nigeria whose production is 13.63% below the budget benchmark of 2.2mbpd.

This implies that the revenue projections are still at risk of a shortfall. Nigeria, like many other oil poor countries, is experiencing a decline in investments required to sustain production. In the off chance of a sudden supply shortage in the oil markets, Saudi Arabia may be one of the few countries with auxiliary capacity to bring the market back into equilibrium.


Energy Analysts and Their Oil Forecasts

Several energy analysts and renowned firms have forecast differ-ent oil price levels in 2016, ranging from $42.9pb1 to $20pb2, to even as low as $10pb3 in a worst case scenario. The International Energy Agency (IEA) in its 2016 Medium Term Oil Market report stated that it is unlikely that oil prices would stabilize in the short term.

The truth is oil prices are unpredictable and it is difficult to determine if the current rally is sustainable or not. We are projecting oil prices to trade at an average of $40-45pb in 2016. At this price level, only a few countries would be able to wobble on one foot only, let alone stand.


Production Costs of Oil Producing Countries

There is so much focus on the benchmark oil price a country pegs its budget assumptions to, while little is said about the yield per barrel. This is a measure of how profitable a country is in terms of its oil production. It is the net of the current price of oil and a country’s cost of producing one barrel of oil.

Kuwait and Saudi Arabia have one of the lowest costs per barrel, which pretty much explains why they can leave the taps of their production on in a flooded market, and still remain profitable. Countries like Nigeria, Angola and Venezuela have their cost of production within the range of $23pb to $35pb, while shale producers like the US, are producing at a cost of $36pb4.

Impact of Lower Oil Prices On Economies

The impact of low oil prices on oil producing economies cannot be overstated. Venezuela recorded a triple digit inflation rate of 180.9% at the end of 2015, while its currency, the bolivar, has lost 98% of its value against the dollar; the country’s fiscal deficit is almost 25% of its GDP.

Saudi Arabia, the global leader had its credit rating downgraded by two notches to A- by Standard & Poor’s, due to weak investor sentiment. Its fiscal deficit is projected to increase to 12-15% of GDP from a fiscal surplus averaging 11% in the 10 years preceding the oil price decline.

According to the IMF, oil would need to be selling at $269pb for Libya to have a balanced budget. Russia slipped into its second recession in six years, while the ruble has lost 16% year-on-year against the dollar.

Aside from the impacts mentioned above, countries are also experiencing increasing inflation due to the depreciating value of their currencies and rising unemployment as companies lay off staff due to revenue shortfall.  



How Have These Countries Responded to the Oil Price Shock?

Governments have adopted different policy measures to reduce the severity of the impact of the oil price shock on their economies.

·         Fuel Subsidy Removal: Many have either removed or cut fuel subsidies, including Saudi Arabia, Ghana, Angola, and UAE. The Nigerian government’s budget for 2016 is silent on sub-sidy payments, which implies one can safely assume it has been eliminated.

·         Currency Adjustment: Angola devalued its currency twice (by 15% in December 2015 and 13% in January 2016), Venezuela devalued by 37%. The Central Bank of Nigeria introduced forex controls in 2015 following two devaluations (November 2014 and February 2015).

·         Spending Cuts: Saudi Arabia, Russia and Angola introduced spending cuts in their 2016 budgets. Nigeria’s budget is expansionary compared to the others; the rationale being to adopt a countercyclical approach to reflate the economy.

Every country is looking for any means of survival to stay afloat despite sinking oil prices.

Current State of the Nigerian Economy

In Nigeria, the growth average for 2015 was dismal at 2.79%, a significant decline from 2015’s full year growth of 6.22%. Government revenue is down by over 60% since the oil price fall started in June 2014.

The monthly statutory allocation shared amongst states is down 40.28% to N370.4bn6 from an average of N638bn in 2014. External reserves are down 25.61% ($9.6bn) to $27.88bn7 from $37.48bn at the end of June 2014 and Nigeria’s trade balance is estimated to be in a deficit position of ($3bn8) in 2015. Moody’s has also placed Nigeria’s Ba3 credit rating on re-view for a possible downgrade amongst about 10 other oil producing countries.

In the past the currency has been adjusted twice- in November 2014 (by 7.73%) and February 2015 (15.56%)- while the CBN imposed forex restrictions in 2015 to address the volatility in the forex market. Meanwhile at the parallel market, the naira tested an all-time low of N400/$ before strengthening to N320/$9.

Goods and services have either increased in price or are unavailable in shops due to the forex restrictions put in place by the CBN and shortage of forex supply. More worrying is the increase in the prices of consumer staples such as garri and sugar that have in-creased by 131% and 67% respectively within the first two months this year. In fact, we are estimating that inflation would cross 10% in February.  



National Income Picture with an Oil Price Scenario of $42.9pb

The national income identity shows how the gross domestic prod-uct of a country is computed. It is written as C+I+G+X-M= Y

Where C= Private consumption; I= Gross fixed investment; G-Government consumption; X= Exports; M= Imports; Y= Output

The table above shows the movement in these aggregates over a 3-year period. All the components declined between the time-frames compared. Economic growth is projected to ease further to 2.7% in 2016. Consumer disposable and discretionary income has dropped significantly.

Capital flows have also declined as investors remain wary of the Nigerian market. The strengthening of the dollar and anticipations for further interest rate increases by the U.S. Fed are also contributing to reverse capital flows out of Nigeria (and other emerging markets).

The external position of the economy has also deteriorated as seen in the table below.

If oil prices fall significantly lower to say $25pb, the economic picture will deteriorate further. Consumer disposable income will shrink some more, affecting the purchasing power of consumers. Corporate earnings and margins will thin out. Companies will lay off more staff which will increase the unemployment rate significantly.

Even the 2016 budget projections will alter: budgeted revenue is projected to decline to N3.58trn from N3.86trn; oil revenue of N820bn could fall to N539bn while the budget deficit could widen beyond the 3% of GDP benchmark.


What Should the Nigerian Government be Doing to Mitigate the Impact of the Oil Price Shock?

Whereas Nigeria cannot influence the direction of oil prices in any-way, the government can influence the severity of the impact of lower oil prices. There are two options available to the government: either do nothing and allow economic gangrene to set in, or adopt a deficit budget plan that must be implemented immediately.

The 2016 budget is based on the premise of a deficit fund-ing. While this is a smart move, timing is of essence. The fracas over the budget numbers has stalled the passage of the fiscal plan which will spill over to the implementation of key projects that are expected to stimulate economic recovery.

Monetary policy should also compliment fiscal policy measures. Several countries have had to adopt a flexible exchange rate system to dampen the im-pact of oil price shocks. Nigeria needs to adopt an exchange rate policy that is in consonance with current market dynamics.

In conclusion, while Nigeria is being affected by the current oil price level, and will likely experience some further economic challenges in the short term, the country now has the opportunity to create a stronger position against this oil price shock -and those to come in the future.

Oil and Petrol Prices: Why Don’t They match up?

Oil prices are on the increase, having reached $40.5pb. Yet, they remain 65.2% lower their $115pb peak in 2014. While economists bemoan the lower prices, consumers have grown increasingly excited with the expectation that this would translate into lower transportation costs, an expenditure that occupies a significant position on their disposable incomes. However, Nigerians are likely to be disappointed.

According to the EIA, oil accounts for just 20% of the cost of a liter of petrol while other costs include government regulations (taxation/subsidy), shipping fees, local competition and supply-demand. While the price of oil may be dropping, these other factors are experiencing stability, increases or removals.

As a result the direction and movement in pump prices may not move in tandem with gas prices at the international front. Rather, Nigerian pump prices are likely to remain the same, if not increase, due to the costs and risks associated with freight, subsidy removal, and the impacts of supply-demand dynamics, competition and forex volatility.

Cost Elements of a Litre of Petrol in Nigeria as at 17th February, 2016


Risky and Opaque Freight Leads to Sticky Pump Prices

In Nigeria, the pump price of petrol is regulated by the govern-ment and currently sells at N86.50 while selling at N86.00 in the subsidiaries of the national oil company. Based on EIA’s break down of the cost component of a litre of petrol, 20% of the N86.50 is N17.30K while freight cost occupies the majority in the cost component of litre of petrol at 41.5%.

Freight cost is a function of: the distance between the refinery and country of destination; (in) efficiencies associated with shipping and loading, and the risk of transport. For example, risk of pirate attack would in-crease cost and potentially impact the efficiency of shipping and loading.

Accordingly, these costs are highly volatile and are prone to geopolitical influences, peculiar to countries that are being threatened by insurgents. Moreover, shipping deals are usually opaque as they are driven by long term relationships as opposed to being seasonal or attached to movements in the commodities market.

The volatility of risk and stickiness of shipping deals means that 41.5% of the pump price that is made up by freight is unlikely to move in tandem with drops in oil prices.

Subsidy Removal Likely to Negatively Impact Pump Prices

In a country where petrol consumption is subsidized, a reduction in oil prices implies subsidy payments will be reduced or eradicated depending on the magnitude of the fall in oil prices relative to the amount initially paid on subsidy per liter of petrol consumed. In 2016 the government will phase out the subsidy regime and analysts expect the pump price of petrol to increase as a result to reflect the true value of the unsubsidized product.

Expectations of an increase are supported by the recent removals of subsidies in other oil producing countries. 14According to Qatar News Agency (QNA), petrol prices increased to QR1.30 ($0.357) per litre, from QR1.00 ($0.275) per liter with the subsidy removal. 15The move was followed by the 50% spike in petrol pump prices in Saudi Arabia in December 2015 when the Saudi government followed suit.

Although the case appears to be different in Nigeria where indication of a subsidy removal led to a marginal reduction of 50kobo in the pump price of petrol in January 2016, this makes a strong case for the possibility of a hike in petrol prices in the medium to long term. With a subsidy removal, pump prices will become exposed to volatility experienced both at the international and domestic markets.

While an unexpected jump in oil prices is highly unlikely at this moment, currency ex-change volatility remains a threat to the stability of pump prices. Given the fact that Premium Motor Spirit is an imported commodity, it is only a matter of time before foreign exchange scarcity currently being experienced reflects on the pump price of petrol.

Other Factors Keep Pump Prices Sticky

Other factors that impact the pump price include product supply-demand dynamics, local competition and exchange rate pressures. All these factors can also have a significant impact on petroleum prices.

In a typical market situation, supply and demand disequilibrium brings about short term fluctuations in market prices. A shortage in supply arising from pipeline disruptions and a shutdown in re-fineries will lead to an upward movement in pump prices.

Conversely, excess supply of petroleum of crude products will push down prices as currently being experienced in the United States. In the case of Nigeria, fuel scarcity arising from delay in subsidy payments and deliberate hoarding behavior has altered equilibrium and increased prices of petrol to a peak.

Competition, reflected by the number of choices in the market place, can also affect pricing. For instance, in Nigeria, the price of petrol varies across states and this is usually heightened during periods of fuel scarcity. This is because of competition and the relative distance between the port of delivery and point of sale.

For instance, while petrol is sold at N87 per liter in Lagos, while prices in the northern parts of the country could go as high as N120 (particularly during periods of fuel scarcity). Also, the difference in petroleum prices between a lone station on a lengthy road and a road where there are many intersections, which may have two or three service stations, is usually significant. As a result, pump price of petrol remains sticky at high or low levels depending on the level of competition with the area.

Furthermore, forex scarcity coupled with the depreciation of the naira is a cost element of imported commodities that cannot be avoided. Most of the refined crude consumed in Nigeria is imported, hence exposing the cost of petrol to exchange rate risk. As a result of the exposure to the exchange rate risk, pump prices are also subjected to imported inflation via exchange rate.

Conclusion and Outlook

It is difficult to predict petrol prices using oil prices as a proxy for the likely outcome in the domestic market. Petroleum prices are more dependent on internal factors such as subsidies, shipping costs and supply-demand dynamics. As a result, petrol prices are not likely to cave in at any point in time given the current economic situation in Nigeria. The removal of the subsidy is likely to increase the pump price and the government is also likely to impose taxes on the consumption of petrol to support its expansionary fiscal policies.

In addition, other factors such as forex scarcity, exchange rate adjustment, geographical location, and local com-petition will play a minor to significant role in the determination of the price of petrol. Based on this premise, it is advised that the public should hold off on any expectations of a reflective decline in petrol prices as internal factors play a significant role in the determination of the price of petrol. External factors, such as declining oil prices, also contribute to the price of petrol but the impact is less than significant which explains why petrol prices remain sticky in Nigeria


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