Removal of subsidies: A good step with promise

Oil & Gas
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Friday, May 13, 2016 9:05AM/United Capital

Implications for the markets

The Nigerian government yesterday announced the stoppage of petroleum subsidy payments to marketers, effectively ending years of fiscal drain, a move we view as a step closer to a deregulated market environment. The price adjustment was motivated by the need to improve availability and allow for a more cost-reflective price for marketers.

In this note, we summarise our views on the likely impacts of this latest move on the markets and naira assets in the short-to medium term.

FX supply constraints drive policy change…
According to the new PPPRA product pricing template, a new retail price band of 135-145 has been set, the midpoint of which is 62.8% higher than the old pump price. Interestingly, this is approximately the cost differential between exchange rate at the official market and the parallel markets, suggesting that the product's supply constraints has been hitherto driven mainly by FX shortages. The new regime allows marketers to source foreign exchange outside the CBN window. Notably, the revised pricing template now reflects a higher FX impact on the landing cost of PMS, as well as wider margin for downstream players.

 …with FX reserves likely to benefit
According to data from the CBN, average monthly FX supply over Q1-16 for the oil and gas sector stands at c.$500.0bn monthly. With oil marketers now free to source FX from alternative sources, we believe a bulk of this figure has effectively been shifted to the parallel market. This should lessen the pressure on the FX reserves especially if crude prices continue to display the same level of resilience seen in recent times. We note that despite recent ascent in crude oil prices, the FX reserve has been on a consistent decline from March 29th to date, creating a dour picture.

Will the parallel market see more pressure?
With demand for the greenback in the parallel market set to rise, the major question that comes to mind is whether higher demand at this segment of the FX market will further widen the official/parallel market gap, especially if the official FX rate is assumed constant. Available data from CBN's website puts average monthly autonomous dollar at c.$4.0bn. Hence we think while there could be some volatility in the interim, impact will likely be short-lived.

Clearly, autonomous dollar supply has always been available but the major bottle neck prior to now appears to be more around pricing in our view, with most holders preferring to sell at the parallel market rate, while seekers understandably favor the official window. With marketers now forced to look at the parallel market, we believe potential supply at that market is robust enough to take-in increased demand, at current price.

Policy move to further stoke inflationary flames… to what extent?
Ordinarily, It would be expected that higher PMS cost will lead to a rise in transportation costs, with attendant impact on Inflation. This plausible scenario is without a doubt daunting, given that inflation already hit a 46-month high of 12.8% in the month of March.

That said, we note that key drivers of sharp jump in inflationary reading over the past two months already factors-in a large chunk of the impact of recent hike in electricity tariff (effected in February) as well as transportation costs as average PMS price across the country over the period rose to N136.0/litre which is only 6.6% below the higher end of the new PPPRA retail price band. 

This suggests headline inflation will need a much stronger push from where it is currently, to sustain current pace of m/m increase.  To add, we take further evidence from a similar occurrence in 2012 where a partial removal of fuel subsidies only had a transient impact on inflation, after the initial shock. Thus, we only expect to see a moderate uptick in inflation from current levels on a m/m basis, and maintain our 2016 average forecast at around 12.5%.

MPC: All pointing toward further policy tightening, likely to be accompanied by some move on the FX front
On the FX side, recent comment by the VP on the need for "substantial review"  of current FX policy which may feature possible devaluation" appears to hint at a shift in the body language of the Buhari-led administration. Also, we believe the rate of depletion of the FX reserve will be concerning for the MPC. This, coupled with the need to attract foreign capital and higher near term inflation expectation from this freer pricing of PMS creates a case for more policy tightening, likely to be accompanied by some further clarity around FX policy.
We believe this move is the beginning of a more competitive terrain for the downstream petroleum sector, and will tilt advantage more towards industry players with scale, robust distribution network and access to capital as well as FX at a competitive price, in our view. In this regard, we favor players with foreign parentage and affiliations, specifically Mobil and Total. The entrance of Dangote refinery in 2017 will also create an interesting dynamic, and will likely further accelerate the pace downward adjustment of pump prices as supply increases.

FI market: Yields likely to continue recent ascent in the near term
For the FI market, higher inflation expectations and the possibility for further policy tightening should push yields further higher in the near term, although should events around the FX policies play out like we anticipate, re-entrance of the foreign money managers will likely see a higher demand for sovereign notes which will ultimately moderate yields

Conclusion:  Not a complete deregulation, but a good step with promise
While recent move definitely creates a more liberalized market, it is clear that the market is not yet fully deregulated given that the new retail pump price per litre is still capped at N135-N145. That said, we do see a path of wisdom, as current price cap should help prevent the possibility of price connivance by industry players in the interim. We believe the market will be fully deregulated once overall supply increases and the domestic refineries commence consistent production at optimal levels. While we look on with interest, one has to say that despite current uncertainties on the fiscal side, this move has in it a lot of promise. 

Are we finally on our way? Only time we tell.


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