In addition, 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. The refineries’ cost of producing petroleum products depends largely on the price at which crude oil is delivered to them. 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-à-vis the export (spot market) price of Nigerian crude oil. If the unit production cost of crude oil is $10 per barrel (compared to spot market price of about $100 per barrel) which is equivalent to 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. Thus, if NNPC is delivering crude oil to the local refineries at less than the international or export (spot market) price of crude oil of $100 per barrel ( N100 per litre), then there is an implicit subsidy in terms of income forgone. However, 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 government will 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.
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 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 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) claims that the government has paid N1.54trillion 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. Also, the Executive Director of PPPRA has debunked the alleged N450 billion kerosene subsidies owed the NNPC by the FG (Umoru, H. Vanguard, and December 4, 2011).
The N1.3 trillion in excess amount paid as subsidy between January and October, 2011 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. The Minister of Finance justified the excess amount thus: "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, but it is not difficult to prove that these three factors cannot for the N1.3 trillion. The dubious list of importers who received the subsidies clearly indicates that “corruption” accounts for a substantial part of the increase in the amount of fuel subsidy. Furthermore, the pricing template which PPPRA uses in computing the amount of subsidy appears 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. 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.
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.
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.
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. Removal or reduction of subsidy will increase the prices of petroleum products and 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.
b) To reduce the cost of production and help to stimulate economic growth by increasing long-run aggregate supply. Energy cost accounts for a significant part of the cost of production. Therefore, a significant increase in the price of petroleum products 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, subsidies are sometimes retained to prevent massive lay-offs or to boost employment.
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. Removal of subsidies can led to a decline or collapse of some ailing industries or those going through structural changes and adaptation. Thus, subsidies may be retained or reduced gradually to protect such industries.
d) To encourage the provision and consumption of “merit” goods and services such as healthcare, education, security and museum. 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.
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 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. Therefore, governments weigh the risks of political instability that could arise from the removal or reduction of subsidies.
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. In addition to the fact that subsidies are Pareto inefficient , other arguments against subsidies include the following:
a) Market distortions: Subsidies distort the free market mechanism and can worsen the allocation of resources. Subsidy on imported petrol 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. 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, the PPPRA’s pricing template for petrol (PMS) for November 2011 includes a financing charge of N2.49 per litre and storage cost of N3 per litre, a bridging fund charge N5.85 per litre, retailers margin of N4.60 per litre, transporters margin of N2.99 per litre and a dealers margin N1.75 per litre, all of which appear too generous and biased in favour of importers and distributors/retailers.
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. There are several reports of high-profit rackets and “round-tripping” of imported fuel and fuel produced by local refineries.
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. 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 local refineries may protect them and thereby prevent them from making necessary changes to become more efficient.
f) Increase in demand: Subsidies increase the demand for subsidized products which could discourage the demand for alternatives or substitutes. For example, the subsidy on petroleum products has led to an exponential increase in the demand for petroleum products, and has discouraged or reduced the demand for, and investment in, alternative energy (or substitutes) such as coal, solar, wind, biomass, geothermal, and hydro. 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.
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. Thus, the local refineries are not able carry out required turn-around maintenance (TAM) of their plants as at when due resulting in frequent breakdowns and persistent underutilization of their installed capacities. If all the local 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. 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. 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. 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. It must be approached with caution after all the factors stated above have been taken into consideration. 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 not sufficiently relied on established knowledge, data and evidence.
b) The testimonies and presentations of government departments at the hearings of 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 insincerity and 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 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.
d) Removing the existing fuel subsidy 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. 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 reject 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 officials who have demonstrated gross incompetence in their testimonies during the fuel subsidy hearings should be fired to serve as a wake-up call for officials to be on top of their jobs and work for the interest of the people.
f) The federal government should 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. The federal government must first demonstrate sincerity 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 two years, 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.
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, 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 for that month. If the projected landing cost is $100 per barrel, 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” with immediate effect. Under these “cashless” arrangements, 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. 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 sold in the international market 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 subsidy paid to PPMC for imported fuel will be relatively small.
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. The quantity that cannot be refined locally can then be given 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, 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 $10 billion in additional oil revenue net of JV cash calls and other oil sector related expenses by the federal government and NNPC.
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 150,000 day (average of 30,000 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 my next paper, I will conducted a more sophisticated analysis of the fuel subsidy and then propose additional solutions to the issue based on welfare economists. Stay tuned.
Dr. Emmanuel Ojameruaye
Phoenix, AZ, USA.
December 14, 2011