Friday, 16 December 2011 06:53

The Political Economy of the Removal of Petroleum Products Subsidy in Nigeria: Part 2 - The Economics 101

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The Political Economy of the Petroleum Products Subsidy Debate in Nigeria:

Part II – The Economics 101

By Dr. Emmanuel Ojameruaye

2. Economics 101 of Fuel Subsidy in Nigeria 

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. 

2.1 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[i]. 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[ii] is N20 per litre, then the supply cost  will be N140 per litre[iii]. 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-à-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[iv]. 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[v]. 

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[vi] 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[vii] 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.[viii] 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.

oil
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.[i]

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.


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Emmanuel Ojameruaye Ph.D

Dr. Emmanuel O. Ojameruaye is President/CEO of Capacity Development International, LLC based in Phoenix, Arizona State, USA. He was Vice-Resident for Research & Program Development with the International Foundation for Education and Self-Help (IFESH), an NGO based in Scottsdale, Arizona State until 2013 when that organization closed its operations. He joined IFESH in 2002, first on loan from Shell International Oil Company until 2008 when he retired from Shell. He worked for the with Shell Petroleum Development Company of Nigeria (SPDC) from 1992 to 2002, as Head Community Development (Western Division) from 1997 to 2002, Head Community and Environmental Issues Management (1995-96) and Head Government and Community Affairs in the Lagos Office. Before joining Shell, he was a National Consultant (appointed by the UNDP) for Nigeria’s National Data Bank Project in the Federal Ministry of Budget and Planning in Lagos (1989-1992) and a Lecturer in Economics and Statistics at the University of Benin in Nigeria (1982-1989). He was also the National Secretary of the Nigerian Economic Society (1986-1990). He holds a PhD degree in economics and has several publications to his credit including three books, Political Economy of Oil and other Topical Issues in Nigeria, A First Course in Econometrics and A Second Course in Econometrics (both coauthored), and several articles on energy economics and community development in the Niger Delta region of Nigeria. He is married with five children.