Post-Subsidy Gasoline Pricing in Nigeria

Introduction

On the day the government in Nigeria changed hands in May 2023, the subsidy on gasoline was “removed” by the newly sworn in President. Indeed, Sec. 205(1) of the Petroleum Industry Act (PIA) passed in August 2021 states that “Subject to the provisions of this section, wholesale and retail prices of petroleum products shall be based on unrestricted free market pricing conditions.” While it was clear from the provisions of the act that the subsidy regime on gasoline had been invalidated, it was not until 2-years later that a new government “declared” or “implemented” its removal. Upon the announcement, the gasoline price jumped from an average of N238/Ltr in May 2023 to N545/Ltr in June 2023– a 130 % increase.

Oil subsidies are a subset of a broader range of energy-related subsidies which governments allow usually with the intention of delivering low energy prices in anticipation that lower factors of production, of which energy is one, will translate to lower price of goods and services and enhance development. This policy intent to deliver energy prices lower than the equilibrium carries significant economic, commercial, and political implications. Governments can deliver oil subsidies in several ways, which include – direct fixing of the fuel price (such as was the case in Nigeria), exemption from or lowering of related taxes, special tax rules, credit subsidies and liability caps, fixing of exchange rates or other factors that give rise to the energy price.

Historically, as OPEC countries, of which Nigeria is one, began to realize higher incomes from their oil revenue in the 1970s, they embarked on ambitious social welfare programmes and infrastructural development projects. These welfare programmes included, amongst other policies, the deliberate shielding of the populace of these countries from the vicissitudes of the oil markets by fixing fuel prices. This was considered a way to “share” the oil wealth, spur development by lowering the cost of the factors of production and soothe the populace with a sense of entitlement within the broader context of economic nationalism. The IEA estimates the cost of “soothing the populace” via fossil fuel subsidies globally at $1trillion globally in 2022 (IEA, 2022)

The arguments for the removal of the subsidy have been well repeated. The proponents for subsidy removal advance reasons such as the corruption-riddled system, the unsustainable fiscal cost to the government, the incentive for smuggling created by the arbitrage between Nigeria’s depressed gasoline prices and that of its neighbours, stunted downstream sector investment, and opportunity for Nigeria to contribute, even in a small way, to the climate change goals engendered by curbed emissions from moderated consumption.

In this article, I will examine the various drivers of the domestic price of gasoline following the loosening of price controls.

Estimates of Subsidy

Before the government gave up gasoline price control, the price of gasoline at the pump was fixed and adjusted from time to time. Thus, to estimate the quantum of consumption subsidy borne by the government, the price gap method the IEA used to estimate subsidies in their reports is invoked. The method takes the difference between the reference price (or open market retail price in our case) and the fixed retail price. The reference price or open market retail price is a price that recognizes the cost of the product from its source of origin and includes the associated costs and taxes required to deliver it to the end consumer at the pump.

Further dividing this difference (between the reference and retail price) by the reference price provides a measure of the proportion of the open market retail price the government bears. Historically, this discount has tended to fluctuate, but according to my recent analysis, it has averaged 35% in the last 10 years. The basic calculation of subsidies for gasoline is:

Using the above framework, the amount spent on gasoline subsidies can be estimated. Between 2012 and 2022, about N11trillion ($45billion) was spent on subsiding gasoline consumption.

The graphic shows that the quantum of subsidy payments has tended to rise and fall with the price of oil. For example, when oil price averaged $111/bbl in 2011, the amount paid in gasoline subsidies amounted to $13.7 billion.

How Domestic Gasoline Price is determined: post-Subsidy

Currently, 100% of gasoline consumed within Nigeria is imported. This, consequently, determines the basis of pricing gasoline in-country: import parity pricing. Before the passage of the PIA, the Petroleum Product Pricing Regulatory Agency (PPPRA) was responsible for determining the price of products within Nigeria as stipulated in Sec. 7 of the now defunct PPPRA act (2003). The PPPRA at the time utilized a pricing template to determine the open market price (which is the import parity price plus the retail and distribution margins). This template is shown below.

The Cost + Freight and Lightering Expenses (SVH) element in the table is provided for illustrative purposes only. However, all the other charges as stipulated by the template can be taken as valid based on this news report from July 2023. The figures highlighted yellow are denominated in the units in the corresponding column headers. For example, the Cost+Freight component is originally stated in $/mt, which will need converting to N/Ltr basis. Similarly, storage charge component (item 7) is originally stated in N/Ltr and is only converted into $/mt basis to display prices in USD terms.

Thus, the template is also useful in highlighting the components of the pricing structure that are impacted by foreign exchange uncertainty. Based on the provisions of the template, the import parity price of gasoline will then be calculated as follows:

Where:

1. IPP is the Import Parity Price of gasoline in N/Ltr
2. ConvFact is the density of gasoline in mt/Ltr
3. ExRate is the USD to NGN Exchange Rate in N/$
4. C is the FOB price of gasoline in NW. E in $/mt
5. F, LE, NPA, and NIMASA are the Freight, Lightering Expense, Nigeria Port Authority Fees, and Nigerian Maritime Administration and Safety Agency Fee, respectively, which are valued in $/mt.
6. FIN, JETTY, and STOR are the Financing Cost, Jetty throughput charge, and Storage charge valued in N/Litre.

To realize the open market retail price, the distribution and retail margins from the template above must be added.

A Predictive Model of Gasoline Prices in NW. E

Oil prices and gasoline prices in NW. E can be shown to be cointegrated. That is data science speak for stating that there is a long-run relationship between oil prices and gasoline prices. Without going into too much detail, I’ll say that the long-term relationship between oil and gasoline prices can be modelled as a linear relationship.

Where Y?is the price of gasoline ($/mt), X is the oil price (Brent) in $/bbl,?and m and c?are regression coefficients. A scatterplot of gasoline and brent oil prices based on 120 months from March 2010.

The model for gasoline price is Y = 8.08X + 126.11.

Retail Price, Oil Price and Exchange rate

International gasoline prices move in tandem with oil prices. Additionally, Nigeria depends on gasoline imports, which are then sold in naira in the domestic market on an import parity basis. Consequently, the drivers of retail prices in an environment devoid of subsidy would be:

1. Crude oil price
2. Clean tanker freight rates
3. US dollar/Naira exchange rate
4. Distribution and retail margins

Historically, clean tanker freight rates have been an average of 3% of the value of gasoline in the NW European market. Further, the distribution and retail margins tend to be fixed. For this reason, I will focus on the impact of oil price and exchange rates on the retail price of gasoline.

The heat map is a guide for the expected open market retail price of gasoline under a combination of oil prices and exchange rates.

For example, based on oil price of $90/bbl and exchange rate of N1000/$1, the model suggests gasoline should retail at N680/Ltr. As expected, the more naira exchanges per dollar, the higher the expected retail price at any given oil price. Similarly, the higher the oil price, the higher the retail price can be expected to be at any exchange rate.

The heat map illustrates the expected direction of movement of retail prices with oil price and exchange rates. Retail prices rarely move in lockstep with international prices and several reasons can be responsible for the deviation of the prices in the heat map from what retails at the gas pump.

1. There are various buffers, contractual provisions or other mechanisms to smooth volatility (eg hedging).
2. The pass-through effect from changes in oil prices to gasoline prices may vary seasonally, thus impacting the model results.

Now that the dynamic between oil prices, exchange rates and expected retail prices has been established, I test my model output against the actual national average gasoline price in Nigeria from May 2022 to September 2023. The model correctly shows that before the removal of subsidy in May 2023, the actual gasoline price in Nigeria priced below what the open market retail price would be. Specifically, with oil prices above $100/bbl in May, June, July, and August 2022, the subsidy is estimated to have ranged between N136/Ltr to N200/Ltr. In the month May 2023, the subsidy is estimated to have shrunk to N47/Ltr.

Upon removing the subsidy, the actual retail price of N545/Ltr at the pump is modelled to have exceeded the open market retail price by N175/Ltr. As of September 2023, with oil price average of $94/bbl and an exchange rate of N760/$1 (as per CBN), the retail price of N540/Ltr came in lower than the actual PMS price at the pump by N86/Ltr. This implies that, on average, petroleum marketers in September had a margin of N86/Ltr above what the model suggests the open market retail price should be. At these levels, the government clearly isn't subsidizing consumers - my model would suggest. Quite the contrary, petroleum marketers are enjoying a premium.

Conclusion

The removal of subsidy on gasoline has been a several decades-long struggle for Nigeria – charged with political and economic tension. While the fixed pricing regime on gasoline lasted, between 2012 and 2022, N11trillion ($45billion) is estimated to have been spent subsidizing gasoline consumption. Two critical events two years apart eventually led to the subsidy removal – the passage of the PIA with the provision for market-reflective petroleum product pricing – and, secondly, the “declaration” that subsidy had been removed on the day the new government was sworn in. In those two years, the subsidy bill is estimated to have been $ 10.3 billion+.

Following the exit of the regime, this article exposes the factors that will drive how much consumers pay for gasoline at the pump. The average price in the month of June 2023, a month after the expulsion of the regime, gasoline prices were 130% higher than the month before. With the climb of oil prices and depreciating exchange rate of the naira against the dollar there’s only one way the prices would go – up! Let’s watch and see how marketers, consumers and the government respond to these changing dynamics.