Market forces - a response

I received an excellent response to my Saturday post via email from Fatai Thomas. I am pasting it in full. I'm sure you'll find it as helpful as I did:

"From an economic perspective, subsidies are generally a bad thing as they create market anomalies. This is a fact globally i.e. once you subsidise something (or do the opposite, slap a windfall tax on it) it encourages people to arbitrage. However, as a policy tool, they are the most potent for encouraging behavior.

In Nigeria, the pump price is fixed by the Government at NGN 65 per litre – 26p a litre. As a benchmark, in the UK the pump price is about 100p per litre. However this price includes about 50p of fuel tax so the “real” pump price is 50p. In other words, at NGN 123 per litre, a UK based fuel retailer can pay for transport, staff, raw material (refined product) and still make a profit.

Today, the Nigerian market is dominated by the major oil marketers. Together they have about 64% of the market. They buy product for NNPC on the world market, transport it to Nigeria and sell it. To fulfill its policy aims, the Government pays them the difference between where they buy and where they are told to sell it.

There are four problems with this in the long-term:
a) The Government is not an efficient and fair organization creating a lot of room for leakage
b) The increase in oil price and population (i.e. consumption) means at some point the subsidy will become unaffordable. I don’t have the statistics to hand but I am sure you can correlate development and fuel consumption (especially in a hot country)
c) The subsidy, although it is very effective as it reaches so many, is flawed because by having a fixed price, the Government has no way of controlling demand i.e. a fixed price means you never reduce your demand handing a windfall profit to the oil marketers (this is why so many people have gone into that business – printing money would be harder!)
d) Finally, anyone who considers building a refinery would not be happy selling into a price controlled market – yes you get a subsidy but it means you don’t enjoy the benefits of the cycle in the good times

So to answer your questions:

Q1 - “how much will the price go up” – I would expect it should not exceed NGN 125 a litre

Q2 - “given the fact that it is much more profitable to sell high quality 'sweet' (low sulphur) Nigerian crude on the international market than locally in Nigeria, how would the government ensure that local crude is made available to the refineries?” – if the local price is the same as the world markets (deregulated), then there is no arbitrage i.e. as a rational seller, I have no incentive to sell abroad or in Nigeria. In actual fact, given that transportation costs would be lower for a Nigerian refined product, the local refinery can afford to pay more than an international refinery. If I am an international refiner, I would be very concerned about Nigeria building its refinery capacity

Q3 – “How can anyone ensure the refineries ramp up their capacity, given that they have never been able to do this previously?” – if it is privately owned and you offer direct incentives i.e. impose a tariff on imported refined products, refineries will get built. After all, this was what happened to allow Dangote to build a sugar plant

Q4 – “The refinery question is surely key to the fuel price eventually dropping - if refineries still do not produce close to national daily need, importing petrol will keep the price of fuel high indefinitely” – I think people should realize that it is a lie that the price will eventually drop. Why would it? Why would I sell a product to a Nigerian at a lower price than a foreigner would pay? Actually the benefit is not really about making the fuel price lower – it’s about creating jobs and energy security as well as using the subsidy money (probably the largest Government expense) to spend on better things. In Europe today, it is the other way round – Governments TAX fuel consumption rather than subsidise! Think how much money Nigeria is losing.

Q5 – “In terms of a political economy context, for how long could high prices (some suggest fuel prices will have to double) be maintained, without widespread protest and industrial action?” – Although a valid question, it is ultimately irrelevant. Nigeria needs widespread protest and industrial action! Ultimately, If you create jobs, people will cope. Trickle down economics

Q6 – Grid power point – a stable refinery market will mean grid power is more of a reality. Again, prices won’t necessarily come down but the Government can at least channel that money into investing in the infrastructure. Also your point about private sector generation is spot-on. In a free market, there is more likely to be competition

As a final point, I think deregulation in all its forms is what Nigeria needs. I doubt there would have been a viable mobile market if it had been left to NITEL. Similarly, we can’t allow large, poorly run and difficult to change state institutions to drive our economic future."