Nigeria’s petrol subsidy has become the bane of our economy’s existence.
Last year, it cost us about ₦1.5 trillion, 35% of our ₦4.26 trillion oil and gas revenue for 2021; an average of ₦125 billion a month. This year, between January and April alone, the NNPC spent ₦950 billion on petrol subsidies; an average of ₦240 billion a month and almost double last year’s average. What’s worse is that the cost is rising every month. In July, the NNPC spent 100% of its oil and gas revenue on the subsidy.
Key takeaways:
The IMF has warned that the petrol subsidy could cost the government up to ₦6 trillion this year as both market petrol price and our consumption continues to rise. With our low oil production, the NNPC definitely can’t afford to keep bankrolling Nigeria’s subsidy habit, leaving the government to take on more debt than it can afford. Even when the government tries to remove the subsidy, it doesn’t have the willpower to make it stick.
So, at this point, we must take several steps back to understand subsidies and why governments use them. But a subsidy is money paid by the government to keep the price of a commodity low. It’s essentially the difference between the market price of petrol (the NNPC says this should be about ₦460/litre now) and the price the government wants us to pay (₦190/litre), also known as the price cap. So, the question we’ll be exploring is why governments resort to price caps and their inevitable effects on an economy.
Luckily, we have a recent price cap we can look at in parallel with Nigeria’s—the G7 oil price cap on Russia.
Why do governments like price caps?
By now, everyone should be aware of Russia’s invasion of Ukraine; if you don’t know, you’ve certainly felt the effects. No thanks to globalisation, Russian president Putin is waging war against Ukraine, so a loaf of bread in Nigeria is more expensive because we import wheat from Ukraine. It’s also partly why oil prices and prices of refined crude oil commodities (diesel, petrol, jet fuel, etc.) are higher in 2022, given lower supplies from Russia.
But, it’s not just impacting Nigeria’s economy.
Other countries also feel the heat through higher prices. Even though US inflation was rising long before Putin invaded Ukraine, we can’t deny that the invasion had an impact. From 7.5% in February, US August inflation was 8.3%, against its 2% target. The story is the same in the UK, where inflation was 6.2% in February and 9.9% in August.
Unfortunately, sanctions against Russia for invading Ukraine could worsen inflation if not carefully managed. Even though Russia’s central bank assets have been frozen and excluded from global financial systems, Russia’s economy is still relatively solid because of its oil and gas exports.
You see, Russia is one of the world's top oil and gas exporters. Prices of oil and refined commodities are already high due to short supply, and while banning Russia from exporting oil and gas would reduce Russia’s war funds, it would lead to even higher prices worldwide. Therefore, any sanction that affects the quantity of supply from Russia will have devastating effects.
So, G7 countries (Canada, France, Germany, Italy, Japan, UK, US, EU) needed to find a policy limiting Russia’s oil and gas earnings while reducing global commodity prices. The solution they landed on is a price cap on oil and refined commodities produced by Russia starting in December. Buyers of Russian oil must purchase at the capped price to access verified shipping and insurance and avoid getting sanctioned themselves.
Take careful note of their motivation for the price cap—lower revenues for Russia to fund its war machine and lower prices (inflation). Striking a balance between both objectives is crucial. On the one hand, stopping Russian oil exports could effectively achieve the first. But, on the other hand, that would mean higher prices for everyone due to limited supply. Remember, Russia is a major supplier of oil.
So, the success of the price cap hinges on Russia’s continued production, meaning the price cap has to be high enough to incentivise Russia to keep producing but low enough to impact global prices. The price cap hasn’t been announced yet, but this is the general idea of how it will be derived.
Coming back home, what’s the motivation for Nigeria’s petrol price cap? Or even its price caps on electricity, university education, domestic gas or the dollar? You could argue that Nigeria’s price caps were implemented to control inflation and make these commodities more affordable and accessible for Nigerians. This is only possible if the price cap is temporarily imposed while the government tries to fix the underlying issues causing the high prices in the first place.
For instance, Nigeria’s petrol price cap was introduced in the 1970s, over 50 years ago, following an oil price shock that increased prices for Nigerians at the time. It was okay for the government back then when the oil dollars were flowing, but those days are long gone. Clearly intended as a temporary relief to an unexpected economic hurdle (like the Russia oil cap), we should have removed the Nigerian petrol cap after the price shock had passed.
So far, we’ve seen two examples of price caps designed more or less for the same purpose; to control inflation. But, while we might be tempted to say that the problem with Nigeria’s price cap is that it’s gone on for too long, the truth is that price caps are generally inefficient and can do more harm than good even when carefully managed.
Why price caps don’t work
G7 countries have been very careful in designing the Russian oil price cap, as is expected when trying to interfere with the balance of demand and supply. They’re betting on Russia keeping the taps flowing on the supply side. Besides setting the price cap just high enough to keep Russia producing, they know Russian oil wells are primarily located in Siberia, one of the coldest places in the world. If Russia stops producing, their wells will freeze, costing millions of dollars to drill them again. On the demand side, the G7 hopes lower prices incentivise countries to adhere to the rules. The demand side is a bit tricky for purely political reasons, given that India and China are Russia’s major buyers who will chafe at following the G7’s orders. But economically, the G7 has tried to cover every chink in the price cap’s armour.
Still, some issues are unavoidable. One obvious problem is in the definition of the price cap —there’s going to be another oil price below the market price at which Russian oil will be sold.
Ask the CBN what happens when multiple prices exist; it creates arbitrage opportunities.
Arbitrage is when an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit. For instance, with the dollar, the official exchange rate is ₦428, but the parallel rate is about ₦700. Anyone with access to both markets can buy from the CBN at ₦428 and sell to the parallel market at ₦700. If you could buy $1 million at the CBN rate and sell at the parallel market rate, you would make about ₦300 million. This also happens with Nigeria’s petrol.
According to the 2023 Medium Term Expenditure Framework (MTEF) from the finance ministry, Nigeria’s subsidy bill keeps increasing because the market price for petrol and the quantity of petrol consumed keeps increasing. What happens here is that the NNPC imports petrol, enough to meet the country’s consumption. But, while petrol in Nigeria is ₦190/litre, it’s almost ₦500/litre in neighbouring countries, creating an unresistable opportunity for arbitrage. Between August last year and August 2022, Nigeria’s petrol consumption has increased by over 10 million litres per day, roughly equal to the daily consumption of smaller countries like Algeria and Kuwait.
While there’s no concrete proof to quantify how much petrol is smuggled, consumption drops every time there’s a hike in Nigeria’s capped petrol price. This shouldn’t be a surprise, given that higher prices lead to demand destruction, but the volume of reduction should ring alarm bells that Nigerians aren’t the only ones consuming NNPC’s petrol.
The 2012 subsidy removal by ex-President Goodluck Jonathan caused Nigeria’s petrol demand to drop from over 56 million litres per day to about 40 million litres per day. Even though the 2017 increase was a hike rather than removal, there was still a slight drop in demand. There was another subsidy removal in 2020, but due to Covid lockdowns, demand was already low.
Since 2011, Nigeria’s petrol demand had never exceeded 55 million litres until last year, when petrol prices worldwide surged to over ₦300/litre. And now, the NNPC says we’re consuming 68 million litres of petrol daily. Unfortunately, it’s tricky to determine what Nigeria’s petrol consumption should be while accounting for the subsidy. For instance, over 40% of Nigerians live below the poverty line, meaning most can’t afford to own cars or generators, making it difficult to determine how many Nigerians consume petrol daily.
Regardless, Nigeria’s petrol consumption figures and price control economic theory strongly suggest that Nigeria’s petrol is smuggled and sold in neighbouring West African countries. The NNPC has also revealed this to be accurate, even though actual smuggled numbers are difficult to determine.
Again, this isn’t unique to Nigeria; it’s a side effect of price controls. It happens in Saudi Arabia and Iran, which also have price caps on petrol, and it will happen with the G7 Russia price cap. For countries like Nigeria, the price cap costs much more than planned because the quantity demanded is inflated. Ultimately, the government spends more on maintaining the price cap than the citizens they’re protecting would have spent.
The second major side-effect of price caps is supply shortages.
Profits, through prices, incentivises suppliers to keep supplying. This is basic economics. The higher the price, the higher the quantity supplied and vice versa. So, if prices are too low, suppliers would stop supplying and find something else to do.
The G7 price cap hinges on Russia keeping supplies stable. If there’s a drop in Russian supply, the market price will increase, defeating the inflation-fighting purpose of the cap. Essentially, the success of the price cap depends on Russia’s willingness to keep drilling. This is the same reason why the NNPC, Nigeria’s national oil company, is the sole importer of petrol—no incentive for any non-state player to get involved. Relying on non-NNPC petrol importers would result in supply shortages and petrol hoarding to induce artificial scarcity to raise prices. Still, we experience shortages when NNPC imports bad petrol or a diesel price hike makes it expensive to transport petrol across the country. So, even though the NNPC and the government are single-handedly keeping Nigeria’s petrol downstream sector running, it’s still super inefficient because there’s no incentive for the private sector to invest in downstream infrastructure like pipelines.
So far, we’ve examined two first-order effects of price caps—supply shortages (and poor development) and arbitrage. But, the risks of a price cap failure could outweigh the benefits because governments fail even harder when markets fail.
When markets fail, the government fails harder
Market failure is the inefficient distribution of goods and services in the free market due to market distortion, i.e. interference in the forces of demand and supply, such as price controls.
The University of Chicago economist Harold Demsetz used a popular analogy to describe the relationship between price controls and inflation in the 1970s. He said it was like breaking the thermometer to control cold weather. But, thermometers respond to, not control, temperature.
Similarly, prices respond to demand and supply; they don’t control them (cause and effect). But inflation and price controls are worse. When you break the thermometer, it doesn’t make the weather worse. But, when price controls go wrong, they can break the economy. Through shortages, arbitrage and underdevelopment, price controls can worsen the economy because they interfere with the balance of demand and supply.
Unfortunately, no matter how well governments plan to ensure price controls don’t lead to market failure, their efforts are never 100% successful. It usually has an even worse effect on the government and the economy. This year, Nigeria’s petrol subsidy will be two times more than our spending on education, healthcare, works and housing combined. The G7 price cap on Russian oil hasn’t been implemented yet, so it’s hard to quantify the gaps. Still, one thing that’s already clear is that there are too many unpredictable or uncontrollable factors like India, China and even Russia, casting doubts that implementation will go exactly according to plan.
