Kicking the Subsidy Habit

In 2014, estimates of global spending on fuel subsidies hovered around $500 billion. Since then, governments have spent less and less subsidising the black stuff. In 2015, Ghana bowed to pressure from the International Monetary Fund (IMF) and deregulated most petroleum product prices, Qatar has developed a formula to let petrol prices fluctuate, and Nigeria managed to phase out controversial fuel subsidy payments in 2015. Most recently, Egypt announced a cut to fuel subsidies as part of its $12 billion deal with the IMF.

Fuel subsidies are not the preserve of oil-producing nations, but they tend to be most popular in those countries. Seen as an easy way of showing the benefit of oil wealth and allowing the public to share in it, such subsidies are a crucial part of the delicate social contract that exists in many oil-rich nations. So what is changing?

From the Niger to the Nile

Though they have tread the same path, the Nigerian and Egyptian experiences are markedly dissimilar. Nigerians will remember the last failed attempt to remove fuel subsidies in 2012, which led to protests across the country that were striking in both size and success. But in 2015, the Nigerian government was able to capitalise on rock-bottom global oil prices that sharply reduced the landing cost of petrol. Even when no allocation was made for fuel subsidy in the record 2016 budget, the population remained unmoved. Meanwhile, Egypt attempted to reduce subsidies in 2014 but abandoned the policy by the next year. Now, dictated by the IMF deal that also involves a float of the Egyptian pound (sound familiar?), the country plans to hike up fuel prices and cut spending on fuel subsidies by over 40% in the next fiscal year – on the path to phasing them out altogether by 2020.

Too expensive

Such steps should have been taken sooner as fuel subsidies make little economic sense. They undermine effects to promote cleaner energy, create ample opportunity for arbitrage, and tend to benefit the rich more than the poor. They are also hugely expensive; Nigeria alone spent $35 billion between 2010 and 2014. This final reason explains the recent progress as the oil price slump weighs on the finances of the leading oil exporters. For Nigeria, there is another powerful argument against fuel subsidies: on a per capita basis, Nigeria is not a particularly oil-rich country. Despite proven oil reserves estimated to be the highest in Africa, Nigeria lags behind in terms of reserves per capita and crude exports per capita, by virtue of its population size (it is the most populous member of OPEC). This is important as it undermines the subsidy defence of being a large oil producer. 

Subsidise people, not petrol

The removal of petroleum subsidies has not come without cost. In Nigeria, prices of Premium Motor Spirit (petrol) were 23% higher at the end of 2016 compared to the previous year. More generally, the partial deregulation of the petroleum downstream sector has caused prices of petroleum products to soar. This has a knock-on effect on other prices, and many people would attest to having to pay more for food, energy, and transport in recent months. Ultimately, the erosion of spending power is keenly felt. And considering Nigeria's struggles with cheap and reliable energy, the poor are disproportionately affected by the rising cost of alternatives. 

The solution to this may lie in a subsidy of a different kind. Governments can cushion the effect of subsidy removal through targeted cash transfers which are more likely to help the poor. The distributional effects are greater as only particular income groups would qualify whereas anyone who buys fuel benefits from the subsidy. Meanwhile, the long-term antidote remains inclusive development, something that oil-rich governments have too often replaced with cheap petrol.

A subsidy – or higher prices – await

But change doesn’t end with the removal of petroleum subsidies. Governments must decide how petrol is priced. Whereas some Arab states have embraced a hybrid global pricing formula, the Federal Government of Nigeria simply raised the petrol pricing band to ₦135 - ₦145. This price is likely based on an exchange rate of ₦285/$1 and oil price of $45 per barrel, the prevailing rates at the time. Neither of these assumptions is valid anymore. Going with ₦305/$1 and $50 per barrel, the landing cost of petrol is estimated to be significantly higher, and margins must still be added to before the final cost can be calculated. Unsurprisingly, there have been calls to increase the pricing band with some reports suggesting current landing cost is already above ₦145.

There are three broad options here: i) bite the bullet and allow petrol prices increase ii) reintroduce a partial petroleum subsidy, perhaps through NNPC iii) formalise a foreign exchange subsidy whereby importers get dollars at a discounted rate. A further increase in petrol prices will deeply frustrate an embattled population still struggling with a rising cost of living, lack of jobs and a very expensive dollar. With trust in the present administration gradually eroding, a subsidy program will be scrutinised and criticised, and strengthen the view that the country is going backwards.

None of the options will appeal to the Federal Government, but with oil prices on the uptrend and the naira still under pressure, this is an issue that will not go away soon. At the time, abandoning subsidies was a pretty simple decision for Nigeria. Figuring out the next step will be much harder. 

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