What to do about the persistent fuel crisis

So here we are again. Another cycle of fuel scarcity. Of course if you’ve lived in Nigeria at any point over the last thirty years then fuel scarcity is not news; it is simply a part of life. But you have to wonder why we have bouts of fuel scarcity in the first place.

Official reasons range from “economic sabotage” to “corruption” to “insensitivity on the part of the Federal Government” to “groups holding the nation to ransom” depending on who you ask. The real reason for fuel scarcity is actually a lot simpler. It is about prices and simple economics.

First a quick detour to get a quick reminder of our good old friends demand and supply. The laws of demand are supply are very simple. On the demand side, people are usually willing to buy more stuff if the price is lower. On the flip side people are usually willing to buy less stuff if the price is higher. In general the higher the price, the less of the stuff people are willing to buy. In the case of fuel, if the price is higher than you buy less fuel and adjust your movements. If the price is low then you buy more fuel and maybe that trip to Ibadan starts making more sense. Either way, how much fuel you choose to buy each day depends on the price. All other things remaining constant of course.

On the supply side the ideas are similar. Ceteris Paribus, if the price of stuff is high then suppliers want to sell more of the stuff. If the price of stuff is low then suppliers don’t want to sell as much of the stuff. If the fuel price is really high then suppliers want to sell lots of their stock. If the fuel price is really low then suppliers don’t want to sell at all.

Bringing the two together, the buyers and sellers eventually settle on a price that makes both sides happy. To see how this happens consider a scenario where for some reason the fuel price was N1 per liter. Of course all the buyers would rush to go fill up their tanks. Demand would be high. For suppliers though, N1 per liter doesn’t sound very attractive. Very few will want to sell. So you end up with high demand and low supply. A smart buyer figures it out and says; “OK sell me fuel at N2 per liter”. At N2 per liter a few buyers get less excited and want to buy a bit less than before. Demand is a bit lower than before. A few sellers get a little bit excited and want to sell just a bit more. A N3? A few more buyers lose interest, a few more sellers get excited. At N10, N20 N30… the smart buyer who wants to buy fuel that the suppliers don’t want to sell keeps bidding just a bit more. As prices go up demand falls, supply rises up until you get to the point where suppliers are willing to sell just as much fuel as people are willing to buy.

 

The same happens at the other end of the system. Imagine for some weird reason the fuel price became N2bn per liter (no typo there). Of course all the suppliers will want to sell all their fuel at that price. On the demand side though, nobody wants to buy fuel at N2bn per liter. Instead you buy a bicycle or join the “trek for Buhari” team. A smart supplier sees that there are no buyers and says; “OK I’ll sell mine for N1bn per liter”. At that price some suppliers lose a little bit of excitement and choose to sell a little bit less fuel. On the demand side a few buyers, maybe Dangote and DAM, decide to just buy the fuel. Another seller see this and decides to offer fuel at N500m per liter. A little less supply, a little more demand and so on. The price continues to fall until you get to the point where buyers are willing to buy just enough fuel as suppliers are willing to sell.

In general prices tend to adjust to make demand and supply match. If prices are high then there is too much supply and too little demand; prices fall. If prices are low then there is too much demand and too little supply; prices rise. At the point where demand and supply are just right, then prices stay there. All other things remaining constant of course.

Now we know demand and supply depend on a multitude of things. For instance, if you buy a new fuel efficient car your personal demand for fuel decreases. If you move close to work and buy a bicycle your demand for fuel decreases. If you get a partner that lives 100km away then your demand for fuel probably increases. Many things could affect the supply of fuel too. Some of the things that could affect the supply of fuel include a change in the price of crude oil, a strike by a fuel union, a discovery that bicycles actually kill people, and so on. The important point here is that demand and supply are constantly changing. Which means that the price at which demand and supply match is constantly changing as well.

What happens if supply is low and demand is high but prices cannot adjust? Say for example the government decides that all fuel must be sold at N87 per liter but that price doesn’t match up demand and supply? Then you have scarcity. At that price buyers want to buy fuel but suppliers do not want to sell. You might have the money, and suppliers might have the fuel but the prices you both want don’t add up so no deal. In general if you have fixed prices then any negative shock to supply, or positive shock to demand, leads to scarcity. Given fixed fuel prices any increase in the price of crude oil leads to scarcity. Any disruption in roads used to deliver fuel or in pipelines causes scarcity. Any increase in demand, such as people wanting to drive half way across the country to celebrate the holidays causes scarcity.

 

Of course the Nigerian case is quite special. The government fixes the price of fuel which means prices cannot adjust. However the government also promises to pay suppliers for any supply shocks. If the price of crude oil goes up, the government promises to pay the difference. If the Naira devalues and fuel import costs go up, the government promises to pay the difference. If interest rates go up and suppliers have to pay more for loans? The government promises to pay the difference. If the ships laden with fuel get to the ports and incur demurrage charges? The government promises to pay the difference. Now I can’t claim to have seen the contracts signed with fuel suppliers but I bet that anything you can think of that could in some way influence fuel supply, the government promises to pay the difference. This difference is what is commonly referred to as “fuel subsidy”. The government doesn’t pay on a day by day basis but pays out the sum of this difference in batches. This of course means that scarcity doesn’t happen when there is actually a supply shock, but when the suppliers decide that “difference” to be paid by the government must be paid now.  You also probably now understand why the amount the government claims to owe the suppliers and the amount the suppliers claim is owed by the government is always very different.

Is removal of fuel subsidy the solution?
The short answer is no. Take a second to think about what the fuel subsidy actually is. The fuel subsidy, minus the other accrued costs owed to suppliers, is really just a failure of government to adjust prices in tandem with the prices of crude oil. To understand why think about what happens if the fuel subsidy is removed today but the government retains the price setting behavior. Then there is no problem but only as long as crude oil prices remain stable. If crude oil prices go up then the government has to increase prices immediately. If it doesn’t then the “difference” it owes to the suppliers increases and the “subsidy” returns. Indeed we have removed subsidies many times before as shown in the graphs below.

fuel2

The blue line is the government sanctioned fuel price in Nigeria in Naira. The red line is the Naira equivalent of US fuel prices, the de facto market price of fuel. You can see clearly that any time the government raise prices the subsidy is removed, or almost. However each time subsidies are removed, the government retains the price setting structure. Which of course means once there’s a shock to fuel supply, such as from an increase in crude prices, the subsidy returns and its back to square one.

Why doesn’t the government raise fuel prices in tandem with global crude oil prices? The short answer is politics. In a system where the government unilaterally sets fuel prices and also needs votes, there is the incentive to manipulate prices to win votes. In such a system prices are not set to align with reality but to score political points. We had a good example a few weeks before the last elections when the government decided to cut fuel prices to N87, re-introducing a subsidy that falling crude oil prices had wiped out. From a rational perspective the decision made no sense, but then politics.

So as long as the government sets prices, they will almost always not respond to realities in the oil market. Which means there will always be a fuel subsidy. Which means there will always be money owed to marketers. Which means there will always be periods of fuel scarcity. The interesting thing is that all this happens even if there is no corruption. Corruption probably makes it worse but fighting corruption alone doesn’t solve the problem. APC take note.

 

The obvious solution is to just stop setting prices. Allow markets set prices and allow prices to change based on the realities of crude oil and the oil industry. Deregulation of fuel prices will allow prices to adjust to supply and demand changes. It means that, short of a war, or something similar, there will always be fuel. The only question is the price.

 

However deregulation of prices has to go hand in hand with deregulation of the downstream section of the oil industry. At least the importing, and distribution side of things. You can’t deregulate prices and have a shady licensing protocol for who can import or distribute fuel. You’ll just create another Dangote. You can’t deregulate prices and have a MOMAN or NUPENG or [insert oil and gas union acronym here] unilaterally setting prices. In that case there will always be fuel but we will all pay through our nose for it. Remember the thing that keeps prices in check is competition.

What about the people, accustomed to buying fuel at a “discount”? All the arguments made against removal of subsidies are still kind of valid. The poor will lose something if fuel subsidies are removed, although the rich will lose a lot more (read more about that here). The political upheaval associated with fuel subsidy removal is probably not something the new administration wants to deal with.

My suggestion; keep the fuel subsidy, but distribute it directly to the people. Sign a deal to distribute the money budgeted for fuel subsidy for the next two years directly to all Nigerians who sign up as tax payers at the federal and state level. To be clear I do not mean promising everyone who signs up N5000 but promising to distribute equally the N165bn budget per head to everyone who signs up and files taxes. We can rationalize this as buying a tax base. Plus it will be clear from the start exactly how much will be spent over the next two years. At the end of the two year period the middle class, who are usually the mobilizers for protests, will be used to the deregulated fuel price. The distributed money can then be better targeted at the poor.
What about refineries? More on that in the next post.

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3 thoughts on “What to do about the persistent fuel crisis

  1. I like the idea of distributing the subsidy as a tax refund. Brilliant stuff.

    PS- There’s a missing link in the second to last paragraph.

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