If I got N100 every time I heard the question, “How can a country blessed with one of the largest reserves of crude oil be importing fuel?”, I would be a millionaire. That question is built on the idea that a country that has crude oil should naturally be refining crude oil. It turns out that is not the case as we are learning the hard way. The reasoning is very simple. To understand this let us examine a simplified oil industry as in figure 1 below.
The business of having crude oil and turning it into fuel to put in your car, or generator, actually involves five different industries. The first is the business of finding and having crude oil. The second is the business of getting that crude oil out of the ground. The third is the business of transporting that crude oil to refineries. The fourth is the business of refining the crude oil, turning into fuel and other products. The fifth is transporting the refined fuel to your filling stations so you can fill up your tank.
Which of these industries does Nigeria have an advantage? Only one. The business of having crude oil. We have crude oil and many others don’t. Does Nigeria have an advantage in the business of getting crude oil out of the ground? Not really. It is of course cheaper to drill oil in Nigeria than it is to extract shale oil in Canada. However if you think of the advantage in terms of Nigerian firms vs foreign firms drilling for oil in Nigeria then there is no real advantage. Although we have tried to rectify this by making that section of the industry very hostile to foreign firms. It is kind of working but the side effect of that strategy is the increase in costs for all firms. Which is not necessarily a good thing but more on that in a bit. Do we have an advantage in the transporting of crude oil? No. Do we have an advantage in the refining of crude oil? No. Marketing? No. So in essence the only part of the industry that we have a real advantage is in having crude oil.
Now think of things from the marketers and distributors perspective. They are the ones who really make the decisions on whether fuel will be imported or bought locally. Two major factors guide their decision to import or source locally. First the fuel has to be available to buy locally. Secondly the fuel refined locally needs to be cheaper than if it was bought on international markets. Even if local businesses refine fuel, it needs to be cheaper than imported fuel, else fuel would still be imported.
In general fuel will be imported if it is cheaper on international markets compared to local markets. Does having crude oil imply that it would be cheaper to refine locally? The answer is no. Many countries may not have crude oil, but every country can buy crude oil. If any country can buy crude oil then having crude oil is not really an advantage. International fuel markets are highly competitive given that any country can buy crude oil, refine it and sell. So if the local industry cannot compete on efficiency and costs then fuel will be cheaper on international markets. And marketers will opt to import fuel rather than buy locally. Which then means your local refineries will disappear.
Why can’t our local oil industry compete?
The next obvious question is why our local refineries cannot compete with international players. The simple answer is the way our local industry is structured. The figure below explains it perfectly.
Basically the NNPC and its subsidiaries run the entire oil industry. Prices across the entire industry are also set by the government, with the exception of the export price of crude oil which is beyond its powers. In essence you have the perfect worst case scenario for business. On the one hand you have a government corporation controlling everything from oil drilling, to crude oil pipelines, to refineries, to fuel pipelines, to marketing and distribution. On the other hand you have a government that sets prices of everything from the retail price of fuel to pipeline use chargers etc. Yes there are independent private players across the industry but most are mandated to partner in some form with the NNPC. The result of this industrial structure is an entire local industry that cannot compete with international players. First there are almost no legal private refineries. So we are not even at the point where locally refined fuel is available but more expensive. It is not even available. The government owned refineries are unsurprisingly in a state of perpetual turn-around maintenance. And so we import.
So what is the plan?
According to most the plan for the oil industry revolves around the petroleum industry bill. The bill aims to break up the NNPCs hold on the oil industry and make it look something like this:
The idea is to break up the industry into bits to reduce some of the corruption and lack of transparency. Disclaimer: there are many other agencies in the PIB not in the diagram above. Plus the positions of the new agencies in the industry are not as rigid. Will this new structure lead to the resurgence of refineries? Probably not. The new refineries will still have to compete with international players and it is not clear that they will be able to do so. The PIB also doesn’t say much about deregulation implying that the government still plans to keep the price controls. All this implies that the post PIB oil industry will probably not be able to compete with international players. Which means we will probably still import fuel.
What do we need to do to have a fighting chance?
First we need to get rid of the idea that government run refineries can work if we just try harder. They can’t. And even if by some kind of miracle they did finish their perpetual turn-around-maintenance, they cannot possibly compete with international players. Its difficult to imagine a scenario where government run refineries will be more efficient and reliable than the cut throat international market.
Second, pricing across the entire industry needs to be deregulated. The government needs to allow a more efficient market driven pricing structure from intermediate supply contracts to the retail end of the industry. Given that we know government run refineries cannot possibly compete, the only alternative is private refineries. But private refineries will not move anywhere near an oil industry where the prices are dictated by the government. Consider the current scenario where the private refineries have to buy crude oil at international prices but sell their refined products at the government mandated prices. No private player will knowingly enter a guaranteed loss making business.
Third, we need to use the natural advantage we have to tip the scales in favor of domestic use of crude oil. Recall the part of the industry we actually have an advantage is in having crude oil. And the determining factor influencing importing or domestic refining of fuel is the relative price. Selling fuel to private domestic refineries at a discount could provide the necessary incentive to build a refinery. Of course by discount I do not mean a fixed price for crude sales to local refineries but a fractional discount. So actual prices paid will still move in tandem with international prices. How much of a discount should be given? Obviously not a Tam David-West style discount where he argues to just give away crude oil for free. Intuitively the discount should be less than the welfare gains from jobs created in refining, Forex savings from not having to import fuel, and perhaps even gains from becoming a fuel exporter. If the discount is larger than the potential gains then its really just a net loss for the entire country.
Finally we need to think small and long term. The government seems to be stuck on the idea of few giant players with giant mega refineries and short term profitability. Nothing wrong with having big players but small players might be key to a fluid and flexible domestic industry. Strategies for multiple small players need to be explored. Small scale refineries with long term crude oil discount deals and expropriation risk guarantees might be the best shot we have at domestic refining.
Irregardless of these ideas it may be that the myriad of problems make domestic refining in Nigeria impractical. Oil refining is after all a cutthroat business globally with relatively small margins. It would be a shame though if we can’t make it work somehow.