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THE IMPACT OF OIL ON NIGERIA’S ECONOMIC POLICY FORMULATION
ABSTRACT
Crude oil is one of the main drivers of economic growth and a key ingredient to sustainable development. It is therefore vital that crude oil products be efficiently and competitively priced in order to accelerate economic growth. The realization of a 10 percent economic growth in Nigeria by the year 2030 requires massive development in the energy sector. Nigeria suffers from a shortage of internal energy resources, including oil and as a result, Nigeria continues to be in the category of net oil-importing developing countries; this subjects the economy to vulnerability to external shocks, notably oil price fluctuations, exposing the country to risks associated with oil prices such as a reduction in aggregate demand, increase in consumption price deflator and reduction in real income. This study empirically explored the effects of crude oil on GDP growth and selected macroeconomic variables in Nigeria. This was achieved by investigating how crude oil prices affect GDP growth, inflation rate and real exchange rate. Literature has presented these three variables as the main indicators of economic health and key variables affected by crude oil prices. Demand for oil in Nigeria has been progressively increasing since the 1970s and this is expected to increase even further from the current consumption of 4.2 million Metric tons per year to 12 million Metric tons by the year 2030. The forecasted rise in demand has been attributed to the achievement and sustainability of the desired 10 percent economic growth, as envisioned in the national vision 2030 blueprint. The study used time series data sourced from BP, WDI, and CBK covering the period 1970 to 2016. This period was chosen so as to capture different oil shocks that have been shown through empirical and theoretical literature to have had an effect on the economy. The study estimated three Autoregressive Distributed lag (ARDL) models to analyze the effect of crude oil on the selected variables in the study. The findings of the study revealed that, crude oil prices have a positive long-run effect on GDP growth. This can be attributed to the fact that Nigeria imports oil and re-exports it to Uganda, Rwanda and South Sudan. The findings also established that Crude Oil Prices have a positive effect on inflation in the long run, while in the short run its lag of one has the effect on inflation rate, meaning that the Crude oil prices for the previous one year affects the current year’s inflation. The relationship between crude oil prices and Real Exchange Rate was negative in the long run. CUSUM and CUSUMQ tests were also conducted and the three models were stable. The study recommends that the government should revive the oil refinery in Changamwe in order to improve the oil value chain and therefore gain from exporting petroleum products as opposed to crude oil. The Energy Regulatory Commission should also moderate oil prices in a way that considers social equity in order to mitigate its effect on inflation.
OPERATIONAL DEFINITION OF TERMS
Crude Oil Prices– It’s a measure of the spot price of various oil barrels.
Brent Blend – A type of Crude oil extracted in parts of the North Sea, in the United Kingdom coast lines and Norway.
GDP Growth – The rate at which a nation’s gross domestic product changes from one year to another.
Exchange rate – It is the price of one currency with respect to another country’s currency.
Inflation – The persistent increase in the general prices of commodities.
OPEC – Organization of the Petroleum Exporting Countries. The member countries include: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, Venezuela. Gabon was an original member but terminated its membership in 1995
Real exchange rate – Price of a country’s currency with respect to another country’s currency, but also adjusted for inflation using the ratio of the foreign prices to domestic prices.
Seven Sisters – The seven companies that controlled the oil prices between 1928 and
1960’s before most countries gained independence. They include: Anglo-Persian Oil company (current British Petroleum); Gulf Oil; Royal Dutch Shell; Standard Oil of
California (SoCal); Standard Oil Company of New Jersey (now Esso); Standard Oil Company of New York (current Exxon Mobil)
West Texas Intermediate – A crude oil grade that is extracted in the United States of America. It has a relatively low density and low sulfur content.
CHAPTER ONE
INTRODUCTION
1.1 Background
Energy is the prime driver of economic growth and a prerequisite for the sustenance of economic development. Energy is used in all aspects of life ranging from household consumption to industrial and mass production. Energy is a key developmental resource that has been outlined among the top ten Sustainable Development Goals (SDG). However, for sustainable development it is imperative that energy be sourced from sources that are affordable and accessible,
Obtaining reliable energy and meeting energy requirement are essential aspects of the general economic development strategy not only in developing countries but in all the countries in the world. Most developing countries are working hard to ensure that they gain access to efficient, reliable and competitively priced energy supplies, this is vital in ensuring maximum gains from energy and hence economic growth.
For economic development to take place, energy access alone is not enough, there is need for efficient utilization of energy resources in a way that is sustainable in the long-term. The primary advantage of this is that it will enable planners to make environmental preservation a key priority in their economic development strategies. Consequently, this will ensure that in policy formulation, focus is placed on long-term strategies as opposed to short-term concerns. It is through this approach also that governments will be a position to meet their economic priority needs with social and ecological inclinations.
The concept of affordability is closely connected to the concept of demand and supply, in the recent past, supply of energy has been a topic of universal concern. Researchers have attributed the volatility of crude oil prices to energy security and termed it as a threat to a stable energy supply (Naveed, 2010). Crude oil is the main energy source that is consumed in greatest proportion as compared to other energy types. Production of other energy sources such as hydroelectric and geothermal energy also relies on crude oil. Therefore, high oil price is a deterrent to economic growth and development as it affects all the spheres of production.
The distribution of crude oil around the world is not uniform. There is much endowment of the resource in some regions and countries while there are those that lack the resource. According to a report by British Petroleum (2016), majority of the oil reserves are located in the Middle East region. Primarily situated in Iran, Iraq, Kuwait, Saudi Arabia and the
United Arab Emirates (UAE). Liquified petroleum gas is found in Russia, Iran, Qatar and Saudi Arabia.
In terms of productions, there is variation in production among regions due heterogeneity in oil reserve distribution. BP (2016) recorded the global oil production in 2015 as 3995.6 Mtoe which is equivalent to 83.57MB per day. Among the regions, the main crude producers include: The Middle East 33 percent, followed by Europe and Eurasia at 21 percent, with North America following at 17 percent, Africa 10 percent, Asia Pacific 10 percent and South and Central America 10 percent.
Global oil consumption varies across regions and countries and is determined by factors such as population, income distribution and primary economic activity in a country
(Naveed, 2010). Global oil consumption is 4059.1 Mtoe, equivalent to 93.3 MB per day. The highest consumers of oil regionally are; Asia pacific 32.4 percent, North America 25.3 percent, Europe 22 percent, Middle East 10 percent, Africa is the least consumer with 3.9 percent. Country wise, USA ranks first with 21 percent share of universal consumption, followed by China 11 percent, then Japan 5 percent, India 4 percent, Russia 3 percent, Saudi Arabia 3 percent, Brazil 3 percent and Iran 2 percent.
In Africa, many countries are viewed as energy poor since majority of the population cannot afford clean and reliable energy (African Development Bank, 2009). The region trails in the global share of oil consumption which stands at 3.9 percent, this is in spite of the continent accounting for one fifth of the global population. The structure of global energy consumption is a revelation of a huge disproportion in the global access to commercial energy. In terms of oil production, Africa contributes 12 percent to the global oil production with largest reserves in Libya, Angola and Nigeria. Despite the high production, oil prices have been rising due to high cost of production and poor infrastructure. The high prices pose a challenge to Africa’s economies since 38 of the 53 countries are net oil importers.
Source: BP statistical Review, 2017
Figure 1.1 shows the price of two different types of oil barrels; West Texas Intermediate
(WTI) quality oil, shown by the blue line, and North Sea oil referred to as Brent crude. The graph shows that oil prices have been fluctuating over the years, however, the two qualities tend to be moving in the same direction. The two lines are typically close to each other indicating that the variation in prices is small with Brent being $3 cheaper, as a result of transport cost and the oil characteristic (more dense and higher sulfur content). However, between 2007 and 2014, there is a significant reduction in the price WTI, $26 cheaper.
Anomalies in their prices have been witnessed in May 2007 when WTI was trading at $63.58 against $71.39 per barrel for Brent; In February 2011, WTI has priced at $85 per barrel while Brent at $103 per barrel, this was attributed to civil turbulence in Egypt and some parts of the Arab Middle East; the anomalies on prices continued for two years (until June 2013) where Brent traded at on an average of $15 higher than WTI. Immediately afterwards (July 2013- December 2013), the price spread was preset but had shrunk to an average $4. In January 2014 however, the disparity increased to $14 but declined towards the end of the year and stabilized at $4 (United States Energy Information Administration, 2016).
From a historical viewpoint, oil pricing mechanism, market development and structure can be divided into four regimes. The first three regimes which lied between 1928 and 1970 were characterized by oligopolistic pricing system. In the first two regimes, the oil market was dominated by an oligopoly of international oil companies while in the third regime, the market prices were controlled by an oligopoly of originally 13 main Oil Producers and Exporting Countries (OPEC).
The international market was initially not open to any country that was not an oil producer; the first split was between the Seven companies that controlled oil prices which were referred to as the seven sisters in 1928 and the OPEC in the 1960s. The seven sisters in 1928 set an Achanacarry agreement with a one-base pricing formula under which freight rates were calculated based on the residual fuel oil (RFO) price, FOB Mexican Gulf, plus fictive freight from the Mexican Gulf to Abadan. It was reviewed in 1947 after World War II when the British and America administrations forced the seven sisters to change the formulae to a two-base formula under which freight rates were calculated either from the Mexican Gulf or from the Persian Gulf, however but in both cases FOB
Mexican Gulf was the oil price that was used in the calculations.
In the 1970’s oil pricing was largely dominated by OPEC, this was mainly influenced by the control of oil fields and resources by the OPEC Countries after the end of colonialism in the 1960s. However, this was short-lived as there was an oil embargo in 1973 and 1974 and also oil price shocks around the same period and in 1979. These events presented an opportunity for non-OPEC countries to investment in oil, it also gave rise to the development of new technologies especially capital machinery that was not largely dependent on oil but on other more efficient energy. As a result, in the early 1980s there was a reduction in global oil consumption in absolute volume terms and subsequently a collapse in oil prices in 1985 /1986 and the culmination of the OPEC structure to more viable structures and consequently to a liquid oil market (Hulten, Robertson & Frank, 1987).
Exchange based pricing system took precedence immediately after the oil collapse in 1986, it is the structure that is currently in place. Over the years it has developed to accommodate the derivative market such as spot, future, physical forwards and paper markets.
There exists limited indigenous energy resources in Nigeria and there is a concern that it may not be sufficient in sustaining the Country’s economic development in the long run and may thus drive the Country into relying on energy imports (Kariuki, 2012).
Currently, Nigeria meets 60 percent of its total energy demand through imports (National energy survey, 2015). National oil (2016) projects the share of imported energy to increase by 10 percent as a result of oil consumption by the Standard Gauge railway and reviving of industries that had collapsed such as Webuye pan paper mills; various irrigation schemes; urbanization that has led to increase in public service transportation and massive importation of cars by Nigerians etc. The challenge, therefore, is to secure adequate oil supplies at the minimum possible cost (National oils, 2016).
Demand for oil has been on the rise over the years and this is expected to rise even further. Meeting soaring demand of oil and realization of most of the goals and aspirations in the vision 2030 blueprint calls for massive development in the energy sector. It is estimated that at the economic growth rate of 10 percent desired in order to achieve Vision 2030, petroleum and gas consumption will grow from the current 4.5 million MT to 12 million MT by 2030 (National oil, 2016).
1.2 Statement of the Problem
Oil is widely used across all sectors of Nigeria’s economy, especially in manufacturing, transportation and power producing sectors. However, the price dynamics of oil have been relatively volatile in the recent years, posing a threat to the various sectors and the overall economy. Nigeria suffers from a shortage of internal energy resources, including oil (National oil, 2016), as a result, Nigeria continues to be in the category of net oil importing developing countries; this subjects the economy to vulnerability to external shocks, notably oil price fluctuations, exposing the country to risks associated with oil prices. Marquize (1986) noted that for a non-OPEC developing country such as Nigeria, oil price risk includes: a reduction in aggregate demand, increase in consumption price deflator and reduction in real income.
It is against this backdrop coupled with a lack of an effective cost-beneficial substitute available that this study sought to examine whether the prevailing hypothesis as propagated by Hamilton (1983), that oil price fluctuations has an adverse effect on a net oil importing country’s macroeconomic performance holds for Nigeria. The endogenous variables used as proxies for macroeconomic performance are GDP growth, real exchange rate, and inflation level. The choice of variables is largely informed by a study by Marquize (1986) which is used as a benchmark. Moreover, according to Pologni and Manera (2008) these three variables are presented as the main indicators of economy’s health. This study contrasts other studies carried out on Nigeria’s data, as it estimates the variables in a system framework, this addresses the shortcomings of non-coexistence bias and allows for a lagged and contemporaneous interconnection among the variables under study including control variables. This also enabled the study measure the long run and short run effects making it possible to determine whether the effect of oil prices on GDP growth and selected macroeconomic variable is temporary or permanent.
1.3 Research Questions
- What is the effect of crude oil prices on GDP growth in Nigeria?
- What is the effect of crude oil price on inflation in Nigeria?
- What is the effect of crude oil prices on real exchange rate in Nigeria
1.4 Objectives of the study
The overall objective of this study was to analyze the effect of crude oil prices on Nigeria’s
GDP growth and selected macroeconomic variables. The specific objectives were to:
- Examine the effect of crude oil prices on GDP growth of Nigerian economy.
- Determine the effect of crude oil prices on inflation in Nigeria.
- Determine the effect of crude oil prices on real exchange rate in Nigeria.
1.5 Significance of the Study
The spirit of the study is to gain an in-depth understanding of the causal relationship between oil prices and the variable that show the health of the economy (GDP growth, inflation rate and real exchange rate), using historical data. The study is vital for additional knowledge in energy economics and the findings will be useful in solving businesses problems that arise as a result of inflation and informing policy makers on ways to cushion the economy whenever the country is faced by drawbacks of oil price fluctuations and volatility.
1.6 Scope of the Study
The study focused on Oil prices and its effect on GDP growth, real exchange rate and inflation in Nigeria. The study covered the period 1970 to 2016. This period was chosen as it covers the major shocks that have affected oil prices and other key economic variables. This includes the oil embargo in 1973/74, oil price increase in the 1973∕74 and 1979/80, the oil price collapse in 1985/86, oil shocks in 2007/08 and the regulation of petroleum product prices by the Energy Regulation Commission in 2010.
