Feature Article of Friday, 30 October 2009
Columnist: Adam, Mohammed Amin
by Mohammed Amin Adam
Centre for Energy Economics and Policy (CEEP) Ghana
The subject of petroleum products pricing has always been a contentious one. Ghana like all developing countries is always faced with the problem of a pricing scheme that will be acceptable to the population but which will not also cripple the economy. This notion has therefore influenced all pricing regimes for petroleum. Particularly, there have been times one wonders whether politics or economics are the main pillars behind our pricing policies. As a result of the problems in the petroleum sector, government embarked on a deregulation process in 1996. A process for publishing and applying an Automatic Adjustment Formula for pricing petroleum products to ensure full-cost recovery was also completed in 2001. The National Petroleum Tender Board (NPTB) was set up to regulate pricing based on the formula. Since October 2005, the deregulation of the petroleum sector was pushed further leading to the establishment of the National Petroleum Authority (NPA) which replaced the Tender Board and which is responsible for monitoring and publishing ‘import parity’ cost of refined petroleum products in to Ghana based on a transparent pricing formula. The main factors that affect petroleum pricing in Ghana are crude oil prices, the exchange rate, taxes and levies and margins. Now under the enhanced phase of deregulation, the OMCs are responsible for importing crude oil and refined petroleum products. There is no doubt that there is significant public interest in petroleum product pricing exhibited through mass strikes and demonstrations. The latest legal suit against the NPA and TOR over the pricing formula has ignited the interest even more. This paper does not cover analysis of ‘ex-refinery differential’ which is the bone of contention before the law court. Rather it looks at the major issues that affect petroleum pricing and the reality which Ghanaians must face.
THE PETROLEUM PRICING FORMULA
There are four different formulae used by the NPA to compute the prices of products.
i. Ex-pump Price = Ex-refinery Price + Taxes/Levies + Margins
ii. Ex-refinery Price = CIF + Related Charges
iii. CIF = Cost (FBO) + Insurance + Freight
iv. Related Charges = Off-loading Cost + In-transit Losses + Inspection + L/C Cost + Financial Cost + Storage Cost + In-plant Losses + Rack Loading Cost + Operating Margin.
These mathematical formulae may not make any meaning to most people. What is important though is that most of these factors change according to both domestic and foreign economic circumstances. Some of the issues that lead to changes in the various components of the formulae are; crude oil prices, the exchange rate, weather conditions on the high seas, efficiency and financial strength of TOR, OMCs and Oil Trading Companies (OTCs), and government’s fiscal regime (taxes and subsidies). There are also issues of transparency, transport fares and general living conditions of Ghanaians which have shaped the economic and political debate on petroleum pricing. However, both politics and economics may be far off the reality. The consensus that should be mobilized now is how much politics and economics need to inform petroleum pricing.
TAXES AND LEVIES Most governments around the world use petroleum taxes and levies to raise funds for development. The petroleum pricing formula in Ghana therefore has different taxes and levies. As at May, 2006, the following taxes and levies were imposed on petroleum prices in Ghana:
Therefore ex-refinery prices at that time was 57% of ex-pump price implying that taxes and levies constituted 43% of the price.
Most of these levies are comparable to what pertains in other countries. For example, the Road Fund Levy of 7% is not very different from the 7.5% in Togo and Tanzania, 8% in Benin, Kenya and Ivory Coast.
Politics and economics affect the type, number and rates of taxes imposed on products. We can imagine what the state of our roads would have been without the Road Fund or where the country would have gotten money to import crude oil without the excise duties. For instance, Ghana’s expenditure on crude oil imports rose from US$500 million in 2005 to US$2.1 billion by the end of 2007 for the same quantity of oil. How the country finances these imports is not oblivious of the implications for economic development.
It must be stated however that the over-reliance on petroleum taxes and levies leads to overpricing of petroleum products. Governments mindful of the repercussions – economic or political, have often resorted to tax review in times of difficulty. As an illustration, following extreme volatility in crude oil prices and increased food crisis in 2008, the government of Ghana removed excise duties and debt recovery levies on premix fuel and reduced same on Kerosene and Marine Gas. The government again reduced taxes in early 2009 to mitigate the hardships resulting from crude price increases. Whether these measures in both cases were realistic or not can be traced to the effects of such measures on government revenues and whether such measures are able to keep prices low for a long time. PETROLEUM SUBSIDIES By far the most politically sensitive issue in petroleum pricing is subsidy. Supporters of price subsidization are often quick to raise social equity concerns of market prices and the implications for macroeconomic management. Opposition to the subsidy debate points to the empirical evidence that the subsidies on petroleum products have been one of the causes of poor performance of state refineries and their economies.
Indeed, subsidies are a big toll on government finances and eventually distort the markets of oil dependent countries. In 2006, subsidies constituted 0.7% of the Gross Domestic Product (GDP). The reality is that subsidies hurt the poor more than they support them in terms of the opportunity cost. That is, the socio-economic development that is sacrificed as a result of such non-productive spending is a heavy price the poor people have to pay for subsidies. Moreover, the benefits of petroleum subsidies are felt in the short-run and usually enjoyed by the rich more than the poor. In the long-run, the state is confronted with using development funds to correct market failures. Since the liberalization of the petroleum sector started, it has been the policy of government to cross-subsidize the products. It must be noted however that even though subsidies are distortionary, it cannot be avoided entirely in a developing country such as Ghana. Higher prices of petroleum products may lead to social and political tensions such as observed in Ghana by the activities of the Committee for Joint Action and the Alliance for Accountable Governance, both of whom organized mass demonstrations against the government.
The Central point though is how to finance subsidies and whether it necessarily must affect petroleum prices. If we are to avoid the distortionary effects of subsidies and yet maintain political harmony, then subsidies on products should be self-financing.
TOR DEBT REPAYMENT
TOR debts as at January 2009 was approximately US$1 billion even though the net would be about US$400 million according to the Minister of Energy , if the liability of TORs creditors are deducted. It is now estimated at US$1.5 billion due to non-payment for refined products imported in to the country and interest accumulation. This certainly captures the liquidity problems of TOR and hence its inability to establish letters of credit.
TOR debts were first introduced in to the pricing regime in 2002 and dubbed, ‘Petroleum Debt Service Surcharge (PDSS).’ In addition to this charge, savings from exchange rate appreciation in the global price of crude oil and petroleum products was to be added to service the debt. The other approach of servicing TOR’s debt was TOR bonds which raised significant amount of money. In 2003, the PDSS was replaced with TOR Debt Recovery Levy.
Whiles the politics of TOR debts continue to dominate the political environment, the economics of those debts show that the banking sector is being squeezed out. TOR’s operations have therefore come at a huge cost to the country. To justify the imposition of the Debt Recovery Levy, several arguments have been made in the past. First, since TOR debts are the results of petroleum subsidization, customers must be made to pay the debts. Second, the Volta River Authority (VRA) which takes about 15,000 barrels of light crude oil per day from TOR to produce power at the thermal plant at Aboadzi, is a public entity, hence the need for the public who are also consumers of cheap power to pay the debt. However, both arguments are flawed on the grounds that both TOR and VRA do not subsidize petroleum products and electric power on their own authority. Subsidies are approved by the government both for political and equity reasons. Therefore, rather than call these debts TOR debts, they should be regarded as government/public debts which the central government whose subsidy policy brought about the debts must take responsibility for.
But the accumulation of debts by TOR cannot be blamed only on government. The disclosure by TOR that OMCs owe it by about US$54 million as of the end of September 2009 does not only show TOR’s inefficiency in financial management but also questions the management of its own commercial viability. Fact is, the OMCs sell on cash basis at prices covering their margins, and how could TOR allow such debt accumulation?
The last eight months of refined petroleum imports suggest that TOR’s operations are not cost-effective except for the jobs it provides to Ghanaians. Since it has not refined oil for the last eight months, its inefficiency and labour costs have not affected prices. This might have accounted for the stability of product prices for some time now despite the fluctuations in crude prices between US$69 and US$75 per barrel of crude for almost three months. Could this be the reason for the ‘ex-refinery differential’ especially if TOR’s refinery cost estimates which is on the higher side were the projections used in the pricing process? If TOR’s refinery costs are higher, is it then prudent for TOR to continue being a burden on government? The reality is that TOR requires recapitalization through privatization. The company needs to operate at full-cost recovery and stop further accumulation of politically motivated debts. A recapitalized TOR will not only ensure efficiency and contribute to the emerging oil economy especially when crude oil production commences, but will also prevent capital flight arising from the use of our foreign exchange for importing refined products. At this time when refiners around the world are operating at 95% capacity, it would have been expected that TOR would exploit the West African market to make profits. Unfortunately, this opportunity has not been explored. TOR’s capacity now stands at 45,000 barrels although it refines 30,000 barrels/day which is 50% of domestic requirements. Recapitalization will therefore push TOR to operate at near full capacity or even increase capacity in anticipation of crude oil production in the country. TOR could also be a tolling refinery by refining crude oil for our neighbouring countries. Nigeria which has very serious refinery capacity shortfalls and imports the bulk of her petroleum products could be a source of good market.
On the other hand, if we do not want to privatize TOR because of its status as a strategic national asset, then again, government should consider giving it a working capital. To make it more efficient, the country should consider creating a competitive environment by allowing private refineries in to the petroleum sector. There is every reason to believe that TOR has the potential to succeed if politics is taken out of its operations and the economics are set right. After all the use of product pricing as a tool for debt payment has proven unsustainable. CRUDE OIL PRICE VOLATILITY There is no doubt that crude oil prices impact heavily on petroleum product prices. This however tends to be asymmetrical. That is, pricing authorities increase petroleum product prices faster when there is increased price of crude oil than they decrease product prices when crude prices fall. In some cases, they are reluctant to adjust prices down unless the decrease in crude prices is noticeably significant. This practice does not build confidence in the pricing regime.
Crude price volatility has been the major problem in petroleum product pricing largely because pricing authorities and governments are yet to find a common ground and most sustainable mechanism to contain volatility effects. Fact is, crude prices are determined by the world oil market and therefore, both consuming and producing countries suffer the shocks of the market.
In Ghana there is the tendency to argue that crude oil prices do not affect product prices because of the use of import parity costs in our pricing scheme. But import parity costs itself is largely affected by crude prices among other factors. This is why product prices are usually adjusted by the NPA when global market prices of crude oil changes. For instance, the NPA has already announced that by the end of October, 2009, it will consider product price adjustments if crude prices continue to increase. There are options for accommodating the effects of volatility though. One way is to build a strategic reserve capacity and release the oil when crude prices are very high. However, financing strategic reserves should not be borne by the government. In most countries there is a levy on petroleum prices to finance strategic reserves.
Another way to accommodate volatility is through price smoothing. In this case, the pricing formula should be based on futures prices of crude whiles refinery costs reflect forward refinery margins. There is empirical evidence that most of the times; futures prices are slightly higher than spot prices because the markets are not perfectly efficient. In this circumstance, the ex-refinery price of futures-induced petroleum prices may be slightly higher than the actual price at least for some time in order to stabilize prices within a defined band. Product price stability is good both for planning by businesses and checking the inflationary effect of crude oil price volatility.
Crude volatility can also be checked through sound exchange rate management. This might be why countries are encouraged to develop refinery capacity whether they are producers or consumers of oil. The foreign currency shortfalls arising from the purchase of refined products are avoided. The rate of local currency depreciation is controlled. The import parity based pricing of crude oil therefore takes care of additional volatilities from exchange rate fluctuations.
PROPOSED PRICE SMOOTHING SCHEME
Since price fluctuations are the major problems in our pricing regime, I have proposed a price smoothing scheme which can accommodate volatilities arising from crude oil prices. This scheme is advantageous for different reasons. It checks the effects of volatility of crude prices and stabilizes domestic prices within a defined band, helps with planning by businesses and is more transparent. The stages of the proposed scheme are stated as follows:
i. Set maximum band of spot prices of crude
ii. Estimate long-run futures prices of crude based on moving averages of past futures prices.
iii. Pricing should be based on futures prices when spot prices are below the maximum band.
iv. The difference between the futures and spot prices should be saved (Differential market price). A fund should be created for this savings.
v. When spot prices are at the maximum band, pricing should be based on spot prices.
vi. If spot price increases beyond its maximum band, pricing should be based on the maximum band and the deficit financed from the savings of the Differential market price.
vii. When spot prices are higher than futures prices but below the maximum band, then pricing should be based on spot prices in order to avoid losses. This proposal is worth the consideration of the National Petroleum Authority.
The debate over petroleum product pricing is endless as far as the country has no control over the global oil market. Confidence building in the pricing regime is however very key to ensure public acceptance of the prices. Both the NPA and Government must realize that it does not serve the country any good purpose if the formula for pricing petroleum products is shrouded in secrecy and in technical jargons. Ghanaians deserve to know the truth and it should be simplified to our understanding. It is also important for customers and the general Ghanaian population to know that ‘cheap’ petroleum prices are not sustainable under current global oil market circumstances. We will not even have the privilege of our emerging status as an oil producing nation to buy cheap petroleum products since the world oil market is highly integrated. We therefore need to moderate our expectations of the oil find. We should also know that the pressure we put on politicians to undermine fundamentals of the petroleum sector is recipe for national economic disaster. Even though some amount of political considerations are necessary for implementing energy reforms and price determination, economics should be the leading factor if Ghana is to manage the petroleum sector more efficiently.