EFFECTIVE MANAGEMENT TECHNIQUEFOR

OIL REVENUE AND SUBSIDY IN NIGERIAN ECONOMYBy

Jumbo GodwinJumbogodwin1@yahoo.com

08036843122

EXECUTIVE SUMMARY

If you ask me, I will probably tell you that the Nigerian financial management structure and philosophy is very faulty. Consider that thepopulation of Nigeria continues to climb unchecked while social demands like subsidy becomes a nightmare for both the governed and theGovernment. The Nigerian state needs a comprehensive social-cultural analysis, for this is the core from which her predicament evolves.Cultural ideologies regarding family size and offspring, needs to be addressed, if Nigeria must keep its population within manageable limitscomparative with her resource. The resource with which Nigeria is administered is limited and has always remained limited since inceptionof the entity called Nigeria, but population has been climbing. This is one reason, aside from corruption; a lot of government policiescannot be executed. And guess what? I think it will get worse. The ASSU strike and other striking sect are just the beginning of thisdisruption. There is so much population demand on the government but revenue is inadequate. This is the bitter and untold truth inNigeria.

While there is need to check arbitrary family size and unrealistic cultural ideologies about offspring, the government needs to adequatelymanage its income and abate corruption.

The continued friction inherent within the Nigerian Socio-political Economy as a result of the tension caused by fluctuating revenue fromOil sale and the need to subsidize retail energy consumption within the Nigerian economy can actually be mitigated with a strategicmanagement tool.

In short, “price risk” is the one single contributing factor causing the whole tension aside from the other issues, like the need for morelocal refineries and vandalism.

When the Nigerian oil price benchmark is at say $70/barrel and national budget are built around this figure, a potential downside risk isleft unmanaged for “Oil Revenues” and at the same time a potential upside risk is left unmanaged for “local Energy Subsidy”The scenario described above is like a “double jeopardy”. The Nigerian economy expect to realize better revenue from sale of crude oil ata “price above the benchmark”, but the “price above the benchmark” will cause the burden of “local Energy Subsidy” to increasedramatically. (See graphical illustration below fig 1a)On the other hand, “price below the benchmark” will distort “Oil Revenues” expectations negatively, but will alleviate the burden of“local Energy Subsidy” on the economy.

There are two very important risks levels that should be effectively managed to improve revenues from oil and reduce the burden ofenergy subsidy significantly on the Nigerian Government-

1) price above the benchmark2) price below the benchmark

Fig. 1aDouble Jeopardy

ANALYSIS

The above price illustration shows clearly the kind of decision that should actually be made at below or above the benchmark price. Theillustration also shows which decision is best at the time and which will yield the most effective management tool.

Point A is the best time to maximize revenue for medium to long term

Point B is not a good time to be subsidizing the whole nation, it will be very expensive to achieve.

Point C is not the best time for maximizing revenue potential

Point D is the right time to employ the medium to long term subsidizing technique, it will be cheaper to achieve at this period

The Dynamics Explained

It is important to note that as price of crude fluctuates so does the price of all other energy products. The prices of energy products havealso been found to have a 1.5 delta comparatively with crude. This is one factor why the Nigerian Government will continue to struggle tomaintain its subsidy programme, and especially in the face of uncontrolled population.

At the period when price of crude has gone above the benchmark, the burden of subsidy will have increased by 150%. To avoid Socio-political tension other projects might be foregone, in order for the subsidy programme to be maintained. Other projects definitely suffer asa result and a serious strain is put on the Central Bank to manage the exchange rate because of falling standard of living, high cost of livingand unabated unemployment.

Now is the time to act! This economic method may not be sustaining for long.

MITIGATION TECHNIQUE

There are multiple channels of mitigating the current situation. But firstly, a team should be convened with the responsibility ofimplementing and managing the channels. “Price risks” are dynamic and so should the team, its mandate and its tools.

Reducing the burden of subsidy

The cheapest period to subsidize is at point “D” on fig 1a above. By factoring in the average annual cost of subsidy, an appropriate riskexposure can be determined to maintain a balanced hedge solution.

Assuming:X is the annual fixed pump price of energy in NigeriaS is the variable average annual cost of subsidyY is the actual cost of supplying energy to Nigerians at any point in timeThen X+S=YY1= Y- b percent of Y at “D” where “b” is the percentage drop in priceS1=S - b percent of Y at “D”At S1 subsidy will be cheap all year long but price cannot remain there for long. The concern is “what if price spikes higher” to say“Y+50% of Y”. What this means is that we spend extra “50% of Y + b percent of Y” on subsidy. This is very expensive; we shouldtherefore make more subsidy deals at “D” and rather save “50% of Y + b percent of Y” for the economy to spend on other projects.

Deals at “D”1. Buy 12 different types of call option contracts into the 12 month annual subsidy budgeting at “D” at between 5 and 10 percent.2. Buy cheap energy futures contract at “D” and liquidate accordingly through the 12 months subsidy cycle3. Open a position on the energy CFD proportional to the annual energy consumption volume at “D” for less than 5% margin and

liquidate according to subsidy demand.

Improving Revenue from OilAt price “A” is where all the sale of the Nigerian crude should always occur. Unfortunately price cannot stay at that price all year long. Sotherefore, more proactive deals should be made at “A” in order to maximize price.

Deals at “A”1. Gradually start Selling crude futures contract to the global market

2. Open a short position in crude oil CFD with less than 5% of current price, but actively manage price with the intention ofmaximizing both portfolio performance and hedging needs.

3. Sell call option contract at premium. Categorize sale into blocks of four types expiring in 3 months.

4. Use the revenue generated from the call option premium to buy put option contract in crude to cover the unexercised call optioncontracts in future.

BENEFITS/CONCLUSION

This is a very effective method of guaranteeing surplus revenue and avoiding the friction of price decline from the benchmark price. It alsoprevents excess cost of subsidy. At the end of the financial year the economy would have actually saved (50% of 2Y + b percent of 2Y)amount of money.

This will be a colossal gain for Nigerian finance and the economy in general. The money saved can be reinvested into other projects andgenerate employment to improve the standard of living of Nigerians.

In addition, Government must start looking for new socio-cultural ideas that will replace the present primitive ones that promoteunnecessarily large family. Or else Nigeria will always live inadequately both at the micro and macro level.

In sum, the frequent tension associated with subsidy will be mitigated pending the time the local refineries are fully operational.