One of the events that shaped the week includes CBNs statement suggesting a potential Naira devaluation making it find a new equilibrium at NGN156/USD from the current NGN150/USD. Given the negative effect of FX volatility on foreign portfolio investors and the fragmented profit taking on the back of positive October performance [NSEASI +2.76%], the market witnessed cautious play during the week while global markets advanced though in a zigzag trend on concerns over Greece referendum and the possibility of Greece pulling out of the European Union.Much in line with our view, the NSEASI reversed Friday after a 2-day downtrend, although closed negative 1.77% for the week. At the closing bell, NSEASI stood at 20,532.41pts while market capitalization came to NGN6.52trillion. We expect mixed trading ahead of a 3-day trading next week. In terms of activity level, volume and value of transactions shrank by 85% and 51% respectively relative to the previous week. A total of 1.3billion units of shares worth NGN 11.98billion were traded in the course of the week.Expectation is that rate across fixed income instruments should stabilize as September 2011 FAAC allocations hit the financial system in the week ahead. We expect the increased liquidity in the system to filter into the fixed income market and money market which will lead to a lowering of rates on Federal Government bonds as well as tenured funds at the interbank market.SUBSIDY |CREATING WEALTH FOR A FEW THROUGH IN-EFFICIENCIESFull deregulation: A disconcerting situationIn spite of Governments repeated desire to diversify the economy, the financial muscle of Nigeria is still largely dependent on petrodollars. 80% of the national budget over the last decade has been financed by revenue from this "economically distracting" national resource, given the nations inability to harness its other potential sources of income. Crude oil, as it is referred to, has become a key driver of the Nigerian economic engine, and fluctuations in its international market prices sends shock waves down the pockets of government and affects the financial position of the nations reserves.Given the humiliating state of the nations four (4) refineries, and the recalcitrant attitude of successive governments towards their repairs resulting in their inability to optimally refine the extracted crude, the downstream sector via importation of refined crude oil, has the potential of being exposed to the vagaries of international petroleum prices as the local refineries produce less than 20% of local consumer needs.Governments attempt at cushioning the effect of global refined oil prices on its populace by subsidizing the pump prices of PMS (petrol) and HHK (kerosene) (given their economic significance on the class of its highest users) might be a thing of the past. Consumers might now be forced to face the stark reality of the price of what they consume whilst, struggling with an economy-wide liquidity squeeze due to the increased monetary tightening activities of the Monetary Policy Committee [MPC].The issue of sincerity of purpose and the precedence of the government in areas of policy implementation comes to play, as arguably, the in-efficiencies of the subsidy program and the loopholes associated create wealth for a few, without a full pass-through to the masses.In our opinion, the removal of the inefficiently managed subsidy would bode well for the economy in the long run, as it is expected that c.NGN1.2trn anticipated savings to the government from the subsidy removal could be channeled to more productive avenues, and encourage foreign participation in the downstream sector. However, its proposed plan for implementation might be a cart before the horse move as the potential benefit might come far too late to ameliorate immediate hardship.Subsidy and the Economy: A global perspectiveSubsidy is used by governments world over to provide support for the masses in the areas of social services such as transport, energy and agriculture sector. Viewed as avenues for re-distributing the nations wealth, major oil producing nations subsidize their petroleum products for local consumption. Venezuela, amongst the OPEC producing nations sells the cheapest petrol at less than US$0.03 a litre, significantly lower than the price in the US ($1.04). According to the international energy agency (IEA), global subsidized consumption of fossil fuels amounted to US$557bn in 2008. It is expected that a removal of subsidy would cut global oil demand by 6.5mbpd in 2020, and the G20 leaders have committed (in September 2009) to rationalize and phase-out over a medium term, inefficient fossil fuel subsidies that encourage wasteful consumption.Although the populace feels the benefit, the subsidy expense reduces infrastructural investments as allocations are altered in a bid to adjust to higher oil prices. The oil subsidy also encourages wasteful consumption as for instance, domestic gas, which is an economically cheaper cooking fuel relative to kerosene, is lowly consumed. However, the demand for kerosene is strong because of the perception that it is cheaper thanks to the c.N90/litre subsidy, which is at heavy cost to the government.Economically, subsidy might not be a realistic long-term policy. The precedence of the Nigerian government presents a dilemma, as benefits seen through lower fuel prices might be better felt, than a Houdini on the reserves expected to be used for infrastructural development.Deregulation: an unavoidable option'The free market economic system encourages competition and investment, which brings in quality, efficiency, varied initiatives and price reduction from competition, thereby improving standards of living.The removal of the petroleum subsidy is an attempt by government to deregulate the downstream sector of the petroleum industry indicating that the government is sensitive to the shortcomings of the existing state-owned refineries and distribution mechanism. It further assumes that both local and foreign investors would be interested in building new refineries, and profitably manage existing refineries (which will require huge investments to revamp) and thus open the market to competitive pricing and marketing.The petroleum marketers (post-deregulation)One of the many rationales for deregulating the downstream petroleum industry is to allow competition by encouraging more companies to get involved and eventually supply the market at competitive prices. This is backed by the awaited Petroleum Industry Bill [PIB] which desires to compel major multinational oil companies operating in Nigeria to refine not less than 50% of their crude oil in the country. Based on the low sulphur content of the Nigerian bonny light (sweet crude), this implies c.47.7mlpd of petrol, which is in excess of the estimated c.40mlpd consumption of petrol in Nigeria. Invariably, there would be Increase in supply, thereby encouraging competition and lowering the pump price.Effectively, the industry will welcome new players and will leave the profitability of the business open to the dictates of economies of scale. Furthermore, revenue generating-ability in the sector will be determined largely by size and comparative advantage, with the big players thriving. Pricing would be a major area of competition post deregulation, in the absence of cartels, as is experienced in the diesel market. With cost of transportation now expected to be borne by the petroleum marketers, we anticipate a concentration of distribution outlets in the coastal areas in order to cut down on the cost of transportation from the ports and jetties. In light of this, Fuel cost is expected be cheaper in coastal areas like Lagos, Port Harcourt and Calabar, whereas the northern regions might witness higher pump prices of PMS and HHK (though there are indications that HHK might not be deregulated). We also expect consumption to shrink as consumers adjust their income to the new pricing level. Also, in our view, we suspect a boom in the mass-transit transportation sector which is largely powered by AGO (Diesel) as consumers [majorly the low-to-middle income earners] are compelled to use public transportation. Notwithstanding, the expected short-term shocks, the economy in the long term should be better off. The level of infrastructural deficit and decay however beclouds the potential benefits of a fully deregulated downstream petroleum industry.Impact on investmentsIn our view, the impact of removal of subsidy on investments, particularly capital market investments, appears remote but could have crippling implications if the government fails to deliver on improving infrastructure. On the back of the removal of the subsidy, we expect an increase in inflation, which will trigger the monetary policy committee to respond with further tightening measures particularly increase in the benchmark policy rate. Portfolio investments might suffer from reduced disposable incomeAssuming a stable marginal propensity to save, reduction in disposable income might affect investors ability to play the capital market especially equities as funds are channeled towards consumption. However, given the over 70% foreign participation in the equities market, and their (foreign investor) limited exposure to the real sector liquidity squeeze, the plight of the equities market might not be significantly influenced by the reduced liquidity of local investors.Given the positive nexus between increasing interest rates and fixed income instruments yield, we see strong attraction into fixed income asset class at a disadvantage to equities market as the need for further increases in the benchmark rate due to the inflationary tendencies of the subsidy removal would trigger rising yields in the fixed income market. Subsidy removal and Monetary PolicyClearly, one of the premises for antagonistic view on the removal of subsidy is the inflationary impact it has on price level. The removal will trigger commodity prices to soar; cost of transportation locally will likewise escalate. Small businesses will be threatened; consumption may reduce as purchasing power will shrink in the short run. This in turn poses a challenge to the monetary authority [Monetary Policy Committee MPC] responsible for maintaining a stable price level and stimulating economic growth. The impact of fuel subsidy removal on price level if brought into perspective with other factors such as excess liquidity from fiscal rascality and expansionary federal government budget, unaided by the import-dependent nature of the economy stresses the need for sharp monetary policy intervention.In a recent extra ordinary meeting on October 10, 2011 held by the MPC, a key resolution was to increase the benchmark rate (Monetary Policy rate MPR) to 12.0% flat. This move, though with potential to hurt real economic growth, is an attempt to front load interest rates in order to curb anticipated inflationary pressure partly stemming from the subsidy removal.Attractiveness to FDIThe growing national orientation towards a more private-sector led economy has attracted private funds from both the domestic and international community into the real sector of the Nigerian economy. Total FDI inflows into the country has grown at a compounded annual rate of 18% in the last 10-years (vs. 7% for developing economies and 22% for Africa) and Nigeria currently absorbs 10% of FDI flows to Africa.A deregulated energy sector in a populous nation like Nigeria, with little or minimum barriers to entry is an economic magnet to foreign investments. Both local and foreign investments into the downstream oil sector will bode well for the industry in the long-run as was experienced in the telecommunications sector with the introduction of the GSM telecommunication platform. Alternatives to direct subsidy removalCurrent comments by the minister of petroleum resources, points to likelihood that the deregulation would be restricted to PMS (petrol), while HHK (household kerosene) would remain regulated in the near-term. In our opinion, an alternate approach to an immediate removal of subsidy on PMS would be a gradual removal stretched over a period of 2-3 years, to cushion the impact and untold hardship, which would be created on motorists by the extra NGN82/litre post deregulation.Taking a cue from post-deregulation in Iran, the government set aside laws for the redistribution of additional revenues to be generated, with 50% going back to the households as cash, 30% geared towards supporting businesses, and 20% to the government. However, we do not recommend this approach, given the CBNs struggle with inflation, and the demand-pull inflationary consequence of a direct cash injection.Fixing the local refineries would significantly increase local productive capacity by c.80% from current output level whilst alternatively; Tax breaks/waiver could be used as incentives, like in the U.S. to lower the cost of production for oil producers.Outlook post-deregulation The governments desire to ameliorate the plight of the poor with revenue savings though laudable has been met with dissenting voices. More than 70% of the 2011 budget was channeled towards recurrent expenditure (largely salaries and wages), whilst an estimated over 45% live below the poverty line. In our opinion, the monthly subsidy amount of over NGN80bn if channeled towards infrastructural developments would no doubt benefit the nation. However the precedence of past governments in managing the nations finances lives a bitter taste, and one wonders if leaving the subsidy with all its inefficiencies might not be a better option that gambling on the sincerity of Government.More allocation to the tiers of Government Cringing under the weight of the new wage structure, state governors would no doubt welcome the removal of subsidy to free more revenue through allocations to their constituencies. In light of the 13% derivation fund that is allocated to the oil producing regions based on the revenue sharing formula, it is expected that the oil producing regions would benefit further from the fattening of governments purses. Furthermore, with the anticipated increase in budget benchmark on oil revenue to $75/barrel and 2.28mbpd, the 2012 budget is expected to be further expansionary, while it major source of revenue is on the decline with crude oil production dipping below 2.1mbpd for the month of September. This coupled with percentage of un-implemented portion of the 2011 budget on infrastructural development in light of the electioneering spending which would be carried over to 2012 shows the need for the government to harness all its sources of income or encourage fiscal consolidation, which should optimally start from reducing recurrent legislative expenditure.We are overweight on the long-term positive impact provided the government deploys the savings appropriately. The public is aware of the need for appropriate pricing but their historic mistrust of government, due from poor record of financial accountability and recklessness, is a major rationale for the general resistance to the removal of subsidies. For the move to succeed, government needs to address these concerns. In addition, savings from the subsidy removal must be judiciously invested in sectors of the economy that will positively impact the majority of the citizenry.
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