AN ANALYSIS OF THE DETERMINANTS OF PETROLUEM DEMAND ELASCITIES IN NIGERIA

BY I.M GANI, ECONOMICS DEPARTMENT INTERNATIONAL ISLAMIC UNIVERCITY MALAYSIA DECEMBER 2011

1.1. Background to the study Energy plays a decisive role in the development process of countries, it not only powers nearly every production process, but it is also an important and fundamental component of the households consumption basket (Nadeem, 1990). In Nigeria for instance, approximately one quadrillion Btu of energy was consumed in 2008, out of which petroleum products accounted for 53% (of which gasoline is 70%), natural gas 39% and hydroelectric power 7% (EIA, 2009). From the foregoing, it may be ascertain that petroleum products and especially gasoline constituted a significant share of Nigerias energy mix. According to Fawibe (2009), petroleum account for over 78% of Nigerias national commercial energy consumption and has been the engine of growth fuelling the entire economy. At this point it is noteworthy that gasoline price and by implication its demand has been subsidized in Nigeria. However, the burden of subsidy on the national treasury and the inability to attract investment in the mid and downstream sector of the Nigerian petroleum sector has made all most all regimes in Nigeria to attempt to deregulate the downstream petroleum sector (Fawibe, 2009). These attempts however, are being strongly opposed by the labour unions, civil societies, opposition political parties and other segments of society (EIA, 2009). The roles gasoline plays to the Nigerian economy; controversies surrounding appropriate pricing; the increasing share of domestic demand and fuel shortages, suggests that estimating the elasticities of demand of the products is of paramount important for policy making, such that any deregulation policy takes in to account the major determinants of demand. This research is motivated by these controversies surrounding the downstream petroleum sector of Nigeria, thus, the research is justifiable and is significant to policy makers and will add to the existing body of literature. 1.2. Statement of the problem Despite the role being played by gasoline to the Nigerian economy, having appropriate policy for the downstream petroleum sector of Nigeria especially on pricing, has been contentious issue; oil subsidy remains one of the most complex socio-economic policy issue in Nigeria. A regulated subsidised pricing regime is operated since the mid-1970s, which has tremendous cost on the industry and the economy at large. For instance, between 2006-2008 over N1.2 trillion was spent on subsidy payments and subsidy claims for 2009 is estimated to reach N600 billion (Adeoye, 2010). In addition to this, subsidy has also discouraged competition 1

and stifled private investment in refineries, encouraged smuggling of petroleum products across neighbouring countries, put pressure on foreign exchange rate, and caused supply shortages (Adenikinju and Fobobi, 2006; CBN, 2007). 1.3. Aims and objectives of the research The research seeks to achieve the following aims and objectives 1- To estimate the short-run and the long-run gasoline demand elasticities in Nigeria. 2- To estimate the long-run price, gasoline demand elasticities in Nigeria. 3- To determine whether the estimated gasoline demand elasticities are significant in influencing petroleum products demand in Nigeria. 4- To determine the implications of these elasticities, to the impending deregulation of the downstream petroleum sector of Nigeria. 1.4. Research hypotheses and questions A hypothesis is a hunch, an educated or intellectual guess, which is advanced for the purpose of being tested and the results be used to explain observations, the formulation of hypothesis follows logically from literature or derived from theory (Burns, 2000), in this study, the hypotheses are derived from the economic theory of elasticity. Thus in order to achieve its aims and objectives, this research formulate to taste and answer the following hypotheses and research questions. 1- H0: Pump price of gasoline, per-capita income, urbanisation among others do not influence the demand for gasoline (in the short run) in Nigeria. H1 : Pump price of gasoline, per-capita income, urbanisation among others are significant in influencing the demand for gasoline (in the short run) in Nigeria. 2- H0: Pump price of gasoline, per-capita income, urbanisation among others do not influence the demand for gasoline (in the long run) in Nigeria. H1 : Pump price of gasoline, per-capita income, urbanisation among others are significant in influencing the demand for gasoline (in the long run) in Nigeria. 1- What are the short-run and the short-run gasoline demand elasticities in Nigeria? 2- What are the long-run gasoline demand elasticities in Nigeria? 3- Are the gasoline demand elasticities significant in determining the demand for petroleum products in Nigeria? 4- What are the implications of the gasoline demand elasticities for the impending deregulation of the downstream petroleum sector of Nigeria? 1.5. Scope and limitations of the research This study is to estimate the short-run and the long-run demand elasticities of gasoline for the period 1980-2010 and to determine their implications for the deregulation of the downstream petroleum sector of Nigeria. Various petroleum products are consumed in Nigeria, which include liquefied petroleum gas (LPG); household kerosene (HHK); premium motor sprit (PMS); high and low pour fuel oil automotive gas oil (AGO); lubricating oil; bitumen and asphalt, grease; wax base oil etc. However, this research will study gasoline because it constitutes 70% of all the demand for petroleum products in Nigeria. Moreover, other products were deregulated with exception of kerosene, which accounts for 7% of demand. The limitations of the research may include difficulties in getting appropriate data given the poor record keeping culture of Nigeria. This may lead the research to use multiple sources of 2

data, such as OPEC, central bank of Nigeria and the national bureau of statistics, World Bank data catalogue. The unavailability of data for a wide range of time has also limited the study period to thirty one years that is from 1980 to 2010 1.6. Significance and justification of the study Since the free market oriented economic reforms implemented in Nigeria in the mid-1980s, successive governments have been battling to deregulate the downstream petroleum sector. However, these efforts are being met by steep opposition especially from the labour union and civil societies and most of these oppositions are not based on empirical evidences. Therefore, estimating petroleum products demand elasticities and especially as well as determining their implications for the deregulation, which this study is aimed at, will provide a basis for policy makers to formulate appropriate deregulation policy in addition to enlightening other stakeholders. Although studies were carried out on the petroleum products demand in Nigeria, none of them particularly focused on the implications of the demand elasticities on the deregulation of the sector. Moreover, the subsidy, urbanisation, sector specific demand elasticities of gasoline demand were not studied despite the enormous role they might play in explaining the demand for gasoline in Nigeria. Therefore, this research is justifiable, as it explore a different approach to petroleum products (gasoline) demand in Nigeria. 1.7. Organisation of the study This study is organised as follows; part one gives the background to the study and states the research problem; it then state the research objectives and formulate the research hypotheses and questions. The significance, justification as well as the scope and limitations of the study were then identified. In the second part of this study related literature will be reviewed and the theoretical framework of the study specified and to be analysed. Part three of this study is the methodology in which, the sources of data to be identified and method to be used in analysing the data is to be highlighted. The model is then specified and its strength and weakness is to be identified. The paper is to be concluded in the last part. 2.1. Review of related Literature Liu (2004) applied a dynamic model to estimate elasticities for members of the Organization for Economic Cooperation and Development (OECD). His findings suggest that electricity, natural gas and gas-oil price elasticities are in general larger than income elasticities, while income elasticities are lower in residential sector than in the industrial sector. However, this study is conducted in developed OECD countries which have different energy policies and energy mix; therefore, assuming homogeinity among them is unrealistic. Thus, a country specific study is desirable, especially on developing and emerging market economies. Moreover, all most all OECD are net oil importers, which have market driven energy sector, thus, a study on net oil exporting countries is needed. To this end, Bhattacharyya and Blake (2008) conducted a study on domestic demand for petroleum products in the period 1982 to 2005 in the Middle East and North African (MENA) region, using dynamic endogenous model and OLS. The research discovered that the demand has grown quite fast in these countries, probably because of fuel price subsidy and rising income. Similarly, gasoline demand has better than other models in terms of producing signs for the parameters. Although, this study captured the nature of the demand of petroleum products in net oil exporting countries where prices regulated, it yet suffers from 3

the homogeinity bias by generalising the results on the entire MENA countries, therefore, failing to identify the elasticities of the demand in the specific countries. In a study on Nigeria an OPEC member, Iwayemi, et al. (2009) formulated and estimated petroleum products demand function for Nigeria using co-integration technique, the overall results revealed that the demand for petroleum products is price and income inelastic; however, kerosene and gasoline have relatively higher short-run income and price elasticities. This confirmed the results found in other net oil exporting countries, such as Kuwait, Gulf Coorperative Commission (GCC) and Middle East and North Africa Association (MENA) regions. However, co-integration technique used by Iwayemi, et al. (2009) and majority of other studies has various limitations. For instance according to Bhattacharyya and Blake (2008), co-integration relationships may be a pretty unlike occurrence and even if these relationships exist, Ordinary Least Square (OLS) yields super-consistent results. Moreover, the studies reviewed so far, do not seem to recognise subsidy as a major feature of most oil exporting countries, which may have impact on the demand elasticities of petroleum products in these countries. In Nigeria for instance, subsidy remains one of the most intricate socioeconomic policy issue over the years (Adenikinju, 2009). In addition to this, some other important determinants of petroleum products consumption in Nigeria, such as urbanisation, sector specific demand (transportation and household) among others are not captured by the above studies. Therefore, this study is set to fill these gaps by estimating the demand elasticities of subsidised petroleum products in Nigeria using dynamic modelling and OLS approach, interprets, and analyses their policy implication in Nigeria especially as regards the contentious petroleum price subsidy issue. 2.2- Theoretical framework of the study This study is underlined by the microeconomic theory of elasticity, which is credited to the work of the renowned British neoclassical economist Alfred Marshal in his book titled Principles of Economics published in 1890. The concept of elasticity provides a means of measuring the effect of price and income changes on quantity demanded of a commodity (Dobson, et al. 1995). Price elasticity of demand measures the change in quantity demanded of a commodity caused by change in price of the commodity, ceteris paribus. Availability and closeness of substitutes to a commodity, proportion of income spent on a commodity among others determines the nature of its elasticity. For instance, petroleum products seem to have virtually no perfect substitutes, thus, their demand tends to be price inelastic especially in the shortrun. Income elasticity on the other hand, measures the responsiveness of quantity demanded of a commodity to a change in income. Income elasticity is positive and less than one for normal goods and negative for inferior goods, normal goods are further classified into necessities whose demand is income inelastic and luxury whose demand is income elastic (Nicholson, 2002). Petroleum products are normal and necessity goods, therefore, theoretically their demand is supposed to be positive and income inelastic. Moreover, the demand for petroleum products is derived from the demand of durable goods and appliances such as cars. Thus, it takes sometimes to respond to changes in prices and income due to habit persistent, technology lock in, stock adjustment etc. Theoretically, it follows that demand for petroleum 4

products is more price and income elastic in the long-run when consumers might have adjusted to the changes than in the short-run (Crotte, et al. 2010). 2.3. An overview of the Nigerian downstream petroleum sector Nigeria has an estimated 36.2 billion barrels of proven oil reserves and 184 trillion cubic feet of proven natural gas reserves. Daily production of oil and gas averaged 1.94 million barrels and 1204 billion cubic feet respectively, Nigeria consumes approximately one quadrillion Btu of energy on annual basis and its per-capita energy consumption is 7.3 million Btu. The Nigerian economy is heavily dependent on oil, which accounts for over 90% of export earnings, about 85% of government revenue and over 40% of GDP (EIA, 2009). In 1950s, Nigerias major source of energy was coal, which accounted for about 70% of consumption; however, since the discovery of crude oil in the late 1950s crude oil gradually dominated the energy mix of Nigeria. Crude oil currently account for 53% of Nigerias energy mix followed by natural gas and hydroelectric power who account for 39% and 7% respectively, coal is virtually absent (EIA, 2010; Kupolokun, 2009). 2.4. Demand of petroleum products in Nigeria Average daily consumption of petroleum products in 2008 stood at 35.66 million litres. Of this figure, Premium Motor Spirit (PMS) or gasoline accounted for 25.96 million litres, Automotive Gas Oil (AGO) or diesel-4.15 million litres, Aviation Turbine Kerosene (ATK)2.87 million litres and Household Kerosene (HHK) or Dual Purpose Kerosene (DPK) accounted for 2.68 million litres (NNPC, 2008). The end use of energy (petroleum products in particular) in Nigeria has shown that household sector account for about 50% of demand while the industrial and the transport sectors account for 30% and 15% respectively (Kupolokun, 2009). This phenomenon could be explained by the continued shrinkage of the industrial sector of Nigeria over the years, due to inadequate power supply, thus leaving the household sector as the major consumer of energy. Moreover, this can be described as an evidence of Dutch disease. An important feature of the Nigerias energy demand and in particular petroleum products, is the rapid increase in their consumption, according to Oladosu and Adegbulugbe (1994) total energy consumption in Nigeria has grown faster than the GDP on aggregate since 1970. For petroleum products, this increase appeared to be in favour of gasoline (PMS) and kerosene (DPK), whose consumption has increased over the years. For instance, in the first quarter of 2009 PMS and DPK accounted for 72.9% and 16.4% respectively of petroleum products consumption, as against 69.27% and 7.14% in 2008. The key factors responsible for this rapid growth in consumption of petroleum products are rapid income expansion due to strong oil export performance and low energy prices. Other factors include fast growing importation of fuel inefficient second hand vehicles (mostly from Japan), acquisition of private electric generators in response to unstable power supply, high population and urbanisation growth rates and smuggling of petroleum products to neighbouring countries (Adenikinku and Folabi, 2006; Iwayemi, et al. 2009). 2.5. Supply of petroleum products in Nigeria Nigeria has four refineries with a combined installed capacity of 445,000 barrels per day (bpd), at optimum capacity the output of these refineries will be 18 million litres daily, which is insufficient to satisfy the domestic demand of refined petroleum products largely PMS estimated at over 30 million litres daily. The refineries are currently operating at far below 5

their installed capacity due to inadequate funding for their routine maintenance and sabotage of their facilities by militants, therefore, the demand short fall of petroleum products, which is almost 85% of demand, is met through importation (EIA, 2009; Kupolokun, 2009). The respective average capacity utilisation of the three refineries in the fourth quarter of 2009 stood at 0.02%, 4.17% and 0.00% for KRPC, PHRC and WRPC respectively, altogether they produced 47 thousand metric tons of finished and intermediate petroleum products (NNPC, 2009). In addition to these refineries, Nigerias downstream distribution facilities include 22 storage depots, 40 private depots, 5,120 km of pipeline network, 24 pump stations, 9 butanisation depots, 5 NNPC jetties and a number of private jetties (Kupolokun, 2009). The market for fuel importation and distribution in Nigeria is characterised by a near oligopoly market structure where few players dominate the market, these players are NNPC and about twelve major and independent licensed importers (Adeoye, 2010). For instance, 13,714.43 million litres of petroleum products was distributed in 2008, the major marketing companies (OandO, Total, African Petroleum, Conoil, NNPC retail, Mobil and Texaco) accounted for 69.85%, and the independent marketers accounted for the remaining 30.15% (NNPC, 2008). The regime of fixed prices for petroleum products, has precluded active private sector participation in the refineries, although government issued licences to eighteen private refineries in June 2001, all have been reluctant to start (Adenikinku and Folabi, 2006). 2.6. Pricing of petroleum products in Nigeria Energy pricing in developing countries and more specifically in oil exporting countries, has been influenced by socio-political motives (Birol, et al. 1995). Nigeria is not an exception to this, although it operated a deregulated oil price regime from 1960-1973, a uniform regulated pricing was introduced in the mid-1970s and government took over the downstream sector of the petroleum industry, which altered the market condition, this might connected with the high oil price in the international market at the time. Since then, petroleum products prices exhibited a period of stable nominal prices punctuated by sudden price changes, the prices often remain at the same level until the government is compelled to revise them upward when faced with economic difficulties (Adenikinku and Folabi, 2006; Fawibe, 2009). In Nigeria there has been a policy of keeping the prices of petroleum products low to extend their use to the poor since oil is considered a national free good, this trend continued until 1986 when market reforms under the structural adjustment programme (SAP) substantially decontrolled the prices (Oladosu and Adegbulugbe, 1994). This culminated into a major price increase in 1993, which remain a turning point in the pricing of petroleum products in Nigeria. The prices witnessed astronomical hike, for instance, the price of PMS-gasoline was increased from 70 Kobo to N3.25 (364%), and kerosene price was increased from 50 Kobo to N2.75 (450%) while AGO-diesel price was increased from 55 Kobo to N3.00 (445%) (Iwayemi, et al. 2009). Currently the petroleum products pricing regulatory agency (PPPRA) is responsible for determining the pricing policy of petroleum products and regulating their supply and distribution. It manages the petroleum support fund (PSF) that was established to cushion the effects of high international oil price on the domestic market (Kupolokun, 2009). The PPPRA employed a fixed pricing formula based on a pricing template of import parity prices plus mark-ups for transportation, distribution, and marketing and guaranteed margins. Going by this policy, PMS prices and until recently kerosene and fuel oil are fixed by government 6

through PPPRA, but the price of diesel was deregulated in 2007 (Adeoye, 2010). The very small ratio of diesel-powered vehicles in Nigeria made this deregulation easier for government, compared to gasoline. 3.1. Methodology Data on gasoline demand, its pump price and real GDP in Nigeria from independence to date constitute the period of this research, however, convenience sampling; a non-probability sampling technique is going to be employed to select the sample period (31 years). This is because the chosen sample period is simply available to the researcher by virtue of accessibility (Bryman and Bell, 2003). The research will cover the period 1980-2010, although Nigeria started operating a regulated (subsidised) petroleum products price regime in 1975 (Fawibe, 2009), the choice of the sample period was informed by availability and accessibility of data. Gasoline is selected being the major subsidised petroleum product in Nigeria. The data to be collected from the above sources is going to be analysed using multiple regression analysis. The term regression was coined by Sir Francis Galton (1822-1911) when studying the relationships among the heights of children and their parents. Multiple regression is concern with describing and evaluating the relationship between a certain dependent variable and two or more other independent variables (Maddala, 2001). 3.2. Model specification Following Bhattacharyya and Blake (2008), Lagged endogenous dynamic model is going to be used as against a simple static model, this is because the latter cannot capture the complex process of adaptation to changes in prices and income and will not be able to pick up the important differences in the rate of adjustment between short and long run (Bhattacharyya and Blake, 2008; Waverman, 1977). More so, the dynamic model is going to be used due to the fact that demand for petroleum products is an indirect demand, they are always consumed with energy using equipment, which are often long-lived and therefore complete adjustment can take a considerable amount of time (Dahl, 1993). This is as a result of stock adjustment mechanism; habit persistence; earlier commitments; costs involved in replacing existing capital stock and lack of information (Al-Faris, 1997; Crotte, et al. 2010). 3.3. Strengths of the model According to Sterner, et al. (1992) the lagged endogenous dynamic model has been the most popular and often the most successful model for demand analysis. It also performed better and produced superior results against other models, such as static, inverted-V lag and polynomial distributed lag models in a study on OECD countries. Co-integration and error correction model seems to enjoy a wide applicability in estimating demand elasticities; however, as reported by Bhattacharyya and Blake (2008) dynamic model estimated using ordinary least square yields super-consistent result. Confirming this, Dahl and Kurturbi (2001) cited in Bhattacharyya and Blake (2008), compare their co-integration and error correction model (ECM) results with a lagged endogenous model, which served as benchmark, they found the results of ECM questionable for short-run elasticities and expressed more confidence in the lagged endogenous dynamic model results. 3.4. Limitations of the model However, in spite of the attractiveness of the lagged endogenous dynamic model, it is major limitations include the potential for multicollinearity problem, between the lagged 7

endogenous variable and some of the independent variables. This may lead to difficulty of disentangling the separate effects of each of the independent variables on the dependent variable and model instability (Maddala, 2001). In order to sort out the problem of multicollinearity, a sample static model is estimated so and the results is compared with the dynamic model results, to determine the impact of the multicollinearity if it exists at all. 3.5. Functional form of the model The model is specified in natural logarithm, that is log-log (log-linear or double log) form to represent the long-run demand for gasoline, this is because it yields elasticities in a convenient form; takes care of heteroskedasticity; removes non-linearity to some extent and normalise the data (Koop, 2000; Vogelvang, 2005). Moreover, according to Huisman (2009) no information is lost by taking the natural logarithm of variables. The model is thus specified as follows. LnPMSCt = 0+ 1LnPMSPt+ 2LnRPCIt + 3 LnURBt + 4LnTRNSt + 5LnHHSt+ 6LnSDEt 7LnPMSCt1 + t 1, to 6 are the respective short-run elasticities and 7 is the coefficient of adjustment. The long-run elasticities are computed using the following formulae adopted from (Vogelvang 2005), 1/ 1- 7, 2/ 1- 7 5/ 1- 7 where 1- 7 is the speed of adjustment to the long-run equilibrium. Other components of the model are described below. LnPMSCt is the log per-capita gasoline consumption in litres LnPMSPt is the log of pump price of gasoline in Naira per litre LnRPCIt is the log of real per-capita income LnURBt is the log of urbanisation (ratio of urban population to total population) LnTRANSt is the log transportation demand for gasoline LnHHS t is the log of household sector demand for gasoline LnSDEt is the log of subsidy expenditure LnPMSCt-1 is the log of per-capita gasoline consumption in litres t is the error term. 3.6. Diagnostic and specification tests Violation of some of the assumptions of multiple regression analysis may invalidate the results of the model, assumptions such as that of homoskedasticity, no autocorrelation and multicollinearity are particularly significant for model stability. Some of the consequences of not conducting such tests include the failure to detect the presence of heteroskedasticity and autocorrelation, which generate inefficient estimators, wrong standard errors and depressed t and F statistics values. In the current study, a White test for heteroskedasticity will be conducted in which the null hypothesis of no heteroskedasticity in the residual of the model is to be tested against the alternative hypothesis that there is heteroskedasticity in the residuals. The popular Durbin-Watson test for first order autocorrelation may not be suitable for an autoregressive model specified in this research (Al-Faris, 1997). Therefore, Breusch-Godfrey Lagrange Multiplier (LM) test of auto or serial correlation is going to be carried out to test for the presence of first order autocorrelation in the residuals of the model. To detect whether there is multicollinearity between the independent variables, a correlation matrix of independent variables is to be observed by running a pair wise correlation of all the independent variables; the respective correlation coefficients are then to be determined and 8

any one greater than 0.8 means serious multicollinearity. Alternatively, Kliens rule of thumb is to be employed; the rule states that multicollinearity may be a troublesome problem only if the R2 obtained from an auxiliary regression is greater than the overall R2 of the main model (Gujarati, 2003). In order for policy implications to be drawn from the results of the model, it has to be stable that is, it is specified in correct functional form and no important variable(s) is omitted. This is to be tested using the Ramsey RESET test.

Conclusion Gasoline plays a significant role to the Nigerian economy, however, in spite of this; appropriate policy for its pricing has remained a contentious and lingering issue. Owing to this knowing the true determinants of gasoline demand in Nigeria is of paramount important, alas previous studies fall short of capturing some of the important determinants of gasoline demand. This study is aimed to bridge this gap and will use endogenous dynamic model to estimate the price, income, urbanisation, subsidy, sector specific elasticities of gasoline demand in Nigeria.

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