What Nigeria Should Have Done About the Oil Prices
On November 22, 2012, I wrote on this blog that the budget benchmark should have been placed at $63.99 per barrel. Read the blog post here.
The Brent Crude closed the week at $70.15. The Nigerian Minister of Finance and the Coordinating Minister of the Economy reduced the budget benchmark from $78 per barrel to $73 per barrel last week. Before the end of the week, OPEC rose from their meeting and told the world that they were not going to cut production and prices dropped and began to hover around the $70 mark, $3 below the budget benchmark. Now the Minister of Finance is going to activate Plan B and probably cut the benchmark to $65 per barrel. If we keep cutting and oil prices keep falling, we will keep cutting until there is nothing to cut again. This is perhaps the second best time to put pro-active measures in place to protect the Nigerian economy. The best time to have done something about this elapsed four months ago, just before oil prices started sliding, and we had about 6 years or so to do something about it.
Over the past decade Institutional Investors have been increasing allocation of their funds to commodities. This exposure was accelerated after the credit crises of 2008 as the global market was forced to grapple with a low yield environment, an after effect of the series of Quantitative Easing. This also forced investors to look the way of emerging economies such as Nigeria, and they fell over themselves to tap into the high yields provided by sovereign bonds, which only ended up crowding out the corporate sectors from borrowing from the fixed income markets. The movement of these hot monies exacerbated the inherent volatility in commodities pricing, which included crude oil. Since Nigeria is highly dependent on oil, the Government should have made efforts to hedge its position a long time ago because of these realities, but we did not.
I understand that it would have been an impossible proposition for the National Assembly to agree to a budget benchmark of $63.99 per barrel, certainly not when oil prices were above $110 over an extended period of time. However, not doing something about this meant that the Nigerian economy was left at the mercy of institutional investors who don't really care about the Nigerian economy. If in the process of wrecking any emerging market, money would be made, by Jove, these conscienceless investors would do it. Nigeria should have thrown these risk back at these big bankers before we got hit.
Before I delve into how Nigeria could have hedged this oil price risk, given the fact that the politicians would never have assented to dropping the budget benchmark when oil prices were high, let me provide some background information. The cause of the oil glut, which led to lowered prices, has been linked to the activities of the shale oil producers. There has been claims that these producers are likely to remain economical, and thus keep oil prices down because most of them would not be driven out of business until oil prices drop to $42. I don't believe that $42 claim one bit, regardless of the source. Many seasoned investors know that it is in the best interest of certain markets to manage information. The market also seem to believe that prices are not likely to drop further than current levels.
The foray of institutional investors into commodities trading allowed large investment bankers across the world to create instruments that are linked to different commodities such as crude oil. Thus an investor who has money but has no business with oil will be able to enjoy a rally or a fall in oil prices depending on how the contract is structured by the investment bank. When the new of shale oil hit and prices began to drop, many investors short the oil prices. This means that they bought financial instruments, which will make money as oil prices slide. When it gets to a certain level, these investors will begin to close out their short positions in order to lock in their profits. If they strongly believe that oil prices will continue to drop, they will keep holding on to these instruments and watch prices slide further. It is interesting to note that after the OPEC meeting, oil prices lost less than 10% and stabilized around the $70 mark. I strongly believe that these investors are closing out their positions and have kept oil prices at this range because they know what the general markets don't know. And what they probably know is that oil prices are near rock bottom, and this is a good time to take profits and leave. If indeed price of oil can reach $42 before most of the shale oil producers can be put out of business, why then has the price refused to drop below the $70 range? While I know that the price may still drop a little further but I am fully convinced that it will be hard for oil price (Brent Crude) to drop below $65.
With this background information. let us analyze what the Nigerian Government could have done to forestall this oil price shock from affecting the economy.
The Minister of Finance (MOF) is a respected figure in world economic circles. She could have used her influence to the benefit of Nigeria. Granted that the State Governors did not allow the proposed Sovereign Wealth Fund to see the light of day, which meant that Nigeria had very little economic buffers in the time of crises. The MOF could have negotiated to buy a put option from the leading global investment banks such as Goldman Sachs and JP Morgan but preferably Goldman Sachs.
This is how the put option would have worked. The MOF could have negotiated for a Brent Crude put option valued at say $95 per barrel. The price for the put option would have been much cheaper when oil prices were hitting the $120 per barrel. With a put option at $95 per barrel, Goldman Sachs would have been obligated to pay any difference in price whenever oil prices drop below $95. For example if oil prices drops to $90 per barrel, Goldman Sachs would have paid Nigeria $5. At $70, they would have been forced to pay $20 per barrel to Nigeria. By negotiating a 5 - 7 year contract, Nigeria can sit back, watch the world writhe as oil price shock hits and begin to put policies in place to diversify Nigerian revenues within the time frame. We would have been spared the rhetorics of raising $1 billion per year from luxury taxes. The Nigerian economy is over $500 billion, and $1 billion is just a drop in the ocean.
By buying the put option at $95, the MOF can negotiate a deal with the National Assembly (NASS) very easily. Once you agree to raise the budget benchmark to $80, they will sit down and listen to whatever you have to say. She could have used that opportunity to lobby the NASS to pass a law backing the SWF and transfer $7.5 per barrel of oil to the Fund. She could also sit down with the State Governments and negotiate to throw $7.5 per barrel at them through the Excess Crude Account (ECA), and they would have hailed her as the best thing to have happened to Nigeria. That way everybody goes home happy. The NASS gets their $80 benchmark, the State Governments get their $7.5 per barrel and the SWF also gets $7.5 per barrel.
Now the question remains on how Nigeria would have funded the put option to be purchased from Goldman Sachs. The MOF could have also negotiated with Goldman Sachs to manage the SWF, and then use that as leverage to water down the cost of the put option. Since she has already gotten the goodwill of the NASS and the Stage Governments, it would have also been easier for her to negotiate payments from the oil prices and thus reduce the effective put option price to say $92 - $93 per barrel, especially when oil prices were up there in the $125 per barrel region.
By purchasing this put option, Nigeria would have transferred all the risk of oil price drop to Goldman Sachs. The bank is considered as one of the critical components of the US economy and the US Governments would do everything to protect the bank. They would not watch the pride of the American economy come crashing down because of an agreement with one tiny country from Africa. That way Nigeria would have effectively transferred all the risks indirectly to the US Government and Nigerians would have been better for it.
Is this too late? It is not too late because I believe that oil prices would still climb. but it may not get to those stratospheric prices we enjoyed over the past few years, so the price of the put option may be more expensive. But at least it will save us from rash policies and we would stop grasping at straws such as luxury taxes that would only bring in $1 billion per year.
We are already here, and the luxury taxes is a step in the right direction, but the MOF should endeavour to do much more to diversify revenues.