Nigeria: Before the oil runs dry

Following the steady decline in oil prices, we deem it fit to revise this report as the arguments herein still remain germane to the need for Nigeria to urgently address its dependence on oil revenues. This report was originally released in December 2010, following the approval for an increase in Nigeria’s minimum wage and its consequences on public sector finances, especially for the federating states.

While the arguments for and against Nigeria’s debt profile continue, we believe the assessment, viability and sustainability of the current model of funding Nigeria’s federating states remains largely ignored. In our opinion, this is fundamental to Nigeria’s ability to achieve and sustain economic growth and development in the long run.

At present, states receive a substantial portion of their income – average of c. N3.8 billion as of June 2014 – from the Federation Account Allocation Committee (FAAC), which is the body responsible for disbursing revenues that accrue to Nigeria’s federation account; the account credited with Nigeria’s oil and non-oil revenues, and from which disbursements are made to the three tiers of government – federal, state and local. For example, between January 2013 and June 2014, FAAC has distributed c. N8.2 trillion (c. $49.1bn) to the federal, state and local governments.

Of particular concern is the accelerated depletion of the nation’s Excess Crude Account (ECA), a saving-for-the-rainy-day account set up by the previous administration for the excess of the actual selling price of the country’s oil over the budgeted price. At present, the ECA stands at c. $4.1 billion from $20 billion in January 2009, indicating disbursements of over $15.9 billion – c. N2.7 trillion – within the period.

Most states in Nigeria are predominantly funded by allocations from the federation account, whilst internally generated revenues (IGR) remain weak and inconsequential in some states. On the average, statutory allocations to states from the federation account is c. 20.4 percent of total disbursements while allocations to the federal and local governments are 40.1 and 15.7 percent, respectively.

Withdrawals from the ECA can also be attributed to the spike in FAAC disbursements, resulting in a rapid decline in the accrued savings from excess crude revenues. Regardless of the sheer volume of funding disbursed since the inception of Nigeria’s federal revenue allocation system, basic infrastructure still remain non-existent or at best very weak while states continue to receive the monthly FAAC allocations. In general, given that recurrent expenditure consumes c. 68 percent of states’ total expenditure, the vast majority of states barely have enough funds left to develop infrastructure that will attract investments and aid growth and development. This has led to an assumed impression that many states in Nigeria “live for FAAC allocations” as their entire economic viability is dependent on the federal government.

For example, as a result of the increase in minimum wage in 2010, states indicated the preference to vest the power to resolve labour issues within a state and by the state government, as opposed to the federal government as is the current practise. The Exclusive List contained in the Nigerian constitution empowers the federal government to deliberate on all labour issues “including trade unions, industrial relations; conditions, safety and welfare of labour; industrial disputes; prescribing a national minimum wage for the Federation or any part thereof; and industrial arbitration.” But, as states seek greater autonomy within the federation, it becomes important that each state begins to seriously look inward to improve economic viability.

We therefore believe that states in Nigeria need to urgently begin to develop a funding model with a long term view of reducing their economic dependence on the federal government. This is also critical to each state’s ability to access the debt capital market for project financing. In our opinion, the current practice of securing repayments to investors in state bonds with an irrevocable standing payment order (ISPO) may be tested extensively in the years ahead if states continue to maintain weak IGR profiles whilst recurrent expenditure continues to increase.

In our theory, a hitherto uneconomically viable state should be able to challenge other economically viable states for the location of industries and other institutions for the creation of jobs and increase in revenues that accrue to the host state. Our theory indicates that this is possible following the implementation of deliberate economic reforms that seek to develop and sustain infrastructural development, which in turn attracts investments. This we believe is an area where fiscal policies such as taxes amongst others, may be well utilised to drive economic growth, as in most progressive countries.

Incentive compatibility

In a distributed or open environment where agents are self-interested and goal oriented, they might pursue any means available to them to maximize their own utility. That could lead to undesirable situations where some agents would try to influence the solving process towards solutions that are more preferable to them, but not necessarily acceptable to others, or sub optimal to all in any case.

In our theory, the concept of incentive compatibility can be used to describe the set of rules or procedures for which, in this case, states within a country collectively agree and find that it is within their best interest to act in unison to achieve an agreed set of goals.

At present, most states rely heavily on the federal purse for revenues as shown on the left side of the diagram above. Truth be told, this situation does not encourage states to aggressively seek ways of generating revenues internally as the incentive is weak.

However, as depicted in figure 6, the right side of the diagram shows a situation where a state’s investments in infrastructure attract private sector growth, which consequently leads to increase in revenues (generally taxes) that will accrue to the state. Thus, making the state’s revenues more robust, independent and sustainable.

One of the key assumptions of our theory is that states will adopt a judicious application of FAAC allocations in the years ahead to develop infrastructure and consequently attract investments. This should be done by gradually scaling back the burgeoning public sector and investing FAAC allocations into hard and soft infrastructure that will support the expansion of private sector activities.

Why is this required? Besides the increasing global awareness for the need to develop alternative sources of energy, we also consider that, according to the Department for Petroleum Resources, Nigeria’s crude oil would not last beyond 25 years at the current rate of depletion. In addition, the oil-producing Niger Delta region of the country remains a flash point as seen by the recent resurgence in militancy in the region, regardless of the government’s amnesty plan. Therefore, in the long term, a state’s viability within the polity rests on its ability to generate internal revenues to sustain growth and development and financial independence.

The Lagos State example

To this end, Lagos State of Nigeria has demonstrated the feasibility of this theory following the accelerated growth of its IGR since 2004. Overall, Lagos State’s funding model underscores our point as it highlights the fact that there is a strong positive correlation between a state’s sustained revenue generation ability and its infrastructural development.

In our analysis of Lagos state’s finances between 2004 and 2013, IGR increased from N34 billion in 2004 to N236 billion in 2013 indicating a 24.0-percent compound annual growth rate (CAGR). Also, statutory allocation as a percentage of total receipts dropped from 40 percent in 2004 to 19 percent in 2013, as a result of the increase in IGR over the years.

Our analysis further revealed that statutory allocation to the state is significantly less than recurrent expenditure, which is an average of c. N115 billion per annum and would have resulted in an average annual shortfall of N70 billion. However, the state’s strong IGR sustains much of the growth in total receipts and investments in infrastructure.

Using the Lagos State as a benchmark, it is evidently possible for states to generate at least 1x the size of their respective statutory allocation received from the federal purse. It has also become obvious that increased investments in infrastructural development will result in an increase in IGR as the state continues to attract new investments whilst existing companies/institutions thrive.

Consequently, states should adopt the doctrine: “if I don’t attract the right form of businesses to my state, I will not have any revenues” – such revenues to the state by way of taxes and levies. With this doctrine imbibed, states will then aggressively seek to increase their IGRs and invest in infrastructural development… and the cycle will evolve.

Is the current allocation mechanism optimal for incentivising the states, economic and infrastructural development? This has to be assessed against the backdrop of the possible elimination of state and private sector incentive compatibility as states continue to rely solely on the federal purse for revenue generation.

The 80-20 rule (Pareto principle) is indirectly operating in Nigeria as approximately 12 percent of the land mass generates 67 percent of federal revenues. At present, the nine oil producing states in Nigeria have a land mass of c. 111,937sq. kilometres which accounts for 12 percent of Nigeria’s total land mass of 923,768sq. kilometres. The states are Abia, 6,320sq. km.; Akwa Ibom, 7,081sq. km.; Bayelsa, 10,773sq. km.; Cross River, 20,156sq. km.; Delta, 17,698sq. km.; Edo, 17,802sq. km.; Imo, 5,530sq. km.; Ondo, 15,500sq. km., and Rivers, 11,077sq. km.

According to the Central Bank of Nigeria’s economic report for August 2014, oil revenues from these states have accounted for 67 percent of federal revenues whilst non-oil revenues have contributed 33 percent.

In this case, our theory compares a country to a company where all divisions are expected to contribute to group revenues. Any other practice would suggest an imbalance in the company’s revenue generation strategy and that certain divisions are not viable thereby hindering overall company growth.

To address this imbalance, each division will need to add to the revenue of the company or country. This we believe can be dealt with by re-directing FAAC allocations into infrastructure development to create jobs and private sector opportunities; at the same time adjusting the size of the public sector to a more manageable level.

Oil revenues: RES IPSA Loquitur

In our analysis of Nigeria’s oil revenues over the last 34 years, it was deduced that the country’s real oil proceeds per capita declined by c. 54 percent to $1.45 in 2013 from $3.13 in 1980, indicating an effective drop in the nation’s real wealth regardless of the increase in nominal oil revenues over the years.

For our analysis, we considered data on the spot prices of Nigeria’s crude oil over the last 30 years which indicates that in 1980 the country sold its prime commodity at $36.98/barrel with production levels at c. 2.059 million barrels per day (mbpd) resulting in revenues of c. $76.14 million per day. As at December 2013, Nigeria’s crude was sold at c. $111.95/barrel whilst production levels were at c. 2.322mbpd leading to revenues of c. $259.88 million per day.

When this nominal increase is weighed against the increase in population from c. 74.5 million in 1980 to c. 166 million in 2013, the result is a 53.2 percent improvement in real income.

However, when oil prices are adjusted for relative value of $1 in 1980 compared to 2013 value, Nigeria’s oil in 1980 was sold at $104.12/barrel in 2013 dollar terms whilst income would be $214.39 million per day. Therefore, the country earned more from oil on a per capita basis in 1980 i.e. $214.39 million per day and $3.13 per capita, than it earns today – 2013: $252.25 million per day and $1.45 per capita.

While oil production levels have remained fairly stable over the last 34 years (fig. 15), other factors such as population, size of the public sector and leakage in the system have increased significantly.

We went further in our analysis to estimate what Nigeria would need to earn from crude oil sales in the years ahead for revenues and oil proceeds per capita to match the levels achieved in 1980 against the backdrop of a young and growing population, increasing public sector spending profile and weak or non-existent investments in infrastructure.

Our estimates indicate that oil proceeds per capita in 1980 is 2.2x that of 2013. Therefore, the country’s crude would have to sell at $239.0/barrel – assuming production levels remain constant – to generate oil proceeds of c. $554 million/day and oil proceeds per capita of $3.13. The possibility of this occurrence is remote.

Overall, our theory posits that incentives are necessary to grow Nigeria’s overall income.

For this state, dependence on statutory allocation for its fiscal operations results in a N1.5 billion deficit. This is because its recurrent expenditure consumes c. 80 percent of total receipts while capital expenditure – required for infrastructural development and growth – is 27 percent of total receipts. Consequently, the state’s deficit will be financed by borrowings, which places further constraints on development as a growing debt profile indicates a gradual increase in debt servicing payments; the opportunity cost being investments in infrastructure.

For this state, we further assume that it has a young population with median age of c. 19 years whilst c. 44 percent of the population is between 0 – 14 years of age. Therefore, beyond the debt that will be inherited by the significant portion of the current population, infrastructural decay and the attendant social problems will most likely result from this funding model.

In our theory, the calculated shift in the funding structure with an emphasis on increasing IGR would result in a robust income profile and surplus. As seen in figure 17, IGR contributes 71 percent to total receipts while contribution from the federal purse is 29 percent. Consequently, the state’s recurrent and capital expenditure is c. 51 and 17 percent of total receipts, respectively.

By and large, a viable and sustainable funding model that generates a surplus increases a state’s attractiveness to investors and enhances its ability to fund infrastructural development via the debt market without exerting pressure on its finances.

If FAAC becomes a domestic infrastructure/development fund available to exclusively fund projects in each state with the goal of making such state independent financially, then the additional income that such state generates makes the whole nation better off.

Essentially, Nigeria will still earn its oil revenues but can then boast of significant additional revenues due to the channelling of existing oil revenues into revenue generating projects. Consequently, overall wealth to the nation can be significantly improved by c. 3.6x i.e. N720 billion/N198 billion (fig. 18). In view of historical precedents, this is arguably the way forward for the country.

Conclusion

If the above holds, perhaps Nigeria’s economic and political administrators should strongly consider evolving the current system into one that stimulates healthy competition, provides incentive compatibility to states to create their own revenues and increase the overall wealth of the nation. As at 2010, 23 of Nigeria’s 36 states were running fiscal deficits. Lagos is the only state that generates IGR exceeding statutory allocation i.e. IGR to statutory allocation ratio of 3.4x (6yr average). This state’s IGR to statutory allocation ratio was 1.5x in 2004 and had increased to 3.3x in 2013 as a result of policies targeted at growing IGR.

While we acknowledge that all states may not perform like Lagos state, we are inclined to enquire as to what incentive does a state, say Niger state, have to enable it attract a blue chip multinational, Nestle for instance, to set up a best-in-class production facility in Minna, the state capital. The multiplier effect of such a development on employment and other economic activities will subsequently result in an improvement in the state’s revenue profile

The foregoing indicates a critical need to move Nigeria towards sustainable economic development. Unfortunately, we believe this may never be achieved with Nigeria’s current revenue sharing mechanism due to the low incentive it creates for states to want to seek other revenue generating options to improve their respective IGRs. The country therefore needs to develop a structure that incentivises and supports states to generate revenues. This is critical to the development of infrastructure in Nigeria, before the oil runs dry.

Tola Odukoya and Sonnie Ayere work for Dunn Loren Merrifield, a full-service investment house headquartered in Lagos

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