How did a review of 2020 Budget Oil benchmark lead to a 90% downward review of oil revenue projections?

Dr Jekwu Ozoemene

A short answer to the question is the “average cost of production” and “margin compression”.

A few days ago, I had cause to debate Nigeria’s average cost of crude oil production both on and off Facebook.

Depending on who you ask, the answer to “what is Nigeria’s average cost of producing one barrel of oil” can range between US$15 per barrel to US$32 per barrel. Yet, for a commodity that accounts for more than 75% of Nigeria’s revenue (until the crash in oil price) and 90% of the country’s FX earnings, this information is crucial to the government’s and the business community’s budgeting and planning.

A little bit of history.

At the 2017 Annual Conference of the National Association of Energy Correspondents (NAEC) which took place in Lagos on August 17, 2017, the then Minister of Petroleum Resources, Dr. Ibe Kachikwu, decried Nigeria’s approximately US$32 per barrel high average cost of crude oil production.

Dr. Kachikwu noted that the Federal Government of Nigeria was focused on reducing the cost to US$15 per barrel and that “initiatives to reduce the cost of crude oil production to US$15 per barrel (were) ongoing”, while “initial consultations (had) been held with stakeholders and cost drivers (had) been identified”.

It is pertinent to note that at the time, Nigeria was the third most expensive country to produce crude oil in the world at US$31.60 per barrel, behind the United Kingdom (UK) and Brazil at US$44.33 and US$34.99 per barrel respectively. In fact, despite the US shale producers’ use of expensive horizontal drilling and hydraulic fracturing technology, crude oil production in Nigeria was still more expensive.

Fast forward a year and a half later.

Speaking at the opening ceremony of the second edition of the Nigerian Oil and Gas Opportunity Fair, (NOGOF), which took place on April 6, 2019, in Yenagoa, Bayelsa state, the then Minister of State for Petroleum Dr. Ibe Kachikwu, noted that the country’s average cost of crude oil production had been brought down to US$23 per barrel and that the target was to further force it down to US$15 per barrel.

In the same statement, Kachikwu disclosed that Nigeria had increased daily production to about two million barrels a day (up from 1.9 million), asserting that the country was close to achieving a 4 million barrels per day production target.

Fast forward to a year later, after Dr. Kachikwu had since left office.

At March 11, 2020, Central Bank of Nigeria’s Round Table in Abuja, the Group Managing Director of the Nigerian National Petroleum Corporation (NNPC), Mallam Mele Kyari, stated that at the moment, the cost of crude oil production in the country was within the range of US$15 to US$17 per barrel.

Now, note the declining cost of production trajectory from US$31.60 per barrel as at late 2017, to the stated US$23 per barrel sometime between 2018 and April 2019, to US$15 – US$17 per barrel somewhere between April 2019 and March 2020.

In essence, within two and half years (August 2017 to March 2020) Nigeria has allegedly been able to reduce its average cost of crude oil production by 50%.

If true then this is a laudable achievement by the Petroleum Ministry, however, it prompts two questions that require answers.

First, based on old production cost analysis, before “initial consultations were held with stakeholders and cost drivers identified”, the cost of producing one barrel of crude oil consisted of two distinct components; the Operating Expense (OPEX) and the upfront Capital Spending (CAPEX).

The OPEX is further broken down into the following; Tax (which averaged US$4.11 per barrel in 2017), Production Costs (averaged US$8.81 in 2017), Administration or Transportation (which averaged US$2.97 in 2017 but is said to have breached US$6 with the ongoing global Contango) and Security.

CAPEX amortization, on the other hand, was said to average US$13.10.

The total of which gave us a cost of production that ranged between US$28.99 per barrel to US$32.02 per barrel.

This leads us to the first question.

What were the cost drivers that enabled Nigeria to reduce its cost of crude oil production by a whopping 50%?

Was it leakages, corruption, poorly structured / priced forward contacts, redundant human resources, reduced CAPEX spend, etc. This information should be made public to add to the body of knowledge or serve as a deterrent (if it was due to foul play).

Which brings us to the second question.

The entire essence of reducing the cost of production is to increase margins, consequently, the true test of a cost reduction exercise is its impact on margins and in how much additional income or savings it generated.

What we know as Nigeria’s oil revenue is made up of several revenue lines; crude oil sales, oil and gas royalties, petroleum profit and gas taxes, gas sales, rent, gas flared penalty, other oil and gas revenues, and licenses and early licenses renewal.

Other than years when there are “licenses and early license renewals”, crude oil sales, gas sales, oil and gas royalties will typically account for circa 50% of this revenue, combined with Petroleum Profit and Gas Taxes, this will result in about 75% of oil revenue.

These are the lines that will be directly impacted by a reduction in the average cost of production.

Assuming that there was no revenue from “licenses and early license renewals” in the period under review, on the face of it, it does appear that Nigeria managed to reduce its cost of producing a barrel of crude oil by approximately 50%.

Let me explain further.

In 2017, oil price averaged US$54.27 per barrel (US$61.39 per barrel in Q4) and average oil production (including condensates) was 1.89 million barrels per day.

At an average cost of production of US$31.60 per barrel, Nigeria’s margin would have been US$22.67 per barrel while actual net oil revenue was N1.102 Trillion (note that net oil revenue as used here is the Federal Government’s portion only).

In 2018, oil price averaged US$71.40 per barrel (circa US$74 per barrel in Q4) and average oil production (including condensates) was 2.019 million barrels per day.

At an average cost of production of US$23 per barrel, Nigeria’s margin would have been US$48.4 per barrel, an increase of 117%, while actual net oil revenue was about N2.08 Trillion.

In 2019 oil price averaged US$64 per barrel (US$67.2 average as of June 2019) and average oil production (including condensates) 2.2 million barrels per day.

At an average cost of production of US$15 per barrel, Nigeria’s margin would have been US$49 per barrel while a US$17 per barrel production cost would result in a margin of US$47 per barrel. As of Half Year (June) 2019, actual net oil revenue was N900.42 Billion which annualized should be circa N1.8 Trillion. I, however, concede that lines like Petroleum Profit and Gas Taxes could have kicked in towards year-end.

In Summary.

Cost of production per barrel allegedly reduced from US$31.60 to between US$15 and US$17 per barrel over a two and half year period, at the end of which;

  1. Margins increased by approximately 117% (US$47-US$49 per barrel in 2019, US$48.4 per barrel 2018, and US$22.67 per barrel in 2017).

  2. The official exchange rate remained constant at N305/US$1.

  3. Crude oil price averaged US$54.27 per barrel in 2017, US$71.40 per barrel in 2018 and US$64 per barrel in 2019.

  4. Oil production improved from 1.89 million barrels per day in 2017 to 2.2 million barrels per day in 2019.

  5. Given prevailing Contango in the international market, the cost of transportation increased from US$2.99 to over US$6 per barrel in 2020.

Despite an improvement in margins over the period, oil revenue stagnated from 2018 to 2019 because of a drop in oil price and this will be further impacted in 2020.

With Bonny Light at US$26.40 (as at April 14, 2020) and spread on Contango narrowing from US$13.45 per barrel to US$5 per barrel) margins are likely to crash from US$49 per barrel to US$6.4 per barrel (at cost of production of US$15 + Contango spread of US$5 = US$20) to US$4.4 per barrel (at cost of production at US$17 + Contango Spread at US$5 per barrel = US$22 per barrel).

This is a margin compression of between 87% to 91% respectively, potentially worse than the US$8 and US$10 per barrel in Nigeria’s revised 2020 budget with an oil price benchmark of US$30 per barrel (80% to 90% margin compression).

Production volumes have also crashed from 2.2 million per day to about 1.7 million barrels per day.

Dr. Jekwu Ozoemene
Managing Director / CEO
Lyceum Alliance Limited.