Review petroleum pricing, introduce equalisation fund for inland freight

In Summary

• The collection from this new levy, will be aggregated into a freight pool in the oil industry and managed prudently by EPRA.

• All the road transportation costs incurred by the oil marketing companies will be paid back to them from the freight pool to nullify the freight element

A fuel attendant at metro station. File
A fuel attendant at metro station. File

The pricing of oil products is often a complex and controversial process.

Unlike most products, oil prices are not determined entirely by supply, demand (which is inelastic), and market sentiment toward the physical product. Rather, supply, demand, and sentiment toward oil futures contracts, which are traded heavily by speculators, play a dominant role in price determination.

Cyclical trends in the commodities market may also play a role. The typical commodity pricing mechanism of spot and futures markets took over as oil pricing mechanism from the OPEC system of official selling prices in the mid-1980s.

As a result of development in the oil industry since 1986, oil has developed into a global, liquid commodity market with all the pricing and trading mechanisms of a global commodity. However, market liquidity is not the only factor affecting prices.

While liquidity provides for transparency and also creates instruments for the hedging of risk, it does not necessarily provide for the competitive pressure to drive prices down. Market structure and the shape of the demand curve are also important to explain the level of prices ( I won't delve too much into this for now for fear of digressing from our topic).

PETROLEUM PRICING

Petroleum retail prices in Kenya are controlled through price capping  that is reviewed monthly by the Energy and Petroleum Regulatory Authority.

EPRA sets maximum pump prices for selected products that remain in force from the 15th of the month until the 14th of the following month.

The Legal framework for petroleum pricing is provided for under the Petroleum Act No. 2 of 2019, Legal Notice No.196 of 2010 and Legal Notice No. 26 of 2012.

The Legal Notice No.196 of 2010 comprises of a petroleum pricing formula that caps prices for super petrol, diesel and dual purpose kerosene. The regulations detail a formula for determining the landed cost of imported petroleum products and other costs along the petroleum supply chain are added to arrive at the pump price.

Such incremental costs include storage and distribution costs, supplier margins and taxes and levies. The importation of super petrol, diesel and kerosene is undertaken through the Open Tender System since November 2003, as per Legal Notice No. 197 of 2003 (Revised in 2012 – Legal Notice No. 24 of 2012).

The OTS is centrally coordinated by the Ministry of Petroleum and Mining and is a very competitive process – Tanzania replicated this process.

OTS allows the oil marketing companies to access petroleum products at the same price and therefore ensures competition in the petroleum market. Since the OTS is run through monthly tenders, it entails sourcing of petroleum predominantly from the spot market whereby petroleum is sourced from the open market without any prior contracts.

The industry recognises that OTS is an effective supply system that creates a competitive and a transparent means of availing the product to Kenyans through economies of scale. Challenges experienced by the OTS have shown spot buying exposes the country to price volatility and unreliability as opposed to long-term supply contracts that come with price stability and reliability.

WHAT DETERMINES FUEL PRICES?

The price of petrol is the sum of taxes and commissions. There is the base price of petrol per litre. Add to that, the other factors that influence the final cost of petroleum products such as distribution and storage costs (through pipelines), the margins that importers and dealers are allowed, as well as nine different levies and taxes.

The prices are inclusive of a rigorous computation of nine different price components embedded in the pricing formula, which include eight per cent VAT in line with the provisions of the Finance Act, 2018 the Tax Laws (Amendment) Act, 2020 and the revised rates for excise duty adjusted for inflation as per Legal Notice No.194 of 2020.

The first port of call is the landed cost or the price at which petroleum arrives at the port of Mombasa. EPRA undertakes the pricing as stipulated in the Energy (Petroleum Pricing) Regulations, 2010.

The regulations introduced a formula EPRA uses in determining the maximum retail pump prices of the regulated products, which are super petrol, regular petrol, diesel and kerosene. This is a cost plus formula that lumps additional costs along the supply chain to the landed cost.

The landed cost is a weighted average cost of all imported cargoes for each grade. Tracking the purchase price of petroleum commodities in, 'over the counter' markets is difficult as transaction prices are normally known only to the two contracting parties.

However, there are publications that list price records. They are called reporting agencies. Platt’s Oilgram and Petroleum Argus are the two most famous ones.

For the sake of our article, we will limit ourselves to only what happens after the petroleum products have landed at the port of Mombasa. Landed costs in Mombasa will normally include FOB (free on board), which is the price for crude or products at the loading port, while CIF (cost, insurance and freight) is one at the destination.

Buyers have to pay the additional costs of transport when buying crude or products at a FOB price, while CIF prices include costs of transportation. Furthermore, the timing of the pricing is different.

FOB prices are taken on the loading date and CIF prices on the unloading date. Since tanker transportation normally takes between a few days and a few weeks, the difference is often appreciable. It is more common for crude to be traded at a FOB price and for products at a CIF price.

This means that crude buyers normally hire tankers to pick up crude at the terminal of oil exporting countries and product sellers usually deliver products to buyers. The landed cost is, therefore, the weighted average cost of all imported cargoes for each grade.

WHOLESALE PRICES

To demystify why petroleum products cost so much in Kenya, a review of the formula that EPRA has provided on its website and that is used to calculate both the wholesale prices and retail prices of the various petroleum products is necessary.

The formula for wholesale prices is as follows;

Pw = Cu (1+ Lp + Ld)+ K (1+ Ld) + mw

Where; * Pw = the maximum wholesale price for super petrol, kerosene or Automotive diesel;

* Cu = the weighted average cost in shillings per litre ex the Kenya Petroleum Refineries Limited (KPRL) and ex Kipevu Oil Storage Facility (KOSF).

* K = the transportation cost from Mombasa to the nearest wholesale depot, which is made up of x percent of pipeline tariff (Kpt) and (100 – x) per cent of road bridging cost (Krd) as set out in the First Schedule.

Lp = the allowed losses in the pipeline as set out in the Second Schedule

* Ld = the allowed losses in the depot as set out in the Second Schedule;

* mw = the allowed oil marketing company’s gross wholesale margin as set out in the Third Schedule.

RETAIL PRICES

For super petrol, kerosene and automotive diesel, the Pricing formula used is: Pr = Pw + mr + z Where,

* Pr = the maximum retail pump price of super petrol, regular petrol, kerosene or Automotive diesel applicable, in shillings per litre;

* mr = the allowed maximum retail gross margin as set out in the Third Schedule;

* z = the delivery rate from the nearest wholesale depot to a retail dispensing site in Shillings per litre as set out in the First Schedule.

While determining the wholesale and retail prices for petroleum products, Economic Regulations incorporates the costs as indicated in the first and second schedule of the Energy (Petroleum pricing) Regulations, 2010.

A recent spate of new taxes and tax hikes by  the Treasury to widen the revenue net has raised concerns over ballooning cost of living.

For instance, available figures for April 15 to May 15 indicates that for a litre of petrol, consumers paid Sh57.58 in taxes and levies alone, which is more than the actual cost of importing fuel, and among these taxes included Excise duty, Road Maintenance Levy, Sh5.40 as Petroleum Development Levy and Sh0.25 per litre as Petroleum Regulatory Levy.

They are also paid Railway Development Levy, Sh18 per litre of kerosene as anti-adulteration levy and Sh0.03 per litre as Merchant Shipping Levy.

Import declaration fee took Sh1.81 per litre of petrol while VAT was Sh9.10 for petrol, Sh3.29 catered for storage and distribution costs, while Sh53.99 was the landed cost of petrol.

Note that oil marketers were paid Sh1.43 billion as compensation for keeping fuel prices unchanged to defuse public outrage over a monthly review that would have pushed costs to a historic high.

The revelations are contained in the Supplementary budget for the year ending this month that was tabled in Parliament. In July 2020, the Petroleum Development Levy was revised upward from Sh0.40 to Sh5.40 per litre in bid to mobilise capital towards a subsidy fund.

The increase came into effect thanks to the Tax Laws (Amendment) Act of 2020. EPRA argues that despite the relatively subdued price of oil in the global market, such a fund is necessary to smooth out volatility.

The steep increase in the petroleum development levy explains the sudden rise in the prices of petroleum products in Kenya. The levy is expected to raise about Sh30 billion annually, up from Sh2.28 billion, with the Exchequer netting hundreds of billions from overall taxes and levies from fuel products.

So far, the ministry has collected over Sh20 billion from the levy. The idea of a price stabilisation fund is to enable the government to moderate transmission of global oil price volatility to the domestic market with little or no budgetary cost.

The move to keep the prices unchanged for the first time since the State started making the monthly price reviews was meant to curb growing public disquiet due to the effect of the fuel price increments on the economy.

Kenya adopted the petroleum price regulation regime in December 2010 with the adoption of the Energy (Petroleum Pricing) Regulations of 2010 following years of market failure that saw a misalignment between global and domestic oil prices.

What should be done in the interim to stabilize petroleum prices?

My recommendation is for the government to do away with the petroleum development fund altogether or for an Equalisation Fund for Inland Freight to be introduced/considered and included as an important element of the pricing structure. This would allow petroleum prices to remain at par all across the country.

For instance, the price of diesel and petrol should cost the same in say Mombasa and in Wajir. This equalisation fund should replace the petroleum development levy of Sh0.40 per litre that has always been charged since 1980s.

The initial purpose of the petroleum development levy, was to develop a retail distribution infrastructure in marginalised regions, where the olil marketing companies were unwilling to invest in.

The advent of independent oil dealers throughout the country, has invalidated the need to continue levying this tax. The pricing mechanism for petroleum prices should be reviewed and an equalization fund for inland freight introduced to replace the petroleum development levy.

The collection from this new levy, will be aggregated into a freight pool in the oil industry and managed prudently by EPRA. All the road transportation costs incurred by the oil marketing companies will be paid back to them from the freight pool to nullify the freight element incorporated in the price build up, followed by routine audits by EPRA to eradicate any chances of misuse.

This would ensure parity in the price of Petroleum products throughout the country. Further to this, long –term agreements generally present the best terms for securing and procuring reliable supplies of petroleum products. According to statistics, 70per cent of worldwide petroleum is procured through long-term agreements.

The contracts are either through government-to-government agreements or commercial with national oil companies. In Africa, for example, the nation of Ghana has such an arrangement in place. The country gained tremendously by hedging half of its crude oil requirements.

Hedging was the reason why Ghanaians had not seen any price increases at the pumps since the beginning of 2011, although crude prices had increased from more than $90 per barrel in December 2010 to about $120.

Hedging policy is, therefore, extremely beneficial to any government, if adopted.

However, to achieve competitive terms through long-term agreements, the quantities must be substantive to provide economic consignments. The implementation of Legal Notice 96 of 2010, which mandated the National Oil Corporation of Kenya to import 30 per cent of the country’s petroleum requirements (25,000 MT AGO and 20,000 MT DPK) should be hastened.

NOCK (currently in financial turmoil) or a newly formed national oil company, should be adequately funded and facilitated to undertake long-term agreements and furthermore, the use of government to government negotiations for the purchase of petroleum products should be encouraged to reduce the impact of high petroleum prices in Kenya.

Since the government has deemed price stabilisation for petroleum products necessary, then the Petroleum Act 2019 should be amended and enhanced to include a price stabilization fund with supporting regulations detailing how it will be operated.

The Petroleum Act 2019 does not explicitly provide for price stabilisation. The legal and regulatory framework would need to be reviewed to permit the creation of such a fund with clear guidelines on the modalities for its operation. This will ensure monies from this fund are not diverted for 'other vital government projects' or 'government emergencies'.

The stabilisation procedures should be anchored in an enhanced pricing formula, to ensure the integrity of supply chain costs and margins are ring-fenced and not distorted by price stabilisation.

The range for wholesale prices of each product would have an upper limit and a lower limit, and if the import‐parity price was higher than the upper limit, the difference would be financed by the fund.

Conversely, if the import‐parity price was lower than the lower limit, the difference would be credited to the fund. The idea of a price stabilisation fund is thus to enable the government to moderate transmission of global oil price volatility to the domestic market with little or no budgetary cost.

Duncan Otieno Ogwang is a petroleum and energy economist

Edited by EKibii