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1.1         Background of the Study

Every economy experiences destabilization at one point in time or another; often referred to as fluctuations. Keynes (1936) describes these fluctuations as the business cycle comprising of high and low economic activities in the economy. The period of high income, output and employment has been called the period of expansion, upswing or prosperity, and the period of low income, output and employment has been described as contraction, recession, downswing or depression. At times, the economy finds itself in the grip of recession when levels of national income, output and employment are far below their full potential levels. A noteworthy feature about these fluctuations in economic activity is that they are recurrent and have been occurring periodically in a more or less regular fashion. Fluctuations in economic activity create a lot of uncertainty in the economy which causes anxiety to the individuals about their future income and employment opportunities and involve a great risk for long-run investment projects (Ahuja, 2012).

This fluctuation is common in the oil market where prices are determined by external forces and this goes a long way to hinder developmental activities. Owing to the fact that revenue is a function of price, any shock in the oil prices will be transmitted on the oil revenue. Prior to recent economic reforms, Nigeria‘s history of oil revenue management had generally been poor (Okogu & Osafo-Kwaako, 2008). This is premised on the fact that managing oil wealth has proven to be a difficult challenge for many countries across the world, and this is evident in Ecuador, Mexico, Nigeria, and Venezuela. In Nigeria, oil revenues have led to huge investments in capital and infrastructure in the 1970s and 1980s but productivity declined and per capita GDP remained at about the same level as 1965. In other words, accumulated oil wealth over a 35 year period of some $350 billion did not raise the standard of living but worsened the distribution of income in Nigeria. Studies show that not only Dutch disease but more importantly waste of capital resources through bad investments and corruption have resulted in this predicament of oil revenue management (Budina, Pang & van Wijnbergen, 2007).

The paradox is that despite the huge resources from oil, Nigeria is still characterized by increasing threats of hunger and poverty. For instance, about 51.6 per cent of the population was living below one dollar (US$1.00) per day as at 2004; and by 2010, the percentage had increased with 61.2 per cent of the population living below US$1.25 per day, coupled with rising youth unemployment and high food prices (NBS, 2010). Consequently, the incomes of most families are not adequate for the basic sustenance of life.


Oil revenue which is the income earned from the sale of crude oil (Ogbonna & Ebimobowei, 2012) plays a key role in Nigerian economy. According to Budina and van Wijnbergen (2008), oil is the dominant source of government revenue, accounting for about 90 percent of total exports, and this approximates to 80% of total government revenues. The problem of low economic performance in Nigeria in recent years has been attributed not only to the failure of government to productively utilize the financial windfall from the export of crude oil particularly from the mid – 1970s, but also due to the frequent fluctuations of prices in the crude oil market. The oil boom of the 1970s led to the neglect of non-oil tax revenues, expansion of the public sector, and deterioration in financial discipline and accountability. In turn, oil-dependence exposed Nigeria to oil price volatility which threw the country‘s public finance into disarray (Yakub, 2008).

The government of an oil-exporting country is confronted with significant uncertainty relating to its export earnings and fiscal revenues. Supply and demand in the oil market are both highly inelastic in the short run, with the result that even small shocks can have large effects on price. The unpredictability regarding oil revenues, which stems from uncertainties about such issues as the future trend in oil prices, the size of the oil reserves, and the cost of extraction is problematic for both short-run and long-run management of the economy (Rewane, 2007).

Fiscal policy involves the use of government spending, taxation and borrowing to influence the pattern of economic activities and also the level and growth of aggregate demand, output and employment (Ebimobowei, 2010; Abata, Kehinde, & Bolarinwa, 2012). Fiscal policy entails government's management of the economy through the manipulation of its income and spending power of government to achieve certain desired macroeconomic objectives (goals) amongst which is economic growth (Medee & Nembee, 2011).

Jhingan (2004), Musgrave and Musgrave (2004), Oner (2002), and Hottz-Eakin, et al. (2009) viewed fiscal policy as mostly to achieve macroeconomic policy; it is to reconcile the changes which government modifies in taxation and expenditure programmes, or to regulate the full employment price and total demand to be used through instruments such as government expenditures, taxation and debt management. Typically, the objective of fiscal policy is directed towards maintaining sound public finances. This invariably amounts to an unwavering commitment to the maintenance of balanced budget by restricting aggregate spending to the size of aggregate recurrent revenue, and a sound public sector balance sheet is by implication achieved (Valmont, 2006; Osuka & Ogbonna, 2010; Jhingan, 2004).

Amongst the fiscal policy responses in relation to oil price/revenue in Nigeria have been the excess crude and the fuel subsidy program. Excess crude refers to the profit obtained when the price per barrel of crude oil exceeds the revenue estimate per barrel made in the budget at the time of its


approval. When this occurs, the surplus profits are held in a separate fund called the Excess Crude Account (ECA) established in 2004. These profits are intended to boost the country‘s revenue when oil prices are low. For instance, the 2006 robust global growth and high oil prices resulted in the excess crude account holding $20 billion. When the global financial crises hit in 2008, causing global demand for oil to drop and prices to fall from $147 per barrel in early 2008 to $35 per barrel in 2009, the country was spared from debilitating budget deficits by savings from the ECA. These spare funds helped stabilize the economy against the negative shock before oil prices rebounded after the 2009 downturn (Soneye, 2012).

The fuel subsidy program is another fiscal policy response to oil price fluctuation in Nigeria and other oil producing countries. Many countries have attempted to reform their fossil-fuel subsidies with varying degrees of success. The motivations behind these reforms can include a desire to reduce fiscal expenditures, improve energy efficiency or to reduce urban air pollution and greenhouse gas (GHG) emissions. However if poorly planned and executed, the removal of subsidies can cause adverse economic, social or environmental repercussions as a result of higher energy prices. Governments that implement subsidy reform badly will pay a high political price. (Laan, Beaton & Presta, 2010).

A subsidy is defined here as any government policy that lowers end-user prices or transfers cash to producers, reduces their cost of operations, bears risk or increases their returns. Consumer subsidies for fossil fuels typically stimulate fuel consumption by industry or the public. Producer subsidies promote domestic exploration, extraction or refining (Laan,et al., 2010). The available literatures on fuel subsidy shows that there is no comprehensive and accurate account of the origin of fuel subsidy as the authors have different opinions regarding the concept of fuel subsidy in Nigeria. Notwithstanding, the researcher has drawn a conclusion from the available literatures regarding the concept of fuel subsidy in Nigeria. The fuel subsidy payment was introduced as a policy into Nigeria in 1973. Under International Monetary Fund (IMF)/World Bank instigation, petroleum subsidy in Nigeria has been stated by the government as the difference between the product domestic price and the export price which said to have started in 1973 with a subsidy of 33.7 percent, when the federal government fixed retail prices of domestic oil consumption at $1.9/bbl (Anyanwu, 1993). Something of a creeping phenomenon, the value of the subsidies has gone from 1 billion in the 1980s to an estimated 6 billion Dollars in 2011. In this period, the specific products targeted for subsidy have changed. Diesel oil has had its associated subsidy redaction while petrol (Gasoline), kerosene (DPK) continues to enjoy a 54.4 % subsidy over the international spot market price at the Nigerian pump (Centre for Public Policy Alternatives [CPPA], 2012).


An important objective of fiscal policy is to promote economic conditions conducive to business growth while ensuring that any of such government actions are consistent with economic stability (Anyanwu, 1993). Given the central importance of the latter, the key objective of fiscal policy in addition to guaranteeing sound public finances is to promote equity in taxation without creating economic distortions or disincentives to wealth creation (Valmont, 2006). Fiscal policy is generally meant to maintain full employment and stabilize growth with its primary tools being government expenditure and taxation or subsidy. For the sake of this study, the major fiscal policy responses to oil price fluctuation will be the excess crude account and fuel subsidy policies, while the overall fiscal effort to stabilize oil price will also be examined.

1.2         Statement of the Problem

Despite the fact that crude oil has been the engine of growth in the Nigeria economy, its fluctuations has led to poor stability thereby reducing predictability and planning by investors. Generally, the economy is faced with high rate of unemployment, wide spread oil spillage, increasing poor standard of living as a result of decreasing gross domestic product, per capita income and high rate of inflation which has led to adverse effect on economic development (Nwezeaku, 2010). The problems with the Nigerian economy have been traced to failure of successive governments to use oil revenue and excess crude oil income effectively in the development of other sectors of the economy (Yakub, 2008). Over all, there has been poor performance of some national sectors such as energy, road construction, air and rail transportation, environmental management and politics. Even the financial system and the investment environment have been deteriorating and inefficient as well as lack of proper turn around maintenance in the oil and gas refineries and associated industries. The systematic collapse of these industries has been attributed to high rate of corruption, militant insurgences, pipelines vandalism and the lack of political will by political office holders to effect the necessary changes (Nafziger & Auvinen, 2008; Thomas, 2008; and Nwezeaku, 2010).

Fluctuations in oil revenue significantly affect the economy at large especially with countries like Nigeria whose oil revenue significantly contributes to national revenue. According to the International Energy Agency (IEA,2004), higher oil prices causes inflation, increased input costs, reduced non-oil demand and lower investment in net oil importing countries. While Adeniyi, Margaret & Osaretin (2012) showed empirically that changes in oil prices have had significant effects on inflation. The figure below shows that the trend for oil revenue is highly fluctuating when compared to non-oil revenue which might affect inflation and increase instability in the economy.


Fig 1.1: Oil and Non-Oil Revenue Trend (₦)


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