Introduction
Energy security is a critical component of a nation's sustainable development. Countries around the world strive to find opportunities to better their security architecture and mitigate any vulnerability. A key commitment made by nations at the 28th Conference of the Parties (COP28) event, was to accelerate the transition away from fossil fuels, triple renewable power and double energy efficiency by 2030. This strategic shift aims to foster environmental sustainability and secure a stable energy future.
Nigeria - a monolithic economy – where every facet of the economy is dependent on crude oil, still faces severe energy security challenges. With insecurity and oil theft on the rise, Nigeria has witnessed decreased investment in the oil and gas industry. This has resulted in decreased daily crude oil production, increase in perennial fuel scarcities, inadequate feed gas for power Generating Companies (GENCos), underinvestment in alternative energy sources (renewables), amongst others. Nonetheless, the Government has taken steps through fiscal and regulatory interventions to address some of these issues. For example, to improve the availability of Premium Motor Spirit (PMS), popularly known as fuel, in the country, the Government (with the approval of the National Assembly) incorporated a provision1 into the Petroleum Industry Act (PIA) to mandate the supply of a portion of daily crude oil production to the domestic market. This regulatory requirement has been a subject of debate with respect to its potential implications for Nigeria's OPEC allocated crude oil production volumes and revenue.
In this article, we have provided comments on the provisions of the Domestic Crude Oil Supply Obligation (DCSO) and its implications for economic development in Nigeria.
Legal Considerations
The DCSO, as defined by the PIA2, is an obligation on upstream crude oil producers to dedicate specific crude oil production volumes for domestic refining. The PIA empowered the Nigerian Upstream Petroleum Regulatory Commission (NUPRC or "the Commission") to issue regulations or guidelines on the mechanism for the imposition of this obligation. Consequently, the NUPRC issued the Production Curtailment and Domestic Crude Oil Supply Obligation Regulations 2023 (Regulations)3. However, the Nigerian Midstream and Downstream Petroleum Regulatory Authority (NMDPRA or "the Authority") was given the responsibility to regularly report to the Commission, crude oil requirements of domestic refineries and where there are shortages or inadequate supply of crude oil.
Some of the key provisions of the Regulations include;
- Empowering the NUPRC to make compliance with the DCSO a prerequisite for the issuance of a crude oil export license. Crude oil production exceeding the relevant DCSO may be exported without restrictions.
- Requirement for the Commission to publish biannually, both on its website and in three national newspapers, the domestic crude refining requirements of operating refineries in Nigeria. This information is to be sourced from the Authority, which provides the Commission with the crude oil requirements of refineries currently operating in Nigeria.
- Requirement for NUPRC to identify and select upstream operators to supply crude oil based on proximity and accessibility of the upstream production site to the refinery's location and the crude oil's specification of the refinery.
- Provision that DCSO must be fulfilled prior to the issuance of crude export permits for a given quarter. However, where there is no demand from any operating refinery within the relevant quarter, the restriction will not apply.
- Empowering the NUPRC to impose administrative penalties on upstream crude oil producers for non-compliance of the DCSO.
The NUPRC has since decided to amend the Regulations as communicated in a notice4 signed by its Chief Executive, in line with current realities. This therefore is an opportune time to discuss the challenges, which if unaddressed, may hinder the effective implementation of the DCSO.
Commercial Considerations
Forward sale agreements play a significant role in determining where and how crude oil is distributed, and this locks the sale of crude oil at future dates and prices. Many upstream crude oil producers have their crude production already tied to long term forward sale or financing agreements with respective non-resident offtakers or financiers (as the case maybe), as such, limiting their control over the available crude left to cater for the demand of domestic refiners. Although the PIA together with the Regulations provide that the domestic demand of refiners be met prior to the exportation of crude oil production, a majority of the referenced agreements were entered into prior to the enactment of the PIA. This may therefore potentially lead to contractual penalties arising from the default of their obligation.
Conversely, domestic refiners may find themselves facing reduced access to crude oil which may lead to underutilization of refining capacity. Qualifying upstream crude oil producers are to supply crude oil based on the volumes allocated by the Commission, as advised by the Authority and in line with the provisions of the Regulations5. However, these allocations may be too small for offtake by the domestic refiners due to logistics and operational constraints. For example, where a domestic refiner requires 25,000 barrels of crude oil and the Commission allocates pro-rated volumes to qualifying upstream crude oil producers, not all producers may be able to fulfil their obligation. Those willing to comply may have received very minimal allocations, making offtake impractical due to logistics and operational complexities associated with such small volume, which could outweigh the potential revenue. In such situations, the refiners may be compelled to seek alternative sources for the supply of crude oil, including, from the foreign market. This can be challenging, as imported crude often comes at a premium, especially given the impact of exchange rate volatility on transportation and the overall cost of sourcing. With the combination of higher input costs due to reduced access to affordable domestic crude and reliance on the more expensive imports, margins are squeezed. This may have a knock-on effect on the entire downstream oil industry, potentially reducing profitability and stifling investments in refining infrastructure.
The PIA also provides for a market driven framework which ensures that supply of crude oil is on a willing buyer, willing seller basis6. This contradicts the DCSO policy which mandates that upstream crude oil producers prioritize domestic supply prior to seeking export permits. Does domestic demand exist? Currently the answer is yes, however, a willing seller may not always be available. While the PIA stipulates that domestic supply prices should reflect international market rates for similar grades of crude oil, this may not guarantee that the upstream crude oil producers will achieve the same returns from domestic sales as they would from the international market. Factors such as exchange rate volatility, infrastructure deficiencies, bureaucratic regulatory processes, security risks amongst others, associated with the Nigerian business environment, may diminish the attractiveness of domestic supply for these producers.
Furthermore, notable policy changes in Nigeria, including the removal of subsidies on PMS and foreign exchange (FX) in Nigeria, have significantly impacted domestic fuel prices, contributing to rising inflation numbers (reaching 34.80% as at December 20247). The Federal Government (FG) through the Federal Ministry of Finance (FMF), introduced the crude for naira deal8 to try and address this issue. This involves the domestic sale of crude oil to local refiners in Naira. Currently, the Nigerian National Petroleum Company Limited (NNPCL) is the sole supplier of crude under this arrangement, but there is growing concern among the upstream crude oil producers that this may be extended to them in future. Given that majority of the costs of these upstream crude oil producers are denominated in US dollars, will it be a prudent decision for the FG to extend the crude for naira deal to other crude oil producers?
Tax Considerations
After addressing the commercial considerations, crude oil producers must carefully assess the potential tax implications when negotiating commercial arrangements and developing operational plans. This due diligence exercise ensures that the potential tax numbers are modelled prior to taking an investment or commercial decision. Specifically, questions regarding the tax implications of supplying domestic refiners rather than foreign refiners arise. Would Withholding Tax (WHT) apply to commercial arrangements relating to domestic crude supply? Would the domestic supply of crude attract Value Added Tax (VAT)?
The application of WHT on income remains an important pre-contractual consideration given its impact on operational cash flow. The WHT Regulations9 lists the various transactions liable to WHT and the related rate of deduction. Crude oil income has typically not been subject to tax even though it was not ever specifically exempted. However, the crude was sold abroad to non-resident entities who were not within the Nigerian tax jurisdiction and so had no obligation to withhold tax. Furthermore, sales in the ordinary course of business were also exempted from the application of withholding tax which would have meant that local sales do not attract any withholding tax. However, the WHT Regulations 2024 (Regulations) have now removed the exemption which applied to sales in the ordinary course of business, from the application of WHT.
The Regulations, effective from 1 January 2025, replaced the exemption with "goods manufactured or materials produced by the person making it" as exempt from WHT.
"Manufacturing" or "production" was defined to include the production of energy, but it is not clear if the production of crude will qualify as the production of energy. Yes, refined products from crude are key to the production of energy but does that mean that the production of crude itself will qualify as a production of energy? The jury is still out on this issue.
Separately, supplies of goods or services to Nigerian resident entities are subject to a consumption tax – VAT, unless specifically exempted. Crude exports have generally been exempted from VAT10. However, no specific exemption exists for the domestic supply of crude oil.
The recently enacted and gazetted VAT Modification Order 2024 (Order), with a commencement date of 1 September 2024, exempts certain petroleum products from VAT. These exempt products include feed gas for all processed gas, aviation turbine kerosene, PMS, automotive gas oil, household kerosene, locally produced liquefied petroleum gas, compressed natural gas, imported liquefied petroleum gas, and crude petroleum oils. It is not clear though what constitutes "crude petroleum oils" and whether it includes crude oil. You will appreciate that the general term used is petroleum products and crude oil is supposedly the raw material from which petroleum products are derived, so does that term also cover it? Would crude petroleum oil refer solely to raw crude oil or oils obtained from crude?
Conclusion
The DCSO introduced by the PIA presents a complex interplay of legal, commercial, and tax considerations for the energy sector and in general economic development in Nigeria. While its intent to promote domestic refining and reduce dependence on imported petroleum products is commendable, its implementation till date still faces significant challenges. The effectiveness of the DCSO is contingent on a delicate balance between ensuring adequate crude oil supply to domestic refineries and mitigating the default of contractual commitments of upstream crude oil producers.
Furthermore, the tax implications of the DCSO require careful consideration to ensure compliance with the details of the relevant tax laws and avoid unintended penalties. The ongoing revision of the varying tax laws in Nigeria via the Nigeria Tax Bill presents an opportunity to address these complexities and create a more conducive environment for investment and growth in the energy sector.
Ultimately, the successful implementation of the DCSO requires a collaborative approach involving the government, upstream crude oil producers, domestic refiners, and the relevant regulatory agencies. By carefully navigating the legal, commercial, and tax complexities, Nigeria can fully harness its crude oil resources to achieve sustainable energy security and economic development.
Footnote
1. Section 109 of the PIA
2. Section 318 of the PIA
3. Production Curtailment and Domestic Crude Oil Supply Obligation Regulations 2023
5. Regulation 13 of the Production Curtailment and Domestic Crude Oil Supply Obligation Regulations 2023
6. Section 109 of the PIA
7. Nigeria Bureau of Statistics CPI and Inflation Report for December 2024
8. Commencement of the crude for naira deal
9. Companies Income Tax (Rates, Etc., of Tax Deducted at source) Regulations 1997
10. Part I of the First Schedule to the VAT Act
The opinion expressed in this article is solely personal and does not represent the views of any organization or association to which the authors belong.
