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Wednesday, February 8, 2023

Western price cap on Russian oil to disrupt the energy market

Since Russia invaded Ukraine in February, US energy policy has pursued two major, seemingly contradictory goals. The first is to keep global oil supplies high enough to keep prices tolerable and public support for sanctions strong. The second is to stifle Vladimir Putin’s war machine by stopping the flow of dollars that Russia earns by flogging oil barrels. Together, they form a circle that is hard to break because when supply closely follows demand amid a lack of new production, the withdrawal of any oil from the market mechanically triggers inflation. Still, the West has tried to defy the laws of physics by creating a growing array of measures to meddle in oil markets.

Those deployed so far have often been piecemeal and involved uncomfortable compromises. America enforced its own sanctions against Venezuela’s violent regime and on November 26 granted permission for Chevron, the US oil major, to increase its oil production there. America has also released huge volumes from its strategic oil reserves; the stockpile is now at its lowest level since 1984. The White House’s least productive effort was aimed at getting Gulf states to produce more. Within months of President Joe Biden punching Muhammad bin Salman, the Saudi ruler, in Riyadh in July, Petrostate and its allies in the Organization of the Petroleum Exporting Countries (OPEC) said they would cut output instead. On December 4, the cartel will meet again. It seems unlikely that a performance boost would help now.

Yet the West’s most carefully constructed campaign to outwit Mr. Putin has not yet begun. In June, the EU announced that on December 5 it would ban imports of Russian offshore oil, which a year ago accounted for nearly 2 million barrels per day (b/d), or 40% of Russia’s oil exports. It also said it would also ban European shipping service providers, tankers and insurance companies from helping non-EU buyers acquire Russian barrels they are avoiding – a powerful tool given the firms’ dominance of the global shipping market. America soon realized that together these two measures had the potential to squeeze global oil supplies. So she insisted on introducing a weakening clause: provided they agreed to pay the maximum price set by the G7 for Russian oil, non-Western buyers could continue to buy European insurance.

As we went to press, the level of this “price cap” was still being debated among Europeans. Some, led by Poland and the Baltic states, want the cap to be kept low to hurt Russian finances. Others, worried about their shipping industry or retaliation from Russia, want to keep it close to market levels. Rumors filtering out of the talks suggest it could end up near $60 a barrel – a discount of almost 30% to the current price of Brent, the global benchmark, at $84 a barrel – which is roughly what Russia is currently selling its crude for. . Whatever the outcome, one thing is certain. Never before has such a layered cake of measures hit the global oil market at once. Much of this has been telegraphed for so long that it can make few waves. But there are reasons to worry that this could rock the boat, at least for a while.


In an optimistic scenario, the sanctions package could succeed in reconciling the West’s two conflicting goals. The embargo would ensure Europe would no longer support Mr Putin’s war: the bloc still bought 2.4 million b/d of crude and refined from Russia last month. Meanwhile, the price cap, a US Treasury official says, would act as a “relief valve” to keep the global market in balance by allowing developing countries to buy Russian oil at a discount. Russia would get less money, whether those countries sign up to the plan or not, because the mere existence of the cap, or so America reckons, would strengthen their bargaining power.

Without a sufficiently low price cap, as is likely to be the case, the cost to Russia would be real but modest. It would add even more unpleasantness to what has been created by a wider arsenal of Western sanctions that may hurt Russia’s economy in the long term but have so far hardly proved definitive. Discounts that carry Russian stamps against regional benchmarks have widened in recent weeks, but remain well below those seen after the invasion. At least the embargo would not upset the oil markets – or so the commodity markets suggest. Brent futures, which in June indicated an annual oil price of more than $100 per barrel, are now closer to $85 (see chart panel). Most traders expect the shift in fuel flows to accelerate this year, with India and China taking over from Europe as Russia’s biggest customers.

This happy story assumes that no logistical snags will prevent a decade-old business formula from making a smooth but rapid transition. However, a less rosy scenario could see sanctions throw a spanner in the works by introducing unwanted friction. Three bottlenecks stand out: squealing tankers, the insurance gap and the global lack of risk appetite.

Start with tankers. Cyprus, Greece and Malta are so big in shipping that Europe’s ban on maritime services to countries that don’t sign up to the cap — and many of them, eager to support American meddling in commodity markets — have signaled they won’t. — could cause a major shortage of ships capable of transporting Russian oil. Claudio Galimberti of Rystad Energy, a data firm, predicts a shortfall of about 70 vessels with a total shipping capacity of 750,000 b/d that will last two to three months.


Eventually, this problem should resolve itself. Industry insiders point to an ever-growing “dark fleet” absorbing the vessels of established sanctions violators in Iran and Venezuela. Russian firms are putting salvaged vessels back into service; EU shipowners are also transferring assets to non-G7 operators. A top energy trader expects to have enough ships to carry Russian crude by February, although vessels to divert refined products such as diesel from short-haul routes in Europe to far-flung new customers in Latin America and Africa may remain rare for some. time.

A bigger potential snag is the crisis in insurance coverage. It’s not like Middle Eastern or Asian countries interested in Russian barrels don’t have local firms with the funds to insure tankers and cargo. What they may soon lack is coverage for much larger risks like oil spills, where liabilities can easily reach half a billion dollars. Few insurers new to the market will look forward to liability for an aging Venezuelan vessel sailing through Denmark’s 15-metre-deep straits, a veteran oil trader says without much collateral.

The problem is that this kind of hedging – hedging – requires deep pools of private capital that are hard to find outside the West. The Chinese and Indian governments could perhaps be persuaded to offer sovereign guarantees, although market insiders doubt they have the stomach for it. In fact, some traders believe Asian buyers could buy less Russian oil rather than more once the insurance ban takes effect.

A third bottleneck could be the lack of appetite outside the G7 for the perceived risks of circumventing the plan proposed by the West. Many do not believe US promises to stay hands off if countries decide to circumvent the limit. It doesn’t help that in its most recent sanctions campaigns, such as those targeting Iran, America has carefully kept the lines of punishment vague to deter anyone from dealing with its enemies.


All of this could cause some of Russia’s oil exports to fall off the map and cause prices to jump. But a much worse scenario is also possible, when Russia voluntarily reduces oil exports and prices get out of control. This could happen if China, which will have to give up its purchases from other countries to buy even more Russian oil, tries to bargain too hard. Rather, it would be a unilateral decision by Mr. Putin. It could come at a huge cost: Russia gets 40% of its export revenue from oil sales. But they might be worth putting up with temporarily if they drive up global prices, hurt the West and give Russia more leverage in negotiations with buyers without causing intolerable damage to wells. The country’s decision to temporarily halt nearly 2 million b/d of oil production during the pandemic has resulted in a long-term capacity loss of only 300,000 b/d, according to Energy Intelligence.

Until now, the energy policy of the g7 group has been elaborated in Washington, DC and Brussels. But to paraphrase Mike Tyson, everyone has a great plan until they get punched in the face – and when faced with setbacks on the battlefield, Mr. Putin is pulling no punches right now. The price ceiling’s first contact with reality can be harsh.

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