The Price Cap On Russian Oil Seems to be Working... For Now
I will be honest: a few months ago, when the West (European Union, United States, Canada, Australia, & Japan) announced a price cap on Russian oil… I didn’t think it would work. I didn’t have any good rationale for this skepticism, other than the fact that it was a gut feeling. Intuition. As an economics student, it’s drilled into you that price ceilings are BAD and INEFFICIENT.
More importantly, such a price ceiling had never been attempted before, and I thought it would fail if for no other reason than I didn’t think the hubristic West had the competence to pull it off. Surely such an audacious plan would backfire, much like most of the other economic sanctions against Russia have backfired or utterly failed.
It still might backfire — we are early days yet, the cap on crude oil was first implemented on December 5th, 2022, and it won’t be fully implemented until February 5th, 2023 when further caps will be imposed on diesel, kerosene and fuel oil — but so far, it seems to be working as intended.
At least, it’s kind of working. It seems like it is going to work. Probably. Maybe.
The price cap is exactly what it sounds like: a maximum price of $60-a-barrel on Russian oil. The intent of the price cap is exactly what it sounds like: to deprive Russia of revenue.
The Ministry of Economy of Ukraine expects that this will cut Russia’s oil profits by at least 50%. That is a biased source, obviously, but not too far out of the realm of what other analysts are expecting. Ultimately, nobody really knows what the actual impact will be on Russia’s finances. All we can do is guess. It’s safe to say, though, that it will deprive Russia of untold billions.
Largely as a result of this price cap, Urals oil (Russian export oil mixture is called “Urals” oil) is currently selling at a discount of roughly 50% compared to the exact same oil produced in other countries. Below is what the spread looks like, you can see it has increasingly widened as the price cap became a reality.
“This spread is the result of the combination of the EU [ban on Russian oil shipments], which is the main factor, and the oil cap,” said Ben Cahill, a senior fellow at the Center for Strategic and International Studies.
My expectations are that this spread is only going to widen in months to come, as Russia maintains its status as an international pariah, and the screws are tightened.
Just two days ago, it was announced that Western nations have agreed to “review” the level of the price cap in March 2023. I would be shocked if they didn’t tighten the screws upon review, and decrease the price cap from $60 to $55 or $50 or even lower. The Centre for Research on Energy and Clean Air (CREA) is recommending lowering the price cap to $25 to $35 a barrel — which would slash Russia's oil export revenue by ~$100 million per day. "Further cuts to Kremlin's revenue will therefore materially weaken the country's ability to continue its assault and help bring the war to an end," CREA said in a report.
The IMF estimates the breakeven price for production of Russian oil is close to $30 or $40 per barrel. As long as the cap remains above that, Russia will have an incentive to keep producing. The last thing Western nations want is for Russia to drastically stop producing oil, which is a very real possibility if they get backed into a corner and feel like they have no other choice.
“The oil product market is arguably the one place where Russia retains meaningful leverage if it chooses to weaponise exports,” says Henning Gloystein, an analyst at Eurasia Group. “Any shortfall of Russian product exports could coincide with higher demand in China, tightening markets even further and raising the prospect of price spikes that renew inflationary pressure.”
Russia’s internal 2023 budget is built using the assumption of $70 for oil, and this budget predicts a 2023 deficit of 2% of GDP. So, if the price of oil is significantly lower than this $70 benchmark, their GDP is likely to drop by 3%… 4%… or more. Last month, Russian Finance Minister Anton Siluanov hinted that the country’s budget deficit in 2023 might exceed the expected 2% of GDP.
Russia can fight this price cap by allowing the ruble to weaken, “thus increasing the ruble value of lower dollar oil receipts, this would raise broader risks to macroeconomic financial stability and likely accelerate capital flight. “
Will this price cap impact Russia’s ability to wage war? No, not really. It will still take a military defeat of Russia by Ukraine (or vice versa) to end the war. This price cap is simply one more bargaining chip.
For starters, Russia has a big financial buffer to work with, because their current account surplus rose to more than $227 billion in 2022, more than double the $108bn surplus from 2021. To offset the damage done by the price cap, they will simply draw from this surplus, take on more debt, and/or increase taxes. Military spending isn’t expected to be touched.
President Vladimir Putin last month called the cap “stupid”, saw no reason to “worry about the budget”, and boasted of his “unlimited” ability to finance the invasion of Ukraine. I believe him. 1 or 2 percentage points of GDP won’t shake his resolve — he’s in too deep for such a marginal increase in the budget deficit to matter.
Last week, Putin signed a decree banning the supply of oil to countries who participate in the oil cap. This ban will come into effect on Feb. 1, next week.
“Russia, as a matter of principle, will not supply oil at the prices set by the West. Russia will look for new markets and logistics even as costs rise," says Russian finance minister Siluanov.
So who will Russia sell their oil to, if not the West?
The Big Winners: India and China
In 2021, India and China combined to purchase roughly 20% of Russia’s oil exports.
In February 2023, it is expected that they will combine to purchase ~70% of Russian oil exports.
They are purchasing this oil at a deep discount to the free market, which is an unexpected windfall for them. I guess the West simply decided they preferred to transfer money from Russia’s pocket to India/China’s pocket, and India/China were all too happy to accept it.
While this hurts Russia, the West is playing right into China’s hands by handing them massive amounts of free/discounted oil. Chinese President Xi Jinping announced last month that the energy partnership was one of the cornerstones of cooperation between the two countries. “China intends to work with Russia to build even closer partnership and cooperation in the energy sector,” said Xi.
Moving forward, I suspect China and India are going to ask for even bigger discounts as their bargaining position improves and they leverage their position as the only buyers. That was explicitly part of the West’s rationale for implementing the price cap: even though they knew only 27 nations took part in the price cap, they were aiming to reduce Russia’s bargaining power with other countries.
The funniest part is that India isn’t even consuming all this deeply discounted oil, they are shrewdly turning around and selling it on the open market at a markup.
As per the Times of India, “During April-October of 2022, India’s total exports where up 12.5% [relative to 2021], while oil product exports soared nearly 70%. In the case of Netherlands, Brazil, Tanzania, Togo, Israel and Oman, oil shipments have soared at a much higher pace.”
These numbers are a couple of months out of date… moving forward, India is expected to export more and more and more of this discounted Russian oil to the world, effectively acting as a middleman between Russia and the rest of the world. In preparation for these increased exports, the government of India just cut taxes on oil exports in order to stimulate them.
The Maybe Winners: Africa?
Last week, Janet Yellen went on a tour through several African countries and repeatedly shilled the talking point that her price cap “could save the 17 largest net oil-importing African countries $6 billion annually.” She encouraged African countries (who aren’t part of the price cap) to use their increased bargaining power to squeeze Russia for deeper discounts.
“While our approach may be exacting, we believe it delivers lasting results. Countries need to be wary of shiny deals that may be opaque and ultimately fail to actually benefit the people they were purportedly designed to help in the first place,” said Yellen. “This can leave countries with a legacy of debt, diverted resources, and environmental destruction.”
I guess it makes sense that Africa could and should take advantage of the cheap Russian oil — just like India and China are doing — but it also feels like Yellen is blatantly trying to manipulate African nations like a puppet master to achieve her own ends. I don’t know… it feels kind of… yucky… to use Africa as a pawn.
Long Term Impact: It May Backfire Bigtime
When Putin stops selling oil to countries participating in the cap on February 1st (next week), Western countries will be left fighting for oil from Norway, Saudi Arabia, United States, etc… meaning the same amount of Western demand will be chasing a lower supply!
Same Western demand + less supply to the West = higher prices
Thus, in the long-term (this price cap is likely to stay in place at least until the war is over) I expect the global price of oil to rise, therefore exacerbating global inflationary pressures at a time when interest rates are already rising.
At least, oil prices will be higher than they would be in a counterfactual world where this price cap didn’t exist.
While this cap will certainly hurt Russia financially, it may hurt the West as well if and when oil prices skyrocket. This is cutting off your nose to spite your face; I understand that in war it’s sometimes necessary to hurt yourself in order to hurt your enemies, but don’t lie to yourself and pretend like you aren’t hurting yourself by cutting off your nose.
In addition to the supply/demand factors exacerbating upside price risk in the long-term, there is also a significant risk that this cap overlooks or underestimates how Russia could influence global oil prices by weaponizing their production. By backing Russia into a corner, Russia could easily react by slashing production. According to Deputy Prime Minister Alexander Novak, Russia “may reduce its oil output by 500,000-700,000 barrels a day in early 2023” in response to the price cap. “We are ready to partially cut our production early [in 2023],” he said in an interview.
Bob McNally, a former energy official in the George W. Bush administration, says Putin “may not be bluffing about slashing oil or natural gas exports”, and that Putin “could withstand the economic pain longer than Washington and Europe.”
“This thing could go horribly wrong,” McNally said. “Let’s say Putin decides to have an endurance contest with the West. Who can survive $6 gas longer?”
"[Western] countries are today praying that Russian oil exports will not go down," says Bjarne Schieldrop, chief commodities analyst at Swedish bank SEB, "Because if they do, then the oil price will spike … to above $200 a barrel.”
What if Putin does something even more unorthodox than slashing production, and implements a floor on Russian oil to counter the ceiling? What then? Are oil-hungry nations like China really going to refuse to buy Russian oil altogether? I doubt it.
“Ultimately, if the price cap regime is implemented and buyers try to adhere to it, then naturally Russia will say 'pay the price or no oil," says Schieldrop.
The bigger picture is that this price cap has accelerated the push towards a multipolar world; it has driven Russia into the open arms of Asia and Africa, and they have embraced one other. Russia’s economy is undoubtedly more intertwined with Asia and Africa than it was a year ago, thus making it harder for them to decouple in the long-term.
By forcing the world to accept a new regime of partitioned oil markets, rather than a unified global oil market, the West is accelerating the creation of a multipolar new world order, which would be to the detriment of NATO’s desired unipolar world order.