Plans to punish Russia through price cap on oil could backfire

The US and Europe have responded to the Russian invasion of Ukraine with financial and military aid to Ukraine and economic sanctions against Russia.

Russia derives most of its export from oil and gas sales. The US has put an embargo on all oil and gas imports from Russia. Europe has implemented a partial ban, intending to halt all oil imports by the sea at the end of 2022 and gradually reduce gas imports.

Additionally, there are plans to introduce a ban on insuring Russian oil cargoes. Present and planned measures to reduce energy imports are part of the sanctions intended to hurt Russia financially. They will also reduce Europe’s dependence on Russian energy and prevent Russia from using the threat of shutting down the energy supply as blackmail in the future.

Europe presently buys around a third of Russian exports of oil and petroleum products. As it will take time and costs for Russia to reorient oil exports to other parts of the world, these measures will immediately impact Russia’s export earnings.

Replacing Russian oil in Europe with oil from alternative suppliers entails longer supply lines for European imports and increased fuel costs for European consumers. Replacing all imports of Russian gas, which accounts for 40 per cent of Europe’s gas consumption, entails the highest adjustment costs and will take years.

Introducing measures that effectively will halt Russian oil exports would cause a deep financial crisis in Russia as it would deprive Russia of most of the export revenue. But it would also trigger a global oil price shock as Russia is the world’s second-largest oil exporter. The US and Europe are searching for measures to reduce Russia’s ability to finance the war without burdening American and European consumers and the global economy.

The American minister of finance, Janet Yellen, proposed at the recent G-7 summit to introduce a price cap on Russian oil. The idea is as follows: Russian crude sells at a discount of USD 30 relative to the world market oil price after the US-EU embargo on oil purchases. On the margin, it costs around USD 45 to produce one barrel of oil in Russia.

If a price cap (max. price) of, for example, USD 50 is introduced, it would still be profitable for Russia to export oil but would reduce the income per barrel by USD 30 compared with the current sales price for Russian oil. On an annual basis, this would amount to around USD 85 - 90 billion in reduced revenues for Russia. The buyers of Russian crude, who already benefit from a discount of USD 30 per barrel, would get a total rebate of USD 60 compared with the world market price. 

The price cap is to be implemented by making it a mandatory requirement for obtaining insurance for Russian oil cargoes and by levying sanctions against insurers that do not comply. The intention is to punish Russia through weakened finances. If it works, it is preferable to a ban on the insurance of Russian oil cargoes as it still would allow for Russian oil exports. Additionally, it could potentially represent a significant relief for consumers in the US and Europe who can continue to rely on Russian oil and obtain a substantial rebate. But will it work?

It is a challenging scheme to implement: A new insurance market may develop with actors that do not abide by the regulations; it may result in corrupt and fraudulent practices as it will become highly profitable to relabel and resell Russian oil. Even if one manages to overcome these problems, there are additional concerns: The scheme is not a surgical tool that can be used to punish Russia and support consumers in the US and Europe without risks of collateral damage.

The embargo on Russian oil has already created a divided oil market as Russian oil is, on average, selling at a discount of USD 30 compared with the world market price. Countries with access to cheap Russian oil pay significantly less for oil and may increase their oil imports without increasing their import bill. This is already causing spillover effects on demand in the unregulated market. A price cap would cause additional upward pressures on the (unregulated) world market oil price.

Russia may retaliate in the gas market by closing pipeline exports of gas to Europe, making the winter months exceedingly unpleasant for European households. In the oil market, the West cannot control the destinations of Russian oil exports. As Russia would have no incentive to continue exports to US and Europe, American and European consumers may draw little direct benefit from the price cap, but would suffer from upward pressure on the world market oil price. Other oil importing countries would compete for cheap Russian oil.

The countries that succeed in attracting Russian oil would attain a considerable advantage. For example, if Kenya can attract Russian oil, it could reduce the current import bill for petroleum products, which could amount to USD 5bn this year at the current oil price by half. The new market conditions may open lucrative economic partnership deals for Russia that partly compensate for the impacts of the price cap; cheap oil may be traded for benefits like access to other natural resources or other financial or political concessions.

Alternatively, Russia could respond to a price cap by reducing or temporarily halting oil exports, causing substantial price hikes in the oil market. Wielding the oil market as an instrument in economic warfare is a risky strategy that could backfire, hurt the US and European consumers, and alienate potential allies.