A better way to target Russian oil

As the war in Ukraine grinds on, Europe and the United States continue to search for tools to do the impossible: cut Russian President Vladimir Putin’s energy earnings without disrupting oil and gas supplies or driving prices through the roof.  The latest option is a cap on the price of purchased Russian oil. But a better and more feasible plan languishes without sufficient advocacy. On May 31, the European Union reached an agreement to ban most Russian crude and refined petroleum imports by the end of 2022. Shipments by sea – which account for about two-thirds of Europe’s purchases from its eastern neighbor – will be forbidden. Poland and Germany also agreed to end pipeline imports. If both measures are implemented, the only Russian oil supplied to the EU will come via the southern Druzhba pipeline, which fuels Slovakia, the Czech Republic, and pro-Kremlin Hungary.  Last year, 56% of Russian crude and 70% of its refined product exports went to Western countries – mostly European nations such as Germany, the Netherlands and Poland. The US, Canada, Britain and Australia, meanwhile, which import little Russian oil, had already announced measures to halt Russian oil imports. With Western buyers closing their wallets, Russia has reoriented sales to Asia, particularly India, which was not previously a major customer, and to some extent China. To sweeten these deals, Russia offers discounts of up to US$30 per barrel, but prices have risen so much (they have been over $100 a barrel since March) that Moscow is earning at least as much as immediately before the war, and 50% more than in the first four months of last year. For now, Russia’s new markets seem secure. If the West were to try to block these sales to Asia – for instance, via a shipping ban – it would anger important allies like New Delhi, invite avoidance (as has occurred for several years with sanctions on Iran and Venezuela), and, to the extent it was successful, drive world oil prices even higher than they already are. This could trigger a global recession, imperil the electoral fortunes of US President Joe Biden and several European leaders, and create political pressure to concede to Russia. Aware of these constraints, Western allies, including Japan, have sought more nuanced instruments. At the Group of Seven summit in Germany last month, leaders agreed to consider a cap on Russian oil imports sold above a certain price. This could be enforced by banning shipping or insurance for cargoes purchased above the limit. Figures discussed for the cap are in the range of $40 to $60 per barrel. But there are numerous problems with this approach. First, it would require the EU to revisit its own ban passed in May, laboriously crafted after long debate with Budapest. Second, the proposed price is too high – well above the likely production cost for Russian companies of $20 per barrel. The Russian state heavily taxes its companies at prices above $25 per barrel. Price caps on refined products would have to be set, too, inviting creative re-labeling. Third, insurers from China and India would likely step in. While Asian insurance providers don’t have the reputation or coverage levels as European firms, they would still be adequate for sales to those destinations. Fourth, as with the “Oil-for-Food” program in Iraq in the 1990s, the cap would invite under-the-table deals and kickbacks. Barring that, Russia would simply play divide-and-rule by selling above the cap to its geopolitical supporters. Finally, Russia may still cut back on oil shipments – as it has already done with gas to Europe and by invoking spurious technical reasons to limit Kazakh oil exports via its territory. Former president Dmitry Medvedev even threatened Japan that its adherence to a cap would see its access to Russian oil cut off, and prices going above $300-$400 per barrel.  More effective solutions have been advanced by Ricardo Hausmann, a Harvard economist and former minister of planning of Venezuela, Harvard Russian scholar Craig Kennedy, and US Treasury Secretary Janet Yellen, among others.  The best of these is a stiff per-volume tariff on imports of Russian petroleum. This would weaken the incentive for buyers to cheat, as they would still face the end-user market price. China, India, and other countries could be brought in by a combination of the stick of shipping sanctions, and the carrot of retaining much of Russian oil earnings themselves. This would create a kind of buyer cartel. But such concepts have achieved oddly little traction despite their economic merits. Whatever mechanism is arrived at, the impact on rival oil producers will be profound. Currently, Moscow cooperates with the Organization of the Petroleum Exporting Countries and other leading producers in the OPEC+ alliance. Saudi Arabia is keen to retain Russia within this framework, even though it can’t currently live up to its production targets.

A better way to target Russian oil

As the war in Ukraine grinds on, Europe and the United States continue to search for tools to do the impossible: cut Russian President Vladimir Putin’s energy earnings without disrupting oil and gas supplies or driving prices through the roof. 

The latest option is a cap on the price of purchased Russian oil. But a better and more feasible plan languishes without sufficient advocacy.

On May 31, the European Union reached an agreement to ban most Russian crude and refined petroleum imports by the end of 2022. Shipments by sea – which account for about two-thirds of Europe’s purchases from its eastern neighbor – will be forbidden. Poland and Germany also agreed to end pipeline imports.

If both measures are implemented, the only Russian oil supplied to the EU will come via the southern Druzhba pipeline, which fuels Slovakia, the Czech Republic, and pro-Kremlin Hungary. 

Last year, 56% of Russian crude and 70% of its refined product exports went to Western countries – mostly European nations such as Germany, the Netherlands and Poland. The US, Canada, Britain and Australia, meanwhile, which import little Russian oil, had already announced measures to halt Russian oil imports.

With Western buyers closing their wallets, Russia has reoriented sales to Asia, particularly India, which was not previously a major customer, and to some extent China.

To sweeten these deals, Russia offers discounts of up to US$30 per barrel, but prices have risen so much (they have been over $100 a barrel since March) that Moscow is earning at least as much as immediately before the war, and 50% more than in the first four months of last year.

For now, Russia’s new markets seem secure. If the West were to try to block these sales to Asia – for instance, via a shipping ban – it would anger important allies like New Delhi, invite avoidance (as has occurred for several years with sanctions on Iran and Venezuela), and, to the extent it was successful, drive world oil prices even higher than they already are.

This could trigger a global recession, imperil the electoral fortunes of US President Joe Biden and several European leaders, and create political pressure to concede to Russia.

Aware of these constraints, Western allies, including Japan, have sought more nuanced instruments.

At the Group of Seven summit in Germany last month, leaders agreed to consider a cap on Russian oil imports sold above a certain price. This could be enforced by banning shipping or insurance for cargoes purchased above the limit. Figures discussed for the cap are in the range of $40 to $60 per barrel.

But there are numerous problems with this approach. First, it would require the EU to revisit its own ban passed in May, laboriously crafted after long debate with Budapest.

Second, the proposed price is too high – well above the likely production cost for Russian companies of $20 per barrel. The Russian state heavily taxes its companies at prices above $25 per barrel. Price caps on refined products would have to be set, too, inviting creative re-labeling.

Third, insurers from China and India would likely step in. While Asian insurance providers don’t have the reputation or coverage levels as European firms, they would still be adequate for sales to those destinations.

Fourth, as with the “Oil-for-Food” program in Iraq in the 1990s, the cap would invite under-the-table deals and kickbacks. Barring that, Russia would simply play divide-and-rule by selling above the cap to its geopolitical supporters.

Finally, Russia may still cut back on oil shipments – as it has already done with gas to Europe and by invoking spurious technical reasons to limit Kazakh oil exports via its territory. Former president Dmitry Medvedev even threatened Japan that its adherence to a cap would see its access to Russian oil cut off, and prices going above $300-$400 per barrel. 

More effective solutions have been advanced by Ricardo Hausmann, a Harvard economist and former minister of planning of Venezuela, Harvard Russian scholar Craig Kennedy, and US Treasury Secretary Janet Yellen, among others. 

The best of these is a stiff per-volume tariff on imports of Russian petroleum. This would weaken the incentive for buyers to cheat, as they would still face the end-user market price.

China, India, and other countries could be brought in by a combination of the stick of shipping sanctions, and the carrot of retaining much of Russian oil earnings themselves. This would create a kind of buyer cartel.

But such concepts have achieved oddly little traction despite their economic merits.

Whatever mechanism is arrived at, the impact on rival oil producers will be profound. Currently, Moscow cooperates with the Organization of the Petroleum Exporting Countries and other leading producers in the OPEC+ alliance. Saudi Arabia is keen to retain Russia within this framework, even though it can’t currently live up to its production targets.

An outright Western ban on Russian oil would drive up prices, thus benefiting Russia’s petroleum rivals. It would also lead to intense struggles for market share in the Middle East’s traditional Asian markets, even though Middle East producers would reorient to sell more to Europe.

India, China and others would have tough choices on whether to buy as much as half their oil from Russia at attractive discounts but with major logistical and legal problems, and at the penalty of dropping their long-standing and reliable suppliers in the Arab Gulf region.

A price cap or tariff would be less disruptive – so long as Russia did not retaliate – but would still invite trading shenanigans. Russian oil output is also likely to decline in the longer term, weakening Moscow’s hand as a competitor to Gulf producers, and suggesting Gulf countries should step up expansion of their own capacity.

As Western efforts to square the stubborn circle of oil prices continue, Middle East oil exporters will watch keenly from the sidelines.

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