In early December, the G7 and EU countries, plus Australia, put a cap on the price at which they would allow sales of Russian exported crude. The cap is $60/bbl with various modifications and adjustments. The rationale for the price cap is that with world oil prices ranging between about $70 and $80 the cap will reduce Russia’s income for fighting the war in Ukraine but will be enough above Russia’s cost of production to allow enough incentive to keep Russian supplies producing and entering the world market. If the cap were too low, Russia might shut-in a significant amount of production causing a worldwide supply shortage. That would leverage into large price increases which would be economically intolerable to the G7 and EU countries and Australia.
Reportedly, Secretary of the Treasury Janet Yellen originally proposed this idea which Daniel Yergin, writing in the December 27 Wall Street Journal, called “ingenious.” The logic of the idea is of course impeccable in Janet Land and the world of European bureaucrats where they spent months negotiating details of the deal and its implementation such as rules for shipping and maritime insurance (as a side note, it is interesting how the East European and Baltic countries who have been under the Russian heel take the hardest line in the negotiations; they have hate for Russia in the marrow of their bones).
Russia’s oil exported west to European and other western markets is known as Urals blend. At the time the price caps went into effect, Russian Urals crude had been trading around $50 per barrel for several weeks.
If prices for export to Europe and the G7 are already around the low $50s and a price cap of $60 is imposed what effect is expected? None, to the rational mind. Certainly not a Russian income reduction. But bureaucrats are not rational.
Russia exports oil from Pacific ports to Asian customers, mainly China and India, who do not care about Ukraine, European sanctions, or Western embargos. Quoted prices are close to world prices. What effect does the price cap have on those markets? Obviously, none. They are still exporting at world prices. The Asian supplies are limited so China, India, and Turkey are taking advantage of the low Urals prices and importing some of that. With China ending its Covid lockdown policy its economy will resume growth and so will its oil demand. Expected Chinese demand increases are already offsetting recession expectations and increasing world prices and the Urals price, as noted above.
The price cap was supposed to be at a level above Russia’s cost of production to keep sufficient revenue flowing to avoid a production shut-in. I have seen Russian production costs reported to be $40 and $20 per barrel. Determining cost of production is a complicated matter for a diverse and extensive group of projects such as the Russian industry and it varies greatly depending on which fields and projects produce the marginal barrels under certain circumstances. Certainly, no one negotiating the level of the price cap knows what Russia’s cost of production is. I doubt the Russians know.
I have also seen discussions of how Russia cannot shut in production because it will damage wells, wells cannot be re-started, and permafrost will melt. All that may be true for some fields or wells but Russian sources are scattered over diverse areas; it has plenty of fields which can be shut in. So the market cap price was negotiated between people who know nothing about which they negotiate.
So considering results of the price cap after one month:
- Russia was already selling its oil at prices lower than the cap to G7 and EU countries.
- Russia’s export volumes have increased because new customers took advantage of the prices lower than world prices and Russia’s export income increased
- Russia’s Asian exports were already at world prices and those customers are not part of the price cap agreement.
- The ruble increased more than 60% against the dollar since the start of the war.
- Countries which imposed the sanctions on Russia (Germany, France, the rest of Europe, the U.S., Canada, and the U.K.) are all suffering various degrees of high inflation, currency weakness, and energy shortages.
- Big Bad Vlad is threatening to shut in several hundred thousand barrels per day of production.
- World oil prices are increasing, including the prices of Russian oil.
So much for sanctions and price caps as a punishment. They can be an effective weapon but one should figure out which way the gun is pointed before pulling the trigger.
What was really confirmed is Chinese demand has much more influence on oil price than floundering bureaucratic attempts to manipulate it. China is the elephant in the room with more than a third of world oil demand.
When considering the effectiveness of the Russian embargo and price cap one should also remember not to underestimate the imaginations of those who skirt rules, many of whom work for governments. Reportedly, the market for old tankers surged in the last few months. Why not? There are several ways to play it. One is to buy cheap Russian crude, blend it with an Arab crude, and feed it into a market that does not care about Ukraine or Europe or sanctions. Another choice is to park that old tanker filled with cheap Russian oil in the Outer Harbor at Singapore or one of a few other reliable locations at a few cents per barrel per month and wait for the price to go up maybe 25 bucks or more in the next year or so. Of course, someone who produces oil for his own refineries could sell it for $80, replace it with cheap Russian oil for his own refinery feedstock, and sell refined products at world prices; an option for several government-owned companies.