Ben Cahill
The G7 has confirmed its plans to impose a price cap on Russian oil. The goal is to keep Russian crude oil and petroleum products on the market to avoid a price spike, while depriving the country of essential revenues for its economy and its war machine. The price cap is a novel approach. Most energy sanctions target export volumes, while this plan would cut prices. But rather than set a new, globally recognized price for Russian oil, the cap is likely to create a multitiered price system. It would cut but not decimate Russia’s oil revenue.
The United States has pushed for the price cap in response to the European Union’s risker plan to ban Russian oil imports. In June, the European Union imposed a sanctions package that will ban seaborne crude oil imports as of December 5 and petroleum product imports as of February 5, 2023 (with some exceptions). Crucially, the sanctions also ban EU companies from providing shipping insurance, brokering services, or financing for oil exports from Russia to third countries. U.S. Treasury officials suggest the EU embargo could reduce Russia’s exports by three to five million barrels per day, which would trigger a massive price spike.
Under the proposed plan, shippers and insurers would have to prove they are supporting Russian oil trade at or below the price cap. Unauthorized trade above that price would require buyers to seek brokering, shipping, insurance, and reinsurance from outside the participating countries. These services would become more scarce and more expensive. For now, there are no plans to impose secondary sanctions to force countries to participate. Many details remain uncertain, and the terms have to be agreed before December 5, when EU sanctions take effect.
There are at least four big challenges for the price cap. First, how will Russia respond? It has already threatened to withhold oil from countries joining the price cap. Supporters of the idea argue that this is a bluff. They note that Russia has limited storage capacity and that halting production in Western Siberia could freeze equipment and damage its oil infrastructure. But it seems presumptuous to assume Russia will accept far lower prices. President Vladimir Putin may bet that cutting off Russian oil will panic the market, creating a price shock that will weaken Western resolve.
Second, will Asian buyers get on board? Currently, India and China are enjoying considerable discounts for Russian crude and can purchase as much as they like. This trade is still legal if they do not deal directly with sanctioned Russian companies or individuals. In theory, the price cap will allow them to buy crude and products at even lower prices. Yet India and China may be skeptical about signing on to a cumbersome monitoring and enforcement system. They will also chafe at another imposition of Western energy sanctions.
Third, what will happen if there are multiple prices in the market? Consider how Russian exports have evolved since February. After Western companies stopped buying, Russia was forced to discount its oil but found plenty of willing customers. Middle Eastern refiners, for example, have been buying Russian crude, refining it, and exporting products. Since demand for cheaper Russian oil will outstrip supply, the price cap could create multiple prices: the global crude price, the capped price for Russian oil, and a shadow price that would settle somewhere between the two. The spread will create enormous arbitrage opportunities for traders.
Fourth, monitoring and enforcement will be challenging. Market players manage to evade sanctions on Iranian and Venezuelan oil through ship-to-ship transfers, illicit tanker trade, and crude blending. Refiners and other buyers will probably find ways to beat the proposed requirements for trading Russian oil. They may seek letters of credit from multiple banks or use several subsidiaries to document deals at the approved price, while paying more in reality.
The oil market is full of clever, rapacious people with strong incentives to bend or break rules. If the price cap is imposed, economic theory will collide with the messy reality of the market. Still, this is a better option than the EU embargo and insurance ban. If the price cap legalizes oil trade with Russia but fails to secure full cooperation from India, China, and other countries, the price cap will score a partial victory. It will avoid the worst-case scenario of a market shortage and a huge price spike—but probably will not dramatically cut Russia’s oil revenue.
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