Will an EU oil price cap limit Russian aggression?

Timothy Ash

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Since the start of Russia’s illegal war on Ukraine, the West has struggled with the difficult question of how to curb Russia’s oil cashflows. How should they cut off Vladimir Putin’s energy profits – used to line Russia’s war chest – while also protecting their economies from price spikes?

After months of member state wrangling and debate, the European Union (EU) has finally agreed a plan which will ban seaborne imports of Russian oil and introduce an oil price cap at $60 a barrel.

The price cap, initially put forward by the G7 in September, is expected to be agreed on 5 December and will see sanctions take immediate effect. However the proposal has been met with mixed reactions by different EU member states, and all eyes are now on Russia to see how the country will react.

Reaching an EU compromise

The road to agreeing a quick oil cap deal has not been straightforward. Two opposing groups formed within the EU which delayed a swift agreement on the oil price cap. One is led by the hawks in Poland and the Baltic states which argue the quickest way to defeat Russia is to collapse its energy revenues by lowering the price cap to the $20-30 a barrel range – crucially lower than the cost of production at approximately $40 a barrel.

The proposal has been met with mixed reactions by different EU member states, and all eyes are now on Russia to see how the country will react

The other group – led by Hungary but also including the larger Russian energy importers Germany and Austria, plus France – argues any overly aggressive market cap will risk destabilizing global energy markets.

They claim this will spur further increases in energy prices to benefit Russia, while also imposing a bigger economic burden on energy-importing EU member states.

There is a fear in this latter group that anything which potentially restricts supplies and further spurs the cost-of-living crisis in Europe will ultimately undermine the popular political will to sustain European support to Ukraine against Russia.

Arguably the differentiating factors between the two groups are risk perceptions around Russia, confidence in the underlying popular support for Ukraine, and the willingness to take economic pain in that cause. Countries such as Poland and the Baltic states see Russia as an existential threat but, further west, risk perceptions of Russia tend to moderate.

However, a compromise has now settled around an oil price cap of around $60 a barrel. Consensus on this number has been helped by existing sanctions and Environmental and Social Governance (ESG) concerns are already working to force Russia to sell its oil at a substantial discount to global oil prices. For example, Urals oil is currently selling at a price close to $60 a barrel, a 27 per cent discount now to Brent’s international crude oil benchmark.

Arguably this soft price cap and the broader and general sanctions regime around Russia are already helping to limit any oil and energy windfall gains from its invasion of Ukraine.

How could Russia react?

Russia has threatened to retaliate by stopping oil sales to any countries participating in the oil price cap. This is likely a bluff as Russia’s own export volumes and total revenues would be hit at a time when foreign exchange reserves have been under sharp downward pressure – falling by more than $100 billion per year to date despite a rising current account surplus.

There are also technical issues for Russia in halting the supply of oil as its storage capacity is finite. Similarly, stopping production at oil wells could cause long-term damage to the country’s production potential.

The West’s struggle to agree an oil price cap underlines the difficulties more generally in applying sanctions to countries such as Russia which play a role in the global supply chain (oil and energy in this case). The objective of sanctions is always to damage the target more than the countries applying the sanctions and there is also a political imperative to maintain sanctions unity.

A global recession brought on by the crisis in Ukraine, and Russia’s offensive action to limit energy supplies to Europe, could ultimately prove to be the straw that breaks the camel’s back

The latter has tended to take priority, resulting in sanctions of the lowest common denominator, moderating both the severity and effectiveness of sanctions as they have been applied to Russia.

But as ever with sanctions, it is important to view them as just one part of a broader coercive Western response to Russia which can include other diplomatic sanctions, military options, and cyber. Sanctions are not a silver bullet, they are meant to change Russian calculus to encourage a change in behaviour.

Limiting Russia’s ability to use its ‘energy card’

One particularly important point when it comes to oil, energy, and commodity markets has been how market forces have mitigated Russia’s own efforts to use the energy card against the West, particularly against Europe.

As Russia has cut gas supplies to Europe – and as gas and energy prices have rocketed – demand, particularly for gas, has adjusted to be significantly lower – 25-30 per cent lower in Germany for example – and global growth has crimped which has finally begun to weigh down on global energy prices.

A global recession brought on by the crisis in Ukraine, and Russia’s offensive action to limit energy supplies to Europe, could ultimately prove to be the straw that breaks the camel’s back, by resulting in significant reduced demand for Russian energy.

Will an EU oil price cap limit Russian aggression? 2nd part

With Russia’s economy weighed down by the costs of war and sanctions, a collapse in total energy import revenues could prove to be fatal to the Putin regime over the medium term.

The West’s efforts to cap Russian oil prices has been met with irritation among other energy producers, particularly in the Gulf, ridiculing what they say are attempts to distort the market. The irony seems to have been lost on these very same OPEC members whose raison d’etre is market manipulation in their favour.

But perhaps the reaction of these states simply reflects a fear that the West’s efforts to coordinate the actions of energy consumers could morph into something which eventually undermines the dominant position of OPEC itself in the global oil market.