Recent G-7 discussions about imposing caps on the price of Russian oil and gas have led to some head-scratching. We see several angles at play in this situation. Below are some thoughts from a political economy standpoint. We are concerned the risk of policy error could be high here.
1. It is far from clear that Russia would play along since it has probably been a net earner of foreign exchange (FX) since the war began.
According to Finnish think tank Centre for Research on Energy and Clean Air (CREA), Russia earned €93 billion from fossil fuel exports (including coal) in the first 100 days of the war, or just shy of $1 billion/day, with the same report citing estimates of $900 million/day for the cost of the war, indicating the exercise has actually been a net FX generator, not least because of the war’s impact on the oil price.[i] If anything, the war expenditure estimate may lean high given that Stockholm International Peace Research Institute estimated total global military spending at close to $2 trillion in 2020 and 2021.[ii] Even applying a heavy discount to headline FX reserves of $587 billion,[iii] Russia can probably stop oil/gas sales entirely for a year without running out of reserves. As we have noted previously, Russia’s war machine is largely domestically sourced, meaning the war itself can be financed largely without access to dollars. True, the domestic fiscal balance does depend on hydrocarbons too, but here again the starting point of debt and deficits is enviable, in our view. What would happen to the global economy were Russia to stop exports entirely on its own accord? We feel it would not be a rosy picture. In our view, the world needs Russian oil more than Russia needs to sell it.
Halting production itself for a prolonged period could involve geological/engineering costs, which are beyond the scope of this analysis. However, given the current supply environment, we submit that any Russian export ban need not be particularly long to trigger price responses in the market.
Recall also that over the last year, Russia's revenues from fossil fuel sales have increased despite falling volumes and discounts due largely to the overall commodity price move—at least part of which was a result of the Ukrainian war. CREA estimated that the 60% increase in prices more than offset the combination of lower export volumes and discounts on Russian oil leading to a net increase of€250 million in average daily Russian revenues from fossil fuel exports between May 2021 and May 2022.
2. It is unclear if the G-7 economies would be able to get significant consumers to comply with price caps given that the status quo has benefited key consumers of Russian oil and gas.
India has emerged as a significant consumer of Russian oil almost overnight, with the country’s share of Russian exports rising from 1% prior to the invasion to 18% in May 2022, with sales widely reported at a discount to notional world market prices.[iv] Crucially, 20% of Indian refinery exports head west of the Suez Canal—to the same countries driving sanctions on Russia.[v] India and China have already been seeing economic gains from the price discounts on crude oil and—especially in India—the refining margin.
3. Beyond economic considerations, India and China signing up to a Western-led price cap on Russia would be a notable deviation from historical precedent.
Both countries have a long tradition of diplomatic independence rooted in their post- and anti-colonial history and politics. This is particularly the case with respect to energy: both have been a lifeline to Iran during various iterations of Western sanctions. The Iran trade offers a template for working around Western sanctions, especially with state-owned ships insured by the sovereign and underwritten by government banks engaging in the trade. India in particular has shown little taste for Western self-sanctioning, with Indian corporates increasing rather than reducing activity in Russia since the invasion.[vi] The Indian military’s still-heavy dependence on Russian arms is a further factor to consider.
The devil remains in the detail
For the caps to work, then, we believe two minimal conditions must hold:
1. Russia doesn’t stop exporting oil and gas out of spite.
2. Complete global compliance with the cap/sanctions regime, notably including India and China as significant marginal buyers of Russian exports.
- Economic considerations alone suggest the cap should be lower than the substantially discounted price the two countries have already been paying.
- India and China would be reversing a decades-long diplomatic posture of non-alignment with and independence from the West, which would itself likely require some further politically-tied discounts or concessions.
If neither condition holds, we believe the caps will likely fail, and quite possibly backfire.
The devil remains in the detail. What specific price will be chosen as the cap price given that Russia’s enormous geographical size and diversity mean Russian supply is spread over the cost curve? How will purchase prices be documented, and how can governments ensure there are no side deals leading to effectively higher prices?
Even if all of the above holds, and loopholes are closed, we believe the risk of policy error is high. Sanctions/caps are easy to impose and proclaim, but history underscores collateral damage risks. As seen in Iran, individual institutional imperatives and regulatory friction can lead to suboptimal macroeconomic outcomes. Specifically, compliance decisions by individual corporates may lead to rejection of otherwise cap-compliant individual deals/cargoes and delays. Predicting the associated loss of supply ex-ante is impossible, but some incremental loss of Russian supply to regulatory/sanctions/cap friction appears inevitable.
Proposals for a price cap on Russian oil and gas may be appealing, but, in our view, do not stand up to scrutiny.
The success of any price cap would be ironically predicated on Russia’s own cooperation, which we believe is far from certain. We are particularly mindful of the collapse in Russian gas flows to Europe.
The incentives—economic and political—for China and India to play along with the West also appear ambivalent. Both countries have shown little appetite for reducing either economic or diplomatic engagement with Moscow. Joining in on price caps could be a significant political turn, and be read as much in Moscow.
There is some speculation that price cap talk is a way for Western governments to start slowly walking back from threats of buyers’ boycotts—a “peak sanctions” moment in effect. This, in our view, would be a more optimistic interpretation from a financial markets perspective. Otherwise, we feel any attempt to force a price cap on Russia may well lead to asymmetric pain on the G-7 economies themselves.
[i] CREA, “Financing Putin’s war: Fossil fuel imports from Russia in the first 100 days of the invasion,” 13 June 2022.
[ii] Stockholm International Peace Research Institute, “Trends in World Military Expenditure, 2021,” April 2022.
[iii] Bloomberg, as of 1 July 2022.
[iv] CREA, “Financing Putin’s war: Fossil fuel imports from Russia in the first 100 days of the invasion,” 13 June 2022.
[v] CREA, “Financing Putin’s war: Fossil fuel imports from Russia in the first 100 days of the invasion,” 13 June 2022.
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