Representative image of a Russian tanker | photo credit: Reuters
The Group of Seven (G7) countries, the European Union and Australia have imposed a price cap on Russian oil transported by sea to make it harder for Russia to finance its war against Ukraine. Under the plan, which came into effect on December 5 , Western companies that dominate the global oil transportation and insurance industry will be barred from offering their services to ship or insure Russian oil purchased at more than $60 a barrel. The price cap is an attempt by the West to reduce Russia’s oil revenues without affecting oil supplies.
It should be noted that since the beginning of the Russian-Ukrainian war, the West has been trying to limit Russia’s energy revenues. At the same time, given that Russia is a major oil producer that contributes more than 10% of the overall world supply, the West has been wary of imposing sanctions that could cause supply to drop sharply. in oil from Russia and drive up oil prices. In fact, it is estimated that crude oil prices could soar as high as $200 a barrel if Russia’s oil supply were to be disrupted by Western sanctions.
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Renowned economists such as Janet Yellen, currently US Treasury Secretary, and Mario Draghi, until recently Italian Prime Minister, have been at the forefront of the idea of price caps, which they say will limit the Kremlin’s oil revenues without affecting the world’s oil supply. . Even though the West has reduced its purchases of Russian oil this year, Russia has been able to sell its oil to India and China to keep its energy revenues up.
The price cap could be seen as an attempt by the West to make buyers of Russian oil pay less for the oil they buy, thereby preventing the Kremlin from profiting too much from its oil sales. Russia has already had to sell its oil at cut rates, which the West sees as a partial success in its efforts to stifle Kremlin revenues by refusing to buy Russian oil. It is estimated that Russia, with a production cost of between $20 and $45 a barrel, will make a small profit on its oil sales.
At the moment, Russian oil is trading at a price below the cap of $60 a barrel imposed by the West. However, the average price of the Russian Urals over the past 10 years has been around $75 per barrel. So while the $60 a barrel price cap is unlikely to negatively affect Russian oil supply or Moscow’s revenue in the short term, it is likely to have negative longer-term effects. When the Urals market price rises above $60, it would increase the chances of traders breaching the price cap. The higher the market price is relative to the price cap, the greater the incentive traders will also have to circumvent the price cap and sell Russian oil at a price above $60 a barrel to willing buyers. This would in effect undermine the West’s efforts to prevent Russia from getting the market price on its oil. But even if the West somehow manages to effectively implement the $60-a-barrel price cap, it cannot really hope to constrain Russia’s revenue through a price cap without affecting also negatively the oil supply at the same time.
Question of incentives
Restricting the price at which Russia can sell its oil will inevitably affect the country’s incentive to pump oil into the market. Economists who support the price cap believe that Russia would continue to export oil as long as the price cap was higher than the cost of producing a barrel of oil for Russia. In particular, Russia maintained oil production even during the COVID-19 pandemic when oil prices fell below $20 a barrel. But expecting Russia to behave similarly in the future with price caps limiting its revenue may be unrealistic. It may well be that Russia expects the drop in demand for oil during the pandemic to be only a temporary misfire; in such a scenario, it might have been more profitable to keep the oil wells in operation instead of shutting them down to reopen them later. If the price cap persists over the long term, however, it is bound to affect Russia’s incentive to keep its oil wells open.
It should also be remembered that in the long term, production decisions are not simply based on the cost of production, but also on the potential rate of return on other investments. If investments in oil do not offer returns at least equal to or better than other sectors, Russia may well decide to reduce its oil investments, which would hurt supply. Such a trend was evident when oil prices fell by around 70% between mid-2014 and early 2016, prompting West Asian oil producers such as Saudi Arabia to consider diversifying their economies into moving away from the oil industry. The West would do well to keep these factors in mind when imposing price caps, thinking that they would have no negative effect on oil supply.
