A Price Cap on Russian Oil Is Unworkable

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The idea of imposing a cap on Russian crude oil prices is the latest example of an unworkable government initiative that seems destined to backfire. The proposal from officials in the US Biden administration, who seem ignorant of the structure of the oil market, will likely be easily circumvented. It will thus do little to damage Russian oil revenues — which might actually be inadvertently boosted — but could double or triple the profits of some oil trading firms, if history is any guide. Other approaches are needed instead, not least an acceleration of efforts to cut oil and gas use.

The price cap proposed by the Biden administration would limit the amount a buyer could pay for Russian oil. Various implementation proposals have been offered. Under one, cargo insurance would be denied to a buyer, unless the price on the bill of lading was below the cap. Here the theory is that most cargo insurance recognized by ports across the globe is written by protection and indemnity (P&I) insurance firms in Europe or the UK.

The proposal could be circumvented, however, by simply creating new insurance underwriters in China, India or Russia. Bloomberg’s Julian Lee notes that Moscow has already created an alternative P&I organization. Whether the insurance would be recognized by ports or shipowners is an open question. The oil trading community could equally create an alternative.

Moscow might also simply offer trading firms the right to bid to buy volumes of oil sold at the price cap. By auctioning these buying permits — which would not be shown on the bill of lading — Russia could capture almost as much revenue. Trading firms, funded by Chinese or Indian banks would quickly step into the breach. Circumvention of the price cap would thus be a simple matter.

There are undoubtedly other means to circumvent the price cap and these, too, will be tried. Having watched the industry for 50 years and worked with some of its less savory traders, including the infamous Bruce Rappaport, I have no doubt that the proposed cap will not depress and might increase Russia’s oil revenue.

Warnings Ignored

Such unintended consequences are nothing new. Time and again governments have ignored the minimal feedback given by the industry about proposed actions. The high prices and shortages of diesel fuel today have occurred because governments paid no attention to warnings about the impacts of aggressive action by the International Maritime Organization (IMO) to limit sulfur in maritime fuels.

The impact of the IMO rules may have been made worse too, as many oil refiners — recognizing the future profit opportunity — contributed to the problem by saying nothing. Those in the oil industry have learned that their views are not wanted, that governments will act regardless of industry views, and that very large profit opportunities can be created by government ineptitude.

Lessons From History

This pattern of behavior has deep roots. Government officials, politicians and the public have been at odds with the oil industry since the end of World War II. The essence of that struggle was captured well by Theodore Levitt, one of the towering figures in marketing (and the inventor of the term globalization) in his 1960 article Marketing Myopia. In this he said: “The gas station is like a tax collector to whom people are compelled to pay a period toll as the price of using their cars. This makes that gas station a basically unpopular institution. It can never be made popular or pleasant, only less unpopular, less unpleasant.”

Following the end of the war governments in Europe also fought the industry, imposing large taxes on gasoline and diesel to preserve foreign currency reserves and repress the industry. The US fought the industry as Texas and other states limited production to hold prices high. The late Senator Henry Jackson led a multiyear study of the industry attempting to show how it violated completion laws.

Mistrust of the industry limited or prevented those who had worked in the industry from taking positions in government, from which they might have smoothed relations. Instead, the industry became more secretive, offering little if any help to those trying to moderate the impact of disruptions such as the Arab Oil Embargo of 1973.

Oil Trading Genesis

In the 1970s, price controls imposed by the US also begat an entirely new oil trading industry. Marc Rich, pardoned by President Bill Clinton for his violations of US oil trading rules, founded one of the world’s largest trading firms. Trafigura is the successor to his efforts.

In the 1980s, the UK industry also did little to instruct the British government on the potential problems with its petroleum revenue tax. Instead, the industry quickly established trading practices that circumvented the impact of the tax and boosted income, including creating the Brent market. Ironically, the short-term actions of the industry, in my view, destroyed much of the clout of the multinational companies, thereby contributing to today’s disastrous situation.

The proposal to impose a cap on Russian crude oil prices is yet another example of an ill-conceived government action. The G7 and particularly the Biden administration need to start their efforts over. Only by creating a united front against Russia, which includes India, Israel, China and probably Brazil, can the old industrial nations affect Russia’s energy exports today. A long-term impact can also be achieved by accelerating efforts to cut oil and gas use. Soaring prices are already helping to do that, with the transition to renewable energy sources continuing to gain momentum too, despite some recent headwinds.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. The views expressed in this article are those of the author.

Oil Trade, Oil Supply, Sanctions, Ukraine Crisis
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