The Achilles’ Heel of the G7 Price Cap

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On the face of it, the idea of a price cap on Russian oil exports is smart. With it, G7 finance ministers aim to prevent a disastrous impact from an EU tanker ban, while lowering income for Russia. Oil bought under the price cap mechanism is allowed again to sail on tankers with insurance and financing from EU-linked companies — the bulk of the global fleet. This is clever, but not without risk. G7 ministers are betting that Moscow will accept a Western-imposed lower price for its oil as it needs the cash, and won’t cut oil exports as it did with natural gas. But that may well happen, as Moscow has said it won’t sell oil to countries that agree to the price cap. If it also refuses to use any services associated with G7 countries, Russian oil will have to sail on non-Western tankers — and there aren't enough vessels to handle Russia’s millions of barrels. The result: less oil, higher prices, and less pain for Russia.

The world has been mostly focused on the EU rule adopted in June that bans imports most of Russia’s crude from Dec. 5, and most products from Feb. 5. The EU was still importing 2.71 million barrels per day of Russian crude and products in August. The bulk of those flows need to find a new home and the EU must find new suppliers to replace these. By itself this ban could create massive havoc in the oil world. Already an additional 1 million b/d or so of Russian crude is flowing to Asia, as products now start finding new buyers as well — resulting in huge discounts and a reshaping of traditional trade flows.

This whole exercise is made much more complicated by a second EU ban that runs parallel to the import ban and blocks EU companies from providing maritime insurance and financial services for Russian crude and products going to non-European countries. In other words: no Russian oil can ship on tankers that have any EU link to finance, services or insurance. This rule effectively means that Russia must find a new fleet for 5.6 million b/d of its seaborne exports. The 1.15 million b/d sailing from Russia’s Far East is already using mostly Asian and Russian vessels. But the 4.45 million b/d sailing from the Arctic, Baltic and Black Seas are using predominantly EU-linked tankers. The question is, how to get this to market? The price cap, promoted by US officials fearing supply shortages, would provide the exception needed to keep that oil flowing.

The G7 has now accepted the price cap as the diplomatic solution that saves the EU from itself, and the world from oil shortages, while limiting Russia’s income to fund its war in Ukraine. And in new guidelines, the G7 essentially puts the onus on oil traders and refiners to truthfully report the price of their Russian cargo, so the G7 can check whether a cargo is eligible for the waiver and the cargo can sail on a Western tanker. Banks, insurance and shipping companies must try to ascertain the price, but cannot be held responsible if they act on wrong information from traders.

The G7 is already claiming its first successes — with the US Treasury noting that Asian countries can get steeper discounts from Russia even if they decide not to join the price cap mechanism now in the making. The G7 argues this lowers the income for Russia. Fair enough, but how will this oil come to market if not on a Western-linked tanker?

Join the Group?

G7 officials haven’t revealed a specific price for the cap yet, but have been clear they want it to be above the cost of producing Urals crude and below its free market value. Russia was making “plenty of money” at $60 per barrel, a US Treasury official said earlier this month, suggesting the price would be well below that. The cost of producing crude oil in Russia could be as low as $15/bbl on average. In fact, the idea is to have three price caps: one for crude, and two for products. The price caps will be reviewed periodically and widely publicized.

Traders have a psychological issue with flat prices. What if the benchmark price falls? They would want to see a fixed percentage discount to the benchmark price. But the G7 wants to limit the upside for Russia’s income, and what if oil goes to $200? A percentage would provide an incentive for Russia to limit supply. A fixed price would offer an incentive to sell as much as possible. Traders can hedge that discount and lock in their profits.

The US and Canada have a ban on Russian oil imports in place. Japan and the UK have mostly stopped buying. Germany, France and Italy are still gorging on Russian oil but will join Dec. 5 as part of the EU ban. India and China or Turkey, the countries already taking more Russian fuel, are unlikely to join the price cap mechanism. They have a good reason not to. Russian Deputy Prime Minister Alexander Novak said last week that Russia would halt supplies to countries that support the G7 initiative.

Skirting the Ban

Herein lies the weakness of the system. If countries do not sign up to it, but still buy Russian oil, they would not have the tankers available to bring the oil to market. The G7 wants that oil to flow, the buyers want it and Russia is probably keen to sell — the G7 is correct that Moscow needs to export oil as this generates the most income for the state, with which wars are financed.

A loophole could be that traders simply show the price they pay, without officially signing up to the system, and get a tanker with Western insurance and finance links. Shippers have said that showing a discount is the easy part: a trader would provide two sets of the bill of lading, one with the price to get the tanker, one with a price they pay the Russians. Traders have argued that the tanker ban is impractical and unenforceable. The US Treasury says that the G7 is aware of all these mispricing tricks, and will punish them. Yet, it might keep the oil flowing.

At the same time, ship brokers see Russia teaming up with countries like India, China or Iran (if the nuclear deal fails) to create a non-Western fleet with sovereign Russian or Chinese insurance and financing, and Indian certifications for the vessels. That would all be above board, and erode the global power of Lloyd’s of London and Western Allfinanz. For now the consensus seems to be that traders think the price cap system is not going to work, and that the bulk of the Russian crude oil and some of the products will sail on non-Western tankers.

Crude prices have continued falling, even though they seem to have established a $90 floor. High product prices have already had an impact on consumption. Gasoline prices have come down, diesel is holding up. Russia barely exports gasoline but sails a lot of diesel, especially to Europe. Already, diesel is short globally, in part due to rising fuel switching away from costly natural gas — the result of lower and now halted Russian gas exports to Europe. This tightness is only set to get worse with the G7 price caps on Russian crude and products. All the threats and cajoling might perhaps pull off a system that on paper could work. But Russian objections are forcing Moscow’s exports onto non-EU tankers. These tankers are in such short supply that Russian exports will come down — cap or no cap.

For more coverage of the Ukraine crisis, visit Ukraine Crisis: Energy Impact

John van Schaik is the editor of Oil Market Intelligence and Energy Intelligence's New York bureau chief. Emily Meredith is a policy reporter and Washington deputy bureau chief.

Sanctions, Crude Oil, Oil Products, Oil Prices, Ukraine Crisis
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