Russia Oil Price Cap: A Lesser Evil or Moral Hazard?

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The US-led push by the G7 to impose a price cap on Russian oil exports is a direct result of worries that the European sanctions on Russian exports that are being implemented from Dec. 5 this year may result in a major fall in Russian exports, resulting in a price hike that directly impacts gasoline in the US. The plan has major flaws, but even if it does not work, it is seen as a lesser evil than a major oil price increase. Implementing a price cap on Russian oil is likely to allow its continued flow, but this may also provide a bonanza for those happy not to play by the rules. That could cause a far bigger moral hazard than the infamous 1995 Iraq “oil-for-food” program.

In its ideal form, the price cap would facilitate the flow of Russian crude to the market, keeping oil prices lower than under an embargo, while preventing Moscow from benefitting from price inflation caused by any real or feared reduction in Russian supply. Non-participating countries buying oil above the cap will be denied Western-dominated services including insurance, finance, brokering and shipping. That would include the London-based International Group of Protection & Indemnity (P&I) Clubs which provides marine liability cover for over 90% of global oil shipping.

Theory Meets Reality

The economic theory behind the plan is almost sound. Capping a price below an equilibrium market price level reduces supply and increases demand. However, international oil markets are not perfect, due to Opec management, and prices are above the marginal cost of production. So, in theory, given the need for revenue, Russia will continue to supply oil as long as the price cap is above its marginal cost of production (usually assumed at about $40 per barrel).

The problem is on the demand side of the equation. Forced to sell at or below the price cap, Russian oil is not only attractively priced, but also free of sanctions, making it a far better alternative than Arab Light, Kirkuk, Murban and other oil grades. Assuming a price cap on Russian crude is set at $60 a barrel, that would make it some $30 cheaper than the similar alternatives. For a typical million-barrel tanker of Russian oil, the one-off benefit to the buyer is $30 million. Demand for such a prize would be overwhelming. Since there would be no market at work enabling the highest bidder to get the oil, how would these heavily discounted barrels be allocated among many buyers and who would manage this allocation? As volatile oil prices change, will the price cap change as well and how?

Let’s assume that the allocation problem was somehow miraculously resolved. Why would current buyers, such as China and India, participate in a system that gives them a large discount of, say, 40%, for very limited volumes — as they are now competing with all the other buyers for non-sanctioned Russian oil — compared with the current discount of some 30% for as much oil as they want?

Of course, accepting a price cap would enable the buyers to freely obtain shipping, Western P&I insurance, and other services. But a bird in the hand may be worth two in the bush. China and India could well require firm volume guarantees before accepting any such proposal. And while the G7 might be tempted to give these, Russia may not cooperate. In fact, Moscow is very unlikely to cooperate as volatility and uncertainty work for it — resulting in higher prices and revenues.

Friendly Beneficiaries

Putting that aside for a moment, in any such arrangement, the Kremlin would clearly have a significant say on the allocation of oil. It would invariably favor “friendly” companies with a history of close working relationships — usually traders used to arranging pre-payments, barter, and other forms of risky trade financing.

Such traders are certain to be the main beneficiaries of any price cap, with little incentive to pass on the benefits to refiners beyond any general downward pressure on the market from greater certainty over Russian supplies. Often registered in offshore tax heavens, such traders would get around the allocation problem by paying “fees” to Russia to secure additional supplies and massive profits. If necessary, as with Iranian and Venezuelan crude, such traders may disguise the origin of cargoes, transferring crude from one tanker to another on the high seas, or blending it with other types of oil.

Lessons From History

The infamous “oil-for-food” program — implemented in 1995, when Iraq was subject to sanctions after its defeat in the 1991 Gulf War — was based on a similar idea. It was a disaster, despite having full backing from most of the international community and the UN. The intentionally low official selling price set for Iraqi barrels encouraged even reputable companies and traders to pay “fees” to various middlemen, enriching the regime of Saddam Hussein in the process. Subsequent investigations into bribery and corruption went as far as some oil majors and to the very top of the UN. And this program involved much smaller monetary sums than those potentially in the proposed price cap mechanism. The incentive to cheat would be immense. And just like Saddam Hussein, Russian President Vladimir Putin could allocate oil tactically to allies and friends or simply use for bribes.

But it appears that Western leaders are prepared to turn a blind eye to such possibility as long the oil continues to flow, and prices remain low. Perhaps this is why the US is ruling out the use of secondary sanctions that worked relatively well for Iranian oil. Europe is not without blame. The idea of imposing a stiff price tariff on Russian imports is a far better and simpler idea, but unlikely to be accepted by the unanimous voting rules within the EU.

Adi Imsirovic is author of the book Trading and Price Discovery for Crude Oils, published by Palgrave McMillan in June 2021. He is a senior research fellow at the Oxford Institute for Energy Studies (OIES), and a former global head of oil at Gazprom M&T in London. The views expressed in this article are those of the author.

Sanctions, Oil Trade, Oil Prices, Ukraine Crisis
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