Capping Russian Oil Prices But Not Income

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Policymakers today often fail to understand the economics of energy markets. This is evident in the G7’s plan to cap Russian oil income. Some commentators have suggested this is an urgent and necessary step to prevent a price surge when an EU embargo of Russian oil imports and financial insurance service restrictions takes effect on Dec. 5, amid fears for the global economy. But in reality the price cap is a waste of time because it can be easily circumvented, and could be a lose-lose strategy for the countries that implement it. The program will lead to higher global oil prices. Russia will benefit from the increase. Furthermore, Russia can offset the impact of the G7 cap by making buyers purchase “entitlements to export oil” from its central bank or another institution, which are not recorded on invoices. These transactions will negate any income losses from the price cap. Call this a “pay-to-play” program.

The US Department of the Treasury issued “preliminary guidance” recently for the G7 price cap — which will take effect on Dec. 5, for maritime transportation of crude oil and on Feb. 5, for maritime transportation of petroleum products. This has three objectives, it explains: to maintain a reliable supply of seaborne Russian oil to the global market, reduce upward pressure on energy prices and reduce the revenues Russia earns from oil.

The Treasury document also details how the rules will be implemented, how those buying, transporting or insuring cargos can comply with the regulations, and the consequences that could befall noncompliant firms. In addition, it describes what records those transacting in Russian oil will be required to keep.

Easily Circumvented

The question now is how can Moscow circumvent the US Treasury’s efforts to circumscribe Russia’s income from oil exports? Here the answer lies partially in how Russian oil exports are managed. Start with the fact that several companies export Russian crude. This means that the Russian government cannot easily impose regulations that change the export price of its oil. However, the government can tax and license exports, and it is through its licensing authority that Russia can outmaneuver US and wider G7 efforts.

Export entitlements that are not transparent to the US are the obvious way for Russia to obtain prices at or near world levels for its exports. Indeed, the US Treasury guidance explicitly warns that it will be looking for efforts to evade its sanctions, such as “unusually favorable payment terms, inflated costs or insistence on using circuitous or opaque payment mechanisms.” It will also watch for “seaborne Russian oil purchased so far below the price cap as to be economically non-viable for the Russian exporter may be an indication that the purchaser has made a back-end arrangement to evade the price cap.” Similarly “excessively high services costs may be an indication that a service provider has made a back-end arrangement to evade the price cap” and “attempts to use opaque payment mechanisms may indicate the customer or counterparty is avoiding creating documentation around payment,” the guidance says.

Despite such vigilance, there is no way for the Treasury to learn of buyers who pay the Russian central bank sums that entitle them to acquire Russian oil. Put bluntly, such transactions are invisible to the Treasury. The easiest way for Russia to circumvent the price cap would be to announce that buyers interested in Russian oil must purchase a license to do so from the country’s central bank. The license price would reflect the difference between world oil prices and the Treasury’s ceiling price. Oil purchases by licensees would be invoiced at the ceiling price or even a discount from the ceiling price. Buyers would obtain such discounts, just as they do today.

But with this approach, Russia’s receipts would be far higher than they would be if collected solely under the price cap. For example, a crude buyer could create a large account with the Russian central bank. Funds would be deducted from the account to procure licenses to cover every barrel it purchases. The purchase invoices, however, would indicate, falsely, that the buyer had paid a price close to the ceiling price established by the US Treasury. The ceiling price strategy, then, would not affect Russia’s oil revenues.

Inherent Dangers

The danger inherent in the price cap program, and being mostly ignored, is that imposing a ceiling price and threatening sanctions could push world oil prices higher. Some suggest that the price would rise as high as $150 per barrel. This boost would occur only if the G7 action “froze” trade in global oil due to the uncertainty regarding the US government’s actions. If it did happen, it could raise Russia’s oil income by 50% while worsening the global recession.

The risk of this market reaction should not be discounted. Economic policymakers and their economic advisers in the US, EU and UK have been incompetent in the current crisis. In short, the proposed cap on Russian oil export prices, if enacted, will make oil producers richer and consumers poorer. Very much like US President Gerald Ford’s “Whip Inflation Now” program in the 1970s, it will be a disaster.

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. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

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Oil Trade, Crude Oil, Oil Products, Sanctions, Ukraine Crisis
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