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The Problems Ahead for the G7’s price cap on Russian Oil

By: Harry Altham, Energy Analyst, Market Analysis EMEA & Asia

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The Problems Ahead for the G7’s price cap on Russian Oil
 
Harry Altham
Energy Analyst, EMEA & Asia
harry.altham@stonex.com

Oil dipped slightly in early trading this morning (BST) due to returning concerns of evaporating demand in the event of a recession. Asian and U.S. stocks declined after a tech-led drop and a bump in ten-year yields to $3.16, and the negative sentiment has carried into oil with the aid of a slightly stronger U.S. dollar. At -$0.30 basis settlement, Brent is showing restraint despite significant production problems in Libya and Ecuador. Libya’s two largest ports have declared force majeure due to blockages by militias and protestors (450k bbd exports offline), while Ecuador’s oil production is disrupted from the standard 520k bbd but is able to partially continue because of the efforts of the army, who are protecting facilities from protestors who want to see President Lasso resign over surging fuel prices. In a sign of the strength of the underlying market, the U.A.E.’s dated Murban crude’s prompt spread is trading at a giant $8.90 backwardation, which exceeds the all-time record Brent prompt spread by $1.15. The steepness of premiums for physical grades in the Middle East was seen as being due to a collapse in demand for Russian oil, but this strength is being matched by higher consumption of Russian oil. 

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Source: ICE, Bloomberg, StoneX
would a price cap actually work?
The G7 nations have agreed to work towards the implementation of a price cap on Russian oil; France, Germany and Italy have also said they would propose the same resolution in the European Union to enforce a price cap, despite recently agreeing a ban on seaborne Russian oil. The revenues Russia is receiving from energy sales are dismantling Europe’s strategy to suffocate the Russian economy; Russia is receiving around $15Bn per month on oil sales alone – and the country is a major gas and minerals exporter. It is expected that Russia will earn over $250Bn this year through energy exports, which is sustaining their economy and the war effort in Ukraine, despite the sanctions.  
We wrote last week of the attempt to use insurance and freight as the mechanisms to enforce this, but we see problems on the horizon. In layman’s terms, the wording in the statement implies a prohibition of the shipping or insurance of Russian oil unless the price paid per barrel is under a certain threshold. For the cap to be effective, Western powers would surely need to impose secondary sanctions on non-compliant countries, which would risk pushing China and India further towards allegiance with Russia. The reason for this is simple: China and India are fast becoming the main purchasers of Russian oil; they are now thought to account for half of Russian seaborne crude transactions (at 1.6M bbd). Once Europe (minus Hungary and Slovakia) has weaned itself off Russian seaborne oil by year’s end, it must target any prospective purchasers of Russian oil via secondary sanctions, which we see as too politically risky for the West to pursue. Moreover, it remains unclear how a price cap could interact with existing European sanctions. Will Europe need to go through another multi-week rigmarole to pass a price cap through the European Parliament? Would the cap replace the existing ban on seaborne crude from the end of this year? And would it get universal support? The E.U. will be keen not to donate political points to President Putin via further internal squabbles, which is likely to be precisely what he wants to see.
Overall, we concur with Janet Yellen, herself an economist, that the price cap has some potential to get off the ground, purely on the basis that China and India would likely be happy to agree to a price cap on Russian oil for their own economic interests. As it stands, any price cap would make those two countries the long-term beneficiaries; this would only change if Europe removed its ban on Russian seaborne crude. From a price perspective, we expect dated non-Russian crude premiums to surge before the end of 2022 in the event that the cap was signed into law. This is because we believe Russia, whose fiscal balance sheet has benefited significantly from higher energy prices, would prefer to starve Europe of that oil for a period of time for political reasons (rather than sell at discounts which could be close to marginal costs of production), leading to inelastic demand for alternative blends from European purchasers. 

 

 
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