Gaming Out the Proposed Price Cap on Russian Oil: KAPSARC [PDF Download]

(KAPSARC, 21.Nov.2022) — In a June 29, 2022, communique, the G7 countries agreed to explore ways to impose a price cap on Russian oil exports. The main mechanism would be a ban on the provision of insurance, logistics and financial services by G7 nations for cargoes sold above the price ceiling. While there are some workarounds, the oil market is overwhelmingly served by G7 service providers, which could create a significant impediment to Russian exports. The G7 accounts for about 30% of the world’s total oil consumption and has called on other countries to join this multilateral effort with the hope of bringing the Russian-Ukraine conflict to a peaceful resolution. While regulating Russian exports would impact all members of the G7 and the rest of the world, the European Union (EU) was by far the largest market for Russian energy before the current crisis, and their energy systems are designed for Russian grades, making it difficult to replace.

With the price cap policy, the western powers are trying to accomplish two goals at once: choke off funding to the ongoing conflict in Ukraine and preserve global access to energy, since pledges to ban Russian seaborne crude in the EU starting December 5 will have less impact if the price cap is successful. There is much debate as to the effectiveness of this plan. Like most economic coercion tools employed in interstate relations, the market is faced with a high level of uncertainty should this price cap be employed. More specifically, the uncertainty is directed toward the effectiveness of price cap enforcement and its consequences on the oil market. Accordingly, this insight strategically reviews three scenarios: a perfect price cap, an imperfect price cap, and Russian retaliation against the cap.

Before beginning, it is important to understand the current context. Once the Ukraine crisis began, many countries, especially in Europe, decreased and/or halted oil imports from Russia in solidarity with Ukraine. This affected Russian oil exports, with the country lowering its output by 800,000 barrels per day so far. In response, Russia sought other markets to sell its crude and refined oil products to. As of mid-November 2022, the price of Brent was hovering in the $90 per barrel (b) range, and Russia has been largely successful in exporting more liquids to India and China at about $70/b-$75/b, or a ~$20/b discount. This also caused a distortion to other major producers whose market shares have been partially affected by Russian oil exports to India and China. China and India have access to a larger global supply of crude, so their experienced market balance is less restricted, and the price paid is likely closer to what the market would pay if Russian supply was freely available. In a pre-crisis market analysis, KAPSARC forecast a mild supply surplus starting in H2 2022 (KOMO, Q1 2022). This serves as a reasonable counterfactual and indicates that prices would be close to the $70/b mark (barring OPEC+ intervention) if there were no restrictions on supply. The unconfirmed range for the price cap is somewhere in the $50/b-$70/b range, which could offer sufficient revenues to Russian oil producers. It would incentivize them to continue production and help fund major items in the Russian federal budget. However, it would make funding the estimated $1bn in daily expenses needed for the “special operation” very costly for the Russian government.

Edtior’s Note: Read the full 7-page report below.

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