Unity within G7, the club for large economies, is rare. Proving the political scribes wrong, the heads of the seven advanced member democracies came together on 2 December 2022. They agreed in one voice to cap the price of Russian oil at USD 60 a barrel. This will take effect after 5 December 2022 for Russian crude and after 5 February 2023 for the range of refined petroleum products. https://ec.europa.eu/commission/presscorner/detail/en/IP_22_7468

Anti-war activists lost no time in welcoming this price cap. As the cap will constrict Russia’s oil revenues and limit Vladimir Putin’s ability to fund his war in Ukraine, it was seen as a laudable move. Plus, unlike an absolute ban on Russian oil, a price cap will ensure crude keeps flowing unhindered and agonies from energy shocks are prevented. Sadly, the 5 December price cap will not achieve these desired objectives.

Can Divert More Oil

Sure, the price cap of USD 60 a barrel locks in the current discounts on Russian oil. But, the locked-in discounts are smaller than what China, India and Turkey, the three key preferred buyers, get. Thus, this trio will not go with the price cap. They will continue to buy Russian crude through shipments by non-European companies. For the Asian trio, it will be business as usual.  https://www.bloomberg.com/opinion/articles/2022-0908/russian-oil-price-cap-may-give-china-india-huge-bargainingpower-julian-lee-l7syvq0s

The price cap will thus ensure major buyers of discounted Russian oil are unaffected. Moreover, China and India can buy Russian oil at any price, if shipped or insured by non-European entities. This crude may be more expensive. Luckily, it will not invite penalties. https://www.nytimes.com/2022/12/02/world/europe/russia-oilprice-cap-explain.html  

What more, the above price cap is not applicable to buyers of Russian crude who transport and insure their purchases with seller-nations who are not parties to the price-cap agreement. This means Russia can divert more oil to buyers outside the group and yet sell more. Put differently, Russian oil can be sold outside the bloc and there are no strictures on this. Clearly, the price cap is not a deterrent.

Poland’s Price-Cap Initiative

As the G7 embargo on Russian oil is effective 5 December and applicable to buyers outside the European Union, price-cap critics are saying the cap is ineffective outside the Union. To blunt this criticism, the Union members will hold another round of deliberations on Russian sanctions soon. The idea is to gain co-operation from a large group of Poland-led pro-Ukraine nations in Europe. This activist group believes the price cap is pointless. https://www.aljazeera.com/news/2022/12/2/eu-agrees-to-60russian-oil-price-cap

Poland’s initiative to lead the group is easily explained. Poland has been keen on negotiating price-cap reviews from the start. Poland did negotiate with success a regular review of the price cap, with an eye on real-time market tracking. The Poland-led group will now review the price cap at regular intervals, starting 15 January 2023. Poland says regular reviews will help fixing the price cap at a minimum 5 per cent lower than Russian crude’s market price.

The Business-Like Polish Plan

Despite the regular review, the Poland-led group, Baltic states included, are lobbying for a price cap, which is low or close to market levels. The group wants the price cap not so high at USD 60 per barrel, which marks a discount of a mere 30 per cent to the global price of USD 85 per barrel.

This is the level around which the standard global benchmark Brent has settled now and this is the regular non-discounted price for Russian oil to non-special buyers, which excludes China and India. https://www.marketscreener.com/quote/stock/SASFIN-HOLDINGS-LIMITED-6582799/news/Sasfin-Forex-DailyMarket-Brent-crude-is-holding-just-above-85-per-barrel-42407541/

In all fairness, the Poland-led group’s plan is quite business-like, for three reasons. One, the plan places the onus of fixing and reviewing the price cap on facilitators of crude sales. Global shipping and insurance companies, many of them based in Europe, are the facilitators. Two, European maritime tanker and insurance companies are permitted to transport Russian crude outside the bloc only with the price cap. Three, any violation of this condition will invite legal liability. Russia’s hostility is on full display here.

The Silver Lining to the Price Cap

Despite these factors, Russia threatens to ignore the Poland plan and refuse to sell oil under the price cap. As Russia relies heavily on European tankers and insurers, hiring alternative providers will be more expensive. Russia’s crude buyers too will find it less secure. Anyway, the primary objective of the price cap is to keep Russian oil flowing and at the same time constrict Russian blood vessels carrying war finance.

There is a silver lining to the price cap however. The price cap allows Russia to sell oil, while it earns less from its sales. Thus, the G-7 honchos are sure they can avoid abrupt contractions in oil supply. Abrupt contractions have the potential to drive gasoline and heating fuel prices sky high, and raise inflation. The theory is yet untested and unproven.

Worse, the price cap of USD 60 a barrel is not low enough to deplete Russia’s war chest. But, when the price cap is low, Russia may not adhere to the price cap decision. Thus, it is essential to set a higher price cap to prod Russia into continuing to channelise much of its oil exports through European and American shipping-insurance companies.

Why the Price Cap is Unworkable

Yet, a higher price cap may not be acceptable for the member-nations as they are dead against enriching Russia and feeding its illegal war machine involuntarily. A higher price cap means defeating the basic price-cap objectives, particularly when Western sanctions have already failed to emasculate Russia’s oil exports. The failure was largely due to buoyant global energy prices, discounted sales to China and India notwithstanding.

Significantly, the price cap will not work also because it is not what it is supposed to be. Really speaking, this price cap is a restriction on shipping and insurance firms. Quite true, the global maritime insurance industry is in large measure controlled by European entities. Many of the shipping-insurance majors too are global biggies from G7. As the price-cap plan bars them from dealing with Russian crude above the price cap, they will be liable for sanction-violations. This is a cruel limitation imposed on them. https://www.10pointer.com/current-affairs/group-ofseven-g7

There is another important reason why the price cap will not work. The cap has been set above what Ukraine’s closest allies, Poland included, want. For them, the USD 60-per-barrel price cap comes as a bitter disappointment. These players feel the price cap is high and will not dent the Russian war chest. They lament the price cap is pointless.

Arithmetic of Pointlessness

A simple arithmetic proves they are bang on. Russia’s production cost is USD 20 a barrel and it has been selling oil at the 3-year average price of USD 80 a barrel. Thus, despite the USD 60 price cap, Russia will make a clean profit of USD 40 a barrel. https://www.reuters.com/business/energy/us-saysrussia-price-cap-should-risk-premium-out-oil-market-2022-09-09/

How will the price cap deter Russia then from waging a wanton war in Ukraine? Thus, a high price cap is in fact no cap at all, it is a travesty of a cap. More, the price-cap plan expects every player in the supply chain to vouchsafe for the price of the crude cargo sold. Experts say records could be manipulated and falsified by vested interests including Russia, just to ensure crude keeps flowing as usual at the current ruling price.

Getting Around the Cap

Sure, Russia is unbothered by the price cap. Meanwhile, Russia has declared it will not sell to countries which adhere to the price cap. There may be countries which love to show they are respecting the price cap and at the same time buy oil at above the capped price. Such countries will find ways to get around the cap. These smart Alec nations will resort to ‘side payments’. They may overpay Russia for unsanctioned non-oil purchases such as wheat.

Such side payments were seen during the UN attempt to slap sanctions on Iraq in 1990. Plus, the US Treasury Department says Russian oil sold under price cap, later transformed or refined outside Russia, is not subject to sanctions. This offers both Russia and its many oil buyers immense scope to get around the price cap. https://www.icrc.org/en/doc/resources/documents/report/57jqap.htm This defeats the basic purpose of imposing a price cap.

Price Cap’s Singular Achievement

Moreover, the price-cap mechanism agreed upon calls for barring errant companies from offering services related to Russian oil for three months. The penalty is seen by many observers as too lenient to discourage violations. Thus, the whole business of price caps is pointless. While the price cap will have no potential to meet its avowed objectives, it will leave energy markets in Europe upset to a large extent. This will be a lose-lose situation.

Yet, as a singular achievement, the USD-60 price cap will ensure Europe no longer funds Putin’s war in Ukraine on a large scale. There are two reasons to believe it will. One, the price cap itself. Two, thanks to the price cap, developing countries will buy Russian oil at a discount, notwithstanding whether they are signatories to the plan or not. Existence of a price cap is sure to bolster the bargaining power of developing countries and enable them to buy discounted Russian oil.

The Three Challenges

Challenges may however emerge from three unforeseen quarters: tanker crunch, insurance deficit and risk anorexia. Cyprus, Greece and Malta are large shipping players in Europe. Sure, Europe will stop the provision of maritime services to nations who are non-signatories. This will create a shortfall in the number of crude-carrying ships available. Russia may rejuvenate junked ships. Plus, the Union may sell its ships to nations outside G7. These factors have the ability to augment carrying capacity for transporting Russian crude.

The insurance crunch however may not be so easy to surmount. Nations in the Middle East and Asia have brawny local players offering insurance services for tankers and cargo. Yet, they may not have the stomach for re-insurance and insuring larger risks including oil spills. China and India may not fill such a vacuum with their local players. This is sure to affect the Russian oil offtake in Asia.

Bad news, deficiency in risk appetite will be G7’s real challenge. America has assured to remain non-interfering if nations circumvent the price cap. In reality, America may not. As a cumulative effect of these factors, Russian crude exports may fall, making global oil prices soar.

Russia’s Sigh of Relief

As an indicator of the emerging negative scenario, America has stopped Russian crude imports. The Union will stop all oil purchases totally on 5 December and all petro products on 5 February 2023. However, sanctions have not been quite effective so far and Russian oil exports have dropped just marginally.

Russia can thus heave a sigh of relief. Though the final ban will affect Russian crude exports, it will not be large enough to cause paralysis. Plus, Russia’s export revenues are booming. Russia’s current account surplus is slated to touch over USD 260 bn this year. https://www.cbr.ru/eng/statistics/macro_itm/svs/bopeval/ Where is then the question of drying up Russia’s war chest?

Why Large Economies Averse

Sure, this is cause for a new worry. As G7 accounts for a wee less than 50 per cent of the global GDP, the price cap may not have much impact on the global energy scene too. Plus, many large economies, China, India and Indonesia included, are averse to kowtow to the West when it comes to sanctions and embargoes.

China is averse because if it nods for sanctions on Russia today, similar sanctions may be slapped on it tomorrow and Russia may not be there for support. India is reluctant because Russia is its oldest and largest partner in defence hardware. Indonesia is not keen because it prefers to take a neutral stand.

Possibility of a Structural Change

On a final analysis, the price cap may usher in one major structural change in the oil market. The price-cap plan of the G7 may end up in the trifurcation of the oil market. Oil not produced in Russia, nearly 90 per cent of the global output, will make up the normal market, where oil will be sold at regular global prices.

A part of Russian oil, which is not much and cannot be exported without help from the West, will be sold under the G7 price-cap plan. Russia’s remaining output will be exported overseas, again without any Western involvement, at a mid-point price between the regular global price and the capped price.

In Conclusion

Despite these possibilities, Russia may still try to throttle gas supplies to Europe. Sad for Russia, it will not be able to do this for long. This is because it needs funds for its war treasury. Thus, the G7 price-cap plan may make Russia’s oil revenues fall, but not by a margin huge enough to cripple its expansionist machine, which is hyperactive now in Ukraine.

In her reaction to the G7 price cap on Russian oil, US Treasury Secretary Janet Yellen said the price cap should benefit low and medium-income countries which have suffered the brunt of high energy and food prices. Later, in her official statement, Yellen added: “With Russia’s economy already contracting and its budget increasingly stretched thin, the price cap will immediately cut into Putin’s most important source of revenue.” Hope her words turn prophetic.