Six months after the beginning of the Russian invasion, the “Devil’s Dance” of Western sanctions and Russian oil exports and revenues has barely begun. The main contest still lies ahead.

No aspect of the Western sanctions on Russia has been more controversial than their impact on Russian oil. It is widely asserted by the Western media (and of course by the Russians themselves) that the oil sanctions have failed. On the contrary, they are said to have contributed to the spike in global oil prices since the beginning of the Russian invasion in late February, and thus have increased Russian oil revenues rather than the opposite.

But is that in fact the case, and if so, why? Is it likely to remain so? Thanks for reading The Devil's Dance! Subscribe for free to receive new posts and support my work.

First, a little bit of background: Russia is currently the second largest oil producer in the world, after the US and just ahead of Saudi Arabia. Approximately 70% of Russian oil production is exported, but oil is also widely used throughout the domestic economy, both as a motor fuel and as a feedstock for chemicals. Oil is thus essential to the Russian economy, and especially to the government’s budget, half of which comes from oil revenues, foreign and domestic.

Consequently Western sanctions have focused above all on driving down Russian oil production, exports and revenues. This is new. The sanctions adopted in the wake of Russia’s occupation of Crimea and eastern Ukraine in 2014-15 aimed only at constraining the long-term development of Russian oil production. They banned investment, services and imports for only three categories: Arctic, offshore and “unconventional” or shale oil. Their main consequence was to halt joint exploration projects with foreign oil majors; but their impact on actual production was insignificant, since virtually no output in those three categories had yet begun. An actual embargo on Russian oil exports was rejected, on the grounds that it would constitute an act of war.

THE NEW SANCTIONS SINCE THE INVASION

That has now changed radically. The sanctions against Russian oil now cover the entire range of Russian oil operations, from upstream exploration and production to refining and exports. The explicit aim is to constrict Russian oil revenues in any way possible, and thus to impede the funding of the war effort against Ukraine. It amounts to total economic warfare.

The new oil sanctions have three faces – restrictions on shipping, on trade in relevant equipment and technology, and on finance. The first aims to prevent Russian oil from being transported and sold. The second bans the participation of Western companies in Russian exploration, development and refining, as well as the supply of oil-related technology. The third targets oil investment, by barring foreigners from investing in or supplying sanctioned Russian oil companies.

Will these measures constrain Russian oil production, exports and revenues? The answer depends very much on the period one is looking at. The underlying logic behind the sanctions is that as time passes, they hit different parts of the industry, and in different ways. (I should add that this is my interpretation, not necessarily the intent of the designers.) In a first phase (essentially the years 2022-23), the impact falls mainly on the export outlets, i.e., the terminals and the tankers. In a second phase (the next three to five years), the sanctions begin the hit the upstream, that is, the actual producing fields. Finally, in Phase Three (starting about five years out), the sanctions hit the outer frontier, that is, exploration and production in new fields in new regions. Over time – in theory, at any rate – the chokehold on Russian oil, from one phase to the next, steadily tightens. But is it working?

THE FIRST THREE MONTHS: CONFUSION FOLLOWED BY ADAPTATION

The first month following the Russian invasion was marked by confusion on all sides. Satellite tracking revealed that the number of tankers near Russian ports had dropped, as tanker operators kept their distance, fearing reputational or legal damage. Consequently Russian exports of both crude and refined products declined. Yet at the same time upstream production remained unchanged, suggesting that oil was piling up unsold at the refineries and the export terminals. There were reports that refineries could not move their output, and refinery throughput abruptly declined. Excess crude, not finding a buyer, may have been stored at the export terminals, where there was initially excess capacity, or in tankers on the high seas.

The following two months brought the first signs of adaptation. Exports rebounded in April and May, suggesting that traders and shippers were discretely beginning to take Russian oil again. Millions of barrels of Russian crude were reported to be floating on the high seas, part of an increasingly “dark fleet,” with no reported destinations and transponders turned off.

But from direct observations it became apparent that a major shift was taking place. Faced with increasing resistance by buyers in northern Europe (previously its preferred destination), Russian seaborne crude began moving away from northern Europe toward Asia, chiefly China and India. Russia offered its crude at bargain terms, with discounts of up to $30 a barrel below the international “Brent” benchmark. India, in particular, proved an eager customer. By late April half of all of Russia’s maritime crude exports had shifted from Europe to Asia.

This shift to Asia was a second-best for Russia, since the longer travel times to India meant significantly higher shipping costs and higher insurance premiums, and also required more tankers. But the stark alternative would have been to cut back exports and accept production cuts in the fields.

THE COMING OIL EMBARGO AND PRICE CAP: WILL THEY WORK?

Throughout these early months, global oil prices had been rising strongly, mainly because of trends in the world economy but partly also because of the uncertainties created by the Russian invasion. Despite some decline in export volumes, Russia’s oil revenues increased sharply. This produced mounting calls for sterner action. In early June, after tense debates among the member-nations, the EU declared on a ban on maritime imports of Russian oil to the EU, to go into effect on December 1 for crude oil and on February 1 for refined products. The embargo is likely to be coupled with a “price cap” on Russian oil, to go into effect at the same time.

The question is, will these work? The crucial challenge will be enforcement. There are three main problems. The first is the nature of the global oil trade. The world of oil tankers and traders is complex and opaque. Tankers fly many nations’ flags, but these typically tell us little about who actually owns them. On the eve of the invasion, it was estimated that perhaps half of all oil tankers handling Russian oil belong to Greek owners, many of them based in Cyprus, with the rest scattered among Russian companies, and some Chinese, Scandinavian and Singaporean companies[1]. Some of these are chartered by oil majors under long-term contracts, but most are also leased to oil traders, who include a growing number of smaller, independent traders and shippers. Tracking who is shipping what to whom is difficult at best – and it is made more difficult by the rapid spread of new technology, which enables tankers to transmit fake their locations – essentially by reporting “digital mirages.” Enforcing an embargo in this world is, at best, like herding cats.

The second problem is the difficulty of finding a weapon that can induce buyers and shippers to co-operate with the embargo and the price cap. The obvious candidate is the maritime insurance industry. On paper, this is a potent weapon; after all, without insurance no port will clear a cargo and no ship will sail. Conveniently, the insurance industry is concentrated in London; Lloyds of London handles most of the world’s shipping insurance. But a ban on insurance is surrounded with uncertainties: Will London’s insurers actually co-operate, and in what ways? Are there alternative insurance centres the Russians could turn to? The Russians themselves have talked about providing reinsurance, although so far there is little sign of it. In London, insurers are uneasy about the role being assigned to them, pointing out that they are “not normally close to the price at which the oil is traded.” Given these unknowns, it is not surprising that the insurance ban has lost favour in recent weeks, and there are reports that the UK government has cooled towards the idea.

But in that case, how will the European/UK embargo on maritime traffic be enforced? The third problem is lack of co-operation. India and China are unlikely to co-operate with a price cap. But the greater problem may turn out to be disunity within the European Union itself. To begin with, adopting a price cap will require a unanimous decision of the European Council, and Greek shipowners have urged the Greek government to withhold its agreement.

Meanwhile, Russia’s crude exports to Asia, after peaking in late April, have actually been fading steadily, while exports to Europe began moving from northern Europe to the Mediterranean. Whereas on the eve of the invasion crude exports to northern Europe outweighed those to the Mediterranean 3 to 1, by late August the ratio had flipped to the opposite.

If this trend continues, it suggests that the main battleground over the implementation of the coming EU embargo and the adoption of a price cap will be over crude deliveries to the Mediterranean, almost all of which go to Turkey and, increasingly, to Italy. These could be the most problematic parts of the coming EU embargo to enforce.

In sum, there are three uncertainties ahead: first, the enforcement of the coming EU oil embargo; second, the deterrence effect of any secondary sanctions against shipping companies (mainly bans on insurance); and third, a possible slowdown in Asian oil demand for oil, chiefly as a result of the declining performance of the Chinese economy. The “thermometer” that brings these three together is the discount on the price of Urals crude, which acts as a measure of risk vs. reward in the Russian export trade. It is perhaps symptomatic of the market’s present assessment that there has been a slight declining trend in the discount, suggesting that both Russian exporters and Western shippers are betting that enforcement will be slack and that demand for Russian oil will remain strong.

Conclusion: the impact of the oil sanctions after six months of war

Six months after the beginning of the Russian invasion, the “Devil’s Dance” of Western sanctions and Russian oil exports and revenues has barely begun. The main contest, mainly over the coming EU oil embargo and the price cap, still lies ahead.

But the real question ahead is the longer-term impact of the sanctions on upstream production and on the overall prospects for the future of Russian oil. There is no sign, so far, that the oil sanctions have had any significant impact on Russian oil production in the first six months of the war. But what about farther out? That will be the subject of my next Substack.

Thane Gustafson is the author and co-author of eight books on Russian affairs, including most recently Wheel of Fortune: the Battle for Oil and Power in Russia (2012), The Bridge: Natural Gas in a Redivided Europe (2020), and Klimat: Russia in the Age of Climate Change (2021), all with Harvard University Press.