Jury still out on the effectiveness of the oil price cap scheme on Russian exports

Jury still out on the effectiveness of the oil price cap scheme on Russian exports
The jury is still out on if the crude and product sanctions on Russia will work as expected. / bne IntelliNews
By Ben Aris in Berlin February 7, 2023

The oil market took a double shock on December 5, when an EU ban on importing Russian oil and an oil price cap scheme were introduced simultaneously. That was followed by a product ban on February 5 which has only just gone into effect. Analysts say that it is still too early to assess the effectiveness of these sanctions, or predict how much damage they will do to the Russian budget.

“This overlap was, of course, by design, since one of the original motivations for the cap was to keep Russian oil flowing to global markets as the EU embargo took effect, " says Robin Brooks, chief economist with Institute of International Finance (IIF). “However, this overlap now also means that it is premature to make a full assessment of the cap.”

The embargo has had an effect insofar as instead of a few days steaming from the Baltic ports to western European ports, Russian oil now has to travel halfway round the world to Asian markets, drastically increasing the cost.

The oil price cap is hard to assess as well, as these longer delivery routes have also increased the discount that Russia must offer Asian customers. Add the fears of a global recession, and these two factors have kept the contract price for Russian oil below the $60 level where the cap kicks in. Consequently Russian oil exports have been able to continue largely unimpeded, but there has been a rejiggering of the global oil trade.

“For now, the jury on the effectiveness of the cap is still out. Russia’s growing “shadow fleet” of oil tankers is cause for concern, as it affords Russia the means to ship oil outside the cap as prices rise,” says Brooks.

Brooks says that the oil price cap will probably become more relevant as the year wears on. As shipping companies work through the logistics of running the new routes and Russia’s own fleet grows, the discount on Urals blend compared to Brent is likely to narrow again.

At the same time, if global recession fears fade, and China’s economy in particular bounces back from its COVID shutdown last year, then oil prices may rise, both of which will lift the price of Russian crude up towards the price cap level of $60.

“We expect that the Urals discount will narrow going forward as the logistics of shipping Russian oil get worked out. A rise in global oil prices would add further impetus for the G7 price cap to bind. At this stage, however, it is too soon to make a full assessment of the effectiveness of the G7 cap,” says Brooks.

A central issue is compliance with the cap, even if the $60 level has not currently been breached, says Brooks. “Given the legal and reputational damage that comes with violating the G7 cap, our assumption is that virtually all Western-owned oil tankers operate under the G7 price cap mechanism,” Brooks adds.

On average, Western-owned ships constitute around 50% of Russian seaborne crude, but there is wide variation across key exit points from Russia, according to IIF. Compliance is likely highest for exports out of Baltic and Black Sea ports, while it is likely lower in the Pacific and the Arctic, where western-owned oil tankers play a smaller role.

The growing “shadow fleet” is also cause for concern going forward, according to IIF, as it affords Russia the means to export oil outside the G7 price cap mechanism. Greek shippers have been particularly co-operative with Russia and increased their share of oil carried from 35% pre-war to some 55% now. Moreover, Greek shipping companies have been selling their oldest tankers to Russia bolstering its shadow fleet capacity.

“One avenue Western policy makers may want to explore is a ban on the sale of Western-owned oil tankers to Russia, to prevent the shadow fleet from growing further,” says Brooks.

Oil products ban

Over the weekend, the embargo and price ceiling for the much more widely distributed Russian oil products came into force, the impact of which experts say are even harder to judge.

Until now, Europe buys half of all its imported diesel from Russia, and Russia sends 40% of its oil products to the EU. Despite this heavy interdependency in the short term, experts do not expect an immediate shock for the market. Nevertheless, like crude oil, the make-up and functioning of the products market is in for big changes.

On February 5 new rules were introduced, including a ban on the transportation of Russian oil products by sea, as well as a ban on insurance of such transportation, the provision of brokerage and financial services if the cost of oil products exceeds a products price cap.

Different oil products have different price caps: for those traded at a premium to crude oil (such as diesel and gasoline), the ceiling will be $100 per barrel; for cheaper ones traded at a discount to crude oil (for example, fuel oil), $45. The caps of $100 and $45 implies a discount on oil products of about 25% to the price in North-Western Europe, The Bell reports.

However, analysts warn that since the products ban and cap were introduced the market and prices have become extremely opaque, making it hard to say what prices products are actually being sold at. Europe is particularly dependent on the import of Russian diesel.

As the product sanctions were designed to not only reduce the Kremlin’s export revenues but also to avoid shortages on the market, the system has been set up so that Russia can redirect its product flows to new markets. For example, both Turkey and Morocco saw jumps in the import of Russian diesel in December and are likely to turn into major transit routes for these exports. There is nothing in the rules that prevents this and Russian oil is being refined in India and the resulting “non-Russian” oil products sent to Europe.

However, the experts say that the shift in the market has been big and it will need a few months to find a new equilibrium. So far, the shipment route for Russian diesel has hardly changed according to Goldman Sachs, two weeks before the embargo came into force, only about 10% of the volumes that Russia traditionally supplied to Europe ceased to be delivered by the usual routes. By comparison, two weeks before the oil embargo went into effect on December 5, Russia diverted 50% of its oil.

The business as normal for diesel highlights Europe’s dependence on Russian diesel and also the high level the cap was set up to avoid interrupting these deliveries for the meantime. It also suggests that Russia is finding it hard to find new customers for its diesel.

“This may be a sign that finding new markets for oil products is physically more difficult than for oil,” Alan Gelder, vice president of British consulting firm Wood Mackenzie, told The Bell. “Russian diesel will have to be transported much further.”

Wood Mackenzie forecasts that diesel exports from Russia will fall from 730,000 bpd by about 200,000 bpd this quarter compared to the fourth quarter of 2022.

If no new buyers for Russia’s oil products can be found then production will have to be cut, but so far there are no plans for that. However, if Russian diesel fails to enter new markets, the shortage will lead to another surge in energy prices for consumers in Europe this summer. Motorists and truck drivers are especially at risk.

Last year, Russia supplied Europe with about 700,000 barrels per day (bpd) of diesel and that amount of diesel will be hard to redirect in the short term. Europe will not run out of fuel and has built up a safety cushion to ease the blow, but like with crude oil, the structure of the market is being drastically remade with unpredictable consequences and the dynamics of the fluctuating prices and the impact of caps on these will make a large difference, say experts.