Wednesday, 09/21/2022 Published by: Jason Lindquist

Economic sanctions can be a powerful tool to punish a country or group, especially if they involve an essential commodity like crude oil. Imposed for a variety of reasons (military, political, social), sanctions can cause serious harm to the targeted entity. But levying them effectively is not as simple as it may seem, and even the most well-intentioned plans can fall short or have unintended consequences or backfire altogether. In today’s RBN blog we look at a plan by the U.S. and its allies to limit the price of Russian crude oil and the significant challenges in designing a cap that is effective and enforceable.

Russia’s catastrophic invasion of Ukraine sent a jolt through the international community and tensions shot higher Wednesday after Russian President Vladimir Putin announced a massive call-up of military reservists and made other thinly veiled threats about Russia’s military capabilities. Apart from the humanitarian tragedy unfolding, the subsequent increase in energy prices and their effect on inflation has been by far the most significant concern for energy this year. Much like with the 1973 oil embargo, as we discussed in Part 1 of this blog series, the U.S. has explored and in some cases implemented a host of options to bring energy prices under control, from the record Strategic Petroleum Reserve (SPR) withdrawals that ramped up this spring and summer and a waiver of summer ethanol blending limits to proposals such as a ban on U.S. crude exports, a windfall profits tax on energy producers and suspension of the federal gasoline tax.

The most recent idea to gain traction with politicians is a cap on the price of Russian crude, with G-7 finance ministers pledging September 2 to implement such a plan, something the Biden administration has been working on for months. The G-7 (Canada, France, Germany, Italy, Japan, the UK and the U.S.), along with other allies and partners, would attempt to prohibit the seaborne transportation of Russian crude oil unless purchased at or below a yet-to-be-determined price cap. This comes after the EU, on June 3, adopted a partial embargo against Russian oil that will ban seaborne imports as of December 5 and ban refined product imports as of February 2023. (Pipeline imports of crude oil and refined products will remain exempt, as some EU members depend on Russian imports via the Druzhba pipeline.) There is serious concern that the EU’s new sanctions, in addition to the major disruptions going on in the gas market (more on that in a moment), could send energy prices higher and tip the global economy into a recession, a risk that U.S. Treasury Secretary Janet Yellen said the cap is intended to mitigate. (Yellen said the price cap would keep Russian barrels flowing to Europe; without it, Russia could end up shutting in production, causing global prices to spike.) Russia, which has close ties to EU member Hungary and supplies about half of its crude oil, has long shown a willingness to use its energy supplies as a weapon and has been using its crude oil and refined products as a wedge against EU unity and as a tool to limit the impact of sanctions.

We should also note that Russia has also sought to maintain leverage over Europe through its exports of natural gas, with the continent typically relying on Russia for more than 40% of its supplies. Following Russia’s attack on Ukraine in February, the International Energy Agency (IEA) and the EU published proposals to reduce Europe’s reliance on Russian gas by the end of 2022 and to eliminate it by 2030, when the last of the existing gas-supply contracts will expire. Russia responded by threatening to cut off gas supplies to any “unfriendly” nation that did not pay for its gas in rubles, a potentially devastating economic blow for countries like Germany, which relied on Russian supplies for more than half its natural gas in 2021. Russia cut deliveries to Poland and Bulgaria in April (see Where Do We Go From Here), then to others in May. More recently, Russia’s state-owned Gazprom shut its Nord Stream 1 pipeline, which links Russia with Germany, on August 31. Service was to resume September 3, but Gazprom said service will not resume until equipment repairs are made, although its widely believed the outage is simply additional retaliation for sanctions against Russia. Recently, Putin suggested that if Germany wanted more gas, it could lift sanctions preventing the opening of Nord Stream 2.

Russia’s energy exports may be down in terms of volume since the invasion, but efforts to hit Russia financially have been largely ineffective, generally offset by higher global crude and gas prices, which is a major justification for why the U.S. has been pushing for agreement on the price cap. Even with Russia’s crude selling at a discount to international price markers, the overall rise in prices since their invasion has outweighed the discount. Russia’s energy ministry said in August that it expects energy export revenues to reach $338 billion in 2022, up nearly 40% from $244 billion in 2021. Consequently, while sanctions may have made it more difficult for Russia to manage its energy exports and overall economy, which the International Monetary Fund (IMF) sees contracting by 6% this year (the IMF sees global GDP growth at 3.6%), it’s not due to lost energy revenue and there is no indication it is causing Putin to reconsider or scale back his aggression against Ukraine. The opposite may in fact be true because the loss of Russian energy appears to be impacting the EU more negatively than it has Russia. (We should also note that the sanctions against Russia have the potential to be very damaging in the long term.)

We’ll come back to the question of efficacy in a bit, but first we’ll discuss how the cap might be set, and what the price would be. The initial cap will be “based on a range of technical inputs and decided by the full coalition in advance of implementation,” the G-7 finance ministers said in their September 2 statement, which was long on flowery language but short on details. In additional guidance issued September 9, the U.S. Treasury Department said participating countries will be able to help set the cap and that a coalition with a “rotating lead coordinator” will consider a range of factors — but did not hint at what those would be or how they would be balanced. U.S. officials have said the plan would set a specific price point for Russian crude (and two others for refined products, although what those might be hasn’t been specified) that limits what Russia can earn from each barrel without driving those barrels from the global market, which in theory would also help reduce the upward pressure on global energy prices. In other words, there is an acknowledgement that Russian exports are required for the global energy market to balance, so prices need to be high enough to pull those barrels in but not so high as to strengthen Putin’s position — a tricky proposition, even without considering what Russia’s reaction might be.

The G-7’s proposed price cap is not only highly complex and reliant on the compliance of dozens of countries, it’s also untested and unprecedented in scope. In addition to uncertainty about how exactly the price cap would be set, there are significant questions about the overall plan, including how it would be enforced, how effective it would be, and how Russia might respond.

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To have the maximum effect, the price cap would have to have broad international cooperation, but odds are that major buyers like China and India would not follow the proposed cap, as they stand to benefit by purchasing the commodities at distressed prices. They would, however, be incentivized to use the price cap as leverage in purchasing Russian crude. The IEA said in its most recent Oil Market Report that Russia’s exports of crude oil and refined products to the U.S., Europe, Japan and South Korea have fallen by nearly 2.2 MMb/d since the invasion, a consequence of the sanctions levied against Russia, but about two-thirds of those volumes have been re-routed to other markets. India, for example, has a large refining sector and has been using its recent increases in Russian crude imports — now at about 600 Mb/d, up from about 90 Mb/d last year — to become a refining hub, allowing it to sell diesel into the same markets that ban the Russian crude it was made from — a nice arbitrage opportunity for them. India’s petroleum minister has said the country will study the price cap proposal but that they see no conflict in buying oil from Russia despite the war in Ukraine. The U.S. has reached out to India and other nations, including South Korea, in search of additional support for the plan, but no new commitments have been made public.

While designing a cap that is widely accepted and can be effectively implemented is one thing, finding the right price level is equally challenging, if not more so. In a perfect scenario, the cap would greatly reduce Russia’s ability to finance the war in Ukraine while keeping its barrels on the global market — but finding that sweet spot is no easy task. If set too low, it only encourages Russia and other nations to circumvent the cap because there are strong financial (and sometimes political) incentives to do so. If set too high, the cap is not much of a punishment for Russia, given that its assumed to be offering discounts of around $20/bbl to $30/bbl, which, at today’s prices north of $85/bbl is still well above its breakeven costs, which are estimated to be around $40/bbl to $50/bbl. Also, if the price cap is set at a specific price point, as the G-7 has indicated, Russia’s discount could be greatly reduced or eliminated if global oil prices happened to drop sharply once the cap was in place, and it’s unknown how quickly the price cap would be able to adapt to changes in the market.

The G-7 finance ministers said enforcement of the cap will be based on a “recordkeeping and attestation model covering all relevant types of contracts,” while minimizing the administrative burden for market participants. The intent is to set up a process that allows each party in the supply chain to demonstrate or confirm that Russian oil has been purchased at or below the price cap, as shown in Figure 1 below.

Figure 1. Example of Compliant Transaction. Source: U.S. Treasury Department

Here’s how the compliance process would work, according to the U.S. Treasury Department:

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But if a coalition of willing nations were to agree on a maximum price for Russian crude, would it be enforceable? How difficult would it be to prevent illicit trades where entities pay one price but report another? The strategy envisages a “cooperation framework across jurisdictions” to ensure compliance and enable monitoring and supervision, but a plan that centers on widespread cooperation in a global market runs the risk of being easy to circumvent. Guidance from the Treasury highlights several red flags for possible price cap evasion — including evidence of deceptive shipping practices, a refusal to provide the necessary pricing information, indications of manipulated shipping documents or falsified information (see Figure 2 below) unusual payment terms or payment mechanisms, abnormal shipping routes, and use of newly formed companies or intermediaries — but the repercussions for violating the price cap’s rules are not as clear, and there are some potential loopholes in the wording. Those that make “significant purchases” of crude oil above the cap or knowingly provide false information “may” be subject to a sanctions enforcement action, but that’s as specific as the Treasury guidance gets at this point.

Figure 2. Example of Prohibited Transaction. Source: U.S. Treasury Department

The process is intended to create a safe harbor from liability for service providers in cases where they inadvertently deal in oil purchased above the price cap due to falsified records provided by others. (If a service provider without direct access to price information reasonably relies on a customer attestation, that provider would not be held liable for potential sanctions.)

The architects of this buyer’s cartel maintain that if the price cap is set correctly — meaning high enough that Russia would be earning some money on each barrel — it would be irrational for Russia not to sell into it. But Russia has already said it will not sell to any country that follows the price cap. So far, the tight global energy market and resulting price spikes have benefited Russia while their adversaries struggle to meet basic energy needs. Russia has already been moving larger volumes of crude oil to China and India since the invasion, so it could seek to increase those shipments or find new buyers, even if they require steeper discounts than seen today. Given that Russia’s behavior can be erratic, there are other possible actions that Russia might pursue to cause the global price of crude to spike again.

Putin upped the stakes in Ukraine significantly during a speech Wednesday, announcing plans to call up 300,000 military reservists and accusing the West of using “nuclear blackmail” against Russia while also referencing Russia’s own nuclear arsenal, saying it would use “all the means at our disposal” for protection. In the short term, it’s a volatile situation, but as sanctions against Russia become harsher and the war drags on, Putin’s retaliation could escalate in dangerous ways that are difficult to predict.

To incorporate the price cap, the EU will have to amend a package of sanctions that is set to take effect December 5. That will require the unanimous agreement of all 27 member states. As noted earlier, Russia has close ties to EU member Hungary and has pressed it to limit sanctions by the bloc. And while the reaction to Russia’s invasion was swift, it was hardly universal, as demonstrated by the countries happy to buy crude at discounted rates.

In the vernacular of former Defense Secretary Donald Rumsfeld, there are things we know about the current situation and the debate over a price cap, such as how the oil markets have responded to Russia’s invasion of Ukraine and how Russia has found a way to continue moving its crude, despite the sanctions against it. There are also several things that we don’t know yet, such as how a price cap would ultimately function, how it might impact the global crude market, and how Russia might respond, along with many other questions. Then there’s the last group, the things we don’t know we don’t know. With a price cap this complex and with so many actions and reactions possible in the global market, it’s difficult to predict how things may play out and what unintended circumstances may arise. All of that makes it very questionable who such a price cap would actually end up hurting. And it could be all of the above.

“The Hard Way Every Time” was written by Jim Croce and appears as the 11th song on Jim Croce’s fifth and final studio album, I Got a Name. Personnel on the record were: Jim Croce (lead, backing vocals, rhythm acoustic guitar), Maury Muehleisen (lead acoustic guitar, backing vocals), Michael Kamen (ARP Synthesizer, oboe), Terence P. Minogue (strings, backing vocals), Tommy West (bass, piano, backing vocals), and Steve Gadd (drums).

I Got a Name was recorded at The Hit Factory in New York City in 1973 and produced by Terry Cashman and Tommy West. The album was released posthumously in December 1973, as Croce and his guitarist, Maury Muehleisen, tragically died in a plane crash in September 1973 after leaving their concert in Natchitoches, LA. The album went to #2 on the Billboard 200 Albums chart and has been certified Gold by the Recording Industry Association of America. Three singles were released from the LP, including the title song, “I Got a Name,” which was released the day after the plane crash. The song was first heard in the motion picture The Last American Hero, released in July 1973. It has been covered by many artists, including Jerry Reed, Helen Reddy, Lena Horne, and Sammy Kershaw.

Jim Croce was an American folk-rock singer, songwriter and musician. Croce grew up in the Philadelphia area and started playing in bands there in his teens. He released his first album, Facets, on his own independent label in 1966, selling all 500 albums pressed. He met his future wife, Ingrid, around this time. The two played together as a folk duo for a time in the late sixties until the early seventies. In 1969, Capitol Records released an album of theirs entitled Jim & Ingrid Croce. After focusing more on his songwriting skills and writing songs about the common working man, Croce secured a record deal with ABC Records in 1972. He released five studio albums, three live albums, 21 compilation albums and 12 singles. His wife Ingrid continued to record and perform after his death until vocal cord problems forced her to retire from the music business in 1984. Their son, A.J. Croce, still records and performs.

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