The Crude Report - EU oil embargo: is it just an eastbound funnel?

Author Argus

Argus experts address several questions, including the recent rise in eastbound Russian crude flows amid self-sanction by some western buyers and how much of a “surprise” was the EU embargo. How easily can Russia, China, India work around insurance restrictions?

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Transcript

Tom Reed: Hello, everybody, and welcome to the latest in our series of podcasts, "The Crude Report." I'm Tom Reed, VP of crude and products for China at Argus, and I'm delighted to be joined by David Fyfe, our group chief economist, and top brain. David and I are going to be attempting to answer the question, EU oil embargo, is it just an eastbound funnel? David, this is really the key question, isn't it? By essentially embargoing imports of Russian oil, albeit with country-specific carve-outs, is the EU simply allowing other countries with which it competes economically, if not strategically, to snap up very, very cheap oil? Is the EU shooting itself in the foot here? I think it would be great actually to start if maybe you could bear to summarize the current state of play. What's the EU done? Has it done it in concert with the U.S., the U.K., and Western allies, in Asia, that sort of thing?

David Fyfe: Okay, Tom. Thanks very much. Hi. No, I think you're absolutely right to raise the sort of political dimension. I mean, we had in early May European Commission President von der Leyen announcing to great fanfare that there was an imminent embargo on oil deliveries into the European Union that was imminent. And, of course, what then followed was several weeks of fairly tortuous negotiations, sometimes seemingly quite heated, notably on the part of some of the Central European countries who receive pipeline oil from Russia and, therefore, have limited alternative sources of supply. But in early June, what was announced was that there would be an outright embargo on crude oil. And remember the EU, historically, has bought about 2.3 million barrels a day of crude from Russia. So the seaborne portion, about 1.5 million barrels per day, from the end of this year, will be subject to embargo, so no more purchases by EU member countries.

There's a carve-out for pipeline crude supply, which historically is sort of 800,000 barrels a day or so that normally comes down the Druzhba "Friendship" pipeline into Central and Western Europe. Now effectively, the carve-out is gonna allow Hungary, the Czech Republic, and the Slovak Republic to carry on buying crude beyond the end of this year. And that's probably 250,000, 300,000 barrels per day. So the seaborne portion will be cut off from the end of this year in terms of EU buyers. And then, 1.3 million barrels per day of refined products which EU countries normally purchase from Russia that will be phased out by sort of around February 2023. So much for the sort of oil embargo bit of it. And, that's aimed at essentially trying to curb the sort of $8 billion to $10 billion a month that Russia receives in terms of revenues. And remember, the whole justification for going for an oil embargo is that oil represents 40% of total Russian export revenue. So it's sort of, three times as much on a monthly basis as Russia gets for its gas sales globally. So that's why oil is being targeted.

But almost more important than the embargo itself was the stipulation that EU and potentially U.K. and other associated European countries would be prevented from providing maritime insurance for cargos of Russian oil wherever they are headed. And, obviously, in the context of what we've been seeing over the last two to three months with elevated sales into Asia, in particular, that on paper could, if anything, be even more sort of pervasive an impact on the market than the EU embargo itself. So, I mean, our view is probably that the market could deal with this embargo, the impact of this embargo, the loss of maybe 2 million, 2.5 million barrels a day net. Assuming that flows into Asia, were able to continue, but if they're not, then, obviously, that would be correspondingly much more bullish for the market. But, I mean, I wonder if I could sort of throw the hot potato back to you because we've seen China, India, and others picking up the slack, buying more Russian discounted crude. Is this opportunistic? How long can this continue? And how would China and India, for example, consider the potential insurance ban, in particular? Is that gonna be effective going forward?

Tom: I mean, this is really interesting because...of course, and it's worth...just as an addendum to that whole thing about sanctions, the EU also sanctioned the provision of this kind of financial services, broking insurance, reinsurance for any deals done after the 4th of June. There's this six-month wind-down period. So, in theory, you can only get insurance now if you are doing it for a cargo that you agreed to buy before the 4th of June. And certainly, in the months immediately after the invasion, so I'm talking March, April, and before this ban came into effect, we saw an absolute surge in loadings of Russian crude for Asia, for China, and India, in particular. On the face of it... the price of physical North Sea Dated, the benchmark for Atlantic Basin crude, it's pretty stubbornly stuck above $120 a barrel. It's very, very high. On the face of it, that should choke off these eastbound flows of Russian crude because it suggests that those cargos would command far higher prices in Europe now.

But our friends at Vortexa estimate that China and India will receive each, 1.2 million barrels a day of Russian crude by sea this month [June] . That's a relatively modest increase for China, which has always been Russia's main customer, but it's a huge step up for India, which only took 80,000 barrels a day before the war and is now pretty much at parity with China in terms of a market for Russian crude. Typically, how that's sort of panned out as we see lots more ESPO Blend, light sweet ESPO Blend going into China from Northeast Asia, that's the Northeast Asian market, but vast amounts of medium sour Urals heading to India from the Black Sea and the Baltics.

Now, a lot of those cargos arriving in June will have traded before the EU's 4th of June cutoff date. They traded back in March and April when the physical differential for Russian grades fell off a cliff. It's now the spot discount for Urals versus North Sea Dated is something in the region of $35 a barrel. It's a huge, huge discount. And it does appear that purchases of Russian crude by India and China have actually fallen slightly in response to sanctions, albeit not by much. Most of the declines seems to have occurred in mid-May when the big commodity trading houses stopped acting as intermediaries between Russian producers and end-users. But as I say, the decline has been in the region of 300,000 barrels per day, and we are talking about sales overall of more than 2 million barrels a day.

Most of the decline seems to have come from India where there is a significant dependence on U.K. markets for reinsurance, as well as use or membership of the International Group of Protection and Indemnity clubs. IGP&I clubs based in the city of London, which help ship owners to pool their insurance risk, and claim to represent 90% of the world's ocean-going tonnage. But reinsurance is another really sticky point. Even Chinese insurance companies tend to use U.K.-based reinsurers. I think it's interesting that for now, the U.K. has not followed the EU's lead in sanctioning provision of financial services. Although, as you mentioned, we're expecting some announcements to come out of the G7 meeting over the weekend. And we are recording this before the G7 summit, so our listeners do have an advantage in possibly knowing the outcome of those talks while we continue to speculate wildly.

And, in theory, that leaves a loophole wide enough to sail a VLCC through. But sanctioning the cargo rather than the vessel itself I think is a pretty smart move, as you say, potentially very effective. Ship owners may be willing to risk sanctions being imposed on 20-year-old vessels at the end of their shelf life. These are ships that have already put in a useful lifetime of service and are now nearing their, sort of, natural scrappage point, and maybe they would end up carrying pariah cargos like Urals. But if that cargo or the vessel are uninsured and the insurers themselves can't lay off that risk in the reinsurance market, a lot of ports won't allow their vessel to dock. And this is something I think that does concern buyers in India and China as well.

There are likely to be workarounds. One clearly unattractive alternative is simply to sail a ship without insurance. That is very risky, dangerous, and very few ship owners will want to consider that. Another might be to offer sovereign insurance for cargos. This is something that Japan provides, albeit theoretically, for imports of Iranian crude. A couple of years ago, they said they would provide up to $8.5 billion worth of insurance for imports of Iranian crude. Japanese firms don't actually...I don't think import Iranian crude, but Tokyo's offer still stands. And cargo insurance is a relatively small percentage of any given cargo value. It's usually a couple of cents in the barrel, so, well, probably within the scope of national governments to underwrite.

David: And, you alluded to, from an EU perspective, the potential fly in the ointment, almost, that they're now confronting, which seems to be a U.S. administration which has sort of woken up to the potential threat that this insurance ban might provide in terms of really restricting Russian flows into the broader international market. As you say, the coming weekend [26-28 June], we're gonna see the G7 summit in Bavaria. We've got a Biden administration that is thinking, "Can we suspend our domestic U.S. gasoline taxes to try and provide some relief? Do we look at export restrictions on U.S. products' exports to try and help the U.S. domestic consumer?"

And the final element they're now considering and trying to bolt onto the EU sanctions package is the concept of a price cap for Russian exports. In other words, to say if you, the Asian buyer of a cargo, agree to pay below a yet-to-be-determined price related to production costs potentially, we'll allow you to use and we'll allow European insurance and reinsurance providers to provide cover for your vessels. It sounds a very, very messy sort of set of conditions to put on flows, but it's clearly a sign that the U.S. has sort of woken up to the risk that prices could even potentially be headed higher if an outright ban on insurance was put in place.

I mean, at Argus, in the past before the embargo even was put into place in the EU, we made an argument that maybe more market-related mechanisms, a tariff rather than outright bans or embargoes might be more economically efficient, but nonetheless, we are where we are, and this is what the EU has put in place. So as you say, our listeners may be in a better position than we are depending on when the webinar is broadcast. But I suppose the broader question is, does this all really matter? The Chinese economy is stuttering in the face of renewed COVID-19 outbreaks and problems dismantling lockdowns, the global economy is confronting rising interest rates. And, would President Putin really pay much attention to these sanctions in any case, or just press on regardless?

Tom: Yeah, I mean, there are so many questions. I have so many questions about this, but, I mean, the price cap, potentially a relatively sensible solution, but the devil is gonna be in the details. I suspect even in the immediate wake of this summit in Bavaria, a lot of those details will yet to have been thrashed out. And, it's quite clear that a one-size price cap might not fit all, right? This is why we see crude moving from the Baltics to China. It's because there are very, very different prices in each location. There's a very, very high price at the point of delivery and a very low price at the point of loading, and companies prepared to risk the social or political, blowback from moving those cargoes to make a lot of money from doing it.

So there's gonna have to be some sort of sweet spot when the G7 comes to discussing exactly where it's gonna put this price cap, and it'll be really interesting to see the mechanics of how that work. I think politically, it's quite a good idea because, of course, you're punishing supply without punishing demand, and this issue does threaten to drive a wedge between the West and India or worsen relations with China, and potentially, the price cap idea might be something that could appeal to those consumer countries. But, to your other point, yeah, I mean, the global economy is not in a happy place right now. Certainly in China, even if you could dramatically divert huge amounts of Russian crude to that market, are you essentially pushing on a string if the Chinese market cannot absorb it?

And I think it's very clear that despite having come out of lockdown, despite having ended those very devastating lockdowns in Shanghai, Beijing in March, April, in June, the economy is still struggling and it might be not until later this summer that we barely begin to see China's economy start to recover. And when it does, as you point out, it's gonna have to be domestically driven because inflation is already starting to eat into those, kind of, demand for manufacturing exports from China. So Chinese factories may not be humming to the extent that they used to be.

David: And, as China goes, so goes the world, real concerns about whether central banks in the Atlantic Basin can modulate their rate rises to prevent outright recession. And, we tend to forget in terms of oil demand globally, growth in oil demand, historically, is hinged on global GDP growth of about 2% real, not 0% real. Current forecasts have at best about 3% global GDP growth this year and next year, and those have been revised down probably for this year by about 2 percentage points over the last 12 months. So we're not far from an area that actually could result in fairly anemic oil demand growth in 2022 and 2023. So I suspect, Tom, we're gonna have to come back to the whole issue of the embargo and the price caps once we know...

Tom: And demand destruction.

David: And demand destruction. So I guess we may revisit this subject in a future podcast.

Tom: Yeah. But I think as you are suggesting, we are now comprehensively out of time and we must draw a veil over proceedings. Thank you, everybody, who's dialed in to listen. Do join us again for future editions of "The Crude Report." And I hope you've all enjoyed this one very much. Thank you from me and David. Goodbye.

David: Bye.

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