From the Economist's Chair: Does the cap fit?

Author David Fyfe, Argus Chief Economist

The US has persuaded EU and G7 partners to dilute their maritime insurance ban on oil shipments to Asia with a price cap mechanism, the structure, implementation and effectiveness of which remains highly uncertain.

Crude and refined products exports generated 37% of Russia’s export revenues in 2021. After much deliberation, the EU in early-June agreed a package of sanctions designed to largely eliminate member states’ purchases of Russian petroleum by late-2022/early-2023. The provision also potentially blocks EU and UK insurance cover for Russian oil cargoes headed to non-EU markets by end-2022.

Russia export revenues

The oil embargo has two main aims. Price rises faced by EU member states will be lessened by targeting oil rather than gas, while hitting Russia’s primary source of revenue is designed to curb its financial ability to prosecute the war. US and European politicians have been stung by the juxtaposition of domestic fuel price inflation and an 11% annual rise in Russia’s seaborne crude exports for January-June. Despite Urals and ESPO trading at $40 discounts vs. benchmark grades, estimated Russian crude revenues are also over 45% higher in January-June than last year.

The plot thickened after the G7 Leader’s Summit in Bavaria, held 26-28 June, which saw agreement to dilute the EU’s proposed maritime insurance ban with a price cap beginning in December for Russian crude shipments. Purchasers outside the EU and G7 would then only have access to European-based maritime insurance and financial services provided they pay below a yet-to-be-determined ceiling price for Russian crude cargoes. The cap may be based on “production costs-plus” and could come in at levels around USD 45 per barrel. It would be designed to simultaneously reduce Russian export revenues and avoid further rises in international crude prices that would result from an across-the-board insurance ban.

Leaving aside the political optics of western oil sanctions seemingly concocted on the hoof, and the lag before such a scheme is due to be introduced, there remain major questions over the formulation, implementation and potential effectiveness of the price cap itself.

Emerging market purchasers of Russian oil (substantially India and China) and large western insurance companies need to be persuaded to observe, administer and police the plan for it to have any chance of success. Most commercial tanker owners and related insurers can probably be corralled into the scheme. However, Russian, Indian or Chinese shippers with their own insurance might potentially sustain (albeit reduced) flows to Asian buyers prepared to offer premia to Russia to guarantee supplies. Much will depend on President Xi’s commitment to his “no limits” partnership with Russia trumpeted at the February Winter Olympics, and its value relative to surging domestic fuel prices and other economic pressures. A question therefore of politics versus economics.

Identifying a “Goldilocks” price, which slashes Russian export revenues but also incentivises Moscow to keep supplying world markets will also be a challenge. Although rouble revenues from oil sales have begun to erode due to capital controls and rouble appreciation, Moscow nonetheless stands to accumulate a sizeable war chest by end-year when the insurance ban and price cap are due to be implemented. Russian oil producers have technical constraints on production shut-ins, but export flows could be curtailed as a short-term political and retaliatory tactic. This is already happening in the case of European gas supplies.

While the price cap idea doubtless aims to lever world crude prices lower, it could equally create the unintended consequence of a two-tiered market. China and India could end up paying substantially less for crude than beleaguered consumers in the Atlantic Basin, increasingly reliant on displaced Middle Eastern, West African or Latin American cargoes not subject to a formal price cap.

There is clear political attraction in a price cap scheme designed to simultaneously curb Russian revenues while also sustaining oil supplies to the world market. But the time and complexity involved in designing, implementing and enforcing it means that neither a shrinking of President Putin’s war chest, nor consumer relief from high fuel prices, is on the immediate horizon.

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