From the Economist's Chair: Is an oil embargo on Russia really the smartest move?

Author David Fyfe, Argus Chief Economist

The EU is struggling to get everyone onboard for an outright embargo on oil imports from Russia, but could follow a more flexible, market-driven route.

Western governments are scrambling to impose ever-more punitive sanctions on Russia, desperate to end a war that is both a humanitarian tragedy for Ukraine and a looming inflationary disaster for the rest of the world. At the same time governments are taking emergency domestic measures to cushion the blow that upwardly spiralling world commodity prices have dealt to their citizens.

They have deployed energy tax reductions and outright subsidies in merry contempt of supposedly inviolable open-market principles, and have at the same time torched long-term commitments to cutting dependence on hydrocarbons. It seems that the old saw which states “the surest cure for high prices is high prices” has been forgotten in pursuit of the (albeit commendable) goal of protecting the most vulnerable consumers.

As it becomes clear that the war in Ukraine will most likely be a lengthy affair, so EU states are turning to measures previously thought unlikely – direct energy sanctions on Russia. This despite the fact that Europe as a whole sources around 25% of its oil imports from Russia, along with 50% of its coal imports and 60% of its natural gas. Crucially however, Russian dependence on Europe as an outlet for its oil and gas exports is higher still, at 50% for oil and 80% for gas.

So while energy sanctions will undoubtedly be both disruptive and costly for EU states, the supposed logic is that they will impose still higher costs on Russia itself.

In particular, oil embargo proposals from the European Commission are predicated on the importance of oil in Russian export earnings. In 2021, Russia earned the equivalent of USD 15 billion per month from crude oil and refined products exports – 40% of total export earnings and three times as much as the country took from natural gas exports.

And since two-thirds of Europe’s oil imports from Russia are seaborne, Europe is in theory better placed to source substitutes for oil than for gas. At the same time, shipping bottlenecks could also limit Russia’s ability to re-route oil cargoes intended for Europe to longer-haul destinations.

The EU proposal is for member states to stop importing crude oil from Russia within six months of enactment, with refined oil products imports ending no later than end-2022.

But is there a need for an outright embargo now, and is an embargo in the form drawn up by the EU likely to work?

Several arguments suggest it is not.

First, existing US, EU and G7 financial sanctions (targeting the Russian Central and commercial banks and state-controlled oil operators Rosneft, GazpromNeft and Transneft) have already led a swathe of European oil buyers voluntarily to halt spot market purchases from Russia, and to discontinue lapsing term import contracts. These actions could reduce Russian oil imports into Europe by over 2 mb/d, or 75% of pre-crisis levels.

Such “self-sanctioning” has already turned Russian crude exports into distressed oil. Urals crude, trading pre-crisis within USD 2 per barrel of North Sea Dated Brent, is now discounted by close to USD 35 per barrel. Not surprisingly, distressed cargoes have found buyers in India and China, even though China’s recent lockdowns have depressed crude appetite overall.

While the threat of imminent EU embargo is supporting global crude prices at levels higher than would otherwise be the case, steeper Urals discounts and reduced purchases point to a market that is already savaging Russia’s oil revenues.

Secondly, while western government are keen for Russia’s income to fall as fast as possible, an embargo may actually be a blunt instrument for achieving that. European importers who lack access to alternative supplies will either need extended exemptions, financial compensation to enable alternative infrastructure investment, or both if they are to be shielded from a catastrophic economic hit from sanctions.

The Hungarian government has so far opposed the EU embargo outright, potentially undermining the unanimity required for such a measure to pass into EU law. The EU for its part is offering exemptions until 2024 for Hungary, Slovakia and the Czech Republic to cease pipeline oil imports from Russia. This highlights the uneven consequences of an import embargo as a tool for penalising Russia, and arguably undermines the embargo from Day One.

Thirdly, there exist sanction mechanisms distinct from an embargo which could more effectively reduce Russian revenue, while better offsetting the economic pain importer nations are facing from both the war and from associated global energy inflation pressures. Oil tariffs or levies would be one such form of “smart sanctions”.

They would allow consumers heavily dependent on Russian supply to continue purchases, albeit potentially at a higher cost. Ultimately, buyers would decide whether to pay such a tariff based on the availability of alternative supplies. Since Russia will have problems selling into alternative markets, and Europe can relatively easily buy from elsewhere, any price increase for EU consumers due to the tariff itself could be offset by Russia having to cut its asking prices to keep its European buyers.

Asian buyers would most likely demand the same discounts, further reducing Russian revenues. The broader inflationary impact on international prices could therefore be less than with an embargo.

Arguably, tariffs would be politically more palatable across a diverse EU membership than a heavier-handed embargo, even though they are more complex to administer, and as some observers note, potentially prone to WTO or ECJ challenge. The EU could potentially, however, counter on national security grounds or by asserting that tariffs simply mirror the export taxes Russia itself levies on hydrocarbons.

EU governments could divert tariff revenues to a range of uses including financial assistance for low-income energy consumers, extra energy diversification and transition investment, or aiding post-war Ukrainian reconstruction.

Leaving short-term administrative expediency aside, European politicians would better serve their citizens in the long-run by harnessing the power of markets, and more market-responsive mechanisms, in their fight against Russian aggression.

Learn more about the Argus Crude report

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