Price Caps on Russian Hydrocarbons: Be Careful What You Wish For

Recent G-7 discussions about imposing caps on the price of Russian oil and gas have led to some head-scratching. We see several angles at play in this situation. Below are some thoughts from a political economy standpoint. We are concerned the risk of policy error could be high here.

1. It is far from clear that Russia would play along since it has probably been a net earner of foreign exchange (FX) since the war began.

According to Finnish think tank Centre for Research on Clean Energy and Air (CREA), Russia earned €93 billion from fossil fuel exports (including coal) in the first 100 days of the war, or just shy of $1 billion/day, with the same report citing estimates of $900 million/day for the cost of the war, indicating the exercise has actually been a net FX generator, not least because of the war’s impact on the oil price.[i] If anything, the war expenditure estimate may lean high given that Stockholm International Peace Research Institute estimated total global military spending at close to $2 trillion in 2020 and 2021.[ii] Even applying a heavy discount to headline FX reserves of $587 billion, [iii] Russia can probably stop oil/gas sales entirely for a year without running out of reserves. As we have noted previously, Russia’s war machine is largely domestically-sourced, meaning the war itself can be financed largely without access to dollars. True, the domestic fiscal balance does depend on hydrocarbons too, but here again the starting point of debt and deficits is enviable, in our view. What would happen to the global economy were Russia to stop exports entirely on its own accord? We feel it would not be a rosy picture. In our view, the world needs Russian oil more than Russia needs to sell it.

Halting production itself for a prolonged period could involve geological/engineering costs, which are beyond the scope of this analysis. However, given the current supply environment, we submit that any Russian export ban need not be particularly long to trigger price responses in the market.

Recall also that over the last year, Russia's revenues from fossil fuel sales have increased despite falling volumes and discounts due largely to the overall commodity price move—at least part of which was a result of the Ukrainian war. CREA estimated that the 60% increase in prices more than offset combination of lower export volumes and discounts on Russian oil leading to a net increase of EUR 250mm in average daily Russian revenues from fossil fuel exports between May 2021 and May 2022.

2. It is unclear if the G-7 economies can ensure compliance with price caps given that the status quo has benefited key consumers of Russian oil and gas.

India has emerged as a significant consumer of Russian oil almost overnight, with the country’s share of Russian exports rising from 1% prior to the invasion to 18% in May 2022, with sales widely reported at a discount to notional world market prices.[iv] Crucially, 20% of Indian refinery exports head west of the Suez Canal—to the same countries driving sanctions on Russia.[v] India and China have already been seeing economic gains from the price discounts on crude oil and—especially in India—the refining margin.