Ukraine’s allies let Russia off the hook

For months, energy analysts have worried about what might happen on December 5, when two things were bound to happen. First, a European ban on maritime imports of Russian oil would come into effect. Second, the world’s advanced economies would impose a price cap on Russian oil.

December 5 has arrived, and… not much has changed. This is good news for oil buyers, as markets are not registering any unusual worries about supply disruptions. But the status quo in energy markets also suggests that the West’s latest effort to reduce Russia’s war capability is a misfire. Russia looks likely to continue earning billions from oil sales, providing crucial funding for Russian President Vladimir Putin’s illegal war in Ukraine.

Europe agreed in June to ban Russian oil imports from December, with the lag providing a window to get oil from other sources. The boycott aims to make it harder for Russia to sell its most valuable exports and to reduce oil revenues which make up 30% of Russia’s federal budget.

But Russia can sell that oil elsewhere, and it has found new buyers while Europe has found new sellers. The United States developed the concept of a Russian oil price cap, or a maximum amount that participating nations would pay, as a way to reduce Russia’s oil revenues regardless of who buys them. If enough major nations stick to the cap, in theory, it will drive down the price each buyer pays for Russian oil and reduce Russia’s oil revenue. Even countries that do not participate in the price cap, such as China and India, will demand lower prices for Russian crude if the price cap lowers the benchmark price.

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For this to work, the price cap needs to be correct – and this is where the system seems to falter. On December 2, the Group of Seven countries (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States) plus Australia set the cap at $60 a barrel. Ukraine and some of its allies wanted a cap as low as $30. Russian oil is already selling at a discount to market prices due to existing sanctions that complicate such purchases. Buyers demand compensation for the additional risk in the form of a lower price.

The discount on Russian oil is about $25 compared to the price of Brent crude (BZ=F) the European benchmark. The current price of Brent is around $83 per barrel. So the G-7 price cap of $60 matches the price buyers are already paying for Russian oil, and it’s high enough for Russia to make a profit.

“We’ve been hesitant to hit Russia where it hurts,” said Robin Brooks, chief economist at the Institute of International Finance, wrote on Twitter December 3. “That’s why we…set the G-7 ceiling price at $60. This is the path of least resistance in the short term, but we are giving Putin the means to wage an “eternal war” in Ukraine.

Poland and other Eastern European countries that border Russia initially pushed for a $30 price cap, as did Ukraine itself. Brooks speculates that Greek shipping tycoons whose ships carry more than half of Russia’s oil exports pushed for a higher cap and won, for now. Ukrainian President Volodymyr Zelensky criticized the $60 cap and basically said it wouldn’t accomplish anything.

Before the war, it cost Russia about $40 to produce a barrel of oil, on average, according to research firm Energy Intelligence. So Russia makes money at any price above $40. This explains why the hawks wanted a price cap of $30, which would force Russia to take losses, depending on the magnitude of the price cap.

There are several wildcards with the price cap regime, and it’s possible the G-7 coalition would rather wade gently than risk a reckless plunge. Russia has declared that it will not respect any price cap, which raises the question of how Russia might react if the cap really starts to hurt. The most destabilizing thing Russia can do is stop exporting oil altogether, which would cause world prices to skyrocket, given that Russia provides 10% of the world’s supply. It would do a lot of damage to Russia itself, beyond just the loss of revenue. Russia does not have the storage facilities to store an indefinite amount of oil, and shutting down rigs and other oil infrastructure can destroy equipment. But Putin grows increasingly desperate as his disastrous war in Ukraine drags on and the Russian military suffers devastating losses.

The G-7 group can also lower the price cap whenever they want, and they can do so in a gradual way, which slowly compresses Russia. “There is an inherent tension between (1) significantly reducing Russia’s export earnings and (2) avoiding physical shortages in the global oil market,” analysts at investment firm Raymond James wrote. in a December 5 report. “Policymakers are aware of the current inflationary pressures and the political complications that arise from them.”

Western sanctions against Russia following its Feb. 24 invasion are straining that country’s economy, which could shrink by 5% or 6% this year. But it could be much worse for Russia. “They have managed the impact of the sanctions much more effectively than most international observers expected,” Mark Galeotti of Mayak Consulting recently said on the Geopolitics Decanted podcast. “There is no way we can cancel the Russian system.”

Ukraine’s economy, on the other hand, could shrink by 30% this year, as Russia repeatedly attacks energy infrastructure and flattens entire cities. Rebuilding Ukraine once the war is over could cost $750 billion, three times more than all the energy revenue Russia normally earns in a year. Ukraine clearly feels more urgency than some of its allies to put Russia on its heels, while leaders in the United States and other places, barely touched by the road, want to help Ukraine as long as ‘it doesn’t cause political unrest at home. The shootout war, meanwhile, continues as incrementalism fails to turn the tide one way or the other.

Rick Newman is a senior columnist for Yahoo finance. Follow him on Twitter at @rickjnewman

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