At the 26-28 June G7 summit in Bavaria, leaders said they would consider a price cap on Russian oil, to cut Putin’s oil rent while minimising the negative impacts on the global economy. This blog post discusses this proposal and how it might work, notably to help understand whether this could improve the current western embargo regime.
The western embargo regime and its shortcomings
A few weeks after Russia’s invasion of Ukraine, Canada, the United States and Australia banned imports of Russian oil, while the United Kingdom announced a phase down by the end of 2022. These measures were more about political signalling than economic substance, given these countries’ limited reliance on Russian oil (zero in the case of Canada, and between 2% and 9% of domestic demand for the others).
Given its high reliance on Russian oil imports (covering 25% of its demand), the European Union initially refrained from similar measures. However, after difficult internal negotiations, the EU agreed at the end of May to embargo seaborne Russian oil imports in six months’ time and Russian oil product imports in eight months’ time. The EU also sought to hinder Russia’s ability to redirect oil flows to third countries. Over 90% of the world’s ships are insured via the International Group of P&I Clubs – a London-based association of insurers. In agreement with the UK, the EU banned insurance for ships carrying Russian oil, making the shipping of Russian oil more expensive as it will have to rely on less-efficient insurance.
The EU’s move has significantly scaled-up the EU response to the Russian aggression against Ukraine. It has also raised two important issues.
First, the EU’s pre-announced embargo will make Russia even better off in the near term. Despite the announcement of western sanctions, Russia’s fossil-fuel revenues have not declined, because of a surge in oil and gas prices and the slow phase-out of imports into Europe. Meanwhile, countries including India and China have increased their purchases of Russian oil substantially. Russia still earns more than $600 million a day from oil. Its oil and gas revenues in 2022 might reach a record $285 billion. That would exceed the 2021 figure by more than one-fifth.
Second, the insurance ban might end up very costly for the global economy. It would prevent a large portion of Russian oil from being sold into the market, driving up oil prices for almost everyone, except countries that can purchase discounted Russian oil notwithstanding the EU transport sanctions. This issue has been a particular concern for the Biden administration, which has consistently warned the EU against a full Russian oil embargo given its potential negative repercussions for the global economy.
The first issue is temporary, and should disappear once the EU embargo finally enters into force. But the second issue is structural, especially if the EU embargo proves to be successful. This is what the G7 seeks to address with its proposal.
The G7 alternative: instead of suppressing Russian oil exports, apply a price cap
The G7 proposal seeks to mitigate any negative consequences for the global economy of the EU shipping insurance embargo by letting third countries import as much Russian oil as they want, as long as it is traded below a fixed price cap. This would also free-up non-Russian oil for the countries imposing embargoes, so they are better off, too.
The G7 proposal thus seeks to leverage the dominance of western allies in shipping, banking and particularly maritime insurance, by denying the provision of such services to any entity that tries to buy Russian oil above a threshold price. This means essentially forcing the world into a buyers’ cartel. The cap could be set at a price somewhere between Russia’s marginal cost of production and the price of its oil before the February 24 invasion of Ukraine: between $40 and about $60 per barrel.
A price cap just above Russia’s cost of production, the idea goes, should reduce Russia’s profits drastically while preserving its incentives to sell, as not selling would mean Russia will not receive any profits and it would have to shut downs oil wells, a costly operation. For the price cap to be possible, the EU’s announced ban on insurance services for Russian oil shipments would have to be partially lifted.
Four implementation problems
When it comes to implementation, four main problems can be identified with the G7 proposal.
First, the insurance-related sanctions might not work because Russia or some third countries – such as China – can provide the insurance contracts themselves. These might not have the same standing as western insurance and might not be accepted for transit through essential ports and canals, but countries may nevertheless decide that obtaining Russian oil is worth the risk if it is still clearly cheaper than other suppliers. Whether this would ultimately be successful, given that actual shipping and financing could also be sanctioned, is a different matter. In this respect, the deployment by the United States of extra-territorial secondary sanctions to enforce restrictions imposed on Russia would be important, though so far, the Biden Administration has steered away from this.
Second, even with perfect transport sanctions, price caps are hard to enforce because importing countries might try to circumvent the price cap through side payments, as happened when a similar scheme was imposed on Iraqi oil in the 1990s. Imagine for example that India pays a higher than usual price for arms deliveries from Russia. Could it be proved that this is a side payment for oil? Will the G7 be ready to enforce sanctions if that happens? It seems that the proposed buyers’ cartel is not very credible.
Third, the Organisation of the Petroleum Exporting Countries might react badly, reducing oil supply because it does not like price caps. Lower prices might discourage additional production/exports from being brought to the market. More importantly, OPEC will view such a price-cap with suspicion because a successful experience might encourage the global buyers’ community to extend the mechanism beyond OPEC. Consequently, it is possible OPEC might seek to obstruct a cap by, for example, supporting Russian exports or reducing OPEC exports.
Fourth, Russia might reduce oil supply. Russia might even decide to place a tactical bet and cut off oil supply altogether. It could then call upon its sizeable cash reserves to sit it out. In such a case, some analysts warn that oil prices could increase substantially, though others argue that Russia is unlikely to do that, because it would harm its relationship with OPEC and also because an abrupt production interruption would damage its own oil wells. The loss of revenue would also cause substantial and immediate pressure on Russia’s currency and overall economy. Other scenarios are possible. If the price cap does not allow for any profits to be made, Russia could also choose to reduce its production to a minimal level that does not require closing oil wells, rather stopping exports completely. Producing more would not make much sense since there are no additional gains, while conditions on global oil markets would relax, to the benefit of sanctioning countries. If the price cap does allow for some profits, Russia might prefer to sell as much oil as it can, taking into account that a part of former European demand cannot be redirected. A middle road of producing somewhat less does not seem likely in this situation because Russia would be supplying the world with oil, thus reducing the price Europe pays on markets, without maximising its own profits.
Can the G7 proposal improve the current western embargo regime?
A closer look at these four implementation problems reveals that only two of them are actually specific to the price cap, the other two being common to both this proposal and the current western sanctions regime.
The risk of the insurance sanctions being circumvented by finding such services elsewhere and the risk of Russia cutting off oil supplies altogether are common issues. There is not much western allies can do to mitigate these risks, apart from placing (namely from the US side) secondary sanctions on the third-country insurers providing their services to tankers transporting Russian oil. However, the risk that countries make side payments to Russia to get its oil, and the risk of OPEC reacting badly to the oil price cap, are specific to the G7 proposal. On these, specific solutions will have to be found to mitigate risk.
All in all, the G7 proposal if successfully implemented might improve the current western sanctions regime because it might minimise the negative impacts on the global economy. However, it is clear that tough trade-offs make it difficult for the G7 proposal to achieve its double goal of maximising pressure on Russia, while minimising impacts for the global economy.
For instance, the oil price cap might be set at too high a level to really dent Putin’s oil rent. The current EU approach in the longer run might be much more impactful, but only at the risk of pushing global oil prices higher, negatively impacting the global economy.
Given its complexity, the price cap proposal is not going to happen through implementation of a straightforward mechanism. Should G7 countries manage to agree a price cap, several challenges will arise over time, paving the way for continued adjustment. Success will be determined by the G7’s ability to bring China, India and other developing countries onboard and thus avoid opportunistic behaviour. This will depend on the west’s willingness to invest substantial soft and hard power – including the threat of secondary sanctions – to enforce at least tacit acceptance of the oil price cap by non-western countries.
The authors are grateful to Jeromin Zettelmeyer, Maria Demerzis, Elina Ribakova, Ben McWilliams and Giovanni Sgaravatti for their insightful comments on previous drafts.
Lenaerts K., S. Tagliapietra, G. Zachmann(2022) A possible G7 price cap on Russian oil: issues at stake’, Bruegel Blog, 13 July