7 min readFeb 6, 2023 09:41 AM IST
First published on: Feb 6, 2023 at 07:04 AM IST
Last week, the US and the EU banned the purchase of petroleum products from Russia. Two months earlier, on December 5, they had imposed a similar ban on Russian crude oil. At that time they had announced that any third-party buyer that paid more than $60/bbl for Russian crude oil would be denied access to Western insurance, finance and brokerage services. The ban on petroleum products will also be accompanied by a price cap, albeit at two levels. One level will be for commodities like diesel that sell at a premium to crude oil and the other for commodities that sell at a discount like fuel oil. The precise numbers have yet to be announced.
The idea of a cap was first put on the table when the price of oil was in triple digits and Russia was earning more from its exports than it had earned prior to the Ukraine invasion. This was galling for the US as it negated the impact of the sanctions. The purpose of the cap was two fold. One, to keep Russian oil flowing into the international market. This is because Russia accounted for 10 per cent of global supplies and a complete cut off would send prices into the stratosphere. And two, to reduce Russian export earnings by pushing down production and compelling buyers to pay less than the international price.
The price cap accompanied by the sanction was conceptualised to achieve both objectives. The former was above the average cost of production of Russian oil of between $ 25-40/bbl, and therefore, an incentive for Russian companies to continue producing. The latter complicated access to essential services and constrained, therefore, the trade and shipment of Russian oil.
Ever since this idea was first mooted, I have wondered about its viability. For it is a well-known economic precept that administrative price (and income) controls do not work and that, if anything, they provide profitable arbitrage opportunities for wily traders. I am not one for conspiracy theories but I have asked myself why a world class economist like Janet Yellen would put her weight behind such an idea when in a different avatar as an economics professor, she would, most likely, critique it as a blunt and ineffective instrument. I have reflected whether the progenitors of this idea had objectives other than those publicly stated.
Two months into this cap, I see trends — some unexpected — that give partial credence to my reflections. First, as was anticipated by all experts, the cap does not work. It contains too many loopholes. Thus, for instance, one easy way of circumnavigating the cap would be for the seller to state a price in the bill of lading at the port of loading that is at or below the cap price and then adjust it upwards vide freight and other charges. Buyers pay on the basis of the delivered price. More pertinently, Russia is rumoured to have gathered a shadow fleet of tankers to bypass the western insurers.
Second, Russia’s production has fallen by between 800kbd to 1 mbd which is approximately 25 per cent of the country’s exports. This has reduced export earnings. But hardened traders are still transacting in Russia. Several have (re)registered their offices in countries that are not subject to sanctions like the UAE and have exploited the arbitrage opportunity to buy “low” and sell “high”.
Third, the cut back in Russian crude (and products) has tightened the market. Prices are currently holding because winter has been relatively mild – the US has released more barrels from their strategic petroleum reserve than expected and the Chinese demand has been laggard. This trend might, however, reverse. Saudis and the UAE are not likely to draw on their surplus producible capacity to offset the gap created by the reduction in Russian exports. And China is determined to return to the high economic growth trajectory. If and when prices do spike, the progenitors of the cap might well find themselves hoisted by their own petard.
Four, Saudi Arabia must be discomfited by the knowledge that a price cap has acquired shape and that the US may be tempted to apply it against them if prices ever reached politically uncomfortable levels. There are many reasons why the Saudis are looking to place their relations with the US on a transactional base and why India is regarded as an increasingly important strategic market. But one reason may well flow from this discomfiture.
Five, Europe has been adversely impacted by the price cap. This is because they are disproportionately dependent on Russian crude and products. They have had to turn to the US, Middle East and India to meet their shortfall and in response the suppliers from these countries have redirected their cargoes to the European market at a premium. In an ironic twist, Indian refiners are sourcing crude from the eastern seaboard of Russia, shipping it to their refineries — predominantly in Jamnagar — and then moving the products, mainly diesel, to Europe. The extended trading distances have tightened the shipping markets. Tanker freight rates have ratcheted up and the stock price of shipping companies are close to historic highs.
Finally, and perhaps the reason I used the word “conspiracy” earlier, US petroleum companies have benefited most from Europe’s plight. In a flourish of commercial opportunism, the US administration has allowed Chevron to return to their concessions in Venezuela but on condition that the crude oil produced by them will be sold only into the US. They have done this notwithstanding that they still do not recognise President Nicolas Maduro. This decision will allow US companies to convert a relatively inexpensive heavy crude oil into higher value added, lighter products like diesel for export at a premium to Europe. Combined with the fact that US LNG has already predominately replaced Russian gas, it would be no exaggeration to suggest that Europe has been pushed into a relationship of energy dependency with the US. The price cap has redesigned the contours of energy geopolitics.
The writer is chairman and distinguished fellow, Centre for Social and Economic Progress
The idea of a cap was first put on the table when the price of oil was in triple digits and Russia was earning more from its exports than it had earned prior to the Ukraine invasion. This was galling for the US as it negated the impact of the sanctions. The purpose of the cap was two fold. 
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