EXPLAINER: how a price cap on Russian oil might work
Europe is scrambling to find alternatives to Russian crude oil, natural gas and coal. But the fact remains that despite recent cuts in the amount that the EU buys from Russia, Moscow’s revenues from hydrocarbon exports still surged 40% year on year in May, as noted in a recent study, owing to sky-high prices. This is even taking into account the fact that Russia’s Urals oil is trading at a steep $30 discount to Brent, because of sanctions and buyers shunning the product. At the same time, some EU member states have limited ability to make further reductions in volumes.
This is why a proposal is now gaining traction in Brussels and Washington to cap the price of Russian oil imports, depriving the Kremlin of revenue to finance its war in Ukraine. But this proposal could prove tricky to implement and could have significant negative implications for the global economy.
Leaders of the G7 advanced economies on June 28 reached a broad agreement to find ways of introducing the cap, but the technical work is still to come.
“This is a very ambitious and demanding project, and there is still a lot of work to be done,” German Chancellor Olaf Scholz said at a concluding press conference.
French President Emmanuel Macron added that while “the idea to put a cap is a very good one, there is technical difficulty.”
Introducing a price cap on Russian oil might also pave the way for a cap on Russian gas prices as well.
How the cap would work
The US had initially pushed for a Russian oil price cap that could be enforced by lifting sanctions on the insurance of cargo ships that handle the country’s crude, in return for a price deal. Those sanctions would be lifted for countries that agreed only to purchase Russian oil at a settled maximum price, creating an incentive for the price cap to be complied with. G7 leaders said they viewed this as the preferred option.
“We will consider a range of approaches, including options for a possible comprehensive prohibition of all services, which enable transportation of Russian seaborne crude oil and petroleum products globally, unless the oil is purchased at or below a price to be agreed in consultations with international partners.”
While the US and Canada have already prohibited Russian oil purchases, the EU is yet to take this step until the end of the year, and so the price cap is designed to serve as a stopgap.
The price cap could be set at or close to Russia’s marginal cost of production, ensuring the Kremlin makes no profit from its oil exports. At the same time, Russia would have an incentive to keep on exporting the crude, because the alternative would be the costly shut-in of fields and the loss of strategic markets overseas, potentially causing irreparable damage to its oil industry.
To enforce the price cap, G7 countries and their allies could make it illegal for any bank or company in their jurisdiction to support shipments of Russian oil that exceed the price cap. Russian oil exporters would therefore have to sell oil at or below the oil and provide verifiable proof, or lose access to shipping, insurance, ports and financial services in G7 member states. In the case of insurance, for example, the International Group of Protection & Indemnity Clubs in London covers around 95% of the global oil shipping fleet.
On the other hand, buyers that have maintained a more neutral stance towards Russia such as India would have the incentive of cheap oil to abide by the price cap. Indian oil refiners are already securing lucrative deals for discount Russian oil. The threat of secondary sanctions on those that do not comply with the cap would provide a stick to complement that carrot.
Difficulties and dodges
For the price cap to work in practice, though, there would have to be a clear enforcement mechanism that avoids confusion and cheating. If enforcement is uneven, then it is likely to create even greater volatility on the global oil market.
Somewhat similar measures were implemented against oil producers in the past, such as the oil-for-food programme by the UN in 1995 that allowed Iraq to sell oil in exchange for food and medicine. Oil buyers paid money into an escrow account run by BNP Paribas, with some of the funds being used to pay for war reparations to Kuwait. But that programme was beset with widespread corruption and abuse.
Meanwhile, despite the intentions, the price cap might encourage some buyers such as India and China to actually ramp up oil supply from Russia, because, after all, they would be paying less. Therefore the cap might fail to deprive Moscow of revenue, as Russia would be able to offset some of the lost price with increased volumes; that is, unless the cap was complemented with co-ordinated global reductions in Russian oil purchases, which buyers such as India have already shown they are unwilling to agree to.
Using insurance markets to implement the cap might also cause the price of non-Russian crude to soar amid fears of future shortages. This would hurt the global economy and could make buyers more willing to risk penalties for violating sanctions. Buyers that are not aligned with Western policy towards Russia might also accept Russian or other insurance.
Indian has already blown a hole in this scheme after an Indian insurance company agreed to offer Russian tankers safety certification to a Dubai-registered subsidiary of Russia’s biggest ship operator Sovcomflot on June 23. That will allow Russia to export oil to Indian even if the Western insurance sanctions are put into effect.
Moreover, certification by the Indian Register of Shipping (IRClass) could well be accepted by Russia’s other nonaligned customers in the developing world, most of which have refused to join the western sanctions. bne IntelliNews reported, the enthusiasm for the West’s sanctions outside of the G7 countries is only lukewarm.
Data compiled from the IRClass website shows that it has certified more than 80 ships managed by SCF Management Services (Dubai) Ltd, a Dubai-based entity listed as a subsidiary on Sovcomflot's website, Reuters reports.
India's ship certifier is one of 11 members of the International Association of Classification Societies (IACS), top-tier certifiers that account for more than 90% of the world's cargo-carrying tonnage. The Russia Maritime Register of Shipping was also part of the group until March, when its membership was withdrawn following a vote by 75% of IACS's members. However, only four of the 11 members (UK, Norway, France, and the US) have withdrawn their services from Russian ships due to sanctions.
An IACS spokesman told Reuters that IRClass' actions were, “not a matter for discussion by the association,” and that members of the association were free to make their own commercial decisions.
With the Indian IRClass certification Russian ships have then turned to their domestic insurance companies for cover. Sovcomflot's chief executive told reporters earlier this month that the group had insured all its cargo ships with Russian insurers and the cover met international rules. Reuters reported that the Russian state-controlled Russian National Reinsurance Company (RNRC) has become the main reinsurer of Russian ships, including Sovcomflot's fleet.
RNRC is under the control of the Central Bank of Russia (CBR). The CBR raised RNRC's capitalisation to RUB300bn ($6bn) from RUB71bn and hiked its guaranteed capital to RUB750bn so the firm had adequate resources to provide reinsurance.
Indian authorities have also accredited the privately owned Russian insurance giant Ingosstrakh as an insurance company for shipping oil, which means vessels the company insures can enter Indian ports. Ingosstrakh was formerly owned by Czech investment holding PPF and Italian insurance giant Generali, which “froze” its 38.5% stake in the company in March, but has no plans to sell it, according to reports. Russian oligarch Oleg Deripaska is also a major shareholder. Ingosstrakh earned just over a third of its premiums of $910mn from marine insurance in 2021.
Allianz, Europe’s biggest insurer, which offers a wide range of insurance products in Russia, has also said it has intension of exiting the market, the Financial Times reported in March.
Export of oil to India have boomed this year as it takes advantage of the deeply discounted prices. Russian grades accounted for about 16.5% of India's overall oil imports in May, compared with about 1% in all of 2021.
If the price caps are put in place and the insurance ban made to work, then there is also the risk of a drastic reaction from Russian President Vladimir Putin, who could respond by cutting oil and possibly gas exports to Europe, plunging its markets into economic chaos, even if doing so hurts Russia and its hydrocarbon industry considerably in the process.