Oil sanctions are a spent cannon

When sanctions on Russia’s oil were introduced they were hailed as a deadly blow to Russia’s finances and were expected to swiftly bring the Kremlin to its fiscal knees. However, not only has the Kremlin been able to successfully avoid the sanctions by rerouting the bulk of its oil exports to Asia, but the West finds itself in a position now where it dare not enforce the existing sanctions, let alone make them tougher.

“The effectiveness and credibility of energy sanctions are on the line,” Kyiv School of Economics (KSE) said in its latest update on Russia’s oil business. “The key mechanism through which embargoes on Russian oil and the G7/EU price cap regime have weighed on export earnings and budget revenues – the discount on Russian supplies vs. global prices – is showing signs of trouble. For Urals grade crude oil, for instance, it declined from $40 per barrel in January to below $14 per barrel in September. Reduced volumes play a role but so does Russia’s growing ability to rely on a sanctions-proof fleet of vessels. These issues need to be addressed urgently to maintain pressure on Russia and ensure that the sanctions regime remains credible.”

The problem is that the West is more afraid of spiking oil prices than it is of Ukraine losing the war. The oil price cap sanctions were specifically designed not only to reduce the amount of money the Kremlin gets from exports but also to maintain the same volumes of supply to the market in order to keep prices down.

At the same time, the version of the cap chosen – $60 per barrel, not $30 some have been calling for – also meant that most oil trade was unaffected by sanctions this year as prices have hovered around the cap price.

The upshot has been that the Kremlin has not been starved of money and after a poor start to the year Kremlin Inc. went back into profit in May. (chart) It is now on course to easily meet the Ministry of Finance (MinFin) target deficit of 2% of GDP by the end of this year and enjoy economic growth of 2.8%, while Germany and the UK are likely to fall into recession. “The worst is over” Prime Minister Mikhail Mishustin told a conference of Russia’s economic elite in October.

Oil sanctions have lost much of the potency they had immediately after their imposition as the global energy markets adjust to their distortions and experts increasingly view sanctions as more of a symbolic gesture than a significant deterrent.

The change has been highlighted by the US government's recent decision to impose secondary sanctions on two shipping companies for breaking the oil price cap sanctions for the first time on October 13.

The UAE-registered company Lumber Marine and Turkish Ice Pearl Navigation were accused of transporting Russian oil at prices ranging from $75 to $80 per barrel – well above the established price ceiling – and are now barred from transporting Russian fuel.

These sanctions the first of their kind against violators of the price ceiling, but the practice is widespread, according to a recent study by The Peterson Institute for International Economics (PIIE) and Kyiv School of Economics (KSE), which have documented widespread cases of EU-flagged tankers simply ignoring the sanctions, especially in the Pacific Ocean.

The US is not expected to impose a widespread crackdown on Western-flagged shipping companies for ignoring the sanctions regime for fear of reducing volumes of crude being shipped too far and driving up the price of oil further.

“Instead, the actions of the US should be interpreted as either an attempt to save face in light of the largely ineffective price ceiling or as a means to intimidate violators and potentially increase the transaction costs associated with Russian oil,” The Bell reports.

The oil sanctions have been put in a bind by the rising price of oil after OPEC+ put through voluntary production cuts earlier this year and recently extended them to the new year. Oil price rose to around $90 a barrel as a result and as demand is expected to rise an oil deficit on the market is looming, making it increasingly sensitive to supply reductions.

The situation has been made even more tense by the eruption of a second war, in the Middle East, after Hamas attacked Israel on October 7.

In an effort to increase the supplies of oil on the market and so manipulate prices lower to hurt Russia, the US has been increasingly lenient when it comes to the implementation of oil sanctions on Iran, which has seen its exports climb to 3mn barrels per day (bpd) as a result. Iran's crude oil production reached 2.85mn bpd in July, which was then only 72,000 bpd short of becoming the third-largest oil producer in OPEC in September.

Fears that Iran could get drawn into a wider war in the region that would see its crude exports tumble are adding to the already tightening market. And Iran is also in a position to strangle oil ships navigating the chokepoint of the Strait of Hormuz, which would lead to a major oil crisis.

By a similar logic, the US has just announced a deal to drop oil sanctions on Venezuela in an effort to increase the volumes on the market and bring prices down. With US elections looming and after the Biden administration has run down its strategic petroleum reserves to their lowest level in 40 years, the White House now has few other options to coax oil prices down before the vote; Biden released 15mn barrels from the US strategic reserve just ahead of the midterm elections last year to pull prices at the pumps down before the vote. The reserve inventories shrank from 594mn barrels at the end of 2021 to just 372mn barrels by the end of last year, where they have remained. Prices are now surging again due to the ongoing conflict in the Middle East.

Adhering to the $60 per barrel limit appears increasingly challenging. The discrepancy between the ceiling and actual oil prices provides an incentive for buyers and shippers of Russian oil to get creative in finding ways to circumvent these restrictions.

During much of last year, even as the price climbed over $60, shippers found dodges that kept them within the letter of the law. The $60 price refers to the FOB (free on board) price of oil. Russian shippers signed contracts at this price but the added surcharges like transport and insurance legally add as much as $17 to the price of a barrel without breaking sanctions.

However, now that the difference between the $60 cap and the current price has grown much larger, these sorts of dodges work less well, pushing shipping companies to find more elaborate workarounds.

In September, Russia's oil export revenues saw a significant increase, reaching $18.8bn driven by soaring oil prices. The Urals oil blend exceeded the $60 ceiling as early as July and surged past the $83 mark in September. Consequently the discount of Urals to Brent, which once reached $40, has narrowed to approximately $10.

The problem with the oil ceiling is that it remains a fixed value unconnected to the current market dynamics, making it vulnerable to manipulation when oil prices significantly exceed $80 per barrel. Experts contend that the current environment, marked by heightened oil prices due to geopolitical tensions, renders the effective enforcement of the ceiling increasingly improbable.

The West is left very reluctant to impose widespread sanctions on violators as if these are effective that will only drive up oil prices and the high cost of oil will boomerang back on the West, increasing inflation and slowing their growth further.

Sanctions still hurt

Even if the sanctions are not having the desired effect, they have still caused Russia a great deal of pain. However, as the market adjusts to the shock of sanctions on Russia that pain is starting to fade.

Russia’s oil production increased by 10,000 bpd on the month to 9.48mn bpd in September, the International Energy Agency (IEA) said in a report on October 12. Output of oil and condensate increased by 40,000 bpd on the month to 10.81mn bpd mainly because of higher production of oil condensate, the agency said. Oil production by OPEC+ increased by 450,000 bpd to 36.38mn bpd in the period, down by 540,000 bpd as compared with the maximum output allowed by the oil agreement. 

Oil production remains down from its pre-war levels, but by nowhere as much as was hoped. 

In September production was down to 9.4mn bpd, off from the peak production pre-war of some 11mn bpd. After the war started a report from Yale predicted oil production would fall to as little as 6mn bpd and even the Russian energy ministry said output could fall by 15%. None of that happened.

Energy sanctions, in particular the EU embargo, weighed on Russian exports via sharply wider discounts. However, the Urals-Brent spread has narrowed from $40/barrel in January to below $14/barrel in September. At current export volumes, a $10/barrel change in the crude oil price means ~$18bn in earnings per year.

1023 Russia OOTT shrinking discounts threaten key mechanism of energy sanctions

“A key challenge for the price cap coalition going forward is that the regime’s leverage appears to be declining quickly. Russia’s reliance on G7/EU services, especially P&I insurance, for seaborne crude oil exports fell to 35% in August. Important regional differences are emerging, with Baltic and Black sea exports more reliant than Pacific Ocean ones,” KSE said in its October chartbook that tracks Russia’s oil business.

Prior to the sanctions 95% of shipping insurance was done by EU institutions, which gave the G7 the confidence that it could enforce the oil price cap. However, after Russia rapidly put together a shadow fleet of tankers to carry its oil, which are insured by Russian companies, that has blown a large hole in the enforcement mechanism.

1023 Russia OOTT composition of seaborne crude oil exports by insurer KSE

In September, Russian oil export earnings reached $18.8bn, the highest reading since July of last year that puts Moscow on track for a high current account surplus this year if this continues.

At the same time, the weaker ruble is supporting budget revenues from oil extraction taxes and export duties, as a weak ruble generates more from dollar-denominated oil tax revenues, making it easier to fund the budget.

Russian Finance Minister Anton Siluanov revised his estimate for the federal budget deficit on October 17, saying he now expects it to come in under 1% of GDP, down from the earlier forecast of 2% of GDP. Following the disastrous defect results in January many analysts were forecasting that the deficit will be 3-4% of GDP or even higher.

“Ukraine’s allies urgently need to consider lower price caps, better enforcement to step-up pressure on Russia,” KSE warned.

1023 Russia OOTT federal budget oil revenues, in ruble billion KSE 

​Russian oil exports bounced back in September – by 200,000 bpd for crude oil and 200,000 bpd for oil products. Shipments to China increased by 300,000 bpd, while those to India and Turkey declined by 100,000 bpd each. The three countries together accounted for roughly two-thirds of Russia’s total exports in January-September.

“Higher global prices and smaller discounts on Russian exports have led to significant upward revisions of oil prices. Importantly, our projection still assumes a moderate widening of discounts due to improved price cap enforcement. Nonetheless, export earnings from oil are forecast to come in $24bn higher this year than previously expected,” says KSE.

In KSE’s updated forecast, oil and gas exports will reach $223bn in 2023, $211bn in 2024, and $196bn in 2025. Considering the the third quarter outturn of current account components, KSE projects an overall surplus of $59bn for this year.