Russian oil price discount shrinking, sanction dodging widespread

A recent study by the KSE Institute, led by senior economist Benjamin Hilgenstock, found that Russia is successfully avoiding oil sanctions and that the discount it has to offer on its barrels of oil are tightening in comparison with the benchmark Brent blend.

While Russia has found ways to bypass these sanctions, the study also proposes measures to make them more effective.

The study delves into an extensive dataset, both public and confidential, “connecting the dots” between Russia's macroeconomic situation, sanctions and the specific methods Russia employs to evade these restrictions.

One key aspect highlighted in the study is the discount Russia receives on its oil exports compared to global market prices. The price cap on Russian oil, introduced on December 5, led to a gradual reduction in this discount.

“Energy sanctions are a key driver, but there are signs of trouble. International sanctions play an important role here. We estimate that Russia has lost around $100bn in oil export earnings since the start of its full-scale invasion of Ukraine. Furthermore, its failed weaponisation of natural gas flows to Europe has cost around $40bn. With capital outflows likely continuing this year, sharply lower foreign currency inflows have had a sizable effect on the ruble – and significantly restricted the regime’s policy space. However, discounts on Russian oil – the key mechanism through which sanctions worked – have narrowed sharply in recent months,” KSE said in its latest Russian chartbook for September.

At its low point the price of Russia’s Ural’s blend oil fell to circa $35 in April 2022, which represents a $35 discount to Brent. However, since then as Russia successfully worked out alternative routes and found new customers, primarily in Asia, that discount has closed and today is around $8. At the same time, the price of the Urals blend has risen and is currently trading at around $74 – significantly more than the $60 price cap limit.

The price of oil has been pushed up and broke above $90 a barrel this week, following the coordination action of the OPEC+ cartel members to cut production that has created an oil deficit.

The recent extension of output cuts by Saudi Arabia and Russia out to year-end will lock in a substantial market deficit to the end of 4Q23. So far this year, OPEC+ output has fallen by 2mn barrels per day (bpd), with overall losses tempered by sharply higher Iranian flows.

Non-OPEC+ supply rose by 1.9mn bpd to a record 50.5mn bpd by August. World supply in 2023 will rise by 1.5mn bpd, with the US, Iran and Brazil being the top sources of growth.

As a result, Russia’s oil export revenues surged by $1.8bn to $17.1bn in August (chart), as higher prices more than offset lower shipments, according to the latest International Energy Agency (IEA) oil report for August. Led by a decline in product shipments, total Russian oil exports eased by 150,000 bpd in August, to 7.2mn bpd, 570,000 bpd below a year ago. Shipments to China and India slumped to 3.9mn bpd from 4.7mn bpd in April and May but accounted for more than half the total volumes. (chart)

“Russian exports of crude oil and oil products fell 9% in June-August vs. March-May (crude: -5%, products: -16%),” KSE said in its report. “China and India both reduced purchases (by 10% and 21% respectively) as discounts on Russian oil narrowed. Moderate cuts to oil production play a role here, as does the redirection of refinery output to the domestic market.”

While the twin oil sanctions that came into force in December and then for oil products on February 5 hurt the Russian budget, it has since recovered and is now back in profit. (chart)

The deficit breached the RUB2.9 trillion (2% of GDP) full-year target in April, rising to RB3.3 trillion, but since then has fallen back to RUB2.5 (1.8% GDP) inside the 2% target for the full year.

Sanctions busting

To circumvent the sanctions, Russia employs two primary methods. First, it uses outdated tankers owned by Russia, known as its “ghost fleet”, which do not rely on Western insurance and so operate entirely outside the oil price cap sanctions regime. With the size of the fleet at an estimated 400 tankers or more, this fleet is large enough to ship almost all Russia’s crude exports, which used to go to Europe, to Asia, where it can be sold at full prices to partners there that are not participating in the sanctions regime.

Secondly, traders, including ships belonging to EU members, submit false information to authorities, claiming compliance with the price cap when it is not met, a practice referred to as “attestation fraud.”

Both methods are in use, says Hilgenstock, with slightly over half of Russia's oil being shipped using the shadow fleet. “Attestation fraud is widespread, as there is minimal enforcement, no requirement for original contracts or evidence, and inadequate penalties for violations,” says Hilgenstock.

Widespread sanctions busting amongst EU-owned shippers was also found by a similar study conducted by Peterson Institute for International Economics (PIIE). The problem on the Pacific coast is especially bad where ships don’t have to pass through EU-controlled waters.

“While the EU embargo has been effective, the success of the price cap appears to have been limited at best,” PIIE says “The price cap was intended as an innovative step to reduce Russia’s revenues while keeping its oil flowing to the global market… Many energy experts were sceptical about the price cap regime’s effectiveness when it was announced, citing the potential for circumvention. But the problems appear to be more fundamental.”

“G7/EU companies remain involved to a significant degree [in Pacific deliveries], indicating that the cap is not enforced properly,” PIIE said. “Because of these defects, financial sector sanctions should be adopted to strengthen oil price cap implementation and curb Russia’s ability to accumulate assets abroad.”

To make the sanctions more effective, the study suggests requiring proper insurance on all ships passing through European or Western waters. This would compel Russia to use Western insurance infrastructure for all shipments through the Baltic Sea. Additionally, investigating attestation fraud and imposing penalties for violations could enhance enforcement.

Furthermore, the study proposes lowering the price cap to approximately $30 per barrel, which would still incentivise Russia to produce oil as it remains above their production costs.

Without stronger enforcement and adjustments to the sanctions, Russia is anticipated to gain an additional $17bn this year and $33bn next year, according to the study. Taking action to prevent this influx of funds is crucial, as it would help avoid supporting actions that could prolong the conflict in Ukraine.

Read the full report via the link below: