In response, dramatic countermeasures are being undertaken everywhere, with quantitative tightening in the US, an unprecedented 75 basis points hike by the European Central Bank, and now a Group of Seven (G7) plan to impose a “price cap" on oil from Russia. The proposed price cap joins the freezing of Russian central bank reserves and the denial of Swift access to Russian banks as new and controversial weapons in the global economic warfare arsenal.
A bit of background before we unpack the price cap. Russia is the second largest producer of crude oil in the world, producing a little bit less than the US and a little bit more than Saudi Arabia each day. It produces over 11% of the global total demand of approximately 100 million barrels per day. After the war in Ukraine started, Russia has been exporting about 7 million barrels per day, retaining about a quarter of its daily production for domestic use. Russian export revenue from oil currently averages about $20 billion per month. Russia’s nominal gross domestic product (GDP) for 2021 was $1.71 trillion, and oil and gas exports made up 60% of its export basket. Germany, Turkey and Belarus are the main export destinations for Russian gas over pipelines. The 1,200-kilometre Nord Stream 1 pipeline runs under the Baltic Sea from Vyborg in Russia to Lubmin in Germany. In response to Moscow’s actions, Germany has said that it will not certify the Nord Stream 2 pipeline that runs roughly parallel to the first one. Prior to the war, Russian gas exports to the EU and UK had declined from about 16 billion cubic foot per day (bcf/d) in 2019 to about 11 bcf/d in 2021. Gas and oil supply from Russia to Europe and the UK has declined in a range from 50% (Germany) to 100% (UK). Russia is offering its excess oil to countries like India, China and Turkey. For the gas, there are few takers, except for Turkey, Belarus and Kazakhstan.
At a time when the EU is attempting to wean itself away from Russian oil and gas, there is an effort led by the US to impose a price cap. The rationale offered for this is to “defund Russia’s war effort", since much of Russia’s surplus comes from oil and gas exports. Technically, this is a not a global cap on Russian oil prices, it is limited to the G7 nations. In economics speak, this attempt at a buyer’s cartel represents a case of ‘oligopsony’. The US claims that the imposition of this price cap by the G7 will benefit all other countries, particularly India and China.
The price cap in reality is what economists call a ‘price collar’. The lower limit of the price is designed to be high enough over the marginal cost of production to incentivize Russia to produce the commodity, and the upper limit is designed to limit “profiteering from a war premium".
The mechanism to enforce this price cap is through insurance companies. Insurers that insure Russian seaborne oil are largely Western and account for about 85% of total trade. They will be expected to only allow oil to be ferried by Very Large Crude Carriers (VLCCs) if the contracted price is below a certain (constantly adjusting) threshold. The G7 price collar proposals appear to replace a complete ban on insuring Russian oil shipments that was due to come into force in early December as part of the EU’s sixth sanctions package.
While Western insurers in the shipping industry are indeed a choke-point even for supply to China and India, the G7 plan has too many moving parts to succeed. To mix metaphors, the prospect of leakage is very high. Economics literature is rich with lore of failed price caps.
Price caps trigger market mechanisms that seek to circumvent them and also give rise to a grey market. In this case, there are many actors in a global web with incentives that add political, military and strategic goals to economic rationality. Hence, the price collar has a low probability of success.
Russia has already set up alternate insurance arrangements for shipping oil, and India and China may consider these sufficient (though intermediary ports may still pose a problem). Seizing an opportunity, some countries like Malaysia have been exporting more oil to China than they make, allowing for intermediary shipments from Venezuela, Iran and Russia. Other cash strapped countries like Sri Lanka may consider following suit.
India is unlikely to be in a hurry to make a decision on joining the price cap coalition. India’s classic ‘wait and see’ approach is of great value here. If the G7 price cap fails, as is quite likely, then India can continue to be a trusted partner to Russia for discounted oil. If the cap somehow succeeds, then India can use its success as further leverage in its discussions with Russia.
The world cannot cut off Russian oil supply completely. According to some estimates, if Russian oil supply of 6-8 million barrels per day is taken off the global market, oil prices would soar to $380 per barrel. Since hydrocarbons remain a major source of energy, any oil price above $200 would create political upheavals almost everywhere in the world.
P.S. “It takes something more than intelligence to act intelligently," said Fyodor Dostoyevsky, author of Crime and Punishment.
Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand
