Why a cap on Russian oil prices won’t work

A cap will change little in the balance of power between Russia and the West

EU leaders are scrambling to reach a deal on a price cap for Russian oil imports before a full ban on purchases of Russian crude takes effect on December 5.

Despite agreeing on the measure, initially proposed by the G-7, member states have failed to agree on a price at which to cap purchases, with some insisting on a lower cap to ensure Russia has fewer funds to support its war in Ukraine and others arguing for a higher cap to deter Moscow from slashing production, which could send global prices soaring.

The Kremlin still depends on oil revenue to support its public spending, so a cap could force it to capitulate on Ukraine. But while Europe figures out the nuts and bolts, Russia has been making plans of its own to reduce its reliance on energy profits and Western markets.

Importance of Oil

The energy sector, especially oil, is critical for the Russian budget. Extraction and export of oil and natural gas constitute a substantial portion of the budget – nearly 43%, not counting the profits of large energy companies and taxes from related industries.

Struggling under sanctions pressure and still recovering from the COVID-19 pandemic, the Russian economy is in dire need of stimulus through large cash injections from the state.

For years, the Kremlin’s ability to provide such stimulus came not only from tax revenue but also from revenue derived from extracting and exporting oil. But if these funds shrink – say, because of an EU-imposed price cap – there will be questions over Russia’s ability to provide economic relief while also continuing to support its military operations in Ukraine.

In the near future, the budget will likely increasingly slip into deficit. Non-oil income is also experiencing a downward trend because of tougher sanctions and the economic slowdown.

But Moscow’s biggest concern is clearly energy revenue, which began to decrease in the summer as oil and gas production and exports fell. It’s easy to see, then, why Western governments chose the oil sector as one of the main targets of their sanctions campaign.

The idea behind a price cap is to block shipping, insurance and reinsurance companies – most of which are based in G7 countries – from handling Russian oil shipments worldwide, unless that oil is priced lower than the ceiling set by G-7 countries and their allies. But that’s easier said than done.

EU Participation

Because Europe was the most important market for Russian energy exports, the EU’s participation will be key to making the cap scheme work.

According to the International Energy Agency, Russia exported an estimated 4.7 million barrel of oil per day in 2021, of which 2.4 million went to Europe.

China is the largest single importer of Russian crude, importing 1.6 million bpd.

Russia supplies roughly 20% of Europe’s refinery crude throughput – a relatively low%age for the entire bloc, but some European economies are more dependent on Russian oil or on crude in general than others.

This is why EU negotiators ended talks on a cap on Nov. 28 without an agreement. Some member states want to cap prices above $65, while others – like Poland and the Baltic states – want to cap them at $30, arguing that a lower price

would be more likely to force Russia to make concessions on Ukraine.

Unlike natural gas prices, which have been rising in recent months as the winter approaches, global oil prices have been falling and are now in the $80-$85 per barrel range.

Urals oil – Russia’s main export blend – is discounted by about $20-$25 per barrel because of reduced demand for Russian exports. Poland and the Baltic states consider the European Commission’s proposed cap at between $65 and $70 too generous – this is, after all, the price that the Urals has been trading at over the past few weeks.

The proposal is favored by EU states with large shipping industries, such as Greece and Cyprus, that want to make sure there will still be oil to ship. Moreover, it’s a price that some EU members and the G-7 – including the United States – have already agreed to. It’s unclear what will happen if the bloc sets another price, but if a deal isn’t reached by next week, member states will have to suspend Russian oil imports altogether on December 5, as they agreed to do in May, and block imports of Russian petroleum products on February 5.

Poland and other member states also reportedly want to discuss a review mechanism for the price cap – which would help ensure that the price remains close to Russia’s marginal cost of production as it shifts over time. It’s a way to help guarantee that the cap deprives Moscow of its ability to finance its war in Ukraine and incentivizes the Kremlin to continue pumping crude.

The bloc doesn’t want Moscow to shut down production completely, since that could drive up global oil prices and damage European economies.

This strategy assumes that the Kremlin will want to continue to sell its oil to European markets even after a cap is imposed. It also assumes Moscow wants to maintain good relations with some EU members so it can have some influence over decision-making. While this may be the case, Moscow may also have another strategy in mind.

Russia’s Counter

Moscow has been preparing for tougher sanctions for a while. Its first task was to find ways to become less dependent on oil and gas revenue. Its second was to reconsider how it spends its financial resources to make its expenditures more effective and less rigid, especially as it prepared for its invasion of Ukraine and the financial consequences that would ensue.

The Kremlin thus introduced some changes that will lessen the pain of a price cap. The most important change was to its rules on how to use excess oil and gas revenue.

According to a mechanism adopted in 2018, revenue earned from oil sales above a certain price is used to purchase foreign currency to replenish the National Welfare Fund. The base price for Urals oil in the 2018 budget was set at $40 per barrel, with an annual indexation of 2%.

The 2022 price was set at $44.20 per barrel, lower than the market price. Only after contributing 7% of gross domestic product to the NWF could the government spend some of its reserves, constraining its ability to support other industries and stimulate the economy. But it was also a fairly successful strategy, one that allowed Moscow to accumulate substantial reserves without compelling it to spend them in a certain way.

After its invasion of Ukraine began, Russia announced a temporary suspension of the rule. And in November, President Vladimir Putin signed into law an amendment to the budget code, which assumed 8 trillion rubles in oil and gas revenue from 2023 to 2025.

It also anticipated a budget deficit of 2% of GDP in 2023 and of 1.4% in 2024 due to increased spending. The amendment thus allows for 2.9 trillion rubles in spending from the NWF in 2023 and 1.6 trillion rubles in 2024.

The oil and gas industry will likely incur much of the cost of this spending. According to the amendment, the profit tax rate for exporters of liquefied natural gas will increase to up to 34%, and the mineral extraction tax on oil and coal mining companies will also increase. It’s likely that taxes on non-oil sectors will also slowly rise.

Last week, Putin signed a law introducing a 7% excise tax on sugar-containing drinks beginning next July. The Kremlin is shifting the economic burden to the population – albeit slowly to avoid provoking widespread anger.

What’s more, the European Commission’s proposed cap at $65-$70 isn’t too far off from the Kremlin’s own budget projections for the year.

If it expects to earn 8 trillion rubles in oil revenue, it would need to produce 9 million to 10 million bpd (roughly its output now) in order to sell its oil at $60-$75 per barrel. So even if a cap is introduced, it can continue to sell its oil to European customers without making major adjustments to its budget.

The Kremlin’s strategy will only help mitigate the effects of a cap; it won’t replace oil revenue completely. But it also buys Moscow some time – which could mean that it won’t be in any rush to negotiate an end to the Ukraine war.

It has enough resources to resist Western pressure tactics, and EU member states seem to be considering a cap that’s mostly in line with its own expectations for fuel prices. Simply put, it will change little in the balance of power between Russia and the West.