Since the start of the war in Ukraine, Russia has been speeding up its pivot to the East amid Western sanctions. In the meantime, the G7 has been working on a price cap on Russian oil to curtail Moscow’s oil revenues used to fund its war. The cap will also be set at a level to keep Russian oil flowing into the market to avoid an energy security crisis when the EU’s Russia import ban begins in December for crude oil and in February for oil products.
After several months of discussion, the oil price cap plan is finally taking shape. On 6 October 2022, the European Union (EU) published its eighth sanctions package with more details on how it will cap the oil price. Specifically, the sanctions prohibit any vessels transporting Russian crude oil priced above the cap from obtaining shipping services (including insurance, financing, brokering, and bunkering) from companies in the EU. On 12 October 2022, the US Treasury Secretary Janet Yellen cited an oil price cap of USD60 per barrel. The assumption of the above mechanism is that Russia’s tanker fleet is too small to transport the massive amount of crude oil it needs to export. It will take a long time for Russia to expand its own tanker fleet, and hence its oil production and revenue could be reduced. Therefore, if Russia refuses to sell at the cap, it will likely be forced to cut production, enforcing long-term costs on its oil fields.
It appears that these measures will undermine the prospect of Russia’s energy sector. However, the price cap is still an untested mechanism with question marks over its efficacy as well as potential implications for Russia–Asia energy cooperation.
Why is it difficult to find the right range for a price cap?
Implementing the G7 price cap in the global commodity market could be extremely challenging. To make a significant impact, the cap cannot be too high. However, if the cap is too low, it could attract more buyers to Russia who are looking for a “discount”. If it is set below the cost of production, Russia would have to disagree with sales at this level. A price cap of USD 60 per barrel, as cited by the US Treasury, is close to the historical average and is around 20% lower than what Russia is selling now. Although the US Treasury argued that this price would be sufficient to reduce Russia’s oil revenue, it appears to be a modest arrangement.
First, the oil price cap is considerably higher than Russia’s cost of oil production, thus allowing Russia to sustain its oil export capability. Second, taking the Russia–Saudi price war in 2020 as a lesson, rich energy resources allow Russia to better weather market volatility; hence, Moscow is willing to sacrifice some of its export revenue to deprive the West of energy supplies. Third, in the coming years, a potential worldwide recession will likely hammer oil prices, making the USD 60 cap not so meaningful.
More importantly, an effective G7 price cap needs the participation of large emerging countries and developing countries, especially from Asia – a key target of Russia’s pivot to the East amid Western sanctions. Without their endorsement, Russia will be able to continue to shift its exports to Asian buyers and partially buffer its revenue lost due to Western sanctions. Moreover, it is also not difficult for potential buyers to sidestep the enforcement efforts of the sanctions and price cap, as they can always rely on non-Western fleets and insurance companies who are willing to handle Russian oil or top up the shipping service fee to offset the need to lower oil prices.
How would Asia respond to the price cap?
The price cap does not appear to be a necessity for Asian buyers like China and India to join, given that they seem to have been buying Russian oil crude unwanted by European buyers with discounts anyway. Although the price cap could still further weaken Russia’s bargaining power in its oil sales to Asia, it is unrealistic to assume that Russia will trade at those price levels. Moreover, by joining the price cap, Asian buyers could risk their commodity trade and relationships with Russia.
Secondary sanctions appear to have its own limitation either, given that China and India have become the new biggest buyers of Russian oil. It would be a tough decision for the US to impose sanctions on Russia, China, and India at the same time. Indeed, the US will likely avoid starting trade wars on multiple fronts, considering the impact on the global market and supply chain. Such a concern will only leave more room for Russia–Asia energy cooperation. Therefore, if a price cap on Russian oil is announced, Asian countries will likely sign their own agreements with Russia and continue to buy Russian oil at their own discounted rate.
Asia scenario: higher bargaining power and higher reliance on cheap Russian fossil fuels
A lower price could help Russian oil increase its share in the global market, driving competition among producers. It could even increase the bargaining power of Asian buyers if the price cap on Russian oil is used as a reference point in trade negotiations with other oil producers. For example, Iran is facing fierce competition from discounted Russian crude and is reportedly cutting its own crude price to defend its market share.
The idea of a price cap is also encouraging the formation of a cartel of buyers who could intervene in the oil market and prices. Therefore, it has raised concerns among OPEC countries that they could be the next target if the price cap succeeds in forcing Russia to follow Western rules. This is also the reason why OPEC producers are unlikely to help by increasing their oil production to help stabilise the market if the price cap triggers retaliation from Russia to shut down its exports to participating countries.
While developing countries will be the major beneficiaries of cheap Russian oil prices, economic benefits and energy security will increase their reliance on Russia. The longer they rely on discounted Russian supply, the harder it will be for them to remove Russia from their supply chain. Closer economic ties could eventually push them further into Russia’s political orbit. Moreover, cheaper oil will also disincentivise them from phasing out fossil fuels, thus hindering the energy transition to cleaner fuels.
In the long run, while the energy war will remain a headache for Europe and Russia, Asia will likely become a major beneficiary in this geopolitical turmoil.