Russian Oil Price Caps Mostly Symbolic

EU members agreed to a $60 per barrel price cap on seaborne Russian oil last Friday, following through on a US-led aim to limit, if not sever, financing sources for Moscow’s brutal war in Ukraine—without destabilizing global oil markets. The EU, G7 and Australia implemented it Monday, although there is a 45-day transition period before it is enforced. Coverage suggests this “watershed” moment ushers in an “unpredictable new phase” for oil markets, with Turkey’s premature enforcement efforts getting wide attention as alleged evidence.^[i] But in our view, there are few surprises here. The cap has been under public discussion for months. Furthermore, it was set above discounted levels Russia reportedly sells oil at now—mainly to Chinese and Indian buyers, who aren’t even party to the agreement. Hence, we don’t see this changing much for markets.

Western governments first proposed a price cap this summer. But only now, after hemming and hawing for weeks, has the EU been able to settle on a $60 ceiling for Russian oil delivered by ship. This filled in a key detail from the G7’s September plan, coming alongside the EU’s embargo on buying Russian crude, which has gradually taken effect this year. In practice, the new price cap bans Western companies from insuring, financing or shipping Russian oil bought above $60. That price level is subject to change and will be reviewed every two months starting in mid-January. Theoretically, it will be adjusted to stay at least -5% below average Russian crude oil prices—as tabulated by the International Energy Agency (IEA), not necessarily actual transactions, which are harder to track—if all 27 EU member countries and the G7 agree unanimously. Upon any change, there would be a 90-day grace period for ships at sea to comply.

Also note what the price cap doesn’t cover: Russian natural gas, which Europe is more dependent on (though it is growing less so). While a gas price cap is being discussed, talks have been contentious. EU meetings scheduled for December 13 could yield a breakthrough on this front, but energy ministers are reportedly far apart.

Besides leaving Russian gas arrangements untouched, the price cap has some other pretty big holes off the bat. Russian crude prices—as measured by its Urals blend—are estimated to be around $49 – $53.50 per barrel.^[ii] That is quite obviously below the $60 cap, supporting the widespread view that this measure was only ever intended to be symbolic. Will January’s review see this differently, i.e. putting the IEA’s baseline closer to actual prices buyers are paying? Can Western parties even pull off unanimous agreement on a lower ceiling?

The seeming incoherence of a price cap above Russia’s current discount market prices and the complex mechanism to lower the cap highlights the tension during its negotiation between sapping Russian coffers and ensuring enough supply to meet global oil demand. While the price cap could sink below market levels, squeezing Russia’s oil revenues—and oil flows to the world—the unanimity required suggests this would be a tall order. For now, it appears the policy goal of preserving adequate global oil supplies—and preventing price spikes—has the upper hand.

To that end, for global oil markets, Russian supply continues flowing to big consumers China and India. According to recent reports, Russia shipped around 2.7 million barrels per day (bpd) of its oil products in November, just under February’s pre-sanction 2.9 million level.^[iii] As Europe has stepped back, other buyers have stepped in. We don’t see the price cap and embargo changing that. While Western firms dominate trade finance and insurance, throttling Russian oil transport through the developed world, non-Western shipping and maritime services companies have filled the void to direct flows to China and India. Middle Eastern and Asian firms, for example, are buying up old Greek and Norwegian tankers—at record prices—to take advantage of sky-high charter rates in this trade.

This is what matters for oil prices and Energy stocks: global supply and demand. Exhibit 1 shows supply was just above demand in November. Maybe demand exceeds supply in coming months—maybe not. This of course depends partly on what OPEC+ (which includes Saudi Arabia and Russia, the world’s second and third largest oil producers, respectively) decides. On Sunday, it left its production quotas unchanged, after cutting them by 2 million bpd on October 5. However, OPEC+ wasn’t meeting its daily quotas—by about 2 million barrels—so the decision just brought it closer to what it was already producing.

Exhibit 1: Global Oil Supply and Demand in Balance

Source: FactSet, as of 12/7/2022. Monthly global oil supply and demand, January 2015 – November 2022.

Meanwhile, oil prices have declined -15.5% since October’s quota cut, bringing the decline since March 8’s peak to -40.2%, as world-number-one producer America has cranked up output.^[iv] In the wake of Russia’s Ukraine invasion, many feared the West’s sanctions might remove Russian oil from markets altogether, but that has proven unfounded—global supply has exceeded demand since July. In our view, oil prices ultimately key more off overall production-consumption fundamentals. Marginal moving parts within that—like the price cap and OPEC+ quotas—may affect the bigger picture and are worth paying attention to. But if global oil supply and demand stay roughly in balance going forward as we expect, oil prices probably won’t sway massively in either direction.

From a broader market perspective, we think all the handwringing over the West’s Russian oil price cap shows sentiment continues to underrate reality. Markets are working largely as usual. Although perhaps disappointing from the perspective of hurting Russia’s revenue, global energy supplies and trading have been more resilient at meeting demand than many thought likely at the war’s onset. Trade routes for Russian petroleum products have reshuffled, but their new alignments still contribute to total output. India’s Russian oil imports have jumped to around a quarter of the total from about 2% pre-invasion.^[v] China’s have risen to over a fifth from 16% last year.^[vi] India and China buying leaves more from non-Russian sources for others. For better or worse, that is helping the world avoid much-feared disruption.

The global economy—and Europe—face headwinds this winter, and risks from unintended policy consequences remain. But the likelihood of a catastrophic oil supply shock and ever-escalating oil prices seem increasingly remote to us. We think this will be a better-than-expected outcome bullish for markets.