Update on the Price Cap: Aiming for Partial Compliance, Underestimating Potential Russian Supply Cuts

This note was originally published Oct 15 2022 as part of my IMF meetings recap.

Oil Price Cap, Russia sanctions and Energy Risks

On the side lines of the meetings, there were many discussions on the next steps in the economic pressure campaign on Russia and assessment of the unprecedented efforts taken so far. Representatives of the  gathering of sanctions coalition met on Friday, emphasizing that some of the most effective measures continue to be export controls on technology. The goal of the sanctions writ-large on Russia continues to be degradation of the military industrial complex and the war effort not policy change per se.

Indeed while the IMF reflected economic consensus in admitting that Russia’s economy didn’t contract as much this year, they expect a similar decline next year, when the impact of current fiscal drag, especially for the private sector, more costly and lower quality imports, weaker fuel and resource exports kicks in. The current mobilization is adding to this disruption as some human capital flees to neighboring countries and as others are called up even if they work for key sectors and overall resource allocation is impaired. This own goal is likely to continue to weigh on Russia’s economy this year and into next year.

The G7 and especially the US remain committed to the oil price cap, despite many lingering questions on implementation and associated potential disruptions as it comes into effect early in December. From the US perspective, the cap remains the key way to mitigate the potential damaging baseline of the planned EU fuel embargo. The OPEC+ debacle and associated US-Saudi critiques have if anything increased the commitment to the price cap rather than reducing it. US officials, especially at Treasury seem most focused on keeping Russian molecules flowing without boosting revenues. Others in the coalition are more focused on cutting Russian revenues. In the last few weeks, more details have become available about the price cap, which aims to provide an exemption to the EU ban on providing services to cargos of Russian fuel as long as the price is right, below a maximum that has yet to be set. In fact the initial price remains a major piece of the puzzle. Numbers ranging from $40-70/barrel being mentioned as potential price targets, with $55-60 being more likely. It remains to be seen if this is really a sweet spot.

US officials are holding to their plan to avoid use of secondary sanctions as a penalty and preferring to focus on the carrot (cheaper fuel) rather than sticks (sanctions, especially on allied-based entities). Many members of Congress see things differently, but realistically its unlikely that a major administration constraining measure is passed in the near-term. Overall, I hold to my view that the administration would see partial compliance as a win or relative success. This would involve big EM buyers getting close to the target price, use of some G7 services and perhaps some alternate services providers (China most likely, but some relocated UAE based services are possible). Key EM buyers countries are unlikely to formally join the cap, but may arrange discounts at close to the price. That might be considered a win. The big uncertainty remains whether Russia would continue to produce at these levels. Given the weaker energy prices due to global slowdown, some of the discounted volumes being negotiated are not far off the price being considered. 

The US believes that unlike gas, Russia needs the oil export revenues. While that’s true, ultimately (oil is a bigger share of the Russian budget), I wouldn’t put it past Russia to cut production in the short-term looking to test out whether the pain is asymmetric in the short-term, especially while buyers and sellers are adjusting to the new rules. Thus the USG may be over estimating Russian export volumes and need for cash (particularly since they are struggling to spend some of what they have).

Another element of this partial compliance goal is evident in how US officials talk about alternate service providers. Rather than insisting that there are no viable alternatives, In his speech in NYC, Wally Adeyemo conceded that countries could use alternate providers, but suggested that they would likely be costlier (perhaps in the short-term), poorer quality and untested. Overall, the net result is likely to be more competition among service providers and eventually lower US/G7 leverage. We may be a long ways from such fragmentation, but the incentive to create them is rising and is likely to add to frictions and costs of operations.

Overall, last week’s OPEC+ meeting and the war of words between the US and Saudi Arabia also hung over many discussions. I’ve written elsewhere about the meeting and how it reflected both OPEC concerns about sluggish global growth, a need to level set for underproducers and likely interest in not making it easy for the US price cap to be implemented, given their concern about disruption and replacement. Since then, there’s been some bachkchanneling about some producers who may have had qualms (most likely targets are those few with spare capacity) and increased and dangerous ire from many US officials elected and appointed. Overall, its probably more noise than policy change, but its dangerous noise which is unhelpful in building resilience. It also contrasts with the carrot rhetoric for importing countries. The US has important decisions to make about how to incentivize countries operating in the grey zone who are important for sanctions implementation and global resilience. threatening the end of ties with another major energy producer while trying to squeeze one of the largest ones and continuing to coerce policy change from two medium-sized ones does not seem wise.

The extreme high gas prices and soft rationing seem to be dampening household demand for natural gas in Germany, which along with storage facilities seem to suggest that Europe might eke its way through the winter at high cost, but perhaps without outages. The market “working” is a costly adjustment tool with many industrial users idled. Moreover, weak demand and diversion to China helped redirect cargos from Asia, something that’s unlikely to be replicated next year. Here’s hoping that the winter that is coming is not too cold. After all, there are a lot of other sources of uncertainty, higher financing costs and negative feedback loops that might not yet be in our baseline scenarios. 

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