On, 25 November, EU officials have again failed to reach consensus on the price for Russian oil that would allow an exemption from the EU ban on using its services to transport and sell Russian seaborne crude (aka the G7 price cap). Officials have agreed to resume talks next week, a week out from the 5 December implementation date, and it is still likely (and probable) that they come to some consensus on price, likely at a lower price than the Commission and US proposed $65/70, perhaps closer to the $55-60 that had prevailed until a month or so ago. Moreover, the chance of no agreement by 5 December has clearly risen, justifying a closer look at that scenario. This post looks at the state of play, the possible impacts of a no price cap at least for a few weeks and some broader thoughts on US-EU/G7 burden sharing on a range of global issues.
Bottom line: Overall, the G7 has clearly struggled to meet their target of announcing the cap “well before December 5” as hoped for, this will increase the implementation time, incentives to find other channels and potentially disruption in global oil markets. Most scenarios point towards greater discounts on Russian oil, more shut-in production and rising costs of non-Russian oil in the near-term. Critical uncertainties include the willingness of buyers to experiment with non-G7 service providers, which will vary by country risk tolerance, as well as the decisions of the few OPEC+ countries with spare capacity.
This exemption, commonly known as the g7 price cap, was intended to meet the dual goals of keeping Russian oil flowing but cutting the price that Russia receives to hurt Russia more than the global economy. Getting that balance right has always seemed difficult, particularly given Russian agency in the matter and the interests of countries willing to operate in the grey zone, but had seemed better than the alternatives of either continuing to exempt Russian energy sales from sanctions (and supporting FX earnings) or seeing a massive price spike in the cost of non-Russian oil. That is still likely the case, even if the prevailing higher price might have erred too far towards the keeping oil flowing, suggesting that a slightly lower price might better justify the new paperwork involved and reinforce the benefits of G7 services.
The current dispute seems to have lined up between Eastern European countries like Poland and Lithuania who have been proponents of toughest sanctions on Russia and reportedly wanted a price of around $20/barrel (now $30) and Southern European countries like Greece, Cyprus and Malta who are active in the shipping trade, and wanted a price of $70. Others including Germany seemed supportive of the higher price target ($65-70/barrel) that the US and the Commission settled on, even though that price erred on the side of keeping oil flowing vs cutting revenues. Surprising to many, this price level would be similar to what Urals is trading at, suggesting little incremental benefit or revenue decline. Side agreements including sanctions on Russian pipelines in Europe and other sectors may be part of the negotiation. The Southern shipping countries reportedly already negotiated a concession that would only ban a violating vessel for only 90 days rather than permanently. Beyond the benefit to them, it may also reduce the risk of new vessels being added to Russia’s shadow tanker fleet.
The dividing lines are perhaps not surprising, but it does seem like one of the most significant diplomatic challenge in the allied coalition so far. After all the UK and US (and to a lesser extent EU) had recently rolled out very detailed guidance on the sanctions exemption in recent days and weeks, sending the message the price cap was on the glide path to approval, admittedly not as much before the implementation date as some officials hoped when they announced G7 enforcement in September. Indeed, OFAC even issued a general license allowing Japan to import oil from its Sakalin -2 project without being subject to the price cap, undoubtedly an important negotiation needed to keep Japan’s buy-in. Detailed guidance on the attestation approach, how much manipulation of the oil is needed to comply with the cap, and approved transportation options have all been clarified. As such it seems surprising that the divides over price within the EU weren’t signalled to a greater degree ahead of this given the sheer amount of diplomatic bandwidth expanded on it since June.
What might failure to reach a price exemption look like? The EU embargo on supplying services to Russian seaborne crude would likely go into effect as planned and Russian oil might have more challenges finding buyers. More oil would likely be transported via so-called shadow fleet of tankers not controlled by western players and more oil would use grey market or even black market channels. Some buyers worried about western sanctions (even if the US has signalled a reluctance to use secondary sanctions) would likely eschew these cargos, while even those a little more risk-tolerant might struggle to find alternate channels especially in the short-term. More Russian oil would likely come offline, might pile up in ports in the Middle East and South East Asia and buyers would likely demand even larger discounts commensurate with the risk. Overall, it would become even more difficult to assess the price of Russian oil (not that its easy now). Over time, alternate channels might develop, especially if the Chinese become somewhat more willing to develop their own service channels, perhaps for their own imports. They are likely to be more wary about supplying these services to others such as India and may remain wary of sanctions, limiting the deployment.
The response of other OPEC+ members is key, especially those in the GCC, who are the only ones with spare capacity, albeit not enough to replace major outages from Russia. The rumours of a potential OPEC boost in production earlier in the week seemed specious if framed as a political quid pro quo, but somewhat more realistic as contingency planning for potentially greater Russian outages. A real supply shock is one of the few things that might budge some of these producers who have been very worried about the continued demand shock from China and global slowdown. As I and others have argued, MENA OPEC members don’t want to make it easy for the US/G7 to have oil price setting power, but they also worry about spikes that might undermine demand for their key commodity.
Impacts on G7 leverage? As we have approached the December 5 implementation of the already approved EU embargo, and the proposed price cap, I’ve gotten somewhat more worried about the potential disruption to oil markets (risk of more Russian oil coming off line) and the potential long-term impacts to US/G7 leverage as countries look to reduce their reliance. Both seem even greater if there is no agreement on an exemption. This reflects not only the risk that more Russian oil might fail to find a buyer, thus driving up the price for non-Russian oil on actual or assumed supply reductions, but also the fact that failure to reach a cap might create further incentives to utilize new non-G7 services for the transport of Russian oil. The EU embargo and price cap leverages European dominance of insurance and associated financial services. Already the G7+ attempts to use their channels were likely to boost incentives for EM buyers to test out new channels that reduce reliance on G7 services. While these new pathways including insurance are so far untested, may be less reliable and would expose both providers (say Chinese banks and insurance or new UAE domiciled, Russian-linked energy traders and shipping companies) to new counterparty risk, those risks might be increasingly a bet some are willing to take on the margin given that a sizeable amount of oil might fail to reach the market. This potential loss of leverage is not a good reason to agree to a bad deal, but is a pivot point worth watching as are other factors like use of Western financial channels and the composition of reserves.
EU officials have agreed to meet again on Monday in the hopes to reaching consensus on the price ahead of the planned 5 December implementation date. there is still time to communicate this price but time is running short. As I told the NYT last week “the longer it is before there’s a price released, the greater the risk it is that more oil temporarily comes off line because buyers wait and see” their sanctions risks and price opportunities. That is even more true now, as compliance departments in the companies that need to produce attestations will need time to assess their risks, and buyers outside of G7 countries do the same. Some countries such as South Korea and Taiwan for example are likely to be more cautious, others like India less so, but may still be reliant on service providers. Many countries, including China remain reluctant to directly violate sanctions, but have been operating in the grey zone. Indeed, deployment of alternate service providers would circumvent sanctions but would not necessarily directly violate them. It all suggests more volatility in global oil markets and difficulty assessing Russian revenues as pricing mechanisms become even more opaque. At the same time, we will also see greater reliance on alternate parts of the US campaign to weaken Russia’s military industrial complex.
Western Cohesion showing cracks? Beyond the specifics about the price cap itself, this standoff is talking place amid some broader concerns about coordination about the Western countries that dominate the Russian sanctions coalition. Its not lost on me that this almost-11th hour standoff is happening as there has been an increase in public discontent about burden sharing over the war (see especially politico Europe reporting), but also concern from US allies about its efforts to regenerate the US economy via critical minerals/EV subsidies and other policies aimed to reduce the security risks of Chinese supply chains including the unilateral 7 October export controls on the most cutting edge semi-conductors. They have also criticised the energy cost advantage held by the US, including on natural gas and power. Some of these concerns hold more weight than others, especially given decisions made earlier by Europe that maintained its reliance on Russia and left it more vulnerable. On the energy side too, while US market prices for natural gas are much lower than in Europe, some regions are more exposed to global markets (the North east) versus others who are net beneficiaries, while both US, European and Chinese energy companies and shippers gain from some of the price differential.
Still, some of these frictions will only grow as both the costs of Russia’s war and the reassessment of China’s role in key global supply chains mount.While the new export controls are targeted to the most leading edge chips and manufacturing capabilities, the US faces a challenge getting key allies to match them, even as they also balance the efforts to lure new production to the US in critical industries. Similarly, on the critical minerals/EV issues, the Inflation Reduction Act (IRA) incentives for mining, processing and battery production in the US/North America has triggered accusations of protectionism as it shifts EV incentives from those produced anywhere to rewarding those that reduce reliance on Chinese battery supply chains. The latter is a valid initiative, as is the US wariness about its stimulus leaking out, but it will need to be managed to make sure it does indeed raise the bar on production dynamics. This shift is but the most obvious example of a view that the Biden administration articulated from the start, the desire to allow like-minded nations more space to support their domestic economies and industries in their goal of making democracies work better for their populations. The balancing act of supporting these new critical supply chains, fostering “healthy competition” among allies and like-minded nations to reduce security risks while avoiding the costs of bidding up the price for some new plants will be an ongoing issue.
Overall, the US/EU (and broader G7+) share a goal in supporting Ukraine in the face of continued Russian assault and will likely come to some terms on these issues, but ongoing issues around burden sharing (support of Ukraine versus support of domestic populations, costs of reshaping supply chains in the short and near-term) are only likely to build. These can and will need to be managed both for short-term and longer term, lest competition amongst like-minded nations fail to “meet the moment.”
Ziemba Insights 