Some thoughts on Russian oil Price Cap and oil markets

At the beginning of December, the oil price cap and the EU bans on transporting Russian oil hit the one year mark. This was rightly “commemorated” with a lot of analysis about the limited effectiveness of the cap and Russian energy sanctions, particularly since mid 2023 when prices rose with OPEC+back in the drivers seat. However much of the anniversary commentary drew on analysis through October, before the recent enforcement shift finally began from the US government.

Since then two other important things have happened. 

• Oil prices have steadily fallen as markets discounted the possibility of the sort of supply disruption in the Middle East that would take a lot more Iranian and GCC oil offline. 
• Demand for fuel has been soft while new supplies, particularly from the Americas have been added over the last year. 

These two trends are linked – and have contributed to explaining why markets either don’t see the OPEC+ cuts as credible or sufficient. With significant spare capacity from the GCC available to potentially offset losses else where, the degree of geopolitical risk premium may have seemed over-stated. 

Meanwhile, given the opacity of certain producer data – Russia notably – has left market actors wary of trusting the planned production cuts and concerned about the economic demand outlook. As others have written, the OPEC+ cuts were announced in a way that made them less than a sum of their parts. In fact they were announced in piecemeal fashion by each country and involved cuts from the 2024 baseline means everyone needs complex tracking systems to do their balances. The willingness of OPEC+ producers to all parrot the “cuts may be extended past March” shows the limits of their mixed forward guidance. Overall this opacity amid the higher rates and macro trends mean market actors will wait to see what is actually delivered. 

This softer price environment means paradoxically a better time for enforcement actions. On the enforcement side, the designation of a handful of tankers in three separate enforcement actions since October  does seem to be raising the risk premium and increasing the discount on Russian oil. OFAC’s request for information for a wider array of companies seems to be adding to this effect. As a result, those involved in tanker tracking seem to suggest that some of the associated European entities that had stayed in the trade are now leaving. The price discounting effect may be greater given that it is coinciding with broader global benchmark price declines. Ask producers of Western Canada Select what happens to their discount when global benchmarks fall. While Russian Urals is far from the less-sought-after heavy crude, the longer and more costly journeys, along with payment friction suggest that it should experience some greater discounting. 

I wrote recently that one risk of the delayed enforcement is that the grey fleet could become more entrenched rather than less. This remains a risk given the compliance costs and lack of clarity on the commitment to enforcement. Whether this scenario comes to pass depends on whether the companion policy of encouraging higher quality insurance is successful. Will the European ports on the Baltic, mandate such insurance for ships transiting their waters but not docking? Will India, the key buyer, which still faces challenges finding a settlement currency for trade, be willing to take on the costs? 

On the fundamental side, there is clearly more oil available and more oil being held on the sidelines. What seems less clear is the demand side. The demand picture has not changed a lot in the last few months or not to the extent consistent with the price decline. The degree of soft landing from the US, sequencing of rate cuts and the recent weakness of China (which is increasingly reliant on external demand) remain important questions. So far global demand looks ok, which means that if OPEC+ sticks to its cuts, the market could again tighten later in the year – unfortunately risking a semi-permanent presence of illicit fuel trade and with OPEC facing a lengthy period of lower production. This in turn will likely increase the amount of domestic investment in OPEC countries.