Commentary on Political Economy

Wednesday, 11 January 2023


Crude reality: Oil sanctions on Russia are having a big effect

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Russia’s oil is now trading at less than half the international price. The West’s price cap and supporting sanctions, introduced only a month ago, appear to be biting.

Over the past few days, Russia’s flagship product, Urals crude, has traded around $US37.80 ($54.80) a barrel even as the international benchmark, Brent crude, has been trading at just under $US80 a barrel. That’s a 53 per cent discount.

Before the G7 economies and Australia imposed the $US60-a-barrel cap on the price of Russian oil on December 5, Urals grade oil was trading at a 30 to 35 per cent discount to Brent crude. Before Russia invaded Ukraine, the discount was only about 6 per cent.

Russia’s oil price is feeling the sting of sanctions over its invasion of Ukraine.

Russia’s oil price is feeling the sting of sanctions over its invasion of Ukraine. CREDIT:AP

With Western financial and non-financial sanctions and the withdrawal of Western companies and their capital and technologies impacting its industry, Russia’s oil revenues were its lifeline last year.

The average price it received of about $US76 a barrel offset a 122 million-barrel reduction in oil sales since the invasion as the United States, Europe and others stopped buying its oil. It redirected its sales to China, India and Turkey, albeit at discounted prices and with higher transport costs because of the distance to those markets relative to the former sales into Europe.

Now those sales are at or below Russia’s production costs, generally thought to between $US30 and $US40 a barrel. Freight costs for Russian oil, below $US3 a barrel before the invasion, are now three or four times that amount.

Russia has said it would monitor the oil market this quarter before deciding how to respond to the price cap.

It would appear that the diminished pool of remaining buyers are exploiting the leverage provided by their status and the G7 sanctions to drive hard bargains, in the knowledge that Russia is dependent on its oil income to finance the war in Ukraine.

Even with the solid oil and gas revenues it generated last year, Russia incurred a budget deficit of $US56 billion last month, wiping out a surplus for the first 11 months of the year and producing its worst budget outcome since the initial impact of the pandemic. It’s only the second deficit Russia has experienced in the post-Soviet era.

While it is budgeting for a 2 per cent surplus this year – based on a forecast of $US70 a barrel for its oil — that would be eliminated if its oil continued to fetch current prices.

The G7 sanctions are backed by the withdrawal of insurance and financing from tankers carrying oil sold above the $US60-a-barrel cap. When they were implemented last month, Russia said it would refuse to sell its oil to anyone who observed the cap, or even referenced it in their shipping documentation.

Given the paucity of buyers and, it would appear, the paucity of ship owners willing to transport Russian crude even within the cap, for fear that they might get caught up in the sanctions, that’s not much of a threat.

More potent would be the potential, which Russian energy officials have floated, for Russia to cut its production.

There have been suggestions by those officials that it could remove 500,000 to 700,00 barrels a day from the global market, which would conventionally have a very material impact on international prices. It has also mooted putting a floor price on its exports.

How effective responses like those would be is difficult to assess, given the uncertainties surrounding the outlook for the global economy.

If China is able to negotiate its current wave of COVID-19 infections and reopen its economy successfully, that would help demand for Russian oil. With the World Bank cutting its forecast for global growth this year from 2.9 per cent to 1.7 per cent, however, the global economic outlook is grim, with flow-on consequences for demand for oil and oil prices.

Gas prices in Europe, which soared in the aftermath of the invasion, are now back to pre-invasion levels,

Russia has said it would monitor the oil market this quarter before deciding how to respond to the price cap.

It is conceivable that it might seek to enlist the support of the OPEC+ cartel (of which it is a member) to try to increase the impact of any production cuts of its own.

It has said any measures it takes would be in line with market-based principles, which presumably means responding to weak demand by withdrawing supply.

There had been those within the G7 discussions who argued for a much lower cap than the $US60 a barrel settled on, and the level of the cap will be reviewed regularly.

At this early stage, however, it would appear that the combination of the chilling effect of the sanctions – ship owners will be fearful of transporting oil without insurance and the UK, US and Europeans have a stranglehold on that market – and the weakening global economy and oil prices have made any discussion about lowering the cap irrelevant.

The new sanctions on Russian oil were brought in last month.

The new sanctions on Russian oil were brought in last month. CREDIT:ANDREY RUDAKOV

Russia’s other big energy export, gas, also isn’t faring well. Between Russia throttling supply and the Europeans (who were reliant on Russia gas before the invasion) slashing their purchases, those revenues have also been severely reduced.

An unusually mild winter so far, gas storage at almost full capacity and a desperate scramble by the Europeans to secure LNG, virtually regardless of price, has — with measures to reduce consumption — blunted the political and economic threats posed to Europe by its willingness to continue supporting Ukraine and its former reliance on Russian gas.

Gas prices in Europe, which soared in the aftermath of the invasion, are now back to pre-invasion levels, and the Europeans are expressing confidence that, not only will they get through this northern winter without an energy crisis-inspired meltdown of their economies but they will be in a good starting position for winter 2024.

That would undercut Russia’s leverage and its hope that energy shortages and the social and political pressures they might generate would undermine Europe’s military and financial support for Ukraine.

The myriad sanctions the West imposed on Russia last year were always going to take quite some time to have material impacts, given their nature and the progressive way they were rolled out and the fact that Russia started the war with very strong financial foundations. The effects were always going to be attritional rather than immediate.

Russia got through last year, with the help of strong oil prices and revenues, in relatively good shape even though the effects of the West’s measures began to show up late in the year. This year might be rather more challenging.

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