What progress? A critical review of the price cap in an above-cap market era
The meaning of $60 and its mechanical flaws
Introduction
On December 5th, 2022, the Price Cap Coalition (Coalition), made up of the Group of Seven (G7) countries, the European Union and Australia, put into force a $60 per barrel price cap on Russian crude oil. The cap enables traders and producers to access shipping and other Western services that support the circulation of Russian crude oil to third-party countries only if that crude oil is purchased at or below the price cap. The goal was to ensure uninterrupted and cheap access to Russian oil for consumers that stand no chance of competing with wealthier nations on global markets, while minimizing Russian export revenues. Evidence might support that the latter has been successful when it shows a faltering of Russia’s economy. Russia’s central bank reported a drop in 28 per cent of total export goods from 2022Q4 to 2023Q1, with 40 per cent of that drop caused by a decline in oil exports. Evidence also might support the former. Russian oil continues to flow to Asia at affordable prices and has begun to flood African markets as well.
Policymakers have applauded the results. The US Treasury Department, in its price cap “Progress Report”, gave the mechanism stellar reviews. But now, with Russian crude trading above $60, the cap’s effectiveness must be reevaluated. As we will see, confounding factors may have had better explanatory power for the way Russia’s economy has tilted during the price cap’s lifespan. This reality necessitates revisiting the price cap and assessing what the selected $60 per barrel price cap really means, and if there are alternative ways to meet Coalition goals in an above-cap market era.
Assessing causal priority
There are five main reason to believe that the price cap by itself can’t explain the decline in Russian revenues from oil exports, let alone the larger Russian economy. First, embargoes on Russian oil from European countries automatically cut out much of Russia’s most profitable consumer base, forcing Russia to sell to other customers at discounted rates.
Second, global prices have slumped relative to post-invasion prices, causing a natural deficit in revenues. S&P Global Commodity Insights estimated Russia’s fiscal breakeven oil price at a Brent $114 per barrel in 2023, up from $64.47 before Russia invaded Ukraine. This is wildly unattainable given the Urals/Brent discount widening following the invasion, which has kept Russian prices down anywhere from $20 - $40 per barrel below the global benchmark.
Third, there have been both known and unknown violations of the price cap around the world. Russian crude exported out of the port of Kozmino on Russia’s Pacific coast has consistently been priced and sold above the price cap. It was found that 96 per cent of shipments for which data is available from this side of Russia were transacted above the price cap at an average price of $70 per barrel. Fifty percent of these shipments received Western services forbidden by the price cap, a blatant violation of the Coalition agreement and the likely result of falsified documentation. Fudged papers and contract adjustments, wherein the physical price was redistributed to service-based line items to bring the physical price below $60 per barrel, may also constitute price cap violations. For instance, if the point of sale is $65 per barrel, counterparties may drop the physical price below $60, making up for the decrease in price with an increase somewhere else in the agreement.
Fourth, the well documented ‘dark’ or ‘shadow’ fleet has taken many barrels out of the public view. Much of the volume afloat is simply unaccounted for, meaning price negotiations are done privately between known or unknown counterparties.
And fifth, the price cap mechanism hasn’t really been tested (until very recently). The decline in oil export revenues for Russia cannot be linked to the price cap because the price of oil did not rise above $60 per barrel, meaning that Western shipping and insurance firms could continue to work with Russian-interest market players.
Eras tour
But that was in the below-cap era on oil’s world Eras Tour. The above-cap era began on July 12th, when Urals began trading above $60 per barrel. This jump came alongside bullish trends in global benchmarks and forecasts of higher demand through the end of the year as well as OPEC+ production cuts. These cuts left gaps in the global heavy crude supply, which Russia has and Asian countries need.
Like any economic sanctions on energy, market conditions are largely to blame forthe alleged ‘effectiveness’ of sanctions. Global demand has until recently been muted and supply has been steady. The relatively low cost of Russian crude accounted for much of the Kremlin’s budgetary issues. Thus, a causal link between the price cap and dents in revenue is difficult to ascertain. Sure, it is possible to argue that the price cap’s power isn’t necessarily in its coerciveness but rather its deterrence. Operators, importers and financiers simply do not want to do business wherein an insurance policy can be suddenly voided if the price cap were triggered.
But what we have seen is that the shady business built up around illicit trade isn’t too concerned with a $60 breach: market players either knowingly violate the cap or entrench themselves in the dark fleet market.
They also might secure insurance and other business necessities from alternative sources. For instance, India’s Gatik received safety certification from an Indian agency and reflagging in unconventional registries such as that in landlocked Mongolia. Japan has said it is willing to provide coverage for claims under $10 million, while Russia itself has guaranteed $9 billion for reinsurance. China is set on building up its domestic P&I coverage, too. Ultimately, plunging into an underfunded insurance pool may be a risk that Russian-interest market players take.
Let’s get something done for real, no cap
With Urals trading above the price cap, the Coalition must do something about the mechanism. Analysts have worried that the Biden administration’s fixation with the price cap’s apparent ‘victory’ is distracting POTUS from exploring other options. Leading commentators have argued for better enforcement. But the Coalition seems insouciant. While the White House adopts “soft” enforcement measures, the European Union has no plans to revise the cap at all.
What revisions could even be made? Increasing the cap would be hugely unpopular. Lowering the cap would be pointless. While quicksilver energy markets regularly undulate around certain dollar-value bounds, Coalition responses aren’t as swift. Who knows? By the time the U.S. Treasury calculates the monthly average of prices to determine its Urals price, the Russian flagship grade could slip below the cap and enforcement could become complicated, although this probably won’t be the case now. This requires a critical review of the price cap’s mechanics.
My argument stems in part from this price assessment issue. The greatest downfall of the cap stems from its inflexibility to react to exogenous market forces. Perhaps the Coalition never predicted Urals would hit $60 and perhaps that is why many have argued that the cap was set too high. That aside, it is obvious that the cap has had mechanical flaws since its inception and therefore requires restructuring in today’s above-cap market era.
The meaning of 60
While $60 is a nice, round, political figure, the way it is determined is most likely unsubstantiated, rendering it epistemologically insufficient. Let’s begin with the Coalition agreement itself. As far as I know, the agreement makes no mention of a price assessment that it will reference to enforce the cap. Is it a futures price or a physical price? If it’s the former, then the price would be inauthentic because Urals no longer trades on Western exchanges, forcing leading PRAs such as Argus and Platts to rely on physical values gleaned from conversations with market contacts, many of whom may rely on inaccurate sources. This has resulted in the price of Urals’ being more notional than exact, creating uncertainty for policymakers and private sector participants that need to determine exactly when the price cap should be enforced.
These assessments may even show discrepancies between Urals’ Baltic versus Black Sea routes, which the Coalition also does not specify. On any given day, these prices may differ by as much as two dollars. On July 14th for example, Argus assessed that Urals originating from Primorsk priced under the cap while Urals from the Black Sea priced above the cap:
While this detail may seem minor, it illustrates the lack of concrete guidance and reference point from the Coalition. Put together, inaccurate information and incongruent price assessments make it difficult for Western providers and insurers to determine if the cargoes they are servicing are kosher or not.
The cap’s lack of dynamism also fails to insulate it from exogenous factors that make Russia’s crude more valuable. Who could have predicted that an impasse between Turkey and Iraq would cut out 450,000 barrels per day of sour Kurdish crude flowing through Ceyhan, creating more demand for Russian Urals? It is events like this that reveals the cap’s flaws. The wide Urals/Brent discount can no longer be taken for granted. A more dynamic cap is needed to account for market signals outside of Russia.
A better approach
The price cap has produced good results only ostensibly. Communicating a $60 per barrel price cap is politically convenient: most people can grasp what it means without having to understand just how labyrinthine the global oil market is. But $60 is just a number and the state of affairs no longer supports that the price cap is a viable tool.
Perhaps a better strategy would be to flip the equation on its head and ask not how high the price cap should be set to inflict pain on the Russian economy, but at what price does Russia need to sell its oil to maintain a balanced budget. Reuters recently made the claim that the breakeven price of Urals is assumed to be $70.1 per barrel. While this is above the price cap, it may better inform how to deprive Russia of what money it needs while keeping oil flowing to poorer countries, delivered by market players that have no incentive to take big risks and operate without Western insurance and services. Instead of relying on one number that pays no attention to what’s happening in the crude grade markets that compete with Urals, the Coalition should adopt a flexible cap that factors in Moscow’s breakeven point and a target Urals/Brent discount. This could be as simple as setting a price cap at a certain fraction of the breakeven point, or as complex as weighing this fraction against a target Urals/Brent discount, such as 40 per cent.
I am no mathematician, but I’m almost certain some economists from Coalition parties could come up with an appropriate equation derived from desired outcomes rather than an arbitrary price point. Of course, an assessment of Urals will still be needed. That is why the Coalition should designate a single (and as unambiguous as possible) methodology to assess Urals for this more dynamic formula. The Coalition should actively publish this methodology so that private market participants in the West and elsewhere know what territory they are operating in on a daily basis.
Did the price cap work until it didn’t? Perhaps Treasury’s next “Progress Report” won’t be so sunny. But what is certain is that something needs to be done. If the ultimate goal is to bring Russia’s economy to its knees then so far the price cap hasn’t worked. Russia’s economy is expected to grow by 1.5 per cent this year. Yet, some others warn of an economic bubble ready to burst. Only time will tell what happens next.
What we want is to keep Russian exports visible under the auspices of Western shipping services and insurance companies. What we don’t want are oil prices to run away well past $60, rendering any hope of worthwhile enforcement a distant pipedream. That would do too much damage to the Coalition’s credibility and force more market players to the dark side. But if oil does spike, we need to be smarter about numbers and present something more nuanced than what meets the eye.