Will the Oil Price Cap Work?

The G7 countries – the U.S., U.K., Canada, France, Germany, Italy and Japan – have provisionally agreed to impose a price cap on Russian oil. The cap will apply to crude oil from December 5th and refined products from February 5th.

A major reason why Western sanctions haven’t turned the rouble to “rubble”, as Joe Biden said they would, is that Russia has been earning huge revenues in the oil and gas markets – thanks to elevated prices of those commodities. Western countries want to put a stop to this; hence the oil price cap.

But why a price cap? Why not just threaten sanctions against any country that buys Russian oil? There are two reasons. First, other countries – especially China – wouldn’t stand for this. Second, Western countries don’t actually want Russian oil to leave the market. They want it to keep flowing – just at a lower price.

Why is that? If Russian oil left the market, the price of oil would skyrocket. Since the end of the Second World War, the inflation-adjusted oil price has never exceeded $170 per barrel. But if Russian oil was no longer available, it could reach more than twice that level – bringing the world economy to a standstill.

The logic behind the price cap is that the oil price remains relatively stable, but Russia ceases to earn outsize profits. So how will it work?

Western countries actually do have some leverage over Russia when it comes to oil. Much of the shipping and insurance services that facilitate the distribution of Russian oil is based in Europe (shipping in Greece; insurance in London). The plan is to announce that such services will only be available for shipments where the agreed price is below the price cap.

Suppose the market price is $100, and the price cap is set at $50. India proposes to buy a shipment of oil from Russia. Western shipping and insurance services will only be available if India agrees to pay $50 per barrel or less.

Russia has already warned it won’t sell oil to any country that imposes a price cap. But the West is hoping Russia will be forced to comply. After all, shutting down oil wells is expensive and risks scuppering future production.

Now, Russia did manage to cut production during Covid when demand for oil cratered. But proponents of the price cap say it won’t be so easy this time, as Western oil companies have gone and taken their expertise with them. Sceptics, however, say that Russia knows how to manage its own oil industry.

Successfully cutting production would presumably hurt Russia, but by less than you might think. Remember there’s a quantity effect and a price effect. Russia would be selling less oil, but would be earning more money per barrel.

Another possibility is that major buyers like China and India refuse to go along with the price cap. So far, India’s petroleum minister has said he will “look carefully” at the proposal, while noting he has “moral duty” to Indian consumers – not the West. Meanwhile, China’s Foreign Ministry has called for “dialogue and consultation”, which has been taken as lack of support. (That China would oppose the price cap is hardly surprising.)

So how will Russia’s customers get their oil if Western shipping and insurances services aren’t available? Some people claim that tankers can be rerouted from elsewhere, and that Russian or Asian companies can provide insurance. Others claim there’s no enforcement mechanism. What’s to stop a customer paying the price cap, and then making up the difference with a side payment?

Indeed, if the price cap falls well below the market price – which is the whole point – won’t every buyer in the market want Russian oil? Why pay $100 per barrel for Saudi oil, when you can get Russian oil for $50? Buyers will then bid up side payments until the ‘true’ price of Russian oil is close to the market price.

The best-case scenario for the West is that Russia complies with the price cap and side-payments are small.

What seems more likely, though, is some combination of production cuts and alternative distribution channels – which will hurt both Russia and the West. Russia will earn less revenue, and Westerners will pay more for their oil (at a time when Europeans are paying vastly more for their gas).