Russian Oil Price Cap Could Be Biden’s Biggest Energy Folly Yet

There are two likely consequences of the price cap on Russian oil exports that G7 leaders agreed to in early September – and neither is good for the policy’s architects.

The idea behind the price cap is to expand the reach of sanctions on Russia to third countries, thereby limiting the windfall the Kremlin is receiving from higher oil prices while also lessening the impact on prices in sanctioning countries. But there are flaws in this thinking.

First, big buyers of Russian oil like China and India will likely ignore or evade the cap and keep providing vital funding for Russia’s war machine with their purchases.

Second, the price cap creates a considerable disruption to Russian oil supply that will send global prices skyrocketing, keeping Russian oil income buoyant while punishing the global economy.

At a minimum, a cap injects greater supply risk into oil markets that will ultimately be reflected in oil prices. Although crude is trading at 9-month lows due to concerns about a global recession, consumers shouldn’t get comfortable with current price levels.

The price cap is an example of Western policymakers trying to have their cake and eat it, too, when dealing with Russia.

The G7 believes it has devised a clever way of keeping Russian oil flowing to markets outside the EU, which will ban most imports of Russian crude starting December 5th. Under the arrangement, if Russia sells oil at a G7-mandated price below market rates, it can still use G7 members’ insurance, financing, brokering, and maritime shipping services.

These services dominate the global oil trade. For instance, the London-based International Group of Protection & Indemnity (P&I) Clubs provides marine liability insurance for over 90% of the worldwide oil shipping trade.

The G7 — the United States, UK, Canada, Germany, France, Italy, and Japan — is betting that Russia will be so desperate for dollars that it will submit to selling under the price cap system. And even if consumer countries do not sign on to the price cap, Washington believes the plan will give these nations more leverage to negotiate lower prices for Russian oil, thus dealing a blow to Moscow’s oil revenues.

Ideally, a price cap would facilitate the continued flow of Russian oil, keeping prices lower than they otherwise would be under a full embargo while preventing Moscow from benefiting from price inflation caused by supply restrictions.

The plan sounds good in theory, but in practice, it is fraught with risk.

That’s because policymakers fail to understand the workings and economics of energy markets. The reality is that a price cap can easily be circumvented. Just ask any oil trader.

The G7 member nations have, for the most part, either already imposed embargoes on Russian energy exports or plan to, so the cap’s effects are not aimed at their imports.

The cap targets heavy buyers of Russian oil like China, India, and, to a lesser extent, Turkey. These third-party countries have not signed on to the cap. After Russia said it would refuse to sell oil to any country that does join the cap, we shouldn’t expect them to, either.

These are countries that are either allied with Russia (China), worried about their energy security (India), or, in the case of Turkey, a little bit of both.

For them, losing access to Western insurance, financing, brokering, and maritime shipping is a challenge, but not an insurmountable one.

Some countries — including Russia — are already stepping in to provide alternative insurance for Russian energy exports, allowing energy trade with Moscow to continue uninterrupted.

These third-country buyers can also make it look like they are playing ball with the G7, while continuing to import Russian energy simply by paying the cap price and then paying Russian sellers an additional amount on the side.

Less scrupulous traders could even use falsified bills of lading or other forgeries to get around the price cap.

Moreover, the Biden administration has already said it does not plan to use Iran-style “secondary” sanctions on Russian oil sales to enforce compliance with the cap. These secondary harsher sanctions can see offenders banned from accessing the U.S. financial system.

But even with secondary sanctions, there are workarounds. Indeed, significant volumes of sanctioned Iranian and Venezuelan oil continue to find buyers despite sanction regimes.

The price cap crackdown carries the potential for blowback from Moscow, too.

The G7 assumes Russia is a rational actor that will make decisions purely based on economics. In reality, Moscow is looking increasingly desperate in its war with Ukraine, and it blames the West for starting an economic war against it.

Russia has already cut off natural gas supplies to Europe via the Nord Stream 1 pipeline, driving European gas prices through the roof – with a knock-on effect on global gas markets.

Who is to say it won’t use the energy weapon in oil markets, too?

While Russia would never take its oil exports to zero, it could cut enough to drive up global prices. This “lower volume, higher price” strategy could keep Moscow’s oil revenues robust while inflicting pain on the G7 price cap architects.

Russia also remains an integral member of the expanded OPEC+ group. The top members of the OPEC+ cartel are fed up with the West’s meddling and intervention in energy markets. Saudi Arabia is more aligned with Moscow than Washington today. There is no love lost between the Saudi-led cartel and the Biden administration or the European Union.

Members of OPEC+ have already fired a shot across Washington’s bow by announcing a modest cut in production for October. The cartel has warned more cuts could be in the cards, too. The cartel group also benefits from a “lower volume, higher price” strategy.

So, what is the most likely outcome of the G7 price cap? Given that it is not practical or enforceable, it serves primarily as an added supply risk in an oil market that can ill afford another one – not with global spare production capacity so low.

The result of the EU embargo on Russian energy exports and the price cap could be Russia sending more barrels to China, India, and, perhaps Turkey, using primarily Russian, Chinese, and Turkish flagged ships. Russia might offer discounts to sweeten the deal, but nothing near the cap set by the G7.

What production Moscow can’t sell to third-party countries could instead be shut in, supporting higher oil prices while preserving the resource for later extraction. The International Energy Agency now expects Russian production to drop by 1.9 million barrels a day once the EU embargo goes into full effect.

That may be the best-case scenario for the G7. The worst is full-blown Russian retaliation and the use of oil exports as a weapon, which could deliver a bullish shock to the market, pushing prices as high as $150 a barrel.

Such a scenario could increase Russia’s oil income by as much as 50 percent while exacerbating global recessionary pressures.

The risk of this market reaction cannot be overstated – especially since the Biden administration and EU and UK policymakers have proven themselves incompetent in the current energy crisis, and the price cap could be their coup de grace.