Washington’s Oil Price Cap Won’t Work-And Putin Knows It

For the past several months the U.S. has been shopping around other advanced democracies a scheme to coordinate the placement of a cap on the price Russia can charge on its energy exports to deprive Putin of revenues fueling his war in Ukraine. A nearly 50% rise in Moscow’s inflow of oil and gas export revenues has been driven by the sector’s skyrocketing prices since the onset of the war. To Putin’s amusement, Washington’s attempt to cobble together an agreement among its allies to cap the price Russia can charge for its oil and gas sales has not been easy going for Washington.

U.S. allies are rightly circumspect about the convoluted design of Washington’s plan in a market that is far more complex than the U.S. understands; its ability to accomplish the stated goal—terminating Putin’s belligerent conduct in Ukraine; and that it’s proposal won’t backfire, inflicting substantial costs on the advanced democracies, indeed far more than it will on Russia.

Meanwhile enlarged oil and natural gas revenues still make their way to Moscow; the bloodshed of Ukrainians mounts; and the already numerous casualties of young Russian male military conscripts rise exponentially.

Unfortunately, this is not surprising.

In fact, it’s bedeviling why Washington has not proposed more effective policy instruments readily available that could significantly curb Russia’s oil and gas export revenues and thus substantially shrink Putin’s war chest.

It is hard to understand why Washington has not focused on instituting alternatives, including market-oriented, transparent and more economically intuitive mechanisms drawn from the arsenal of international trade policy.

The Fundamental Flaws of the U.S. Oil Price-Cap Scheme

The design of Washington’s proposed oil price-cap is contorted and inextricably fraught with contradictions. The most salient of these is the program relies on command-and-control mechanisms—that is, non-market-based measures—for setting the ceiling price (“the cap”).

But that price is not driven by supply and demand. Rather it involves imposing an artificially constructed margin above notoriously difficult-to-estimate Russian per barrel extraction and production costs.

As in all oil and natural gas producing countries, not only do these costs vary across the wells in Russia’s resource producing regions, but they also are not fixed, changing over time. As such costs rise or fall, the U.S. scheme would require altering the level of the price cap to maintain consistency. If changes in the price-cap were not made, incentives and disincentives would be created across wells leading to a crazy quilt of spatial output distortions.

It is not difficult to imagine that the institution of such an administrative framework and the distortions it will produce would engender even more risk into global oil and gas supply and demand than is already the case as a result of the war in Ukraine thus putting upward, not downward, pressure on prices for oil and gas. The odds are this would create a bias towards more not less oil and gas revenues making their way to Putin’s coffers.

Washington’s program also would be exceptionally difficult to monitor independently, creating opportunities for evasion and corruption—not just in oil transactions conducted in Russia, but in bills of lading for transporting Russia’s oil and gas outside its borders; how customs charges are applied; insurance rates for oil tankers; and so on. As anyone who has worked on the ground in Russia and similar kleptocracies (think: China) knows well, such command-and-control measures and opportunities for corruption are exactly the type of paradigm in which Putin thrives.

In fact, fears have arisen by the U.S. of the potential presence of such aberrant behavior—not only by Russia and its foreign allies who purchase its oil (think: India) but even among oil and gas market participants within the G7 countries. This has driven Washington to consider the imposition of a network of secondary sanctions to curb such cheating. The contemplation of resorting to such steps is prima facie evidence that Washington is fearful its chosen paradigm for penalizing Russia is full of holes.

More fundamentally, the design of the U.S. policy seems to reflect that its core framers and advocates lack deep practitioner knowledge of how the global market for oil and gas is actually structured and functions. This is odd as there is no shortage of such experts and seasoned executives within the industry across the U.S., including in Washington.

Suffice it to say, that market is notoriously complex and comprised of a multitude of geographically dispersed parties with highly differentiated interests, many of whom are extremely sophisticated. To many, this may belie the fact that oil and natural gas are relatively homogeneous commodities that trade across multiple borders on a daily basis.

In principle, such homogeneity can foster cheating on regulatory constraints placed on oil and gas exports, such as those to be imposed on Russia. After all oil and natural gas are not branded per se. Indeed, it’s not as if they are easily marked by different colors, smells, or labelling. Still, information flows tracking tanker shipments, for example, are increasingly sophisticated and robust—that is unless intentional mislabeling of such supplies and other forms of evasion and corruption occur.

Still, the success and effectiveness of the U.S. price-cap policy (indeed of any economic policy) ultimately depends on the extent to which the parties concerned (the U.S. and the other advanced democracies, including their citizens, companies, workers and consumers) understand the objectives and the mechanics of the price-cap. Regrettably, in this case, there has been a fundamental inability by Washington to succeed in its messaging.

Perhaps the starkest example of this is that Washington’s pursuit of the price-cap is based on the hope of achieving multiple objectives that are largely inconsistent with one another. They also run counter to powerful market forces.

In a nutshell, the U.S. is seeking to cap oil prices at levels lower than the currently high market rates generated by the war in Ukraine to alleviate the softness in global economic growth they have engendered. Yet at the same time, the U.S. is seeking to set a price level for oil that is just higher than Russian oil production costs so as to not remove Russian oil supplies from the world market that otherwise would exacerbate the fall in global GDP growth. This tangled set of objectives of trying to “have your cake and eating it too” is one of the principal reasons allies have not signed on to Washington’s program.

Experienced framers and executors of public policymaking know well the golden rule for success: If an initiative’s design is overly complex; its rationale cannot be expressed in a compellingly intuitive manner where the linkage between cause and effect is abundantly evident; and its workings lack sufficient transparency, that is its death knell.

To this end, it is not a good sign that in Washington’s campaign to bring-on allies to the price-cap proposal it is having to reformulate the model time and time again, inevitably adding on “bells and whistles” to find “takers.” While the price-cap is well-intentioned, it shuns lessons from decades of policy-making—in oil and many other markets: Complex “Rube Goldberg” schemes almost always fail. Is it any wonder the U.S. is having trouble enlisting the support of its allies?

Potential Paths Forward to Undercut Putin’s Objectives

The sad irony of the U.S. oil price-cap proposal is it stands in sharp contrast to the leadership Washington displayed in February executing a well thought out, comprehensive set of financial sanctions by the world’s advanced democracies on Russia’s banking system, related institutions and Putin’s cronies soon after Russia’s invasion of Ukraine. It amounted to a sanction strategy whose cross-country coordination and effectiveness is unprecedented over the last half century. (One would have to look back to the sanctions applied to South Africa for its apartheid regime between the 1950s and 1990s to find a comparable strategy.)

Are there alternative sanction strategies regarding Russia’s oil and gas sector Washington should consider in lieu of its price-cap regime? Yes. Here are two.

One would be for the U.S. and its allies to apply a uniform tariff on imports of Russian oil and gas. Collectively coordinated, such a regime would make Russian oil more expensive on world markets thus curbing revenue accruing to Putin.

Of course, it would also increase oil prices consumers face in the countries imposing the tariff. But the difference between this strategy versus an oil price cap oil is that the extra revenues from the tariff would accrue to consuming countries’ treasuries. Would such a hike in the price of oil consuming countries face raise energy costs and thus stunt economic growth? Perhaps. But not if the governments in question direct the tariff revenues to stimulate domestic consumption and productive investments: think, greater spending directed toward job creation and construction in public mass transit or similar projects.

A second form of oil-specific sanctions would be for the U.S., allied with a few other large oil producers—Canada, Saudi Arabia, Iraq, United Arab Emirates, Brazil, and Kuwait—to ramp up production and flood the world oil market with additional output to drive down oil prices Russia is able to earn. Such “predatory pricing” would be a sure-fire method to utilize oil as a vehicle to weaken the foundation of the Russian economy.

This would seem to be a no-brainer sanction to be put on the table. In theory, at least. Why?

For starters, the Saudis have recently moved in the exact opposite direction—restricting output. Beyond Canada it is not clear whether the U.S. could get the Saudis and other large oil producers to go along with this approach. Many of them have far less antagonistic—indeed even benign or friendly—relations with Russia.

Should Washington, London, Brussels, and Ottawa be able to persuade Riyadh to expand output, that would surely drive down oil prices. But it is unlikely—given the overall size of the global oil market and the additional volume of oil the Saudi’s (currently) could produce—that prices would fall dramatically enough—and remain at a level—to inflict significant harm on Russia’s oil revenues.

To do that, coordinated releases would be needed from oil consuming countries’ stockpiles, such as the U.S. Strategic Petroleum Reserve (SPR). And such coordinated drawdowns would need to be both substantial (relative to the current volume of oil in the global market) and sustained.

The goal is to not only increase supply sizably relative to demand, but also send a credible signal to the overall oil market that the supply-demand balance has structurally shifted. Failing to do both will unlikely have the desired impact on oil prices. A surely unsatisfactory outcome would be one where an enlargement of supplies fails to move prices lower. In fact, if such a strategy does backfire, it may well result in oil prices to increase since oil buyers and sellers could lose confidence in the stability and integrity of the market.

Regrettably, the core issue for effective predatory pricing remains this: while conceptually flooding the supply of global oil markets to reduce oil prices could be the most effective approach to penalize Russia, the reality is that current world oil stocks are unlikely to be large enough for this to work.

Equally important, even if coordinated drawdowns are done adroitly and do significantly lower world oil prices and thus adversely affect Russia, they may also engender new risks to oil consuming countries on the domestic front.

First, there would be heightened national security risks—unless our petroleum stockpiles were able to be replenished quickly in the future and with low-priced oil.

Second, there would be increased environmental risks since the cheaper oil would serve to stimulate consumption and thus emissions of greenhouse gases and erosion of progress made on sustainability.

Mitigation of such risks, however, can be accomplished if surcharges were added to our retail prices of fossil fuels in order to curb excess consumption of them. Indeed, this is a policy that, as I have argued elsewhere, should have already been in place in the U.S. Regrettably it has not. Like the collection of revenues from the import tariff scheme described earlier, these surcharges would go to national treasuries and could fund alternative energy investments and new infrastructure in mass transit, for example, while Russia would be only able to receive low prices.

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As is almost always the case, it’s rare to find economic policies that are “silver bullets.” A careful assessment of the benefits and costs across imperfect alternatives—including their relative workability—must be weighed. The lack of simplicity, transparency, and protection against corruption inherent in the oil price-cap scheme all point to its questionable efficacy and the need to devise alternatives.