Imagine shopping at a flea market with your best friends. The item you crave adorns the shelves of many sellers, but they don’t have enough of what you want. There’s one prominent seller with plenty of the stuff, but all of you hate him because of what he has done.
Still, you walk up to him and say: “We will continue to punish you, indeed isolate you so that you won’t even have your prized corner spot in next year’s flea market, but we want to buy tons of your product at a price we set.” The seller, intrigued, asks: “After all the things you have done to me, I don’t want to talk to you until you bring things back to the way they were. That aside, suppose I am interested. What would be that price?”
You respond: “Your cost price. We don’t want you to profit from the deal. Your agreement will help us tremendously in the short term. We will then have regrouped fully and kicked you out of this flea market next year.”
This unserious “Russian oil cap” proposal went into effect on Monday this week. If Russia goes along, or so the Western hubris goes, Russian oil would flow freely, and the low price would deprive Russia of oil profits to fund the war. Because Europe’s maritime shipping and insurance industries dominate the world’s sea lanes, the complex agreement relies heavily on the private sector to police the deal.
Shipping papers must show that oil in a ship’s tanks was sold to the shipper at or below the price cap. Only then are insurance companies allowed to provide the ship with insurance. Only afterward can the vessel arrive at EU ports for consumption within the European states or further shipping to other countries. If market participants fail to follow the rules, they will be held legally liable for violating EU sanctions.
The system is ripe for fraud — a shipper could falsify papers, for example — but the West went forward with the proposal anyway. First championed by the US Treasury secretary Janet Yellen at a Congressional hearing in June, it was signed last week by all 27 EU member states, joined by the G-7 and Australia. Russia, as the provider of the oil, was not a signatory to the deal.
In June, the talk was that the price would be set a few dollars above the cost of Russian production, $15-$20. But as the months wore on, the cap price went up and up. The cap deal the West announced last week was so watered down that it was a far cry from the original aggressive statements. The cap was set at $60 a barrel when crude was trading at about $65, much higher than Russia’s cost of production.
Russia has been selling to India and China at $60-$65 a barrel, so the deal ironically locked in a price at which Russia could derive billions in profits by selling to the very countries that have steadfastly imposed sanctions. But there is a bigger problem. If Russia refuses to sell at the oil cap price, oil markets could shoot up, creating havoc. Indeed, this is precisely what Russia threatened it would do.
On Sunday, Russian Deputy Prime Minister Alexander Novak said that Russia was “working on mechanisms” to undermine enforcement of the cap without elaborating. “We will sell oil and oil products only to countries that will work with us on market conditions, even if we would have to lower production,” he said on Rossiya-24, a Russian state news network.
If Russia refuses to sell to oil cap countries, Russian inventories will rise, assuming that Russia cannot find sufficient buyers (India, China, South Africa, Brazil) outside the cap deal to consume its oil. Russia does not have storage capacity for all the oil it produces, so, over time, it will lower or even stop production. With the world’s second-largest producer’s oil off the market, prices would rise dramatically unless other OPEC nations make up the slack.
Russia would suffer in the short-term as revenues fall, but countries worldwide would hurt even more. Russia can afford to take this risk until March as the brutal winter has slowed the war anyway. Besides, at higher oil prices, Russia could continue generating the same profits at lower volumes.
The agreement also doesn’t penalize India or China for buying Russian oil. The $60 cap will be valid until January 15, when the E.U. will again review the price. Officials said that the goal is to keep the price at 5 per cent lower than the price Russian oil is being traded at the market. Again, this is a far cry from starving Russia of oil revenues.
If there’s one thing we have learned from the war, it is that, despite recent setbacks, Putin has outsmarted the collective leadership of the West because he knows that he has something that the world badly wants.