While we are just four days away from the price cap sanctions imposed on Russian origin crude oil to take effect from December 5th 2022, the global markets are bracing for volatile uncertainty especially as price cap levels are yet to be announced by the G7 coalition with EU and Australia.
Post Ukraine invasion, Crude oil after touching peaks of 130$/bbl in June 2022, has lately cooled down at 84$ amid global slowdown, China lock down restrictions and slowing demand, despite supply cut of 2mbpd by OPEC in the month of October 2022. Further, Russian Urals crude is trading at $ 48 / bbl, which is almost at a discount of 36$ from North Brent crude (Urals is a major Russian crude grade that is exported).
The West has demonstrated their objection against Ukraine’s invasion by Russia and to curtail Russia’s war machine (wars are very expensive) and cripple down Russian economy, couple of countries have imposed sanctions on Russia, with United States, UK, EU proclaiming their position. In their latest package of sanctions, the G7 have announced price cap sanctions on seaborne Russian crude oil.
This note focuses on breaking down the topic of price cap sanctions imposed by G7 and what it holds for the global markets.
Crude & Petroleum trade share
Since the West’s motive behind the sanctions is to strip down Russia’s revenue stream, sanctions are imposed on its major revenue generators - the petroleum products. On Ukraine's invasion, US imposed sanctions against the import of Russian origin crude oil and petroleum products. EU and UK followed. Petroleum products account for circa 54% of Russia’s total exports, with crude oil having 30% share, petroleum products having 18% share and natural gas 6%. Pre-invasion, the major markets of Russian petroleum products have been EU, UK, Turkey, Asia – preferably China, Japan, Korea.
Russia is second largest exporter of crude oil in the world. In 2021, Russia exported nearly 4.7 million barrels per day (mbpd) of crude oil to the world, out of which 2.4 mbpd was exported to Europe and 1.6 mbpd to China. EU typically imports from Russia through two modes of transport – sea and pipeline. Russian Urals grade is majorly traded in Europe. Northern Europe is fed by sea transport and landlocked countries of Eastern Europe (Hungary, Solvakia) are fed through Druzba pipeline. Russia transports ESPO grade crude oil to East Asia through ESPO pipeline and sea transport (ESPO is acronym for East Siberian Pacific Ocean). ESPO is a sweeter grade crude and Urals are sourish.
In March 2022, UK announced its decision to phase out their reliance on Russian crude oil by the end of this year. In June 2022, European Union announced its ban on imports of Russian crude oil by its member states, however exempting pipeline imports by (landlocked) member states due to heavy reliance and no alternative arrangements in short run. EU imported 29% of its total crude oil imports from Russia in year 2020, citing heavy reliance on Russian crude oil. Post EU embargo on seaborne Russian crude, imports by Northern Europe have fallen significantly and they are meeting their crude oil requirements from United States and Norway. US also announced ban on Russian origin crude oil and petroleum products into US, however, their dependency on Russia is less.
Price Cap Sanctions effective Dec 5, 2022 and Feb 5, 2023
Despite several sanctions imposed, Russia’s crude oil exports have remained intact, as Russia has been successful in finding new markets in form of increased exports to Turkey, India, and China, by selling crude oil at discounted rates. Since the Russia’s seaborne exports of crude oil has remained relatively stable, G7 coalition + Australia with EU announced another set of sanctions on seaborne transport of crude oil in form of price cap effective December 5, 2022 and on Russian petroleum products effective February 5, 2023. Thus, Russian crude oil can be imported through sea by third party countries if the price is at or below the cap price level. Coalition has banned providing maritime services to seaborne Russian crude oil if the trades are above the price cap levels. However, the importers and refiners will continue to receive oil maritime services provided the imports of seaborne Russian crude oil are at or below the price cap. As per US recent guidelines issued on 22-Nov-22, maritime services include shipping, insurance, financing, trading/ brokering, customs brokering.
US have issued exemptions to the Price cap for below trades -
Japan (part of G7) can import Russian crude oil till Sept 2023 without subject to price cap
Bulgaria and Croatia (part of EU) can also import Russian crude oil without being subject to price cap
EU land locked countries (which currently receive supplies from Russia through pipeline) can import crude oil through sea without subject to price cap if pipeline supplies are interrupted due to reasons not in control of Europe. Thus, if pipeline supplies from Russia to these member states get interrupted then they can buy seaborne Russian crude without being subject to price cap. Although EU in its sixth sanctions package imposed embargo on Russian crude, it has exempted these landlocked member states that receive crude oil through pipeline. Russia transports oil to Eastern and Central Europe through Druzba pipeline (Germany, Poland, Belarus, Hungary, Slovakia, the Czech Republic and Austria). Thus, the landlocked countries shall continue to receive Russian crude through Druzba pipeline and remain outside price cap.
The petroleum products refined from Russian crude oil by importer country purchased at or below price cap will not be subject to the price cap and can be sold freely in the market.
Why Price Cap?
The rationale behind the price cap, as per the coalition nations is – they want to trim Russia’s revenue, but at the same time, they want Russian crude oil to keep flowing in the market as any shortages will result into oil shock and would add to their inflation worries. The price cap would be decided in a manner that it is above Russia’s production cost so that it is incentivised to keep running the crude oil production, but not too high that it funds the war. US has also clarified that the price cap is excluding freight, insurance etc, thus it will be on FOB basis. As a matter of fact, the price cap is still not fixed by the coalition, when we are just 4 days away from the implementation date.
Critical elements that play role in maritime transport of Russian crude oil
Insurance
Insurance is one of key services that enables movement of oil by sea, particularly P&I (Protection & Indemnity) insurance that relates to third party liability claims. UK is leader in P&I cover, writing 60% of global cover. EU and UK together hold major share of 85-90% of Insurance, re-insurance, and financing services of Russian crude oil. The West believes that without Western insurance, seaborne transport of crude oil cannot happen. Thus, countries that would not agree to the price cap, would have to eventually buy Russian crude oil at or below price cap if it wants Western insurance. However, the developing arrangements suggest that Western insurance can be well substituted. Russian companies are exporting crude oil to many countries on delivered basis. Thus, insurance, shipping etc will be the responsibility of the seller and thus importing countries need not seek insurance. The possibility of Russian insurance companies providing the insurance cover appears more likely to replace western insurance.
The Western companies are already fearing losing significant share of business if the countries not falling part of price cap find alternatives to Western insurance.
While plying uninsured ships appears as an alternative, it is less likely to be executed as many sea routes do not allow uninsured ships to sail (e.g. Turkey, Suez Canal – it is one critical sea route that connects west to east maritime transport) and the exposure taken by the ship owner is large owing to damages and claims.
Shipping
Arrangement of fleet is one vital factor. The scope of maritime services provided by the coalition countries subject to price cap also include shipping services. Thus, ships owned by these countries / companies can carry Russian crude for third party countries only if the imports are at or below the price cap. EU and G7 nations enjoy large market share in Russian tanker trade. Greeks are single largest owner of global crude oil tankers, followed by Cyprus and Malta. Thus, G7 estimates that availability of tankers will curtail for shipments above the price cap.
The freight rates have already soared 3 times since Ukraine’s invasion due to shifts in global trade. However, as per market reports, Russia has begun building its own dedicated fleet, including expanding shadow fleet, which it may use to move crude oil above the price cap. Russia may seek end of life / older tankers and as per few reports, rates for ships in their second decades have soared. As per few other reports, Russia has enough fleet under shadow arrangement to cater to its total global exports - including pipeline quantities.
On the other hand, if Russia takes time to accumulate fleet to evade the price cap, Russian production may reduce for some time and that shall push the crude prices higher. Thus, likelihood of price cap evasion by Russia persists, suggesting ineffectiveness of price cap decision taken by the West. The Greeks are already concerned about losing their sizable business on account of price cap if Russia’s alternative fleet arrangement grows.
Payments
U.S. in its recent guidelines has stated that processing, clearing, and sending of payments by intermediary banks is not included under the sanctioned scope of maritime services. There are no prohibitions or requirements related to processing, clearing, of sending of payments by intermediary banks. Also, services related to foreign exchange transactions and clearing of commodities futures contracts are outside the scope of ‘financing’. Yet, there shall remain ambiguity on part of banks on payment and settlement in US Dollars for Russian crude purchased above the price cap. As for India, RBI has given a go-ahead for opening of vostro accounts in India by Russian banks. Till now, nine Russian banks have opened rupee vostro accounts in India. Vostro accounts are generally by a foreign bank in another country’s currency for carrying our inter-currency transactions. With help of vostro accounts, transaction settlement between India and Russia can happen in rupees.
Shift of trade flows leading to squeeze in tanker markets
After Ukraine’s invasion, Europe has been phasing out its reliance on Russia’s crude oil. Share of Northern Europe in Russia’s total seaborne exports of crude oil has fallen significantly from ~1.2 mbpd to ~0.1 mbpd. However, the overall exports have remained intact owing to shift due to high imports by Turkey, China and India.
Northern Europe’s crude oil requirements are being met majorly from U.S, Norway. Due to these shifts in the global trade, the tanker market is squeezed, owing to higher demand of tankers and due to additional time consumed for tankers to sail from U.S. to Europe (17+ days) as compared to lesser time taken for transportation from Russia to Europe (4-5 days).
Russia’s response to Price Cap
Russia has reiterated several times that it will stop the supplies to all those countries participating to the price cap, thus posing risk to global supplies and spike in the oil prices. Russia is in the process of issuing a decree to ban sale of Russian crude oil by Russian companies or any trader to countries agreeing to the price cap.
Russia has supplied around 3 mbpd of crude oil through sea in month of November 2022, which is more so at levels of pre-invasion. It is to be noted that ships leaving Russian ports whose destination is not known are increasing to newer highs.
Considering Russia’s past actions and repeated warnings on price cap, Russia may simply stop the supplies to price cap nations. Russia however, may have to find alternative markets like Africa, Latin America, Asia. Although it would be successful, as these markets are located at farther distance, time consumed by tankers for onward and return journey will be higher and will thus constrain the availability of tankers in market. Thus, this may also impose an upward pressure on freight rates and oil prices.
If G7 tries to impose harsher price cap, another possibility, although remote, would be Russia cutting off the diesel / gasoline supplies to Europe and other unfriendly countries, the price cap sanctions on which are effective from February 5, 2023. Currently, diesel market is tight due to demand-supply factors and the global prices are already very high. Any further shortage in the market will be a calamity.
We all know that US, UK, EU are facing the heat of multi-decade high inflation (link) to which magnified natural gas prices has added fuel to the fire. Despite packages of sanctions imposed, Russia’s war machine has continued, and none would have expected the Nord stream 1 gas supplies to remain shut for a long time. Europe’s heavy reliance on natural gas from Russia left it dry as Russia closed off the pipeline tap indefinitely. (link).
Price Cap Decision
Since the official announcement of price cap in September 2022, price cap levels are yet to be announced. G7 and coalition members are seen to be having difference of opinion as to what should be the level of price cap, as it shall require estimating cost of production of Russia and strategically fix the price to incentivize Russia to keep the oil flowing in the global markets. The price cap itself appears to be milder version of sanctions.
While U.S, EU are proposing the price cap at 65-70$ which is closer to historical average price of Russian Urals crude, European countries are struggling to arrive at consensus on final price cap levels as Poland, Estonia are stubborn about their proposal of keeping the price cap at 20-30$ which is nearer to Russia’s production cost. It is ironical to note that the West’s proposal of price cap is much higher than current Russian Urals price of 48$.
If the price cap levels are lower than traded price of Russian crude oil – stricter sanctions – may be responded by Russia notoriously by cutting off supplies of petroleum.
If the price cap level is fixed higher than Russian crude traded price, the countries are free to trade for Russian crude oil and would also be able to avail Western insurance, shipping and other maritime services. As EU, US are proposing a higher price cap, it suggests easier approach rather than harsher stance towards Russia. Another relaxation by West to sanctions is that price cap levels are on FOB basis excluding insurance and freight, allowing flexibility for fluctuations in freight and insurance costs not being covered under the price cap.
Failure to arrive at price cap till now, has left the buyers in limbo.
Russian Urals is trading at FOB rate of discount of 36$ from North Sea brent crude and these are FOB rates. Whereas ESPO crude is trading at 73$, lower by 11$ to Brent. ESPO crude is supplied to China, Japan, Korea through oil pipeline.
The price cap will be successful for the coalition members when Europe halts purchase of crude oil and European ships and maritime services are used to buy Russian crude at or below the price cap. West is aware of the impending risks that global economy is facing if price cap sanctions are stricter. It may be likely that the price cap is fixed somewhere near to Russian crude price, so that Russia does not lose much on the front and continues to sell crude oil in global markets.
As a lot of business for West is on stake, coupled with looming risks of high oil prices against global high inflation and recession fears, they may arrive at a decision that meets everyone's interest and share common ground, to keep global supply chain, energy security and economic health in control.
-Ushma Zunzavadiya
The above views expressed are solely personal and do not represent that of my employer’s.
Refer below for references and notes.
Sources:
Bloomberg, Reuters, Argus reports, S&P Platts.
References:
Russia’s export profile - https://oec.world/en/profile/country/rus?yearSelector1=exportGrowthYear25
Pipeline Exemption by EU - EUR-Lex - 32022R0879 - EN - EUR-Lex (europa.eu)EU Energy Imports - https://ec.europa.eu/eurostat/cache/infographs/energy/bloc-2c.html
Older tanker rates and demand - https://www.tradewindsnews.com/tankers/elderly-tanker-values-rally-as-eu-closes-in-on-russian-oil-embargo/2-1-1363335
Shadow tanker fleet - https://www.tradewindsnews.com/tankers/brs-shadow-fleet-large-enough-to-accommodate-russian-oil-exports/2-1-1358714
Notes:
G7 – include US, UK, Canada, Germany, France, Italy and Japan.
Northern Europe include – Netherlands, Poland, Lithuania, France, Germany, Spain, Sweden, UK.
Mediterranean region include – Italy, Turkey, Greece, Croatia, others.
EU typically imports from Russian through two modes of transport – sea and pipeline. Northern Europe is fed by sea transport and landlocked countries of Central and Eastern Europe are fed through Druzba pipeline. Russia transports crude oil to Eastern Asia through ESPO pipeline and sea transport.
P&I (Protection & Indemnity) is the policy, ship owners purchase to protect them against liability claims from crew, passengers and third parties. Liability claims include those such as collision, property damage, pollution, environmental damage, and removal of wrecks. P & I club is an association composed of shipowner’s members to support seafarers' safety and well-being by providing the required necessities. Protection against any damage and Indemnity for claims from third parties.
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