Oil market attention turns to price cap

Oil markets are watching closely for how a price cap on Russian oil will be implemented by G7 nations. The European Union’s latest round of sanctions on Russia (their eighth round agreed at the start of October) included an explicit endorsement of a price cap, backing up a plan agreed by the G7 earlier in September. The G7 plan is meant to reduce revenue for Russia’s government and increase the economic penalties of its war in Ukraine. The G7 idea envisages a “comprehensive prohibition of services” in trade and transport of Russian oil unless the oil and products were “purchased at or below a price determined by a broad coalition of countries” that intend to implement the cap.

The EU plan has put more of the G7 plan into practice as the latest sanctions would allow “European operators to undertake and support the transport of Russian oil to third countries, provided its price remains under a pre-set cap.” The timeline for the cap to come into force is December 5th for crude oil, when a complete ban on EU imports of seaborne Russian oil takes effect, and February 5th 2023 when a similar ban on petroleum product imports comes into effect.

Services are the key

EU and UK dominance of global insurance and shipping services is the main leverage the G7 countries have in implementing a price cap. According to the International Group of P&I clubs, a grouping of shipping insurance providers based out of the UK, they cover roughly 90% of global seaborne cargoes. Several of the world’s largest oil tanking firms would also likely be covered under the G7 plan.

The price cap mechanism would notionally allow Russia to continue exporting oil to third party countries (ie, those that have not imposed outright bans on importing Russian oil) and seeks to avoid a sharp drop in Russia oil and product exports. There appears to be distinction here between US and EU sanction action with the US trying to avoid a complete halt in Russian exports whereas the EU is maintaining a near complete embargo on Russian oil.

If third party nations choose to make use of G7-origin services (insurance, shipping etc) then they will have to buy at the price cap or below, setting a ceiling for the price of oil and potentially helping to limit inflation in importing nations. Market expectations seem to be centred around a price level of USD 60/b, around 15% lower than Russia’s main export grade has been recently trading. The US Treasury has estimated that emerging economies would save up to USD 160bn if they adhered to the plan. European nations (including Turkey and the UK) imported around 4.5m b/d of Russian oil and products in 2021 so roughly that is the scale of trade that would need to be diverted, a large amount of oil that would also help to push energy price inflation lower.

Price cap requires buy in from all sides

However, the plan could also become subverted and act as a price floor. Russia may choose not to sell to countries that are participating in the price cap plan and instead shut-in production and exports even at the expense of losing out on revenue.

A near 5m b/d cut in crude and product exports would be enormously bullish for oil markets but bearish for global growth and inflation. The scale of drop from December is likely to be smaller given that Russia has already limited flows but nevertheless, lower oil exports will create more challenges for the global economy already beset by high inflation, tightening monetary policy and slowing growth.