Europe’s decision to enforce a price cap of $60 per barrel on Russian oil to drive down the country’s oil revenues without causing a surge in prices is theoretically bearish, said MUFG, a Japanese bank holding and financial services firm.



“We have been sceptical on the practicalities of its success,” said MUFG’s Global Markets Research wing.



MUFG draws three key conclusions of what could transpire next – beyond Russia’s reaction function – acknowledging that the above conditionalities may vary significantly over time and with global supply-demand balances:



Chinese demand

Perhaps most critically, is weaker Chinese demand may limit Russia’s ability to export oil outside of the price cap regime and, with it, encourage adherence to the price cap, until Chinese demand strengthens again (likely from Q2 2023 onwards).



Damage to shut-in oil infrastructure: Second, is the damage the price cap could cause from any sudden halts in Russian production. Some Russian oil fields are old and low pressure, with only ~80% of the shut-ins that occurred during both April 2022 and the initial draconian lockdown periods of Covid in Q2 2022, having recovered.



Non-economic factors exogenous to the price cap: Finally, it is unclear as to what, if any, non-economic factors exogenous of the price cap framework could emerge whereby pressure from non-G7 nations may also be a core consideration in the decision-making process.



Largest tranche

Following months of planning and wrangling, the largest tranche of sanctions on Russian crude oil to date is now in effect. EU member states have agreed to implement a $60/b ceiling on global purchases of seaborne Russian oil with an adjustment mechanism to keep the cap at 5% below the market price.



The aim is clear – squeeze Russia’s oil revenue by prohibiting entities from insuring, shipping or trading Russian crude anywhere in the world unless it is sold below this price cap, whilst concurrently seeking to avoid exacerbating the prevailing tightness in global oil markets by keeping Russian oil flowing (predominantly to China, India and Turkey).



“Yet how big this impact will be remains ambiguous. The latest developments change our perspectives to some extent but at this stage the information vacuum to decipher whether the price cap will avert market volatility and/or whether Russia could cause disruptions beyond what we believe could transpire, is unknown,” MUFG said.



Unanswered questions

There are still critical unanswered questions that will shape the impact of the measures on global oil markets, such as (i) the depth of non-European insurance markets; (ii) the appetite of tanker owners to participate in trade with Russia; and (iii) precisely how effective enforcement of the cap can be.



MUFG breaks down the implications of the price cap through various channels:



What the specific oil sanctions entail. As of December 5, the EU will ban the import of crude oil produced in Russia and transported by sea. There is an exemption for Bulgaria, which can continue to import seaborne Russian crude oil until the end of 2024, under contracts that were concluded before June 2022. Pipeline Russian flows are unaffected, although both Germany and Poland – where critical Russian piped crude oil flows into the continent – have said they would cease such imports by the end of 2022.



The UK and EU will also introduce a ban on maritime services that allow the transport of Russian oil, including to third countries – those that are neither Russia nor the sanctioning country. The list of banned services includes insurance, brokerage and importantly the EU-based tanker fleet that include vessels owned in Greece and Cyprus. These restrictions won’t apply if oil is bought at or below the capped price.



Functioning of the price cap – monitoring, enforcement and loopholes



Customarily, vessels obtain insurance cover from the London-based International Group of P&I Clubs. This group uses a reinsurance programme that is heavily dependent on the EU, necessitating that its services will only be allowed if oil is shipped under the cap. Yet, there are some alternatives.



Russia’s Ingosstrakh Insurance Co was been a key Russian underwriter of P&I cover in recent months and could be one option. Though, when questioned last month, the entity has offered no guidance when asked if it would act to fill the void. Crucially, the depth and breadth of Russia’s insurance market is negligible in size relative to conventional players which could act as an impediment should Russia seek a more domineering role for its domestic entities.




The price cap will only be applicable to seaborne deliveries of Russian oil. As such, flows via the key Druzhba pipeline to Europe are still permitted. There’s also a carve out for Kazakhstan’s CPC crude oil blend which is exported from a Russian port. Having said that, there will be further talks this week that could see some tweaks to the rules. Bulgaria has an exception that allows it to continue importing crude oil due to its “specific geographical exposure”. Alongside that, Japan received an exemption for oil produced from the Sakhalin-2 project that’s destined for Japan. The UK, which had been waiting on the EU, has an exceptions in place for environmental emergencies, which would allow the clean-up of spillages. The EU is likely to follow suit. That came after Turkey said it was planning more stringent insurance checks due to the risk of environmental damage.



Shadow shipping fleet

Russia has inaudibly amassed a fleet of more than 100 ageing tankers (through direct and indirect purchases) to help circumvent the new sanctions, according to shipping broker Braemar.



Whether such quantum of fleet will be large enough to maintain a full rate of exports in the long term is uncertain. What is clear is that the growing risk of carrying Russian oil has seen tanker earnings spike for cargoes loading after December 5.



Creation of multiple prices

Since demand for cheaper Russian oil will outstrip supply, the price cap could create multiple prices – (i) global crude price; (ii) the capped price for Russian oil; and a (iii) shadow price that would settle somewhere in-between. This spread could create arbitrage opportunities for buyers and lead to volatility and potentially a drain on liquidity.



Russia’s reaction function

Russia has consistently said it won’t sell oil to countries that participate in the price cap. Russian Deputy Prime Minister, Alexander Novak declared that the plan may result in significant risks for commodity markets, including market deficits.



Furthermore, Russian Foreign Minister Sergei Lavrov stated on December 1 that Russia would continue to negotiate with its partners “directly over the pricing of crude sales”, noting that “there is always an element of balance of interests”, including on prices.



Notwithstanding these clear remarks from the Russian authorities, uncertainties remain abound at the current juncture. MUFG envisages Russia’s reaction function, by and large, taking one of two options:




Accepting the price cap, with revenue optimised by maximising exports to levels constrained by the physical limits of having to redirect ~5m b/d from Europe, to more distant end-consumers in Asia. The EU oil embargo – loading deadline December 5 for crude and February 5 for products – is a separate regulation to the G7 price cap, and will still limit exports, requiring a ~0.7m b/d sequential fall in production by Q2 2023.



Consistent with shipping broker reports that Russia has amassed a large shadow fleet of oil tankers, Russia may be compelled to continue its flows to end-consumers at prices higher than the price cap (but likely still discounted from global benchmarks). Russia could maintain such flows as these vessels wouldn’t be reliant on P&I insurance or transportation services and would additionally be unlikely to require such services in the future given the age of the vessels in question. In any case, the binding constraint in this scenario could rather be the willingness of end-purchasers to engage in activity that side-steps EU policy goals as well as market pricing power of Russia given the sheer magnitude of its current exports.



Motivation to retaliate

Ultimately the motivation for Russia to retaliate is a function of four key factors, in MUFG's view:



Price cap threshold. The lower the cap, the larger incentive to cut flows/evade the cap.



Global oil price levels. The higher Brent crude prices are (for a given cap and discount), the higher are the incentives to cut flows.



Russian oil discounts. The larger are discounts for Russian crudes trading outside of the price cap (for a given Brent price and cap), the lower the incentive to cut flows.



Price reverberation. The larger is the impact of cutting a given volume of exports on global prices, the larger the incentive to cut flows. Three key takeaways of what could transpire next at face value, the EU price cap threshold of $60/b endeavours to minimise Russian revenues whilst simultaneously limiting retaliation risks.



“We believe an important decision is permitting the price cap to fluctuate with crude benchmarks, as incentives are conditional with global prices, balances and discounts. In effect, this results in a backwards-bending supply curve, as supply is likely reduced in response to higher prices. To avoid this, we believe the price cap would need to rise next year, given our $105/b average 2023 Brent crude forecast.”-



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