Price Cap on Russian Oil Exports Would be Futile; West Should Opt for Tariff Instead
At last month’s G-7 summit, President Joe Biden formally presented the idea of a price cap on Western purchases of Russian oil, something his counterparts agreed to consider. Their motivations are certainly well-meaning: to diminish the amount of oil revenue accruing to a regime currently conducting military aggression in Ukraine while also minimizing economic damage to Western economies already suffering from an inflationary surge.
Sadly, this price cap mechanism ignores the working realities of global oil markets and is likely doomed to futility. To significantly reduce Russian oil revenue, Western leaders have only two sets of policy options: to boost Western oil supply and/or to decrease Western oil demand. An oil price cap does neither. Worse still, it will not be difficult to bypass: Russian oil would likely continue being rerouted to Asia and could just as easily keep going to Europe and North America blended with other feedstock. Thus, Western leaders would be well-advised to shift their priorities to alternatives that actually work, such as an import tariff.
Though details on how the cap would work are yet to be finalized, the broad contours appear to be as follows: The West would provide a selective waiver on sanctions for Russian seaborne imported oil, in particular allowing access to Western maritime insurance and other key services, if said oil was purchased at some maximum mandated price or below. (The proposal seems to have originated with U.S. Treasury officials trying to reverse the potential damage from another misguided policy, the EU decision to sanction all seaborne Russian oil exports.) Recently, officials have suggested that that price cap may be around half of current market prices for Russian oil, so roughly $40-$60 per barrel.
The proposal, at first blush, appears promising. After all, the West is collectively the largest buyer of Russian crude, consuming about 70% of Russian oil exports. The potency of Western sanctions targeting maritime insurance was demonstrated against Iran in 2011-2012, arguably forcing Tehran to come to the negotiating table. Estimates vary, but average Russian oil production breakeven costs are roughly $30-$40 per barrel, so, at the margin, Russia should still be willing to accept the capped price.
However, the feasibility of this proposal rests on a fundamental misunderstanding of how global oil markets work. Given the fungibility of oil as a commodity and the inherent flexibility of global oil flows, it is nigh impossible to dictate by regulation any price that does not reflect supply-and-demand fundamentals.
To illustrate, let’s suppose that the global equilibrium price for crude oil absent Western sanctions or price caps was $100 per barrel. An average Russian oil company produces the oil at $35 per barrel, and ships it at a $5 logistical cost to a customer in Germany; the remaining $60 per barrel gets split, with $50 in taxes going to the Russian state and the remainder to the company (which itself is likely partly or fully state-owned).
Now suppose the West implemented this price cap scheme at $40 per barrel. Suddenly, the Russian producer is confronted with a choice: Still sell the oil at $40 to his German customer and enjoy exactly zero in profit or find a different buyer. The Russian producer will almost surely choose the latter and there will be no shortage of willing non-Western buyers.
We have already seen how buyers in China and India have been perfectly willing to replace Western customers, buying about twice and five times as much Russian oil through June relative to pre-war flows, respectively. They have been incentivized by reported discounts of $30 per barrel, while accepting presumably inferior insurance from the Russian National Reinsurance Company (RNRC). But, for Russia, selling oil at $70 is far better than $40.
Supporters of the price cap might argue that it may cost far more to ship oil to China or India than to Europe, the destination for which existing infrastructure is optimized. But transportation costs would have to rise to an absurd $65 per barrel (the difference between the cost of production and the equilibrium market price for oil) for this argument to matter; again, today it costs only about $5 a barrel to ship a cargo of oil 10,000 kilometers on the high seas.
Only the harshest of secondary sanctions or even threats of kinetic action against Russian oil transportation infrastructure might plausibly grant Western markets the monopsonic power to dictate price terms to Russian suppliers. But that’s clearly not what the G-7 leaders have the stomach to contemplate.
Price cap enthusiasts might also argue that neither China nor India have the scope to absorb such volumes of Russian oil. But what is stopping the Chinese, Indian or, for that matter, Swiss trading companies from entering the oil re-export market, perhaps refining or mixing Russian crudes with other blends to make them less sanctionable and happily pocketing the difference between their discounted feedstock and the international price? In fact, media reports suggest many shadowy companies, both Asian and Western, have emerged to take advantage of this arbitrage.
Lastly, with oil prices being so highly volatile, there is no guarantee that global equilibrium prices will stay above $40 per barrel forever. An economic recession, which many fear is coming given tighter monetary policy, may cause prices to crash below $40, making the price cap obsolete.
Bottom line: Oil markets are fungible and globally integrated. Much like how shutting off Russian airspace merely caused Western airlines to skirt the edges of Russian territory to reach their original destinations, this Western price cap may cause inconvenience for Russian producers and Western consumers (while providing fat profits to those able to arbitrage markets), but the molecule will eventually get to where it is demanded. Western leaders must focus on policies that are compatible with these market forces to be effective.
Fundamentally, to damage Russian oil revenue Western leaders have only two sets of policies under their control, as noted above: to increase Western oil supply and to decrease Western oil demand. Happily, the obvious solution to do both is staring us in the face: Western nations should tariff Russian oil imports.
At a stroke, this will drive a wedge between the after-tax price of oil in Western markets and the price received by Russian producers, incentivizing U.S. and European producers not subject to the tax to increase their supply while Russian suppliers would not see any benefit. It will also cause downward pressure on Western demand for oil in the medium term, by spurring more energy efficiency and investments in alternative energy.
A tariff is far more transparent and easier to implement than a clumsy maximum-price diktat. Of course, smuggling to avoid the tariff will be inevitable (especially if the tariff rate is set too high) but implementing a tariff can build upon the West’s long-standing value-added-tax and customs infrastructure to enhance enforcement. The private sector would be more comfortable with absorbing a tariff (a fact of life) than a newfangled price cap, reducing damage to the economy. A price cap, on the other hand, would force the private sector to run through yet another gauntlet of price inspectors checking every transaction for compliance, and would likely engender a riot of illegal activity and lawsuits while deterring legitimate investment.
And as a bonus, the tariff revenue will be collected not so much by non-Western arbitrageurs but by Western governments for use in Ukrainian post-war reconstruction or other worthy causes. Sadly, the initial suggestion of a tariff by U.S. Treasury Secretary Janet Yellen seems to have gone nowhere, leading to her subsequent support for this nonsensical price cap.
Of course, the one thing a tariff does not do is reduce immediate oil prices and relieve inflationary pressure in the West. Unfortunately, no one (except maybe Saudi Arabia, depending on its spare capacity) can deliver such an outcome and begging non-Western producers to produce more is not a geopolitically sound energy strategy. The iron laws of the market dictate that there's no free lunch and the United States (with its intolerance for higher hydrocarbon taxes) and particularly the European Union (with its blithe over-dependence on Russian hydrocarbons) are now paying the price for a generation of poor energy policy. We should not add to this disappointing legacy with a pointless price cap.
Daniel P. Ahn
Daniel P. Ahn is a global fellow at the Woodrow Wilson International Center for Scholars and a former chief economist of the U.S. Department of State.
The opinions expressed herein are solely those of the author. Photo shared under a Pixabay license.