Putin Can’t Count on the Global Oil Market

The oil market became truly global only three decades ago with the collapse of both the Soviet Union and the barriers created during the Bolshevik Revolution a century earlier. That coincided with the economic rise of China, which turned an energy self-sufficient albeit poor country into the world’s largest importer of oil. While there have been some restrictions in the global market since then—notably, sanctions on Iran and Venezuela—economic efficiency has largely determined how barrels flowed around the globe. Until now. In the months following Mr. Putin’s invasion, the European Union and the U.K. announced they would prohibit the import of Russian crude oil effective Dec. 5. They also agreed to ban insurance and shipping “services” by their companies for Russian crude-oil shipments anywhere in the world. This meant that Moscow would be cut off from what had been its largest market— nearly four million barrels a day— and that much of the world’s tanker fleet would no longer be able to carry Russian barrels. The U.S. was alarmed by Europe’s impending prohibition, fearing it could lead to a world oil shortage and spike in prices. Thus the Biden administration developed an ingenious idea: a price cap. The policy is intended to keep Russian oil flowing while reducing the Kremlin’s earnings from oil exports. After intense negotiation, the U.S., EU and Group of Seven adopted a cap at $60 a barrel, to be reviewed periodically. As long as Russian oil is bought below $60, a trader can handle it, a broker can insure it, and a tanker can carry it. The details of the cap are complicated. Players along the value chain, from initial purchaser to shippers, must “attest” that they didn’t exceed the price cap. The penalties range from public shaming by their governments to large fines and outright sanctions. The policy is working so far, thanks to a slowing world economy that has weakened petroleum prices, fear of unknown liability among market actors for violating the cap, and higher tanker rates. The current price of Russia’s main export barrel is in the mid-$40s—about 45% below the benchmark price for oil and more than 33% below the estimated $70 price on which Russia’s 2023 budget is based. This steep drop is welcomed by countries like India, which imports 85% of its oil and has gone from a negligible importer of Russian oil to vying with China to be the largest importer, albeit at heavily discounted prices. Weak global economic growth will continue to facilitate the effectiveness of the price cap, keeping the market in a surplus and holding prices down. That could change if global oil demand spikes—say, on the heels of China’s lifting its zero-Covid policy. But such a rebound is down the road. The more immediate challenge comes in February, when the price cap will be extended to “products” produced by Russian refineries. That includes gasoline and diesel, the latter of which is essential to European transport. Mr. Putin, who has denounced the price cap as “stupid” and “robbery,” has made clear that he can’t stand Western countries’ setting the price of his oil. The Kremlin has assembled a “shadow” armada of 100 or more secondhand tankers that will attempt to evade the ban on Western tankers. Chinese and Indian companies can provide some of the missing maritime insurance, but that will still leave a significant gap. The most potent weapon in Mr. Putin’s arsenal is a production cut. He has already pursued that strategy with natural gas, inflicting significant hardship on the Continent. In an October speech, Mr. Putin cited Milton Friedman: “If you want to create a shortage of tomatoes,” put on price controls, and “instantly you will have a tomato shortage. It’s the same with oil or gas.” (Mr. Putin noted that Friedman can’t be “branded a Russian agent of influence.”) He has renewed the threat of “a possible cut in production” and this week is expected to issue a decree banning sales to countries observing the price cap. Mr. Putin has been nudging the Organization of the Petroleum Exporting Countries Plus—the group of oil-exporting countries of which Russia is a part—to embrace another production cut, but so far to no avail. In its place, Russia might cut its exports by a million or more barrels, hoping to tighten the market and send prices upward. The Kremlin might calculate that the resulting increase in price would more than offset the losses from the lower volumes of exports. The aim would be to create a shortfall, additional economic pain and a mad scramble for supplies, with the ultimate goal that countries would be pitted against each other and the coalition supporting Ukraine would splinter. That has been Mr. Putin’s playbook on European natural gas, too, which he’s hoping will succeed this winter, possibly aided by further disruption in gas supplies. Yet there’s a crucial distinction between the gas and oil markets—and an additional constraint with which Moscow must contend. Sharp oil cuts and the attendant price increases would be felt not only by European countries but also by those important to Russia, namely India and China, which together received about 70% of the country’s total seaborne crude-oil exports in December. A Russian production cut would require more-intense collaboration among Western countries and companies, but they might be able to offset the effects by withdrawing more from the billion-plus barrels held by the U.S. and other allies in strategic reserves. Even then, such drawdowns might not be necessary given the current downward pressure on oil demand. A production cut could well end up adding to the Kremlin’s long line of miscalculations. In cutting output, it would be assuming that higher prices would compensate for the reduction in volume. But after a spike, Russia might find that prices don’t make up for the lost production. The result would be a further cap on its critical oil revenue. And this it would have done to itself.