Europe struggles to renounce Russian energy
Given the region’s significant dependence on Russian piped natural gas, most of the European Union members and Ukraine’s other allies have been careful, so far, to avoid implementing sanctions that could disrupt flows of natural gas. Nevertheless, flows have been curtailed significantly.
Initially, Russia cut gas flows to European nations that did not accept new RUB-based payment terms for Russian gas (i.e., Poland, Bulgaria, Finland, Denmark, and the Netherlands). Second, gas flows through the Nord Stream 1 pipeline have been reduced to 40% of capacity since mid-June. Russia claims the absence of a turbine, stranded in Canada due to the sanctions the latter introduced against Gazprom, caused the reduction, while Western officials see the reduction as politically motivated. Although Canada recently agreed to return the repaired turbine to Germany, worries around gas flows persist, coalescing around the Nord Stream 1 maintenance period from 11–21 July and the question of whether gas flows will resume afterward. Russia’s ability to disrupt flows also extends to other regions: It recently expanded control over an LNG project in the Sakhalin oblast, which ultimately could further reduce the available supply of gas globally and increase the competition for limited LNG cargoes, thereby increasing costs for all consumers.
The European Union agreed at the end of May to phase out the import of Russian oil and petroleum products by the end of this year, though exemptions have been granted to a few Eastern European nations, most notably Hungary, for piped oil. The ban should affect roughly 90% of Russian imports and includes a prohibition against providing insurance for transporting Russian oil. Currently, Ukraine’s allies are discussing the introduction of a price cap for Russian oil that would likely fall within a USD 40–60 per barrel range, according to media reports. The goal here is to keep Russian barrels in the market without allowing Russia to reap the benefits of high prices. We are skeptical that such a price cap would achieve the desired effect. Implementation of such a mechanism would depend on Russia being unable to find customers willing to buy at higher prices or on it not curtailing exports when prices offered are deemed too low. With a cap well below market prices, demand for those discounted barrels would likely be very strong. Asian refineries could opt to pay prices above the price cap to secure higher supply of discounted barrels and to avoid paying higher market prices.
Russia’s oil production has recovered since April, and while its oil is selling at a discount, it has significantly expanded deliveries to China and India. Europe has reduced its imports since the start of the war but is still importing considerable amounts, as well. Russia is also able to affect dynamics in the wider oil market via its membership in the OPEC+ group of producers, the influence it enjoys in Libya (where some Russian mercenaries are present), and the regulatory power it wields over the pipeline delivering Kazakh oil to the Black Sea, as the export terminal is located in Russian territory.
Russia can weather a period of lower export revenues
Surging prices for energy and other commodities, combined with ongoing exports, have contributed to a massive current account surplus for Russia this year: USD 68bn in 1Q22 and USD 70.1bn in 2Q22, significantly above the ranges of prior years. Oil and gas budget revenues remain important for public finances, but Russia’s low debt level and (so far) contained budget deficit should enable it to weather a period of lower export revenues. Reduced energy exports at lower prices amid a tightening sanction regime would pose significant challenges to Russia’s economy in the long term. But Russia’s leadership may be willing to employ its leverage now when curtailing supply unilaterally in a tight market will would likely push up prices for the remaining exports, in anticipation of reestablishing or rerouting exports at a later point in time.
Downside risks have increased
In sum, we think that Russia has demonstrated its readiness to use energy flows as a tool to increase pressure on its adversaries in recent weeks, regardless of forgone export revenues. If current conditions hold, the European economy would likely still be able to avoid gas rationing, but the likelihood that Russia further limits its supplies is considerable, in our view—at least as likely as the former.