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Why oil import restrictions hurt Russia more than the price cap

Sanctions in response to the invasion of Ukraine led to a substantial decline in Russia’s crude oil revenues in 2022 and 2023. This column argues that the decline in revenue was due almost entirely to the embargo on Russian crude oil imports, which forced Russian oil exports to be redirected from Europe to more distant customers in Asia and conferred market power on India and China. In contrast, while a price cap deprived Russia of financial resources that were spent on additional tanker purchases, its effect on the Russian oil export price was negligible. The findings demonstrate the importance of considering economic realities when desgning sanction regimes.

Russia’s crude oil revenues declined substantially in 2022 and 2023 as voluntary and formal sanctions were imposed in response to the invasion of Ukraine. The formal sanctions imposed at the end of 2022 comprised an embargo on Russian crude oil imports and a price cap that allowed countries not participating in the sanctions the use of Western maritime services for imports of Russian crude at prices below the cap. There has been an ongoing debate among policymakers and academics about these sanctions and their effectiveness (e.g. Johnson et al. 2023).

In recent research (Kilian et al. 2024), we make the case that the decline in Russian oil revenue in 2023 was due almost entirely to the embargo, which forced Russian oil exports to be redirected from Europe to more distant customers in Asia and conferred market power on India and China. In contrast, while the price cap deprived Russia of financial resources that were spent on additional tanker purchases, its effect on the Russian oil export price was negligible. The main benefit of the price cap was to persuade the EU and the UK to abandon its plans for a general ban on Western maritime services for transporting Russian oil, which could have triggered a global shortage of crude oil and a recession.
Why the G7 oil price cap was introduced

When the global community planned its response to Russia’s invasion of Ukraine in 2022, aspirations to defund Russia’s economy via sanctions were ambitious. Some, including Johnson and Hosoi (2022), advocated for a near-complete ban on Western purchases of Russian crude oil and refined products. Such aspirations were tempered by concerns that isolating Russia would harm the global economy. In 2020, Russia produced 11% of global oil, far more than it consumed domestically. Cutting Russia off from the world oil market would have damaged Russia’s economy and reduced its ability to fund the war effort; but it would also have risked spiking global oil prices and sending the world into a recession.

Against this backdrop, the EU, the G7, and other countries imposed voluntary restrictions on Russian oil exports while developing a plan to impose formal sanctions on Russia. Initially, the EU’s sixth sanctions package, which was announced in June 2022 and was to take effect in December 2022, included an embargo on Russian crude oil and a ban on the use of Western maritime services to transport Russian oil by sea. While the embargo allowed Russia to sell its oil elsewhere, the idea of a ban on the use of Western financial services to transport Russian oil raised concerns that Russia would be unable to export its oil at all, given that most oil shipping worldwide relies on Western insurance and related financial services.

In response to this dilemma, at the suggestion of the US Treasury, the G7 proposed a price cap that would relax the maritime service ban beginning in December 2022. Under the price cap, oil and refined products sold at a price below the cap would be allowed to use Western maritime services. The goal was twofold: punish Russia by limiting its market to distant buyers, thereby reducing the price Russia receives for its oil (more on this below), and curtail Russia’s ability to finance the war in Ukraine by capping the price it would receive for oil exported using Western maritime services (Van Nostrand 2023).

Explaining the decline in Russian oil export revenues

A question of great policy interest is whether the embargo and/or the price cap reduced Russian oil export revenues and diverted Russian resources away from the war effort, and how this outcome was achieved. Our study is the first to provide quantitative evidence of the effects of these sanctions. It draws attention to four key facts. First, Russian oil export revenue declined substantially in 2022 and 2023 due to a reduction in the price it received for oil sold abroad. Russia’s oil export volume, in contrast, remained roughly constant. Second, about half of the price discount Russia was forced to accept on its crude oil exports was a result of needing to absorb higher shipping costs associated with selling to India and China, which are located much farther away than Russia’s previous customers in Europe. Third, there is evidence that the remainder of Russia’s oil price discount was the result of increased Indian and Chinese market power. As the only remaining buyers that could absorb large quantities of Russian oil exports, these countries were in a position to take advantage of Russia’s need for oil revenue to fund the war effort. Fourth, the G7 price cap, while serving the important political objective of relaxing the ban on Western maritime services to transport Russian crude, had little to no effect on the oil price received by Russia. This can be seen by examining the pattern of Russian oil export prices in 2023 relative to the price cap.

Understanding the impact of the price cap on the oil price received by Russia

Figures 1a and 1b show that the price Russia received for its oil in 2023 was systematically lower than the Brent price, which is a commonly used benchmark for global oil prices. Whether the price received by Russia exceeded the price cap of $60/bbl depended on the time and export location. The price of exports of Russian Urals crude from Black Sea and Baltic Sea ports in Figure 1a was below the price cap for the first half of 2023, implying that the price cap was irrelevant to the determination of the price that Russia received. These shipments were unfettered by restrictions on the use of Western maritime services. In the second half of 2023, however, the discount that Russia was forced to accept on its Urals crude decreased. Clearly, either the price cap was not being enforced or shippers of Russian oil had sufficient access to non-Western maritime services to transport oil, consistent with the emergence of a large ‘shadow’ fleet of tankers operating outside of the Western services umbrella (or some combination thereof). In contrast, Figure 1b shows that the corresponding price Russia received for its Pacific (ESPO) crude was above the price cap throughout 2023. Again, the availability of a shadow fleet, along with ineffective Western enforcement of the price cap, can explain these results.

What we have learned with the benefit of hindsight

While there is a range of less direct channels by which a price cap or the announcement of a price cap might have influenced the export price of Russian oil, we show that there is no empirical support for these alternative explanations. Our findings are in stark contrast to the expectations of many market participants, policymakers, and commentators at the time the sanctions were imposed. For example, Tsigas et al. (2022) estimated that an allied trade embargo would reduce Russian real GDP by 14%, while the US Treasury was expecting that the price cap would reduce the probability of a sanctions-induced Russian oil supply shock and curtail funding for Russia’s war effort. Some observers also expected the mere announcement of the price cap to lower the global price of oil and Russian oil revenues substantially.

These expectations appear, in retrospect, to have correctly anticipated some effects while missing others. The embargo on imports of Russian oil appears to have been implemented successfully by the EU and its allies, with significant effects on Russian export revenues, as described above. However, many analysts appear to have under-estimated the ease with which a shadow fleet would be brought to market, or the difficulty of enforcing the price cap policy that, in essence, sought to prohibit highly profitable trade between willing market participants operating outside of the sanctions regime. US Treasury officials who designed the price cap were aware of the requirements for its success: effective enforcement and the absence of a shadow fleet (e.g. Johnson et al. 2023). It appears, however, that these requirements were more difficult to achieve than was expected initially, which explains recent efforts by the US Treasury to tighten the enforcement of the price cap.

Why it matters how the reduction in Russian oil export revenues was achieved

Over the past 70 years, sanctions have become an increasingly popular alternative to armed conflict for resolving international disputes (e.g. Morgan et al. 2023). Yet imposing sanctions on a large, resource-rich country like Russia may result in unintentional consequences for countries not being targeted, and even for the sanctions-imposing countries themselves. It is thus essential to learn from past and current sanctions regimes whether sanctions have been effective and, if so, for what reasons.

The lessons learned from the ongoing sanctions on Russian oil can be distilled into three lessons. First, trust only in what you can control. Countries have the agency to buy (or not to buy) from whichever country they choose. Second, attempts to restrict or compel behaviour that is misaligned with the incentives of non-participating countries are extremely difficult to enforce. Large financial benefits of circumventing sanctions are usually too attractive to forego. Finally, economic constraints will carry the day. The embargo on Russian oil has succeeded due to the real economic cost of shipping oil over long distances, and due to the higher bargaining power conferred to the few remaining buyers.
Source: CEPR

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