Originally published on Forbes.com on December 4, 2022

A disparate oil-purchase response of European countries to the war in Ukraine makes the oil-cap agreement quite remarkable. It will also be successful if the oil price cap of $60 /bbl is low enough to reduce Russian export revenue but high enough to keep Russian oil flowing to markets.

Are sanctions imposed by the West on Russia working? Russia is a primary exporter of crude oil (about 5 million barrels a day) and refined oil products: gasoline and diesel (about 3 million barrels a day). These amount to roughly 40% of Russia’s total export revenues.

In contrast, export revenues from natural gas amounted to only 5% in 2019 compared with 26% for crude oil plus refined products. There is not much to be gained by restricting gas exports from Russia, but everything to be gained by the West restricting exports of crude oil and its refined products.

Russia collected an enormous amount, $430 billion, over the last 12 months from oil and gas exports to Europe alone. One estimate is that revenue from Russia’s crude oil exports has increased by 41% in this time, due to high global prices of oil.

Sanctions related to crude oil have not worked when applied to Russia. Even though it’s complicated, the West has not given up, and has recently introduced what looks like the mother of all oil-related sanctions.

Changes in oil imports by European countries.

It is insightful to see how European countries have responded to the war Russia imposed on Ukraine, which began in February 2022. Figure 1 shows the results from November 2021, before the start of the Ukraine war, until May 2022.

Slovakia and Hungary, two landlocked countries highly dependent on Russian oil, both increased their imports significantly. Conversely, Finland and Poland, also highly dependent, radically decreased their imports of Russian crude.

The large economies of Germany and the Netherlands reduced their imports significantly, as frequently reported in the press, as did Belgium. But other strong economies did not. France was unchanged while Italy nearly doubled its oil imports.

There was no consensus in actions by these countries to reduce imports of Russian oil, in spite of what’s been reported. Possibly this was the motivation for EU leaders to gather last September to hammer out an agreement to reduce oil and its refined products from Russia. Although it took a couple of difficult months, this data makes it seem remarkable that three agreements central to Europe’s future were achieved.

Three agreements since December 1, 2022.

Three agreements are due to kick in on Monday, December 5. The first agreement is a price cap on oil bought from Russia. This was determined by the G7 group of industrialized economies which consists of the US, Canada, the UK, France, Germany, Italy, Japan, as well as the EU.

Why is this important? Russia’s exports of crude oil and refined oil products (gasoline and diesel) constitute a disproportionate fraction, 40%, of the country’s export revenues, which are considered to pay costs of the war on Ukraine. If their exports of oil are reduced or stopped, this would squeeze the profiteering by Russia.

The price cap was set at $60 per barrel (/bbl) – low enough to reduce Russian export revenue but high enough to keep Russian oil flowing to markets.

The second agreement by the G7: Nations that try to cheat and pay above the cap to import oil from Russia will not be able to insure their oil tankers using the big insurance companies out of western places like London.

Russia says it will cut all energy supplies if the G7 implements this agreement, but this is unlikely as Russia needs to export all the oil it can – it’s their major export revenue to offset their economy which is shrinking.

The third agreement stems from EU nations: Most of these 27 nations won’t be able to buy Russian crude oil delivered by sea starting on December 5, 2022. And they won’t be able to buy refined oil products coming by sea from Russia starting two months later on February 5, 2023.

For a few EU countries such as Hungary and Slovakia, this agreement is a moot point because they are landlocked. Slovakia (81% now) and Hungary (64% now) increased their oil imports from Russia from November 2021 to May 2022 (Figure 1), perhaps because they anticipated EU cuts of Russian oil and its products.

The UK and US have already banned imports of Russian oil.

The big question — will the cap help or hurt?

The EU set the oil price cap at $60 /bbl – ideally low enough to reduce Russian export revenue but high enough to keep Russian oil flowing to markets.

Poland wanted a cap at $20/bbl, perhaps because it got almost 40% of its oil from neighboring Russia in May 2022. Ukraine wanted $30/bbl to cause a heavier hit on Russia. Many nations in the EU wanted $65-$85/bbl to ensure stability in the global oil market. A compromise settled on $60/bbl.

The EU wanted to avoid a worldwide oil shortage. They may have remembered what happened in the OPEC oil embargo of 1973-1974 when OPEC reduced their production of oil which led to a global shortage. OPEC also stopped sales of oil to the US and other countries that supported Israel in the Yom Kippur war. Global oil prices quadrupled from $3/bbl to nearly $12/bbl and surged even more in the US. This episode came to be known as “the first oil shock”.

Could EU countries be hurt by the sea-going oil import ban? Countries in Figure 1 such as France and especially Italy who have not been reducing their imports from Russia would be affected more. Note that Italy’s largest refinery is owned by Lukoil, a Russian company, and it contributes a fifth of Italy’s refining capacity.

Germany and Netherlands have been lowering their imports from Russia so they should be in better shape. One practical solution would be for EU members to buy oil from other exporting countries, such as the US.

The EU has said the new agreements could reduce its Russian oil imports by 90%, which would make it a decidedly successful sanction, although the sanction is expected to take months to reach its full effect.

Meanwhile, of course, Russia will be striving to boost its oil sales to other countries. China and India are big countries that need a lot of oil, and they are already buying more from Russia. China and India have been steadily importing 1.1 million b/d and 0.8 million b/d, respectively, from Russia since May 2022. Before the war on Ukraine, China was at 0.9 million b/d while India imported virtually nothing from Russia. India’s imports from Russia have increased by 0.8 million b/d and that’s a lot of oil from just one country.

Recent numbers of sea-going oil shipments reveal Russia exports close to 3.1 million b/d by sea. After about 1.9 million b/d to China and India, Turkey imports 0.35 million b/d, Italy 0.34 million b/d, and Netherlands 0.23 million b/d.

It’s unclear what effect the proposed oil cap of $60 /bbl will have on these countries who are already buying Russian crude at a discount. Earlier in 2022, Russian Urals crude oil was discounted $30 / bbl from the global benchmark, Brent crude. The discount made it $20 cheaper by the end of September 2022.

On top of this, sanctions on Russian banks by the West are making it difficult for the main importer, India, to pay for Russian oil in roubles rather than rupees or dollars.

Takeaways.

The oil-purchase response of European countries to the war Russia imposed on Ukraine has been disparate, which makes the oil-cap agreement quite remarkable.

The large economies of Germany and the Netherlands reduced their oil imports from Russia significantly. But other strong economies did not. France was unchanged while Italy nearly doubled its oil imports.

Russia’s exports of crude oil and refined products (gasoline and diesel) constitute a disproportionate fraction, 40%, of the country’s export revenues, which are considered a well of money to pay costs of the war on Ukraine. If their exports of oil are reduced or stopped, this would squeeze the profiteering by Russia.

The EU oil price cap at $60 /bbl ideally avoids a worldwide oil shortage. They may have remembered what happened in the OPEC oil embargo of 1973-1974 that led to a global shortage and worldwide oil prices quadrupled from $3/bbl to nearly $12/bbl.

The EU has said the new agreements could reduce its Russian oil imports by 90%, which would make it a decidedly successful sanction, although the sanction is expected to take months to reach its full effect.

Though the measures will most certainly be felt by Russia, the hit will be softened by Russia’s determination to sell its oil to other markets such as India and China – which are currently the largest single buyers of Russian crude oil. It’s unclear what effect the proposed oil cap of $60 /bbl will have on these countries who are already buying Russian crude at a discount.