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Imposing A Price Cap On Russian Oil Is An Ineffective Way To Force Russia Into Peace – Paul Tolmachev

Linear simplistic logic is an excellent way to quickly satisfy the political demands of the electorate. The Western public’s demand for restrictions on the Russian Federation’s ability to continue its policy and the corresponding active measures are satisfied by Western political elites in the spirit of the leftist-populist agenda that has been dominant in most developed countries for the last 20 years. The real effectiveness of the decisions of the authorities of the collective West, primarily in Europe, with respect to the Russian Federation goes far behind the loud proclamations and the false reality that are so quickly sold to the electorate.

In particular, I am referring to restrictions on the export of Russian oil and its redistribution as the main source of export revenues for the Russian budget and the ability of the current government to finance its policies.

The ineffectiveness and actual meaninglessness of such restrictions – both the decision to refuse to buy tanker oil and petroleum products and the discussed price cap – becomes clear on closer examination in light of realities and data.

Why is the oil embargo ineffective? Lets me remind you briefly.

First, replacing oil revenues with other sources of financing for the implementation of the chosen political course is not too difficult a task for the Russian government. The low level of treasury debt at 21% of GDP and low interest rates on deposits make it possible to borrow an additional 5%-10% of GDP. This would increase the national debt to the same non-critical 25-30% of GDP. Raising the rates on deposits will increase the amount of assets of commercial banks, which will eventually go towards the purchase of government bonds. Besides, the assets in the accounts of the Ministry of Finance allow to execute all budget expenditures in full for quite a long period – just over 12 months.

Second, Russia has the highest share in the volume of the world’s traded exports, which amounts to 17%, i.e. every sixth ton of oil traded in the world between countries is of Russian origin. In case any buyer refuses to buy a considerable part of this volume, this part will be redirected to another buyer. In this case it is possible to discount the price from today’s market levels, but this will simultaneously mean pressure on the market prices tomorrow, which will generally reduce the actual discount. In the case of a hypothetical situation when Russian oil is completely blocked, the subsequent market disequilibrium will create a giant inflationary overhang, because it is impossible to promptly replace such a huge hypothetical deficit. And with the already difficult situation in the world economy, balancing on the verge of recession, and high inflationary pressure, such a situation will send economies not just into recession, but into depression. This is obviously unacceptable to the political authorities of developed countries. This is one of the reasons why I call the situation with the complete blockade of Russian oil exports hypothetical, or, rather, impossible.

What are the realities?  The equilibrium in the market is preserved, and the share of the main exporters fluctuates insignificantly. Russian oil was actively filling the European market before the embargo began. At the same time, Asian buyers are using the existing discount to increase Russian purchases.

This is an important factor for maintaining a balance even after the embargo is imposed. The European side will need to replace the falling out imports from Russia, and it will do so, including by increasing the volume of supplies from the Middle East. Middle Eastern sellers will be forced to reduce the corresponding supply volumes to other buyers, particularly Asian countries.  And here Russian oil will compensate for those very falling out volumes, providing itself (even with a discount) with a sufficient cash flow to maintain macroeconomic and fiscal stability. As a result, the market equilibrium necessary for both producers-sellers and consumers-buyers of oil in the world is preserved in any case. As has been said before, significant distortions will lead to extremely painful consequences for the whole world economy and all its agents, which they are certainly not interested in, to put it mildly.

We should also not forget that, given the state domination of the Russian economy and its corresponding structure with oil and gas dependence, the volume of production and uninterrupted sales in general is more important than the price. The continuous cycle of production, processing of sales and transportation provides a multiplicative effect both for the oil and gas complex itself and for many related industries and other industries. As long as this cycle persists, the existing economic system in Russia is functional and the social situation is stable, despite the inevitable decline of GDP and the quality of life of the population. 

Thus, neither before the start of the embargo on Russian exports to Europe, nor afterwards, the decision taken cannot significantly affect the Russian government’s ability to ensure the fulfillment of budget expenditures, regardless of their volume and direction.

As for the price cap for the Russian side as a seller, such an idea looks even more populist and helpless than the adopted embargo. In fact, the idea of the embargo meant limiting the volume of Russian exports, i.e. the embargo is aimed at reducing total revenues as a source of formation of the Russian budget. The price cap, on the other hand, means limiting revenues, i.e. the level of profitability and, accordingly, the profit of the Russian side, which merely reduces budget revenues. This will have even more insignificant consequences for the Russian side.

An important point lies in the way in which the revenue side of the Russian budget, which is targeted in particular by the price cap, is formed.  The Russian budget is accounted for and executed, of course, in the national currency, that is, rubles. Due to the fall in imports of goods and the actually insignificant reduction of raw hydrocarbon exports, the national currency has strengthened considerably, which negatively affects the revenue side of the budget. (This, by the way, is one of the important points in the discussion of the real threats and risks for the Russian economy, consisting, in particular, in a hypothetical complete embargo on all imports).

The depreciation of the ruble is now an important real factor in reducing the economic capacity of the Russian government to finance the chosen political course, because it is necessary to balance between preservation of budget revenues (and this requires a weak ruble) and social stability, which depends primarily on stable purchasing power, i.e. on inflation – for what a strong ruble is needed.

In order to increase ruble financing of priority budget items, such as the military defense complex, it is necessary either to raise the ruble exchange rate or increase sales of the gross product, i.e. to increase the economic result one way or another. To preserve social loyalty and stability, the Russian government logically chose to increase export deliveries even at a discount, because to increase budget revenues at the expense of an exchange rate increase in export revenues means weakening the ruble, which is not advisable for social policy.

The imposing a price cap will actually reduce the amount of convertible currency, i.e. dollars flowing into the economy, which will naturally increase the ruble value of the budget, i.e. increase its revenues. The Ministry of Finance will continue to balance the budget, but now at the expense of the exchange rate difference.

Of course, ruble appreciation may have a negative impact on consumer opportunities and increase inflation, creating social tension. However, the government is quite capable of increasing government spending to maintain stability through social programs, state order, indexation and direct subsidies. It can do this, as mentioned above, for example, by increasing the volume of government debt and raising the rate on deposits, which, incidentally, may reduce consumer activity and offset the inflationary effect of the weak ruble.

Let’s assume that a price cap is imposed, and Russian oil has restrictions for exports to Europe at the level of the purchase price, for example, no more than $50 per barrel. Obviously, other buyers of Russian oil – other countries – will also not want to buy Russian oil for a higher price. Moreover, some of them will want to buy Russian oil at $50 and then, bypassing the conditions for secondary sanctions on the resale of Russian oil (there are plenty of mechanisms and technologies for such operations, as the example of Iran, among others, shows), will sell it at the real market price.

It would seem that the Russian side will really be limited in the amount of revenues coming from oil. However, no one has limited Russia’s ability to sell oil for $50. Therefore, the Russian side, as a rational economic agent, will try to find a new balance of benefits and costs. It will decide to whom and what volumes to supply.

This means that by redirecting volumes, for example, to India, Russia will not supply this volume to Europe. Europe, in order to replace these missing volumes it will have to buy them from another seller, for example, from India, but at market price, or at least at a higher price than the ceiling price. Accordingly, the cost of this very “Indian” oil will be higher than that determined for Russia.

In case the alternative seller for Europe is not the conditional India with its “Russian-Indian” oil, but the Middle East with its real, Middle Eastern oil, then these falling out supplies from the Middle East to India, which will now be directed to Europe, will again be compensated by Russia. Oil sales between India, the Middle East and Russia will not be as strictly controlled and regulated as those with Europe or other countries that have joined the price cap.

In the end, we have all the same equilibrium, only formed in a different sequence.

In addition to the above, Russia has a significant advantage by being able to decide to whom and when it will increase export flows. And this means that the ability to influence the overall balance of world oil exports and supplies will remain virtually at the same level. However, the Russian side will now have greater leverage to obtain the benefits it needs from countries that can increase imports of the goods it needs in exchange for an increase in oil supplies to resell these countries’ surpluses at market prices and make additional profits.

Arguments about regulatory and supervisory mechanisms on the part of the countries participating in the sanctions coalition do not look realistic. These measures include both secondary sanctions for countries and companies that do not comply with the terms of the sanctioning countries, and, for example, indirect restrictions: for example, a ban on transport insurance, etc. Without going into details and procedural details of why this will not work, or at least will be extremely ineffective as a result, we can say that such mechanisms are, in fact, direct interference in the complex market mechanism of the integrated world economy – no matter how well-intentioned such interference may be justified. And this, first, means risks associated with regulatory distortions of the market, and second, the market and its participants will be able to adjust and adapt to maintain benefits and costs at a level of efficiency acceptable to them in any environment, whether it concerns individual economic agents or entire countries. 

Are there any measures or solutions capable of creating really significant risks for Russia and somehow affecting the sustainability of the macroeconomic and social situation in the country? Absolutely, but this is a topic for a separate discussion.

Selling the simplest and, at first glance, most effective solution to gain electoral loyalty is the simplest, most linear and often most effective way for socio-populist political elites in democracies to gain or retain power. But this approach has an extremely short planning horizon, since any such solution, once implemented, soon turns out to be ineffective and have large side effects. To eliminate these inevitable side-effects, elites make no less populist decisions, thus prolonging their life cycle time after time in as linear and primitive a way as possible. This happens until “nullification” occurs – an economic and socio-political crisis of varying degrees of severity, when the effect of a suddenly low base allows more complex but more effective and long-term decisions to be made. We have had the opportunity to observe this constant populist policy in developed and developing countries over the past 20 years.

The measures such as imposing oil price cap offered by the international sanctions coalition to limit Russian budget revenues obviously belong to this very category of populist solutions. They are aimed at satisfying the immediate wishes of the voter and have an extremely short horizon, after which the inevitable risks will either force the elites to make more balanced and complex decisions (which, incidentally, are overdue not today and not even 5 or even 10 years ago) or will lead to significant changes that will allow such decisions to take place.

So, we will be watching.

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The Russian-born Paul Tolmachev is portfolio manager at BlackRock (London, UK) with more than $500 million in personally managed assets. He also is a visiting scholar at the Stanford Institute for Economic Policy Research, where he researches institutional and political economy, decision science and social behavior. Paul Tolmachev is a Certified Professional in Philosophy, Politics and Economics (PPE Program), Duke University. Having 20 years’ experience on the financial markets, Paul Tolmachev held management positions in leading Russian and international investment and wealth management firms. As a research scholar for the past few years, he has also specialized in the analysis of macroeconomics, politics, and social processes. Paul is a columnist and contributor to a number of international think tanks and publications, including Duke University, Mises Institute, Eurasia Review, Investing.com, etc.