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How the Russian Government Keeps Getting Richer: Why the Price Cap on Russian Oil is Failed – Paul Tolmachev

I have written about the real inefficiency of the restrictions imposed by Western countries on Russian oil imports repeatedly and in detail throughout the year 22. Now, at the end of February 2023 and after the first months of the price ceiling, it is safe to say that this inefficiency is confirmed and is gaining momentum: it is impossible within the global market to neutralize one of its significant integrated players by exogenous and directive regulations, while leaving a huge room for maneuver. In fact, it could not be otherwise – simply by virtue of obvious and unavoidable factors, which I and many respected colleagues spoke about long before.

However, in the expert and information space – both in Russia and the West – the position that the embargo and the price ceiling will significantly reduce the revenue opportunities of the Russian budget is still dominant. This point of view, both by government representatives and broadcast in the media, may be due either to a superficial look at factual data, or to a deliberate (for various but understandable reasons) ignoring things that are obvious when examined in more detail. 

Without touching on the political nuances and assessments, in this text I would like to show in a cursory, simplified and generalized way why no significant consequences for Russian oil export revenues and the targeting of their direct beneficiaries from the introduction of a price ceiling on Russian oil exist and are not foreseeable in the near future. Moreover, we cannot rule out the probability that the gross revenue from crude oil exports will exceed the average figure for the last few years in 2023.

As I noted earlier, to declare that all Russian oil is now sold at a large discount and that the budget is and will continue to be under-received in this regard is to wishful thinking or to manipulate public opinion.

First of all, it should be clearly understood: the discount of the Russian oil Urals to Brent is applicable only to the oil, which is still supplied to Europe, or rather, to several European countries, including Hungary, Slovakia, the Czech Republic and Bulgaria. This is oil that is now pumped mainly through the Druzhba pipeline, and in much smaller volumes than before, delivered by tankers, which amounts to about 2 million tons per month – about 20% of the former crude oil exports to Europe.  Indeed, this oil is worth less than $50 a barrel. However, the remaining 80% of former European supplies are quite successfully diverted to Asia, where it is sold at actual market prices at a slight discount to the Brent price.

For a clearer understanding of the picture let’s turn to the details, revealing superficial judgments and unworked estimates, and look at things soberly.

For a reference point and as comparative data, it makes sense to take the results of Russia’s oil exports in 2021. First, the regional allocation of exports was close to a decade-long average, which cannot be said about the year 2022, let alone the beginning of 2023. And second, the fact that the physical volume of crude oil exports in 2021 was at the lower end of the range for the past several years will make estimates and a more conservative view of the near future.

So, in 2021, Russia’s total crude oil exports were approximately 231 million tons of oil, or 1 billion 663 million barrels. Of these:

– 30% went to China by pipeline and from the port of Kozmino, which is about 69.3 million tons, or 499 million barrels

– 23% went to other countries, not including the EU, which is 53.13 million tonnes or 382 million barrels

– 47% went to the European Union, amounting to 108.6 million tonnes or 782 million barrels

Shipments to the EU were structured as follows:

– 60%, i.e. 64.6 million tons, or 467 million barrels, were tanker shipments

– 40%, i.e. 43.2 mln tons or 311 mln barrels were supplies by oil pipelines.

On the whole, converting oil export estimates into barrels (1 tonne of oil is approximately 7.2 barrels), we can say that Russia supplied Europe with about 2.16 million barrels a day: 1.297 million barrels of tanker oil and 864,000 barrels of pipeline oil.

The average selling price of Russian oil in 2021 was $66 per barrel.

Accordingly, total annual export revenues were about $108 billion, of which:

– $33 billion went to China,

– $23 billion went to other countries, excluding the European Union, and

– The European Union accounted for $52 billion.

Daily sales to the EU were about $143 million in 2021.

With the imposition of the embargo and the price ceiling, oil shipments to Europe have fallen, as noted above, to 20% of the previous volume, that is, to 21.7 million tons per year, or 1.8 million tons per month. In barrels, that’s about 156 million tons per year, 13 million barrels per month and 434,000 barrels per day, respectively. The reduced volumes now go mainly through the Druzhba pipeline and in very small quantities by tanker from several Russian ports.

I will not dwell on the explanation of the process of formation of the Urals quotation in Europe as a factor that affects the adequacy of the Russian oil price assessment in general. Let us assume as a fact that the discounted price of Russian crude oil in Europe today is about $50 per barrel.

Then the volume of current exports to Europe at the current price of Urals in Europe in monetary terms will be $21.7 million a day, $651 million a month and $7 billion $812 million a year, respectively. The fall in annual export volumes to Europe from the 2021 figures is $44 billion, taking into account the 2021 average price of $66 per barrel and the current price of Russian oil in Europe of $50 per barrel.

However, the dropped out volumes from the European supplies, primarily the tanker oil volumes, are almost completely recanalized to Asia, primarily to China and India. That is actually 87 million tons, or 626 million barrels a year, now go in the Asian direction. That amounts to 52 million barrels per month and 1.73 million barrels per day, respectively.

According to the customs data of India and China, the price discount for Russian oil is only 3% of the market price of Brent, which can be defined on average as $80 per barrel for the purpose of more conservatism in estimates. That is, in fact, the selling price of Russian oil in Asia is about $77 per barrel.

It is not difficult to calculate that the daily volume of sales of Russian oil recanalized in Asia amounts to $133.2 million in monetary terms. In monthly terms, this is almost $4 billion, in annual terms – $48 billion.

As we can see, the recanalized supplies to Asia more than make up for the drop-off in oil revenues relative to 2021 figures: the drop-off of $44 billion from European exports is compensated by $48 billion from Asian sales at actual market prices.

The reason why Asian buyers are not taking advantage of the price ceiling is obvious: there are simply no such advantages for them. Middle Eastern and Latin American suppliers have redirected shipments to Europe to replace exports from Russia that fell out. Accordingly, Asian buyers are forced to make up for the lack of supplies from previous suppliers with supplies from Russia. In other words, there is virtually no supplier choice for Asian buyers as a consumer option: they are forced to make up for imports at the expense of Russian oil, which completely neutralizes for them the benefits of the price ceiling.

The world oil market is a system with an established and constantly restored equilibrium. Shortage in one of its parts will be compensated and recompensated by the other part, which will eventually lead to the establishment of the established balance.

Russia was able to recanalize exports by quickly resolving the issue of oil tankers on the ocean: about 200 tankers are now delivering oil to the ports of India and China.

Here it should be noted that the price of transportation due to complication and lengthening of logistics has nominally increased many times: from 3 dollars for tanker transportation of 1 barrel – up to 20 dollars on average. And this means that to calculate the net earnings from the Asian exports would have to subtract $20 from the average selling price in Asia of $77 per barrel.

Then the price in the Asian direction would be $57-60 per barrel. Which means the annual revenue of recanalized Asian exports would be $37 billion versus $48 billion without the logistics discount. But even in this case, the fallout from closing the former exports in the European direction relative to 2021 figures would be only $7 billion.

Nevertheless, we count gross revenue as it was counted in all previous years, because logistics costs are operating expenses included in the calculation of net income as a taxable base. And any operating expenses and logistics costs are quite “manageable” and elastic for determining the actual margin and taxable base of net income, depending on the purpose.

In particular, the above-mentioned freight costs appear to be much lower than those estimated in the Hellenic Shipping News bulletin, since several hundred tankers, apparently purchased by Russian oil companies, are actually integrated into the production chain. This reduces costs considerably by distributing logistics costs in an optimal way within the business.  The main external costs become insurance and towing, but even here different ways of “optimization” are possible.

Since tankers are obviously not hired through Baltic Exchange (Baltic Trading and Freight Exchange), there is simply no actual information about real prices and costs of transportation.  Practical control of transportation by oil companies themselves may allow them to manage costs quite effectively without reducing final revenues. For example, logisticians controlled by Russian oil companies can declare high transparatory market cost of transportation and declare oil sales on FOB terms below the price ceiling. (FOB is a delivery condition where the buyer himself arranges delivery from the moment the delivered oil is loaded on board the tanker. CIF – a condition under which the seller takes delivery to the buyer). This will allow carriers to take advantage of freight insurance or commercial financing from international and reputable insurance companies and banks. Accordingly, the profit from the high freight price will compensate for the discount in the price of oil sales. And this is just one of the ways to optimize flows and costs.

Therefore, it seems more reasonable to calculate exactly the total gross revenue to estimate oil export revenues and compare them with potential or past performance.

At the same time, the former sales to China through the port of Kozmino and the Chinese pipeline, which accounted for about 30% of total crude oil exports, remain in place, and there are quite market prices at an average of $75 per barrel.

Assuming that export sales to other countries, which accounted for about 23% of exports, will also remain, but the price will be around the introduced ceiling of $60 per barrel (which is a very conservative assumption and a significant prognostic discount), it is not difficult to imagine what the economics of crude oil exports in 2023 will be relative to the benchmark total of 231 million tons, or 1 billion 663 million barrels:

– $7.8 billion in current sales to Europe (at about $50 per barrel)

– $48 billion – recanalized sales to Asia (at about $77 per barrel)

– $37 billion – previous supplies to China by pipeline and through the Kozmino port (at about $75 per barrel)

– $23 billion – deliveries to other countries (at a ceiling price of $60 a barrel).

As a result, we get about $116 billion in projected total gross revenues from the export of crude oil from Russia while maintaining the volume of physical sales at the level of 2021. This is $8 billion more than oil export revenues in 2021!

In this case, the average export sale price would be $70 per barrel, which, as we can see, is, to put it mildly, above the established price ceiling. 

We made a number of conservative assumptions:

– Took the price ceiling boundary for the price of exports to “other countries” at $60

– discounted the price of oil recanalized to Asia to a lower value than the current Brent price

– assumed that physical export volumes would be below consensus projections and would be a value equal to 2021’s 231 million tons, or 1.663 million barrels, when export sales in physical terms were at the lower end of recent years.

At the same time, we did not take into account several important parameters that could somehow discount our estimated gross revenue. 

First, it is the real dynamics of sales: it is possible that oil sales will fall in the face of an impending recession.

Secondly, the inflationary discount will certainly reduce the real income from oil exports.

 Thirdly, substantially increased operating costs, e.g. for transportation, may be a significant factor in shaping the margins and taxable base of oil companies.

Fourthly, freight insurance conditions may also be considerably tightened through globalization of sanctions pressure, and there may be fewer ways to “optimize” for Russian sellers.

Finally, fifth, the state of capacities and their technical “health” may also affect the volume of produced and sold oil.

Nevertheless, all of these are variables that largely depend on how they are managed and how they are accounted for.

A living example of this is the current binding of the export price to the actually unrepresentative price of the Urals grade in Europe for calculating “oil taxes” inside Russia. With the transfer of the benchmark price to Brent or the Dubai grade, the export revenues of the budget will certainly increase.  

Another example is the management of logistics costs, which can be minimized by delivery terms or by integrating transportation services into the sellers’ production chain.

All these, as one famous and respected Russian investor likes to say, are “creative issues”.

I hope that no one has any doubts about the presence of such “creative” abilities, or, more precisely, about the ability of Russian Government to deceive and manipulate.

 Personally, I have no doubts about this.