By Pierre Terzian
Thanks to maritime transportation, which accounts for about 85% of international oil trading (as compared to 15% for pipelines), the market’s great flexibility enables it to adapt to new circumstances. The international gas trade, split almost equally between maritime transportation (LNG) and gaslines, is less flexible. The dominant role of maritime transportation in international oil trading makes it possible for crude oil prices in different parts of the world to be closely correlated. Excluding temporary bottlenecks and exogenous factors (wars, natural disasters, etc.), price differentials are mainly due to crude oil qualities and transportation costs. The absolute value of prices, excluding exogenous factors and speculation, is a result of supply and demand, with inventories on land and at sea acting as adjustment variables. Apart from any political constraints, all physical players operate, in principle, by seeking the greatest possible economic efficiency: the highest prices for sellers and the lowest for buyers.
Impact of financial players
Financial players, for their part, have a significant impact on the oil market. As a matter of fact, they are very keen on exogenous (geopolitical, psychological) factors, which lead to high price volatility, as has prevailed ever since the Ukrainian crisis broke out. Embargoes are exogenous factors par excellence. A European embargo on Russian oil would certainly increase the market’s imponderables, providing fertile ground for financial players and speculation.
Normally, during a physical transaction, the price per barrel is determined using a formula involving the reference crude oil price (Brent, WTI, etc.) along with a premium or discount. In the case of Russian oil, it is to be expected that price negotiations will henceforth involve a strong “geopolitical” discount if the European Union (EU) imposes sanctions.
The emergence of crude oil prices is often ascribed to cyclical and structural relationships between supply and demand. Since the appearance of oilrelated financial markets, and more recently the proliferation of Exchanged Traded Funds (ETFs), listed on the stock exchange, which replicate the reference prices of crude oils, even individuals can speculate on oil-price trends. A keen appetite for commodity investments has led to an unprecedented influx of liquidity into these markets. Oil prices are therefore often disconnected from the physical fundamentals of the market (and variations are amplified) due to the intervention of investors and speculators who gamble that oil prices will fall or rise. The challenge for these new players is to find investment opportunities which aren’t correlated with the stock and bond markets.
Two types of embargoes can work effectively: a physical blockade of the land and/or maritime borders of an exporting country (an extremely rare situation) and an embargo coupled with so-called “secondary” sanctions which hit third countries. For a country (or a group of countries) to be able to impose such sanctions, it must have deterrent economic and political power and be determined to use it. The exercise of economic deterrence depends directly on the degree of political determination. This can be seen in the case of Iran, hit by Donald Trump’s US sanctions since 2018. After Joe Biden arrived in the White House (in January 2021) with his stated desire to seek a nuclear agreement with Tehran, the Washington’s political determination to apply secondary sanctions against buyers of Iranian oil has declined: Iran has since doubled its oil exports.
The embargo that the EU is trying to impose on Russian oil is unlikely to be accompanied by secondary sanctions, at least initially. On the other hand, if the political and military situation deteriorates further, it is by no means impossible that the EU will be tempted to resort to secondary sanctions. For its part, the United States has made it known (via its Energy Secretary) that the “option” of secondary sanctions on Russian oil is already being considered. Pending possible secondary sanctions, the European embargo on Russian oil would be more like a refusal to buy it, a policy that some European companies and countries have already adopted voluntarily.
Reworking flows of crude oil
EU member states will seek (and are indeed already seeking) supplies from other oil-exporting countries. International trading will have to be reworked. In theory, it sounds simple: countries that sell more oil to Europe will sell less to others; these will fill the void by sourcing from other countries, one of which will necessarily be Russia, as long as the global oil supply doesn’t increase sharply. In reality, countless adjustments will have to be made in terms of logistics and the adaptation of refining facilities. This will be both difficult and costly, and will necessarily entail delays.
Both in Russia and within the EU, where some refineries don’t have access to the sea and depend entirely on Russian pipelines, it will be more difficult to rework flows of refined products than those of crude oil. The EU has promised financial compensation to countries such as Hungary and Slovakia, whose refineries are landlocked. Will these countries be able to obtain supplies of crude oil and/or products through other channels (rail, road, river) while waiting for their pipelines to be reconfigured, a process that will take several years? In Russia, refineries which can’t export their output due to a lack of new roads have already reduced their operations, and some of them are threatened with closure. However, the world’s refining capacity had already decreased in recent years: according to OPEC, the current rise in oil prices is due to a shortage of products rather than crude oil. Over the last three years, the world has lost about 4 MMb/d of refining capacity, according to OPEC, including 2.7 MMb/d since the onset of the Covid-19 pandemic.
Crude oil price discounts and the Russian budget
A reworking of the international oil trade will lead to losses in economic efficiency. Transportation and processing costs will increase. Forced to buy its oil from sources more distant than Russia, Europe will probably have to deal with an unfavorable price differential. Its refineries will have to adapt to other available crude oil qualities. While this alone isn’t enough to push international oil prices higher (costs will rise instead), it certainly isn’t a bearish factor either.
For its part, Russia will be (and is already being) forced to offer oil price discounts, not only to compensate for the additional costs (transportation and processing) that customers will incur by buying its crude oil, but also to convince them to face the potential political risks (angering the United States and Europe). The higher the oil price, the more buyers will be attracted by Russian discounts, and the more Moscow will be able to cushion the downward shock to its income, provided that its export volume doesn’t fall too far. So if Russia grants a $35/b discount on a price of about $110/b, it will still have $75/b left. The equilibrium price set in its 2022 budget is $44.2/b. The average price of its benchmark Urals crude oil fell from around $90/b in JanuaryFebruary 2022 to about $80/b in March-April (-11%).
Since the beginning of the war, the volume of Russian oil and commodity exports has fluctuated from one month to the next. The aversion of Western companies against buying supplies from Russia is driving down the volume of the country’s exports, whereas price discounts granted by Moscow are, on the contrary, encouraging some countries (China and India in the lead) to buy more Russian oil. In March and April 2022, the volume of Russian oil exports was observed to have decreased by about 1 MMb/d on average, as compared to exports of around 8.2 MMb/d before the crisis. In terms of volumes, Russia’s losses must therefore amount to around 12%. If one includes the price factor, between JanuaryFebruary 2022 and March-April 2022, Russia should therefore have lost about 22% of its oil export revenue.
Security of supply
To ensure its security of supply, the EU should conclude long-term purchase contracts with take-or-pay obligations; but such contracts, which are very common in the gas trade, are rare in oil. Otherwise, the EU will only replace its dependence on Russian oil with a dependence on other countries, many of which are politically unstable. Russia, which was the world’s largest oil exporter until it invaded Ukraine, will remain very influential in the market. Its alliance with Saudi Arabia within OPEC+ seems intact. Under normal circumstances, a fall in Russian oil exports would be in the best interests of neither the EU nor the United States, as it would encourage higher prices. But this is a time for political rather than economic considerations.
Washington suggests that the EU might impose a ceiling on the price of Russian oil
On May 17, US Treasury Secretary Janet Yellen suggested that the EU might consider imposing an import “cap” or “tariff” on the price of Russian crude oil. Such a measure would either complement an embargo or offer an alternative to it. Yellen reportedly proposed the formation of a “cartel of oil buyers” which would be as large as possible. The idea of a price cap or an import tariff on Russian oil can only have a chance of succeeding if it is backed by a very large number of countries. The basic assumption is that all oil-importing countries benefit from lower prices, and that a cap or tariff on the price of Russian oil would force all oil prices downwards. If the “cartel of oil buyers” wasn’t large enough, secondary sanctions would hit importers of Russian oil.
Pierre Terzian is an economist specializing in energy issues. He is the founder of the Paris-based Petrostrategies think tank.