What is the idea behind the price cap?

The G7 countries plan to use their financial dominance to prohibit the insurance, transportation and export financing of Russian oil for countries that buy Russian oil above a specified price.

Some publications have discussed a $40-$60 price range that will keep Russia interested in oil production.

To implement the price cap, the G7 must create a “buying cartel”. If the G7 countries succeed and the biggest consumers participate, Russia will face a difficult choice. The country will either have to supply oil at a set price or lose oil revenue, which is vital to its budget.

Russian oil exports

In June, oil exports from Russia totaled 7.4 million bpd, compared to an average of 7.75 million bpd in January-June. Sanctions have made Russian oil “toxic”, and Russian Urals are sold at a significant discount to Brent oil.

According to Neste, the current spread between Urals and Brent exceeds $30. While Brent is trading near the $95 level, Russia is selling its oil at around $65 a barrel.

In this situation, a price cap set at the $60 level does not seem to be a big deal for Russia as it is already selling its oil close to that level.

Russian ruble and sanctions

USD/RUB hit highs near the 120 level in March as foreign investors rushed out of the country while Russian citizens bought foreign currency for fear of a total financial meltdown.

In response, the Russian Central Bank imposed currency controls. Meanwhile, imports from Russia have plummeted due to sanctions. A combination of exchange controls and falling imports strengthened the rouble. USD/RUB bottomed at the 50 level at the end of June before rebounding to 60. The strong ruble is a headache for Russian exporters, while importers cannot take advantage of the situation as many potential suppliers cannot sell goods to them because of the sanctions.

Russia’s current problem is the excessive flow of foreign currency. Worse still, ‘virtual’ money, dollars or euros, could turn into nothingness at any time if the sanctions war escalates. Western countries have already frozen the assets of the Russian Central Bank, which is now trying to minimize the use of dollars and euros inside Russia.

Simply put, Russia does not want too much foreign currency which can be frozen at any time and cannot be used to purchase goods and services. It is important to understand this when considering the potential reaction to the oil price cap mechanism.

Politics trump economics

The year 2022 is full of examples where countries have implemented actions and measures that would harm them economically if they felt it was politically important to do so.

There is little reason to think that Russia would view the oil price cap mechanism as an economic exercise. Most likely, the decision will be purely political.

As we have seen above, Russia does not need foreign currencies which cannot be used to buy goods. As a result, Russia may want to reduce its exports to countries that participate in the price cap mechanism and sell oil to willing buyers.

In 2021, Russia exported 2.4 million barrels to the EU. Assuming that Russian exports decline by around 4 million barrels in 2023 (extreme scenario), the price of oil could easily settle between $100 and $150, or even more.

Interestingly, the revenue (in rubles, which is important for the Russian budget) that Russia will get from selling 7.4 million bpd at $60 per barrel with a USD/RUB at 60 is almost equal to the revenue that Russia will receive by selling 3.4 million bpd at $100 per barrel with USD/RUB at 80. Prior to February, USD/RUB was fluctuating near the 75 level, and the country could afford USD/RUB in the range from 70 to 90 without triggering high inflation.

Overall, it remains to be seen whether the Russian oil price cap will succeed. To have a real chance of success, the G7 will need China to join the deal. Politically, this scenario seems increasingly unlikely after Pelosi’s visit to Taiwan. China will still get Russian oil at a discount and gain a competitive edge over the US and EU if oil nears the $150 level.

From a commercial point of view, the attempt to implement the price cap mechanism could lead to a complete cut in the supply of participating countries and lead to a massive recovery in the oil market. However, traders will have to wait until October-November before markets begin pricing in such scenarios.

For an overview of all of today’s economic events, check out our economic calendar.