G7 Price cap on Russian Oil to take effect soon as Ukraine war rages; All you must know

US, EU and G7 nations have decided to put a price cap on Russian oil which is about to take effect from today, December 5. Before the Russian oil price cap is discussed, it is important to take a quick glance at fundamentals of energy. Some common sources of energy include:

• Oil, which is a fossil fuel that is extracted from the ground and refined for use as fuel.
• Natural gas, which is a fossil fuel that is extracted from the ground and used as a source of energy. LNG is natural gas that has been cooled to a liquid state, making it much easier to transport over long distances. Because it is a liquid, LNG takes up much less space than natural gas, making it more practical to store and transport. When LNG reaches its destination, it is typically converted back into a gaseous state for use as a fuel.
• Nuclear power, which is the use of nuclear reactions to generate electricity.
• Solar power, which is the use of the sun's energy to generate electricity.
• Hydroelectric power, which is the use of the energy of moving water to generate electricity.
• Wind power, which is the use of the energy of wind to generate electricity.

The price cap is on Russian oil. Russia exports oil, crude oil to be more specific, and gains revenues from it. All governments need revenues to carry out their policies, be it building schools, highways, funding social security or war. War is a capital intensive exercise. No other human pursuit drains capital as quickly as war. 

The concept of debt emerged in renaissance Italy because the Italian city states, who were fighting amongst themselves, did not have enough revenue to carry out war. The goal of West’s price cap on Russian oil is to limit the amount of revenue that Moscow can generate from export of crude oil. The underlying belief is that the revenue Russia gains, will in some way or other be used by Russia to boost its war effort. The intention is to undermine the source of that revenue, to help Ukraine. 

Price cap has been set at $60

The price cap has been set at $60 per barrel, which is higher than what was expected. So, how does the price cap work? Russia oil is transported through ships in most cases, as most importers do not have direct pipeline connections with Russia. Naval vessels carrying these shipments need insurance and here is the crucial bit - most insurers are based in Europe and the UK. If the price of Russian oil is above the oil cap, insurance companies will simply refuse to insure the shipments. The decision, in essence, bans “Western companies from insuring, financing or shipping Russian oil unless it is sold below $60 a barrel,” as per a report from the Wall Street Journal. 

Limitations and vulnerabilities of the price cap

Russia is already selling a significant amount of its oil to developing nations in Asia. These nations need oil to ensure energy security, it is unlikely they will participate in the oil cap. Moreover, the $60 per barrel price cap is somewhat odd because Russian oil is already being sold at around that price. This is the reason Ukrainians have expressed disappointment at the price cap. 

A price cap of around $50 would have made it difficult for Russia to balance its budget, as per a report from ABC news. Ukraine wants the price cap to be at a lower level, but that has a cost as well. If the price cap is set at a level lower than Russia’s operating cost, Russia would simply shut down its oil rigs. 

This may seem like good news, as it would damage Russia’s revenue stream. But it won’t damage just Russia’s revenue stream, it will impact global energy markets in a dangerous manner. Supply of oil is limited. There are importers and exporters. Russia is an exporter. 

If Russia shuts down its oil rig because it is not able to make any profit, Russian oil would effectively disappear from the international energy market. However, the energy demand of nations who import will remain the same. Demand will remain constant and supply will go down, which will result in a major spike in oil prices. This will be bad news from European nations as well, because most of them are energy importers as well. 

Surge in oil prices is not in their interest. In the unlikely circumstance that Western nations decide to lower the price cap at a future date, as Ukraine wants them to, other nations might set up their own insurance service. There is also something called “dark fleets” which are not covered but quite well known in commodity trading circles. If harsher restorations are placed, “dark fleets” will provide a way around them. 

Context

In recent months, since the Ukraine-Russia war began, there has been a lot of talk about weaponisation of economy, finance, energy, etc. A dispassionate look at the past suggests weaponisation of economy and finance are as old as war. Consider British blockade of France during the Napoleonic Wars. The British navy blockaded French ports, preventing French ships from trading with other countries and depriving the French government of vital income.

This weakened the French economy and made it more difficult for them to continue fighting the war. Or the American Civil War, in which the Union blockaded Confederate ports to cut off their trade and revenue. This was a key factor in the Union's eventual victory, as it weakened the Confederate economy and made it more difficult for them to finance their war effort. War has never been limited to the battle field.