The year 2022 has been unusual for managing economies. Inflation has risen to levels not seen in five decades, a war has broken out in central Europe, supply disruptions are affecting many sectors and rolling lockdowns are still a fact of life in China, with only a few major disruptions. to name.
In response, dramatic retaliation is being erupted everywhere, with quantitative tightening in the US, an unprecedented 75 basis points hike by the European Central Bank, and now a Group of Seven (G7) “price cap” on oil from Russia. “Planning to set up. The proposed price cap denies SWIFT access to Russian banks in the form of freezing Russian central bank reserves and a new and controversial weapon in the global economic warfare arsenal.
Before we unpack the price cap, a little background. Russia is the second largest producer of crude oil in the world, producing slightly less than the US and slightly more than Saudi Arabia every day. It produces more than 11% of the global total demand of about 100 million barrels per day. Since the start of the war in Ukraine, Russia has been exporting about 7 million barrels per day, retaining about a quarter of its daily production for domestic use. Russian export revenue from oil currently averages about $ 20 billion per month. Russia’s nominal gross domestic product (GDP) for 2021 was $1.71 trillion, and oil and gas exports made up 60% of its export basket. Germany, Turkey and Belarus are the main export destinations for Russian gas on the pipelines. The 1,200-kilometre-long Nord Stream 1 pipeline runs from Vyborg in Russia under the Baltic Sea to Lubmin in Germany. In response to Moscow’s actions, Germany has stated that it will not certify the Nord Stream 2 pipeline which runs almost parallel to the first. Before the war, Russian gas exports to the EU and UK fell from about 16 billion cubic feet per day (bcf/d) in 2019 to around 11 bcf/d in 2021. The supply of gas and oil from Russia to Europe and the UK has declined in the range of 50% (Germany) to 100% (UK). Russia is offering its surplus oil to countries like India, China and Turkey. For gas, there are few buyers except Turkey, Belarus and Kazakhstan.
At a time when the European Union is trying to distance itself from Russian oil and gas, a US-led price cap is being attempted. The proposed rationale for this is “to thwart Russia’s war effort”, as most of Russia’s surplus comes from oil and gas exports. Technically, this is not a global limit on Russian oil prices, it is limited to the G7 nations. In economics speak, this attempt by a buyer’s cartel represents a case of ‘oligopsony’. The US claims that the implementation of this price cap by the G7 will benefit all other countries, especially India and China.
In fact, the price range is what economists call the ‘price collar’. The lower limit of the price is designed to be higher than the marginal cost of production to encourage Russia to produce the commodity, and the upper limit is designed to limit “profiteering from the war premium”. Is.
The mechanism to enforce this price cap is through the insurance companies. The insurers that insure Russian marine oil are largely Western and account for about 85% of the total trade. They will be expected to allow movement of oil by Very Large Crude Carriers (VLCCs) only if the contracted price is below a certain (continuously adjusting) threshold. The G7 price collar proposal replaces a complete ban on insurance of Russian oil shipments that came into force in early December as part of the EU’s sixth sanctions package.
While Western insurers in the shipping industry are actually a choke-point for supplies to China and India, there are a lot of moving parts for the G7 plan to be successful. To mix metaphors, the potential for leakage is enormous. Economics literature is rich in the science of failing value limits.
Price caps trigger market mechanisms that seek to circumvent them and also lead to a gray market. In this case, the global web has many actors with incentives that combine political, military and strategic goals for economic rationality. Therefore, the price collar has a low probability of success.
Russia has already established alternative insurance arrangements for oil shipping, and India and China may consider these adequately (though intermediary ports may still pose a problem). Taking advantage of an opportunity, some countries such as Malaysia are exporting more oil from China, allowing intermediary shipments from Venezuela, Iran and Russia. Other cash-strapped countries like Sri Lanka may consider the following suit.
India is unlikely to be in a hurry to decide on joining the price cap alliance. India’s classic ‘wait and see’ approach is very important here. If the G7 price cap fails, as is quite likely, India can remain a reliable partner of Russia for concessional oil. If this boundary somehow succeeds, India can use its success as further advantage in its discussions with Russia.
The world cannot completely cut off Russian oil supplies. According to some estimates, if Russian oil supplies of 6-8 million barrels per day are removed from the global market, oil prices will rise to $ 380 per barrel. Since hydrocarbons remain a major source of energy, any oil price above $200 will cause political upheaval almost everywhere in the world.
“It takes more than intelligence to act wisely,” said Fyodor Dostoyevsky, author of P.S. Crime and Punishment.
Narayana Ramachandran is the chairman of Include Labs. Read Narayan’s mint column at www.livemint.com/avisiblehand
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