China and India hold the key to the success, or failure, of a price cap on Russian oil proposed by the G7. Asia's largest oil consumers are expected to buy even more cheap Russian crude if the US-led coalition's attempt to starve President Vladimir Putin of oil earnings to fund its war in Ukraine plays out.
But the market remains divided over whether the latest efforts to hurt Russia financially will fall flat or even backfire, accelerating a potential global recession.
Far from expecting China and India to join the G7 price cap alliance, the US hopes the price cap will expand the discount for Russian crudes on the global market giving Asian refiners additional leverage to negotiate down prices in supply talks with Russia.
Cheapening the value of Russia's oil exports rather than stemming their flow to world markets has become the West's key priority.
Russian crude exports remain close to pre-war levels and the value of its oil has been recovering in recent weeks due to tight markets for physical barrels. At the start of the summer, Europe's remaining buyers of Urals crude enjoyed discounts of up to $40/b vs Dated Brent. Although still well below the pre-war discount for Russia's key export grade to Brent of $2.5/b in January, they have halved to a $20/b discount since early August, data from S&P Global Commodity Insights shows.
Supported by strong Chinese and Indian demand, Eastern Russia's ESPO crude blend has seen its discount to Dubai crude shrink from $25/b in July to around $5/b in early September, according to the IEA.
"Regardless of which options the countries take, the price cap helps us achieve our objectives by putting downward pressure on the cost of Russian oil exports," the US Treasury Department's Assistant Secretary for Economic Policy Ben Harris said Sept. 9. "Ultimately, we believe the price cap would be successful in our goal of substantially hurting Russia's main source of revenue."
As it stands, the cap mechanism requires two key elements to get it off the ground — coordinating a ban on providing insurance services needed to ship Russian oil above a certain price and setting that price ceiling below current market values but above the cost of production.
Too low and the price cap could trigger Russian retaliation by shutting in swathes of oil production that will boost global crude prices, further fuel inflation and deepen the world's energy crisis. Too high and Russia will continue to benefit from redirecting its oil away from Europe at current prices.
"The most critical issue is the level of the price cap," said Ehsan Khoman, MUFG's EMEA head of emerging markets research, "Set it at zero and it's akin to an embargo as Russia will not sell its oil for free but set it at market prices then its novelty is quite trivial."
Putin has already said he would halt all oil exports to countries imposing a price cap. That would mean Russia attempting to redirect even more oil exports to its key trading allies China, India and Turkey.
The G7 appears to be banking on Russia redirecting more oil flows to Asia rather than retaliating by shutting in production. With Russia's energy exports normally funding more than half of Russia's government budget, the US believes Putin will be loath to simply turning off the spigots and should opt to absorb a bigger discount for his oil.
"The price cap is greater than marginal costs of production for Russia so there is a clear economic incentive for Russia to continue to produce oil and sell it," US Treasury's Assistant Secretary for Terrorist Financing and Financial Crimes Elizabeth Rosenberg said.
The main lever to implement the price cap is the ability to control global shipping insurance, which some detractors note, provides ample opportunity for less scrupulous importers to sidestep the G7 imitative.
But with more than 95% of the global oil tanker fleet covered by shipping insurers in G7 countries, it's unclear if refiners would risk using potentially inferior Russian alternatives to the global insurance standard.
Others note that widespread ship-to-ship transfers of Russian oil to evade sanctions could still undermine the scheme in the same way that sea transfers helped support Russian exports near pre-war levels since March.
But Rosenberg believes that shipping insurance will be a tougher hurdle to overcome.
"The oil price cap policy will be applied to cargoes of Russian oil and refined products no matter how many times the cargoes have moved from ship to ship, or transshipped from an initial purchaser to another as long as the cargoes are on the water," Rosenberg said. It is still possible for countries to work entirely outside of the oil price cap, using services outside the G7 price cap coalition but it might be "economically difficult" to do so, she added.
Russia also faces major infrastructure and logistical costs to divert oil flowing to Europe to other customers. A market where Russia diverts some 3 million b/d of crude and products from Europe to Asia, for example, would stretch tanker availability due to the longer voyages. Tanker voyages from Russia's Baltic ports to Asia take more than twice as long as cargoes loading from the Persian Gulf where most Asian supply originates.
The ability of refiners in China and India to substitute increasing volumes of Middle East crude with Urals may also limit the amount of oil that Russia can send to the East. Russian crude exports to India and China have already more than doubled from pre-war levels to 2 million b/d and not all plants will want to process higher rates of Russian crude.
At the same time, China's domestic oil demand is also under threat due to recurring COVID-19-related lockdowns. Platts Analytics predicts Chinese oil demand will contract for the first time in decades this year, by 95,000 b/d or 0.6%.
Some oil supply losses from Russia are seen as likely even if EU reworks its existing sanctions to incorporate the price cap mechanism before year-end. Platts Analytics forecasts Russian disruptions peaking at 1.5 million b/d in Q1 2023 due to the EU import bans which could be "tempered" by the price cap.
Goldman Sachs estimates that the world can still expect to lose about 1 million b/d of Russian supply versus pre-war levels due to incomplete redirection to alternative non-NATO buyers under a price cap.
Done right, the price cap mechanism could drive down Russia's energy revenues and avoid a recession-triggering surge in global oil prices. If Russia decides to bite the bullet and shut in swathes of production in retaliation the additional pain will be shared globally.