Why a price cap on Russian oil is a bad idea

For many months, the Biden administration has been pushing for its allies to agree a price cap on Russian oil purchases. They have been sceptical — I think rightly so, as I will try to convince you in this note. Yet at the last G7 summit in Germany, the US seems to have browbeaten its partners into including at least a nod to the price cap option in their communiqué.

The US Treasury has devoted quite a bit of public diplomacy effort to this. I myself have been at the receiving end of the sales pitch. So have many others. So why is the US government so keen on this idea, and why do I remain opposed to it?

For an answer to the first question, read a piece by the Brookings Institution’s David Wessel, which channels US Treasury thinking as well as anything I have seen. As Wessel sets out, the objective is twofold: “to reduce the flow of oil revenues that are financing Russia’s war machine [and] to prevent an economically catastrophic increase in oil prices” if the EU implements its recently decided (partial) oil embargo and sanctions on shipping insurance for Russian oil cargos.

The proposed solution — keep the oil flowing but only if it is sold at a bargain-basement price — sounds appealing. So why am I at best unconvinced?

Start with the factual claim in the argument. The EU’s partial ban on oil imports and oil shipping insurance sanctions will come into force by the end of the year. The assertion from Washington is that this will lead to a devastating new oil price rise once the restrictions are applied. Does the US government know something oil traders do not? Because at the time of writing, those who buy and sell oil for a living are pricing Brent crude at about $98 today and about $90 for December or January delivery. So they either disagree with the US government that the EU sanctions will matter for the global oil market or, more likely, they have already priced in the effects. Either way, anyone who thinks they know more than the markets can secure their January oil supply for $90 a barrel now. So it is not clear that one of the problems US leaders are worried about actually exists.

Second, how about the more altruistic-sounding challenge of preventing Russian president Vladimir Putin from raking it in on higher oil prices? There is no doubt that Russia’s oil revenues have soared despite stable or falling volumes. But here it is the logic rather than the facts that fail in the American position. If the premise is that EU shipping insurance sanctions will be effective, so that Russian oil supplies will be removed from global markets, it is at least theoretically consistent to believe that prices could go up (even if the empirical evidence from oil markets says something else). What is not consistent is to think that Russia would be paid for that oil since, by hypothesis, it would be prevented from selling it.

Alternatively, the thinking may be that the sanctions will not work, so Russia will still be able to sell its oil. But if so, there is no reason to think oil prices will go up. At most, oil will be traded in a more roundabout way — with oil previously shipped to Europe now shipped to more remote markets, and those markets’ previous suppliers starting to sell more to Europe instead. But at most, these frictions will marginally increase the price Europeans will pay. Others may well see lower prices because Russia has to offload its supplies in new markets — as the large discount it must already accept on Urals crude already shows.

I suppose you could construct a model where the sanctions are a little bit effective, so Russian sales fall, but only a bit — and that partial supply contraction sends prices up by so much that Moscow ends up with larger revenues. If so, Washington’s alleged altruistic motive should prompt it to support the EU to make its sanctions tougher, rather than push back against them. And we should be very clear about what the US is asking for: what sounds like getting tough on Russia (capping the price it can earn) is in practice bullying Europe into being less tough (softening its sanctions for oil cargos below a certain price).

A more realistic worry is that the sanctions only come into force later, but markets have priced them in today, so we are foolishly (but temporarily) paying the price of sanctions without achieving the goal of cutting off Putin’s revenues from them. The right way to fix this, of course, is to speed up the implementation of sanctions — not lobby and waste diplomatic time and capital on trying to soften them.

Third, while not quite economically illiterate, there is something obscurantist in economic officials’ willingness to focus on the downsides but not the benefits of market-set energy prices. The price mechanism is powerful, and the economy’s ability to respond is often underestimated. As I have argued in the past, we should not try to contain market-clearing energy prices. Instead, we should help those truly in need, while letting the incentives to economise on energy use work. And they are already working: we are seeing oil consumption fall in advanced economies.

It is true for gas consumption as well. According to EU figures, the flow of Russian gas is already as low as 30 per cent of normal averages. That suggests European consumers have already managed to adapt significantly, painful as the higher prices have been. A new study by a group of Hertie School economists carefully constructs a model of projected German gas demand based on past years to separate adaptation to the crisis from other factors affecting demand such as the weather. They find that in March and April, consumers cut back demand by 6 per cent. Industry started economising much earlier, cutting demand as soon as prices started rising in late 2021. On average, companies have managed to get by with 11 per cent less gas than they normally would.

Capping the oil price would reverse all the incentives for this. And it would do harm beyond the immediate crisis. It would signal to both consumers and industrial users that as soon as oil prices go up, politicians will do anything to bring them down. In other words, they do not mean what they say about either decarbonisation or reducing their dependence on Russian oil specifically. For this is the core objective without which the US proposal makes no sense: to continue burning Russian oil, but ideally at a low price. Showing that dependence, of course, just enhances Putin’s ability to threaten the west into submitting to his designs. It is worse than hypocritical, it is a policy of geopolitical self-harm.

Other readables

• Paul Krugman is always worth reading, whether you agree with him or not. His latest column on the “Humbug economy” is particularly useful. Krugman points out that different data about the US economy are so all over the place as to give a completely contradictory picture. With one exception: all indicators show inflation expectations are modest. Remember that when you take in the latest inflation score (below).

• In last month’s marvellous essay on James Joyce’s Ulysses and the author himself, David McWilliams explores the kinship between the poet and the entrepreneur.

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