How To Sanction Russian Oil Without Harming The West – EMEA TRIBUNE Breaking News, World News, Latest News, Top Headlines

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As a Russian naval cruiser Moscow was engulfed in flames on the Black Sea earlier this month, Vladimir Putin met with senior ministers to address another unintended consequence of his war on Ukraine – one far less dramatic than the sinking of a flagship but more dangerous to the ultimate strength of his regime. The agenda for this meeting was to find solutions to what was euphemistically called “the current situation in the oil and gas sector”. Looking tired and nervous at times, Putin listed a list of issues plaguing Russia’s most strategically important industry. But the main challenge he was trying to tackle seemed new to him: what does Russia do if the West stops buying its oil?

Putin seems to have been caught off guard by the recent shift in Western sentiment towards a Russian oil embargo, and perhaps with good reason. As recently as late February, when the first new round of sanctions was announced, the West made it clear that they did not apply to energy exports. But in the wake of Russian atrocities in Bucha and elsewhere, support has grown for an embargo on Russian oil exports – the Kremlin’s biggest source of government funding. Since then, the United States and Canada have imposed a ban. EU policymakers have signaled their desire to follow this lead, but have struggled to agree on how to implement an embargo that avoids excessive self-harm. A ban could trigger an oil shock that would plunge the global economy into recession, drive up global food prices and weaken unity among Ukraine’s allies.

In response to the embargo threat, Putin urgently asked his ministers to present a plan by June 1 for the construction of new oil export infrastructure to “friendly” countries. This request had a whiff of desperation, as such an infrastructure would take years to build, and is therefore of little use today. But in issuing his order, Putin unwittingly pointed to some structural vulnerabilities in Russia’s oil industry – weaknesses that hold the key to resolving the EU embargo dilemma.

When it comes to its oil exports to the West, Russia faces limits in its ability to redirect or reduce those volumes. These constraints stem from the sheer size and rigidity inherent in the Russian production and transport system. These limitations have been largely ignored in recent sanctions debates. But, if properly harnessed, they allow the West to craft smart sanctions that could reduce Russia’s oil revenues while avoiding an oil price shock. Moreover, they could also finance reparations to Ukraine at the expense of Russia.

The first of these vulnerabilities is Russia’s limited ability to redirect its Western export volumes to other markets. A glance at the map reveals that Russia’s export infrastructure of pipelines, railways and sea terminals is heavily oriented to the West. This is not surprising, since Russia has been exporting oil to Europe since the 1870s. The West is now by far Russia’s biggest customer, absorbing some 6 million barrels of Russian oil a day. , more than half of Russia’s total production. In contrast, Russia’s export infrastructure to Asia is relatively modest. The first and only pipeline to China and the Pacific was only completed in 2019 and carries less than 15% of Russia’s total output.

So what would happen to those 6 million barrels a day if the West stopped buying? Russian officials threatened to send it “elsewhere”, while the media focused on stories of increased sales in China and India. But this threat of a redirection to Asia is a paper tiger.

For starters, pipeline capacity from Russia to Asia is already full. This means that the redirected oil would have to travel by sea from terminals in the Black Sea and the Baltic. To move that much oil over such a long distance would require some 230 supertankers – 30% of the world’s fleet – operating day in and day out. Such a massive maritime flotilla (if it could even be chartered in the first place) would require a small army of third-party facilitators: maritime insurers, bankers, commodity traders, shipowners, etc. Some of these third parties are already avoiding the Russian oil trade, fearing current sanctions. If the West imposes a full and coordinated embargo on Russian exports, including sanctions on third parties allowing the trade, most of the ships in the flotilla will never leave. The risk of sanctions would be too great. Instead, volumes that previously flowed west would become “stranded” on Russian shores.

Which begs the question: what would Russia do with all that blocked oil? The response highlights the second strategic vulnerability of Russian oil. Russia lacks large-scale storage capacity, so the only option would be to leave all that oil in the ground, i.e. not produce it in the first place. Known as the “production shutdown,” this scenario would be seriously damaging to Moscow for a number of reasons, some obvious, some less so.

The most obvious would be the loss of vital export revenue. Less obvious, however, is the extensive damage that a prolonged, large-scale shutdown could do to Russia’s upstream production capacity. Russia is not like Saudi Arabia, where advantageous geology and advanced infrastructure create immense turnaround capacity – the ability to vary production levels quickly and efficiently. Most Russian oil wells have low throughputs and poor economics. A prolonged, large-scale shutdown would mean the painstaking closure of tens of thousands of these marginal wells, many of which may never become profitable again. It could also jeopardize the complex pressure maintenance programs essential to the profitability of the field.

Restoring lost production capacity in marginal fields after a long period of shutdown would be a very slow and expensive process – if at all possible. When Russia suffered a major drop in production in the early 1990s, it took more than a decade, along with large amounts of Western capital and technology, to restore production to previous levels.

Beyond the operational consequences, there would be still other negative consequences of a confinement. This would weaken support for Putin in Russia’s major oil-producing regions. This would erode Russia’s position in the OPEC+ cartel and jeopardize Russia’s export market share. Finally, it would deprive Putin of the main source of economic rents used to maintain his authoritarian rule.

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With the diversion to Asia a pipe dream and the shutdown a catastrophic risk, Russia is proving to be much more dependent on the West to absorb its oil than many Western policymakers realize. And that reliance gives the West the leverage to impose smart oil sanctions that can achieve Western goals while minimizing self-harm.

How would these sanctions work? Western governments would start by announcing a complete embargo on all Russian oil exports. This should include secondary sanctions against third parties, thus blocking large quantities of oil exported to Russia. But the embargo would include provisions allowing Russia to resume exporting its stranded oil, provided it sells through a special Western-administered sanctions regime that severely limits revenue sent back to the Kremlin.

Under this regime, Russian producers would sell their exported oil at normal market prices. But they would not receive the full market price for the sale. Instead, the Sanctions Administrator would pay them a reduced price only enough to cover their production costs, excluding any amount for Russian taxes. In Russia, average production costs are around $20 a barrel, before taxes. The difference between that $20 of “at cost only” product and the actual market price would go into a special fund for Ukraine’s reparations.

For example, if the oil sells for $80 a barrel, the Russian seller would get a “cost” payment of $20, while the remaining $60 would fund Ukraine’s reparations. Compare that to what is happening now: the Russian seller receives the full $80 a barrel, of which $55 is passed on to the Russian government as taxes. Indeed, the cost Russia must pay to avoid a painful lockdown is to give up all its oil profits (including taxes) to rebuild Ukraine.

Kremlin revenues have been slashed, a supply shock averted and half a billion dollars a day for Ukraine reparations – there must be a catch. The catch is that Russia cannot be forced to export its stranded oil. Selling would clearly be in Russia’s economic interest: it receives just enough to keep its most strategic industry afloat while avoiding a crippling lockdown. But it wouldn’t be at all surprising if Russia chose – at least initially – to shut down production in hopes of upending global markets and breaking Western resolve. The Kremlin could also apply its own sanctions; in fact, the EU is already working hard to prepare for the possibility of restrictions on gas exports to Europe.

But the longer Russia has chosen to shut down its oil, the more serious the consequences, both economically and geologically. Putin has already lost a flagship in this war. He can think twice before scuttling his most strategic industry.


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