Washington’s Oil Price Cap Won’t Work—And Putin Knows It

For the past several months the U.S. has been shopping around to other advanced democracies a coordinated scheme to place a cap on the price Russia can charge on its oil and natural gas exports to deprive Putin of revenues fueling his war in Ukraine. A nearly 50% rise in Moscow’s inflow of oil and gas export revenues has been driven by the sector’s skyrocketing prices since the onset of the war.

To Putin’s amusement, the attempt to cobble together such an agreement has not been easy going for Washington.

U.S. allies have been rightly circumspect about three things.

First, the convoluted design of Washington’s plan seems to reflect incomplete understanding of the dynamically changing transactional complexities of this global market—not just the sale of oil per se but of the attendant transport, insurance and other services—and how historically, participants in commodity markets deeply nested in political economy dynamics, find the wherewithal to circumvent regulatory constraints.

In this regard, keep your eye on how smoothly tankers and insurers—and the governments with which they are affiliated or licensed—respond. If experience is any guide, ensuring how one’s self-interest is met will vary across parties. Unforeseen market distortions and aberrant conduct will no doubt emerge.

Second, they are skeptical of the price-cap’s ability to accomplish the ultimate goal—sufficiently constraining Russia’s oil revenues so that Putin terminates his war in Ukraine. After all, the fundamental objective that should guide the design and execution of any sanction is to alter systemically the conduct of the target.

This is a key point. The likelihood that the price-cap will help engender a recession—perhaps a deep and long one—in Russia is high. While such a turn of events may be a necessary condition to lead Putin to withdraw from Ukraine, in and of itself it is unlikely to be sufficient. It is the war’s end that the framers of the price-cap proffer as the objective.

Third, allies of the U.S., especially those in Europe, are rightly concerned the price-cap mechanism will backfire because of reductions in production volumes by Putin—indeed by OPEC—inflicting costs on the advanced democracies, indeed perhaps more than it will on Russia.

I’ll add a fourth point that has not been discussed: the price-cap will likely generate environmental repercussions. Lowering oil prices will surely increase the composition and intensity of fossil fuel consumption and thus climate change. At the same time, the pressure to short-cut the sanction regime through cheating in the tanker market by playing fast and loose in oil transport by using sub-par ships raises the risks of oil spills and other forms of environmental degradation.

Weaponizing oil provides an important opportunity for the U.S. and the other advanced democracies to alter extant market incentives that are driving our over-consumption of oil and natural gas and thus degradation of our economies’ sustainability.

Meanwhile, enlarged oil and natural gas revenues still make their way to Moscow, Ukrainian bloodshed mounts, and the already numerous casualties of young Russian male military conscripts increase exponentially.

It’s bedeviling why Washington has not chosen more readily available and explainable effective policy instruments to significantly curb Russia’s oil and gas export revenues and thus substantially shrink Putin’s war chest.

The U.S. and its allies have a long (albeit tortured) record of regulating oil and natural gas prices. In fact, there are a number of robust lessons to be drawn from that experience to shed light on alternatives that could be superior to a price-cap, including market-driven, transparent and economically intuitive mechanisms.

Indeed, one of the lessons of policy making is that if it is difficult to explain to market participants—from producers to consumers—how and why a policy measure will work, including compared to alternatives, and how to easily measure its effectiveness, the initiative may not have the actual impact sought.

The Flaws of the U.S. Oil Price-Cap Scheme

The design of Washington’s proposed oil price-cap is contorted and fraught with contradictions.

The most salient of these is the program relies on command-and-control mechanisms—that is, non-market-based measures—for setting the ceiling price (“the cap”). In other words, that price is not driven by supply and demand. Rather it involves imposing an artificially constructed margin above notoriously difficult-to-estimate Russian per-barrel extraction and production costs.

Not surprisingly, in trying to just launch the program, there has been protracted haggling among the G7 to reach agreement on the level for the initial price. It’s as if the world’s advanced democracies are behaving like Soviet states. No doubt, Putin must be chuckling about this.

Moreover, as in all oil and natural gas producing countries, extraction and production costs vary across the wells in Russia’s resource producing regions. They also are not fixed, rising and falling over time. As such behind-the-border costs rise or fall, the U.S. scheme would require manually changing the level of the price-cap to maintain consistency of the price-cost margin. If such alterations in the price-cap were not made, there would be a regime change in incentives and disincentives created across Russia’s wells and geographies. That could generate a crazy quilt of spatial distortions in production and ultimately of supply entering the market.

It is not difficult to imagine that the institution of such an administrative framework and the aberrations it could produce would engender more pricing uncertainty into a portion of global oil and gas supply and demand than is already the case as a result of the war in Ukraine, as well as more uncertainty in insurance and cargo rates. It’s conceivable, but not assured, that such regulatory-induced uncertainty could put upward pressure on prices for oil and gas for Russian oil purchases outside the price-cap. This could create a bias towards more not less oil and gas revenues making their way to Putin’s coffers.

Washington’s program also would be exceptionally difficult to monitor independently, creating opportunities for evasion and corruption—not just in oil transactions conducted in Russia, but in bills of lading for transporting Russia’s oil and gas outside its borders; how customs charges are applied; insurance rates for oil tankers; and so on.

As anyone who has worked on the ground in Russia and similar kleptocracies (think: China) knows well, such command-and-control measures and opportunities for corruption are exactly the type of paradigm in which Putin and other leaders in such environments thrive. Having spent a good part of my career in such countries—indeed trying to help them reform on this score—I speak from experience.

In fact, fears have arisen by the U.S. of the potential presence of such behavior—not only by Russia and its foreign allies who purchase its oil (think: India) but even among oil and gas market participants within the G7 countries.

This has driven Washington to consider the imposition of a network of secondary sanctions to curb such cheating. The contemplation of resorting to such steps is prima facie evidence that Washington is fearful its chosen paradigm for penalizing Russia is full of holes.

Suffice it to say, oil and gas markets are notoriously complex and comprised of a multitude of geographically dispersed parties with highly differentiated interests, many of whom are extremely sophisticated. To many, this may belie the fact that oil and natural gas are relatively homogeneous commodities that trade across multiple borders on a daily basis.

In principle, such homogeneity can foster cheating on regulatory constraints placed on oil and gas exports, such as those to be imposed on Russia. After all, oil and natural gas are not branded per se. Indeed, it’s not as if they are easily marked by different colors, smells, or labelling. Still, information flows tracking tanker shipments, for example, are increasingly sophisticated and robust—that is unless intentional mislabeling of such supplies and other forms of evasion and corruption occur.

The success and effectiveness of the U.S. price-cap policy (indeed of any economic policy) ultimately depend on the extent to which the parties concerned (the U.S. and the other advanced democracies, including their citizens, companies, workers and consumers) readily understand the objectives and the mechanics of the price-cap. Regrettably, in this case, there has been a fundamental inability by Washington to succeed in its messaging.

Perhaps the starkest example of this is Washington’s pursuit of the price-cap is based on the hope of achieving multiple objectives that are largely inconsistent with one another. They also run counter to powerful market forces. What do I mean?

In a nutshell, the U.S. is seeking to cap oil prices at levels lower than the currently high market rates generated by the war in Ukraine to alleviate the softness in global economic growth they have engendered. Yet at the same time, the U.S. is seeking to set a price level for oil that is just higher than Russian oil production costs so as to not remove Russian oil supplies from the world market that otherwise would exacerbate the fall in global GDP growth. This tangled set of objectives of trying to “have your cake and eating it too” is one of the principal reasons allies have not signed on to Washington’s program.

Experienced framers and executors of public policymaking know well the golden rule for success: If an initiative’s design is overly complex; its rationale cannot be expressed in a compellingly intuitive manner where the linkage between cause and effect is abundantly evident; and its workings lack sufficient transparency, that is its death knell.

To this end, it is not a good sign that in Washington’s campaign to bring on allies to the price-cap proposal it has been having to re-formulate the model several times, adding on “bells and whistles” to find “takers.”

While the price-cap is well-intentioned, it shuns lessons from decades of policy-making—in energy and many other markets: Complex “Rube Goldberg” schemes almost always fail. Is it any wonder the U.S. is having trouble enlisting the support of its allies?

Potential Paths Forward to Undercut Putin’s Objectives

The sad irony of the U.S. oil price-cap proposal is it stands in sharp contrast to the leadership Washington displayed in February executing a well thought-out, comprehensive set of financial sanctions by the world’s advanced democracies on Russia’s banking system, related institutions and Putin’s cronies soon after Russia’s invasion of Ukraine. It amounted to a sanction strategy whose cross-country coordination and effectiveness is unprecedented over the last half century. One would have to look back to the sanctions applied to South Africa for its apartheid regime between the 1950s and 1990s to find a comparable initiative.

These sanctions are causing far more pain to the Russian economy than the “exit” of Western firms is being made out to be; in fact, it is far from clear how much bona fide exit has actually taken place in Russia.

There are two alternative sanction strategies for Russia’s oil and gas sector that Washington and its allies should consider in lieu of the price-cap regime. They are not command-and-control but rather dynamic and their effects are market-driven.

One would be for the U.S. and its allies to apply a uniform tariff on imports of Russian oil and gas. Collectively coordinated, such a regime would make Russian fuels more expensive on world markets, reduce demand for Russian oil and thus curb revenue accruing to Putin. Of course, it would also increase the oil prices consumers face in the countries imposing the tariff. But the difference between this strategy versus a price-cap is the extra revenues generated by the tariff would accrue to the treasuries of consuming countries since they are the ones charging the tariff.

Would such a hike in the price of oil-consuming countries raise energy costs and thus stunt economic growth? Perhaps—of course depending on the magnitude of the tariff. But the risk of this would be diminished if the governments in question quickly recycle the tariff revenues they collect to stimulate domestic consumption and productive investments: think, greater spending directed toward job creation and construction in public mass transit or similar projects.

Equally important, as noted above, creating downward pressure on the oil and gas prices consumers in the U.S. and our allies pay, the price cap actually creates incentives for using more not less fossil fuels. This would exacerbate the existing gap between the social cost and market price of such fuels thus worsening greenhouse gas emissions. As I’ve written before in this space, a tariff specific to oil and gas imports would increase the relative prices of those commodities and bring social costs in line with market prices. The sustainability benefits of enacting such a policy should be obvious, especially in aftermath of COP27.

A second form of oil-specific sanctions would be for the U.S., allied with a few other large oil producers—Canada, Saudi Arabia, Iraq, United Arab Emirates, Brazil, and Kuwait—to ramp up production and flood the world oil market with additional output to drive down oil prices Russia is able to charge. Such “predatory pricing” would be a sure-fire method to utilize oil as a vehicle to weaken the foundation of the Russian economy.

This would seem to be a no-brainer sanction to be put on the table. In theory, at least.

Why?

For starters, the Saudis have recently moved in the exact opposite direction—restricting output. Beyond Canada it is not clear whether the U.S. could get the Saudis and other large oil producers to go along with this approach. Many of them have far less antagonistic—indeed even benign or friendly—relations with Russia.

Should Washington, London, Brussels, and Ottawa be able to persuade Riyadh to expand output, that would surely drive down oil prices. But it is unlikely—given the overall size of the global oil market and the additional volume of oil the Saudi’s (currently) could produce—that prices would fall dramatically enough—and remain at a level—to inflict significant harm on Russia’s oil revenues.

To do that, coordinated releases would be needed from oil-consuming countries’ stockpiles, such as the U.S. Strategic Petroleum Reserve (SPR). And such coordinated drawdowns would need to be both substantial (relative to the current volume of oil in the global market) and sustained.

The goal is to not only increase supply sizably relative to demand, but also to send a credible signal to the overall oil market that the supply-demand balance has structurally shifted. Failing to do both will unlikely have the desired impact on oil prices. A surely unsatisfactory outcome would be one where an enlargement of supplies fails to move prices lower. In fact, if such a strategy does backfire, it may well result in oil prices increasing since oil buyers and sellers could lose confidence in the stability and integrity of the market.

Regrettably, the core issue for effective predatory pricing remains this: while conceptually flooding the supply of global oil markets to reduce oil prices could be the most effective approach to penalize Russia, the reality is that current world oil stocks are unlikely to be large enough for this to work.

Equally important, even if coordinated drawdowns are done adroitly and do significantly lower world oil prices and thus adversely affect Russia, they may also engender new risks to oil-consuming countries on the domestic front.

First, there would be heightened prospective national security risks—unless our petroleum stockpiles were able to be replenished quickly, ideally while oil prices are soft.

Second, as highlighted earlier, there would be increased environmental risks since the cheaper oil would serve to stimulate oil purchases by consumers and firms in the U.S. and our allies. This would increase emissions of greenhouse gases and thus erode progress made on sustainability.

Mitigation of such risks, however, can be accomplished if surcharges were added to our retail and wholesale prices of fossil fuels to curb excess consumption of them. Indeed, this is a policy that, as I have argued elsewhere, should have already been in place in the U.S. Regrettably it has not. Like the collection of revenues from the import tariff scheme described earlier, monies generated by these surcharges would go to our national treasuries (and designated for our investment in mass transit etc.) while Russia would be only able to receive low prices.

As is almost always the case, it’s rare to find economic policies that are “silver bullets.” A careful assessment of the benefits and costs across imperfect alternatives—including their relative workability—must be weighed. The lack of simplicity, transparency, and protection against corruption inherent in the oil price-cap scheme all point to its questionable efficacy and the need to devise such alternatives.