A Big Bang? Anticipating the Impact of Europe’s Sanctions on Russian Energy

What are the likely real-world consequences of the European Union’s recently announced sanctions on Russian crude oil? In many respects, the oil embargo formally codified the current state of affairs. In April and May, many European buyers started to boycott Russian crude, though Russian-owned refineries such as Lukoil’s ISAB in Italy or German refineries controlled by Rosneft increased their purchases. Based on the drawn-out negotiations to come up with the EU’s sixth package of sanctions, it also appears that a gas embargo is off the table—at least for the moment.

In the meantime, there are already certain changes in global energy flows. Russia has diverted a large share of exports to India and China, for example, while European buyers have increased purchases from West Africa and Latin America. Some analysts were quick to predict that Russia would not be able to divert much of its flow to the east, focusing on the inadequate spare capacity of pipelines going to the Pacific and China, and failing to take into account the possibilities of diverting seaborne trade from Europe to Asia. 

In fact, Europe likely will be able to switch shipping and supply patterns to supplant Russian crude with oil from the Atlantic basin that was previously intended for Asia, allowing Russian volumes to take over Asian markets. However, costs incurred from increased shipping distances and corresponding freight charges will be mostly carried by Russian sellers, as shipping distances from Africa and Latin America to Europe are shorter than to Asia. Russia’s primary European export outlets—the Baltic port of Primorsk and the Black Sea port of Novorossiysk—may continue to function as before, but profit margins will be hurt if the crude is then sent on a sixty-day journey to new destinations instead of the typical two weeks to reach European refineries.

Just a few months ago, at the beginning of 2022, the global oil tanker market was suffering from overcapacity, and any increased demand for shipping was welcomed by the industry. Today this still seems to be the case, as freight rates have only increased slightly, indicating that spare tanker capacity is still sufficient to meet the increased demand.

The trade environment is becoming more difficult for Russian sellers looking for a share of the overseas market. They are now at the mercy of the smaller number of potential buyers who are not worried about sanctions risks. These buyers are demanding stiff discounts on global oil price benchmarks, but—luckily for Russian producers—with headline oil prices firmly in the three-digit range, even after discounts and increased shipping costs, the price for Russian crude has remained in or above the $60–70 range. Russia’s windfall may be smaller than it would like, but such prices are still higher than what Russian corporate and state planners had assumed in their long-term projections.

Another challenge for the EU is reducing its dependency on Russian diesel fuel imports. Currently, Europe is the world’s largest importer of diesel, buying 50–60 million tons per year. More than half of that originates in Russia. The obvious fallback would be to import more from either Saudi Arabia or India, which traditionally export diesel to Africa and lower-income parts of Asia. Ironically enough, any increased Indian diesel exports to Europe are likely derived, at least in part, from its surging imports of Russian crude. 

Either way, the resulting pattern will be the same as for crude: politics are becoming more important than geography in shaping energy flows, and rational logistical schemes are being replaced by politically dictated alternatives. Some important global choke points, like the Suez Canal, will see a substantial increase in two-way traffic of both crude and product shipments, which may start to create problems and delays.

So what exactly has been achieved by the EU’s sixth package? The announcement allows European leaders to mollify critics who have complained—with good reason—that the EU’s purchase of Russian oil far outweighs its economic and military assistance to Ukraine. In practice, however, the new restrictions will not substantially reduce the revenue that Russia receives from sales of oil and other refined products. If anything, the new prohibitions might actually make life easier for Russian producers for the next six months. By effectively allowing trade to continue unimpeded, the EU is removing a degree of uncertainty over the possibility of an abrupt ban that could leave some cargoes stranded midway. Now that risk has been largely removed.

The EU has also backtracked on measures that might have hindered Russia’s ability to trade in oil by disrupting shipping. At the moment, the majority of Russian cargoes leave the country on tankers sailing under Greek, Maltese, and Cypriot flags that are insured or reinsured by the Lloyds of London insurance exchange and the International Group of P&I Clubs, also based in London.

Greece, Malta, and Cyprus raised objections to a ban on the transporting of Russian cargoes by European-flagged vessels. Though it is relatively easy to change the registration of a vessel to a different flag of convenience (e.g., Panama, Liberia, or the Marshall Islands), such moves merely lead to the loss of registration fees for the European countries and would not achieve much else.

The sixth sanctions package also included an EU insurance ban on Russian ships that will be enacted in six months, and the UK will most likely soon follow with a similar set of insurance sanctions. Lloyds of London is the main global exchange for marine insurance, and the reinsurance market is dominated by a handful of European and American players. Uninsured or underinsured vessels would not be allowed to enter any major port or pass through important shipping choke points such as the Bosporus or the Suez Canal. 

The state-controlled Russian National Reinsurance Company (RNRC) has already stepped into the breach, according to Reuters, providing state guarantees to Russian companies insuring tankers. While it is not unreasonable to ponder the viability of Russian state-backed guarantees nowadays, similar guarantees were provided by the Iranian authorities when tankers carrying that country’s oil were hit by similar sanctions in 2012, and industry insiders told Reuters that the replacement Russian state cover would likely be a feasible workaround.

All things being equal, if the EU’s plan for weaning itself off Russian petroleum exports actually succeeds, then the global economy will be looking at a potential energy crisis. The tightening of the Iranian sanctions regime in 2017 and 2018 sent oil prices soaring from around $50 to $80 per barrel due to a production cut of 1.3 million barrels per day (bpd) and export reductions from 3 to 1.7 million bpd. At the beginning of 2022, Russia was exporting close to 5 million bpd of crude oil and 2.5 million bpd of petroleum products.

Iranian production curtailments were quickly compensated for by production increases from other OPEC+ members, including Russia, who were sitting on ample amounts of spare capacity from the pre-2014 golden era. U.S. shale production was also on the upswing at the time. In 2022, following eight years of substantially reduced upstream investments, further influenced by severe production cuts enacted in 2020 in response to the pandemic-induced drop in demand, spare production capacity is extremely limited.

OPEC+ spare capacity probably amounts to 1.5 million bpd in the United Arab Emirates and 2 million bpd in Saudi Arabia, with some analysts quoting substantially lower numbers. According to the U.S. Energy Information Agency (EIA), U.S. production could grow by 0.7 million bpd. The rest of the world has been struggling to sustain existing production levels; for example, OPEC+ has not been able to keep up with its proposed production increase schedule since the fall of 2021.

The Biden administration has been lobbying Saudi Arabia since March to increase output to dampen rising oil prices and to compensate for the Russian volumes lost due to boycotts and overcompliance by sanctions-wary entities. Saudi Arabia has been recalcitrant, citing the need to keep some capacity in reserve for an emergency.

At the beginning of June 2022, OPEC+ agreed on an accelerated production increase schedule. However, if fully implemented, this arrangement would only bring volumes to the levels targeted when the “return to normal” plan was devised in July 2021. Meanwhile, U.S. commercial crude oil stocks are below the five-year range, both in terms of barrels and days of supply, despite the ongoing 1 million bpd release from the Strategic Petroleum Reserve.

A similar situation could arise on petroleum product markets. Developed markets have seen refinery closures: in 2021, global refining capacity contracted for the first time in thirty years. Traditionally, the world maintained up to 20 percent of spare refining capacity, but closer analysis may show that the slack is concentrated in older and more primitive refineries, which are unable to manufacture the required products. A genuine loss of 80 million tons of Russian diesel exports may also be difficult to replace.

So, if we assume that the total of the current 7.5 million bpd of Russian petroleum exports will be slashed in half, with the other half managing to make its way past the sanctions barriers, the world petroleum balance would be short 3 to 4 million bpd, which is comparable to all of Western Africa’s production or Japan’s consumption. Such a disruption has the potential to exceed the previous oil crises of 1973, 1979, and 1991, and unlike the previous disruptions, it promises to last not just a few weeks or months, but years.

The six-month grace period will give the world some time to prepare, but with production capacity already tight, as reflected by current oil prices, there is little surplus production that could be stored for the future. The global oil industry has, since 2014, lived under a capital crunch and in cost-cutting mode. The project pipeline is quite dry, with no new major additions expected in coming years. Saudi Arabia has recently announced plans to increase its production capacity by 1 million bpd, raising its maximum sustainable capacity to 13 million bpd. But according to the plans, it will take five years to implement that goal.

On the one hand, the design of the European sanctions clearly signals that there is a plan to keep these measures in place for years, if not forever. That is based on the assumption that by the time the sanctions could be lifted based on a change in the strategic situation, decarbonized Europe will no longer need Russian oil. This does create some certainty for potential oil investors. On the other hand, for at least the last five years, both the oil industry and oil and gas investors have lived under a constant barrage of appeals to accept that their industry is doomed, that their assets are stranded and should be written off, and that investing more in oil production is foolish and irresponsible.

The impending and almost inevitable energy crisis poses an interesting dilemma to policymakers. The energy transition has just received a huge boost: not necessarily from climate change considerations, but from the standpoint of energy security and energy independence. Russian President Vladimir Putin, with his threats of a very cold coming winter, will probably prove more persuasive than the Swedish activist Greta Thunberg talking about very hot summers some years from now.

These security-driven investments in energy transition might bring forward a material decline in demand for hydrocarbons by a decade. Investments in production capacity increases tend to pay back over long periods—sometimes fifteen to twenty years—and this acceleration of the oil twilight might discourage any investments in major projects even further.

On the other hand, increased energy transition investments will not bear fruit for a few years, and the world needs an energy bridge from now to then. Governments might have to come up with schemes that would guarantee a decent return on these investments or set up mechanisms for buyout and retirement of this capacity created in the state of emergency. These investments, potentially scaling to hundreds of billions of dollars, will be another deadweight loss and cost of the war in Ukraine. 

By:

• Sergei Vakulenko