The G7’s recent proposal to impose a price cap on Russian oil may look good on paper, but would be difficult to enforce in practice, and is unlikely to achieve its aim of limiting Russia’s ability to finance its war against Ukraine.
Oil markets and the OPEC cartel have been a favorite subject of game theorists since the 1973 oil crisis prompted by a Saudi Arabia–led embargo. If implemented, a price cap on Russia oil will likely achieve little more than providing more food for thought for those theorists.
Oil is an unusual commodity: its price is much higher than the average short-term production cost and much lower than the average utility value to the consumer; plus, it has very low short-term price elasticity both on the production and consumption side. These aspects make it extremely hard to establish a fair value price, and lead to price volatility from $20–30 to $120–130 per barrel. Sometimes these wild fluctuations are caused by a sudden influx or reduction in supply, like in 1986, when Saudi Arabia tripled its production in the space of a few months, or by sharp reductions in demand, like in the aftermath of the 2008 financial crisis or during the COVID shutdowns in the spring of 2020.
At other times, the driving factor is a sudden realization that one of the parties has market power—like after the relatively short-lived Arab oil embargo in 1973—or that, on the contrary, it does not, as it transpired in the fall of 2014, when the world suddenly discovered that the United States was no longer the main importer of crude but an exporter, and a growing one at that.
The rationale behind the proposed price cap, to be implemented through a buyers’ cartel using a mixture of enticement and coercion, is quite clear. The Western coalition is rapidly coming to the conclusion that the world does not have sufficient spare oil production capacity to replace Russian oil, even taking into account the traditional stalwarts of the last resort like the Persian Gulf states. Warnings to this effect have been issued forth from various quarters, including public comments by oil industry executives and communications between G7 leaders at the recent summit.
It seems that Russia comprises too large a share of the supply of the already tight oil market for its volumes to be replaced. Worse still, partial exclusion is driving prices so much higher that Russia would earn more money by selling less oil, which would defeat the purpose of the plan. Less developed countries are already complaining about sky-high energy prices damaging their economies, and it would be difficult to make major energy importers such as India and China join the embargo if, on the one hand, the high price of non-Russian crude would hurt them, and on the other hand, there is the lure of an ample supply of discounted Russian crude.
On paper, the plan to establish a large cartel that would keep Russian oil flowing at a low price is a magic bullet. It is based, however, on an assumption that Russia would prefer to see some revenue, as long as it covers the marginal cost of production and allows for some profit, rather than to leave the oil in the ground and see no money at all.
That indeed might be a rational approach in a single-turn game. But Russia is a strategic player with a somewhat exotic value function, adept at negative-sum games. In addition, at least for now, hard currency revenue is of limited value for Russia, as illustrated by the plummeting dollar and euro exchange rates on the Moscow exchange. The existing combination of unprecedented sanctions and boycotts makes it next to impossible to import entire categories of goods and services, and leaves few opportunities to exchange hard currency for anything useful.
With that in mind, Moscow could well be inclined to call the West’s bluff and establish not a price ceiling but a floor for its crude, prohibiting exports at a price lower than that threshold. Initially, that could reduce the supply to the world markets, drive prices up, and then Moscow could simply wait for buyers’ cartel defectors to come knocking at its door.
It would all come down to who blinked first, and right now Russia probably has more resilience than at least some oil-importing nations, which would be enough. Russia doesn’t need to get everybody to buy its crude again, just a few buyers with increased orders.
Establishing a buyers’ cartel—even if its initial purpose was not to deal with the market as a whole but with a single rogue seller—may have other consequences. If successful, it would be ominous news for OPEC and Saudi Arabia, so it would be in their interests to torpedo it.
There are also doubts over the effectiveness of the proposed mechanism for enforcing the price cap. The scheme’s architects apparently struggled to come up with a strong coercive measure, so the plan was for Western insurance providers to deny their services to Russian cargoes not complying with the cap. But the Russian government is currently busy both building its own insurance vehicles and arranging for insurance from Asian companies. Moscow will need it anyway in the wake of the looming December embargo on insuring tankers carrying Russian oil, so withholding insurance may not be as effective as planned.
It would also be easy to invent a mechanism to circumvent the price cap. For example, Russian companies may resort to bundling oil together with other goods, selling oil at the capped price and other goods or services at a highly inflated price to make up for the difference between the capped and real market value. There has been plenty of research carried out into how these techniques work in other price-controlled markets, such as housing or foodstuffs. The G7 strategists may have to return to the drawing board.
