Global Courant
In January 2023, Russian President Vladimir Putin instructed senior Kremlin officials to find solutions to something he called the “discount” — a problem he feared could cause “budget problems.” Putin referred to the large price cuts or “rebates” that Russian oil exporters have been forced to offer to willing buyers amid Western sanctions.
Since oil exports are the largest contributor to Russian state revenues, these cuts are cause for concern. They are largely responsible for a 25% year-on-year decline in Russian fiscal revenues for January and February.
During that period, spending also increased by 52%, mainly due to the large-scale invasion of Ukraine by Russia. The result is a growing deficit that threatens to erode Moscow’s economic resilience.
These cuts are a direct result of the European Union and G7 oil sanctions against Russia and have proved more challenging for Moscow than many expected. They have cut Russia’s current earnings and may also curb future windfalls as prices rise.
But the Kremlin has developed countermeasures to thwart sanctions. Chief among them is to assemble a “shadow fleet” of tankers that can carry Russian oil with impunity. While Moscow’s shadow fleet has been steadily expanding, it will probably be years before it is large enough to shield all Russian exports from sanctions.
But as the shadow fleet expands, these tankers — many of them outdated and poorly maintained — pose an increased risk of oil spills in coastal regions from the Baltic Sea to the Sea of Japan. To counter these threats, coalition policymakers and coastal states will need to take strong action.
The Russian oil sanctions consist of two separate embargoes. The first is an EU/G7 ban on Russian oil imports, forcing Moscow to find new buyers for nearly three-quarters of its oil exports. For an exporter the size of Russia, this has proven to be a challenge.
A worker checks monitoring equipment at the Slavyanskaya compressor station, the starting point of Russia’s Nord Stream 2 pipeline. Photo: TAS
For 140 years, Russia has regarded Europe as its main export market. The vast oil infrastructure is primarily designed to move oil westward, with more than 80% of exports going by sea through European waters. Sanctions force these cargoes to be shipped to lesser-known markets that are more restricted and remote.
There are only two major buyers for Russian crude oil: China and India. Before February 2022, China bought nearly 20% of Russia’s exports and has since ramped up imports slightly. The major buyer of Russian crude – which absorbs more than half – is India, which previously imported almost no Russian oil.
Lack of competition on a large scale has given Indian traders strong bargaining power to get the high discounts that worry Putin. The longer distances to the market have also increased Russian freight costs, further depressing Moscow’s operating results.
Moscow has taken two measures to counteract the discounts. One is to ease the overabundance of Russian crude oil by announcing a cut in exports. The other is to sell more to China to regain pricing. But additional supplies to China must come from Russia’s distant Baltic and Black Sea ports, as exports to China from Pacific ports are nearly full.
This means higher freight costs and an unwanted increase in the Russian need for tankers. That makes Russia even more vulnerable to the second EU/G7 embargo – a so-called “price cap” that prohibits EU and G7 entities from providing shipping services for Russian marine oil priced above a certain value.
For crude oil, this capped price is currently US$60 per barrel. The price cap is designed to limit Russia’s ability to take windfalls from high oil prices while avoiding the supply shock that an unconditional ban on shipping services would cause.
Russian tanker needs are immense and it is a challenge to meet them without relying on European maritime services. From ship financing to fleet ownership, Europe plays a disproportionate role in all aspects of global oil shipping, particularly in the complex area of mandatory oil spill liability insurance.
Approximately 95% of the global fleet is insured by a sophisticated non-profit network of mutual insurance societies, the International Group of P&I Clubs (IG).
The IG insures industry-wide liabilities that are too large for the commercial insurance industry to cover. Being based in Europe, the IG requires insured vessels to meet the price cap as a condition of cover. Compliance with sanctions is the trade-off that shipowners make for what is an indispensable part of their business model.
Russia is increasingly turning to a fringe group of tankers – the so-called “shadow fleet” – to reduce its IG-insured fleet dependency. Shadow tankers normally spend most of their service life as IG-insured vessels in the regular fleet. But in the final years before retirement, many tankers are sold to second-rate operators who exploit them for money.
Some operators are anonymous “shadow” investors based outside the EU/G7 countries and pursue a risk-friendly business model that replaces IG policies with cover from niche, low-transparency insurers.
While some insurers are reportedly undercapitalized and offer inferior policies, they compensate shadow tanker owners through relaxed insurance standards and a laissez-faire approach to sanctions that allow them to do lucrative business in Iran, Russia and elsewhere.
Since the summer of 2022, the number of shadow tankers transporting oil from Russia has been growing. Over the next few months, these oil-laden ships will sail through busy maritime bottlenecks in Europe and Asia.
A September 2022 collision in the Singapore Strait highlights the danger they pose. As their numbers continue to grow, so does the risk of a catastrophic spill.
Russian President Vladimir Putin has strategically exploited the country’s oil exports. Image: Twitter
Despite its growing shadow fleet, Russia still relied on IG-insured tankers for more than 60% of its exports in March 2023. So far, this has cost Russia little, as most of its oil still trades below the price limit.
But if prices rise, Russia may have to choose between cutting exports or lowering prices. It may try to avoid this choice altogether by underreporting transaction prices — a scheme it already appears to be testing on some payloads.
Oil sanctions continue to weigh on Russian revenues, but Moscow is stepping up its evasion efforts. Coalition policymakers can counter these efforts by lowering the price cap and improving oversight.
Coalition nations should also encourage Russia’s remaining major importers to resist Russian pressure for kickbacks, kickbacks or other compensation, lest such practices increase pressure for secondary sanctions.
Finally, to counter the increased risk of a catastrophic spill, coastal states will have to push for an end to lax enforcement of shadow tanker safety regulations.
Craig Kennedy is a former Vice President at Bank of America Merrill Lynch, a Center Associate at Harvard’s Davis Center for Russian and Eurasian Studies, and author of the Substack newsletter Navigating Russia.
This article was originally published by East Asia Forum and has been republished under a Creative Commons license.
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