How the Oil “Price Ceiling” Will Affect the Russian Economy
Two Potential Scenarios
On the fifth of December, the European Union set a ceiling of $60 per barrel on the price of Russian oil. How will this affect the Russian economy? Alexander Potavin, an analyst at “Finam,” one of the largest investment groups in Russia, proposes considering two scenarios of further development of events with the oil market and the Russian ruble: favorable and negative.
Let’s start with the positive. At the end of November, Russian oil exports by sea remained stable. Bloomberg reported that in the twenties of the month, sea shipments increased from 2.67 to 2.89 million barrels/day, and the average for the last month was 3 million barrels/day.
By the end of November, the supply of Russian oil to Europe (not including Turkey) had fallen to a 4-week average of 460 thousand barrels/day. Of this volume, only about 335 thousand barrels/day will have to find new markets after December 5. Industry analysts note that in a positive scenario, Russian oil exports will decrease by about 0.3-0.4 million barrels per day after the introduction of the embargo in December.
In turn, these falling volumes of oil exports will support world oil prices. This means that the inflow of foreign currency into the domestic Russian market will not change significantly, and the ruble will maintain relative stability. This means a range of 63–68 rubles to the dollar for the first half of next year.
The decline in oil prices and fall in production volumes predicted in the second scenario is also a real possibility. At least on the eve of the introduction of the “price ceiling” in December, buyers of Russian oil were demanding very large discounts. In early December, the cost of Russian Urals oil (which previously accounted for 60% of exports) fell below $45 per barrel (with shipment from the port of Primorsk). The discount on Urals crude relative to Brent has widened to $35, as there are no customers to buy Urals, Argus analysts say.
East Siberian ESPO oil, which is supplied from Pacific ports to China, now costs around $69/barrel. Russian oil is bought by small non-state Chinese refineries without regard for the “price ceiling.” But the discount on it is also now growing: now it is $6/barrel, while a month ago it was no more than $2/barrel. Such a significant discount costs Russian oil exporters about $4 billion a month in the form of lost profits, which greatly reduces Russia’s tax revenues from exports.
Since December 5, two types of sanctions against Russian oil have begun at once, namely:
• an embargo on maritime shipments of oil from Russia to Europe;
• US, UK, and EU bans on the provision of transport, financial and insurance services to tankers working with those who buy oil from the Russian Federation above the designated “price ceiling.”
In addition, from February 2023, a ban on Russian oil products will come into force in the EU. This will also be a serious blow, because 54% of petroleum products exported from Russia previously went to Europe.
“Russia may be forced to reduce oil production due to the new package of sanctions, which includes a ‘price ceiling’ and a ban on insurance of tanker transportation,” Deputy Prime Minister Alexander Novak said earlier. For the Russian oil industry, this would mean the arrival of hard times – as in the depleted fields discovered in the days of the USSR, the well stocks were not able to be restarted after the crisis of falling production due to the pandemic, even with modern technologies.
Such large buyers of Russian oil as China and India do not officially support the “price ceiling.” However, despite their strategic partnerships with Russia, China and India suspended some purchases of Russian oil in the second half of November until the specifics of this type of sanctions are clarified.
What will be the consequences for the Russian Federation of all these restrictions?
Russian oil companies will face an increase in logistics costs, because a tanker’s journey from Primorsk (the largest Russian oil port in the Baltic, the end point of the Baltic pipeline system) to European ports was 3-4 days, and the journey to India is about a month. As a result, cargo turnover will decrease, and freight costs increase.
In Russia, the cost of oil production varies greatly depending on the field. On average, the cost in the country of oil extraction from the ground is $10–12 per barrel. If we add taxes to this, then on average through the oil industry, net costs rise to $40–50/barrel. Added to this are the expenses of companies, and other fees to the budget. If oil ends up selling at $60/barrel, then companies retain very little in profit.
However, at the current exchange rate of the ruble, an oil price of $50/barrel is not enough by historical standards for Russian oil companies. The ruble price of a barrel of oil is now approximately 63×50 = 3150 rubles. The level comfortable for the industry was usually considered to be over 4000 rubles per barrel. Our tax base depends on oil prices; that is, even if oil prices fall to $40–50 per barrel, our oil industry can remain profitable, but at the expense of tax cuts (leading to falling budget revenues). Thus, a lower limit on the cost of oil from Russia can be at the level of $50/barrel, but then the exchange rate needs to be not 62, but 80 rubles per dollar. In this case, production volumes will not fall due to unprofitability.
However, Russia’s budget revenues from oil production and exports continue to decline. The head of the Ministry of Finance, A. Siluanov, has raised the estimate of the federal budget deficit from 0.9% of GDP to 2.0% of GDP. This means a sharp increase in budget injections into the economy at the end of the year, which can create inflation risks in 2023. The budget for 2023 has a deficit of 2.9 trillion rubles, but now there are risks of the budget deficit exceeding even this planned value.
These risks are associated with a possible shortfall of oil and gas revenues in the context of a fall in world oil prices, and due to the entry into force of the “price ceiling.” Let me remind you that the budget is calculated on an average annual price of Urals oil of about $70 per barrel, but now it has fallen to $45 per barrel. Plus, there will almost certainly be a decline in export volumes with the redistribution of the remaining sea supplies of Russian oil and petroleum products from the EU to third countries. And on the other hand, the strong ruble exchange rate (the budget is based on an average dollar exchange rate of 68.3 rubles) also means a smaller volume of ruble oil and gas revenues. This does not even take into account the risks of continued growth in budget expenditures related to the ongoing military operations of the Russian Federation in Ukraine.
A critical level for the state budget of the Russian Federation, with production of 10 million barrels/day, will be if the price of oil drops to $45–50/barrel. In this case, the shortfall in revenues in the amount of 2 trillion rubles will require a sequestration of the budget or a significant weakening of the ruble. If in 2023 oil prices are weak, and at the same time the volume of oil production and exports from the Russian Federation decreases, then the exchange rate will clearly not be as strong as it is now. The return of the dollar exchange rate to the level of 75 rubles is simply a matter of time.
According to the May forecast of the Ministry of Economic Development, the average annual exchange rate of the ruble in 2023 will be 77 rubles per dollar, while Urals oil will cost $71.40/barrel. The Central Bank expects a price for Urals of $65/barrel next year; the regulator traditionally does not give a forecast for the exchange rate.
In the worst-case scenario, if Russia does not manage to replace the banned supplies to Europe at all and taking into account the consensus forecast for the sales price of oil, the average ruble exchange rate in 2023 will be about 70–80 rubles per dollar. In the optimistic version – with the redistribution of 100% of exports – a rate of 65–75 rubles per dollar is expected. Obviously, the higher the price of oil and the stronger Russian commodity exports are, the stronger the ruble exchange rate will be.
Those parameters that are already laid down in the budget law have been taken into account by the Bank of Russia when forecasting inflation of 5–7% in 2023. In the event of their significant divergence towards a larger deficit, the Central Bank is likely to tighten monetary policy (raise the interest rate) in order to keep inflation within its forecast and achieve the goal of reducing it to 4% in 2024. The rate hike will have a negative impact on the activity of economic entities, which will lead to an overall decline in the country’s GDP next year.
The Russian economy has yet to reach its lowest point of decline; this will happen in the first quarter of next year, according to analysts surveyed by Bloomberg. According to their forecast, by the end of January–March 2023, the decline in Russia’s GDP may reach a nadir, exceeding 8%.
Conclusion
If the export of Russian raw materials continues to slow down in value terms, imports recover, and the expatriation of capital by the population continues to grow – then we will see a strong weakening of the ruble by the end of 2023.
To somehow temper all of the above, it is worth noting that in the autumn of this year, the main factor in the collapse of oil prices was China’s policy towards COVID-19. But as we know, all countries have already gone through this path of an increase in the number of cases and quarantines – and after 4–6 months of the crisis, the epidemiological situation will begin to improve. This means that the mobility of the population will go up, which will lead to a significant increase in demand for fuel. If by that time the supply of Russian oil has indeed decreased, the shortage of oil on the world market will certainly push oil prices above $100/barrel – which means that the funeral of the ruble can be postponed for some time.
