The Russian Oil Price Cap: A Repackaged Status Quo
Depending on future actions, there's also a interesting possibility of increasing petrodollars returning home and rising alternative petrocurrencies.
Crude oil has had a strong bullish run for a while now. With OPEC+ nations maintaining increase in production along plans made years in advance and largely refusing to budge in response to rising demand, oil prices were already spiking for almost a year before the Russian “special military operation” in Ukraine.
However, since the start of this month till the 22nd, the US Oil ETF (NYSE ticker: USO) – which invests primarily in futures contracts for light, sweet crude oil, other types of crude oil, diesel-heating oil, gasoline, natural gas, and other petroleum-based fuels – is down nearly 6%:
Over the past week alone, the drop was a staggering 8.4%.
This is being tied to the U.S. Federal Reserve's decision to enact what is commonly referred to as a "Fed rate hike". The "Fed rate" refers to the Federal funds target rate. A group within the U.S. Federal Reserve System - the Federal Open Market Committee (or FOMC) - sets a target range for the federal funds rate, which provides a reference for the interest rates large banks charge each other for "overnight loans".
Banks typically borrow overnight loans from each other to meet liquidity requirements mandated by regulators. The average of the interest rates banks assign for these loans is called the "effective federal funds rate". This rate is influenced by the target rate. As a result, loans become more expensive for economic participants - be they merchant or consumer - interest payments increase. When this rate is hiked, this provides an impetus for all economic participants to spend less and save more, thus reducing the total money supply and easing inflation. The higher cost of business for companies in the face of fewer business transactions signals lower revenues and earnings, which is reflected by an impacted business growth rate and stock valuations.
Over the decades, this has impacted oil prices as well. Oil prices rise when the supply-demand gap is tilted towards higher demand. With less business, less demand is implied. Thus, oil prices take a dip. This is clearly evident in patterns in abrupt shift in crude oil trajectories over the past years in the pre-pandemic era.
However, what bears noting that “dovish” moves by the Fed – meaning small changes in the rate – do little to address extensive inflationary momentum. For instance, it took significant amounts of U.S. government assistance through the Troubled Asset Relief Program (TARP) wherein large amounts of debt, mortgages and even shares of troubled companies were purchased to “promote financial stability” before inflation settled briefly in a downward trend. Crude oil prices followed this downward trend to a point before galloping away again (and with it inflation rates).
It bears noting that the Consumer Price Index (CPI) measures a “basket” comprised of percentages of various items such as food, energy, electricity, etc. to provide an indicator for directionality of price increases. In other words, it isn’t an “average” increase of household expenses (i.e. inflation); actual increases in wheat, bread, meat, lumber and fuel (of any kind) are far in excess of the CPI rate. The notional “rate of inflation change” has steadily gone well past levels seen during the 2008 Financial Crisis.
Given the supply-demand gap that remains unchanged by OPEC+ and exploration & production restrictions in the U.S., crude oil prices has impacted household savings. Prices of energy assets – including the stocks of oil & gas companies – rose almost in tandem. With no effective inflation-adjusted wage increases to stave this off, there is now a downward pressure being implied on consumption.
Over a course of 10 days, i.e. June 10th till June 17th, the S&P 500 fell by 12%, the largest fall in the year so far. In terms of 50-Day Moving Averages (50-DMA) – a simple and effective tool used by traders to analyze the technical health of stocks, with those being above this line being considered “healthy” and those below it “not healthy” – the S&P 500’s level as of the 20th was 10% below its 50-DMA.
Meanwhile, the 50-DMA Spread – the difference between the upper and lower limits of the 50-DMA – for energy sector constituents within the S&P 500 was a little more than 10%.
In the past week alone, the number of energy sector constituents’ stocks above their respective 50-DMA has gone from 100% to zero. Furthermore, virtually every major U.S. oil company now indicates as “oversold”:
“Drinking Poison to Quench Their Thirst”
As of all of this wasn’t enough, it was announced on the 21st of June that the U.S. Treasury – in consultation with some U.S. allies (read: Canada) – is working on a “Russian oil price cap” to limit the increased revenues the Russian government is enjoying from high crude oil prices. One means being explored effectively increases ease of transport of Russian crude oil. Due to the prominence of EU/UK-based companies in the shipping insurance field, the sixth round of European sanctions on Russia included a ban on insuring seaborne oil cargoes out of Russia, effectively contributing to oil prices skyrocketing. While details are sketchy at this point, there are indications that a proposal is being floated that the ban would be rescinded if the companies shipping oil out of Russia only pay a certain price per barrel. As of right now, EU officials have stated that this would be very difficult to do.
Now, it bears remembering that the term “Russian oil price cap” is about as meaningful as the current U.S. administration calling the current high-inflationary circumstances “Putin’s price hike”: the latter assertion was refuted by Federal Reserve Chairman Jerome Powell on the 22nd. In the former’s case, it’s simply a restoration of the status quo back to OPEC+ (of which Russia is a member of).
This is significant on a number of fronts: for instance, due to sanctions on energy movement out of Russia, the Russian government - in a bid to continue its presence in the energy market - began offering Indian importers steeply discounted oil in April. India is the world’s 3rd-largest energy consumer but Russian oil imports ordinarily (i.e. in Full Year 2021) accounted for a little over 1% of India’s imports due to high transit costs. Under the discount regime and factoring in the increased transit risks as well as the lower grade of oil, the deal was estimated to have a slight upside for the importers.
Predictably, Western powers - led by the U.S. - attempted to reverse the Indian government’s decisions during the course of a “India-US 2+2 Ministerial Dialogue”. It did not go down well with India’s straight-talking Foreign Minister whose response went viral:
Undeterred by Western efforts at moral shaming, India’s Russian energy imports reportedly increased nine-fold, albeit from a very low base, in May. The Indian minister delivered another response to continued criticism/”concerns” from European politicians, which also went viral:
“Europe has to grow out of the mindset that Europe's problems are the world's problems but the world's problems are not Europe's problems. If it is you, it’s yours. If it is me, it’s ours.”
- S. Jaishankar, Indian Minister of External Affairs
Minister Jaishankar’s comments also included an oblique reference to Europe taking care of its population at a cost to other nations. As it turns out, European sanctions have a rather cynical “carve-out”: while the EU/UK axis effectively bans Russian energy transactions in its territory, it doesn’t prohibit energy imports into their territories. As a result of the costs being lower for European consumption, European refiners received a larger discount from the Russian government than Indian importers on a “delivered basis”: the latter effectively availed a $10 concession while European refiners are assumed to have received much higher concessions.
China, the world’s 2nd-largest energy consumer, has been more vociferous in defending Russia after the “special military operation” began. In response, U.S. Treasury Secretary Janet Yellen (the leader of the “oil price cap” action being explored) warned China during an Atlantic Council event:
“The world’s attitude towards China and its willingness to embrace further economic integration may well be affected by China’s reaction to our call for resolute action on Russia”
- U.S. Treasury Secretary Janet Yellen
Like India, Chinese diplomats and government functionaries stiffly rebutted any attempts to be cowed into acquiescence. In further commentary via a State newspaper (which had no byline; a practice to indicate this view can be considered as an “extension” of the government’s position), it was stated, “By prolonging the war in Ukraine, the US government is trying to shift the problems to other countries. But this is just drinking poison to quench their thirst.”
After initially not participating in significantly greater purchases of Russian crude oil on account of differences in grade that Chinese refineries typically process, data now shows that Russian oil imports displaced top Chinese supplier Saudi Arabia in May. Furthermore, on the 17th of June, China outright expressed support for Russia's sovereignty and security while recommending that all parties push for a proper settlement in a “responsible manner”.
In effect, both Eastern powerhouses are - publicly - pretty fed up with Western double-talk. It’s extremely likely that other developing nations’ policymakers and think-tanks are taking notes and thinking things through.
Other Possible Measures and Consequences
There are a number of reasons for both countries - who have a tense relationship with each other - to not consider going with Western nations’ directives or “suggestions”, given their historic experiences (even post-Independence) with cultural and geopolitical high-handedness from the Western bloc. Given that neither country will give up on national interests for any reason and no additional source of supply or an increase in supply are on the cards, it’s inconceivable that either nation will stop or even limit imports.
One objective of the “Russian Oil Price Cap” mission (for lack of a better term) is to “push down the price of Russian oil and depress Putin's revenues”. It’s thus possible that a couple of other scenarios based on historical fact patterns.
Option No. 1 would be to apply pressure on countries to not pay the Russian government for oil imports. This was already attempted by SWIFT sanctions on seven Russian banks. However, it bears noting that SWIFT is just a financial messaging service, which isn’t really unique. Russia has the SPFS system established by the Central Bank of Russia, China has the CIPS network created by the People’s Bank of China and India has the Structured Financial Messaging Solution (SFMS) system, which is being scaled up to connect Indian banks to the global banking system via a secure closed-end network. Furthermore, international payments to Gazprom for Russian energy aren’t made via SWIFT anyways. Other countries have the option to access any of these networks to make their payments for Russian energy.
Option No. 2 lies in in the structuring of the standard “oil contract” itself which, largely by default, is denominated in U.S. dollars. The U.S. could somehow impose an upper limit on the number of U.S. dollars a Russian “oil contract” could be denominated in per-barrel terms, which could technically be considered a “price cap”.
Now, the reason for this is purely historical: in 1944, the U.S. held most of the world’s gold and agreed to redeem any U.S. dollar for an equivalent value if other countries pegged their currencies to the U.S. dollar. This created the “gold standard” and the U.S. dollar became the world’s “reserve currency”. In 1971, after stagflation created requests for gold redemption from several countries, President Nixon abolished the gold standard.
The close relationship between the U.S. and Saudi Arabia (since 1945) - which even endured decades of Arab-Israeli conflict, during which both were at opposite ends - resulted in an agreement to price oil contracts in U.S. dollars in 1979. The “petrodollars” collected for oil deliveries would be recycled back into the system via contracts for American companies while the balance would be used to pay higher salaries in the exporting countries and create sovereign wealth funds (thus leading, for example, to Saudi funds owning stakes in Lyft, Uber, FedEx, PayPal, Walmart, Pinterest, Lucid and Twitter, among others). These investments don’t account for all the dollars paid in; the balance continues to reside in the exporters’ central banks, largely cut off from the U.S. money supply.
For importers, this hasn’t been a great proposition in recent times: the U.S. dollar is consistently considered a “strong performer”, despite $3 trillion being “created” in 2020 alone with a substantial amount invested into holding imperiled financial assets to promote stability.
This consideration coupled with rising crude oil prices is a “double whammy” that perturbs their balance of trade. Both China and India have been working on denominating their oil contracts on their respective currencies for some time now.
After sanctions were imposed on Iran, India paid for oil payments using a mixture of rupees and euros and eventually settled for paying exclusively in rupees. On the 20th of June, it was reported that a consortium of Indian and Russian banks have concluded discussions on an agreement to directly translate roubles to rupees without the U.S. dollar as a benchmark and outside of SWIFT primarily to support energy transactions. The Russian institutions could also receive authorization to invest in Indian assets with idle rupee balances. This follows shortly after Tehran’s envoy in India Mr. Ali Chegeni offered to restart rupee-rial transactions once sanctions are eased. Mr. Chegeni further estimates the eventual growth in bilateral trade to be about $30 billion.
Similarly, China has been negotiating with Saudi Arabia an agreement to settle oil contracts in Chinese yuan. While being reported as being of “only symbolic value” in Western media, it has been reported that a number of Saudi officials favour this shift to ease business with China. Once these kick off, it’s an even bet that exporters such as Saudi Arabia, Iran and Russia will iron out similar deals with both importers and possibly others.
So what of the petrodollars held in the exporters’ reserves? Well, importers would diversify their reserves (and inherent currency risks) by incorporating more Indian rupees, Chinese yuan, Japanese yen, South Korean wons, Brazilian reals, South African rands, et al. These petrodollars would end up being repatriated back to the U.S. and create an increase in money supply, which could exacerbate inflationary pressures.
Did someone say “That could never happen”, dear reader? Well, other notable “nevers” that come to mind are: “Electric cars can never be viable”, “Communism can never be popular in America” and a “a reality TV star can never become President”.
Instead of the aphorism “Never say “never”’ or any equivalents of thereof, lets consider the world thus: the sky is blue, the grass is green and the possibilities are numerous with varyingly dynamic inevitabilities.
The events in play bring about an interesting idea that finds little purchase in the larger media complex: the Great Delink between the West and East. More on that on another day. Stay tuned and hit “Subscribe” to receive future articles directly if you haven’t already!