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A cap on Russian oil prices would be a dangerous escalation

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A cap on Russian oil prices, set by the United States and its allies, is expected to be adopted in the coming weeks. One question is how such a ceiling might work. Another is whether it’s a good idea. The complicated and uncertain answer to the first question is a reason to be uneasy about the second.

A price cap makes economic sense. But much more than the economy is at stake here. Russia sells oil at a significant profit, and the price cap limits some of that profit. Russia derives about 30% of its entire federal budget from oil and gas revenues, so removing that will hurt President Vladimir Putin’s war on Ukraine.

Let’s say the price of oil is $100 a barrel and extraction costs Russia $50 a barrel. The profit on this oil is $50 a barrel. Now assume a ceiling price of $70 per barrel. Russian profit drops to $20 a barrel – but oil will still be produced. Well-adjusted price controls would redistribute revenue to buyers of Russian oil, without interfering too much with oil supply.

Enforcement should go through marine services, such as transport vessel insurance. The G-7 countries plus Australia, which are discussing the cap, would prevent their companies from selling these maritime services unless they help enforce the cap. Currently, many of these services are sold in western countries, especially in the UK.

One problem is how to fix the ceiling at the right level. The plan is to set a hard cap, rather than some percentage cut from world oil prices. As world oil prices change, the cap should be adjusted, preferably quickly. Given that it took months to accept the idea of ​​a cap, it remains to be seen if this would be possible. And things only get worse if the Western coalition against Russia breaks down, or if the bureaucracies involved are slow.

If the price cap ends up being too low and Russian oil is pulled completely from world markets, it could significantly worsen what is already a severe global economic downturn.

A second problem is that Russia could simply sell the oil to countries that are not part of this agreement to cap prices, including China and India. But selling more to these countries could force Russia to lower the price. And while China and India are unlikely to join the G-7 plan, the very existence of the price cap gives them bargaining power over Russia.

The bottom line, however, remains: any drop in Russian government revenue could be considerably less than an oil price cap plan might indicate. And that doesn’t even take into account what Russia might gain by selling oil on the black market. Countries outside the G-7 would be incentivized to buy tankers, insure them themselves, and use them to ship Russian oil without price caps.

But the major problem is that of escalation. To the extent that the price cap harms Russia, it could take countervailing measures, and not only in Ukraine. Retaliation could also take place in energy markets. Russia could cut off deliveries to Europe, where it still sells gas. Or he could take a tougher stance on oil markets and promote the same within OPEC. Or Russia could step up military or terrorist attacks on Western Europe’s energy import infrastructure.

Specific predictions are difficult. But so far Putin has shown a propensity for escalation, so the risks are real.

One question is whether the G-7 should step up, given the current situation. Another is whether the preferred method of escalation should be, say, military supplies, rather than energy markets.

Unfortunately, the oil price cap can be seen as a sign of weakness rather than a signal of strength. The strongest option would be to stop buying Russian oil altogether. A price cap indicates how badly we need it and what economic and diplomatic subterfuge we are willing to engage in to get it. It remains to be seen whether this signal discourages Putin or emboldens him.

It is also worth wondering how other nations will react. Suppose the G-7 succeeds in driving down the price of Russian oil. Why not extend this strategy, for example next time against Saudi Arabia? After all, the notion of a tax on oil imports, the effect of which is broadly similar to a price cap, has been debated for decades. If it works on Russia, it could also work on smaller countries without nuclear weapons.

As most countries understand, however, the longer-term result would be weaker trade ties with the West and less investment in energy capacity. Qatar has already signaled that it may not be so eager to sell as much gas to Europe in the future.

It is possible, of course, that the price cap works. But I can’t bring myself to predict that the best outcome is the most likely.

More from Bloomberg Opinion:

• Maybe the world needs this cut in Russian oil production after all: Julian Lee

• Russian oil price cap worth a try: editors

• The Saudi-Russian oil axis snubs Biden: Javier Blas

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is co-author of “Talent: How to Identify the Energizers, Creatives and Winners in the World”.

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