Will EU oil embargo really hurt Russian war machine?

With the first phase of the European Union's ban on Russian crude oil and petroleum products kicking in on Monday, December 5, European countries will stop buying seaborne crude oil from Russia with limited exceptions, robbing Moscow of revenues that it needs to sustain its war efforts in Ukraine.

The embargo comes simultaneously with a price cap backed by the Group of Seven advanced economies on Russian oil, also meant to hurt Russia's oil earnings while ensuring that it does not send oil prices skyrocketing.

With the European Union having already shunned much of Russian oil over the past six months and Russia already selling much of its crude at steep discounts, it remains unclear just how big a blow the oil embargo and the price cap would inflict on Kremlin's war chest.

How will the EU oil embargo work?

The EU announced in June it would ban Russian seaborne crude oil imports from December 5 and refined oil products from February 5 as part of its sixth sanctions package against Russia. The ban covers 90% of the EU's oil imports from Russia as a temporary exemption was made for pipeline crude oil.

The idea is to hurt the Russian oil industry, whose massive profits are being used by Moscow to bankroll its war in Ukraine. Last year, the EU imported about €70 billion ($74 billion) worth of crude oil and refined petroleum products from Russia.

The embargo also prohibits European shipping services providers from insuring and financing shippers carrying Russian oil to third countries if the cargo is bought above the price cap.

The measure is aimed at raising the cost of shipping Russian oil as in the absence of European firms, who are dominant players in shipping and other maritime services, Russian oil tankers would have to turn to less-efficient insurance markets.

What is the G7 oil price cap?

The prospect of an embargo on Russian seaborne crude oil imports by its biggest buyer as well as a ban on maritime services made US authorities anxious, who feared the embargo would cause a massive spike in oil prices.

They proposed capping the price of Russian seaborne crude oil, a plan that would allow European firms to continue providing insurance and financial services to shippers carrying Russian oil to third countries as long as the oil is purchased at or below an agreed cap level.

"This means essentially forcing the world into a buyers' cartel," Brussels-based Bruegel think tank said in July.

The G7 and Australia on Friday agreed to a $60 a barrel price cap on Russian seaborne crude after much wrangling among the European Union members.

While the cap is meant to punish Russian President Vladimir Putin for the conflict in Ukraine by hurting Moscow's oil profits, it is also aimed at ensuring the continued flow of Russian oil to the global markets to prevent oil prices from soaring.

EU countries will not be allowed to buy seaborne Russian oil even if the prices are at or below $60 a barrel as the EU oil embargo supersedes the price cap plan.

How would the EU embargo and G7 price cap impact Russia?

The move is unlikely to cause a major dent in Russia's finances as Moscow is already selling much of its crude at around $60 a barrel. However, it would limit the country's oil profits in case global oil prices suddenly start soaring.

As the EU, which relied on Russia for about 30% of its oil needs prior to the war in Ukraine, has already drastically cut down seaborne oil imports from Russia over the past months, Russia has been forced to sell its oil to the likes of China, India and Turkey at significant discounts.

A $60-a-barrel price cap still preserves Russia's incentives to sell given that it's still above its cost of production of between $30 and $40 a barrel.

While China, India and Turkey are unlikely to join the West's plan, the existence of a price cap could increase their bargaining power, forcing Moscow to offer steeper discounts, in a blow to its profits.

The EU embargo means Russia will have to redirect another 1 million barrels of crude oil a day, a figure that's only likely to go up when Germany and Poland stop purchasing Russian oil via the Druzhba pipeline, which has been exempted from the current ban, from 2023.

However, rerouting all that oil would be a challenge for Moscow given the limited export capacity at Russian ports, the lack of an alternative to Druzhba (the East Siberia Pacific Ocean (ESPO) to China is already reaching capacity), a shortage of tankers and skyrocketing shipping costs for Russian crude.

Moreover, India and China could struggle to absorb much more Russian oil, notwithstanding deep discounts, as they have long-term supply contracts with Middle-Eastern oil producers, including Saudi Arabia and the UAE.

Moscow's failure to reroute its oil shunned by the EU could tighten global oil markets, pushing up prices and boosting Russia's oil revenues, a risk that experts are not discounting.

Russian oil output is set to fall by 1.4 million barrels per day next year after the EU embargo comes into effect, the International Energy Agency said last month.

How could Russia respond?

Russian Deputy Prime Minister Alexander Novak said on Sunday Moscow would not sell oil to countries that observe the price cap and that it was ready to cut production to compensate for lost exports.

"We are working on mechanisms to prohibit the use of a price cap instrument, regardless of what level is set, because such interference could further destabilize the market," said Novak.

Georg Zachmann, an energy expert at Bruegel, said Russia will not accept selling oil under the cap to "demonstrate independence, to put pressure on global markets and the West, [and] to avoid such price caps becoming an established instrument."

Russia, which relies heavily on foreign-flagged tankers, could resort to a "shadow fleet" of ships to bypass Western restrictions on its oil, following the examples of heavily sanctioned Venezuela and Iran. It is reported to have amassed a fleet of over 100 aging tankers this year. While the fleet could ease some of Moscow's pain, it would hardly be enough to cure it.

What would be the impact on oil markets?

The oil embargo and price cap are only expected to create more uncertainty for oil markets which are already having to contend with weak demand amid recession fears and COVID-19 restrictions in China.

Brent crude prices have fallen to around $85 a barrel, down nearly 40% from their multiyear high in March just days after Russia invaded Ukraine.

"We see modest supply risk around the EU oil embargo and oil price cap as Asian buyers' interests are aligned with Russia's fiscal needs which limit the risk of deliberate supply withdrawal by Moscow," Deutsche Bank analysts said in a note to clients.

Oil markets are bracing for a much bigger disruption when the EU's import ban on Russian refined oil products like diesel comes into effect on February 5.

The IEA said the Western restrictions "will add further pressure on global oil balances, particularly on exceptionally tight diesel markets."

"The competition for non-Russian diesel barrels will be fierce, with EU countries having to bid cargoes from the US, Middle East and India away from their traditional buyers," it said.

Europe has been building up its diesel stocks ahead of the February 5 deadline by securing higher imports from the rest of the world over the past months. Europe's diesel imports from Russia have increased in the past two months from their post-war lows of 450,000 barrels a day in September, while imports from the rest of the world have more than doubled this year, Rystad Energy data showed.

"When it comes to diesel, the European Union is caught between a rock and a hard place," Rystad Energy's Mukesh Sahdev said. "Europe neither has the refining capacity to make diesel nor it can import to plug the hole that will be created by Feb 5."

Edited by: Srinivas Mazumdaru