Oil price cap and falling cost of crude worry Kremlin

Russia last year weathered the impact of energy sanctions and gas export cuts to Europe. But 2023 will be a lot tougher, with lower energy prices and bigger discounts on Russian crude — underpinned by the $60-a-barrel G7 price cap — starting to worry Kremlin economists.

President Vladimir Putin last month called the cap “stupid”, saw no reason to “worry about the budget”, and boasted of his “unlimited” ability to finance the invasion of Ukraine. Oil and gas revenues, at Rbs11.6tn ($168bn), last year reached their highest level since 2011 on the back of high prices and a redirection of crude exports to Asia, mainly India and China.

But with oil prices falling and the costs of the war widening Russia’s deficit last year to 2.3 per cent of gross domestic product, Putin and his officials see financial risks ahead. “You need to look at this discount so that it does not create any budget problems. Discuss it and deliver your proposals,” he told officials last week after Alexander Novak, deputy prime minister, admitted the crude discounts were “the main risk”. 

With oil and gas revenues accounting for 40 per cent of the federal budget, the biggest challenge to Russia’s plans is the combination of the widening discount and falling energy prices. The Energy Information Administration, the US energy department’s statistical arm, forecasts Brent to average $83 a barrel in 2023, down 18 per cent on last year.

“The word ‘discount’ is the key effect of the sanctions. It has become a part of Russia’s oil reality for a long time,” said Viktor Katona, a lead crude analyst at commodity analysis group Kpler.

Line chart of $ per barrel showing The spread between Brent and Urals is widening

Buyers of Russian oil are demanding increasingly wider discounts to Brent, the crude benchmark. Last year, the discounts deprived Moscow of an estimated $50bn, according to the Kyiv School of Economics, equivalent to 12% of its planned revenue. At $35-$40, the spread between the price of Brent and Urals, the leading Russian blend, is around 10 times greater than before the invasion last February.

Urals dipped after the $60-a-barrel cap was introduced on December 5 and is currently trading at $44 — about 48 per cent below Brent, according to energy data provider Argus. It is also way below the $70 level used as the basis for Russia’s 2023 budget, which predicts a deficit of 2 per cent of GDP.

“This spread is the result of the combination of the EU [ban on Russian oil shipments], which is the main factor, and the oil cap,” said Ben Cahill, a senior fellow at US-based Center for Strategic and International Studies. “Even if Russia’s export volumes pick up, it will not be a big problem [for the west]. They are getting what they wanted: a well-supplied market with Russia getting less revenue,” he added.

“The few remaining important importers, such as India and China, have a lot of market power,” added Georg Zachmann, a senior fellow at Brussels-based think-tank Bruegel.

How price and production changes would affect Russia’s 2023 oil revenues. Heat map comparing Urals oil price with production. The current Urals price is $55 meaning it needs to produce 10.5 million barrels per day to break even.

That combination is depriving the Kremlin of an estimated €160mn a day, according to a study by the Helsinki-based Centre for Research on Energy and Clean Air (CREA).

CREA estimates that Russia’s earnings from fossil fuel exports in December fell 17 per cent month on month, reaching the lowest level since last February. The finance ministry shows a 7.5 per cent growth in oil and gas revenues for the same period, reflecting a 20 per cent loss in the rouble’s value last month and a windfall tax levied on Gazprom.

Russia’s 2023 budget projects a 23 per cent fall in all oil and gas revenues compared with 2022, while the Kyiv School of Economics (KSE) predicts the decline could be twice as much.

Based on finance ministry data, if oil production falls 7-8 per cent on 2022 levels, which Novak says is possible, and the average Urals price is $50 a barrel, Russia will be deprived of 23 per cent of its projected oil and gas revenues for 2023. If Urals averages $35, it would face a 45 per cent shortfall.

An oil tanker moored n Novorossiysk, southern Russia.
An oil tanker moored n Novorossiysk, southern Russia. Falling oil prices and the costs of the Ukraine war widened Russia’s deficit last year to 2.3 per cent of gross domestic product © AP

Revenues could take another hit when a separate G7 ban on refined oil products comes into effect next month. China and India prefer to buy cheaper Russian crude to refine at their own plants. So Russia will find it difficult to find new markets for kerosene, diesel and other products, even at a lower price, said Kpler’s Katona.

Russia last week also admitted there was a “risk” of lower gas exports than predicted, though gas provides only a fraction of the revenues from oil.

Despite the challenging outlook, falling revenues will not necessarily constrain Putin’s ability to wage war.

If 2023 goes in line with forecasts, Russia can cover the losses and fund the conflict at planned levels. It will continue to borrow internally, mainly from state banks, and withdraw money from its $148bn wealth fund, including by selling holdings of Chinese renminbi.

Renminbi sales started on January 13, aiming to cover an expected shortfall in oil and gas revenues of Rbs54.5bn ($798mn) this month. Moscow has sufficient renminbi reserves enough for several years of such interventions, Sberbank CIB analysts wrote.

In the likely event that revenues were lower and, as in 2022, spending higher than planned, Russia will have to either increase borrowing, continue tapping the fund — which Putin is reluctant to do — or reduce spending on economic development and infrastructure, as in previous hard times, said Alexandra Prokopenko, a former central bank official.

But with the Ukraine war the principal focus of Kremlin policymaking, military spending — which accounts for almost a third of expenditure in 2023 — will be the last to suffer any damage, she said.

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