Russian energy embargo 5/6

What the energy trade war might look like?

< < < Part 4 Economic consequences of the embargo in the short to medium term

What the energy trade war might look like?

The general situation today is quite different than at the beginning of March when the idea of an energy embargo first appeared. Back then it looked like the Russian forces could take Kyiv, but the war itself did not look like a protracted all-out affair but more like a skirmish, something akin to US invasion of Panama with a goal of a quick and swift regime change. Then might still have been some hopes of a possible reconciliation with Russia. Today, on one hand, it is clear that the Russian blitzkrieg has failed, but Russia is still keen to get at least something from the war, such as to keep its hold of the seized territories to keep the land bridge to Crimea and control on its water supplies, on the other hand, Ukraine is more and more confident and is probably prepared to fight at least for the return to status quo ante bellum, if not to try to re-conquer Donbass. The West seems to have lost any hopes for Russia under the current regime, considers it a dangerous threat, and is prepared to treat it as an adversary until the regime changes.

Unless Russia suffers a strong defeat in the expected battle of Donbass in May, the war would probably turn into a stalemate with solidifying lines of control, and the urgency of strong action on the Western side might subside. There would not be an imminent disaster or catastrophe to prevent, no hot crisis to intervene. On the other hand, there is a strong call and growing consensus that the strategy of masterly inactivity towards Russia or some symbolic gestures is over and a more proactive role is needed. Given that the actual military involvement is taboo, economic war seems the only way forward, and energy embargo is widely seen as the tool for the occasion. As we have discussed earlier, it will be a costly and painful act for Europe, so we see now some attempts to come up with mechanisms that on one hand will deprive Russia of energy exports revenue, and on the other hand not create a crisis of global proportions, and this can only be achieved by somehow keeping the Russian volumes in the global energy balance.

There are many possible schemes, involving escrow accounts, tariffs, etc., that would leave some control over Russia’s energy revenues in the hands of the West, divert a part of proceedings to Ukraine as reparations, etc. The success of the embargo would also depend on how tight it will be, and whether it would be possible to convince or force China and India to join it. But in the times of energy shortages, it would be extremely difficult to convince these countries to join the suffering, and the lure of cheap and abundant energy bfrom Russia to those who defy the embargo might be stronger than the fear of the West’s wrath. Perhaps, the easiest way to limit Russian income would be to allow it to trade with China and only with China, hoping that the Chinese monopsony will drive the price close to the marginal cost of production and leave Russia with almost no resource rent. In this case, the hit on the Western buyers would also be lower as China would not compete for the supplies from the rest of the world ex Russia. However, this policy would create an extreme advantage for China and strengthen its competitive position in the global economy, and may strengthen the Russian-Chinese alliance. Considering that just 6 months ago the main Western concern was Chinese ascendancy and China’s growing ambitions, this would also be a difficult policy choice.

Tariffs, escrow accounts etc. might not work as planned though. Proponents of such measures assume that a) Russia might be desperate for revenue and would be willing to agree even to rather low payments with limitations on possible use and b) that Russia is a rational player and would prefer to have a small profit to having no profit at all. In my opinion, none of these assumptions is true. Russia is not desperate, at least, not yet, and Russia is keen and adept at playing negative-sum games, when it hurts its adversary more than it hurts Russia.

I would not also exclude a scenario where Russia might actually accelerate the events. The West has unleashed an unprecedented sanctions campaign on Russia. The Russian response was quite limited – there were not any substantial assets that Russia could freeze in retaliation, and international business is writing off its Russian operations by its own initiative. Probably, the only material blow so far was the closure of the Russian air space for international operators. Knowing Putin’s vindictiveness and understanding his need for a symbolic win, not only against Ukraine but also against Ukraine’s backers one would definitely expect more. In 2014 the Russian response to the Western sanctions was relatively restrained, probably because Russia did not take them seriously and was hoping for some normalization when the West would turn off what Russia saw as grandstanding and get back to the good old pragmatic realpolitik. In 2022 Russia does not hold such illusions and judging by the rhetoric of Mr. Putin and Mr. Lavrov, considers the current conflict as a clash of civilizations, and is not willing to pull any blows. The only area, where Russia can materially hurt the West economically is the energy trade, and we will probably see some battles, initiated by Russia, on that front as well.

So far, the West was keen to buy Russian energy and was even ready to pay for it in dollars and euros, but limited Russia’s ability to exchange those dollars and euros for the goods it needs. Russia does not need the money as such, but only as a mean of exchange for something useful, so it was not too long before the Russian government realized that this trade is somewhat lopsided and one of its legs does not work. After the US, EU and UK have frozen the Russian Central Bank accounts and assets in dollars and euros, even the monetary part is under suspicion – as the Fed and ECB have full control over all the non-paper USD and EUR in circulation, accumulated revenues can instantly become frozen and, for example, passed to Ukraine for reparations.

For now, Russia is trying to shift the energy trade to its own turf, and the “gas for roubles” scheme is the first volley of this battle. For now, on the face of it does not do much, after all, the western buyers would still pay in euros and receive the gas, albeit through an intermediary and through an account, based in Russia, instead of Luxembourg. The EU Commission is saying that even this chain would create a breach of sanctions – but this is not a bug, but a feature – Russia does want to force its trading partners into a situation where they would have to break sanctions and EU rules if they want to continue to receive Russian goods. Russia’s goal is to start to make its own rules for oil and gas trade, and not just to comply with increasingly restrictive EU rules.

Most likely it would not stop there, and once the western buyers would agree to gas for roubles trade in principle, the scheme might, for example, change further so that the buyer would have to obtain the roubles without the automatic help of Gazprombank. I am speculating here, but Russia might establish a separate currency exchange with the only roubles allowed into it would be the ones earned by non-domestic companies bringing certain categories of goods to Russia and selling them for roubles, and the energy buyers would have to buy their roubles there. This would be a way to make foreign companies do the work of breaking trade barriers and defying embargoes for the Russian government.

On the other hand, Russia does see a resolve on the European side to stop any energy trade with Russia, and if this is deemed inevitable, Russia might decide to make the first move, at least trying to make it as costly and uncomfortable to the West as possible. So far, any European plans for cessation and gradual termination of energy dependency on Russia assume that Russia will be passive, will try to cling to what remains of the trading relationship in order to scrape whatever revenue is left in it. This might not be the case. Russia is already stopping gas supplies to Poland and Bulgaria for a refusal to comply with the gas for roubles arrangement.

Late spring is the least effective time to start a gas war, as it is the time of lowest gas demand, and the effects would not be seen immediately and it gives buyers the time to prepare. Poland and Bulgaria are not as vulnerable as other countries, as they do not need much gas in the summer and have alternative supply routes and sources and will have more before the heating season starts in the fall.  On the other hand, to make the winter gas war more effective and devastating, Russia will need Europe to have as little gas in storage as possible, assuming that they would not be able to bring alternative gas to fill the storage (there is a summer peak of LNG demand driven by Japan, Taiwan and other hot climate countries with air conditioning electricity demand).

In the meanwhile, we may also observe some interesting dynamics inside the EU. Different countries have different attitudes towards conflict with Russia. It will be difficult to reach a consensus required for a costly and painful measure like a far-reaching energy embargo, and some countries may take an activist stance, effectively forcing the hand of the union as a whole and imposing harsher measures with effects beyond their borders. Poland and Bulgaria both control entry points of Russian gas pipelines into the EU, the 33 bcm Yamal-Europe line going to Germany, and the 15 bcm line, which gets the gas from the Turkish stream and delivers it to Serbia, Hungary, and Austria. Both countries might stop these routes leaving Russia with less available transportation options and effectively forcing their indecisive neighbors into joining the embargo.

The news suggests that at the moment the EU discusses an oil embargo. Oil revenues were historically 3 times higher than gas and the EU hopes that Russian oil can be replaced much easier than Russian gas. There will be efforts to preclude Russia from sending its oil to the countries that do not support the embargo. We already know many of these measures, as they have been applied to Iran. There will be attempts to threaten secondary sanctions to the potential buyers, controls over money flow, aimed at interception and freezing of possible payments, and efforts to limit the number of ships available for this trade. Embargo might include a ban on insuring marine vessels carrying Russian crude and oil products, a ban on servicing and bunkering of the ships, involved in the trade and other similar measures. Russian oil trade goes through some choke points, controlled by the EU and NATO to various degrees, such as the Danish straights, and there might be cases of ships being stopped, searched, and seized. This is unlikely to happen to the Russian-flagged vessels, as it might lead to direct armed confrontation, but might serve as a deterrent to Panama- or Liberia- flagged tankers, and Greek-flagged ships might also be banned by serving this trade directly by the EU legislation.

At the same time, there will be a diplomatic effort to convince Saudi Arabia and OPEC in general to increase oil production. The outcome is unclear – Russia has been busy to cultivate its relationship with OPEC, UAE, and Saudi Arabia since 2014, and despite the spat in 2020, they were improving and becoming stronger. UAE has served as the safe harbor for the Russian money, private jets, and luxury yachts leaving the US, EU, and the UK. The long-standing Saudi-American special relationship has been under pressure, there was less economic interdependency since the US has become an oil-exporting nation, and politically there were growing tensions since Khashoggi affair. OPEC might decide to increase production to some extent, but for a different reason – to prevent a major economic crisis, demand destruction, but also to keep potential future competition at bay, as a period of too high prices might stimulate additional investments in oil production outside OPEC and lead to future capacity glut, just as it happened in 2010-2014. We might assume, that the degree of action by OPEC will be dictated only by these considerations, and not by solidarity with Europe or willingness to join the anti-Russian coalition.

With all said, the chances of the energy trade war are quite high, and we have already discussed the possible effects in Part 3 of this note.

Part 6: The longer-term and wider outcomes of the looming energy trade war. > > >