Russia fires its oil weapon, but is it a blank?

Why would Russia decide to cut production now, and what effects might the cut have?

The stated reason for the reduction is to drive prices up. The announcement of that reduction, however, had only a modest impact on global prices. Brent crude rose about 2 per cent to $US86.39 a barrel over the weekend.

Wild card China

The wild card in terms of the impact of the reduced supply is China, and whether its economy does rebound significantly from last year’s “zero-COVID” policy-constrained low-growth environment. Strong growth in China could drive a surge in demand for energy even as Russia’s reduced production cuts supply.

The global economic outlook is, however, at best for one of weak growth, if not recession, so even strong growth from within China may not produce the oil shock Russia seems to believe or hope its cut to output will generate. Anything less than a big bounce within China would see the cuts having only minimal price effects.

It’s also worth noting that while Russia has had some success in assembling a shadow fleet of tankers to circumvent the effects of the sanctions that support the price caps – the West’s stringent sanctions on insurance and finance for cargoes sold at prices above the cap – the average price it says it received for its oil in January was, at just under $US50 a barrel, well below the cap.

Even if the global price for oil would surge, the caps would still restrict the price Russia could receive for much of its output and those buyers still willing to buy its oil would still be able to use the caps as leverage to extract prices well below the free market price.

China might have a friendship with Russia with no limits, but it has gorged itself on ultra-cheap Russian oil since the caps were imposed. India, without that close relationship, has done the same. It would be irrational of them to do otherwise.

Thus, even if the “weaponisation” of Russian oil were to drive up global oil prices, there is no guarantee that Russia would extract material benefit from it.

There are analysts who believe the announcement of the cap was Russia’s attempt to extract political gain from production that would have been falling anyway.

Falling production

The withdrawal of western companies and their technology from Russia would inevitably have an impact on Russia’s oil industry, particularly on the technically complex fields in Siberia where western expertise and technology have been particularly important as fields have aged and wells have gotten deeper. Most Russian production is in the permafrost, making operations very challenging.

Those reserves and their infrastructure will have been degraded, and will continue to be degraded, by the broader sanctions the West imposed in the immediate aftermath of the invasion of Ukraine.

Even if Russia could have sustained production at or around pre-invasion levels, there’s the question of finding markets for its oil when most of the developed world has decided not to buy it.

While there are some workarounds – shipping the oil to third parties, mixing it with other supplies and then selling it back into Europe, for instance – those come at a significantly higher cost/reduced revenues and don’t obscure the reality that Russia is now largely dependent on China and India to maintain its sales volumes.

Russian oil has flooded those markets. Absent a surge in global demand that is yet to emerge and which is unlikely unless China’s own resurgence is very strong, those markets could easily become over-supplied, in which case Russia would have a serious problem because it has minimal oil storage capacity.

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There would have to be far larger forced production cuts that would have a permanent impact on Russia’s oil industry and the finances of a government that is dependent on its oil and gas revenues (and has lost its major gas market, Europe, as a consequence of the war in Ukraine).

Russia is an associate member of OPEC, which stared down Joe Biden’s pleas for it to produce more oil when global prices initially spiked after the invasion. It has already indicated that it won’t increase production to offset Russia’s production cuts.

OPEC has already been operating with production constraints. Its members cut their output (theoretically) by two million barrels a day last year.

Those cuts were theoretical because the cartel wasn’t producing at its previously agreed levels anyway and, after a brief spike to $US139 a barrel at the onset of the invasion, didn’t prevent the oil price from trending down steadily towards $US80 a barrel, and below, last year.

Russia’s 500,000 barrels a day, if they exist, might, when coupled with OPEC production disciplines, have an impact if the global economic performance is more robust than anticipated. It will probably take bigger cuts – and bigger losses from its capped revenues – for that impact to be more than modest without a strong global recovery.

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