Brace yourselves, the oil war is here

Filipinos may face a cost of living crisis so severe that the recent price increases of sugar and onions will seem like a small bump on the road. In months to come, successive price increases may be felt in transport, power, food and most manufactured goods. The reason? The oil war between Russia and western economies.

We are already feeling it. Last month, the cost of gasoline, diesel and kerosene increased by P2.80, P2.25 and P2.40 per liter, respectively. This follows a P1 increase in gasoline and P0.50 increase in diesel in January. It will get worse.

But first, some context. Following Russia’s invasion of Ukraine, the United States and NATO imposed stiff economic sanctions on Russia. In response, Russia cut oil supply to Europe. This resulted to oil prices rising from $70/barrel in November 2021 to $117/barrel in July 2022.

Due to the price hikes, Russia ended up making more money from oil exports than it did prior to the sanctions. Whereas Russian oil revenues would typically amount to some $50 billion in normal years, it peaked at $90 billion in 2022 due to elevated prices. Meanwhile, expensive oil triggered an inflation crisis across Europe, reverberating around the world.

Last Dec. 5, the European Union, G7 and Australia collectively laid out another plan to cripple the Russian economy and starve Mr. Putin of funds to fund his war. The group formed a “buyers monopoly” and together, decided to impose a price cap of $60/barrel for Russian oil. $60 is low enough to restrict Russian profits but high enough to incentivize Russia to keep selling her oil. The price cap came into effect last Feb. 5.

One would ask – why not simply call an embargo on Russian oil?

An embargo will cause more damage. Russia accounts for 11 percent of oil production. To factor out 11 percent of oil supply will trigger a supply shock. This will give Saudi Arabia and China reason to increase their oil prices exorbitantly – experts estimate to as high as $170/barrel.  Saudi Arabia and China account for 12 percent and 5 percent of oil production, respectively. At $170/barrel, we can expect runaway inflation worldwide. Note, the Philippines derives 30 percent of its oil supply from China.

How can the EU, G7 and Australia be sure that no other nation buys oil from Russia at more than $60/barrel? The truth is, they cannot. But they can make it extremely difficult for Russia to sell.

See, Europe has a virtual monopoly of shipping lines and maritime insurance. In fact, half of Russia’s seaborne exports of oil are transported using Greek oil tankers and 95 percent of them are insured by London’s International Group of Protection & Indemnity Clubs.

Bear with me as it gets technical here – buyers of oil are grouped into three tiers of actors. Tier 1 consists of refiners, importers, commodity traders and brokers. Tier 2 consists of financial institutions and shippers. Tier 3 consists of insurance brokers, hull and machinery insurers, reinsurers and P&I Clubs.

Here is how the three interact. Tier 1 must retain and share price information with Tier 2 and Tier 3. They do so through documentary attestations such as invoices, receipts, sales contracts and proof of payables. For its part, Tier 2 actors are mandated to request, retain and share the price information with auditors and Tier 3 actors. Tier 3’s duty is to receive the attestations from Tiers 1 and 2 and make sure the price cap is complied with. If oil is sold above the price cap, Tier 3 actors are mandated to refuse insurance coverage and/or cargo lading.

Sounds airtight, right? Not quite. Russia has found ways to circumvent the system to sell oil above the price cap.

For one, oil tankers are rigged with an Automatic Identification System (AIS). The AIS is a location tracker that determines the origin and route of a tanker. Ships usually switch off their AIS in pirate-infested zones. Russian tankers have made it a practice to keep their AIS switched off for most legs of the journey. While tankers are invisible to radars, ship-to-ship cargo transfers are done.   Oil is delivered on another vessel originating from another country. Mind you, oil barrels have no Russian marking, giving no hint of its origin.

Second, Russia is building its own insurance system. Although massively capital extensive, Russia can justify tapping into its reserves to fund this endeavor as it stands to lose some $72 billion a year in oil revenues if it does not. This initiative is ongoing.

Third, Russia announced a ban on oil exports to all countries that abide by the price cap. This puts the European Union, G7 nations, Australia and all other supportive nations at the mercy of Saudi Arabia and China.

There are two probable outcomes here. Russia’s ways to circumvent the price cap will prove ineffective and will relent to sell her oil at $60/barrel. In which case, oil prices will remain stable and inflation staved off. Russia’s finances will wane, making it difficult for her to continue financing her war.

The second probable outcome is that Russia will refuse to sell oil to western nations and their allies, putting all at the mercy of Saudi Arabia, China and other oil-producing countries not aligned with NATO. In which case, oil prices will skyrocket and so will inflation. Meanwhile, Russia will keep its oil revenues flowing by selling oil to India, China and non-NATO allies.

I bet on scenario two simply because India and China are already buying Russian oil, albeit at a discounted price. With China and India providing the base petro-profits, Russia can now refuse to sell oil to western economies and not cripple her own economy.

The Philippines will do well to prepare for imminent oil price shocks and a cost of living crisis.

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Email: [email protected]. Follow him on Twitter @aj_masigan