Why Russian Energy Exports Have Yet to be Sanctioned

In the hours and days following the Russian invasion of Ukraine, many observers around the world asked why the U.S. and Europe did not immediately place the most extreme economic sanctions possible on Putin and the Russian government. To be specific: while considering possible responses to such an extreme military escalation by a nation so dependent on selling energy commodities, many wonder why the West has avoided going directly after the Russian government’s oil and natural gas revenues? While answering that question fully would require far more than a blog post, we hope to address some of the biggest questions and themes that help provide a clearer picture of what has already happened, what is likely to persist and what it means for global energy markets.

Understanding Europe’s dependency on Russian energy supplies is crucial to understanding why Western allies have been so hesitant to take some of the heaviest-hitting measures possible against the Russian energy sector. An ever-growing list of unprecedented global events have unfolded over the past few days, including:

• The U.S. and Europe kicking select banks off the SWIFT financial payments system
• NATO Response Forces activated for the first time
• The EU, Germany and other European nations historically known for their neutrality agreeing to supply arms to Ukraine
• BP, Shell, and ExxonMobil announced they were exiting the Russian oil and gas sector
• Sanctions enacted directly against the Central Bank of Russia and Putin himself
• Completed but yet-to-be-in-service Nord Stream 2 natural gas pipeline indefinitely sanctioned, goes bankrupt

However, one thing that has not changed over this period is that the U.S. and EU have yet to directly sanction Russian oil and gas exports. Amid the rapid escalation of events and sanctions, the fact that cutting oil and gas flows have been directly avoided by both Russia and the West is proof of the hierarchical economic significance of the oil and gas trade, and the awareness of the mutually assured economic destruction for everyone involved.

 

Quantifying Russia and Europe’s Mutual Dependency

Russia is the world’s second largest producer of natural gas behind the United States, at around 1.8 bcm per day. Russia is currently tied for the second-largest oil producing nation globally by volume with Saudi Arabia at 10 million bpd, behind the United States. Oil and gas make up 60% of the total Russian economy’s exports, accounting for nearly 20% of Russian GDP and 40% of Russian government revenues. This makes oil and gas sales crucial for continued funding of the Russian military and broader government services. The EU is Russia’s largest trading partner and accounts for nearly 40% of Russia’s total global trade, with about half of Russia’s oil exports and 70% of their natural gas exports going to Europe.

Likewise, imports of Russian energy commodities are crucial to the European economy, European oil refiners, and the continent’s electricity generation. According to Eurostat data, Europe is using more natural gas than ever. Although the risk of becoming dependent on Russian supply has been acknowledged for some time, Russia’s share of total EU natural gas imports has risen from 31% in 2010 to 38% in 2020. Even with the renewable electricity generation buildout over the past 20 years in Europe, Russia’s share of total EU natural gas imports is down only slightly to 38% in 2020 from 41% of total imports in 2000. Russia’s share of total EU oil imports has declined to 23% in 2020, falling from 27% in 2010 but up from 18% in 2000. Despite total EU imports of coal falling 20% over the past 20 years, Russia’s share of EU coal imports has surged from just 9% in 2000 and 21% in 2010 to 46% in 2020. In the near-term, there are simply no global alternatives to these volumes that do not entail far higher prices, and the development of severe shortages if they were to be completely cut off due to Russian strategy or Western sanctions.

 

How Past Energy Policy Decisions are Limiting Sanction Options

It’s important to understand some of the trends in European energy markets that helped create high energy dependency rates for so many Western European nations. Policy failures in an EU-wide, multi-decade electricity market liberalization process (in which many countries continued to maintain monopolies on domestic energy markets) continue to leave their mark on electricity markets and gas prices across the continent. Other key components of this dependency on Russian energy commodities, however, have not come as a result of policy failures but are instead well-known policy tradeoffs.

Many of the most historically prolific oil and gas production regions in Europe were known to be peaking in the early 2000s. While the fracking revolution in the U.S. helped reverse the long-term decline in U.S. oil and gas production (which had been forecast for many years to be nearing “peak oil” production), European nations did not follow the U.S.; instead, many have banned or effectively banned using this technology to access European deposits. As a result, domestic crude oil production in the EU truly did peak in the early 2000s (even including North Sea crude production not included in the chart below).

Likewise, with hopes of decarbonizing the energy grid, European policy makers pushed to eliminate the dirtiest parts of electricity production on the continent, starting with coal. Plans to rapidly retire coal-fired electricity generation, accompanied with other environmental concerns, led domestic coal production in the EU to plummet 67% between the year 2000 and 2020. However, with coal-fired electricity generation only declining by about 50% over that 20-year period, domestic coal production declines outpaced those of demand, leading to greater dependence on the EU’s cheapest alternative: Russian imports.

Likewise, a growing dependency on imported natural gas from Russia was a known policy tradeoff on the path toward limiting carbon emissions. European natural-gas-fired electricity generation has jumped 69% over the past 20 years. Not only does natural gas produce electricity with lower carbon intensity than coal and oil, but natural gas generators are also nimble and can scale production up or down quickly. Given the absence of grid-scale electricity storage technology coupled with a growing volume of renewable power generation from intermittent sources like wind and solar, the functionality provided by natural gas is needed by grid operators in order to prevent power outages when the wind isn’t blowing and the sun isn’t shining. With no prospects of quickly or materially boosting domestic production, imported natural gas has long been acknowledged as the key transition fuel needed to bridge the gap between fossil fuels and renewable electricity generation.

Lastly, the Fukushima nuclear disaster in 2011 had a lasting and sizeable impact on nuclear generation on the continent. Germany began rejecting investments in nuclear energy with its Atomic Energy Act in 2011 following the Fukushima disaster, and other nations followed. EU nuclear-powered electricty generation has now declined 26% since its peak in 2004.

 

Energy as a Strategic Military Asset

Access to vital commodities needed to heat and feed a population, and any leverage that can be placed against one nation by another’s access to those commodities, has been a key component of wars throughout history. Tactically speaking, taking advantage of frozen ground for moving heavy military equipment and Europe’s winter dependency on Russian natural gas has for many years been a major reason why a late-winter invasion was thought to be the best strategic timing for Russian movement. This winter, energy markets may have provided an extra economic incentive.

Global coal prices had already moved to record-highs in October as China and India were both short the key fuel needed for their electric grids moving into winter. In October, both Chinese and Indian thermal coal prices surged to levels four times that of prices seen in the same seasonal period in 2019, and more than double the peak seen in the winter of 2020. Global coal prices are once again surging in response to Russian sanctions, with Newcastle Coal prices in Europe more than doubling in less than a week.

Like coal, European natural gas prices were already at record highs (and surging higher) heading into winter. Low inventory levels, fears of a cold winter and weakness in wind-powered electricity generation were largely to blame. As early as late summer, market analysts had been eyeing Russian flows of natural gas into Europe; highlighting suspicious flow activity that looked to be Russia trying to limit European inventories. A warmer-than-expected late winter weather pattern had helped prices ease in January before the invasion, but natural gas prices in Europe have now more than doubled since mid-February and are setting new record highs despite pipeline flows from Russia being so far uninterrupted.

Global crude production plummeted amid the COVID-19 demand crash. This was followed by a slow and steady approach of boosting production by both OPEC+ and independent producers in the U.S. which has simply not kept up with the pace of the demand recovery. The world has been undersupplied crude oil from a supply and demand balance perspective since late 2020, and refiners have been chipping away at global inventories – which are now well below recent historic averages – since that time. A number of OPEC+ nations like Nigeria and Angola (which just so happen to produce good substitutes for Russian crude) are failing to meet their production targets amid aging oil fields suffering from many years of underinvestment. As a result, crude prices trended steadily higher over the past two years and are now back to their highest since early 2014, before markets crashed and entered the era of U.S. fracking and prolific shale oil production.

Given that Putin likely anticipated some degree of sanctions would hit demand for Russia’s energy commodities as an outcome of the invasion of Ukraine, it’s easy to see how he would try to leverage the fact that global energy commodity markets were already in short supply. Furthermore, if you’re going to only sell a limited volume of something due to potential sanctions, you can reduce the hit to revenues by selling less volume at a far higher price.

 

Current Sanctions and Market Incentives Are Limiting Russian Exports Despite Carveouts

Even with the U.S. and European nations stepping up with the most severe financial sanctions in recorded history by cutting some Russian banks from the SWIFT payments system and directly sanctioning the Central Bank of Russia, the concern over impacting energy supplies to Europe is still evident in this activity. Special carveouts or exemptions in the SWIFT sanctions for Sberbank PJSC and Gazprombank highlight the desire to cut nearly all transaction capabilities except those that most risk energy supplies to Europe. However, this doesn’t mean that Russian exports are slipping by unscathed.

Despite the lack of sanctions on Russian energy exports, corporate financial incentives and risk management initiatives are already limiting Russian commodity exports. While Russia exports large volumes of oil and natural gas via pipeline to both Europe and Asia, waterborne shipments of commodities are more vulnerable to market incentives, given that most entities that facilitate this trade are private or public companies with financial exposure in the West.

Pressure from individuals all over the world has likely helped push BP to announce that they will exit their 20% stake in Russian oil giant, Rosneft, at a cost of up to $25 billion. Equinor (which is majority owned by the Norway) has announced it will divest its joint ventures in Russia. Shell announced they are exiting all of their oil and gas ventures in Russia, including the Sakhalin 2 LNG project. Exxon Mobil announced it would exit its oil and gas operations in Russia, valued at over $4 billion, including its management of the Sakhalin Island oil and gas production facilities. This leaves pressure on companies like Total Energies to follow suit.

Doing business with Russia now can not only bring bad PR, but also risks being caught up in a trade that is either unknowingly already sanctioned or becomes sanctioned given both the vast number of sanctions announced and rapid pace at which they could continue. Insurers, creditors and shippers all play a vital role in international trade and are increasingly seeking to avoid this risk. As legal teams clarify sanction details, we may see some of this aversion reverse, but the widespread and entangling banking sanctions that have been announced (in addition to the potential for bad press) should continue to dissuade energy trade with Russia.

The world’s largest and second largest shipping companies, MSC and Maersk (along with Hapag Lloyd and Ocean Network Express) have stopped shipments to and from Russia. Russia’s largest buyer of coal, China, is already struggling to secure financing for Russian coal, according to reports. Some of China’s largest state-owned banks, like ICBC, have stopped issuing letters of credit for the purchase of Russian commodities at this time. A number of banks around the world that help finance trades like HSBC are already winding down relationships with Russia. Evidence of this aversion to Russian oil shipments is already seen in Russian Urals crude prices, which have dropped to a record discount compared to the European crude oil benchmark, Brent.

 

The Impact of a Potential Unilateral U.S. Embargo of Russian Energy Imports

The option for the U.S. to place an embargo on Russian energy imports to America is still a possibility regardless of what the EU ultimately decides, given how little the U.S. depends on Russian energy commodities. While U.S. imports of Russian oil have certainly trended higher since the Trump administration sanctioned Venezuelan crude in January 2019, the U.S. imports no LNG from Russia.

According to EIA data, total U.S. imports of Russian oil averaged 670,000 bpd in 2021. To put it in perspective, this amounts to 7.9% of total U.S. oil imports last year. It’s also important to point out that of this 670,000 bpd, just 198,000 bpd was crude oil. The vast majority of U.S. imports of Russian oil, some 354,000 bpd, are of unfinished oil products, alongside small volumes of residual fuel oil and distillate fuel oil.

The U.S. being the largest producer of both crude oil and natural gas globally will help cushion the relative blow to the U.S. economy, but ultimately, oil trades and is priced in the international market. However, because of limited U.S. LNG export and global LNG import capacity, natural gas prices in the U.S. will be far more insulated from the impact of the potential global loss of Russian supply than will U.S. crude oil or refined fuel prices. Currently, European natural gas prices are more than ten times as expensive as the U.S. natural gas benchmark.

It is likely that most U.S. companies, if not directly impacted by sanctions, will voluntarily avoid doing business with Russia. While the U.S. can get by sourcing this oil from elsewhere, it will come at a cost. Furthermore, the lack of Russian crude on the global market portends lower availability of refined fuels for importing to the East and West coasts. The need to more economically move oil and LNG from the Gulf Coast of the U.S. to the East and West coasts will only rise the longer Russian volumes are avoided or sanctioned. In this regard, one of the most helpful policy changes from Washington, D.C. for U.S. refiners would be eliminating the Jones Act. This would allow foreign vessels (which far outnumber those available under the Jones Act) to move product from the Gulf Coast to the East and West coasts. While this would certainly be helpful for oil refiners and blenders in these regions, it would be even more significant for LNG cargoes, given that there are no U.S. built and crewed LNG tankers; therefore no U.S.-produced LNG can currently be shipped to U.S. LNG import terminals.

 

Expected Impact to Global Oil Flows

European refiners imported some 1.7 million bpd of Russian crude oil via tankers last year, 85% of which consisted of Urals crude, according to data from Kpler. In addition to waterborne flows, the Druzhba pipeline system can supply up to 1.4 million bpd of Urals crude to the continent. In total, about a quarter of Europe’s crude oil imports originate in Russia. If this stream dried up, European refiners would face the near impossible task of having to source alternatives for this medium sour grade in an already undersupplied market.

Given the volumes at stake, no single source could provide adequate cover for a fallout of Russian crude oil. Instead, Europe will have to diversify its crude oil supply. U.S. offshore-produced grades like Mars and Poseidon are comparable to Urals in both density and sulfur content. U.S. Gulf Coast refineries typically have more wiggle room with their crude slate than their European counterparts and increased overseas demand for these grades has in the past led to brief periods in which several hundred thousand barrels per day of Mars found their way to the export market. Iranian crude, particularly Iranian Heavy, would make another good substitute for Urals. Talks in Vienna could soon lead to a full force return of Iranian crude exports and this will help soften the blow of lost Russian barrels. However, given that we expect Iranian production to only rise 1.0 to 1.3 million bpd this year if the sanctions are lifted, this volume would still be dwarfed by potential Russian losses.  Currently, most Iranian oil not refined domestically is being exported to China.

Europe represents—by far—the largest buyer of Russian crude oil, taking in around half of the country’s crude and condensate exports. A sanctions regime would leave few markets still available for Russian oil; the most impactful of which is China. Russian crude has in recent years gained foothold particularly among independent refiners in Northern China. The Eastern Siberia – Pacific Ocean pipeline system (ESPO) can transport up to 1.6 million bpd from the source to near the Sino-Russian border. From there, 1 million bpd can continue their journey to export terminals on the pacific coast, while 600,000 bpd flow directly to Chinese refiners. ESPO crude is a favorite among Chinese refiners, with two-thirds of waterborne ESPO exports last year flowing to the northern part of the country alone. Provided enough tanker availability and China finds new means of payment, the infrastructure would allow flows to China to increase 250,000 to 350,000 bpd from current levels, should output increase.

The sanctions fallout, however, would mostly hit Urals crude, a grade many of the region’s refineries cannot process in vast quantities; meaning even hefty discounts would have a less-than-proportional effect on Chinese demand for Urals. As a result, if we see China find a way to import increasingly discounted Urals, a solid chunk of that volume is likely to find its way into storage.

 

Looking Forward

In less than a week, the Russian invasion of Ukraine has caused a massive shift in energy policy around the world. While the EU is currently putting together a plan to try to address the issue of energy dependence on Russia, countries like Germany are already taking drastic action. In what has rightly been called an about-face, Germany’s Chancellor and Vice Chancellor have announced the possibility of extending the lifespans of coal-fired and even nuclear generators. Previously, Germany had planned to phase out all coal plants by 2030 and to shut their last nuclear generators this year. Germany has also announced plans to build out LNG import terminals and natural gas storage capacity. This will likely be a common theme across European energy policy in the coming months despite broader goals to continue to add renewable generation and decarbonize energy production– particularly following a recent change in the EU’s green financing taxonomy to include natural gas and nuclear power investments as “green.”

If extensive market avoidance of Russian exports continues in the coming months or we see widespread sanctions on Russian oil and gas announced, this will mean sustained higher energy prices the world over until other global producers can step up, and/or high prices limit demand. Unfortunately, the time needed to materially lift oil and natural gas production and build the requisite infrastructure to move and utilize these volumes will take longer than anyone is hoping for, and would risk global refined oil product shortages, as well as Europe’s ability to heat homes and keep the lights on next winter. Energy inflation is set to weigh on economic growth and household budgets further than what has already been witnessed this winter. The risk of a global stagflationary recession, which we already feared moving into the winter, has been greatly exacerbated as a result of Russia’s invasion of Ukraine and the corresponding response by governments and businesses the world over.