10 essays analyzing the strengths and weaknesses of the Russian Federation were released by the Center for New American Security (CNAS): “Identifying Russian Vulnerabilities and How to Leverage Them”
Vulnerability 5: Russia’s Reliance on Oil and Gas
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- INTRODUCTION
- VULNERABILITY 1: RUSSIA’S DEFENSE INDUSTRY
- VULNERABILITY 2: RUSSIAN ARMS SALES
- Vulnerability 3: RUSSIA’S TECHNOLOGY AND CYBER INDUSTRIES
- Vulnerability 4: RUSSIA’S FINANCIAL SECTOR
Russia’s economy remains staggeringly dependent on hydrocarbon sales, a dependence that leaves the country’s economic well-being at the mercy of energy prices and vulnerable to actions that could disrupt the inflow of energy revenues.
By Edward Fishman
In 2022, sales of oil, petroleum products, and natural gas accounted for more than 60 percent of Russian export revenues and over 40 percent of budget revenues. Among large economies, Russia stands out for its lack of diversification and reliance on selling commodities. In a ranking of economic complexity by academics at Harvard University known as the Economic Complexity Index, Russia places below not only powerhouses like the United States, Japan, and China but also Belarus and Saudi Arabia.
The Russian government has routinely emphasized the need to diversify the country’s economy. But ultimately, the Kremlin has balked at implementing the measures required to do so, such as empowering an entrepreneurial class, fostering a stable business environment, and protecting private property. To the Kremlin, any benefits of such steps are outweighed by the threat they could pose to Vladimir Putin’s grip on power.
In the wake of Russia’s full-scale invasion of Ukraine, the prospects for diversification have gone from slim to none. Foreign investment has dried up. At least 500,000 Russians, many of whom are young and highly educated, have fled the country. Sanctions and export controls have crimped Russia’s access to microelectronics and other foreign components, leading to plummeting manufacturing output. Auto production slumped by nearly 70 percent in 2022, hitting the lowest levels since Soviet times. It is little wonder that, despite Moscow’s threats to refuse to sell oil below the G7 price cap, Russia has continued to sell oil in record volumes at steep discounts. There is even evidence that Russia failed to abide by its February 2023 pledge to cut oil production by 500,000 barrels per day, which may have undermined the Organization of the Petroleum Exporting Countries’ (OPEC) efforts to buoy prices. Russia simply has no other choice: it must sell as much oil as possible if it wants to keep its economy afloat.
Russia’s attempts to weaponize its gas sales to Europe, moreover, have failed to advance the Kremlin’s objectives. Natural gas was supposed to be Russia’s trump card. Before 2022, Russia accounted for roughly half of the EU’s natural gas imports, and the EU accounted for a whopping three-quarters of Russia’s gas exports. While the relationship was one of interdependence, it was widely believed that Russia held the upper hand. Gas, unlike oil, is mainly transported via pipelines, so one source cannot readily substitute for another.
Yet when Russia began shutting off gas sales to several EU member states, the EU quickly adapted. It surged Imports of liquefied natural gas from the United States and Qatar; it reined in energy consumption and tapped other domestic energy sources; and it benefited from a relatively warm winter. The result was that the EU weathered the storm, reducing Russia’s share of its gas imports to just over 10 percent, while Russia’s gas exports nosedived. Russian gas exports fell by 25 percent in 2022 and are projected to decline by as much as 50 percent this year, hampering the Russian government’s revenues.
Before its full-scale invasion of Ukraine, Russia was heavily dependent on oil and gas sales. Today, it is even more dependent on them. It has no viable alternative sources of income, and its ability to withstand another sharp decline in oil and gas revenues has been weakened. Russia has just a small handful of buyers left for its hydrocarbons, giving China and India massive leverage in price negotiations. It has even worse prospects for diversifying its economy. And it is entirely shut out of international capital markets, so it cannot borrow money to plug any budget deficits, which are rising as oil and gas revenues plunge and military spending skyrockets.
Russia’s dependence on hydrocarbon sales is its greatest economic vulnerability
Russian Efforts to Mitigate or Offset the Vulnerability
The Russian government is acutely aware of its reliance on oil and gas revenues. In 2022, Moscow overestimated the leverage its natural gas exports gave it over Europe and attempted to weaponize them. The ploy backfired, and now Russia’s gas revenues will be depressed indefinitely. Russia’s gas exports, however, have never been as important as its sales of oil and petroleum products. Oil and petroleum products accounted for over $220 billion in export revenues in 2022, more than twice that of natural gas.
In December 2022, the EU imposed an embargo on purchases of seaborne Russian crude oil, and the G7 imposed a price cap on Russian oil sales. The price cap bans the provision of G7 services—including shipping, maritime insurance, and other financial services—for sales of Russian oil that exceed a fixed cap, currently set at $60 per barrel. Before the invasion, the EU was Russia’s biggest market for oil. In 2021, roughly half of Russia’s oil exports were destined for the EU. By early this year, that figure was down to under 10 percent.
Having lost the European market, Russia has been forced to ship oil out of its main export terminals in the Baltic Sea all the way to India. The implications are significant. The journey from the Russian ports of Primorsk and Ust-Luga to major EU import terminals takes less than a week; the journey to India takes more than a month. Because of far higher shipping costs and lower demand for barrels of Russian oil, India has obtained significant pricing power over Russia, driving up discounts for Urals, Russia’s flagship brand of crude oil. As a result, following the EU embargo and the G7 price cap, Russia’s oil revenues have fallen sharply. In the first half of 2023, Russian oil revenues were down by roughly 50 percent from the previous year.
While it is impossible to cleanly isolate factors, evidence points to the EU embargo, not the price cap, playing the primary role in depressing Russia’s oil revenues. Russia is routinely selling oil to China out of the Pacific port of Kozmino for prices above the cap. It has also recently sold its flagship oil, Urals, out of its Baltic ports for prices that exceed the cap. This suggests that the price cap is not currently functioning as a binding constraint on the price of Russian oil, even when shipping and insurance services from the G7 are used. (The “shadow fleet” does not appear to be large enough yet to ship all of Russia’s oil, and it does not solve the problem of insurance, though Russia has recently made headway in that area by shipping perhaps as much as three-quarters of its oil exports using non-Western insurance.) The fact that the price cap is not serving as a binding constraint indicates that there is substantial room to increase pressure on Russia’s oil revenues.
The picture for gas is even worse than it is for oil for the Kremlin. After losing most of the European gas market, Russia has found it impossible to identify alternative buyers. There just isn’t enough demand, much less pipeline capacity, to place all the gas Russia used to ship to Europe. (China and Russia have been negotiating for the construction of a new pipeline called Power of Siberia 2, but Beijing has dragged its feet on concluding the deal.) As a result, Russia has had to curtail gas production significantly. Combined with the hit to oil revenues, the reduction in gas sales has cut Russia’s total energy revenues in half. Anton Siluanov, Russia’s Finance Minister, put it bluntly: “There is a problem with energy revenues.” This “problem” has led to a sizable budget deficit, which stood at roughly $25 billion through the end of August.
To try to shore up its budget, the Russian government has changed the way it taxes oil sales. Oil taxes are now indexed to the price of Brent crude as opposed to Russia’s flagship Urals product because Urals is selling at massive discounts to Brent. While this will help Moscow collect more tax proceeds from a shrinking pie of total oil revenue, it will also reduce resources for Russian oil companies. This will decrease the incentives for Russian oil companies to invest in production. In effect, Moscow is trying to squeeze as much tax money as it can from its oil sales today, even though this will further weaken its oil sector in the future. Again, the Kremlin lacks other viable options.
Barring an unforeseen turnaround in oil prices, Russia’s budget deficit will continue to grow. The Kremlin will need to sell more and more of its foreign currency holdings to finance its deficits, as it has already started to do. Over time, it’s only option may be to allow the ruble to plunge against the dollar—and indeed, the ruble has slid significantly against the dollar thus far in 2023. A weaker ruble will increase the ruble-denominated value of Russia’s oil revenues, but it will also worsen inflation, undermine living standards, and destroy Putin’s narrative that Russia is thriving under Western sanctions and that the war in Ukraine is not making life any worse for ordinary Russians.
Russia has limited options to contend with its increasing dependence on oil and gas sales. And they are all bad.
Opportunities for the U.S. and its Allies to Exploit the Vulnerability
Since Putin launched his full-scale invasion of Ukraine, the West has tried to walk a fine line on sanctions. On the one hand, the West has attempted to impose “swift and severe consequences” on Russia’s economy, as President Joe Biden promised. But on the other hand, it has tried to do so while largely sparing Russia’s energy sector. It has not done this out of charity but, rather, because of concerns that aggressive sanctions on Russia’s oil and gas sales could spike global prices, which, in turn, could worsen inflation, throw the West into recession, and endanger political support for Ukraine.
The December 2022 EU embargo on Russian oil, coupled with the price cap, marked a change in this approach—but only to a limited degree. The price cap itself was born of fears that a blanket EU ban on insurance and other services for Russian oil could rattle markets. Russia’s oil revenues have fallen in the wake of these policies, but the situation is not so dire yet that it could undermine Putin’s war effort.
The West possesses multiple options to further exploit Russia’s critical dependence on oil and gas sales. These options could be used independently or in combination, and they can be modulated depending on how much pressure the West wants to exert on Russia’s economy and on what timeline.
For Oil and Petroleum Products
OPTION 1: STRENGTHEN THE PRICE CAP ON RUSSIAN OIL AND PETROLEUM PRODUCTS
In designing the price cap policy, the G7 was more concerned about the possibility of overcompliance than undercompliance. These concerns were rooted in projections by multiple market analysts that the price cap would boost world oil prices. As a result, compliance obligations for insurers and shipping companies are relatively light. For instance, in the EU regulations, if a tanker is found to have shipped Russian oil above the price cap, it is banned from G7 insurance and other services for just 90 days. A penalty this mild can easily be considered a cost of doing business.
To strengthen the price cap, the G7 can threaten to impose sanctions on any entity—whether it is a commodities trading firm, a refinery, a vessel, a shipping company, or an insurance provider—that knowingly participates in a transaction for Russian oil that exceeds the price cap. For example, if a Russian vessel ships Russian oil for a price that exceeds the cap while benefiting from G7 insurance coverage, the G7 could impose sanctions on that vessel. The same sanctions could apply to a United Arab Emirates–based commodities trader or a Chinese oil refinery. Such a policy would significantly raise the costs of violating the price cap. It would almost definitely lead to stricter adherence to the cap, giving buyers of Russian oil even more leverage in price negotiations. Once the new policy is in place, the G7 would be well positioned to lower the cap as necessary to put more pressure on the Kremlin’s oil revenues.
OPTION 2: IMPLEMENT FINANCIAL SANCTIONS TO LIMIT RUSSIA’S USE OF ITS OIL PROCEEDS
G7 sanctions on several of Russia’s largest state-owned banks as well as restrictions on the Central Bank of the Russian Federation immobilized the stocks of Russia’s economy. But they did not immobilize the flows into Russia’s economy. As a result, throughout the war, Russia has continued to rake in hundreds of billions of dollars in revenues from energy exports, which it can use to buy imports and support its currency in a relatively unencumbered fashion. In essence, Russia has been able to amass large “shadow reserves”—stockpiles of cash that do not accrue to the balance sheet of the central bank but function much like ordinary central bank reserves. This is a gaping hole in the sanctions regime.
The G7 can use financial sanctions to stymie the flow of oil money into Russia’s economy and limit how the Kremlin can use it. The first step is to impose blocking sanctions on all the key nodes of Russia’s energy sector, including big production companies, such as Rosneft and Gazprom, and financial institutions, such as Gazprombank. Even though the two largest banks in Russia, Sberbank and VTB, are under blocking sanctions, as is Rostec, the biggest Russian defense conglomerate, the energy sector retains free access to the global financial system—except transactions to raise new debt and equity, which have been banned since 2014. This odd situation, in which none of the major firms in Russia’s energy sector face blocking sanctions, is a relic of the early days of the 2022 sanctions campaign, when G7 leaders feared spiking oil prices. Fixing it is long overdue.
The G7 can use financial sanctions to stymie the flow of oil money into Russia’s economy and limit how the Kremlin can use it.
The second step is to amend the exemptions (found in OFAC General License 8G) that permit virtually all energy-related transactions with Russia. The exemptions could be narrowed such that payments for Russian oil and petroleum products cannot be repatriated to Russia. The proceeds would need to stay in the country that bought the oil and could only be used for bilateral trade in humanitarian goods, such as food, medicine, and medical devices. A similar regime on payments for Iranian oil successfully trapped more than $100 billion in Iran’s oil money in overseas bank accounts. There is no reason that such a campaign could not be applied to Russia.
As with the price cap, such financial sanctions would continue to allow Russian oil to flow to global markets. Moreover, the policy would provide an incentive to buyers of Russian oil, such as China and India, to comply, as it would encourage Russia to buy more humanitarian goods from these countries. It is possible that Russia could retaliate against such a policy by refusing to sell oil, but that would cause a host of problems, from requiring a shut-in that damages existing wells to endangering Russia’s relationships with its key oil buyers. While divining Putin’s actions is a fool’s errand, Russia would retain a powerful incentive to keep selling oil even under such financial sanctions.
For Natural Gas
OPTION 1: BAN EU IMPORTS OF RUSSIAN NATURAL GAS VIA BOTH PIPELINES AND LIQUEFIED NATURAL GAS (LNG)
Russian exports of natural gas to Europe have plummeted since early 2022. The declines initially resulted from Russia’s attempt to weaponize natural gas by banning sales to EU members, such as Poland and Bulgaria. They then worsened when Nord Stream 1 was shut down by an act of sabotage. At the time of writing, Europe is importing the equivalent of 26 billion cubic meters (bcm) of pipeline gas from Russia, a steep drop from the roughly 140 bcm it was buying from Russia before the war.
To provide European businesses with the clarity they need to make long-term investments in alternative energy sources, the EU could permanently ban the import of natural gas from Russia via pipelines. This would ensure that, even if the war in Ukraine becomes a little-discussed frozen conflict, the EU-Russia gas relationship will not be revived. Additionally, in 2022, the EU bought 22 bcm of Russian LNG, purchases that currently face no restrictions. The EU could also ban the import of Russian LNG, depriving the Kremlin of the last piece of the European energy market that remains open to it.
OPTION 2: IMPOSE SECONDARY SANCTIONS ON INVESTMENTS IN NEW RUSSIAN GAS PROJECTS
Russia lacks viable, near-term options to place the large quantities of natural gas it used to sell to Europe. To do so over time, Russia will need to invest heavily in new pipeline capacity to Asia as well as LNG facilities and export terminals. The West can complicate these plans by threatening to impose secondary sanctions on banks and companies that invest in such projects. Without access to Western financing and technology—and with foreign firms facing the threat of secondary sanctions—Russia’s efforts to reroute its natural gas production will be rendered exceedingly difficult, if not impossible. China, for instance, may never sign up for Power of Siberia 2.
There is also a useful precedent for these sanctions. The Iran Sanctions Act requires the U.S. government to impose secondary sanctions on any firm that makes a significant investment in Iran’s energy sector. After the passage of the 2010 Comprehensive Iran Sanctions, Accountability, and Divestment Act, the State Department was afforded a “special rule” that it could use to negotiate gradual wind-downs of investments in Iran’s energy sector. The State Department leveraged the special rule to good effect, securing agreement from companies such as Total, Eni, and Shell to exit Iran. A similar regime applied to investments in new Russian gas pipelines and LNG projects could put a decisive end to Russia’s role as a major player in gas markets.
