Understanding the Risks of Sanctioning Russian Oil

With secessionist events in Ukraine unfolding, further U.S. and EU sanctions against Russia remain a policy option.

Russia’s oil sector fuels roughly forty percent of the country’s current budget, so finding an effective way to sanction it is an obvious target for the United States and its western allies. Before sanctioning Russian oil, however, it is essential to answer one key question: how will markets respond to eliminating exports from today’s largest global oil producer? The answer to this question is not reassuring—neither for Russia, nor the West. Any steps to sanction crude therefore should be considered with extreme caution.

In 2013, Russian oil output stood at a record high of 10.5 million barrels per day, surpassing that of Saudi Arabia, the world’s historic swing producer. Flow it does, but not without significant help from outsiders. Western service companies are needed to maintain Russian oil fields, international energy majors bring cutting edge technology to new development projects in Siberia or the Arctic, and joint ventures inject the necessary finance. U.S. sanctions will be able to target all of that, thus driving up costs in the Russian oil sector and reducing output.

Yet, energy sanctions are much more than a technical issue. Oil is the world’s most actively traded physical commodity. It permeates today’s highly globalized economy. On any given day, more than ninety million barrels of crude and petroleum products are consumed, and over 55 million barrels of crude and petroleum products traverse the globe. As such, it will be impossible to impose “targeted” sanctions on oil. Supplies taken out of the market in one place—even if done only gradually—impact every nation, producer, and consumer.

To be sure, a complex oil value chain makes it impossible for even major players such as ExxonMobil or the International Energy Agency to accurately predict future oil prices. The truth is, with this level of integration, experts haven’t a clue how sanctions will distort global oil markets. What is guaranteed is that if only a fraction of the current Russian output is taken off market, this will lead to a short-term price spikes. In the past a market contraction of this size was dubbed an “oil crisis.”

Adding to that, futures and derivatives markets are also built on the price of underlying oil commodities. At least 200 billion barrels a year, worth in the order of $20 trillion, are priced off the Brent benchmark—the world’s major oil basket. Even small supply distortions could therefore amplify and have a significant impact on global energy prices. The biggest risk will however be triggering a market roller coaster, which is even harder for citizens, politicians, and industry to weather than only higher prices.

What’s more, it remains unclear whether oil sanctions will have their desired effect. And previous incidents won’t help in predicting the outcome of larger, sustained market interruptions.

The world was a different place in 1979 when President Carter enacted sanctions on Iran, freezing their assets, and again in 1995 when President Clinton expanded sanctions to include trade with Iran’s oil industry. Massive globalization hadn’t yet taken place. As such, the geo-economic impact of limiting a country’s ability to export oil once had limited reach. OPEC easily made up the 2 million barrels per day of displaced Iranian oil in 1979. This is in stark contrast with what is possible today when seventy-two percent more oil is traded worldwide than when the first sanctions were enacted.

This is also why the United States’ newly found oil riches wouldn’t shield the country from the price shock that is likely to result from serious oil sanctions against Russia. America remains wired into the global oil market, and this will translate into price spikes in NYMEX traded oil futures and for consumers at the pump. Russia, in turn, will not necessarily suffer in the way intended. While any oil price hikes will harm Russian citizens and business, they would stand to benefit the Kremlin’s state coffers, partially making up for the loss in market shares.

Sanctioning Russia’s oil remains on the table. But playing this card comes with serious economic risk for all. The burden is on Washington and Brussels to weigh this move carefully. Moscow, in turn, should be prepared for the West to sanction oil—not because it makes sense, but because the course of events might lead to actions whose outcomes are eventually undesirable.