Making senses of Yellen’s oil cap proposal

In the aftermath of their invasion of Ukraine, the US and its coalition partners agreed to isolate Russia by sharply restricting trade; and with Russia being among the largest exporters of crude oil and natural gas, the sanctions caused buyers of these products to face critical energy shortages. Prices for these commodities had been rising even before Russia’s invasion on February 24th, but they really spiked in the weeks following.

Futures market price data offer the most transparent and reliable picture of market price history for these two commodities, generally; but pricing differences due to variations in quality and location certainly exist. In any case, before the invasion, the August crude oil futures contract had been trading in the mid-$80 range per barrel; but by early June, the price reached $120. Since then, the price has fallen back down into the mid-$90s.

A similar story applies to natural gas. In February, the August natural gas contract was trading in the mid-$4 per mmbtu. The price more than doubled by early June, but it’s since settled back to the low $6 per mmbtu range. The history for both commodities certainly contributed to the still high pace of inflation we’ve experienced through June; but both prices have retreated from their recent highs starting in early July.

The higher energy prices have benefited Russia, as they’ve still been able to sell energy to China and India — two huge customers that have not agreed to abide by the sanctions; and while the sanctions may be hurting Russia in terms of its ability to buy needed goods from abroad, elevated energy prices have bolstered demand for Rubles. After initially falling to its lowest value relative to the dollar in more than 10 years when Russia invaded Ukraine, the Ruble’s value has since fully recovered and then some.

The latest response by the Biden administration to the apparent financial wellbeing that Russia has been experiencing has been to float the idea of capping the price of Russian-sourced oil. This prospect is currently being spearheaded by Treasury Secretary Yellen; but thus far it doesn’t appear to be gaining much traction.

I’ve undertaken a complete turnaround on this proposal. Initially, when I first heard it, I couldn’t believe it. Why, in the face of energy shortages, would anyone think about imposing a price cap? Every economist understands that price caps simply induce shortages. They don’t eliminate them. It took some time, but I finally appreciated that the idea has merit — a lot of merit — and it’s worth pursuing.

Generally, the problem with sanctions is that they won’t work unless a critical mass of market participants agree to the terms. In this case, China and India haven’t been willing to go along with the original proscriptions. Yellen is clearly hoping that while these countries haven’t been willing to abide by the original sanction terms, perhaps they would agree to join the coalition on a limited basis, by refusing to pay beyond some maximum price. Ultimately, Yellen is asking these energy purchasers to exert greater market authority, hoping that Russia will accommodate to the lower prices.

This pricing dynamic is quite interesting. Russia needs to sell its oil and gas, and China and India need to buy it. Yellen clearly believes that China and India have ceded too much authority in the pricing of these products, and she’s prodding these and other purchasers to renegotiate the terms. What I had originally considered to be a silly idea at first glance I now understand to be one with virtually no down-side. In the worst case, nothing will happen; and we’d be left exactly where we are. Or, alternatively, China and India will collectively use their market power to reduce their energy costs at Russia’s expense. The behind the scenes work to be done is corralling those buyers currently not abiding by the sanctions and jawboning them to achieve a consensus as to the cap level that they’d be willing to sign onto.

I wish Secretary Yellen luck.

In the aftermath of their invasion of Ukraine, the US and its coalition partners agreed to isolate Russia by sharply restricting trade; and with Russia being among the largest exporters of crude oil and natural gas, the sanctions caused buyers of these products to face critical energy shortages. Prices for these commodities had been rising even before Russia’s invasion on February 24th, but they really spiked in the weeks following.

Futures market price data offer the most transparent and reliable picture of market price history for these two commodities, generally; but pricing differences due to variations in quality and location certainly exist. In any case, before the invasion, the August crude oil futures contract had been trading in the mid-$80 range per barrel; but by early June, the price reached $120. Since then, the price has fallen back down into the mid-$90s.

A similar story applies to natural gas. In February, the August natural gas contract was trading in the mid-$4 per mmbtu. The price more than doubled by early June, but it’s since settled back to the low $6 per mmbtu range. The history for both commodities certainly contributed to the still high pace of inflation we’ve experienced through June; but both prices have retreated from their recent highs starting in early July.

The higher energy prices have benefited Russia, as they’ve still been able to sell energy to China and India — two huge customers that have not agreed to abide by the sanctions; and while the sanctions may be hurting Russia in terms of its ability to buy needed goods from abroad, elevated energy prices have bolstered demand for Rubles. After initially falling to its lowest value relative to the dollar in more than 10 years when Russia invaded Ukraine, the Ruble’s value has since fully recovered and then some.

The latest response by the Biden administration to the apparent financial wellbeing that Russia has been experiencing has been to float the idea of capping the price of Russian-sourced oil. This prospect is currently being spearheaded by Treasury Secretary Yellen; but thus far it doesn’t appear to be gaining much traction.

I’ve undertaken a complete turnaround on this proposal. Initially, when I first heard it, I couldn’t believe it. Why, in the face of energy shortages, would anyone think about imposing a price cap? Every economist understands that price caps simply induce shortages. They don’t eliminate them. It took some time, but I finally appreciated that the idea has merit — a lot of merit — and it’s worth pursuing.

Generally, the problem with sanctions is that they won’t work unless a critical mass of market participants agree to the terms. In this case, China and India haven’t been willing to go along with the original proscriptions. Yellen is clearly hoping that while these countries haven’t been willing to abide by the original sanction terms, perhaps they would agree to join the coalition on a limited basis, by refusing to pay beyond some maximum price. Ultimately, Yellen is asking these energy purchasers to exert greater market authority, hoping that Russia will accommodate to the lower prices.

This pricing dynamic is quite interesting. Russia needs to sell its oil and gas, and China and India need to buy it. Yellen clearly believes that China and India have ceded too much authority in the pricing of these products, and she’s prodding these and other purchasers to renegotiate the terms. What I had originally considered to be a silly idea at first glance I now understand to be one with virtually no down-side. In the worst case, nothing will happen; and we’d be left exactly where we are. Or, alternatively, China and India will collectively use their market power to reduce their energy costs at Russia’s expense. The behind the scenes work to be done is corralling those buyers currently not abiding by the sanctions and jawboning them to achieve a consensus as to the cap level that they’d be willing to sign onto.

I wish Secretary Yellen luck.