With oil exports the largest contributor to Russian state revenues, these discounts are a cause for concern. They are largely to blame for a 25 per cent year-on-year contraction in Russia’s budget revenues for January and February. That period also saw a 52 per cent spending increase, mostly caused by Russia’s full-scale invasion of Ukraine. The result is a mushrooming deficit that threatens to erode Moscow’s economic resilience.
These discounts are a direct result of the European Union and G7 oil sanctions against Russia and have proven more challenging for Moscow than many anticipated. They have reduced Russia’s current revenue and can also curb future windfalls should prices rally.
But the Kremlin has been developing countermeasures to thwart sanctions. Chief among them is assembling a ‘shadow fleet’ of tankers able to transport Russian oil with impunity. Though Moscow’s shadow fleet has been steadily expanding, it will likely be years before it is large enough to shield all Russia’s exports from sanctions. But as the shadow fleet expands, these tankers — many ageing and poorly maintained — pose an increased risk of oil spills in coastal regions from the Baltic to the Sea of Japan. To counter these threats, coalition policymakers and coastal states will need to take robust action.
Russian oil sanctions consist of two separate embargos. The first is an EU/G7 ban on Russian oil imports, which has forced Moscow to find new buyers for nearly three-quarters of its oil exports. For an exporter of Russia’s size, this has proven a challenge. For 140 years, Russia has looked to Europe as its principal export market. Its sprawling oil infrastructure is primarily designed to move oil westward, with over 80 per cent of seaborne exports plying European waters. Sanctions are forcing these cargoes to be shipped to less familiar markets that are more constrained and remote.
Only two large buyers remain for Russian crude — China and India. Before February 2022, China was buying nearly 20 per cent of Russia’s exports and it has since stepped up imports modestly. The big buyer of Russia’s crude — absorbing more than half — has been India, which previously imported almost no Russian oil. Lack of competition at scale has given Indian traders powerful bargaining leverage to extract the deep discounts that are worrying Putin. The longer distances to market have also boosted Russian freight costs, further shrinking Moscow’s bottom line.
Moscow has taken two measures to combat the discounts. One is to ease the glut of Russian crude by announcing a cut in exports. The other is to sell more to China to regain pricing leverage. But additional deliveries to China must come from Russia’s distant Baltic and Black Sea ports because China-bound exports from its Pacific ports are close to capacity. This means higher freight costs and an undesirable increase in Russia’s tanker needs. That makes Russia even more vulnerable to the second EU/G7 embargo — a so-called ‘price cap’ which bans EU and G7 entities from providing shipping services for any Russian seaborne oil priced above a certain value. For crude oil, this capped price is currently US$60 a barrel. The price cap seeks to limit Russia’s ability to reap windfall revenues from high oil prices while avoiding the supply shock an unconditional ban on shipping services would cause.
Russia’s tanker needs are immense and meeting them without relying on European marine services is a challenge. From vessel finance to fleet ownership, Europe plays an outsized role in all aspects of global oil shipping, particularly in the complex area of mandatory oil spill liability insurance. Some 95 per cent of the global fleet is insured by a sophisticated not-for-profit network of mutual assurance societies called the International Group of P&I Clubs (IG).
The IG insures industry-wide liabilities that are too large for the commercial insurance sector to cover. Because it is based in Europe, the IG requires insured vessels to comply with the price cap as a condition of coverage. Complying with sanctions is the trade off that shipowners take for what is an indispensable part of their business model.
Russia has increasingly turned to a marginal group of tankers — the so-called ‘shadow fleet’ — to reduce its IG-insured fleet dependence. Shadow tankers normally spend most of their service life as IG-insured vessels in the mainstream fleet. But in the final years before they are retired, many tankers are sold to second-tier operators who sweat them for cash.
Some operators are anonymous ‘shadow’ investors based outside EU/G7 countries and pursue a risk-friendly business model where IG policies are replaced with coverage from niche, low-transparency insurers. While some insurers are reportedly undercapitalised and offer inferior policies, they compensate shadow-tanker shipowners through relaxed insurance standards and a laissez-faire approach to sanctions that allows them to pursue lucrative business in Iran, Russia and elsewhere.
Since the summer of 2022, the number of shadow tankers transporting oil from Russia has been growing. Over the coming months, these vessels will pass through crowded maritime chokepoints in Europe and Asia laden with oil. A September 2022 collision in the Singapore Strait highlights the danger they pose. As their numbers continue to grow, so too does the risk of a catastrophic spill.
Despite its swelling shadow fleet, Russia still relied on IG-insured tankers for over 60 per cent of its exports in March 2023. So far, this has cost Russia little, since most of its oil continues to trade below the price cap. But if prices rally, Russia may have to choose between cutting exports or prices. It may try to avoid this choice altogether by underreporting transaction prices — a scheme it appears to be pilot-testing on some cargoes already.
Oil sanctions continue to take a toll on Russian revenues, but Moscow is stepping up its evasion efforts. Coalition policymakers can counter these efforts by ratcheting down the price cap and enhancing oversight. Coalition countries should also encourage Russia’s remaining large importers to resist Russian pressure for kickbacks, offsets or other compensation lest such practices increase pressure for secondary sanctions. Finally, to combat the heightened risk of a catastrophic spill, coastal states will need to push for an end to lax enforcement of safety regulations for shadow tankers.
Craig Kennedy is a former Vice Chairman at Bank of America Merrill Lynch, a Center Associate at Harvard’s Davis Center for Russian and Eurasian Studies, and author of the Substack newsletter Navigating Russia.