An optimal price cap incorporates retaliation risk. Reports today suggest that the
G7 is considering a price cap on Russian oil of c.$65-70/bbl, substantially higher than
the $40-60/bbl range discussed earlier this year, which was meant to merely cover
the cost of production. However, this was an incomplete analysis, as it did not
consider Russia’s influence on global prices. If a price cap is set too low, Russia
would be incentivized to evade the cap and market its crude at (discounted) global
prices, maintaining most of its exports via an extensive ‘shadow fleet’, independent
of G7 financial and transportation services. Higher global prices would result.

A higher cap can keep prices lower in the end. This is a classic ‘Stackelberg
game’, where the G7 must anticipate Russia’s response to their price cap decision.
We analyze this game using some conservative assumptions on Russia’s (commonly
overstated) crude discounts, as well as our Brent pricing framework, finding a price
cap of $70+ may be sufficient to preclude Russian retaliation. The G7’s updated
proposals seem more appropriate, minimizing Russian revenues whilst also limiting
retaliation risk. To that end, today’s price action reflects a downward reassessment
of the latter risk. However, the announcement increases the risk of retaliation from
other global exporters, for whom the price cap may set a concerning precedent.

But higher prices can also result in lower supply. It is important that this cap
fluctuates with crude benchmarks, as incentives of the game vary with global prices,
balances, and discounts. This can result in the phenomenon of a backwards-bending
supply curve, as supply is actually reduced in response to higher prices. To avoid this,
we believe the price cap would need to be raised to c.$80-85+/bbl next year, given
our $110/bbl 2023 Brent forecast.
Loopholes keep cap enforcement weak. Nevertheless, we do not expect a
production impact of the price cap beyond the 0.6 mb/d sequential fall in Russian
supply due to the (separate) EU oil embargo, as we do not think it is enforceable.
The cap is largely implemented via attestation with ‘safe harbor’ clauses for ‘Tier 2
and 3’ players in the export supply chain (e.g. insurers, vessel owners, charterers,
shippers, downstream traders/brokers, end-consumers), that waive them of liability
if supplied with falsified receipts.

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