Jul 5, 2022 - Economy

Biden's Russian oil plan aims to prevent an economic catastrophe

G7 leaders in Germany

G7 leaders in Germany last week. Photo: Brendan Smialowsky/AFP via Getty Images

The headlines from a gathering of the Group of 7 world leaders last week focused on diplomacy around the Russia-Ukraine war. But the summit could have massive consequences for the world economy.

  • The Biden administration advanced a novel strategy to allow Russian oil to trade with its price capped, something officials view as essential to preventing a catastrophic price surge.

Why it matters: The world economy is exceptionally fragile right now, and a new oil spike would amount to a global crisis. The G7 is seeking to prevent that from happening, while also keeping financial pressure on Russian President Vladimir Putin.

  • But there is much high-stakes diplomacy and legal work ahead to execute the strategy. And depending on how Russia reacts, the strategy could backfire.

State of play: As oil prices cratered today amid fears of recession, the U.S. and its allies face a dilemma. They want to cut off Russia's ability to profit from selling crude oil. But spiking prices mean that Moscow can reap windfall profits by selling to countries willing to ignore sanctions.

  • The novel approach developed by the Americans, and embraced in principle by G7 leaders last week, is to use Western dominance of financial services as a source of leverage.
  • The idea is that financing and insurance to ship Russian crude oil will only be legal if the oil is sold at a level that is only slightly profitable for Russia.

The upshot: If it works, Russian oil can remain on the world market and prevent prices from skyrocketing further, but without excessively enriching Russia.

  • That would be a remarkable diplomatic achievement for the Biden administration, and help the world avert a possible economic crisis that would likely result from $200 per barrel oil (Brent crude oil, used in Europe, was trading at about $103 at noon Tuesday).
  • Treasury Secretary Janet Yellen has told her global counterparts that this strategy is the best option to avoid a worldwide recession, sources tell Axios. If successful, the strategy would amount to a signature achievement of her time in the role.

Yes, but: Analysts warn that there is much that can go wrong in execution, and there's a serious risk of things backfiring.

What they're saying: "The most obvious and likely risk with a price cap is that Russia might choose not to participate and instead retaliate by reducing exports," wrote JPMorgan analysts in a note.

  • The analysts estimate that if Russia cut back oil supply by 3 million barrels per day in retaliation, prices would jump to $190 a barrel. In an extreme scenario of cutting by 5 million, the world would be looking at $380 per oil barrel.
  • American officials are betting that Putin's need for revenue, and to keep his country's oil output flowing, will dissuade him.

Another risk is that Russian energy importers like China, India and Turkey decline to participate, finding workarounds to the Western shipping companies and the financing networks that support them.

  • American officials are betting that those countries will prefer to avail themselves of Western shipping and prefer cheaper oil anyway.

The bottom line: The outlook for the world economy hinges in no small part on if an unconventional strategy will work.

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