Russian President Vladimir Putin famously miscalculated by sending an unprepared army to fight a four-day war in Ukraine that’s now in its fourth month. But Putin got one crucial thing right: the value of oil as a shield to protect Russia’s economy and keep his ruthless war going.
The United States, Europe and many other countries have layered withering sanctions on Russia, cutting many of its banks and much of its economy off from the rest of the world. Those are now causing widespread shortages of imported goods and other problems, resulting in hefty inflation and a nationwide decline in living standards for ordinary Russians.
But sanctions have not stanched Russia’s revenue from oil sales, the single largest source of government funding. In fact, the spike in oil prices caused in part by Putin’s own war led to record-high energy revenue for Russia in March and April—when most of the sanctions were already in effect. In the first four months of 2022, Russia earned half of its planned energy revenue for the year, putting it on a path to exceed its own targets while prosecuting the biggest European war since the Allies defeated Hitler in 1945.
That energy revenue is a vital shock absorber that lets Putin prolong his war, offset some of the pain Russian citizens feel and maintain his iron grasp on power.
“Russian imports are collapsing, but Russian exports, because of the high cost of energy, are actually doing very, very well,” Iikka Korhonen of the Bank of Finland said during a May 25 online forum sponsored by the Peterson Institute for International Studies. “If you want to do something to Russia’s fiscal revenues, trying to have an effect on energy exports is of utmost importance.”
Europe is now trying to do exactly that. On May 31, the European Union reached a deal to phase in a partial ban on Russian oil and oil products. The aim is to ban up to 90% of the oil Europe buys from Russia by the end of the year, with an exception for oil sent by pipeline to a few landlocked countries that can’t get oil from other sources by ship. A ban on refined Russian oil products will kick in next year, assuming there’s no resolution to the war. A complete boycott starting immediately, as the United States and United Kingdom have imposed, would obviously be more effective, yet the European bancould still thin Putin’s main source of cash, if it holds.
Will Russia be able to find other buyers?
The main question is whether Russia will be able to find other buyers for its oil, and the answer is probably yes. Russian oil, known as Urals, is already selling for about $30 per barrel below the market price, because of difficulties financing purchases that sanctions have already caused. Russia’s cost of production is between $20 and $30 per barrel, so it still makes money, given that market prices are around $120. The European boycott could enlarge the discount, however, cutting into revenues more. If demand for Russian products fell enough, it could clog the domestic industry because Russia has very little storage space and oil infrastructure can’t be turned on and off easily.
There’s a risk for the boycotting countries, as well. High energy costs are already causing economic pain and political discord in Europe, the United States and elsewhere. For a boycott on Russian oil to work, it must, by definition, limit or destroy Russia’s ability to sell oil. But taking the world’s third-largest producer out of the market would create even more acute shortages than there are now, with corresponding price hikes. Gasoline prices in the United States could eclipse not just $5 per gallon but maybe even $6, with higher prices still in Europe and many other places. The higher the cost of sanctioning Russia, the tougher it will be to maintain political support for sanctions—which Putin probably knows.
Policymakers are still looking for better ways to punish Russia without the collateral damage. Spanish economist Luis Garicano and other policy experts argue in favor of stiff new European tariffs on Russian oil and gas, which would cut demand for Russia’s energy, especially if the tariffs rose over time. European purchasers would pay more, but the new tariff revenue could fund rebates that offset the higher prices. The higher cost of Russian products, meanwhile, would lead buyers to other sources, another way to cut demand for Russian energy and reduce revenues to the Kremlin. Biden administration officials are exploring whether they can use financial sanctions to achieve a similar effect. One downside is possible confrontation with nations that buy Russian oil, such as Turkey, India and China.
An improvised economic war
Like the military war on the battlefields in Ukraine, the economic war is an amalgam of proven tactics and improvisation, with each side trying to break the other. What’s clear so far is that sanctions are hammering Russia’s consumer economy, which relies heavily on global suppliers, even for domestic production. Prices of some consumer products are 60% higher than at the end of 2021. Without semiconductors and other foreign components, auto and airplane production in Russia has essentially stopped. Car sales in April were 80% lower than the year before.
“Russian companies, at the moment, are unable to get many of the components and spare parts it takes to run any manufacturing industry, in any country,” Korhonen said.
Workers remain on the job, doing little or no work, but that can’t last.
Russia has stopped publishing unfavorable economic data, but data from other countries shows that some nations not participating in formal sanctions have nonetheless curtailed trade with Russia, isolating it further. Chinese exports to Russia, for instance, have fallen by half since the war started, suggesting Russia’s most important ally isn’t willing to take much or any economic risk to support Putin’s unnecessary war. Russia’s GDP will probably fall by 10% or more this year, which would be two to three times the shock of the Great Recession in the United States from 2007 to 2009.
A slush fund Putin has many uses for
In other ways, Russia is surprisingly resilient.
“Sanctions have severely hindered Russian banks’ ability to conduct international transactions,” researchers at the Institute for International Finance wrote in a June 1 analysis. "Yet, the financial system as a whole has withstood the shock much better than expected.”
During the last few years, Russia has built its own internal digital payments system and taken other steps to withstand precisely the sort of sanctions it faces now. The ruble, which plunged at the outset of the war, has stabilized, with government intervention, and Russia has been able to lower official interest rates it aggressively hiked at the start of the war, to keep capital in the country.
If Russia’s oil revenue keeps rolling in, Putin has a slush fund he can use in a number of ways. He could top off pensions and provide other subsidies to businesses and consumers, to limit discontent over the war’s toll on the Russian populace. Or he could funnel it into the war effort and the security apparatus that keeps Putin in power.
“My expectation is this money will be channeled toward the war effort and the domestic police, rather than pensions,” economist Elina Ribakova of the IIF said during the Peterson event.
Ukraine and its allies, of course, hope that’s a choice they can preempt.