The Coming EU Embargo of Russian Oil, Russia’s Economic Challenges, and the Question of Operational Capacity

The Coming EU Embargo of Russian Oil, Russia’s Economic Challenges, and the Question of Operational Capacity 1

When the EU commits to a measure to undermine Russia that the US opposed as unproductive, one has to wonder when rationality and self interest left the room. The West is only beginning to suffer the cost of blowback from economic sanctions against Russia in terms of higher energy and food costs, which are soon to be followed by price increases and shortages of other commodities where Russia has significant market share. Yet the EU is launching an embargo of Russian oil, just after Poland, Bulgaria, and Finland have decided to cut themselves off from Russian gas, and Russia is also in a spat with Germany after Germany seized Gazprom’s operations there.

The EU is set to provide more details about its scheme this week, so we’ll give only a high level discussion now.

There is always the possibility that the EU program will be unexpectedly well thought out, particularly in terms of contingency planning, despite the idea only having been mentioned as a possibility at the start of March and getting more serious interest in early April.

Our concern is the limited time to consider such a big change means there may be quite a few unknown unknowns. To give an idea of scale of study it takes to understand a system, it took a team of physicists 7 years to identify and map the physical inputs and outputs of Australia and deliver their findings in the early 2000s. And at least in Germany, and I suspect in other EU countries, energy rationing schemes have industry taking the cuts first, households last. In a world of extended supply chains and just-in-time manufacturing, which creates fragility and tight coupling, it’s all too easy to have energy-shortfall-induced problems at one company propagate to others in the same sector.

Admittedly, the EU is not planning to wean itself fully off Russian oil until the end of the year, but that still seems aggressive.

It’s even more difficult to judge the Russian side of the equation, but we’ll also briefly discuss the latest update by its central bank governor, Elvira Nabiullina, which we’ve embedded at the end of this post.

One factor in the West v. Russia economic war equation that does not appear to be getting enough attention is what we call operational capacity, in this case of governments, both their own capabilities and their ability to marshal and direct private sector resources. We discussed it repeatedly in connection with 2015 Greece bailout negotiations (see here for instance). Our concern is the West will be tested and found wanting.

First to Janet Yellen’s cautionary remarks to Europe about barring Russian oil, via the April 21 Financial Times:

Janet Yellen, US Treasury secretary, urged Europe to be “careful” about imposing a complete ban on Russian energy imports, warning of the potential harm such a move could inflict on the global economy.

“Medium-term, Europe clearly needs to reduce its dependence on Russia with respect to energy, but we need to be careful when we think about a complete European ban on say, oil imports,” Yellen said during a press conference in Washington on Thursday.

She said an immediate ban by the EU would “clearly raise global oil prices” and “would have a damaging impact on Europe and other parts of the world”. Yellen added that “counter-intuitively”, a total embargo may not have such a negative impact on Moscow’s finances, with Russia benefiting from higher prices.

The focus of western allies should instead be on trying to reduce “proceeds from sales of oil and gas” for Russia. “If we could figure out a way to do that, without harming the entire globe through higher energy prices that would be ideal. And that’s a matter that we’re all trying to get through together,” she said.

Even when an oil embargo was more a talking point than a serious idea, in early March, German chancellor Olaf Scholz was firmly opposed. But in April, Scholz came around to agreeing with Climate and Economy minister and Green Party member Robert Habeck, that while Germany could not go cold turkey on Russian oil, it could wean itself off it by year end. The end of Germany’s opposition appears to be what has allowed the plan to move forward. Here’s the key argument per Politico last week:

Berlin could handle an embargo on Russian oil imports, Germany’s Climate and Economy Minister Robert Habeck said on Tuesday, suggesting the country could end its dependence on Moscow within “days.”

Habeck, speaking at a press conference in Warsaw, said that Germany had managed to slash its reliance on Russian oil by two-thirds in recent weeks, reducing the share of imports from 35 percent before Russia’s invasion of Ukraine to 12 percent now.

The remaining Russian imports supply the Schwedt refinery in eastern Germany, he added, as other sites had already switched to alternative suppliers. Schwedt, which is run by Russia’s state-owned Rosneft, supplies the vast majority of the Berlin-Brandenburg capital region with fuel.

Let’s put on our skeptic hat. First, this is spring, when energy demands are lower than in the late fall and winter. Second, thanks to the Shanghai lockdowns, there’s been a slowdown in industrial activity, which likely had some impact on German companies. Third, the US has been shipping some of its strategic petroleum reserve releases to Europe, so that could have directly or indirectly benefitted Germany. Those strategic petroleum reserve releases are set to end in October. Fourth, there is a good possibility that some of that oil is actually laundered Russian oil. For instance, at least as far as the US embargo is concerned, I understand that oil sold out of storage is not considered Russian origin. Another play is to mix Russian oil with oil from other sources, and as long as the Russian oil is not more than half of the total, it’s not considered Russian. I hope knowledgeable parties will pipe up and indicate if these practices are still, erm, accepted and what if any other laundering techniques are in use.

And finally, the rule of 80/20 says the first 80% is pretty easy and the last 20% is hard. So getting that last 12% of Russian oil supply to zero is likely to include going without, as opposed to finding other sources.

And remember, this is just Germany. All of Europe is now committed to this program (save Hungary, which is participating under duress and thus is particularly likely to find ways to cheat). So the “Where do we get it?” problem now has more countries competing for non-Russian supplies.

So across Europe, one can expect:

As Yellen predicted, higher energy prices, particularly since the old purchases with Russia were denominated in euros, while new sources are likely to be denominated in dollars, and the euro has fallen against the dollar. So Europe will suffer a currency bite on top of the price increase generated by the embargo

European countries being faced with having to position themselves somewhere on the spectrum of energy austerity due to difficulty of getting replacement supplies and/or unacceptably high costs, or oil laundering (Russia sells oil at a discount on world markets, by the time it wends its disguised way back to Europe with all those middlemen in between, it is at or higher than world price, but likely not quite as pricey as other options.

And as Yellen also intimated, Russia may come out ahead due to even higher oil prices. It can afford some combination of lower volumes and if needed, more discounting.

Now let us look briefly at Russia. The reason the West is trying even harder with energy sanctions is that they expected Russia to collapse with the massive financial sanctions. Not only did it not, to my knowledge, it didn’t even have to rescue a single bank.

Moreover, Russia just dropped its policy rate a second time, from its emergency level of 20% to 14%. Note that Russia also implemented special lower rate regimes to priority activities, such as mortgages. The rouble is now at 71 to the dollar, stronger than it has been since Juky 2020 despite the dollar being super strong, save for a brief blip up in November 2021.

Russia’s successful emergency response points to the advantages of having a not very financialized economy but even more important, apparently a high degree of operational capacity. As Nabiullina describes below, the main contributor to inflation is the loss of Europe-sourced goods; those and their replacements have been bid way up. She indicates that inflation ex that is markedly lower and is falling due to a reduction in domestic demand (consumers are saving).

As we have repeatedly said, Russia having handled the financial challenge vastly better than anyone anticipated does not mean that it will manage the real economy transition anywhere near as quickly or well. Nabiullina anticipates that shock will be the most acute over the next six months, with the economy bottoming at the end of the year.

So we will have a real world test of the ability of Europe and Russia to manage economic restructurings, with Russia’s being vastly more fundamental and thus more prone to failure or shortfall.

Offsetting that are signs that Russia retains some muscle memory from its old central planning days and may have found useful ways to redeploy some of those skills. Scientist GM pointed out how Russia has been able to surpass the West in missile development, and it appears to be simply by dint of diligent application, despite being comparatively impoverished. From his comment:

Currently in service:

Being deployed now:

But presumably there are a few already made and a single one of these can sterilize the whole of the UK; as, very ominously, publicly discussed on mainstream TV in Russia yesterday:

There is no Western equivalent to any of these and there will not be until the end of the decade the earliest.

In development:

Which will be a game changer too. And not even purely because of its military implications — if they have been able to work the propulsion in this context, this will revolutionize all sorts of nuclear power applications in other areas.

BTW, China and India seem to be well ahead of the US in hypersonic missiles and HGVs too.

This is what neoliberalism does.

The Russians had a really rough decade in the 1990s but then seem to have pulled it together. Although it remains to be seen how their R&D will do in the future — most of the fancy doomsday weaponry that gives them a major advantage right now actually seems to be resurrected late-Soviet projects (so much for the USSR having collapsed due to being technologically backward), The foundation of the advances of the 2040s and 2050s (if there is still anyone alive then) will have to be modern Russia, which is not the USSR. We will see, there are both reasons to be skeptical and optimistic about that. The Avangard development was still headed by this guy:

Who is 89 now. Whether have have people in their 30s and 40s on the same level taking over we don’t know.

The US on the other hand should have no problem attracting top talent, but it voluntarily killed its own space program (because it had a trillion a year for Pentagon grifters but somehow did not have a measly ten-twenty billion a year to directly support R&D) then handed it to the “private sector”. And these are the results — it fell behind dramatically and mow it has to plat catch up. Let nobody fool you into believing that the fact that for a decade the US had to rely on the Russians to get stuff and astronauts in space and the fact that the US fell behind on advanced missile tech are completely unrelated to each other.

That may seem like a long-winded anecdote but it helps illustrate a point: Russia still knows how to make things. By contrast, what passes for Western elites are in thrall to symbol manipulators and speculators. That is why there is reason to question whether Europe has a good grasp of what it is getting itself into with its Russian energy embargoes.

00 Statement by Bank of Russia Governor Elvira Nabiullina in follow-up to Board of Directors meeting on 29 April 2022 | Bank of Russia

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