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Fueling war: Russia's aggression persists amidst high oil prices and ineffective sanctions

Russia's ability to sustain its military endeavors hinges on the substantial revenues derived from its oil and gas sector, which forms the bedrock of the nation's budget. In the first year of the conflict, these earnings soared to unprecedented heights. As 2023 draws to a close, they are poised to decline, yet they will still surpass the average of the past decade. Looking ahead to the next year, the government anticipates a resurgence in economic fortunes. Based on these optimistic expectations, an unparalleled wave of expenditures has been strategically laid out. While some economists may deem this optimism as excessive, a discernible truth emerges: the prevailing scope of sanctions does not impede Russia's ability to offset excessive expenditures with augmented revenues.

  • What underlies the government's optimism

  • Could oil prices decrease?

  • What about the sanctions?

  • The bottom line

Russia has managed to increase its budgetary expenditures, infuse the defense industry with funds, and finance the ongoing conflict in Ukraine with surprising ease, despite facing sanctions and the need to overhaul its economy. According to the budget proposal for the years 2024-2026, next year's total expenditures are set to rise by over 20% compared to 2023, reaching a staggering 36.6 trillion rubles. Nearly a third of this substantial sum is allocated to “National Defense” expenditures, and in practice, the military budget will be even larger, as some costs directly or indirectly related to the support of the Ukrainian invasion are embedded within civilian categories.

The remarkable resilience of the Russian economy during wartime may seem puzzling at first glance but can be explained rather simply. In 2022, the conflict sparked a sharp increase in energy resource prices. As a result, the budget reaped record oil and gas revenues in the first year of the war, amounting to 11.6 trillion rubles. This marked a 28% increase from 2021. It is evident that revenues will decline in 2023, yet they will remain above the average of the past decade. The government expects even stronger growth in oil and gas revenues in 2024, with a 30% increase to 11.5 trillion rubles. Adjusting for inflation, this is still lower than the exceedingly successful year of 2022, but the goal remains ambitious.

What underlies the government's optimism

Oil and gas revenues refer to the budget's income generated from taxes on the extraction of natural resources and export duties on oil, gas, and their byproducts. Typically, revenue calculations are based on the average annual prices of Urals crude oil, the export cost of natural gas, and the exchange rate of the ruble to the dollar. These are referred to as base revenues, which contribute to the budget, while any additional income flows into the National Welfare Fund (NWF).

The Ministry of Economic Development's forecast, which forms the foundation of the new budget, assumes that oil production and exports will see a minor decline in 2024. This is due to Russia's voluntary reduction of production as part of agreements with OPEC+ partners. By doing so, cartel members maintain global prices at levels comfortable for them.

The government's plan anticipates that the price of a barrel of Urals crude oil will rise from $63.4 to $71.3 in 2024. This increase is partly attributed to the growth in global prices but is primarily due to reducing the Urals-Brent discount to $15. (According to the Ministry of Finance, in October, the discount was less than $11, roughly corresponding to the cost of transporting Russian oil to India.) Income obtained from the sale of Russian oil priced above $60 per barrel will be directed to the NWF. In the previous year, a different mechanism was in place, with base revenues initially fixed at 8 trillion rubles. Prior to that, the cutoff price was $45. The amount of oil and gas revenues will be affected by the ruble's devaluation more than by the rise in global prices, as the budget for 2023 was planned with a significantly stronger ruble.

Could oil prices decrease?

For Russian oil to be sold at prices exceeding $71 per barrel, the average price of a barrel of Brent crude oil in 2024 would need to be around $86, which is roughly the current rate. This estimate doesn't appear overly optimistic. By way of comparison, the U.S. Department of Energy expects Brent prices to rise to $95.

There are no apparent triggers for a significant price drop. Despite the global economic slowdown, there is already an oil market deficit due to Russia and Saudi Arabia reducing production. Given their decision to extend limitations into the next year, the deficit is expected to persist, according to the International Energy Agency (IEA). Russia needs extra funds for the destruction of Ukrainian cities, while Saudi Arabia, conversely, is investing in ambitious projects like the construction of futuristic cities. Strangely, their interests have aligned.

Of course, there are less optimistic forecasts for Russia. For instance, analysts at Citi predict that Brent prices will only remain above $80 in the first quarter of 2024 and will drop below $70 in the fourth quarter. However, they base these predictions on global GDP growth of just 1.7% for the next year. This is considerably worse than the forecasts of the International Monetary Fund (IMF) and other reputable analytical centers, which anticipate slightly less than 3% growth.

Moreover, oil prices could also rise. In 2023, the United States eased sanctions against Iran, resulting in a sharp increase in Iranian oil shipments to levels not seen in several years. If Iran becomes embroiled in conflicts in the Middle East, its oil shipments will be disrupted, causing prices to rise again. The Bruegel think tank forecasts that in such a scenario, a barrel of Brent could cost at least $100.

As of now, the market remains relatively stable. After a sharp surge triggered by Hamas's attack on Israel, oil prices quickly stabilized. Even the influential alarmist Nouriel Roubini does not view disruptions in Persian Gulf supplies as the most likely scenario.

What about the sanctions?

The impact of sanctions on Russian oil has fallen short of expectations.

Towards the end of the previous year, Europe ceased its purchases of Russian oil. Simultaneously, a related measure, known as a price cap, came into effect, which other importers had to adhere to in order to access the services of European and G7 insurance and shipping companies. Currently, this cap is set at $60 per barrel.

Initially, the enforcement of the price cap created the illusion of effectiveness. The reason behind this was that the average price per barrel of Urals crude oil continued to be evaluated with an element of inertia. However, these evaluations were mostly disconnected from actual shipping, as new major buyers like India and China began to use different ports for their trade.

It became increasingly evident earlier this year that India and China were, indeed, paying considerably more for Russian oil than the capped $60 per barrel. Right after the sanctions were imposed, the average price soared to $74, as confirmed by a group of economists including Tatiana Babina (Columbia), Benjamin Hilgenstock (KSE), Oleg Itzhoki (UCLA), Maxim Mironov (IEU), and Elena Rybakova (IIF), who had access to classified data from Russian customs. Presently, as per IEA estimates, Urals crude is selling on average at a $12 discount compared to Brent, meaning that the discount is even lower than the Russian government's initial forecast.

The major challenge with the sanctions lies in the lack of a robust enforcement mechanism. Furthermore, European shipowners and insurers were not even required to provide documentary evidence that their Asian counterparts were genuinely adhering to the restrictions. Adding to the complexity is the fact that a significant proportion of Russian oil is transported by the so-called shadow fleet, which was specially established to circumvent such sanctions.

It wasn't until October that the United States finally took measures against violators of the price cap. They targeted two shipowners from Turkey and the UAE, along with their tankers. Concurrently, the Price Cap Coalition, an alliance of the architects behind the price cap, urged market players in maritime transportation to exercise more vigilance in ensuring sanctions compliance.

Hence, the transition to settlements for exports in national currencies, particularly the Indian rupee, which cannot be readily converted or repatriated without the approval of Indian financial authorities, has posed some minor inconveniences for Russia. Popular belief holds that the rupees left stranded in exporters' accounts contributed to the devaluation of the ruble this year, although other significant factors played a role. Presently, the issue of rupee repatriation appears to be resolved, according to statements from Russian bankers.

The bottom line

The global economic landscape appears to favor Russia. Even amid the slowdown in global GDP growth, the Russian government's plans seem quite realistic. Moreover, if the crisis in the Middle East doesn't de-escalate and the price of a barrel of Brent crude surpasses $100, Russia could potentially reap export windfalls in 2024 that are comparable to the first year of the conflict.

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