G7 Price Caps on Russian Oil Will Cause Worldwide Oil Shortages and High Prices

How many times do world leaders have to relearn basic economics?

The big news on September 2, 2022, was that G7 countries had agreed to impose price caps on Russian oil.  One headline that caught my eye was, “G7 Russian oil price cap one of “most powerful” tools to fight inflation, Yellen says.”

Ms. Yellen, the current Secretary of the Treasury and former Chairman of the Board of Governors of the Federal Reserve System went on to say, “This price cap is one of the most powerful tools we have to fight inflation and protect workers and businesses in the United States and globally from future spikes caused by global disruptions.”

Since Ms. Yellen is a Ph.D. economist, she has to know that price controls have never worked and always lead to shortages and higher prices.  Unfortunately, her current role as a politician supersedes her background in economics.

The G7 is calling their plan a price cap, but their terminology does not change the fact that they are imposing price controls that will negatively affect the global oil market.  Since G7 nations control 90% of international shipping traffic, they think they can control the price of crude through access to shipping and shipping insurance.  They are fooling themselves.

Russia is the world’s third-largest crude oil producer behind the U.S. and Saudi Arabia and the second largest exporter of refined petroleum products. So the world needs Russian crude oil and refined petroleum products, and they will find their way into world markets at whatever price buyers are willing to pay, regardless of the G7 price cap. Buyers such as China, India, and many other countries could care less if the oil they need was produced in Russia and will ignore the G7 price caps.

Do price controls work?

A quick internet search of the history of price controls yields thousands of examples of failures going back to ancient Egypt, where price controls led to the ownership of all land by the state and eventually its collapse, to the failure of Nixon’s domestic price controls of crude oil following the Arab oil embargo.  Kings, queens, despots, and duly elected presidents have tried unsuccessfully to impose price controls. They all thought they were uniquely intelligent and powerful, as do the current Presidents of the G7 countries.

I recall from my economics courses a story about University of Chicago economist Harold Demsetz giving a lecture at the University of Winnipeg. He used an analogy that using price controls to reduce inflation is like responding to cold weather in Winnipeg by breaking the thermometer.  His point was that thermometers merely respond to temperature the same as prices indicate the underlying economic pressures from the interaction of supply and demand.  Breaking a thermometer does not cause the temperature to rise, and controlling prices do not cause prices to fall.

So instead of breaking the market thermometer with price controls, the solution is to let the market work, which will happen anyway.  An adage of free market economics is that the best cure for high prices is high prices. The interaction of buyers and sellers will determine the market clearing prices of oil and gas.

The basic supply and demand model shows that a market is in equilibrium when the price buyers are willing to pay equals the price sellers are willing to sell.  A market imbalance is created if the market solution is not allowed to prevail, say through price controls.  If the price cap is set below the market price, then the supply of the commodity will be less than the quantity demanded, and a shortage is created, spawning a black market. Artificially low prices always lead to shortages and higher prices.

How will the G7 choose the price cap for Russian crude?

How will the G7 countries decide the price of Russian crude oil?  G7 officials say they will establish a price cap high enough that it is worth it for Russia to continue selling oil but low enough that it hurts the country’s economy and hinders Putin's ability to fund his war in Ukraine.  How do the G7 leaders know what that price is? They must think they are smarter than Putin.

• Will that G7 established price cap be less than the market-determined Brent crude oil less than the Brent price?

• How much lower will the controlled price be, and will it float with the Brent price or be fixed?

• Will the U.S. impose price controls on U.S. producers of crude oil and natural gas so that U.S. oil producers don’t profit from the price controls on Russian crude? Would that price apply to U.S.-produced crude oil sold within the U.S.?  Will the U.S. impose export restrictions on oil and gas producers, as Energy Secretary Granholm threatened in a letter dated August 18, 2022? If so, a new can of worms is waiting to be opened.

• As they say, the devil is in the details, so we shall see.

What happens after price controls are imposed?

It is not hard to guess what will happen after the G7 price cap on Russian-origin crude oil is established.  A worldwide scramble for alternative supplies will cause rapid increases in global oil prices. 

How much will they increase?  The sky is the limit, but $150 or $200 per barrel or higher is certainly possible.  Some countries will choose to buy Russian oil at a discount from the price cap and will figure out how to get around the G7 mandates.  We know that China, India, and much of Asia do not care if the crude oil they need comes from Russia.

The inevitable result of the G7 countries thinking they can control the price of Russian crude and its price is stupidity and hubris on display.  Predicting the outcome is easy. 

The G7 attempt to control the cost of Russian crude oil will fail, but crude oil flows will have been altered, and many countries will suffer the consequences. Unfortunately, the supply problems created by this attempt will linger.

What should be happening instead?

Instead of attempting to control Putin’s behavior with price caps, G7 members Germany, France, Italy, and England should focus on emergency measures to start drilling their oil and gas reserves and building the infrastructure to import more oil and natural gas from the U.S. and other producing countries. A prime example of undeveloped oil and gas reserves is the Paris Basin, a shale deposit under Paris where the Schlumberger brothers developed their downhole mapping technology, which is geologically similar to the Bakken shale in North Dakota. But France passed a law in 2011 that bans hydraulic fracturing, so the Paris Basin remains undeveloped.

All European countries need to immediately eliminate the laws and restrictions that have prevented the development of their oil and gas. Europe allowed the anti-fossil fuel movement to prevail, but they must now retake control of their energy situation with sound, long-term energy policies.

Germany began surrendering their energy independence in 1970 when it struck a deal with Russia to buy 10% of its natural gas from Russia, which evolved into Germany depending on Russia for over one-half of its natural gas. Putin strengthened the energy dependence trap for Germany with Nord Stream 1 and 2, and he is now springing that trap.

Putin has been playing 3D chess while Europe has been playing checkers, and we are witnessing the unfortunate but predictable results.