Can Europe cut off supplies of Russian oil? If it does, how can it replace imports of Russian crude? Can Russia switch and sell its oil to other markets such as in Asia? Is there enough demand in new markets to absorb all the oil Russia now sells to Europe? These are the burning questions of the day as the energy war between Russia and the West escalates.

Following Russia’s announcement that it will stop deliveries of gas to Poland and Bulgaria on April 27, the energy war has moved into an active phase. The EU banned imports of coal from Russia as part of the fifth package of sanctions in April, the first time Russian energy had been targeted. But now Russia has cut off supplies of large amounts to two EU members and the list of countries included in the embargos is likely to get longer as the summer arrives.

It is going to be a difficult process. The EU is committed to reducing its dependence on Russian oil, but it remains dependent. Brussels is currently actively discussing a sixth package of sanctions that will include some bans on oil. But the realities of energy supply requirements mean it can't just stop importing Russian oil tomorrow. Gas sanctions are even more difficult and plans to end those are being put off for the meantime, as Russian gas supplies are extremely difficult to replace.

Around half of Russia’s 4.7mn barrels per day (bpd) of crude exports go to the EU. Europe gets roughly a third of its gross available energy from oil and petroleum products, in sectors from transportation to chemicals production. Europe has paid Russia a total of €14bn for oil imports since the start of the war two months ago and about three times more for gas imports. In total the EU imported €44bn worth of Russian oil, gas and coal in just the first two months of the war, estimates the Centre for Research on Energy and Clean Air (CREA).  

Germany was by far the largest importer of oil, gas and coal from Russia, totalling €9.1bn, followed by Italy (€6.9bn), China (€6.bn), the Netherlands (€5.6bn), Turkey (€4.1bn) and France (€3.8bn), according to CREA.

“In the short term, Russia has no replacement for Europe as the source of demand. The majority of the country’s fossil fuel exports are transported to Europe via pipelines, as well as ports on the Baltic Sea and Black Sea. The LNG terminals or alternative pipeline connections to divert pipeline gas exports elsewhere simply do not exist. The varieties of crude oil and coal exported to Europe struggle to find other buyers, as there are few refineries and power plants designed to use them,” CREA said in a report.   

However, even before the official sanctions kick in, Russia’s exports volumes have already been falling due to the self-sanctioning by traders that are avoiding Russian hydrocarbons if they can, which have become toxic once again. A glut of unsold oil is building up in Russia, while the discount between the benchmark Brent blend and Russia's Urals blend has blown out from the traditional $2 to $30. 

In just the last month up until mid-April, deliveries of oil to the EU fell by 20% and coal by 40%, while deliveries of LNG rose by 20%, according to CREA. EU gas purchases through pipelines increased by 10%. Oil deliveries to non-EU destinations climbed by 20%, and with major changes in destinations. Russian deliveries of coal and LNG outside the EU increased by 30% and 80% respectively.

The EU and Russia are joined at the energy hip. Russia’s detractors have argued that the money the EU sends to Russia each week to pay its energy bills is used by the Kremlin to fund its war machine. However, at the same time Russia is currently pumping its contractual maximums of gas via the Ukrainian pipelines and also paying Kyiv hundreds of millions of dollars a month in transit fees that in turn Kyiv is using to fund its own war machine. Both sides are in effect helping to fund the military effort of the other.

Oil independence on its way

EU countries are voluntarily winding down Russian oil supplies where they can and as fast as they can to escape this uncomfortable bind. Germany has already cut Russian imports of crude oil from 35% of its total imports in February to 12% now, according to German Vice-Chancellor Robert Habeck, who added that Germany is “very, very close” to full independence from Russian crude imports.

“We are united in the EU and between Germany and Poland: we must quickly free ourselves from the grip of Russian imports,” he said. In practice, this “intensified co-operation in the field of oil” will entail new supply countries and new supply contracts, something the relevant companies are frantically working on, Habeck’s economy and climate action ministry said.

Germany has two large refineries at Leuna and Schwedt that are hooked into the Russian Druzhba oil pipeline and entirely dependent on Russian crude supplies. However, Germany has been actively working with Poland on the option of importing crude by ship through the Polish port of Gdansk that would then be transported to the two refineries.

However, EU members are split on cutting off Russian oil because of the economic damage it will do to their countries. An energy embargo would hurt Europe as much as it hurts Russia.

Oil and oil products made up more than a third of Moscow’s export revenues last year. Currently, Europe spends around $450mn per day on Russian crude oil and refined products, approximately $400mn per day on gas, and roughly $25mn on coal, according to think-tank Bruegel as cited by Euractiv.

An emergency meeting of EU energy ministers is planned for May 3, where the oil ban will be discussed. European Union's top diplomat Josep Borrell said the topic will be discussed again at the next EU summit due at the end of May, but that he did not expect any final decision on the matter before then.

Some of the EU countries that have been blocking the ban are reportedly weakening their positions under pressure from their peers. While Poland and the Baltic states have been holding out for a total ban, other countries are suggesting things like smart sanctions designed to limit the Kremlin’s revenues, but not blocking oil imports completely.

Germany and Hungary have been the most vocal opponents of a total ban on Russian oil, as they are both heavily dependent on Russian supplies. While Germany has been actively working to reduce its dependence with some success, now Hungary is also more amenable to reducing Russian oil supplies. According to Eurostat, in 2020 Hungary imported 44.6% of its oil from Russia.

The Hungarian prime minister’s chief of staff, Gergely Gulyas, said last week that the Hungarian government “would like to see what proposals are on the table and whether these proposals include alternatives to substitute raw materials from Russia,” reports Euroactiv. He added that a ban on gas was “pointless,” but that there were “more alternatives” for oil.

Hungary’s MOL oil company is currently set up to refine the sour Russian oil, and to re-engineer it to handle other blends would involve heavy investment and take months of work to complete. Before any of this work is done an alternative source of crude would have to be secured.

“We do not see this today, and without it, it is irresponsible to talk about sanctions in any other area,” Gulyas added.

The challenge of ending oil imports from Russia

From all the sanctions that could be imposed on Russia, those on oil remain one of the most effective, as they would seriously harm the Kremlin’s finances and wreak real damage on Russia’s oil industry by destroying a significant part of its production that would be very difficult to revive should Russia rebuild its infrastructure to send the oil to new markets. That infrastructure would also take about five years to build at a cost of billions of dollars. In the meantime, oil wells, unable to ship their crude, will quickly overflow, as what storage capacity Russia has is already full, and have to be shut down. The technical details of how oil wells work means that once a well is closed it is difficult to restart and much of the oil in the ground can be lost.

“Oil is where the EU has more leverage vis-à-vis Russia: diversification away from oil is less challenging than natural gas, and Russia’s reliance on oil for FX inflows and budget revenues is substantially higher,” said Elina Ribakova and Benjamin Hilgenstock, economists with the Institute of International Finance (IIF), in a recent note. “We expect an oil embargo by the EU to be a multi-step approach rather than an abrupt discontinuation of imports.”

Sanctions can target many parts of the business, other than a flat ban on all imports. Amongst the ideas being thrown around at the moment are monthly limits on volumes, secondary sanctions on tankers that limit Russia ability to send its oil elsewhere by ship, and payment for oil into escrow accounts that limit the Kremlin’s access to the money, amongst other ideas.

A quarter of Russia’s fossil fuel shipments arrived in just six EU ports. The largest ports receiving fossil fuels from Russia are Rotterdam (estimated value of shipments €1,500mn) and Maasvlakte (€1,200mn) in the Netherlands, followed by Trieste (€1,000mn) in Italy, Gdansk in Poland, and Zeebrugge and Antwerp in Belgium. Stopping shipments to these ports alone would eliminate 23% of seaborne demand, CREA said in a report.   

But getting any measure passed by an EU unanimous vote remains a challenge when so many and widely different national interests are at stake. Moreover, Russia may consider some of these ideas, such as the use of escrow accounts, as a breach of contract and use that to justify breaking the contract and ending deliveries unilaterally.

Still, a ban on oil is much easier to implement than sanctions on gas for several reasons, argues IIF.

First is that the supply of oil to Europe is already substantially more diversified than that of gas. Russia accounts for roughly 25% of total imports (vs. 35% for natural gas) and Europe’s own production makes up a larger share of supplies as well. The more widespread use of ships to deliver oil also makes life easier as opposed to the pipelines that dominate the gas business; only 30% of Russian oil deliveries arrive in Europe by pipe.

“The Druzhba pipeline network, fully commencing operations in 1964, transported 720,000 barrels per day [bpd] from oilfields in Russia’s Western regions to refineries in the Czech Republic, Germany, Poland and the Slovak Republic last year. The remaining roughly 70% are so-called “seaborne” oil, exported overwhelmingly from Baltic Sea ports,” said Ribakova and Hilgenstock. “To put these numbers into perspective, daily crude oil production in Russia amounted to 10.5mn bpd, total exports to 4.4mn bpd and exports to EU countries to 2.3mn bpd in 2021. A partial or complete EU embargo of Russian crude oil would undoubtedly have a meaningful effect on prices, possibly driving Brent up to $200 per barrel, but substituting volumes would likely be possible.”

While the rest of the world would suffer from soaring prices and insufficient supplies, blockading the EU market to Russian exports of oil would do far more damage to Russia’s finances.

Hydrocarbon exports have accounted for around 50-60% of total goods exports in the recent past and reached $76.3bn in the fourth quarter of last year – the highest in ten years, according to IIF. For the year as a whole, the value of oil exports stood at $243.8 bn.

“Considering price dynamics in 2022, especially since Russia’s invasion of Ukraine, this is unlikely to have changed in the first quarter of this year; in fact, an all-time record current account surplus of $58.3bn points to a further increase,” say Ribakova and Hilgenstock. “Depending on Russia’s ability to redirect exports to other buyers, an EU embargo could dramatically impact FX inflows.”

Russia’s vulnerability is that while it mostly exports raw materials, it is heavily dependent on the imports of non-commodities, and machinery and technology in particular. The double whammy of cutting the Kremlin off from the hydrocarbon revenues coupled with banning exports to Russia of high precision machines and advanced technology could have a devastating effect on Russia’s economy.

On the fiscal side, Russia relies heavily on revenues from the extraction and export of hydrocarbons. Crude oil, petroleum products and natural gas brought in RUB11 trillion over the past twelve months – or 25% of total revenues over the same period – with mining and quarrying taxes on crude oil accounting for almost two-thirds of the total, says IIF.

“A significant decline in exports and eventually production, as a result of an embargo, could have a meaningful impact on the budget and may make difficult spending cuts necessary,” says Ribakova and Hilgenstock. “One important caveat: a decline in volumes would be partially compensated for by the likely increase in global oil prices. In addition, a weaker ruble could, depending on the size of the depreciation, even lead to an increase in revenues in local currency terms. However, through its impact on FX inflows, an oil embargo would still represent a significant challenge for Russia.”

Go east!

Clearly banning Russian exports of oil to the West will be extremely painful for Russia, but the key question is to what extent the country would be able to redirect crude oil to other potential buyers, including China and India.

Russia dominates Europe’s oil supplies, accounting for 25% of all oil deliveries. Most of Europe wants to diversify away from Russian oil, but adding to the difficulties is that much of this oil is delivered not by ship but the Druzhba pipelines, as bne IntelliNews reported in a deep dive into Russia’s oil business.

Russia is already an important energy partner for China as its second-largest supplier of crude oil and coal and third-largest supplier of natural gas, and Russia is looking to China to take up some of the slack.

“Over the last twelve months, pipeline crude oil deliveries to Europe and China accounted for 16.9% and 18.4% of the total respectively. The other key export modes were Baltic Sea ports (26.0%) and Pacific Ocean ports (23.3%),” says IIF. “While oil tankers can theoretically be rerouted anywhere, Baltic Sea ports would be highly unsuitable for exports to Asia due to the extremely long and expensive journey. This means that crude oil would have to be redistributed within Russia via pipelines, either to China or to ports allowing for reasonably quick shipments to China and/or India. Exports via pipeline have risen considerably in recent years; however, the capacities of the Atasu-Alashankou pipeline through Kazakhstan and the Eastern Siberia-Pacific Ocean (ESPO) pipeline are limited,” says IIF.

The main problem Russia faces is that the bulk of its oil and gas export infrastructure is pointed westwards and it has very limited infrastructure that connects it to the east.

It is also bottled up geographically, despite having a territory that spans half the globe. If Russia is excluded from the western markets, then it has little access to the sea in the west. As it has only two warm-water ports of its own in the west it is very reliant on the Baltic ports, but these are easily put off limits to Russian crude by secondary sanctions on tankers and marine insurance. Its own ports in the Black Sea are also constrained by the Bosphorus straits. Even if Russia’s tankers get out into the Mediterranean, secondary sanctions could easily block them from using the Suez Canal, meaning they would have to steam right their way around Africa to reach Asia.

To the south Russia could send oil via the Central Asia pipelines, but most of these pipelines flow in the opposite direction, but the main problem is exports out of Central Asia and on to the lucrative markets of SE Asia are currently corked by Afghanistan and the Taliban, which has not yet agreed to build significant pipeline infrastructure over its territory.

But Russia is already pushing to develop the southern channel and promised to build a new $2.5bn natural gas pipeline in Pakistan, accompanied with the traditional parallel arms deal.

To the east the bulk of the border is with China, where there are only two significant pipelines from Russian oil and gas fields into the Middle Kingdom, both with small capacity. Moreover, the north-western territories are amongst its most underdeveloped, as the bulk of the population live on the southern coast and China has little in the way of a domestic pipeline network.

The main oil pipeline leading from Russia to China is the ESPO pipeline but it is already running nearly at full capacity: recent data indicate that 30% of its 100mn tonne capacity is used for crude oil deliveries to China and an additional 35% for flows to Russia’s most important Pacific Ocean terminal for “seaborne” oil in Kuzmino, reports IIF. The Atasu-Alashankou pipeline provides a capacity of 20mn tonnes per year (tpy), of which roughly 50% are used for shipments to China.

“This means that a little less than half of all Russian crude oil exports to China are conducted through pipelines and that the existing infrastructure would allow for an additional 45mn tpy – roughly one-third of Russia’s exports to the EU,” IIF says.

Even if there were more spare pipeline capacity to Asia, it is not clear that China would be willing to buy the extra Russian oil; Beijing has made it clear it is following a policy of diversified energy imports. If China were to take up all the slack created by an EU ban on Russian oil imports, that would take Russia’s share in China’s oil intake up over 45% – something Beijing is unlikely to be comfortable with.

“China’s stated objective is to limit the reliance on individual crude oil suppliers to around 15% of total imports. In 2020, Saudi Arabia and Russia reached this threshold,” says Ribakova and Hilgenstock.

India relied on Russia for only 1.3% of its oil imports last year and is a more promising option for Russia. Indeed, India has already signed off on a supply deal since the war started for oil and metal supplies, but all at deeply discounted prices.

Still, a rapid increase in oil imports from Russia could be technically challenging, as there is little transport infrastructure linking the two markets.

“Exports would have to be conducted exclusively via ships and create infrastructure-related challenges similar to those mentioned above,” says Ribakova and Hilgenstock. “In addition to infrastructure constraints, the threat of sanctions could significantly limit Russia’s ability to redirect oil exports, and thus complement an EU embargo.”

The US has used secondary sanctions very effectively in the case of Iran and is wheeling out the same now to try to plug the leaks in the West’s sanctions regime against Russia.

Not so the European Commission, which considers the extraterritorial application of sanctions illegal and may prefer directly sanctioning the shipping industry.

Overall, the EU stands a better chance of preventing the redirection of “seaborne” vs. pipeline exports due to the involvement of third parties. With the war in Ukraine unlikely to end anytime soon, measures related to energy imports from Russia will remain at the top of the agenda.