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FOCUS: Russia-Ukraine War

Backfired! How Russia's Playing Games With Gas Prices Became A Big Problem For Its War

A complex compensation mechanism for fuel companies, currency devaluation, increased demand due to the war, logistics disruptions, and stuttering production growth have combined to trigger price rises and deepening shortages at home in the Russian energy market. That is a real risk for the war in Ukraine.

photo at night of workers at a gas plant

Workers in the Murmansk region of Russia overlook Novatek's gravity-based structure platform for production of liquefied natural gas

Vladimir Smirnov/TASS/ZUMA
Ekaterina Mereminskaya

Updated Sep. 20, 2023 at 3:20 p.m.

In Russia, reports of gasoline and diesel shortages have been making headlines in the country for several months, raising concerns about energy supply. The situation escalated in September when a major diesel shortage hit annexed Crimea. Even before that, farmers in the southern regions of Russia had raised concerns regarding fuel shortages for their combines.

“We’ll have to stop the harvest! It will be a total catastrophe!” agriculture minister Dmitry Patrushev had warned at the time. “We should temporarily halt the export of petroleum products now until we have stabilized the situation on the domestic market.”

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As the crisis deepens, experts are highlighting the unintended consequences of government intervention in fuel pricing and distribution.

The Russian government has long sought to control the prices of essential commodities, including gasoline and diesel. These commodities are considered "signalling products", according to Sergei Vakulenko, an oil and gas expert and fellow at the Carnegie Endowment. Entrepreneurs often interpret rising gasoline prices as a signal to adjust their pricing strategies, reasoning that if even gasoline, a staple, is becoming more expensive, they too should raise their prices.

The specter of the 2018 fuel crisis, where gasoline prices in Russia surged at twice the rate of other commodities, haunts the authorities. As a result, they implemented a mechanism to control these prices and ensure a steady supply. Known as the "fuel damper," this mechanism seeks to balance the profitability of selling fuel in both domestic and foreign markets.

A ticking time bomb

If fuel prices are higher abroad than in Russia, the government provides additional compensation to oil companies for supplying the domestic market. Conversely, if foreign prices are lower, oil companies contribute to the government's budget. This mechanism guards against a scenario in which nearly all fuel is exported, creating a domestic shortage.

In their “quest to maintain control”, Vakulenko points out, the government has decided to “tether real fuel prices to strict inflation-based increments, regardless of how logical or reasonable market fluctuations might be”. This endeavor, Vakulenko explains, is akin to the authorities attempting to peg the exchange rate of the dollar at a fixed value, say 70 or 80 rubles, and compensating banks for the difference between this rate and the market rate.

However, this attempt to outsmart the market has planted a ticking time bomb. Oil companies have long been required to bear substantial costs to maintain price stability. In the previous year, when oil prices were particularly high, these compensations amounted to a staggering 2.2 trillion rubles ($23 billion), nearly a fifth of the total windfall generated from the oil and gas industry, which amounted to 11.6 trillion rubles ($120 billion).

While the government's efforts to control fuel prices may yield short-term stability, they come at a considerable cost, potentially jeopardizing the long-term financial health of the oil and gas sector and the broader economy.

Photograph of Vladimir Putin as he visits the Amur Gas Processing Plant

Russia, Amur Region - September 13, 2023: Russia's President Vladimir Putin visits the Amur Gas Processing Plant


Economic pressures and fuel price increases

The war effort demanded a substantial infusion of funds, and at the beginning of 2023, Russia's budget deficit was escalating at an alarming pace. In response, the Ministry of Finance proposed a drastic measure: halving the surcharge on fuel prices.

Minister Anton Siluanov anticipated that this move would save the government around 30 billion rubles (310 million USD) each month, if not more. However, that this fiscal relief would come at the expense of higher fuel prices within Russia was not lost on the government. As the surcharges dwindled and more fuel found its way into export channels, the internal prices would naturally rise. The consequence of this internal price hike would be a narrower gap between domestic and international prices, ultimately resulting in reduced compensation.

The average consumer's primary concern is not the stock exchange but the price at their local gas station.

Indeed, fuel prices began their ascent shortly after Siluanov's announcement, well before the September 1 implementation date for the halved compensation. AI-95 gasoline saw a 74% increase in price on the St. Petersburg stock exchange since the start of 2022, AI-92 rose by 76%, and diesel surged by 58%. Even the Federal Antimonopoly Service (FAS) stepped in, urging nine oil companies to bolster their gasoline supply to the exchange, believing that increased supply would help drive down prices.

However, the average consumer's primary concern is not the stock exchange but the price at their local gas station. By September, data from Rosstat revealed that gasoline prices had risen by 7.7%, while diesel prices had climbed by 5.5%. Although these increases surpassed the general inflation rate of 3.7% over eight months, they did not initially ring alarm bells among the public.

For the time being, the wholesale price hikes were not immediately translating into retail price increases. Furthermore, as far back as April, Siluanov had sought assurances from the FAS that oil companies would refrain from raising prices. FAS primarily oversees retail operations. However, it was evident that oil companies could not sustain these retail prices indefinitely; some gas stations were already operating at a loss. Gasoline trading had become unprofitable since mid-June, and diesel fuel followed suit in mid-August. At that point, there had been no indications of a turnaround in profitability, as noted by Nikolai Baranov, project manager at the research group Petromarket. Strikingly, despite the challenges faced by gas stations, refineries were reportedly enjoying unprecedented profitability.

How does Russia manipulate gas prices?

Russia exerts a disproportionate influence over energy prices because of the state control of major natural gas reserves and its dominance over exports to Europe. In 2021, before the invasion of Ukraine, Russia provided for 40% of European gas demand. It is exported through Gazprom, Russia’s state-backed company whose market supplies have the power to drastically change the energy economy.

Russia’s influence was already apparent before the invasion of Ukraine, when Vladimir Putin began to reduce the quantity of energy exported whilst simultaneously ridiculing the European Commission for their concern. But the height of the crisis came in the summer of 2022, after Gazprom disrupted deliveries to several European companies. One of these involved the halting of electricity deliveries to Finland, seen as a consequence of their application to NATO. That August, gas prices peaked at €345/MWh.

The market's response and shortages

Endlessly challenging the fundamental laws of the market is unsustainable, and the economy is unforgiving in this regard. While rising prices are a concern, in some areas, the situation has escalated to a point where fuel is becoming scarce. This outcome can be traced back to a sophisticated mechanism designed to artificially cap prices, which, as it turns out, has become too intricate and has faltered.

In theory, when prices on the stock exchange surge, it should be more lucrative for oil companies to increase their fuel supply, thereby applying a brake on further price increases. However, this dynamic has its limits, much like how excessive loads can eventually wear down and damage metals and structures.

The ceiling would soon be breached.

Within this complex compensation scheme, there was a critical stipulation: if the exchange price of gasoline or diesel surpassed the yearly threshold by more than 20%, then all budgetary payments would be nullified, regardless of the price at which the fuel was sold. This provision was intended to rein in price hikes.

Vakulenko explains that "Up to a certain point, it benefits all companies to cooperate in keeping prices within the 20% range." However, prices continued to climb, and companies grew increasingly certain that the "ceiling" would soon be breached. With everyone losing their budgetary payments, the rationale shifted. It became more advantageous to wait for even higher prices rather than sell within the 20% corridor.

Vakulenko emphasizes that “this is rational behavior, and blame cannot be assigned”. What was initially meant to curb price increases ultimately exacerbated their ascent and laid the groundwork for shortages.

This complicated situation was compounded by currency devaluation, which made exports particularly appealing. A stronger dollar meant greater revenue in rubles, thereby incentivizing selling abroad. Maxim Malkov, head of the oil and gas practice at Kept, an audit and advisory firm, points out that this occurred during a period of heightened demand, driven by the agricultural harvest, refinery maintenance challenges, and, notably, the ongoing war. The military's increased need for diesel fuel, especially in the southern regions, further strained domestic supplies.

Moreover, the war and accompanying sanctions disrupted logistics, leading to a surge in road freight transportation, which, in turn, escalated fuel consumption. According to the ATI.SU exchange, demand for road freight transportation in Russia surged by 61% from January to June. Rates for popular Russian routes also climbed by an average of 38% over the year, including a 10% increase over the past three months.

While demand soared, fuel production remained relatively stagnant. Russian oil refineries produced approximately the same amount of gasoline as in August 2021 and 2022, according to the Ministry of Energy. However, it's worth noting that exports decreased in August, hitting a 10-month low of 2.27 million barrels per day, as reported by S&P. Analysts attribute this decline to seasonal refinery maintenance and transportation disruptions stemming from a shortage of wagons and locomotives due to the conflict in Ukraine.

In sum, a complex interplay of factors, including the intricate compensation mechanism, currency devaluation, increased demand due to the war, disruptions in logistics, and a lack of production growth, has led to a challenging situation in the Russian fuel market, with rising prices and shortages becoming increasingly pronounced.

Photograph of an oil pump's silhouette as the sun goes down.

September 14, 2023, Republic Of Tatarstan, Russia: A pump jack operates in an oil field developed by Yamashneft.


The road ahead

Once a nation embarks on a path of restrictive measures in its fuel market, reversing course becomes increasingly challenging. The suggested remedy to alleviate the situation involves curbing exports, but not an outright ban as proposed by Patrushev. Instead, a focus is placed on what is known as "gray exports," where oil products acquired within the domestic market find their way abroad. However, this approach is not without its complications, primarily because compensation has already been disbursed from the budget for these products.

To restrict gray exports, the government intends to compile a list of authorized companies permitted to engage in petroleum product exports. But this tactic of introducing new restrictions to address existing ones raises fresh concerns. It risks placing an added burden on the government, potentially necessitating subsidies for Gazprom and the oil industry, as economist Igor Lipsits points out.

Authorities have, in effect, imposed an additional tax on car owners to fund military operations in Ukraine.

Moreover, this strategy may not effectively curtail rising prices. Olesya Nikiforova, director of Kept's tax and legal consulting department, predicts that “On the stock exchange, prices are likely to continue their ascent, driven by the significant impact on refinery margins once compensation is entirely lost after prices exceed the 20% threshold.”

In essence, it appears that the authorities have, in effect, imposed an additional tax on car owners to fund military operations in Ukraine, Lipsits says. This approach, while aimed at addressing pressing financial needs, may inadvertently aggravate the challenges in the fuel market, potentially leading to further price hikes for consumers.

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