Publications: Notes at the Margin

A US Floor Price for Crude: An Appropriate Retaliation Against Russian Aggression (May 17, 2017)

 

Russia declared economic war on the United States in March 2020 when it initiated its oil market battle with Saudi Arabia, bringing global crude oil prices crashing down from $60 per barrel in February to under $15 in April of that year. The Russian aggression continued in May 2021 when hackers took control of the Colonial Pipeline, disrupting the southeastern United States’ gasoline and diesel supply. And then there is the SolarWinds hack of the US government’s computer system in the spring of 2020.

 

The US retaliation to these acts of economic warfare has been minimal to date. A few individuals have been sanctioned. US banks have also been prohibited from participating in the primary market for Russian bonds after June 14, 2021.[1] To the perpetrators, the tepid reaction suggests a country incapable of responding forcefully.

 

The United States, though, can implement meaningful, harsh measures to counteract the Russian incursions. We believe imposing a crude oil floor price in the US would be an effective and appropriate punishment. The price floor, computed as the difference between a set price level and, say, the daily Dated Brent price, would be converted to a fee imposed on all crude oil and petroleum product imports. (Countries that did not participate in Russia’s effort to destroy the US oil industry would be exempted.) For example, a fee of $5 per barrel would be imposed on imports if the current Dated Brent price were $5 below the floor. (See the appendix for a detailed explanation of the floor price.) President Biden has the authority to impose a floor price under Section 232(6) of the Trade Act of 1962, a provision the Trump presidency used aggressively.[2]

 

Implementing this scheme would alleviate the perceived need of US producers to appease Russia by limiting drilling and exploration. For example, Harold Hamm, CEO of Continental Resources, bowed to the country on May 12 when he demanded that private firms not expand production. Without naming the Russians, Hamm spoke like British prime minister Neville Chamberlain, who negotiated an agreement with Nazi Germany in September 1938. In this case, Hamm was blunt:

 

Harold Hamm, founder of Continental Resources, on Wednesday said private companies must do their part to help keep oil markets from oversupply as public companies focus on returning capital to shareholders over output growth.

 

“There is a lot of good discipline that is happening today,” Hamm told an audience at a North Dakota oil conference. “We expect private companies to do their part.”[3]

 

Chamberlain hoped that war could be avoided by mollifying Hitler. One can sympathize with his view, given the state of the British economy in 1938, its depleted military, and the heavy losses suffered during World War I. One can also sympathize with Hamm and other independent producers. Russia was permitted to drive oil prices down, causing immense financial hardship to US firms. Hamm and others have expressed concern that an increase in US output will precipitate another assault.

 

The floor price proposed here would protect US producers from such an attack. Production could be raised without fear of Russian action.

 

A substantial boost in US output would also put significant pressure on Russia, particularly if global consumption does not increase. The pressure would rise if global prices moved lower. The Russian economy would experience severe losses. These deficits would be greater if Middle Eastern producers raised production in reaction to world price decreases. For example, the UAE and Saudi Arabia could partially offset a price decline in this manner. Russia, on the other hand, could do little. Thus, the floor price is the perfect form of economic retaliation against it.

 

Another benefit of a floor price would be its positive environmental effects. Low world prices would likely halt Russia’s effort to develop oil production in the Arctic. Rosneft has indicated it expects to bring in a new partner in its Vostok project by the end of the year. It has already sold ten percent to a trading company for $8.5 billion, implying the development will cost at least $85 billion. The money will not be forthcoming, and Rosneft will never proceed if prices fall sharply.[4] Other major environmentally threatening projects around the world would also be curtailed.

 

In addition, a floor price would accelerate the replacement of fossil fuels in the US by providing a price umbrella for renewable energy. Renewable energy projects are already competitive with fossil projects. As EIG’s Phillipe Roos writes, “Renewable energy doesn’t just hold the crown as the cheapest form of power generation around most of the globe—its cost lead over conventional energy looks likely to strengthen and stay permanent.”[5] In the United States, a floor price would make the economics of replacing conventional internal combustion powered cars with electric vehicles better and better as power generation costs fall.

 

A floor price would lead to greater reliance on short-cycle oil production projects as well, along with reducing the number of large, long-lived oil-producing ventures developed. These changes would permit a quicker transition away from fossil fuels as renewables become available.

 

Finally, the floor price could be used as a financial carrot to achieve a more rapid methane emissions reduction. Most US producers report production costs at less than $50 per barrel. A $70-floor price would then leave significant room for them to capture most of the fugitive methane.

 

In setting the floor price, the Biden administration should use a price of $68 per barrel (the current Dated Brent price) or lower to avoid distorting oil commodity markets. Choosing a higher price could destabilize prices as traders with short positions would have to scramble to cover their holdings.

 

In this report, we document the reasons supporting a price floor reprisal against the Russians, highlight its impact on US producers, and suggest some of the key international effects. The floor price idea was initially advanced in the 1980s. In the appendix, we offer more details on it and discuss why it could be easily implemented in 2021, thanks to the development of large liquid markets for oil.

 

 

To receive the full report along with futures issues of Notes at the Margin, please Contact Us or send us an Information Request for subscription information.