In a series of reports in March, we warned that the demand on March 23 by Russia’s President Vladimir Putin that going forward “unfriendly nations” pay for Russian natural gas imports in rubles or face a cut off in supplies was not simple bluster or a currency sideshow that could be quietly swept under the rug, as was almost universally quickly concluded by reporters, analysts, markets, and even by many European leaders.
After all, the argument went, Moscow has been converting 90% of its gas revenues into rubles already, so what would really change, both sides for now need each other, and so why pick that fight?
We warned, however, that Putin’s decree that buyers set up a ruble account was a de facto demand that the European Union break its own sanctions, that it would result in a stand-off between Russia and the EU over imports of natural gas, and that with the war in Ukraine continuing to escalate, and with the EU seriously eyeing sanctions on Russia’s oil, it would in fact likely result in the cutting of natural gas supplies by Russia as payments started to come due in May.
And here we are, heading into May, with the European Commission giving guidance that Putin’s ruble mechanism constitutes a violation of its sanctions, with Russia cutting off gas supplies to Poland and Bulgaria for their refusal to comply, and with Berlin acknowledging movement on the oil sanctions front – all in one week.
As the European Union searches for an effective response, here is the latest state of play on the natural gas stand-off, as well as on European proposals to sanction Russian oil.
Struggling to Avert More Gas Cut-offs
EU officials say there is still considerable confusion among EU governments as to how to treat the system proposed by the Putin decree at the end of March.
Governments like Poland and Bulgaria have refused to set up the ruble account with Gazprombank that was demanded by Putin as payments have come due, and as a result Russia stopped deliveries of gas to both countries as of Wednesday.
This cut-off, in isolation, is not a disaster for either country, as they have natural gas in storage and will receive alternative gas deliveries from EU countries as part of the EU solidarity mechanism — Poland from Germany (the same Russian gas as before, only now sold via Germany) and Bulgaria via a pipeline from Greece.
So, there will be no immediate shortages anywhere, but could it happen to others?
The European Commission has now formally issued guidance to EU governments explaining why setting up a second, ruble account as demanded by Russia is in fact tantamount to breaking EU sanctions.
The logic, exactly as we noted when Putin released his March decree, is that while until now paying euros or dollars into an account at Gazprombank completed the transaction of buying Russian gas, after the Putin decree the purchase is only legally finalized once the euros or dollars are converted into rubles and deposited in the ruble account.
The conversion of euros or dollars into rubles is effectuated by the Central Bank of Russia, and that is the point at which the sanctions regime is broken — EU entities cannot do any business with the sanctioned Russian central bank and because the conversion is done by Gazprombank on behalf of the EU entities, they are, indirectly, doing business with the Russian central bank.
What’s more, there is no time limit set for when the conversion must take place, so the Commission argues the new mechanism can even amount to EU entities giving the Russia central bank short-term loans — again, prohibited under the sanction regime. The CBR has tried to allay these specific concerns by announcing a two-day time limit on FX conversions today, but that does not address the larger sanctions issue at hand.
EU leaders, and markets, had hoped that after some chest-thumping on the ruble, Putin would acquiesce to a work around on what in effect sounds very much like a technicality, as in the end Russia would get its money for the gas it sells, and EU governments get their gas. That was the whole idea behind the EU not sanctioning Gazprombank in the first place — to give those in the EU who cannot quickly stop buying Russian gas a way out.
But missing in that calculus was an understanding that breaking the sanctions resolve was, in fact, Putin’s objective, rather than theatrics that when it came to money could be quietly negotiated away.
Not surprisingly, the Commission’s legal guidance is now being contested by many lawyers and major gas importing firms, such as Germany’s Uniper and Austria’s OMV, who have said that in their legal opinion there is nothing wrong at all in setting up a ruble account.
Ambassadors of EU governments also asked the Commission on Wednesday to “clarify” matters, which boils down to asking the EU executive to find a way out for those who still need to buy the gas, including Germany, Austria, and Hungary.
The Commission has offered an awkward “solution,” suggesting that companies importing Russian gas should include a declaration with the payment in euros or dollars that the transfer of euros or dollars has finalized the transaction on their part. In in other words, they do not care what happens afterwards with the conversion into rubles, and that all that happens after the euro transfer is purely internal Russian business.
The Commission hopes that such a declaration on the part of the EU buyer would move the completion of the purchase back to the moment of payment in euros, rather than the moment Gazprombank finishes the conversion into rubles, but the Russians would have to agree to that. “It would be advisable to seek confirmation from the Russian side that this procedure is possible under the rules of the Decree,” the Commission said.
That definition of the point of contract completion is, however, the critical leverage point that we noted had been set by Putin in Paragraph 6 of his decree in March, and that with it required the opening by EU entities of ruble accounts.
We doubt Moscow will just walk that back.
One way or another, some legal ruse will still have to be created by the EU because Germany, Austria, and Hungary, and probably a few others, are not yet fully ready to disconnect from Russian gas.
Not yet, without a great deal of pain.
Oil Sanctions – Working Through Unworkable Proposals
EU sanctions on Russian oil, however, are drawing closer, with Germany declaring on Tuesday that it may be able to wean itself off Russian oil “within days,” rather than by the end of the year as declared before.
This could pave the way for some form of sanctions on buying Russian oil by the whole of the EU soon, perhaps as early as next week, maybe the week after that, depending on how quickly other countries heavily dependent on Russian oil like Lithuania, Finland, Slovakia, Poland, Hungary, Germany, Belgium, and France find alternatives.
Interestingly while the EU, and most notably Germany, as we expected has been moving closer towards sanctioning Russian oil, some of the hesitation it appears now is emanating from the White House, sensitive to its continued inability to drive oil prices lower before the US mid-term elections in November.
Nevertheless, political pressure keeps mounting to turn the economic heat up even higher on Russia, and a special summit of EU leaders to discuss Russia, Ukraine, sanctions, arms deliveries, migration, and food shortages caused by the war has been set for May 30-31.
Some EU officials have indicated to us that oil sanctions could be the big “deliverable” of that meeting, even though that is a month away. The timing is in fact hard to pinpoint, especially with EU officials aware that new, tragic developments in the Ukraine war could force their hands into a major measure more quickly than they might be prepared.
The various ideas for oil sanctions under discussion all have a common theme, which is that whatever is introduced would be introduced gradually, over time or after an adjustment period, to avoid any cliff-edges, as was the case with the ban on Russian coal imports which will only take effect from mid-August.
More problematic is that the ideas floating around are still somewhat tortured.
These include putting a tax on Russian oil or an import tariff, which seem rather half-baked, as they would mean, under both options, a further increase in the price of petrol, an even higher inflation rate in the EU, and the cost being borne directly by EU consumers rather than by Russia.
There is also a proposal by Italy, which some sources in the Commission dismiss as flat-out crazy, for the EU to form a buyers’ cartel that would set a ceiling for the price of oil they would be willing to pay, in the hopes that as the biggest buyer of Russian oil, the EU could exert some “pricing power.”
It seems strange to think Russia would yield to such arm-twisting when it can sell its oil elsewhere.
Finally, Estonia has presented an idea for setting up an escrow account for EU payments for Russian oil which could only be used by Russia for non-war-related spending, again, a “solution” that would seem hard to imagine Moscow would ever agree to.
But for all these obstacles, the political effort appears well underway in the EU for an oil sanction regime against Russia, most likely well within a month.