Why is Russia Choking Off Gas Supplies and How Should the West Respond?

Why is Russia Chocking Off Natural Gas Supplies?

If an Embargo of Russian Gas is a Good Idea, Why is Russia Cutting Off Supplies?

In earlier posts I have pressed for an embargo on Russian natural gas exports. I still think this makes sense, but I can also see the wisdom of a buyers’ cartel that would cap the price that Europe would pay for Russian gas (also explained here). What gave me pause in these thoughts was Putin’s decision (and I am assuming it was his idea) to reduce Russian gas exports through the Nord Stream pipeline. Why would he voluntarily forego this revenue? Does he really think it hurts the West more than it hurts him? Does he just think that Western leaders, particularly German leaders, are so weak-willed that even a small amount of pain will cause them to collapse like a house of cards? Is he just acting like a spoiled child, threatening to hold his breath until his parents give in?

The Role of Contracts

One clue as to what is behind the choking off of gas supplies is the excuse offered: technical problems with the generators that push the gas through the pipeline. The company responsible for maintaining the compressors says that it is unaware of any problems. Why offer this excuse? Presumably the gas flowing through the Nord Stream pipeline is sold under a long-term contract with a fixed price (or some complicated formula that limits the extent of fluctuation in the price). What this means is that even though natural gas prices in Europe are exceptionally high, Russia is receiving a price for the gas that is substantially lower.

Isn’t Russia Contractually Obligated to Supply the Gas?

There is, probably, an out in the contract, for technical problems or “acts of god” that make it difficult to supply the gas. My guess is that Putin is using this ruse to limit Europe’s ability to stockpile gas for this coming winter.

What Should the West Do?

If there are contracts that govern the sale of gas through Nord Stream and other pipelines, the West ought to seize the opportunity created by Russia’s abrogation of its responsibilities under those contracts. The West should “renegotiate” the terms of purchase under those contracts at a lower fixed price determined by a Western buyers’ cartel. By the way, there is no reason why this arrangement should not survive the end of Russia’s war against Ukraine. It is important to remember that this is at least the second time that Russia has, probably, violated the terms of its contracts. The first was when they insisted on payment in rubles.

Would this Work?

I am assuming a lot of facts in this argument and would welcome others, who know the details of the Nord Stream agreement, to weigh in. However, if I am right, a buyers’ cartel for gas delivered by pipeline from Russia to Western Europe could accomplish two important objectives. One, it would deny Putin an important source of funds for carrying out his unprovoked war against Ukraine. Two, it would mitigate the harm to Western Europe from continuing to impose sanctions on Russia.

What Would Putin Do?

In response, Putin could do any of the following. First, he could realize that, in the long run, his situation is hopeless and withdraw his forces from all of Ukraine and cease all hostile acts against Ukraine. (I know this isn’t likely, but one can only hope that at some point Putin will come to his senses.) Or second, he could double down on the spoiled child model and refuse to sell gas at the cartel price, in which case we have a de facto embargo. Or third, he could accept that, once again, he has overplayed his hand and accept what he is offered for his gas.

Price Cap on Russian Oil and Gas Exports?

Oil Or Gas Transportation
Oil tanker on the high sea

There is a proposal, backed by the U.S., to cap the price of oil and gas purchased from Russia. Janet Yellen, the U.S. Treasury Secretary, is apparently attempting to find international support for this plan. I am skeptical that this proposal will work, but it is not impossible.

The first thing to remember is that even if it does work, the objective is to deny Russia some of the revenues from its energy exports. Even if it worked perfectly, it would not lower world oil and gas prices. Why? Because world oil and gas prices are determined by global supply and demand. Capping the price that Russia can receive for its exports will not affect either supply or demand, unless it causes Russia to export less.

That is not to say that a price cap is a bad idea. There are two ways in which it might work.

The first way recognizes that the West has a degree of market power over Russian exports that must arrive by pipeline. If there is no feasible way for Russia to redirect these exports to other markets, Western countries can exercise that power by collectively refusing to pay more than the cap. If Russia wants any revenue from these exports it must accept the price cap. The oil and gas purchased through this buyer’s cartel can then be resold at market prices. The best way of doing this is for the oil and gas to be auctioned off by the buyer’s cartel with the difference between the price cap and the market price being shared by the participants in the buyer’s cartel.

The second way that the price cap might work, that is often mentioned in the press, is for the West to use its control over finance, shipping and insurance markets to coerce Russia to sell its oil and gas exports at the price cap. The problem with this mechanism is that it would be difficult to prevent purchasers from separately compensating Russia for the sale. If China or India, for example, receive the discounted oil and gas they can have a side deal to pay Russia the difference between the price cap and the market price or some portion of it. It is not at all clear to me how we intend to prevent these side deals. It is also not clear to me why Russia would sell its exports to anyone unwilling to provide the side payment.

My feeling is that the first of these two plans is plausible and worth trying. The second proposal strikes me as very difficult to execute effectively. It would leak faster than a ruptured tanker.

Tariff (or Price Cap) on Russian Oil and Gas Exports as an Alternative to Boycott

A tanker on the high sea

The Economist published an excellent article yesterday about a way to begin gradually cutting off oil and gas revenues to Russia. Since an outright embargo on Russian oil and gas exports appears unlikely, much the same thing could be accomplished by a tariff.

In the limit, a very high tariff would be the same thing as an embargo. A lower tariff allows Europe to wean itself more gradually from Russian oil and gas and provides an economic incentive for markets to seek out other alternatives. It still allows some Russian oil and gas to enter Europe for very high value uses, but it places the social costs of subsidizing Russia’s war against Ukraine on those who want the benefit of using Russian oil and gas. Alternatively, if Russia wants to maintain its current level of oil and gas exports, Russia would have to absorb the cost of the tariff by lowering its prices. Either way Russia gets a smaller revenue stream.

As a side benefit, European countries get a new stream of revenues they can use to offset the impact of high energy costs on their economies. They can use these revenues to lower other taxes or rebate them on a per capita basis to their citizens. As long as they don’t use the revenues to subsidize oil and gas consumption, the European economies will adjust efficiently to reduced supplies of energy from Russia. Ideally countries that impose the tariff could use all or some of the proceeds to arm Ukraine.


The good news about a tariff on Russian energy exports is also the bad news. It is gradual. Because it is gradual, it gives Russia more time to adapt.

A tariff also suffers from some of the same limitations as a boycott. Russia can send oil to India and India can export oil to Germany. Unless the tariff is also placed on energy exports from countries that do not, themselves, impose the tariff on Russian energy exports, Russia can, at some expense, evade the tariff. This is less true of Russian natural gas exports, since these generally flow through pipeline systems that cannot be easily redirected. Therefore, to the extent that it can be done, the tariff should apply to Russian energy exports and energy exports from countries that do not impose the tariff on Russia. One side benefit of this approach is that it can induce countries that are currently neutral to embrace the anti-Russian tariff, to protect themselves from having their own exports be subject to the tariff. This gets complicated, but it is certainly worth considering. Perhaps starting with a tariff on Russian gas exports would be a good beginning.

A Price Cap as an Alternative to a Tariff

A tariff on Russian oil and gas exports is a way for Europe to take advantage of the fact that it has a degree of monopsony power over Russia with respect to Europe’s purchases of oil and natural gas. This power is more significant with respect to oil and gas imports via pipelines, since these products cannot easily be redirected to other markets.

A price cap could accomplish the same thing. However, in the case of a price cap the difference in value between the cap and the market price is captured by the importer rather than the importing government. In cases where the government is the importer this is irrelevant. The value of the price cap approach over a tariff is largely cosmetic because it allows the importing government to claim (falsely) that it is not responsible for higher prices. In general, we favor the tariff over the price cap approach as more transparent, but for governments that find the tariff politically unpalatable a price cap is a workable alternative.

Inflation, Gas Taxes, and Ukraine

A number of states and the federal government are, or are considering, lowering gasoline taxes to offset the impact of inflation on consumers. Assuming that the gas taxes made sense in the first place, and that this is intended to be temporary, this is bad public policy.

What Causes Inflation?

Supply chain problems, surging demand as the global economy recovers from Covid and the impact of the war in Ukraine are all causes of relative price increases. As some commodities become harder to obtain, the price of the affected goods can be expected to rise relative to the price of other goods. These things are not in themselves the root causes of inflation. Absent accommodating monetary policies from central banks, like the Federal Reserve Bank (Fed) in the U.S., these price shocks would be accompanied by declines in the prices of other goods or an overall reduction in economic activity, rather than inflation.

Doesn’t Lowering Gas Taxes Reduce the Pain of Inflation?

Ok, you say, lowering gas taxes may not address the root causes of inflation, but doesn’t it reduce the pain to consumers?

Lower gas taxes can be thought of in two ways.

One, absent an increase in other forms of taxation, it is an economic stimulus payment, the exact opposite of what is needed in a period of escalating inflation.

Two, it is a relative price subsidy. If you subsidize the consumption of a commodity you get greater demand for it. One of the problems in persuading European countries to boycott Russian oil and gas exports is that the global demand and supply of oil and gas are highly inelastic, in the short run. That means that the quantity of oil and gas demanded and supplied does not change very quickly in response to price changes. As a result, even small changes in supply (or demand) result in very large changes in price, in the short run. By lowering gas taxes, the United States is subsidizing the purchase of oil and making the global demand for oil even more inelastic than it would otherwise be. That will mean that the pain of boycotting Russian oil and gas will be even higher in Europe than it would otherwise be.

Impact on OPEC Incentives.

A variable tax on oil imports was considered, in the 1970’s, but was rejected because, by reducing the elasticity of demand, a variable tax actually increases the incentive for OPEC to reduce supplies to drive up oil prices.

So What Should We Do?

What we should be doing, to lower inflation, is what we should have been doing for months. The Fed needs to end its open market purchases of bonds and begin raising interest rates. How far should this go? At least far enough that short and long-term interest rates meaningfully exceed the expected rate of inflation.

Should the West Boycott Oil and Gas Exports from Russia?

I am inclined the think that the answer to this question is a resounding “Yes”!

But the issue is complicated, because oil, and natural gas to a lesser extent, are globally traded commodities. It is absolutely true that Russia depends on the revenues from oil and gas sales. If we could cut off these revenues, it would be tremendously helpful in forcing Putin to alter his course. But can we?

Unfortunately, oil is a, mostly, fungible commodity. If oil is not exported from Russia to western Europe, it can with relative ease be exported to other countries, notably China. Switching the direction of these exports is not costless for Russia. The pipelines for the export of oil are, presumably, full. In the short run, redirecting Russian exports of oil to China, and elsewhere, will require shipping it by sea using tankers, or moving it by rail.

In the grand scheme of things, while capacity constraints on redirecting Russian oil exports are not trivial, they are hardly insurmountable. The bottom line is that boycotting the purchase of Russian oil will probably not hurt Russia all that much. For the same reasons, the very same factors that make a boycott of Russian oil exports ineffective at hurting Russia make the impacts of such a boycott very small for the Western allies. Once the oil hits the international market it limits the effect of the boycott on world oil prices. My own take is that boycotting Russian oil exports is probably worth trying. At worst, it will have relatively little impact on world oil prices, but it will impose some costs on Russia in the effort to circumvent it.

To the extent that it does work by preventing Russia from exporting some oil, it will increase world oil prices somewhat and that will have negative impacts in the U.S., Europe and elsewhere. I will address what we should and shouldn’t do to offset those impacts below.

Natural gas, while traded globally, is harder to redirect in the short run. Russia has a pipeline to China, which is probably full, but they have just entered a deal to construct a new one. The good news is that will take some time to build. (Although nowhere near as much time as it would take in the U.S. or western Europe to construct.) Russia has some capability to liquify natural gas for export by sea, but this, too, is presumably operating at capacity and will take some time to expand. A boycott of natural gas exports from Russia would, therefore, impose real short-term costs on Russia. Precisely because it would be effective it would also dramatically increase the cost of natural gas in Europe and elsewhere. Europe has some capacity to import more Liquified Natural Gas (LNG) but much of that excess capacity is in Spain, which is not linked by pipeline to the rest of Europe. The U.S., unfortunately, is currently operating at capacity in terms of its ability to export LNG. Higher natural gas prices in Europe will redirect available LNG supplies to Europe but there will be pain in Europe as a result of those higher prices. On balance, in my view, the pain for Russia of losing this source of revenue will be worth the pain of higher prices in Europe.

What should the U.S. do to offset the pain of higher oil and gas prices? There are some good policy options. Drawing down oil from the Strategic Petroleum Reserve and encouraging other countries to do likewise is absolutely appropriate. That is what these strategic reserves are for. We should also be using whatever leverage we have with Saudi Arabia to increase its oil exports. This should probably not be that difficult since the Saudi’s have a short term economic incentive to take advantage of these high oil prices and a long-term objective of not driving markets away from oil. We may be able to increase oil and gas production in the U.S. by lightening up on efforts to restrict that production (to achieve climate goals), but I am not sure this is quantitatively significant.

What we should not do is attempt to shield consumers from the impact of higher prices by lowering taxes on oil and gas. To do otherwise would be to effectively subsidize oil and gas consumption, which would be totally counterproductive.

If you agree or disagree, or you would like to add something on this issue, please submit a comment below.