Last month I wrote that "not everyone believes" the EIA's estimate for Russia's April oil production, and in fact, the EIA has revised up Russia's oil production to 10.71 mbpd, 0.2 mbpd higher than its prior estimate for April.

The EIA reports Russian oil production falling in May by 0.1 mbpd to 10.63 mbpd, but that estimate may also prove too conservative. Russia no longer publishes oil production statistics, so firm numbers are hard to come by. Notwithstanding, MarineLink reports that Russia's seaborne oil exports from its western ports hit a 4-year record of 2.4 million barrels per day (mbpd) in May. In the first quarter, Russia's gasoline exports were up 37% over the same period in 2022. Russia’s exports suggest high levels of oil production in that country.

Fig. 1
Source: EIA, Princeton Energy Advisors

In terms of oil prices, the situation has not changed much since our last report. Despite Saudi production cuts, Brent continues to languish, falling back to $75 / barrel at writing. As a result, Russia's Urals oil price also remains below the $60 / barrel cap, although, as before, Russia's eastern ESPO oil price remains above the cap threshold, standing at nearly $66 / barrel at week end.

Fig. 2
Source: Bloomberg, OilPrice.com, PPA

The Urals discount -- the difference between the Urals and Brent oil prices -- widened a bit this week to $21 / barrel on average. Notwithstanding, the Urals discount is now smaller than before the price cap was implemented, leaving the impression that the price cap today is wholly ineffective.

Fig. 3
Source: Bloomberg, OilPrice.com, PPA analysis

The rationale for the Saudi production cut of this past week and its almost immediate failure warrants a brief digression. This requires a technical explanation of the concept of excess inventories, for which I apologize up front.

A typical US refinery will normally hold 25 days of crude oil in inventory for day-to-day operations. For example, if a refinery were processing 1 million barrels per day (mbpd) of crude oil, we would expect it to hold 25 million barrels (mb) of crude in inventory. Inventories above this level are excess, in the sense that refiners and traders would normally be incentivized to run these inventories down to normal operating levels. If our hypothetical refinery had 30 mb of crude inventory but needed only 25 mb, we could say that 5 mb were excess.

We can also model this on a global scale, with the EIA providing both historical and forecast inventory levels. If we run the numbers, we can see that excess crude inventories have grown from 330 million barrels (mb) at the beginning of the war to 630 mb today. That's a big number. Running off current excess inventories could take more than a year, and possibly two.

Excess inventories have been accumulating because global oil demand, particularly from China, was unexpectedly weak in the first half of the year. Further, the EIA and other analysts expected Russian supply to be pulled from the market, and that clearly has not happened. Indeed, it is reasonable to assume that Russia is pumping oil as fast as it can to sate its hunger for cash. This is typical of state-owned producers operating in cartels like OPEC. Private companies like Exxon or Shell produce more oil when prices are high and cut production when prices are low. OPEC does exactly the opposite. When prices are low, cartel members need more cash to balance their national budgets and therefore produce more oil, thereby depressing already weak oil prices. When prices are high, OPEC tends to be slow to add capacity in order to maximize selling prices per barrel. Russia appears to be acting as OPEC does in similar situations, that is, maximizing production to maximize revenue in a weak oil price environment given its wartime needs.

The EIA has revised its global oil demand forecast upward and global supply downward following the recently announced Saudi production cut. Nevertheless, these revisions offer no more than the prospect of a balanced market. That is, without Saudi production cuts, excess inventory would have continued to accumulate, pushing prices down even further. If we accept the EIA's estimates of global balances and its forecasts for global oil supply and demand as plausible -- and I do -- then oil prices should remain reasonably soft, largely in the recent price range, for the balance of the year. In other words, oil prices remain soft because the world has massive excess crude oil inventories.

This is largely good news for Ukraine, as oil prices seem on track to remain muted, thereby depriving Russia of much needed cash.

On the other hand, the structure of both the embargo and price cap remain dreadful. The Urals and ESPO price discounts are clearly being converted into 'store credits' which Russia can and is using to buy influence and actual goods and services. Chechen strongman Ramzan Kadyrov showed footage of "new vehicles purchased for Chechen units participating in the SMO". These are China Tigers, armoured personnel carriers, produced by Shaanxi Baoji Special Vehicles Manufacturing, a north China military contractor. Moscow is no doubt the indirect purchaser. But with what? The Urals discount provides leverage and a source of funds for Moscow to purchase Chinese arms. The price cap and embargo, as currently structured, are a significant factor in drawing China into the conflict. It's not just an alliance of like-minded autocrats. There's also money in it.

Now imagine that Russian oil sanctions were manifest in a legalize-and-tax system allowing the western powers to capture the value of the Urals discount and give it to Kyiv. Properly run, such a program would generate $4.5 bn / month for the war effort.

Consider: On June 6, the Russians blew up the Kakhovka Hydroelectric Power Plant. Ihor Syrota, head of Ukraine's state-owned energy company Ukrhydroenergo, was quoted in the Kyiv Independent as saying that reconstruction will take at least five years and $1 billion. If the Urals discount were captured by the western allies and provided to Ukraine, the Kakhovka dam could be rebuilt with one week's cash flow. And the contract could be offered to China. This would give Beijing a reason to take a positive view of Kyiv and refrain from leaning excessively towards the Russian side.

As currently constructed, the price cap and embargo are creating a coalition of countries with a financial interest in perpetuating the conflict and acceding to Russia's requests. Take that money away, give it to Ukraine, and Russia's international support will quickly fade, as will the appetite of Russia and China to prolong the war.