Could the US Midterms Determine the Fate of Ukraine?

Summary

• The EU plans to ban crude oil imports from Russia and, alongside the G7, cap Russian oil prices on 5 December.
• We think these moves are more likely to lower than increase global oil prices because they will add to oil buyers’ bargaining power.
• A GOP victory in the midterms could see the US cut its support to Ukraine. In turn, this could force a settlement and limited easing of sanctions.

Market Implications

• Bullish risk assets as the market is underpricing the likelihood of de-escalation.

Stepping Up the Sanctions

Since it invaded Ukraine on 24 February, Russia has become the most sanctioned country in the world. These sanctions are broad, restricting access to everything from the global financial system through to technology and dual-use goods and services. But from a global macro perspective, the most important sanctions are the restrictions on exports of energy commodities. This is because energy is the main market where Russia is a dominant player.

The EU plans to ban crude oil imports from Russia and, alongside the G7, cap Russian oil prices on 5 December. G7 and EU countries have yet to agree on the level of the cap. But it is to be set above Russian production costs to incentivise Russia to keep producing.

Brokers, insurers and shippers of Russian oil will implement the cap. They will be legally responsible for ensuring the Russian oil sales they are facilitating are occurring at a price below the cap. Because 90% of brokering, funding and insurance services for oil shipments are located in G7/EU countries, the cap is expected to lower prices, though of course there will be leakages.

The EU, the main destination of Russian energy exports, has struggled to implement a ban so far. This is perhaps understandable given its long-term dependence on Russia. For instance, its ban of imports of oil from Russia includes an exception for crude transported by pipeline. This is to accommodate countries like Hungary, Slovakia and the Czech Republic that are landlocked and depend on oil delivered through the Druzhba pipeline with Russia.

And while the EU used to receive about three quarters of Russian pipeline gas and LNG, it has yet to ban them. This reflects EU dependency on Russian gas plus a veto from Hungary, an EU member whose government is also politically close to Russia. Supply reductions have been Russia’s decision so far.

Cap on Russian Oil Prices Likely to Lower Global Prices

Brent prices are currently about 5% lower than on 24 February, the start of the Ukraine invasion (Chart 1). This could reflect the lack of sanctions so far plus Russia seeking to diversify beyond Europe. Unlike oil, coal and natural gas prices are about 40% and 20% higher, reflecting sanctions and voluntary supply reduction by Russia.

On balance, I see the implementation of the cap on 5 December as more likely than not to lower global oil prices. This is because, by reducing Russia’s options, the cap will increase the bargaining power of buyers of Russian crude, whether or not they are formally participating in the scheme. 

While China and India have refused to participate in sanctions against Russia, they have still bought Russian oil at deeply discounted prices. Furthermore, nonaligned countries such as Indonesia have already announced interest in buying Russian oil at a discounted price. 

The risk to prices could come from the supply side. Because the scheme is rather complex, insurers could refuse to cover Russian oil altogether. However, since the purpose of the cap is to avoid an oil price shock, the restriction on insurance would likely be relaxed in such an instance. A precedent is the relaxation of the EU ban on the shipping of Russian coal to third countries. 

The main risk to prices could come from Russia shutting down its production rather than complying with the cap. However, I do not see Russia as likely to intentionally trigger an oil shock because:

• The G7 and EU intend to set the cap above Russia’s production costs to incentivise it to keep pumping.
• Russia has already shut down gas supplies to the EU, losing an important revenue stream (Chart 2).
• Russia has already agreed with OPEC on a 2mnb/day cut in production, and OPEC is not seeking to engineer an oil price shock (under the deal, Russia is not expected to cut its production).
• Cutting exports could damage Russia’s oil producing capacity if they involved deep production cuts.

Three Sanction Scenarios

I now discuss three sanctions scenarios (status quo, lighter and stronger sanctions) and their likelihood. To clarify, I am not standing in moral judgement of these possible outcomes.  Rather, I am analysing them so readers can better anticipate their market consequences.  The war in Ukraine is a tragedy and Russia’s responsibility.

The Status Quo Lasts (60%)

The war could last for some time as the parties are currently far apart in their expectations.  Russia’s war crimes have radicalised the Ukrainian side, which now wants to regain all territories seized by Russia since 2014. It is also making progress in regaining territories lost since 24 February.

On Russia’s side, defeat, or the loss of Crimea and/or Luhansk and Donetsk, could lead to Putin losing power. It is therefore not an option. He has just mobilized 300,000 reservists and wants to see them in the field. Putin also likely wants to see if a European winter without sufficient energy supplies weakens the resolve and unity of the EU and its allies. 

Should the war continue without further escalation, the current sanction regime could continue, possibly with limited impact on oil prices, the global economy and financial markets. I give this scenario a 60% likelihood over the next 4-5 months as winter will likely halt military operations. 

On the other hand, the longer the war continues, the greater the risk of escalation, especially if Ukraine continues to gain territory. An escalation in turn could lead to stronger sanctions.

Escalation Could See Stronger Sanctions (5%)

Once fully implemented, the current sanction regime will still allow some Russian foreign trade and related access to the global financial system. This contrasts the sanctions on North Korea and Iran that ban all exchanges with these countries.

Tightening Russia’s sanction regime would involve excluding all Russian actors from the global financial system and pursuing third countries transacting with Russia. This could prove more difficult than with North Korea and Iran, which have much fewer allies than Russia. Even China agrees on the need to contain North Korea. And most Middle-East countries, including Saudi Arabia, support sanctions against Iran. 

But escalating sanctions on Russia to a North Korean/Iran level would be difficult and costly for the US. Therefore, Russia would have to escalate their transgression of international norms to include the use of tactical nuclear weapons and/or mass killings of the civilian population.

I think these escalations are unlikely. Putin tends to prefer underhanded operations, for instance, anonymous sabotage. These are more likely to confuse and divide his adversaries.  By contrast, another atrocity against civilians could bolster the EU and G7 unity and push nonaligned countries closer to the West. I consequently give this scenario only a 5% probability: not a tail risk, but not a large risk either.

Such an escalation would be very negative to markets. Risk assets would sell off over the risk of nuclear escalation. Also, eliminating Russian oil from global markets would likely bring a price shock.

However, the coming mid-term elections could change the risk landscape dramatically.

US Elections Could See Easing of Sanctions (35%)

The midterms are three weeks away. The GOP seems poised to take over the House while the Senate is now a tossup as the Democrats have been losing ground since the summer.

In the US, foreign policy is the president’s domain. However, Congress must approve spending, and GOP control of the House would effectively give it a veto over the budget – including support to Ukraine.

House minority leader Kevin McCarthy recently announced that, should the GOP take the House, it would pare down aid to Ukraine. More broadly the consensus on support to Ukraine is eroding within the US foreign policy establishment. This aligns with former President Trump’s ‘America First’ views, espoused by a growing share of Republicans. 11 GOP senators and 57 GOP House members voted against the last Ukraine aid package in May.

Because the US is the main provider of aid to Ukraine, a reduction in US funding would be difficult to offset with aid from other countries. Without enough aid, the Ukrainian government may have no alternative but to negotiate. Getting Russia to the negotiating table would likely involve sanction relief. 

Sanction relief would be positive for markets. However, because the foreign intervention lobby is very strong in the US, I give this scenario only a 45% probability. That is, I see a 90% chance that the GOP will win the House but only about a 40% chance it will enact plans to cut aid to Ukraine.

Market Consequences

The market is underpricing the risk that a victorious GOP could cut aid to Ukraine, which in turn could lead to de-escalation. Once the midterms are over, the GOP program will come into greater focus. That could change perceptions of the risks associated with the war in Ukraine in a positive manner for markets.