The unprecedented and extensive sanctions to limit Russia’s oil export income, including the EU embargo and an oil price cap imposed by the Group of Seven (G7) countries in December 2022, have successfully reduced Russia’s export earnings and budget revenues. However, it has not starved Russia of money. A study by the Peterson Institute for International Economics (PIIE) found that Russian companies have built up a secret slush fund of about $147bn in 2022 and have added maybe another $50bn in the first half of this year that is held in obscure offshore accounts around the world.

This money is not under the direct control of the government, but PIIE says that the government is certainly aware of its exitence and knows roughly which companies have and how much, even if it doesn’t know exactly where the money is. The secret slush fund provides an extremely large pool of cash that the Kremlin can utilise to pay for illicit imports of sanctioned goods and services.

There is no doubt that the twin sanctions on Russia crude and oil products imposed on December 5 2022 and February 5 this year have massively disrupted Russia’s finances.

“In the wake of the sanctions, Russia’s current account surplus fell from $124bn in January-May 2022 to $23bn in the same time frame in 2023,” Elina Ribakova (of PIIE, Benjamin Hilgenstock of Kyiv School of Economics Institute and Guntram Wolff of the German Council on Foreign Relations wrote in the report. “Less clear is the impact of each different measure initiated by the West to punish Russia for its invasion of Ukraine in early 2022. Evidence indicates, however, that the embargo has had more of an effect than the price cap, in part because the cap’s level is too high and enforcement is lacking.”

With the sanctions in place the low price of the Urals blend, which Russia’s Ministry of Finance (MinFin) uses to calculate oil taxes, means Russia’s companies have an incentive to sell their Russian-produced oil to their own refineries in Europe at as low a price as possible to reduce their tax bill. However, once refined, the same companies sell on their now European oil products on the European market at full price. The scam means the margins on refined oil sales have skyrocketed, with the profits from selling to European customers being held in European banks.

The sanctions leakage is due to multiple factors and Russian companies selling crude to their own refineries at low prices is only one of them. According to the calculations of the report’s authors, based on proprietary data, Russia’s export earnings from oil remain substantial, at about $50bn in January-April 2023, but not all of this makes its way to the Kremlin’s coffers at home.

“As the Bank of Russia has not been able to conduct reserve operations in US dollars or euros because of sanctions imposed in early 2022, Russian banks and corporates acquired $147bn in new assets abroad last year – and little is known about their physical locations or currencies of transaction,” the report says. “These funds may not formally belong to the Russian government, but they could be used to increase monetary and fiscal policy space.”

As bne IntelliNews reported in February this year, the oil price cap sanctions have focused on banning any transport of Russian Urals blend oil that costs more than $60 per barrel, but the Ural’s price of oil has become increasingly meaningless, allowing Russian-owned refineries in Europe to build up slush funds of cash held legally in international banks.

“Because of the EU embargo, European buyers of Russian oil have essentially disappeared, and Russia is accepting price discounts [in places like Asia] to maintain export volumes from ports on the Baltic and Black Seas that have traditionally supplied Europe,” says PIIE.

Another effect of the sanctions is Russia is accepting a range of other currencies in oil deal settlements. Between the start of the full-scale invasion and the end of 2022, the share of dollar and euro transactions in Russian goods trade fell from around 80% to slightly less than 50%, PIIE reports, and the shares of ruble- and yuan-denominated transactions rose, according to the Bank of Russia. Such payments fall outside the sanction’s regime.

Oil sanctions hit the budget

There are other schemes for selling oil elsewhere to India, China, Senegal and other Russian partners, that produce cash in various denominations, but all outside the G7 sanctions regime. The result of the sanctions has not been to cut Russia off from these oil revenues, but to create extremely large flows of “dark money” from a business that was relatively transparent and well monitored before sanctions.

For example, the Urals blend price of oil was previously estimated, as most shippers shared their price information with the specialised press; however, now there are so few European deals for Urals and owners are so reluctant to share information, and the Russian companies are deliberately driving prices down for tax purposes as to make the price data unrepresentative of what is actually happening on the market.

The Russian budget reported a very deep deficit of RUB3.3 trillion, or 2.3% of GDP, in 2022 and a big RUB1.7 trillion budget deficit in January that swelled to hit its full-year target after the first ten days of March of RUB2.9 trillion ($93.8bn).

However, this is a reflection not of a fall in oil exports or prices paid so much as a change in the way oil leaves and the money is paid. The old system is broken and MinFin is the loser, but not the companies.

Russian Finance Minister Anton Siluanov said at the start of this year that the large January budget deficit was temporary and that oil revenues would recover as the ministry set about remaking the way oil taxes are calculated. In the meantime, the Urals benchmark has been abandoned and a simple Brent blend benchmark-minus-discount introduced, as well as many other accounting changes. And indeed, Russian budget revenues surged in June as oil exports completed their switch from Europe to Asia and the deficit fell to RUB2.5 trillion, back inside the 2% of GDP target for the full year, in July.

$60 cap too high and ignored entire in Pacific ports

“While the EU embargo has been effective, the success of the price cap appears to have been limited at best,” PIIE says “The price cap was intended as an innovative step to reduce Russia’s revenues while keeping its oil flowing to the global market. It allows G7/EU providers of shipping services, including ship owners and insurance companies, to remain involved in the trade with Russian oil as long as the oil is sold below a certain price. This threshold was set at $60/barrel for crude oil. Many energy experts were sceptical about the price cap regime’s effectiveness when it was announced, citing the potential for circumvention. But the problems appear to be more fundamental.”

Most experts agree that the $60 cap was set too high. For most of this year the price of Urals has been below $60 making the cap irrelevant. As a result EU-owned ships, especially Greek ships, have been widely employed to carry Russian oil perfectly legally.

When the cap was first being discussed, Russia’s ardent foes like Poland were arguing for a $35 per barrel cap but thanks to lobbying by Greece and others a higher $60 cap was adopted.

It has only been in August, when the price of Urals rose above the $60 mark to $70-$80, but as the volumes of Ural blend sold to Europe have fallen from circa 30% of the EU imports pre-sanctions to 2% now, the sanctions still make little difference to Russia’s oil trade.

As for exports from Russia’s Pacific Ocean ports, which never supplied Europe and where, therefore, the EU embargo could not have an impact, prices stayed above the $60 per barrel threshold without having an affect on shipping and where even EU-owned ships widely ignored the sanctions.

“But G7/EU companies remain involved to a significant degree [in Pacific deliveries], indicating that the cap is not enforced properly,” PIIE said. “Because of these defects, financial sector sanctions should be adopted to strengthen oil price cap implementation and curb Russia’s ability to accumulate assets abroad.”

PIIE reports there is now clear evidence of widespread sanctions violations at Russia’s Pacific Ocean port of Kozmino.

“Data on shipments show that half of the oil was exported on vessels that were either owned or insured by entities in G7/EU countries in the first four months of 2023,” PIIE reports. “At the same time, 96% of exports for which price information is available were priced above the cap’s $60/barrel threshold, with an average price of more than $70/barrel. This means that at least 24mn barrels with prices above $60/barrel appear to have been transported on vessels that fall under the cap’s regulations. These violations are likely the result of straightforward falsification of the records oil buyers are required to provide to G7/EU shipping and insurance companies with regard to price cap compliance.”

PIIE recommends that the West crackdown on violations and use Office of Foreign Assets Control (OFAC) and the UK Office of Financial Sanctions Implementation [OFSI], as well as EU member states’ institutions to police the business.

“Regulators should also mandate that G7/EU insurance and shipping companies retain full documentation of trades, contracts and transaction prices. Sanctions should be enforced on a “strict liability” basis, meaning commercial participants would be liable for sanctions violations, and additional financial institutions in Russia and third countries should be subject to sanctions,” PIIE recommends.