After the twin price cap sanctions were imposed on Russian oil exports on December 5 and February 5, Ukraine’s supporters cheered as the cost of Russia’s key Urals blend collapsed to a low of $37.8 per barrel at a time when Brent was trading over $80.

The trouble is, the price of the Urals oil price is increasingly meaningless. And that is a problem, as the two oil price schemes are tied to the Urals FOB (free on board) price of oil and so give the Kremlin a way to export its oil at much higher prices without breaking the oil price cap ceiling of $60. A recent study showed that Russian oil companies are actually getting over $80 per barrel in cash for a barrel, despite the fact that the FOB Urals price is under $50. 

The evidence that games are being played has been building in the last month. In a sign that something was up with the Urals price, in January the Ministry of Finance (MinFin) abandoned using Urals as the trigger for the budget rule that determines when excess oil revenues are siphoned off into the National Welfare Fund (NWF). Now it uses a calculation of the actual revenues earned from oil exports to set the threshold, ignoring the price of Urals.

Then budget revenues from oil and gas revenus collapsed in December and January, but the oil companies continue to report record profits. 

What appears to be happening is the budget has indeed seen a sharp fall in revenues, but the leading oil comapnies are still making huge profits. The sanctions mean they are no longer interested in reporting large profits but instead report as low a price for selling Urals as possible, which reduces their tax burden. In what is tantamount to a new transfer pricing scheme, the difference between the price the companies report and the cash they actually make accumulates in thier non-transparent offshore trading companies, creating a huge slush fund that in theory the Kremlin has access to. 

Urals price dynamics

The goal of the two sanctions, coupled with an EU embargo on buying Russian oil, was to cut the Kremlin off from its most lucrative source of earnings but at the same time keep Russian oil flowing into the market and to avoid a price spike. The breakeven price for the Russian budget in the budget law assumes a Urals price of $70.2 per barrel.

Last year the average price of oil was on a par with the budget assumption but tumbled by a quarter in December year on year to $50.47 and then again to $46.82 in January.

At its low point, Bloomberg reported, citing Argus Media statistics, that the discount on Russia’s Urals oil compared to Brent had surged to 50% so that on January 6, the oil price in the Baltic port of Primorsk fell as low as $37.8 per barrel, whereas the price of Brent crude oil on the same day was $78.57 per barrel – a difference of $40.8.

And indeed, Russia’s budget revenues collapsed in December after oil and gas revenues crashed by 46% y/y. The federal budget had been in surplus for 11 out of last year’s 12 months, but suddenly plunged by almost RUB4 trillion ($53bn) in one month – more than the planned deficit for the whole year – as the first oil embargo came into effect, leaving the budget with a 2.3% deficit at the end of the year. Likewise, the budget started January in equally poor shape with a RUB1.76bn deficit – its lowest level in a decade and almost as much as the planned deficit for the whole year. Mission accomplished.

But not so fast. While the headline discount for Urals appears to be around $35 against the traditional $2 less than Brent sold for before the war, since the sanctions were threatened the Urals price for oil has become increasingly irrelevant.

More red flags were waved when the Central Bank of Russia (CBR) reported the current account data for 2022.

“The updated current account forecasts are a bit confusing: the average oil price for 2022 was down by -$15/barrel, but the exports of oil was almost unchanged at about RUB0.5 trillion for the year, but should have been down about 10%. One hypothesis for this is the Bank of Russia believes Urals benchmark price is flawed and understates export price,” Alexander Isakov, head of macroeconomic analysis at Bloomberg and former head of research at VTB Capital said in a tweet in January.

Top oil analysts Chris Weafer, the founder and CEO of Macro Advisory, and Christof Ruehl, senior research scholar at the Centre on Global Energy Policy, told bne IntelliNews in a recent podcast on oil that January was “just one data point” and partly caused by both a change in the tax code and new large one-off payments, not just a collapse in Urals prices, adding that the revenues will probably recover in March and April at the latest.

Three markets in one

The first problem is the EU market for Russian crude imports is actually three markets: piped oil to countries like Hungary; Russian oil producers delivering to their own refineries in Europe; and the open market import of Russian oil by European buyers.

“There were three distinct groups of buyers of Russian crude, and only one of those groups’ purchases define the closely watched European Urals price,” Sergey Vakulenko, an oil specialists, said in a note for the Carnegie Centre.

“The first group comprised refineries connected to the Druzhba pipeline that were in long-term contracts with Russian suppliers, with prices linked to the published Urals prices in the Mediterranean and northwest Europe. These refineries did not have any viable alternatives to Russian supplies. The second group was made up of refineries fully or partially owned by the Russian oil giants Rosneft and Lukoil, from Romania to the Netherlands. Their volumes were supplied directly by their Russian owners, usually via European-registered trading arms, such as LITASCO for Lukoil and Energopole for Rosneft. The third group consisted of a few refineries that were still willing to buy Russian crude on the open market. Only their purchased volumes impacted the European Urals price,” added Vakulenko, who has written a series of papers digging into the Urals price issue.

With the volumes of Urals bought on the open market tumbling, the share of income from this deeply discounted oil is dwindling, whereas the piped oil is more consistent and the share of revenues earned from Russian companies sending oil to their own refiners has soared.

To make things worse, the discounts reported in the open market part of the business have become unreliable, as the market has gone into stealth mode as many market participants have stopped sharing their deals data.

“[Oil news] agencies have gone over to conducting surveys: they call up traders and ask them what prices they pay and then quote that. Those numbers ended up in the press and become the perceived price,” but it’s not necessarily representative of what the price is,” Elina Ribakova, deputy chief economist at Institute of International Finance (IIF), told bne IntelliNews in a recent podcast on the economic impact of sanctions on Russia’s economy.

Russian oil companies making record profits

The exports from Russia to refineries owned by Russian companies have soared as the leading Russian companies cash in on distortions caused by the sanctions.

Vakulenko reports that most of the voyages from Russia to Italy in recent months went to the ISAB refinery on Sicily owned by the Russian major Lukoil (which it has recently agreed to sell, but will retain its other refineries).

Tankers going to the Netherlands, meanwhile, moored at the berth in Rotterdam harbour that feeds the Zeeland Refinery, in which Lukoil has a 45% stake. Lukoil also owns the main Bulgarian refinery in Burgas on the Black Sea, as well as a refinery in Constanta, Romania. Italy doubled its purchases of Russian crude from 0.65 to 1.3mn tonnes per month, while Bulgarian volumes went up from 0.3mn tonnes in an average pre-war month to 0.7mn in October 2022.

And here is the rub: while the price for Urals quoted on the Baltic Exchange, the main exchange for Russian oil export deals, tumbled by 50%, the price for the refined product like diesel and naphtha did not change. That introduces a huge spread between the cost of crude and the ultimate refined products. Normally a refinery earns a $10 margin on turning a barrel of crude into a more valuable refined product, but in second half of last year this margin swelled to $40-$50, making refineries insanely profitable.

In an indication that the numbers don’t add up, while MinFin reported that oil and gas receipts were down by almost half in December, the leading Russian oil companies are reporting record profits.

Since the war started the leading Russian companies are no longer obliged to report their results but in November privately owned Russian oil major Lukoil stated that profits had doubled y/y in January to September to RUB648bn ($8.6bn) after sales were up by 52% to RUB2.3 trillion ($39.6bn). The same month the board announced that it would pay a full 100% of cash flow as the 2021 dividend and launched a second $3bn share buyback programme. Unlike most big Russian companies, Lukoil’s importance to the EU economy means it has so far largely escaped the Western sanctions.

State-owned oil major Rosneft was also reporting high profits, although its bottom line was hurt after Germany appropriated some of its assets. Rosneft said its nine-month net income was RUB591bn ($9.4bn), down 15% from a record-high RUB696bn reported for the same period in 2021. That follows on from a spike of record profit in the first half of 2022 of RUB432bn ($7.2bn) despite the sanctions. Rosneft said it had successfully reorientated its exports to Asia. The fall in profits in the third quarter was largely due to the loss of its German assets and is nowhere as large as the 46% fall in oil and gas revenues seen by MinFin.

The story is the same at Gazprom Neft, the oil production arm of the state-owned gas behemoth Gazprom, which reported a four-fold increase in profits in 2022 last week to an all-time record RUB503.4bn ($6.7bn). Like Lukoil, sales were up by half y/y to RUB3.1 trillion, making it Russia’s fastest growing oil producer in terms of production.

Business is booming at all these leading oil producers. The price of Urals oil may have plunged in December, but the number of shipborne oil cargos leaving Russia has continued to unchanged suggesting that demand has not been affected. The strong profits of the companies does not tally with the collapse in revenues reported by MinFin unless the price of Urals is no longer a good indication of the profits that oil companies are making.

This might change in 2023, as Lukoil in particular is in talks to sell more its refineries in Bulgaria, Romania and Moldova, while the governments of these countries are switching away from Russia crude supplies, but in the meantime the leading Russian companies remains extremely profitable.

One of the side-effects of this was not just it provides a way for Russia to dodge sanctions, as sanctions key to the FOB price of Urals leaving Russia, but it also means the profits accumulate to the oil companies’ offshore trading arms inside the EU, not the government, which charges tax on the FOB Urals price at Primorsk.

Kremlin second tax manoeuvre

Russia earned a massive $227bn current account surplus in 2022 on paper – more than double the surplus of $120bn in 2021, itself an all-time record. However, it turns out that the Kremlin probably has little access to a lot of that money, as the cash is accumulated not in the Kremlin’s coffers as oil tax revenues, but in the oil companies' offshore accounts. 

The government has already reacted by performing a second “tax manoeuvre”, more adjustments to the tax code to better tax Russia’s oil companies, says Macro Advisory’s Weafer and this work is likely to be ongoing.

In order to have a more realistic price of oil the Russian government is also currently talking about adopting the Dubai crude price as a better benchmark, or simply using Brent minus a discount as the benchmark.

The Kremlin maybe unable to tap the excess profits that oil companies are making – MinFin is currently in negotiations with the Russian Union of Industrialists and Entrepreneurs (RSPP), the big business lobbying association, asking them to make a “voluntary” payment of RUB200bn ($2.6bn) – but the companies can largely offset the loses they have from selling cheap Urals crude on the open market with the outsized profits they make from selling oil products in the EU market to European customers.

The de facto transfer pricing refined oil business also creates large slush funds of privately owned cash outside Russia that can also be used to buy technology and other sanctioned goods to keep these companies in business. IIF’s Ribakova speculates that the Kremlin has a good idea of where and how much money is in these funds and has some, limited, control over them.