The impact of Western sanctions on the energy sector

• 1 year, 6 months ago (2023-05-04)
• Junior Isles

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Steven Farmer, Partner, Aaron Hutman, Partner, Iris Karaman, Associate

Pillsbury Winthrop Shaw Pittman LLP

As Russia’s largest industry, the Russian energy sector has been a focus of United Kingdom, European Union, United States and other western sanctions designed to deter the continuation and escalation of the conflict in Ukraine. However, the issue of Russian energy dependency has posed a challenging balancing act for Western governments, as they seek to limit profits from Russia’s energy sector while also ensuring their own energy demands are met.

With sanctions touching on every aspect of Russia’s energy supply chain, these actions have reportedly begun to successfully dent the sector’s revenue, but their long-term effectiveness is uncertain given the increase in Russian oil imports by non-aligned countries and a growing trend of sanctions circumvention.

Russian energy import bans

Following the invasion of Ukraine in early 2022, the UK, EU and US took steps to restrict the import of Russian energy products, but the implementation varied due to differing needs and dependencies.

The US was the first to ban the import of Russian crude oil, petroleum and certain petroleum products, liquefied natural gas (LNG) and coal on 8 March 2022. The EU shortly followed suit with a ban on the import of Russian coal and Russian crude oil and petroleum products. Notably, the EU oil import ban was subject to temporary country-specific derogations for certain EU member states particularly reliant on Russian oil. The UK also introduced prohibitions on the import of Russian coal and crude oil and petroleum products, which entered into force later in the year and a further ban on the import of LNG effective from 1 January 2023.

While the import of Russian gas to Europe and the UK has not yet been broadly sanctioned (with the exception of LNG imports in the UK), there have been some steps to limit supply over time. For example, German Chancellor Olaf Scholz revoked the preconditions necessary to certify Nord Stream 2, a pipeline which runs from Russia through Germany, on February 22, 2022. Soon after, the US sanctioned Nord Stream 2 AG, the company which owns the pipeline, effectively halting the project.

Challenges remain for the EU to introduce more severe gas sanctions given its significant dependency on Russian gas imports, accounting for 45% of total gas imports prior to the invasion. Nevertheless, the dependency on Russian gas has prompted the acceleration of the EU’s green transition. This has been demonstrated by the introduction of a new temporary emergency regulation (2022/0367), which aims to fast-track the approval procedures for renewable energy projects to diversify away from Russian gas.

The Price Cap Coalition

With important export restrictions causing global energy prices to increase materially, in an attempt to limit Russia’s ability to benefit from these extraordinary market conditions and to further reduce Russian energy revenue and limit future cash flow, the UK, EU and US alongside Canada, Japan and Australia (the “Price Cap Coalition”), imposed price caps on Russian-origin crude oil effective 5 December 2022 and petroleum products effective 5 February 2023.

The price caps are implemented as a ban on the transportation of Russian seaborne crude oil and petroleum products to third countries and certain associated services, except where the products are purchased at or below the applicable capped price. Notably, a $60 per barrel price cap on seaborne crude was introduced.

Sanctions on equipment and parts

The UK, EU and US each imposed additional export restrictions on equipment and parts used in energy production, with the aim of curbing Russia’s long-term ability to pursue oil and gas exploration and other energy projects.

Energy investment and financing sanctions

The UK, EU and the US have also each adopted measures targeted earlier in the business process – aiming to thwart foreign investment and access to finance for Russian energy projects.

The latest US measures prohibited all new investment into the energy sector by a US citizen/entity. The EU adopted similar restrictions on acquiring or extending ownership in Russian or third-country entities operating in the Russian energy sector, and granting new loans to, or creating any new joint ventures with, such an entity. The UK imposed an outright prohibition on investments in Russian companies and land, as well as broad restrictions on new loans and credit to Russian companies.

Looking ahead

It is likely that the US, EU and UK will adopt further sanctions on the Russian energy sector (including, potentially, Russian origin gas and nuclear). Looking ahead, their long-term impact will depend to a large degree on the market appetite of non-aligned jurisdictions to engage in trade with Russia as buyers of energy commodities. India, for example, has seen a 16-fold increase in oil imports from Russia since the invasion.  However, Russia has significant legacy investment in capacity to serve western markets, and it is not clear how much supply China, India and other non-aligned countries will be able to purchase, and at what prices (particularly with the price caps appearing to have direct and indirect impact).  The amount of profit available to Russia from its energy exports will be important to watch as the war in Ukraine drags on in 2023.