G7's Price Cap on Russian Oil Fails to Raise Prices as Predicted

The G7's price cap on Russian oil defied textbook predictions by not leading to higher prices, but rather pushing them down. Researchers Lukasz Rachel and Catherine Wolfram explored this phenomenon in a paper published in the American Economic Review.

In response to Russia's invasion of Ukraine in 2022, the G7 imposed a $60 per barrel price cap on Russian oil carried by Western companies' tankers. Many analysts expected the policy to backfire, with some predicting oil prices could reach $380 if Russia retaliated by cutting production.

Rachel and Wolfram's research found that tightly enforced caps can actually raise oil output and lower world prices when market power, uncertainty, and financial constraints are accounted for. They built a model around three key factors: market power, dynamics and risks in the global oil market, and financial frictions.

The researchers showed that Russia's market power and ability to influence global prices limited its likelihood of cutting production in response to the price cap. Instead, the cap deprived Russia of its ability to raise prices above the competitive level, incentivizing higher production. Additionally, the value of oil reserves decreased due to the price cap, leading to a faster extraction rate.