The Price Cap Era And The Demise Of The Free Energy Market  

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By Irina Slav

  • The G7 plan to put a price cap on Russian crude is at odds with free market principles.
  • If Russia goes through with its plan to stop selling oil to capping countries, this might result in a further cut in its oil production.
  • Price-capping initiatives open the door to more consistent market intervention in the future.

Price caps are all the rage these days on the energy scene. The European Union is capping the price of gas and the G7 group is trying to cap the price of exported Russian oil. Both amount to direct market intervention of the sort normally associated with authoritarian regimes. Could price caps kill the free market? The idea of a free market is one where the price of a product or commodity is determined purely by its fundamentals: supply and demand. The reality is that there is no completely free market today. There are too many large market players—investment banks, for instance, or sovereign wealth funds—that have enough power to swing prices on any given day.

Yet market swings are one thing. Direct intervention is quite another. In times of crisis and panic, however, decisions that need to be made are rarely of the popular variety. The gas price caps in the European Union are perhaps the best example so far.

Some fifteen members of the bloc supported the idea of capping the price of imported natural gas. That sounds like a popular decision. It is, however, decidedly not popular among the suppliers of this gas, including Norway, Qatar, and the United States.

One of the notable opponents of the EU-wide gas price cap was Germany, which is also the biggest gas importer in the bloc.  A price cap “always harbors the risk that the producers will then sell their gas elsewhere,” Chancellor Olaf Scholz said in comments on the cap, effectively summing up the biggest problem with capping prices artificially.

The bigger problem is that this capping constitutes direct government interference in how markets operate, which prevents them from continuing to operate. And this risks a real breakdown.

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If we look at price caps as a sort of subsidy—which is the way Germany is implementing its own price caps, with lower gas and electricity prices for a certain level of consumption—the picture, and the risk, may become clearer.

Subsidizing a product or a service normally leads to greater demand for this product or service. But if supply is limited—and gas supply for Europe from producers other than Russia is indeed limited—market prices would go up.

This means the governments subsidizing the product or service would need to pay more to subsidize it. And this, in turn, would lead to higher taxes because the money has to come from somewhere. In the end, the consumers end up paying more anyway, just in a more roundabout way.

This is a highly fragile system, as evidenced by the breakdown of the economies of the former Soviet block after the fall of their totalitarian governments and the return to free markets where prices were determined by demand and supply after years of heavy subsidizing. It was not a pretty picture.

Meanwhile, as EU leaders mull their caps over, the G7 has announced it will be ready with its price cap on Russian oil within weeks. Apparently, the idea of having a floating price has been dropped in favour of a fixed price, to be enforced by insurers and financial service providers residing in members of the group. Yet many questions remain unanswered.

These were most recently summed up in this Reuters story, which said that what the G7 is betting on is mainly the fact that 95 percent of the world’s shipping fleet gets its insurance from the International Group of Protection & Indemnity Clubs, which is based in the UK. If these insurers refuse to cover Russian cargos, then these cargos are going nowhere.

Of course, commentators have noted that buyers could also insure the cargos, meaning China and India could continue receiving Russian oil in substantial volumes as long as they can secure vessels, which might also be a challenge.

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Yet the very fact that the world’s seven wealthiest countries have come together to cap the price of the world’s most traded commodity is a big deal: in a way, it is a market intervention larger in scale than the EU gas price cap idea. And this makes it potentially more dangerous.

If Russia goes through with its plan to stop selling oil to capping countries, this might result in a further cut in its oil production. This, in turn, would shrink the already tight global supply, pushing oil prices higher and contributing to inflation that the whole world is struggling with.

The biggest risk, however, is that these price-capping initiatives open the door to more consistent market intervention in the future. If it can happen once, it could happen again, and each consecutive time it would be easier and probably feel more natural. And if this sort of intervention becomes chronic, so to speak, it would mark the end of even the illusion of a free market and the beginning of a new era.

By Irina Slav for Oilprice.com

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