Summary: Engineering a Crisis in a Bid for Leverage

This report examines Moscow’s motives for trying to prevent U.S. authorities from seizing the oil tanker Bella 1 at the start of the Venezuelan oil blockade. To date, explanations have centered on two theories: that the Bella 1 was covertly transporting Russian arms, or that Moscow was simply safeguarding its shadow fleet.

As this report shows, neither theory stands up to scrutiny. Instead, the evidence indicates that the Bella 1 was part of a broader, more ambitious Russian reflagging operation involving nearly a dozen tankers then off the Venezuelan coast. Its aim: to muster a “spoiler” fleet of Russian-flagged tankers immune to U.S. seizure and capable of thwarting Washington’s effort to blockade Venezuelan oil. How Moscow hoped to use that capability remains unclear: to support an embattled ally? Or, perhaps, as a bargaining chip in negotiations with Washington over Ukraine.

In the end, Moscow’s gambit failed—in part because of poor judgement and flawed execution, but also bad luck. Instead of providing Moscow more leverage, it further eroded the credibility of Russian red lines.

This episode fits into a broader pattern of ill‑considered Kremlin operations designed to manufacture leverage over Western adversaries by engineering artificial crises. We should expect more stage‑managed crises, as Moscow increasingly views bargaining with Kyiv’s allies as its best hope for securing an advantageous way out of its Ukrainian quagmire.

Foiling Russian gambits—lessons from the Bella 1 affair

The failure of the Kremlin’s operation offers policymakers useful insights into how to blunt the impact of Russian provocations:

1. recognize these operations for what they are—improvised, speculative gambles by an overstretched regime seeking to gain leverage at minimal cost;

2. avoid buying into a manufactured “crisis” narrative. Moscow is counting on public alarm to push policymakers toward concessions they don’t need to make;

3. be skeptical about the credibility of Moscow’s red lines. With resources strained, Moscow is increasingly resorting to hollow threats; and

4. seek solutions that avoid rewarding Moscow for engineering crises merely to resolve them.

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About the author

The author is an historian, energy analyst, and retired international investment banker. He spent more than 20 years with Morgan Stanley and Bank of America Merrill Lynch, where he was a Vice Chairman. During his career in finance, he gained extensive experience negotiating with Russian corporate executives and government officials. He is affiliated with Harvard’s Davis Center for Russian and Eurasian Studies and currently writes on Russian energy, finance and political history. Since 2022, has also been conducting a longitudinal study of Russia’s shadow fleet.

Table of contents

Introduction: Why did Moscow Reflag the Bella 1?

Part 1: Clouds on the Horizon — The Skipper’s Arrest Bodes Ill for the Bella 1

Part 2: A Spoiler-State Move—Moscow’s Special Operation to Reflag the Bella 1

Part 3. Moscow’s Motives for Saving the Bella 1—Prevailing Theories Debunked

Part 4: Mystery Unraveled—The Bella 1’s Reflagging was Part of a Broader Scheme

Part 5: Moscow’s Ultimate Aim—Solidarity with Caracas or Bargaining Power over Ukraine?

Part 6: Could a Russian-flagged Fleet Have Defied the U.S. Blockade? Kremlin Blunders Weakened its Chances.

Conclusion: Russian Gambits and How to Foil Them—Lessons from the Bella 1 Affair.

Appendix: Moscow’s Venezuelan “Spoiler” Fleet

Introduction: Why did Moscow Reflag the Bella 1?

For Russia it’s a very important thing, because if there will be [an] attack [on the Bella 1] from [the] US it will be considered as [an] attack on Russia and it could lead to [a] very critical or maybe even [a] crisis situation between Russia and [the] US. The problem today is much more than this, because already 5 tankers near, which are standing near [sic] Venezuela raised the Russian flag and declared that they are Russian. So, it might make the whole picture more complicated…

Andrei Fedorov, member of Vladimir Putin’s advisory team and a former Deputy Foreign Minister, in a January 2026 BBC radio interview.

The Bella 1 raises the Russian flag.

In the closing days of December, as the U.S. Coast Guard cutter Munro shadowed the fugitive Bella 1 deep into the Atlantic, the crew of the 23‑year‑old tanker broke out paint from the ship’s stores and sloppily emblazoned the Russian tricolor across its hull. For the officers aboard the U.S. vessel, the intended meaning would have been unmistakable: Russia has asserted it exclusive sovereign jurisdiction over the Bella 1. Any party with a grievance must now seek redress through Moscow.

Put more simply: the Bella 1 was now under Russian flag protection; stand down.

Moscow’s attempt to rescue the Bella 1 by hastily reflagging it to Russia bore the hallmarks of a Kremlin-run special operation

On learning of this dramatic turn of events, two questions immediately came to mind. Had Moscow, indeed, extended its flag protection to the fugitive Bella 1? If yes, why?

The events that followed soon left no doubt about the first question: not only had Moscow extended its flag protection to the Bella 1, but it was also taking a range of additional measures to deter the U.S. from seizing the vessel. These included:

• hastily generating “Russian” bona fides for the vessel—the purchase of the vessel by a Russian company, acceptance into Russia’s flag registry, issuance of a Russian vessel survey certification, etc.—all aimed at bolstering Moscow’s claim of a legitimate interest in the Bella 1;

• lodging formal diplomatic protests with Washington asserting Russia’s exclusive jurisdiction over the vessel;

• putting senior officials in front of Western media to draw red lines and warn of an impending “crisis situation;” and

• deploying a Russian naval escort to back up its red-line threats.

To anyone familiar with the workings of the Russian state, the rapid deployment of such a substantial range of state resources bore the hallmarks of a Kremlin‑run spetsoperatsiia (special operation)—one requiring authorization at the highest levels.

Current theories about Moscow’s motives center on arms smuggling or protecting Russia’s shadow fleet. Neither, however, stands up to scrutiny.

These extraordinary efforts make the second question all the more compelling: why was Moscow doing this? Why all this effort to protect a vintage, OFAC‑sanctioned tanker, with little intrinsic value, no oil in its tanks, and no apparent prior ties to Russia?

Explanations of Moscow’s motives have centered on two theories: that the Bella 1 was covertly transporting Russian arms, or that Moscow was simply safeguarding its shadow fleet. On closer inspection, however, neither explanation holds up to scrutiny.

Instead, the reflagging appears to be part of a broader, more ambitious scheme designed to thwart the Venezuelan oil blockade and, potentially, gain leverage in ongoing negotiations with Washington over Ukraine.

Instead, the evidence points to an altogether different motive. As this report shows, Moscow’s efforts around the Bella 1 were part of a much broader, more ambitious reflagging operation—encompassing at least ten other tankers off the Venezuelan coast. This operation looks designed to muster a fleet capable of challenging Washington’s blockade of Venezuelan oil. If successful, it had the potential to be quickly scaled up.

Initially, Moscow’s operation had a slim chance of success—made slimmer by Kremlin blunders. It unraveled when Caracas agreed to coordinate oil exports with Washington.

The operation had a conceivable pathway to success—at least initially. Analysis suggests that U.S. tanker seizures were following restrictive targeting criteria, and a laden tanker under undisputed, exclusive Russian jurisdiction might not necessarily be seized. The arrest of the Bella 1 should not be read as evidence to the contrary, since the U.S. likely viewed Russia’s claims of exclusive jurisdiction to be impaired by prior U.S. enforcement claims.

But Kremlin blunders hurt the broader operation’s chances of success. While Caracas’s decision to coordinate oil exports with Washington led to the ultimate failure of Moscow’s scheme.

How Moscow might have used a blockade-breaking capacity remains unclear. Perhaps to support an embattled ally. Or perhaps as a valuable bargaining chip in ongoing negotiations over Ukraine.

Report overview

This report maps out the broader contours of Moscow’s special operation to develop a blockade-disruption capability.

Part 1 provides some background on the Bella 1 and how it came to be in harm’s way.

Part 2 details the three phases of the special operation: establishing the Bella 1’s “Russian credentials,” issuing red-line threats and backing those up with military force.

Part 3 debunks the two prevailing theories explaining Moscow’s motive for trying to rescue the Bella 1.

Part 4 shows that Moscow’s special operation to extend flag protection went well beyond the Bella 1, encompassing at least ten other tankers off the Venezuelan coast, and that its aim was to assemble a fleet capable of circumventing the U.S. blockade with impunity.

In Part 5, the report speculates that, had the operation succeeded, Moscow could have employed this blockade‑breaking capability either to support an embattled ally or as a bargaining chip in negotiations with Washington over Ukraine.

Part 6 shows Moscow’s operation had a conceivable pathway to success, although it narrowed by blunders in execution.

The Conclusion warns of further Russian efforts to gain leverage through manufactured “crises” and draws lessons from the Bella 1 affair on countering Russian gambits.

Part 1: Clouds on the Horizon — The Skipper’s Arrest Bodes Ill for the Bella 1

The first sign that trouble might be brewing for the Bella 1 came on December 11^th, as it was steaming in ballast westward across the Atlantic. That’s when news broke that U.S. forces had seized the Skipper, a 20-year-old crude carrier that had just lifted a cargo out of Venezuela (see figure 1).

The Bella 1 and the Skipper bore much in common: both were falsely flagged tankers far past their prime and subject to U.S. sanctions for transporting Iranian oil.

The Bella 1 and the Skipper had much in common. Both vessels had spent nearly all their service lives with established operators in the mainstream fleet. And both had now reached an age when many tankers have already been sold for scrap.

But as sometimes happens in a tanker’s twilight years, the Bella 1 and the Skipper found themselves under new managers intent on squeezing out a few more years of profit by employing them in the Iranian shadow trade. That trade mostly involves covertly transporting oil from the Persian Gulf to a cohort of risk-friendly, independent refiners in China.

OFAC sanctions had limited the commercial prospects of both tankers.

Before long, both tankers found themselves sanctioned by the U.S. Treasury for helping finance Hizballah and the Iranian Revolutionary Guard Corps. While an OFAC listing didn’t put them out of business entirely, it severely limited their commercial prospects. Shipping databases show flag registries increasingly shunned them. In time, they each resorted to flying a false Guyanese flag. This meant they claimed to be on Guyana’s national shipping registry, when, in fact, they weren’t. No valid flag means a tanker is “stateless” under maritime law, which makes it vulnerable on the high seas. Third countries can board the vessel and claim jurisdiction over it.

In addition to losing their flags, both the Skipper and the Bella 1 had also lost their “class renewal” certifications. A class renewal survey is a critical document issued every few years by specially accredited “classification societies.” It confirms that the vessel complies with an extensive set of technical safety standards set by the International Association of Classification Societies (IACS) in conjunction with the International Maritime Organization (IMO). Even shadow tankers try to maintain a valid “class renewal” survey, since without one, they lose the ability to berth at oil terminals around the world—including many in China.

Both vessels also had the bad luck to be approaching Venezuela just as the U.S. was imposing its oil blockade.

With their commercial prospects diminished, the Skipper and the Bella 1 did something many tankers in the Iran trade do from time to time: they headed across the Atlantic to lift a cargo out of Venezuela. After all, most Iranian and Venezuelan export barrels go to the same risk-friendly, Chinese buyers, through similarly opaque channels, so experience in Iran’s shadow trade is directly relevant to Venezuela’s.

Unfortunately for these two tankers, however, their decisions to take on Venezuelan charters put them precisely in the wrong place at the wrong time.

News of the Skipper’s seizure alerted the Bella 1 that it could be sailing into harm’s way

On December 12^th, as news of the Skipper’s seizure continued to reverberate, Reuters reported that the US was planning to seize more ships transporting Venezuelan oil. Over the next two days, the Bella 1, still deep in the Atlantic, appeared unfazed by developments, and continued to make headway at a normal speed.

On December 15^th, however, at around 05:00 Eastern Time, some 50 nautical miles east of Antigua, the Bella 1 abruptly came about and began slowly retracing its route back into the Atlantic. That looks to be the moment when the vessel realized it was potentially sailing into harm’s way—and that it could soon share the fate of the Skipper.

As Washington formally announced its blockade on Venezuelan oil exports, the Bella 1 realized its peril, cut its AIS transponder, and made a run for it…

The next day, Washington confirmed it was imposing a formal blockade on all tanker traffic in and out of Venezuela. At that point, it appears, the Bella 1 fully recognized its peril. On the 17th, the 23-year-old Aframax switched off its AIS transponder and made a run for it.

…but U.S. forces were soon in hot pursuit.

But by that point it was too late. The U.S. Coast Guard appears to have spotted the stateless, OFAC-sanctioned tanker and was giving chase. By the 20^th, a U.S. federal magistrate judge had issued a warrant for the Bella 1, and the U.S. Coast Guard attempted to exercise its right of visit with an uncoerced boarding. Unlike the Skipper, however, the Bella 1 refused to the request and began issuing distress calls with U.S. forces “in active pursuit.”1

Part 2: A Spoiler-State Move—Moscow’s Special Operation to Reflag the Bella 1

When the Bella 1 decided to resist U.S. boarding and take flight, Russian officials quickly spotted an opportunity for political advantage by meddling in the standoff.

Soon the eyes of the world were on the drama unfolding in the mid-Atlantic. Among those watching, no doubt, were senior security officials in Moscow. As backers of Nicolás Maduro, they would have been concerned that the oil blockade was putting another Kremlin ally at risk so soon after the embarrassing collapse of the al-Assad regime.

But the Kremlin’s concerns would not have been limited to the fate of the Chavista regime. As skilled spoilers, they would have been looking for ways to gain political advantage for Moscow by meddling in the standoff—whether it helped the Maduro regime or not.

As a consummate spoiler state, Putin’s Russia is constantly on the lookout for unconventional, low-cost opportunities to generate advantage for itself by inserting itself into third-party conflicts. This is, after all, the regime that brought us the Wagner Group, which transformed state-backed mercenary “spoilerism” into a lucrative, scalable business model.

The Bella 1’s flight from U.S. forces offered just such an opportunity for Russian meddling. As news of the standoff emerged, officials in Moscow would have recognized that the Bella 1’s lack of flag protection left it highly vulnerable to U.S. seizure. But if Moscow were to extend Russian flag protection to the distressed tanker, it could claim exclusive sovereign jurisdiction, and demand that the U.S. drop its pursuit.

Reflagging a tanker in the middle of a standoff would be a consummate spoiler-state move. But its effectiveness would rely on the U.S. recognizing Moscow’s claims.

Moscow has been increasingly preoccupied with flagging. Formerly permissive flag states have been deregistering Russian shadow tankers, leaving a growing number stateless and exposed.

It’s unlikely that this flagging stratagem—protecting a beleaguered tanker by granting it Russian flag protection—was devised on the spur of the moment. Tanker flagging has been a topic of growing concern in Moscow over the past two years. When Moscow first began assembling its proprietary shadow fleet in 2022, it studiously avoided flagging or owning these vessels in Russia—presumably to reduce the risk of sanctions as well as outright seizure, should a state of war be declared. This meant, however, that Moscow would need to find other flag states willing to register its shadow tankers. With time, however, this has become increasingly challenging, posing a dilemma for Moscow.

Under maritime law, flag states are responsible for ensuring that all vessels on their registers comply with international safety standards. For tankers, this includes having a valid class renewal survey and carrying adequate spill liability insurance. Many tankers in Russia’s expanding shadow fleet, however, appear to have cut corners on compliance norms. Increasingly, they found themselves getting deregistered by stricter flag states, which has forced them to rely on a small number of flag states, with a reputation for lax oversight, to maintain a valid registration.

The rapid expansion of shadow shipping since late 2022 has, in turn, caused alarm among many coastal states. They have responded by urging overly permissive flag states to observe global standards. These efforts have met with notable success. Consequently, Russia’s shadow tankers have increasingly struggled to maintain a valid registration. After multiple deflaggings, many have been forced to resort to the perilous practice of flying a false flag.

The recent seizure of the Grinch illustrates the vulnerability of falsely flagged Russian shadow tankers in international waters near Europe.

In parallel, European maritime authorities have been stepping up pressure on Russian shadow tankers operating in regional waters. Consider, for example, the recent fate of the Grinch (IMO 9288851), a 22-year-old Aframax sanctioned for its role in funding Russia’s war on Ukraine. Since 2022, it has lifted over 20 cargoes out of Russia under 4 separate flags. In early January, it departed from Murmansk apparently flying a false Comorian flag and carrying a cargo of EU/UK-sanctioned crude worth an estimated $38 million. On January 22, 2026, in Mediterranean international waters, it was boarded and detained by the French Navy (with UK assistance).

Continency planning around the growing seizure risk to its own fleet likely helped Moscow quickly launch an operation to extend flag protection to the Bella 1.

With third-country flagging increasingly hard to secure and European navies targeting falsely flagged vessels, it’s likely Russia’s security services have been revisiting their “no-Russian-flags” policy. This likely explains the steady uptick of late in Russian shadow tankers flying Russian flags. And this review likely includes continency plans for rapidly extending Russian flag protection to stateless shadow tankers under pursuit by adversaries.

Moscow’s on-going preoccupation with tanker flagging likely explains the speed with which it both spotted the opportunity presented by the Bella 1 and rolled out a complex operation to exploit it. Indeed, the operational blueprint is likely based on pre-existing contingency plan. It just required some tweaking to accommodate the peculiarities of the Bella 1.

Moscow’s reflagging operation unfolded in of 3 phases: (1) “Russify” the tanker, (2) draw a bright red line around it, and (3) back its warnings with a naval escort.

At some point in mid-December—likely between when the Bella 1 took flight on the 15^th and then resisted boarding on the 20^th—authorities in Moscow took the decision to come to the tanker’s assistance. This operation unfolded in three phases (see figure 2).

Phase 1: Devise some “Russian” bona fides for the Bella 1

The first phase entailed creating the most compelling case practical for a Russian claim over the Bella 1. For its gambit to work, Moscow needed the U.S. to recognize Russia’s its claim of exclusive sovereign jurisdiction over the tanker. Russia could have based its jurisdictional claim over the Bella 1 simply on the strength of a decision to accept the vessel into its flag registry. For decades, certain countries have built substantial commercial businesses by extending “flags of convenience” to vessels with no intrinsic ties to the flag state. Maritime law mentions the need for a “genuine tie,” but fails to specify what that entails.

Moscow wasn’t satisfied, however, with a tenuous flag‑of‑convenience claim. It wanted to signal—unmistakably and convincingly—that Russia had a serious interest in the Bella 1 and would go to considerable lengths to defend its jurisdictional claims. To bolster the credibility of that claim, Moscow quickly set about creating “Russian” credentials for the Bella 1.

Within a week, Moscow arranged a sale of the tanker to a Russian buyer, a Russian flagging, a Russian home port, a name change…

This began with ownership. For the past two years, the Bella 1 had been owned by a Turkish domiciled company and transporting Iranian oil, according to OFAC. One of the first items in Moscow’s operational plan was to establish Russian ownership of the tanker. A sale to a small, little-known Russian company based in Ryazan was hastily arranged. Moscow, one imagines, used its contacts in Tehran to seek out the owners and arrange the sale. And no doubt, the prior owners were delighted to unexpectedly receive an offer for their distressed tanker whose cashflow-generating potential and market value could soon plummet to zero.

By December 23^rd, the sale had been registered with the International Maritime Organization (IMO), along with a new vessel name: the Marinera (apparently from the Spanish word for “sailor”).

The following day, December 24^th, the Bella 1 was officially entered into the Russian flag registry, with Sochi as its home port. The irony, of course, is that the tanker would never be able to actually call on its home port, since VLCC-class tankers, such as the Bella 1, are too large to transit the Turkish Straits.

…a Russian-issued class renewal survey, and, in all likelihood, a Russian spill-liability insurance policy.

With the Bella 1 now set up with a Russian owner, flag and home port, Moscow next set about arranging a Russian class renewal survey for the vessel. Under the IMO’s enhanced survey program for oil tankers, a class renewal survey normally requires—among other things—that a vessel is brought into dry dock for a thorough examination of its hull and machinery. With the Bella 1 deep in the Atlantic, however, this was not a possibility. But that didn’t put off the team running the Bella 1 operation. And on December 30, the Russian Maritime Register of Shipping improbably delivered a class renewal survey for the vessel.

To round off the credentialization of the Bella 1’s as a “Russian” vessel, one also imagines Moscow arranged for a Russian domestic insurer to issue a spill liability (P&I) policy for the tanker underwritten by the Russian Central Bank. That appears to be standard practice for vessels acquired for the Russian shadow trade. In defiance of international convention, however, Russian insurers haven’t been making the list of covered tankers readily accessible to the public. So here we can only speculate.

Phase 2: Lay down red lines

With all these freshly minted Russian bona fides in hand—ownership, flagging, home port, class survey and, likely, P&I coverage—Moscow launched phase 2 of its operation: drawing a red line around the “Russian” tanker Bella 1 and issuing threats. This began on December 31, when Russian diplomats delivered a démarche to the U.S. State Department and Department of Homeland Security requesting that the U.S. stop its pursuit of the Bella 1.

Moscow issued formal diplomatic complaints to Washington demanding it recognize Russia’s claims…

According to the Russian Ministry of Foreign Affairs, Moscow provided “authoritative information on the Russian national affiliation of the vessel” (“достоверную информацию о российской принадлежности судна”). In subsequent commentary, the Ministry of Foreign Affairs asserted that Russia’s claims on the vessel were beyond questioning, and that any suggestions that the Bella 1 was operating under a false flag were “baseless.” The Ministry asserted that the U.S. had no rights to stop and inspect the vessel on the high seas without the explicit consent of its flag state, Russia.

…and put senior figures in front the media to amplify Russia’s claims and issue threats of an impending “crisis.

To amplify its claims, Moscow pushed out commentary in the domestic and foreign media. This included a BBC radio interview with Andrei Fedorov, a former Deputy Foreign Minister and now an advisor to Putin. His remarks were clearly calibrated to draw a bright red line around the Bella 1 and leave little doubt that Moscow would respond robustly to any U.S. effort to cross it:

For Russia it’s a very important thing, because if there will be [an] attack from [the] U.S. it will be considered as [an] attack on Russia and it could lead to [a] very critical or maybe even [a] crisis situation between Russia and [the] U.S.

The threat was explicit: if the U.S. seizes the Bella 1, Russia will see it as an attack on Russian sovereign territory that could trigger a full-blow international crisis.

Phase 3: Send in the navy

At the start of January, with “Russian” bona fides now established, red lines drawn, and U.S. forces still in pursuit, the Bella 1 switched its AIS transponder back on. By this point, it had reached the North Atlantic and was reportedly heading for the protection of Russian territorial waters near Murmansk. As a VLCC-class tanker, the Bella 1 could not find safe harbor in the Russian waters of the Baltic or Black Sea; it was too large to navigate geographical chokepoints of the Danish and Turkish Straits. Its best hope for sanctuary would be to reach Russian waters in the Barents Sea.

On January 6^th, reports emerged that Moscow had dispatched a naval task force, including a submarine, to escort the Bella 1. It’s unclear from reports exactly where the task force was or when it had been dispatched. But with this, Moscow implemented the third stage of its special operation: backing up its claims and red lines the threat of military force.

Moscow’s operation soon unraveled, however, when as U.S. forces, undeterred by Russian claims and threats, seized the Bella 1.

On the following day, however, south of Iceland, the flight of the Bella 1 came to a sudden end when fast-roping Navy Seals boarded the tanker and took control. Moscow’s elaborate, two-week operation to avert a U.S. seizure had failed.

After the seizure, no escalation followed. Moscow’s red lines and threats of a crisis turned out to be a bluff.

The Russian response to the Bella 1’s seizure—or lack thereof—is noteworthy. Russia deliberately inserted itself into the middle of a U.S. stand-off with a stateless vessel and then methodically tried to ratchet up tensions—issuing formal protests, declaring red lines, deploying naval force and warning of an impending “crisis.”

But when the U.S., with apparent indifference, crossed Russia’s red line, the promised crisis failed to materialize. The Russian Foreign Ministry issued a plaintive statement expressing its “serious concern… over the unlawful use of force” against the Bella 1, and declaring that the Russian Federation had not given its consent for the boarding. Apart from that, the response was decidedly muted. Russia had, in effect, blinked.

Moscow’s claim to exclusive jurisdiction is open to challenge under maritime law, which may help explain its muted response.

As we shall see in Part 6, Russia’s claim to exclusive jurisdiction over the Bella 1 is open to challenge under maritime law. Prior to Russia’s purchase and flagging of the Bella 1, the U.S. had already engaged the tanker and determined its stateless status. Under U.S. law, once statelessness is determined at initial encounter, the U.S. may claim jurisdiction over the vessel—a practice not prohibited under international maritime law. So, by the time the Russian buyer purchased the Bella 1 several days later, the U.S. had likely already asserted legitimate jurisdictional over it.

In effect, the buyer had knowingly bought damaged goods. In deciding to buy a stateless tanker operating in violation of international law and undergoing arrest by U.S. authorities, he should have realized his ability to unilaterally determine the tanker’s future jurisdiction might be compromised. He was being naïve—or disingenuous—in expecting that a subsequent Russian registration would guarantee exclusive and uncontested Russian sovereign jurisdiction. Caveat emptor.

This defect in Russia’s claim may explain the Kremlin’s muted response. That, along with the fact that the U.S. and UK had called Moscow’s red-line bluff.

But pundits and parliamentarians responded with fury at the Kremlin’s perceived impotence.

But the Kremlin’s perceived impotence provoked fury among pundits, bloggers, and parliamentarians: “[Washington] steamrolled us;” “The decision to re‑flag the vessel under Russia placed the Russian Federation in a highly disadvantageous position;” “Why were [the Russian] ships sent? Just to show the flag? If they were given a mission, then the tanker should have been taken backl” “The Kremlin’s red-lines are drawn in disappearing ink.”

The operation turned out to be little more than a pantomime of Cold War brinkmanship—a clumsily stage-managed crisis.

In retrospect, the Bella 1 affair looks like Moscow trying to reenact a moment of Cold War brinkmanship—think Check Point Charlie, the Berlin Airlift, or the Cuban missile crisis. Only this time, instead of an organically emerging standoff, it looks like a fabricated crisis, artlessly engineered to look like the real thing. Moscow’s initial efforts to present the Bella 1 as an object of vital national interest were a transparent sham. While its deterrent threats were full of sound and fury, they turned out to lack real commitment.

In the end, what we had was not high-stakes brinkmanship, but a Cold War pantomime. And once its bluff was called, Moscow hurried to change the subject. First time tragedy, second time farce.

Part 3. Moscow’s Motives for Saving the Bella 1—Prevailing Theories Debunked

What were Moscow’s motives for mounting a full-scale operation to save the Bella 1? The prevailing explanations are unsatisfactory.

Having exposed Moscow’s special operation for what it was—a hastily improvised, Cold War pantomime—we now turn to the question of ultimate objectives. What did Moscow hope to achieve with these theatrics? Why mobilize substantial resources and put significant credibility on the line for the sake of the Bella 1?

Explanation 1: There might have been smuggled Russian arms aboard. Rebuttal: the U.S. hasn’t reported finding any weapons.

Explanations of Moscow’s motives have centered around two theories—neither satisfactory. The first speculates that the Bella 1 may have been carrying Russian weapons. To date, however, U.S. authorities have not confirmed any arms shipments were on board the tanker.

Had there been, it would likely be in Washington’s interest to disclose them. The covert conveyance of Russian weapons could have compromised the vessel’s rights of innocent passage and provided additional justification for the U.S. seizure—if not necessarily in the maritime courts, then at least in the court of public opinion. So, it’s reasonable to conclude from Washington’s silence that the Bella 1 was probably not transporting arms.

Explanation 2: Moscow was protecting its shadow fleet. Rebuttal: the Bella 1 is decidedly not part of Russia’s shadow fleet.

The second explanation is that Moscow was trying to “protect” Russia’s shadow fleet. But on closer examination, this explanation also doesn’t stand up. To understand why, we first need to set aside a common misconception about the undifferentiated nature of the shadow fleet.

What we commonly call the “shadow fleet” is really two distinct fleets: one primarily serving Iran and Venezuela, the other assembled by Moscow since 2022 expressly the Russia trade.

It’s common to speak of “the shadow fleet,” as if it were one large, undifferentiated pool of marginal tankers serving the world’s sanctioned exporters. But that framing overlooks a fundamental reality: these vessels don’t form a single shadow fleet at all, but rather two distinct and separate fleets:

1. an original shadow fleet that has long been serving Iran and, more recently, Venezuela;

2. a Russian “proprietary” shadow fleet, which Moscow began systematically assembling in mid-2022 expressly to serve Russia’s own peculiar needs.

This is no mere academic distinction. To understand the constraints on Russian oil exports and the impact of sanctions, it’s essential to understand the separate nature of Moscow’s proprietary fleet. It is the outgrowth of a deliberate Kremlin policy decision taken in May 2022, in the opening months of its full-scale invasion of Ukraine. That’s when Moscow resolved to assemble its own stand-alone shipping capability that could end Russia’s reliance on Western maritime services. The question was: where would the tonnage come from?

Chartering shadow tankers from Iranian and Venezuelan trade wasn’t a viable solution. There were issues around capacity, suitability and reliability.

Instead, Moscow set about assembling its own Russia-dedicated fleet. At its core are some 90 legacy vessels from Russia’s state-owned fleet and over 400 vintage tankers purchased second hand expressly for the Russian trade (see figure 3).

Roughly half the capacity of Russia’s dedicated shadow fleet has been impaired by attrition or sanctions (see figure 4).

Nonetheless, Moscow’s shadow fleet has substantially reduced Russia’s reliance on Western shipping services, which now account for around half Russia’s crude and product exports (see figure 5). For more on the emergence of Moscow’s Russia-dedicated shadow, see Navigating Russia’s “Russian Shadow Fleet FAQ.”

With few exceptions, tankers tend to be firmly in either the Russia trade or the Iran and Venezuelan trades.

With very few exceptions, shadow tankers don’t regularly shuttle between Russian and Iranian or Venezuelan charters—lifting a cargo from Primorsk in February, another from Kharg Island in May, and a third from Kozmino in July. Instead, they tend to remain firmly rooted in either the Russia trade or the Iranian/Venezuelan trade.

Russia’s fleet is separate and distinctive not just in the tankers that constitute it, but also in other important respects, including…

And there’s good reason for this bifurcation of the global shadow fleet. The two fleets differ fundamentally in their operating scope, vessel profile, methods of operation, and, in all likelihood, their sources of acquisition financing.

…vessel profiles…

Those differences are driven by a range of understandable factors. For example, Iran and Venezuela rely heavily on VLCCs (“very large crude carrriers”), the largest class of supertanker in widespread use today. They are cost efficient for long-haul operations. But VLCCs are almost entirely absent from Russia’s fleet, for the simple reason they are too large to transit the Turkish and Danish Straits, through which most of Russia’s oil flows.

…the nature of Western sanctions imposed on them and the resulting need for subterfuge—or lack thereof…

And then there is a difference in the nature of sanctions on Russia versus Iran and Venezuela. The latter two exporters have long been subject to full secondary OFAC sanctions. This imposes high risks on all parties in the trade, leading to the widespread use of subterfuge to hide origins and destinations. It’s fear of OFAC secondary sanctions that cause tankers to go dark, spoof their locations, and blend cargoes mid-voyage through ship-to-ship transfers.

…the breadth of their addressable markets…

And the risk of secondary sanctions also greatly reduces the addressable market for Iranian and Venezuelan oil. The vast majority goes to a group of quota-constrained, risk-friendly, domestic-oriented, independent refiners in Shandong Province, China.

By contrast, until late 2025, most Russian oil exports were not subject to U.S. secondary sanctions. Russian exporters and their buyers in non-EU/G7 markets had little need to hide their transactions. As a result, subterfuge by Russia’s proprietary tankers was—contrary to common misconception—uncommon. And Russia’s addressable market has been far broader, routinely including dozens of countries.

…their likely sources of acquisition financing…

And then there’s acquisition financing. Estimated purchase costs for Russian shadow tankers acquired since 2022 exceed $15 bn. Much of this has likely been financed by Russian banks. It would make little sense to put Russia’s over-stretched credit capacity to work buying tankers that spend half their time serving competing exporters.2

…and spill liability insurance.

The same thing goes for mandatory spill liability insurance underwritten by the Russian Central Bank. Most Russian shadow tankers appear to carry Russian policies today—it’s one of the hallmarks of Russia’s proprietary fleet and is needed for access to ports in Turkey, India and elsewhere. It makes no sense for Russia to extend its limited underwriting capacity to tankers primarily serving Iran or Venezuela.

Moscow knows very well which tankers are in its proprietary shadow fleet—and the Bella 1 was most certainly not one of them—at least not before December 2025.

It was Moscow that assembled Russia’s dedicated shadow fleet. So, it knows very well which tankers are in it and which ones aren’t. And the Bella 1 was most decidedly not part of Russia’s proprietary fleet—at least not before it was suddenly “Russified” in late December 2025.

The Bella 1 was squarely centered in Iran’s shadow trade

Rather, the Bella 1 was squarely centered in the Iranian shadow trade. The evidence firmly supports this:

• In 2021, UANI, an NGO that monitors the Iranian shadow trade, added the Bella 1 to its Iranian “ghost armada” list.

• In 2024, OFAC sanctioned the Bella 1 specifically for its involvement in supporting the Iranian Revolutionary Guards Corps and Hizballah—with no mention whatsoever of its involvement with Russia.

• In 2025, the tanker again appears to have transported Iranian oil several times; and

• the Bella 1 has likely never loaded a single barrel of oil at a Russian port, and certainly not since 2022.

Since the Bella 1 wasn’t part of Russia’s proprietary fleet, speculation that Moscow was just trying to “protect one of its own shadow tankers” falls apart.

This leads us back to the question of Moscow’s motive. Once we recognize both the distinctive nature of Moscow’s dedicated fleet and the fact that the Bella 1 was not part of it, the argument that Russia was “protecting one of its shadow tankers” falls apart.

Similarly, it’s hard to see why Moscow would have gone to such lengths and put so much credibility on the line simply to safeguard a stateless, superannuated tanker in service to a competing exporter.

In short, neither of the two prevailing theories—weapons smuggling and protecting Russia’s shadow fleet—hold up to scrutiny. But the evidence does support a third explanation—which we explore in Part 4.

Part 4: Mystery Unraveled—The Bella 1’s Reflagging was Part of a Broader Scheme

The key to understanding Moscow’s interest in the Bella 1 is to recognize it was part of a broader effort muster a fleet of reflagged shadow tankers near Venezuela in late December.

What, then, were Moscow’s motives for reflagging the Bella 1? The key to unravelling this mystery is to recognize that Moscow’s operation wasn’t just about the fate of one tanker. It was part of a broader, more ambitious plan, involving the reflagging of numerous other vessels off Venezuela. If successful, the operation would have given Moscow a powerful tool for disrupting Washington’s pressure campaign against the Maduro regime.

The Fedorov interview explicitly ties the Bella 1 to these other tankers that had “raised the Russian flag” and warns that Moscow’s red line encompasses to them all.

To recognize the full scope and ambition of the operation, let’s turn again to the BBC interview with Andrei Fedorov, the senior Kremlin advisor. After declaring that an attack on the Bella 1 would be considered “an attack on Russia” that could trigger a “crisis”, he went on to say:

The problem today is much more than this [i.e., the Bella 1], because already 5 tankers near, which are standing near [sic] Venezuela raised the Russian flag and declared that they are Russian. So, it might make the whole picture more complicated…

Shipping records confirm at least 10 other shadow tankers near Venezuela were reflagging to Russia in late December and early January

Analysis of shipping records confirms Fedorov’s claims—and then some. The Bella 1 wasn’t the only tanker near Venezuela that was reflagging to Russia in late December and early January. There were at least 10 other such tankers that had then “raised the Russian flag and declared that they are Russian.” In noting this, Fedorov was signaling that Russia’s red-line claim of sovereign jurisdiction wasn’t limited just to the Bella 1. It extended to a expanding tanker fleet in the waters near Venezuela (see figure 6).

Fedorov warns the presence of this Russian-flagged fleet would “make the whole picture more complicated” for Washington—in other words, it could thwart the U.S. oil blockade.

As for the motive behind this rash of reflaggings, Fedorov all but spells it out when he warns that the presence of so many Russian‑flagged tankers near Venezuela “might make the whole picture more complicated.” In other words, “more complicated” for the United States. If Washington bowed to Moscow’s demands for the unimpeded passage of Russian‑flagged tankers, Moscow would suddenly have the means at hand to break the U.S. blockade of Venezuelan oil.

The real aim of Moscow’s reflagging scheme, it appears, was to develop the capacity to challenge the U.S. oil blockade

And that appears to be the real motive behind Moscow’s reflagging operation: to create the capacity to thwart Washington’s oil blockade. If Moscow could muster a fleet of Russian‑flagged tankers around Venezuela that enjoyed immunity from U.S. seizure, it would then control the means to keep Maduro’s exports flowing.

Most of these vessels had strong Russian ties, but three had Iranian ties.

It’s important to note that, unlike the Bella 1, nearly all these other reflagged vessels had strong ties to Russia. Between them, they had lifted over 100 cargoes out of Russia since 2022, and all had been sanctioned by OFAC for their involvement in the Russia trade. Arranging their reflagging would have likely been a relatively simple matter.

The remaining two, like the Bella 1, had Iranian ties. And curiously, the very same Russian-registered company that acquired the Bella 1 on December 23^rd, Burevestmarin LLC, also bought these other two Iranian-linked tankers just two days later, according to shipping records.

The picture emerges of a rushed effort by Moscow to quickly muster a Russian-flagged fleet in the waters nearby Venezuela. Most of that tonnage was being supplied by Russia-linked shadow tankers. Their OFAC sanctions had greatly reduced their prospects in the Russia trade, bringing them, by varying routes, to Venezuela. To augment that capacity, Moscow appeared to be working its contacts in Tehran to opportunistically acquire and reflag nearby Iranian-linked vessels—such as the Bella 1.

(For more details on the make-up of Moscow’s reflagged Venezuelan fleet, see Appendix: Moscow’s Venezuelan “Spoiler” Fleet.)

Moscow had a reasonable chance of deploying enough Russian-flagged tonnage to Venezuela to pose a credible threat to Washington’s blockade.

For its gambit to be credible, Moscow would need to maintain a steady stream of Russian-flagged tonnage heading to Venezuela. The reflagged fleet already on hand was sufficient to keep exports flowing at significantly reduced levels for several weeks—but no more. In the meantime, there were numerous other Russian shadow tankers within two week’s sail from Venezuela—many of them impaired by OFAC sanctions, underutilized and relatively expendable.

The big questions boiled down to: would Washington allow Russian-flagged tankers through its blockade? And if so, how would Moscow use that leverage?

If Moscow kept scrambling to reflag vessels, it could present a sustained, credible challenge to Washington. The big question then became: would the U.S. let these Russian-flagged tankers through? As we shall see in Part 6, the answer is not as straightforward as some might think.

First, however, we briefly consider the question: if Moscow succeeded in developing a blockade-breaking capacity, how would it use it?

Part 5: Moscow’s Ultimate Aim—Solidarity with Caracas or Bargaining Power over Ukraine?

How would Moscow have used its blockade-breaking capability? It might have used it to aid an embattled ally, or…

The only question remaining is this: how did Moscow intend to use the blockade-breaking capacity of its spoiler fleet? The Kremlin was likely considering two options. First, Moscow could have used it to aid an embattled ally by keeping Venezuelan oil flowing.

…or wielded it as a valuable bargaining chip in a quid-pro-quo proposal to Washington around Ukraine—an updated version of Moscow’s 2019 offer.

Alternatively, Moscow might have considered trying to transform this capability into a bargaining chip to trade with Washington in exchange for concessions around Ukraine. If so, it wouldn’t have been the first time Moscow proposed a quid pro quo to Washington involving Venezuela and Ukraine.

Moscow has been a long-time supporter of the Chavista regime, though not necessarily a steadfastly loyal one. In 2019, Russia reportedly proposed a quid pro quo to Washington: Russia would withhold support from Venezuela in exchange for a free hand in Ukraine. At the time, Washington reportedly declined.

By late 2025, Venezuela had climbed to the top of Washington’s agenda. With the U.S. now intent on removing Maduro, Moscow might have judged the moment ripe to revisit the Venezuela-Ukraine quid pro quo. The capacity to frustrate the U.S. blockade—and then to offer that leverage in exchange for concessions on Ukraine—would certainly strengthen the appeal of Moscow’s proposal, or so the Kremlin might have calculated.

Letting the Venezuelan blockade remain in place would have also substantially benefitted Moscow’s own newly sanctioned oil producers, by supporting prices…

Apart from concessions on Ukraine, Moscow would have gotten two other benefits from trading away its capacity to break the blockade. The first is upward pressure on sagging oil prices. A protracted U.S. blockade would squeeze global supply, helping boost Moscow’s own tumbling export revenues.

…and opening up critical demand for sanctioned oil among China’s risk-friendly independent refiners.

Second, it would have made it easier for newly sanctioned Russian producers to find willing buyers for its OFAC-sanctioned barrels. Since late 2025, some 80% of Russian production has come under OFAC secondary sanctions—similar to what Venezuela and Iran have long faced. Global demand for OFAC-sanctioned barrels is very limited—most of it concentrated among China’s risk-friendly independent refiners. They absorb most of Iranian and Venezuelan exports—demanding deep discounts for their risk.

Newly imposed sanctions on Russian producers are forcing them to compete with Iran and Venezuela to supply this import-quota-constrained market. A blockade on Venezuelan supply eliminates a major competitor, easing pressure on sanctioned Russian exporters (see figure 7).

For the moment, however, we can only speculate about how Moscow might have used its leverage, because by mid-January, events had transpired that made its spoiler fleet of little value—either to as a lifeline for a defiant Caracas or as a bargaining chip against Ukraine.

Part 6: Could a Russian-flagged Fleet Have Defied the U.S. Blockade? Kremlin Blunders Weakened its Chances.

Would Russian-flagged tankers been allowed to transport Venezuelan crude through Washington’s “complete blockade?” It’s a question worth asking.

For Moscow’s blockade-thwarting scheme to work, its Russian-flagged “spoiler fleet” would need effective immunity from U.S. seizure. Two things could have made that possible:

1. the U.S. believed these tankers had an indisputable right of passage under maritime law and agreed to respect it; or

2. the U.S. considered Russia’s red-line threats to be credible and preferred not to risk an escalation.

Both these scenarios might seem unlikely, especially after mid-December, when Washington declared a “complete blockade of all sanctioned oil tankers going into and out of Venezuela” and started seizing vessels. But Washington’s blockade might not be as “complete” as the headlines suggest.

Tanker arrests under Washington’s “complete blockade” appear to comply with restrictive targeting criteria, in an effort to remain consistent with maritime law.

Analysis of vessels arrested to date reveals a distinct pattern—one that seems to be designed to keep these seizures consistent with maritime law. All 7 tankers arrested to date under Operation Southern Spear appear to have had attributes that left them vulnerable to seizures that, arguably, are consistent with maritime law.

Most of the seized tankers were stateless. Maritime law does not prohibit such vessels from being boarded and arrested by states asserting jurisdiction over them.

Of the 7 arrested tankers, 4 or 5 appear to have been stateless at the time of their initial encounter with U.S. authorities—either because they were flying a false flag or none at all.

As noted earlier, stateless ships do not enjoy the same protection on the high seas as legitimately flagged ships, which fall under the exclusive sovereign jurisdiction of their flag states. UNCLOS explicitly grants third-country warships a right to board ships suspected of being stateless (article 110).

The crucial question then follows: how far does the boarding state’s jurisdiction over a flagless vessel extend? Maritime law is silent on the matter; as the UN Maritime Crime Manual puts it, “there is no settled answer” to jurisdictional scope. States take a range of views. The Manual goes on to observe that a state “may determine that…it can assert the same jurisdiction over the suspect vessel as it could assert over a vessel of its own nationality” (see section 15.4(g)).

In other words, since no state enjoys exclusive jurisdiction over a flagless ship, any state encountering it can assert its own jurisdiction.

Some legal scholars argue this expansive view of jurisdiction justifies Washington’s arrest of U.S.-sanctioned, stateless tankers.

For decades, U.S. maritime law has taken this more expansive view on jurisdiction. In U.S. jurisprudence, if a U.S. Coast Guard arrests a stateless ship under a federal criminal warrant, it’s as though it were arresting a U.S. flagged ship. And that’s exactly the argument some scholars are making when they say the arrest of stateless, sanctioned tankers like the Skipper doesn’t violate international maritime law.3

Similarly, if a tanker’s flag state gives the U.S. permission to board and arrest a tanker, that too is consistent with maritime law—which could account for 2 more seizures.

Two of the 7 tankers, however, appear to have been indisputably flagged at the time of boarding and arrest. The flag state for both was Panama. Which means Panamanian consent would have been needed for both the boardings and the arrests to be consistent with international maritime law.

And there is some indication the U.S. may have received such consent. The U.S. and Panama have a long-standing boarding agreement, which appears to have been used to secure boarding consent. And there is some suggestion that Panama may have also given consent to the arrest of these vessels, because they had violated maritime rules. Further disclosures

How would Washington have responded to a Russian-flagged tanker laden with Venezuelan oil? The fate of the Bella 1 might not be indicative.

The point of this legal analysis is not to opine on maritime law. It’s to show that the scope of U.S. arrests appears to be restrictive in their targeting criteria. Arrests have been limited either to tankers (i) that were stateless or (ii) whose flag states may have provided consent. Which suggests an effort to keep the arrests consistent with maritime law.

Which begs the question: what would the U.S. do if confronted with a Russian-flagged tanker laden with Venezuelan oil? If the tanker is on the high seas, properly flagged and engaged in normal commercial activity, in most cases it would enjoy a right of innocent passage under maritime law. Would the U.S. acknowledge and respect that right by allowed the tanker to pass?

Russia’s claim to exclusive jurisdiction over the Bella 1 may be compromised under maritime law in a way the other Russian reflaggings aren’t.

At first glance, some might conclude from the seizure of the Russian-flagged Bella 1 that the U.S. will not allow a Russian-flagged tanker to pass.

But on closer examination, that is probably a misreading of the Bella 1 arrest. The Bella 1 was reflagged under highly unusual circumstances. These may have compromised Russia’s claim to exclusive jurisdiction in a way that other Russian reflaggings did not.

Sequencing matters. Prior to the reflagging, the U.S. had already asserted its legitimate enforcement jurisdiction over the Bella 1.

To understand why, we need to focus on sequencing. Recall, that on December 20^th, the U.S. had its initial encountered with the Bella 1. The U.S. Coast Guard approached the tanker, determined it was stateless, and requested exercise its legitimate right of visit in order to execute a federal warrant for the arrest of the sanctioned tanker. The captain refused to honor the right of visit and fled. The Coast Guard gave chase, mobilized a team of coercive boarding specialists, and completed the arrest.

There are three important considerations here.

1. At the time of initial encounter, the Bella 1 was stateless. This gave the U.S. a right to assert its enforcement jurisdiction over the vessel.

2. The U.S. asserted its jurisdiction when it initially attempted to board the tanker and exercise its federal warrant.

3. The arrest of the Bella 1 was a continuous enforcement action lasting from first engagement to completion of the seizure. The jurisdiction rights the U.S. asserted at the outset continued throughout the enforcement action, provided the ship remained in international waters.

The Russian buyer had acquired damaged goods: a stateless vessel with a pre-existing jurisdictional claim on it that was now in the middle of an enforcement action.

Now, overlay the Russian actions onto this sequencing. On December 23^rd, a Russian company acquired title to the tanker. But by that point, tanker they were buying was seriously impaired, as the buyers should have been aware:

• The previous owners had been operating in violation of international law by flying a false flag. This had put the jurisdictional rights of the tanker in jeopardy.

• Three days earlier, U.S. had asserted its legitimate right of enforcement jurisdiction over the tanker and had begun an action to take the tanker into custody.

This pre-existing U.S. claim impaired Russia’s subsequent claim to exclusive jurisdiction.

Russia certainly has a right to flag the vessel and claim sovereign jurisdiction. But the exclusivity of that claim is impaired by a pre-existing U.S. claim. The U.S. claim attaches at the moment of engagement—back on December 20^th. Flagging the stateless tanker doesn’t retroactively nullify the U.S. claim. And it doesn’t really matter that the arrest of the tanker hasn’t yet been completed. What matters is that it’s a single, ongoing enforcement operations that’s already underway.

This U.S. likely considered the reflagging of the Bella 1 as distinct from the other reflaggings. We shouldn’t draw general conclusions based on it.

The point here is not to opine on the merits of the case. It’s just to show that the U.S. likely considers the reflagging of the Bella 1 distinct from the other reflaggings. In the case of the Bella 1, the U.S. had already asserted jurisdiction prior to the reflagging. And this impaired Russia’s claims of exclusive jurisdiction. But with almost all of the other reflagged vessels, it doesn’t appear that the U.S. had engaged with them prior to their reflaggings. And so there is no prior U.S. claim compromising Russia’s claim of exclusive jurisdiction.

So, we shouldn’t assume from the arrest of the Bella 1 that the U.S. has repudiated all Russian claims of exclusive sovereign jurisdiction and will indiscriminately seize any Russian flagged tanker. For the U.S. the case of the Bella 1 was special.

In its eagerness to acquire more tonnage for its spoiler fleet, Moscow overreached; it should have anticipated that the U.S. would assert its prior rights.

By the same token, Moscow, too, should have recognized the case of the Bella 1 was special. It’s understandable the Bella 1 was a very attractive acquisition target for Moscow’s Venezuelan spoiler fleet: a capacious, vintage VLCC just a few days out from Venezuela.

But the Bella 1 feels like a case of overreach typical of a struggling regime. With a U.S. enforcement action already underway, the Bella 1 was clearly damaged goods. Caveat emptor. The U.S. was very unlikely to surrender its legitimate prior rights. If Moscow underestimated this risk, it was bad judgement. If they weren’t aware of the risk, it was gross negligence.

Overreach wasn’t Moscow’s only mistake. There were others. First, the failure to follow through on threats further compromised Moscow’s red lines.

Misjudging likely U.S. jurisdictional claims wasn’t Moscow’s only blunder in the Bella 1 affair. Three more blunders stand out.

First, when the U.S. rejected Moscow’s legal claims, Russia tried to intimidate the U.S. into standing down with an escalation threat. There were Fedorov’s warnings of a “crisis” in relations, and the deployment of a submarine escort. In the end, however, Russia’s escalation threat failed to deter the U.S., which appeared to act with impunity.

Abroad, the Kremlin looked weak; at home, it looked craven and incompetent.

Second, when Russia described its flagging of the Bella 1 as “temporary,” it provided new grounds for asserting the tanker’s statelessness.

The second error came from the Ministry of Foreign Affairs. In its January 8^th complaint about the seizure, it stated that Russia had extended “temporary” flag protection to the Bella 1 (“временное разрешение на плавание под государственным флагом Российской Федерации”). To maritime scholars, this phrasing is a red flag. It suggests the Russian flagging of the Bella 1 was somehow provisional or short-term.

That, in turn, provides additional avenue for arguing the Bella 1 was stateless under maritime law. Article 92 of UNCLOS prohibits vessels from switching between two flags, “using them according to convenience.” Ships that do can be treated as if they were stateless. This blunder further undercut Russia’s claims to exclusive jurisdiction.

Third, by explicitly linking the Bella 1 to the other Russian reflaggings, Fedorov invites claims of statelessness against them all, narrowing Moscow’s chances of success.

The third blunder came in the Fedorov interview. He explicitly associates the flagging of the Bella 1 with other Russian reflaggings near Venezuela. As noted above, however, Moscow has compromised its claims over the Bella 1 by describing its flagging as “temporary.” By linking all these reflaggings together, Fedorov opens up a challenge to Russia’s jurisdictional claims over all of these hastily reflagged vessels.4

In the end, one is left with the impression of a hastily improvised operation by an overstretched team.

Moscow’s reflagging gambit ultimately unraveled when Caracas bowed to U.S. pressure to coordinate oil exports. The spoiler fleet lost its purpose.

For all these blunders, it’s still possible Moscow’s reflagged fleet might have succeeded in challenging Washington’s blockade. The U.S. might have deemed their reflagging legitimate. And it might have been unwilling to interdict a legitimately flagged Russian tanker, laden with Venezuelan oil and listed by OFAC. We can only guess.

In the end, what caused Russia’s reflagging scheme to unravel was not so much its blunders, but its bad luck. Not long after Maduro’s capture on January 3^rd, the rump Chavista regime bowed to pressure from the U.S. and began coordinating oil exports. With that, the purpose of Moscow’s reflagging operation—defying the U.S. blockade—fell away, along with its hopes of gaining new bargaining leverage over Washington.

The fate of Moscow’s spoiler fleet.

As for the fate of Moscow’s spoiler fleet, the Bella 1 and the Veronica remain in UK and U.S. custody. The two small, legacy Sovcomflot product tankers that delivered naphtha to Venezuela late last year have now left Venezuela, in ballast, without incident it appears.

Of the remaining seven vessels, several are still laid up in Venezuelan waters, gathering barnacles under their new Russian flags. The others switched off their beacons one after another and silently slipped off the grid, their current locations unknown.

Conclusion: Russian Gambits and How to Foil Them—Lessons from the Bella 1 Affair.

The Bella 1 affair marks the convergence of two destabilizing trends: shadow shipping & stage-managed crises designed to extract leverage.

The Bella 1 affair marks the convergence of two destabilizing trends from Russia: a broad assault on hard‑won international standards in seaborne transport—a milestone of the rules‑based order—and a growing reliance on gambits designed to extract leverage through stage‑managed crises. As such, it offers valuable lessons for policymakers.

The report concludes with insights into countering the second trend: Russia’s growing use of provocations and stage‑managed crises

Russian provocations are symptomatic of a struggling regime trying to create bargaining leverage on the cheap. Unfortunately, we should expect more of them.

It’s important to consider gambits like the Bella 1 affair in the broader context of Russia’s war on Ukraine. Ukraine has become a quagmire for Moscow—a relentless drain on dwindling resources, fueling growing political risks at home.

Moscow is now searching for an advantageous exit from the conflict. It understands it cannot spend its way to a decisive battlefield advantage or break Ukraine’s resolve by striking cities. Instead, its best hope now lies in bargaining with Kyiv’s Western allies.

But Russia has few bargaining chips left. As a result, the Kremlin is increasingly trying to manufacture leverage by staging artificial crises—cutting gas supplies, attacking subsea infrastructure, sending drones into civilian air corridors. And most recently, mustering a Russian-flagged tanker fleet to break the Venezuelan oil blockade.

So long as these gambits offer advantage, they will continue. That is why the signal failure of the Bella 1 affair deserves attention: it offers policymakers useful guidance on how to blunt the impact of Moscow’s stage‑managed provocations.

Four useful takeaways on foiling Russian gambits:

1. Recognize these operations for what they are—improvised, speculative gambles by an overstretched regime hoping to win some leverage on the cheap.

2. Avoid buying into a manufactured “crisis” narrative. Moscow is counting on public alarm to push policymakers toward concessions they don’t need to make.

3. Be skeptical about the credibility of Moscow’s red lines. With resources so strained, the Kremlin is increasingly resorting to hollow threats and bluffs.

4. Seek solutions that avoid rewarding Moscow for engineering crises merely to resolve them

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Appendix: Moscow’s Venezuelan “Spoiler” Fleet

In addition to the Bella 1, there were at least 10 others tankers nearby Venezuela that reflagged to Russia in late December 2025 and early January 2026 (see figure 8)

Of these, the first 8 bear the hallmarks of Moscow’s proprietary shadow fleet. Each has been sanctioned by OFAC for its involvement in Russia’s wartime oil trade. Two are legacy Sovcomflot vessels. The others had changed hands since mid-2022, dropped their International Group spill liability insurance, and focused on the Russian trade. All but one appear to have been flying false flags at the start of December, with the eighth already on its fifth flag in less than two years.

It’s worth noting how these vessels came to be near Venezuela in late 2025. There are no strong indications that their presence in the area was the result of premeditation by Moscow. It appears to be happenstance (though some role for contingency planning can’t be entirely ruled out).

The two legacy Sovcomflot tankers had been laid up for much of 2025, after being sanctioned by OFAC in January. Late in the year, however, they were dispatched to Venezuela to deliver cargoes of Russian naphtha—part of an uptick in such deliveries in recent months, according to the team at Centre for Research on Energy and Clean Air. Each is a smaller, clean product tanker—able to transport crude, but not an obvious or desirable choice.

As for the remaining 6 Russian shadow tankers, each was on its way to Venezuela well before the imposition of the U.S. blockade. And each was a refugee of sorts from the sanctions campaign against Russia’s shadow fleet. As noted above, each had been acquired in the second-hand market since 2022 and put to work in the Russia trade. A premium price would likely have been paid for them in the frothy tanker markets of 2022-2024, where valuations were aggressively bid up by high demand out of Russia.

OFAC sanctions, once imposed, would have severely impaired the cash-generating capacity of these vessels. Most importers of Russian oil refuse to accept cargoes transported by an OFAC-sanctioned tankers. Many soon had their class renewal surveys withdrawn and struggled to maintain a flag registration, hopping from one flag to another in rapid succession. The frequency of their loadings out of Russia fell sharply. Work appears to have been increasingly hard to come by. This may have left their equity owners struggling to service hefty acquisition debt loads.

In search of employment, each of these tankers eventually made their way, in ballast, to Venezuela. Once there, they took up humble work as coastal shuttles, transporting oil from one Venezuelan port to another. No doubt the pay was poor, but owners saw it as a better option than selling the tankers for scrap to the shipbreaking yards of Chittagong.

In addition to these 8 reflagged Russian shadow tankers, there are two more tankers off the Venezuelan coast that were reflagged to Russia around late December / early January. One is the Lillian (Sokolo). It’s an ancient VLCC, built in 1998 that was sanctioned by OFAC in March 2025 for involvement in the Iranian trade. Like the Bella 1, it set sail in ballast from the Gulf of Oman for Venezuela towards the end of 2025—one assumes to lift a cargo of Venezuelan oil. It reached Venezuelan waters several days before the Bella 1 changed course and headed back into the Atlantic.

The second is the Veronica (Galileo). It’s a curious outlier of sorts. An Aframax built in 2002, it appears to have come under Russian management around 2020. On February 22, 2022, two days before Russia’s full-scale invasion of Ukraine, OFAC sanctioned the Veronica (then the Pegas) as an asset belonging to a Russian bank involved in financing the defense sector. Log data for it is scarce, but it doesn’t appear to have loaded any oil at Russian ports from 2022 onward. It appears, however, to have found employment in the Iranian shadow trade; shipping databases even show it flagged by Iran from mid-2022 until the end of 2025. Oddly, however, it doesn’t appear on UANI’s list of Iranian-linked shadow tankers. From 2021 through late 2025, the owner of record was a company registered to an apartment in a remote mountain town in southern Dagestan—not a common ownership domicile in the tanker world. And since late 2024, the Veronica, appears to have also found work as a coastal shuttle tanker in Venezuela.

It’s probably no coincidence that, on December 25, just two days after the Bella 1 was acquired by a Russian-registered LLC, Burevestmarin, that same company tripled the size of its tanker fleet when it bought the Lillian and the Veronica. Burevestmarin, it appears, was being used as a vehicle for acquiring Iranian-linked vessels then near Venezuela. One wonders how much Burevestmarin paid for these tankers and who the lucky sellers were. Because within three weeks, two of those three vessels would be in U.S. custody. As for the Lillian, it went dark in early January. Last recorded location—just inside Venezuelan waters off the coast of Aruba.

Credits

Credit: frontispiece, public domain, National Art Gallery, Feodosiia, Ukraine.

Source: Wikipedia

Disclaimer: No Advice

The author of this Substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

© Copyright 2026, by Craig Kennedy. All rights reserved.

Endnotes

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A full report on the new Russian oil sanctions should be released soon.

New measures target demand for Russian exports and mark the most significant development in oil sanctions policy since 2022

New measures taken by the US, the UK and the EU mark the most significant development in oil sanctions policy towards Russia since 2022. They are poised to substantially cut Moscow’s oil revenues in 2026 while intensifying the worst crisis in Russia’s energy sector since the 1990s. Given time to take their toll, they should accelerate the deterioration of Moscow’s ability to fund its war on Ukraine, strengthen the West’s negotiating position, and weigh on the Kremlin’s war calculus—and even more so if certain follow-on measures are taken.

The new sanctions seek to reduce demand for Russian oil among major importers, like India and Turkey. Additionally, they have the potential to sharply reduce oil tanker capacity available to Russian exporters. The imposition of these measures represents a more assertive use of the West’s considerable leverage over Russia’s energy sector.

As seaborne storage becomes constrained, Russia could be compelled to shut in between 1.6 and 2.8 million barrels a day for lack of buyers and/or tanker capacity

As oil importers and shippers adjust to the new risk environment, and Russia’s seaborne storage capacity becomes constrained, Moscow will be compelled to gradually reduce export volumes—for lack of buyers or tankers—possibly both. That, in turn, will compel Russian oil producers to undertake a sizeable, unplanned, winter-time shut-in of production, which could impair the future productivity of affected wells.

Based on market analysis, this report estimates Russia’s export volumes could, in time, fall by between 1.6 and 2.8 million barrels a day, as Russia’s seaborne storage capacity approaches its limits—assuming a basic level of enforcement (see Figure 1). That represents between 16% and 28% of Russia’s current oil production. In financial terms, this translates into an estimated $30 to $55 bn reduction in annual export revenues. It could also lead to a decline in state budget income of as much as 10%—possibly more.

A large, compelled shut-in could also harm Russia’s economy, weaken its leverage with key trading partners and undermine its leadership in OPEC+.

Apart from damaging the state budget, a large, compelled shut-in would have a range of other negative repercussions for Moscow. With the energy sector and its adjacent industries accounting for an estimated 30% to 40% of GDP, a large shut-in would harm the broader economy. It could also impair upstream production capacity, cause alarm and disaffection in the Russian public, weaken Moscow’s leverage over major importers, like India and Turkey, and undermine Russia’s leadership in OPEC+.

Three new measures will help erode non-EU/G7 demand for Russian oil.

Three specific measures are driving this shift in sanctions strategy. One has attracted much attention, while the other two have been relatively underappreciated.

1. Sanctioning of 80% of Russian oil production. First, there are the high-profile designations by the US, UK and EU of leading Russian oil producers, putting nearly 80% of Russian output under sanctions.

2. UK/EU sanctioning of a major non-UK/EU refiner for its dealings in Russian oil. Second, there is the recent designation by the EU and the UK of a Chinese refiner for importing Russian oil, “including dealing with UK-specified ships” as expressed by the UK government. This marks the first time the EU and the UK have designated a major non-Russian-owned, third-country refiner for dealing in Russian oil. With this move, the EU and UK are leveraging access to their valuable markets and services to deter major refiners from importing sanctioned Russian oil. This new development should complement OFAC’s secondary sanctions capabilities.

3. UK/EU imposition of an import ban on refineries processing Russian oil (“closing the refining loophole”). Third, in January 2026, the EU and UK are introducing a ban on imports of refined products from refineries processing Russian oil. As by far the world’s largest importer of refined products and a prime market for large refiners in India and Turkey, this new measure promises to dampen demand for Russian cargoes, whether sanctioned or unsanctioned.

A stark choice for larger refiners: cheap Russian oil vs valuable Western services and markets

Together, these new measures present large, non-EU/G7 refiners with a stark choice: either stop buying Russian oil or risk losing access to valuable Western services and markets that underpin the global oil trade.

Russia’s likely evasion measures: smuggling, fraudulent rebranding, and deep discounts

Russia will likely attempt to circumvent these new measures by using two well-established stratagems: smuggling and fraudulent rebranding. Smuggling is unlikely to create new, large-scale demand for sanctioned oil. Refiners already disinclined to buy sanctioned Iranian or Venezuela barrels are unlikely to start buying sanctioned Russian barrels now—especially on a scale large enough to satisfy Moscow’s much larger needs. The risks are high—Russian oil is just too easy to track.

Smuggling will likely be most useful to expand sales to risk-friendly, independent “teapot” refiners in Shandong Province, China, that already import sanctioned Iranian and Venezuelan oil. But Beijing imposes import quota restrictions on these refiners. So, to keep exports to China from falling, Russia will need likely need to displace some of entrenched Iranian and Venezuelan suppliers for quota-constrained demand (see Figure 2).

Fraudulent rebranding, however, offers more promise. Marketing agents can broaden demand by falsely claiming that sanctioned cargoes were produced by unsanctioned Russian companies. Shrinking overall demand for Russian oil could help constrain this. Expanding producer sanctions from 80% to 100% of Russian output would eliminate it completely.

A third evasion stratagem is deeply discounted pricing. If prices are low enough, some refiners will find the economics sufficiently compelling—even if it means foregoing product exports to Europe. Deep discounting may also be needed to (i) win market share among risk-friendly Chinese importers and (ii) compensate refiners elsewhere for taking heightened Russia risk, especially if it becomes apparent that fraudulent rebranding is widespread.

The partial collapse of Russia’s shadow fleet has caused renewed dependency on mainstream tankers.

Apart from declining demand by importers, a collapse in available tanker capacity could also leave Russian oil stranded and compel a large shut-in. Moscow’s ill-conceived shadow fleet project has been hit hard by attrition and sanctions; roughly half its capacity is either operationally impaired or has dropped out of normal service altogether (see Figure 3).

Consequently, mainstream tankers now transport nearly half of Russia’s seaborne exports (see Figure 4).

If mainstream tankers exit the Russia trade—either because of excessive risk, or a maritime services ban—Russia could have to shut in as much as 2 mm b/d for lack of available tonnage.

Were mainstream shippers to exit the Russian trade en masse, the resulting shortage in available tonnage could compel Russia to shut in some 2+ mm b/d. Most of that volume would likely drop out of Baltic flows, since average voyage times are longer and use more shipping capacity per daily export barrel.

Two things could cause such an exit:

1. mainstream maritime service providers judge that risks under the new regime to be too high; or

2. the EU/G7 scrap the price cap and impose a full ban on Western services. Recent press reports indicate a full maritime ban may be under consideration.1

Moscow is staving off a shut-in by storing oil at sea. The resulting supply overhang is depressing the Urals price.

For the moment, the Kremlin is staving off a dreaded winter shut in by, in effect, storing stranded oil at sea. The resulting supply overhang has deepened the Urals discount to benchmark Brent beyond $25.00 per barrel—painful for Moscow, but still preferable to a large volume cut.2 At some point, it will become impractical to keep increasing Russia’s seaborne storage volumes, compelling Russia to cut output.

Follow-on measures the US, UK and EU might take to intensify the impact of the new sanctions

Moscow will be worried about several potential follow-on measures that would intensify the impact of sanctions

• impose a ban on all maritime services: this would deny Russia access to the mainstream fleet;

• widen the company sanctions to include all Russian oil producers—this would make fraudulent rebranding much harder, effectively deny Russia access to the mainstream fleet; and likely increase the size of a shut-in

• sanction the remaining vessels in the shadow fleet: this would reduce Russia’s ability to deliver oil to key markets, like India and Turkey.

Either way—whether through lower prices or lower volumes—the new sanctions are poised to further erode Russian oil’s war-funding capacity and substantially strengthen the West’s hand in negotiations.

Moscow’s war-funding strategy: (a) maximize cash extraction from the energy sector and bank lending; (b) avoid taxing the public.

These new sanctions threaten to further undermine Moscow’s faltering war-funding strategy. Since 2022, the Kremlin has sought to cover the extraordinary costs of its war on Ukraine by maximizing cash extraction from two sectors:

1. oil and gas (by tapping accumulated windfall savings and hiking taxes on current cashflows); and

2. banking (by aggressively expanding corporate lending, including soft loans for arms manufacturing).

The strategy worked well through 2024, but by 2025 surplus capital reserves were depleted. Worse still, the sectors now face serious structural problems.

Through 2024, this strategy worked well. It generated abundant cash that funded an expanding war budget, kept budget deficits low, fueled economic growth and created an illusion of unyielding Russian economic resilience. And, importantly, it allowed the Kremlin to avoid a politically perilous general tax hike.

In 2025, however, Moscow’s funding strategy began to falter as surplus capital reserves in banking and energy became—in the words of Russia’s Central Bank head—“exhausted”. Bank credit capacity had been overextended, while oil and gas savings had been heavily depleted.

Worse still, each of these sectors now face serious structural problems that are eroding their capacity to generate additional cash.

The oil and gas sector has slid into its worst crisis since the 1990s, which is progressively weakening its capacity to generate free cashflows.

The oil and gas sector is sliding into its worst crisis since the 1990s—the result of confiscatory taxation, strategic blunders, Western sanctions (especially on oil field technology), increasingly challenging geology and drone strikes. Upstream oil production is suffering from falling productivity, diminished access to critical high-end technologies, stranded capex, exorbitant capital costs, underinvestment, short-sighted highgrading, increasing well costs, rising watercuts, and declining new-well flow rates (see Figure 5 and Figure 6).

These problems, along with weaker oil prices, help explain the accelerating decline in energy sector contributions to the Kremlin’s wartime finances (see Figure 7 ).

Banks are suffering from $200+ bn of mandated lending to arms manufacturers that is not subject to fundamental credit-risk management requirements.

In the banking sector, the Kremlin’s excessive reliance on off-budget, state-directed lending to fund the arms manufacturing sector appears to have created a large, unhealthy anomaly in the banking system. In 2022, the Central Bank eased lending restrictions, unleashing a massive surge in corporate lending. Nearly a third of that lending has been directed to Russia’s 5 core arms manufacturing sectors through what appears to be a state-mandated, unlimited line of soft credit for defense. Total debt of these sectors now exceeds $200 bn and makes up over 23% of all corporate lending in rubles by Russia’s banks (see Figure 8).

To facilitate lending to the notoriously uncreditworthy arms sector, the state has introduced a special defense-sector regulatory framework that suspends fundamental credit risk management requirements. Defense sector loans are not subject to standard initial credit approvals. Nor are banks required to periodically reassess default risk on outstanding loans and set aside reserves when default risk increases. Instead, banks are allowed to simply assume the loan is in good standing and set aside no provisions as a buffer against a potential default.

This special defense-sector lending framework has created a dark pool of poorly understood and poorly managed default risk that is not reflected in official data.

This extraordinary suspension of fundamental default-risk management principles has created a large pool of opaque, unmeasured and poorly managed default risk at the heart of the Russian banking system. But because these loans can be marked as “good,” the actual default risk exposure of Russian banks is significantly higher than public disclosures suggest.

This likely explains reporting by Bloomberg, sourced from Russian banking insiders and documents, that three leading banks have internally discussed the potential need for a Central Bank bailout because “their assessment of the quality of their loan books is far worse that what official data show.”3 It’s worth noting that the state has injected close to $10 bn in capital from its wealth fund into several leading banks in 2025.

It is also making the banks far more cautious, leading to a collapse in lending growth in 2025, which has further undermined the state’s war-funding strategy

The Central Bank has warned banks not to count on the state automatically assuming the bad debts of state-owned companies and urged them to be much more conservative in their overall risk management.

This has helped drive a collapse in credit expansion in 2025, further undermining the Kremlin’s war-funding strategy (see Figure 9 ). As the Central Bank urged, the state has slowed credit expansion to the arms sectors (see Russia’s Hidden War Debt). Meanwhile, lending growth to the 73 other sectors making up the “real” economy has fallen below inflation.

Faltering finances have forced the Kremlin to cut funding for the war and hike general taxes. The cash crunch is likely to worsen in 2026 and weaken Moscow’s negotiating hand.

As its war-funding strategy began to falter in 2025, the Kremlin found that a period of abundant, low-risk cash had abruptly ended, followed by one of risk-laden cash scarcity. It has been forced to do two things it hoped to avoid: cut funding for the war and raise taxes on the public (see Figure 10).

As structural problems in banking and energy progressively worsen in 2026—spurred on by the new oil sanctions—Moscow’s cash crunch will likely intensify, weakening its leverage at the negotiating table.

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About the author

The author is a Russian energy analyst, historian and former investment banker. For over 20 years, he worked at Morgan Stanley and Bank of America Merrill Lynch, where he was a vice chairman. He has advised companies worldwide and led numerous transactions, including Russia’s largest ever corporate acquisition and financing. He received an undergraduate degree and a doctorate from Harvard and a masters from Oxford, where he was a Rhodes Scholar. He is affiliated with Harvard’s Davis Center and conducts ongoing analysis of Russian energy and finance. He is also writing a history of the Russian oil industry, from 1860 to the present, and its impact on civil society formation.

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Credit: frontispiece, Public domain. Source: https://commons.wikimedia.org

Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

© Copyright 2025, by Craig Kennedy. All rights reserved.

Endnotes

Hovhannes Aivazian (Ivan Aivazovsky), Seascape, 1860.

Executive summary

Shadow tanker sanctions are forcing Russia to rely more heavily on the sanctions-compliant mainstream fleet.

With ceasefire negotiations at an impasse, policymakers will be seeking additional ways to increase economic pressure on Russia. Recent developments around the shadow fleet provide some fresh options. Large-scale tanker sanctions in 2025 have helped significantly reduce Russia’s shadow fleet capacity—down some 46%—without destabilizing energy markets (see Figure 1).

This, in turn, has forced Russian exporters to rely increasingly on sanctions-compliant mainstream tankers to ship their oil (see Figure 2). For Moscow, quickly restoring lost shadow fleet capacity is risky, expensive and impractical.

This provides policymakers with enhanced leverage for introducing new measures to restrict Russia’s all-important oil export revenues.

Moscow’s rising dependency on mainstream tankers provides policymakers with enhanced leverage over Russia’s all-important oil exports.

Part 1 of this report examines how policymakers might use this leverage to pursue fresh options for further restricting Moscow’s oil revenues. These options include low-risk, high-impact measures that can reduce (a) the revenue per barrel realized by exporters and/or (b) overall volumes exported. Gaining control over Russia’s vital oil revenue stream would put further strain on Russia’s increasingly stretched war finances. It would also further sap Moscow’s confidence that time is on its side.

Part 2 of this report is a Russian shadow fleet “explainer” in the form of an FAQ. It aims to provide a concise, accurate profile of the fleet—its origins, function, and vulnerabilities—and to correct various misconceptions surrounding it.

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About the author

The author worked for many years as an investment banker at Morgan Stanley and Bank of America Merrill Lynch, where he was a vice chairman. During his banking career, he advised companies and governments around the world and led numerous financings, including Russia’s largest ever corporate transaction. He received an undergraduate degree in Russian studies and a doctorate in history from Harvard and a masters in Middle Eastern languages from Oxford, where he was a Rhodes Scholar. He is a Center Associate at Harvard’s Davis Center and is currently conducting research on Russia’s energy economy. He is also writing a history of the Russian oil industry, from 1860 to the present, and its impact on civil society formation.

Table of Contents

Executive summary

Preamble: Russia’s ailing oil and gas sector

Part 1: Emerging Options for further constraining Russian oil revenues

Introduction: Russia’s growing dependency on mainstream tankers

Background: the Kremlin’s flawed shadow fleet strategy

Solutions: new options for restricting Russia’s oil revenues

Part 2: Russian Shadow Fleet FAQ

Preamble: Russia’s ailing oil and gas sector

The health of Russia’s all-important oil and gas industry is steadily deteriorating under the strain of sanctions, heavy taxation, and strategic mismanagement.

Since the 1960s, Russia has relied on oil exports to the West to fund its military industrial complex. By the late 1980s, however, excessive taxation, poor strategic management and loss of access to western technology helped send Soviet Russia’s oil sector into steep decline.

While we are likely far away from a collapse of that magnitude, those same forces are at work again today—steadily degrading the health of Russia’s oil sector along with its war-funding capacity. Sector updates for Kremlin officials must make for grim reading.

Consider, for example, the litany of bad news from the oil sector:

• production costs are up and field productivity down, as Russia’s reserves of “easy” oil are progressively exhausted, while access to the advanced Western technology Russia needs for “difficult” oil is tapering off;

• sanctions have blocked Rosneft’s massive $100 billion Vostok Oil development project from coming on stream;

• refineries packed with high-end, Western equipment are suffering from lack of servicing and spare parts, not to mention a steady barrage of drone strikes;

• tanker sanctions and attrition have sidelined shadow fleet vessels worth some $8.5 billion;

• sanctions continue to cause Urals oil to be sold at far deeper discounts to benchmark Brent than was historically the case;

• year to date, oil is averaging far below the 2025 budget’s Urals breakeven price of $69.97; and

• industry investment budgets are being squeezed by higher taxes and lower revenues.

News from the LNG sector is no better:

• sanctions have paralyzed Novatek’s high-profile, $25 billion Arctic LNG 2 project just as it was loading its first cargoes, undercutting Russia’s ambition to become a top-4 LNG supplier;

• Yamal LNG’s $8 billion in annual sales to Europe could be phased out by 2027;

As for Gazprom, the company’s newly released 2024 financial results use accounting sleight-of-hand to boost headline profit numbers, while the cashflow statement shows a company that continues to lose money:

• gas export revenues are down 64% from 2022 levels;

• the company’s cash reserves fell by another $3.4 billion in 2024 (net of debt repayments);

• with $69 billion in debt and facing record-high interest rates at home, the company spent $7.7 billion in interest alone in 2024—most of which appears to have been booked as a capital expense, thus boosting headline profit figures;

• burdened with a large, regulated domestic business, Gazprom’s gas division still appears to be suffering large negative cashflows. Gazprom now relies on its profitable oil division to stay afloat;

• the company looks likely to continue losing money in 2025, off the back of lower oil prices and the termination of Ukraine transit volumes.

Though no Kremlin technocrat would dare say this out loud, many are surely thinking it. The Kremlin’s ill-judged weaponization of Gazprom’s exports to Europe decimated a business that took half a century to build. In doing so, it wiped out the main source of profit for what had been Russia’s largest taxpayer and most strategically important company. It’s hard to overstate the self-harm caused by this reckless blunder.

While the industry is unlikely to collapse, sanctions are weakening its ability to perform its dual roles of (i) funding the war-budget and (ii) driving the broader economy.

This isn’t to suggest that Russia’s energy industry will collapse tomorrow. It’s built for stress. But so long as the industry lacks access to the holy trinity of (i) advanced Western energy technologies, (ii) cheap and abundant Western risk capital, and (iii) premium Western markets, the condition of the sector is likely to deteriorate further.

And this will steadily diminish the sector’s ability not only to fund Russia’s militarized budget, but to play its role as the engine of Russia’s broader war economy.

Because it’s not just the sector’s contributions to the state budget that make it so vital to Russia’s war effort. The hard currency generated by export oil sales helps facilitate Russia’s heavy reliance on imported materiel, equipment and components for the war. Its large domestic capital and operational budgets have an expenditure multiplier effect. And both Gazprom and the Russian oil majors are obliged to provide domestic consumers with cheap, below-market energy—which amounts to a hidden tax that can be worth tens of billions of dollars a year.

In one critical area—oil export revenues—sanctions have fallen far short of their potential. Recent developments, however, provide Western policymakers with new options for further restricting oil revenues.

While sanctions have done much to help degrade the oil and gas sector’s war-funding capacity, there is one critical area where sanctions have fallen well short of their potential: reducing oil export revenues. Recent developments around the shadow fleet, however, offer policymakers some new options for stepping up the pressure on Russia’s all-important oil revenues. This report reviews those developments and outlines these options.

Overview of report

Part 1: New options for further constraining Russian oil revenues

Part 1 of this paper analyzes recent shipping data showing that tanker sanctions have sidelined a large number of Russian shadow tankers, substantially reducing the fleet’s usable capacity. That drop in capacity, in turn, has compelled Russian exporters to rely more heavily on sanctions-compliant mainstream tankers—giving policymakers enhanced leveraged over Russia’s oil export revenues. The paper then outlines how policymakers might use their improved leverage to further restrict Russia’s oil revenues. Options include pragmatic, low-risk, high impact measures that can restrict either the revenues exporters can earn per barrel and/or the volume of barrels they are able to export.

Part 2: Shadow Fleet FAQ—dispelling misconceptions

Part 2 provides an “explainer” about Russia’s shadow fleet in the form of an FAQ. It aims to provide a concise, accurate profile of the fleet—its origins, function, and vulnerabilities—and to correct various misconceptions surrounding it.

Part 1: New options for further constraining Russian oil revenues

Introduction: Russia’s growing dependency on mainstream tankers

The sharp drop in Russian shadow fleet capacity following Q1 tanker sanctions has forced Russian exporters to rely more heavily on sanctions-compliant mainstream tankers.

Since mid-January, there has been a significant shift in oil export patterns out of Russia. For certain key export streams—most notably the high-volume flow of crude out of the Baltic—the share of Russian shadow fleet tankers has been falling sharply (see Figure 3). In the second half of 2024, shadow vessels accounted for over 60% of the crude tankers loading at Russia’s Baltic terminals. By the end of March 2025, this had abruptly plunged to below 40%. Filling the gap has been a surge in loadings by mainstream crude carriers.

The collapse in shadow fleet loadings is not the result of Urals prices dropping below the $60 price cap level; the plunge was already well underway before quoted prices fell beneath the threshold. Rather, it’s the result of the abrupt and sizeable loss of usable shadow fleet capacity in the wake of OFAC’s January 10^th jumbo tanker sanctions, which targeted some 158 oil tankers. It was helped along by additional tanker sanctions by the UK and the EU at the end of February.

All told, this recent round of jumbo sanctions—along with earlier sanctions and attrition—have reduced the overall capacity of Russia’s shadow fleet by some 46%. Thus, to keep exports whole on tonnage intensive export streams—like Baltic crude—Russian exporters have been forced to rely more heavily on the sanctions-compliant mainstream fleet. Falling oil prices have simply helped get risk-averse mainstream operators more comfortable re-entering the Russian trade. But risk-friendly mainstream operators have been in the Russia trade since sanctions were introduced.

This increased dependency on Western shipping capacity provides policymakers with new leverage over Russia’s oil export revenues

This rising dependency on mainstream shippers is actually a reversion to the status quo ante before the launch of Russia’s shadow fleet initiative in May 2022. If this reversal can be maintained and further advanced, it opens up fresh opportunities for policymakers to put pressure on Russia’s oil export revenues.

Before examining those opportunities, it’s important to understand why tanker sanctions have been effective and how policymakers can enhance that efficacy.

Background: the Kremlin’s flawed shadow fleet strategy

The Kremlin hastily improvised its shadow fleet strategy in the Spring of 2022 when it belatedly realized its vulnerable oil export supply chain was at risk of sanctions.

The global oil trade is structured around a range of critical services in which Western countries play a central role. These include shipping, trading, finance and insurance.

For decades prior to 2022, Russia relied heavily on this ecosystem of services for practically all its seaborn oil exports. It was convenient, competitively priced and efficient.

This heavy reliance on Western service, however, left Russia’s oil export supply chain highly exposed to potential Western sanctions. Prior to 2022, however, Moscow showed little concern over this risk. While it toiled to safeguard its banking and other sectors from sanctions, no new initiatives were taken to safeguard its oil export supply chain. The Kremlin appeared to think Russia’s oil exports were so vital Western economies as to be sacrosanct; Western policymakers would never dare impose sanctions regardless of Moscow’s transgressions.

This illusion was punctured in weeks immediately following Russia’s February full-scale invasion of Ukraine, as select Western service providers and importers began voluntarily shunning Russian oil exports. In parallel, European public opinion quickly shifted in support of sanctions on Russian oil.

This strategy aimed to reduce Russia’s sanction exposure by building out a parallel oil shipping ecosystem free from reliance on Western services.

The Kremlin quickly realized its complacency had been ill-judged. In May, it announced a hastily improvised strategy to protect its exports from supply chain risk by building out its own, Russian-controlled export ecosystem (see Figure 4). This initiative involved a scramble to develop its own, stand-alone capabilities in finance, trading and maritime insurance.

Its centerpiece is a Russia-dedicated shadow fleet that is free from Western ties and mistakenly believed to be immune to Western sanctions.

The centerpiece of this strategy was the creation of a large, proprietary tanker fleet—commonly called the Russian “shadow fleet.” Tankers in this fleet would have two distinguishing features: (i) they would be fully dedicated to the Russia trade; and (ii) they would be free of any commercial ties to critical Western services, such as hard-to-arrange spill-liability insurance. This, it was mistakenly thought, would render them immune to Western sanctions pressure. They could carry cargoes in contravention of sanctions without fear of losing access to sanctions-compliant Western critical services, such as financing or insurance.

A fleet of over 500 exporting vessels was eventually assembled, including nearly 100 tankers from Russia’s pre-existing state fleet and over 400 tankers bought second-hand at an estimated cost of $14 billion.

The shadow fleet initiative immediately ran up against the challenge of scale. Russia accounts for roughly 10% of oil exports by producer countries. Its tanker capacity needs are very large. How would it source enough vessels that were free of ties to Western service providers?

Russia’s shadow fleet would end up being comprised of tankers from two distinct groups. The first group were tankers already belonging to Russian companies—principally Russia’s state-owned shipping company, Sovcomflot (“SCF”). These amounted to nearly 100 tankers, and they form the core of the Russian shadow fleet.

The second group of tankers came from acquisitions in the used tanker markets. In the three years since May 2022, more than 400 tankers have steadily been acquired second-hand—mostly from mainstream fleets via intermediaries it appears (see Figure 5). Once acquired, these tankers would be scrubbed of any commercial ties to Western companies—most notably, spill liability insurance. They are then put to work full time on the Russia trade. The estimated acquisition cost to date: around $14 billion, based on comparable transaction analysis.1

By the end of 2024, the legacy component of Russia’s shadow fleet accounted for some 20% of active capacity, with the recently acquired portion accounting for around 80% (see Figure 6).

It’s notable that relatively few tankers from the pre-existing “global” shadow fleet—which supports Iran and Venezuela—have entered the Russian shadow fleet. The chief barrier seems to be suitability. Many of those vessels are too large to load at Russian ports. Others, it appears, may be unwilling or unable to provide the high degree of commitment and reliability that Russia’s tightly balanced export system requires.

The flaw in Russia’s shadow fleet strategy: key importers, such as Indian refiners, are unwilling to cut ties with the mainstream oil trading ecosystem

Russia’s parallel supply-chain strategy turns out to suffer from one major flaw: major importers—like Indian refiners—weren’t prepared to sever their ties with the mainstream oil trading ecosystem (see Figure 4 above). They were happy to buy Russian oil above the price cap and to have those cargoes delivered by shadow fleet tankers—but not if it meant jeopardizing access to valuable advantages only available in the mainstream oil market. These include hard-to-replicate services and features such as:

• low-cost, quality spill-liability insurance for their massive product export businesses,

• U.S. dollar accounts for settlements,

• access to the London derivatives markets, and

• the ability to export products to Europe—Indian refiners’ largest export market.

Unwilling to put their access to mainstream services at risk, major importers are refusing to accept cargoes on sanctioned tankers.

This flaw in Russia’s strategy was made apparent in October 2023, when OFAC started a limited, 5-month campaign of direct sanctions on Russian tankers. Some 40 vessels were targeted. Each was soon sidelined, when importers refused to accept cargoes transported by a sanctioned vessel. Over the summer of 2024, the UK and the EU joined in with a phased campaign of tanker sanctions.

Consequently, tanker sanctions have been broadly effective and have helped reduce Russian shadow fleet capacity by 46%.

It wasn’t, however, until January 2025, that Western authorities issued a sanctions list expansive enough to sideline critical mass of Russian shadow fleet capacity. That’s when OFAC sanctioned some 183 vessels working the Russian energy trade, 158 of which were oil tankers. Analysis of shipping data through the end of March 2025, shows that the January OFAC listings, along with earlier tanker sanctions and some general fleet attrition, have reduced active Russian shadow fleet capacity by some 46% (see Figure 7).

The jumbo Q1 2025 tanker sanctions demonstrated that large numbers of tankers could be targeted at once without destabilizing markets.

Some observers had feared that sanctioning a very large number of Russian shadow tankers all at once could significantly disrupt the global energy markets. A collapse in Russian shadow fleet capacity might cause a sudden and severe drop in Russian export volumes or a prolonged increase in freight rates.

But those scenarios didn’t materialize. What did happen, however, is that mainstream tankers expanded their loadings in Russia to fill the void left by sidelined shadow tankers—as mentioned at the outset (see Figure 3 above).

The Q1 2025 sanctions mark an important inflection point in efforts to restrain Russia’s oil export revenues. They are proof of concept that tanker sanctions can sideline a large portion of the shadow fleet in one go without destabilizing the markets.

Solutions: new options for restricting Russia’s oil revenues

Western authorities have “cracked the code” on rolling back the shadow fleet at scale. This opens new options for restricting Russia’s oil revenues.

In effect, sanction authorities have “cracked the code” on how to roll back the shadow fleet at scale. In the process, they are compelling Moscow to become increasingly reliant once more on sanctions-compliant Western shipping services. This provides policymakers with enhanced leverage over Russia’s all-important oil exports, which opens up new options for restricting Russia’s oil revenues.

How might Western policymakers take advantage of this enhanced leverage? A potential program could look like this.

Step 1: further enhance leverage through a follow-on, large-scale round of tanker sanctions: increase dependency on Western services by further reducing active shadow fleet capacity. Policymakers might achieve this by imposing another large-scale round of sanctions on par with OFAC’s January listing; this could push dependency levels on the mainstream fleet to over 90% from key ports.

Rolling back the rest of the shadow fleet would have the additional benefits of (a) reducing environmental risk along coastlines around the world and (b) opening up more commercial opportunities for shipowners that invest the care and expense into observing international standards and regulations.

Step 2: discourage reconstitution of the shadow fleet: dissuade Moscow from attempting to rebuild its shadow fleet, by clearly signaling that any additional shadow tankers introduced into the Russia trade are at risk of being sanctioned;

Step 3: implement revenue restricting measures: introduce one or more of these value- and volume-restrictng measures:

Value-constraining measures: these are measures aimed at reducing the net revenue per barrel received by exporters.

• Lower the price cap. This uses the existing price cap mechanism. With most Russian oil shifted back onto mainstream tankers, a drop in the price cap might prove effective. But it might also still be vulnerable to price attestation fraud, if bad actor traders are providing shipowners false information.

• Impose a freight surcharge. This could be a more transparent and effective measure than the price cap. Mainstream tankers lifting from Russia would be obligated by policymakers to impose a special sanctions “freight surcharge” on top of their normal freight rates; they would then remit this surcharge to a collection agent bank appointed by policymakers (see Figure 8). Proceeds could help fund Ukraine defense and reconstruction.

Mainstream shipowners—regardless of where they are domiciled—would need to comply with the sanctions surcharge obligation as a condition of maintaining access to EU/G7-based marine insurance, ship mortgages and other critical services. (Mainstream fleet owners operating in Russia continue to show very high levels of commitment to Western based spill liability insurance.) Russian exporters would ultimately bear the cost of this surcharge, since it could not be passed on to importers in the highly efficient oil markets. A surcharge of $15 per barrel could, for example, transfer some $25 billion a year from Russian exporters to Ukraine.

Volume-targeted options: these options aim to reduce Russian revenues by curbing Russian export volumes. Given Russia’s significance in the global oil markets, any volume-related measures need to be carefully calibrated to avoid counterproductive market disruptions. Today’s soft oil markets provide a relatively low-risk environment in which to pare back Russian export volumes.

Recently, sanction authorities have tried to curb Russian export volumes by sanctioning specific producing companies. This, however, has had little noticeable effect on overall export volumes. That’s, in part, because the beneficiary ownership of most export barrels can be relatively easily obscured onshore, before they are presented for export.

• Impose loading bans at specific terminals. An alternative way to curb export volumes would be to ban mainstream tankers from lifting oil from specific Russian export terminals. There are 18 or so major active terminals around Russia, with limited options for shifting capacity from one terminal to another. Policymakers could decide what portion of Russian export volumes to remove from the market and configure terminal bans to meet those aims.

  Mainstream tankers would avoid lifting cargoes from banned terminals. Shadow tanker capacity would be too diminished to manage loads out of the banned terminals, leaving export barrels stranded on shore. As storage facilities are overwhelmed, Russian producers would be compelled to shut in some of their production.

  Targeting flows from specific terminals has several potential advantages over targeting production from specific companies:

  • it’s far easier for sanctions authorities to monitor where oil is loaded than where it is produced, limiting options for evasion through falsifying origin;

  • shippers have greater clarity over what is and is not permitted oil; and

  • it also offers the flexibility to dial up or down volumes as needed by adding or removing export terminals from the list.

Conclusion: rolling back the shadow fleet and diminishing Moscow’s control over its oil exports will further undermine the Kremlin’s confidence that time is on its side.

Maintaining control over its oil export revenues remains a strategic priority for Moscow. They are critical for funding an increasingly expensive war without having to resort to the problematic options of heavier borrowing or more tax hikes. Hence, the extraordinary effort and expense Moscow has invested into its shadow fleet strategy. But as with other major Kremlin initiatives, this strategy has turned out to be fundamentally flawed.

Western policymakers now have an opportunity to sideline Russia’s shadow fleet entirely. In doing so, they can gain significant sway over Russia’s oil revenues and exert further pressure on Moscow’s stretched wartime finances. What’s more, it would weigh on Russia’s war calculus by sapping the Kremlin’s confidence that time is on its side.

Part 2: Russian Shadow Fleet FAQ

What is the Russian shadow fleet?

When and why did Moscow develop its shadow fleet strategy?

What are the key distinguishing features of a Russian shadow fleet tanker?

Where did Russia source the tankers in its shadow fleet?

Why have so few Russian shadow fleet tankers been sourced from the “global” shadow fleet?

What happens when a tanker is acquired for Russia’s shadow fleet?

When was Russia’s shadow fleet acquired?

Who owns Russia’s newly acquired shadow tankers?

How much has Russia’s shadow fleet cost to assemble?

How does the shadow fleet help Russia circumvent sanctions?

Does that mean the Russian oil export revenues have remained undiminished by sanctions?

What has been the impact of Western sanctions imposed directly on shadow fleet tankers?

Why are these tanker sanctions effective?

With the sharp drop in available Russian shadow fleet capacity, have exports cargoes been shifting back to the mainstream fleet?

Wasn’t it the drop in the Urals price that caused the surge in mainstream fleet loadings in Russia?

Won’t Russia just buy more tankers and convert them for use in the shadow trade?

So, up to now, has Russia’s shadow fleet been a clever strategy worth the high price tag? Or a flawed strategy that wasted scarce investments resources?

What is the Russian shadow fleet?

It’s a group of over 500 vessels—many currently inactive—that has been assembled under a May 2022 Kremlin directive aimed at reducing Russia’s considerable exposure to potential Western sanctions on its oil exports.

It’s helpful to think of these vessels as a “proprietary” or “dedicated” Russian fleet—something quite distinct both from (i) the global mainstream fleet and (ii) the pre-existing “non-Russian” or “global” shadow fleet that has long serviced sanctioned regimes, such as Iran.

When and why did Moscow develop its shadow fleet strategy?

Moscow hastily devised its shadow fleet strategy in May 2022, when its long-held assumption that the West would never sanction Russian oil exports turned out to be ill-founded.

For decades, Russia has relied almost entirely on Western companies—shippers, insurers, traders, banks—to manage its seaborne oil exports. And most of those exports went to Western buyers (see Figure 9).

After the initial round of Russia sanctions in 2014, Moscow launched no new initiatives to reduce this dependency. The Kremlin appeared confident the West would never dare sanction Russian energy exports, regardless of Moscow’s transgressions.

In the weeks immediately following the February 2022 invasion, however, that confidence was shattered. Western companies involved in the Russia oil trade temporarily suspended operations to review legal and reputational risks. Export volumes collapsed, Russia’s limited storage capacity was quickly overwhelmed, and producers were forced to shut in 1 million barrels a day in output (see Figure 10).

Exports soon resumed, but the episode was a wake-up call for the Kremlin: it had misjudged Western tolerance, leaving Russia’s oil revenues seriously exposed. That risk became more elevated over the course of April, as news of Russian war atrocities increasingly turned European public opinion in favor of sanctioning Russian oil.

The Kremlin hastily improvised a plan, which Putin announced in May. Russia would undertake to create a Russian-controlled oil-export supply chain separate from the mainstream supply chain. And at its core would be a vastly expanded, Russian-controlled tanker fleet—one not reliant on Western maritime services and fully dedicated to the Russia trade.

What are the key distinguishing features of a Russian shadow fleet tanker?

To determine whether a tanker belongs to Moscow’s proprietary shadow fleet, it’s usually sufficient to look for two distinguishing markers:

1. is the vessel dedicated to the Russia trade, only handling Russian cargoes?

2. does it carry spill liability insurance issued by the Europe-based International Group of P&I Clubs (“the IG”)?2

If the answers are “yes” and “no” respectively, then there’s a very high likelihood that the tanker in question is part of Moscow’s proprietary fleet. When a tanker meets these two qualifications, further examination usually reveals additional telltale signs concerning changes in ownership history (see below: “What happens when a tanker is acquired for Russia’s shadow fleet?”).

Other markers, such as flagging, country of registered ownership, subterfuge activities—like spoofing—are far less indicative of membership in Russia’s shadow fleet.

Where did Russia source the tankers in its shadow fleet?

Russia’s shadow tankers come from two main sources (see Figure 11):

1. The core of Russia’s shadow fleet consists of close to nearly 100 tankers that were owned by Russian companies prior to 2022, principally Russia’s state-owned Sovcomflot.

2. Nearly all the rest—over 400 vessels—have been steadily acquired since May 2022 through purchases in the second-hand tanker market. Most have been bought from mainstream fleets selling off their aging assets. (These sales appear to often be conducted in back-to-back transactions involving third parties).

Consequently, when profiling a tanker lifting from Russia, if the vessel lacks an IG spill liability policy (see the previous question), a review of its ownership history will usually reveal either (a) the vessel at some point was owned by Sovcomflot or another Russia-based shipowner, or (b) that the vessel has been sold at some point since May 2022. Further examination usually reveals that at the time of sale, the vessel dropped its IG policy and began regularly lifting cargoes from Russia.

Contrary to early expectations, only a small fraction of the tankers active in the Russia shadow trade have crossed over from the “global” shadow fleet.

Why have so few Russian shadow fleet tankers been sourced from the “global” shadow fleet?

Many of the tankers in the “global” shadow fleet don’t appear to be suitable for Russia’s specific needs. Some are VLCC class tankers, which are too large to load at Russian terminals. Others simply appear unable or unwilling to provide the levels of commitment and reliability Russia’s tightly balanced export system requires.

What happens when a tanker is acquired for Russia’s shadow fleet?

To make a newly acquired tanker fit for service in the Russian shadow fleet, it needs to be scrubbed of any commercial ties to Western service providers. Such ties make it vulnerable to price-cap sanctions.

First and foremost, that means cancelling the vessel’s European-based spill liability insurance. Such insurance is mandatory under international regulations, however, so alternative arrangements must be made. Sometimes, these consist of opaque, dubious policies issued by Russian insurers. In other cases, insurance arrangements appear to have been entirely fraudulent.3

Additionally, ownership gets structured through anonymous shell companies in various low-transparency offshore jurisdictions. Vessels are also often reflagged to national registries with a reputation for lax enforcement of global shipping standards and regulations.

When was Russia’s shadow fleet acquired?

Russia’s shadow fleet has been steadily acquired over the last three years (see Figure 12. The highest concentration of purchases happened in Q4 2022 and Q1 2023, as the price cap was coming into force.

Who owns Russia’s newly acquired shadow tankers?

Ultimate beneficiary ownership cannot be determined based on public information. Various data points—acquisition patterns, commercial and technical managers, reflaggings, etc.—along with other information suggest ownership is likely distributed among a wide range of companies and investments groups that are either Russian or Moscow-friendly. All are likely to be working closely in league with the Russian state. As common in state-capitalist systems, the line between state and private sector activity is often blurred.

How much has Russia’s shadow fleet cost to assemble?

Estimated acquisition costs since May 2022 come to around $14 billion, based on comparable market transaction analysis. Many of these acquisitions have likely been financed with state-directed concessionary loans

As for Russia’s legacy fleet, most of these vessels were acquired as new builds more than a decade ago. Estimated current market value of the legacy fleet on a like-for-like basis comes to around $3.5 billion.

How does the shadow fleet help Russia circumvent sanctions?

Russia’s shadow fleet strategy circumvents sanctions by avoiding reliance on Western service providers in the export supply chain, rather than concealing the origins and destinations of their cargoes.

Contrary to much reporting, Russia’s shadow fleet doesn’t rely primarily on subterfuge to evade sanctions. Most don’t routinely manipulate their AIS signals (“spoofing”) or engage in “dark” ship-to-ship transfers.

That’s because concealment isn’t required to evade most of the current Russian oil sanctions. Until very recently, Russian oil sanctions have mostly focused on value, not volume. They aim to constrain the value-per-barrel that Russia gets for its oil, rather than reduce the overall volume of exports. That is the explicit aim of the price-cap—to limit value. And price-cap related sanctions were mostly primary in nature—they only applied to companies based in the sanctioning states.

Accordingly, Russia’s circumvention strategy has involved creating a parallel supply chain/export ecosystem that doesn’t rely on any critical Western services (see Figure 13). By avoiding any reliance on Western services—so the thinking went—Russia’s shadow tankers could openly ship cargoes priced above the cap and importers could safely purchase them.4

(In January, however, OFAC sanctioned two specific oil companies, Gazprom Neft and Surgutneftegaz. This has created an incentive for concealment that may prove—in some cases—to be counterproductive. As argued elsewhere in this report, export terminal bans may be a more effective means of restricting export volumes).5

Does that mean the Russian oil export revenues have remained undiminished by sanctions?

No. Western sanctions have significantly reduced Russia’s oil export revenues—by many tens of billions of dollars since late 2022. Nonetheless, it’s fair to say that sanctions have fallen far short of their potential for limiting Russia’s export earnings, while avoiding counterproductive market disruptions.

To date, Russian oil export sanctions have targeted value, rather than volume. They have sought to reduce how much Russia receives per barrel on its exports. A simple way to observe the impact that sanctions have on value is by tracking the discount at which Urals grade crude trades relative to benchmark Brent. Historically, Russian exporters could sell Urals at port in the Black Sea or the Baltic—on an “FOB” basis—for a $1 to $2 per barrel discount to Brent. The buyer would then pay for freight and insurance.

Since 2022, however, the Urals discount has exploded, ranging from $10 to $40 per barrel (see Figure 14). What’s caused it to widen so? Two things.

First, there is the EU/G7 ban on Russian oil. Historically, the largest market by far for Russian oil exports was nearby Europe. Most of Russia’s pipeline, and export terminal infrastructure—even many of its refineries—were developed with the aim of facilitating sales to Europe (see Figure 9 above).

The import ban, however, has forced Russian oil to travel much further to market, pushing up freight costs and pushing down FOB prices—which are net of freight. To make matters worse, the import ban means Russia must now sell into a smaller pool of demand. This weakens Russia’s bargaining power, forcing it to offer significant discounts, especially to very large buyers like India.

Second, the price cap figures in as well. A significant amount of Russian exports have continued to be transported by sanctions-compliant mainstream tankers. There is evidence that Russian exporters have managed to hire mainstream tankers to carry cargoes priced above the cap by providing fraudulent attestations about the price of their cargoes. Nonetheless, the heightened risk that mainstream tankers assume when lifting oil out of Russia has likely contributed to a “Russia risk” premium that mainstream shippers price into their freight charges, especially when reported market prices are above the price cap.

What has been the impact of Western sanctions imposed directly on shadow fleet tankers?

On the whole, direct tanker sanctions have been effective, although their impact has been lessened by long delays and—some would argue—an excessively restrained approach. In October 2023, OFAC launched a measured campaign of tanker sanctions. It consisted of a series of small-scale listings phased over a 5-month period that ended up targeting some 40 shadow fleet tankers.

These direct sanctions proved highly effective in removing tankers from normal commercial service. Practically all targeted tankers stopped loading oil for export. The problem wasn’t effectiveness, but scale. These sanctioned vessels amounted to less than 15% of Russia’s then-active shadow fleet capacity. Additional purchases compensated for this loss.

In the summer of 2024, the UK and the EU also began directly sanctioning shadow tankers, which helped further disrupt Russian shadow shipping patterns.

It wasn’t, however, until January 2025, that direct tanker sanctions caused a major and sudden reduction in active shadow fleet capacity. That’s when OFAC resumed tanker sanctions with a jumbo listing that targeted over 180 vessels.6 In late February, the EU and the UK also issued substantial lists.

By late March 2025, some 46% of Russia’s proprietary shadow fleet had been effectively removed from normal commercial service (see Figure 15). That’s mostly the result of tanker sanctions, with attrition also accounting for a modest fraction.

Why are these tanker sanctions effective?

Tanker sanctions are effective, because many of Russia’s large oil-importing customers don’t want to receive oil shipped on sanctioned tankers. These importers value their access to mainstream oil trading ecosystem, and don’t wish to put that access at risk. Consequently, Russia has been forced to sideline most of its sanctioned tankers and provide “clean,” unsanctioned tankers when delivering to these customers.

This sidelining of sanctioned tankers reflects a fundamental flaw in Russia’s parallel supply-chain strategy (see Figure 13 above). Moscow managed to execute part of that strategy, but not all of it. It has managed to create several Russian-controlled links that are free from Western commercial ties, such as trading, shipping, and insurance. But it has failed to replicate the final, critical link: a set of major importers willing to sever ties with the mainstream oil trading ecosystem.

This is a critically important point. Russia’s biggest importers are Indian, Chinese and Turkish refiners. Most of these greatly value unfettered access to the mainstream oil trading ecosystem. That ecosystem is structured around a range of valuable Western based services that Russia’s own supply chain simply can’t offer—and many of Russia’s biggest customers simply don’t want to do without.

Take, for example, large Indian refiners. India is the world’s second largest refined product exporting country. To deliver their export cargoes to market, Indian refiners depend on tankers insured —and often owned—by European companies. Not only is Europe providing the shipping, it’s also the most prized and largest market for Indian product exports. To hedge risks, Indian refiners rely on the massive, London-based oil derivatives markets. And they rely on access to U.S. dollar accounts for settlement, since the global oil trade is dollar denominated.

So it was no surprise when, in February, India’s oil minister said it would not accept any Russian oil delivered on US-sanctioned tankers. As one official said: "We don't want to take risk. We are not going to touch any cargo that involves sanctioned entity or ships in the supply chain.”

With the sharp drop in available Russian shadow fleet capacity, have exports cargoes been shifting back to the mainstream fleet?

Yes, they have. The jumbo sanctions from Q1 2025 have sharply reduced the shadow tanker capacity available to Russian exporters. Rather than cut exports, they have been chartering more mainstream tankers.

This is especially evident among crude tankers loading in the Baltic. Crude exports from Russia’s Baltic terminals rely more heavily on shadow fleet tonnage than any other export streams. The loss of shadow tanker capacity has been especially pronounced here.

Consider the following. In the second half of 2024, less than 40% of the crude tankers loading at Russia’s Baltic ports were from the mainstream fleet. The shadow fleet averaged over 60%. By the end of March 2025, however, those ratios had reversed, the shadow fleet loadings plunging below 40% (see Figure 16).

Wasn’t it the drop in the Urals price that caused the surge in mainstream fleet loadings in Russia?

No. This argument confuses causality. Some commentators have incorrectly ascribed the increase in mainstream tanker loadings to the fall in the Urals price below the cap. The surge began well before Urals dropped below the cap. That’s because exporters faced a sudden drop in the availability of unsanctioned shadow fleet tonnage and opted to charter more mainstream tankers, rather than shut in production.

Throughout the period the price cap has been in place, mainstream tankers have been active in the Russia trade—even when quoted FOB prices were far above the price cap. They were allowed to do this under the sanctions rules, because they received attestations claiming their cargoes were priced at or below the cap. Many of these attestations may have been fraudulent, but that was a risk at least some mainstream operators were prepared to take—though not all.

Almost immediately after OFAC’s January 10 jumbo listing, a shortage of available, unsanctioned shadow tankers was felt along shadow-heavy export routes, in particular crude flows out of the Baltic. Risk-friendly mainstream tankers responded quickly to fill the void, and the resulting surge in mainstream loadings was already apparent in the second half of January (see Figure 16 above). That happened despite the Urals price remaining above the cap at that point. And throughout the second half of January, the quoted Urals price remained above the price cap.

As global oil prices dropped further in Feburary, Urals dropped below the cap. It’s at that point that more risk-averse operators among the mainstream fleet felt comfortable re-entering the Russia trade. And they have found demand for their services, because of the collapse in available unsanctioned shadow fleet tonnage.

Which raises an interesting question: if the price cap were dropped well below the current price (now in the low 50s), what would happen? Would enough risk-friendly mainstream operators remain to meet Russia’s needs without a further drop in the price? Or would Russia have to drop its prices to attract the more risk-averse mainstream operators?

Won’t Russia just buy more tankers and convert them for use in the shadow trade?

Probably not—at least not at anything like the previous scale. Assembling the shadow fleet was a very costly proposition, requiring hundreds of tankers to be purchased in the used markets over the course of the last 3 years. As noted above, an estimated $14 billion has been spent acquiring these vessels. The like-for-like market value of the sanctioned tonnage is approximately $8.5 billion based on past comparable transactions. Replacing those tankers by buying in the used market would almost certainly bid prices up even higher. So, this would be a slow and very costly process to begin with.

What’s more, the success of the Q1 jumbo sanctions in sidelining shadow tankers acts as a huge disincentive to investing more in the fleet. If Western authorities can render a tanker commercially unusable simply by putting it on a list, spending billions more in precious investment capital risks throwing good money after bad.

The same disincentives would also discourage shipowners from the “global” shadow fleet from chartering out their vessels into the Russia trade. If it carried a high risk of a direct sanction, many owners might prefer not to take the risk.

Much, however, depends on the posture of Western sanctioning authorities. If they continue to actively discourage importers from accepting cargoes shipped on these vessels, then Russia is unlikely to go on another used tanker shopping spree.

So, up to now, has Russia’s shadow fleet been a clever strategy worth the high price tag? Or a flawed strategy that wasted scarce investments resources?

On balance, Moscow’s shadow fleet appears to have been a flawed and costly strategy. A few of the vessels in the fleet—those working the short haul Pacific trade—have almost certainly been good investments. The ESPO oil price has traded far above the price cap, meaning each shadow tanker cargo captures significant margins above the cap. The short-haul routes to China mean a tanker can deliver many cargoes in a year.

But Russia’s Pacific trade requires only a fraction of the total tonnage needed to keep Russia’s exports flowing. Had Moscow simply maintained a small shadow fleet focused on that trade, it would almost certainly have been a lucrative investment.

The same can’t be said for the shadow trade out of the Baltic. Most of these tankers have been carrying Urals, which has often been below the price cap since December 2022 (see Figure 12). Shadow tankers working the Baltic-to-India route can take up to five times as long to complete a round trip as their Pacific counterparts. Most of these tankers have probably not generated enough additional above-price-cap revenue to justify their high price tags and hefty financing costs.

Worse still, many have had their commercial lives cut short by sanctions. Many of those vessels almost certainly have acquisition loans still outstanding, but no income stream with which to service these loans.

So, while a fraction of Moscow’s acquired fleet has generated very healthy returns on investment, the large majority have almost certainly been a waste of money on a large scale. That marks another failure in strategic thinking by Moscow’s often overhyped technocracy. Billions get spent on a fleet to circumvent sanctions when the fleet itself turns out to be highly vulnerable to direct vessel sanctions.

But then it’s worth recalling that these are the same people who complacently assumed that Western markets and service providers would continue to fully support Russia’s oil exports regardless of any transgressions by Moscow. That mistaken judgement—as we saw above—led to the March-April 2022 export crisis, which led the Kremlin to hastily improvise its shadow fleet strategy. And, thus, one strategic misjudgment led to another.

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Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

© Copyright 2025, by Craig Kennedy. All rights reserved.

Endnotes

Working Draft

This report identifies a new dimension of Russia’s war-funding strategy: a heavy reliance on off-budget debt to supplement its defense budget allocations. Excessive reliance on this off-budget funding strategy has elevated Russia’s systemic credit risk to a point that it is constraining the Kremlin’s war finances and could weigh on it war calculus.

Summary

Moscow has been stealthily pursuing a dual-track strategy to fund its mounting war costs. One track consists of Russia’s highly scrutinized defense budget, which analysts have routinely deemed “surprisingly resilient.” The second track—largely overlooked until now—consists of a low-profile, off-budget financing scheme that appears to make up a major portion of Russia’s overall war expenditures. Under legislation enacted in February 2022, the state has taken control of war-related lending at Russia’s major banks. It is directing them to extend preferential loans—on terms set by the state—to a wide range of businesses providing goods and services for the war. Since mid-2022, this state-directed war-funding scheme has helped drive a large part of Russia’s anomalous ₽36.6 trn ($446 bln) surge in overall corporate borrowing.

Initially, this off-budget war-funding scheme proved advantageous to Moscow by helping limit defense spending in the budget to levels that are easily managed. That misled budget-watchers into concluding—incorrectly as it turns out—that Moscow faces no serious risks to its ability to sustain funding for its war on Ukraine. More recently, however, Moscow’s heavy reliance on state-directed preferential lending has begun to cause serious, adverse consequences at home. It has become the main driver of Russia’s 10% inflation and has sent the Central Bank’s key rate to a record 21%.

More broadly, Russia’s off-budget war debt is significantly elevating systemic credit risk, both for the near- and medium-term. High interest rates are driving up corporate distress levels in the “real” economy and raising fears of widespread bankruptcies. The Central Bank has voiced concern over “aggressive” lending and inadequate capital buffers in the banking industry. What’s more, the state has now saddled the banks with large amounts of problematic, corporate war loans. Many could turn toxic once the shooting stops and defense contracts get cancelled. Worse still, relaxed oversight rules on defense-related loans mean bank regulators might not see these problems arising until it’s too late.

By late 2024, the Kremlin had been briefed on these rising risks and warned that change is needed. This poses a dilemma for Putin: continue relying on off-budget debt, and you further increase the risk of cascading credit events that undermine Russia’s image of “surprising resilience” and weaken its negotiating leverage. The alternatives: a major increase in the budget deficit—with the bad optics that entails—or a sharp reduction in spending on the war. This may explain Putin’s recent complaint to his generals that they can’t “keep pumping up spending to infinity.”

These new developments are likely to affect Moscow’s war calculus in two ways:

1. Moscow will be less inclined to believe time is on its side—the longer it must fund elevated war costs, the greater the risk of escalating credit events;

2. Moscow will prioritize sanctions relief aimed at boosting cashflows to help with politically perilous post-war debt restructuring and rearmament. Concessions that would provide the greatest cashflow relief include (i) an easing of oil sanctions, (ii) the resumption of pipeline gas deliveries to Europe and (iii) the unfreezing of Russia’s wealth fund.

Given Russia’s financial challenges, maintaining these constraints on Russia’s cashflows insures Ukraine and its allies retain substantial leverage. If kept in place past a ceasefire, they could be instrumental in securing a final, comprehensive peace settlement—including reparations.

About the author

The author worked for many years as an investment banker at Morgan Stanley and Bank of America Merrill Lynch, where he was a vice chairman. During his banking career, he advised companies and governments around the world and led numerous financings, including Russia’s largest ever corporate transaction. He received an undergraduate degree in Russian studies and a doctorate in Russian and Middle Eastern history from Harvard and a masters in Middle Eastern languages from Oxford, where he was a Rhodes Scholar. Currently, he conducts research on Russia’s energy economy at Harvard’s Davis Center and is writing a history of the Russian oil industry and its impact on civil society. He also is the author of the Substack Navigating Russia.

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Table of Contents

Introduction: In Search of Russia’s War Debt

Chapter 1: Russia’s Anomalous Corporate Credit Surge

Chapter 2: The Relentless Driver of the Credit Surge—State-Directed, Preferential Bank Loans

Chapter 3: How the Kremlin Seized Control of Defense-Related Bank Lending

Chapter 4: How Big is Russia’s Off-Budget War Debt? A Broad Estimate

Chapter 5: Moscow’s Conjuring Trick. How Off-Budget War Debt Keeps the Defense Budget Looking “Surprisingly Resilient”

Chapter 6: A New Threat on the Kremlin’s Radar—Credit Event Risk

Conclusion: Bonfire of the Cashflows

Appendix 1: Credit Surge Raw Data

Appendix 2: Russia’s Evolving Business of War. Identifying War-related OKVED2 Industrial Sectors

Introduction: In Search of Russia’s War Debt

Where is Russia’s war debt? Burdened by sanctions and showing only modest revenue growth, how is the Russian state paying for Europe’s largest war in 75 years while borrowing so little?

Where is Russia’s war debt? That is one of the puzzles of Russia’s full-scale invasion of Ukraine. Large wars normally go hand in glove with heavy state borrowing. Indeed, Western banking arose in part to help states pay for increasingly expensive wars.

And yet, Russia—despite waging Europe’s largest war in 75 years—appears to be paying nearly all its war costs out of pocket, from current tax revenues. At least that’s the impression one gets on initial inspection of the numbers. Federal budget deficits have been remarkably modest—under 2% of GDP in 2023 and 2024. So too has the state borrowing used to cover them. At the same time, Moscow’s budget revenues have grown very little in real terms since 2021. And sanctions have denied Russia access to most of its sovereign savings.

So, how, then, is Moscow covering the extraordinary costs of what looks to be a very expensive war? Where is the money coming from? Even the Soviet Union imposed war bonds on the public. Where are Russia’s “Special Military Operation” bonds?

Western analysis of Russia’s war finances often focuses too narrowly on the federal budget, overlooking a large “off-budget” component in Russia’s war-funding strategy.

Close observers of Russia’s budget will be quick to respond that the defense part of the budget has been growing much faster than the budget itself, thus boosting funding for the war. That observation is undeniably true. But it also illustrates a methodological problem in how we have been analyzing Russia’s war finances. We have been laboring under the assumption that the Kremlin runs all revenues and costs for the war through the federal budget. Consequently, all matters are viewed through the lens of the budget, and all questions are answered with reference to the budget. For example, when we ask “where is Russia’s war debt?” the answer comes back “there’s no substantial new debt in the budget, so it must not exist.”

But is it reasonable to limit ourselves to the budget when assessing Russia’s war finances? After all, any IMF official3 or scholar of state capitalism4 will tell you, the boundary between public finances and private markets is often blurred. Almost every state transgresses this boundary from time to time to direct private capital towards political priorities. Some, however, do it more frequently than others.

Examining relevant financial evidence outside the budget changes our picture of Russia’s war funding strategy and the risks around it.

Why should we think Russia—no stranger to transgressing boundaries—is any different? Why should we assume the Putin regime—facing its most costly and risk laden crisis ever—is scrupulously observing the boundary between Russia’s budget finances and the private capital markets? Perhaps it’s time to set aside these presuppositions and look at the relevant data with fresh eyes.

That is what this report aims to do: to take a fresh look at Russia’s war-funding strategy by broadening the scope of analysis beyond the budget. And once we do that, we begin find data and other evidence showing that Russia’s elusive war debt does, in fact, exist. Indeed, it appears to be quite substantial. It’s simply not sitting on the government’s balance sheet, where you’d normally look for it. Instead, it’s somewhere unexpected, lightly camouflaged, but otherwise hiding in plain sight.

The three key conclusions of this report

Based on analysis of this extra-budgetary data and evidence, this report draws three key conclusions:

1) the Russian state has been drawing discreetly but heavily on financial resources from outside the budget to fund its war effort; this “off-budget” funding strategy is a material part of its overall war-funding strategy;

2) Moscow’s off-budget strategy suffers from serious structural flaws; its overuse has elevated systemic risks in the economy, especially credit event risk;

3) By Q4 2024, senior figures in Moscow had begun recognizing the risks posed by their off-budget funding strategy; they now face a funding dilemma that could weigh on their war calculus.

The Kremlin’s strategy for dealing with the cash crisis at Gazprom offers insights into its off-budget strategy for funding its war costs: raise cash by borrowing in the corporate debt markets.

A confession. When I first stumbled across evidence of Russia’s missing war debt, it was quite by accident. I was investigating a different, but related, debt puzzle: how the Kremlin was dealing with the dual funding crises it had inflicted on Gazprom, its largest taxpayer.

After the Kremlin crippled Gazprom’s core business—exports to Europe—the company’s once mighty gas division was hemorrhaging cash. Those losses, in turn, threatened to trigger a debt service crisis. Gazprom is one of the world’s largest corporate borrowers. At the end of 2023, it was laboring under an estimated gross debt of some $80 billion, based on its IFRS accounts. With most of its European revenues gone and its domestic business apparently losing money, how would Gazprom manage its towering debt load?

As Russia’s most strategically important company, Gazprom’s cash problems were not only a challenge for management, but for the government as well, which owns a controlling stake in the business. My question was: how would the state respond to this funding crisis? Would it liberalize domestic gas prices? No—that’s way too inflationary and risked social unrest. Would it cut the gas giant’s taxes? No—the federal budget was already running a deficit.

Instead, the government’s solution was more radical: have Gazprom do something that’s rarely advisable for a debt-laden company with a structural cashflow deficit—borrow more money. And that’s exactly what the company did—and at record high interest rates. Since late 2022, the group has issued nearly 40 separate ruble bonds in Russia’s local markets raising ₽1.4 trillion ($15.8 bn). By late 2024, its borrowing costs had topped an eyewatering 22%. By comparison, as recently as November 2021, Gazprom had borrowed in the London markets with a razor thin coupon of just 1.85%.

The state is pragmatically, but recklessly, using Russia’s credit markets to channel money quickly where it’s needed, but with little apparent regard to how that debt gets repaid.

Gazprom’s slow-motion cashflow trainwreck is still playing out. But that’s a story for another day.

It does, however, bear on this report in two important ways. First, it reveals one of the strategies the Kremlin is using to address emergency funding needs in the teeth of a crisis. If a company needs funding quickly, as Gazprom did, the state has the company raise that cash in the corporate credit markets. For a sophisticated borrower like Gazprom, that can be done through the bond market. But it can also be done through Russia’s much larger corporate bank loan markets as well.

When you think about it, that’s a pragmatic funding strategy for the state: the corporate credit markets are Russia’s deepest, most liquid pools of readily investable capital. Money can be raised fast and at scale. And the government doesn’t have to mess around with adjustments to the federal budget or amendments to the tax code. If a strategically important company like Gazprom is short on cash, just find someone who will lend it to them.

But this can be a reckless strategy, too. Especially if it prioritizes political expedience over commercial concerns like the borrower’s credit quality and liquidity profile. Bank credit committees and regulators are there to reduce the risk of imprudent lending. Politically directed lending, however, often dispenses with these safeguards.

Russian markets keep lending heavily to a troubled Gazprom—₽1.4 trillion ($15.8 bn) and counting—because they see it as “too big to fail.” It’s just thinly veiled government debt.

Based solely on Gazprom’s deteriorating credit statistics, a sober credit committee might think twice before lending to the cash strapped company. But for special companies like Gazprom, creditworthiness isn’t just the sum of its cashflows—intangible factors also come into play. As Russia’s most strategically important company and a quasi-sovereign borrower, it’s the quintessence of “too big to fail.” And that’s pretty much what the Russian credit rating agencies have been saying in their reports when explaining their AAA rating for Gazprom’s ruble bond: ignore the company’s fundamentals—the state will never let this company go under.5 And this explains why the markets keep taking up new Gazprom issuances: in their eyes, it’s just thinly veiled government debt.

The state, in effect, is imposing losses at Gazprom by making it to supply the Russian market at deeply discounted prices, and then having the company cover those losses borrow heavily in the market. Meanwhile, the market is willing to lend because it believes the state will bail out Gazprom if it gets into trouble.

In the short term, that’s a nice outcome for the government. It spares the government the burden of having to raise debt or taxes to subsidize Russian gas prices. So, to all outward appearance, the state appears unfazed by the steep decline of its one-time national champion. In reality, there’s plenty of lending happening against the state’s credit; we just don’t see it, because it’s all on Gazprom’s balance sheet. But sooner or later there will be a reckoning—Gazprom can’t finance losses with debt forever. And when that happens, the state (and the taxpayers) will have to pay the bill—unless, of course, large-scale sales to Europe resume…

It’s not just Gazprom borrowing aggressively. There’s been an anomalous and large 71% surge in corporate debt since mid-2022, up ₽36.6 trn ($446 bn)…

So, the situation at Gazprom reveals how the state is using the corporate credit markets to address funding crises by having them lend money directly to the companies that need it. And for a sophisticated, too-big-to-fail company like Gazprom, that’s not a huge surprise; it’s a pragmatic stop-gap solution, especially if you think you can scare Europe into resuming Russian gas purchases with hollow threats of sending it all to China.

What did come as a surprise, however, was the second thing I came across in my Gazprom research. It turns out that Gazprom isn’t the only Russian company borrowing with abandon. When you dusted off the Central Bank’s much neglected data set on Russian corporate borrowing, something quite remarkable and unexpected appeared: a perfect hockey stick—a long flat trendline that suddenly inflects upward (see Figure 1).

Figure 1

…its scale is very large. It dwarfs key budget metrics, like oil and gas revenues, the defense budget or incremental government borrowing…

After years of low growth, in mid-2022, Russian companies suddenly began borrowing aggressively. The scale of incremental corporate borrowing was immense: ₽36.6 trn ($446 bn) from July 2022 through November 2024 (see Appendix 1).6

That’s 1.9 times the size of the defense budget for the same period, 7 times what the state had borrowed and 21.3% of 2023 GDP (see Figure 2). And it perfectly coincided with Russia’s partial shift to war footing.

Figure 2

…and the sectors taking on new debt the fastest are those providing goods and services for the war—2.7 times faster than non-war-related sectors

Moreover, closer examination of the data revealed the borrowing was highly concentrated in industry sectors providing the goods and services you would need to wage a large-scale land war. These war-related sectors consist of 4 core arms manufacturing sectors and 11 additional sectors providing essential goods and services required by the state for the war (see Appendix 2). Debt growth rates for these two war-related sectoral groups have tracked very closely with one another (see Figure 3). And since mid-2022, they have sharply outpaced debt growth in Russia’s 63 non-war-related industry sectors.

Figure 3

If this is Russia’s elusive war debt, why has the state chosen to impose it on companies providing war-related goods and services to the state, where credit quality has been notoriously poor?

So, was this it? Had I stumbled across Russia’s elusive war debt?

But it didn’t make sense. Why would you load up a lot of corporate balance sheets with war debt? Russia’s core arms manufacturers are nothing like the sophisticated, once-cash-rich Gazprom. They are notoriously bad credits, living hand-to-mouth off underpriced government contracts and perpetually on the brink of insolvency. As for the legion of new companies enlisted into war effort, they might be more efficient businesses, but their wartime contracts would dry up as soon as the shooting stopped. Why would banks take on so much risk? How are they going to get repaid? Not all these borrowers are too big to fail. How could bank credit committees sign off on such madness?

Since 2011, the state has orchestrated off-budget bank loans to defense contractors to discreetly supplement the politically sensitive defense budget—a funding strategy dubbed the “credit scheme”

It was then that I recalled the Russian defense sector’s quiet history of off-budget “credit scheme” financings. Back in 2007, Vladimir Putin launched a high-profile rearmament program. His promise to Russia: deliver Soviet-era military strength without Soviet-style economic mismanagement.

But within 3 years, the program had gone off the rails. His initial rearmament budget—highly unrealistic and poorly managed—quickly disappeared into the blackhole of Russia’s military industrial complex with little to show in return.

It was an embarrassing scandal, and it posed a dilemma. To get the program back on track would require a major increase in spending. But a big hike in the defense budget risked undermining Putin’s carefully cultivated image as a responsible steward of the public purse.

As it would many years later with Gazprom, the Kremlin turned to Russia’s corporate credit markets for a funding solution. Dubbed the “credit scheme,” it involved banks making sizeable state-guaranteed “loans” directly to arms manufacturers. It was launched on New Years Eve 2010, with an edict issued by then Prime Minister Putin. As Julian Cooper, a veteran scholar of the Russian defense sector, observed not long after:

“[the] resort to sizeable state guaranteed credits is also a means of supplementing the defence budget: the real volume of military expenditure is now larger than shown by the budget alone.”7

In short, the “credit scheme” enabled the Kremlin to manage the politically sensitive problem of high defense costs by discreetly funding a portion of them “off-budget” with the help of the banks.

The credit scheme suffered from structural flaws—especially the need for frequent bail outs by the state—but it proved politically expedient in the decade up to 2022.

Over the short-term, this scheme worked quite well. But it suffered from two fundamental flaws. First, many of the borrowers couldn’t repay the debt—in fact, they probably struggled just to service the interest. Starting in 2016, the state had to step in almost annually with large bail outs that got discreetly booked in classified sections of the budget. The heavy debt burden impeded the performance of the contractors. And it created risk for the lending banks, which appear to have suffered losses despite credit support from the state.

Despite these problems, however, the state remained committed to this off-budget funding scheme and encouraged its expansion. Levering up the defense sector with debt helped reduce the headline number on the defense budget—and that it seems was deemed a good thing.

The Kremlin greatly expanded this off-budget defense funding scheme in 2022, even passing legislation obligating banks to lend on terms unilaterally imposed by the state

In the run up to 2022, as the Kremlin was planning how to pay for the extraordinary costs of a full-scale invasion of Ukraine and the large-scale occupation that could follow, it saw this off-budget credit scheme as an important part of its war-funding strategy.

But here it ran up against the second flaw in the credit scheme. To work, the banks needed to be on board, since it was their credit creating capacity that allowed the scheme to work. But the banks appear to have sustained losses in the 2019/2020 bailout had reportedly soured on lending to the problematic sector.

When it comes to getting the banks to cooperate, the Kremlin, of course, can always twist arms and call in favor. But doing that at scale is cumbersome and inefficient. So, to make sure the banks didn’t drag their feet about taking more exposure to bad credit risks, the Kremlin did something quite remarkable. In December 2021, it quietly introduced legislation legally obligating banks to extend preferential loans to defense-related companies on terms unilaterally set by the state—size, maturity, credit qualifications, everything. In short, on the eve of its full-scale invasion of Ukraine, the Kremlin was formally seizing control of defense-related lending at Russia’s leading banks. The law was passed and signed into effect on February 25^th, 2022, as Russian armored columns continued to pour across the Ukrainian border.

Outline of the report

This report focuses primarily on what happened next: how Moscow has used the off-budget funding scheme as a stealthy component of its overall war funding scheme. It estimates the size of the scheme and shows it to be material relative to defense budget spending. It explores Moscow’s rationale for relying on this scheme—which appears to be similar to what it had been prior to 2022: to manipulate public perceptions around defense spending for political gain. And it identifies how the flaws inherent in the regime have elevated systemic risks—especially credit risks—in Russia, as the state has relied excessively on this flawed system of hidden state borrowing to cover its mounting war costs. It concludes with thoughts about how Moscow’s loosening grip over its key sources of cash is likely to weigh on its war calculus.

Chapter 1 reviews Russia’s anomalous and large-scale corporate credit surge and benchmarks it against the federal budget.

Chapter 2 examines a striking discovery the Central Bank of Russia (CBR) made during its ongoing struggle to tame high inflation by cooling corporate borrowing. As it has hiked the key rate from 7.5% to 21%, it observed a “highly heterogeneous” response by borrowers. Debt levels among companies borrowing at normal market terms stopped growing—as expected. But borrowing by a second group of companies enjoying state-backed “preferential loans” continued to surge upward, “insensitive” to rising rates.

Chapter 3 recounts the rise of systematic state-backed preferential lending to fund the defense sector. It tells the largely untold story of the “credit scheme” (кредитная схема), briefly described above, including a remarkable twist in the plot that occurred in late 2021, when the Kremlin was planning funding for its full-scale invasion of Ukraine. Intent on expanding the credit scheme to fund invasion and occupation but apparently concerned the banks might not be fully cooperative, the Kremlin quietly pushed through a new law imposing full state control over all war-related lending at Russia’s leading banks. It was a classic state-capitalist power move.

Chapter 4 analyzes Central Bank sectoral data on corporate lending to determine whether the scale of state-directed, off-budget lending for the war is a material part of Russia’s overall war funding strategy. It measures lending growth in 15 war-related sectors and estimates how much of that has gone to fund war-related goods and services. Even on conservative assumptions, off-budget lending appears to have been a material part of Russia’s war funding strategy. The quantitative and qualitative analysis used to identify the industrial sectors engaged in war-related activities is presented in Appendix 2.

Chapter 5 addresses the question of Russia’s motive for relying so heavily on off-budget funding for the war, rather than funding more of it through the state budget. It runs hypothetical analysis showing how consolidating all Russia’s war costs on the state budget could have substantially increased both the defense budget and state borrowing needs. It argues that the credit scheme continues to serve the same function as it did prior to 2022: to gain political advantage by manipulating public perceptions around the size of Russia’s defense spending. By limiting visible spending in the budget, the credit scheme helps Russia’s war finances appear “surprisingly resilient,” “sustainable,” and facing no significant risk. That image enhances Russia’s bargaining power in any eventual negotiations.

Chapter 6 observes how Moscow’s excessive reliance on its off-budget credit scheme has elevated systemic economic risk in Russia, especially credit event risk. The CBR has identified corporate credit growth as the primary driver of Russia’s high inflation and state-directed preferential lending as the main driver of corporate credit growth. That means Moscow’s off-budget credit scheme is helping fuel inflation.

Beyond inflation, the Kremlin’s off-budget credit scheme is elevating systemic credit risk—in 3 ways.

(i) by increasing financial distress in the “real” economy. The CBR says the rate insensitivity of preferential lending weakens the effectiveness of rate hikes; only “real” economy companies curb borrowing. Consequently, to achieve its inflation targets, the CBR must hike even more aggressively. That has driven rates to prohibitive levels (21%), increasing the risk of financial distress in the real economy—as reports of looming bankruptcies in the coal mining sector reflect.

(ii) by eroding credit quality and weakening regulatory oversight in the banking sector. The CBR has voiced concern over “aggressive” lending, and inadequate liquidity and capital buffers in the banking sector, brought on in part by a 2022 relaxation in macroprudential policies in response to sanctions. Worse still, prior to 2022, the CBR is reported to have greatly eased reporting and monitoring requirements around defense-related lending. Consequently, it’s possible financial sector loan statistics look healthier than they really are—and neither the regulator nor the banks themselves have an accurate read of the true levels of risk exposure;

(iii) by increasing the likelihood of large-scale restructuring needs among war-related borrowers. A ceasefire will likely deliver a double-blow to war-related borrowers: a reduction in contract revenues and access to soft loans. A large wave of defaults could ensue crystallizing credit risk at the banks and imposing an immense bailout burden on the state.

The Conclusion observes that wars are fought on cashflows, and that the Kremlin has gradually been losing control over its 3 key sources of cash: (i) its sovereign wealth fund, (ii) oil and gas revenues and (iii) domestic borrowing. It argues that this is likely to weigh on Russia’s war calculus in 2 ways: (i) Moscow will be less inclined to believe time is on its side—the longer it must fund elevated war costs, the greater the risk that credit-related events weaken its negotiating leverage; and (ii) Moscow will prioritize sanctions relief aimed at boosting cashflows to help with politically perilous post-war debt restructuring and rearmament.

The report Appendices include, among other things, a technical discussion laying out the quantitative and qualitative analysis used in screening the sectoral data used in the report.

This report differs from some other assessments of Russia’s war finances because it looks at Moscow’s overall war-funding strategy rather than focusing on the published defense budget.

Some readers may be aware of earlier Western assessments of Russia’s war-funding capacity that may appear to be at odds with the findings of this report. That’s mostly because we look at different data sets and ask different questions.

Many previous assessments of Russia’s war finances focus on Russian budget data—its revenues and expenditures. Based on those numbers, they conclude—not unreasonably—that Moscow’s war finances appear “surprisingly resilient.” And they often interpret elevated levels of defense allocations in the 2025 and 2026 budgets to mean that Russia is ready and able to fund a long-term war of attrition.

Some assessments conclude that the main risk to Russia’s war finances is oil price. Sophisticated analysis, such as that by Richard Connolly and Dara Massicot, also astutely point out that in the event of a major retreat in oil prices, the Russian government likely still has plenty of headroom to borrow (though it will now have to pay nearly triple the rates of late 2022).8

This report does not take a view on the sustainability of Russia’s published defense budget. It sees the published defense budget as part of a broader war-funding strategy, which includes the off-budget credit scheme—the main focus of this report. In some ways, it is complementary to those budget-focused assessments.

This report seeks fresh insight into Russia’s war finances by looking at underexamined evidence of large-scale, off-budget funding in the corporate credit markets. It’s hoped that other researchers will choose to train their skills on Russia’s extrabudgetary funding schemes. As they do, our understanding of Russia’s war finances is likely to evolve. We’ll be more likely to recall Aleksei Kudrin’s prophetic 2012 warnings of a profligate rearmament program that would impoverish Russia’s future. And our head-scratching over Russia’s “surprising resilience” will soon give way to talk about the Kremlin’s all-too-habitual imperial overreach.

For policymakers, this report identifies a new dimension of Russia’s war-funding strategy and flags risks arising from it—especially systemic credit risk—that could constrain Moscow’s war finances and weigh on its war calculus.

For policymakers, this report identifies a new dimension of Russia’s war-funding strategy: a heavy reliance on off-budget debt to supplement its defense budget allocations. It also shows how excessive reliance on this off-budget funding strategy has elevated systemic credit risk to a point that it could become a constraining factor on Moscow’s war finances and weigh on it war calculus.

Acknowledgements

I would like to acknowledge the generosity of many friends and colleagues who have taken the time to engage with analysis in this report and provide valuable feedback. This report has also benefited greatly from the insightful research of other analysts and scholars, some of which is cited in the notes to Chapter 4 and Appendix 2.

Chapter 1: Russia’s Anomalous Corporate Credit Surge

Russia’s wartime borrowing is immense—but it’s not where you’d expect to find it.

Wars are notoriously expensive. To soften the impact on taxpayers, states routinely finance wars with debt, spreading costs out over time.

Russia’s war on Ukraine should be no different. As the largest war in Europe for seventy-five years, waged under extensive sanctions, you’d expect to see large-scale borrowing to finance formidable costs. And, indeed, we do see a large, anomalous spike in Russian borrowing since mid-2022. It’s just not where you’d expect it to be. Instead of accumulating on the state’s balance sheet as it often does, Russia’s wartime debt surge has built up on company balance sheets across the corporate sector.

Since Russia shifted to a war footing in mid-2022, Russian companies have increased their outstanding debt by 71%, amounting to ₽36.6 trillion or $446 billion in incremental borrowing

For years prior to 2022, Russian corporate debt grew at a modest pace (see Figure 4). From July 2022, however, it abruptly began to surge—just as parts of the Russian economy were shifting to a war footing. Through November 2024, Russian companies added ₽36.6 trillion to their outstanding debt. That converts to $446 billion at historical rates (see Appendix 1). Corporate bank loans, which make up most borrowing, surged by 76%, with some sizeable corporate sectors doubling, even tripling their borrowing from banks.10

Figure 4

This corporate credit surge is large by comparison to budget metrics, significantly exceeding state borrowing, the defense budget, and total oil and gas revenues over the same period.

In the context of Russia’s economy, ₽36.6 trillion is a large number. It comes to 21.3% of 2023 GDP and equals total federal budget revenues for 2024.

The corporate credit surge is also significantly larger than certain key budget figures pro-rated across the same time period (see Figure 5). It is:

• 1.9 times larger than the Russian defense budget;

• 1.5 times larger than total oil and gas tax revenues; and

• 7 times greater than incremental government borrowing.

Figure 5

What explains Russia’s corporate credit surge? It has exhibited some unexpected behavior, including a lack of responsiveness to rate hikes.

What accounts for this curious, abrupt and relentless surge in corporate borrowing? No doubt a number of factors are behind it. For example, a short-lived boom in residential housing has likely driven some of the loan growth in building construction. And large borrowers like Gazprom that used to fund abroad are now largely reliant on the domestic credit markets. But the corporate surge is immense, and such factors appear to account for only a fraction of it.

What’s more, the corporate credit surge has also exhibited some unexpected behavior. It began in mid-2022, exactly at the time that Russia began shifting large parts of the economy to a war footing. Since, it has had 29 months of continual growth (see Figure 6). Even more notable, it continued its relentless surge despite two aggressive rounds of rate hikes by the central bank.

Figure 6

Fortunately, we aren’t the only ones trying to understand what’s driving the corporate credit surge. The Russian Central Bank (CBR), too, has been scrutinizing the credit surge. That’s because this relentless expansion in credit has been a major driver of Russia’s rising inflation, helping push official levels close to 10%—far above the CBR’s target levels of 4%.

In its analysis of what’s behind the corporate surge, the CBR has made some revealing observations. We examine these in Chapter 2.

Chapter 2: The Relentless Driver of the Credit Surge—State-Directed, Preferential Bank Loans

Why, despite two rounds of aggressive rate hikes, has the Central Bank struggled to constrain the corporate credit surge?

“The situation is highly heterogeneous.” Those were the words the Russian Central Bank (CBR) governor used in November 2024 to describe an alarming development in the corporate credit markets. During the previous 15 months, the CBR had conducted two rounds of aggressive rate hikes in an effort to cool off the corporate credit surge. Unrelenting corporate borrowing had become the primary driver of rising inflation. Yet, despite raising the key rate from 7.5% starting in July 2023 to a record level of 21% by October 2024, the CBR was struggling to slow the unrelenting expansion of corporate credit.

After its tightening round, from July through December 2023, when rates had more than doubled to 16%, the CBR thought it had gotten borrowing under control (see Figure 7). But its victory was short-lived. By Q2 2024, borrowing was once against accelerating, which led to a second round starting in late July 2024.

Figure 7

Consumer borrowing fell sharply, helped by the termination of a popular program of state-subsidized home mortgages in July. But corporate borrowing continued to surge to record highs, much to the consternation of the bank. Indeed, the second round of tightening saw the largest increase in corporate debt of any three consecutive months of the corporate credit surge (see Figure 8).

Figure 8

The corporate debt market has split into groups of borrowers: (1) a rate-sensitive group that has curbed its borrowing and (2) a group that is largely “insensitive” to rate hikes and continues taking on new debt

What was driving the surge? Why was it so unresponsive to tightening? For months, the CBR had been gradually piecing together the puzzle. By November 2024, it had an answer.

The market for corporate loans had split into two distinct groups—become “highly heterogeneous” in the CBR’s terminology. One group was borrowing at market (on normal market terms). This at-market group responded as expected to a sharp rise in rates: they curtailed their lending. The second group, by contrast, was borrowing off market, receiving “preferential” terms of credit (льготное финансирование). It was this group of “preferential” borrowers that was proving largely “insensitive” to rate hikes.

This rate-insensitive group has blunted the effectiveness of the CBR’s main inflation-fighting monetary tool: rate adjustments

For the CBR, the “insensitivity” to rates shown by these preferential borrowers posed a major challenge. The rate hike is its primary tool for fighting inflation. But if a large class of borrowers is immune to higher rates, the CBR is greatly disadvantaged in its fight against inflation. As the CBR observed:

“Preferential loans are weakly sensitive to changes in monetary policy. The larger their share, the more the key rate needs to be changed to influence credit activity, demand and inflation.”13

In other words, to cool down lending when preferential loans are prevalent, the CBR needs to hike even more aggressively than it would normally have to do.

This, however, has a perverse and undesirable effect: it squeezes out the most efficient users of capital, those borrowing “at market”—while the normally less efficient preferential borrowers continue to take on debt. So, rate hikes were doing significant damage to the “real” economy while having limited impact on the remaining driver of credit expansion—the preferential borrowers.

These rate-insensitive borrowers come from certain sectors, have revenues tied to state-contracts and receive state-directed “preferential” bank loans, often with low interest rates

Who, then, were these rate-insensitive, preferential borrowers? From CBR commentary on the problem, the following portrait emerges. They are associated with certain industrial sectors;14 their business is closely “tied to state orders”15 and “state contracts”;16 the state provides these borrowers with support in the form of “preferential” borrowing terms;17 credit support from the state can take a range of forms, including principal guarantees.18 But for these borrowers, support is often taking the form of interest rate subsidies, where the borrower pays a fixed rate well below the normal market rate and the state pays the lending bank the difference between the market rate and the “preferential” rate.19 In a high-rate market, the demand for such loans becomes very strong, and can even exceed the needs of the borrower.20 Quantifying preferential lending is a challenge21 because the CBR lacks comprehensive data.22

In short, Russia’s rate-insensitive corporate borrowers are companies that tend to do government contract work in certain unspecified sectors; in connection with those contracts they receive state-directed, preferential bank loans—routinely with subsidized interest rates; and their relentless demand for credit during the second tightening round (August – October 2024) was so strong that it pushed corporate borrowing to a new 3-monthly record, even as incremental demand from at-market borrowers dried up.

Conventional borrowing is driven by commercial calculations, while state-directed, preferential borrowing is driven by the state’s political agenda.

The essential difference between conventional, at-market borrowing and state-directed preferential borrowing boils down to the nature of the credit decision. With conventional borrowing, the decision is driven first and foremost by the commercial calculations of company management. With state-directed, preferential loans, however, it is the strategic priorities of the state that drive the borrowing decision. The state adjusts borrowing terms and conditions in pursuit of its political agenda.

What could be so important to the state that it would allow preferential borrowing to thwart the Central Bank’s battle against inflation?

By late October, the CBR seems to have understood its conventional monetary tools were inadequate to rein in the corporate credit surge. Higher rates were having little effect on borrowing. Insatiable credit demand from rate-insensitive, preferential borrowers was, in effect, stripping the gears on Russia’s monetary transmission mechanism.

How then to tackle the problem of unyielding preferential borrowing? Since this borrowing is driven by political, not commercial, objectives, the CBR recognized it would need a political solution. So, on the 28^th of October, the CBR head met with Vladimir Putin and other senior officials to discuss what Putin described as “a sensitive and important topic—the dynamics and structure of [Russia’s] corporate debt portfolio.”23 Three days later, she would also present her case in a speech to the Russian Duma where she called for the curbing of state-directed preferential lending. We will return to these meetings in Chapter 6.

While the state uses soft financing to pursue various agendas, the scale and timing of the corporate credit surge strongly suggests much of this preferential lending is being used to fund the war.

Throughout its public commentary on preferential lending, the CBR remains vague about the specific nature of the state demand that is driving it. No doubt, it’s a mix of things. The state has been using various forms of soft financing for a range of projects, from agricultural subsidies to port and rail construction.

Those needs, however, have been around for years and have never fueled a major credit surge. And while they are priority areas of investment—especially agriculture—we can see from sectoral borrowing data these sectors account for only a small fraction of Russia’s incremental borrowing.

What, then could it be? Three clues points strongly to one answer:

• the surge in borrowing coincided with the shift of much of the economy to a war footing in mid-2022;

• since then, there have been major increase in budget funding for war-related state contracts; and

• whatever these borrowers are doing for this state, it must be of immense importance, if the state is willing to sign off on record levels of new corporate borrowing at the same time the CBR is ratcheting rates to record highs in a desperate effort to cool off lending.

The obvious answer these clues point to is that this wave of preferential lending is being used to fund companies engaged by the state in the war.

In the next two chapters, we shall examine the data around this question. If, indeed, much of this state-directed preferential lending is going to fund the war, it wouldn’t be the first time the state relied on such off-budget credit funding to supplement the defense budget. As we shall see in Chapter 3, for over a decade prior to 2022, the state was regularly and discreetly funding a significant portion of its rearmament program using similar state-directed preferential bank loans.

Chapter 3: How the Kremlin Seized Control of Defense-Related Bank Lending

In February 2022, the Russian state quietly and formally seized control of defense-related lending at Russia’s leading banks when an amendment was passed to the Law on State Defense Procurement.

To understand what’s behind much of Russia’s corporate credit surge—and, indeed, much of what afflicts the Russian economy today—a good place to start is a largely overlooked amendment to the Law on State Defense Procurement. It states that all banks authorized to work in the defense sector:

“shall be required…to provide defense contractors and subcontractors with preferential financing on terms set by the government of the Russian Federation for the purposes of fulfilling state contracts and state defense procurement contracts.”25

This amendment was quietly submitted by the Kremlin to the Russian parliament in December 2021, approved on February 22, 2022 and signed into law by Putin on February 25, 2022—as Russian columns continued to stream across the border into Ukraine.

The “authorized banks” mentioned in the law refer to a list of banks approved for managing financial transactions for state defense contracts. These include a handful of Russia largest banks as well as several banks with close ties to Russia’s defense sector.

Banks would be obligated to extend preferential loans to defense-related businesses on terms unilaterally set by the state

In its brief commentary on the amendment, the official government newspaper, Rossiiskaia Gazeta, elaborated on the kinds of preferential financing terms the state might be setting:

“they include the size of loans being received, the conditions of their repayment, as well as any requirements concerning the financial condition of the borrowers and their creditworthiness.”26

While the amendment may be short, its implications are far reaching. It amounts to the state’s commandeering of the credit resources of Russia’s leading banks to fund its war needs. It deprives the banks of all discretion over the lending decisions to defense-related companies and cedes those authorities to the state. Exercised to its full extent, this law would be tantamount to state expropriation of the banks.

In the next chapter, we shall look at just how far the state has gone since 2022 in exploiting these powers to direct preferential bank loans to a wide range of companies now engaged in Russia’s war.

For a decade prior, the state had already been directing banks to make preferential loans to defense contractors to cover shortfalls in defense budget funding for rearmament.

In this chapter, however, we go back in time to gain insight into the roots of the February 2022 amendment. As it turns out, funding Russian defense contractors with state-directed preferential bank loans was hardly a new idea in 2022. For over a decade, the state had been systematically using preferential bank loans to cover substantial shortfalls in budget funding for Russia’s costly rearmament program. We shall look at why the state resorted to this as part of its defense funding strategy and the inherent flaws in this strategy—flaws that have gone unaddressed and pose a significant risk to Russia’s defense finances going forward.

In 2007, Putin launched a high-profile rearmament program, but by 2010 it was mired in embarrassing scandal and cost overruns.

As in 2022, in 2010 the Russian state faced a crisis in its defense industry, one it would end up addressing with help from its banks. Just 3 years earlier, In 2007—with coffers swelling from high oil prices and productivity gains from imported oilfield technology—Putin launched a major 8-year rearmament program. His promise to the Russian people: restore Russia’s Soviet-era military might while avoiding Soviet-style economic mismanagement.

By 2010, however, Putin’s grand rearmament program was in trouble. Cost budgets had been far too optimistic, while Russia’s production capacity had been greatly overestimated. Less than halfway into the program, funds were already running low with little to show in terms of new production. Putin was forced to abandon the old program and announce a new, ten-year program with a significantly higher price tag. A deputy minister was dispatched to explain that this time they had gotten the math right and wouldn’t make the same mistakes again.27

A major spending increase was needed to get back on track, but this risked tarnishing Putin’s carefully managed image as a prudent manager of the public purse.

The Kremlin was interested in avoiding a sudden and dramatic step up in defense spending, so it wanted to backload the plan, pushing some 70% of the expenditures out to the second five years. This presented a dilemma, however, because contractors needed more money straightaway if they were to get back on track. Putin faced a stark choice: scale back his rearmament ambitions or risk appearing soft on spending discipline.

A solution was found: the state would limit budget increases by discreetly arranging state-guaranteed bank loans to arms manufacturers to cover their funding shortfall.

A solution was soon found that would get more money to arms contractors without adding more costs in the budget...at least not straightaway. The state would arrange for several large Russian banks to provide 5-year loans to arms manufacturers to supplement the inadequate funding coming from the state budget.

There was only one hitch: the banks appear to have been unwilling to lend without a repayment guarantee from the state. That was not at all unreasonable. The sums involved were large, while many of the borrowers of record were likely to be very high credit risks. Many will have been heavily dependent on state contracts—which were still being negotiated—so their future revenue flows were uncertain. And many were largely unreconstructed legacy defense enterprises from the Soviet era with highly opaque cost-structures.

To address this problem of repayment, the state offered to the banks to guarantee the principal (but not the interest) of the loans. And on December 31, 2011, an edict was issued by then Prime Minister Vladimir Putin spelling out the terms.28 Judging by the subsequent amendments to this edict, new 4- or 5-year loans continued to be issued under this guarantee facility at least into 2016.29

This lending program wasn’t classified. There are odd references here and there, but there seemed an effort to play them down. When, for example, the Duma was rushed to approve enabling legislation, the head of the Defense Committee described them in a floor statement in nearly impenetrable bureaucratese:

“a new, important mechanism related to the formation and stimulation of the implementation of state defense orders, which consists of the provision of state guarantees.”30

By 2016, however, the cash-poor arms contractors predictably could not repay much of their debt. The state then paid off the banks under the guarantee agreement.

Over the next several years, little was said about these loans as they steadily accumulated on the balance sheets of Russia’s arms producers. By 2016, however, some ₽1.2 trillion in debt (an estimated $37 billion at historical rates) had built up, and some two thirds appears to have gone bad, with trouble on the way. That’s when the state had to step in and perform on its guarantees by repaying the loans. To fund this repayment, it needed money from the budget. And because it was a sizeable amount, some public explanation was required, which brought the loans back into the public eye.

In October 2016, addressing the Duma’s budget committee, Finance Minister Anton Siluanov offered the following brief explanation for what was behind the state’s supplementary funding need. Referring back to the late 2010 edict he explained:

“It was decided that arms manufacturers would take out loans with state guarantees so that they could more quickly implement the state armament program and fulfill the president's order to rearm our army within the allocations provided in the budget. These loans were used to manufacture products for military use.”31 [author’s emphasis]

Funds, of course, were duly allocated and tucked away into an expanded, classified part of the budget.32 A year later, in October 2017, Siluanov would be back asking for another ₽200 billion to repay debt borrowed under the state-guarantee.33

Despite the default, the “credit scheme” worked well for the state, by keeping a significant portion of defense costs off the budget for years. More loans were forthcoming.

In effect, then, through this state-directed “credit scheme” the state had managed to arrange five years of supplementary “off-budget” funding for defense procurement before it had to pay a single ruble from the budget. While there continued to be criticism from some quarters about excessive defense spending, this rollover of the “credit scheme” did not garner that much media attention. The Kremlin’s illusion of a financially disciplined rearmament program remained largely untainted.

Which perhaps made the rest of Siluanov’s statement to the committee easier to understand. By “repaying the so-called enterprise loans” the state would be “freeing these enterprises from their debt burden, so that they had the opportunity to borrow again”34 [author’s emphasis].

By 2019, debt distress in the sector had grown severe enough that Putin had to intervene and a difficult restructuring plan was negotiated with the banks.

And borrow they did. By the end of 2019, sector debt had grown still larger, to ₽2.7 trn and the sector was in distress again—an entirely predictable outcome. Banks and their borrowers were at loggerheads. But it’s not clear how much of this debt was fully backed by explicit state guarantees. The banks were demanding the state to step in and assume the bad debts, while defense contractors called for “non-productive” bankers to write off the debt.35 The debt load had become so onerous, it was impeding progress with rearmament.

Things had gotten bad enough that Putin had to publicly weigh in on the matter. He convened a meeting of senior officials to discuss the euphemistically named “program on the financial recovery of defence sector organizations.” He sanctimoniously harangued arms manufacturer for the “large debt burden” they had accumulated. It had become, he said, “the restraining factor” that was “seriously limiting the possibilities for diversifying production [and] introducing advanced technologies.”36

This, however, was the Kremlin passing the blame onto others for it own policies. It was Putin, after all, who had been Prime Minister in 2010 and whose name is at the top of governmental edict establishing the original “credit scheme.”

In due course, a compromise restructuring was agreed for part of the debt. The details were once again classified, but reports suggest the state assumed a portion of the bad debt, and forced lenders restructure the rest with long maturities and low interest.37

The state responded with a sector audit, but remained committed to state-directed preferential lending

How did the state respond to the second major sectoral debt crisis in less than five years? It did two things.

First, it launched a widespread financial audit of the defense sector. With debt continuing to accumulate in the sector, it appeared to be seeking a better understanding of how great the insolvency risk was. The audit came back in 2020 with reports of significant financial distress, with some companies crushed by debt-to-EBITDA ratios running into double digits. And these heavy debt loads were weighing on progress across the defense sector. As the head of the commission had once described the impact of the debt burden: “now the defense sector is an exercise bicycle: you crank the pedals, but you don’t go anywhere.”38 Following the audit, he went on to observe that the debt problem must be solved for the sector to make further progress.39

Second, the state advanced its plans to develop a special, state-owned bank, Promsviaz’ Bank (PSB), dedicated to the defense sector. After the painful experience of the 2019-2020 settlement, some of the banks authorized to service the defense sector had cooled on more lending to the sector. The plan was that PSB would, in time, consolidate much of the sector banking business. In theory, consolidating sector banking into a single institution would also give the state better control over sector finances. And PSB began issuing preferential, low-interest-rate loans aimed at reducing the risk of financial distress.40

The off-budget “credit scheme” shouldn’t be thought of as real corporate lending, since there seemed to be little reasonable expectation that much of it would get repaid.

What are we to make of this decade of chronic debt and default? One way to describe it is as a Kremlin conjuring trick: by levering up the defense sector with debt, the Kremlin appears to be making good on its promise to deliver soviet-era military strength while keeping the defense budget in check. As Julian Cooper, a veteran scholar of the Russian military, would astutely observe not long after:

“[the] resort to sizeable state guaranteed credits is also a means of supplementing the defence budget: the real volume of military expenditure is now larger than shown by the budget alone.”41

The fact the state was levering up the defense industry to get better returns on its budgetary investments is not in and of itself a conjuring trick, nor a betrayal of its public promise. For many businesses, having some debt in the capital structure is advisable, provided there’s a reasonable expectation they can manage the load.

And it’s exactly that “reasonable expectation” that seems to have been missing here from the very outset. There’s a reason the banks received state guarantees on their loans under Putin’s edict No. 1215 from 2010. It’s because all the key players—the borrowers, the lenders and the state—almost certainly knew Russia’s legacy defense sector was an unacceptably high credit risk. Many borrowers would struggle to repay the debt they were being forced to take; they might even struggle to service the interest payments. And scholarly research throughout the 2010s has repeatedly confirmed the weak financial state of much of the sector.42 And the cycle of borrowing and default briefly recounted above bears out the research.

The sector had chronically weak finances owing to underpriced state contracts, corruption and the assumption among managers that the state would bail out their bad debts.

Several reasons account for the chronically poor financial state of the sector.

First, there is what has been called the “pricing problem” (проблема ценообразования). Around 2008-2010, under then Defense Minister Serdiukov, the state reportedly became more aggressive and adversarial in its pricing of arms procurement contracts, pushing prices below what contractors claim they needed to cover costs and expenses. As an effective monopsonist, the state had superior bargaining leverage over the contractors and had begun to exercise it. Arms manufacturers had little choice but to sign contracts, even they could well result in losses.43 For many them, the Russian state was practically the only buyer for their products. This left them chronically short of cash.

The second reason was corruption. Part of the state’s rationale for low-balling contract prices was an effort to crack down on corruption, which was (and remained) rampant in Russia’s arms procurement. Price structures were highly opaque, cronyism rampant, and management often had little incentive to want cash to accumulate on the balance sheet.

Third, of course, was moral hazard. If the state had guaranteed this debt already, why should enterprise managers make provisions for debt repayment?

On top of it all, interest expense on these loans was only adding to the cashflow shortfalls at many of these companies. That was a finding of an Audit Chamber investigation into defense sector finances published in early 2013 It went on to add that a majority of defense sector enterprises were so technologically antiquated, that it would make more sense to build new factories from scratch than upgrade existing plant.44 The heavy burden of interest charges was also evident in the 2020 special audit.45

The “credit scheme” is better understood as hidden state borrowing, or “state-directed, off-balance-sheet debt funding” to be more technical.

Sector companies may be the borrowers of record, but the de facto borrower here is the state. These are cash injections that the state has “compelled” the companies to take—in lieu of fully priced contracts—so that they can cover their production costs. And it was the state whose credit the banks were counting on when they disbursed the funds. And it was the state that repaid the loans when they came due. Moreover, in many cases, there probably was never any reasonable expectation that the borrowers of record would be able to repay the debt themselves.

So, what in effect, we have is a case of “sham” borrowing, or “hidden” state borrowing, as the IMF might put it. The state is orchestrating these loans, providing the enabling credit and then paying them off.46 A more precise, though clunkier, label might be “state-directed, off-balance-sheet debt funding.” The state is using its credit to raise debt to fund the companies but directing the banks to structure the debt as company loan so that it stays off the state’s balance sheet until it’s time to repay.

And the state’s motive was clearly to provide supplementary defense funding above and beyond was was readily visible in the federal budget.

As to the state’s motive, two officials have provided similar explanations: it was to provide adequate funding for defense contractors while also limiting defense budget expenditures. We’ll recall Siluanov’s 2016 explanation to the Duma. He explained the purpose of the loans was to "implement the state armament program and fulfill the president's order to rearm our army within the allocations provided in the budget”47 (author’s emphasis). In 2011, a deputy defense Minister put it more bluntly: “Taking on state-guaranteed loans to carry out defense orders…is a compelled measure. The reason for it is that spending allocations in the armament budget are very unevenly planned: 31% for 2011-2015 and 69% for 2016-2020.”48

As often with “hidden” state borrowing, it’s riskier and costlier than normal state borrowing. In this case, it has worsened financial distress throughout the defense sector, led to disruptive debt restructurings, and created significant financial risk for Russia’s leading banks. It would have been far less risky, disruptive and costly had the state simply borrowed the money directly in the bond markets and used it to pay higher prices in its procurement contracts.

But state’s using “hidden” debt are often willing to put up with these costs and risks—to a point—as the price of achieving a desirable political outcome—often in the form of politically advantageous optics. In Moscow’s case, it appears to have found its off-budget “credit scheme” a useful—albeit somewhat unwieldy—tool for reducing the headline numbers on Russia’s defense budget and delivering on Putin’s promise to restore military strength without fiscal mismanagement.

More precisely, it was a form of hidden, supplementary revenues to compensate for underpriced contracts.

Pavel Luzin has characterized the peculiar function of these loans very well in his insightful 2020 essay, “Russia’s arms manufacturers are a financial black hole.” He observes that these loans “do almost nothing to increase [the] profitability” of these companies. Instead, preferential bank loans might:

“allow the state to compensate the military industrial complex for its losses through other budgetary streams — without publicly inflating its defence and security expenses.”49

In short, the state is using its hidden borrowing to pay what amounts to hidden revenues to the companies to help keep them afloat.

For the “credit scheme” to work, the state needs the credit-creating capacity of the banks. But banks had begun to sour on the high-risk defense sector.

Companies might have little say in whether they get compensated with more richly priced contracts or loans they don’t have to repay. They were “compelled” to take out the loans. But banks, in theory, did have a say—at least until February 2022, when the government passed the amendment commandeering them to fund the war. After banks apparently took some losses in the 2019/2020 bailout,50 it appears some banks were souring on the more lending to the sector. Promsviazbank was poised to consolidate sector debt.

To remove the risk of bank reluctance and make the credit scheme fit war-time use, the Kremlin put forward legislation giving the state full control over defense lending at the banks.

It appears, however, that the Kremlin had second thoughts as it laid plans for a full-scale invasion and subsequent occupation of Ukraine. Defense related costs were bound to soar. The off-budget “credit scheme” could prove a valuable tool both for directing cash quickly where it’s needed, “without publicly inflating” its defense budget, to paraphrase Luzin.

But why pass a law effectively expropriating the banks? If banks are reluctant to lend, they can find ways to drag their feet. Of course, a call from the right senior Kremlin official can often solve a problem. But where lending needs to happen at scale, such ad hoc solutions are impractical. To stop foot dragging and free up senior officials for other things, a law obliging the banks to lend to defense-related borrowers on terms unilaterally set by the state is simply a prudent measure.

As we shall see in the following chapters, however, the extent to which the state has come to rely on this carte blanche credit scheme since mid-2022 is anything but prudent.

Chapter 4: How Big is Russia’s Off-Budget War Debt? A Broad Estimate.

How material is Russia’s off-budget lending to its overall war-funding strategy? CBR sectoral data allows us to broadly estimate its scale.

In this Chapter we address the important question of materiality. How material has off-budget defense funding been relative to defense budget allocations since mid-2022? If it hadn’t existed, would it have been clearly missed?

To answer this question, we need to broadly estimate the amount of state-directed preferential lending that has been extended to war-related companies.

Fortunately, we are able to make such an estimate thanks to sectoral lending data published by the Central Bank. While the data is not sufficiently granular to allow precise, single-point estimates, it is suitable to support a broad estimate that provides a reasonable indication of scale. And for our purposes—establishing materiality—a reasonable indication of scale is all we need.

Even on our most conservative assumptions, off-budget funding appears material to Russia’s overall defense funding strategy

The analysis in this chapter concludes that off-budget defense-related lending makes up a material part of its overall war-funding strategy, even on our most conservative set of assumptions.

Central Bank data break corporate lending into 78 separate industrial sectors, allowing us to estimate borrowing trends of defense-related sectors

As we did when measuring Russia’s overall corporate debt surge (see Chapter 1), in this chapter we are making use of on Central Bank data sets on the Russian credit markets. The main difference is that this data provides ruble corporate bank debt broken out across 78 separate non-financial industrial sectors, covering everything from gambling to oil and gas extraction.51 These sectors follow standard Russian industry classification system known as OKVED2. This allows us to track monthly changes in bank borrowing levels across a wide range of industrial sectors. So, for example, we can see that the outstanding debt of companies involved in “production of motion pictures, video films and television programs, publication sound recordings and sheet music” (#59 in the OKVED2 system) has fallen by 34.3% or around ₽5 billion ($45 million) between mid-2022 and the end of November 2024.

By contrast, companies involved in the “production of chemical and chemical products” (OKVED2 #20) has increased by 127.2% or around ₽1.93 trillion ($23.5 billion) over this same time (see Figure 9). It’s not surprising that the chemicals sector should be taking on more debt during a war; it’s customarily seen by military analysts as one of the 4 OKVED sectors comprising the Russian arms manufacturing industry. Prior to 2022, it was tracked as a proxy for economic activity around Russia’s military industrial complex.

Figure 9

This ₽1.93 trillion in incremental borrowing is, in fact, a large number. It’s equal to 10% of Russia’s entire federal defense budget over this same period. Now, consider that—as a rule of thumb—around half the defense budget goes to arms procurement.52 That means that the amount of “debt” capital injected since mid-2022 just into this single war-related industry sector, chemicals, equals roughly 20% of Russia’s entire estimated arms procurement budget for the same period. That data point alone should alert us to the potential significance of Moscow’s off-budget credit scheme in the overall structure of its war-funding strategy.

15 sectors have been identified as likely to be (i) providing a significant level of war-related goods and services and (ii) receiving substantial amounts of state-directed preferential loans.

Of the 78 industrial sectors in the CBR data, we have identified 15 as directly relevant to estimating the scale of Russia’s off-budget war-funding scheme. The methodology and analysis involved in identifying these sectors is detailed in Appendix 2 and involves the application of qualitative and quantitative screening tests. The screening process has produced a group of 15 sectors that we can say with a reasonable degree of confidence (a) are likely to be providing the state with a significant level of war-related goods and services, and (b) appear to be receiving substantial amounts of state-directed preferential loans.

This list further breaks down into two subgroups:

• 4 core sectors customarily associated with legacy arms manufacturing (see above); and

• 11 “other war-related sectors.”

Borrowing behavior of these two subgroups tracks very closely to one another (see Figure 10). At the same time, they also sharply deviate from that of the remaining 63 sectors that did not clear our screening thresholds and are deemed to be “non-war-related.”

Figure 10

Estimating the scale of war-related debt: high- and low-case assumptions

In making our estimate, we will draw on incremental borrowing data from these 15 sectors. We begin by calculating the total increase among the war-related sectors in outstanding bank debt from July 2022 through November 2024. This provides us with a maximum estimate—our “high-case” estimate.

Next, we need to make a risking adjustment to account for the likelihood that not all borrowing in all sectors is state-directed, war-related preferential lending. In our 4 core arms manufacturing sectors, we assume 100% of borrowing is war-related. But in the 11 “other war-related sectors” we assume some incremental borrowing in our data may be unrelated to the war. Our screening process, however, suggests the non-war portion is not likely to be very large. This is evident in how these sectors scored in our screening tests (see Appendix 2). This is also reflected in how closely they track our benchmarks for fully dedicated war-related sectors—the 4 core arms production sectors (see Figure 10).

To be on the conservative side, however, we are running a “low-case” estimate that assumes only 50% of the incremental debt of these 11 sectors is war-related. The conservative quality of that assumption can be seen in the steady upward growth trend over the course of 2024, including August through November 2024, when debt levels among at-market borrowers stopped growing (see Chapter 2).

To summarize our input assumptions:

• High case:

  • 4 core manufacturing sectors = 100%

  • 11 other war-related sectors = 100%

• Low case:

  • 4 core manufacturing sectors = 100%

  • 11 other war-related sectors = 50%

Figure 11 shows the estimation analysis. Starting from the top down, the black vertical bar labeled 100% is our primary benchmark. It represents the headline defense budget figure, pro-rated for the 29 months running from July 2022 through November 2024.53

Figure 11

Beneath that is our estimated range of state-directed defense-related preferential lending. The dark red band represents our low-case estimate, which comes to 72% of our benchmark. The light-red band represents the range of values between our low-case and our high-case estimate, which totals 118% of our benchmark. The midpoint of the range is 95%.54

At the bottom are two additional benchmarks representing the annual defense budgets for 2023 (on the left) and 2024 (on the right).

Even at the low end of our range, off-budget funding appears material to Russia’s overall defense funding strategy

Even at the low end of our range, the estimated amount of off-budget, war-related lending comes to nearly three quarters of our pro-rated defense budget figure for the same period. As a percentage of total combined pro forma defense spending (budget + off-budget), our estimated range runs between 42% and 54%. That easily meets and exceeds any reasonable standard for materiality.

Chapter 5: Moscow’s Conjuring Trick. How Off-Budget War Debt Keeps the Defense Budget Looking “Surprisingly Resilient”

When announcing the big defense spending increase in Russia’s 2024 budget, the finance minister sent two important messages

In September 2023, Finance Minister Anton Siluanov sent shudders through Western capitals by unveiling a headline defense budget number that was some 68% higher than the 2023 figure. He described the increase with the following words:

“The priorities of the budget are set out in the structure of the budget expenditures. The structure of the budget shows that the main thrust is on ensuring our victory—the army, defense capability, armed forces, fighters - everything necessary for the front, everything necessary for victory is in the budget. This is a considerable strain for the budget, but it’s our unconditional priority.”57

As students of Russia’s Civil War will recognize, this is a bureaucrat’s lumbering riff on Lenin’s much pithier “Everything for the front! Everything for Victory!” (Все для фронта! Все для победы!). But through the verbiage, two messages come through—one pointed, the other more subtle.

Message #1: Russia is ready to spend what it takes to win and willing and able to bear the strain—a message validated by Western assessments.

The first, pointed message is that Russia is ready and able to spend what it takes to win. As Pavel Luzin astutely observed about the big increase in the 2024 defense budget, it appeared designed “to scare Kyiv and its supporters into accepting a ceasefire.”58 Moscow was telling us it was ready to spend what it takes to win. While it might be a strain, it was one Russia was prepared to bear.

Western analysts were soon running a ruler over these figures and confirming Siluanov’s basic claim: these figures might be a bit of a stretch, but they are achievable barring a steep and protracted drop in the oil price. What helped was that the overall increase in the budget was just 22%. The overall increase was all going to defense, plus some cannibalization of other non-defense spending.

Message #2: Everything Russia needs for the war is in the budget—a subtler message that goes largely unnoticed, but is patently untrue.

But there was a second, more subtle message in his statement that likely went unnoticed by many: everything Russia requires for the war is in the budget. That’s a statement Siluanov would like us to believe, but as we saw in Chapter 4, it’s simply not true. A material part of Russia’s war funding is structured off-budget.

And Siluanov, of course, knows it’s not true. After all, it was Siluanov who in 2016 went before the Duma budget committee to explain the rationale behind the credit scheme: to provide extrabudgetary funds to arms producers so they could “fulfill the president's order to rearm our army within the allocations provided in the budget” (see Chapter 3). And it is Siluanov who continues to allocate additional budget funds to cover subsidized interest charges on preferred loans. Indeed, Siluanov probably knows better than anyone just how much funding “for victory” is being arranged each month outside of the budget.

Why is Moscow keeping so much of its war-funding off-budget? As in the past, it seems intent on manipulating public perceptions around the size of its defense spending.

It should come as little surprise that a Russian finance minister might dissemble about Russia’s defense expenditures in time of war. The interesting question is: to what end?

As we saw in Chapter 3, prior to 2022, the “credit scheme” was largely an exercise in managing domestic perceptions around Russia’s billowing defense spending. The aim: promote an image of the Kremlin as a disciplined manager of the public purse, one that won’t allow military spending to spiral out of control as it did in Soviet times.

It’s worth noting that in Soviet times, manipulating public perceptions around defense was a well-used tool of statecraft. As the historian, Mark Harrison, has shown, throughout the Soviet period, Moscow tailored defense spending disclosures to manipulate Western perceptions for political advantage.59

Shifting costs off-budget allows Moscow to artfully craft a Goldilocks defense budget: large enough to menace, but small enough to be sustainable.

Here we arrive at the crux of the matter. Our analysis through Chapter 4 shows that Russia’s war costs are substantially higher than the budget numbers would suggest, and that much is being discreetly funded off-budget using state-directed bank loans. As before 2022, this off-budget funding gives Moscow flexibility in managing how much overall defense spending to channel through the highly scrutinized federal budget.

This flexibility has allowed Siluanov to artfully craft what might be called a “Goldilocks” defense budget: it’s big enough to be menacing, but small enough to appear sustainable. What’s more, it gives the impression of Moscow being “surprisingly resilient”—as some Western assessments have phrased it. Despite waging the largest European war in 75 years, having lost access to most of its sovereign savings and laboring under an extensive sanctions regime, Moscow’s publicly visible war finances appear unfazed: budget deficits are well below 2% of GDP, sovereign debt up only modestly and there seem to be no risks looming on the horizon.

This conjured image of risk-free resilience greatly enhances Moscow’s bargaining leverage

This image of risk-free resilience confers tangible advantages to Moscow since it greatly enhances Russia’s bargaining leverage in any prospective negotiations. Moscow appears able and willing to fight on indefinitely without jeopardizing the prosperity of its people. So, to persuade Moscow to stop fighting will require grievous concessions on the part of Ukraine and its allies.

We know now, however, that not everything is in the budget. To see the full picture of Moscow’s war finances, we must look at its off-budget funding as well. And when we do, this picture of risk-free resilience begins to change—in two ways.

First, the overall cost of fighting the war looks much bigger and not nearly so sustainable. Based on our estimate in Chapter 4, Moscow’s off-budget war debt is roughly the size of its on-budget headline defense allocation. If all that had been funded through the budget, the defense figure would have roughly doubled. The resulting budget deficits would have ballooned up 5.5% and 6.2% in 2023 and 2024 (using the mid-point of our estimate). Deficits would have accounted for a full quarter of the 2023 and 2024 budgets.

Could Moscow have managed? Probably. It’s likely it could have covered the deficits with debt. But the additional issuance needed would have been sizeable: 4.5 times more than it has so far issued since mid-2022 (see Figure 12). And total government debt today would be 137% above mid-2022 levels.

Figure 12

With numbers like that, efforts by Moscow to promote an image of risk-free resilience and sustainability would have gotten much less traction in the analytical community. And that would have translated into a weaker position at the bargaining table.

When we look beyond the budget at the totality of Russia’s war funding strategy, it’s not just more war costs we see. We also begin to see a new kind of risk—systemic credit event risk—emerging as a consequence of Russia’s heavy reliance on its off-budget credit scheme. It’s a significant risk and has the potential to weigh on Russia’s war calculus. We examine it in Chapter 6.

Chapter 6: A New Threat on the Kremlin’s Radar—Credit Event Risk

In late October, 2024, a high-profile industrialist very publicly raised the alarm over the threat of widespread corporate bankruptcies posed by interest rates.

“If we continue to work like this, the majority of our enterprises will practically go bankrupt.”62 That was the soundbite that made headlines across Russia on October 23, 2024. They were uttered by Sergey Chemezov, one of the lions of the Moscow elite, during a speech to the upper house of the Russian parliament. Chemezov is long-time associate of Vladimir Putin, having served together with him in Dresden in the 1980s.63 Now Chemezov holds the important position of CEO of Rostec (Rostekh), Russia’s sprawling state-owned arms conglomerate. Along with being Russia’s leading supplier of arms to the state, Rostekh is also Russia’s largest arms dealer. As such, Chemezov is both a beneficiary and victim of the state’s heavy reliance on off-budget debt funding for the war. Many of his innumerable subsidiaries have likely received preferential loans.64

But Chemezov was specifically complaining about how the high cost of debt is pushing his arms export into the red. Customers, he explained, pay advances of 30 – 40% on weaponry that can take more than a year to produce. A working capital loan would normally be used to fund the balance of production costs. But with debt capital costs above 20%, borrowing would wipe out his profits.

By late 2024, borrowing costs for companies had become prohibitively high, with yields on AA-rated corporate bonds at 27%, while BBB bonds topped 37%.

Chemezov was drawing attention to a growing problem. Since the start of 2024, the cost of corporate borrowing had been rising dramatically in Russia (see Figure 13). For blue-chip, AA-rated corporate borrowers, yields had risen from 14% to 27%. For BBB-rated borrowers, the increase was even steeper, surging from 16% to 37% by year end. With capital priced that high, few companies can borrow and make a profit.

Figure 13

These soaring rates are driven by several things. First, there’s the rising key rate. Then there’s competition for capital from state-backed preferential borrowers. And, finally, there are growing investor concerns over default risk. Bond buyers are concerned that such expensive debt can tip previously healthy borrowers into distress. And, so, they demand a premium to take credit risk on corporate borrowers.

To show a concerned public he was tackling the problem, Putin convened a top-level meeting on “the dynamics and structure of [Russia’s] corporate debt portfolio.”

Two days after Chemezov’s speech, on Friday October 25, the CBR hiked the key rate a record high 21%. The following Monday, October 28^th, Putin convened a meeting of top officials dedicated to what he called “a sensitive and important topic for our business people… the dynamics and structure of [Russia’s] corporate debt portfolio” and corporate credit grew at (see Chapter 2).65 Chemezov’s concerns over corporate insolvency had clearly been heard. And with bankruptcy now in the headlines, Putin needed to reassure the public that he was on the case and would sort things out.

The CBR chair, Elvira Nabiullina, was the first to speak after Putin. We don’t, unfortunately, have a transcript of what she said, but judging by her numerous public statements at the time, we know some of what was on her mind.

The head of the CBR likely urged Putin to back her call to curtail state-directed preferential lending by arguing it was elevating two systemic risks in the economy: (i) inflation…

She would almost certainly have been seeking Putin’s support in pressuring the government to curtail its heavy reliance on preferential lending to fund the war. Later that week, she would say publicly that she was in active discussions with the government to find alternative ways to provide “state support” to companies.66

To persuade Putin of the need to find another way to fund his war, she would likely have cited two systemic risks that the state’s off-budget strategy was acting to elevate. One was inflation risk, which we noted in Chapter 2. Unchecked growth in corporate borrowing had, in the CBR’s view, become the primary driver of Russian inflation. And state-backed preferential lending had become, by the second half of 2024, the main driver of corporate borrowing. Preferential loans were “insensitive” to interest rate hikes and continued to grow despite tightening, thus fueling inflation. (see Chapter 2). On the continued use of rate hikes to battle inflation, Nabiullina and Chemezov were at odds.

… and (ii) credit event risk. High borrowing costs and deteriorating credit quality could lead to illiquidity and insolvency in companies and banks.

The second systemic risk was one that the CBR had been increasingly voicing alarm over. That was credit risk—the risk that high borrowing costs and the deteriorating credit quality of corporate borrowers and bank balance sheets could lead to problems with illiquidity, insolvency and bankruptcy.

The CBR head was worried about “the risk of over indebtedness of major companies”…

Here, again, Nabiullina would have drawn a direct line from Moscow’s excessive use of preferential lending to elevated levels of credit risk. In her November Duma address and elsewhere, she voiced “concerns” around the “consequences” of preferential lending. “Preferential borrowing is paid for… by ‘non-preferential’ borrowers (through borrowing at elevated market interest rates).”67 With so much preferential lending, she warned, “the risk of over indebtedness of major companies can start to grow.”68 And here Nabiullina and Chemezov shared the same concerns.

…but also that the easing of bank regulations in response sanctions had led banks to “lend aggressively” while “neglecting to maintain” adequate liquidity and capital buffers.

Nabiullina’s publicly voiced credit concerns didn’t stop with corporate default risk. She was also concerned about the state of the banks. On the surface, some of Russia’s banks appear to be doing very well. When interest rates are high, they can make good money by paying depositors several percentage points below what they charge borrowers. This boosts bank revenues.

But Nabiullina appears concerned that banks are managing their businesses imprudently and not recognizing losses when they should. The reason has to do with “regulatory easing.” This refers to a complex set of rules that the CBR sets to insure banks don’t lend too much, keep a close eye on the credit quality of their loan book, and maintain adequate capital and liquidity to withstand market shocks.

During the initial sanction of 2022, the CBR greatly relaxed regulatory policy, to help banks manage. Since then, however, the CBR had not managed to reimpose its standard policy. Now she was worried that the banks had taken advantage of lax oversight and taken on too much risk: “Regulatory easing measures made it possible for banks to expand lending aggressively neglecting the need to maintain a more liquid asset structure and to additionally accumulate capital buffers.”69

It wouldn’t be that surprising if banks took advantage of lax oversight to take excessive risks. But in fairness to the banks, some didn’t have full control over their loan book. With the February 2022 amendment to the Law on State Defense Procurement, the state had effectively taken over control of all credit decisions around defense-related lending. They were obligated by law to issue any defense-related loan on any terms the state might dictate. That could well have contributed to what the CBR deemed “aggressive” lending by the banks and the CBR’s concern over the legacy of 2022 regulatory relaxation. And Nabiullina probably raised this concern with Putin.

Worse still, a special regulatory waiver for problematic defense sector loans could make banks look healthier than they really are and prevent regulators from spotting trouble early

But there’s a deeper and potentially much more problematic issue with the banks arising from defense-related lending. One wonders whether Nabiullina dared to bring it up with Putin.

In the years prior to 2022, when the state was encouraging banks to participate in its preferential lending schemes to the defense sector (see Chapter 3), the Central Bank waived certain reporting and monitoring requirements for loans to defense-related borrowers.70 Lending to chronically distressed arms manufacturers posed a problem to banks, because many of these loans were likely to go bad. Even if banks were confident the state would eventually step in with a bailout, having problematic loans on the books is costly. Banks are supposed to monitor the financial health of their borrowers; if a loan starts to look “doubtful,” banks must make expensive adjustments to their reserves to offset the risk.71

Waivers, however, reduced the need to monitor the financial fitness of their defense-related borrowers and flag problematic loans as doubtful. For the banks, that’s a double-edged sword. On the one hand, if they don’t have to mark problematic loans as “doubtful” they are spared the very real costs. On the other hand, by not adjusting their reserves, they are exposing the themselves to greater risk of failure.

What’s more, not having to flag these problematic loans risks making the banks look healthier than they really are, misleading regulators (and the public). Indeed, the banks themselves may have a less accurate picture of their true risks, if they have reduced their monitoring of the financial health of defense-related borrowers.

That’s not such a big thing if defense-related lending is a small part of your loan book and the state will soon be stepping in with a bailout. That might have been the case prior to 2022, but that no longer seems to be the case. Banks appear to have been loaded up with a large amount of state-directed, defense-related loans (see Chapters 3 and 4). That means there could be a significant amount of credit risk in bank loan books that is not being accurately reported. That’s especially problematic for the Central Bank, since it can prevent it from spotting trouble at banks early on. That increases the risk that trouble at a bank could cascade into the market before the Central Bank has a chance to step in with a bailout.

As for the preferential borrowers themselves, they may struggle to repay their loans once the shooting stops, their contracts are cut and they have no more access to cheap credit.

Elevated credit risk arising from the state’s off-budget defense debt not only affects “real” economy companies and the banks. There are the preferential borrowers themselves—the companies providing war-related services to the state. They face major insolvency risk from the state’s off-budget policy—though it is likely to materialize only further down the road.

Under the state’s off-budget credit scheme, they remain the borrowers of record of a large amount of debt. Some may be doing well for the moment, thanks to a combination of state contracts and abundant credit at below-market rates. Others may be struggling to service their interest payments, despite the discounts.

The big question is: what happens when the fighting stops, war-related contracts get cut and it’s time to repay the principal on all this debt?

From this big question many others follow:

• Will we see a wave of sector defaults start to occur as we did prior to 2022—only on a far larger and broader scale and encompassing not only core defense manufacturers, but a range of civilian companies enlisted into the war effort?

• How long will it take the state to audit the true extent of the problem?

• How quickly will the state move—or be able to move—to prevent contagion and protect the banks?

• How great will the cost of a bailout be?

• How will Moscow structure the bailout? Will it bail out the companies from the budget—as it did before? Or will it go down the bank recapitalization route?

• If Moscow uses the budget, how will it fund the bailout? Through a big tax hike? Or heavy government borrowing?

The Kremlin now has a sense of the systemic risks unleashed by its heavy reliance on off-budget war debt, and understands there are no quick fixes.

Thanks to Chemezov and Nabiullina, by November of 2024 Putin had begun to recognize the systemic credit risks Russia’s excessive reliance on off-budget war debt had unleashed. On more than one occasion, he would admonish Siluanov to exercise good judgement in how preferential lending was used. And he appears to be supporting Nabiullina in her crusade to replace preferential debt with equity funding—which would ease inflationary pressure.

But admonishments to Siluanov and encouraging more IPOs won’t fix the problem Moscow has created. With each passing week it seems, there are new signs of credit risk materializing. Company debt servicing costs are rising, consuming cashflows and pushing companies towards distress.72 Problems with arrears are on the rise.73 There is news of debt distress afflicting vulnerable sectors, such construction74 and retail shopping complexes,75 while the government is preparing rescue measures for the coal industry.76 And Russian economists forecast a wave of bankruptcies starting in the 2^nd quarter.77

The insidious nature of credit risk makes it a more pressing problem than inflation or slowing GDP. That poses a financing dilemma that could weigh on Moscow’s war calculus

The scary thing about credit risk is its insidious nature. It is different from the slow-burn risks of declining GDP or even inflation. It’s more akin to seismic risk. You can sense when it’s building up, but you can’t predict when and where it will strike and with what intensity. All you know is that it has the potential to spin out of control quickly and be very disruptive.

And this poses a dilemma for Moscow. If it keeps relying heavily on off-budget debt funding, it increases the risk that a series of credit events erode its artfully crafted image of resilience and weaken its hand at the negotiation table.

So, what are the alternatives? The Kremlin can cut back on off-budget funding and shift more of its war costs onto the budget. That may be what’s behind the anomalous 14-fold increase in the January 2025 budget deficit.78 Shifting costs may ease inflationary pressure and credit risk a bit, but it can make Russia look weaker at the negotiating table.

Putin appears to understand that any solution starts with a big cut in defense spending—which can ease near-term risks.

The only real way to address these risks is to stop spending so much on the war. And it appears Putin now understands this—at least that’s the impression one gets from an apparently unguarded comment in his annual Ministry of Defense speech back in December. In his 2022 speech, a munificent Putin promised “no limits whatsoever on financing. The country, the government will provide everything the army asks for, everything.”79 Two years on, Putin was in a much more miserly mood as he scolded his generals: “we cannot keep pumping up [defense] expenditures to infinity.”80

In the medium-term, Russia’s large pool of hidden war debt is at risk of going bad, causing on-going problems for the state and risks to the banks.

If Russia slashes spending on the war, it will somewhat ease pressure on real-economy companies and the banks. But a large pool of hidden war debt will still remain on company balance sheets across Russia. Once the shooting stops, much of that debt will be at risk of turning toxic. We may see a repeat of the serial defense sector defaults of the decade before 2022—only on a far larger scale. If and when this debt does go bad, there will be many questions about how to deal with it and many risks—especially to the banks—the arise along the way.

Conclusion: Bonfire of the Cashflows

Wars are fought on cashflows—and Moscow has been steadily losing control over its three main sources of cash

Wars are fought on cashflows, not GDP. And the risks overhanging Moscow’s wartime cashflows have never been greater than they are today.

Going into the 2022 full-scale invasion, the Kremlin had three major sources to draw on for ready cash: (1) its sovereign wealth fund measuring in the hundreds of billions of dollars, (2) its all-important oil and gas export revenues and (3) the government’s domestic borrowing capacity.

One by one, however, each has become more fraught with risk or lost altogether, through a combination of Kremlin mismanagement and eroding effect of sanctions. And with those losses, the landscape of risk around Russia’s war finances has changed for the worse.

(1) in a remarkable blunder, the Kremlin lost control over most of its sovereign wealth savings early in 2022

The first cash source the Russian state lost control of—in a remarkable blunder—was its sovereign wealth savings. For years following its 2014 invasion of Ukraine, the Kremlin’s vaunted financial team developed its much heralded “fortress Russia” strategy, designed to render Russia invulnerable to future financial sanctions. Inexplicably, however, they left the vast majority of liquid wealth fund—some $300 billion in value—sitting on Western accounts, where they were promptly frozen in 2022. In an earlier day, such financial malpractice would have triggered accusations of “wrecking.”

(2) Its gradual loss of control over its all-important hydrocarbon revenues began with its self-inflicted and crippling blow to Gazprom that plunged the company into losses.

Moscow’s grip over its second source of cash—oil and gas export receipts—has also been significantly loosened, though the story with each is quite different. The more surprising story was gas, since this loss was self-inflicted. The Kremlin’s immensely ill-judged gambit to weaponize European exports in 2022 backfired spectacularly. Moscow enjoyed a short-lived revenue windfall, but at the expense of plunging its most important company into a cashflow crisis from 2023 on. European sales are simply irreplaceable; Russian sales are loss-making, while China offers no alternative on a meaningful scale. The once mighty Gazprom is now reduced to issuing ruble bonds now yielding 22% and higher to cover its shortfalls.

Oil sanctions have taken longer to bite, but are now effectively shrinking Russia’s shadow fleet and putting its oil revenues under greater pressure

Oil has been a more involved story of cat and mouse, though Moscow now looks poised to bow to the inevitable. Early on, Russia’s heavy reliance on tanker transport was identified as its critical vulnerability, its “Achilles heel.”81 The challenge was how to exploit that vulnerability to reduce oil revenues without triggering a destabilizing supply shock. Two years of moves and countermoves ensued, as Russia skirted price-cap sanctions by assembling a parallel “shadow” fleet at an estimated cost of over $10 billion. By early 2024, however, Western authorities had zeroed in on direct tanker sanctions as the most effective way to sideline Russia’s shadow fleet. By early 2025, they scaled up tanker sanctions, precipitating a Russian tanker crisis and deepening discounts on Russian crude.82

Moscow now faces a tanker dilemma. Buying more used tankers risks throwing bad money after good, given their vulnerability to targeted sanctions. But the alternative means relying more heavily on mainstream tankers, leaving oil revenues more exposed to sanctions. And it’s doubtful Moscow attempts to engineer a supply shock by withdrawing barrels from the market for any extended period. Higher prices would only invite OPEC and U.S. producers to step up production and steal Russia’s market share. What’s more, the Kremlin’s impotence in Syria has diminished its political clout in the region—along with Moscow’s ability to pressure regional producers to show OPEC+ solidarity, should Moscow decide to unilaterally cut exports.

(3) Moscow’s heavy reliance on its flawed scheme of off-budget borrowing has needlessly elevated insidious systemic credit risk, further limiting Russia’s war funding options.

The third troubled source of cash, of course, has been wartime borrowing—the focus of this report. The problem was not so much the borrowing itself—a more orthodox strategy of transparent, AAA state bonds issuances, supplemented with additional tax hikes, would have left Russia’s war finances in far better shape than they are today.

But Putin, a dissembler schooled in the dark arts of reflexive control, simply couldn’t resist the temptation to seek political advantage in financial deception. So, he took his already flawed credit scheme from 2010 and rendered it even more dangerous by imposing full state control over war-related bank lending and eliminating prudent reporting requirements on this debt. Then, as the war dragged on, he overused the scheme, fueling inflation and forcing interest rates to distress-inducing levels.

Now Russia is awash in insidious, systemic credit risk. Corporate distress levels are rising in the “real” economy. This will erode the credit quality loan books at Russian banks—made even riskier by poor visibility around problematic corporate war debt. And once the shooting stops, the time will come for a large-scale, politically perilous restructuring of toxic war-time debt.

Putin is now aware of the elevated credit risk and the dilemma it imposes, causing him frustration over the high costs of the war.

Thanks to Chemezov and Nabiullina, Putin is now aware of his credit risk problem and the funding dilemma it imposes. His frustration can be seen in the stark shift in his war-funding rhetoric seen in his annual speech to the Ministry of Defense. In 2022 he was promising his generals “no limits whatsoever on financing. The country, the government will provide everything the army asks for, everything.”83 By 2024, he admonished them saying: “we cannot keep pumping up [defense] expenditures to infinity.”84

The risk environment around the Kremlin’s war finances is deteriorating—especially because of rising credit risk. And this is likely to weigh on its war calculus in 2 ways.

The main finding of this report is that the risk environment around the Kremlin’s war finances is deteriorating—with insidious, systemic credit risk becoming a significant factor during the second half of 2024. And the Kremlin has become aware and concerned by this. This report doesn’t predict a coming crisis or a collapse in Russia’s ability to fund the war. But it does show how the risks of such a crisis have gone up significantly and will likely rise still higher if Moscow continues to rely heavily on its off-budget war-funding scheme.

The changing risk landscape around Moscow’s war finances will likely weigh on Moscow’s war calculus in a couple of ways.

(1) Moscow will be less inclined to believe time is on its side—the longer it must fund elevated war costs, the greater the risk that credit-related events weaken its negotiating leverage.

First, Moscow will be more inclined to believe time is not on its side. The longer it takes to achieve a ceasefire and the longer it must fund heavy war costs, the higher the risk of credit problems accumulating that dispel its image of “surprising resilience” and weaken its negotiating leverage.

Moscow will, no doubt, redouble its efforts to suppress bad news and project resilience. But serious credit risk can’t be fully suppressed—its telltales are all about. Like with Ableukhov’s timebomb in Petersburg, we don’t know how destructive it will be, but we know the timer has been set, and there’s no escaping its relentless ticking.

Ukraine and its allies will no doubt recognize that it’s not in their interest to appear in a hurry to get a deal. Moscow is painfully aware that it cannot match the combined resources of a resolute West in an extended test of wills.

(2) Moscow will prioritize sanctions relief aimed at boosting cashflows to help with politically perilous post-war debt restructuring and rearmament.

The state will no doubt try to hide from taxpayers just how much wartime borrowing there is to repay. To mitigate domestic political risks and speed rearmament, Moscow will no doubt prioritize Western concessions that deliver large boosts to its cashflows. These include an easing of oil sanctions, the return of Gazprom pipeline deliveries to Europe and—the Kremlin’s holy grail—the unfreezing of its wealth fund. In view of Russia’s financial challenges, Ukraine and its allies will, no doubt, recognize the immense leverage these cashflow constraints provide. And they will see the advantage of keeping these constraints fully in place until a final, comprehensive settlement—including reparations—has been secured.

Appendix 1: Credit Surge Raw Data

Appendix 2: Russia’s Evolving Business of War. Identifying War-related OKVED2 Industrial Sectors

CBR sectoral data allows us to broadly estimate the scale of state-directed preferential lending in support of the war effort.

To determine how material Russia’s off-budget credit scheme is to its overall war-funding strategy, we need a rough estimate of its size. We can make this estimate using sectoral lending data published by the CBR. It provides monthly corporate borrowing data for 78 distinct industrial sectors, based on Russia’s widely used OKVED2 classification system. These data reflect borrowing trends across a range of sectors from gambling to oil and gas extraction. They also provide us with a reasonable basis for making the broad estimate we need for determining the materiality of Russia’s off-budget war funding (see Chapter 4).

To use of these data in a methodologically rigorous manner, they are subjected to a multi-step process of qualitative and quantitative screening and risking.

To use these data in a methodologically rigorous manner, we need to screen out from the list of 78 industrial sectors those which are not relevant for our analysis. Additionally, where there is reasonable uncertainty, we need to apply a range of risking factors. To accomplish that, we follow a four-step process:

1. determine the scope of goods and services the state requires for prosecuting its war in Ukraine. That determination involves analyzing and adjusting for the transformational effect this war is having on the scale and scope of the state’s defense-related resource requirements as well as the evolving profile of the companies providing those resources;

2. apply a qualitative test to screen out sectors unlikely to be providing war-related resources in significant measure based on their functional profile;

3. apply quantitative tests to screen out companies unlikely to be receiving state-directed preferential loans on a meaningful scale; and

4. apply risking factors to sectors where we suspect there may be a mixture of war-related and non-war-related incremental borrowing.

This appendix details the first three steps of this process. It results in a list of 15 sectors which—based on both qualitative and quantitative screening tests—we can say with a reasonable degree of confidence (a) are likely to be providing the state with a significant level of war-related goods and services, and (b) appear to be receiving substantial amounts of state-directed preferential loans. The fourth step—the application of risking factors—is carried out in the estimation process detailed in Chapter 4.

An ancillary observation arising from the research for this appendix is the significant transformational effect this war is having on Russia’s defense-related economy. Not only has it significantly broadened the scope of goods and services required by the state for defense and substantially increased their scale, it has also changed the profile of companies providing these resources. In particular, it appears to have greatly expanded the role of civilian, private sector companies across all aspects of the war effort, from supply chain management to arms manufacturing, to operations services and even to the recruitment and fielding of fighting units.

In one of the ironies of this war, Vladimir Putin may have finally achieved—after a fashion—his long-sought goal of defense-sector “diversification” (диверсификация). Rather, however, than taking the form of defense enterprises diversifying into civilian lines of business, as Putin has long exhorted them to do, it has been civilian private sector actors diversifying into the defense business.

The creation of a Coordinating Council for resourcing the war in October 2022, with the Prime Minister in charge, was aimed at galvanizing this transformation

To determine the state’s scope of resource requirements for its war effort, we begin by examining how these resources are being organized. In October 2022, 8 months into the full-scale invasion, Russia significantly altered the administrative regime for provisioning resource requirements for the war. In that month, Vladimir Putin established an ad hoc interministerial body called the “Governmental Coordinating Council for suppling the requirements of the Russian Federation Armed Forces, other troops, military formations and bodies.” In includes top officials from a range of ministries and bodies, including the “power ministries” (силовые структуры), but is chaired by the Prime Minister and appears to be firmly under civilian control. According to its founding decree, it has full broad powers, with control over all aspects of resourcing the war, from contracts to resource allocation.85

It was set up after 8 months of disastrous performance by the Russian army, including retreats from Kyiv in the spring and the collapse of Russian lines around Kharkiv in September. Judging from his public comments on the rationale for establishing the Coordinating Council, Putin appears to have lost confidence in the military’s ability to oversee the coordination of resources for the war. As he explained at the November 2022 meeting of the Council:

“Let me remind you that we launched this [council] to radically improve the quality of coordination and the pace of work of ministries, departments, regions and enterprises - both in general, but also in the implementation of state defense procurement and in supplying the special military operation.”86

It is clear from much of Putin’s early commentary on the Council’s objectives that the early performance of Russian arms and equipment did not meet expectations, despite 15 years of rearmament funded by many trillions of rubles of investment. Consequently, there needed to be a root-and-branch change in how the war effort was being resourced.87

The civilian-led Coordinating Council has been invested with broad powers, including over contracts, contractors and funding.

For the purposes of this analysis—determining the scope of goods and services being resourced by the state—the establishment of the Coordinating Council reveals three things. First, a significant shift in the administrative coordination of defense-related resources. Prior to this full-scale war, much of the coordination of defense-related resources had been centered in and around the Defense Ministry. With the advent of a full-scale war, however, a far broader scope of resources would be needed. The Kremlin took the view that this coordination effort would be better managed at the senior-most levels of the government and led civilian ministers.

Moreover, it role would not be a purely passive one of monitoring. The presidential decree gave the Council broad powers over resourcing all aspects of the war effort and, most importantly, the power of the purse. It was given discretion over contracts, contractors, pricing and “the amounts and sources of financing” needed to pay for it all.88

The scope of resourcing overseen by the Coordination Council extended well beyond arms manufacturing to include a range of goods and services for operations, from construction services to transport and logistics.

Second, the scope their mandate is broad, reflecting the needs of a full-scale war. It ranges far beyond arms procurement and compensating personnel, which for years had been a primary focus of the Ministry of Defense. It includes supplying the full range of operational needs of a major land war, one in which Russia is occupying Ukrainian territories the size of Bulgaria and managing a 1,000-kilometer front line. The range of operations goods and services would be broad, and the presidential decree establishing the Council spells them out: among other things, medical and sanitary services, repair and restoration works, construction and installation works, provision of logistics, transport, etc.89

The Coordination Council has transformed the resourcing of the war by enlisting “countless” businesses from the private sector to provide everything from arms manufacturing to construction services to supply chain support.

The third thing of note about the Council is its explicit mandate to address the many shortcomings of the military industrial complex. Importantly, the Council has been explicitly instructed to engage companies from outside of the legacy defense sector to participate in arms production. Putin stated this clearly and emphatically in Councils inaugural meeting. In explaining the rationale behind establishing a new, ad hoc body to coordinate resourcing of the war effort, he says following “standard bureaucratic procedures” and “previously established standards,” would not yield results:

“To achieve a qualitatively new outcome, it is not enough to follow the beaten path - I have already said this several times - interacting only with a narrow circle of familiar actors... new manufacturers must appear - efficient, modernly equipped and ready to work in the required new format and produce the required quality of this or that product” [author’s emphasis].90

And these “new manufacturers” wouldn’t be limited just to arms production, itself. Putin says they should be sought out for a range of war-related production and services from “medicine production to the construction sector in the widest sense of the word.”91

In November 2022, Prime Minister Mishustin, who heads the Coordination Council, elaborated on Putin’s call to broaden the scope of companies engaged in the war effort. As the TASS headline read, “Mishustin calls for small and medium sized businesses to be engaged for supplying the Special Military Operation.”

"It is necessary to more actively involve a larger number of enterprises, including representatives of small and medium businesses, in the processes of supplying material and technical resources. Only a part of the production we need is of a closed nature, carried out by specialized enterprises. The rest can be mastered by private companies as well. For this, we need to provide them with technical specifications and design documentation” [author’s emphasis].92

Over the coming months, top officials from Putin on down comment on the novel and significant contribution of the private sector across an entire range of goods and services, from supply chain support to construction and civil engineering services to weapons innovation, design and construction.

During an address to the Ministry of Defense collegium in December 2023, Putin underscored the unexpected extent to which civilian technology and engineering businesses have been effectively drafted into the war effort:

“It’s important to further increase the delivery of the weapons most in demand, as I have said. This includes creating a production line of unmanned aerial vehicles from heavy attack vehicles to ultra-small vehicles. [It’s important] to attract high-tech businesses and engineering design companies into development and production. By the way, I want to thank them for this. Many private enterprises, which were previously far removed from the defense industry, have taken on various projects and are carrying them out – quickly, efficiently and with good quality. It’s simply terrific. Many, probably, didn’t even expect it” [author’s emphasis].93

Later in the same session, the then defense minister, Sergei Shoigu details the “colossal” effort involved in building out defensive fortifications along what he described as a 2,000 kilometer line of engagement in occupied areas of Ukraine. Even assuming Shoigu was padding the numbers, the engineering, construction and installation works he cites are substantial:

“Seven thousand kilometres of minefields, 1.5 million anti-tank Piramida-type barriers, 2,000 kilometres of anti-tank ditches, 12,000 prefabricated reinforced concrete structures, 3,000 platoon strongholds, 45,000 bunkers, and over 150,000 equipment hideouts.”94

While he praises the work of military engineers, he also acknowledges that civilian sector engineering firms had also been engaged in the effort “by decision of the Supreme Commander-in-chief” (i.e., Putin).95 That was probably a begrudging acknowledgement, since it was the machinations of another civilian sector contractor, the late Evgenii Prigozhin of Wagner Group notoriety, that had done so much to expose the limitations and inadequacies of the legacy defense establishment. Five months later, Shoigu would be replaced as Minister of Defense.

Finally, consider this statement by Anton Alikhanov, Russia’s Minister for Economy and Trade from August 2024. He is discussing the unprecedented expansion of resources now dedicated to military production. He starts by noting a sharp increase in the workforce at Russia’s traditional arms factories. But then he adds:

"And this does not take into account the civilian branches [of industry], which are also actively helping in terms of raw materials, components and other materials. Based on the most modest estimates, we have about 900 civilian enterprises engaged in the production of military and dual-use products. But in fact, the companies providing supplies to the defense complex are far greater in number. It’s simply impossible to count them all” [author’s emphasis].96

RIA Novosti, a state-owned news agency, went on to report that

“Alikhanov also emphasized that this synergy between the two branches of the manufacturing industries [i.e., civilian and military branches—author] is one of the factors behind the efficient implementation of the tasks set forth by the President to increase the production of weapons along with military and specialized equipment [author’s emphasis].”97

Western analytical literature also observes Russia’s increased reliance on both (i) civilian companies and (ii) foreign imports to resource the war, as supply-chains are fundamentally reconfigured.

The limitations of Russia’s military industrial complex and the outsourcing trends that ensued—both to domestic civilian companies and to foreign suppliers—are widely observed in recent Western specialist literature. As the team at CNA has shown, Russia’s traditional defense industry is facing significant constraints during the war, owing to years of underinvestment in modernization, a dysfunctional industry consolidation process, and a largely failed import substitution program.98 As Massicot and Connolly have argued, the lack of investment in productivity makes the traditional defense sector more vulnerable to the labor shortages we see today in Russia.99

And the team at CSIS has astutely noted “shifts in the military supply chains” towards more companies with “a principally civilian footprint.” They observe: “[Russia] has moved away from tailored high-end military components toward dual-use or even purely civilian technologies.”100

Western analysis has made similar observations about Russia’s growing dependence on imported machine tools, components and munitions—as important substitution has largely gone into reverse. The team at KSE exposed large scale patterns of parallel imports, as Russia sourced banned Western dual-use components through third countries.101 CNA has described how Russia has turned to cooperative foreign countries to address everything from shell hunger (North Korea) to custom machine tools (China), to advanced drone weapons systems (Iran).102 And the CSIS team has observed that with the evolution of Russia’s foreign supply-chain dependency, more Russian companies “with a principally civilian footprint [are] finding themselves on sanctions lists.”103 And many of the companies now being used to facilitate imports are not well-established import firms but likely shell companies.104

In short, since 2022 the business of war in Russia has been fundamentally transformed. Accordingly, we should think afresh about how to adjust our methods and practices for analyzing it.

Russia’s full-scale invasion of Ukraine marks the first protracted, full-scale foreign war Russia has fought in the post-Soviet period. Authority over resourcing the war has been placed in a newly formed body headed by civilians and sitting outside of the traditional power ministries. It has an explicit mandate to transform how things are done and, specifically, to integrate civilian private sector capabilities across the board. The scale and scope of resource requirements has been vastly expanded. The supply chains have been fundamentally reconfigured. The profile of companies engaged in defense activities has been transformed.

In short, the business of war has been fundamentally transformed in Russia from what it was just a few short years ago. As analysts, we should be alert to this and prepared to think afresh about how we adjust our practices, methods and perspectives. Here, it is worth recalling the recommendations offered by Eliot Cohen and Phillips O’Brien on how to enhance the quality of assessing a system as complex as Russia. We should broaden the range of skills, experience and analytical perspectives contributed to the discussion.105

That includes re-examining the scope of OKVED2 sectoral categories we consider when examining Russia’s war finances and not limiting ourselves just to legacy arms manufacturing.

Having surveyed the evolving resourcing needs for Russia’s war effort, we now turn to the second step in our evaluation process: screening OKVED sectors based on qualitative considerations. This involves examining the range of goods and services provided under each OKVED sector and identifying those that match the state’s war-related resourcing requirements discussed above.

We begin with four OKVED sectors that military analysts have used, by convention, as proxies for conducting longitudinal analysis of arms manufacturing economic activity during times of relative peace. They are:

• #20 Production of chemicals and chemicals products;

• #25 Production of finished metal products, except machinery and equipment;

• #26 Production of computers, electronic and optical products; and

• #30 Production of other transport vehicles and equipment.

These four categories represent the core of Russia’s legacy military industrial complex. Investment in and output from these sectors has risen significantly during the war. As we shall see, borrowing has likewise increased substantially. We can say with a high degree of confidence that these sectors are being heavily drawn on to resource the war effort. As such, they also provide us with a useful benchmark for some of our quantitative screening of other sectors.

Based, however, on the war-time defense-related resourcing needs of the state discussed above, these 4 categories alone do not begin to cover the full scope of goods and services being sought by the state. A few example suffice to illustrate. As we saw, civilian, private sector engineering and construction groups have been engaged by the state to help constructive the extensive fortification systems built in occupied Ukraine. One would not expect any state-directed preferential loans provided for those activities to be reflected in the figures for the 4 core legacy arms manufacturing sectors. They would likely be booked in one of several other sectors relating to construction and engineering.

And what of the extensive trade finance required for Russia’s rapidly proliferating cross-border supply chains? For example, intermediary companies facilitating the import of North Korean shells and missile, Chinese CNC machines and Iranian Shahed drone technologies will all need large amounts of trade finance and working capital. And as noted above, “countless” civilian companies have been newly engaged in facilitating these supply chains, including arranging the expensive business of parallel imports of sanctioned dual-use components through third countries. Under which OKVED category will loans to these import agents and facilitators be booked? Again, it is unlikely to be reflected in borrowing data for our 4 core legacy arms manufacturing sectors. Some of this trade finance lending, however, might be booked under OKVED2 code #46, which includes companies engaged in wholesale import trade activities for a broad range of goods other than motor vehicles and motorcycles.106

Based on analysis of the OKVED2 classification system and the stated resource requirements of the Coordination Council, we have identified 12 additional sectors that appear likely to be contributing a significant amount of goods and services to the war. They constitute our long-list of “other war-related” OKVED sectors. They are:

• 19-Production of coke and refining of oil products

• 41-Construction of buildings

• 42-Construction of civil engineering structures

• 43-Specialized construction work

• 49-Land and pipeline transport activities

• 24-Metallurgical production

• 46-Wholesale trade, except wholesale trade in motor vehicles and motorcycles

• 52-Warehousing and auxiliary transport activities

• 62-Computer software development, consulting services in this field and other related services

• 63-Information technology activities

• 71-Architectural and engineering design activities; technical testing, research and analysis

• 72-Scientific research and development.107

As noted above, it is almost certain that some of the incremental debt taken on by these sectors since mid-2022 is not war related. We correct for that in three ways: through the application of the two quantitative screening tests further below and by applying risking factors to our final list of “other war-related sectors” when carrying out estimation analysis detailed in Chapter 4.

Test #2: the time window test. Did the sector significantly grow its debt load both in absolute and relative terms during second tightening round, when state-directed, “insensitive” borrowers dominated?

The second test we apply is a quantitative one designed to confirm whether a given sector has been taking on substantial amounts of state-directed preferential debt. It takes advantage of what we learned from the Central Bank about the bifurcation of the corporate borrowing market during the second round of rate hikes, from August through October 2024 (see Chapter 2). As the CBR explained, incremental debt levels of sectors borrowing “at market” stopped growing; by contrast, incremental borrowing by sectors receiving state-directed preferential loans kept growing at high rates and in large amounts.

This market bifurcation allows us to conduct a “time-window” test that shows whether a sector has been receiving substantial amounts of state-directed, “rate-insensitive” debt. If it has been borrowing heavily between August and October and showing signs of steep growth in its overall outstanding debt levels during this period, it is likely to have been receiving state-directed preferential loans. This strengthens our conviction that these sectors have been providing goods and services for the war.

Figure 14 shows a distribution of all 78 sectors based on both absolute amounts borrowed and the relative change in the sector’s total debt during these three months. Our provisional list of “other war-related sectors” is represented by the red dots on the scatter plot. From this distribution, it is evident that all but 1 of our 16 provisionally short-listed sectors both (a) borrowed significant amounts during this period (>$300 million) and (b) saw significant 90-day growth in their outstanding debt (>3.5%) during this time window. By contrast, only 8 of the remaining 62 sectors cleared both these screening thresholds. As a result, 93.75% of our provisional short-list cleared the screening threshold demonstrating the likely presence of state-directed preferential lending, whereas only 12.9% of the remaining 62 sectors cleared the threshold.

Figure 14

Figure 15 shows this same data in tabular form for the top 25 sectors by size of incremental debt added. All sixteen of our provisional candidates make the top 25. One of these, “warehousing and auxiliary transport activities,” is the outlier. It has both borrowed a relatively small amount this period and shown only modest levels of overall growth in outstanding debt. For this reason, we are excluding it from our provisional list of other war-related sectors going forward.

Figure 15

The non-war-related sectors on this list make for informative reading. Seven of the 7 pass both our threshold tests. Nonetheless, they are excluded from our list for qualitative reasons. A few observations:

• The list includes food related sectors—food production and fisheries—that would be expected to attract state-backed lending. While food is a core provisioning requirement for the war, these industries will be primarily serving the broader civilian population. Consequently, they are not included in our list.

• This list also includes systemically important extractive industries, such as oil and gas and mining. There appears to be some state-directed lending to these sectors, especially for the construction of infrastructure. It is also possible that recent lending to the coal industry may be a state-directed effort to inject liquidity into a sector that is in financial distress according to recent reports.108 Again, however, these sectors are unlikely to be receiving state-directed loans to facilitate the provision of goods and services directly to the war effort. Hence, they are not included in our list.

• Finally, there is the curious case of “head office activities; management consulting” which added an extraordinary $3.1 billion notching up 13.7% growth for the quarter. This may simply show that consulting is profitable in all markets. But there is another potential explanation. The Coordinating Committee may be enlisting consultants to help coordinate the highly complex supply-chain trade logistics around parallel imports and import diversification. And this borrowing number could reflect the large amount of trade finance and working capital that would be required to maintain these supply chains. To err on the conservative side, however, we are leaving them out of our list.

Based on the time-window test, then, we will not be adding sectors to our provisional list, but we will be cutting one: warehousing and auxiliary transport activities.

Test #3: back-testing borrowing growth trends for our newly included and excluded sectors against benchmark sectors.

Our data also reveal useful trends in longer-term growth in outstanding debt levels. Figure 16 shows long-term growth in outstanding debt for the 78 sectors broken into three groups:

• First, there are the 4 core sectors associated with legacy arms manufacturing. They serve as a benchmark for borrowing trends by sectors heavily engaged in the war process and known to receive state-directed preferential loans.

• Next, there are the “other war-related-sectors”—the 11 sectors that passed both our function and time-window tests.

• Finally, there are the “non-war-related sectors” made up of the remaining 63 sectors.

Prior to mid-2022, the total debt in all three groups rose at roughly the same modest rate. But after mid-2022, growth in our 15 war-related groups surged, growing 2.7 times faster than the remaining 63 groups.

Moreover, our two war-related groups grew in remarkably close tandem with one another over this period. Outstanding debt levels for the 4 core arms manufacturers and the 11 other war-related sectors rose by 136% and 116% respectively. This sharply distinguishes the borrowing patterns of our 11 other war-related sectors from the 63 non-war-related sectors while closely associating them with our 4 benchmark sectors.

Figure 16

Applying our three screening tests, we have reduced our original 78 sectors to a list of 15 sectors that we can say with reasonable confidence (i) are likely to be providing a significant portion of goods and services to the war effort and (ii) appear to have been receiving substantial amounts of state-directed preferential loans (see Figure 17). These consist of the 4 core arms manufacturing sectors plus the newly tested 11 “other war-related” sectors.109

Figure 17

Endnotes

*******

UPDATE, February 14, 2025: The full report—including updated numbers—has now been published on Navigating Russia and can can be found at: Russia’s Hidden War Debt (full report).

*******

[Below is the draft Executive Summary from a forthcoming report entitled Russia’s Hidden War Debt. The full report is expected to be published in the coming days on Navigating Russia.]

Moscow has been stealthily pursuing a dual-track strategy to fund its mounting war costs. One track consists of the highly scrutinized defense budget, which analysts have routinely deemed “surprisingly resilient.” The second track—largely overlooked until now—consists of a low-profile, off-budget financing scheme that appears equal in size to the defense budget. Under legislation enacted on the second day of the full-scale invasion, the Kremlin has been compelling Russian banks to extend preferential loans to war-related businesses on terms set by the state. Since mid-2022, this off-budget financing scheme has helped drive an unprecedented $415 billion surge in overall corporate borrowing. This report estimates that $210 to $250 billion of this surge consists of compulsory, preferential bank loans extended to defense contractors—many with poor credit—to help pay for war-related goods and services.

Initially, this off-budget defense financing scheme proved advantageous to Moscow by enabling it to maintain its official defense budget at manageable levels. That misled observers into concluding—incorrectly as it turns out—that Moscow faces no serious risks to its ability to sustain funding its war. More recently, however, Moscow’s heavy reliance on its off-budget, compulsory lending scheme has begun to cause serious, adverse consequences at home. Not only has it become the main driver of inflation and interest rate hikes, but it is also creating the preconditions for a systemic credit crisis.

In late 2024, the Kremlin became increasingly aware that its off-budget funding scheme is unleashing potentially disruptive systemic financial risks, such as prohibitively high interest rates, liquidity and reserve problems at banks, and a severely compromised monetary transmission mechanism. For Moscow, credit event risk—with its seismically disruptive potential—will be of far more immediate concern than slow-burn risks like declining GDP. Moscow now faces a dilemma: the longer it puts off a ceasefire, the greater the risk that credit events—such as corporate and bank bailouts—uncontrollably arise and weaken Moscow’s negotiating leverage. Moscow’s emerging financing dilemma is likely to weigh on its war calculus and offers unexpected negotiating leverage to Ukraine and its allies. This report details ways well-informed negotiators can exploit Moscow’s growing financial vulnerability.

Executive Summary

This report examines Russia’s strategy for funding its war on Ukraine. It assesses Russia’s ability to sustain elevated war-time expenditures and identifies vulnerabilities that can be exploited by Ukraine and its allies.

It has three key findings:

1) The Russian state has been pursuing a two-track strategy to cover its mounting war costs, supplementing its highly scrutinized defense budget expenditures with funding from an off-budget defense financing scheme that is similar in scale, but has been overlooked by analysts;

2) Unlike its federal defense budget expenditures, which remain at sustainable levels, Russia’s off-budget funding scheme is proving much more problematic to sustain;

3) This now poses a funding dilemma for Moscow that could weigh on its war calculus, while providing Ukraine and its allies valuable, new negotiating leverage; this report details ways to exploit Moscow’s growing financial vulnerability.

What follows is a summary of each of these three findings.

1)The Russian state has been pursuing a two-track strategy to cover its mounting war costs, supplementing highly scrutinized defense budget expenditures with funding from an off-budget financing scheme that is of similar scale, but has been largely overlooked.This off-budget funding stream is authorized under a new law, quietly enacted on February 25, 2022, that empowers the state to compel Russian banks to extend preferential loans to war-related businesses on terms set by the state.Since mid-2022, Russia has experienced an anomalous 71% expansion in corporate debt, valued at $415 billion or 19.4% of GDP (see Figure 1).

This incremental corporate credit surge is large compared to key budget metrics (see Figure 2). It significantly exceeds both total oil and gas revenues and defense budget expenditures over the same period and is 6.5x times larger than incremental government borrowing.

According to analysis of sectoral lending data, over 70% of the corporate credit surge went to sectors engaged in war-related activity (see Figure 3).

Not all lending to these sectors has necessarily been going to fund goods and services for the war. Based, however, on analysis in this report, it is estimated that between 50% and 60% of the wartime corporate credit surge ($207 to $249 billion) has gone to fund war-related business under the government’s off-budget funding scheme. These are loans that the state has compelled banks to extend to largely uncreditworthy, war-related businesses on concessionary terms. At this scale, Russia’s off-budget funding stream roughly equals total expenditures flowing through the federal defense budget.

Between 2010 and 2022, the Kremlin used a similar off-budget financing scheme—though on a smaller scale—with the express aim of surreptitiously supplementing funding for its costly rearmament program while appearing publicly to maintain budget discipline. The current scheme achieves a similar goal of allowing official budget spending to remain at sustainable levels, creating a misleading impression about the resilience of Russia’s war-funding capacity.

In short, Russia’s total war costs far exceed what official budget expenditures would suggest. The state is stealthily funding around half these costs off budget with substantial amounts of debt by compelling banks to extend credit on “off-market” (non-commercial) terms to businesses providing goods and services for the war.

2) Unlike the defense budget, which has been maintained at sustainable levels, Russia’s off-budget defense funding scheme became much more problematic to sustain during the second half of 2024; it has grown so large that it is driving inflation, pushing up interest rates for “real” economy borrowers to well above 21% and creating the preconditions for a systemic credit crisis. In the second half of 2024, the Central Bank of Russia (CBR) began identifying the state’s preferential corporate lending scheme as a significant threat to Russia’s economic stability. As the main contributor to monetary expansion, it has been driving Russia’s rising inflation. Worse still, because this lending is strategic rather than commercial in nature, the CBR observes that it has been largely “insensitive” to interest rate hikes, blunting the CBR’s main tool for combatting inflation (see Figure 4). Consequently, to cool off overall borrowing, the CBR says it has been forced to tighten far more aggressively than would otherwise have been needed.

High borrowing costs are causing financial distress among otherwise healthy companies in the “real” economy, leading the CBR to voice concerns over “the risk of major companies becoming overindebted.” These at-risk companies likely includes Gazprom, which has been borrowing heavily in the domestic markets at 22% and higher to cover losses from the collapse of its core business—European exports.

The CBR has also voiced concern over the condition of major banks, which have been operating under greatly eased regulatory policies since sanctions were stepped up in early 2022. According to the CBR, some banks have taken advantage of eased policy to lend “aggressively” without maintaining sufficient “short term liquidity” and adequate “capital buffers.”

Additionally, bank credit risk has likely been significantly increased by the large amount of state-compelled lending to weak-credit businesses that may struggle to service their loans, especially once defense spending is reduced. This creates the prospect of a systemically destabilizing pool of toxic debt spreading across the corporate credit markets.

In a possible sign of how problematic bank loan books have become, in November 2024, the CBR announced a long-awaited schedule for tightening bank regulatory policy—only to turn around in December and unexpectedly postpone its tightening plans.

Russia’s off-budget defense funding schemes have turned toxic twice before—in 2016-17 and again in 2019-20. Both times, the state had to assume large amounts of bad debt. Given the scale of today’s off-budget credit scheme, the potential bail out could be extremely burdensome for the state—totaling as much as half of Russia’s entire 2024 federal budget. This could constrain state finances for an extended period, including its ability to fund future rearmament—provided, of course, that Russia doesn’t receive substantial sanctions relief.

In short, it is now apparent that Moscow’s heavy reliance on off-budget bank financing to help fund the war is creating the preconditions for a systemic credit crisis. By driving up interest rates, it is creating financial distress among companies in the “real” economy. And by imposing significant amounts of debt on war-related companies that are likely to default over time, it risks overwhelming banks with a wave of toxic debt. Unsurprisingly, since late October, the CBR been publicly calling on the government to curtail its preferential funding scheme. But this would undercut the state’s ability to maintain current levels of war funding without a major increase in official defense budget expenditures.

3) By late 2024, the Kremlin had become aware of the systemic credit risks unleashed by its off-budget defense funding scheme. This has created a dilemma that is likely to weigh on Moscow’s war calculus: the longer it relies on this scheme, the greater the risk a disruptive credit event occurs that undermines its image of financial resilience and weakens its negotiating leverage. Moscow’s emerging financing dilemma offers unexpected negotiating leverage to Ukraine and its allies. There are two key measures that well-informed negotiators can take to exploit Moscow’s growing financial vulnerability.

On October 28^th, Vladimir Putin convened a meeting of senior officials, including the head of the CBR, to discuss problems around the “structure and dynamics” of Russia’s “corporate debt portfolio.” Since then, he has publicly shown heightened sensitivity to defense spending levels and the state’s use of preferential lending to achieve “strategic tasks.” Additionally, there continues to be negative news flow around rising levels of financial distress in both the corporate and consumer sectors.

Unlike the slow-burn risk of inflation, credit event risk—such as corporate and bank bailouts—is seismic in nature: it has the potential to materialize suddenly, unpredictably and with significant disruptive force, especially if it becomes contagious. At this point, Moscow is unlikely to be worried that a major credit event risk could destabilize the government. Or even prevent it from maintaining elevated spending on the war. It can probably still fall back on major tax hikes and increases in state borrowing—though clearly prefers not to.

Moscow greater concern is likely Russia’s deteriorating credit environment could unleash events that dispel the widespread misperception—artfully promoted by Moscow—that Russia’s war finances are sustainable and face no significant risks. That misperception provides Moscow with valuable leverage in prospective negotiations. Moscow’s practice of manipulating perceptions around defense spending for political advantage is nothing new; it was widely practiced in Soviet times as part of a broader campaign of reflexive control.

Moscow now faces a dilemma: the longer it puts off a ceasefire, the greater the risk that credit events uncontrollably arise and weaken Moscow’s negotiating leverage.

This is a serious enough concern to factor into Moscow’s ceasefire calculus. Specifically, it could incentivize Moscow in two ways:

i. to prioritize relief around revenue-constraining sanctions as a condition of a ceasefire; this would provide much needed additional resources for restructuring large-scale, toxic corporate war debt while also funding rearmament;

ii. to favor a ceasefire sooner rather than later, to reduce the risk that a credit event weakens its negotiating leverage; if, however, Moscow believes significantly greater sanctions relief could be achieved by prolonging hostilities, it may be prepared to take the risk of doing so.

Ukraine and its allies can exploit Moscow’s funding dilemma by taking two measures:

i. Quietly voice confidence that Western resources can outmatch Russian resources in a war of attrition, backing up that message with a renewed package of funding and arms along with stepped up sanctions enforcement—following up on the January 10, 2025 ratcheting up of energy sanctions. Moscow fully understands it simply cannot prevail against a resolute deployment of Western resources. Which is why it invests so much effort into persuading Western opinion otherwise, in hopes of inducing despair and fatigue that lead to unnecessary concessions. A renewed display of Western resolve will weaken Moscow’s confidence in its ability to secure negotiating advantage through bluff and deception. The prospects of having to match superior Western resources in an extended conflict will only deepen Moscow’s concerns over its newly emerging funding vulnerability. This will pressure it to quietly reconsider its calculus of confrontation, as we have seen it do many times before.

ii. State robustly and categorically that sanctions relief is entirely off the table in any ceasefire negotiations and will only be considered as part of a comprehensive peace settlement—including reparations—that is negotiated and approved by Ukraine. In the face of renewed Western resolve, one thing that could cause Moscow to prolong fighting is if it believed it could gain additional sanctions relief by fighting on. By categorically removing sanctions relief from any ceasefire talks—and persuading Moscow that this is non-negotiable—it will weaken Moscow’s incentive to prolong fighting. It is also tantamount to calling Moscow’s bluff that its finances remain robust and sanctions have been ineffectual. Moreover, maintaining sanctions—with robust enforcement—will also constrain Moscow’s ability to rearm following a ceasefire, while leaving Ukraine and its allies with powerful negotiating leverage in any eventual comprehensive settlement.

Moscow’s funding challenges only increase from here, especially if coalition countries enforce more fully the powerful energy sanction tools at their disposal.Through continued resolve and a clear understanding of Moscow’s vulnerabilities, Ukraine and its allies can realize the full potential of their negotiating leverage, avoid making unnecessary concessions, and reduce the longer-term risks posed by Russian revanchism.

About the author

The author worked for many years as an investment banker at Morgan Stanley and Bank of America Merrill Lynch, where he was a vice chairman. During his banking career, he advised companies and governments around the world and led numerous financings, including Russia’s largest ever corporate transaction. He received an undergraduate degree in Russian studies and a doctorate in Russian and Middle Eastern history from Harvard and a masters in Middle Eastern languages from Oxford, where he was a Rhodes Scholar. Currently, he conducts research on Russia’s energy economy at Harvard’s Davis Center and is writing a history of the Russian oil industry and its impact on civil society. He also is the author of the Substack Navigating Russia.

[The full report, Russia’s Hidden War Debt, is expected to be published in the coming days on Navigating Russia.]

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Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

© Copyright 2025, by Craig Kennedy. All rights reserved.

On December 16, 2024, twelve countries from Northern Europe announced an initiative to “disrupt and deter” the shadow fleet by “requesting relevant proof of insurance” and to “assess and action upon” the information gathered.

In light of this news, some readers may be interested in learning more about Russian shadow fleet insurance and potential deterence mechanisms. While this report is already somewhat dated, readers interested in those topics may still find some value in it.

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The following are highlights from an upcoming report to be published on Navigating Russia.

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Report Highlights

The crisis of the shadow fleet: expansion has stalled and is at risk of reversal as the fate of the fleet slips out of Moscow’s control.

• Russia’s shadow fleet has been slipping into a crisis over the past year, buffeted by challenging economics and increasingly perilous sanctions.  That’s the picture emerging from extensive analysis of the relevant shipping and financial data.

• These forces have stalled the growth of the shadow fleet and threaten to reverse it. A diminished fleet would undermine Moscow’s main price-cap evasion strategy and weaken Russia’s incentives to adhere to OPEC+ cuts.

Shadow fleet expansion began to decelerate sharply in mid-2023…

• The crisis began in Q2 2023, when the number of tankers bought quarterly for Russia’s shadow fleet dropped off sharply, following three quarters of aggressive expansion (see Figure 1). By Q4, purchases were down some 70% off Q1 highs.

• The main driver of shadow fleet expansion since June 2022 has been the acquisition of aging, second-hand tankers—mostly from mainstream operators—that are then repurposed for Russia’s shadow trade. These bought-for-purpose vessels account for some 90% of growth (see Figure 2). By contrast, tankers hired in from other shadow trades, like Iran’s, have contributed only marginally. This fact is often overlooked in analysis but critical for understanding fleet dynamics.

… as many newly purchased tankers failed to generate sufficient benefits to the state to justify their record-high purchase costs.

• What accounts for last year’s sharp slowdown in quarterly growth? It’s not that Moscow had satisfied its tonnage requirements—far from it. Shadow fleet capacity remains below 50% of what Russia needs for a stand-alone fleet (see Figure 1 above). (The actual shadow shipping capacity active in Russia today is equivalent to some 270 Aframax class tankers—a figure far smaller than commonly reported.)

• Challenging economics were likely to blame for the initial slow down. Fleet expansion has been costly. An estimated $8.5 billion—largely financed by the Russian state it appears—has been spent acquiring aging vessels at record prices, most with only 2 to 3 years of expected service life remaining (see Figure 3).

• Assembling a stand-alone shipping capability—able to keep Russian exports whole—would likely take several more years and cost upwards of $25 billion (1.3% of 2023 GDP) in total for initial acquisitions. Additionally, maintaining fleet strength in the face of high attrition would require billions more each year, rising to some $7 billion per annum (2% of Russia’s 2023 federal budget) at full fleet strength.

• But for much of 2023, many newly purchased shadow tankers failed to unlock enough additional revenues above the cap to justify the heavy draw on state resources needed to acquire them. Economically, the state would have been better off relying more heavily on the mainstream fleet.

• What’s more, routes with low economic returns—those with long voyage times and cargoes priced at deep discounts, like western-ports-to-India—required far more tankers to service them than high-return routes like Pacific-ports-to-China (see Figure 4).

• With capacity needs on the high-return routes already satisfied by mid-2023 (see Figure 5) and Russia’s budget deficit widening, enthusiasm for continuing to fund a high rate of fleet expansion appears to have slackened.

Growth was further impeded last October, when OFAC launched an effective campaign of measured tanker blockings. It reduced incentives for further investments…

• Moscow’s buy-to-grow fleet strategy suffered a further setback after October, when OFAC began imposing blocking orders on select shadow tankers, rendering them unusable for normal export operations. To date, 40 vessels representing some 15% of fleet capacity have been blocked (see Figure 6).

• And then there are negative knock-on effects arising from the market’s perception of rising risk around the fleet, such as recent reports of major Indian importers refusing any deliveries on Sovcomflot tankers (20-25% of shadow fleet capacity), for fear of sanctions “contagion.”

…and placed control over future fleet size largely in OFAC’s hands.

• Now, the fate of the fleet depends largely on OFAC’s next step—specifically, on whether it continues to block more tankers and at what pace.  Coalition enforcement authorities have expressed an interest in downsizing the fleet. A moderately stepped-up blocking program could significantly reduce fleet size with little risk to shipping and energy markets (see Figure 7).

• Significantly downsizing the shadow fleet would shift more export barrels back to the price-cap constrained mainstream fleet (where price-attestation rules appear in need of further tightening).

If OFAC acts to downsize the fleet, it would expose more revenues to price cap restrictions and incentivize Moscow to pursue a volume-over-value export policy.

• If the shadow fleet does get downsized and mainstream compliance is tightened, it would incentivize Moscow to revert to a volume-over-value export strategy.  This, in turn, would reduce Moscow’s incentive to coordinate cuts with OPEC in support of higher prices.

• By contrast, a prolonged pause in OFAC’s blocking campaign could encourage Moscow to push harder for higher oil prices and accelerate fleet expansion.

Conclusion: distress is rising across the Russian oil and gas sector.

• The shadow fleet crisis is part of a broader pattern of mounting distress across the Russian energy sector, as sanctions—compounded by Kremlin incompetence—take their toll:

  • oil field productivity is falling;

  • Arctic LNG 2 has just been mothballed for lack of ice-class tankers;

  • Gazprom—deprived of its main source of revenue by Putin himself—now struggles with insolvency;

  • and Russia’s sprawling refining capacity is fast becoming a casualty of war. 

• The trajectory is clear: Russia’s hydrocarbon strength is fading.

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About the author

The author is a former vice chairman at a global investment bank. He holds a doctorate in Russian and Middle Eastern History and is writing a history of the Russian oil industry and its impact on civil society.

Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

© Copyright 2024, by Craig Kennedy. All rights reserved.

Summary

Could Moscow’s shadow fleet be running into sanction headwinds?  Recent developments suggest so.  Consider, for example, the nine tankers transporting Sakhalin oil to India last month that unexpectedly failed to deliver their cargoes—for reasons that remain unclear.  Weeks on, they remain adrift at sea, seemingly unable to secure new buyers.  Then there are the seven shadow tankers sanctioned by OFAC between October and early December: none appears to have lifted or delivered a single cargo since getting “blocked.”  Ships aside, Moscow has also seen a handful of its “under-the-radar” oil traders hit with sanctions by the U.S. and Britain.  And then there’s state-owned Sovcomflot’s flag-of-convenience fiasco. During the first half of January, the company has been scrambling to reflag some fifty tankers after they were abruptly dropped by Liberia.  But by letting most of its fleet fly Liberia’s U.S.-administered flag throughout 2023 while also sometimes transporting oil priced above the cap, the company likely caused some 75% of its tankers to violate sanctions rules, putting them at risk of OFAC action.

These setbacks—and others—are the direct result of a recent campaign by price-cap coalition countries to step up pressure on intermediaries in the shadow oil trade.  The campaign has included a series of public enforcement actions against a small sampling of market players—shipowners, ship brokers and oil traders.  It has also, reportedly, involved private overtures to a range of other entities—foreign banks, flag registries, insurers and the like—urging them to show greater diligence in their price-cap compliance.  And some, like the Liberian registry, appear to have taken the message to heart.

But while the coalition’s campaign is clearly getting some traction, its scale thus far has been too limited to achieve what really matters: a major reduction in Russian oil export revenues. 

Nonetheless, the campaign is surely setting off alarm bells in the Kremlin.  And understandably so.  The initial phase of the new campaign has the hallmarks of a probing operation.  Though limited in scale, it has nevertheless managed to flush out vulnerabilities in Moscow’s circumvention strategy.  Once identified, those weaknesses can be more aggressively targetted, causing real damage to Kremlin finances.

For many months, Moscow has been toiling to construct a shadow shipping infrastructure beyond the reach of coalition authorities.  At its core is a gradually expanding fleet of shadow tankers.  But it also involves networks of critical intermediaries, like traders, banks, ship brokers, flag registries, insurers and others.  As usual, Moscow has sought to project an aura of invincibility around its creation—presenting it as a formidable, well-oiled machine hardened against external interference.  But as those who built it know, in reality it’s a jerry-rigged contraption, assembled on the fly—less ghost armada, more Potemkin flotilla.  And like similar Kremlin improvisations, it’s turning out to be riddled with weaknesses and imperfections.

Two vulnerabilities in particular are likely to concern Moscow.  One is the campaign’s ability to erode the cost-effectiveness of the shadow trade by increasing the risk premium associated with it.  Each announcement of additional sanctions ratchets up the level of perceived risk in the market.  As compensation for this rising risk, intermediaries will seek higher fees while importers will demand deeper discounts.  A case in point: it was Indian demands for unacceptably deep discounts that reportedly prevented the nine tankers mentioned above—each with a significant risk profile—from completing their deliveries. 

There’s even circumstantial evidence suggesting the Indian buyers may have taken risk management a step further, perhaps demanding price-cap linked pricing.  That would be a nightmare scenario for Moscow since it would effectively give coalition policymakers the power to influence prices in Russia’s largest market for seaborne exports.

The second major vulnerability exposed by the new coalition campaign is OFAC’s apparent ability to sideline shadow tankers with blocking orders.  As noted above, none of the seven sanctioned shadow tankers has yet to return to service.  Were OFAC to block a much larger number of vessels, it could substantially reduce the footprint of the shadow fleet. This, in turn, would force Moscow to rely more heavily on the ample mainstream fleet, where revenues would be more exposed to price-cap restrictions.  Moscow is surely pushing hard to return its blocked vessels to service. If they eventually succeed, watch who is willing to receive their cargoes and whether OFAC takes measures to discourage them.

Beyond blocking orders, coalition states have other powers they could use to shrink the footprint of the shadow fleet.  EU states, for example, could use their maritime legal rights to prevent improperly insured shadow tankers from lifting cargoes from Russia’s Baltic ports—through which half the country’s seaborne exports flow.  And if Moscow finds an increasing number of its costly shadow tankers blocked, excluded or otherwise unusable, it might stop trying to buy more.

Like Prospero, coalition authorities now appear to have the power to conjure up a perfect storm around Russia’s shadow fleet.  How hard will they press their advantage?  And what countermeasures might Moscow come up with?  Only time will tell.  But a year into the price cap, the situation remains as dynamic as ever.

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Introduction: a half billion dollars of Sakhalin oil stranded at sea

In early November, at Russia’s remote De-Kastri export terminal, a cargo of oil from nearby Sakhalin Island was loaded for what should have been a routine, one-month voyage to India.  Four weeks on, however, as the cargo was deep in the Bay of Bengal, less than a day out from its destination port, the tanker transporting it abruptly idled its engines and began to drift.  Over the course of December, a similar scenario would play out with seven other tankers transporting Sakhalin crude to India.  One by one, at various points along the well-travelled route, they cut their engines and stopped making way.  By the end of the month, an estimated half a billion dollars of Sakhalin oil filled the holds of a string of idled tankers stretching from the Korean Strait to the Laccadive Sea (see Figure 1 below).

This was anomalous.  For months, a steady stream of Sakhalin crude regularly plied the routes from De-Kastri to Vadinar, Paradip and other Indian ports.  Then, over the course of a few weeks, shipments along this lucrative artery gradually seized up.  Meanwhile, the heavy flow of India-bound tanker traffic from Russia’s other ports carried on unabated.

Viewed from afar, it looked as though some issue had unexpectedly arisen around these Sakhalin cargoes, a sticky problem buyer and seller were having a hard time resolving.  At the end of December, weeks after the first tanker had suspended its voyage, the idled tankers abruptly signalled new destinations outside of India.  Those vessels already near India reversed course and began steaming eastward.  Negotiations appeared to have hit an impasse, and the seller was doing the maritime equivalent of storming out of the room. 

Why did these sales of Sakhalin oil to India fall apart? 

What happened?  Why did this seemingly routine series of shipments fail to be delivered?  In the Russia-India oil trade, which sees over 750 shipments a year totalling some $40 billion in value, this episode is highly unusual.  And while Sakhalin deliveries account for only 10% of Russia’s oil sales to India, given India’s central importance to Russia’s war finances, it’s worth examining this unexpected trade rupture more closely and trying to unravel the mystery of the failed De-Kastri cargoes.

Varying explanations for the breakdown have appeared in the press.  One maintains there was a problem with payment mechanics.  The parties had decided to settle in dirhams, but the Sakhalin exporter was having trouble arranging accounts for settling the trades.  Another report claims the standoff was over price.  Indian buyers were demanding discounts that the seller wasn’t prepared to pay.  Still others imply it all had something to do with sanctions. 

Structure of the report and key conclusions

Three different explanations—each plausible.  Which is correct?  In search of an answer, this report examines the Sakhalin-India trade from several angles.

Part 1: The coalition’s campaign of stepped-up enforcement is causing a sea change in sanction risk around the shadow trade. The report begins a brief overview recent moves by OFAC and other enforcement agencies and how they are reshaping the risk environment around Russia’s shadow trade. 

Part 2: The two-stage structure of Sakhalin-to-India shipments. It then describes the two-stage shipping pattern used for delivering Sakhalin cargoes to India.  That’s important to understand since it increases the exposure of Sakhalin cargoes to sanctions risk.

Part 3: A risk analysis of tankers involved in the failed De-Kastri deliveries. There follows a forensic analysis of the fifteen tankers involved with the failed De-Kastri deliveries, assessing each vessel for a range of relevant risk markers, such as who flags, insures and manages the ship.  It turns out that the tankers involved with the December Sakhalin deliveries have a high concentration of sanction-related risk attributes.  This may have caused these Sakhalin cargoes to appear particularly risky to prospective buyers and other transaction counterparties, especially against the backdrop of OFAC’s stepped-up enforcement campaign.

Part 4: Why were the De-Kastri cargoes turned away from India? A speculative fourth explanation. Armed with this knowledge, the report then assesses the plausibility of each of the three explanations behind the failed De-Kastri deliveries—payment mechanics, pricing and general sanctions risk.  It finds all three explanations plausible, and mutually compatible, but ultimately insufficient to make sense of the facts at hand.  It goes on to speculate that, given the risks involved, the Indian importers might have sought to “de-risk” the trades by requiring they comply with the price cap—a condition the Russian sellers were unwilling to accept, even in the absence of another firm offer for the cargoes.

Conclusion: If enforcement efforts are scaled up they could reduce the footprint of the shadow fleet and inflict real damage on the Kremlin’s oil income. The report concludes by observing that the coalition’s stepped-up enforcement campaign appears to be gaining traction, but will need to be substantially scaled up to have a major impact on Russia’s oil finances.  It observes further that the coalition has potent options it could pursue—should it choose—that could substantially reduce Moscow’s ability to use its shadow fleet and compel it to rely more heavily on the mainstream fleet, where price-cap policies have a better chance of constraining Russian oil revenues.

Appendix: Sovcomflot’s flag-of-convenience fiasco—a mass, forced reflagging from Liberia to Gabon is now underway. In the opening days of January, Sovcomflot has been scrambling to reflag some 50 tankers, after they were abruptly dropped from Liberia’s U.S.-administered registry.  Nearly all have reflagged to Gabon, which has now become the leading flag in the Russian shadow fleet, and whose tanker registry is not dominated by Russian shadow vessels.   Reflagging might reduce the sanctions risk these tankers pose to third parties, but it doesn’t cleanse them of their past offences—they remain “at risk.” Market sentiment towards them may largely hang on whether OFAC moves to sanction more of them.

Part 1: The coalition’s campaign of stepped-up enforcement is causing a sea change in sanction risk around the shadow trade

The end of 2023 saw an unexpected sea change in the sanctions risk around Russia’s shadow trade.  What was thought to be a relatively benign environment for shadow shippers and other market participants—like Emirati bankers and Indian importers—has suddenly started looking more fraught with risk. 

This perception of rising risk comes in response to a series of enforcement actions that OFAC began imposing on a targeted range of shadow trade intermediaries starting in October.  It began with the blocking of a handful of shadow tankers.  The specific charge against them: transporting oil priced above the cap while relying on restricted, U.S.-based marine services.  Under U.S. rules, that’s a violation of the price cap and puts the offending party “at risk” of enforcement actions.  More recently, OFAC has taken action against several “under-the-radar” traders as well as a ship management group.  OFSI has also sanctioned a commodities brokerage active in the Russia trade and four UAE-based ship managers.

A major administrative blunder by Moscow in managing the shadow fleet has left half of it “at risk” of OFAC sanctions for price-cap violations.

When OFAC started sanctioning shadow tankers for price-cap violations back in October, it came as something of a surprise.  Shadow tankers were supposed to be safe from price-cap sanctions, since their commercial relationships are structured to avoid using restricted marine services—like insurance and broking—based in coalition countries.  When tankers are being repurposed for the shadow trade, Kremlin bureaucrats overseeing the process should ensure they are scrubbed of all such service ties.  Those ties get replaced with services from non-coalition providers. At least that’s how it’s supposed to work.

But in a major blunder, the Kremlin officials overseeing Russia’s shadow fleet neglected to sever ties to U.S.-based companies providing a critical, restricted marine service: flagging.  A large number of Russian shadow ships continued to rely on U.S.-based flagging services—over 100 by my count—long after sanctions were introduced.  A similar blunder was made with U.S.-based spill liability insurance, though on a smaller scale. 

Because of these missteps, nearly 150 shadow tankers—including three quarters of the Sovcomflot fleet—continued to rely on restricted U.S. marine service providers during part or all of the first year of sanctions (see Dangerous Waters).  Many—perhaps all—may have relied on these restricted services while also carrying cargoes priced above the cap.  Under U.S. law, that constitutes a sanctions violation.  The offending vessels—as many as half Russia’s active shadow fleet—might now be “at risk” of OFAC enforcement action.

An OFAC enforcement action against a tanker is no hollow threat. Of the handful of tankers OFAC has blocked since mid-October, none—as of early January 2024—has lifted or delivered a cargo since being listed.  For the moment at least, getting blocked is tantamount to being put out of operation.

Such “at risk” tankers can also present a threat of “contagion” to any other shadow trade participants involved with them.

That alone is bad news for the shadow fleet.  What’s worse, however, is that at-risk tankers can become vectors of “contagion” putting other parties at risk.   Market actors—say, an Emirati banker or Indian buyer—participating in deals involving above-cap cargoes that are transported by tainted tankers are, themselves, potentially in violation U.S. sanctions rules.  They, too, could be subject to an enforcement action.

As if to underscore the “contagion” risk to market intermediaries, on December 20^th, OFAC added several “under-the-radar” oil traders to its SDN list.  In justifying its enforcement action, OFAC cited—among other misdeeds—the chartering of tankers that “have been identified as having engaged in the transport of Russian crude oil priced above $60 per barrel after the price cap came into effect while using services of a covered U.S.-based provider.”

All these adverse developments—the imposition of price-cap sanctions on a handful of shadow tankers, the realization many more vessels might already be at risk, and the sanctioning of traders for making use of tainted tankers—only serve to increase the perception of risk around the shadow trade. 

These elevated risks likely spell higher costs for Moscow.

Markets price risk.  When risks around the shadow trade rise, someone has to bear the additional costs.  In this case, it looks like that someone is Moscow.  These risk-related costs can take different forms.  Buyers will demand deeper discounts.  Service providers ask higher fees.  Some participants might even take things a step further.  Instead of demanding increased compensation for sanctions risk, they may seek to mitigate it altogether by refusing to participate in transactions priced above the cap.  Indeed, as we shall see below, that may be what was behind the rupture in the Sakhalin-India trade.

This new reality of shadow trade risk would likely have been on the minds of various parties involved with the Sakhalin cargoes.  That includes not only the sellers, but the prospective Indian buyers and the Emirati bankers involved with settlement of the transactions.   

By December of 2023, one thing they would likely have been doing was scrutinizing more closely the tankers involved with those trades.  How much risk did they pose to importers and other transaction participants if their cargoes did not comply with the price cap?  Were they already on the sanctions list?  Or might they be among those vessels “at risk” and potentially subject to enforcement? 

In the next section, we’ll address these questions when we take a closer look at the sanctions risk profile of the tankers carrying the Sakhalin cargoes.  First, however, a brief word about the peculiar two-stage shipping process along the De-Kastri-to-India route.

Part 2: The two-stage structure of Sakhalin-to-India shipments

De-Kastri to India: a tanker-intensive route

By Russian standards, De-Kastri is an export terminal of modest proportions.  It handles some 200,000 barrels a day of crude, produced on nearby Sakhalin Island.  That’s just a quarter of what comes out of Russia’s main Pacific port at Kozmino, located some 1,200 kilometers down the coast from De-Kastri.

Lifting out of De-Kastri poses significant logistical challenges.  As Chekhov describes in Sakhalin Island, his unflinching 1895 exposé of the penal colony at Sakhalin, De-Kastri is ice bound for half the year and suffers from treacherously shallow waters.  What was true 130 years ago remains so today. Consequently, loadings are done through an off-shore, single-point mooring system.  And because of the ice risk, De-Kastri is serviced by a dedicated fleet of seven, double-hulled, ice-class Aframax tankers belonging to Sovcomflot (“SCF”), Russia’s state-owned shipping company.

Prior to December, some 80% of De-Kastri’s exports were routinely sold to India, the remaining 20% going to China. The outbound trip to China can be comfortably done in a week to 10 days and is normally done end-to-end by one of De-Kastri’s dedicated ice-class tankers. 

A two-stage process for deliveries to India

The deliveries to India, however, are a more complex affair (see Figure 1 above).  A direct round trip from De-Kastri can easily exceed 50 days. Using expensive ice-class tankers for the long-haul voyage to India is an inefficient use of these expensive vessels.  With vessels away from their home port for so long, Russia would need a much larger number of dedicated, specialized tankers to keep De-Kastri exports flowing.  To avoid this problem, nearly all deliveries to India are conducted in two stages, with the ice-class tankers acting as short-haul shuttles. 

In Stage 1, a cargo is loaded at De-Kastri onto an ice-class Aframax, which transports it to Yeosu Anchorage, a lightering area just off the southern tip of Korea. There, the cargo is transferred ship-to-ship (STS) into a standard tanker for the onward journey to India (Stage 2). 

This two-stage process also means that India-bound cargoes are normally handled by two different vessels en route.  In the case of the 9 aborted Sakhalin-to-India deliveries, some 15 different ships were involved:

• Stage 1: six “shuttle” tankers from De-Kastri’s dedicated ice-class fleet, and

• Stage 2: nine “delivery” tankers from the broader shadow fleet.1

Given the “contagion” problem noted above, the more shadow tankers involved with a cargo, the greater the chance it could get “tainted” by being handled by an at-risk tanker.  Contagion becomes an especially acute risk if the oil being shipped is routinely quoted at price levels well above the cap. And for many months, that has been the case with the Sokol-grade crude shipped from De-Kastri.  

Part 3: A risk analysis of tankers involved in the failed De-Kastri deliveries

Risk profiling: tankers transporting crude from De-Kastri to India in late 2023 show a significant number of markers associated with U.S. sanctions risk—especially Liberian flagging.

With De-Kastri logistics mind, we now take a closer look at the risk profile of the 15 vessels involved in the failed deliveries to India (see Figure 2 below). To start with, none of these vessels is from the mainstream fleet.  As noted earlier, all the ice-class STS shuttle tankers belong to Sovcomflot.  Seven of the nine delivery tankers do as well.  The remaining two are shadow tankers with opaque ownership structures. 

The matrix in Figure 2 assesses each of these vessels for four significant risk markers: 

1)      formal sanctions by OFAC;

2)      flying a U.S.-administered flag, such as the Liberian flag;

3)      management services provided by Sun Ship Management, a Dubai-based subsidiary of Sovcomflot that was sanctioned by OFAC on December 20, 2023; and

4)      using American P&I Club insurance after the introduction of the price-cap and, possibly, while transporting oil priced above the cap.

As shown in the matrix, every cargo, bar one, was handled by at least one tanker with a significant risk marker. As for the outlier cargo, number 7, it, too, is associated with certain other attributes that some might consider risky. 

Let’s take each risk attribute in turn.

1)      Already sanctioned by OFAC: 1 cargo affected

Only one of the cargoes was carried by a tanker formally sanctioned by OFAC.  That’s delivery vessel 1 (“D-1”), which is the NS Century.   Its parent company, a single-ship special purpose vehicle, was added to OFAC’s SDN list and the vessel “blocked” on November 16^th.  Like other sanctioned long-haul tankers, it was cited by OFAC for carrying oil priced above the cap while relying on restricted (“covered”) coalition marine services.  In the case of the NS Century, it appears that the covered service in question was flagging.  Like most SCF vessels, the NS Century was registered with Liberia, which outsources its flagging operations to a private company based in the U.S. state of Virginia.2

2)      Flying a U.S.-administered flag: 6 cargoes affected

In addition to the NS Century (D-1), five other delivery tankers were also flying the Liberian flag—an adverse mark on their risk profiles.  If OFAC deems their cargoes to be priced above the cap, their reliance on U.S.-based flagging services could constitute a violation of U.S. sanction rules.  These five additional vessels would then potentially be at risk of enforcement action in the future.  And even if those vessels haven’t been subject yet to actual sanctions, third parties that participate in transactions involving their cargoes could, potentially, be in violation of U.S. sanctions rules according to the price-cap sanctions guidelines.

3)      Management services provided by Sun Ship Management, a sanctioned entity: 3 cargoes affected after sanctions on Sun Ship were announced

One of the delivery vessels is, according to IMO data, managed by Sun Ship Management D Ltd (“Sun Ship”), a Dubai-based subsidiary of Sovcomflot.  Sun Ship was sanctioned by OFAC on December 20^th.  Five shuttle tankers are also reported to be managed by Sun Ship.  Two of them (S-3 and S-2) handled cargoes (#8 and #9) after Sun Ship’s December 20^th sanction date. 

Based on IMO data, Sun Ship does not appear to be in the ownership chain of any of the 24 or so SCF tankers it reportedly manages.  Consequently, no vessels were explicitly blocked when Sun Ship was sanctioned.  Nonetheless, the involvement of a sanctioned entity like Sun Ship in the chartering process might increase the perceived risk around a cargo in the eyes of some market participants. 

4)      Previously insured by the American Club while carrying an above-cap cargo: possibly 1 cargo affected

Based on International Group insurance records, one vessel appears to have been insured by the American Club earlier in 2023.  While insured, it transported a cargo out of the Pacific that OFAC might deem to have been priced above the cap.  If so, that would put the vessel at risk of enforcement actions for price-cap violations.

When tallied up, that comes to eleven distinct risk markers affecting eight different cargoes.3  What’s more, all but two of these cargoes may pose a threat of “contagion” to third parties: any traders, banks or importers that participate in transactions involving these cargoes, are potentially violating U.S. sanctions law and could be subject to enforcement actions. That’s a lot of risk for counterparties to manage.4

December shipments to India from Russia’s western ports as well as from Kozmino were likely deemed to pose far less risk compared to those from Sakhalin

But what about the dozens of other Russian cargoes arriving in India during December?  What kind of risk profile did they have?  These break down into two groups.  By far the largest are Urals shipments from Russia’s western ports.  They were delivered by a wide variety of vessels—some with risk attributes similar to those noted above, others without.  Notably, however, Urals prices in December hovered around or below the price cap.  Consequently, even if the transporting tanker is, say, Liberian flagged or American-club insured, if the cargoes are at or below the cap, importers might see them as relatively low risk. 

Then there have been the handful of ESPO crude cargoes shipped from to India from Russia’s Pacific port of Kozmino since early December.  Like Sokol grade crude from De-Kastri, ESPO is routinely quoted at prices well above the price cap, and has done so for many months.  As with the Sakhalin Sokol cargoes, the high price of ESPO represents a significant risk factor.  But unlike with the failed Sakhalin deliveries, however, the tankers transporting ESPO cargoes to India during this period have almost none of the risk attributes dogging the Sakhalin deliveries (see Figure 3 below).  None was sanctioned by OFAC; none flew problematic, U.S.-administered flags; none was managed by Sun Ship, and just one appears to have been insured by the American P&I Club at the time.

Forensic analysis suggests the Sakhalin cargoes may have looked riskier than other recent India-bound cargoes from Russia—and were therefore singled out for additional risk-management measures.

In summary, what this forensic analysis of sanctions risk suggests is that December’s India-bound cargoes from Sakhalin may have looked much riskier to Indian importers than those arriving from elsewhere.  And it stands to reason that their higher risk profile might explain why cargoes from Sakhalin—but not elsewhere—were the ones that ran into trouble

Part 4: Why were the De-Kastri cargoes turned away from India? A speculative explanation

With these forensic observations in mind, let’s return to our initial question: why did the Sakhalin cargoes fail to get delivered?  We’ll begin with the three varying explanations reported in the press.

Explanation 1: there was a problem arranging settlement in dirhams

One report suggested there was a problem with payment mechanics.  It claims that India and Russia had agreed to settle their trades in UAE dirhams, but that the Sakhalin exporter “has been unable to open an account with a bank in the UAE to accept dirham payments.”

Settlement currency has reportedly been a vexed issue in the Russia-India oil trade for months.  Moscow is eager to move away from the dollar, since it reduces sanctions risk and limits Washington’s ability to track trade flows.  India has pushed for settlement in rupees, which Moscow roundly rejects, because of convertibility issues.  Moscow has pushed for settlement in yuan, which some Indian buyers resist for political reasons.

As a compromise, Russia and India have reportedly been settling in UAE dirhams.  The dirham has good liquidity, is supported by a developed banking system, and is stable, thanks to its dollar peg.  But here the peg is both blessing and curse.  Maintaining it means the UAE must hold large dollar reserves and have ready access to dollar clearance and U.S. correspondent accounts. This, however, may make Emirati banks sensitive to concerns from U.S. officials.5

Plausible? Yes: Emirati banks are reportedly under pressure not to service trades violating the price cap; they might now fear “contagion” risk from involvement in tainted transactions.

We can only speculate on why a Russian oil exporter might have trouble opening up a settlement account in dirhams.  The reason could have something to do with reported efforts by U.S. officials to enlist Emirati banks into supporting the price cap.  Since October, some UAE banks are said to be taking a tougher line on Russian-oil related business, to assure compliance with the price cap.  It’s conceivable that UAE banks were not satisfied that Sakhalin cargoes complied with the cap and refused to provide settlement services for them.  If so, it marks a notable win for OFAC. 

Explanation 2: Indian buyers were demanding a deeper discount than Russian sellers were prepared to offer.

An alternative explanation for the failed deliveries concerns price.  This explanation comes from none other than India’s Oil Minister, Hardeep Singh Puri, who addressed the issue at a briefing on January 3^rd.  “There is no payment problem,” he averred, “it is a pure function of price at which our refiners will buy.”   

Plausible? Yes.  But the way in which these trades fell apart—suspended mid-voyage, long delays at sea, failure to secure alternative buyers—is unusual and suggests something more might be going on than just a disagreement over price. 

As the largest importer of Russian seaborne crude and Russia’s largest swing importer, Indian buyers have significant pricing power.  They’ve used this to great effect in the past to beat down prices.  So, it would come as no surprise to learn that Indian traders are driving a hard bargain.  And with over 750 oil cargoes a year now arriving in India from Russia, agreeing pricing has become a routinized process. 

So, a sudden failure to agree pricing around a cluster of nine cargoes out of Sakhalin is quite unexpected.  And the manner in which these price negotiations collapsed is highly unusual.  Agreements for delivery appear to have already been made and some tankers were already within a day or two of landing at an Indian port.  But instead, the tankers were kept idling for days, even weeks.  That’s not at all the normal-course pattern of price discovery for the Russia-India trade. In fact, it’s quite extraordinary.  And that suggests something more may have been going on than haggling over price.

We’ll explore what that might be further below.

Explanation 3: it has something to do with sanctions—again, entirely plausible.

A third explanation offered in the press has been that the De-Kastri delivery debacle is somehow related to the step-up in sanctions enforcement. 

We know, of course, that Indian authorities have been concerned about sanctions risk presented by the OFAC-blocked NS Century.  That’s a matter of public record.  And we saw above that other idled tankers with Sakhalin cargoes suffer from a relatively high risk-profile when it comes to sanctions.  Those flying Liberian flags appear to have risk profiles similar to the NS Century, prior to its sanctioning.  In the new sanctions environment, it’s entirely possible Indian authorities and importers view the Sakhalin tankers as laden with risk.  So, it’s entirely plausible that sanction concerns help explain these failed deliveries.

Which explanation is correct? Perhaps they all are, to some degree, but ultimately price likely played a major role.

These three explanations are not mutually exclusive—perhaps they are all true to some degree.  At root, the failed deliveries look to be a sanctions problem, arising from cargoes with a bad risk profile at a time of stepped-up sanctions enforcement.  That root cause, in turn, could have caused the payment mechanics problem and the dispute over pricing.  So, perhaps the answer to the question “which explanation is correct?” is “all of the above.” 

But an important question remains unanswered.  In the end, the deal probably wasn’t aborted over payment mechanics: alternatives are available to the dirham.  The ultimate sticking point would seem, then, to be price.   At least, that’s how it looked through the end of December, when the nine tankers carrying Sakhalin all abruptly turned away from India, and five of them signaled new destinations in China. Based on that data, a reasonable conclusion to draw was that the Russian sellers didn’t like the price on offer in India and had secured better bids elsewhere.

Subsequent events, however, call into question the conclusion better bids had been secured elsewhere. More than than weeks on, not a single De-Kastri cargo has reached China.  What’s more, three of the five tankers previously signalling for Chinese ports have dropped those designations.  And the two still signalling China suspended their voyages over many days ago.  They’ve been idling in the Riau Archipelago along with other ships from the troubled group.  Three group vessels are now signalling “for orders”—indicating they have no buyers.  None appears headed to a destination port to unload its cargo.

But the usual behavior of the Russian sellers suggests the deliveries were aborted over more than just a pricing disagreement

If, then, the Russian sellers had no firm bid from Chinese buyers, why did they break off negotiations with India?  Hardball negotiating tactics?  Unlikely.  Such behavior is highly out of character for the more than 750 shipments of Russian oil now arriving annually in India.  Moreover, by walking away from the table without a firm bid in hand, the Russian exporters risked turning into distressed sellers—which is just what appears to have happened.  Not an enviable position to be in.

Circumstantial evidence suggests the Indian buyers might, perhaps, have sought to de-risk these problematic cargoes by requiring pricing linked to the price-cap

One possible explanation—purely speculative it must be stressed—is that the disagreement with the Indian buyers wasn’t just over a few dollars of discount.  It was more fundamental than that and binary in nature.  It’s possible that the buyers—considering the the risk profile of these particular cargoes and the overall worsening risk environment around the shadow trade—may have sought to safeguard themselves by requiring that pricing in these trades comply with the price cap. 

For the Russian sellers, any explicit linkage to the price cap would have been a non-starter.  Moscow is intent on preventing buyers from linking pricing to the price cap.  The Kremlin made that clear in Putin’s December 2022 decree on the price cap.  The only substantive action of this otherwise hollow decree was to prohibit sales contracts “that directly or indirectly provide for the use of a mechanism for capping the price.” 

For Moscow, such linkage is a non-starter, since it hands pricing power to coalition authorities.

It would be easy to understand Moscow’s neuralgic response to any demand for price-cap linkage—especially with a buyer as important as India.  Once that precedent is established, it puts pricing power into the hands of coalition policymakers.  If they chose to ratchet down the price cap, Indian traders could claim—with straight faces—that they have no other choice but to reduce their offers. 

In a normal market, Russian exporters could just find a better buyer elsewhere.  But the market for Russian oil exports is no longer normal, thanks to the coalition ban on imports.  It’s highly concentrated.  With Russia’s loss of access to Europe—its primary oil export market for over a century—India emerged as the only buyer ready to provide secure, predictable offtake on the scale Russia needs for its dislocated volumes.  But that has given India outsized bargaining power relative to Moscow, which it has used to impose deep discounts. 

This time, however, when India tried to use its whip hand to impose tough terms, the Russian sellers didn’t cave.  They chose to walk away with no other firm bid in hand, perhaps preferring to risk ending up as distressed sellers rather than accept pricing linked to the price cap.  Which leads one to suspect that the real stumbling block—the real explanation behind the De-Kastri mystery—might not have been simply a difference in price, but a demand by India that the cargoes comply with the price cap.

Whatever the case, with no apparent buyers, the exporters of these Sakhalin cargoes now appear to be distressed sellers.  That can only hurt Russia’s overall bargaining power in the export markets.  It sends a signal that something is seriously amiss with Russian exports, further elevating perceptions of risk around the Russian shadow trade.  And after months of making incremental progress with thwarting oil sanctions, Moscow suddenly looks on the defensive as coalition authorities seize the initiative.

Conclusion: If enforcement efforts are scaled up they could reduce the footprint of the shadow fleet and inflict real damage on the Kremlin’s oil income

The breakdown in the Sakhalin-India trade appears likely to be the result of an elevated sense of risk around the shadow trade.  If so, then chalk it up as a win for the coalition’s new campaign.  It’s notable the coalition has achieved this outcome through a very restrained use of its sanctioning powers.  The tanker capacity blocked thus far amounts to just 1.5% of the total capacity Russia needs to keep exports whole. 

But while recent events may provide proof-of-concept for the coalition’s new campaign, it’s important to keep things in perspective.  At its current scale of deployment, this strategy is likely to have only a marginal impact on Russian revenues.  Daily exports from Sakhalin to India account for less than 3% of Russia’s total daily seaborne flows.  And it likely won’t be long before they resume flowing to the market. 

Meanwhile, although transaction costs may be rising across the board and pricing discounts deepening in some markets, it’s far from certain whether recent events will be enough to have a major impact on Russian revenues.  Further action on a larger scale will likely be needed. 

Coalition members have potent options available for further constraining Russian oil revenues, should they choose to deploy them.

Coalition members have various options for scaling up their campaign—should they chose to.  The most potent might be to focus on constraining Russia’s ability to use its shadow fleet—to shrink its footprint, so to speak.  This would force Russia to rely more heavily on the mainstream fleet, where price-cap policies have a better chance of constraining revenues.

Options include limiting Russia’s ability to use its shadow fleet, by scaling up blocking orders on shadow tankers…

They could approach this task in two ways. First, OFAC could significantly scale up the list of blocked shadow tankers.  This is a powerful tool.  The tankers blocked thus far appear to be effectively out of service.  In the three months since the SCF Primorye was blocked on October 12, it has yet to lift a single new cargo, despite having reflagged from Liberia to Russia in early December 2023.  The same holds for all the other sanctioned shadow tankers.

As discussed in Dangerous Waters, upwards of 150 active shadow tankers are likely to already be in violation of U.S. price-cap rules and subject to enforcement.  So, instead of limiting itself to just listing 7 long-haul shadow tankers, OFAC could decide to scale this up assertively, by blocking dozens of vessels at a go. To avoid any material supply disruptions, they could time the blocking orders for when vessels are in ballast.

…perhaps even targeting shadow vessels that haven’t relied on restricted coalition marine services…

OFAC could ratchet up the pressure another notch and begin blocking shadow fleet tankers regardless of whether they have relied on restricted U.S. services.  Nothing appears to be stopping this.  An executive order is in place that allows OFAC to sanction entities for contributing to Russia’s harmful foreign activities simply for operating in the marine sector of the Russian economy.  No price-cap infraction is explicitly required. 

That point seems underscored in OFAC’s December 20^th press release announcing sanctions on three “under-the-radar” oil traders.  In recounting the offending activities of the three traders, OFAC calls out each for having “sharply increased its share of the trade of Russian oil.”  But only one of the three is explicitly cited for involvement with price-cap-violating tankers. 

Were OFAC to begin blocking the most active shadow fleet tankers simply for their “sharply increased…share” in the Russian oil trade—regardless of whether they relied on coalition marine services—it would have an even greater chilling effect on the shadow trade.  Participants would grow more cautious still, and costs rise even higher—all at Moscow’s expense.  Moreover, sidelining a large number of shadow tankers and declaring all shadow vessels “fair game” would likely result in a major reallocation of export cargoes back to mainstream shippers.  It could also discourage Moscow from further bankrolling the expansion of the shadow fleet.  Why spend billions on richly priced vintage vessels only to have them sidelined by OFAC with the stroke of a pen? Or when importers are increasingly reluctant to buy the cargoes they carry if priced above the cap?

…and introducing an spill insurance verification program, starting in the Baltic, that could restrict the shadow fleet’s access to ports handling half Russia’s export volumes.

To further limit Moscow’s ability to rely on its shadow fleet, coalition partners could follow the lead of the Turks and introduce a spill liability insurance verification program for tankers passing through European waters (see Measuring the Shadows).  This program aims to assure that tankers operating in European waters are compliant with spill liability insurance requirements mandated under international law. 

The initial focus should be on rolling out a verification program at navigational chokepoints in the Baltic, through which half Russia’s seaborne trade flows.  Under applicable maritime law, EU member states enjoy adequate powers to make certain that tankers passing through their waters meet insurance standards required under international law.  Tankers in violation of statutory insurance requirements would not enjoy rights of innocent passage. Given the shadow fleet’s track record of brazen disregard for spill insurance requirements, a verification program could effectively exclude many if not all shadow tankers from lifting cargoes at Russia’s Baltic ports.  This would significantly reduce the risk of an environmental catastrophe.  Moreover, by excluding a large number of shadow operators from the Baltic, it could significantly increase Russia’s reliance on legally insured, mainstream vessels.

Coalition authorities appear to have seized the initiative and put Moscow on the back foot—at least for the moment.  How hard will they press their advantage?  And what countermeasures might Moscow come up with?  Only time will tell.  But a year into the price cap, the situation remains as dynamic as ever.

Appendix: Sovcomflot’s flag-of-convenience fiasco—a mass, forced reflagging from Liberia to Gabon is now underway.

A massive reflagging of some 50 Sovcomflot tankers is currently underway, after the Liberian administrators reportedly informed the Russian company of its plans to expel a large number of tankers from its registry.  Liberia’s decision comes in the wake of OFAC’s strategy of stepped-up pressure on intermediaries. 

Liberia’s decision has compelled Moscow to hastily reflag most of its SCF tankers to Gabon in the early days of January.  As of the January 11^th, some 46 (64%) SCF tankers previously registered in Liberia have been reflagged en masse in Gabon, based on analysis of AIS data (see Figure 4 below).  More are likely to follow suit in the coming days.  We may also see other non-SCF shadow tankers reflagging away from Liberia and the Marshall Islands in the coming weeks.

This mass reflagging has made Gabon the leading flag of the Russian shadow trade, with over 90 shadow tankers (including the SCF tankers) now flying Gabon’s colors (see Figure 5 below).  At the same time, this move gives the Russian shadow fleet a dominant position among oil tankers registered in Gabon, accounting for over 75% of the class.6  SCF is following in the wake of another sizeable group of shadow tankers that reflagged to Gabon earlier in 2023, after being deflagged by the U.K.-administered registry of St. Kitts and Neavis. 

It will be interesting to see how this move affects market sentiment around shadow fleet risk.  Now that these ships appear to have severed all ties with U.S.-based services, will concerns over “contagion” abate?  Only time will tell.  Reflagging might, indeed, provide a bit more protection for anyone participating in future deals involving these reflagged tankers.  But it doesn’t cleanse the tankers themselves of their past offences.  If they carried non-compliant cargoes in the past while flying the Liberian flag, they likely remain “at risk” of enforcement action.  Market sentiment, then, may largely hang on what future moves OFAC has in store.

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Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

Endnotes

Recent OFAC sanctions have focused on a handful of Russian shadow tankers. That’s surprising, since Moscow’s shadow fleet was designed to legally circumvent the price cap, keeping it safe from sanctions.

But the Kremlin got careless with its costly fleet, putting up to half its vessels at risk of similar blocking orders. Moscow-friendly traders and others might also be at risk. To date, OFAC’s campaign has been restrained. But that could change.

Either way, Russia’s shadow trade is looking much riskier for all involved. Expect Moscow to pay a price in higher freight rates, deeper price discounts and more exposure to the price cap.

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Executive summary

Since mid-October, OFAC has sanctioned eight oil tankers for price-cap violations. While the agency’s actions have sidelined these ships—at least for now—the enforcements have drawn some scepticism for their seemingly limited scope. But there’s more going on here than many realize, much of it unexpected.

OFAC’s blocking program looks focused not on the mainstream fleet, but on Russia’s growing shadow fleet, to which seven of the eight blocked ships belong. That’s surprising—and important—because shadow tankers were supposed to legally sidestep the price cap, making them “immune” to price-cap sanctions.

It now appears, however, that the Kremlin got careless while assembling its shadow fleet—and not just with these seven ships. A large number of Moscow’s shadow tankers could now be at risk of OFAC action. So, too, could those who trade their tainted cargoes. If OFAC keeps going after at-risk actors, the Russian oil trade will become even riskier business, pushing up transaction costs and squeezing Moscow’s all-important oil income.

Sanction rules prohibit EU/G7 entities from providing key marine transport services—like chartering and insurance—except when cargoes comply with the price cap. To legally circumvent these rules, the Kremlin has been assembling a fleet of tankers cleansed of all ties to EU/G7 marine service providers.

Along the way, however, Putin’s anti-sanction technocrats got careless in their sanctions hygiene and left some U.S.-based service relationships in place. The eight tankers blocked so far, for instance, are all flagged in countries that outsource their flag registry businesses to private U.S. companies. Under U.S. price-cap rules, flagging is one of the six restricted marine transport services. What’s more, the U.S. price-cap rules allow OFAC to pursue not only the providers of restricted services, but any entity anywhere that relies on restricted U.S. services when transporting Russian oil priced above the cap. That includes shadow tankers.

Significantly, Moscow’s flag-state problem isn’t limited to these seven ships. Over 100 of Moscow’s active shadow tankers fly flags whose registries are run by U.S. companies. That includes three quarters of Sovcomflot’s tanker fleet.

Using U.S.-based flagging services wasn’t the Kremlin’s only blunder. Some 30 or so shadow tankers apparently carried U.S.-issued spill liability insurance—another restricted service—while disregarding the price cap. Altogether, just over half Russia’s active shadow fleet may now be in violation of price-cap sanctions and at risk of OFAC enforcement action.

Worse still for Moscow, these at-risk shadow ships may have acted as vectors of “contagion,” infecting other participants in the shadow trade. Anyone who dealt in these tainted cargoes might, potentially, have violated U.S. rules and could now be at risk of enforcement actions. That includes the commodity brokers who marketed those barrels and the importers who bought them. The handful of shadow tankers currently blocked may be just the tip of a problem that runs broad and deep.

Blocking orders can significantly limit the usefulness of a tanker. They can be even more crippling for a commodity trading house. How many at-risk tankers—or traders—will end up on OFAC’s sanctions list? It’s hard to say. Enforcement agencies must walk a fine line between combatting the shadow trade and spooking mainstream shippers still active in Russia. If too many of the latter quit Russia, export volumes will fall, putting upward pressure on prices. OFAC’s posture will likely evolve with circumstances.

Moscow will, of course, try to restore these sidelined vessels to service. Perhaps, in time, it will succeed. But marked by sanctions and blocked from any dollar-denominated transactions, they will be of more limited use.

One thing seems certain, however. With each entity added to OFAC’s list, the shadow trade becomes a riskier business for all involved. As that realization takes hold, shadow trade participants will demand more compensation for their risk. That means higher freight rates for shippers, richer commissions for traders and deeper discounts for importers. And all that comes out of Moscow’s pocket.

What’s more, as shadow tankers get blocked, Russian exporters becomes more reliant on mainstream tankers, and thus more exposed to price-cap limits. All the more reason to keep pushing for better price-cap compliance by mainstream vessels.

Finally, this episode is a salutary reminder that the Kremlin’s vaunted technocrats are, in fact, quite fallible. This episode will be added to a lengthening list of major unforced errors, like leaving sovereign funds exposed to freezing orders and unilaterally wrecking Gazprom’s $80 billion European export business.

* * *

Introduction: the suspended voyage of the NS Century doesn’t bode well for Moscow’s shadow trade.

It should have been just another routine delivery of Russian oil to India. Instead, it turned into a stark reminder of the long reach of the U.S Treasury. On November 18th, the NS Century, an oil tanker belonging to Russia’s state-owned shipping company Sovcomflot (SCF), was nearing the end of its three-week voyage. The 17-year-old Aframax was just a few days away from delivering a cargo of Sakhalin crude, valued at an estimated $50 million, to the port of Vadinar. But just before 4 pm, as the vessel was rounding the southern coast of Sri Lanka, it suddenly deviated from its expected course. For the next two hours it steamed due south, away from India and deeper into the Laccadive Sea, before idling its engines and beginning to drift.

The cause of this unexpected course change had nothing to do with mechanical failure or navigational mishap.  Rather, it was the result of actions taken two days prior in Washington.  OFAC, the sanctions arm of the U.S. Treasury, announced it was “blocking” the NS Century and adding its owner of record—a Liberian shell company—to its formidable “Specially Designated Nationals” (“SDN”) list.  In short, the NC Century had been sanctioned.  That called into doubt not only the tanker’s ability to deliver its cargo to India, but to remain fully active the oil trade.

Blocking a tanker limits its usefulness in the heavily dollarized oil trade

Blocking a vessel prohibits it from involvement in any transactions using the U.S. financial system.  So, it wouldn’t be possible, for example, to sell the NS Century’s cargo for dollars on arrival in India.

In the global seaborne oil trade, operating outside the dollar settlement system is challenging. The business is heavily dollarized.  Oil prices are universally quoted in dollars.  To efficiently run an export business on the scale of Russia’s—with daily sales in the hundreds of millions and buyers spread across 70 countries—requires currencies that are stable, convertible, widely available, liquid and easy to hedge.  That’s not easy to do while avoiding the dollar, and other price-cap coalition currencies, like sterling and the Euro.  That’s why the U.S. Treasury expressly permits a handful of Russian banks to settle energy trades in dollars.  Otherwise, Russia might struggle to maintain export volumes, putting upward pressure on prices.

Moscow, of course, recognizes that dependency on dollar settlement creates a strategic vulnerability.  The stranding of the NS Century is a tangible example. For months, the Kremlin has been pushing exporters to settle oil sales in alternative currencies.  There’s been considerable success with sales to China.  Sales to India have also shown progress, though here the going has not been easy.

Consider, for example, last summer’s currency row.  India plays a critical role in sustaining the Russian oil trade. It’s the only available large-scale buyer for Russia’s flagship Urals grade crude.  As such, Indian buyers enjoy significant bargaining power, which they have used to extract deep discounts on price. 

In July, however, India reportedly pushed its advantage a step too far, when it insisted Russia accept payment for oil in rupees.  The aim was to encourage Russia to invest more in India and import more Indian goods.  Russian exporters flatly refused. The Russian Central Bank was unwilling to accept rupees because of their limited usefulness outside India.  

Currencies like the UAE dirham have been more successfully used for the Russia trade.  But the dirham doesn’t offer an entirely clean escape from the dollar system.  Washington has reportedly been stepping up pressure of late on UAE banks to ensure compliance with the price cap when processing Russian oil transactions, apparently with some success.  With the dirham pegged to the dollar, the UAE must maintain large dollar reserves and ready access to dollar clearance, which may make Emirati banks sensitive to pressure from US officials.

For the NS Century, the possibility of conducting trade outside the dollar system might help it return to service at some point.  Time will tell.  But its ineligibility for use in dollar-linked transactions puts limits on its usefulness.

A tanker in violation of sanction can also be “contagious”—potentially putting those buying and selling its cargo at risk of getting sanctioned.

But settlement isn’t the only challenge a tanker like the NS Century can pose.  As we shall explore in more detail below, a buyer that purchases its current cargo—regardless of the settlement currency—it likely to be violating U.S. sanction rules, which could land it on the dreaded SDN list.  In effect, NS Century is currently “contagious.”  What’s more, it has likely been contagious to other counterparties for months, potentially putting all the traders and buyers dealing in its recent cargoes at risk.

So, it came as little surprise when, on November 17^th—the day after the NS Century was sanctioned—Indian officials raised the alarm.  According to reports, India’s shipping ministry had misgivings about allowing the tanker to berth at Vadinar.  Given the legal and political complexities involved, however, it prudently passed the decision over to the foreign ministry. 

No favorable resolution was quickly forthcoming.   Lacking clearance to dock in India, the NS Century stopped making way on November 18^th and enter its holding pattern.  At this writing, nearly a month on, the situation remains unresolved.  The blocked tanker—along with its valuable cargo—remains idle and adrift in the Laccadive Sea. 

*  *  *

While assembling its shadow fleet, the Kremlin got careless with its sanctions hygiene and failed to take certain simple preventative measures…

The NS Century is not alone in having been effectively sidelined by OFAC.  It is but one of eight such vessels blocked since mid-October.  All the others were in ballast when sanctioned. Since, none has lifted any new loads.  Most are now idle at anchor, scattered across the maritime periphery of Eurasia.  Some have found refuge in Russian ports—Murmansk and Ust Lugansk.  Others are idle off the coasts of Algiers, Malta, China and, of course, Sri Lanka.

Notably, six of these sanctioned vessels belong to Sovcomflot.  The seventh is an anonymously owned shadow tanker.1  The eighth is a Turkish owned vessel carrying IG insurance, which marks it as a member of the mainstream fleet. 

What’s somewhat surprising is that the SCF and shadow tankers were thought to have been effectively immunized from price-cap enforcement actions.  They had supposedly severed the kinds of ties with EU/G7 marine transport services that could trigger a sanctions violation if they transported oil priced above the cap.  But something seems to have gone wrong.  It appears Kremlin officials got careless with their sanctions hygiene and allowed these vessels to continue using restricted Western marine services.  Which is how these blocked tankers ended up in OFAC’s crosshairs.

U.S. price-cap sanctions target any entity—U.S. or otherwise—involved with cargoes priced above the cap while relying on restricted U.S.-based marine transportation services

To understand how these ships got sanctioned and whether more might be at risk, we need to look at the special way the U.S. has structured its version of the price-cap rules.  A year ago, the price-cap coalition countries (“the coalition”) banned their nationals from providing maritime shipping services for the Russian oil trade.  These services include things like shipping, trading and insurance (“covered services”).  An exception is made, however, if the oil involved is sold at or below a capped price set by coalition policymakers. 

For most coalition countries, price-cap enforcement focuses on domestic businesses and individuals.  The price cap rules developed in the U.S., however, go a step further.  They allows OFAC to sanction violators regardless of where they are based: “any person who evades” the price cap while relying “on U.S. service providers who provide covered services…may be a target for OFAC enforcement action” (emphasis mine). 

The Kremlin’s shadow-fleet strategy: assemble a fleet scrubbed of any ties to restricted coalition marine services and, thus, able to carry cargoes priced above the cap without violating sanctions

So, if Moscow wanted to be able to sell oil above the price cap while not falling afoul of U.S. price-cap sanctions, it would need to develop a parallel shipping eco-system untainted by reliance on any covered shipping services provided by coalition entities—especially those based in the U.S.  Trading, finance, chartering, insurance, etc.— shadow tankers would need to be scrubbed of any such services provided by coalition-based companies.  And, once those ties were cut, alternative arrangements would need to be put in place.

That would be no easy task.  Coalition entities play an outsized role in many of the world’s core shipping services.  Some 95% of the global tanker fleet relies on coalition-based companies for one or more covered service.  Historically, Russia has been heavily reliant on Western shipping services.  Given the immense scale of Russia’s shipping needs, arranging alternative providers of these services —especially tanker chartering and insurance—would be all the more challenging.  

But that is exactly what Moscow set out to do, starting in summer 2022.  The central thrust of this project has been to assemble a stand-alone, “sanction-proof” fleet of tankers that is large enough to manage all Russia’s export needs, while being neither owned, insured or otherwise reliant on coalition service providers (see Measuring the Shadows).  That would allow these to carry cargoes priced above the price cap without violating sanctions.

This supposedly sanction-proof fleet is made up of tankers from Russia’s state-owned fleet, Sovcomflot…

The core of this fleet is made up of the roughly 80 tankers belonging to Russia’s state-owned shipper, Sovcomflot.  SCF’s estrangement from coalition service providers happened early, abruptly, and not of its own initiative.  Shortly after Russia’s full-scale invasion of Ukraine, the EU sanctioned SCF, with far-reaching consequences.  The Europe-based International Group of P&I Clubs (the “IG”)—provider of compulsory spill insurance to nearly all the world’s tankers—cancelled SCF’s coverage.  To keep the fleet in service, the Russian Central Bank, through its re-insurance subsidiary, stepped in with an insurance guarantee.  Next, European banks called in large loans, forcing SCF to liquidate part of its fleet.  Still other Western service providers followed suit.  By late summer of 2022, SCF had been thoroughly stripped of commercial ties to coalition-based covered services—or so it seemed.

Because SCF covers only some 15% of Russia’s shipping needs, Moscow has sought to augment it by assembling a fleet of anonymously owned shadow tankers.  Across the global tanker markets, unidentified investors—many likely bankrolled by Russian loans—began aggressively buying vintage tankers from the mainstream fleet and putting them to work in Russia’s shadow trade.  As with SCF, service ties with coalition-based providers were cut.  Ownership, insurance and flagging were all routinely changed.

…along with vintage tankers recently purchased from the mainstream fleet for redeployment in the shadow trade

Separately, Russian exporters began aggressively shifting their business away from large, western commodity traders in favor of a new crop of smaller, lesser-known groups based mostly in the Gulf and the Far East.  Some are directly affiliated with certain Russian exporters, others appear to enjoy very cozy relations.

Progress towards standalone fleet has been slow, but steady.  By late summer of 2023, Moscow had assembled more than 250 tankers—shadow and SCF combined—supposedly “immune” from price-cap sanctions.  That’s enough tonnage to manage just over half the country’s crude and product volumes at full export capacity, provided shadow vessels are allocated shorter, more efficient routes.  Russia’s remaining export volumes, however, continue to be shipped by tankers chartered from the mainstream fleet, and, thus, subject to price-cap restrictions.

But for some tankers, the shadow-fleet task force somehow neglected to sever ties to restricted U.S.-based services.

When OFAC announced its first sanction of a SCF vessel on October 12, citing “the use of U.S.-based service providers” while transporting oil priced above the cap, the effectiveness of Moscow’s “immunization” strategy was called into question.  When five more SCF vessels and one shadow ship got sanctioned for the same infractions over the course of November and early December, it was clear something had gone wrong with Moscow’s efforts to sever ties to covered service providers.  Somewhere along the line, the Moscow’s technocrats had gotten careless. 

Which services were they? And how many shadow tankers does this affect?  

The pressing question now becomes: how widespread is the problem?  To answer that question, we need to identify the “U.S.-based” service relationships have triggered the OFAC enforcement.  OFAC has provided no specifics, but an educated guess is possible. 

The lists of covered services put out by the EU, UK and U.S. vary somewhat, but none is long.  The U.S. list notes six prohibited marine transportation services: 

1.      trading/commodities brokering,

2.      financing,

3.      shipping,

4.      insurance,

5.      flagging, and

6.      customs brokering.

Of the first four, none appears likely to have gotten these vessels sanctioned.  U.S. traders have largely pulled back from Russia.  As noted above, exports are now dominated by niche players based outside of coalition countries. 

U.S. lenders will be on a very tight leash by their compliance departments when it comes to Russia.  They would be very unlikely to provide any trade or acquisition financing involving Russian oil or shipping.  When it comes to basic settlement services, however, there is an explicit allowance for the Russian oil trade—so long as the entities involved are not sanctioned. 

As for ship ownership, a U.S. connection looks unlikely, too.  Shadow vessels tend to be owned by single-asset special purpose vehicles registered in offshore tax havens outside of coalition countries.  So, ownership is unlikely to be the issue.

Insurance is straightforward: none of the sanctioned ships carries spill liability coverage from the American Club, the only U.S. based P&I club.  Hull and machinery insurance data is harder to come by. But such insurance is also rather easier to secure from non-coalition providers.  So, insurance looks unlikely.

That reduces our list to flagging and customs brokering.  On the latter, it seems improbable anyone would hire an American customs broking company to clear Russian oil cargoes arriving in markets like India and China.  So, we can probably set that aside as “unlikely.”  

All tankers sanctioned so far have continued to use U.S.-based flagging services, which may be what put them in violation of price-cap rules and at risk of being sanctioned.

That leaves flagging.2  At first glance this, too, appears to be a non-starter.  None of these tankers is U.S. flagged.  But on closer inspection, a curious pattern emerges.  Seven of the eight tankers—including all six SCF ships—are Liberian flagged.  The eighth blocked tanker is flagged in the Marshall Islands. 

These flag registries provide numerous critical services a tanker needs to operate internationally. These include certifying a tanker’s compliance with a range of statutory regulations concerning things like spill liability, structure integrity, pollution prevention, crew welfare, etc.  Registries also maintain records relating to ship particulars, such as ownership and encumbrance.

Running a ship’s registry involves an immense amount of paperwork and due diligence, much of it technical in nature.  Many states offering flags of convenience outsource the administration of their registries to private companies based elsewhere.  Gabon’s ship registry, for example, is administered by a company based in the UAE.  Gabon has become a flag of choice for many vintage tankers that have recently converted to the Russian shadow trade. 

According to their websites, both Liberia and the Marshall Islands also outsource their registry operations to private companies.  In both cases, those companies are based in the U.S. state of Virginia.  So, if you’re a tanker flagged in Liberia or the Marshall Islands, all your flagging services will be provided to you by U.S.-based companies.  It’s quite likely, then, that it was reliance on U.S.-based flagging services that got these tankers sanctioned.3

The flag-state problem appears to be widespread.  Some 40% of Moscow’s supposedly sanction-proof fleet has been flying flags administered by private U.S. companies based in Virginia.

If continuing to use U.S.-based flagging services is the problem, how widespread is it among the active shadow fleet?  Very widespread.  Shadow fleet flagging is concentrated in just a handful of states.  The top seven account for over 95% of the fleet. 

Of those seven, the single most popular flag is… Liberia.  Some 88 shadow fleet tankers—including 55 from Sovcomflot—fly the Liberian flag.  Another 23 are registered in the Marshall Islands, making a total of 111 shadow tankers that are using U.S. flagging administrators.  In effect, that means nearly 40% of the fleet Moscow has painstakingly assembled—at huge expense—to circumvent the price cap, may now, instead, have inadvertently violated those very price-cap rules, putting all those tankers at risk of OFAC enforcement actions.  For Moscow, those flags of convenience may turn out to be anything but. 

What’s worse for Moscow, there may be another problematic category of covered services apart from flagging: spill liability (“P&I”) insurance.  The International Group of P&I Clubs includes a U.S.-based member called the “American Club.”  As noted above, none of the currently blocked tankers has recently insured with the American Club.  But a significant number of other shadow tankers have. 

In April, it was reported that the American Club cancelled P&I coverage for a group 34 tankers because of price-cap violations.  Within a few weeks, the St. Kitts & Nevis ship registry—administered out of the U.K.—deflagged roughly the same group of tankers.  Relying on a U.S.-based P&I insurance provider while violating the price cap would likely put these tankers at risk of enforcement actions. 

If shadow tankers relying on U.S.-based P&I insurance are added in, the number of vessels now in violation of sanctions could be upwards of 145 vessels—or well over 50% of the active shadow fleet.

That would bring the total number of shadow tankers at risk or already sanctioned to 145.  That’s well over 50% of the total number of tankers currently engaged in Russia’s shadow trade.4 This figure includes some 75% of the entire Sovcomflot tanker fleet.  

These are staggering figures.  And they mark what can only be described as a massive blunder on the part of Moscow’s anti-sanction technocrats.  What makes the error even more egregious is that it could have been so easily avoided.  Moscow had ample time in the run-up to sanctions to reflag its SCF tankers to a low-risk flag state.  SCF would have had extensive, regular exposure to its U.S. based flag administrators.  It boggles the mind that no one connected the dots.

And as vintage vessels were being gradually purchased from the mainstream fleet for redeployment in the shadow trade, they could have easily swapped U.S.-linked flags for less problematic ones at the time of purchase.  That’s standard procedure for conversions into the shadow fleet.  Someone was asleep at the switch.

The same is true for compulsory P&I insurance.  As newly purchased vessels get repurposed for the shadow trade, their IG insurance is routinely dropped, replaced by opaque arrangements of questionable adequacy.  Most of the tankers expelled from the American Club last April had only recently been acquired for the Russian shadow trade.  It’s hard to find any sound reason why their new owners didn’t drop IG coverage at the time of sale—like everyone else does.  Again, it just looks like a careless—and potentially costly—error.5

These at-risk tankers may have acted as vectors of “contagion,” potentially putting those who traded and imported their tainted cargoes in violation of sanctions as well.

Moscow’s tanker blunder has a range of ramifications—all harmful to its interests.  By giving OFAC a legitimate basis for deploying its potent SDN list, the Kremlin has worsened the overall risk environment around the Russian oil trade.  More specifically, it has shown that many tankers thought immune to sanctions are now at risk of enforcement. 

What’s more, for months, these vessels may have been acting as vectors of “contagion,” potentially putting other market participants at risk.  OFAC’s price-cap guidance says, any market participants that “make purchases of Russian oil or Russian petroleum products above the price cap and that knowingly rely on U.S. service providers who provide covered services…will have potentially violated [price-cap sanctions]…and may be a target for an OFAC enforcement action.”  

We’ll leave it to the lawyers to opine on whether traders and importers “knew” the tankers in their trades were “rely[ing] on U.S. service providers.”  Some will surely argue that since those services were provided to the shipowners, their trading and importing clients “weren’t aware” there was a problem and, thus, they did not “knowingly rely” on U.S. covered services.  That argument might get some traction on transactions completed prior to OFAC’s first sanctions announcement on October 12.  Perhaps.

But for any transactions after October 12^th, the market was on notice that at least some shadow tankers had sanctionable U.S.-servicing issues.  Thereafter, if traders and importers didn’t know the vessels carrying their cargoes were contagious, they should have.  A warning had been issued. It was incumbent on them to do their due diligence.

As markets come to recognize how widespread the contagion may be within the shadow trade, levels of perceived risk will likely rise.  That could push up transaction costs, widen spreads to benchmark prices, and hit Moscow’s bottom line.

Regardless of which way the contagion call goes, what’s clear is that levels of perceived risk around Russia’s shadow trade will go up.  Suppliers of shadow trade services and importers of oil priced above the cap will demand compensation for the additional risk they now face. 

These risks are spread across the supply chain:

• higher carrying risk—reducing shipowner appetite and pushing up freight rates

  Shadow tanker owners may hike their rates for cargoes priced above the cap.  Rising risk may also cause mainstream tankers to raise rates for Russian cargoes.  Mainstream ship owners are already feeling the chill of stepped-up scrutiny from sanction enforcement agencies.  Three of the largest Greek fleets are reported to have pulled out of Russia in recent weeks over risk.  Tighter supply from the mainstream fleet can only push Russian rates higher.

• Higher handling risk—causing traders to demand higher compensation

  The coterie of friendly commodity traders managing Russian exports may also demand more compensation for the additional risks they now face.  As noted above, many may already be in violation of U.S. sanction rules.  As sophisticated charterers of commercial vessels, arguments that they didn’t “knowingly rely” on U.S. covered services may be hard to sustain.  

  And if dealings with contagious shadow tankers haven’t put them at risk, then providing false price attestations to mainstream shippers may have.  The U.S. price-cap rules say providing “false information, documentation, or attestations” to U.S. providers of covered services “will have potentially violated the [price cap]… and may be a target for an OFAC enforcement action.” So, if they’ve ever provided a false attestation to a mainstream tanker insured by the American Club, financed by a U.S. bank, owned by any U.S. investors or flagged by a state outsourcing its registry operations to a U.S. company, that trader may already be at risk.

  Commodities traders may be particularly sensitive to sanctions risk.  Getting blocked from dollar settlement systems is a crippling blow for any trader handling large-scale, long-haul oil trades.

• Higher performance risk—causing importers to see Russia as a less reliable supplier

  Importers, too, will see a range of higher risks around Russian oil.  To start with, performance risk has gone up.  If you contract for a Russian cargo, how certain can you be that it will arrive?  Look at the NS Century.  Savvy Indian and Chinese traders will likely use deteriorating performance risk as a hammer to beat down Russian prices.

• Higher “contagion” risk—causing exposed importers to demand deeper discounts to compensate for stepped-up risks.

  As with traders, some importers might already be in violation of U.S. sanctions for buying oil transported by a contagious tanker.  In future price negotiations, these importers could argue “Russian oil is full of hidden risk.” As compensation, they could demand yet deeper discounts on price relative to market benchmarks. 

In the end, all these higher transaction costs and deeper discounts amount to the same thing: a squeeze on oil revenues flowing back to Moscow.

Idled shadow tankers will force Russian exporters to rely more heavily on the mainstream fleet, exposing more of their revenues to price-cap limits.

OFAC sanctions can squeeze Russian oil income in on other important way: by reducing the availability of shadow tanker capacity.  It’s been two months since first group of tankers was sanctioned. They all remain out of service, and there’s no certainty when—or if—they’ll resume transporting Russian oil.  In the meantime, the reduction in available shadow vessels will force Russian exporters to rely more heavily on the mainstream fleet.  That, in turn, means greater exposure to the price cap.  The more tankers OFAC sanctions—the greater the exposure.

But for price-cap exposure to really make a difference, compliance more robust and caps set at lower levels.  Recent analysis suggests effective compliance by mainstream tankers has been poor.  Russian exporters appear to be using mainstream vessel to ship cargoes priced above the cap.  The likely explanation: fraudulent price attestation.  Traders chartering mainstream tankers are underreporting prices to secure use of their vessels without making genuine reductions in pricing. 

To improve the integrity of price attestations, policymakers should require that only coalition-based traders are allowed to issue price attestations to mainstream vessels.

One way to reduce false attestations is to make certain that traders providing them are subject to audit and legal action by coalition states.  In other words, make sure the traders providing pricing information to ship owners have deep business ties in coalition countries.  This creates higher levels of accountability.

Many coalition-based traders were previously active in Russia, and some might be prepared to re-engage.  Moscow, of course, would now prefer to keep them out—fraudulent attestations have become a core evasion technique.  But if policymakers start requiring attestations to be issued by coalition-based traders, Russian exporters will have to sell through them if they want access to mainstream tankers. 

Sidelined shadow vessels may also struggle to service the Kremlin-subsidized loans likely used to acquire many of them

The idling of shadow tankers has second order costs, too.  Many vessels have recently been acquired second-hand at record-high prices, with aggregate acquisition costs on the order of five billion dollars.  Much of this has likely been bankrolled by Russian banks, which are now offering cut-rate loans—deeply subsidized by the government—for ship acquisition.  Sidelined vessels, however, aren’t able to generate income.  If the list of blocked tankers grows, we could see a string of loan restructurings and defaults.

How fast and how far might OFAC go?  It’s hard to say.

The consequences of Moscow’s tanker blunder—higher transaction costs, deeper discounts, and greater exposure to the price cap—are all bad news for the Kremlin.  But how bad might it get?  Much depends on how far OFAC plans to go with its blocking campaign.  That’s hard to tell—OFAC doesn’t tip its hand. 

There is, however, one intriguing data point that may or may not indicate the potential scope of OFAC’s plans.  In mid-November, it was reported that OFAC sent letters to ship managers across a number of countries requesting information on some 100 vessels suspected of violating sanctions.  It’s not clear from media accounts whether those letters went to managers of shadow tankers or mainstream tankers or a combination of both.  If the letters mostly concerned shadow tankers, then the number of ships targeted is broadly in line with number of shadow tankers using U.S.-based flagging services—111. That would suggest OFAC’s list of potential targets is aggressively long.

OFAC will likely try to walk a fine line: ratcheting up the pressure on Moscow, but without spooking the mainstream shipping markets

Even if OFAC does have a long target list, it may continue to proceed with restraint—at least for now.  Rising risk, as we’ve seen, can hit Moscow’s bottom line.  But if it rises too far too fast, it could spook the mainstream shipping markets.  Russia trade could then suffer from a shipping capacity shortage, constraining export volumes and pushing up energy prices.  Ultimately, the speed and scope of OFAC’s campaign will be shaped by evolving market sentiment.

Expect Moscow to be hard at work trying to return blocked vessels to service…

And then, of course, there’s the question of Moscow’s response to sanctions.  Kremlin troubleshooters will now be hard at work, looking for ways to return these idled assets to service.  Potential solutions run the gamut.  SCF management has said they will petition for removal from the SDN list.  That, however, could take some time. 

In the interim, expect a mass reflagging of vessels flying problematic colors.  Many flag states may refuse to take them on.  Several have already reportedly come under increased pressure to be more robust in requiring shadow ships on their registries to comply with international shipping regulations. But some flag of conveniences somewhere is likely to embrace such a windfall business opportunity. 

…though they will likely face significant limitations.

If these tankers do find a flag state that will take them and are returned to service, they will be operating with significant limitations.  Questions around compliance with international safety requirements will only grow.  So too will the environmental threat these vessels pose.  All this will only strengthen the case for demanding verification of adequate spill liability insurance before granting innocent passage through European waters.

Some ports may be reluctant to allow entry to blocked tankers—even once they’re reflagged.  Expect Moscow to also mount an aggressive push to restore port entry rights in key markets like India and China.  It will be interesting to see if those countries relent.  They cannot be happy that Moscow’s poor sanctions hygiene has put their own importers at risk of sanctions.  If they think receiving a blocked tanker might invite OFAC to sanction one of their at-risk companies, they may discretely advise Moscow to dispatch those vessels elsewhere.

If the list of block tankers expands significantly, some of Moscow’s schemers might explore more aggressive solutions.  They could, for example, fabricate entirely new identities, replete with false IMO numbers, flag registrations and other essential certifications.  It’s been done before.  They might even steal a page from the great Ukrainian writer, Nikolai Gogol, and try to swap identities with similar vessels slated for the shipbreaking yards.  

But impostor tankers with fraudulent paperwork would be hard to use where Russia’s need is greatest: in the heavily monitored waterways of Europe, through which 80% of Russia’s export oil flows. The risk of detection and detention is just too high.  Instead, such dubiously documented ships would probably end operating mostly on the high seas, shuttling cargoes between major lightering zones. 

* * *

Measures coalition members can take to keep the pressure on Moscow

There is a range of measures that policymakers and enforcement officials can take to keep the pressure on Moscow.  These include:

• OFAC can continue adding tankers to the SDN list as quickly as practical;

• OFAC might also add one of the new coterie of Moscow-friendly commodity traders to the list—perhaps starting with a smaller player, to minimize disruptions to flows. 

• OFAC might also speak with major importers, such as China and India, to help them understand the risks their importers run by continuing to receive cargoes priced above the cap and carried by blocked or at-risk tankers.

• Coalition policymakers could improve price-cap compliance by allowing price attestations to be issued only by traders based in coalition countries.

• Coalition policymakers can pressure flag states hosting at-risk shadow tankers to deflag them—especially tankers already sanctioned. For those not at risk, they should more robustly enforce international regulatory requirements, such as adequacy of spill insurance. States offering to flag sanctioned vessels should be pressured not to.

• European policymakers could safeguard the environment and pare back the shadow fleet by introducing an on-line spill insurance verification requirement, initially for the Baltic, that requires compliance with existing international conventions and IMO guidelines as a precondition for innocent passage through European waters.

The Kremlin’s blundering technocrats

Finally, at this moment in time, when the Kremlin is trying its hardest to strike a pose of invincibility, it’s useful to recall how capable its technocrats are of massive blunders.  The sanctioned tankers debacle will be added to a growing list of major unforced errors, like leaving sovereign funds exposed to freezing orders, unilaterally wrecking Gazprom’s $80 billion European export business and cynically believing Europe would never have the spine and moral conviction to impose oil sanctions.  

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Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

Endnotes

August 2023

This analytical report assesses on-going Russian efforts to circumvent the price cap and recommends high-impact measures for implementing oil sanctions more effectively.

Oil sanctions have been taking a toll on Russia, but Moscow has been hard at work on strategies for circumventing them.  With Russian oil now trading above the price cap, the effectiveness of those strategies is being put to the test.  Western policymakers have the sanction tools needed to thwart Moscow’s evasion efforts and further erode Russia’s economic resilience.  But only if specific measures are taken to improve how those tools are used.  If measures aren’t taken, sanctions could be at risk of unraveling.

Abstract

After some early success, oil sanctions are now being put to the test as Urals rises above the $60 price cap.

In recent months, oil sanctions have been taking a toll on Moscow’s revenues. The EU/G7 embargo has profoundly disrupted markets for Russian oil, forcing exporters to offer unprecedented discounts to secure large-scale demand. But prices have firmed up over the summer. And with Urals now quoted above $60, the effectiveness of the price cap is being put to the test.

Moscow has been hard at work on developing circumvention strategies. Its shadow-fleet strategy has made progress, but faces significant challenges.

For months, Moscow has been developing strategies aimed at circumventing the price cap.  Chief among these is an effort to assemble a fleet of shadow tankers able to transport oil with impunity, regardless of price, and large enough to keep Russia’s export volumes whole.  The fleet has expanded substantially, but Moscow’s shipping needs are immense; the fleet currently at Moscow’s disposal has reached only a third of the capacity that Russia requires for full export autonomy.  Gathering a shadow fleet big enough to keep exports whole will likely be very expensive and take years to amass.

A complementary strategy of price attestation fraud, however, has the potential to substantially subvert the sanctions regime.

In parallel, Moscow has also been developing a complementary strategy of price attestation fraud.  It seeks to use mainstream, sanction-compliant tankers to transport oil priced above the cap by exploiting known vulnerabilities in the sanction compliance regime.  Policymakers are aware of this strategy, and have taken preliminary steps to counter it, though it’s not clear whether these measures will be adequate.  If left unchecked, pricing fraud could substantially subvert the sanctions regime.

The high-stakes option of oil weaponization has now become a remote risk.

Moscow’s push to develop these circumvention strategies followed its decision last winter to quietly back away from earlier threats to weaponize oil exports by withholding volumes and engineering a supply crisis.  For Moscow, weaponization was a high-risk option that amounted to playing dice with its all-important oil revenues.  The resulting price surge could have proved short lived, leaving support for Ukraine undiminished and Moscow in a far weaker position, with revenues down, OPEC relations strained and shut-in production capacity steadily decaying.  Moreover, as Moscow approached its decision point late last year, its broader risk environment was rapidly deteriorating, with its gas weaponization strategy faltering, energy prices tumbling, and military setbacks mounting.   Customary Kremlin conservatism kicked in, dampening Moscow’s appetite for a high-stakes gamble.  And that appetite looks unlikely to return anytime soon.

Policymakers possess the sanction tools needed to counter Moscow’s evasion efforts but must take specific steps to improve how sanctions are implemented if they are to succeed.

EU/G7 policymakers now have the necessary sanction tools to counter Moscow’s circumvention strategies and further constrain Moscow’s access to critical windfall revenues.  But to succeed, they must improve how current sanctions are being implemented.  With finite enforcement resources, they should focus on high impact measures that will both intensify the economic impact on Moscow and safeguard sanctions from Moscow’s efforts to unravel them.

This report details four such measures:

• ratcheting down price caps, which could actually reduce inflationary pressure;

• reducing the risk of price attestation fraud by whitelisting traders allowed to charter price-cap compliant, mainstream tankers;

• cracking down on the involvement of EU/G7 entities in the sale of used tankers to Russian or undisclosed buyers;

• requiring ships transiting EU/G7 territorial waters to verify that their spill liability insurance is adequate and current, which can sharply reduce both shadow tanker activity and the risk of a catastrophic accident.

Oil sanctions are worth the extra effort to get right, because of the unique and indispensable role that periodic oil windfalls play in the political economy of the Putin regime.  They renew regime vitality, strengthen cohesion of elites and restore appetite for risk.  Oil sanctions, if assertively implemented, can dim Moscow’s hopes for future windfalls and increase risk aversion. In turn, heightened caution can hasten the day Moscow recognizes a retreat from Ukraine has become its best option.

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Table of Contents

A note on terms and data.

Executive Summary

Measuring the Shadows: Introduction

Part 1: Moscow’s “physical” evasion strategy: assembling a sanction-proof fleet

Chapter 1: Russia’s peculiar shadow fleet—evading sanctions through immunity, not subterfuge

Chapter 2: Measuring the Shadows—how big is the sanction-proof fleet in Russia?

Chapter 3: How many shadow tankers does Moscow need in all?

Chapter 4: Can Russia close its “tanker gap?”

Part 2: Moscow’s “paper” evasion strategy: engaging mainstream tankers using fraudulent pricing information

Chapter 5: The Kozmino Mystery: How did mainstream, compliant-fleet tankers end up transporting Russian oil priced above the cap?

Part 3: Moscow’s strategy for boosting prices

Chapter 6: Moscow contrives to have OPEC solve its oil price problem

Part 4: Helping Moscow fail faster

Chapter 7: Improving sanction implementation. Four high-impact recommendations for safeguarding sanctions and strengthening their impact

Conclusion: No more oil windfalls—hastening Russia’s retreat from Ukraine

Appendix: A brush with disaster in the Danish Straits—shadow tankers menace the Baltic

Recommended resources on Russian oil sanctions

Acknowledgements

Endnotes

A note on terms and data 

Throughout this report, the term “oil” refers to both crude and refined products together.  So, “Russian oil export volumes” would mean the combined export volumes of Russian crude and refined product. 

The terms “EU/G7” and “price-cap alliance” are shorthand for the alliance of countries participating in oil sanctions against Russia.  In addition to EU and G7 member states, these include countries such as Norway, Australia, and South Korea.

Except where otherwise noted, the analysis in this report is based largely on shipping, ownership and insurance data that are current as of early July 2023.

Executive Summary

Late last year, Moscow abandoned the idea of weaponizing oil exports in response to the introduction of EU/G7 oil sanctions.  It opted, instead, to develop strategies for circumventing the price cap.  As Urals tops the $60 per barrel price cap, the robustness of EU/G7 oil sanctions will face their first major test in face of Moscow’s circumvention strategies.

The first of Moscow’s two circumvention strategies involves assembling a fleet of “sanction-proof” shadow tankers.

Moscow’s evasion efforts have centered around two complementary strategies.  The first of these involves assembling a fleet of “sanction-proof” shadow tankers able to disregard the price cap openly and with impunity.  To enjoy immunity from sanctions, however, these tankers need to be neither owned, financed nor insured by EU/G7 entities.  Otherwise, they face significant legal or commercial consequences for violating the price cap.  The pool of such sanction-proof tankers, however, is very limited.  Some 95% of the global tanker fleet arrange their mandatory oil spill liability (“P&I”) insurance through the non-profit International Group of P&I Clubs (the “IG”), which is centered in Europe and requires covered vessels to observe Russia sanctions.  Much vessel financing and many charterers require IG P&I policies since there is no comparable alternative in the market.  Because of the broad global footprint of hard-to-replace EU/G7 marine insurance, however, some 95% of the global fleet faces significant legal and/or commercial consequence for violating sanctions.  That leaves only a small pool of vessels suitable for the shadow-tanker business model (see Executive Summary Figure 1).

This fleet has grown substantially since last summer…

Since last summer, the cohort of shadow tankers active in Russia has grown substantially.  Their capacity has increased by nearly 12 million deadweight tons, the equivalent of around 110 Aframax class tankers—the most widely used tanker class in the Russian trade (see Executive Summary Figure 2). 

… primarily through purchases from the mainstream fleet, not recruitment from the global shadow fleet…

Moscow’s shadow fleet appears to be primarily “bought” not recruited.  Few of these tankers come from the broader global shadow fleet.  Only 11%, for example, appear to have been engaged in the Iran trade.  Instead, some 82% of these tankers have changed hands since March 2022, with most having recently been aging tankers in global mainstream fleet.  Once sold to new, anonymous owners, they were stripped of any ownership and insurance ties that could make them vulnerable to sanctions and put to work in the Russia trade.

…but so too have Russia’s shipping needs, as the EU/G7 embargo forces its oil to more distant markets.

At the same time Moscow’s shadow fleet has been expanding, so too has its need for tanker capacity. The EU/G7 import embargo has displaced over 70% of Russia’s seaborne exports, forcing most of it to be rerouted from destination ports in Europe to more distant, less familiar markets East of Suez (see Executive Summary Figure 3).

The net effect has been to roughly double the amount of tanker capacity Moscow needs just to maintain the same level of daily deliveries. Through June 2023, Moscow has maintained daily exports of oil (crude plus refined products) at six million barrels per day or above since February 2022. To sustainably keep exports whole going forward while completely circumventing the price cap, Moscow would need a standalone, sanction-proof fleet of some 68 million deadweight tons of capacity—equal to around 637 Aframax tankers (see Executive Summary Figure 4).

The sanction-proof fleet active in Russia covers only a third the size it needs to be to keep exports whole and free from price-cap constraints.

When the capacity of Moscow’s active shadow fleet is combined with that of Russia’s state-owned shipping company, Sovcomflot, it totals around 22 million deadweight tons, equal to some 205 Aframax tankers (see Executive Summary Figure 5). This is roughly double that of a year ago, but still comes to less than a third of Moscow’s need. The result is a “tanker gap” equal in size to some 432 Aframax tankers.

The resulting “tanker gap” will be hard to close.

The prospects for closing this large gap anytime soon are dim, owing to structural impediments. Despite significant efforts, Moscow only managed to reduce its tanker gap by some 20% from July 2022 to June 2023 (see Executive Summary Figure 6).

Used market prices have soared…

The aggressive buying activity in the cohort of 16-to-20-year-old tankers—which provides most of the tonnage for the shadow fleet—has caused record high valuations in the used tanker markets. Prices for 15-year-old Aframaxes have more than doubled owing to constrained supply (see Executive Summary Figure 7).

…and supply is constrained…

To substantially close the tanker gap would put immense additional upward pressure on used tanker prices. Even after the recent heavy buying in the market, Moscow’s sanction-proof fleet currently accounts for just 17% of the carrying capacity of all 16-to-20-year-old tankers worldwide in the relevant classes. To close the tanker gap, that figure would have to quadruple to 69% and require an accelerated acquisition campaign of unprecedented scale (see Executive Summary Figure 8).

…weakening the economic rationale of the program, which may help explain the recent slowdown in shadow fleet expansion.

At today’s valuations, that program would easily exceed $15 billion and already calls into question whether such a high upfront price tag is justified by future, risk-adjusted returns. But given the limited liquidity in the tanker markets, any effort to buy this many tankers on a compressed time scale would push the ultimate price tag far higher, further eroding the economic rationale behind Moscow’s tanker expansion program. More simply put, Moscow’s shadow tanker strategy has pushed used tanker prices so high that further expansion is getting hard to justify on economic grounds. That may help explain the sharp slowdown in shadow fleet expansion observed since May (see Executive Summary Figure 2 above).

* * *

Moscow’s second circumvention strategy seeks to fraudulently ship non-compliant cargoes on mainstream tankers by exploiting a known price-cap compliance vulnerability.

Moscow’s second strategy for circumventing sanctions seeks to secure capacity on mainstream tankers for cargo priced above the cap.  This involves exploiting a known vulnerability in the price-cap compliance regime.  Owners of mainstream tankers must obtain a “price attestation” from traders stating that the cargoes they are shipping comply with the price cap.  Many of the traders now handling Russian exports are based outside EU/G7 jurisdictions and have close ties to Russian exporters.  This means they face no sanction risk for dealing in oil priced above the cap.  It also means if a Russian cargo can be sold above the price cap, but no shadow tanker is available to lift it, these traders have an incentive to fraudulently secure capacity from mainstream vessel by providing a price attestation that falsely claims the cargo is price-cap compliant.

Due diligence by ship owners is supposed to prevent this bad-actor scenario from occurring…

This scenario—bad actors committing price-attestation fraud—is a known vulnerability in the price-cap compliance regime and was flagged by policymakers in guidelines to market participants last fall (see Executive Summary Figure 9).  To avert it, policymakers advised ship owners to perform due diligence when taking on customers and provided red flags to watch out for. 

…but it doesn’t appear to have worked adequately on exports from Kozmino in the early months of sanctions…

On its own, this advice does not appear to have been sufficient to prevent price-attestation fraud. Russia’s ESPO grade crude, which ships primarily out of the Pacific port of Kozmino, has consistently been quoted above the price cap since December. Available data appear to show that traders shipped large volumes of oil priced above the price cap on mainstream tankers, quite likely by providing fraudulent price attestations. After this came to the attention of sanction enforcement officials, the U.S. Treasury issued a warning in April. Since then, the volume of Kozmino exports lifted by mainstream tankers has fallen below 10% (see Executive Summary Figure 10).

…and it’s not clear that adequate measures are yet in place to prevent price attestation fraud from recurring today as Urals surges above the price cap.

It is surprising that price-cap compliant tankers were lifting large volumes from Kozmino in the early months of sanctions, since so many of the traders active in the Kozmino trade would likely have triggered one or more due diligence red flags. And it’s not entirely clear what’s behind the more recent retreat of the mainstream fleet from Kozmino. Is the result of more exacting diligence standards by ship owners? Or is it a decision by traders and Moscow to deploy additional sanction-proof tankers to the lucrative Kozmino trade, most of which goes to nearby China and thus requires only a small number of dedicated tankers to maintain. This becomes a very relevant question as the Urals grade crude surpasses the price cap, since the Urals trade requires a far larger amount of tanker capacity to maintain (see Executive Summary Figure 11).

Moscow opted for the low-risk strategy of price-cap circumvention instead of the high-risk strategy of oil weaponization.

Moscow adopted these two, low-risk circumvention strategies in lieu of the high-risk strategy of oil weaponizing that it had been previously threatening. Weaponization would have involved engineering a global supply crisis by slashing export volumes. That, however, would have been an extremely high-risk strategy, gambling as it does with Russia’s all-important oil revenues. It had a significant chance of backfiring if the resulting price surge proved short lived and Ukraine’s supporters remained resolute in the face of market turmoil. Moscow would have then ended up in a weaker position, with export volumes sharply reduced, revenues down, market share lost, OPEC relations damaged and shut-in production capacity steadily deteriorating. Its decision to forego weaponization was likely influenced by the deteriorating risk environment of late last fall, as Moscow’s gas weaponization strategy faltered, energy prices tumbled, and military setbacks mounted.

Nonetheless, the impact on Russia’s budget has been painful, with the 2023 budget plunging into deficit while its estimated fiscal breakeven oil price jumped by 77%.

Moscow’s circumvention strategy combined with the rising costs of its war on Ukraine have placed strains on the Russian budget. Budget revenues from oil were down 47% year-on-year in 1H 2023, despite Brent averaging only 25% lower, owing in part to a significant widening in the discount at which Urals trades to Brent. Historically, discounts had been in the $1 to $2 range, but under sanctions have routinely ranged from $20 to $30. The discount, in turn, has been driven by Moscow’s loss of pricing power, as India has emerged as the only reliable buyer in size for its diverted Urals flows and used its quasi-monopsonist leverage to extract painful discounts from Russian exporters. This collapse in oil revenues has helped push Russia’s 2023 budget into the red, with a ballooning deficit that by the end of April was already 17% ahead of full-year 2023 forecasts. Accumulated surpluses from 2022 are being consumed. The discount and war costs have also caused the estimated 2023 fiscal breakeven price to skyrocket to $114, up 77% over pre-February 2022 levels, and greatly exceeding that of the OPEC+ cartel’s other leading producer, Saudi Arabia (see Executive Summary Figure 12).

Moscow’s third anti-sanction strategy has been to contrive to have OPEC lift prices with cuts while avoiding any reduction in its own exports

In the face of the painful discount, Moscow could have unilaterally reduced Urals exports to regain some pricing power. But throughout the winter and spring, it remained highly reluctant to unilaterally cut output, and export levels remained at or above levels of January and February 2022 (see Executive Summary Figure 13). Instead, Moscow contrived to have its OPEC partners raise prices by cutting output, while avoiding any export cuts of own.

This radical shift in price sensitivities along with other consequences of Russia’s war on Ukraine appear to have strained relations between Moscow and OPEC.

This, however, proved a challenge. Moscow’s war on Ukraine has strained its relations with OPEC in many ways, and not just because of the radical realignment of oil price sensitivities. The deep discount at which Moscow has been selling Urals to India has depressed pricing more broadly for Gulf exporters in the Indian Basin. The doubling of Moscow’s tanker usage has pushed freight rates up for all exporters. By weaponizing of gas and grain, and threatening to do the same with oil, Moscow has roiled global energy and food markets, creating additional challenges for the cartel and its member states. By suppressing standard oil industry data disclosures and using oil tanker locational “spoofing” and other forms of subterfuge to obscure export flows, Moscow has made it more difficult for OPEC to monitor Russian production and export activity. And OPEC producers do not appear pleased by the development of a novel sanction designed to constrain oil export revenues—the price cap—which Russian atrocities precipitated.

OPEC has seen through Moscow’s deceptive efforts to manipulate the cartel into rebalancing the market while avoiding any real cuts itself.

To maintain support of OPEC in the face of these growing strains and induce them to cut, Moscow has pursued a strategy of scaremongering and deception. They have misrepresented the price-cap as a “buyers’ cartel”—an absurdity, since EU/G7 countries are forbidden from buying Russian oil—and claimed Washington intends to use it against all OPEC producers. And they announced in February what appears to have been a sham unilateral output cut, intended to induce other OPEC partners to cut as well. But OPEC has seen through Moscow’s charade and required an actual cut in exchange for reciprocal support. A reduction in Russian crude exports appeared to be underway in July. But with the substantial recent rise in Russian refining runs, it’s likely that the cut in crude exports will be largely offset by an increase in product exports.

* * *

High oil prices will now put the robustness of EU/G7 sanctions to the test.

Moscow’s complementary circumvention strategies—expanding its sanction-proof fleet to the extent it can and falsifying price attestations to ship non-compliant cargoes on mainstream tankers when no shadow tankers are available—have yet to be put fully to the test. But this may soon change as Urals prices rise above the price cap. Despite their weaknesses, Moscow’s circumvention strategies retain the potential to severely undermine sanctions. Fortunately, however, EU/G7 policymakers now have in place the legal framework needed to render both these strategies largely ineffective and further constrain Moscow’s access to critical windfall revenues.

To avoid wholesale subversion of sanctions, specific adjustments need to be made to how the sanctions framework is being implemented.

But to work effectively and avoid wholesale subversion, specific adjustments need to be made around how that framework is being implemented. If made, these adjustments can significantly increase fiscal and psychological pressure on the Kremlin leadership—all without increasing inflationary pressures in the energy markets. But if policymakers do not move swiftly to make adjustments, they risk seeing the full-scale subversion of Russian oil sanctions and unleashing further upward pressure on energy prices.

These four measures can make a substantial difference.

Drawing on detailed analysis of the first half year of sanctions, this report recommend four specific, high-impact adjustments to the current framework that can help assure sanctions are effective, not subverted.

Recommendation #1: Lower the price cap

The arguments in favor of a lower price cap are overwhelming, while the rationale behind the higher cap has now fallen away.

Last autumn, the main argument against setting a lower price cap was that Moscow might retaliate by engineering a supply crisis that would spur inflation and potentially trigger a recession. This, in turn, would erode support for Ukraine. Since then, however, the risk of oil weaponization has greatly receded (see Introduction), removing the main argument in favor of a higher price cap. At the same time, additional arguments supporting a lower cap have only gotten stronger, namely:

• sanctions have been having a tangible impact;

• Moscow has routinely been willing to export at prices far below $60 a barrel;

• the ruble’s recent collapse lowers Russia’s breakeven oil price, making it easier for producers to cover costs at lower oil prices;

• Moscow’s large tanker gap means most of Russia’s seaborne exports remain exposed to the price cap; exposure levels could rise above 80% if insurance verification is implemented (see recommendation #4);

• a higher price cap has, contrary to intent, ended up increasing Moscow’s incentive to cut output to push up prices, rather than decreasing it.

As weaponization risk receded over the winter, and the discount pushed market prices for Urals down to $40, an unexpected thing happened. The high, $60 price cap, that was intended to reduce incentives for Russia to cut output ended up, perversely, increasing them (see Executive Summary Figure 14). The high price cap gave Moscow unrestricted upside potential of $20 per barrel. Put otherwise, if the market price rose from $40 to $60, Moscow would be able to capture 100% of that $20 upside, since the high price cap ensured access to mainstream tankers for cargoes priced up to $60.

Had, by contrast, the price cap been lowered, say, to $35, it would have limited Moscow’s ability to capture upside value from rising prices, since its sanction-proof fleet was only large enough to move a fraction of its exports at full market prices. The rest would have to be transported by mainstream tankers at the capped price. With less to gain from higher market prices, Moscow’s incentive to cut its own output (and badger OPEC to do likewise) would have been significantly weaker.

The same would hold true today. If price caps were dropped to $35, it would weaken Moscow’s incentive to keep any cuts in place. Moscow might revert to doing what it did last time it faced low effective prices and maximize output.

Recommendation #2: Combat price attestation fraud by developing a “whitelist” of approved traders.

It makes little difference at what level the price cap gets set if price attestation fraud goes unchecked. Moscow would have enough unrestricted access to mainstream tanker capacity to keep export volumes whole, regardless of price. That, in turn, would create even greater incentives for Moscow to push for higher pricing, since it could capture 100% of revenues at any price.

This makes price attestation fraud by bad-faith brokers as great a threat to sanctions as the shadow fleet—perhaps even greater. Policymakers need more effective measures for preventing pricing fraud. Lessons should be drawn from the apparent use of fraud at Kozmino earlier this year.

The critical task of screening out bad-faith traders should not rely solely on “know-your-client” due diligence by mainstream tanker owners.

The crux of the problem is that the burden of identifying potentially bad-faith traders is left to ship owners. They are required to conduct their standard “know-your-client” due diligence when engaging customers and provided red-flag guidelines on what to watch out for.

This approach is unworkable. Standards of due diligence and the resources for conducting it will vary significantly from one ship owner or operator to the next. So too do the potential consequences of grossly negligent diligence. Invariably, some bad-faith traders will remain in the mix, potentially a large number.

Enforcement agencies should pro-actively develop whitelists of allowed traders.

To effectively combat attestation fraud, enforcement agencies need to play a more proactive role in screening out bad actors. They could start by developing a “whitelist” of broker/traders authorized to provide pricing information. This whitelist could be made up of well-established commodity trading groups based in EU/G7 countries, and therefore subject to legal action for violating sanctions and providing false pricing information. Moreover, as EU/G7 entities, they would be required to retain and, if necessary, disclose underlying transaction documents to authorities.

For a mainstream EU/G7 owned or insured tanker to transport Russian oil, it must receive its price attestation from a whitelisted trader. Failure by ship owners to obtain price attestations from a whitelisted trader would be considered a violation of sanctions. Many EU/G7 traders have extensive experience trading out of Russia and some may welcome the opportunity to re-engage, if clear guidelines are provided by enforcement authorities. That might not eliminate bad-actor risk entirely but should go most of the way.

Recommendation #3: Crack down on the involvement of EU/G7 entities in the sale of used tankers to Russian or undisclosed buyers

One way to limit the expansion of Russia’s shadow fleet is by further constraining supply. Shadow tankers are often purchased from mainstream operators—many based in the EU/G7—during the process of fleet renewal. There is plenty of consternation among some ship brokers about lack of compliance by more risk-friendly competitors. As one commented: “So people who think they can ignore the rules and still go out and do business, I say ‘more fool them’, and I hope they have a lot of sleepless nights and wake up with a knock on the door.”1

Enforcement agencies should crackdown on the involvement of any EU/G7 entities in the sale of used tankers either to Russian or undisclosed buyers. This should include not only the sale of EU/G7 owned tankers but the involvement of any EU/G7 brokers, banks or other advisors in such sale. Authorities should encourage whistleblowing to help generate leads. Investigating a case would have a chilling effect on the trade, especially if its results in a substantial fine or conviction.

Even with such prohibitions and stepped-up scrutiny, sales by EU/G7 ship owners into the used market will likely continue to find their way into the Russia shadow trade. But these deterrent efforts can slow down the transaction flows and increase costs for Russian buyers by introducing a risk premium and additional intermediaries.

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Conclusion of Executive Summary: No more oil windfalls—hastening Russia’s retreat from Ukraine

Together, all these recommended measures aim to do one thing: tightly constrain Moscow’s access to windfall oil revenues. Like other sanctions, this will help erode Russia’s economic resilience, diminishing its means for financing its war of aggression against Ukraine.

At the same time, Russian oil sanctions are different from other sectoral sanctions and have the potential for a qualitatively greater impact. Periodic oil windfalls play a unique and indispensable role in the political economy of the Putin regime. They renew regime vitality, restore appetite for risk and help maintain cohesion among fractious elites.

Oil sanctions, if assertively implemented, can dim Moscow’s hope for renewed access to oil windfalls. That would unsettle Kremlin leaders and help increase their risk aversion. Such heightened caution was on display last December, when Moscow chose not to weaponize oil. And it was on display more recently, during the Prigozhin Affair, when Putin shied away from direct confrontation. It can also hasten the day Moscow changes its calculus and recognizes that a withdrawal from Ukraine has become its best option. That prospect makes it worth taking pains to ensure oil sanctions work as well as they can.

Measuring the Shadows

Introduction: The safe bet—Moscow opts to counter oil sanctions with circumvention, not weaponization

Last December, Moscow decided against weaponizing its oil exports in response to new sanctions, opting instead for a lower-risk strategy of circumvention. Now, as Russian oil rises above the price cap, EU/G7 policymakers have the tools needed to counter Moscow’s evasion efforts and enhance the impact of sanctions, but only if they take specific measures to improve how sanctions are implemented.

The “diskont”

“You need to sort out this discount problem, so it doesn’t cause any problems with the budget.” Those were the instructions Vladimir Putin gave last January to Alexander Novak, his deputy prime minister in charge of energy. Novak had been briefing Putin on the painful $30+ discounts that Russian exporters were then having to offer to secure firm demand for Urals grade crude. This “diskont”—as Putin referred to it—was many times greater than the one-to-two-dollar spreads to benchmark Brent typical in the past. With oil revenues the single largest contributor to the Russia’s budget, Putin was right to be concerned.2

The discount was largely the result of the abrupt ending to Russian oil’s 145-year romance with its most important export market, Europe. Over many decades, Russia had built out a massive infrastructure of pipelines and ports to deliver crude and refined products to a sprawling European customer base. Following Russia’s full-scale invasion of Ukraine, however, European customers gradually began shunning Moscow’s oil—culminating in a full-scale embargo this past winter.

An historic shift in global trade patterns ensued. Hundreds of tankers loading each month at Russia’s Baltic and Black Sea terminals no longer set course Hamburg, Rotterdam, or Augusta. Instead, in search of new buyers, they embarked on long voyages to distant markets, mostly East of Suez. As Novak would explain to Putin, shippers were taking advantage of the tainted status of Moscow’s oil to gouge Russian exporters on freight rates. Shippers were reportedly charging as much as $15 a barrel to transport Russian crude from the Baltic to West Coast India, ten times what it would have cost a year earlier.3

But high shipping costs weren’t the only thing behind the discount. In addition to being much further away, the markets still open to Russia were smaller, less familiar and more concentrated. The bulk of Russia’s dislocated crude was going to a single buyer, India. Such a concentrated market weakened Russia’s pricing power, allowing Indian traders to drive hard bargains. Unless Moscow could reduce the glut of Russian oil now pouring into the Indian Ocean basin, or find a broader range of buyers for it, the dreaded diskont looked destined to persist.

* * *

Last year, Moscow struggled to develop a strategy for countering oil sanctions

The EU/G7 sanctions pose the greatest potential threat to Russia’s oil industry since Soviet times. The discount is just one of numerous vexing, often unanticipated problems thrown up by it. The sanctions have forced hard choices on Vladimir Putin, decisions he will not have taken lightly, given oil’s unique place in the political economy of Russia. Oil is the largest contributor to the Russian budget. Russian energy exports generated record revenues in 2022, providing a momentary fiscal buffer against broader sanctions. By contrast, in the first half of 2023, weak oil and gas revenues—down 47% year on year—helped drive a ballooning budget deficit.

But for Putin, Russia’s oil industry is about more than just balancing the budget—it provides the very lifeblood of this authoritarian system of rule. Throughout Putin’s tenure in power, Russia has, from time to time, reaped massive windfall revenues from periods of high oil prices. Putin has single mindedly promoted these windfall opportunities and covetously consolidated control over the hundreds of billions of dollars in surplus revenues they have generated. Oil windfalls provide him the means to buy the loyalty of elites, bully enemies and paper over failures of an otherwise anemic economy. Oil windfalls have also bank-rolled adventurism abroad, including Russia’s war of aggression against Ukraine. The Kremlin’s appetite for such adventurism is never higher than when its coffers are flush with petrodollars.

For many months, Moscow has struggled to develop a coherent strategy for countering sanctions. When oil sanctions were first mooted by the EU in the Spring of 2022, Kremlin officials were scathing, branding sanctions as “suicidal” for Europe. They confidently asserted that Moscow would build new pipelines and ports and reroute Russian oil to more promising markets. But their bravado soon faded over the summer, as Kremlin officials came to grips with just how deeply dependent Russian oil exports were on EU/G7 markets and marine transportation services. If sanctions went ahead, there would be no quick or easy fixes.

With no quick fixes to hand, the Kremlin began threatening to weaponize oil exports…

Soon, Kremlin officials were adopting a different, more menacing tone as they made thinly veiled threats to weaponize oil exports. These threats echoed what was already happening with Russia’s European gas exports. For months, Moscow had been methodically engineering a gas supply crisis in Europe, sending markets into a panic. By late summer, European gas prices had skyrocketed to 30 times recent averages. An anxious Europe braced for a cold, dark winter.

In the months leading up to sanctions, Moscow looked poised to weaponize oil, just as it was doing with gas (and grain). Analysts projected price spikes to $350. Economists feared a supply shock could tip the global economy into recession. Markets watched anxiously to see how Moscow would respond as the December sanctions deadline approached.

…but eventually backed away from this high-risk option.

Then something remarkable happened. As crude sanctions came into force on December 5th, Moscow fell silent. Days passed and then weeks, with no formal response. Conflicting rumors circulated of draft decrees containing various retaliatory measures. But when a presidential decree was eventually issued at the end of December, it proved underwhelming. It did little more than forbid the mention of price caps in sales contracts. It included no measures that would in any way constrain the supply. Analysts scratched their heads, markets yawned, Urals slumped, and Russian export volumes continue to ship unabated.

Moscow’s climbdown came in the face of a rapidly deteriorating risk environment—too many things were going wrong all at once.

For policymakers in charge of Russian oil sanctions today, understanding the significance of Moscow’s December climbdown is essential for making good policy decisions going forward. And for those responsible for Kremlin threat assessment more broadly, Putin’s response to the challenge of oil sanctions makes for a valuable case study in his diminishing appetite for risk.

Last December’s strategic decision not to weaponize oil exports was made against the backdrop of a rapidly deteriorating risk environment for the Kremlin. Things had started going wrong across a number of fronts. First, Moscow’s gas weaponization policy—which looked so promising in the early autumn—by December was backfiring badly, thanks largely to European resourcefulness, resilience, and unity. Strategic gas partnerships stretching back 50 years were torched overnight. Gas prices were tumbling. The Russian budget—which ran a surplus for the first eleven months of 2022—suddenly lurched into deficit.

As for the oil industry, it wasn’t just the discount that was causing trouble. As crude sanctions came into force, concerns over the price cap caused Chinese state-owned, Greek, and other mainstream tankers to abruptly stop loading at Russia’s largest Pacific port. Russian exporters struggled to mobilize the modest number of shadow tankers needed to fill the gap. Pacific export volumes collapsed by half. While the mainstream fleet continued to call on Russia’s major western ports, events in the Far East were an unsettling sign of how heavily dependent Russia remained on EU/G7 marine transportation.

Meanwhile, Moscow’s covert effort to buy up second-hand oil tankers was bumping up against constrained supplies. The price for a 15-year-old Aframaxes class vessel had climbed nearly 130% over the preceding 12 months. To top it off, Putin’s hopes that OPEC would boost slumping oil prices at its December meeting were dashed when the cartel opted not to cut. In a revealing moment of discord, OPEC ministers chose, instead, to wait and see whether Moscow might save them the trouble of cutting by following through on threats of a large, unilateral cut. On top of all this, on the battlefield, military setbacks were mounting, forcing a mobilization that was both unpopular and poorly executed

Weaponizing oil was a high-risk move that could easily go wrong—just as gas weaponization had—but with far more serious consequences for regime resilience.

It was against this backdrop of spiraling risk that Kremlin leaders were being forced to respond to the imposition of sanctions. In the best of circumstances, weaponizing oil would be a high-risk option. Without OPEC firmly on board and global oil demand robust, a unilaterally engineered price spike could quickly falter and fade. And when it did, Moscow would be left in a far weaker position, with revenues down, market share lost, OPEC ties strained and shut-in production capacity steadily deteriorating. Moscow’s failed gas gambit has just demonstrated how easy it was for an engineered supply shock to go wrong. What’s more, the leverage Russia enjoyed over European gas markets was far stronger than over global oil. To gamble, and lose, with Russia’s gas industry was a painful act of hubris. But to then play dice with Russia’s indispensable oil industry was a potentially fatal act of folly.

Putin would well understand that getting oil policy wrong in the middle of a war could jeopardize the regime’s stability, as the Soviet leadership had demonstrated in spectacular fashion. In the face of mounting risk, customary Kremlin conservatism kicked in, dampening the appetite for a confrontational, high-stakes gamble with oil. And that appetite looks unlikely to return anytime soon.4

Moscow opted, instead, to pursue a lower-risk, anti-sanction policy centering around circumvention rather than confrontation.

Having set aside weaponization as too risky, Moscow decided instead to pursue a much lower-risk policy of circumvention. This involves maximizing output and then trying to sell as much as possible outside of the price cap regime. This strategy does not pack the potential recession-triggering punch of weaponization, but nor does it run the risk of backfiring spectacularly.

In pursuit of circumvention, Moscow and its trading affiliates have experimented with a range of tactics. Some of these are clandestine in nature—such as “dark” ship-to-ship transfers and the locational “spoofing” of tankers. These methods of subterfuge at sea—a curious blend of steampunk and cyberpunk with a bit of Bond thrown in—have captured the public imagination—and understandably so. But when measured against the immensity of Russia’s export volumes, such clandestine operations are marginal at most. They simply don’t offer scalable solutions for circumventing the price cap. Consequently, they’re not the strategies Moscow is banking on.5

Moscow’s 3 core strategies for circumventing sanctions

Instead, Moscow has been focusing the main thrust of its efforts on three core anti-sanction strategies.

The first involves assembling a stand-alone, “sanction-proof” fleet of oil tankers. This fleet, made up of state-owned Sovcomflot oil tankers along with an expanding roster of “shadow tankers,” relies mainly on effective immunity from sanctions—rather than subterfuge—to circumvent the price cap. The great challenge Moscow faces is: can it assemble a large enough fleet to meet Russia’s immense tanker capacity needs?

The second strategy, which is complementary to the first, focuses on exploiting the global mainstream, price-cap-compliant fleet. It seeks to use mainstream tankers to carry cargoes priced above the cap by providing ship owners with fraudulent pricing. It relies on a known vulnerability in the price-cap compliance regime that can result in mainstream ship owners relying on pricing information from bad-faith oil traders. If left open, this loophole could allow Moscow to fully subvert the price cap. The challenge for Moscow, however, is that stepped-up enforcement of existing price-cap rules could quickly close this loophole.

The third strategy is not really a new one, but dates back to Moscow’s 2016 decision to collaborate with OPEC to manage global oil prices. Moscow is continuing to rely on OPEC collaboration to regulate prices, rather than pursuing an aggressive, value-over-volume policy involving large, unilateral cuts. What’s changed, however, is the sudden upward jump in Russia’s fiscal breakeven oil price, along with Moscow’s more aggressive use of cynical scaremongering and deception against its OPEC partners. Moscow was contriving to get the producer cartel to cut, while Russia maintained full output, but OPEC has strong armed Moscow into making cuts as well…or so it seems.

With Urals now trading above the cap, Russia’s circumvention strategies are now being put to the test…

In recent weeks, these coordinated cuts by OPEC+ have tightened oil markets, narrowing the Urals discount and pushing market prices above the $60 price cap. Moscow’s circumvention strategies are now being put to the test. EU/G7 policymakers possess the sanction tools needed to thwart Moscow’s evasion efforts. That’s thanks in large measure to extraordinary levels of multilateral collaboration and innovation among alliance countries last year.

…and EU/G7 policymakers must improve how sanction tools are being used to ensure they remain effective.

But for those tools to work effectively, lessons must be drawn from the first half year of oil sanction, and specific adjustments must be made in how these tools are used. If made, alliance countries can counter Moscow’s evasion efforts and further erode Russia’s economic resilience. And they can shake confidence inside the Kremlin by dashing hopes in future oil windfalls to revitalize the regime. If, however, lessons aren’t drawn and adjustments not made, sanctions could be at risk of unraveling.

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Contents of the report

Measuring the Shadows explores each of these strategies in detail and assesses their potential for subverting the effectiveness of sanctions. It also offers policymakers a set of specific recommendations—based on lessons learned over the last half year—for improving the implementation of the existing sanctions framework.

The report is broken into seven chapters. The first four concern Moscow’s effort to assemble a sanction-proof fleet.

Chapter 1 examines the central role shadow tankers play in Russia’s circumvention strategy, and how their immunity to the legal and commercial deterrence of sanctions is far more important to Moscow than any subterfuge operations they may occasionally conduct.

Chapter 2 measures the size of the sanction-proof fleet currently active in Russia.

Chapter 3 estimates the number of sanction-proof tankers Moscow would need to keep exports whole and fully sheltered from the price cap. This quantity, it turns out, far exceeds the number of sanction-proof tankers active in Russia. The result is a substantial shortfall—or “tanker gap”—amounting to some two-thirds of the total volume Moscow needs for full export autonomy.

Chapter 4 assesses Moscow’s prospects for closing this tanker gap through recruitment and acquisition. It concludes that closing the tanker gap in any reasonable timeframe is highly unlikely, owing to limited supply, rising costs and a steepening treadmill of attrition.

Chapter 5 examines Moscow’s second, complementary evasion strategy. It traces how, in the early months of 2023, Russian exporters managed to engage mainstream tankers to carry cargoes priced above the price cap apparently by providing them with fraudulent pricing information.

Chapter 6 explores Moscow’s efforts to manipulate its OPEC partners into cutting output to boost oil prices while trying to avoid any substantive cuts of its own.

Chapter 7 details four specific recommendations to safeguard existing sanctions and help them function more effectively:

• lowering the price cap, which both reduces Moscow’s oil revenues while also reducing its incentives to cut volumes to boost prices;

• combating price attestation fraud by developing a whitelist of approved traders;

• cracking down on the involvement of EU/G7 entities in the sale of used tankers to Russian or undisclosed buyers;

• requiring ships transiting EU/G7 territorial waters to verify that their spill liability insurance is adequate and current, which can sharply reduce both shadow tanker activity and the risk of a catastrophic accident.

This report concludes that the recent rise in the existing sanctions framework provides policymakers with the tools they need to thwart Moscow’s strategies and impose much greater economic costs on the Kremlin, but only if these tools are used more effectively.

Measuring the Shadows is part of on-going analytical research into Russian oil sanctions. Its key conclusions are based in part on detailed modelling of Russian shipping patterns using open-source data. Its judgements are informed by the author’s 25-year career in the global financial markets—including extensive professional exposure to Russian oil executives and government officials—as well as prior academic training in Russian and Middle Eastern languages and history.

Part 1: Moscow’s “physical” evasion strategy: assembling a sanction-proof fleet

Chapter 1: Russia’s peculiar shadow fleet—evading sanctions through immunity, not subterfuge

The shadow fleet active in Russia today differs from shadow fleets elsewhere. Instead of relying primarily on subterfuge operations to circumvent sanctions, Russia’s “sanction-proof” tankers rely on immunity from the legal and commercial deterrence.

Not all shadow fleets are the same. Moscow’s fleet relies primarily on sanctions immunity rather than subterfuge to circumvent the price cap.

Since last summer, Moscow has been trying to assemble, through chartering and outright acquisition, a fleet of tankers capable of circumventing price-cap restrictions. These tankers would allow Moscow to receive the full market value for its oil when market prices are above price-cap limits set by the EU/G7 alliance. The core of this sanctions-circumvention fleet consists of tankers from Russia’s own state-owned shipping company, Sovcomflot (SCF). Supplementing them is a swelling roster of shadow tankers that have begun lifting oil from Russia over the last twelve months.

Moscow’s shadow fleet is similar in some respects to shadow fleets found elsewhere…

Much has been written about the shadow fleet in Russia. It is often assumed to be similar to the shadow trade in sanctioned oil elsewhere in the world, such as Iran. The comparison is valid, but only to a point. Shadow tankers operating outside of Russia tend to have four distinguishing features:

1. they are old,

2. anonymously owned,

3. focus on sanctioned oil and

4. seek to evade sanctions monitors by engaging in deceptive shipping practices.6

Nearly all shadow tankers active in Russia share the first three characteristics—advanced age, anonymous ownership, and focus on sanctioned oil.

… except it does not rely on subterfuge as its primary means of evading sanctions.

But the fourth characteristic—subterfuge—is not a defining feature of the Russian shadow trade. That’s because, unlike elsewhere, shadow tankers active in Russia do not need to rely on subterfuge to circumvent sanctions. To be sure, some shadow tankers transporting Russian cargoes are involved in subterfuge operations. This has been documented by valuable reporting on incidents of “dark” ship-to-ship transfers, AIS “spoofing” and other deceptive shipping practices.7 And in some cases, these practices are likely being used to smuggle Russian oil into closed markets, like the EU.

But it’s important to keep the scale of these clandestine operations in perspective. The aggregate volumes involved in such physical subterfuge operations normally represent only a few percentage points of Russia’s total seaborne exports. In the greater scheme of Russia’s circumvention strategy, subterfuge operations are, at most, of marginal significance. Moscow is primarily using the shadow fleet in a very different, quite overt way to evade sanctions. And as EU/G7 authorities consider how to allocate limited enforcement resources on Russian sanctions, focusing on tanker subterfuge at sea is unlikely to be the best option. Taking steps to limit overall shadow-tanker activity and combat fraudulent pricing information will have a much higher impact (see Chapter 7).

Most Russian oil transported by its shadow fleet is carried overtly, with no effort at concealment.

The simple reason is that, unlike elsewhere, subterfuge is simply not required to sidestep the sanctions imposed on Russia. Most Russian oil transported by shadow ships today in circumvention of the price cap is carried overtly, with no effort whatsoever at concealment. There are no ship-to-ship transfers, AIS signals remain switched on and undistorted, and cargoes are easy to track from loading to landing.

Many sanctions regimes include a “secondary” sanctions feature, like U.S. sanctions on Iran. That means all parties to a transaction, regardless of their jurisdiction, are subject to sanctions, thus creating a shared need for concealment and subterfuge.

The reason subterfuge is not needed arises from a fundamental difference between the oil sanctions imposed on Russia versus those imposed elsewhere, such as Iran. The Iran sanctions have a secondary component. This allows punitive measures to be taken against third-party entities around the world. The U.S. Treasury can, for example, impose sanctions on third-country importers if they are caught dealing in sanctioned Iranian oil. So, to reduce their risks, third parties handling Iranian oil seek to obscure its origins. Consequently, stealth and subterfuge have become the stock-in-trade of the shadow fleet active in Iran.

But Russian oil sanctions are “primary” sanctions only, with a focus on EU/G7 entities; they thus create an opportunity for third-country entities to openly import Russian oil free from sanctions risk.

But the Russia shadow trade is different. Russia sanctions are primary only. Unlike Iranian sanctions, they apply only to entities based in the EU/G7+ sanctioning countries themselves—not to third-country businesses. So, an importer from a non-sanctioning country faces no legal risk of direct sanctions for trading in Russian oil.8

For Moscow, what matters most is not a tanker’s capacity for stealth, but whether it is immune to the deterrent force of sanctions—whether it has the ability to disregard the price cap openly and with impunity.

Consequently, when it comes to assembling its shadow fleet, the attribute of greatest interest to Moscow is not a tanker’s stealth and subterfuge. It’s something more mundane: it’s a tanker’s immunity to the deterrent force of sanctions—an immunity that renders it “sanction proof.” This quality gives a tanker the ability to openly and reliably transport Russian cargoes priced above the price cap without concern for legal or commercial repercussions. In short, they can disregard the price cap with impunity. Together, these tankers form what can be called Moscow’s “sanction-proof fleet.”

Deterrence takes two forms: legal and commercial.

In the scheme of Russian oil sanctions, deterrence comes in two forms: legal and commercial. Whether a ship is subject to these deterrents depends on two things: (1) where their owners are based and (2) who provides their critical marine services—especially mortgage finance and liability insurance.

(1) Legal deterrence is limited to EU/G7 ship owners; violating sanctions can land them in court.

Ship owners based in the EU or G7 are subject to legal deterrence. If they violate the price cap, they are violating the law of the country in which they are based. If caught, they will likely end up in court.

(2) Commercial deterrence affects any ship owner worldwide who relies on EU/G7 entities for key marine services, such as ship financing and insurance.

Ship owners based outside price-cap alliance countries don’t face legal action for violating sanctions. But they can face painful commercial consequences. Most ship owners based in non-sanctioning countries rely on EU/G7 entities for certain critical marine services. If those ship owners violate the price cap, their EU/G7 marine service providers are obligated by law to terminate their service arrangement.

In some cases, those services might be easy to procure from providers outside the EU/G7. But not all. For example, EU/G7 banks have a broad global footprint in the ship mortgage sector. If a non-EU/G7 ship owner funded by a European bank violates sanctions, they could find themselves forced into a painful loan restructuring. For some ship owners, the prospect of a loan restructuring will be sufficient to deter them from violating sanctions.

The EU/G7 service sector with the broadest global footprint is marine insurance, which provides mandatory spill liability (P&I) coverage to some 95% of the global fleet through the Europe-headquartered International Group of P&I Clubs

As significant as EU/G7 may be in ship financing, the EU/G7 marine service sector with by far the broadest global footprint is marine insurance (see Figure 1). Specifically, it’s the highly specialized area of oil spill liability (“P&I”) insurance, which is mandatory for oil tankers. Some 95% of the global tanker fleet obtain their P&I insurance through a quasi-monopolistic network of not-for-profit, mutual assurance societies called the International Group of P&I Clubs (the “IG”).

Comparable alternative coverage at scale does not exist, creating a strong commercial deterrent to violating sanctions…

Because nearly all the principal clubs are based in EU/G7 countries, the IG requires all insured vessels to comply with Russian sanctions as condition of insurance. And because comparable alternatives to IG P&I coverage simply don’t exist at scale, the IG enjoys a near-monopolistic grip on the mainstream tanker market. IG coverage is often compulsory for securing loans from mainstream banks, entry to key ports and charter opportunities with large oil concerns. Consequently, fear of losing it acts as a powerful commercial deterrent to violating the price cap.

…which may help to explain why China’s state-owned tanker fleet, which is insured through the International Group, has—apparently out of an abundance of caution—stopped lifting oil from Russia since the introduction of sanctions.

As an illustration of this, consider the case of COSCO, China’s state-owned shipping giant. COSCO has China’s largest tanker fleet, which it insures through the IG. In 2019, however, COSCO went through a painful ordeal when OFAC imposed sanctions on a key subsidiary of its tanker business in connection with the Iran trade. The subsidiary’s business was severely disrupted as Western banks, traders and P&I insurers temporarily withdrew services. After eight months of back and forth, sanctions were dropped. Memory of that painful experience may help explain the conservative approach COSCO is taking to the Russia trade. Prior to sanctions, COSCO tankers regularly carried Russian oil cargoes. Since December 5, it’s hard to find a single COSCO tanker that has lifted from a Russian port.

Tankers either owned or financed by EU/G7 entities will also usually be insured by the IG. That, at least, is the case for pretty much any of the medium-to-large-size tanker classes (i.e., over 25,000 deadweight tons) that handle nearly all the Russian export trade. Mainstream European or American lenders will be reluctant to lend without proper insurance. Without taking on large amounts of debt, EU/G7 ship investors cannot get the levered returns they seek.

But for EU/G7 ship owners, having an IG P&I policy isn’t just enabling levered returns. It’s also about managing catastrophic risk. These investors are based in countries with relatively robust legal systems able to impose large punitive damages on ship owners for catastrophic spills. And under international conventions, ship owners bear ultimate liability for oil spills. So, to take on ownership risk, EU/G7 investors will want to be sure their insurance provides bullet-proof protection from unlimited liability. When it comes such protection, along with related matters such as track record of payouts, financial transparency, capital adequacy and good corporate governance, there is simply nothing comparable to P&I coverage from an IG club.

The small segment of the global fleet not insured by the International Group possesses the immunity to sanctions that Moscow seeks for its shadow fleet…

Those tankers not insured by the IG, then, tend also to be neither owned nor financed by EU/G7 entities. For Moscow, that’s a charmed combination. This lack of ownership and service ties to sanctioning countries endows these tankers with the effective immunity to sanctions that Moscow seeks. It’s these tankers that can carry cargoes priced above the price cap—no questions asked—and face no legal or commercial consequences for doing so. They are the “sanction-proof” tankers Moscow seeks to assemble into a fleet large enough to transport all Russian oil exports free from price-cap exposure.

…making insurance status a fairly accurate litmus test for distinguishing between mainstream and sanction-proof tankers in the Russia trade.

For those observing tankers loading out of Russia and wanting to distinguish which are sanction-proof and which are not, the vessel’s insurance provides an easy, nearly foolproof, litmus test. If a tanker is insured for P&I through the IG, it’s almost certainly a mainstream, price-cap compliant tanker. If it doesn’t carry IG P&I, it’s very likely to be a sanction-proof tanker able to transport non-price-cap-compliant cargoes without regard for sanctions

Chapter 2: Measuring the Shadows—how big is the sanction-proof fleet in Russia?

Despite substantial growth over the last year, Moscow’s fleet expansion program remains far from its goal of export autonomy and appears to be slowing in the early summer.

Can Moscow assemble a large enough fleet to close the “tanker gap?”

This chapter examines a critical question for the Kremlin—and EU/G7 policymakers, too: can Moscow assemble enough sanction-proof tankers to meet most of or all its export needs? We’ll start by measuring how many sanction-proof tankers are already active in Russia. Next, we’ll estimate how many Russia would need to form a stand-alone fleet capable of sustaining recent export volumes free from any price cap limitations. As we shall see, there is a sizeable capacity gap between what Moscow currently has and what it needs. Finally, we’ll assess Moscow’s prospects for being able to close this “tanker gap” in any practical timeframe. Among other things, this assessment will consider aggregate costs and available supply in the used tanker markets.

Two categories of tankers make up Russia’s sanction-proof fleet: state-owned Sovcomflot tankers and “shadow fleet” tankers.

Since February 2022, most tankers loading in Russia continue to be from the mainstream fleet. They are either EU/G7 owned, financed, or insured—in some cases all three. This means they will have strong legal and commercial incentives to observe sanctions by being price-cap compliant.

Apart from this mainstream, price-cap compliant fleet, a parallel “sanction-proof fleet” has been active in growing numbers in the Russia trade since the summer of 2022. It’s made up of two categories of tankers: those from state-owned Sovcomflot and the so-called “shadow fleet” (see Figure 2).

The capacity of Sovcomflot tankers active in the Russia trade has remained stable over the last year, averaging the equivalent of around 70 Aframax tankers.

Prior to Russia’s full-scale invasion of Ukraine, tankers from Russia’s state-owned shipping company, Sovcomflot (SCF), were part of the mainstream fleet. They were insured by the IG and financed by Western banks. But when SCF was sanctioned in March 2022, the IG cancelled their insurance and Western banks pulled their loans.

Now, with no residual ties to EU/G7 service providers, SCF vessels are able to transport non-price-cap-compliant cargoes with impunity. Over the past year, the capacity of SCF vessels involved in the Russia trade has remained stable and equivalent, on average, to the capacity of 70 Aframax tankers (see Figure 3).9

The source of growth for Russia’s sanction-proof fleet has come from a surge in “shadow tankers” into the Russia trade.

In addition to Sovcomflot tankers, the second category of tankers making up Russia’s sanction-proof fleet are shadow tankers. The roster of shadow tankers engaged in Russia has expanded significantly since the summer of 2022. Like SCF, they have no apparent reliance on EU/G7 finance or insurance. Unlike SCF, however, their ultimate beneficiary ownership remains largely anonymous. Their owners of record are typically single-ship shell companies, registered in off-shore tax havens, whose ultimate beneficiary ownership is difficult to determine based on publicly available information.

Shadow fleet tonnage active as of June 2023 equaled that of some 135 Aframax tankers

Since summer 2022, the capacity of shadow fleet tankers active in the Russia trade has expanded significantly, by the equivalent of some 110 Aframax tankers. By mid-June 2023, the total carrying capacity of Russia’s active shadow fleet equaled around 14.5 million deadweight tons, or the equivalent of 135 Aframax tankers.10 This capacity is distributed among some 163 different shadow tankers currently active in Russia, with deadweight tonnage ranging from 30,000 to 165,000 tons.

Shadow tankers active in Russia have had a mixed record of consistent dedication to the Russia trade.

Moscow will be aware that the shadow tankers engaged in the Russia trade have a mixed track record of consistent engagement. Among tankers active in Russia through mid-June 2023, well over half (57%) had loaded only once or twice in Russia since mid-March 2022. And fewer than a third (29%) had built anything resembling a solid track record of dedication to the Russia trade by lifting at least four times or more, with only a handful lifting ten or more times over this period (see Figure 5).

The low percentage of tankers with established track records can’t just be explained away by the relative novelty of shadow tanker activity in Russia. As Figure 6 shows, there is a weak correlation between the number of months a shadow tanker has been engaged in Russia and the number of Russian cargoes it has loaded (R² = 0.2859). Some tankers have managed a dozen loads in fewer than 7 months. Others started lifting over a year ago but have managed only two or three loads since.

This lack of consistent dedication to the Russia trade comes both from the opportunistic pursuit of business in other markets…

What explains this lack of consistency? Part of it appears to be the opportunistic nature of some of the shadow tanker owners. Russia is just one of several places where they seek business, and they move in and out of the Russia trade as it suits them. Many appear to avoid time charters—long-term leasing arrangements—preferring to charter on a spot basis.

And the Russia trade simply may not suit some shadow tanker owners, even if the rates are lucrative. It can, for example, pose certain risks and burdens not found in the Iranian trade. Routes can be long and demanding, exposing crews and vessels to harsh winter conditions and ice hazards in the Baltic. By comparison, voyages from Iran to India or even China can be far less taxing. Lifting from Russia’s Western ports also brings shadow vessels into European territorial waters, which may expose them to greater risk of seizure if they have fallen afoul of secondary sanctions imposed on Iran or other regimes.

…and unexpected operational interruptions that shadow tankers are prone to.

But this lack of consistency is also driven, in part, by the high incidence of unexpected operational interruptions to which shadow tankers seem to be prone. These incidents range from collisions to detentions to scrapes with the law. Here is just a sampling of things that have gone wrong in recent months for shadow tankers engaged in the Russia trade:

• An 18-year-old Cook Islands-flagged tanker, fully loaded out of Vysotsk, lost power in May while navigating the treacherous Danish Straits, straying from the narrow channel and nearly running aground a mile off the pristine coast of Langeland (see Appendix: A brush with disaster in the Danish Straits—shadow tankers menace the Baltic).

• a 20-year-old Panamanian flagged Aframax, laden with Russian oil, lost control and collided with a cargo ship last fall in the congested Strait of Malacca. No spill was reported. It was dispatched to China for repairs where it remains ten months on;

• a Vietnam flagged tanker was detained in port by Spanish authorities in February, possibly in connection with banned Russian-origin cargo, and later released;

• a 19-year-old Indian registered tanker went into dry dock in Dubai last fall for repairs shortly after unloading its Russian cargo, only to languish there for seven weeks before resuming operations;

• a 17-year-old Liberian flagged Aframax began regularly lifting oil from Russia following a seven-week detention in a European port early this year, after extensive deficiencies were uncovered during in a port-state inspection;

• and then there’s the case of the 20-year-old, Liberian flagged Suezmax that had just finished unloading its Russian cargo in Sicily last November when the US Treasury imposed sanctions on the vessel and its owner for financing Hizballah and the Iranian Revolutionary Guard. The vessel managed to slip out of port and avoid detention, but has remained at anchor in the Eastern Mediterranean ever since.

Such frequent troubles are no mere coincidence. As we shall see below, it’s the inevitable result of a business model built around a high appetite for risk and an aggressive attitude towards compliance-related cost-cutting. So long as Russia choses to rely on the shadow fleet, it will need to factor in an elevated level of unreliability into its plans.11

To ensure more tankers dedicate themselves exclusively to the Russia trade, Moscow appears to be covertly funding the acquisition of shadow tankers rather than relying on market forces to ensure an adequate supply of shadow tanker capacity.

It is in Moscow’s interest to reduce this risk of unreliability and inconsistency. Normally, exporters could manage this risk by engaging tankers in long-term time-charters. That option, however, may not be widely available in the shadow tanker market.

But there is an alternative to time charters when it comes to ensuring availability of tankers: owning these vessels outright. Senior Russian officials have long been discussing the need for Russia to assemble a proprietary fleet as well as the formidable financing needs this would entail.12

It’s very likely Moscow has begun acting on these plans. A remarkably high percentage of tankers active in Russia—some 82%—have changed hands since March 2022 (see Figure 15 below). How many of these sales represents covert Russian buying can’t be determined from publicly available information. Some sales were almost certainly to non-Russian buyers and conducted in the normal course of shadow fleet renewal. By its nature, the shadow fleet has high rates of turnover. But it’s likely that at least some of these purchasers—perhaps a large portion of them—are covert Russian buyers, an observation echoed by some ship brokers. If so, it would represent Moscow’s efforts to secure higher levels of shadow fleet commitment to the Russia trade by gaining control of tankers through direct ownership (a more detailed discussion of the costs and challenges of Moscow’s apparent acquisition program can be found in Chapter 4 below).

The pace of shadow-fleet expansion was highest over the winter but has slowed significantly since May.

It’s notable, however, that after a strong surge in numbers over the winter, the rate of shadow fleet expansion has slowed significantly from May into July 2023 (see Figure 4 above). This could be just a momentary downturn. But it may also reflect deeper structural impediments that Moscow’s fleet expansion program has begun to encounter, such as a decline in the availability of suitable tankers and rising costs. In Chapter 4, we shall examine these structural impediments in greater detail. First, however, we must estimate a key quantum: how many tankers does Russia need to keep its exports whole and untouched by the price-cap?

Chapter 3: How many shadow tankers does Moscow need in all?

The EU/G7 import ban has doubled Russia’s shipping needs. The Sovcomflot and shadow tankers currently active in Russia covers barely a third of the capacity Moscow needs for a stand-alone, sanction-proof fleet. The result is a gaping “tanker gap.”

Prior to Russia’s full-scale invasion of Ukraine, some 75% of seaborne oil exports went to EU/G7 countries, principally in Europe.

It’s hard to overstate the significance of the EU/G7 ban on Russian oil imports. They abruptly terminated a 145-year history of Russian oil exports to Europe that has endured through revolutions and world wars. In recent years, Russia’s oil sales to the EU had become what is likely the largest bi-lateral, single-commodity trade in the history of global commerce. And then suddenly, in under a year, it all but disappeared. Such a seismic shift was bound to pose huge challenges to Moscow, and it has.

Chief among these has been the need to find new buyers in markets that are smaller, more concentrated, much more remote, and far less familiar. Prior to Russia’s full-scale invasion of Ukraine, some 75% of Russia’s seaborn exports flowed to EU/G7 countries. Most of these exports were shipped through Russia’s highly developed export hubs on the Baltic and the Black Sea to nearby destination ports in the EU, UK, and Turkey. Only a trickle flowed East of Suez (see Figure 7).

The EU/G7 ban on Russian imports has forced exports to reroute to new markets East of Suez, nearly doubling Russia’s shipping capacity needs.

From March 2022 through February 2023, the map of Russian exports gradually but profoundly shifted (see Figure 8). In the early months, voluntary self-sanctioning by some importers drove the trend, with the imposition of hard sanctions eventually completing the transformation.

Sanctions have had the smallest impact on Asia-bound flows through Russia’s capacity-constrained ESPO pipeline. Most of these continue to end up in China either directly overland or shipped by sea via Russia’s Pacific ports.

Russia’s much larger westbound flows, by contrast, have been profoundly disrupted. The immense seaborne flows, previously destined for European destination ports, are still exiting Russia via its western ports in the Black Sea and the Baltic. But now they sail past Hamburg and Rotterdam, continuing on to distant markets located mostly East of Suez. These seaborne flows have been augmented by barrels formerly shipped overland to Central Europe via Russia’s Druzhba pipeline. Most of these—some half million barrels a day—have now been rerouted to Russia’s Baltic or Black Sea ports for shipping by sea to new markets far beyond Central Europe. The longer distances to market have roughly doubled the tanker capacity Russia needs to keep it exports whole.

Most of Russia’s dislocated oil has gone to India or Asian trading hubs, with less than 10% going to China

Over half of Russia’s dislocated oil has gone either to India or trading hubs in the UAE and Singapore. Contrary to some reports, however, only a small portion—less than 10%—reaches China (see Figure 9). Several things explain this.

• First, Russia’s straitjacket of pipelines and ports forces most dislocated oil westward, making freight costs to distant China unattractive. Russia’s constrained East Siberian pipeline system doesn’t allow significant amounts of dislocated oil to be moved overland to China or the Pacific coast.

• Second, China seeks to diversify supply. With Moscow already one of its top two suppliers (alongside Saudi Arabia), appetite for incremental Russian oil is likely limited.

• Finally, Moscow itself is trying to reduce its dependence on mainstream tankers. Shipping from western ports to China requires two-thirds more tanker capacity than to India. And the more tankers Russia needs to keep exports whole, the more exposed it becomes to the risk of price-cap limitations.

To sustain current export levels fully sheltered from the price cap, Moscow would need a fully dedicated, stand-alone, sanction-proof fleet equal in capacity to 637 Aframax tankers…

Russia’s seaborne export levels have remained stable, averaging over 6 million barrels a day of crude and refined products in recent months, despite the fundamental shift in Russian export patterns. Currently, most Russian seaborne oil is transported by mainstream tankers, which are obligated to comply with the price cap. For Moscow to completely avoid exposing any of its exports to price caps, it would need to rely on a stand-alone fleet of sanction-proof tankers. To keep fleet size to a minimum, Moscow would want every tanker in it dedicated exclusively to the Russia trade, with no one working part time for other exporters. At any given moment, a fleet tanker would need to be either laden with Russian oil and outbound to its destination port, or in ballast returning to a Russian port to lift a new cargo (see Figure 10).

To transport Russia’s full export volumes on a sustained basis, free from any price cap restrictions, Moscow would need a fully dedicated, sanction-proof fleet with an estimated capacity equal to 637 Aframax tankers, based on analysis of recent shipping patterns (see Figure 11).13

Currently, Moscow’s active sanction-proof fleet covers less than a third of these needs…leaving a yawning “tanker gap” equal to some 432 Aframax tankers.

The combined capacity of Russia’s current sanction-proof fleet—Sovcomflot vessels plus shadow fleet—comes to 21.9 million deadweight tons, the equivalent of some 205 Aframax tankers. That covers just 32% of Russia’s total capacity requirements for a stand-alone, sanction-proof fleet (see Figure 12). The result is a large shortfall in capacity—a “tanker gap”—of around 46.2 million deadweight tons, or some 432 Aframaxes.

To fully circumvent the price cap on a sustainable basis, Moscow will need to close this yawning gap. But until it does, Moscow will remain heavily dependent on the ample supply of mainstream tankers ready to transport oil from Russia, provided it’s price-cap compliant.14 In the next chapter, we examine Moscow’s prospects for closing the tanker gap.

Chapter 4: Can Russia close its “tanker gap?”

Full export autonomy for Russia looks years away as structural factors in the tanker markets—constrained supply, rising costs and high levels of attrition—impede Moscow’s efforts to quickly close the remaining gap.

Despite a year of effort, Moscow has managed to reduce last summer’s tanker gap by only 20%.

Moscow’s prospects for quickly closing this yawning tanker gap are not good. Despite a major push over the last year, which included gathering much low-hanging fruit, Moscow only managed to reduce its tanker gap by a mere 20% (see Figure 13). At that pace, it will take years for Moscow to reach its goal of a stand-alone, sanction-proof fleet. But even last year’s modest pace of expansion looks unlikely to be sustainable.

The reason: the shadow fleet in Russia is mostly purchased, not hired. Moscow is finding that it can’t rely on the spot charter market to provide the kind of fully dedicated shadow tanker capacity it needs. Instead, a large portion of the shadow fleet now active in Moscow appears to have been purchased in the second-hand tanker markets specifically for the Russia shadow trade—much of it likely financed with Russian money.

Three formidable structural challenges will impede Russia’s efforts to expand its shadow fleet: constrained supply, rising prices and high attrition.

But a fleet expansion program of Russia’s magnitude that relies on buying up used tankers faces formidable challenges that can impede growth. These include:

(1) constrained market supply: a constrained supply of tankers in the global fleet that are suitable for conversion to the shadow trade;

(2) rising prices: sharply rising costs for acquiring these tankers; and

(3) high levels of fleet attrition due to age: as Russia’s shadow fleet expands, attrition rates rise, requiring an increasing portion of acquisition spending to go towards fleet renewal rather than further expansion.

It appears the impediments of short supply and rising costs may already be at work, judging from the sharp slowdown in shadow fleet expansion over May and June (see Figure 4 above).

* * *

Historically, Moscow relied on the spot chartering markets to meet most of its tanker supply needs.

When it comes to securing tanker capacity, exporters have three basic options they can turn to:

(1) Spot chartering: hiring vessels on a voyage-by-voyage basis, akin to hailing a taxi to take you to the airport;

(2) Time chartering: leasing a tanker for a longer period of time and using it for multiple round trips; and

(3) Vessel ownership: owning the tanker outright.

Historically, Russia has done all three. It owned a fleet of tankers through Sovcomflot, and some exporters leased vessels on a time-charter basis. But by far the largest source of tonnage prior to sanctions (and still today) was from spot charters. As mainstream vessels deliver cargoes from exporters around the world to destination ports in Europe or China, they would then tender for spot charters at a nearby Russian port. It’s much like a taxi dropping off a departing passenger at the airport and then picking someone up from arrivals. The proximity of Russia’s export terminals to the two largest importing markets in the world assures Russia a large, steady, competitive supply of mainstream tankers on tap.

The spot chartering model works well when there is an overabundance of available vessels. But when there’s a very limited supply of vessels—as in the case of the shadow fleet—the spot chartering model works poorly. If a Russian exporter doesn’t want to charter a price-cap compliant, mainstream tanker, it could be left waiting a long time for a shadow tanker to become available for a spot charter. As we shall see in Part 2, that’s exactly what happened at the Russian port of Kozmino last December, when mainstream tankers stopped loading in the weeks immediately following the introduction of crude sanctions (see Figure 21).

The spot charter market has not worked well for recruiting shadow tankers from the pre-existing fleet; only 11% of shadow tankers active in Russia, for example, have also participated in the Iran trade.

Commentators had expected Russia would succeed in recruiting many shadow tankers from the global shadow fleet that had grown over the years to service Iran, Venezuela and other sanctioned regimes. That simply hasn’t happened. Only 11% of Russia’s active shadow fleet, for example, appears also to have participated in Iran’s large shadow trade (see Figure 14).15

Russia’s struggle to hire shadow tankers on a spot charter basis may explain much of the trouble it has had with shadow tanker commitment (see Figure 5 and Figure 6 as well as the discussion in Chapter two). Many third-party shadow tanker owners simply appear unwilling to dedicate their vessels full time and exclusively to the Russia trade. Nor do many appear ready to lease out their vessels on a time charter basis. One can speculate on why so few shadow tankers switched from the Iran to the Russia trade, but it’s hard to know with any certainty.

Consequently, Russia’s shadow fleet is mostly being bought not hired. Tankers are purchased—mostly from the mainstream fleet—rather than recruited from the pre-existing global shadow fleet.

Given the challenges of chartering fully dedicated shadow tankers from the existing global shadow fleet, a growing number of shadow tankers have entered the Russia trade as the result of outright sales. Some 82% of shadow tanker capacity active in Russia has changed ownership since March 2022 (see Figure 15). Most of those purchases have been from mainstream sellers. The new owners, typically opaque shell companies registered outside the EU/G7, dropped IG P&I coverage for their new vessels, thus rendering them effectively sanction-proof and fit for the Russian shadow trade.

Buying used tankers for conversion to the shadow trade is nothing new. The shadow fleet business model centers around buying mainstream tankers cheaply and then sweating them for cash.

This pattern of buying tankers from the mainstream fleet for conversion to the shadow trade is nothing new. For years it has been core to the shadow fleet business model. This business model involves purchasing aging tankers cheaply and sweating them for cash during their few remaining years of service. Costs are cut by slashing expenditures on maintenance, safety, and spill liability insurance. Revenues are enhanced by pursuing lucrative cargoes of sanctioned oil. The shadow fleet model often also involves moving the vessel’s registration to a “black-listed“ or “grey-listed” flag state—one known for lax enforcement of international standards of safety and insurance when certifying ships on their registers.

The challenge for Moscow is this: its demand for shadow tankers is unprecedented in size, while the global supply of vessels suitable for the shadow trade is constrained.

The main challenge for Moscow’s fleet expansion program is the sheer magnitude of sanction-proof tanker capacity it needs. It’s many times greater than what previously sanctioned exporters have required. That’s a function of both Russia’s larger volumes and the longer average voyage times compared, say, to an exporter like Iran. But the supply of mainstream vessels worldwide suitable for conversion to the shadow trade is constrained. That begs the critical question: are there enough suitable tankers available at economically rational prices to meet Russia’s sanction-proof shipping needs?

The tanker industry’s need for large amounts of capital while exposed to catastrophic spill risk binds most of the global fleet in a web of compliance obligations incompatible with the shadow fleet business model.

To understand the reasons for the constrained supply, it’s necessary to understand a unique challenge facing the global tanker fleet: how do you finance a highly capital-intensive industry in the face of massive oil spill liability exposures that are many times greater than the value of the ships and cargoes themselves? Over the decades, ship owners, banks, insurers, and regulators have negotiated a solution that is imperfect but functional. It involves binding the vast majority of tankers in the global fleet in a web of compliance obligations aimed at protecting investment capital from catastrophic risk. Compliance involves spending significant sums both on safety and maintenance designed to reduce the risk of spills as well as quality insurance needed to limit liabilities when spills occur. These compliance obligations are costly to uphold and can last for years, making most tankers unsuitable for conversion to the shadow trade for most of their service life.

Three factors in particular interact to create these compliance obligations: debt, insurance and statutory inspections.

1. Debt. First, the global fleet of oil tankers must be continually renewed through the construction of new vessels. To finance newbuilds, which can cost $100 million or more, ship owners rely extensively on specialist bank lending. This financing often takes the form of a ship mortgage, secured against the vessel and its future cashflows, and other forms of structured finance. Capital markets have also been planning a larger role.16

2. Insurance. Second, for mainstream bankers to lend, they need protection against the risk of a catastrophic spill that could prevent repayment of the loan. As a condition of the loan, they will require that the tanker complies with costly statutory safety and maintenance requirements and carries quality P&I insurance, with IG insurance being standard for the industry.

3. Inspections. Third, to help reduce the risk of spills in the first place, regulatory bodies and quality insurers require a range of regular safety inspections. By far the most consequential are those conducted as part of the Enhanced Survey Program (ESP), which is overseen by the International Maritime Organization (IMO), shipping’s supranational governing body. Under the ESP, a tanker must undergo extensive structural surveys every 5 years as a condition of recertification, with levels of scrutiny rising over time.

Together, these three factors impose a three-phase lifecycle on most tankers which includes a narrow window, late in life, when vessels become suitable for the shadow trade (see Figure 17).

Phase 1, up to 15 years old, is the “high compliance” mainstream phase.

The first phase is largely driven by the maturity schedule of ship mortgages. With loans typically extending 10 to 15 years, tankers will be bound by lending and insurance conditions to remain highly compliant with regulatory requirements throughout this period. They’ll need to spend enough on maintenance to make certain they pass the ESP recertification surveys at year 5, 10 and 15. And since the International Group will generally be providing the P&I insurance coverage, ships will be prohibited from taking up the sanctioned oil trade during this period. Most mainstream lenders will also impose covenants prohibiting any trade in sanctioned oil. These highly compliant ships make up what can be called the “mainstream fleet” or “compliant fleet.” By extension, all these ships are obligated to be “price-cap compliant.”

Phase 2, the “shadow fleet window” runs between ages of 16 to 20 years, when compliance obligations ease…

At 16, however, with the initial mortgage paid down, the third renewal survey passed and a fresh recertification in place, compliance obligations on a tanker ease significantly. At this point, a typical tanker has only a few years of service left. It still retains some residual value in the second-hand market, but hull fatigue and the ravages of time are taking their toll. By the time the tanker turns 20, it often makes more economic sense to sell the vessel for scrap than attempt to pass a fourth recertification survey.17

It’s during this phase, between the ages of 16 and 20, that mainstream operators often opt to sell off these aging vessels and use the proceeds to fund fleet renewal. These sales provide a steady supply of tankers to the secondary market. The buyers of these vintage vessels tend to be niche, end-of-service-life operators. Some pursue the mainstream fleet business model—but not all.

…making tankers well suited for purchase and conversion into shadow service.

Tankers in this age cohort make ideal candidates for conversion to the shadow fleet. With only a few years of expected service life, they are typically cheaply priced. They are likely unencumbered with debt, which means quality insurance can be dropped in favor of coverage from an often obscure, low-transparency provider of indeterminate quality. And since owners have little expectation of eventually submitting the vessels for its fourth recertification survey at age 20, maintenance costs can be slashed to the bone.

Instead, once the vessel reaches 20 years, these exhausted tankers will typically get beached with a favorable tide at one of the sprawling ship breaking yards at Chittagong—the graveyard of the global fleet. There, they are sold for scrap. These hulking carcasses can lie on the sands for months, leaching toxic heavy metals into sediments and water, while low paid workers laboring in Dickensian conditions strip them of metal parts which are dispatched to nearby steel mills for recycling.18

Phase 3, from 21 years on, is marked by high rates of attrition and scrapping.

The final phase comes after age 20. Many vessels will already be scrapped by this point. When freight rates are exceptionally high, however, strong cash generating potential can justify the expenditures needed to pass a fourth recertification survey. In time, age will cause utilization rates to decline. Very few tankers will make it to a fifth recertification survey.

The shadow fleet active in Russia exhibits the same characteristic clustering of tankers in the 16-to-20-year-old age group as the global shadow fleet; 87% of the tonnage is above the age of 15.

Vessels younger than 15 or older than 20 can and do get bought for conversion into the shadow trade. But between the higher upfront costs for younger vessels and the limited remaining service years for older ones, the economics can be challenging. So, it’s no surprise, then, that the average age of shadow tankers active in Russia exceeds 18 years, with some 87% 16 years or older. What is also notable and typical is the very sharp step down in the vessel count between ages 20 and 21—a result of recertification attrition (see Figure 16).

On paper, the global supply tankers of suitable age and class is sufficient to cover Russia’s shadow-tanker needs, but not by much; Russia needs an extraordinary 69% of this cohort—four times current levels.

On paper, the global supply of 16-to-20-year-old long-haul tankers in classes suitable for loading in Russia is sufficient to cover Russia’s tanker gap—but not by a large margin. Russia’s active sanction-proof fleet already represents some 17% of this worldwide cohort of 16-20-year-old tankers from the relevant classes. To cover Russia’s tanker gap, that figure would need to rise four-fold, to an extraordinary 69% (see Figure 17).19 And to maintain the current ratios among tanker classes used in the Russia trade, some 100% of Aframaxes and 78% of Suezmaxes worldwide in this age bracket would need to be operating as shadow tankers exclusively dedicated to the Russia trade.

The Russian shadow trade under sanctions has driven a large demand surge in the used markets for second-hand tankers—up 71% year on year.

There is an active global market in used oil tankers. During the twelve months following Russia’s full-scale invasion of Ukraine, second-hand markets saw a 71% year-on-year surge in sales of the tanker classes suitable for the Russian export trade. Most of that incremental volume—some 73% of it—was driven by tankers that were subsequently deployed into the Russian shadow trade (see Figure 18).

Higher demand has caused market prices to rise sharply. Prices for vintage Aframaxes, for example, are up 130% year-on-year.

As you would expect, this surge in demand has had a knock-on effect on asset values, especially for the vintage vessels favored in the Russian shadow trade. Over the same twelve months through February 2023, for example, the market value for a 15-year-old Aframax—the workhorse of the Russian trade—ballooned from $16.5 million to $38 million—a dizzying 130% rise in value (see Figure 19).20

Limited liquidity in the used tanker markets means any effort to quickly close the tanker gap will only put further upward pressure on prices...

This asset price sensitivity to increased demand sets up a real challenge for Moscow. As large as the Russian buying splurge was in the 12 months up to February 2023, it pales in comparison with Russia’s need going forward. Russia’s current tanker gap is so large that it exceeds the combined capacity of all tankers of relevant classes sold worldwide during the 12 months to February 2023, across all age groups combined (see Figure 20). Most of those trades involved Greek and/or Chinese counterparties and had nothing to do with the Russian shadow trade. For Moscow to buy more than a fraction of what it needs over the next twelve months would put further upward pressure on asset valuations.

At recent valuations, all-in acquisition costs for Moscow’s fleet expansion campaign could easily approach $20 billion. Any effort at quickly closing the tanker gap could push the price tag much higher.21

This begs two more questions: who has the balance sheet to fund such a large acquisition program? And can the potential economic benefits of a stand-alone fleet justify such a massive up-front investment? Traditional shadow fleet investors lack access to large-scale, mainstream ship finance, and it’s unlikely they have anything approaching the financial firepower to fund such a program. The acquisition costs are just too great. Even if they could cobble together funding, their business model is very value conscious. They would likely be put off by escalating asset values. And given the short payback periods required under the shadow fleet model, and the high volatility of freight rates, they will be especially cautious about overpaying for acquisitions.

…weakening the investment case underpinning the acquisition program and creating financing challenges.

This leaves the Russian state as the most likely source of funding. It has both the motivation to put capital at risk as well as the financial means needed, through a combination of budgetary resources, state bank credits and oil exporter balance sheets. It’s widely speculated within the shipping broking community that Russian money may be behind many of the recent purchases around Russia’s shadow fleet.22

As asset prices rise, the investment case becomes increasingly hard to make. For Russian producers, the economic case for investing in highly priced tankers with short remaining lives is very challenging. A large majority of any resulting windfall revenues will get taxed away by the state. The only party for whom it makes sense to fund such a program is the state itself, since it would be the primary beneficiary. But to generate enough incremental tax revenue over the course of a year simply to cover acquisition costs at today’s valuations, FOB crude prices would need to average $16 a barrel over the price cap for that entire period. Possible? Yes. Likely? Far from certain. And that’s simply to break even. Moreover, as we saw above, limited liquidity in the used tanker markets is likely to push acquisition costs much higher if Russia presses ahead with an aggressive acquisition campaign. And that means Moscow would need an even higher windfall margin to have certainty of payback in a meaningful period.

The final impediment to fleet expansion: the steepening treadmill of attrition.

As Russia’s aging shadow fleet expands, fleet attrition becomes an issue, with new acquisitions increasingly used for replacing attritted capacity rather than for fleet expansion.

It’s not only constrained supply and asset inflation weighing on Moscow’s expansion program. Many of the acquired vessels have very limited remaining service lives (see Figure 16 above). As Russia’s shadow fleet grows, an increasing number of newly purchased tankers will simply be replacing tankers lost to attrition, rather than expanding the size of Moscow’s fleet. Thus, we can expect the interlinked constraints of supply and cost along with the treadmill of attrition to greatly impede Russia’s ability to quickly assemble a stand-alone, sanction-proof fleet.

* * *

A year into its fleet expansion program, Moscow now likely recognizes the formidable structural impediments it faces. This realization will add impetus to efforts at finding alternative ways to circumvent the price cap. In Part 2, we examine Moscow’s most promising alternative method, one with the potential to completely subvert sanctions if policymakers don’t take adequate steps to address it.

Part 2: Moscow’s “paper” evasion strategy: engaging mainstream tankers using fraudulent pricing information

Chapter 5: The Kozmino Mystery: How did mainstream, compliant-fleet tankers end up transporting Russian oil priced above the cap?

In parallel to its “physical” strategy of assembling a sanction-proof fleet to circumvent sanctions, Moscow appears to have been developing a “paper” strategy as well. It works by exploiting known vulnerabilities in the price-cap compliance regime. The aim is to fraudulently engage mainstream tankers to carry cargoes priced above the price cap by providing them with inaccurate pricing information.

Price attestation fraud appears to have been used to secure mainstream tankers at Kozmino following the introduction of sanctions.

Because most grades of Russian oil have traded below their price caps for most of the time since sanctions came into force, the robustness of price-cap monitoring and enforcement has not yet been widely put to the test. The recent surge in Urals prices will change that. Until July 2023, however, there was only one major export stream which was routinely quoted above its price cap: ESPO blend crude exported from Russia’s Pacific port of Kozmino. As such, it provides a useful case study in the deployment of Moscow’s “paper” circumvention strategy and efforts by sanction authorities to counter it.

Mainstream tankers mostly dropped the Kozmino trade in early December, causing export volumes to collapse…

Before the introduction of crude sanctions in early December 2022, 75% of Kozmino exports were routinely lifted by mainstream tankers. These included a core group of Chinese state-owned and Greek-owned vessels that transported some 45% of Kozmino flows. In the weeks immediately prior to the sanctions deadline, Urals grade crude—which ships primarily from Russia’s western ports—fell far below the $60 price cap. But not ESPO, which continued to be quoted well above it. As the sanctions came into force, most mainstream tankers, including the core group, abruptly stopped loading at Kozmino—apparently over price cap concerns. With the sudden withdrawal of the mainstream fleet, export volumes out of Kozmino plunged and a capacity crisis appeared in the making (see Figure 21).

Russian traders appear to have anticipated a looming capacity crunch at Kozmino. Accordingly, November and December saw a surge in shadow tankers arriving at Kozmino Bay to help cover the expected shortfall. As sanctions kicked in, however, not enough shadow and SCF tankers had gotten enlisted into the Kozmino trade. The numbers weren’t even close to what was needed. By mid-month, exports were down 55%, helped by heavy weather.

Then a curious thing happened. Throughout December, a trio of Turkish- and Indonesian-managed mainstream tankers had continued lifting oil from Kozmino. Because they were insured by the International Group, they were obligated to observe the price cap as a condition of their P&I coverage. Indeed, all IG P&I clubs were requiring that any covered tanker doing business in Russia had to submit a special, written representation that they would comply with the price cap or forfeit their P&I coverage.23

In addition to that, for every cargo they lifted from Russia, they were obligated under G7/EU sanction rules to obtain a “price attestation”—written confirmation that the cargo was not priced above the price cap. This price attestation would normally be provided by the tanker’s charter customer. In practice, this price attestation would typically be coming from the trader or broker chartering the vessel. It would appear that the three IG insured tankers we obtaining such price attestations. Failure to do so would have lead to cancellation of their IG coverage, but as of July 2023, all three remained covered by the IG.

…but by mid-January, many had returned.

The continuous operation of these few mainstream tankers at Kozmino likely did not go unnoticed. And it seems word soon got around the market that price attestations were being provided to IG-insured vessels lifting oil from Kozmino confirming that cargoes were price-cap compliant. In early January, other mainstream tankers began to return to Kozmino and by the second half of January, even Greek ships were loading once again. Come February, the share of mainstream tankers in the Kozmino trade had largely recovered, briefly reaching 60%, before tapering back down to around 40% for much of the spring.

Throughout this period, the quoted ESPO price at Kozmino remained well above the price cap. Which leaves us with the following mystery: did Moscow really cut prices on some of its ESPO export barrels to secure capacity on mainstream, price-cap compliance tankers? Or were the price attestations fraudulently underreporting the value of the cargo?

It appears they were duplicitously engaged to carry non-compliant cargoes by bad-faith traders providing fraudulent price attestations.

When EU/G7 policymakers were developing the price cap, they identified a potential vulnerability in the price-attestation regime: the reliability of the pricing information depended on the truthfulness of the traders providing it. A bad-faith trader could fraudulently under-report a cargo’s value to secure the services of a mainstream tanker. To manage this risk, policymakers urged ship owners to exercise due diligence when taking on clients and detailed red flags to watch out for. The U.S. Treasury even provided a diagram to illustrate the bad-actor risk (see Figure 22).24 But is due diligence by ship owners and operators sufficient to root out bad-faith traders?

Many traders now handling the Russia trade are immune from sanction risk, with little to deter them from misleading shippers.

Historically, top tier global commodity trading groups played a significant role in handling exports out of Russia. These included the trading arms of major oil companies, the commodities trading teams at bulge bracket investment banks, and global commodities trading houses. All these groups have deep commercial interests in EU/G7 countries. Not surprisingly, most have now largely or completely withdrawn from the Russia business, owing to a mix of legal and reputational concerns.

The resulting vacuum has largely been filled by third-tier players based primarily outside EU/G7 jurisdictions. Consequently, this new cohort of traders is largely immune from sanctions. They face no significant consequences for handling trades priced above the price cap or providing fraudulent price attestations. Moreover, a number of these traders also have attributes that would trigger red flags detailed by policymakers in their guidelines to the EU/G7 marine transportation industry.25

Evidence suggesting attestation fraud includes…

Proving attestation fraud is difficult without access to underlying contractual information on a ship-by-ship basis. But there are two sources of evidence that strongly suggest traders have been duping mainstream tankers into carrying oil priced above the price cap by providing fraudulent information.

…sales contract data…

First, there are published data that appear to include details from sales contracts between Russian producers and traders for crude exports out of Kozmino in late 2022 and early 2023. Nearly all these contracts indicate sales prices at Kozmino that are well above the price cap.26 The data do not associate any specific tankers with specific contracts. But the aggregate volumes reflected in the contracts are large enough that some of these non-price-cap-compliant cargoes would have ended up being transported by mainstream, IG-insured tankers active at Kozmino under sanctions.

…and the notable failure of Chinese state-owned tankers to resume the Kozmino trade.

The second piece of evidence is the continued absence from Kozmino of Chinese state-owned tankers following the introduction of sanctions. Prior to sanctions, they had been a mainstay of the Kozmino trade. Unlike the Greek shippers, however, they did not return to Kozmino after the introduction of sanctions. Instead, they stayed away, even as other mainstream tankers returned to Kozmino and the ESPO volumes being shipped to China grew.

There are several plausible explanations for the enduring absence of state-owned Chinese tankers. But one seems especially compelling: alone among mainstream tanker owners, Chinese state-owned shippers are in a position to know the underlying prices of most Kozmino export cargoes, since most end up in China. These cargoes are being bought by Chinese importers and contractual information is being gathered by Chinese state customs officials. Given COSCO’s painful ordeal with sanctions in 2019 (see Chapter 1 above), they would be reluctant to jeopardize their P&I insurance by accepting a price attestation they know to be fraudulent.

The potential price-cap fraud at Kozmino came to the attention of sanction authorities early on. In April, the U.S. Treasury issued a warning to mainstream shippers about the risk of fraud at Kozmino and urged them to exercise adequate diligence.27 In the weeks that followed, the mainstream fleet’s share in the Kozmino trade went into sharp decline, falling below 10% by June, with price-cap compliant vessels increasingly yielding to sanction-proof vessels. For the moment, at least, this direct challenge to the effectiveness of the price cap seemed in retreat.

Sanction enforcement officials have urged shippers to exercise vigilance, but it’s unclear whether sufficient measures are in place to substantially reduce the risk price certification fraud.

While attestation fraud may be in retreat at Kozmino, that shouldn’t be taken as a sign that it has been effectively neutralized as an evasion strategy. Moscow doesn’t need to rely on price attestation fraud to shelter its Kozmino exports from the price cap. The Kozmino-to-China route is among Russia’s shortest export voyages, utilizing only 7% of Russia’s total capacity needs. That makes it small enough for Moscow to easily service it with a fraction of the sanction-proof fleet at its disposal. And with sanction-proof vessels now lifting over 90% of Kozmino volumes, its displacement of the mainstream fleet is nearly complete.

The Urals trade, however, is another matter altogether. The tanker capacity needs to keep Urals and other crudes flowing from Russia’s western ports is far greater than the capacity needed at Kozmino—more than eight times greater (see Figure 23). It’s very unlikely Moscow will be able to manage all its Urals flows only with sanction-proof vessels. If Urals remains above the price cap for long, Moscow is likely to resort once again to price attestation fraud, rather than cutting prices, to keep export volumes whole.

So far, not enough appears to have been done to prevent future attestation fraud. The U.S. Treasury announcement in April was a shot across the bow to EU/G7 owned and/or insured tankers, but it did not address the underlying problem. So long as mainstream tankers are allowed to rely on pricing information from suspect trading groups—ones that fail to meet red flag guidelines laid out by the enforcement agencies themselves—the price cap remains at risk of unravelling completely.

Part 3: Moscow’s strategy for boosting prices

Chapter 6: Moscow contrives to have OPEC solve its oil price problem

Moscow has used scaremongering and deception to try to manipulate OPEC into rebalancing the market while Russia avoids any real cuts itself. But the export cartel appears to have seen through Moscow’s charade.

The EU/G7 embargo of Russian oil has significantly weakened the bargaining power of Russian exporters, especially for Urals blend cargoes.

Oil sanctions have been imposing costs on Russia by causing many Russian cargoes to be sold at extraordinary discounts. Throughout the first half of 2023, Putin has been focused on reducing the discount and propping up oil prices, and understandably so.28 Since the start of Russia’s full-scale invasion of Ukraine, extraordinary discounts on crude alone have deprived Russia of tens of billions of dollars in lost revenue. These lost revenues likely exceed those directly attributable to the price caps, which, until recently, have mostly been well above market prices.

The underlying cause of the discount is Moscow’s abrupt loss of access to coalition export markets—European markets in particular. Urals blend crude accounts for roughly a third of Russian seaborne exports and is shipped almost exclusively from Black Sea and Baltic ports. Over the last fifty years, it had been sold almost entirely to European refiners. The import ban has forced Moscow to seek out new buyers, mostly East of Suez, in markets that are smaller, farther, and less familiar (see Figure 7 and Figure 8 above). To secure firm demand at scale, Moscow has relied heavily on the only readily accessible large buyer—India (see Figure 9 above). Since December, India’s dominant position among Urals importers has weakened the bargaining power of Russian exporters, enabling Indian traders to impose deep discounts.

Moscow’s circumvention strategy relies on OPEC to support slumping Russian oil prices.

Moscow’s third anti-sanction strategy takes aim at this painful and persistent problem by trying to shore up oil prices. The obvious solution to the problem is to generate greater competition among buyers of Urals. Moscow has sought out alternative buyers, but with limited success. As discussed in Chapter 3, Chinese demand for cargoes from Russia’s western ports faces multiple constraints—higher freight costs, greater need for tanker capacity and China’s policy of supply diversification. The next rational step to close the discount would be to cut supplies of Urals.

Moscow has been highly reluctant to reduce exports unilaterally. Instead, Moscow has contrived to enlist its OPEC partners in the effort to solve its pricing problems. Relations between Moscow and its OPEC+ partners—Saudi Arabia in particular—are often more fraught than public displays of bonhomie might suggest. Their interests are often misaligned, and sanctions have only exacerbated this misalignment. To obscure the misalignment, Moscow has been conducting a campaign of scaremongering and deception against its OPEC partners in hopes of both maintaining cartel support for Russia and manipulating OPEC into making additional cuts for Moscow’s benefit.

Yet sanctions—and Moscow’s reaction to them—have harmed the interests of leading OPEC producers...

Russian oil sanctions—and Moscow’s response to them—have hurt the interest of leading OPEC producers in several ways. First, there is Russia’s aggressive push into new markets East of Suez. Much of Russia’s growing market share in places like India has come at the expense of OPEC’s Gulf producers. To gain market share in the large sizes it needs, Russian exporters have offered deep discounts on Urals. This, in turn, has softened regional prices for OPEC exporters, too. Russian competition in East of Suez markets has forced OPEC’s Gulf producers to reroute some of their barrels to more distant markets in Europe. The longer distances mean higher freight costs. And these cost increases have been compounded by the sharp jump in global freight rates resulting from the dislocation of Russian exports from Europe. That’s good for shippers, but less so for producers.

Apart from turf battles over market share and higher freight costs, Moscow’s war of aggression has led to the development of a novel sanctions scheme—the price cap. No major oil exporter can be pleased with that development.

…and vastly increased Russia’s sensitivity to oil price levels relative to other leading OPEC producers.

Oil sanctions have also vastly increased Russia’s breakeven oil price relative to other leading OPEC producers, such as Saudi Araba. By early 2023, the high costs of Russia’s war of aggression coupled with weaker pricing power for exports has caused Russia’s fiscal breakeven oil price to jump 77% (see Figure 24).29

To distract from these issues and shore up OPEC support for Russia, Moscow has resorted to scaremongering, falsely claiming the price cap is a “buyers’ cartel” aimed at all OPEC producers.

Moscow has sought to distract from the harm it has done to OPEC’s interests and shore up OPEC support for Russia by scaremongering. This has taken the form of trying to persuade OPEC members that the price-cap is a buyers’ cartel intended to dictate oil prices. A buyers’ cartel is, of course, the stuff of an OPEC ministers’ nightmares. And to ratchet its partners’ anxieties even higher, Moscow has claimed Washington intends to deploy the price cap against all OPEC producers—with Russia simply the first in line.

EU/G7 sanctions, of course, do not even remotely resemble a buyers’ cartel. To start with, the countries imposing this can’t even buy Russian oil. Non-sanctioning countries, by contrast, are free to buy as much as they wish at whatever price they negotiate. The price cap is a primary sanction targeting EU/G7 marine transportation services exclusively—nothing more. All this notwithstanding, Moscow exploited early confusion about the novel price cap to portray it in a way calculated to play on OPEC fears.

Initially, at least, Moscow’s scare tactics appear to have gotten some traction. In October 2022, OPEC announced a surprise October 2022 cut which was seen by some as a sign solidarity with Moscow in the face of pending sanctions. Then, in mid-March 2023, shortly after meeting with his Russian counterpart, Saudi Arabia’s oil minister publicly warned that any attempt to impose price caps on producer states would lead to “counter-responses with intolerable consequences.”30

Moscow has tried to manipulate OPEC into cutting output by dubiously claiming Russia had led the way with its own unilateral cuts, when available data indicated otherwise…

Scaremongering was just a prelude to a broader attempt by Moscow to contrive to have OPEC cut output while Russia maintained full production. At its December meeting, shortly before crude sanctions came into effect, OPEC refrained from making any cuts, despite declining markets. Ministers preferred to wait to see how Moscow responded to sanctions. In February, Moscow announced a half million-barrel cut in March, though details were sketchy. It then began intensively lobbying OPEC partners to follow suit. The problem, however, was that Moscow’s supposed March cut wasn’t being reflected in export levels. Despite the Kremlin’s repeated assurances that cuts had been made, as of June overall exports numbers appeared, if anything, to be rising (see Figure 25).31

…and additional data was being suppressed or manipulated.

Meanwhile, Moscow had begun suppressing domestic production data on the grounds of “national security.” This reduced OPEC’s ability to monitor Russian production trends. Then tankers lifting out of Russia were then caught “spoofing” their AIS signals to conceal loadings at Russian ports.32 This only further undermined the credibility of Moscow’s supposed cuts.

OPEC appears, however, to have seen through Moscow’s charade.

By early July, Moscow’s campaign of scaremongering and its charade of apparently faux production cuts seemed to be straining relations with OPEC. At that point, Saudi Arabia appears to have strongarmed Moscow into announcing a “additional” 500,000 b/d cut, while pledging to extend its own existing cuts by a mere month. In the kabuki of OPEC+ pronouncements, this can be read as a face-saving way of forcing Moscow to finally make the cuts it claimed to be making back in February. As of late July, it appears Moscow may finally be reducing its Urals flows, helping to boost Urals prices and reduce the Brent spread.

Part 4: Helping Moscow fail faster

Chapter 7: Improving sanction implementation. Four high-impact recommendations for safeguarding sanctions and strengthening their impact

With Urals now trading above $60, the price cap is being put to the test. Policymakers have the sanction tools needed to safeguard sanctions and strengthen their impact, but only if specific improvements are made in how those tools are used. This report details four high-impact improvements informed by lessons learned over the last half year of sanctions.

Moscow opted against weaponizing oil in favor of a strategy of maximizing exports while developing ways to circumvent the price cap—a strategy that has met with mixed success.

Over the winter, Moscow made a fundamental strategic decision not to respond to sanctions with an engineered supply crisis, but to maximize output while expanding its capabilities to circumvent the price cap. This strategy of maximization and circumvention has met with mixed success. Russian tax receipts on oil in the first half were down 47% year-on-year, off an average Brent price that was down by only 25%, with sanctions—largely thanks to the wide Urals discount.

The main thrust of its circumvention strategy has been to expand its fleet of sanction-proof tankers. After a year of intense endeavor, Moscow has effectively doubled the size of the sanction-proof tankers at its disposal. But that increase was off a low base, and a yawning “tanker gap” remains. Moscow still relies on the price-cap compliant, mainstream fleet for some two thirds of its shipping capacity. Formidable obstacles of supply, cost and attrition make it unlikely Moscow can close this gap any time soon.

Moscow does appear to have had some success in fraudulently securing mainstream tankers to carry non-price-cap compliant cargoes by exploiting vulnerabilities in the compliance regime. But sanction authorities are alert to the challenge; if they step up enforcement of existing guidelines, it could sharply curtail this practice. If they fail to act, however, it could seriously undermine the effectiveness of sanctions. Finally, Moscow’s campaign of scaremongering and deception directed at its OPEC partners appears to be faltering. If Moscow wants OPEC’s help in boosting prices, it will need to share the pain of real cuts.

EU/G7 policymakers should be applauded for their collaboration and innovation in developing the sanction tools needed. But it’s still too early to say whether they will prove effective…

As for the effectiveness of sanctions, it’s still too soon to render a verdict. EU/G7 policymakers should be applauded for collaborative achievement of designing and rolling out an innovative sanctions framework—the price-cap—with little disruption to the market. Europe’s bold decision to end its 145 years of oil imports from Russia has significantly weakened Russia’s pricing power for Urals, forcing it to accept deep discounts to find firm demand. And the price cap has added risk to any dealings with Russian oil, which has likely contributed to the discount, at least at the margins. But with the recent reduction in Urals exports, the discount is narrowing. Improved market knowledge by Russian exporters might also be helping reduce the discount.

…since they are only now facing their first real test as Urals rises above the cap.

The high levels at which the caps were set means, until very recently, they have remained mostly untested in their ability to constrain Russia’s ability to capture full market prices. Where they were put to the test—at Kozmino—they showed vulnerability to attestation fraud.

Much depend on whether improvements are made in how sanction tools are used…

Now, with Urals trading above the price cap, the effectiveness of sanctions is going to be put to the test. On paper, the tools available to EU/G7 sanction officials appear sufficient to do the job intended. But much comes down to how effectively these tools are employed. If steps are taken to improve their use, they can thwart most of Moscow’s efforts at circumvention and painfully constrain Russia’s access to oil revenues. If no additional steps are taken, however, oil sanctions will be at risk of unravelling.

…based on lessons drawn from the first half year of the price caps.

The last six months of sanctions have provided many useful lessons on how their implementation can be improved. Given the finite resources of sanction enforcement agencies, however, it’s important to focus on those with the highest impact. The following four recommendations seek to do just that:

Four high-impact recommendations for better implementation.

The following are four specific recommendations improving how these sanctions are employed. They draw on lessons learned during the first half year of sanctions. 

Recommendation #1: Lower the price cap.

Last autumn, the main argument against setting a lower price cap was that Moscow might retaliate by engineering a supply crisis that would spur inflation and potentially trigger a recession. This, in turn, would erode support for Ukraine. Since then, however, the risk of oil weaponization has greatly receded (see Introduction), removing the main argument in favor of a higher price cap. At the same time, additional arguments supporting a lower cap have only gotten stronger, namely:

• sanctions have been having a tangible impact: they are eroding Russia’s economic resilience as the recent collapse of the ruble and the emergency rate hike shows. A more assertive price cap will dial up the fiscal pressure.

• Moscow has routinely been willing to export at prices far below $60 a barrel: Moscow has demonstrated a willingness to maximize exports at prices below $40 a barrel.

• the ruble’s recent collapse lowers Russia’s breakeven oil price, making it easier for producers to cover costs at lower oil prices. Today’s $60 price cap for crude is more than double estimated full-cycle costs of producing Russian oil. The recent collapse of the ruble will only lower the breakeven oil price for Russian producers (and the federal budget)—making them less sensitive to a lower price cap.

• Moscow’s large tanker gap means most of Russia’s seaborne exports remain exposed to the price cap; exposure levels could rise above 80% if insurance verification is implemented (see recommendation #4). Over half Russia’s seaborne exports are currently exposed to the price cap, owing to Russia’s shortage of sanction-proof ships. If European coastal states require insurance verification from oil tankers, as Turkey has done, it could sharply curtail Russia’s shadow trade (see recommendation #4, below). The share of seaborne exports exposed to the price cap could rise to over 80%.

• a higher price cap has, contrary to intent, ended up increasing Moscow’s incentive to cut output to push up prices, rather than decreasing it. As weaponization risk receded over the winter, and the discount pushed market prices for Urals down to $40, an unexpected thing happened. The high, $60 price cap, that was intended to reduce incentives for Russia to cut output ended up, perversely, increasing them (see Figure 26). The high price cap gave Moscow unrestricted upside potential of $20 per barrel. Put otherwise, if the market price rose from $40 to $60, Moscow would be able to capture 100% of that $20 upside, since the high price cap ensured access to mainstream tankers for cargoes priced up to $60.

Had, by contrast, the price cap been lowered, say, to $35, it would have limited Moscow’s ability to capture upside value from rising prices, since its sanction-proof fleet was only large enough to move a fraction of its exports at full market prices.  The rest would have to be transported by mainstream tankers at the capped price.  With less to gain from higher market prices, Moscow’s incentive to cut its own output (and badger OPEC to do likewise) would have been significantly weaker. 

Lowering the price cap today would weaken Moscow’s incentives to keep any cuts in place.

The same would hold true today.  If the price caps were dropped to $35, it would weaken Moscow’s incentive to keep any cuts in place.  Moscow might revert to doing what it did last time it faced low effective prices and maximize output. Moreover, if shadow fleet activity is reined in by the introduction of an insurance verification requirement—thus widening the tanker gap (see below)—, it will further limit Moscow’s access to upside revenues from higher prices.

For anyone still concerned that lowering the price cap might spur Moscow to weaponize oil exports, consider the following two things. Ratcheting down the price cap in two medium-sized steps of, say, $15 each instead of one big step of $30 could reduce the risk of a confrontational response. It might also reduce the risk of an overreaction by a jittery market.

Second, expect Moscow to respond to any discussions of a lower price cap with saber rattling and threats—these are, after all, a core competency of Kremlin statecraft. But also recognize that the risk environment for Moscow is far more adverse today than it was in the fall of 2022, when it was last threatening to weaponize oil. If the Kremlin lacked the risk appetite to weaponize oil back then, it will be even less inclined to make such a high-risk gamble today.

Recommendation #2: Combat price attestation fraud by developing a “whitelist” of approved traders.

It makes little difference at what level the price cap gets set if price attestation fraud goes unchecked. Moscow would have enough unrestricted access to mainstream tanker capacity to keep export volumes whole, regardless of price. That, in turn, would create even greater incentives for Moscow to push for higher pricing, since it could capture 100% of revenues at any price.

This makes price attestation fraud by bad-faith brokers as great a threat to sanctions as the shadow fleet—perhaps even greater. Policymakers need more effective measures for preventing pricing fraud from taking hold. Lessons need to be drawn from Kozmino.

The critical task of screening out bad-faith traders should not rely solely on “know-your-client” due diligence by mainstream tanker owners.

The crux of the problem is that the burden of identifying potentially bad-faith traders is left to ship owners. They are required to conduct their standard “know-your-client” due diligence when engaging customers and provided red-flag guidelines on what to watch out for.

This approach is unworkable. Standards of due diligence and the resources for conducting it will vary significantly from one ship owner or operator to the next. So too do the potential consequences of grossly negligent diligence. Invariably, some bad-faith traders will remain in the mix, potentially a large number.

Enforcement agencies should pro-actively develop a whitelist of permitted traders who are EU/G7-linked and exposed to sanctions risk.

To effectively combat attestation fraud, enforcement agencies need to play a more proactive role in screening out bad actors. They could start by developing a “whitelist” of broker/traders authorized to provide pricing information. This whitelist could be made up of well-established commodity trading groups based in EU/G7 countries, and therefore subject to legal action for violating sanctions and providing false pricing information. Moreover, as EU/G7 entities, they would be required to retain and, if necessary, disclose underlying transaction documents to authorities. Ship owners could nominate additional candidates for the list, but they would be subject to vetting and approval by enforcement agencies.

Mainstream tankers would only be allowed to lift from Russia when a whitelisted trader is party to the sales transaction and provides the price attestation.

For a mainstream EU/G7 owned or insured tanker to transport Russian oil, it would need to receive its price attestation from a whitelisted trader. Failure to obtain price attestations from a whitelisted trader would be considered a violation of sanctions. For EU/G7 shipowners, this would trigger legal action. For non-EU/G7 owners of mainstream tankers, it would invalidate their International Group P&I insurance coverage and—depending on their banking syndicate—possibly be a breach of loan covenants.

If Russian exporters wished to use EU/G7 owned, financed or insured tankers to transport their oil, they would need to ensure that a whitelisted trader is party to the trade and can provide pricing attestations to vessel owners. Many of the leading EU/G7 commodity groups routinely lifted out of Russia prior to sanctions. They have extensive experience and relationships in Russia and should be able to smoothly slot back into the Russia trade if clear guidelines are provided by enforcement authorities.

Russian exporters would be certain to push back against this. But the only way to effectively manage the risk of price attestation fraud is to ensure that the party providing the information faces significant legal and commercial repercussions for price-cap violations. And that means an EU/G7 linked trader needs to be a party to any sale using capacity from mainstream tankers. What is more, the whitelisted trader will also retain information on shipping costs and other transaction related fees, which can help reduce the risk of price-cap manipulation through offshore transfer pricing. Whitelisting won’t eliminate bad-actor risk entirely but should have a major impact.

An important note. Whitelisting is best done in tandem with a reduction in the price cap. Because of their superior market knowledge and capabilities, top-tier traders will likely be able to negotiate higher realized prices for Russian oil when selling to importers than the third-tier traders currently handling Russian exports. It’s important that Moscow doesn’t benefit from these improved pricing (which, in effect, means a smaller discount to benchmark prices). The best way to prevent that from happening is to lower the price cap.

Recommendation #3: Crack down on the involvement of EU/G7 entities in the sale of used tankers to Russian or undisclosed buyers

One way to limit the expansion of Russia’s shadow fleet is by further constraining supply. Shadow tankers are often purchased from mainstream operators—many based in the EU/G7—during the process of fleet renewal. Policymakers should prohibit EU/G7 entities from selling used tankers either to Russian buyers or anonymous buyers. EU/G7 based shipping brokers should face similar restrictions.

To obscure the involvement of Russian money in a transaction, Russian buyers can, of course, arrange sham, back-to-back transactions through cutouts. Tracking down wrong doers is resource intensive. But there is plenty of consternation among some ship brokers about lack of compliance by more risk-friendly competitors. As one commented: “So people who think they can ignore the rules and still go out and do business, I say ‘more fool them’, and I hope they have a lot of sleepless nights and wake up with a knock on the door.”33 Enforcement agencies should encourage whistleblowing to help generate leads. Investigating a case will have a chilling effect on the trade; imposing penalties will do that even more.

Even with such prohibitions and stepped-up scrutiny, sales by EU/G7 ship owners into the used market will likely continue to find their way into the Russia shadow trade. But these deterrent efforts can slow down the transaction flows and increase costs for Russian buyers by introducing a risk premium and additional intermediaries.

Recommendation #4: Require tankers passing through EU/G7 territorial waters to provide verification that their mandatory spill liability insurance is adequately capitalized and remains current.

Turkey has used its coastal state rights to require tankers transiting its territorial waters to confirm their P&I insurance as a condition of passage. EU/G7 states should follow suit.

In December 2022, Turkey required that oil tankers transiting its territorial waters must, as a condition of passage, provide direct confirmation from their P&I insurers that the vessel was adequately insured. In doing so, the Turkish government was exercising its rights as a coastal state to deny passage to any tanker that could not verify it carried valid mandatory spill liability insurance required under international convention. European coastal states should follow suit by requiring verification of adequate insurance from tankers transiting their territorial waters.34

The insurance arrangements of many shadow tankers are notoriously opaque, with reports of ships carrying policies that are fraudulent or inadequately capitalized. Many of flag states of these vessels—responsible for ensuring compliance with international standards—have been grey-listed or black-listed for their poor track records of enforcement.35 If adopted, an insurance verification requirement could exclude non-compliant shadow tankers from EU/G7 waters and limit the total size of the Russian shadow trade to well under 20% of total seaborne volumes.

If Moscow has its way, nearly 300 shadow tankers, laden with Russian oil, will transit European territorial waters every month, creating a “potentially catastrophic” situation.

Coastal states around the world, but especially in Europe, face a growing environmental threat from Russia’s insatiable demand for shadow tankers. Some 300 vessels a month, laden with Russian oil, transit European waters. At present, only a minority are shadow tankers. If Moscow had its way, however, nearly all of them would soon be shadow tankers.

At the heart of the shadow fleet problem is a long-standing conflict between negligent flag states that fail in their duty to fully enforce international shipping standards and coastal states that suffer the consequences. Countries like Russia, that seek to expand the shadow fleet, make the problem worse by incentivizing lax enforcement. As the chairman of the Danish maritime pilots’ union recently observed, there has been “a drop in the standard of the tonnage that serves the Russian oil ports, both on ships and crew. The ships are older and the crew has a different standard than we are used to.” He went on to warn that the situation is “potentially catastrophic.”36

The shadow fleet business model increases spill risk by cutting spending on safety requirements, dropping quality insurance coverage…

As discussed in Chapter 4, the shadow fleet business model relies on generating quick returns by buying aging tankers cheaply and sweating them for cash in the final years of service. This typically includes slashing costs on safety requirements. It also involves dropping quality P&I insurance in favor of opaque insurance arrangements of indeterminate quality. Shadow investors may be less concerned than their mainstream counterparts over whether their insurer has adequate funds to cover claims. If insurance fails to pay out, shadow ship owners can fall back on their cloak of anonymity for protection from liability claims.

…and by registering with blacklisted flag states that certify them to operate while turning a blind eye to their deficiencies.

A ship’s “flag state” is responsible for certifying that it complies with international standards—including safety and insurance—and is fit to operate. But the flag-state system is notoriously problematic. There is often no inherent connection between flag states and the ships they register. They offer flags of convenience for a fee, and the relationship is purely transactional. Worse, standards of enforcement vary widely from state to state, with the worst offending flag states routinely included in “blacklists” maintained by multilateral regulatory bodies. Shadow tankers gravitate towards these blacklisted states, which allow them to maintain certification while cutting corners and avoiding scrutiny.

One shadow tanker has already broken down and nearly run aground in the treacherous Danish Straits.

The growing presence of shadow tankers has already caused one near disaster in European waters. In May, an 18-year-old vessel laden with 340,000 barrels of Russian oil, lost power as it was negotiating a treacherously narrow turn in the Danish Straits, just a mile off the pristine shores of Langeland. In distress and rapidly losing steerage, the vessel strayed out of the channel into shallow waters, just a few boat lengths away from a 10.8 meter shoal. Fully laden, the vessel drew 13 meters. Still making headway, a grounding and possible hull breach looked imminent. A full account of this harrowing episode can be found in the Appendix: A Brush with Disaster in the Danish Straits--Shadow Tankers Menace the Baltic.

Chokepoints routinely channel over 80% of Russian tanker traffic through the territorial waters of European coastal states…

Over 80% of Russia’s seaborne oil exports regularly transit EU/G7 territorial waters. These passages occur around several maritime chokepoints—most of them unavoidable for tankers loading in the Baltic and the Black Sea (see Figure 27. Map of navigational chokepoints where Russian seaborne oil must transit territorial waters of EU states or the UK). The chokepoints routinely channel maritime traffic within 12 nautical miles of the coasts of one or more of the following countries: Estonia, Finland, Germany, Sweden, Denmark, France, the United Kingdom, Spain and Greece.37

…giving them the right to impose certain conditions on oil tanker transit, just as Turkey has done.

By channeling tanker traffic so close to their shores, these chokepoints expose these states to a greater risk of ruinous harm from a shadow tanker spill. At the same time, the need for shadow tankers to transit their territorial waters also provides these coastal states with the authority under maritime law to take measures to stem the threat posed by these poorly maintained, questionably insured vessels.

European coastal states should require all transiting tankers to verify that their P&I insurance is current and adequately capitalized.

But regulatory action is required. Following Turkey’s lead, they should put in place a requirement that laden oil tankers wishing to transit their territorial waters must be carrying spill liability insurance mandated under international convention and that their insurers provide suitable verification that their policy remains in force and is adequately capitalized.

Fortunately, a pragmatic, transparent and satisfactory framework for P&I verification already exists. What is more, some 95% of the global tanker fleet already use it. This means that requiring verification as a condition of passage poses negligible risk to the normal flow of traffic. The only tankers whose right of passage would be impaired are those with opaque, inadequate or non-existent arrangements for their mandatory insurance.

A suitable disclosure framework is already in place and used by 95% of the global fleet.

Examples of this verification framework can be found on the website of the International Group of P&I Clubs and those of its member clubs. They include regularly updated vessel search functions and coverage details of all insured tankers. They also make it possible to assess the capital adequacy of each of the P&I clubs by regularly publishing independently audited financial accounts and maintaining investment grade ratings from leading credit rating agencies. With an IMO vessel number and a few keystrokes, coastal state regulatory authorities and members of the public can quickly determine the status of an IG insured ship as well as the capital adequacy of its insurer.

Verification would require insurers to provide four key disclosures.

EU/G7 coastal states should make such verification of insurance mandatory for all tankers claiming rights of innocent passage. Specifically, tanker owners would need to make certain that their P&I insurers provide the following public disclosures:

1. a searchable, on-line database of all vessels currently under cover by the insurer: ideally, this would be updated daily. It would include basic identifying details of the vessel under coverage, the kind of insurance coverage provided, expiration dates, status of policy, etc. This allows authorities and the public to verify in real time that a vessel’s coverage remains current and has not been dropped or cancelled. Any insurance company will already maintain such a database internally; making it public simply requires setting up a webpage.

2. financial statements conforming with international accounting standards and audited by a reputable international accounting firm (a list of approved accounting firms would be advisable);

3. An investment grade credit rating from a major credit rating agency, which would help provide comfort that the company is adequately capitalized; and

4. a history of payouts on all oil-industry related P&I claims in recent years.

Additionally, any tanker owner wishing to transport oil through EU/G7 waters would need to make the name of their current P&I insurer publicly available through Equasis, the EU-based, multilateral shipping transparency database. Equasis already lists P&I insurers for nearly every tanker worldwide, but not those in the shadow fleet.

The effect of this verification scheme would be to prevent uninsured or underinsured tankers from menacing coastal states in Europe. By barring their passage through European territorial waters, this would also reduce the risk of spills elsewhere, both on the high seas and in the territorial waters of non-European coastal states.

Verification isn’t just about providing adequate funds for clean-up and compensation but reducing the risk of spills in the first place.

A verification requirement will help make certain critical funds are available for spill mitigation, clean-up, and compensation. But its benefits go well beyond that. It also reduces the risk of a spill happening in the first place. Quality P&I clubs are usually mutually funded by large groups of ship owners. Club members have liability for claims made against any vessels in their club. Consequently, they are highly incentivized to make certain that all club members are made to adhere to international safety and maintenance standards.

Shadow tanker insurance arrangements are notoriously opaque. There are anecdotal reports of shadow tankers carrying undercapitalized or sham insurance policies.38 These opaque providers may end up lacking the funds to make a payout or simply refusing to pay at all, which has been known to happen. Such dubious, contingent arrangements reduce incentives to ensure all covered vessels comply with statutory safety and maintenance requirements. And lower compliance standards mean higher risk of accidents.

A verification regime would probably cause shadow tankers to stop loading at Russia’s western ports…

It's likely that the introduction of a verification regime would cause many shadow tankers to withdraw from European territorial waters, rather than arrange the necessary disclosures. Verification would require a level of transparency that is at odds with the shadow fleet business model. It would also likely require additional spending to secure adequate insurance and to meet higher standards of safety and maintenance—all of which are inimical to the economics of the shadow trade.

…which would limit their potential share in Russia’s seaborne exports to under 20%.

In place of these retreating shadow tankers, Russian exporters would need to charter compliant, mainstream tankers to lift oil from their Baltic and Black Sea ports. This could limit the shadow fleet to operating only out of Russia’s Pacific coast ports. That would limit the total amount of Russia’s seaborne oil handled by the shadow fleet to well under 20%. It’s likely, of course, that the Kremlin might consider enhancing its state-backed P&I insurance scheme to meet verification requirements and expanding it to include many or all the shadow tankers active in Russia—or at least those covertly owned by Russian money. But it’s unlikely Russia’s P&I scheme could meet the required disclosure requirements anytime soon.

If European policymakers don’t assert their maritime rights and a spill occurs, the public will ask why the environmental safety of their coastlines was entrusted to the sole discretion of blacklisted flag registries in remote countries.

As those familiar with maritime law will know, the need for coastal states to exercise their rights to safeguard their internal and territorial waters arises when flag state fail in their duties to ensure vessels on their registries comply with statutory international standards.39 European policymakers would be well advised to assert these coastal rights to their fullest extent in the face of the challenge posed by Russia’s expanding shadow fleet. If tomorrow, an uninsured shadow tanker spills Russian oil on their coastlines, the public will demand to know why their governments failed to exercise these rights and chose instead to entrust the safety of their shores solely to registry offices in blacklisted flag states like Cameroon, Comoros and Vanuatu.

Conclusion: No more oil windfalls—hastening Russia’s retreat from Ukraine

Together, all these recommended measures aim to do one thing: tightly constrain Moscow’s access to windfall oil revenues. Like other sanctions, this will help erode Russia’s economic resilience, diminishing its means for financing its war of aggression against Ukraine.

At the same time, Russian oil sanctions are different from other sectoral sanctions and have the potential for a qualitatively greater impact. Periodic oil windfalls play a unique and indispensable role in the political economy of the Putin regime. They renew regime vitality, restore appetite for risk and help maintain cohesion among fractious elites.

Oil sanctions, if assertively implemented, can dim Moscow’s hope for renewed access to oil windfalls. That would unsettle Kremlin leaders and help increase their risk aversion. Such heightened caution was on display last December, when Moscow chose not to weaponize oil. And it was on display more recently, during the Prigozhin Affair, when Putin shied away from direct confrontation. It can also hasten the day Moscow changes its calculus and recognizes that a withdrawal from Ukraine has become its best option. That prospect makes it worth taking pains to ensure oil sanctions work as well as they can.

Appendix: A brush with disaster in the Danish Straits—shadow tankers menace the Baltic

An 18-year-old shadow tanker, laden with Russian oil, loses power in the treacherous Danish Straits and nearly runs aground.

Disaster seemed imminent in the Danish Straits this past May, when an aging tanker, laden with 340,000 barrels of Russian oil, lost power and strayed out of the treacherously narrow shipping channel into shallow shoals just a few hundred meters off scenic Langeland (see Figure 28).

The vessel bore all the hallmarks of a shadow tanker plying the Russia trade. 

The 18-year-old vintage tanker was en route from the Russian oil terminal at Vysotsk, not far from St. Petersburg, and would eventually signal Kalamata, Greece, as its destination.  The waters off Kalamata had become notorious in recent months as a rendezvous for tankers conducting dangerous ship-to-ship transfers of Russian oil. The tanker had recently changed hands, selling for an eye-popping $21 million. That’s double what it would have gone for just a year earlier. Demand for aging tankers suitable for the Russian shadow trade has fueled a red-hot seller’s market.

Since the sale, the tanker was being managed out of the UAE and used for the Russia trade. Its new, anonymous owner reflagged the vessel to the remote Cook Islands—a grey-listed jurisdiction, ranked in the bottom 20% of flag states for ensuring that vessels in its registry comply with international safety, security, labor and environmental standards.40

It had recently dropped it International Group P&I coverage.  Details of any replacement coverage were hard to come by.

Worryingly, but typical for Russia’s shadow fleet, the tanker had recently changed the provider of its spill oil liability (“P&I”) insurance. Under international convention, P&I insurance is mandatory for oil tankers and provides essential funds for cleanup, compensation, and wreck removal. Prior to its sale, this vessel carried spill liability insurance issued by the International Group of P&I Clubs (“IG”). The IG is a sophisticated network of non-profit, mutual assurance clubs made up of and funded by ship owners. As underwriters, members have a strong financial interest in assuring all vessels insured by the IG meet statutory safety standards. Thanks to its high transparency, investment grade ratings, and a strong track record of payouts, the IG provides P&I coverage to 95% of the global tanker fleet, with aggregate coverage totaling in the trillions of dollars.

We can only assume the new owner had obtained P&I coverage from an alternative provider, but confirmatory details are hard to come by. So, if the ship were to run aground, breaching the hull and spilling oil, local authorities and the public could not know with confidence that essential funding would be in place. If the new insurance turned out to be undercapitalized, or worse—a sham—local communities would not only suffer from catastrophic environmental damage, but would be left with the cleanup bill, too. Seeking compensation from the owner of record—a single-ship, shell company with a brass plate address in the Marshall Islands—could amount to little more than chasing phantoms. Opacity confers impunity.

340,000 barrels of oil, rudderless and adrift, in Denmark’s main maritime thoroughfare, with only a few meters of under keel clearance and just a mile off the coast.

As the decelerating vessel veered out of the deep, narrow fairway, it approached a warning beacon alerting mariners to the hazardous shoal beyond. The vessel, which drew 13 meters fully laden, was on course for a 10.8 meter shoal just a few boat lengths ahead. Within five minutes, the vessel would signal that it was “not under command,” meaning it had lost its ability to maneuver and posed a menace—340,000 barrels of oil, rudderless and adrift, in Denmark’s main maritime thoroughfare and just a mile offshore.

During those critical five minutes, the hulking vessel still retained some residual steerage. As a grounding appeared imminent, the ship managed to come about 90 degrees to starboard, cut directly back across the busy shipping channel then entered shallow waters to the east. For the next hour, the tanker drifted some two kilometers outside the channel, with just a few meters of under-keel clearance at time. Eventually, it reached deeper waters where it dropped anchor for repairs. Five hours later, it was back underway. Another 24 hours on, it finally exited from the tortuous channels of the Danish Straits, with its notorious topography of rocky shoals and shallow, sandy bays.

The falling standard of crew and vessels is “potentially catastrophic.”

Commenting on the incident to Danish TV2, the chairman of the Danish maritime pilots’ union voiced concern over falling standards out of Russia: “We have seen that there has been a drop in the standard of the tonnage that serves the Russian oil ports, both on ships and crew. The ships are older and the crew has a different standard than we are used to.” He went on to warn of the dire threat this posed: “Those of us who sail in the Great Belt know how busy it is… [with] potentially catastrophic consequences for the marine environment.”41

Recommended resources on Russian oil sanctions

Several research groups around the world are doing valuable work on Russian oil sanctions. The following list is by no means comprehensive but merely a starting point for those wishing to learn more.

The Kyiv School of Economics is producing a Russian oil tracker along with valuable analytical reports, such as this from July 2023.

Bruegel has, similarly, been publishing a Russian oil tracker and publishing valuable analytical reports, including this July 2023 report.

CREA, in Finland, has also been compiling valuable analytics and publishing separate reports.

Simon Johnson, Łukasz Rachel, and Catherine Wolfram have been applying econometrics to explain the working of the price cap as in this recent report.

Thane Gustafson, a veteran Russia watcher and the dean of Russian oil and gas studies, has been writing on Russian sanctions more broadly in his substack, The Devil’s Dance.

Other valuable reporting and analysis is being done by the investigative team at Lloyd’s List, Julian Lee’s team at Bloomberg, and TankerTrackers.com.

Do note that where different groups are quantifying similar metrics, such as export volumes, there are often deviations among results from one group to the next.  This is attributable to a range of factors, including methodology, timing and the scope of data included. 

Acknowledgements

This report has benefited from the generous input of many colleagues. My thanks go in particular to Thane Gustafson, Catherine Wolfram, Jacob Nell, Simon Johnson, Natalia Shapoval, Ben Hilgenstock, Elina Ribakova, Borys Dodonov, Vladyslav Vlasiuk, Dan Berkowitz, Isaac Levi, Lauri Myllyvirta, Meri Pukarinen, Michael McFaul, Bronte Kass, Richard Morningstar, Steve Hellman, Edward Chow, Edward Fishman, Chris Miller, Benjamin Schmitt, Mai Rosner, Tania Babina, Anna Vlasiuk, Tim Sellers, Andrew Meier, Cathy Mannick and many others. The views expressed in this report are mine alone.

Disclaimer: No Advice

The author of this substack does not provide tax, legal, investment or accounting advice. This report has been prepared for general informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, investment or accounting advice. The author shall not be held liable for any damages arising from information contained in the report.

© Copyright 2023, by Craig Kennedy. All rights reserved.

Endnotes

October 2022

The following essay is a summary of on-going research examining Russian oil under sanctions.

Sanctions will hit Moscow’s seaborne oil exports harder than many expect—and much more than the Kremlin is letting on.  Russia’s oil export system will be severely constrained under sanctions since it relies heavily on the physical and financial infrastructure of Ukraine’s allies.  This deficiency arises from two things: pipelines to the wrong places and an underdeveloped tanker fleet.  Together, they threaten to strand in country up to half Moscow’s export oil—over 3 million barrels a day—once sanctions are fully in place.  The price cap mechanism provides a path back to market for Moscow’s stranded barrels by permitting them to access prohibited infrastructure—though at a price.  

The Kremlin says it won’t go along with the price cap—and that’s no surprise.  With losses on the battlefield and mounting pressure at home, Moscow is increasingly resorting to economic warfare.  Its weapon of choice—contrived disruptions of energy supplies.  This time it looks intent on engineering an oil shock by holding back its stranded barrels.  And as usual, Moscow will try to shift the blame to others, falsely claiming that “price collusion” is “driving supply out of the market.” But the price cap is no buyers’ cartel driving out supply with manipulated prices; any oil Moscow can deliver on its own will trade at negotiated prices, much as it does today.  The price cap was created to get oil into the market. Think of it as tolled access to infrastructure that enables otherwise stranded barrels to reach buyers overseas.  Moscow’s misdirection is easier to spot when you realize it has a big stranded oil problem brewing—an inconvenient truth it wants to hide from allies and enemies alike. 

Marine shipping is a critical link in Russia’s oil export supply chain—and a vulnerable one, too.  Six million barrels a day of Russian crude and oil products—around 80% of its total export volumes—must travel by sea to reach markets abroad.  The scale of these seaborne operations is immense.  On any given day this summer, some 290 oil tankers were engaged in the Russia trade—about 10% of the global long-haul fleet.  So great was the need for export shipping tonnage that Russia’s own sizable national fleet carried only one in seven of the country’s seaborne export barrels.  The rest were loaded onto vessels owned, financed, and insured by foreign companies—mostly from countries allied with Ukraine. 

Soon, as sanctions come into force, those same countries will withdraw their unrivaled marine service businesses from the Russian oil trade.  When they do, Russia will struggle to muster anything close to the shipping capacity it needs to maintain recent export levels.  A full-blown tanker crisis will likely ensue, one that risks leaving up to half Moscow’s export barrels stranded on Russian shores.

Putin knows Russia’s oil export supply chain is vulnerable to sanctions...

Vladimir Putin is painfully aware of Russia’s deep dependency on foreign shipping and knows an export crisis is looming.  This supply chain vulnerability was dramatically exposed in the early days of the war, when foreign shippers, banks and insurers suspended operations at Russian ports.  Though the suspension was brief and loadings quickly resumed, the accumulated backlog of stranded oil was so severe, that upstream producers were forced to make an emergency cut of a million barrels a day. The lesson for the Kremlin was clear: Moscow might control supply chain from the wellhead to the waterfront, but once Russian oil is at sea, Westerners are largely at the helm.

This vulnerability is the product of Putin’s own hubris. For years, he has taken for granted that Europe would never spurn Russian oil—that no matter what Moscow might do, ships from Europe would always arrive at Russian ports, ready to load oil bound for Rotterdam, Augusta and beyond.  Thus, last Spring, when reports of Russian atrocities in Ukraine turned European opinion in favor of oil sanctions, Putin was caught entirely by surprise, and his complacency quickly gave way to anger and alarm.

…and has convened a task force to find solutions. 

Putin hastily convened a task force of senior government officials.  Europe’s “erratic” call for sanctions, he explained, marked a “tectonic” shift for Russia’s oil industry.  “It’s no longer enough for us just to produce oil.  We must build out an entire integrated supply chain right down to the end consumer.”  This should include everything from “pipelines and ports” to “trade settlement in local currencies … and insurance services.”  And he tasked the assembled officials with fixing this foundational flaw in his fortress Russia strategy.1

Their public posture has been scornful and defiant…

Early on, the leader of the task force, Deputy Prime Minister Alexander Novak, was scornful of sanctions in his public statements: “If you want to reject Russian energy deliveries, go right ahead.  We’re ready for it.” And he was coolly confident in his assertions that Russia’s would overcome all challenges: “We will not be left without a market… we are already creating new transport routes, creating new supply chains, new financial instruments, including settlements in national currencies.”2

…but clearly they are struggling with the enormity of the task.

But as the task force got down to work, the immensity of the undertaking became more apparent.  For example, in their analysis shipping capacity requirements, they estimated that the national tanker fleet would need to grow fourfold to be able to redirect all Moscow’s export oil to new buyers in Asia.  But with shipyard orderbooks full and used tanker markets shallow, such a transformation could take years to accomplish.  The task force also busied itself creating spill-liability insurance for foreign shipowners that wouldn’t be subject to sanctions.  Such sanction-proof coverage, not widely available today, would be critical to retaining access to foreign tankers.  But progress was slow.  And that’s not surprising: it’s a highly complex area of insurance involving massive cross-border risk management and complex multilateral agreements.3

By July, Putin had grown frustrated with the task force’s lack of progress.  He gathered his officials again and warned them that sanctions “are harming us… and many risks are still out there.”  Then he delivered a stinging rebuke for what he saw as their “lax attitude” and “I-don’t-give-a-damn” approach.  But no amount of bluster, however, could undo years of complacency.  As one senior task force member commented last month with bureaucratic understatement: “It’s clear we’re experiencing problems…it’s not a quick process.”  And with sanction deadlines now quickly approaching, some Russian oil companies are bracing for the worst.  One small, state-owned producer, allegedly with close ties to the security services, is even including in its contingency planning a scenario that assumes a 100% shut-in of production under sanctions.4

Sanctions will disrupt Russia’s exports in two ways: by sharply increasing its shipping capacity needs… 

Once implemented fully, G7-EU sanctions will disrupt Moscow’s marine export system in two ways.  First, they will cause a steep rise in Russia’s need for shipping capacity.  Sanctions will ban imports of Russian oil into the EU—by far its largest market up to now.  Instead, Russia will need to reroute most of these European volumes to non-sanctioning markets, primarily in Asia.  But Russia’s oil infrastructure requires over 80% of its seaborne exports to ship out of western ports on the Black Sea and Baltic.  This means average voyage times will climb sharply as tankers must sail beyond European waters to more distant Asian ports East of Suez.  Longer voyage times mean more tankers are needed just to maintain the same level of daily exports.  If Moscow wants to maintain recent export volumes, these longer voyage times, combined with other logistical factors, will increase the tanker capacity it requires under sanctions by approximately 120% compared with June, based on projection in my model of Russian oil exports at risk.  

…and causing the supply of foreign shipping capacity available to Russia to collapse.  

Russia’s rapidly rising demand for shipping capacity will run headlong into a second disruption caused by sanctions: a precipitous collapse in the supply of foreign tanker capacity available to Moscow.  Just as Russia’s shipping needs are doubling, sanctions will likely deny Russia access to over 90% of the global fleet, based on my analysis.  This will happen because of a G7-EU ban on certain marine services—including financing and insurance—for any ships exporting Russian oil, regardless of destination.  The only exception will be for cargoes sold at a discounted price fixed by the sanctioning alliance—commonly known as the “price cap.” 

Many foreign shipowners will be deterred from the Russia trade by the risk of losing vessel financing…

The marine services ban will hit Russia hard because of the outsized role Western finance and insurance play in the oil transport industry.  It’s an asset intensive business and relies heavily on leverage to make the economics work.  Western banks remain the industry’s leading source of debt financing and normally require borrowers to comply with sanctions as a condition of their loans. This compliance requirement will act as a strong deterrent to any indebted shipowner interested in the Russia trade.  Carrying sanctioned oil would violate the terms of their loans and force them to seek refinancing with non-Western lenders—an onerous, costly process fraught with risk. 

…and almost all of them by the invalidation of critical spill liability insurance that’s not readily available at scale elsewhere...  

An even greater source of deterrence will be marine insurance.  Nearly every shipowner in the world today—be they Chinese, Turkish or Norwegian—carries a billion dollars of mandated spill-liability coverage for each tanker they own.  Known as P&I (“protection and indemnity”) insurance, it caps shipowners’ spill liability, and is essential for entry at ports around the world and a standard requirement in bank financing.

With thousands of tankers in service, aggregate liability coverage for the industry runs into the trillions of dollars, a sum too large for the traditional insurance markets take on.  To manage such extraordinary risk, the industry has created a complex, specialized, cartel-like body, known as the International Group of P&I Clubs or “the IG.”  It is a network of not-for-profit, mutual assurance “clubs” made up of the shipowners themselves, whose pooled contributions cover policy payouts.  Supplemental cover comes from re-insurance arrangements with many of world’s leading commercial insurers. 

Companies from sanctioning countries play a leading role in the International Group, ensuring its observation of sanctions… 

G7 and EU businesses play an outsized role in the IG, both at the club level and among the re-insurers.  As a result, when these governments impose sanctions, the IG tends to observe them.  The prospect of losing P&I coverage is likely to deter the vast majority of shipowners from carrying sanctioned Russian oil.  The problem they face is that alternative, sanctions-proof coverage, of comparable quality and scalable to Russia’s needs, simply doesn’t exist today and doesn’t look likely to emerge in the coming weeks.

…along with the 95% of the world’s tanker owners who insure through the IG. 

So effective is the IG at meeting the industry’s coverage needs that some 95% of the world’s tanker owners rely on it for their P&I insurance.5 The outliers fall into two categories. First, there are the sanctioned national fleets from major producing countries, like Iran and Russia.  Because of the strategic nature of these fleets, their respective governments have arranged ad hoc P&I policies for them backed by state guarantees.  It’s far from certain whether such sovereign guarantees will be made available to foreign shipowners.  It’s even less certain whether those shipowners would find such sovereign-backed policies attractive: they might not enjoy the strong legal protections in the event of a dispute, and ongoing banking sanctions might put receipt of payouts at risk. 

The second category includes a marginal group of aging, anonymously owned, risk-friendly vessels often referred to as the “shadow fleet.”  These vessels may carry substandard or even fraudulent P&I coverage from suspect insurers.  They also tend to be non-compliant with numerous other mandated industry standards and specialize in transporting sanctioned oil.6

The net effect, then, of the withdrawal Ukraine’s allies from Russia’s oil trade will be a massive squeeze on its capacity to transport oil, with Russia’s capacity needs doubling at the same its access to foreign capacity collapses precipitously. 

China is unlikely to provide extraordinary help with either ships or insurance…

But what of Russia’s rapidly expanding customer base among countries not participating in sanctions?  Can they provide solutions to Moscow’s tanker troubles?  Some observers are quick to assume China will.  And at first glance, there’s reason to think that might be so.  It’s a leading tanker owner, has deep pockets, and gets some 15% of its imported crude from Russia.  Surely it could use its tanker fleet or balance sheet to help an ally.  But a closer consideration of the Russia-China energy relationship suggests this is unlikely to happen.  Of the various interested parties in China—insurers, shipowners, refiners, and the state—none appears to have a sufficiently compelling reason to push for extraordinary measures to help Russia out. Indeed, some will directly benefit from a tanker crisis in Russia.  Let’s consider each in turn.

…as neither insurers, shipowners, refiners, nor the state have much to gain by it...

China’s marine insurers rely on co-insurance arrangements with the International Group to cover Chinese vessels.  China’s leading P&I insurer is believed by some to be next in line for full membership in the International Group.7 Chinese insurers have resisted past calls by shipowners to write P&I coverage for sanctioned Iranian oil, since such coverage wouldn’t be backed by their co-insurance arrangements with the IG.  As one Chinese industry official explained: “We are talking about $1 billion (per tanker).  No single insurance company can handle that.”  Instead, China has opted to rely on Iranian and shadow fleet vessels to transport US-sanctioned Iranian oil to China.8

…mostly owing to the peculiar logistics of the Russia-China oil trade and the structural incompatibility of China’s tanker fleet. 

As for China’s major commercial fleets, they are barely active in today’s Russian oil trade.  In June, for example, less than 1.5% of the tonnage of China’s two dominant tanker fleets—COSCO and CME—was engaged with in the Russia trade.9  And that is unlikely to change, because their fleet composition is structurally unsuitable for the Russia trade. Some 80% of their tanker tonnage consists of VLCCs (“very large crude carrier”).  These are the largest class of tanker commonly in service today but are physically too large to load at Russian oil sea terminals, owing to navigational chokepoints and other factors.  As for the remaining 20% of their tonnage, it would likely make a difference only on the margins for Russia.

China’s VLCC-heavy fleet was developed with the Persian Gulf trade in mind.  That’s why Chinese shipowners pushed to be allowed to remain in the Iran trade, once it was sanctioned.  Their efforts, however, were unsuccessful.  The Russia trade is far less attractive for them, so it’s hard to imagine they’ll be pushing any harder—or have any more success—to stay in the Russia trade.

China’s independent refiners may even gain substantial pricing leverage from Russia’s scarcity of shipping capacity. 

Next come China’s savvy independent refiners, who may even quietly welcome Russia’s shipping woes.  Once sanctions are in place, they will be far closer to Russia’s Pacific ports than any other major buyers.  Russian voyage times to the next closest major market are three times as long.  Three times the journey means three times the tankers needed just to deliver the same daily volumes. If Russia is rationing tanker capacity, this gives Chinese traders extraordinary pricing leverage.  A senior Russian oil executive and seasoned China negotiator observed with dread: “they will bring us to or knees as soon as they become the only buyers.”10

Finally, there is the Chinese government itself.  Sanctions pose little risk to most of Beijing’s current import volumes from Russia.  Almost all China’s current imports come either overland by pipe, or from Russia’s nearby Pacific ports.  Average Pacific port voyage times to Chinese ports are shorter than to any other major market open to Russia under sanctions.  If you were rationing scarce tanker capacity and trying to maximize daily export volumes, Pacific deliveries to China would be the first place you would allocate capacity.  And Russia’s fleet can easily cover these Pacific exports to China on its own.    

Any incremental imports of size would need to be shipped from Russia’s distant western ports—a very inefficient use of China’s structurally incompatible fleet.  

If, however, Beijing wanted to significantly increase imports from Russia, it would require extraordinary amounts of additional tanker capacity.  The reason is the peculiar logistics of the Russia-China oil trade.  Most of China’s current imports come via the East Siberian-Pacific Ocean pipeline, which is now at capacity.  And additional volumes would need to come from Russia’s distant Western ports on the Black Sea and the Baltic—none of which can load VLCCs.  Attempting to use China’s ill-suited fleet would make for a highly inefficient use of tonnage. 

If, for example, China wanted to add an additional 10% of Russian crude to its import mix, it would need to allocate to the Russia trade on a full-time basis some 70% of the tonnage of China’s two dominant tanker fleets, by my calculations.11 And since those vessels would all lose their IG P&I coverage, Beijing would also need to make up for tens of billions of dollars of lost liability coverage.  Beijing may deem this an imprudent use of both strategic shipping assets and sovereign credit, regardless of the discount it might be able to demand.  If additional cheap Russian oil is what China seeks, it could get that through the price cap mechanism and save its fleet and balance sheet for better uses. 

India, with a much smaller fleet and little marine P&I, is also unlikely to provide solutions for Russia’s shipping capacity shortfall. 

India, likewise, is unlikely to shore up Moscow’s supply-chain weaknesses.  Its marine P&I industry is only in its infancy.  Its commercial tanker fleet is far smaller than China’s and it relies on foreign vessels for most of its imports.  Moreover, the shipping capacity needed to keep recent export volumes flat to India would be three times that required for China, because of the greater distances from Russian sea terminals (India is currently supplied mostly from Russia’s Western ports, China out of the Pacific).  It’s hard to see how India can be of much help to Russia with either insurance or boats.12

Capacity will come mostly from Russia’s national fleet and the risk-friendly “shadow fleet,” but still fall well short of Russia’s needs…

Russia will likely end up relying on two sources for shipping capacity under sanctions: 1) its own national fleet, Sovcomflot (SCF), and 2) the so-called “shadow fleet.”  The latter is a marginal group of aging tankers with anonymous ownership and an appetite for transporting sanctioned crude.  Russia’s own fleet could offtake up to 25% of recent seaborne volumes, if deliveries to the closest open markets were prioritized, based on my estimates.  The shadow fleet is substantially larger than SCF, though estimates of its size vary.  Like China’s fleet, however, the shadow fleet, too, is top heavy with VLCCs that cannot load at Russian ports.  For this and other reasons, the gross tonnage of the shadow fleet must be substantially discounted when estimating how much effective shipping capacity it could provide to Russia. 

…making possible a drop in export volumes of up to 3.3 – 3.9 million barrels per day, absent any capped price sales, once sanctions are fully in force...  

Together, the capacities of SCF and the shadow fleet will fall far short of what Russia will require under sanctions to maintain recent export levels, based on my projections.  The impact of this constrained shipping capacity on export volumes will be substantial, leaving a large portion of Russian exports stranded in country.  Once sanctions are fully in place, Russia’s total crude and product exports (seaborne + land) could fall by as much as 3.3 to 3.9 million barrels a day from a baseline of 7.5 million barrels a day, absent any sales under the price cap mechanism or revisions in the planned G7-EU sanctions.  This decline is likely to phase in gradually from October through the end of January, as foreign shippers start avoiding cargoes that might not reach their destination ports prior to the December 5th and February 5th cutoff dates.

…and cuts in deliveries to more distant markets, like India, as tanker capacity rationing is introduced. 

Such a decline would have a major impact on oil markets.  It would also have implications for specific importers of Russian oil.  Absent capped price sales, Moscow would need to ration scarce tanker capacity.  If it rations these with the aim of maximizing volumes, it will likely decide to cut deliveries to more distant overseas markets, like India, while prioritizing closer-in markets, like China and Turkey.

The market consensus appears more optimistic about the resilience of Russia’s export supply chain than the view expressed here.  

Many market observers expect declines in Russian exports, but not generally of the magnitude given here.  They tend to see Russia’s supply chain as being more resilient than my analysis would indicate.  Some believe shipowners wishing to continue in the Russia trade will find alternative sources of P&I insurance.  Others think Russia’s surreptitious purchases of used tankers could bridge the gap.  Still others point to various subterfuge shipping schemes—already being tested—that might be used in smuggling operations. 

…but Russia’s various anti-sanction schemes may lack sufficient speed and scalability—the scale of Russia’s export requirements is immense; they will likely only help around the margins. 

All these observations have merit and highlight measures Russia is trying to develop to lessen the impact of sanctions.  And no doubt some of these anti-sanction measures will succeed…but only within certain limits.  What they all face the is the challenge of scalability: can they be quickly scaled up to a magnitude that will fundamentally change outcomes for Russia?  When it comes to Russia’s massive oil exports needs, the importance of scale cannot be overstated. 

Providing credible, sanctions-proof P&I coverage on the scale Russia needs would involve complex, multi-lateral agreements involving cross-border asset pooling and risk-sharing on a very large scale—and all quickly papered up by legal advisors.  That’s a heavy lift. 

Take, for example, marine insurance.  To transform outcomes for Russia, it wouldn’t be enough to arrange sanction-proof “spot” P&I coverage for, say, 30 or 40 ships that occasionally lift sanctioned Russian crude and need a one-off coverage of those cargoes when they do.  To be transformational requires much more.  To reduce Russia’s projected export decline to, say, 1 million barrels a day would require on the order of an additional 200 vessels from the licit fleet going into the sanctioned Russian oil trade on a full-time basis, by my estimates.  That, in turn, would require $200 billion of acceptable, sanctions-proof P&I cover to replace their invalidated IG policies.  Can enough well-capitalized parties, with expertise in marine insurance and not subject to sanctions, be engaged to write two-hundred billion dollars of P&I policies by the end of the year for shipowners from around the world?  Perhaps, but it feels like a stretch.

Buying up tankers in the second-hand market and clandestine smuggling operations also face practical challenges of scalability. 

Or consider the threshold test for Russia’s tanker acquisition program.  Can Russia realistically hope to finance and purchase the equivalent of 12% of the global Aframax and Suezmax fleet over the next two months?  And where would prices in the resale market go as the acquisition campaign rolled out?  Or consider what is required to scale up ship-to-ship (STS) transfers for smuggling operations at scale.  With tanker capacity being rationed, would Russia have nearly enough vessels to conduct the many inefficient, capacity-intensive STS transfers needed to smuggle, say, two-million barrels a day into Europe?  And wouldn’t an operation that big also be easy to spot and interdict? 

Those are the kinds of threshold tests that a transformational anti-sanctions solution would need to meet.  It’s not inconceivable that one or more could be met, but it seems unlikely, especially in such a short time frame.13

Oil sanctions pose an ethical dilemma: withdrawing from Russia’s blood-oil trade could lead to widespread economic hardship. 

Oil export revenues are Moscow’s most important source of funding for its brutal war against Ukraine.  It was moral outrage over this brutality that led Ukraine’s allies to ban imports of Russian oil and prohibit businesses from engaging in this lucrative trade.  But because of Russia’s weak supply chain, an oil supply shock could ensue under sanctions that would cause widespread economic hardship.

The price cap addresses this dilemma by striking a balance between two competing goods.  It allows otherwise stranded Russian oil to reach markets using the export infrastructure of Ukraine’s allies… 

The price cap is designed to address the dilemma of oil sanctions (here I should be clear that by “designed” I speak of function, not intent; the price cap was developed and implemented by others, and I cannot speak with authority to their intent; what I describe here is how I believe the price cap as structured will likely function).14 It creates a pathway to market for stranded export barrels that Russia is incapable of delivering on its own.  It does this by allowing those stranded barrels to be shipped via the physical and financial infrastructure of Ukraine’s allies.

…while also limiting excess profits on those sales. 

As often with infrastructure, there is a toll.  In this case, it takes the form of a cap on the price Moscow can receive for its otherwise stranded barrels.  And that capped price is set with the aim of limiting excess profits.  

The price cap will have little direct impact on barrels Russia can export on its own—nor is it designed to. 

But what of those barrels that Russia can deliver to markets on its own, without help from Ukraine’s allies?  How will the price cap affect them?  The price cap is not designed to control the pricing of these “non-stranded” barrels.  It does not create some form of buyers’ cartel trying to impose off-market pricing on supplies already in the market.  The global oil markets are too broad and efficient to sustain large-scale, cross-border collusion among buyers.  For any barrels Moscow can deliver to customers on its own, it will be free to negotiate prices in the market.

For the price cap to be effective, Moscow must choose to sell its stranded oil, which now looks increasingly unlikely.  

For the price cap to work, however, Moscow must choose to produce and sell its stranded export barrels.  That was never a forgone conclusion (as I wrote last April), and now appears even less likely…at least in the near term.15

Moscow is waging an economic war that aims to cause hardship through disrupting commodity supplies… 

Moscow is waging hybrid warfare against Ukraine and its allies.  In addition to its kinetic attacks on Ukrainian soldiers and civilians alike, it is waging an economic war that targets not only Ukraine and its allies, but the entire international community.  Moscow’s weapon of choice is the engineered disruption of commodity exports—its own and Ukraine’s.  Gas and grain are just two recent examples. 

The aim of Moscow’s commodity disruption stratagem is to erode international support for Ukraine.  It does this in two ways—one obvious, the other less so.  The obvious way is by inflicting indiscriminate economic hardship through higher prices and shortages of basic goods like food and energy. 

…and stoking social divisions with false narratives. 

The less obvious way is by stoking social divisions within countries backing sanctions.  It does this by spinning false narratives that shift blame for supply disruptions onto western political leaders, while denying Moscow’s primary agency.  This cut-and-blame tactic was on full display when Moscow throttled gas supplies to Europe and disingenuously claimed technology sanctions were at fault.

Moscow now looks intent on expanding this economic war by causing an oil supply shock...

With recent setbacks on the battlefield and growing pressure at home, the Kremlin now looks intent on expanding its economic war—this time by engineering an oil supply shock.  It is already deploying a false narrative aimed at shifting the blame.  It goes like this: Russia stands capable and ready to keep supplying markets with our oil.  But Western politicians seek to weaken Russian through a buyers’ cartel that imposes non-market prices on our freely traded oil. As anyone knows, when you artificially depress prices, it drives out supply.  So, if there’s a supply shortage—blame the price cap.

…and then disingenuously blaming it on the price cap. 

As with all Kremlin gaslighting, it is artfully crafted around half-truths and misdirection.  Here, Moscow starts with the false claim that it will be capable of delivering its oil to the market.  But that’s not true for the large portion of oil that is likely to be stranded.  Moscow then claims that the price cap will drive this supply out of the market through manipulated pricing.  And here we see the sleight-of-hand.  The price cap doesn’t drive supply out of the market—since the volumes it affects aren’t even in the market in the first place—they’re stranded in Russia.  The price cap does just the opposite—it enables those stranded volumes to get into the market by providing access to infrastructure. 

Were Moscow actually capable of getting those volumes to market on its own, it would do so and then sell them at negotiated prices—much as it does today.  There would be no price cap, because there wouldn’t be any need for one.  It only exists because Moscow can’t move all its oil on its own—it’s dependent on help from Ukraine’s allies.

To sum up, the price cap is not a buyers’ cartel for managing prices on oil that’s already in the market; it’s tolled access to infrastructure for delivering stranded oil to the market.  But to grasp this, it helps to be aware of Russia’s stranded oil problem—an inconvenient truth Moscow wishes to hide from allies and enemies alike.  Beware Moscow’s misdirection.

Alternative scenarios could still play out.  

A Kremlin-engineered supply shock appears at this point quite likely, but not yet inevitable.  There are alternative scenarios that could still play out.  If, for example, Iran sanctions are dropped, Moscow may be able to secure additional tanker capacity from the shadow fleet.  Indeed, the shadow fleet could end up expanding significantly in response to demand from Russia.  And as Iran’s large inventories in storage get released into the market, this could blunt the impact of an oil shock.  Moscow might then prefer to up its sales volumes. 

And sales through the price cap cannot be entirely written off.  It would be very characteristic of the Kremlin to quietly test the integrity of the price cap mechanism early on by allowing a few cargoes to be sold through it.  They would seek out vulnerabilities in compliance and monitoring systems that could be exploited to Moscow’s benefit.  If the opportunities for exploitation appeared sufficiently attractive, Moscow might scale up sales through price cap regime. 

Finally, if oil prices slump and Moscow is pressed for cash, it might increasingly avail itself of the price cap simply because it needs the money.

A supply shock—if it comes—will inflict hardship on the international community, roil the markets and test the resolve of Ukraine’s allies.  If their resolve holds and prices settle, Moscow would emerge a much diminished force: banished from its largest market, awash in stranded hydrocarbons, beset by decaying production systems, and starved of vital export revenues.

This essay is a summary of on-going research examining Russian oil under sanctions. 

The quantitative analysis in this essay is based on a bottom-up model of Russia’s oil export infrastructure and the evolving patterns of Russia’s seaborne oil trade.  The model’s data sets include empirical observations of some 1,500 loadings at Russian ports in recent months and the tracking of voyage data, based on data feeds from a commercial, third-party marine tracking service.  Unavoidably, some of the analysis relies on my subjective judgements.  These are informed by familiarity with Russian-language industry source materials, a twenty-five-year career in the global financial markets, more than a decade of living and working in Russia, thousands of hours of discussions with engineers and executives from the Russian energy industry, and first-hand exposure to a number of its leading figures. 

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My essay in Politico on how the rigidity of Russian oil holds the key to smart sanctions

Vladimir Putin appears to have been caught off guard by the recent recent shift in Western sentiment towards a Russian oil embargo. In response, he has urgently tasked his ministers to develop plans for new export infrastructure that would expand access to “friendly” markets. But the urgency of his call for projects that would be many years in the making only highlights Russian oil’s current dependency on the West—a vulnerability that holds the key to smart oil sanctions.

For more, click here for my essay in Politico. And follow me on Twitter @CraigKennedy77

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April 2022

Robust cash flows from Russian oil exports are blunting the impact of sanctions.  Calls for a full embargo, however, face political resistance over fears that a supply shock could trigger a recession and undermine Western unity.  This paper makes recommendations on how to enhance the economic impact of oil sanctions while mitigating their harmful effects on the world economy.  They include a proposal to augment a full oil embargo with a smart embargo option. This option could eliminate Russian tax revenues on oil exports, while also averting a supply shock and providing funds for Ukraine reparations at Russia’s expense.  The proposal takes advantage of vulnerabilities in the Russian oil industry that have been largely overlooked in the current sanctions debate. 

Executive Summary

The continued flow of oil export revenues into Russia is blunting the impact of Western sanctions.  At today’s prices, Kremlin tax receipts on export oil alone will cover 70% of Russia’s Federal Budget for 2022.  The most obvious remedy to this problem—a full embargo on Russian oil exports—continues to face resistance from some European policy makers.  They fear an oil supply shock would trigger a recession that, in turn, could undermine the Western unity needed to counter Russian aggression.

This paper makes recommendations on how to structure an oil embargo strategy in a way that enhances its economic impact.  These recommendations include a proposal for a smart embargo option that could stem the flow of Russian tax revenues from oil exports while also averting a politically risky global supply shock.  What is more, it would also fund Ukraine reparations at Russia’s expense. 

These recommendations take advantage of certain structural vulnerabilities in the Russia oil industry—largely overlooked in the current sanctions debate—that severely limit Russia’s ability to redirect or reduce the 6 million barrels a day it exports to the West—over half its total output.  Russia itself consumes around a quarter of its own output.  The balance, however, must be exported (Figure 1).  China buys less than 20% of these exports, while the West normally absorbs over 70%.  These Western imports represent more than half Russia’s entire oil output.

Figure 1

In the event of an embargo, Russia has threatened to redirect its Western export volumes elsewhere.  But these “export substitution” threats are hollow—the volumes are far too large to redirect.  Russia’s Western export volumes are far too large for China and India to absorb without abandoning their practice of diversifying supplier risk and relying on Russia for nearly half their oil imports.  Significant infrastructure and logistical constraints also limit Russia’s ability divert oil East.  And if the West imposes secondary sanctions on any enablers of Russia’s seaborne oil trade, Russia would struggle to redirect more than a fraction of its Western exports.

If export substitution is not possible, Russia’s only real option under a Western embargo would be to leave the banned oil in the ground.  This would mean “shutting in” more than half its current output.  That’s an immense quantity of oil, equal to roughly 6% of global output.  Such a scenario would be severely damaging to Moscow for several reasons, some self-evident others less so.  Most obvious would be the loss of vital export revenues.  While these might be offset by higher prices for Russia’s few remaining exports, the offset would likely be partial and short-term only. 

Less evident than revenue loss, however, is the severe damage an extended, large-scale shut in would do to Russia’s upstream production capacity.  It could render tens of thousands of marginal wells uneconomic and compromise complex pressure management systems at the field level.  This risk is well appreciated by Russian reservoir engineers, but less evident to Western policy makers.  Additionally, this could also deeply undermine political support for the Putin regime in Russia’s oil producing regions.

A major shut-in would also erode Russia’s standing in OPEC+ and put Russia’s export market share at risk.  Finally, it would erode the mainstay of Russia’s centralized, rent-gathering economy that helps enable an authoritarian form of government.

If export substitution is a chimera and a large-scale shut-in potentially catastrophic, Russia is far more dependent on the West to absorb its oil than many Western policy makers may realize.  This dependency gives the West significant bargaining leverage—but only if it acts collectively.  Properly exploited, it can be used to design smart oil sanctions that achieve Western objectives while minimizing self-harm. 

There are different ways to exploit this leverage, such as imposing a special export tax.  This paper proposes augmenting a standard embargo with an “oil-for-reparations” smart embargo option that allows for controlled export sales while severely restricting the proceeds remitted to Russia.

Under this framework, the Western governments would agree to proceed with a full embargo of Russian oil exports (Figure 2).  But the embargo would include a special provision that would allow Russian producers to keep exporting oil, provided all proceeds are channeled through a special Payment Authority established by the West. The Payment Authority would remit a portion of the sales proceeds back to the Russian producer—enough to cover average production costs excluding all Russian taxes, but nothing more.  

Figure 2

Based on average Russian costs, this would be around $20 -$25 a barrel or roughly a quarter of today’s oil price.  The remaining surplus—what would normally flow to the Kremlin as taxes—goes instead to Ukraine for reparations (Figure 3).  At today’s prices that would be around $55 a barrel, equal to around a half a billion dollars a day.  Accordingly, this framework could be called the “Oil-for-Reparations (OFR) Sanctions.”

Figure 3

This Oil-for-Reparations framework has several advantages: 1) it funds Ukrainian reparations at Russia’s expense, 2) it prevents an oil price shock and 3) it slashes Russian oil tax revenues, with severe consequences for the Russian budget.  Its chief drawbacks are 1) some corporate oil export revenues continue to flow back into Russia and 2) it cannot be imposed unilaterally; Russian producers must agree to sell.

This last point—the need for compliant sales by Russia—is a significant uncertainty.  As part of the framework, the West must impose secondary sanctions on any non-compliant export sales outside of the sanctions regime.  This would make it all the more difficult for Russia to redirect a significant portion of these volumes elsewhere.  Russia’s Western volumes would, in effect, become “captive oil.”

That would present Russia with a stark choice: either agree to export under the sanctions regime, or voluntarily elect to shut in most export oil (Figure 4).  While agreeing to sell is clearly in Russia’s economic interest, it’s entirely likely the Kremlin would opt instead—at least initially—to start shutting-in in hopes of roiling global markets and breaking Western resolve.  And one cannot assume that Putin will be fully briefed on the catastrophic impact such a shut-in could have on Russia’s oil sector.

Figure 4

Even if Russian opts for a shut-in, there are still significant advantages to including a smart embargo option.  For one thing, Russia might decide, instead, to participate—if not immediately, then at some later point.  Additionally, having this option goes some way to shifting responsibility for the shut-in—and the resulting supply shock—away from the West and onto Russia.  Politically, that shifting of responsibility is valuable.  The price spike following a full shut in will be painful for oil consumers everywhere.  OPEC, likewise, will not welcome loss of control over prices.  The smart embargo strategy shows a good-faith effort by the West to prevent a supply shock.  If a supply shock does occur, Russia will have to share the blame, including from erstwhile ally China.

The West should also prepare an expansion of current oil field services sanctions.  At present, these are very limited and have little impact on current production.  Russia is growing increasingly dependent on Western oil field equipment, services and technology to maintain production levels.  The West should prepare to expand these sanctions to ban all Western oil field services in Russia, especially If Russia opts for a self-imposed shut-in.

* * *

Table of Contents

Part 1 is an overview of Russia’s oil production and exports.  It shows how Russia exports three quarters of its oil output and how 70% of those outputs flow to the West. 

Part 2 discusses Russia’s highly progressive oil tax regime on exported oil, in which 80 cents of every incremental dollar is captured by the state as oil prices rise above $25 dollars a barrel.

Part 3 shows that Russia’s threats to divert Western export volumes elsewhere are hollow.  Faced with constrained demand, infrastructure and shipping logistics along with secondary sanctions risk, Russia would struggle to divert more than a small fraction to Asia.

Part 4 shows that Russia’s only actual option to selling West is shutting-in production, but that this is an unattractive option for Moscow, since it would deny it vital tax revenues and severely damage its upstream oil production capacity.

Part 5 makes recommendations on how to exploit Russia’s high dependency on Western oil markets.  They include augmenting a simple embargo with a restricted-proceeds option that would slash Russia’s oil tax receipts, while averting an oil supply shock and providing funds for Ukraine reparations at Russia’s expense.

An Appendix addresses a technical issue of how to maintain market pricing for Russian export sales in the Oil-for-Reparations framework.

Part 1: Russian Oil Export Volumes—Heavily Skewed to the West

Russia exports three quarters of its production...

Russia typically exports over 8 million barrels a day of oil—that’s about 75% of its total current output of nearly 11 million barrels a day (Figure 5).  This makes it one of the world’s largest exporters, accounting for one in every eight barrels traded in the international markets.  About 60% of the oil Russia exports is in the form of crude, but another 40% goes out as refined products, such as diesel, fuel oil and naphtha, a fact often overlooked in media reports on Russian exports.  

Figure 5

...and relies on the West to buy 70% of its exports—equal to more than half of total Russian oil output.

Russia relies on heavily on the West to buy most of its oil exports, more than 70 percent (Figure 6).  This means Russia sells more than half the oil it produces to the West, either as crude or in the form of refined products.  China, though the single largest buyer, accounts for less than 20% of Russia’s export sales or around 15% of Russia’s total production.

Figure 6

Part 2: Russia’s Aggressive Oil Tax Regime—the Mainstay of State Finances

As oil prices rise above $25 a barrel, 80% of each incremental dollar goes to the State

Taxation of export oil has long been the mainstay the Putin regime. This is possible because Russian oil is cheap to produce and the Russian government taxes oil aggressively. Industry costs have been creeping up in recent years as declining, low-cost fields are replaced by more expensive new ones.  Nonetheless, Russia’s full-cycle costs remain mostly in the range of $20 - $25 (these are the costs to find, develop, produce and move a barrel of oil). 

Russian oil taxes are closely tied to the oil price.  Taxation begins as prices rise above $15 a barrel.  As prices rise above $25, the marginal tax rate rises to near 80%. This means for every incremental dollar in the oil price above $25, the state takes 80 cents.  At today’s Urals blend price of $80, for example, the Kremlin is collecting $55 for every barrel exported (Figure 7).  The remaining $25 goes to the producer to cover costs.  Some tax relief is available for certain projects, such as greenfield developments.

Figure 7

Today, oil exports alone generate nearly $500 million in tax receipts every day—enough to fund 70% of the 2022 Federal Budget

Russia’s tax haul on oil exports is immense, which makes it the largest single source of government revenues.  Currently, oil exports alone are generating nearly a half billion dollars a day in tax receipts.  To put that in context, that’s enough to fund 70% of Russia’s entire federal budget expenditures for 2022 (Figure 8). 

Figure 8

Part 3:  The illusion of export substitution: why Russia would not be able to redirect a significant portion of its Western export volumes East, especially if secondary sanctions are imposed

Rising calls in the West to ban Russian oil are threatening Moscow’s most important source of tax revenue.  In response, Moscow has threatened to divert Western export volumes elsewhere.  Media stories follow highlighting stepped up sales to China and India.  Concerns arise about export substitution to Asia.  But a close examination shows that the threat of Asian export substitution is a paper tiger. 

There are three major reasons for this, all of which arise from the immense scale of Russia’s Western export volumes. 

1.      These volumes are far too large for Chinese and India to absorb without abandoning their practice of diversifying supplier risk and relying on Russia for nearly half their oil imports.

2.      Russia would quickly run up against significant infrastructure and logistical constraints as it tried to divert its Western exports East.

3.      If the West imposes secondary sanctions on Russian exports, the chilling effect on critical intermediaries for the long-haul seaborne oil trade would make it difficult for Russia to redirect more than a fraction of its Western volumes.

Let’s cover reason each in turn.

1) Asian Demand Limits

China and India together would not be able to absorb Russia’s Western exports without taking on unacceptable concentration risk—the volumes are simply too great...

Asia is home to the first and third largest oil importers in the world, China and India.  Large as they are, however, the collective West is far larger—importing double China and India combined (Figure 9).  And when it comes to imports of Russian oil, the West’s relative volumes are even greater—four times as much.  

Figure 9

Scale matters when the question of Asian export substitution comes up.  At present, Russian supplies only 9% of China and India’s combined oil imports.  Were they to try to absorb the volumes Russia normally sells to the West, their dependency on Russia for imported oil would jump to nearly 45%.

Taken individually, the story for each country is much the same. 

...Russia’s share in Chinese oil imports would jump to 47%...

For China, Russia is already one of its top two suppliers, providing around 14% of China’s imported oil (Figure 10).  Were China to absorb Russia’s western export volumes on a pro-rata basis with India, Russia’s share in China’s imports would grow to 47%.  To make room for all this new Russian oil, China would need to cut back other suppliers by 39%. 

Figure 10

...while for India, it would skyrocket to 40%.

The story with India would be much the same (Figure 11).  The only real difference being that Russia’s current share in India’s import portfolio is very low—around 1.5%.  With no direct pipeline connection, all Russian oil to India must go by sea.  Russia’s low share in Indian imports illustrates how uncompetitive it is to ship Russian oil from the Black Sea or Baltic to India.  But if India were to absorb Russia’s Western exports pro rata with China, Russia’s share in Indian exports would rise to 40%.  And it would also have to cut back it other suppliers by 39%.

Figure 11

It is hard to imagine either country voluntarily accepting such a high level of concentration risk around a single supplier.  Both are heavily reliant on oil imports and manage oil import risk by broadly diversifying suppliers.  For China, this is a formal national security policy.  Absorbing that much Russian oil would mean abandoning efforts to manage import risk.  Absorbing even half of Russia’s Western export volumes would still create very high levels of Russia dependency, especially China, who would be relying on Russia for a third of its oil imports. 

Other factors would also limit incremental demand, such as existing OPEC supply relationships...  

Beyond concentration risk, there are other factors that would limit China and India’s appetite for additional long-term Russian supply agreements.  To begin with, it would mean cutting back other suppliers by 39% for both China and India under the scenarios above.  Many of these suppliers are OPEC members with whom they have long-standing supply relationships they may be reluctant to upend. 

... and concerns over numerous Russia-specific risks

And then there are numerous Russia-specific risks.  Russia is already saddled with Western sanctions, with more likely to come.  Russia also has a track record of weaponizing energy exports.  Russia faces severe infrastructure and logistical constraints on its ability to reliably transport large incremental volumes to Asia (see below).  And if the West imposes secondary sanctions under the OFR Program, these constraints become even more severe.

At distressed prices, China and India will likely be opportunistic buyers, but cannot be counted on to absorb large portions of Western volumes on an on-going basis

To be sure, China and India will pick up incremental supplies from Russia on an opportunistic basis, if the price is right and the risks manageable.  But it’s hard to imagine them being willing to absorb more than a fraction of normal Western export volumes on an on-going basis.

2) Russian Infrastructure & Logistic Constraints

Russia’s export infrastructure is heavily skewed Westward, creating major logistical constraints and vulnerabilities for redirecting Western volumes to Asia

Russia’s river of oil flows mostly West.  This has been the case since the late 1870s, when Russian oil first reached Western European markets.  Today, exports flow West through an immense infrastructure of pipelines, ports, refineries, and rail links (Figure 12).  These took decades to build and cost tens of billions of dollars.  These exports are supported by a dense commercial network of bankers, traders, refiners, insurance brokers and shipping companies, many with deep and long-standing expertise in the Russian oil trade.

Figure 12

Most Russian exports come from fields in West Siberia and the Volga-Urals basin and over 80% of them are destined for Europe.  Some volumes travel via the Druzhba pipeline (opened in 1964) directly to European refineries.  Others are shipped by tanker out of the Black Sea and the Baltic on short runs to Europe.  En route out of Russia, 45% of Western exports are run through one of the two dozen refineries in Western Russia.

Russia’s much smaller Eastern export infrastructure is already running near capacity

Russia’s Eastern export infrastructure is young and modest by comparison to its Western counterpart.  The first long-haul export pipeline from West Siberia to China reached full capacity only in 2019.  At 4,188 kilometers, it is the world’s longest oil pipeline and took over a dozen years to complete at a cost of some $25 billion.  It can deliver 600,000 barrels a day directly to China’s Daqing refinery and another 1 million barrels a day to Russia’s Pacific oil terminal at Kozmino.  But this totals only about a fifth of Russia’s Western export capacity. 

Additionally, two much smaller terminals send exports out of Sakhalin Island.  Russia’s eastern export infrastructure is already running near capacity.  It would not be able to carry significant portions of Western volumes to new, Asian markets.  Significantly expanding this capacity would take years and billions of dollars.

The only way to redirect large Western volumes to Asia is by oil tankers out of the Black Sea and the Baltic...

If Russia wanted to divert significant Western export volumes to Asia, it would have to move them by tanker from terminals in the Black Sea and the Baltic.  Rerouting all those Western volumes would put well over a million barrels a day of additional load on Russia’s main sea terminals, which could pose a bottleneck. 

...but this would strain global capacity, requiring a quarter of the world’s super tanker fleet

But by far the greater challenge would be finding enough oil tankers to carry all that oil to Asia. Currently, Russia’s seaborne exports make short trips to Mediterranean and Northern European ports.  To shift those volumes to Asia would demand larger vessels that would need to spend 10 times as many days in transit, with a round trip taking the better part of three months. 

Moving that much oil over that much distance would require a dedicated fleet of some 200 VLCCs (very large crude carriers) working day in and day out.  That’s equal to a quarter of the entire global VLCC fleet.  And half the time, those vessels would be returning empty back to Russia.  It’s doubtful Russia would be able to charter this much capacity at any economic price.  Russia does have its own modest tanker fleet, but it could barely manage a tenth of the volumes involved.

3) Secondary Sanction Risk

Russia’s greatest barrier to export substitution would be secondary sanction risk, which would likely shut down most non-compliant seaborne trade.

In the end, this analysis of global tanker capacity is somewhat academic, since most of these tankers could probably never be chartered in the first place.  The reason—the secondary sanctions risk  

As noted above, almost any additional volumes Russia sells to Asian buyers would need to go by sea.  But seaborne oil is much more vulnerable to sanction risk than pipeline oil.  This is especially true with Russian oil.  It would have to rely on an immense fleet setting sail through heavily monitored waterways like the Bosphorus and the Danish Straits. From there, they would have to sail 40 plus days to their destination, while carrying cargos worth $150 million.  A large-scale operation like this involves a host of intermediaries: banks to provide letters of credit, cargo financing and payment transactions; charter shipping companies; marine insurers and commodity traders (Figure 13). 

Figure 13

Were the West to impose secondary sanctions on seaborne sales to Asia, it would have a deeply chilling effect on this trade.  Few of the needed intermediaries would be prepared to risk sanctions.  Russia might be largely reduced to relying on its own small fleet.  The only other volumes likely to evade sanctions are the 10% of exports already going to China via overland pipelines. In short, if the West imposed secondary sanctions on non-compliant sales to Asia, Russia would struggle to divert even a small portion of its Western volumes East. 

Part 4: An extended, large-scale shut-in of Russia’s oil output would severely damage a large part of its upstream production capacity. 

Russia’s only real option to selling half its oil to the West is to leave it in the ground...

If export substitution is not possible, Russia’s only option under a Western embargo would be to leave the embargoed oil in the ground.  This would mean “shutting in” more than half its current output, equal to roughly 6% of global oil production.

...but this is a highly unattractive option for Moscow.