Research Highlights Podcast
July 29, 2026
The economics of sanctioning a petrostate
Lukasz Rachel and Catherine Wolfram discuss the G7 price cap on Russian oil and why it defied textbook predictions.
Source: ROMAN DZIUBALO
In response to Russia’s 2022 invasion of Ukraine, the G7 imposed a price cap of $60 per barrel on all Russian oil carried by tankers owned, insured, or serviced by Western companies. Many analysts expected the policy to backfire, with some warning that oil could reach $380 if Russia retaliated by cutting production.
In a paper in the American Economic Review, authors Simon Johnson, Lukasz Rachel, and Catherine Wolfram argue that tightly enforced caps can actually raise oil output and push world prices down when factors like market power, uncertainty, and financial constraints are accounted for.
Rachel and Wolfram recently spoke with Tyler Smith about why the textbook intuition on price caps fails in Russia’s case and how their framework might be used to set caps in the future.
The edited highlights of that conversation are below, and the full interview can be heard using the podcast player.
Tyler Smith: Why did you think it was time for a new theory of price caps on nonrenewables?
Catherine Wolfram: The real driver was that, in 2022, after Russia's full-scale invasion of Ukraine, the G7 countries implemented a price cap on Russian oil. This was a brand-new policy tool, and one where we thought the standard economic intuition—if you put a price cap on a good, that will cause the producer to want to produce less—wasn't actually applicable. So, we wanted to work through the economics of this brand-new sanctions policy, this brand-new instrument of statecraft. That was one main motivation. And we realized that the literature hadn't really taken on the fact that many of the major oil producers are petrostates—countries like Russia, Saudi Arabia, and Iran get a huge share of their total fiscal budget from oil sales. So, we wanted to think about how that impacted the incentives of those producers.
Smith: Why were many analysts worried that Russia would significantly cut production?
Lukasz Rachel: The basic logic is very intuitive, which is the reason it was so appealing. If you introduce a price cap, if you cap the price the producer can receive for its resources, then the rewards to producing more are curtailed, and so production might fall. Now, if you layer market power on top of this intuition—Russia is a very large producer, one of the largest, and the largest exporter of oil and oil products—then what you get as a result of this potential cut in production is a big oil supply shock in global markets. And remember, this was all happening at the same time that the post-COVID global supply shocks were playing out. That's where the fears of higher oil prices globally were coming from. The issue is that this logic basically took as given that the producer would cut production. What we wanted to do in this paper is think carefully through the problem of the producer—what decisions need to be made by a producer who has market power. We wanted to analyze whether such a cut would in fact take place once the price cap was introduced. And it turns out that the effect of market power in that setting is actually to limit the likelihood of a production cut. That's where the standard intuition gets things wrong.
Smith: How did you change the baseline model to make it more consistent with the actual decision problem Russia faces?
Rachel: We built a model around three main ingredients, and we chose them carefully to match Russia's actual situation. The first, as we already discussed, is market power. Russia is a big producer and a big exporter, and presumably it takes into account how its own decisions impact world prices and the market situation. It is not a passive price taker.
The second important issue we wanted to take on board is the dynamics and risks involved in the global oil market. Oil prices, and commodity prices more generally, fluctuate widely over time. So we wanted a framework that takes the realistic amount of uncertainty and price swings into account. In our model, we estimate the price process directly from decades of oil price data. This uncertainty matters because if you impose a price cap today, it might bind today, but because prices might move in the future, it might stop binding tomorrow. And all of those expectations will ultimately affect behavior. As we argue in our paper, the key thing about production decisions when it comes to non-renewable resources is the intertemporal nature of the problem.
And then the third factor we wanted to zoom in on is financial frictions. In the context of Russia, it's obvious—Russia is spending an enormous amount of resources and money on running the war, while at the same time being curtailed by other sanctions. For example, the West froze around $300 billion of central bank reserves and cut off borrowing. Russia had to finance the expensive war while also financing the rest of the state's operations. So we wanted a framework that could speak to the financial constraints this producer faces. And if you put these three pieces together, you get a model that behaves very differently from the standard dynamic framework that dominates the textbook treatment of oil extraction.
Smith: When you add all of these new pieces—the market power, the dynamism, the financial frictions—you find that the simple intuition is completely turned on its head. An exporter actually wants to extract more resources. Why should we expect a country like Russia to actually produce more oil when facing a price cap?
Rachel: Let me emphasize two forces here. The first stems directly from market power. A big producer with market power normally holds some production back precisely because it's trying to restrict supply in order to raise the price above the competitive level. But once a binding price cap is in place, restricting supply doesn't have the benefit it usually does—it doesn't raise the price above the cap. So the price cap is depriving the producer of its market power. Once you think that through, it's clear why the price cap might actually incentivize higher production, higher extraction.
The second force is a little subtler. It has to do with the overall value of the oil reserves. Because the price cap limits the upside from the producer's perspective, it limits those glory days when oil prices would be very high in the future and revenues would be very high—at least when the price cap is expected to be around for a while. That means that, in expectation, the oil reserves underground are less valuable. And when your reserves are worth less—especially when you've got a war to finance and other demands on the budget—the rational thing to do is to burn through reserves faster and use the money now. We call this the nonhomotheticity effect in the paper. Again, it works to increase the desired extraction rate when the price cap is put in place.
When you put these two things together, we show that it's not correct to simply truncate the producer's supply curve, leaving the rest of it in place. Instead, the entire supply curve shifts outward as the price cap changes—technically speaking, as the stochastic environment in which the producer operates changes. And these effects are strongest precisely when the producer has a lot of market power, which speaks directly against the intuition that you should be very careful about sanctioning a producer with large market power, with large market shares.
With a perfect cap, there's no tension—you just impose a price cap as low as possible, or as close as possible to the producer's marginal cost. But when the price cap is leaky, there's a real trade-off because pushing the cap lower inflicts more pain on the producer, but it also raises the odds of an oil price spike.
Lukasz Rachel
Smith: What is the best-case scenario for a well-enforced price cap against Russia?
Wolfram: The actual sanctions policy was designed with two very distinct goals in mind. One was to reduce Russia's revenues. The second was to stabilize world oil markets, to stabilize prices. When the price cap was enacted in 2022, the world was coming out of COVID and there were all these supply chain disruptions. We were starting to see inflation, so there was a real concern that if we took the typical approach to sanctioning a big oil producer—which was to cut off their oil supply entirely—that would spike prices. So, those two goals—reducing Russia's revenues and keeping oil on the market—are often seen in contrast, as though you can do one or the other.
But what our paper points out is that if you have a perfectly enforced price cap, you can actually do both. You can seriously hit Russia's revenues. We do some calibration in the paper, and we show that a perfectly enforced $60-per-barrel cap would reduce Russia's revenues by the equivalent of wiping out more than half of its oil reserves. That's a huge hit. And on the global market side, we show that instead of causing a spike, a perfectly enforced cap can actually push world prices down—because you're putting Russia in a situation where it doesn't have the incentive or the ability to exercise market power anymore. That can bring more supply to the market. With a perfectly enforced price cap, there's really no trade-off, which is the optimal perspective from a policymaker imposing a sanction.
Smith: As you point out in the paper, the real world is more complicated than a perfect price cap. How does leakage outside of the price cap change Russia's incentives to extract oil?
Wolfram: The idea was that the price cap applied as long as sales took place using Western services or services provided by the countries enforcing the price cap. Those included, importantly, things like insurance, whether the tankers were flagged by a member of the price cap coalition, and financing—trade finance is an important component of oil sales. So, for services like those, provided by members of the price cap coalition, the idea was that if you're using them for oil transactions, then you can't carry, insure, or finance oil sold for above $60 per barrel.
But, by some estimates, Russia was able at the very outset to divert oil into what's called the shadow fleet. And then the shadow fleet grew from about 20 percent of its sales to about two-thirds. Unfortunately, what this does is not only move oil above the price cap, it also brings back Russia's incentive to exercise market power. So, unlike the stabilizing effect we mentioned, when they don't have the incentive to exercise market power, this brings back the destabilizing price increase, with Russia seeking to maximize profits on its non-price-cap sales, the sales it's making through the shadow fleet.
Smith: When we look at this from the point of view of the sanctioning countries, how does it change their calculus, and what is their optimal response when you have these leakages?
Rachel: The leakage introduces a genuine dilemma from the sanctioning countries' perspective. With a perfect cap, there's no tension—you just impose a price cap as low as possible, or as close as possible to the producer's marginal cost. But when the price cap is leaky, there's a real trade-off because pushing the cap lower inflicts more pain on the producer, but it also raises the odds of an oil price spike.
This happens because the producer has the greatest incentive to shut in and sell outside the price cap precisely when oil markets are tight. The intuition is that when the price is already high, the producer can export only outside the cap regime, using only the shadow fleet or the leakage, which further raises global prices and therefore cushions the producer's revenue from the much lower volumes it exports. That's a real dilemma because precisely when oil markets are already tight, when prices are already high, this mechanism kicks in, and the sanctioned producer effectively worsens the global supply situation.
What our framework gives the policymaker is the ability to trace out the optimal choice of the price cap given the policymaker's preferences. The framework doesn't tell you precisely what to do, but it tells you how you should adjust your policy based on the degree of leakage you observe and on your preferences. A cautious policymaker, for example, who is terrified of a price spike, might land on something like a $55 price cap, while a more hawkish policymaker who would tolerate more market risk to hurt Russia would push the price cap lower.
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“A Theory of Price Caps on Nonrenewable Resources” appears in the July 2026 issue of the American Economic Review. Music in the audio is by Sound of Picture.