A Perfect Storm, New Sanctions and the ‘Special Military Operation Social Contract’: How falling oil prices and the introduction or non-introduction of additional sanctions threaten the Kremlin

The three pillars of the military-economic miracle

The Russian economy is indeed close to a perfect storm, i.e. a situation where several relatively independent negative factors coincide in time. In this case, their convergence serves as a kind of mirror image of the positive shock of 2022–2024.

Over the course of three years, amid sweeping Western sanctions, the Russian economy demonstrated remarkable adaptability. After a brief downturn in 2022, it unexpectedly returned to confident growth; over seven consecutive quarters, annual growth rates hovered around 5%, whereas in the 2010s the economy grew by an average of just 1% per year.

Three main factors underpinned this development. The first was exceptionally high prices for energy commodities. Energy prices, especially for gas, which Moscow was still selling to Europe at the time, had already begun to rise in 2021. As a result, Russia’s export revenues for 2021 and 2022 amounted to nearly $1.1 trillion. Considering that in the ten pre-war years average annual revenues stood at around $425 billion, the additional income over these two years reached $240 billion. This almost precisely matches the higher-end estimates of capital outflows from Russia in 2022 due to the war and sanctions. Thus, it was effectively offset, and another $420 billion in 'normal' export revenues (equivalent to around 20% of GDP) remained available to the economy.

The second factor was a sharp increase in government spending and other forms of state support in the form of guarantees and subsidies. The Russian government estimated the total fiscal stimulus, that is, the overall level of state support to the economy, at 10% of GDP.

The third factor was 'forced' corporate investment. In the face of the sanctions shock, firms had to invest in restoring supply chains, building new export infrastructure, and so on. Sometimes this resulted in genuine import substitution, but to a large extent these investments created new capacity that did not so much expand the economy’s potential as replace what had been lost. Thus, as new infrastructure was built to support trade in an eastward direction, the old infrastructure supporting trade with the West remained underutilised.

Procyclical policy and double shock

For around 15 years prior to the full-scale invasion of Ukraine, the Russian government’s economic policy was counter-cyclical. This meant that during periods of high revenues from commodity exports, it accumulated reserves, and during periods of low revenues, it spent them. In 2022–2023, in response to sanctions and the need to rapidly scale up production for a protracted war of attrition, the authorities abandoned this approach. Despite relatively high export revenues in 2023 and 2024 ($425 billion and $434 billion respectively), the government did not accumulate but rather spent its reserves. The liquid assets of the National Wealth Fund declined, when under such export conditions they should have been increasing. At the beginning of 2022, liquid assets stood at $112 billion; today, they amount to around $40 billion. This implies that each year the government spent all its oil and gas revenues plus, on average, an additional $20 billion from reserves.

The dual stimulus received by the Russian economy in 2022–2023 (from export revenues and government injections) led to overheating and a spike in inflation, which rose above single-digit levels. The Central Bank had to respond by raising interest rates. This suppressed lending and ultimately led to a slowdown in growth. And it was precisely at this moment that oil prices, and thus Russian export revenues, began to decline.

As a result, the economy has found itself in a situation of a dual negative shock: the opposite of the dual positive shock of 2022–2024. Firstly, there has been a reduction in overall export earnings; secondly, a reduction in government spending. Due to the pro-cyclical policy of 2022–2024, the reserves usually used by the government to cushion the blow of low prices are now severely limited. The prospect of their complete depletion is causing significant concern for Putin, and the government has already begun to cut spending.

Although the economic authorities appear ready to begin reducing the key interest rate, the impact of such a reduction is likely to be limited. In a situation where Russia is cut off from all external financial resources, a fall in export revenues will directly affect the total funds available within the economy and, therefore, the cost of investment capital.

Oil and sanctions: the price of the issue

The worst possible news for Putin at the moment would be a tightening of economic sanctions, particularly those targeting Russian oil.

The worst possible news for Putin at the moment would be a tightening of economic sanctions, particularly those targeting Russian oil. The paradox is that the West now finally has the opportunity to capitalise on the effects of its sanctions policy – a policy which, in previous years, seemed largely ineffective. This ineffectiveness was due in part to the fact that Russian exports, especially energy, could not simply be removed from the global market. Such a scenario would have triggered a price shock amidst a supply shortfall. Today, however, the oil market is experiencing a surplus, and OPEC+ countries are increasing supply in an attempt to reclaim the market share they lost due to voluntary production cuts (→ Re: Russia: Three-Way Fork).

Ukraine and the G7 countries have proposed lowering the price cap to $45 or even $30 per barrel (a decision that has been blocked by the US). Although the cap has never functioned as a prohibitive measure, it has forced Russia to sell its oil at a discount. According to estimates by the Kyiv School of Economics, discounts and logistical complications caused by sanctions have reduced Russia’s oil and petroleum product export revenues by $145 billion over three years. On average, the discount on Russian oil during the price cap regime has been around 10%. At high oil prices, this was unpleasant but not painful, although it did force the government to spend reserves instead of accumulating them. Under conditions of a perfect storm and falling export revenues, this additional loss now appears far more alarming.

So what is the real cost of the matter and the likely consequences? According to revised projections, the Russian budget currently assumes a price of $56 per barrel instead of $70. If the cap is lowered to, say, $40 per barrel and the threat of secondary sanctions proves effective, this could very likely push the price of Russian oil below $50 per barrel.

Last year, Russia's revenues from oil and oil product exports amounted to $189 billion, according to estimates by the International Energy Agency. A 20% price drop, which is the current baseline used by Russia’s Finance Ministry, would (by rough estimates) mean that revenues in 2025 might fall to around $152 billion. Factoring in a further 10% discount on Russian oil, that figure could drop to approximately $133 billion. Budget revenues would thus fall, in addition to the already planned 2.6 trillion rouble decline, by another 1.1 trillion roubles. In the most severe scenarios, the effect of sanctions could be even greater, given the surplus in the oil market and the faster-than-expected growth in OPEC+ supply.

Incidentally, this is not all bad news for Russian exports. Gas export revenues are also likely to decline following oil. In addition to a collapse in coal exports, Russian steel shipments are under severe pressure, and a poor harvest threatens grain exports. As a result, total export revenue may fall by between $60 billion and $70–75 billion under harsh new sanctions scenarios, which means a drop from $434 billion in 2024 to roughly $365–355 billion, or a decrease of 15–17%. This is significantly less than the 32% fall in 2015, but already approaching the 20% drop recorded in 2020.

The ‘special military operation social contract,’ Putin's two fronts, and Trump's help

Such a scenario will not lead to the collapse of the economy or the federal budget, but it will undoubtedly create significant strain both on the economy, which will most likely slip into negative territory, and on the social sphere.

It will undoubtedly significantly limit Putin's ability to wage war beyond 2025. In any case, it will almost certainly lead to the destruction of the ‘special military operation social contract,’ whereby, although ‘Putin's war’ (and the accompanying atmosphere of growing repression) is perceived by the Russian population as a social and moral cost, it remains an era of economic comfort, if not prosperity.

That said, Donald Trump could yet save Putin. For two months now, the US President has successfully avoided increasing economic pressure on the Kremlin. Although he first issued threats of this nature as far back as 30 March, he has consistently refused to take any action, always justifying his position by claiming he is supposedly close to 'closing a deal'. In reality, however, to Moscow's benefit, the United States is not only refraining from tightening sanctions, but may even be loosening them. Russian tankers under US sanctions are once again transporting Russian oil, Bloomberg reports, an indication that their partners no longer see secondary sanctions as a credible threat.

This delay has already allowed the Kremlin to prepare for a new summer offensive in more favourable conditions. The war of attrition currently being waged in Ukraine is being fought on two fronts: on the battlefield and the arena of Russia’s economic capacity. On the battlefield, Putin failed to gain sufficient military advantage during 2022–2023. However, a favourable export environment enabled him to regroup and prepare for the 2024 offensive, the results of which were ultimately limited. Today, the Kremlin is launching a new offensive and enjoys a certain advantage on the battlefield, but its economic rear is vulnerable. For now, though, it is shielded by the President of the United States.