Sulfur content is another important factor. High-sulfur (or “sour”) crude oil requires more complex processing to convert into clean fuels, increasing costs and causing additional wear and tear on refinery equipment.
The Impact of Sanctions on European Refineries
The EU’s decision to sanction Russian oil poses major challenges for European refineries. Russian Urals crude oil, the main type imported from Russia, is an essential part of the energy mix of many EU countries. Its sudden unavailability has forced these countries to seek alternative sources. However, substituting Russian crude oil with other types is not as straightforward as it might appear.
Figure 1 Total EU crude oil imports by quality characteristics before and after the introduction of sanctions.
Our research shows that, considering the quality of crude oil, the elasticity of substitution is much lower than previously estimated. In other words, replacing Russian crude oil with other types is difficult due to its unique chemical properties. Consequently, the economic costs of sanctions could be higher than expected. When the EU sanctions Russian crude oil, refineries that relied on Urals crude oil must either source a similar type from another country, which is challenging due to limited availability, or switch to a different type of crude oil altogether. This switch can lead to inefficiencies, higher costs, and potentially lower outputs of refined products, all of which have broader economic implications.
Using our estimates of the elasticity of substitution, we approximate production disruptions and calculate changes in input costs for refineries. Our first exercise is inspired by the economic concept of a production function where we assume two different functional forms: one treating crude oil as a homogeneous product and another accounting for quality differences among crude types. Our findings indicate that crude oil is more challenging to substitute across different types when quality differences are considered. By examining various hypothetical scenarios, we demonstrate that production disruptions are significantly greater when quality differences are considered, with disruptions reaching up to 7 percentage points when comparing pre- and post-embargo oil trade flows (see Figure 1). This finding is consistent with reports from U.S. consultancy Baker & O’Brien, which indicate that a full-conversion complex refinery could experience up to a 7% reduction in distillate production after switching from Russian Urals to WTI.
In a subsequent analysis, we calculate an exact input cost price index, taking into account changes in available crude varieties. Comparing cases that treat crude oil as a homogeneous product with those considering quality differences, we found that in the pre-sanction period from 2021 to 2022, observed prices and calculated price indices increased by about 43%. However, once the sanctions took effect, the CES price index declined by 16.8% compared to the observed decline of 13.6%. This attenuated increase likely reflects an increase in available crude varieties. However, this approach overlooks quality differences. When accounting for these differences using the Nested CES production function, the price index only declined by 6.12%, largely driven by the harder substitution between crude types. Thus, the loss of Russian medium-sour crude oil could not be replaced with an equivalent type, leading to a smaller decline in input costs for refineries than observed or suggested by the CES price index.
Table 1 Exact crude oil import price index for the Euro Area.
Conclusion
A common argument in the debate over crude oil sanctions has been that European countries can simply source crude oil from other regions. This is partially supported by the data in Figure 2, which shows that when the EU embargo took effect in late 2022, Russian crude oil imports disappeared, and U.S. crude oil imports nearly tripled to replace it. However, comparing the quality of oil imported from Russia before the sanctions with the quality imported from the U.S. after the sanctions (Panel b, Figure 2) reveals a significant issue. European refineries, which previously imported medium-sour crude oil from Russia, had to switch to WTI — a very light, sweet crude oil — from the U.S.
Figure 2 European crude oil imports from the United States and Russia before and after the start of the EU crude oil embargo.
These differences in the chemical composition have two major disadvantages for European refineries. First, U.S. crude oil trades at a premium and causes thus higher input costs. Second, although of higher quality, U.S. crude oil yields less diesel and jet fuel but more gasoline than previously imported Russian Urals. Given the comparatively larger market share of diesel fuel in Europe, this presents a non-trivial concern.
Although these costs accrue to EU refineries rather than consumers directly, they are reflected by the average change of diesel fuel relative to gasoline prices. Following the sanctions against Russia and the effective loss of access to medium sour crude oil (see Figure 1), which has a higher boiling point and yields a larger share of diesel fuel, the relative price of diesel increased in the vast majority EU member countries and by 8.2% on average (see Table 1). This suggests that the higher input costs for refineries, due to the involuntary deviation from the optimal crude slate, were passed on to EU consumers in the form of higher output prices, in particular of diesel fuel.