The international oil trade is a tricky one. Power generation, transport, agriculture, construction and huge swathes of industrial output are totally reliant on consistent and timely deliveries of black gold. A nation deprived of oil will fall to its knees almost immediately. Oil exporting nations meanwhile are just as dependent on crude oil because it often makes up the bulk of their economic output. It is little wonder therefore that oil is often subjected to sanctions, embargoes, tariffs, price caps and any number of trade restrictions limiting the free flow of this vital resource.

Ongoing oil sanctions

In a bid to put economic pressure on Russia, the US recently enacted measures penalising countries who continued to buy Russian oil and gas. As part of the same gesture, the European Union has banned seaborne imports of Russian crude oil and has reduced its reliance on such by around 90% compared to five years ago. Venezuela has been subjected to US sanctions, which have substantially affected the country’s output and revenue. Iran is also no stranger to such measures, having long been subject to US sanctions levelled against its crude exports.

But what happens when a given nation is sanctioned in this way? Does the leadership of the affected country simply throw up its arms and give up? What are they to do? Leave the money on the ground? Logistically, how would a sanction be enforced anyway?

In reality, enforcement is very difficult. There is no global police force to survey every inch of every border, nor one to monitor every shipping lane or port. International law is only real as far as it is applied. Crude oil has the added complication of being largely fungible. Without advanced forensic techniques, it is very difficult to say where a given volume of oil came out of the ground. This is made all the more complex when different oils are blended together to obfuscate their origin. Besides, almost no one cares enough to find out. No tracking number, no clear properties besides density and sulphur content. Perhaps sanctioned countries can export after all. As the saying goes, where there is a will, there is a way.

Shadow fleets

Provided the country in question is not landlocked, getting the oil to the coast is trivial. But this is where oil exporters begin to employ a certain level of… creativity. The first problem is finding a vessel willing to take on the sanctioned cargo. Some sanctions cover entire shipping fleets, as is the case with the US sanctions on Sovcomflot, Russia’s state-owned shipping giant, while others reach all the way down to specific vessels. Any company caught transporting illegitimate crude oil will likely face harsh punitive measures from anyone planning on staying in America’s good books. To bypass this, such cargoes are typically loaded onto older vessels of unclear ownership, registered in jurisdictions far removed from traditional shipping networks. Suffice to say these vessels have less than optimal insurance coverage and often make use of flags of convenience. These tankers would utterly fail any kind of environmental or safety inspection and would otherwise be condemned to a one-way trip to an Indian scrapyard. The ship’s paperwork would certainly raise a few eyebrows in any respectable port of entry.

Alas, beggars cannot be choosers. Once loaded with the outbound crude oil, the laden tanker gets on its merry way. While at sea, the vessel will likely turn off its AIS transponder, an unsafe practice which makes it invisible to other ships and essentially untrackable. It may also provide false information to marine traffic systems, such as port of origin and cargo type. One by one, these ghost ships take to the high seas, together forming a shadow fleet of crude oil tankers intent on evading detection at all costs.

To cover their tracks even further, tankers will transfer their cargo to other vessels while still at sea, often in international waters, far away from prying eyes. Some journeys may implement several ship-to-ship transfers, creating further confusion. Certain vessels may even pretend to be different vessels entirely, making the trail of ownership utterly impossible to unravel. The receiving ship will inherit a catalogue of forged documents and possibly even rename and reflag at sea – just like Nicolas Cage in Lord of War.

The crude oil eventually makes its way onto the final cargo ship. Destination: China.

Teapot refineries

Shadow fleets have become ruthlessly effective at their task, but constitute only the first step in evading sanctions. Crude oil is of limited use until it has been refined, which is where the next stage of the operation comes into play. Once the tanker enters Chinese waters, it sets course for one of the lesser-known ports of entry, typically in Shandong province. These ports are located in close proximity to small independent crude oil processing plants known as “teapot refineries” due to their reduced scale. These teapots typically process around 50,000 barrels a day, which is only a tenth of what a major refinery would handle. Such installations are not state-run and therefore operate at a greater distance from the normal compliance standards enforced by Chinese law. This allows them to be somewhat more opportunistic and flexible with whom they choose to do business.

Teapot refineries, due to their age and size, are not as efficient as their larger counterparts. Moreover, they often lack the more advanced technology necessary to produce high-end products such as jet fuel or low sulphur diesel. Their economic viability stems from their ability to purchase sanctioned oil, which is priced substantially lower than the market rate. After all, the seller is in no position to haggle and is more than happy to get any price above the cost of extraction. Iranian crude will typically sell $20 per barrel below the Brent benchmark, while Venezuelan oil may be acquired at up to a $30 discount. Once the vessel is cleared to dock, the port authorities are assured that everything is definitely above board and the cargo is marked as originating from Malaysia or somewhere. Wink wink, nothing to see here officer.

Alternative payment rails

This brings us neatly onto to question of payment. Going to all the effort of avoiding sanctions at sea is totally useless if the seller cannot take payment once the shipment reaches its destination. In many cases, the nation in question will have no access to USD wire transfers and will likely have been blacklisted from the SWIFT messaging network. Once again, a measure creativity is required. In the case of Chinese Teapot refineries, payment may be settled in Renminbi (RMB) via local Chinese banks. Those funds are then used to purchase goods in China, such as vehicles, infrastructure, or advanced telecoms equipment.

Other times, the currency step is skipped entirely and the countries in question engage in barter trade instead. Iran and India have resorted to such trades in the past, in which Iranian crude oil was exchanged for pharmaceuticals and food items. Arrangements can even involve three different parties, engaging in triangular bartering agreements including oil, equipment and military support for example. Extreme operations, such as crude oil sales from Russia to North Korea, are so opaque as to be essentially unknowable.

Cryptocurrencies are a growing option for evading financial sanctions and are used extensively among all the countries mentioned above, but present some critical flaws. Firstly, just as in the traditional banking system, accounts/addresses can be monitored, blocked and blacklisted. By necessity, blockchain forensics is a growing discipline and the usual cat-and-mouse games are alive and well. The bigger problem however is the issue of on/off ramps. Sending a $1 billion transaction is trivial on any blockchain, but how does the recipient turn that into cold hard cash? Over-the-counter desks for this kind of thing can be found in Hong Kong and the UAE, but would struggle with the volumes typically required. Smaller amounts are always possible, but it is easy to see why bartering remains so prominent.

Bottom line

The moral of the story is that true sanctions are impossible. No enforcement agency has the power and reach to stop countries from trading with one another should they wish to do so. Enforcing a strict sanction can even have the opposite of the intended effect, because it forces the targeted nation into becoming more economically resilient, as is the case with Russia for example. As for the future of teapot refineries, it is difficult to make predictions. Supply and demand both fluctuate considerably within international oil markets and smaller refineries are more vulnerable to such volatility. Sanctions are even more fickle, imposed and lifted with little warning. Such clandestine operations are at the mercy of temperamental geopolitical trends, but for the time being, shadow fleets and teapot refineries are not going anywhere.