Saudi Arabia and Russia share common goals of diversifying and modernizing their economies, but future cooperation could be difficult until they find a way to overcome their competing goals in the global energy markets.

Russian President Vladimir Putin enters the hall to meet with Saudi Arabia's Defense Minister Prince Mohammed Bin Salman, left, in the Konstantin Palace outside St. Petersburg, Russia, Thursday, June 18, 2015. Photo: Mikhail Klimentyev/RIA-Novosti, Kremlin Pool Photo via AP

In just the past few months, dramatic changes have occurred in the highest echelons of the Saudi elite, with significant implications for Saudi foreign policy in the Middle East and the future direction of global energy markets.

For example, Ali al-Naimi, the long-time minister of petroleum and mineral resources who served under three kings, has been replaced by Khalid al-Falih, the former CEO of Saudi Aramco (the nation’s energy juggernaut). This shakeup at the top of Saudi Arabia’s oil industry is especially significant because it occurred against the backdrop of Prince Mohammad bin Salman unveiling an ambitious economic reform plan labelled Vision 2030, which sets the target of transforming the Saudi kingdom into a diversified economy, an investment powerhouse and a global hub for trade and logistics.

Saudi Arabia, long perceived as a Byzantine gerontocracy, is now on the verge of falling under the sway of this 30-year-old deputy crown prince. As Saudi Arabia’s defense minister and the president of its Council for Economic and Development Affairs with huge sway over the country’s oil sector, Prince Mohammad bin Salman is the rising star of Saudi politics.

Since King Abdullah’s passing away in January 2015, Saudi Arabia, under Mohammad bin Salman’s guidance, has managed to initiate multiple actions that hint at further change ahead. Riyadh launched a military operation in Yemen against Houthi forces deposing President Hadi. Saudi Arabia has also taken part in a coordinated effort of oil-producing countries to curb their production before calling it off two months later.

Saudi Arabia’s budget crisis

Complicating matters is the fact that Saudi Arabia is currently in the middle of a budget crisis. As the price of crude oil fell by more than 50 percent between mid-2014 and early 2015, most of the petro states have suffered one way or another. Despite being the world’s second-largest oil producer, the Wahhabi kingdom has seen its budget deficit skyrocket to 15 percent ($98 billion) in 2015. If the low-price environment were here to stay for a longer period of time, Riyadh would run out of money within 3-4 years.

For 2016 Saudi authorities forecasted a budget deficit of $87 billion and decided to implement a privatization plan to avoid market volatility and social unrest. Apart from bringing housing utilities closer to non-subsidized market levels, the plan aims to open up the healthcare, education and military sectors of the economy to foreign investment. Saudi Arabia is also getting ready to introduce its first non-religious tax, the VAT, in late 2016 or early 2017, although basic goods such as bread, milk or water would be exempt from it. A “sin tax” on tobacco products and sugary beverages might follow shortly afterwards.

The new Mohammad bin Salman-led administration intends to go even further and sell a 5 percent stake in Saudi Aramco, the country’s economic flagship representing three-quarters of government revenues and 45 percent of Saudi Arabia’s GDP. Amongst oil sector specialists, it is assumed that up to the 5 percent that will be offered in 2018 via an initial public offering that should yield $20-30 billion.

Closely intertwined with its decision to open up Saudi Aramco to investors, Riyadh announced its objective of creating a $2 trillion megafund aimed at diversifying Saudi Arabia’s economy away from oil. There has been almost no information on the funding source of this far-reaching endeavor, yet it seems that its scope will eventually be much smaller, as the $2 trillion seems to represent the total worth of Saudi upstream assets, which the government has no intention of selling.

Generally speaking, not everything coming out of Saudi Arabia’s leading political circles should be taken at its face value, as there is a no-nonsense power struggle for the top political post. Mohammad bin Salman is doing his utmost to retain as much control as possible over different spheres of Saudi Arabian life.

Amid intensifying rumors about King Salman’s ailing health, Mohammad bin Salman managed to attain, perhaps only temporarily, unprecedented levels of political influence. In this, his appeals to reform the heavily oil-dependent economy played a major part in improving his public standing.

This will not be an easy task – even the IMF expects Riyadh’s oil revenues to remain at close to 40 percent of GDP, as Saudi Arabia’s abundant oil reserves make it the most suitable place on earth to produce crude. With 261.1 billion barrels worth of recoverable oil reserves (18 percent of the global total), more than 60 years of reserve life and production costs between $7 and $10 per barrel, Saudi Arabia is bound to remain the oil market’s key actor and OPEC’s leading force.

So plentiful are its resources that Saudi Arabia can afford to keep 0.5 million barrels per day of potential output shut down in the Saudi-Kuwait Neutral Zone. The Neutral Zone consists of the Khafji oil field that has been temporarily shut down for two years already, allegedly due to its non-compliance with Saudi environmental standards, and the Wafra field shut down since March 2015 in view of operational difficulties. The decision to put them back into operation rests within the competencies of the Saudi king and the Kuwaiti emir; however, market conditions ought to be more favorable for such a move.

Current disputes notwithstanding, Saudi Arabia is the world’s second oil producer with an average 2015 output of 10.2 million barrels of oil per day. Given its spare production capacity of 2 million barrels per day, it could shoot forward to first place anytime it wanted, yet so far it has pursued a policy of not depressing oil prices below the Kingdom’s comfort zone (which is, however, significantly lower than that of other oil-producing nations). Still, with 18 percent of global oil reserves and 13 percent of global oil supply, Saudi Arabia might pull off some unpredictable moves in the future to secure its market position.

Also read: "Why Saudi Arabia could decide to compromise with Russia"

How will Saudi moves influence Russia?

It is difficult to find a sphere in which Russia and Saudi Arabia have the potential to form natural alliances. Within the oil sector, they traditionally compete for global leadership. Despite some rumors concerning a possible Iskander missile sale to Riyadh, Saudi Arabia’s military orientation is staunchly pro-Western when it comes to arms sales. Politically, Riyadh perceives Russia’s support of the current Syrian regime, as well as its presumed rapprochement with Iran on Middle Eastern matters, in a highly negative manner.

However, one factor unites the two countries – their unwillingness to see the current status quo change considerably. Both countries enjoy a steady supply of revenue from energy resources; consequently they do not want to see oil’s viability as a transportation fuel falter. If the Syrian and Yemeni conflicts would end in a way that neither side feels muscled out, one could foresee a similar scenario for political matters, too.

As soon as the new administration of the Ministry of Petroleum and Mineral Resources entered into office, speculations on Saudi Aramco raising its 2016 output, bolstered by CEO Amin Nasser’s comments, began to proliferate. Yet after numerous claims regarding an inevitable rise in oil production during 2016, Saudi Arabian officials seem to have embraced the current state of affairs. As Al-Falih stated in June, Riyadh would rather fight the long-term battle for global market share than lead protracted minor price wars.

This conciliatory tone might be partly the result of typical attempts to change perceptions in the market since Saudi-Iranian tensions have in no way become less intense. However, it is also a thinly disguised hint that Saudi Arabia sees the $50 per barrel environment as a convenient one. This might be good news for oil producers across the globe, especially the American shale industry that is highly dependent on Saudi policies, as the last two years have forced them to produce crude at a loss.

Russia ought to keep a close eye on Saudi actions, as it was to a large extent Riyadh’s refusal to adhere to OPEC quotas in December 2014, as well as its abandonment of the Doha talks this May, that has made any sort of oil price coordination impossible amongst leading oil-producing nations.

Russia has largely adjusted to the low oil price environment. After double-digit numbers last year, this year’s inflation is presumed to reach 6 percent. Having reached its short-term peak in late 2015, unemployment is plateauing at 5.7 percent, which means the government has managed to avoid a 2008-2009-style crisis (when the unemployment rate hovered around 9 percent). Since mid-2014 Russia’s foreign debt decreased by almost 30 percent, to the level of $516 billion as of April 2016.

Yet, despite some minor successes in stabilizing the country’s economy, most major challenges remain – Russia is still in recession, with limited access to mid- and long-term international financing, a painstakingly high Central Bank base rate and unbearable household credit conditions.

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Russia needs Saudi Arabia’s collaborative approach if it wants to dampen the oil market’s oscillations, thus providing suitable macroeconomic conditions for it to overhaul critical segments of its economy. Were Russia to revive economic growth, several overdue initiatives might finally be put into practice, for instance, raising the retirement age, privatizing state-owned companies (including Rosneft) and improving the country’s proverbially underdeveloped infrastructure. These measures could and should be done regardless of the future implementation of sanctions.

Moscow and Riyadh’s aims are congruent in this respect as both countries are struggling to relinquish their dependence on natural resources. They both aspire to erect a new economy, modern and diversified, that would be ready to cope with the challenges of the 21st century.

The countries’ coexistence on the energy market will not be devoid of conflicts. Against the background of Iran’s comeback, Saudi Arabia will opt for a more aggressive approach on traditional Russian market outlets in Europe. In this vein, Saudi Aramco has signed in June 2016 a long-term oil supply contract with Poland’s leading oil company in what was previously thought to be Russia’s domain. Russia might be forced to play along as the Sunni-Shia rivalry migrates to the energy sector.

Yet, the Achilles heel of Saudi-Russian cooperation still lies within the political realm. The prompt rise of Mohammad bin Salman is indicative of Saudi Arabia’s increasing assertiveness in political matters. The Syrian and Yemeni conflicts ought to end in a way that at least partially placate Riyadh’s concerns, thus keeping the Saudi-Iranian clash under check. Were this to materialize, any structural or generational changes within the Saudi kingdom should not culminate in an escalation of tensions and worsening or relations with Russia.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.