How a Tenuous Saudi-Russia Oil Alliance Could Melt Down

After a historic glut—partly of their own making—Saudi Arabia and the rest of the Organization of the Petroleum Exporting Countries, joined by Russia and even a helping hand from the Trump administration, agreed to slash crude output by an unprecedented 9.7 million barrels a day in April. Compliance has been remarkable. In mid-July, they agreed to allow production to increase by 1.6 million barrels a day.

The latest adjustment was a reflection of a demand picture that seems to be improving. Yet that very development could hobble cooperation between Saudi Arabia and Russia going forward.

“Under $40 [a barrel], they were able to come together. The higher the price, the harder it will be to get Russia to go along with continued production cuts—especially once you get to $50 a barrel for Brent Crude,” says veteran OPEC-watcher Gary Ross, Chief Executive Officer of Black Gold Investors.

Saudi Arabia and Russia, the second and third largest oil producers behind the U.S., have a tenuous partnership. While Russia made a rare show of cooperation in 2017 to prop up battered oil prices, that agreement fell apart earlier this year, devolving into a price war greatly worsened by the pandemic. Before that, Russia failed to follow through on all three deals it had struck with OPEC since 1998, according to the Center for Strategic and International Studies.

Both countries could clearly do with higher oil prices: Russia’s economy could contract by as much as 6% this year, according to the World Bank. President

Vladimir Putin

has warned the coming recession could be worse than the slump the country experienced in 2008-09. Saudi Arabia’s economy could shrink by 6.8%, according to the International Monetary Fund. While both face pressure, price objectives pull them in different directions. Saudi Arabia needs oil prices to be at $94 per barrel to balance its budget. Russia claims it can balance its budget at $42, though Helima Croft, global head of commodity strategy at RBC Capital Markets, figures it is more like $65 once its actual security budget is included.

Whatever the actual break-even is, the recent easing of cutbacks might already be too much.

“They lost the momentum for price,” Mr. Ross said. Ms. Croft said in a report discussing the production increase that the “margin for error appears rather slim and the cost of miscalculation could be calamitous.”

The Kingdom in particular treads a fine line internally. To deal with the economic fallout resulting from the oil demand collapse, Saudi Arabia has implemented some unpopular measures this year, tripling its value added tax and suspending its cost of living allowance to state employees. Meanwhile, King Salman was recently hospitalized to treat an inflamed gallbladder, raising questions about succession. Though his son Crown Prince

Mohammed bin Salman

has been the de-facto leader, and a popular one, an official change of power could make additional austerity measures more delicate. RBC notes that power transitions in Saudi Arabia traditionally come with temporary increases in domestic spending.

Meanwhile, Russia, which values market share, faces internal pressure from its energy companies to allow higher production: Many smaller firms, which account for more than a million jobs, are at risk of going bankrupt. This is partly because of the way the Russian tax system is structured: Any windfall gains from higher oil prices tend to go to the state, not the companies, creating an incentive for energy companies to increase volume at lower prices to generate profit, explains Ms. Croft.

Russia also has a lever that Saudi Arabia lacks: Its currency drops when its economy falters, while Saudi riyals are pegged to the U.S. dollar. Russian energy companies pay their costs in depreciated rubles, while exporting in dollars or euros, according to Paul Sheldon, chief geopolitical advisor at S&P Global Platts. Russia is also especially sensitive to letting prices surpass the level that would allow U.S. shale producers to gain market share.

Once you add in the objectives of other countries, the picture gets even messier. The budget situation for other OPEC members looks even more dire than Saudi Arabia’s, creating temptation to stray from the agreed cuts as prices stabilize. Relationships within the organization have been strained since April.

It took an unprecedented emergency to get the Saudis and the Russians together earlier this year. Getting that cooperation to continue to prevent another leg down in oil prices looks like a long shot.

—Jinjoo Lee

Write to Jinjoo Lee at jinjoo.lee@wsj.com