Global prisoner’s dilemma will determine electricity prices

For those whose livelihood is impacted by electricity prices and who have a bit of spare time on their hands this Easter, it might pay to spend a couple of hours watching the movie “A Beautiful Mind”.

The film is about the life of mathematician and Nobel Laureate John Nash who pioneered the study of game theory, which at its simplest is a way of calculating the likelihood of different decisions and outcomes in negotiations and social situations.

Game theory, as it tuns out, is particularly relevant to tonight’s virtual meeting of most of the world’s oil producing nations. They will consider whether and by how much they will cut oil production and recover the price of oil. This will flow on to the price of gas, and in turn the price of electricity in the National Electricity Market.

Gas is so influential to Australian electricity prices because gas fired peaking power stations are the marginal cost generators, and how they bid into the market mostly sets the spot price. Gas peakers buy gas on the spot market, and so will always bid to cover their fuel costs. High gas prices means they have to bid higher and wholesale electricity prices increase. Cheap gas prices mean they bid lower, which means lower wholesale prices.

VWA quarterly average NEM electricity prices and spot gas prices

Wholesale electricity prices have halved since the start of the year following a combination of factors like easing demand and increasing renewables generation. But the overwhelming factor to push electricity prices lower has been the sharp drop in spot gas prices.

The negotiations at the OPEC++ meeting tonight (that’s OPEC plus Russia, plus Norway, Brazil and Canada) bear a remarkable similarity to the Prisoner’s Dilemma, a basic game theory scenario which considers how two prisoners negotiating for their own freedom are more likely to not co-operate, even if it is in their own interests to do so.

Last time OPEC+ met, Russia and Saudi Arabia decided to ramp up production, just as global demand was falling (by around 30 per cent so far) as a result of the lockdowns and constrained commercial activity in response to the COVID-19 pandemic.

This was seen as a deliberate, strategic attempt by the second and third largest oil producing nations to use the pandemic to crush oil prices long enough to cripple output by their major rivals, in particular by sending higher cost, high debt US shale oil competitors broke.

The problem with this strategy is it hurts their own revenues too, particularly if prices fall as low as they have (below USD$30 a barrel). To sustain this strategy prices need to be held high enough to minimise self-harm, but low enough to hurt rival oil producers.

In the manoeuvring ahead of tonight’s meeting, Russia has signalled it is willing to to cut production, but only if US oil producers cut production too.¬†Smaller oil producers like Algeria face severe economic problems if the low oil prices continue, and are trying to encourage both the meeting to take place and agreement on production costs.

Smaller producers can’t stop the larger nations from overproducing. Russia wants to use the crisis to curtail US production, whether by negotiation now or financial harm later. The US is now the world’s biggest oil producer and, to date, been reluctant to meet with OPEC let alone cut production deals with them.

Like the Prisoner’s Dilemma game, even if the best interests of all the participants are served by co-operation, that doesn’t mean they are going to agree.

The impact on the wholesale price and investment in the NEM will continue to be impacted by these negotiations regardless of the outcome of tonight’s meeting.