Drowning in Tokens

A pragmatist’s take on perceived scarcity and artificial demand

The world has fallen in love with the magical Rube Goldberg machine of money — TOKENS. Everyone wants to tokenize everything, and there’s a massive pipeline of token supply that is coming to market. But without any demand for these assets, what is a token actually worth?

Supply Without Demand is a Dangerous Game

I’ve seen the story of markets with a glut of supply but no natural demand play out before. When I started working in Oil & Gas in 2008, shale gas was the hottest thing around. Companies focused on the exploration and production of assets — finding shit and getting it out of the ground — were going absolutely crazy. Companies saw a cheap resource that could be exploited to juice valuations and rushed to get it out of the ground. Here’s a 5 part rundown of how to flood the market and destroy price:

Production Costs Skyrocket due to Demand for Production Assets

Rigs, which were an important part of the production process and often rented, were leasing at 10–20x their normal rates. Some companies even starting buying rigs in the midst of the frenzy. Crews of labor would rent at 3 to 4x their normal rate. There used to be a joke that the lowest member of the crew on a rig, the so called “rig pig“ was living a life better than most company executives. I worked with several waste trucking companies that were making $20 million PER YEAR hauling waste with re-purposed garbage trucks.

Nabors Industries ($NBR) is a company that specialized in onshore rigs, including a special type of rig called a “jack up” rig that could “walk” itself from one well site to the next on the same drilling pad which helped maximize speed to production. At the peak of the shale frenzy, Nabors stock was trading at $46. Today it trades at $7.

Everyone Overpays to “Squat” on Assets they Believe are Scarce

In the US onshore oil industry, there’s someone called a “landman” who goes around leasing subsurface and mineral rights from private citizens. During the shale boom, landmen were making out like bandits. Companies were buying up leases left and right, and paying ridiculous amounts to lock up land in what they believed was a constrained supply market. Prices skyrocketed from $2 an acre in 2000 and $30 an acre in 2005 to $2,400 an acre in 2008 to $5,000 an acre in 2014 (yes I know wet and dry leases command different prices, simplifying here, go with it).

Under most leases, companies have the right to drill for a period of time, after which the lease expires unless there is a producing well on the property. Once the frenzy faded and natural gas prices fell due to a glut in supply, you can imagine what state companies found themselves in.

Stuck with dead assets on the balance sheet, companies started drilling on leases at a loss in the hopes that they might eventually recover millions of dollars in leasing costs. A very expensive lesson in option pricing, if you ask me (thanks to my professor, Robert Merton, for teaching me how to ask better questions when pricing options).

Infrastructure Capacity aka CAPEX Investments Constrains the Ability to get Supply to Market

However, in the rush to pump assets (CASH MONEY HONEY) out of the ground, companies forgot that this proliferation of new supply coming to market also required entirely new infrastructure. Now the challenge was that in traditional asset plays, once a well was built, assets would flow for 20 years or longer, declining slowly over time. Therefore, most companies would build a pipeline to get gas from the well to a processing plant, where the gas would be turned into a product that was homogenous enough to sell, and from there, connected to a national network of pipelines that all lead to Henry Hub — the primary exchange point where most US gas is priced. Because assets flowed for a long time and because the value chain was vertically integrated, capital investments in this “gas gathering and processing” infrastructure were often recouped within the first few years.

In shale plays, the cost economics were significantly different. There was a rapidly declining curve — a well could be 90% depleted within 2 years, and connecting the dozens of wells in one field (gathering) and then piping to a processing plant could require miles and miles of costly pipeline. Here’s the problem with hard infrastructure that requires CAPEX to build. When the proverbial well runs dry, you still have to find a way to recover your investment costs. In these new shale plays, traditional production companies didn’t invest in building gathering and processing capacity. So — we saw a glut of private equity backed companies evolve — called midstream MLP’s. PE funds went crazy for MLPs, which spurred a massive spree of investment. Here’s a great primer from Oppenheimer Funds if you’re curious. MLPs were the hottest asset, promising 7 to 10% yield per year, and dozens of MLPs sprung up to cater to this new market of supply coming online.

Artificial Demand Can Only Last So Long

MLPs operate on a “toll road” model. Here’s the problem with toll roads. If you want to connect, say, Dallas and Houston — the first toll road will make money. If someone builds a second toll road, then you either need more demand i.e. more cars on the road, or prices will fall to a point where Toll 1 at t1 + Toll 2 at t1 = Toll 1 at t0. Here was the problem with midstream MLPs. A bunch of money, or CAPEX, was spent building toll roads between locations that had temporal, or short term demand. When no long term demand materialized, they were stuck with toll roads few people wanted to drive on.

Companies spent all of their time focused on accommodating supply but didn’t think about long term drivers of demand. CAPEX investments operate on a different timescale than market fads. Cleverly, many of these MLPs signed multi-year contracts to cover costs. They created artificial demand using a financial contract. But once these contracts expired, the market got very wise very quickly. And unfortunately, you can only juice the numbers for so long. Let’s at $EEP and $PAA, two of the MLPs focused squarely on shale plays in isolated parts of the gas transportation grid. Slow build from 2002 to 2009 (anticipation) then a sustained run up as supply ballooned (2009 to 2012), contracts expired and a rapid drop (2014 onward). The similarity in the two charts (and nearly every MLP stock chart) is eerie.

Source: MarketWatch $EEP

Source: MarketWatch $PAA

In the End, a Lack of Natural Demand Trumps Speculative Demand

Anyone who has ever taken Econ 101 has conducted a simple exercise to find price at the intersection of the supply curve and the demand curve. Here’s what was so fascinating about the shale gas boom. When natural gas prices first spiked in the early 2000s, many E&P companies set out to find new sources of gas that had some basic characteristics:

1. Low production costs, including lifting cost aka the cost to get product to market (OPEX)
2. A large reservoir that could justify $20 billion or more in capital expenditure (CAPEX)
3. A friendly political environment and relative geopolitical stability, or the ability to influence / create it
4. Proximity to markets with demand but no supply (natural buyers)
5. MOST IMPORTANTLY — profitability in a wide range of supply demand scenarios and market price scenarios (this is called risk management FYI)

Several large firms, notably ExxonMobil where I used to work, invested heavily in bringing new gas supplies online. Their Papua New Guinea project took nearly 15 years from start to finish, and cost $19 billion dollars. When massive new sources of supply come on line, the cost economics of an industry fundamentally change. In the craze to exploit the seemingly limitless boom of natural gas, many companies forgot to take the broader macro market into account.

The failure on the supply side was incomplete market data, or an inaccurate modeling of the supply curve. When the shale gas boom was attracting crazy amounts of capital, people didn’t account for the major gas projects that were already underway, including Exxon’s Papua New Guinea project, BP & Statoil’s Sakhalin project, and the massive Queensland project. These projects, once completed, would bring new supply online around 2013, and continue ramping up through 2020. As a result, financial investments were made on the basis of a flawed supply model.

The failure on the demand side was speculating on future drivers on demand without any proof of demand. As an applied mathematician, I spent 2006 to 2012 building the models for the oil and gas demand curve. We assumed economic growth would continue at the same pace, and perhaps even accelerate. No one accounted for 2008. We all assumed carbon markets would drive demand for natural gas, a cleaner burning fuel source. An artificial driver of demand, the idea of “clean energy” was an absolute farce. Very few people modeled the alternate scenario — that no one would care about “clean energy” and that no one was willing to pay to retrofit existing power generating infrastructure to use gas instead of coal. Understanding and modeling demand is critical to pricing supply production.

Henry Hub is the onshore sale point for US natural gas. Let’s look at what’s happened to spot prices at this sale point over time.

Source: EIA.gov (link here)

That’s an ugly chart. That’s what happens when you over-invest in supply without proving demand.

And more importantly, let’s look at the companies who were built just to bring this supply to market. Chesapeake Energy $CHK was a sleepy energy company in Oklahoma until it became the hottest company in the industry, snapping up land, leases, and drilling rights across the US to bring shale gas to market. At its peak, the company traded at $60. Last year, the company had to halt trading numerous days to prevent the stock from slipping below $1. The story ended badly for its backers and its shareholders, and its founder, Aubrey McClendon, went from being a messiah to a pariah in a matter of months.

Source: Marketwatch $CHK

At this point, you’ve probably had enough of the Oil & Gas shit, and you’re asking when we get to the dope, super-awesome crypto stuff.

Let me ask you — does this sound familiar?

Here’s my takeway — history doesn’t always repeat, but it often rhymes. Let’s take the lessons from one market and apply them to another.

We have the exact same issue in tokenland. Everyone is so busy pumping out resources aka tokens that we have forgotten the fundamentals of supply and demand, long term risk management, and the dangers of buying options that are improperly priced.

Alright — let’s run this down!

Production Costs Are Skyrocketing due to Demand

The cottage industry of ICO service providers are charging absolutely exorbitant rates. I’ve seen figuring ranging from 3 to 10% and they’re absolutely jaw-dropping. Projects that want to capitalize on the “closing window for ICOs” (a phrase I have been hearing since the summer of 2017 and I have yet to see the window because at this point it’s a fucking garage door and we should just back up the BRINKS truck and take people for all they’ve got) are more than happy to pay any price so long as they believe they can get their turn at the Rube Goldberg magical money printing machine. The problem is that people then start making long term capital planning and investment decisions based on a short term anomaly in the market. I have every reason to believe that over time, the price charges by ICO service providers will fall to the marginal cost of production.

Production constraints are a short term phenomenon. A cursory glance at Adam Smith’s writing on “the invisible hand” of markets makes this all the more obvious. Only real execution capability will stand the test of time, and sadly, real execution capability is in short supply in tokenland. In the absence of differentiating factors and competitive advantage, it is difficult to justify charging massive premiums on production assets, especially when those costs cycle back into the overall cost of production of the actual traded asset. Effectively, ICO service providers are cannibalizing themselves.

Everyone is Overpaying to “Squat” on Assets they Believe will be Scarce

I am increasingly skeptical of the idea that traditional venture investors are well suited to investing in the emerging crypto asset class. Venture investors and family offices have fueled the “landman” hype of token land. The problem is that just like in the real world, there’s limited land to squat on. So-called “hot” token deals don’t even go to average investors anymore, they get farmed out to VC’s, crypto funds (I refuse to call them hedge funds), and industry insiders who are basically buying options on the protocols they believe will win the battle for the “Web 3.0” (I don’t know what that phrase means so don’t ask). Prices for tokens continue to skyrocket despite the fact that token sales are increasingly sketchy and in the bad parts of the oil field. However, under this continued illusion that supply is somehow constrained, the frenzy for tokens will continue unabated. I have yet to see a single VC run a price sensitivity analysis on the entry price for a token. If someone has, please publish it. Venture land needs you! The VC thought leadership olympics around crypto are so loud it’s getting hard to hear, but it’s deafeningly silent when it comes to data-driven insights.

What will happen when all of these firms get stuck with “dead” assets on their balance sheet? As I like to say, the shit rolls downhill. More sophisticated investors will find a way to pass their bags to less sophisticated investors, and so on, until eventually everyone is up to eyeballs in their shit and drowning and suffocating in shit and then finally someone pulls the drain on the shitpool and it all gets flushed out or we all end up swimming in shit. That’s a whole lot of shit.

You former consultants will chuckle fondly at this series of images from a deck called “The Shit Rolls Downhill”

Maybe we should all collectively work on better models for pricing the cost of holding this proverbial “shit,” and figure out a more … analytical way to approach option pricing. Squatting on tokens may seem like a smart idea, but have we ever run the numbers on the true cost of a failure to price our expectations appropriately?

Infrastructure Capacity aka CAPEX Investments Constrains the Ability to get Supply to Market

This is my favorite crypto investment thesis. “I invest in infrastructure.” I’ve fallen into this trap myself, and have only recently begun examining what I actually mean when I say this.

As a thesis, this sounds good. But what does it actually mean in the context of crypto assets? Infrastructure is a sexy category of investment in tokenland because it is more analogous to traditional categories of investment like enterprises SaaS, financial services business, and other business models with clear metrics and a known pathway to profitability. In a world of uncertainty, businesses that appear to generate revenue regardless of market dynamics feel safer that businesses who don’t have a known path to profitability. I would argue that today, many infrastructure companies are profitable because they fill a temporary niche in the market, not because they have successfully identified and solved a long term problem that will continue to exist for the next several decades. Second-order problems are easy to identify and solve for. Root causes of these problems are much more challenging to untangle and take much more energy to solve.

I would argue that many infrastructure businesses today cannot or will not separate recurring revenue from price appreciation of the underlying assets, likely because a significant portion of revenue can be attributed to speculation rather than actual business growth. In a market where asset values are rapidly increasing, it’s easy to believe that investing in additional capacity is going to be profitable. However, hard infrastructure takes a long time to build and markets often change quickly in times of stress or temporary anomalies. Venture funds are the MLPs of cryptoland.

VCs and crypto funds cannot get enough of infrastructure — companies that couldn’t raise a $1M seed a year ago are now raising $20M seed rounds. Entire funds have been capitalized on the thesis of investing in “picks and shovels.” Most infrastructure companies, like pipelines, operate on a toll or fee model. You can build all the pipelines you want, but if there’s no assets to pump through them, no one will earn a toll. It’s unclear that demand for tools that cater to speculative investors will stand the test of time.

Artificial Demand Can Only Last So Long

We are living in a world where token projects are trying desperately to use their massive pools of financial capital to recruit social and human capital aka attention and talent. We’ve seen many interesting ways cryptocurrency projects have tried to generate demand, or at least create the perception thereof. Let’s think through the dynamics.

Projects have far too much money and far too many tokens (supply) on their balance sheets, but little to no demand for these tokens that will push price up the supply curve. Tokenland has far too much financial capital. Social capital is more scarce, but often teams can use financial incentives to “buy” social signaling and virtue signaling from investors. Once the initial sale is over and scarcity has disappeared, projects often resort to printing press releases announcing partnerships and other news to stay relevant. Given how crowded the market is, it takes a lot to capture the attention of the crypto community and to fuel further speculative demand. Bids for attention are becoming increasingly extreme, and tokenland is already pretty extreme. If startupland is any indication, this article about the desperate things companies do for attention at SXSW fills me with anticipation for the crypto conference circus 2018 edition.

From a longer presentation on cryptoassets and capital formation

This is where ecosystem funds come into play. The token economy has fully embraced the idea of artificial demand curation. Ecosystem funds are seeded with cash or tokens on the balance sheet, managed by VCs or other notable community members, and set up for the sole purpose of driving demand for tokens. It’s a brilliant ploy by VCs and asset managers to basically take money from these overfunded projects, charge a management fee and performance fee, and add assets to their balance sheet. It’s a brilliant ploy by crypto projects to drive headlines and continue to compete for relevance and the perception of demand.

A few notable examples are the $2 million IOTA fund, now updated to $10 million, likely because other projects are putting up far higher numbers. Blockstack has a $25 million “Signature” fund. EOS has a $325 million fund managed by Galaxy. Every project is throwing cash, tokens, or some combination thereof at people who may want to build on their platform. Even if an explicit fund isn’t announced, well capitalized companies like, say, Ripple, can simply use assets on the balance sheet to curate demand through investments, like its $25 million investment in Omni, a physical storage startup that really has nothing to do with payments.

What we see is that market players are spending much of their time focused on finding new ways to deploy this supply, but not focusing much on long term drivers of demand. Again, investments operate on a different timescale than market fads. Clever funds will sign multi-year contracts and earn millions in management fees. This is a clear example of creating artificial demand using a financial contract. In tokenland, there is a lot of money floating around meaning this type of activity could continue for a very, very long time. But in the end, value will accrue to projects who can build natural demand, or engage in network acquisition to acquire the demand for other networks with similar use cases (Andy Bromberg wrote about hostile takeovers recently). But until the signals for natural demand can be separated from noise, I expect markets will continue to curate the illusion of demand through even more ecosystem funds that fuel the circular maelstrom of speculative capital.

In the End, a Lack of Natural Demand Trumps Speculative Demand

Please stop saying “tokenomics.” I fully appreciate “tokenomics” will likely be the name of the next Nassim Taleb book and then I can just speak only in his book titles and say “skin in the game” and “black swan” and “tokenomics” and “fooled by randomness” and someone will have to put me out of my misery (Jill Carlson I give you permission to take me out back like Ol’ Yeller).

Token economics are supply and demand. We are pumping out shitloads of supply but we have zero evidence of natural demand. Say it with me — there is NO NATURAL DEMAND FOR (MOST) TOKENS. Let’s go back to the five factors driving capital investment decisions in Oil and Gas land.

1. Low production costs, including cost cost to get product to market (OPEX) — Check! The ERC20 token standard makes it easy to produce a token, and getting it listed on an exchange can be coordinated with capital. Pay to list is a common practice.
2. A large pool of supply that could justify capital expenditure (CAPEX) — Check! Since we are minting our own tokens, and in most cases, keeping 80–90% in the coffers of the company, projects have continued supply to keep flooding onto the market long after the initial sale.
3. A friendly political environment and regulatory stability — Not Clear. I could fill entire volumes writing on the regulatory environment in crypto, but suffice it to say that regulators are watching closely, trying to figure it out, and some jurisdictions will be unfriendly while others will become natural havens where market activity flees.
4. Proximity to markets with demand but no supply (natural buyers) — Fail! There is no *proven* natural demand for tokens. There are hypothetical models for demand, but since most systems and network architectures have yet to be implemented or even tested, most demand is speculative. Demand is also driven by financial investors seeking gains, rather than applications or users needing the token for a specific purpose. Sale structures have been geared towards financial investors instead of natural buyers, which may in turn create a disincentive for natural demand to exist, because speculators have driven up token prices to a point where natural users would rather substitute another asset.
5. Profitability in a wide range of supply demand scenarios and market price scenarios — Fail! I have only seen one project ever offer supply and demand sensitivity modeling to its token holders. I have yet to see a project offer a detailed capital management plan to token holders. The practice of risk management in crypto is a big fat zero, and in the rare cases it does exist, the scenarios entertained by both sellers (suppliers) and buyers (demand) are simplistic and naive in design. This is not a blanket criticism of projects. It’s simply an observation that the art and science of risk modeling in crypto investing is still largely immature and underdeveloped. I plan to spend more of my time focused here in the coming months.

I made this on IMGflip. My gift to you.

Damn, You’re Depressing Me

So if you’ve gotten this far, you’re probably thinking I must suffer from cognitive dissonance.

I am Excited about Tokens, but we Don’t Need to Tokenize Everything

There are natural limits to the market’s ability to absorb the endless supply of tokens. There is a bound to how quickly we can push supply onto an increasingly saturated market. Until the marginal value that can be extracted from the investment community for ideas that have no demand is 0, I imagine we’ll continue to see the effects of market saturation depress growth. Here’s what I ask myself:

• Instead of focusing myopically on supply and being part of the buying spree for artificially “scarce” assets, can we ask more sophisticated questions about demand?
• What is the natural demand for a token or a cryptocurrency?
• Instead of focusing on the ICO or the fundraise as the goal, can we start to develop the body of thought around how natural demand fits into these tokenized networks?
• Can we develop new financial models for how we can measurably and reliably curate demand instead of blindly throwing money at ideas?
• Instead of pushing tokens to market in an attempt to curate artificial demand, can we use natural demand to pull tokens to markets when they are needed?

These are the types of questions I’m asking myself and all of the folks I hang out with here in tokenland. There may not be any answers, yet, but at least we can start asking better questions.

The practice of risk management and the development of more robust analytical tools needs more attention. I plan to spend more time focusing on translating portfolio management theory and financial risk management concepts to the world of cryptoassets so that I can get better at finding signal in this ocean of noise.

Building blockchain protocols and a useable, resilient, sustainable cryptocurrency ecosystem will take a long time. I am incredibly impressed by all of the teams working to build a long term vision of how cryptocurrencies and tokens can create a new model for how distributed systems get implemented at scale.

In the words of the economist Thomas Osenton, “Every product or service has a natural consumption level. We just don’t know what it is until we launch it, distribute it, and promote it.” We’re in the early days of untangling and understanding the dynamics of cryptocurrencies and tokens. I worry that without better questions and without a more critical look at the underlying economics of these systems, we will see an entire generation of companies and ideas go up in flames.

Thanks to Jill Carlson for pushing me to write. In her words — ideas are no good in your head or in emails. Write it down, share it, and learn by getting feedback. Thanks to Jeremy Welch for pointing out the fallacies in my reasoning and my use of “flowery” language.