What happens when the price of Bitcoin falls below the cost of mining?
In recent months, a topic that has not been discussed as of late has resurfaced as the bear market continues to wear market participants down.
What happens to Bitcoin when it becomes unprofitable to mine?
In the commodity markets, when a commodity like gold becomes unprofitable to produce, marginal producers begin to exit the market. After a period of consolidation this leaves only the lowest cost producers to continue production. The market therefore reaches a new price equilibrium. Satoshi anticipated this and Bitcoin attempts to emulate this natural balancing process using a built-in difficulty-adjustment mechanism.
Today, the break-even costs for mining Bitcoin is approximately $4000 per BTC at the current difficulty level of ~5 trillion, assuming a very conservative~$0.05 per kWh. In reality, most if not all Chinese miners are likely to have an “all-in sustaining cost” (AISC) that is much lower than that considering economies of scale and merge-mining etc. AISC as used in the precious metals mining industry refers to the lowest commodity price a producer can tolerate before free cash flow turns negative and lights start turning off. The profitability of each of these Bitcoin mining operations sit on a AISC spectrum, and when price continues to fall, the most expensive miners will first exit the market. Bitcoin mining profitability, on average, is already at its lowest historically.
A quick primer on the difficulty adjustment mechanism. Bitcoin’s network difficulty changes every 2016 blocks, and at the desired and target rate of 10 minutes per block, 2016 blocks would take exactly two weeks to compute. If the previous 2016 blocks takes more than two weeks, the difficulty is adjusted lower and vice versa, but by no more than a factor of 4 each time to prevent sharp adjustments. Hypothetically, if the Bitcoin’s price continues to fall significantly, the difficulty could theoretically be recursively adjusted to a point (“death spiral”) where one could potentially even begin mining on a laptop.
For the first time in 2018, we experienced a drop in difficulty and hash rate (of 3.5%), which tells us the highest-cost miners have started abandoning the network. This implies their AISC was likely higher than $6–7k per BTC, that the opportunity cost of their capital was higher than the margins they were receiving from Bitcoin, or that there were some other SHA-256 coins that were more profitable than Bitcoin to mine and that it was worth the time, trouble and liquidity risk to temporarily move away from Bitcoin. The second scenario is unlikely as Bitcoin mining machines are specifically manufactured to mine Bitcoin and cannot be repurposed.
This begs the question: What if a large number of miners left the network, to the point that the network slows to a complete crawl? If block creation speed slowed down dramatically, could the next difficulty adjustment never come along?
I would argue such a scenario isn’t likely to happen. Marginal producers would have the greatest economic incentive to bear short-term losses to trigger the next difficulty adjustment as they would be the prime beneficiary given the marginal producers at any price point will experience the largest delta change in profits. Also, unlike traditional commodity producers where the length of time to the next market upturn is completely unknown and effectively a gamble, measured in years, and therefore requires maximum fiscal prudence for both debt and shareholders, Bitcoin operates on a much quicker, fixed and predictable cadence of 2016 blocks which gives any Bitcoin producer cashflow visibility, knowing the next profitable season is just around the corner.
Furthermore, miners generally do not react immediately to lower prices, but instead due to their already large upfront capital expenditure, can be expected to continue to mine for as long as MR>MC, or even willingly bear short-term losses as any miner would tend to have a positive expectancy for Bitcoin’s price in the medium-term. While some miners will pivot to other SHA-256 coins, such altcoins are generally not the target of larger operations as there is insufficient liquidity for a miner to liquidate for capital expenditures and ongoing costs. The long-term survivability of alt-currencies are also in doubt and inventory risk is non-zero.
This in no way implies that the breakeven cost can be seen as a price floor. In Bitcoin’s case, unlike commodities, mining activity responds to price, not the other way round.