The Fundamentals of Bitcoin Mining Economics
Examining the Key Drivers of Profitability in the Bitcoin Mining Business
At its core, bitcoin mining is a commodity production business:
- The end-product, bitcoin, is regulated as a commodity by the Commodity Futures Trading Commission.
- There exist robust and growing spot and derivatives markets around the end-product.
- Units of the end-product are largely undifferentiated from, and are fungible with, one another — a hallmark of traditional commodities.
- As with traditional commodities, the process of producing bitcoin requires significant upfront investment in fixed assets and is extremely energy intensive.
- Market participants with low marginal cost of production enjoy sustained competitive advantages (more on this later).
- And like traditional commodity markets, successive layers of the supply chain refine or add value to the commodity to transform it into a state that is more useful for particular end-markets. We see this in oil and gas markets, with the concept of upstream, midstream, and downstream operations, but it also exists in bitcoin mining: miners produce hash rate and sell it to mining pools, which in turn “refine” the hash rate by using it to create blocks that are more useful to the Bitcoin network. (Credit to our friends at Luxor for advancing this view of miners and their relationship to pools.)
Comparing Bitcoin mining revenue to other commodity production revenue adds some perspective:
Figure 1: Estimated Annual Production Revenue of Various Commodities
The economics of bitcoin mining can be complicated and entail several unknown variables:
Figure 2: Simplified Bitcoin Mining Economics — Knowns & Unknowns
In Figure 2 above, the light blue terms represent variables that are neither known to nor controlled by the miner. As in most commodity production businesses, revenues are highly variable and cyclical, and costs tend to be stable and relatively predictable.
This dynamic means miners focus on what they can control: the cost side of the equation. A miner’s relative positioning on the industry cost curve is paramount. The cost of power is particularly important, as this input alone accounts for the vast majority of a miner’s cash operating expenses. The lower a miner’s cost of electricity, the higher that miner’s profit margin in bitcoin bull markets and the more resilient that miner is during price drawdowns. According to BitOoda’s Bitcoin Mining Hashrate and Power Analysis (July 2020), 50% of bitcoin mining capacity pays $0.03 or less per kWh for electricity today, which represents a steady decline from previous years’ levels (Figure 3).
Figure 3: Estimated Mining Industry Power Cost Curve
A critical factor that distinguishes Bitcoin from other commodities is its fixed supply and fixed issuance schedule. In traditional commodities, producers generally increase output in response to increases in demand (i.e., higher market prices for the commodity). When the price of gold increases, gold miners have a clear market incentive to invest in additional exploration, machinery, and labor to extract more gold from the earth. Indeed, given sufficiently high market prices it would become economical to scour the galaxy in search of gold-rich asteroids from which to extract the metal for sale on earth. This responsiveness of supply to increases in demand brings commodity prices back down.
By contrast, Bitcoin’s supply is perfectly inelastic (Figure 4) thanks to its hard cap of 21 million units and the difficulty adjustment that occurs every 2,016 blocks. The difficulty adjustment is the feature of the protocol that regulates the issuance of new bitcoins and — you guessed it — continually adjusts mining difficulty such that new blocks are found every 10 minutes on average, regardless of how much hash rate joins (or leaves) the network.
Figure 4: Perfectly Inelastic Supply Curve
The difficulty adjustment is also the key to what some have appreciated as Bitcoin’s “Number Go Up” technology, which ensures that any changes in demand for the commodity manifest in its price, since the total bitcoin supply and its issuance schedule are both fixed.
This dynamic also has some non-obvious implications for low-cost miners during bitcoin bear markets. As bitcoin’s price falls, miners with a higher marginal cost of production may power off their machines as their operating costs exceed their revenue. This results in a decline in total network hash rate. But due to Bitcoin’s difficulty adjustment, the same number of bitcoins continues to be produced, meaning remaining miners are now earning a greater share of total bitcoin-denominated mining rewards than they were previously (ignoring the USD-denominated value of those bitcoins). For low-cost miners who have already adopted bitcoin as their unit of account, this is an ideal scenario, as it allows them to accumulate more bitcoins than during a bull market. Miners still using fiat currencies as a measuring stick will also enjoy outsized returns, provided they can survive for the remainder of the bear market with a treasury of bitcoins that will appreciate when Number Go Up again. Indeed, bitcoin’s price has experienced several bull / bear cycles, but the nadir of each bear market has been multiples higher than the peak of the prior cycle. These cycles have been driven by adoption waves, as demand for bitcoin the asset and Bitcoin the network has increased, as well as the quadrennial block subsidy halvings, which reduce the flow of newly issued bitcoin to the market.
Forecasting for Bitcoin Mining
When thinking prospectively about bitcoin mining profitability, the key factor is not the price of bitcoin or network hash rate alone, but rather the relationship between the two. When bitcoin price appreciation outpaces increases in network hash rate, mining conditions improve. Conversely, when network hash rate growth outpaces bitcoin price appreciation, the outlook for mining worsens.
Rather than forecasting the trajectory of price and hash rate separately, we prefer to collapse them into a single metric that captures their relationship: daily revenue per unit of hash rate, expressed using dollars per terahash per second per day ($ / TH / s / day) (Figure 5). This metric aims to answer the question, “for a given unit of hash rate, how much revenue can a miner expect to earn each day?” Note, forecasting a constant $ / TH / s / day does not necessarily indicate an expectation that both price and hash rate will remain flat over time. Rather, it could express a view that — in general and over the long term — network hash rate follows bitcoin price. That is, any increases in bitcoin price will eventually be equilibriated by commensurate increases in network hash rate, and vice versa.
Figure 5: Daily Revenue per Unit of Hash Rate (Trailing 2-Week Average)
Importantly, there is an asymmetry to how quickly network hash rate tends to respond to changes in bitcoin price. When price decreases, hash rate drops more or less immediately, as miners whose cash operating costs exceed their fiat-denominated revenues shut off their machines (Figure 6).
Figure 6: Immediate Hash Rate Response to Bitcoin Drawdown — March 2020
In contrast, when price increases, there is generally a delay of several months before the network sees a commensurate increase in network hash rate (Figure 7). It takes time for new miners to identify site locations, source power contracts, build out facilities, and place and receive machine orders; and for machine manufacturers to secure space at the semiconductor foundries, order more components, assemble more machines, and deliver them to end customers. BitOoda’s research report estimates this delay typically lasts 4–6 months.
Figure 7: Delayed Hash Rate Response to Bitcoin Bull Run — 2017–18
Since March 2020, daily revenue per unit of hash rate has increased sharply, as bitcoin price has skyrocketed from ~$5,000 to ~$60,000, a roughly 1,108% increase, while hash rate has grown from 119 EH / s to 167 EH / s, an increase of merely 40% (Figure 8).
Figure 8: Delayed Hash Rate Response to Bitcoin Bull Run — 2020–21 (Indexed)
While this lag in hash rate growth is generally to be expected, we suspect the effect has been particularly acute since March 2020, when COVID-19 lockdown policies disrupted global supply chains and a chip shortage — also related to COVID-19 — beset the broader semiconductor industry. All this means it has been exceptionally challenging for miners to procure mining machines with which to outfit new operations over the past 12 months.
Volatility & Miner Profitability
Figure 9 depicts a hypothetical miner’s operating margins across various daily revenue assumptions (expressed as revenue per unit of hash rate) and operating expense thresholds, assuming latest-generation hardware is purchased at current market prices. For context, based using today’s bitcoin price and network conditions, daily revenue per unit of hash rate sits near $0.35 / TH / s. Following the third block subsidy halving, however, this metric reached an all-time low of ~$0.070 / TH / s in July 2020 (Figure 10).
Figure 9: Sensitivity Analysis — Bitcoin Mining Operating Margins (%) (Includes Depreciation)
Figure 10: Daily Revenue per Unit of Hash Rate (Trailing 2-Week Average) — 2020 Halving
Interestingly, at $0.07 / TH / s / day, miners who have purchased latest-generation machines at today’s prices wouldn’t be generating enough revenue to cover their depreciation expense alone — even assuming $0 of other operating expenses (free electricity!). This is a testament to the frothiness of ASIC market today as well as the widespread expectation that constructive mining conditions will persist in the near to medium term. At today’s level of ~$0.35 / TH / s, miners with BitOoda’s average electricity cost of $0.03 / kWh are enjoying operating margins of ~72% (assuming no additional operating expenses beyond machine depreciation). This ~$0.35 / TH / s would need to fall below $0.10 / TH / s for this average electricity cost to result in negative operating margins. Assuming no change in bitcoin price and average transaction fees, this would require hash rate to increase from ~167 EH / s to close to 600. In summary, it’s a good time to be a bitcoin miner, but the favorable conditions have largely been reflected in the prices of mining machines (Figure 11).
Figure 11: Bitcoin Mining Machine Pricing
Figure 12 displays this same operating margin data in graphical form:
Figure 12: Bitcoin Mining Operating Margins at Various Revenue and Cost Thresholds
In reality, most miners assess whether to continue mining based on their cash operating margin, a profitability metric that excludes machine depreciation, which is a non-cash expense. Said differently, the average miner will continue running their machines until their cash costs exceed their revenues. This dynamic can be examined through a miner’s EBITDA margins, which are shown in Figure 13 across various daily revenue per unit of hash rate and cash operating expense thresholds:
Figure 13: Sensitivity Analysis — Bitcoin Mining EBITDA Margins (%) (Excludes Depreciation)
And again, in graphical form (Figure 14):
Figure 14: Bitcoin Mining EBITDA Margins at Various Revenue and Cost Thresholds
First, notice the difference in the margin curves in Figure 12 vs. those in Figure 14. Clearly, cash margins are much healthier across the board when compared to fully burdened operating margins; at today’s machine prices, machine depreciation will be an even larger expense for most miners than their power bill (albeit a non-cash one)!
Take note of those miners who fall below break-even on a cash cost basis toward the left end of the curve (>$0.07 / kWh). These will likely be miners who entered the game late in the cycle at higher power costs — the hobbyist who plugged an old S9 into his apartment at $0.10–0.20 / kWh when it became profitable to do so, the new entrants who got FOMO and locked themselves in to long-term hosting contracts at $0.07–0.10 / kWh when bitcoin hit $50,000, etc. When mining conditions deteriorate as they did after the 2020 halving, these miners will find themselves underwater and will shut off their machines, provided their hosting agreements don’t penalize them for doing so. By contrast, the average miner, at $0.03 / kWh, still remains profitable on a cash basis even into the $0.06 / TH / s range. This illustrates the importance of securing low-cost power for miners who hope to operate for the long-term and through multiple price and hash rate cycles. Keep in mind, the above analyses exclude income and other taxes, which can be a significant expense for miners depending on their geographic location.
- Bitcoin mining resembles traditional commodity mining in many ways, but Bitcoin’s perfectly inelastic supply means any changes in demand manifest in the asset’s price. As in traditional commodity production businesses, one’s relative positioning on the cost curve is paramount. Low-cost producers generate healthy returns in constructive market conditions and enjoy downside protection in bear markets.
- Miners’ costs are relatively predictable, whereas revenues are uncertain owing to fluctuations in bitcoin’s price and network hash rate.
- For miners, the relationship between bitcoin’s price and hash rate is more important than either variable on its own.
- The two largest expenses for a miner are electricity and depreciation. Accordingly, mining returns are most sensitive to one’s cost of power and initial capex. Successful long-term miners will minimize both.
- The time lag between increases in bitcoin’s price and network hash rate creates brief windows of high profitability for miners with existing hash rate.
- Bitcoin mining conditions have improved considerably following the 2020 halving, as the increase in bitcoin’s price has dwarfed hash rate growth. This dynamic has largely been reflected in the machine market, as ASIC prices continue to skyrocket.
- With no relief in sight for the current machine shortage and supply chain constraints, conditions will likely continue to favor miners as this bull cycle progresses. As in previous cycles, however, higher-cost producers who enter late in the game and overpay for machines will suffer when hash rate inevitably catches price.
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