Crypto Becomes Too Cheap to Mine
Recent news suggests widespread stress in the crypto mining industry. Similar stress in commodity markets often indicates that the commodity is too cheap and likely to rise. Will crypto behave in the same way as commodities?
Mining stress
Last Thursday shares of Bitcoin miner Core Scientific plunged by 78% in one day as the company warned of a liquidity crunch and likely insolvency. “Operating performance and liquidity have been severely impacted by the prolonged drop in the price of Bitcoin, a rise in electricity costs, increased competition and litigation with bankrupt Celsius Networks,” – Bloomberg cited the company’s regulatory filing. Core Scientific is one of the world’s largest miners of Bitcoin, so the news shows the degree of stress in the crypto-mining industry.
Indeed, other major mining companies, which so far remain solvent, look very depressed. Share prices of most miners have fallen much more than Bitcoin itself, losing about 80% this year and even more since their highs last November.
Stock prices of Riot Blockchain (blue), Hut 8 Mining Corp (orange), and Marathon Digital (green)
There is a number of fundamental factors undermining the economics of these companies. Crypto drop this year coincides with much higher energy prices, pushing up electricity costs.
Bitcoin (orange) and US prices of coal (black) and natural gas (blue)
Bitcoin network difficulty continues to increase, further straining mining companies. Mining business requires increasingly more computational power, which becomes more expensive due to electricity price, and gets in return Bitcoins priced much lower than before.
Bitcoin price (black) and mining difficulty (blue)
As the final nail in the coffin, Ethereum’s recent transition to proof-of-stake has left miners completely out of Ethereum business.
Commodities analogy
In commodity markets, producers' stress often indicates that the commodity is too cheap and likely to rise. Commodity prices are famously volatile and cyclical, and that is reflected in the economics of commodity-producing companies. When prices are high, producers enjoy hefty cash flows. Sooner or later, that leads to an investment boom, increasing production but usually at higher costs. When the economic situation deteriorates and prices fall, higher-cost producers are pushed out of business, balancing the market.
Let’s consider oil prices. Oil is the most liquid commodity traded in the financial markets. Unlike gold, oil is usually moved more by micro (oil-specific) factors than a general macro. Oil fundamentals are well-studied and widely known. That makes oil a perfect example of commodity cycles.
The chart below shows that oil prices could not sustainably fall below $40 per barrel during the last decade. This figure is close to the estimated average production costs during the period (current costs are probably much higher due to inflation).
Oil price (Brent)
The oil price drop in 2014-16 is particularly representative of a commodity cycle. Before 2014 oil was very expensive compared with production costs, stimulating large-scale investments in new projects. The oil market even invented a new method of production (shale oil), which quickly became mainstream in the US, making the US one of the largest oil-producing countries in the world.
US oil production (thousands of barrels per day)
Shaded area represents a recession
However, shale companies turned victims of their own success, because the world did not need as much oil as they produced. The prices plunged in 2014-15, forcing higher-cost producers (mostly shale companies) to go out of business or to increase efficiency. The price drop led to lower US production in 2015-16, which provided the oil market with the necessary time to adjust and eventually stabilize the prices in 2018-19 (before further volatility due to the coronavirus).
Is crypto different?
I’m inclined to view the current stress of crypto mining companies as similar to the oil crisis of 2014-16. If something is so cheap that some major producers go insolvent and others barely survive, it’s just too cheap. Such situations in the commodity markets usually are great mid-term buying opportunities.
But there is a caveat. Lower oil production has nothing to do with oil quality as a fuel, but much lower Bitcoin mining can theoretically reduce the speed and reliability of payments, negatively affecting its adoption. I think that the current mining situation is far from it, but investors should be aware of this risk. In this case, proof-of-stake Ethereum provides good diversification to Bitcoin and other PoW cryptocurrencies.
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