Compute North, one of the largest mining companies in the United States, filed for bankruptcy, affecting at least 200 creditors. Will the crypto mining industry usher in a major reshuffle?

what happened

Compute North , the second-largest Bitcoin mining hosting provider in the United States, filed for Chapter 11 bankruptcy protection last week. The company quickly followed up that filing with another court order to sell liquidated assets under Section 363 of the Bankruptcy Code to repay the approximately $140 million in debt it had accumulated.

Compute North’s bankruptcy may be the biggest mining-related news to emerge from the 2022 downturn.

The company provides $700 million worth of equipment hosting services to approximately 84 mining entities, including public companies such as Marathon Digital Holdings .

Compute North was founded in 2017 as a crypto mining operation and later expanded into colocation services that provide low-cost electricity for data centers, according to the company’s website. In April, the company broke ground on a 300-megawatt colocation facility in Texas.

Now, as Compute North looks to auction off assets, its customers may face a situation where service agreements are rewritten under new management. Some miners may even be forced to leave their hosting locations, while others may face the risk of defaulting if rates rise.

The broader context: Cruel economics crushing Compute North's profits

Large-scale Bitcoin mining is expensive. Not only does it require a lot of energy and expensive machines, it also requires very expensive electrical equipment (transformers, panels, power cables, and related items) that must be matched to the scale of the mining machines, and miners or mining companies also need containers or warehouse space to store them.

Due to scale and cost factors, miners often rely on hosting providers such as Compute North to save the cost and effort of setting up their own Bitcoin mining farms. Miners provide the machines and the host is responsible for the power supply. Under these agreements, the two parties sign a contract to lock in a hosting rate for a specific period of time. These contracts can vary, but generally include a fixed price for electricity, which may include profit or revenue sharing agreements.

As shown in the above figure, Compute North has more than 20 subsidiaries that operate various aspects of the business.

Most of them (those under the “Operating Companies”) are wholly owned by Compute North, while others are joint ventures with NextEra Energy and Marathon Digital Holdings. Additionally, CN Borrower LLC is now owned by Generate Capital, Compute North’s primary lender (more on that later).

Compute North's contracts typically last 3-5 years and lock in fixed electricity prices for customers. The problem is that Compute North does not lock in its own electricity prices with its electricity suppliers through long-term power purchase agreements (PPAs). Meanwhile, in Texas (the state with most of Compute North's customers and where Compute North has expanded most aggressively), average industrial electricity prices increased 64% from July 2021 to July 2022, from $5.20/kWh to $8.21/kWh.

According to its Chapter 11 filing, Compute North said that "typical [colocation service agreements] do not expressly allow it to pass on increased energy costs to customers," so the colocation company is left to absorb these rising electricity rates without being able to recover the costs from its customers.

Compute North's revenue is being eaten away by the crypto bear market. Bitcoin's hash price -- a measure of how much miners can earn for a day's work -- has fallen 68% so far this year.

So when Compute North's main operating cost (electricity) soared, its profit margins, already weakened by market conditions, were squeezed again.

Compute North's main lender triggers 'technical default'

While Compute North did not state this in its filing, the company’s shaky revenue situation likely prompted its primary lender, Generate Capital, to trigger a technical default.

A technical default is a default caused by a failure to comply with some aspect of the loan terms (other than regular payments).

Generate Capital opened a $300 million credit line for Compute North in February, of which Compute North received $101 million. According to Compute North's bankruptcy filing, Generate Capital claimed that Compute North was in technical default, which prevented Compute North from obtaining credit and gave Generate Capital control of two Compute North mines (one in Kearney, Nebraska, and one in Granbury, Texas), as well as a $23.6 million bank account.

Outlook and Implications: Compute North facility is still in operation, but will soon be sold

With its main credit line closed and profits evaporating, Compute North filed for Chapter 11 bankruptcy protection. Often referred to as a reorganization bankruptcy, Chapter 11 allows a company to continue operating while it develops a plan to satisfy creditors.

According to the filing, the Minnesota-based company owes at least 200 creditors up to $500 million, and Compute North estimates that its assets are worth between $100 million and $500 million. As far as creditors are concerned, Compute North:

• $99,809,696 owed to NextEra Energy, an electric utility with which Compute North had a joint venture for a facility in Texas;
  

• $21,013,027 owed to Marathon Digital Holdings, a publicly traded bitcoin mining company;

• $7,466,005 owed to Foundry , a subsidiary of Digital Currency Group ;

• About 30 other companies totaled $18,374,138.
  

To repay the debt, Compute North filed a motion with the U.S. Bankruptcy Court for the Southern District of Texas to auction off its assets. If the sale is approved, Compute North can sell up to $1,000,000 worth of assets outside of the auction on a de minimis basis.

The bulk of the sales, however, will take place in an auction that will begin on November 1, 2022. The auction will include any assets controlled by Compute North, including bitcoin mining containers, bitcoin mining machines, and its most valuable asset — data centers.

If Compute North's business is split, what will happen to customers?

The asset auction is sure to attract bidders from all parts of the crypto mining industry, including financial institutions and energy companies active in the sector. These players will now have the opportunity to gobble up the assets at a bargain price.

It is anyone’s guess who will buy which assets, most importantly which company will own the data centers, which is a headache for customers operating on these sites. Given the thin margins on current hosting agreements, new management will undoubtedly want to rewrite them, and some miners may be excluded from the agreements, while others may choose to leave.

For example, Marathon Digital has reached an agreement with Compute North competitor Applied Blockchain to obtain another power and warehouse space to house current and future mining equipment. Regarding the bankruptcy, Marathon Digital's stock price fell 10% on the day the news broke, but the stock price has rebounded sharply in the past week. It is also worth noting that Marathon's computing power through its proprietary mining pool Marapool has not declined in the last month.

In addition to Applied Blockchain, Bitcoin miners that may be eliminated by the reorganization may seek a new home from Core Scientific, the largest Bitcoin mining hosting provider in the United States. However, according to the 10-Q filing, Core Scientific lost $4.7 million in hosting services in the second quarter of 2022.

Without a deeper look at Core Scientific’s operations, it’s impossible to tell whether the loss was caused by higher power prices and a lack of PPAs, or by data center outages during the summer heat (Core Scientific does a lot of business in Texas). Still, industry sources say Core Scientific has the ability to pass on rising power costs to customers if prices rise.

The situation is a stark reminder that public and private miners who have their own power contracts and run their own data centers, even if expensive, don’t have to worry during times of market uncertainty. Companies like Riot , Argo, Hut 8, Bitfarms , and Cleanspark don’t have to worry about counterparty risk with hosting providers.

For those who use hosting providers, uncertainty about hosting alternatives looms as mining profits decrease and electricity costs rise. Over the past few years, it has not been uncommon for Bitcoin miners to abandon long-term PPAs as electricity costs have been falling and average hosting rates in the industry have been rising.

As a result, Compute North customers may be caught between the best of two bad scenarios, either sticking with the uncertainty during the Compute North restructuring process or seeking a new one with another hosting provider.

It is too early to tell whether this situation will evolve into credit contagion, but as Compute North's data centers are sold to new management, the impact of the bankruptcy on other miners/mining companies will become more apparent, and investors in these companies will need to be very aware of the mining power sources of their portfolio companies to determine whether reallocation or diversification is needed.