Where will Bitcoin miners go as the bear market comes?

Key Summary

Given the backdrop of falling Bitcoin prices and rising energy costs, the economics of Bitcoin mining have become challenging in recent months, potentially prompting some miners to shut down machines, liquidate Bitcoin reserves, and/or restructure their cost structures.

The period of rapid credit expansion from 2020 to 2021, followed by rising capital costs observed in 2022, accelerated the adverse impact on Bitcoin miners amid falling prices.

introduce

With the decline in Bitcoin prices and the rise in energy prices, the profit margins associated with Bitcoin mining have been compressed significantly, likely forcing some miners to shut down. Similar to past cyclical declines in cryptocurrencies, uninformed experts have begun to advance the uninformed theory that if no miners can mine profitably, they will shut down their machines and liquidate their Bitcoin reserves, further increasing selling pressure. According to this theory, transactions will then be unable to be verified or confirmed across the network, and the network value will drop to zero. Obviously, this is wrong.

The reality is much more nuanced, and in fact, one of Satoshi Nakamoto’s core innovations, difficulty adjustments, allows the Bitcoin network to naturally absorb and recover from shocks like this. That is, there is an “equilibrium” of network hashrate, where a reduction in mining difficulty promotes a recovery in mining activity. In this way, mining reflects the rise and fall of the broader credit cycle. What we are seeing now is that Bitcoin’s hashrate is currently hovering near all-time highs despite falling revenues. As we will explore in this report, the period of rapid credit expansion from 2020 to 2021, and the rising cost of capital observed in 2022, have accelerated the negative impact on Bitcoin miners in the face of falling prices.

To better understand these mechanisms, we must first understand the key factors that drive Bitcoin miners’ profitability, including:

• The technical capabilities of the mining equipment (i.e. newer mining equipment is more efficient, which can reduce costs)

• The average hashrate of the entire network (the lower the network hashrate, the lower the difficulty of mining, and therefore the higher the profit)

• Electricity cost per kWh (lower energy costs make mining more profitable and vice versa)

• The price of Bitcoin (the higher the price of Bitcoin, the more profitable it is to mine, and vice versa)

Break-even analysis

While it is in the right direction to calculate the "breakeven" cost structure for the average Bitcoin miner based on the inputs detailed above, the reality is that two of these factors, mining machine efficiency and energy costs, vary widely among mining operations around the world. In addition, mining costs can vary depending on a particular operator's labor and capital expenditures, including initial outlays for machinery and construction costs, as well as the depreciation schedule of said machinery.

For the purposes of this analysis, we focus on the marginal production cost, which represents the cost of mining one bitcoin at an already operating site, assuming the machines are already in place and ongoing maintenance costs are minimal. Other factors in the miner cost analysis include depreciation of ASICs and/or hosting facilities (direct production costs), as well as indirect costs such as wages and SG&A (total production costs).

The table below describes marginal cost scenarios for various mining efficiency models and electricity costs based on static inputs of Bitcoin price and network hashrate (approximately $20,000 and 190 EH/s).

As shown in the table above, the current low Bitcoin price and increased network hashrate (and therefore mining difficulty) means that only the latest generation of mining machine models and/or operations with relatively low electricity costs can profitably mine Bitcoin in the current environment.

The Importance of Difficulty Adjustments

Because miners rely on mining rewards (composed of newly created Bitcoin and transaction fees) to cover operating expenses, lower Bitcoin prices suppress the purchasing power of these outputs, making it more difficult to pay expenses. As a result, miners with the highest production costs will no longer be profitable and will be forced to stop mining, similar to the production cost dynamics of traditional commodities. However, unlike traditional commodities such as gold, where production costs and operating expenses are slow to respond to changes in the gold price, Bitcoin's production costs are designed to dynamically adjust every two weeks based on current market conditions.

Every 2016 blocks (roughly every 14 days, an epoch), the Bitcoin protocol adjusts the difficulty (of mining new blocks) to reflect the average hashrate (representing the hashrate trying to mine the next block) during that period. The adjustment is based on a protocol rule that states that Bitcoin blocks are created every 10 minutes on average. If blocks are created every 9 minutes on average, instead of every 10 minutes, the mining difficulty increases. Conversely, if a block is created every 11 minutes on average, the difficulty decreases. Difficulty adjustments are an important component of the Bitcoin protocol that not only ensures Bitcoin's tight monetary policy, but also allows the network to continuously adapt and absorb shocks associated with changes in profitability inputs mentioned above.

So miners are selling?

Another common concern during cyclical downturns in Bitcoin mining is the extent to which miners sell Bitcoin. In reality, no matter where the market is in the cycle, there are some miners with lower profit margins who may sell some of their Bitcoin-denominated revenue. In times of market turmoil and falling Bitcoin prices, profit margins are compressed across the board, which naturally forces more miners to become net sellers of Bitcoin, whether they are simply trying to ride out the storm or shut down operations indefinitely. However, even if all newly issued Bitcoin were immediately sold on the market every day, this would only equate to daily selling pressure of 900 Bitcoins. Moreover, as a percentage of the average daily trading volume of Bitcoin on major exchanges, daily new issuance only accounts for 1.0-1.5% of total trading volume.

More importantly, greater selling pressure may come from miners, who may be forced to exit the market completely or liquidate part of their Bitcoin reserves due to over-leveraged management operations and being too close to margin calls. Evidence of such selling can be observed through the disclosures of some large public mining companies. From January to May of this year, 15 public mining companies reported that they mined nearly 22,000 Bitcoins, and their holdings of Bitcoin increased from 35,000 Bitcoins to 47,000 Bitcoins during this period. This reflects a net sales of approximately 10,000 Bitcoins (according to The Block data). This group includes mining companies that have historically executed a Bitcoin liquidation strategy, such as Iris Energy, Mawson, Greenidge, BIT Digital, and CleanSpark, as well as companies that have recently modified their Bitcoin holding strategies based on market conditions: mining companies such as Core Scientific, Marathon, Riot, Bitfarms, hu8, Argo, and HIVE, which had previously committed to a 100% holding strategy at the end of 2020 (which worked well during price appreciation and strong fundraising in 2021), but many companies were forced to reconsider their capital structures in 2022.

The following figure shows the amount of Bitcoin liquidated by each mining company from 2022 to date

In May, Core Scientific reduced its Bitcoin reserves by 20%, raising approximately $80 million, while Argo and Riot began liquidating a portion of their monthly production. Conversely, Marathon made small cuts to their reserves, while Hut8 and HIVE maintained their full holding strategies. Bitfarms liquidated 3,000 Bitcoins (approximately half of their reserves) in June to de-leverage its $100 million outstanding loan from Galaxy. Collectively, Riot, Core Scientific, Argo, and Bitfarms account for more than half of the Bitcoin sold by this group of public companies so far this year. Not surprisingly, many of these public mining companies are down approximately 75-95% from their 2021 highs.

The following chart shows the decline in share prices of various mining companies

Credit cycles in the context of Bitcoin mining

It is worth noting that the landscape of bitcoin mining financing has changed dramatically since previous cyclical downturns, as the number of lenders providing various forms of liquidity to mining operators has grown rapidly, particularly throughout 2021. In addition to traditional financing methods such as issuing common stock, bonds, or convertible notes in private and public markets, bitcoin mining companies have begun to obtain loans from crypto companies such as Genesis Capital, NYDIG, Silvergate, Foundry, Galaxy Digital, BlockFi, Securitize, and BlockFills, using their bitcoin holdings or ASIC mining equipment as collateral (it is worth noting that Coinbase offers loans through its lending platform, which can be secured by bitcoin. However, to date, no loans have been issued that are secured by mining equipment or future mining revenue). These loans are primarily structured in an overcollateralized manner and are primarily executed by mining operators with aggressive expansion plans in 2021, such as Bitfarms, Marathon Digital, Greenidge, and Core Scientific. In addition, certain mining operators are able to structure debt agreements based on revenue sharing (usually denominated in bitcoin).

In addition, some non-crypto native financial entities have issued loans to Bitcoin mining companies in 2021 to purchase more ASIC mining machines, mainly to expand mining infrastructure and capacity throughout North America in response to China's computing power migration. For example, venture debt firm Trinity Capital signed a senior secured equipment financing clause in December 2021 to provide Hut8 with a $30 million loan. In June 2021, private credit investment firm WhiteHawk Finance signed a $40 million loan agreement with Stronghold Digital, allowing the mining operator to add new mining machines. According to The Block, the annualized interest rate for both transactions was around 10%.

Based on the financial statements of a group of the largest publicly traded or privately held bitcoin mining companies, it is estimated that these entities raised more than $5.8 billion (75% of which was equity financing) during 2021. According to The Block, these companies raised approximately $2.4 billion in October and December 2021 alone, accounting for more than 40% of their total financing for the year. Debt financing also saw a huge increase towards the end of 2021, with convertible notes accounting for the majority of debt financing in Q4 2021, followed by secured loans, senior unsecured notes, and loans secured by bitcoin holdings or mining equipment. Marathon, one of the largest publicly traded bitcoin mining companies, issued $747 million in convertible bonds in November, the largest debt financing executed by a bitcoin mining company to date.

Another way to describe the 2021 funding surge directionally is to analyze the dilution of common stock of publicly traded bitcoin mining companies. Marathon, Riot, Argo, HIVE, Bitfarms, and Hut 8 have all significantly increased their number of shares outstanding in 2021, after being relatively flat in 2020. This dilution also coincides with a strategic shift by these entities to hold the vast majority of mined bitcoins at the end of 2020, rather than liquidating them, in order to mitigate operating expenses.

Given the decline in Bitcoin prices in recent months and the resulting compression in mining operators’ profit margins, the funding environment for the industry has changed significantly since the end of 2021. It has become extremely difficult to raise funds in the open markets, and while private lending activity has continued into 2022, funding channels have narrowed significantly in the current context. Many mining companies have aggressively expanded their operations over the past 1-2 years and have leveraged their balance sheets to expand their operations (intentionally or unintentionally assuming that Bitcoin prices would remain flat or higher), but are now forced to restructure their operations and in many cases liquidate part of their Bitcoin reserves to meet regular expenses as well as loan payments or margin calls. As less cautious miners continue to face challenges, these conditions should provide opportunities for consolidation across the mining industry in the second half of this year. This same sentiment was expressed by a mining panel at the Consensus conference in Austin, Texas earlier this month.

That being said, there are reasons to believe that some miners, especially those taking a more conservative approach, will be able to appropriately take advantage of the expansion of funding channels described above. All else being equal, more liquid capital markets that facilitate increased infrastructure investment to make mining operations more efficient (through updated equipment and/or lower electricity costs using renewable or stranded energy) should give these players greater flexibility.

Hedging strategies

Additionally, a stronger Bitcoin derivatives market should give miners more options in potential hedging strategies. If miners are concerned about falling Bitcoin prices, one strategy they would employ is to buy put options on publicly traded mining company stocks (with strike prices around their production costs), which have historically been high-beta bets on Bitcoin prices. Additionally, to fund these option purchases, miners can simultaneously buy (sell) covered call options to implement a cost-free collar strategy.

Another strategy is writing (selling) Bitcoin futures contracts to hedge spot exposure. In terms of strategic hedging, a recent development is the concept of hash rate derivatives (allowing miners to effectively "go long" on the prospect of rising hash rate, as they are essentially "short" hash rate when their profitability rises when network hash rate falls), but these markets are relatively new and illiquid. However, the simplest hedging method may still be a strategy of continuously converting part of your Bitcoin into fiat currency.

The following figure shows the net flow of Bitcoin by miners

Where are we in the cycle?

While the Bitcoin mining ecosystem has matured significantly since previous cyclical downturns, analyzing past mining cycles is an effort to estimate where we are in the current cycle. From 2017 to 2019, we can observe a cyclical progression that is very similar to today’s trajectory. In late 2017, Bitcoin’s price began to grow faster than the network’s hashrate, which led to an influx of new miners and expansion of operations to take advantage of this mismatch (similar to the expansion observed throughout 2021). Then, as the price peaked in late 2017, the deployment of new equipment continued to cause the network’s hashrate to continue its upward trajectory (similar to the rise in hashrate observed throughout much of 2022 despite falling Bitcoin prices).

Eventually, the price of Bitcoin fell again in November 2018, at which point many miners became unprofitable and were forced to shut down their machines (similar to Q2 2022). Around this time, the network hashrate peaked (around 54 EH/s) and began to decline as miners shut down and the difficulty of mining adjusted downward. The network hashrate then bottomed out at around 35 EH/s (coinciding with the low point of Bitcoin price just below $4,000) and began to recover. Looking back at the current cycle, it seems that the network hashrate peaked in May at around 237 EH/s and has fallen to around 200 EH/s in recent weeks.

Therefore, while the mining market may still be far from equilibrium in terms of hashrate, evidence of miner selling and shutdown activity has begun to manifest itself in the form of declining network hashrate and ultimately mining difficulty in recent months. If these downward trends continue, we believe the point at which they subsequently begin to flatten out could mark the beginning of a bottoming process based on trends observed during the 2018 crypto winter.

The following figure is a chart showing the trend of Bitcoin price and computing power.

Summarize

In these difficult market conditions, the conservative approach of many mining operators is to liquidate some of their Bitcoin holdings as prices fall. As unprofitable miners exit, we expect hashrate to decline and the downward-adjusted difficulty to also decline, creating a new equilibrium that better supports network activity. We view lower steady-state hashrate as a potential bottom for the cycle, which would be a precursor to new entrants. At the time of writing, the network's hashrate continues to decline and is currently around 180 EH/s. The recent decline in network mining difficulty also supports the claim that miners have been shutting down machines in recent weeks. While subject to change, this metric will be critical to monitor going forward.

We may also see broader consolidation in the mining industry as larger, well-capitalized players acquire smaller operators that have been forced out of the market. This process appears to be underway as graphics card prices have been steadily declining so far this year (down about 15% month-over-month in May, according to Decrypt) and top-tier mining rigs are being sold at significant discounts on the secondary market (about 65% off last year’s highs). So while we will see various miners continue to sell off portions of their holdings or mining equipment in this environment, or even be acquired outright, we also recognize that this process represents a natural, self-correcting property of the Bitcoin network, rather than a bug.