Welcome to Episode 75 of the podcast.
Today’s discussing is focused on the economics of bitcoin mining but I would be remiss to continue the episode without first attributing the ideas contained in it to Mr. Murray Stahl. Stahl, is the only person that I’ve heard discuss the subject in the way that I will present it here today and I’ve found his viewpoint to be extremely insightful. His views combine his practical knowledge of bitcoin mining with his decades of experience in investing and offer a framework through which we can make sense of bitcoins price action across time. So with that brief set up out of the way, let’s jump into today’s discussion of bitcoin mining economics.
To begin, in mining and other commodity industries, technological improvements continue to bring the cost of extraction down over time. This phenomenon is evident in the oil and gas industry, specifically in relation to horizontal drilling. Horizontal drilling, commonly referred to as fracking, allows drillers to access multiple different depths and points within an oil basin all from a single surface pad. Prior to this development, drillers were confined to a narrow range of depths directly below each well. This limitation necessitated the drilling of multiple wells across the surface area above each oil field in order to fully extract the oil below.
Constructing a single horizontal drilling pad requires less time, labor, and resources than drilling dozens of separate vertical wells would require. In terms of absolute energy expended, a single well pad will always be less costly than would be drilling multiple wells to access the same reserve. It’s clarifying to think in terms of total resources expended on drilling rather than dollars spent to drill when analyzing the cost of resource extraction. This is because currency is constantly depreciating via inflation and comparing extraction costs from decades ago to today’s cost in dollars would not give a clear picture of the actual resources expended unless the figures were corrected for inflation, something which is difficult if not impossible to do accurately.
Understanding that technological advances lower commodity extraction costs over time helps us understand the commodity business cycle. Consider the following example where the cost to produce a barrel of oil equals X. Due to technological improvements, the cost to extract a barrel of oil is reduced to X minus 20%. For a brief period of time, the market allows existing companies to benefit from the 20% efficiency gain in the form of higher profit margins but the increased margins don’t last forever. This is because outside entrepreneurs see increased profit margins in the industry and themselves enter the business to capture excess profits. As entrepreneurs bring more supply into the market, prices are driven lower, until supply and demand forces eventually bring the price per barrel down from X to X minus 20%. The competitive forces of supply and demand eventually erode the profits that technological breakthroughs brought about.
Following this line of reasoning, we see that commodity production costs set the lower limit at which commodities can be sold. This is because no business owner can remain in business for long if they’re selling products below their cost of goods sold. If oil costs $80 per barrel to produce then oil companies must sell each barrel slightly above $80 dollars just to remain profitable. If the cost of production rises to $90 dollars per barrel, then again, the price of oil in the market must rise to just above $90 in order for the company to earn a profit. If oils production cost falls to $70 per barrel then the price of oil, all else being equal, will also fall. This is because temporarily increased profit margins will draw in competition, competition will increase supply, and competitors will undercut each other to retain market share until they reset the price to just above the new cost of production.
With that overview out of the way, consider what would happen if global oil production were suddenly cut in half? This is not to say that companies themselves would curtail their extraction efforts but rather to imagine a scenario in which only half as much oil came out of the ground, regardless of humanities efforts to extract more barrels. In this scenario the oil companies keep the existing wells on line and even bring new ones into production as fast as possible but the actual barrels extracted from the earth remain stubbornly 50% lower than before. Under these circumstances, the price to produce a barrel of oil would at a minimum double because the producers have to cover their 2x increase in production costs. In fact, the production cost per barrel of oil could rise well above the 2x baseline price increase if enough additional resources were devoted to extraction. This is because no amount of increased effort could yield more supply but would incur increased costs.
Now that we understand the economics of commodities, let’s apply the same thought process to bitcoin production. To begin, bitcoin has a cost of production just like commodities do and the primary input costs are energy and equipment. Multiply the price per kilowatt hour of electricity times the power consumption of each bitcoin mining machine, commonly known as ASIC’s, and you can easily calculate the first of two main input cost, the cost of energy. Because ASIC machines breakdown and require replacement with newer technology the cost of depreciation along with the machines original purchase price must all be factored into the second primary input cost, which is the cost of the machines themselves. Combining these two costs together gives you the mining cost per bitcoin.
Similar to commodities, technological improvements bring the production cost per bitcoin down over time. This is because, all else being equal, more efficient machines require less power and make more computations per second thus increasing a minors likelihood of capturing the next ten minute block reward. This means that a bitcoin minor, just like an oil producer, will see their profit margins improve as their input costs decline. Improved bitcoin mining profit margins draw in competition just like improved margins in oil and gas brought competition to that market.
At this point, however, the price behavior of bitcoin and oil diverge. As discussed previously, increased profit margins draw in competition, which increases supply, which eventually collapses a commodities spot price to the new lower cost of production. In essence the seeds of destruction are sewn into a commodity’s future price as soon as technology reduces that commodity’s cost of production. Bitcoin, however, is different from a commodity for the simple reason that no amount of effort can accelerate its production. Both its supply schedule and its total supply are capped.
This fixed issuance schedule make bitcoin economics resemble our imaginary oil scenario wherein global oil production fell by half and no amount of effort could bring more barrels to the surface. Like our imaginary scenario, bitcoin’s production falls by half every four years at an event known as the halving and because the supply is halved the production cost per coin doubles.
Two useful conclusions can be drawn once you understand bitcoin mining economics. First, bitcoin’s cost of production puts a floor on bitcoins spot price. The spot price occasionally dips below production cost, but not for long and not by much. From the perspective of a bitcoin miner the reason behind this is obvious. Selling mined bitcoin for less than they cost you to produce is a doomed business model. Miners would be better served by turning their machines off whenever bitcoin’s spot price dipped below their cost of production because they could buy new coins cheaper in the open market. Like everything else in economics, however, this action has a second order effect because miners who shut down equipment increase profit margins for their competition and in turn start the process over again.
Second, no increase in the effort devoted to bitcoin mining can ever produce more than the scheduled amount of coins. Because of this miners are constantly faced with the question of how much they’re willing to expend to “mine” each new coin. Increased mining effort increases the minor’s cost which in turn raises the lower bound of the bitcoin spot price in an ever increasing cycle. Furthermore, the cost of production goes up by at least 2x every four years when the halving occurs. The halving decreases bitcoin rewards by 50% and thus increases the cost of production by 2x, further driving the lower bound of bitcoins spot price upward.
Understanding the economics of bitcoin mining applies to investors in the following ways. First, acquiring bitcoin when the spot price dips below production cost is the best way to ensure that your investment remains profitable. Because the spot price rarely remains below the cost of production for long you know that coins purchased under these conditions are likely to increase in value sooner than coins purchased well above production cost. You can track bitcoins production cost relative to the spot price at the following link: https://en.macromicro.me/charts/29435/bitcoin-production-total-cost. The link can also be found at our Substack page under the “Reading” tab, where we list some of our favorite websites including MacroMicro’s Bitcoin Average Mining Cost.
Second, investors should understand that, all else being equal, production costs will double at each halving. This doubling in production cost raises the floor on bitcoins spot price by a factor of 2x for reasons previously discussed. Understanding these two models grounds investors analysis in real world economics rather than in over hyped predictions and price targets.
We at Special Situation Investing have increasingly come to rely on the spot price relative to bitcoin’s production cost relationship when making bitcoin purchase decisions. Before understanding the model described in this write up, we purchased bitcoin at all different price points, some of them well above production cost, and have seen the utility of this framework as it improved our own purchase decisions. If you’ve found today’s discussion useful I encourage you to study the charts provided on the MacroMicro website so that you too can better understand the dynamics behind bitcoin mining and hopefully improve your own decision making in the process.
With that we wrap up Episode 75 of the show. As always we thank you for your support and encourage you to subscribe to our free Substack page where you can find additional content and show transcripts. While we’re on the topic of bitcoin, we always encourage our audience to listen to podcasts through the Fountain app where you can earn daily bitcoin micro payments just for listening and can support podcasters like us with payments a small as a single sat. Thanks again, and we’ll see you again next week.
SUBSTACK-ONLY
Here’s our top two podcasts from last week. Enjoy!
Rick Rule on Resource Talks
Ole Hansen on MacroVoices
Share this post