Where Does Bitcoin’s Value Really Come From?

Critics of cryptocurrency say that the blockchain-based currencies have no inherent value. Unlike gold or other alternative stores of value, prices of crypto coins like Bitcoin are based solely on speculation and are thus doomed to always be volatile.

That’s not exactly true, though. For better or worse, mining coins like Bitcoin consumes vast amounts of electrical power. That power has an intrinsic value. Mining also requires complex hardware, which is scarce. Again, that gives the coins a fundamental cost to create, and thus some intrinsic value.

What is that value? Let’s explore.

Electric Power Used to Create a Bitcoin

Globally, the Bitcoin network uses about 110 Terawatt hours per year of power, according to Harvard Business Review. That’s more than many countries, and around 0.5% of the whole world’s power consumption, for a single cryptocurrency network.

Any way you cut it, that’s a lot of power. That consumption is for the whole network, though, not just the mining that directly creates coins. How much does mining one Bitcoin actually consume? For an answer to that question, we can look to the cryptocurrency publication Miner Daily. They ran the numbers on Bitcoin mining and determined that creating one Bitcoin burns through about 143,000 kWh (Kilowatt-Hours) of electrical power.

That’s as much power as around 10 average American homes use in a full year. Again, it’s a lot of electricity — and that’s to make a single Bitcoin. Presumably, the value of the electricity used to create a Bitcoin is then captured in that Bitcoin’s intrinsic value.

Value of a Bitcoin’s Power

All that power has a monetary value. But what is that value? It’s hard to quantify exactly because Bitcoin miners are masters of reducing their power costs. Many situate their mining rigs near ample sources of renewable, cheap power to reduce their electric costs.

Assuming that usage displaces other users of that renewable power (a big assumption, as we’ll get to) it makes sense to use the average value of a kWh of power to estimate the value of the power needed to mine one Bitcoin.

The average cost of a kWh in the USA is 13.72 cents as of 2022.

Using that average, we can determine that mining a Bitcoin consumes about $19,610 worth of electrical power. Assuming that the resulting Bitcoin captures at least the intrinsic market value of the power used to create it, that gives a Bitcoin an inherent value of around $20,000 based on electrical costs alone.

Value of Hardware

There are other hard costs associated with creating a Bitcoin other than electrical power, too. The mining hardware required for mining Bitcoins is pricey. To see just how pricey, we can again turn to Miner Daily. They estimate that the cost of hardware needed to mine a single Bitcoin averages around $4,000 per coin.

That seems like a reasonable figure. It also confirms that the most expensive input for Bitcoin creators is the cost of electrical power. Cost of hardware is a factor, but it’s about 1/5 the cost of electrical power. Again, we can assume that the cost of the hardware needed to mine a Bitcoin is then reflected in the coin’s market value. That adds another $4k of intrinsic costs to each coin.

Putting it Together

There are surely other costs required for Bitcoin mining that might get captured in a coin’s value, like the costs of land needed to host mining hardware, taxes, and more. But let’s focus on the core costs of electrical power and mining hardware for this analysis. Combined together, those total about $24,000 per Bitcoin in terms of an intrinsic cost of production, based on my estimates.

That’s substantially more than the average cost estimated by other places like Miner Daily itself, which estimates a cost of around $11,000 per Bitcoin. Why the difference? Miner Daily uses an average electric cost of around 5 cents per kilowatt-hour. Again, miners are good at minimizing input costs, so that’s probably a reasonable estimate of what individual miners pay.

I’m not so interested in individual miners’ costs, though. I’m more interested in the overall market value of the inputs needed to create a single Bitcoin. Electrical power generation, at least in the short term, is largely a zero-sum game. If Jane the Bitcoin miner uses 1kWh of $0.05 electrical power from a renewable source, she has displaced that KWH from the market. Someone else likely has to pay more and pollute more to use a replacement KWH for the one she displaced through mining.

If I wanted to calculate Jane’s costs, I would use the $0.05 figure, as Miner Daily does. To calculate the total market cost of the power, though, it makes more sense to use the average KWH price, since that’s the market value of the power consumed by the mining operation.

That difference — using average market prices instead of the price paid by individual miners — accounts for the difference between my cost estimate and Miner Daily’s.

Circling Back to Pricing

If it costs around $24,000 to create a single Bitcoin, what does that mean for the cryptocurrency’s price? As I write this, Bitcoin is priced at around $40,000. Is that price rational?

If it’s true that the intrinsic value of a Bitcoin is around $24,000, then Bitcoin is currently trading at a multiple of 1.66 times its intrinsic value. That’s certainly far lower than the historic average price-to-earnings ratio of the S&P 500, which is typically between 13 and 15x.

There’s a difference, though. Companies in the S&P 500 earn revenue by performing valuable work. Bitcoin doesn’t earn anything. So looking at a price-to-earnings ratio for other securities like stocks isn’t that helpful, even though crypto markets are often compared to the stock market.

A better approach is to look at another type of alternative currency that is also mined, only this time with actual heavy equipment from the actual ground instead of by using fancy computers: gold.

How does gold’s price compare to the cost of mining it? In 2020, gold miners enjoyed record margins. While the price of gold was around $2,000 per ounce, the cost to extract each ounce from the earth was around $1,200. That means gold (at least in 2020) was priced at almost the exact same 1.66 price to extraction cost ratio as Bitcoin.

Gold miners haven’t always made such heady profits. In 2015, the amount of profit they took home on each ounce of gold was about half of what it is today. Still, if Bitcoin hewed fairly close to the ratios we see with gold, that suggests it would be priced somewhere between $30,000 and $40,000 per coin, based on the intrinsic electric and hardware costs to create it.

Caveats and Issues

Of course, that doesn’t at all mean Bitcoin’s price will stay in that range. In 2020, the coin’s value dropped to less than $10,000, likely as people lost faith in crypto in general. The value has also swung much higher, up to around $60,000 per Bitcoin.

Gold prices aren’t nearly as volatile. But then, they’ve had millennia to stabilize. Bitcoin is relatively new, and there’s clearly a huge impact of speculation inherent in its price — both on the good side (when the price far exceeds the coin’s intrinsic cost of creation) and the bad side (when the price goes way lower than that cost.) Markets are very capable of shrugging off rational valuations, at least in the short term. That means Bitcoin’s price will likely remain volatile.

Bitcoin is also different in that the difficulty of mining it — and thus the intrinsic cost of creating a coin — changes dynamically based on how many players are in the market.

This may happen to some extent with physical currencies like gold, too. When prices increase, mining companies may be more willing to go after harder to extract gold in tougher geographic locations, for example. But with Bitcoin, these changes are transparent and built into the network. That throws another wrinkle into predicting a Bitcoin price since the cost to create a coin is often a moving target.

Takeaways

When people say that Bitcoin’s price “isn’t based on anything,” they’re wrong.

The value of an asset like a baseball card truly isn’t based on anything other than speculation — printing a $1 million card costs just as much as printing a $1 one, so the card’s value isn’t based at all on the cost of creating it.

Bitcoin, in contrast, does have an intrinsic cost for the creation of each coin, which is presumably captured in the coin’s value. Generally, that cost is the cost of the electricity needed to produce each coin, plus the cost of the necessary hardware. Here, we estimate that cost at around $24,000 at the current moment.

Just because there’s a cost to create each Bitcoin, though, that doesn’t necessarily mean the coin’s price will in any way reflect that cost. Over time, it’s likely that ratios of price to cost will stabilize, as they largely have with gold. Rationally, they shouldn’t turn negative.

Yet crypto is a new kind of asset, and speculation plays a huge role in its price. It’s possible to estimate the intrinsic creation cost of a Bitcoin. It’s not possible to predict how the market will choose to actually price it.