Crypto Market Commentary
27 October 2019
Doc's Daily Commentary
The 10/25 Trade School with Doc is listed below.
The proof-of-Work miner industry is a complex, volatile and challenging industry to succeed in. Not only are miners exposed to the volatility and underlying technological risks of the asst being mined, they are also exposed to long term energy contracts, hardware depreciation cycles and continual global competition.
It is a really difficult industry to succeed in. The one saving grace is that for fixed supply cryptocurrencies like Bitcoin, Decred and ZCash, the inflation schedules are known in advance and the share of hashrate can reasonably relate to an income stream. Assuming the miner leverages at the correct time (at the start of a bull market) and looks after their equipment, they will be profitable for a longer period of time. However get the timing of your investment wrong, and the volatility of the asset will wipe your business out.
This piece is looking at some of the mechanics of what makes a profitable miners business tick over and where the major pitfalls are. This is inspired by this paper, written by a Decred developer who developed mathematical model which analyses the cost to attack a network. For those interested, it is certainly worth a read.
Capital upfront costs
Miners have costs associated with CAPEX (capital expenditure, up front costs) and OPEX (operational, continual costs).
Through the early stages of a miners existence, it is the CAPEX which dominates the cost side of the equation. This includes the financing costs to borrow capital and invest in ASICs or GPUs depending on the chain. These devices are usually state-of-art such that the maximum hashrate can be drawn from the most efficient machines. Some miners may start out with second hand equipment however this comes with risk of defects and is likely to be hardware that is no longer competitive in terms of hashrate as new chips are manufactured.
The ideal scenario for a new or expanding miner is to deploy hardware CAPEX at the bottom of a bear market when weak miners from the previous cycle have capitulated. This means that their share of the hashrate will be maximized (less competition), equipment will be discounted (second hand or new at fire sales) and the coin is trading at a discount and likely to appreciate. The big risk is…the coin doesn’t appreciate.
Mining equipment needs to pay itself off as quickly as possible to eliminate the high borrowing costs and pay back the machine cost such that it becomes only OPEX costs that need to be dealt with. The miners who look after their equipment by ensuring optimum air conditioning, regular servicing and consistent operation schedules will ultimately outlast those who run them in a dirty basement. As a result of this highly competitive environment, bitcoin mining in particular is potentially one of the fastest industries in history to progress from a hobby to full industrial scale.
The other advantage of hardware paying itself off quickly is that the actual cost of operation reduces down to just the operational side. That means that the miner now has the ability to expand the operation as the old machines are now operating at a much lower cost basis. You can start to get a picture of how the strongest miners leverage up at the end of a bear market, pay off their machines through the bull and then sit tight with their profitable machines until the next bear offers an opportunity to re-expand.
The miners who fail are usually those who expand and enter during the bull market who’s CAPEX costs eat them alive when the bear comes around.
If a miner remains profitable and pays down their CAPEX costs, the dominant expense tends towards operational costs such as man-power, electricity, rent and maintenance. Whilst these costs are relatively small overall, since mining is a global industry, all revenue streams will converge towards the costs basis. In other words, over time miners will expend costs (CAPEX and OPEX) exactly equal to the revenue gained. For every 1BTC mined, costs input to get it will approach a value of 0.9999999BTC over time.
The reason for this dynamic is that if you are a miner producing BTC for 0.90 BTC in costs, eventually another miner will undercut you by spending 0.91 BTC. As the CAPEX costs are relatively similar given the state-of-art chips are also competitive, OPEX costs and efficient capital management is actually what separates the strong from the weak at the end of the day.
This highlights the miners underlying equation – Miners buy BTC with power and sell it for USD, ideally at a profit.
As a result, we are seeing more and more Bitcoin miners establishing themselves near hydro-power plants which often have spare capacity and provide cheap renewable electricity. This is usually a symbiotic relationship between the power station and the miner. Power generation works best when there is constant demand, a baseload which is exactly what a miner provides. Powering peoples homes goes through peak and trough cycles during the day where demand drops at night and peaks morning and afternoon.
The miner can provide a steady, reliable baseload power over a long period of time. This provides certainty to a power station and in some cases can actually be just what the power station needs to be built in the first place. It is not an unlikely scenario that Bitcoin miners can become part of the business case for renewable power generation projects given the guaranteed long term energy contracts.
Capitalising on Miner Mechanics
As retail investors, we can capitalise on understanding the miner mechanics of a blockchain. Remember, miners are trading power for BTC and we are trading fiat currency for that same BTC. In a way we are buying power at a premium to that spent by the miner to acquire the BTC. If we understand when miners are selling at a discount to their costs, we are buying coins below their costs of production.
This is exactly the same equation as investment in Gold albeit with a different set of specifics but often the All in Sustaining Costs (AISC…weird right) is used to compare gold miner performance and ‘fair’ value.
The first tool is using the difficulty ribbon, shown on Willy Woos site. This shows a ribbon of moving averages of the difficulty level. When the ribbon is expanding it indicates that hashrate competition is increasing and strong. More miners means difficulty is in an uptrend. Conversely, when miners capitulate and close doors, the hashrate drops and the difficulty ribbon starts to squeeze.
This compression of the difficulty ribbon indicates that the cost of producing BTC for the strong miners is decreasing. Competition leaves the market and thus the survivors share of the global hashrate goes up. This means for the same OPEX, they generate more BTC. Thus they can sell less to cover costs and Hodl more in anticipation of the next halving bull run. This acts to reduce supply hitting the market and if demand remains strong, will lead to a price increase
We can see the same thing occurring for Decred at the current moment. Price has been under heavy sell pressure in recent months which by my estimation is a result of miners going too hard, too fast and expanding without the price appreciation to back it up.
Here we can see the difficulty exploding higher in early 2018, partly due to ASICs coming online and replacing GPUs but also due to more miners getting into the space. A very useful metric is the red line which is the total USD paid by Decred as a block subsidy. Remember that miners costs are in USD terms and thus knowing what the blockchain is paying for that service is a valuable tool.
We can see that Decreds difficulty ribbon has compressed since around Jun 2019 and price is again touching the red line. Any further below the red line and miners will all be underwater, some will fail and the cycle begins again.
At the end of the day, it all comes down to supply and demand. We are the demand for BTC competing with fiat currency as our investment vehicle. Miners are competing with both power and USD to find blocks and produce BTC to flip it to us at a profit.
This dynamic will evolve, at breakneck pace I suspect, particularly as institutional products like futures and options come live to support miners income generation. For a miner, the dream is selling physically settled call options. If price goes above and the option gets exercised, they are happy to sell the BTC plus take the option premium. On the other hand, if the price remains below the strike price, they pocket the premium and repeat on the next contract.
This will eventually become a very liquid market place and aide in price discovery and probability analysis. Overall, the Bitcoin market is financialising and professionalising at a rate not seen in history. A truly remarkable market to trade, experience and watch unfold.
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