Coinbase Research: The Bear Market Arrives, Where Are Bitcoin Miners Headed?

Authors: Brian Cubellis & Li Liu

Original Title: 《Bitcoin mining: investment cycles》

Compiled by: GaryMa 吴说区块链

Key Summary

In the context of falling Bitcoin prices and rising energy costs, the economic viability of Bitcoin miners has been challenged in recent months, potentially prompting some miners to shut down machines, liquidate Bitcoin reserves, and/or readjust their cost structures.

The rapid credit expansion from 2020 to 2021, followed by rising capital costs observed in 2022, has accelerated the negative impact on Bitcoin miners in the face of declining prices.

Introduction

As Bitcoin prices decline and energy prices rise, the profit margins associated with Bitcoin mining have been significantly compressed, likely forcing some miners to shut down. Similar to past cyclical declines in cryptocurrency, uninformed experts have begun to propose ignorant theories that if miners cannot profitably mine, they will shut down machines, liquidate their Bitcoin reserves, further increasing selling pressure. According to this theory, transactions across the entire network would then be unable to be verified or confirmed, leading to a network value of zero. Clearly, this is incorrect.

The reality is much more nuanced; in fact, one of Satoshi's core innovations—difficulty adjustment—allows the Bitcoin network to naturally absorb and recover from such shocks. That is to say, there is a "balanced" network hash rate where a decrease in mining difficulty promotes a recovery in mining activity. In this way, mining reflects the broader credit cycle's ups and downs. What we see now is that despite declining revenues, Bitcoin's current hash rate hovers near historical highs. As we will explore in this report, the rapid credit expansion from 2020 to 2021, along with rising capital costs observed in 2022, has accelerated the negative impact on Bitcoin miners in the face of declining prices.

To better understand these mechanisms, it is essential to grasp the key factors driving Bitcoin miners' profitability, which include:

• The technical capability of mining machines (i.e., newer mining equipment is more efficient and can lower costs)
• The average hash rate of the entire network (the lower the network hash rate, the lower the mining difficulty, thus the higher the profits)
• The cost of electricity per kilowatt-hour (lower energy costs make mining more profitable, and vice versa)
• The price of Bitcoin (the higher the Bitcoin price, the more profitable mining is, and vice versa)

Break-even Analysis

While it is correct to calculate the "break-even" cost structure for typical Bitcoin miners based on the inputs detailed above, the reality is that two of these factors—mining machine efficiency and energy costs—vary significantly across global mining operations. Additionally, mining costs may differ depending on the specific operator's labor and capital expenditures, including initial outlays for machines and buildings, as well as the depreciation schedule for the said machines.

For this analysis, we focus on marginal production costs, which represent the cost of mining one Bitcoin at an already operational site, assuming machines are in place and ongoing maintenance costs are minimized. Other factors in miner cost analysis include depreciation fees for ASIC 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 various marginal cost scenarios based on Bitcoin prices and network hash rates with static inputs (approximately $20,000 and 190 EH/s).

As shown in the table above, the current depressed Bitcoin price and elevated network hash rate (and thus increased mining difficulty) mean 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.

Importance of Difficulty Adjustment

Because miners rely on mining rewards (composed of newly created Bitcoins and transaction fees) to cover operational expenses, lower Bitcoin prices suppress the purchasing power of these outputs, making it more difficult to pay expenses. Therefore, the 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 like gold, where production costs and operating expenses respond slowly to price changes, Bitcoin's production costs are designed to adjust dynamically every two weeks based on current market conditions.

Every 2016 blocks (approximately every 14 days, or one epoch), the Bitcoin protocol adjusts the difficulty of mining new blocks to reflect the average hash rate during that period (representing the hash rate attempting to mine the next block). The adjustment is based on a protocol rule that stipulates the average creation time for Bitcoin blocks is 10 minutes. If blocks are created on average every 9 minutes instead of every 10 minutes, mining difficulty will increase. Conversely, if blocks are created on average every 11 minutes, the difficulty will decrease. Difficulty adjustment is a crucial component of the Bitcoin protocol, ensuring not only Bitcoin's strict monetary policy but also allowing the network to continuously adapt and absorb shocks related to the aforementioned profitability inputs.

So Are Miners Selling?

During the cyclical downturn of Bitcoin mining, another common concern is the extent to which miners are selling Bitcoin. In reality, regardless of where the market is in the cycle, some miners with lower profit margins may sell a portion of their Bitcoin-denominated revenues. During market turmoil and falling Bitcoin prices, profit margins are broadly compressed, which naturally forces more miners to become net sellers of Bitcoin, whether they are simply trying to weather the storm or shutting down operations indefinitely. However, even if all newly issued Bitcoins were immediately sold on the market every day, this would only amount to a daily selling pressure of 900 Bitcoins. Furthermore, as a percentage of the daily trading volume of major exchanges, newly issued Bitcoins account for only 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 entirely or liquidate part of their Bitcoin reserves due to managing operations that are over-leveraged and too close to margin calls. Evidence of such selling can be observed through disclosures from some large publicly listed mining companies. From January to May of this year, 15 publicly listed mining companies reported that they mined nearly 22,000 Bitcoins, with their holdings increasing from 35,000 Bitcoins to 47,000 Bitcoins during this period. This reflects a net sale of approximately 10,000 Bitcoins (according to The Block data). This group includes mining companies that have historically executed Bitcoin liquidation strategies, such as Iris Energy, Mawson, Greenidge, BIT Digital, and CleanSpark, as well as companies like Core Scientific, Marathon, Riot, Bitfarms, hu8, Argo, and HIVE, which have recently modified their Bitcoin holding strategies based on market conditions. These companies previously committed to a 100% holding strategy at the end of 2020 (which was effective during price appreciation and strong financing in 2021), but many were forced to reconsider their capital structures in 2022.

The following chart shows the amount of Bitcoin liquidated by various mining companies from 2022 to date.

In May, Core Scientific reduced its Bitcoin reserves by 20%, raising approximately $80 million, while Argo and Riot began liquidating part of their monthly output. In contrast, Marathon slightly reduced their reserves, while Hut8 and HIVE maintained their full holding strategy. Bitfarms liquidated 3,000 Bitcoins in June (approximately half of their reserves) to remove leverage from a $100 million outstanding loan from Galaxy. Overall, Riot, Core Scientific, Argo, and Bitfarms accounted for more than half of the Bitcoin sold by this group of publicly listed companies this year. Unsurprisingly, many of these publicly listed mining companies have seen their stock prices decline by about 75-95% from their 2021 peaks.

The following chart shows the stock price declines of various mining companies.

Credit Cycle in the Context of Bitcoin Mining

It is noteworthy that the financing landscape for Bitcoin mining has changed dramatically since the previous cyclical downturn, as the number of lenders providing various forms of liquidity to mining operators has rapidly increased, 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 also begun to obtain loans from crypto companies such as Genesis Capital, NYDIG, Silvergate, Foundry, Galaxy Digital, BlockFi, Securitize, and BlockFills, using their held Bitcoins or ASIC mining equipment as collateral (notably, Coinbase offers loans through its lending platform that can be secured by Bitcoin. However, so far, no loans have been issued secured by mining machines or future mining revenues). These loans are primarily structured in an over-collateralized manner, executed mainly by mining operators such as Bitfarms, Marathon Digital, Greenidge, and Core Scientific, which actively expanded their plans in 2021. Additionally, some mining operators have been able to construct debt agreements based on revenue sharing (usually denominated in Bitcoin).

Moreover, some non-crypto-native financial entities issued loans to Bitcoin mining companies in 2021 to purchase more ASIC mining machines, primarily to expand mining infrastructure and capacity across North America in response to the migration of hash power from China. For example, the venture debt firm Trinity Capital signed a senior secured equipment financing agreement in December 2021, providing Hut8 with a $30 million loan. In June 2021, the 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 data, both of these transactions had annualized interest rates around 10%.

Based on the financial statements of a group of the largest publicly listed or private Bitcoin mining companies, it is estimated that these entities raised over $5.8 billion during 2021 (75% of which was equity financing). According to The Block data, these companies raised approximately $2.4 billion in just October and December 2021, accounting for over 40% of their total annual financing. By the end of 2021, debt financing also saw significant growth, with convertible notes accounting for the majority of debt financing in Q4 2021, followed by secured loans, preferred unsecured notes, and loans secured by Bitcoin holdings or mining machines. Marathon is one of the largest publicly listed Bitcoin mining companies, issuing $747 million in convertible bonds in November, the largest debt financing executed by a Bitcoin mining company to date.

Another way to describe the financing surge in 2021 is to analyze the dilution of common stock of publicly traded Bitcoin mining companies. Marathon, Riot, Argo, HIVE, Bitfarms, and Hut 8 all significantly increased the number of shares outstanding in 2021, while remaining relatively flat in 2020. This dilution coincided precisely with the strategic shift of these entities, which at the end of 2020 held the vast majority of mined Bitcoins instead of liquidating them to alleviate operating expenses.

Given the recent decline in Bitcoin prices and the resulting compression of mining operators' profit margins, the financing environment for the industry has changed significantly since the end of 2021. Raising funds in the public market has become extremely difficult, and while private lending activity has continued into 2022, financing channels have clearly narrowed in the current context. Over the past 1-2 years, many mining companies aggressively expanded their operations and leveraged their balance sheets to grow (intentionally or unintentionally assuming Bitcoin prices would remain flat or higher), but they are now forced to restructure their businesses, often liquidating part of their Bitcoin reserves to meet regular expenses as well as loan payments or margin calls. As less prudent miners continue to face challenges, these conditions should provide opportunities for consolidation across the mining industry in the second half of this year. Earlier this month, a mining panel at the Consensus conference in Austin, Texas, expressed the same sentiment.

That said, we have reason to believe that certain miners, particularly those taking a more conservative approach, will be able to appropriately leverage the expansion of the aforementioned financing channels. All else being equal, more liquid capital markets should help increase infrastructure investment to improve the efficiency of mining operations (by updating equipment and/or reducing electricity costs through renewable or stranded energy), providing these participants with greater flexibility.

Hedging Strategies

Additionally, a more robust Bitcoin derivatives market should provide miners with more options for potential hedging strategies. If miners are concerned about falling Bitcoin prices, one strategy they might adopt is to purchase put options on the stocks of publicly listed mining companies (with strike prices around their production costs), which historically has been a high beta bet on Bitcoin prices. Furthermore, to fund the purchase of these options, miners could simultaneously buy (sell) covered call options to implement a costless 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 rates, as they are essentially "shorting" hash rates when their profitability rises as network hash rates decline), but these markets are relatively new and have lower liquidity. However, the simplest hedging method may still be the strategy of continuously converting a portion of Bitcoin into fiat currency.

The following chart shows the net flow of Bitcoin for miners.

Where Are We in the Cycle?

While the Bitcoin mining ecosystem has matured significantly since the previous cyclical downturn, analyzing past mining cycles is essential to estimate our position in the current cycle. From 2017 to 2019, we observed a cyclical process very similar to today's trajectory. At the end of 2017, Bitcoin's price began to rise faster than the network hash rate, leading to an influx of new miners and business expansions to capitalize on this mismatch (similar to the expansion observed throughout 2021). Then, as prices peaked at the end of 2017, the deployment of new equipment continued to drive the network hash rate upward (even as Bitcoin prices fell, similar to the hash rate increase observed for most of 2022).

Ultimately, Bitcoin's price fell again in November 2018, at which point many miners became unprofitable and were forced to shut down machines (similar to the second quarter of 2022). Around this time, the network hash rate peaked (at approximately 54 EH/s) and began to decline as miners shut down and mining difficulty adjusted downward. Subsequently, the network hash rate bottomed out around 35 EH/s (consistent with Bitcoin's price low slightly below $4,000) before beginning to recover. Returning to the current cycle, it appears that the network hash rate peaked in May at around 237 EH/s and has recently declined to about 200 EH/s.

Thus, while the mining market may still be far from equilibrium in terms of hash rate, evidence of miners selling and shutting down activities in recent months has begun to manifest in the form of declining network hash rates and ultimately mining difficulty. If these downward trends continue, we believe that the points at which they begin to flatten, based on trends observed during the 2018 cryptocurrency winter, may mark the beginning of a bottoming process.

The following chart shows the trends of Bitcoin prices and hash rates.

Conclusion

In these challenging market conditions, many mining operators' conservative approach is to liquidate part of their held Bitcoins as prices decline. As unprofitable miners exit, we anticipate that hash rates will decline, and the downward-adjusting difficulty will also decrease, creating a new equilibrium that better supports network activity. We believe that a lower steady-state hash rate is a potential bottom of the cycle, which will be a precursor for new entrants. At the time of writing, the network's hash rate continues to decline, currently around 180 EH/s. The recent decrease in network mining difficulty also supports the notion that miners have been shutting down machines in recent weeks. While this may change, this metric is crucial for monitoring going forward.

We may also see broader consolidation in the mining industry as well-capitalized larger firms acquire smaller operators forced to exit the market. This process appears to be underway, as GPU prices have steadily declined so far this year (according to Decrypt data, they fell about 15% month-over-month in May), and top mining machines are being sold at significant discounts in the secondary market (about 65% lower than last year's peaks). Therefore, while we will see various miners continue to sell portions of their held Bitcoins or mining equipment in this environment, or even be fully acquired, we also acknowledge that this process represents a natural, self-correcting characteristic of the Bitcoin network rather than a bug.