Cyclicality in the Bitcoin Mining Industry can have a Small but Notable Impact on the Bitcoin Price

In this post we will briefly explain the cyclical nature of the Bitcoin mining industry and the impacts it has on bitcoin exchange markets. For a basic intro to mining economics, please refer to our 2018 blog post on the subject here, and for a comprehensive refutation of the so-called ‘mining death spiral’ which tends to reappear with every downturn in the bitcoin price, please refer to our 2020 insights post here.

If you read no further, these are the summarised points of the article:

• Bitcoin miners are persistent participants in bitcoin exchange markets

• Their financial position determines whether or not, and to what degree, they retain their mined bitcoin or immediately sell it into the market

• If miners become distressed due to adverse market conditions, their accumulated bitcoin inventory will also potentially be sold into an already weak market

• While this would represent a persistent selling pressure, compared to the possible selling pressure from existing bitcoin holders, the ongoing selling pressure from miners is relatively low at only around 1,000 btc per day

• We currently find ourselves in an ‘inventory flush’ period of mining, meaning that we have not yet reached the point of maximum distress for miners

A huge thanks to Leo Zhang at Alkimiya for the development of a lot of the conceptual groundwork used in this kind of analysis.

The bitcoin mining market can be characterised by distinct periods of combinations between developments in hashrate and price. We refer to these periods (slightly differently to Zhang’s original work) as: Mining Gold Rush, Inventory Flush, Shakeout, and Rebalancing. These four periods are characterised by unique combinations of growth and contraction between bitcoin price and hashrate:

1. Mining Gold Rush: price growth rate high, hashrate growth steadily rising

2. Inventory Flush: price drops, hashrate growth rate continues to rise

3. Shakeout: price continues to drop, hashrate falls

4. Rebalancing: price and hashrate move in balance

These four periods are linked and notable to the bitcoin exchange markets because they impact the way miners choose to either sell or retain the coins they earn through the block reward.

Depending on which period you choose as the starting point, a mining cycle will proceed from a Mining Gold Rush period of exceptionally high profitability, where the purchasing power of bitcoin has been consistently growing faster than the difficulty to produce bitcoin. As the bitcoin price tops out and starts retracting into a bear market, the delay between mining investment decisions and actual deployment of hardware (generally between 6 - 18 months depending — amongst other things — on the miner’s hardware seller relationships, the jurisdictional friction of the chosen site, and the deployment experience of the miner) causes hashrate and difficulty to keep growing well after the bitcoin price has topped out. Finally, the increasing difficulty causes the cash cost of mining to catch up to — and for the highest-cost miners exceed — the price of bitcoin. Many miners become distressed and we enter the Shakeout phase. During the shakeout phase, both price and hashrate contract, and hardware flows from the highest-cost and most poorly capitalised miners to those with the lowest costs and the healthiest balance sheets. The highest cost mining operations are flushed out of the market and the difficulty reduction redirects block rewards to the surviving miners. We then enter the Rebalancing phase where both price and hashrate stabilises, and the cycle repeats.

We can observe a near-perfect example of this cycle progression during the 2017-2019 mining cycle. Starting from a period of rebalancing where price and hashrate were both relatively stable, the price then started growing at a much higher pace than the hashrate could match, triggering a Mining Gold Rush. Then as the price topped out around the start of 2018, delayed hashrate deployment continued even as bitcoin entered a bear market. In November 2018, the bitcoin price and the cash cost of mining finally crossed over for a large part of the active miners, and many were forced to shut down. We then entered the Shakeout phase where hardware changed hands from high- to low-cost miners. As price then began to rapidly recover in the spring of 2018, we again entered a Mining Gold Rush and the cycle began anew.

After the Mining Gold Rush between September 2020 and November 2021, the correction in recent months is therefore again forming a more challenging environment for mining companies. Yet again, it is increasingly becoming both more difficult to produce bitcoin and less lucrative to sell bitcoin. The profitability of mining is therefore beginning to squeeze, bringing us ever-closer to a Shakeout.

As before, hardware on order, often since times deep in the middle of the Mining Gold Rush period, keep being deployed, driving hashrate and difficulty up even as bitcoin prices are falling. With industry-wide revenues beginning to falter, high-cost miners operating at the margin — depending on the strength of their balance sheets — might soon begin the process of capitulation, selling first their bitcoin, and if conditions get bad enough their machines, to recoup capital costs and hope for survival.

(interestingly, in the middle of this cycle we saw a large drawdown in hashrate which was wholly unrelated to market conditions, but was rather caused by the Chinese mining ban during the summer of 2021)

In line with expectations, the average price of mining hardware units has also fallen since the bitcoin price has decoupled from hashrate in mid-November 2021 (the start of the Inventory Flush period), totalling a 39% drawdown in $/TH/s across all units. The drawdown in hardware prices is mostly a result from a supply-demand mismatch as manufacturers, having put in chip orders at the foundries during the Mining Gold Rush are now overproducing machines. While this is happening right now, we are not yet at the point where existing miners exacerbate the problem by selling cash-flow negative machines into an already distressed market. We can observe some data supporting this in that hashrate from low-efficiency units (Antminer S7s and S9s) has remained steady throughout the same period.

However, the network composition of hardware units may soon skew towards more efficient units as the cash-flow from operating these low-efficiency machines turns negative. Below we find that miners with a relatively high power cost (0.06 $/kWh) are no longer cash-flow positive when operating Antminer S7s and S9s (now outside the breakeven threshold). As a result, miners that have entered high power cost agreements may soon shut down segments of their operations, and likely contribute to the already falling prices of mining hardware as they look to exchange out-of-profit units on secondary markets.

As you can see from the chart above, only the lowest of the low-cost miners are able to deploy low-efficiency units under current bitcoin market conditions. This means that if current conditions persist, they will be the only operators able to achieve positive cash-flows from 1st generation ASICs, and will also likely be able to source them at very low prices.

Should the trend of price and difficulty extend for long enough, mining revenue may drop below a threshold where only a concentrated set of industry participants remain cash-flow positive. This is the Shakeout. Miners with particularly low power costs (less than 0.03 $/kWh) or high efficiency machines (less than 40 W/TH) are well positioned when conditions are at their worst, meanwhile those with high power costs and low efficiency machines are at high risk of needing to shut down their hardware.

In these scenarios, miners with negative cash-flows and high expectations of future mining revenue are faced with the decision to either further finance their operations with some combination of debt, private equity arrangements, or the cash preemptively stowed on their balance sheet. Alternatively, miners with lower confidence in future mining revenues may reach full capitulation, selling all capital assets and bitcoin holdings to meet any outstanding liabilities as they wind up and exit the market.

It’s worth noting that publicly listed miners also have the option to finance operations through public equity markets, however, company executives may be scrutinised for diluting shareholders in a calendar year when bitcoin mining company stocks have decreased 58% on average. It is likely also true that management teams are less incentivised to dilute shareholders in bear markets, when the effects of dilution, due to investor appetite being very low, are at their peak.

With the added difficulty of raising capital in public markets, mining firms Argo (184 btc), Cathedra (235 btc), Riot (250 btc), and Cleanspark (285 btc) have collectively sold nearly 1,000 coins since February 2021 ($29 mm, at the time of writing). According to what we could find in public filings, listed miners have approximately 43.7k btc ($1.33 bn, at the time of writing) left on their balance sheets. We find it plausible these firms are strengthening their balance sheets in preparation for potentially worsening economic conditions. When other miners get distressed, cash as we all know, is king.

There is a chance that Chinese miners sit on comparatively much larger bitcoin holdings than Western public miners, but we have nearly zero visibility into their balance sheets. Moreover, we find it more likely that Chinese miners would sell their hardware rather than sacrifice the coins they already own, given how hard it is to acquire bitcoin relative to hardware in China—and especially KYC-free ones.

Overall we suggest that it is a good idea for investors to monitor the trending relationship between bitcoin price and difficulty, the prices of mining hardware, and the holdings of publicly listed mining companies—especially those that are highly leveraged and have recently made large purchases of new machines that are not yet operational. If mining profitability continues to dredge lower, leading deeper into the inventory flush period of the mining cycle, we may cross over into a Shakeout phase where some miners are likely to capitulate and sell both their bitcoin holdings and mining hardware to recoup venture costs.

The mining market may thus be a canary in the coal mine of sorts, signalling a lower phase of the bear market. However, if previous cycles carry any predictive power, capitulation in the mining industry has tended to correspond strongly with overall market bottoms, possibly signalling the imminent beginning of the Rebalancing phase.

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