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Bitcoin valuation and production cost (3)

by | Jan 13, 2020 | 0 comments

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After  having discussed about the Bitcoin pricing on the base of its Network value (article published  on 11/14/19)  and on the base of its ‘scarcity’ ( see article published on 11/21/19)-, let’s have a look now on an approach based on its production cost.

Bitcoin is based on the Proof of Work (PoW)

It’s necessary to remind that the proper functioning of the Bitcoin Blockchain requires the validation of transactions carried out on the network. These transactions are grouped into blocks where each added block is validated at regular intervals by ‘miners’ who should solve a kind of mathematical equation. The resolution of this mathematical problem is very computationally intensive. This consensus mechanism on which the Blockchain Bitcoin is based is called Proof-of-Work (PoW). The difficulty of the mathematical equation to solve for a block of transactions to be undermined is periodically readjusted. Nevertheless, this difficulty tends to increase constantly except during prolonged bear markets. It was the case in 2018, and at that precise moment, the difficulty decreased in front of the loss of financial interest of the miners for Bitcoin mining.

(see the chart below showing the difficulty of mining a new block on the Bitcoin)

The almost uninterrupted growth in the difficulty of mining Bitcoins inevitably leads to an arms race on the part of miners to obtain ever more computing power.

Chart showing the constant increase of the Hash Rate   

(Hashing : mathematic way to enable the security/ cryptographic process for mining Bitcoin)

In this way, miners maximize their chance of receiving  the reward  which is paying the miner who is successful in solving the encryption problem and who is validating the block of transactions. The reward  is currently 12.5 bitcoins but it will decrease to 6.25 bitcoins in May 2020 (read our article published on 10/31/2019 about the  coming Bitcoin Halving ). This division of the reward will make the creation of new Bitcoins even rarer. This scarcity will inexorably increase the price of Bitcoin but also increase competition between miners who will continue to try to have ever more computing power available.

The computational power of miners being obtained through the purchase of computer equipment specialized in Bitcoins mining. This type of famous equipment is called ASIC  (acronym for Application Specific Integrated Circuits).

Bitcoin mining induces  High Power consumption

 Cambridge Bitcoin Electricity Consumption Index

As mentioned, the process to validate a transaction’s block and create new bitcoins results in  very high power consumption. According to the Bitcoin electricity consumption index calculated and maintained by the Cambridge Centre for Alternative Finance (see the above chart), Bitcoin consumes 70 Terawatt-Hours per year to ensure the reliability and security of its network. This electricity consumption places the Bitcoin Blockchain just above Colombia, a country with a population of 48 million !.  

Bitcoin Mining simplified microeconomic model

A miner has an incentive to mine if, and only if, the total revenues generated  by the mining  activity on a given period exceeds  the total costs incurred by this activity.

But it also must be taken into account the potential  increase capacity of mining and it gives the following equation :

(1)      PBTC (Bitcoin price) >  A x Nm

Nm is the number of miners in the network

A is a constant number equivalent to the mining profitability equation (Revenues/Costs)

The equation (1) shows us that the price of a bitcoin is affected by the number of miners in the network. The price of a Bitcoin depends on the demand for bitcoin in a context of limited supply.   An increase of the Bitcoin price gives the miner a greater incentive to mine, which leads to a rise in the number of miners in the network. However , this increase cannot exceed the network profitability threshold  (PBTC /A) that  implies mining costs larger than revenues.

Therefore, it is clearly the price of Bitcoin the only factor that motivates  a player to mine and develop (or not) his activity. But the true economic reality is much more complex as the miners don’t all work  in the same conditions and do not have :

1/ identical computing power

2/ identical electricity cost

As said,  miners can also maximize their production by buying  more sophisticated hardware, forming large mining pools (mining farms) that combine their computing power, and by setting up business in countries with the cheapest electricity costs.

Mining cost in different countries

As the electricity cost is the key parameter  of the mining cost , let’s now have a look on the different electricity tariffs depending on regions and countries. Elite fixures  gives information on electricity prices to provide Bitcoin mining facilities all over the world (see the map and chart)

So, the miner ‘Holy grail’ is obviously based on cold weather countries (in order to refrigerate machines) and low electricity prices.

At looking more in details the numbers , we can see that :

South Korea  is the most expensive country to mine  Bitcoin (26170$), even if this country controls the majority of the capital invested in the Bitcoin industry at the same time

Venezuela is the cheapest country to mine with a ludicrous cost of 531$, thanks to State subsidies.

-In France, the cost level of 7930$ is in the average.

And for countries with favorable (cold weather) conditions as:

-the United States (at the world  ranking 41) the  average cost is 4758$

 –Russia and Iceland  have the respective costs of  4675$ and 4746$.

For China, the country that is bringing together the largest stake of the mining capacity, has an average cost of 3100$.But low cost Chinese miners can pay even less , a cost estimated  by JP Morgan at roughly 2400$  per bitcoin, helped by deals with power producers. These miners take the opportunity of direct electricity purchase agreements, like with  aluminium shelters that are looking for selling electricity excess production.

Conclusion

Even if the cost to produce a good or a service is not an absolute determinant for a minimal price of this good (or service), economical  rationality says that an equilibrium is found at a level where the production cost gives at least a break even, as a ‘floor’ price. All things and costs being equal, (electricity  prices and amortization of the hardware ASIC machines), a global mining cost average is around 6000$/7000$ and seems to constitute a minimal price for Bitcoin.

Below this price, supply would decrease (maybe except in China where the costs are much lower) , but based on this assumption, the reduced difficulty of mining would give a boost to new supply that would bring back an equilibrium later on.

On this base, and at the current price, Bitcoin is justifying its production cost (but not much more) This current cost is probably offering a floor level to Bitcoin today.

About the editor…

A passion : Economics, behavioural finance and emerging digital assets

Yves started his career in the asset management in 1986 where he worked at different positions as manager of equity funds and diversified funds. at Crédit Commercial de France and later, at Barclays group in Paris. In 1998, he took the lead of equity funds and diversified funds, then of the whole fund management business at the French team of the Dutch Robeco group  before joining Natixis Asset Management in 2012 as Director of the Equity Investment business unit. Yves left Natixis AM in 2018 to start as an independant player for professional investors and corporates (advisor and fund raiser).

He likes to engages in sports that test his endurance like running and swimming, Yves is also fascinated by social sciences, and more specifically by history and economics. But this is the economics mechanisms behavioural aspect and the markets behavioural analysis that are a constant source of thought and discussion. Since few years, the blockchain issue and emergence of crypto assets is a new field of passion and opportunities for him.

Yves Maillot

Financial markets and asset management

Yves Maillot

Financial markets and asset management

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