What's with the Bitcoin hash rate?
Summary: Although the Bitcoin price has crashed this year, the hash rate has gone up as Bitcoin miners have turned on more computational power, and this has worsened the miner profitability. This may lead to more centralization and lasting selling pressure from miners.
By verifying Bitcoin transactions, miners are compensated with a mining reward and the transaction fees paid by users. This amounts to 6.25 Bitcoins every 10 minutes for the mining reward, whereas the paid transaction fee is of insignificant importance to the revenue of miners. As the revenue of a miner is denominated in Bitcoin, the dollar amount a miner gets to cash out is completely dependent on the price of Bitcoin.
Other things being equal, one would expect a tumbling Bitcoin price to cause a diminishing hash rate, as miners can no longer afford to uphold the same computational power due to hardware and electricity costs denominated in dollars. Yet, the quite opposite has transpired in the past year. Although the Bitcoin price has declined, the hash rate has increased. The most plausible explanation for this negative correlation is that either the profit of miners was through the roof last year or miners are mining at a loss this year – or in reality; somewhere in between those two.
No one has pricing power, but production cost differs
The various miners do not have pricing power once they sell newly mined Bitcoins. On the other hand, the costs of mining a Bitcoin vary greatly due to the variation in the cost of electricity, equipment, and maintenance across mining undertakings. By and large, it is advantageous to have a large operation. The greater operation may offer lower electricity, equipment, and maintenance costs, plus permit the purchase of newer and more efficient equipment before other minor miners.
By normal circumstances, the mining industry is relatively competitive as a miner competes against many miners and has to keep its production costs low. Over time, only the most effective miners survive, which often turns out to be the large mining enterprises. In theory, the surviving miners keep adding hash rate to the network until it is no longer profitable, pushing the mining difficulty up, which is a function of the total hash rate.
“We deliver your ordered mining rigs in 2022”
Following the surge of the Bitcoin price in 2020 and 2021, the discrepancy between the production cost and price of Bitcoin increased, making it more profitable to mine than ever. This condition of elevated marginal profits appears to be favorable for a miner. Indeed, they were but only if you were already in possession of the right equipment. Following the massive growth in demand for equipment upon the surge in the Bitcoin price and the fact that mining equipment manufacturers could not source sufficient parts such as chips during the pandemic, an immense shortage in mining rigs emerged.
Yet, this shortage did not sufficiently cool down the demand, when in fact many miners started pre-ordering rigs from manufacturers with delivery scheduled for 2022, likely because the miners expected the higher marginal profit per mined Bitcoin to continue well into 2022. To profit from this belief, they had to obtain their fair share of state-of-the-art rigs already in 2021 but with delivery in 2022. Even worse, some miners even took loans to finance these purchases.
Are the mining rigs sunk cost?The belief of many miners turned out to be everything but true. Since November 2021, the Bitcoin price has been on a downward trajectory, greatly pushing down the marginal profit for the miners. Not only has the price of Bitcoin negatively impacted the marginal profit, but the production cost has mostly increased as well, particularly since the electricity cost has skyrocketed in many countries, so the mining costs are now estimated to be above the price of Bitcoin.
Although the mining conditions have greatly worsened, many pre-ordered rigs have been delivered this year. So, miners have been in limbo on whether to consider the rigs as a sunk cost and start to mine on them by only considering the variable costs such as electricity, to drive the rigs directly to a waste disposal site or to sell them second-hand. It appears that miners have chosen between all of these three options.
The decision to mine on new rigs has resulted in a steadily greater hash rate. Similarly, the sudden oversupply of rigs has completely demolished the market for rigs. It is estimated that there are up to 500,000 unopened rigs simply in the US because some miners cannot mine profitably, although the rigs are considered a sunk cost. The latter, alongside the lower Bitcoin price and the higher mining difficulty, have crushed the demand for new rigs, causing the prices of new rigs to decrease by around 70% in the past 12 months.
A dangerous cocktail
To sum up, the mining environment has turned into a much darker place in the last years, given a much lower Bitcoin price, a higher mining difficulty due to excess capacity, and elevated electricity costs. If you merge these factors with the fact that some major mining enterprises took on debt last year to acquire mining rigs, you have a dangerous cocktail. Not only are these miners expected to regularly repay part of the loans, but if they are to refinance them in the future, they are likely to have a much higher interest rate, further pushing the financials of these miners.
At this time, it appears that some miners can no longer keep their heads over water. In the past couple of months, various miners have filed for bankruptcy, including Compute North, whereas others have warned of potential bankruptcy, including Core Scientific. The latter has lost $1.7bn this year. Iris Energy stated recently that it has unplugged rigs, as they are producing insufficient cash flow. With no vast relief in sight e.g., a higher Bitcoin price or a lower mining difficulty, we may only have seen the tip of the iceberg.
The increased hash rate does technically enhance the security of the Bitcoin network. Yet, with various miners filing for bankruptcy, the greater hash rate may provoke the network to be more centralized. Over time, the large and highly effective miners may acquire troubled miners, potentially limiting the majority of the hash rate to these large miners. It is not positive for Bitcoin to potentially have less decentralization because it is its main selling proposition.
Too, in this environment, miners generally dump newly mined Bitcoins on the market as soon as they are mined to free up cash. This implies that there is constant selling pressure of Bitcoins, which needs to be absorbed by the buy side for the price not to decrease further. This is contrary to when miners were highly profitable. In these times, miners often kept the majority of their mined Bitcoins.
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