Theory #1 – The Miner’s Breakeven
A month or so ago, we came across this fascinating chart by Fundstrat’s quant, Sam Doctor.
What the chart claims to show is this – there is somehow a trailing breakeven price at which Bitcoin has historically traded above. Using a 1.8x average Price/Breakeven (the latest effort to fit a relative value multiple to Bitcoin price), he thinks Bitcoin (BTC-USD) should trade at ~$36k by 2019 Year end.
Here are the assumptions underlying the thesis:
While P/BE could prove to be an important psychological indicator, We’d strongly caution against anyone using this metric as a fundamental indicator. In fact, unlike commodities, Bitcoin’s average breakeven price likely has no bearing whatsoever on Bitcoin’s intrinisic value.
Bitcoin Mining Economics Are Different
The concept behind Bitcoin’s breakeven price as a support level comes from the world of conventional commodities where prices are believed to be driven by the cost of production. With commodities, supply and demand schedules are flexible and the following demand-supply curve might apply:
In this context, calculating producers’ breakeven is important as their collective production, combined with demand, results in a shortage/surplus, which in turn influences prices upward/downward.
Bitcoin, on the other hand, has a fixed supply schedule which looks like this:
Because Bitcoin’s supply is determined mathematically (its difficulty rate is adjusted every 2 weeks or so in response to the growth in hash power), its supply curve is inelastic. As a result, Bitcoin’s supply-demand graph probably looks something like this:
Whether the typical miner breaks even or not is irrelevant. As unprofitable miners exit the difficulty adjusts in response to ensure the supply conforms to the mathematically pre-determined schedule.
Therefore, the Bitcoin supply schedule is fixed as long as the lowest cost producer remains in production.
Breakeven Theory #2 – The “Lowest Cost Producer” Floor Theory
Another interesting theory posited by JPMorgan was that the most important breakeven is that of the lowest cost producer, e.g., a low-cost Chinese miner benefiting from low energy costs through a PPA.
This makes sense considering the concentration of hash power in the Bitcoin network, most of which comes from Chinese mining pools.
Using a discounted tariff of ~$0.03/kWh, the most affordable miner is likely to be located in a low-cost region in China with a breakeven amount of ~$3,200/coin.
Should all other miners drop out, the breakeven number falls to $1,750. Should this happen however I’d think the real marginal cost would eventually fall to almost zero as the difficulty adjusts downward to compensate. Zero marginal cost is unlikely to happen as there’d also be zero barriers to entry, so a $1,750 breakeven seems practical.
Some time two years or so ago when the consensus opinion was that oil would find a floor at ~$50 or so where the shale breakeven point lay.
The same logic is being applied to Bitcoin, i.e., below a certain breakeven, miners (producers) will turn unprofitable, leading to lower supply (bitcoin) flooding the market, and thus restoring equilibrium.
Meanwhile, the amount of hash rate added to the Bitcoin network has risen substantially.
While miners cant control overall supply, they can control their share of the block reward by increasing their share of overall hash rate. That implies that a mining pool controlling a large proportion of the network hash power can control its share of bitcoin, but overall supply remains the same.
Along with the block reward, miners also receive fees for verifying a transaction on the network. The fee portion is determined by supply-demand, i.e., how much a sender is willing to pay vs. how much a miner is willing to be paid.
So far, we’ve seen little evidence of miners gaining a higher share of the pool by raising fees. Overall mining revenue/coin produced has remained constant, with step changes downward in line with block halving.
(Source: Blockchain.info, Author Estimates)
The Conclusion: It’s All About Demand
Bitcoin mining is certainly an important consideration with regard to the overall network; however, I believe a breakeven approach may hold little weight for predicting future Bitcoin prices beyond being a purely psychological indicator.
In fact, I ran my own analysis on how much it would theoretically cost to produce a coin using an Antminer S9 purchased in January 2018 with typical breakeven (“BE”) and lowest breakeven (“LBE”) assumptions.