Bitcoin mining is a notoriously energy-intensive endeavor and that puts plenty of regulatory and environmentalist eyeballs on the industry. As if those issues aren’t enough, bitcoin miners contend with elevated energy costs. That can crimpbitcoin pricing -- and their bottom lines.
For a Bitcoin miner to be profitable, the price of the mined cryptocurrency must exceed the company’s mining costs. In a hypothetical scenario, a miner is coming out ahead if its expenses to mine a single a bitcoin are, say $10,000, but the spot price of the digital currency is $30,000.
That’s an example of the cost of production valuation model, which states, at a minimum, bitcoin must be worth the price it costs to mine or else mining activity would cease.
“Out of all the valuation theories we’ve explored, the cost of production model stands out as the most pragmatic. If a breakeven operating price for bitcoin exists, it’s logical that it would encompass the ongoing energy expenses required to maintain the ledger,” noted Morningstar analyst Madeline Hume.
Cost of Production Not Perfect
The cost of production valuation model has relevant applications for investors examining the impact of energy costs on bitcoin miners’ bottom lines. But Hume says the model isn’t perfect.
“The key limitation plaguing the cost of production model is that its independent and dependent variables are locked in a feedback loop. Production costs influence prices, but crucially, prices also influence production costs,” she adds.
Not to mention the point that bitcoin miners often engage in market timing with little success. It’s worth acknowledging that the industry is young and likely learning some lessons along the way. But many of these companies have a penchant for boosting activity whenbitcoin pricesare high and scaling back when prices slump. That much was seen during the crypto winter of 2022.
Consider another hypothetical. Imagine if oil production costs were intimately tied to spot prices and exploration and production companies only drilled at the height of oil bull markets. That would pinch profitability.
There are other variables for crypto investors to consider. This includes the cost of production, total addressable market, stock-to-flow, and network effects.
“The logic of the cost of production model suggests that if the marginal cost to produce another unit of bitcoin is higher than the current price, production will slow until equilibrium is restored via a higher price or more-efficient supplier base,” observes Hume. “But for cryptocurrency specifically, a breakeven price higher than the current price does not necessarily signal that bitcoin is cheap. Or that sloppy miners will exit the market en masse.”
Bottom line: The model isn’t perfect. But it can be relevant for investors looking to get a handle on some of the headwinds miners encounter.
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