Bitcoin mining profitability: Key insights for investors

Overview

The analogy between mining precious metals and digital proof-of-work assets is sometimes misleading. However, from an investor’s perspective, it has certain merits. Both traditional mining and crypto mining are ways of gaining exposure to the asset extracted but are shaped by additional physical and economic factors. This article will give an overview of these externalities while largely abstracting from what drives the price action of BTC itself.

Key insights

• The Bitcoin (BTC) mining industry is capital-intensive and subject to high equipment churn, as ASICs are rapidly becoming more efficient. Since 2014, the hashing power of top-of-the-line mining rigs has grown by around 200x. This means short times to break even are desirable when investing in mining rigs.
• As of May 2023, the largest publicly traded mining companies in North America are Marathon Digital Holdings Inc, valued at $312 million; Hut 8 Mining Corp, valued at $246 million; and Riot Platforms Inc, valued at $193 million.
• The key determinants of mining profits are cheap electricity and a share of the total network hashing power. Therefore, Bitcoin mining is a highly competitive industry that can only provide stable returns through constant upgrading of the infrastructure.

Concept

Mining hardware performs a massively parallel search for so-called nonces to form a correct block. A nonce is a 256-bit number within the block header that can be freely chosen by the miner. However, only a vanishingly small fraction of possible nonces result in a correct block. A nonce is only correct when it happens to push the hash of the entire block below a certain value, called the difficulty target.

When people speak of network difficulty, they usually don’t refer to the difficulty target, but to the number of different nonces that need to be tried, on average, to find a correct block. Traditionally, this number is truncated by a factor of 232. At the time of writing, Bitcoin’s network difficulty is at 48 * 1012. This means miners need to collectively try around 206 * 1021 — i.e., 206 sextillion nonces to find the correct one.

Roughly six blocks are mined every hour and the network automatically adjusts the difficulty every 2,016 blocks (two weeks) to stabilize the rate or block production to this target. This regular difficulty adjustment means that, in the long run, only three network parameters matter for miners, namely:

1. The network total hash rate (H) and the miner’s hash rate (S)
2. The block subsidy, currently at 6.5 BTC, subject to halving every four years (m)
3. The average transaction fees per block (n).

The other key determinants of mining profitability are external to the network and include:

1. BTC’s market price (P)
2. The efficiency (k) of the mining hardware used, usually given in J/TH
3. The price of electricity (p).

The expected daily income from a mining operation is then given by the following expression:

D=144*m+n*P*S/H−k*S*p*1d

144 is the number of blocks per day. This equation encapsulates the essential features of the mining industry. It is a competitive race to gain and defend a certain share of the network’s power. It is also an instrument to utilize cheap electricity wherever it is available.

Over the years, mining hardware has undergone rapid evolution. The Bitmain Antminer S3 released in 2014, one of the early ASICs, integrated circuits specifically created just for BTC mining, had a hash rate of 0.48 terahashes per second (TH/s) and required 763 Joules of electricity per TH. For comparison, the S19 XP Hydro from March 2022 has a hash rate of 255 TH/s with only 21 J/TH required. The figure below summarizes this rapid evolution.

In addition to this, the interest in Bitcoin has steadily been growing, and more people have flocked to the mining industry. Both of these factors combined have meant that the total network hash rate has exploded and, sometimes, even outpaced the growth of BTC’s price. Thus, older mining hardware rapidly becomes obsolete unless an operation has access to very low-cost or free electricity. 

This can pose the risk of not breaking even on the investment in a mining rig. Given how quickly hardware evolves, a time to break even of less than 12 months is desirable.

Potential

There are several avenues for getting exposure to the mining industry. According to data from the chain bulletin, the United States currently makes up more than one-third of the Bitcoin network’s hash rate at 130 exahases per second (EH/s). Many of the U.S. companies involved in mining are publicly traded on stock exchanges. The Cointelegraph Research Monthly Trends report offers a regular roundup of the most important news affecting the evaluation of these stocks. The public mining companies with the highest evaluation are shown in the bar chart below:

There are also some more direct forms of getting into crypto mining as a private individual. Hosting facilities charge customers for operating hardware from there. Hashrateindex offers a database of such mining farms.

Most recently, hash rate marketplaces, such as NiceHash, have been created, where users can buy and sell hash rates. This way, the buyer absorbs the uncertainty associated with mining rewards, as block rewards are inherently stochastic and transaction fees on the network vary. On top of such marketplaces, more complex financial instruments such as hash rate derivatives have also been created. These were pioneered by FTX and are now offered by Luxor. They can be used to gain exposure to mining but also for miners to hedge themselves against certain industry risks.

Risk

Investing in mining operations can be a way of increasing one’s exposure to BTC’s future gains. However, it also carries additional risks.

Due to negative press surrounding the potential environmental impact of Bitcoin mining, the U.S. State of New York and the Canadian province of Manitoba have introduced mining moratoria. The state of Texas recently reduced the incentives given to mining businesses that take a load off the electricity grid during periods of high wind energy output. Furthermore, the Biden administration is considering a 30% energy tax on Bitcoin miners, which would reduce the competitiveness of U.S. miners internationally. Especially under bear market conditions, where profit margins are thin, this could negatively impact the evaluation of mining stocks.

As the mining industry is capital-intensive, many operations are debt-financed. As profits are very sensitive to BTC’s price action, this has sometimes led to overleveraged mining entities. During the 2022–2023 bear market, several publicly traded U.S. mining firms failed to service their debt. This coincided with a strong innovation cycle in the ASIC industry, which meant that much of the hardware financed with this debt is now slowly turning obsolete.

Conclusion

In conclusion, investing in the Bitcoin mining industry can provide exposure to BTC as an asset but remains subject to external factors, such as electricity prices, hardware innovation cycles and regulatory risks. There are several avenues for getting exposure to the mining industry, including publicly traded mining companies, hosting facilities and hash rate marketplaces. Overall, the mining industry is a complex and rapidly evolving sector that requires careful consideration before investing.

This article is for information purposes only and represents neither investment advice nor an investment analysis or an invitation to buy or sell financial instruments. Specifically, the document does not serve as a substitute for individual investment or other advice.