Our interest in the mining process, and in the economics of the cryptocurrency mining process, in particular, was piqued by Murray Stahl and the activities and research of FRMO Corp and Horizon Kinetics into Cryptocurrency.
Mining as an Asset Class
During the FRMO Corp 2017 Annual Meeting, Murray Stahl gave the following example of the profitability of Bitcoin mining:
To mine cryptocurrencies, you can buy servers and depreciate them on some sort of reasonable schedule, based on their estimated useful life. If we hold back enough cash to the equal or compensate for the depreciation rate, then the unit value will remain constant. As an example, if you depreciate $100 worth of equipment, and hold back $100 of cash from the mining profits, you have $100 less net equipment, and you have $100 more cash.
The book value will remain the same, and you basically pay out the balance of the profits to the shareholders. In that way, you could have a business in which you’ve created a new security that doesn’t fluctuate in price; it’s just the dividend payout that fluctuates. Sometimes the dividend is higher and sometimes it’s lower; people can live with that. But the accounting value will always be the same.
That’s a complicated concept to absorb; sometimes I need to explain it five times for people understand, but that’s the way it works. Income is very important in modern-day asset allocation.
Horizon Kinetics has already raised funds for partnerships around cryptocurrency mining (or rather Consensus Money Seigniorage, as we believe they would rather call it). Furthermore, based on various statements made by Murray Stahl and his partner Steve Bregman, it is to be expected that Horizon Kinetics will expand its offering of mining-related investment products, most likely through a closed-end investment fund.
The Profitability of Mining
The Economics of Mining has characteristics that make it feasible as an asset class, in our opinion. It should come as no surprise that profit margins in mining can fluctuate quite wildly. Why is that? The biggest factor is the fluctuation in the price of the cryptocurrency that is being mined.
However, there are other factors that affect profitability:
- The cost of miners (also known as workers) can fluctuate
- The electricity prices can vary
- Machines can perform or underperform
- The Difficulty Rate and number of miners and nodes
Nonetheless, as is the case with Bitcoin, the whole system is designed for mining to be profitable over the long term. As Murray Stahl explained in a Consensus Money Podcast:
So, there were times when cryptocurrency mining went to break even. It happens. But it’s not going to stay there very long because cryptocurrency mining is designed to equilibrate. So let’s just say that it was unprofitable for a number of weeks. Well, most of these companies were very poorly capitalized.
So they can’t operate without profitability. They didn’t have huge cash reserves to operate unprofitably. What they would do to save cash is that they would turn off their machines. Which you can do in 30 seconds. If they turn off their machines, what happens is that the difficulty rating? Which you will recall, is the probability of solving this equation. If they turn up their machines, the difficulty rating goes down because there are fewer machines trying to solve the problem.
So when difficulty rating goes down and you leave your machine on, your machine necessarily becomes more productive. The probability of earning a coin goes up. So ultimately the whole thing is designed to equilibrate.
So, I’ve never really seen it being, maybe I’ve seen it for a day or two, get modestly unprofitable. Of course, it really isn’t moderatly unprofiitable, even so. Because when people calculate the cost of mining a coin, remember they are adding in the hosting fee plus the depreciation. The depreciation is not a cash expense. So on a GAAP basis, you might not be profitable but on a cash basis, you’re very profitable.
As Cryptocurrencies gain acceptance and their user base grows, many of them will be designed to have miners facilitating the system and the transactions flowing through that system. As acceptance and usage grow, mining will become a part of the conventional capital markets and become an asset class.
Investing in Mining as a Service Contract
What sets investing in mining apart from investing directly in the cryptocurrencies is that, with mining, you are not speculating on the price of the cryptocurrency. The mining operations are productive assets as they produce yields.
Think of it this way: You could mine cryptocurrency but every time you get your mining reward, you exchange it for your local fiat currency. Once you have paid for your operating costs, you will have something left over. Your operations will yield a return irrespective of the price fluctuations of the cryptocurrency itself.
There also exists such a thing as Mining-as-a-Service. There are a number of mining companies, that sell mining agreements to customers. These contracts can have durations, ranging from 3 months up to 2 years and are sold on a per hertz per-second basis.
At How to Value Stuff, we have not been doing any mining ourselves. We are, however, active buyers of mining contracts. In our experience, although this differs widely between providers, mining contracts carry extremely high investment yields at the moment. We will publish more about our experience with mining contracts in future posts.
More Thoughts on Crypto
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