Don't Panic

Welcome to the fourth post in a series about bitcoin mining basics. In the last post, I looked at an example small home bitcoin mine and explored its performance during one year of hypothetical operation. This time, let's examine the cost of mined bitcoin, from three different points of view. The goal is to develop tools to evaluate a mine's performance in order to make business decisions based on data rather than emotion.

Dollars In, Bitcoin Out

Suppose you spend $1000 setting up a small mine, which then nets (after operating expenses) about .001 BTC per day. Your first day's haul looks like some very expensive bitcoin, but the dollars spent per bitcoin mined declines every day. If (huge assumption) your mine continues producing at the same rate for 1000 days, you will have accumulated 1 BTC for a $1000 investment. That seems like a pretty good deal at today's prices, except for the fact that it took almost three years to get there. If the mine runs long enough, it will produce bitcoin for pennies. More accurately, it will have, over its operational life, produced bitcoin for a time-averaged cost of pennies. True, perhaps, but not a very useful paradigm.

Cost of Power

At the opposite end of the cost spectrum lies the notion of mining bitcoin for the cost of electricity. If a mine grosses $10 worth of bitcoin per day and costs $2/day to run, it makes 80% profit! Pay no attention to the cost of equipment, electrical wiring upgrades, etc. I think this is the most common and misleading misuse of the terms 'cost' and 'profit' in a cryptomining context. Gross revenue less operating expenses is not 'profit,' but EBITDA (earnings before interest, taxes, depreciation, and amortization).

Mines that have run long enough to pay back their owners' initial outlay might claim to produce bitcoin for the cost of electricity. For newer mines, or mines with newly expanded capacity, operating expenses alone understate the cost of mined bitcoin.

For a bitcoin mine, zero EBITDA leads to the critical concept of electrical breakeven. Although the cost of power alone does not accurately measure the cost of mined bitcoin, bitcoin can't be mined for less. To cover its power bill, a mine has to produce bitcoin exceeding the cost of electricity divided by the current exchange rate. No need to lay out a formula with hashrates and difficulty and cost per kW-hr: if power costs $2/day and bitcoin trades at $10,000, a working mine must produce at least .0002 BTC/day. If the mine can't do that, the miner should pull the plug and buy bitcoin instead of electricity. It seems like an obvious concept, but I have seen forum posts where miners say they run their outdated energy-hog equipment below electrical breakeven. They justify such foolishness by saying they pay the power bill out of pocket rather than liquidating precious bitcoin for it. Sure enough, they do continue to accumulate bitcoin, paying higher than market price for it.

Timing is Everything

Accountants go to great (possibly absurd) lengths to synchronize business income and expenses. For example, the purpose of depreciation is to spread the cost of equipment over its productive life. This allows managers to look at financial statements for any period of time and see income along with related expenses corresponding to the same time period. The US tax code includes provisions for accelerated depreciation to incentivize investment in business plant and equipment. Never mind that. For this topic, we'll recognize the cost of mining equipment at a constant rate ('straight-line' depreciation).

To depreciate equipment, you first have to estimate its life. Mining machines eventually fail in a way that is not worth the cost to repair. More likely, advances in technology and increased competition render the machine cost ineffective (unable to meet electrical breakeven) before it dies outright. The useful life of bitcoin mining hardware is probably three years or less. The Antminer S7, introduced August 2015, already runs below electrical breakeven in some areas (it depends on local utility rates). A cloud mining contract has a stated expiration date, usually one or two years. The exact same concept goes by the name 'amortization' when applied to intangible things like contracts.

To add depreciation to the previous example, let's estimate the productive life of the $1000 mining machine as 1000 days. That gives daily depreciation of $1. The miner paid cash for the machine and operates it at home, so he has no interest or other expenses besides $2/day for power and $1/day depreciation. There you go: however many bitcoin he mines in a day, they cost $3. We could add complexity to the point of insanity – a tiny bit of the cost of the home, a little added air-conditioning cost, internet service, cost of turning on lights to check the machine, etc. You get the idea.

As long as the mine yields bitcoin with value exceeding $3/day, it covers all of its costs and rewards the miner with a profit. On any such profitable day, mining bitcoin is cheaper than buying it. If the mine performs at a profitable level (on average) throughout its life, the venture succeeds in providing its owner with a return on his or her investment. Along the way, the all-important price-over-difficulty (E/D) parameter drives the value of bitcoin the mine can produce. At any time, the average cost of mined bitcoin is the total depreciation to date divided by net bitcoin (net after electricity cost) mined to date. That's the same denominator as in 'Dollars In, Bitcoin Out,' above, but the numerator reflects how much of the equipment's life has been 'spent' mining (e.g., $365 after one year of the example machine).

Incidentally, I want to stress that bitcoin cost as derived here represents the financial cost of mined bitcoin. In the United States, the 'cost basis' for computing taxable gain or loss when selling or spending mined bitcoin is defined differently (a topic for another post).

Trying to Make Oranges into Apples

In the first post of this series, I made a qualitative comparison between investing in a bitcoin mine and investing in bitcoin. The extended time over which a mine acquires bitcoin makes direct comparison difficult. In some respects, mining more closely resembles dollar-cost averaging bitcoin purchases. A profitable mine produces more bitcoin than one can buy for the same daily money (electricity plus depreciation). It may or may not end up producing more than one could have bought for the same up-front investment.

In the next post, I will address the timing issue and methods for arriving at a more direct comparison of different investments. That will also provide tools and insight needed to make objective go, no-go decisions about starting or expanding mining activities. Thanks for reading!

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Next post: Time-Travel Voodoo for Mining Decisions