January 1, 2022

Insights and analysis for the professional investor

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Bitcoin (BTC) - $16,581.06

Ether (ETH) - $1,198.95

Prices as of 12/23/22 @ 6:05 p.m. ET

Welcome to Crypto Long & Short! And happy New Year!

Like last week's Christmas Day newsletter, this week's New Years Day newsletter will be short and sweet.

So let's shortly and sweetly address the struggle of bitcoin mining companies in 2022.

– George Kaloudis

How Can Bitcoin Miners Survive in 2023?

It was a perfect storm for bitcoin mining companies in 2022: Interest rate hikes increased the cost of capital, mining bitcoin became less profitable as hashrate stubbornly trudged upward while bitcoin's price tumbled and mining companies' treasury management strategies failed them.

The result of the tempest shows up in the stock prices of the five biggest public miners by hashrate. In 2022, Core Scientific ($CORZ), Riot Blockchain ($RIOT), Bitfarms ($BITF), Iris Energy ($IREN), and CleanSpark ($CLSK) traded down 99%, 85%, 91%, 92% and 79%, respectively.

Ouch.

No, this doesn't mean that Bitcoin is dead or that bitcoin is destined for $0. I have quite literally written the opposite. It doesn't even necessarily mean that the public mining companies will disappear. What it definitely does mean is that we're due for (and are in the midst of) a bit of restructuring and strategy rationalization that will leave the mining industry better than it was before.

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What was wrong before?

For the last few years, some miners have held onto the bitcoin they mined, opting instead to finance operations with debt and other capital. This works really well when two things hold true:

The price of bitcoin is increasing, so the amount of people looking to get involved in Bitcoin for the sake of not missing out is high.
The cost of capital is cheap, so the amount of people looking to get involved in Bitcoin for the sake of yield is high.

And these two things were true for the last couple of years. So we had this really weird situation where bitcoin mining companies, who are in the business of mining bitcoin, weren't explicitly making money by mining bitcoin. Instead, they were making money by financing the mining of bitcoin.

This is a bit of an oversimplification, but really just a bit.

In our theoretical world, a bitcoin mining business makes money like this: The business has bitcoin mining machines which mine bitcoin, and the business in turn exchanges a portion of that mined bitcoin to pay for the expenses needed to run the business.

In our wacky world, a bitcoin mining business makes money like this: The business has bitcoin mining machines which mine bitcoin and the business in turn takes capital from the debt or equity markets to pay for the expenses needed to run the business.

I'm not saying companies do this exactly, but there are mining companies like Marathon Digital that have stuffed all the bitcoin it has mined the last 26 months on its balance sheet, rather than selling any of it to pay for operations.

Bluntly, this doesn't make a shred of sense to me. I stand by the idea that businesses should strive to function as a going concern in the long run – without a dependence on the capital markets – and make more money than it costs to make that money. Otherwise, that business shouldn't exist.

So when our wacky world moves on to a place where: 1) the price of bitcoin is decreasing, 2) the cost of capital is increasing, and 3) bitcoin mining is getting more competitive, you might be in for a world of hurt.

Well, all those things happened in 2022, so cue the recent news of a Core Scientific bankruptcy, a fulsome restructuring and capital infusion to save Argo from bankruptcy, and the resignation of Bitfarms' CEO.

So what's better now?

What now? We know the public mining companies are struggling, but amid all the pessimism there's (of course) reason for optimism.

See, in theory, mining companies will mine when it's profitable and won't mine when it's not profitable. The mining machines these companies run can be shut off and turned on easily.

But in practice, miners aren't shutting down and ramping up their operations based on the everyday price movements of bitcoin or electricity. Instead, miners mine consistently through market vacillations. And because of that, there is a need to practice some sort of treasury management strategy that extends beyond "hold all the mined bitcoin."

The strategy would involve some sort of consistent exchange of a portion of mined bitcoin to fund operations. Because eventually the price of bitcoin might start going down or the price of electricity might start going up.

Or both.

Public markets investors value both a predictability of cash flows and upside valuation potential. Public bitcoin mining companies have the latter in spades, but the former is sorely missing. A proper treasury management solution should anticipate and mitigate the unevenness of profitability associated with the markets that govern the bitcoin mining industry.

This strategy wouldn't allow a mining business to hold on to as much bitcoin as possible to sell at an elevated value during a bull market, but it would allow the mining business to more easily handle market stress. Besides, miners aren't in the business of timing markets; they're in the business of mining.

So whatever happens now, at the very least we should expect that the mining companies that survive this perfect storm and market downturn will make some sort of change. I think big, public mining companies will revisit their "hold all the mined bitcoin" strategy and that should better equip them to thrive well into the future.

Assuming, of course, the miners learn anything from this.