Bitcoin’s Rising Difficulty Squeezes Miners

Bitcoin’s difficulty adjustment rises 9.26%, the second largest increase this year. Hash price heads for new lows as miners’ profitability is squeezed as hash rate rises amidst public miner expansion.

Difficulty Adjustment Rises 9.26%

Bitcoin’s latest difficulty adjustment came in at 9.26% earlier today, its second largest increase this year behind 9.32% back in January. As per usual, the increase is a result of a surge in hash rate over the last two weeks driving faster block production times. Now both hash rate and difficulty sit just below all-time high values. Hash rate is up 10.27% over the last 30 days. 

What looks to be the driving forces behind the hash rate increases over the last of couple weeks are a few factors: larger public miners are getting more rigs plugged in which are in alignment with their 2022 expansion plans; we’re getting past the hotter summer months, especially in Texas where miners were temporarily shutting down rigs per incentives from their purchase power agreements; price rallying to $25,000 will drive more hash online and less efficient rigs shift hands to more efficient, competitive operations. It’s difficult to quantify which is the most impactful force, but all seem to be playing a role in hash rate growth. 

To see this level of rise in difficulty this quickly is a rare occasion and looks less sustainable than gradual rises in hash rate and difficulty we’ve seen in the past. If anything, the latest difficulty rise brings more pressures to miners’ profit margins at a time where we think bitcoin price has further to fall. 

Hash price continues its fall from its golden period, down nearly 17% over the last 30 days. If the increase in hash rate is mostly driven by prefinanced expansion plans by major public miners, the hash rate increase isn't reflective of a sustained increase in hash rate coming online on the margin.

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As you can see by the charts above, even a reversal in the short term doesn’t change the long-term trend of an ever-increasing hash rate and rising network difficulty. 

We’ve previously highlighted some analysis from Arcane Research that showed major public miners' baseline bitcoin production cost (based solely on electricity prices) were around $6,000 to $10,000. You can read more on that research by clicking the above link or reading “Bitcoin Hash Rate Plummets 17% From All-Time High.” Although we haven’t performed this analysis ourselves or triangulated the data, there’s one estimate that points to an “all-in” bitcoin production cost across public miners to be closer to $27,600 in Q2 of this year. This cost would include general expenses, maintenance, payroll, interest expenses on outstanding loans and other costs outside of electricity.  

Even assuming that estimate could be heavily overstated because we don’t have insight into the quality or methodology of the analysis, a bitcoin price hovering around $20,000 still puts major public miners on the ropes to achieve profitability on each bitcoin mined. 

Source: BlocksBridge Consulting

Developed by Checkmate, Glassnode lead analyst, a log regression model of bitcoin price and difficulty can give us a fair value-like view of bitcoin based on its rising production cost. It just so happened that the 2022 year low bounced nearly right off this model. It acted as an equilibrium-like point with price hovering below and above its production cost similar to other commodities. Every bear market cycle before has seen price drop and sustain below this production cost estimate. We still take the view, as we’ve had for months, that it’s more probable that the bitcoin lows are not in yet. At the very least, we will retest previous lows of around $17,500.

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Although that thesis is largely legacy finance driven, we’re in a time where miner capitulation doesn’t necessarily look like it has reached its conclusion. Financial conditions are limiting any additional access to major capital to fund operations via debt or equity raises, we’ve seen record selling of bitcoin production and treasuries over the last month and the fact that hash price (miner revenue per terahash), a measure of miner revenue standardized for rising hash rate, has always made new all-time lows throughout previous bear markets. 

It’s important to keep in mind the cyclical nature of bitcoin mining. As profitability skyrockets during periods of price appreciation, profit margins in the mining industry also soar. This leads to massive investment into new bitcoin mining infrastructure, which leads to much higher hash rates, with an obvious lag time. This new investment is often deployed over the following quarters/years after the initial plan of investment, leading to surging hash rate during a period where price has already pulled back meaningfully from its highs. 

The effect of rising hash rate and/or falling price impacts miner profit margins the same, downwards. It is thus notable and logical that the bitcoin hash price makes new lows every subsequent bear market cycle, as hash rate continues to push all-time highs as new machines arrive to the network with greater efficiency. 

This is why over the long term, we think of bitcoin as a digital synthetic commodity. A commodity money similar to gold that can be teleported near instantaneously across the planet, due to the difficulty adjustment and the economic incentives of mining with waste energy, bitcoin has a production cost that is programmatically rising. 

Although variable and subject to short-term market forces, bitcoin’s average unit production cost is rising over the long term with each subsequent upwards difficulty adjustment and block reward halving event. 

This reality is remarkably not understood by most participants in the legacy financial system today. Most still view bitcoin as a manic speculative asset driven by the animal spirits of market forces, without the understanding that bitcoin has a tangible marginal production cost that is ever rising, grounded in real-world energy expenditure and electrical infrastructure. 

This misunderstanding is the reason for the vast long-term asymmetry we still believe exists in bitcoin.

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Not financial advice.