Wednesday, October 26, 2011

Bitcoin Price Drivers

The value of a Bitcoin seems hard to peg, with the exchange rate to USD reaching above 30 USD/BTC earlier this year, and dropping to below 3 USD/BTC a few months later.

The main question discussed in this post is: what determines the value of a Bitcoin? And how significant are the different factors? Yes, we are searching for the Bitcoin price drivers, and we intend to analyse Bitcoins relationship to wholesale energy prices.

Around every 10 minutes 50 BTC are mined, which is the collective target rate of the Bitcoin network. That means 7200 BTC are created per day, and at the current rate, that translates to around $20,000 USD/day. And with approximately $100,000 worth of Bitcoins exchanged on the exchanges each day, miners cashing in could account for up to one fifth of the current daily traded volume. This then stands to be a large portion of daily volume, and has the power to be the main price determinant. It should be considered more closely.

Mining also has costs denominated in conventional currencies, and therefore also helps tie the Bitcoin value to conventional currencies. The hardware and energy used for Bitcoin mining must both be purchased with conventional currency. The hardware constitutes a fixed cost, and the energy is the variable cost. Considering that the hardware is a sunk cost for current miners, it will be profitable for them to mine when energy costs are below the value of the resulting Bitcoins, and it will be unprofitable to mine when energy costs are above the value of the resulting Bitcoins.

The behaviour of the miners is therefore determined by the difference between energy cost and Bitcoin value. This is well-known amongst miners. But the aggregate market dynamics it creates is not well investigated, so this is an interesting topic for Bitcoin traders.

Electricity is the commodity consumed by miners, and the wholesale price of electricity is generally determined by a combination of the price of coal, the price of gas, the price of oil/gasoil or the weather. Electricity, energy commodities and weather all have heavily traded futures markets, so discovering a relationship would have great implications for Bitcoins.

So let us try to relate Bitcoin to energy numerically.

Expected payout for a miner is (h*B) / (D * 2^32), where h is the number of hashes computed, B is the number of Bitcoins received per block and D is the difficulty. A block pays out 50 BTC and the difficulty is currently 1468195 - which means a miner would currently have to compute around 1.26*10^14 hashes per Bitcoin. A Radeon HD 6990 is estimated to manage about 1.84*10^6 Hashes per Joule, meaning a 6,8541,843 Joules are spent per Bitcoin mined, or just above 19 kWh.

In an ideal world, the miner would have access to a wholesale electricity market, say the PJM, where a futures contract for Nov 11 is trading a little below $44 USD/MWh. With this price, you would get a marginal cost of generating 1 BTC at 0.836 USD.

That means, for those with access to wholesale, or near-wholesale, electricity prices, mining is worthwhile at this difficulty level. A sophisticated miner could have access to lock in electricity rates on the spot market, and would continuously monitor the spot electricity price, the network difficulty, and the exchange rate between Bitcoin and the local currency.

Although this could very well be a profitable strategy, it would probably be a mistake, with all due respect, to assume that miners are running such a sophisticated setup.

Using the EIA residential sector electricity prices, around 12 cents per kWh for US average throughout 2011, we get an estimated cost of around $2.30 per Bitcoin, which seems much less lucrative, but is still below the current exchange rate.

Electricity prices vary from region to region, so it would be difficult to find a single one that acts as a price driver for Bitcoin - but many energy and power markets move in parallel, and such moves could theoretically influence the Bitcoin exchange rate by influencing the marginal cost of mining.
But Bitcoins are currently traded way above this marginal cost of wholesale mining, which means there is either a limiting factor in play here, or the demand rate for Bitcoins simply exceeds 50 BTC/10 minutes.

We will go more into detail on this in a later post - stay tuned!

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