Cost of production price theory

Trader Proposes Mining Cost of Production Market Theory

A trader proposes that Bitcoin miners are firmly in control of the market. We crunch the numbers to see if the theory holds credibility.

Quick take;

  • Trader Filb Filb anticipates miners are withholding selling block rewards as they seek to maximise revenue per unit by creating a pre-halving price bubble
  • The mining cost of production is identified as an important price point given that it generates either an incentive for miners to sell or not to sell their block rewards based on where the market price is in relation to the cost.
  • The USD value of block rewards in relation to daily trading volume indicates that selling pressure by miners in the spot and futures market is likely to have a material impact on price movements

An anonymous trader who posts online as Filb Filb (@filbfilb) has proposed a price theory based on the mining cost of production. Using this theory, Filb Filb previously speculated that the market would bottom out between $3 k and $4.5 k. Filb Filb made this speculation in March 2018 when prices opened the month above $10,000 and many traders maintained optimistic outlooks for cryptocurrencies rebounding to all-time-highs.

Cost of Production

The theory is based on the relationship between market price and the cost of production miners are incurring to generate each bitcoin. The theory proposes miners will apply strong selling pressure in both the spot and futures market when the price of bitcoin is significantly above its cost of production. On the other side, when prices decrease towards the cost of production, inefficient miners go out of business and a strong incentive to not sell arises for other miners who stay in business.

“…the price of any commodity tends to gravitate towards the production cost. If the price is below cost, then production slows down. If the price is above cost, then profit can be made by generating and selling more.”

Satoshi Nakamoto, February 21st 2010

An article in CoinTelegraph noted that Filb Filb believes miners to be “firmly in control of the market”.  Selling pressure from miners in the spot market can be identified as a high frequency of sell orders for the amount of 12.5 BTC, the current block subsidy. The futures market can also be used by miners as methods to lock in future profits and hedge against the possibility of market prices dropping below the cost of production. This is typically attractive when futures prices trade at a premium above spot prices, known as a state of contango.

Miners may also be willingly withholding selling the supply they produce as they look to distribute their supply on the market at even higher prices. Filb Filb noted “saying all the time in the bear market about these 12.5 BTC orders… They disappeared in the bull market this year and came back at 13K.” In an analysis posted on TradingView, Filb Filb speculated that miners will limit selling pre-halving to create a new price bubble.

Filb Filb currently estimates the mining cost of production to be approximately $6,500. The trader anticipates we will see miners limit the selling of the bitcoin they produce, further spurring price increases with a goal to maximise revenue per unit and sell at a later point. The last bi-annual report issued by CoinShares in June estimated the cost of production to be approximately $5,600 and as low as $3,500 for miners operating at the lowest costs. Such figures may provide an estimate of how low the market will go if Filb Filb’s theory proves to be accurate again. 

The Difficulty Ribbon

Analyst Willy Woo (@woonomic) recently introduced a new metric based on the same underlying concept of the selling pressure miners apply playing a pivotal role in price movements. The introduced metric, called the difficulty ribbon, takes eight simple moving averages of the difficulty level of mining on the Bitcoin network.

Difficulty reductions occur as the result of inefficient miners coming offline. Such miners typically sell high quantities of their block rewards to meet production costs. When such miners come offline, the higher-margin miners who remain sell less of their block reward on the market.

When the metric compresses or turns negative, this is indicative of inefficient miners ceasing operations. With such miners being a large source of market selling pressure, ribbon compression corresponds closely with market capitulation. 

“Typically we see this at the end of bear cycles, after miners capitulate, the lack of miner selling pressure allows the price to stabilise and then climb; the classic accumulation bottom.” 

Willy Woo

Crunching the Bitcoins

But how significant is the selling pressure provided by miners? If we were to believe the volume figures which CoinMarketCap feeds us, the amount of bitcoin that miners generate would only represent a small fraction of the volume which is traded daily. However, it has become clear this year through research from Bitwise Asset Management and the Blockchain Transparency Institute that the majority of exchanges are reporting artificially inflated figures. The team at Messari put together an alternative volume figure, known as the “Real 10” taken from the ten exchanges that are believed to be reporting accurate volume figures.

The 24-hour “Real 10” daily exchange-traded volume on Messari as of August 4th is $727 million. This is approximately half of the $14.5 billion which CoinMarketCap proposes. With daily block subsidy rewards miners receive being approximately 1,800 bitcoin per day, this equates to approximately $19.5 million at current bitcoin prices of $10,850.  Adding on average daily fees over the past 30 days on top of this would mean Bitcoin miners have approximately $20.3 million in value to potentially sell on the market each day. Although this represents approximately 2.7% of Real 10 daily traded volume, it is likely to have a material impact. Firstly, the newly minted bitcoin supply brought on the market by miners would all be on the sell-side. Furthermore, this constant sell-side pressure would be offloaded into individual markets procured by exchanges. Although the Real 10 volume is $727 million, the ten exchanges which make up the Real 10 volume figure will be more subject to significant price drops in the face of significant selling pressure. This was demonstrated recently in price discrepancies between Bitstamp and other exchanges when large market orders were executed on Bitstamp. 

These calculations also do not account for the impact of miners selling futures instruments which can serve as a forward-looking estimate of spot price. The price of the futures market closely ties with the underlying spot market and the impact of futures can be amplified through the capability to add enormous amounts of leverage to positions. The role miners play in such markets is unclear. Another bitcoin trader has noted that they take into account the difference between the futures price and spot prices as a gauge of mining selling pressure in the market.

Satoshi Foresees A Change

“The increased production would increase the difficulty, pushing the cost of generating towards the price. In later years, when new coin generation is a small percentage of the existing supply, market price will dictate the cost of production more than the other way around.”

Satoshi Nakamoto, February 21st 2010

While Filb Filb’s theory is based on the selling behaviour of miners pushing market prices to the cost of production, Satoshi anticipated that the inverse will take place in the long-term. As the issuance of newly minted bitcoin decreases, while simultaneously getting issued into an ever-larger supply, Satoshi anticipates market prices will have a larger impact on miners cost of production than the other way around.