To mine or not to mine: How crypto mining compares with buy and hold

The simplest method would be to purchase the underlying cryptocurrency outright from an exchange. Several crypto exchanges offer this service and since some of them require a “wallet”, it is best to set this up first. The easiest way to buy a crypto coin is to open an account with an exchange and transfer fiat money into it from a “wallet”. Some exchanges accept bitcoin for payment. Crypto exchanges include Cryptopia, Coin Exchange, Bittrex, Bitfinex and Coinbase.

The currency we are using throughout our analysis is Electroneum (ETN), which is currently one of the most heavily traded cryptocoins on Cryptopia. Based on a spot price of 9.728 cents on March 6, 2018 (USD/SGD rate of 1.32), $10,000 buys some 102,796 ETN coins. Buying a cryptocurrency on a crypto exchange is just like buying stocks on a stock exchange. Upside potential is unlimited, whereas downside is capped at the amount invested. The value of cryptocurrencies depends on the supply and demand, the application of that particular currency and the technology behind it.

Economics of a mining rig

A second way of gaining exposure would be by investing in a cryptocurrency mining rig designed to mine a cryptocurrency of the investor’s choosing. This would require an initial capital outlay for the purchase of the physical mining rig and a monthly maintenance payment for the upkeep of the mining rig and to cover electricity costs. The key advantage of this type of exposure is the investor’s ability to capitalise on the inverse relationship between the price of a cryptocurrency and the average mining efficacy. Essentially, cryptocurrencies are structured so that as they fall in value, they become easier to mine.

The reward output in number of coins increases as the price of the cryptocurrency falls. From an investment perspective, a mining rig actually reduces downside risk so long as the marginal increase in mining efficacy exceeds the steepness in depreciation of the cryptocurrency. This reduction in downside risk comes at the expense of capital expenditure (capex) such as the initial capital outlay for the mining rig, and operating costs, which mainly consist of electricity cost. The operating profit payback period (to be examined later) depends on the investment strategy adopted, market price of the cryptocurrency, operating costs and any additional capex spent.

Mining power was initially determined by a computer’s central processing unit power until application-specific integrated circuit (ASIC) chips were created solely for bitcoin mining. These allowed for significant increases in mining speed, rendering CPU-based mining uneconomical and obsolete. However, owing to the initial popularity and control of ASIC-powered microchips by the initial miners, newer alternate coins such as ETN have been designed to be ASIC resistant with the intention of preserving the core decentralisation aspect of cryptocurrencies. Thus, mining speed for most new alternative cryptocurrencies generally relies on one’s graphics processing unit (GPU) capability.

Mining rig sellers and hosting companies in Singapore such as Cryptomouse generally include at least three GPUs in their most affordable mining rigs. Interestingly, owing to the recent surge in demand, GPUs have become increasingly scarce and have seen a minimum 20% price appreciation over the last six months. Mining rig sellers are seeing a 50-week order backlog, which makes purchasing a new mining rig increasingly difficult.

Should this trend continue — as the cryptocurrency mining sector grows — mining rig investors could see the market value of their mining rigs increase over time, assuming the market value appreciation exceeds depreciation and amortisation (D&A). The return on the hardware itself could even exceed the return obtained from a cryptocurrency appreciating in value.

Valuing a mining rig

A mining rig can be valued like any traditional income-generating asset using a discounted cash flow model to calculate the net present value (NPV) of expected future cash flows. We assume a forecast horizon of 24 months, which we believe to be the prime useful life of a mining rig. The drivers of value are the price and type of cryptocurrency being mined, the marginal increase in mining speed relative to the increase in electricity and maintenance costs, and the marginal benefit of mining a specific coin versus its marginal change in mining difficulty. Revenue is subject to the type of strategy an investor pursues to actually realise return in fiat currency terms, the price of ETN and number of ETN mined (dependent upon mining difficulty). As such, we have analysed three scenarios under two different strategies for comparative purposes. Otherwise, operating costs, D&A and capex are consistent m-o-m.

Key assumptions to note

We have assumed the initial cost of the mining rig to be $6,500, running on the following specifications: 7x AMD Radeon RX 580 DDR5 8GB RAM, Intel Pentium G4400 3.3GHz LG1511 Processor, Biostar TB250+ motherboard, 1,600W power supply unit, 4GB RAM, 16GB solid state drive and an open air cooling mining rack. This yields an estimated hash rate of 200 to 210MH/s and electricity consumption of 830kWh. Electricity is likely to cost $180 per month and external hosting an additional $30 per month. We have also assumed a useful life of 24 months for a mining rig and it is depreciated on a straight line basis with no additional capex. We forecast a consistent mining rate of about 100 coins per day based on rates in whattomine.com. We assume a cost of capital of 15% a year (1.3% a month), which is basically the return an investor should at least expect for the risk he is taking. We also assume that the mining rig realisable net asset value if sold at the end of the 24-month period attracts only a 30% discount to cost (although fully depreciated).

Scenario 1: Mining for monthly income at constant ETN prices

Coins mined are sold at each month-end. Operating profit over a 24-month period is estimated at $1,971.80, giving a total operating profit return of 30.3%, or 15.2% a year. Net loss over two years, which takes into account depreciation, is likely to be $4,416.20, translating into a yield of -69.1%, or -34.6% a year. It would take 78 months to get back the cost of investment of $6,388.

Scenario 2: Mining for monthly income (2.5% m-o-m, rising ETN prices)

Here, the mining assumptions are the same, but we factor in a 2.5% monthly increase in the price of ETN (see Table 2 for illustration). This strategy would give a 24-month total operating profit yield of 69.1%, or 34.5% a year. The rig would still make a net loss of $1,977 over two years, translating into yield of -30.9%, or -15.5% a year.

Scenario 3: Coin accumulation strategy (2.5% m-o-m, rising ETN prices)

This is similar to Strategy 2, but coins mined per month are not sold at month-end, but held until the 24th month. This yields a total operating profit of $7,642.30 and a net profit of $1,254 over 24 months, translating into a net profit yield of 19.6%, or 9.8% a year. This strategy incurs a 3.2% monthly cash burn. Furthermore, assuming the mining rig is not obsolete after Month 24, the investor would have essentially obtained a free income-generating asset.

Comparing how our mining rig performs

We examined returns over a time period using three scenarios (see Table 3), which have led us to conclude that cryptocurrency mining as a short-term income-generating strategy is perhaps not ideal. However, if the coins mined rise to certain levels over a two-year period, the return on investment could exceed 100% in Scenario 3 using the coin accumulation strategy. In Scenarios 1 and 2, the mining rig is immediately cash flow positive. Even if that were the case, investing via a mining rig is a long-term investment.

Based on our three scenarios, the coin accumulation strategy yields a superior return if an investor can sustain the monthly cash burn. Another strategy would be to buy a cryptocurrency and hedge downside risk by purchasing a mining rig focused on that specific cryptocurrency.

An investor could also reduce their payback period by encashing ETN whenever it surpasses the investor’s upside target. If an investor is bullish, the portfolio should remain net long ETN and if bearish, the investor should sell some ETN at spot and accumulate more coins as the price falls and difficulty decreases.