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… Bitcoin Mining

This is part three of a four-part series of posts on the Economics of Oil. Previous posts:

Oil PumpThe Economics of Gas Prices

The Economics of International Oil Price Conspiracies

The Economics of Airfare

 

BitcoinFirst off, at this point you are probably wondering what similarities Bitcoins have to oil. I suppose that the main hypothesis of this post is that Bitcoins are nothing more than a plain old commodity, just like oil, and they are subject to the same market forces. In fact, at this moment “Bitcoin miners” are struggling with the same issues that shale oil producers in North Dakota and oil sands extractors in Alberta, Canada are struggling with.

Bitcoins are a digital currency. They do not exist in any physical form, and there is no central monetary authority, like the United States Federal Reserve or the European Central Bank, that can issue new Bitcoins. The currency was established in 2009 on a system of computers. The computers maintain a running log of every Bitcoin transaction (basically a big long list of debits and credits) known as the “Blockchain.” The computers interact with each other to clear transactions and verify that their registries on the Blockchain are legitimate. Every time a user successfully verifies a block of transactions (which is a complicated computing algorithm that needs to be “solved”) the transactions are processed and that user receives a pre-determined number of newly minted Bitcoins for her efforts.

The designers of Bitcoin programmed the software so that the algorithms that need to be solved to verify the Blockchain and win yourself new Bitcoins get solved about every ten minutes. As more computers are added to the system, the algorithms are programmed to get more difficult. And with more and more user-systems vying for the new Bitcoins, more and more powerful computer systems are needed to be the first system to successfully verify the Blockchain and win the digi-cash. Basically, mining Bitcoins is deliberately designed to get progressively more difficult over time. Cloud computing companies are literally selling use of their systems to Bitcoin miners. Massive amounts of capital are being put into configuring powerful computer systems. And this comes with its own costs and externalities. A lot of electricity is needed to cool super-computing systems, and if the electricity is generated through non-renewable means then there is the additional cost of the pollution that is generated.

A Bitcoin mining operation

A Bitcoin mining operation

The similarity between Bitcoins and oil, I contend, is not because Bitcoins are “mined” in this digital sense. Rather, it is because we allocate capital to Bitcoin mining in much the same way we allocate capital to oil extraction. Bitcoins have absolutely no intrinsic value. They only have value as expressed in terms of other currencies (such as US Dollars or Euros). So, ostensibly, Bitcoins have exchange rates and have an ever changing value to them. Yes, certain companies do accept Bitcoins in lieu of traditions currencies, but prices are still expressed in the traditional currency and then converted into Bitcoins based on the prevailing exchange rate. This is what drives Bitcoin miners to devote their computing power to Bitcoin mining. They can then sell their Bitcoins for other currencies and use that money in the traditional sense.

Bitcoin Price Chart

The value of a Bitcoin, expressed in US Dollars

 

So when the exchange rate, or rather the value of Bitcoins goes down, there is less incentive for Bitcoin miners to devote their computing power to Bitcoin mining because they could be using their super computers for more lucrative endeavors. And mining Bitcoins is an expense endeavor. It requires ever more sophisticated computer equipment as well as vast amounts of electricity to cool the computers. And this is just like oil. It costs money to get oil out of the ground and into barrels, just like it costs money to mine Bitcoins. And if the price of oil falls below what it costs a company to extract oil, that company will shutter rigs until the price of oil climbs back up. All the same, if the value of Bitcoins drops below what it costs to mine them, the digital mining company will flip the switch to ‘off.’

Another interesting attribute about Bitcoins is that every four years, since the currency’s establishment in 2009, the number of Bitcoins that can be mined by a new block verification halves. So from 2009 through the end of 2012 the number was 50, now it is 25, and in 2017 it will be 12.5. By 2030 the number of Bitcoins will be limited to around 21 million. To me, this raises an interesting question. If Bitcoin only works because the people mining the coins for a profit are also verifying the Blockchain, once there are no more Bitcoin to mine, won’t everyone spending massive amounts of money on super-computing capabilities just stop bothering, making it impossible to verify transactions and trade Bitcoins, essentially destroying the currency? There needs to be an expectation that the value of a Bitcoin will be perpetually increasing, otherwise the entire system will cease to function.

And that is precisely what is happening right now in the United States oil extraction business (well, not a total destruction of value, but the drop in the price of oil is certainly concussing the current system). The number of oil rigs in the United States, as reported by Baker Hughes, peaked in October at 1,609 rigs. It has since fallen to 1,421 rigs. This basically indicates that exploration for new oil, which accounts for an enormous initial investment, is dropping off; however, United States domestic production is still surging. US crude production added 60,000 barrels a day last week, according to the Energy Information Administration (EIA). That puts the United States at 9.19 million barrels a day. However, as the price continues to fall and companies alter their exploration and investment plans, we very well may see domestic production peak.

An abundance of oil was discovered in North Dakota that was relatively cheap to extract, given the price of oil. So producers flocked to western North Dakota (a place where even geese wouldn’t flock to) and started to drill baby, drill. Over the same time period, emerging economies, such as China, and developed economies, such as those of Europe and Japan, slowed down. The demand for oil decreased, but the supply was steadily increasing. This has precipitated a large drop in the price of oil. Normally, we would expect Saudi Arabia to cuts its own production of the black gold to stabilize the price, but as I previous wrote, I believe they are not doing that this time around for political reasons. But it doesn’t hurt that this “price war” could help drive the Bakken Shalers out of business. Whereas Saudi Arabia only spends between $5 and $6 to get a barrel out of the ground, in North Dakota it costs maybe $42 on average to extract it out of the ground and get a 10% return on capital. The lower oil goes, the more it hurts American and Canadian producers, whereas Saudi Arabia has $900 billion of cash reserves on hand to ride out any prolonged dip in the price of oil.

Crude Prices

As a result of the flooded market and Saudi Arabia’s decision, the price of oil has dropped below the point at which it is profitable to continue to pump it out of the ground in the Bakken Shale fields of North Dakota. North Dakota, which has undoubtedly had the best performing economy in the country, even throughout the Recession (home prices in North Dakota actually went up through the Recession, whereas in most of the rest of the country they were plummeting), may finally see its wings melt. Texas, Oklahoma, Colorado, Louisiana, Alaska, and parts of Canada, may also see employment losses. The Federal Reserve Bank of Texas has estimated that there may be 140,000 job losses in Texas alone in 2015 as a result of the drop in the price of oil. Policy makers and regulators are also bracing for some troubles ahead for certain banks, housing markets, and even state budgets that rely on oil revenues.

Fill Up at the PumpHowever, over all, the drop in the price of oil will be good for the American economy. By saving at the pump Americans will be able to pad their savings accounts as well as go out and buy other things that will spur the economy. The Keystone Pipeline, which has been in the headlines for years now, might wind up being a moot point after all. The Pipeline was intended to bring crude oil from the oil sands of northern Alberta, Canada, to the US Gulf Coast. But oil sands extraction is costly and may drop in the future now that the price of oil is so much lower. If the pipeline ever gets built nothing may ever run through it.

As for Bitcoins, the only possible positive outcome of the boom (or is it a bubble?) that I see is that computing power might become exchange traded. First, companies became exchange traded on stock markets. And since then commodities and even more obscure assets like shipping contracts (Baltic Dry index) have become traded on exchanges. I don’t see any reason why computing power couldn’t become exchange traded in the future. Cloud computing companies are already offering their services over the internet to global markets; if there is enough volume in the market all that is needed is for the contracts to be standardized so that they could be traded freely between suppliers, consumers, and even speculators.

In the case of Bitcoin, I fear that by creating this digital currency and beginning to accept payments denominated by it, we are simply letting people with immense computing power at their disposal generate wealth for themselves. In addition, they are diverting their computing power from other uses that might be better for society, such as genomic coding, and in the process driving up the price for computer processing for the rest of us.

Sources:

http://www.economist.com/blogs/babbage/2011/06/virtual-currency

http://www.economist.com/blogs/economist-explains/2013/04/economist-explains-how-does-bitcoin-work

http://www.bloomberg.com/news/2015-01-14/gravy-train-derails-for-oil-patch-workers-laid-off-in-downturn.html

http://www.bloomberg.com/news/2015-01-15/oil-advances-as-opec-forecasts-slower-growth-in-u-s-supply.html

http://www.marketwatch.com/story/bitcoin-price-plunges-prompting-concerns-about-mining-activity-2015-01-14-121034915

http://www.economist.com/blogs/economist-explains/2014/12/economist-explains-4

http://www.marketwatch.com/story/opec-is-wrong-to-think-it-can-outlast-us-on-oil-prices-2014-12-02

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… Oil

Having now written four articles on oil, its price, and the consequences that has for everyday uses of oil, such as gasoline and airfare, I have decided to turn these into a series of posts I am calling the Economics of Oil.

Fill Up at the PumpPart 1:

The Economics of Gas Prices

 

 

Oil PumpPart 2:

The Economics of International Oil Price Conspiracies

 

 

airplanePart 3:

The Economics of Airfare

 

 

Bitcoin MiningPart 4: 

The Economics of Bitcoing Mining*

 

 

As always, comments are welcome and encouraged, even if you disagree with me on any point.

*And yes, you will see just how much similarity Bitcoin mining has to oil

… Airfare

airplaneWith the plummeting price of oil the news is filled with articles about how even though jet fuel is the number one cost that airlines incur (around one quarter to one third of total operating expenses), airfares are not going to go down anytime soon. Airlines tack-on “fuel surcharges” to their ticket prices, which can be especially high for international flights. A few airlines are publicizing that they are decreasing or eliminating their fuel surcharges, but for the most part, they are staying in place for now. Intuitively, this does not make sense. In fact, it does not even seem fair. And to me this illustrates the possible existence of a market failure which ought to be explored and if it is found to exist, eliminated, insofar as it can be.

The market for air travel is an oligopoly – a very cramped one, at that, in the United States, which I have written about before. And this in and of itself lends itself very sticky prices. However, disregarding that reality of the market, I believe that there are other forces at play colluding to keep the price of airfare high through those pesky fuel surcharges, despite the falling price of oil, and commensurately, jet fuel.

Oil_Jet Fuel Price Change

Airlines purchase hedging derivatives, called swaps which are based on the price of oil and/or jet fuel. Basically, they are bets on the future price of the commodity (jet fuel is refined from oil, but other variables, such as refinery capacity, make it so that jet fuel and oil do not move 1:1). If an airline thinks that oil is going to go up, which would increase their costs, they can buy a swap that says that over a certain dollar amount, say $100, the counterparty (such as a bank) would have to pay the difference. Then, if oil moves to $110, the airline would only have to pay $100 and the bank would pitch in the last $10. If, on the other hand, the price of fuel dropped to $90, then the airline would be caught buying fuel at $90 and having to pay an additional $10 to the bank. Other forms of derivatives, such as options, can also be used with similar results.

So, as you can guess, the airlines have purchased a lot of upside protection, so right now they are still paying high prices for jet fuel, based on their derivative contracts, even though prices have plummeted. This is one of the reasons why fuel surcharges still hang over airline tickets. Anyone who has read my blog in the past may be thinking to themselves that this sounds vaguely familiar. In fact, it is very similar to the interest rate swaps debacle that Detroit got itself into.

Right now, Delta and Southwest, who were both lauded a few years ago for wise hedging strategies, are reeling the most from the swing in oil prices. American Airlines, on the other hand, has less derivatives exposure, so it is set to gain more from the drop in the price of oil. Importantly though, even though American Airlines is set to gain, the oligopolistic nature of the market will mean that few of the saving will be passed on to travelers. American can keep its prices high precisely because Delta and Southwest can’t drop prices. The only people who are set to gain are American Airlines shareholders (and the bankers, of course).

The fact of the matter is, for any swap, the two counterparties take contrarian bets. In our case, the airline wins when prices go up, and the bank wins when prices go down. So to be on the other side of the bet, the banks must have seen the potential for oil prices to decline. Rarely do you hear that banks are the ones suffering from being on the wrong side of hedges. Maybe the banks are superior pricing models, or maybe they account for such a large share of international volume that they can influence the price through clandestine means. I don’t know, but it seems that their clients are always the ones taking outsize bets and losing the house. I completely fail to see the wisdom by which everyone espouses the abundant use of derivatives.

And now, with oil so very far off its relatively recent highs, airlines, especially in Europe, are looking to lock in new hedging positions, betting that prices for oil won’t drop below $40/barrel. I think it is only a matter of time before an international airline blows-itself up financially up with a backfiring derivatives strategy. Not only do airlines hedge their jet fuel risk, they engage in foreign exchange hedging, and refineries, which have close financial ties to airlines, hedge as well.

This is part three of a four-part series of posts on the Economics of Oil. Previous posts:

The Economics of Gas Prices

The Economics of International Oil Price Conspiracies

The Economics of Bitcoin Mining

 

Sources:

http://www.reuters.com/article/2014/12/23/us-oil-hedging-airlines-idUSKBN0K10AJ20141223

http://www.indexmundi.com/commodities/?commodity=jet-fuel&commodity=crude-oil

http://en.wikipedia.org/wiki/Fuel_hedging

http://www.cnbc.com/id/102336174#

… International Oil Price Conspiracies

Last September I posted an article on gas prices (to which someone had a very thoughtful Reddit response), why prices were falling, and how to account for price discrepancies within the United States. Since then, the international price of oil has kept falling and falling. Earlier this week the price even punctured the $50 a barrel mark.

Crude Prices

This precipitous fall in the price of oil has caused conspiracy theorist to claim that the United States is secretly engineering markets to put pressure on our international enemies such as Venezuela, Russia, and Iran. Do I think that the United States is doing this? Yes, absolutely. But do I think this is a conspiracy? Hardly.

Exhibit A is the recent appointment of Department of the Treasury Under Secretary for Terrorism and Financial Intelligence, David S. Cohen, to the Number Two spot at the CIA (Deputy Director). The White House is not hiding anything about this guy. They say he administered anti-terrorism funding programs, particularly against ISIS, as well as sanctions against Iran and now Russia. Economic espionage is official government policy, and it does not seem to me that they are trying to hide that at all from anyone.

Oil producing countries, particularly the members of OPEC, have been using the price and quantity of oil as a foreign policy tool for decades. Exhibits B & C, the 1967 & 1973 Oil Embargoes, where Arab countries used their leverage in the energy market to place political pressure on the United States. The United States, too, has used oil as a political tool in the past. Many historians claim that Pearl Harbor was the result of Japan’s hand being forced by an Allied embargo on oil reaching Japan.

To return to the economic, not political, side of things, the market for oil is an oligopoly. There are a few large suppliers, and there are significant barriers to entry (primarily being that certain countries simply do not have the natural resource underneath them in the ground). More specifically, the market for oil resembles a Dominant Firm Oligopoly, with Saudi Arabia being the dominant firm. As the world’s largest producer of oil (13% of world production), it commands a great deal of pricing power – power that smaller “firms,” such as Venezuela, Ecuador, Nigeria, Iraq, Iran, Libya, and Qatar cannot match. So theoretically, Saudi Arabia could sell its oil at a lower price, and the other countries would have to lower their posted price, or else their clients would turn to Saudi Arabia, which has plenty of oil to supply if it wants to.

And that is exactly what Saudi Arabia is accused of doing, through an arrangement made with the United States (many people point to a meeting Secretary of State John Kerry had in Saudi Arabia back in September). The conspiracy theorists claim that Saudi Arabia is selling its oil at a lower-than-market rate by keeping productions levels too high relative to international demand in order to drive down the price of oil internationally, in an effort to put pressure on the governments of Iran, Syria, Russia, and Venezuela. These countries all conveniently happen to be enemies of the United States and Saudi Arabia, and they are all also conveniently highly-dependent on oil prices for government revenue and social pacification.

Saudi Arabia, from a purely economic point of view, has an incentive to cut production, which would send prices higher. Higher prices mean higher profits, which is better for their economy. Other oil producing nations feel the same way. However, the stars may have aligned this time for the US and Saudi Arabia to strike a deal and keep prices down. The US gets the assist of pressure on its enemies; and not just Russian and Iran. At the meeting between Kerry and the Saudis in September, the Saudis agreed to join the US coalition against the Islamic State. Saudi Arabia, on the other hand, may have bought itself support in its fight against the Assad regime in Syria, and the low prices will put pressure on producers in the United States and Canada, where it costs a lot more money to get the stuff out of the ground than it does in Saudi Arabia. Everyone at the table (a table set for two) gives a little and takes a little.

So do I think that the United States and Saudi Arabia are at least in part engineering the fall in oil prices for their own political motives? Yes, absolutely. But do I think that this is a conspiracy? Absolutely not. This is just business as usual for the United States, where an economist is going to be our Number Two Spy.

This is part three of a four-part series of posts on the Economics of Oil. Other posts:

The Economics of Gas Prices

The Economics of Airfare

The Economics of Bitcoin Mining

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