Everything is a risk-on asset when the US central bank is heavily subsidizing awful financial behavior, such as the irresponsible use of leverage. But while Bitcoin was dragged along for the ride, we can’t assume that projects like Bitcoin suffer from all the same problems as the overall markets. Let’s begin by unpacking what actually happened to oil this week.
The main thing to understand about the current price action in oil is that what we’re actually discussing are futures contracts, which have an expiration date. This month’s contract expired on April 21.
The other thing is 99% of people who buy futures aren’t seeking deliverables. Rather, they’re speculators, and the contracts change hands constantly. How does that work?
Let’s say I run a company that makes cornmeal. I buy a corn futures contract because I want that corn to be delivered to me at a set price. That’s beneficial because it means I’m not as exposed to massive fluctuations in the overall market in the future. Let’s imagine corn prices go crazy and double, then drop to where they were previously. The only people interested in that are speculators, not the actual people making cornmeal, who want to lock in the price they pay for corn, providing a level of predictability in their business. Speculators face the real pain of swings in commodity prices, and it’s the same for all futures markets.
The problem for speculators is when you buy a futures contract, you’re obligated to receive the commodity tied to it. The oil is typically delivered to a storage facility such as in Cushing, Oklahoma, but due to a global oversupply and collapse of demand, there’s no more storage for all the physical oil connected to these futures contracts. Companies are giving people money to take these contracts off their hands because they don’t have the physical space to store the oil. To exacerbate the problem, it takes more energy and capital to shut down and restart oil refineries and extraction processes than to just keep it all running. Oil tankers are being used to store the excess, while the US Strategic Oil Reserve is completely full. This scenario had an extremely low likelihood to happen, and yet it happened.
We’re in a unique situation where no one wants to buy the futures contracts the oil speculators purchased, because they expect oil prices to only get cheaper from here. That’s unfortunate for speculators who waited until the last minute to sell their contracts to avoid getting a raw deal, but when oil fell to sub-zero prices, those people still had to pay up before barrels of oil were shipped to their flats.
Anthony Pompliano recently said, “The stock market is not a representation of the economy, it’s a representation of central bank actions.” That’s half-true because while the central bank may bail out huge, debt-ridden companies, the true measure of real economic activity is found in the Russell 2000, which is an index composed of smaller businesses than the DOW Jones or S&P 500.
The Russell 2000 club is making money. On average they have positive cash flow, these are profitable companies that aren’t insanely overvalued (looking at you, TSLA). This part of the economy doesn’t rely as heavily on central bank intervention.
The fact that these larger, irresponsible, outdated companies can survive on bailouts and subsidies is a force that eventually snaps the other way, toward the underlying, human economy.
All markets are a reflection of psychology, exemplified this week in crude prices collapsing to negative levels. Everyone was paying attention to the expiration of oil futures contracts, so we at least knew volatility would be abnormally high.
Brent crude futures contracts expire on May 1. We may have a repeat of what happened in US oil futures in nine days, and it’s perplexing that we’re not seeing an orderly exit from Brent crude (Brent’s delivery hubs are more diverse than those in the US, so it may be enough to prevent negative prices).
We have an empirical example of what happens in the exact same environment, an instrument that tracks the same commodity, while the world overproduces 30 to 35 million barrels a day, but Brent hasn’t collapsed. The future expiry date is nine days ahead, so speculators will wait and pray for an upswing while everyone else shorts the long-tail event. That’s a testament to market psychology.
- Commodity futures traders rarely take physical delivery.
- Speculators pay others to take contracts off their hands, avoiding physical deliveries.
- The global shutdown of commerce led to immense over-supply of oil and few counterparties willing to buy existing futures contracts.
- Therefore: Negative Oil prices
Bitcoin’s death is a possibility — the network could fall to a 51% attack, or the project may splinter into several pieces. But there are some stark differences between oil as a commodity and Bitcoin as a medium of exchange and store of value.
People are still interested in the project. They’re still buying Bitcoin for its value as a long-tail uncorrelated risk-on asset. In the future, people may purchase Bitcoins for novelty reasons, so it can meet some level of demand even at $1 as it’ll hold historical value.
It’s doubtful that Bitcoin goes to zero because psychologically, it’s already known as an elastic asset, and there’s pent-up demand. The virtues of Bitcoin are the immutability of the ledger, finality, and speed of transactions, and some pseudo-anonymity of using it as a means of exchange. These virtues remain valid regardless of whether the masses will use it as a store of value. Speculators even praise Bitcoin’s price volatility and non-correlation (until recently) with other markets.
Before oil was utilized as an energy substance, it was considered a net negative. Imagine you’re a pre-industrial farmer, and you strike oil. Suddenly your farm is flooded with a sticky, horrible substance that deadens the earth, and your property is ruined. Once oil became an energy source, it was completely re-valued. In the same vein, Bitcoin may enjoy mass adoption as it’s found to be useful in a variety of situations, but that’s only food for thought.
You can turn Bitcoin mining rigs on and off with ease, that’s not so easy with oil. While both assets are affected by shutdowns in supply, the real difference happens at the level of storage. Oil has a steep overhead cost for physical storage, while Bitcoin is a digital asset. You can pay somebody to store your oil because there’s nowhere to put it, but you could place 10,000 Bitcoin on a laptop hard drive. The difference in maintenance costs is enormous, and because Bitcoin cannot experience issues with deliverables like oil futures can, Bitcoin cannot go negative for the same reason oil did.
Bitcoin requires physical storage space and energy input, but it’s one of the most elastic assets in terms of price that we’ve seen in recent years. The S&P 500 crashed about 30% in March, considered one of the worst crashes we’ve seen in a decade. In the Bitcoin market, that’s called a Tuesday.
In addition, Bitcoin’s halving events are pre-planned through the year 2100. Demand may suddenly crater or wane over time, but people are used to its huge price swings. That wasn’t the case for oil, which is generally thought to be an inelastic asset, which means less radical price fluctuations.
When miners go out of business, it’s not necessarily bad for the Bitcoin ecosystem. Miners have closed down in the past, some due to poor business practices or unacceptable local energy prices.
With Bitcoin, it’s not just the difficulty adjustments that challenge the system. For example, if the price crashes and 25% of miners shut down, effectively decreasing overall hash power by the same amount, there’d be what’s called “dynamic difficulty adjustments” that occur at set intervals in time to recalibrate the block time to be more frequent. That means it would cost less energy to mine each block, so the remaining miners expend less energy. This lowers their break-even cost and stabilizes prices. Speculation and mining participation increase and the cycle continues.
It’s helpful to think of Bitcoin miners as producers of oil. They’re the ones who are actually pulling this stuff out of the ground. Whereas the “whales” (high-net-worth individuals or investment groups) are the people who speculate on futures contracts. The speculators don’t actually produce anything but have money to invest in the underlying asset. They may not even touch the actual asset if they’re speculating on Bitcoin futures contracts.
We need to remember Bitcoin wasn’t created to solve business inefficiencies. It was meant to be a distributed ledger with pseudo-anonymity, but it was also designed so that if anyone had enough hard drive space and bandwidth, they could run a full Bitcoin node. Today, it may take you a couple of centuries to mine a Bitcoin in that way.
Right now, the cost to mine one Bitcoin stands around $6,800. With the current economic situation and the Bitcoin halving coming next month, many fear that the project will fail due to miners finding it unprofitable to continue their business.
- Near-zero cost of storage means no physical storage crunch (it cannot go negative).
- There’s intrinsic demand for Bitcoin based on its speculative nature, price elasticity, uncorrelated risk-on asset status, and low barrier to entry (price likely won’t go to zero).
- Dynamic difficulty adjustment means price stabilizes relative to the cost of inputs (energy costs remain reasonable).
It’s often the case when people say “Bitcoin will die” or “go to zero” that they’re really saying “Bitcoin will not live up to my expectations.” I hope this write-up has helped to bring some people’s expectations down to earth, and perhaps added a sober degree of confidence in the project for the long term.
This was written in partnership with Paul Buckton, and I credit an enormous level of effort to his insight while organizing these ideas.