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Wednesday, July 18, 2018

High gain high risk investments: If cryptocurrencies are commodities, Bitcoin is like oil – Five ways how they are similar

If we want to understand the new age cryptocurrencies, we need to look at the commodity markets and how they function. Here are a few similarities that Bitcoin has with crude oil trading, that could have Prince Alwaleed and Jamie Dimon think again.

Written by Sandip Sen | Published: October 24, 2017 2:43:11 pm
Cryptocurrency, Bitcoin, Bitcoin value, blockchain technology, Basecoin, Cypherium, Google Amazon, Microsoft, stable cryptocurrency, digital currency, Bitcoin market share, cryptocurrency market Saudi billionaire and one of the biggest stakeholders in the oil industry Prince Alwaleed in an interview to CNBC opined yesterday that Bitcoin would implode. (Representational)

Cryptocurrencies could be difficult to understand and invest probably because they are erroneously named. They could possibly be renamed as crypto-commodities. In the US and Canada, all digital currencies are given the status of commodities. They are widely used in the derivatives market and can be bartered. The profits from their trade is treated as business income and they are subject to anti-money laundering laws. But very few nations may be as progressive as North America in adopting new opportunities.

Saudi billionaire and one of the biggest stakeholders in the oil industry Prince Alwaleed in an interview to CNBC opined yesterday that Bitcoin would implode. This came a month after JP Morgan boss Jamie Dimon, another big investor in oil, called it a Ponzi scheme. However, once we consider cryptocurrencies as commodities, it becomes much easier to understand them. Also the most popular of the cryptocurrencies, Bitcoin resembles the most popular commodity oil.

Here are five ways that they may be similar:

Limited supplies

Both Bitcoins and oil have common constraint of limited supplies. It is approximately 1540 billion barrels of oil that can be drilled from proven current day reserves, as per a 2012 report. In case of bitcoins, it is just 21 million bitcoins that can be mined. The lifespan of oil reserves is just around 50 years. In the case of bitcoins, the mining can be done for close to 150 years.

Volatile prices

A look at oil prices over the last 150 years gives an idea of how prices of such commodities are controlled. Way back in 1869, oil prices surged in the US at $55 per barrel when it was a novelty. Prices were volatile and crashed, rose again to peak at $75 per barrel. But after a decade, new technology and new oilfields eased the supplies and prices slumped to below $25 per barrel and never really recovered for a century.

A look at oil price curves for the next century shows that it seldom breached the $30 mark. The prices only peaked after the Yom Kippur war in the 1970’s when the OPEC producers cartel was formed and later after 2000 when the ICE cartel dominated oil trading.

Bitcoin is today going through the first decade volatility. It is a relatively new commodity that is understood by few. The production process is relatively complex and risk prone. But as the prices soar, more technology brains will put their minds and money in it. Before the end of the decade the supply may outstrip the demand and leading to it being eventually stabilized. Some experts feel that it would stabilize around the $3000 mark, though it is too early to predict its future.

Difficult Mining

Like oil drilling, Bitcoin mining is for specialists dedicated to the block-chain technology. The idea looks simple enough but the implementation has several intricacies. You need to invest significant amounts when you start mining and then constantly upgrade your equipment to achieve a certain level of productivity. Most of the mining equipment is made in China. Though the basic equipment is found on eBay or Amazon, the upgrades are rarely found other than in a few provinces of China. If that was not so, China might not be controlling 70% of the Bitcoin production in the world.

This is similar to the fact that for more than a century after oil was discovered, it was the US which had a dominant control on oil drilling and supply technology. Almost all the oil drilling equipment, the piping and valves of the supply chain were products made in the US. Technology was closely guarded and big oil companies which controlled global oil supplies before the seventies were also mostly American.

Complex processing

In Saudi Arabia, drilling and processing oil for commercial use is a huge and extremely complex industry. Controlling and managing oil and gas fields and storing, and processing their output requires high technology and billions of dollars of investment.

Bitcoin mining has similar challenges. China has created four big mining pools that make it easier to find bitcoins. The hash rate of individual miners is combined so that the pool has a better chance of finding a block. The biggest of them all is the Antpool with around 22 per cent the hash rate. India by contrast mines just 4 per cent of the global bitcoins and has one big mining pool GBMiners that controls around 3.4% of the hash rate.

Sophisticated supply chain

Today, trading in oil is more profitable than producing oil, possibly due to overly complex and sophisticated oil supply chain. Oil volatility is controlled by buyer nations who have invested in huge reserves of oil. 28 nations including the US and the OECD nations besides China have nearly 90 days oil storage to counter volatility created by the OPEC and ICE oil cartels. For this major investment in transportation, storage tanks and security are needed, which needs to be continuously upgraded.

Investment in Bitcoins is similar. The exchanges from where you buy bitcoins need to be verified and closely monitored. It’s storage in personal wallets is critical and needs expertise. The place where you store it and how you ensure its security without hackers raiding into your system is an area where technology and know-how is needed. Since mining of bitcoins is going to get more and more difficult every 4 years, security of your bitcoins will become more difficult with use of multi layered passwords and complex protocols. Like oil, bitcoins is a huge learning curve. It is not easy but worth investing in.

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