Bitcoin Mining’s first major bankruptcy creates uncertainty for key partners, opportunity for others

What happened

Compute North, the second largest bitcoin mining hosting provider in the US, filed for Chapter 11 bankruptcy last week. The company quickly followed that filing with another court order requesting a 363 bankruptcy sale to liquidate assets to cover the roughly $140 million in debt it has accumulated.

The bankruptcy is perhaps the biggest bitcoin mining news to emerge in 2022’s bear market. Compute North hosts $700 million worth of equipment for around 84 mining companies, including publicly traded companies such as Marathon Digital Holdings. Now, with the hosting provider looking to auction off its assets, those customers may face a situation where their service agreements are being rewritten under new management. Some miners may even be forced out of their hosts, while others may face default even if prices rise.

Broader Context: Vice Grip Economics Crush Compute North’s Margins

Large-scale Bitcoin mining is expensive. Now, most people know that it requires a lot of energy and expensive machinery, but miners also need very expensive electrical equipment (transformers, panels, power lines and things like that) that scale with the size of their fleet, and they also need containers or warehouse space to store them .

Given the scale and cost, miners will often rely on hosting providers like Compute North to abstract the cost and effort of building out a Bitcoin mining farm themselves. The miners supply the machines, and the host supplies the power. Under these agreements, the two parties sign a contract that locks in a hosting price for a specific period of time. These contracts can vary, but typically include a set price for power, which may include a profit or revenue sharing agreement.

As the graphic above illustrates, Compute North has over 20 subsidiaries that operate the various aspects of this business. Most of these (the companies under the “Operating Companies silo”) are wholly owned by Compute North, while others are joint ventures with NextEra Energy and Marathon Digital Holdings. In addition, CN Borrower LLC is now owned by Compute North’s primary lender, Generate Capital (more on this later).

Compute North’s contracts typically last 3-5 years and lock in a fixed power rate for the miner. The problem is that Compute North did not lock in its own electricity rate with its electricity suppliers via a long-term power purchase agreement (PPA). Meanwhile in Texas, a state that hosts a significant portion of Compute North’s customers and where Compute North is expanding most aggressively, average industrial power prices increased 64% from July 2021 to July 2022, from $5.20/kWh to $8.21 /kWh.

According to the Chapter 11 filing, Compute North said that a “typical [hosting service agreement] does not expressly permit the passing on of increased energy costs to customers’, so the host company has to eat the rising electricity prices without recovering the costs from the customers.

And the revenue Compute North earned was eroded by Bitcoin’s bear market. Bitcoin’s hash price – a measure of how much income miners can reap in a day’s work – has fallen 68% so far this year.

So when Compute North’s primary operating costs (power) increased, margins, already reduced by market conditions, were effectively crushed.

Sensing Trouble, Compute North’s primary lender triggers technical standard

Although Compute North does not state this in its filing, it is likely that the company’s unsustainable revenue situation drove its primary lender, Generate Capital, to trigger a technical default.

Generate Capital opened a $300 million line of credit for Compute North in February, of which Compute North drew $101 million. According to Compute North’s bankruptcy filing, Generate Capital claimed that Compute North was in technical default, which cut off Compute North’s access to credit and gave Generate Capital the right to take control of two of Compute North’s facilities (one in Kearney, Nebraska and one in Granbury, Texas, as well as a $23.6 million bank account.

Outlook and Implications: The Compute North facilities are operational for now, but will soon be sold

With its primary line of credit closed and margins evaporating, Compute North filed for Chapter 11 bankruptcy. Commonly referred to as a reorganization bankruptcy, a Chapter 11 allows the company to continue operations while it devises a plan to satisfy creditors.

As for creditors, Compute North owes $99,809,696 to NextEra Energy, a power company with which Compute North entered into a joint venture for one of its Texas facilities; $21,013,027 to public Bitcoin miner Marathon Digital Holdings; $7,466,005 to Foundry, a subsidiary of Digital Currency Group; and $18,374,138 to about 30 other entities.

To pay off this debt, Compute North filed a petition with the US Bankruptcy Court in the Southern District of Texas to auction off its assets in a 363 bankruptcy sale. If the sale is approved, Compute North may sell up to $1,000,000 worth of assets outside of the auction in a de minimis sale.

However, the bulk of the sale will take place in an auction starting on November 1, 2022. This auction will include anything and everything Compute North controls, including bitcoin mining containers, bitcoin mining machines, and the data centers, the latter of which will be the most sought-after assets.

Decision points: What happens to clients if Compute North’s business is split?

The asset auction is sure to draw bidders from all corners of the Bitcoin mining industry, including financial institutions and energy companies active in the sector. These players will now have the opportunity to gobble up assets for kroner on the dollar.

It’s anyone’s guess right now where the pieces fall in terms of purchase, but depending on who ends up with which data center, it could mean headaches or hell for the clients operating those sites. Given that current hosting service agreements are unprofitable, the new management will no doubt want to rewrite these agreements. Some miners may be forced out of their deals, while others may choose to leave.

Marathon Digital, for example, has already secured a deal with Compute North competitor Applied Blockchain for another power and storage space to house the public miner’s current and future fleet of mining machines. As for the bankruptcy, Marathon Digital’s stock fell 10% the day the news broke, but the stock price has largely rebounded from this over the past week. It’s also worth noting that Marathon’s computing power, via its proprietary mining pool Marapool, has not gone down in the past month in light of the bankruptcy.

In addition to Applied Blockchain, Bitcoin miners who may be evicted from the restructuring can look to Core Scientific, the largest Bitcoin mining host in the US, for a new home. However, Core Scientific lost $4.7 million from its hosting services in Q2 2022, according to its 10-Q filing.

Without an inside look at Core Scientific’s operations, it’s impossible to tell whether this loss was a result of increasing power rates and a lack of PPAs or whether it stemmed from data center downtime during the summer heat waves (Core Scientific has significant operations in Texas). That said, industry sources say Core Scientific has the ability to pass on rising power costs to its customers in the event of power surges.

The situation is a salient reminder that public and private miners who own their own power and data centers, while expensive, have one less thing to worry about in times of market uncertainty. Riot, Argo, Hut 8, Bitfarms and Cleanspark, among others, do not have to worry about the counterparty risk of hosting providers.

For those using hosting providers, with thinner mining margins and rising power costs, there is uncertainty surrounding hosting options. It was not uncommon for Bitcoin miners over the past few years to forego long-term PPAs because power costs had decreased and hosting rates have increased on average for the industry.

As such, Compute North clients may be stuck between choosing the best of two bad situations by either staying with uncertainty amid Compute North’s restructuring or seeking new uncertainty with another hosting provider.

It is too early to say whether the situation will develop into credit contagion or not, but the bankruptcy’s effect on other miners will become clearer as Compute North’s data centers are sold to new management.

Investors in these companies will be well suited to understand the source of strength of portfolio companies in order to determine whether reallocations or further diversification is necessary.