MIN E 408: Mining Enterprise Economics

Real Options
Dealing with choice

What is an option/future
Contract between two parties. One sells the other buys.
Put: You get the option to sell something for a certain price at a certain
time
Call: You get the option to buy something for a certain price at a
certain time

It is called an option because you have the right (but not obligation) to
follow through with your purchase (call) or sale (put)
Future = obligation
European: Exercise your option only at the expiry of the contract
American: Exercise your option anytime before the expiry of the
contract
Rarely are commodities actually exchanged, often just used to hedge

08-1

Option Example
Say you purchase an option to buy a $400k house (it could be a stock
etc) for $5000 today. The option expires in one year (European
option). Consider two different scenarios:
1) during the year Fort McMurray booms again and the house market
explodes. One year later the house is worth $800k. You exercise
your option and make $397k.
2) a second global economic collapse occurs and one year later it is
worth $200k. You gladly walk away from your option and are down
$5k.

Real Options
What have we covered so far:
Static NPV-does not consider uncertainty
Sensitivity analysis-vary one variable and see how it affects the NPV
(does not consider interrelationships/correlations between variables)
Decision tree-probability to follow some path, reduce complex problem
to a series of smaller ones
Monte Carlo Simulation-extends NPV to consider known
uncertainties/unknowns:
There are known knowns. These are things we know that we know (NPV). There are known
unknowns (MCS). That is to say, there are things that we know we don't know. But there are also
unknown unknowns (???). There are things we don't know we don't know.

Donald Rumsfeld
MCS does not consider the business choices operating mines have
But MCS does not consider all of the known unknowns
What aspects of mining/management does our NPV/MCS not
consider?

08-2

Option
Defer
Expand or
contract
Abandon
Stage
investment
Switch inputs
or outputs

Description
To wait before taking an action
until more is known or timing is
expected to be more favorable

Examples
When to introduce a new product, or
replace an existing piece of
equipment

To increase or decrease the

scale of an operation in
response to demand

Increasing or decreasing production

using stockpiles/equipment/layoffs

To discontinue an operation and

liquidate the assets

Temporary or permanent mine

closure

Staging of research and

To commit investment in stages
giving rise to a series of valuations development projects or financial
commitments to a new venture,
and abandonment options
option to abandon at each stage
To alter the mix of inputs or
Produce a different product
outputs of a production process
depending on the market
in response to market prices
6

Real Options History

Introduced in 1973 by Black and Scholes (Merton, 1977 is also an important
reference): contingent claims analysis
Real options deals with optimal planning for real options (not just financial
options)
Consider taking a long position on the option and a short position on the
actual stock. Gains from one offset the losses from the other. This is
essentially the risk free rate (sometimes called the risk free rate of return).
To calculate, can set up a partial differential equation and solve (Black and
Scholes)
In mining, similar concept for a real option: The more flexible a project is the
more valuable it is, i.e. it allows the owner to respond to future events in ways
that increase the value of the project
Purchasing the property gives you the option to explore
Exploring gives you the option to develop, which gives option to produce

08-3

Risk
Some projects have much larger NPVs, 5x as large

Yes mining is a risky business but

We can shut down if prices drop or costs rise
We can hedge against price uncertainty
We can diversify our portfolio (different minerals)

Copper
Mines in
Canada
21 operational
between 19801993
All had some
event
Valuing Managerial Flexibility:
An Application of Real-Option
Theory to Mining Investments
Margaret E. Slade1, 2001

08-4

Real Options

Advantages

Consider additional information/options/management strategies available

during mining

Risk

Commodity cycles

New reserves

Very important in the mining industry as the decisions we make are usually
larger ($) than in other industries, high capital and long payback periods

Disadvantages

Can significantly alter the NPV of a project, if the options are not considered
carefully and correctly, misevaluation is possible

Can be massaged

More time consuming to set up

Have to analyze the options and the criteria for the options

Options not usually independent

RO Example

08-5

NPV
i=12%
Annual income: (0.025oz/ton 9000ton/day 320days/yr 0.75
350$/oz)=$18,900,000/year
NPV over 10 years is $20.986M

IRR=36.64%
Project is feasible

Decision Tree

3 gold prices 3 ore recovery

3 ore grades 3 investment
Consider one branch:
((0.02 oz/ton 9000 tons/day
320 days/year 70% 250 $/oz)
12,000,000$/year) (P/A12,10)
15,000,000 = 25,848,384.00$
The probability of this branch
occurring is:
35 30 20 25% = 0.53%
Consider all branches, max is
$93M, the min is -$30M and
the weighted average is
$20.4M @12%

08-6

MCS

RO
Price is constant one year, then may go up or down
If gold grade drops below 0.025oz/ton (and price is low
enough) it is not economical to mine the gold
Option to either temporarily shut down mining or
selectively mine (mine high grade ore to make a profit)
NPV = $70M

08-7

Comparison
MCS

NPV:

$21.1

$20.4M

$21.3

$70M

Real Options Evaluation

Need to decide when in the project to exercise your option
Just make if statements in Excel

Basic application is to consider the following option in each

year, select the one that maximizes NPV

Full production
Fraction of production (could stockpile, costs may decrease)
Temporary shutdown (may have an expense)
Expand production (will have an expense)
Reopen mine if closed (will have an expense)

Goal is to produce when prices are high and costs are low
Need to estimate the cost of each option (cost to shut down
and cost to start back up)

08-8

Real Options 2

Example
A MCS style ROs application
True ROs are quite a bit more difficult
Here is what it looked like in 1985 (yes, that is 1985,
consider DCF is ~1910s and that is what most people use)

Example

Consider the following mine (ignore inflation):

10% discount rate
Variable Costs = $90/t
Fixed Costs = $5M/year
Constant grade
10 years of production at 1Mt/year
Price may vary, follows geometric Brownian motion:
Drift = 5%
Volatility= 20%
Should estimate these from analyzing past prices

Initial price is $110/t of ore (just to ignore prices/grades/etc)

You have the option to close the mine (which does not cost
anything) and reopen at a later date (which costs $7M)
Consider some realizations, and incorporate the option to
close down the mine.

08-9

Aside: geometric Brownian motion

Some random process, (used to model stock prices in the
Black Scholes model)
Time=max of 1
Drift () and volatility () modeled from historic prices
Just look at the change in prices over a fixed time
period
Equation:

is just a random number, N(0,1)

Solve for S then add to S
S is the price in the previous year
t is the time step

Other options
In a similar way we might be able to make an excel sheet to
consider:
production
Expansion

This would be quite a bit harder, might have to consider

VBA

08-10

Option to close and reduce

production
Could consider stockpiles (need to keep track of how much
room left) then sell at a future higher price
In this example NPV<0 if price falls below 100
Consider shut down

08-11