Using real options to value and anage a mine expansion decision at a multi-zone deposit

CIM Bulletin, Vol. 1, No. 1091, 2006

M.R. Samis, D.G. Laughton and R. Poulin

The file is a zipped PDF document.Real options valuation is an alternative net present value framework that is able to incorporate both management flexibility and dynamic project risks. In this paper, management is considering the development of a satellite low-grade zone while operations in a developed high-grade zone continue. If the low-grade zone is developed prior to high-grade zone exhaustion, mine capacity must be expanded before additional production from the low-grade zone can be processed. This expansion can be avoided only if low-grade zone development is delayed until the high-grade zone is exhausted. The real option model presented here allows the development and capacity expansion decisions to be reconsidered on a discrete half-year basis. It delineates price regions, for given levels of high-grade zone reserves, in which it is optimal to develop the low-grade zone, defer low-grade zone development, and abandon the mine irrevocably.Applications of real options to mining project valuation have previously used fixed production plans (FPP) to describe project structure. FPPs aggregate geological structure, such as deposit zones, into pre-determined production profiles summarizing development and production operations over a project time horizon. These real options applications extend their project structure models with global forms of project flexibility, such as irrevocable abandonment and temporary closure, and decision trees in which each branch of the tree represents a FPP. In some situations, these models may be inappropriate because they may overlook operating strategies that arise from managing the production from individual deposit zones. Such shortcomings can reduce the understanding of project operating policy.This paper analyzes an expansion decision at an operation exploiting a two-zone deposit using the real options valuation framework and a project structure model called the fleXible Discrete Mine Production (XDMP) model. The XDMP model extends previous real options mining applications by identifying development and production activities associated with specific deposit zones, in addition to global project operations. It also recognizes that capital expenditures can be used for either inflexible, zone-specific (e.g. access development to a zone) or flexible, multi-zone purposes (e.g. truck purchase that can work in any zone). Finally, it incorporates operating strategies that take advantage of geological structure such as closing a high-cost zone in response to a fall in mineral price.The XDMP results are compared to three low-grade zone development fixed production plans (no development, immediate development, and delayed development) that are valued with the discounted cash flow (DCF) and real options valuation methods. The results show that a DCF valuation model with no operating flexibility (i.e. a static spreadsheet cash flow model) may at times produce project values that are significantly higher than those produced with a flexible real options valuation model, contrary to the results often presented in other real options papers. They also show that combining fixed production plans with the real options method can underestimate the value of the project, due to an incomplete description of management flexibility, and provides misleading recommendations for the low-grade zone development decision. The results also demonstrate that complex mine planning considerations can be combined with advanced financial methods to provide project net present values and operating policy recommendations that reflect inherent project risks.In a broader context, this paper shows that corporate risk management principles are also important at the project level. These ideas and insights can assist management with capital allocation decisions and provide a better understanding of the risks and opportunities associated with a particular project. However, these principles cannot be applied from a purely financial background; detailed knowledge of the project’s technical and physical structure is equally important to ensure that non-financial project considerations are also incorporated into the valuation model. Real options valuation methods and advanced risk management principles are sufficiently flexible to integrate detailed market risk information with a detailed project description into a valuation model, with which sound capital allocation decisions can be made and capital productivity improved.