Real Options: Buzzwords or A Misunderstood Tool in Mining

By Dr. Luis A. Martínez Tipe, PhD Director General & Principal Researcher, CAIDTech Originally published: February 1, 2018

Mineral projects are complex businesses that demand a constant assessment of risk. This is because the operating life of a mine project is normally given in the order of tens of years and its value is typically influenced by many underlying economic, operational and physical uncertainties, such as prices, grades, qualities, schedules, quantities, and social and environmental issues, among others, which are not known with certainty at the beginning of the project.

Among all the techniques that mine organisations use to measure profit and loss associated with a proposed mineral project, the discounted cash flow (DCF) and the Net Present Value (NPV) – which are based on expected values and a risk adjusted discount rate – are the most widely used in the mining industry. The problem with the DCF-NPV, however, is that in cases involving uncertainty and non-linear processes, as is the case in the mine optimisation/evaluation process, single estimated (average) values are often of little use because of their lack of accuracy in describing an uncertain process over time. 

One key technique that has emerged in recent years to overcome the limitations of the DCF-NPV, in dealing with uncertainty, is the Real Options (RO) approach. Real options are important in strategic and financial analysis because traditional valuation tools such as NPV ignore the value of flexibility. 

In mining, real options analysis is mainly concerned with investment decisions under uncertainty. This is because investment expenditures in mining that have two very important characteristics:

• The expenditures are at least partly irreversible; in other words, sunk costs that cannot be recovered once committed;

• These investments can be delayed, so that the firm has the opportunity to wait for new information to surface about prices, costs, and other market conditions before it commits resources.

Real options analysis in particular invalidates the simple net present value rule as it is commonly taught to students and professionals: “Invest in a project when the present value of its expected cash flows is at least as large as its costs”. This rule is incorrect because it ignores the opportunity cost of making commitment now, and thereby giving up the option of waiting for new information – as a matter of fact, the opportunity cost must be included as part of the total cost of investing.  That is, if a mining firm uses the NPV technique to decide in investing or not in a single technological project, where the cost of the investment “I” is known and fixed, but the value of the project, “V”, varies over time (because the underlying variables that vary over time such as, prices and market demand), the simple net present value rule will suggest to invest as long as “V>I”. However, as demonstrated by several experts in project evaluation (see for example McDonald and Siegel, 1986), this is incorrect because since the future values of "V" are unknown there is an opportunity cost to investigate today; e.g., prices and market demand could increase/decrease in the future. Hence the optimal investment rule is to invest when "V" is at least as large as a critical value "V*" that exceeds the investment, "I". Hence, the simple NPV rule is not just wrong; it is often very wrong (in the face of uncertainty) - for some explanation see: https://www.linkedin.com/pulse/why-mine-plans-based-average-assumptions-wrong-dr-luis-martinez/.  However, despite that the application of RO in mining is not new (see for example the work done by Brennan and Schwartz, 1989), and that to some extent during the last years it has proved to be a powerful way of thinking about decision making in mining in the face of uncertainty, it still is not adopted as a standard technique for mine project evaluation. Some of the reasons for this are depicted in Figure 3.

Because the reasons indicated in Figure 3, in mining, real options theory is in danger of becoming a victim of its own uncomprehensive success and complexity. Furthermore, in our experience, too many people who speak of “real options” have not read a serious book or article on the subject and frequently use the term loosely to invoke the concept of real options in support of whatever it is they wish to do when dealing with making decisions in the face of uncertainty. As a result, the theory’s core concepts have been widely misunderstood in mining and its basic tenets frequently misapplied, and often been criticized for shortcomings in the results obtained, or simply not being considered at all when making final key investment decisions. Current economic downturn has brought the winds of change to the mining industry encouraging development of new disruptive technology. The problem with a disruptive innovation that changes the mining industry’s traditional patterns is that it requires advanced valuation techniques to quantify and measure its current benefit; i.e., traditional NPV analysis will not be able to quantify appropriately these benefits due to the high capital cost incurred at the beginning of the project to implement the disruptive technology; suggesting, in most of the cases, the non-implementation of it. Some examples of these disruptive technologies are:

1. Implementation of grade engineering in an open pit mine to improve metal recovery and quality;

2. Transition from open pit to underground block caving; and 

3. Implementation of drones and autonomous or near autonomous loading and hauling fleets in an open pit mine operation.

Therefore, it is obvious that new valuation approaches are needed to be able to quantify the benefits that new disruptive innovations and technologies could bring to mine operations; otherwise over time, the technology’s usefulness will be undermined. It is here where real options analysis plays a key role allowing decision makers to properly quantify the benefits a new disruptive innovation, or technology, can provide to their mining projects. So the question is: How to make real options analysis a standard valuation technique in the mining industry?  I believe that a good starting point is educating both current and future engineers and managers about the concepts and applications of real options in the mining industry. It is also important to generate new user friendly mining tools and software engines that can allow engineers and managers (students and professionals) apply these advanced concepts, i.e., not only real options but new advanced optimisation and data science concepts, when making key final investment decisions in the face of uncertainty.  For those interested in learning about the concept of real options, some books to read are: - Investment under uncertainty, by Dixit and Pindyck

- Strategic investment- Real options and games, by Smith and Trigeorgis; and

- Real options – A practitioners guide, by Copeland and Antikarov. Unfortunately there are not many papers with applications of real options in mining but if you stay tuned we will publish some of the works done with real options in mining in future articles. If you have questions or comments about the application of real options in mining or how it could be of assistance in your projects, please feel free to write to contact@randoanalytics.com  Editor's note: This article was written in 2018. Since then, CAIDTech has developed and applied the probabilistic frameworks described here across multiple mine projects in Latin America and Australia, integrating geological variability, operational dynamics and economic uncertainty into a single quantitative model. Learn more at [caidtechnology.com]