Reasons why Real Options Analysis (ROA) is not widely adopted in the mineral industry

Abstract

Real options analysis (ROA) is an advanced technique for valuing mineral projects that generates more useful information for decision-makers in the mining industry than that generated using discounted cash flow (DCF) method, yet the latter is much more commonly used in the industry. Why? The answer to this question motivates the thesis. The slow adoption of ROA in the mineral industry has been investigated by several researchers. The outcomes of these previous studies have had minimal impact on the industry because these researchers adopted an approach that focused solely on the quantitative shortcomings of ROA. Until now, little empirical evidence existed on the qualitative reasons that impede the mainstream adoption of ROA as a valuation technique in the mineral industry in spite of its well-established advantages. This thesis advances a series of innovative solutions to address this gap. First, it develops a novel system approach to ROA based on practical assumptions. Secondly, it applies this system approach to a real mine case study to identify the value-added information generated by the ROA method compared with the DCF method. Finally, based on the case study output, the study engages industry experts to identify the qualitative reasons for the relatively low uptake of ROA in the mining industry. In developing the novel system approach to applying ROA, the study focused on building a framework that incorporates realistic modelling of project uncertainties, careful modelling of the value of mineral assets and development of a user-friendly end-user tool that simplifies the process. The system real options (SRO) tool was developed using Matlab to estimate the economic value of projects using ROA. SRO reduces the complexity in ROA application and integrates the method with Monte Carlo simulation and statistical distributions to enable mineral projects under uncertainty to be realistically valued and optimised. To identify the additional information that ROA generates over the DCF method in mineral project valuation, SRO was used to re-value a gold mining project, Adinkra Mine, initially valued using the DCF method in 2004. The initial DCF method valued the project at $493 million; however, SRO recorded a $528 million mean project value with a 62% probability of the project returning a higher value than the DCF value. In addition, the value of the option to expand the mine’s capacity was analysed using the SRO tool to guide the company in its strategic decision-making. Subsequently, the company’s country expansion program was assessed using SRO to determine the value of each project under different in-country scenarios. The results of the DCF and ROA were statistically compared with the actual (real) project outputs from 2004 to 2015. The results indicated a higher correlation between the actual (real) project outputs recorded from 2004 to 2015 and the valuation results recorded using the ROA method. In addition, using the ROA approach enabled useful information to be generated that showed significant potential for improving the way mining companies manage risks and uncertainties as well as strategically placing their assets to optimise value. Based on the additional information generated from the application of ROA, 14 industry experts were purposively sampled and interviewed to identify the qualitative reasons for the slow adoption of ROA in the mineral industry. The industry experts highlighted trust in the method, lack of education, poor communication of results, absence of software packages and the industry’s inability to adopt innovation as the main hindrances affecting the practical implementation of real options in the mineral industry. The feedback from the experts was used to construct a change framework based on the works of Everett Rogers in Diffusion of Innovations (2003) and Eliyahu Goldratt and Jeff Cox in The Goal (2004). This framework addressed the challenges associated with the bottlenecks in the application of ROA. It also discussed practical ways of making ROA compatible with and less complex for mineral operations. The framework further identified partnerships, demand from stakeholders, and link to operational capability among others as means of improving the adoption of ROA in the mineral industry.