Valuing a Mine as a Portfolio of European Call Options: The Effect of Geological Uncertainty and Implications for Strategic Planning

Abstract

Mine valuation under market and geological uncertainty is an active research area. Twenty years ago, a seminal paper by Brennan and Schwartz described the application of Real Option Theory to the valuation of mines where metal prices are volatile. The study focused mainly on the impact of metal price uncertainty on the value of a mine. Geological uncertainty was not considered. For a simple mine model, this paper describes the close analogy between the decision to process a mining block at a given date and the European call financial option. The value of the European call depends primarily on the share price model, the present share price, the price volatility and the time to expiry. A mining block is either processed when the metal price covers the processing costs or otherwise stockpiled as waste. Metal prices and technical variables like grades, recovery, and costs are uncertain. Using geostatistical simulations, the study shows that grade uncertainty may introduce asymmetries in the block value greater than metal price uncertainty. The asymmetries are more pronounced for blocks with larger uncertainty. Greater value is given presently to these blocks assuming the block grades are perfectly known at the time of mining. The extension of this concept from individual blocks to the mine scale is done by considering a mine panel as equivalent to a portfolio of European call options. Implications for strategic planning are illustrated with a gold mine panel-scheduling example. Gold price was modelled with a Geometric Brownian Motion process. The case study shows that the value of the panel and its development strategy depend on the level of geological uncertainty and price volatility. However, the example shows that the benefits of optimising the panel under geological uncertainty is an order of magnitude below the benefits of resolving the geological uncertainty.