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Tedypendah
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Joined: May 26th, 2013, 10:11 am

Valuation of a mine using options techniques

April 10th, 2017, 6:23 pm

Hi,

Does anyone know if a "Real Options' approach to the Valuation of a Mine has any useful practically. Meaning can a RO approach be any useful to management decision making compared to Net Asset Value or Discounted cashflows?

This applies to prospecting and exploration. For example the options may be; Option to prospect or not, option to expand etc 

I have seen some papers online but I don't know successful this has been?
Last edited by Tedypendah on May 7th, 2017, 3:53 pm, edited 1 time in total.
 
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outrun
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Joined: January 1st, 1970, 12:00 am

Re: Valuation of a mine using options techniques

April 10th, 2017, 7:41 pm

I would start with the revenues side: can you hedge the expected future production in forward markets? Or maybe there is a natural hedge, or a related comodity (proxy)? There are also various views on how much future production you want to sell up front.

Next value the operational optionality, e.g. the option to stop production during periods when the revenues drop below the operational cost. This should increase the value (reduce the loss) of your operation. Some costs can be reduced by stopping production  (wages, wear and tear / maintenance) others not..

Once you have the revenues modelled, and potentially removed market price risk in those revenues via hedging, you can then look at the investment side. I'm not sure if there are investment choices to be made?  Perhaps first invest in research to try and determine the amount of commodity you can get out of the mine? Based on that outcome decide it you stop or continue. This type of modelling is sometimes done in the pharma sector using compound options. A new medicine typically has various costly trials periods. Each trial outcome can make you decide to pull the plug and stop investing in further trials.
 
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Traden4Alpha
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Re: Valuation of a mine using options techniques

April 10th, 2017, 9:23 pm

NAV or discounted cashflows are fine in the absence of optionality but the value of mine, especially in the early stage of buying the claim, concession, or rights is unknown and dependent on multiple decisions. For example, the decision to exercise the option to invest in exploration would be contingent on a priori expectations of the volume of recoverable material and the realized price of the material if there is anything down there. That option to explore does have value as a function of the chance and extent that the price of the commodity fluctuates and reaches a high value. A second stage real option of investing in opening the mine also exists and has a value that depends on the amount of found reserves, cost of opening the mine, and future price of the commodity. Real option theory and methods are a way of modeling these decisions that are contingent on unknown variables which may be a function of volatile economic conditions or other uncertainties that will be revealed in the future.

Hedging really isn't possible in the early stages of a mine if the amount of recoverable material is unknown. Also, even the amount is known, hedging would only be used if the current price of the commodity were high and the mine owner wanted to lock in revenues. If the current price of the commodity is below the cost of extraction & refining, the mine seems to have a negative NAV. But under real options theory, the mine might be worth a lot if the price of the commodity is volatile and might readily jump above the cost of extraction & refining at some point during the duration of the option.

If the mine will definitely be profitable, you don't need real options theory. But if the NAV looks low or negative but might be very high if prospecting results or prices turn out favorably then real options help you evaluate the value of having the right to prospect or open the mine in the future.
 
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dweeb
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Re: Valuation of a mine using options techniques

April 25th, 2017, 8:51 pm

From memory one issue with the mine RO example is that commodity (forward) prices have mean reversion, which affects the forward value as a function of the vol term structure. There's an annual RO conference - this year in Boston:
http://www.realoptions.org/
 
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dweeb
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Re: Valuation of a mine using options techniques

April 25th, 2017, 9:05 pm

Re; hedging – some big commodity firms intentionally don’t hedge – investors get an exposure to the commodity cycle. Plus these firms also have natural hedges.
Re; operational optionality – a Nat Gas power plant is an example. Relatively little start-up costs, and can switch on/off when power prices spike.