The real option value of mining operations using mean-reverting commodity prices

Abstract

By determining the optimal price threshold of mining activation, this research aims at estimating a mine’s in situ value by incorporating its real option value (ROV). The traditional discounted cash flow (DCF) method, the standard tool for economic feasibility studies in mineral industry, can be problematic since it fails to address uncertainties and operational flexibilities (Trigeorgis Adv Futures Options Res 4:S1537164, 1990; Schwartz J Financ 3:923–973, 1997; Slade J Environ Econ Manag 41:193–233, 2001; Abdel Sabour and Dimitrakopoulos J Min Sci 47(2):191–201, 2011). DCF normally results in under-evaluation when significant price variability is present in commodity prices such as gold, silver, copper, and recently rare earths. A mining project is more valuable in expected value terms if it is activated following an appropriately chosen price threshold. In this work, the commodity price is modeled using a mean-reverting process, which is more relevant to commodity economics than the generally used Geometric Brownian motion process (Pindyck and Rubinfeld 1991). It is shown that the value of flexibility is significant and peaks when mining cost equals spot price; the exercising price threshold increases as average cost rises and probabilities of exercising the option are estimated. ROV method provides a tractable and realistic scheme to evaluate a mine’s in situ value and a strategy to manage mining activities.