Using Real Options to Value and Manage Exploration
Graham A. Davis, Michael Samis, 2005. "Using Real Options to Value and Manage Exploration", Wealth Creation in the Minerals Industry: Integrating Science, Business, and Education, Michael D. Doggett, John R. Parry
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This paper considers the two main uncertainties facing an exploration manager, geological uncertainty and price uncertainty, within a real options framework. The paper presents two models of exploration. The first model considers only geological uncertainty and reveals how geological and economic factors influence exploration activity and the value of an exploration property. In particular, the model shows that exploration activity will logically respond to changes in the economic and technical environment. One outcome of this model is that higher geological uncertainty enhances exploration project value when initial resource estimates are small and harms projects that have quality resources. The second model considers both geological uncertainty and price uncertainty, and reveals important differences between exploration for commodities such as gold, which exhibit random walk prices and increasing future price uncertainty, and exploration for base metals, which exhibit reversion to a mean price level and saturating future price uncertainty. Under a value-maximizing policy gold exploration should, during periods of low and moderate prices, focus on promising green-fields deposits and deposits with previous positive exploration results while deferring geologically unpromising green-fields prospects until prices improve. This is because given gold’s random walk price characteristic, there is always a chance that higher and higher gold prices could make up for poor geological potential. An expanded exploration policy that includes the deferred greenfields prospects is warranted when prices are higher. On the other hand, our model suggests that unpromising green-fields copper projects should not be kept in deferral mode during low prices, since future prices are capped by the trend of copper prices to a long-run mean. Green-fields copper projects should therefore either be explored immediately if promising or permanently abandoned if unpromising, regardless of current copper price. Since the geology and economics of the gold and copper examples have been designed to be as comparable as possible, these model differences in exploration behavior are driven entirely by the difference in price behavior of base metals, which exhibits reversion, and gold, which does not. That optimal exploration policy depends on the commodity brings to light the importance of modeling both geological and economic (price) uncertainty when valuing and managing exploration projects.
All of this is done within a real options analysis. Traditional discounted cash flow analysis ignores the nonlinearity of the payoffs to exploration and thereby undervalues exploration activity. The real options framework, which captures the nonlinearity of these payoffs, shows that in some cases where the traditional discounted cash flow value of an exploration project is negative, exploration activity can be value creating and should nevertheless proceed. Real option modeling thus provides economic validation of decisions that exploration managers often take in spite of traditional valuation criteria that recommend against taking such action.
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Global political and economic developments shape both the demand for minerals and primary metals and their supply. Overall, demand has moved broadly in step with economic activity over the past 30 years. Notwithstanding the collapse of the Soviet Union and Eastern Bloc countries, demand grew more rapidly in the second half of the period than the first. The performance of individual products within this general trend largely reflects the specific nature of their main end uses. The geographic center of demand has shifted away from the mature industrial economies of North America, Western Europe, and Japan toward the newly industrializing countries of the Pacific Rim, China, and India. Mine production rose with demand, but not always in precise step. New capacity was required not just to meet demand, even where that was static, but also to offset the continuing effects of ore depletion. There were also changes in the location of production in response to geopolitical forces, the depletion of ore reserves, and the changing economics of extraction and processing. The number of mines contracted, especially during the 1990s, and the scale of mining operations was increased in order to achieve the requisite cost savings. Prices fluctuated in response to changing balances between supply and demand, trending downward from the early 1970s until the early 2000s. Most products witnessed at least one sharp price spike during the period, usually with continuing repercussions. Prices picked up from 2003, but generally not back to their earlier peak in real terms. Profitability varied according to the products concerned. In many years the average rates of return on capital employed have been insufficient to cover the risks involved.