Resources Policy 39 (2014) 115123

Contents lists available at ScienceDirect

Resources Policy
journal homepage: www.elsevier.com/locate/resourpol

A numerical study for a mining project using real options valuation

under commodity price uncertainty
Md. Aminul Haque n, Erkan Topal, Eric Lilford 1
Department of Mining Engineering, Western Australian School of Mines, Faculty of Science & Engineering, Curtin University, Bentley, WA 6102, Australia

art ic l e i nf o a b s t r a c t

Article history: Commodity price is an important factor for mining companies, as price volatility is a key parameter for
Received 25 September 2013 mining project evaluation and investment decision making. The conventional discounted cash ow (DCF)
Received in revised form methods are broadly used for mining project valuations, however, based on commodity price uncertainty
10 December 2013
and operational exibilities, it is difcult and often inappropriate to determine mining project values
Accepted 26 December 2013
Available online 5 February 2014
through traditional DCF methods alone. In order to more accurately evaluate the economic viability of a
mining project, the commodity price and its inherent volatility should be modelled appropriately and
Keywords: incorporated into the evaluation process. As a consequence, researchers and practitioners continue to
Real options valuation develop and introduce real options valuation (ROV) methods for mining project evaluations under
Historical volatility
commodity price uncertainty, incorporating continuous time stochastic models. Although the concept of
Discounted cash ow
ROV arose a few decades ago, most of the models that have been developed to-date are generally limited
Stochastic differential equation
Partial differential equation to theoretical research and academia and consequently, the application of ROV methods remains poorly
Finite difference method understood and often not used in mining project valuations. Analytical and numerical solutions derived
through the application of ROV methods are rarely found in practice due to the complexity associated
Jel Classication: with solving the partial differential equations (PDE), which are dependent on several conditions and
G13 parameters. As a consequence, it may not generally be applicable to evaluate mining projects under all
Q3
project-specic circumstances. Therefore, the greatest challenge to ROV modelling is in nding
numerically explicit project values. This paper contributes towards the further development of known
theoretical work and enhances an approach to approximating explicit numerical project values. Based on
this work, it is possible to formulate more complex PDEs under additional uncertainties attached to the
project and to approximate its numerical value or value ranges. To ensure the project is protable and to
reduce commodity price uncertainty, delta hedging and futures contracts have been used as options for
deriving the PDE. Moreover, a new parameter for taxes has been incorporated within the PDE. This new
PDE has been utilised to approximate the numerical values of a mining project considering a hypothetical
gold mine as a case study. The explicit nite difference method (FDM) and MatLab software have been
used and implemented to solve this PDE and to determine the numerical project values considering the
available options associated with a mining project. In addition, commodity price volatility has been
determined from historical data, and has again revealed price volatility as having a signicant impact on
mining project values.
& 2014 Elsevier Ltd. All rights reserved.

Introduction Options valuation as a valuation methodology was introduced in

The application of real options valuation concepts for valuing
real assets is a growing area in the theory and practice of nance
and economics. Over the last few years, many studies have
presented the ROV method as a promising technique for valuing
natural resource investments under conditions of uncertainty.
n
Corresponding author. Tel.: 61 450 671899.
E-mail addresses: mdaminul.haque@student.curtin.edu.au,
aminul202@yahoo.com (Md.A. Haque), e.topal@curtin.edu.au (E. Topal),
dr.evlilford@gmail.com (E. Lilford).
1
Corporate Director, public and private companies.
1973, when three well-known economists, Fischer Black, Myron
Scholes and Robert Merton formulated a mathematical model,
known as the BlackScholesMerton option pricing model (Black
and Scholes, 1973; Merton, 1987). Approximately four decades ago,
Myers (1977) coined the term real options in that well- known
paper, observing that corporate investment opportunities can be
viewed as call options on real assets. Since then, numerous
researchers have addressed investment opportunities under
uncertainty using the real options approach. Although DCF meth-
ods are broadly used for project evaluations, several studies have
found that managers often do not necessarily follow the forecasts
reected in a DCF method (Colwell et al., 2003; Hayes and Garvin,

0301-4207/$ - see front matter & 2014 Elsevier Ltd. All rights reserved.
http://dx.doi.org/10.1016/j.resourpol.2013.12.004
116 Md.A. Haque et al. / Resources Policy 39 (2014) 115123
1982; Hayes and Abernathy, 1980). Almost one and a half decades
later, researchers are beginning to understand why the DCF method
and its variants do not properly explore the explicit value of an
investment under uncertainty as they typically fail to take into
account managerial exibilities and nancial options associated with
reducing risks and optimizing prots and investment returns.
Due to the extensive growth of nancial markets and embedded
managerial options, the exibilities around taking decisions for
investments largely depend on market conditions. Brennan and
Schwartz (1985) solved the value and optimal production policy of
a natural resource investment, contingent on the price of a commod-
ity with a recognisable future market.
These authors presumed that there are no arbitrage opportu-
nities available for trading in the real (the natural resource) and
the nancial (the futures market) assets. The literature around real
options in the mining project investment arena is not new. The
concept of using real options frameworks in the mining industry
rstly came about through Brennan and Schwartz (1985). In that
study, authors introduced a continuous time stochastic model and
developed theoretical works for natural resource investments.
Gradually, real options theory was introduced into natural
resources investments decision making by Brennan and
Trigeorgis (2000), Copeland and Antikarov (2001), Dixit and
Pindyck (1994), Trigeorgis (2000, 1996, 1993), Topal (2008).
Although considerable work has been done to implement real
options theory in mining projects through continuous time sto-
chastic models, most of the studies were limited to being academic
and theoretical work (Brennan and Schwartz, 1985; Cortazar and
Casassus, 1998; Colwell et al., 2003; Cortazar et al., 2001).
The mathematical complexity included in project uncertainties, as
well as the difculty of solving the complex mathematical models, do
not make the real options valuation methods more useful to practi-
tioners and the mining industry at large. As a consequence, the
numerical simulation concept for determining project values through
the ROV method is not readily available and numerical results of
mining project values have been overlooked and probably under-
stated. An additional reason for its limited use can be the mathema-
tical challenge in solving higher order and dimensional PDEs due to
the inclusion of several parameters and conditions. Moreover, to nd
the mining project value is a challenging task compared to other
industries due to extensive uncertainties and the nite project life
associated with the mining project. Therefore, ROV methods are not
accepted widely in the mining and minerals industries, even though
the concept of real options valuation was introduced a few decades
ago. Consequently, in this study, ROV methods will be utilised to
investigate the numerically explicit mining project value under
commodity price uncertainty which is one of the most important
factors for mining investments. As the commodity price moves
randomly, a geometric Brownian motion (GBM) model has been
considered to represent the price movement of the commodity. To
reduce the mining project risks and to make investment decisions in
the mining project, several real and nancial options have been
implemented and discussed in this paper, which is not possible in
traditional DCF methods or in Binomial option pricing (Binomial
lattice/tree model) methods. In order to calculate numerical values for
a gold mining project, a higher ordered PDE (Black- Scholes equation
type PDE) will be constructed using the GBM model with the
inclusion of nancial market tools such as options, hedging and
futures market contracts. This PDE will then be solved numerically
through FDM and MatLab tools to obtain mining project values for
that gold project.
The rest of this paper is organised as follows:
 Model for commodity price movements and derivation of the
PDE section describes the model for commodity price move-
ments and the derivation of the PDE;
 Determination of commodity price historical volatility section
determines and discusses the historical commodity price (gold
price) volatility;
 Available options for mining project section briey describes
available options for mining projects;
 Numerical results and discussions section exhibits numerical
procedures for solving the PDE and discusses the results of
project values for a gold mine; and the conclusion and future
work are discussed in Conclusion section.
Model for commodity price movements and derivation of the
PDE
In this section, we have considered a stochastic model to
represent the commodity price movements and constructed a
PDE for approximating the numerical values of mining projects.
The model for commodity price movements
Mining project investment has the managerial exibilities of
selecting options for opening, temporarily closing, postponing or
abandoning the project arising mainly from the uncertainty
around commodity prices. While a mine is closed, it will typically
incur maintenance costs. It is assumed that the dynamics of the
commodity price (i.e. output price), P, will be in accordance with
the following stochastic differential equation (Cortazar et al., 2001;
Lima and Suslick, 2006):
dP
r  dt sdw 1
P
here, P is the spot unit price of the commodity, r is the risk free
rate of interest, is the mean convenience yield on holding one
unit of that commodity, s is the volatility of returns of P, dw is the
Wiener increments of the geometric Brownian motion of P.
The value of the mine is dened as V VP; Q ; i; . Here, i is the
indicator variable which takes the value one if the mine is open
and zero if it is closed; describes the operating policy such as
opening, temporarily closing, postponing and abandoning the
mine, and Q is the total reserve.
Derivation of the partial differential equation (PDE) using the
stochastic differential equation (SDE)
To nd the numerical project value, we will derive a PDE
through the Eq. (1), with the help of commodity futures market
and hedging strategies. If the commodity futures market is
arbitrage free, that is there is no arbitrage opportunity, then
management has the exibility to enter into a long position for
investment in the mining project and a short position in the
futures contracts for hedging commodity price risk (Brennan and
Schwartz, 1985; Bellalah, 2001; Colwell et al., 2003; Cortazar and
Schwartz, 1997; Dixit and Pindyck, 1994).
Dene the value of the mine: V V(P, Q). Now, consider the
mining company adopting the options as a long position for
investment in the mining project V V(P, Q), and a short position
in V=P units of output (commodity). In dt interval of time, this
project leads to a cash ow, qP  C1  Gdt  V=PPdt, where
C is the total cost (CAPEX, OPEX, working capital, etc.) per unit of
commodity and G is the total tax.
Therefore, the total return on the portfolio is:
V V
dV  dP qP  C1  Gdt  Pdt 2
P P
 Md.A. Haque et al. / Resources Policy 39 (2014) 115123 117

Applying Ito0 s Lemma, V V(P, Q) Standard deviation is also known as historical volatility which is a
statistical quantity that gives an implication about the unpredict-
V V 1 V2
dV dP dQ dP2 3 ability of the asset value or price over time. It is the standard
P Q 2 P 2
deviation of an asset0 s historical returns. If the asset reects a gold
Substituting the value of dV from (3) into (2), the total return commodity, then the historical volatility is the standard deviation
on this portfolio becomes of gold historical returns. Commodity price volatility will be
V V 1 2 V V V determined from historical data through the log return method.
dP dQ dP2  dP qP  C1  Gdt  Pdt 4 Let Pt denote the price (closed price/adjusted price) of gold at the
P Q 2 P 2 P P
end of day t and Pt  1 denote the price (closed price/adjusted price)
According to Bellalah (2001), Cortazar and Schwartz (1997), a of gold at the end of day t  1. Assuming no dividend is paid, then
mining company with a long position for an investment in a the log return on an investment in physical gold between days
mining project and a short position in commodity futures con- t 1 and t is dened as:
tracts can hedge its risk and should earn a return equal to at least

the risk free interest rate plus the country risk premium associated Pt
r t ln
with the country where the mining project is situated. The country pt  1
risk premium is denoted by C. Therefore;
V V 1 2 V V V Historical volatility estimation
dP dQ dP2  dP qP  C1  Gdt  Pdt
P Q 2 P 2 P P
V Black and Scholes (1973) indicated that the parameter s2 is the
r C Vdt  r Pdt 5
P variance rate of return on the stock prices. Black and Scholes
When the mine is operated at a rate q, the reserve will change considered this as a known parameter which is constant through-
accordingly, dQ  q dt ;and (5) becomes the following PDE: out the life of an option. In their paper prior to a seminal one,
Black and Scholes provided additional perception into the variance
1 2 2 2 V V V
P s  q r  P  r C V qP  C1  G 0 6 rate of return and they assessed the instantaneous variance from
2 P 2 Q P the historical series of stock prices. They thus dened volatility as
Subject to the boundary condition: the amount of irregularity in the returns of the underlying assets.
Black and Scholes determined what today is known as the
VP; 0 0
historical volatility, which is used as a proxy for the expected
This means that when the reserves are exhausted, the value of volatility in the future.
the mine is zero. To be mathematically correct and to solve the Estimation of gold0 s historical volatility is based on the calcula-
PDE (6) numerically. We also assume tion of the standard deviation of gold0 s return, which has evolved
2 V based on the calcualtion of variance. The steps and the formulae
0; Q 0 follow:
P 2

2 V 1. Taking the log returns of gold prices, relating today0 s gold price
2
1; Q 0 to yesterday0 s gold price. This is r t lnP t =pt  1 , the continu-
P
ously compounded return
Brennan and Schwartz (1985) mentioned that there is no 2. Calculating the variance of the log returns based on the formula
analytical solution for this type of problem i.e. PDE (6). We will s2 1=n 1nt 1 r t  r2
therefore approximate the numerical solutions of the PDE (6) where r 1=nni 1 r i
through the nite difference method (FDM) using MatLab soft- 3. Taking the square root of the variance to get the standard
ware, which will commensurately provide the numerical values of deviation, and converting it to an annualised volatility. The
the mining project. daily historical volatility is given by
s


1 n
Determination of commodity price historical volatility s r t  r2 :
n1 t 1

To nd the numerical values of a mining project, commodity

price volatility is needed as one of the input parameters to solve
the PDE (6). Therefore, in this section we will determine the gold
price volatility (for a case study, gold is considered here) from the
historical data. We have selected the data over the period from
January 02, 1998 to July 03, 2013, as we mainly wanted to use the
immediate past 15 to 16 years historical data to get an overview of
the gold price historical volatility. Moreover, during this period
and specically between the year 2007 and mid-2013, gold prices
have been uctuating signicantly. Furthermore, there was a
signicant global recession in 2008, a consequence of the global
nancial crisis (GFC), which impacted the gold market and almost
every other market.
Historical volatility
In economics and nance, the concept of standard deviation is
comparatively diverse and is generally applied to the annual rate
of return of an investment to compute the investment0 s volatility.
To compare volatilities for different interval lengths, it is
generally
p articulated in annual terms by the formula, san
s  h, where h is the number of intervals per annum. If the
daily data is used, the interval is one trading day and h 252, if the
interval is a week, h52 and for monthly data, h 12.
Fig. 1 shows the daily gold prices in nominal money terms (in
trading days) in year 2012. It is apparent that the gold price has
been uctuating and its volatility in year 2012 is 16.51%.
Fig. 2 demonstrates gold prices on nominal money terms
(monthly data is used) since January 02, 1998 to July 03, 2013.
It is apparent that the gold price has randomly changed and has
escalated between year 2007 and 2012. In January 02, 1998 the
gold price was US$288.00/oz; since then, it has increased gradually
each year. Due to the global nancial crisis in 2008, the gold price
uctuated signicantly between January 2008 and December
2008. In January 2008, the gold price was US$846.75/oz, in March
2008 the price was US$1,011.25/oz, and in November 2008 the
118 Md.A. Haque et al. / Resources Policy 39 (2014) 115123

Gold price in US dollar in year 2012

1850

1800

Gold price in US$ per ounce

1750

1700

1650

1600

1550

1500

1450

1400
Jan 03, 2012
Jan 13, 2012
Jan 26, 2012
Feb 07, 2012
Feb 17, 2012
Feb 29, 2012
Mar 12, 2012
Mar 22, 2012
Apr 03, 2012
Apr 19, 2012
May 01, 2012
May 14, 2012
May 24, 2012
Jun 08, 2012
Jun 20, 2012
Jul 02, 2012
Jul 12, 2012
Jul 24, 2012
Aug 03, 2012
Aug 15, 2012
Aug 28, 2012
Sep 10, 2012
Sep 20, 2012
Oct 02, 2012
Oct 12, 2012
Oct 24, 2012
Nov 05, 2012
Nov 15, 2012
Nov 27, 2012
Dec 07, 2012
Dec 19, 2012
Month

Fig. 1. Gold price in US dollar per ounce in the year 2012.

Data source: Only Gold.com, Georgia Sonora Co. Inc. http://www.onlygold.com/Index.asp.

Gold price in US dollar from January 02, 1998 to July 03, 2013
2000
1800
Gold price in US$ per ounce

1600
1400
1200
1000
800
600
400
200
0
Jan 02, 1998
Jul 01, 1998
Jan 04, 1999
Jul 01, 1999
Jan 04, 2000
Jul 03, 2000
Jan 02, 2001
Jul 02, 2001
Jan 02, 2002
Jul 01, 2002
Jan 02, 2003
Jul 01, 2003
Jan 01, 2004
Jul 01, 2004
Jan 04, 2005
Jul 01, 2005
Jan 03, 2006
Jul 03, 2006
Jan 02, 2007
Jul 02, 2007
Jan 02, 2008
Jul 01, 2008
Jan 02, 2009
Jul 01, 2009
Jan 04, 2010
Jul 01, 2010
Jan 03, 2011
Jul 01, 2011
Jan 03, 2012
Jul 02, 2012
Jan 02, 2013
July 03, 2013

Year

Fig. 2. Gold price in US dollar per ounce from January 02, 1998 to July 03, 2013 (monthly data has been used i.e. rst trading day of each month).
Data source: Only Gold.com, Georgia Sonora Co. Inc. http://www.onlygold.com/Index.asp.

price was US$713.50/oz. On December 03, 2012, the gold price was
US$1,720.00/oz. Therefore, the past observation shows over the
last 15 years, the gold price has increased considerably into early
2013. Thereafter, the gold price retraced noticeably, being during
the period beyond May 01, 2013.
Gold price (in nominal money terms) volatility has been
determined from historical data using Microsoft Excel through
the log return method. Fig. 3 represents the gold price volatilities
from January 02, 1998 to July 03, 2013. In 1998, the annual
historical gold price volatility was 12.96 %. This volatility gradually
increased year-on-year and in 2001, it reached 26.16%. Thereafter,
the volatility reduced but still managed to peak at 36.44% in 2003.
There is a dramatic volatility decline from the year 2003,
followed by a stabilized period in years 2004 and 2005. After that,
the volatility evidently uctuated. The gold price volatility can be
explained by the underlying drivers of gold prices during the
period January 02, 1998 to July 3, 2013. The average gold price
volatility was 22.27% during this period and the standard deviation
was 7.56% over the mean gold price volatility. Over the same
period, the minimum gold price volatility is shown as 12.96% and
the maximum gold price volatility is shown as 36.61%. Therefore,
the maximum peak of the volatility is around 36.61% in 2008, and
it occurred as a direct consequence of the turmoil in most
international markets due to the global nancial crisis and
commensurate global recession during this period (Shaee and
Topal, 2010).
Available options for mining project
In real options valuation, management can choose to exercise
different real options during the life of the mine for different
scenarios, as the mining project involves many uncertainties
while an investment in a mining project is partially irreversible.
Musingwini et al. (2007) developed an index value to measure the
available exibility within a mining operation. If the index value is
less than 1, this indicates that the operation does not have any
notable available exibility. On the other hand, an index value
greater than 1 suggests the operation exhibits exibility. It is
worth a mention that to have the exibility available in the future
 Md.A. Haque et al. / Resources Policy 39 (2014) 115123
Gold price volatility from January 02, 1998 to July 03, 2013
40.00%
35.00%
Gold price volatility in %
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Fig. 3. Annual historical gold price volatility from January 02, 1998 to July 03, 2013 (daily data has been used).
Data source: Only Gold.com, Georgia Sonora Co. Inc. http://www.onlygold.com/Index.asp.
to reduce the associated risk, a premium has to be recognised or
paid upfront which means that additional costs will be borne by
the project, which will be reected in its value. Botn et al. (2012)
highlighted a case study to measure and manage mining dilution
uncertainty successfully, and in it they demonstrated that the
mining operation0 s operating systems needed to be resized to
handle the exibility, requiring an additional capital expenditure
(CAPEX) outlay. Management can choose the following real
options to invest in a mining project for maximizing prots or
alleviating losses. Furthermore, several exibilities and options
have been discussed in the numerical results sections under the
different scenarios.
Delay and abandon option
Due to mineral commodity price depreciation, management
can delay the commencement of a project or delay to commence
the mine operation of an already-developed mine. When the
maximum project value is 0, implying total cash ows of the
project are negative inclusive of capital development costs, then
management can delay the project or temporarily close the mining
operation (if the mine is already operating), and observe whether
the commodity price goes up or down, the currency depreciates or
appreciates, etc. before acting. A delay/defer option gives the
opportunity to management to wait until all the circumstances
become more advantageous. If the entire perceived outcome
becomes unfavorable and the total cash ow of this project is still
negative, then management can adopt the abandon option and
leave or abandon the project permanently. When the mineral
commodity price decreases over a protracted period, the manage-
ment should take the abandon option and sell the capital equip-
ment (salvage assets) or the whole project. The abandon option is
tantamount to exercising an American put option.
Temporary closure option
If the mine is operating and the commodity price declines
noticeably, then management can discontinue mine production
temporarily and incur maintaining costs during the closure period.
At a future point, when the commodity price improves, manage-
ment can then reopen the mine. For this, maintaining and reopen-
ing costs need to be calculated and added with the other costs
(notably OPEX and CAPEX) for determining the total cost per unit
of commodity.
119
Year
Accelerate or decelerate and expansion options for mine operation
Acceleration or deceleration of mine production rates has an
impact on mining project values. If the commodity price increases
markedly (or the currency depreciates against the US$, because
gold is priced in US$), then management can accelerate the
production rate which helps to recognize a higher project value
and investment return. To increase the production rate, it may
require the investment of additional capital to create the necessary
surplus capacity, but the overall mining costs may be decreased
due to the reduced life of the mine. Conversely, when the
commodity price decreases signicantly (or the currency appreci-
ates), then management can decelerate the production rate which
will yield lower project values and returns and associated costs
upfront, but this may increase the life of the mine (dependent on
cut-off grades). If the commodity price holds strong and is possibly
higher than the price at which the mine plans were drafted, then
management can choose the expansion option and increase the
mine production rate to lock in higher project values and returns.
In this option, some part of the ore body which was not
economical to exploit previously will now be economical and
the life of the mine may be increased exploiting that newly
dened economic portion.
Numerical results and discussions
In this section we demonstrate the procedure of discretizing
the PDE (6) through the nite difference method (FDM), and
consider a case study of a hypothetical gold mine for the
determination of numerical project values and discussions.
Discretization of PDE with FDM
We employ the explicit nite difference method (FDM) and
discretize the PDE (6), in Derivation of the partial differential
equation (PDE) using the stochastic differential equation (SDE)
section:
1 2 2 2 V V V
P s  q r  P  r C V qP  C1  G 0
2 P 2 Q P
V s2 2 2 V 1 V 1
)  P  r  P r C V  P  C1 G 0
Q 2q P 2 q P q
!
V n;j 1  V n;j s2 V n 1;j  2V n;j V n  1;j
)  nP2
Q 2q P2
120 Md.A. Haque et al. / Resources Policy 39 (2014) 115123


1 V n 1;j  V n  1;j maximum gold price volatilities were 12.96% and 36.61% respec-
 r  nP
q 2P tively, and the standard deviation was 7.56% from the mean gold
1 price volatility. Therefore, to approximate the gold mining project
r C V n;j  nP  C1  G 0
q values, the future gold price volatility is forecast at 77.56% with
the mean volatility 22.27% as a proxy for future gold price
s2 volatility. Numerical project values have been shown using those
) V n;j 1 V n;j n2 V n 1;j  2V n;j V n  1;j Q
2q parameters valued through MatLab software.
n Fig. 4 shows project values of the mine under different
r  V n 1;j  V n  1;j Q
2q scenarios before the mine is temporarily closed. When the gold
1 price volatility is 22.27%, the maximum project value is US
 r C Q V n;j nP C1  GQ
q $763,620 (Fig. 4(a)), and when the volatility is 29.83% (the average

2 2  volatility 7.56%, standard deviation), the maximum project value
1s n n is US$427,700 (Fig. 4(b)). Conversely, if the gold price volatility
) V n;j 1 Q  r  Q V n  1;j
2 q 2q decreases to 7.56% from the average volatility i.e.14.71% (the


s2 n 2 r C average volatility7.56%, standard deviation), the maximum pro-
1 Q  Q V n;j
q q ject value becomes US$1,725,600 (Fig. 4(c)).

2 2 
1s n n Fig. 4(d) and (e) display that in the case of the minimum
Q r  Q V n 1;j nP  C1  GQ volatility i.e. 12.96%, the maximum project value is US$2,207,200,
2 q 2q
and at the maximum volatility i.e. 36.61%, the maximum project
We nd the solution: value decreases and drops to US$284,550. Hence, from the
V n;j 1 an V n  1;j bn V n;j cn V n 1;j dn 7 simulation results (Fig. 4(a)(e)), it has been observed that
commodity price volatility is a signicant issue for the mining
where
project0 s evaluation. It has been noted that when the gold price
1 Q 2 2 volatility increases, the project value of the mine decreases and
an n s  nr 
2 q when the gold price volatility decreases, then the project value
increases.
Q 2 2
bn 1  n s r C
q
Accelerate or decelerate options for mine operation
1 Q 2 2
cn n s nr  If the commodity price increases noticeably then management
2 q
can accelerate the production rate (q) which helps to realize a
dn Q nP  C1  G higher project value and associated returns (Fig. 4(f)). When the
commodity price decreases signicantly, then management can
Here, P n nP; n 0; 1; N reduce the production rate (q) which will generate a lower project
Q j Q jQ ; j 0; 1; J value and return at that time (Fig. 4(a)), but may increase the life
of mine and provide an opportunity to wait until more favorable
V n;j VP n ; Q j conditions return for realizing a higher project value.
From our simulation results (Fig. 4(a) and (f)), it has been
VP 0 ; Q 0 V0; Q 0 realized that when the annual mine production rate is 131,997 oz
of gold the maximum project value is US$763,620, and when the
VP N ; Q J VP n ; 0 0
production rate is 160,597 oz of gold the maximum project value
is US$929,070 (other parameters remain the same). The results
Case study of a hypothetical gold mine show that when the production rate increases, the project value
increases as well.
To show the approximate numerical values for a mining project Resultant values largely depend on total operating costs as
under different scenarios and with a number of available real well, because numerical simulations show that if the total cost is
options, we consider the following case study. lower, then the project value is higher (Fig. 4(g)). From the
Consider a hypothetical underground gold mine which simulations (Fig. 4(f) and (g)), it has been observed that when
extracted 395,560 ounces of gold at an average grade of 6.52 g/t, the total cost per ounce of gold is US$877.41, the maximum project
over the years 2006 to 2009. value is US$929,070 and if the total cost is US$811.50 per ounce of
Management continued the mine operation for 3 years, and gold, the maximum project value is US$1,014,000 (other para-
thereafter, due to the reduced gold price, mining operations were meters remain the same).
suspended in 2010. Management closed the mine temporarily and
incurred the maintaining costs during the closure period. In 2011,
the gold price increased markedly and the management of the Temporary closure option
mine decided to reopen the mine and exploit the lower grade After the temporary closure of the mine, when the commodity
material, which had an average grade of 4.54 g/t. The gold mine price rises signicantly, management can reopen the mine. In this
has a possible remaining reserve of approximately 285,620 ounces case, management could approximate the project value through
of gold (1.78 million tonnes of ore). this same PDE and program. To achieve this, maintaining and
In this case study from Table 1, the xed pre-tax operating cost reopening costs need to be calculated and added to the other
(OPEX, CAPEX, etc) per ounce of gold is US$141.71 (before the mine operating costs.
is temporarily closed). Therefore, the total production and sales Consequently, when management reopens the mine for
cost of each ounce of gold is US$877.41 (US$735.70 US$141.71). extracting the remaining reserve of 285,620 oz. of gold, from
Gold price volatility has been calculated from the past historical Table 2 in the case study, the xed pre-tax operating cost per
data, since January 02, 1998 to July 03, 2013. The average gold ounce of gold is US$170.68 and the closing and reopening mine
price volatility during this period was 22.27%, the minimum and costs i.e. the maintenance costs, are US$33.61 per ounce of gold.
 Md.A. Haque et al. / Resources Policy 39 (2014) 115123 121

Hence, the total cost per ounce of gold is now US$919.39
(US$715.10 US$170.68 US$33.61).
Fig. 5 shows project values of the mine when it has reopened
after temporary closure. Fig. 5(a) shows the project value of this
hypothetical gold mine which has a remaining reserve 285,620 oz,
when the average gold price volatility is 22.27% and the annual
production rate is 89,155 oz. The maximum value of this hypothe-
tical gold mine is US$500,350.
Table 2
The characteristics/data sets of the hypothetical gold mine (the mine is reopened
after being temporarily closed; all nancial gures expressed in real, July 2013
money terms).

Table 1 Total remaining reserve 285,620 ounces of gold

The characteristics/data sets of the hypothetical gold mine (Prior to production Average ore production rate 557,220 tonnes/per year
before the mine is temporarily closed; all nancial gures expressed in real, July (approximately)
2013 money terms). Average gold production rate 89,155 ounces/per year
(approximately)
Total reserve 395,560 ounces of gold Average grade of gold 4.54 g/t
Average ore production rate 593,900 tonnes/per year Gold price US$1,647.35 per ounce
(approximately) Total milling and sales costs US$715.10 per ounce
Average gold production rate 131,997 ounces/per year Fixed pre-tax operating costs US$170.68 per ounce
(approximately) (OPEX, CAPEX etc)
Average grade of gold 6.52 g/t Total mine closure costs US$4,450,000
Gold price US$1,626.55 per ounce Total cost for reopening the mine US$ 5,150,000
Total milling and sales costs US$735.70 per ounce Gold price mean volatility 22.27%
Fixed pre-tax operating costs US$141.71 per ounce Standard deviation of volatility from the 7.56%
(OPEX, CAPEX etc) mean volatility
Gold price mean volatility 22.27% Risk free interest rate 6.00%
Standard deviation of volatility from the 7.56% Country risk premium 3.00%
mean volatility Depreciation and amortization charges nil
Risk free interest rate 6.00% Convenience yield for holding gold 3.00%
Country risk premium 3.00% Corporate taxes 30%
Depreciation and amortization charges Nil
Convenience yield for holding gold 3.00% Note: Above data has been considered based on US dollars, therefore to determine
Corporate taxes 30% project values in other currencies, the data and currency must be converted from
their local currency at the prevailing and forecast future currency exchange rates.

Fig. 4. Project value of the mine in (log scale) when reserve Q 395,560 oz, r 6.00%, 3.00%, q 131,997 oz, C 3.00%. (a) s 22.27%, q 131,997 oz, (b) s 29.83%,
(c) s 14.71%, (d) s 12.96%, (e) s 36.61%, (f) s 22.71%, q= 160, 597 oz, (g) s 22.71%, q= 160, 597 oz, C 811.50, (h) s 22.27%, p 877.41 and (i) s 12.96%, p 877.41.
122 Md.A. Haque et al. / Resources Policy 39 (2014) 115123
Fig. 5. Project value of the mine in log scale when reserve Q 285,620 oz, r 6.00%,
P 919.39.
Fig. 5(b) shows that when the minimum gold price volatility is
12.96% and the annual production rate is 89,155 oz, the maximum
value of this hypothetical gold mine is US$1,446,300.
Hence, from our simulation results (Fig. 5(a) and (b)), it has
again been observed that when the gold price volatility increases,
the project value decreases and vice versa. Therefore, our numer-
ical simulation results suggest that it would be better to operate a
mining project when the commodity price volatility is below the
average volatility or at least at the average volatility. For this
reopened mine, it is also possible to show the values of the mine
under different scenarios as in Fig. 4, depending on acceleration or
deceleration of production rates and changes to costs and volati-
lities. To avoid the inclusion of too many gures, the results have
been shown for 3 cases only.
Delay and abandon option
When the maximum project value is 0, being total cash ows of
the project are negative or zero, then management can delay the
project to start the operation or temporarily close the mining
operation if the mine is open, until advantageous conditions arise.
If the total cash ow of this project is still negative, then manage-
ment can adopt the abandon option and leave the project perma-
nently. This scenario usually occurs when the total cost per unit of
commodity is closest to the unit price of the commodity.
Fig. 4(h) and (i) reect the value of the project as negative when
the reserve is 395,560 oz of gold and the volatility is 22.27% and
12.96%, respectively. Therefore, management can delay the project or
temporarily close or adopt the abandon option and leave the project.
In this case, the lowest gold price is US$877.41 per ounce for which
the project value is negative and there is no positive cash ow. This
might be considered the critical gold price for this project at which
the temporary closure of the mine is triggered.
Similarly, Fig. 5(c) represents the value of the project being negative
when the remaining reserve is 285,620 oz of gold and the volatility
22.27%. Therefore, management should adopt the abandon option and
leave the project permanently. In this case the lowest gold price is US
$919.39 per ounce for which the project value for the remaining
reserve is negative and there is no positive cash ow. This may be
reected as the critical gold price for this project above which point
reopening of the mine may be considered. Therefore, mining project
values are greatly inuenced by commodity price as well as volatility.
Conclusion
In this study, we have used real options and considered several
management exibility options to approximate mining project
values numerically. Besides these, for reducing mining project risk
3.00%, q 89,155 oz. C 3.00%. (a) s 22.27%, (b) s 12.96% and (c) s 22.27%,
and capturing commodity price uncertainty, we have derived a
PDE using hedging strategies (delta hedging) and futures contracts
through commodity futures markets, being Black- Scholes0 model
based on geometric Brownian motion. This will help mining
companies to approximate project values through optimizing
and maximizing prots and minimizing mining losses. In tradi-
tional DCF methods as well as Binomial lattice/tree models, it may
not be possible to adequately consider these types of nancial and
economic fundamentals. In the study, we evaluated managerial
exibilities through several real options for approximating project
values which seemingly assist the mining company and its
associated management to take appropriate decisions for invest-
ment under different scenarios. Moreover, we have shown the
process to approximate the numerical values of the mining project
by solving the PDE numerically through the use of FDM and
MatLab software.
In addition, we have shown the impact of commodity price
volatility on a mining project0 s valuation. There is a strong relati-
onship between commodity price volatility and market perfor-
mance, as well as mining project values. When volatility increases,
the risks associated with the commodity price increases and
investment returns decrease and, consequently, project values
typically decrease. From the past historical data (January 02,
1998 to July 03, 2013) gold price volatility has been determined.
During this period, the average gold price volatility was 22.27%,
the minimum gold price volatility was 12.96% and the maximum
gold price volatility was 36.61%. The standard deviation was 7.56%.
From our numerical simulation results, it has been observed that
when the gold price volatility increases, the project value of the
mine decreases. Therefore, mining project values can be greatly
inuenced by commodity price volatility. Hence, the numerical
simulation results advise that it might be more protable to run a
mining project when the commodity price volatility lies either
below the average volatility or at the average volatility. Project
values also depend on the production rate, commodity price and
total costs (CAPEX, OPEX, taxes, etc.). When the commodity price
increases (or the currency depreciates against the US$), then man-
agement can adopt the option to accelerate the production rate
inuencing the parameter q, which apparently benets in obtaining
higher project values and simultaneously decreases unit mining
costs. On the other hand, when the commodity price decreases (or
the currency appreciates against the US$), then management may
adopt the option to decrease the mine production rate which may
increase the life of the mine and provide management with the
opportunity to wait until favorable conditions for recognizing a
higher project value returns. The analysis is also largely dependent
on total costs. Numerical simulations show that if total costs are
lower, then the project value typically increases.
 Md.A. Haque et al. / Resources Policy 39 (2014) 115123
Furthermore, due to the commodity price depreciation and
large mining costs, management can delay the project, take the
temporary closure option or adopt the abandon option. If the
maximum project value is 0, wherein the total project cash ow is
negative or zero, then management can choose the temporary
closure option and wait until a favourable commodity price
returns or adopt the abandon option and leave the project
permanently when the overall outlook becomes unfavourable.
Although we considered gold mining as a case study to determine
the numerical values of a mining project, using this PDE and
program makes it possible to evaluate any mining project values
for any commodity, both for underground and open pit mines too.
In this study, we notably considered commodity price uncertainty,
but exchange rate uncertainty has an impact on a mining project
value as well. We will leave the determination of project values
considering commodity price and exchange rate uncertainties,
jointly, for future research undertakings.
References
Black, F., Scholes, M., 1973. The pricing of options and corporate liabilities. J. Polit.
Economy 81 (3), 637654.
Botn, J.A., Castillo, M.F.D., Guzman, R.R., Smith, M.L., 2012. Real options: A tool for
managing technical risk in a mine plan. In: SME Annual Meeting, Feb. 1922,
2012, Seattle, WA, USA.
Bellalah, M., 2001. On Irreversibility, Sunk Costs and Investment under Incomplete
Information. R&D Management Journal 31, 115126.
Brennan, M.J., Trigeorgis, L., 2000. Project Flexibility, Agency and Competition: New
Developments in the Theory and Application of Real Options. In: Brennan,
Trigeorgis (Eds.), Oxford University Press, New York
Brennan, M.J., Schwartz, E.S., 1985. Evaluating natural resource investments. J. Bus.
58 (2), 135157.
123
Colwell, D., Henker, T., Ho, J., Fong, K., 2003. Real option valuation of Australian gold
mines and mining companies. J. Altern. Invest., 2338 (Summer)
Copeland, T.E., Antikarov, V., 2001. Real Options: A Practitioner0 s Guide. Texere,
New York, London.
Cortazar, G., Schwartz, E.S., 1997. Implementing a real option model for valuing an
undeveloped oil eld. Int. J. Oper. Res.-ITOR 4 (2), 125137.
Cortazar, G., Casassus, J., 1998. Optimal timing of a mine expansion: implementing
a real options model. Q. Rev. Econ. Finances 38, 755769.
Cortazar, G., Schwartz, E.S., Casassus, J., 2001. Optimal exploration investments
under-price and geological-technical uncertainty: a real option model. R&D
Manage. 31 (2), 181189.
Dixit, A., Pindyck, R., 1994. Investment Under Uncertainty. Princeton University
Press, Princeton, NJ
Hayes, R., Abernathy, W., 1980. Managing our way to economic decline. Harvard
Bus. Rev. 58, 6677 (4(JulyAugust).
Hayes, R., Garvin, D., 1982. Managing as if tomorrow mattered. Harvard 60 (3),
7179.
Lima, G.A.C., Suslick, S.B., 2006. Estimating the volatility of mining projects
considering price and operating cost uncertainties. Res. Policy 31 (2), 8694.
Merton, R.C., 1987. A simple model of capital market equilibrium with incomplete
information. J. Finance 42, 483510.
Musingwini, C., Minnitt, R.C.A., Woodhall, M., 2007. Technical operating exibility
in the analysis of mine layouts and schedules. J. South Afr. Inst. Min. Metall. 107,
129136.
Myers, S.C., 1977. Determinants of corporate borrowing. J. Finan. Econ. 5, 147175
(November).
Shaee, S., Topal, E., 2010. An overview of global gold market and gold price
forecasting. Res. Policy J. 35 (3), 178189.
Topal, E., 2008. Evaluation of a mining project using discounted cash ow analysis,
decision tree analysis, Monte Carlo simulation and real options using an
example. Min. Miner. Eng. 1 (1), 6276.
Trigeorgis, L., 1993. Real options and interactions with nancial exibility. Finan.
Manage. 22 (3), 202224.
Trigeorgis, L., 1996. Real Options: Managerial Flexibility and Strategy in Resource
Allocation. The MIT Press, Cambridge, NA
Trigeorgis, L. (Ed.), 2000. Risk Books, London