1 2000 Sait of Bzonomic Goole Sova Pact 12,2008, pe 27-2 Chapter 14 Using Real Options to Value and Manage Exploration Gewian A. Davis! Colorado School of Mies, 1500 Minos St, Golden, CO 80401 AND MICHAEL Saatts AMEC Americas Li, 2020 Winston Park Drive - Suite 700, Oakvills, Ontario, L6H 6X7, Canada Abstract This paper considers the two main uncertainties facing an exploration manages, geological uncertainty ‘and price sincertainy, within areal options framework. The paper presents two models of exploration, The First model considers only geological uncertainty and reveals how geological andl economic factors influe ‘ence 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 3nd technical environment. One out come of this model is that higher geological uncertainty enhances exploration project value shen initial resource estimates are small and harms projects that have quality esourees. The second miodel considers, both geological uncerainty and price certainty, nd reveals important differences between exploration for commodities such as gold, which exhibit random walk prices and increasing fiture price uncertainty, and exploration for hase metals, which exhibit reversion to a mean price level and saturating fare price luncertairiy, Under a value-maximizing poliey gol! exploration should, during periods of low and moder ste prices, focus om promising greenfiekls deposits ad deposits with previous positive exploration results ‘hile deterring geologically unpromising greensields prospects until prices improve. This is because given. goles random walk price characteristic, there is always a chance that higher and higher gold prices could imake up for poor geological potential, An expanded exploration policy that includes the deferred green fields prospects is warranted when pricesare higher. On the other band, aur cael suggests that unpprom ing green fields copper projects should not be kept in deferral made during low prices, since future prices tre eapped by the tfend of copper prices ta long-ran mean, Greenfields copper projects should Tote either he explored immediately it promising or permanently abandoned if wnpromising, regardless oF current capper prive. 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 tentitely by the difference in price behavior of base metals, which exhibits resersion, and gold, which docs ‘not, That optimal exploration policy depends on the commodity brings to fight the importance of model ing both geological and economic (price) uncertainly when valuing and ntanaging exploration projects ‘All of this is done-within a real options analysis. Traditional discounted cash flow analysis ignores the nonlinearity of the payofls ts exploration and thereby undervalues exploration activity The real options Framework, which captures the nonlinearity of these payolfs, shows that in some cases where the tradi tional discounted cash flove value of an exploration projeet is negative, exploration activity ean be value creating and should nevertheless proceed. Real option modeling thus provides economic validation of decisions that exploration managers often take in spite of tradihional valuation criteria that recommend against taking such action, Introduction ofa probability density function representing posible quan tities of mineral that might be extracted under the various ‘economic and technical scenarios that could unfold given, ‘Tite Ma PURPOSE of exploration is to generate reserves. In this paper we stray from the Joint Ore Reserves Commitee (ORC) very specific definitions of resousee and reserve classifications and define reserves as the quantity of miner- alization in a specific location that is of sufficient geological assurance and economic value to be profitably mined, either now or in the future, under currently forecast market and technical conditions. Thus, in our usage, the reserve {quantity is not known with certaingy, but is rather the mean, ‘Corresporsting author: emul, gdavisstminesed ‘current information. A resource is the portion of that same mineralization that either has insulficient geological assur- ance or economic value to be considered a reserve at the time. Our generic definition allows us 10 discuss reserves, and resources in a stochastic and intertemporal sense, which is vital ina veal options perspective. Real options are optionson real asets as opposed to finan cial asseis. Howell et al. (2001) provide a readable introduc- tion to real options. Karly real options research incidentally focused on the option to develop a mine or explore for oil 273on (Brennan and Schwartz, 1985; Paddock et a, 1988). The focus was on price andl cost uncertainty, in contrast 0 the decisionanalytic models of exploration ‘dating back 10 the 1960s that considered only geological uncertainty and took the economic variables as known, Only recently have real options models of exploration quantified both price and geo- logical uncertainty (€.g,, Cortazar etal, 2008; Martzoukos, 2000, 2008), although one of the main technical artifaets of exploration that appears in the decision-analytic models, imperfect information trom sampling, is still omitted, Our paper extends these recent models by introducing imperfect ormation into a real options model of exploration, ven the increasingly sophisticated quantitative geolog- ical models of exploration there has been a call to add ‘equally quantitative models of the economic parameters influencing exploration decisions (¢.g,, Lerche, 1997, p. 1637). In this paper we seek to do just this. Our hope is that, by quantitatively modeling exploration as an economi activity, exploration managers and geologists can m: ter decisions, decisions that add more value to the firm and the economy and that ultimately result in the more effi- Gient generation of reserves. Our model also allows for the valuation of exploration projects, even those that are highly speculative. Models are, by design, ations of reality, Our ‘mode! is no exception; we have left out many of the com- plexities that geologists and exploration managers must wrestle with and that mate the job of exploration manage- ‘ment and valuation so difficult That sid, we include to of the largest drivers of exploration activi, ineral quantity uncertainty and mineral price uncertainty. The result is a tool for exploration planning and management that appears to explain certain reabsvorld phenomena. Perhaps more important, the insights lerived through quantifica- of the exploration process may lead to improvements in exploration decision-making, Guiding Principles In guiding our modeling efforts we look to five irrefutable facts that characterize exploration. First, exploration is a lumpy irreversible investment activity; it has an initial irre versible capital outlay over some finite period, followed by sequential options for further irreversible capital outlay over subsequent periods. Medeling exploration activity requires investment theory that characterizes investment as li inveversible, and sequential Second, dollars are spent on exploration eoly where there is some expectation of an economic return at the ead, of the exploration sequence. That expected retrn is prin- cipally the discovery of new reserves, This does not mean, that every project needs to lead to the discovery of reserves. Indeed, economic failure, where the discovery isa resource too stall or of too low a grade to be extracted ata profit, is the norm (Kester, 1994, p. 56). Exploration has probabilities, as low as 1 in 1,000 of moving beyond grassroots stages, and. as low as 1 in 10 of finding an orebody in the few properties, that warrant major exploration effort (Percrs, 1978). This second irrefutable fact reveals that the appropriate eco- DATS AND Sants nomic model of exploration activity should be grounded in investment theory where expected (or mean) payotts, rather than mos likely payots, guide decision making, ‘Third, the payoffs o exploration axe nonlinear—the pay- ‘off to success proportional to the quality aad quantity of reserves while the cost of failure is limited via abandonment ‘options that ean be exercised at any point in the explo- jon sequence. This means that our investment theory, in calculating the expected payofl, must adequately take ito account the sionfinearity of the payoff function that is gen erated via the abandonment option, Fourth, exploration investment is unlike most other investment activites due to dhe long time frame between the expenditure of capital and the realization of revenues. [An analysis of 54 major base- and preciousmetal deposits, around the Pacific rim by Sillitoe (1995) reveals that the time fros0 initial exploration spending to the discovery drill hole averaged 14 vears for base metal deposits and 22 y {or gold deposits. Theres then an average of a further 13.5 years t0 first produetion for base metal deposits and 7 years to frst production for gold deposits. Taat i, where explo- ration is successful there is an average of 27.5 years from initial spending to cash flow generation for base meral deposits. The average at gold deposits is 29 years. We do not know of any other private-sector economic activity with such a long lag between the start of investment spending and the beginning of income receipts. Under traditional discounting this distant income is worth almost nothing in present value terms at the start of an exploration program, causing Newendorp (1975) to recommend an undis. counted analysis of exploration cash flows. This i cleatly ie given that there isa cost of capital and invest What we need is an investment model that can tely discount far-off payments for cost of capital and Hhout destroying their present vale nally, exploration investment is not investment in tan- sible capital such as buileings or machines. I is sequential investment in information, initially with the goal of locating aresource, and then with the goal of reducing the wacer™ tainty over the quantity and quality ofthat resource to bring itinto a reserve. Research and development (R&D) invest ment spending has this same characteristic. Models of R&D recognize that compounding over time, that mulple expansion and abandonment options exist during the development path, and that the main pay- off to investment is information (Paxson, 2008). Our model should have these characteristics, 100 ‘The first and second facts of exploration, that its a Jumpy and irreversible investment decision guided by expected payofis, lend themselves to traditional discounted cash flow (DCF) analysis, However, facts three, fous, and five—that exploration has nonlinear payofts and abandon ‘ment options, has 2 long time frame between expenditure and cash flow generation, and has an oucome that isin intermediate stages updated information rather tha cash Aows—indicate that teaditional DCF models are not likely to be suitable. An options framework, on the other hand, is a good candiclate, as it deals explicitly with each of theseLUSING REAL, OPTIONS TO VALUE AND MANAGE EXPLORATION nuances of the economics of exploration. Indeed, explo~ ration is an option on information, and it is difficult to value options with anything other than option pricing the- ory. Since ar issue here are decisions over real assets, real option theory is ideal Exploration has long been guided by economics (e.g. Grayson, 1960; Kaufman, 1963; Davis et al., 1973; Peters, 1978; Megill, 1979). Expenditures in aggregate have been observed to vary with mineral prices, exploration costs, exploration success rates and mining firm profitability in 2 that is consistent with exploration activity being uncter~ taken in response to varying economic factors (Eggert, 1988; M.S, Enders and RA. Leveille, unpub. data, 2004), Furthermore, considerable evidence exists that exploration is an economic activity that provides a positive return on investment (e.g., Mackenzie and Woodall, 1988; M.S, Enders and RA. Leveille, unpub, dara, 2004; Schodde, 2004). The application of real options represents a natural progression in the study of exploration and the enhance- ‘ment of this economic return, Some Preliminaries Prior to developing our model we review some prelimi ries for readers new (0 the concept of uncertainty and, -al options. Other readers can skip directly to the next sec- tion, where we present our analysis of the exploration, process ‘The nature of uncertainty in exploration Real options (RO) models always specify quite clearly the nature of uncertainty wo be considered. The «wo main sources of uncertainty affecting exploration decision-mak- ing are current geological uncertainty anit future commod- ity price uncertainty. Geological uncertainty is, in the absence of exploration effort, constant through time, To a small extent one can learn more information about a min- eral lease or property by learning of exploration results from surrounding leases. But for the most part, geological information must be purchased, thus making learning ‘endogenous In the limit, itis technologically feasible to resolve most of the geological uncertainty in this regard: itis possible to drill the entire Yease at Wm spacing, gen for all intents and purposes, an exact map of any mineralization veithin the lease boundary. A more reasonable sequence of exploration activities would he as follows: identify an area of likely min- ‘outcrops, cralization, either through or through some preliminary soil sampling and trenching; drill in selected hope of further reducing rather than eliminating uneer- tainty; and then make decisions based on this new informa on. Broadly speaking, wherever there is motivation for planned spending to reduce uncertainty, agents are weigh= ing up where to spend and when to stop spending, These decisions are based on the recognition that spending in some areas is likely to ereate more valuable information than spending in other areas, and that at some point an extra dollar spent drilling does not produce an ineremental sure’ signals such 2 dollar's worth of information, Exploration is, baldly, an eco- nomic activity that produces information, motivated by cost- benefit analysis, andl thus is amenable 10 analysis using fairly simple and well-established economic tools Economic uncertainty, on the other hand, is partially or fully resolvable only through waiting. This is called exoge- nous learning. For example, the London Bullion Market emoon $US fixing price of gold on January uncertain as of writing this paper, but will have tainty tomorrow, much Jess uncertainty on Janus ary 6, 2010, and will be known with certainty on January 8, 2010. One ean spend money now to try and forecast the price on January 7, 2010, but no amount of money will resolve the uncertainty. Other uncertainties that affect the 's of a mine, such as mining cost inflation, envi- ronmental and social Cost requirements, and taxation struc- lures, also become evident over time. This difference Ddetween the two major areas of uncertainty (geological and economic) explains why previous models have either dealt with one or the other but not both. The value/uncertainty relationship Exploration creates information, and information has value whenever it enables bewee decision-making. For example, the more information about the reserve location, grade, and tonnage at mine development, the more likely that the mine and mill will be optimally sited, designed, and sized (Glanville, 1985; Gocht etal, 1988; Smith, 1997) ‘The value penalty arising from uncertainty in the geology of a reserve is evident in the market. In the oil and gas industry, developed and producing proven reserves have three times the value of developed and producing probable reserves, and there is evidence that similar discounting, ‘occurs with mineral reserves (Davis, 2003). Traditional eco- nomic views of exploration, which see exploration as only increasing geological assurance as a technical requirement prior to extraction (e-g., McKelvey, 1974), fail to recognize this value/uncertainty relationship. In RO models, increas: ing geological assurance not only moves resources between the traditional inferred, indicated, and measured ¢ xgories, but can turn a resource into what we call a reserve in this paper simply by reducing geological uncertainty and thereby assuring profitable extraction by increasing the likelihood that optimal mine and mill location and design decisions will be made. Valuing future uncertain payoffs The discounted cash flow (DCF) method isthe most come ‘mon method of ealculating the net present value (NPV) of the payolls fzom investment, be they the vale of informa: tion gains within an exploration program or the payofls cre. ated by any other investment. This technique aggregates time and risk adjustments into a single discount rate. That discount rates used to bring the fire payoffs to a present ‘alue so that their sum can be weighed against the present cost of the investment. Unfortunately, the use of DCF dis count rates in the resource industries is often inhesently flawed since it common practice w use a single Constant276 discount rate aero a wide range of projects, with perhaps An arbitrary boost for early stage exploration projects. Most projects have widely varying risk characteristis So that dif ferent éiscount rates are required. Yet, there is no easy way to determine the required project-specific discount rate (Fama, 1977; Myers and Turnbull, 1977). Even within a given project, the use of 2 constant discount rate over all «ash flow periods presumes that cash flow risk is increasing invaspecified manner that is unlikely w match the nature of the risk in the project (Robichek and Myers, 1966; Myers and Turnbull, 197) The RO method shares the same theoretical foundation as the DCF method but uses a risk adjustment that is unique to each project and the level of risk inherent in that project (Jacoby and Laughton 1992; Salahor, 1998; Samis etal, in press). In particular, each source of uncertainty afecting a project net eash flows identified, the net cash flow risk that this generates is priced using market information or finan- cial models, and then the tiskeadjusted net cash flow is saljusted for the time value of money. For example, if a net cash Now is affected by price wacertainty, the RO technique replaces thai uncertain price stream with its certainty equi= alent, in this ease a marketderived forward price. Geologi- cal uncertainty is treated in a similar manner. Because of their differing risk atuibutes, copper projects are dis- counted at a different rate than geld projects, and early stage projects are discounted ata different rate from lare stage projects (Laughton and Jacoby, 1993). Discount rates tend to decline for the more distant cash flows, resulting in even the dlstant positive cash flows of an exploration project having significant postive present value. ‘Modeling Resource Uncertainty and the ‘Value of Information In modeling and valuing exploration activity, current geological uncertainty and future economic uncertainty are interwoven. The value of drilling another hole now is affected by the expected price of the mineral several years n the future, since this is the price that each unit of min- ceral found will vkimately fetch upon extraction. And the price of the mineral several years in the future depends on the supply forthcoming at that time, which depends on the amount of exploration activity now. Clearly this is a com- plex process, and one that will have to be simplified if we are to make any progress. As with earlier works (e.g, Kau ‘man, 1963; Newendorp, 1975; Howe, 1979, Ch. 10: Harris, 1990) we begin by taking prices as certain and focus only on initial geological uncertainty. We extend the earlier work by emphasizing the economics of exploration deci- sions, After developing this economic model of exploration decision-making, we add price uncertainty in the case study in the next section of the paper A model of resonrce uncertainty aod the outcome of exploration In this section of the paper we build a simple model of exploration through which particular management and val- uation insights can be revealed. Our statistical model of the information gained by exploration is based largely on DAVIS AND Saas Campbell and Lindner (1985, 1985) and Kaufiman (1968) ‘To simplify matters we will consider exploration activity at the level of the project. We assume that exploration is guided by rational decisionmaking aimed at spending dol fars only when there is an acceptable expected retura to doing so. ‘Ateach point in time the company or government weighs up taking some discrete exploration ‘activity at a given prospect, comparing the costs associated with this activity ligninst the rewards thatthe activity is ikely to produce Rewards come in the form of new geological information In all cases information will hve value, in the sense that it will create better decisions on subsequent spending on exploration or development than in the absence of that information, In some cases the information will reveal that itis optimal to terminate an exploration program because the information likely to be gained from the next stage of exploration is not worth the cost the project will either be deferred or abandoned, ori wll move into development In other cases the information will indicate that additional exploration spending is warranted, The value created by the improved information is dixcourted for risk and time sich that it can be weighed against the exploration costs. Explo= ration creates wealth when the present value of expected benetits, appropriately discounted in a RO framework, exceeds she present value of expected costs ‘To begin, consider a mineral lease that contains R> 0 units of economically recoverable mineral, though F may note lige enough to warrant development of a mine and therefore may not be a reserve, The level of Ris unknown to the entity that owns the lease. Reconnaissance has lease and is the basis for what we will call prior beliefs about the level of R There sevidence that within a basin or goo- logical region reserves have a log normal distribution (Kaufman, 1963; De Geoflvey and Wignall, 1985, p. 25-26, Harris, 1990, p, 300-801), A log norma cisuibution there- fore seems to be a reasonable starting point when modeling geologists inferences about Let these prior belief the fore be the log normal distribution Ff ~ Jy 4 8), where py ismean of the log ofthe beliefs anal dis the variance of the log of beliefs. The tilde on A, suggests tat itis ranclom xatiable, and the 0 subseript indicates time, with current time being 2ev0. Given the properties of log normal disti= butions, che expected or mean size ofthe economic miner alization at time zero is Ry= expla +0389) a ‘The variance susrounding this estimate is Var( Ry) = lexpl2uy + dflHexpldy]-U, (2) which has the desirable property that more promising prospects have mon economic mineralization; the coefficient of vari stant for all deposit sizes and is equal to (expl6§ Depending on the level of and geological assurance surUSING REAL, OP IONS TO VALUE AND MANAGE EXPLORATION rounding the estimate, R, may define either a resource oF reserve at this point. For coneretenens, we assume that itis resource due to lange Var()). The intial beliefs about Fe find Var(f&) contain composite information about the is rution of means of reported field sizes of reserves ofthis {eoogical nature or area, the variance of possible fel sizes ssociated with each mean, and information from early Stage exploration (Kaufman, 1963), The initial resource estimate is almost centaim be wong, with Ry # R Never- theless its the best information available and must be vsed when making decisions ahost whether oF aot to continue exploring the property ‘A tractable ease treats the next stages of exploration a a series of discrete sampling events, #= 1,2). ranging from geological napping (i= 1) wo pattern drilling For now we assume that ail nstages af exploration, if under. taken, must be completed sequentially with no option of going directly to development and no option for absndon- ment at any stage. If exploration is not undertaken tle pro- ject must be abandoned. Only through exploration can ‘enough information be gained to warrant proceeding ith project clevelopment should the resource become a fee In essence, we assume tial existing vesource uncertainty i too high to warrant moving directo development diling, and that management must decide whether or not to com: mit now to an allor-nothing exploration program to prove the resource Tina departare from most decsionanalytc exploration models, we treat exploration as Bayesian sampling from a continuous distribution rather than sampling {vom 2 sin plified binomial or uinomial cistibution. In this sense o node! will take on the flavor of a real options model, which uncertain variables are mocicled as eontintous. Each stage of exploration generates an estimate X, of the quaine tity of economic mineralization. These exploration oxt- ccarwes randomly deviate from R because there is known terror or noke 6 associated with sampling, abn to a detec: tion probability of less than 1 (De Geoffrey and Wignall, 1985).* The level of a indicates the degree of sampling ésror in sampling stage 1, typically motieled as being decreasing function of exploration expenditure nd explo- ration efficiency within the sage (De Geoffrey and Wignall, 1985, p. 75-76). Alternatively, stages with less sampling error could be treated as having a simple-eqaivalent size n > 1 Although 6? will probably decrease as each sampling Stage becomes more targeted, to simplify matters we treat (Fas constant across cach slage of exploration. We noted above that df is the variance ofthe log of initial beliefs bout the resource size. Ttis useful 10 think of 8 as tnypothetially ing generated by m previous stages of explo. ration given sampling error in cach stage, oF 8 = c/n wget al, 2005). For pling outcomes updating given die Howe (1970, p 212-218). “More sophinsiated mals eat the initial resource parameters and neauarementeror aeunkasnn (Kalina, 1973), 277 (Kaufman, 1963, p, 162). That is, the initial nesource uncer tainty could equally be expressed as the outcome of m pre- vious stages of exploration, each stage identical to the stages of exploration to follow. Then, define X,=43l0g Xj @) a8 the log mean of the succeeding mstage subsequent sam- pling exercise. This new information is combined with the previous information abou to create an updated or pox {erior resource distribution 2 A priori, an unbiased sampling exercise is expected to return the prior resource estimate, with postexploration uncertainty atound this estimate going to Zero as the num ber of stages (exploration elfort) goes to infinity. These properties of the Sampling program are brought about by the Bayesian assampiion thaitsampling error introduces an independent log normal process with known precision. Yt other words, sampling wil have an indepenclent log normal distribution J, (12, 02) with process mean exp + 0.502] = R and process variance fexp|2u + 0*]}lexp(d")-1), Kaufman (1963) shows that given this assumption the post-explo- ration resource under Bayesian updating iF, ~F,(dy 32). where Joy = Oy +X, @ Cage laa (5) o By expla, +0582 explin, + 0.50%/(m+ nC) and vor( lexp(4u,+ 521 texpl3zh. 8) Equation (4) shows that the new information will be com- bined with the old sia a finear weighting system. Equation (5) describes the weighting system, where more weight is placed on the sampling results when mis larger and 1 is, smaller, pethaps duc to a large sampling program or low sampling error. Equation (6) reveals that the new resource sariance parameter is less than the initial variance parame- tersince 3,2 = 02/( m+ n) 0. This isthe essence of proving a resource. Equation (7) provides the new resource estimate, which will only change {rom original estimate Ry iT, #4 + 0.882 = py + 0.882 =I Ry thal is, ifthe log sample mestn is different from the log oF the initial resource expectation. Equation (8) isthe variance of the revised resource distribution. Some (e.g., Hasket, £2003) argue that exploration should always decrease var ance, whereas Galli etal, (2001) suggest that a variance278 increasing with mean resource size isa desirable property of any sampling program. Equation (8) shows that the variance of the resoutce estimate can increase i the revised mean of the log of resources, 4, inereases, consistent with Gall eal. ‘Compare these outcomes to popular decision-analytic roel of exploration activity tha assume that exploration yeveals a binomial positive or negative Outcome Rigg, Tonspihat completely sesohes uncertaing. Thats, sampling ‘would produce X ¢ Xs ) this model). Gf course, in this case there would be no need for sampling stages 2 through 1, as all resource uncer- tainty would be resolved in stage 1. Another way of saying thisis that sample outcomes are perlectly correlated or fectly dependent. In our model, sampling instead updates the resource estimate Ry and the variance arouncl that esti- mate without ever completely resolving uncertainty Exploration decisions must be made prior to having the information resulting from the exploration program, and so for our analysis we must trea the exploration omcore Ryasthe random variate Xe with an anueipated mean X, (mean of possible means)” Given the prior resource dist iribution Ry, sampling (with exs0r) isa priori assumed! to he from a Tog normal process f, (Ry. ©). Since expected explo- ration payoffs are based on the mean or expected resource, itis the preposterior disteibution of the possible posterior resource means R, (see eq. 7) that is of interest, Let the dis: iribution of these possible updated resource means be fy. Ry will then incorporate prior infgrmation 2 as well as the Anticipated sampling outcome X,. Kaufman (1963) shows that given n stages of planned sampling the prepostevior mean resource quantity has a log normal distribution B= fyi) 4 05 Pip» Bias © where wy) there are many possible resource quantities after exploration, only one of whieh will be real- ized. The distribution of these possible resource quantities is log normal. Equation (10) gives the variance parameter rellecting the range of possible resource quantities, with Var(Fi,) = lexpl2py + 6F]Mexplael. (1) Comparing equation (11) to equation (2), we ean see that exploration is expected to reduce the variance around the resource estimate since via equation (10) 63,< 63. Kaufman also shows that the amicipated| mean of the updated resource estimate is F, = exply + 0.50%/m] = expla, + 0.5 ay Exploration should, if itis unbiased, not be expected to change the initial resource estimate. From equations (12) and (1), AVIS AND Saas RoR, as desired. Endogenous or controlled learning that is not expected to change the prior belief about the mean of a random vaviable, as isthe case here, is called pure learning (Marvoukos, 2003), and is often. used to model the R&D. process within firms, We mentioned the similarity between exploration and R&D above. cas) Calculating the value of exploration information This statistical model of geological uncertainty resolu- tion, which would seem to model reakworld attributes of exploration and information updating quite well, i at the heart of the exploration program. Preposterior belicls as described in equations (9) through (13) can now be used to generate expected benefits of the exploration sequence, which in twin are weighed against the costs of the sequence. Ifthe anticipated benefits are greater than the anticipated costs, all in present value terms, the exploration program creates wealth and will be undertaken. Ifthe antic ‘pated costs outweigh the anticipated benefits all 1m pre- sent value terms, the property will be abandoned, We will now show that although exploration is not expected to increase resources (eq. 18) itcan nevertheless be valuable, ‘even where the initially estimated resource R, is too small © ‘warrant mine development should more resource not be found. Adding the economics to the model, let the present value of the expected cost of the n-stage exploration program be Claus 2), where cost is increasing with the length of the exploration program » and the inital resource estimate Ry, and decreasing in the noise associated with each sampling stage 0° (more detailed exploration is more expensive) Upon completion of the program the property may be developed ifthe resource becomes a reserve or abandoned, if the resource is uneconomic. Given the prevailing mineral price, let the sve (n) NPV of this option wo develop the pro- perty after exploration he NPV,(R,, 62) 2 0, where the option value is increa decreasing in posterior reserve uacertainty 63, The value discounting associated with 2 is not only a result of risk aversion as in Campbell and Lindner (1985), but also due to the fact that ex post facto subopuimially sized mines and, ills are inefficient and ean only be made more elficient rough expensive expansion or contraction expenditures Again, information has value. Define resource quantity 7 as the minimum that will lead to exercise of the mine development option upon comple: tion of exploration, For a guideline on representative val- ues of for various mineral types, see Gocht et al. (1988, p. 112), although 7 will vary with resource quality and com- modity price. The gross payoffs of the exploration program, are now as shen in Table 1. If after exploration the updated resource size is R, = ment abandons the property and NPV, B.A on the other hand, after exploration the tipdated resource is, R, > 7, R, becomes a reserve and the firm or government will exercise the option to develop the property, gaining a 1g in posterior reserve size R,, andLUSING REAL, OP HONS TO VALUE AND MANAGE EXPLORATION Gross Payuls foun Exploration n Posterior Resoutee Sire By Poseior ronree are ‘Gros pay from exploration 0 Nevitily 62 project value of NPV, (Ry, 62) > 0. The gross project payof? is thus 1,0) 20, max(NPV, (Ry, 82), (ay which is nonlinear (convex) in f, The present value of the net exploration payoll can be represented as, Bin) maxi NPV, Fy 633.0) Cla Ryo). (15) where Bin isa discount factor e 9 that takes into account only the time value of money. We only discount forthe time value of money because at the point of making the devel ‘opment decision resource risk has heen reduced to 8, and the value effects of this remaining uncertainty have already bycen taken into account in the calculation of NPV, 33 The time discount factor Bl) is increasing in the’ number of stages of exploration since more exploration takes more time: dian > 0, However, even ifthe exploration program will take decades, the discount factor Bn) does not reduce the present value ofthe ultimate payoff t almost zero, ait wwould fit included a isk premium, since itonly adjusts for the cost of money. ‘An example will illustrate the model. Consider a small, latestage gold project with an anticipated $50 M develop: ment cost aier n stages of exploration based on the initial resource estimate fy, Assume a sicstage exploration pro- gram (0+=6) that will take five yeats to complete and a cone tinuously compounded ime discount rate of r= 5 percent per year: With these parameters, B(») = 0.78.4 Assume that the present value of exploration costs is C= $(!%) $10 Ri, probably reasonable for a property at this stage of development given that Schodle (2004) caleutates a gold Gnding cost of $32/07 through all stages of exploration, It 8320.75 and shen m= 2 and from equation (6), 8 = 0.1875.° This reveals that there will be remaining resource uncertainty after exploration, although itis less than inital resource uncertainty. Assume that this remaine ing uncertainty is low enough that any economic mineral ization can be mined, with @ postexploration resouree value of $50/07 given price and extraction cost expectar “A traditional sskajusted dscnont rate of 186 woul vee ie > 0.47 unfainyredlcing project ale by 10%. exploration were co take 20 ears Blo would be 0.37 escounting only for tame, compared with BC) DFO a 8% cso rina vesgerce coefficient of variation the reduced! uncertainty From sping 279 tions, The gross exploration payoff is then max(NPV, (ify, [50 R, -$50 M, 0), shower as ine (1) of Figure 50,000 o7 and 2 Moz. The discounted (to stage 0) gross exploration payoff B(n)max(NPV,(f,, 83), 0) = 0.78 max($50 R,-$50 M, 0) is shown as line (2) in Figure 1. These are the present value payoffs from explo- ration conditional on each updated resource estimate. For example, an updated reserve R, = 1.25 Moz will have a pay- fff with’ present value of $9.7 M, while an updated resource R, = 950,00) oz will have a zero present value pay- off. In this example 7, the size at which the postexploration resource isa reserve, is 1.0 Moz — ° & aoe LO 3 veo! Tes * oo Dene ‘Goidesouee Mos) nw (2 Oszauned NO Tea nyc ste Rea Opten Eperaton =v tion ofthe resource esti and the horizontal Pa. 1. Exploration projet sae asa Resource levels greater than fray be defined ay reserves, Line (2) Fee sents the present vale ose post exploration projet athe sar of explo Fation. Line (3) fhe traditional drscounted cath Ram watson ofthe ‘exploration project, the discounted payoll from exploration less the ‘exploration cost C. Line (1) ithe eal option ealeulation af the explo Fation project sale, The task is now to manage and value the option to invest in exploration, as of stage zero. Traditional DCF analysis would esting the anticipated resource quansiy after exploration B, which, from equation (13), isthe sare asthe prior resource estimate 2, calculate the anticipated gross exploration payol alter ge 1, max(NPV, (B,, 62). 0) = max (NPV, (Ry, 83), 0), discount that anticipated payoff for time and resource esti- mation uncertainty Var(R,), and deduct the present vali of exploration costs. If we follow the standard finance assumption that resource uncertainty is unsystematic and, ‘ean be diversified away and that the firm or government is risk neutral, the decision-maker ean make a decision hased on pure discounted expectations: DCF, = Bla) max(NPV,(R,, 62). = Cm Ry 0), (6)280 Under the traditional DCF framework, exploration will proceed when the ordered pair (Ry,52) produces a postive DCF. Returning to the numerical example, DCF, = 0.78 max{$50 R, - $50 M, 0) -$10/, Line (3) in Figure t shows DCE, values for prior resource estimates Ry of between 50,000 oz and 2 Moz. Exploration will proceed for any ini- tial resource estimate of greater than 1.34 Moz since DCF, >-0 for these resource quantities. For initial resource este rates of less than 134 Moz, the DCR, of proceeding with exploration is negative, so the property will be abandoned. In this DCF decision framework, projects where the prot ability of success is 1 in 10 or Ness, 28 is the case when initial resources are estimated at 500,000 62 0F less, are far from satisfying the hurdle «0 go forward with exploration.® This proves problematic with intuition and evidence thar explo- ration is often warranted when the chance of suecess isin that order: The essential problem with this DCF valuation approach is that the nonlinear (convex) payoff structure is ignored. This is remedied by the more comprehensive real Options approach, Let h( Fe y4,3) represen the preposte- jor log normal distribution of expected resource quanti- ies upon completion of exploration given the prior resource estimate parameters and 6, where PCR ley) <1) Ji mapa, a and PCR, andi) > = [Eo 89) n= 1 PUR pdf) >. “This last expression represents the probability that the resource will hecome a reseree alter n sages of exploration Conditional on ji and 8}. The preposterior real option tale of expected benefits from exploration is? i(n) Jmax(NPV, (R,, 52), 0) AR, iny.d2)AR,, (17) and the stage zero real options expected exploration prop- erty value is| RO, = Bln) [maxi NPV, (7, 52), A(T, My SPAR, Clu, Ryio%) 2 = Cn, R02). (is) Exploration will go ahead whenever RO, > 0 conditional on the ordered pair (yp). When max(NPV, (Ry. 82), 0) i ‘convex in Fi, which isthe case whenever 7> 0, the value in ‘equation (18) will be greater than the value in equation (16) via Jensen's Inequality, and the resource size eutott for continued exploration will be smaller dian under the DCF approach, possibly even smaller than ¥. This isa key insight from real options analysis. For the numerical example above the real option explo- ration value, RO, is depicted in Figure 1 as line (4). While the log normal distribution of preposterior resource esti= PO Gompared to.a DCF benefit estimate of po)anaxI NPV, (TIE MR, dy apatne 01 ‘ avis AND suas mates lends itself to the potential for closed-form solitons for ROy, we estimate RO, using a Monte Carlo simulation «rset 50,000 trials All postive values on line (4) reveal the value generated by exploration, for without exploration all of this value would be lost (the project would be aban- doned at stage 0). Now she exploration program will go. ahead for any initial resource estimate greater than 900,000, 7, rather than the 1.84 Moz cutoff under traditional DCF analysis. If the current resource estimate is less th: 300,000 07 the project will be abandoned, since at these els going ahead with exploration costs more than the pre- sent value of any revenutes that are likely from mining whi mate reserves. A 1.5 Moz resource has a current valne of $10.9 M, more than double the estimate using uaditional DCF analysis, A 950,000-02 resource is now worth $0.6 M,, compared with being worthless via the traditional DCF approach. Since we have used the same discount factor Bin) in both the NGF and real options calculations and valu stage n mineralization in both cases at $50/02, the d tence between the line (4) ana line (3) valuations in Figure 1 is solely due to the real options recognition that decisions about whether or not to develop the project are made con- Gitional on the outcome of the exploration program, an option to develop, whereas the traditional DCF approach assumes that the decision is made at time 0, based on Ry* 1 exploration at aR = 910,000-0%, deposit has a3 in 10 chance of exploration success, success defined as proving an expected 1 Moz or more. Explo- ration is nevertheless economic for properties with any- ‘thing more than 900,000 07 of resources at stage 0 because of the high payoffs of an unexpected but large find, with the downside limited t0 exploration costs. The real options model is showing this and allowing for speculative explo- ration, whereas the iraditionai DCF model does not A Generalized Model of Exploration. ‘The above analysis, while depicted in Figure 1 for the specific parameter values given in the example, is com- pletely general. Given any gross payoff function, line (1), that is convex in current resource quantity, Jensen's, Inequality will cause the real option resource valué line (4) to bea smooth and strictly convex continuous function, everywhere above line (3), the DCF resource valuation line. ‘The seal option value line is anchored at the origin and, asymptotically approaches line (3) as initial resources, become infinite. The exploration cutoff resource quantity will always be lower in the real options analysis han in the traditional DCF analysis, and the exploration project vale will always be higher. Most significantly, exploration can be justified where initial resource estimates are fess than required to support a mine, Ry < % In addition, through some comparative static exercises the real options model provides rich insights into factors influencing exploration decisions: i practcesthe ves caleulated uring the traditional DCF approach ‘wou probably be even lene than ine (3) since thisapproch yell di ‘oun veg age n sesource risk move eaily thy 9 ou reteUSING REAL. OPTIONS 10 VALUE AND MANAGE EXPLORATION 1. Exploration project value is ot monotone in initial resource quantity. Lines (3) and (4) are anchored at the origin and slope downwards and then upwards as ini resources increase (Fig. 4. Traditional project valuation shows the worst, or most uneconomic, projest, ie the Lowe {st point on line (3), (0 be that with an initial resource esti mate of 7 Real options shows the most uneconomic pro- jecs, the lowest point on line (4), to be that with an initial resource estimate of well less than 7: Real options are thus more forgiving in werms of smali size resources. Line (4) shows real option exploration project vahte to be les sensi Live to resource size than traditional DCF exploration pro- ject value, shown as line (3) 2, Additional stages of exploration always provide gross saluc through the valueotinlormation effect. Equation (6) shows that additional stages of exploration lawer 8 which ive have assumed will increase NPV,(R,, 52) for any Ry. ‘This causes 710 shift elt and the slope of the upward-trend. {ng portion of line (1) to increase. In addition, via equation (10). more sampling stages increase the variance ofthe pos sible posterior resource quamtiies. This is a result that is not picked up in the taditional DCF analysis. Both effects will ause the real option value of the exploration properly tw increase: the first effect causes line (4) to rotate upwards, while vhe second effect eauses the rotated line (4) 0 be less convex. Exploration creates value even though it is not expected to increase the quantity of the resource, 3. There is an optimal amount of exploration to commit xo atstage zero. An increase in exploration effort increases Cn, Ryo?), causing a downward rotation in lines (3) and (4) that offsets the gains outlined in the preceding paragraph, Asa result, there wll bea valuemaxintizing exploration effort n* that will depend on the cost of exploration, the pavotl value function NPV. (Zi, 62), and initial resource beliel 4. Higher simpling precision, if tis costless, will increase exploration activity and the value of exploration. Higher sampling precision towers 02, and, via the specification 3 = 62/1, lowers mt From equations (¥0) andl (1) this causes Vari) increase, which will result in line (4) being Sess convex. The amount of and value of exploration projects will increase. The elfects here are very similar to an increase in the numbey of sampling stages. Indeed, inereased sary 1g precision and increased sampling size are imperfect litutes in exploration value generation. Traditional DCP analysis would not pick up this effect. 5, Lower exploration costs increase exploration activity and the value of exploration. Lower exploration costs will rotate lines (3) and (4) upwards. The amount of and value of exploration projects will increase. 6. Higher margins upon extraction increase exploration activity and the value of exploration. Higher margins shift 7 to the left and make the upward-trending portion of line (1) sweeper, neteasing the ainount and value of exploration projects. The impact of higher margins on exploration is not identical 10a decrease in exploration costs, But has the same broad effects. The impacts of mineral price on explo- ration activity have been noted (R.C. Schodde, unpub. lata, 2008; Natural Resources Canada, 200), oy 7, Higher interest rates will reduce exploration activity and lower the value of exploration. Higher anterest rates wil increase the Bn) discount factor, rotating she upward slop- ing portion of line (3) clockwise and thereby rotating fine (A) clockwise, Exploration activity will decrease, and the value of any given exploration project will also decrease. ‘This assumes prices and costs are not affected by the change in interest rates. Ithey are, tie-impacts of interest rates wil be combined with the previously noted impacts af prices {paragraph 6 above) and costs (paragraph 5 above) on exploration, 3. Higher initial resource uncertainty beneficial to exploration project value, Initial resource uncertainty is parameterized as 6. ln exacaining the effects ‘fan increase in 8 we wish to preserve the initial resource estimate fy which means that via equation (1) an increase in df must be offset by a decrease in py, Tha i, = expl sy + 0.562] must be held constant. Equations (10) and (11) reveal that such a compensated increase if increase in Var(,), with positive valuatios impacts as in paragraph (4) above. But equation (6) reveals that an, increase in 7 (a decrease in 1) will increase 63, remaining, resource uncertainty after exploration. This will lower NPV, (Fy 52). The wltimate impact on exploration prop- erty value is ambiguous. ‘To show this using the numerical example, assurne that 4}, the variance parameter on the initial resource este, rises from 0.75 to 1.50, with mconsequenty falling from 210 1. This increases the coefficient of variation on initial resources to 1,866 from 1.087. From equation (6) 62 rises from 0.1875 10 0.214. We assume that thisinevease in 8: lows ers developed resource value from $80/02 to $40/02 due 10 the increased ex post facto suboptimality of the ikely plant ‘design associated with an inereased 53. Exploration cost G remains unchanged, Figuse 2 plots the original (lines 3and 44) and new (lines | and 2) tradiioml DCF and real option valuations. Increasing initial resource uncertainty has, increased exploration project real option value for projects of about 1.0 Moz or less (compare lines 2 and 4), while ‘decreasing exploration real option project value for projects of greater than about }.8 Moz. A 900,000-02 project has, increased from a real options exploration value of -$43,000 toavaluc of $415,000, while a I.1 Moz project has decreased in value from $8 to $2.4 M. The observation that incxeasing, ‘uncertainty does not always benefit option holders has beet pointed out by Davis (2002). In that paper, asin this model, increasing uncertainty is most likely to be beneficial for out ‘ofthe-money options, of, in Figure 2, initial resouece esti mates to the left of 7, Of Course, in traditional DCF analysis, increasing uncertainty always reduces asset value (Fine 1 in Fig. 2s eerywhere on or below line 8). Yetan exploration property with 900,006 0 of certain resource is clearly less \aluable in our example than a resource that has a mean of 900,000 o7 and some variance around that mean that allows, for reserves to be discovered. Itis only through uncertainty, the possibility of ultimate resources being greater than 1 Mor in this case, that exploration becomes valuable at sites with small resource estimates. not necessarily results in an(Ga eso (ee) aS Wlorpat hapten etantee TT oneaascema nyc Fc. 2 Exploration project le when inital resource uncer isi ‘dace pay il exoorce uncertain Line (3) fp esents the orignal dco om exploraion, which the sme 3 line (3 in Figure 1. Cin exploration project, an ine (4) represent the original real option ale of Ae exploration projet, wih edhe wine a ine (4) in igure [creased inal rere aneerainy has lower the tadtional exploration property Sali, sine ine (1) everywhere below ine (3). The rea pion ac is Higher under neseasecl warevtiny when inital resources are elow about Mou and loner whe ital resprresave above about | Moz While our model of expioration and leaming is very sim= ple, all of these insights are in accordance with what we ‘would expect. Our main result is that exploration can have value even when the traditional DCF value of the investment negative, but only for resource quantities above some lower bound; exploration of all projects regardless of initial resource expectations is not warranted. The framework also, reveals that over time, as exploration costs rise, exploration will become less valuable and more likely 10 be curtailed on, properties where resources are low. On the other hand, mineral price rises will tend to offset the effects of the higher exploration costs. We have modeled the reakworld realization that increasing exploration precision and effort provides value that can offset its cost, and that exploration effort will respond to changes in macroeconomic variables such as exploration costs, mineral prices, and interest rates Finally, those holding, leases with low initial resource esti- mates would want higher initial resource uncertainty, whereas those holding high quality leases woul The model has an additional use. Having bi of late-stage exploration project value, reconna mization now becomes possible given payoff line (4) (Fig, 1). To date such payoffs to reconnaissance have been pre- sented qualitatively (J. Hronsky, unpub. data, 2004; R.C. Schodde, writen commun., 2004) with a view to suggesting a minimum and maximum target size for reconnaissance, We now have a way to model the payoffs quantitatively, Managing the Exploration Program under Price and Resource Uncertainty While informative, the anat nomic (price) uncertainty a is to date has ignored eco- in important management avis AND Saas alternative, the option to defer late-stage or even initial ‘exploration in lowprice environments, Project deferral can hea valuable alternative to project abandonment AAs noted earlier, priceand reserve uncertainty are rarely modeled together, and exploration deferral is even more rarely modeled. To our knowledge the only other paper to model both reserve and price uncertainty ara the option t0 defer exploration is Cortazar etal. (2003). In that model, there are 11 posible resource outcomes, & Initially there isa prior expectation over these resource outcomes, fy Explo- zation over four stages lasting a total of eight years serves 0 resolve all uncertainty over R.A single poor exploration out come results in project abandonment, whether this is opti- ral or not. Exploration can be costlessly and perpewially deferred at any stage pending improvement in the eco- nomic environment. Under these assumptions Cortazar et al, find considerable value to deferring exploration in low price emiranments. In their worked example a $1,000 M. posteievelopment prospect with a current NPV of -$6.29 M hhasa real option value of $3 M dollars, with the option to deter exploration contributing $1.6 M to the $3 M. In this section we augment our model via a reakworld case study that considers reserve unceriainty and price wertainy. Our example and treatment is simitas to that of ‘ontazar etal, only we have five possible discrete levels of R, assume diat there is still uncertainty over Rafer exploration is completed, allow for repeated exploration upon a nege- tive sampling outcome (since exploration information is imperfect), explicitly model resource updating in a Bayesian framework given exploration meastiyentent e1r0r, impose costs while deferring exploration, and impose finite time periods over which exploration cai be deferred. We use a discrete resource disttbution because this i how the participants in the case study thought about possible explo- ration outcomes. While the original case study involved gold, we also fabricate a hypothetical copper exploration example because copper prices exhibit reversion to a long- term equilibrium price, whereas gold. prices do not (Schwartz, 1997). This difference leads v9 markedly differ- cent exploration decisions in the vatious price environments Exploration lease background infurmation A company wishes to value and manage a geological anomaly that has been identified by an aesial geophysical survey during a greenfields exploration program. The geo- graphical reyion in which the anomaly is located is Large find has seen some previous exploration activity. A govern- ‘ent geological database is publicly available with oxer 700 entries identifying various regional geological anomalies, the exent of exploration, and the results of exploration to date at each anomaly. Company geologists also have long exploration experience in the region. Based on this infor mation, the senior geologists within the company grouped the posible deposit outcomes for the anomaly into five ore- body size classifications: (1) a world-elass (WC) deposit Rye with a probability of 0.15 percent; (2) a large-scale (LS) deposit Ry, with a probability of 0.35 percent; (3) a mid sized (MS) deposit Rys with a probability of 2.0 percentLUSING REAL OI TION TO VALUE AND MANAGE EXPLORATION (4) a smallsized (SS) deposit Reg with a probability of 5.0 percent; and (5) a waste deposit (resources of less than 7 the minimum size needed to mine the resource) with a probability of 92.5 percent. Tables 2a and 2b lst the geo logical and economic characteristics of each deposisiz for ‘each metal. The probabilities of each deposit size reflect {he priors that wil inform dhe analysis, a discrete version of the continuous deposit distribution Thy ~ fy 4, 83) pre- sented abore. Given the above probabilities and assuming no economic mineralization in the waste case, the gold lease has a time zero resenurce size R of 100,000 o7 and the copper lease hasa resource size R,of 0.051 billion i. While these estimates are by nature subjective. they are held to fepresent an accurate reflection of knowledge about dhe $orebody given the information at band. Exploration sam pling will then serve to upstate these priors asin equations (a) through (8), with more weight being placed on the exploration outcome (i) the less the exploration measure- rent error, and (i) the less the cevtainty over the original priots. At this stage, for instance, we would expect consid: trable weight ta be given to the exploration outcomes. “The NPV values presented in the as column of Tables 2a and 2 are calculated using the waditional DCF eash low approach that is common in the ming industey. The gold project NPV values are calculated with a forecast gold price 0 $400 oranda riskadjusted discount rate of 8 percent/y swously compounded. The copper project NPV values are caleulated with a forecast price of $1.00/Ib and a dis count rate of 12 percent/yr continuously compounded ‘These NPVs assume that the » stages of exploration are complete ancl that a particular deposit type with reserve R denoted in column 4 of Table 2a oF 2b has been discovered. The expected grass exploration payoll, NPV, (Ry, 52), is roughly $1 M for the gold case and $6 M for'the copper case. Prior to development the project is also subject to 2 feasibility study. That study costs $300,000 plus a variable Tut. 24. Characters 283 cost proportional to the expected capital cost of the project. For example, for the R, in Tables 2a and 2b, the expected Feasibility cost is $2.7 M A staged exploration program and management operating, decisions ‘The company’s geologists have developed a three-stage (= 3) sequential exploration program for the anomaly, each stage being one year in iength. Exploration costs are Incurred at the start of each stage. Exploration results upon completion of each stage are categorized as good, fair, oF poor. This sampling outcome is then combined with the prior information about the deposit to obtain an updated, deposit description in a Bayesian framework described in detail below. The first stage of exploration costs $1 M and. consists of surface geochemical sampling, mapping, and. reverse circulation drilling, The second stage of explo- ration costs $2 M and involves detailed geochemical sam pling and diamond drilling. The third stage of exploration, costs $3 M and involves a futher geochemical study, exten- sive diamond drilling, and specialized geologic interpreta- tion, Upon completion of exploration the firm must imme- diately either begin development or abandon the property. ‘Managers can elect at the beginning of each stage to pro- ceed with exploration, to defer the next stage of explo- ration for two years ata cost of $75,000 annually, oto allowe the lease to lapse at no cost, iF exploration is deferred, the exploration managers must decide at the end of a woryear deferral period to either abandon the lease at no cost or to start the next siage of exploration. Figure 3 delineates the exploration decision twee for both the gold and copper leases. The immediate decision is whether or not to pro- ceed with exploration. Certainly, with cumulative explo- ration costs of $6 M, an expected feasibility cost of $2.7 M, and expected gross exploration payofTs of roughly $1 M for the gold property and $6 M for the copper property, the sof Posble Gold Projects ‘aptal Developmen Annual’ Pradiction Dor Deposit Sie Grade Gold expendiine horton priuction ie NPV Spe _twsilliom tore) (8/0) (Moz)_“(Srallion) (eas) __(anilion tore)__(yeats) (Sar) (S/4)_ (Smilin) Woritclas 720 Lop 3330730 1 300 We 28 0 Large 100 12060 sno 8 160 wo 20 al Midsize 6 130 15m 80 8 60 6 199) as Smal 6 Lao os 2 bs 4 a7 or Tans 2b. Characteristics of Posible Copper Project Capit Devapment —Annwal— frodueuon Unit open Der Deposit Sic Grde Copper expenditire horn preduetion life XPV Type (wilion tose) (2) (hilton i) million) (years) (milion rove) (ears) (S/b)(S/A)_ (Silion) World chs 720~~«OG«1R05, 70 4 100 is 0a so 90 Large lo ome sz son 8 60 0 040 Bi 4626 Midsize e086 OH 120 8 60 6 ns as 1058 Seal 630 os a la 4 nas 78284 DAVIS AND Sans ‘Actes: Detaled geochemical / Dutaton: + Year, Cost USS3.0N4 Actes: Extonsve éamand ring /Speciazed geological Pre-tonsi imerpretaton and esting. er Exploration activity outcomes: {Go0dFa Pose ' stege2 i : Duration: 1 Year, Cost USS2.0M | to year dtetal a haw wih an anu st Diamond citing ment Exploration activity outcome volusso07s Mt Good / Fai / Poor ' {Laps Si Year cost uss.om | ate 1 Year; Cost: US$1.0M | Two year: — Aeties: Sutace ‘aman anon cot 2822... fed mapping ints Ne cmap. | Eipomaton azivy oveomes,” — LOUSSDOTEM. Good Fal Poor i ‘Lepse ' (tess | woyoerdsoral guage 1 ‘etn an anal cost joussoorsM {hapse, cusps T=0 years T= T year T=2 years 3, Exploration decision te for both the gold and copper eases. Ateach of thce stages of exploration the dec- siow i wheter 10 proceed wi exploration, to defer exploration fortwo years, oF 1 Ft the lease Lapse abandon the lease) I deferral is chosen the decision atthe end ofthe deleral period hocomes whether to proceed with that stage of fxploration of iet the lease lapse. At he end ofthe thid wage of exploration the lease moves immediate, ito prefer ‘Slityfeasbiity andl developinent. Deferral coats 80.075 M per year Stage L exploration cost $M, stage 2 cost SM ad stage 3 cost $3 M economics are not favorable at first appearance. However, as we will show, the geological aud price uncertainty, com- ined with the ability to abandon exploration should either price or reserves drop, provides these properties with enough real option value to warrant at least the first stage of exploration in miost price environments, Goological uncertainty and information updating Completing an exploration stage provides information that allows exploration managers to reassess whether itis beneficial w continue exploring. As in our earlier model, exploration provides imperfect information and does not resohe all uncertainty about the deposit. Figure 4 outlines this partial resolution of geological uncertainty over the life of the exploration program, Updating of deposit probabil- ites starts after the first stage of exploration, where swage T exploration moves the program to one of the outcomes in the second column in Figate 4. By the end of the program a final sct of deposivtype probabilities exists, with resoli- tion sill imperfect (8 > 0) ‘Asin the frst part of the paper, the updated probabilities at each stage are calculated with Bayes Theorem, Given the discrete nature ofthe deposit sizes inthis example, the dis: crete version of Bayes Theorem gives the posterior probae bilities: -(DepesisieA Outcome meet ®ALu0m| Depo) PIDept) PO spesHIES Outcome) “$< eeEAGuomne;| Dept) Pept) ‘The index “I” indicates the ype of deposit among the total number of deposit possibilities, N = 5. The index "7 ind cates the exploration activity outcomes (EAOutcome) fora particular exploration stage. Each stage of exploration has three possible outcomes (j= poor, fair, and good) P(Deposit) isthe probability that a particular deposit may occur given the current information available atthe start of an exploration sage. When there is exploration meastre- ment error, 02 > 0 and P(Deposig | EA Outcome) € (0.1) ‘due t0 error in the signals from exploration, The numerator of the righthand side of Bayes Theorem represents the joint probability that Deposit, and Explo- ration Outcome, both oceur atan exploration stage, given past exploratiog outcomes, The Tist term of wumeraton, P(Exploration Outcome, | Deposit), is an indication of the {quality of information provided by the current exploration stage and the exploration program asa whole. Thisis whereUSING REAL OPTIONS TO VALUE AND AUANAGE EXPLORATION Revs epi darian er esiving SE expose ess Exploration Fic 4, Revol of exploration neering. indenakinga sage of exploration lakes one year andl rene cuher 2 goed, ait. oF poor exploration outcome The boxes hold We depot probabiliies atthe srt ofeach exploration sage 12133 conditional on previous explora dlepost ype remains ew posible stagetree exploration outcomes ae not shown, the geologist’s confidence in the exploration measurements, is injected into the model. This term stipulates the probabil- ity that the exploration stage would return « particular out come given that a specific deposit is actually there Determining the priors P(Deposity requires professional geological opinion fiom someone familiar with the geolog- ical setting and exploration program. AS we noted before the information is imperfect, but it is the best available information upon which to make a decision. The informa- tion is, of course, improved as exploration proceeds, which is the value of exploration activity. Devising an exploration ouncome probability tree for a multistage exploration program is nota simple task, Fig ‘illustrates this; despite extended effort working with geo ogists’ expectations about this deposit, the tree still con- tains a few inconsistencies, even though by construction the ‘expectations are unbiased. For example, after a fair stage 1 result and a good stage 2 result the probability of a world ‘lass leposit occurring is 1.2 percent, higher than the 1.1 percent probability of a world-class deposit occurring after a good stage I result and a good stage 2 result, While it would be reasonable for a fair-good sequence to yield a more optimistic resource view Han a good-fair sequence due to the superior information from stage 2 exploration, & good-good sequence must lead to better prospects than a lls. Fach exploras outcome sees to pada the asesied proba Inlities of the resource beng cert deposit ype Ina break with Ment motes of exploration, ler the stage of exploration. The final probabilities over nvertainty over the we Give deposi pes for the 27 fairgood sequence. Geologists valuing an exploration pro- gram must expend considerable effort to ensure that such Inconsistencies are removed {rom the exploration tree Mineral price uncertainty We model gold and copper prices over the life of the exploration program by one-fictor geometsie Brow:tian motion (in the case of gold) and mean reverting (in the case ‘of copper) stochastie processes. Details ofthese processes can be found in Laughton and Jacoby (1993), Sslahor (1998), and Sami (2000). The parameters used to construct these price models are presented in Table 3. Figure 5 depicts the time zero gold price forecast and forecast confidence bounclaries for the next 10 years when the spot price of gold is $400/0z. The gold price model incorporates flat expected nominal gold price, reflecting a lease rate equal yo the bond rate of 5 percent The gold price model has two important characteristics. First, gol price uncertainty increases with the forecast horizon. This 's highlighted by confidence boundaries that continue t© move apart. Second, a price shock results in a shift of price Gold lease rates are wll les tan the hon rate, Oe patameter a tues are chosen toe consistent with the price forecasts that what we bbserve practitioners using in DCF valuations286 “Ty, Parameters forthe Gold and Copper Price Process Price model parameter Gold Copper Garventspot price (foror$/th) 400 1.00 Longiern pricemedian —(S/arer$/Ib) N/a 8, Growth sate ofthe pice median (/st) 0720.00 Price woltiy (orn 883 Correlation between metal and inarket mneertainiy. 9 o4 os Drie of masher sk, PRK oa oa Rate of mean reversion (hal ie, ycats) Naot [Nonna sk fee ate (5/9, ‘continuously discounted) 5050 ‘expectations. Thisis illustrated (Fig. 5) in a scenario where the gold price decreases from $400/02 o $820/0z.0ver the first wo years of exploration. The revised price forecast and confidence boundaries dite to the 20 percent price shock are outlined starting in year two. The real options model takes all such price scenarios and rexised expectations into account on a probability-weighted basis when calculating the time zero Value of an asset Gold price uncertainy is assumed to have a low correla- tion with general financial market uucertainy (ie. has a low Capital Asset Pricing Model beta). This is consistent with the gold mining industry practice of using low risk: adjusted discount rates. The long dashed lines in Figure 5 delineate the risk-adjusted (RA) yold price expectations used in the RO computations, When the gold price is $400/oz at time zero, the risk adjustment trims a few dok lars off the gold price forecast a8 compensation for tisk Similarly if gold price in year two turns out to be $390 07, a revised riskadjusted gold price expectation is used there= aie, which again trims few dollars off the gold price fore- DAVIS AND Saatts cast at time two for risk. These long dashed lines are also, known as the gold forward price, as quoted on NYMEX or COMEX. In each price forecast the compensation for risk increases the further into the future the price is forecast Figure 6 outlines the expected prices and confidence bounddaries for the copper price model. A key character of the copper price model is price reversion, the result of supply/demand influencing price behavior. The copper price model parameters in Table 3 assumne price reversion 10, long-term equilibrium of $0.98/T. Mean reversion causes the longterm forecast of copper price to be largely unaf= fected by the level of copper price in year zero oF year to; after a hypothetical price shock of -55 percent between year zero and year two the year two forecast of copper price in year 10 is almost the same as the year zero forecast of price in year 10, Price reversion also affects risk discounting. In the pres: ence of reversion, price uncertainty almost saturates (stops growing) in the long-term. The confidence boundaries in, Figure 6 exhibit this in that the 80 percent confidence ange for longaerm copper prices eventually stabilizes with an upper boundary of $1.37/b ane a lower boundary of '$0,68/1b, Reflecting this stabilization of price risk, the GE ference between the expected copper price and the tisk adjusted expected copper price (or the forward price, again delineated by the long-dashed lines) increases ini= tially and then stabilizes with the saturation of copper price uncertainty. Jn a DCF framework, this risk adjustment effect could only be achieved by using a declining discount rate as the cash flows become more distant, Valuation results ‘The real option method folds all of this geological and 3 Project ime (years) Ao Year 3 revsod exported pica TE Year ovsed Pk apace rico ‘oar 3 fesed 0% Sanco as 3. Gold price model. The vertical ans sons the pice of god an the horizontal ais shows years from the srt ofthe exploration project. The solid line delineates go price expectations, ofthe price mica, gen 8 cures (Stage {eto} spot price of $400/0r The dashed lines outing the 90 and 10 percent coafidese Goundares ari this Fore ‘cut, based on gold prices following a random walk stochastic procens."The Bigute also shows the tskathysted (RA) "expected price, which sao the forward gol price curve. the path of gold follows ranean walk between yea Oa Seat 2 that resin a year 2 price oF 820/02, the updated expectationsand confidence houndaries sro at expee- ion, aswell asthe forward eave, wll be ae depicted, Becase ofthe random walk nature of go prices the confidence Tpoundaris on any pice forecast are always nea the forecast horizon ineressc,USING REAL, OPTIONS TO VALUE AND MANAGE EXPLORATION price ($1) Rov & o + 2 3 4 287 5 6 7 8 8 w Project ina (years) — Year 0 expected price = ~Year 0 RA expected orice == “Year 0 10% conticence boundary — = Year 0 90% conidence Bounaary Fi. 6, Copper price mode sorte exploration proce The solid tive del (stage et0) st price of $1:00/1. The dase eso ——Yoar?2 vised expected price == Yoar 2 revised FA expected price “Year 2 revised 10% cantidence boundary 0 “Year2 revised 90% confidence boundary 1 vetical avs sons the price of copper: an the horizontal axis shows years from the ates copper price expectations, o the priv mean given a erent he WO and I pevce onfidence boundaries around this Toveeas, based ot sapper prices folloning a mean reverting sochaste pores The figure also shows the riskadjusted (RA) expected pre, whith Halo the ores copper price cute the path of copper follams 2 do Themen yeas Und year 2 that rents in year price Sb. ward path dated expectations a contdence boundaries around tha expectation, aswell asthe forward curr, wil bess depicted. Note tht the shorter downward pace dit does x change greatly the Tonge ‘expected copper price. This becanse ofthe menn reversion of eoppes price Price reversion alk cus the uncertainty srrounting ture ple expectations to saturate ae shown by the parallel price uncertainty into the lease vate calculation, where opt- imal decision-making is assumed across the equivalent of thousands of price and reserve scenarios. The calculations ‘were completed with a non-commercial Visual Cs program, ‘The program uses a directed graph algorithm to construct the underlying exploration devision tree. Given an initial exploration state, the algorithm considess the decisions pos: sibilities at each state and then generates a set of future ‘exploration states based on these decisions. This process cot tunues at each new exploration State generated until either:a Japse exploration state (abandonment) or a lease develop- ment statis reached, A description ofthe directed graphing algorithm can be found in Cormen etal. (1990) ‘Once the decision tree is built, exploration outcomes and their occaerence probabilities and associated posterior deposit probabilities ace attached to each decision node Exploration outcome paths are then generated to each of the conditional exploration outcomes at future exploration decision nodes. Given the stochastic nature of prices, the valuation algo rithm requires dynamic programming and the Projected Suecessive-OverRelaxation (PSOR) finite difference method to approximate the underlying DCF or RO vahwation equ tion. A general discussion of the underlying RO mine valua- tion equation can be found in Samis (2000) and the PSOR finite differeace approximation can be found in Wilmot ct al, (1993). The value calculation starts by caleulating the NPV for each deposit outcome Rey Kyy Ry and Ry Using ofthe longterm price forecast confidence boundaries, seal option discouming of expected cash flows. These values tse the economic parameter specified in Tables 2s, 2, ancl 3.and incorporate an option 10 abancion the operation once: itis developed and in production. Since reserve uncertainty remains at the end of each of the 27 exploration outcome paths, the terminal value of each exploration outcome path ‘weights these NPVs by the probabilities associated ith the particular exploration outeome path to come up with 27 NPV, (Zi, &%) values, From this the expected feasibility cost isdedlucted to obtain the gross expected exploration payofs Dynamic programming is then used to work rectrsively back through the exploration tree. For each explora outcome decision node, the present value of contin exploration is calculated using the PSOR approxims of the underlying valuation equation ovet a range of mine ‘ral prices. The approximation starts with the expected NPVof the lease one period into the Future (ie, aU the ‘end of the current exploration phase) and incorporates the costs associated with the current exploration phase. A ‘comparison is then macle between the present value of continued exploration and the present values of deferring, exploration for two years or letting the lease lapse at each mineral price within the price range. The lease NPV isthe maximum value genetated by continuing exploration, deferring exploration, or absandoning the lease. The val ation calculation moves to the decision nodes at the next earlier time period once all decision nodes have been valk ued ata particular time.288 This numerical approach wkes into account all possible price and deposit outcomes, and, working recursively from the end of the exploration program, calculates a probabil- ry-weighted initial value given optimal decision-making 3s new price and reserve information unfolds over time, ‘Time 0 DCF and Real Option tease valuations A time zero DCF NPV can be calculated for each lease using the economic data in Tables 2a, 2, and 3. Assuming a Mat price forecast of $400/02 for gold and $1.00/Ib for copper, we noted previously that the time zero expected {F085 payoff atthe end of exploration was $1 M for the gold property and $6 M fac the copper property. Bringing these payolls back to time zero, deducting the present value of the $2.7 M feasibility study, and deducting the present value of the sequemtial exploration expenditures at time t= 0, | and 2, gives a gold lease value of -§6.7 M and a copper lease value of -$2.8 M. Neither project is economically viable under this valuation technique: When mineral price and reserve uncertainty, appropri- auely discounted within a real option framework, is com- bined with the ability to manage the exploration process ‘both leases have a positive RO value. Given a time zero gold price of $400/or and copper prize of $1,00/1b (the same assumptions as in the DCF calculation), the gold lease has time zero RO valtte of $0.575 M, and the copper lease has a Lime zero RO value of 80.191 M In essence, the copper and gol deposits in this case study are equivalent to deposits of Jess than 1.35 Moz and greater than $00,000 07 in size in the hypothetical example in Figure I. Static DCF valuations cal- calate negative resource valutes, while RO valuations caleu late positive vahtes. This isthe standara problem with D analysis ~ valuable exploration that can be conducted in stages is quantified as a negative NPV endeavor when the assumption is made that all exploration east be conclucted sequentially: Even if we allow fora complete dynamic analy- sis using decision trees that take into account geological and price uncertainty, the copper lease has n0 vale at 81.00/b Copper when discounted using a DCF framework, The gold lease has a value of $0.197 M, one-third of the value calcu lated in real options model. The differences here are due to the fact tat real options analysis takes into account the risk: reducing impacts of flexibility and price mean reversion, while a decision tree approach that uses an exogenously specified discount rate is no better than the standard DCF technique in accurately reflecting the risk attributes of the projects Figure 7 shows the time zero real option exploration prox Jject NPVs and optimal exploration decisions for the gold Tease over a range of spot prices, The RO method indicates that when price is below $314 07, this lease has no value and should be abandoned since holding costs are likely 10 ‘outweigh the present value of any eventual mineral rev- ‘enues, Exploration should be deferred when the gold price is between $$14/a2 and $456 /02, paying holding costs in the mean time. Exploration should sian immediately when the gold price is above $456/0z. At $100/07, the gold tease salute of $0,575 M is duc to the ability to defer stage 1 explor avis AND Siam n for two years, waiting to see if gold price rises before mitting to the frst stage. Ifit were not for the flexibility inherent in the sequential exploration process the lease ‘would have no value and would be abandoned. The time zero real option exploration project NPVs and stage 1 exploration decisions for the copper lease over a range of spot prices are delineated in Figure &. This lease is, abandoned if the copper price is below $0.52/1b, whereas stage | exploration is started if the price is above this level Sage | exploration is not deferred at any price. The intu- ition here is that, with saturating price uncertainty, the value of waiting for more price information is small—the ‘operator knows here the price level is going with reason- able certainty. Given a $75,000 cost per period for waiting, ing for the small amount of price information that will he revealed over time is not optimal in our exarnple, The time zero RO NPVs for the gold and copper leases vary differently with spot price because of the different pric- ing models, The gold lease valuation has a convex shape similar to a financial call option because gold is assumed to, follow a random walk price process, which isalso standard, price model assumption for financial stocks. The copper lease valuation has a concave shape at high prices because of price reversion. The copper price is assumed to revert to {$0.88,/1b, so when the copper price is:thove this level there is the expectation that price will fall in the future, This results in a diminishing marginal value of higher spot cop- per prices. Schyvartz (1997) finds a similar effect in a devel ‘opment copper property valuation. In practice, one would therefore expect to see gold lease valucs being less sensitive than coppet leases to price movements at low prices, but ‘baving nore sensitivity than copper to price movements at high prices. Time 1 Real Option NPV payoff diagrams (prior tothe start of shoge 2 exploration) ‘Once exploration begins, the RO value ef both leases changes in response to the assessment of geological infor- mation gained from completing an exploration stage. Fig- ures 9 and 10 outline the RO lease NPVs over a range of ineral prices and results (poor, fait, or good) of stage | ‘exploration. In our example, good or fair results increase the lease NPV while poor results decrease the lease NPV. ‘The figures also show decisions about stage 2 exploration ‘once the stage I outcome is revealed. The option to explore ‘again upon poor stage | exploration results adds value to the lease in all but low price ewsironments.!” OF interest in Figure 10 isthe virtual insensitivity of cop- per lease value to copper price. This again is due to price reversion. Itis price reversion that also prevents the project. from being abandoned at low copper prices when the stage T outcome is good or fait—low prices will revert 10 the ‘mean, and itis therefore beter to pay maintenance costs "One ofthe best examples of this isthe 75 dil holes atthe Hernlo tepid eleposit in Canada that came up showing no connie inert tion. The 76Wt note found dhe deposit (Mining four, 2003) See also ‘Smith (2005) for the value of We option to dh agin,USING REAL OPTIONS 10 VALUE AND AIANAGH: EXPLORATION 30} 4 Bos ° 3 20, Bis 4 2 Pad 2 10 : 05 2. 00 ee a a a ae) Gold price ($/oz) —fplore tase ++ Dolerexporaion —-—— Abandon lease 0 gold lease rel option NPV (prot tothe start of stage I exploration), The ses ais measures lease ‘aontal as meres eurrent gold price, Leave vale i mncteasing in cuirent gold pric. The Figire flo shows the valuemasamiing exploration decisions ae afetion of current gold price snd he impli ok price forecast ace Fig. 5). Atal gold paces helow S3)1/07 this gold lease should e abandoned, At prices between S8U/07z and $436/02 stage i expoation should be deleted two years, at cost of $75,000 per yeat and then reevaluated. At pvesabowe $430/02 ge l exploration should proceed smmmedinteh. Ata gold price of $100/02 the exploration Kase Risa real option value of 80575 M though stage 1 exploration short he deferred for two Sears and then teased 95 & 2 Time O lease value ($ milion) oot a 020 040 © 060080 = 10012040 1.60 1.80 ‘Copper price (Sib) — Explore lease === -Abandon lease Fic, 8, Time 0 copper lease reat sption NPV (prior to the stat of stage 1 exploration). The vertical axis measures lease vale, al the horizontal axis measures curren copper price. Lease value is creasing in current copper price The igure aug shows the valuemaxiniing exploration decaaons function of eortent capper pce ant te ipl copper price forecast (sce Fig). Atal coppet prices helow 80 52/% this copper lease should be shandomed. A prices shove $0.52/Th stage 1 exploration shoul! proceed immediately. Ata copper prize cf 1.00/1h the exploration leawe hae Steal option value of $0-191 M, and stage } exploration shou be atrted metals contrat to gold leases, cope per lence stauld ether be explored immediately or absadoned since there ix no longterm pace iakormation 10 Be Jglned by deferringshe exploration decison, 289290 Davis AND Saants 2007 e180 g = 3 3 i 50} 00 pent Ee pabie oB8 FETE Oe "380.275 Gale price ($02), Tire = 1 year A Gocdesut-orpiowe = wr Good el dele SF esut-exoe = © + Fair rout dor S—Poorrett-expore = © = Poorest daler = = hoenson ase - Tine presi payot Fic. 9, Gold lease real option NPV atthe end of stage # exploration (lime 1. Asa rest of the outcome of stage 1 explo- ‘ation the wale the leases updated. The top curve shows the time J valve ofthe lease afer a good stage 1 exploration it ‘ome The next lower curve shows the value of the lee afer afi tage exploration ogteames The bottom curve shows he Salle ofthe lewe nly poor sage [exploration outcome. The dashed line wth no markers shows the tine | expected save OT the lease prior the information gud Irom stage | exploration. In thiscase, good and lar sage | exploration outcomes serve 19 create he value ofthe lease, hile a poor owieome decreases the vale ofthe lease. The figure also some the opt nal sage 2 exploration decision given current (ne 1) gold price and sae | exploration ontcomte, Cold pices which sage ‘exploration deferred decrease fom $41,010 $454 ta S480 8 sage 1 exploration outcomes pone fo Poor fair to gout Sin the abandonment tigger price decreases om $3867 07 10 S286 ox ta S240 00 [oak shown a8 age exploration resils improve from poor to fa to good 140 - a -— 40. 20 00. one ‘020. 040 060 080 100 120 140 160 1.80 Copper price (Sb), Time = 1 year Food result- explore ~~~ Good result-defer Fair resut- explore <-Fairresult- deter Poor resut- explore © = Poor result - abandon =o Time 1 pre-esut payot Fs 10. Copper lease teal option NPV at dhe en of stage {exploration (time 1). Asa rel of the outcome of tage I expler {ation the value ofthe lee updated, The top care showsthe tine Tale ofthe less alter goud uae exploration outcome, The nest lower curve sons these ofthe lee alt ar stage Lexploration outcome. The hotiom cue shows the alc the ease after poor stage | exploration outeome, The dished ine wth Ro markersshows the time L expected vali ofthe lease poe {wthe information gained trom stage | exploration. In this se good and fir stage L exploration outcomes serve to increas the Sale of he Wace, wile a poor oueonne decreases the value of the lewe, The Figure sa shows the opm stage 2 exploration Aci gem curren (ame 1) copper price and stage | exploration outcome. I the outenne of sage | exploration ipo ste 2cxploration sunderaken ihe copper price f greater than 0.94/1b. Otherwise, the lease sabanwoned. stage I exploration reveals gond or fir eat, tage 2 expinnion ws eleried if copper price i less than S0-S4/1b, and undertaken immediatly Copper price higher than thie A property with tof good rela stage [exploration i never abandonedLusINe OPTIONS TO VALLE AND MANAGE EXPLORATION 291 ‘The final columns in Figures 11 and 12 show the prices at which the feasibility (S, for scoping! study should be undertaken given that the previous three stages of explo ration have been undestaken. Ifprice is below this level the project should be abandoned because the quantity of the Fesouce has remained below the resouree/reserve cutoll % {Asin the model inthe previous section, metal price and ore quality together determine 7; poor exploration results can nevertheless produce reserves when price is high enough such that 7is a low value. For example, a good/ poor/ poor gold exploration owteome procluces a sufliciently high est- mate of R,to define this a reserve, as used in this paper, a8 Jong asthe god prices above 8890/07 upon completion of exploration. Model differences between gote and base metal exploration ‘This real options model of exploration reveals important differences between exploration for gold, which exhibits random walk prices and increasing future price uneer- tainty, and for base metals, which exhibit reversion to a mean price level after a price shock and saturating price Fic. (1, Eyction of veal option NPV and decison vles or the god lease when the gol price it 400/02. Tis shows indecision tee Somat the information contained within Figure 9 forall stages of exploration ‘The fist col ‘inn shows that at $400, god the expacaon property worth SI 373 M at tae 0 Exploraton shoul proceed For Spot gold prices above 186 ad should he detered for spot pices of benwecn $450/0r and L402. t price of ess Sloe the lease shoul be abandoned, The second column shes the same information contingent ona $1002 f0ld price ar sie band the outcome of stage 1 exploration. Column 3 shows the information contingent on a $4002 {fold price at time Dane the outcome of stage Land exploration, Colunnn shuns the iornation cogent St00/oe gold price at hme Sad the outcome of stage 1.2. and S exploration, fd column 12 8400/07 ysl price ane 3 _g>od exploration outcontes yield atime 8 projet tale OF $190.3 M, snd scoping (preteasbity easily devo mnt shoul proceed for any gold price grees than $200/02- On the other had 2 5400 gold price and thee fr {xploration ottcomes yield atime % project value of $21.7 M, and scoping (prefeasbiliy feasibly development) Should proceed forany time 3 gold price grester than $312/or.292 DAIS AND Good. 103M sie. 523M J>sosz ncsosx OW fr sow, b=so3m Decision abbreviations p Sats Ine cope lease when the copper price it $1.00/16. This thin Fgune I forall stages of exploration, The frst colon shows at shold proce for spot coppe picerabowe how the sine information contin slows the iformson contingent on ration content 14 Jexploraton. In column 1aSL00Ab capper pice al tec Manel scoping should procced seyandless of the capper price E = Explore D_ = Deter exploration S__ = Scoping study A =Abandon lease G F P i. 12, Evolution of real option NPV and decision rales fort shows in dein tee Format the ion 531.00 copper ihe exploration property senorth 90.191 M tine 0, Explore 5052), al soul be abandoned for spot prices of $.52/ly or las.The secret entonaSL00/Abcopperpice atime and the cutcome ofsiage | exploration, Colun SLM/b copper price at tine 2 and the eatconte of tage Ind 2 exploration. Column 4 seme the AASLOI/Ah copper price at ime Sand the outcome of age L, 2a ood exploraon Sutcomes eld a tine 8 project ale of S76 “Too poor exploration outcomes lead to project abandonment regardless ofthe copper pice uncertainty: For example, our case study supports a gold exploration policy that focuses on deposits with previous positive exploration results during periods of moderate prices, while deferring geologically unpromising deposits, and an expanded exploration policy that inchides the deferred gieensielts deposits when prices are higher. The intuition here is that unpromising deposits may ultimately become valuable due to increasing gold prices, and that they should be kept in reserve until price improves. Re ‘world evidence of gold exploration activity in the 1990s sup- ports this rend. On the other hand, our model suggests that npromising green-fields copper projects not be kept in deferral mode waiting for higher prices, since prices are ‘capped by the trend 10 a long-run mean; greenields copper projects should either be explored if promising or aban- doned if unpromising. Given this we would not expect, .greenfields copper exploration expendlitures to be sensitive to the price eyele, but rather an ongoing activity as long as price execeds some minimum level (col. | of Fig. 12). M.S Enders and R.A. Leveille (unpub. data, 2004) report exactly, this policy at Phelps Dodge. Our model also shows that later stage copper deposits with positive exploration outcomes should be deferred in low price environments, since they will become valuable once price reverts to the mean, and so these should show some exploration response 10 price swings. This, combined with constant spending on green- fields projects across the price eycle, would then be revealed, asgreenfields exploration constituting a higher proportion of total expenditure during the bottom of the price cycle and a lower proportion at the peak of the price cycle. There isample evidence that this is broadly the case for base met- als. In addition, we would expect to See stage 2 gold explo- ration spending respond to movements in gold prices, while ‘we would expect stage 2 copper exploration spending for fair and good outcome properties to be ongoing for all but very low prices (Figs. I] and 12). Empirically, gold explo- ration expenditure does seem to be more responsive 10, price than base metal exploration expendixare (RC. Schocide, unpub. data, 2003). Since the geology and economics of our gold and copper ‘examples have been designed to be as comparable as possi- ble, these motel differences are driven entirely by the difUSING REAL OPTIONS TO VALLE AND MANAGE EXPLORATION ference in price behavior of base metals, which exhibit price reversion, and gold, which docs not. If one wants to, model and value exploration, and to thereby explain the differences that are found between base metal and gold exploration, stich pricing details must be included in the model of exploration. Modeling only the uncertainty in a resource is unlikely to capture these effects, ‘This paper models the wo main uncertainties facing ant exploration manager, geological uncertainty and price uncertainty, in a real options framework aimed at directing exploration decisions such that project value is maximized, Both models show that ie some cases where the traditional discounted cash flow value of the project is negative, explo- ration activity can be value creating and should proceed, The fiyst model considers only geological uncertainty and reveals the many geological factors influencing exploration activity and the value of an exploration property: The second model adds price uncertainty. The second model reveals important differences berween exploration for gold, which exhibits ran- dom walk prices and increasing future uncertainty, and the exploration for base metals, which exhibit reversion to a mean price level and saturating price uncertainty. ‘Our modelsjusify the aggresive decisions that exploration mmianagers often make, even in the face of contrary advice from traditional discounted cash flow models. That the valua- sion models are now giving the right signal isa significant step forward in managing andl valuing exploration projects Acknowledgments ‘We owe immense gratitucle to Richard Schodde of WMC for thought-provoking discussions of exploration econoss- ies, and to Gordon Kaufman, William Navidi, and Luis Tenorio for statistical advice. Michael Sasmis would also like to thank julian Verbeek of RSG Consulting for help devel oping an earlier version of this model. Two anonymous ref eres, editors Jeff Hedenguist, Michael Doggett, and Jack Parry, and Margaret Armstrong, DeVerle Hatt, and isina Khindanova offered useful suggestions that have shaped the paper's exposition, We also thank Spiridon Martzoukos for useful comments on an earlier draft REFERENCES Ci B., 2005, The option value of aequir ilfiell preaction enhancement projet Jour sal of Applied Corporate Finance «17, 0. 2,910, Brennan, Mand Schwartz. ES. 1985, Bvaluating, natural resource Investment Journal of Baines. 38, no. p. 133-187, Campbell, HLF and Linder BK 1885, On optimal vesource fen 96 ono Leer 5, p: 265-268, 1985, A model of mineral exptora ‘omic fora. 95, p. 146-160, Comen, EH, Leverson. CE. and. Rivest RL "algorithms: Cambridge, MU. 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