Resources Policy 42 (2014) 83–92

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

Cut-off grade: A real options analysis

Matt Thompson a,n, Drew Barr b
a
Queen's School of Business, Queen's University, Kingston, Ontario, Canada K7L 3N6
b
Kinross Corporation, 25 York Street Suite 1500, Toronto, Ontario, Canada M5J 2V5

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

Article history: In this paper we examine the impact of forward price uncertainty on the optimal cut-off policy of mines.
Received 24 February 2014 We employ a new real options model for determining the optimal cut-off grade of ore under stochastic
Received in revised form prices. The economic insights and consequences of incorporating uncertainty into the cut-off decision
1 October 2014
making process are shown to be in opposition to that of traditional deterministic cut-off theory. Key
Accepted 3 October 2014
among the new insights is that when prices are stochastic, optimal cut-off grades are much lower than
Available online 12 November 2014
those determined using traditional deterministic models that are currently used in practice. This implies
JEL classification: that the traditional techniques may lead to greater resource waste than is optimal. This effect is most
Q pronounced for higher volatility metals, marginal mines, higher discount rates and longer valuation time
Keywords: horizons. In addition to the important insights, the new model produces valuations, sensitivities and
Mining policy optimal cut-off strategies that can be used to enhance project valuation, mine operation, hedging
Real options strategy determination, mine design and risk management decisions.
Cut-off grade & 2014 Elsevier Ltd. All rights reserved.
Stochastic optimization

Introduction
Ore is defined as a concentration of a mineral or aggregate of
minerals from which a valuable constituent such as a metal can be
economically extracted for profit. Underneath this deceptively
simple definition, lies the challenge of determining precisely what
“economically extracted” means. The optimization of the defini-
tion of ore has important consequences in the valuation, financing,
design, operation, and risk management decisions made by mining
firms while also having implications for public policy. In order to
understand the trade-offs involved in the definition of ore it is
important to understand the fundamentals of the design and
operation of a mine.
Mining engineers use the term grade, to describe the fraction of
metal that is contained in a mass of rock. The cut-off grade is the
minimum grade that is required in a given mass of rock to consider
it ore. Any material not passing this minimum criteria is defined as
waste and is (for the most part) irreversibly discarded. Therefore
the lower the choice of cut-off the less material is wasted, however
a lower cut-off results in a lower average quantity of usable metal in
the same amount of ore being processed. Since maximum ore
processing capacity is generally fixed, lower cut-off values lead to
slower metal output rates (since less metal is produced in the same
amount of ore processed). Raising the cut-off has the opposite
n
Corresponding author.
E-mail addresses: mthompson@business.queensu.ca (M. Thompson),
drew.barr@kinross.com (D. Barr).
effect; increasing the amount of waste while also increasing the rate
of metal production. The economic definition of ore requires that
one must balance the benefits of increased production rates, against
the costs of wasting material and an increased rate of resource
depletion.
Cut-off decisions are influenced by the present value of future
metal prices, and (Lane, 1964) is considered to be the seminal
work in understanding and optimizing the resulting trade-offs.
The important insight utilized in this work is that higher cut-off
rates result in faster production. Given the time value of money,
present production is more valuable than future production, all
else being equal. Hence traditional cut-off theory argues that some
waste can be justified as profit maximizing if it shifts more
production earlier in time. Consequently, larger risk adjusted
discount rates result in higher cut-off values and more waste.
Since the publication of this important work, cut-off determina-
tion by discounted cash flow maximization has become the norm
in industrial and academic circles. Later works have since
extended this initial breakthrough work including (Lane, 1988;
Ataci, 2014; Bascetin and Nieto, 2014; Rendu, 2008; Gholamnejad,
2014) however, all have continued to utilize the discounted cash-
flow framework.
The discounted cash flow (DCF) approach is predicated on the
mathematical fact that if all cash-flows are a linear function of
price, then the expected value of the cash-flow function of the
random price variable is just the linear function evaluated at the
expected value of that variable. Hence, in the linear case, the price
distribution is irrelevant, only the expected future prices (and their
discounted values) matter. Real options theory argues (among

http://dx.doi.org/10.1016/j.resourpol.2014.10.003
0301-4207/& 2014 Elsevier Ltd. All rights reserved.
84 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92
other things) that managerial flexibility such as the ability to
adjust production rates with price changes (cut-off optimization),
or to temporarily suspend/abandon production or any other non-
linearities, changes the mathematics in a way that invalidates the
expected value argument upon which the discounted cash-flow
approach is based. Jensen's inequality tells us that the expected
value of a nonlinear function of a random variable is not the
same as the nonlinear function evaluated at the expected value
of that variable. Hence the price distribution does matter in the
nonlinear case.
The first paper to incorporate real options theory in natural
resource project valuation was Brennan and Schwartz (1985).
Other authors following this example have written extensively
on the use of real options in mining including: Sabour and Poulin
(2006), Samis and Poulin (2001)), Trigeorgis and Schwartz (2004),
Dessureault et al. (2007), Dogbe et al. (2007), Guj and Garzon
(2007), and Shafiee and Topal (2007). None of these citations
however consider cut-off grade optimization.
Most of the real options mining literature to date has consid-
ered finite choice models. Examples include options on the timing
of opening a mine, options on whether or not to expand the mine,
or options to temporarily or permanently abandon the mine. All of
these types of options present yes/no type decisions throughout
the time horizon. In contrast to these finite choice models, cut-off
optimization under uncertainty is an optimal control problem in
which the cut-off level (or levels in the case of multiple processes)
can take on any continuous value. Hence numerical techniques
such as the least-square Monte-Carlo approach that is used so
successfully in Sabour and Poulin (2006) and that rely on the
finite choice assumption can become cumbersome and possibly
intractable in mathematical settings for which the set of possi-
ble decisions is very large. Hence numerical methods specifically
designed to incorporate both finite choice and optimal control are
required.
The first paper to incorporate price uncertainty in cut-off grade
optimization was Krautkraemer (1988). In this paper the mineral
deposit was represented by a cylinder with the highest grade at its
axis, and decreasing grades outwards towards the cylinder's
circumference. This simple geometry and grade distribution
allowed for the development of an analytically convenient solu-
tion. Unfortunately the method could not be applied to the more
complex geometry and grade distributions found in actual mines.
Mardones (1993) took a different approach and attempted to
extend Lane's work into the contingent claims framework, how-
ever in this work the cutoff grade was not optimized simulta-
neously with the value function.
In the ground breaking work of Johnson et al. (2010), both
stochastic price and a more detailed geological model were incor-
porated. The mine was divided into thousands individual blocks, the
order of extraction of which was assumed to be sequential and
required to be known a priori. A partial differential equation (PDE)
was then derived for the optimal value of the mine from which the
optimal strategy for processing the blocks could be determined.
From this initial block ordering, the model then decided whether to
process or waste each given block, at a given time, in a yes/no
binary pattern. This is an effective approach if a block ordering is
given a-priori however, it is highly dependent on this ordering.
If the block ordering is changed a different cut-off strategy may
result. Another difficulty with this approach is that in practice
the exact mineral content of any given block is highly uncertain
until the block has been exposed, and without this accurate
knowledge of this information, a feasible block ordering cannot
be made. In addition, multiple blocks of ore and waste are
routinely processed simultaneously in order to maintain a steady
flow of ore to the processing plant. These facts make the required
fixed, sequential, a-priori block ordering difficult to employ in
practice. Johnson et al. (2010) also did not allow for temporary
mine closure.
In this paper we develop a stochastic dynamic model for cut-off
grade optimization for use in mining valuation and optimal opera-
tion, that accurately describes the engineering realities. The model
does not require an a-priori block ordering but can incorporate any
feasible mining schedule.1 Only those inputs that are already
produced by current mining industry software and are familiar to
mining professionals are needed. The optimization problem is
formulated and solved as a system of nonlinear PDEs that can be
solved with a specially designed numerical implementation. The
PDE simultaneously solves for the value, optimal cut-off strategy,
and the hedging statistics for every possible future price scenario.
This information can subsequently be used to simulate optimal
mine operation through time in order to assess and measure the
operational, market and margin risk of mining firms.
The model does not rely on arbitrage assumptions and as such
can be used for speculation purposes. However, when combined
with modern asset pricing theory and using financial parameters
determined from the prices of market observed derivatives, the
model can be easily calibrated and produces unambiguous valua-
tions and dynamic cut-off strategies.
In addition, several new insights into the economic definition
of ore are explored. Among these insights is the observation that
in the presence of market uncertainty, cut-off grades are far lower
than those predicted using the traditional deterministic models
that are commonly implemented by mining companies. This ef-
fect is most pronounced for marginal mines and is greater when
discount rates are higher. Another key insight is that when valu-
ation time horizons are longer, cut-off values are dramatically
lower. Often governments consider longer time horizons than
mining firms suggesting that without the correct public policies
in place these two parties' interests may not be properly aligned.
The recent related work Evatt et al. (2013) discusses a general
methodology for quantifying the effect of price uncertainty within
reserve estimates, in order to provide both the expected reserve size
and the associated distribution. The (Evatt et al., 2013) paper makes
use of a PDE model similar to the one developed in this paper but
requires a cut-off strategy as an input. Hence the numerical method
for calculating cut-off strategies presented in this paper provides a
complimentary tool for use with this aforementioned work.
In the next section we describe the engineering model, in
section “Modeling price dynamics” we develop the financial
model, in section “PDE Derivation” we derive the PDEs and
describe the numerical solution method and in section “Results”
we illustrate the solution with data inspired from the Grum
deposit of the Faro mine complex located in the Yukon. In section
“Discussion and explanation of results” we provide an explanation
for the observed results and provide a explanation for why cut-off
policies that account for price uncertainties are at odds with
traditional cut-off theory.
Mining model
In this section we first provide a general description of the
physical component of the model before developing the mathe-
matical representation. The model aspires to match standard
mining engineering practice as closely as possible in order to
achieve the most realistic description of the problem.
Open pit mine design is a multi-step process which involves
the determination of a number of technical parameters and the
1
To be clear, the algorithm presented here does not optimize block-ordering it
only determines cut-off strategy from an average phase distribution.
 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92
design of a number of aspects of the operation. The initial input
into the design process is a resource model. The resource model is
a spatial representation of the ore-body as interpreted by geolo-
gists. Although there are a number of formats the resource model
can take, by far the most common is a three dimensional array of
blocks, referred to as a block model. A resource geologist assigns
properties to each block in the array, such as its metal grade(s),
density and geological characteristics using various geo-statistical
methods.
Based on the resource model, mine planning engineers esti-
mate the mining capacities the deposit could support. Rough
operating costs can then be determined from these capacities.
With this information and a few other technical parameters,
planning engineers can develop the ultimate pit limits. The
ultimate pit is the excavation such that no combination of blocks
could be subtracted or added to the outline that would increase
value (Whittle, 1990). Several commercial software packages,
including Whittle TM, have become industry standard tools used
to determine the ultimate pit based on all the required technical
parameters.
Once the ultimate pit has been outlined the design engineers
begin to schedule the extraction of the material within this
excavation limit. This long term, life-of-mine, scheduling is usually
done in a series of successively more detailed stages. The first
stage is the development of intermediate excavation limits called
push-backs. A series of push-backs are nested within the pre-
viously determined ultimate pit. Push-backs are designed to help
ensure a sufficient ore feed at all times to meet the plant capacities
as well as bring forward cash flows and delay costs as much as
possible. The push-backs can then themselves be further divided.
The result of the scheduling process is a sequence of excavations
within the ultimate pit that are to be mined in order. Each of these
sequenced excavations will henceforth be referred to as a phase.
The distribution of grades within the phase can be determined
be querying the resource model. Each phase may consist of
hundreds or possibly thousands of individual blocks that have
been chosen to achieve a feasible mining schedule. While the
exact mineral content of each block has a very high degree of
uncertainty prior to excavation, by combining many such blocks
into a phase the overall grade distribution of the phase is known
with a high degree of accuracy.
Once the long-term mine excavations and schedule have been
defined, the cut-off grade strategy is determined. While the mine
design and phases are generally fixed once in operation, the cut-
off strategy used for scheduling production of the mine is flexible
and can be adjusted in response to market forces. During the
mine's operation, short term planning staff schedule multiple
simultaneous block extractions such that the overall material is
extracted as closely as possible to the target waste to ore ratio,
known as the strip ratio, dictated by the chosen cut-off grade and
the grade distribution of the accessible material. This ensures a
steady flow of ore to the processing facility and prevents oscilla-
tions between over and under utilization of the processing
capabilities. Individual block extraction is only scheduled once
the cut-off definition is given and the grade of each block is known
with a higher degree of certainty.
From the stripping ratio given by the cut-off definition, the rate
of resource depletion then depends on which of the processing or
the mining constraint is binding. The processing constraint is the
maximum capacity of the processing unit, while the mining
constraint is the maximum amount of rock that can be excavated
at a given time. Ore and waste are then extracted in the propor-
tions given by the stripping ratio until one of these two constraints
limit the rate of further extraction. It is in this way that the phase
distribution and the cut-off decision dictate the rate of metal
production, resource depletion and all associated costs.
85
With this technical background in hand we can begin the
mathematical description of the model. We begin by defining the
key variables of the problem. Let I be the size of the total deposit
remaining and n be the total number of phases in the mine design.
Then let j(I) be a function mapping ½0; I max   R-½1; 2; …; n  N
that determines the current phase number given a value of I where
Imax is the total amount of material contained in the ultimate pit.
Any volume of rock within a given phase can be classified by its
fraction of recoverable metal content. This fraction is referred to as
the recoverable grade of the rock. Let g be the recoverable grade of
a given piece of rock (i.e. if g ¼0.05 then 5% of the rock, if
processed, could be turned into metal). Furthermore let PDjðIÞ ðgÞ
be the phase distribution: the total amount of rock in phase j(I)
with recoverable grade g. Phase distributions given in histogram
form are direct outputs of standard mine design software (such as
SURPAC). Finally let S be the spot prices of the metal.
From these basic definitions, if S represents the price of metal
and t the current time, then we can define cðS; I; tÞ to be the grade
value that is to be determined by the model. For simplicity of
exposition, from this point on we will suppress the functional
dependence notation of c. c is defined such that if a unit of rock
contains metal grade fraction g then if g Z c the rock is considered
ore, otherwise it is considered waste. Thus c is the point that
delineates the distinction between ore and waste. The total
amount of ore OðI; cÞ in phase j(I) is therefore given by
Z 1
OðI; cÞ ¼ PDjðIÞ ðgÞ dg tonnes ð1Þ
c
and the total amount of waste WðI; cÞ in the phase is
Z c
WðI; cÞ ¼ PDjðIÞ ðgÞ dg tonnes: ð2Þ
0
The stripping ratio of waste-to-ore SRðI; cÞ is then given by
WðI; cÞ
SRðI; cÞ ¼ : ð3Þ
OðI; cÞ
If Kmine and Kproc are the maximum mining and processing
constraints respectively (measured in tonnes per year) then the
resource depletion rate or extraction rate ExðI; cÞ measured in years
is given by
ExðI; cÞ ¼ minðK proc ð1 þ SRðI; cÞÞ; K mine Þ ð4Þ
To understand Eq. (4) suppose the stripping ratio SR was 3. Then
three units of waste are extracted for every one unit of ore, so the
maximum rate that we could extract material from the deposit
before hitting the processing constraint would be 4Kproc. If this
value was greater than the mining constraint Kmine then Kmine
would determine the extraction rate. The rate of change of I is
therefore given by
dI
¼  ExðI; CÞ ð5Þ
dt
In Fig. 1 we plot Ex as a function of cut-off for a single phase of
the Faro mine complex. We see from this graph that when cut-off
grade is zero all rock is sent to the processing mill and the
extraction rate is at its slowest. As cut-off increases the rate of
extraction increases in a nonlinear fashion, until the maximum
mining rate restricts further increase.
In addition to the extraction rate we know the rate of produc-
tion of metal while operating in phase j(I). Metal production is
simply the product of the processing rate multiplied by the
average recoverable grade of ore in the phase, in other words
the quantity Q ðI; cÞ of metal produced is
R1
ExðI; cÞ c gPDjðIÞ ðgÞ dg
Q ðI; cÞ ¼ ð6Þ
1 þ SRðI; cÞ OðI; cÞ
where the first of the two above fractions is the amount of ore
86 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92

processed and the second of the two is the average grade of the x 10
8
Annualized Total Production Cost By Cuttoff Grade
ore being processed. In Fig. 2 we plot Q as a function of cut-off for a 5

single phase of the Faro mine complex. Note the original data
consisted of two metals but we have consolidated them into a
4.5
single metal for ease of exposition. The extension to the poly-
metalic case is discussed later. From this graph we can see that the
output rate initially increases with c as higher grade ore causes

Total Production Cost ($)

4
output rates to increase. Output rates then begin to decrease once
the maximum mining rate constraint limits the delivery of ore to
the processing facility leaving some processing capacity idle. 3.5
Finally if the cost of extraction is Cmine dollars per tonne and the
cost of processing is Cproc dollars per tonne and the fixed costs are
Cfixed then the cashflow generated in an interval of time dt 3

measured in years is given by

  2.5
ExðI; cÞ
CflowðS; I; cÞ ¼ S  Q ðI; cÞ  C mine ExðI; cÞ C proc  C fixed dt:
1 þ SRðI; cÞ
ð7Þ 2
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14
Cutoff Grade

Fig. 3. Annualized production costs as a function of cut-off.

Annualized Mine Extraction Rate By Cuttoff Grade
0.3

Fig. 3 depicts production costs as a function of cut-off. This graph

0.25 shows that production costs increase initially with cut-off level until
Fraction of the Mine Extracted per Year

the maximum mining rate constraint limits the amount of ore sent
to the processing mill thereby reducing total processing costs.
0.2 In the case of a poly-metallic mine the definition of cut-off
must be modified slightly. Since ore is converted to cash at the
spot price that prevails at the time of extraction if we have M
0.15
metals in the deposit with grades g 1 ; g 2 ; …; g M respectively each
with spot price S1 ; S2 ; …; SM then the cut-off c is defined by the
0.1 inequality
∑M
i ¼ 1 Si g i
Zc
0.05 ∑M i ¼ 1 Si

and the integrals in Eqs. (1), (2) and (6) must be modified to the
0 appropriate multiple integral representation.
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
Cutoff Grade

Fig. 1. Annualized rock extraction rate (fraction of deposit per year) as a function of Modeling price dynamics
cut-off.
The fundamental consideration in cut-off grade determination
is the trade-off between present and future price levels. In
addition hedging activities rely on futures contracts. Hence a
natural framework to account for these two considerations is a
x 105 Annualized Metal Production Rate By Cuttoff Grade
3.5 forward curve pricing model. Let Fðt; TÞ be the expected metal
price for delivery at time T given information available at the
3
current time t where t oT and where the expectation is taken
under some, as of yet unspecified, probability measure. At this
point we are intentionally agnostic as to the probability meas-
2.5
Tonnes of Metal Produced

ure so that the subsequent analysis applies equally to valuation

or speculation purposes. In a real options, no-arbitrage based
2 approach the risk neutral probability measure is used and Fðt; TÞ
would represent the market observable futures curve (hence no
1.5 price forecasting is required in the no-arbitrage framework).
Since we have assumed that Fðt; TÞ is the expectation under the
1 chosen measure it cannot have a drift in that same measure
(otherwise Fðt; TÞ would not be the expectation, Fðt; TÞ plus the
0.5 drift would be). Hence we employ a standard lognormal model of
the form
dFðt; TÞ
¼ σ e  ηðT  tÞ dX
0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 ð8Þ
Fðt; TÞ
Cutoff Grade
where σ and η are constant and where dX is the standard
Fig. 2. Annualized metal production in tonnes as a function of cut-off line
intercept given. increment of Brownian motion.
 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92 87

In Clewlow and Strickland (Preprint) it was shown that under Black–Scholes equation for equity derivatives. If r is the discount
suitable differentiability assumptions, a spot price S consistent rate, let
with this model is Z T 
  VðΦ; I; t; cÞ ¼ maxE e  rðτ  tÞ CflowðΦðτÞ; Iðτ Þ; cðτÞÞ dτ : ð15Þ
dS ∂ lnFð0; tÞ σ2 c
þ ηð lnðFð0; tÞÞ  lnðSðtÞÞÞ þ ð1  e  2ηt Þ dt þ σ dX:
t
¼
S ∂t 4 Where E½ is the expectation under the chosen probability
ð9Þ measure, conditioned on the information available at time t.
Hence the model in Eq. (8) is the standard mean reverting This equation can be rewritten as
Z t0
lognormal model used in most real options mining literature,
adjusted to ensure that the forward prices match the initial value V ¼ maxE e  rðτ  tÞ CflowðΦ; I; cÞ dτ
c t
Fð0; TÞ exactly. The exponential decay rate parameter η in Eq. (8) Z T 
 rðτ  tÞ
corresponds to the mean reversion rate of Eq. (9). Rather than þ e CflowðΦ; I; cÞ dτ
t0
using either of these equivalent formulations, in this paper we will Z t0
use a third equivalent form, but one that gives rise to better ¼ maxE e  rðτ  tÞ CflowðΦ; I; cÞ dτ
c t
computational properties. Z 
T
Given the initial expectations curve Fð0; TÞ we know that at any
e  rðτ  t Þ CflowðΦ; I; cÞ dτ
0 0
þ e  rðt  tÞ
time t t0
Z 
 Z t  t0
e  rðτ  tÞ CflowðΦ; I; cÞ dτ þ e  rðt
0 0
1 ¼ maxE  tÞ
VðΦ ; I 0 ; t 0 Þ
Fðt; TÞ ¼ Fð0; TÞexp  σ 2 e  2ηðT  tÞ þ σ e  ηðT  sÞ dXðsÞ ð10Þ c t
2 0

If we let
where Φ and I 0 are the (unknown) values of Φ and I at time t 0 4 t.
0
Z t
By letting t 0 be a small increment greater than t (i.e. t 0 ¼ t þ dt)
Φ¼ e  ηðt  sÞ dXðsÞ ð11Þ
0 then employing Ito's lemma we expand the right hand side of the
above equation in a Taylor's series using (13) and (5) to yield
then since the spot price S(t) at time t is always simply Fðt; tÞ we
also have V ¼ maxE½CflowðΦ; I; cÞ dt þ ð1  r dtÞV þ ð1  r dtÞ
c
 
1 ðV t  ηΦV Φ þ 12 V ΦΦ  ExðI; cÞV I Þ dt þð1 r dtÞ dX
SðtÞ ¼ Fð0; tÞ exp  σ 2 e  2ηðT  tÞ þ σ e  ηðT  tÞ Φ ð12Þ
2

Therefore rather than deriving a stochastic differential equation Eliminating all terms that go to zero faster than dt and simplifying
for S it is easier to use Φ as the random variable and use Eq. (12) to shows that
convert back and forth between the two representations. Differ- 0 ¼ maxE½ðV t  ηΦV Φ þ 12 V ΦΦ  ExðI; cÞV I
entiating equation (11) with respect to t shows that this variable c

obey the stochastic differential equation  rV þ CflowðΦ; I; cÞÞÞ dt þ V Φ dX:

dΦðtÞ ¼  ηΦðtÞ dt þ dXðtÞ ð13Þ Taking expectations and dividing through by dt gives

By using Φ instead of S we achieve many advantages. Firstly,
the stochastic equation for ϕ is simple, and time independent.
Secondly, by using this change of variables there is no need to
bootstrap a time-dependent convenience yield or instantaneous
volatility function in order to ensure that the future expectations
of S match those of the initial forecast Fð0; TÞ, because Eq. (12)
handles these details. Moreover, in contrast to the spot price SDE
of Eq. (9), in this formulation the function Fð0; tÞ need not be
differentiable. It need not even be continuous. Any initial forecast
can be applied without affecting the validity of the SDEs or the
numerical solution procedure. Lastly, the PDEs that result from
using this change of variables have improved stability properties
and the resulting differentiation matrix becomes time indepen-
dent, so that its computationally expensive construction need not
be re-calibrated at every time-step.
If we change variables from S to Φ then the cash flow model of
Eq. (7) must be modified accordingly to
 2  2ηðT  tÞ þ σ e  ηðT  tÞ Φ
CflowðΦ; I; cÞ ¼ Fð0; tÞe  ð1=2Þσ e Q ðI; cÞ
 exhausted the value is zero
ExðI; cÞ
 C mine ExðI; cÞ  C proc  C fixed dt: ð14Þ
1 þ SRðI; cÞ
PDE derivation
Now that we have representations for the dynamic processes
which govern the variables I and Φ, we can set out to derive
equations for the optimal value VðΦ; I; tÞ in a way analogous to the
max½V t  ηΦV Φ þ 12 V ΦΦ  ExðI; cÞV I  rV þ CflowðΦ; I; cÞÞ ¼ 0
c
The only two terms in the above equation involve c, so the optimal
value for c maximizes
max½  ExðI; cÞV I þ CflowðΦ; I; cÞ: ð16Þ
c
This result implies that if cn ðΦ; I; tÞ represents the value of c that
maximizes Eq. (16) then
V t  ηΦV Φ þ 12 V ΦΦ  ExðI; cn ÞV I  rV þ CflowðΦ; I; cn Þ ¼ 0: ð17Þ
We now have two conditions which will allow us to simulta-
neously determine the optimal mine value VðΦ; I; tÞ and the
optimal strategy cn ðΦ; I; tÞ. It remains only to define boundary
conditions.
The terminal condition at time T is evident from Eq. (15), and is
given by
VðΦ; I; TÞ ¼ 0 ð18Þ
The boundary condition for I ¼0 is that once the mine has been
VðΦ; 0; tÞ ¼ 0:
Two more boundary conditions are required in order to complete
the formulation, this is where the option to temporarily shut-
down comes into play.
Let WðΦ; I; tÞ be the value of the mine given that it has been
temporarily shut down. Let Coffline be the costs of maintaining the
mine in this state and let C turnon be the cost of transitioning from
an off-line state to an on-line state and let C turnoff be the costs
of transitioning from an on-line state to an off-line state. By
88 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92
repeating the steps in the derivation of V we find that since Ex  0
when off-line W must obey the PDE
W t  ηΦV Φ þ 12 W ΦΦ  rW  C offline ¼ 0 ð19Þ
with
WðΦ; I; TÞ ¼ 0 and ð20Þ
WðΦ; 0; tÞ ¼ 0: ð21Þ
The values of W and V are tied to each other because of the
option to switch between on and off-line states by paying the
appropriate transition fee. If Φn1 ðIÞ represents the value of Φ for
which it is optimal to switch to an off-line state from an on-line
state given I, then the value matching condition requires that
VðΦ1 ðIÞ; I; tÞ ¼ WðΦ ðIÞ; I; tÞ  C turnoff :
n n
ð22Þ
The value of Φ1 ðIÞ is determined from the “smooth pasting
n The partial derivative with respect to I in Eq. (17) is far more
condition:”
∂VðΦ1 ðIÞ; I; tÞ ∂WðΦ1 ðIÞ; I; tÞ
n n
¼ ð23Þ
∂Φ ∂Φ
Similarly if Φ2 ðIÞ represents the value of Φ for which it is
n Eq. (17) is always negative the boundary information flows into
optimal to switch to an on-line state from an off-line state given I,
then the value matching condition requires that
WðΦ2 ðIÞ; I; tÞ ¼ VðΦ2 ðIÞ; I; tÞ  C turnon :
n n
ð24Þ
The value of Φ2 ðIÞ is determined from the “smooth pasting
n
condition:”
∂WðΦ2 ðIÞ; I; tÞ WðΦ2 ðIÞ; I; tÞ
n n
¼ ð25Þ
∂Φ ∂Φ
Eqs. (22) and (23) are lower free boundary conditions respect to
Φ while Eqs. (24) and (25) provides an upper free boundary
condition on W with respect to Φ. One final boundary condition is
required for each of the PDEs V and W. As Φ approaches infinity so
too does the spot price of metal and the chances of the temporary
shut down decision ever being exercised goes to zero, in addition
all ore is considered economical and the operating strategy
becomes constant. In such price regions the function V is therefore
linear in S. Numerically it is impossible to solve for values of Φ at
71 so a far field boundary condition must be applied in which
the infinite boundary condition is applied at finite values of Φ
chosen to be sufficiently far that the probability of Φ ever reaching
these extremes is negligible and as such the approximate location
of the boundary condition has no impact on the solution in the
region of interest.
Numerical solution method
In what follows, an explicit finite difference solution to the PDE
is employed. However due to the nature of the system of PDEs of
interest, direct application of standard finite difference methods
that are commonly used to solve Black–Scholes type equations are
unstable for the given application. Instead a flux-limiting upwind
scheme must be employed similar to what was used successfully
in Thompson et al. (2004) for power plant valuation and was
outlined in Thompson et al. (2009) for gas storage valuation.
We begin by discretizing each of the independent variables Φ
and I into a grid. Let V ki;j and W ki;j correspond to the value of V and
W at the ith grid point value of Φ, the jth grid point value of I at
time step k for the functions V and W respectively. Then the first
step would be to calculate all of the appropriate partial derivatives
at each grid point at a given time step. For example the partial
derivative with respect to Φ at interior grid point i would be
calculated using the formula
∂V ki;j V kiþ 1;j  V ki 1;j
¼ ð26Þ
∂Φ ð2δΦÞ
where δΦ is the distance between grid points in the Φ axis. The
second partial derivative with respect to Φ at interior grid point i
would be calculated using the formula
∂2 V ki;j V kiþ 1;j 2V ki;j þ V ki 1;j
¼ ð27Þ
∂Φ
2
ðδΦÞ2
Derivatives at the boundary can be determined simply by
applying the condition that values are linear in price when prices
are extremely high or low, to predict the values of V kiþ 1;j or V ki 1;j
outside the grid via extrapolation.
complicated and cannot be calculated the same way as the
derivatives with respect to Φ. Since Eq. (17) depends only on the
first derivative with respect to I, it behaves as a hyperbolic
equation in the I dimension. Since the coefficient in front of VI in
the solution domain from smaller values of I and derivative
approximations must only use information at values of I less than
or equal to the current level. This concept is referred to as upwind
differencing in the computational fluid dynamics literature.
Due to the fact that there is no diffusion in the I dimension,
second order accurate upwind differencing schemes can suffer
instabilities and wild spurious numerical oscillations can occur.
The intuition behind this is that since numerical differentiation,
represents the division of two small quantities, it is quite suscep-
tible to high frequency noise. For diffusive PDEs this effect is
reduced by the smoothing nature of diffusion. However hyperbolic
equations do not smooth high frequency noise but rather shift
initial data along characteristic lines.
One approach to overcoming these spurious numerical oscilla-
tions is to use a first order upwind differencing scheme. The
drawback with this approach is that it can be less accurate and
therefore spatial step sizes need to be smaller. This can increase
the computational complexity of the problem. The reason why
first order upwind differencing schemes work for hyperbolic
problems is that they actually create an artificial numerical
diffusion. In essence they work because the numerical errors act
as a diffusion in the problem. This insight lead researchers to a
class of numerical schemes known as total variation diminishing
(TVD) schemes. The basic premise of such techniques is to use a
second order accurate scheme everywhere except in places in
which the slope is changing rapidly, when this occurs a tiny
amount of artificial diffusion is introduced to prevent instability.
In this way one can achieve stability and preserve second order
accuracy see LeVeque (1992). A full discussion is beyond the scope
of this paper and interested readers are referred to LeVeque
(1992). One such TVD scheme is known as the “minmod slope
limiter” finite difference formula and it is given by
∂V ki;j  ðV ki;j  1  V ki;j Þ
¼
∂I δI
αþ k α k
þ ðV i;j  V ki;j  1 Þ  ðV  V ki;j Þ ð28Þ
2δI 2δI i;j þ 1
where
!!
V ki;j  1  V ki;j  2
α þ ¼ max 0; min 1;
V ki;j  V ki;j  1
 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92
and
!!
V ki;j  V ki;j  1
α  ¼ max 0; min 1; k : with the expected time of processing. Such an assumption would
V i;j þ 1  V ki;j
Finally, in the explicit finite difference case we approximate the
time derivative by
∂V ki;j V ki;j  V ki;j 1
¼ : ð29Þ
∂t δt
In solving the PDE we use a backward recursion. If K represents
the last time step, then from the time T boundary conditions (18)
we know V Ki;j ¼ 0 and W Ki;j ¼ 0 for all i and j. Given knowledge V ki;j
and W ki;j at any k we can calculate ∂V ki;j =∂I using Eq. (28) and from
this we can find cki;j by optimizing Eq. (16). We then substitute
these values of c along with the derivative approximations in Eqs.
(26)–(29) into Eq. (17) and solve for V ki;j 1 . By applying the
equivalent formulas for W we can also find W ki;j 1 . To apply the
boundary conditions (22) and (24) at the k  1 time-step, we
compare the values of V ki;j 1 with those of W ki;j 1 for all i and j
and if V ki;j 1 o W ki;j 1 C turnoff then we set V ki;j 1 ¼ W ki;j 1  C turnoff
and if W ki;j 1 o V ki;j 1  C turnon then we set W ki;j 1 ¼ V ki;j 1  C turnon . For
a reference on using this approach to solving the free boundary
problem (smooth pasting) in this way see Tavella and Randall
(2000). The conditions for stability are that δt r δΦ and that
2
δΦ r 2=maxjηΦi j.
Model assumptions, limitations and extensions
Before we proceed to the numerical results of the proposed
model we will briefly discuss some of the assumptions and
limitations of the model. Additionally, extensions and impro-
vements that we have left out of the current analysis in order
to avoid overcomplicating the model and obscuring the main
insights, are discussed.
In the above formulation it is assumed that the choice of cut-off
grade is continuous in time as opposed to being discrete. This does
not however, imply that cut-off decisions must be constantly
changed, as the subsequent results will show. What the contin-
uous time assumption does imply is that if prices change sig-
nificantly enough to warrant a different cut-off policy, that policy
can be implemented without delay. One could also model cut-off
decisions as occurring at finite pre-defined time intervals. In such
a model if market prices change, management would be prevented
from changing the cut-off policy until the next artificially defined
time-step. Since typically management is free to make such
decisions when they see fit, the continuous time assumption is
justified. Even though in practice cut-off is only changed periodi-
cally when market prices dictate the continuous time assumption
provides for the flexibility of the timing of those changes to occur
whenever management requires.
In this formulation we only consider a single processing mode.
Often mines will have more than one processing method such as a
mill and leach bed for instance. To incorporate multiple processing
types into the model, each process would have its own character-
istics and would require its own cut-off level. Such cases are easily
incorporated into the above framework. The resulting PDEs would
be the same except that the functions Ex and Cflow would contain
more than one cut-off variable and the optimization in Eq. (16)
would be multi-dimensional and hence take slightly longer.
However, neither change would significantly impact the computa-
tional complexity of the model as the computational complexity of
finite difference solutions to PDEs is governed mainly by the
number of independent variables (Φ and I) which is unaffected
by the number of processing modes.
Some mines also have the option of stockpiling below cut-off
grade ore for future processing. This could be modeled as a
89
separate processing type whereby instead of receiving the spot
price, such metals receive the discounted futures price associated
be easy to implement however, some of the real optionality
associated with the timing of the storage option would be lost.
To correct for this storage error a commodity storage model such
as those found in Secomandi (2010), Lai et al. (forthcoming), Lai
et al. (forthcoming), Carmona and Ludkovski (2010), Chen and
Forsyth (2007), and Thompson et al. (2009) would need to be
developed and solved simultaneously with the cut-off optimiza-
tion. Such complexity is beyond the scope of the current paper.
So far we have only considered mines with a single metal.
Extensions to the polymetallic case is straight forward in the
modeling sense, in that the above PDEs would contain more than
one Φ variable and associated partial derivatives, there would also
be cross-derivative partials if the metals were correlated. The finite
difference based solution approach used in this paper could
be extended to at most three metals before the computational
complexity becomes impractical. For cases involving more than
three products, RBF-PDE approaches such as those found in
Thompson (2013) or sparse grid techniques such as those found
in Reisinger and Wittum (2007) would have to be employed. Since
the vast majority of mines have three or fewer metals present in
economically significant quantities, for most applications the finite
difference framework will be sufficient.
The above model also assumes only one stochastic factor is
responsible for the fluctuations in the future price expectations.
Adding more than two additional sources of risk would require the
use of the more sophisticated numerical techniques mentioned
above. However, for simplicity we leave the extensions to those
cases for future work. Most real options mining models in the
literature have fewer than three risk factors so this assumption is
not overly restrictive. More importantly understanding and
demonstrating the nature of the impact of stochasticity on cut-
off grade is more transparent and easier to visualize in the single
factor case.
Results
In this section we implement the proposed model and inves-
tigate the impact of price stochasticity on the economic definition
of ore. For simplicity we assume that all phases have identical
phase distributions and we use the extraction rate function shown
in Fig. 1, the metal production function shown in Fig. 2, and the
production cost function shown in Fig. 3. None of these assump-
tions affect the complexity of the algorithm or the solution
methodology and have only been made to facilitate the exposition.
A more complicated phase design would make it difficult to
distinguish between the effects of price stochasticity from those
of changing geology.
We see in Fig. 1 that at the lowest cut-off level where at least
some ore is present in the deposit, the extraction rate is 0.2. This
implies that it takes 5 years to extract all the material from the
mine. When the cutoff rises to approximately 0.035 the extraction
rate levels off at approximately .25 which corresponds to a mine
life of 4 years. Hence without temporary abandonment the mine
life varies from 4 to 5 years depending on cut-off choice.
In all experiments the initial futures curve Fð0; TÞ is assumed to
be the constant Fð0; TÞ ¼ $1520 per tonne. The values of the
various cost parameters are as follows: C turnon ¼ $1; 000; 000,
C turnoff ¼ $1; 000; 000 and C offline ¼ $1; 000; 000 per year. The dis-
count rate was assumed to be r ¼0.1 and η was taken to be zero.
The range of Φ values corresponds to and initial spot price range
of just over $300 to just under $11; 000.
90 M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92

Fig. 4 shows the value of the mine as a function of the initial
spot price corresponding to 4 different levels of volatility and time
horizon. The first combination is σ ¼ 0; T ¼ 5 which corresponds to
the deterministic price case, identical to that assumed by tradi-
tional cut-off models, with a time horizon of 5 years. The second
combination σ ¼ 0; T ¼ 10 is another deterministic example but
with a longer planning horizon. Note that these two curves are
identical. Due to the time value of money and the flatness of the
futures curve, the optimal strategy is extract value now (if prices
are profitable). So long as the time horizon length is sufficiently
long to extract all profitable ore, extending the time horizon
beyond this point is inconsequential. The third combination
corresponds to σ ¼0.4, T¼ 5 and the fourth combination to
σ ¼ 0.4, T ¼10. In each of these cases we see that the value under
the stochastic model is always higher than under the deterministic
model. Moreover the highest valuation corresponds to the longer
time horizon. The realization that valuations are higher in the
stochastic case is a basic finding in all real options models. The
intuition behind this finding as volatility increases the likelihood
of very high or very low prices increases. But the option to
temporarily shut down production caps the losses associated with
low prices. With the negative impact of low prices capped and the
x 109 Value as a Function of Spot Price (I=1)
3 cases mentioned earlier. When I ¼0 the mine has been completely
σ =0, T=10
2.5
σ=0, T=5
σ =.40, T=5
σ=.40, T=10
2
1.5
Value $
positive impact of high prices unaffected, the expected value
increase.
Fig. 5 shows the optimal cut-off grade as a function of spot
price for each of the aforementioned four cases. In each case we
see that as the price falls to very low levels the optimal cut-off
strategy rises dramatically. With very low prices only the highest
grade ore is considered economic. In the zero volatility case the
optimal cut-off policy monotonically decreases with increasing
prices until a constant equilibrium value is reached. However the
same cannot be said for the non-zero volatility cases. In the
marginal price region where the asymmetry is the greatest we
see cut-off values far lower in the stochastic examples than in the
deterministic ones and this effect is greater for the longer time
horizon. In addition, for prices that are within the region for which
the mine would be operating, the optimal cut-off curve is
relatively flat in the price variable. This means that even if cut-
off is continuously monitored, the optimal cut-off would only need
to be adjusted in the event of extreme price fluctuations. This
indicates that continuous dynamic cut-off monitoring and control
would not typically result in frequent changes to the cut-off
definition. The key result would seem to be that cut-off depends
on market price volatility.
In Fig. 6 we hold the spot price constant at $1520 (the marginal
price) and we plot valuations as a function of I for each of the four
depleted and so the value in all cases is zero. The value is also zero
for all values of I in the two deterministic cases because the price
$1520 was chosen to be at the margin. For the two stochastic cases
value increases as I increases as the larger resource base inherently
contains greater option value. Also note that valuations are higher
and increase faster in the longer time horizon case.
Finally, in Fig. 7 we plot cut-off levels as a function of I for each

of the four scenarios considered. This figure shows two striking

1 features: first that cut-off levels (and hence waste) is highest in the
deterministic cases compared to the stochastic ones, and second
that cut-off is the lowest in the longer time horizon case.
0.5

0 Discussion and explanation of results

−0.5 So far these examples point to two crucial observations for cut-
500 1000 1500 2000 2500 3000 3500 4000
off theory in general. The first observation is that a firm that used
Spot Price $
the traditional deterministic cut-off optimization and ignored
Fig. 4. Mine value as a function of initial spot price for three different volatilities. price uncertainty would, in this example, have wasted large

x 108 Value as a Function of I (Spot Price=$1520)

5
Optimal Cutoff Grade as a Function of Spot Price (I=1)
0.07
σ =0, T=10 4.5
0.065 σ =0, T=5 σ =0, T=10
σ =.40, T=5 4 σ=0, T=5
0.06 σ =.40, T=10 σ =.40, T=5
3.5 σ=.40, T=10
0.055
3
Cutoff Grade

0.05
Value $

2.5
0.045
2
0.04

1.5
0.035

0.03 1

0.025 0.5

0.02 0
1000 1500 2000 2500 3000 3500 4000 0 0.2 0.4 0.6 0.8 1
Spot Price $ I

Fig. 5. Cutoff as a function of initial spot price for three different volatilities. Fig. 6. Value as a function of I for different parameters.

Optimal Cutoff Grade as a Function of I (Spot Price=$1520)
0.04
0.035
0.03
0.025
Cutoff Grade
0.02
0.015
0.01
0.005
0
0 0.1 0.2 0.3 0.4 0.5 0.6
I higher to a government than to a mining firm if both are using a
Fig. 7. Cutoff as a function of initial spot price if I was initially 0.5 for three different
volatilities.
amounts of valuable material, a fact that has social and environ-
mental implications beyond the purely economic impacts. The
second observation shows that under the stochastic model, time
horizon has a large impact on cut-off. This implies that a firm
using a stochastic cut-off grade model with a finite mineral lease
will have a higher cut-off (and hence waste more material) than a
party with a longer time horizon, such as a government issuing
mining leases, would find optimal. Another observation from Fig. 7
is that in both stochastic examples the cut-off levels increase with
I. In other words, as the resource becomes more plentiful waste
levels are higher than when the resource is more scarce (assuming
the same time horizon).
These insights can be explained if one considers the fact that
cut-off decisions involve a trade-off between prices today and
prices in the future. If the present value of prices are expected to
decline then the optimal strategy is to extract more quickly (higher
cut-off) in order to receive the highest possible price for the metal.
In the absence of stochasticity or real optionality, and all else being
equal, the time value of money suggests that money today is more
valuable then money in the future so prices would be expected to
fall which in turn leads to the high cut-off decision. However, this
changes in the face of uncertainty and real optionality. If one
considers that a mine will not blindly continue to produce metal if
it is unprofitable to do so, then when calculating the “effective”
expected future price from the perspective of the mine, the
portion of the price distribution that results in temporary or
permanent suspension of production should be capped accord-
ingly, as the mine will never actually realize any of these large, low
price induced losses. With these low prices capped by the real
optionality, and the higher prices unaffected or even enhanced by
cut-off flexibility, the “effective” expected future price (from the
mine's perspective) increases. In addition, the more volatile the
price distribution the higher this “effective” expected future price
becomes. In this way volatility and uncertainty act in the opposite
manner as the discount rate, with the former raising the present
value of the“effective” expected future price (from the mine's
perspective) and the latter lowering it.
The extent to which uncertainty and nonlinearities counteract
the time-value-of-money effect determines just how suboptimal
the traditional cut-off assumptions are and consequently how much
excess waste is being produced by mines that employ traditional,
deterministic cut-off strategies. When volatility and cash-flow
nonlinearities are an important aspect, the determination of the
M. Thompson, D. Barr / Resources Policy 42 (2014) 83–92 91
definition of ore is intertwined with the optimal production and
operations strategy of the mine. Hence effective, practical models
and numerical techniques that can incorporate both cut-off grade
optimization and real optionality, such as the one presented here
become indispensable.
Conclusions
The examples shown in this paper suggest two new insights
σ =0, T=10 into the economic definition of ore. The first is that in the presence
σ =0, T=5 of market uncertainty, cut-off grades are lower than those pre-
σ =.40, T=5 dicted using traditional deterministic models. This implies that the
σ =.40, T=10
traditional view may be leading to far greater resource waste than
is optimal. The second important insight is that when valuation
time horizons are longer, cut-off values are lower. Since govern-
ments typically consider longer time horizons than mining firms
0.7 0.8 0.9 1 with finite land lease agreements, the extrinsic value of ore will be
stochastic framework. Governments therefore have an interest in
encouraging the use of stochastic cut-off models in the mining
industry in order to reduce resource waste and increase valua-
tions. They should also be careful in setting mineral extraction
agreements in order to ensure that their interests and those of
their private partners align as much as possible.
The insight that uncertainty has significant and profound
impacts on cut-off grade definition, which is one of the most
fundamental operational decisions in mining, motivates the need
for further research into mining models that account for cut-off
strategies in the face of price uncertainty.
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