by Edward G. Lee and David M.
Strang
Vlual8tIXoIn t chnrques
t usetd 'i
lPart llthlree:@ Real1 op1@tion v;al|uatio@n approBach
he previous two articles dis-
cussed valuation methods
T that have been or are cur-
rently being used in the mining
industry (ME, October 2003, pp.
11-12 and November 2003, pp. 8-9).
In this article, the authors will ex-
plore Real Option Valuation
(ROV) and learning models. They
will highlight how this valuation
approach can capture the value of
management decisions (options)-
a concept that current methods .
largely ignore.
The theories behind ROV were
first discussed and proven in the
academic world in the 1980s. ROV
was derived as a method of valua-
tion to account for the intangible
value of management's ability to
exercise managerial options when
market conditions change. In ana-
lyzing the value of publicly traded
companies, academic researchers
discovered that, in many instances,
the market value of well managed
companies exceeded the value of
their underlying assets and those of
their competitors. How could that
be? The researchers found that the
equity markets believed that well-
run companies had management
teams that created managerial op-
tions that would give them flexibil-
ity to react to, or take advantage of,
uncertainty in their respective in-
dustries.
The landmark research into the
existence of real options was con-
ducted using examples from the
natural resources industries. The
landmark paper published by
Brennan and Schwartz (1985) was
based on a study of the "classic"
managerial options held by the
Edward G. Lee and David M.
Strang are managing di-
rector and manager, respect-
ively, with Standard and
Poors Corporate Value Con-
sulting, 199 Fremont St.,
4th Floor, San Francisco, CA
94105, phone 415-498-6537,
e-mails edward lee@stan-
dardandpoors.com, david_-
strang@standardand-poors.com.
8 DECEMBER 2003 MeMINING ENGINEERING
the
FIG. 1.
Relationship between management's options and three uncertainties for four
periods.
e~
Opratig Oaaig|Oeaig|Oeaig1
managers of gold mines. These
options gave management the right
to open, place on care and mainte-
nance or close mines in response to
fluctuations in the gold price.
Since the development of the
theory and ROV valuation meth-
ods, ROV has been widely adopted
in the oil and gas, and pharmaceuti-
cal industries for acquisition and
capital budgeting investment deci-
sions. Both industries face similar
uncertainties that arise in the min-
ing industry. These include large
capital commitments, uncertain
pricing and difficult operating envi-
ronments. This valuation method
has started to gain some accep-
tance within the mining industry,
but its adoption is not yet wide-
spread.
The premise of ROV builds on
the foundation made by decision
analysis and other similar types of
binomial decision tree or simula-
tion valuation methodologies.
Those methods rely purely on
management's assessments of the
probabilities of future events oc-
curring and management's re-
sponses to uncertainties in the
marketplace being defined upfront.
ROV uses market data to quantify
the probability distribution for
market-based uncertainties. And it
incorporates learning functionality
into the model that allows adjust-
ma no 'dustr
:
ment of management options as
the relationship between market
and project-specific uncertainties
change.
For example, in the manage-
ment of a gold mine, managers are
faced with four basic decisions on
an annual basis: operate as is, ex-
pand production, place the mine on
care and maintenance, or close the
mine. These decisions or manage-
ment options are influenced by
three main uncertainties: changes
in the gold price, changes in operat-
ing costs and the increase or de-
crease in the mine's ore reserve.
Figure 1 shows the relationship
that exists between management's
options and the three uncertainties
for four periods.
Management decisions and op-
tions (yellow boxes) are influenced
by the managerial options exer-
cised in the previous period. These,
in turn, are influenced by uncer-
tainties (green ovals). A learning
function is built into the above
model through the relationship
between the management options
and the exploration uncertainty at
different time steps. The basis for
management exercising an option
in a period is partially determined
by what was learned about the ore
reserve (exploration) in the previ-
ous period.
The traditional approach to
valuation has been: the future is
uncertain ... a good valuation re-
quires a very good job of "guess-
ing" about the future. That usually
translates into lots of detail, mul-
tiple sensitivity analyses and little
A:tileN
Editor:
I enjoyed John Tilton's article
"Creating wealth and competitive-
ness in mining" (ME, September
2003, pp. 15-22). I worked for
Kennecott at Bingham Canyon
from 1949 to 1955 with an 18-
month break during the Korean
Conflict.
When I returned to Bingham
Canyon in July 1951, 1 was made
the mine's first industrial engineer.
Then, in the early 1980's, I was with
Sohio on the team that evaluated
its acquisition of Kennecott and
worked with Frank Joklik after the
acquisition. I was also with Utah
International when it had Island
Copper and started up the Escon-
dida Mine in Chile.
I have a few bits of information
that readers might find interesting.
When I first joined Kennecott as an
engineer trainee, the company re-
ally did not know what to do with
me and Dean Kerr, my fellow min-
ing engineering friend. We were
the first graduate engineers to be
hired after World War II. As a con-
sequence, I worked as a day la-
borer on all the different jobs
around the mine - powder mon-
key, train brakeman, shovel oiler,
track gang member and churn drill
sampler.
At that time, all ore and waste
transportation was by train and the
mine was fully electrified with tow-
ers on every bench. Bulldozers had
just been recently introduced.
There were 27 different unions at
the mine.
When Kennecott came with
Sohio, not a lot had changed.
Trucks were being used on the up-
per levels but most of the pit was
still electrified for rail transport.
The first thing that had to be
understanding. The ROV approach
accepts that the future is uncertain
and suggests that a good valuation
requires a very good job identifying
potential responses to the range of
possible future conditions. This
_.I I i
in$p13res
memorioe of Bingham Canion
done was to change the labor situa-
tion, which was impossible. This
was true across the American cop-
per mining industry. To make this
happen, the industry took a major
strike. The companies were truly
ready to shut down completely if
proper changes with the unions
could not be made. The companies
held their ground and succeeded.
Only then could the investments
required to introduce new technol-
ogy be justified.
When I was at Bingham Can-
yon, they had two men on a bull-
dozer. That was for "safety"
purposes. One man was to watch
the bank. Instead, he read comic
books sitting on the rock pile.
Three people - operator, oiler and
ground man - operated shovels.
The trains had a brakeman hanging
off of the last car.
The mine was using percussion
drills to drill 75-mm (3-in.) holes at
the bottom of the banks. A 50-mm
(2-in.) pipe was inserted into the
75-mm (3-in.) holes to push down
the explosives to "spring" cham-
bers at the base. This was done so
that adequate powder could be
inserted to blow up the banks.
Care was needed to locate the
holes so that the "springing" charge
did not blow over any electric tow-
ers. The main blasts often did.
ANFO and rotary downhole drill-
ing were introduced when I was
industrial engineer.
I recently visited the Bingham
Canyon Mine. It almost looked
like the mine was not operating.
All the electric towers are gone, as
are the railroad tracks. Just a few
shovels and 'little" trucks are vis-
ible and a crushing station way
down in the pit. That is it. The ore
moves out by conveyor all the way
MINING ENGINEERING
approach is more consistent with
how an investor views a project.
And it provides the user with a
better measurement of value and a
roadmap of how to manage the
project in the future. E
__
to the mill. But, of course, now
they are reaching excessive depths
and will, in 10 years or so, have to
go underground to continue to
mine. The price of copper had bet-
ter improve. The obvious and rela-
tively easy innovations have been
made.
The shovels I worked on when I
was first there were old steam
shovels that had been elecirified. It
took two men to run the bucket -
one to move it up and down and in
and out and one to swing it around
to the rail cars. The latter then
pulled the lanyard to dump the
rock into the car.
Trucks at that time were re-
stricted in size because of transmis-
sion limitations. This was over-
come by introducing the electric
wheel. The next limitation was tire
capabilities. Tires were improved
tremendously and now there are
huge 270- to 360-t (300- to 400-st)
trucks. I understand frame limita-
tions and suspension may be the
controlling factors now.
The point is,where does the U.S.
copper industry go from here. Ro-
botic trucks using geopositioning?
Obviously, labor costs are still a
major factor. Also, the compara-
tive advantages overseas opera-
tions have in terms of lower labor
costs and better ore bodies are go-
ing to win. Copper moves easily
anywhere in the world. The impacts
of environmental requirements are
yet to be fully sorted out and sus-
tainable development, whatever
that means, is a real challenge.
Tilton's article inspired many
memories and thoughts. Thanks
for a good article. E
Hugh Evans
Boulder, CO
El DECEMBER 2003 9
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TITLE: Valuation techniques used in the mining industry. Part

three: Real option valuation approach
SOURCE: Mining Engineering 55 no12 D 2003
PAGE(S): 8-9
WN: 0333501669001

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