Option pricing: A new approach to mine valuation

"Uncertainty is an important feature of many investments, but it is especially important for mineral properties. Mine properties often entail large investments and fixed commitments. Managers in the mining industry often view price uncertainty as undesirable, due to the possibility that the price of the mined commodity will fall to a level that prevents the firm from recovering its investment and fixed costs. This paper identifies pitfalls in conventional valuation methods and outlines a new approach to valuation based on option pricing theory and dynamic programming. In the process, it identifies generic strategies for organizing mine production in ways that allow the owner to benefit from the uncertainty in mineral prices. IntroductionRisk is pervasive in the mining industry. The operation and maintenance of a mine may involve high, and unavoidable, fixed costs. A mine owner can only begin to recover these fixed costs if the price of the mined commodity is greater than the incremental cost of production. But the prices of many minerals are extremely volatile. The price volatility of copper has been significantly higher than the price volatility of a typical stock, for example. A mine owner cannot be sure that the price of the mineral product will remain high long enough for the firm to recover its capital and fixed costs.Mine owners are able to minimize their losses during periods when the output price is below the incremental cost of production by temporarily closing operations. During these periods they incur only fixed costs. While shut-downs help minimize losses, the y do not help the firm recover its initial investment. If output prices remain low long enough, the fixed costs and original investment may never be recovered. High fixed costs, therefore, lead to substantial downside risk."