Real Option Identification Framework for Mine Operational Decision-Making

Abstract

Identification of opportunities for applying real options (RO) in mining operations is a major challenge to decision-makers. In order to make optimal decisions in uncertain times, managers require a full understanding of the relationships between risk, uncertainty and flexibility. RO analysis, which captures the value of any managerial flexibility that may exist in a project, provides a proactive management of uncertainty. Thus, it enhances optimal decision-making. However, it is important that a structured framework is created to identify project uncertainties and areas available to cultivate flexibility. In this paper, uncertainty identification framework in a mining operation is proposed, and areas for managerial flexibility and their application domains within the mining cycle are mapped as well. To avoid complex mathematical models, which hinder the adoption of RO analysis in mining operations, a relationship between risk measure (beta) and flexibility (flexibility index) is derived and applied. This implies that if a project beta is known, then the expected option values and volatility of future cash flows can be precisely estimated. Once the option value is calculated using the derived equation, a modified smooth pasting condition with the mean value theorem is subsequently applied to estimate the optimal value. This combination of beta, flexibility index and mean value theorem can be used as a decision criterion for screening various options within a mining project.