USING REAL OPTIONS TO INTRODUCE FLEXIBILITY IN

MINE PLANNING UNDER UNCERTANINTY

Juan Alejandro Quiroz Retamal1, Nelson Victor Morales Varela and Bastian Rudloff
Stein
Delphos Mine Planning Laboratory, Advanced Mining Technology Center (AMTC),
Universidad de Chile

ABSTRACT
Today, mine plans are optimized for a fixed set of parameters (prices, costs, resource model,
etc.), knowing that they will not realize and the plan will have to be changed in the future.
Uncertainty (in grades, market, etc.) is included only as a post-analysis through variability of
said parameters. We postulate that more robust decisions, higher and more reliable project
values are possible by considering uncertainty from the beginning of the mine planning process.

We illustrate these ideas by using real options to study how the introduction of flexibilities in
the planning process. This allows us to study how robust the decisions made in the standard
planning procedure are, and also to see how the flexibility impacts the final value of the project.
We present this technique in two case studies.

The first case study considers the uncertainty due to the delay between the moment when
equipment purchase orders are placed, and the start of the operation in a long-term mine
planning in an open-pit. The option consists of determining the optimum fleet size so that the
expected NPV of the project is maximized over a number of scenarios.

The second case study refers to the life of an underground mine that consists of several sectors
and uncertainty in prices. In this case, the options refer to the optimum timing of the mine
sectors (when to start their production) so that the value of the project is maximized.

1
Mining Engineering, Master´s Mining Candidate, Universidad de Chile.
E-mail: juquiroz@ing.uchile.cl

1
INTRODUCTION

Recently, mine planning has progressed to integrate more and more variables to the planning
process and has developed tools to achieve more robust plans in terms of expected value and
fulfilment of promises productive, maximize profit and/or the expected return for shareholders.
Unfortunately, a significant gap still exists between what is planned (and offered as value) and
the result of the implementation of the mine plans in the operation. One of the more important
reasons for this is that the whole process is affected by various sources of uncertainty that are
not properly accounted for in the mine planning process. These differences are reflected mainly
in: (a) income, (b) costs, (c) mineral reserves and (d) investments.

The sources of uncertainty in Mining although numerous, can have varying degree of impact on
the business and can be of different nature. For example, uncertainty sources can be classified
as external or internal. External uncertainty is defined as one such that its source lies outside the
company, the main example here is the market (commodity price, price of key inputs,
investment amount, etc.). Internal uncertainty is dictated by the assets of the company and its
organization. For example, geological and operational uncertainties fall in this category. On this
basis, the three types of uncertainty that govern the mining business are mainly: geological,
operational and market. (Mayer Z Kazakidis V, 2007)

The problems created by uncertainties in a mining project, occur precisely because there is no
methodology or tool that integrates uncertainty properly into the mine planning process: the
standard software tools are oriented towards the optimization of a fixed plan under a predefined
set of parameters, therefore the robustness of the plan can only be tested after the plan has been
computed and there is no way (using standard methodology) to integrate flexibility into the
construction of the plans. Flexibility is understood in this article as (Mayer Z., Kazakidis V
2007) as the ability of a system to sustain performance, preserve a certain cost structure, adapt
to changes in internal and external operating conditions, or take advantage of new development
opportunities during the life cycle of the mine operational modifications.

This article aims to illustrate how the introduction of flexibility in decision-making for planning
permits to address sources of uncertainty. This approach, being general, is shown in this case by
applying real options for upgrading and constructing of mine plans under uncertainty,
contemplating both market and geological flexibility. Specifically, we consider two case
studies.

There are several ways to address uncertainty through flexibility in the planning procedure. In
this paper, we work using the framework provided by real options, because they provide not
only a theoretical framework, but also valuation mechanisms that allow to compute flexible
solutions in reasonable time (as opposed to, for example, stochastic programming, that relies on
dynamic programming approach requiring an exponential number of decisions to be computed).

Real Options in Mining

An option is the right (but not obligation) to perform a certain action in a given time (in the
future). This right is established by paying a “price” (for example, an increase in the
investments), and produces a net difference in the expected value of a project or asset: the
“value” of the option.

2
Several researchers have tried to apply real options to evaluate different types of flexibilities
under different sources of uncertainty. Independently of the characteristics used in the
investigations, all these studies conclude that this methodology (real options) produces a profit
increase over the use of discounted cash flows when applied to real options.

In the case of mining projects, there are 3 factors that affect or determine the optimal
investment decisions. (Drieza, Kicki and Saluga, 2002; Topal 2008).

- The investments are partially or completely irreversible, this means that capital
investment is required to establish the operation, with this initial investment cannot be
recovered.
- Uncertainty exists about the future rewards of the investment. Some of these variables
can have significant effects on future mines, such as commodity prices, deposit
characteristics (geology) and operating costs.
- Finally, the investor has a margin of action in the timing of investment. Indeed,
investment in a mine does not happen immediately, there is a delay between the
decision of the mine and the investment in the project occurred.

Samis y Poulin (Samis and Poulin, 1996) showed that:

“Project value is influenced by economic uncertainties and physical environment, a dynamic

structure of project risks and the ability to use, multiple and mutually exclusive projects.”

The NPV is extensively used in mining projects although it is incapable of accounting for these
influences on the value of the project. Samis and Poulin evaluate two different articles in copper
and gold mines and project value calculated by the discounted cash flow (DCF) and real options
valuation (ROV) techniques, concluding that ROV was more flexible and suitable for mining
projects compared to DCF.

Most papers that apply ROV use very simple or hypothetical examples of projects in the mining
or oil industries, and compared the traditional analysis of cash flows with ROV (McKnight,
2000).

METHODOLOGY

The methodology used in this paper, for the construction of flexible plans over time, is a
feedback and iterative methodology which has the following stages:

1. Build a long-term plan, under the standard methodology mine planning (base case, for
comparison).

2. Model and / or simulate the sources of uncertainty though simulation of scenarios.

3. Identify potential flexibilities and model them with an optimization model (for
example linear programming), considering the restrictions and design options.

4. Valuate the options of the simulated scenarios.

5. Analyse results and compare with base case.

3
As mentioned before, we illustrate this methodology in two case studies. The first case study
considers fleet size decisions under geological uncertainty due to the delay between the moment
when equipment purchase orders are placed. The second case study studies the how the optimal
timing and mining rates change according to uncertainty in prices for a big mining complex
consisting of several sectors. We detail these cases next.

Case 1: Optimal fleet size to address geological uncertainty through flexibility in the
sequencing of an open pit mine

In this case study we are interested in evaluating the reliability of the selection of the size of the
transportation fleet with regards to geological uncertainty. The aim is to model the change
(learning) about the geology between the instant in which the equipment purchase orders are
placed and the moment in which operations begin.

The inputs for the case study are: the economic and operational parameters and a fixed mine
design. Geological uncertainty is modelled through different block models constructed by the
Kriging method (the base case) and conditional simulations. We use then an optimization model
that schedules the extraction in the long-term at the phase-bench level, so optimal schedules are
constructed for each scenario and transportation equipment investment (option price). We
compare then the different plans in terms of NPV, Variance and other indicators like reliability.

Notice that the design of the pit phases is the same for all the conditional simulations and the
Kriging model. Indeed, a more detailed study may consider different designs, but this is
difficult to do as there is no automatic design tool or algorithm.

Being more precise, the methodology in this use study is:

1- We construct N+1 block models: 1 with the Kriging method and N conditional
simulations.
2- For each of these N+1 block models, we construct an optimal long-term schedule
using a mixed linear program that works at the bench-phase level, therefore obtaining
N+1 sequences and N+1 NPVs.
3- In order to simplify the analysis and reduce computational times, we use these NPVs
to rank the conditional simulations and group them into n classes. The first class
corresponds to the N/n with lowest NPV, and the last to the N/n scenarios with higher
NPV. Within each class, the scenario with the lower NPV is chosen as a
representative.
4- For each of these n representatives, and based on the updated reserves, the optimal
sequence is constructed depending on transportation investment, so the production
plan is evaluated in detail including the actual CAPEX and OPEX that apply in each
case.
5- Finally, we evaluate the robustness achieved by each plan in terms of the investment
level on transportation.

Using the procedure above, we obtain a pool of options to choose from depending on geological
deposit conditions, the reliability they want to achieve, the option price to pay and the expected
value

4
Case 2: Optimal mining project under market price uncertainty

This case study deals with a copper mine with several sectors (7) that include 6 underground
operations and 1 open-pit, all coexisting and affected by external resources, like a shared plant
and transportation system, as well as constraints associated to precedence and subsidence
limitations between the projects.

In this case study, we are interesting in the flexibility of advancing and delaying the start of
production sectors depending on price uncertainty to study the variability of optimal periods to
start each project, and to analyse how this impacts the production plans (particularly the rates)
and the value of the overall mine, and potentially to determine, if possible, simple rules (for
example, price ranges) indicating that a project must start before planned, or that the project
may be discarded.

Table 1 Productive Sectors

Sector Start of Operations

A In Operation

B In Operation

C 2027

D 2039

E 2048

F 2064
Figure 1 Production Plan
G 2068

We start with a given reference plan indicating, constructed using the traditional parameters and
methodology. For each sector (A, B, C, D, E, F, and G), the plan states: the starting period,
production plan (ore tonnages and grade), and costs per ton in a yearly basis (depending on ore
price). We are also given overall capacity constraints and precedence relations between the
projects (for example, subsidence constraints between the open-pit and underground sectors).

We then model uncertainty using price paths that are constructed using a General Mean
Reverting Process (see Figure 2). Therefore, using the reference plan (tonnages, grades and
costs), and the different price paths, we can evaluate the NPV of each sector.

Furthermore, we implemented a mixed integer program that allowed us to compute the optimal
schedule of the projects, which means to change the starting periods and potentially rates. Using
this, we studied the robustness of planned decisions in terms of price uncertainty by looking at
the changes in these decisions over the price paths.

5
As in the first case study, we do not change the reserves in the plans depending on the price
paths, because that would require manual optimization that is not possible over a significant
number of price paths.

5
4
3
US$/lb

2
1
0

2085
2013
2017
2021
2025
2029
2033
2037
2041
2045
2049
2053
2057
2061
2065
2069
2073
2077
2081

2089
2093
Years

Figure 2. Price Paths to model uncertainty

RESULTS AND DISCUSSION

In this section, we present the results and discussion of the case studied introduced in the
previous section.

Case 1: Sequence Flexibility in open pit mine under geological uncertainty

In the actual case study, we used N=100 scenarios and selected n=10 classes. We have 11
sequences: “Krig”, for the base case; and sequences 1 to 10, each one optimal for its
corresponding representative of the class.

The decision to incorporate flexibility in the sequences of the plan is based on the increased
productivity which allows switching between sequences that may be carried out under these
conditions. For this, the methodology considers the sequence 8 as the starting sequence as it is
one that provides the highest expected value. Additional sequences are considered as the
investment (price of the option) in transportation increases. Thus 10 options were obtained,
each with options and option prices values generated (change in the respective CAPEX). Table
2 presents every option in order of increasing price, and the sequences that are feasible at each
investment level. As expected, as the price of the option increases this allows for a greater
productivity based on more equipment haulage, transport and perforation, which can be decided
among a larger number of extraction sequences. Thus all options were evaluated and the
obtained results are shown in Table 2.

Finally, Table 3 summarizes the information regarding each option. We observe that, while this
set of data reliability (measured as the probability of having a positive NPV) does not have

6
substantial changes, the expected NPV values and the standard deviation observed in each case
are interesting to note.

Table 2 Available Sequence to run for each of the available options

Option

1 2 3 4 5 6 7 8 9 10
Op. Price [MUS$] 0.0 0.3 4.2 5.0 9.4 12.6 42.2 47.8 66.5 69.3
Krig. Krig. Krig. Krig. Krig. Krig. Krig. Krig. Krig. Krig.
8 8 3 3 3 3 1 1 1 1
9 8 6 6 4 3 3 2 2
Feasible Sequences

9 8 8 6 4 4 3 3
9 9 8 6 5 4 4
10 9 8 6 5 5
10 9 8 6 6
10 9 8 7
10 9 8
10 9
10

Table 3 Detailed results by opton: Expected VAN, Price, Standard Deviation, Reliability

Option 1 Option 2 Option 3 Option 4 Option 5

Option Price [MUS$] 0.0 0.3 4.2 5.0 9.4

E(NPV) [MUS$] 338.4 342.5 345.5 348.8 345.2

Option Value [MUS$] 0.8 4.9 7.9 11.2 7.6

Reliability 0.977 0.975 0.979 0.979 0.978

Stan. Dev [MUS$] 169 174 170 171 172

Discount Investment [MUS$] 3015.4 3015.8 3020.2 3021.1 3026.5

Option 6 Option 7 Option 8 Option 9 Option 10

Option Price [MUS$] 12.6 42.2 47.8 66.5 69.3

E(NPV) [MUS$] 342.5 317.5 324.2 306.6 307.2

Option Value [MUS$] 4.9 -20.2 -13.4 -31.0 -30.5

Reliability 0.977 0.973 0.981 0.976 0.975

7
Stan. Dev [MUS$] 172 164 156 155 157

Discount Investment [MUS$] 3030.1 3064.1 3070.3 3092.2 3095.5

Case 2: Optimal underground project under market price uncertainty

In this case we compare the base case plan given by the traditional methodology (i.e. no option
to change timing and rates) and the optimal plans that use the option to change project starting
periods and rates. After running the optimization model on N=200 price paths, all equally
probable. Table 4 shows a summary of these results. It should be mentioned that for the
evaluation we used a yearly discount rate time that is constant and equal to 8%, and that the
integrality gap in the mixed integer program was set to 0.1%.

Table 4 Statistical summary evaluations for different simulations of the copper price.

With Option Without Option Difference

Max NPV MUS$ 36,919 36,734 185
Min NPV MUS$ 18,877 18,860 17
Expected NPV MUS$ 26,435 26,329 106
Std.Dev. NPV MUS$ 3,421 3,394 27

Table 4 shows how the addition of flexibility in the plans increases the NPV of the project. This
can also be seen in Figure 3, where the histogram value of each of the case studies and the
curve of % of accumulated value are presented. While NPV differences may look relatively
small, we observe that they hide very relevant changes in the project, as it is shown in Figure 4.
Indeed, the overall plan is very robust up to year 2040, which is due to the precedence and
subsidence constraints proper of the case study, but there is a lot of variability starting at this
point, in terms of project timing and production.

Histogram E(NPV)
10 100%
% Value Acumulative

8 80%
Probability

6 60%
4 40%
2 20%
0 0%
NPV

With Option Without Option

Acumulative WithOut Option Acumulative WithOption

Figure 3 Histogram and % accumulative value according to case study.

8
 Production plans for each Copper Price Path
300

250

200
Kt/d

150

100

50

0
2028
2013
2016
2019
2022
2025

2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070
Years

Figure 4. Production Plan for each Copper Price Paths (base case in black)

Another element to explain the relatively small difference in expected NPVs is presented in
Figure 5 and corresponds to the effect of the discount rate. Indeed, Figure 5 shows the
discounted and non-discounted cash flows as well as the cumulative discounted value of the
whole project (as percentage). We can see that by year 2040, when the changes in the plans are
observed, the cumulative value of the project is close to 85% of the total, i.e. the possible
variations in the beginning of the projects can affect at most the 15% of the total project value.
Conversely, these relatively small changes correspond to very large variations on the non-
discounted cash flows.

Cash Flow without discount rate Cash Flow with discount rate Acumulative Value's project

4500 100
4000
3500 80
Acumulative Value's project
Cash Flow [MUS$]

3000
60
2500
2000
40
1500
1000 20
500
0 0
2013
2017
2021
2025
2029
2033
2037
2041
2045
2049
2053
2057
2061
2065
2069

Years

Figure 5. Discounted and non-discounted cash flows over project life.

9
Another type of analysis that can be performed using the methodology is the variability of the
starting periods for each sector. We present some of them in Table 5 (Sectors A, B and C are
not included because they always start in the same years because the capacity and precedence
constraints force that). In the table, by “Starting year” we mean the first investment period and
by “%” the frequency over the scenarios (price paths).

Table 5 Optimal sector starts depending on price paths

Mine D Mine E Mine F Mine G

Starting years % Starting years % Starting years % Starting years %

2029 81.0 never 0.5 never 23.0 never 2.5

2030 18.0 2035 81.0 2054 73.5 2049 77.5
2031 0.0 2036 17.0 2055 1.0 2050 19.0
2032 0.0 2037 0.5 2060 0.5 2051 0.5
2033 0.0 2040 0.5 2061 2.0 2054 0.5
2034 0.50 2056 0.5 >2061 0.0 >2055 0.0

For example, we observe Sector F never begins in the period in which it was planned in the
base case (2056). Indeed, with we see that with probability 73.5% it is convenient to start the
investments for this sector 2 years before planned. Conversely, there is a 23% of the scenarios
in which the sector can be discarded. We recall that these plans take into account all required
interactions between the projects in terms of total production capacity and interferences.

Table 6. Analysis of the probability of discarding Sector F

Copper Price 2 2.1 2.2 2.3

Year of Decision 2053 2052 2053 2052 2053 2052 2053 2052
# discard paths 3 3 5 4 7 5 9 7
# total paths 12 9 17 12 22 17 31 27
% discard paths 25.0 33.3 29.4 33.3 31.8 29.4 29.0 25.9
Copper Price 2.4 2.5 2.75 3
Year of Decisions 2053 2052 2053 2052 2053 2052 2053 2052
# discard paths 15 11 16 15 26 20 33 30
# total paths 47 40 58 50 96 84 131 119
% discard paths 31.9 27.5 27.6 30.0 27.1 23.8 25.2 25.2

Table 6 shows a more detailed analysis made for the sector F, assuming that the project should
start in 2054, for different price scenarios going from 2 USD/lb up to 3 USD/lb, assuming that
the decision (of performing the project or not) has to be made either in 2052 or 2054. For these
years, we count the total number of paths so that the price is at most the given value (# total
paths), the number of paths (among those) in which the project is discarded, and the

10
corresponding percentage. We observe that, in fact, the probability of rejecting the project is at
least 25%, but can go up to 33%, depending on the decision date and price scenario

Finally, we also performed a good case/bad case by selecting some limit price paths that are
presented in Figure 6, with the correponding plans in Figure 7. This analysis shows how
different the plans actually are, both in terms of value and reserves (Table 7).

Copper Price Paths

4,00

3,00
US$/lb

2,00 Sim A
Sim B
1,00

0,00
2017
2013

2021
2025
2029
2033
2037
2041
2045
2049
2053
2057
2061
2065
2069
Figure 6. Limit price paths (best and worst cases).

Production Plan for Sim B Production Plan for Sim A

300 300
250 250
200 200
150 150
Kt/d

kt/d

100
100
50
50
0
0
2013
2016
2019
2022
2025
2028
2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070

2025
2013
2016
2019
2022

2028
2031
2034
2037
2040
2043
2046
2049
2052
2055
2058
2061
2064
2067
2070

Figure 7. Deaggregated (by sectors) production plans (good price case “B”, and bad price
case “A”)

Table 7 Analysis of differences in mineral reserves

Production Plan Sim A Production Plan Sim B Difference

Reserves Kton 4,214,719 4,653,458 438,739
NPV MUS$ 21,476 26,751 5,295

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CONCLUSIONS

We have presented some applications of real options to study the impact of flexibility in mine
planning, either in terms of expected NPV, variability or reliability of the plans obtained. We
illustrate this application in two case studies. The application performed in this case is different
than in other studies in the sense that it is more adapted to the mining industry.

The results show that, indeed, it is possible to generate coverings while maintaining or even
increasing the value of the project by introducing some flexibility in some of the outcomes of
the planning process. In the first case study, this flexibility is gained in the scheduling of the
production, by considering different options regarding the size of the mining capacity, and it is
used to increase expected value while maintaining reliability. In the second case study, the
flexibility is put into the timing of a mine sector, and a criteria are developed (based on price) to
determine whether it is convenient to start a certain project earlier than expected; even in a very
constrained scenarios.

In both case studies, the data and option scenarios were limited in terms of the impact produced.
We believe this impact will increase when more powerful options are considered. For example,
in the case of the second study, a lot more flexibility can be gained if the production plans of all
the projects are allowed to change. This requires a deeper analysis and a higher level of detail,
in terms of investments and costs for example, that we plan to do as future work.

A main result of this paper is that the methodology of real options is very versatile, extendable,
and applicable to mining; but (as it is known), the actual impact of this strongly depends of
other parameters like the level of variability and the value of the project. For example, for very
long-term scenarios (Case 2), the actual impact is not clear or diminished considering the effect
of the discount rate over a time horizon longer than 50 years.

REFERENCES

Mayer Z, Kazakidis V. (2007). “Decision making in flexible mine production system design
using real options”. Journal of Construction Engineering and Management, Vol. 133, No. 2, p.
169-180.

Drieza, J A, Kicki, J and Saluga, P, 2002, Real Options in mine Project budgeting-Polish
mining industry example, in Risk Analysis III.

Topal, E, 2008. Evaluation of a mining project using discounted cash flow analysis, decision
tree analysis, MonteCarlo simulation and real options using an example, Mining and Mineral
Engineering, 1:62-67.

Samis, M R and Poulin, R, 1996. Valuing management flexibility by derivative asset valuation,
in98th Annual General Meeting of the Canadian Institute of Mining, Metallurgy and
Petroleum(Canadian Institute of Mining, Metallurgy and Petroleum: Montréal

McKnight,R T,2000. Valuing mineral opportunities as options, Mining Millenium Content

Management Corp,Toronto,Canada.

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