Uncertainty and Risk in Mineral Valuation - A· User's Perspective
lan C Runge
ABSTRACT
The words "Uncertainty" and "Risk" pervade every
discussion about mining exploration and investment.
Perhaps these terms are subjectively understood by
industry professionals, but objective portrayal of these
concepts outside the industry is a woefully undeveloped
science. This paper addresses current industry
understanding and practice regarding quantitative risk
assessment techniques, and provides examples of the
application of three of these techniques. ProbabiIistic
techniques for f"mancial risk assessment are valuable
adjuncts to conventional financial analy~is, and address
a range of issues not assessable by any other means.
The value of whole-of-project probabiIistic risk
assessment is currently debatable for decision-making
purposes, but is seen as important as a mechanism to
focus attention to the critical issues that ultimately
lan Runge is an investment strategist and non-
executive Chairman of Brisbane based Runge Mining
(Australia) Pty Ltd, an international mining consulting
firm active in Australia, Asia, USA, and South Africa.
After founding Runge Mining in 1977, he built the
firm into its current leading position worldwide in
open pit mine design and in the application ofcomputer
technology to mine planning. Work undertaken by
Runge Mining is characterised by the integration of
economics in each stage of the technical evaluation,
and Runge has been running a tireless campaign for a
better appreciation of economics throughout the mining
industry. He was Chairman of the Southern Queensland
Branch of the AusIMM in 1992 and in that same year
organised and chaired the 3rd Large Open Pit Mining
Conference in Mackay entitled Maintaining and
Improving the Economics ofOpen Pit Mining. Runge
is the author of some 18 papers in the areas of mining
economics and open pit mine design and equipment
applications.
Runge retired from full time involvement with
Runge Mining in 1992, and since that time has been
undertaking additional research in economics, and
selected assignments in mining economics, investment
strategy and training. He now lives in McLean,
Virginia, and is currently finalising the writing of a
new textbook in this field entitled Mining Economics
and Strategy due for publication in 1995.
6887 Churchill Road,
McLean, Virginia, USA 22101.
Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994
impact on project success. The dissection of project
capital into risk and non-risk components provides
valuable insights into risk characteristics not readily
quantifiable in any other way. This technique also
provides a framework for more objective ''what in"
scenario evaluation and for the capital structure of
resource projects. Finally, mechanisms for the valuation
of undeveloped reserves are examined, and guidelines
suggested. The importance of reliability in production
cost estimates is highlighted and the impact of early
development on reserve valuations is discussed. The
importance of economics throughout all stages of the
evaluation process is fundamental.
INTRODUCTION
Ofall those expensive and uncertain projects, however,
which bring bankruptcy upon the greater part ofthe people
who engage in them, there is none perhaps more perfectly
ruinous than the search after new silver and gold mines. It
is perhaps the most disadvantageous lottery in the world,
or the one in which the gain of those who draw the prizes
bears the least proportion to the loss of those who draw
the blanks: for though the prizes are few and the blanks
many, the common price ofa ticket is the whole fortune of
a very rich man. Projects of mining, instead of replacing
the capital employed in them, together with the ordinary
profits of stock, commonly absorb both capital and profit.
... Such in reality is the absurd confidence which almost
all men have in their own good fortune, that wherever
there is the least probability of success, too great a share
ofit is apt to go to them ofits own accord.
(Emphasis added)
Adam Smith (1776) in: The Wealth of
Nations
RISK-BASED VALUATION
TECHNIQUES IN USE
Despite censure by Adam Smith, the "father of
economics", after two centuries the mining industry
continues to produce gold and silver in record tonnages.
Whilst not disputing the claim that "mining ... commonly
absorb[s] both capital and profit" clearly this is not so in
the long run. After 2 18 years, the owners of the capital
are presumably not continuing to invest in mining on this
basis. In considering what differentiates mining from other
business enterprises so skilfully dissected in Smith's
seminal volume, one characteristic stands alone - risk.
Risk based techniques commonly used for valuing
mining properties and for management and investment
decision-making can be categorised three ways:
119
1. Experience of the mine operator
2. Conservatism - in design and project selection, and
3. Quantitative methods.
In the experience of the author the first two methods so
outweigh the third that if it were not for the topic of this
paper it would not rate a mention.
All companies rely on the experience of their managers
and directors - small companies almost exclusively. Large
mining companies are increasingly managed using "business
school" methods and frequently there is no one on the
board of these companies who has "come up through the
ranks." Risk assessment by reliance on the direct mining
experience of board members is no longer possible. In
these companies two methods of managing risk and
uncertainty are used; either: the company takes over the
mineral enterprise of a smaller company when its risk can
be understood, or: projects are designed with more
conservatism, perhaps over-conservatism, to reduce the
risk to a level with which technically oriented personnel
are comfortable. Unfortunately, this approach is only viable
for relatively rich deposits, and is itself not risk-free. Apart
from the commercial risk of passing over potentially viable
projects, this approach also commits a commercial error of
degrading the profitability of projects that do get going.
In the opinion of the author, there are many factors in
mining that quantitative methods will never be able to
assess as well as an alert experienced operator can. The
aim of quantitative methods must be to faithfully capture
the experience of key personnel in the whole company, ~llld
present this in an objective way to senior decision-makers
in the company - even if these decision-makers themselves
do not have direct experience related to the valuation in
question.
The input of operating experience, and the value of
quantitative risk assessment techniques changes throughout
the life of a project. In this paper, quantitative risk-based
methods are considered over the full range of mineral
valuation tasks - from undeveloped deposits, mining
enterprises already in production, through to the methods
of understanding risk and uncertainty for capital investment
decision-making in the normal course of a mining
company's business.
The discussion of quantitative risk assessment
techniques is timely. The largest mining companies are
now managed as professionally as any other business
operating competitively on the world stage. Thin margins
and low grade ore bodies leave no scope for over-
conservative design. Mining companies that have not
changed to this professional management approach have
been (or may soon be) taken over by less-technica1ly-
oriented management professionals who have the skills to
extract value out of hitherto undervalued mining assets.
Quantitative risk assessment techniques have the scope to
allow better valuations and better decision-making at this
level. The scope of this paper addresses the questions:
120 Sydney. 27 - 28 October 1994
• How can the risk be correctly portrayed to avoid arbitrary
discounting, or to avoid erosion of the profit potential
through unnecessary conservatism; and
• How can operational, financial and marketing procedures
be put in place to reduce the economic impact of
uncertainties on the value of mineral enterprises?
Uncertainties do not necessarily mean risk in an
environment designed to accommodate them.
The scope to achieve this is partially set out in the
balance of this paper using examples from actual
applications. There is potential for much wider application.
The tools for undertaking this are now available and usable
beyond the largely academic context where they have been
employed in the past.
RISK OR UNCERTAINTY?
In his ground-breaking dissertation entitled "Risk,
Uncertainty and Profit," Frank Knight (1921) opened up a
debate that remains poorly understood even today. Knight
distinguished between events that are capable of actuarial
treatment (called "risks"), stochastic events not capable of
such treatment (called "uncertainty" by Knight), and other
issues. The precise terms used by Knight have not withstood
the tests of time, but the important distinctions remain.
Within the mining industry and in the wider general business
community, today's idea of "uncertainty" probably covers
both these areas; with "risk" having quite a different
meaning to the one used by Knight. The definitions set out
below have.been used in this paper.
Uncertainty refers to some future event or outcome
that cannot be determined in advance or is not definitely
known. Uncertainty may arise on economic grounds
because information is not free - an additional drillhole to
resolve some uncertainty in orebody definition may not
yield knowledge enough to offset the cost. Alternatively,
uncertainty may be an inherent characteristic unable to be
resolved by known technology or additional expenditure.
Where the cause of the uncertainty is known or where there
is a consistent history these uncertainties may be actuarially
assessable, but in many cases this is also not possible.
Uncertainty does not necessarily mean risk. Risk is the
potential exposure associated with an outcome that falls
short of expectations. If the uncertainty is actuarially
assessable, then there may be scope to reduce the risk
through insurance and other devices - concepts explored
in-depth by Knight, and also examined by Barnett and
Sorentino (1994). Even with a great deal of uncertainty,
there is not necessarily much risk if the return from the
project is not sensitive to the unknown elements, or if there
is scope for the project to be adapted to accommodate the
elements that have in practice turned out to be different to
the original expectation. Even in the assessment of
undeveloped deposits, valuations must consider any inherent
characteristics that enhance or detract from this adaptability.
For example; polymetallic ore bodies where there is limited
Mineral Valuation Methodologies Conference
control on the proportions of metals extracted may not analysis techniques such as the ones outlined by Sorentino
offer as much scope for adaptability in the mine design (1994) offer scope to accomplish this.
following differential metal price changes as ore bodies
where the different metals can be mined separately. TWO CAVEATS FOR MINING
The balance of this paper focuses on the defmition of INDUSTRY RISK
risk set out above. This involves:
In an industry known for a high degree of inherent risk,
Analysing uncertainties to detennine the sensitivity of
a multitude of misperceptions and management
any mineral valuation to the uncertainty,
inefficiencies can frequently be explained away by the
• Defining corporate objectives with respect to risk-based adverse impact of unknowns. Whether the "unknowns"
investments and valuation, and interpreting results from could have been "knowns" at the time of the decision - and
quantitative risk analysis techniques, and perhaps different decisions may have been possible - is
seldom evident after the fact. The following two examples
• Examining, understanding and designing alternate mine
provide a rudimentary introduction to this thorny issue,
plans that provide different profiles of risk and return,
which ultimately must be addressed in any discussion aimed
and that minimise the translation of uncertainty into
at improving the professionalism of how the industry is
risk.
operated and reducing the risk for anyone investing in it:
In the author's experience, most uncertainties in
individual mineral valuations are too project-specific to be Market "Cyclicity"
assessed reliably using actuarial methods or methods such
as capital asset pricing models common in the securities The cyclical nature in the market pricing for most
industry. Simply put - if the uncertainty can be analysed in mineral commodities has always been a characteristic of
these tenns, then assessment of it is probably outside the the industry. The unpredictability of these cycles is accepted
scope of technical mining industry professionals. as one of the inherent risks of participating in the industry.
Discussion of this fonn of uncertainty will therefore not be This acceptance demands re-examination.
covered in this paper.
Derivatives Markets. In the opinion of the author, the
development of these markets and their application for
DECISION-MAKING FRAMEWORK
minimisation of market price risk will be acknowledged in
the history books as one of the greatest advances in the
The primary difficulty in objectively analysing project-
mining industry in this century. For the gold industry, the
specific risks stems from the limitations in the approach
first phase of this development has already occurred - the
adopted. The decision-making framework and the tools
commencement of a large number of projects that, but for
that have been developed for fonnulating valuations and
the risk-minimisation allowed through these markets, would
assessments of mineral projects are essentially static.
not have occurred. The second phase is now starting -
Almost all valuations start from some relatively fixed changes in mining technology (eg: larger, more cost-
view of the world, or perhaps a number of alternate efficient, but less flexible equipment) to capitalise on
scenarios, and valuations are made according to these techniques that hitherto have not been considered due to a
scenarios. For consistency of reporting of reserves for perceived need for greater flexibility.
statutory reasons, the "static" valuation approach is
To date, the premiums that mining companies have
probably preferred - infonned markets like consistency in
paid to layoff this risk into the general market have been
technical reporting and like to make their own judgments
minimal. With uncertainty in profit perfonnance due to
of changing value with changing exchange rates and metal
market pricing issues removed, the attention of mining
prices. The shortcomings of the static approach are probably
companies can be directed to production and cost
outweighed by the ease with which the market can
management. Priorities in management have changed
understand this type of assessment.
substantially.
For management reasons, this approach is not adequate.
Unfortunately, the majority of mineral commodities
Time has proved that the mineral projects that have
cannot yet take advantage of these markets because to date
perfonned the poorest in comparison to their owner's
they have only been developed for well-traded, well-
original expectations - the real risk - have been the ones
understood and uniquely defined commodities. Derivatives
with the least ability to adapt when change was necessary.
markets for additional commodities will undoubtedly be
Planning for adaptability across a range of scenarios is a
developed in time. Lacking such a mechanism, the
well-supported idea until the more adaptable plan turns out
exploitation of most commodities requires market price
to require more capital or have a superficially lower return
variability to be accommodated either through the design,
on investment. Any real risk assessment technique must
finance structure, deposit selection criteria, or marketing
address and quantify this issue. It requires a dynamic
arrangement; but even in these cases the "risk" as perceived
approach both to the design of the mine and to the
bears re-examination.
assessment of it. Monte Carlo and similar probabilistic

Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994 121

 Variability, or Long Term Trend? Market cyclicity
may indeed be a risk in many mineral projects, but in the
opinion of the author often the cyclicity gets the blame but
the real culprit is the long term trend. Even the success of
forward sales in the gold industry has been less due to the
removal of cyclical variations and more due to forward
sales at higher prices - a misreading of the trend in the
futures markets - to the benefit of the producers.
Figure 1 shows the price of copper on the London
Metals Exchange plotted monthly over a 20 year period
Figure 1
Monthly LME Copper Price
US cents/lb, Unadjusted for Inflation.
Source: US Bureau ofMines. "Metal Prices in the
United States through 1991"
175 1 - - - - - - - - - - - - - - - - - - - - 1
150 I-------------------jl----I
125 1 - - -......- - - - - - 1 - - - - - - - + - I ' 4 - J t 1
100 I - - -....- - - - - f h r - - - - - - -........-~
75 1--__f~I___r-__f_--.:!!lr_J\_--__f--~
5OH-JHt+--'----------------I
25 I----.--r--r----.r----r---r--r----r-,--,.--J
~~ ....~"" ....~~ ....~'O ....~q, ....# . .#
.... . .# . .C# . .' . .#.
from 1970, and without adjustment, this graph appears to
show the classical pattern of cyclicity imposed over a gradual
rising price. The gradual rising price is consistent with the
notion that costs and prices gradually increase over time as
shallower, richer deposits are worked out and mining
progresses into deeper,lower grade ore bodies.
Figure 2 shows the same information corrected for
inflation together with monthly production statistics from
the USA over the same period.
Whilst many interpretations can be put on this data, the
following points - perhaps a narrow opinion of this author -
illustrate that the simple "explaining away" of poor
performance based on unpredictable variability may be
more of a management issue than a "risk" issue.
1 After adjustment for inflation, there is no rising trend,
but a downward trend. In real terms, prices declined at
122 Sydney, 27 - 28 October 1994
Figure 2
Monthly'LME Copper Price, Production and Trend
(Prices adjusted for Inflation - ref: 1987 US cents/
lb).
460 350c
400 300c
360 250c
300 200::
WE CopptN Priat
(CIII7ts per fb.)
adjusted to 1987$
260 150c
200 100c
150 50c
501-.1---------11-----------1
OL.--L._l-....L.--JI...-....L.--JI...-....L.--Jl--L._L...J
..~ ~.f' ~~....~ ..~ ~ ..# , ..' ..' ..'
an average rate of 2% percent per year over the period.
In the 100 year period 1890 through to 1990, prices
declined in real terms by 0.7% per year. Over the
period of any long term mining investment, scenarios
predicated on a rising or stable real price are clearly
ignoring this trend. This is a systematic error
independent of the cyclicity of the market. Similar
trends have been plotted for most mineral commodities.
2 Whilst there is certainly variability and volatility, prices
could only loosely be described as "cyclic." A more
accurate characterisation would probably be a long term
down trend shown by the dotted base line interspersed
with occasional price "spikes." This implies
characteristics of the market that may be entirely
explainable and offering scope for accommodation in
the mine design, rather than something that is inherently
an unknown.
3 If "pure" cyclicity is an inherent characteristic of the
market, then logically companies would aim to increase
production to capitalise on periods of high price, and
reduce production at other times. Yet this is not what
the graphs show. In reality, producers with low marginal
costs increase production during times of reducing
price - offsetting high cost producers who go out of
business. Production may not change, but production
capacity is gradually reduced. Price "spikes" occur
(are caused) when demand exceeds supply and when
no additional supply is forthcoming - a market imbalance
that is resolved by high prices driving potential buyers
out of the market. This phenomenon is not something
Mineral Valuation Methodologies Conference
 that producers have been readily able to capitalise on
except to try to stay in business until the next price
"spike."
If the above characterisation of the industry is correct,
and on the premise that it applies across a wide range of
mineral commodities, then apparent "risk" due to volatility
and cyclicity is something that can be addressed by changed
capital structures, proper cognisance of long term trends,
and design of projects to accommodate change.
Characterising it as a "risk" evades the issue.
''Inherent'' Risk
Whilst discussion elsewhere in this paper could be
interpreted as being critical of qualitative risk assessment
methods, the notion that project risks can be quantified,
categorised, and assigned some ~ value in some objective
way is incorrect. Risk is not "inherent" and independent of
the operators who are making the decisions, and even an
aggregation of projects comprising a firm or industry group
is made up of individual participants making their own
value judgments. The ex post analysis of certain aggregates
may well demonstrate strong correlations between
variability and return on investment, but this is not a
meaningful piece of information for anyone managing or
evaluating anyone project.
What characterises the mining industry perhaps more
than any other industry is that the cost of information to
reduce uncertainty is itself a significant factor in operational
decision-making. Operators have to make a management
decision as to the appropriate trade-offs:
1 If some uncertain event materialises in an adverse way,
are there enough alternatives available to achieve
objectives despite the change? or
2 If some uncertain event can be made more certain by
additional expenditure, is the additional expenditure
justified by economic advantages elsewhere (eg:
allowing more efficient mining methods), and can these
advantages be capitalised on?
In practice, resolution of uncertainties is undertaken
iteratively. Small expenditures are used to understand
"unknowns" better or to understand how to accommodate
adverse events better. The outcome of initial investigations
determines the extent to which risks are accepted or
uncertainties researched further and ultimately
accommodated in the mine design.
At the two extremes, probably few mining projects
would be economical. Spending a minimal amount on
resolution of uncertainties will likely result in continual
under-performance due to "unexpected technical factors."
Alternatively, a project operated by management that is too
risk-averse will similarly under-perform due to excessive
expenditure on analysis and so-called planning, delays in
reacting to change, and unwarranted conservatism in design.
Examples in both categories abound.
Mineral Valuation Methodologies Conference Sydney. 27 - 28 October 1994
There are very few "inherent" risks in mining projects.
Mining is a scknce of managing uncertainty, to achkve
an optimum balance between risk and return. Perhaps
this "optimum" results in a risk and a return higher than
most other industries, and only in this sense can the industry
as a whole be fairly categorised by its variability in returns
compared to other industries.
DECISION-MAKING UNDER RISK
AND UNCERTAINTY
METHODS IN USE
According to Sorentino and Barnett (1994), the most
commonly used risk evaluation methods in Australia [are]
Sensitivity Analysis and Discount Rate adjustment.
Certainly where there is an attempt at some objective
consideration of risk in the decision-making process, then
these two methods predominate. However there is a third,
more commonly used method - procrastination. Whilst
this is hardly a typical topic for a technically oriented
paper, it merits consideration in this context. Senior industry
decision-makers rarely reach such positions of responsibility
by chance. If procrastination at this level is such a
widespread practice, then the conclusion must be that the
uncertainty that senior personnel inherently understand
through experience is somehow not being faithfully
portrayed in the information being presented to them. More
pragmatic decision-makers will simply adjust the discount
rate to allow acceptance or rejection of a project if their
experience tells them so to do, but frequently there is no
more objective basis to the rate selected than there is
objectivity to artificial delays.
There is no suggestion that the practices widely used to
make decisions under the impact of risk and uncertainties
are wrong. To the contrary, all value is subjectively
determined. If objective (read: quantitative) methods of
risk assessment are inconsistent with the subjective
valuations of experienced personnel - and this happens so
frequently - then more than likely there is a shortcoming
with the quantitative techniques. This issue is addressed in
the final three sections of this paper.
All quantitative techniques for risk assessment involve
some form of discounting of future cash flows into the
present, and, following Sorentino and Barnett (1994),
adjustment to the discount rate is one of the primary
techniques used to account for the risk. This leaves open
the question of which rate to use. Considering the
pervasiveness of this technique, its application and choice
of rates is frequently characterised by an amazing
indifference. Discount rates, interest rates, and the "cost of
capital" are frequently used interchangeably. The following
section critiques the elements making up the "required"
discount rate in a mining context.
123
DISCOUNT FACTORS
Expected Returns
The expected return that a new project must yield is
ultimately determined by the return available from the best
alternative use of a company's resources. Nevertheless,
the number of alternatives available to a company at any
one time is limited, and most firms use guidelines for their
"required" return. New projects must demonstrate a return
exceeding this guideline to be considered. A very common
guideline used by large companies in the minerals' industry
is an after-tax discounted cash flow return of 15 percent,
assessed on a constant money basis (over and above
inflation).
Since this is a common guideline, yet few companies
achieve this return, a reconciliation of the aimed-for return
and the achieved return is warranted. There is a difference.
Pindyck and Solimano (1993) differentiate between the
required return needed to trigger investment, and the average
realised return, and note that
hurdle rates that firms require for expected returns on
projects are typically three or four times the cost of
capital.
An exhaustive dissection is outside the scope of this
paper, however the following three components are
noteworthy:
Cost of Capital.
If a company is to stay in business in the long term then
the minimum return must at least cover the cost of capital.
Whilst conceptually this is not hard to calculate, for
particular projects the marginal cost of capital for that
project may be greatly different to the cost of capital
calculated from existing equity yields and debt finance
rates. Nevertheless, going into any new venture, there
should be a high chance (perhaps a 90% probability) of
exceeding the cost of capital. If there is a 90% probability
of exceeding the cost of capital, then the "expected" return
(50% probability) must be substantially more than the cost
of capital.
This criteria - the "90% probability of' criteria - is
referred to as the "risk" criteria in the balance of this paper.
It refers to either the probability of exceeding the cost of
capital as in the case above, or the net present value that
there is a 90% probability of exceeding (in the case of
valuation of undeveloped reserves).
Non Project Costs.
above issues, a number of adjustments to any fixed
guidelines seem to be self evident.
The guideline for project investment typically excludes
a number of overhead or non-project costs that ultimately
have to be funded using the cash flow from successful
projects.
124 Sydney, 27 - 28 October 1994
A mining enterprise in business for the long term has to
cover the exploration costs of finding replacement projects
for the ones currently being exploited, and for maintaining
technology perhaps unconnected with any existing projects.
A guideline for this "allowance" can be found by comparing
the annual expenditures on exploration with revenues from
actual production. In the late 1980's in Australia, non-
energy mineral exploration amounted to 7.5 percent of the
value of mineral production - an amount that in aggregate
comes from the top of the revenue stream of each operating
project. This figure is not necessarily typical (there are
huge variations year to year) and there is no indication that
the expenditure yielded economically attractive deposits
sufficient to replace the ones mined out. Nevertheless, on
the assumption that 7.5 percent of the revenue from an
operating mine is necessary to find a new "mine" to replace
it, how does this relate to the "required" return on
investment? Clearly this varies from mine to mine, however
one example project studied by the author showed a
reduction in the return on investment of approximately 2.5
percent after this revenue reduction - a factor that seems to
be intuitively consistent with industry experience.
Other non-project costs such as research and
development and corporate overheads perhaps account for
a further 1.5 percent. Lacking a more thoroughly researched
"allowance" for revenue directed away from operating
projects, it is suggested that provision for a reduction in
return due to non-project costs may typically be about 4
percent.
Asymmetry in Returns.
If project returns are in-fact expected returns, then
notionally there should be a 50 percent chance of improving
on the return, offset in the long run by a 50 percent chance
of doing worse. Even projects with greater variability
should yield the expected return on average. In reality,
most practitioners would probably agree that variations
from the expected return are likely to be asymmetric - with
returns above expectation unlikely to balance returns below
expectation. For example: A selling price above expectation
will attract competitors into the market, but a selling price
below expectation will have to be accommodated in the
project return. "Base Case" returns probably represent
median (most commonly occurring) events, not mean (50
percent probability of better, 50 percent probability of
worse) events.
Guidelines for Discount Rate Determination
While acknowledging the difficulty in quantifying the
1 Projects that enhance the existing businesses of a
company have a lower cost of capital than projects that
take the company into new areas. Markets will assign
Mineral Valuation Methodologies Conference
 the lowest premium and the lowest cost of capital to 1 Dissatisfaction with the current state of affairs, or
businesses that they understand the best. how the existing state of affairs is likely to develop in
the absence of action. This is the "do nothing"
2 Projects that have extensive reserves - beyond the typical
alternative - one of the options against which new
15 year life of discounted cash flow studies - should be
potential projects must be assessed, and is itself not
credited with a reduced commitment to funding
risldess.
exploration expenditure. A project having 30 years of
reserves, with the 15 to 30 year reserves being viable 2 An envisaged more satisfactory state of affairs. This
now, is clearly more valuable than a project with only a is the "expected value" criterion for evaluation of new
limited 15 year life - even if this value is not apparent in potential projects, and
the discounted cash flow analysis. To consider these
3 A sufficiently high probability that purposeful
projects on a par, the example above suggests a direct
behaviour can bring about the envisaged outcome.
allowance of 2.5 percent lower required return, with
This is the "risk" criterion - defmed for the purposes
pro-rata adjustments for other projects depending on
of this paper to be a 90 percent probability ofexceeding
reserve life.
some reservation rate or value.
3 The likely changes in technology throughout a project
If two alternative investment options have the same
life should be considered. Projects having limited scope
expected return, and one has a higher variability than the
for change (eg: coal mines supplying to dedicated power
other, then there is no ambiguity as to which one should
stations) may be credited with a lesser commitment to
be chosen. The option with the higher variability has a
funding corporate technology development to consider
lower probability of exceeding the reservation rate or
them on a par with projects that are subject to greater
value, and therefore has a higher risk. Any form of risk
change.
assessment is only meaningful where there is a trade-off
4 Asymmetry of returns frequently stems from a projects' between risk and return. The "do nothing" alternative
inability to capitalise on beneficial events (eg: short will frequently have a higher probability of achieving its
term price rises) and the inefficiency of being reactive return (lower risk) than any other option. Projects offering
rather than pro-active to adverse events. Projects whose higher returns require the extra return (over a less risky
deposit characteristics, industrial climate, or fmancing alternative, or compared to the "do nothing" alternative)
and management structure limit this sort of change to offset the extra risk.
should indeed be discounted (higher rates of return
Note that this decision-making environment does not
required) in comparison with projects that have the
require two physically separate ''projects''. The two
scope to capture "upside" potential.
options in question may be two alternate ways to develop
5 Using the risk criteria (probability of exceeding the the same project, or "develop now", versus "do more
cost of capital), projects with lower risks should be exploration and then develop."
treated differently to projects with higher risks. The
most evident example in this category is a capital
investment aimed at improving an existing business (no
additional output, capital justified on reduction in
operating costs) compared to an equivalent amount of Figure 3
capital used to expand production. The former case is "Classical" Representation of the Return on
not subject to market price risk - the biggest risk in Investment
most mineral projects - and is not depleting reserves. for Two Alternative Investment Options.
There is a clear case for this sort of investment to carry
a substantially lower "required" return on investment
than greenfields investments or investments in expanded
capacity.
Examples of the use of the above guidelines are set out
in the sections following.

PROBABILISTIC ASSESSMENTS
AND APPLICATIONS

INTERPRETING PROBABILISTIC RESULTS

According to Mises (1966), there are three prerequisites

for human action (necessary preconditions for decision- 12.5% 13.0% 14.0% 14.5% 15.0% 15.5%
making), viz: Retum on Investment

Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994 125


Figure 4
Probabilistic Representation of the Return on
Investment for Two Alternative Investment Options
Retllm on Investment
Figure 3 illustrates the typical but uninfonnative way
two alternatives are classically presented to decision-makers.
The presentation only addresses the "expected value"
criterion, not the "risk" criterion.
With the one-dimensional detenninistic presentation in
Figure 3, the option with the higher return on investment is
always favoured. A risk-averse competent decision-maker
favouring the option with the lower return has little choice
but to accept the option with a higher return or to delay and
perhaps frustrate the evaluation process. Figure 4 shows
the same infonnation as Figure 3 presented in probabilistic
tenns.
The presentation in Figure 4 allows alternatives to be
assessed using both the risk criteria, and the expected return
criteria. Assuming the same cost of capital (say: 10 percent),
the project with the higher expected return on investment
has a 16 percent chance of losing money whereas the
alternative project has only an 8.4 percent chance of losing
money even though it has a lower expected return.
Which criteria should be used? A number of guidelines
have been set out by Runge (1990), but to date the study of
objective criteria for this sort of assessment is still in its
infancy. The key to using the risk criteria relates to the
cost of capital. If the cost of capital is likely to be unchanged
regardless of the success or failure of the project (or
expected success or failure ofthe project), then the primary
criteria should be the expected return. If the success or
failure of the project is likely to have an impact on the cost
of capital, then the risk criteria should be the primary
detenninant.
126 Sydney, 27 - 28 October 1994
In making technical assessments of mineral reserves or
valuations of mining properties, the outside world does not
expect values based on just a 50 percent chance of success
(the expected value criteria). Technical assessments -
particularly assessments by independent experts - are
expected to be risk-free. This sort of assessment should be
made using the risk criteria - perhaps adopting a guideline
of less than 10 percent probability of failure.
THE VALUE (AND DIFFICULTV) OF
PROBABILISTIC ASSESSMENT.
The difficulty in estimating the underlying probabilities
in this sort of assessment is acknowledged, but this does
not mean that meaningful knowledge cannot be gained
even with this limitation. Probabilistic methods fill two
important functions that cannot be addressed easily in any
other way.
1 They provide a mechanism for personnel who
understand any element of uncertainty associated with
an investment to quantify this. The individual subjective
or objective assessments can be separately defined but
collectively analysed. The discipline imposed on
individual skilled team members to consider
uncertainties in their area of knowledge frequently
results in substantial changes and improvements in the
robustness of plans, and this knowledge often cannot be
drawn out and assimilated in any other way.
2 There are certain elements that are incorrectly portrayed
in any detenninistic analysis. Using a detenninistic
variable is tantamount to assuming no variability - a
case that may result in a systematic error. Analysts
accustomed to cutoff grade problems will find this sort
of problem familiar. There are parallels in financial
evaluation, and in these cases even an assumed
underlying stochastic characterisation will yield more
reliable results than a detenninistic assessment.
The following case study illustrates one use of the
technique in valuing a project for equity participation.
A CASE STUDY - JOINT VENTURE
EQUITY VALUAnON
Valuation of projects for equity participation is a
particularly apt application of stochastic financial evaluation
techniques. Every project is subject to varying fonns of
risk, and besides the direct funding contribution, the primary
value of joint venture arrangements derives from the
differing contribution each party makes to offsetting these
risks. The operator in the venture has the skills and
knowledge for objective decision-making concerning
production, and has the capacity to provide guarantees of
production that other participants cannot do from their own
resources. Financiers provide the same service in their
area. The third partner (in most joint ventures) contributes
by way of understanding market risks and typically has the
Mineral Valuation Methodologies Conference
capacity to provide some guarantees regarding market
offtake.
Figure 5
A customer (as an equity Participant) who buys a certain Change in Net Present Value of Project with
amount of some product annually from a variety of sources Change in Contracted Offtake
can provide a guarantee to purchase one tenth of this amount
from one particular source at essentially no cost - provided
the guaranteed price is no more than the price that would
J12m
have been incurred anyway. The reverse is not true of the
producer. The loss in revenue incurred by a producer in
the absence of a sale may have a big impact on project
.. J1Clm /
economics. Whilst accountants in large companies are
increasingly wary of the contingent liabilities (and doubtful
value) associated with guarantees, it is the differential value
~
~
c:
~
Slim /
of these guarantees that form the basis of risk sharing and
ultimately the valuation of individual equity stakes over
the notional net present value of future cash flows. This is
~
~ S5m /
the basis of the analysis described below.
·5

~
~
Cl S4m
/
Offtake Guarantees

This original study was undertaken for a coal producer

(.)

$2111
/
in the Hunter Valley of NSW and was modelled using the
"@RISK" program running through a financial model set
up using Lotus 1-2-3. Because of the proprietary nature of
$Clm
V
~ 1~ 2(1'1; ~ ~ 5~

the work actual results have been changed slightly in this
paper and some of the logic has not been presented.
Nevertheless, the. example described below captures the
essence of the analysis, which is considered applicable to a
wide range of similar problems.
This particular project came into the owner's hands
only after a large amount of money had been spent on
assessing many prior unsuccessful opportunities. The first
question to be addressed was therefore: "What premium
(above the direct cost of refunding exploration in this
project) should a new participant pay to enter this project at
the point where its profitability was essentially assured?"
The second question regarded market offtake. Existing
partners only had the resources to guarantee about 60 percent
of the offtake - either by delaying start-up until such offtake
was guaranteed, or by transference of existing contracts.
The primary contribution of a new participant was seen to
be access to markets that would not otherwise be accessible,
or in the guaranteeing of offtake in the early years when the
project was most sensitive to (loss of) cash flow. Assuming
all the output could be placed at current coal prices, the
project appeared viable.
The conventional (deterministic) cash flow analysis
assumed that whatever coal was produced would be sold.
This is a correct assumption. If you don't think that you
can sell it, you don't produce it, and if you do produce it
the marginal return from selling it cheaply is still much
better than not selling it at all. Placing a value on an
offtake guarantee requires the base case to have a less-than
lOO percent chance of selling the offtake, or at least, some
substantial discount on sales that cannot be made into long
term markets. For the base case probabilistic analysis, the
assumption was made that all the output could be sold, but
that tonnages not pre-committed would be subject to the
GUBnlfltBBd Contract Tonna{}8 (% of output)
success ofcontract negotiations with uncertainties as defined
below. It was assumed that production not sold on a
contract basis would be placed on the spot market at $10.00
per tonne discount - a sale price that exceeded the marginal
costs of production but which rendered those tonnes
unprofitable. The base case probabilistic definition of
market offtake is set out below.
Probability of New, Long Term Contracts. It was
assumed that three serious opportunities for new contracts
would present themselves annually, and that for anyone
opportunity, there was a 10 percent chance of success. A
maximum of one new contract per year was also assumed.
Contracts were assumed to run indefinitely, once awarded,
although it would have been a simple matter to also model
expiration (and re-winning) of existing contracts based on
any assumed criteria within the experience of the marketing
personnel. Contracts were assumed to vary in size anywhere
from 100,000 tonnes annually to 500,000 tonnes.
Offtake by New Equity Participant. The purpose of
the assessment was to value this (guaranteed) offtake.
Annual tonnages ranging from nil through to 50 percent of
mine output were considered, although to participate as an
equity partner in a project whose economics had already
been demonstrated to be quite attractive the existing owners
believed that the new participant should at least speak for
25 percent of the mine output - either by way of contracted
tonnage or by some underwriting arrangement.
Figure 5 shows the results of the analysis comparing
the increase in Net Present Value of the project with

Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994 127

increasing guaranteed offtake. Net present values shown In making the above assessments, the owners were
are mean values detennined after lOO or more stochastic quite aware that the one factor affecting coal mine
recalculations of the cash flow for each point on the graph. profitability the most in the early 1980's was shortfalls in
delivered tonnages early in the mine life. The time it takes
At a 15 percent discount rate, the project base case
to find and consolidate long tenn supply relationships with
(with uncertainties in market offtake) showed a net present
customers is frequently underestimated, and until this
value of approximately $32 million after including all
exploration, land acquisition, and capital expenditures. In
other words, a mining company who seeks a (real) return Table 1
of 15 percent could afford to pay all past and future direct Quantities and Probabilities of Uptake
costs and up to $32 million just for the ownership rights to (Underwriting Agreement of 500,000 tonnes
the project per year)
From Figure 5, if the ownership rights include a
guarantee for 25 percent of the project offtake at market Probability of nil tonnage taken up 9%
prices, then this adds approximately $8 million of value.
Average tonnage taken up 1.2MT
Unless the new participant chooses to pay a direct premium,
this kind of guarantee implies a maximum equity stake for (total quantity over five year life of agreement)
the new participant of 20 percent «$32m. + $8m.) x 20% =
Probability that maximum tonnage taken up 12%
$8m.) - a level at which the value that the new participant
adds to the project equates to its' proportion of the (new)
total project value.
consolidation has been achieved there is the continuing
risk of tonnage shortfalls. Though not common in the coal
Figure 6
industry, this sort of situation is frequently handled in other
Change in Net Present Value of Project with Size of
industries through underwriting arrangements. One further
Underwriting Agreement
analysis was undertaken to examine the value of such an
arrangement.
S1.4m +-------------~~

Underwriting Option
S1.2m -+-----------?~--__I
The underwriting option was an alternative considered
on top of the long term supply contract, and was looked at
S1.0m -+--------~-----___l as a mechanism to offset the risk over the critical first five
years of full production for the project. At the end of the
SO.Bm + - - - - - - 7 ' - - - - - - - - _ _ 1
five year period it was considered that there would be a
sufficiently high probability that long term contracts would
be in place that such an agreement would no longer be
SO.6m +------..~----------i necessary. Underwritten quantities varying from 100,000
tonnes to 600,000 tonnes per year were examined and
$DAm -+---+--------------1 assumed a discount on market price of $2.50 per tonne.
Since this tonnage was just residual output pending
commitment to long tenn contracts its value to the project
SO.2m -+-~'----------------1 was primarily one of cash flow rather than return. The
change in Net Present Value with change in underwriting
SO.O m -f--'--t--'''--+--'--+---'-+--'--t---o.--t
tonnage is shown in Figure 6.
o 100 200 300 400 500 600
Compared to the long term offtake guarantee at market
Und6rwritt8f1 Tonnage ('000 tonnBS/ysar) prices, a limited tenn underwriting agreement at discounted
prices is naturally of less value. This is reflected in the
change in expected NPV shown in Figure 6. Nevertheless,
To achieve this result the new equity participant does
this modelling also highlighted possible short term cash
not have to directly buy the coal, it must only guarantee the
flow restrictions and the adverse effects on decision-making
sale. Nevertheless, the two are not necessarily equivalent.
in cases of offtake shortfalls early in the mine life.
Without an actual purchase the tonnage may still be
Discussion of this is too complex to allow easy
competing in the marketplace - perhaps in competition
summarisation in this paper.
with the mines own sales personnel seeking to place the
balance of the uncommitted tonnage. In this case, the In the absence of an underwriting agreement, the existing
simulation may need to be modified to account for the owners effectively take the risk on placement of this tonnage
changed probabilities of residual offtake. themselves. Similarly, from the underwriters point of view,
the potential that no tonnage will be taken up must be

128 Sydney, 27·28 October 1994 Mineral Valuation Methodologies Conference

balanced against the risk that all of the tonnage will be
taken up. Table 1 sets out the probabilities and average
quantities calculated after 500 simulations of the cash flow,
assuming a five year underwriting agreement for 500,000
tonnes per year.
RELIABILITY IN PROBABILISTIC
ASSESSMENTS WITH UNCERTAIN INPUTS
The ultimate test of any evaluation technique is the
value of the results that it provides. What is encouraging
from the above example and other studies undertaken by
the author is that in many cases the results turn out to be
quite robust despite the imprecision of many of the inputs.
There is a reason for this. The value of the modelling is in
its treatment of the interrelationships between variables.
The modelling of interrelationships primarily requires
variables to change; it is less important whether their
variability is characterised by a normal distribution,
lognormal distribution, or any other distribution.
This conclusion does not apply universally. The case
study looks at the change in return on investment with
change in one of the model inputs - in this case, a model
input that can only be thought of in some stochastic way.
A whole-of-project analysis, for example, would need all
stochastic variables faithfully modelled to allow a
probabilistic assessment of the return on investment such
as shown in Figure 4. This is not a trivial task. Given that
very few decision-makers know how to interpret the results,
currently the value of the results obtained are unlikely to be
enough to pay back the effort.
This does not mean that whole-of-project assessment
should not be undertaken. The technique models all the
important variables simultaneously, and it is possible to
use the model itself to determine whether the results are
sensitive to the characteristics of the input. Even if the
characteristics of an input are unknown, the model can be
simulated over a range of inputs. If the results of the
model change, then this is a signal that better definition of
the input is necessary. The model itself is an invaluable
guide to understanding which parts of the underlying plan
(with uncertainty) translate most into uncertainty in the
result. These are the parts that clearly need to be understood
the best.
This is the second "success" of probabilistic models
used by the author - the value from understanding the
problem better. In the example above, many practitioners
could probably pick holes in the logic used for modelling
contracted market offtake. Nevertheless, before the
probabilistic assessment the previous deterministic
assessment assumed 100% success in placing all the mine
output from the first day. Compared to the primitiveness
(and unwitting optimism) of the deterministic method the
probabilistic logic looks thoroughly professional. Only in
the modelling process is there a mechanism to capture and
document the logic that drives many of the participants in a
study. When this logic is brought out into the open, there is
Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994
scope for contribution, improvement and scrutiny by others
on the project team resulting in easier auditing and improved
decision-making - both of which result in risk reduction.
STRUCTURING INVESTMENTS FOR
RISK MINIMISATION
PROBABILISTIC ANALYSIS, OR
"WORST CASE" SCENARIOS?
Perhaps corporate environments should focus on
achieving some expected return, but in the experience of
the author, most decision-making is focused on guaranteeing
some minimum acceptable outcome. This is probably
true even in cases where the cost of capital is not at risk in
the event of failure of the project. Probabilistic methods
have a way of representing this that incorporates all the
financial factors likely to impact on the cash flow, however
their reliability is subject to the precision with which the
underlying probabilities can be estimated, and this is no
easy task. Sorrentino (1994) refers to the ceteris paribus
assumption (all other things remaining unchanged) when
discussing deterministic sensitivity analysis, but
probabilistic analysis is also subject to this limitation.
Probabilistic analysis only succeeds in rolling back the
changes as far as the underlying technical buildup - it
offers very limited scope for changes to the mine plan in
the face of changes in any of the variables in the model.
An typical example illustrates this dilemma. Following
completion of a planning study, a typical financial
assessment might be concerned with the impact of an
increase in the price of fuel oil contemporaneously with an
increase in the cost of labour. There might even be a
change in the selling prices of the mines outputs (perhaps
some products increased in price, whereas others decreased
in price) at the same time. Financial models for this sort of
assessment can be readily analysed using probabilistic
methods. In reality, however, if all of this happened, the
mine plan would also change. Resources would be
redirected into producing more of the products whose selling
prices had increased and relatively less of the products
whose prices had decreased. Equipment that operated on
electricity would be more heavily used over equipment
more dependent on fuel oil.
In the long run, it is the ability or inability of the
project to adapt to these sorts of changes that establishes
the real risk. Any comprehensive risk assessment must
consider the ability of the project to accommodate this type
of technical change. Mine planning tools for doing this are
not very advanced, however there is one technique,
developed by the author, that partially addresses this issue.
The technique is aimed at dissecting the capital that goes
into a project, determining how much of it is really at risk,
and making judgments based on the return on the risk
capital.
129
 Table 2
Deterministic "Base Case" Cash Flow
Alternative "A" (Capital Intensive Method)
Year Year Year Year Year
0 1 2 3 4

Production 10,000 10,000 10,000 10,000

Unit Revenue $10 $10 $10 $10
Total Revenue $100,000 $100,000 $100,000 $100,000

Capital Cost $200,000

Claimable Depreciation $50,000 $50,000 $50,000 $50,000

Unit Operating Costs $1.915 $1.915 $1.915 $1.915

Total Operating Costs $19,149 $19,149 $19,149 $19,149

Taxable Profit $30,851 $30,851 $30,851 $30,851

Tax Payable at 35% $10,798 $10,798 $10,798 $10,798

Cash Flow ($200,000) $70,053 $70,053 $70,053 $70,053

Discount Factor at 15% 1.000 0.870 0.756 0.658 0.572
Present Value ($200,000) $60,916 $52,970 $46,061 $40,053
Net Present Value $0

Table 3
Deterministic "Base Case" Cash Flow
Alternative "B" (Less Capital Intensive Method)
Year Year Year Year Year
0 1 2 3 4

Production 10000 10000 10000 10000

Unit Revenue $10 $10 $10 $10
Total Revenue $100,000 $100,000 $100,000 $100,000

Capital Cost $100,000

Claimable Depreciation $25,000 $25,000 $25,000 $25,000

Unit Operating Costs $5.957 $5.957 $5.957 $5.957

Total Operating Costs $59,575 $59,575 $59,575 $59,575

Taxable Profit $15,425 $15,425 $15,425 $15,425

Tax Payable at 35% $5,399 $5,399 $5,399 $5,399

Cash Flow ($100,000) $35,027 $35,027 $35,027 $35,027

Discount Factor at 15% 1.000 0.870 0.756 0.658 0.572
Present Value ($100,000) $30,458 $26,485 $23,031 $20,027
Net Present Value $0

130 Sydney, 27 - 28 October 1994 Mineral Valuation Methodologies Conference

 •

The logic behind the analysis is identical to the logic
employed during the final stages of setting up a financial
structure ofa project, but has value in helping select projects
and in highlighting at an early stage the potential risk areas
and potential design to best accommodate them. It also
focuses attention more directly at the risk capital rather
than the whole capital, and in the view of the author, this is
correctly where attention should be directed, given that
management is representing the shareholders who are the
residual claimants and ultimate bearers of this risk.
"AT RISK" CAPITAL APPROACH
The "At Risk" capital approach does not aim to be as
sophisticated as the probabilistic methods discussed above,
although there is no difficulty in combining the two
approaches to address an expanded range of risk-based
issues. The "at risk" approach aims to objectively focus
attention on the "worst case" scenario to:
risk and non-risk tranches, and valuing each element
differently.
Because of space and complexity limitations in this
paper the following case study is limited to just financial
considerations in the "worst case" scenario, however the
normal use (and most valuable use) of the technique is
when technical changes to the mine plan are also included.
EXAMPLE STUDY -
RETURN ON RISK CAPITAL
The example used in this study compares two
alternatives for implementation - both achieving the same
production into the same market, and achieving the same
return on investment - in this case a return on investment
of 15 percent. There are three steps in undertaking the
analysis set out in the following three sections and Tables
2 to 8.

I Force critical examination of this scenario from a Conventional Analysis·

management viewpoint (if it happens, what exactly
Return on Whole of Capital Invested
would we do?), and ensure that operational,
management, financial, or marketing arrangements do
The first step in the analysis is to undertake a
not inhibit management's ability to actually react to
conventional deterministic discounted cash flow analysis.
this circumstance, and
The simple discounted cash flow model assuming a selling
2 Provide a mechanism for project selection based on the price of $10 per unit for both cases, no inflation, and a tax
return on risk capital, not just return on the total capital. rate of 35 percent is set out in Tables 2 and 3 respectively.
In this sense, the "at risk" approach is doing for
The discounted cash flows which represent the "base
individual project investment what some of the
case" for both alternatives are (barring the gross
derivatives markets are now doing for more marketable
simplifications) identical to the kinds of cash flows
financial instruments; ie, dissecting cash flows into
undertaken daily by almost any investment analyst. The

Table 4
Deterministic ''Worst Case" Cash Flow
Alternative "A"
Year Year Year Year Year
0 I 2 3 4

Production 10000 1‫סס‬oo 10000 10000

Unit Revenue $8 $8 $8 $8
Total Revenue $80,000 $80,000 $80,000 $80,000

Claimable Depreciation $50,000 $50,000 $50,000 $50,000

Unit Operating Costs $2.202 $2.202 $2.202 $2.202

Total Operating Costs $22,021 $22,021 $22,021 $22,021

Taxable Profit $7,979 $7,979 $7,979 $7,979

Tax Payable at 35% $2,792 $2,792 $2,792 $2,792

Cash Flow $0 $55,186 $55,186 $55,186 $55,186

Discount Factor at 15% 1.000 0.870 0.756 0.658 0.572
Present Value $0 $47,988 $41,729 $36,286 $31,553
Net Present Value $157,555

Mineral Valuation Methodologies Conference Sydney. 27 - 28 October 1994 131

 Table 5
Deterministic ''Worst Case" Cash Flow
Alternative ''B''
Year Year Year Year Year
0 1 2 3 4
Production 10000 10000 10000 10000
Unit Revenue $8 $8 $8 $8
Total Revenue $80,000 $80,000 $80,000 $80,000

Claimable Depreciation $25,000 $25,000 $25,000 $25,000

Unit Operating Costs $6.851 $6.851 $6.851 $6.851

Total Operating Costs $68,511 $68,511 $68,511 $68,511

Taxable Profit ($13,511 ($13,511 ($13,511 ($13,511

Tax Payable at 35% ($4,729) ($4,729) ($4,729) ($4,729)

Cash Flow $0 $16,218 $16,218 $16,218 $16,218

Discount Factor at 15% 1.000 0.870 0.756 0.658 0.572
Present Value $0 $14,103 $12,263 $10,664 $9,273
Net Present Value $46,302

Table 6
Components of Risk and Non-Risk Capital nnder ''Worst Case"
Conditions

Component of Initial Capital Alternative Alternative

"A" "B"

Capital NOT at risk $157,555 $46,302

(78.8%) (46.3%)

Capital at risk $42,445 $53,698

(21.2%) (53.7%)

net present value of the project in both cases is zero. The
initial capital has yet to be spent. To allow easier
comparison, for this example the operating and capital
costs of the two cases have been arranged so that both
cases show a 15 percent rate of return, which is assumed to
be the opportunity cost of capital.
"Worst Case" Analysis -
Determining the Non-Risk Capital
The second step is to prepare a worst case scenario,
and assume that this develops after the expenditure of the
initial capital (or indeed at any time through the project
life). In this example, it is assumed that the "worst case"
involves an immediate drop in selling price by 20 percent,
and an increase in operating costs by 15 percent. This
scenario is applied to both cases, although the normal
situation would involve worst case scenarios that are
different for each alternative. Tables 4 and 5 set out the
cash flow that would then be applicable to this "worst
case" scenario for both alternatives.
1 The model assumes that the initial capital expenditure
has already occurred, resulting in the net present value
of future cash flows for Alternative "A" of $157555
(compared to the initial capital outlay of $200,000) and
$46302 (compared to the initial outlay of $100,000) for
Alternative "B".

132 Sydney. 27 - 28 October 1994 Mineral Valuation Methodologies Conference

 Table 7
Cash Flow Dissected into Risk and Non-Risk Elements
Alternative "A"
Year Year Year Year Year
0 1 2 3 4

Cash Flow (from Table 2) ($200,000) $70,053 $70,053 $70,053 $70,053

Cash Flow - Non-risk Basis ($157,555) $70,053 $70,053 $47,883 $0
Discount Factor at 10% 1.000 0.909 0.826 0.751 0.683
Present Value ($157,555) $63,685 $57,895 $35,975 $0
Net Present Value $0
Cash Flow - Risk Capital ($42,445) $0 $0 $22,170 $70,053
Discount Factor at Rate below 1.000 0.813 0.660 0.537 0.436
Present Value ($42,445) $0 $0 $11,897 $30,548
Net Present Value $0
Discount Rate 23.06%to set Net Present Value of "Risk" Cash Flow to Zero

Table 8
Cash Flow Dissected into Risk and Non-Risk Elements
Alternative "B"
Year Year Year Year Year
o 1 2 3 4

Cash Flow (from Table 3) ($100,000) $35,027 $35,027 $35,027 $35,027

Cash Flow - Non-risk Basis ($46,302) $35,027 $17,496 $0 $0
Discount Factor at 10% 1.000 0.909 0.826 0.751 0.683
Present Value ($46,302) $31,842 $14,460 $0 $0
Net Present Value $0
Cash Flow - Risk Capital ($53,698) $0 $17,530 $35,027 $35,027
Discount Factor at Rate below 1.000 0.856 0.733 0.628 0.538
Present Value ($53,698) $0 $12,857 $22,000 $18,841
Net Present Value $0
Discount Rate 16.77 % to set Net Present Value of "Risk" Cash Flow to Zero

2 Even though the project is now only "worth" less, the
initial capital expenditures can still be depreciated from
the full amount for tax purposes.
3 The Alternative "B" worst case scenario involves tax
losses which in this analysis are assumed to be available
to offset taxable profits elsewhere in the company.
If the analysis truly represents the worst case, then
clearly this component of the original capital is not at risk.
The amount of capital "at risk" in the two cases is shown
in Table 6.
From the point of view of risk management, the capital
that is not at risk has (theoretically, at least) a 100 percent
chance of achieving the hoped-for return. Any amount of
this capital can be accommodated in the capital structure
of the company and the effect will be neutral so long as it
achieves the same return as the cost of capital. Accordingly,

Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994 133

this capital is only "required" to cover its cost (the cost of GUIDELINES FOR USE OF THE
capital) - assumed in this case to be 10 percent. "AT RISK" CAPITAL APPROACH

"At-Risk" Analysis - Return on Risk Capital
The capital that is at risk must be at the centre of
management focus, and the returns on this capital are the
ultimate source of growth for the company. Better projects
are clearly the ones that achieve the highest return on this
capital.
In the third step, the original cash flow is subdivided
into two components, with the earliest cash flows being
directed to paying back the non-risk component at the cost-
of-capital discount rate, and only after this non-risk return
has been achieved does the risk component of the initial
capital start to be paid back. The discount rate that balances
the risk cash flows is the effective return on the "at risk"
capital. The two cases are set out in Tables 7 and 8
respectively.
This presentation shows a clear difference between the
two cases. Alternative "A" has a lower amount and a
lower proportion of its initial capital at risk, and accordingly
shows an effective return on the risk capital of about 23
percent. Conversely, Alternative "B" with a lower overall
capital requirement is clearly more sensitive to the "worst
case" scenario. This alternative has a higher amount of
capital at risk, a much higher proportion of its capital at
risk, and consequently a much lower (16.77%) return on its
risk capital. Alternative "A" should be selected.
Whilst the above analysis favours the more capital
intensive case, this is not always the case. Typically, more
capital-intensive alternatives are also less flexible, with a
higher proportion of capital at risk in the worst case scenario.
The "At Risk" analysis also signals the appropriate (or
at least the maximum) debt: equity ratio for the project,
and provides an objective mechanism for subsequent
evaluations based only on equity contributions. In this
respect, the tabulation set out above is very familiar to
analysts involved in the structuring of finance for major
projects - the only difference in this instance being the use
of the same tools for initial selection and planning of
projects.
Worst case scenarios are always prepared for major
projects, but in the experience of the author, these tend to
be fairly superficial and undertaken only in the financial
evaluation phase. The study of worst case scenarios as a
guide to mine planning is something that is undertaken
only occasionally. Most insiders have difficulty envisaging
"worst case" scenarios. To be most useful, worst case
scenarios should not just involve remodelling an unchanged
mine plan. Changes to the plan are always required. Capital
investments and divestments are usually necessary but these
are normally well justified on an incremental return basis,
even if they require the expenditure of capital at a time
when the project is performing "most poorly." It is this
very happening - the need for additional capital at the time
of poorest performance - that this sort of analysis is aiming

Table 9
Illustrative Deterministic Cash Flow
Unit Value of Reserves based on the Life of the Reserve
Year Year Year Year Year Total Aver. Marginal
1 2 3 4 5 Values Values Value

Discount Factor at 15% 0.870 0.756 0.658 0.572 0.497

3-Year Life Reserves
Production 1 1 1 3
Cash Flow $12 $12 $12

Present Value of Cash Flow $10.43 $9.07 $7.89 $27.40 $9.13

4-Year Life Reserves

Production 1 1 1 1 4
Cash Flow $12 $12 $12 $12

Present Value of Cash Flow $10.43 $9.07 $7.89 $6.86 $34.26 $8.56 $6.86

5-Year Life Reserves

Production 1 1 1 1 1 5
Cash Flow $12 $12 $12 $12 $12

Present Value of Cash Flow $10.43 $9.07 $7.89 $6.86 $5.97 $40.23 $8.05 $5.97

134 Sydney, 27 - 28 October 1994 Mineral Valuation Methodologies Conference

to foreshadow. Before project commencement, it may not
be possible to predict the occurrence of the worst case
scenario, but at least the capital structure of the project can
be put in place ahead of time so that if there is a problem
shareholder value is not reduced further by the inability to
adjust to it.
THE ECONOMIC VALUE OF
UNDEVELOPED DEPOSITS
The valuation of undeveloped deposits is the key area
where outsiders look to industry professionals for primary
guidance. Such valuations are called upon when one party
is not fully at "arms length" from the opposite side of the
transaction. [If all parties are at arms length, then
commercial considerations are the primary determinant -
any "professional" valuation is for broad guidance only].
Given the wide consensus on how this sort of valuation
should be conducted (present value of future cash flows) it
may be surprising how the huge differences in valuation
commonly observed can be determined. The reasons for
this are readily explainable, and arise from the differences
in valuations based on:
• The use of average values rather than marginal values
The degree of confidence in production cost estimates,
and
• The likelihood of bringing reserves into production
sooner rather than later.
The conditions under which each of the criteria should
be used are best illustrated by an example.
VALUAnON OF RESERVES IN THE
GROUND - AN EXAMPLE
Whilst this author claims no expertise in valuing oil
reserves in the ground, the wealth of available commercial
literature regarding this sort of evaluation makes an example
based on it quite instructive. The technique applies
conventional and probabilistic discounted cash flow
analysis, and is identical whether the valuation applies to
oil production or for more conventional extraction of coal
and minerals.
All evaluations of this type begin by estimating the
margin between the cost of production (including capital
costs for any long term valuation) and the likely selling
price. This difference represents the likely future cash
flows to repay the cost of finding and/or acquiring the
reserves. The present value of the likely future cash flows
is calculated by discounting at the company's opportunity
cost of capital. By convention, reserve valuations are
normally presented as a dollar value per unit of reserves in
the ground.
For this example, two hypothetical cases have been
analysed:
Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994
Case "A" • the case where production costs are very "low"
in relation to the selling price. The values used in this
case assume a selling price of $20 per barrel and a cost
of production inclusive of capital repayment of $4 per
barrel. Current day cash flows are therefore $16 per
barrel.
Case "B" . the case where production costs are "high" in
relation to the selling price. The values used in this
case assume a selling price of $20 per barrel and a cost
of production inclusive of capital repayment of $8 per
barrel. Current day cash flows are therefore $12 per
barrel.
To illustrate the average and marginal value calculations,
a simple deterministic analysis for reserves exploitable
over three, four, or five year periods has been set out in
Table 9.
The table illustrates a number of simple but important
distinctions to be drawn when reserves are valued:
I When reserves are expressed in terms of their
exploitation life (and present values then divided by the
total reserve), the per unit valuation is the same. A
I00 tonne reserve exploited at 10 tonnes per year over
10 years has the same per tonne value as a 10 tonne
reserve exploited at one tonne per year over 10 years
(assuming of course that the costs of production are the
same).
2 An extension of reserves that extends the mine life is
not as valuable as an extension of reserves that allows
an increased production rate for the same mine life -
Figure 7
Value of "Oil" Reserves. Case "A" - Low Cost
of Production
\I..:B.:,:/U.:.:8..:0_'R
__es.:..:....:e__ un_it:...~
N...:.e..:..s..::.(p_e_ _,..... ..,
$9.00 ...
$8.00 4-~.-----------------1
$7.00 +-~--~-------------..,
$6.00 -l---~- ~------- ----i
$5.00 +------P~-"""""::-
$4.00 +---"Io~---+----~c-""":"""","~---i
$3.00 - l - - - " ' r ' ' ' r - - + - - - - - -
$2.00 +---------~'loo.c_----------+-_1
$1.00 +-----+---~~_.;;:_----+-_i
5 6 7 8 11 10 11 12 13 14 15 16 17 18 III 20 21
Explohation Period - Years of Reserves
135
 even if the costs of production are unchanged. In the
above example, a 25 percent increase in reserves from Figure 8
the four year life case to the five year life case values Value of "Oil" Reserves.
the extra reserve at $5.97 per unit, compared to a value Case ''B'' . ''High'' Cost of Production
of $8.56 per unit if the extra reserve allowed expansion
and exploitation over the same four year period. Value of Reserves (per unit)
$7.00 . - - - - - . . . . : : . . - - - . , ; : . . . . - - - - - - - - - . .
Many "independent" valuations take place in an
environment where the party acquiring the reserves already
has an operating mine nearby. The value of the reserves $6.00 -r-~----------------1

depends on whether their acquisition allows mine expansion

(and often, production cost economies of scale) or is directed s~.oo T---~~--------------1
just at mine life extension.
The above trivial example is inadequate for real life
application, because of uncertainties in reserve definition,
reliability or unreliability in production cost and selling
price estimates, and in tax considerations. Accordingly, a $3.00 -r--~~~__t-----...:::.~~---~

more robust example has been prepared using the "@RISK"

software, running through a simple model set up on an $2.00 -r--~-~rl----=::::.....;;;,a;~---~-~
Excel spreadsheet. In this model, both cases assume a tax
rate of 35 percent, depreciation (depletion) of reserves for
$1.00 -r----~o;;;:::----=~;;;::------~-~
tax purposes over the life of the reserve, and production
cost uncertainty characterised by a "normal" distribution
with a standard deviation of 10 percent (the "high" $0.00 l.:-~~-l..~-~I-.J..~:::~S3:s.J
5 6 7 8 9 10 11 12 13 14 15 1/1 17 18 19 20 21
confidence case) and 50 percent (the "low" confidence
case). No variability was applied to the selling price. ExpIoitaJion Period - Years 01 Reserves

As an independent expert whose advice is expected to

have a high degree of confidence, valuations should be
period, its average value reduces to $3.51. In other
based on the risk criterion. Net present values are not the
words, a 10 unit reserve exploited over 10 years at a
"expected" values used in Table 9, but are stochastically
rate of one unit per year has a net present value of
determined estimates having a 90% probability of being
$60.80, whereas the same reserve exploited at 0.5 units
exceeded.
per year over 20 years has a net present value of $35.13.
Since expenditure on finding or acquiring the reserves
2 Because the production cost is only small in relation to
is a sunk cost, this cost is ignored. As with Table 9, an
the selling price, reserve valuations are not very sensitive
opportunity cost of capital rate of 15% was used for this
to the confidence in production cost estimates. Even
evaluation, although following the discussion on discount
with low confidence in production cost estimates the
rates earlier in this paper, this rate could arguably be reduced
average value of reserves is reduced by only 15 percent.
by the "exploration" premium (2.5% in the previous
The technical focus in any valuations should be on
example).
reserves rather than production cost estimates.

RESERVES VALUATION· PROJECTS 3 Spending money to increase reserves is only a viable

WITH LOW PRODUCTION COSTS
Figure 7 shows the calculated values of reserves (per
barrel) for Case "A" based on exploitation over periods of
5 to 21 years. Each "Average Value" point on the graph
has been derived after approximately 250 stochastic
discounted cash flow calculations similar to Table 9, and
the "Marginal Values" represent the change in total net
present values as reserves are extended from (for example)
10 year reserves to 11 year reserves and so on.
A reserve with economics similar to Figure 7 that can
be exploited over a 10 year period beginning
immediately, having a high confidence in the production
cost, has an average value of $6.08 per unit - or about
38 percent of the current day cash flow per unit. If the
same reserve can only be exploited over a 20 year
proposition if they can be found at a cost less than their
value. In this case, if additional reserves allow the
output of an existing 10 year life mine to be expanded,
then up to $6.08 per unit (the average value) can be
spent. If additional reserves merely allow extension of
the mine life, then $2.29 per unit (the marginal value) is
the limit of expenditure. A ten percent increase in
reserves that allows production to be expanded by ten
percent is worth 2.6 times as much as a ten percent
increase in reserves that just extends the life of the
project by this percentage of time.
4 With no scope for expansion (meaning that additional
reserves only have marginal value) and very low
production costs, this situation probably characterises
oil reserves in the Middle East. The cost of finding
additional oil is quite low, but so too is the value of

136 Sydney, 27·28 October 1994 Mineral Valuation Methodologies Conference

 adding this new oil to the reserve base. In addition, the
economics in this environment provide relatively little
incentive for refinement of production cost estimates.
RESERVES VALUATION - PROJECTS
WITH HIGH PRODUCTION COSTS
Figure 8 shows the comparable situation where the
direct costs of production are a much higher proportion of
the selling price - a situation more characteristic of most
mining developments. Indeed, very few mining
developments would have total production costs (excluding
exploration) of just 40 percent of the selling price, so
certainly this (Case "B") example is the one more applicable
to mineral valuation.
1 A reserve with economics similar to Figure 8 that can
be exploited over a 10 year period beginning
immediately, having a high confidence in the production
cost, has an average value of $4.35 per unit - or about
36 percent of the current day cash flow per unit. This
figure is similar to Case "A", and is to be expected
because of the high confidence in the production cost
estimates used.
2 Because the production cost is now much larger in
relation to the selling price, reserve valuations are much
more sensitive to the confidence in production cost
estimates. With low confidence in production cost
estimates the average value of reserves is reduced by
more than 40 percent.
3 If the market has only low confidence in the technology
used to exploit the deposit it places very little value on
increases in reserves. The present value of 20 years of
reserves at low confidence levels is much lower than
the value of 10 years of reserves at high confidence
levels. In this situation valuations based on reserves in
the ground are less reliable than valuations that focus
on precision in production cost estimates. The
management focus by owners of this type of
undeveloped resource must be on refinement of the
technology for production, not reserve extensions.
4 Even with high production costs, if there is also a high
confidence in the production technology, then reserves
in the ground are very valuable if they can be exploited
qnickly. This situation probably characterises oil
reserves in the mainland USA where high costs of
finding oil are justifiable because of the long history
(and reliability in production cost) and the ability to
bring new reserves into production quickly. In cases
where plants have surplus capacity and production can
be increased through import replacement, marginal
production costs may also be very low. Increases in
reserves can be assessed at average value, not marginal
value - placing a value on them higher even than much
lower cost reserves elsewhere in the world.
Mineral Valuation Methodologies Conference Sydney, 27 - 28 October 1994
ECONOMIC GUIDELINES AND FOCUS
FOR VALUATIONS
Technical professionals must make their own
assessments with regard to the technical criteria in the
evaluation, guided by the importance or otherwise of the
elements discussed below.
The following guidelines based purely on the above
economic analysis can therefore be deduced:
1 If additional reserves provide for increases in production,
then their value may be several times as much as
additional reserves directed at just extension in mine
life. If higher production rates also mean lower
production costs, then value is increased further.
2 If production costs are likely to be high relative to the
selling price, then the focus on valuing (and adding
value, in the case of mine operators) must be on
achieving high confidence in production cost estimates.
Where production cost uncertainties leave little margin
below the selling price, then reserve valuations on a per
unit basis end up being purely nominal. In these cases,
the idea of adding value (or objectively arriving at a
valuation) is only meaningful where there is a
demonstrated consistent production cost history.
Management skills are vital.
3 The valuation of reserves is very dependent on the
expediency with which they can be exploited. Delays
in potential start-up of projects have minimal impact on
the fundamental economics of the project itself, but
have dramatic impacts on the value and life of reserves
and priorities for exploration. An operating mine with
potential to expand (and where this potential is stymied
through (say) Government or environmental action) ends
up getting only a fraction of the value from its
exploration effort. The dramatic difference (reduction)
in value when exploration efforts are just applied to
extending the life of a mine may mean that there is no
economic value in exploring for a decade or more.
4 Whilst not quantitatively analysed, the value of
undeveloped reserves is very sensitive to changes in tax
rates - particularly in cases where differential rates
apply for early exploitation.
5 Valuations based on quantities of reserves in the ground
are also very sensitive to the state of development in the
country. A developing country with low costs of
production (and greater production cost uncertainties)
can be valued on the basis of reserves and will typically
require large reserves (long production life) to be
economically attractive. In these cases, the marginal
cost of finding additional reserves is quite low - it has
to be, because the marginal value of additional reserves
is low, and it wouldn't be viable unless the marginal
value exceeded the marginal cost. This explains why
developing countries frequently have very large reserves
(expressed as years of production).
137
6 In developed countries where the cost offinding reserves
is high and the costs ofproduction are also high, reserves
can also be valued by the quantity in the ground. These
assessments are only meaningful if production
technologies are well understood and reserves can be
brought into production quickly. This partially explains
why the more developed countries frequently have fewer
reserves (in terms of years of production) - it is not that
they actually have fewer reserves still in the ground, or
that "most" of their deposits hav~ been exploited. The
fastest way to eliminate value (if this was the aim) from
reserves in developed countries is to introduce
production cost uncertainties and delays in bringing
projects into production.
There has been a tendency in the past to consider
"reserves" as a technical term, independent of economics.
This is understandable, given the history in Australia of
having rich deposits whose reserve valuations were much
less sensitive to the economics of exploitation. In the
future, the economics of the reserve definition will be
much more vital, and apart from the more obvious
statements of assumed selling prices and production costs,
a ftrm statement as to the production rate, likely variability
in production rates, production cost confidence, and
assumed timing of cash flows will be essential.
138 Sydney, 27·28 October 1994
REFERENCES
Barnett, D W and Sorentino, C, 1994. Discounted Cash
Flow Methods and the Capital Assets Pricing Model.
Mineral Valuation Methodology (VALMIN '94)
Conference, Sydney, 27-28 October, 1994. (The
Australasian Institute of Mining and Metallurgy:
Melbourne).
Knight, Frank H, 1921. Risk, Uncertainty and Profit,
(University of Chicago Press: Chicago, 1971. Originally
published in 1921 by Houghton Mifflin Company).
von Mises, L, 1966. Human Action - A Treatise on
Economics, 3rd revised edition, (Henry Regnery
Company: Chicago).
Pindyck, R S and Solimano, A, 1993. Economic Instability
and Aggregate Investment, in NBER Macroeconomics
Annual, 1993, (Eds: Blanchard, 0 J and Fischer, S.)
(National Bureau of Economic Research, MlT Press,
Cambridge, Mass.).
Runge, I C, 1990. Assessing Risk and Capital Investment
Criteria in Mining Projects, in Proceedings Mincost
'90, Sydney (Australasian Institute of Mining and
Metallurgy: Melbourne).
Smith, A, 1776. An Inquiry into the Nature and Causes
ofthe Wealth ofNations, Campbell, RH and Skinner,
A S General Editors, (Liberty Classics, Indianapolis,
1976. Originally published by W. Strahan; and T.
Cadell in the Strand, London, 1776).
Sorentino, C and Barnett, D W, 1994. Financial Risk and
Probability Analysis in Mineral Valuation, Mineral
Valuation Methodology (VALMIN '94) Conference,
Sydney, 27-28 October, 1994. (The Australasian
Institute of Mining and Metallurgy: Melbourne).
Mineral Valuation Methodologies Conference