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Cut-off grade: A real options analysis

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  • Thompson, Matt
  • Barr, Drew

Abstract

In this paper we examine the impact of forward price uncertainty on the optimal cut-off policy of mines. We employ a new real options model for determining the optimal cut-off grade of ore under stochastic prices. The economic insights and consequences of incorporating uncertainty into the cut-off decision making process are shown to be in opposition to that of traditional deterministic cut-off theory. Key among the new insights is that when prices are stochastic, optimal cut-off grades are much lower than those determined using traditional deterministic models that are currently used in practice. This implies that the traditional techniques may lead to greater resource waste than is optimal. This effect is most pronounced for higher volatility metals, marginal mines, higher discount rates and longer valuation time horizons. In addition to the important insights, the new model produces valuations, sensitivities and optimal cut-off strategies that can be used to enhance project valuation, mine operation, hedging strategy determination, mine design and risk management decisions.

Suggested Citation

  • Thompson, Matt & Barr, Drew, 2014. "Cut-off grade: A real options analysis," Resources Policy, Elsevier, vol. 42(C), pages 83-92.
    • Handle: RePEc:eee:jrpoli:v:42:y:2014:i:c:p:83-92
    DOI: 10.1016/j.resourpol.2014.10.003
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    References listed on IDEAS

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    1. Jeffrey A. Krautkraemer, 1988. "The Cut-Off Grade and the Theory of Extraction," Canadian Journal of Economics, Canadian Economics Association, vol. 21(1), pages 146-160, February.
    2. Mardones, JoseLuis, 1993. "Option valuation of real assets : Application to a copper mine with operating flexibility," Resources Policy, Elsevier, vol. 19(1), pages 51-65, March.
    3. Nicola Secomandi, 2010. "Optimal Commodity Trading with a Capacitated Storage Asset," Management Science, INFORMS, vol. 56(3), pages 449-467, March.
    4. Matt Thompson, 2013. "Optimal Economic Dispatch and Risk Management of Thermal Power Plants in Deregulated Markets," Operations Research, INFORMS, vol. 61(4), pages 791-809, August.
    5. Rene Carmona & Michael Ludkovski, 2010. "Valuation of energy storage: an optimal switching approach," Quantitative Finance, Taylor & Francis Journals, vol. 10(4), pages 359-374.
    6. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-157, April.
    7. Matt Thompson & Matt Davison & Henning Rasmussen, 2004. "Valuation and Optimal Operation of Electric Power Plants in Competitive Markets," Operations Research, INFORMS, vol. 52(4), pages 546-562, August.
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    Cited by:

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    2. Mahmoud A. Eissa & Boping Tian, 2017. "Lobatto-Milstein Numerical Method in Application of Uncertainty Investment of Solar Power Projects," Energies, MDPI, vol. 10(1), pages 1-19, January.
    3. Inthavongsa, Inthanongsone & Drebenstedt, Carsten & Bongaerts, Jan & Sontamino, Phongpat, 2016. "Real options decision framework: Strategic operating policies for open pit mine planning," Resources Policy, Elsevier, vol. 47(C), pages 142-153.
    4. Ahmadi, Mohammad Reza & Shahabi, Reza Shakoor, 2018. "Cutoff grade optimization in open pit mines using genetic algorithm," Resources Policy, Elsevier, vol. 55(C), pages 184-191.
    5. Siña, Matías & Guzmán, Juan Ignacio, 2019. "Real option valuation of open pit mines with two processing methods," Journal of Commodity Markets, Elsevier, vol. 13(C), pages 30-39.
    6. Liu, Yuanxin & Zheng, Ruijin & Chen, Sisi & Yuan, Jiahai, 2019. "The economy of wind-integrated-energy-storage projects in China's upcoming power market: A real options approach," Resources Policy, Elsevier, vol. 63(C), pages 1-1.
    7. Mohammadi, Sadjad & Kakaie, Reza & Ataei, Mohammad & Pourzamani, Eshagh, 2017. "Determination of the optimum cut-off grades and production scheduling in multi-product open pit mines using imperialist competitive algorithm (ICA)," Resources Policy, Elsevier, vol. 51(C), pages 39-48.
    8. Biswas, Pritam & Sinha, Rabindra Kumar & Sen, Phalguni, 2023. "A review of state-of-the-art techniques for the determination of the optimum cut-off grade of a metalliferous deposit with a bibliometric mapping in a surface mine planning context," Resources Policy, Elsevier, vol. 83(C).
    9. Jackson J. Tan & Fernando L. Trinidad, 2018. "A real options model for loan portfolios of actively traded Philippine universal banks," Journal of Global Entrepreneurship Research, Springer;UNESCO Chair in Entrepreneurship, vol. 8(1), pages 1-24, December.
    10. Asad, Mohammad Waqar Ali & Qureshi, Muhammad Asim & Jang, Hyongdoo, 2016. "A review of cut-off grade policy models for open pit mining operations," Resources Policy, Elsevier, vol. 49(C), pages 142-152.
    11. Savolainen, Jyrki, 2016. "Real options in metal mining project valuation: Review of literature," Resources Policy, Elsevier, vol. 50(C), pages 49-65.
    12. Jyrki Savolainen & Ramin Rakhsha & Richard Durham, 2022. "Simulation-based decision-making system for optimal mine production plan selection," Mineral Economics, Springer;Raw Materials Group (RMG);Luleå University of Technology, vol. 35(2), pages 267-281, June.
    13. Mazzarano, Matteo, 2020. "Estimating total potential material recovery from EEE in EU28," Resources Policy, Elsevier, vol. 68(C).
    14. Rahimi, Esmaeil & Akbari, Afshin, 2016. "Application of KKT in determining the final destination of mined material in multi-processing mines," Resources Policy, Elsevier, vol. 50(C), pages 10-18.

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    More about this item

    Keywords

    Mining policy; Real options; Cut-off grade; Stochastic optimization;
    All these keywords.

    JEL classification:

    • Q - Agricultural and Natural Resource Economics; Environmental and Ecological Economics

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