Using Real Options to Value and Manage Exploration
Authors: Davis Graham A. , Samis Michael 
Published: February 2024

Abstract
This paper considers the two main uncertainties facing an exploration manager, geological uncertainty and price uncertainty, within a real options framework. The paper presents two models of exploration. The first model considers only geological uncertainty and reveals how geological and economic factors influence exploration activity and the value of an exploration property. In particular, the model shows that exploration activity will logically respond to changes in the economic and technical environment. One outcome of this model is that higher geological uncertainty enhances exploration project value when initial resource estimates are small and harms projects that have quality resources. The second model considers both geological uncertainty and price uncertainty, and reveals important differences between exploration for commodities such as gold, which exhibit random walk prices and increasing future price uncertainty, and exploration for base metals, which exhibit reversion to a mean price level and saturating future price uncertainty. Under a value-maximizing policy gold exploration should, during periods of low and moderate prices, focus on promising green-fields deposits and deposits with previous positive exploration results while deferring geologically unpromising green-fields prospects until prices improve. This is because given gold’s random walk price characteristic, there is always a chance that higher and higher gold prices could make up for poor geological potential. An expanded exploration policy that includes the deferred greenfields prospects is warranted when prices are higher. On the other hand, our model suggests that unpromising green-fields copper projects should not be kept in deferral mode during low prices, since future prices are capped by the trend of copper prices to a long-run mean. Green-fields copper projects should therefore either be explored immediately if promising or permanently abandoned if unpromising, regardless of current copper price. Since the geology and economics of the gold and copper examples have been designed to be as comparable as possible, these model differences in exploration behavior are driven entirely by the difference in price behavior of base metals, which exhibits reversion, and gold, which does not. That optimal exploration policy depends on the commodity brings to light the importance of modeling both geological and economic (price) uncertainty when valuing and managing exploration projects.
All of this is done within a real options analysis. Traditional discounted cash flow analysis ignores the nonlinearity of the payoffs to exploration and thereby undervalues exploration activity. The real options framework, which captures the nonlinearity of these payoffs, shows that in some cases where the traditional discounted cash flow value of an exploration project is negative, exploration activity can be value creating and should nevertheless proceed. Real option modeling thus provides economic validation of decisions that exploration managers often take in spite of traditional valuation criteria that recommend against taking such action.