The commodity super price cycle and real options: Implications for the Greeks of mining firms

• Date: 01 January 2018
• Published date: 01 January 2018
• Author: José Guedes
• DOI: http://doi.org/10.1016/j.rfe.2017.04.002

ORIGINAL ARTICLE

The commodity super price cycle and real options: Implications

for the Greeks of mining firms*

Jos

e Guedes

Universidade Cat

olica Portuguesa, Palma

de Cima, 1649-023 Lisbon, Portugal

Correspondence

Jos

e Guedes, Universidade Cat

olica

Portuguesa, Palma de Cima, 1649-023

Lisbon, Portugal

Email: jcg@ucp.pt

Abstract

The Real Options Approach (ROA) to the management and valuation of mining

firms should impart a distinctive pattern to the time path of the Greeks displayed

by such firms during the recent price super cycle. This paper simulates the delta,

gamma, vega and rho of a gold mining firm holding a portfolio of heterogeneous

mines over the recent gold price cycle, to find out the telltale signs that the ROA

should leave on the trajectories exhibited by such variables during that period.

We show that the ROA and the standard NPV approach to mine management and

valuation predict markedly different trajectories for the Greeks.

JEL CLASSIFICATION

G13, G17, G31, D81, Q30

KEYWORDS

Gold price super cycle, Mine management, Mine valuation, Mining investments, Real options

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INTRODUCTION

The last decade has witness a full swing in the price of extractive commodities or a super price cycle, to use the popular

expression adopted by the financial media. Gold, which traded at roughly 1100 USD per ounce in early 2010, rose to a

peak of 1900 USD in March of 2011 after which it steadily declined, reverting to the same price level of 1100 USD per

ounce in July 2015. A similar boom and bust pattern in commodity prices, if anything more extreme, was observed within

the same time period for silver, copper and iron ore.

Such price gyrations offer a unique opportunity to researchers to test the real options approach (ROA) to the valuation

of mining firms. Under such an approach, a mine can be either active or inactive, optimally switching between the two

states depending on the price of the underlying commodity; a mining firm, in turn, consists of a portfolio of mines, each

one with its own option to switch between the two states. Borrowing from the financial options literature, the Greeks of the

mining firm consists of measures of the firm’s exposure to the exogenous variables driving its value such as the price level

and price volatility of the underlying extractive commodity and the risk-free interest rate.

In this paper we simulate the delta, gamma, vega and rho of a representative gold mining firm throughout the recent

price super cycle. Specifically, we simulate the Greeks generated by mine activation and inactivation decisions based on a

ROA to mine valuation and management and, alternatively, based on the standard NPV rule. Such simulations allow us to

generate theoretical trajectories for the firm’sGreeks, yielding testable hypotheses about the performance of the two valua-

tion methods during the gold price cycle which may be empirically evaluated by looking at the actual trajectories displayed

by the Greeks of a sample of gold mining firms over that period. We extend the analysis by subjecting two valuation multi-

ples, Enterprise Value(EV)-EBITDA and Enterprise Value(EV)-Annual gold production, to the same process of analysis,

*We acknowledge the support from FCT –Portuguese Foundation of Science and Technology for the project UID/GES/00407/2013.

First published online by Elsevier on behalf of The University of New Orleans, 8 April, 2017, https://doi.org/10.1016/j.rfe.2017.04.002

Received: 28 June 2016

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Revised: 29 March 2017

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Accepted: 7 April 2017

DOI: 10.1016/j.rfe.2017.04.002

Rev Financ Econ. 2018;36:33–46. wileyonlinelibrary.com/journal/rfe ©2017 The University of New Orleans

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