Agnico - Eagle Mines

Summary

Dan Acker, senior portfolio manager at National Securities of Toronto, wants to decide whether he should liquidate the portfolio’s position in Agnico-Eagle Mines (AEM). AEM is a gold mining company based in Canada. It had been performing well over the past several months but suffered a large one-day sell-off. Mr. Acker wants to value the company using a DCF analysis, but realizes that DCF valuations are likely to undervalue resource companies such as AEM as the DCF valuation does not value the flexibility provided at a mining company’s decision nodes when extracting commodities from the ground. Hence, the valuation has to be expanded to include the value of unmined metals. Specifically, the unmined metals in the ground need to be valued as a real option using a Black-Scholes model.

Valuing mining operations as an option

A mining company has the right, but not the obligation, to extract and sell the metal from the ground at any time, and do so when the commodity price rises above the extraction cost. The value of this un-mined gold, therefore, could be estimated using options-based methodology.

• Exercise price (X) is the one time cost of developing the mine and the recurring extraction costs. This can be inferred from similar project costing.
• The underlying asset value (S) is the value of AEM’s gold reserves. This could be estimated using geologist estimates for quantity and a simplified assumption that the price of gold appreciates at the risk-free rate each year
• The length of time the company can wait without losing the opportunity is the time to expiration (t). In the case of mining, this is the length of time it takes to exhaust the resources and the lease length, taking into account that the company can delay starting the mining operation until optimal market conditions are evident without the lease starting.
• The riskiness of the project is reflected in the standard deviation of returns on the asset (σ). In the case of gold mining, this depends both on the variability of gold prices and the variability in the estimate of gold reserves.
• Time value is given by the risk free rate (r), the maturity of government bond with equal maturity to the time of expiration of the option. For mining operations, it is important to increase the size of reserves to keep the risk free rate higher and increase the length of the option.