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Option valuation of delaying the start of an underground coal mine to implement coalbed
methane drainage.
by
Wael Jaber
A dissertation submitted in partial fulfillment of the requirements for the Diploma of Imperial
College London in Metals and Energy Finance.
Department of Earth Science and Engineering
Imperial College London
London
SW1 2AZ September 2012
2
ABSTRACT
Coal has the distinctive ability to store large volumes of methane, which typically get
released during mining activities. Coalbed methane drainage is performed before or during
mining activities for safety and economic reasons. The proper design and timing of CBM
drainage typically results from a static and long-term economic analysis, whereby value is
a function of coal extraction and long-term operational and financial estimates. In fact, coal
prices are very volatile, which in turns brings volatility to production cash flows and
enhances the project value. In turn, volatility brings flexibility and allows management to
determine whether to start CBM drainage earlier and delay coal mining in order to match
best market conditions and maximize value creation.
Given a hypothetical coal mining project with associated CBM drainage, the study first
aims at assessing the viability of the project through DCF valuation, sensitivity analysis and
risk analysis. The project appears to be economically viable with a NPV of 306M$ and a
10% probability of economic loss. Project profitability is mainly sensitive to commodity price
and yield as well as mining operating expenditures.
Then, the study aims at exploring 1, 2 and 3 years coal mining delay options. On the
one hand, DCF valuations of the base case and three delay options show the lost value
increases with the delay period ranging from 34M$ at 1 year delay to 92M$ at 3 years
delay. On the other hand, real option valuations of the three delay scenarios gained value
in delaying increases with the delay period, ranging from 24M$ at 1 year delay to 34M$ at
3 years delay. Economically, it is clearly not profitable to delay coal mining by 1, 2 or 3
years. This result was expected since coal projects typically create value in the long-term
added to the fact that initial production cash flows carry much of the NPV weight.
Pre-mining CBM drainage results in several economic benefits, which were ignored in
this study, that could affect the project economics as well as justify a delay of coal
extraction activities to implement pre-mining CBM drainage. On the one hand, there are
mining-related benefits such as lower ventilation costs, lower development cost and a
greater productivity. On the other hand, methane utilization options could bring additional
value and volatility to the project. Finally, EPC or other non-mining related issues could
force the delay of coal extraction. Performing such study can help management in
assessing the economic impact of a delay.
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TABLE OF CONTENT
ABSTRACT 2
LIST OF TABLES 5
LIST OF FIGURES 6
1. INTRODUCTION 7
2. COAL MINING PRACTICES 8
3. COALBED METHANE DRAINAGE 11
1. What is coalbed methane? 11
2. CBM drainage 12
1. Vertical wells 13
2. Gob wells 14
3. Horizontal boreholes 15
4. Cross-measure boreholes 16
3. Benefits associated with CBM drainage 17
1. Mining economic benefits 17
2. Methane utilization options 18
4. Cost of implementation 19
4. FINANCIAL VALUATION OF MINING PROJECTS 20
1. Discounted cash flow valuation 20
2. Real option valuation 22
4
5. STUDY BACKGROUND AND METHODOLOGY 26
1. Problem statement 26
2. Technical background 28
3. Financial background 31
6. RESULTS AND DISCUSSION 33
1. Quantitative analysis 33
1. DCF valuation 33
2. Sensitivity Analysis 37
3. Monte Carlo simulations and risk analysis 39
4. Option valuation 46
2. Qualitative analysis 48
7. CONCLUSIONS 49
8. REFERENCES 51
9. BIBLIOGRAPHY 53
10. APPENDIX 54
5
LIST OF TABLES
Table 1: Range of cost estimates for different CBM drainage methods (USEPA, 1999).
Table 2: Hypothetical thermal coal deposit characteristics.
Table 3: Coal mining and processing parameters.
Table 4: CBM occurrence and drainage parameters.
Table 5: 1, 2 and 3 years Product A price volatility.
Table 6: Yearly cash flow calculation procedure for DCF valuation.
Table 7: Base-case DCF valuation.
Table 8: Summary of DCF valuation results.
Table 9: Monte Carlo simulations results.
Table 10: Summary of option valuation results.
Table 11: Comparison of the delay lost and gained values.
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LIST OF FIGURES
Figure 1: Overview of the different coal types (World Coal Association, 2012).
Figure 2: Coal surface mining (Colorado School of Mines, 2012).
Figure 3: Coal underground room-and-pillar mining (Colorado School of Mines, 2012).
Figure 4: Coal underground longwall mining (Colorado School of Mines, 2012).
Figure 5: CBM retention and migration across a coal seam (Al-Jubori et al, 2009).
Figure 6: Vertical pre-mining wells degasification method (USEPA, 1999).
Figure 7: Methane flow stimulation techniques (USEPA, 1999).
Figure 8: Vertical gob wells degasification method (USEPA, 1999).
Figure 9: Vertical gob wells and horizontal boreholes methods (USEPA, 2005).
Figure 10: Horizontal and cross-measure boreholes methods (USEPA, 2005).
Figure 11: Long Call and Put positions net payoff profiles.
Figure 12: Overview of the base case analysis and three delay options.
Figure 13: Five-years trend of Product A coal prices (Index Mundi, 2012).
Figure 14: Project sensitivity analysis.
Figure 15: Risk vs. combined DCF and Sensitivity analysis (Bilodeau, 2009).
Figure 16: Analytical approach to risk analysis (Bilodeau, 2009).
Figure 17: Combinatorial approach to risk analysis (Bilodeau, 2009).
Figure 18: 1-year Product A price probability distribution.
Figure 19: Mine Capex probability distribution.
Figure 20: Average mining Opex probability distribution.
Figure 21: 1-year production cash flows probability distribution.
Figure 22: 1-year NPV probability distribution.
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1. INTRODUCTION
Underground coal mining is one of the oldest mineral extraction activities and has
traditionally faced operating challenges related to coalbed methane. Indeed, coal has the
distinctive ability to store large volumes of methane gas within its micro-porous structure,
which typically get released during coal extraction. In addition of the lost value of this
resource and its impact on global warming, methane directly affects mine safety and
productivity.
CBM undoubtedly has to be drained, which has been traditionally performed using a
well-designed ventilation system. However, due to increased productivity and a trend
towards recovering deeper seams, coal mines now have to deal with increasingly higher
amounts of CBM. It is often found more economical to implement a methane degasification
system before and/or while extracting coal, with a scaled-down ventilation system.
The design and timing of a CBM drainage system typically results from a long-term
economic analysis, based on fixed operational and financial estimates. In fact, such
parameters are volatile, which brings value and flexibility to the project; couldn’t a coal
mine use CBM drainage as a strategic tool to delay coal mining by a couple of years so
that production best matches expected coal prices and value creation is maximized? In
other words, given CBM drainage has to be implemented, this study aims at assessing the
flexibility a coal mine has in determining whether to start CBM drainage earlier and delay
coal mining in order to optimize coal extraction and maximize value creation.
Clearly, this study carries more of an intellectual work than a realistic analysis, as a coal
mining project typically creates values over the long term and the first few years would not
get much attention. For the purpose of the study, a hypothetical underground coal deposit
with associated CBM resources, assumed to be located in the US, will be considered.
Operational and financial parameters will be realistically estimated.
In a first part, the literature surrounding coal mining, CBM drainage as well as financial
valuation of mining projects will be reviewed. Then, a base case analysis, whereby CBM
drainage and mine development start at the same time, will be carried out with associated
sensitivity and risk analysis. Finally, the option valuation of delaying mining activities by
one, two or three years will be assessed. While it is assumed extracted methane is not
marketed, there clearly are methane utilization options as well as mining economic benefits
in carrying CBM drainage, which will be discussed.
8
2. COAL MINING PRACTICES
Coal is a valuable combustible, sedimentary and organic rock, mainly composed of
Carbon, Hydrogen and Oxygen. Coal formation results from the accumulation,
consolidation, preservation and alteration of organic matter. Coalification is the process
whereby organic matters get subject to an increasingly higher amount of pressure and
temperature, which results in the transformation of peat into brown coal. Coal maturation is
an extremely slow process and today coal began its formation during the Carbonaceous
Period, 360 to 290 million years ago (World Coal Association, 2012).
Different types of coal exist and vary based on a complex range of physical and
chemical parameters, including calorific value, moisture content and volatile content. As
depicted on Figure 1, coal quality is defined by its rank whereby a high-rank coal, such as
Anthracite, has fully matured and it is very valuable in that it has a high calorific value, a
low moisture content and less volatiles. In opposition, a low-rank coal, such as Lignite, has
almost undergone no maturation.
Figure 1: Overview of the different coal types (World Coal Association, 2012).
Different types of coal hence find different uses. On the one hand, thermal coal is a can
be used for power generation. On the other hand, coking coal is used for steel production.
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Also, coal can be used in the cement, chemical and pharmaceutical industries. About 7Bt
of coal were used last year worldwide and global coal consumption has grown faster than
any other fuel since 2000, with the main users being China, USA, India, Russia and Japan
(World Coal Association, 2012). Coal has always been a strategic, efficient and cheap
source of energy to support economic growth and the development of society. Even though
environmental concerns are rising nowadays, depleting resources and rising demand keep
supporting the ever-growing coal mining industry.
Depending on the coal seam location and geology, coal can be mined at the surface or
underground. Today, about 60% of the world coal production is produced underground. On
the one hand, surface (open-cast) mining appears to be economically viable when the coal
seam is near surface, less than 100m deep typically. Surface mining operations cover a
very large area (many square kilometers) and follow a typical sequence. As depicted on
Figure 2, overburden is first removed using a dragline to expose the coal seam. Then, the
exposed seam is drilled, blast and hauled using shovels and trucks in successive strips.
Finally, rehabilitation is ongoing rehabilitation whereby the overburden is put back in place.
Surface mining allows a recovery of 90% or more of the coal in place (USEPA, 2009).
Figure 2: Coal surface mining (Colorado School of Mines, 2012).
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On the other hand, underground coal mining involves two techniques: room-and-pillar
and longwall. First, as depicted on Figure 3, room-and-pillar approach is applied at shallow
depths and involves mining the coal seam developing a network of rooms, leaving pillars in
place for support. Such pillars can take up to 40% of the coal volume in place, which is a
loss, even though some pillars can be recovered (robbed) at the end. Room-and-pillar
mining requires the use of continuous miners to extract the coal (USEPA, 2009).
Figure 3: Coal underground room-and-pillar mining (Colorado School of Mines, 2012).
Second, as depicted on Figure 4, longwall mining is applied at greater depth and only
to deposits with simple geology. The method involves mining the coal seam across a panel
(face) located between two parallel tunnels (gates). It allows recovering of more than 75%
of the coal in place. Longwall mining requires the use of a continuous miner to develop the
gates and a shearer, with hydraulically powered shields for roof support, to mine the face in
repeated passes. Advance mining involves developing the gates and face together moving
forward, while retreat mining involves developing the total length of gates first and mining
the face backward (USEPA, 2009).
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Figure 4: Coal underground longwall mining (Colorado School of Mines, 2012).
3. COALBED METHANE DRAINAGE
1. What is coalbed methane?
Coal seams form over millions of years as a result of the coalification process, whereby
carbon-rich organic matters get buried and subject to an increasingly higher amount of
pressure and temperature that lead to the concentration of carbon and the release of large
volumes of hydrocarbon gases. Once generated, methane (CH4) get mainly adsorbed and
retained within the coal matrix as a result of hydrostatic pressures as well as stored in the
cleats. Clearly, methane occurrence increases with coal rank and coal seam depth. As
depicted on Figure 5, methane desorbs from the micro-porous structure when hydrostatic
pressures decrease as result of mining or draining. It then diffuses across the matrix and
flows through cleats (USEPA, 2009).
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Figure 5: CBM retention and migration across a coal seam (Al-Jubori et al, 2009).
2. CBM drainage
CBM, which is a valuable resource, typically gets released during coal extraction. In
addition of the lost value and its impact on global warming, methane is an explosive gas in
the range of 5% to 15% in the air. In the US, methane concentrations in the mine cannot
exceed 1% in mine working areas and 2% in all other locations (USEPA, 2005). Clearly,
CBM has a direct impact on mine productivity and safety, and has to be drained.
CBM drainage has been traditionally performed using a well-designed ventilation
system, which would ensure a sufficient level of fresh air throughout the mine to dilute the
methane to meet safety requirements. Often, in very gassy mines, a CBM degasification
system is used to complement a scaled-down ventilation system. In this case, there are
numerous CBM drainage methods, which could be implemented before and/or during
mining activities. The choice of a method as well as the drainage timing would typically
depend on the mining approach, the coal seam properties, the methane volume to recover
and its intended use (USEPA, 2005). The following section introduces the four most
understood and implemented degasification methods in the US (USEPA, 1999).
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1. Vertical wells
A “vertical well” refers to a well drilled through one or multiple coal seam layers, as
seen on Figure 6, ahead of mining operations to pre-drain the methane from the coal seam
and surrounding strata. Such wells are typically operated 2 to 7 years before mining starts
and require the stimulation of the coal seam to activate the flow of methane. Hydraulic
fracturing and open-hole cavity, depicted on Figure 7, are typical completion methods; they
aim at reducing the hydrostatic pressures and enhance permeability to allow a proper
desorption and flow of methane gas.
The volume of recovered methane from vertical wells will depend on site-specific
conditions as well as the number of years the wells are drilled ahead of mining. Generally
speaking, such method allows a recovery of up to 70% with wells drilled 10 years in
advance. Most importantly, since the recovered methane is not contaminated by ventilation
air from mine working areas, this method allows the recovery of nearly pure methane
(>950Btu/cf), which is suitable for pipeline injection without further upgrade (USEPA,
2005).
Figure 6: Vertical pre-mining wells degasification method (USEPA, 1999).
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Figure 7: Methane flow stimulation techniques (USEPA, 1999).
2. Gob wells
A “gob well” refers to a well whose purpose it to recover the methane from the gob
areas of a mine after coal has been extracted and the overlying strata caved. As depicted
on Figure 8, such well is typically drilled 3 to 15 m above the target coal seam prior to
mining. As mining advances, the surrounding methane-charged strata start to fracture
allowing the methane to flow through the gob well up to surface. Hence, such method
drains the methane during mining operations.
Depending on geological conditions and the number of wells, gob wells allow the
recovery of up to 50% of methane emissions. Recovered methane is of lower quality since
contaminated with mine air (300 to 950 Btu/scf) and can be used either for power
generation or pipeline injection after being upgraded (USEPA, 2005).
In comparison with vertical wells, gob wells face many challenges including the lack of
consistently high gas content, short production life and application to overlying strata only.
However, they appear to be the most effective method to reduce methane content in
rapidly moving longwall faces, contributing to mine safety and productivity (USEPA, 1999).
Generally speaking, vertical wells and gob wells are very popular in the US.
15
Figure 8: Vertical gob wells degasification method (USEPA, 1999).
3. Horizontal boreholes
A “horizontal borehole” refers to a hole drilled horizontally through the coal seam from
the development entries of the mine, as opposed to from surface, as shown on Figure 9
and Figure 10. Such boreholes, which are typically about 200 m long and drilled shortly
before mining, aim at draining methane from the unmined areas to reduce the flow of gas
as mining progresses.
Clearly, this is a short-term methane drainage method that can recover only up to 20%
of methane emissions. However, the recovered methane is nearly pure (>950 Btu/scf) and
can be directly injected into pipelines (USEPA, 2005).
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Figure 9: Vertical gob wells and horizontal boreholes methods (USEPA, 2005).
4. Cross-measure boreholes
A “cross-measure borehole” refers to a hole drilled at an angle to the coal seam from
existing mine development entries. As depicted on Figure 10, such holes play a similar role
to horizontal boreholes in that they aim at draining shortly before mining takes place.
Cross-measure boreholes can be used in complement to horizontal boreholes as they
allow the drainage of overlying and underlying strata, while horizontal boreholes drain the
target coal seam exclusively.
Similarly to horizontal boreholes, cross-measure boreholes allow the recovery of up to
20% of methane emissions at a nearly pure level, making it suitable for pipeline injection.
Cross-measure boreholes are mainly used in Eastern Europe and are still under
experimental use in the US, where vertical wells easily drilled from surface proved to be
economically viable (USEPA, 1999).
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Figure 10: Horizontal and cross-measure boreholes methods (USEPA, 2005).
3. Benefits associated with CBM drainage
1. Mining economic benefits
Safety is more than a priority in mining; it is a value. CBM drainage implies a full
understanding and control of the occurrence of CBM within an underground coal mine.
Hence, CBM drainage undeniably contributes towards a safer mining environment.
CBM drainage results in numerous additional mining economic benefits, more or less
quantifiable, but all crucial for the viability of a coal mine. A primary objective of CBM
drainage consists in enhancing coal productivity by avoiding repeated slowdowns and
downtimes. Such benefit is very valuable in an extremely competitive mining industry
considering the value of coal that comes off an average longwall operation is about
100,000 to 200,000 $ per shift. Second, CBM drainage leads to ventilation power costs
savings since the ventilation system has less methane to handle. Savings would depend
on the quantity of air saved, electrical power costs, mining and ventilation plans; situations
were encountered whereby a well-designed ventilation system allowed a reduction by half
18
of ventilation requirements. Indirectly, reduced ventilation requirements result in less mine
developments, hence additional savings, as well as a greater access to coal reserves,
hence additional productivity (USEPA, 2009).
Finally, last but not least nowadays, CBM drainage has a positive environmental
impact. Considering methane is major greenhouse gas, 20 times more effective in trapping
heat than CO2, its capture can seriously help preventing global climate change.
2. Methane utilization options
CBM is a valuable energy resource, which once recovered, can find multiples product
uses that could further enhance mine productivity. Methane utilization options vary
depending on several factors including the project location, methane quality, pipeline
availability, mine electricity demand and electrical power cost (USEPA, 2005).
First, high quality, 90% pure, methane (>950 Btu/scf) can be directly injected in a
natural gas pipeline. This option requires the proximity of a pipeline network and is
interesting enough given a high natural gas price that could generate profits despite the
costs of production, processing, compression and transportation. Otherwise, the mine
could use this methane to generate power on-site and/or as a fuel to mine vehicles.
Then, medium quality methane (300 to 950 Btu/scf) can still be injected in a natural gas
pipeline but requires either gas enrichment or maintenance of the pipeline (USEPA, 2005).
The pipeline injection option is preferred when methane is in the upper boundary of the
heat content range. When the gas quality is closer to the lower boundary, methane can be
used either for power generation or a substitute for other fuels for local use at the mine
where natural gas, fuel oil or coal would be normally used.
Finally, low quality methane (<300 Btu/scf) does not typically require the
implementation of a degasification system since the concentration of methane is usually
below 1%. In this case, methane is released to the atmosphere via the ventilation exhaust
system. While this methane cannot be used as a primary energy source, ventilation air
methane can be used either as combustion air (internal combustion engine, turbine, coal-
fired power plant) or oxidized to produce heat (USEPA, 1999).
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4. Cost of implementation
The economic viability of a CBM drainage system is based upon the capital costs of
installing the system as well as the operating costs of maintaining and developing it.
Nowadays, with the increasing implementation of CBM drainage, sufficient data have been
compiled to reasonably estimate the costs of implementing such system, as detailed in
Table 1. The technique and associated costs are well-understood.
Table 1: Range of cost estimates for different CBM drainage methods (USEPA, 1999).
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Overall, a CBM drainage system is made up of two components: CBM drainage and CBM
gathering / delivery (USEPA, 2011). On the one hand, CBM drainage includes the gas
wells as well as wellhead blowers used to boost gas flow. Some wells are drilled at the
start of the projects and accounted for as capital costs, others are drilled every year as
mining progresses and considered to be operating costs. Wellhead blowers are simply
moved from well to well. On the other hand, CBM gathering and delivery includes all piping,
valves and meters necessary to transport the gas from the wellhead blower to its use point
through a compressor. Such components get installed as mining progresses; hence, they
are treated as operating costs.
4. FINANCIAL VALUATION OF MINING PROJECTS
1. Discounted cash flow valuation
The economic viability of a mining project has been traditionally assessed with the help
of a discounted cash flow valuation, whereby the value of a project is simply the net
present value of the unlevered free cash flows this project is expected to generate over its
life, discounted at an appropriate rate of return. A DCF valuation is based on the principle
that money received tomorrow is worth less than the same amount of money received
today and the NPV reflects the amount, timing and somehow uncertainty of future cash
flows. Hence, this valuation method is only applicable from the development stage onward
where there exist reliable technical and financial data to estimate future cash flows from
production estimates (Buchanan, 2012).
The DCF valuation is subject to five key value drivers (Baurens, 2010), which fall under
three main headings:
Revenues
Production rate: mining aims at extracting, separating and marketing a natural resource.
Clearly, this is the fundamental asset and the greater the production rate, the greater the
amount of money that can be made out of it, given market conditions, and the greater the
project value. The production depends on numerous factors including the very important
mining and processing recoveries.
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Commodity price: once the valuable resource has been extracted, the greater its unit price,
the greater the amount of money that can be made out of it. In fact, commodity price is the
key driver behind mining. It is because resources are sought after and have a high enough
value that mining companies explore for deposits and mine them. Commodity price is
beyond the control of a mining company and is subject to a great deal of uncertainty.
Hence, it requires a careful analysis of future supply and demand to produce the most
accurate long-term forecast to be used in the DCF.
Costs
Capital costs: capital costs are costs in a particular year, typically at the start of the project,
which will produce benefits in future years. They typically account for the costs of building
the mine and the plant (including the purchase of equipments).
Operating costs: operating costs are those costs that produce benefits only in the year in
which they are incurred. They account for the costs of operating the mine (extracting and
separating the valuable resource) and include fixed costs (overheads) and variable costs
(cost per tonne of commodity).
Risk
Discount rate: this is the rate used to discount expected future cash flows to produce the
NPV. It is the key parameter underlying the time-value of money principle and could
significantly impact the value of a project depending on its life. It requires careful
considerations and is usually determined in two ways:
Pre-determined discount (hurdle) rate appropriate for this project based on market
expectations given specific company, industry and country risk premiums.
Weighted average cost of capital (WACC), which is a function of the funding structure
ratio and the relative cost of financing using debt and equity. It is determined as follows
(Baurens, 2010):
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WACC = %Equity x Cost of Equity + %Debt x Cost of Debt
Where,
Cost of Equity = rf + β ( rm – rf )
Cost of Debt = Interest rate x ( 1 – Tax rate )
Given all mining and financial factors were reliably estimated, the DCF valuation
involves the calculation of a NPV, determined as follows (Buchanan, 2012):
NPV = C0 + C1 / (1+i) + C2 / (1+i)2 + … + Cn / (1+i)n
Where,
Cn = Net cash flow at year n
i = Project discount rate
Basically speaking, based on a simple DCF valuation, a project can only be accepted if the
NPV is positive, which means that expected future positive cash flows generated
commodity sales are high enough to justify the costs of extracting that commodity.
2. Real option valuation
The economic viability of a mining project has been traditionally assessed via DCF
valuation, whereby the net present value of a project is the value a company would earn if
the project were accepted. Logically, positive NPV projects are accepted whereas negative
and marginal NPV projects are rejected. Clearly, DCF valuation neglects the value of
embedded managerial and operational options, which underestimates the value of a
project and could result in rejecting marginal projects that are in fact attractive (McKnight,
2000).
Financially speaking, a call (put) option gives its holder to right, but not the obligation,
to buy (sell) a specific asset, at a pre-specified strike price at or before a pre-determined
23
expiration date (Damodaran, 2005). As depicted on Figure 11, the holder of a call option
would only be in-the-money and exercise if the value of the underlying asset exceeds the
strike price, whereas the holder of a put option would not exercise if the value of the
underlying asset is less than the strike price. In both cases, the option has a price and the
price of the underlying has to increase or decrease enough to recover this cost before
making profits.
Figure 11: Long Call and Put positions net payoff profiles.
The value of an option depends on five key parameters related to the underlying asset
and market conditions (Damodaran, 2005):
Value of underlying asset (V): an option is a derivative; it derives its value from the
value of an underlying asset. An increase in value of the underlying would increase
the value of a call, whereas a decrease in value of the underlying would increase the
value of a put.
Price of underlying asset Strike price
Call Net Payoff Profile Put Net Payoff Profile
24
Strike price (K): by definition, the strike price is the price paid to buy or sell the
asset. The lower the strike price, the more chances a call has to end-up in-the-
money and the higher its value. Similarly, the higher the strike price, the more
chance a put has to end up in-the-money and the higher its value.
Volatility of the underlying asset (σ): a significant movement in the value of the
underlying asset increases the chances of being in-the-money. The option holder
cannot lose more than the price of the option; hence, the variability in the value of
the underlying asset is very sought after and increases the value of both call and put
options.
Time to expiration (T): the exercise period it that period during which the option
holder has right to buy or sell. The longer this period, the more chances the
underlying asset is given to change in value and the greater the value of both call
and put options. A European option can only be exercised at maturity, while an
American can before or at maturity.
Risk-free interest rate (r): the buyer of an option pays a price upfront to acquire it;
this is an opportunity cost accounted for through the riskless interest rate. Also, as
explained below, the present value of the strike price enters in the valuation of an
option. It increases the value of a call and decreases the value of a put
In 1973, Black and Scholes introduced a unique and path-breaking model for valuing
options. The model is based upon a replication of the option returns with a portfolio made
up of the underlying asset (shares typically) and a risk-free asset (bonds typically). Two key
and bright ideas were followed in setting up and solving the model (Schwartz & Trigeorgis,
2004):
The option can be priced by arbitrage. Since both the option and the replicating
portfolio have the same payoff, they must have the same price; otherwise, one could
buy the cheap alternative and sell the expensive one.
25
The option can be price in a risk-neutral framework. Since the option derives its
value from an underlying asset and can be replicated, it has the same value in risk-
neutral and real worlds. In this case, the relevant discount rate is the risk-free rate,
which is easily determinable.
A call option can be valued using the Black and Scholes model according to the following
equation:
C = V * N(d1) – K * e – r * T * N(d2)
Where,
d1 = [ ln ( V / K ) + ( r + σ2 / 2 ) * T ] / [ σ * √(T) ]
d2 = d1 – σ * √(T)
And,
e = exponential function
ln = natural logarithmic function
N(x) = standard normal distribution function
The model applies only to European options and assumes markets are efficient, interest
rates remain constant and are known, asset returns are lognormally distributed and the
volatility of these returns are constant (McKnight, 2000).
“Real options” is a term used to describe those options that occur in the “real” business
world. An undeveloped mining project can be viewed as a real option in that it derives most
of its value from the price of the underlying commodity, which is variable, and carries a
valuable flexibility in determining when to start development. Clearly, this flexibility has a
positive value that can only enhance the NPV of a project. Such option is comparable to a
call option in that the underlying asset is the project itself and according to the following
analogies (Baurens, 2010):
26
Value of underlying asset (V): present value of operating cash flows expected to be
generated from developing the project, not including capital investments. This
parameter can be determined from a DCF valuation of the project
Strike price (K): present value of development cost; i.e., the cost of developing
(exercising) the project (option). This parameter can be determined from a DCF
valuation of the project. It is assumed this cost remains constant and the project
uncertainty gets reflected in operating cash flows.
Volatility of the underlying asset (σ): volatility of production cash flows, which results
from the variability of the commodity price, which is the key value driver behind a
mining operation.
Time to expiration (T): time period at the end of which (European option)
development can start (the option can be exercised).
Risk-free interest rate (r): risk-free rate corresponding to the option expiring date.
The Real option valuation yields an enhanced NPV (ENPV) value, which is certainly
greater than the NPV obtained from DCF valuation since the option value can only be
positive because of the inherent valuable flexibility. In addition, providing a better estimate
of the true value of an asset, ROV can support management team in making strategic
decisions as complementary tool to the conventional DCF valuation.
5. STUDY BACKGROUND AND METHODOLOGY
1. Problem statement
Given CBM drainage has to be implemented, this study aims at valuing the flexibility a
coal mine has in determining whether to start CBM drainage earlier and delay coal mining,
in the expectation of better coal prices, to maximize value creation. As depicted on Figure
12, on the one hand, a base case analysis will be performed, whereby mine development
and CBM drainage start at the same time in year 1. On the other hand, three options will be
27
explored, whereby CBM drainage would still start in year 1 but mine development gets
delayed by 1, 2 or 3 years.
1 2 3 4 5 6 7 8 9 years
Production
Drainage + Development Prod1 Prod2 Prod3
Drainage Dev1 Dev2 Dev3
Figure 12: Overview of the base case analysis and three delay options.
There are three windows to the study: a DCF valuation, a real-option valuation and a
qualitative discussion. First, DCF valuation of the base case and the three delay options
aims at assessing the lost value in delaying coal production by 1, 2 or 3 years. Second,
DCF data together with other financial parameters are used as an input to the real-option
valuation to assess the option value in delaying coal production by 1, 2 or 3 years. Here, it
is important to point out that the impact of earlier (1 to 3 years) CBM drainage on
ventilation power cost savings is neglected since most of the savings are already realized
28
implementing CBM drainage in parallel with a ventilation system. Furthermore, the CBM
model used to estimate drainage costs assumes the use of vertical gob wells; these are
normally used when drainage is performed while mining whereas vertical wells are used for
pre-mining drainage (delay options). Previous Table 1 shows that capital and operating
costs are almost identical for both methods; CBM drainage base case cost estimates can
then be reliably used to value the delay options. Finally, the study neglects any methane
utilization, which would improve mine economics but are negligible compared to revenues
generated from coal production. Hence, a range of potential methane uses will be
discussed with the respective benefits and barriers.
2. Technical background
The study relates to two technical windows: coal mining and processing as well as
CBM drainage.
COAL MINING AND PROCESSING
A hypothetical coal mining project was made up from collected data (USEPA, 1999) as
well as assumptions based on typical coal mining design parameters. It is assumed the
project involves mining a coal deposit that would yield two products, A and B at a 70:30
proportion, with significant CBM volumes to justify CBM drainage. The characteristics of
the deposit considered for the purpose of the study are presented in Table 2.
Table 2: Hypothetical thermal coal deposit characteristics.
Coal seam depth 400 m
Coal seam length 6600 m
Coal seam width 4200 m
Coal seam thickness 1.83 m
Average coal density 1322 kg/m3
In-situ Coal tonnage 68 482 260 t
29
While Product A is the main commodity, it is assumed to be less valuable than Product B;
respective spot prices as of the start of the project, in September 2007, are assumed to be
equal to 73.33$/dmt and 120$/dmt.
Two main mining approaches are typically considered for underground coal mining:
room-and-pillar and longwall, as previously descrived. Here, it is assumed the deposit
would be mined following an underground longwall mining approach using three
continuous miners and a longwall in a systematic manner (USEPA, 1999). Then, it is
assumed an off-take agreement would be established to process mined-out coal.
Considering Product A is the main one, coal preparation would be done in a plant
optimized for the extraction of Product A, keeping the 70:30 proportion, while Product B is
extracted as a separate by-product stream. Volumetric relationships are of critical
importance in the context of coal mining. Mining dilution and recovery, coal moisture
content and wash recovery are key factors that should carefully be optimized since they
determine the mined-out coal quality and subsequent revenues and costs. Following Table
3 summarizes coal mining and processing parameters; Appendix 1 provides more detailed
information.
Table 3: Coal mining and processing parameters.
Mining recovery 90 %
Mining dilution 5 %
Total diluted Coal mined 64 715 735 t
Coal Production rate 2 640 000 t/year
Diluted product A yield 66,67 %
Diluted product B yield 28,57 %
Product A wash recovery 90 %
Product B wash recovery 50 %
Mining OPEX 15,25 $/t
Transportation OPEX 2 $/t
Product A Processing OPEX 5 $/t
Product B Processing OPEX 10 $/t
Mine CAPEX 44 000 000 $
Pre-production period 2 years
Ramp up period 2 years
Production period 26 years
30
Practical yield optimization was performed to keep the 70:30 proportion based on Product
A and B respective wash recovery, processing cost and commodity price. It was found that
Product B price should remain above 105$/dmt for it to be produced as a separate stream.
Otherwise, only Product A would be produced, while B would go to waste.
CBM DRAINAGE
CBM drainage implementation typically aims at reducing ventilation power costs by
lowering mine ventilation requirements. Studies show that CBM drainage can only be
implemented economically if CBM emissions exceed 11m3/t (USEPA, 1999). For the
purpose of this analysis, it is assumed methane emissions equal 17m3/t. Given the proper
studies, such CBM emissions allow the mine to implement CBM drainage to improve
mining economics. Following Table 4 summarizes CBM occurrence and drainage
parameters; the complete model output is presented in Appendix 2.
Table 4: CBM occurrence and drainage parameters.
Methane content 17 m3/t
Methane recovery 60 %
Methane drained 2.76 mcf/day
CBM drainage OPEX 2 175 000 $/year
CBM drainage CAPEX 883 000 $
Pre-production period 1 years
Production period 19 years
A range of CBM drainage techniques and designs could be implemented and would
require careful analysis. For the purpose of the study, a cash-flow model developed by the
USEPA, which aims at evaluating the potential economic feasibility of recovering and using
CBM, will be used (USEPA, 2011). Given assumptions about the cost and productivity of
CBM drainage, gathering and delivery components and provided coal mining and methane
drainage inputs, the model generates a cash flow analysis of the CBM drainage system.
The model assumes vertical gob wells, drilled from surface, are used to recover gob gas
methane. Since this study focuses on the stream of revenues generated from coal
31
production, neglecting methane utilization, the most-basic methane end-use scenario was
selected, which is methane enclosed flaring. The only revenues generated from flaring
methane come from carbon credits, which are negligible in comparison to coal production
revenues.
3. Financial background
In addition to the technical background, the study requires the consideration of financial
parameters: commodity price, taxation and discount rate.
COMMODITY PRICE AND VOLATILITY
Two key value drivers in the context of DCF and RO valuations are commodity price
and volatility. As depicted on Figure 13, a retrospective and hypothetical view on the coal
market was considered for the purpose of the study since the market was very volatile
during past few years, which brings more interest to the delay option valuation.
Figure 13: Five-years trend of Product A coal prices (Index Mundi, 2012).
1
2
3
32
As a reminder, the deposit is expected to yield two products, A and B, at a 70:30
proportion. As of September 2007, start of the project, Product A and B spot prices are
assumed to be respectively equal to 73.33$/dmt and 120$/dmt. Furthermore, it is assumed
Product B is sold at a long-term constant contract price, while Product A is sold at spot
price. Hence, Figure 13 depicts the hypothetical five-year trend of Product A spot price.
Product A price volatility is the key option value driver; 1, 2 and 3 years windows are
considered in turn for the three delay options.
Monthly product A prices were collected over 1, 2 and 3 years and used to determine
Product A historical price volatility over these respective periods according to the following
procedure:
1. Determine monthly price movement
Rm = Pt / Pt-1
Where,
Pt = Commodity price at month t
Pt -1 = Commodity price at month t-1
Rm = Monthly price movement
2. Calculate the average monthly price movement over 1, 2 and 3 years respectively
RT = Σ ( Rm ) / n
Where,
n = Number of months within the period T considered
RT = Average monthly price movement over the period T considered
3. Determine how far monthly price movements vary from the average
σ = √ [ Σ ( Rm - RT) 2 / (n-1) ]
33
Table 5 summarizes Product A price volatility over 1, 2 and 3 years.
Table 5: 1, 2 and 3 years Product A price volatility.
Product A monthly price volatility ($/dmt) Product A monthly price volatility (%)
1 year 38.94 14.69
2 years 37.94 14.59
3 years 32.01 12.48
As seen and expected, volatility decreases as the delay period increases. Indeed, the
greater the time period, the more averaged and the less volatile values become. This can
easily be observed on previous Figure 13, whereby the year 1 price increase gets canceled
in year 2 before increasing again in year 3.
TAXATION
Taxation is an inevitable and critical part of a mining project, which varies depending
on the project location and has a strong impact on the project value. In this case, it was
arbitrarily assumed a royalty rate of 5% is applied to revenues before taxing the operating
margin at 30% and ignoring depreciation allowances.
DISCOUNT RATE
It is assumed the project is entirely equity funded; hence, there is no need to calculate
a WACC. A hurdle rate can be established to reflect expected returns given risks
surrounding the project. An arbitrary and typical discount rate of 12% was set here.
6. RESULTS AND DISCUSSION
1. Quantitative analysis
1. DCF valuation
34
DCF valuations of the base case and three delay options were completed in order to
assess the lost value in delaying the start of coal extraction activities. Indeed, given CBM
drainage starts at year 1 whatever the option, there is a lost value in delaying coal
extraction activities since revenues are brought forward and get more heavily discounted.
Table 6 summarizes the steps followed in calculating yearly cash flows and subsequent
Table 7 shows the first five years of the base-case DCF valuation. As seen, the project is
viable with a NPV equal to 306M$.
Table 6: Yearly cash flow calculation procedure for DCF valuation.
Product A revenues = Diluted coal production x Diluted A yield x A wash recovery x A price
+ Revenues
Product B revenues = Diluted coal production x Diluted B yield x B wash recovery x B price
- Royalty Total revenues x Royalty rate
Mining OPEX = Mining cost x Diluted coal production
+
CBM drainage OPEX
+
Transportation OPEX = Transportation cost x Diluted wet coal production
+
Product A Processing OPEX = Diluted wet product A mined x A processing cost
+
- Opex
Product A Processing OPEX = Diluted wet product B mined x B processing cost
Mine CAPEX
+ - Capex
CBM drainage CAPEX
- Tax Tax rate x (Revenues – Royalty – Opex)
= Annual cash-flow
35
Table 7: Base-case DCF valuation.
Year 1 2 3 4 5
Diluted minable Coal (t) 64 715 736 64 715 736 64 715 736 63 395 736 61 415 736
% Capacity mined 0% 0% 50% 75% 100% Diluted Coal production (t) - - 1 320 000 1 980 000 2 640 000
Diluted wet coal production (t) - - 1 386 000 2 079 000 2 772 000
Diluted product A mined (t) - - 880 000 1 320 000 1 760 000 Diluted wet product A mined (t) - - 924 000 1 386 000 1 848 000
Product A recovered (t) - - 792 000 1 188 000 1 584 000 Product A revenues ($) - - 58 077 360 87 116 040 116 154 720
Diluted product B mined (t) - - 377 143 565 714 754 286
Diluted wet product B mined (t) - - 396 000 594 000 792 000 Product B recovered (t) - - 188 571 282 857 377 143 Product B revenues ($) - - 22 628 571 33 942 857 45 257 143
Total revenues ($) - - 80 705 931 121 058 897 161 411 863
Royalty ($) - - 4 035 297 6 052 945 8 070 593
Mining OPEX ($) - - 21 136 500 31 704 750 42 273 000
Drainage OPEX ($) - 2 175 000 2 175 000 2 175 000 2 175 000 Transportation OPEX ($) - - 2 772 000 4 158 000 5 544 000
Product A Processing OPEX - - 4 620 000 6 930 000 9 240 000 Product B Processing OPEX - - 3 960 000 5 940 000 7 920 000
Total OPEX ($) - 2 175 000 34 663 500 50 907 750 67 152 000
Operating margin ($) - (2 175 000) 42 007 135 64 098 202 86 189 270
Mining CAPEX ($) 22 000 000 22 000 000 - - - Drainage CAPEX ($) 883 000 - - - -
Total CAPEX 22 883 000 22 000 000 - - -
Tax ($) - - 12 602 140 19 229 461 25 856 781
Cash Flow ($) (22 883 000) (24 175 000) 29 404 994 44 868 742 60 332 489 Discount factor 0.89 0.80 0.71 0.64 0.57
PV Cash Flow ($) (20 431 250) (19 272 162) 20 929 894 28 514 896 34 234 274
NPV ($) 306 303 320
As shown in Table 8, after splitting it up, there are three main components to the DCF
valuation for the purpose of study: the present value of drainage costs, mine developments
costs and production cash flows. First, the present value of drainage costs is found
discounting annual CBM drainage costs, capital and operating, which are spread over 20
36
years, to year 1. This value remains the same whatever the delay option since it is
assumed CBM drainage starts at year 1 whatever the option. Second, the present value of
mine development costs is found discounting mine development costs, which are spread
over 2 years, to year 1. This value is expected to decrease as the delay increases since
coal mining is delayed and cash flows get more heavily discounted. Finally, the present
value of production cash flows is found discounting mine production cash flows, excluding
drainage costs, which are spread over 26 years once development is completed, to year 1.
This value is expected to decrease as the delay increases since coal mining is delayed and
cash flows get more heavily discounted. As the delay period increases, the NPV
decreases; the lost value in delaying is found as the difference between the base-case
NPV and the delay option NPV.
Table 8: Summary of DCF valuation results.
PV Drainage costs ($) 16 212 548 $
PV Mining CAPEX 37 181 122 $
PV Production CF ($) 359 696 990 $ Base case
NPV ($) 306 303 320 $
NPV_1 ($) 271 748 048 $ 1 year delay
LV_1 ($) 34 555 272 $
NPV_2 ($) 240 895 127 $ 2 years delay
LV_2 ($) 65 408 193 $
NPV_3 ($) 213 347 876 $ 3 years delay
LV_3 ($) 92 955 443 $
One could notice the NPV decreases as the delay period increases as a result of the
time value of money effect. Hence, as expected, there is a lost value in delaying coal
mining by 1, 2 or 3 years, which increases with the delay period. The lost value is
significant, reaching almost one third of the overall project value after only 3 years delay.
Clearly, economically speaking, only a couple of years delay could be potentially explored.
37
2. Sensitivity Analysis
A DCF valuation is a static valuation approach whereby technical and financial
parameters are estimated over the long-term in order to assess the expected return on the
project. The estimation of complex and partly unpredictable parameters such as commodity
price, costs and recoveries would clearly rely on sound economic / technical studies and
empirical results as well as subjective judgments. Clearly, such analysis would ignore
economic uncertainty, which is the “uncertainty of financial outcomes as a result of the
uncertainty of the estimates” (Bilodeau, 2009).
A sensitivity analysis is performed to assess the how sensitive project returns and
investment decision criteria are to critical project parameters. In fact, key technical and
financial parameters are individually varied over a range that reflects the margin of error,
which in turn affects the NPV of the project. A sensitivity analysis results in a spider
diagram, which plots absolute changes of the profitability of a project against relative
changes in project parameters.
As a complementary tool to the DCF valuation, an analysis was performed to assess
how sensitive the project NPV is to a selection of key parameters, which resulted in the
spider diagram presented in Figure 14. Six parameters were varied over a +/- 30 $ range:
mine CAPEX, average mining OPEX, average processing OPEX, overall wash recovery,
product A yield and product A. All these parameters are key value drivers in that they
impact either on revenues or costs. Note that only product A was considered here since it
is the main commodity. On the one hand, increase in Product A yield and/or price lead to
an increase of the NPV. This result makes sense since the yield determines the quantity of
available Product A (the valuable resource) and the price its value. First, even though less
of Product A implies more of Product B, the plant was optimized to extract Product A and
too much of Product would not add much value since half of it would end up in wastes.
Second, the impact of Product A price on the NPV is very strong; a 10% increase in
Product A price would result in a 15% increase in value. Obviously, commodity price is the
key factor behind mining (a certain product is mined because is a valuable as result of
supply and demand) and the main value driver. On the other hand, increase in mine
CAPEX and/or mining OPEX lead to a decrease of the NPV. This result makes sense since
both factors are costs, which decrease revenues and the resulting NPV. Clearly, OPEX are
expected to have a stronger impact on the NPV since they are directly applied against
38
revenues and on a repetitive basis over the whole project life. Mine CAPEX probably don’t
impact much the NPV since they are low compared to generated revenues and only
applied over the first two years; mine CAPEX may also be underestimated in this case.
Furthermore, it is important to point out that the study ignored the economies of scale
effect, whereby CAPEX and OPEX vary inversely. An increase in CAPEX typically aims at
maximizing mine capacity, which in turn minimizes OPEX. Finally, it is interesting to notice
that the overall wash recovery does not impact the NPV. This result is somehow surprising
since an increase in recovery implies a greater amount of valuable product, which is
expected to increase the NPV. However, one should remember this is the overall recovery,
which was optimized to extract Product A and B in a certain proportion to maximize value.
Figure 14: Project sensitivity analysis.
39
Such sensitivity analysis appears to be a very useful and relevant tool for decision-making
at a design and operational level. Indeed, it helps management in determining the key
technical and financial factors, which have greater impact on the NPV and should be
carefully monitored to meet project expectations.
3. Monte Carlo simulations and risk analysis
As previously described, a DCF valuation requires the use of long-term estimates of
technical and financial parameters. In the absence of uncertainty, such approach is a
realistic, relevant and accurate one for project evaluation. In fact, mining projects are
surrounded by a great amount of operational and financial uncertainly, which introduces
risk and complicates the forecast of parameters (Zare et al., 2008).
While sensitivity analysis reflects the economic uncertainty of a project, it does not
assess the economic risk of the project. Indeed, it does not consider the probabilities
associated with the occurrence of the possible values of each parameter. A risk analysis
accounts for these probability and helps assessing the economic risk, which is the “
possibility of financial loss due to the possible occurrence of undesirable outcomes”
(Bilodeau, 2009). It is a probabilistic approach to financial valuation, in opposition to
deterministic valuation, which translates uncertainties associated with project parameter
estimates (estimated as probability distributions) into a probability distribution of profitability
measures (NPV and IRR). In fact, a risk analysis involves simulating new models.
Simulation is a powerful analytical tool that could be used to simulate the variability of key
technical and financial parameters, with respect to a base-case model, and assess the
corresponding impact on project profitability.
The analysis involves assigning a distribution to each of the sensitive parameters, with
corresponding most-likely value and standard deviation, and combining them to determine
the probability distribution of profitability measures. As depicted on following Figure 15, in
opposition to a DCF valuation and corresponding sensitivity analysis, which focus on a
mean (estimate) along with its margin of error, the risk analysis determines the most-likely
value associated with a standard deviation.
40
Figure 15: Risk vs. combined DCF and Sensitivity analysis (Bilodeau, 2009).
There are two techniques that could be used in performing a risk analysis (Bilodeau, 2009).
On the one hand, the analytical technique is an exact and numerical approach, which only
requires the mean and standard deviation of each of the variables in order to combine
them and determine the mean and standard deviation of profitability measures. As shown
on Figure 16, this approach requires all variable to have the same distribution. Also, If the
parameters are not independent, the covariance of the two variables must be subtracted
from the sum of the variances.
Figure 16: Analytical approach to risk analysis (Bilodeau, 2009).
On the other hand, the combinatorial technique is a simple approach that assumes the
interdependency of the different variables, assigns a distribution to each and combines
them to produce a distribution of the profitability measures with corresponding probabilities.
As depicted on Figure 17, this approach is simple in that it doesn’t require all variables to
have the same distribution and results directly in a distribution of the profitability measures
41
with corresponding probabilities. Input variables are randomly sampled, a large number of
times, and combined to produce probability distributions of the profitability measures. This
second approach is the most widely used, in the form of Monte Carlo simulations.
Figure 17: Combinatorial approach to risk analysis (Bilodeau, 2009).
Monte Carlo simulations of the most sensitive parameters were performed here, using
the Crystall Ball add-in to Excel, and subsequently used as assumptions to simulate their
impact on project profitability. Results are summarized in Table 9 below.
Table 9: Monte Carlo simulations results.
Mean Standard deviation 1 year Product A price 73.33 $/t 38.94 $/t 53 % 2 years Product A price 73.33 $/t 37.94 $/t 51 % 3 years Product A price 73.33 $/t 32.01 $/t 44 %
Mine Capex 40 000 000 $ 4 000 000 $ 10 % Average mining Opex 15.25 $ 1.53 $ 10 %
1 year PV Production CF 359 683 373 $ 235 196 115 $ 65 % 2 years PV Production CF 359 683 373 $ 230 381 491 $ 64 % 3 years PV Production CF 359 683 373 $ 192 752 689 $ 54 %
NPV 306 488 275 $ 236 431 322 $ 77 %
42
First, Product A commodity price variability was considered since it is the main DCF and
RO value driver. Lognormal distribution appears to be the best to model commodity price
since those cannot take negative values. Hence, as depicted on Figure 18, which is the 1-
year Product A price probability distribution, base case Product A price (73.33$/t) was set
as mean while the standard deviation was set equal to the 1 Product A price volatility, as
previously determined. Similarly, 2 and 3 years Product A price probability distributions
were simulated. As seen in previous Table 9 and expected, the greater the period
considered (1, 2 or 3 years), the smaller the Product A price volatility.
Figure 18: 1-year Product A price probability distribution.
Then, cost variability was also considered as unexpected variability or bad estimates could
have a significant impact on project viability. It was assumed both capital and operating
expenditures follow a normal distribution with 10% volatility. Only mine capital expenditures
and average mining costs probability distributions, respectively depicted on Figure 19 and
Figure 20, were considered since they have the greatest impact on project value. Also, as
depicted, the distribution was narrowed to -10% / +20% considering costs have a greater
probability of taking higher values than initially estimated and are unlikely to take extreme
values.
43
Figure 19: Mine Capex probability distribution.
Figure 20: Average mining Opex probability distribution.
44
In the context of RO valuation, value is driven by the volatility of the underlying asset,
which are production cash flows and whose volatility results from the volatility of the
commodity price (Product A here) mainly as well as the volatility of capital and operating
costs. Hence, commodity price and average mining Opex probability distributions were
subsequently used as input assumptions in determining how volatile production cash flows
are over 1, 2 and 3 years in turn. Following Figure 21 shows the resulting typical production
cash flows probability distribution. The distribution is the same over 1, 2 and 3 years but, as
seen in previous Table 9 and expected, the greater the period considered, the smaller the
production cash flows volatility. 1, 2 and 3 years volatilities will subsequently be used to
value the 1, 2 and 3 years delay options.
Figure 21: 1-year production cash flows probability distribution.
Finally, one of the main reasons behind Monte Carlo simulations of operational and
financial parameters is to assess the variability of the project profitability, represented by its
NPV. Similarly, commodity price, mine capex and average mining opex probability
distributions were used as input assumptions in determining how volatile the NPV is. Only
the 1-year NPV probability distribution was explored here, as depicted on Figure 22.
45
Figure 22: 1-year NPV probability distribution.
Probability distributions of operational and financial parameters as well as project
profitability are very useful in assessing the economic risk surrounding a project and
assisting management in decision-making. Indeed, for the purpose of performing a DCF
valuation, it would be more suitable to use an expected / most-likely value of each of the
parameters (determined as the average of a distribution), rather than using single-value
estimates. In addition, the expected NPV, as determined from the NPV probability
distribution, provides management with a more relevant and risk-adjusted value of the
profitability of the project. As seen in previous Table 9, the expected project NPV, which
accounts for the uncertainties surrounding operational and financial parameters, is 50M$
smaller than the NPV estimated from single-value estimates. Finally, the final NPV
probability distribution can be used to assess the probability of economic loss, which the
probabilities of getting a negative NPV (area under the curve below 0). Here, the probability
of economic is about 10%. Such analysis is critical in the context of high-risk and marginal
projects.
46
4. Option valuation
Option valuation of the three delay options was completed in order to assess the
gained value in delaying coal extraction activities. Indeed, given CBM drainage starts at
year 1 whatever the option, there is a gained value in delaying coal extraction activities
resulting from the value of flexibility management has due to the volatility of production
cash flows.
Since CBM drainage starts at year 1 whatever the option, the option value results
purely from the flexibility in delaying coal extraction activities. Hence, the strike price of the
option is equal to the cost of developing the mine, i.e. the present value of mine
development costs, and the asset value is equal to the profits made out of the mine, i.e. the
present value of production cash flows. Table 10 summarizes RO valuation results. The
NPV is equal to the project value, excluding drainage costs. The enhanced NPV accounts
for drainage costs. The option value (OV) is the difference between the ENPV of each
delay option and the base case NPV.
Table 10: Summary of option valuation results.
Asset value 359 696 990 $
Strike price 37 181 122 $
sigma 1 70 %
sigma 2 64 %
sigma 3 54 %
T1 12 months
T2 24 months
T3 36 months
Rf 5 %
NPV_1 346 685 185 $
NPV_2 354 773 483 $
NPV_3 356 822 229 $
ENPV_1 330 472 637 $
ENPV_1 338 560 935 $
ENPV_1 340 609 681 $
OV_1 24 169 317 $
OV_2 32 257 615 $
OV_3 34 306 361 $
47
As expected, the option value in delaying coal extraction activities increases with the delay
period since the strike price gets more heavily discounted, while the underlying asset is
more exposed to volatility. Interestingly, one could notice the delay gained value decreases
as the delay period increases; i.e. most of the delay gained value is earned in early years.
This is probably due to the fact the option is already in-the-money (base-case NPV is
positive) and could be exercised at any time added to the decrease in volatility as the delay
period increases. Hence, economically speaking, one could infer that it wouldn’t be
interesting to explore a greater delay period.
The economic viability of a delay option can only be assessed comparing lost vs.
gained values in delaying the start of coal extraction activities, as summarized in following
Table 11.
Table 11: Comparison of the delay lost and gained values.
Gained value ($) Lost value ($)
Option 1 24 169 317 34 555 272
Option 2 32 257 615 65 408 193
Option 3 34 306 361 92 955 443
Clearly, it would only be interesting to delay coal extraction if the delay gained value is
greater than the lost value. In such case, the company has the flexibility to, theoretically,
delay mining activities in the expectation of better market conditions. Previous results show
that, while the delay option value is quite significant and in the same order of magnitude as
the lost value, it remains smaller than the lost value resulting from a delay of coal
extraction. Hence, the company has no economic reasons to delay coal extraction by 1, 2
or 3 years. This result was expected since coal mining companies would typically create
value over the long-term and delaying the initial production cash flows, which carry most of
the NPV weight, could only have a negative economic impact.
A 1-year delay period could potentially be considered since delay and lost value are
close. One could wonder what would have made the 1-year delay option interesting; i.e.
quantitatively, what factors could have made the gained value greater than the lost value.
Given asset value and strike price come from the DCF valuation and remain constant,
volatility and time are the two key value drivers. While the option value is expected to
48
increase with both volatility and time, keeping time constant and equal to 1 year, only a
very strong volatility would eventually make the gained value greater than the lost value.
2. Qualitative analysis
There are various limitations to this quantitative analysis, which should be discussed as
they could affect the project economics as well as the decision-making process (USEPA,
2009). Indeed, added to the improved safety, pre-mining CBM drainage has several
additional benefits, which were not accounted for in this study. First, the greater the amount
of CBM drained before mining, the lower ventilation operating costs will be; this study
assumed ventilation operating costs stay the same whatever the delay period. Second, the
greater the amount of CBM drained before mining, the greater the productivity because of
less production slowdowns and downtimes; this study ignored the decrease in production
lost value as a result of pre-mining CBM drainage. Finally, pre-mining CBM drainage
reduces development costs due to lower ventilation and increases reserves, as previously
high-methane concentration areas get accessible; this study ignored the potential decrease
in development cost and increase in coal reserves.
In addition, the study ignored potential methane utilization options, which could
significantly improve the viability of the project and encourage the delay of coal extraction
by 1 or 2 years. Indeed, depending on the methane quality, extracted CBM can be either
injected in a natural gas pipeline, or used on-site for power generation or as a fuel
substitute. Incorporating methane utilization to the study would make natural gas and
electricity prices volatility additional option value drivers to coal price volatility. For instance,
a high natural volatility combined with high coal price volatility could encourage the
company in delaying coal extraction by 1 year to drain more of CBM and inject it in a
natural gas pipeline.
Finally, the study only considered coal mining and CBM drainage related factors and
ignored potential EPC issues. Indeed, mining is a capital intensive and risky business that
requires the use of huge and complex equipments that require proper design and
integration. Some of these equipments should be ordered a long time before development
period and can be very expensive due to scarcity. It could happen that the company is
offered a significant discount to wait an extra year before receiving its equipments; such
discount could affect the project economics and justify a delay of coal extraction while
49
implementing CBM drainage. Similarly, the company many not the choice but wait and
delay its operations. Performing such delay option analysis can help in assessing the
economic impact of a delay and support decision-making.
7. CONCLUSIONS
Given coal mining and associated CBM drainage activities, this study aimed at
assessing the viability of the project through a DCF valuation, sensitivity and risk analysis
as well as the flexibility management has in determining whether to delay coal extraction
through a real-option valuation. The following conclusions were reached:
CBM is a valuable resource stored within the coal seam and that gets released during
mining. It has to be drained before or during mining activities for safety and economic
reasons. CBM drainage is performed using either or a combination of a well-designed
ventilation system and degasification technologies. Combined systems are becoming
popular due to high-ventilation costs as well as the potential of recovering and using
CBM.
CBM drainage timing typically results from a static and long-term economic analysis,
whereby the focus and value-creation driver is coal extraction in association with fixed
operational and financial estimates.
Given CBM drainage always starts at year 1, there is a lost value in delaying coal
extraction by 1, 2 or 3 years. This loss in value results from the time value of money
effect as production cash flows are brought forward and get more heavily discounted.
The greater the delay period, the greater the loss in value.
DCF valuations of the base case and three delay options show the project is viable with
a NPV of 306M$ and a lost value that increases with the delay period ranging from
34M$ at 1 year delay to 92M$ at 3 years delay.
The sensitivity analysis shows the project viability, represented by its NPV, is mainly
sensitive to commodity price and yield as well as mining operating expenditures.
50
Using long-term single-value operational and financial estimates for DCF valuation
ignores the economic risk surrounding the project. Monte Carlo simulations account for
this uncertainty by assigning a probability distribution to key parameters and simulating
the impact they have on project profitability.
Monte Carlo simulations of Product A price, mine capital expenditures and average
mining operating costs were performed. These assumptions were subsequently used in
assessing the variability of production cash flows and the project NPV. It appears to be
a 10% risk of economic loss.
Given CBM drainage always starts at year 1, there is an option gained value in delaying
coal extraction by 1, 2 or 3 years. This gain in value results from the volatility of
production cash flows, which is due to the volatility of commodity prices. The greater the
delay period, the greater the gain in value since there is a greater exposure to volatility.
Option valuation of delaying the start of coal extraction by 1, 2 or 3 years shows the
gained value in delaying increases with the delay period, ranging from 24M$ at 1 year
delay to 34M$ at 3 years delay.
Economically, it can only be profitable to delay coal extraction by 1, 2 or 3 years if the
value gained in delaying is greater than the value lost. While the delay option value is
quite significant and in the same order of magnitude as the lost value, it remains
smaller. Hence, the company has no economic justification to delay coal extraction by
1, 2 or 3 years.
This result was expected since coal mining companies would typically create value over
the long-term and delaying the initial production cash flows, which carry most of the
NPV weight, could only have a negative economic impact. 1-year gained and lost
values are close and a 1-year delay could potentially economically be considered given
production cash flows are subject to a very strong volatility.
51
Pre-mining CBM drainage results in several mining economic benefits, which were
ignored in this study. Lower ventilation costs, lower development cost and a greater
productivity are few of the factors resulting from pre-mining CBM drainage and that
could the project economics as well as affect the decision-making process.
Methane utilization was neglected and offers plenty of potential. Drained CBM can be
injected in a natural gas pipeline or used on-site for power generation or as a fuel
alternative. Considering natural gas and power price and volatility could bring another
dimension to the project and favor pre-mining CBM drainage.
EPC or other non-mining related issues could force the delay of coal extraction. The
study carried out can help management in assessing the economic impact of a delay as
well as considering the economic benefit of performing pre-mining CBM drainage.
8. REFERENCES
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[Accessed 20th June 2012].
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Energy Finance, Imperial College, London, March 2012.
Colorado School of Mines – Energy and Minerals Field Institute (2012) Coal Mining
Methods [Online] Available from: http://emfi.csmspace.com/ [Accessed 15th August 2012].
52
Damodaran, A. (2005) The Promise and Peril of Real options. [Online] Available from:
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2012].
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[Accessed 8th August 2012].
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Schwartz, E.S. & Trigeorgis, L. (2004) Real Options and Investment under Uncertainty.
Massachusetts, USA. MIT Press.
USEPA (1999) Guidebook on Coalbed Methane Drainage for Underground Coal Mines.
[Online] Available from: http://www.epa.gov/cmop/docs/red001.pdf [Accessed 20th June
2012].
USEPA (2005) Identifying Opportunities for Methane Recovery at U.S. Coal Mines: Profiles
of Selected Gassy Underground Coal Mines 1999-2003 [Online] Available from:
http://www.epa.gov/cmop/docs/profiles_2003_final.pdf [Accessed 20th June 2012].
USEPA (2009) Coal Mine Methane Recovery: A Primer [Online] Available from:
http://www.epa.gov/cmop/docs/cmm_primer.pdf [Accessed 30th June 2012].
USEPA (2011) User’s Manual for the Coal Mine Methane Proejct Cash Flow Model
[Online] Available from: http://www.epa.gov/coalbed/resources/cashflow_model.html
[Accessed 3rd July 2012].
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http://www.worldcoal.org/coal/ [Accessed 15th August 2012].
53
Zare, M., Sereshki, F. & Aziz, N. (2008) Application of financial risk analysis for project
evaluation at a large coal mine. [Online] Available from:
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2012].
9. BIBLIOGRAPHY
Kumar, H. & Mathews, J.P. (2012) An Overview of Current Coalbed Methane Extraction
Technologies. [Online] Available from:
http://www.netl.doe.gov/kmd/RPSEA_Project_Outreach/07122-27_CBM_Initial_review.pdf
[Accessed 20th June 2012].
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[Accessed 20th June 2012].
54
10. APPENDIX
Appendix 1: Project data.
ORE RESERVES
Coal seam depth 400 m
Coal seam length 6 600 m Coal seam width 4 200 m
Coal seam thickness 1.83 m Coal volume 50 727 600 m3
Average coal density 1 350 kg/m3
In-situ Coal 68 482 260 t
Mining recovery 90 % Mining dilution 5 %
Average moisture content 5 %
In-situ Coal recovered 61 634 034 t Dilution added to ore 3 081 702 t Diluted minable coal 64 715 736 t
MINING RATE
# production days 330 days/year
# shifts 2 shifts/day
Longwall production 3 000 t/shift Continous miner production 1 000 t/shift
Longwall production 1 980 000 t/year Continous miner production 660 000 t/year
Coal Production rate 2 640 000 t/year
COMMODITIES
Product A yield 70 % Diluted product A yield 66.67 %
Product B yield 30 % Diluted product B yield 28.57 %
Product A wash recovery 90 % Product B wash recovery 50 %
Overall recovery 78 %
Product A price 73.33 $/t Product B price 120 $/t Average price 87.33 $/t
55
MINE COSTS
Longwall OPEX 14 $/t
Continuous miner OPEX 19 $/t 15.25 $/t Average mining OPEX 15.25 $/t
A Processing OPEX 5 $/t B Processing OPEX 10 $/t
Avg. Processing OPEX 6.50 $/t
Mine CAPEX 40 000 000 $ Estimated overheads 10 %
Mine CAPEX 44 000 000 $
Transportation cost 2 $/t
MINE SCHEDULE
Pre-production period 2 years Ramp up period 2 years
Production period 24.51 years
COALBED METHANE
Methane content 17 m3/t Methane liberated 44 880 000 m3/year Methane recovery 60 %
26 928 000 m3/year 951 mcf/year Methane drained
2.61 mcf/day
CBM drainage OPEX 2 175 000 $/year CBM drainage CAPEX 883 000 $
Pre-production period 1 years
Production period 19 years
TAXATION
Tax rate 30 % Royalty rate 5 %
FINANCIAL
Hurdle rate 12 %
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Appendix 2: CBM drainage cash-flow model output.
57
