Types of Mineral Assets

Mineral assets can generally be classified into four types of properties: speculative, exploration, development, and producing.  Speculative properties have very little assurance of mineral potential.  Exploration properties have enough potential that expenditure of exploration dollars is warranted.  Development properties are the outcome of a successful exploration exercise, and warrant development into a producing asset.  Producing assets are those that are in production.

Economists would have each type of property valued via a fundamental analysis, discounting a projected stream of future income.  This becomes difficult, however, for speculative and exploration properties, as information on production potential and the timing of that production, if any, is so poor as to render projections of income largely meaningless.  In addition, these properties are seen by the market as options on information, in that owners have an option to spend money to obtain more information about the nature of the asset.  Income approaches are inappropriate when valuing such options, and so, we either need to use real options or decision analysis techniques in valuing these types of properties, or look to actual trades to infer their values.  The latter suggests a comparable sales approach, in which case the resultant values will be fair market values and not fundamental values.

In sum, economists have very little to offer on the fundamental value of speculative and exploration properties.  For this reason, most economic (fundamental) analysis begins when properties are in the development or production stage.  The advent of real options and decision analysis has allowed us to move back to valuing properties at the exploration stage, but this is a new type of analysis that is still finding its feet, and is not yet well accepted by industry or the courts.

The Value of a Mineral Asset Equals the Value of its In-ground Reserves

For all property types, asset value is a joint product of any potentially extractable mineral located beneath the earth’s surface and any installed capital that is used to extract that mineral.  One can arbitrarily divide the mineral asset’s total value between the two types of assets, typically deducting the cost of installed capital (a drill hole, for instance) from the total asset value to derive the value of the extractable mineral.  But such accounting is arbitrary – the extractable mineral is worth nothing without the installed capital, and the installed capital is worth nothing without the extractable mineral.  That is, there is nothing inherently valuable about a drill hole, and so one cannot value it at cost.

Another valuation principle, and the primary focus of this paper, is that the total value of the joint asset, which I will for convenience call the mineral asset, is derived solely from the prospect of ultimately extracting the mineral for a profit.  This principle holds regardless of the valuation technique used, be it income-based or comparable sales, and of the purpose of the valuation, be it fundamental value or fair market value.  If the mineral asset is never expected to generate a penny, it has no value.

Mineral Asset Values Change from Day to Day

Whether valuing the royalty owner’s position, the extractive firm’s position, or the asset, the volatility of mineral price means that value will vary widely from day to day, week to week, and year to year.  In an interesting study of gold mining assets, Peter Tufano of Harvard University measured the sensitivity of gold company value to changes in gold price.  He found that a 1% change in gold price typically caused a 2% change in mining company value.  Gold prices are highly volatile, with daily changes of 1% a common occurrence.  In valuations, therefore, especially for purposes of litigation, it is vital to establish a date on which to value the asset, and to use the market’s (in the case of fundamental analysis) or buyer’s and seller’s (in the case of fair market value) forecasts as of that date in the valuation.

The Value of a Mineral Asset is Highly Dependent on Reserve Certainty The quantity of ultimately recoverable reserves is only known upon permanent abandonment of the asset, and at the date of valuation the amount of reserves is always uncertain.  This provides a challenge for valuation, as not knowing the amount of reserves means that the productive life of the asset must be estimated.  Nevertheless, in order to perform a fundamental valuation, we must have some ex ante estimate of the quantity of valuable material that can be extracted.  The uncertainty surrounding the estimate of extractable reserve is called reserve risk.

The mining and petroleum industries each have their own reserve uncertainty classification systems.  The mining industry uses the terms Inferred Resources, Indicated Resources, and Measured Resources to indicate increasing geological confidence.  Standard definitions are given in Figure 1.  The first thing to take away from these definitions is that the most uncertain category of reserves, Inferred Resources, is so uncertain and so unlikely to translate one for one into more certain reserves that no income projections can reasonably be made.  This is not to say that these types of reserves have no value, but that their value is highly speculative, and are worth little per unit until upgraded to the Indicated or Measured categories via additional exploration work.

In the oil and natural gas industry, reserve uncertainty is denoted by the categories of Proved Reserves, Probable Reserves, and Possible Reserves, with Possible Reserves coinciding roughly with Inferred Resources.  The mining industry also uses these reserve classifications: “Probable” mineral reserves are the currently economic portion of Indicated Resources, and “Proven” reserves are the currently economic portion of Measure