School of Science and Engineering Application of the Real Options in Engineering Design and Decision Making: Focus on Mine Design and Planning at Operational Level Ajak Duany Ajak This thesis is presented for the Degree of Doctor of Philosophy of Curtin University July 15, 2018 i Declaration ii Abstract Risk and uncertainty have dominated business news headlines in recent times. However, opportunities generated by real or perceived risk and uncertainty are less mentioned. Traditional engineering practices are generally risk-averse, a tendency which diminished opportunities that resulted from positive treatment of risk and uncertainty. Flexibility and strategic adaptability are essential for long-term corporate success, and real options (RO) analysis is applauded as a preferred tool for analysis. Nevertheless, its application in engineering design has been sluggish compared to its financial application. This thesis is comprised of four journal articles, utilising analytical methodologies including a binomial decision tree that was applied to create a switching option between pits regarding changing ore grades and fluctuating commodity prices, a stochastic process with jump diffusion which was applied to analyse option to delay, to abandon the operations and to stage the investment and predictive data mining which was utilised in the analysis of ROs in managing geological uncertainty for optimal decision making in mining operations. Additionally, a RO identification framework for mine operational decision making has been proposed, a relationship between risk measure (beta) and flexibility (flexibility index) is derived and applied, and a modified smooth pasting condition with the mean value theorem is subsequently applied to estimate the optimal value. This research argues that engineers and decision makers should view uncertainty as a source of value. Adaptation of this view may shift the debate on how mine planners and engineers approach uncertainty. Thus, the thesis extends the idea that uncertainty cannot be eliminated but rather the opportunities that it presents can be leveraged by having a flexible system. This thesis is one of the few, if not the only research piece to have applied a predictive data mining algorithm for creating managerial flexibility at a mine operational level. The research supports future studies and encourages the use of RO analysis in engineering design and decision making as it enhances understanding of the rationale for flexibility in design. Moreover, the thesis proposes a flexibility domain map for managerial decision making by creating an uncertainty identifications framework and RO application domains within the mining system. This introduction of managerial flexibility on the shop floor is a critical step as ROs have not been used at a mine operational level before. In addition to furthering the academic debate about the critical role of data utilisation and highlighting the new area of research, particularly the integration of data analytics into mine design and planning process, this thesis has opened up a new research frontier on how the concept of ROs can be integrated with technology, particularly with data analytics. There is currently a disconnect between big data and mining operations which generates huge data that is not adequately utilised to create value. iii Acknowledgement The author would like to acknowledge the contribution of my distinguished professors and supervisors whose names are Dr Eric Lilford and Professor Erkan Topal. I would also like to acknowledge the contribution of the Curtin University and Australian Government Research Training Program Scholarship in supporting this research and above all, I am deeply appreciative and grateful to my family and particularly to my dear wife Maggy Adol Aman who has endured loneliness as she sacrificed a lot in supporting me for the last five years of my studies. iv List of publications Ajak, A. D., and Topal, E. (2015). Real option in action: An example of flexible decision making at a mine operational level. Resources Policy, 45, 109 - 120. DOI: 10.1016/j.resourpol.2015.04.001 Permission Regarding Copyright: I warrant that I have obtained, where necessary, permission from the copyright owners to use any third-party copyright material reproduced in the thesis or to use any of my own published journal articles in which the copyright is held by Elsevier Ltd. Ajak, A. D., Lilford, E., and Topal, E. (2018). Valuing the Unknown: Could the real options have redeemed the ailing Western Australian Junior Iron ore Operations in 2013 - 2016 Iron Price Crash. International Journal of Mining, Reclamation and Environment. DOI: 10.1080/17480930.2018.147914 Permission Regarding Copyright: I warrant that I have obtained, where necessary, permission from the copyright owners to use any third-party copyright material reproduced in the thesis or to use any of my own published journal articles in which the copyright is held by Informa UK Limited registered in England under no. 1072954 and trading as Taylor & Francis Group. Ajak, A. D., Lilford, E., and Topal, E. (2017). Application of predictive data mining to create mine plan flexibility in the face of geological uncertainty. Resources Policy, 55, 62 - 79. DOI: 10.1016/j.resourpol.2017.10.016 Permission Regarding Copyright: I warrant that I have obtained, where necessary, permission from the copyright owners to use any third-party copyright material reproduced in the thesis or to use any of my own published journal articles in which the copyright is held by Elsevier Ltd Ajak, A. D., Lilford, E., and Topal, E. (2017). A real option identification framework for mine operational decision-making. Natural Resources Research. DOI:10.1007/s11053-018-9393-4 Permission Regarding Copyright: I warrant that I have obtained, where necessary, permission from the copyright owners to use any third-party copyright material reproduced in the thesis or to use any of my own published journal articles in which the copyright is held by International Association for Mathematical Geosciences. v Statement of contribution of others vi Table of contents 1.1 Background ......................................................................................................................................... 1 1.2 Research questions .............................................................................................................................. 3 1.3 Aims and objectives ............................................................................................................................ 4 1.4 Real options in mine design and planning for operational decision making ...................................... 5 1.5 Major strands and layout of the thesis ................................................................................................ 6 1.5.1 Theoretical analysis on the application of real options in engineering design ............................. 6 1.5.2 Methodologies and practical application of RO in engineering design ....................................... 7 1.6 Significance and contribution of this research .................................................................................... 9 2.1 Definition of key terms ..................................................................................................................... 12 Options ................................................................................................................................................ 12 Real option .......................................................................................................................................... 12 Flexibility ............................................................................................................................................ 13 Uncertainty .......................................................................................................................................... 13 2.2 Historical context of the option theory: financial options ............................................................... 14 2.3 Strategic and technical classification of RO ............................................................................... 15 2.4 RO ‘on’ project ................................................................................................................................. 15 2.5 RO ‘in’ project at strategic level ....................................................................................................... 17 2.6 RO ‘in’ project at the operational level: Past attempts to include flexibility at the tactical level ........................................................................................................................................................ 18 2.7 Why RO is not gaining popularity in engineering design and at the operational level .......... 19 2.7.1 Conceptive challenges impeding the adaptation of RO ‘on’ project ......................................... 19 2.7.2 Computational challenges facing adaptation of RO ‘in’ project ................................................ 20 2.8 Real options conventional analytical models .................................................................................... 21 vii 2.8.1 Black and Scholes ...................................................................................................................... 22 2.8.2 Standard risk-neutral valuation and probabilities .....................................................................