Land in the Marcellus Shale natural gas play is currently leasing for $10,000 per acre. 100 acres are needed in order to drill for natural gas. Leases last for three years, and if no drilling occurs within those three years then the land goes back on the market. In other words, if a lease is signed in Year 0, then the company holding the lease must drill and complete a well in Year 0, Year 1 or Year 2. If this does not happen then the lease expires at the end of Year 2 and that parcel of land can be re-leased.

The cost to drill and complete a well is $5 million, incurred entirely in the year in which the well is drilled. There are no other operating costs to extract natural gas other than the drilling and completion. Currently (in Year 0), the present value of the revenues from the gas well are $3 million. Each year, there is a 40% probability that the present value of revenues will go up to $8 million for a well drilled in that year, and a 60% probability that the present value of revenues will be $3 million for a well drilled in that year.

Calculate the value of a 100 acre parcel of land in the current year (Year 0). Remember that leasing in Year 0 gives you the option to drill in Year 0, Year 1 or Year 2. Also remember that to calculate the value of the land you need to make a comparison with a scenario where you lease the land in Year 0 and are committed to drilling in Year 0 (like the land problem from class). Does land appear to be over-priced, under-priced, or priced correctly?

Also note: Discount rate is 10% per year.