What Exactly Is A Farmout Agreement And What Do I Need To Know?

A contractual agreement with an owner who holds a working interest in an oil and gas lease to assign all or part of that interest to another party in exchange for fulfilling contractually specified conditions. The farmout agreement often stipulates that the other party must drill a well to a certain depth, at a specified location, within a certain time frame; furthermore, the well typically must be completed as a commercial producer to earn an assignment. The assignor of the interest usually reserves a specified overriding royalty interest, with the option to convert the overriding royalty interest to a specified working interest upon payout of drilling and production expenses, otherwise known as a back-in after payout (BIAPO).

The party that acquires the rights to drill and earn an assignment of the leasehold interest, receiving a farm-in is the Farmee. The party that originally owns the leasehold interest and assigns the farmout is the Farmor.

Farmouts are utilized when one company has acreage which another company wishes to acquire through drilling. The company with the acreage position has determined that it is not intelligent for it personally to undertake the costs and risk of developing the acreage (at least initially), but does not wish to see its leases expire. The company willing to undertake the drilling has a prospect idea which it wishes to develop, but does not control the acreage. Under the farmout, the first company (the "farmor") agrees to assign acreage to the second company (the "farmee") in return for the second company performing specified drilling and testing obligations, with the first company also reserving an interest in the acreage assigned and in the production from the wells drilled by the second company.

"Farming out" makes sense if a company is unable to develop expiring acreage due to budgetary constraints or it wishes to reduce or eliminate risk and improve economics as a percentage of investment and is willing to accept in return a reduced acreage position (and thus a reduction in potential aggregate return).

"Farming in" makes sense if a company's budget can stand the costs of drilling and the company is willing to accept greater costs and risks to gain or increase its acreage position in the area and thus increase its potential aggregate return.

From the standpoint of the farmee, the reason for entering into the farmout agreement is simple: it wishes to acquire an interest in acreage controlled by the farmor. Since, historically, most members of the oil and gas industry have been unwilling to sell potentially valuable undeveloped leaseholds for cash,1 and since earning by drilling has tax advantages from the standpoint of the acquiring party,2 the farmout represents the most effective (if not in most instances the only) method of acquiring such acreage.

From the standpoint of the farmor, the motivation for entering into the agreement may be more complicated. Its objectives may include maintaining its leases; having the area evaluated and tested; or securing a cost and risk free interest in production. All of these motivations may be present in a given transaction to a greater or lesser degree. However, how the farmout should be structured from the standpoint of the farmor will vary, based upon which of the objectives is of primary importance.

Areas of Negotiation -- In General. In negotiating the farmout, the parties will primarily be concerned with three basic issues: the extent of the farmor's maximum commitment (the "subject matter" determination), what the farmee must do to earn an interest in the acreage (the "earning requirements"), and what will be assigned to the farmee if these earning requirements are satisfied and what the farmor will reserve ("interests assigned and reserved").

There are numerous other topics that will be covered in the written farmout contract. However, these three subjects are the key to insuring that there has been a "meeting of the minds" between the farmor and the farmee.

-- Subject Matter of the Farmout. Frequently, the farmout agreement establishes "mini-maxi" parameters: the farmee must satisfy certain minimum requirements if it is to earn anything under the farmout but its earning may be increased up to a specified maximum interest if it performs more than the "bare minimum" earning requirements. Thus, the farmor must determine the maximum amount of acreage which it is willing to commit to the farmout, assuming maximum performance by the farmee (the "farmout area" designation), and the maximum depth to which it is willing to commit this acreage to the farmout (any "farmout depth" limitations).

Obviously, the more the farmor is willing to commit to the deal, the easier the farmout is to sell and the more favorable the terms to the farmor. However, since the farmor will be reducing its acreage position within the farmout area, it may prefer to farm out a limited amount of acreage on less favorable terms to itself in return for retaining its full position in the balance of the acreage it owns in the general area.3 Also, while as discussed below the farmee's earning will normally be limited to the depths to which it drills in its earning wells, the farmor may have certain formations which it wishes under any and all circumstances to retain for its own subsequent development.

Once the parties have agreed upon the maximum amount of acreage to be committed to the farmout, and the maximum depth to which such acreage will be committed, both must also agree as to what to do if additional leases are subsequently acquired within the farmout area by either party to the arrangement. It may be that there is no "open" (unleased) acreage within the farmout area, in which case the point is moot. (Industry practice is to agree that the parties will have the right to share in any extensions or renewals of the leases committed to the farmout.) However, if there is open acreage, or other companies which are not parties to the farmout own leases within the farmout area, the farmor and the farmee must decide whether or not to include an area of mutual interest provision in the agreement.

Absent an express "AMI" provision, there is no implied right to share in additional leases acquired by the other party, even though those leases lie within a "contract area" covered by an existing contract between the acquiring party and another industry member. Thus, if there is to be a right to share in subsequent lease acquisitions, this must be spelled out in the contract.

A final determination concerning the leases to be assigned is whether the farmee will earn its interest simply by satisfying the earning requirements or whether the farmor expects a cash consideration to be paid in addition to the performance of the drilling and testing obligations. In a typical farmout by a major oil company, there will be no cash changing hands. However, if the farmor is an independent, it is quite common that the farmee is required to make a cash payment to the farmor to reimburse it for the costs of working up the prospect and to cover its costs of lease acquisition.

-- Earning Requirements --- Wells to be Drilled. The farmout agreement must spell out the number of wells to be drilled as "earning wells" by the farmee, the amount of acreage earned by the drilling of each such well, and whether the drilling of one or more of the wells is mandatory (a "required" well) or optional.

If the farmout area is limited to a single drilling and spacing unit, there is but one well to be drilled; whether the drilling of that well is merely a condition of earning (an "optional" well) or is a contractual obligation (a "mandatory" well) is simply a matter for negotiation.

If the farmout area covers multiple possible well locations, it is quite common that the farmee must drill several wells to earn an interest throughout the entire farmout area. Quite commonly, the drilling of the first well will be mandatory and such drilling will earn the farmee an interest in the drilling and spacing unit upon which that well is located and -- in the case of an exploratory farmout -- in certain offsetting drilling and spacing units. If the farmee wishes to earn an interest in the balance of the farmout area, it may do so by drilling additional earning wells, with such additional drilling normally being optional with the farmee.

If the farmout area is not too broad, the agreement will normally provide for the drilling of a specified number of additional optional earning wells. For broad farmout areas, a "continuous drilling" provision may be included, under which the farmee may continue to earn additional acreage so long as it commences a new earning well within a specified number of days following the completion or abandonment of the last earning well. Also, if the farmor is committing its leases over a very broad farmout area, there may be more than one mandatory earning well.

A careful study of the farmout agreement may show that some wells labeled as "mandatory" are in fact only optional conditions of earning. Thus, an early article in the contract describing such a "mandatory" well may be followed by a subsequent "performance" provision stating that the only penalty for failing to drill the "mandatory" well is a loss of the acreage which otherwise would have been assigned. It is also important for a farmor to realize that most smaller farmees assume that all earning wells are simply conditions of earning, no matter how the farmout agreement is worded. If the farmor wishes to insure that the farmee considers itself contractually committed to the drilling of the mandatory earning wells, it may wish to insert a "non-drilling payment" provision in the agreement specifying an agreed monetary compensation which shall be paid by the farmee to the farmor if the mandatory earning wells are not drilled.






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