Understanding farmout agreements

A farmout agreement is a contractual agreement between an owner who holds a working interest in a lease, also known as the “farmor,” and another company, known as the “farmee,” who is assigned all or part of the working interest. As noted in the North Dakota Law Review, “[t]he primary characteristic of a farmout is the obligation of the assignee to drill one or more wells on the acreage as a prerequisite to the completion of the transfer to him.” These types of agreements are prevalent in the oil and gas industry and are widely used. The farmee must perform specific obligations per the agreement, such as drilling gas wells, oil exploration, testing, and obtaining general geological information.

The contract should specify pertinent details, such as:

• Drilling depths
• Deadlines
• Time frames
• Costs, and
• Any royalties on income generated.

A farmor might want to enter a farmout agreement to reduce risk while also retaining their own interest in the land. In some situations, a farmor does not have enough money to continue operations but knows there are likely more profit opportunities to be made and therefore seeks out a third party to undertake some or all of the project. This way, the land gets developed while also generating cash flow, often in the form of royalties.

Example

An example of a farmout agreement would be if a farmor, we'll call him Frank, works for Smith Oil Co. but has a working interest in the land. This means that it is up to Frank and the professional landmen he has hired to work the land, as Frank pays all the expenses and receives all the net revenue. He hires a geologist to inspect the land and finds out that the land is productive and will yield a high return. However, things take a turn for the worse, and Frank is out of money. The initial financial expenditures Frank spent on paying his landmen and buying equipment have his pockets empty. He knows the land still has the potential to yield a high return if only he could dig deeper. Then, Rothschild Oil Co. comes into the picture and sees an opportunity, thus reaching out to Frank, knowing that a lot of money could be made on Frank's land, and seeks to enter into a farmout agreement. Rothschild Oil Co. has lots of money and seemingly endless resources and thus could provide a great opportunity for Frank to maintain his interests while also making money he otherwise couldn't have made on his own. Rothschild Oil Co. is willing to drill and pay the costs, gaining an interest in the acreage, while Frank receives royalties or production payments. If the farmout agreement is appropriately executed with all terms and conditions negotiated effectively, this agreement could be beneficial to both parties.

How does a farmor decide if its economically feasible to drill?

Once an acreage position is acquired in the prospect area, the company must make an economic analysis and decide whether to make the initial investment of drilling an exploratory well. If a decision is made to drill, classic economic formulas for evaluating an investment are used to determine:

• The average annual rate of return on investment,
• The number of times the expenditure is returned,
• Discounted cash flow, and
• Payout, which is the number of years required to recover the investment measured from the first day of oil or gas production.

Benefits of farmout agreements

Farmouts are fundamental and essential to the exploration and development of oil and gas operations around the world. There are many reasons as to why a farmor and farmee may enter into a farmout agreement with one another, the first being to share risk. In a situation where a farmor might not have enough resources needed to develop gas or oil explorations, a farmee comes in to share in the risk, costs, and expenses of moving the project forward. For example, a project might require drilling an expensive or high-risk well. Starting these large-scale operations often requires significant initial capital. This can be most beneficial in circumstances where the cost of drilling reaches ranges of tens of millions of dollars. In other circumstances, oil exploration might be for non-commercial purposes, in which millions of dollars are spent and then relinquished to the government, thus receiving no profit to compensate the project. It is in those cases that sharing risk and utilizing farmout agreements can be most beneficial. Additionally, a farmout agreement can benefit the farmee because it is a cost-effective way of earning acreage. The farmor agrees to allow the farmee to drill in exchange for a future interest in the production in the form of royalties or production payments. The farmor's motivation for entering into a farmout agreement would be to continue his operations where he otherwise would not have been able to on his own. He gets to share costs and therefore minimize risk, and even learn from the farmee's operations. Further, he gets to obtain and share extensive geological information from the farmer. The farmee has different interests motivating him to enter such an agreement. He may want to obtain acreage quickly and without any leasing operations. He gains an interest in land that would otherwise not be used to its fullest potential and gets to utilize his own equipment and landmen that also might not have been used otherwise. Both sides get to develop an area while sharing the risk.

Negotiating farmout agreements

There are many factors to consider when engaging in negotiations of a farmout agreement. Firstly, it is essential to consider the other party's motives and reasons for entering into such an agreement. Considering these interests is likely to help both parties reach an agreement with better efficiency and remain aware of the other party's intentions. Each party to the contract may have terms that they insist on being included and might have different terms that are more flexible. Identifying these terms early on helps to understand how far to push the other side and make negotiations easier. Often when negotiating a farmout agreement, the farmor and farmee discuss what acreage the farmee may earn, the specifications of the type of work the farmee has to do to earn the acreage, and the consideration or financial benefit the farmor will receive. The contract itself will contain specific provisions too, such as:

• Identity of the leases and land,
• Obligations and duties of both parties, and
• Any further development of the land.

The agreement should be explicit on precisely what each party is required to do. For example, issues may arise when the word “completion of the well” is included in a provision but has little to no definition and/or context, thus leading the parties to interpret the word “complete” very differently.

Finally, included in the agreement should also be geological requirements. They should be as clear as possible, with names, addresses, phone numbers of all designated people involved and assigned representatives who will be present for testing and operations. Although these things seem minimal at first glance, they should be negotiated before completion and signing of the agreement because it can directly affect costs and payment schedules which is often the center of disagreements later. Disagreements will inevitably cause delays and then more costly operations. The goal of negotiations is to minimize future potential issues by addressing them prior to finalizing the farmout agreement.

Other issues

There are many terms and conditions to be considered in forming the farmout agreement. For instance, today it is common practice for a farmout agreement to include work on multiple wells rather than just one, as it used to be back in the 80s (Oil and gas law digest). Many issues arise with this type of agreement even though it is common, and it is crucial to identify and address them. Questions that may come up include:

• Is there an obligation or an option to drill additional wells?
• What happens in the event of a delay in commencing work?
• When one well is completed, how soon after should drilling begin on the next well?
• What interests will each party hold if the farmee abandons the work?

Including options in the agreement can be very beneficial to the farmee who retains the option and the right to continue drilling as long as they meet specific requirements, with the ability to assess market conditions, geology, prices, and other business factors as they go along.

Another issue that may arise in the context of a farmout agreement occurs when the parties fail to record notice of the farmout. Generally speaking, recording statutes provide protection to a purchaser without notice. A third-party bona-fide purchaser can easily come in and put the farmer's interests in jeopardy. An easy solution to this problem is to ensure there is a record of the farmout agreement in the county where the land is located.

A related issue to the instance mentioned above occurs when the record itself is unclear about whether and when the farmee receives an interest under the farmout agreement. This is because the farmee often does not earn such interest until after drilling is completed. Therefore, may lose this interest by failing to describe these terms with particularity within the recorded memorandum of the farmout agreement. Ensuring that these terms are clearly drafted and timely recorded is crucial to prevent issues down the line, as farmout agreements tend to have complex terms.

Finally, the legal descriptions of the land should be included in the agreement to prevent issues and confusion in the future. In addition, each of the following pieces of information should be included as well:

• The farmor and farmee's interests,
• Recording information,
• Timing for payments,
• Royalty amounts,
• Date of the lease,
• Any burdens running with the lease, and
• Any other special provisions.

In Professor Kendor P. Jones' paper, Something Old, Something New: The Evolving Farmout Agreement, he illustrated through an example issue that may arise in structuring a farmout agreement:

The parties to the farmout agreement must be aware of the provisions in the leases assigned. For example, in Isler v. Texas Oil & Gas Corp.25, the agreement indicated that the farmor would make delayed rental payments on the federal lease assigned. The agreement also included that the farmor if the farmor ceased making them, they would give the farmee notice.

However, the agreement further provided that the farmor would have no responsibility to the farmee if they failed to make such payments. The farmor, through oversight, failed to make rental payments, and the lease expired. The farmee drilled two wells on the lease before it learned that the lease had expired. The farmee sued the farmor for breach of contract and on a tort theory. The Tenth Circuit reversed a jury award for the farmee, holding that the exculpatory provision in the farmout agreement meant what it said.

Key takeaways

Farmout agreements are widespread in the oil and gas industry and are widely used. Early farmout contracts used to be simple and informal. Today, however, they are far more complex with much more detailed provisions and drawn-out negotiations. Parties might seek a farmout deal to reduce risk, share in costs, share geological information, and work productive land for profit. When drafting a farmout, it is vital to shed light on both parties' intentions and motivations to engage in effective negotiations. Finally, provisions should be clear enough to minimize future disagreements and misinterpretations.

Any questions about farmout agreements? Contact the experienced attorneys at Newburn Law so that we can help you navigate all points in your potential farmout agreement.