Farmout Agreements are one of the most widely used agreements in the oil and gas industry. However, there is no largely adopted model form. As such, they vary a great deal. Kanes Forms has provided several Farmout Agreement Forms, but these have not been adopted as an industry standard, and so every farmout agreement approached must be fully analyzed and every term must be understood. This multi-part article will summarize the common ground, and provide a framework for analyzing the various options for certain provisions.
A Farmout Agreement is an agreement with a working interest owner (“Farmor”) whereby the Farmor agrees to assign working interest to the Farmee in exchange for certain contractually agreed services. Typically these services include drilling a well to a certain depth, in a certain location, in a certain timeframe, and also typically stipulates that the well must obtain commercial production. After this contractually agreed service is rendered, the Farmee is said to have “earned” an assignment. This Assignment comes after the services were completed, and is subject to the reservation of an overriding royalty interest in favor of the Farmor.
This overriding royalty interest is usually said to be a “convertible override.” This means that upon payout, which is the point where the drilling costs have been recouped from production from the well, the Farmor can elect to convert this override into a portion of the working interest. This decision whether to convert or not depends on whether the Farmor wishes to join in production costs in exchange for the possibility of a larger return on NRI. If the Farmor does not wish to take the risks associated with the cost-bearing working interest, he will choose not to convert the override. If the Farmor is comfortable with the project costs and proceeds from the well, he will decide to convert his override into working interest. All of these terms are negotiable in the Farmout Agreement.
Here’s an example. You are working as a landman for David Oil Co. You have retained a small battalion of field landmen and leased up a nice large area your geologist believes will be productive. This gives you 100% of the working interest. You pay 100% of the expenses, and receive 100% of the net revenue interest (all the proceeds less royalty burdens, overriding royalty burdens, tax, etc.). Your geologist is excited and believes the geology is ripe to provide a high return. However, given the particular geology, you will need to drill directionally to a deep formation. The deeper the formation, the more it’s going to cost, and you’re not sure you have enough in your budget to pay for it.
In comes Goliath Oil Co., who was late to the play and wasn’t able to lease your area. Goliath has a lot of money and it wants in because its geologists agree that there is a lot of money to be made in your area. Rather than wait around for your leases to expire, Goliath chooses to approach you and offer to ”farm in” to your working interest. It is willing to drill the well(s) for you and pay the drilling costs (what is known as a “drilling carry”), in exchange for you assigning them a percentage of your working interest. Another way to think of it is obtaining drilling services where the consideration is an assignment of working interest rather than cash.
Negotiating the Farmout Agreement
As with all negotiations, understanding the other party’s interests and motivations is key to effective negotiation and properly structuring a complete deal. Knowing this will also help you understand the other party’s best alternative to the negotiated agreement. You will be able to better estimate how far the other party will be willing to give and take in negotiating the terms of the Farmout Agreement. The following are the most common interests motivating Farmors and Farmees.
Interests Motivating the Farmor:
- Drilling so as to maintain the lease (satisfy primary term, avoid Pugh clause consequences, satisfy continuous drilling obligations, etc.);
- Monetizing an abandoned prospect;
- Sharing risk;
- Obtaining geological information from the farmee and the farmee’s operations; and
- Drilling a well for lease purposes (such as avoiding Pugh clauses, preventing drainage, and adhering to continuous development clauses).1
Interests Motivating the Farmee:
- Quickly obtain acreage;
- Obtain acreage without leasing operations, and without expending capital on buying leases;
- Utilize equipment and personnel that would otherwise not be utilized;
- Gain interest in a prospect area that is already leased, but the farmor is not developing; and
- Desiring to develop an area while sharing risks.2
Thoroughly understanding both your motivations and the other party’s motivations are essential to effective negotiation and deal-making. This is crucial so that you understand you and your adversary’s must-haves and true bargaining room. Every good negotiator does this whether they consciously think of it or not. Understanding your motivations and alternatives are important to keep your head on straight and to ensure you are picking the right battles. On the other hand, understanding the other party’s motivations and alternatives is crucial for two main reasons: (1) you will better know how far you can push the other side to obtain favorable terms and conditions, (2) you will better understand and anticipate which terms the other side will insist on, and (3) you can make the other side’s alternatives less attractive, harder to implement, or less valuable, all of which may help your side of the negotiations.
In my experience, including when I was in the heavy construction industry, knowing what the other party was truly after made negotiations much easier. It is not always possible, but when we can closely narrow in on our motivations and confidently estimate the other side’s motivations, we seldomly fight tooth and nail over every provision, and are able to focus in on what actually matters to each party. In the end, we have better agreements.
Tune in next week for part two, where we will discuss Five Basic Key Provisions of a Farmout Agreement.
I’d love to hear your thoughts, comments, stories, and suggestions in the comments! What were the factors motivating your most recent Farmout Agreement?Footnotes: _____________________________________