An Insight into Farmout Agreements in Oil and Gas Operations

What Constitutes a Farmout Agreement?

Farmout agreement is quite essential in oil and gas industry to bring an operator. Generally, in the farmout agreements, the operator is the one that brings in a larger holding of land. It is an agreement between the two companies in which one company, the "farmee", agrees to accept an interest in property in exchange for funding exploration, drilling or production expenses. In this situation the farmee takes over operation of the lease being farmed out. The advantage to the farmor (the land owner) is that he receives a minimum royalty payment for his participation; the advantage to the farmee is that he receives a working interest without a large initial cash outlay. As a general explanation we can say that farmout agreements are used in order for the land owner to re-finance its project and for the opposite party to acquire an interest in a property it believes may be profitable. The farmout agreement generally contains the provisions below:

The property will have minimum royalty which is usually a guaranteed sum of money for the land owner in consideration that the land owner gives the project to the other party.
The land owner shall receive a bonus in the event that the other party re-sells the land.
Notice can be given to the land owner if the investor wants to abandon the project totally , before, a drilling or mining has been done.
The land owner shall be provided with samples about the work conditions of the project.
The land owner cannot terminate he agreement before the drilling process is finished, as the agreement contains deadlines, which should be fulfilled.
The other party is obligated to submit documents to the land owner for their review and approval.

Essentials of a Farmout Agreement

The key elements of a farmout agreement in the context of an oil and gas joint operating agreement are the farmor (the current holder of the property to be farmed out), the farmee (the transferee), the term of and the conditions for earning, the date by which the election must be made, and the assignment of interests from farmor to farmee.
At the outset, it is important to note that a farmout agreement will often be incorporated into the broader scope of a joint operating agreement with the incorporation by reference and incorporation into the farmout agreement.
The reason for this is that a farmout agreement often contemplates the eventual partnership of the farmor and the farmee in the form of an oil and gas joint operating agreement. Therefore, there are a number of earn-in conditions contained in the joint operating agreement, for example, that the farmee must include a pro-rata share of the property to be farmed out under the joint operating agreement to other parties in the farmor’s wholly owned lands in the area of the farmed-out lands. Likewise, associations may be required to sign the farmout agreement as an affiliate of the farmor, or to tender a guarantee of the farmor’s obligations under the earn-in conditions. Subsequently, in order to ensure a swift and smooth transition and the farmee’s ability to profit from the farmout, the terms and conditions of ancillary agreements and executions of documents contemplated by the farmout agreement, will be required.
Unlike the broader scope of a joint operating agreement, a farmout agreement is quite a formalistic agreement to give one party a right to earn an interest in oil and gas lands while the broader scope of a joint operating agreement sets out the more detailed mechanics of the operation of the oil and gas lands. What are some of the more practical and operational reasons for executing a formal farmout agreement? A farmout agreement will allow farmor and farmee to keep costs low at the outset of their relationship. It will also allow farmor and farmee to limit their risks for exploration drilling by keeping their interests limited to an overall share of production.
A farmout agreement will contain the terms by which the farmee will earn an interest or interests in an exploration play, or another facet of exploration and evaluation with the oil and gas interest. Often, the agreement outlines terms for the farmee to earn an interest in subsurface rights, surface rights, facilities, equipment, geological data, seismic data, regulatory approvals, and title opinions. It is usually made clear in the farmout agreement that the purposes of the farmout agreement does not include or limit other forms of conveyance of the oil and gas interests. The farmout must therefore be read in conjunction with the conveyances made pursuant to the farmout agreement to construct an overall picture of the renewed and joint venture relationship.
Farmout agreements will also usually include a date by which the farmee must make its election. This date will depend on a number of factors and will be set forth so that farmor can begin drill timing calculations and file proper documents with AER (the Alberta Energy Regulator) and Alberta Land Titles. For all intents and purposes and presumably for the purposes of efficiency of the farmee, if a farmee is unable to meet a date under the agreement, other avenues of recourse may be sought by the farmor, as well.
Overall, a properly drafted farmout agreement provides both parties with more certainty in respect of the rights and obligations and also the ability to recover any amounts owing to the parties pursuant to the remedies.

Advantages of Using Farmout Agreements

Farmout Agreements have several benefits for both the farmor and farmee in any oil and gas acquisitions. The farmor, the lessor, is able to preserve its cash and credit for other ventures while the farmee obtains exploration rights, exploration data, equipment and expert manpower. Both parties are able to mitigate risk while increasing their profits and decrease lease preservation costs. In addition, the farmor may reduce the number of wells it needs to drill and may get a lump sum up front payment or a monthly rental payment while keeping an interest in lease production.
One of the most significant benefits of a farmout will be the distribution of financial risk between the farmor and farmee. A farmor that retains all rights typically sees more upfront costs and lower profits during exploration phases. However, with the distribution of risk between the two parties, the farmor will benefit from upfront rental payments or receiving a share of any oil or gas revenues.
A farmor can also keep a small percentage of any exploration costs that were incurred during pre-farmout phases. The farmor will benefit from production revenues at a lower upfront cost as long as the farmee explores and produces successfully within the terms of the farmout agreement. Any successful well allows the farmor to explore and receive revenue from that well.
The farmee benefits from several incentives under a farmout agreement. The farmee initially saves money by not having to prepay royalties or lease payments. Then, during exploration, the farmee will receive 100% of any royalties or bonuses from the successful wells. As wells are successfully drilled, the farmee has greater access to more oil and gas reserves and the farmor does not have to finance the costs of drilling operations, even though the farmee may stall those operations.
The farmee typically benefits more from non-competitive farmouts that spur development of oil and gas reserves for the good of all parties involved.

Considerations and Concerns in Farmout Agreements

Though farmout agreements can provide financial and operational benefits to both parties, there are nearly always risks involved in the transaction that can affect the farmor and farmee if they do not behave prudently and with an eye to protecting their respective interests. Altered Interests. To the extent farmor and farmee have negotiated the wellbore title and/or surface use agreements, as farmout parties seek to promote communication and reduce disputes, each party should also seek to address its relative interest in the wellbore and/or the surface use rights. For example, in the event that the farmee’s drilling program ultimately increases the number of wells drilled beyond what was originally contemplated by the farmout agreement, or the number of wells drilled per wellbore exceeds five, each party’s relative interest should be addressed to account for the altered circumstances. A wellbore title and surface use agreement is an ongoing relationship between the farmor and farmee, and should always be regarded as such. It does not need to be burdensome, but especially where a farmor is ultimately to receive an overriding royalty interest in a wellbore and/or surface use rights, it bears repeating that the concern of diminishing the farmor’s interest in the wellbore and/or reducing the farmor’s surface use rights addresses concerns that are best addressed as the farmout relationship becomes one with each party’s interests aligning. Costs and Timing. On the other hand, both parties should take care to protect their interests in the drilling, completion, liability and abandonment costs for each well financed by the parties. Failure to do so could lead to over-runs or under-runs in terms of capital expenditures on any one well. Particularly where the farmor is financing a portion of farmee’s drilling, completion, and abandonment costs, the farmor should take care to account for any inflated expenditures that could undermine the farmor’s expected return on investment. In turn, the farmee should monitor timely performance in its areas of operation, to ensure the farmee obtains the promised permit time, rig time, and drilling time. Operational Risks. As discussed herein, farmout agreements should outline the initial scope of the farmout relationship, to the extent possible. In light of the unexpected twists and turns inherent inherent in the exterior economy, geology, market and industry standards, a good farmout agreement can only do so much to limit the parties’ risks. In addition to any expectations unique to each farmout relationship, the parties should each understand certain risks that accompany a farmout agreement, and limit their risks through diligence, regular communication, and open-mindedness when unexpected events arise.

Farmout Agreements and Joint Ventures

Farmout Agreements Versus Joint Ventures In Oil And Gas
Similar to a joint venture, a farmout agreement allocates control over an oil and gas development project to two or more parties. As spelled out in the agreement, the party with the larger investment — called a "farmee" — will take over project management from the "farmor," and the latter will retain a portion of revenue upon completion.
Unlike joint ventures, however, the participating companies in a farmout agreement continue to operate independently of each other . A farmout typically allows the operator to reduce its risk and capital costs. The farmee, by taking on the developmental role, reduces its risk involved in exploring new projects because of the limited cash investment.
In contrast, joint ventures involve two or more parties that retain control over their independent businesses after the development process is under way. While the overall purpose may be the same, such as developing a drilling project, one party (the operator) has majority control over it. Divided control over project operations is a major difference between these two arrangements.

Legal Aspects of Farmout Agreements

Farmout agreements are an integral part of the oil and gas industry, where multiple entities often work together to extract resources from hydrocarbon reserves. In order to ensure that the interests of all parties are protected, and that agreements are executed properly, it is important to understand the broad legal considerations involved.
This "Farmout Fundamentals" series is designed to provide an overview of the various aspects of farmout agreements, covering the pros and cons for all parties involved, the most common legal pitfalls that can occur, and what you can do from a legal perspective to avoid them.
In this section, we will discuss the general legal considerations involved in drafting a farmout agreement, how the terms of the agreement can impact its enforceability in a court of law, and negotiation tips to ensure all parties are protected.
General legal considerations in a farmout agreement
The legal considerations in a farmout agreement will generally center upon the distribution of rights and obligations between the parties, payment terms, and performance requirements. The legal concepts of consideration, offer, acceptance, and capacity will also be relevant.
Specific issues
With these and other legal issues being considered, here are some specific legal issues to take into account when drafting and executing a farmout agreement:
Negotiation and execution considerations
There are several aspects of the negotiation process that can help ensure both farmout parties are fairly protected from liability or unfair business practices. These include:
Considerations in future dealings
When negotiating and drafting a farmout agreement, it’s important to take into account future dealings the parties might have. Since this is part of an ongoing transaction, there may be other contracts involved between the parties. This could influence how the farmout agreement is structured, so keep in mind any other relevant agreements.
Covering the bases
One of the things businesses entering into a farmout agreement should always keep in mind is that this is essentially a contract visualized in spatial relationships — so in order to avoid any voids, and to cover all bases, the land being farmed out should be defined in such a way that its boundaries are clear.
Locations or depth ranges should be clearly defined, and if any exceptions should apply to these areas, such as the exclusion of mineral rights or other specified matters, this should also be clearly stipulated in the terms of agreement.
As far as the resources themselves, if any exceptions apply to certain portions of the resources (or to any minerals) or if there are specified minimum quantities of resources that must be met, this must be made clear in the written document. Otherwise, it would be difficult to hold either party accountable if either were to pull out of the deal in its entirety or were unable to meet terms.

International Instances of Farmout Agreements

Idemitsu Petroleum in 2006 was successful in securing development financing from a farmout agreement with Idemitsu Kosan. Petroleos Mexicanos ("PEMEX") also entered into a farmout agreement with global oil and gas company RFE Investment Partners for the purchase of 12.5% interest in the onshore Sonda de Campeche oil field in Mexico for US$250 million. The agreement required PEMEX to divest its interest in the oil field before it can develop a neighbouring deepwater oil field in the Gulf of Mexico, as PEMEX had far exceeded its field development budget in recent years. The agreement has been hailed as being essential in spurring additional exploration in the region.
China National Offshore Oil Corporation ("CNOOC") and Reliance Industries last year entered into a farmout agreement whereby CNOOC acquired a 30% interest in Reliance’s oil and gas blocks in India in exchange for carrying Reliance’s costs related to the yet-to-be-drilled blocks and paying Reliance US$1.36 billion. Similarly, CNOOC entered into a farmout agreement with Canada’s MEG Energy Corp in 2013 for a 50% interest in 165 square miles of oil sands in Alberta. CNOOC paid US$150 million for the interest and agreed to fund an additional US$3 billion in expenditures over the next 10 years.
Merit Energy Company and MegaWest Energy Corp formed a joint venture in Utah in 2012, with Merit serving as the operator. MegaWest had previously acquired oil sands in Utah in 2010 for US$50 million through a farmout agreement with privately held North Plains Energy – Merit was not involved at the time. Later, Merit acquired North Plains’ 70% interest in what was originally a 50-50 Joint Venture in 2011 through a structured buy-out that included acquiring the existing debt when North Plains defaulted.
The Martha field is a gas producing field located about seven kilometres south of Repsol YPF’s Loma Los Rios Field in Tierra del Fuego, Argentina. In the second quarter of 2007, Pacific Rubiales Energy Corp acquired a 41.667% interest in and became the operator of the Martha gas field in a joint venture agreement between OceanaGold Corporation and Geopark Marion, Corp. Subsequently, in 2011, Pacific Rubiales gained control of the Martha field by purchasing the remaining 58.33% interest from OceanaGold and Geopark. The Martha joint venture agreement provided Pacific Rubiales with a right of first refusal if either OceanaGold or Geopark wished to sell its interests in the property within the first five years of the agreement, which allegedly it did not exercise.

Future Directions for Farmout Agreements

Emerging Trends in Farmout Agreements
Expect to see more efficient use of technology in farmout agreements in the future, as companies lower costs by utilizing the latest Industry Standard Land System (ISL). Farmouts have traditionally been a method for oil and gas lessees to generate revenue while developing resources without incurring transaction costs. Both parties look for maximum benefits from the transaction while mitigating risk, and this has remained true despite the changes that the industry has undergone to restore investor and global confidence in the past few years.
Growing focus on production
More companies are asking for full detail sooner, paying a retainer or an early completion, or allowing one party to perform the work for a set fee. This is both to speed up the process and because prospective lessees want to avoid costly delays. This is especially true of large companies, who cannot afford to box themselves into long term relationships with unpredictable expenses. Although traditional farmout structures will likely remain popular, there are increasing numbers of brokers emerging to facilitate other arrangements.
Technological impact
Technology is changing the way oil and gas companies can assess properties , and it is giving investors real time data, making negotiations simpler and more accurate. Digital deals, in which the land and payment provides all documents in a digital format will continue to grow.
Due diligence is strengthened through the use of Geographic Information Systems (GIS) and other technologies, which will likely lead to a higher rate of successful deals.
Risks
Many believe that farmouts will only be considered by low-risk investors, including those whose portfolios are geographically dispersed. Even seasoned investors are proceeding with caution, weighing every option as the world moves toward stricter regulations and shrinking budgets.
The increasing popularity of farmouts, however, is expected to mean that more capital will be released from traditionally firm long-term financing – releasing cash which may reduce the impact of falling commodity prices. As sovereign wealth funds, which were neutral to the energy sector in the past, continue their investment in fossil fuel, it will be increasingly common for them to sell some of their less valuable properties in strategic farmouts, to free up additional cash for further investment.