An oil and gas Farmout agreement is a commitment by the owner of an oil and gas lease, the Farmor, to assign all or part of the working interest in that lease to another party, the Farmee. It is not clearly established when the first Farmout agreement was executed, but by the 1940’s the term Farmout was freely used.
Farmout Agreements are often the most commonly negotiated agreements in development of a field, after the oil and gas lease. In a Farmout agreement, the primary consideration being services, rather than the exchange of money, makes it different from the conventional drilling transaction. The Farmee agrees to exchange services for an assignment of a future percentage of ownership in a certain lease or leases, which occurs when the required acts are accomplished. The typical act to be performed under a Farmout agreement is the drilling of one or more oil and/or gas wells.
Farmout agreements typically provide that the assigned working interest will be transferred to the Farmee upon the completion of:
The drilling of an oil and/or gas well to the defined depth; or
The drilling of an oil and/or gas well that produces at viably commercial levels as defined in the agreement.
Both 1 & 2 must be accomplished within a certain timeframe.
Farmout agreements usually include a complete definition of “payout” by stating exactly what will be deducted in calculating the payout amount.
Reasons to Enter Farmouts:
Farmors often enter into Farmout agreements in order to:
Preserve a lease by satisfying a primary term requirement, avoid Pugh clause consequences, satisfy continuous drilling obligations, etc.
Share risk or monetize an abandoned project; and
Obtain geological information from the Farmee and the Farmee’s operations.
Farmees often enter into Farmout agreements in order to:
Obtain an acreage position quickly;
Obtain acreage without leasing operations, and without expending capital on buying leases;
Utilize equipment and personnel that would otherwise not be utilized;
Develop an area while sharing risks;
Obtain geological information; and
Gain interest in a prospect area that is already leased, but the Farmor is not developing.
The negotiation of a Farmout agreement primarily rests on the goals and strengths of the negotiating parties. In a Farmout, the Farmor usually reserves an overriding royalty interest, with the option to convert the overriding royalty interest to a working interest in the lease, upon payout of drilling and production expenses, otherwise known as a back-in after payout (BIAPO). As an example, the agreement may provide for:
BPO - Before Payout of Costs: 3% overriding royalty.
APO - After Payout of Costs: Option to keep 3% ORRI or convert to 25% WI (subject to royalty burden)
Payout occurs when the Farmee has recovered all of its drilling costs out of its share of production after deducting its operating costs, certain taxes, and other expenses.
Issues with Farmouts:
1. For land departments and title examiners, failure to record notice of the Farmout may result in lack of notice and therefore failure to protect the operator’s lien rights. Recording of a memorandum of the Farmout agreement in the pertinent county solves this issue.
2. The conditions for earning an assignment and when the assignment will be delivered to the Farmee should be clearly drafted in the Farmout. Once the Farmee receives the assignment, it should be timely recorded in the county where the lands are located for the same reasons as discussed above.
3. Third, the election of the Farmor to retain an overriding royalty interest or convert it through a “convertible override” to a BIAPO working interest affects the rights of both parties and their successors-in-interest. Therefore, the Farmor’s election must be clear from the records. The election should be reflected either in the recorded assignment or in a subsequently recorded instrument.
4. Other Farmout provisions of note include the formation of an AMI, or area of mutual interest, which obligates one party to the Farmout to offer the other party a certain percentage of the interest the first party acquires in oil and gas rights within the defined geographic boundary of the AMI.
5. A Farmout may contain a call on production clause, under which the Farmor has a continuing preferential right to purchase all oil and gas production from the Farmout acreage.
Since there is no model form currently being used, Farmout clauses and construction may differ. Therefore, a Farmout must be carefully dissected in order to fully understand the obligations of each party to the agreement.