The Farmout: What You Need To Know

(This post originally appeared on www.oklahomaminerals.com on December 3,2016)

All,

In many areas now designated as the SCOOP and STACK, there are oil and gas leases that have been held-by-production for decades. It is often a boon for the current operator of the vertical wellbore and his working interest partners to have an asset so highly desired by horizontal operators. Often, the horizontal operators will not pay the asking price the vertical operators demand for their production and outright sale of their oil and gas leases, and thus, the only items on the trade blocks are the deeper, usually undeveloped formations that the horizontal operator desire to develop and exploit. There are many ways to strike a deal in the patch, but today’s article will focus on the farmout agreement.

A farmout agreement is a common agreement in oil and gas transactions where the current working interest owner (“Farmor”) agrees to convey all or a portion of his working interest in the oil and gas lease to a second party (“Farmee”) who desires to drill a well on the oil and gas lease. The primary difference between a farmout and an assignment is that the Farmee must drill and/or complete one or more wells (the “Earning Well”) in order finalize the transfer of the working interest in the oil and gas lease.

The Farmout: What You Need To Know

A potential Farmor might entertain a farmout for a number of reasons. He might not have the expertise, knowledge, or technical equipment in order to exploit the geology. He might be unsure of the geology or unwilling to take the risk. He also might not have the capital to deploy to drill the new well.

The Farmee might entertain a farmout for a number of reasons. Likely, as in the case in the SCOOP and STACK, is that a farmout might one of the only methods for the horizontal operator to obtain rights in his desired formation that is currently held by production by existing oil and gas leases. He will also have the requisite capital and technical expertise to incur the risks of drilling the Earning Well.

There are a number of key terms that must be defined in the farmout agreement. The following should be specified:

1. The commitment – Does the Farmee have to drill one well to earn the agreement or multiple wells? Or does the Farmee have to expend a certain dollar amount instead aspecified number of wells? Does the Farmee have to drill-to-earn or produce-to-earn the Earning Well?
2. The term – How long does the Farmee have to commence operations?
3. The oil and gas leases to be earned by the Farmee
4. The target formation and well location of the Earning Well
5. The Farmor’s retained interest – What formations is he reserving from the conveyance? Is he reserving an overriding royalty interest? Are there any back in after payout provisions? How are these provisions calculated?
6. The Form of Assignment of Oil and Gas Leases to be recorded after the farmout has been earned by the Farmee.

In conclusion, farmouts are one of the ways for horizontal operators to obtain working interest in held-by-production properties and farmouts differ from assignments in that there must be an action performed by the Farmee for him to earn the working interest in the oil and gas leases. There are a multitude of ways to structure a farmout agreement, however, these are the basics provisions that need to be hashed out by the Farmor and the Farmee. If there are any other topics you would like to discuss, please mention your ideas in the comment section.

More to follow,

Berlin