The Strategic Importance of Farm Outs – Part 3

The previous articles in this series* highlighted the strategic reasons for farm out transactions and some common terms found in farm out agreements.  This article looks in more detail at some of the fundamental legal and contractual issues that should be considered when drafting and negotiating farm out agreements. [* by Richard Metcalf and Vivek Katyal of Norton Rose*, the international law firm]

For the purposes of this article: ‘Licence’ refers to a petroleum licence or other type of concession under which a government grants E&P rights; ‘Farmee’ refers to the company acquiring the interest in the Licence and performing the work obligations; ‘Farmor’ refers to the company disposing of the interest in the Licence; ‘Transferred Interest’ refers to the percentage interest in the Licence transferred to the Farmee; and Retained Interest refers to any interest in the Licence retained by the Farmor.

The farm out obligation

The following should be addressed to ensure that each type of work obligation is clear and unambiguous:

(a)        Seismic work

Seismic obligations are defined by reference to a certain number of lines being ‘shot’.  Where the farm out obligation is the payment of the Farmor’s share of the costs of  seismic work it may be advisable for expenditure to be capped at an agreed level.

(b)        Drilling of well(s)

Any wells forming the basis of a farm out obligation must be defined as precisely as possible.  Whether the wells relate to the exploration, appraisal or development stage, a well can be defined in a number of ways, including:

(i)          Target depth/geological structure;

(ii)         Location (i.e. the co-ordinates);

(iii)        Timing:  A date for commencement of drilling and a date by which the farm out obligation should be completed should be specified.  It is advisable to include a provision enabling the target date(s) to be extended as a result of circumstances beyond either party’s control;

(iv)       Abandonment: The farm out obligation sometimes extends to the temporary or permanent abandonment of a well;

(v)        Substitute wells: If the Farmee encounters drilling problems and abandons the drilling of a well prior to fulfilment of its work obligation, the Farmee will typically be deemed to be in default of its obligations under the Farm-Out Agreement unless it elects to drill a substitute well. However, the Farmee should seek to ensure that his work obligation will not entail the drilling of endless wells, since he would have already incurred costs in drilling the first well for which the target depth may not have been reached due to reasons beyond his control.  A solution is to include a financial cap on the actual costs of drilling the obligation well and/or any substitute well.  This solution could apply equally to situations where the Farmee is performing the drilling obligation or where he is “carrying” the Farmor’s share of drilling costs;

(vi)       Licence obligations: Any drilling obligation should comply with the obligations in the Licence, especially if the well to be drilled forms part of the initial Licence obligations.

Payment obligations

Nowadays drilling is often required to be conducted by the Operator and the Farmee will bear the Farmor’s share of such well costs, usually up to a specified cap.  Viewed simply, the farm out obligation is satisfied either when the well has been successfully drilled and the Farmee has borne the Farmor’s share of the drilling costs, or when the Farmee has paid a sum up to an agreed amount.  However, payment obligations often need to be tied into the target depth references, because if the Farmee reaches its financial cap but the well has not met its target depth, the Farmor will not wish to transfer a percentage of its Licence interest if the well obligation has not been fulfilled.

The issue of costs also needs to be considered when negotiating and drafting the farm out obligation, especially in situations where the Farmee is carrying the Farmor’s drilling costs.  The Farmee will inevitably want to keep drilling costs down, but if the Farmor is the Operator then it will have no incentive to keep the costs as low as possible.  One solution is a financial cap on the well costs to be borne by the Farmee.

Timing of transfer of Transferred Interest

In essence, the assignment of the Transferred Interest can take place at one of two stages:

(a)        Upon completion of the obligation

Consideration for the transfer of the Transferred Interest is invariably the fulfilment of the farm out obligation, so the assignment takes place when such obligation has been completed; in fact many believe that the transfer should not take place until then.

(b)        Following execution of the farm out agreement and receipt of governmental consent

It is not uncommon for the transfer documentation in respect of the Transferred Interest to be executed forthwith upon receipt of the government’s consent to the farm out, perhaps even before drilling commences.  Transferring an interest before the work obligation has been completed obviously exposes the Farmor to a higher degree of risk.  It is therefore imperative (assuming this is the desired commercial outcome), that protection for the Farmor is included to the effect that the Transferred Interest will be re-assigned to the Farmor if the work obligations are not performed satisfactorily.

Voting/Decision making

Unless the Farmee is a party to the relevant joint operating agreement he will be unable to have a direct say in the way the Licence interest is handled and will not have an automatic right to attend operating committee meetings.

Obviously, if the Farmee is responsible for the Farmor’s share of well, development or other costs, it would wish to have a say in the decisions relating to the drilling of a well or other such activity to which the costs it is paying relate.

As a compromise, the Farmee can require the Farmor to consult it on key decisions. In a development farm out, where the Farmee is bearing all of the Farmor’s share of costs (in addition to those relating to the Transferred Interest), a Farmee will be very keen to influence the Farmor’s vote at operating committee meetings to the extent possible.

*  Richard Metcalf, Partner and Vivek Katyal, Associate, work at Norton Rose LLP.  For further information or to discuss the legal and contractual aspects of farm out agreements in more detail, please contact Richard Metcalf (Richard.metcalf@nortonrose.com) or Vivek Katyal (vivek.katyal@nortonrose.com) directly.

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