The Strategic Importance of Farm Outs – Part 1

For small and big oil companies alike, farm out deals play a significant role in the oil and gas business.  For some small companies farm outs present an opportunity to add value to an exciting exploration prospect.  For larger companies, these deals play a critical role in portfolio management.

Whatever your perspective, farm out agreements are amongst the most common in oil and gas, coming second only to granting instruments.  All investors and companies will want to make sure they understand how these agreements work.

The term farm out is used to describe the disposal of all or part of an interest in a licence or contract by the interest holder.  This can be for cash, in which case the transaction is a simple sale, or for some other consideration.  If the disposal is for cash then the transaction may also be labelled A&D – acquisition and divestment.

However, in most of the industry, the term “farm out” is usually taken to mean the disposal of a part interest in a licence in return for the assumption of an obligation.  This type of farm out almost always takes place at the exploration stage and only very rarely during appraisal or development.  Often the obligation assumed is the drilling of a well or the shooting of seismic.

From the perspective of the interest seller, known as the “farmor”, farm outs present an opportunity to attract new money into an exploration prospect.  This can allow small companies that are tight on funding to complete their obligations to the government and thus avoid full relinquishment.

The buyer of the interest, the “farmee”, may also have greater technical capabilities and therefore can present to the farmor an opportunity to manage the project’s cost and risk profile more effectively.

For the farmee, farm outs play a crucial role in its efforts to rationalise and optimise its portfolio.  The deal could allow it entry to an interesting asset, or perhaps gain it access to a licence or region which was previously off limits.  Another motivation for the farmee may be the gathering of new geological information which would allow it to better understand the hydrocarbon potential of the region.

Of course, all farm out deals are regulated and the parties will need to ensure that they are in compliance with the terms of the licence or contract.  The approval of the government will be required before the deal is complete.

Even a cursory internet search will show that farm out deals are ubiquitous and the recently announced agreement between Mediterranean Oil and Gas (MOG) and Genel Energy is a good example.

In this farm out deal MOG’s 100% interest in Area 4, offshore Malta, will be farmed out to Genel.  Genel will acquire 75% MOG’s interest in the Area 4 Offshore Malta Production Sharing Contract.  This covers blocks 4, 5, 6 and 7.

In return, Genel will make an immediate cash payment to MOG of $10 million, presumably to cover past costs and a possible premium, and commit to pay for the first exploration well which will be drilled to a minimum depth of 2,500m.

Genel also commits to pay for a second exploration well, up to a maximum of $30 million.  If the costs of the second well exceed $30 million then Genel, at MOG’s option, is required to provide finance to MOG for its share on agreed terms.

Under this farm out agreement MOG is to remain as operator for the first exploration well at which time, or at an agreed later date, Genel can elect to become the operator.

In Part 2 I will explore farm out deals further, providing more examples of recent transactions and an overview of the main commercial terms used in these important agreements.

Comments

  1. Thanks for sharing an very useful information. It was very helpful to get to know about farm out and its importance for large size business. Very interesting one. Great post.

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