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PLATINUM GOLD SILVER BRONZE SAN FRANCISCO SEMINAR

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FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND

58

th

Annual Meeting - San Francisco June 13-16, 2012

Presented by:

Lester Zitkus Vice President –Land, Eastern Division Chesapeake Energy

Contributor:

Steven D. Bryant Jr.

Associate Landman, Eastern Division Chesapeake Energy

AAPL Copyright © 2012. All Rights Reserved.

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Introduction

 Farmout Agreement (defined): an agreement to assign an interest in acreage in return for the conduct of, or payment for, drilling or testing operations on that acreage  Since the end of World War II, the oil and gas farmout has become nearly as important as the oil and gas lease AAPL Copyright © 2012. All Rights Reserved.

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Structure

 The structure of a Farmout agreement and its essential terms are determined primarily by:  The goals of the parties entering into the agreement; and  The negotiating strengths of the parties

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Why Farmout? (Farmor’s Perspective)

 Motivating factors (historically):  Lease preservation  Risk sharing  Obtaining geological information to evaluate other leases held by the Farmor or to delineate the boundaries of a “play”, and  Drilling an “obligation well”

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Why Farmout? (Farmee’s Perspective)

 Motivating factors:  Quickly acquiring an acreage position or obtaining reserves while sharing risks and costs  Using available cash, equipment, or personnel (particularly if Farmee is a drilling services company)  Positively evaluating a prospect that the Farmor has dismissed; and  Farmee may earn acreage not otherwise available

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Five Important Considerations of Farmouts (In General)



(1) The legal duty imposed

: whether drilling the well under the terms of the Farmout is a

covenant

or a

condition

 Distinction between a

covenant

or a

condition

: relates to the liability of the Farmee for failure to drill

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Important Considerations:



(1) Legal duty imposed (continued)



Covenant

: If the Farmee promises to drill a well on the premises, then the Farmee may be held liable if it fails to perform the promise (also known as an “obligation” Farmout)

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Important Considerations:



(1) Legal duty imposed (continued)



Condition:

Farmout) the more common Farmout agreement structure (also called an “option”  Sometimes, Farmout agreements make initial drilling a

covenant

of the Farmout, but permit the Farmee to escape the obligation if it encounters unforeseen conditions in drilling.

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Five Important Considerations of Farmouts (continued)



(2) What must be done in order to earn the Assignment

 The number of wells drilled  The number and kind of tests to be conducted  Farmout agreements usually require strict compliance by the Farmee  Drill to the depth specified   Complete all tests specified; and Obtain production in paying quantities  Provisions for partial performance, substantial performance or even earning without commercial production

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Important Considerations:



(2) What must be done in order to earn the Assignment (continued)

 Types of Farmouts Requiring Different Types of Performance :  “Produce-to-Earn” Farmouts  “Drill-to-Earn” Farmouts  “Shoot-to-Earn” Farmouts  Shoot-to-Earn agreements are becoming less common in “resource” plays

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Five Important Considerations of Farmouts (continued

)



(3) What is earned

 What a Farmee earns by performing under a Farmout agreement is determined by these variable factors:  Number of leases and the working interest percentage owned in each  The depth earned under each lease  The substances (gas, oil, or other hydrocarbons) covered by the Farmout  Interests reserved by the Farmor

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Important considerations:



(3) What is earned (continued)

 Determining factors:  The negotiating strengths of the parties  The type of project (risk/reward); and  Capital costs

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Important considerations:



(3) What is earned (continued)

 The interest “earned” can be divided, undivided, or combined:  Divided interest (defined): Farmor and Farmee own interests in separate tracts  Undivided interest (defined): Results in the Farmee and Farmor each owning an interest in the tract  Combined interest (defined): Gives the Farmee the entire interest in the drillsite tract until payout and an undivided interest in acreage outside of the drillsite tract. The parties then jointly develop the undrilled acreage

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Five Important Considerations of Farmouts (continued)



(4) Number of wells that are subject to the Farmout

 Previously, the typical Farmout covered the drilling of a single well  Multiple-well Farmout considerations:  The time between the completion of a well and the commencement of drilling of the next well  The testing required  The interest earned by the Farmee if it stops drilling; and  Whether the drilling of subsequent wells is an option or an obligation

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Five Important Considerations of Farmouts (continued)



(5) Timing of issuing the Assignment of the Farmout

 At the time of the Farmout agreement  Conditional Assignment  Subject to an obligation to re-convey if Farmee fails to perform  Only if the Farmee performs the conditions precedent  Other Considerations  Administration

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Miscellaneous Issues

 Horizontal Drilling and its effect on Farmouts  Regulatory Issues  Damages for lack of performance  Abandoned Wells  Timeliness of Performance

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Selected Issues: Duty owed the Farmor by the Farmee



Energen Resources MAQ, Inc. v. Dalbosco

(Tex. App. 2000) 

Facts:

 Plaintiff farmed out its interest in several leases to the Defendant’s predecessor-in-interest and, pursuant to the Farmout agreement, acquired 25% working interest in the well drilled on the Farmout acreage following payout of the well   There was no operating agreement governing the operation of the well Defendant plugged and abandoned the well without first notifying the Plaintiff and giving it an opportunity to assume the operation of the well 

Holding:

 Court held that the Defendant breached its duty to notify the Plaintiff that it intended to cap the well, regardless of the fact that the Farmout was silent on the matter  Court cited industry custom and usage as requiring such notice

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Selected Issues: Duty owed the Farmor by the Farmee (continued)



Amoco Production Co. v. Texaco, Inc.

(La. App. 2003) 

Facts:

  Amoco Farmed out its interest in five leases to Texaco’s predecessor-in-interest Farmout agreement provided that: “if the Farmee intended to surrender, let expire, or release its rights in any part of the lease acreage, it would provide the Farmor with not fewer than 60 days advance notice thereof and, if so requested by the Farmor, reassign its rights in such portion of the lease acreage to the Farmor.”  Texaco subsequently abandoned the unit well and allowed the non-producing portion of the leases to expire without first notifying Amoco  Because only the non-producing portion of the leases were released, there was no significant decrease in the royalties received by Amoco so as to alert it to Texaco’s abandonment  Texaco then acquired new leases covering the released acreage. New gas deposits underlying the acreage were discovered, generating millions in revenue  Sixteen yeas after the lease acreage was first released, Amoco learned of the lease cancelations and filed suit against Texaco 

Holding:

On appeal, the court upheld $30,000,000 damage award to Amoco for Texaco’s failure to give Amoco prior notice before allowing a portion of the leases to expire in breach of the Farmout agreement

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Selected Issues (

continued):

Drafting issues



EOG Resources, Inc. v. Wagner & Brown, Ltd. (

Tex. App. 2006) 

Facts:

 The earning provision in the Farmout agreement contained the following language: “100 feet below the deepest producing interval.”  It was unclear as to whether this referred to the vertical depth of the test well

or

the geological formation at which production was established at whatever depth such interval is found 

Holding:

Court held that the provision referred to the vertical depth of the test well 

Osborn v. Anadarko Petroleum Corporation (

Wyoming 2000) 

Facts:

 Farmout agreement provided that if the Farmee

abandons

the test well, then the Farmor was entitled to convert his overriding royalty interest into a 50% working interest  Farmor believed that converting the test well into a water injection well constituted this

abandonment



Holding:

On appeal, court held that conversion of an oil and gas well from extraction to water injection for purposes of secondary recovery operations, when the well is part of a pooled unit and retains its share of production in the unit, does

not

constitute abandonment

FARMOUT AGREEMENTS: FARMOR, FARMEE, AND BEYOND



Resources:



Amoco Production Co. v. Texaco, Inc.

, 838 So. 2d 821 (La. App. 2003).



Energen Resources MAQ, Inc. v. Dalbosco

, 23 S.W.3d 551 (Tex. App. 2000).



EOG Resources, Inc. v. Wagner & Brown, Ltd.

, 202 S.W.3d 338 (Tex. App. 2006).

 John S. Lowe,

Oil and Gas Law in a Nutshell

(5th ed., West 2009).

 John S. Lowe,

Analyzing Oil and Gas Farmout Agreements

, 41 Sw. L.J 759 (1987).

 Kendor P. Jones,

Something Old, Something New: The Evolving Farmout Agreement

, 49 Washburn L.J. 477 (2010).



Martin v. Darcy

, 357 S.W.2d 457 (Tex. App. 1962).



Osborn v. Anadarko Petroleum Corp.

, 996 P.2d 9 (Wyo. 2000).