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Farmout agreement

A farmout agreement differs from its sister agreement, the purchase and sale agreement (PSA)

Farmout agreement

In the oil and gas industry, a farmout agreement is an agreement entered into by the owner of 1 or more mineral leases, called the farmor, and another company who wishes to obtain a percentage of ownership of that lease or leases in exchange for providing services, called the farmee.

The typical services described in farmout agreements is the drilling of 1 or more oil and/or gas wells.
A farmout agreement differs from a conventional transaction between 2 oil and gas lessees, because the primary consideration is the rendering of services, rather than the simple exchange of money.
This is an agreement whereby the operator that owns the lease does not want to or cannot afford drill on it, so he “farms it out” to another operator who drills the well and after he recoups his costs, i.e., payout, the Farmoutor comes back in for an agreed interest.
These are not standard agreements, so the insurance specs need attention, especially the definition of “payout,” (if your client is the Farmoutor).
Very briefly, it should say that payout includes the cost of drilling and completing the well less any insurance proceeds.
This qualification is to keep the Farmoutee from getting the proceeds of control of well insurance and then recouping his payout, also.

Farmout agreements typically provide that the farmor will assign the defined quantum of interest in the lease(s) to the farmee upon the farmee finishing:
  • the drilling of an oil and/or gas well to the defined depth or formation, or
  • drilling of an oil and/or gas well and the obtaining of commercially viable production levels.
Farmout Agreements are the 2d most commonly negotiated agreements in the oil and gas industry, behind the oil and gas lease.
For the farmor, the reasons for entering into a farmout agreement include:
  • obtaining production,
  • sharing risk,
  • obtaining geological information.
Farmees often enter into farmout agreements, because they:
  • wish to obtain an acreage position,
  • need to utilize underutilized personnel,
  • need to share risks, or
  • desire to obtain geological information.
A farmout agreement differs from its sister agreement, the purchase and sale agreement (PSA), in that the PSA addresses an exchange of money or debt for immediate transfer of assets, whereas the farmout agreement addresses an exchange of services for a transfer of assets, and that transfer is often delayed until a later date (such as when the 'earning barrier' has been met).

Next, the Joint Operating Agreement (JOA).
This is the agreement by which the mineral lease owner gets others to invest in the well.
An operator is appointed–usually the mineral lease owner, who typically owns the largest interest - and the investors become non-operating working interest owners.

By far the most frequently used instrument in this transaction is American Association of Professional Landmen (AAPL) Form 610.
This form states the relationship between the operator and the non-operators concerning the drilling and production of the well(s).
There is one small clause that says that the operator is not responsible for damages or liabilities unless he is grossly negligent.
And that is all that is said about the subject.
The insurance section merely says that the operator will carry workers’ compensation insurance and then references Exhibit D.
The problem is that there is no Exhibit D proffered from the AAPL.
Each exhibit is whatever the operator puts in and they are all different, ranging from very sophisticated to almost ineffectual.
Since this document becomes the linchpin in the event of a loss, the insurance specifications should be well drafted, and they should expand the concept that the operator is not responsible for losses unless grossly negligent, that is, state who is responsible, have an enforceable hold harmless agreement, etc.

Next, the Drilling Contract.
As with the JOA, various forms exist but the most commonly used are those promulgated by the IADC.
Other forms range from heavily operator-weighted ones used by large, sophisticated operators to extremely simple ones offered by small 1-2 rig drilling companies.
There are various indemnifications in these agreements, some that can be negotiated, some that can be modified and many that are firm.
And, as in the JOA, the insurance specs are woefully lacking.

Read the reservoir damage, pollution damage, in-hole equipment and other indemnifications clauses.
Focus on the operator’s liability for damage to the drilling rig assigned in the sound location and the environmental damage clauses.
The drilling contractor indemnifies the operator for any damage to the drilling rig, except for damage occurring under these 2 clauses.
Since 2003 this is the operator’s sole responsibility, i.e., he gets no relief from any insurance the drilling contractor is carrying.
And, a recent court case broadens what losses are considered under the sound location clause.
To make matters worse, the operator seldom carries insurance that will pay for the rig, or at least for the total replacement cost.

Also, compare the warrantee in the Control of Well policy regarding the BOP (Blowout Preventer) to the contractor’s warrantee concerning the same subject, then note the indemnification of the contractor for control of well costs.
The operator will inspect the BOP to make certain it is working.
The drilling contactor will inspect it for the same reason.
The gumbo gets real thick later in the contract, however, when the operator indemnifies the drilling contractor for costs of well control, damage to the hole and damage to the reservoir, i.e., everything that can happen if the if the BOP is not inspected and the well blows out.

The governing instrument - the Master Service Agreement (MSA).
This is a different animal from the JOA and the drilling contract in that there is not a benchmark contract to work against.
While all MSAs should aim toward the same goal, each operator and each well service company has its own version, and there can be great differences.
Primarily, your concern is that your client is using an MSA.
Make sure that the terms contain, at best, the indemnities found in the IADC drilling contract concerning mutual indemnities for injury to employees.
In Texas, you must make certain that the MSA follows the restrictions and exceptions prescribed in the Texas Oilfield Anti-Indemnity Act, (which should be required reading for any broker handling operations in the state).

The Charter Agreement.
Wet operations require tugs and barges to be chartered quite frequently.
As with the MSA, the Charter Agreements vary greatly.
Compare the agreement with charterer’s legal liability insurance policy–a must for anyone operating in the water–particularly looking at the bare boat exclusion and its relationship to work barges.