CHAPTER 1 OPERATING AGREEMENTS, FARMOUTS, TERM ASSIGNMENTS, AREAS OF MUTUAL INTEREST, REASSIGNMENT OBLIGATIONS, AND RIGHTS OF FIRST REFUSAL
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OPERATING AGREEMENTS, FARMOUTS, TERM ASSIGNMENTS, AREAS OF MUTUAL INTEREST, REASSIGNMENT OBLIGATIONS, AND RIGHTS OF FIRST REFUSAL
Kelly Hart & Hallman LLP
Midland, TX
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WILLIAM B. BURFORD is a partner in the Midland, Texas, office of Kelly Hart & Hallman LLP. He received a Bachelor of Science degree in geology from the University of Texas at Austin in 1975, and is a 1978 graduate of the University of Texas Law School, where he was a member of the Texas Law Review. He has practiced in Midland since his graduation, primarily in the area of oil and gas title and transactional matters. He has served, since its inception, on the joint editorial board for the development of title examination standards established by the Real Property, Probate and Trust Law and Oil, Gas and Energy Resources Law Sections of the State Bar of Texas. He currently serves as the Texas reporter for the Rocky Mountain Mineral Law Foundation's Mineral Law Newsletter and is a past chair of the State Bar of Texas Oil, Gas and Energy Resources Law Section
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TABLE OF CONTENTS
I. Introduction
II. Operating Agreements
A. Operating Agreements Generally
B. Operating Agreements' Title Effects
1. Unitization
2. Allocation of Burdens
3. Nonconsent Penalties
4. Failure of Title
5. Maintenance
6. Other Title Provisions
C. Recordation of Operating Agreements
III. Farmout Agreement and Term Assignments
A. Farmouts Defined
B. Title to Farmed Out Interests
C. Material Contents of Farmouts
1. Property Subject to Agreement
2. Farmor's Reserved Interest
a. Overriding Royalty Interest
b. Reversionary Interest
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c. Retained Working Interest
3. Earning Requirements
a. Drilling
b. Single or Multiple Operations
c. Other Factors
4. Other Common Provisions of Farmouts
a. Well Takover Rights
b. Call on Production
c. Reassignment Obligations
d. Rights of Refusal
e. Areas of Mutual Interests
D. Term Assignment
IV. Restrictions on Transfer
A. Rights of Refusal
B. Areas of Mutual Interest
C. Reassignment Obligations
D. Other Restrictions
V. Conclusion
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I. Introduction.
The most fundamental legal instruments defining the rights of a producer of oil and gas usually are the oil and gas lease and assignments of interests under it. Agreements among those holding working interests under oil and gas leases, though, such as farmout agreements and operating agreements, are typical in all but the simplest oil and gas titles. These kinds of agreements may have a present effect on a company's ongoing operations or on an acquisition, or they may have some prospective or contingent effect such as by granting one or more of the parties the right to acquire or reacquire the subject property. How these collateral agreements and the rights and obligations they create should be analyzed and dealt with is the subject of this presentation.
As it is with all other aspects of title, the land professional's first principle must be to take into account all of the information and advice that the employer or client may be expected to need for a clear and comprehensive understanding of its rights and duties concerning the affected property. There are some common features of farmout agreements, operating agreements, and other agreements among working interest owners that are essential to a complete understanding of their limitations and risks. How these might best be approached will be taken in turn.
II. Operating Agreements.
More often than not, there are multiple owners of the right to develop and operate land for oil and gas production, either because of fractional undivided ownership in a particular tract on which a well has been drilled or is to be drilled or because of differing ownership in various tracts that must be pooled or combined to satisfy regulatory requirements or to arrange for orderly development. Yet practicality dictates that one person or entity be responsible for the conduct of operations. The joint owners of operating interests who desire to develop and operate a tract or area in which each of them own interests typically enter into an operating agreement under which one will conduct operations for the owners' mutual benefit. Such agreements deal with the mechanics of the development and operation of the land for oil and gas production, prescribing which of the owners may conduct operations under what circumstances and how costs and liabilities will be shared. They also include provisions that affect, or may affect, the respective parties' rights to oil and gas production. Land and title professionals must be alert to an operating agreement's impact on title to any tract within its contract area and make the client or employer aware of its effect.1
A. Operating Agreements Generally.
Although other forms exist and they are sometimes drafted without reference to a standard form, the vast majority of operating agreements in existence today are undoubtedly on one of the American Association of Professional Landmen (AAPL) Form 610 model forms, versions of which bear publication dates of 1956, 1977, 1982, 1989 and 2015. Although there usually are a few modifications and additional provisions, and
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sometimes more than a few, it is surely accurate to say that most provisions of nearly every operating agreement a land professional may encounter will be based on one of these standard forms, and that the general scheme of the forms of the agreement has remained constant through the AAPL's adoption of the successive versions.
Because the forms of operating agreement are so familiar, it is reasonable to assume that a land professional need not advise management in detail of each and every provision of an applicable operating agreement. For example, the provisions of an operating agreement granting liens and security interests are of course extremely important and have a direct bearing on title; but a landman is justified in assuming that anyone with the least industry experience will understand that an operating agreement includes those standard provisions. The landman should of course take into account the existence of any known operating agreement and note its form and essential features such as the area covered, the parties, and the term, as well as any important features that are not common to all agreements on the same form. If it is on one of the standard forms, that sort of general reference may be sufficient except where there are material departures from the standard form or where, under the circumstances, the respective owners' rights and interests are different from those observable from their legal title.
B. Operating Agreements' Title Effects.
Several aspects of the typical forms of operating agreement, or particular provisions, may affect the owners' beneficial interests in the contract area.
1. Unitization.
Where working interest ownership differs among different tracts composing the contract area of an operating agreement, the parties typically agree that all of them will share the cost of operation and all oil and gas production in proportion to their respective contributions, usually on an acreage basis. To give a very simple example, Working Interest Owner A, owning oil and gas leases on 100% of the mineral estate in E½ Section 1, may enter into an operating agreement with Working Interest Owner B, the owner of leases on 100% of the mineral estate of W½ Section 1. The operating agreement, if typical, will provide that all costs of drilling and operating wells anywhere in Section 1, and all oil and gas produced from those wells, will be shared 50% by each of Owners A and B. The effect, although there has been no transfer of legal title (and the usual forms of operating agreement include a disclaimer of any intention to effect a cross-conveyance), 2 is to pool the parties' interests in a manner that creates beneficial ownership interests in the entire tract that are quite different from the legal title that appears of record.
It should be obvious that the beneficial or "contractual" ownership in such a "working interest unit" should be reported, and made prominent, in any communications concerning land within the contract area. Moreover, the landman should be aware, and should be certain management is aware, that any examination or review of title to the working interests committed to the agreement cannot be strictly limited to some portion that is less than all of the contract area of the operating agreement. The reason is that conveyances and other transactions involving only a divided portion of the area might affect the contractual interests of the parties to the transactions in the entire contract area. 3
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In the example above, Working Interest Owner A might assign its leasehold interest in E½ Section 1 to Working Interest Owner C, so that C becomes entitled to A's contractual 50% working interest in all of Section 1. If the materials examined for a title examiner's opinion on W½ Section 1 are derived from a search of the public records that is limited to instruments affecting only W½ Section 1, the examiner might not become aware of C's ownership. The landman requesting such an opinion or searching the records should take steps to ensure that the title materials on which the examiner or researcher will rely include all those affecting working interest title to any part of the contract area, at least from the date of the operating agreement forward.
2. Allocation of Burdens.
The manner in which an operating agreement provides that royalty and overriding royalty burdens are to be allocated among the parties' interests can create special difficulties, and where these occur they should be taken into account. Where royalty burdens against all working interests are uniform, no such difficulty ordinarily arises: The parties...
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