CHAPTER 6 THE ANATOMY AND PREPARATION OF OCS FARMOUT AGREEMENTS
| Jurisdiction | United States |
(May 1989)
THE ANATOMY AND PREPARATION OF OCS FARMOUT AGREEMENTS
Professor of Law Southern Methodist University 214-692-2595
Dallas, TX 75275
Oil and gas farmout agreements are important devices in spreading the risks of oil and gas exploration and development on the Outer Continental Shelf, as well as in onshore operations. In fact, because both the costs and risks (as well as the rewards) of offshore development are greater than those usually associated with onshore operations, oil and gas farmout agreements may play a more important role in operations on the Outer Continental Shelf than in onshore operations.
The structure of an Outer Continental Shelf farmout agreement does not differ substantially from that of its onshore counterpart. The function of farmout agreements is essentially the same whatever the environment in which they are used. Thus, there are relatively few essential issues that determine the basic structure of the farmout agreement. I have discussed these issues at length elsewhere.1 In this paper I will simply summarize the points made in that more extensive paper and point out some interesting characteristics of OCS farmout agreements.
A. The Purpose of the Farmout
Because the farmor — the entity farming out the lease for development — generally proposes the farmout agreement, it is the farmor's purposes that are usually reflected in the agreements supplied to me for review. The farmor's reasons for farming out an OCS lease may include (1) lease preservation, (2) lease salvage, (3) risk sharing, (4) exploration and evaluation, (5) access to market, (6) obtaining reserves, (7) drilling an
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"obligation" well, and (8) testing a business relationship.2 In each case, the farmor gives up a portion of its interest in its lease or leases to another to further what it regards as its own interest. The goals of the parties, particularly the goals of the farmor, may profoundly affect the structure of the agreement. For example, where the farmor seeks to salvage some of its investment in a lease by enticing someone else to take the risk of conducting drilling operations on it, the farmout agreement is likely to reflect very liberal terms; it suits the farmor's purpose to make the deal attractive to entice the farmee to drill. In contrast, when the farmor's primary purpose in farming out is to develop exploratory information to be used to evaluate other perspective drill sites in the area, the farmout agreement is likely to contain extensive and explicit requirements for drilling and testing.
Because large lease bonuses are generally paid for OCS leases, lease maintenance or lease salvage are probably the most common purposes of OCS farmout agreements. The best prospects are drilled early in their lease's primary terms. Drilling on less attractive prospects gets postponed from year to year until the last year of the primary term when a farmout is proposed. As a result, the terms of OCS farmout agreements are generally reasonably liberal toward the farmee, but the dates by which the farmee must perform are likely to be critical.3
B. The Duty Imposed: Option or Obligation
Like onshore farmout agreements, most OCS farmout agreements make drilling an earning well an option rather than an obligation. Some agreements provide specifically that the farmee "may commence" drilling, but that the farmee will earn only if a well capable of production is obtained. Others provide that the "farmee agrees to commence" the drilling of a test well but conclude that "the failure of farmee to commence the initial test well...will not result in farmee's liability to farmor for damages, but shall result only in farmee's loss of all rights
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under this Agreement." Either formulation makes drilling an option rather than a obligation.
The primary significance of classifying a farmout agreement as an option farmout or an obligation farmout is the effect of the failure to perform under the agreement. When the farmout is drafted as an option to drill, failure to drill will cost the farmee the benefits it might have earned. When the farmee is obligated to drill, failure to drill may expose the farmee to very substantial liabilities for breach of its agreement. In a majority of states, including Oklahoma and Louisiana, the remedy for breach of an obligation to drill is apparently the cost of drilling the promised well.4 In a minority of states, including Texas, the remedy is the benefit that the one party would have received had the other drilled the well as promised.5 That benefit may be measured by the production that would have resulted had the well been drilled as promised. Other available measures of damages include the value of the retained interest or the value of the information the drilling would have developed.6
C. The Substitute Well Provision
The substitute well provision of a farmout agreement addresses the rights of the parties in the event that the initial well is not drilled to completion. Generally, farmout agreements provide that if physical conditions in the hole or mechanical problems with drilling equipment prevent completion of the earning well, the farmee earns an option to drill a substitute
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earning well.7
Substitute well provisions are especially important to a farmee where the farmee has an obligation to drill the initial well. Even where drilling is an option rather than an obligation, however, the substitute well provision may be very important to a farmee because the clause is a vehicle by which the farmee may be able to preserve the benefits that it sought to earn by entering into the farmout agreement.8
Substitute well provisions are particularly important in Outer Continental Shelf farmout agreements because of the high risks and expenses associated with drilling offshore, and because of the possibility that the earning well will discover substantial quantities of hydrocarbons, but that the farmee will not wish to construct a platform in that location or may not be permitted to do so. Recognizing these risks, some offshore farmout agreements give the farmee the right to a substitute well if the initial well is not completed as a producing well without requiring that mechanical or geologic conditions prevent completion as a producer.9
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D. Defining the Objective Depth
The "objective depth," or the "contract depth" as it is sometimes called, is the depth to which the farmee must drill to earn its interest under the farmout agreement. Objective depth usually is described either by reference to the number of feet to be drilled or by a description of the formation to be explored. In offshore farmout agreements, objective depth is sometimes defined by reference to mud weight, in recognition that unknown geologic circumstances make it in appropriate to designate either a definite footage or a specific target formation.10
Objective depth provisions are particularly important in OCS farmout agreements because the hostile environment in which OCS operations take place substantially compound the problems of ascertaining when the objective depth has been reached. Either designating the objective depth by footage or by reference to a formation may cause interpretative difficulties. Where the objective depth is measured by footage, disputes may arise over how footage is to be measured. No industry custom or usage
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exists as to whether a footage reference is a reference to measured depth, the distance down the hole actually drilled, or to vertical depth, the vertical distance from the top to the bottom of the hole. Apparently, there is general agreement that the starting point for depth measurement in OCS operations is sea level. Where the method of describing the objective depth is to refer to a formation that the farmee will test, the risk arises that reasonable and prudent geologists will not agree whether that formation has or has not been tested. A device that may minimize this risk is to refer to a "control well," another well that has tested the formation sought.11
E. Testing and Confidentiality Provisions
Lawyers sometimes pay insufficient attention to the schedule of tests required in a farmout, considering them technical boilerplate. Tests should not be so considered. Testing provisions are always an essential issue of a farmout agreement because the tests that must be performed if the farmee is to earn add substantially to the costs and risks of the farmee. Performance of the testing schedule is both a condition of earning and a substantial cost factor to the farmee.
OCS farmout agreements generally contain more extensive and explicit testing provisions that onshore farmout contracts. This difference probably follows from the fact that data from wells drilled on the Outer Continental Shelf is more valuable than data from onshore wells. The OCS is a relatively new drilling area. Fewer exploratory wells have been drilled than onshore.
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Furthermore, wells are more expensive to drill in the OCS than onshore, so that fewer wells will be developed even in developed areas. As a result, there is little information available from sources other than drilling operators, and such data as is available is very expensive. It is in the farmor's interest to require the farmee to test fully the earning well and share the information.
In addition, some tests not always required in onshore farmout agreements are de facto a prerequisite to qualifying a well as capable of production in paying quantities under 30 C.F.R. § 250.11 , which classifies resistivity or induction electric logs, sidewall cores and wireline formation tests and mud-logging analyses as "reliable evidence." Because the regulation specifically designates such tests, farmout drafters frequently require them.
Offshore farmout agreements also almost always bar or limit...
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