CHAPTER 7 SOMETHING OLD, SOMETHING NEW: THE EVOLVING FARMOUT AGREEMENT

• Jurisdiction: United States

Oil and Gas Agreements: The Exploration Phase
(Mar 2010)
CHAPTER 7
SOMETHING OLD, SOMETHING NEW: THE EVOLVING FARMOUT AGREEMENT^*
Kendor P. Jones
Welborn Sullivan Meck & Tooley, P.C.
Denver, Colorado

Kendor P. Jones is a shareholder in Welborn Sullivan Meck & Tooley, P.C. in Denver. After obtaining his B.A. and J.D. degrees from the University of Virginia, Mr. Jones worked for several years for Wall Street law firms and then joined the newly formed law department at Union Pacific Corporation. He served as Assistant General Counsel at Union Pacific Corporation and its subsidiary, Union Pacific Resources Company, for twenty-three years, in New York City, Fort Worth, and Denver. In 1994, he retired from corporate life and re-entered private practice joining his present firm, where his practice focuses on oil and gas law. Mr. Jones chaired the Oil and Gas Program of the 39th Annual Rocky Mountain Mineral Law Institute in 1994 and he has presented a number of papers at annual and special oil, gas, and natural resources institutes and continuing education seminars. He has served as Adjunct Professor of Oil and Gas Law at the University of Denver Sturm College of Law since 2000. Mr. Jones is a former Trustee of the Rocky Mountain Mineral Law Foundation and is a current member of the Colorado Bar Association Board of Governors and a Bar Foundation Fellow. He has been designated as a Colorado Super Lawyer by 5280 Magazine and has been listed in the Best Lawyers in America every year since such publications established an oil and gas category

I. Introduction

The three most important instruments for oil and gas development have been and continue to be the oil and gas lease, the joint operating agreement, and the farmout agreement. Of the three, the lease is by far the most senior¹ and it has received the most analysis by commentators and the courts. However, as Professor John Lowe notes in his comprehensive article on farmout agreements,² since the end of World War II, the oil and gas farmout has become nearly as important as the oil and gas lease, in part, he believes, as a reaction to the increased risks and costs of deeper drilling and in the proliferation of small oil companies anxious to make deals with their larger brethren.³ This article will define a farmout agreement; review the basis for its structure--the goals of the parties and applicable tax law; and identify its key characteristics. It will then address selected issues involving farmouts, with an emphasis on recent cases. Finally, it will consider the evolution of the farmout agreement from the simple, one or two page document first used by the parties to develop a single well prospect, to the complex, multi-paged, multi-faceted document that is used today to develop large exploration plays, with increased costs and risks that have fundamentally altered the form of the agreement.

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II. Definition of a Farmout Agreement

An oil and gas farmout agreement has been defined as "an agreement by one who owns drilling rights to assign all or a portion of those rights to another in return for drilling and testing on the property."⁴ The entity that owns the drilling rights is the "farmor," while the entity that receives the right to drill is the "farmee."⁵ A farmout agreement differs from an operating agreement in that under a farmout agreement the farmee is seeking to earn an interest in the farmor's lease, while the parties to an operating agreement already own joint interests in a lease or leases or in the contract area and agree to combine these interests for joint operations.⁶ Another distinction is that the farmee "carries" the farmor--pays the farmor's share for all or a part of the costs to drill the well--while the parties to an operating agreement share such costs "heads up," in proportion to their respective ownership interests in the lands covered by the operating agreement.⁷

III. Structure of the Farmout

A. Goals of the Parties

The structure of a farmout agreement and its essential terms are determined by two considerations: the goals of the parties for entering into the farmout agreement and the applicable tax rules. The farmor may have a variety of reasons for wishing to farmout its interest. In his 1987 article, Professor Lowe identified seven factors that may motivate

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the farmor,⁸ including: (1) lease preservation; (2) lease salvage (i.e., monetizing a prospect that the farmor has condemned); (3) risk sharing; (4) obtaining geological information to evaluate other leases held by the farmor or to delineate a "play"; (5) access to the farmor's market for the sale of the farmee's production; (6) securing reserves to fill the farmee's transportation or refining needs; and (7) drilling an "obligation well" (e.g., a well required to prevent drainage, to further develop the leasehold or to prevent the application of a Pugh clause).⁹ Today, because of deregulation and the ability to hedge, access to the farmor's market is not as important as it was in 1987. Similarly, securing reserves is less of a concern, because, in normal circumstances, there are ample supplies of gas for pipelines to transport and crude for refiners to process.

The factors Professor Lowe identified in 1987 that may motivate the farmee's decision to enter into a farmout included: (1) quickly acquiring an acreage position or obtaining reserves; (2) using available cash, equipment or personnel (particularly if the farmee or its affiliate is a drilling services company); (3) a positive evaluation of a prospect that the farmor has dismissed; and (4) the desire to become active in the area, but also to share the risks.¹⁰ In the present environment, at least with respect to the farmouts covering substantial acreage that are discussed in Section VI, the desire to enter a new area, but to share the risks, is of paramount importance.

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B. Applicable Tax Rules

Complicated tax rules govern the structure of a farmout agreement and dictate its terms. The following discussion summarizes the applicable tax rules.¹¹ A farmout agreement is a form of "sharing arrangement." The essential feature of such an arrangement is that one party makes a contribution to the acquisition, exploration, or development of an oil and gas property and in return is given a share of the production from the property to which the contribution is made.¹² The contribution may be of acreage, money, goods or services, while the share of production transferred may be a working interest, a carried or net profits interest, an overriding royalty, or a production payment.¹³ The contribution must be to the property in the production of which the contributor is given an interest and, if the contribution is money, it must be made or agreed to before the costs have been incurred.¹⁴

The contributor in a sharing arrangement has made a capital investment and it acquires a depletable interest in the production.¹⁵ Neither the contributor nor the recipient realizes taxable income or loss from the contribution or transfer, because the transfer of a property interest for development is treated as the formation of a new

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economic venture, rather than a sale of property or services.¹⁶ If, as is the case with most farmouts, the farmee receives an operating interest for its contribution, the tax consequences depend on whether the entire operating interest or an undivided share of such interest is transferred to the farmee. When the farmee receives the entire working interest, it may deduct all of the intangible drilling costs (IDC)¹⁷ it pays to drill and complete the well against current income, so long as there is no possibility that the farmee's working interest in the drillsite acreage will end before the complete payout of the costs of drilling, completing, and operating.¹⁸ The IDC deduction is a very important incentive to the oil and gas industry since IDCs typically amount to between 50% and 80% of the total costs of drilling and completing a well. The IDC deduction allows investors to drill up their profits at the end of each year.¹⁹

In 1977, the IRS changed the rules of the game for farmouts with Revenue Ruling 77-176.²⁰ It modified application of the sharing arrangement concept to farmouts that involved transfers of interests in acreage outside of the well site by declaring the well site acreage and the outside acreage to be separate properties.²¹ The IRS treated the interest in the acreage outside of the well site acreage as a separate transfer subject to tax since

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the farmee made no contribution to the development of the outside acreage.²² Therefore, the farmor realizes taxable income equal to the difference between its basis in the outside acreage assigned and the fair market value of such acreage. The farmee is also deemed to have received taxable income equal to the fair market value of such outside acreage since it made no capital investment in such acreage. Thus both parties realize "phantom income" from the transaction.²³ There are a variety of devices that avoid or minimize the impact of Revenue Ruling 77-176.²⁴ The most popular of these devices is the tax partnership. The partnership is formed for tax purposes, but not for state property law purposes because the parties would then be exposed to joint and several liability. Section 721 of the Internal Revenue Code is used to designate both the well site acreage and the additional acreage as the "property" of the tax partnership.²⁵ The parties accomplish this designation by stipulating in the farmout agreement not to elect out of subchapter K of the Internal Revenue Code and agreeing to allocate income and deductions on a partnership return.²⁶

IV. Key Characteristics of the Farmout Agreement

In his 1987 article, Professor Lowe identified five key characteristics of, or areas covered by, a traditional farmout agreement.²⁷ The following analysis will address these key characteristics...