Common Stock Returns around Farmout Announcements in the Oil and Gas Industry.

• Author: Distadio, Luiz Fernando

1. INTRODUCTION

This paper investigates market reactions to announcements of farmout contractual agreements by Australian oil and gas explorers, a widely used strategy to jointly conduct exploration and appraisal activities in the pursuit of economic hydrocarbon discoveries. Farmouts "are very popular with smaller oil and gas producers who own or have rights to oil fields that are expensive or difficult to develop" (OilNow 2020). In terms of economic importance, Jones (2010) considers farmouts to be equivalent to oil and gas leases in terms of significance to the oil and gas industry. According to Jones (2010), one of the main factors motivating the use of these cooperative arrangements is the increasing presence of small oil and gas firms. Similarly, Sanford (1998) argues that farmouts are common alliances in the oil and gas industry, where farmors allow competitors to exploit their own assets on behalf of the alliance partners. Industry participants suggest that "... without them (farmouts), some oil fields would simply remain undeveloped due to the high risks facing any single operator" (OilNow 2020). Currently, there is only limited descriptive evidence on these important contractual arrangements. (1)

The main objective of a farmout is to exchange partial exploration rights or working interests of the permit owner ("farmor") for benefits in the form of exploration activity commitments to be undertaken by the incoming party ("farminee"). In practise, such deals allow resource-constrained farmors to progress exploration effort whilst remaining partially exposed to the project's risks and rewards. From the farminee's perspective, these alliances are an opportunity to participate in high-risk projects held by small oil and gas explorers. Consequently, this form of strategic alliance plays an important role in encouraging the participation of small firms and thus promoting competition in the oil and gas exploration industry.

We analyse farmout contractual agreements in the context of cooperative arrangements in the financial economics literature. (2) Although definitions vary, farmouts meet the broad scope of an alliance being an informal agreement involving at least two separate firms with some level of mutual commitment (Chan et al. 1997; Weston and Weaver 2004). The level of cooperation in farmouts is flexible and can take the form of medium-term non-binding agreements between two or more firms or long duration alliances focused on sequential or staged exploration effort of a given oil and gas permit. (3)

We investigate three theories and provide empirical evidence in relation to stock price reactions to farmout announcements. First, the "pooling of resources" theory argues that participants conduct alliances to combine complementary resources necessary for undertaking the project of interest. In the farmout setting, we investigate resource pooling that can be either financial or technical in nature. Second, certification theory assumes that characteristics of the incoming party in a project has potential to convey quality signals on either the venture prospect or the project vendor. Ozmel et al. (2013), for instance, find evidence of contributions of past alliances with pharmaceutical companies and venture capitalists to biotech firms' exit outcomes. Lastly, we test a hypothesis building on real options theory, which considers investment projects as real options due to their sequential nature. Myers (1977) supports the interpretation of real investment projects as call options given that a project's value derives at least partially from sequential or incremental investments. We note the paucity of research applying real options theory to strategic alliances, which is a further contribution of this study.

Evidence on alliance formation in the capital market context is relatively scarce. We contribute to the strategic alliance literature by providing the first empirical study of the capital market implications of farmouts. To date, alliance studies on oil and gas firms focus mainly on the strategies used either to bid for oil and gas leases or buy acreage with established oil reserves. For example, Beshears (2013) examines the level of productivity for solo and alliance lease bids based on estimates of economic outputs and finds evidence consistent with the expertise and information theory as the main determinants of superior alliance productivity. (4) In contrast, McConnell and Nantell (1985) and Chan et al. (1997) undertake their alliance investigations by applying an event-study approach to cross-industry samples. They find significant wealth effects around deal announcements, consistent with the synergy hypothesis.

We adopt the event-study approach to examine stock price reactions to farmout agreements announced by listed energy firms on the Australian Securities Exchange (ASX) between 1990 and 2016. (5) The sample comprises 589 and 389 announcements released by farmors and farminees, respectively. Results show that farmout agreements are important economic events, exhibiting a positive average excess return of 2.51% for the farmors on the announcement day. The corresponding average market reaction to farminees' announcements is 0.40%. Over a three-day event window [-1, 1], farmout announcements generate a positive cumulative average abnormal return of 3.60%, compared with 1.90% for farminees.

The focus of our cross-sectional tests is on farmors, as farminees are typically larger firms and thus report less detail in relation to their participation in the farmout deals on the basis of materiality. (6) Our multivariate analysis of farmor announcement returns provides evidence consistent with the resource pooling hypothesis. Disclosure of farminee financial commitment to the project is positively related to abnormal returns. Furthermore, proxies for technical resource pooling, such as farmout permits featuring unconventional targets, are also associated with higher abnormal returns. Finally, we find evidence of a positive association between oil price uncertainty and farmors' abnormal returns, supporting the interpretation of farmouts as real options on the underlying oil and gas targets.

This paper is organized as follows. Section 2 reviews relevant literature on cooperative arrangements and develops our hypotheses. Section 3 discusses the data and research methods used in our empirical tests. Section 4 presents empirical results and conducts additional sensitivity analysis. Section 5 concludes.

2. RELATED LITERATURE AND HYPOTHESES

2.1 Resource pooling

A characteristic of small firms is high information asymmetry and difficulty in raising capital to invest in often high-risk projects (Bui et al. 2020). Oil and gas exploration firms bear similarities to early-stage mining explorers and biotechnology start-ups. For example, small biotechnology firms hold portfolios of risky capital-intensive projects and face capital rationing due to their restricted access to funding. Alliances have been one way early-stage biotechnology firms mitigate funding constraints. Lerner et al. (2003) investigate sources of project funding for small biotechnology firms, with evidence suggesting public market conditions are an important determinant prompting the use of alliances as a financial channel. They find that relinquishment of project control rights are associated with time periods when the project owner raises little external financing. Alliances with pharmaceutical companies are a means through which capital is injected into specific R&D projects (as opposed to venture capital funding of small firms), the rights to which are extensively negotiated with the alliance partner (Robinson and Stuart 2007). Alliance studies also feature in other high-risk industries, with Palia et al. (2007) investigating co-financing strategies in the movie industry between small production firms and large studios. They find evidence that larger film projects, in terms of budget size, are more likely to be undertaken via alliances.

Consistent with this prior alliance literature, oil and gas farmouts are a useful setting for testing the financial resource pooling theory as firms are likely to engage in co-financing strategies with the common objective of making oil and gas discoveries. Small oil and gas exploration companies holding exploration permit portfolios lack the necessary financial resources to explore and develop all their prospects (Sanford 1998; OilNow 2020). In contrast, larger companies are interested in participating in risky ventures with potentially high payoffs. Thus, we expect higher excess returns to be associated with farminees' financial commitments disclosed in farmors' announcements. We pose our financial resource pooling hypothesis as follows.

H1a: Farmors announcing farmout agreements disclosing financial commitments from counterparties are associated with higher abnormal stock returns. McConnell and Nantell (1985) examine the wealth effects of joint venture announcements, testing for synergies arising from resource pooling. The synergy argument suggests deals benefit all participants due to more efficient asset employment (Berkovitch and Narayanan 1993; Johnson and Houston 2000). Further, these prior studies suggest the pooling of resources may extend beyond purely financial benefits, incorporating broader technical collaboration. Chan et al. (1997) investigate whether alliances involving sharing of specific knowledge or proprietary information (proxied by the presence of R&D) yield higher excess returns to the alliance partner's shareholders, relative to non-R&D deals. Although there is evidence of significant abnormal returns to both groups of deals, excess returns stemming from R&D-related alliances are not statistically different from the remainder of the sample. Das et al. (1998) examine the value creation of technological joint venture alliances vis-a-vis marketing cooperation aiming to increase...