JurisdictionUnited States
42 Rocky Mt. Min. L. Fdn. J. 299 (2005)

Chapter 3


Mark K. Boling
Southwestern Energy Company
Executive Vice President and General Counsel

Copyright © 2005 by Rocky Mountain Mineral Law Foundation; Mark K. Boling

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I. Introduction
II. The Exploration Venture
A. The Project Entity
B. The E&P Agreement
III. Defining the E&P Agreement
IV. Common Contractual Considerations
A. Contract Formation
B. Statute of Frauds
C. The Parties--Capacity to Execute/Ability to Perform
D. Recording Statute Considerations
E. Words to Use/Words to Avoid
F. The Operating Agreement
V. Documenting the E&P Agreement
A. Exploration/Participation Agreements
B. Farmout Agreements

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I. Introduction

The business of exploring for oil and gas is unquestionably one of the most exciting businesses around. Many factors contribute to this excitement, but perhaps the greatest single factor is that the oil and gas explorationist's main competition is mother nature. From the origination of the prospect idea, to the drilling of the initial well to test the idea, geologists, geophysicists and engineers pool their collective talents in an effort to "outsmart" mother nature and get her to share some of the energy resources that we need to sustain our world economy. Although technological advances have helped improve our industry's drilling success rate, the exploration business remains an always challenging and sometimes cruel business that is not for the faint of heart.

Most E&P companies attempt to manage this "exploration risk" in two ways. First, the companies hire the most talented people they can find and equip them with the most advanced exploration tools they can afford. Without a doubt, the most important ingredient for success in the E&P business is having a creative group of "exploration minded" people that work together as a team to generate exploration opportunities. The second method E&P companies use to deal with exploration risk is to establish an exploration venture and share the risk with one or more other parties. This paper will focus on this second risk management technique and discuss some of the basic considerations that go into documenting the exploration venture.

II. The Exploration Venture

The term "exploration venture" means different things to different people. When I use this term, I intend for it to include any association or common enterprise between two or more persons that is formed for the joint exploration and development of lands that are believed to be prospective for oil and gas exploration.

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A. The Project Entity. The exploration venture may take the form of a separate legal entity (the "Project Entity") that is created for the sole purpose of conducting the joint exploration and development activities. Under this type of arrangement, the newly formed Project Entity (e.g. General Partnership, Limited Partnership or Limited Liability Company) owns the venture's assets and the participants in the venture own an equity interest in the Project Entity. Each Project Entity agreement (e.g. Partnership Agreement, Limited Partnership Agreement or LLC Regulations/Operating Agreement) contains provisions that set forth (i) the ownership interests of each participant, (ii) each participant's obligation to contribute capital to the venture, (iii) the method by which the participants will manage the venture's activities, (iv) the allocation of income, expenses, deductions and credits among the participants, (v) the events that will cause the dissolution, termination and liquidation of the Project Entity, (vi) the intended income tax treatment of the venture's activities and (vii) various other matters relating to the administration of the Project Entity's affairs. Since this ownership structure can impose significant limitations on a participant's ability to assign, pledge or otherwise dispose of its interest in the venture, its use is usually limited to those situations where special tax considerations (e.g. special allocations of deductions or credits) or participant considerations (multiple individual investors) dictate that a separate legal entity be created.

B. The E&P Agreement. The exploration venture can also take the form of a common enterprise that is bound together by contractual commitments, but is not a separate legal entity. Under this type of arrangement, the ownership of, or the right to acquire an ownership interest in, the venture's assets is vested directly in each participant. The participants then enter into a contractual agreement (an "E&P Agreement") that sets forth the respective rights and obligations of the participants with respect to the joint exploration and development of the venture's assets. The remainder of this paper will focus on the documentation of three types of E&P Agreement: the Exploration Agreement, the Participation Agreement and the Farmout Agreement.

III. Defining the E&P Agreement

Before discussing the basic considerations that go into documenting these three types of E&P Agreements, it is first necessary to establish a common definition for each of the three agreements. I must caution you that the following definitions are based solely on the author's experience in preparing these types of agreements and the arbitrary conventions I have

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used to distinguish between the three agreements may differ from those of other oil and gas practitioners.

When I use the term "Exploration Agreement", I am referring to a joint exploration and development contract that covers a large amount of acreage that requires a significant amount of exploration activity (e.g. 3-D or 2-D seismic survey, magnetic survey and/or geochemical survey) before the participants can identify prospects and drill wells on such acreage. The term "Participation Agreement" refers to a joint exploration and development contract that covers one or more defined prospects that are "drill bit ready" (i.e. no significant exploration activity is required before the initial test well is drilled). The term "Farmout Agreement" refers to a contract by which one party (the farmor) agrees to assign all or a portion of its oil and gas rights in certain acreage to another party (the farmee) in exchange for the performance of certain obligations (usually including the drilling of one or more wells) by the farmee. For convenience, I will sometimes refer to the Exploration Agreement, the Participation Agreement and the Farmout Agreement collectively as the "E&P Agreement".

IV. Common Contractual Considerations

While each E&P Agreement has its own special drafting considerations, there are several contract issues that are common to all of these agreements. Some of these issues are discussed below.

A. Contract Formation. The only thing worse than having a business deal fall through because the parties cannot agree on the contract terms, is having a dispute with the other party over whether a contract exists or not. The legal analysis of contract formation is relatively straight forward (Has there been an offer? If so, has the offer been accepted?). However, the line between "preliminary negotiations" and "offer and acceptance" can often be blurred by the actions of the parties during negotiations (e.g. when one party detrimentally relies on the promises or actions of the other party). The issue is further complicated in those jurisdictions that readily impose an obligation on each party to "negotiate the contract in good faith".

The easiest way to avoid this problem is to prepare a term sheet or letter of intent early in the negotiation process that contains clear and unequivocal language negating any inference that a binding contract is intended to be formed prior to the execution of a definitive E&P Agreement. The

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following are examples of language that could be used in a term sheet or a letter of intent to avoid the "unintended contract".

Example 1:

This term sheet sets forth the basic terms and conditions under which ABC Exploration Company ("ABC") is willing to participate with XYZ Exploration Company ("XYZ") in the joint exploration and development of the Program Area and is being submitted for discussion purposes only. This term sheet, even if accepted by XYZ, shall not create any obligation on the part of either ABC or XYZ to consummate the transaction described herein. Neither ABC nor XYZ shall have any obligation with respect to the subject matter of this term sheet unless and until the parties execute a definitive Exploration Agreement incorporating the terms hereof.

Example 2:

Upon execution of this letter of intent, the parties agree to undertake, diligently and in good faith, to devote such time and resources as are reasonably necessary to prepare, negotiate and execute a definitive Exploration Agreement incorporating the terms hereof (the "Definitive Agreement") by ________, 2005. If the Definitive Agreement has not been executed by the parties on or before ________, 2005, then this letter of intent shall terminate and no party shall thereafter have any further rights or claims against, or obligations to, any other party. For the period commencing with the execution of this letter of intent and ending on ________, 2005, ABC agrees that it shall not, directly or indirectly, encourage, solicit or entertain any other offers, inquiries or proposals for, or engage in any discussions with respect to, the joint exploration and development of the Program Area.

Except for the covenants contained in the immediately preceding paragraph, this letter of intent, even if accepted by XYZ, shall not constitute a binding obligation on the part of either XYZ or ABC and no such obligation shall arise until the execution of the Definitive Agreement.

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B. Statute of Frauds. Since each E&P Agreement is a...

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