Oil and gas contracts

	Development Geology Reference Manual
Series	Methods in Exploration
Part	Land and leasing
Chapter	Oil and gas contracts
Author	James C. Tinkler
Link	Web page
PDF	PDF file (requires access)

Because of the diversity of ownership of oil and gas interests and/or the need to share economic risks, the oil and gas industry has utilized a number of different contractual arrangements. The most common types of contracts used are farm-outs-farm-ins, or well trade agreements, and joint operating agreements.

Farm-outs and farm-ins (Well trades)[edit]

When the owner (farmor) of an oil and gas working interest agrees to assign an interest in a lease (called the farm-out area) to another party (farmee) in consideration of the farmee drilling a well or wells (farm-out wells) on the farm-out area, the farmor is said to have made a farm-out and the farmee has made a farm-in. Sometimes the farmee may be required to do more than drill a well, including performing geological and seismic studies or paying a cash consideration for past costs incurred by the farmor.

These farm-out agreements are usually accomplished in a nonrecordable form of letter agreement that typically contains provisions relating to the following:

Names of the parties and the effective date of the agreement
Description of the leases and lands to be farmed-out
The location, well objective depth, commencement date, and geological requirements of the farm-out wells
Substitute or lost hole well provisions in the event the initial farm-out wells are lost because of drilling problems
Earning requirements of the various possibilities, such as a dry hole, a producer, a producer at any depth, more than one well, continuous drilling, and so on
Rights retained by the farmor, including working interest, overriding royalty, net profits, or combinations of these interests
Tender of wells or leases before abandonment and/or surrender
Negotiation and setting out of the terms of the joint operating agreement if the farmor retains a right to a working interest
Obligations for rental and/or royalty payments in the event of production
Liabilities of the parties and insurance provisions
Obligations to tender interests to the farmor if the farmee obtains extensions or renewals of farm-out leases
General clauses related to notices and information furnished to the parties, audits, marketing of production, access to the wells, and gas processing

The marketing of farm-outs and their negotiation and preparation require many skills. The terms of a farm-out deal vary with the market conditions of the times. Promotion is an art in itself. It involves allowing the farmor to receive more than what costs would have been if 100% of risks associated with the farmor's eventual interest after farm-out had been paid for by the farmor.

During recent years, the term "third for a quarter" has been the basis for promotion of many farm-out deals. In these deals, the farmor attempts to recover all or as much of its past costs as the market will bear, along with the costs of the drilling of a well (to casing point, to dry hole, or through production facilities), reserving for the farmor as a back-in a percentage of the working interest (25% in "third for a quarter" deals) after the farmee has recovered the costs of the promotion (called after payout). For example, if a farmor owned 100% of the farm-out area and had land, geological and seismic studies, and estimated dry hole farm-out well costs of $300,000, the farmee, using a ratio of 3 to 4, would pay 100% of those costs for a 75% interest. A arty paying 1/3 of the costs on the same promoted basis would pay $100,000 for a 25% working interest.

Joint operating agreements[edit]

Anytime two or more owners of working interests decide to share the risk of drilling, development, or operations related to the production of oil and gas, they enter into what the industry calls a joint operating agreement (JOA) or, simply, an operating agreement. The JOA generally provides for one of the parties to act as the operator for the parties on the joint area covered by the JOA. It also specifies the operation for which the JOA was formed (the drilling of a well) and how costs and revenues will be shared, determined, and accounted for. In addition, it provides for each party's rights to the production obtained and sets out how leases will be acquired, maintained, transferred, and disposed.

Most JOAs are predicated on the basis that the operator will not profit from its management of the joint interests. Except in an emergency, it must obtain authorization from the other parties (the nonoperators) to spend money for the joint account. Also, except in certain limited circumstances, no party may prevent another party from proceeding with operations that it desires to undertake at its own cost, risk, and expense. In these cases, if less than all the parties to the JOA proceed with a project on their own and in the event production is obtained from these sole expense or sole account operations, the consenting parties who took the risk for the project are allowed to recover from the nonconsenting party's share of production 100% of the costs incurred on behalf of thenonconsenting party plus a substantial additional percentage, usually several hundred percentage points depending upon the risks of the project. The percentage is

higher for exploratory wells than for development wells.

Additional subjects covered by a JOA include the following:

Handling of title examination and the effect of loss or failure of title upon a party's interest
Designation, resignation, and removal of an operator
An operator's rights, duties, and liabilities
Providing for the initial project, usually a test well's objective depth, commencement date, location, and abandonment procedures
Expenditures and liabilities of the parties, including liens and payment defaults; payment and accounting requirements; limitations on expenditures to drill, deepen, rework, and plug back; and other operations
Handling of rentals, shut-in payments, and minimum royalties
Taxes
Insurance
Internal Revenue Service elections
Claims and law suits against the parties
Term of the JOA
Acquisition, maintenance, or transfer of interests
Other provisions, such as notices, force majeure, designation of areas of mutual interest, taking of production, gas balancing, preferential rights to purchase interests offered for sale by any party to the JOA, and compliance with laws and regulations

One of the more important parts of a JOA is the accounting schedule, which usually appears as an exhibit to and becomes a part of the JOA. This exhibit consists of five or six pages of fine print in a form developed by the Council of Petroleum Accountants Society, hence, it is called the COPAS form. The form, which is revised periodically, spells out the specific accounting methods that the operator must use to account for expenses and revenues.

Onshore JOAs used today stem from work done by the American Association of Petroleum Landmen (AAPL) to create a standard form to simplify and facilitate the negotiation of JOAs with equitable results for all the parties concerned. Revision of AAPL Form 610 was last accomplished in 1989. Offshore JOAs in present use vary from party to party, but are similar in format to the onshore JOA. The American Petroleum Institute, who first created a model form Offshore Operating Agreement in December 1984, is presently attempting to standardize the offshore JOA.

The principal differences between the onshore and offshore agreements are in the areas related to penalties (which are higher offshore than onshore because of the cost and risk) for nonconsent operations and to the number of decision points for consent or nonconsent on future high cost operations. In addition, many nomenclature changes are needed to reflect the different operational activities occasioned by an ocean environment. Also, because of intense federal and state regulation, other factors complicate the offshore agreements, such as environmental control, compliance with federally mandated nondiscriminatory practices, and the different provisions needed to handle potential catastrophes affecting insurance and liability protection.

Other agreements[edit]

There are a variety of other special agreements used in oil and gas exploration and development activities.

Well support agreements[edit]

The three types of well support agreements are dry hole contribution, bottom hole contribution, and acreage contribution.

A dry hole contribution is used by drilling parties to obtain money contributions from parties whose working interest leases located near the well to be supported will benefit from the drilling results. Dry hole contributions are paid (usually an agreed upon amount based on footage drilled) only in the event that the drilling results in a dry hole drilled to the depth specified. The party paying the contribution is entitled to all of the well data.
A bottom hole contribution is similar to a dry hole contribution except that the agreed upon money contribution is paid whether the well is completed as a producer or abandoned as a dry hole.
An acreage contribution is similar to a dry or bottom hole contribution except that the nondrilling party agrees to contribute all or part of the leases located near the support well rather than money.

Joint exploration and development agreements[edit]

These agreements or ventures arise from situations in which two or more parties pool their divided or undivided interests to share the costs and risks of either exploration or development or both. Typically, geological, seismic, and/or petroleum engineering studies, surveys, or evaluations are requisites to the agreements. Also, the typical venture involves large areas of mutual interest involving potential future lease acquisitions. Some of the participants may pay a disproportionate share of the costs of the venture for a chance to participate. These transactions may be very complex.

Bidding agreements[edit]

Bidding agreements commonly involve frontier or offshore areas where unleased public sector oil and gas interests will possibly become desirable to a group of companies who may wish to share the high bid costs and bid as a group. The group may have been formed as a result of joint exploration and/or development activities, or it may simply be a case of where a financial party desires to bid with a more knowledgeable industry partner or venturer. These agreements may be extremely complex as to methodology in determining what to bid, with whom, and at what time, as well as in the preparation process for a competitive lease sale. The formulas for participation after a sale may also be complex. Federal and state antitrust laws and other laws pertaining to penalties for collusion further cmplicate the processes.

Purchase or acquisition agreements[edit]

Purchase agreements arise when two or more parties agree to share in the future purchase of either exploratory or producing oil and gas interests. These agreements usually spell out the subject matter to be considered for purchase; the interests of the parties; how prepurchase and after purchase costs, if different, will be borne; how revenues will be shared if one or more of the parties is entitled to a disproportionate share; and all of the operating provisions to be invoked upon purchase of the interests.

Seismic option agreements[edit]

Seismic option agreements result from a party obtaining the right to purchase oil and gas interests, conditioned upon the results of a new seismic survey and/or evaluation of existing seismic. Sometimes a cash consideration must be paid for the option.

Lease exchange agreements[edit]

Lease exchange agreements involve situations in which two or more parties exchange rights and interests in an oil and gas lease in one geographic area for rights and interests in another area.

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Oil and gas contracts