By Mr Abayomi Akinjide M.A., LL.M. (Cantab)

Barrister and Solicitor of the Supreme Court of Nigeria. Solicitor of England and Wales.

I suspect that it is not obvious to non practitioners in the oil and gas business what the terms "farm-out" and "farm-in" mean. Apparently, these terms of art derived from a nineteenth century American practice in which sharecroppers were given an opportunity to earn a living by working land for farmers in return for a share in the proceeds of the crops.

Farm-out defined

The established textbook on oil and gas, Daintith & Willoughby - Untied Kingdom Oil and Gas Law (Second Edition), has the following definition: "A farm-out is an agreement whereby a third party agrees to acquire from one or more of the existing licensees an interest in a production licence, and in the operating agreement relating to it, for a consideration which, in oil industry practice, will normally consist of the carrying out of a specified work obligation, known as the earning in obligation, used in the drilling of one or more wells."

In the notes for editors to the text of a Department of Energy (before it was taken over by the Department of Trade and Industry) press release dated 27th November 1990 entitled "New Statement on Guidelines for Oil and Gas Farm-in Deals", farm-ins are described as follows: "Farm-ins are the oil industry term for deals where a company, not at present a licensee on a particular licensed area, can acquire an interest from one of the existing licensees. The transfers of interest are generally made in return for exploration or other commitments, for exchanges of licence interests, or for cash".

The Nigerian Petroleum (Amendment) Decree 1996 (Decree No.23) provides that "farm-out" means "an agreement between the holder of an oil mining lease and a third party which permits the third party to explore, prospect, win, work and carry away any petroleum encountered in a specified area during the validity of the lease". You will see therefore that farming-in is a way of acquiring a licence interest and, conversely, farming-out is a way of disposing of a licence interest. In this article, I am using the term "licence interest" or "concession interest" loosely to include the bundle of rights which a participant in an oil and/or gas joint venture owns.

Touching briefly on the other methods of buying and selling licence interests, these are as follows:-

a) Share Acquisitions. In terms of documentation this is usually an easier method of acquiring a licence interest because the buyer is acquiring the shares in the company which owns the licence interest. On the other hand, with an acquisition of assets, there will be a whole raft of documentation (which will increase depending on the number of licence interests that are being transferred), including assignments of interests, assignments of licence, novations of operating agreements, transportation agreements, pipeline agreements, lifting arrangements, oil and gas sales contracts, novations or amendments of unitisation agreements (if the field has been unitised) etc. If the buyer decides to make a share acquisition the nature of the acquisition will depend on the form of the target. If the company is a private company then a relatively straightforward private company acquisition can take place if the shareholders of the target company are willing to sell, although in practice the mechanics of the transaction, as opposed to the legal issues, will be more complex the more widely spread the shareholding in the company is.

Additional considerations will apply where the legal interest of the shares is separate from the ownership of the beneficial interest. If the target company is a publicly listed company, the acquisition can take the form of either a "recommended takeover", if the board of directors of the target company recommends to the shareholders of the target company that they accepted the offer by the buyer, or alternatively a "hostile takeover" (contested takeover), where an offer is made by the buyer to buy the target company and the terms of the offer are rejected by the board of directors of the target company.

An obvious difference between a share acquisition and a farm-in is that in the share acquisition, the buyer is buying everything within the target company which may include a number of subsidiaries involved in any range of activities apart from oil and gas exploration and production, its tax history, its assets and liabilities etc. In other words, it buys the lot.

b) Swaps. This involves the swapping of assets (with or without a cash element) as opposed to, say, a cash consideration. This method of acquiring a licence interest is particularly popular where the parties involved are short of cash and it is also a popular way of rationalising an assets portfolio in order to concentrate on areas of particular strategic importance to a company.

Another important aspect of swaps is that they are a way of avoiding the standard pre-emption clause (pre-emption rights are essentially rights which entitle each partner in an oil and gas joint venture to require any of its co-partners that wants to sell or otherwise dispose of its licence interest to a third party instead to transfer the licence interest to it).

By standard pre-emption clause is meant those pre-emption clauses which do not address the question of what happens if the consideration for an asset is not entirely in cash. Such a pre-emption avoidance technique is referred to as procuring "the unmatchable deal". The idea is that the seller and the buyer are able to strike a deal which the seller's partners will not be able to match or which is impossible to compare with what the pre-empting partners are able to offer, if the pre-emption provision says that the transfer may only go ahead to an outside third party on terms which are better for the transferor than those proposed by its partners. The principle is that you cannot compare pineapples with mangos.

c) Licensing rounds. The most straightforward way, perhaps, is through the licensing rounds conducted by the host government (the Ministry of Petroleum Resources in Nigeria or the Department of Trade and Industry in the United Kingdom). However, due to various reasons, some of them political, which may come into play in the decision about who gets what, this is not a very reliable way of obtaining a decent acreage.

I now turn my attention to farming-out/farming-in.

A farm-in has four basic characteristics. Firstly, one company (the seller) has a licence interest. Secondly, another company (the buyer) agrees to pay the seller's costs for a particular activity, usually a well, perhaps a seismic programme. Thirdly, in return the seller transfers to the buyer part of the seller's interest. Fourthly, the seller retains part of its interest.

What are the motives of a company for farming-in or farming-out?

In general, companies farm-in for the opposite reasons to those farming out. One reason is that the buyer has funds and a shortage of acreage and prospects and, conversely, the seller has acreage and is short of funds.

A second reason is rationalisation. The seller may want to get rid of acreage which is peripheral to its main operations. This may be instigated following a change of management or when one company takes over another company and inherits a diverse portfolio of acreage which may require consolidation in particular areas. An additional motivation to rationalise can be that the seller has a small equity holding in a concession which will take almost as much management time as a much larger holding. Often companies will dispose of assets which consume time and effort to an extent which they regard as disproportionate to their value in order to concentrate on acreage where they have reasonably sized interests.

Thirdly, the buyer may want the operatorship of the joint venture. This can be achieved by buying the interests of a licence holding operator or by increasing by buying the interests of a licence holding operator or by increasing the size of one's participating interest to a level whereby one will become the operator.

Fourthly, proximity to local production infrastructure, platforms and pipelines is also a strong motive for seeking a farm-in in a particular vicinity, especially if the farming-in party has an interest in the infrastructure, platforms or pipelines. The farming-in party can use its vote to ensure that future development on the concession will use the nearby facilities and so provide additional income for it and its partners owning the nearby facilities. In a situation where the party farming-in has an interest in an adjoining concession there is an additional advantage that, as a co-owner of the data valuable to its neighbouring interest and, even though it will be subject to be very difficult to prove that the data is being used for a purpose not permitted by the joint operating agreement.

Fifthly, a company may wish to acquire a "marginal oil field". This is now a topical issue in Nigeria due to a situation where the government would like to see more exploration activity in areas which, due to available data and/or size, may not be attractive to the major oil companies (see advertorial for Nigerian National Petroleum Corporation in The Guardian, Saturday, August 24, 1996). The honourable Minister of Petroleum Resources in September 1996, recognises that "The term "Marginal Field" has a complex definition as it means different things to different people or corporate bodies"…"Marginal Fields shall be defined as fields having the following characteristics: (i) low stock tank oil initially in place and therefore low reserves (ii) long distance from existing production facilities thereby making them economically unviable to be put on stream (iii) fields not yet considered for development because of marginal economics under the current market and fiscal conditions (iv) fields with crude characteristics that are different from current streams (such as crude with very high viscosity and low API gravity) which cannot be produced through conventional methods (v) all fields with one or more wells which have not been developed by the operating companies as a consequence of the companies' ranking. This in effect would include all unappraised discoveries and undeveloped fields but excludes fields with high gas and low oil reserves(vi) producing fields which have become uneconomical to produce when close to or past abandonment limits".

In the context of the North Sea, a number of farm-outs have taken place, involving so called "fallow acreage" which are akin to the Nigeria marginal oil fields and where the Department of Trade and Industry are interested in promoting some exploration activity.

Lastly, farming-in can be a good way of building knowledge, particularly if the company is a small company with no operatorship and it has staff to train.

What are the main types of farm-ins?

The different forms of farm-in turn principally on what is perhaps the most important provision in a farm-in agreement, which is the nature of the obligation of the party farming-in. There is the "exploration farm-in", which would typically involve the carrying out of seismic work, which can be done by a third party or the operator or might be done by each company separately or only one of them, and also the drilling of an appraisal well or wells. There is the "appraisal farm-in", where the work obligation will aim to establish the size and nature of the indicated deposit and will include the drilling of an appraisal well or wells. The key feature for the party farming-in is to become a party to the joint operating agreement, and also to be able to participate in any eventual development and to be able to influence the development through the decision making process established in the joint operating agreement. There is also the "development farm-in". The commercial dynamics will determine who gets what in this type of farm-in because it is essentially a sharing of risk and reward. The party farming-out will have established that there are commercial oil and gas deposits and it will be selling some of its interest to the party farming-in where typically the obligation of the party farming-in will be to perform all or part of the development work.

The farming-out party's retained interest is usually referred to as the "carried interest" or the development carry".

Lastly, in the context of the United Kingdom oil and gas industry, there is the "earn-in", which is a form of farm-in but differs from a normal farm-in only in the timing of the consent of the Secretary of State for the farming -in party to become a licensee. Under the terms of such an agreement, the party farming-in will perform whatever obligation it is required to perform but will not received governmental approval until the work obligations are complete. The rationale for this is that the original licensee must ensure that the work programme it submits to the host government when bidding for the licence is completed before it can use the licence for trading purposes. If the Secretary of State does not give consent, the agreement will provide that the farming-out party will reimburse the farming-in party all of its costs in the abortive transaction. The position of the party earning-in is obviously inferior to that of the party farming-in from a legal viewpoint in that the interest comes at a later date.

Finally, as a practical matter for those involved in farming-in and farming-out, it can be seen that since the whole farm-in/farm-out transaction is dependent on government consent, it is advisable to consult the relevant arm of the government at an early stage when negotiating this sort of agreement. The government will be interested in the identity of the farm-in party (in some cases, its nationality), its financial strength and its technical ability. In the draft Guidelines for Farm-Out and Operations of Marginal Fields, the conditions for entry prescribed by the Nigerian Department of Petroleum Resources include the requirement for the operating company to show evidence of technical competence and financial capability, the party farming-in must be a citizen of Nigeria but may have a foreign technical partner who must not have more than forty per cent. Equity participation in the venture vehicle, and the prior consent of the Honourable Minister of Petroleum Resources is required on the payment of prescribed fee.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.