SMU Law Review

Volume 41 Issue 3 Article 2

1987

Analyzing Oil and Gas Farmout Agreements

John S. Lowe
Southern Methodist University, Dedman School of Law, [email protected]

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John S. Lowe, Analyzing Oil and Gas Farmout Agreements, 41 SW L.J. 759 (1987)
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 ANALYZING OIL AND GAS FARMOUT
AGREEMENTS*
by
John S. Lowe**

CONTENTS
. .. . .. . .. . .. . . .. . .. . .. . . .. . .. . .. . . .. .
I. W HAT IS A FARMOUT? 763
II. THE STRUCTURE OF A FARMOUT ........................... 765
A. The Applicable Tax Rules .............................. 765
1. Intangible Drilling Costs ........................... 766
2. Sharing Arrangements and Revenue Rule 77-176 .... 768
a. Assign No Outside Acreage .................... 771
b. Minimize the Value for Revenue Rule 77-176
Purposes ...................................... 773
i. Present Assignment ......................... 773
ii. Assign Continuous Restricted Options ....... 775
c. The Tax Partnership ........................... 776
d. Conclusion .................................... 777
B. The Purposes of the Parties ............................ 778
1. The Farmor's Purposes in Entering an Agreement .. 778
a. Lease Preservation ............................. 778
b. Lease Salvage .................................. 779
c. Risk Sharing ................................... 780
d. Exploration and Evaluation .................... 780
e. Access to M arket .............................. 780
f. Obtaining Reserves ............................. 781
g. To Drill an "Obligation" Well .................. 781
2. The Farmee's Purposes in Entering into a Farmout 782
III. PREPARING AND ANALYZING THE FARMOUT AGREEMENT 782
A. Prelim inary M atters ................................... 782
1. Reputation and Solvency .......................... 782
2. Reasonableness of the Proposal .................... 783
3. Preliminary Negotiations .......................... 783
4. Satisfying the Statute of Frauds .................... 785
a. Authority of an Agent ......................... 785
b. Designation of the Parties ...................... 786

* Copyright John S. Lowe, 1987.

** B.A., Denison University; LL.B., Harvard University. Professor of Law and Associ-
ate Director of the National Energy Law and Policy Institute, University of Tulsa; Visiting
Professor of Law, Southern Methodist University, 1987-1988.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

c. Identification of the Land Covered .............. 787

d. Consideration .................................. 788
5. Coordination with Farmed-Out Leases ............. 788
6. Drafting Techniques ............................... 790
a. Use Prefatory Statements of Purpose ............ 790
b. Use Appendices for Standard or Complex
Provisions ..................................... 791
c. Define the Terms Used ......................... 791
B. Key Characteristics of a Farmout ....................... 792
1. The Duty Imposed: Option or Obligation .......... 792
2. The Earning Factor: Produce to Earn or Drill to
E arn ............................................. 793
3. The Interest Earned: Divided Interest, Undivided
Interest, or Combination ........................... 794
4. The Number of Wells: Single or Multiple Well
Farm outs ......................................... 795
5. The Form of the Agreement: Agreement to Transfer
or Conditional Assignment ........................ 796
IV. ESSENTIAL ISSUES OF FARMOUT AGREEMENTS .............. 797
A. Drilling the Earning W ell .............................. 797
1. W hat Is Farmed Out .............................. 797
2. Costs and Expenses ............................... 797
3. Failure of Title .................................... 798
4. Title Inform ation .................................. 799
5. Geologic Information .............................. 799
6. Location of the W ell .............................. 800
7. Choice of Contractors ............................. 801
8. Commencement of the Well ....................... 802
a. Commencement of Operations .................. 802
b. Commencement of Actual Drilling .............. 803
9. Completion of the W ell ............................ 803
10. Time M easurement ................................ 804
11. Objective D epth ................................... 805
a. Footage vs. Formation ......................... 805
i. Footage .................................... 806
ii. Form ation ................................. 806
b. Standard of Testing ............................ 807
c. What About Shallow Production? ............... 807
d. What About Drilling Deeper? .................. 808
12. Produce to Earn or Drill to Earn .................. 808
a. Produce to Earn Farmouts ..................... 809
b. Drill to Earn Farmouts ........................ 810
13. Performance as an Option or Obligation ............ 811
a. Classification Problems ......................... 811
b. O ption to D rill ................................ 812
c. Obligation to D rill ............................. 812
1987] FARMOUT AGREEMENTS 761

14. The Substitute W ell Clause ........................ 814

a. Escape Provisions .............................. 815
b. Substitute W ell Provisions ...................... 817
i. Option or Obligation ....................... 817
ii. W ell Details ................................ 817
15. The Performance Standard ......................... 818
a. Conduct of Operations ......................... 818
b. The Earning Standard .......................... 818
B. W ell Inform ation ...................................... 820
1. Tests to be Conducted ............................. 820
2. When Must the Farmee Supply Testing
Inform ation? ...................................... 821
3. Confidentiality .................................... 822
C. W hat Is Earned? ........ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 822
1. A rea Earned ...................................... 822
2. Depth Lim itations ................................. 824
3. Substances ........................................ 827
4. Percentage Earned ................................ 828
5. Nonoperating Interest Reserved .................... 829
6. Conversion ....................................... 832
7. Payout ........................................... 833
a. Requiring More Than the Tax Rule ............. 835
b. Requiring Less Than the Tax Rule ............. 836
8. Proportionate Reduction ........................... 837
D . Adm inistration ........................................ 838
1. Operating Agreement .............................. 838
2. Handling Lease Payments ......................... 839
3. Compliance with Leases ........................... 840
4. Abandonment and Takeover ....................... 841
5. Reassignment Provisions ........................... 842
a. Perpetual Assignment with Reassignment
O bligation ..................................... 843
b. Automatic Reversion ........................... 843
c. Reversion upon Declaration .................... 844
6. Area of Mutual Interest Provisions ................. 844
7. Restrictions upon Assignment ...................... 846
8. Calls on Production, Options to Purchase, and Prior
Com m itments ..................................... 849
9. Liability, Insurance, and Indemnity ................ 851
a. Liability ....................................... 852
i. Joint Ventures and Mining Partnerships ..... 852
ii. Liability by Status as Record Title Owner ... 855
b. Insurance ..................................... 856
c. Indemnification Provisions ...................... 857
10. Regulatory Provisions ............................. 860
a. Environmental Regulations ..................... 860
b. Equal Employment Opportunity Clause ......... 861
762 SOUTHWESTERN LAW JOURNAL [Vol. 41

c. Compliance with Conservation Laws ............ 861

d. Securities Regulation ........................... 861
e. O thers ......................................... 861
11. Dealing with Bankruptcy .......................... 862
12. Terms of the Assignment .......................... 865
13. R ecording ........................................ 866
V. CONCLUSION ............................................... 867

INCE the end of World War II, the oil and gas farmout agreement

has become nearly as important and commonplace in the petroleum

industry as the oil and gas lease. In part, this is a reaction to the
increased risks and real costs of deeper drilling.' The phenomenon also re-
flects an increase in sophistication and a proliferation of small oil companies,
both of which resulted from sharp increases in real prices for oil and gas in
2
the 1970s.
Though farmout agreements are ubiquitous in the late 1980s, practitioners
and scholars have not standardized farmout agreements to the degree that
they have oil and gas leases. Parties often enter into farmout agreements on
the basis of informal "letter agreements." Legal writers have given relatively
little attention to provisions and interpretative problems of farmout agree-
ments. 3 Yet, one does not need a crystal ball to predict that farmout agree-
ments will demand an increasing percentage of the time of oil and gas
lawyers and of the courts as the years go by. The purpose of this Article,
therefore, is to analyze the structure of typical agreements and consider

1. Though the average depth of wells drilled in the United States between 1975 and 1981
remained virtually the same (4,531 feet average in 1975 versus 4,501 feet average in 1981),
average drilling costs increased 155%, from an average of $177,793 to $453,691. See 1986
ENERGY STATISTICS SOURCEBOOK 45, 47, 49, 51, 63, 66-67, 109-10, 116-17. During that same
time period, United States natural gas reserves decreased 12%, from approximately
228,000,000 MMCF to 201,500,000 MMCF, while United States oil reserves declined 10%,
from approximately 32,700,000,000 barrels to 29,500,000,000 barrels. Id.
2. The average price of crude oil at the wellhead in the United States increased from
$3.89 per barrel in 1973 to $31.77 in 1981. See id. at 295. The average price of natural gas at
the wellhead increased from 21.6 cents per MCF to $1.98 during the same period. Id. Partly
in response, United States employment in oil and gas extraction increased from approximately
273,900 in 1973 to a peak of 708,300 in 1982. Id. at 395.
3. Though none are comprehensive, several excellent papers address issues of farmout
agreements. See I L. MOSBURG, STRUCTURING EXPLORATION DEALS ch. 3 (1983); T. FAY,
DRAFTING STANDARD FORM FARMOUT AGREEMENTS (A.B.A. Sec. Nat. Res. L. Monograph
Series No. 1, 1986); Bledsoe, A Detailed Look at Farmout Agreements, ADVANCED OIL, GAS
AND MINERAL LAW COURSE, 1986 TEX. OIL, GAS & MIN. L. SEC. N-I; Brown, Assignments
of Interests in Oil and Gas Leases, Farm-OutAgreements, Bottom Hole Letters, Reservations of
Overrides and Oil Payments, 5 INST. ON OIL & GAS L. & TAX'N 25 (1954); Cage, Anatomy of
A Farmout, 21 INST. ON OIL & GAS L. & TAX'N 153 (1970); Glass, Farmout Agreements,
WORKSHOP ON BASIC OIL AND GAS INSTRUMENTS, 1985 A.B.A. SEC. NAT. RES. L.;
Himebaugh, An Overview of Oil and Gas Contracts in the Williston Basin, 59 N.D.L. REV. 7
(1983); Klein & Burke, The Farmout Agreement. Its Form and Substance, 24 ROCKY MTN.
MIN. L. INST. 479 (1978); Lamb, Farmout Agreements-Problemsof Negotiation and Drafting,
8 ROCKY MTN. MIN. L. INST. 139 (1963); Schaefer, The Ins and Outs ofFarmouts: A Practi-
cal Guidefor the Landman and the Lawyer, 32 ROCKY MTN. MIN. L. INST. 18-1 (1986); Scott,
How to Preparean Oil and Gas FarmoutAgreement, 33 BAYLOR L. REV. 63 (1981).
1987] FARMOUT AGREEMENTS

some of the problems and alternatives that practitioners must confront in

4
drafting or reviewing farmout agreements.
Farmout agreements are important tools of a big business, and only the
creativity of draftsmen and negotiators limits the options that the parties
may consider. While this Article does not cover everything that one might
want to know about farmouts, it does attempt to cover the basic issues that
an agreement must address and to collect representative language. Even in
these respects, however, the Article is not complete. In particular, many
types of clauses are omitted because the author could not find examples
within the time strictures of writing.

I. WHAT IS A FARMOUT?

An oil and gas farmout agreement is an agreement by one who owns drill-
ing rights to assign all or a portion of those rights to another in return for
drilling and testing on the property. 5 The individual or entity that owns the
lease, called the "farmor" or "farmoutor," is said to "farm out" its rights.
The person or entity that receives the right to drill, referred to as the
"farmee" or "farmoutee," is said to have "farmed in" to the lease or to have
entered into a "farm-in agreement."
The origin of the term "farmout" is not clear. Professor Hemingway has
said that the term's use goes as far back as ancient Roman times, when the
state transferred the right to collect certain taxes to private individuals who
received a fee for their services. 6 Other commentators have attributed
"farmout" to the term used in baseball:

4. This Article is made possible by a grant from the Oil, Gas & Mineral Law Section of
the Texas State Bar Association, and by the assistance of dozens of lawyers and landmen who
responded to the author's request for suggestions and who provided more than one hundred
example agreements. Those who responded included: Carol B. Arnold, Houston; David M.
Arnolds, Denver; L.L. Atwell, Jr., Midland; Karen A. Berndt, Houston; Henry C. Brumley,
Wichita; Wilson H. Busby, Tulsa; Lewis C. Cox, Roswell; Wayne Cummings, Dallas; Shonnie
L. Daniel, Tulsa; Andrew B. Derman, Dallas; Frank Douglass, Austin; Theresa U. Fay, Dal-
las; Terry Noble Fiske, Denver; Douglas B. Glass, Houston; James C.T. Hardwick, Tulsa;
Terry E. Hogwood, Houston; Albert D. Hoppe, Houston; Charles C. Keeble, Houston; C.
Glyn King, Midland; Robert F. LeBlanc, Tulsa; Robert W. Lee, Tyler; William J. Legg,
Oklahoma City; Pat Long, Amarillo; Thomas W. Lynch, Dallas; Charles F. Mansfield, Tulsa;
Martha L. Marshall, Oklahoma City; Clyde 0. Martz, Denver; Peter C. Maxfield, Laramie;
Steven F. Meadows, Dallas; George J. Morgenthaler, Minneapolis; Joseph W. Morris, Tulsa;
R. Clark Musser, Oklahoma City; Kevin McDonald Myles, Denver; Ljubomir Nacev, Tulsa;
W.F. Pennebaker, Midland; James M. Piccone, Denver; David E. Pierce, Topeka; Howard F.
Saunders, III, Amarillo; Hugh V. Schaefer, Denver; John R. Scott, Dallas; Richard S. Simms,
Houston; Ronald T. Sponberg, Midland; Ernest E. Smith, Austin; Jeanmarie B. Tade, Hous-
ton; Anthony F. Winn, Pittsburgh; and Thur W. Young, Pittsburgh. Sample provisions
quoted throughout this Article are taken from example agreements provided unless the source
is otherwise identified.
The author gratefully acknowledges also the support of Margaret Carpenter, his secretary,
and the research assistance of Anne L. Box, Mark A. Haney, Charles L. Hamit, Brett M.
Godfrey, and Eric Carlson, while they were students at the University of Tulsa College of
Law. Of course, the responsibility for the statements made remains with the author.
5. E. KUNTZ, J. LOWE, 0. ANDERSON & E. SMITH, CASES AND MATERIALS ON OIL
AND GAS LAW 624 (1986).
6. Hemingway, The Farmout Agreement: A Story Short But Not Always Sweet, I NATU-
RAL RESOURCES AND ENVIRONMENT No. 2 (1985).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

[I]n the oil and gas industry it has substantially the same connotation as
it has in the more familiar baseball vernacular. Like the rookie ball-
player who may be farmed out to a minor league team for further train-
ing, an oil and gas lease may be farmed out for development. In
baseball, the major league team frequently retains some kind of interest
in the player, and the grantor in a farm-out transaction retains some
7
kind of property interest in the oil and gas lease.
Whatever the term's origin, "farmout" has become firmly entrenched in the
oil and gas industry, though the courts did not use it until 1957.8
Farmout agreements must be distinguished from other commonly encoun-
tered kinds of oil and gas contracts such as operating agreements, support
agreements, and seismic options. An operating agreement is an agreement
between owners of the right to drill in an area that sets out the rights and
duties of each in operations on the property subject to the contract. 9 The
primary distinction between an operating agreement and a farmout agree-
ment is functional. A farmout agreement is a contract by which one party
earns an interest in an oil and gas lease owned by another, while an operat-
ing agreement is entered into to define the rights and duties of parties who
already own joint interests in a lease or a drilling unit and to combine those
interests for joint operations. Another distinction is that the farmee "car-
ries" the farmor for all or a portion of the drilling costs in a farmout, while
the parties to an operating agreement generally share the costs of drilling.
Typically, those who enter into a farmout agreement also will execute an
operating agreement to govern their rights after they have performed the
farmout contract. 10
A support agreement, sometimes referred to as a contribution agreement,
is a contract by which one party agrees to contribute money or acreage to
another party in return for geological information developed by the drilling
operations of the other."I Subtypes of support agreements are typically de-
scribed by reference either to the conditions upon which payment will be
made or to the form of the contribution. A dry hole agreement is a support
agreement in which the obligation to make payment is conditioned upon the
drilling of a dry hole. 12 A bottom hole agreement is a support agreement
that conditions the obligation to pay upon drilling to total depth and test-
ing. 1 3 An acreage contribution agreement typically looks very much like a
bottom hole agreement, except that the contribution for drilling and testing
comes in the form of interests in property that the contributing party owns,
14
rather than in money.

7. C. RUSSELL & R. BOWHAY, INCOME TAXATION OF NATURAL RESOURCES 7.02

(1986).
8. Cage, supra note 3, at 153-54. Cage asserts that the court in Petroleum Fin. Corp. v.
Cockburn, 241 F.2d 312, 313 n.2 (5th Cir. 1957), first used the term "farmout."
9. J. LOWE, OIL AND GAS LAW IN A NUTSHELL 350 (1983).
10. See infra notes 346-51 and accompanying text.
11. J. LOWE, supra note 9, at 347.
12. 8 H. WILLIAMS & C. MEYERS, OIL & GAS LAW 255 (1987).
13. Id. at 84.
14. Id. at 14.
1987] FARMOUT AGREEMENTS

Support agreements are closely related to farmout agreements, particu-

larly farmout agreements for the purpose of exploration and evaluation. A
well drilled under a support agreement is located on a lease owned by the
drilling party, while under a farmout agreement a well is drilled on a lease
owned by the contributing party. Timing may be the functional distinction.
If the support agreement develops positive information, the party who
agreed to make the contribution may follow it up by proposing a farmout.
Indeed, in a variation upon an acreage contribution agreement, the contrib-
uting party will promise to farm out designated property if the drilling party
will test its own lease.
A seismic option agreement may also be preliminary to a farmout agree-
ment. A seismic option agreement is a contract in which one party agrees to
conduct geophysical tests on the property of another, with the option or
obligation to farm into or to buy a specified amount of acreage thereafter.'"
Parties often use a seismic option when they deal with large leases in unex-
plored areas.
Many problems are common to operating agreements, support agree-
ments, seismic option agreements, and farmout agreements, 16 all of which
may be described as "exploration agreements." Frequently parties make
agreements that encompass more than one kind of contract and blur the
distinctions made here. Nonetheless, these distinctions are helpful for ana-
lytical purposes and they reflect the practice of the oil and gas industry.

II. THE STRUCTURE OF A FARMOUT

The interaction of two major factors determines the structure of a farmout

agreement, the way that its essential terms are put together. One is the tax
rules applicable. The other is the purposes of the farmor and the farmee in
entering into the agreement.

A. The Applicable Tax Rules

Farmout agreements are drafted with a wary eye upon the Internal Reve-
nue Code. In fact, complicated tax rules dictate the structure of a farmout
agreement. This section reviews the basic tax concepts that apply to

15. See Vander Ploeg, ParticularProblems in the Structuring ofBroad Area Exploration
Contracts, 5 E. MIN. L. INST. § 14.01 (1984); Himebaugh, supra note 3, at 31-32.
16. See L. MOSBURG, supra note 3, ch. 2 (support agreements); A. DERMAN, JOINT OP-
ERATING AGREEMENT: A WORKING MANUAL (A.B.A. Sec. Nat. Res. Monograph Series No.
2, 1986) (operating agreements); Hardwick, AAPL Model Form Operating Agreement-I 982:
Changes and Continuing Concerns, 1982 ROCKY MTN. MIN. LAW SPEC. INST. ON OIL AND
GAS AGREEMENTS (operating agreements); Moore, Joint Operating Agreements-Is There Re-
ally a Standard That Can Be Relied Upon?, 5 E. MIN. L. INST. § 15.01 (1984) (operating
agreements); Vander Ploeg, supra note 15, § 14.01 (seismic options and support agreements);
Young, Oil and Gas Operations." Who Does What, To Whom, For Whom, and Who Pays, How,
and When, 27B ROCKY MTN. MIN. L. INST. 1651, 1652 (1982) (operating agreements);
Young, Oil and Gas Operating Agreements: Producers 88 Operating Agreements, Selected
Problems and Suggested Solutions, 20 ROCKY MTN. MIN. L. INST. 197, 198 (1975) (operating
agreements).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

farmouts and explains how they affect the arrangements that the parties
negotiate.

1. Intangible Drilling Costs

The intangible drilling cost (IDC) deduction provides a very important
incentive to the oil and gas industry. Section 263(c) of the Internal Revenue
Code grants the IDC deduction. 1 7 It permits those who drill oil or gas wells
to take a deduction against current income for the intangible costs of drilling
and completing wells. 18 Intangible drilling costs are generally defined as
those costs that have no salvage value in themselves and are "incident to and
necessary for the drilling of wells and the preparation of wells for the pro-
duction of oil and gas."' 19 Intangible drilling costs include the costs of
wages, fuel, repairs, hauling, and supplies used in drilling, fracturing and
cleaning wells, site preparation, and construction of derricks, tanks and pipe-
lines necessary for the drilling and preparation of wells for production. 20
Intangible drilling costs typically amount to between 50% and 80% of the
total costs of drilling and completing an oil or gas well. The IDC deduction
makes oil and gas investments attractive to tax-oriented investors because
intangible drilling costs are such a large percentage of the total costs of drill-
ing and completing a well. The IDC deduction allows investors to drill up
21
their profits at the end of each year.
The IRS has limited the IDC deduction by applying what may be called
the "complete payout" limitation. 22 Simply stated, the limitation provides

17. I.R.C. § 263(c) (West Supp. 1987).

18. Id. The deduction is subject to many limitations. Noncorporate taxpayers who de-
duct IDCs may be subject to minimium taxes and may be limited to the amounts actually at
risk. See C. RUSSELL & R. BOWHAY, supra note 7, 11.01-.06, 14.19. Integrated oil compa-
nies must capitalize a portion of intangible drilling costs under I.R.C. § 291(b), (c) (West
Supp. 1987), and all who claim the deduction are subject to the recapture provisions of id.
§ 1254.
19. Treas. Reg. § 1.612-4(a) (1965).
20. Id. For a list of typical costs incurred in the exploration and development of oil and
gas and a suggested treatment of such costs for intangible drilling costs deduction purposes, see
C. RUSSELL & R. BOWHAY, supra note 7, 14.12.
21. See C. RUSSELL & R. BOWHAY, supra note 7, 14.11-A. The percentage depletion
provisions of I.R.C. § 613A are also important.
22. See Rev. Rul. 71-207, 1971-1 C.B. 160; Rev. Rul. 71-206, 1971-1 C.B. 105; Rev. Rul.
70-336, 1970-1 C.B. 145, modified, Rev. Rul. 80-109, 1980-1 C.B. 129; Rev. Rul. 69-332, 1969-
1 C.B. 87. The language of the first three revenue rulings is virtually identical:
Section 263(c) of the Code, as implemented by section 1.612-4 of the Income
Tax Regulations, provides an option to charge to capital or to expense the intan-
gible drilling and development costs incurred in the drilling of oil and gas wells.
This option is available only to an operator who is defined as one who holds a
working or operating interest in any trace or parcel of land either as a fee owner
or under a lease or any other form of contract granting working or operating
rights. Section 1.612-4(a)(3) of the regulations, however, provides the following
limitation on the option which is pertinent here:
* * * except that in any case where any drilling or development project is
undertaken for the grant or assignment of a fraction of the operating rights, only
that part of the cost thereof which is attributable to such fractional interest is
within this option. . ..
Thus, the limitation in the regulations is operative if the drilling and develop-
ment project is undertaken "* * * for the grant or assignment of a fraction of
1987] FARMOUT AGREEMENTS

that one may not claim an IDC deduction except to the extent that (1) one
actually pays or accrues the expense, and (2) one will own the working inter-
est for which the payment is made for the complete payout period. 23 One
cannot take a tax deduction for intangible drilling costs paid for by another.
For example, if a farmor and a farmee were to enter into a farmout agree-
ment on a 50% "straight-up" basis, with the farmor contributing the farmed
out lease, the farmee paying all costs of drilling and completing the well, and
the farmor and the farmee sharing operating costs and profits equally, 50%
of the total IDC deduction would be lost. The farmee, who actually paid
100% of the costs, could deduct only the 50% of the IDCs that it paid
because it would earn only 50% of the working interest. The farmor would
be entitled to no IDC deduction because the farmor paid none of the intangi-
ble drilling costs. Thus, a potential tax benefit would be lost 24 and the
farmee would suffer a substantial increase in the cost of performing the
agreement.
Because of the complete payout limitation, farmout agreements are
drafted in a way that often seems strange to those who are not aware of the
tax rules. The farmee earns an interest in the working interest of the drill
site acreage equal to the percentage of the costs that it pays. The farmee, for
example, would earn 100% working interest for paying 100% of the drilling
and completion costs, 75% working interest for paying 75% of drilling and

the operating rights * * *." The carryingparty will have undertaken the drilling
and development projectfor the entire working interest only if he holds the entire
working interest throughout the complete pay-out period. If the carrying party
holds the entire working interest for a period that is less than a complete pay-out
period he will have undertaken the drilling and development project for the frac-
tion of the operating rights that he receives as his "permanent" share in the
mineral property.
Rev. Rul. 70-336, 1970-1 C.B. at 145 (emphasis added). For similar language see Rev. Rul.
71-207, 1971-1 C.B. at 160 and Rev. Rul. 71-206, 1971-1 C.B. at 105.
The language quoted does not address whether an agreement would satisfy the complete
payout test if the definition of payout in the farmout agreement did not require that the farmee
retain the working interest until payout, but in fact the farmee did retain it. In Rev. Rul. 80-
109, 1980-16 C.B. 129, modifying Rev. Rul. 70-336, however, the IRS concluded that the mere
possibility of a premature termination of the farmee's interest was disqualifying.
23. Rev. Rul. 70-336, 1970-1 C.B. at 145; Rev. Rul. 71-206, 1970-1 C.B. at 105; Rev. Rul.
71-207, 1971-1 C.B. at 160. The language of the revenue rulings is virtually identical as to the
definition of the "complete payout":
The determination of the complete pay-out period requires an interpretation of
the carried interest agreement and the performance of the parties under the
agreement. As a general principle, however, the period ends when the gross
income attributable to all of the operating mineral interests in the well (or wells,
in the case of agreements covering more than a single well) equals all expendi-
tures for drilling and development (tangible and intangible) of such well (or
wells) plus the costs of operating the well (or wells) to produce such an amount.
Rev. Rul. 71-206, 1970-1 C.B. at 105. See Rev. Rul. 70-336, 170-1 C.B. at 145-46, and Rev.
Rul. 71-20, 1971-1 C.B. at 161, for similar language.
24. The farmee's tax benefit may not be irrevocably lost, because the farmee could capital-
ize the portion of the IDCs not deducted and recover the IDC through cost depletion over the
productive life of the well. The parties likely will substantially discount a deferred tax deduc-
tion in making their deal, however, so that for practical purposes it may be considered lost.
Moreover, if the farmee qualifies for percentage depletion under I.R.C. § 613A, capitalized
costs effectively are lost because percentage depletion may be taken on a zero basis.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

completion costs, etc. The farmor, which typically has a substantial invest-
ment in the lease, provides for a flow of income by retaining a nonoperating
interest such as an overriding royalty interest. The farmor will often retain
the right to "back in" to a working interest in the well site acreage after
"payout," that is after the farmee has recovered all of its costs of drilling,
completing, and producing the well. The IRS has accepted such transac-
tions as qualifying the farmee to deduct the full percentage of IDC it pays so
long as there is no possibility that the farmee's working interest in the drill
site acreage will end before complete payout of the costs of drilling, complet-
25
ing, and operating.

2. Sharing Arrangements and Revenue Rule 77-176

The IRS generally recognizes a farmout agreement as a "sharing arrange-
ment," which it has defined as a transaction in which one party makes a
contribution to the acquisition, exploration, or development of a mineral
property and reserves as a consideration an interest in the property to which
the contribution is made. 26 A sharing arrangement does not trigger recogni-
tion of income for tax purposes because the transfer of a property interest for
development is treated as formation of a new economic venture, rather than
as a sale of property or services.2 7 The Internal Revenue Code contains sev-
eral sections that permit sharing arrangement treatment to the formation of
new businesses.2 8 IRS administrative memoranda, rather than specific code
provisions, have recognized farmouts as sharing arrangements. 29 The IRS

25. See Rev. Rul. 80-109, 1980-1 C.B. 129. For an example of the strictness of the IRS
position, see infra notes 340-43 and accompanying text. Although the logic of the revenue
rulings should permit a farmee to claim a fraction of the IDCs as long as the complete payout
limitation is met for that fraction, the black letter law of the revenue rulings states that the
farmee must hold 100% of the operating rights until payout. See P. MAXFIELD & J. HOUGH-
TON, TAXATION OF MINING OPERATIONS 9.04[5][b][ii] (1987).
26. Gen. Couns. Mem. 22,730 (1941). A general counsel memorandum is an informal
statement of principle for guidance of agency personnel.
27. See P. MAXFIELD & J. HOUGHTON, supra note 25, §§ 9.01-.05.
28. See I.R.C. § 351 (West Supp. 1987) (no gain or loss recognition on exchange of prop-
erty for stock of corporation); Id. § 721 (no gain or loss recognition to partnership or any of its
partners when contribution of property is made to partnership in exchange for interest in capi-
tal and profits).
29. See Palmer v. Bender, 287 U.S. 551 (1933). In Palmer the United States Supreme
Court characterized oil and gas in place as a reservoir of capital investment of the parties who
agree to share in production. Id. at 557. The Court reasoned that parties to a pool of capital
should consider transactions involving assignments of interests in oil and gas that required the
assignees to assume all or part of the burden of exploitation as contributions. Id. at 557-58.
The IRS adopted the "pool of capital" concept in Gen. Couns. Mem. 22,730 (1941). In Gen.
Couns. Mem. 22,730 the IRS recognized that the drilling party under a farmout agreement
could deduct the full amount of intangible drilling costs paid or incurred if that party complied
with the complete payout limitation discussed above. One source interprets Gen. Couns.
Mem. 22,730 to mean that acquiring an interest in a mineral property in return for services
related to development of the property does not result in income either to the person perform-
ing the services or to the person receiving the services if three conditions are met:
First, . . . if the interest received is an economic interest in mineral in place
for depletion purposes . . . and only if such interest is acquired for services or
equipment related to exploration or development. An interest would, therefore,
not qualify if it was received for services rendered after the property was devel-
1987] FARMOUT AGREEMENTS

reasons that the exchange of interests for development in a farmout agree-

ment constitutes a contribution by the parties to a pool of capital. The par-
ties to a farmout agreement therefore do not recognize income from the
farmout transaction. A farmout is treated as a tax-free transfer, which has
been a very important incentive to its use by the industry.
The little world of farmout agreements turned upside down in 1977 when
the IRS changed the rules of the game with Revenue Ruling 77-176.30 Reve-
nue Ruling 77-176 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. 3 1 Thus, while the transfer of interest in the well site acreage in
exchange for drilling remained sheltered from tax as a sharing arrangement,
the IRS treated the interest in acreage outside of the well site acreage as a
32
separate transfer subject to tax.

oped, if it was not an economic interest in mineral in place, or if it was otherwise

unrelated to development ...

Second, an economic interest in the mineral in place must be the agreed-upon

consideration for the services or equipment in order to be received without
tax . ..
Third, the economic interest must be in the property to which the contribu-
tion is made.
A. BRUEN & W. TAYLOR, FEDERAL TAXATION OF OIL AND GAS INVESTMENTS 5.02, at 5-2
to -3 (1985) (footnotes omitted). The typical farmout transaction does not result in realization
of income by either the farmor or the farmee because it meets these three conditions. See also
Linden, Income Realization in MineralSharing Transactions: The Pool of Capital Doctrine, 31
INST. ON OIL & GAS L. & TAX'N 487, 508-09 (1981) (discusses income realization in typical
farmout transaction).
30. Rev. Rul. 77-176, 1977-1 C.B. 77, 79. A revenue ruling is the IRS's formal statement
of its position regarding a particular fact situation and the reasoning for that position. A
revenue ruling is not law, but effectively warns taxpayers that failure to comply with the posi-
tion taken will result in a tax assessment. See M. SALTZMAN, IRS PRACTICE AND PROCE-
DURE 3.03[21[a] (1981).
31. Rev. Rul. 77-176 reasoned as follows:
Before the assignment of the working interests to X in the instant case, the oil
and gas lease was, within the meaning of section 614(a) of the Code and section
1.614-1(a) of the regulations, one property in the hands of Y. Upon assignment,
X received two separate economic interests in the tract or parcel of land, each
such interest being a separate section 614 property [apparently because of the
difference in the percentage of the working interests owned in the drill site and
the surrounding acreage.] The entire working interest in the drill site to which
X made a contribution in the form of drilling was one property, and the undi-
vided one-half of the working interest in the portion of the tract exclusive of the
drill site was a second property. Likewise, Y retained two separate properties in
the tract or parcel of land. The overriding royalty interest reserved in the drill
site was one property, and the undivided one-half of the working interest re-
tained by Y in the balance of the tract exclusive of the drill site was a second
property.
Rev. Rul. 77-176, 1977-1 C.B. 77, 79.
32. Rev. Rul. 77-176 concluded that:
Because the acreage exclusive of the drill site is a property separate from that
to which the development contribution was made, drilling by X on the drill site
did not represent a capital investment in the development of the acreage exclu-
sive of the drill site, and the Federal income tax consequences of the transfer
from Y to X of the undivided one-half of the working interest in such acreage is
not determined under the pool of capital concept.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

An example may help in understanding Revenue Ruling 77-176. Assume

that Y owns a 640-acre lease subject to 40-acre spacing. Assume that Y and
X enter into a farmout agreement by which Y agrees to assign to X 100% of
the working interest in a 40-acre well site plus 50% of the working interest
in the 600 acres outside the well site tract, with Y reserving a 1/ 16th overrid-
ing royalty interest in production from the well site tract and an option to
convert that overriding royalty interest into a 50% working interest after
payout of the initial well. Assume further that Y's basis in the 50% interest
in the 600 acres outside the well site earned by X is $6,000, but that the
market value of the 50% interest in the outside acreage when it is actually
transferred is $100,000 because the transfer occurs after the drilling of an
initial well on the well site tract has proved the outside acreage.
Revenue Ruling 77-176 reasons that neither Y nor X is subject to any tax
as a result of the transfer of interest or the conduct of drilling operations
upon the well site acreage. Since Y transfers to X an interest in the well site
in exchange for development of the well site, the transaction is a sharing
arrangement. The transfer of the interest in the remaining 600 acres, how-
ever, relates to another property. The transfer of that interest does not qual-
ify as a sharing arrangement because X has made no contribution to the
development of the outside acreage. Drilling the well is viewed as develop-
ing only the separate property of the well site acreage. Revenue Ruling 77-
176 therefore concludes that Y has received taxable income equal to the dif-
ference between its basis of $6,000 in the fractional interest in the outside
acreage assigned and the fair market value of $100,000 at the time of the
assignment. 33 X, on the other hand, is deemed to have received $100,000 of
taxable income, since its drilling expenditures are not a capital investment in
the development of the property of the outside acreage. Both Y and X there-
fore have incurred a tax liability, but the transaction has generated no cash
flow for either to use to pay taxes. Tax lawyers call this nightmare "phan-
'34
tom income."
35
The IRS made application of Revenue Ruling 77-176 prospective only.
In addition, commentators have criticized its reasoning and a successful
challenge may yet be forthcoming. 36 Nonetheless, the ruling is a major tax

Id.at 79-80.
33. Y may be subject to tax at ordinary or capital gains rates depending upon whether the
transaction occurred before or after the effective date of the Tax Reform Act of 1986 provi-
sions relating to capital gains and whether Y is considered a "dealer." Cf Corn Prods. Ref.
Co. v. Commissioner, 350 U.S.46 (1955) (corn futures not capital assets since integral part of
taxpayer's manufacturing business).
34. See D. WINDISH, TAX-ADVANTAGED INVESTMENTS ch. 16 (2d ed. 1985).
35. The revenue ruling specifically states that it will apply retroactively "to transfers made
before April 27, 1977, or to transfers made pursuant to binding contracts entered into before
such date." Rev. Rul. 77-176, 1977-1 C.B. at 79-80. In addition, the IRS issued a technical
advice memorandum indicating that it would not apply related theories reaching the same
result to pre-April 27, 1977, transactions. See Tech. Adv. Mem. 83-11-005 (Nov. 19, 1982).
36. See Crichton & Griffin, Securities Problems and Tax Implications of Oil and Gas In-
vestments by Non-Industry Financiers,27B ROCKY MTN. MIN. L. INST. 1333, 1392-97 (1982);
Gregg, Oil and Gas Farmouts-mplications of Revenue Ruling 77-176, 29 INST. ON OIL &
GAS L. & TAX'N 601 (1978); Note, New Tax Treatment of Oil and Gas Farm-Outs. A Threat
to Domestic Production, 15 Hous. L. REV. 387 (1978). Most of the criticisms of the reasoning
1987] FARMOUT AGREEMENTS

trap for the oil and gas industry, and a variety of devices have been sug-
gested to avoid or minimize it. 37 Among the most popular suggestions are
(a) avoiding the transfer of an interest in "outside" acreage; (b) structuring
the farmout to minimize the value of outside acreage transferred; and
(c) redefining the "property" subject to the farmout by use of a tax
partnership.

a. Assign No Outside Acreage

Y and X can avoid Revenue Ruling 77-176 entirely if the farmout transfers
no interest in any acreage outside the well site tract. Then there is only a
single transaction relating to a single property, and the sharing arrangement
concept protects both Y and X from recognizing income. No tax is due if Y
and X agree that X will earn 100% of the working interest in a 40-acre drill
site tract in exchange for drilling a well on a 640-acre lease, subject to a
1/16th overriding royalty interest reserved to Y that Y can convert upon
payout of the well to a 50% working interest in the well site tract.
The problem with this transaction lies with its economic structure, not its
tax structure. Limiting the interest earned to the well site tract strips from
the farmout much of the incentive for X. There is a severe limit on the profit
opportunity for X if the farmout's purpose is to explore undeveloped leases.
A farmee will not easily decide to take 100% of the risk of drilling a wildcat
well 38 in return for a 50% interest in the well subject to an overriding roy-
alty burden and no interest in development wells. In order to make the busi-
ness deal workable between Y and X, Y will probably have to provide X with
additional incentives. For example, Y may have to accept a lower overriding
royalty and agree to accept a lesser percentage back-in, or even give up the
back-in altogether. These possibilities may make the transaction less attrac-
tive to Y, and yet still be insufficient to satisfy X. Thus, while the parties can
easily avoid the tax consequences of Revenue Ruling 77-176, the economic
cost may be unacceptable.
A less certain variation on the theme of avoiding Revenue Ruling 77-176
by transferring no interest in outside acreage is for Y to agree to assign to X
100% of the working interest in the entire 640 acres in return for drilling a
well on the 40-acre drill site tract. The 640-acre assignment from Y to X
may be subject to a 1/16th overriding royalty, which X can convert upon

of Rev. Rul. 77-176 center upon application of § 614 of the Internal Revenue Code. Note,
supra, at 388-414. The revenue ruling describes interests transferred in the drill site and in
acreage outside the drill site, which are parts of the same lease, as separate property within the
meaning of § 614(a) of the Code. Rev. Rul. 77-176, 1977-1 C.B. 77, 79. A strong argument to
the contrary is that since both interests were working interests in the same lease they should be
treated as interests in a single property under § 614(b). Only one reported case, Burke v.
Blumenthal, 504 F. Supp. 35 (N.D. Tex. 1980), to date has challenged the validity of Rev. Rul.
77-176. In Burke the plaintiff sued for declaratory injunctive relief arguing that the revenue
ruling appeared "unconstitutional, unlawful, null and void" because it erroneously interpreted
§§ 61 and 100 1(a) of the Internal Revenue Code. Burke, 504 F. Supp. at 37 n. 1. The federal
district court dismissed the case on the grounds that the court lacked subject matter jurisdic-
tion. Id. at 36.
37. See infra text accompanying notes 38-59.
38. 8 H. WILLIAMS & C. MEYERS, supra note 12, at 974.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

payout as to the well site acreage, or at any time as to the outside acreage.
Thus, while X will own the entire working interest in the entire 640-acre
tract, if X decides to drill an additional well on the property, Y will be able to
convert its interest in the additional acreage and participate in drilling as a
working interest owner.
This device is less certain to avoid taxation than the first alternative.
While the form of a transaction that avoids the transfer of an interest in an
outside acreage is maintained, the substance is not. 39 It is highly probable
that the initial well drilled on the property will drain no more than the 40-
acre drilling unit established. That is the purpose of the state in establishing
the drilling unit. If so, X's contribution to drilling will develop only the well
site acreage and X will receive an extra interest in outside acreage. Y's right
to convert its overriding royalty interest in the outside acreage will add fuel
to the fire of the argument that the substance of the transaction is the same
as that considered in Revenue Ruling 77-176. Thus, the IRS may regard the
outside acreage as a separate property under Revenue Ruling 77-176 and
assess tax on that acreage. Since the market value of X's 100% working
interest in the outside acreage subject to Y's right to convert will be roughly
the same as the value of X's interest after the conversion has taken place, the
tax liability should be approximately the same as if the parties had not se-
lected the illusory form.
A final variation of avoiding Revenue Ruling 77-176 by assigning no
outside acreage in the farmout agreement is to make the farmee's earning an
interest in the well site acreage contingent upon performance by drilling, but
to give the farmee a noncontingent option to acquire additional interests in
the outside acreage at an agreed price. 4° The farmout transaction is split
into two parts. In one the farmee earns by drilling. In the other, a suppos-
edly unrelated transaction, the farmee buys an option to drill additional
wells at a fixed price. If the farmor may terminate the option if the farmee
fails to drill the initial well, however, this device may be attacked as a sham,
or IRC section 83 may cause the surrounding acreage to be valued and taxed
to the farmee after the well is drilled. 41 In addition, the purchase option
must be at fair market value, or the farmee as well as the farmor may be

39. That substance prevails over form in taxation matters is well-established. See Com-
missioner v. Court Holding Co., 324 U.S. 331, 334 (1945); Gregory v. Helvering, 293 U.S. 465,
470 (1935); West v. Commissioner, 150 F.2d 723, 727 (5th Cir.), cert. denied, 326 U.S. 795
(1945).
40. The following example illustrates a noncontingent option to purchase an interest in
outside acreage:
Farmee, upon execution of this agreement, shall be entitled to purchase an undi-
vided _% of Farmor's interest in the - 1/4 of Section -, Township -, Range
-, - County, -, limited to the depth stated above and without warranty of
title express or implied. Farmee shall pay Farmor for such interest at a rate of
$_ per net mineral acre, proportionately reduced. Such payment shall be made
no later than - from the date of Farmee's execution hereof.
41. I.R.C. § 83 (Supp. III 1985), provides in part:
If, in connection wth performance of services, property is transferred to any
person other than the person for whom such services are performed, the excess
of-
(1) the fair market value of such property . . . at the first time the rights
1987) FARMOUT AGREEMENTS

required to recognize income. 42

b. Minimize the Value for Revenue Rule 77-176 Purposes

Another general approach to Revenue Ruling 77-176 structures the
farmout agreement between Y and X so that, while the revenue ruling may
still trigger the adverse tax effect, its impact will be minimized. A present
assignment, an assignment of the working interest in acreage outside the well
site contemporaneous with execution of the farmout agreement, is one
method. Another method is to structure the agreement so that the farmee
earns a restricted drilling option, rather than a portion of the working inter-
est in the outside acreage.

i. Present Assignment
If Y assigns its interest to X at the time that they enter the farmout agree-
ment, rather than after the earning well has been drilled, the tax effect
should be less burdensome for both Y and X because the value of the interest
in the outside acreage will be less. Suppose that in the hypothetical situation
discussed above 4 3 Y assigned X 100% of the working interest in the well site
acreage and an undivided 50% of the working interest in the additional acre-
age at the time that they executed the farmout agreement. By the logic of
Revenue Ruling 77-176, the value of the additional property transferred
should be determined as of the time the contract was executed. 44 Further-
more, the value should be substantially less since the drilling of the earning
well has not yet proved the outside acreage. For example, assume that in the
hypothetical situation above, the parties agreed to a present assignment of
half the working interest in the acreage outside the well site tract at the time
that they executed the farmout agreement, and that the fair market value of
that interest at the time of assignment was $10,000. Revenue Ruling 77-176
would cause both Y and X to recognize income for tax purposes, but Y's
taxable income would be the difference beween the fair market value of

...are not subject to a substantial risk of forfeiture, whichever occurs ear-

lier, over
(2) the amount (if any) paid for such property,
shall be included in the gross income of the person who performed such services
in the first taxable year in which the rights ... are transferable or not subject to
a substantial risk of forfeiture, whichever is applicable.
Id. One commentator has argued that Congress did not intend § 83 to apply to farmout trans-
actions. Linden, supra note 29, at 531-33. The IRS, however, has given some indication that it
does not agree. See Lofgren, Eccentric Orbits-A Tax Overview of Oil and Gas Transactions, 7
E. MIN. LAW INST. 12-1, 12-25 to -27 (1986).
42. The transaction, structured as a separate sale of the option to drill on the outside
acreage, is subject to tax. I.R.C. § 83 (Supp. III 1985). If the farmee pays a fair price for the
option, it recognizes no taxable income. Id. Whether or not the option price is fair, the farmor
receives taxable income to the extent that the value of the option exceeds its allocated basis.
43. See supra text accompanying notes 30-34.
44. Rev. Rul. 77-176 reasons that Y and Xs taxable income is determined by the fair
market value of the interest transferred in the acreage outside the well site at the time of the
transfer, because that is when the transaction is consummated. Rev. Rul. 77-176, 1977-1 C.B.
77, 79-80. If the transfer takes place at the time of the execution of the farmout agreement, the
value should logically be set at that time.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

$10,000 and Y's $6,000 basis. X's income would be $10,000, rather than
$100,000. Both Y and X would receive phantom income, but at levels with
45
which they probably could cope.
Present assignment presents both practical and theoretical difficulties,
however. The major practical problem is what Y can do if X does not drill
the well. By its present assignment, Y has given up the control provided by
withholding the assignment of interest until after performance. Unfortu-
nately, neither of the commonly encountered solutions is entirely satisfac-
tory. One solution is to draft the agreement so that the interest assigned to X
is regained by Y if X does not drill the earning well. Providing in the
farmout agreement for the reassignment of the interest by X may accomplish
this result. If X is unable or unwilling to drill the earning well, however, X
may likewise be unable or unwilling to make the reassignment. This prob-
lem can be overcome by (1) placing a fully executed reassignment in escrow
at the time that the farmout is executed, (2) by drafting the present assign-
ment in the form of a sublease that automatically terminates if the farmee
does not perform, 46 or (3) drafting the present assignment in a nonrecord-
able form and simply refusing to provide the farmee with a recordable as-
signment until the farmee has performed. Whether these convoluted
structures will stand up under the IRS's scrutiny, however, is a matter for
concern. Only a property lawyer is likely to view as significant the difference

45. The present assignment also appears attractive because it should avoid the never-re-
solved tax issue of whether transfer of an interest in acreage outside the well site after comple-
tion of an earning well under a farmout agreement is transfer of a "proven" property within
I.R.C. § 613A(c)(9) (West Supp. 1987) so that percentage depletion is unavailable to the
farmee. If the transfer of interest takes place before the drilling of the earning well, the prop-
erty almost certainly cannot be proven.
46. The following example illustrates a sublease that terminates automatically upon a
farmee's failure to perform:
Farmor hereby subleases and assigns to farmee, its successors and assigns, for
the term hereinafter specified, the following rights in the farmout leases:
(1) All of Farmor's right, title and interest in the Farmout Leases insofar as
the Farmout Leases cover lands lying within the Drilling and Spacing
Unit within which the Earning Well is located; and
(2) an undivided _% of Farmor's right, title and interest in the Farmout
Leases insofar as the Farmout Leases cover the balance of the Farmout
Lands;
subject, however, to the reservation to Farmor, its successors and assigns, of
Farmor's Reserved Interest [provided for elsewhere in the agreement], and of all
other interests in the Farmout Leases and Farmout Lands not expressly sub-
leased and assigned to farmee.
This sublease and assignment will remain in effect until the Commencement
Date [of drilling operations], and so long thereafter as Farmee shall remain in
compliance with the Earning Conditions. Upon satisfaction by Farmee of the
Earning Conditions, this sublease and assignment shall remain in effect for so
long as any of the Farmout Leases, or any extensions or renewals thereof, re-
main in effect as to any portion of the Farmout Lands; provided that, upon
completion of the Earning Well, this sublease and assignment shall terminate
insofar as the Farmout Leases cover depths below the Farmout Depth.
Upon the expiration of the term of this sublease and assignment, all rights in the
Farmout Leases shall revert to Farmor, its successors and assigns, free and clear
of all liens, encumbrances, burdens or obligations created by or through Farmee,
its successors or assigns.
L. MOSBURG, PROBLEMS AND PITFALLS IN EXPLORATION AGREEMENTS 218-20 (1982).
1987] FARMOUT AGREEMENTS

between an interest that is vested in the farmee subject to defeasance if the

farmee does not perform and one that is contingent upon drilling the earning
well.
A risk also exists that IRC section 83 will apply to unravel the purpose of
the assignment. Section 83 provides that an interest subject to a "substantial
risk of forfeiture" is to be valued at the time that that substantial risk no
longer applies, rather than when the interest is received. 47 When the interest
assigned to the farmee is subject to reassignment, perfection by recording, or
reverter, section 83 arguably will defer valuation of that interest in the
outside acreage until (and if) the farmee actually fulfills its obligation,
48
and
the outside acreage is no longer subject to a risk of forfeiture.
A second possible solution is for the farmor to forgo the right to obtain
back the interest conveyed to the farmee, and instead to couple the present
assignment with the farmee's covenant to drill the earning well secured by50a
liquidated damages provision 49 and a performance bond or other security.
While this solution will work in theory, it is likely to prove very difficult to
negotiate or to put into effect.

ii. Assign Continuous Restricted Options

Another way to minimize the effect of Revenue Ruling 77-176 is to struc-
ture the farmout agreement so that X earns no working interest in acreage
other than the drill site, but acquires successive options to drill additional
wells on the outside acreage. For example, the farmout agreement may pro-
vide that X, by drilling the initial well, earns a nonassignable option to drill
an additional well at a location of its choice on the outside acreage within
three months of completion of the earning well. Exercise of the option may
earn another option, and so forth. 51 As an alternative, the parties may draft
the agreement so that the farmee earns an interest in the outside acreage by
drilling an initial well in the drill site, but an interest that automatically

47. See supra note 41.

48. Larason, How to Structure the Farmoutand Avoid Its Pitfalls, in MATERIALS ON OIL
AND GAS CONTRACTS 127-28 (J. Lowe ed. 1986).
49. For a discussion of liquidated damages provisions, see infra text accompanying notes
239-41.
50. For an example of a performance bond clause, see infra note 242.
51. See, e.g., Energy Reserves Group v. Tarina Oil Co., 664 S.W.2d 169 (Tex. App.-San
Antonio 1983, no writ), in which the farmout provided that:
You agree that in the event we timely commence the re-entry operations upon
the C-I well, we shall have an option for a period of one-hundred twenty (120)
days from the date said well is recompleted as a producer of oil or gas. . . to re-
enter the Cooke B-I well located on the lands described under lease No. 1 above
and to re-work said well . ...
In the event we have timely commenced re-entry operations upon the B-I
well, you grant to us an option for a period of one-hundred twenty (120) days
from the date we either recomplete said well as a producer of oil or gas or aban-
don same as a dry hole, to re-enter the Cooke A-I well located on the lands
covered by leases Nos. 2 through 5 as listed above ....
Id. at 174. For a discussion of "completion" and similar terms, see infra text accompanying
notes 189-95.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

terminates unless continuous drilling occurs. 52 Assigning continuous re-

stricted options may avoid Revenue Ruling 77-176, since it is not within the
ruling's literal terms. More likely, however, this structure will merely mini-
mize the value of the outside interest earned. A restricted option possesses
some minimal fair market value, but it is minimal, at least until several suc-
cessful exercises of the option greatly increase the value of the remaining
acreage subject to the successive options.
Again, however, the attempt to frame the farmout agreement to avoid or
minimize Revenue Ruling 77-176 has a price that Y and X may not wish to
pay. The restricted option minimizes the effect of Revenue Ruling 77-176
because the economic value of a restricted option is substantially less than
the economic value of an unrestricted working interest in the outside acre-
age. Both Y and X will take the economic truth into account in their deal-
ings. All other things being equal, X will find it less attractive to enter into a
farmout agreement with Y in which X takes the risk of drilling to earn a
restricted option to drill rather than an unrestricted working interest. The
result appears to be that either properties that would have been drilled
before the promulgation of Revenue Ruling 77-176 will not be drilled, or Y
will have to give other incentives to induce X to enter into the agreement.

c. The Tax Partnership

The most popular device to avoid Revenue Ruling 77-176 is the tax part-
nership. By forming a partnership for tax purposes, but not for state prop-
erty law purposes because that would expose them to joint and several
liability, 53 Y and X can circumvent the revenue ruling's conclusion that the
outside acreage earned by X is a separate property. 54 This is done by using
IRC section 721-the same section of the tax code that categorizes contribu-

52. For example:

If the test well is completed as a well capable of producing oil and/or gas in
paying quantities, then, unless Farmoutee shall commence another well within
one hundred twenty (120) days after completion of the test well, there shall be
effective as of the date hereof, an automatic reversion to Assignor of the interest
hereby assigned to all acreage in the farmout area that is not included in a gov-
ernmentally prescribed proration or drilling and spacing unit for the test well.
Subsequent wells must also be commenced within one hundred twenty (120)
days after completion of the preceding well. All such wells shall be drilled to a
depth sufficient to test the same intervals or formations productive in the test
well in which commercial production is established. Cumulative credit shall be
given for faster drilling. Farmoutee shall not be required to drill any additional
wells, but when Farmoutee fails to commence any well within the prescribed
period, there shall be an automatic reversion to Assignor of the interest hereby
assigned, effective as of the date hereof, except as to each tract (as described
above) upon which there is located a well capable of producing oil or gas in
paying quantities.
53. See infra text accompanying notes 406-33.
54. For a definitive discussion of tax partnerships, see Gregg, supra note 36, at 627-39.
Mr. Gregg, however, concludes that a formal partnership is the safest way around Rev. Rul.
77-176. Gregg, supra note 36, at 632; see also Priestly, Tax Partnershipsin the Oil and Gas
Industry, THE LANDMAN, June 1983, at 9 (discusses formal tax partnerships); Wegher, Taxa-
tion of Earned Interests-The Impact of Revenue Ruling 77-176, 24 ROCKY MTN. MIN. L.
INST. 521 (1978) (discusses tax partnerships).
1987] FARMOUT AGREEMENTS

tions to the capital of a partnership as a nontaxable sharing arrangement-to

designate both the well site acreage and the additional acreage as the "prop-
erty" of the tax partnership. 55 The parties accomplish this designation by
using a typical farmout agreement with the special provision that the parties
agree not to elect out of Subchapter K of the Internal Revenue Code 56 and
57
agree to allocate income and deductions specially on a partnership return.
The economics of the farmout arrangement remain virtually the same as
before Revenue Ruling 77-176; only the form is different.
To the nontax lawyer, a tax partnership may sound like a classic example
of form over substance, but it appears that the IRS has tacitly accepted its
effect. Shelter from the ravages of the revenue ruling is not without cost,
however. In order to establish a valid tax partnership, a partnership return
must be prepared and filed annually, so long as the partnership is in exist-
ence. 58 Preparation of the partnership return requires substantial expendi-
tures for legal, accounting, and administrative support that many companies
begrudge. Furthermore, some are concerned that regulations recently issued
under IRC section 704(b) will interact with section 613A and section 704(c)
to undermine the economic attractiveness of a farmout where a tax partner-
59
ship is used.

d. Conclusion
Revenue Ruling 77-176 provides a classic example of bad tax policy. It
has not raised substantial revenues. Indeed, it has probably cost the govern-
ment taxes, because the major oil companies that are the focus of IRS com-
pliance audits are well aware of its requirements. They have hired the
necessary lawyers, accountants, and administrative personnel to analyze
farmout proposals for Revenue Ruling 77-176 implications and to prepare
the documents necessary to minimize or avoid it. As a result, major oil com-

55. I.R.C. § 721 (1982 & Supp. III 1985).

56. The following provision is from a tax partnership agreement attached to a farmout
agreement:
1. Notwithstanding any provisions of the above referred to Farmout Agree-
ment or Operating Agreement to the contrary, the parties hereto have agreed
not to elect to be excluded from the application of Subchapter K of Chapter 1 of
Subtitle A of the Internal Revenue Code of 1954 and all amendments thereto
(hereinafter called the "IRC") and similar provisions of the State Income Tax
Law. The parties further agree to the provisions hereof regarding the reporting
of income, gains, losses, expenses, costs, and credits for Federal and State in-
come tax purposes.
57. Taxpayers may allocate profits and losses without recognition of income, so long as
these profits and losses cannot be valued immediately. Diamond v. Commissioner, 492 F.2d
286, 288-91 (7th Cir. 1974). A transfer of property, however, could result in income under
Treas. Reg. § 1.721-1 (1956).
58. I.R.C. § 6031 (Supp. III 1985). Some lawyers and accountants that I have talked with
believe that the partners can terminate a tax partnership in the tax year following its creation.
Others are concerned that quick termination may throw into question the "substantial eco-
nomic effect" required to make the tax partnership work in the first place. See Treas. Reg.
§ 1.704-1(b)(2) (as amended 1985).
59. See Lofgren, supra note 41, at 12-27; see also Houghton, Braden & Harris, Housing
Your MineralActivities in the Right Structure, 31 ROCKY MTN. MIN. L. INST. 6-01, 6-03 to -04
(1985) (discusses substantial economic effect of operation of tax partnerships).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

panies rarely violate the tenets of the ruling. In addition, they deduct the
cost of the lawyers, accountants, administrative staff, and support facilities
that they rely upon for compliance. Of course, the IRS must pay for the
auditors and support facilities that it needs to audit for Revenue Ruling 77-
176 compliance, as well. Though no figures are available, it is a fair bet that
Revenue Ruling 77-176 has resulted in a net loss of tax dollars when compli-
ance and auditing costs are considered.
In addition, the IRS seemingly chooses to enforce the ruling selectively.
Substantial numbers of tax assessments would result if the IRS would audit
the little players, the thousands of "ma and pa" oil companies that have
never heard of Revenue Ruling 77-176 to say nothing of the devices to avoid
it. Such audits have not taken place, however, probably because the IRS has
concluded that it would be politically unpopular and would throw many
companies into bankruptcy while raising little revenue.
In short, Revenue Ruling 77-176 should embarrass tax policy makers. As
long as the ruling remains IRS policy, however, there is a major tax trap for
the unwary in farmout transactions.

B. The Purposes of the Parties

Any one or a combination of several factors may motivate the parties to a
farmout agreement. Because the goals of the parties profoundly affect the
structure of the agreement, a brief consideration of the parties' purposes is
worthwhile.

1. The Farmor'sPurposes in Entering an Agreement

The management of an entity that owns an oil and gas lease may wish to
farm out that lease for a variety of reasons. Any list of reasons must include
(a) lease preservation, (b) lease salvage, (c) risk sharing, (d) exploration and
evaluation, (e) access to market, (f) obtaining reserves, and (g) drilling an
"obligation" well. In each case, the farmor gives up a portion of its interest
in its lease or leases to another to further what it regards as its own interests.

a. Lease Preservation
Oil and gas leases are typically drafted to expire at the end of a primary
term, 60 and oil companies frequently find themselves holding leases that they
evaluate as good risks, but that they cannot test or develop within their pri-
mary terms. The inability to act may result from cash or credit shortages,
inadequate number or skills of personnel, corporate reorganizations, or even
managerial inefficiency. Whatever the precise reason, the lessee's rights
under a typical oil and gas lease terminate automatically and completely at
the end of the primary term unless the lessee or an assignee is conducting
drilling operations. Automatic termination wipes out in an instant all of the

60. The lease primary term is an option period, during which the lessee can hold the
leased property without obligation to drill. See E. KUNTZ, J. LOWE, 0. ANDERSON & E.
SMITH, supra note 5, at 127.
1987] FARMOUT AGREEMENTS

money that the lessee may have spent acquiring and evaluating the prospect,
and ends the lessee's prospects of developing the resources covered by the
lease. Though far more oil and gas leases terminate at the end of their pri-
mary terms than are drilled, lease termination is an anathema to oil compa-
nies. Drilling is considered the natural order of things both by potential
farmors and potential farmees. A primary motivation of farmors in entering
into farmout agreements, therefore, is to prevent lease termination.
When lease preservation is a strong motivation, one may expect relatively
liberal farmout terms. The object of the contract is to entice the farmee to
drill. The farmor's main goal is not achieved if that is not done. Thus, while
drilling may be an obligation of the farmee, and completion of a well capable
of production is certain to be a requirement, 6 1 testing requirements are likely
to be minimal, and the percentage of interest earned and the acreage earned
by the well are likely to be high, though the farmor will try to retain deep
rights.

b. Lease Salvage
Far more frequently than farmors admit, their motivation to farm out is to
try to salvage something of value from a lease that the farmor's geologists
and geophysicists evaluate as a poor prospect. As one correspondent wrote
me, "We are liberal with farmouts because our goal is to get anything done
on an area we have condemned. If something is found, we are that much
better off." While this motivation may seem at first blush to be akin to P.T.
Barnum's "bigger fool" theory, oil and gas exploration is such an uncertain
science that the farmor's specialists are as likely to be wrong as to be right.
The farmee is free to draw its own conclusions as to whether and how to
proceed. When the farmee suspects that the farmor may be seeking to sal-
vage its lease, the agreement should provide that the farmor make its geo-
logic and geophysical information and evaluations available and, if drilling is
an obligation, that the farmee will have a reasonable period of time after
receiving the information to withdraw from the agreement. 6 2
A salvage motivation is closely related to a lease preservation motivation.
The distinction is that when lease preservation is the motivation, the farmor
would drill if it could, while when salvage is the motivation, the farmor has
decided that it does not wish to drill. Both motivations are similar, however,
in that the farmor hopes to end up with an interest in production without
spending any more money. Where the farmor's purpose in farming out is to
salvage its lease, the terms of the farmout will be similar to those found when
its goal is lease preservation, but may be even more liberal. The farmor's
focus is likely to be the size of its retained interest. In addition, drilling is

61. To maintain the lease in its secondary term, a well capable of producing in paying
quantities must exist, even if the lease savings provisions are to be relied upon to preserve it.
See id. at 171-80, 187-98. Thus, a "drill to earn" farmout serves little purpose if lease preserva-
tion is the primary goal.
62. For a discussion of farmout clauses requiring the sharing of geological and geophysi-
cal information, see infra text accompanying notes 163-64.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

likely to be an option rather than an obligation, because the farmor has rela-
tively little to lose if the farmed-out property is not drilled.

c. Risk Sharing
Modern oil and gas wells are tremendously expensive to drill in compari-
son to wells drilled in the earlier years of the United States oil and gas indus-
try. 63 When confronted with drilling costs that may reach tens of millions of
dollars, few companies are so big that risk sharing is not an attractive option.
While a lessee may prefer a sale of a portion of its lease coupled with a joint
operating agreement, because it permits the lessee to remain in control of
operations, the lessee may also consider farming out, particularly if the pro-
posed farmee is considered to be a good operator. Where the farmor's pri-
mary purpose in farming out is risk-sharing, the parties may structure the
farmout agreement much like a joint operating agreement: drilling will be
an obligation rather than an option, the farmee will earn its interest merely
by drilling, the farmor may share a part of the costs, and the farmout may
cover multiple wells.

d. Exploration and Evaluation

Sometimes the goal of a farmor's management in farming out is to obtain
geological information from its leases so that it can evaluate other leases that
it holds in the same area. Although the farmor in this situation hopes that
the farmee's operations will yield production, the farmor's primary purpose
in entering the agreement is similar to its purpose in entering into an acreage
contribution agreement. The farmor wants the information that drilling
operations will produce, whether or not drilling operations locate
hydrocarbons.
When the farmor's primary purpose in farming out is to develop explora-
tory information, the contract will emphasize the tests to be conducted in
the course of drilling, the formations to be tested, and the depth to be drilled.
The number and complexity of the tests that they require typically distin-
guish exploratory farmouts from other kinds of farmouts. Exploratory
farmouts are also likely to contain area of mutual interest clauses, 64 which
obligate the farmor and the farmee to share leases on properties that may
look attractive as a result of the exploratory drilling. Whether drilling is an
option or an obligation, whether the farmee will earn by completing a well
capable of production or merely by drilling to a specified depth and testing,
and what percentage interest will be earned in what acreage are all matters
that will depend upon the bargaining leverage of the parties.

e. Access to Market
A lessee is unlikely to drill even good geologic prospects if it lacks access
to market. Though there is always a market for oil, logistical problems such

63. See supra note 1.

64. See infra text accompanying notes 372-77.
1987] FARMOUT AGREEMENTS

as lack of manpower or transport in the area may make marketing impracti-

cal. When there is a surplus of natural gas, an operator may find it impossi-
ble to locate a buyer at any reasonable price. Thus, another possible
motivation for a lessee to farm out leases is to acquire access to markets for
the production anticipated from drilling. Giving an interest to an operator
that has the capability to market may be the best deal available to a farmor.
When access to market is the farmor's motivation to offer the farmout, the
parties will probably structure the agreement much like an agreement moti-
vated by lease preservation. Terms are likely to be liberal, testing require-
ments are likely to be minimal, and production to earn will be required. The
farmor will insist, however, upon placing the burden of marketing upon the
farmee. The farmor will either retain an overriding royalty convertible at its
option 65 or require the farmee to agree to market the farmor's share of pro-
duction on the same terms and conditions that the farmee obtains for itself.

f ObtainingReserves
Yet another motivation for one who owns a lease to farmout is to obtain
commitment of the reserves that may be discovered by drilling on the lease.
Obtaining reserves is a common motivation for pipelines to farm out leases
they hold, particularly in times of gas shortages. Pipelines have a legal obli-
gation to make gas available to their customers. Their primary business is
transporting and selling gas, not exploration and production. Therefore,
pipelines often build up inventories of oil and gas leases with the intention of
farming them out to producers who will drill on them and sell the gas back.
Refining companies may follow a similar procedure. Pipelines and refiners
sometimes establish their own exploration subsidiaries.
When obtaining reserves is the farmor's motivation, the key provision in
the farmout agreement will be a "call" on production by the farmor or a
commitment to a gas contract. 66 The farmor will prefer a firm commitment
to drill from the farmee, and if the farmor has the bargaining leverage, it
may impose onerous testing requirements that will help it evaluate other
leases that it may hold in the area. Commonly, however, the terms of a
farmout agreement motivated by obtaining reserves will be very liberal ex-
cept for the call or commitment provisions.
g. To Drill an "Obligation" Well
While oil and gas leases typically impose no express obligation upon the
lessee to drill wells, drilling may be an implied obligation. Even during the
primary lease term, the courts require the lessee to protect against drainage,
if the lessee can do so profitably. 67 When the lease is being held by produc-

65. See infra text accompanying notes 301-14.

66. See infra text accompanying notes 399-405.
67. In most states, this is true even though the lessor has accepted delay rental payments.
Rentals waive the covenant to test, but not to protect against drainage. Texas Co. v. Ram-
sower, 7 S.W.2d 872, 875-77 (Tex. Comm'n App. 1928, judgmt aff'd). But see, e.g., Clear
Creek Oil & Gas Co. v. Bushmaier, 161 Ark. 26, 255 S.W. 37, 38-39 (1923) (lessor not entitled
to recover damages for lessee's failure to explore and develop gas wells on leased premises
 SOUTHWESTERN LAW JOURNAL [Vol. 41

tion, and a reasonable, prudent operator would drill additional wells or ex-
plore further, the law implies an obligation upon the lessee to protect the
interests of the lessor. 68 When the appropriate means of protection, develop-
ment or exploration is to drill, the industry refers to the drilling of an "obli-
' 69
gation well."
The hallmark of an obligation well farmout is that the farmee will have a
binding legal obligation to drill on the farmed-out acreage. Since the
farmor's primary purpose in farming out is to relieve itself of legal liability to
its lessor, an obligation to drill is essential. All other issues are negotiable.

2. The Farmee'sPurposes in Entering into a Farmout

The farmee's purposes in entering into a farmout agreement often mirror
the motivations of the farmor. The farmee may be interested in entering into
a farmout because (1)the farmout is the quickest or cheapest way to obtain
or expand an acreage position or to obtain reserves; (2) the farmee may have
cash, or equipment and personnel that it wishes to keep busy; (3) the farmee
may highly evaluate a property that the farmor has dismissed as a poor pros-
pect; or (4) the farmee may want to become active in an area, but be unwill-
ing or unable to take the risks alone.
In addition, a farmee may be interested in a farmout proposal simply be-
cause it is available. Oil company landmen are inveterate deal makers. It is
not uncommon to find a particular company involved in substantial numbers
of farmouts both as a farmor and as a farmee without any clear-cut pattern
to the trades.

III. PREPARING AND ANALYZING THE FARMOUT AGREEMENT

The process of preparing a farmout agreement or analyzing a proposed or

disputed agreement is very much the same. In each case, the drafter must
scrutinize the essential provisions of the instrument both separately and in
their relationship to the structure of the agreement. This section of this Ar-
ticle considers that process in relation to preliminary or background matters,
the key characteristics of the farmout agreement, and issues that must be
addressed.

A. PreliminaryMatters
1. Reputation and Solvency
Some deals should not be made. The best drafted contract cannot fully

when lessor accepted payments of annual rentals under oil and gas lease providing that pay-
ment thereof in lieu of drilling well should continue lease).
68. In Texas and Oklahoma, apparently no implied obligation to explore further exists
separate from the implied covenant to develop. But see Sun Exploration & Prod. Co. v. Jack-
son, 715 S.W.2d 199, 201-03 (Tex. App.-Houston [1st Dist.] 1986, writ granted) (lessee may
be obligated to conduct further development operations on leased premises if further explora-
tion would be beneficial to both lessee and lessor). For discussion of the issue and its signifi-
cance see J. LOWE, supra note 9, at 292.
69. See 8 H. WILLIAMS & C. MEYERS, supra note 12, at 563.
19871 FARMOUT AGREEMENTS

protect a party from another who is a knave or a fool. The farmor and the
farmee must both confront the possibility of substantial losses if the farmout
transaction proves unsuccessful. People in the oil industry sometimes forget
this basic principle, particularly in the press of an attempt to maintain a
lease about to expire. A review of a farmout agreement should begin by
asking questions about the reputation and solvency of the proposed business
partner.

2. Reasonableness of the Proposal

The second step in the review of a farmout proposal or agreement should
be to consider what is reasonable for the parties to agree to do, given the
circumstances of time and economics. How long until the leases to be
farmed out will expire? Are drilling rigs readily available? How likely is it
that title curative will be required? 70 Will it be necessary to obtain conserva-
tion orders 7 1 or to comply with special conservation rules? 72 A transaction
that cannot be consummated is not a good business deal.
3. PreliminaryNegotiations
Parties often negotiate farmout agreements through an exchange of let-
ters. Disputes may arise over whether the parties have formed a binding
contract, or whether they have merely engaged in preliminary negotia-
tions. 73 Smith v. Sabine Royalty Corp.74 illustrates the problem. In Sabine
Royalty Corp. Sabine, a fractional mineral interest owner, wrote Smith, an-
other mineral interest owner who had expressed an interest in acquiring the
right to drill, proposing terms under which it "would be willing" to lease to
Sabine's subsidiary, which in turn would farm out to Smith. 75 The letter
concluded: "If you wish to pursue this arrangement, please let us know and
the appropriate instruments will be forwarded for your review." '76 Without

70. The farmout agreement should entitle the farmee to all of the farmor's title informa-
tion. Often, the farmout agreement specifically provides for this right. See infra note 161 for
an example of language that provides for title information to be delivered to the farmee. As a
practical matter, however, title information may be made available to the farmee before the
parties form the agreement so that the farmee can evaluate the feasibility of drilling within the
time proposed.
71. In Oklahoma, for example, extensive title work prior to obtaining orders from the
Corporation Commission spacing property for drilling is required. See Harry R. Carlile Trust
v. Cotton Petroleum Corp., 732 P.2d 438 (Okla. 1986), cert. denied, 55 U.S.L.W. 3871 (U.S.
June 30, 1987). In Carlile the Oklahoma Supreme Court held that publication notice to those
whose interests are affected by spacing is constitutionally insufficient if the applicant could
ascertain their identity with due diligence, because establishment of spacing units is an adjudi-
cative function of the Corporation Commission. Id. at 444. Locating those owners and giving
them notice is time-consuming as well as expensive.
72. In Texas, for example, the Railroad Commission may require special proceedings if
the farmout well is to be drilled on an exception tract under rule 37, or if sour gas may be
anticipated under rule 36.
73. See generally Trower, Enforceability of Letters ofIntent and Other PreliminaryAgree-
ments, 24 ROCKY MTN. MIN. L. INST. 347 (1978) (discusses whether parties have formed
binding contract or have merely engaged in preliminary negotiations).
74. 556 S.W.2d 365 (Tex. Civ. App.-Amarillo 1977, no writ).
75. Id. at 367.
76. Id.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

replying, Smith drilled on the premises and claimed the right to a farmout of
Sabine's interest. A Texas court of civil appeals rejected
77
the claim on the
ground that the parties had never agreed to be bound.
A more recent case on point is Getty Oil Co. v. Blevco Energy, Inc.7
Blevco Energy requested a farmout of certain leases from Getty, and Getty
replied that "Getty Oil will farmout to Blevco Energy, providing a mutually
acceptable agreement can be resolved . . . . -79 Subsequently, however,
Getty drilled upon the property itself and completed an excellent well.
Blevco sued Getty, and the trial court awarded Blevco Energy $2 million in
actual damages and $4 million in punitive damages. The appellate court
reversed on the grounds that no contract existed; the parties had merely an
agreement to agree.80
These cases suggest that the best course is to state clearly in any letter
8
exchange whether or not the parties intend to create a binding agreement. '
In addition, an offer to farmout should be subject to a specific termination
82
date.
At least two writers have urged that farmout agreements ought not be
entered into in the form of "letter agreements," an exchange of letters, or a
letter signed by both of the parties.8 3 Letter agreements may be a perfectly
adequate vehicle for a contract, of course, and they are appealing because of
their apparent simplicity. The problem is that "the nature of a letter agree-
ment makes it improbable that the parties have included detailed provisions
which will apply in the event the transaction does not progress as ex-
pected."'8 4 The better practice is to take the extra step of preparing a formal
85
farmout agreement.

77. Id. at 368-69.

78. 722 S.W.2d 51 (Tex. App.-Eastland 1986, no writ).
79. Id. at 53-54.
80. Id. at 54.
81. See Schaefer, supra note 3, at 18-1, -8; see also infra note 85 (illustrates language used
in this type of farmout agreement).
82. The following clause limits the duration of the farmout offer: -9. EXECUTION.
This Farmout Agreement shall be null and void at Farmor's option if the duplicate original
hereof enclosed herewith is not executed by Farmee and returned to Farmor within - days
after the date shown below Farmor's signature." T. FAY, supra note 3, at 48.
83. Cage, supra note 3, at 156; Scott, supra note 3, at 65.
84. E. KUNTZ, J. LOWE, 0. ANDERSON & E. SMITH, supra note 5, at 618. Petroleum
Fin. Corp. v. Cockburn, 241 F.2d 312 (5th Cir. 1957), exemplifies the complications that may
occur with letter agreements. In Petroleum Fin. Corp. the parties disagreed, and the court
found that the letters and telegrams exchanged were ambiguous as to whether the farmor
warranted a present title subject to defeasance or merely agreed to transfer merchantable title
in the future. Id. at 317-18.
85. The parties might include the following language, modeled upon language suggested
by Schaefer, supra note 3, at 18-9, in routine proposal letters:
[insert if the parties intend to be bound] We agree that the copy of this letter
executed by both of us shall constitute a binding agreement between us to all of
the terms and conditions set forth. We anticipate, however, that we will execute
a formal farmout agreement at a later date, the provisions of which will replace
and supersede this agreement in all respects.
[insert if the parties do not intend to be bound] We agree, however, that this
is a preliminary letter of intent that shall not create any legally binding obliga-
tions between us until we have executed a formal farmout agreement.
1987] FARMOUT AGREEMENTS

4. Satisfying the Statute of Frauds

Virtually all United States jurisdictions have adopted the statute of frauds
to minimize disputes and fraud. The rationale for the statute is that certain
kinds of agreements are so prone to dispute and outright fraud that they
should be unenforceable unless they are evidenced by a writing. 86
Farmout agreements fall within the scope of the statute of frauds if they
are contracts for the transfer of an interest in land. 87 Most states probably
will so classify farmout agreements, whether the interest created by an oil
and gas lease is viewed as an estate in land or as a profit A prendre,8 8 and
whether the form of the contract is an agreement to convey or a conditional
transfer. An oil and gas lease creates an interest in land whether it is classi-
fied as a fee simple determinable estate in the minerals or a profit Aprendre.
The lease's subject matter is an interest in land 89 whether the farmout agree-
ment is in the form of a bilateral contract or a unilateral contract. Only in
states that treat the oil and gas lease as a mere license can one argue that the
farmout agreement need not comply with the statute of frauds. Courts will
likely apply the statute even in those states, however. 90
Compliance with the statute of frauds does not require a formal contract.
Compliance occurs if there is "some memorandum or note thereof. . . in
writing, and signed by the party to be charged therewith" or that party's
agent. 9 1 On the other hand, it is not enough that there is a formal instru-
ment. To comply with the statute of frauds, a contract must identify the
parties and the subject matter, and a bilateral contract requires
consideration. 92

a. Authority of an Agent
A common statute of frauds issue that arises in a variety of oil and gas
contract contexts is the authority of the agent who executes the contract.

86. The recital to the Statute of Frauds, 29 Car. 2, ch. 3 (1677), stated that its object was
the "prevention of many fraudulent Practices, which are commonly endeavored to be upheld
by Perjury and Subornation of Perjury." See also Willis, The Statute of Frauds-A Legal
Anachronism, 3 IND. L.J. 427 (1928) (discusses historical background of statute of frauds).
87. See, e.g., OKLA. STAT. ANN. tit. 16, § 4 (West 1986). Interestingly, TEX. Bus. &
COM. CODE ANN. § 26.01(b)(4) (Vernon 1968 & Supp. 1987) applies only to contracts for the
"sale of real estate." In any event, an oil and gas lease is "real estate" under Texas law, and a
farmout agreement is subject to the statute of frauds. White v. McNeil, 294 S.W. 928, 930-31
(Tex. Civ. App.-Fort Worth 1927, no writ).
88. See E. KUNTZ, J. LOWE, 0. ANDERSON & E. SMITH, supra note 5, at 109.
89. J. LOWE, supra note 9, at 29.
90. Although Kansas, for example, has embraced the ownership-in-place theory of oil and
gas rights, Kansas considers an oil and gas lease as personal property, a mere license. None-
theless, Kansas courts have held oil and gas leases subject to the statute of frauds. For an
excellent discussion, see D. PIERCE, KANSAS OIL AND GAS HANDBOOK § 4.11 (1986). See
also Lohse v. Atlantic Richfield Co., 389 N.W.2d 352 (N.D. 1986), holding that an oral agree-
ment or bonus, royalty, and delay rentals did not create an enforceable contract even though
the parties agreed to use a "standard form."
91. 8 Stat. 405, § 4, 24 Car. 2, ch. 3, § 4; Lynch v. Davis, 181 Conn. 434, 435 A.2d 977,
980 (1980).
92. RESTATEMENT OF CONTRACTS § 207 (1932); RESTATEMENT (SECOND) OF CON-
TRACTS § 131 (1979).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

Most oil and gas contracts are between corporations, partnerships, limited
partnerships or other forms of business entities, rather than individuals, be-
cause of the magnitude of the financial obligations involved. The question of
whether or not the individual who purports to act for a corporation or a
limited partnership actually has the authority to act is always a potential
problem.
Representations in the agreement can minimize the problem. While rep-
resentations of agency cannot create powers that do not exist, they may stim-
ulate a disclosure of limited authority from the negotiator. Furthermore, if
others in the negotiator's organization who have authority to bind it are
aware of the negotiator's representations, a basis for a finding of apparent
authority may be laid. 93 The only certain way to ensure that the agent sign-
ing the agreement has authority is to require a properly executed power of
attorney or a certified copy of evidence of authority.

b. Designation of the Parties

The statute of frauds requires that the parties to the agreement be identifi-
able. 94 Failure to do so will cause the agreement to be unenforceable. Cohen
v. McCutchen9 5 provides a good example. In Cohen the contributing party
made and signed a support agreement proposal in a form that failed either to
state the name of the party to receive the contribution or to provide for his
signature. 96 The Texas Supreme Court upheld summary judgment against
the administrator of the estate of the party who was to receive the contribu-
tion on the ground that the statute of frauds requires that both parties be
97
identifiable from the written agreement or supporting memoranda.
The statute of frauds does not require that the parties to a contract for the
transfer of an interest in land be named. 98 Compliance with the statute oc-
curs if they are described sufficiently to permit their identity to be estab-
lished by parol evidence. Thus, a reference in a farmout agreement to a
"farmor" who is the "owner" of specifically described leases should satisfy
the statute. 99
There are important practical reasons, however, for specifically naming
the parties to the farmout agreement and indicating addresses and telephone
numbers of each in the agreement. Under the terms of the agreement or in
the event of emergencies, notices may need to be given or communication
established. Having the vital information ready at hand in the body of the
agreement will save time and minimize confusion. A well-drafted farmout

93. Apparent authority is "[S]uch authority as a principal intentionally or by want of

ordinary care causes or allows third person to believe that agent possesses." BLACK'S LAW
DICTIONARY 88 (5th ed. 1979); see also W. SEAVEY, HANDBOOK OF THE LAW OF AGENCY
§ 8(D) (1964) (similar definition of apparent authority).
94. TEX. Bus. & CoM. CODE ANN. § 26.01 (Vernon 1987).
95. 565 S.W.2d 230 (Tex. 1978).
96. Id. at 232.
97. F. & W. Grand Co. v. Eiseman, 160 Ga. 321, 127 S.E. 872, 876 (1925).
98. See id., 127 S.E. at 875 (reference to "lessor" as "owner" held sufficient).
99. See Westland Oil Dev. Corp. v. Gulf Oil Corp., 637 S.W.2d 903, 908-11 (Tex. 1982).
19871 FARMOUT AGREEMENTS

agreement will have no difficulty meeting the statute of frauds requirement

that the parties be identifiable.

c. Identification of the Land Covered

The agreement must sufficiently describe the land subject to a farmout
agreement to permit it to be located to meet the standard of the statute of
frauds.u° ° This requirement can pose a problem, particularly in those
farmout agreements that are in letter form and refer only generally to the
leases and areas covered. Westland Oil Development Corp. v. Gulf Oil 'o'
illustrates the principles applicable. In Westland an area of mutual interest
clause in an assignment of the farmee's rights under a farmout agreement
provided as follows:
5. If any of the parties hereto, their representatives or assigns, acquire
any additional leasehold interests affecting any of the lands covered by
said farmout agreement, or any additional interest from Mobil Oil Cor-
poration under lands in the area of the farmout acreage, such shall be
02
subject to the terms and provisions of this agreement.
The Texas Supreme Court held that the reference to "lands covered by said
farmout agreement" satisfied the statute of frauds because the letter agree-
ment specifically identified "said farmout," and the farmout agreement iden-
tified contained a specific description of the land subject to the leases.'0 3 The
court deemed the reference to "lands in the area of the farmout acreage"
insufficient to permit introduction of parol evidence to determine the intent,
however.' 0 4 The court said that parol evidence "should be used only for the
purpose of identifying the land with reasonable certainty from the data in
the memorandum, and not for the purpose of supplying its location or
description."10 5
A similar issue with a similar result arose in Stekoll Petroleum Co. v.
Hamilton.10 6 In Hamilton the farmout arrangement extended to the farmee
the right to choose 4000 acres from a 5000-acre block of land, leaving the
farmors with 1000 acres "equitably checkerboarded in a fashion similar to
the checkerboarding in" another block.' 0 7 The Texas Supreme Court held
that the agreement failed to describe adequately the property in question
because the agreement did not clearly define the checkerboard pattern and
because the contract did "not contain the statement of data or means or a
method by which . . .the land will be certainly and clearly identified."' 0 8
These two cases illustrate that the description of leases subject to the

100. Id.at 908.

101. 637 S.W.2d 903 (Tex. 1982).
102. Id.at 905.
103. Id.at 909.
104. Id.
105. Id. at 910; see also Getty Oil Co. v. Blevco Energy, Inc., 722 S.W.2d 51, 53 (Tex.
App.-Eastland 1986, no writ) (failure of any writing to identify property allegedly subject to
farmout agreement provided court alternative ground for reversing trial court).
106. 152 Tex. 182, 255 S.W.2d 187 (1953).
107. Id.at 188-90, 255 S.W.2d at 191.
108. Id.at 190-92, 255 S.W.2d at 192.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

farmout agreement must be as detailed and explicit as possible. The parties

should use a proper legal description, rather than a plat map. 10 9 The de-
scription should include the legal description of the property, the source of
the legal description, the names of the lessor and lessee, and the recording
information for the leases farmed out. The description may also refer to
depth limitations or lease burdens. The information frequently will be so
lengthy that it will be included in an exhibit attached to the farmout
agreement. "10

d. Consideration
The statute of frauds requires that consideration, expressly or impliedly
stated in the agreement, must support a bilateral contract."' Farmout
agreements occasionally specifically recite that monetary consideration has
been given, "t2 though whether it is actually paid is often doubtful. When the
farmout agreement makes drilling an obligation of the farmee, however, one
can find consideration in the promises that the parties make to one another.
Consideration in the form of a promise for a promise is the essence of a
farmout agreement in which drilling is mandatory. The more typical option-
to-drill farmout agreement may be classified as a unilateral contract, which
needs no consideration.' '3

5. Coordination with Farmed-Out Leases

It is axiomatic that the farmee can get no better rights under a farmout
agreement than the farmor owns under the leases subject to the agreement.
Often, however, the parties to a farmout agreement fail to examine the terms
and the validity of the leases farmed out. Rarely are proposed farmout
agreements presented with copies of the subject leases attached. The parties
will likely execute the farmout agreement without a close examination of the

109. In Heirs & Unknown Heirs of Barrow v. Champion Paper & Fibre Co., 327 S.W.2d
338 (Tex. Civ. App.-Beaumont 1959, writ ref'd n.r.e.), the court of appeals held that a map
of a subdivision drawn on a scale of one inch to 800 feet was too uncertain to fix the location
because "even the width of a line drawn upon the map must represent several feet." Id. at 347.
110. For example:
EXHIBIT "A"
Attached to and made a part of that certain Farmout Agreement dated (date) ,
from (Name of Farmor) to (Name of Farmee)
Oil, Gas and Mineral Lease dated __ , between __ , as Lessor, and
__ , as Lessee, recorded in Volume __ , Page _ of the Oil and Gas
Records of - County, Texas, covering the following described lands sit-
uated in said county and State:
_ acres, more or less, being the __ _ Survey, _ of
County, Texas, and described in a Deed from _ to _ dated
_____, and recorded in Volume -, Page _ of the Deed Records of
County, Texas.
I 11. RESTATEMENT (SECOND) OF CONTRACTS § 131 comment h (1979); see also Lynch v.
Davis, 181 Conn. 434, 435 A.2d 977, 979 (1980); Briand v. Wild, 110 N.H. 373, 268 A.2d 896,
897-98 (1970).
112. For example, one major oil company uses forms that begin, "For sufficient considera-
tion, receipt of which is hereby acknowledged .... "
113. See RESTATEMENT (SECOND) OF CONTRACTS § 131 comment h (1979). Performance
supplies consideration for a unilateral contract. Id.
1987] FARMOUT AGREEMENTS

leases being farmed out since most farmout transactions make drilling an
option rather than a firm obligation.
The farmor and the farmee both take risks if they fail to examine the
leases subject to the farmout. Isler v. Texas Oil & Gas Corp.114 illustrates a
risk to the farmee. In Isler TXO farmed out an oil and gas lease on federal
lands in New Mexico to Isler. TXO made the farmout without warranty of
title. The agreement provided that TXO would make delay rental payments
or give Isler notice before ceasing to make them, but it specifically stated
that TXO would have no responsibility to Isler for a failure to make the
payments. 11 5 TXO, through
oversight, failed to make rental payments, and
the lease expired. Isler completed two wells on the premises before learning
that the lease had expired. Isler sued TXO, claiming damages both on a
theory of breach of contract and on a theory of tort. A federal court jury
awarded damages against TXO for negligence." t6 The Tenth Circuit re-
versed, applying New Mexico law, on the ground that the farmout agree-
ment meant what it said:
The effect of confusing the concept of contractual duties, which are vol-
untarily bargained for, with the concept of tort duties, which are largely
imposed by law, would be to nullify a substantial part of what the par-
ties expressly bargained for-limited liability. Unless such bargains are
against public policy (covered either by prohibitory statutes or well-de-
fined, judge-made rules such as unconscionability), there is no reason in
fact or in law to undermine them. Indeed, it would be an unwarranted
judicial intrusion into the marketplace.'17
The farmor may also hurt itself by failing to coordinate the terms of the
farmout with the underlying leases. In Davis v. Zapata Petroleum Corp. 118
Davis farmed out to Zapata under a farmout agreement that required Zapata
to commence drilling and continue either until Zapata achieved production
or until thirty days after Zapata provided Davis notice of its intent to cease
operations. Zapata commenced drilling three days before the end of the pri-
mary term, but then gave Davis notice of its intent to cease. Davis accepted
the notice, took over the well, and found another farmee. The lessor subse-
quently evicted the new farmee from the land on the grounds that the lease
had terminated because operations had ceased for longer than the period
permitted by the lease operations clause." 9 Davis sued Zapata for damages
it had incurred, but lost in a jury trial. A Texas court of civil appeals upheld
the judgment on the basis that the farmout agreement set Zapata's obliga-

114. 749 F.2d 22 (10th Cir. 1984).

115. This provision is typical in farmout agreements. The Isler case does not quote the
applicable provisions, but many of the farmout agreements collected included formulations of
similar effect. See infra text accompanying notes 352-53.
116. 749 F.2d at 22.
117. Id. at 23.
118. 351 S.W.2d 916 (Tex. Civ. App.-El Paso 1961, writ ref'd n.r.e.).
119. A lease operations clause addresses the problem of drilling operations that are begun,
but not completed by the end of the primary term. The clause defines drilling operations,
generally deemed to be in progress when continuing for more than a 30-, 60-, or 90-day period,
as constructive production for purposes of the lease habendum clause. See E. KUNTZ, J.
LOWE, 0. ANDERSON & E. SMITH, supra note 5, at 188-98.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

tions rather than the lease. 120 The court noted that "such requirements
might well have been greater, or less, than those required to maintain the oil
12 1
and gas lease in effect."
These cases clearly and consistently apply the principle that a farmout
agreement means what it says. The courts will not include by implication in
the farmout agreement requirements of the leases that are farmed out or
motivation of the parties. Thus, it is crucial that the parties to a farmout
identify the important components of the leases being farmed out and incor-
porate them specifically in their agreement.

6. Drafting Techniques
Drafting is an art rather than a science. Every drafter has favorite tech-
niques, and few agree as to what works best. Experts in the area do agree,
however, that "if it may be ambiguous, it is ambiguous."1 22 Clarity of mean-
ing is the goal, and the following techniques may be helpful.

a. Use of Prefatory Statements of Purpose

When the primary purpose of the farmout can be identified-for example,
to preserve a lease about to expire or to test a particular formation-one
should include a prefatory statement of that purpose. The courts struggle to
make sense of the instruments before them, as do managers in oil companies
and their counsel. A clear statement of the purpose of an agreement may
avoid disputes or lend support to the interpretation urged.
Pasotex Petroleum Co. v. British American Oil Producing Co. 123 illustrates
the usefulness of prefatory statements. In Pasotex Petroleum Co. the
Oklahoma Supreme Court held that a farmee abandoned performance of a
farmout agreement when it failed to drill a well to test a deep formation, but
completed a well in a shallower formation. The court reasoned that:
Our examination of the record convinces us that the paramount idea
and purpose on the part of defendant in negotiating and making the
agreements with plaintiff was to secure a deep test well that would test
the productivity of the Basal Oil Creek Sand. In addition to the value
of a producing well from this sand there was also the important feature
of the geological knowledge that defendant would acquire and the influ-
ence this would have on defendant in determining whether it would
expend the large sums . . .necessary in securing renewals of a large
number of leases that would soon expire. Such a test well was not
drilled. 124
The result turned on the finding of the purpose of the agreement. Extrinsic
evidence had to be introduced to prove the point, however. A prefatory
statement might have avoided litigation, and made the result more certain.

120. 351 S.W.2d at 925.

121. Id.
122. See supra note 4.
123. 431 P.2d 373 (Okla. 1966).
124. Id. at 381.
1987] FARMOUT AGREEMENTS

b. Use Appendices for Standard or Complex Provisions

Many of the farmout agreements collected did not attempt to deal with
standard or detailed provisions in the body of the agreement, but instead
attached appendices containing these terms.1 25 This drafting technique of-
fers a number of advantages. First, it makes possible an apparently simple,
purpose-oriented farmout agreement. Second, it discourages those who ne-
gotiate the agreement from making changes in provisions that the lawyers
may view as important boilerplate. Third, the technique minimizes the op-
portunities for ambiguity or conflict between the terms of the farmout agree-
1 26
ment and related instruments, such as the assignment.
Use of appendices has a single, but substantial, disadvantage. That disad-
vantage is the risk that those negotiating the agreement will regard the ap-
pendices as incidental to the transaction and thus not give them the attention
that they deserve. 127 Negotiators can easily fall into the trap of regarding
appendices as unimportant.

c. Define the Terms Used

Persons active in the oil business often think of the industry as a mono-
lithic whole, although the better view probably is as a group of regional in-
dustries. Both practices and terminology differ from place to place. Parties
therefore must define carefully the terms used in a farmout agreement, either
in the text of the contract as they are used or in a separate definitions
28
section.'
Even commonplace terms may be considered ambiguous. In Holly En-
ergy, Inc. v. Patrick129 the farmout agreement provided that a well capable
of producing in paying quantities would earn "that portion of the captioned
quarter section situated within the production unit established for that
well. ' 130 The farmor assigned its interest in two full quarter sections,

125. See, e.g., Exhibit A to the agreements of Sun Exploration and Production Company
discussed in T. FAY, supra note 3, at 55-58, which includes many of the substantive provisions
addressed in this paper in four pages of fine print.
126. A nightmare for the lawyer or administrator working with farmouts is that the terms
of an assignment made pursuant to a farmout agreement will be inconsistent with the terms of
the farmout. Whether the terms of the assignment comport with the farmout is often a point
of dispute between farmor and farmees. See, e.g., Holly Energy, Inc. v. Patrick, 239 Kan. 528,
722 P.2d 1073, 1074-75 (1986). For a discussion of Holly Energy, see infra notes 129-32 and
accompanying text. An obvious problem of merger will arise if that occurs. One correspon-
dent who responded to my request for comments, Dean Eugene Kuntz, suggested that the
parties might draft the farmout to refer to an assignment to be made "on the attached form of
assignment covering the lands, leases and interests, and subject to the limitations set forth, in
such form of assignment." This suggestion would minimize the possibilities for conflict be-
tween the terms of the assignment and the terms of the farmout relating to the assignment.
127. See Lamb, supra note 3, at 141 (criticizing the "conglomerate mess" that may result).
128. One of the agreements collected devoted nearly two full pages to definition of terms,
including contract lands, leases, earning well, subsequent well, drilling unit, contract depth,
well costs, operating costs, leasehold costs, lease maintenance costs, casing point, working in-
terest, working interest percentage, and operator. See also art. II of the short form farmout
agreement attached to Bledsoe, supra note 3, ex. 1.
129. 239 Kan. 528, 722 P.2d 1073 (1986).
130. 722 P.2d at 1075 (emphasis in original).
 SOUTHWESTERN LAW JOURNAL (Vol. 41

though the spacing pattern for the two wells was only forty acres. The
farmor later asserted that the farmee should have received only assignments
of the forty-acre well sites. The Supreme Court of Kansas affirmed a trial
court's refusal to grant the farmor relief on a variety of claims, upholding the
trial court's finding that the term "production unit" was ambiguous.13' The
court pointedly noted that "it would have been a simple matter for Holly to
clearly state in the farmout agreement that only one well was contemplated
and that if successful Patrick would receive an assignment as to forty acres
only."' 32 A complete definitions section, though rarely seen, is advisable.

B. Key Characteristicsof a Farmout

When one shifts from preliminary matters to substantive analysis, it is
important to determine the key characteristics of any farmout proposal or
agreement. On these provisions may turn the likelihood of the transaction's
business success or failure. The key characteristics of a farmout agreement
generally include the provisions relating to (1) the duty imposed, (2) the
earning factor, (3) the interest earned, (4) the number of wells to be drilled,
and (5) the form of the agreement.
1. The Duty Imposed.: Option or Obligation
People in the industry frequently classify farmout agreements as "option
farmouts" or "obligation farmouts." An option farmout agreement provides
that drilling is a condition of the farmee's earning the agreed interest. An
obligation farmout agreement is one in which drilling is a promise by the
farmee.1 33 If drilling is an option, it is a condition of earning. If drilling is
an obligation, it is a covenant-a legally binding promise.
All things being equal, the farmor would probably always prefer to struc-
ture the farmout agreement so that the farmee covenants to drill. All things
are rarely equal in negotiations, however, and the vast majority of farmout
agreements make drilling an option rather than an obligation. This situation
may indicate that lease salvage is a common motivation.134 It may also re-
flect the attitude of the farmors' managements as to what is fair.' 35 Perhaps
most likely, drilling as an option results from simple economics. In the usual
farmout situation, the farmee holds the bargaining leverage. The farmor

131. Id.at 1079.

132. Id.
133. An obligation farmout should not be confused with a farmout in which the farmor's
purpose is to have drilled an obligation well. See supra text accompanying notes 67-69. The
former refers to the structure of the agreement. The latter refers to the motivation of the
farmor in entering the agreement. In fact, however, a farmout given because the farmor needs
to have an "obligation well" drilled will almost certainly be structured as an "obligation
farmout." On the other hand, farmouts motivated by other purposes may also be so
structured.
134. See supra text accompanying note 62.
135. The vice president for land of a large independent oil company once told the author
that his company, as a farmor, would never insist that a farmee covenant to drill because it was
as often a farmee as a farmor. While that statement may have been an exaggeration, what the
deal-makers regard as ethical or good business practice certainly may affect the structure of
agreements.
19871 FARMOUT AGREEMENTS

wants to "move" the leases being farmed out and so the farmee, which is
understandably reluctant to make a firm commitment to drill, can negotiate
an option to drill.
The primary significance of classifying a farmout agreement as an option
farmout or an obligation farmout is the effect of failure to perform under the
agreement. When the farmout is structured as an option to drill, failure to
drill will cost the farmee the benefits it might have earned. When the farmee
is obligated to drill, however, failure to drill may expose the farmee to very
substantial liabilities. 136 The classification of the agreement as an option
farmout or obligation farmout may also affect the rights of the parties in the
1 37
event of bankruptcy.

2. The Earning Factor: Produce to Earn or Drill to Earn

A second way to categorize farmout agreements for analytical purposes is
by reference to what will earn an interest for the farmee. A produce-to-earn
farmout agreement is drafted so that the farmee earns an interest in the
property being farmed out by drilling and completing a well capable of pro-
ducing in paying quantities. A drill-to-earn farmout agreement requires less.
The farmee can earn its interest merely by drilling to a specified formation or
formations and conducting agreed testing.
Lansinger v. United Petroleum Corp.138 illustrates the importance of the
distinction between produce-to-earn and drill-to-earn farmouts. In
Lansinger the farmee drilled a well under a farmout requiring completion of
a well capable of producing in paying quantities, but the farmee neither hy-
draulically fractured it nor equipped it to produce. The court quieted title in
favor of the farmor, noting that it was not sufficient "to complete a well
having some indications of oil, or a well which might be developed into a
well producing oil in paying quantities," 139 and denied the farmee additional
time to complete the well.' 4°
The produce-to-earn farmout, which was the subject in Lansinger, is the
more usual because the most common motivation for a farmor to farm out is
to preserve a lease, and a party cannot maintain a lease without a well capa-
ble of producing in paying quantities. A drill-to-earn farmout structure is
usually found in agreements where the farmor is motivated by a desire to
explore. Conceptually, this structure is closely related to an acreage contri-
bution agreement. 14 1 Parties will likely use both as part of a coordinated

136. Thus, when drilling is an obligation rather than an option, the farmee must determine
its ability to perform before entering into the agreement. In addition, the farmee must also
have examined the title of the farmed-out properties before committing itself to an obligation
to drill. In the alternative, the agreement may provide that the farmee has a specified period of
time to review title and to reject it without liability. Lamb, supra note 3, at 160; see infra note
162 and accompanying text.
137. See infra text accompanying notes 859-72.
138. 14 Ohio App. 3d 398, 471 N.E.2d 869 (1984).
139. 471 N.E.2d at 871 (quoting Murdock-West Co. v. Logan, 69 Ohio St. 514, 69 N.E.
984, 985 (1904)).
140. Id. at 872.
141. See supra text accompanying note 14.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

exploratory program to evaluate an area. Drill-to-earn farmout agreements

may also be used when the well to be drilled is an obligation well. A dry
hole will satisfy the legal obligation as effectively as a producing well when
the farmor farms out to satisfy an implied covenant to its lessor.

3. The Interest Earned. Divided Interest, Undivided Interest, or

Combination
A divided interest farmout provides that the farmee and the farmor end
up owning interests in separate tracts. A simple example is an agreement by
which a farmee earns all of the farmor's interest in a specified lease for drill-
ing. Another example is a farmout, perhaps entered into to preserve a lease,
that allows the farmee to earn the farmor's interest in a drillsite tract for
drilling and completing a well capable of producing in paying quantities, yet
leaves the farmor with the full leasehold interest in the acreage outside the
drillsite tract. 142 A variation, called a "checkerboard" scheme, provides that
the farmee earns the farmor's interest in drillsite acreage plus the farmor's
interest in every other drillsite unit around the drillsite tract, leaving the
43
farmor the interest in the remaining tracts.
An undivided interest farmout provides that the farmee earns an undi-
vided portion of the farmor's interest in a tract. For example, a farmee may
earn 75% of the farmor's interest in only the drillsite in return for paying
75% of drilling costs, so that the farmor and the farmee become tenants in
common. Such arrangements frequently arise when a farmor's primary rea-
son for farming out is lack of cash. By assigning a part of its interest, the
farmor gets a lease developed that it would not otherwise be able to drill,
while maintaining a percentage interest. 44
Many farmouts are structured so that the farmee earns a combination of
divided and undivided interests. The classic farmout structure gives the
farmee a divided 100% interest in the drillsite acreage until payout and an
undivided interest in acreage outside the drillsite. 145 Parties frequently use
combination farmouts when the object of the farmout agreement is to test
large undeveloped tracts.
Classification of a farmout as a divided interest farmout or an undivided
interest farmout is of primary significance in determining how much empha-
sis analysis should place upon the ongoing relationship of the farmor and the
farmee. If the farmout is of a divided interest, then once the farmee has
earned its divided interest in a given tract, the relationship of the parties is
no more complicated than that of any other two owners of adjacent proper-
ties. Analysis of a divided interest farmout thus should focus on what the
farmee has to do to earn its interest. When the parties are to end up owning

142. For examples of well site only assignments, see infra notes 275-76.
143. For an example of a checkerboard assignment, see Stekol v. Hamilton, 152 Tex. 182,
255 S.W.2d 187, 190-91 (1953). See also 8 H. WILLIAMS & C. MEYER, supra note 12, at 119.
144. See supra text accompanying notes 22-25 for a discussion of the complete payout tax
concept, which is apparently satisfied so long as the farmee maintains an interest in the well for
the payout period equal to the percentage of the IDCs it pays.
145. See supra text following note 32; infra note 277.
1987] FARMOUT AGREEMENTS

undivided interests, however, the ongoing relationship of cotenants will re-

quire that close attention be given to those provisions of the farmout and
operating agreements that relate to the ongoing duty of the parties to one
another and to their lessors, as well as to what has to be done to earn.

4. The Number of Wells. Single or Multiple Well Farmouts

In the classic farmout arrangement, the farmee earns an interest in the

farmor's acreage by drilling a single well. When large tracts of land are
involved, however, farmout agreements frequently require that several wells
be drilled.
A multiple well farmout agreement is substantially more complicated than
a single well agreement. The parties must carefully define the timing of drill-
ing operations for wells after the first well to be certain that the farmee has
adequate time to complete one operation before beginning another. The
farmout's testing provisions must be considered to determine whether the
tests required in the drilling of the initial well must also be required in subse-
quent wells. The parties must include provisions to address what happens if
the farmee completes some, but not all, of the multiple wells contemplated.
Typically, multiple well farmout agreements will provide that the farmee
will keep producing wells that it has completed. 46 Such is not always the
case, however; some multiple well farmouts punish the farmee for failure to
47
perform fully. 1

146. For example:

In addition to any other remedies which may be available to Farmor, its succes-
sors and assigns hereunder, this Agreement shall terminate and be of no further
force and effect should Farmee fail to drill any of the Test Wells required by,
and in the manner specified by, the terms and provisions of this Agreement.
However, this provision shall not cover acreage which has been previously drilled
and subleased in accordance with the terms and provisions of this Agreement.
(Emphasis added.)
147. The following provision, for example, would give the farmee only half of the acreage it
is to earn if it fails to drill all the wells promised:
If Farmee, as Farmee may so do without breaching its obligations under this
Agreement, shall fail to complete the drilling, testing and equipping of all of said
six (6) net wells in the manner and within the time provided in this Agreement
then Farmee shall have earned, and shall be entitled to receive an assignment
from Farmor covering, the following leasehold interests, to-wit:
(i) As to each of said test wells completed by Farmee for production, an undi-
vided one-half of Farmor's right, title and interest (subject to the propor-
tionate share of presently-existing burdens and obligations) in the leases set
forth in Exhibit "A" insofar as said leases cover the government-surveyed
section of land on which each of such wells is located, but only insofar as
said leases cover the interval from the surface to the base of the __
Formation; such well, the equipment and material therein and thereon and
the production therefrom shall be owned equally by the parties hereto and
shall be operated in accordance with the Operating Agreement attached
hereto;
(ii) as to each of said test wells completed as a dry hole by either Farmee or
Farmor, Farmee shall be entitled to assignments covering an undivided
one-half of Farmor's right, title and interest (subject to a proportionate
share of presently existing burdens and obligations) in the leases set forth
in Exhibit "A" insofar as said leases cover the government-surveyed sec-
 SOUTHWESTERN LAW JOURNAL [Vol. 41

5. The Form of the Agreement: Agreement to Transfer or Conditional

Assignment

Farmout agreements traditionally have taken the form either of an agree-

ment to convey or a conditional assignment. The essential difference in the
two is the point in time when the farmee acquires an interest in the farmed-
out property. When the farmout is in the form of an agreement to convey,
the farmee obtains its rights only if it performs the conditions made prereq-
uisite by the contract. 148 When the farmout is in the form of a conditional
assignment, the farmee obtains an interest in the farmed-out property when
the agreement is made, subject to an obligation to reconvey or 149
to automatic
termination if the conditions subsequent are not performed.
The farmout's form may have enormous practical significance to the par-
ties' rights and liabilities. The farmor's primary advantage in structuring a
farmout as a contract to convey rather than a conditional assignment is that
the farmor retains title to the property farmed out until after the farmee has
performed. Administratively, this is simple for the farmor, and it saves the
time and effort required to clear title in the event that the farmee does not
perform. In addition, structuring a farmout as a contract to convey may
mitigate the problems of liens being attached due to the farmee's default or
0
of claims as a result of the farmee's bankruptcy.15
The farmee's interests virtually mirror the farmor's. The farmee, under a
conventional agreement to transfer farmout, may find the farmor slow to
provide the earned assignment or inclined to quibble over whether it is really
due. Further, the assignment when finally made may come burdened with
liens attached while the farmee was drilling the earning well. If the farmor
should go bankrupt before the assignment is made, the farmee may never get
the assignment.

tion of land on which such well is located, and insofar as such leases cover
the interval from the surface to the base of the - Formation.
As to each such producing well, Farmee shall retain ownership of the material,
equipment and supplies located therein and thereon; providing, however,
Farmor shall have free use of each such property and the production from each
such well shall be owned equally by Farmor and Farmee; it being understood
that maintenance and operating costs shall be shared by Farmor and Farmee in
accordance with the terms of the Operating Agreement, Exhibit "D" attached
hereto. Should such property be transferred, sold, salvaged or otherwise dis-
posed of, Farmor shall receive 50% of the proceeds or credits received
therefrom.
This provision would subject the farmee to the ravages of the complete payout limitation as
well, because the farmee would not earn the full interest in the well site acreage and would lose
a part of the IDC deduction.
148. See, e.g., Lansinger v. United Petroleum Corp., 14 Ohio App. 3d 398, 471 N.E.2d 869,
871-72 (1984); Energy Reserves Group v. Tarina Oil Co., 664 S.W.2d 169, 172-73 (Tex.
App.-San Antonio 1983, no writ).
149. See, e.g., Vickers v. Peaker, 227 Ark. 587, 300 S.W.2d 29, 31-34 (1957) (automatic
termination); Mengden v. Peninsula Prod. Co., 544 S.W.2d 643, 647-49 (Tex. 1976) (obligation
to reassign).
150. For a discussion of bankruptcy and its effects on farmout agreements, see infra text
accompanying notes 459-72.
1987] FARMOUT AGREEMENTS

IV. ESSENTIAL ISSUES OF FARMOUT AGREEMENTS

Having considered preliminary matters and having noted the key charac-
teristics of the agreement, the reviewer or draftsman is ready to analyze the
essential issues that any farmout agreement must address. This section of
the Article discusses the following issues: drilling the earning well, well in-
formation, what is earned, and administrative provisions.

A. Drilling the Earning Well

1. What Is Farmed Out
Generally a farmout agreement covers leases owned by the farmor, but on
occasion mineral rights may be farmed out as well. The leases and lands
covered by the farmout may be described in the body of the farmout agree-
ment. More often an appendix incorporated by reference contains this infor-
mation. When the parties list leases subject to the farmout in an appendix,
they may also include other information, such as existing burdens and lease
terms. The obvious and easily avoidable problem is inaccuracies or discrep-
51
ancies in description of the properties.1
The agreement may also provide that the farmee's rights will extend to
extensions and renewals of the leases covered.1 52 Extension and renewal
provisions are unnecessary in the farmout if the operating agreement be-
comes effective when the farmout is executed, in which case the provisions in
the operating agreement probably supersede those of the farmout agreement.
In any event, extension and renewal provisions of farmout agreements often
53
parallel operating agreement provisions. 1

2. Costs and Expenses

Almost by definition, a farmout is an agreement by which the farmee
agrees to pay the costs of the operations contemplated. Generally that un-
dertaking is explicitly stated in the farmout. 54 As is discussed below, how-
ever, a provision that the farmee will be responsible for all costs and
expenses is not a perfect shield against liability for the farmor. 55

151. See supra text accompanying notes 100-10.

152. The following example is a concise renewal and extension provision: "The interests
reserved herein, or in any assignment hereunder, to Farmor shall apply to any renewal, exten-
sion, or new lease covering any part or all of the Contract Acreage that - may acquire,
directly or indirectly, within two years after expiration of the Lease."
153. Compare Art. VIII.B. of the 1982 AAPL Model Form Operating Agreement with the
provisions of the clause quoted supra note 152. Application of extension and renewal provi-
sions frequently provide a source of dispute between farmors and farmees. See Cage, supra
note 3, at 169-73.
154. For example: "The entire cost, risk and expense of drilling, testing, completing,
equipping and operating the well(s) or of plugging and abandoning the well(s) and restoring
the surface if a dry hole shall be borne by farmee." Of course, the parties must appropriately
modify this language if the farmee will earn less than 100% of the working interest in well-site
acreage and pay only the proportion of costs equal to the interest earned.
155. See infra notes 406-38 and accompanying text.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

3. Failure of Title

Failure of title is a risk that is customarily imposed upon the farmee in

farmout agreements. While in principle the farmor and the farmee should
negotiate covenants of title from the farmor, farmout agreements rarely con-
tain a general warranty of title by the farmor. None of the farmout agree-
ment examples collected included a general warranty, and only a few
contained a special warranty 56 or a specific representation.1 57 Indeed, most
of the contract examples included a disclaimer of any warranty, 15 8 and a few
specifically placed the farmee on notice of possible title defects.' 59 Some

156. A farmout special warranty follows:

Any assignment from farmor to farmee shall be without warranty except for a
limited warranty as to the farmor's own acts in favor of farmee, including an
express representation and warranty by farmor that the interest assigned is not
subject to any obligation or burdens by or through farmor, other than the les-
sor's royalty. Also, farmor warrants that the interest to be assigned to farmee is
free of any mortgage or any other encumbrance by or through farmor including
indemnification of farmee from any loss or deficiency under such warranty or
representation.
157. The following represents that the farmor holds title, but stops short of warranting it:
Farmors represent to the Farmee that to their best knowledge after reasonable
investigation they own the working interests and the net revenue interests in the
land and depths covered by said leases described in Exhibit "B"; that the only
Agreements to which Farmors' interests in said leases are subject are the Agree-
ments described in Exhibit "B"; that said leases are in full force and effect except
for the following: _; and that Farmors are free to assign their interests
in said leases to Farmee on the terms of this Agreement without the consent of
any third party. Farmors agree to use their best efforts to maintain said leases in
full force and effect during the term of this Agreement prior to the commence-
ment of the Initial Earning Well (as defined below) so that such leases remain in
full force and effect during the term of this Agreement.
The following representations focus on the burdens of the leases farmed out, as well as title:
Farmor represents, but does not warrant that as of the date hereof, it owns an
interest in the leasehold interest created by the lease at least equal to an undi-
vided - interest therein, and that other than the landowner's royalties and one
or more overriding royalty interests aggregating - percent of 8/8ths there are
no other overriding royalty interests, production payments, net profits obliga-
tions, carried working interests and payments out of or with respect to produc-
tion which are of record in the county and state identified on page 1 hereof and
with which the lease is burdened as of the date hereof (the "existing burdens")
so that the existing burdens aggregate a total of - percent of 8/8ths of produc-
tion, and without regard to any non-consent provisions in the operating agree-
ment and without making any provisions for operating costs, farmee will be
entitled to receive - percent of - percent of the production attributable to its
interests in the lease.
158. A specific disclaimer of warranty, for example, may state, "Farmor makes no repre-
sentation with the respect to the status of their title to the leasehold interests covered hereby,
and it is understood that this farmout is being given without warranty of title, either expressed
or implied."
159. For example:
Farmor hereby expressly advises farmee that there is currently litigation pend-
ing which may directly or indirectly raise certain questions concerning title to
the farmed out lands, and hereby specifically refers farmee to the following
cases: _ . It is understood and agreed that any operations undertaken
by farmee pursuant to this agreement are done so at its sole risk and expense
without any representations of any kind or character made by farmor as to title
to the farmed out lands.
1987] FARMOUT AGREEMENTS

states may imply title warranties from the use of words of grant,' 60 so the
parties should be specific as to their agreement.

4. Title Information
Because the typical farmout agreement does not include a warranty of
title, the farmee should satisfy itself that the farmor has title before con-
ducting drilling operations. That task is made easier if the farmor will agree
to share with the farmee title information that it may have, as is commonly
done.' 6 ' One reviewing a farmout agreement for a farmee should alert the
farmee to the importance of actually obtaining and reviewing title docu-
ments relating to the leases farmed out. Particularly when the farmout
agreement obligates the farmee to drill, rather than merely giving it an op-
tion, the agreement should provide that 1the farmee can withdraw from the
62
agreement if it is not satisfied with title.

5. Geologic Information
The farmor will frequently agree to provide the farmee with whatever geo-
logic and geophysical information and interpretations it has developed. The
farmout agreement should specifically provide for the sharing of such infor-
mation, 163 subject to disclaimers of accuracy and requirements of confidenti-

160. See, e.g., TEX. PROP. CODE ANN. § 5.023 (Vernon 1984).
161. Bledsoe, supra note 3, at N-5. For example:
Upon request by Farmee following execution of this Agreement, Farmors shall
provide the Farmee copies of said leases and copies of all title documentation
material to the acreage subject to this Agreement in Farmor's files relating
thereto, including without limitation copies of all title opinions and reports,
rental receipts, and title curative documents. Such title documentation shall be
provided without warranty by Farmors as to accuracy. Any title examination
performed by Farmee with respect to the Initial Earning Well referred to below
to be drilled on said leases shall be performed at the sole cost of Farmee and the
Farmee shall deliver copies to Farmors of any title opinions or reports acquired
by Farmee with respect to such well.
Id. For a discussion of Isler v. Texas Oil & Gas Corp., 749 F.2d 22 (10th Cir. 1984), which
illustrates the risk to the farmee of an inadequate title examination, see supra text accompany-
ing notes 114-17.
162. An example of a clause giving the farmee a right to avoid the agreement in the event
of defects is:
Farmor has furnished to farmee all material in farmor's possession relevant to
the determination of farmor's title to the leases subject to this agreement. If
farmee does not object to farmor's title of the leases in the manner described
below by __ farmee will be deemed to have accepted farmor's title to the
leases. If farmee raises reasonable objections to farmor's title to the leases by a
writing delivered to farmor by _ , farmor will have until __ to cure
any title objections to the reasonable satisfaction of farmee. Should farmor fail
in this respect, this agreement shall become null and void.
163. For example:
Upon request of Farmee, Farmors shall provide Farmee with reproducible cop-
ies of any geological, geophysical or other information which Farmors have ac-
quired with respect to said leases and which Farmors have the right to provide.
Such information will include, but will not be limited to, maps, cross sections,
and geological interpretations; field tapes and associated support data, final rec-
ord sections (processed using standard processing techniques), shot point loca-
tion maps and other materials related to any seismic operations conducted by
 SOUTHWESTERN LAW JOURNAL [Vol. 41

ality. In the alternative, the agreement should specifically indicate that the
farmor will not share geologic and geophysical information. 164

6 Location of the Well

If a farmor's purpose in entering into the farmout agreement is to save its
lease, it may be willing to let the farmee drill at a location of its choice. 1 65 If,
however, the farmor's purpose is to obtain geologic information or to satisfy
an express or implied covenant of a lease, the farmor may designate the loca-
tion precisely. Moncrief v. Martin Oil Service, Inc. 166 illustrates the impor-
tance of clearly designating the location of the well if a specific location is
important to the parties. In Moncrief Martin farmed out to Moncrief in a
farmout agreement that provided that "the interest earned by operator
[Moncrief] hereunder shall be in consideration for the drilling of the well on
lands belonging only to Martin." 1 67 The agreement also contained a propor-
tionate reduction clause that provided that the interest earned by Moncrief
in the Martin acreage would be reduced to the proportion that the amount of
the Martin acreage within the participating area for the test well bore to the
total acreage within the participating area. After Martin and Moncrief exe-
cuted the agreement, Martin agreed to amend it so that "if our acreage on
the first Test Well does not earn your Company its full interest under the
Agreement, . . . the drilling of subsequent tests can earn the interest agreed
to.' 168 Moncrief then drilled several wells, spending between $13 and $14
million dollars in the process. Martin refused to assign the interest that
Moncrief claimed he had earned because the additional wells drilled were
not located "on lands belonging only to Martin."' 69 The trial court found in
favor of Moncrief, the farmee, because the amending letter did not specifi-
cally embrace the requirement of the initial contract. 70 The appellate court
upheld this position on the ground that the agreement did not require posi-
tively that subsequent tests be located on Martin's acreage, so that the trial

Farmor; and well information, such as logs, drilling and completion reports, and
engineering information.
The farmor would probably prefer to make geologic information supplied by the farmor specif-
ically subject to a continuing confidentiality obligation of the farmee. See infra text accompa-
nying notes 271-72.
164. An example of a clause specifically disclaiming any obligation of the farmor to provide
geological or geophysical information follows:
Farmor shall not be required to provide farmee with any geophysical or geologi-
cal information that farmor may have, and farmee shall likewise not be required
to provide farmor with any such information except the information specifically
set forth in § - hereof, whether such information is presently in the possession
of farmor or farmee or is hereafter acquired.
165. An example of a clause permitting the farmee to select the location of the earning well
follows: "Farmee's Choice: Farmee shall have the right, but not the obligation, to commence
on or before_ , operations for the drilling of well (the "Initial Earning Well") at a loca-
tion of Farmee's choice on the - of Section _ ,Township -, Range _ ,
The.discretion given the farmee will be illusory if the tract identified is small.
166. 658 F.2d 768 (10th Cir. 1981).
167. Id. at 769-71.
168. Id. at 771.
169. Id. at 773.
170. Id.at 770.
1987] FARMOUT AGREEMENTS
17
court's decision was not plain error. 1
Even when the farmor and the farmee can agree that the location of the
well is an essential part of their agreement, they may encounter practical
problems in formulating the designation. Exact locations are hard for the
farmee to satisfy and will lead to dispute. A mathematically determinable
point (e.g., "the center of the SE/4 of the NW/4") may be difficult to locate
when it comes time to spud the drilling rig. A general location (e.g., "within
330 feet of the center of the NW/4" or "in the NW/4") will generally be
adequate to protect the interests of both parties. The farmee must satisfy
itself, however, that it can meet lease restrictions and conservation agency
rules by drilling in the general area identified.
Farmout agreements often provide for the initial well's location "at a legal
location of farmee's choice."' 172 This language is appropriate where the
farmor's purpose is to extend the farmed-out lease. If the geological infor-
mation obtained from drilling is important to the farmor, however, this lan-
guage may not accomplish the farmor's goals, particularly if the tract is
large. Geological information from a well drilled near the edge of the tract
may not be as valuable as that from its center. A risk likewise arises that
describing the location as "a legal location of the farmee's choice" will per-
mit the farmee to earn its interest by obtaining an exception tract drilling
permit 173 to drill close to the edge of the farmed-out acreage near a produc-
174
ing well outside the farmout area.
In farmout agreements as in other contracts, a drafter should never use
the phrase "at a mutually agreeable location." If the parties cannot subse-
quently agree upon a location, the courts will probably hold the farmout
175
agreement to be an unenforceable agreement to agree.

7. Choice of Contractors

Farmout agreements usually make drilling an option or obligation of the

farmee. Since few farmees own their own drilling rigs, the parties must ordi-
narily contemplate that the farmee will subcontract the drilling operations.
The agreement's language needs to reflect this intention by providing that
the farmee "will commence or cause to be commenced actual drilling."
When read with the restrictions on assignment usually included in farmout

171. Id.
172. See T. FAY, supra note 3, at 7.
173. State oil and gas conservation agencies generally issue exception tract drilling permits
either to protect correlative rights, when strict adherence to the rules would result in drainage,
or to prevent waste when strict adherence would result in oil or gas never being produced. E.
KUNTZ, J. LOWE, 0. ANDERSON & E. SMITH, supra note 5, at 79. Whether either rationale
would justify issuance of a permit in the circumstance described is problematic.
174. T. FAY, supra note 3, at 6. Fay suggests the language used should read "at a legal
location as required under the spacing requirements in effect at the time of the execution of the
farmout agreement." Id. at 7.
175. Cf the discussion of Getty Oil Co. v. Blevco Energy, Inc., supra notes 78-80; see also
Klein & Burke, supra note 3, at 494. For a discussion of the Statute of Frauds, see supra text
accompanying notes 86-113.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

agreements, the reference to "cause to be commenced" will permit the

farmee to subcontract.
At least three alternatives exist to a general agreement to permit the
farmee to subcontract. First, the farmor may choose the subcontractor. A
farmee will rarely accept this option, however, because it will give the
farmor control of a crucial provision of the agreement. Second, the farmee
may select the contractor subject to certain articulated standards that the
chosen contractor must meet. Third, the farmor and farmee may agree on a
contractor; for example, the farmee may be given the right to choose the
contractor, subject to approval by the farmor. This last alternative is accept-
able only if the parties avoid the agreement to agree problem by providing
that the farmor can withhold approval only for reasonable cause.
8. Commencement of the Well
Most farmout agreements specify a date by which the farmee must com-
mence drilling in order to satisfy the agreement. If the parties anticipate title
problems or if equipment appears to be in short supply, the agreement may
provide for an extension of the commencement date. 176
Commencement provisions vary in their terminology. Such provisions
sometimes parallel those usually found in oil and gas leases and merely
require that the farmee commence "operations"' 177 or "drilling."' 178 The
requirement more frequently is that the farmee "commence the actual drill-
179
ing" of a well.

a. Commencement of Operations
When the farmee is required merely to commence operations, all that is
likely to be required of the farmee is that before the date specified it do
something on the farmed-out land that directly relates to or is preparatory to
actual drilling.' 8 0 In addition, those activities must be pursued diligently
and in good faith until a well is actually spudded' 8 ' and completed. This is
the usual interpretation of the meaning of "commencement of operations" in
an oil and gas lease. 18 2 One of the classic cases cited to support that rule
involved a farmout. In Vickers v. Peaker 8 3 deep rights under a lease were
assigned to the farmee. The assignment required that the assignee "com-

176. An example of a clause permitting extension of the commencement date follows:

Provided, however, that the commencement date shall be extended for any per-
iod reasonably necessary for farmee to satisfy itself that title to the proposed
drill site for the initial well is safe for drilling purposes and for up to thirty days
in the event a suitable drilling rig is not available by the commencement date.
177. See supra note 165.
178. For example: "On or before __, Farmee agrees to commence the drilling of a test well
in accordance with all of the terms and provisions of the Agreement ...."
179. For example: "On or before -, Farmee shall commence the actual drilling of a test
well (Initial Well) at the following location: ...."
180. See E. KUNTZ, J. LOWE, 0. ANDERSON & E. SMITH, supra note 5, at 157-62.
181. "Spudding" refers to the first boring of the hole in drilling a well. 8 H. WILLIAMS &
C. MEYERS, supra note 12, at 843.
182. Id.
183. 227 Ark. 587, 300 S.W.2d 29 (1957).
1987] FARMOUT AGREEMENTS

mence the drilling of a well" before a specified date.184 The farmee, before
that date, entered into a drilling contract, surveyed and cleared the location,
constructed a road to the location, obtained a drilling permit, and moved
material to the drill site. The drill bit did not actually pierce the earth until
nearly a month after the date specified, however. The Arkansas Supreme
Court held that the time of spudding was immaterial, asking the now famous
rhetorical question: "Does 'baking a cake' begin with the preparation of the
dough, or only with the actual placing of the dough in the oven?"' 85 By this
analysis, virtually any activity of the farmee on the land will be sufficient to
commence the well properly, extend the lease, and satisfy the farmout
86
agreement. 1

b. Commencement of Actual Drilling

When the farmout agreement provides that the farmee must commence
the "actual drilling" of a well, however, something more is probably re-
quired. Reference to commencement of "actual drilling" is likely to require
that a drill bit have pierced the ground.' 8 7 A more certain variation requires
that the well be "spudded" by a particular date.18 8

9. Completion of the Well

Farmout agreements often specify, in addition to a commencement date, a
date by which the earning well must be completed. The primary reason for
specifying a completion date is to insure that the farmor will possess the
information obtained from drilling so that it can evaluate other leases that it
may have in the area. Like "commencement," the term "completion" may
lead to dispute, particularly when the farmout agreement provides for the
drilling of several wells, or when the farmee seeks to drill a substitute well.
Two cases illustrate the point well. In Seale v. Major Oil Co. 189 a farmout
agreement obligated Seale to drill two wells, the second within 45 days after
"completion" of the first. Seale drilled the first well to the objective depth
and abandoned it as a dry hole. He then refused to drill the second well,
contending that he was unable to "complete" the first well since it was a dry
hole, and that therefore he had no obligation to drill the second. The court
held that the contract as a whole did not use "completion" to mean comple-

184. 300 S.W.2d at 30-32.

185. Id. at 32.
186. Professor Williams summarizes the law as follows:
In brief, drilling operations may be described as any work or actual operations
undertaken or commenced in good faith for the purpose of carrying out any of
the rights, privileges or duties of the lessee under a lease, followed diligently and
in due course by the construction of a derrick and other necessary structures for
the drilling of an oil and gas well, and by the actual operation of drilling in the
ground.
3 H. WILLIAMS, OIL AND GAS LAW § 618.1, at 323-24 (1986).
187. For a discussion of the federal regulations and cases interpreting "actual drilling oper-
ations," see I LAW OF FEDERAL OIL AND GAS LEASES § 14.05[2] (1986).
188. See T. FAY, supra note 3, § 2.1(b) of the farmout agreement.
189. 428 S.W.2d 867 (Tex. Civ. App.-Eastland 1968, no writ).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

tion as a producing well, however, but to mean "completion of the required

work on the well whether it became a producer or not."' 90 In a recent case,
Modern Exploration,Inc. v. Maddison,19' the court interpreted a lease provi-
sion requiring the lessee to drill a well within 270 days of "completion of
drilling on the first well" or lose its rights to all undrilled acreage.' 9 2 The
court held that "completion of drilling" was unambiguous and meant "when
the well's total depth [was] reached, not when the operator [chose] to perfo-
19 3
rate the cement plug that he chose to insert into the well."'
The parties to a farmout agreement will probably have different expecta-
tions of the meaning of "completion" in different contexts.' 94 When the
farmout agreement requires the farmee to complete a well capable of produc-
ing in paying quantities in order to satisfy the agreement, as in cases when
the primary purpose of the farmout agreement is to maintain a lease about to
expire, "completion" probably means drilling to total depth, testing, fractur-
ing or acidizing, and equipping the well for production. Until those steps
have all been taken, the well is not capable of producing. Conversely, when
the farmee can earn by merely drilling and testing, as is often the case when
the primary purpose of the farmout agreement is to obtain geologic informa-
tion, "completion" likely requires only that the farmee has drilled the well
and performed the agreed tests.
Farmout agreements obviously should define "completion." Surprisingly,
only a few of the example agreements collected do so. A draft AAPL Form
provided the following definition: "A 'completed well' is a well which has
been fully equipped for the taking of production, through and including the
tanks for an oil well and through and including the Christmas tree for a gas
well, or plugged and abandoned, as a dry hole."' 95

10. Time Measurement

The farmout agreement's commencement and completion provisions are
susceptible to disputes over the point from which time is to be measured.
This appears particularly true when time is measured by reference to some
other event. For example, if completion is required within "90 days after

190. Id. at 869.

191. 708 S.W.2d 872 (Tex. App.-Corpus Christi 1986, no writ).
192. Id. at 876-77.
193. Id. at 876. The reasoning of the court is unclear because the words just before the
quoted phrase read " '[c]ompletion of drilling' logically imports the time when no further drill-
ing is needed, when oil or gas has been reached and the well is capable of producing .... "
Id. The reference to "the well is capable of producing" is not the equivalent of "when no
further drilling is needed."
194. Cf Edwards v. Hardwick, 350 P.2d 495, 500 (Okla. 1960) (court concluded that term
"completion" means well drilled to specified sand or depth, and such well so prepared for use
of various methods of treatment to obtain production of oil and gas).
195. AAPL draft Form 635, § 2(a) (Kraftbilt, Tulsa 1987). The quoted provision is appro-
priate for a "produce to earn" farmout. Another phrasing of the provision could read:
"'Completion' means the point at which testing is completed as required in order to receive a
production allowable from the Texas Railroad Commission." For a "drill to earn" farmout,
the following phrasing might be appropriate: "'Completion' of a well for the purposes of this
Agreement shall be defined as the release of the completion rig, if the well is completed for
production, or release of the drilling rig, if the well is plugged and abandoned."
1987] FARMOUT AGREEMENTS

commencement of drilling," the parties may not agree either when particular
actions were taken or whether those actions were sufficient to commence
drilling. Provisions that the farmee must commence actual drilling "90 days
after acceptance of this offer" or exercise its option for a substitute well
"within 60 days after release of the drilling rig" may also lead to factual
disputes as to when acceptance occurred or the rig was released.
Measuring time by reference to events may lead to disputes as to how the
parties are to count days. An accepted principle of general contract law
holds that the day a contract is executed is not counted in measuring time,
while the party required to perform has until the end of the last day to per-
19 6
form. Only a few cases apply that principle to oil and gas leases, how-
197
ever. In the interests of certainty, a specific calendar date is preferable,
whether the parties are referring to commencement or completion of the
well. If the farmout agreement specifies a calendar date, the farmee must be
careful that the date inserted is reasonable. By the time negotiations are
completed, the date provided for, even if reasonable when the parties began
negotiating, may no longer provide the farmee adequate time to perform.
Farmout time measurement issues are made more important by "time is of
the essence" provisions found in most farmout agreements. In Texas one
court has held that commencement of drilling operations in a timely manner
under an operating agreement was not essential to maintaining the agree-
ment because nothing in the agreement indicated that the parties intended it
should be. 198 A different result probably would be reached under most
farmout agreements, however, either because time is specifically made of the
essence 99 or because the agreement requires absolute performance of all of
the terms and conditions of the agreement for the farmee to earn. 2° ° All but
a small percentage of the example agreements collected contained one or the
other of these clauses, and some contained both. An alternative to providing
for specific time periods is to require "diligent operations" or "diligent and
continuous operations." The opportunities for disagreement as to the mean-
ing of those terms are obvious, however.

11. Objective Depth

a. Footage vs. Formation
The "objective depth," or the "contract depth" as it is sometimes called, is
the depth that the farmee must drill under the terms of the farmout agree-
ment in order to earn its interest under the farmout agreement. Objective

196. See Columbia Pictures Corp. v. DeToth, 26 Cal. 2d 753, 161 P.2d 217, 220 (1945);
Pitcock v. Johns, 326 S.W.2d 563, 565-66 (Tex. App.-Austin 1959, writ ref'd).
197. See, e.g., Winn v. Nilsen, 670 P.2d 588, 590 (Okla. 1983).
198. Argos Resources, Inc. v. May Petroleum, Inc., 693 S.W.2d 663, 665 (Tex. App.-
Dallas 1985, writ ref'd n.r.e.). But see United Carbon Co. v. Monroe, 92 F. Supp. 460, 465
(W.D. La. 1950), holding that time is implicitly of the essence in drilling contracts, presumably
including farmout agreements.
199. An example of a "time is of the essence" clause is: "Time is of the essence to this
agreement and to all its terms and conditions."
200. See infra note 261.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

depth usually is described either by reference to the number of feet to be

drilled or by description of the formation to be explored. Either may cause
interpretive difficulties.

i. Footage
The farmout agreement sometimes will describe the objective depth by the
feet to be drilled. For example, the farmor and the farmee may agree that
the farmee will drill the test well to 5,000 feet. A footage description of
objective depth is inherently flawed, however, unless the agreement also ad-
dresses how footage is to be measured. No industry custom or usage exists.
The intention of the parties may be that the reference be to measured depth,
the distance down the hole actually drilled, which can be determined by
measuring the drill pipe utilized. This method is probably the easiest. The
reference to footage, however, may also refer to the vertical depth. Vertical
depth will be different from measured depth, because inevitably the hole
drilled will deviate somewhat from the perpendicular.
Even if the parties plainly intended the footage reference to refer to mea-
sured depth or to vertical depth, ambiguities remain as to how to determine
those depths. Is the reference to objective depth, the deepest point reached
by drilling, or to completion depth, the depth to which the well is plugged
back for testing and a completion attempt? Furthermore, from where is the
depth to be measured? It will make a difference whether the starting point
for measurement is the kelly bushing, 20 1 the surface, or sea level.
There are relatively few disagreements over how to measure footage. The
farmor and the farmee usually have an unspoken or oral understanding as to
how to make the measurement. The lawyer drafting or reviewing a farmout
agreement should not rely upon the innate desire of the parties to get along,
however. The agreement itself should define how to measure the footage.

ii. Formation
A second method of describing the objective depth in a farmout agreement
is to refer to a formation that the farmee will test or to one in which a well is
to be completed. A common formulation states that "farmee agrees to drill
... to a depth sufficient to adequately test the formation
... 202 An objective depth described by reference to the formation to be
tested is more common than one described by footage. The farmor may not
be certain that the information or production that it wants can be developed
within a footage limitation, since geologic formations are often tilted or bro-
ken. On the other hand, the farmee will not want to be obligated to waste
money by drilling deeper than is necessary to test or to obtain production.
Therefore, unless the farmor and farmee are certain that the farmee will find

201. The kelly bushing is a device fitted to the floor of the drilling platform through which
passes the steel pipe that transmits torque from the rotary table to the drill string and rotates
the drill bit. S. PALMER, PETROLEUM INDUSTRY GLOSSARY 109 (1st ed. 1982).
202. When drilling in an unexplored area, the reference may be "to the basement rock," if
a specific objective formation cannot be identified.
1987] FARMOUT AGREEMENTS

their objective at a particular depth, description of the objective depth by

reference to the formation to be tested will be the favored method.
Description of the objective depth by formation may also lead to misun-
derstandings. There may be ambiguity as to what the formation is called.
The same formation may have different names even in the same general area.
Similar names may describe very different formations. Even if there is no
ambiguity as to the formation to be tested, recognizing it when it is found
may be difficult. The same formation may have different lithological charac-
teristics in different areas. 20 3 In addition, a formation may be broken or
overthrust, so that it is found at several widely separated depths in the same
area.
The solution to these problems again is precise drafting. A drafter may
minimize problems in recognizing the formation by referring (1) to a "con-
trol well," another well that has tested the formation sought, 20 4 or (2) to a
description of the formation published by a state or federal geological sur-
veyor or bureau of mines. A description of the formation to be drilled and
tested may also be combined with footage limitations. This device avoids
dispute and limits the farmee's obligation in case the formation is encoun-
tered at substantially different depths. 20 5 Such a combination is probably
the most frequently used method of describing the objective depth.

b. Standard of Testing
The farmout agreement's clause describing the objective depth often re-
quires that the objective depth be tested "to the farmor's satisfaction. ' 20 6
The courts would impose a standard of reasonableness upon the farmor. 20 7
The farmee would clearly prefer, however, that the agreement express the
standard of testing by what the reasonable, prudent operator would do under
the circumstances or "to the farmee's satisfaction."

c. What About Shallow Production?

A recurring problem in farmout agreements is determining the rights of
the parties if the farmee encounters production in a formation at less than
the objective depth. There are at least three possible solutions. The agree-
ment may require the farmee to drill to and test the objective depth notwith-
standing the shallow discovery. Completion of a shallow well, perhaps with
limitations imposed upon the depth earned, may satisfy the objective depth

203. Lithology is the study of rocks. WEBSTER'S NINTH NEW COLLEGIATE DICTIONARY
698 (9th ed. 1985). Geologists often describe rocks by their overall physical characteristics,
which they refer to as their "lithological characteristics."
204. Note, however, that if the control well is a substantial distance from the well to be
drilled, the farmout earning well may not encounter the formation tested by the control well.
205. A provision in the farmout agreement may state, for example, that "[t]he Test Well
will be spudded by Farmee on or before __ and will be drilled to a true vertical depth of
__ feet below the surface or __ feet below the bottom of the __ formation,
whichever is less ...."
206. See infra note 261.
207. A fundamental principle of contract interpretation applied by courts is the standard of
reasonableness. E. FARNSWORTH, CONTRACTS 492 (1982).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

provision. 20 8 Finally, production from the shallower depth may satisfy the
objective depth of the requirement if the farmee tests the objective depth or
drills a substitute well.

d. What About DrillingDeeper?

Farmout agreements less frequently address whether the farmee can drill
deeper than the objective depth. The farmee may want to drill deeper be-
cause geological information obtained in drilling the well suggests that the
productive formations will not be found where they were expected. Geo-
logic information may indicate that deeper drilling will result in better
production.
Again, there are at least three options. The farmor, which is entitled to all
drilling information, may prefer to keep deeper rights. Second, the farmor
may allow the farmee to drill deeper only if the farmee tests the objective
depth as well as the deeper formation, 20 9 or if the farmee later drills a substi-
tute well to test the objective formation. Finally, the agreement may give the
farmee an option to drill a deeper well after a test of the objective forma-
tion.210 Whatever is the intent of the parties, the agreement should be
specific.

12. Produce to Earn or Drill to Earn

What the farmee has to do to earn its interest under the farmout agree-
ment is a key characteristic of the agreement,2 1 1 as has been discussed above.
The farmee's obligations also present substantial interpretative and drafting

208. An example of a clause permitting the farmee to complete in a shallower formation

than the objective depth is:
If during the drilling of the Earning Well, operator shall encounter what it be-
lieves to be potential production in a zone encountered at a depth shallower than
Contract Depth, then if operator elects not to drill deeper, operator may test
and/or make a completion attempt in such shallower zone. For the purposes
hereof, such shallower zone shall be deemed to be a Contract Depth and thereby
fulfill the drilling commitment created hereby.
209. For example, the following language specifically permits the farmee to drill beyond
the objective depth.
Farmee shall drill the Earning Test Well to a depth sufficient to thoroughly test
the _ formation, or to a maximum depth of seven thousand three hundred
(7,300) feet below the surface, whichever is the lesser depth; provided that noth-
ing contained in the foregoing shall prevent Farmeefrom drilling to such deeper
depth below the provided depths as Farmee may elect.
(Emphasis added.)
210. An example of a clause giving the farmee an option to drill a deeper well after com-
pleting a well in the objective formation is:
Farmee shall have the option for a period of - days after the release of the
drilling rig from the initial well to drill any well on the subject lands to any
depth deeper than the depth drilled in the initial well. In the event that farmee
exercises its option and drills a well to such deeper depth, farmor shall, subject
to the other provisions of this agreement, grant to farmee the leasehold interest
in the lands subject to this agreement to a depth of 100 feet below the strati-
graphic equivalent of the total depth reached in such deeper drilling.
211. See supra text accompanying notes 138-41.
19871 FARMOUT AGREEMENTS

problems. These problems are somewhat different in produce to earn

farmouts than in drill to earn farmouts.

a. Produce to Earn Farmouts

The primary problem with produce to earn farmouts is in the choice of
language used to express the production requirement. Some farmouts
require merely a capability of "production. ' 212 Others require capability of
"production in paying quantities ' 2 13 or "production in commercial
' 2 14
quantities.
The meaning of such terminology is not precise. In the context of oil and
gas leases, courts have reached a variety of interpretations of similar terms.
For example, courts have held that the term "commercial quantities" re-
quires that operating revenues be greater than operating costs, 2 1 5 that there
be production merely "of sufficiently large amount to be sold by the owner to
a buyer for transport elsewhere, ' 21 6 or that there be a probability that the
revenues of offset wells will pay back the cost of their drilling plus a profit. 2 17
"Paying quantities" is also a term that may have different meanings in differ-
ent contexts. When the issue is whether a lease is maintained by marginal
production, "paying quantities" generally requires merely that the revenues
from production exceed operating costs. 2 18 When the issue is whether the
lessee owes the lessor a duty to develop or to protect against drainage, the
term generally requires that the probable revenues from drilling pay the
costs of drilling, completing, and operating, and return a reasonable
2 19
profit.
Each of these definitions may be appropriate in a produce to earn farmout.
The meaning of the terms may differ according to the circumstances in
which they are used. When the farmout's purpose is lease maintenance, the

212. For example: "If the Test Well is commenced and thereafter drilled to Contract
Depth and completed and equipped forproduction in accordance herewith, Farmor will assign
to Farmee .... " (Emphasis added.)
213. For example:
In the event you are successful in completing a well or wells capable of produc-
ing oil or gas in paying quantitieson said land and in compliance with all of the
terms and conditions hereof, then farmor, upon your written request, shall exe-
cute and deliver to you an assignment of its rights, title, and interest in and to all
of the oil and gas held under said lease in and to each governmental proration
unit of said land upon which you finally complete a well capable of producing oil
or gas in paying quantities ....
(Emphasis added.)
214. See Landauer v. Huey, 143 Colo. 76, 352 P.2d 302, 308 (Colo. 1960); see also 2 of
the farmout agreement attached at Scott, supra note 3, at 84.
215. Texaco, Inc. v. Fox, 228 Kan. 589, 618 P.2d 844, 847 (1980) ("commercial quantities"
synonymous to "paying quantities" for purposes of maintaining lease in secondary term).
216. State v. Wallace, 52 Ohio App. 2d 261, 369 N.E.2d 781, 785 (1976) (issue was propri-
ety of plugging order of state conservation agency).
217. Pan Am. Petroleum Corp. v. Shell Oil Co., 455 P.2d 12, 14-17 (Alaska 1969) (issue
was whether blowout constituted "discovery in commercial quantities" so that lessee of state
lease became entitled to pay reduced royalty rate).
218. Clifton v. Koontz, 160 Tex. 82, 90-92, 325 S.W.2d 684, 690-92 (1959).
219. See 5 E. KUNTZ, A TREATISE ON THE LAW OF OIL AND GAS § 58.3 (1964) (discusses
appropriate cases).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

agreement serves that purpose so long as operating revenues are greater than
operating expenses over a reasonable time. 2 20 When the purpose of the
farmout is to satisfy an obligation of the farmor to drill an offset, develop-
ment, or exploratory well, drilling and attempting to complete satisfy the
obligation, so that any production should be sufficient to earn. When the
purpose of the farmout is to obtain exploration of its leases, discovery of a
formation that will permit the drilling and profitable operation of additional
wells may well be the intent of the parties. In addition, a case can be made
that the parties intend that rights will be earned under a produce to earn
farmout only when a well is drilled and completed capable of producing
enough to pay costs of drilling, completing, and operating, plus a reasonable
profit; this makes sense, for example, when joint development of a field or
dedication of reserves is the business purpose of the farmout agreement.
The first definition of production is the one most likely to be intended by
farmor and farmee, because it is the definition generally used in leases. It
therefore comes to mind first. In addition, the most common reason for a
farmout agreement is lease maintainence. Often, however, the terms of the
agreement suggest nothing about the intent of the parties. To avoid ambigu-
ity and dispute, the parties should carefully define whatever term is used to
describe "produce to earn."

b. Drill to Earn Farmouts

Parallel interpretative problems arise with drill to earn farmout agree-

ments. The term "drill," whether couched as a covenant or a condition,
may require drilling to an objective depth and testing the formation found.
For example, that may be the parties' intent when the farmout's purpose is
to drill a court-ordered "obligation" well to satisfy an implied covenant to
develop or to protect against drainage. The same term may require only
drilling to the objective depth, with a decision at the casing point 22' to test
or not, 2 2 2 when the purpose of drilling is to satisfy an implied covenant to
drill an exploratory well. A case may even be made that the farmor and the
farmee intend that the drill to earn farmout be satisfied when the farmee has
timely commenced in good faith and diligently pursued drilling operations,
even though the objective depth is never reached. Such a definition would be
appropriate, for example, when a court order is satisfied if impenetrable sub-
stances or conditions are encountered that make abandonment necessary.
Again, specificity is the watchword for the drafter.

220. As long as operating revenues are greater than operating expenses, the underlying
lease is maintained. J. LOWE, supra note 9, at 176.
221. The casing point is the point where "a well has been drilled to the objective depth
stated in the initial notice, appropriate tests have been made" and a decision is to be made
whether to complete it and equip it for production. 8 H. WILLIAMS & C. MEYERS, supra note
12, at 109.
222. For an example of the type of agreement, see Modern Exploration, Inc. v. Maddison,
708 S.W.2d 872, 875-76 (Tex. App.-Corpus Christi 1986, no writ), discussed supra text ac-
companying notes 191-93.
1987) FARMOUT AGREEMENTS

13. Performance as an Option or Obligation

As discussed above, whether performance of the farmout provisions is the
farmee's option or obligation is one of the key characteristics of the farmout
agreement. 22 3 In addition, that choice presents significant problems for the
lawyer drafting or reviewing the agreement. The problems begin with classi-
fication of language in farmout agreements.

a. Classification Problems
Classification of farmout language as making drilling a covenant to per-
form or a condition of earning may be difficult. Many drafters word farmout
provisions relating to commencement of initial drilling as a covenant, but
then follow with language that transforms the obligation to drill into a mere
condition of earning.2 2 4 One must read the agreement as a whole to deter-
225
mine whether drilling is an option, an obligation, or a bit of both.

223. See supra text accompanying notes 133-37.

224. Lamb, supra note 3, at 154. One example agreement provides:
2. Initial Test Well. On or before __ , Farmee shall commence or cause
to be commenced the actual drilling with suitable rotary equipment of a well
• . . and shall thereafter continuously prosecute such drilling operations in a
diligent and workmanlike manner until the well reaches a depth sufficient in
Farmor's judgment to test __

12. Failure to Drill. Farmee shall not be liable in damages to Farmor for
failure to commence, drill, test, complete or equip the Initial Test Well as herein
provided, but any such failure shall result in the loss to Farmee of all rights
under this agreement. The foregoing shall not be construed to preclude or limit
any rights Farmor may have in law or in equity, by virtue of Farmee's negli-
gence or willful misconduct, or for any breach by Farmee of any other obliga-
tion under this agreement (including, without limitations, the obligations to
provide information to Farmor and to indemnify Farmor as hereinafter
provided).
Scott, supra note 3, at 83, 87. The last sentence of the quoted 12 makes that paragraph
something less than a complete release of the farmee from liability, however. The farmee does
not have to drill under the example language, but if the farmee does drill, it must comply with
the contractual provisions or face liability. See infra text accompanying note 229.
225. For example, the language following makes drilling a clear-cut obligation:
Farmee shall drill a well, hereinafter called the Earning Well, strictly in accord-
ance with the following well specifications:
(a) Location:
(b) Spudding Deadline:
(c) Required Depth: -
(d) Completion/Plugging Deadline: __
The obligations of Farmee hereunder are firm obligations and covenants as well
as conditions to earning the assignment(s) provided for.
In contrast, the following language indicates that drilling is a condition for earning, and that a
failure to drill will not result in liability:
"Farmee shall have the option, but not the obligation, to drill a well at the
location designated below and thereby earn the rights set forth below to the
leases described at Exhibit -, all subject to the terms, limitations and conditions
set forth below."
The possibility exists to make commencement of drilling an option, but to make completion of
a well commenced an obligation. For example:
If the test well is commenced, farmee agrees to drill the test well to a depth at
which the __ formation has been properly tested therein or to a depth of
__ feet, whichever is first reached (objective depth) and to complete the test
 SOUTHWESTERN LAW JOURNAL [Vol. 41

b. Option to Drill
When the farmout agreement gives the farmee an option to drill, difficult
practical and conceptual problems arise. For the farmor, one problem is
whether the farmee that has commenced drilling may choose to forfeit its
right to earn under the farmout agreement in order to avoid sharing valuable
information obtained in its drilling operations.2 26 If drilling truly is an op-
tion, the farmee presumably may choose to abandon operations at any time
and for any reason. 227 The abandonment provisions of the farmout, which
typically give the farmor the right to take over drilling operations, may mini-
mize this problem. 228 Releasing the farmee from liability for not drilling,
but specifically providing for liability for failure to provide promised infor-
229
mation, may also solve the problem.

c. Obligation to Drill
When dealing with a farmout agreement that makes drilling the farmee's
legal obligation, the issue of liability for failure to perform is of crucial im-
portance to both farmor and farmee. There is a split of authority as to the
measure of damages for breach of an express promise to drill. In a majority
of states, including Oklahoma and Louisiana, the remedy is apparently the
cost of drilling the promised well. 230 In a minority of states, including
Texas, the remedy is the benefit that the one party would have received had
the other drilled the well as promised. 23 1 That remedy may be the "lost
royalty," which is defined as the royalty that would have resulted had the
well been drilled as promised.2 32 Other available measures of damages in-

well for production or plug and abandon the well as a dry hole, in full compli-
ance with the terms and provisions of section - below.
226. Hardwick, OperationalAgreements in the Shadow of Bankruptcy-What Can Be Done
to Structure Agreements in Order to Minimize the Problems of a Party that Later Goes Bank-
rupt, 1986 ROCKY MTN. MIN. L. SPEC. INST. ON PROBLEMS AND OPPORTUNITIES DURING
HARD TIMES IN THE MINERALS INDUSTRY 6-1, 6-2.
227. Id.
228. See infra note 357.
229. See supra note 224.
230. Fite v. Miller, 196 La. 876, 200 So. 285, 286 (1940); Ardizonne v. Archer, 72 Okla. 70,
178 P. 263, 265-66 (1919). These cases, like most of those cited in this article, deal with breach
of a drilling covenant in a lease. Professors Williams and Meyers have asserted, however, that
the problems are the same in the context of breach of a farmout as they are in breach of a lease,
so that the rules should be the same. See 2 H. WILLIAMS & C. MEYERS, OIL AND GAS LAW
§ 432.2 (1985). Professors Williams and Meyers also cite cases from the federal courts, as well
as courts in Colorado, Kansas, and Montana, as adopting the cost of drilling rule. 5 H. WIL-
LIAMS & C. MEYERS, OIL AND GAS LAW § 885.1 (1985).
231. See, Guardian Trust v. Brothers, 59 S.W.2d 343, 345 (Tex. Civ. App.-Eastland 1933,
writ ref'd). Professors Williams and Meyers cite cases from the federal courts, as well as from
courts in California, Alberta, and Kentucky, as adopting the lost royalty rule. See 5 H. WIL-
LIAMS & C. MEYERS, supra note 230, § 885.2. See also Stinnett v. Damson Oil Corp., 813
F.2d 1394 (9th Cir. 1987) (a recent case applying the rule).
232. For an excellent analysis and collection of the cases dealing with the measure of dam-
ages, see Annotation, Right and Measure of Recovery for Breach of Obligation to Drill Explora-
tory Oil or Gas Wells, 4 A.L.R.3D 284 (1965). In GuardianTrust a Texas court of civil appeals
reasoned, "The true and ultimate purpose of all parties to the lease was 'the mutually profita-
ble production of oil, gas or other vauable mineral.' " 59 S.W.2d at 345 (citation omitted).
The court concluded, therefore, that the lost royalty was the appropriate measure of damages,
1987] FARMOUT AGREEMENTS

clude the value of the retained interest 233 or the value of the information that
234
drilling would have developed.
The Texas rule that the remedy for the breach of an express promise to
drill is the value of the performance to the obligee is better law than the
majority rule. 235 The Texas rule places a heavy burden of proof upon the
farmor whose farmee has failed to perform, however. Martin v. Darcy is a
case in point. 236 In that case Martin promised to drill a well under an as-
signment of a farmout from Darcy but failed to do so, though the well was
later drilled and completed as a dry hole by another. Darcy sued and recov-
ered $3000 on the theory that the interest that he had retained had possessed
a market value of $6000 and that he would have sold half of it before com-
pletion of the well had Martin drilled it. The appellate court reversed the
award on the basis that to recover Darcy would have had to have shown
(1) that the profits he claimed had been contemplated by the parties when
the agreement was made and (2) that he actually would have sold his inter-
est. 237 The problem, as the court in Martin v. Darcy noted, is that at the
time the farmout is negotiated no one knows what the farmor will do with its
interest, including the farmor. Therefore, at least the second element of
proof required to establish a basis for recovery of damages can rarely be
23 8
proved.
Because of the difficulty in a state like Texas of proving actual damages for
breach of a farmout agreement obligating the farmee to drill, the parties may
include a stipulation of liquidated damages in the agreement. 239 It is difficult

noting that the cost of drilling would be inappropriate because such a measure is not the value
of performance to the obligee but "the cost of performance by the obligor." Id. at 346. The
"lost royalty" rule is not rigidly applied, however:
After an early adoption of the cost of drilling as the measure of damages, the
Texas courts have apparently rejected any mechanical application of that rule
and have now adopted a flexible test under which the plaintiff is entitled to
recover the value of the performance of the contract to him, such value to be
determined in the light of the peculiar facts of each case.
Annotation, supra, at 299 (footnotes omitted).
233. See Martin v. Darcy, 357 S.W.2d 457, 459-60 (Tex. Civ. App.-San Antonio 1962,
writ ref'd n.r.e.); see also 5 H. WILLIAMS & C. MEYERS, supra note 230, § 885 (discusses other
measures of damages). A value of retained interest measure would be particularly appropriate,
in the author's view, in a "lease salvage" type farmout.
234. See Atlantic Oil Prod. Co. v. Masterson, 30 F.2d 481, 482 (5th Cir. 1929). Using the
value of the information that was to have been obtained would be particularly appropriate in
what the author calls an "exploration and evaluation" farmout.
235. The Texas rule is "better" law because it is the usual rule for recovery of damages for
breach of contract. Hadley v. Baxendale, 9 Exch. 341, 26 Eng. L. & E. 398 (1854). In fact,
Hadley v. Baxendale formed the basis of the decision in Whiteside v. Trentman, 146 Tex. 46,
170 S.W.2d 195 (1943).
236. 357 S.W.2d 457 (Tex. Civ. App.-San Antonio 1962, writ ref'd n.r.e.).
237. Id. at 460.
238. Id. A detailed statement of the purpose of the farmor in entering into the farmout
would help significantly in meeting the burden of proof. See supra text acccompanying notes
123-24.
239. An example of a liquidated damages clause is: "FAILURE TO DRILL; DAM-
AGES. If farmee fails to drill the test well as required by § __ , farmee shall pay to farmor
on or before _ - dollars ($ ) which shall be deemed farmor's liquidated damages
arising out of farmee's failure to perform." In the author's opinion, the more detail included,
the better the agreement.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

to draft a liquidated damages clause with certainty that it will be enforced,

however. 240 Of particular concern in drafting liquidated damages provisions
in farmout agreements is the need when setting damages to take into account
the extent of performance. The extent of performance would be important
in determining actual damages, and stipulated damages might not be
awarded if they grossly exceed actual damages. 24 ' An agreement to pay the
estimated cost of drilling an obligation well, therefore, probably would be
classified as an unenforceable penalty when the breach occurs after drilling
to the casing point.
Other alternatives for the farmor worried that a farmee will fail to per-
form a farmout agreement drafted as a covenant to drill include obtaining
security for performance, escrow of drilling funds, and requiring a perform-
ance bond.2 42 However, negotiating any of these is likely to complicate
forming the agreement. Furthermore, it is an axiom of the industry that
when performance guarantees are necessary, they are unobtainable.

14. The Substitute Well Clause

Another axiom of the oil and gas industry is that "if something can go
wrong, it will go wrong." That maxim particularly applies to well drilling,
especially drilling exploratory wells. Mechanical breakdowns are almost in-

240. Agreements for stipulated damages are enforceable if courts determine such damages
to be estimated compensation for injuries, but not if courts classify them as penalties. Courts
have often said that the distinction between a penalty and liquidated damages is that a penalty
is not a measure of compensation for breach, but a security for actual damages. See, e.g.,
Gregory v. Nelson, 147 Kan. 682, 78 P.2d 889, 892 (1938); Jones v. Mays, 248 S.W. 129, 130-
32 (Tex. Civ. App.-Austin 1923, writ dism'd); Bourland v. Hufihines, 244 S.W. 847, 848-52
(Tex. Civ. App.-Amarillo 1922, writ dism'd). To be enforceable, a liquidated damages provi-
sion must meet two requirements. First, the court must find that the amount of damages to be
reasonably anticipated would be difficult to ascertain because of uncertainty or indefiniteness.
The contract provision should contain a specific statement of agreement of the parties to this
effect. Second, the stipulated amount must be either a reasonable estimate of probable dam-
ages or reasonably proportionate to actual damages.
241. Stewart v. Basey, 150 Tex. 666, 245 S.W.2d 484, 486 (1952) ("The universal rule for
measuring damages for the breach of a contract is just compensation for the loss or damage
actually sustained. . . . A party has no right to have a court enforce a stipulation which
violates the principle underlying that rule.").
242. An example of a clause requiring a surety bond to guarantee performance of farmout
agreements follows:
You agree to deliver to farmor a bonded form attached hereto as Exhibit -
executed by you as Principal and by a corporate surety acceptable to farmor. In
the event you should fail to comply with the obligations contained in this
farmout agreement to pay all persons who furnish labor or material for use in or
in connection with the drilling of the initial or any subsequent test well hereun-
der, or fail to prevent the filing of liens against the leasehold estate subject
hereto, then you and the surety on your bond shall be jointly and severally liable
to farmor in the amount of - payable forthwith upon such default at _
Upon your completion of the initial test well and all subsequent test wells, if
any, at the location, within the time, in the manner and to the depth specified
and upon your furnishing to farmor evidence, satisfactory to it, that all persons
have been paid for labor performed or material furnished in connection with or
in the actual drilling of such well(s) and that there are no other claims for dam-
ages or liens of whatsoever nature against the above described leases resulting
from the drilling of such well(s), you and your surety shall be discharged from
any obligation thereunder.
1987] FARMOUT AGREEMENTS

evitable. No matter how thorough and professional the geologic and geo-
physical analysis, there is always a risk of encountering unexpected
conditions or impenetrable formations. Farmout agreements, therefore, al-
most always contain a substitute well clause that sets forth circumstances
that excuse the farmee from drilling the earning well and give it the right to
drill another earning well.

a. Escape Provisions
When the agreement obligates the farmee to drill the well, both parties
will be vitally concerned with the escape provisions-the terms of the substi-
tute well clause that set out the circumstances in which the farmee may
abandon its drilling operations. 243 Without such provisions, the farmee that
fails to perform covenanted drilling operations may be liable. Even if drill-
ing under the farmout is merely an option of the farmee, the escape provi-
sions of the substitute well clause are important. The farmee that fails to
drill an option well will lose its rights to earn under the farmout, unless the
escape provisions provide for a right to drill a substitute well.
Escape provisions vary widely. Some farmouts excuse performance where
"igneous rock or other impenetrable substances are encountered at a lesser
[than the objective] depth.''244 Others let the farmee escape its obligations

243. The escape provisions of the substitute well clause must be read in conjunction with
the force majeure clause, if any, in the farmout agreement. A force majeure clause may
broaden the circumstances under which a party may excuse a failure to perform. For example,
the following clause is substantially broader than most substitute well clause escape provisions:
If Farmee is rendered unable, wholly or in part, by force majeure to carry out
its obligations or to meet its deadlines under this agreement, other than the obli-
gation to make money payments, it will give to Farmors prompt written notice
of the force majeure with reasonably full particulars concerning it; thereupon,
the obligations or deadlines of Farmee, insofar as they are affected by the force
majeure, shall be suspended during, but no longer than, the continuation of the
force majeure. Farmee shall use all reasonable diligence to remove the force
majeure as quickly as possible.
The requirement that any force majeure shall be remedied with all reasonable
dispatch shall not require the settlement of strikes, lockouts or other labor diffi-
culty by Farmee contrary to its wishes; how all such difficulties shall be handled
shall be entirely within the sole discretion of Farmee.
The term "force majeure" as employed herein shall mean an act of God,
strike, lockout or other industrial disturbance, act of the public enemy, war,
blockade, public riot, lightening, fire, storm, flood, explosion, governmental re-
straint, governmental inaction, nonavailability of drilling equipment or other
equipment or personnel, and any other cause whether of the kind specifically
enumerated or otherwise, which is not reasonably within the control of Farmee.
The following is a farmout force majeure clause keyed to the force majeure clause of the under-
lying oil and gas lease:
Force Majeure-any obligation of a party to this Agreement shall be suspended,
and any time deadline provided in this Agreement shall be extended, for any
period during which performance of such obligation or the meeting of such
deadline shall be prevented by the occurrence of any force majeure circum-
stance. For purposes of this paragraph, a "force majeure circumstance" shall
mean any of the events described in paragraph - of the Oil and Gas Lease
attached hereto as Exhibit _. The party affected by a force majeure circum-
stance shall give notice to the other party the occurrence of such circumstance
and shall take all reasonable action to remove such force majeure circumstance.
244. R. Olsen Oil Co. v. Fidler, 199 F.2d 868, 869 (10th Cir. 1952).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

when it encounters "a formation or other physical condition in the well

which renders further drilling impracticable. ' 245 The agreement sometimes
246
spells out what will render the drilling impracticable.
Farmout escape provisions are often vague and ill-defined because the par-
ties are attempting to provide for the unknown. Strictly speaking, for exam-
ple, no substance is "impenetrable. ' 24 7 One should note, however, that the
focus of most formulations is upon physical conditions in the hole 248 or
mechanical difficulties not caused by the farmee's negligence. The cost of
conducting operations, the farmee's economic circumstances, or market con-
ditions do not generally provide a basis for escape from a drilling
249
obligation.
The parties may negotiate broad escape provisions to relieve the farmee
from a drilling obligation or to preserve its right to drill substitute option
wells. Escape provisions may take into account the costs of drilling, 250 time
expended, 251 technology, 252 or make reference to what the reasonable, pru-
dent operator would do in the circumstance. 25 3 Indeed, it is common for

245. See Scott, supra note 3, at 83. One commentator has described any language that
refers to impracticality or defines impracticality as a "Gulf Coast Clause." See Glass, supra
note 3, at 6. "Impractical" and "impracticable" are apparently used interchangeably in such
clauses. It is not clear to me that they have precisely the same meaning; they do not in plain
English.
246. For example:
loss of circulation, partial loss of circulation, water flow, domal formation, ab-
normal pressures, heaving shale, or similar formation, salt or other similar con-
dition, is encountered which makes drilling abnormally difficult or hazardous,
causes sticking of drill pipe or casing, or other similar difficulty which precludes
drilling ahead under reasonably normal procedures ....
Another example makes drilling impracticable when drilling gets "to such lesser depths at
which pressures are encountered which would cause a reasonable prudent operator to require
the utilization of a mud weight of 16.0 pounds per gallon or greater .... "
247. At least one commentator has said flatly of "impenetrable substances" that "I am
uncertain as to its meaning." Lamb, supra note 3, at 157.
248. In R. Olsen Oil Co. v. Fidler, 199 F.2d at 870, the court defined the phrase "igneous
rock and other impenetrable substances" as used in farmout agreements in New Mexico and
Oklahoma to mean "to reach a geological formation.., which, in the business ofproduction of
such minerals, it is recognized will reasonablypreclude the probability offinding oil or gas in or
below such formation." (Emphasis in original.)
249. John Scott, however, notes that drafters of escape provisions often do not refer to
physical conditions in the hole and that such formulations may arguably be stretched into
broad force majeure clauses. Scott, supra note 3, at 83 n.33.
250. For example: "If in drilling ... a condition or formation is encountered which ren-
ders further drilling impracticable for the reason that the cost per foot of such further drilling
would be in excess of 150 percent of the cost per foot anticipated in the AFE . . . . Farmee
may cease drilling operations . ... "
251. What some have called a "72 hour continuous efforts" clause will permit the farmee to
cease operations if it has made a good faith continuous effort for 72 hours to solve the problem.
L. MOSBURG, supra note 3, § 3.03.
252. For example:
Operator shall use its best efforts to drill or cause to be drilled the earning well
to be situated on a drilling unit comprising a portion of the contract lands, and
which well shall be drilled to (i) Contract Depth or (ii) a depth where there is
encountered a practically impenetrable substance making further drilling in
light of existing technology impossible or impracticable.
253. For example:
If, in the drilling of the initial test well, operator encounters a drilling condition
1987] FARMOUT AGREEMENTS

option farmouts to provide that the farmee can abandon drilling of the initial
'2 54
well "for any reason."
While the use of general terms in drafting escape provisions is probably
unavoidable because of the uncertainties inherent in drilling, the parties
should be as specific as possible. When the farmor and the farmee have
established a working relationship in prior dealings, the farmor may agree to
escape provisions that give the farmee substantial discretion. When the par-
ties have no prior relationship, or when the farmor's experience with the
farmee suggests that the farmee is inefficient or untrustworthy, the parties
should state objective criteria. Both the drafter and his client must recog-
nize, however, that even specifically enumerating the circumstances that will
excuse the farmee from drilling will not preclude factual disputes over
whether or not the enumerated circumstances have occurred.

b. Substitute Well Provisions

i. Option or Obligation
The initial issue in any substitute well clause is whether drilling a substi-
tute well is an option or an obligation. If the initial well is an obligation of
the farmee, the farmor will probably wish to make the substitute well an
obligation. The factors that led the farmor to bargain for a covenant to drill
are likely still to apply if the farmee abandons the initial attempt. The
farmee, on the other hand is likely to want an option to walk away from the
deal if its efforts and expenditures have been unsuccessful, at least unless it
has reason to believe that the same circumstances will not arise in drilling a
second well.
Most farmout agreements make a substitute well an option, even though
the parties structure the drilling of the earning well as a covenant of the
farmee. An alternative is to make drilling the substitute well an obligation of
the farmee unless there are reasonable grounds to believe that conditions
similar to those that caused abandonment of the earning well will also arise
255
in drilling the substitute well.

ii. Well Details

The agreement should also address the requirements of drilling operations
for a substitute well. In providing for a substitute well's commencement
date, the parties must take into account the termination date of the lease
farmed out. They must also allow for the practical problems of arranging to
drill; typically farmors and farmees agree to allow 60 to 90 days. If the

or substance before reaching the above specified depth or formation which can-
not be overcome by means or methods customarily used by prudent operators in
the area, then and in such event, the test well may be plugged and abandoned at
the depth at which the substance or condition is encountered and operator is
hereby granted and given an option to commence and drill a substitute well for
said well.
254. Glsas, supra note 3, at 6.
255. L. MOSBURG, supra note 3, at 186-88.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

agreement provided a completion deadline for the earning well, the parties
will need to modify that date appropriately for a substitute well.
The location of the substitute well is likely to be a troublesome matter. If
adverse conditions encountered in drilling were the farmor's reason for
abandoning the initial well, it is likely that similar conditions will be encoun-
tered in any substitute well drilled close by. On the other hand, if the
farmor's geologic information suggests that hydrocarbons are most likely to
be found at the location of the initial well, or if the farmor particularly wants
information from that location, the farmor will not want to give the farmee
25 6
discretion to drill elsewhere.
One way to break an impasse either as to the location of the substitute
well or as to whether the farmee is to be obligated to drill it, is to provide the
farmee an incentive in the form of a larger percentage, deeper depth, or more
acreage in the earning provisions. If the farmee that has tried in vain to drill
an initial well in a location tries a second time and succeeds, it may make
sense to the parties that the farmee should earn more than it would have had
the initial well been successful.

15. The Performance Standard

a. Conduct of Operations
Since a farmout agreement is a business transaction similar to a construc-
tion contract, a "good and workmanlike" standard of performance may be
implicit. 257 Many agreements specifically define the standard to which the
farmee must work, however, usually by reference to due diligence and good
and workmanlike conduct. 25 8 Obviously the standard set may affect sub-
stantially the farmee's potential liabilities and chances of earning.

b. The Earning Standard

The farmee has the burden of proving that it has met the standard set by

256. A formulation that farmees should avoid is what one may call an "illusory" substitute
well right, such as would be created by a substitute well provision that called for the farmee to
have the right to drill a substitute well "at a location acceptable to farmor." Such a provision
may not be enforceable at all. If enforceable, it gives the farmor complete control of the substi-
tute well.
257. Cf True Oil v. Gibson, 392 P.2d 795, 797-800 (Wyo. 1964) (drilling not "com-
menced" under terms of lease when preliminary activities not performed with good faith inten-
tion of completing performance).
258. A typical example of a clause defining the standard of performance in the conduct of
operations is:
All test well and substitute well operations will be conducted with due diligence,
in a good and workmanlike manner, in compliance with all laws, rules, regula-
tions and orders of governmental authorities asserting jurisdiction, with the
terms and provisions of the leases affected and with the provisions of all third
party agreements relating to such operations, including any agreements with
other parties in the chain of leasehold title, and without cost, risk, liability or
obligation to farmor, expressly or by implication. Farmee will pay all bills
before delinquency and will keep and preserve the lease free of all liens, charges
and encumbrances arising out of their acts and operations thereon . . ..
(Emphasis added.)
1987) FARMOUT AGREEMENTS

the farmout to earn its interest. 259 Absolute performance will be the pre-
sumed requirement. It has been held that substantial compliance is inappro-
priate for farmout agreements. 260 Most farmout agreements specifically
require absolute performance by the farmee to earn its interest. 26' On occa-
sion, however, the farmor will accept the farmee's substantial perform-
ance. 2 6 2 A farmee's representative should certainly negotiate the issue.
Farmees should avoid two performance standards occasionally found in
farmout agreements. One requires that the farmee perform "to the farmor's
satisfaction" in order to earn the interest. 263 Though a standard designated
by reference to the discretion of one of the parties will probably be limited by
reasonableness, 264 such a standard is an invitation to litigation. A second
pernicious performance standard requires that the farmee must request as-
signment of its earned interest in writing within a specified period and that it
forfeits the interest if it fails to do so. 265 Such a provision may well be en-
forceable on the theory that a court's function is to give effect to the agree-
ment that the parties have made, rather than to write the contract that the
266
parties should have written.

259. See Inexco Oil Co. v. Crutcher-Tufts Corp., 389 F. Supp. 1032, 1040 (W.D. La. 1975);
see also Klein & Burke, supra note 3, at 494-95 (discusses Inexco Oil and the parties' interest in
depth as substance of farmout agreement). But see Vickers v. Peakers, 227 Ark. 587, 300
S.W.2d 29, 32 (1957) (court found "unless" assignment pursuant to farmout had not termi-
nated although drilling never reached objective depth).
260. Inexco Oil Co. v. Crutcher-Tufts Corp., 389 F. Supp. 1032, 1040 (W.D. La. 1975).
261. See, e.g., Scott, supra note 3, at 84 (requires assignment by farmor only "If Farmee
. . . complies fully with all the provisions of this agreement to Farmor's satisfaction.").
262. For example:
In drilling all wells under this Agreement, Farmee shall conduct all operations
connected therewith in accordance with the standards of a reasonably prudent
operator. Farmee shall employ such practices as are consistent with sound engi-
neering, effective geological exploration, and oil field safety. Farmee shall sub-
stantially comply with all applicable laws and governmental rules and
regulations.

For all wells drilled under this Agreement, Farmee shall substantially perform
and comply with all of the material covenants, terms, and provisions contained
in Exhibit "B", entitled "Provisions Applicable to Test Wells", attached hereto
and made a part hereof by reference.

Upon substantial compliance with each of the material covenants, terms, and
conditions set forth in this Agreement, each Farmor shall upon written demand
by Farmee, assign or cause to be assigned to Farmee . . . the following:
(Emphasis added.)
263. See, e.g., supra note 261.
264. Supra note 207.
265. See Scott, supra note 3, at 84. For example: "Farmee shall request any assignment
earned hereunder in writing within 30 days from completion of the earning well. If such
timely request is not made, all rights and interests which farmee may then have under or by
virtue of this agreement shall automatically terminate." Id. Several of the agreements col-
lected contained similar language.
266. Cf. Chevron USA, Inc. v. Belco Petroleum Corp., 755 F.2d 1151, 1154-55 (5th Cir.
1985); Royal Bank of Canada v. Joffre Resources Ltd., [1985] 5 W.W.R. 75, 80-81 (Alberta
Q.B.).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

B. Well Information
The second major group of important issues addressed in farmout agree-
ments relates to the information that the parties develop in the course of
drilling the well. What tests are to be conducted? What information is to be
shared by the farmee with the farmor? When and under what conditions is
the sharing to take place? These issues fundamentally affect the farmee's
cost of performance. They also affect the value of the farmout transaction to
both the farmor and the farmee.

1. Tests to be Conducted
The parties often list tests that the farmee must perform in the course of
drilling in an appendix attached to the farmout agreement. Because of their
physical location and because the lawyers who draft or review farmout
agreements often do not understand the technical terms that are used to
describe the tests, the testing provisions tend to get little attention. That
oversight can be very expensive for both the farmor and the farmee.
The tests required under the farmout are important to the farmee because
the farmee is obligated to pay the costs of testing. If the farmout requires
extensive and expensive testing, the burden of drilling increases greatly. An
attorney drafting or reviewing a farmout agreement on behalf of a farmee,
therefore, must either understand the necessity for and the probable costs of
the tests required or specifically defer to the business judgment of the client
on these matters.
A "blank check" requirement that the farmee test "to the farmor's satis-
faction" should be avoided. When possible, the contract should set out the
specific tests to be conducted. When that is not possible because the parties
cannot agree or cannot foresee what will be necessary, reference to the pru-
2 67
dent operator standard may be advisable.
The farmor is equally concerned about what tests are to be conducted.
Even if the farmor's primary purpose in farming out is to get a well drilled to
preserve its lease, the testing information is likely to be important for what it
may tell the farmor about other leases that it may own in the area. Where
the farmor's goal in farming out is to get leases explored, the information
developed from testing may prove more important to the farmor than
whether or not the drilled wells produce in paying quantities. One drafting
or reviewing a farmout agreement for a farmor, therefore, needs to under-
stand equally as much as any counterpart working for the farmee what the
various kinds of tests that the agreement may specifically require and what
kind of information they may develop.
Farmout agreements commonly provide that the farmor's representatives

267. For example: "In the course of drilling the initial well or any substitute well provided
for herein, farmee agrees to do such evaluation and to have made such electric, radiation and
porosity surveys as a prudent operator would do, or have made, under the same or similar
circumstances. ... (Emphasis added.) It may also be advisable, at least from the farmee's
view, to provide specifically that testing need not be done if there are no commercially viable
"shows" of hydrocarbons.
1987] FARMOUT AGREEMENTS

will have "the freedom of the rig floor," which in the trade means that the
farmor has the right to all information derived from testing in the course of
drilling. 268 In addition, many agreements will specifically require the farmee
269
to provide testing information.
As a practical matter, the importance of testing to both the farmee and the
farmor means that the attorneys representing the parties cannot work in a
vacuum. They must consult with their clients' scientific personnel. They
must ask the hard questions. Is there a clear understanding as to what the
terminology used to describe the testing means? What will it cost? Will the
information produced be worth the cost? When and under what conditions
is information to be supplied?

2. When Must the Farmee Supply Testing Information?

When the farmee must supply information derived from testing may be
crucially important to the farmor. The farmor may have leases in the area
that it needs to evaluate before their primary terms expire. The farmee may
"steal a march" on the farmor by withholding testing information until the
farmee can use it in evaluating its leases or formulating its lease acquisition
program for the area. Farmout agreements, therefore, commonly set time
limits for the farmee to provide testing information. 270 When the agreement
requires absolute performance to earn, the farmee should give careful con-
sideration to these time limits.

268.Cage, supra note 3, at 165; Klein & Burke, supra note 3, at 502.
269.For example:
Farmees shall afford the duly authorized representatives of farmor, at their sole
risk, access to the Test Well on all operations incident thereto and shallfurnish
farmor all information pertainingto or obtainedfrom all operationsconducted in
connection therewith, including daily drilling reports, copies of any sample
analyses made, all reports to government agencies, all test results and copies of
all logs (including casing logs) and surveys (including velocity surveys) made,
together with such other notices and information as are customarily furnished
by the operator to a non-operator working interest owner.
(Emphasis added.)
270. For example:
The party drilling any well provided for in the Agreement to which this exhibit
is attached, agrees and binds itself to observe and comply with the provisions
hereinafter contained; failure to comply with such provisions shall release
Farmor from its obligations and covenants contained in said agreement.

2. During the drilling of any well:

c. As soon as available, furnish Farmor with records and representative sam-

ples of all cores taken; copies of the results of cores.
d. Furnish Farmor daily progress reports by telephone or telecopy giving the
nature of all work done and depth and formation penetrated beginning with the
date actual work is commenced at the location and continuing until drilling,
logging, testing, completing and equipping is completed or if a dry hole, the well
has been plugged and abandoned.

f. Notify Farmor immediately when a show of oil or gas has been encountered
in drilling or coring, and before any formation is tested or electrical surveys are
run, notify Farmor in sufficient time for farmor to have representatives present.
(Emphasis added.)
 SOUTHWESTERN LAW JOURNAL [Vol. 41

3. Confidentiality
The parties may also want to bar or limit the dissemination of the infor-
z
27
mation developed in testing by including confidentiality provisions.
While damages may be difficult to prove, confidentiality clauses should be
enforceable if damages are proved.2 72 In addition, their very presence is
likely to avoid disputes.

C. What Is Earned?
There are four dimensions to what is earned by drilling under a farmout
agreement: the surface area earned, the depth limitations, substances cov-
ered, and the percentage of interest earned by drilling. In addition, both the
farmor and the farmee must concern themselves with the farmor's overrid-
ing royalty, the "carried" costs, pooling provisions, conversion rights, the
payout definition, and proportionate reduction provisions.

1. Area Earned
In principle, the farmor's and the farmee's interests under a farmout
agreement will always conflict with respect to the acreage that is to be
earned. In practice, however, the parties negotiate the area to be earned by
the farmee so that it bears a fair relationship to the risks that must be taken.
As a general rule, the greater the risks that the farmee must take, the greater
the area earned by drilling under the farmout agreement.
The most narrow assignment that may be earned under a farmout agree-
ment may be called a "borehole assignment." A borehole assignment con-
2 73
veys to the farmee only the area actually drained by the borehole drilled.

271. For example, the following confidentiality provision is from an offshore farmout
agreement:
A. The seismic data acquired pursuant to this farmout agreement will be the
sole property of farmee and its participants, although black line copies of display
sections and a map showing the location of shot points used shall be furnished to
farmor for its information and use only.
B. Except as provided in subsection A immediately above, the parties hereto
agree that all geophysical, geological, engineering, technical, production tests or
other data obtained from all wells drilled under this agreement shall be the
property of farmor and farmee and shall be maintained as confidential informa-
tion for a period of five (5) years from the date hereof, or until such information
is made public by the Minerals Management Service, unless both parties agree in
writing to a lesser period of time. It is understood that the filing of reports by
farmee which are required by governmental agencies shall not constitute a
breach hereof. It is also agreed and understood that farmee will be permitted to
provide each participant named in Section X below, with a copy of the informa-
tion and data referred to in this paragraph, subject to the confidentiality provi-
sions of this paragraph.
C. It is understood and agreed that in the event that farmee agrees to relin-
quish all of its rights under this agreement, the provisions of this section shall
not apply to farmor and farmor shall be able to use such data in such attempt or
attempts to further farmout this lease.
272. Cf Gladys Belle Oil Co. v. Turner, 12 S.W.2d 847, 848-49 (Tex. Civ. App.-Austin
1929, writ ref'd) (covenant to reassign held enforceable); see infra text accompanying notes
362-65.
273. An example of a borehole assignment is:
1987] FARMOUT AGREEMENTS

The farmee does not earn the right to participate in infill drilling. 274
A second form of limited assignment, and one very commonly seen in the
industry, is a "drill site assignment." A drill site assignment provides that
the farmee earns the rights to a specified amount of acreage that is desig-
nated as the drill site. Generally, the drill site includes the acreage dedicated
to the drilling or spacing unit that is approved by the state agency with juris-
diction. When there is no state designated drilling or spacing unit, the par-
ties may describe a drill site assignment as a square 275 or a circle 276 around
the top of the borehole.
Finally, the farmor may assign the farmee not only the drill site acreage,
but acreage outside of the drill site. 277 Assignment of outside acreage is par-

Assignor. . . does, subject to the terms and provisions herein contained, hereby
transfer, sell, assign and convey unto the said Assignee, its successors or assigns,
without warranty of title, express or implied, all of Assignor's right, title and
interest in and to the oil and gas rights only as covered by the oil, gas and
mineral lease described in Exhibit "A", attached hereto and by reference made a
part hereof. . . insofar and only insofar as such lease covers rights specifically
limited to the well bore of the __ well located in Section _ ,_ County,
__ together with such interest's part of all the production, if any, produced
under such oil, gas and mineral leasefrom such well bore and a like interest in all
personalproperty,fixtures and equipment located on the lands described in Ex-
hibit "A" or used or obtained in connection with such well bore of the - well.
(Emphasis added.)
274. An unresolved question is whether the assignee of a borehole assignment under a
farmout agreement acquires any right to prevent the farmor from drilling an infill well or to
recover damages as a result of the drilling of an infill well that will cause substantial drainage.
There may also be question about whether a borehole assignment meets the complete payout
test. See supra text accompanying notes 22-25.
275. The following describes the assigned tract as a square:
If Farmee [drills] . . . then Farmee shall have acquired all of Farmor's undi-
vided right, title and interests to an undivided __ leasehold interest in and
to the Lease and the Lands, insofar and only insofar as the Lease and Lands
cover and affect the proration unit established for the Test Well, which prora-
tion unit shall be established in accordance with the rules prescribed or permit-
ted by the Railroad Commission of Texas. In the absence of a designation of a
proration unit by the Railroad Commission of Texas, then if the Test Well is
classified as an oil well, then the acreage assigned thereto shall be 80 acres; if the
Test Well is classified as a gas well, the acreage assigned thereto shall be 320
acres. In either case, the acreage assigned to a well shall be in the shape of a
square, as nearly as practicable,with a Test Well in the center thereof. For the
purposes of determining whether the Test Well is an oil well or a gas well, the
classification thereof in any form filed in respect thereto with the Railroad Com-
mission of Texas shall be conclusive.
(Emphasis added.)
276. The following describes the tract assigned as a circle:
[After drilling the earning well] you will upon written request to the farmor be
provided with an assignment with farmor's interest in its lease(s) or portion of
lease(s) under that portion of the Farmout Area included in the unit established
for the earning well. Should a unit not be established, said assignment shall
cover farmor's interest under that portion of the Farmout Area included in an
area having a radius of 300 feet around the earning well.
277. An example of an earning provision that would give the farmee acreage outside of the
drill unit, which might be appropriate for use in an exploratory "drill to earn" agreement,
follows:
If [the farmee earns] . . . the farmor will assign to farmee:
(a) an undivided 50 percent of the operating rights and working interests of
farmor in the leases subject to this agreement; (b) if, and only if, the test well
 SOUTHWESTERN LAW JOURNAL [Vol. 41

ticularly common when the farmout is primarily for exploratory purposes.

27 8
As discussed above, the practice presents special tax problems.

2. Depth Limitations
Just as oil and gas leases may be subdivided into separate surface tracts,
they can be subdivided into deep and shallow rights. Farmout agreements
often sever leases by placing depth limitations upon what the farmee earns
by drilling. Depth limitations may be stated on a footage basis; for example,
"6000 feet" or "the total depth drilled. 12 79 In the alternative, earned rights
may be limited by reference to a described formation, generally either the
deepest penetrated by drilling operations 280 or the deepest actually produc-
ing.2 8 ' The strictest limitation, rarely seen but often discussed, limits the
farmee's rights to those formations actually producing. Yet another alterna-
tive limits what the farmee earns to the stratigraphic equivalent of the well
drilled. 28 2 Finally, the parties may use some combination of limitations.
All of these limited assignments present potential problems. All are sus-

is completed for production of oil and/or gas, 100 percent of the remaining
operating rights and working interests of farmor in the land within the desig-
nated drilling and spacing unit established by the __ Commission for the
test well, excepting and reserving to farmor [an overriding royalty interest
convertible upon payout] ....
278. See supra text accompanying notes 30-34.
279. An example of a total depth drilled limitation is: "All acreages assigned shall be
limited to a depth equal to one hundred feet (100') below the total depth penetratedby the test
well drilled on the drilling unit acreage." (Emphasis added.) The reason for reference to a
specified depth below that actually penetrated is to give the farmee a right to drill deeper, if
need be, in order to maintain the production on its well. Sometimes, agreements will grant a
specific easement for such purposes:
[The assignment shall] reserve to Farmor all rights below the stratigraphic
equivalent of the base of the deepest producing sand as defined in the well com-
pletion form filed with the Texas Railroad Commission, except for a vertical
easement which shall be assigned to Farmee for operational purposes only in the
upper one-hundred feet (100') of those reserved depths.
280. An example of a deepest formation penetrated limitation is:
If Farmee timely commences the drilling of the Initial Test Well, drills it to the
contract depth and fully and completely complies with all the other terms, con-
ditions and requirements of this Agreement, upon the completion of the Initial
Test Well or Substitute Well as a well capable of producing oil and/or gas in
paying quantities, Farmee will have earned an assignment of 100% of Farmor's
interest in 160 acres around the drill site tract, being the - quarter of section
, township -, range __ , _ County, _ and limited from the
surface to the base of the deepest formation penetrated.
(Emphasis added.)
281. An example of a deepest producing formation limitation, taken from a draft AAPL
Form 635 farmout agreement, is "ifan assignment is earned, the rights earned will be as
follows: "limited to the interval from the surface down to and including, but not below, the
base of the deepest producting formation in the earning well." This approach appears more
limited than a deepest penetrated formation limitation because it is quite likely that a well
drilled will be produced from a shallower depth than the deepest depth penetrated.
282. An example of a stratigraphic equivalent limitation follows:
If the Earning Test Well is drilled and completed as a well capable of producing
oil or gas in paying quantities, each Farmor shall assign to Farmee one hundred
percent (100%) of the right, title and interest of such Farmor in those portions
of the oil and gas leaseholds described in Exhibit "A" (down to and only down to
the stratigraphicequivalent of the total depth drilled in the Earning Test Well)
1987] FARMOUT AGREEMENTS

ceptible to interpretative disputes similar to those that arise in describing the

objective depth. 283 When what is earned is limited to a specified depth ex-
pressed in feet, the method used to measure the depth may be ambiguous.
The drafter should take care to describe the limitation by reference to verti-
cal depth or measured depth and to define precisely how to measure
284
depth.
If the depth limitation is stated by reference to a formation, the identity
and location of the formation may be open to question. In addition, a special
problem is likely to be confronted. When the agreement limits the assign-
ment to the base of a specified formation or to some specified number of feet
below the base of the formation, the formation must be identified and lo-
cated, and its base must be clearly discernible. That task may be relatively
easy, particularly in areas in which many wells have been drilled or where
the lithology at the base of the formation changes abruptly and distinctly. In
exploratory areas or in geologically complex areas, however, stating a depth
limitation by reference to a formation may be an invitation for geologists to
disagree.
A similar problem arises when the description of the assignment refers to
the "stratigraphic equivalent" of the depth drilled or of the formation pene-
trated. The term "stratigraphic equivalent" is used frequently in areas in
which noncontiguous parts of the same formation may be found at substan-
tially different depths because of overthrusting or faulting. The general ef-
fect of a reference to stratigraphic equivalent is to give the farmee the right
to the benefits of its risk-taking by giving it the right to sedimentary strata it
drilled, wherever found.
The specific effect of limiting the depth earned to the stratigraphic
equivalent may not be clear, however. There are several potential problems.
First, the term has a deceptively reassuring sound; it suggests a straightfor-
ward scientific test that in fact does not exist in every case. Reasonable ge-
ologists may disagree as to whether particular formations or zones are
stratigraphic equivalents, and even articulate geologists may have difficulty
explaining its application to judges and jurors in terms that they can under-
stand. 285 Second, the term stratigraphic equivalent is potentially ambiguous

which are included within the spacing unit for the Earning Test Well as estab-
lished by the applicable state oil and gas regulatory agency or by statute ....
(Emphasis added.)
283. See supra text accompanying notes 201-05 (discusses objective depth); see also
Niblack, Some Consequences of HorizontalDivision of Oil and Gas Leaseholds, 8 ROCKY MTN.
MIN. L. INST. 1 (1963) (discusses how segregation is effected and rights and duties incident to
operations of segregated estate).
284. See supra text accompanying note 201.
285. As I have worked as a consultant, arbitrator, and expert witness, I have formulated
(with tongue only partly in cheek) what I call the "reasonable prudent law professor rule of
complexity." I am a reasonable, prudent law professor, of better than average intelligence and
education, and if I cannot easily understand a concept or its application, neither will a judge or
jury. "Stratigraphic equivalent" fails my test.
This is not to say that "stratigraphic equivalent" should not be used as a limitation. One
lawyer who replied to my request for comment said:
Obviously, the term "stratigraphic equivalent" is less definite than a fixed mea-
 SOUTHWESTERN LAW JOURNAL [Vol. 41

because it has at least three different meanings. Geologists recognize time- 28 8

28 7
stratigraphic, 28 6 biostratigraphic, and rock-stratigraphic equivalents.
The parties to a farmout generally wish to refer to rock-stratigraphic
equivalency, and the way they identify the objective depth may suggest their
intention. 28 9 The parties should specifically define the term "stratigraphic

sured depth, but it is no more indefinite than naming a particular formation

(e.g., the 'Upper Morrow Formation') as the objective to be tested by the earn-
ing well-which, of course, is a common way to describe how deep the farmee
must drill. In either case, geologists could (but usually do not) disagree.
286. Time-stratigraphic equivalents are the sediments deposited and the rocks formed dur-
ing a specific time; i.e., in a given era, epoch, or age. North American Commission on Strati-
graphic Nomenclature, North American Stratigraphic Code, arts. 80, 81, in 67 AM. A. PETR.
GEOL. BULL. 841, 869 (1983) [hereinafter Strat. Code]. The Stratigraphic Code uses the term
"chronostratigraphic" rather than "time-stratigraphic." Petroleum geologists generally use
the latter term, however. For a comprehensive, practical discussion of terminology, see Owen,
Commentary: Usage of Stratigraphic Terminology in Papers, Illustrations,and Talks, 57 J.
SEDIMENTARY PETROLOGY 363 (1987). For example, geologists refer to sands deposited dur-
ing the Pennsylvania Era, a time interval, as Pennsylvanian sandstones, a time-stratigraphic
interval measured by thickness. Strat. Code, supra, arts. 66 and 67, at 868. Time-stratigraphic
intervals are generally thicker than individual rock-stratigraphic intervals, which form most
petroleum reservoirs. Consequently, they are not of immediate importance to petroleum ge-
ologists. A time-stratigraphic interval, therefore, will rarely be what the parties intend when
they refer to "stratigraphic equivalent" in a farmout agreement; their reference is more likely
to be to the potentially petroleum bearing rock layers themselves.
287. Bio-stratigraphic equivalents are rocks that contain similar fossils. WEBSTER'S THIRD
NEW INTERNATIONAL DICTIONARY 218 (3d ed. 1981). See also Strat. Code, supra note 286,
arts. 48 and 49, at 862. "Zones" are examples of bio-stratigraphic units. Id. art. 53, at 863.
Geologists frequently use zones as references.
288. Rock-stratigraphic equivalents are mappable rock layers with distinctive top and bot-
tom boundaries. Strat. Code, supra note 286, arts. 22 and 23, at 855-58. (The Stratigraphic
Code uses the term "lithostratigraphic," but geologists generally use the term "rock-strati-
graphic.") The "formation" is the primary rock-stratigraphic unit. For example, the
"Caseyville formation" is described in H. WILLMAN, E. ATHERTON, T. BUSCHBACH, C. COL-
LINSON, J. FREY, M. HOPKINS, J. LINEBACK & J. SIMON, HANDBOOK OF ILLINOIS STRA-
TIGRAPHY 163-83 (Illinois Geological Survey Bulletin No. 95, 1975). Formations may contain
smaller rock-stratigraphic intervals that are designated as "members." Strat. Code, supra note
286, art. 25, at 858. For example, in southern Illinois, the Pennsylvania-age Caseyville forma-
tion comprises four separate members. From top to bottom they are the Pounds Sandstone
Member, the Drury Shale Member, the Battery Rock Sandstone Member, and the Lusk Shale
Member. Stratigraphic sequence, or position, is the primary criterion used to distinguish be-
tween the sandstone members and the shale members. The distinctions are difficult to make;
they cannot be made with only a short core sample, a hand specimen, or a small outcrop of the
formation. Furthermore, none of the sandstone members is comprised only of sandstone or
even one type of sandstone. For a discussion of local variability within the Pounds Sandstone
and the Battery Rock Sandstone over a distance of eleven miles, see Koeninger & Mansfield,
Earliest Pennsylvanian Depositional Environments in Central Southern Illinois, in DEPOSI-
TIONAL AND STRUCTURAL HISTORY OF THE PENNSYLVANIAN SYSTEM OF THE ILLINOIS BA-
SIN, PART 2; INVITED PAPERS; NINTH INTERNATIONAL CONGRESS OF CARBONIFEROUS
STRATIGRAPHY AND GEOLOGY 76-81 (J. Palmer & R. Dutcher eds. 1979). Alternatively,
geologists may describe rock-stratigraphic equivalents by reference to the type of sedimentary
rock they constitute; e.g. the Caseyville Sandstone or the Battery Rock Sandstone.
289. The most common way to designate an objective depth in a farmout is by naming an
objective rock-stratigraphic unit, whether it is a formally designated formation or member
(formally designated rock-stratigraphic units are listed in G. KEROHER, LEXICON OF GEO-
LOGIC NAMES OF THE UNITED STATES FOR 1936-1960 (United States Geological Survey Bul-
letin No. 1200 (1966)) or some other informally designated but locally recognized unit, such as
the Red Fork Sandstone in Oklahoma. (The Red Fork Sandstone is informally, but effectively
described in L. JORDAN, SUBSURFACE STRATIGRAPHIC NAMES OF OKLAHOMA 165
(Oklahoma Geological Survey Guidebook No. 6, 1957)). As indicated above, a formation is a
1987] FARMOUT A GREEMENTS

equivalent," however, as biostratigraphic or rock-stratigraphic and, where

possible, refer to well-defined "marker formations. ' 290 Third, a strati-
graphic equivalent may not exist. A limit on depth earned to the "strati-
graphic equivalent," therefore, may not be a limit at all. 29' To avoid this
possibility, the farmout agreement should state a maximum depth to be
earned.292

3. Substances
An assignment of interest in a lease under a farmout agreement may cover
all substances covered by the lease. A farmout that is not specifically limited
will have this effect. 29 3 Sometimes, however, an assignment of interest under
a farmout specifically limits the substances covered to oil and gas, or to one
or the other. 294 The special circumstances of the parties will determine what
substances a farmout covers. For example, the owner of a lease in a known
oil producing area may be willing to farm out gas rights, but not oil
295
rights.

rock-stratigraphic unit. See supra note 288. This suggests that the parties intend that "strati-
graphic equivalent" in the portion of the agreement limiting what is earned is meant to be
"rock-stratigraphic equivalent." If the objective depth is defined as a zone, the inference is
that "stratigraphic equivalent" means "bio-stratigraphic equivalent." No inference arises if
the objective depth is stated in feet.
290. See supra note 289.
291. For example, a formation that has been broken by faulting may also have been pushed
laterally a substantial distance so that an offset well drilled may never encounter the "strati-
graphic equivalent" of the formation or zone in the earning well in any of the three senses
discussed above.
292. For example: "In no event will Farmee earn any rights below a depth of - feet."
293. The rule of construction that a description that is not limited by reference to a frac-
tional interest or to minerals or surface will be construed to be without limitation has been
called the "100% rule." See Ellis, Rethinking the Duhig Doctrine, 28 ROCKY MTN. MIN. L.
INST. 947, 954 (1982).
294. For example, the following assignment is for gas rights alone:
RIGHTS ASSIGNED: Subject to the terms and conditions set out herein,
Owner hereby grants to Operator the exclusive right and privilege of exploring,
testing, and developing the Operating Areafor gas and, in connection therewith
Operator shall be entitled to exercise all the rights and privileges granted the
Lessee under the terms of said oil and gas lease as concerns gas and all of the gas
production from the Operating Area as shall be owned by Operator subject to
the following [royalties reserved].
(Emphasis added.) The following language conveys oil rights only:
It is expressly provided that this farmout agreement only covers "oil and oil
rights" and all rights, titles and interest ancillary or pertinent thereto, including
without limitation all right, title and interest of farmor in and to casinghead gas.
"Casinghead gas" as used herein is hereby defined as the same defined in the
statutes, regulations and judicial decisions of the State of Texas to which refer-
ence is here made.
(Emphasis added.)
295. Severing oil rights from gas rights can lead to dispute between the parties as to
whether production is "oil" or "gas." A precise chemical or scientific definition is difficult
because variations in temperature and pressure both in the reservoir and at the wellhead deter-
mine whether hydrocarbons will be produced in liquid or gaseous state. The distinction can
have enormous economic consequences, however. An example is the "white oil" dispute in the
Texas Panhandle, in which owners of oil rights have argued that overproduction of gas has
caused lighter components of oil to vaporize, and owners of gas rights have argued that gas
was being produced as oil after artificial cooling. For general discussion, see Cartwright, Texas
 SOUTHWESTERN LAW JOURNAL [Vol. 41

When the interest earned by the farmee is limited to gas or to oil, the
agreement should address the definition of the substances covered. A simple
way is by reference to the classification of the farmout well by the conserva-
tion authority; e.g., anything produced from a well classified as a gas well is
considered to be "gas" for purposes of the farmout. 296 If this approach is
chosen, the agreement should also deal with what will happen if the conser-
vation authority changes the classification of the well. An approach that
protects the interests of both the farmor and the farmee is to continue the
farmee's rights to production from the well drilled, but to modify the acreage
earned to conform to the spacing approved for the new classification of the
29 7
well.
A farmout that covers oil but not gas, or gas but not oil, is an invitation to
controversy. Because the meaning of "oil" and "gas" and "oil well" and
"gas well" is unclear in many states, a drafter should avoid the distinction
unless the business deal requires it.298

4. Percentage Earned
The percentage earned by the farmee in the leases assigned is also of obvi-
ous importance to the parties. The higher the percentage, the better for the
farmee. As discussed elsewhere, the working interest earned by the farmee

Tea on Ice, TEX. MONTHLY, Mar. 1985, at 98. Owners of oil rights appear to be winning that
particular dispute. See Hufo Oils v. Railroad Comm'n, 717 S.W.2d 405 (Tex. App.-Austin
1986, no writ) (white oil was not oil for well classification purposes); Hufo Oils v. Colorado
Interstate Gas Co., 802 F.2d 133 (5th Cir. 1986) (white oil production may not be used to
classify a well as an oil well under an operating agreement).
296. For example:
the term "gas" as used herein shall mean gas, including all liquid hydrocarbons
and other constituent elements produced from a gas well or gas pool, and the
classification of a well as a "gas well" or a pool as a "gas pool" by the Oil
Conservation Division of the Energy and Minerals Department of the State of
New Mexico, or other governmental agency exercising like jurisdiction, shall be
conclusive.
297. For example:
It is specifically agreed that if the [name of well] located in [description] is
hereafter reclassified by the [conservation agency] as an oil well or if the pool
from which said well is producing is hereafter reclassified by the [conservation
agency] as an oil pool, then, and in that event, this Contract and Operating
Agreement shall be automatically contracted and modified as of the date of such
reclassification to cover an Operating Area consisting only of the [description]
containing 40 acres, more or less, as concerns oil rights from the surface to the
subsurface depth of 2,900 feet, but in no event below the base of the __
Formation.
The term "oil" as used herein shall mean any petroleum hydrocarbon pro-
duced from a well in the liquid phase and which existed in a liquid phase in the
reservoir and any gas or vapor or both gas and vapor indigenous to and pro-
duced from a pool classified as an oil pool by the [conservation agency].
If this Contract and Operating Agreement is contracted and modified in ac-
cordance with this Article X, at every place where the term "gas" or "gas
rights" is used in this Contract and Operating Agreement, the term "oil" or "oil
rights" shall be substituted therefor on and from the date of such contraction
and modification. Except as expressly stated in this Article X, this Contract and
Operating Agreement shall remain otherwise unchanged and unamended by the
operation of the provisions of this Article X.
298. See Cage, supra note 3, at 160.
1987] FARMOUT AGREEMENTS

in the well site acreage must at least equal the percentage of the drilling costs
paid by the farmee if the farmee is to claim the intangible drilling cost deduc-
tion.299 Only rarely do farmout agreements fail to meet this standard. 3° °
The size of the percentage interest earned by the farmee in farmed-out
acreage outside of the drill site unit, as well as the interest retained by the
farmee after the farmor's "back-in," is subject to negotiation. One general-
ization that can be made, however, is that the interest earned by the farmee
in drilling tends to be greater in times of economic downturn. When mar-
keting conditions make drilling less attractive, the farmor must sweeten the
pot to entice the farmee to take the risk. On the other hand, the better the
prospect being farmed out, the more attractive drilling becomes to the
farmee, even for a smaller percentage of interest. Farmees must evaluate
offers with common sense and an eye upon the market in the area.

5. Nonoperating Interest Reserved

Most farmout agreements provide that the farmor reserves a nonoperating
interest in production from the earning well or wells during the payout pe-
riod. Usually, the interest reserved is in the form of an overriding royalty
interest, 30 1 but other types of nonoperating interests may also be encoun-
tered. One author has suggested that the interests of the farmor may be
better served in some circumstances by reserving a net profits interest rather
30 2
than an overriding royalty.
The reason for the retained nonoperating interest is the complete payout
tax rule; the farmee must hold a working interest in the earning well until
payout in order to obtain the full benefit of intangible drilling cost deduc-
tion. 30 3 The farmor, on the other hand, will want to realize a cash flow from
the farmout. Since the tax rules effectively bar the farmor from owning a
portion of the working interest until payout, the farmor generally will re-
serve an overriding royalty interest. Thus, the interests of the farmee in ob-
taining full tax benefits and the interest of the farmor in obtaining a cash
flow are both served when the farmor reserves a nonoperating interest.
The economic impact of the nonoperating interest reserved by the farmor
is extremely important to the parties' business deal. In this respect the inter-
ests of the farmor and the farmee are in direct contradiction. The farmor
will invariably seek a larger retained nonoperating interest rather than a
smaller one. In boom times, the farmor commonly retains a 1/8th overrid-
ing royalty. The farmee generally seeks to minimize the size of the nonoper-

299. See supra text accompanying notes 17-25.

300. The intangible drilling cost deduction is of great importance to the farmee. Depriving
the farmee of this deduction is worth nothing to the farmor, since the farmor cannot claim the
deduction unless it pays the costs. See id.
301. An overriding royalty is a royalty interest, an interest in production or proceeds free
of the costs of production, carved out of the lessee's interest in an oil and gas lease. E. KUNTZ,
J. LOWE, 0. ANDERSON & E. SMITH, supra note 5, at 427-28.
302. L. MOSBURG, supra note 3, at 283-84. Net profits interests frequently are reserved in
California farmouts. See Himebaugh, supra note 3, at 23-24.
303. For a discussion of the complete payout principle, see supra text accompanying notes
22-25.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

ating interest retained by the farmor. When the industry is in recession,

farmees are usually more successful than when the industry enjoys
prosperity.
One commentator has suggested compromising the interests of the farmor
and the farmee by providing for a sliding scale overriding royalty interest
keyed to production. 3° 4 Another has noted that sliding scale overriding roy-
alties do not work well in practice because "part of the incentive to improve
production was taken away, there was an open invitation to questionable, if
not fraudulent production control methods, and the accounting headaches
were multiplied. ' 30 5 Today, the more common approach is an overriding
30 6
royalty that increases after payout.
Drafting for a retained nonoperating interest presents interesting
problems. One of the most important is whether the retained interest is to be
inclusive or exclusive of existing burdens. A retained interest that is inclu-
sive of existing burdens, typically the landowner's royalty and overriding
royalties created for landmen or geologists, places the risk of excess burdens
upon the farmor, at least in part. 30 7 Consider for example, the farmor that
reserves an overriding royalty equal to the difference between existing bur-
dens and 25% of total production because it believes that the lease is subject
only to a 3/16th landowner's royalty, when in fact the lease is also subject to
a 1/16 overriding royalty reserved by the lease broker who originally took
the lease. The overlooked "excess" overriding royalty will consume the
farmor's retained interest. 30 8 In contrast, a retained interest that is exclusive
of existing burdens places the risk of excess burdens upon the farmee from
the start; the interest reserved is in addition to other burdens upon
production.309

304. Hemingway, supra note 6, at 3, 5.

305. Cage, supra note 3, at 164.
306. For example, the following clause would increase the farmor's retained overriding
royalty after payout: "At payout (i.e., after such Well has paid to you from the working
interest 100 percent of your expenses of drilling, completing, equipping and operating said
well) farmor's overriding royalty interest will increase to the difference between 30 percent
(30%) and the royalties, overriding royalties, and/or other leasehold burdens."
307. An example of a retained nonparticipating interest that is inclusive of existing burdens
is: "The assignment shall reserve to farmor an overriding royalty equal to the difference be-
tween existing lease burdens of record as of the date of this agreement and - percent." An-
other version states:
Until farmee has recovered out of the proceeds from the sale of production from
the Initial Test Well or Substitute Well all of the costs and expenses farmee
incurs in the drilling, testing, completing, equipping and operating the Initial
Test Well or Substitute Well, farmor will retain and reserve 6.25 percent over-
riding royalty interest, inclusive of all other overriding royalty interest and lease
burdens above the normal 12.5 percent land owners royalty interest.
308. Of course, if known and unknown burdens exceed 25%, the excess burden will fall
upon the farmee, unless there has been a warranty of title by the farmor.
309. An example of a retained interest exclusive of outstanding burdens is:
Assignor reserves unto itself, its successors and assigns over, above and in addi-
tion to all royalties, overriding royalties and other burdens, if any, against the
production from said leases, an overriding royalty of - of all of the oil and - of
all of the gas, casinghead gas, condensate and other liquid or gaseous hydrocar-
bons produced and saved from or attributable to said leases during the terms
1987] FARMOUT AGREEMENTS

A second problem relates to the possibility that the farmee will want to
drill an additional well on the farmed-out acreage before the earning well has
paid out. Will the farmor have the right to participate in the drilling of a
second well, or should the farmor be limited to its nonoperating interest?
The farmor and the farmee are likely to have conflicting economic interests
at stake. If a farmor reserves a nonoperating interest convertible at payout
to a working interest, the agreement should address what the rights of the
3 10
farmor in a subsequent well drilled before payout will be.
Third, is the problem of pooling. The farmout agreement should make it
3 11
clear that the farmee has the right to pool the farmor's retained interest.
Otherwise, a question arises as to whether the farmee may pool and bind the
3 12
farmor, particularly in Texas.
Finally, the clause providing for the retained nonparticipating interest
should specify what costs, if any, the retained interest must bear. Overriding
royalty interests are generally free of costs of production, but may be subject

thereof, including any extension or renewals taken within six months of termina-
tion of said leases ....
310. An example of a farmout provision reserving to the farmor the maximum flexibility
with respect to additional wells drilled before payout is:
If farmee decides to drill an additional well on any assigned acreage prior to
payout of the earning well, farmor shall have the option to either (1)participatein
the well or (2) be carried in the well while reserving the overriding royalty and
option to convert to a working interest as provided in [reference to reservation
provision]. Should farmee choose (1) above, this choice shall be effective with
respect to all of the assigned acreage, but farmor shall continue to be carried to
payout on any well previously spudded. Should farmor choose (2) above,
farmor's election at payout shall be effective with respect to all of the assigned
acreage when the first well to payout on the assigned acreage pays out, but
farmor shall continue to be carried to payout on any well previously spudded.
(Emphasis added.)
311. For example:
[Pooling] Assignor grants Assignee, insofar as Assignor has the right to do so
and subject always to the terms and conditions of the Leases herein assigned, the
right to pool or combine said Leases with other leases or lands so as to establish
units containing not more than 640 surface acres (plus 10% tolerance) for the
production of gas well gas. In the event any Lease or Leases assigned herein is
(are) pooled or unitized with other leases or lands for production of gas as here-
inabove provided, the overriding royalty reserved herein shall, as to the lands
covered by this Partial Assignment which are so pooled, be paid to Assignor in
the proportion that the number of acres assigned herein and so pooled bears to
the total number of acres in such pooled unit.
It would be preferable for the clause to provide specifically that pooling by the farmee would
bind the farmor's reserved nonparticipating interest.
312. In Texas a pooling or unitization agreement does not bind the owner of a prior out-
standing royalty interest. MCZ Inc. v. Triolo, 708 S.W.2d 49, 57 (Tex. App.-Houston [1st
Dist.] 1986, writ ref'd n.r.e.); Brown v. Getty Reserve Oil Co., 626 S.W.2d 810, 814 (Tex.
App.-Amarillo 1982, writ dism'd). Contra 2 H. WILLIAMS & C. MEYERS, supra note 230,
§ 221.1(7); Williams, Stare Decisis and the Poolingof Nonexecutive Interests in Oil and Gas, 46
TEX. L. REV. 1013, 1015-27 (1968). This doctrine originated in Brown v. Smith, 141 Tex. 425,
431-32, 174 S.W.2d 43, 46-47 (1943). The court in Brown noted that an overriding royalty
owner's interest is real property under Texas law and that a pooling agreement involves a
cross-conveyance of the joining parties interests. Id. Proceeding from this basis, the court
held that absent any showing of intent on the part of the reserved royalty owner, the conferring
of a mineral leasehold did not confer the right to dispose of the royalty owner's property. Id.
at 47. See Jones, Non-ParticipatingRoyalty, 26 TEX. L. REV. 569, 571, 598-606 (1948) (dis-
cusses implications of Brown case).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

to costs subsequent to production.31 3 The law on the issue is not so clear as

to make specific drafting unnecessary, however. The meaning of the terms
net profit interests, production payments, and carried interests is even less
clear. Use of such terms invites litigation unless they are specifically
3 14
defined.

6. Conversion
The conversion provision of a farmout agreement addresses whether the
retained nonoperating interest that the farmor retains to provide a cash flow
will be converted at some point in time to a share of the working interest.
There are three possibilities: no conversion, mandatory conversion, and op-
tional conversion. Which of these the farmor or the farmee may prefer will
depend upon circumstances and the goals of each.
When the agreement lacks any conversion provision, the nonoperating in-
terest retained by the farmor will continue as long as production from the
well continues. That may be attractive to a farmor needing additional cash
flow or commitment of reserves, or to one distrustful of the business acumen
of the farmee, or anticipating marginal production. Omitting a conversion
provision may also be attractive to a farmee expecting prolific production. A
nonoperating interest (for example, a 1/16th overriding royalty) will be less
of an economic burden if production is prolific than if it is marginal. Gener-
ally, however, the parties to farmout agreements are actively involved in the
oil business and have a predilection in favor of full participation. Relatively
few farmouts omit conversion provisions for the nonoperating interest re-
315
tained by the farmor.
If the nonoperating interest retained is convertible to a working interest,
the farmee generally prefers mandatory conversion. 3 16 Mandatory conver-

313. See Cline v. Angle, 216 Kan. 328, 532 P.2d 1093, 1097 (1975). Often, a farmout
clause that reserves an interest in the farmor will specifically state that the interest is free of all
production costs. For example: "This overriding royalty shall be free and clear of all costs of
production, gathering, completion, dehydration, trucking, transportation, marketing, treating,
and taxes except applicable windfall profit, excise, ad valorem, gross production and severance
taxes."
314. See Aminoil USA, Inc. v. OKC Corp., 629 F. Supp. 647, 650-54 (E.D. La. 1986). In
Aminoil the farmor and the farmee disagreed over whether actual or imputed interest and legal
expenses were properly chargeable against the net profits account. Id. at 648. The jury was
permitted to consider expert accounting testimony, since the agreement was not explicit. Id. at
650.
315. If the farmor does not have the right to convert its overriding royalty, the agreement
may provide to increase it after payout. See supra note 306.
316. An example of a mandatory conversion provision follows:
If and only if, the test well is completed for the production of oil and/or gas,
farmor shall assign to farmee 100 percent of its operating rights and working
interest in the acreage within the designated drilling and spacing unit established
by the __ Commission for the test well, excepting and reserving to farmor,
in addition to any other overriding royalties or nonoperating burdens on pro-
duction, an overriding royalty of 1/16th of an 8/8ths of all oil, gas and associ-
ated substances produced and saved from the test well until payout of the well,
at which time the reserved overriding royalty of farmor shall terminate and 50
percent of the operating rights and working interest offarmor assigned under this
subsection will automatically revert tofarmor,and the test well, the material and
1987] FARMOUT AGREEMENTS

sion, or no conversion, gives the farmee additional certainty. The farmor, in

contrast, generally prefers to maintain flexibility by retaining an option
either to retain its overriding royalty or to "back in" to a working inter-
est. 31 7 The structure adopted usually reflects nothing more than the bar-
gaining leverage of the parties.
The conversion structure adopted may present some special drafting
problems. One is whether the farmor that either elects not to convert its
nonoperating interest into a working interest or is barred from doing so, has
a right to participate in in-fill drilling. This is similar to the problem dis-
cussed above of whether the farmor should participate in drilling before pay-
out, and similar drafting devices will deal with this situation. 3 18 Another
problem is the effective date of the conversion, whether mandatory or op-
tional. Farmout agreements often make the conversion effective on the first
day of the month following payout. 319 While that approach may be admin-
istratively convenient, the delay may cost the farmor a substantial amount.
The farmor with an option to convert will prefer to have its election effective
320
immediately.

7. Payout
As discussed above, the payout definition in a farmout agreement is of
crucial importance if the farmee is to obtain the benefits of the intangible
drilling cost deduction. 32' For the farmee to obtain the full benefit of the
deduction, it must own a share of the working interest of the well drilled
equal to the percentage of the intangible drilling costs claimed until recovery
of all of the costs of drilling, completing, equipping, and operating attributa-
ble to that interest. 322 Conversion of the farmor's retained interest must not

equipment therein and thereon, and all production thereafter recovered there-
from and the operating rights and working interest in the farmed out lands in
the drilling and spacing unit will be earned thereafter by farmor and farmee in
equal 50 percent shares.
(Emphasis added.)
317. An example of a conversion option is:
If the Initial Well or any Subsequent Earning Well reaches the Objective Depth
and is completed as a commercial well, and if it has been drilled in accordance
with all of the terms and conditions of this agreement, farmee shall have earned,
and farmor will deliver upon farmee's written request an assignment of the oil
and gas rights as defined in this Article. The assignmment shall:
6. Reserve to farmor the option after payout to convert its overriding royalty
to a - percent (_ %) working interest in the assigned acreage and in all
leasehold equipment, materials, and production.
See also Scott, supra note 3, at 84-85 ( 6(d) of example agreement).
318. See supra note 310 and accompanying text.
319. For example: "Any such exchange [of an overriding royalty interest for a working
interest] shall be effective as of 7:00 a.m. on the first day of the month after the month in which
payout occurred." See Cage, supra note 3, at 165.
320. See supra note 310, in which the quoted optional conversion provision continues:
"The party shall promptly execute a recordable instrument setting forth farmor's election,
which shall be effective as of 7:00 a.m. on the first day following payout."
321. See supra text accompanying notes 17-25.
322. For the language of the revenue rulings' definition of complete payout, see supra note
 SOUTHWESTERN LAW JOURNAL [Vol. 41

occur before complete payout. Drafters have devised no "magic" language

to express the complete payout definition. 323 No tax problem should arise,
however, so long as it is apparent that the complete payout test is
324
satisfied.
Whatever the definition of payout adopted, the parties face the practical
problem of determining whether payout has occurred. Most farmout agree-
ments provide for periodic reports from the farmee to the farmor. 32 5 In ad-
dition many agreements give the farmor specific audit rights for an agreed
time.3 2 6 Still, interpretive disputes frequently arise. In Humble Exploration
Co. v. Amcap Petroleum Associates-1977327 the parties disagreed over
whether the Windfall Profit Tax should be included with "production, sever-
ance or other similar taxes" in calculating payout.3 28 The court of appeals
held that it should because for the farmee the tax was a liability that reduced
the proceeds of production it actually received. 329 In Continental Oil Co. v.
American Quasar Petroleum Co. of New Mexico, Inc. 330 the issue was
whether expenses incurred by a farmee as the result of a blowout were to be
taken into account even though they were covered by insurance. 33' The
Tenth Circuit held that they were, because the farmout agreement did not
require the farmee to obtain insurance, and the farmee could not claim the
premiums paid as a cost in computing payout.3 32 In Mengden v. Peninsula
Production Co.333 the dispute was whether production from pooled units was

323. Some definitions do not even mention the term "payout":

At such time as Farmee has recovered out of its share of production from the
Earning Test Well an amount equal to all costs to Farmee for all services and
material necessary for developing, equipping, operating, and maintaining the
Earning Test Well, including all drilling, testing and completion costs of said
Earning Test Well, and for ad valorem, severance, and other taxes upon or mea-
sured by production and applicable to Farmee's working interest share of pro-
duction, each Farmor shall have the separate right to convert its reserved
1/16th of 8/8ths overriding royalty, as proportionately reduced pursuant to the
provisions of Section __ above, into a like proportion of an undivided fifty per-
cent (50%) share of the working interest in the Earning Test Well site or portion
thereof to which its said overriding royalty applied . ...
324. For an excellent and comprehensive discussion of "Payout" for tax purposes, see P.
MAXFIELD & J. HOUGHTON, supra note 27, 9.04[5].
325. See Scott, supra note 3, at 85:
Each calendar month following each assignment requested hereunder, and until
the final notice of payout, Farmee will furnish Farmor a report showing in rea-
sonable detail the monthly and cumulative status of payout and the supporting
data therefor. Promptly after payout occurs, Farmee shall so notify Farmor and
advise that the option is exercisable.

Id.
326. The agreement attached at Scott, supra note 3, at 85 continues, "For two years follow-
ing each payout, Farmee shall maintain, and Farmor shall have the right to audit, all records
pertaining thereto."
327. 658 S.W.2d 860 (Tex. App.-Dallas 1983, writ ref'd n.r.e.).
328. Id. at 862.
329. Id. at 863.
330. 599 F.2d 363 (10th Cir. 1979).
331. Id. at 364.
332. Id. at 365.
333. 544 S.W.2d 643 (Tex. 1976).
1987] FARMOUT AGREEMENTS

to be allocated wholly to payout of the farmout upon which the wells were
located or apportioned between the farmouts in proportion to the acreage
that each contributed to the units. 334 The Texas Supreme Court held that
apportionment was required on the basis of a labored interpretation of the
agreement. 335 These cases clearly suggest that payout should be defined as
fully as the parties can agree.
Another problem is how to handle money contributions that may be re-
ceived by the farmee. Most farmouts are silent on this issue. When the
farmout does address the issue, generally the parties will agree that the
farmor and the farmee will share money contributions proportionately to
their ultimate interests in the farmed-out acreage. 336 The farmee would pre-
fer to reserve contributions for itself, and that is sometimes done, particu-
larly in agreements in which the farmor retains only a nonoperating interest
without right of conversion. 337 Of course, if the operating agreement is
made effective upon the execution of the farmout agreement, the provisions
338
of the operating agreement will govern.

a. Requiring More Than the Tax Rule

Often the farmee and the farmor negotiate a variation on the payout con-

334. Id. at 644.

335. Id. at 648.
336. The most common way of accomplishing this is to credit the amount of cash contribu-
tions to payout. For example:
Farmoutor hereby relinquishes to farmoutee all of farmoutor's working interest
in said well and the production therefrom until such time, hereafter called the
"payout", as the gross revenue from said production (or market value, if taken
or sold by farmoutee) equals the cost of drilling, testing, completing, equipping
and operating said well, plus the cost of marketing production therefrom, but
less any cash contributionfor or on account of the drilling of said well.
(Emphasis added.) Note, however, that the language does not address acreage contributions.
337. The parties probably assume that the farmee is entitled to keep contributions if the
agreement does not address the issue. They should explicitly address this issue, however, to
avoid argument as to whether an implied obligation to share contributions exists. Cf Smith,
Duties and Obligations Owed by an Operator to Nonoperators, Investors, and Other Interest
Owners, 32 ROCKY MTN. MIN. L. INST. 12-1 (1986) (discuss implied duties).
338. See art. VIII.C. of the AAPL 1977-610 Model Form Operating Agreement. This
model provision provides:
While this agreement is in force, if any party contracts for a contribution of cash
toward the drilling of a well or any other operation on the Contract Area, such
contribution shall be paid to the party who conducted the drilling or other oper-
ation and shall be applied by it against the cost of such drilling or other opera-
tion. If the contribution be in the form of acreage, the party to whom the
contribution is made shall promptly tender an assignment of the acreage, with-
out warranty of title, to the Drilling Parties in the proportions said Drilling
Parties shared the cost of drilling the well. If all parties hereto are Drilling
Parties and accept such tender, such acreage shall become a part of the Contract
Area and be governed by the provisions of this agreement. If less than all par-
ties hereto are Drilling Parties and accept such tender, such acreage shall not
become a part of the Contract Area. Each party shall promptly notify all other
parties of all acreage or money contributions it may obtain in support of any
well or any other operation on the Contract Area.
Id. The AAPL 1982-610 Model Form Operating Agreement contains a similar agreement.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

cept. Depending upon the adversaries' respective bargaining powers, they

may define payment more liberally or more restrictively.
So long as the complete payout tax rule is satisfied, the farmee is entitled
to the full intangible drilling cost deduction. Thus, a farmout agreement
drafted so that the event that will permit the farmor to convert its nonoper-
ating interest to a working interest is some multiple of the cost of drilling,
completing, equipping, and operating the earning well, will result in no ad-
verse tax effect upon the parties.
One circumstance in which the parties may agree that the payout defini-
tion should include expenses not required by the tax rules is when a substi-
tute well has been drilled. So long as the substitute well is not considered to
be a continuation of the initial well, 339 tax law does not appear to require
that the initial well's costs be considered in computing payout. The farmee
will certainly want them to be considered, however. Surprisingly, farmout
definitions of payout rarely focus upon this issue. A farmout that contains a
substitute well clause should specifically address whether the costs of drilling
an unsuccessful initial well are to be taken into account in computing payout
of the successful substitute well.

b. Requiring Less Than the Tax Rule

If the parties choose a definition of payout not as restrictive as that of the
Internal Revenue Service, the farmee may lose a portion of the intangible
drilling cost deduction. A classic example, called the "basket payout" prob-
lem, 3 40 arises in the context of the multiple well farmout. In Revenue Rul-
ing 80-109, the IRS denied deduction of 25% of IDCs incurred by a farmee
who entered into a farmout agreement to drill wells on two noncontiguous
tracts in exchange for 100% of the working interest in each tract until the
aggregate income from both tracts equaled payout, after which the farmee
was entitled to a 75% working interest in each tract. 34 1 The IRS reasoned
that because it was possible that one of the properties would pay out for the
other, the complete payout principle was not satisfied. 342 The basket payout
problem can be avoided by drafting the payout provision of the multiple well
farmout agreement so that payout is determined on an individual well
343
basis.

339. One could conceivably view a substitute well as a continuation of initial drilling opera-
tions, however, particularly when the farmee is obligated to drill the substitute well. See, e.g.,
Holt Oil & Gas Corp. v. Harvey, 801 F.2d 773, 780-81 (5th Cir. 1986) (sidetracking operation
part of drilling of initial well under art. VI.A. of 1977 Model Form Operating Agreement).
Article VI.B.4 of the 1982 Model Form Operating Agreement attempts to clarify the
ambiguity.
340. The term "basket payout" is used to describe the situation where the revenues from
more than one well are used to compute payout. Brand, Acreage Contribution Trades,
LANDMAN, May 1982, at 16.
341. Rev. Rul. 80-109, 1980-1 C.B. 129.
342. Id.
343. The following is a well-by-well payout provision:
For these purposes, "payout" shall be deemed to occur when proceeds or mar-
ket value of production from any well completed on the above described lands,
(after deducting production taxes, royalty, overriding royalty and like burdens)
1987] FARMOUT AGREEMENTS

8. ProportionateReduction
Farmout agreements generally contain proportionate reduction clauses for
the same reason that they are found in oil and gas leases. In leases, the
proportionate reduction clause protects the lessee against having to pay
more than the percentage of royalty and the amount of other lease payments
bargained for. 34 4 If the lessor owns less than 100% of the mineral interest,
the clause will proportionately lessen his royalty. In a farmout agreement,
the proportionate reduction clause works to reduce the farmor's retained
nonoperating interest and the working interest to which it may be converted
if the farmor owns less than the percentage lease interest that it purportedly
has farmed out.
Proportionate reduction clauses in leases and farmout agreements also in-
volve much the same interpretative problems. The most common dispute is
whether the parties intended that the proportionate reduction clause should
apply in a particular situation. A farmout agreement typically deals with
three "blocks" of property interests of different sizes and types belonging to
the farmor. One block is the interest farmed out to the farmee. The second
block is the nonparticipating interest reserved. The third is the interest to
which the nonparticipating interest reserved converts after payout. An
agreement can define all of these blocks as "net" percentages, without pro-
portionate reduction, or it can state them as "gross" numbers, subject to
proportionate reduction. Disputes arise when the parties mix these
situations.
Consider a situation in which a farmor signs a farmout agreement pur-
porting to farm out 100% of the working interest, subject to a 6.25% over-
riding royalty interest convertible to 50% of the working interest after
payout, but the farmor only owns a 25% working interest. The stage is set
for trouble if proportionate reduction provisions do not specifically apply to
all three interests. If the proportionate reduction provision does not apply
specifically either to the overriding royalty reserved or to the after-payout
conversion right of the farmor, the farmee may find the economics of its deal
substantially less attractive than it originally anticipated. If proportionate
reduction does not apply to the interest farmed out, and the farmor has war-
ranted title, the farmor may be liable.
The drafting technique is easy to state, but difficult to apply consistently.
The technique requires either that the farmout state all three of the farmor's
interests, the leases farmed out, the nonoperating interest reserved, and the

shall equal 100% of Second Party's actual cost of drilling, testing, equipping and
completing the well, including the actual cost of any reworking, deepening or
plugging back, plus 100% of the actual cost of operation of the well; the pro-
ceeds of production and the cost of such development and operation to be attrib-
utable only to the undivided interest subject hereto if less than the full interest in
the oil and gas. Payout shall be determined and the option shall be exercised
separately as to the proration unit aroundeach well drilledon the above described
land.
(Emphasis added.)
344. J. LOWE, supra note 9, at 251.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

after-payout conversion, in gross and then proportionately reduce them, or

3 45
that all three interests be stated as "net" and none be reduced.

D. Administration
Farmout agreements may include a variety of administrative provisions.
Administrative provisions are not generally essential to the structure of the
contract; the parties could perform under a farmout agreement if they were
omitted entirely. Properly drafted administrative provisions make the par-
ties' relationship under the agreement smoother, however, and may be cru-
cial to the business success of the agreement. Administrative provisions may
be as important in particular situations as any of the essential issues of
farmout agreements.

1. OperatingAgreement
Because the farmor and the farmee are likely to end up owning working
interests in a producing well or in leases that they may jointly develop, oper-
ating agreements accompany most farmout agreements. 346 The parties often
attach an operating agreement as an exhibit to a farmout agreement.3 4 7 The
parties may also incorporate the operating agreement by reference or refer to
348
it in an agreement to agree.

345. The most common way of stating proportionate reduction provisions in farmout
agreements is to provide that the farmout covers, and the farmee can earn, "all of Farmor's
right, title and interests" in operating rights and working interests in specified leases, and then
to provide for proportionate reduction of the overriding royalty reserved and the working
interest to which it may be converted in separate provisions. "Cleaner" draftsmanship would
include a single proportionate reduction provision applicable to all three blocks of property
interests.
346. Of course, if the farmor retains only a nonconvertible nonparticipating interest such as
an overriding royalty, an operating agreement is not necessary.
347. For example:
Farmor and Farmee agree to execute an Operating Agreement, in the same form
as the instrument attached hereto as Exhibit B, which shall govern the conduct
of operations pertaining to the Earning Well. Except as otherwise expressly pro-
vided in this Agreement, the terms and provisions of the Operating Agreement
shall apply to and govern the rights and obligations of the parties with respect to
all of the land included in the Drilling Unit for such well, the Leases included in
such Unit, the Earning Well drilled thereon, the production therefrom, and the
rights and obligations of the parties relating thereto, and shall be effective as of
the date of commencement of operations for drilling the well with respect to
which the Operating Agreement is executed. In the event of a conflict between
the terms and provisions of the Operating Agreement and this Agreement, then
the terms and provisions of this Agreement shall prevail and control. Any delay
in executing the applicable Operating Agreement shall not prevent it from con-
trolling the rights and obligations of the parties, and in such event the parties
shall have the same rights and obligations as if the applicable Operating Agree-
ment had been timely executed.
(Emphasis added.)
348. For example:
If Farmor elects to exchange its reserved overriding royalty interest for a lease-
hold interest as provided for in Paragraph - above, then from the effective date
of such exchange any and all further operations on the lands covered by the
assigned lease(s) shall be pursuant to the terms of a mutually acceptable operat-
ing agreement which shall (a) designate you as operator; (b) use an identical
1987] FARMOUT A GREEMENTS

An issue that the parties must address is when the operating agreement
should become effective. The more common approach makes the operating
agreement effective at the time that the farmor and the farmee become coten-
ants of the working interest. That may be after drilling of the earning well
when the farmee earns an interest as a cotenant with the farmee in acreage
outside the drill site. When the farmee earns no interest in outside acreage,
the operating agreement may become effective only when the farmor's re-
349
tained nonparticipating interest in the well converts to a working interest.
Another approach makes the operating agreement effective from the exe-
cution of a farmout, insofar as it does not conflict with the farmout agree-
ment. 350 This approach is appropriate when the farmee pays less than all
the costs of drilling in return for a proportionate part of the working interest
or when a conditional transfer occurs at the time the farmor and the farmee
sign the agreement. Even when the farmor and the farmee are not co-own-
ers, this approach offers the advantage of applying to what is often a very
informal agreement the very detailed provisions of the model form operating
agreement. The detailed provisions may not fit, however, and the farmor
and the farmee may disagree as to whether they apply. Moreover, making
the operating agreement effective upon execution of the farmout increases
the risk to the farmor of vicarious liability. 35'

2. Handling Lease Payments

An administrative problem that most farmout agreements address is
whether the farmor or the farmee is to make payments that may come due
under the farmed-out leases. The most common structure provides that the
farmor will make all payments until the earned interest is assigned, subject

accounting procedure as that attached hereto as Exhibit _, except that the ad-
justment of overhead rates provided for in said accounting procedure shall be
adjusted from the date of this Agreement and (c) provide for a 300% cost re-
coupment provision for non-consent operations through the wellhead.
(Emphasis added.)
349. The following is an example of a clause providing that the operating agreement will
become effective only when the farmee and the farmor become cotenants:
The Joint Operating Agreement attached hereto as Exhibit "C" and by refer-
ence made a part hereof will become applicable to all the Subject Lands to the
depth provided in the assignment as provided in this agreement as follows:
A. As to the Earning Test Well Site in which a Farmor may elect to convert its
reserved overriding royalty interest to a working interest as provided in
§ 11.2(b) above, upon the election of such Farmor to so convert.
B. Immediately upon Farmee receiving an assignment of interst as herein pro-
vided as to all other of the Subject Lands and Subject Leaseholds.
In the event of a conflict between the provisions of this Farmout Agreement
and the Joint Operating Agreement attached hereto as Exhibit "C", the provi-
sions of this Farmout Agreement shall control; provided that the provisions of
the Operating Agreement concerning payment of rents, royalties, expenses, con-
struction costs, drilling and exploration costs, judgment claims, liabilities, and
liens and defense of lawsuits, and any other costs or liabilities incurred in respect
of operations conducted pursuant to such Operating Agreement shall control
with respect to such operations.
350. See supra note 347.
351. See infra text accompanying notes 406-38.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

to total or partial reimbursement by the farmee. 352 This structure makes

administrative sense even when the farmor assigns the interest upon execu-
tion of the agreement rather than after the drilling of the earning well. The
risk of losing a lease as a result of making improper payment of delay rentals
or shut-in royalties is minimized by having the farmor, which already has
the leases "set up" on its administrative records, continue to make pay-
ments. Of course, the parties may agree to the contrary, as for example
when the farmor is farming out and withdrawing from the active conduct of
business.
A related issue is what liability, if any, the farmor has if loss of title results
from the farmor's failure to make lease payments properly. Farmout agree-
ments usually disclaim any liability by the party handling the payments for
loss of title as a result of a failure to make payments properly. 353 The ration-
ale for limiting liability is that administration is undertaken as an accommo-
dation, rather than for a profit from the administrative activity.

3. Compliance with Leases

Farmout agreements typically include general language obligating the
farmee to comply with all express or implied covenants of the leases farmed
out. 354 The genesis of such language is probably the farmor's concern that
courts will classify the transaction as a sublease so that the farmor will re-
main liable to its lessors for breach. 3 55 A farmee should be aware that such

352. For example:

Farmors shall continue to pay delay rentals or shut-in royalties coming due after
the date of this Agreement required to maintain in force any of said leases, and
until completion of the Initial Earning Well or the earlier termination of
Farmee's rights hereunder, Farmee shall within thirty (30) days after receipt of
billing by Farmors reimburse them for 50 percent of any delay rentals or shut-in
royalties so paid. Farmors shall also make any and all shut-in royalty payments
that may become due to perpetuate any of said leases on which the Initial Earn-
ing Well is drilled hereunder, and will furnish Farmee within thirty (30) days
from the date thereof copies of receipts evidencing timely payment. Farmee will
reimburse Farmors for 100 percent of such shut-in royalty payments made with
respect to the Initial Earning Well. Delay rentals and shut-in royalties payable
with respect to said leases (other than those within the spacing unit containing
the Initial Earning Well) following the completion of the Initial Earning Well
shall be borne 50 percent by Farmors and 50 percent by Farmee and shall be
paid as provided in the Operating Agreement.
353. Scott, supra note 3, at 86, 10. This provides that: "Farmor shall pay any delay
rentals, shut-in royalties or minimum royalties which may become due. . . [but] Farmor shall
never be liable as a result of any failure to make such payments, or portion thereof, in a proper
and timely manner." Id.; see also supra text accompanying notes 114-17 (discusses case with
similar clause).
354. For example:
Assignee hereby assumes and agrees to comply with all obligations and cove-
nants, express or implied, imposed upon the lessee in the herein above identified
Leases or contained in any intermediate assignments thereof insofar as concerns
the interests and premises included in this Partial Assignment, and agrees to
indemnify and save harmless Assignor from any risk, liability or expense of
whatsoever kind accruing thereunder from and after the effective date hereof.
355. A farmout may well be classified as a sublease because of the rights that the farmor
retains. See Klein & Burke, supra note 3, at 486-88. If so, the farmor may remain liable to its
original lessor for breach by the farmee on a theory of privity of estate despite the language
1987] FARMOUT AGREEMENTS

language may impose upon it a risk of loss of its rights under the farmout,
especially when the agreement requires absolute performance in order to
35 6
earn.

4. Abandonment and Takeover

Most farmout agreements contain provisions requiring the farmee to give
notice of its intention to abandon a well that it is drilling or operating, and
allowing the farmor to elect to take over operations. The reason for aban-
donment and takeover provisions is that commencement of drilling opera-
tions or production is a substantial potential benefit to the farmor, which the
farmor does not want to lose because of premature abandonment by the
farmee. Abandonment and takeover provisions give the farmor a second
chance to drill or operate the farmed-out property.
The abandonment clause commonly provides that the farmee has the right
to abandon, if the farmee gives notice of its intent to abandon. 35 7 When this
approach is taken, the clause usually gives the farmor a specific period of
time after receipt of notice within which to express its consent or to elect to
take over. Consent is implied after the time has run.
The farmee should note carefully the timing and procedures set forth for
notice, because failure to comply will likely result in liability. 358 In addition,

found in most oil and gas leases relieving the lessee of liability to the lessor after assignment of
its interest.
356. See supra text accompanying notes 259-62.
357. The following provisions of § 5.1 of the draft AAPL Form 635 farmout agreement are
typical:
In the event any farmout well is completed as non-productive of oil or gas, or as
one not capable of producing oil and/or gas in paying quantities or ceases pro-
duction, farmee shall immediately give farmor written notice of the proposed
plugging and abandonment. Farmor shall have thirty (30) days after receipt of
such written notice within which to elect to take over the well for the purpose of
conducting additional operations as it desires; except that if a drilling rig is on
location, notice to plug and abandon may be given by telephone and farmor's
response shall be limited to forty-eight (48) hours, exclusive of Saturday, Sunday
and legal holidays. In the event farmor fails to advise farmee of its respective
election within the predescribed period of time, then such well shall be plugged
and abandoned by farmee in accordance with the terms hereof. Farmor shall
have the right to take over such well using so far as necessary, at farmor's ex-
pense, the tools and workmen of farmee. Farmor shall pay reasonable salvage
value of material and equipment in and on said well, less the cost of salvaging
same and acquire said well for its own use and purposes.
The preceding language might not give the farmor the right to take over a well that the farmee
abandoned before completion, for example, a well that the farmee abandoned under the escape
provisions of the farmout agreement. The following language would avoid that limitation:
Neither the Earning Test Well nor any Substitute Well shall be abandoned with-
out the prior written consent of farmor first had and obtained or without forty-
eight (48) hours prior notice having been given by farmee to farmor. Farmor
may elect within said forty-eight hour period to examine and make tests of said
Earning Test Well or a Substitute Well at its sole cost and risk. Farmor may
within said forty-eight hour period or prior to the conclusion of its tests, which-
ever occurs later, but in no event later than three days after its receipt of notice
from farmee, elect to take over from the farmor, said Earning Test Well or a
Substitute Well so examined . . ..
358. Cf Gladys Belle Oil Co. v. Turner, 12 S.W.2d 847, 848-49 (Tex. Civ. App.-Austin
1929, writ ref'd) (oil company held liable for a failure to reassign lease as contract required).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

the farmee will prefer that the takeover provisions relieve it of liability for
the cost of rig time and plugging. Also, the farmee will want payment for
the value of salvageable equipment that it leaves in the hole or on the lease
after a takeover by the farmor 3 5 9 The farmor must examine the notice pro-
visions carefully to insure that it has adequate time to make a decision about
taking over the well, and that it can man an operation it takes over within
the time provided.

5. Reassignment Provisions
The obligation of the farmee to reassign the lease rights subject to the
farmout agreement goes hand in hand with the right of the farmor to take
over drilling operations and the right of the farmee to abandon drilling or
operations. If the farmout is of the conditional assignment form, reassign-
ment provisions are necessary to clear title, even if the assignment is struc-
tured as a determinable interest that automatically terminates if the farmee
does not perform. 360 Reassignment is particularly important if the original
assignment was recorded. Even if the farmout is of the agreement to transfer
form, release and reassignment of rights that may have been earned are de-
sirable to bar title claims at a later date. The reassignment clause may also
become important when the lease farmed out has ceased to produce in pay-
ing quantities. If the farmee decides not to work over, recomplete, or redrill,
the farmor may wish to get back its operating rights so that it may act, but
may not feel safe in asserting the right to operate without formal
36
reassignment. 1
Gladys Belle Oil Co. v. Turner 362 illustrates the role of the reassignment
clause. In Gladys Belle the court held a company that failed its reassignment
obligation liable for damages equal to the value of the leases that should have
been reassigned. 363 The farmout agreement provided that "ifthe [farmee]

See infra text accompanying notes 362-65. Proof of damages would be difficult, since a well
that the farmee decides to abandon probably has little demonstrable market value. Arguably,
however, a court might measure the damage as the cost of drilling a well to the depth at which
the farmee abandoned operations. See Fite v. Miller, 196 La. 876, 200 So. 285, 289-90 (1940);
Ardizonne v. Archer, 72 Okla. 70, 178 P. 263, 265-66 (1919).
359. Glass, supra note 3, at 16. For appropriate language, see supra note 357.
360. The well takeover clause often includes reassignment provisions. For example:
"Farmee shall, if requested to do so by Farmor, reassign said lease acreage insofar as it covers
the portion being surrendered, expiring or abandoned to Farmor free of any encumbrances
suffered by, through or under Farmee." Or the clause may provide:
We shall thereafter [after notice] have the portion for thirty (30) days to require
you to make a reassignment of the assigned premises or that portion thereof that
you wish to surrender or abandon. Such reassignment shall be free and clear of
all lease burdens, overrides and payments out of production in excess of or in
addition to those previously existing.
361. Of course, if the farmor and the farmee have operated the producing property as
cotenants, the operating agreement reassignment provisions will apply. See, e.g., art. VIII.A.
of the 1982 AAPL Model Form Operating Agreement.
362. 12 S.W.2d 847 (Tex. Civ. App.-Austin 1929, writ ref'd); see also McLaughlin v.
Ball, 431 S.W.2d 305, 306-07 (Tex. 1968) (suit by assignor against assignee of oil and gas leases
for failure of assignee to give assignor written notice of assignee's election to surrender leases
resulting in assignor being denied opportunity to reacquire leases).
363. 12 S.W.2d at 848-49.
1987] FARMOUT AGREEMENTS

should desire . . . to surrender any of said leases or not to prosecute devel-

opment . . . he will reassign said lease or leases . . . not less than ninety
days before [they] will expire . . . . -364 Both the farmor and the farmee
assigned their interests. Ultimately, the farmee's assignee permitted one of
the leases to expire, and the farmors' assignees sued. The appellate court
sustained damages awarded by the trial court, noting that though the parties
to the suit were not in privity of contract, the rights and obligations created
by the contract were independently assignable. 365 The reassignment clause
is not mere space filler.
Generally, reassignment provisions require that the farmee represent that
the leases reassigned are free of liens or warrant clear title except as to clouds
that existed before the farmee took the property. 366 This approach is consis-
tent with the obligations typically imposed upon a farmee to "conduct oper-
ations at no cost to the farmor" and to indemnify the farmor against loss.
Some farmout agreements have no reassignment provisions, however, rely-
ing upon the abandonment and takeover provisions alone. Specific reassign-
ment provisions can be classified into at least three different general forms:
(a) perpetual assignment with reassignment obligation, (b) automatic rever-
sion, or (c) reversion by declaration. Each may present problems.

a. PerpetualAssignment with Reassignment Obligation

The most common reassignment form is a contractual obligation to reas-
sign, like that in Gladys Belle Oil Co. v. Turner.367 The advantage of such a
formulation, particularly when it is coupled with an assignment placed of
record, is that it imposes upon the farmee the duty to plug an abandoned
well and restore the premises. 368 The disadvantage of a contractual obliga-
tion to reassign is that the farmor may have difficulty compelling the farmee
to reasign, particularly if the farmee has subleased or assigned interests to
others.

b. Automatic Reversion
A second common formulation is to draft the reassignment provision so
that the farmed-out interests revert automatically to the farmor if the farmee
abandons or ceases production. 369 One problem with this approach is that

364. Id. at 847.

365. Id. at 849.
366. See supra note 360.
367. See supra text accompanying note 362. For the language of an example clause, see
supra note 360.
368. Of course, the agreement of the farmor and the farmee as to responsibility for plug-
ging or restoration will not preclude the state from asserting its police powers to the contrary.
See infra text accompanying notes 436-38.
369. For example:
[The assignment shall] [b]e effective as of the date of well completion and pro-
vide for reversion to Farmor of all rights assigned upon the earlier of (a) thirty
(30) days after cessation of all production from or allocated to the assigned
premises unless production is restored or operations for restoration of produc-
tion are commenced within the thirty (30) days and production is restored
within a reasonable time after commencement of such operations, (b) forty-five
 SOUTHWESTERN LAW JOURNAL [Vol. 41

terms like "abandonment" and "cessation of production" may not have

clear meanings, and litigation may result. Furthermore, the right of rever-
sion may expose the farmor to liability for plugging or restoration just as
370
surely as owning a contractual right to reassignment.

c. Reversion upon Declaration

A theoretical drafting alternative is to provide that after no production for
some specific time, or after production has fallen to some agreed level for a
specific time, the farmor can cause the farmed-out interest to revert to the
farmor by filing a declaration of reversion. Language similar to that found
37
in lease pooling clauses might be used. '

6 Area of Mutual Interest Provisions

Because the farmor and the farmee become "economic partners" under a
farmout agreement, farmouts sometimes include "area of mutual interest"
provisions, usually referred to as "AMI provisions." An AMI provision
gives the farmor and the farmee the right to share in interests acquired by
the other in a designated contract area, which may be the same as or larger
than the farmout contract area, upon agreed terms. 372 AMI clauses are par-

(45) days prior to any lease termination, or (c) the shut-in of the last producing
well on the assigned acreage for more than one (1) year. Farmee shall evidence
the reversion by a reassignment to Farmor, free and clear of all liens, claims or
encumbrances, except those existing at the date of this agreement; provided,
however, the reversion shall be effective whether or not Farmee reassigns to
Farmor.
(Emphasis added.)
370. See infra text accompanying notes 434-38.
371. There are practical difficulties, however, with providing for reversion of the farmee's
interest upon the filing of a declaration by the farmor. First, since the procedure is not specifi-
cally authorized by statute, it may merely cloud title. Second, recording officers may refuse to
accept such declarations or refuse to index them where they will appear in the chain of title.
Perhaps the most workable method of obtaining reassignment at the will of the farmor is to
have the reassignment executed and delivered to the farmor at the time of the initial assign-
ment, subject to the understanding that it will be recorded only upon default. It is likely that
few farmees will agree to this, however.
372. An example of an area of mutual interest clause follows:
Article X. (a) If either farmor or farmee acquire, during the period from exe-
cution of this agreement to the expiration of one year from the completion of the
last earning well (i.e., either the initial earning well or a subsequent earning well)
under this agreement, any oil and/or gas interest or right to acquire such inter-
est in lands within the Area of Mutual Interest depicted on Exhibit "A" hereto
and within a spacing unit containing a well drilled or proposed to be drilled
under this agreement and containing a portion of Said Leases, the acquiring
party shall offer the non-acquiring party, in the manner provided for in Article
XV.F. of the operating agreement, an undivided 50 percent so acquired to the
extent contained within such spacing unit. All operations on any such interest
in which the non-acquiring party elects to participate shall be governed by Ex-
hibit "C" hereto and the operating agreement.
(b) If during the period described in Article X.(a) above either farmors or
farmee acquire any oil and/or gas interest or right to acquire such interest in
lands within the boundaries of the area of mutual interest and outside all spacing
units containing wells drilled or proposed to be drilled under this agreement,
then (i) if the interest is acquired by purchase, the acquiring party shall offer the
non-acquiring party an undivided 50 percent of the interest so acquired and
1987] FARMOUT AGREEMENTS

ticularly common in exploratory farmouts.

Area of mutual interest provisions are not peculiar to farmout agreements,
and have been the subject of analysis elsewhere. 373 Two particularly impor-
tant problems should be noted in this discussion of farmout agreements,
however. One is whether an AMI provision that is not limited in time vio-
lates the rule against perpetuities. A Kansas case holds that an area of mu-
tual interest agreement is purely contractual, that it is not subject to the rule
against perpetuities because it creates no rights in real property. 374 An AMI
clause in a farmout may also be held to be within an exception to the rule for
options to extend leases, if it is viewed as impliedly limited to the duration of
the leases. 375 However, it has been argued that a perpetual AMI might well
violate the rule, so that the AMI provision should be specifically limited in
376
time.
A second and more practical concern to one drafting or analyzing an AMI
clause in a farmout agreement is what land or leases are to be subject to the
AMI provision. The parties should specifically define the geographical area
to which the AMI applies. In addition, the clause should address what
kinds of interests are subject to the mutual interest provisions. Are surface
interests, mineral interests, and royalty interests to be covered as well as
leasehold interests? What about property acquired that may be partly within
and partly outside of the contract area? Finally, the provision should ad-
dress whether, if the farmor or the farmee acquires several properties at
once, the election to acquire will apply to the package as a whole or permit

(ii) if the interest is acquired by farming or other agreement requiring the drill-
ing of a well or performance of other act besides the payment of money in order
to earn or acquire the interest, the acquiring party shall offer the non-acquiring
party an undivided percentage interest in the acquisition sufficient to vest 25
percent thereof in farmors and 75 percent thereof in farmee. Such offer shall be
made and accepted in the manner provided in Article XV.F. of the operating
agreement. All operations on any such interest in which the non-acquiring
party elects to participate shall be governed by Exhibit "C" hereto [drilling,
geological, and engineering requirements] and the operating agreement.
In the absence of a specific AMI provision, the courts will not likely give either the farmee or
the farmor the right to share in interests or leases acquired on adjacent acreage. See Opco v.
Scott, 321 F.2d 471, 472-73 (10th Cir. 1963). But see Smith, Duties and Obligations Owed by
an Operator to Nonoperators,Investors, and Other Interest Owners, 32 ROCKY MTN. MIN. L.
INST. 12-1, 12-49 to -57 (1986).
373. See Zarlengo, Area of Mutual Interest Clauses Regarding Oil and Gas Properties:
Analysis, Drafting, and Procedure,28 ROCKY MTN. MIN. L. INST. 837, 837-83 (1982) (check-
list for analysis and drafting).
374. First Nat'l Bank & Trust Co. v. Sidwell Corp., 234 Kan. 867, 678 P.2d 118, 127
(1984) (quoting Courseview, Inc. v. Phillips Petroleum Corp., 258 S.W.2d 391, 393 (Tex. Civ.
App.-Galveston 1953, writ ref'd n.r.e.), rev'd and remanded on other grounds, 298 S.W.2d
890 (Tex. Civ. App.-Galveston 1957), modified, 158 Tex. 397, 312 S.W.2d 197 (1958)).
375. See Zarlengo, supra note 373, at 850, discussing the exception of the RESTATEMENT
OF PROPERTY § 395 (1944).
376. Id. Zarlengo, supra note 373, at 849-50. For specific language that limits the AMI
agreement to one year after completion of the last earning well, see supra note 373. If the
farmout agreement specifies a completion date for the earning well, such language almost cer-
tainly will comply with the rule against perpetuities. If there is no specific completion date,
however, a well commenced possibly could not be completed within the perpetuities period.
An interesting subissue of AMI clauses, if the clause violates the rule against perpetuities, is
whether the clause is void or whether the whole farmout agreement is void.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

the nonacquiring party to pick and choose among the properties. 37 '

7. Restrictions upon Assignment

Farmout agreements often include restrictions upon assignment. From
the farmor's view, a restriction may be a practical necessity. The farmor,
having located a farmee that it considers skilled, trustworthy, and solvent,
wants to be certain that the rights given by the farmout are not transferred
to a farmee that possesses none of those attributes. If the farmor wishes to
restrict assignment of rights under the farmout, it must do so specifically and
unambiguously.3 78 Courts will strictly interpret restrictions, 379 and will not
3 80
imply them from the terms of a reassignment clause in the farmout.
The farmor may pay a price for restricting assignment, however. Usually
the farmor's goal is to get a well drilled on the farmed-out acreage. To the
extent that the restriction against assignment makes it difficult for a farmee
to raise money by assigning interests, it may be counter-productive. 38 1
Thus, the parties may choose to make the rights of the farmee freely assigna-

377. Zarlengo, supra note 373, at 872-76.

378. Probably the most common formulation is a flat proscription. For example: "This
Agreement shall not be assigned in whole or in part by Farmee without the prior written
consent of Farmor." Some proscriptions of assignment are more specific, probably in an at-
tempt to avoid an implied limitation of "reasonableness":
No provision of this agreement or of any assignment [lease] made or issued here-
under shall be modified, altered or waived except by the express written agree-
ment of Farmor. This agreement is personal to Farmee, and Farmee shall have
neither the right nor the power to assign this agreement, in whole or in part, to
another party without the express prior written consent of Farmor thereto.
Likewise, Farmee shall have neither the right nor the power to assign any inter-
est, in whole or in part, under any assignment [lease] made or issued pursuant
hereto without the express prior written consent of Farmor thereto. Farmor
may withhold its consent to any such proposed or attempted assignment for any
reason or no reason in the sole discretion of Farmor. Any attempted assignment
made in contravention of this provision shall be, at Farmor's sole option (and in
addition to any other remedy available to Farmor at law or in equity), voidable
and of no force and effect. The granting of consent by Farmor to any such
assignment shall be effective only as to the specific assignment then the express
subject of such consent, and all subsequent assignments which may be proposed
or attempted shall likewise be expressly subject to the hereinabove stated and
reserved rights, power and authority of Farmor.
Some parties have couched proscriptions in affirmative language, though their effect is still to
limit: "This AGREEMENT shall inure to the benefit of and be binding upon the Parties
hereto and their successors and assigns; provided, however, Farmee shall make no assignment
of its rights hereunder without Farmor's prior written consent."
379. Gladys Belle Oil Co. v. Turner, 12 S.W.2d 847, 848-49 (Tex. Civ. App.-Austin 1929,
writ ref'd). A reassignment clause in a farmout provides that the farmee will reassign to the
farmor any leases transferred under the agreement that it decides to surrender or not to de-
velop. See supra text accompanying notes 360-71.
380. See Rainbow Oil Co. v. Christmann, 656 P.2d 538, 546-47 (Wyo. 1982). In Rainbow
Oil Co. the court held that a right of first refusal included in a farmout agreement obligating
the farmees to offer to sell the interest earned back to the farmor if the farmees "shall elect to
sell their interest" was not triggered by a company officer's transfer of interests to his company
in satisfaction of his fiduciary obligations or by a gift to one of the farmees' children. Id. at
543-44. In Palmer v. Liles, 677 S.W.2d 661 (Tex. App.-Houston [1st Dist.] 1984, writ ref'd
n.r.e.), the court held that a restriction on assignment without written consent did not create a
right of first refusal, but merely gave rise to a claim for actual damages suffered. Id. at 663.
381. Glass, supra note 3, at 15.
1987] FARMOUT AGREEMENTS

ble, 38 2 to permit assignment to identified parties, 383 to permit assignment

when the proposed assignee is financially strong, 384 to permit assignment
when it is likely to be conducive to getting the property drilled, 385 or to limit
3 86
the restriction in time.
In addition, the farmor faces a risk that courts will regard a broadly

382. A clause that permits assignment, but specifically keeps the original farmee obligated
to the farmor is:
The rights hereunder may be assigned in whole or in part by Farmee, but, prior
to the date when an assignment or lease is earned hereunder, if Farmee assigns
an interest in the Farmout Interests pursuant to this letter agreement, Farmee
shall remain liable to Farmor and Farmorshall have the right to look solely to
Farmee in connection with any cause of action it may have with respect to this
agreement, to the same extent as if such assignment had not been made by
Farmee.
(Emphasis added.)
383. The following is an example of a clause that permits assignment to identified parties:
This Agreement shall not be assigned in whole or in part . . . . However,
Farmor specifically agrees to allow Farmee to make an assignment to its partici-
pants in the __ Exploration Program, namely, . These partici-
pants currently share in all costs and liabilities of the Program with Farmee.
Also, Farmor agrees to allow __ to make an assignment to an affiliate.
When such language is used, the agreement should define "affiliate."
384. The following language addresses financial suitability as a basis for permitting
assignment:
Farmee shall not assign, transfer or otherwise dispose of any rights hereunder
without first obtaining written consent from Farmor; provided however that
Farmor shall neither unreasonably deny or delay its assent to such request if
Farmee satisfies Farmor that its proposed assignee exercises at least the same
degree of financial responsibility as Farmee. This agreement shall be binding
upon and inure to the benefit of the parties hereto and their respective heirs,
successors and assigns.
385. For example:
The following assignments, conveyances and successions of a Farmee's rights
and interests under this Agreement may be effected without the prior written
consent of Farmor, to-wit:
(i) a conveyance by reason of the death or legal incapacity of a party compris-
ing Farmee;
(ii) a conveyance to a spouse or issue of a party comprising Farmee;
(iii) a conveyance to a trust for the benefit of a spouse or issue of a party
comprising Farmee;
(iv) a transfer to another party comprising Farmee;
(v) a transfer to a joint venture or partnership (general or limited) of which a
party comprising Farmee is a member and has the sole authority, irrevoca-
bly during the term of such entity, to act for such entity with respect to the
properties that are the subject matter of this Agreement.
All other assignments, conveyances and successions of a Farmee's rights and interests under
this Agreement shall be effected only with the prior written consent of Farmor, which consent
will not be withheld unreasonably.
386. A restriction limited in time follows:
Assignee agrees not to assign, either in whole or in part, its interest in said land,
or in the oil or gas to be produced therefrom, without the written consent of
Assignor, the restriction to be effective for fifteen (15) years from the date hereof
Any assignment shall contain a limitation requiring that the written consent of
Assignor must be obtained prior to any further assignment. No such assignment
or assignments, although made with the written consent of Assignor, shall sub-
ject said land or any portion thereof, to any overriding royalty, payments out of
production, net profit obligation, carried interest or any other obligation in addi-
tion to those created under the terms hereof.
(Emphasis added.)
 SOUTHWESTERN LAW JOURNAL [Vol. 41

drafted restriction upon assignment as an unenforceable disabling restraint

against alienation.3 8 7 Most lawyers look to landlord and tenant law as they
draft restrictions on assignments in farmout agreements, reasoning that the
farmor's interest in restricting earning rights under the farmout and operat-
ing rights after the farmed-out acreage has been earned is as important as the
identity of the tenant to a landlord. 388 The analogy overlooks the fact that
the nature of an oil and gas lease differs from a real property lease. The
former is either a fee simple determinable estate in land or a determinable
profit A prendre or license, rather than a mere term of years. Courts are
more likely to tolerate restrictions upon alienation that will eventually termi-
nate than those that may be perpetual. 38 9 Though no court appears to have
thoroughly discussed the issue, a Canadian commentator has argued that
broad restrictions on assignment in farmout agreements should not be
390
enforceable.
A step short of declaring restrictions upon assignment to be invalid disa-
bling restraints is to reason that they are not covenants running with the
land, but mere personal service covenants. When this characterization is
adopted, restrictions upon assignability are valid only as to executory con-
tracts, because after performance "the contract is no longer one for personal
services and the reason for non-assignability no longer exists." '39 1 Following
this reasoning, the Tenth Circuit upheld an order requiring specific perform-
ance of a promise to convey acreage under a farmout in Socony Mobil Oil Co.
v. Continental Oil Co. 392 when the farmee's assignment to which the farmor
393
objected took place after the earning well had been drilled.
Something less than a complete proscription can, in most cases, meet the
farmor's interest in restricting assignability. The parties can restrict assign-
ment until the farmee performs the farmout contract, but permit it thereaf-
ter, since the interests of the farmor are most acute while drilling is

387. A disabling restraint is one that expressly denies the grantee the power to transfer the
estate or declares any attempt to transfer automatically void. Except when used in spendthirft
trusts, disabling restraints are always held void. R. BERNHARDT, REAL PROPERTY IN A NUT-
SHELL 77 (West 1982).
388. RESTATEMENT OF PROPERTY § 410 (1936) provides that:
A promissory restraint or forfeiture restraint on alienation of a legal posses-
sory estate for years is valid if, and only if
(a) the estate for years is created as the result of a business transaction, the
requirements of the rule against perpetuities are satisfied and the re-
straint is
(i) imposed at the time the estate for years is created, or
(ii) agreed to thereafter as a business transaction by the persons who
are in the relationship of landlord and tenant ....
389. RESTATEMENT (SECOND) OF PROPERTY §§ 406, 407, 410 (1973). A limitation upon
the restriction similar to that supra in note 386, therefore, is doubly attractive.
390. Nowack, Restrictions Against Alienation in Agreements Relating to Oil and Gas Inter-
ests, 23 ALBERTA L. REV. 62, 73-74 (1985); see also Scott, Restrictionson Alienation Applied to
Oil and Gas Transactions, 31 ROCKY MTN. MIN. L. INST. 15-1 (1985) (discusses restrictions
on assignment in agreements).
391. Prudential Fed. Sav. & Loan Ass'n v. Hartford Accident & Ins. Co., 7 Utah 2d 366,
325 P.2d 899, 904 (1958).
392. 335 F.2d 438 (10th Cir. 1964).
393. Id. at 442.
19871 FARMOUT AGREEMENTS

progressing. 394 When the farmor's likely reasons for objecting to an assign-
ment can be identified, the farmout agreement can specifically spell out those
reasons, and limit assignment in those circumstances. 395 Assignment may
also be barred subject to the farmor's consent, "which consent shall not be
unreasonably withheld. ' 396 "Reasonableness" limitations should prevent
classification of a restriction upon assignment as a disabling restraint. 397 Fi-
nally, the agreement may permit the farmee to make partial assignments so
long as it remains the operator and legally responsible to the farmor. 398

8 Calls on Production, Options to Purchase, and Prior Commitments

Some integrated oil companies with refining capacity routinely include in
their farmout agreements calls on production, options to purchase, or prior
commitments. A farmor whose purpose in farming out is to obtain reserves
or to acquire access to market may also include these devices. A call on
production gives the holder a right to require another to sell its share of
production to a purchaser designated by the farmor. 399 An option to

394. For example:

It is agreed that the Farmee's rights and interests under this contract shall not
be assigned prior to the time that the Farmee has earned the interest provided
for in this agreement by drilling a conforming well; provided, however, that
after the Farmee has earned an assignment of interest under this agreement, the
Farmor agrees that Farmee may assign the interest so earned in whole or in
part.
395. For example, the following:
Farmee shall not assign any interest in this Assignment until it has given
Farmor notice of the complete details of the proposed transaction and Farmee
has received Farmor's written consent to assign. Farmor will not unreasonably
withhold its consent to assign, but consent may be withheld when Farmor, in its
sole discretion but in good faith, believes such assignment may diminish the
value of Farmor's rights, reservations, and exceptions under this Assignment.
Of course, the more specific the standard the better.
396. For example:
Farmee, for itself, its successors and assigns, covenants and agrees that prior to
the drilling and completion of the Earning Test Well and Farmee's compliance
with the performance of all of the terms and provisions of this agreement, it will
not transfer or assign this agreement without the prior written consent of
Farmor, which consent shall not be unreasonably withheld.
Often, the parties will couple a "reasonableness" limitation with more specific limitations. For
example language, see supra note 385.
397. See RESTATEMENT (SECOND) OF PROPERTY § 406 comment i (1973). This section
includes a list of factors that tend to support a conclusion that a restraint is either reasonable
or unreasonable. Id. Section 407 of the Restatement makes these factors applicable to defeasi-
ble possessory estates in fee. Id. § 407.
398. Glass, supra note 3, at 15; see supra note 382.
399. A very broad call might read as follows:
6.1 Oil Production. Farmor shall have a continuing option to purchase
Farmee's share of oil and liquid hydrocarbons produced and saved from the
Farmout Lands through standard lease separator facilities, to the extent such
production is attributable to the interest assigned to Farmee hereunder. The
option may be exercised by Farmor at any time and from time to time while
such production continues, by giving written notice thereof to Farmee not less
than 30 days before the date on which farmor's purchases are to commence.
The price paid by Farmor for such production shall be equal to the prevailing
wellhead market price then being paid in the same field for production of the
same or similar grade and gravity, or if there is no such prevailing price being
 SOUTHWESTERN LAW JOURNAL [Vol. 41

purchase is more limited. It gives the holder a right to purchase another's

production, but only if the other elects to sell.400 A prior
40 1
commitment binds
both the farmor and the farmee to a sales contract.
Calls on production and options to purchase present drafting problems.
The duration of the call or the option, how and when it may be exercised,
and how to determine the price to be paid for production are issues that the
parties must address as specifically as possible to avoid the objection that the
call or option is an unenforceable agreement to agree. Prior commitments
present similar problems when the contract terms are to be determined later.
All of these devices may present unsettled legal issues. Whether calls on

paid in the same field, the prevailing price being paid in the nearest field.
Farmor may terminate its purchases by giving written notice thereof to Farmee
not less than 30 days before the date of termination.
62 Gas Production. Farmor shall have the option to purchase Farmee's share
of gas, including casinghead gas, produced and saved from the Farmout Lands
through standard lease separator facilities, to the extent such production is at-
tributable to the interest assigned to Farmee hereunder. When Farmee's gas
becomes available for purchase initially and at any time thereafter, Farmee shall
so advise Farmor in writing and Farmor shall have 60 days thereafter to give
Farmee written notice of Farmor's election to purchase the gas at the prevailing
wellhead market price paid for gas at the same or similar quantity and quality in
the same field (or if there is no such price then prevailing in the same field, then
in the nearest field in which there is such a prevailing price) pursuant to compa-
rable purchase contracts entered into on the same or nearest preceding date as
the date of Farmor's election to purchase gas hereunder.
T. FAY, supra note 3, at 57.
400. An option to purchase might read as follows:
Assignor reserves and is hereby given the optional preferential right at any time
and from time to time to enter into a contract to purchase or designate a pur-
chaser for all of Assignee's gas produced from said land, such right to be exer-
cised as follows. If Assignee elects to sell gas production and shall receive a
bona fide offer acceptable to it to purchase such gas production, it shall
promptly furnish Assignor written notice thereof and Assignor shall have ninety
(90) days after receipt of such notice to elect either to enter into a contract to
purchase such gas on the same terms and conditions of such offer, or to desig-
nate a third party purchaser of such gas on either the same terms and conditions
or (in its sole judgment) on more favorable terms and conditions to Assignee,
and if any such third party purchaser is designated, such designation shall be
binding on Assignee. If Assignor fails to notify Assignee within said ninety (90)
day period of its election to exercise such right, then it shall have no right to
exercise said preferential right during the contract term. If Assignor does not
exercise such optional preferential right and for any reason Assignee shall not
thereafter accept said offer, or if Assignee accepts said offer and the resulting
contract expires or is terminated or renegotiated, then the foregoing reservation
of said optional preferential right shall continue in full force and effect and said
optional preferential right shall apply with respect to any new offer or renegoti-
ated offer to purchase gas from said land.
401. An example of a prior commitment clause for gas follows:
All interests in natural gas and casinghead gas presently owned by farmee
within the area of interest, and all interests in natural gas and casinghead gas
hereafter owned, or, controlled by farmee within the area of interest will be
subject to a gas purchase contract with farmor as buyer and farmee as seller, a
copy of which is attached hereto as Exhibit -. Said gas purchase contract is
being executed contemporaneously with the execution of this agreement.
Sometimes the commitment will be to enter into a contract at a later date on terms prevailing
in the market at that time. In such cases, a prior commitment may contain price terms much
like those of the call seen supra note 399.
19871 FARMOUT AGREEMENTS

production or options to purchase create interests subject to the rule against

perpetuities is uncertain. To avoid the issue, some drafters limit calls and
options to the perpetuities period 40 2 and require that the contract to which
production is committed be executed with the farmout. 4 0 3 Another area of
concern is that calls, options, or prior commitments may violate federal or
state antitrust laws. Whether antitrust is a real problem will depend upon
the characteristics of the companies involved, the amount of land subject to
the call, option, or prior commitment, and the competition in the area.
A third unsettled issue is whether a call, option, or prior commitment may
subject the farmor and the farmee to corporate taxation, which would
sharply limit the value of the intangible drilling cost deduction and the per-
centage depletion allowance to both parties, as well as subject them to
double taxation of distributions. A farmout transaction creates an associa-
tion taxable as a corporation if it possesses sufficient corporate characteris-
tics. 4° 4 To avoid corporate taxation, the parties to oil and gas transactions
ordinarily structure the arrangement so that each has the right to take pro-
duction in kind or separately dispose of it. One of the essential characteris-
tics of an association taxable as a corporation is a joint profit objective. 5 If
the parties have the right to take in kind, they have no joint profit objective;
they have separate individual profit objectives. When production is subject
to a call, an option to purchase, or a prior commitment, the farmout agree-
ment does not meet the literal requirements of an association taxable as a
corporation.
Perhaps the reason that calls on production, options to purchase, and
prior commitments do not appear more frequently in farmout agreements,
however, is the chilling impact that they have upon the business deal of the
parties. In the usual situation, neither the farmor nor the farmee wants to tie
up its share of production from the farmed-out property. Each prefers to
reserve the flexibility to sell production at a later time.

9. Liability, Insurance, and Indemnity

The risks inherent in oil and gas drilling are enormous. People may be

402. For example:

We shall have and shall reserve the optimal right for a period of twenty-one (21)
years from the date hereof, to purchase all oil produced and saved from the
lands and leases committed hereto at the prevailing market price; said price is
meant to be that price being paid in the immediate field for oil of like kind,
quality and gravity, in like quantities and under contracts providing for similar
conditions and durations, such price to be determined from month to month.
Some courts might imply a "reasonable" limitation upon the duration of the call. Rex Oil Co.
v. Busk, 56 N.W.2d 221 (Mich. 1953).
403. See supra note 401.
404. Treas. Reg. § 301.7701-2(a)(1) as amended in 1983 lists six corporate characteristics:
associates, a joint profit objective, continuity of life, centralization of management, limited
liability, and free transferability. For minerals transactions, whether title is in the name of one
of the parties may be a seventh factor.
405. I.T. 3930, 1948-2 C.B. 126 and I.T. 3948, 1949-1 C.B. 161 reason that if the parties
have the right to take in kind, there is no joint profit objective. For a discussion of this subject,
see Houghton, Braden & Harris, supra note 59, at 6-8 to -10.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

injured, massive pollution may occur, and great cost overruns are routine.
Therefore, both the farmor and the farmee should be concerned about their
potential liability, and the insurance and indemnity provisions of the
farmout agreement.

a. Liability
The farmor and the farmee may assume that each will be liable only for its
own contracts and torts since the relationship of the parties is no closer than
that of cotenants. Nevertheless, the relationship established under a farmout
agreement may provide grounds for vicarious liability. These include
(i) joint ventures and mining partnerships, and (ii) liability as a record title
owner.

i. Joint Ventures and Mining Partnerships

A joint venture is "a special combination of two or more persons, where,
in some specific adventure, a profit is jointly sought, without any actual part-
nership or corporate designation. ' ' 40 6 It is a partnership for a single transac-
tion. A mining partnership is an association of two or more persons to
jointly conduct a business and to share in the expenses, profits, and losses of
the enterprise. 40 7 It is a cross between a tenancy in common and a true
408
partnership.
The joint venture and mining partnership concepts may be viewed as sepa-
rate40 9 or as indistinguishable. 4 10 Either theory or both may be used to im-
pose liability upon the farmor or the farmee for damages or expenses
incurred in drilling under a farmout agreement. 4 11 The classic case in the
area is Shell Oil Co. v. Prestidge.4 12 In Prestidgethe court held Shell liable as
a joint adventurer for injuries suffered by Prestidge while Shell's farmee
drilled at a site in Idaho. 4 13 The court held that the farmout agreement and

406. Griffin v. Reilly, 275 S.W. 242, 246 (Tex. Civ. App.-Amarillo 1925, no writ).
407. Ellis v. Lewis, 119 Okla. 201, 202, 249 P. 295, 296 (1926).
408. Gilbert v. Fontaine, 22 F.2d 657, 660 (8th Cir. 1927).
409. The primary distinction between a joint venture and mining partnership is that the
former has the characteristic of delectus personae; that is, the death or bankruptcy of one of the
partners terminates a joint venture, and a joint venturer has the right to exercise choice in
admitting new members to the enterprise. In contrast, a mining partnerhsip does not automat-
ically terminate upon death or bankruptcy; the purpose of the relationship is mining, and since
that purpose would be thwarted and the property damaged by debate over new partners, the
mining partnership interest is freely transferable. Munsey v. Mills & Garitty, 115 Tex. 469,
480-89, 283 S.W. 754, 758-62 (1926).
410. In Smith v. Rampy, 198 S.W.2d 592, 594-98 (Tex. Civ. App.-Amarillo 1946, no
writ), the court used the terms interchangeably.
411. Brimmer, Mining Partnerships, 15 ROCKY MTN. MIN. L. INST. 85, 95 (1969). See
generally Boigan & Murphy, Liabilities of Non Operating Mineral Interest Owners, 51 U.
COLO. L. REV. 153, 164-82 (1980) (discusses contract and tort liability of mining partnerships
and joint ventures); Fiske, Mining Partnership,26 INST. ON OIL & GAS L. & TAX'N 187 (1975)
(discusses generally mining partnerships and joint ventures); Jones, Mining Partnershipsin
Texas, 12 TEX. L. REV. 410, 414-31 (1933) (discusses elements of mining partnerships in
Texas).
412. 249 F.2d 413 (9th Cir. 1957).
413. Id. at 416.
1987] FARMOUT AGREEMENTS

the actions of Shell's employee satisfied the elements of a joint venture: a

contract between the parties, substantial contributions to the enterprise, and
4 14
joint control.
A recent unreported case from Oklahoma that imposed liability upon a
nonoperator under an operating agreement on the basis of a mining partner-
ship illustrates how that theory may be used against the parties to a farmout.
In Dresser Industries, Inc. v. Crystal Exploration & Production Co.4 1 5 the
Tenth Circuit Court of Appeals found both the operator and Crystal, a non-
operating working interest owner, liable to pay for services and material pro-
vided by Dresser. 41 6 The court held that a mining partnership requires a
joint interest in the property, an express or implied agreement to share in the
profits and losses of the venture, and cooperation in the project. 41 7 The
court's analysis focused on whether sufficient cooperation existed to impose
liability. 4' 8 The court held that management or conduct of operations by
the nonoperator was not necessary. 4 19 It was sufficient that Crystal:
kept in close contact with Schick [the operator], receiving almost daily
reports; Crystal asked for and received completion procedures prior to
their implementation in order to allow its engineers time to discuss the
procedures with Schick; Crystal made recommendations regarding pro-
cedures with Schick and Schick accepted them; employees of Crystal
visited the location and discussed procedures with Schick and engineer-
ing consultants hired to drill and complete the well. 420
These comments could refer to a farmor's activities under many farmout
42
agreements. '
A realistic assessment of the risk of liability as a mining partner or joint
venturer in a farmout agreement is difficult because precisely what will trig-
ger liability is uncertain. In Blocker Exploration Co. v. FrontierExploration,
Inc.422 the Colorado Supreme Court held that a cotenant of an oil and gas
lease is not liable as a mining partner unless the cotenant takes an active role
in the conduct of operations or the agreement gives the cotenant a right to
participate in management or control. 423 The court stated that "co-owner-

414. Id.
415. No. 84-1160 (10th Cir. July 12, 1985).
416. Id. slip. op. at 6-7.
417. Id. at 4.
418. Id. at 4-6.
419. Id. at 5.
420. Id. at 5-6.
421. Of course, the facts will vary from situation to situation:
If the farmoutor simply waits to be advised of completion of the earning work,
and upon verification makes the necessary assignment, in the absence of any
other involvement, it probably is not a mining partnership. But if the
farmoutor, with or without specific provisions in the agreement, injects himself
into the drilling effort by offering or providing assistance, or exercising influence
or discretion, then he may be committing himself to mining partnership status
with the farmoutee.
Fiske, supra note 411, at 207-08.
422. 740 P.2d 983 (Colo. 1987).
423. Id. at 987.
 SOUTHWESTERN LAW JOURNAL [Vol. 41

ship alone does not give rise to a mining partnership. ' 424 Both Texas and
Oklahoma courts have made similar comments. 425 The Colorado court
noted that:
[A] non-operating working-interest member "should not be considered,
without more, a mining partner if his only rights are to take in kind,
receive reports, inspect books, make an election of whether to join in a
particular phase of exploration/development (commonly known as a
'go-no-go' decision), or has the right of approval of specified
' 426
expenditures.
Quoting the court of appeals, the Colorado Supreme Court held that "the
determining factor is related to the degree of active participationin control or
'427
management of the venture that is exercised by a co-tenant or co-owner.
As a practical matter, the ease with which liability as a mining partner or
joint venturer is triggered may differ from state to state. Oklahoma and Ar-
kansas apparently require less than Colorado and Texas. Oklahoma appar-
ently requires only (1) a joint interest in the property, (2) an agreement to
share in profits and losses, and (3) cooperation in the project to establish a
mining partnership. 428 Arkansas may impose liability upon virtually any
cooperative drilling arrangement on a joint venture theory.4 29 Colorado and
Texas, however, have not embraced the joint venture theory. In Colorado
and Texas a plaintiff who seeks to establish a mining partnership must prove
the right or exercise of "control" over the development of the property,
430
rather than mere cooperation.

424. Id. at 985.

425. See, e.g., Luling Oil & Gas Co. v. Humble Oil & Ref. Co., 144 Tex. 475, 486-87, 191
S.W.2d 716, 722 (1945); Templeton v. Wolverton, 142 Tex. 422, 428, 179 S.W.2d 252, 255
(1944); Rucks v. Burch, 138 Tex. 79, 82-83, 156 S.W.2d 975, 976 (1941); Texas Oil & Gas
Corp. v. Vela, 405 S.W.2d 68, 76-77 (Tex. Civ. App.-San Antonio 1966), rev'd, 429 S.W.2d
866 (Tex. 1968); Nolen v. Rig-Time, Inc., 392 S.W.2d 754, 756 (Tex. Civ. App.-Corpus
Christi 1965, writ ref'd n.r.e.); see also McAnally v. Cochran, 170 Okla. 368, 46 P.2d 955, 957
(1935).
426. 740 P.2d at 988 (quoting the Colorado Court of Appeals in Blocker, 709 P.2d 39, 42-
43).
427. Id. at 985 (emphasis in original) (quoting 709 P.2d at 42).
428. The Dressercase, supra note 415, is an example of the liberal Oklahoma view of what
it takes to constitute a mining partnership. See also Oklahoma Co. v. O'Neil, 440 P.2d 978,
984-85 (Okla. 1968) (evidence supported finding that mining partnership or joint venture in
development and operation of oil and gas leases existed between plaintiff and defendants).
429. See Texas Oil & Gas Corp. v. Hawkins Oil & Gas, Inc., 282 Ark. 268, 668 S.W.2d 16,
17 (1984). In Hawkins the Arkansas Supreme Court held that the 1977 model form operating
agreement established a joint venture between the operator and the nonoperator. Id. at 17.
Although the issue before the Arkansas Supreme Court was whether the operator owed a duty
to the nonoperator, the court's reasoning in finding a duty would also result in the imposition
of liability upon the nonoperator.
430. See Blocker Exploration Co. v. Frontier Exploration, Inc., 740 P.2d 983, 987 (Colo.
1987). Frontieris an example of the relatively strict view of what it takes to impose liability as
a mining partnership. See also Hamilton v. Texas Oil & Gas Corp., 648 S.W.2d 316, 320-21
(Tex. App.-El Paso 1982, no writ) (when operator of oil and gas well had full control of all
operations, operator and nonoperator working interest owner were not a joint venture); Duni-
gan Tool & Supply Co. v. Carroll, 60 S.W.2d 296, 298 (Tex. Civ. App.-Austin 1933, writ
ref'd) (to establish mining partnership, joint ownership of mining property, joint operation,
shares of profits, community of interest, and mutual agency necessary). For an excellent dis-
cussion of the cases from the various states, see Boigan, Liabilities and Relationship of Co-
1987] FARMOUT AGREEMENTS

Because what will result in liability as a joint venturer or mining partner is

uncertain, the parties should take great care in drafting the farmout agree-
ment. The parties should, and routinely do, disclaim status as partners or
co-adventurers, 43 1 though such "bootstrapping" language is not determina-
tive. 432 In evaluating any farmout proposal, a reviewer must take into ac-
count a substantial and ever-present risk of liability. The possibility that
insurance or indemnification can protect against such liability is discussed
4 33
below.

ii. Liability by Status as Record Title Owner

A court may impose liability on the basis of a party's status as an owner of
property. In Houser v. Brown 434 an appellate court held that one who ac-
quired an oil and gas lease upon which there were unplugged oil wells was
liable to plug those wells, despite the fact that he did not know they existed
when he purchased the lease. 435 While the problem is not the fault of the
lessee, he has a connection with the property that justifies application of the
state's police power. This reasoning could result in liability being imposed
upon either party to a farmout for the default of the other. The Texas court
of appeals in Austin applied similar reasoning in Railroad Commission v.
Olin Corp.4 36 when it found a nonconsenting nonoperator under an operat-
ing agreement liable for plugging after the operator defaulted. 437 The court
held that the nonoperator's reversionary rights was sufficient to support the
liability. 4 38 The inference is clear that the appeals court would find a farmor
liable for a farmee's default in plugging.
The rationale of these cases may be extended to mechanics liens, surface
restoration, and other potential liabilities. Again, though drafters should at-
tempt to avoid liability by including boilerplate language in the farmout

Owners Under Agreements for Joint Development of Oil and Gas Properties, 37 OIL & GAS
INST. 8-1, 8-39 to -48 (1986).
431. For example:
The liabilities of the Farmor and the Farmee hereunder shall be several and not
joint or collective, and nothing in this Agreement or in any instrument executed
or delivered pursuant hereto shall be deemed to create a partnership, associa-
tion, joint venture or agency relationship between the parties or to create any
fiduciary obligation between them. No party hereto shall have the authority to
bind any other party hereto for any obligation or otherwise to act as agent for
another party for any purpose whatsoever, it being understood that all opera-
tions conducted by farmee as operator hereunder and under the Operating
Agreement are conducted as an independent contractor not subject to the con-
trol or direction of Farmee as to the means or manner of performance.
Such disclaimers may also buttress the position of the farmor and the farmee that they are not
an association taxable as a corporation. See supra note 404.
432. Gragg v. James, 452 P.2d 579, 587 (Okla. 1969).
433. See infra text accompanying notes 439-45.
434. 29 Ohio App. 3d 358, 505 N.E.2d 1021 (Ct. App. 1986).
435. 505 N.E.2d at 1024.
436. 690 S.W.2d 628 (Tex. App.-Austin 1985, writ ref'd n.r.e.).
437. Id. at 631.
438. Id.; see Conine, Rights and Liabilitiesof CarriedInterest and Nonconsent Partiesin Oil
and Gas Operations, 37 INST. ON OIL & GAS L. & TAX'N 3-1 (1986).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

agreement, it is unlikely to be effective. Insurance, indemnity, and the finan-

cial stability of one's economic partner are better protections.

b. Insurance
Even without a recognized theory of liability, both the farmor and the
farmee are likely to find themselves in court if someone is hurt in drilling or
operating. Many farmout agreements therefore specifically provide that the
farmee must carry substantial insurance for liabilities such as workers' com-
pensation, employers' liability, contractual liability, public liability, and au-
tomobile liability. 439 A surprising number of the farmout agreements
reviewed, however, contained no insurance provisions. When the farmout
agreement does not impose an obligation upon the farmee to provide insur-
ance, the operating agreement may. 440 Article VII.G. of the 1982 Model
Form Operating Agreement requires the operator to provide insurance for
the joint account of the parties. 441 Two problems exist with the provision,

439. For example: "Farmee shall during its operations hereunder, maintain workmen's
compensation insurance and general liability insurance with bodily injury limits of $300,000
per occurrence and property damage insurance with a limit of $100,000." A more comprehen-
sive example follows:
During the term of this agreement, farmee shall provide the following minimum
insurance coverage:
(1) Worker's Compensation Insurance in accordance with the laws of the
State of Texas;
(2) Employer's Liability Insurance, with limits of not less than $500,000 per
accident;
(3) Comprehensive General Liability Insurance including contractual liabil-
ity coverage insuring the indemnity agreement in this agreement with
limits of not less than $500,000 for bodily injury, sickness or death in
any one occurrence and $500,00 for loss of or damage to property in any
one occurrence; and
(4) Comprehensive Automobile Liability Insurance covering all vehicles
used by farmee, with minimum limits of $500,000 applicable to bodily
injury, sickness or death in any one occurrence and $500,000 for loss of
or damage to property in any occurrence.
For liabilities assumed hereunder by farmee its insurance shall be endorsed to
provide that the underwriters waive subrogation against farmor and its agents
and employees. Prior to the commencement of drilling operations, farmee shall
furnish farmor with evidence of the required coverage. Any assignee of farmee
shall comply with these requirements. Such evidence shall be furnished to
farmor at [insert address] and shall identify the Contract Acreage.
440. See supra text accompanying notes 346-5 1.
441. Art. VII.G. of the 1982 A.A.P.L.-610 Model Form Operating Agreement (Kraftbilt,
Tulsa) provides:
At all times while operations are conducted hereunder, Operator shall comply
with the workmen's compensation law of the state where the operations are be-
ing conducted; provided, however, that Operator may be a self-insurer for liabil-
ity under said compensation laws in which event the only charge that shall be
made to the joint account shall be as provided in Exhibit "C." Operator shall
also carry or provide insurance for the benefit of the joint account of the parties
as outlined in Exhibit "D", attached to and made a part hereof. Operator shall
require all contractors engaged in work on or for the Contract Area to comply
with the workmen's compensation law of the state where the operations are be-
ing conducted and to maintain such other insurance as Operator may require.
In the event automobile public liability insurance is specified in said Exhibit
"D", or subsequently receives the approval of the parties, no direct charge shall
1987] FARMOUT AGREEMENTS

however. First, article VII.G. refers to an exhibit, which may not include all
the desired coverages or amounts of coverages. 44 2 Second, the operating
agreement may not take effect at least until the farmee has earned its interest
and perhaps until payout triggers the farmor's conversion right.4 4 3 If the
farmor relies upon the operating agreement to provide for insurance cover-
age, care must be taken that the operating agreement will be effective during
all operations under the farmout. 4" The preferable approach is for the
445
farmout to contain its own insurance provisions.
Unfortunately, providing for insurance coverage in the farmout is not a
cure-all either. First, the farmor must ensure that the farmee actually ob-
tains and maintains the required coverage. The farmor can do this in a vari-
ety of ways, including itself holding the policy and paying the premiums.
Second, an insurance policy is no better than the coverage provided, and
many policies specifically exclude or limit coverage for risks such as environ-
mental pollution and blowout. Finally, the obligation to defend imposed by
446
an insurance policy extends only to those designated as insured parties.

c. Indemnification Provisions
Because of the risk of liability inherent in drilling arrangements and the
uncertain protection of insurance, most farmout agreements contain provi-
sions requiring the farmee to indemnify the farmor against liability. 447 Less
often, the agreement will include an agreement of the farmor to indemnify
the farmee. Of course, any indemnification is no better than the resources of
the party offering it.

be made by Operator for premiums paid for such insurance for Operator's auto-
motive equipment.
442. Id.
443. See supra text accompanying note 349.
444. Arguably, the insurance provisions of article VII.G. of the 1982 AAPL Model Form
Operating Agreement are inconsistent with a typical agreement to transfer farmout, because
the interests of the parties under the farmout are dissimilar from those of the operator and
nonoperators under the operating agreement.
445. See, e.g., the second example supra note 439.
446. See Texaco, Inc. v. Hartford Accident & Indem., 453 F. Supp. 1109, 1112 (E.D. Okla.
1978). In Texaco Judge Joseph B. Morris ruled that an insurance company was not required
to defend a claim against Texaco as a result of an explosion at a gas station because the policy
in question covered the gasoline transporter and did not name Texaco. Id. at 1112. The court
rejected the contention that the transporter was the agent of Texaco on the grounds that Tex-
aco and the transporter had stipulated to the contrary. Id. at 1113. While the court specifi-
cally reserved the issues of liability and indemnity under the insurance policy, the case stands
as a warning to farmors, and all nonoperators, because farmout agreements, and operating
agreements, usually disclaim an agency relationship. One can deal with the problem, of
course, by obtaining an endorsement to the policy. For a hair-raising discussion of the limits
of liability insurance, see Boigan, supra note 430.
447. For example:
Maintenance by farmee of said insurance is in no manner to be considered a
limitation of the indemnities set out herein. To the extent allowed by law,
farmee shall indemnify and hold farmor harmless from and against any and all
claims for damages for every kind to persons or property arising out of or in
connection with farmee's operations on the lease, including claims based on acts
of farmee's contractors, successors, and assigns, except as to any liability arising
out of operations and/or actions of the farmor. ...
 SOUTHWESTERN LAW JOURNAL [Vol. 41

There is good reason for cross-indemnification. The greater risk is that

the farmor will be targeted in a suit brought as a result of the farmee's ac-
tions, since the farmee controls the drilling operations. The farmor will gen-
erally have representatives at the well site, however, and their negligence
may expose the farmee to liability.
A point to examine closely is whether the indemnification provision pur-
ports to indemnify the parties from their own negligence. The farmor may
insert a provision totally shifting risk even for its own negligence. 4 4 8 More
likely, the parties will agree to a "knock-for-knock" provision making each
responsible for its own employees, contractors, or subcontractors regardless
of negligence. 44 9 Or, the farmor may convince the farmee that it should

448. For language that specifically excludes the operations or actions of the farmor from
the indemnity, see supra note 447. The following provision, taken from a drilling contract, is
not so limited. In fact, it specifically provides that the contractor will indemnify the company
against claims of "the Company's employees" . . . and damages to "property of the Com-
pany" including those "arising out of the sole or concurrent negligence of the Company":
Contractor agrees to protect, defend, indemnify and hold the Company, its em-
ployees, directors, officers, free and harmless from and against any and all losses,
claims, liens, demands and causes of action of every kind and character and
costs thereof including without limitation judgments, penalties, interest, court
costs and any legal fees incurred by the Company in defense of same (including
attorneys fees incurred in enforcing this indemnity), arising in favor of any
party, including, without limitation governmental agencies, Contractor's em-
ployees, the Company's employees, or any third party, on account of claims,
liens, demands, debts, personal injuries, death, damage to property including
property of the Company, and all other claims of any character, which arise out
of, result from or are in any way connected with Contractor's work or its acts,
.. . including losses, claims, liens, demands and causes of action of every kind
and character arising out of the sole or concurrent negligence of the Company to
the full extent such indemnification is permitted by the applicable law. Contrac-
tor further agrees to investigate, handle, respond to, provide defense for and
defend any claims or suits at its sole expense and agrees to bear all costs and
expenses related thereto . ...
449. An example of a knock-for-knock indemnity provision, taken from the American Pe-
troleum Institute's Model Form Drilling Contract 4C1 (1st ed. Feb. 1983) follows:
11.3 Contractor agrees to protect, defend, indemnify, and save Operator, its
joint owners' and their respective officers, directors, and employees harmless
from and against all claims, demands, and causes of action of every kind and
character, without limit and without regard to the cause or causes thereof or the
negligence of any party or parties, arising in connection herewith in favor of
Contractor's employees or Contractor's subcontractors or their employees, on
account of bodily injury, death, or damage to property. If it is judicially deter-
mined that the monetary limits of insurance required hereunder or of the indem-
nities voluntarily and mutually assumed under Subparagraph 11.3 (which
Contractor and Operator hereby agree will be supported either by available lia-
bility insurance, under which the insurer has no right of subrogation against the
indemnitees, or voluntarily self-insured in part or whole) exceed the maximum
limits permitted under applicable law, it is agreed that said insurance require-
ments or indemnities shall automatically be amended to conform to the maxi-
mum monetary limits permitted under such law.
11.4 Operator agrees to protect, defend, indemnify, and save Contractor and
its officers, directors, employees and joint owners harmless from and against all
claims, demands, and causes of action of every kind and character, without limit
and without regard to the cause or causes thereof or the negligence of any party
or parties arising in connection herewith in favor of Operator's employees or
Operator's contractors or their employees, other than those parties identified in
Subparagraph 11.3, on account of bodily injury, death, or damage to property.
1987] FARMOUT A GREEMENTS

accept a modified knock-for-knock provision making the farmee responsible

for the negligence of the farmor's contractors and subcontractors as well as
its own, on the theory that the farmee is in control of wellsite operations and
therefore responsible for safety.
Those drafting or analyzing indemnification provisions should be aware
that state statutes may limit their effect. Several states, including Texas,
have enacted anti-indemnity statutes that void agreements to the extent that
they indemnify a party for its negligence or that of its employees, contrac-
tors, or agents. 450 The policy of such legislation apparently is to redress the
inequality of bargaining power that may force a contractor to accept onerous
indemnification terms.
Anti-indemnification statutes generally merely void offending provisions.
Providing for prohibited indemnification carries no penalty other than lim-
iting the offending provision. 45 ' Furthermore, some anti-indemnification
statutes, like the Texas statute, 4 2 have an exception that permits indemnifi-

If it is judicially determined that the monetary limits of insurance required here-

under or of the indemnities volunarily and mutually assumed under Subpara-
graph 11.4 (which Contractor and Operator hereby agree will be supported
either by available liability insurance, under which the insurer has no right of
subrogation against the indemnitees, or voluntarily self-insured in part or whole)
exceed the maximum limits permitted under applicable law, it is agreed that said
insurance requirements or indemnities shall automatically be amended to con-
form to the maximum monetary limits permitted under such law.
450. A discussion of the Texas and Louisiana laws is found at Tade, The Texas and Louisi-
ana Anti-Indemnity Statutes as Applied to Oil and Gas Industry Offshore Contracts, 24 Hous.
L. REv. 665 (1987). The statutes include CAL. CIv. CODE § 2782 (West Supp. 1987); LA.
REV. STAT. ANN. § 9:2780 (West Supp. 1987); MICH. COMP. LAWS ANN. § 691.991 (West
1987); MIss. CODE ANN. § 31-5-41 (1986); N.M. STAT. ANN. § 56-7-2 (1978); N.Y. GEN.
OBLIG. LAW § 5-324 (McKinney 1987); TEX. Civ. PRAC. & REM. CODE ANN. §§ 127.001-
.008 (Vernon 1986); Wyo. STAT. § 30-1-131 (Supp. 1980). Section 127.003 of the Texas stat-
ute provides in part that:
(a) Except as otherwise provided by this chapter, a covenant, promise, agree-
ment, or understanding contained in, collateral to, or affecting an agreement
pertaining to a well for oil, gas, or water, or to a mine for a mineral is void and
unenforceable if it purports to indemnify a person against loss or liability for
damage that:
(1) is caused by or results from the sole or concurrent negligence of the
indemnitee, his agent or employee, or an individual contractor responsible to
the indemnitee ....
451. TEX. CIv. PRAC. & REM. CODE ANN. § 127.003 (Vernon 1986). This provision is
contrary to the general rule in Texas, as well as in most other states. Generally, indemnifica-
tion against one's own negligence is not contrary to public policy so long as the agreement of
the parties is clear. See Ethyl Corp. v. Daniel Constr. Co., 725 S.W.2d 705 (Tex. 1987). In
Ethyl Corp. the Texas Supreme Court adopted the "express negligence doctrine," which re-
quires the intent of the parties to indemnify the indemnitee from the consequences of its own
negligence to be "specifically stated within the four corners of the contract" in order to be
effective. Id. at 708. But see Meloy v. Conoco, Inc., 784 F.2d 1320, 1322 (effect of Louisiana
anti-indemnity statute limited to nullifying indemnity for indemnitee's own negligence or
fault), vacated, 792 F.2d 56, certified to La. S. Ct., 794 F.2d 992 (5th Cir. 1986).
452. TEX. CIV. PRAC. & REM. CODE ANN. § 127.005(a) (Vernon 1986) provides that the
anti-indemnity provisions do not apply "to any agreement that provides for indemnity with
respect to claims for personal injury or death to the indemnitor's employees or agents or the
employees or agents of the indemnitor's subcontractors" if the indemnity is supported by in-
surance. The section provides, however, that "[t]he amount of insurance required may not
exceed 12 times the state's basic limits for personal injury, as approved by the State Board of
Insurance in accordance with Article 5.15, Insurance Code." Id. § 127.005(c). On this basis,
 SOUTHWESTERN LAW JOURNAL [Vol. 41

cation for one's own negligence to the extent that insurance supports the
indemnity. Thus, broad indemnity provisions should continue to be a prior-
ity for each party.

10. Regulatory Provisions

Some farmouts, particularly those drafted in recent years, include lengthy
provisions addressing regulatory matters such as compliance with environ-
mental law, Equal Employment Opportunity Commission regulations, con-
servation regulations, or securities laws. These provisions, typically
regarded as boilerplate by the parties, become important in assigning respon-
sibility or liability.

a. Environmental Regulations
One of the most common regulatory provisions in farmout agreements
provides that the farmee agrees to comply with all applicable environmental
regulations. Such a regulatory clause may be short 45 3 or long. 454 An envi-
ronmental compliance clause serves two major purposes. First, it should put
the farmee on notice of environmental regulations of concern. Of course, the
farmor should disclose any specific concerns. Likewise, counsel for a farmee
who encounters an environmental compliance clause should inquire specifi-
cally whether the farmor is aware of particular potential problems. A sec-

the maximum enforceable indemnity under § 127.005, as of the time this Article is written,
was $300,000.
453. A short version of an environmental compliance clause follows:
You recognize that one of the primary concerns of the oil industry is compliance
with anti-pollution provisions of the environmental regulations. One of the
principal considerations of this contract, without which it would not have been
made by Farmor, is your agreement, evidenced by your execution hereof, to
comply with all Federal, State, and local laws and regulations concerned with
prevention and/or control of pollution. You now and hereafter shall hold
Farmor harmless from any claims, actions or causes instituted and/or damages
or penalties incurred for your failure to timely comply therewith.
454. An example of a more elaborate environmental compliance clause follows:
Operator agrees to comply with the Clean Air Act (42 U.S.C. § 1857) and the
Federal Water Pollution Control Act (33 U.S.C. § 1251) when conducting oper-
ations involving nonexempt contracts. In all nonexempt contracts with subcon-
tractors, Operator shall require:
(1) No facility to be utilized by Subcontractor in the performance of this con-
tract with Operator is listed on the Environmental Protection Agency
(EPA) List of Violating Facilities. See Executive Order No. 11738 of Sep-
tember 12, 1973, and 40 C.F.R. § 15.20.
(2) Prompt written notification shall be given by Subcontractor to Operator of
any communication indicating that any such facility is under consideration
to be included on the EPA List of Violating Facilities.
(3) Subcontractor shall comply with all requirements of Section 114 of the
Clean Air Act (42 U.S.C. § 1857) and Section 308 of the Federal Water
Pollution Control Act (33 U.S.C. § 1251), relating to inspection, monitor-
ing, entry, reports, and information, as well as all other requirements speci-
fied in these Sections, and all regulations and guidelines issued thereunder.
(4) The foregoing criteria and requirements shall be included in all of Subcon-
tractor's nonexempt subcontractors, and Subcontractor shall take such ac-
tion as the Government may direct as a means of enforcing such
provisions. See 40 C.F.R. § 15.4 & 5.
1987] FARMOUT AGREEMENTS

ond function of an environmental compliance clause is to provide clear

notice of the applicability of the agreement's indemnification provisions.

b. Equal Employment Opportunity Clause

Equal employment opportunity compliance clauses now frequently appear
in farmout agreements, particularly those drafted by counsel for large corpo-
rations. Federal law may well require such provisions. 45 5 Even if not re-
quired, however, they are helpful because they put the farmee on notice and
clarify responsibility.

c. Compliance with Conservation Laws

Some farmout agreements state specifically that the farmee must comply
with all conservation laws and rules. Conservation compliance language
probably mirrors the expectation of the parties to the farmout agreement.
After all, the farmee has the responsibility for conducting drilling and pay-
ing drilling costs. It may also remind the farmee that it cannot count on the
farmor to do the things that are usually done before a well is drilled, such as
check and clear title. When a conservation compliance clause is used in an
agreement that makes absolute performance the standard of performance,
however, failure to comply with its terms may be cause for termination of
the farmee's rights.

d. Securities Regulation
Some attorneys counsel that farmout agreements should include an ad-
ministrative clause addressing securities regulation to obtain the farmee's
representation and warranty that it is a "sophisticated investor" and that it
will comply with the requirements of securities laws in its dealings with
farmed-out leases. While such bootstrapping techniques do not guarantee
compliance, they put the parties on notice of potential problems and make
clearer the responsibility for taking action to comply with applicable securi-
ties regulations.
e. Others
The number and length of miscellaneous administrative provisions in-
crease as federal and state legislative branches work. A review of farmout
agreements collected from major oil companies revealed that additional reg-
ulatory compliance clauses had obviously been added from time to time to
cover a variety of regulatory concerns, including compliance with the Occu-

455. The Equal Employment Opportunity Act, 42 U.S.C. § 2000e-2(a) (1982) provides:
It shall be an unlawful employment practice for an employer
(1) to fail or refuse to hire or to discharge any individual, or otherwise to
discriminate against any individual with respect to his compensation,
terms, conditions, or privileges of employment, because of such individ-
ual's race, color, religion, sex, or national origin . . ..
The Equal Employment Opportunity Act defines an employer as a person engaged in industry
affecting commerce who has 15 or more employees for each working day. 42 U.S.C.
§ 2000e(b) (1982).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

pational Safety and Health Act, 4 5 6 the Rehabilitation Act of 1973,4 58

4 57
veter-
ans preferences, and affirmative action plans, to note only a few.

11. Dealing with Bankruptcy

The possibility that one's business partners will go bankrupt must enter
into the planning of anyone active in the oil and gas industry. When bank-
ruptcy occurs before the drilling of the earning well or before the delivery
and recording of the earned assignment, the Bankruptcy Code may undo
what the farmee and the armor have sought to accomplish in their
agreement.
The farmor whose farmee files for bankruptcy is very likely to fail to
achieve whatever purpose motivated it to make the agreement. While a
farmee's bankruptcy trustee may drill under a farmout agreement, more
likely nothing will happen until the property subject to the farmout has been
tied up in bankrutcy proceedings for so long that it is too late for the farmor
to drill itself or to find someone else to perform.
The farmee's position is even worse. If its farmor goes bankrupt while the
farmee is conducting drilling operations under a farmout that makes drilling
an option of the farmee, the farmee may face the hard choice of either walk-
ing away from its expensive hole in the ground or finishing its operations and
confronting the claim of the bankruptcy trustee that he can reject the
farmout agreement, and the farmee's earned right. If the farmout agreement
makes drilling an obligation, the farmee must consider the possibility that
the bankruptcy trustee will reject the contract and the interest earned by the
farmee, even if the farmout well is drilled.
Two provisions of the Bankruptcy Code are especially troublesome. First,
section 544 gives a bankruptcy trustee power to avoid any transfer or obliga-
tion voidable by a bona fide purchaser. 4 59 These so-called "strong-arm"

456. 29 U.S.C. §§ 651-678 (1982).

457. Id. §§ 701-796(i).
458. As this manuscript was being prepared for the printer, the industry began using a new
kind of regulatory clause in farmouts, growing out of FERC Order No. 500, 52 Fed. Reg.
30,334 (Aug. 14, 1987). Order No. 500 was adopted by the Federal Energy Regulatory Com-
mission (FERC) to address the plight of pipelines confronted with take-or-pay liabilities. It
established an interim rule requiring that a producer of natural gas that wished to use open-
access transportation under FERC's rules had to offer to credit gas transported against the
transporting pipeline's take-or-pay obligations under pre-June 23, 1987, gas contracts on a
volumetric basis. Order No. 500 also required that the offers to credit come from the owner of
the lease as of June 23, 1987, even though the lease was transferred thereafter. Thus, a farmor
might be required to offer credits against its take-or-pay claims against a pipeline so that its
farmee could transport gas for the farmee's account. If the farmor refused, the farmee might
find itself unable to get its gas to market. Overnight, clauses clarifying the rights of the farmor
and farmee began to appear in farmout agreements. Generally, such clauses stated either
(1) that the farmor would offer take-or-pay credits, or (2) that the farmor would not offer such
credits and specifically put the farmee on notice of its risk.
459. 11 U.S.C. § 544(a)(3) (Supp. III 1985) provides that:
The trustee shall have, as of the commencement of the case, and without regard
to any knowledge of the trustee or of any creditor, the rights and powers of, or
may avoid any transfer of property of the debtor or any obligation incurred by
the debtor that is voidable by ... a bona fide purchaser of real property, other
than fixtures, from the debtor, against whom applicable law permits such trans-
19873 FARMOUT AGREEMENTS

powers probably empower a bankruptcy trustee to set aside any unrecorded

transaction. Thus, the trustee may avoid both farmout agreements struc-
tured as contracts to assign after performance by the farmee and assignments
actually made but not recorded when the bankruptcy proceedings are filed.
Section 541(d) imposes possible limits upon the strong-arm powers of the
bankruptcy trustee. Section 541(d) limits the interest acquired by the trustee
in property in which the debtor owns only a legal interest rather than an
equitable interest to the legal interest. 4 60 The legislative history suggests,
however, that the intent of Congress may have been to protect 461
only mort-
gages by section 541(d), and the case law is inconclusive.
The parties can avoid the problem presented by section 544 by the rela-
462
tively simple but cumbersome device of recording the farmout agreement.
Farmout agreements are almost never executed with the formalities required
for recording, however. In addition, whatever their form, farmout agree-
ments may not qualify as recordable instruments in the eyes of some record-
ing officers. Finally, the recording fees for an extensive farmout agreement
are high, and many farmors and farmees will prefer to take the risk of bank-
ruptcy of the other rather than have the terms of their business deal spread
on the record. The parties will more likely accept the recording of a memo-
randum of the farmout agreement. Memorandum filings are not generally
done, but one commentator has urged that they become the norm and pro-
463
vided forms to use to do So.
The parties cannot so easily avoid section 365, the second provision of the
Bankruptcy Code that is likely to apply. Section 365 gives a bankruptcy
trustee authority to accept or reject "any executory contract of the
debtor. ' 464 If a farmout agreement is "executory," the trustee may reject
the agreement, leaving the farmee with a successful drilling venture, but a
financial disaster. 465 The precise meaning of "executory" is unclear. The

fer to be perfected, that obtains the status of a bona fide purchaser and has
perfected such transfer at the time of the commencement of the case, whether or
not such a purchaser exists.
460. Id. § 541(d) provides in part:
Property in which the debtor holds, as of the commencement of the case, only
legal title and not an equitable interest, such as a mortgage secured by real prop-
erty . ..sold by the debtor but as to which the debtor retains legal title to
service or supervise the servicing of such mortgage. . . becomes property of the
estate . . . only to the extent of the debtor's legal title to such property, but not
to the extent of any equitable interest in such property that the debtor does not
hold.
461. See Davis, Unassigned Oil and Gas Interest in Bankruptcy, 22 TULSA L.J. 325, 329-34
(1987).
462. See infra text accompanying notes 477-81.
463. A. DERMAN PROTECTING OIL AND GAS LIEN AND SECURITY INTERESTS (A.B.A.
Sec. Nat. Res. L. Monograph Series No. 6, 1987). While this monograph primarily analyzes
memorandum filings for operating agreements, it also addresses the use of memorandum filings
for farmout agreements. Id. It notes that the use of memorandum filings may also perfect
interests under the Uniform Commercial Code. Id.
464. 11 U.S.C. § 365(a) (1982 & Supp. III 1985).
465. Disaster may be too strong a term. Arguably, § 365(i)(1) of the Bankruptcy Code,
which permits a purchaser in possession under a contract "for the sale of real property" to
obtain title notwithstanding the trustee's rejection of the contract, will protect the farmee in
 SOUTHWESTERN LAW JOURNAL [Vol. 41

seminal law journal article on the subject has suggested it should mean con-
tracts "so far unperformed that the failure of either to perform would consti-
tute a material breach excusing the performance of the other. '466 The Tenth
Circuit has defined "executory," however, as meaning that "neither party
[has] completely performed and the obligations of each [remain] com-
plex."' 4 6 7 By either definition, however, the typical agreement to transfer
farmout structure should be subject to the powers of the trustee under sec-
tion 365, until the farmee has drilled the earning well, and perhaps until the
468
assignment is actually made.
To avoid the application of section 365 the parties must structure the
farmout agreement to conditionally assign the farmee's interest when the
agreement is signed or before drilling is commenced, rather than after the
well is drilled. Even this may not be enough, however. The conditions of
the assignment (e.g., reversion upon failure to drill or reversion of deep
rights after drilling) may be enough to keep the contract executory, since the
parties will have to file title-clearing releases. 469 In addition, the trustee may
consider a conditional assignment of the farmee's interest a "fraudulent"
transfer that the trustee may set aside under section 548 of the Bankruptcy
Code. Section 548(a)(2) gives the trustee authority to avoid transfers made
within a year before the filing of bankruptcy for less than the reasonable
equivalent sale of the property transferred when the debtor was either insol-
vent when the transfer took place or became insolvent as a result. 4 70 If the
farmout agreement is of the typical "option to drill" variety, there is a strong

this situation. Whether a farmout agreement is a contract subject to § 365(i)(1) is not clear,
however. The argument appears particularly questionable in states like Oklahoma and Kan-
sas, in which oil and gas leases are not clearly "real estate." See Hinds v. Phillips Petroleum
Co., 591 P.2d 697, 699-700 (Okla. 1979) (oil and gas leases create interest in realty, but interest
created is personal property, not real property, interest); see also In re J.H. Land & Cattle Co.,
8 Bankr. 237, 239 (W.D. Okla. 1981) (applying Kansas law that oil and gas lease is personal
property in nature of profit A prendre to conclude that bankruptcy trustee possessed authority
to reject lease as executory contract). In In re Heston Oil Co., 69 Bankr. 34, 36 (N.D. Okla.
1986), however, a U.S. district court rejected the holding of J.H. Land & Cattle Co., ruling
that an oil and gas lease in Oklahoma creates a profit Aprendre and an estate in real property
in the nature of a fee interest and is not executory since it has been fully performed by the
lessor. Even if § 365(i)(1) does not apply, the farmee would be able to assert a nonadministra-
tive claim for damages under §§ 501 and 502. 11 U.S.C. §§ 501, 502 (1982 & Supp. III 1985).
Still, the farmee that becomes entangled in the bankruptcy proceedings of its farmor is likely to
lose the benefit of the risk it took.
466. Countryman, Executory Contracts in Bankruptcy. PartI, 57 MINN. L. REV. 439, 460
(1973).
467. Workman v. Harrison, 282 F.2d 693, 699 (10th Cir.), cert. denied, 414 U.S. 1068
(1973).
468. Cf Davis, supra note 461, at 336-40 (discusses defining executory contract). See also
Pearce, Keeping Oil and Gas Leases Alive: A Review of Both the Mineral Lessee's Obligations
and Possible Ways to Keep the Lease in Effect, 1986 ROCKY MTN. MIN. L. SPECIAL INSTITUTE
ON HARD TIMES IN THE MINERALS INDUSTRY 8-54.
469. Some bankruptcy cases suggest that a contract is executory even though the only act
remaining to be accomplished under the purchase agreement is the delivery of the deed. See
Davis, supra note 461, at 339. But see the reasoning of the court in In re Heston Oil Co., 69
Bankr. 34, 36 (N.D. Okla. 1986). Is making an assignment any more onerous that defending
title?
470. 11 U.S.C. § 548(a) (1982 & Supp. III 1985) provides in part:
The trustee may avoid any transfer. . . that was made or incurred on or within
1987] FARMOUT AGREEMENTS

argument that consideration for the transfer was inadequate, since the
farmee promised to do nothing.4 7' The inadequate consideration argument
is also available when the assignment is conditional; the farmee has no bind-
ing obligation. The only sure way of avoiding treatment of the farmout
agreement as an executory contract under section 365 of the Bankruptcy
Code is to couple the advance assignment of the farmee's interest with a
binding obligation to drill by the farmee, a structure that will often not fit
472
the business needs of the parties.
The farmor and the farmee may well choose to take the risk of bankruptcy
of one of the parties and the intervention of the bankruptcy courts in struc-
turing farmout agreements. Pre- and post-contract administration can
lessen the risks to some degree, however. The financial stability of one's
business partners is a primary consideration in whether to make a deal.
Once the contract is executed, the farmee, which has the obligation to pay
drilling costs and thus more to lose, should continue to monitor the fortunes
of the farmor and avoid spending money or entering into binding contracts
when the farmor's finances look shaky.

12. Terms of the Assignment

Few farmout agreements are recorded. Once an agreement has been fully
performed, however, the farmee generally receives a recordable assignment
of interest. When this structure is followed, it is important that the terms of
the farmout agreement and the terms of the assignment not conflict, or a
473
dispute may arise as to which prevails. Phillips Petroleum Co. v. Stack
illustrates this problem. In Stack the assignment followed the farmout
agreement by a day, before the drilling of either of the two required wells.
Subsequently, Stack, the farmee, refused to assign Phillips the overriding
royalties on lease extensions and renewal leases that were required by the
farmout, but not mentioned in the assignment. Stack contended that the
agreement had merged into the assignment, or that the assignment had su-
perseded the agreement. The Mississippi Supreme Court focused upon
Stack's admission that he had been obligated to drill the two wells provided
for by the farmout even though the assignment did not mention that require-

one year before the date of the filing of the petition, if the debtor voluntarily or
involuntarily-...
(2)(A) received less than a reasonably equivalent value in exchange for such
transfer or obligation; and
(B)(i) was insolvent on the date that such transfer was made or such obli-
gation was incurred, or became insolvent as a result of such transfer
or obligation;
(ii) was engaged in business or a transaction or was about to engage in
business or a transaction, for which any property remaining with
the debtor was an unreasonably small capital; or
(iii) intended to incur, or believed that the debtor would incur, debts
that would be beyond the debtor's ability to pay as such debts matured.
471. Hardwick, supra note 226, at 6-22.
472. Id. at 6-21.
473. 231 So. 2d 475 (Miss. 1969).
 SOUTHWESTERN LAW JOURNAL [Vol. 41

ment. 474 The court concluded that the intent of the parties was that the two
instruments together constituted the contract between the parties. 475
The Stack result is not a foregone conclusion in similar fact situations,
because it turned upon the Mississippi court's finding of the intent of the
parties. Another court confronted with similar facts might well mechani-
cally apply the rules of merger to conclude that the terms of the assignment
prevail in the event of conflict. Both the farmor and the farmee, therefore,
should pay close attention to the terms of the assignment to be certain that
they are correct and complete. In the alternative, incorporating the terms of
the assignment in an attached appendix can minimize the possibilities of
conflict. Thus, the farmout agreement will provide merely that the assign-
ment will be made "on the terms and conditions set forth" in the
476
appendix.

13. Recording
As discussed above, the parties do not usually record farmout agreements.
They probably should. Other than the administrative expense that may be
involved for the farmor to clear the record if the farmee fails to perform,
which the farmor can deal with by having the farmee execute releases or
reconveyances when the farmout is executed, and which at worst is no more
burdensome than the routine land work of clearing title of old leases, there
really is no good reason not to record the farmout or a memorandum of
477
it.
Recording the farmout agreement does not prejudice the farmor.
Whether or not the parties record the farmout agreement, the farmor's lease-
hold interest is likely to be subject to mechanics' and materialmen's liens if
the farmee fails to pay its bills. 478 A recorded agreement, however, may save
the farmor's retained nonparticipating interest. 479
Recording is particularly important to the farmee. One can argue that the
farmee's interest ought not to require recording for protection because the

474. Id. at 481.

475. Id. at 482.
476. See supra note 126.
477. See the discussion of memorandum filing at A. DERMAN, supra note 463; Morgen-
thaler, PlanningAhead for a Co-Participant'sBankruptcy: A Stitch in Time, 32 ROCKY MTN.
MIN. L. INST. 13-1, 13-6 to -20 (1986). A simple statement that "upon request of any party,
the parties hereto shall execute and acknowledge a memorandum of this Agreement in record-
able form" can provide authority to file a memorandum. The parties could also execute a
memorandum at the signing of the farmout.
478. See Superior Oil Co. v. Etheridge, 219 Ark. 289, 242 S.W.2d 718, 720-23 (1951); Zone
Oil & Gas Co. v. Dudley & Heath Drilling Co., 474 P.2d 395, 397-99 (Okla. 1970). Cf Texon
Energy Corp. v. Dow Chem. Co., 733 S.W.2d 328, 330 (Tex. App.-Houston [14th Dist.]
1987, no writ), holding a farmor liable for drilling costs where the farmor had approved an
authorization for expenditure and executed an operating agreement. But see Dews v. Hallibur-
ton Indus., Inc., 708 S.W.2d 67, 70 (Ark. 1986), holding that a farmor is not liable either for
legal or equitable liens upon the leasehold as a result of a farmee's default.
479. See Zone Oil & Gas Co. v. Dudley & Heath Drilling Co., 474 P.2d 395, 399 (Okla.
1970). In Zone the court refused even to consider the argument that Zone's production pay-
ment was not subject to the lien because the parties had not recorded the conveyance in which
the payment was reserved. Id.
1987] FARMOUT AGREEMENTS

practice of not recording farmouts is so well established that third parties

should be placed on inquiry notice of the possibility of their existence. One
may assert that the farmee's possession of the property under a farmout
agreement should put others on notice of its claims. These arguments are
tenuous and dependent upon particular facts, however. 4 80 The surest way
for the farmee to protect its rights is by recording. In many states, recording
puts third parties on notice of the provisions of unrecorded agreements re-
48 1
ferred to in the recorded instrument, as well as of the terms on the record.

V. CONCLUSION

The review of more than one hundred example farmout agreements, and
discussions with dozens of lawyers incident to the preparation of this Arti-
cle, have largely confirmed the author's personal preconceptions about
farmout agreements. First, the structure of farmout agreements is very
much a function of tax rules. Farmout agreements are business agreements
entered into by people who seek to make a profit, and compliance with the
tax rules often makes the difference between profit and loss in our society.
All farmout agreements reviewed were obviously drafted with an eye to giv-
ing the farmee the full benefit of the intangible drilling cost deduction. Con-
cern with other tax issues was also apparent.
Second, although the tax structure of farmout agreements is very much
the same, their substantive provisions vary widely. In part, the difference in
substantive provisions is reflexive; once a company has been burned by a
particular problem, it drafts to avoid it in the future. In part, also, the wide
variety of substantive provisions in farmout agreements reflects the vitality
of American businessmen and their lawyers. "Dealmaking" is often every
bit as important in whether or not a venture is profitable for both of the
parties as the underlying value of the properties farmed out. The agreements
reviewed reflected the high creativity index of the oil and gas industry.
Finally, however, farmout agreements are susceptible to orderly analysis,
and not enough attention is given to that analysis. Understanding the pur-
poses that may lead the farmor or the farmee to enter into a farmout agree-
ment, the essential provisions that the agreement must contain to achieve
those goals, and the alternatives available to the draftsman are the keys to
successfully preparing or analyzing a farmout agreement. The goals of each
of the parties will determine how the agreement will be put together and
what provisions will be emphasized. The essential provisions of an agree-

480. See O'Kane v. Walker, 561 F.2d 207, 209 (10th Cir. 1977). In O'Kane the court held
that a conveyance for a low, but not unreasonably low, price was not sufficient to put the
purchaser on inquiry notice. Id. The case also contains an excellent discussion of when in-
quiry notice is given. Id. at 208-09; see also Hill, Title Repositories, Recording, and Construc-
tive Notice, 29 ROCKY MTN. MIN. L. INST. 469, 477 (1983).
481. See Westland Oil Dev. Corp. v. Gulf Oil Corp., 637 S.W.2d 903, 905 (Tex. 1982). In
Gulf Oil Corp. the court held that an assignment gave notice not only of the operating agree-
ment referred to in the assignment, but also to farmout agreements referred to in the operating
agreement. Id.; see also Pasternak v. Lear Petroleum Exploration, Inc., 790 F.2d 828, 830
(10th Cir. 1986) (farmee bound by terms of operating agreement referred to in its farmout
agreement).
868 SOUTHWESTERN LAW JOURNAL [Vol. 41

ment are those without which any farmout agreement will be incomplete.
Drafting alternatives help keep the agreement flexible and responsive to the
parties' needs.
The aim of this Article has been to develop an analysis of the purposes
and essential considerations of a farmout, and to collect alternative provi-
sions that may be of use to the draftsman. In a sense, this Article is unfin-
ished. It will never be finished, because only the creativity of businessmen
and their lawyers limits the variety of provisions that may be included in a
farmout agreement.