Best Practices in Negotiating and Drafting Farm-Out Agreements

On June 1st, 2020, the Department of Petroleum Resources (“DPR”) launched the Marginal Field Bid Round. The Bid Process is expected to last for six months. After selection of the winning Bid, payment of signature bonus, and grant of Presidential Approval, Awardees are required to negotiate a Farm-Out Agreement with Block holders (i.e Oil Mining Leaseholder “OML”). 

Paragraph 17 (4) of 1st Schedule to the Petroleum Act defines Farm-Out Agreement “as an agreement between the holder of an oil mining lease and a third party which permits the third party to explore, prospect, win, work and carry away any petroleum encountered in a specified area during the validity of the lease”. 

Whilst title to Asset is derived from DPR Licensing, the actual contractual terms that govern the handover and operation of Marginal Field Assets are based upon the Farm-Out Agreement between the Block holder and Awardee. Contrary to popular belief, the Bid process is not the most difficult phase in the acquisition of marginal fields; rather it is the negotiation phase. 

The reason is that it involves lots of complex and time-consuming negotiations to arrive at mutually acceptable terms. For instance, during the 2003 licensing rounds the selection phase took months while the negotiations phase took upwards of two years. Under the 2020 Bid Round rules, Parties must endeavor to complete the Farm-Out Agreement within 90 days. Based on the 2003 experience this timeline may not be realistic.

This Article examines challenges facing legal draftsmen in the course of negotiating, designing, and preparing Farm-Out Agreements drawn up in pursuance of a Marginal Field Award. The Block holder that originally owns the leasehold interest and assigns the farm-out is known as “Farmor”. The Awardee who acquires an assignment of the leasehold interest is known as “Farmee.

Commercial Points for Negotiation 

The Block holder and Awardee will be able to reach mutually acceptable terms when they recognize and accommodate the other party’s interests and motivations. Identifying the potential risks which a party may face if something goes wrong is the basis for understanding its motivation and interests. Recognizing the potential risks faced by parties is the best starting point for negotiations. The following key negotiating points can serve as a reminder of critical issues for parties to consider as they embark upon Farm out negotiations; 

1. Fiscal Considerations affecting both Farmor and Farmee

To arrive at mutually acceptable Farm-out terms, parties must as of necessity agree on important equitable and commercial considerations. According to Sections 10 and 11 of the Guidelines for Award and Operation of Marginal Fields in Nigeria (2020) key commercial negotiating points include; 

i. Parties must determine the worth of the farm-out interest (taking into account the status of the field i.e. whether it is in the appraisal or development phase of its life cycle as such consideration affects the value and associated risks).

ii. Amount of Overriding royalty to be paid by Awardee to Block Holder

iii. Parties must negotiate dollar per barrel payable to Block Holder representing tariff (in cash or kind) for transporting and processing extracted crude oil. 

2. Commercial Considerations affecting Farmee

Both the Block holder and Awardee need to appreciate the critical risks and issues that affect their respective positions as this is essential to effective negotiation and deal-making. Key commercial considerations that may arise from Farmee’s perspective include;

• Relationship of Parties after Farm-Out –  Agreement is between two parties namely the holder of the Oil Block and the Awardee. The Agreement serves as a hand over the document which confers full responsibility to Farm Out Area on Awardee. To this end, the farm out Agreement must be clear as regards the rights, liabilities, obligations, and responsibilities of parties. Farmee would want the Farmor to recognize and preserve his appraisal / deep drilling rights. Such rights include the option to develop fresh work programs and deploy new technologies to grow reserves and enhance production. Where new data becomes available that indicates the geological structure of the Field extends beyond the Farm-Out Area, Farmee would seek redetermination of Field Area. 

• The geological risk associated with the field – Geological risk refers to uncertainty surrounding the reservoir potential of the field. Marginal fields are discoveries, abandoned without a proper appraisal. Geological Information available at the time of licensing may not be an accurate portrayal of reservoir potential. To this end, the Farmee would seek contractual terms that compel Farmor to hand over information on the field as well as share geological data on formations that lie proximate to Farm out area.   

• Reducing Financial Exposure – The justification for farming out low yield fields to small indigenous companies is that they can profitably develop them utilizing considerably lower overheads so that the Farmee aims to avoid contractual obligations that increase their financial exposure. From the Farmee’s prospective financial costs associated with adhering to contractual obligations on Insurance, decommissioning, zero gas flare policy are additional expenses that must be capped.

• Avoid Contractual Restriction on Farmee’s ability to act independently – Operations are at Farmee sole risk and expense and should not hinder Farmor’s existing operations. Farm out Agreement must contain clear terms as to leave no one in doubt as regards the Independent nature of Farmee’s operations. Farmee must be solely responsible for funding his entire exploration and production costs, paying taxes, obtaining its right of way permits and other regulatory approvals, etc. Farmee must avoid contractual obligations that restrict their ability to independently engage third parties. 

C.  Commercial Considerations affecting Farmor

The main commercial considerations that may arise from Farmor’s perspective may include;

• Unfettered Access to Monitor Field Operations –  Farmor would insist on contractual clauses that permit him to access Books, records, accounts of Farmee, etc. Proper accounts will enable Farmor to calculate its fair share of override royalty. Farmor would require inspections to ensure that petroleum operations carried on by the Farmee do not adversely impact Farmor’s operations. Farmor may demand indemnity to cover third party liabilities arising from operations within the farm out area that spill onto the Block holder’s Area.

• Farm Out Agreement must conform with Block holder’s prior obligation under OML – Farm out Areas are carved out of Block holder Area which is already subject to contractual terms. The Farmor is contractually bound under OML to set aside money to cover decommissioning costs. At the time of executing OML, this obligation extends to all oil fields in the Block Area including the marginal field asset. 

Farmor may demand some kind of performance bond to ensure Farmee compliance.  Farmor may insert contractual clauses that hold Farmee accountable for environmental pollution arising from Farmee operations, such as gas flaring, oil spillage, or other pollutants that damage host Communities. Farmor would also want to reserve the right to demand that Farmee suspend operations in event of environmental pollution that spills over onto the Block holder area.

• Safeguards to compel the Farmee to pay outstanding Fiscal claims – Farmee must pay Farmor overriding royalty on production and handling charges for the evacuation of crude. Farmor may insert on contractual clauses that safeguard its ability to collect outstanding fees and charges. 

Use of Model Contracts 

DPR Guidelines do not contain Model Contract templates to guide legal draftsmen concerned with designing the Farm out Agreement. The only reference to the content of Farm out Agreement is to be found in Section 12 of Guidelines for Award and Operation of Marginal Fields in Nigeria (2020) which mandates they contain contractual clauses such as Indemnity, Farm out Area, Field data, Appraisal, and Deep drilling rights, decommissioning and abandonment, sole risk, community development, etc. 

The lack of a Nigeria centric Farm out Agreement template frustrates the work of legal draftsmen. In future, regulators need to come up with Model Contracts since it helps promote standardization across the Industry. This in turn will reduce cost and risk of doing Oil & Gas Business, increase consistency and ensure certainty which reduces the likelihood of legal disputes.

Fortunately for Energy Lawyers they can resort to Model Contract templates drawn up by International bodies such as Association of International Petroleum Negotiators (AIPN) or United Kingdom Offshore Operators Association (UKOOA also referred to as Oil and Gas UK) as a starting point for negotiations. Legal Draftsmen can also reference Farm Out Agreements used by indigenous Companies that acquired marginal Field Licenses in 2003. 

Whatever the choice, when adopting any of these Model Contracts, one needs to bear that these contracts cover Farm Out Agreements used in the traditional sense by Petroleum Companies operating in the U.K or North America and differ from the unique Nigerian situation envisaged under Marginal Field Policy. 

The use of model contracts should be adopted with clear understanding and knowledge of the Law, Policy, practice and emerging trends governing Marginal Field operations in Nigeria. The Author personally recommends using AIPN Model Form International farm-out agreement which was last updated in 2019. Legal draftsmen need to understand the limits of Model Contracts. They must not be applied dogmatically, but rather modified to fit circumstances and peculiarity of the transaction at hand.

Tips for Drafting Model Contracts 

Drafting of commercial agreements such as Farm Out Agreement is a skill which is acquired over time and call mark of experienced legal draftsmen. The primary role of legal draftsmen is to express in clear and unambiguous language the common intention of contracting parties. The following quick tips may help;

• Need to understand the other party’s motivations and interests.

• Need for adequate knowledge of facts and the Law. 

• Need to adopt the most appropriate negotiation template and Model Contract precedent.

• Proper risk allocation strategy

• Consider third party issues

• Consider overhead contractual obligations. For instance Block holder decommissioning obligations under OML

• Use plain and simple English wordings. This allows for quick interpretation

• Pay particular attention to contractual clauses that govern decision making process on issues that have cost implication. For instance how to assess default and liability for none performance of contractual obligation.  

• Pay attention to applicable Laws on Fiscal terms, environmental consideration, host communities, local content, etc.

Article prepared by M.I.B Hassan LL.M (Dundee) BL, the Author of “Marginal Oil Fields Policy; The Law, Practice and Emerging Trends”   available at www.Lkseminars.com.ng