2009 is likely to be a year of consolidation in the oil&gas industry in response to the economic downturn. As Alec Carstairs writes opposite, last summer, the sector seemed to be faring well, with the oil price peaking at record highs of above $147 a barrel in July before crashing.
Now it’s a different world. Notwithstanding Opec’s latest quota cut, the combination of the credit crunch/recession and collapse of oil prices will have a significant impact, especially on smaller oil&gas exploration and production companies.
The volatility in the oil price could act as a major impediment to the progression of deals due to uncertainties as to what the future holds. The plummeting oil price has also amplified the difficulty of obtaining capital and raising finance – a huge issue for North Sea minnows.
As little as six months ago, such companies often had little difficulty borrowing money to finance their operations. However, the global credit crunch has changed that.
Although the 25th Offshore Licensing Round suggests promise – with many relative newcomers listed as offerees – it is important to remember that applications for these licences closed in May, when oil prices were still climbing.
Today, many smaller exploration companies with no production to generate cash find they now cannot pay for exploration commitments.
We have already seen one or two highly leveraged companies struggling to raise finance to fund their operations as a result of the credit crunch, and this trend is likely to increase in 2009. Majors, on the other hand, often have significant amounts of cash and strong revenues.
With many such companies now having better credit ratings than the banks, they are much better positioned to weather the storm caused by the chaos in the capital markets. This differential in fortunes means majors are in a strong position to buy into some of the acreage held by smaller companies by way of a corporate takeover, asset purchase for cash or farm-out agreement.
A farm-out involves a party disposing of part of an interest in an existing licence in return for payment by the acquiring party in respect of, or performance of, certain operations under the licence (usually drilling operations), meaning that the company “farming-out” will ultimately have to pay a lesser amount than it would normally have to pay in respect of a given licence operation (or even nothing at all) in return for giving up part of its equity.
Smaller companies use farm-outs as a way of getting around cash-flow problems. In any case, such firms will have to consider alternative arrangements in order to avoid breaching their existing payment obligations under drilling agreements and work obligations under their petroleum licences.
Unlike other standard agreements, there is no UK Continental Shelf standard form agreement to perform a farm-out, mainly due to the many commercial differences from one deal to another. There are various key points to bear in mind when drafting and negotiating a farm-in/farm-out agreement, but the main goal to aim for is precision and clarity.
The agreement needs to specify the work to be done by the party farming-in, in the case of wells, by reference to the location, target depth and geological target.
For example, the clause specifying the well to be drilled might state, “The well shall be drilled within the defined area to 7,200ft TVDSS or sufficient to test the (x) formation (whichever is the shallower)”. It should also clarify what costs relating to the drilling are to be borne by the party farming-in. Depending on the bargaining power of the parties, a financial cap on the costs may be negotiated.
Other important points are the timing of drilling obligations, particularly where these are related to a work obligation.
The parties will also need to consider what happens in a “worst-case scenario” where drilling does not take place or otherwise fails, for various reasons, to complete satisfactorily. Provision could be included to drill a substitute well.
If the acquiring party in the farm-out is not acquiring an interest in the whole licence, the extent of the interest needs to be defined precisely by reference to co-ordinates to be included in an appendix. It is important to make it clear whether the percentage referred to is a percentage of the whole licence or simply a percentage interest of the other party’s interest.
An example of appropriate wording might be, “Farm-out interest means fifty per cent (50%) of company A’s five per cent (5%) percentage interest (being a 2.5% percentage interest) in and under the operating agreement (but only to the extent that it relates to the farm-out area)”.
Certain consents will be required from BERR (or soon, its successor in function, DECC) in relation to the transfer of the licence interest and the undertaking of drilling operations.
There are two main options for the timing of the transfer itself. The interest could be transferred when the party farming-in has fulfilled its obligations, or the interest could be transferred as soon as possible after signature of the farm-out agreement. If the former structure is chosen, it is essential to include a provision to transfer the interest back to the party farming-out if the work is not completed.
In addition to the farm-out/farm-in agreement, other documents will be required. Typical examples include a confidentiality agreement, a well operator agreement, a JOA amendment or novation, a licence assignment and possibly a trust deed. The farming-in party will need to become party to all the field agreements, just as with an asset deal, so consent will be needed from all the other parties to those agreements.
These are difficult times for the industry, just like the rest of the economy. No one knows how badly the current economic climate and oil price will affect business in 2009.
Taking time and trouble to ensure that contractual obligations are unambiguous and precisely drafted is a good investment in order to create maximum economic certainty for the parties entering into such arrangements.
Penelope Warne is head of energy at Cameron McKenna LLP
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