Farmout

Key Takeaways

• A farmout is the assignment of resource interests to a third party for development, often in oil, gas, or mineral sectors.
• The farmee commits capital to develop the interest and pays the farmor a share of the proceeds as royalties.
• Farmout agreements allow companies to mitigate risk and share development costs with other parties.
• Smaller producers use farmouts to develop challenging fields, reducing costs and risk.
• A back-in after payout (BIAPO) option allows the farmor to regain a working interest after drilling costs are recovered.

What Is a Farmout?

A farmout is a specific type of agreement in the oil, natural gas, or mineral industries where a property owner transfers part or all of their interest to another party to carry out exploration and production activities. This arrangement allows the original owner, or 'farmor,' to mitigate financial risk and share potential profits with the 'farmee,' who conducts the necessary development operations. Farmout agreements are a common practice in the energy sector, enabling companies to leverage expertise and resources for developing challenging or expensive fields.

How Farmout Agreements Work

A company may decide to enter into a farmout agreement with a third party if it wants to maintain its interest in an exploration block or drilling acreage but wants to reduce its risk or doesn't have the money to undertake the operations that are desirable for that interest. Farmout agreements give farmees a potential profit opportunity that they would not otherwise have access to. Government approval may be necessary before a farmout deal can be finalized.

The farmor usually receives a royalty payment once the field is developed and producing oil or gas, with the option to convert the royalty back into a specified working interest in the block after paying for drilling and production expenses that were incurred by the farmee. This type of option is commonly known as a back-in after payout (BIAPO) arrangement.

Tip

Farmout agreements are effective risk management tools for smaller oil companies. Without them, some oil fields would simply remain undeveloped due to the high risks facing any single operator.

Farmout Agreement Example with Kosmos Energy

Farmout agreements are very popular with smaller oil and gas producers who own or have rights to oil fields that are expensive or difficult to develop. One company that makes frequent use of this type of arrangement is Kosmos Energy (NYSE: KOS). Kosmos has rights to acreage off the coast of Ghana, but the cost and risks to develop these resources are high because they are underwater.

To help reduce these risks, Kosmos "farms out" its acreage to third parties like Hess (HES), Tullow Oil, and British Petroleum (BP). Doing so allows these offshore blocks to be developed and generate cash flow for all the parties involved. A farmee like Hess takes on the obligation to develop the field and, in return, has the right to sell oil that is produced there. Kosmos, as the farmor, earns a royalty payment from Hess for supplying the acreage and the natural resource.

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