De-Risking Petroleum Exploration and Production – the Farm-Out Agreement
That there is always some uncertainty of outcome associated with knowing whether a concession interest area contains commercially recoverable reserves of petroleum is one of the few certainties which exists in the business of exploring for and producing petroleum. To be successful, upstream companies must mitigate this uncertainty of outcome to the greatest extent possible.
This article examines the manner in which an upstream company is able to mitigate such uncertainty of outcome by divesting all or part of its interest in a concession or a project through a farm-out agreement.
The farm-out agreement will need to reconcile the competing interests of the farming-out party (which seeks to mitigate the uncertainty of outcome by shifting the risk to the farming-in party) and the farming-in party (which itself seeks to mitigate the uncertainty of outcome by leaving as much of that risk as possible with the farming-out party).
Certainty v. potential
The lifecycle of any upstream petroleum project can be characterised according to three essential phases:
exploration and appraisal (as the petroleum prospectivity of the concession interest is assessed);
project development and petroleum production (assuming that there are commercially realisable volumes of petroleum in the concession interest area); and
decommissioning and abandonment (as the petroleum production and transportation infrastructure within the concession area is removed or made safe upon the permanent cessation of petroleum production from that area).
Each of the three phases described above has a particular level of uncertainty associated with it. The exploration and appraisal phase of an upstream petroleum project will represent the high water mark of uncertainty regarding petroleum prospectivity. The process of exploring and appraising the concession will reduce this uncertainty (although the outcome of those activities may not always be the desired one). By contrast, the petroleum prospectivity of a project during its development and production or decommissioning phases will be much more certain because the project has already demonstrated that it is capable of petroleum production.
The uncertainty associated with a project is not the only factor that changes as it moves through its lifecycle. There are also differing degrees of upside potential associated with a project as it moves from one phase to the next. The upside potential of a concession will be at its highest during the exploration and appraisal phase, because prior to the start of exploration activities there is a zero base level of expectation attached to a concession. As the concession moves into production and then decommissioning that potential generally diminishes.
The correlation that exists between the certainty of outcome and upside potential of a project can simplistically be depicted as follows:
At the point in the lifecycle of a project where its certainty of outcome is at its lowest, the upside potential of that project is at its highest. Correspondingly, as a project moves through its lifecycle, the greater level of knowledge gained about that project has the effect on the one hand of increasing the certainty that surrounds it, and on the other of decreasing the likelihood that further upside will be realised.
Structuring a farm-in opportunity
Where an upstream company is farming out its interests in a concession, the portion of the risk of uncertainty of outcome around the prospectivity of the opportunity, corresponding to the interest in the concession which is being farmed out passes from the farming-out party to the farming-in party. The balance struck between the parties to a farm-out agreement will reflect the point, relative to the schematic shown above, at which the sale and purchase of the concession interest is effected.
The level of uncertainty of outcome in respect of a concession will colour the economics of the farming-in party’s bid to farm-in, and the fiscal terms which it is prepared to offer as a condition of doing so. An under-appraised asset will generally result in a lower level of consideration being payable; and a reduced level of uncertainty of outcome relating to a concession (through a greater level of appraisal of that concession) should result in a higher level of consideration being paid as a condition of entry to the concession. Similarly, the degree of upside potential attached to a concession will condition a farming-out party’s expectations as to the value it can expect to achieve from divesting part of its interest in that concession. An appraised asset which shows potential may increase the expectations of the farming-out party whereas a concession interest entering the decommissioning and abandonment will offer little upside potential, consequently reducing the headline level of consideration that a farming-out party will expect to achieve from that interest.
The farming-in party will be keen to de-risk its investment in the concession through the amount of consideration which it pays, and the manner of the payment of that consideration to the farming-out party. The precise formulation adopted in a particular farm-out agreement will depend on the negotiating strength of the parties. Some of the ways in which the parties may try to manipulate the consideration structure to their benefit are examined in the paragraphs below.
Concession costs and carries
The objective of a farming-out party is to realise some value from the divestment of all or part of its interest in a particular concession or project. The value that the farming-out party wishes to realise may not be purely financial. The purpose of the farm-out may be to gain the benefit of the particular skillset of the farming-in party or to mitigate the political risks of the project through the introduction of another party, such as a locally-based partner. That said, the primary driver for the majority of parties farming-out an interest in a concession is to generate financial value from that interest. Where a farming-out party intends to remain a party to a concession or a project, this financial value may be comprised of a number of different components: the recovery of costs already expended on a project, the deflection of costs that will need to be incurred on a project in the future and the generation of a pure profit element from a concession or project.
In reflection of the amount of appraisal which has taken place in respect of a concession, the consideration payable by the farming-in party could include a contribution to the past costs which were incurred by the farming-out party in effecting the appraisal. This contribution could be specifically identified as such in the farm-out agreement, or could be unspecified within a wider, general figure for consideration which is specified in the farm-out agreement.
The consideration payable by a farming-in party may also be directly related to the costs which will necessarily be incurred in association with mitigating the uncertainties attaching to a particular concession. This is of particular value to a farming-out party where it remains party to the concession which is the subject of the farm-out agreement and would otherwise have a continuing obligation to fund its residual participating interest share of those costs under the terms of a joint operating agreement for the concession.
In reflection of this, the farming-out party could require (under the terms of the farm-out agreement) that the farming-in party will carry the share of the costs of defined future appraisal works (such as the costs associated with conducting seismic or other survey work or of drilling exploration wells or further appraisal works) which would otherwise fall due for payment by the farming-out party. From the perspective of the farming-out party this consideration reflects only a deflection of the costs which it would otherwise be obliged to incur, often without any form or premium or uplift, and does not generate an obvious profit on the disposal by the farming-out party of its interest in the concession.
In any such carry arrangement there are a number of structural issues which must be addressed between the farming-out party and the farming-in party. These relate to:
the specific definition of the costs to be incurred;
the extent of the carry offered by the farming-in party to the farming-out party (including a possible cap on the intended carry costs); and
whether any part of the carried costs which are unspent should still accrue to the farming-out party or should remain with the farming-in party.
However, the most fundamental issue to consider in respect of the structuring of any carried costs interest under a farm-out agreement is whether or not all or part of the carried costs paid by the farming-in party are later repayable (from the proceeds of sale of produced quantities of petroleum) to the farming-in party by the farming-out party. This will be a matter for negotiation between the farming-out party and the farming-in party.
If the carried costs are so recoverable by the farming-in party then the carry is popularly described as ‘soft’; if the carried costs are not so recoverable by the farming-in party then the carry is described as ‘hard’. A hard carry is akin to a further element of consideration payable by the farming-in party (which ordinarily would not be refundable by the farming-out party), whereas a soft carry is akin to a form of loan by the farming-in party to farming-out party (which ordinarily would be refundable by the farming-out party).
Where the farm-out agreement provides for a soft carry then the farming-in party is running credit risk on the eventual repayment by the farming-out party, for which the farming-in party might require the provision of some form of collateral support in respect of the farming-out party’s repayment obligations.
While a carry arrangement may provide the means for a farming-out party to finance its share of ongoing costs under the concession, it will not be as valuable to a farming-out party as upfront cash consideration that is paid on completion of a farm-out. A carried interest will delay the value received by the farming-out party as a result of the divestment of part of its concession interest and introduces additional risk for the farming-out party. The full value of the carry may not ultimately be realised by the farming-out party. Supervening events could result in the abandonment of some or all of the carried obligations or, where a soft carry exists, the carry may be repayable. In these ways, a carry arrangement may offer only a temporary respite for the farming-out party. Ultimately, the very risks that a farming-out party seeks to mitigate through the divestment of its interest in a concession could be passed back to that farming-out party.
Deferred (contingent) consideration
The farming-in party could seek to reduce the level of risk associated with its investment into a concession by deferring part of the consideration which would otherwise be payable to the farming-out party on completion of the transaction. This deferred consideration element will be paid later by the farming-in party if a certain condition, which evidences the elimination of a defined risk to which the farming-in party would otherwise have been subject, is met. This is the essence of deferred, or contingent, consideration.
Deferred consideration, where it does not carry a premium, payable by the farming-in party in recognition of the fact of the deferral, is not obviously attractive to the farming-out party. A farming-out party will have a clear preference for the payment of the full value of the consideration by the farming-in party at the earliest possible opportunity but the dynamics of the particular transaction might give no choice to the farming-out party but to accept a deferral.
The contingency event which allows for a deferred payment of part of the consideration by the farming-in party, and which could even lead to the justifiable non-payment of that deferred consideration, will need to be carefully defined. Common contingency events include:
(1) Reserves enhancement – the deferred consideration could be payable when an independent third-party certifies the existence of certain quantities of petroleum within the concession interest area. This could require a recognition of the migration of contingent resources to reserves, and/or of reserves through the gradation of reserves probabilities (3P to 2P; 2P to 1P), in each case by reference to an agreed method of petroleum classification.
(2) Development milestones – the deferred consideration could be payable when a certain development milestone associated with the underlying petroleum project has been achieved within a defined timeframe. This could relate, for example, to the making of a commercial discovery, the submission of an agreed field development plan to the government or the approval of that field development plan by the government.
(3) Production milestones – the deferred consideration could be payable when a certain volume of petroleum has been produced from the project. There could also be a series of production payment milestones, payable when different levels of petroleum production have been achieved.
From the farming-in party’s perspective the deferred consideration only becomes payable to the farming-out party when the contingency event which relates to the deferred consideration has occurred. This gives the farming-in party significant comfort that the farm-out agreement has been de-risked. Correspondingly, the farming-out party takes the risk that the contingency event is not achieved, and that the deferred consideration is not paid by the farming-in party.
The inclusion in a farm-out agreement of a mechanism which provides for the payment of contingent consideration brings certain challenges. As noted above, careful definition of the contingency event is essential (including a consideration of whether a pro rata share of the deferred consideration should be payable if a pro rata share of the defined contingency event has been achieved, and a consideration of what happens if a supervening event occurs which makes impossible the continued performance of the contingency event, despite its initial performance).
The farm-out agreement should provide a mechanism for determining proof of the satisfaction of a contingency event (such as through the appointment of a third-party auditor, working (wherever possible) to the parameters of a defined set of industry metrics) and a mechanism for the quick and effective resolution of disputes between the parties to the farm-out agreement relating to the satisfaction of the contingency event.
The farming-out party should also recognise that because it is not receiving payment of the full value of the agreed consideration up front from the farming-in party upon completion of the farm-out agreement then it is running credit risk on the eventual payment by the farming-in party, for which the farming-out party might require the provision of some form of collateral support in respect of the farming-in party’s obligations. A mechanism for addressing the farming-in party’s unremedied failure to make payment when due to the farming-out party might also be specified in the farm-out agreement. This could require the entire transaction to be unwound in the farming-out party’s favour, so that the underlying interest is restored to the farming-out party.
The key structural issue to be noted in connection with deferred consideration relates to the role the parties to the farm-out agreement will play after completion of the farm-out agreement. Much depends here on whether the farming-in party will be the sole owner of the concession, or whether the farming-out party will maintain a continuing participating interest in the concession post-completion.
If, under the terms of the farm-out agreement, the farming-out party is selling the entirety of its interest in the concession to the farming-in party then the farming-out party will require a robust set of performance covenants from the farming-in party in respect of the management of the interest after completion of the sale. The farming-out party will not want to see the farming-in party have absolute freedom to dictate the manner in which the interest is developed post-completion, out of a concern that the farming-in party could do little with the interest and thereby defeat progress towards satisfaction of the defined contingency events and payment of the deferred consideration.
Ultimately, the protections to be afforded to the farming-out party against the indolence of the farming-in party could include a right of the farming-out party to step back in to the management of the concession interest, but this will require careful definition and would be subject to whatever regulatory consents are necessary to a transfer of a concession interests.
If, under the terms of the farm-out agreement, the farming-out party is selling only part of its interest in the concession to the farming-in party then the farming-in party and the farming-out party will both remain involved in the management of the concession (with their relationship governed by a joint operating agreement). This situation also brings its own difficulties, however, demonstrating the inherent conflict of interest that exists between the two parties:
Farming-in party as operator – the farming-out party will need to ensure that the terms of the joint operating agreement are sufficient to give the farming-out party a right to compel the proper performance of the concession, so that the contingency events are properly performed by the farming-in party and the deferred consideration becomes payable.
Farming-out party as operator – the farming-in party will need to ensure that the terms of the joint operating agreement are sufficient to prevent the development of the concession from being pursued in a manner which all too obviously promotes the early achievement of the contingency events, possibly at the expense of the optimal performance of the concession, in order that the farming-out party recovers its deferred consideration above all else.
In either of these cases the terms of the joint operating agreement could require some significant modification in order to protect the respective interests of the parties. If the farm-out agreement relates to an interest in respect of which a joint operating agreement already applies then the other parties to the concession, who are party to the joint operating agreement but not to the farm-out agreement, will be unwilling to see the terms of their joint operating agreement modified solely in order to reflect the essential operational mechanics of the farm-out agreement.
Before embarking upon the exercise of structuring a deferred consideration payment mechanism in the farm-out agreement the parties should also take care to consider the applicable tax consequences to them both of implementing such a mechanism. Although the farming-out party’s expectation of future revenues from the farming-in party is entirely contingent, the deferred consideration mechanism could imply the receipt of taxable revenue in the hands of the farming-out party and could result in a tax liability which is unmatched by a corresponding receipt of revenue.
The analysis set out above in respect of deferred consideration assumes that the amount payable by the farming-in party is entirely reflective of the risk to be taken by the farming-in party as a consequence of the intended investment, and even if the deferred consideration is payable by the farming-in party then it only entitles the farming-out party to recover the base level of consideration to which it originally would have been entitled, but for the deferral of consideration resulting from the deferred consideration mechanism.
A deferred consideration structure may be a more attractive prospect to a farming-out party where it is applied to achieve value for the future performance of an asset. Deferred consideration can bridge the gap between a farming-out party’s aspirations in respect of the value that may be realised from the upside potential of an interest in a concession and a farming-in party’s concerns regarding the uncertainty associated with that concession.
In such circumstances, the farm-out agreement is structured so that the farming-in party is obliged to pay a premium to the farming-out party if a defined contingency event comes to pass. This premium payment model could apply as an uplift to the amount of deferred consideration payable by the farming-in party, in recompense for the risk taken by the farming-out party in agreeing to such a structure.
Alternatively the premium could be entirely decoupled from any deferred consideration element. The premium could be structured simply as a further payment due from the farming-in party in addition to the base consideration which has already been paid by the farming-in party upon completion of the farm-out agreement. The premium would be paid upon the occurrence of a defined contingency event.
Where a farming-out party sells the entirety of its interest in a concession it could do so on the basis of receiving a reduced amount of consideration from the farming-in party upon completion of the farm-out agreement, but with the commitment of the farming-in party to pay a continuing royalty to the farming-out party. The royalty would be paid by the farming-in party pro rata to future levels of petroleum production from the interest.
Both the farming-in party and the farming-out party can benefit from the implementation of such a royalty structure. Through accepting the payment of a royalty the farming-in party not only shares some of the risk associated with the continued production of petroleum from the interest with the farming-out party, but also pays a reduced upfront amount of consideration in respect of that interest. As a royalty-holder however, the farming-out party retains a continuing economic interest in the concession, with the benefit of whatever upside potential can be realised from that interest, despite having sold its interest in the concession.
The ongoing management tensions described above that arise under a deferred consideration structure will also apply where a royalty structure is put in place in respect of an interest. In order to protect its future economic interest as a royalty-holder, the farming-out party will require performance covenants from the farming-in party in respect of the proper management of the interest after completion of the sale, to ensure that petroleum is produced and the royalty becomes payable by the farming-in party. These covenants are not always achievable however, and much will depend on the size of the royalty as to what protections will be offered.
The divestment by a farming-out party of all or part of its interest in a concession will bring with it a commensurate de-risking of that interest for the farming-out party. This de-risking can be represented as follows:
Although the divestment of an interest may benefit both parties to a farm-out agreement, this article has demonstrated that the consideration structure adopted under a farm-out agreement may result in some of that risk being passed back to the farming-out party. A carry or deferred consideration structure may offer a farming-out party the opportunity to realise greater value from the upside potential of its concession interest but such structures also increase the likelihood that some or all of the risks that the farming-out party had hoped to transfer to a farming-in party will ultimately be borne by the farming-out party.
Unless a royalty interest is taken by a farming-out party, the divestment of a concession interest also represents the complete alienation of the divested participating interest share in the concession from that party. The short-term benefit achieved by the farming-out party through the divestment may not offer the ability to realise sustained value enhancement that upstream companies need from their asset portfolios. In this sense, financing techniques, which share many of the upside potential benefits of royalties, without diluting the equity held in an upstream company’s portfolio, may offer a more attractive long-term solution than divestment.
While it will never be possible to eradicate entirely the uncertainties which exist in the business of exploring for and producing petroleum, the divestment by an upstream company of all or part of its interests in a particular concession is one method by which such uncertainties can be managed and mitigated to avoid overexposure to downside risk for a particular company. The application of one or more of the structuring options examined in this article can further operate to balance those uncertainties for both the divesting and the incoming parties enabling each party to achieve a commercial deal commensurate to its appetite for risk.