In this episode we discuss the different types of oil and gas deals and partnerships including: how different oil and gas companies work together, what agreements they use, how a company can be an operator in some wells and also a non-operated working interest partner in other wells that another company operates. Plus we cover the strategies and tactics often involved with these types of acreage trades and agreements.
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Types of Operator Partnerships and how they affect mineral and royalty owners
All of this starts with one important event: the signing of an oil and gas lease. This is important because the oil and gas lease creates the leasehold or working interest.
To recap: “A working interest is an ownership in an oil and gas lease (also known as a “leasehold interest”) that provides the owner with the right to explore and produce oil, gas, or other minerals. The working interest owner, bears their proportional share of the cost of drilling, completing, and operating a well in return for their share of the oil and gas produced.”
“There are two types of working interests, operated and non-operated. As you might expect, the owner of the operated working interest is responsible for all aspects of drilling and operations for the lease. The non-operated working interest owner is consulted on decisions related to the lease but are not involved with actually operating any wells.”
To learn more, listen to MRP 7: Working Interests for Mineral Owners.
The oil company that drills a well on your minerals is considered the operated working interest owner. The company that drills the well is called the operator and there usually can only be one operator for a given lease.
Other parties that own oil and gas leases within the spacing unit for that well but who aren’t the ones actually drilling the well are called non-operated working interest owners or non-operated cotenants. The operator will usually enter into a Joint Operating Agreement or JOA with the other working interest owners to agree to the rights and obligations of all working interest owners.
Resources to learn more about working interests:
I cover these topics in more detail in my upcoming online course Minerals Management Basics (when it is available, it can be found under “Courses” in the menu for this website.
Trading Leases
When an operator identifies an area they would like to explore, or drill wells, they will use seismic data and geologists will identify the likely best parts of that formation in a particular area. Then it is up to the landman to obtain oil and gas leases in that area so they can drill a well or multiple wells.
The first company to lease mineral rights in an area has an advantage but soon speculators and other operators may also enter the area and start leasing. What results often is a patchwork of oil and gas leases covering that basin or play. Operator will try to obtain contiguous acreage to develop but sometimes others may have leased tracts within their planned drilling spacing units
To solve this problem, companies will often trade acreage in an area. For example, let’s say that Operator A has 90% of the leases in a Spacing Unit and Operator B has 10% of the leases in that Spacing Unit (a Spacing Unit is the acreage that is pooled together for one or more wells). In the adjacent spacing unit the percentages may be reversed with Operator B owning 90% of the leases and Operator A having only 10% of the leases. One way that they can try to increase their interest in the spacing unit where they plan to be the operator is to swap acreage.
In the previous example, Operator A may swap their minority interest in Operator B’s unit in exchange for Operator B’s minority interest in their unit. So at the end of the swap, Operator A would own 100% of the leases under the unit they plan to drill and Operator B owns 100% of the leases under their planned unit.
Deals aren’t usually that straightforward but companies can also pitch in money to pay for the difference in value between swapped acreage but the important thing to understand out of this example is they will try to consolidate acreage where they own the majority of the leases. These types of deals aren’t confined to a single basin or play. Sometimes companies have interest in each other’s wells across multiple basins or oil & gas plays so they could trade their acreage in one play for acreage in another play that is more strategic to that company.
The lease trades may be covered by a lease exchange agreement as well as lease assignments which are recorded in the county where the leases are located.
Selling Leases
Another common situation is that once others in the industry catch wind that an operator is leasing in an area, they will try to swoop in and lease up a bunch of acreage as well in hopes of flipping it to the operator at a profit and sometimes also reserving an overriding royalty interest in the leased tracts. The moral of the story is that oil and gas leases can be bought and sold or traded. This is very common practice.
The important takeaway for mineral owners is that even if you sign an oil and gas lease with one company, they may end up selling the lease to another company before or after a well gets drilled. You might sign a lease with a landman who flips it to the operator that eventually drills a well. Later down the road that operator may drill a well to hold the lease and assemble other leases to sell to another operator. Your lease may change hands multiple times before and even after a well gets drilled. In most cases, you don’t have a say in who it gets sold to (unless you have enough bargaining power to negotiate a clause that requires your prior written consent before a Lessee can assign the lease to another party).
A company doesn’t need to own 100% of the leases in order to permit and drill wells but the chances for success in funding the drilling and completions costs really require that they own the majority of oil and gas leases with the spacing unit for the planned wells. In order to obtain a pooling order for a planned Drilling Spacing Unit (DSU), many states require that an operator obtains consent from the majority of mineral owners (in the form of an oil and gas lease). In these states with statutory pooling, operators have the ability to recoup the costs of carrying the non-consenting working interest owners.
In other cases, an operator may want to own all of the oil and gas leases under a planned well. For example, if they are drilling an exploratory well and they would like the results to remain confidential. They may not want other non-operated working interest owners to have access to information about the exploration well in which case they would want to own 100% of the leasehold interest under that exploration well. This is because the non-operated working interest partners would at minimum see production results and costs through their Joint Interest Billings and that would tip the hand as to whether or not the well was successful, and how successful that well is.
The document that outlines the terms between the operated working interest and non-operated working interest partners is called a Joint Operating Agreement.
Joint Operating Agreements
Next to the oil and gas lease, this is one of the most important documents that govern oil and gas exploration and production. As mentioned, this is an agreement between the parties that own oil and gas leases within the same tracts or adjacent tracts that make up a drilling spacing unit where one or more wells will get drilled.
In the patchwork example we just talked about there are times where maybe operators each own a large percentage of leases overlapping each other and both may want to maintain operatorship within that area instead of selling or trading that acreage. So an alternative arrangement is to document who will be the operator in a given area and each party’s rights and duties in terms of the operated and the non-operated interests. I’ve seen this several times as well in the Appalachian Basin in Pennsylvania as well as the Permian Basin in Texas. That said, these types of agreements exist in virtually all oil and gas plays.
If you own a non-operated working interest in a well, the Joint Operating Agreement or JOA is an important document. It is the bible in terms of your rights and responsibilities with respect to owning an interest in the area covered by the agreement which is often called the “contract area”. The contract area may also be referred to as an Area of Mutual Interest (AMI).
Believe it or not these are some of the more straightforward arrangements in the oil and gas industry but there are others that are more creative in terms of how the different parties work together and of course this all is documented in the Joint Operating Agreement as well as other agreements. What we’ve talked about so far are when the operator is the one that actually drills the well and pays the majority of the costs associated with that work.
Farmout Agreements
In another agreement called a Farmout, the oil and gas lease can be assigned to a third party for development. In exchange for this assigned acreage, the third party called the “farmee” pays the owner of the leases “the farmor” money upfront for the interests and usually also commits to spending money within a certain amount of time to drill one or more wells.
This can be beneficial to the owner of the leases who would like to see it developed before the leases expire (and it becomes worthless) but simply doesn’t have the capital to drill the wells necessary to hold the leases when considering the other investment opportunities the company has.
Of course, the company will want to benefit from the upside potential of any wells that are drilled so they’ll usually keep an overriding royalty interest in the leases and may also have an option to convert it back into a working interest at some point in the future (usually after the farmer recovers the cost of drilling and completing the wells covered by the farmout agreement). This situation is called a Back in after payout agreement.
Again, this is really useful for the smaller operator who just doesn’t have the capital to develop all of the acreage they have leased. For the owner of the oil and gas working interest who assigns this interest it is called a farm-out. For the third party who pays for that interest in exchange for drilling one or more wells, it is considered a farm-in agreement from their perspective so those terms refer to the same thing but just depending on whose perspective you’re looking at it from.
Resources Mentioned in This Episode
- MRP 7: Working Interests for Mineral Owners
- MRP 126: Deep Dive on Investing in Mineral Rights, Royalties, and Working Interests
- Introduction to Joint Operating Agreements
- Farmout Agreements: The Basics, Negotiations and Motivations
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