Navigating oil and gas farm-in and joint venture agreements: Key issues, pitfalls and best practices

Farm-in and joint venture agreements are mutually beneficial tools for risk sharing, capital allocation and project development, particularly in the exploration and early development stages where costs and risks can be significant. Documenting these arrangements, however, is rarely straightforward. Parties are often required to simultaneously navigate complex legal, commercial and operational dynamics to protect their interests and ensure a project’s long-term viability.

In this article, we explore key issues, pitfalls and best practices in farm-in and joint venture arrangements in Australia’s oil & gas industry.

Agreeing on scope, timing and costs

A key early step in any farm-in arrangement is defining the scope of work that is to be undertaken by the farmee. Any uncertainty around the exploration or development program (what it includes, when it starts and how it will be funded) can cause tension and delay. Considering this, farm-in and joint venture agreements should clearly outline (at a minimum):

• the initial work programs and timelines for delivery;
• milestone events (e.g. the particulars around the completion and stimulation of a well, or the specific requirements for seismic acquisition and interpretation); and
• budget estimates and cost-sharing mechanisms.

Failure to do so can result in disputes over whether a party has met its obligations under the relevant agreement and is entitled to earn its interest.

Structuring your farm-in

There are various ways to structure a farm-in arrangement, with the choice typically reflecting the parties’ commercial intent, as well as timing and regulatory requirements. 

Common structures include:

1. Deferred earn-in, where the farmee earns an interest upon meeting agreed milestones (e.g. acquiring seismic or drilling a well).
2. Upfront transfer, where a transfer of tenement interest occurs at the time the agreement is executed or shortly thereafter, and is subject to the farmee meeting minimum work and expenditure obligations.
3. Option structures, allowing the farmee to opt into an interest following a period of evaluation or the occurrence of a future event – for example, where the farmee pays for the right (i.e. the option) to farm into a permit if drilling yields positive results.

It is also not uncommon for farm-in arrangements to be multi-phased or staged which allows for the farmee to earn its interest progressively. For example, a 25% interest for the acquisition and interpretation of seismic data, and then a further 25% upon completion and stimulation of a well.

Each of the above structures have their own advantages or disadvantages, depending on whose interests are being prioritised. For example, upfront arrangements allow the farmee to immediately establish a legal interest which may be useful for financing and for having influence over operations. Conversely, a deferred farm-in allows the farmer to retain full ownership and control of the interest until the farmee has earned its interest, and in doing so, reducing the risk of requiring a re-transfer of interest. Similarly, option structures allow flexibility and risk mitigation for the farmee if early exploration results are uncertain.

Tax implications also differ between these structures, including the applicability of any farm-in duty concession, so ensuring the right structure is used is important in preventing any unexpected duty liability.

Operator vs non-operator rights and decision-making

Tension can arise between operator and non-operator roles in a joint venture relationship. The operator typically conducts the day-to-day management of operations, whilst the non-operators are eager to maintain oversight and control over key decisions.

A well drafted joint operating agreement (JOA) should include:

• a robust decision-making framework, which includes clearly outlining the decisions that require unanimous consent, and those that only require majority approval;
• deadlock provisions, which outline what happens when parties cannot satisfy the relevant decision-making threshold. Resolution mechanisms may include independent expert determination, arbitration and buy-sell clauses; and
• a clear delineation of operator duties, including standards of performance, reporting obligations and expenditure controls (including the extent of pre-approved over expenditure).

Naturally, operators often seek a broad discretion to manage operations efficiently and, to the extent possible, unilaterally. By contrast, non-operators want protection that they will not be liable for poor decision-making or unchecked spending. Balancing these interests is a common pain point for parties during negotiations.

Default and withdrawal provisions

To maintain project momentum, manage risks and, if necessary, facilitate exits, JOAs should clearly set out the consequences of a party’s default or failure to meet its commitments. Key provisions may include:

• dilution mechanics, which allow for a party’s interest to be reduced (i.e. ‘diluted’) in proportion to its unfulfilled obligations;
• buy-out or forced sale clauses, which enable a non-defaulting party to acquire a defaulting party’s interest in the joint venture. Typically, the amount payable for the interest will be market-based or otherwise determined by an expert, however a discounted rate may be agreed to prevent the defaulting venturer from profiting from its default. Buy-out clauses can be triggered by various events, including a failure to fund, default on obligations or a desire to exit the venture; and
• deemed withdrawal or forfeiture provisions, which, if triggered, reduce the defaulting participant’s interest to zero, with the corresponding increase in the interests of the other venturer(s). These clauses operate in a similar way to buy-out clauses and may be triggered due to a party’s failure to comply with obligations or a dilution of their interest below a specified threshold (e.g. 5%).

Certainty around how and when these mechanisms apply is essential to avoid disputes or an unintended forfeiture of interest. The parties should also take care to ensure that any default and withdrawal provisions are not excessive relative to the loss suffered by the non-defaulting parties, in which case they may be deemed to be a penalty at law and unenforceable.

Negotiation pain points: Importance of managing expectations early

There are certain issues that tend to cause tension during farm-in or joint venture negotiations. These include:

1. Operator rights and control, as noted above, the inherent disparity between the interests of the operator and non-operator routinely causes friction during negotiations.
2. Liability sharing, particularly in relation to accepted carve outs to the liability regime. For example, whether a party’s indemnity extends its agents, subcontractors and invitees, and whether the operator has complete protection regardless of any misconduct on their part.
3. Approval thresholds for material decisions, specifying what matters require majority versus super majority versus unanimous approval is a key commercial issue that causes tension, particularly when a party has its own internal approval requirements that it needs to satisfy.
4. Audit and inspection rights, as noted above, non-operators are eager to ensure transparency into the joint venture’s expenditure and performance. To that end, non-operators may seek unfettered access to the operator’s relevant books and records which can, in turn, create administrative and commercial challenges for the operator.
5. Transfer and change-of-control clauses, particularly when one party seeks exit flexibility and therefore broad rights to dispose of its interest, whilst the other values stability and certainty about their project partner.

Engaging with these issues and agreeing an ‘in-principle’ position early can help prevent roadblocks later on.

Implications

Farm-in and joint venture arrangements provide valuable pathways for resource collaboration, risk management and capital deployment. That said, poorly structured arrangements or gaps in documentation can lead to unexpected costs, project delays and disputes.