What is Farmout

Farmout is the assignment of part or all of an oil, natural gas or mineral interest to a third party for development. The interest may be in any agreed-upon form, such as exploration blocks or drilling acreage. The third party, called the "farmee," pays the "farmor" a sum of money upfront for the interest and also commits to spending money to perform a specific activity related to the interest, such as operating oil exploration blocks, funding expenditures, testing or drilling. Income generated from the farmee's activities will go partly to the farmor as a royalty payment and partly to the farmee in percentages determined by the agreement.

BREAKING DOWN Farmout

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.

Farmout agreements work because 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.

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 risk to develop these resources is high because they are underwater.

To help reduce these risks, Kosmos "farms out" its acreage to third parties like Hess (HES), Tullow Oil and 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.

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.