Sección de contabilidad

The conversion provision of a farmout agreement addresses whether the retained nonoperating interest that the farmor retains to provide a cash flow will be converted at some point in time to a share of the working interest. There are three possibilities: no conversion, mandatory conversion, and optional conversion. Which of these the farmor or the farmee may prefer will depend upon circumstances and the goals of each.

When the agreement lacks any conversion provision, the nonoperating interest retained by the farmor will continue as long as production from the well continues. That may be attractive to a farmor needing additional cash flow or commitment of reserves, or to one distrustful of the business acumen of the farmee, or anticipating marginal production. Omitting a conversion provision may also be attractive to a farmee expecting prolific production. A nonoperating interest (for example, a 1/16th overriding royalty) will be less of an economic burden if production is prolific than if it is marginal. Generally, however, the parties to farmout agreements are actively involved in the oil business and have a predilection in favor of full participation. Relatively few farmouts omit conversion provisions for the nonoperating interest retained by the farmor.315

If the nonoperating interest retained is convertible to a working interest, the farmee generally prefers mandatory conversion.316 Mandatory

313. See Cline v. Angle, 216 Kan. 328, 532 P.2d 1093, 1097 (1975). Often, a farmout clause that reserves an interest in the farmor will specifically state that the interest is free of all production costs. For example: “This overriding royalty shall be free and clear of all costs of production, gathering, completion, dehydration, trucking, transportation, marketing, treating, and taxes except applicable windfall profit, excise, ad valorem, gross production and severance taxes.”

314. See Aminoil USA, Inc. v. OKC Corp., 629 F. Supp. 647, 650–54 (E.D. La. 1986). In

Aminoil the farmor and the farmee disagreed over whether actual or imputed interest and legal expenses were properly chargeable against the net profits account. Id. at 648. The jury was permitted to consider expert accounting testimony, since the agreement was not explicit.

Id. at 650.

315. If the farmor does not have the right to convert its overriding royalty, the agreement may provide to increase it after payout. See supra note 306.

conversion, or no conversion, gives the farmee additional certainty. The farmor, in contrast, generally prefers to maintain flexibility by retaining an option either to retain its overriding royalty or to “back in” to a working interest.317 The structure adopted usually reflects nothing more than the bargaining leverage of the parties.

The conversion structure adopted may present some special drafting problems. One is whether the farmor that either elects not to convert its nonoperating interest into a working interest or is barred from doing so, has a right to participate in in-fill drilling. This is similar to the problem discussed above of whether the farmor should participate in drilling before payout, and similar drafting devices will deal with this situation.318 Another problem is the effective date of the conversion, whether mandatory or optional. Farmout agreements often make the conversion effective on the

If and only if, the test well is completed for the production of oil and/or gas, farmor shall assign to farmee 100 percent of its operating rights and working interest in the acreage within the designated drilling and spacing unit established by the Commission for the test well, excepting and reserving to farmor, in addition to any other overriding royalties or nonoperating burdens on production, an overriding royalty of 1/16th of an 8/8ths of all oil, gas and associated substances produced and saved from the test well until payout of the well, at which time the reserved overriding royalty of farmor shall terminate and 50 percent of the operating rights and working interest of farmor assigned under this subsection will automatically revert to farmor, and the test well, the material and equipment therein and thereon, and all production thereafter recovered therefrom and the operating rights and working interest in the farmed out lands in the drilling and spacing unit will be earned thereafter by farmor and farmee in equal 50 percent shares.

(Emphasis added.)

317. An example of a conversion option is:

If the Initial Well or any Subsequent Earning Well reaches the Objective Depth and is completed as a commercial well, and if it has been drilled in accordance with all of the terms and conditions of this agreement, farmee shall have earned, and farmor will deliver upon farmee’s written request an assignment of the oil and gas rights as defined in this Article. The assignment shall:

* * *

6. Reserve to farmor the option after payout to convert its overriding royalty to a ____ percent (____%) working interest in the assigned acreage and in all leasehold equipment, materials, and production.

See also Scott, supra note 3, at 84–85 (¶ 6(d) of example agreement). 318. See supra note 310 and accompanying text.

first day of the month following payout.319 While that approach may be administratively convenient, the delay may cost the farmor a substantial amount. The farmor with an option to convert will prefer to have its election effective immediately.320