Since 2015, bankruptcy courts have seen a steady flow of oil and gas bankruptcies — totaling around $106.8 billion in aggregate debt[1] — with no slowdown in sight.[2] These cases bring along the complex transactions common in the industry, governed by differing state laws and raising novel issues under the Bankruptcy Code. One such issue is the application of 11 U.S.C. § 541(b)(4)(A) to oil and gas agreements. That section excludes from property of the estate a debtor’s interest in oil and gas that has been transferred under a “farmout agreement.” But what constitutes a farmout varies according to state law and the agreement itself. Whether the interests underlying these agreements are property of the estate has important consequences in a bankruptcy case.
The quintessential oil and gas transaction is the lease.[3] In its most basic form, a mineral owner conveys its right to explore, develop and produce oil and gas to an operating company in exchange for a royalty. A lease typically lasts for a primary term but will continue beyond the primary term if a producing well is drilled. If the operating company fails to drill a producing well by the end of the primary term, the lease terminates, and the interest reverts to the mineral owner. While termed a “lease,” the agreement typically conveys title of the subsurface rights to the lessee during the term.[4] And so, in most states, the lease conveys a real property interest subject to divestiture.[5]
But in the real world, oil and gas operations are more complicated. A lessee may transfer its interests to multiple other parties who then explore, develop and produce subsurface, with varying arrangements for the payment of royalties, costs and so on between the parties. Those working the interest may themselves be subject to various subagreements. So the transactions and interests involved vary deal to deal, and other subarrangements and agreements are common.
One such example is the farmout agreement. Farmouts and traditional leases “are different documents used to accomplish different ends.”[6] Under a lease, the landowner retains title to the surface while conveying its interest in the subsurface to the operating company for a term.[7] A farmout, on the other hand, is commonly an agreement between the operating company or other entity that holds or controls a lease (the “farmor”) and another operator (the “farmee”), usually when the lease term is about to expire, and the farmor has yet to develop and is at risk of losing its lease.[8] So the farmor “farms out” its interests in the lease to the farmee to begin development and production before the lease terminates for a cut of the production value. The primary characteristic of these agreements is that the farmee takes title to the farmor’s interest only after it has finished its obligations to develop the interest, saving the interest from reverting to the landowner.[9] Thus, a farmee may invest significant resources trying to develop and drill before it ever retains an interest in the subsurface.[10]
Under § 541(a), the filing of a bankruptcy petition creates an estate comprised of the debtor’s tangible and intangible property. This includes a debtor’s interest in oil and gas leases, which can provide the estate with income to pay creditors. For example, the royalties a debtor receives can fund a plan, or a trustee may sell an underlying mineral interest free and clear under § 363.[11] But § 541(b)(4)(A) contains an exception, excluding from the estate a debtor’s interest in oil and gas that has been transferred under a farmout:
Property of the estate does not include … any interest of the debtor in liquid or gaseous hydrocarbons to the extent that —
(A)(i) the debtor has transferred or has agreed to transfer such interest pursuant to a farmout agreement or any written agreement directly related to a farmout agreement; and
(ii) but for the operation of this paragraph, the estate could include the interest referred to in clause (i) only by virtue of section 365 or 544(a)(3) of this title ….[12]
So whether an agreement constitutes a farmout has major consequences to the debtor, the estate and the creditors. And given that whether an agreement constitutes a farmout varies by state law and by the terms of each agreement, whether a debtor’s oil and gas interest is part of the estate is subject to great uncertainty. While the Code does define “farmout agreement” in § 101(21A), that definition is far broader than how the term is understood in the oil and gas industry and may cover agreements never intended to be farmouts in the first place.[13]
For example, in In re Poivey, a chapter 7 debtor had an oil and gas interest that had been leased to an operating company, for which she received around $2,159.56 per month.[14] The trustee sought to sell the interest free and clear under § 365, but the debtor objected, arguing that the interest had been transferred under a farmout agreement and was therefore not property of the estate subject to sale. The trustee contended that the debtor’s agreement was a true lease and not a farmout. Under Texas law, a lease transfers a real property interest (that is, the subsurface rights) from the mineral owner to the lessee for the lease term. But under a farmout, a lessee operator (the farmor) does not transfer any subsurface property rights to the farmee unless the farmee completes certain development obligations under the agreement. The debtor’s agreement in fact conveyed subsurface rights and was therefore a lease under applicable state law. But the debtor argued that regardless of state law or industry custom, the agreement was a farmout under the Bankruptcy Code’s broad definition of the term:
[T]he term “farmout agreement” means a written agreement in which:
(A) the owner of a right to drill, produce, or operate liquid or gaseous hydrocarbons on property agrees or has agreed to transfer or assign all or a part of such right to another entity; and
(B) such other entity (either directly or through its agents or its assigns), as consideration, agrees to perform drilling, reworking, recompleting, testing, or similar or related operations, to develop or produce liquid or gaseous hydrocarbons on the property.[15]
The debtor argued that her lease was a written agreement through which oil and gas interests were transferred, and for which the operator agreed to develop and drill as consideration, satisfying the basic definition of farmout under § 101(21A).
Acknowledging the quagmire created by § 101(21A), the bankruptcy court characterized the issue as “very odd, perhaps even absurd ....”[16] On the one hand, the debtor’s lease was a true lease under state law and, under industry custom, should therefore be property of the estate, but on the other hand, the lease did appear to satisfy the Code’s broader definition, excepting it from the estate. “[D]id Congress intend for something that would not be considered a ‘farmout agreement’ in the oil and gas industry to be one for purposes of the Bankruptcy Code?”[17]
Ultimately, the court was not forced to resolve the issue because the debtor had otherwise failed to show that her interest could have been included in the estate only through § 365 or 544(a)(3) of the Code, the final element of § 541(b)(4)(A)(ii). While the court was able to avoid the issue in Poivey, the issue will certainly arise again in the future — particularly given the uptick in oil and gas bankruptcies each year. And if § 101(21A) is construed broadly, many oil and gas leases may be considered farmouts — and excluded from the estate — that were never intended to be when drafted.
[1] Haynes and Boone, LLP Oil Patch Bankruptcy Monitor, August 12, 2019, available at https://bit.ly/2GP6luz (last visited Aug. 15, 2019).
[2] See, e.g., id; Christopher M. Matthews, “U.S. Drilling Slowdown Triggers Oil Bankruptcy,” Wall Street Journal, July 1, 2019.
[3] See generally Deborah D. Williamson, When Gushers Go Dry: The Essentials of Oil & Gas Bankruptcy, at 6-7 (ABI 2d Ed. 2016).
[4] Id. at 8.
[5] Id.
[6] In re Poivey, 2018 WL 550580, at *4, 2018 Bankr. LEXIS 171 (Bankr. E.D. Wis. Jan. 24, 2018).
[7] Id.
[8] Id.
[9] In re Poivey, 2018 WL 550580, at *4 (Bankr. E.D. Wis. Jan. 24, 2018); 2 Williams & Meyers, Oil and Gas Law § 432 (2018) (noting that key characteristic of a farmout agreement “is the obligation of the assignee to drill one or more wells on the assigned acreage as a prerequisite to the completion often transferred to him”).
[10] In re Poivey, 2018 WL 550580, at *5.
[11] See id. at *1 (trustee sought to sell debtor’s mineral interests — subject to a lease — free and clear under § 363(b) and (f)).
[12] 11 U.S.C. § 541(b)(4)(A)(i) and (ii).
[13] In re Poivey, 2018 WL 550580, at *3-4.
[14] Id. at *2.
[15] 11 U.S.C. § 101(21A).
[16] In re Poivey, 2018 WL 550580, at *5.
[17] Id.