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Texas Supreme Court says contract language beats industry custom

Earlier this month, the state Supreme Court overturned a $27.7 million verdict in a dispute over an oil and gas “farmout” agreement. In a 5-4 decision, the narrow majority held that the plain language of a contract should override industry customs relating to farmout agreements.

How farmout agreements generally work

In general, a farmout deal is a contract between a drill operating company and a working interest owner. The working interest owner assigns a part of their interest to the drilling operator in exchange for services, usually drilling the well to a given depth in a specific location.

These arrangements are common where one party has already leased an oil field, but drilling will come at a high cost. The drilling operator comes in and covers expenses in exchange for a percentage of the working interest, rather than waiting around for the working interest owner’s lease to expire.

Carrizo Oil & Gas uses farmout agreement to block the sale of land in Caddo Arch Bend

In the case that came before the Texas Supreme Court, Carrizo Oil & Gas had used the interest it had under a farmout agreement to block a deal that would assign development rights to 22,000 acres of land in northern Texas. Carrizo’s farmout agreement with Barrow-Shaver Resources Co. allowed Carrizo to block the sale, but the parties disagreed on whether doing so complied with industry customs. Carrizo was the lone holdout of 32 interested parties in the deal between Barrow-Shaver and Raptor Petroleum.

The Supreme Court’s ruling upheld a 2017 decision by an appeals court that the contract between Carrizo and Barrow-Shaver was unambiguous and did not require Carrizo to act reasonably. However, counsel for Barrow-Shaver argued that interpreting the deal in this way allows parties with a small interest to blow up a huge deal, turning a “pittance into a payday.”

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