THE .L~ITOECNEY GENERAL 

OF-XAS 

Honorable Bob Armstrong Opinion No. M-943 

Commissioner 

General Land Office Re: Whether a proportionate 

Austin, Texas 78701 cost of preparing natural 

gas from State leases for 

market may legally be 

deducted from the State's 

Dear Commissioner Armstrong: royalty interest. 

Your request sets out the following facts. The lease 

operator holds several State oil and gas leases in the Gulf 

of Mexico upon each of which it has drilled several wells 

that produce natural gas. On each lease one of the wells is 

a platform well or production deck well upon which are heaters, 

gas production separators, dehydrators, and metering devices 

for gas, condensate, and water. Each lease also contains one 

or more satellite wells upon which are a heater, meter, regulator, valves, and flow lines running from the satellite well 

to the platform well. After the gas has been processed through 

the above mentioned facilities, it is sold by the operator 

to the gas gatherer-purchaser at the platform well. 

You further state that the lease operator seeks to 

deduct from and thus charge against the State's 1/6th royalty 

a proportionate part of the amortization of the costs of the 

above mentioned facilities, a 6% return on the investment, 

and the costs of operating these facilities. 

Against this background you specifically request 

that this office '. . . review Opinion No. WW-196, along with 

our past and current oil and gas lease forms and advise us 

whether the charges asked for by the companies can be legally 

justified." 

The statutory authority pursuant to which the royalty 

provision of the State oil and gas lease in question must 

conform is Sec. 8 and Sec. 10 of Art. 5421c, Vernon's Civil 

Statutes. Section 8 reads in part: 

"All islands, salt water lakes, . . . and 

that portion of the Gulf of Mexico within 

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Honorable Bob Armstrong, page 2 (M-943) 

the jurisdiction of Texas . . , shall 

be subject to lease by the Commissioner 

of the General Land Office . . ., in 

accordance with the provisions of all 

existing laws pertaining to the leasing 

of such areas of oil and qas; . . . : 

provided further, that the royalty 

reserved to the state shall be not less 

than one-eighth (l/8) of the gross production or value of oil, gas and sulphur. 

1, . . . (Emphasis added) 

Section 10 reads in part: 

"The areas included herein shall be leased 

for a consideration, in addition to the 

cash amount bid therefor, of not less than 

one-eighth (l/E) of the gross production of 

oil, or the value of same, that may be produced and saved, and not less than oneeighth (l/E) of the gross production of gas, 

or the value of same, and not less than oneeighth (l/8) of the gross production of 

sulphur, or the value of same that may be 

produced, that may be produced and sold off 

the area, and not less than one-sixteenth 

(l/16) of the value of all other minerals 

that may be produced, and an additional 

sum of twenty-five cents an acre per year 

for each year thereafter until production 

is secured. . . ." 

The gas royalty provision contained in the State lease 

question reads as follows: 

" 3 . When production of oil and/or gas 

is secured,the Lessee agrees to pay or 

cause to be paid to the Commissioner of 

the General Land Office at Austin, Texas, 

for the use and benefit of the State of 

Texas, during the term hereof; . . . 

(B) As royalty on any gas, . . . produced 

from any well and sold by Lessee, or used 

by Lessee for purposes which are not 

exempted from royalty payments . . . (l/6) 

of the value of the gross production, but 

in no event shall the royalty be based on a 

price of less than the highest market price 

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in 
Honorable Bob Armstrong, page 3 (M-943) 

paid or offered for gas in the general area, 

or the price paid or offered to the producer, 

whichever is the greater; . . ." (Emphasis 

added) 

Analysis of the statutes and the State lease is light of the 

case law and former opinions of this office dealing with 

these leases and statutes provides the basis for the reexamination of Opinion WW-196. 

Sections 8 and 10 of Art. 5421c, were originally 

promulgated by Acts 1931, 42nd Leg., p. 452, ch. 271. Sec. 

10 has remained unchanged to date, but Sec. 8 has been amended 

several times, the most recent and important being by Acts 

1957, 55th Leg., p. 434, ch. 209, 51, effective May 10, 1957, 

which added the proviso underlined in the above quoted portion 

of Sec. 8. In addition, Acts 1957, supra, stated that "All 

laws or parts of laws in conflict herewith are expressly 

repealed." Therefore, Sec. 8, on and after May 10, 1957, is 

the statutory authority for the clause in the State lease 

specifying the royalty reservation to the State. Prior to 

this amendment, however, Sec. 10 was the controlling statutory 

provision insofar as the royalty reservation clause in the 

State lease is concerned. 

Comparison of the Sec. 8 royalty provision with that 

contained in Sec. 10 leads us to the conclusion that a material 

change was effected with respect to royalties on oil and sulphur. In effect, by the 1957 amendment, Sec. 8 deleted from 

Sec. 10 the qualifying language ". . . that may be produced 

and saved, . . .II as this pertains to the royalty payable on 

oil and the language II. . . that may be produced, that may be 

produced and sold off the area, . . ." as this pertains to 

sulphur. However, the absence of such modifying language in 

Sec. 10 and Sec. 8 in regard to the royalty provision pertaining to gas demonstrates a distinguishably consistent 

statutory standard. The various gas royalty reservations, 

i.e., that ". . . gross production of gas, or the value of 

same. . ." as used in Sec. 10 of Art. 5421c, and ". . . gross 

production or value of . . . gas . . ." used in Sec. 8 of 

Art. 5421~~ and ". . . value of gross production . . ." used 

on the State lease form, are synonomus in meaning. We are 

of the opinion that with respect to gas, the State must receive 

its fractional interest based on the value of the entire 

production of gas without any deductions from the gas volume 

produced (Attorney General Opinion V-475) (1948), or the value 

thereof. In this we are fully supported by the authorities 

and the language of the State lease, as will be pointed out below. 

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. 
Honorable Bob Armstrong, page 4 (M-943) 

We are supported by way of analogy with Article 5368, 

Vernon's Civil Statutes, commonly referred to as the Relinguishment Act, which specifies, in part, that: 

'1. . . No oil or gas rights shall be 

sold or leased hereunder for less than 

ten cents per acre per year plus royalty 

. . . and in case of production shall 

pay to the State the undivided onesixteenth of the value of the o-and gas 

reserved herein, and like amounts to the 

owner of the soil." (Emphasis added) 

This language was construed in the case of Greene vs. Robison, 

117 Tex. 516, 8 S.W.2,d 655, 660 (1928), to mean: 

I, 

. . . We interpret the Act to fix a 

minimum price of 10 cents per acre 

per annum and the value of one-sixteenth 

of the gross production free of cost to 

the state. for which the state is willinc 

to sell the oil and gas, . . ." (Emphasis 

added) 

It is our opinion, and we are supported by Attorney General's 

Opinion O-6398 (1945), that within the phrase "the value of 

one-sixteenth of the gross production free of cost . . .," 

the term "free of cost" must be given the same meaning as the 

term "free royalty" used in Sec. 4, Art. 5421c, and defined 

in the case of Wintermann vs. McDonald, 129 Tex. 275, 102 S.W.Zd 

167, 173 (1937), that is: 

II 

. . . The term 'free royalty' introduced 

into this Act must mean that the interest 

reserved to the State in the minerals 

produced on school land sold under the 

terms of the Act must not bear any part 

of the expense of the production, sale, 

or delivery thereof." (Emphasis added) 

We do not recognize any material distinction between 

the language delineating the basis for gas royalty to the State 

used in Sec. 8 and Sec. 10, Art. 5421c, and the language of 

Art. 5368, previously construed by the Court. Our conclusion 

is that the phrase in Sec. 8, Art. 5421c, to the effect that 

M . . . the royalty reserved to the state shall be not less 

than one-eighth (l/E) of the gross production or value of oil, 

gas and sulphur . . ." must be construed to mean that the royalty 

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Honorable Bob Armstrong, page 5 (M-943) 

interest of the State must not bear any part of the expense 

of the production, sale or delivery of production of gas, and 

oil and sulphur for that matter, from a State lease. The 

State lease conforms to the statutory language and, therefore, 

is to be given the same meaning and effect. 

In the case of California Company vs. Udall, 296 F.2d 

384, (D.C.Cir. 1961). the Court had before it a statute and 

lease issued under the Mineral Leasing Act, Sec. 17, Mineral 

Leasing Act as amended, 41 Stat. 443 (19201, as amended, 

60 Stat. 951 (1946), 30 USCA 8226(c). The statute provides, 

in part, that the: 

"Leases shall be conditioned upon the 

payment by the lessee of a royalty of 

12-l/2 per centum in amount or value 

of the production removed or sold from 

the lease." 

The question before the Court was whether certain cost of 

conditioning the gas for market were chargeable to the lessor's 

royalty interest. The Court sustained as reasonable the 

Secretary of Interior's decision that "production" was the 

product [gas] in marketable condition as well as sustaining 

the premise of his decision that *. . . since the lessee was 

obliged to market the product, he was obligated to put it in 

marketable condition; . . .". Relevant to our analysis of 

the State lease in question here is the fact that the Secretary 

of the Interior had promulgated pursuant to the statutory language 

quoted above the following regulations governing leasing: 

"221.47 Value basis for computing 

royalties. The value of production, for 

the purpose of computing royalty shall be 

the estimated reasonable value of the 

product . . . . Under no circumstances 

shall the value of production. . . be 

deemed to be less than the gross proceeds 

accruing to the lessee from the sale 

[of the product]." 30 C.F.R. 5221.47 

(1959): and 

"221.35 Waste prevention; beneficial use. 

The lessee is obligated to prevent the 

waste of oil or gas and to avoid physical 

waste of gas the lessee shall consume it 

beneficially or market it or return it to 

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Honorable Bob Armstrong, page 6 (M-943) 

the productive formation." 30 C.F.R. 

5221.35 (1959) 

The latter part of the first regulation reads essentially the 

same as the phrase following "value of gross production" in 

the State lease form, that is: 

"but in no event shall the royalty be 

based on a price of less than the highest 

market price paid or offered for gas in 

the general area, or the price paid or 

offered to the producer, whichever is the 

greater: . . .ll 

The second regulation reads essentially the same as the first 

sentence in provisions 3(F) in the State lease form. Section 

3(F) reads as follows: 

"Lessee agrees to use reasonable diligence 

to prevent the underground or above ground 

waste,of oil or gas, and to avoid the 

physical waste of gas produced from the 

leased premises, Lessee shall either market said gas or use same beneficially in 

operations on the leased premises." 

It is our opinion that California Company vs. Udall, 

supra, clearly sustains our position that the lessee-producer 

of gas from a State lease, pursuant to the terms of the lease, 

must pay royalties without any deductions for the cost of 

producing, sale or delivery of the gas so produced. The same 

result was reached in Gilmore vs. Superior Oil Co., 192 Kan. 

388, 388 P.2d 602.; Skaggs vs. Heard, 172 F.Supp. 813 (S.D.Tex. 

1959); California Company vs. Seaton, 187 F.Supp. 445 (D.D.C. 

1960). 

Our position is further supported in principle by 

Pan American Petroleum Corporation vs. Southland Royalty Co., 

396 S.W.Zd 519 (Tex.Civ.App. 1965, error dism.), where on page 

524 the Court said: 

"It has long been established that a royalty 

interest is one that is free of cost of 

producing, saving and preparing the product 

for market. Miller vs. Speed, Tex.Civ.App. 

248 S.W.2d 250 (n.w.h.)" 

To the same effect, Merrill, Covenants Implied in Oil and Gas 

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Honorable Bob Armstrong, page 7 (M-943) 

Leases (Second Edition), Section 85, Page 214, states that: 

"If it is the lessee's obligation to market 

the product, it seems necessarily to follow 

that his is the task also to prepare it for 

market, if it is unmerchantable in its 

natural form. No part of the cost of marketing or of preparation for sale is chargeable to the.lessor. This is supported by the 

general current of authority." 

Attorney General's Opinion NW-196 (1957) specifically 

deals with the fact situation where the gas must be transported 

some considerable distance from the leased premises by the 

lessee in order to sell the gas to a pipeline purchaser. To 

that extent, Opinion NW-196 is distinguishable from the present 

situation on the facts and we do not reconsider that portion of 

the Opinion. However, in all other regards, Opinion W-196 

is expressly overruled because it is based on an erroneous 

interpretation of Sec. 10, Art. 5421c, with respect to gas 

processing charges and after May 10, 1957, it is no longer 

the controlling statute delineating the mineral reservation to 

the State. In addition, the rationale and authorities cited 

in that opinion are generally in point where the lease in 

question provides that royalties are to be based upon the 

value of gas at the wellhead and are distinguishable from and 

not definitive of the applicable statutory language of Sec. 8, 

Art. 5421c, used in the State lease. This distinction is 

material as is pointed out by Skaggs vs. Heard, supra, at 

page 816: 

"Plaintiff concedes the general rule 

that, where a lease provides for royalty 

on gas marketed or utilized by the lessee, there is an implied obligation upon 

the lessee to use reasonable diligence 

in marketing the gas7 but says that thi's 

does not mean that the lessee is to pay 

all of the costs or expenses of marketing, transporting, processing or treating the gas, citing numerous cases where 

gas was not sold at the well or on the 

lease but was carried a great distance 

to market8 or was enhanced in value by 

processing into b 

plants,g or both, TO 

-products in expensive 

or depending on provisions altogether different from those 

used here.11 Many other cases are cited 

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. 

Honorable Bob Armstrong, page 8 (M-943) 

and discussed by counsel on both sides. 

All are distinguishable on one or the 

other of the grounds noted above. 

7 

Cole Petroleum Co. v. United States Gas 

& Oil Co., 121 Tex. 59, 41 S.W.2d 414, 

86 A.L.R. 719: Masterson vs. Amarillo 

Oil Co, Tex.Civ.App., 253 S.W. 908; 11 

Tex.Law Review 401-438. 

8 

Kretni Development Co. v. Consolidated 

Oil Corp., 10 Cir., 74 F.2d 497, (where 

a pipe line was laid 90 miles by the 

lessee); Scott v. Steinberger, 113 Kan. 

67, 213 P. 646; Robert v. Swanson, Tex. 

Civ.App., 222 S.W.2d 707. 

9 

Danciger Oil & Refineries, Inc. v. Hamill 

Drilling Co., 141 Tex. 153, 171 S.W.Zd 

321; Le Cuno Oil Co. v. Smith, Tex;Civ. 

APP.~ 306 S.W.2d 190. 

10 

Matsen v. Hugoton Production Co., 182 

Kan. .456, 321 P.2d 576. 

11 

Cf. Phillips Petroleum Co. v. Johnson, 

5 Cir., 155 F.2d 185, calling for 1/8th 

of the net proceeds derived from gas at 

the mouth of the well." 

The leare in question clearly provides that the basis on which 

the royalty to the State must be paid can in no event be less 

then the greater of the price offered to or received by the 

producer or the highest market price paid or offered for gas 

in the general area. Generally, the royalty to the State will 

be baaed upon the price for gas received by the producer at 

the point where the producer delivers the gas to the pipeline 

purchaser. Nothing in the language of the leare contemplates 

any deduction8 for.gathering , compression or dehydrating the 

gar by the leoree-producer from the price he receives before 

computing the State's royalty interest. 

-4619- 
. 

Honorable Bob Armstrong, page 9 (M-943) 

Consideration of provision 4 in the State lease form 

governing the manner and form of payment of royalty to the 

State further supports our position. The provision reads as 

follows: 

" 4 . All royalties shall be paid to the 

Commissioner of the General Land Office 

at Austin, Texas, during the life of this 

lease, on or before the 30th day of each 

succeeding month, for the month in which 

the oil and/or gas was produced, and shall 

be accompanied by a sworn statement of the 

owner, manager, or other authorized agent, 

showing the gross amount of oil produced 

since the last report, and the amount of 

all dry gas, residue gas, casinghead gas, 

and other products produced therefrom, 

sold or used for the manufacture of gasoline, 

and the marke~t value of the oil, dry gas, 

residue gas, casinghead gas, and other 

products produced therefrom, together with 

a copy of all daily gauges of tanks, meter 

readings, pipeline receipts, gas line receipts 

and other checks and memoranda of the 

amounts produced and put into pipelines, 

tanks or pools and gas lines or gas storage. 

In all cases the authority of a manager 

or agent to act for the Lessee herein must 

be filed in the Gener'al Land Office." 

Relevant to the question here, we note that while this provision requires a sworn statement to be submitted detailing the 

volume and market value of the dry gas produced, sold or used 

and put into pipelines, tanks or pools and gas lines or gas 

storage, it does not provide for an accounting of any producing, 

processing, transporting or marketing charges. Common mense 

dictates that were it contemplated that the pro rata share 

of these charges would be deductible from the royalty interest 

of the State, such charges would be specifically required ss 

part of the sworn statement referred to in provision 4. 

The lessee or operator of a natural 

gas well located on a State tract may not 

legally deduct from the royalty due the 

State a pro rata portion of the cost of 

-4620- 
. 

Honorable Bob Armstrong, page 10 (M-943) 

production, gathering, compression, 

dehydration, sale or delivery of the 

natural gas produced on the State tract. 

Attorney General Opinion No. WW-196 

(1957) is overruled to the extent necessary to conform with is opinion. 

truly yours, 

Prepared by: 

J. Milton Richardson 

Linward Shivers 

Rex H. White, Jr. 

Assistant Attorneys General 

APPROVED: 

OPINION COMMITTEE 

Kerns Taylor, Chairman 

W. E. Allen, Co-Chairman 

James H. Quick 

Harold G. Kennedy 

Houghton Brownlee, Jr. 

W. 0. Shults 

MEADE F. GRIFFIN 

Staff Legal Assistant 

ALFRED WALKER 

Executive Assistant 

NOLA WHITE 

First Assistant 

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