### THE .L~ITOECNEY GENERAL OF-XAS

Honorable Bob Armstrong Opinion No. M-943 Commissioner General Land Office Re: Whether aproportionate Austin, Texas 78701 cost ofpreparing 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 ofwhich ithas drilled several wells that produce natural gas. On each lease one of thewells is aplatform well or production deckwell upon which areheaters, gas production separators, dehydrators, andmetering devices forgas, condensate, andwater. Each lease also contains one ormore satellite wells upon which are aheater, meter, regulator, valves, and flow lines running from the satellite well to theplatform well. After the gashas been processed through the above mentioned facilities, it is soldby 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 aproportionate 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 forby the companies can be legally justified."

The statutory authority pursuant towhich the royalty provision of the State oil and gas lease inquestion must conform is Sec. 8and Sec. 10ofArt. 5421c, Vernon's Civil Statutes. Section 8reads inpart:

"All islands, saltwater lakes,
. . .and that portion of the Gulf of Mexico within -4612-Honorable Bob Armstrong, page 2 (M-943)

the jurisdiction of Texas
. . ,shall be subject to leaseby the Commissioner of the General Land Office

. . .,in accordance with theprovisions 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 orvalue of oil, gas and sulphur. 1,

. . . (Emphasis added) Section 10 reads inpart: "The areas included herein shall be leased for a consideration, in addition to the cash amount bid therefor, ofnot less than one-eighth (l/E)of the gross production of oil, or thevalue of same, thatmay 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 thevalue of same thatmay be produced, thatmay be produced and sold off the area, and not less than one-sixteenth (l/16)of thevalue of all other minerals thatmay be produced, and an additional sum of twenty-five cents an acre per year foreach 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 topay or cause tobe paid to the Commissioner of the General Land Office atAustin, Texas, for the use and benefit of the State of Texas, during the termhereof;
. . . (B) As royalty on any gas, . . .produced from anywell and soldby Lessee, or used by Lessee forpurposes which are not exempted from royalty payments
. . . (l/6) of the value of the gross production, but inno event shall the royalty be based on a price of less than thehighest market price -4613- inHonorable Bob Armstrong, page 3 (M-943)

paid or offered forgas in the general area, or theprice paid or offered to theproducer, 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 thebasis for the reexamination of Opinion WW-196.

Sections 8and 10 ofArt. 5421c,were originally promulgated by Acts 1931, 42nd Leg., p. 452, ch. 271. Sec. 10has remained unchanged todate, but Sec. 8has been amended several times, themost recent and important being by Acts 1957, 55th Leg., p. 434, ch. 209, 51, effective May 10, 1957, which added theproviso 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. 10was 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 leadsus to the conclusion that amaterial change was effected with respect to royalties on oil and sulphur. In effect, by the 1957 amendment, Sec. 8deleted from Sec. 10 thequalifying language ".
. .that may be produced and saved,
. . .II as this pertains to the royalty payable on oil and the language II.
. .thatmay be produced, thatmay be produced and sold off the area, . . ."as this pertains to sulphur. However, the absence of suchmodifying language in Sec. 10and Sec. 8 in regard to the royalty provision pertaining to gas demonstrates adistinguishably consistent statutory standard. The various gas royalty reservations, i.e., that ".
. .gross production of gas, or the value of same. . ."as used inSec. 10of Art. 5421c, and ".
. .gross production or value of
. . .gas . . ."used in Sec. 8of Art. 5421~~ and ".
. .value of gross production

. . ."used on the State lease form, are synonomus inmeaning. We are of the opinion thatwith respect togas, 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 thevalue thereof. In thiswe are fully supported by the authorities and the language of the State lease, aswill be pointed out below. -4614-

.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, inpart, 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 ofproduction shall pay to the State the undivided onesixteenth of thevalue 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, 117Tex. 516, 8S.W.2,d655, 660 (1928), tomean:

I,

. . . We interpret theAct to fix a minimum price of 10 cents per acre per annum and thevalue of one-sixteenth of the gross production free of cost to the state. forwhich the state iswillinc to sell the oil and gas, . . ." (Emphasis added)
It is our opinion, andwe are supported by Attorney General's Opinion O-6398 (1945), thatwithin the phrase "thevalue of one-sixteenth of the gross production free of cost
. . .," the term "free of cost"must be given the samemeaning 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 'freeroyalty' introduced into thisActmust mean that the interest reserved to the State in theminerals produced on school land sold under the terms of theActmust notbear any part of the expense of theproduction, sale, ordelivery thereof." (Emphasis added)
We do not recognize anymaterial distinction between the language delineating thebasis forgas royalty to the State used in Sec. 8and Sec. 10,Art. 5421c, and the language of Art. 5368, previously construed by the Court. Our conclusion is that thephrase 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 tomean that the royalty
-4615-Honorable Bob Armstrong, page 5 (M-943)

interest of the State must not bear any part of the expense of theproduction, sale ordelivery of production of gas, and oil and sulphur for thatmatter, from a State lease. The State lease conforms to the statutory language and, therefore, is tobe given the samemeaning 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), 30USCA 8226(c). The statute provides, inpart, 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 theproduction removed or sold from the lease." The question before the Court was whether certain cost of conditioning the gas formarket 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] inmarketable condition aswell as sustaining the premise of his decision that *.
. .since the lessee was obliged tomarket the product, he was obligated toput 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 ofproduction, for the purpose of computing royalty shall be the estimated reasonable value of the product
. . . . Under no circumstances shall the value ofproduction.

. .be deemed tobe less than the gross proceeds accruing to the lessee from the sale [oftheproduct]." 30 C.F.R. 5221.47 (1959): and "221.35 Waste prevention; beneficial use. The lessee isobligated toprevent the waste of oil or gas and to avoid physical waste of gas the lessee shall consume it beneficially ormarket it or return it to
-4616-Honorable Bob Armstrong, page 6 (M-943)

theproductive formation." 30C.F.R. 5221.35 (1959) The latter part of the first regulation reads essentially the same as thephrase following "value of gross production" in the State lease form, that is:

"but in no event shall the royalty be based on aprice of less than thehighest market price paid or offered for gas in the general area, or theprice paid or offered to theproducer, whichever is the greater:
. . .ll The second regulation reads essentially the same as the first sentence inprovisions 3(F) in the State lease form. Section 3(F) reads as follows:

"Lessee agrees touse reasonable diligence toprevent the underground or above ground waste,of oil or gas, and to avoid the physical waste of gasproduced from the leased premises, Lessee shall either market said gas or use samebeneficially in operations on the leased premises."
It isour 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 soproduced. The same result was reached in Gilmore vs. Superior Oil Co., 192Kan. 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 inprinciple by Pan American Petroleum Corporation vs. Southland Royalty Co., 396 S.W.Zd 519 (Tex.Civ.App. 1965, error dism.), where onpage 524 the Court said:

"Ithas longbeen established that a royalty interest is one that is free of cost of producing, saving and preparing the product formarket. 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
-4617-Honorable Bob Armstrong, page 7 (M-943)

Leases (SecondEdition), Section 85, Page 214, states that:

"If it is the lessee's obligation tomarket theproduct, it seems necessarily to follow that his is the task also toprepare it for market, if it is unmerchantable in its natural form. No part of the cost ofmarketing or ofpreparation 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 gasmust be transported some considerable distance from the leased premises by the lessee in order to sell the gas to apipeline purchaser. To that extent, Opinion NW-196 isdistinguishable from the present situation on the facts andwe do not reconsider that portion of the Opinion. However, inall other regards, Opinion W-196 is expressly overruled because it isbased on an erroneous interpretation of Sec. 10,Art. 5421c, with respect togas processing charges and after May 10, 1957, it isno longer the controlling statute delineating themineral reservation to the State. In addition, the rationale and authorities cited in that opinion are generally inpoint where the lease in question provides that royalties are tobe based upon the value of gas at thewellhead and aredistinguishable from and not definitive of the applicable statutory language of Sec. 8, Art. 5421c, used in the State lease. This distinction is material as ispointed out by Skaggs vs. Heard, supra, at page 816: "Plaintiff concedes the general rule

that,where a lease provides for royalty on gasmarketed or utilized by the lessee, there isan implied obligation upon the lessee to use reasonable diligence inmarketing the gas7 but says that thi's does notmean that the lessee is topay all of the costs or expenses ofmarketing, transporting, processing or treating the gas, citing numerous cases where gas was not sold at thewell or on the lease but was carried a great distance tomarket8 orwas enhanced invalue by processing into b plants,g orboth,TO -products in expensive or depending onprovisions altogether different from those used here.11 Many other cases are cited -4618-.

Honorable Bob Armstrong, page 8 (M-943)

and discussed by counsel onboth sides. All aredistinguishable on one or the other of the grounds noted above. 7Cole Petroleum Co. v. United States Gas &Oil Co., 121 Tex. 59, 41 S.W.2d 414, 86A.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., 10Cir., 74 F.2d 497, (where apipe linewas laid 90 miles by the lessee); Scott v. Steinberger, 113Kan. 67, 213 P. 646; Robert v. Swanson, Tex. Civ.App., 222 S.W.2d 707. 9Danciger Oil &Refineries, Inc. v. Hamill Drilling Co., 141Tex. 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. 11Cf. Phillips Petroleum Co.v. Johnson, 5Cir., 155 F.2d 185, calling for 1/8th of the net proceeds derived from gas at themouth of thewell." The leare in question clearly provides that thebasis onwhich the royalty to the State must be paid can inno event be less then the greater of theprice offered toor received by the producer or thehighest market price paid or offered forgas in the general 

### area. Generally, the royalty to the State will be baaed upon the price forgas received by theproducer at thepoint where the producer delivers thegas to the pipeline purchaser. Nothing in the language of the 

### leare contemplates 

### anydeduction8 

### 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 ofprovision 4 in the State lease form governing themanner 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 atAustin, Texas, during the life of this lease, on or before the 30thday of each succeeding month, for themonth inwhich the oil and/or gaswas 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 themanufacture of gasoline, and themarke~tvalue of the oil, dry gas, residue gas, casinghead gas, and other products produced therefrom, together with a copy of alldaily gauges of tanks, meter readings, pipeline receipts, gas line receipts and other checks andmemoranda of the amounts produced andput into pipelines, tanks or pools and gas lines or gas storage. In all cases the authority of amanager or agent to act for theLessee herein must be filed in the Gener'alLand Office." Relevant to the question here, we note thatwhile this provision requires a sworn statement tobe submitted detailing the volume and market value of thedry gas produced, sold or used andput into pipelines, tanks orpools and gas lines or gas storage, it does not provide foran accounting of any producing, processing, transporting ormarketing charges. Common mense dictates that were it contemplated that thepro 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 inprovision 4.

The lessee or operator of anatural gas well located on a State tract may not legally deduct from the royalty due the State apro 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

-4621-