1 United States Court of Appeals,

Fifth Circuit.

No. 94-40246.

NICOR EXPLORATION COMPANY, Petitioner,

v.

FEDERAL ENERGY REGULATORY COMMISSION, Respondent.

April 27, 1995.

Petition for Review of an Order of the Federal Energy Regulatory

Commission.

Before REYNALDO G. GARZA, DAVIS and BARKSDALE, Circuit Judges.

W. EUGENE DAVIS, Circuit Judge:

N ICOR Exploration Company petitions this court to review a

Federal Energy Regulatory Commission order granting Robert W.

Scarth authority to collect incentive-based rates for natural gas

pursuant to § 108 of the Natural Gas Policy Act ("NGPA"), 15 U.S.C.

§§ 3301 e t seq. The commission concluded that the "area rate

clauses" contained in gas supply contracts signed by NICOR and

Scarth's predecessors authorize Scarth to collect § 108 rates. The

central issue raised by NICOR is whether the Commission's

interpretation of the c ontracts conflicts with Fifth Circuit

precedent and Oklahoma contract law. We agree that the Commission

failed to properly apply state contract law in construing the area

rate clauses and that, under state law, Scarth failed to satisfy

his burden of proof. Accordingly, we vacate the Commission's order

and remand the case to the Commission for entry of an order denying

Scarth's request for a rate increase.

I.2

In 1970, NICOR signed three gas supply contracts with Scarth's

predecessors, GHK Co., Sun Oil Co., and the Amerada Hess

Corporation (the "Producers"). Under the terms of the contracts,

the Producers agreed to sell NICOR ga s from the Green # 1-1 Well

located in Beckham County, Oklahoma. Between 1988 and 1989, Scarth

purchased the Producers' interests in the three contracts and

requested the C ommission to reclassify the Green Well as a

"stripper" well so that he could collect higher incentive-based

rates under § 108 of the NGPA. NICOR filed a petition with the

Commission opposing Scarth's rate increase.

The Supreme Court's Mobile-Sierra Do ctrine prohibits the

Commission from granting a rate increase to a producer unless the

producer's contract authorizes a rate inc rease. U nited Gas Pipe

Line Co. v. Mobile Gas Serv. Corp., 350 U.S. 332, 76 S.Ct. 373, 100

L.Ed. 373 (1956); FPC v. Sierra Pacific Power Co., 350 U.S. 348,

76 S.Ct. 368, 100 L.Ed. 388 (1956). While NICOR's contracts

provided for a fixed initial price per unit of gas, each contract

contained an area rate clause allowing the Producers to increase

t he contract price under certain circumstances. Scarth contends

that these area rate clauses authorize the rate increase he

requests. The area rate clauses are similarly worded:

If the Federal Power Commission, or any successor governmental

authority having jurisdiction in the premi ses, shall at any

time hereafter prescribe, for the area in which the contract

is located, a hig her, applicable, just and reasonable area

rate for the purchase of gas than the price herein provided to

be paid, then the price to be paid by the Buyer to Seller for

gas delivered under the provisions of this Agreement shall be

increased to equal such higher price effective as of the date

such hi gher price is made applicable to the gas sold1 The only substantive difference is that the area rate

clause in the Amerada Hess contract omits the phrase "just and

reasonable."

2 Order 23, 6 FERC (CCH) ¶ 61,229 (March 13, 1979); Order

23-A, 7 FERC (CCH) ¶ 61,247 (June 12, 1979); Order 23-B, 8 FERC

(CCH) ¶ 61,130 (Aug. 6, 1979). The Commission promulgated Rule

3 hereunder. 1

These clauses thus author ized the Producers to increase the

contract price to match the maximum rate for the area established

by the Federal Power Commission ("FPC"), the Commission's

predecessor.

The scope of area rate clauses became a matter of extensive

litigation with t he passage of the NGPA in 1978. Prior to 1978,

the FPC established "just and reasonable" area rates based on the

producer's cost of service. The NGPA eliminated the FPC's power to

set area rates and, in its place, established nation-wide statutory

rate ceilings. Section 104 of the NGPA essentially adopted the

FPC's cost-based methodology for setting the rates of most natural

gas committed or dedicated to interstate commerce prior to 1978.

15 U.S.C. § 3314. However, § 108 of the NGPA establishes special

"incentive-based" rates for low output "stripper" wells. 15 U.S.C.

§ 3318. These incentive-based rates are significantly higher than

§ 104's cost-based rates. Attempts by producers to obtain § 108

rates raised the issue of whether pre-NGPA area rate clauses

authorized producers to collect higher NGPA incentive-based rates.

The Commission addressed the scope of pre-NGPA area rate

clauses in three agency orders, Orders 23, 23-A, and 23-B ("Order

23"), 2 and in Independent Oil & Gas Ass'n of W. Virginia, 10 FERC23 after extensive feedback and comment from gas producers,

pipelines, and local distributors. The Fifth Circuit upheld the

order in Pennzoil Co. v. FERC, 645 F.2d 360, 384 (5th Cir.1981)

(" Pennzoil I ").

4 ¶ 61,214 (1980) ("Opinion 77"). In Order 23, the Commission

concluded that nei ther the language of the NGPA nor the

Commission's regulations precluded producers from relying on

pre-NGPA area rate clauses to obtain higher rates under § 108 of

the NGP A. 6 FERC (CCH) ¶ 61,229. The Commission further

concluded, however, that variatio ns in the language and

circumstances of these clauses preve nted a uniform construction

that would apply to all contracts. I d. The Commission thus opted

for a c ase-by-case approach to interpreting area rate clauses.

Since area rate clauses are "inherently ambiguous", the Commission

decided that the focal point of i ts inquiry should be the mutual

intent of the parties at the time the contract was signed. I d. In

other words, the Commission would attempt to glean from extrinsic

evidence whether the parties would have agreed to incentive-based

rates if these rates had been available at the ti me the contract

was signe d. The Commission also established procedures for

purchasers and third parties to protest rate increase requests.

Id.

In Opinion 77, the Commission formulated specific guidelines

for interpreting area rate claus es. Opinion 77 establishes a

two-part inquiry for determining the parties' intent. First, the

Commission must consider extrinsic evidence p robative of intent,

including the parties' negotiations, course of dealing, and other5

evidence of the circumstances surrounding the contract's execution.

10 FERC at 61 ,397. If the Commission finds "no reliable and

probative evidence of intent" or if "such evidence is

inconclusive," however, Opinion 77 requires the Commission to look

to the language of the ar ea rate clause and apply a three-prong

formula to decide whether the clause allows § 108 rates:

In such situations, we will generally conclude that a contract

containing an area or national rate clause does not authorize

collection of all NGPA rates if it contains the following

disqualifying terms:

(1) it refers to rates established or prescribed by an administrative body;

(2) it couples the reference to administrative action with a

reference to the Natural Gas Act or the "just and

reasonable" standard of that Act; and

(3) it contains no additional language which has the effect of

uncoupling the link between agency action and the

statutory standard of the Natural Gas Act.

Id. at 61,398. According to the Commission, references to both

administrative rate-setting and the NGA's "just and re asonable"

standard generally indicate that the parties intend to limit price

increases to cost-based rates. Id. On the other hand, the

Commission concluded that languag e severing the link between

administrative action and a cost-based standard suggests that the

parties intend to allow price increases to the maximum rate allowed

by statute, whether cost-based or incentive-based. Id.

Applying Opinion 77's methodology to NICOR's cont racts, an

administrative law judge ("ALJ") concluded that the area rate

clauses did not authorize Scarth to collect § 108 incentive-based

rates. 56 FERC ¶ 63,023 at 65,094 (1991). According to the ALJ,6

the extrinsic evidence of the parties' mutual intent failed to

support Scarth's contention that the parties intended the area rate

clauses to authorize rate increases up to the maximum level

permitted by law:

The course of performance evidence, as well as the evidence on

the other items involving reliable and probative extrinsic

evidence of the parties' intent, is clearly insufficient to

support Scarth's contention that th e [area rate clauses] in

issue en title it to collect payment of section 108 NGPA

ceiling prices.... In sum, such evidence not only does not

suffice to overcome Scarth's admitted burden of demonstrating

... the contracting p arties' intent to pay and collect

incentive-based NGPA section 108 rates, but rathe r supports

the concl usion that the [clauses] in question contemplated

payment and collection of only cost-based prices.

The ALJ also applied Opinion 77's three-prong formula and found

that the language of the area rate clauses satisfied the formula's

three elements.

The Commission initially affirmed the ALJ's order. 58 FERC ¶

61,203 (1992). On motion for rehearing, however, the Commission

reversed its earlier order and concluded that NICOR's area rate

clauses authorize Scarth to collect incentive-based rates under §

10 8. 63 FERC ¶ 61,034 at 61,184—61,186 (1993). The Commission

first found that the parties' extrinsic evidence of mutual intent

was inconclusive as to whether they intended the area rate clauses

to authorize rate increases up to the maximum level permitted by

law. The Commission then applied Opinion 77's three-part formula

to the language of the area rate clauses. The Commission concluded

that the area rate clauses authorized § 108 rates because each

clause failed to satisfy one or more elements of Opinion 77's

formula. Id.3 The Commission expressly addressed the impact of this type

of language in Opinion 77:

Such an uncoupling could occur, for example, where a

reference to the Natural Gas Act or the "just and

reasonable" standard is supplemented by the phrase "or

successor statutory authority" or words of similar

import. In this circumstance, the parties commit their

contractual destiny to a change in the statutory scheme

and give advance acceptance to the outcome of the

legislative process.

7 According to the Commission, the area rate clause in the

Amerada Hess contract failed to refer to the NGA or to the "just

and reasonable" standard as required by the second prong of the

formula. The Commission further concluded that the area rate

clauses in the GHK and Sun contracts similarly allowed § 108 rates

because the presence of the phrase "any successor or governmental

authority" uncoupled the link between the contracts' references to

administrative action and the " just and reasonable" standard. 3

According to the Commission, this language is consistent with

Congressionally-established rates under the NGPA.

NICOR requested judicial review of th e Commission's final

order pursuant to 15 U.S.C. §§ 717r(b) and 3416(a)(4). We granted

Robert W. Scarth's motion to intervene in support of Commission's

order.

II.

NICOR maintains that the Commission's application of Opinion

77's methodology in the present case conflicts with Fifth Circuit

precedent and O klahoma contract law. NICOR contends that the

Commission failed to follow state law in construing the area rate

clauses as required by this court's decision in Pennzoil Co. v.8

FER C, 645 F.2d 360, 384 (5th Cir.1981) (" P ennzoil I "). Before

addressing the merits of NICOR's petition, however, we must first

address a threshold jurisdictional issue raised by Scarth.

A.

As a preliminary matter, Scarth questions whether NICOR

properly preserved the arguments raised in it s petition. Scarth

contends that NICOR waived these arguments when it failed to file

any objections to the ALJ's initial order. Although the ALJ ruled

in favor of NICOR, Scarth points out that the ALJ relied on the

same methodology that NICOR now assails.

Scarth bases his waiver argument on 15 U.S.C. § 717r(b).

Secti on 717r(b) grants courts of appeal original jurisdiction to

review final orders issued by the Commission. However, this

section further provides that "[n]o objection to the order of the

Commission shall be considered by the court unless such objection

shall have been urged before the Commission in the application for

rehearing." This waiver provision is construed as a strict

jurisdictional limitation on this court's power to review the

Commission's orders. T ennessee Gas Pipeline Co. v. FERC, 871 F.2d

1099, 1107 (D.C.Cir.1989).

Our review of the record persuades us that Scarth's waiver

argument is without merit. Although NICOR failed to raise any

objections to the ALJ's application of Order 77 or to the

Commission's initia l order affirming the ALJ's decision, NICOR

raised its objections in a motion for rehear ing following the

Commission's final order reversing the ALJ and ruling against9

NICOR. Until that point in the proceeding, NICOR was the

prevailing party. We reject Scarth's claim that § 717r(b) requires

a prevailing party to file objections to a favorable ruling by an

ALJ in order to preserve its right to appeal if the ALJ's decision

is later reversed by the Commission. As long as a party in Nicor's

position presents its objections to the Commission in a timely

motion for rehearing, § 717r(b)'s requirements are satisfied. We

therefore conclude that NICOR properly preserved the issues raised

in its petition by timely raising its objections in its motion for

rehearing following the Commission's final order. We now turn to

the merits of NICOR's argument that the Commission failed to follow

Oklahoma law in interpreting the area rate clauses.

B.

In Pennzoil I, we held that the Commission must apply state

contract law in construing gas supply contracts. 645 F.2d at 387.

While the court recog nized that the Commission may formulate and

apply "general principles of contract law" to construe ar ea rate

clauses, "specific determinations of contractual authority in the

[Commission's] protest procedures must take account of and follow

any differences with general contract law that the ap propriate

state con tract law may have." I d. at 383-84. In deciding which

state's law applies, the Commission should apply the state law that

would "govern the parties' dealings were there no regulation at all

of the contract's subject matter." Id. at 387.

NICOR contends that the Commission's application of Opinion

77's interpretive standards runs afoul of Pennzoil I because it is10

inc onsistent with Oklahoma contract law. NICOR focusses on two

aspects of the Commission's methodolo gy that it argues are

inconsistent with Oklahoma contract law. First, NICOR faults the

Commission for basing its interpretation solely on language in the

area rate clauses that the Commission admits is ambiguous without

also considering the extrinsic evidence of the parties' intent.

Second, NICOR contends that the Commission's methodology

essentially relieved Scarth of his burden of proving that the area

rate clauses permit § 108 rates.

We must first address NICOR's contention that O klahoma

contract law governs the interpretation of the area rate clauses at

issue. In P ennzoil I, we held that the choice of which state's law

to app ly "is properly a matter within federal common law." 645

F.2d at 387. NICOR contends that Oklahoma law governs because the

three contracts were negotiated and signed in Oklahoma, and because

the subject matter of the contracts concerns gas produced from an

Oklahoma well. Moreover, neither Scarth nor the Commission dispute

the applicability of Oklahoma law, and none of the co ntracts

contain forum selection clauses.

Although we are not bound by Oklahoma choice of law rules,

these rules may guide us in deciding whether Oklahoma law should

apply in the present case. Oklahoma choice of law rules for

contracts require courts to apply "the law of the state (1) chosen

by the parties, (2) where the contract was entered into, or (3) the

place of performance if indicated in the contract." M oore v.

S ubaru of America, 891 F.2d 1445, 1449 (10th Cir.1989) (inter nal11

citations omitted). Because of Oklahoma's extensive contacts with

the three contracts, we agree that Oklahoma law should apply.

Turning to the Commission's application of Oklahoma law, we

generally do not defer to the Commiss ion's interpretation of gas

supply contracts unless t he Commission relied on its factual or

technical expertise in reaching its conclusions. T ennessee Ga s

Pipeline Co. v. FERC, 17 F.3d 98, 102 (5th Cir.1994). Deference is

not appropriate where the Commission relies "solely on the words of

the contract," or where the central issue before the court is the

Commission's application of state law. I d.; Pennzoil Co. v. FERC,

789 F.2d 1128, 1135 (5th Cir.1986) (" Pennzoil I I "). In such

cases, the construction of a contract is not "enhanced by the

agency's expert understanding of the indu stry." E l Paso Natural

Gas Co. v. FERC, 881 F.2d 161, 164 (5th Cir.1989). Because NICOR's

objections focus on the Commission's application of Oklahoma state

contract law, the Commission's co nstruction of the area rate

clauses in this case is not entitled to deference. We therefore

review the Commission's order de novo.

We agree with NICOR that the Commission's application of

Opinion 77 to the present case conflicts with Oklahoma contract

law. Oklahoma law directs courts to consider extrinsic evidence of

the parties' mutual intent in cases where the language of a

contract is ambiguous. S ee Mercury Investment Co . v. F.W.

Woolworth Co., 706 P.2d 523, 529 (Okla.1985); Okla.Stat.Ann. tit.

15, § 152 (West 1993). Extrinsic evidence relevant to determining

the parties' intent includes the circumstances surrounding the12

execution of the contract and the parties' negotiations. Public

Service Co. of Okla. v. Home Builders Ass'n of Realtors, Inc., 554

P.2d 1181 (Okla.1976). Oklahoma's version of the Uniform

Commercial Code (" U CC") similarly provides that courts should

construe ambiguous contracts with reference to the parties' course

of dealing and course of conduct. Okla.Stat.Ann. tit. 12A, §§ 1-

205, 2-202.

The Commission failed, however, to give any weight to the

extrinsic evidence of the parties' intent in concludi ng that

NICOR's area rate clauses authorized § 108 rates. While the

Commission initially considered extrinsic evidence concerning the

parties' negotiations and course of dealing, the Commission

concluded that this evidence was inconclusive. The Commission then

construed the area rate clauses solely on the basis of the language

of the clauses and Opinion 77's three-part formula:

Since the Commission found that none of the parties produced

such evidence of mutual intent, the Commission affirmed the

ALJ to that extent and, like the ALJ, resolved the matter

solely by application of the interpretive standards.

66 FERC at 61,769.

In construing the language of area rate clauses, however, the

Commission must consider " all evidence—contract language, oral and

written extrinsic evidence and evidence of course of performance."

Hunt Oil Co. v. FERC, 853 F.2d 1226, 1237 (5th Cir.1988) (emphasis

in original). This evidence must "be b alanced to determine the

parties' intent." Id. In Hunt Oil, we reversed the Commission's

interpretation of an area rate clause based on the Commission's

failure to consider extrinsic evidence of intent. As in the4 Hunt does not indicate whether the Commission applied

Opinion 77's three-prong formula.

13 present case, the Commission concluded that the extrinsic evidence

of the parties' intent was inconclusi ve and thus based its

interpretation solely on the language of the clauses. 4 We

concluded that the Commission's methodology was defective because

" Pennzoil I does not permit ambiguities or conflicts to negate

c onsideration of any part of the overall picture." Id. The

Commission thus erred in discarding the extrinsic evidence in the

instant case based on its conclusion that the evidence was

"inconclusive."

The Commission's approach is also inconsistent with state law

to the extent that it narrowly focuses on specific phrases in the

area rate clauses without considering the language of the clauses

and contracts as a whole. Oklahoma law requires courts to consider

a contract as a whole "without narrowly con centrating upon some

phrase or language taken out of context." B onner v. Oklahoma Rock

Corp., 863 P.2d 1176, 1184 (Okla.1993); s ee also Okla.Stat.Ann.

tit. 15, § 157. The Commission acknowledged that the references to

administrative rate-making and the "just and reasonable" standard

in the GHK and Sun contracts supported NICOR's contention that the

contracts did not authorize § 108 incentive-based rates. However,

the Commission decided that the contracts authorized § 108 prices

based on the presen ce of the phrase "successor governmental

authority." Thus, the Commission essentially treated this phrase

as dispositive without considering the language of th e area rate14

clauses as a whole.

Finally, we agree that the Commission erred by relieving

Scarth of his burden of proving by a preponderance of the evidence

that the area rate clauses authorized § 108 rates. In applying

Opinion 77, the Commission essentially shifted the burden of proof

by requiring NICOR to prove the absence of co ntractual authority

for § 108 rates. The ALJ concluded that Scarth failed to satisfy

his burden of proof with regard to the extrinsic evidence of

intent. Although the Commission accepted this finding, it applied

Opinion 77's three-part formula because NICOR failed to prove that

the parties mutually intended to limit rate increases to cost-based

rates:

Scarth failed to p rove a mutual intent to authorize the

pay ment of incentive rates. However, t his also means that

NICOR did not prove by a preponderance of the evidence that

the parties had the mutual intent to limit area rate clause

price escalations to on ly cost-based rates. Under the

procedures established in Opinion No. 77, to win the case at

the evidentiary stage and not reach the interpr etive

standards, NICOR had to prove by extrinsic evidence that its

alleged intent was shared by each of the producer/sellers.

66 FERC at 61,771 (emphasis added). Moreover, in applying Opinion

77's interpretive formula, the Commissi on essentially created a

presumption i n favor of Scarth. The Commission held that, as a

general rule, area rate clauses authorize § 108 rates unless the

language of the clauses satisfy all three prongs of Opinion 77's

interpretive formula. 63 FERC at 61,184.

The Commission's allocation of the burden of proof conflicts

with this court's holding in Pennzoil I that the producer bears the

burden of proving that an area rate clause authorizes15

incentive-based rates under the NGPA. 645 F.2d at 370. Scarth's

failure to prove by a preponderance of the extrinsic evidence that

the parties mutually intended to allow non-cost-based rates would

have resulted in a judgment in favor of NICOR in Ok lahoma state

court. S ee 5A Corbin on Contracts § 1230 at 511 (1964). When the

Commission relieved Scarth of this burden by turning to Opinion

77's interpretive formula, the Commi ssion failed to comply with

Pennzoil I and state contract law.

We conclude, therefore, that the Commission failed to follow

state contract in construing NICOR's area rate clauses. Based on

the findings in the ALJ's order and the Commission's original order

affirming the ALJ, Scarth failed to prove by a preponderance of the

evidence that the contracting parties intended to authorize § 108

prices. Scarth thus failed to meet his burden of proof under

Oklahoma contract law and Pennzoil I. We therefore VACATE the

Commission's order and REMAND the case to the Commission for entry

of an order denying Scarth's request for a rate increase. S ee Hunt

Oil, 853 F.2d at 1233.

VACATED and REMANDED.