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The Attorney General of Texas 

December 31, 1982 

MARK WHITE 

Attorney General 

Supreme Court Buildmg 

P. 0. Box 12546 

Austin. TX. 76711.2548 

5121475.2501 

Telex 9101674-1367 

Telecopier 51214754266 

1607 Main St., Suite 1400 

Dallas, TX. 752014709 

214/742-6944 

4624 Alberta Ave.. Suile 160 

El Paso. TX. 799052793 

9151533-3464 

:220 Dallas Ave., Suite 202 

HOUS,O”, TX. 77002-6966 

71316500666 

606 Broadway. Suite 312 

Lubbock, TX. 79401-3479 

6061747-52?6 

4.109 N. Tenth. Suite B 

McAllen. TX. 785c1.1665 

5 I21362~4547 

200 Main Plaza, Suite 400 

San Antonio. TX. 762052797 

5121225-4191 

An Equal Ooportunityl 

Affirmative Action Employer 

Mr. Bob Armstrong 

Comr4issioner 

General Land Office 

1700 North Congress 

Stephen F. Austin Building 

Austin, Texas 78701 

Opinion No. MW-550 

Re: Interpretation of royalty 

provisions of state leases or 

lands dedicated to the Permanent 

School Funds and Permanent 

University Fund 

Dear Mr. Armstrong: 

You have requested an opinion from this office regarding the 

calculation of royalties due for gas produced from state leases where 

the state’s lessee sells the gas pursuant to a contract which provide: 

that the purchaser reimburse the lessee for any severance tax paid ir 

regard to the production of that gas. 

The current General Land Office lease form, “Revised Lease Fore 

9-81 ,‘I provides: 

The Lessee agrees to pay... (B) Non-Processed gas: 

As a royalty on gas.. . part of the gross 

production or the market value thereof. at the 

option of the Lessor, such value to be based on 

the highest market price paid or offered for gas 

of comparable quality in the general area where 

produced and when run. or the price paid or 

offered to the producer, whichever is the 

greater.... 

The instant question arises only where the state has elected to takl 

its royalty in cash rather than in kind. Although question 

concerning the effect of federal price controls have been raised ant 

will be addressed, this opinion will initially address the issues 0

the assumption that prices are not governmentally established. 

A hypothetical may help explicate the analysis of these. issues 

Assume that “A” leases permanent school fund lands productive of ga 

at a one-fifth royalty. In the relevant month “A” produces on, 

thousand mcf of gas. “A” has a contract with “B” for the sale of al 

gas produced at the price of $5.00 per mcf plus any severance tax pai, 

by “A” as a result of such production. 

p. 2000 
Mr. Bob Armstrong - Page 2 (MW-550) 

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A brief discussion of the Texas severance tax on gas is necessary 

prior to pursuing that hypothetical further. Section 201.051 of the 

Tax Code provides: “There is imposed a tax on each producer of gas.” 

Section 201.052 further provides: 

(a) The tax imposed by this chapter 

is at the rate of 7.5 percent of the 

market value of gas produced and saved 

in this state by the producer. 

Sections 201.101 and 201.102 respectively provide: 

The market value of gas is its value at the 

mouth of the well from which it is produced. 

If gas is sold for cash only, the tax shall be 

computed on the producer’s gross cash receipts. 

Payments from the purchaser of gas to a producer 

for the purpose of reimbursing the producer for 

taxes due under this chapter are not part of the 

gross cash receipts. 

Section 201.001(5) defines producer to include royalty owner. 

The state, however, has been held to be exempt from severance tax 

liability even though as a royalty owner it falls within the statutory 

definition of producer. Group Number 1 Oil Corporation v. Sheppard, 

89 S.W.2d 1021 (Tex. Civ. App. - Austin 1935. writ ref’d). Under 

section 201.051, the tax collection obligation is imposed on the gas 

producer. 

Returning to the above hypothetical. further assume that there 

has been no increase in severance tax since the execution of the 

contract between “A” and “B”. Cf. Attorney General Opinion H-176 

(1973). Thus, we see the followingpayments made: 

Price: 

Total Production 

Times Base Price 

Total Base Price 

Total Base Price 

Times X Necessary to Yield $5/mcf Net of 

Severance Tax 

Equals Severance Tax Due on Entire Production 

Times Non-Exempt Producer’s Share of Production 

Equals Total Severance Tax Paid and Reimbursed 

Plus Total Base Price 

Equals Gross Price 

1000 mcf 

x$5 mcf 

$5000 

$5000 

x.081 

$ 405 

x.80 

S 324.00 

$5000.00 

$5324.00 

p. 2001 
Mr. Bob Armstrong - Page 3 (NW-550) 

State’s Royalty: 

GLO Method: 

Gross Price 

Times Royalty Percentage 

Equals Minimum Amount of Royalty 

Producer’s Method: 

Total Production 

Times Royalty Share 

Equals State’s Share of Production 

Times Base Price 

Equals Minimum Amount of Royalty 

$5324.00 

x.20 

$1064.80 

1000 mcf 

x.20 

200 mcf 

x$5 mcf 

$1000 

tinder either method of royalty calculation both the gross price and 

the severance tax amount remain the same. 

Under the assumed facts, where the price is a negotiated one. 

“the gross price paid or offered to the producer” is $5.324.00 for one 

thousand mcf of gas. Thus, the state’s royalty of twenty percent of 

the market value of the gross production is a minimum of $1.064.80, 

not $1.000.00. The royalty due may be higher than that if comparable 

sales dictate that result but it cannot be less. 

Certain producers, in advocating the second royalty calculation 

method noted above, have contended that it is inequitable to reach the 

foregoing conclusion because to do so results in the state receiving 

more for its portion of total production than the producer receives. 

Under the approach advocated by those producers, both the state and 

the producer would be compensated at a rate of $5.00 per mcf net of 

severance tax. This result strikes those producers as the only just 

result. The result, however, is that the state receives a lower 

royalty than the producer who is liable for severance tax. Severance 

tax liability is a cost of doing business to which the state is not 

subject. Adopting a formula to protect producers from that expense is 

no more justified than adopting one which takes into account, for 

example, federal income tax liability. 

The argument made by those producers seems premised on the 

misapprehension that the severance tax is paid on particular units of 

gas, like an ad valorem tax. It is not. It is a tax on the privilege 

of engaging in the business of producing gas in Texas which is 

computed on the basis of the amount of gas produced. 

The conclusion advocated by those producers does not, in any 

event, follow from the analysis which they make. If the state’s 

fractional part of production, that is. the percentage of production 

reflected in the state’s royalty share. is. as those producers 

advocate it should be. segregated from the total production in 

measuring the royalties due to the state the result is a higher 

royalty than that resulting from the calculation advocated by the 

p. 2002 
Mr. Bob Armstrong - Page 4 (Mw-550) 

General Land Off ice. The result of that analysis is that there are. 

in effect. two sales of gas: one sale of 200 mcf of gas at $5.00 per 

mcf reflecting the state’s share, and one sale of 800 mcf of gas at 

$5.405 per mcf, reflecting the producer’s share. Since the producer’s 

share is a directly comparable sale under free market conditions, the 

characterization of the transaction between “A” and “B” in that manner 

results in the state receiving 200 mcf times $5.405 per mcf or 

$1,081.00 rather than the $1,064.80 resulting from the General Land 

Office’s method of calculation. That result, however. is artificial 

since the transaction is, in fact, only one sale of gas. The 

purchaser has agreed to pay and the producer baa agreed to accept 

$5.324.00 for 1000 mcf of gas, not $1.000.00 for 200 mcf and $4.324.00 

for 800 mcf. 

Thus, absent price controls, the state’s royalty is to be 

calculated on the basis of the entire consideration paid to the 

state’s lessee for the production from the state lease including 

severance tax reimbursement. Whether the existence of the Natural Gas 

Policy Act of 1978 (hereinafter NGPA). 15 U.S.C. section 3301 et seq., 

alters this result as to production covered by its terms will be 

discussed. next. 

The NGPA sets ceiling prices on initial sales of natural gas. 

Title 15, section 3320 of the United States Code provides: 

(a) a price for the first sale of natural gas 

shall not be considered to exceed the maximum 

lawful price.. . if such first sale price exceeds 

the maximum lawful price to the extent necessary 

to recover -- (1) State Severance taxes 

attributable to the production of such natural gas 

borne by the seller.... 

Thus, one who has natural gas which has not previously been sold can 

sell that gas for the applicable ceiling price plus any applicable 

severance taxes for which that individual is liable. The fact that 

section 201.001 of the Tax Code defines producer to include royalty 

owner and that the state, although nominally a producer where it owns 

royalty interests, is exempt from severance tax liability does not 

make the state a seller within the meaning of the NGPA and. therefore, 

subject to the price limitations. 

If we amend the foregoing hypothetical so that the gas produced 

by “A” is subject to the NGPA’s price ceiling and the base contract 

price of $5.00 per mcf of gas is the ceiling price, we have the same 

economic result between “A” and “8”. The royalty calculation issue. 

however, requires additional analysis due to the supreme court’s 

holding in Exxon v. Middleton. 613 S.W.2d 240 (Tex. 1981). that the 

stat”8 of g=s under federal price control is relevant to the 

determination of market value for royalty calculation purposes. 

p. 2003 
Mr. Bob Armstrong - Page 5 (NW-550) 

As noted above, the transaction between “A” and “B” can be 

characterized as, in effect, two sales: one of the state’s 200 mcf of 

gas, as to which no severance tax is due for the $5.00 ceiling price; 

and one of “A’s” 800 mcf of gas, as to vhich severance tax is due for 

the $5.00 ceiling price plus $.405 per mcf as severance tax 

reimbursement. If this characterization is legitimate’ then the 

state’s gas sold for $5.00 per mcf and the sale of ‘A’s” gas for 

$5.405 per mcf is not a comparable sale under the Middleton analysis. 

From “B’ a” perspective, however’ the transaction appears different. 

‘B’ purchases 1000 mcf of gas for $5’324.00, or for $5.324 per mcf. 

As noted above, the severance tax is an occupation tax not an ad 

valorem tax. The use in our hypothetical of 80% of the total 

production as a basis of calculating the severance tax due from “A” 

does not imply that there are two sales of gas. That calculation 

merely reflects an allocation of the tax liability resulting from that 

production activity. The tax liability is necessary because the 

severance tax statute defines producer to include royalty owner. The 

NGPA does not purport to limit the amount of royalty which may be paid 

for gas produced. 

The state owns a royalty interest. A royalty owner’s right to 

receive payment of the money due upon production is a contractual 

right to a money judgment. Shell Oil Company v. State, 442 S.W.2d 457 

(Tex. Civ. App. - Houston [14th Dist.] 1969, writ ref’d n.r.e.). The 

result in that case is not inconsistent with the taxability of the 

royalty interest as an interest in real property under the ad valorem 

tax statutes. 

We note that a federal district court in Oklahoma has construed 

section 3320 of the United States Code differently. See Hoover and 

Bracken Energies, Inc. v. United States Department ofthe Interior, 

No. 81-461-T (W.D. Okla., filed Nov. 18, 1981). However, this ruling 

is not binding upon us, it is on appeal, and appears to be 

inconsistent with Mobil Oil Corporation v. Federal Power Commission, 

463 F.2d 256 (D.C. Cir. 1972). 

In summary, there is only one sale of 1000 mcf of gas and the 

state is entitled, as its royalty, to a minimum of 20% of the 

consideration paid by “8” and received by “A” in that sale. “A” is 

making, just as in the free market situation, one sale of gas for 

$5.00 per mcf plus any severance taxes due. 

The foregoing result is to be distinguished from the result under 

the NGPA, 15 U.S.C. section 3316(b), Intrastate Rollover Contracts. 

Part (2)(A) of that subsection provides: 

In the case of any first sale under any 

[intrastate] roll-over contract of natural gas... 

which constitutes a State government’s... natural 

w* production, or royalty share or other 

p. 2004 
Mr. Bob Armstrong - Page 6 (MW-550) 

interests... in natural gas production... the 

maximum lawful price... shall be the maximum 

lawful price... under section 3312. 

This constitutes an exception to a general rule under section 

3316(b) which provides for a maximum price of $1.00 (adjusted for 

inflation) or the old contract price, whichever is higher, for 

intrastate rollover contract gas. This price will generally be less 

than that allowed for the natural gas constituting the state's royalty 

share. The effect of section 3316(b) of the NGPA is to create tvo 

categories of gas, that is. to work the kind of segregation of the 

hypothetical 100 mcf of gas which certain producers have advocated. 

The fact that the terms of the NGPA do not alter the state law 

regarding the obligations among the parties is irrelevant. By its 

very terms, section 3316 segregates, for the purpose of determining 

price, the gas attributable to the state's royalty interest from the 

remainder of the gas produced. 

SUMMARY 

The state's royalty on gas is calculated on the 

basis of the market value of the gas produced, but 

is in no event less than "the price paid or 

offered to the producer." There is no basis in 

law for the treatment of the sale as, in effect, 

two sales at different prices' one of that 

percentage of the gas equal to the state's royalty 

percentage and one of the remainder of the gas 

produced. The state is entitled to' at minimum, 

its royalty percentage of the total consideration 

including any severance tax reimbursement received 

by the lessee/producer without regard to how that 

total is calculated. 

MARK WHITE 

Attorney General of Texas 

JOHN W. FAINTER, JR. 

First Assistant Attorney General 

RICHARD E. GRAY III 

Executive Assistant Attorney General 

Prepared by Carl Glaze 

Assistant Attorney General 

p. 2005 
Mr. Bob Armstrong - Page 7 olw-550) 

APPROVED: 

OPINION COKMITTEE 

Susan L. Garrison, Chairman 

Jon Bible 

Rick Gilpin 

Carl Glaze 

Patricia Hinojosa 

Jim Moellinger 

p. 2006