Opinion ID: 1265995
Heading Depth: 1
Heading Rank: 8

Heading: the royalty interest

Text: It has been deemed to be in the public interest that the consumer be able to purchase natural gas at artificially low prices. Toward this end, producers have been allowed to receive only a just and reasonable rate of return for the gas delivered. These rates which the producer (Mobil) may charge the pipeline carrier (Northern) are fixed by the FPC as a matter of utility rate setting. The rate is fixed to allow the producer its reasonable costs of production plus a reasonable return on its investment. The rate is derived from cost data rather than prevailing field prices. See, e.g., Permian Basin Area Rate Cases, 390 U.S. 747, 20 L.Ed.2d 312, 88 S.Ct 1344; Shell Oil Company v. F.P.C., 520 F.2d 1061 (5th Cir.1975); Placid Oil Company v. Federal Power Commission, supra; In re Hugoton-Anadarko Area Rate Case, 466 F.2d 974 (9th Cir.1972). The discussion of the Court in Shell Oil Company v. F.P.C., supra, sheds some light on the rate fixing process: ... [T]he Commission adhered to cost as the basis for the new national rate. The FPC utilized the methodology developed by it in Area Rate Proceeding (Permian Basin), 34 FPC 159 (1965), aff'd, Permian Basin Area Rate Cases, 390 U.S. 747, 88 S.Ct. 1344, 20 L.Ed.2d 312 (1968), as modified in the second Southern Louisiana proceeding, Area Rate Proceeding (Southern Louisiana), 46 FPC 86 (1971), aff'd, Placid Oil Co. v. Federal Power Commission, 483 F.2d 880 (5th Cir.1973), aff'd sub nom., Mobil Oil Corp. v. FPC, 417 U.S. 283, 94 S.Ct. 2328, 41 L.Ed.2d 72 (1974) [So. La. II]. Basically the rate was determined by projecting the average cost of finding and producing `new gas,' i.e., gas discovered after January 1, 1973, over the estimated life of the producer wells and adding a 15 percent annual rate of return. Historical items of cost were predicted for the future to attempt to insure that the producer would recover its actual expenses at the time work is done. Relating these estimated costs to the commonly accepted unit of gas sold to the consumer results in a maximum allowable rate for natural gas in cents per Mcf, i.e., thousand cubic feet. (520 F.2d at 1066) Factors of production cost and return on investment considered by the FPC in arriving at the just and reasonable rate producers may charge include the following: (1) successful well costs, (2) dry hole costs, (3) lease acquisition costs, (4) costs of other production facilities, (5) other exploration costs, (6) exploration overhead, (7) area gathering costs, (8) production operating expense, (9) production tax, (10) recompletion and deeper drilling cost, (11) royalty expense, (12) regulatory expense, (13) net liquid credit (subtracted from costs), (14) return on production investment, (15) return on working capital. See, Shell Oil Company v. F.P.C., supra; Placid Oil Company v. Federal Power Commission, supra. Royalty, it will be noted, is one of the producer's expenses which is considered in arriving at the ultimate FPC rate. The amount paid by the producer to the royalty owner is an expense just as the wages paid to his drilling crews and the price he pays for the pipe he sinks in the ground. These other costs are controlled by market forces. Royalty should be treated no differently. Area rates do not take into account cost variances of individual producers. Placid Oil Company v. Federal Power Commission, supra. If royalty costs or other costs incurred by a particular producer are higher than those contemplated by the FPC in establishing the rate, that producer may seek individualized relief. See, Mobil Oil Corp. v. FPC, supra. The final company-wide rates established by the FPC in the instant action share a common basis with area rates and national rates  all are based on the producer's costs. In its settlement negotiations with the FPC, Mobil presented company-wide cost of production information. The record indicates Mobil did not present specific cost information on its production under the instant A and B contracts (two of some 200 contracts involved in the company-wide settlement). Had Mobil chosen to do so, it could have presented its royalty costs under the A and B contracts to the FPC on the basis claimed by the appellee royalty owners since these cases were pending when Mobil filed its settlement proposal. All the rates established for the five-year period involved in this controversy were determined by the producer's company-wide cost of production. Even the two periods totaling some 24 months Mobil was allowed to retain the full contract price it had received were determined by an analysis of Republic's (Mobil's predecessor) and Mobil's revenue and costs of production. The FPC rate is totally unrelated to the value of the commodity gas. For the benefit of the consuming public, the rate is set to give the producer a reasonable return on its production costs and investment. It need only be high enough to avoid being confiscatory. FPC v. Texaco Inc., 417 U.S. 380, 41 L.Ed.2d 141, 94 S.Ct. 2315. Neither the value of the gas nor the price it will command in the unregulated marketplace is taken into consideration in fixing the FPC rate. The gas is, in essence, being given away. The FPC controlled rate which the producer receives is not in payment for the commodity gas; it is to cover the producer's costs and provide a certain return on the producer's investment. With respect to proceeds leases, the majority says the measure of royalty is the FPC rate which the lessee-producer receives for the gas. To say that a landowner's share of gas produced on his land is to be measured by the producer's cost of production, which is totally unrelated to the value of the gas and which is reflected by a rate fixed for the purpose of protecting the consuming public by an agency having no jurisdiction over the royalty owner, his lease, or the amount of his royalty payment, is, in my judgment, incongruous. This offends my sense of logic. It taxes credulity to the breaking point. All royalty clauses, whatever the language, deal with the same interest of the landowner  royalty. Royalty is the landowner's share in the oil and gas actually produced which is paid as compensation for the right to drill and produce. See, Magnusson v. Colorado Oil and Gas Corp., 183 Kan. 568, 331 P.2d 577; Skelly Oil Co. v. Cities Service Oil Co., 160 Kan. 226, 160 P.2d 246; Rutland Savings Bank v. Steele, 155 Kan. 667, 127 P.2d 741. The landowner's royalty interest is not a share of the producer's cost of production. It is not a share of an amount totally unrelated to the value of the commodity gas. It is not a share of an amount fixed for the protection of the consuming public by an agency that has no jurisdiction over the landowner or his lease. The landowner's royalty interest is a share in the value of the gas actually produced. Because the physical properties of gas do not permit its being stored, the royalty owner takes his share of the commodity in the form of dollars rather than a share of the gas itself. But, royalty is still tied to the gas produced. Gas  the commodity  is at the heart of the royalty obligation of all gas leases. Gas  the commodity  does have a value in the market. The FPC rate which is neither related to or based on the commodity gas or its value in the market simply cannot be, in logic or in law, the measure of the landowner's royalty interest in the gas produced on his land. Relying on Waechter v. Amoco Production Co., 217 Kan. 489, 537 P.2d 228, adhered to after rehearing, 219 Kan. 41, 546 P.2d 1320, the majority summarily decides the FPC rate is the measure of royalty under the proceeds leases now before this court. Waechter, in my opinion, was incorrectly decided. Relying on it here compounds the error. Waechter noted that proceeds and market value royalty clauses are not the same. It said that under a proceeds lease, the lessor chooses not to be tied to the uncertainty of the market, but instead chooses to take his royalty share from whatever the lessee can get for the gas  relying on the lessee's economic self-interest to obtain the best price possible. Under this rationale, whatever amount the producer receives must be the measure of royalty. While I understand this distinction, I do not think it can be stretched to the point of completely breaking away from the commodity gas which is the basis for royalty. Under a proceeds lease, is it possible the lessor contemplates the price received and his royalty share will be determined by something other than the commodity gas? Surely if the landowner's royalty interest is in a share of the value of the gas produced, his royalty payment will be determined by, or at the very least be related to, the value of the commodity gas regardless of whether his lease calls for a royalty share of the market value of the gas or the proceeds of the sale of the gas. Proceeds and market value are both measures of the lessee's royalty obligation  an obligation which commands payment to the lessor for a portion of the gas produced. Both are related to the commodity gas and its value. This common aspect of the royalty obligation of all gas leases has not gone unnoticed. One commentator has observed that while a literal distinction can be made between proceeds and market value royalty provisions, in practice, courts seem to apply the same standard  market value at the wellhead  whether a lease predicates royalty on proceeds, market value or market price. See, Siefkin, Rights of Lessor and Lessee with Respect to Sale of Gas and as to Gas Royalty Provisions, Fourth Oil and Gas Inst. 181, 214 (Matthew Bender 1953), and cases cited therein. Professor Sneed, after recognizing that proceeds does afford a different standard than market price or market value, says the parties probably contemplate this standard will yield no different return from any other standard. Sneed, Value of Lessor's Share of Production Where Gas Only Is Produced, 25 Tex. L. Rev. 641, 655 (1947). Some of the leases themselves illustrate the common basis underlying both the proceeds and market value types. The modified Parker lease provides: ... (1/8) of the gross proceeds at the prevailing market rate.... If proceeds means actual sales price, and market rate means the market value for the gas, this clause is obviously contradictory. It can have only one meaning: out of the proceeds the lessee realizes, the lessor shall be paid royalty for the gas produced on the basis of market value at the well. When one recognizes the common element in all gas royalty clauses  a share of the value of the commodity gas produced  it becomes clear that the meaning of proceeds just stated above must apply to all the proceeds leases before the court. The FPC rate imposed on the producer is completely unrelated to the gas produced or its value. It is a utility rate based essentially on costs of production. In this case, the arbitrated contract price of the A and B contracts is the only evidence of the market value of the commodity gas. This contract price and not the FPC rate is tied to the gas produced and its value. This value must serve as the basis for the lessor's royalty share under the proceeds leases. Out of the proceeds the lessee realizes from the sale of the gas produced, the lessor should be paid his royalty share on the basis of the market value at the well as evidenced by the arbitrated contract prices. It is well established that the landowner's royalty share of the gas produced is free of the costs of production. In 3 Williams & Meyers, Oil and Gas Law, § 643.2, p. 529 (1975), it is said: Inasmuch as gas royalty is ordinarily payable in money rather than in kind and is measured by value or proceeds at the wellhead, it is not customary, as in the case of the oil royalty payable in kind, to specify that the royalty is free of cost of production. Freedom from such costs of production is implicit in the provision for payment of a share of the proceeds or value at the wellhead.  (emphasis supplied) In Johnson v. Jernigan, 475 P.2d 396, 399 (Okla. 1970), the court stated: ... `Gross proceeds' has reference to the value of the gas on the lease property without deducting any of the expenses involved in developing and marketing the dry gas to this point of delivery. Given the proposition that royalty is free of the costs of production, using the FPC rate as the basis for determining royalty creates a paradox: royalty, which is not to be burdened with any costs of production, is determined by a rate based on costs of production. Surely, this cannot have been the result intended by the parties. Justice Fromme would have the FPC rate serve as the basis for royalty under both proceeds and market price (he distinguishes between market price and market value) royalty clauses. He says that although the two types of royalty clauses are different, such difference does not prevent the amount received as proceeds from adding up in dollars to as much as that received as market price. I do not agree with his view that the FPC rate may serve as the basis for royalty. I do, however, agree that the amount of royalty may be the same in dollars under both proceeds and market value leases. As I have pointed out at length, the FPC rate is foreign to the basic nature of the royalty interest. The FPC rate is ill-suited to serve as the measure of royalty under proceeds leases. Market value can and must serve as the measure of royalty under both the market value and proceeds leases now before this court. Under the circumstances at hand, the one-eighth royalty payment under both types of leases simply amounts to the same in dollars. The majority makes a distinction between proceeds and market value leases, but fails to recognize another distinction: proceeds in a regulated and an unregulated market. As noted in Texaco, Inc. v. Federal Power Commission, 474 F.2d 416, 422 (D.C. Cir.1972): ... [an unregulated industry] is governed by the market while ... [a regulated industry], by definition, is the subject of active governmental control. The market value of gas and the just and reasonable rates mandated by the Natural Gas Act are two separate and distinct things. FPC v. Texaco Inc., supra. Proceeds in the form of an imposed, governmentally controlled cost of production rate are certainly not equivalent to the proceeds from a sale of gas in an unregulated market. The former is a sum commanded by cost factors unrelated to the commodity gas or to its price or value. The latter is a sum commanded by the gas produced. Royalty based on the proceeds from a sale of gas in an unregulated market is necessarily tied to the value of the gas, because it is the gas that commands the price received by the producer. Royalty based on proceeds in the form of the FPC ceiling rate is at odds with the royalty interest  a share of the value of the gas produced.