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                                                    The Attorney General of Texas
                                                                          December        31,   1982

    MARK WHITE
    Attorney General


                                                    Mr. Bob Armstrong                                  Opinion    No.    MW-550
    Supreme          Court     Buildmg
                                                    Comr4issioner
     P. 0. Box       12546
     Austin.TX.        76711.2548
                                                    General Land Office                                Re:     Interpretation      of royalty
     5121475.2501                                   1700 North Congress                                provisions      of   state   leases   or
     Telex    9101674-1367                          Stephen F. Austin Building                         lands dedicated       to the Permanent
     Telecopier     51214754266                     Austin,   Texas   78701                            School      Funds       and   Permanent
                                                                                                       University     Fund
     1607   Main       St., Suite     1400
     Dallas, TX.        752014709                   Dear Mr. Armstrong:
     214/742-6944
                                                           You have requested     an opinion     from this    office   regarding   the
                                                    calculation   of royalties   due for gas produced      from state    leases  where
     4624 Alberta            Ave.. Suile      160
     El Paso. TX.            799052793
                                                    the state’s   lessee  sells  the gas pursuant     to a contract   which provide:
     9151533-3464                                   that the purchaser    reimburse   the lessee    for any severance     tax paid ir
                                                    regard to the production     of that gas.

      :220 Dallas Ave., Suite                202
                                                           The current    General    Land Office       lease     form,   “Revised   Lease   Fore
      HOUS,O”,   TX. 77002-6966
      71316500666
                                                    9-81 ,‘I provides:

                                                                The Lessee agrees to pay...             (B) Non-Processed       gas:
      606 Broadway.             Suite 312                       As a royalty       on gas.. .                part of the gross
      Lubbock,     TX.        79401-3479
                                                                production       or the market value           thereof.      at the
      6061747-52?6
                                                                option      of the Lessor,      such value       to be based on
                                                                the highest       market price     paid or offered          for gas
      4.109 N. Tenth.   Suite B                                 of comparable        quality    in the general          area where
      McAllen.    TX. 785c1.1665                                produced       and when run.         or    the   price     paid    or
      5 I21362~4547
                                                                offered       to    the    producer,        whichever       is   the
                                                                greater....
      200 Main Plaza, Suite 400
      San Antonio.  TX. 762052797                   The instant     question    arises    only where the state        has elected    to takl
      5121225-4191                                  its    royalty    in    cash    rather    than     in    kind.    Although    question
                                                    concerning     the effect     of federal    price     controls  have been raised      ant
       An Equal        Ooportunityl                 will   be addressed,      this opinion     will   initially    address    the issues   01
       Affirmative       Action     Employer        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
                                                                                           -I


                                     (MW-550)




       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                                                           1000      mcf
Times Base Price                                                            x$5      mcf
Total Base Price                                                          $5000

Total Base Price                                                          $5000
Times X Necessary  to Yield $5/mcf Net of                                 x.081
    Severance Tax
Equals Severance  Tax Due on Entire Production                            $ 405
Times Non-Exempt Producer’s  Share of Production                           x.80

 Equals Total Severance       Tax Paid    and Reimbursed                  S 324.00
 Plus Total Base Price                                                    $5000.00
 Equals Gross Price                                                       $5324.00




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




State’s    Royalty:

GLO Method:
   Gross Price                                                                 $5324.00
   Times Royalty Percentage                                                        x.20
   Equals Minimum Amount of            Royalty                                 $1064.80

Producer’s  Method:
   Total Production                                                            1000          mcf
   Times Royalty    Share                                                      x.20
    Equals State’s   Share of Production                                         200         mcf
   Times Base Price                                                             x$5          mcf
    Equals Minimum Amount of Royalty                                           $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
