            THE     .L~ITOECNEY           GENERAL
                          OF-XAS




Honorable Bob Armstrong          Opinion No. M-943
Commissioner
General Land Office              Re:    Whether a proportionate
Austin, Texas 78701                     cost of preparing 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 of which it has drilled several wells
that produce natural gas. On each lease one of the wells is
a platform well or production deck well upon which are heaters,
gas production separators, dehydrators, and metering devices
for gas, condensate, and water. Each lease also contains one
or more satellite wells upon which are a heater, meter, regu-
lator, valves, and flow lines running from the satellite well
to the platform well. After the gas has been processed through
the above mentioned facilities, it is sold by 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
a proportionate 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 for by the companies can be legally
justified."

          The statutory authority pursuant to which the royalty
provision of the State oil and gas lease in question must
conform is Sec. 8 and Sec. 10 of Art. 5421c, Vernon's Civil
Statutes.  Section 8 reads in part:

          "All islands, salt water lakes, . . . and
          that portion of the Gulf of Mexico within

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Honorable Bob Armstrong, page 2          (M-943)



         the jurisdiction of Texas . . , shall
         be subject to lease by the Commissioner
         of the General Land Office . . ., in
         accordance with the provisions 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 pro-
         duction or value of oil, gas and sulphur.
         . . .1, (Emphasis added)

          Section 10 reads in part:

          "The areas included herein shall be leased
          for a consideration, in addition to the
          cash amount bid therefor, of not less than
          one-eighth (l/E) of the gross production of
          oil, or the value of same, that may be pro-
          duced and saved, and not less than one-
          eighth (l/E) of the gross production of gas,
          or the value of same, and not less than one-
          eighth (l/8) of the gross production of
          sulphur, or the value of same that may be
          produced, that may be produced and sold off
          the area, and not less than one-sixteenth
          (l/16) of the value of all other minerals
          that may be produced, and an additional
          sum of twenty-five cents an acre per year
          for each year thereafter until production
          is secured. . . ."

The gas royalty provision contained in the State lease in
question reads as follows:

         "3 . When production of oil and/or gas
         is secured,the Lessee agrees to pay or
         cause to be paid to the Commissioner of
         the General Land Office at Austin, Texas,
         for the use and benefit of the State of
         Texas, during the term hereof; . . .
         (B) As royalty on any gas, . . . produced
         from any well and sold by Lessee, or used
         by Lessee for purposes which are not
         exempted from royalty payments . . . (l/6)
         of the value of the gross production, but
         in no event shall the royalty be based on a
         price of less than the highest market price
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Honorable Bob Armstrong, page 3            (M-943)



            paid or offered for gas in the general area,
            or the price paid or offered to the producer,
            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 the basis for the re-
examination of Opinion WW-196.

          Sections 8 and 10 of Art. 5421c, were originally
promulgated by Acts 1931, 42nd Leg., p. 452, ch. 271. Sec.
10 has remained unchanged to date, but Sec. 8 has been amended
several times, the most recent and important being by Acts
1957, 55th Leg., p. 434, ch. 209, 51, effective May 10, 1957,
which added the proviso 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. 10 was 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 leads us to the conclusion that a material
change was effected with respect to royalties on oil and sul-
phur. In effect, by the 1957 amendment, Sec. 8 deleted from
Sec. 10 the qualifying language ". . . that may be produced
and saved, . . .IIas this pertains to the royalty payable on
oil and the language II. . . that may be produced, that may be
produced and sold off the area, . . ." as this pertains to
sulphur. However, the absence of such modifying language in
Sec. 10 and Sec. 8 in regard to the royalty provision per-
taining to gas demonstrates a distinguishably consistent
statutory standard. The various gas royalty reservations,
i.e., that ". . . gross production of gas, or the value of
same. . ." as used in Sec. 10 of Art. 5421c, and ". . . gross
production or value of . . . gas . . ." used in Sec. 8 of
Art. 5421~~ and ". . . value of gross production . . ." used
on the State lease form, are synonomus in meaning. We are
of the opinion that with respect to gas, 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 the value
thereof. In this we are fully supported by the authorities
and the language of the State lease, as will be pointed out below.
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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 Relinguish-
ment Act, which specifies, in part, 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 of production shall
          pay to the State the undivided one-
          sixteenth of the value 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,
117 Tex. 516, 8 S.W.2,d 655, 660 (1928), to mean:
          I,
               . We interpret the Act to fix a
                   .   .

          minimum price of 10 cents per acre
          per annum and the value of one-sixteenth
          of the gross production free of cost to
          the state. for which the state is willinc
          to sell the oil and gas, . . ." (Emphasis
          added)

It is our opinion, and we are supported by Attorney General's
Opinion O-6398 (1945), that within the phrase "the value of
one-sixteenth of the gross production free of cost . . .,"
the term "free of cost" must be given the same meaning 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 'free royalty' introduced
                   .   .

          into this Act must mean that the interest
          reserved to the State in the minerals
          produced on school land sold under the
          terms of the Act must not bear any part
          of the expense of the production, sale,
          or delivery thereof."  (Emphasis added)

           We do not recognize any material distinction between
the language delineating the basis for gas royalty to the State
used in Sec. 8 and Sec. 10, Art. 5421c, and the language of
Art. 5368, previously construed by the Court. Our conclusion
is that the phrase 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 to mean that the royalty

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Honorable Bob Armstrong, page 5          (M-943)



interest of the State must not bear any part of the expense
of the production, sale or delivery of production of gas, and
oil and sulphur for that matter, from a State lease. The
State lease conforms to the statutory language and, therefore,
is to be given the same meaning 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), 30 USCA 8226(c). The statute provides,
in part, 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 the production removed or sold from
          the lease."

The question before the Court was whether certain cost of
conditioning the gas for market 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] in marketable condition as well as sustaining
the premise of his decision that *. . . since the lessee was
obliged to market the product, he was obligated to put 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 of production, for
          the purpose of computing royalty shall be
          the estimated reasonable value of the
          product . . . . Under no circumstances
          shall the value of production. . . be
          deemed to be less than the gross proceeds
          accruing to the lessee from the sale
          [of the product]."  30 C.F.R. 5221.47
          (1959): and

          "221.35 Waste prevention; beneficial use.
          The lessee is obligated to prevent the
          waste of oil or gas and to avoid physical
          waste of gas the lessee shall consume it
          beneficially or market it or return it to

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Honorable Bob Armstrong, page 6            (M-943)



          the productive formation."   30 C.F.R.
          5221.35 (1959)

The latter part of the first regulation reads essentially the
same as the phrase following "value of gross production" in
the State lease form, that is:

          "but in no event shall the royalty be
          based on a price of less than the highest
          market price paid or offered for gas in
          the general area, or the price paid or
          offered to the producer, whichever is the
          greater: . . .ll

The second regulation reads essentially the same as the first
sentence in provisions 3(F) in the State lease form. Section
3(F) reads as follows:

          "Lessee agrees to use reasonable diligence
          to prevent the underground or above ground
          waste,of oil or gas, and to avoid the
          physical waste of gas produced from the
          leased premises, Lessee shall either mar-
          ket said gas or use same beneficially in
          operations on the leased premises."

          It is our 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 so produced. The same
result was reached in Gilmore vs. Superior Oil Co., 192 Kan.
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 in principle by
Pan American Petroleum Corporation vs. Southland Royalty Co.,
396 S.W.Zd 519 (Tex.Civ.App. 1965, error dism.), where on page
524 the Court said:

          "It has long been established that a royalty
          interest is one that is free of cost of
          producing,  saving and preparing the product
          for market. 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

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Honorable Bob Armstrong, page 7            (M-943)



Leases   (Second Edition), Section 85, Page 214, states that:

           "If it is the lessee's obligation to market
           the product, it seems necessarily to follow
           that his is the task also to prepare it for
           market, if it is unmerchantable in its
           natural form. No part of the cost of mar-
           keting or of preparation for sale is charge-
           able 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 gas must be transported
some considerable distance from the leased premises by the
lessee in order to sell the gas to a pipeline purchaser.   To
that extent, Opinion NW-196 is distinguishable from the present
situation on the facts and we do not reconsider that portion of
the Opinion. However, in all other regards, Opinion W-196
is expressly overruled because it is based on an erroneous
interpretation of Sec. 10, Art. 5421c, with respect to gas
processing charges and after May 10, 1957, it is no longer
the controlling statute delineating the mineral reservation to
the State. In addition, the rationale and authorities cited
in that opinion are generally in point where the lease in
question provides that royalties are to be based upon the
value of gas at the wellhead and are distinguishable from and
not definitive of the applicable statutory language of Sec. 8,
Art. 5421c, used in the State lease. This distinction is
material as is pointed out by Skaggs vs. Heard, supra, at
page 816:

           "Plaintiff concedes the general rule
           that, where a lease provides for royalty
           on gas marketed or utilized by the les-
           see, there is an implied obligation upon
           the lessee to use reasonable diligence
           in marketing the gas7 but says that thi's
           does not mean that the lessee is to pay
           all of the costs or expenses of market-
           ing, transporting, processing or treat-
           ing the gas, citing numerous cases where
           gas was not sold at the well or on the
           lease but was carried a great distance
           to market8 or was enhanced in value by
           processing into b -products in expensive
           plants,g or both, TO or depending on pro-
           visions altogether different from those
           used here.11 Many other cases are cited
                             -4618-
    .




Honorable Bob Armstrong, page 8             (M-943)



          and discussed by counsel on both sides.
          All are distinguishable on one or the
          other of the grounds noted above.

          7
           Cole Petroleum Co. v. United States Gas
            & Oil Co., 121 Tex. 59, 41 S.W.2d 414,
            86 A.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., 10 Cir., 74 F.2d 497, (where
           a pipe line was laid 90 miles by the
           lessee); Scott v. Steinberger, 113 Kan.
           67, 213 P. 646; Robert v. Swanson, Tex.
           Civ.App., 222 S.W.2d 707.

          9
              Danciger Oil & Refineries, Inc. v. Hamill
              Drilling Co., 141 Tex. 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.
         11
              Cf. Phillips Petroleum Co. v. Johnson,
              5 Cir., 155 F.2d 185, calling for 1/8th
              of the net proceeds derived from gas at
              the mouth of the well."

The leare in question clearly provides that the basis on which
the royalty to the State must be paid can in no event be less
then the greater of the price offered      to or received by the
producer or the highest market price paid or offered for gas
in the general area.      Generally, the royalty to the State will
be baaed upon the price      for gas received by the producer at
the point where the producer delivers the gas to the pipeline
purchaser. Nothing in the language of the leare contemplates
any deduction8   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 of provision 4 in the State lease form
governing the manner 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
          at Austin, Texas, during the life of this
          lease, on or before the 30th day of each
          succeeding month, for the month in which
          the oil and/or gas was 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 the manufacture of gasoline,
          and the marke~t value of the oil, dry gas,
          residue gas, casinghead gas, and other
          products produced therefrom, together with
          a copy of all daily gauges of tanks, meter
          readings, pipeline receipts, gas line receipts
          and other checks and memoranda of the
          amounts produced and put into pipelines,
          tanks or pools and gas lines or gas storage.
          In all cases the authority of a manager
          or agent to act for the Lessee herein must
          be filed in the Gener'al Land Office."

Relevant to the question here, we note that while this provi-
sion requires a sworn statement to be submitted detailing the
volume and market value of the dry gas produced, sold or used
and put into pipelines, tanks or pools and gas lines or gas
storage, it does not provide for an accounting of any producing,
processing, transporting or marketing charges. Common mense
dictates that were it contemplated that the pro 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 in provision 4.



               The lessee or operator of a natural
          gas well located on a State tract may not
          legally deduct from the royalty due the
          State a pro 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 nec-
          essary 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




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