Petition — Federal Energy Regulatory Commission v. Pennzoil Producing Co.

(7-648

N

0.

= a OTT AOAK, JR., CLERK

Iu the Supreme Court of the United States

OCTOBER TERM, 1977

FEDERAL ENERGY REGULATORY COMMISSION,

PETITIONER

‘

Ue

PENNZOIL PRODUCING COMPANY, ET AL.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

WADE H. McCCREE, JR.,

Solicitor General,

RICHARD A. ALLEN,

Assistant to the Solicitor General,

Department of Justice,

Washington, D. C. 20530.

ROBERT R. NORDHAUS,

General Counsel,

PHILIP R. TELLEEN,

Attorney,

Federal Energy Regulatory Commission,

Washington, D. C. 20426.

INDEX

Page

Opinions below... 2

Jurisdiction = 2

Questions presented 2

Statutes involved eet 3

SR Ret bial sacl 3

Reasons for granting the writ - 9

Conclusion... * 20

Appendix A . AEC la

NE ae 10a

a 1 ET ST ee See | 12a

Appendix D SME ad wididiPrccahes 14a

Re TL

CITATIONS

Cases:

Atlantic Refining Company v. Public Serv-

ice Commission of New York, 360 U.S.

El Paso Natural Gas Co., 54 FPC 145, re-

versed sub nom. Southland Royalty Co.

v. Federal Power Commission, 543 F.

2d 1134, certiorari granted, June 27,

1977, No. 76-1587... 7, 8, 16

Federal Power Commission v. Sunray DX

ros Oe ee a 13

Federal Power Commission v. Texaco Ine.,

| SRN een oN mon fp

Federal Power Commission v. Transcon-

tinental Gas Pipe Line Corp., 365 U.S.

Il

Cases—Continued Page

Lightcap v. Mobil Oil, 221 Kan. 448, 562

P.2d 1, certiorari denied, October 3,

1977, No. 76-1694. 10, 18

Mobil Oil Corporation v. Federal Power

Commission, 417 U.S. 283 7,14

Mobil Oil Corporation v. Federal Power

Commission, 463 F. 2d 256, certiorari

denied, 406 U.S. 976 —s_—- 5, 10

Northern Natural Gas Co. v. State Cor-

poration Commission of Kansas, 372

I re NY 19

Phillips Petroleum Co. v. Wisconsin, 347

U.S. 672 _ eke 9,18

Securities and Exchange Commission v.

Ralston Purina Co., 346 U.S. 119 19

United States v. Bacto-Unidisk, 394 U.S.

784 . 19

United States \ v. . Southwestern Cable Co.,

392 U.S. 157. de tN Oe IA PR 19

Statutes:

Natural Gas Act, 52 Stat. 821, as amend-_

ed, 15 U.S.C. 717 et seq.:

Section 4,15 U.S.C. 717 12

Section 4(a), 15 U.S.C. 717¢(a) med 3

Section 5(b), 15 U.S.C. 717d(a). 12

Section 7(b), 15 U.S.C. 717f(b) . 6,15

Organization Act,

~ <Dab-e 95-91, 91 Stat. 565:

Section 402(a)(1)(C) ss 1

er 1

Miscellaneous:

Executive Order 12009, 42 Fed. Reg.

46267 _ ews ipabiahectamdeteate 1

ju the Supreme Court of the United States

OCTOBER TERM, 1977

No.

FEDERAL ENERGY REGULATORY COMMISSION,

PETITIONER

v~.

PENNZOIL PRODUCING COMPANY, ET AL.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

The Solicitor General, on behalf of the Federal

Energy Regulatory Commission,’ petitions for a writ

*On September 30, 1977, pursuant to the provisions of the

Department of Energy Organization Act (DOE Act), Pub. L.

95-91, 91 Stat. 565 and Executive Order No. 12009, 42 Fed.

Reg. 46267, the Federal Power Commission ceased to exist.

Its functions and regulatory responsibilities were transferred

to the Secretary of Energy and the Federal Energy Regula-

tory Commission which, as an independent commission with-

in the Department of Energy, was activated on October 1,

1977. Pursuant to Section 402(a)(1)(C) of the DOE Act,

“the establishment, review, and enforcement of rates and

charges for the transportation and sale of natural gas” in

interstate commerce is “transferred to, and vested in,” the

Federal Energy Regulatory Commission. The “savings pro-

visions” of Section 705 of the DOE Act provide for the sub-

stitution of the Federal Energy Regulatory Commission for

the Federal Power Commission in pending litigation such as

this case.

(1)

2

of certiorari to review the judgment cf the United

States Court of Appeals for the Fifth Circuit.

OPINIONS BELOW

The opinion of the court of appeals (App. A,

infra, pp. la-9a) is reported at 553 F. 2d 485. The

initial opinion and order (No. 753) of the Federal

Power Commission (App. D, infra, pp. 14a-26a) and

its opinion and order (No. 753-A) denying rehear-

ing (App. E, infra, pp. 27a-38a) are not officially

reported.

JURISDICTION

The judgment of the court of appeals was entered

on June 6, 1977 (App. B, infra, pp. 10a-lla). The

Commission’s application for rehearing was denied on

September 1, 1977 (App. C, infra, pp. 12a-13a). The

mandate of the court of appeals issued on September

9, 1977. On August 26, 1977, Mr. Justice Powell

extended the Commission’s time for filing a petition

for a writ of certiorari to and including November

3, 1977. The jurisdiction of this Court is invoked

under 28 U.S.C. 1254(1) and Section 19(b) of the

Natural Gas Act, 52 Stat. 831, as amended, 15 U.S.C.

717r(b).

QUESTIONS PRESENTED

1. Whether the Commission has authority under

the Natural Gas Act to perinit lessee/producers of

natural gas to pass through to interstate customers

the producers’ royalty costs that are based on the

unregulated intrastate market price of natural gas.

2. Whether the Commission has authority under

the Natural Gas Act to permit lessee/producers of

natural gas to pay royalties “in kind” in the form of

natural gas that the landowner/lessors can then sell

on the intrastate market, and thus to permit pro-

ducers to abandon certificated interstate service in

quantities of gas solely for the financial benefit of the

lessors,

STATUTES INVOLVED

Section 4(a) of the Natura! Gas Act, 52 Stat. 822,

as amended, 15 U.S.C. 717¢(a), provides:

All rates and charges made, demanded, or re-

ceived by any natural-gas company for or in

connection with the transportation or sale of

natural gas subject to the jurisdiction of the

Commission, and all rules and regulations af-

fecting or pertaining to such rates or charges,

shall be just and reasonable, and any such rate

or charge that is not just and reasonable is de-

clared to be unlawful.

STATEMENT

Pennzoil Producing Company (Pennzoil) and Shell

Oil Company (Shell) sell gas produced from the Gib-

son Field, in Terrebonne Parish, Louisiana to United

Gas Pipe Line Company (United). The gas is pro-

duced under leases obtained by Pennzoil and Shell

from Williams, Inc. (Williams) dated August 29,

1934, and July 24, 1952. Each lease provides for pay-

ment of a royalty equal to a fixed percentage (14 in

the 1934 lease; 14 in the 1952 lease) of the value of

1

the gas preduced, calculated at the “market rate” or

“market price” prevailing at the well (App. D. in-

fra, p. 13a).

Royalties under the leases have always been paid

on the basis of the regulated rates at which the gas

from the leaseholds has actually been sold in inter-

state commerce. However, in 1973 and 1974 Williams

demanded payment by Shell and Pennzoil of royalties

based on intrastate market values of natural gas,

ranging from 35 cents to 70 cents per Mcf (1,000

cubic feet) for the period October 1, 1971 through

December 31, 1973, and 70 cents per Mcf thereafter.

These market values substantially exceeded the rate

ceilings established by the Commission for the sales

of gas by Shell and Pennzoil. By a letter of June 5,

1974 Williams purported to terminate the leases for

alleged underpayment of royalties due under the

leases (App. D, infra, p. 15a).

In 1974, Pennzoil and Shell filed a petition in a

state court in Louisiana praying for a judgment de-

claring that Pennzoil and Shell were properly dis-

charging their royalty obligations under the leases.

Williams filed an answer and a counterclaim claiming

royalty underpayments of $3,731,683.79 (App. D,

infra, p. 16a).

Shell, Pennzoil and Williams subsequently entered

into a settlement agreement, under which Pennzoil

and Shell would apply to the Commission for au-

thority to pay a royalty based, in essence, on the

higher of 78 cents per Mcf or 150 percent of the

highest area or national rate permitted by the Com-

5

mission. Alternatively, Pennzoil and Shell would seek

Commission authorization to abandon that portion of

the gas sold under the leases which is attributable to

Williams’ royalty interest, i.e., 4 and 14 of the gas

produced under the 1934 and 1952 leases, respectively,

so that that portion of the gas could be paid in kind

to Williams for sale on the intrastate market. Ac-

cordingly, Pennzoil and Shell filed petitions with the

Commission seeking special relief from the area and

national rates established by the Commission to per-

mit them to pass through to United the higher royalty

rates called for in the settlement or, if this relief

was denied, to permit them to abandon to Williams

the portion of the gas produced under the leases that

was attributable to Williams’ royalty interests (‘roy-

alty gas”) (App. D. infra, p. 16a).

After a hearing on the petitions, the Commission

in January 1976 issued an opinion (App. D, infra,

pp. 14a-26a) affirming the initial decision of the

administrative law judge denying the requested re-

lief. With respect to the requested rate increase, the

Commission observed that while it did not have juris-

diction over the royalty owners or over the royalty

payments made to them by producers,’ it did have

jurisdiction over the rates charged by producers to

an interstate pipeline (id. at 21a-22a). The Commis-

sion concluded that it had no authority under the

Natural Gas Act to grant the requested rate increase,

stating (id. at 22a-23a):

2 Mobil Oil Corporation v. Federal Power Commission, 463

F. 2d 256 (C.A. D.C.), certiorari denied, 406 U.S. 976.

6

In the instant proceeding, the impetus of the

settlement is the market value of the royalties

and no consideration has been given to regulated

rates. As such, we cannot permit any incre-

mental royalty costs resulting from this settle-

ment, or resulting from any judgment by a state

court regarding royalty payments, to be passed

on to the pipeline if these incremental royalty

costs are based on any other factors than the

regulated just and reasonable rate. On this point,

we note the Supreme Court’s warning in FPC v.

Texaco, [417 U.S. 380], that the Commission is

not free to equate just and reasonable rates with

the prices for gas in the marketplace. Accord-

ingly, we believe that we are not free to allow

royalty costs, whicn are based on market values,

to be passed on to the pipelines as just and rea-

sonable rates. A contrary result would not “.. .

afford consumers a complete, permanent, and ef-

fec.ive bond of protection from excessive rates

and charges” [quoting from Atlantic Refining

Company v. Public Service Commission of New

York, 360 U.S. 378, 388].

The Commission also concluded that abandonmert

of the royalty gas to Williams should not be author-

ized under 15 U.S.C. 717f(b) (App. D, infra, pp.

23a-24a). The Commission found that the supply of

natural gas in the leaseholds was not so depleted as

to warrant cessation of service, and that the public

convenience and necessity would not be served by

granting an abandonment authorization that would

“likely result in the subject gas being diverted from

the interstate market to the intrastate market” (App.

7

D, infra, p. 24a). The Commission subsequently de-

nied petitions for rehearing (App. E, infra, pp. 27a-

33a) in an opinion and order reaffirming the reasons

set forth in its initial opinion and rejecting conten-

tions that this Court’s decision in Mobil Oil Corp. v.

Federal Power Commission, 417 U.S. 283, established

the authority of the Commission to allow royalty

costs based on market value to be passed on to pipe-

lines. The Commission stated that “[w]hile indicat-

ing that relief on some grounds may be possible [ Mo-

bil Oil Corp.] does not state under what conditions

relief should be granted, nor does it define when the

right to gain relief matures” (App. E, infra, p. 29a).

The court of appeals reversed the Commission’s

orders (App. A, infra, pp. la-9a). The court viewed

Federal Power Commission v. Texaco Inc., 417 U.S.

380, as inapplicable, apparently because “[t]his case

deals with royalty cost under specific leases” (id. at

* Moreover, the Commission disagreed with Shell and Pennz-

oil that the Commission was forced to choose between losing

4 or 4 of the gas to the intrastate market as called for in

the settlement, and possibly losing aii of the gas if the leases

were cancelled as a result of the state court litigation. Rely-

ing on its previous decision in El Paso Natural Gas Co.. 54

FPC 145, ceversed sub nom. Southland Royaity Co. v. Federal

Power Commission, 543 F. 2d 1134 (C.A. 5), certiorari

granted, June 27, 1977, No. 76-1587, the Commission ex-

pressed the view that Williams could not unilaterally termi-

nate deliveries to United if he terminated the leases. “(ijt

the lease were cancelled and Williams were to undertake to

sell the subject gas, Williams would simply assume the obii-

gations of Pennzoil and Shell to continue service to United,”

unless the Commission authorized abandonment (App. D,

infra, p. 24a).

8

6). Inasmuch as Commission rate regulation is cost-

based, the court held that the Commission had erred in

determining that it was not permitted to pass through

to interstate customers the cost to lessee/producers

of market value royalty payments. The court relied

on Mobil Ow Corp. v. Federal Power Commission,

supra, for the proposition that producers are entitled

to special relief from the Commission if their royalty

payments are higher than those provided for by the

applicable area or natural rate established by the

Commission (id. at 7).

On the issue of alternative relief, the court directed

the Commission to reconsider its decision not to per-

mit abandonment of the royalty portion of the gas.

Relying on its decision in Southland Royalty Co. v.

Federal Power Commission, 543 F. 2d 1134 (C.A. 5),

certiorari granted, June 27, 1977, Federal Power

Commission v. Southland Royalty Co., No. 76-1587,

the court held that the Commission had been mis-

taken in concluding that the gas, having once been

dedicated to interstate commerce, could not be with-

drawn from that service by the lessor without aban-

donment authorization in the event that the leases

were terminated for failure to pay royalties based on

the unregulated market price.’

*On the Commission’s limited petition for rehearing, the

court deleted from its opinion the final statement that “[i]t

may well be that the ‘present or future public convenience or

necessity’ will suggest the propriety of abandoning a frac-

tion of the gas in Williams’ property, rather than lose the

entire amount from the interstate market. This decision is for

|

9

REASONS FOR GRANTING THE WRIT

This case presents two issues of substantial im-

portance to the administration of the Natural Gas

Act, 52 Stat. 821, as amended, 15 U.S.C. 717 ef seq.:

first, whether the Commission has authority to permit

a producer to pass through to interstate customers

royalty costs based on the unregulated market price

of gas; and second, whether the Commission, in lieu

of passing through such costs, may permit a producer

to abandon a portion of his gas from dedicated inter-

State service. The ruling of the court of appeals that

the Commission has authority to grant both types of

relief will, unless overturned, allow the rate set by

the Commission for sales of natural gas for resale in

interstate commerce to be based to a significant ex-

tent on the unregulated rate prevailing in the market

for intrastate sales. It will thus substantially under-

cut the Commission’s effective regulation of inter-

state sales pursuant to the authority recognized by

this Court in Phillips Petroleum Co. v. Wisconsin, 347

U.S. 672.°

the Commission.” (App. C, infra, pp. 12a-13a). In its opinion

on rehearing the court stated “[w]Je agree with the Commis-

sion that the statement was premature, if construed to be

decisional, and unnecessary with respect to our decision”

(id. at 18a).

* While it might be argued that the effect of the decision

below is limited because the court of appeals held only that

the Commission had authority to grant the requested relief,

not that it was compelled to grant such relief, the court’s

holding and rationale indicate otherwise. The decision below

rejected the Commission’s view that the grant of relief would

10

The two issues presented here are among a number

of related issues that all derive from the widespread

use in gas leases of clauses that require the producer

to pay royalties to the lessor based on the “market

value” or “market price” of the gas sold. The first is-

sue presented by such clauses is whether “market

value” clauses refers to the regulated interstate mar-

ket price at which the gas is actually sold, or the un-

regulated intrastate price which, in recent years, has

been substantially higher than the interstate price.°

be inconsistent with the regulatory scheme of the Act; it thus

forecloses the Commission from denying relief on that ground.

The decision would limit the Commission to reviewing the

circumstances of each case to determine whether particular

royalty costs were or were not permissible for other reasons—

for example, whether they were imprudently incurred. The

Commission would be precluded from denying relief on the

ground that use of unregulated market prices as a basis for

determining a significant component of the regulated rate

would undermine the basic purpose of the Act.

*In Lightcap Vv. Mobil Oil, 221 Kan. 448, 562 P.2d 1, certio-

rari denied, October 3, 1977, No. 76-1694, the Supreme Court

of Kansas construed certain “market value” royalty provi-

sions involved in that case to mean the unregulated intra-

state market, and required the producers to pay royalties on

that basis. In Mobil Oil Corp. v. Federal Power Commission,

463 F. 2d 256, 265 (C.A. D.C.), certiorari denied, 406 U.S.

976, however, the court suggested that such a construction not

only might “run counter to the intention of the parties, un-

less there is something to rebut the fair presumption that

they contemplated interstate movement and market prices

compatible therewith,” but also might contravene public policy

if not the Supremacy Clause. Although this Court denied cer-

tiorari in Lightcap, the petitioner has filed a petition for re-

hearing, and the Commission intends to file a memorandum

in support of that petition in view of the relationship between

the issue there and the issues presented in this case.

11

A second issue is whether the Commission has juris-

diction over royalty agreements.’ A third issue, pre-

sented in this case, is whether, if “market value”

royalty provisions refer to the intrastate market, the

Commission has the authority to include the higher

royalty in the producer’s cost basis, and thus pass

through the higher costs to interstate consumers. A

fourth issue, also presented in this case, is whether

the Commission alternatively may permit a producer

to pay royalties in the form of gas that the lessor

may then sell on the intrastate market, and thus

abandon a portion of his gas from dedicated inter-

state service.

While this petition addresses the issues presented

in this ease, those issues cannot be considered in isola-

tion from the other issues that are different facets of

the same problem.

1. The decision below that the Commission may

permit producers to base their interstate prices on

royalty costs that are in turn based on the unregu-

lated intrastate market value of natural gas is, we

*In Mobil Oil Corp. v. Federal Power Commission, 463 F.

2d 256 (C.A. D.C.), certiorari denied, 406 U.S. 976, the court

of appeals, reversing the Commission, concluded that royalty

owners were not “natural gas companies” subject to Commis-

sion jurisdiction under the Act. The court did not appear to

view its decision as having a decisive impact on royalty levels, —

however, since it apparently believed that the presumed in-

tention of the parties to gas leases, as well as considerations

of public policy and federal regulation, would lead courts to

construe “market value” clauses to mean the regulated market

at which the gas was actually sold and expected to be sold.

See note 6, supra.

12

submit, contrary to decisions of this Court. In Federal

Power Commission vy, Texaco Inc., 417 U.S. 380, this

Court reaffirmed the well-established principle that

the Commission’s responsibility under the Natural

Gas Act is to establish interstate rates at levels that

are “just and reasonable” (15 U.S.C. 717c, 717d(a) ),

and tat this responsibility is not met by establishing

an interstate rate that is based solely on the unregu-

lated marketplace. In that case the Court rejected a

Commission rate order that sought to regulate the

rates of small producers indirectly through the Com-

mission’s regulation of the rates of large producers

and of pipelines who purchased gas from the small pro-

ducers and whose cost of service was therefore based

in part on the prices paid to small producers. Since

the order appeared to permit the large producers and

pipelines automatically to pass through prices paid to

the small producers that were based on the prevailing

unregulated market, the Court rejected it, stating

(417 U.S. at 397-399):

[W]e * * * stress that in our view the prevailing

price in the marketplace cannot be the final meas-

ure of “just and reasonable” rates mandated by

the Act. It is abundantly clear from the history

of the Act and from the events that prompted its

adoption that Congress considered that the natu-

ral gas industry was heavily concentrated and

that monopolistic forces were distorting the mar-

ket price for natural gas. * * * In subjecting

producers to regulation because of anti-competi-

tive conditions in the industry, Congress could

not have assumed that “just and reasonable”

13

rates could conclusively be determined by refer-

ences to market price [footnote omitted }.

See also Federal Power Commission y. Sunray DX

Oil Co., 391 U.S. 9, 25.

The same principles apply here. It is evident that

for the Commission to permit a producer to base his

interstate rate on royalty costs based on the intra-

state market price would result in interstate rates

which are in significant part “conclusively * * * de-

termined by reference to market price.” °

The court of appeals stated that Texaco was “in-

applicable” to this case, but gave little indication of

its reasons for that conclusion (App. A, infra, p. 6a).

As Texaco itself indicates, the fact that royalty costs

are one of several components of the producers’ cost

is immaterial; they are a significant component, and

the principles affirmed in Texaco do not suggest that

the Commission can determine a part of the inter-

state rate that it promulgates solely on the basis of

the unregulated market so long as it does not deter-

mine the whole rate on that basis. The Act does not

permit the Commission to depart from its obligation

to establish just and reasonable rates up to a point,

so long as it adheres to that standard the rest of the

* Contrary to the court of appeals’ view (App. A, infra, p.

7a), royalty costs that are based on the intrastate market

price of gas are different from other costs (e.g., drilling costs),

because allowing a producer to pass such royalty costs through

to interstate customers results in a price for interstate gas

that is based in part on the unregulated market price of gas,

contrary to the principles established in Texaco and other

decisions.

14

way.’ As the Court said in Texaco, supra, 417 U.S.

at 399, “the Act makes unlawful all rates which are

not just and reasonable, and does not say a little un-

lawfulness is permitted.”

2. The Commission’s decision in this case is not

inconsistent with Mobil Oil Corp. v. Federal Power

Commission, 417 U.S. 283, relied on by the court be-

low (App. A, infra, p. 7a). The Court in Mobil

upheld an area rate promulgated by the Commission.

In response to Mobil’s objection that the Commission

had failed to provide for automatic rate adjustments

to accommodate anticipated increased royalty costs,

the Court observed that “Mobil’s argument is hypo-

thetical at this stage and * * * in any event an affected

producer is entitled to seek individualized relief.”

417 U.S, at 328. In making that observation, the

Court did not discuss or purport to determine the

entitlement to relief under all circumstances, or to

decide in particular whether a producer would be

* Moreover, in practice, as in this case, the Commission is

usually required to discharge its responsibilities under the Act

by determining the justness and reasonableness of particular

cost components presented to it for consideration. Accord-

ingly, in this case the Commission stated (App. D, infra, p.

22a):

[W]e cannot permit any incremental royalty costs * * * to

be passed on to the pipeline if these incremental royalty

costs are based on any other factors than the regulated

just and reasonable rate.

The Commission’s conclusion was not incorrect simply because

other cost components of the producers’ rate were just and

reasonable.

Es eter | ee ee

~ ee ence.

15

entitled to a rate increase to reflect royalty costs based

on the unregulated market.

This Court in Mobil merely recognized that the

Commission may grant special relief in some in-

stances where actual costs are higher than those pro-

vided for in the regulated rate. It does not follow

that the Commission may permit royalty payments

based on the unregulated price of the very commodity

that is subject to federal regulation—natural gas—

to be borne ultimately by the consumers of gas sold in

interstate commerce. If royalty costs determined by

the unregulated price of gas sold in intrastate com-

merce were passed on to the interstate consumer,

a different category of interstate gas would be created,

the price for which would be determined in substan-

tial part by intrastate market values and would

fluctuate with those values. As recognized in Texaco,

this would be no regulation at all.

3. The court below also erred in concluding that

the Commission had authority under the Act to per-

mit the producer, in lieu of passing through increased

royalty costs to its interstate customers, to pay its

lessors royalties in the form of gas which they could

sell on the intrastate market, thus abandoning that

gas from the interstate service to which it had been

dedicated. As the Commission correctly found, neither

of the two conditions for abandonment under Section

7(b) of the Act, as amended, 15 U.S.C. 717f(b), had

been met. First, the available supply of gas had not

been “depleted to the extent that continuation of serv-

ice is unwarranted.” Second, there was no basis for

16

finding that “the present or future public conven-

ience and necessity permit such abandonment.” The

standard by its terms refers to the public conven-

lence and necessity; it does not justify abandonment

simply to serve the financial interests of royalty own-

ers or producers.”

4. If, as we contend, the Commission may not

under the Natural Gas Act permit producers to pass

through royalty costs based on unregulated market

prices, or alternatively to abandon a portion of their

gas, we recognize the possibility—which concerned the

court below (App. A, infra, p. 8a)—that producers

might be caught between state court decisions that

“market value” leases refer to the unregulated market

and the Commission’s refusal to pass through such

market value royalty costs or permit abandonment

of dedicated gas.*’ While we believe that in any event

'? Moreover, the Commission concluded that there was no

basis for permitting abandonment of a portion of the gas

through payment in kind to avoid abandonment of all of it

in the event the lessors terminated the leases since under the

Commissions decisions, a lessor may not terminate certified

interstate service commenced by his lessee without abandon-

ment authority from the Commission under Section 7(b). The

validity of those decisions is now pending before this Court in

Federul Power Commission Vv. Southland Royalty Co., No. 76-

1587, certiorari granted, June 27, 1977, and this aspect of the

instant case should at least await resolution of that case.

‘' As yet there has been no state court ruling in this case

on the meaning of the royalty clauses in the leases involved;

the parties by their settlement pretermitted that question

pending the outcome of this proceeding. As the Commission

recognized, however (App. D, infra, p. 22a), “the impetus of

the settlement” was the unregulated market price of gas.

17

the Commission’s position is mandated by the Act and

the Act’s purpose to protect interstate consumers of

gas, it should be noted that there are possible ave-

nues of relief for producers faced with demands

from lessors that their royalty costs be based on the

unregulated price of natural gas.

One type of relief could be this Court’s limited

reshaping of the holding by the court of appeals in

Mobil Oil Corp. v. Federal Power Commission, 463

F. 2d 256 (C.A. D.C.), certiorari denied, 406 U.S.

976, that landowner/lessors are not natural gas

companies under the Act and that accordingly neither

they nor their royalty agreements are subject to

Commission jurisdiction. Such a reshaping would

not necessarily require a determination that land-

owner/lessors are fully jurisdictional in the sense.

for example, of being required to make filings with

the Commission. Rather, it would be sufficient for

this Court to determine that despite the nonjurisdic-

tional status of landowner /lessors, royalty payments

are nevertheless subject to regulation in the sense

that producer /lessees need not pay royalties which

exceed the amounts permitted by the Commission to

be passed on to jurisdictional pipelines.

Such a determination, we submit, would be con-

sistent with this Court’s recognition that when Con-

gress passed the Natural Gas Act, it “did not desire

* * * that an important aspect of this field be left un-

regulated,” but intended instead to establish a compre-

hensive regulatory scheme. Federal Power Commis-

sion v. Transcontinental Gas Pipe Line Corp., 365

18

U.S. 1, 19. The Act “was so framed as to afford

consumers a complete, permanent and effective bond

of protection from excessive rates and charges.” At-

lantic Refining Co. v. Public Service Commission of

New York, 360 U.S. 378, 388. See also Phillips Pe-

troleum Co. v. Wisconsin, 347 U.S. 672, where this

Court, reversing the Commission, held that the Com-

mission had jurisdiction not only over pipelines and

their rates but also over the rates at which producers

sell natural gas to pipelines for resale in interstate

commerce, on the ground that those rates “may have

a direct and substantial effect on the price paid by

the ultimate consumers.” 347 U.S. at 685.

An alternative, though related, type of relief for

producers would be a determination by this Court

that lower courts err when they Anterpret “market

value” leases that underlie interstate sales as requir-

ing royalty paymenis based on the intrastate market

price of the gas. One such state court determination

was the basis of a petition for a writ of certicrari

to the Kansas Supreme Court, Mobil Oil Corp. v.

Harry Lightcap, et al., No. 76-1694. Although this

Court denied certiorari in that ease on October 3.

1977, we are advised that the petitioner on October

28, 1977, filed a petition for rehearing of the decision

denying certiorari. As noted (note 6, supra), the Com-

mission intends to file a memorandum in support of

that petition for rehearing. In view of the relation-

ship between that issue and the other issues discussed

in this petition, we believe that the construction of a

“market value” lease provision is not solely a ques-

tion of state law, but is a question of federal law

19

under the Natural Gas Act. Our belief rests on the

principle that “[t]he federal regulatory scheme

leaves no room either for direct state regulation of

the prices of interstate wholesales of natural a? **

or for state regulations which would indirectly achieve

the same result.” Northern Natural Gas Co. v. State

Corporation Commission of Kansas, 372 U.S. 84, 91;

footnote omitted. A decision by this Court that mar-

ket value leases underlying interstate sales must be

interpreted in light of the regulated rate of those sales

would obviate any bind on producer/lessees between

royalties based on intrastate prices and the impermis-

sibility of the Commission’s allowing the flow-through

of sucl. market value royalty costs.

5. It is axiomatic that the Natural Gas Act, like

other federal regulatory legislation, should be in-

terpreted in furtherance of the Act’s general pur-

pose to protect consumers by effective regulation of

natural gas wholesale rates. Cf. Securities and Ex-

change Commission v. Ralston Purina Co., 346 U.S.

119; United States v. Southwestern Cable Co., 392

U.S. 157; United States v. Bacto-Unidisk, 394 U.S.

784. The Commission, accordingly, concluded that it

is not permitted to pass through market value royalty

payments that are based on the unregulated price of

natural gas or to permit abandonment of gas dedi-

cated for interstate service solely to accommodate

the financial interests of private parties. The con-

trary holding of the court of appeals would signifi-

cantly impair the Commission’s ability to implement

one of the Act’s basic objectives, and therefore war-

rants review by this Court.

20

CONCLUSION

For the foregoing reasons, the petition for a writ |

of certiorari should be granted. |

Respectfully submitted.

WADE H. McCREE, JR.,

Solicitor General.

RICHARD A. ALLEN,

Assistant to the Solicitor General.

ROBERT R. NORDHAUS,

General Counsel,

PHILIP R. TELLEEN,

Attorney,

Federal Energy Regulatory Commission.

NOVEMBER 1977.

la

APPENDIX A

UNITED STATES COURT OF APPEALS

FIFTH CIRCUIT

Nos. 76-1626, 76-1831 and 76-2128

PENNZOIL PRODUCING COMPANY, SHELL OIL COMPANY,

UNITED GAS PIPE LINE COMPANY, PETITIONERS

Vv.

FEDERAL POWER COMMISSION, RESPONDENT

June 6, 1977

Petitions for Review of an Order of Federal Power

Commission (Texas Cases).

Before CLARK, RONEY and TJOFLAT, Circuit

Judges.

RONEY, Circuit Judge:

Caught in the squeeze between the regulated price

of its gas, which price included royalty costs at the

interstate price, and the claims of landowners for

increased royalty payments based on higher intra-

state rates, the gas producers petitioned the Federal

Power Commission for relief. Two alternatives were

given the Commission: first, let the producers’ inter-

State price be increased by the amount of increased

royalty the producers will have to pay as determined

by state litigation or settlement of pending lawsuits;

or, second, let the producers “abandon” the royalty

2a

portion of gas produced so that gas can be delivered

to the royalty owner in kind, unburdened by the re-

strictive interstate price.

As to the first alternative, the Federal Power Com-

mission failed to realize it had the authority to grant

relief. As to the second, the Federal Power Commis-

sion misunderstood the law as it has now been defined

in Southland Royaliy Co. v. FPC, 543 F.2d 1134 (5

Cir. 1976). We reverse and remand for further

consideration.

Due to the gross disparity between the higher un-

regulated prices of intrastate gas sales and the lower

regulated prices of interstate sales,’ lessors, whose

royalty payments are determined by the “market

value” or the “market price” of the gas, have brought

numerous suits against the interstate producers-

lessees claiming royalty payments based on rates

higher than those prescribed by the Federal Power

Commission.* Many of these long-term leases were

entered into long before this disparity in prices arose,

and some even before the Commission began regulat-

ing rates for interstate gas sales.’ Thus, neither lessor

‘See Southland Royalty Co. v. FPC, 543 F.2d 1134 (5th

Cir. 1976).

* See, e.g., Phillips Petroleum Co. v. Bynum, 155 F.2d 196

(5th Cir.), cert. denied, 329 U.S. 714, 67 S.Ct. 44, 91 L.Ed.

620 (1946) ; Foster v. Atlantic Refining Co., 329 F.2d 485 (5th

Cir. 1964); Texas Oi! & Gas Corp. Vv. Vela, 429 S.W.2d 866

(Tex. 1968).

* Pennzoil Producing Company and Shell Oil Company sell

in interstate commerce natura! gas produced from Louisiana

acreage leased from Williams, Inc. Pennzoil operates under a

8a

nor lessee anticipated the problem that would arise

over the nondefined terme in the leases: “market

value” and “market price.”

In a lawsuit filed on May 24, 1974, and currently

pending in Louisiana state court,‘ a lessor asserted a

royalty claim based on intrastate prices for natural

gas, which greatly exceed the ceiling rates established

by the FPC for interstate sales. After Williams, Inc.

demanded by letter payment of royalties based on

intrastate rates, Shell and Pennzoil brought the law-

suit seeking a judgment declaring that their reyalty

obligations were properly discharged by payments

based on Commission-established rates. Williams

counterclaimed for undePpayment of royalty obliga-

tions in the amount of $3,731,783.79. On June 18,

1975, Shell, Pennzoil and Williams entered into a set-

tlement agreement providing two major alternatives

—one involving monetary payments, and the other

involving payments of gas in kind—either being de-

pendent on FPC authorization.

The first alternative provided that the payment

of royalties would be based on the higher of the fol-

lowing prices: (1) 7&¢ for Mef for 1975 with annual

1934 lease, while Shell operates under a 1°‘ and a 1952 lease.

The 1934 lease provides for royalty payments equal to one-

eighth of the value of the gas produced, calculated at the

“market rate” prevailing at the well. The 1952 lease contains

a similar provision, requiring royalty payments equal to one-

fourth of the value of the gas produced, calculated at the

“market price” prevailing at the well.

* Shell Oil Co. & Pennzoil Producing Co. v. Williams, I nc.,

et al., Docket No. 573-581, Civ.D.Ct., Orleans Parish, La.

4a

increases of 1.5¢ per Mcf; or (2) 150% of the high-

est area or national rate permitted by the FPC.

Pennzoil and Shell would then flow through these in-

cremental royalty costs to their customer, United Gas

Pipe Line Company. Although the FPC does not have

jurisdiction over the amount paid royalty owners,

Mobil Oil Corp. v. FPC, 149 U.S.App.D.C. 310, 463

F.2d 256 (1971), cert. denied, 406 U.S. 976, 92 S.Ct.

2409, 32 L.Ed.2d 676 (1972), it does have authority

over interstate rates charged by the producers. Phil-

lips Petroleum Co. v. Wisconsin, 347 U.S. 672, 74

S.Ct. 794, 98 L.Ed. 1035 (1954) ; section 4 of N atural

Gas Act, 15 U.S.C.A. § 717c. Thus, special relief

from the ceiling rates established in FPC Opinion

Nos. 598 * and 699° is required for petitioners to pass

these costs on to United.

The second alternative provided that in lieu of the

increased monetary royalty payments, Shell and Penn-

zoil would deliver to Williams its royalty share of the

gas in kind for sale in any market, which presumably

would bring the higher intrastate prices. This sec-

ond proposal would require the FPC’s consent to the

° Southern Louisiana Area Rate Proceeding, 46 FPC &6

(1971), aff'd sub nom., Placid Oil Co. v. FPC, 483 F.2d 880

(5th Cir. 1973), aff'd sub nom., Mobil Oil Corp. Vv. FPC, 417

U.S. 283, 94 S.Ct. 2328, 41 L.Ed.2d 72 (1974).

* Just and Reasonable National Rates for Sales of Natural

Gas From Wells Commenced on — January 1, 1973, and

New Dedications to Interstate Co merce on or after Janu-

ary 1, 1973, 51 FPC 2212, aff’d sub nom., Shell Oil Co. v. FPC,

520 F.2d 1061 (5th Cir. 1975), cert. denied, 426 U.S. 941, 96

S.Ct. 2661, 49 L.Ed.2d 394 (1976).

5a

abandonment of that portion of gas attributable to

Williams’ royalty interests, as required by section

7(b) of the Natural Gas Act, 15 U.S.C.A. § 717¢.

Sunray Mid-Continent Oil Co. v. FPC, 364 U.S. 137,

153, 80 S.Ct. 1392, 4 L.Ed.2d 1623 (1960).

In FPC Opinion Nos. 753‘ and 753-A,* the Commis-

sion denied either form of relief. First, the Commis-

sion denied it had authority to allow producers of nat-

ural gas to increase their rates above the FPC ceiling

set for gas sold in interstate commerce to reflect the

increased cost of “market value” or “market price”

royalty obligations under existing leases. Second, the

Commission held that “present or future public con-

venience or necessity” did not permit the abandon-

ment of the royalty portion of the gas, which had

been dedicated to interstate commerce by the lessees.

Section 7(b) of Natural Gas Act, 15 U.S.C.A. § 717f

(b). The petitions for review attack both of these

decisions.

Opinion 753 defined the “real issue” in this case to

be whether the FPC “can legally grant any form of

rate relief above either an area or nationwide just

and reasonable rate solely because the producer selling

the gas in interstate commerce may be obligated to

make a royalty payment based not upon the regu-

lated price the producer receives for the gas, but

rather on the ‘market value’ of the gas.” Relying on

* Opinion and Order Denying Special Relief and Abandon-

ment, FPC Docket Nos. RI 76-8, -10 (January 30, 1976).

‘Opinion and Order Denying Rehearing, FPC Docket Nos.

RI 76-8, -10 (February 27, 1976).

—_—

6a

FPC v. Texaco, Inc., 417 U.S. 380, 94 S.Ct. 2315, 41

L.Ed.2d 141 (1974), the Commission concluded that it

was “not free to allow royalty costs, which are based

on market values, to be passed on to the pipelines as

just and reasonable rates.”

Texaco, however, is inapplicable to the instant case.

Texaco dealt with the question of the effect of intra-

state prices of gas on interstate rate regulation. The

Supreme Court held that the final measure of “just

and reasonable” rates, mandated by sections 4 and 5

of the Act, could not be the prevailing price in the

unregulated marketplace. Prompting this holding was

the historical justification for general regulation of

interstate prices, to prevent excessive profiteering by

members of the heavily concentrated and monopolistic

natural gas industry through distorted market prices.

417 U.S. at 397-398, 94 S.Ct. 2315. Thus, the Su-

preme Court held that other factors must be taken

into consideration. 417 U.S. at 399, 94 S.Ct. 2315.

This case deals with royalty cost under specific leases.

The Federal Power Commission has taken a cost

plus profit approac) to gas rate regulation. A cost-

based methodology was approved by the Supreme

Court in Permian Basin Area Rate Cases, 390 U.S.

747, 88 S.Ct. 1344, 20 L.Ed.2d 312 (1968). One of the

components of a producer’s costs is clearly its royalty

expense, representing the amount a producer must pay

to the landowner for the privilege of extracting gas

from the reserves underlying his land. Shell Oil Co.

v. FPC, 520 F.2d 1061, 1068 (5th Cir. 1975), cert.

denied, 426 U.S. 941, 96 S.Ct. 2661, 49 L.Ed.2d 394

Ta

(1976). This cost petitioners seek to pass through to

their customer, United, through a rate increase. They

do not seek to increase their profits but merely to

maintain those margins already determined by the

Commission to be just and reasonable in its earlier

rate proceedings. Because the Commission does not

have jurisdiction over the amount of royalties charged

by the lessor under a natural gas lease, Moti! Oil

Corp. v. FPC, 149 U.S.App.D.C. 310, 463 F.2d 256,

263, cert. denied, 406 U.S. 976, 92 S.Ct. 2409, 32

L.Ed.2d 676 (1972), the only way in which petition-

ers-lessees can protect themselves from loss of profits

in the event of an adverse state court decision is to

ask for an increase in the allowable rates to be

charged their customers.

This is not to say that every additional cost must

be passed through to the customer to protect a pro-

ducer’s level of profits. The Commission has author-

ity to consider the reasonableness of any costs in-

curred. Mobil Oil Corp. v. FPC, supra, at 263. Deter-

mination of the reasonableness of a cost necessarily

requires consideration of market price. In all proba-

bility, the reasonableness of a great many costs of gas

production must be determined by the prevailing mar-

ket price in an uncontrolled market. The Commission

has failed to suggest why royalty costs in an un-

controlled market are any different from any other

cost. Permian and Shell Oil should have been looked

to for guidance by the Commission, rather than

Texaco.

8a

Petitioners followed the proper procedures in peti-

tioning the Commission for special relief and were

entitled to a determination of the merits of their

requests. In Mobil Oil Corp. v. FPC, 417 U.S. 283,

94 S.Ct. 2328, 41 L.Ed.2d 72 (1974), aff'd Placid Oil

Co. v. FPC, 483 F.2d 880 (5th Cir. 1973), decided the

same day as Texaco, the Supreme Court, in response

to Mobil’s complaint that the FPC failed to provide

automatic adjustments in area rates to compensate for

anticipated higher royalty costs, reiterated the Court

of Appeals’ finding that “ ‘[i]f, as subsequent events

develop, the producers are put in a bind by their

royalty obligations, they may certainly petition FPC

for individualized relief.’” 417 U.S. at 328, 94 S.Ct.

at 2355. Pennzoil and Shell have been put in such a

bind. If they lose the state court litigation, they are

faced either with termination of their leases, which

could divert the entire amount of gas from interstate

commerce, or with increased royalty payments, which

would absorb funds otherwise available for explora-

tion and development.

In denying abandonment of the royalty portion of

the gas, which is allowed under section 7(b) of the

Natural Gas Act only when “the available supply of

natural gas is depleted to the extent that the continu-

ance of service is unwarranted,” or when “the present

or future public convenience or necessity permit such

abandonment”, the Commission relied on its decision

in El Paso Natural Gas Co., et al., FPC Opinion

No. 737 (July 11, 1975), appeal then pending sub

nom., Southland Royalty Co. v. FPC, 5 Cir., 543 F.2d

ee

9a

1134 (1976). The Federal Power Commission held

in El Paso that once a fixed-term lessee dedicates gas

to interstate commerce, the lessor cannot withdraw

that gas from interstate commerce absent Commission

approval, upon termination of the lease. Thus the

Commission was under the impression that Williams’

gas was trapped in the interstate market, whether or

not the leases were terminated.

This Court reversed the Commission’s decision in

Southland Royalty Co. v. FPC, supra, and held that a

lessee could not dedicate to interstate commerce the

gas remaining at the expiration of his fixed-term

lease. Thus the Commission was acting under the

wrong legal premise. It is appropriate to remand this

issue to the Commission for reconsideration in light

of Southland Royalty. It may well be that the “pres-

ent or future public convenience or necessity” will

suggest the propriety of abandoning a fraction of the

gas in Williams’ property, rather than lose the entire

amount from the interstate market. This decision is

for the Commission.

REVERSED AND REMANDED.

10a

APPENDIX B

UNITED STATES COURT OF APPEALS

FIFTH CIRCUIT

OCTOBER TERM, 1976

76-1626

Nos. 76-1831

76-2128

FPC Nos. RI76-8 and RI76-10

PENNZOIL PRODUCING COMPANY, ET AL., PETITIONERS

versus

r

FEDERAL POWER COMMISSION, RESPONDENT

Petitions for Review of an Order of the

Federal Power Commission (Texas Cases)

Before CLARK, RONEY and TJOFLAT, Circuit

Judges.

lla

JUDGMENT

This cause came on to be heard on the petitions of

Pennzoil Producing Company, Shell Oil Company and

United Gas Pipe Line Company for review of an

order of the Federal Power Commission of the United

States, and was argued by counsel:

ON CONSIDERATION WHEREOF, It is now

here ordered and adjudged by this Court that the

order of the Federal Power Commission in this cause

be, and the same is hereby reversed: and that this

cause be, and the same is hereby remanded to the

Federal Power Commission in accordance with the

opinion of this Court.

June 6, 1977

12a

APPENDIX C

UNITED STATES COURT OF APPEALS

FIFTH CIRCUIT

Nos. 76-1626, 76-1831, 76-2128

PENNZOIL PRODUCING COMPANY, ET AL., PETITIONERS

Vv.

FEDERAL POWER COMMISSION, RESPONDENT

Sept. 1, 1977

Petitions for Review of an Order of Federal Power

Commission (Texas Cases).

ON PETITION FOR REHEARING

(Opinion June 6, 1977, 5 Cir., 1977, 553 F.2d 485)

Before CLARK, RONEY and TJOFLAT, Circuit

Judges.

PER CURIAM:

In its petition for rehearing, the Federal Power

Commission asserts that language in the opinion may

erroneously indicate the prejudgment of an issue not

before the Court, i.e., the effect of our decision in

Southland Royalty Co. v. FPC, 543 F.2d 1134 (5th

Cir. 1976) on a state court termination of a lease,

particularly one not limited by a fixed-term.

13a

In order to pull from the opinion any indication as

to how Southland might apply to the facts of this

case, we delete from our opinion the last two sen-

tences found at the end of the final paragraph, which

read as follows:

It may well be that the “present or future public

convenience or necessity” will suggest the pro-

priety of abandoning a fraction of the gas in

Williams’ property, rather than lose the entire

amount from the interstate market. This decision

is for the Commission.

We agree with the Commission that the statement was

premature, if constructed to be decisional, and unnec-

essary with respect to our decision.

IT IS ORDERED that the petition for rehearing

filed in the sbove entitled and numbered cause be and

the same is hereby DENIED.

l4a

APPENDIX D

UNITED STATES OF AMERICA

FEDERAL POWER COMMISSION

Before Commissioners: Richard L. Dunham, Chair-

man; Don 8S. Smith, John H.

Holloman III, and James G.

Watt.

Docket No. RI76-8

Docket No. RI76-10

PENNZOIL PRODUCING COMPANY

SHELL OIL COMPANY

OPINION NO. 753

OPINION AND ORDER

DENYING SPECIAL RELIEF

AND ABANDONMENT

(Issued January 30, 1976)

Pennzoil Producing Company (Pennzoil) on July 1,

1975, and Shell Oil Company (Shell) on July 18,

1975, filed applications seeking special relief from the

just and reasonable rates * established under Opinion

* Sections 4(a) and 5(a) of the Natural Gas Act, require

that all rates received by a “natural gas company” be “just and

reasonable”. 52 Stat. 822, 823 (1938); 15 U.S.C. §§ 717c(a),

717d(a) (1970).

See, e.g., FPC v. Texaco Inc., 417 U.S. 380 (1974).

l5a

Nos. 598 * and 699° in order to flow through to their

customer, United Gas Pipe Line Company (United),

higher royalty rates called for in a settlement agree-

ment dated June 18, 1975, with their lessors, Wil-

liams, Ine. and others (Williams).

The gas involved is produced in the Gibson Field,

Terrebonne Parish, Louisiana, from leases with Wil-

liams dated August 29, 1934, and July 24, 1952. The

1934 lease provides for payment of a royalty equal to

one eighth (1x) of the value of the gas produced cal-

culated at the “market rate” prevailing at the well.

The 1952 lease provided for a royalty of one-fourth

of the value of the gas calculated at the “market

price” prevailing at the well. By letters dated June A

1973, and March 27, 1974, Williams demanded pay-

ment by Shell and Pennzoil of royalties based on mar-

ket values ranging from 35 cents to 70 cents per Mcf

for the period October 1, 1971, through December 31,

1973, and 70 cents per Mef thereafter. By letter of

June 5, 1974, Williams purported to terminate the

leases (Exhibit No. 3).

* Area Rate Proceeding et al. (Southern Louisiana Area),

46 FPC 86 (1971), aff'd sub nom. Placid Oil Co. v. FPC, 483

F.2d 880 (5th Cir. 1973); aff’d sub nom. Mobil Oil Corp. V.

FPC 417 U.S. 283 (1974).

* Just And Reasonable National Rates For Sales Of Natural

Gas From Wells Commenced On Or After January 1, 1978,

And New Dedications To Interstate Commerce On Or After

January 1, 1973, Docket No. R-389-B, Opinion No. 699, 51

F.P.C. 2212 (June 21, 1974), reh. denied, Opinion No. 699-H,

52 F.P.C. —— (December 4, 1974, aff'd sub nom. Shell Oil Co.

v. FPC, 520 F.2d 1061 (5th Cir. 1975).

l6a

On May 24, 1974, Sheil and Pennzoil filed a petition

in the Civil District Court in the Parish of Orleans,

Louisiana * praying for a Judgment declaring that the

petitioner’s interpretation of “market rate” and “‘miar-

ket price” was correct, that they have properly dis-

charged their royalty obligations on the basis of

Commission established rates and that the leases are

still in effect (Exhibit No. 4). They also asked for a

temporary restraining order, which was granted.

Williams filed an answer and reconventional demand

(counterclaim), with an amendment alleging market

prices for the gas for the period October 1, 1971, to

April 30, 1975, ranging from $.35 to $1.40 per Mcf

and underpayments of $3,731,683.79 (Exhibit Nos.

5, 6).

In the settlement of June 18, 1975, Pennzoil and

Shell would apply to the Commission for authority

to pay a royalty based on a price of 78 cents per Mcf

for 1975 and 1.5 cents per Mcf more each year or

150 percent of the highest area or national rate per-

mitted, plus Louisiana severance tax, Federal taxes

and Btu adjustment. Alternatively, Pennzoil and

Shell would ask for authority to deliver to Williams

one-eighth or one-fourth, as the case may be, of the

gas attributable to their respective interests, and to

abandon their sales of this gas to United.

If the Commission approves the price alternative,

Pennzoil and Shell would pay a royalty for 1974 equal

* Shell Oil Company and Pennzoil Producing Company V.

Williams Inc., et al, Civ.D.Ct. Orleans Parish, La., Docket

No. 573-581.

17a

to what would have been paid based on a price of

45 cents per Mcf, but only to the extent the Commis-

sion permits them to recover such amounts from

United. If the Commission approves the alternative

delivery of the gas to Williams, Pennzoil and Shell

would pay an additional royalty until the date of a

final order.

After the Commission’s order becomes final and

non-appealable the parties would dismiss their Louisi-

ana civil suit. Pennzoil and Shell are to use their

best efforts to obtain the approval of the Commission.

If the Commission refuses to do so on or before Febru-

ary 1, 1976, either Williams or Shell and Pennzoil,

acting together, may terminate the agreement. In

separate agreements United agreed to make the addi-

tional payments or to release the royalty gas (Ex-

hibit Nos. 7, 8).

In its order of August 29, 1975, the Commission

denied the petitions of Pennzoil and Shell for special

relief and prescribed a hearing on the issue relating

to the abandonment of the royalty gas. On Septem-

ber 22, 1975, the Commission granted rehearing and

provided that the hearing cover the issue of special

relief. The hearing was held before Presiding Admin-

istrative Law Judge Samuel Z. Gordon on Septem-

ber 23, 1975, at which Shell, Pennzoil and United pre-

sented evidence. Shell was afforded additional time to

present certain factual data as to prices, volumes and

cost and did so on September 29, 1975. The costs it

presented were derived from national costs with a

figure for operating expenses from the 1934 and 1952

18a

leases substituted for the national figure. Shell was

given opportunity to file additional cost data but ad-

vised that it did not intend to do so (Exhibit No. 10),

although it filed answers to written interrogatories

submitted by the Commission staff.

In his initial decision issued November 24, 1975,

the Judge denied special relief on the ground that

the producer must establish that his overall costs in-

curred in the operation of the particular well or group

of wells are higher than area or nationwide rates, or

that his out-of-pocket expenses will exceed revenues.

Pennzoil, he said, had made no such showing and

Shell had attempted to use the nationwide costs with

a 4.5 cents figure for operating costs and a royalty

figure based on $1.40 per Mcf market value.

The Judge also determined that Pennzoil and Shell

have not established that abandonment of the royalty

interest is permitted by the public convenience and

necessity. Williams has agreed to accept higher roy-

alty payments computed on the basis of 78 cents per

Mef, he pointed out, and Shell has shown that it

could absorb higher royalty costs while Pennzoil has

not made a showing that it could not. Furthermore,

the abandonment should be denied because William’s

claim is unadjudicated. He would also deny the re-

quested surcharge for past royalties.

Exceptions were filed by Pennzoil, Shell, United,

stobil Oil Corporation (adopting those of Pennzoil

and Shell) and the State of Louisiana, and a brief

opposing exceptions was filed by Staff.

19a

Since the filing of the exceptions Pennzoil on Janu-

ary 20, 1976, filed a motion for leave to lodge a docu-

ment with the Commission and to comment on the

Commission’s Opinion No. 749 ° prescribing rates for

flowing gas. The document is a letter dated Janu-

ary 5, 1976, from counsel for Williams requesting

answers to interrogatories in the Louisiana litigation

and stating that Williams intended to reactivate the

state proceedings as soon as possible under the settle-

ment agreement. In its comments on Opinion No. 749

Pennzoil says that, as to the old gas, the royalty

increment under the settlement would be added to

the Opinion No. 749 rate,’ rather than to the South-

ern Louisiana Area rate. Pennzoil argues that the

Opinion No. 749 rate should apply even though it is

granted special relief here* because this is not a

typical relief case since all increased sums will be

passed directly to the lessors. Since we are denying

the requested relief as discussed below, it is not neces-

sary to determine this issue.

Pennzoil objects to the Judge requiring project cost

evidence, saying that the cost inquiry should be limited

to the costs and revenues associated with the price

° Just And Reasonable National Rates For Sales Of Natural

Gas From Wells Commenced Prior To January 1, 1978,

FPC , Opinion No. 749, Docket No. R-478, —— F.P.C.

—— (December 31, 1975).

° The Opinion No. 749 rate is 23.5 cents per Mef 23.5 cents

per Mcf prior to July 1, 1976, and 29.5 cents per Mcf there-

after, subject to adjustments.

* See Opinion No. 749, at 48-49.

a 2

.

20a

increase. It argues that the risks of the Williams

litigation render the current price inappropriate and

lease termination is a serious possibility. If Williams

wins in the litigation, Pennzoil says, it might be able

to sell the gas in intrastate commerce, or it might sell

all of the gas under a new contract at 130 percent of

the national rate under Section 2.56a(a) (2) (iii) of

the Regulations * and Opinion No. 742°, and for all

of the gas this would be 27 cents per Mcf more than

Pennzoil is currently collecting. It further contends

that market value royalties involve considerations dif-

ferent from those involved in the determination of

other items of cost since royalties are flowed-through

to the lessor. Finally, it notes that substantial risks

are avoided by an increase in average price from

40.91 cents per Mcf to 44.55 cents per Mcf or 3.64

cents, none of which inures to Pennzoil’s benefit.

Shell makes similar arguments about the lack of

necessity for showing overall costs, saying that proof

of overall costs is not required in a special relief case.

Likewise Shell argues that failure to approve the set-

tlement risks interstate gas supply and threatens

higher prices, and asks the Commission to consider

the end result. United urges that the settlement be

approved in the public interest as concerned with the

certainty of gas supply and reasonable prices. Louisi-

ana argues that the Judge failed to apply proper

°18 C.F.R. § 2.56a(a) (2) (iii).

*Small Producer Regulation, Docket No. R-393, Opinion

No. 742, FPC ——.

2la

standards in denying rate relief contending that

changed circumstances have made no longer appro-

priate the royalty cost assumptions that went into

the applicable rate structures, and Louisiana supports

the settlement as a reasonable and appropriate resolu-

tion of the issues. On the other hand the staff argues

against reliance on non-cost factors and Shell’s use of

national cost figures, which it points out are only

averages.

PRICE RELIEF

The real issue in this proceeding is whether the

Federal Power Commission can legally grant any

form of rate relief above either an area or nation-

wide just and reasonable rate solely because the pro-

ducer selling the gas in interstate commerce may be

obligated to make a royalty payment based not upon

the regulated price the producer receives for the gas,

but rather on the “market value” of the gas. More-

over, as in this proceeding, the question becomes some-

what speculative because of litigation between pro-

ducer lessees and lessors over the extent of such roy-

alty obligations.

While sympathetic to the plight of the producers

who face or may face litigation on the value of roy-

alties, we today must find that such producers are

not entitled to rate relief. While we admittedly do

not have jurisdiction over royalty owners as such ”

and, therefore, over royalty payments by producers to

*°See Mobil Oil Corporation v. FPC, 463 F.2d 256 (D.C.

Cir. 1972).

22a

lease owners, we do have jurisdiction over the rates

charged by producers to the pipelines for sales of gas

for resale in interstate commerce and those rates

must be “just and reasonable”." Hence, if a producer

desires to compute royalty payments based on a rate

in excess of our applicable just and reasonable rate,

he may unilaterally do so. However, if a producer

attempts to flow this cost through to the pipeline and

ultimately to the consumer, we must determine if

this incremental royalty cost is just and reasonable.

Yet, in making this finding, it would be inconsistent

and contrary to the Commission’s mandate to estab-

lish a just and reasonable rate and at the same time

allow a producer selling at that just and reasonable

rate to increase this rate for additional royalty pay-

ments which are based on other factors than the

regulated rate.

In the instant proceeding, the impetus of the settle-

ment is the market value of the rovalties and no con-

sideration has been given to regulated rates. As such,

we cannot permit any incremental royalty costs re-

sulting from this settlement, or resulting from any

judgment by a state court regarding royalty pay-

ments, to be passed on to the pipeline if these incre-

mental royalty costs are based on any other factors

than the regulated just and reasonable rate. On this

point, we note the Supreme Court’s warning in FPC

v. Texaco, supra, that the Commission is not free to

“See Mobil Oil Corporation v. FPC, et al., 417 U.S. 283

(1974); FPC v. Texaco, Inc., 417 U.S. 380 (1974).

23a

equate just and reasonable rates with the prices for

gas in the marketplace. Accordingly, we believe that

we are not free to allow royalty costs, which are based

on market values, to be passed on to the pipelines as

just and reasonable rates. A contrary result would

not “. . . afford consumers a complete, permanent, and

effective bond of protection from excessive rates and

charges.” *

ABANDONMENT

Pennzoil argues that abandonment of the royalty

portion of the gas should be allowed under Section

7(b) of the Natural Gas Act ™ as in the public con-

venience and necessity if price relief is not granted.

Pennzoil says the choice here is between losing one-

eighth of the gas and risking the loss of all of the

gas. While United prefers the requests for increased

rates, it says the Commission should approve the

* See Atlantic Refining Company V. Public Service Commis-

sion of the State of New York, 360 U.S. 378, 388 (1959).

8 Section 7(b) provides:

No natural-gas company shall abandon all or any por-

tion of its facilities subject to the jurisdiction of the

Commission, or any service rendered by means of such

facilities, without the permission and approval of the

Commission first had and obtained, after due hearing,

and a finding by the Commission that the available sup-

ply of naturai gas is depleted to the extent that the con-

tinuance of service is unwarranted, or that the present

or future public convenience or necessity permit such

abandonment.

52 Stat. 824 (1938); 15 U.S.C. § 717f(b) (1970).

24a

requests to abandon the royalty portion of the gas if

price relief is denied.

We find no reason to grant abandonment on the

basis of this record. There is no showing “that the

available supply of natural gas is depleted to the

extent that the continuation of service is unwarranted,

or that the present or future public convenience or

necessity” requires that abandonment be authorized.

The supply of natural gas involved in this case is

not depleted so abandonment may not be approved

for that reason. Moreover, the public convenience and

necessity, present or future, is not served by granting

an abandonment authorization that would likely re-

sult in the subject gas being diverted from the inter-

state market to the intrastate market.

Since “there can be no withdrawal of that supply

[of natural gas] from continued interstate move-

ment without Commission approval” ™ once the gas

is dedicated, we do not share the concern of Pennzoil

and United that Williams could terminate deliveries

to United even if the leases were cancelled as a result

of state court litigation. If the lease were cancelled

and Williams were to undertake to sell the subject

gas, Williams would simply assume the obligations of

Pennzoil and Shell to continue service to United. El

Paso Natural Gas Company, Texaco Inc., Docket Nos.

CP75-209, CI75-594, Opinion No. 737, —— F.P.C.

—— (July 11, 1975), rehearing denied, Opinion No.

737-A, F.P.C. (September 3, 1975), re-

** Atlantic Refining Co. v. Public Service Commission of

New York, 360 U.S. 878, 389 (1959).

25a

hearing granted on limited issue, Opinion No. 737-B,

— F.P.C. (December 18, 1975), appeal pend-

ing sub nom. Southland Royalty Co. v. F.P.C., No. 75-

2851 (5th Cir.). In such a case, Williams would not

be entitled to the status afforded a royalty owner by

Mobil Oil Corp. v. F.P.C., 463 F.2d 256 (D.C. Cir.

1971), but would be a natural gas company making

sales for resale of natural gas in interstate commerce

subject to the Commission’s jurisdiction. Phillips

Petroleum Company vy. Wisconsin, 347 U.S. 672

(1954). We, therefore, deny the alternative requests

for abandonment.

SURCHARGE

Pennzoil argues that the surcharge contained in

the settlement to pay Williams for alleged past under-

payment of royalties was not settled in the Commis-

sion’s orders, is not a retroactive rate increase, repre-

sents less than the full claim and should be allowed.

For the reasons set forth above in denying the re-

quested price relief, we also deny the requested sur-

charge.

The Commission further finds:

The initial decision issued November 24, 1975, in

these proceedings denying the applications of Pennzoil

and Shell for special relief or abandonment, and a

surcharge should be affirmed for the reasons set forth

above.

26a

The Commission orders:

(A) The initial decision issued November 24, 1975,

in these proceedings is affirmed for the reason set

forth above.

(B) The petitions otf Pennzoil and Shell requesting

special relief or abandonment and a surcharge are

denied.

(C) The motion to lodge a document and comment

filed on January 20, 1976, is granted.

(D) Exceptions not granted are denied.

By the Commission.

[SEAL]

KENNETH F. PLUMB,

Secretary.

27a

APPENDIX E

UNITED STATES OF AMERICA

FEDERAL POWER COMMISSION

Before Commissioners: Richard L. Dunham, Chair-

man; John H. Holloman III,

and James G. Watt.

Docket No. RI76-8

PENNZOIL PRODUCING COMPANY

Docket No. RI76-10

SHELL OIL COMPANY

OPINION NO. 753-A

OPINION AND ORDER DENYING REHEARING

(Issued February 27, 1976)

Pennzoil Producing Company and Shell Oil Com-

pany on February 13, 1976, and United Gas Pipe

Line Company (United) on February 26, 1976, have

filed applications for rehearing of the Commission’s

Opinion No. 753 and order issued January 30, 1976.

The Opinion and order relate to gas produced by

Pennzoil and Shell in the Gibson Field, Terrebonne

Parish, Louisiana and sold to their customer, United

Gas Pipe Line Company. The lessors in the Field,

Williams, Inc. end others (Williams), had demanded

higher royalties based on the market price for the gas;

28a

a civil suit in Louisiana had commenced on the ap-

plicability of the market price; and on June 18, 1975,

Pennzoil, Shell and Williams had entered into a set-

tlement agreement under which Pennzoil and Shell

would apply to the Commission for authority, among

other things, to pay a royalty based on a price of 78

cents per Mcf, or alternatively abandon the royalty

gas to Williams. Pennzoil and Shell also agreed to

pay Williams a surcharge for alleged past underpay-

ment of royalties and proposed to flow through the

increased royalties and the surcharge to United.

In its Opinion No. 753 and order the Commission,

in adopting the initial decision of the Administrative

Law Judge, denied the special relief, the surcharge

and the abandonment. Pennzoil and Shell contend

that the Commission is in error and, Pennzoil states

that, while the settlement agreement was subject to

cancellation by February 1, 1976, Williams has agreed

that the settlement will not be cancelled before

March 1, 1976.

In the first place Pennzoil contends that the Com-

mission has authority to allow increased rates to re-

flect royalty payments based on prices in excess of

ceiling rates. The Commission said that it was not

free to allow royalty costs, which are based on market

values, to be passed on to the pipeline as just and

reasonable rates. Pennzoil cites Placid Oil Co. v.

F.P.C., 483 F.2d 880 (CA5, 1973), where the Court

said that if producers are put in a bind by their

royalty obligations they may petition the F.P.C. for

individualized relief, and Mobil Oil Corp. v. F.P.C..,

29a

417 U.S. 283 (1974), affirming Placid and saying that

a producer affected by higher royalty obligations is

entitled to seek individualized relief. While indicating

that relief on some grounds may be possible, this case

does not state under what conditions relief should be

granted, nor does it define when the right to gain

relief matures.

In F.P.C. v. Texaco Ine., 417 U.S. 380 (1974), the

Commission was instructed to insure “that the rates

paid by pipelines, and ultimately borne by the con-

sumers, are just and reasonable” and that “the pre-

vailing price in the market place cannot be the final

measure of just and reasonable rates mandated by the

Act.” While Pennzoil argues here that the price in-

crease is based on a number of factors, including the

risks of the Williams litigation, the propriety of the

settlement, and the fact that it is not based on the

full market price, it is plain that the royalty is to be

based on 78 cents, which is the settlement’s reflection

of market prices, that are above the area ceiling

prices.

The area ceiling prices are intended to be just and

reasonable rates. The Commission was upheld in de-

termining just and reasonable rates for the Southern

Louisiana arez in Mobil, supra. The Commission de-

termined just and reasonable national rates in Opin-

ions Nos. 699 and 699-H and was affirmed on ap-

peal." In arriving at the national rates costs of pro-

' Just and Reasonable National Rates for Sales of Natural

Gas from Wells Commenced on or after January 1, 1973, Opin-

ion No. 699, 51 FPC 2212 (1974); Opinion No. 699-H, ——

30a

duction were used and royalties were computed at

16 percent of total costs. (51 FPC at pp. 2272-2273)

It is for these reasons that the Commission is not

free to allow royalty costs, which are based on market

values, to be passed on to the pipelines as just and

reasonable rates.

Pennzoil argues that it is an entirely different

question when we are dealing with an incremental

price that does not generate excessive profits, but

Texaco says that “a little unlawfulness” is not per-

mitted. In this connection American Petrofina Com-

pany of Texas (Operator), et al., FPC :

Docket Nos. RI75-17 and RI75-19, issued March 3,

1975, is not in point. In that case the company was

given relief because of the costs of additional neces-

sary compression. There was no question of the rea-

sonableness of compression costs or whether they were

determined on the basis of lower interstate prices or

higher intrastate prices. Nor are the El Paso Natural

Gas Company, FPC , Docket No. RP74-22,

et al., orders issued November 29, 1974, and Janu-

ary 29, 1975, in point. In that case the Commission

had originally prevented El Paso from collecting a

rate increase based on increased royalties which had

not yet been paid, but in the cited orders we allowed

such rate increases to go into effect subject to refund

saying that E] Paso had begun paying the increased

royalty charges but our review raised a number of

issues relating to the justness and reasonableness of

FPC , Docket No. R-389-B, issued December 4, 1974; aff’d

Sub. Nom. Shell Oil Co. v. F.P.C., 520 F.2d 1061 (CA 5, 1975).

On ee

TA At SR Al Manel aT ie ares bits Oe

Orem Usenet LE

3la

the proposed rates that required further considera-

tion by the Commission. Thus in El Paso the validity

of the increased charges based on royalties was not

determined.

Pennzoil further argues that the price increase is

just and reasonable, pointing out the risks of the

Williams litigation and contending that the gas may

be diverted from the interstate market. Pennzoil also

notes that no one has contended that the costs in-

volved were improvidently occurred. These considera-

tions are not controlling. The Commission does not

have the power to base a part of the regulated price

on the unregulated market value of intrastate gas.

Pennzoil also objects to the statement that the Com-

mission cannot permit incremental royalty costs re-

sulting from any judgment by a state court from being

passed on to a pipeline if the incremental costs are

based on any other factors than the regulated just and

reasonable rate. Pennzoil says that this is dicta and

it should be eliminated. Since there is no state court

judgment and it is indeed dicta, it will not be neces-

sary to discuss it further at this time. Pennzoil’s

arguments on the issues of abandonment and sur-

charge are sufficiently covered in the original opinion,

and need not be addressed again.

Shell has listed specifications of error that relate

lo the discussion of the Administrative Law Judge as

well as to our discussion in Opinion No. 753. These

matters have largely been covered. Shell contends,

inter alia, that we have not considered the end result

of our decision on the consumer, saying that the gas

32a

supply may be lost. The gas supply here that is dedi-

cated to interstate commerce cannot be diverted to

intrastate commerce. At the same time, if royalty

costs could be based on higher intrastate market

values, the impact on the consumer could extend far

beyond this case. It is not in the public interest that

national rates be distorted in the manner contemplated

by Shell, which would create a new species of inter-

state gas which would rise and fall with intrastate

market values.

Also Shell says that the Commission has foreclosed

any consideration of the market value royalty problem

in any forum and has therefore deprived Shell of its

property without due process of law. In this proceed-

ing a hearing was held; the Presiding Judge issued

an initial decision to which exceptions were taken:

and the Commission considered the issues on the basis

of the record. There is no dispute whatever about the

facts relating to the computation of the proposed

rates based upon market value royalties. Pennzoil,

Shell and United have expressed their views, and the

Commission determined that special relief should not

be granted on the basis of market value royalties.

United’s contentions are covered by Opinion No. 753

and this Opinion.

The Commission further finds:

The assignments of error and grounds for rehearing

of Opinion No. 753 and order in the applications for

rehearing filed by Pennzoil, Shell, and United present

no facts or legal principles that would warrant any

33a

change in or modification of the Commission’s Opin-

ion No. 753 and order as supplemented by the above

discussion.

The Commission orders:

The applications for rehearing filed by Pennzoil and

Shell on February 13, 1976, and United on Febru-

ary 26, 1976, are denied.

By the Commission.

[SEAL]

KENNETH F. PLuMp,

Secretary.

WG. 8. Government painting orice, 1977 249467 983