Petitioners Brief — Federal Energy Regulatory Commission v. Pennzoil Producing Co.

Supreme Court brief1979

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No. 77-618 La ICHAEL RODAK, JR., CLERK

Iu the Supreme Court of the United States

OCTOBER TERM, 1978

FEDERAL ENERGY REGULATORY COMMISSION,

PETITIONER

PENNZOIL PRODUCING COMPANY. ET AL.

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE FIFTH CIRCUIT

BRIEF FOR THE FEDERAL ENERGY

REGULATORY COMMISSION

WADE H. McCREE, Jr.,

Solicitor General,

STEPHEN R. BARNETT,

Deputy Solicitor General,

RICHARD A. ALLEN,

Assistant to the Solicitor General,

Department of Justice,

Washington, D.C. 20520.

ROBERT R. NORDHAUS,

General Counsel,

HOWARD E. SHAPIRO,

Solicitor,

MCNEILL WATKINS, II,

Attorne u;

Fy de ral Ene ry Re gulatory Com ni iSsion,

Washington, D.C. 20426.

INDEX

Page

Opinions below 1

Jurisdiction 2

Questions presented 2

Statutes involved | 3

Statement | 3

Summary of argument __ 12

Argument:

I. Under the Natural Gas Act the Com-

mission may not authorize producers to

pass through to interstate consumers

royalty costs based on the unregulated

intrastate price of natural gas 16

A. Basie principles of rate regulation

establish that the Commission has

no authority to permit producers

to pass through royalty costs based

on the unregulated market price of

natural gas 17

B. The court of appeals’ decision would

significantly impair the Commis-

sion’s ability to ensure just and rea-

sonable rates 22

C. The arguments advanced by re-

spondents and the court of appeals

do not support the court’s decision 26

1. The increased royalty costs that

Shell and Pennzoil seek to pass

through are based on the unreg-

ulated market price 26

Argument—Continued

2. The fact that “market value”

royalty costs are only part of the

producers’ total costs does not

provide a basis for distinguish-

ing this Court’s decision in Fed-

eral Power Commission v. Tex-

aco, lie., 417 U.S. 380

3. The fact that “market value”

royalties are costs actually paid

by the producers does not au-

orize or require the Commission

to permit them to be passed

through to interstate consumers.

4. This Court’s decision in Mobil

Oil Corp. v. Federal Power Com-

mission, 417 U.S. 283 does not

Support the decision of the court

of appeals mae

II. The Commission properly denied the

request to allow abandonment of roy-

alty volumes of gas dedicated to inter-

State commerce sis

Conclusion

CITATIONS

Cases:

Atlantic Refining Co. vy. Public Service

Page

Commission, 360 U.S. 378 9,19, 22, 30

Bowles y. Willingham, 321 U.S. 503

Burlington Truck Lines vy. United States,

871 U.S. 156 rerenasntpabsonabigieececs ch,

Ill

Cases—Continued Page

El Paso Natural Gas Co., 54 F.P.C. 145,

affirmed sub nom. California v. South-

land Royalty Co., No. 76-1587, decided

May 31,1978 sss ats ae DRE 10

Federal Power Commission v. Sun ray DX

OUCo,391US.9 = | 20

Federal Power Commission v. Texaco,

Inc., 377 U.S. 33 RA ON ec OU? } 19

Federal Power Commission v. Texaco

Inc., 417 U.S. 380 --.-..--.-13, 18, 19, 20, 27, 28

J. M. Huber Corp. v. Denman, 367 F.2d

Kingery v. Continental Oil Co., 434 F.

eee ies salt ER rn Se AS a 5

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

562 P.2d 1, certiorari denied, 434 U.S.

cap eS LOE Set oe IS 5

Mobil Oil Corp. v. Federal Power Com-

mission, 417 U.S. 283. 4, 10, 15, 17, 24, 30, 32

Mobil Oil Corp. v. Federal Power Com-

mission, 463 F.2d 256, certiorari de-

nied, 406 U.S. 976 — 5, 8, 18, 32, 35, 37

Northern Natural Gas Co. v. State Cor-

poration Commission of Kansas, 372

a clay, A EOE EN 36

Opinion No. 598, Area Rate Proceeding,

46 F.P.C. 86, affirmed sub nom. Mobil

Oil Corp. v. Federal Power Commission,

oor Ga Gee : 4

Opinion No. 699, 51 F.P.C. 2212, affirmed,

Shell Oil Co. v. Federal Power Commis-

sion, 520 F.2d 1061, certiorari denied,

426 U.S. 941 34

Cases—Continued Page

Opinion No. 699-H, Just and Reasonable

National Rates for Sales of Natural

Gas, 52 F.P.C. 1604, affirmed sub nom.

Shell Oil Co. vy. Federal Power Commis-

sion, 520 F.2d 1061, certiorari denied,

426 U.S. 941 mace | 4

Permian Basin Area Rate Cases, 390 U.S.

747 a 17, 18, 19, 21, 30

Phillips Petroleum Co. v. Wisconsin, 347

U.S. 672 ne Se

Placid Oil Co. vy. Federal Power Commis-

sion, 483 F.2d880 _ 80, 31

426 U.S. 941 | Witness i 20

Southland Royalty Co. vy. Federal Power

Commission, 543 F.2d 1134, reversed

sub nom. California vy. Southland Roy-

alty Co., No. 76-1114, decided May 31,

1978 11, 13, 22, 39, 40, 41

Whitehall Oil Co. vy. Boagni, 225 La. 67,

229 So.2d 702 5

Statute:

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

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

Section 4(a), 15 U.S.C. W17e(a) 3, 12,

17, 1la

Section 7(b), 15 U.S.C, 717f(b) 3, 37, la

Miscellaneous: Page

S. Rep. No. 95-1126, 95th Cong., 2d Sess.

_.., es ae 17

The Natural Gas Policy Act of 1978, H.R.

5289, 95th Cong., 2d Sess. (1978) 17

ieee

Gu the Supreme Court of the United States

OCTOBER TERM, 1978

No. 77-648

FEDERAL ENERGY REGULATORY COMMISSION,

PETITIONER

Vv.

PENNZOIL PRODUCING COMPANY, ET AL.

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE FIFTH CIRCUIT

BRIEF FOR THE FEDERAL ENERGY

REGULATORY COMMISSION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. la-

9a)" is reported at 553 F.2d 485. The order on re-

hearing of the court of appeals (Pet. App. 12a-13a)

is reported at 558 F.2d 816. The initia] opinion and

order (Opinion No. 753) of the Federal Power Com-

*“Pet. App.” references are to the appendix to the petition

for certiorari filed by the Federal Energy Regulatory Com-

mission. “A.” refers to the Appendix in this Court.

(1)

mission (A. 254-263, Pet. App. 14a-26a) and its opin-

ions and orders (Nos. 753-A, 753-B) denying rehear-

ing (A. 290-295, Pet. App. 27a-33a; A. 296-299) are

not officially reported.

JURISDICTION

The judgment of the court of appeals was entered

on June 6, 1977 (Pet. App. 10a-lla). The Commis-

sion’s application for rehearing was denied on Sep-

tember 1, 1977 (Pet. App. 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

petition was filed on that date and was granted on

June 12, 1978 (A. 303). The Court’s jurisdiction

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

Natural Gas Act, as amended, 15 U.S.C. 717r(b).

QUESTIONS PRESENTED

1. Whether the Natural Gas Act permits the Com-

mission to establish rates for the interstate sale of

natural gas that pass through to interstate consumers

royalty costs based on the unregulated price of nat-

ural gas in the intrastate market.

2. Whether the Commission properly denied a re-

quest to permit lessee/producers of natural gas to

abandon volumes of gas dedicated to interstate serv-

ice so that those volumes could be paid as royalties

“in kind” to landowner /lessors and sold on the intra-

state market.

STATUTES INVOLVED

Sections 4(a) and 7(b) of the Natural Gas Act,

52 Stat. 822, 824, as amended, 15 U.S.C. 717e(a),

717f£(b), are set forth as an Appendix, infra, p. la.

STATEMENT

Respondents Pennzoil Producing Company (Penn-

zoil) and Shell Oil Company (Shell) sell gas pro-

duced from the Gibson Field in Terrebonne Parish,

Louisiana, to respondent United Gas Pipe Line Com-

pany (United) for resale in interstate commerce, as

authorized by certificates of public convenience and

necessity issued by the Commission, The gas is pro-

duced under leases obtained by Pennzoil and Shell

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

1934, and July 24, 1952. The leases provide for pay-

ment to the lessor of royalties equal to fixed frac-

tions—one-eighth under the 1934 lease, one-fourth

under the 1952 lease—of the value of the gas pro-

duced. That value is to be “calculated at the market

rate prevailing at the well,” or “calculated at the

market price prevailing at the well” (A. 138, 145).

Pennzoil and Shell have always computed and paid

their royalties under the leases as fractions of the

rates actually received by them for the Sale of the gas

in interstate commerce, which rates since 1954 have

been established by the Commission.’ In 1975, 1974,

and 1975, however, Williams demanded payment by

* See Phillips Petroleum Co. v. Wisconsin, 347 U.S. 672.

Pennzoil and Shell of royalties based on intrastate

market values of natural gas. Those values assertedly

ranged from 35 cents to 70 cents per Mcf (1,000 cubic

feet) for the period October 1, 1971, through May

31, 1974, and from $1.30 to $1.40 per Mef from June

1, 1974, through April 30, 1975 (A. 72-74, 119-121,

160-161). Those intrastate market values substan-

tially exceeded the ceiling rates established by the

Commission for the sale of the gas by Pennzoil and

Shell.” When Pennzoil and Shel] refused to pay the

higher royalties, Williams purported to terminate the

leases for underpayment of the royalties due (A. 160,

255).

In 1974, Pennzoil and Shell Aled a petition in a

State court in Louisiana seeking a judgment declar-

ing that they were properly discharging their royalty

obligations under the leases (A. 75-79). Williams

counterclaimed for royalty underpayments in excess

of $3.5 million (A. 120). The principal question be-

fore the state court was whether the terms “market

rate” and “market price” in the royalty provisions of

the leases referred to the unregulated intrastate mar-

*In 1975, for example, both Pennzoil and Shell received

31.11 cents per Mef for some of the Gibson field gas sold to

United, and 59.88 cents for the remainder (A, 42, 66-67).

These rates, which included some adjustments, were estab-

lished by the Commission’s Opinion No. 598, Area Rate Pro-

ceeding (Southern Louisiana Area), 46 F.P.C. 86, affirmed sub

nom. Mobil Oil Corp. v. Federal Power Commission, 417 U.S.

283; and Opinion No. 699-H, Just and Reasonable National

Rates for Sales of Natural Gas, 52 F.P.C. 1064, affirmed sub

nom. Shell Oil Co. v. Federal Power Commission, 520 F.2d 1061

(C.A. 5), certiorari denied, 426 U.S. 941.

ket (as Williams contended) or to the regulated Com-

mission rate at which the gas was actually sold (as

Pennzoil and Shell contended) (see A. 91-94).'

On June 18, 1975, before the state court ruled on

that question, Pennzoil, Shell, and Williams entered

into a sett’ement agreement (A. 15-25). The agree-

ment provided that Pennzoil and Shell would apply

to the Commission for authority to pay royalties

based, in essence, on the higher of 78 cents per Mcf

(increasing 1.5 cents per year after 1975) or 150

percent of the highest area or national rate per-

‘Royalty provisions based on “market value,” “market

price,” or similar terms appear to be fairly common in natural

gas leases, although the Commission has no precise informa-

tion concerning the number of leases containing such pro-

visions or the volumes of gas covered. The issue whether

such provisions refer to the unregulated intrastate market

price or to the regulated rate at which the gas is actually

sold is currently pending in numerous cases, but has been de-

cided or considered in only a few reported decisions. One of

these is Lightcap v. Mobil Oil Corp., 221 Kan. 448, 562 P.2d

1, certiorari denied, 434 U.S. 876, petition for rehearing pend-

ing. In Lightcap and Kingery Vv. Continental Oil Co., 434 F.

Supp. 349 (W.D. Tex.), the courts held that such provisions

referred to the unregulated market. Cf. J. M. Huber Corp. v.

Denman, 367 F.2d 104 (C.A. 5). The District of Columbia Cir-

cuit, however, expressed a contrary view in Mobi! Oil Corp. V.

Federal Power Commission, 463 F.2d 256, 265, certiorari de-

nied, 406 U.S. 976. The courts of Louisiana have not yet ruled

on the issue, although one case indicates the Supreme Court of

Louisiana’s view that the “market value” of gas sold for

resale in interstate commerce can be established only by refer-

ence to the just and reasonable rate set by the Commission.

Whitehall Oil Co. v. Boagni, 255 La. 67, 229 So.2d 702, 764-

705. See also discussion, infra, pp. 35-37.

a i

mitted by the Commission, and that they would ask

the Commission for authority to “pass through” these

increases to their interstate customer, United (A.

16, 18). Alternatively, Pennzoil and Shell would seek

Commission authorization to abandon that portion of

the gas sold under the leases which was attributable

to Williams’s royalty interest—that is, one-eighth and

one-fourth of the gas produced under the 1934 and

1952 leases, respectively—so that that portion of the

gas (“royalty gas”) could be paid in kind to Wil-

liams for sale on the intrastate market. The au-

thority to be sought under the Agreement would

apply to sales of gas after the effective date of a

Commission order granting the authority (A. 21,

" II-A).°

Pursuant to the agreement, Pennzoil and Shell

moved the state court to stay their litigation pending

disposition of the contemplated proceedings before the

Commission (A. 23), and the state court granted the

motion. When and if the Commission granted either

form of relief, the parties would move to dismiss the

State court action (ibid.). If the Commission denied

both forms of relief, the parties would resume their

State court litigation.

In addition, © II-B of the agreement (A. 21) provided that

the producers would pay Williams additional royalties on

volumes of gas delivered in 1974 (see A. 163-164). Shell and

Pennzoil later sought Commission approval to pass through to

United such retroactive payments as well (A. 163-164, 188-

191). The Commission denied all the prospective relief re-

quested and also authority to pass through the retroactive

payments. See the discussion at pp. 8-10, infra.

As the agreement provided, Pennzoil and Shell

filed petitions with the Commission seeking special

relief from the area and national rates established

by the Commisison to permit them to pass through

to United the higher royalty rates called for in the

settlement. Alternatively, they requested permission

to abandon to Williams the portion of the gas pro-

duced under the leases that was attributable to Wil-

liams’s royalty interests (A, 2-14).°

The Commission’s administrative law judge, after

a hearing, denied the petitions (A. 159-193). He

concluded that under decisions of the Commission and

the courts, exceptional relief from an area or nation-

wide rate established by the Commission is warranted

only when a producer can demonstrate “that his

overall costs incurred in the operation of the par-

ticular well or group of wells are higher than the

applicable Commission-established area or nationwide

ceiling rates, or, even more stringently, that his out-

of-pocket expenses will exceed revenues” (A. 171).

He found that Pennzoil had made no attempt to make

such a showing (A. 175). He found that while Shell

had made the attempt, the facts showed that at juris-

* United intervened in the Commission’s proceeding and

supported the petition by Pennzoil and Shell. United contended

that the settlement was reasonable in view of the risk that the

state court litigation might result in termination of the leases

and thus diversion of the entire supply of gas from the inter-

state market (A. 52-53). United had agreed with Shell and

Pennzoil to pay the higher prices called for by the settle-

ment, “it being understood that the increases would be re-

flected in United’s jurisdictional rates”—that is, passed on to

its customers (United Br. in Opp. 3).

dictional rates Shell would still make an annual profit

of more than $290,000 from its leases if it paid Wil-

liams royalties based on the 78-cent settlement figure,

or an annual profit of more than $168,000 if it lost

the state court litigation and paid Williams royalties

based on the asserted current intrastate market price

of $1.40 per Mcf (A. 178-180). The administrative

law judge also denied the alternative request for the

abandonment of the royalty gas, on the ground that

the standards for abandonment under Section 7(b) of

the Act, 15 U.S.C. 717f(b), had not been met (A.

185-188).

The Commission affirmed the decision of the ad-

ministrative law judge, but on somewhat different

grounds (A. 254-263; Pet. App. 14a-26a). With re-

spect to the requested rate increase, the Commission

observed that it did not have jurisdiction over the

royalty owners or the royalty payments made to them

by the producers,’ and that a producer could “uni-

laterally” compute and pay royalties on any basis the

producer chose (A. 260). The Commission held that

it did have jurisdiction over the rates charged by the

producer to an interstate pipeline, but that it would

be inconsistent with its statutory mandate to permit

the pass-through of costs based on the unregulated

market price of gas (ibid.). The Commission stated

(A. 261):

In the instant proceeding, the impetus of the

settlement is the market value of the royalties

* Citing Mobil Oil Corp. v. Federal Power Commission, 463

F.2d 256 (C.A. D.C.), certiorari denied, 406 U.S. 976 (A. 260).

and no consideration has been given to regu-

lated rates. As such, we cannot permit any

incremental royalty costs resulting from this set-

tlement, 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 Com-

mission is not free to 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” [quoting from Aflantie Re-

fining Company v. Public Service Commission,

360 U.S. 378, 388].

Having concluded that to grant the price increase

based on the unregulated rate would be at odds with

the purpose of the Act, the Commission did not ad-

dress the administrative law judge’s determinations

that Shell and Pennzoil had not demonstrated suffi-

cient economic hardship to warrant relief from an

area rate under the traditional Commission standards.

The Commission also concluded that abandonment

of the royalty gas to Williams should not be authorized

under Section 7(b) (A. 261-263). The Commis-

sion found that the supply of natural gas in the lease-

holds 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 au-

thorization that would “likely result in the subject gas

being diverted from the interstate market to the intra-

state market” (A. 262). The Commission rejected the

argument of Pennzoil and Shell that abandonment of

royalty gas would be in the public interest because

otherwise Williams would cance] the leases, which

would result in losing all of the gas to the intra-

state market instead of only the royalty gas. The

Commission held that Williams could not unilaterally

terminate deliveries to United if it terminated the

leases (A. 262). Relying on its decision in El Paso

Natural Gas Co., 54 F.P.C. 145, affirmed sub nom.

California v. Southland Royalty Co., No. 76-1587, de-

cided May 31, 1978, the Commission stated (A. 262):

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.

The Commission subsequently denied petitions for

rehearing (A. 290-295; Pet, App. 27a-33a). It re-

affirmed the reasoning of its initia] opinion and re-

jected contentions that this Court’s decision in Mobil

Oil Corp. v. Federal Power Commission, 417 U.S

283, established the authority of the Commission to a]-

low royalty costs based on market value to be passed

on to pipelines. The Commission stated that “[w)hile

indicating that relief on some grounds may be pos-

sible, [Mobil] does not state under what conditions

relief should be granted, nor does it define when the

right to gain relief matures” (A. 291).

The court of appeals reversed the Commission’s

orders (Pet. App. la-9a). The court viewed the

Texaco case (417 US. 380), on which the Com-

mission had relied, as inapplicable (Pet, App. 6a).

The court held that, since Commission rate regula-

tion is cost-based, and “To]ne of the components of a

producer’s costs is clearly its royalty expense” (ibid.),

the Commission had erred in determining that it was

not permitted to pass through to interstate customers

the cost to lessee /producers of royalty payments based

on intrastate market value. The court relied on this

Court’s decision in Mobil Qil Corp. v. Federal Power

Commission, supra, for the proposition that producers

are entitled to special relief from the Commission

if their royalty costs, reasonably incurred, are higher

than those provided for by the applicable area or na-

tional rate established by the Commission (id. at 7a-

8a). The court observed that “[i]n all probability, the

reasonableness of a great many costs of gas production

must be determined by the prevailing market price in

an uncontrolled market,” and said the Commission had

failed to explain “why royalty costs in an uncon-

trolled market are any different from any other cost”

(id. at 7a).

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. vy.

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

5), subsequently reversed in California vy. South-

land Royalty Co., No. 76-1114, decided May 31, 1978,

the court held that the Commission had been wrong

in thinking that the gas from the leaseholds “was

trapped in the interstate market, whether or not the

leases were terminated” (Pet. App. 9a).*

SUMMARY OF ARGUMENT

A. Basie principles of rate regulation under the

Natural Gas Act prohibit the Commission from au-

thorizing a rate increase above the applicable area

or national rate to accommodate a producer’s royalty

cost that is tied to the unregulated intrastate market

in natural gas. The Commission’s responsibility un-

der Section 4(a) of the Act is to set “just and rea-

sonable” rates for interstate sales of natural gas.

Several relevant principles, approved by this Court,

govern the Commission’s exercise of that responsi-

bility. First, the Commission is not required to set

rates with reference to each producer’s particular

costs, but may set rates on an area-wide or nation-

wide basis. Second, the Commission is not required

to consider costs that are unreasonable. Third, the

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

court deleted from its opinion the final statement:

It may well be that the “present or future public con-

venience 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.

The court explained: “We agree with the Commission that

the statement was premature, if construed to be decisional,

and unnecessary with respect to our decision” (Pet. App. 18a).

Commission should not set rates on the basis of costs

that arise from contract clauses providing for indefi-

nite price escalations or that are otherwise unrelated

to the circumstances or the economics of the particu-

lar operation. Fourth, as this Court held in Federal

Power Commission vy. Texaco, 417 U.S. 380, the Com-

mission may not establish rates on the basis of the un-

regulated market price of natural gas. The forego-

ing principles, particularly those set forth in Texaco,

establish that the Commission has no authority to

permit rate increases based on royalty costs tied to

the unregulated market for natural gas.

Bb. The court of appeals, in holding that the Com-

mission had the authority to pass through such

royalty costs, did not expressly hold that the Com-

mission was required to do so. But the rationale and

the necessary implications of the court’s holding

would effectively compel that result in many cases.

The court’s decision would thus significantly impair

the Commission’s ability to establish just and reason-

able rates.

The court’s decision was based on its view that

producers are entitled to individualized rate velief

when, as the court thought to be true of Shell and

Pennzoil, they are placed by their royalty obligations

in a financial bind that reduces the funds otherwise

available to them for exploration and development.

The decision seems thus to establish a presumption

that such relief must be granted unless exceptional

circumstances are present. At best, the decision would

require the Commission to review the circumstances

of each case to determine, for example, the reason-

ableness of the producer’s having incurred particular

royalty costs tied to the unregulated market. The

Commission would be prohibited from excluding such

vosts generically on the ground that their inclusion

would be inconsistent with the basic purpose of the

Act.

C. The arguments advanced by respondents and

the court of appeals do not Support the court’s de-

cision.

1. Contrary to respondents’ assertion, the royalty

costs in this case are based on the unregulated mar-

ket. Although those costs are presently embodied

in a settlement agreement, the settlement reflects

the claim being settled—a claim for royalties based

on the unregulated market. As the Commission held,

the only reason Shell and Pennzoil agreed to pay

royalties higher than they had been paying was the

claim made against them in state court for royalties

based on the unregulated market.

2. As Texaco indicates, it is immaterial that

royalty costs are only one component of the producers’

costs, or that they do not equal the unregulated price

of gas, but are only a percentage of that price. What-

ever the size of the cost component, the Act does not

permit this method of calculating just and reasonable

rates.

3. Contrary to the court of appeals’ view, royalty

costs based on the price of natural gas in the un-

regulated market are not the same as other costs of

production that may properly be determined by ref-

erence to unregulated markets. The critical difference

is that the royalty costs at issue here are tied to the

unregulated price for the very commodity whose price

the Commission is charged with regulating.

4. The court of appeals also erred in concluding

that Mobil Oil Corp. v. Federal Powe; Commission,

417 U.S. 283, holds or Suggests that the Commission

has authority to grant the rate increases requested by

Shell and Pennzoil here. in Mobil, this Court viewed

as hypothetical, and therefore declined to rule on, a

producer’s claim that the Commission, in an area rate

proceeding, had failed to provide for future increases

in royalty costs. In stating that producers oppressed

by individual costs might seek individualized relief.

the Court indicated nothing about the circumstances

in which such relief might be appropriate.

In fact, it is well-established that the Commission

will not authorize special relief from an area rate

unless a producer can show that its costs exceed its

revenues at that rate—a showing neither Shell nor

Pennzoil could make in this case. The court of appeals

therefore erred in concluding that, because Shell and

Pennzoil may face increased royalty costs from state

court judgments that would “absorb funds otherwise

available for exploration and development” (Pet. App.

8a), the Commission was required to consider their

requests for special relief.

The Commission properly denied the alternative

request of Shell and Pennzoil to allow abandonment

of “royalty gas” from the leaseholds so that it could

be paid “in kind” to the lessor for sale on the intra-

state market. The contrary determination of the

court of appeals was based on its decision in South-

land Royalty Co. vy. Federal Power Commission, 548

F.2d 1134, which this Court later reversed in Cali-

fornia v. Southland Royalty Co., No. 76-1114, de-

cided May 31, 1978. This Court’s decision estab-

lishes that the Commission was correct and the court

of appeals in error.

ARGUMENT

I, UNDER THE NATURAL GAS ACT THE COMMIS-

SION MAY NOT AUTHORIZE PRODUCERS TO

PASS THROUGH TO INTERSTATE CONSUMERS

ROYALTY COSTS BASED ON [nk UNREGU-

LATED INTRASTATE PRICE OF NATURAL GAS

The court of appeals held that the Commission has

authority under the Natural Gas Act to permit pro-

ducers to pass through to pipelines, and hence to

interstate consumers, royalty costs based on the un-

regulated price of natural gas in the intrastate mar-

ket. We will show that (A) the decision is contrary

to basic principles of rate regulation established by

the Act and by decisions of this Court; (B) although

the court did not expressly hold that the Commission

was required to permit the pass-through of such

royalty costs, its holding that the Commission has the

authority to do so, and the rationale for that holding,

would significantly impair the Commission’s ability

to fulfill its statutory mandate of ensuring just and

reasonable rates; and (C) the reasons offered by the

court and respondents in support of the decision are

unpersuasive.’

A. Basic Principles of Rate Regulation Establish That

The Commission Has No Authority to Permit Pro-

ducers to Pass Through Royalty Costs Based On

The Unregulated Market Price of Natural Gas

Section 4(a) of the Natural Gas Act, 15 U.S.C.

717c(a), requires the Commission to ensure that all

rates charged for the transportation or sale of natural

gas subject to the Commission’s jurisdiction are ‘just

and reasonable.” As a general ma iter, the Commis-

sion, like most rate-regulating bodies, establishes rates

on the basis of the seller’s costs plus a reasonable

rate of return. See Permian Basin Area Rate Cases,

390 U.S. 747, 756-762. Several other well-settled

principles, however, also govern the Commission’s

rate-setting responsibilities under the Act.

First, the Commission has authority to establish

the maximum rates producers may charge on an

area-wide or nation-wide basis, and is not required to

promulgate an individual rate for each producer on

the basis of his own particular costs. Permian Basin

Area Rate Cases, supra; Mobil Oil Corp. v. Federal

Power Commission, 417 U.S. 288. In recent years,

the Commission has in fact promulgated rates on an

*Congress is presently considering a bill entitled The

Natural Gas Policy Act of 1978, H.R. 5289, 95th Cong., 2d

Sess. (1978). On August 18, 1978, a conference committee re-

port was issued on the bill reflecting agreement on the part of

the managers of the House and Senate. S. Rep. No. 95-1126,

95th Cong., 2d Sess. To the extent that future legislature

appears to affect the issues in this case, we will advise the

Court in a supplemental memorandum.

area-wide or nation-wide basis." While the Com-

mission may grant special rate adjustments or other

relief to a producer in exceptional circumstances, it

is not required to do so merely because the producer’s

own costs exceed the area or national average.

Permian, supra, 390 U.S. at 770-772. As this Court

said in Federal Power Commission vy. Texaco, 417

U.S. 380, 387: “That every rate of every natural gas

company must be just and reasonable does not re-

quire that the cost of each company be ascertained

and its rates fixed with respect to its own costs.”

Second, the fact that one or even all producers in-

cur a particular cost does not require the Commission

to include all of that cost in the rate base if it is

excessive or unreasonable. If, for example, a pro-

ducer or group of producers were paying a price for

drilling material that was twice the price reasonably

available from other suppliers, or were using piatinum

instead of steel pipe, the Commission would not be re-

quired to pass those costs on to interstate pipelines,

and hence to interstate consumers, as part of the

jurisdictional rate. See Permian, supra, 390 U.S. at

824-825, n. 115; Mobil Oil Corp. v. Federal Power

Commission, 463 F.2d 256, 263 (C.A. D.C.), cer-

tiorari denied, 406 U.S. 976. Rather the Commis-

sion’s responsibilities under the Act are “so framed

as to afford consumers a complete, permanent and

Oil Co. V. Federal Power Commission, 520 F.2d 1061 (C.A, 5),

certiorari denied, 426 U.S. 941 (upholding national rates).

eifective bond of protection from excessive rates and

charges.” Ailantic Kefining Co. v. Public Service

Commission, 360 U.S. 378, 388 (emphasis supplied).

Third, in accord with its responsibility to ensure

that rates are reasonable, the Commission may refuse

to establish rates that reflect contract clauses provid-

ing for indefinite price escalations. In Permian this

Court affirmed the Commission’s refusal to permit

rate increases based on such clauses, citing the Com-

mission’s statement that to allow the increases would

not be “in accordance with the principles upen which

a rate structure should be based” and would be “in-

compatible with the public interest.” 390 U.S. at 782-

783 (quoting from the Commission’s orders in 34

F.P.C. 159, 236 and 25 F.P.C. 379, 380). That is so

because the escalation clauses “cause price increases

* * * to occur without reference to the circumstances

or economics of the particular operation, but solely

because of what happens under another contract.” 34

F.P.C. at 373; 390 U.S. at 782-783. See also Federal

Power Commission vy. Texaco, Inc., 377 U.S. 33, 42.

Fourth, the Commission is not permitted by the

Act to establish regulated rates on the basis of the

unregulated market price of natural gas. To do so is

inconsistent with the very notion of rate regulation,

and this Court expressly so held in Federal Power

Commission v. Texaco, 417 U.S. 380. In that case the

Commission sought by rule to exempt small jurisdic-

tional producers from most of the regulatory require-

ments of the Act, including individual certification,

filing of rate increases, and refund obligations. The

Commission sought to regulate the rates of the small

producers only indirectly, through its regulation of

large producers and pipelines who purchased gas from

the small producers and whose costs theiefore re-

flected the prices paid to the small producers.

The Court rejected the Commission’s rule. The

Court noted that the rule appeared to permit the

large producers and pipelines to pass through auto-

matically the unregulated prices they paid to the

small producers, and that “the implication appears to

be that reasonableness would be judged by the stand-

ard of the marketplace” (417 U.S. at 396). The

Court stated (id. at 397-399) :

[W]e should also stress that in our view the pre-

vailing price in the marketplace cannot be the

final measure of “just and reasonable” rates man-

dated 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 natural gas industry was heavily con-

centrated and that monopolistic forces were dis-

torting the market price for natural a"

subjecting producers to regulation because of

anti-competive conditions in the industry, Con-

gress could not have assumed that “just and rea-

sonable” rates could conclusively be determined

by reference to market price. Our holding in

Phillips [347 U.S. 672] implies just the opposite.

* * * [Footnote omitted].

See also Federal Power Commission vy. Sunray DX

Oil Co., 391 U.S. 9, 25-26, where the Court specifically

rejected the contention that prevailing market prices

—in the form of contemporeneous contract prices—

could be equated with “just and reasonable” rates

under the Act.

The court of appeals’ decision is contrary to the

foregoing principles, and particularly to those set

forth in Texaco. Shell and Pennzoil have requested

the Commission to approve an increase in their juris-

dictional rates that would be based on the price of

gas in the unregulated market. That increase, and

hence a significant part of the entire rate, would

“conclusively be determined by reference to market

price” (Texaco, supra, 417 U.S. at 399)."'

Furthermore, if the Commission permitted a rate

increase based on the unregulated market price, ju-

risdictional rates would be subject to unpredictable

fluctuations and escalations that are beyond the con-

trol of the Commission, are unrelated to “the cir-

cumstances or economics of the particular operation,”

and are solely a function of “what happens under

[o]ther contract[s].” Permian, supra, 390 U.S. at

782-783. In this case, for example, Williams claimed

that Pennzoil and Shell owed royalties on the basis

of market prices ranging from $.35 per Mef in 1971

(A. 115) to $1.40 per Mef in 1975 (A. 119-121).

Market prices will no doubt continue to fluctuate,

and probably to escalate if present trends continue.

No less than in Permian, to permit increases in juris-

This is so notwithstanding the settlement and the use of

the royalty figures set forth in that settlement; the settlement

reflected the claim being settled, and that claim was for “mar-

ket value” royalties determined by the intrastate market. See

pp. 26-27, infra.

dictional rates on the basis of such unpredictable

market fluctuations would be inconsistent “ ‘with the

principles upon which a rate structure should be

based.’”” 390 U.S. at 782.”

B. The Court of Appeals’ Decision Would Significantly

Impair the Commission’s Ability to Ensure Just and

Reasonable Rates

As we have shown, the court of appeals disre-

garded basic regulatory principles in holding that

the Commission has authority to permit producers to

pass through royalty costs based on the price of gas

in the unregulated market.” The court, however, did

12 Moreover, from the standpoint of the interstate consum-

ers for whose protection the Act was passed (Atlantic Re-

fining Co. v. Public Service Commission, supra), the circum-

stances of this case provide no reason for permitting Shell

and Pennzoi! to increase their rates in response to their

lessor’s demands for higher royalty rates. As discussed infra,

pp. 37-41 and note 24, this Court’s decision in California V.

Southland Royalty Co., No. 76-1114, decided May 31, 1978,

establishes that’the lessor, if he terminated the leases, would

be required to continue the interstate service at applicable

Commission rates. Thus there is no reason to impose a higher

rate on interstate consumers merely because of the private con-

tractual arrangements between the parties in this case.

1's While the basic scheme of the Act prohibits the Commis-

sion from allowing the pass-through of such costs, the prohibi-

tion has practical significance only when, as in this case, a

producer seeks Commission authorization for a rate higher

than the applicable area or national rate. The Commission’s

area and national rates are ceilings; nothing bars a producer

trom charging a lower rate. If the Commission establishes a

just and reasonable ceiling rate on the basis of factors unre-

lated to the price of gas in the intrastate market, and a par-

ticular producer has a royalty cost that is based on the intra-

= ree

not expressly require the Commission to permit the

pass-through of such costs. It might be suggested,

then, that the Commission can still refuse to grant

such permission, in which case the court’s decision,

however erroneous, might not be particularly signifi-

cant. The necessary implications of the court’s deci-

sion, however, would compel the Commission to per-

mit such pass-throughs in many, if not most cases,

and thus to increase rates on the basis of an illegal

factor. The decision would thus seriously impair

the Commission’s ability to ensure just and reason-

able rates.

The court’s decision would in practice affect the

level of just and reasonable rates in several ways.

First, the Commission, as we have noted (pp. 17-18,

supra), is not required to calculate its rates with ref-

erence to each producer’s particular costs, but may use

area or national averages. In individual cases, the

Commission might be justified in declining to permit

the pass-through of “market value” royalty costs even

if it had the authority to grant such permission. But

if many producers incur a significant cost that the

courts hold to be properly includable in the rate base,

as the court of appeals has effectively held here, that

state market price, there is nothing that prevents that pro-

ducer from paying that cost and reflecting it in his rate, so

long as the rate he charges does not exceed the Commission’s

ceiling. What the Act prohibits is the Commission’s establish-

ment of ceiling rates based on the price of natural gas in the

intrastate market, or, as is proposed in this case, the Commis-

sion’s authorizing a particular producer to charge a rate in

excess of the applicable ceiling because of costs pegged to the

price of gas in the intrastate market.

cost will affect the average. The number cf “market

value” royalty provisions in gas leases, together with

the substantial cost impact of such provisions if they

are held to refer to the intrastate market, may well

produce such an effect."

More important, even if the costs in question here

were incurred by only a few producers, it is doubtful

that, under the court’s rationale, the Commission

would be justified in denying individualized rate re-

lief to those producers. For the court’s conclusion was

based, at least in part, on its view that Shell and

Pennzoil would be “ ‘put in a bind by their royalty

obligations’”’ if they lost the state court litigation,

and on the court’s apparent view that this Court’s

decision in Mobil Oil Corp. v. Federal Power Com-

mission, 417 U.S. 283, requires the Commission to

provide individualized relief to producers in such cir-

cumstances (Pet. App. 8a). At the least, therefore,

the decision appears to establish a heavy presump-

tion that individual relief must be granted to such

producers, and would preclude the Commission from

denying relief on the basis of its view that rate

increases based on the price of gas in the unregu-

lated market are inconsistent with the purpose of the

Act.

'* As noted earlier (p. 5, note 4, supra), the Commission

does not have information concerning the number of leases

containing “market value” royalty provisions or the amounts

of gas underlying such leases, but the volume of pending

litigation over such provisions suggests that their impact

(if interpreted to refer to the intrastate market) would be

significant.

In some cases the Commission might conclude that

a given producer had been unreasonable in incurring

royalty costs based on the intrastate market price.

Under the court’s rationale, however, the Commis-

sion plainly could not conclude that incurring such

costs was unreasonable per se. And if the court is

correct that under the scheme of the Act such costs

may properly be included in the rate base for Com-

mission-established rates, it is difficult to see what

circumstances would justify a conclusion that in-

curring the costs was unreasonable.

In short, the court of appeals’ decision, at best,

would require the Commissior to review the circum-

stances of each case to determine whether particular

royalty costs based on the intrastate market for

natural gas were or were not permissible for in-

dividualized reasons. The decision would prohibit

the Commission from excluding such costs generically

on the ground that their inclusion would undermine

the purpose of the Act. The likely consequence of the

decision would be to establish a strong presumption

that such costs must be included, and that petitions

such as that of Shell and Pennzoil must be granted

by the Commission in the absence of exceptional cir-

cumstances.

C. The Arguments Advanced by Respondents And The

Court of Appeals Do Not Support The Court’s

Decision

1. The Increased Royalty Costs That Shell and

Pennzoil Seek to Pass Through Are Based on The

Unregulated Market Price

Respondents Pennzoil and Shell have argued thai

the increased royalty costs they seek to pass through

to interstate consumers are not based on the intra-

state market price but on prices agreed to by Shell,

Pennzoil, and Williams as part of their settlement.”

The argument ignores the realities of the situation

and was properly rejected by the Commission.”

The cause of the settlement was the claim being

settled: the claim by Williams that Shell and Penn-

zoil owed it royalties based on the intrastate market

price. Shell and Pennzoil have never suggested any

other reason for agreeing to pay royalties substan-

tially higher than they had been paying for years.

Thus the Commission correctly observed (A. 261) that

“the impetus of the settlement is the market value of

the royalties and no consideration has been given to

regulated rates.”

If we are correct that passing through royalty costs

based on the intrastate market price of gas offends

the basic scheme of the Act, private litigants can-

1% Pennzoil Br. in Opp. 9; Shell Br. in Opp. 3, n. 3.

‘® The court of appeals did not address this argument but

implicitly rejected it, since its opinion addressed the merits

of the Commission’s position that it had no authority to pass

through royalty costs based on the intrastate market price.

not make such a result acceptable by agreeing on

royalty costs that are somewhat less than the royalty

owner’s original “market value” claim.”

2. The Fact that “Market Value” Royalty Costs

Are Only Part of the Producers’ Total Costs

Does Not Provide a Basis for Distinguishing

This Court’s Decision in Federal Power Com-

mission v. Texaco, Inc., 417 U.S. 380

The court of appeals stated that this Court’s de-

cision in Texaco, supra, was “inapplicable to the in-

stant case” (Pet. App. 6a). The court gave little

indication of its reasons. But they appear to be

based on the view, amplified in the arguments of

respondents,” that the jurisdictional rate considered

in Texaco was determined solely by reference to the

unregulated market price, whereas in this case only

one component of the producers’ cost would be deter-

mined by reference to the unregulated market price.

The claim is factually incorrect. The cost at issue

in Texaco was the price the regulated producers paid

17 See Texaco, supra, 417 U.S. at 399.

8 The court said that “[t]his case deals with royalty cost

under specific leases” (ibid.). But that scarcely distinguishes

Texaco, where, as the court recognized, this 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 unres ‘lated marketplace” (ibid.). Nothing in the Act

suggests—and the court did not claim—that rates for the

interstate sale of gas “under specific leases” need not be “just

and reasonable.”

1° Pennzoil Br. in Opp. 10; Shell Br. in Opp. 2-3.

for gas purchased from the small producers. Like the

cost at issue here, it was only one component of the

total costs of the regulated producers. Under the

Commission’s plan in Texaco, that component would

have been included with all the other costs of the

regulated producers to determine their jurisdictional

cost base. )

More important, as 7’exaco itself indicates, the fact

that royalty costs are only one of several components

of the producers’ costs is immaterial. They are a

significant component, and the principles reaffirmed

in Texaco do not suggest that a part of the inter-

state rate approved by the Commission may be based

solely on the unregulated market so long as the whole

rate is not determined on that basis. As this Court

stated, “the Act makes unlawful all rates which are

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

lawfulness is permitted” (417 U.S. at 399).

Nor does the particular ratio between the royalty

cost and the unregulated price make a legal difference.

The ratios here are substantial—one-eighth and one-

fourth—but in any event the court of appeals’ ra-

tionale would apply if the leases provided for royalties

equalling 90 percent of the “market value,” thus

resulting in jurisdictional rates approaching parity

with the unregulated market. Whether the cost com-

ponent that is determined by reference to the un-

regulated market is large or small, the Act does not

permit the Commissioner to calculate just and reason-

able rates by that method.

SO <b ERTL» OREN Sette es borne

3. The Fact That “Market Value’ Royalties Are

Costs Actually Paid by the Producers Does Not

Authorize or Require the Commission to Permit

Them To Be Passed Through to Interstate

Consumers

The court of appeals stated, and respondents have

argued,” that royalty costs are no different from any

other cost of production and therefore, under “a

cost plus profit approach to gas rate regulation”

(Pet. App. 6a), should be included in the rate base

if they are reasonable. As the court stated (Pet.

App. 7a):

Determination of the reasonableness of a cost

necessarily requires consideration of market

price. In all probability, the reasonableness of

a great man) costs of gas production must be

determined by the prevailing market price in an

uncontrolled market. The Commission has failed

to suggest why royalty costs in an uncontrolled

market are any different from any other cost.

The difference is plain. The royalty costs at issue

here are pegged to the unregulated market price of

the very commodity whose interstate price the Com-

mission is charged with regulating. In contrast to

the costs of labor, steel, or other elements of produc-

tion whose price the Commission has no responsibility

for regulating, royalty costs based on the unregu-

lated price of natural gas would undermine the

premise of price regulation of natural gas. To allow

the pass-through of such costs would be to ignore the

Act’s objective of “afford[ing] consumers a complete,

2° Pennzoil Br. in Opp. 9-10; Shell Br. in Opp. 2-3.

permanent and effective bond of protection from ex-

cessive rates and charges” (Atlantic Refining Co. v.

Public Service Commission, supra, 360 U.S. at 388),

by spiriting into the just and reasonable rates man-

dated by the Act the very unregulated rates and

charges against which protection was sought. See

also, e.g., Phillips Petroleum Co. v. Wisconsin, 347

U.S. 672, 682-684."

4. This Court’s Decision in Mobil Oil Corp. v. Fed-

eral Power Commission, 417 U.S. 283, Does Not

Support the Decision of the Court of Appeals

The court of appeals relied on this Court’s decision

in Mobil Oil Corp. v. Federal Power Commission,

417 U.S. 283, affirming Placid Oil Ce. v. Federal

Power Commission, 483 F.2d 880 (C.A. 5), for

its conclusion that the Commission has authority, if

not an obligation, to permit the pass-through of “mar-

ket value” royalty costs. The court of appeals rea-

soned that because the state courts may ultimately

determine that the “market price” clauses of the Wil-

21 Moreover, contrary to the court of appeals’ suggestion, the

Commission would not necessarily be required to include

in the rate base other costs of production that were tied by

agreement to fluctuations in an unregulated market. Prevail-

ing market prices for, say, steel or labor may be taken into

consideration when the Commission establishes jurisdictional

rates. But if a producer entered into a long-term labor or

materials contract that fixed his price of labor or materials

on some imprudent basis and not as a function of local con-

ditions or the circumstances of the particular operation, it

would be open to the Commission to determine that the future

pass-through of such costs is unreasonable and not “ ‘in accord-

ance with the principles upon which a rate structure should

be based.’” Permian, supra, 390 U.S. at 782.

RO crt |

liams leases refer to the intrastate market, Shell

and Pennzoil have been “put in a bind” between

the jurisdictional rate and their royalty obligations—

a situation in which they face either termination of

their leases or “increased royalty payments, which

would absorb funds otherwise available for explora-

tion and development” (Pet. App. 8a). The court

concluded that Mobil requires the Commission at least

to consider, and apparently to grant, individualized

relief to producers placed in such a bind (ibid; see

p. 24, supra).

Mobil imposes no such requirement. Nor does the

alleged bind in which Shell and Pennzoil have been

placed, or will be placed, warrant any departure from

the basic principles of rate regulation under the Act.

a. In Mobil the court of appeals and this Court up-

held an area rate promulgated by the Commission.

One of the many objections considered by the Com-

mission and the courts was Mobil’s complaint that the

Commission had failed to provide for automatic rate

adjustments to accommodate anticipated increased

royalty costs. The Commission found the issue to be

premature in the context of the area rate proceeding.

The court of appeals agreed, stating (483 F.2d at

911; emphasis in original) :

[W]e are not willing to alter or stay the imple-

mentation of area wide rates for the entire

industry merely on the basis of what might hap-

pen to some producers’ costs if this statement of

the law prevails.

If, as subsequent events develop, the producers

are put in a bind by their royalty obligations,

they may certainly petition FPC for individual-

ized relief. * * * [W]e find it to be far preferable

to speculative prophesies of future royalty com-

ponents. If the royalty obligations are such as

to make the rates established by [the Commis-

sion’s decision] and approved by us here, con-

fiscatory or otherwise inappropriate, those pro-

ducers who are materially affected will certainly

have recourse to the administrative process.

* * *

This Court “agree[d] with the Court of Appeals

that Mobil’s argument is hypothetical at this stage

and that in any event an affected producer is entitled

to seek individualized relief” (417 U.S. at 328). In

making that observation the Court recognized that

the Commission may grant special relief in some in-

stances where actual costs are higher than those pro-

vided for in the area rate. It did not discuss or de-

termine what those instances might be, or what kinds

of royalty obligations might make the established

rates, in the words of the court of appeals, “‘confisca-

tory or otherwise inappropriate.” In particular, the

Court did not consider whether the Commission either

could or must grant relief for royalty obligations tied

to the unregulated price of gas in the intrastate

market.

b. When that question is considered, the “bind”

that Shell, Pennzoil, and other producers may face

would warrant no such relief. That bind would re-

suit from two rulings. On the one hand, the Court

of Appeals for the District of Columbia held in

Mobil Oil Corp. v. Federal Power Commission, 463

F.2d 256, certiorari denied, 406 U.S. 976, that lessors

(or “royalty owners”) are not natural-gas companies

under the Act and hence that the Commission lacks

jurisdiction over the terms of lease agreements, in-

cluding royalty provisions. On the other hand, some

state courts have held, and others may, that “market

value” or “market price” royalty clauses refer to

the unregulated intrastate market. See, p. 5, note 4

supra.

Even if both rulings are correct (but see the dis-

cussion at pp. 35-37, infra), they do not warrant the

relief requested by respondents. If we assume that

a lessor may charge a lessee/producer any royalty the

latter is willing to pay, it does not follow that the

Commission is authorized or required to pass all of

that royalty on to interstate customers. In Permian

this Court established that neither the Constitution

nor the Natural Gas Act is offended by a rate struc-

ture that denies full recovery of all costs to some

producers. “No constitutional objection arises from

the imposition of maximum prices merely because

‘high cost operators may be more seriously affected

* * * than others,’ Bowles v. Willingham [321 U.S.

503, 618], or because the value of regulated property

is reduced as a consequence of regulation” (390 U.S.

at 769). The Court upheld in that case the Com-

mission’s policy that, while it might grant relief from

the area rate in some circumstances, “a producer’s

inability to recover either its unsuccessful explora-

tion costs or the full 12% return on its production

investment would not, without more, warrant relief,”

and that “the burden would be upon the producer to

establish the propriety of an exception * * *” (390

U.S. at 771).

In accordance with those principles, the Commis-

sion, with the approval of the courts, has established

the policy that it will not authorize departures from

area rates unless a producer can show that its costs

exceed its revenues at the area rate. See, e.g., Opin-

ion No. 699, 51 F.P.C. 2212, 2279, affirmed, Shell

Oil Co. v. Federal Power Commission, 520 F.2d 1061

(C.A. 5), certiorari denied, 426 U.S. 941. In the pres-

ent case the administrative law judge denied relief

on the ground that Shell and Pennzoil had made no

such showing, and that Shell at least would still

derive a substantial profit from its lease even if it

paid the higher royalties (see pp. 7-8, supra).

The Commission, without rejecting these findings,

denied relief on grounds more fundamental to the

scheme of the Act, and we are not suggesting that

the Commission be affirmed on grounds that it did

not itself rely on. We do contend, however, that

the court of appeals erred in holding that the Com-

mission was authorized, if not required, to grant

relief because the producers faced a financial bind

resulting from “increased royalty payments, which

would absorb funds otherwise available for explora-

tion and development” (Pet. App. 8a). Even if a

particular producer’s costs would ‘“‘absorb funds other-

wise available” for those uses, that in itself ts not a

ground for relief from an area rate.

c. In any event, the “bind” asserted by Shell and

Pennzoil, and relied on by the court of appeals, can-

not at this point be assumed to exist. The state

courts of Louisiana have not determined whether the

leases require royalties based on intrastate market

prices or on the regulated prices at which the gas

is actually sold. As noted earlier (p. 5, note 4, supra),

that issue has been addressed in only a few reported

cases, and those courts are divided. In this case the

administrative law judge, noting that “the dire re-

sults envisaged by Pennzoil and Shell from the state

court litigation are, of course, speculative,” expressed

the view that “[i]t is highly doubtful that Williams

would prevail on its claim that ‘market value’ for.

basing royalty payments means a price in excess of

the Commission-established area and nationwide ceil-

ing prices” (A. 182).

While we express no view on the likely outcome

of the state court litigation, we do believe that the

administrative law judge was correct in concluding

that “market value” royalty clauses, properly con-

strued, refer to the market in which the parties con-

templated that the gas would be sold—in this case,

the regulated interstate market. See A.182-183; see

also Mobil Oil Corp. v. Federal Power Commission,

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

U.S. 976.

We also believe that when such clauses apply to

sales within the jurisdiction of the Commission, the

question is one of federal law. When the Commis-

sion establishes jurisdictional rates, it properly takes

into account the funds needed by jurisdictional pro-

ducers for exploration and development, as well as

the fair rate of return. Although an individual pro-

ducer has no entitlement to rate relief on the ground

that his own costs deprive him of funds that the

Commission anticipates will be available to the aver-

age producer, at the same time state courts cannot

impair the Commission’s ability to carry out its re-

sponsibilities under the Act. When state courts, on

the basis of state law, impose on jurisdictional pro-

ducers a cost that the Commission is precluded by the

Act from including in jurisdictional rates, they under-

mine the purposes and impair the effectiveness of the

federal statute. Cf. Northern Natural Gas Co. v.

State Corporation Commission of Kansas, 372 U.S.

84, 97

We have expressed these views in our memorandum

supporting the petition for rehearing of the denial

of certiorari in Mobil Oil Corp. v. Lightcap, No. 76-

1694, where “market value” royalty clauses were

held to refer to the unregulated market. The resolu-

tion of the present case does not turn on the resolu-

tion of the issue in Lightcap; even if the producer’s

royalty obligation is measured by the unregulated

market, the Commission cannot pass through such

increased costs to the interstate consumer. Neverthe-

less, the issues are plainly related. A judicial rejec-

tion of the view that “market value” royalty clauses

refer to the intrastate market, where sales were con-

templated and are actually being made in the inter-

state market, would obviate the “bind” that respond-

ents assert and would promote the regulatory pur-

poses of the Act.”

Il. THE COMMISSION PROPERLY DENIED THE RE-

QUEST TO ALLOW ABANDONMENT OF ROYALTY

VOLUMES OF GAS DEDICATED TO INTERSTATE

COMMERCE

As an alternative to the requested price relief, Shell

and Pennzoil petitioned the Commission to authorize

abandonment, pursuant to Section 7(b) of the Act,

15 U.S.C. 717f£(b), of portions of the leasehold gas

attributable to Williams’ royalty interest (that is, one-

eighth and one-fourth of the gas produced under the

1934 and 1952 leases, respectively), so that Williams

2 In our petition for a writ of certicrari in this case we

suggested that another alternative would be reconsideration

of the decision of the District of Columbia Circuit in Mobil

Oil Corp. V. Federal Power Commission, 463 F.2d 256, certio-

rari denied, 406 U.S. 976, holding that the Commission has

no jurisdiction over royalty payments under leases because

lessors are not natural gas companies within the meaning of

the Act. On further consideration, we do not press that sug-

gestion here. For one thing, the Commission in its opinion ac-

cepted the D.C. Circuit’s decision in Mobil and stated that

lessors and lessee/producers could unilaterally charge and pay

any royalty they desired, so long as it was not passed through

to interstate customers (A. 260; Pet. App. 2la-22a). See

Burlington Truck Lines v. United States, 371 U.S. 156, 168-

169. But see Phillips Petroleum Co. v. Wisconsin, 347 U.S.

672. Further, the purposes of the Act would not require

a conclusion contrary to that of the court of appeals in Mobil

if we are correct in our position that costs calculated on the

basis of the unregulated market cannot be included in regu-

lated rates, and in our position that federal law requires that

“market value” royalty clauses affecting jurisdictional sales be

construed as referring to the regulated rate.

could take this “royalty gas” in kind and dispose of

it in the intrastate market (see pp. 6-7, supra).

Section 7(b) provides:

x» * *®

No natural-gas company shall abandon

fany facilities or any service subject to the

jurisdiction of the Commission] without the per-

mission and approval of the Commission first had

and obtained, after due nearing, and a finding

by the Commission that the available supply of

natural gas is depleted to the extent that the

continuance of service is unwarranted, or that

the present or future public convenience or neces-

sity permit such abandonment.

Shell and Pennzoil argued to the Commission that

the public interest would be served by authorization

to abandon the royalty gas, because otherwise the

leases might be cancelled and all of the gas, not just

the royalty portion, diverted from the interstate mar-

ket. The Commission found this fear unwarranted

(A. 262):

[W]e do not share the concern * * * that Wil-

liams 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 obliga-

tions of Pennzoil and Shell to continue service

to United.

*? It was undisputed that the available supply of gas under-

lying the leased lands was not depleted, so that abandonment

could not be permitted on that basis (see A. 186, n. 15).

eS tent en =

ee NF

The Commission concluded that diversion of the

royalty gas from the interstate market would not

serve the public convenience and necessity, and the

abandonment request was accordingly denied (A.

263).

The court of appeals remanded the issue to the

Commission for reconsideration in light of the court’s

then-recent decision in Southland Royalty Co. v.

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

reversed sub nom. California v. Southland Royalty

Co., No. 76-1114, decided May 31, 1978. The court

held that the Commission “was acting under the

wrong legal premise” in denying abandonment—that

is, “the Commission was under the impression that

Williams’ gas was trapped in the interstate market,

whether or not the leases were terminated” (Pet.

App. 9a).

This Court’s decision in Southland Royalty estab-

lishes that the Commission was correct and the court

of appeals in error. The Court held that the ex-

piration of a lease does not affect the obligation to

continue the interstate service from the leased acre-

age, unless the Commission authorized abandonment:

This issuance of a certificate of unlimited dur-

ation covering the gas at issue here created a

federal obligation to serve the interstate market

until abandonment had been obtained. The Com-

mission reasonably concluded that under the stat-

ute the obligation to continue service attached to

the gas, not as a matter of contract but as a mat-

ter of law, and bound all those with dominion and

power of sale over the gas, including the lessor to

whom it reverted. [Slip op. 6.]

Southland Royalty involved a 50-year lease that

terminated automatically by the passage of time. The

Court’s decision there applies at least as strongly to

the situation posited here, which would be the uni-

lateral termination of a lease by the lessor prior to

its specified term. There is, indeed, even less basis

for the claim that interstate service may be aban-

doned, without the Commission’s approval, by a lessor

who terminates a lease prematurely out of a desire

to divert gas to the more lucrative intrastate market.

Thus, the Commission’s reasoning that Williams

would be obligated to continue the interstate service

initiated by Pennzoil and Shell, even if the leases were

cancelled, is squarely validated by Southland Royalty

(slip op. 7):

Once the gas commenced to flow into interstate

commerce from the facilities used by the lessees,

§ 7(b) required that the Commission’s permission

be obtained prior to the discontinuance of “any

service rendered by means of such facilities.”

Private’ contractual arrangements might shift

control of the facilities and thereby determine

who is obligated to provide that service, but the

parties may not simply agree to terminate the

service obligation without the Commission’s per-

nission.

Correspondingly, the court of appeals’ basis for re-

versing the Commission’s refusal here to allow aban-

donment of the royalty gas has been rejected. In the

light of Southland Royalty, the court‘s holding on this

issue should be reversed, and the Commission’s de-

termination affirmed.”

CONCLUSION

The judgment of the court of appeals should be

reversed.

Respectfully submitted.

WADE H. McCCREE, JR.,

Solicitor General.

STEPHEN R. BARNETT,

Deputy Solicitor General.

RICHARD A. ALLEN,

Assistant to the Solicitor General.

RoBERT R. NORDHAUS,

General Counsel,

HOWARD E. SHAPIRO,

Solicitor,

MCNEILL WATKINS, II,

Attorney,

Federal Energy Regulatory Commission.

SEPTEMBER 1978.

2 As noted supra, p. 22, note 12, this conclusion provides

further support for the Commission’s denial of the rate in-

creases requested by Shell and Pennzoil. If Williams cancelled

the leases and was required to continue the interstate service,

as Southland Royalty held would be the case, Williams’s sales

in interstate commerce would be subject to the applicable Com-

mission ceiling rates. It would be anomalous to permit Shell

and Pennzoil to increase their rates above the ceiling because

otherwise Williams might cancel their leases, when Williams

itself could not charge a higher-than-ceiling rate if it did

cancel.

APPENDIX

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

as amended, 15 U.S.C. 717c(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.

Section 7(b) of the Natural Gas Act, 52 Stat. 824,

15 U.S.C. 717f£(b) provides:

No natural-gas company shall abandon all or

any portion of its facilities subject to the juris-

diction of the Commission, or any service ren-

dered by means of such facilities, without the

permission and approval of the Commission first

had and obtained, after due hearing, and a find-

ing by the Commission that the available supply

of natural gas is depleted to the extent that the

continuance of service is unwarranted, or that

the present or future public convenience or neces-

sity permit such abandonment.

w U. S. GOVERNMENT PRINTING Office; 1978 2727588 m3

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.