Hugoton Production Company v. United States

• Decision Date: 05 April 1963
• Docket Number: No. 46-60.,46-60.
• Citation: 315 F.2d 868
• Parties: HUGOTON PRODUCTION COMPANY v. The UNITED STATES.
• Court: U.S. Claims Court

315 F.2d 868 (1963)

HUGOTON PRODUCTION COMPANY v. The UNITED STATES.

No. 46-60.

United States Court of Claims.

April 5, 1963.

John P. Lipscomb, Washington, D. C., for plaintiff.

Theodore D. Peyser, Jr., Washington, D. C., with whom was Asst. Atty. Gen., Louis F. Oberdorfer, for defendant. Edward S. Smith and Lyle M. Turner, Washington, D. C., were on the brief.

Before JONES, Chief Judge, REED, Justice (Ret.), sitting by designation, and LARAMORE, DURFEE and DAVIS, Judges.

REED, Justice (Ret.), sitting by designation.

This case presents a novel and difficult question relating to the means by which a natural gas producer must compute its percentage depletion allowance under sections 23(m) and 114(b) (3) of the Internal Revenue Code of 1939,¹ the corresponding and similar provisions of the 1954 Code, sections 611 and 613,² and the regulations issued pursuant to these sections. The precise question has been considered only once before, by the Tax Court, in Shamrock Oil & Gas Corp. v. Commissioner, 35 T.C. 979, 1028-1040 (1961).

Section 613 permits a taxpayer holding an economic interest in oil or gas wells to take as a deduction from income 27½% of his "gross income from the property."³ This percentage depletion allowance was first added to the tax laws in 1926,⁴ primarily as a means of simplifying the administration of the "discovery depletion" allowance under which depletion had been based on the fair market value of the mineral property after the discovery of the valuable resource.⁵

Where a producer of gas is not integrated with transportation or processing facilities, and thus sells raw natural gas at the wellhead or in the immediate vicinity of the wellhead, it is a simple matter to determine his gross income from the property: it is the gross proceeds from the sale of his gas, less royalty payments. However, where the producer transports the gas from the wellhead and/or processes the gas before sale, thus increasing its sale price, difficulties arise. From the outset, the producer has been held entitled to include in gross income for purposes of the percentage depletion allowance only so much of the proceeds from the sale of the gas as he would have received had he sold the gas at the wellhead.⁶

In the early cases, however, no attention was directed to the problem of the means by which this figure was to be determined. In three of the cases cited in note 6 — Brea Cannon Oil Co., Signal Gasoline Corp., Consumers Natural Gas Co. — a fixed percentage of the gross proceeds, and in one — Greensboro Gas Co. — a fixed amount, was stipulated to be attributable to the sale of raw gas at the wellhead.

In 1929 the first regulations bearing on the problem were adopted by the Government.⁷ Slight amendments were adopted in 1933⁸ and 1936;⁹ the amended regulations applicable under the 1939 Code provided as follows:

"In the case of oil and gas wells, `gross income from the property\' as used in section 114(b) (3) means the amount for which the taxpayer sells the oil and gas in the immediate vicinity of the well. If the oil and gas are not sold on the property but are manufactured or converted into a refined product prior to sale, or are transported from the property prior to sale, the gross income from the property shall be assumed to be equivalent to the representative market or field price (as of the date of sale) of the oil and gas before conversion or transportation."¹⁰

These remain substantially unchanged under the 1954 Code,¹¹ except that the phrase "(as of the date of sale)" has been deleted. Hence, in the case of an integrated producer, it is the "representative market or field price" at the wellhead which governs. However, the regulations go no farther. They do not define "representative market or field price" nor do they explain how gross income is to be determined if there is no representative market or field price.

The tax years in question in this action for a tax refund are 1952 through 1957. During these years plaintiff, an integrated producer-convertor of natural gas, engaged in the income producing activities detailed in our findings of fact. Suffice it to say that plaintiff sold much of its gas after processing and away from the wellhead. In this action plaintiff contends that gross income for depletion purposes should be computed by multiplying the quantity of gas which it processed and sold in each year by an amount determined to be the representative market or field price for its gas at the wellhead (less royalty payments).¹² The Government, on the other hand, contends that there was no representative price for plaintiff's gas during the tax years in issue, and therefore that gross income from the property should be calculated by taking the gross proceeds from the sale of plaintiff's processed gas and its by-products and subtracting therefrom all costs attributable to gathering and processing the gas, a 10% return on the capital invested in these nonproducing functions and all royalty payments.¹³ Following the terminology in Woodward Iron Co. v. Patterson, 173 F.Supp. 251, 268 (N.D.Ala.1959), we may refer to the method of computation now urged by the plaintiff as a "market comparision" method, and to that urged by the Government as a "proportionate profits" method.

Hence, we must first determine which of these two methods is to be used. Since we conclude that the regulation requires use of a market comparison method in this case, we reach a perhaps more difficult question. The plaintiff contends that the representative market price is to be determined by considering only contracts for the sale of similar gas at the wellhead entered during each tax year in question. The Government contends that the representative price must be calculated as the weighted average price paid during the year in question for comparable gas at the wellhead under contracts in effect during that year, regardless of the year in which the contracts were entered. As to this issue, we conclude in favor of the Government. Our decision is thus in accord with that reached by the Tax Court in the Shamrock Oil & Gas case, supra.

Turning to the first question, the applicable regulations are of unquestioned validity, and are thus binding upon both parties.¹⁴ The regulations provide that gross income from the property shall be assumed the equivalent of the representative market or field price at the wellhead so that, if there is such a price, it must govern here. The Government does not contend that its proportionate profits formula yields such a representative price, but argues only that there is no such price, so that its alternative method may be utilized. We note that although the proportion of profits formula urged by the Government was expressly adopted in the regulations applicable to mining under the 1939 Code,¹⁵ the formula applied only if a representative market or field price could not be ascertained by use of the market comparison method.¹⁶

The Government contends that there is no representative or field price for plaintiff's raw gas at the wellhead. Because there are a variety of factors causing differences in the value of natural gas located within the same or nearby fields,¹⁷ because relatively small proportions of gas are sold at the wellhead, and because almost all such sales are under long-term contracts, it is indeed a difficult task to construct a market price at which particular gas would have sold had it been marketed at the wellhead. The determination of such a price requires that:

"there have been recent, substantial, and comparable sales of like gas to gasoline extracting plants, carbon black plants, and the like, from wells in the area whose availability for marketing is reasonably or substantially similar to that of the gas here involved.

* * * * * *

"* * * the test is what do * * * purchasers pay for gas similar in quantity, quality, and availability to market?" Phillips Petroleum Co. v. Bynum, 155 F.2d 196, 198, 199 (C.A. 5), cert. denied, 329 U.S. 714, 67 S. Ct. 44, 91 L.Ed. 620 (1946).

If evidence of substantially comparable sales can be shown, however, the price so derived is not to be disregarded merely because it is an approximation.

In the present case, the plaintiff presented evidence of sales of gas during the tax years in question sufficiently comparable to its own gas to permit an approximation of the price at which its gas would have sold at the wellhead. The plaintiff presented evidence of 20 contracts for the sale of gas entered during the five tax years in question. Most, though not all, were for sales at the wellhead. A few were for sales from the Hugoton Field, in which the plaintiff's fields are located, while most were for sales from the Hugoton Embayment, the larger area in which the Hugoton Field is located but which extends into Oklahoma and Texas. Plaintiff presented expert testimony to the effect that the gas involved in the particular contracts was comparable to plaintiff's gas and that the price obtained in those contracts was the minimum amount which plaintiff would have obtained for the sale of its gas at the wellhead during the respective years.¹⁸

The Government urges that the contracts do not involve gas comparable in quality and marketability to the plaintiff's gas. But although the Government points to several differences, it presented no evidence that the differences were significant or would have affected the price which plaintiff could have obtained for its gas. For example, the Government stresses that the sales for the most part were outside the Hugoton Field; but plaintiff's experts testified that competition exists throughout the larger Hugoton Embayment and the Government has presented no reason to believe that the sale price would differ because of a difference in location within the Embayment. The Government points out that most of the contracts were for gas located in Oklahoma or Texas, rather than Kansas, and that "each state has its own...