Scofield v. La Gloria Oil and Gas Company

• Decision Date: 09 October 1959
• Docket Number: No. 17196.,17196.
• Citation: 268 F.2d 699
• Parties: Frank SCOFIELD, formerly Collector of Internal Revenue, First District of Texas, Appellant, v. LA GLORIA OIL AND GAS COMPANY, and La Gloria Corporation, a dissolved Texas Corporation, Appellees.
• Court: U.S. Court of Appeals — Fifth Circuit

268 F.2d 699 (1959)

Frank SCOFIELD, formerly Collector of Internal Revenue, First District of Texas, Appellant, v. LA GLORIA OIL AND GAS COMPANY, and La Gloria Corporation, a dissolved Texas Corporation, Appellees.

No. 17196.

United States Court of Appeals Fifth Circuit.

June 16, 1959.

Rehearing Denied October 9, 1959.

C. Moxley Featherston, Marvin W. Weinstein, Lee A. Jackson, Dept. of Justice, Washington, D. C., Carles K. Rice, Asst. Atty. Gen., Russell B. Wine, U. S. Atty., John E. Banks, Asst. U. S. Atty., San Antonio, Tex., for appellant.

Marvin K. Collie, Houston, Tex., Binford Arney, Corpus Christi, Tex., Clyde L. Wilson, Jr., Houston, Tex., Vinson, Elkins, Weems & Searls, Houston, Tex., for appellees.

Before TUTTLE, JONES and BROWN, Circuit Judge.

TUTTLE, Circuit Judge.

This appeal presents the question whether La Gloria Oil and Gas Company is entitled to the statutory depletion allowance of 27½% of its gross profits from the sale of certain heavier hydrocarbons it extracted from wet gas delivered to it for such extraction and recycling by owners of the gas. The answer to this question depends upon whether the complex contractual relations between La Gloria and the owners of the leasehold interests in the gas created in La Gloria an economic interest in the minerals in place, and, if so, whether the entire income from the sale of the heavy hydrocarbons is a part of the production and thus "income from the property" or in part is a result of processing, subsequent to the completion of production.

We decide the first question in the negative, and thus do not reach the second.

The statutory basis for the depletion for the years in question is to be found in Section 23(m) and in Section 114(b) (3) of the Internal Revenue Code of 1939.¹

The facts giving rise to the litigation here are not in dispute. Although complex, they must be understood precisely before the court can match them with other situations on which the courts have heretofore acted. As here reproduced, the statement is taken largely from the taxpayers' brief. The statement, however, includes some matters which are undisputed, but not included in taxpayers' recitation.

In 1940, certain oil and gas companies and individuals owned interests in undeveloped oil and gas leases in the La Gloria Field area. The La Gloria Field area is a multiple-sand oil and gas field in Jim Wells and Brooks Counties, Texas. This area includes the "La Gloria Unit," the "South La Gloria Unit," and the "Moos Unit." The thirty-five producing zones of this field contain reserves of oil and natural gas; approximately 94% of the natural gas consists of the lighter hydrocarbon compound of methane and approximately 6% thereof consists of heavier hydrocarbon compounds. Each of these hydrocarbon compounds exists in a natural vapor state in high pressure reservoirs.

Prior to June 4, 1940, (the date of the first contract with which we are here concerned) five exploratory wells had been drilled in the filed of Magnolia, et al., and established the existence of the hydrocarbon compounds in some of the reservoirs underlying a portion of certain leases. There existed the contingent possibility that the drilling of a number of additional wells would develop substantial reserves of additional hydrocarbon compounds.

Insofar as the La Gloria Field was concerned, there existed no available substantial market for methane, but there did exist available markets for some of the heavier hydrocarbon compounds. Under the conservation laws of Texas, production of natural gas from the La Gloria Field, and the separation therefrom of the heavier hydrocarbon compounds, followed by the flaring of the residue gas (methane) would have constituted physical waste and would not have been permitted. Therefore, the only existing feasible means of producing an economic return from the natural gas reserves was a method of separating the marketable heavier hydrocarbon compounds from the natural gas and then returning the remaining residue to the gas producing formations. The common method of producing and separating such hydrocarbons is cycling, which is the process for producing the maximum quantity of heavy hydrocarbons contained in the high pressure gas in gas reservoirs.

Not only was this production procedure necessary to prevent the waste of the residue gas, but the injection of the residue gas was necessary to maintain pressure in the reservoir. If the reservoir pressure was not maintained by cycling (the only method available), retrograde condensation would occur.

Retrograde condensation is a natural phenomenon that only occurs in high pressure gas reservoirs above a pressure of 1200 pounds.

Through cycling, La Gloria will be able to recover 8,800,000 barrels of heavier hydrocarbons that otherwise would have been lost by retrograde condensation.

Through the medium of an instrument dated June 4, 1940, La Gloria entered into a legal relationship with Magnolia Petroleum Company, et al., the then owners of undeveloped gas leaseholds in the La Gloria Field. The general substance and economic effect of such instrument was as follows:

(1) La Gloria would use its best efforts to unitize the participating area.

(2) Upon obtaining requisite unitization agreement, La Gloria at its expense would construct a cycling plant equipped with necessary appliances, gathering and return lines, with capacity of 150,000,000 cubic feet of gas per day, designed and constructed to process gas for the recovery of natural gasoline, condensate and other products and to return the residue gas (methane) at high pressure into the producing formations. To the extent of 150,000,000 cubic feet of gas per day the plant was exclusively dedicated to the participating area of Magnolia, et al.

(3) At the time operations were commenced for the construction of the cycling plant, La Gloria at its initial expense, would drill and equip a sufficient number of gas wells (not exceeding 20), the number and location and specifications to be determined by Magnolia, to enable production of 150,000,000 cubic feet of gas per day and input wells for the return of gas to the producing formations. La Gloria was to be repaid for such well costs from Magnolia's share of production.

(4) When the cycling plant was ready for operation, La Gloria agreed to operate the plant, take and process the gas for the recovery of heavier hydrocarbons, and to return the residue gas (methane) into the producing formations through input wells furnished by Magnolia, and to continue such taking and processing and return of residue gas during the life of the agreement with the exception that La Gloria could but was not obligated to take gas having less than specified minimum GPM content. The term of the agreement was for the life of the leases, with La Gloria having the right to suspend operations if production diminished below, and was not thereafter increased to, a designated minimum quantity. Under stated conditions La Gloria could process gas of others not parties to the contract.

(5) In consideration of La Gloria's investment and undertakings it acquired 50% of the heavier hydrocarbons "contained in all gas to be produced from" said leases.

Through the medium of an instrument dated June 16, 1941, La Gloria entered into a further legal relationship with Magnolia Petroleum Company, et al. (different owners from the first contract), the then owners of other undeveloped gas leaseholds in the South La Gloria Field. Through the medium of an instrument dated May 31, 1943, La Gloria entered into a legal relationship with The Texas Company, et al., the then owners of other undeveloped gas leaseholds in the Moos Unit. The general substance and economic effect of both instruments is similar to that stated with reference to the first instrument, dated June 4, 1940.

La Gloria on October 24, 1940, obtained from the Railroad Commission of Texas a special order permitting recycling (cycling) of gas in the La Gloria Field. The Commission found that "the proposed plan for recycling will not result in physical waste, but will permit the recovery of a greater volume of liquid products."

Pursuant to such legal relationships La Gloria secured execution of unitization agreements, constructed its natural gas cycling plant with requisite processing facilities, compressors, gathering lines, return lines and meter stations, and constructed additions to and expansions of such facilities, caused sixteen gas wells to be drilled and equipped in the field; all of which expenditures aggregated approximately $5,452,000. It was reimbursed from the owners' share of the minerals for the cost of drilling and equipping the wells.

The flow of the gas in the cycling process is summarized as follows: The high pressure gas was produced from the reservoir up through the well bore through the producing well, through the gathering lines into the plant, the heavier hydrocarbons were removed in the plant, the residue gas (methane) coming out of the plant was compressed to a pressure higher than the reservoir pressure, flowed from the compressors back through the return line into the injection well down through the well bore, back into the reservoir, and the dry injected gas displaced and swept the wet gas containing the heavier hydrocarbons in the reservoir toward the producing well.

An accurate but simplified description of the flow of gas and the hydrocarbon compounds in the separation facilities may be summarized as follows: The wet field gas flowed through the coolers, through regulators where a pressure drop was taken, into separators where as a result of change in pressure and temperature a portion of the heavier hydrocarbons fell out as a liquid by gravity and flowed to the raw feed tanks. The gas containing the remainder of the heavier hydrocarbons flowed from the separators into absorbers, and there came into contact with absorption oil; the additional hydrocarbons were scrubbed...