BLANCHE, Justice.
Plaintiff landowners seek to recover outstanding royalty payments allegedly due under several gas leases executed between plaintiffs as lessors and defendants as lessees. Where gas is produced and then sold off the leased premises, the leases provide for royalty payments to the lessors equal to a percentage or fraction of the market value of the gas sold. Definition of the term "market value" in the context of these gas leases is at the heart of this dispute. Defendants have paid royalties based upon the price received from an interstate purchaser pursuant to a long term sales contract executed in 1961. In essence, defendants maintain that the 1961 contract price is equal to the market value of the gas under the royalty provisions of the gas leases. Plaintiffs assert that royalties are to be calculated on the basis of the current market value of the gas, a value greatly in excess of the 1961 contract price.
The issue presented by this litigation was set out by the court of appeal:
Is the amount due the lessors as royalty under these leases to be based upon the prevailing market value at the time the gas was committed to the purchaser by the lessees under a long term gas sales contract, or is the royalty to be based instead upon the current market value determined on a daily basis the moment the gas is produced and/or delivered to the purchaser? Henry v. Ballard Cordell, 401 So.2d 600 (3rd Cir. 1981), at p. 602.
As noted by the appellate court, this issue is res nova in Louisiana, although it has been the subject of considerable litigation in other jurisdictions. The magnitude of interests affected by its resolution in Louisiana mandated our decision to grant writs in these consolidated cases.
See e.g. Foster v. Atlantic Refining Company, 329 F.2d 485 (5th Cir. 1964); Texas Oil Gas Corp. v. Vela, 429 S.W.2d 866 (Tex. 1968); Lightcap v. Mobil Oil Corp., 221 Kan. 448, 562 P.2d 1 (1977), cert. den. 434 U.S. 876, 98 S.Ct. 228, 54 L.Ed.2d 156 (1977), motion for rehearing denied, 440 U.S. 931, 99 S.Ct. 1272, 59 L.Ed.2d 489 (1979); Tara Petroleum Corp. v. Hughey, 630 P.2d 1269 (Okla. 1981).
The leases at issue affect property in the Cameron Pass Field in Calcasieu Parish. The royalty provisions of the respective leases read as follows:
Davis Lease No. 1, dated March 19, 1953:
Royalty Provision:
On gas, including casinghead gas or other gaseous substance and liquid hydrocarbon content thereof, produced from said land and sold or used off the premises, or for the extraction of gasoline or other products therefrom, the market value at the wells of one-eighth of the gas so sold or used; provided that on gas sold at the wells, the royalties shall be one-eighth of the amount realized from such sale; . . .
Davis Lease No. 2, dated December 10, 1960:
Royalty Provision:
One-sixth (1/6) of the market value of the gas sold or used by Lessee in operations not connected with the land leased or any pooled unit containing a portion of said land; . . .
Davis Lease No. 3, dated June 22, 1964:
Royalty Provision:
18.5% of the market value of the gas sold or used by Lessee in operations not connected with the land leased or any pooled unit containing a portion of said land;
. . .
Rogers Lease, dated September 7, 1962:
Royalty Provision:
On gas, including casinghead gas or other gaseous substance produced from said land and sold or used off of the premises, or used in the extraction of gasoline or other product therefrom by Lessee, the market value at the well of one-fourth (1/4) of the gas sold or used, provided that on gas sold at the well the royalties shall be one-fourth (1/4) of the amount realized from such sale; . . .
The leases were found to be productive of natural gas in 1961. Pursuant to its contractual obligation to diligently market the production, Ballard Cordell executed a sale of the gas to American Louisiana (now Michigan Wisconsin) Pipeline Company, an interstate purchaser of natural gas and the only available market for gas from the Cameron Pass Field in 1961.
The implied covenants which burden the lessee's interest include, among others, the covenant to protect the lease from being drained of hydrocarbons, the covenant to reasonably develop the leased premises, the covenant to market production obtained from the leased premises with dispatch, the covenant to use reasonable care in operations conducted on the lease, and when appropriate, the covenant to seek favorable administrative action to aid the discharge of the lessee's duties under the lease. See R.S. 31:122.
Evidence at trial conclusively established that negotiations between Ballard Cordell and American Louisiana were conducted in good faith and at arm's length and that the resulting sales contract was quite favorable from the standpoint of both defendants and plaintiffs-lessors. The price obtained in the sale was equal to or better than prices in comparable sales made at that time. The price escalation clause, which provided for price increases over the term of the contract, was among the best contained in any such sale. The sales contract extended for a term of 20 years, a customary term for such contracts in the natural gas industry in 1961. Long term sales contracts (extending for as long as the life of the lease) were universally insisted upon by pipeline purchasers to enable them to obtain requisite financing for the construction of capital intensive pipeline facilities.
"Unlike liquid hydrocarbons, gas cannot be stored in surface containers, nor can it be transported by truck. Rather, gas normally is marketable only when the reserves in the field where the lease is situated justify the sizeable capital expenditure necessary to construct and lay a pipeline capable of transporting the gas to its market destination. Pipeline systems, of course, are complex creatures and are quite expensive to construct. Investors traditionally have not been willing to build pipelines unless gas is available in a sufficient quantity and has been committed to the pipeline for an adequately long period, thereby providing the investors with reasonable assurance that they will make a profit on their investment. Thus, the justification for the capital expenditure necessary to construct the pipeline usually comes in the form of long-term gas sale contracts which effectively commit the volume of gas to be sold to the purchaser who will transport the gas through its pipeline to the point of consumption.
Holliman, Exxon Corp. v. Middleton: Some Answers but Additional Confusion in the Volatile Area of Market Value Gas Royalty Litigation, 13 St. Mary's L.J. 1 (1981).
Beginning with the first deliveries of gas to American Louisiana, defendants have made royalty payments to the plaintiffs landowners based on the proceeds actually received for the sale of gas production from the leases under the 1961 sales contract. In 1976, the sales contract price first became out of line with the current market value of natural gas. In 1978, as the disparity between the 1961 sale contract price and prices paid by purchasers in more recent contracts continued to increase, plaintiffs filed this suit for outstanding royalties, contending the leases provide that royalty payments must be calculated on the basis of the current market value of the natural gas.
Plaintiffs' argument relies heavily on the 1934 case of Wall v. Public Gas Service Co., 178 La. 908, 152 So. 561 (1934). In Wall, this Court was required to interpret a mineral lease royalty clause which provided for royalties based upon "the value of such gas calculated at the market price". The controversy in Wall centered on whether the royalties were to be calculated on the basis of the market price in the field, or the market price where the gas was sold (a point two miles from the field). In dicta, however, the Wall court adopted Webster's definition of market price as "the price actually given in current market dealings." (Emphasis supplied in Wall).
The trial court held that the market value provisions of the royalty clauses at issue require that royalties be paid on the basis of current sales, including sales made in the higher-priced intrastate market, which remained unregulated until 1978. Accordingly, the court ordered defendants to account to plaintiffs from September 1976 through the date of judgment for the difference between proceeds actually received under the 1961 sales contract and the current market value of the gas attributable to the fractional share of plaintiffs.
In its opinion, the trial court adopted the following definition of market value:
". . . the market value of a thing is the price which it might be expected to bring if offered for sale in the market."
On appeal, the Third Circuit reversed the trial court judgment. Acknowledging that the market value of a thing is the price which it might be expected to bring if offered for sale in the market, the court of appeal did not agree with the conclusion of the trial court that the term "market value", standing alone, clearly means current market value. Instead, the court of appeal found that the parties to these lease contracts "intended for the royalties to be governed by the market value of the natural gas which prevailed in 1961 when the gas was committed to the purchaser under the gas sales contract rather than by the current market value, to be determined on a daily basis as gas is produced and or delivered to the purchaser." 401 So.2d 600, at p. 604.
For the reasons hereinafter assigned, we affirm the decision of the court of appeal.
The ambiguity in the language of the royalty provisions arises from the failure of the parties to the lease to expressly state whether "market value" means current market value. We note that the same or similar contract language has often been interpreted by the courts of other jurisdictions, and that these cases may be clearly divided according to two distinct lines of legal reasoning.
Although the majority of jurisdictions have interpreted the ambiguity in the royalty provisions against the lessee, they have done so by ignoring the practical realities of the oil and gas industry, and the obligations of the lessee to market the gas at the best possible price at the time the leases were made. These cases hold that the lessee is obligated to pay royalties based upon the current market value of the natural gas, and that this royalty obligation is unaffected by the contracts executed by the lessee for the sale of the gas.
See, e.g. Texas Oil Gas Corp. v. Vela, supra; Lightcap Mobil Oil Corp., supra; Exxon Corp. v. Middleton, 613 S.W.2d 240 (Tex. 1981).
The majority position has been most notably set forth by the Texas Supreme Court in Texas Oil Gas Corp. v. Vela, 429 S.W.2d 866 (Tex. 1968). The mineral lease at issue in Vela provided for royalty payments on gas sold or used off the premises of "1/8 of the market price at the wells." In 1935, two years after execution of the lease, the lessees committed the gas to certain "life-of-the-lease" sales agreements. At the time suit was filed, prices received by others under more recent sales contracts covering gas produced by the same field far exceeded the proceeds generated under the 1935 agreement. The royalty owners contended that the term "market price" as used in the royalty provisions of the mineral lease referred to current prices in the area, rather than the price received under the 1935 sales contract. The Texas Supreme Court agreed.
The Texas Supreme Court recently affirmed its Vela doctrine in Exxon Corp. v. Middleton, supra.
Noting that none of the royalty owners had ever agreed to accept royalties on the basis of the price stipulated in the gas sale agreements, the Texas Supreme Court held that, regardless of the economic realities inherent in the marketing of natural gas, the royalties to which the owners were entitled "must be determined from the provisions of the oil and gas lease, which was executed prior to and is wholly independent of the gas sales contracts." Texas Oil Gas Corp., supra, at p. 870.
As in the instant case, the lessees in Vela presented evidence there was only one available market for the gas at the time of its discovery; the gas could only be sold pursuant to a life-of-the-lease sales agreement. The trial court found that the sales agreements were entered into in good faith and that finding was not attacked on appeal.
In another portion of its royalty clause, the Vela lease provided for calculation of royalties on casinghead gas on the basis of actual proceeds received from the sale of that type of gas. Citing this language, the Vela court concluded that the parties knew how to provide for royalties payable on some basis other than market value and could easily have done so in the case of gas well gas. Instead, the parties to the lease "stipulated in plain terms that the lessee would pay 1/8 of the market price at the well of all gas sold or used off the premises. This clearly means the prevailing market price at the time of use or sale. The gas which was marketed under the long-term contracts in this case was not `being sold' at the time the contracts were made but at the time of the delivery to the purchaser. [citation omitted]. We agree with the Court of Civil Appeals, therefore, that the contract price for which the gas was sold by the lessee is not necessarily the market price within the meaning of the lease." Texas Oil Gas Corp., supra, at p. 871.
The Texas Supreme Court in Vela relied heavily upon the decision by the 5th Circuit Court of Appeal in Foster v. Atlantic Refining Company. Analysis of the 5th Circuit's opinion in Foster indicates that reliance is misplaced. In Foster, the court was required to interpret an atypical royalty clause calling for market price when the gas is run. The Foster court emphasized that the clause expressly provided for the payment of royalty based upon the market price prevailing in the field where the gas was produced at the time of delivery. Such an express provision is conspicuously absent in the type of royalty clauses interpreted by the Courts in Vela and its progeny.
The practical and economic necessities of the oil and gas industry at the time the leases were negotiated are given little or no consideration in the line of cases represented by Vela. Because such factors necessarily would have bearing upon the intent of the parties concerning payment of royalties, the result reached in those cases has been greatly criticized. Among those factors demanding consideration are the following:
See Harrell, Developments in Non Regulatory Oil Gas Law, The 30th Annual Institute on Oil Gas Law Taxation, Southwestern Legal Foundation, 311 (1979); Summers. The Law of Oil Gas, Sec. 589, p. 12, et seq. (1981 Supp.); Holliman, Exxon Corp. v. Middleton: Some Answers but Additional Confusion in the Volatile Area of Market Value Gas Royalty Litigation, 13 St. Mary's L.J. 1 (1981); Fischer, Ascertaining the Value or Price of Gas for Purposes of the Royalty Clause, 21 Okla.L.Rev. 22 (1968).
(1) Where the mineral lease provides for payment to the lessor of a fractional royalty interest, the lease arrangement is in the nature of a cooperative venture: the lessor contributes the land and the lessee the capital and expertise necessary to develop the minerals for the mutual benefit of both parties. "From this arises the affirmative, although implied obligation of the lessee to market or dispose of the product in a reasonable and prudent way to secure the maximum benefit possible for both parties."
Harrell, Developments in Non Regulatory Oil Gas Law, supra.
(2) The ultimate objective of the royalty provisions of a lease is to fix the division between the lessor and lessee of the economic benefits anticipated from the development of the minerals. In the case of oil, a truly fungible product, the lessor is usually given a fractional part of the production, with authority to take or dispose of it as he desires. "Most leases recognize such an arrangement is neither practicable nor realistic for gas. Consequently, they usually contemplate that the lessee will dispose of the gas (in a prudent manner) and pay the lessor the fractional part of the value which he is to enjoy from the enterprise."
Id. at p. 335. Indeed, professor Harrell contends that:
. . . any determination of the market value of gas which admits the lessee's arrangements to market were prudently arrived at consistent with the lessee's obligation, but which at the same time permits either the lessor or lessee to receive a part of the gross revenues from the property greater than the factional division contemplated by the lease, should be considered inherently contrary to the basic nature of the lease and be sustained only in the clearest of cases. At p. 336.
(3) "When most leases currently in production were executed, and certainly until quite recently, it was neither practical nor would it have been prudent for a lessee to refuse to sell the gas under a long-term contract. Such prices were generally higher than the so-called spot or short-term price."
Id. at p. 335.
The Oklahoma Supreme Court in its recent opinion in Tara Petroleum Company v. Hughey, 630 P.2d 1269 (Ok. 1981) took full cognizance of these and other factors in holding:
. . . When a producer's lease calls for royalty on gas based on the market price at the well and the producer enters into an arm's-length, good faith gas purchase contract with the best price and term available to the producer at the time, that price is the "market price" and will discharge the producer's gas royalty obligation. Supra, at p. 1273.
Representative of the minority position on this issue, the Tara court emphasized the duty under which the lessee operates to diligently market gas produced under a lease, and that this duty usually requires the lessee to enter long-term contracts for the sale of the gas.
We have recognized this necessity of the market, and we believe that lessors and lessees know and consider it when they negotiate oil and gas leases. Lessors and lessees also know that during the term of a gas purchase contract gas prices may increase, perhaps substantially. During the term a producer's revenues, fluctuations in production aside, will not increase. Yet if royalty must be paid on the basis of a "current," steadily increasing "prevailing" price, then the lessor's share will take an ever larger and larger proportion of the producer's revenues.
* * * * * *
We believe that our interpretation of "market price" is consonant with the intent and understanding of parties to oil and gas leases. And it is the only interpretation that would operate fairly for producers. Moreover, it is not unfair to lessors. Quite naturally, lessors want to receive as much royalty as possible, but lessees in their own interest seek as good a price as they can get for gas. As long as the contract was reasonable when entered into, and as long as our law recognizes long-term gas purchase contracts as binding in the face of escalating prices, the law should not penalize the producer who was forced into the contract in large measure by his duty to the lessor. Now if the contract was not reasonable when entered into, if it is not at a minimum fair and representative of other contracts negotiated at the time in the field, then a different result obtains. Then the lessee has not protected his lessor in discharging his duty to market the gas, and there is no policy in the law requiring the courts to protect the lessee in interpreting the lease. Supra at pp. 1273 and 1274.
Like the Oklahoma court in Tara, we believe that ambiguity in royalty provisions such as those at issue in this litigation cannot be resolved without consideration of the necessary realities of the oil and gas industry. Strong support is found for this minority position in the articles of our civil code applicable to the interpretation of contracts. See C.C. arts. 1945, et seq. and C.C. arts. 1964, 1966.
Article 1950 of the Civil Code directs us to endeavor to ascertain the common intention of the parties to the contract, where there is anything doubtful in their agreement. In ascertaining this intention (where it cannot be adequately discerned from the contract or agreement as a whole) the circumstances surrounding the parties at the time of contracting are a relevant subject of inquiry. Cooley v. Meridian Lumber Co., 195 La. 631, 197 So.2d 255, 258 (1940). In the instant cases, the known obligation of the lessee to market discovered gas reserves, and the accepted universal practice of marketing such reserves under long-term gas sales contracts provide the background against which these leases were executed.
Andrews Coal Co. v. Bd. of Directors of Public Schools, Parish of Orleans, 151 La. 695, 92 So. 303, 304 (1922). In interpreting a contract "it should be construed in the light of the circumstances surrounding [the parties] at the time it is made, it being the duty of the court to place itself as nearly as may be in the same situation of the parties at the time, so as to view the circumstances as they viewed them, and so to judge the meaning of the words and the correct application of the language of the contract. [Quoting from 13 Corpus Juris, p. 525]. See also Arts. 1945, 1950, 1951, 1955 and 1956.
The custom of the industry may also be considered in determining the true intent of the parties as to ambiguous contract provisions. C.C. arts. 1964, 1966; Fee v. Vancouver Plywood Co., Inc., 331 So.2d 151 (La.App. 3rd Cir. 1976), writ den. 334 So.2d 434 (1976). At trial, defendants presented unrefuted evidence that customary practice in the oil and gas industry required the lessee to pay "market value" royalties on gas in dollar amounts equivalent to the price received under a long-term sales contract (less permissible transportation charges), and the lessors to accept royalty payments so calculated.
Art. 1964. Incidents Supplied by law, equity or usage. Equity, usage and law supply such incidents only as the parties may reasonably be supposed to have been silent upon from a knowledge that they would be supplied from one of these sources.
Art. 1966. Usage as part of contract. By the word usage mentioned in the preceding articles, is meant that which is generally practiced in affairs of the same nature with that which forms the subject of the contract.
Applying the pertinent rules of contract interpretation to the evidence presented in these cases, we find the parties to the mineral leases at issue intended that royalties based on the "market value" of the gas be computed on the basis of the price received for the gas under the 1961 sales contract.
We emphasize that plaintiffs-lessors have never contended in these cases that the 1961 gas sales contract was not made in good faith, or was unreasonable in any respect, whether as to price, contract term or otherwise. On the contrary, when the gas was discovered in 1961, because of the geographical isolation of the Calcasieu Pass Field, there was but one economically feasible market for the gas — the interstate pipeline of American Louisiana. American Louisiana would only agree to purchase the gas under a 20-year sales contract. Uncontradicted evidence at trial established that the price obtained by defendants in the 1961 sale was equal to or better than prices obtained in similar sales in the relevant market area at that time.
As noted by the court of appeal:
The effect of holding in plaintiffs' favor would be to force the lessees to pay to the lessors many times more for their fractional royalty interests than the lessees actually received for all the gas. 401 So.2d at 608.
We do not propose to penalize defendants' good faith compliance with their lease obligations by requiring them to pay royalties based on a current, fluctuating, day-to-day market value of gas several times higher than the price received by them in a sales contract admittedly in the best interest of both lessors and lessees. Had plaintiffs shown that the purpose of the market value royalty clause was to provide them with protection as to price, regardless of what disposition is made of the gas by lessee and regardless of what price was received, then we would arrive at a different conclusion.
But plaintiffs have given us little help, except to claim that we have departed from our long-standing position in Wall, supra. As noted by the court of appeal, the Wall court was not concerned with whether the current market price, as opposed to a past market price was to be used in determining royalty amounts. Apparently, all parties in Wall agreed that the royalties were to be based upon the current market price at the time the gas was produced. None of the parties in Wall introduced evidence of a contrary intent.
In the instant case, only defendants have presented evidence of the intent of the parties to the mineral lease. All of this evidence indicates that the parties intended for a past, rather than a current, market value to control computation of royalties. As did the court of appeal, we find the Wall case clearly distinguishable on this basis.
Therefore, considering all of the circumstances set forth hereinabove which surrounded the parties at the time of contracting, the known obligation of the lessee to market discovered gas reserves, and the accepted, universal practice of marketing such reserves under long-term gas sales contracts, "market value" in the context of these leases could only mean the "market value of the gas when it was marketed under the 20 year gas sales contract.
For the foregoing reasons, the decision of the court of appeal is affirmed.
AFFIRMED.
CALOGERO, J., assigns additional concurring reasons.
DENNIS and WATSON, JJ., dissent and assign reasons.
LEMMON, J., dissents and will assign reasons.