Indonesia explores new model
Indonesia, the country that is credited with giving the petroleum world the petroleum production sharing agreement (PSC) in the nineteen sixties, now seems to be walking away from the model. Under that model, the profit determined after deducting prospecting, exploration, production and operating costs is shared between the host state and the oil company in agreed percentages. Not surprisingly, disputes over what could and could not be deducted were frequent. So from the beginning of this year, that country took a huge step toward eradicating the cost recovery regime for upstream cooperation contracts.
To be clear, the new rules do not affect contracts signed prior to that date. The new system, called the Gross Split Production Sharing Contracts sets out a new economic structure for production sharing contracts (“PSC”) based on dividing gross production between the state and PSC Contractors, without a mechanism for the PSC Contractor to recover operating costs.
Unlike existing PSCs, Gross Split PSCs contain no mechanism for PSC Contractors to recover sunk costs before any sharing with the State. Those familiar with the concession/royalty system would no doubt see the new system as a high rate royalty arrangement where the government’s share comes off the top and leaves the responsibility for all expenditure to the operator. The required capital for operations is to be fully funded – and the risk of operations is to be fully borne – by the PSC Contractor. Not that the new system does not have its own complexities. In fact it does. The percentage gross split for a field is determined by starting from a base allocation, adjusted first by several “variable” components and second, “progressive” components.
Under the system, the base split for oil is 57 percent—43 percent for the state and the contractor respectively while the base split for gas is 52 percent—48 percent for the State and Contractor respectively. The factors taken into account as the variable components are those which address specific matters affecting the cost of developing and commercialising the field. These are: (i) the location of the field (onshore or offshore, and if offshore, the water depth); (ii) the type (conventional or unconventional) and depth of the reservoir; (iii) the availability of supporting infrastructure; (iv) whether the field contains heavy oil or the petroleum specification requires additional costs to be incurred due to high levels of carbon dioxide or hydrogen sulphide; (v) the availability of required equipment and goods in the domestic economy; and (vi) whether the field is in the primary, secondary, or tertiary phase of production.
Additionally, a 5 percent uplift to the Contractor’s split will also be given for a plan of development that is developed for the first time in a PSC work area, most likely the exploration phase. Accordingly, no such 5 percent uplift is available for subsequent plans of development in the PSC work area, or for additional work under an existing plan of development. It works both ways however – a 5 percent reduction in the Contractor’s share of petroleum may also be applied in certain circumstances.
The “progressive” components focus on the revenue generated from the field and adjust the gross split from time to time by reference to the Indonesian Crude Price (“ICP”) and the cumulative total production of oil and gas from the field.
On the face of it, it does seem that the pact weighs heavily against the oil company. However, PWC reports hearing of one Gross Split PSC agreed to date (being for a mature field) actually set at 42.5%: 57.5% Government/Contractor, suggesting the embedded flexibility of the new scheme. Surprisingly, the new scheme seems not to be the biggest problem. Companies fret over bureaucratic delays encountered from having to deal with multiple government institutions outside the control of Ministry of Energy and Mineral Resources such as those responsible for tax, forestry, environment, etc.), as well as local government authorities.
There should be no suggestion that costs are irrelevant. Like any investor, oil companies need to recover their investments as well as their operating costs but under the Gross Split system they do this as deductible expenses from their gross income. No doubt the disputes which arose under the pre-2017 production sharing agreement will now move down from the determination of profit oil to the ascertainment of taxable profit.
Seeking to justify the move, Indonesia’s Energy and Mineral Resources Minister Ignasius Jonan is reported to have said that some people “for years misused the cost-recovery system” and that the new rules will ensure a fairer return for Indonesia for its oil. “I try to be fair to the business and to the public that owns the resources,” he added by way of defence.
While the accounting firm PWC characteristically suggests that it may be too early to determine whether the Gross Split scheme will promote or discourage investment, other commentators, and indeed oil companies themselves, seem unimpressed. In July of this year, Exxon Mobil of the USA withdrew from the East Natuna natural gas project, following the earlier exit of Thailand’s PTT Exploration & Production Plc. There is some doubt whether PT Pertamina, the state oil company has the technical and financial resources at its disposal to develop one of the largest untapped fields in the world.
Industry watchers and analysts wonder both about the logic for the move at a time when some oil companies have been walking away from the country. The sector which has had a long and relatively successful history in Indonesia, has seen its contribution to GDP decline from 6% to 3% in a mere five short years. Using a different measure and a slightly longer, but still short horizon, the situation is probably grim: a decade ago, the sector contributed 25% of the state’s revenue. Now it is less than 5%!
Offering no sign for optimism, during the four-year period 2012 to 2016, investment for exploration in Indonesia shrank from $1.3 billion to $100 million in 2016 and causing Tony Regan, an independent oil and gas consultant based in Singapore, to express the defeatist situation of “an acceptance that oil production is declining rather than saying we can turn this around.”
With a production sharing agreement not dissimilar to that invented and widely used by Indonesia for decades, Guyana may find lessons from that country which would be very instructive.