This is the new era for the oil and gas business in Indonesia.

Prahoro NURTJAHYO Adviser on Investment and Infrastructure Development MINISTRY OF ENERGY AND MINERAL RESOURCES

New era of oil and gas in Indonesia

March 9, 2018

Prahoro Nurtjahyo, adviser on investment and infrastructure development at the Ministry of Energy and Mineral Resources, explains the new gross-split regime, the legal framework behind it and its expected impact on Indonesia’s oil and gas industry. The terms of PSCs were overhauled when the government opted to switch from a cost-recovery model to a gross-split model, removing the burden of cost recovery from the government and courting foreign investors with more attractive terms.

On investment: “The upstream oil and gas industry is a long-term business, but that does not mean that long-term economic variables cannot be agreed between the government and the contractor, for example predicted future oil prices. That is part of the risk that must be calculated by both parties.”

On efficiency: “The GS PSC encourages the contractor to work as efficiently as possible, since the business model underlying the GS PSC contract concept is based the size of the investment return and the profits to be gained by the contractor, and it critically depends on how efficient they are in running their petroleum operations.”

On local content: “The implementation of the GS PSC does not abolish the contractor’s obligations to use domestic goods and services.”

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The government regulation on gross-split production-sharing contracts, GR No. 53/2017, was signed by President Joko Widodo on December 27, 2017, and marked a new era of investment in the upstream oil and gas business in Indonesia. Substantially, GR No. 53/2017 addressed the taxation aspect of the gross-split production-sharing contract [GS PSC] arrangement, providing certainty to the contractor so the economics become logical and attractive.
There is no taxation from the exploration stage until first production, losses can be carried forward up to 10 years, it allows for accelerated depreciation, and the imposition of indirect tax during production period is calculated in the economics to be compensated through split adjustment. With the release of GR No. 53/2017, taxation issues, which were previously the main concerns of business actors, have been sufficiently answered.
By introducing GS PSC in 2017, the government finally succeeded in attracting investors to invest in the oil and gas business in Indonesia, after two consecutive years of receiving less interest from prospective firms in oil and gas block auctions. Two days after the signing of the GR, the Ministry of Energy and Mineral Resources [MEMR] announced five out of the 10 conventional working areas offered had received firm bids. More interestingly, not just local players actively participated in bidding, but also global and international companies including some of the old players such as Mubadala Petroleum of Abu Dhabi, Repsol Exploración of Spain, Premier Oil of the UK and KrisEnergy of Singapore.
For almost a year, dialogues have been carried out intensively with all stakeholders in order to achieve a comprehensive overview of the GS PSC. A thorough understanding of all aspects – including the taxation system, legal basis, mutual benefit for both the government and contractors, economics, reciprocity, local industry, technological proprietary, Indonesian human resource competency and so on – is required. Implementation of the gross-split revenue sharing contract does not mean to diminish the role of the government, but rather to preserve the sovereignty of the state while safeguarding the economics for the contractors. It is intended to achieve a balance of interests and a win-win situation for the government and the investors.


SHARING THE PAIN AND THE GAIN: The oil and gas industry is highly dynamic with potential upsides if large reserves are found and when oil prices are soaring, but also potential downsides when suddenly reservoir pressure is deflated and production drops from the predicted level or when oil prices fall. This high-risk, high-reward portrait is commonly seen and well understood by the actors in this business and in the industry as part of the risk allocation in investment.
Whichever system is used, whether it is gross split or traditional cost recovery, the investor must satisfy their internal investment economics to cover the investment and operating costs with a profit that meets the minimum level of economic indicators such as IRR [internal rate of return], NPV [net present value] etc. The concern about the return of sunk costs, that is, costs incurred in petroleum operations that are not cost recovered, is much longer term, so it is difficult to ensure an adequate return on capital. MEMR Regulation No. 52 of 2017, an amendment to MEMR Regulation No. 8 of 2017, provides additional split for contractors at the beginning of production to assist with the economics of the return on the investment.
It is true that the upstream oil and gas industry is a long-term business, but that does not mean that long-term economic variables cannot be agreed between the government and the contractor, for example predicted future oil prices. That is part of the risk that must be calculated by both parties.
The GS PSC has been sufficiently regulated to address the external factors that are beyond the control of both parties, such as the oil price factor. When the oil price is low, the contractor will enjoy additional profit sharing, so it will still be economically attractive for them to run the operation. Indeed, it will provide protection to investors to maintain the value of the economics against the decline in production or oil prices. Conversely, when the price of oil is high, the revenue share attributable to the government portion will increase. This is the concept of sharing the pain and the gain, where both parties share with each other the benefits and risks. MEMR Regulation No. 8 of 2017 and its amendments have taken into account the conditions under which parties can share in the upsides and downsides.

The GS PSC encourages the contractor to work as efficiently as possible, since the business model underlying the GS PSC contract concept is based the size of the investment return and the profits to be gained by the contractor, and it critically depends on how efficient they are in running their petroleum operations. The more efficient they are, the better their return on investment and profit. They are in control of managing their own operations.
The external variables that influence the economics are adequately addressed under MEMR Regulation No. 8 of 2017 and its amendment, which shall form the terms and conditions of the GS PSC and therefore any external factors that are under the control of the parties will dynamically affect the profit sharing.
Because risk sharing and profits are proportional under the cost-recovery PSC model, at some point contractor behavior is inclined to be inefficient and less prudent in managing their work programme, since the state bears 85% of the cost incurred for oil. With a production sharing arrangement such as cost recovery, under certain circumstances the state is often overly burdened with most of the costs incurred for activities that are not necessary or not prioritised. Moreover, the incentives under the cost-recovery model include an investment credit up to 17%, so contractors tend to take advantage by spending as much as possible, which oftentimes may constitute waste, knowing well that they will get incentives from such expenditures.

LOCAL CONTENT: The policy on local content management is included in the gross-split system as well. Using local content offers contractors significant economic benefits. For example, for an oil and gasfield development with revenues of USD 20 billion, the contractor can earn additional profit sharing of up to about USD 800 million by utilising local content.
It should also be understood that the implementation of the GS PSC does not abolish the contractor’s obligations to use domestic goods and services. All obligations under the related regulations on domestic goods and services must still be complied with by the contractor. Under the GS PSC, contractors are required to use domestic goods and services at a minimum level of 30% if domestic business players can competitively meet the quality and capacity of goods or services sourced from abroad. Therefore, the GS PSC has provided a very attractive fiscal regime for GS PSC contractors to utilise domestic goods or services. Thus, this approach not only provides regime and growth certainty for domestic business players, but it also encourages them to be competitive at the same time.

LEGAL BASIS AND LAWS: The first thing that we need to highlight with regard to the gross split is its legal basis. From the formal and material tests, the concept of the GS PSC as stipulated in MEMR Regulation No. 8 of 2017 and its amendment have satisfied the required elements stipulated in Law No. 22 of 2001 on oil and gas.
The formal substance of the GS PSC, as mentioned above, was satisfied by virtue of the definition of co-operation contract as contemplated in Article 1 No. 19 of Law No. 22 of 2001. A co-operation contract is a production-sharing contract or other contract of co-operation in exploration and exploitation activities that provides more profits to the state, and the result thereof is to be used for the greatest prosperity of the people.
The GS PSC has fulfilled the substantive requirements as contemplated under Article 6 of Law No. 22 of 2001, namely the main terms of the co-operation contract. The ownership of natural resources shall remain in the hands of the government up to the point of delivery. Control of operations management remains vested with SKK Migas (previously BP Migas). Capital and risks shall be borne entirely by the business entity or permanent establishment, that is, the investor.
If we take the example of ONWJ [Offshore North West Java] as the first working area to implement the gross-split system, other than in the above formal and substantive requirements, the articles under the signed GS PSC for the ONWJ work area have met the requirements set forth under Article 11, paragraph 3 of Act. No. 22 of 2001. Specifically paragraph 1 requires co-operation to contain at least the following main provisions: state revenue, the working area and its relinquishment, the obligation to disburse funds, transfer of ownership of oil and gas production, duration and conditions of contract extension etc.
The draft amendment of Government Regulation No. 35 of 2004 has included provisions to ensure that the GS PSC is within the ambit of co-operation contracts in the form of a production-sharing contract.

GROSS SPLIT: The other most frequently asked question is whether the gross-split concept is based on the royalty and tax regimes. The arithmetic of the GS PSC is similar to the concept of oil and gas contracts under the royalty regime. Nonetheless, substantively there is a very basic, fundamental difference between the GS PSC and the royalty concept.
Under the GS PSC system, the natural resources of oil and gas belong to the state up to the point of delivery, as provided for in Article 6 of Law No. 22/2001. Thereby the production proceeds are shared as agreed in the contracts at that point of delivery. Under the concession system, the natural resources of oil and gas in a working area are owned by the investor. The obligation of an investor to the state is to pay the agreed royalty and pay taxes if there is already a profit.
The same principle applies to operations management. Under the GS PSC, operations management is vested in the state through SKK Migas, whereas in the concession system, the investor is in charge of operations management. It is incorrect to say that under the GS PSC format the operations management is no longer in the power of the state. On the contrary, it remains under government control as required by the oil and gas laws, but with the gross-split mechanism, operations and efficiency are the critical factors that the contractors can manage better to meet their own IRR and investment criteria. With the introduction of the gross split, the traditional pattern and approach of operations management under the classic PSC that has been implemented and carried out under the cost-recovery PSC will change to adopt the gross-split mechanism when their original PSC is renewed or extended upon their natural expiry.

OUTLOOK: Upstream oil and gas is still one of the key sources of revenue for the government budget. For 2017, SKK Migas recorded state revenues from oil and gas at USD 13.1 billion. The contribution of non-tax revenues, or PNBP, in this sector is estimated to reach more than IDR 129 trillion [USD 9.47 billion], representing about 50% of the national non-tax revenues in 2017 of IDR 260 trillion [USD 19.1 billion].
According to SKK Migas, investment of USD 14.17 billion in upstream activities in Indonesia is expected this year. The amount of USD 810 million is projected for exploration activities, and the remainder will be coming from exploitation programmes. In addition, a number of oil and gas blocks will be offered at auction early this year to attract more investment in this sector.
In principle, the GS PSC brings the values of certainty, where the incentive parameter is transparent and measurable according to the character/level of complexity of field development and simplicity, encouraging simplification and accountability in business processes between oil and gas contractors and SKK Migas. Thus, the bureaucratic procurement system and the debates that have occurred so far can be reduced. Finally, it will encourage oil and gas contractors and their supporting industries to be more efficient so they will able to cope with oil price fluctuations.
With the new approach of GS PSC, supported by the recovery of global crude prices, this is the new era for the oil and gas business in Indonesia.

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