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Vol. 3 - issue 1
March 2005

Indonesia's Petroleum Contracts: Issues


and Challenges?
by M. Hasan

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INDONESIA S PETROLEUM CONTRACTS


Issues and Challenges
By Madjedi Hasan
ABSTRACT
Indonesia introduced the Production Sharing Contract (PSC) in the mid sixties and the contract
has been used as a model in various developing countries throughout the world. Since its
introduction a new impetus was given to the oil industry. During the ten years period the crude
oil production increased more than three times to 1.7 million barrels a day in 1977. Indonesia
started its role as supplier of LNG during 1977, and became the largest LNG exporter in the
world. However, an overview of worldwide petroleum activities showed that Indonesias
competitive position has been deteriorating steadily for about 25 years.
The prolonged regression is not attributable to crude oil market conditions or the amount of
available risk capital for worldwide industry ventures, which are common to all countries. As
Indonesias political climate had been stable during that time Indonesias relative political
climate did not seem to be contributing to the decline. The investors perception of the
potential for additional oil exploration, development and enhanced oil recovery within
Indonesia was considered to be good to excellent. All the possible factors of significance
appear to be eliminated except for commercial consideration, namely those factors impacting
adversely on the investors return such as contract terms, administrative procedure, crude
pricing practices, approaching contract termination dates, etc.
This report examines the 34 years operation of Production Sharing Contract in Indonesia.
Contractual issues and government policy that have impacted the industry and challenges ahead
of petroleum industry in Indonesia are highlighted. These challenges include the impact of
regional autonomy and new oil and gas law. As the Indonesian oil industrys competitive
position has been declining for years due to principally to commercial/business factors and that
there is no reason to believe the negative, historic trend will change without a meaningful
improvement in the return of investors. This coupled with specific actions of Indonesias
competitors and the long lead time required for major ventures should be one of the central
points of improvement efforts to change the declining trend. The revamping of petroleum
sector as aimed by new oil and gas bill would only be successful if all the key ingredients are
observed.
INTRODUCTION
Indonesia introduced the Production Sharing Contract (PSC) in the mid sixties and to date more
than 300 contracts of all types have been concluded. The PSC was actually first signed in
September 1961 between Asamera and Permina for onshore acreage in North Sumatra.
However, it was not until August 1966 that a new impetus was given to the oil industry when
the first offshore contract was signed between IIAPCO and Permina, covering a block in
western part of Java Sea.

Presented at One Day PSC International Conference


Jakarta, October 10, 2001

Indonesias Petroleum Contract

This report examines the Indonesias Production Sharing Contract in operation. After 34 years
it is timely to look into the results, determine the various factors affecting the results and
identify the challenges ahead. The review is also pertinent as Indonesia is now in the process
of revamping the petroleum sector. A new oil and gas bill to replace the existing oil and gas
mining and Pertamina laws is now before the Parliament and expected to be promulgated by the
year-end. The bill will transform Pertamina to a limited liability company and place Pertamina
on equal footing with all other PS contractors. Also, the Pertaminas dual role as oil and gas
producer and the industry regulator will be removed and a new Implementation Agency will
then be established to administer the Production Sharing Contracts.
The discussion begins with an overview of historic activity data to see the trend on all level of
industry activity within Indonesia and Indonesias competitive position in securing risk capital.
This is followed by a discussion of various contractual terms, highlighting contractual issues
and government policy that have impacted the industry. In closing, the paper will address
challenges ahead of petroleum industry in Indonesia.
INDONESIAS UPSTREAM ACTIVITIES
The petroleum industry in Indonesia has displayed the peaks and valleys of exploration and
development activities. The phase of exploration boom which began in mid 1967 has resulted
in numerous and prolific discoveries and in the opening up of new oil and gas province.
During the ten years period the crude oil production increased more than three times to 1.7
million barrels a day in 1977. Indonesia started its role as supplier of LNG in 1977 when the
facility at Bontang, East Kalimantan was opened and followed by the second plant at Arun,
North Sumatra, a year later.
However, prompted by revised sharing formula 85/15 (in favour of Pertamina) the overall
activities in the oil and gas industry slowed down significantly in 1977. And this fact was
largely responsible for the declining trend of oil production in 1978 and 1979 to approximately
1.6 million barrels a day. Also, contributing to this decline was the US Treasury ruling, which
denied the US companies the benefit of treating a portion of their payments to Pertamina as a
credit against their US income tax return. The ruling held that such payments were royalties
and no portion could qualify as a foreign tax credit.
Exploration activities began to upturn when the government offered economic incentives and
revised the Production Sharing contracts to specify payment of Indonesian income tax.
Numerous discoveries were made; in terms of reserves, the size of discoveries was relatively
small, as compared to those discovered in the early seventies, but their development helped to
offset the productive decline of some older fields. While Indonesia was introducing financial
incentives and moving to the right direction toward finding more oil and gas to support its
economic development, world economy recession in the eighties hampered Indonesias ability
to increase or maintain its production. Nineteen eighty-six and seven were not good years for
petroleum-producing countries throughout the world and Indonesia was no exception.
Fundamental elements of the petroleum industry started to weaken as crude prices dropped, i.e.
exploration expenditures declined and only a few Production Sharing Contracts were signed.
During the 1988 1999 time period, exploration/development activities increased and reached
its peak in 1998, but at a lower level as compared to in the 1970 and 1980s. While the
spending increased, the average number of exploratory wells and seismic activities in the
1990s were below the previous decades. For the period 1991 2000, the average exploration
spending was about USD 1,353 million per year, as compared to USD 353 million and USD
1,133 per annum for the period 1971 1980 and 1981 1990, respectively. The increase in
expenditures reflected more to the increase in unit cost rather than the activity. During 1991 -

Indonesias Petroleum Contract

2000 exploration drilling was split approximately one-third for non-producing or exploration
areas and two-thirds for producing areas. This compares to a one to three ratio for exploration
to producing areas, respectively, during the period 1971 1991.
In the nineties the commercial success rate from exploration drilling continued to decline both
in terms of number and size of discoveries. In the non-producing areas, the commercial success
rate (oil and gas) for the last decade was only about 10% versus 14.3% for the period 1971
1991. In the producing areas, the success rate was considerably higher, with however, an
increasing trend in the number of gas discoveries and also, overall it was still below the
previous years. In terms of size of reserves, the majority of oil discoveries in the 1990 were
below 25 million barrels. A major oil field with sizeable oil reserves has recently been
discovered in Java; nonetheless, the size of discovered oil reserves so far are below the levels
necessary to replace current oil production.
The statistics on gas discoveries may be somewhat skewed. Firstly, most wells were drilled for
finding oil and only re-classified as gas wells after encountering gas. Beginning in the late
eighties, the growing demand for gas for electrical power generation along with the
improvement in gas pricing for domestic use, created a renewal interest in natural gas. Gas
production continues to increase due to new discoveries. Export market of gas is being
developed to place the two giant gas fields in Natuna and Irian on production.
Indonesias future in natural gas is encouraging. Gas reserves are bountiful and more than
sufficient to supply projected domestic and gas export demand well into the next decades. To
day the daily gas sales has reached 1.0 million barrels of oil equivalent and may surpass the oil
production replacing oil as major export commodity when the two giant gas fields are on
stream.
INDONESIAS COMPETITIVE POSITION
As mentioned earlier, the distinct change in trend starting in the early 1980s has been
attributable to the result of the collapse of crude oil prices, which commenced in 1982 and lead
to OPECs policy of restricted production. Such effect of crude price and the effect of the
reduced amount of available risk capital for worldwide ventures on Indonesias historic
activities can be essentially neutralized by comparing Indonesias historic activities to the
historic activities of other countries since world crude oil markets and available risk capital are
basically common denominators for oil countries.
The historic industry data showed that Indonesias percent share of worldwide production was
increasing in late 1970s, but it has been gradually declining ever since. Indonesias percent
share of total wells drilled (exploratory and development) were declining through 1986 and
rather flat afterwards. As expected, the trends appear insensitive to crude price. However,
compared to a group of 15 countries Indonesias percent share has declined in regard to both
production and programs for since 1981 with no perceptible effect due to the changing crude
oil prices. Increases in percent share of total wells drilled in 1986 1990 were attributable to
the substantial increase in wells drilled related to the Duri steamflood.
Based on production rates by country, Indonesia through 1985 has improved its competitive
position relative to OPEC and that Indonesia has regressed in its competitive position relative
to all other countries excluding small producers. Indonesias improved competitive position
within OPEC appears attributable mostly to Indonesias favorable share of OPECs quota
(8.2% percent share of productive capacity in 1985 versus 5.3 percent in 1998). This compares
to the actual Indonesias productive capacity of about 2.5% of total capacity of OPEC.

Indonesias Petroleum Contract

Below are Petroconsultants and US Department of Energy (EIA) data, showing the percent of
Indonesias share of activities for the group of fifteen countries.
ACTIVITY

Production
Exploratory Wells
Seismic Surveys
Development Wells
SLC Price - $/B

INDONESIAS PERCENT SHARE OF A GROUP OF 15 COUNTRIES*


1974

1977

1982

1987

1992

1997

27%
34%
NA
46%
6.50

27%
24%
21%
52%
12.80

18%
21%
18%
38%
34.93

14%
11%
8%
37%
17.69

13.6%
10%
8%
NA
17.35

11.4%
9.4%
NA
NA
19.05

*) Columbia, Trinidad, Norway, UK, Angola, Cameron, Egypt, Nigeria,

Tunisia, Malaysia, Pakistan, Thailand, Australia, New Zealand


The alarming aspect of this data is that Indonesias competitive position has deteriorating
steadily for the last two decades. This prolonged regression of Indonesias competitive position
was clearly not attributable to crude oil market conditions or the amount of available risk
capital for worldwide oil industry ventures. Also, Indonesias political climate had been stable
during that time; therefore, Indonesias relative political climate did not seem to be contributing
to the decline. The investors perception of the potential for additional oil exploration,
development and enhanced oil recovery within Indonesia was considered to be good to
excellent.
All the possible factors of significance appear to be eliminated except for
commercial consideration, namely those factors impacting adversely on the investors return
such as contract terms, administrative procedure, crude pricing practices, approaching contract
termination dates, etc.
PRODUCTION SHARING CONTRACT
Production Sharing Contract is based on a sharing of actual production between the state oil
and gas company and contractor, rather than on the traditional sharing of net profit.
Management will be on the hand of state oil and gas company, while contractors provide all the
financing and sustain the risk of all pre-production costs. In the exercise of this control
Pertamina approves the contractor's budget, work programs, manpower plan scheme of
expenditures and procurement of equipment and services.
The PSC was initially developed for new exploration acreage. As demands for risk capital
continued to increase, the scope of co-operation was also expanded to include Pertamina's
fields and prime acreages previously reserved for Pertamina. This has resulted in various
types of contract; Pertamina determines the type of contract applicable to a block or working
area when offering it to other parties.
The ones that are currently used include Standard Production Sharing Contract (for both
Conventional and Frontier Areas), Production Sharing Contract Joint Operation Agreement
(JOA), Technical Assistance Contract (TAC) and Enhanced Oil Recovery Joint Operating
Body Contract (EOR-JOB). Production Sharing Contract Frontier Area is granted for all nonproducing areas in eastern part of Indonesia, non-producing areas in western part of Indonesia
having water depth of more than 200 meters, located in basins that can be classified as an
intramontane basin, and basinal areas in the west and central part of Kalimantan. Production
Sharing Contracts Conventional Area is granted elsewhere outside those areas. The PSC JOA,
TAC and EO-JOB are reserved for acreage currently or previously operated for Pertamina's
own development areas.

Indonesias Petroleum Contract

The Production Sharing Contract as introduced by Indonesia has been used as a model in
various developing countries throughout the world. Although some can interpret the rules as
being strict, the concept provides private companies with an opportunity for profitable
operation. Over the years several revisions or amendments have been made in the original
contract.
CONTRACTUAL ISSUES
In the 1970s when margins between oil prices and production costs were very high, many
potential problems in the oil sector could be easily overlooked. But as oil revenues plunged,
both government and the contractors were forced to maneuver to protect earnings.
Disagreements over commerciality, new field and secondary recovery incentives, domestic
market obligation (DMO), procurement procedures, audit exceptions, and price basis for tax
and cost recovery became much more difficult to resolve. The following lists few contractual
issues of special importance that emerged over the years; the first three stemmed from
differences in contract interpretation and the others were the impact of government policy.
1. Determination of Commerciality
Following the first revision of PSC in 1976, as compensation of increasing Pertaminas
share, the provision on cost recovery ceiling was abolished in the amended contract. The
deletion of this provision has in essence eliminated the guaranteed income for Pertamina
and Government. As a result in few instances this has caused delays in obtaining
Pertamina's approval to receive commercial status if a discovery is small or marginal. The
introduction of First Tranche Petroleum (FTP) in August 1988 was intended to resolve the
matter. With FTP mechanism in place, in which Pertamina is provided a guaranteed
income from the first 20% of production (or with annual cost recovery ceiling in the TAC
and EOR-JOB), Contractors have now assumed that Pertamina should not be involved in
determination of commerciality.
However, this has apparently not been the case. Pertamina still seems to consider that
commerciality declaration is a significant decision that should remain within its control in
the exercise of its management function. The disagreement on the commercial prospects of
a discovery has stemmed from the absence of contract provision defining technical and
commercial parameters to estimate the recoverable or threshold reserves and forecast of
production, and projected costs and crude price.
2. Financial Incentives
Following contract renegotiations of PSC in 1976, Indonesia provided two types of
incentives for enhanced oil recovery operation and development of new fields. They are in
the form of valuing domestic market oil at prevailing export price for the first five years of
production and investment credit on capital costs associated with production facilities.
Contractor may retain the investment credit if the revenue for Pertamina and Government
from the project over the life of the field will not be less than 49% of total revenues.
For secondary and tertiary recovery, such incentives are applicable for incremental oil
production, that is, all production above an agreed base line, which is assumed to be
primary production. The investment credit and DMO incentive are not applicable to
interim production schemes nor further investment to enhance production and reservoir
drainage in excess of what is contemplated in the original development plan as approved by
Pertamina. Disputes over the incentive claims usually involved the condition of claim and
how the amount shall be computed; they are discussed in the following section.

Indonesias Petroleum Contract

2.1 New Field Incentive


There are three issues when the PSC claims the investment credit. These include
definition of new field, class of capital that are entitled for incentive and ultimate
recoverable reserves net to the state.
a. Definition of New Field
When the incentive was first introduced in 1976, practically any discovery is
entitled for DMO and investment credit. This, however, was not the case in later
years, as Pertamina did not simply agree to Contractor's proposal for classifying a
discovery as a new field, which is entitled for DMO incentive and investment
credit. Pertamina usually agreed to award the incentive only for wildcats or those
located outside producing areas, while subsequent discoveries are not entitled to
receive incentives, unless they are included in the package of initial Plan of
Development.
To resolve the matter, the industry proposed to apply the classification as
developed by American Association of Petroleum Geologist (AAPG) or American
Petroleum Institute (API) regarding new field. The proposal was not acceptable, as
Pertamina is of the view that the API or AAPG classification could not meet the
purpose under which the incentive is given, namely to encourage contractor to
explore outside of their productive fields.
b. Class of Capital Investment
The PSC stipulates, Contractor may recover an investment credit amounting to
17% of the capital investment cost directly required for developing crude oil
production facilities. Pertamina considered that capital costs entitled for
investment credit is only those costs associated with facilities directly leading to
production such as offshore platform, wellhead and subsurface equipment, lifting
equipment, flow lines, gathering equipment, oil jetties, treating plants, gas plants,
excluding supporting facilities. Housing and recreational facilities, construction
utilities and auxiliaries (power plant, workshops, cargo jetties and field roads) and
movables are considered supporting facilities and are not entitled for investment
credit. The contractors viewpoint is that all facilities leading to production shall
include auxiliaries such as power plant, field road and camps, since without these
auxiliaries there will be no production activities.
The new and extended PSC at least have now clearer wording, which essentially
confirmed Pertaminas strict interpretation. The question, however, remains
whether such provision would strictly be applied in the case of large EOR and new
field development projects, which would require a substantial amount of capital for
supporting facilities, such as new camps, etc.
c. Recoverable reserves
The second generation of PSC (1977) stipulated that Contractor may retain the
investment credit if the revenue for Pertamina and Government from the project
over the life of a field will not be less than 49% of total revenues. However, the
contract is silent with respect to the time when an evaluation shall be made to
determine whether or not the Contractor could retain the investment credit.
The matter became complicated with the fluctuating crude oil price since the early
1980's. By virtue of the contract the revenue sharing is affected by changing in
crude price, reserves and costs, with crude price provides the greatest impact.
Some new fields that were approved to receive investment credit based on
estimated reserves and production rate, costs and crude price prevailing at the

Indonesias Petroleum Contract

evaluation might be found several years later to ultimately provide less than 49%
of reserves to Pertamina/Government at depletion. We noted that at least one
Production Sharing Contractor has been asked by the government to return the
investment credit after the audit found that because of lower oil price, Pertamina
and governments revenue from that particular field would ultimately be less than
49% of the total production at the abandonment.
The above issue was finally resolved following the announcement of incentive
package in August 1988 in which the provisions on 49% minimum revenue share
for Pertamina and Government as a condition to claim and retain investment credit
was finally deleted in the new and extended contracts. Nonetheless, for the
extended contracts the question remains as to whether such deleted provision can
be made retroactive or as to how such provision is applied to fields, which are on
production before August 1988.
2.2 Secondary Recovery Incentive
Like the new field incentive, the two sources of conflict are the definition of
secondary recovery and determination of base line production. Pertamina considered
that not all projects involving water injection into the reservoir are considered
secondary recovery operation that is entitled for incentive. Pertamina was of the
opinion that water injection on field peripheral at early life of the field such as in Minas
field is pressure maintenance operation, and therefore does not qualify for financial
incentive under the term of PSC.
On contrary, contractors considered such an issue should be moot as, technically, there
is no difference in the driving mechanisms of injected water and natural water
encroachment in displacing oil throughout the reservoir. Also, injected water has
proved to be as good as a displacement agent as natural water. A review of Indonesias
water flood projects indicated that the successful water injection was usually found in
fields where the water injection was initiated early in there producing life before their
reservoir pressure depleted, which under the old terminology or school such operation
may be called pressure maintenance.
Moreover, the negotiation to reach an agreement on the base line production has been
time consuming and costly, resulted in delays of project start up. The disagreement
covers wide range of issues, starting from the methodology, tools, and determination of
reservoir parameters, recoverable reserves and economic limit.
3. Domestic Market Obligation
The Indonesias PSC requires the contractor to sell 25% of the contractors share oil
Pertamina. The computation for the share oil is based upon the contractors pretax profit
oil share. After 60 months of production from a given field, the price the contractor
receives for the DMO is USD 0.20 or 10% of the realized price under the new incentives
package.
As the amount of obligation is computed based on contractor equity split after cost
recovery, the obligation could theoretically exceed the contractors share of profit oil.
Under such circumstances the deficiency will not be carried forward to any subsequent
year. Also, the contractor will be relieved from the obligation if the recoverable operating
costs exceed the total contractors crude oil entitlement (cost recovery plus investment
credit minus Pertaminas entitlement).
Such limitations are stipulated in the new and extended PSC, but they are absent in the
older contract signed before introduction of FTP and EOR-JOB contract. The absence of
such provision in the old contract and EOR-JOB created no problems initially when the

Indonesias Petroleum Contract

DMO fee was still at the prevailing market price. It was becoming an issue or dispute as an
audit exception after the 60-months incentive window expired where the DMO fee then is
below the market price. The government auditor considered that such a limitation is only
applicable when it is clearly stated in the contract. Contractors view is that there is
essentially no contractors equity oil as long as the recoverable operating costs at particular
years exceed the total crude oil produced minus Pertaminas entitlement. Similar to upfront royalty payment, the application of FTP or cost recovery ceiling is intended to
provide a guarantee to Pertamina for minimum income from petroleum operations.
4. Crude Oil Pricing
Under the Production Sharing Contract, production is shared in kind, and it is necessary to
determine a price to convert oil to dollars in order to calculate cost recovery, profit and
taxes. While the wording may slightly different for each contract, the PSC generally
stipulates that all crude oil for cost recovery and taxes calculation shall be valued at the
weighted average net realized price fob Indonesia received for the calendar year. In
practice, the Government determined the price of crude oil used for calculation, which were
OPEC references oil prices.
At first the companies did not dispute the policy, possibly because the Government Selling
Price (GSP) reference price had worked to their advantage until late 1987 when the market
price was above GSP and possibly in expectation the price would soon recover. However,
as the market continued to decline the PSC were taking the hit as the Government held
them to the official Government Selling Price for purposes of cost recovery and tax. As a
result, lifting of Indonesian crudes was immediately affected and crude oil production was
curtailed by over 100,000 barrels a day in late 1987 and continued to early 1988.
The Government responded to the Production Sharing Contractors objections by first
providing the tax incentive scheme to offset the losses and later agreed to use a market
related formula to determine crude entitlement. Developed together with the industry, the
Indonesian Crude Price (ICP) has been in effect since April 1989.
5. Procurement Procedure
Guided by the People Congress' Decree, in the third year development plan which started in
1979, the government was determined to promote increased use of domestic facilities,
services and supplies, and to emphasize achieving more equitable distribution of
development and its benefits. This emphasis was expressed in various policies and
regulations. One item of interests to the Production Sharing Contractors is a regulation
known as KEPPRES 14A (Presidential Decree 14A) on providing preferential treatment to
the economically weak groups in supplying their product and services.
To ensure compliance with the decree and to seek the lowest prices possible, the
Government, through subsequent Presidential Decrees, established bid review procedure. A
procurement review team was established in the State Secretary Office and the Ministry,
which will review proposals to award bids. In the process of review, the review team takes
a practice to negotiate with the winning bidders for even lower prices.
The Presidential Decree # 14A was originally intended for the government agencies and
state owned companies, but later it applied to oil company capital purchase as well as
purchase of services. Pertamina and the government justified these policies and procedures
on national development grounds, as the government felt they ultimately pay 88 percent of
the costs. In general the Production Sharing contractors did not object to promote the use
of domestic facilities, supplies, etc. (which is not unique to Indonesia), but more to the
procedures that they have to follow. The layers of approvals and sequences of negotiations

Indonesias Petroleum Contract

for lower prices have contributed to substantial delays in the award of contracts, which in
turn affected drilling program, exploration efforts, and capital development programs.
As a result, total exploration and development expenditures of the PS Contractors
continued to decline. The long-term effect has been a reduction of Indonesia's ability to
maintain its high production when crude price market situation improved in the late 1980s.
Recognizing the adverse impact, the government responded by providing additional
economic incentives including streamlining the approval system. These included revising
the delegation of authority and raising the permissible level of expenditure of the PSC for
procurement of materials and services, while preserving management control by Pertamina
through budgeting and auditing processes.
To further response to the industry demand, streamlining the approval continued through
subsequent decrees and the most recent one was issued in February 2000 (Presidential
Decree number 18/2000), which then was followed by Pertaminas President Director
Decree number 077/2000 for implementation. Under the decree the permissible level of
expenditure of the PSC for procurement is again raised and the requirement provision to
obtain approval from State Secretary and Ministry was abolished, therefore final approval
to award bid essentially now lies within Pertamina and the contractors themselves.
The procurement procedure in the recent decree is sound reasonable and encouraging to the
petroleum industry. However, we noted that many domestic service supply companies are
becoming concerned and feel that overseas service companies will soon replace their
position and they will be out of business. In general they do not object to the decree, but
more to the tender requirements set up by the PS contractors. For example, the high bank
guarantees requirements to participate in the tender as required by some major PS
contractors practically prevent them to participate in the tender process. Also, prequalification requirements on projects in some cases are seemingly over-stringent, such as
to working capital and parental guarantees. In their view, this has the effect of eliminating
the domestic service companies in favour of overseas service companies.
THE CHALLENGES
Many of the above contractural issues have been resolved; to maintain active exploration and
development activities, the Indonesian government and the state oil and gas company have
demonstrated resilience and pragmatism in addressing the oil crisis precipitated by the decrease
in world crude prices. However, like any business venture, the petroleum resources
development in Indonesia will likely continue to have challenges. Also, unfavorable factors
originating from both within and outside the country may unexpectedly emerge. The following
lists few issues and challenges ahead of Indonesias petroleum industry.
1. Impact of Regional Autonomy
In 1999 the Government promulgated the Law number 22 and 25 and subsequent
regulations on regional autonomy and fiscal decentralization. The Law number 22
provides the provincial government with greater authority to manage their internal affairs,
except in certain areas such as national security, foreign policy, fiscal and monetary policy,
justice system, religious affair, and strategic policy and national planning. Regional
governments now have the authority to approve investments in all areas except oil and gas,
which remains jurisdiction of central government.
The Law number 25/1999 addresses the sharing or allocation of revenue between the
central and regional governments. Under the law the revenue from oil and gas will be
shared between central and regional government 85/15 and 70/30, respectively. Of the 15
percent of the oil revenue flowing to the region, six percent will go to the district where the

Indonesias Petroleum Contract

10

petroleum operation is located, six percent will be shared among the other districts in the
province, and the remaining three percent will go to the provincial government. The same
sharing formula applies to gas revenue.
While petroleum operations are still within the jurisdiction of Central Government, the
local government now controls many of supporting activities. They may issue regulations
and permits which in the past issued by the Directorate General of Oil and Gas such as for
construction services, utilization of contract area for other non-petroleum activity, waste
petroleum products, environmental control, etc. The law on local taxation gives local
governments the right to impose new taxes and levies within certain limits.
Since entered into effect (January 1, 2001) there has been uncertainty over details of the
implementing regulations, the specific policies to be put into place, and the limits and scope
of the local governments authority. Also, the regional or district government seems to have
little knowledge on the petroleum operation and contract, which has led to that they often
over estimate the forthcoming revenue from oil and gas. This would create uncertainty and
diminish the level of new investments in the petroleum sector.
Another alarming problem to the investor is increasing demand from some provinces for a
new deal. As reformation opens opportunities for Indonesias provinces to gain political
and fiscal autonomy, local interest groups are rushing forward with their own development
plans. These groups are not necessarily seeking either autonomy or independence, but
instead, a degree of control to gain financial advantages. They aim to increase local
prosperity by wrestling control of natural resources through local regulations and other
measures including additional levies and taxes and even take over the operation.
2. New oil and gas law
The effectiveness of the reforms in the petroleum sector will depend largely on the details
of the implementation of new oil and gas law. All of the substantive and procedural
changes will need to be promulgated in the Implementing Regulations. One of the
regulations critical to the PSC operation is the establishment of Implementation Agency.
Under the new law the agency is accountable to President and shall be established within
one year of the laws entry into effect.
Regulations regarding Implementation Agency and how the agency defines its management
role in the PSC will determine the result as whether the oil and gas contractors will be
better off under the new regime or they will operate under the same restrictions as before
but under a new master. The other pertinent regulations in the upstream activity include as
to how exploration acreage will be allocated, tendering process for new blocks and
contract, and transformation of Pertamina into a limited liability company.
3. Contract Terms
Despite the lingering political uncertainty and security problems, the recent survey of
Robertson Research among the 85 multinational companies in 46 producing countries
outside North America placed Indonesia on the top of ten for new exploration after Iran,
Libya, Algeria, Australia, Brazil, UK, Egypt and Angola. The appreciable size of fields
(mostly gas) are being found in Indonesia, however, the overall trend is suggesting that
Indonesia is reaching maturity as petroleum provinces. This requires that Indonesia must
maintain improved oil recovery at a pace or rate sufficient to arrest decline in its oil
productive capacity.
Subsequently, changes to the fiscal system may be required to continue attracting risk
capital. Indonesia has a history of only needing to make small concessionary changes for
its offered acreages to continue attracting serious investors; however, perhaps this will no
longer be case. The recent trend of mergers, consolidation and acquisitions within the oil

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and gas industry will place the exploration budget in fewer hand, thereby the number of
players seeking for exploration rights will likely lessen. Larger adjustments might be
needed in the face of intensifying competition for risk capital.
Many countries are re-evaluating their competitive position. More lenient terms for fields
in remote, high cost areas and marginal fields are expected. Also, fiscal terms will perhaps
need to be adjusted more often than in the past. The need to keep changing the fiscal terms
every time different economic conditions emerge has made the current fiscal terms of
Indonesias PSC looks inefficient. Considerable long-lead time is often required to adjust
in order to make it competitive and this has been responsible to the ups and downs in the
exploration and development activities. A more efficient fiscal regime needs to be
developed so there would be no need to change the terms for different conditions and
situations.
The following lists two provisions in the new oil and gas bill that might become
disincentive factor to the contractor and would require some flexibility in the
implementation.
a. Fiscal regime
For Indonesia, one of the long-standing issues raised by Indonesias Production
Sharing Contractors is tax consolidation, as allowing exploration costs to cross the
fence would give a strong financial incentive for the petroleum industry. As stipulated
in the draft of oil and gas bill, the Government position for not allowing tax
consolidation remains unchanged. This would place Indonesia in a disadvantage
competitive position, since some countries have allowed certain classes of costs
associated with a given field or contract to be recovered from another field or contract.
Moreover, a specific area where the improvement is needed in the future contract is the
economic incentive to attract risk capital for promoting pilot test and application of
improved recovery techniques. This is particularly true for tertiary recovery projects,
which involve more complex processes, requiring high capital and have higher risk.
The incentives would include improved profit split and extending the five-year window
for DMO and investment credit to include pilot tests. The need to maximize the
recovery of oil in place by application of improved recovery technique (IOR) is critical
to complement exploration efforts, which over the past two decades have not resulted
in new reserves sufficient to replenish production.
b. Terms of Contract
The draft of oil and gas bill proposes that the future petroleum contract will not be
more than two terms, or the PSC contract could only be extended one time, making the
term of a petroleum contract will not exceed 50 years. For most of the Indonesias oil
fields the 50 years contract life is perhaps sufficient to deplete 90% of the recoverable
reserves. Nonetheless, blind adherence to strict policy of limiting the contract
extension to only one time could be counter-productive when the result is a denial of
the acquisition of needed technology and good oil conservation practices. In order to
permit maximum use of technological expertise and experience along with their
inventiveness to attain maximum recovery of petroleum reserves, some flexibility in
the terms of contract extension are required.
With exploration is mature the finding for oil is becoming more technically difficult
with each passing day. A significant percentage of new reserves are likely to be found
in the so-called frontier areas, with high costs of development and years of lead-time
needed before actual production can begin. Also, the application of IOR methods
requires long lead-times to test and develop viable projects and considerable risk
capital is required to bring in the production to reality.

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Past experience suggests that it would take 10 to 15 years to establish production and
revenue benefits from the exploration activity in remote and difficult areas. Caltexs
experiences in Duri Field show that it took nearly 15 years to test and develop the fullscale steam flood project into reality since the injection of first steam into the ground in
mid 1967. Furthermore, unlike the oil, in the development of gas reserves both
Pertamina and Contractor often have to find first the effective way to dispose the
product, including finding gas market. Such efforts, which in most cases coupled with
financing effort sometimes, take years to complete and therefore leave the status of
commerciality pending on the outcome of such efforts.
The time to develop the gas market in certain cases may be well beyond the standard
exploratory term of PSC (maximum 10 years). In such situation, Pertamina in previous
precedent has been flexible in allowing the contracts on "moratorium" status, which in
effect is suspending the exploratory term of the contract. Two contracts involving
development of major gas reserves (Natuna and Tangguh) are presently on moratorium
awaiting the market. It would be desirable if such Pertaminas precedent on this
moratorium could be accommodated in a form of general policy or contract provision,
in order to establish a certainty to the contractor.
4. New Model of Contract
Although the Production Sharing Contract is still preferable model contract, the draft of
new oil and gas law accommodates different model of petroleum contract in addition to the
PSC. Such provision in essence is recognition that the Production Sharing model contract
will not necessarily provide maximum benefits and wealth to Indonesia. The benefits are
not only generated cash revenue to the government, but include maximum oil recovery of
oil-in-place and greater growth of employment and local business opportunities.
A close financial analysis of PSC will reveal little or no difference to the other types of
cooperation contract such as contract of work and other types of service contract and even
concession contracts fiscal regime. Also, the risk service contract is not much different
from the PSC risk, financing and daily management from the investor, title (to the
reserves and the extracted oil) and overall supervision with the state company. The
difference lies mainly in the method of payments of fee. Under this type of contract, all
production belongs to the government and the government allows the contractor to recover
its costs through sale of oil or gas and pays the contractor a fee based on a percentage of the
remaining revenues.
The real difference between the PSC and concessionaire system vests legally in the way the
financial regime is structured. In lieu of the investor obtaining all oil/gas and then paying
to the government income tax (plus royalty) on production, the state company obtains all
oil/gas and then shares with the contractor specified percentages of the oil/gas for cost
recovery and profit. But the feature is not that distinctive, as royalty is frequently payable
at the governments option in kind and royalty payable in kind is the equivalent of the part
of the governments profit oil that is derived from the total production before cost recovery
sets in.
Therefore, the relative success of the PSC model seems to lie in that it gives to the
government political and to the company commercial satisfaction, rather than economic
benefit or that petroleum is paid to the government in lieu of cash. A review of countries
by countries petroleum laws indicates that the Production Sharing Contract is popular in
developing and transition countries. These countries have limited financial and managerial
resources, but need to assert conspicuously the sovereignty. On the other hand, the
Production Sharing Contract is absent in countries where foreign investment in oil and gas
does not affect national sensitivities such as all developed and liberalization countries.

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With respect to Indonesia, from the investors viewpoint the Production Sharing Contract
might still be the choice of model contract for oil and gas investment in Indonesia. This is
seen from the legal and fiscal risk viewpoint, in which by virtue of the contract such
ingredients of political risk are essentially borne by the state company or central
government.
The method of cost recovery in Indonesias PSC is contract specific; it is contained in
detailed and highly technical accounting rules attached to the contract and not governed by
generally applicable tax laws and regulations. This feature would allow the contractor to
shift existing taxes and levies of all sorts and arising from all kinds of government
authorities as well as the risk of unpredictable future taxes on the state company or
Pertamina. Given more oil producing provinces now begin to demand more share of the
revenue through additional taxation and levies, such political risk is significant factor in
investment decision criteria.
5. Development of national petroleum industry
In Indonesia, exploration for hydrocarbon began in late 1800s and commercial production
started in North Sumatra after Drakes historic well in the United States. In spite of this
early start the national petroleum industry has grown relatively slow as compared to the
newcomers such United Kingdom and Malaysia. Evidence of this is manifested among
others by that almost all national petroleum companies (except two) holding the
commercial Technical Assistance Contract have sold their controlling stakes to foreign
companies while 65% of the non-commercial TAC are not active due to difficulties to
obtain financing or partner. In the service supply sector, many of domestic companies are
merely serving as an arm length of global distribution and marketing network.
Reasons for non-performing TAC are varied; besides having limited fund for start-up many
of the Indonesia TAC holders seemed to have lack of commitment to take risks or
appreciation on the nature of risk inherent in the oil and gas venture. They believe that
since the TAC deals with producing or shut-in fields, the ventures are not susceptible to
finding risks like exploration venture. Many do not appreciate that the physical and
financial outcome of most attempts in the development of mature fields may well be at least
uncertain as conventional exploration for new fields.
Furthermore, since the TAC usually covers only one oil field, the venture risk is essentially
vested in one pot thereby the undertaking becomes high risk for financing. The difficulties
to obtain financing was also due to that in negotiation of farm-out the holder of TAC
continued to demand to be the operator. The end result is that some of the Indonesias
TAC holder merely served as promoter.
Consequently, equally important as the crude oil and gas production growth in the national
program is the need to strengthening the competitive capacity of national petroleum
industry. The national petroleum industry is not only state owned company but it includes
national private companies and service supply industries as well. The growth of petroleum
activities in Indonesia should not be judged only against the increase in exploration and
development activities, but it has also to be compared to the opportunities opened for
domestic service and supply industries to participate in and benefit from the increased
petroleum activities.
For Indonesia, strengthening the competitive position of national petroleum industry would
place the country in a better situation to face the impact of globalization and the dooms day
when its petroleum reserves are depleted and the country is no longer attractive for
petroleum ventures. In facing the future, Indonesia shall capitalize on its natural wealth to
build competitive national petroleum industry and trained manpower resource.

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The essence of building strong national petroleum industry requires the concerted efforts
by government, production sharing contractors and the domestic service industries to
promote the growth under the competitive and transparent business atmosphere. This will
require a strong commitment to reform with right policy framework. As the first law of
thermodynamics identifies that heat and mechanical work as forms of energy in transit,
which can cause changes in the kinetic, potential and internally stored energy of a system,
the present Indonesias petroleum activity is considered as the energy to cause such
transforms of natural wealth.
In the supply service sector, presently there are about 2700 domestic companies provide
supports to the petroleum activities. They are grouped in seven categories of services,
ranging from fabrication, construction, and supplier to specialized technology. About
500,000 people are employed; the number could be increased by 15% if Indonesia could
formulate the right policy to stimulate the utilization of domestic products and services.
Many of the domestic service companies were established in the 1970 and 1980 in response
to the governments commitment to stimulate and increase the local content. As mentioned
earlier, the Government, through subsequent Presidential Decrees, has issued various
policies and regulations, including preferential treatment to the economically weak groups
in supplying their product and services. All the regulations were aimed at promoting
increased use of domestic facilities, services and supplies. Many have successfully taken
the opportunities opened by the government policy, but after 20 years the overall result is
still below expectation, particularly in the field of high or specialized technology.
The policy of providing preferential treatment to local products is not unique to Indonesia,
and such policy should be continued and enforced fairly. However, its implementation
needs improvement to prevent any misuse and abuse of the policy. The program shall
apply the principle of self-assessment and post audit with full transparency. For example,
in any tender process for procurement, the local content shall be determined at the outset.
This shall be based on a list prepared by a professional representative of the government,
state oil company and/or industry/trade association containing those enterprises within the
country that are capable of providing the materials and equipment and the design and
engineering services.
The conflicting interests of corporate efficiency as demanded by the PSC and the countrys
objectives to develop national petroleum industry will not easily be resolved. Making
profits is the chief goal of the PSC, but every PSC must meet certain social obligations
including supporting the countrys objective and goal of building strong national petroleum
industry. To strike a balance program is necessary; to the PSC it is expected to consider the
capacity and current competitive position of domestic supply service companies in the
international trade in setting up tender requirement, when the desired result is to give equal
opportunities to local products. On the other hand, the domestic companies are expected to
recognize that with the over protection era is not here anymore they could remain viable
only if they deliver good quality products at competitive price.
CONCLUDING REMARKS
There are likely to be challenges ahead of petroleum industry in Indonesia. The challenges
seem clear; to face depleted reserves, new oil must be found to replace the volume being
produced. The Indonesian oil industrys competitive position has been declining for years due
to principally to commercial/business factors and that there is no reason to believe the negative,
historic trend will change without a meaningful improvement in the return of investors. This
coupled with specific actions of Indonesias competitors and the long lead time required for
major ventures should be one of the central points of improvement efforts to change the

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declining trend. Equally important program is building national petroleum industries, capable
to compete in the international market.
The revamping of petroleum sector as aimed by new oil and gas bill would only be successful if
all the key ingredients are observed. The Government, Pertamina and the industry have
demonstrated the resolution needed for Indonesia to maintain a competitive business climate in
a stable political environment and to be proactive than reactive. All key ingredients are present
to sustain a dynamic, aggressive and mutually beneficial petroleum industry in Indonesia.

September 27, 2001

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