Opinion

How to Design Oil & Gas Contract

that Benefits the State
by: Benny Lubiantara *)

In the past one year, discussions in seeking a new model of oil and gas contracts was
quite good, either in a forum, seminar or mailing list related to oil and gas industry. In
a meeting with OPEC President Chekib Khelil, Vice-President Jusuf Kalla mentioned
that the Indonesian government is to change the system of oil and gas contract now
applied, and will not calculate the component of cost recovery put forward by the
oil company. Conversely, the government will open a tender for cost recovery.

I
n foreign countries, such matter is
no new practice, in the case of of-
fering a block that uses a competi-
tive bidding method, any parameter may
become part of the tender, including roy-
alty, cost recovery limit, profit or split,
ROR and others.
It needs to be understood that cost
recovery limit is cost limitation that may
be borne in one period (1 year), which
means, the cost that has not been re-
covered may be carried over into the
following year. Eventually all costs will
be recovered. Cost recovery limit is
most important in the initial develop-
ment of an oil field, as it ensures profit
oil to be shared between the state and
the investor.
Ideally, from the beginning, a model
of oil and gas contract should have an-
ticipated a change of parameter, such as
reserves reflected by production rate, oil
price and cost. In other words, the model
is expected to be quite flexible against
changes of various parameters during the
on-going contract. The changing of pa-
rameter in this respect is related to the
level of profit. A rigid and inflexible sys-
tem may give rise to imbalance in the
proportion of profit sharing. Just to re-
mind, the parameter commonly used to
gauge the government portion id the
Government Take (GT), defined as the
overall income of the government, be it
royalty, tax and profit oil share divided
by the total profit.
Looking for a compatible and
profitable model?
The effort to search for a compat-
ible method of contract to be applied
should be stimulated and studied. How-
ever, it should be remembered that ev-
ery project has a unique risk, so that the
model proposed should reflect the
project’s risk.
Is there the best model of contract?
Periodically, OPEC holds a workshop to
exchange information among fellow
member countries on the experience of
implementing the model of contract in
their respective countries.
On the basis of two workshops held
earlier, the agreement reached was that
one size fits all model does not exist. Why?
Because, the risk faced in each project
differs in the respective countries. Even
in one country risks vary. The contract
model chosen preferably reflects the risk
of said project.
Discussions in the mailing list of oil
and gas communities, blogs and others
(where senior experts, PSC practitioners
and bureaucrats are involved in this dis-
cussion), there are debates, proposals and
critics on the possibility of proposing the
new oil and gas contract model that ben-
efits the state. According to my observa-
tion, so far there are two groups of
thoughts.
1. The group that considers modifica-
tion or improvement of terms &
conditions of the prevailing PSC is
better (modification may be in the
form of cost recovery, sliding scale
profit-oil split, profitability based etc.)
2. The group that is allergic to cost re-
covery and proposes for oil and gas
contract to be directly shared based
on gross revenue.
The mass media at home reported
that Indonesia is to learn from models of
other countries, such as Algeria and Libya
(refers to the statement of VP Jusuf Kalla
after meeting with OPEC President Dr.
Chekib Khelil). Just for information, Dr.
Khelil has a long experience in oil and gas
contract model. He happened to be VP
for Industry and Energy in the World
Bank. One of his papers (1995) entitled:
‘Fiscal System for Oil – The Government
Take and Competition for Exploration
Investment’.
Of course one needs to learn from
other countries, although in fact the two
above-mentioned countries whose ‘flying
hours’ as far as PSC is concerned are rela-
tively ‘junior’ compared with Indonesia.
But it does not mean that the senior is al-
ways better than the junior, moreover if
the senior is lacking in improvisation.
If we look a little in depth into the
contract model in Algeria and Libya,
comparing directly their PSC terms &
conditions, it could be misleading. Why?
First, especially Libya, in general is pro-
spectively higher than Indonesia, thus it is
normal if the terms & conditions are

PETROMINER No. 08/August 20, 2009 68

heavier for the IOC (in a more common
language, the Government Take is
higher). Here the law of the market ap-
plies, ‘demand’ for blocks in Libya is high.
So, Indonesia cannot just place the level
of government take as high as Libya, if
‘demand’ is low ‘price’ will go down too.
Secondly, there is the involvement of
national oil company (NOC) at the develop-
ment stage. This could be in share form of
the NOC of 50 percent in the case of Libya,
or 51 percent shares held by Sonatrach (Al-
gerian NOC). At the exploration stage, there-
fore, the IOC bears 100 percent of explora-
tion cost. At the development stage the NOC
joins in according to its share.
A mailing list friend at
home was amazed at
Algeria’s PSC that limits
cost <=49 percent of total
production. Certainly we
cannot just copy it. They
limit cost recovery by that
percentage, because
Sonatrach funds the 51
percent. It makes sense if
the limit is 49 percent.
In fact here lies the
key. All these years our
minds are always catego-
rized in how to the raise the
government portion by
tinkering with the formula. My experi-
ence proves that this is no easy feat, be-
cause at the same time we must think
within two perspectives, the state and the
contractor (IOC).
By making a formula at random
profitable to the state, may not have any
benefit when the formula causes the
project to be uneconomically viable in
the perspective of the contractor. On the
contrary, it is too extravagant, it might
jeopardize the state. Eventually there will
be a compromise between the two par-
ties, therefore it is called contract. Both
sides agree to reach an optimum position
from their respective perspectives.
Participation
In my view, a more elegant way in
raising the government portion is through
participation (like the case of NOC in
Libya and Algeria). If there is something
to copy from the two countries, I think
this is the method that is worth copying.
Their PSC formulas are too complex, not
worthy of copying.
This is the easy way of increasing the
‘Government Take’. I put the quotation
mark on purpose, because the word
‘Take’ is taken from NOC Take. The logic
is as such: If you wish to gain a bigger
profit share, you must invest (in this case
to participate in funding the development
of the field). Once again this is the elegant
way to obtain a bigger ‘piece of the cake’.
See the following illustration.
By participating the ‘total’ govern-
ment take will obviously increase,. In pic-
ture-1 the government take includes the
portion of the ‘cake’ of the NOC. For sim-
plifying, in this illustration, NOC is con-
sidered to have paid tax with equal rate as
that of IOC. The 50 percent participa-
tion, for instance, in practice it could be
shared between NOC and the region-
owned company, e.g : 40 percent NOC,
10 percent regional government. Conse-
quently, NOC and the regional govern-
ment join in the funding for development
and operational expenditures according
to their respective shares.
Another benefit: NOC (although not
as operator), may get involved directly in
the project. Here cost recovery could be
minimized, as there are more ‘supervi-
sors’. Fellow shareholders would certainly
69
supervise one another (IOC, NOC and
local company).
In various producing countries such
as Norway, there is a regulation that IOC
may not have 100 percent interest in one
block at least it must take two or three
partners. The aim is that fellow partners
have interests and supervising one an-
other. This at least could reduce the bur-
den of the government.
Another thing worthy of note is that
this method is more elegant. The govern-
ment could of course use another method,
directly increase the profit oil split after
tax to 90:10 (from 85:15). All costs are
bone by the investor or IOC. The result,
Government Take will rise
to some 90 percent. But this
method is not so elegant,
because the contractor will
calculate its IRR that would
drop significantly.
As I have said earlier,
the law of the market would
be effective. To obtain the
same ‘total’ of Government
Take (90%), a participation
of 30 percent may be done.
The theory is that the
contractor’s IRR will drop a
little (it depends on how the
exploration cost is reim-
bursed, but will not be as bad as through
the mechanism of increasing the profit split
mentioned above).
The contract of Cepu Block follows
this system (maybe because at that time it
had become a national issue, thereby willy-
nilly the IOC whether compelled or of its
own free will carried out a joint develop-
ment with NOC). The Cepu Bock contract
comprises ExxonMobil (45%), Pertamina
(45%) and local government (10%). ‘Gov-
ernment Take” wise, it is certainly far better
than if ExxonMobil holds 100 percent.
Rather than having headache think-
ing about a compatible formula that has
not showed up yet, why not copy this
NOC participation method. How about
following this pattern in every contract?
*) OPEC Fiscal Policy Analyst, Doctorate Candidate,
International University (IU), Vienna.
PETROMINER No. 08/August 20, 2009