Colouring between the lines: Regulatory challenges remain for sector players

Promulgated in 2001, Indonesia’s Oil and Gas Law forms the backbone of the sector’s regulatory framework along with various supplementary government ordinances and decrees. While the law ostensibly lays out a clear set of rules governing both state and private sector responsibilities, entitlements, liabilities and all manner of legal obligations, different interpretations of regulations by the state have resulted in uncertainty for the private sector. At their core, production sharing contracts (PSCs) outlined in the oil and gas law have provided sufficient incentives and revenue splits to attract many of the world’s most prominent players such as Total E&P, Chevron, ExxonMobil, ConocoPhillips and others. Inconsistent adherence to regulations and unilateral alterations to contracts has also caused consternation among players.

“The contracts themselves are fine, the problem is implementation,” Richard Dinnie, the senior international legal counsel for Total E&P’s Indonesia legal affairs division, told OBG. “The stability of the system and the sanctity of contracts is the biggest issue facing the sector at the moment,” he added. As a result, early stage exploratory efforts have tailed off in recent years and operators of major oil and gas fields have become reticent to make new investments. Rizal Shah, the president director of Offshore Works Indonesia, told OBG, “Regulation of the oil and gas contract tender process limits most service tenders to short terms – typically one to three years – with no guarantee on utilisation. This causes service firms to focus on surviving and limits their ability to make longer-term investments in advanced assets.”

Contractual Obligation

Although the key terms of PSCs are for the most part static in their application, supplemental adjustments made to articles in these contracts can and have resulted in significant changes in the final profit share for each participant. Over the past few years such modifications have come in a variety of forms such as changes in cost recovery, income tax, PSC transfer procedures, and domestic market obligations. In addition, contracts have historically been structured so that commercial operators and not the state bear the brunt of the risk for projects. One of the more controversial regulations exemplifying the differing priorities between the public and private interests is the issuance of government regulation (GR) 79 in 2010 relating to cost recovery of PSCs and income tax treatment for the upstream oil and gas sector. Created to clarify certain income tax matters, GR 79 still poses a number of questions four years after it was enacted. Chief among these are uncertainty as to whether the ordinance can be applied retroactively and how apparent conflicts between the measure and pre-existing tax legislation will be resolved. In an environment where production costs are escalating due to maturing oil fields and related enhanced oil recovery methods being employed, as well as exploration of more expensive and challenging deepwater and frontier resources, the issue of cost recovery is likely to remain a concern for the foreseeable future.

Local Commitments

Another significant provision included in PSCs which has evolved over the years is the domestic market obligation (DMO) clause regulating how much oil and gas the contractor must set aside for sale on the domestic market. The DMO has evolved over time with the introduction of new generations of PSCs, but current contracts require the contractor to supply the domestic market with 25% of both oil and gas production from the contract area out of its own equity share.

Natural gas DMOs are a relatively new addition and only became commonplace following the passage of GR 35 in 2004 (and later GR 79 of 2010) and as such have not generally been put into practice yet as most of the associated PSCs are still in the exploratory stages. How much leeway the government gives in negotiating and interpreting these issues and others – and more importantly how consistent they are in honouring contractual obligations – will go a long way in determining future interest in the country’s oil and gas sector not only for new exploration but also in the extension of existing PSCs.

A number of PSCs for major oil and gas fields are set to expire within the next few years including the Mahakam Block operated by Total E&P Indonesia which expires in 2017. If contract extensions are not reached for any manner of reasons, state-owned energy company, Pertamina, is waiting in the wings and has already made clear publicly that it would be more than happy to take over expiring PSCs.

Another concern for the sector is the pursuance of criminal rather than civil charges brought against three executives of Chevron Pacific Indonesia (CPI) in a bioremediation case. The case came to conclusion in July 2013 when a guilty verdict was handed down by the country’s anti-corruption court in spite of testimony from Ministry of the Environment (KLH) and SKK Migas officials indicating the bioremediation project was in fact in compliance with the applicable laws and regulations of Indonesia. In response the Indonesian Petroleum Association (IPA) issued a statement in July 2013 condemning the verdict, stating, “the criminalisation of the PSC is a very worrying development for both national and international oil and gas firms. The PSC is a business contract, and the IPA’s position is to continually emphasise that disputes arising from PSC project implementation, when shown to have been undertaken in compliance with applicable laws and regulations, should be governed by the dispute resolution process under the terms of the PSC which are based on civil law principles, not criminal law.” This followed a February 2013 decision by the regulator to not extend the work permit of ExxonMobil’s country manager.

Regulator

These issues are further complicated by the changes being instituted within the regulator itself, which is responsible for critical tasks within the sector including awarding of PSCs and the sale of oil and gas from domestic stocks. Little more than a decade after being created in 2002, upstream and downstream regulators BP Migas and BPH Migas were declared unconstitutional by the Indonesian Constitutional Court and subsequently dissolved in 2012. In its place SKK Migas was created using much of the existing personnel and infrastructure and performing essentially the same tasks although it will have oversight from a commission appointed by the Ministry of Energy and Mineral Resources (MEMR).

Although the transition has been relatively smooth, questions still remain regarding the government partner party for PSCs as well as how the new body will handle decisions regarding the impending expiring PSCs as of late 2013.

Complicating matters, SKK Migas chairman Rudi Rubiandini was arrested on graft charges involving $700,000 originating from Singapore-headquartered Kernel Oil by the country's Corruption Eradication Commission (KPK) just eight months in his tenure in August 2013. While the incident did not involve malfeasance regarding upstream oil and gas contracts, the fallout could fuel negative perceptions for the regulator less than a year after its inception.

The Way Forward

Looking to address these and other regulatory issues, the government is currently drafting a new, updated oil and gas law. Among the most pressing issues which are to be reworked in the updated draft legislation are clarification of the division of government and regulatory authorities in the oil and gas sector, confirmation that the body of law pertaining to oil and gas cooperation contracts takes precedence over other more general bodies of law as well as the possible creation of a new developmental body which will take on the state’s PSC representative role formerly carried out by the now defunct BP Migas. In addition, SKK Migas has indicated a willingness to sweeten the pot for oil and gas firms with more favourable PSC splits. However, any major regulatory changes in the oil and gas sector are unlikely to be made prior to the 2014 election.

The Ministry of Finance (MoF) has also moved to boost incentives with the enactment of regulation passed in 2012 (MoF regulation 27) and 2013 (MoF regulation 70), providing a value-added tax exemption for the import of goods in the upstream oil, gas and geothermal sectors for exploratory and exploitation development phases. “In terms of the energy landscape and accommodation of foreign entities, Indonesia has been so flexible for so long that it needs to be careful about suddenly switching to overly protectionist policies,” KK Ralhan, president director of power solutions company Kaltimex, told OBG.

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The Report: Indonesia 2014

Energy chapter from The Report: Indonesia 2014

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