Developing the downstream segment remains Indonesia's focus

As the top nickel producer globally in 2013, the second-biggest coal exporter in 2015 and host to one of the largest copper and gold mines in the world, Indonesia has the capacity to compete with the most prolific mining nations. However, this potential has not necessarily been translated into strong production figures in recent times, and the domestic mining sector has suffered markedly over the past three years due to deteriorating global commodity prices and, more specifically, slowing growth in China, the leading purchaser of Indonesia’s mineral and coal products.

The Mining Law 

Compounding the challenging economic environment has been the turbulence engendered by the ever-evolving legislative landscape governing the sector. The Law on Mineral and Coal Mining No.4 of 2009 replaced the previous legal framework of 1967, and a number of implementing regulations and amendments have been rolled out since its promulgation.

One of these regulations took the form of an export ban on unprocessed ore that came into effect on May 6, 2012. The ban was motivated by the state’s desire to stimulate growth in the domestic smelting industry and to boost value-added exports. Since the restriction, exports of mineral commodities have dwindled, including bauxite, nickel and gold. The sector’s contribution to the economy also slipped from 6% in 2012, when mining and quarrying output was Rp1000trn ($73bn), to around 4% in 2015, when output hit Rp879.4trn ($64.2bn). Export activity also declined, from $66.6bn in 2011 to $33.6bn in 2015.

While a lack of international demand has certainly contributed to these depressed figures, critics have also blamed the shifting legislative framework underpinning mining contracts. The government’s push through various reforms to ensure that more benefits from resource extraction are preserved and reinvested domestically has, according to many observers, ultimately deterred investment and resulted in lost revenue.

Contract Reform 

The 2009 mining law consolidated the contracts of work (CoW) and coal contracts of work (CCoW) framework for foreign investors, and the mining rights framework for Indonesian investors into a single scheme for all mining outfits under a mining business permit (IUP). The law also established a special mining business permit (IUPK) for conducting mining activities in specific areas and a people’s mining licence for smaller operations available to only Indonesian investors. Since the law was passed, he government has signed several renegotiated CoWs and CCoWs for major mining operations, however, many are still in the renegotiation stage.

The operational parameters available to IUP holders are significantly narrower than under CoWs in terms of contract length and concession size. The mines that have operated for decades in Indonesia would not have been feasible under the current system, in which metallic mineral exploration areas are limited to between 5000 ha and 100,000 ha (to be reduced to a maximum of 50,000 ha after three years), with a production area no larger than 25,000 ha, and non-metallic minerals exploration areas are capped at 25,000 ha (reduced to 12,500 ha after two years), and a 5000-ha production area.

In terms of duration, exploration IUP contracts for rocks and non-metallic minerals are restricted to three years, while metallic minerals are limited to seven years. Production IUPs for rocks, non-metallic and metallic minerals are capped at five, 10 and 20 years, respectively. Rock and non-metallic mineral agreements may also be extended twice for a period of five years each, while metallic mineral contracts may be extended twice for 10 years. The less business-friendly nature and limited timeframes of IUPs, along with the export restrictions on unprocessed ore mentioned previously, have had a key impact on the sector (see analysis).

Downstream Segment

The changes to the law regarding raw ore exports applied retroactively, therefore pre-existing contracts were also subject to the stipulations, resulting in substantial shifts in business operations for numerous mines across a range of different commodities, as they were forced to develop processing and refining facilities. The government later issued various implementing regulations to allow mining firms to continue to export certain commodities, including copper, iron and zinc, provided they pay export levies until January 2017 – when the ban ends – and also commit to building downstream facilities. Nevertheless, concerns were raised at the time about the social welfare costs of the shift, due to the low number of employees needed to work in smelters, the potential for job losses if unprofitable mines were to close, and the environmental costs associated with processing and refining installations.

The ore ban is due to be reimposed after its expiry on January 11, 2017, and the economic feasibility of developing the downstream segment continues to be questioned, particularly as the public infrastructure necessary to support such facilities is often inadequate. A lack of income from unprocessed ore also means that in some cases the financial resources to develop the downstream segment have been unavailable. As had been feared, many smaller miners have suspended operations, while larger-scale operations have reduced activities. Completely repealing the restrictions, however, would also create problems for many firms, such as US-based Freeport-McMoRan Copper & Gold, which have been forced to develop smelting facilities to comply with the mining law.

Divestment Requirements

Of equal or perhaps greater significance to mining companies than the curtailment of the duration and plot size of mining contracts is the evolution in the last seven years of divestment requirements for foreign shareholders in mining firms. Initially, Government Regulation No.23 of 2010 set out a minimum divestment of 20% of foreign capital for IUP holders, which had to be reached after five years of operation. This proved short-lived, however, as the government exercised its power – as stipulated in the mining law – to independently set divestment levels and to raise divestment requirements. This was done through the issuance of Government Regulation 24 of 2012 and Ministry of Energy and Mineral Resources (MEMR) Regulation 27 of 2013.

Under the revised timetable, foreign investors in the sector must reduce their ownership to a maximum of 80% six years after production begins; 70% after seven years; 63% after eight years; 56% after nine years; and 49% after 10 years. Local, regional and then federal governments are afforded first rights of refusal for these shares at below-market-value discounted replacement costs, creating an incentive to either participate directly in operations or to transfer them to locally-registered third parties. This requirement has not been challenged by the private sector, but the method with which their shares are valued has been. Currently, the government is first in line to purchase these interests on behalf of the country, paying an amount deemed commensurate with the value of the stake. The divesting companies, however, would prefer a more market-based valuation, which would entail offering shares as initial public offerings (IPO) on the Indonesian stock exchange. “The regulatory environment has not been attractive for foreign investment or even for domestic companies,” Sacha Winzenried, partner and leader of the Energy, Mining and Utilities Practice at PwC Indonesia, told OBG. “It was not attractive during the boom years and is even less so now, particularly when companies are looking to allocate scarce resources.”

To some extent, the country’s export ledger is not helping incentivise investment either. In 2012 and 2013 lucrative nickel ore exports brought in record highs of $1.5bn and $1.7bn in receipts, respectively, as companies scrambled to ship out stockpiles ahead of the ban taking effect. In 2014, however, exports only registered $85.9m, with zero ore exports posted a year later. Meanwhile, bauxite figures fell from $637.6m in 2012 to $744,000 by 2015. Copper shipments declined from $2.6bn in 2012 to $1.7bn two years later; however, this figure rebounded to $3.3bn in 2015 after restrictions were eased on exports of the metal a year earlier.

Draft Law 

In April 2016 the MEMR released a draft of a new mining law to potentially replace the 2009 mining law, and a more comprehensive update arrived in June of the same year. Ostensibly, the latest draft addresses some of the problems encountered over the last few years in yet another reworking of the sector’s regulations. For example, in apparent recognition of private sector players’ discontent with the manner in which divested stakes are valued, the draft law proposes that IUP and IUPK holders with foreign shareholders be able to satisfy their divestment requirements through IPOs on the Indonesian exchange.

Furthermore, the draft suggests that tax and non-tax incentives could be made available to IUP holders that commit to installing processing or refinery facilities, suggesting that the state might adopt a softer and more positive approach to ensuring that the downstream segment is developed in the coming years. To this end, the draft also proposes extending exemptions to the ore export ban to five years for those firms currently engaged in processing activity and in the process of building refining facilities. Nonetheless, revisions to the mining law, which are expected later in 2016, may have a knock-on effect on the stipulations and terms of the final copy of the new law.

Major Players 

These new and uncertain aspects of the regulatory environment are affecting the ongoing negotiations for potential mining licence extensions at some of the country’s most profitable mines. Large mining corporates such as US-based Freeport-McMoRan have a great deal at stake in the outcome of their contract renegotiations and extensions, and the Grasberg mine in West Papua has been a pillar of the company’s position as the world’s largest copper miner for many years. These discussions centre around contractual issues concerning the size of mined areas, the length of contract extensions, royalties, tax regimens, domestic processing and divestment requirements, and the utilisation of local goods and services.

Both the state and large mining corporates have vested interests in swift renegotiations, as copper exports are now dependent on temporary six-month export permits that are taxed at a higher rate. This current system has resulted in inconsistent output for the past few years, as a failure to renew contracts in a timely manner has curbed exports from time to time. For example, after shipping out 1.1m tonnes and 1.5m tonnes of copper ore in 2012 and 2013, respectively, exports were halved to just 715,000 tonnes in 2014 after the blanket export ban. However, after the government reinstated export permissions in certain circumstances for some companies in 2014, the figure rebounded to 1.7m tonnes in 2015. These fluctuations have brought into question the feasibility of planned copper mining investments.

Freeport-McMoRan’s Grasberg mine is the largest copper mine in Indonesia and has been a substantial revenue generator for both the company and the state for years. One issue facing the firm as of mid-2016 is the interpretation of the original CoW agreement allowing Freeport to mine at Grasberg. The deal expires in 2021 and originally included provisions for a series of extensions up until 2041. However, the government has sent mixed signals about the terms of the renewal in negotiations, and the final decision appears to depend on how much each side is willing to compromise. A specific sticking point has been the valuation of the next phase of mandatory divestment, which would double the government’s current 10.64% stake in the mine. Freeport valued the state’s share in the mine at around $1.7bn in early 2016, which the Indonesian government countered with a valuation of $630m.

Leaving The Market

The ongoing negotiations and uncertain regulatory climate were both factors that had a hand in Newmont Mining exiting the Indonesian market altogether in June 2016. Rather than continue any further with negotiations, Newmont entered into a binding share sale and purchase agreement with Amman Mineral Internasional for its 48.5% stake in Newmont Nusa Tenggara, which operates the Batu Hijau copper and gold mine on the Indonesian island of Sumbawa. The $1.3bn deal was contingent on a number of caveats, including the sale of minority stakes owned by the Sumitomo Corporation and Multi Daerah Bersaing.

The new owner of the Batu Hijau mine, Amman Mineral Internasional, is controlled by oil and gas company MedcoEnergi Group and AP Investment, which purchased controlling stakes in the company for $2.6bn in June 2016. The purchase was backed by Bank Mandiri, Bank Negara and Bank Rakyat, the three largest state-owned lenders.

Nickel 

One of the world’s leading nickel producing nations, Indonesia’s nickel output benefitted greatly from robust economic development in China in the early years of the new millennium. Leading up to the 2012 ban on raw exports, Southeast Sulawesi’s mining industry boomed in step with China’s steel production and demand from its smelters. As a result, ore exports grew exponentially from central and western parts of the province. Part of the product’s appeal was that Indonesian miners were able to take advantage of the fact that South-east Sulawesi’s laterite nickel ore was being shipped abroad as ferronickel (or nickel pig iron, NPI) – a mixture of nickel and iron that was less expensive than pure nickel ore from elsewhere.

However, these boom times are over, and the industry has been hit hard in recent years by a sluggish global economy. More importantly, the country’s ban on unprocessed mineral exports has dealt a severe blow to domestic nickel producers, with only larger outfits such as Brazilian multinational mining firm Vale and Indonesian Antam able to comply with the refining requirements.

After producing more than 400,000 tonnes of nickel in 2013, domestic production plummeted to just 177,000 tonnes in 2014 and 170,000 a year later, according to data from the US Geological Survey. The ramifications of this rapid curtailing of output in one of the world’s most prolific nickel producing countries has had an impact not just domestically but internationally. First, Indonesian ore exports to China were replaced largely by shipments from the Philippines, which saw their nickel ore exports achieve a new high of 530,000 tonnes in 2015, overtaking Indonesia as the largest direct shipping ore exporter in the world. Looking to further diversify nickel supplies away from now-unreliable Indonesian exporters, companies from Australia, China, and Japan began showing renewed interest in Solomon Islands after its High Court approved a long-awaited request to develop the substantial Isabel saprolitic deposit. In Indonesia, however, several Chinese companies are moving forwards with plans to construct NPI plants on Halmahera, Java, and Sulawesi. The larger operations that have been confirmed are focusing on low-cost, lower-quality refining processes, which are less likely to support price increases going forward.

One of biggest producers of NPI in Indonesia is a local unit of Chinese steel producer Tsingshan Group, which set about tripling its NPI capacity in 2015. The firm is developing three smelters at a site in Sulawesi, which upon completion in June 2017 are expected to have a combined annual output capacity of 1.2m tonnes of NPI, which will contain 120,000 tonnes of nickel.

Coal 

The coal segment in Indonesia has historically been driven by its export markets, with domestic consumption of secondary importance. However, as global demand has tailed off in recent years, coal prices have been sent into a tailspin and output has plummeted without sufficient domestic demand to pick up the slack. Output fell 14.4% to 392m tonnes in 2015 from 458m tonnes a year earlier, reaching its lowest level since 2011, according to data from the Indonesian Coal Mining Association.

In the face of this softening overseas demand, the state has invested significantly in coal-fired power plants. A succession of power development plans have been launched over the past decade, and the majority of the country’s power is expected to be delivered by coal-fired plants in the future. In 2006 the government announced its first “fast track” programme (FTP I) followed by a second (FTP II) in early 2010, with each plan looking to establish 10 GW of new generating capacity. After mixed results, the two 10-GW plans were replaced in 2015 by a 35-GW plan, for which roughly half of the installed capacity will be derived from coal-fired power plants. As well as investment in power plants, some involved in the sector have called for fiscal support for the training and development of the workforce across the mining industry. “The mining sector needs technology and human resources investment,” Edo Prasetyo, director of Indonesia-based Bangun Arta, told OBG. “It is difficult to find specialised individuals for the different phases of mineral processing.”

Pricing 

From a regulatory viewpoint, the coal industry has been affected to a far lesser extent by the mining law than its mineral counterparts. One of the more significant changes being discussed is the reconfiguration of the country’s coal pricing mechanism. The current format is based on a basket index of a number of international coal prices, though this could change to a more localised system that better reflects the sector in Indonesia. The proposal endorsed by the Indonesia Coal Mining Association is a cost-plus margin formula, which would reconfigure pricing to more closely resemble the domestic environment by widening the scope of the system currently employed for mine-mouth power plants. This particular formula takes the base cost of mining the coal and adds a set margin of 15-25% to determine the price of coal paid domestically and cover stripping costs. Although it appears unlikely that this proposal will be passed in time to take effect in 2017, the new formula under which domestic power grid operator state-owned electricity distributor Perusahaan Listrik Negara will purchase electricity from the 35-GW programme has yet to be determined.

The withdrawal of the coal sector’s legal obligation to set aside a certain amount of coal for the domestic market at set prices has also simplified the sector in recent years. Implemented to maintain energy security at a time when high market prices and strong foreign demand – particularly from India and China – encouraged companies to import large amounts of coal from abroad, the policy has since become a vestige of the energy landscape before commodity prices started to drop off in 2008.

Dwindling Exports 

While domestic coal mining outfits can see an increase in local demand on the horizon, the outlook is far less positive in terms of export figures. The global economic downturn continues to suppress coal demand worldwide, and, most significantly, from big regional consumers like China and India. Furthermore, moves by the two nations to source more of their coal domestically have created more market uncertainty for Indonesia-based exporters. Recent figures add to this unease, with coal exports falling to 367m tonnes in 2015, down from a high of 422.6m tonnes in 2013 and 408.3m tonnes a year later.

Policy changes in India are likely to have a direct and lasting impact on Indonesian exporters of low-rank coal. One of the few large markets for low-caloric-value coal, India has recently made moves to shore up its own domestic coal mining sector to boost its competitiveness. One of the more significant moves along these lines took place in 2015, when India’s government revoked numerous production licences of inefficient operators and re-auctioned them to larger mining companies with proven track records. With the increased efficiency achieved by these new companies, domestic production in the country spiked in early 2016, and costs declined to the point of becoming more attractive than the imported alternatives from Indonesia and other countries.

As of March 2016, the price of Indonesian coal was still lower than the comparable domestic supplies in India, but the gap has been narrowing. Another contributing factor to the waning attractiveness of Indonesian coal is a new measure in the latest Indian budget that instituted a new flat-rate tax on coal applied across the board, meaning that lower-grade coal will be hit relatively harder than higher-value coal. “It is increasingly important to lower costs and increase efficiency, otherwise there is no reason to continue production as prices continue to fall,” Jayaraman Udaykumar, president director of Adani Global, told OBG. “There is no domestic demand for this coal.”

Outlook

Due to the combination of damaging but most likely temporary factors negatively affecting the mining sector, the industry is poised for a recovery in the near future. The country’s substantial mineral and coal reserves remain attractive assets for mining investments, though the government will need to take concrete steps to reduce the perceived risk of investing in the country and address its regulatory shortcomings. The uncertainty surrounding contract extensions and processing requirements are issues demanding particular attention to attract mining investment.

In the medium term, the reticence shown by large companies to invest in capital intensive projects could negatively affect production for as long as 10 years, given the time it takes for such fiscal outlays to yield significant levels of income. Any recovery in the current downturn in commodity prices will, however, boost the mining industry’s outlook.

In the coal sector, exports are expected to remain sluggish unless a substantial global economic recovery takes place, as primary import markets in China and India are not expected increase their appetite for foreign coal supplies. Instead, any recovery for the domestic coal sector will rely heavily on the government’s ability to achieve results from its efforts to rapidly build up Indonesia’s coal-fired power plant capacity over the next decade.

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The Report: Indonesia 2017

Mining chapter from The Report: Indonesia 2017

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