Indonesia’s New Gross Split PSC

by Mike Cuthbertson, Senior Geoscientist and Reservoir Engineer
Posted by Holly Owen on Fri, 10/19/2018 - 13:51

Introduction

In January 2017, under Minister Regulation No 8 of 2017, the Indonesian government announced the release of a new Production Sharing Contract (“PSC”) model, the Gross Split PSC. The updated model contains changes aimed to encourage investment in Indonesia and more efficient operatorship.

The new Gross Split PSC will apply to any new PSC entered into by the State and a Contractor. For existing PSCs, which use the cost recovery model, the Contractor will have the option to switch over to the Gross Split PSC. For expiring PSCs where an extension has already been approved, the cost recovery PSC will continue to apply unless the Contractor wishes to switch to a Gross Split PSC. For expiring PSCs where no extension has been approved, the new PSC will be in the form of the Gross Split PSC.

Source: Australian National University

The Cost Recovery PSC

Indonesia was the first country to issue a PSC and the model has subsequently been adopted by many countries. Under the latest version of the cost recovery PSC, cost recovery takes place after first tranche petroleum (“FTP”) has been deducted. FTP is set at 20% of production and is to be shared between the State and Contractor according to its entitlement percentage. After FTP is deducted, the Contractor is entitled to recover all allowable costs (including production costs) as well as amortised exploration and capital costs. Recoverable exploration costs are limited to the discovery for which the plan of development (“PoD”) has been approved (i.e. not all exploration in the PSC area).

If no commercial discovery is made, the costs are not recoverable, and the Contactor bears all exploration costs.

Issues for the Government

The Indonesian energy industry has been in decline in recent years as supermajors started to withdraw. In 2016, Chevron announced that it would not be extending its contract in the East Kalimantan oil and gas block (expires Oct 2018), which was followed in August 2017 by the sale of its interest in South Natuna Sea Block B. More recently it was revealed that Chevron will not be extending its contract in the Makassar Strait gas block, part of the Indonesia Deepwater Development (“IDD”), beyond 2020. Other major companies to withdraw include ConocoPhillips, which also sold its interest in South Natuna Sea Block B, and ExxonMobil, who have exited the East Natuna gas block. One consequence of the exit of supermajors is that Pertamina (the State owned oil and gas company) has been unable to fill the gap both technically and financially to maintain production.

Indonesia’s crude oil production has been declining since 2000 (Figure 1). A major reason for this is that the majority of production comes from mature fields, where production rates are declining but costs stay relatively constant. In such fields, the cost of incremental recovery through infill drilling, waterflooding or other EOR schemes is high and may be associated with diminishing returns. For example, whilst well costs remain relatively constant, each infill well in a mature field is expected to achieve lower rates (as pressure declines) and recover less volume.

Figure 1 – Historical oil production in Indonesia (kbbl/d) (using data from BP’s Statistical Review of World Energy 2018)

The reason Indonesia’s production is declining and focused to mature fields is the lack of investment in exploration and development in Indonesia. Figure 2 uses data from BP Migas/SKK Migas annual reports to show the evolution of investment between 2008 and 2017. The primary y-axis shows the level of investment in a particular area (e.g. exploration) relative to the 10-yr average in that area and the secondary y-axis shows the total investment (in million US$). The data show that total investment in the oil and gas sector almost halved from 2014 to 2017 and that this reduction is almost entirely accounted for by a decline in exploration and development investments.

Figure 2 – Oil and gas investment in Indonesia 2008-17 (using BP Migas/SKK Migas data)

With a lack of new production coming onstream to replace declining production in mature fields, the cost recovery model has started to put strain on the state revenues. This is in part reflected in proportion of Indonesia’s state revenue that comes from oil and gas, which has reduces from 14% in 2014 to 3% and 5% in 2016 and 2017 respectively (PWC Oil and Gas in Indonesia: Investment and Taxation Guide, 2018).With production costs staying relatively stable and oil production declining, lower oil and gas revenues could become the norm.

Issues for the Contractor

Under the cost recovery PSC, Contractors are required to submit a work programme and budget for approval by Indonesia’s upstream oil and gas regulator, SKK Migas. This requirement means that SKK Migas has control over how a field is developed and, because of the State’s responsibility to cost recovery, there may be situations where the State’s and Contractor’s goals are not aligned. This could result in alterations to PSC work programmes and budgets. This aspect of the PSC is considered unfavourable to Contractors as it limits their freedom to develop fields and provides an additional layer of bureaucracy, which can lead to delays in development.

Over the last decade, increases in cost recovery regulation and the risk of non-compliance have led to a lack of enthusiasm towards exploration and development from E&P companies across Indonesia.

The Gross Split PSC

After the Gross Split PSC was released in January 2017 it was generally met with criticism from industry. This led to the Government and SKK Migas making a number of revisions and a new version was released in September 2017 under Minister Regulation 52 of 2017. The changes made improve the terms for the Contractor. The following sections discuss the most recent terms of the Gross Split PSC.

 

Production Splits

Under the Gross Split PSC, gross production is shared between the State and Contractor based on production splits without a cost recovery mechanism. Costs incurred by the Contractor are deductible for income tax purposes, although under general income tax law, tax losses can only be carried forward for 5 years.

The production splits will be based on an initial position (oil – 57% State, 43% Contractor; gas – 52% State, 48% Contractor) which may be altered based on various factors, including:

Commercial Evaluation

The production split can be revised if a certain economic value is not met for a field for which a POD has been approved. The determination of this economic value is not clear. The adjustment allowed is at the discretion of the Minister and has no maximum limit.

Field Conditions

Consideration is given to the conditions of a PSC with the aim of rewarding Contractors for developing oil and gas resources in more challenging environments. The conditions include location (onshore/offshore/water depth), reservoir depth, reservoir type and CO2/H2S content amongst others. Examples of adjustments for H2S content and infrastructure are shown in Tables 1 and 2.

Table 1 and 2 – Production split adjustments for H2S content (Table 1) and infrastructure (Table 2)

In the event that further appraisal and/or development of the field leads to differences in the initial parameters on which the production split was based, adjustments to the production split can be made.

Oil & Gas Price

Monthly adjustments will be made to the production split calculation based on oil price according to a formula-based approach using the Indonesian Crude Price (“ICP”) (Adjustment = [85 – ICP] * 0.25%) (Table 3). The ICP is an index determined by Dirjen Migas (Director General of Oil and Gas) and is based on a moving average of a basket of eight internationally traded Indonesian crudes. A similar approach is taken to gas prices (Table 4).

Table 3 (oil) and 4 (gas) – Production split adjustments according to oil and gas price

Cumulative Production

Adjustments will be made based on the cumulative production in the PSC, with the Contractor receiving a diminishing split as more oil and gas is produced (Table 5).

Table 5 – Production split adjustments according to Contractor’s cumulative production

Potential Impacts

The intention of the Gross Split PSC is to increase the Contractor’s share of oil and gas, encourage Contractors to lower their operations costs and allow Contractors to operate more efficiently. However, whether the increased production allocation makes up for the removal of cost recovery is a point of debate. The reduction of operating costs will take time and, at least in the near term, it is likely that Contractors will be forced to look to international service companies in order to reduce costs, leaving Indonesian service companies worse off. 

There is much uncertainty around which costs will be considered tax deductible under the Gross Split PSC. Although industry has lobbied the Government for clarifications no response has yet been given. The 5-year carry forward period is disadvantageous to exploration as in many cases it may take longer than 5 years for a discovery to reach production and generate revenue against which costs can be deducted.

Until some precedent is established, it is thought that the negotiation of production splits will not be consistent across PSCs and Contractors. Such negotiations are likely to require prolonged dialogue with SKK Migas at the initial stage and at each subsequent adjustment. Furthermore, in the event of significant disagreement between SKK Migas and the Contractor there is no clear appeal system laid out in the new terms.

In the absence of cost recovery, the State’s share of oil and gas will be higher over the early years of production. This means it will take longer for the Contractor to recoup investment costs, which will result in increased project uncertainty and a delayed return on investment

One scenario in which Gross Split PSCs may be advantageous to Contractors is where PSCs containing mature assets are renewed. In such instances the high capital spending has already occurred and under the Gross Split PSC the Contractor would likely be rewarded with a greater share of production. However, it is not been made clear what happens in the event that a cost pool still remains at the point of renewal. This needs to be clarified by the Government and SKK Migas.

Image source: www.energyrecovery.com

The Role of SKK Migas

Under the cost recovery PSC, one of the main roles of SKK Migas was to manage the cost recovery system through the review and approval of plans for development, authorisations for expenditure, work programmes and budgets and the procurement process. Under the Gross Split PSC, Contractors will still be required to submit a work programme and budget, but it is only the work programme that needs to be approved by SKK Migas. The budget will only serve as a supporting document in SKK Migas’ review of the work programme. SKK Migas still has control and oversight over the execution of the PSC but the control is limited to formulating policies on the work programme and budget.

SKK Migas’ role in the procurement of services and goods also appears to be changing under the Gross Split PSC, although regulations are unclear. On the one hand, the Gross Split PSC seems to allow Contractors to independently procure goods and services. This suggests that SKK Migas’ procurement guideline PTK 007, which required SKK Migas to approve procurement tenders over a certain amount and permit only certain contractors to bid for work, would no longer apply. However, comments made by Prahoro Nurtjahyo, an advisor on investment and infrastructure development at the Ministry of Energy and Mineral Resources suggested that Contractors will still need to meet obligations to use domestic goods and services. In fact, one of the factors affecting the production split in a Gross Split PSC is the level of local content used and could lead to a 4% increase in the Contractor’s share.

Potential Impacts

Although the intention of the Gross Split PSC is to allow Contractors to operate more cost effectively, it seems that SKK Migas will still have a significant role in reviewing and approving work programmes . Despite the relaxation over budget reviews, they are intrinsically linked to the work programme and by having a say in the work programme, SKK Migas still effectively have a say on the budget.

It is very unclear as to how procurement will be managed under the Gross Split PSC and what SKK Migas’ exact role will be. It seems that the sanction could be applied in the event of non-compliance to Local Content Requirements, with the loss of 4% of the production split. It may be the case that such a loss is offset by the savings made by the Contractor in procuring services from international providers.

 

Domestic Market Obligation

Under the Gross Split PSC, the Contactor will no longer have to sell a portion of production to the Indonesian market at a discounted price. Instead, the DMO is set at 25% of gross production, with the Contractor supplying an amount equal to 25% multiplied by its entitlement percentage. The price received by the Contractor for its share of DMO will be the ICP.

Potential Impacts

This change benefits the Contractors by increasing their revenue from DMO. Conversely, the domestic market must pay more for their oil, perhaps signalling a lowering of subsidies in Indonesia and more integration with the world crude market.

 

Asset Ownership

Under the Gross Split PSC, the State will continue to own all property purchased by the Contractor (i.e. land, goods and equipment). This is consistent with the cost recovery system.

Potential Impacts

Under the cost recovery PSC this was justified as the Contractor could recover the cost of procuring such assets. However, with the removal of the cost recovery system, it is difficult to see the justification in allowing the State to assume ownership of assets it has contributed nothing towards. With the incentive of asset ownership removed, it is likely that Contractors will continue to lease equipment, something which will not reduce operating costs in most cases.

 

Economic Impact

Whilst the Indonesian Government feels it has provided a means by which to increase the reward to Contractors, it is felt by some industry participants that this may not be the case.

A study by Wood Mackenzie based on the January 2017 Gross Split PSC terms compared difference operation scenarios (e.g. oil field size, onshore/shelf/deep water and oil/gas) under the cost recovery and Gross Split PSCs. The study showed that the Contractor’s Net Present Value at a 10% discount rate (NPV10) was lower in each development scenario under the Gross Split PSC unless reductions of 10-20% in operating costs were applied. Given that E&P companies have already made significant reductions in operating costs in the lower oil price environment, it is questionable whether further reductions of 10-20% are achievable. Finally, the study found that the negative impact on the Contractor’s NPV10 was much greater for gas projects than for oil projects.

However, the September 2017 revisions made by SKK Migas have certainly made the Gross Split PSC more attractive. The economic analysis presented in Figure 3 shows that, under the revised terms, the Gross Split PSC gives a higher internal rate of return (“IRR”) and NPV across a number of scenarios.


 

Figure 3 – Economic Analysis on IRR (top) and NPV (bottom) for various fields under different PSC models. Source: docdroid, Kementerian ESDM

The link between the Gross Split PSC and oil price should make the conditions competitive in the event of an oil price crash and shows a willingness by the Indonesian Government to share the burden. Conversely, if oil prices rise, the production split is reduced but it is expected that such reductions are offset by the benefits of higher oil prices.

 

Conclusions

It was generally recognised that the cost recovery PSC needed revision to improve the prospects of oil and gas investment in Indoneisa. The Gross Split PSC represents a shift in how oil and gas resources are handled by the government and SKK Migas in IndonesiaThe Government’s and SKK Migas’ willingness to make revisions based on industry feedback has been welcomed. Nevertheless, many aspects remain uncertain, in particular the rules over local procurement.

The Gross Split PSC will undoubtedly make Contractors more conscious of their costs in Indonesia and should lead to more efficient, cost-effective operatorship. The effect it will have on Contractors’ attitudes towards exploration is less clear and more time is needed to assess this area.

In April 2018, Premier Oil, Mubadala Petroleum and Kris Energy acquired the Andaman II PSC and Mubadala Petroleum acquired the Andaman I PSC. These were the first new Gross Split PSCs awarded and their adoption provides encouragement.

Many E&P companies will continue to adopt a ‘wait and see’ approach before committing to a Gross Split PSC. However, if the upcoming 2018 bid round is successful, it will be another vote of confidence for the model and will encourage further investment.

Image source: www.indonesiaexpat.biz