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1 February, 2017
On 16 January 2017, the Indonesian Minister of Energy and Mineral Resources ("Minister") announced a new regulation which will see the country's approach to revenue and cost sharing under production sharing contracts ("PSCs") change dramatically.
Under Minister regulation No 8 of 2017 ("Regulation")1, new PSCs entered into in Indonesia will apply a 'gross split' mechanism to allocate production from petroleum operations under those PSCs, as between the State and the PSC contractor ("Contractor"). This will see Contractors being allocated a potentially higher percentage share of gross production under new PSCs in exchange for removal of the existing cost recovery mechanism.
Existing PSCs will be largely unaffected, although Contractors may request to amend their existing PSCs to apply a gross split mechanism if they choose.
The new gross split mechanism has been applied in the Offshore North West Java (ONWJ) block PSC which was signed on 16 January 2017 with a PT Pertamina subsidiary as Contractor.
Background to the Regulation
Since the dissolution of BPMIGAS in late 2012, the administration of the cost recovery mechanism has been challenging for the Government. The Government reiterated on a number of occasions that cost recovery was a burden to the State budget and that the Government was losing revenue from cost recovery, particularly as the cost recovery allocation in the State budget has been increasing year after year.
According to reports, last year the Government's share of oil and gas revenues was reduced by $13.9 billion to account for oil and gas cost recovery, significantly more than the $12.86 billion in non-tax revenues realised from the sector. Commission VII overseeing energy has also agreed to the Government’s request to reduce the 2017 cost recovery budget to $10.4 billion from the original proposal of $11.7 billion.
Easing budgetary pressure is perhaps the main driving force behind the Government's initiative in introducing the gross split scheme. The gross split mechanism also potentially reduces the level of political involvement in the administration of upstream oil and gas business activities.
Fiscal features of a Gross Split PSC
Under a gross split PSC, gross production will be allocated between the State and the Contractor based solely on production splits, without involving an operational cost recovery mechanism. On this basis, the Contractor's entitlement to production for each lifting period, and the resulting revenues, will be determined based solely on its gross split percentage, which is determined on a pre-tax basis.
This contrasts to existing PSCs in Indonesia, as well as PSCs in other jurisdictions, where gross production from a field, after deduction for first tranche petroleum (if relevant), is first applied to reimburse the Contractor for the eligible operating costs which the Contractor incurred in conducting petroleum operations in relation to that field2 (i.e. cost recovery). Any production remaining after first tranche petroleum and cost recovery in existing Indonesian PSCs is then shared between the State and the Contractor based on fixed production splits.
The Government will continue to derive its income from the State's respective split of revenues under the PSC, together with certain bonuses and income tax and other indirect taxes payable by the Contractor. However, in the case of a gross split PSC, the State's entitlement to production will not be reduced as a result of cost recovery.
The Contractor's net income will be determined after deducting its applicable income tax. Tax incentives (and other incentives) may apply, but these are not addressed in the Regulation and will be in accordance with prevailing laws and regulations relating to tax and incentives in the upstream oil and gas sector. Although the gross split PSCs will not contain a cost recovery mechanism, operational costs that have been incurred by a Contractor may be applied as a deduction in the Contractor's income tax calculation.
Determining the initial gross split percentages for each field
The Regulation provides that each gross split PSC shall have an initial "base split" percentage to be applied to each field developed within the contract area, which will be adjusted based on a number of field-specific and variable factors.
The initial base production splits are:
a. Oil – 57% State : 43% Contractor
b. Natural Gas – 52% State : 48% Contractor
The base splits will be adjusted based on a number of field-specific factors, and this adjusted "initial" split will be applied by the Minister (acting on the recommendation of the head of SKK Migas) for the purposes of calculating the State and Contractor's respective share of production at the time of approval of each field's plan of development ("POD").
Notably, the field-specific factors include key physical characteristics of each oil or gas field to be developed within the PSC contract area, such as the location, depth and type of the reservoir, as well as chemical composition of the oil or gas contained within the reservoir. The adjustments take into account and reward the Contractor for additional risks and expense associated with more challenging developments. For example, adjustments could be as much as an additional 16% in favour of the Contractor for deepwater developments (e.g. more than 1000m deep), recognising the additional risks for the Contractor associated with the development of those fields.
Adjustments to the initial production split
The initial gross split will be further adjusted over time, as follows:
a. If, on commencement of commercial production it becomes apparent that the field-specific components are different to what was anticipated at the time of setting the initial split, then the splits may be adjusted to reflect the prevailing conditions.
b. The initial split will also be adjusted to reflect two key variable factors, being the price of oil (based on the monthly Indonesian Crude Price), and the volume of the Contractor's cumulative production of oil and gas. Adjustment to the split due to the oil price will be calculated each month by SKK Migas, based on its evaluation of the variable factors, meaning the State and Contractor's respective percentages will vary on a month to month basis.
Impact of the Regulation on other key PSC features – ownership of land and assets, other provisions
As is the case under existing PSCs, the Regulation provides that all goods and equipment that is directly used for upstream oil and gas activities and are purchased by the Contractor shall be owned by the State (and managed by SKK Migas).
In addition, land that has been acquired shall be owned by the State. All plots of land that have been acquired must be subsequently certificated pursuant to prevailing laws and regulations.
The Regulation also confirms some basic requirements to be set out in the gross split PSC, which are consistent with the current approach under existing cost recovery PSCs. These include:
a. A domestic market obligation of 25%.
b. Submission to, and approval by, SKK Migas of work programs and budgets.
c. The Minister is to approve the first POD, and the head of SKK Migas for any subsequent POD.
d. Utilisation of local workers/employees, goods and services.
e. Data obtained from oil and gas activities to be owned by the State.
f. Indonesian participant, firm commitment, unitisation, relinquishments, etc shall be carried out in accordance with prevailing laws and regulations.
Impact on existing PSCs
Existing PSCs will not be automatically affected by the new Regulation, although Contractors with existing PSCs may request to transition to gross split PSC terms if they prefer. This may be an attractive option to some Contractors, depending on the physical characteristics of the fields within their PSC. If Contractors who request this option still have outstanding operational costs that have not been recovered on conversion of the PSC to the gross split mechanism, any such unrecovered operational costs may be taken into account to increase the Contractor's split.
Otherwise, existing PSCs in place prior to the issuance of the Regulation shall continue to be valid until the expiry of those contracts in accordance with their terms.
However, there are also a number of PSCs currently in effect in Indonesia which are approaching expiry in the short to medium term. The treatment of these areas going forward is contemplated by the Regulation and, in particular, the Regulation provides that:
a. management of a contract area which has expired, but which will not be extended, shall subsequently be managed under a gross split PSC (i.e. if a new PSC is granted in respect of that contract area); and
b. for a contract area that is due to expire but will be extended, the Government may determine whether to grant extension on the basis of a cost recovery type PSC, or require the Contractor to operate under a gross split PSC for the extension period.
As a transitional measure, the Regulation provides that PSCs which have expired or are due to expire, but for which an extension approval has been granted as at the date of the Regulation, those PSCs may continue to be in the form of a cost recovery PSC or the Contractor may request that the Government enter into a gross split PSC with that Contractor in respect of the extension period.
Key implications for Contractors
The new gross split PSC regime represents a significant change in the fiscal terms of Indonesian PSCs. Some of the key implications for Contractors include:
a. Priority and timing of recovery of operating costs: Under current Indonesian PSCs, cost recovery is prioritised over the State's profit oil and gas share, which means that Contractors may recover their eligible investment costs before the State takes its profit share (except for first tranche petroleum). The absence of cost recovery in gross split PSCs will mean that the State's entitlement to oil and gas in early years of production under a gross split PSC will be higher. As a result, Contractors may need to wait longer to recover their investment costs under gross split PSCs. This changes the dynamics of a Contractor's investment and potentially increases their investment and funding risk. Contractors will likely place increased emphasis on reserves and production forecasts when making their investment decisions, and may seek to mitigate their cost exposure where there is more uncertainty in terms of investment recovery (e.g. when agreeing firm work commitments).
b. Responding to oil price changes: The Regulation provides for a greater percentage share in favour of the Contractor during low oil price periods, reflecting a willingness of the Government to share more of the downside of lower oil prices and perhaps to encourage continued investment in Indonesia even during challenging periods of the oil price cycle. The trade-off for this is that the State enjoys more of the upside during periods of high oil prices, where its gross split percentage is increased.
c. Gross splits determined on a field-by-field basis: The ability to adjust the base and initial gross percentage splits, at POD and commencement of production respectively, to take into account the field-specific factors set out in the Regulation allows each field to be assessed separately and for the production split to be tailored accordingly. This mechanism also allows for changes in certain circumstances between POD and commencement of production to be factored into gross split percentages. There are, however, prescribed limits on the amount by which the gross split percentages can be adjusted, which may not fully reflect the impact of the specific factors on commerciality of a field and could limit overall flexibility in terms of the fiscal arrangements which will apply.
d. Agreeing adjustments to gross split percentages: The adjustment of gross split percentages initially and on an ongoing basis will no doubt require ongoing dialogue and agreement between the Contractor and SKK Migas and may give rise to disagreement. In addition, concerns have been raised as to whether involvement of the Ministry of Finance will be required in determining the adjusted splits, given that they will have an impact on fiscal matters which involve the State.
e. Ownership of assets: One of the key tenants of the PSC regime is that title to goods and equipment which are used in petroleum operation vest with the State. The cost recovery mechanism has always been a key justification for this principle. As cost recovery is not a feature of the gross split PSCs in Indonesia, Contractors may query the rationale for the State's title to assets used in petroleum operations, particularly where the cost of those assets has not been recovered by the Contractor through production.
1. Note that the Regulation was signed by the Minister on 13 January 2017, and announced on 16 January 2017.
2. In earlier generation Indonesian PSCs, cost recovery applies on a contract area basis, rather than a field-by-field (ring fencing) basis.
For further information, please contact:
Daniel Reinbott, Partner, Ashurst
daniel.reinbott@ashurst.com
