How to Design Oil & Gas Contract that Benefits the State

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.
n foreign countries, such matter is no new practice, in the case of offering a block that uses a competitive bidding method, any parameter may become part of the tender, including royalty, 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 recovered may be carried over into the following year. Eventually all costs will be recovered. Cost recovery limit is most important in the initial development 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 anticipated 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 parameter in this respect is related to the level of profit. A rigid and inflexible system may give rise to imbalance in the proportion of profit sharing. Just to remind, 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.
PETROMINER No. 08/August 20, 2009


Looking for a compatible and profitable model? The effort to search for a compatible method of contract to be applied should be stimulated and studied. However, it should be remembered that every 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 discussion), there are debates, proposals and critics on the possibility of proposing the new oil and gas contract model that benefits the state. According to my observation, so far there are two groups of thoughts. 1. The group that considers modification 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.) The group that is allergic to cost recovery 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 relatively ‘junior’ compared with Indonesia. But it does not mean that the senior is always 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 prospectively higher than Indonesia, thus it is normal if the terms & conditions are


heavier for the IOC (in a more common language, the Government Take is higher). Here the law of the market applies, ‘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 development 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 (Algerian NOC). At the exploration stage, therefore, the IOC bears 100 percent of exploration 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 categorized in how to the raise the government portion by tinkering with the formula. My experience proves that this is no easy feat, because 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 parties, 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’ government take will obviously increase,. In picture-1 the government take includes the portion of the ‘cake’ of the NOC. For simplifying, in this illustration, NOC is considered to have paid tax with equal rate as that of IOC. The 50 percent participation, for instance, in practice it could be shared between NOC and the regionowned company, e.g : 40 percent NOC, 10 percent regional government. Consequently, NOC and the regional government 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 ‘supervisors’. Fellow shareholders would certainly

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 another. This at least could reduce the burden of the government. Another thing worthy of note is that this method is more elegant. The government 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 reimbursed, 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 willynilly the IOC whether compelled or of its own free will carried out a joint development with NOC). The Cepu Bock contract comprises ExxonMobil (45%), Pertamina (45%) and local government (10%). ‘Government Take” wise, it is certainly far better than if ExxonMobil holds 100 percent. Rather than having headache thinking 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

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