Part 1 of 2: Bad proposition for oil mining contractors
T.N. Machmud, Jakarta
The Jakarta Post carried a news article under the same title on April 5, 2004 reporting an interview with Iin Arifin Takyan, Director General of Oil and Gas of the Ministry of Energy and Mineral Resources.
In that interview Iin reportedly said that the draft government regulation on oil and gas upstream activities, still under discussion, may stipulate that Production Sharing Contractors (PSC's) must offer regions in which they operate a "10 percent stake in their business in a bid to increase the regions' share in oil and gas production".
We may hereby offer a comment on the said Post article in the context of the current deliberations on the suggested new language in the latest version of the RPP Hulu (draft government regulation on upstream oil and gas activities) specifically with regard to farm-outs and the 10 percent working interest to the regions.
This news did not come as a surprise to the already nervous world of oil and gas investors. It is our understanding that the latest draft of RPP Hulu, contains a provision on "farm-outs", i.e. the sale of a percentage working interest, requiring PSC's when they consider selling a percentage or all of their working interest to a third party, to give priority to a national company.
Reportedly, in another provision, the same document states that PSC's are required to offer a 10 percent participating interest to a regionally owned business entity. We recall that past and present practices already call for a 10 percent share to be offered to Indonesian participants in a block where a Plan of Development is approved for a first commercial discovery. That has become an accepted business practice, although implementation of that provision in some instances has caused operational headaches and dissolution of partnerships.
Although, on the surface, the new language may appear just a slight deviation from what hitherto has been standard operating practice, it is a different dimension altogether. One needs to understand that most PSC's operate in partnerships together with several other investors which together constitute the PSC group. The group may consist of only two, but sometimes eight to ten partners. This is a capital intensive and high risk business.
By bringing in partners, the original signatory to the PSC contract seeks to reduce his risk. The partnership appoints one of the partners to lead the group called the "operator". The operator is responsible to BP Migas (the regulatory body for the upstream oil and gas industry) for the execution of the work program and speaks for the group.
These partnerships, even in the best of circumstances, give rise to difficult management situations even if the group consists of knowledgeable, financially strong and experienced oil people.
However, if we start bringing in the regions as yet another partner, we may drive the PSC into a situation which they may find intolerable. Firstly, the so called farm-out provisions in past and present PSC contracts has worked well over the past 30 years of PSC practice. This arrangement was wisely introduced by the founding fathers of the PSC concept as they understood very well that investment funds must be allowed to flow in and out freely. In PSC language this is called free ingress and egress. Reason is that partnerships change over time.
If a partner acquires an interest in a block, but gets into financial problems a few years later and wishes to sell his interest, the operator seeks approval for that farmout which approval used to be quickly obtained. This procedure did well for this country as we have seen a steady stream of partners come and go over the years. The main concern to the country was and still is that PSC operations go on uninterruptedly.
This was also one of the reasons why Indonesia was considered to be a good place to invest as it understood the needs of the investor. Secondly, when the requirement came along later that a 10 percent working interest had to be offered to an Indonesian participant selected by Pertamina this was initially not seen as a good development as the PSC wanted to freely pick and chose their own partners.
However, the Exhibit D attached to the past and present PSC contracts described the procedure of offering a 10 percent to an Indonesian participant in detail and provided enough safeguards to make sure the PSC could firmly deal with incompetent or financially delinquent partners.
For anyone to join the PSC group as a partner the original principle still applies, whether through a farm-out from the PSC, or by being offered a 10 percent working interest at the time of a first discovery, that in all instances the partner is there for one reason only, namely, to help fund the operation and, if he does, he gets a proportional share in the revenue stream. The aspiring Indonesian partner, therefore, has to agree to and carry out the full obligations of becoming a partner.
The rules dealing with a partnership are laid down in a partnership agreement, or operator/non-operator agreement. Of course he has to be financially capable. Someone may declare him to be financially capable but the proof of the pudding is in the eating. That new partner will need to "meet the cash calls from the operator". The cash calls are the operator's invoices for what each partner has to pay monthly proportionate to his working interest and in addition he may have to pay 10 percent of the sunk cost which can be quite substantial.
Between the operator and the other partners there exists an operating agreement which spells out the cash call arrangements. The well being of the venture depends on each of the partners meeting their respective financial obligations in an orderly, disciplinary and timely manner.
If any of the partners fail to meet the cash calls that partner will be eliminated based on the terms of the operating agreement which establishes the rights and obligations of the partners.
The writer, formerly CEO of Arco Indonesia, is now Executive Director of the Graduate School of Business of Bina Nusantara University