Part 1 of 2: Plan for oil contractors to offer 10 percent stake to regions

Part 1 of 2: Plan for oil contractors to offer 10 percent stake to regions

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