Developing RI gas market

James Castle and Todd Callahan, CastleGroup, Jakarta

Aggressive new players from Asia, Australia and the Middle East are successfully challenging Indonesia's decades-long domination of Asia's LNG market. In a sign of the times, a Japanese power utility recently announced that it would curtail purchases from Indonesia by 2.3 million tons per year, another utility from Taiwan recently chose Qatar over Indonesia for a US$8.6 billion LNG contract and the country has lost important bids in China.

Although such setbacks are extremely disappointing, they may be a blessing in disguise. Waning LNG exports may finally encourage Indonesia to rethink its domestic energy strategy. The wave of observers now calling on the government to pay greater attention to developing the country's domestic gas market and reduce its dependence on regional LNG buyers are right.

Indeed, energy analysts have been saying this for years. In a nation with burgeoning energy needs, more of the nearly 3 trillion cubic feet of gas produced each day in Indonesia should be utilized at home. It is cheaper and cleaner than alternative sources. More LNG and piped gas ought to be sold in Java and other areas of the country that face mounting energy shortages.

Still, despite extensive reserves, Indonesia's domestic gas sector remains remarkably underdeveloped compared to its neighbors. This is due to the fact that gas has traditionally been developed for the lucrative export trade while the domestic market, where investment in pipelines and other enabling infrastructure is minimal, has been largely ignored.

And, although subsidies are coming down, Indonesia's energy economy continues to be over-reliant on expensive fuel oil products. A switch to gas would produce enormous savings for the country. In some cases, diesel is actually cheaper for PLN than gas because the Ministry of Finance pays the difference and it does not affect PLN's cash flow. This is a real blow both to energy efficiency and the countrys finances. It is a pernicious distortion that must be eliminated.

In a concrete example of how much can be saved, consider power generation. The country is hemorrhaging money by burning diesel and mfo at its plants across Java. At current prices, diesel costs approximately US$4.50 per unit while gas costs $2.50 to $3.00 per unit. Switching to gas would save the country up to $300 million annually.

Given the growing appetite for electricity, the shift would yield even higher savings in subsequent years. For this reason, PLN needs more public support to sign gas supply agreements from Ujung Pangkah, Oyong, ONWJ, Kepodang and Corridor (see box). Beyond PLN, demand for gas from other customers like Perusahaan Gas Negara (PGN), the state fertilizer producers and other large users is also expanding. Hence it is imperative to bring more gas fields on line to keep pace with demand.

Despite the clear economic case for gas, several financial obstacles are preventing policy changes that will drive greater gas consumption. One perceived impediment is price. Although Indonesia's most expensive gas is still much cheaper than diesel, buyers tend to view gas as a commodity in which the price should be the same in all cases.

In the Indonesian context, where the sector is still undeveloped, this view is incorrect because gas is not a freely traded commodity. Both buyer and seller need to make long term commitments to justify the investment needed to realize the benefits of gas utilization. Prices differ because every gas field is unique and has different development costs.

In negotiations, the buyer's reference point should not be the cheapest gas in Indonesia. It should be the cost of alternative fuels and what constitutes an acceptable price for both buyer and seller for the specific development in question.

A second obstacle to completing more gas agreements is the various guarantees that producers require. Production sharing contract operators need Standby Letters of Credit (SBLCs), take- or-pay clauses and other contractual assurances before investing in projects that typically deliver returns over 20 year periods.

In the case of PLN, SBLCs are a particularly serious stumbling block because of bank lending limits. With PLN's demand for SBLCs in the range of $800 million per year and credit availability to PLN under current lending limits only $550 million, PLN cannot sign appropriate guarantees.

To overcome this problem, PLN has asked Bank Indonesia not to include its SBLCs in the legal lending limit with government linked banks like BNI and Bank Mandiri. High-level consideration should be devoted to removing this obstacle so that PLN can rationalize its energy needs.

There is compelling logic for this request because even though SBLCs do represent exposure, they are not identical to direct loans. The SBLCs do not represent actual drawdowns. They are only potential drawdowns that are unlikely to be used in full.

The lack of a more robust domestic gas sector has handicapped the economy and cost the government hundreds of millions of dollars per year.

After more than five years of economic crisis, Indonesia can no longer afford an energy mix that depends on expensive fuel oil products, especially imported ones when there is an alternative local fuel available in abundance. PLN and other large industrial users must gradually break this dependence with the help of Bank Indonesia and the Ministry of Finance. If this can be accomplished, significant government progress will have been made in restoring the economy and placing the country on a sounder footing.

James Castle is the founder of CastleAsia, a leading research and business information company based in Jakarta. Todd Callahan is a technical advisor at the same firm.