The future of the oil and gas industry in Indonesia

The future of the oil and gas industry in Indonesia

By Ronald G. Pate

The pioneer of the Indonesian oil business, A.J. Zijlker, was
shown an oil seep in North Sumatra in 1883 and after a sample was
analysed in Batavia, he founded Voorloopige Sumatra Petroleum
Maatschappij (VSPM). Two years later, VSPM drilled the Telaga
Tunggal-1 well to a depth of 121 meters. The first oil well in
Indonesia flowed 150 liters of oil and the Telaga Said field was
discovered.

The age of the automobile was in the future and what ships
traveled the seas unaided by wind burned coal for power. Oil was
used in various remedies and thanks to the vision of George
Bissel, an American scholar and businessman who financed the
Edwin L. Drake oil discovery in Titusville, Pennsylvania, in
1859, it was also being widely used as a luminant. The future of
the oil industry was unknown in the later part of the 19th
century, but the industrial revolution on the horizon would
ensure its continued growth and importance in the approaching
century.

Now, some 140 years on, it is reasonable to question the
future of the business, especially in Indonesia, where its
direction has such a huge economic impact.

Geographical description

The islands of Indonesia stretch from the continental shelf of
northern Australia to the continental shelf of Southeast Asia.
Indonesia has a total area of 9.8 million square kilometers, of
which more than 7.9 million square kilometers are under water.
The total land area of approximately 1.9 Million square
kilometers is distributed among 13,667 islands. Of these, there
are five major islands, Sumatra, Java, Borneo (Kalimantan),
Sulawesi and New Guinea (Irian Jaya), and about 300 smaller
island groups.

Sumatra, Java, Kalimantan and the smaller islands between are
part of the Sunda Shelf of the Asian Continent. To the east,
Irian Jaya and the Aru Islands lie on the Sahul Shelf of the
Australian Continent; water depths on these two shelf areas are
less than 200 meters. Between these two shallow water provinces
are the islands of Sulawesi and the island groups of Nusa
Tenggara and Maluku. These islands are located in deep seas where
depths reach to 5,000 meters.

Geologically, Indonesia can be divided into two regions at the
Makassar Strait between Kalimantan and Sulawesi. Sixty
sedimentary basins of Tertiary Age have been identified
throughout the archipelago. The 21 sedimentary basins of western
Indonesia are relatively large and mostly located onshore or in
shallow water. Conversely, the 39 sedimentary basins in eastern
Indonesia are generally smaller and predominantly located in deep
water. Fourteen basins produce oil and gas, 11 in western
Indonesia and three in eastern Indonesia. Most of the producing
basins are considered to be mature from an exploration viewpoint,
leaving eastern Indonesia with most of the exploration potential.

Business considerations

Longman's Dictionary of Contemporary English offers a very
simple definition of business -- the activity of buying and
selling goods and services. Though not explained, clearly the
motivation behind the activity is profit -- buying at a cost
lower than the sales price. In terms of the oil and gas industry,
the cost of buying goods would ultimately be the cost of finding
the resource, producing it and getting it to market.

In remote and inhospitable environments of Indonesia, drilling
costs can run from US$15 million to more than $40 million. Not
many companies have the resources for entry into this kind of
business, and fewer still have the stomach for the risk. The
author is uncertain of the current statistics, but typically,
rank wildcats (exploration wells drilled in remote areas) are
successful less than 8 percent of the time. The measure of
success being finding hydrocarbons in sufficient quantities to
warrant installing pipelines and production facilities required
to get them to market.

When the oil price is high enough, companies can hazard monies
to drill exploration wells -- ever mindful that oil prices
fluctuate and a severe downturn can make a scientific success
into an economic disaster.

Before these factors are considered, the company must
understand the Indonesian Production Sharing Contract (PSC). Oil
and gas operations in Indonesia are controlled by the PSC under
the control of the state oil company, Pertamina, with the
contractor responsible for operations. In 1976, the government
adjusted the production split to 85 percent for the government
and 15 percent for the contractor (85:15) for oil and 70:30 for
gas after cost recovery. Costs are recovered by the contractor
from Pertamina's share of production provided the contractor has
followed guidelines established by the government's coordinating
agency, BPPKA.

In February 1989 incentives were introduced for frontier
areas. Equity splits for frontier areas and pre-Tertiary
production in older areas were adjusted to an incremental sliding
scale - 75:25 for production up to 50,000 barrels of oil per day
(BOPD), 80:20 for 50,000 to 150,000 BOPD and 85:15 for production
over 150,000 BOPD.

Then there are taxes to consider. Tax rates are progressive
with the top bracket for businesses outside mining, oil and gas
sectors of 30 percent for income above Rp. 50 million ($6,250 at
exchange rate Rp. 8000/$1). In addition to corporate taxes, there
is a Value Added Tax of 10 percent, sales tax on luxury goods and
the usual taxes on land, facilities, etc.

In the oil and gas sector, the composite tax rate applying to
contracts signed before 1984 is 56 percent (45 percent basic
income tax and 20 percent withholding tax on the balance).
Contracts from 1984 pay 48 percent tax (35 percent basic income
tax plus 20 percent withholding tax on the balance).

Companies that can afford to take the risks associated with
oil and gas exploration are mostly multinational companies with
worldwide operations. Consequently, subsidiary companies
operating in Indonesia are competing with subsidiaries in the
U.S., the UK, South America and Africa for corporate dollars to
spend on exploration. The ability of the Indonesian subsidiaries
to compete depends very much on how well Indonesian tax laws and
contractual regulations stack up against those of other
governments.

For the past few years, Indonesian tax laws and PSC terms have
not been the most attractive.

Add to all these considerations the perceived political
uncertainties of the present government and the uncertainties
associated with the devolution of certain authority and
responsibility to the regions plus the risk of having operations
suspended, or shut down all together, by militant locals without
fair and equal treatment under the law (the Manulife situation --
currently being discussed on international business news TV
broadcasts -- is the latest of many situations when multinational
companies have been denied equal treatment) and it becomes very
difficult to convince corporate management to spend money on
exploration in Indonesia.

Trends in exploration

Operating companies in Indonesia present work programs and
budgets to Pertamina for approval in the fall of each calendar
year. In Table 1, the oil price drops from about $30/bbl at the
end of 1990 to about $16/bbl in the first half of 1994 and the
number of exploration and delineation wells tracks the trend.
When the oil price started rising, so did the number of wells.
The correlation is very poor after the middle of 1997.

What is clear from the table is that exploration drilling is
not tracking the price of oil. Part of this could be the
uncertainties that companies have about the ability of the
Organization of Petroleum Exporting Countries (OPEC) cartel to
maintain production discipline. The spike in oil prices at the
end of 1990 was certainly short lived. With OPEC's historical
lack of production discipline, it is understandable if companies
presented pessimistic work programs for 2000, expecting once
again to see a retreat in prices. However, the performance of the
oil price this year and the forecast of continued global demand
should have given some reassurance of relative stability in oil
prices in the near term.

Pete Stark of IHS Energy presented a paper at the AAPG/IPA
Convention in Bali in October which demonstrated that activity
has been picking up in Indonesia. Simon Crellin of Arthur
Andersen showed a similar trend in an article published in the
SEAPEX Press. It will be interesting to see the drilling totals
for this year and learn what has been budgeted for next year.
That will give an indication of what the near term future will be
for the sector.

Data from the Ministry of Mines and Energy published on the
U.S. Embassy website indicates that average daily crude and
condensate production fell 3.7 percent from 1,556,600 barrels per
day in 1998 to 1,500,300 barrels per day in 1999, an annual
decline of 13.7 percent.

While production was declining, crude oil imports rose 17
percent in 1999 to meet a 6 percent increase in demand for fuel
products. Minister of Mines and Energy Susilo Bambang Yudhoyono,
in a keynote speech at the Energy and Mining Investment
Opportunities in Indonesia conference, explained that Indonesia's
oil and gas resources are estimated at 73 billion barrels and 308
trillion cubic feet (TCF), respectively. The proven and potential
reserves are 9.7 billion barrels of oil and 160 TCF of gas. At
current production rates (549 million b/d for oil and 3 billion
SCF for natural gas), proven and potential reserves will last
another 18 years for oil and 53 years for natural gas.

Without getting into a discussion on the "goodness" of the
potential reserves estimates, Indonesia clearly has to consider
carefully the management of its hydrocarbon resources, including
the future management of the Coastal Plains Pekanbaru oil block
(Caltex contract to expire in 2001). Unfortunately, at this
critical time, when so much depends on good management and
decision making, Pertamina is in the midst major procedural
reforms and restructuring (both long overdue) to curtail
corruption and improve efficiency.

Considering the remaining exploration potential for producing
basins, the only way for Indonesia to significantly increase its
proven and potential oil reserves is to encourage investment in
eastern Indonesia. Unfortunately, the most prospective basins in
the east are in the middle of extreme sectarian violence or
escalating separatist sentiment.

To reverse these downward trends and improve the prospects of
the oil and gas industry in Indonesia will require recognition of
the situation by the government and Pertamina and strategic
initiatives to solve the social/political/security problems in
the country and improve the tax and contractual environment to
stimulate investment. How well the government and Pertamina
management cope with these complex issues, only time will tell.

The author has been an explorationist in the oil and gas
industry for 36 years, the last 20 in Indonesia.