Transparancy problems in oil and gas industry

Parulian Sihotang and Alex Russell, Department of Accountancy and Business Finance University of Dundee, United Kingdom

Years of accusations of corruption, collusion and nepotism in Indonesia's oil and gas industry have threatened the country's economic development. The legislature took the first steps towards repairing the damage by passing the oil and gas bill No 22/2001 which became effective on Oct. 23, 2001. Its aims are laudable and modernist.

It follows the premise that in order for an industry to thrive and prosper, it should be freed from the bureaucratic fetters of government. The new bill aims to achieve this result by establishing an implementation agency (badan pelaksana) and a regulatory agency (badan pengatur) which will assume duties previously assigned to the state oil and gas company Pertamina.

The implementation agency replaces Pertamina in managing Production Sharing Contracts (PSC) with private oil and gas companies, thereby eliminating the dual but conflicting role of Pertamina as regulator and player in the upstream petroleum sector. The law also removes Pertamina's monopoly in the downstream sector by assigning responsibility for managing domestic fuel distribution and supply to the regulatory agency.

The follow-up to the passing of the bill has, however, had mixed success. Thus, although the implementation agency was set- up on July 16 through regulation No.42/2002, the government seems to be unable to establish the regulatory body. Arguably, the government is moving in the right direction, albeit slowly.

The first and crucial step, which is the macro-institutional restructuring process, has been achieved by implementing the new oil and gas law. However, it should be noted that micro- institutional restructuring and redesigning is urgently needed in order to guide properly the real day-to-day operational activities that create and add value to the industry.

The urgency of the need for a revamping of the industry is underscored by the alarming revelation by Rachmat Soedibyo, the Chairman of the Implementation Agency, of the on-going declining trend of investment in the Indonesian up-stream sector (Kompas, Dec. 3, 2002).

What reforms are necessary?

Research by experts from the University of Dundee, UK, into the problems facing the Indonesian petroleum industry has shed light on the actions that need to be taken.

First, there is a need to reform the requirement that all companies operating in the Indonesian up-stream petroleum sector must adopt government-tendering procedures when procuring goods and services. These outmoded requirements create an unduly lengthy procurement process and have become a source of KKN.

Further, they provide loopholes for oil companies to mark-up their project costs by inflating their capital and operational costs. Currently, oil companies must use "middle" companies (established under the Indonesian commercial law) as sub- contractors for the procurement of goods and services.

This government-tendering requirement, as argued by Thomas Walde in his book last year, The Indonesian Production Sharing Contract: An Investor's Perspective, has imposed contractors' Indonesian "crony" contracts on unwilling foreign companies, that in the end makes Indonesia uncompetitive and shifts income from the state to the crony-politician subculture.

The process forces the oil and gas industry to subsidize noncompetitive companies. Redefining this tendering procedures would constitute a 30 per cent cost saving, according to Tengku Nathan Machmud in The Indonesian Production Sharing Contract: An Investor's Perspective (2000), while the Boston Consulting Group claimed that restructuring such tendering/procurement processes could potentially benefit USD 16 billion for the industry over 5 years period (BCG Report, 1998).

Second, action must be taken to prevent petroleum companies from overstating their costs and expenses by exploiting serious ambiguities in the current PSC cost recovery scheme.

Under the PSC contractors recover all costs out of the cash from the sale of crude oil. The remaining crude oil is then shared between the government of Indonesia/Pertamina and the contractors based on an agreed formula.

The contractor's cost recovery mainly consists of the current year "non-capital costs" (i.e. the cost of day-to-day operations) plus the depreciation for "capital costs" (i.e. the drop in the value of their equipment for example).

These terms look very straightforward in theory. In practice, however, there are many gray areas that become a source of dispute when determining the contractor's total costs. Senior government auditors revealed to the researchers that there is a tendency for oil companies to accelerate cost recovery to get a positive cash flow benefit by overstating the non-capital costs while understating capital costs, or treating some of the capital costs as non-capital costs.

The auditors had further concerns relating to the misclassification of certain costs (tangible versus intangible etc), the inappropriateness of certain overhead allocations, the fraud possibilities relating to the technical fee charged by the home office, and undetected transfer pricing.

Third, bureaucracy needs to be reduced. For example, the procedures for the Working Program and Budget (WP/B) and Authorization for Expenditure (AFE) force any oil company to prepare and submit at least 17 budget schedules, 16 financial reports and 13 AFEs for obtaining government/Pertamina approval. Surely, government would not want this burden on the industry to continue. Indeed, some oil companies claim that the government/Pertamina can never evaluate these WP/B and AFEs properly because they do not have key-performance indicators, benchmarks or other world-wide standards to match them against.

Fourth, there is an urgent need for audit reform.

Current host government audits focus too narrowly on financial compliance and concentrate only on companies' cost recovery. In the interests of sector efficiency there is a crying need for performance audits to be introduced.

Accordingly, the host government audit of oil companies needs to be risk-based and analytical utilizing key-performance indicators including social and environmental performance. Further, the overlapping financial audit of oil companies conducted by three governmental institutions (Pertamina, the Government Internal Auditing Office (BPKP) and the Supreme Auditing Office (BPK)) is ripe for rationalization.

Finally, investors need to be reassured that a demand for regional government participation in the industry, possibly extending to participation in fiscal affairs, will not harm their interests.

The reforms outlined above are based on developing best industry practice in Indonesia and are essential steps in creating a favorable environment for the much needed inward- investment that is vital to Indonesia's economic future.