Transparancy problems in oil and gas industry

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.