Client Update 26 January 2017

Lawyers

 

New Era in Oil & Gas Sector as Government Moves from Cost Recovery to Gross Split Mechanism

1. Introduction

The Government has instituted a new mechanism for sharing out production from oil and gas fields as between the State and its contractors ("Contractor") under Production Sharing Contracts ("PSC"). The new "Gross Split" mechanism is set out in Minister of Energy & Mineral Resources Regulation No. 8 of 2017 ("MEMR 8/2017"), I which came into force on 16 January 2017, while the first PSC to employ the new arrangement was signed on 18 January 2017, covering the Offshore North West Java working area operated by state energy firm Pertamina, which had recently expired.

2. Production Sharing: Gross Split vs Cost Recovery

As discussed in greater detail in Section 4 below, the Gross Split mechanism appears likely to be applied to new PSCs going ahead, replacing the long-standing Indonesian production sharing concept, under which the share or take of the Contractor is set as a fixed percentage of gross production (before tax), calculated after recovery of the Contractor's costs under the cost recovery regime.

Despite having been conceived in Indonesia and adopted by many oil and gas producers around the world over the last 50 years, the cost recovery regime has come under increasing scrutiny at home in recent years due to its high cost. Not only does it demand that the Government set aside large sums every year in the State Budget to cover cost recovery expenses, but also requires layers of scrutiny, controls, and bureaucracy to ensure that it works effectively. In addition, despite cost recovery being a business arrangement, inadvertent miss-allocation could leave those involved liable to criminal charges for inflicting losses on the State.

By contrast, the Gross Split mechanism directly carves up gross production as between the Contractor (before tax) and the State, without any deductions being made, including deductions by the Contractor for cost recovery. However, the take allocated to the Contractor is grossed up and may be further adjusted to compensate for the Contractor's expenses.

As regards the implementation of the Gross Split mechanism, under Article 23(2) of MEMR 8/2017, the control authority of SKK Migas II is now limited to approving Contractors' Work Programs & Budgets ("WP&B"), whereas previously it had the final say on virtually every aspect of Contractor operations. It is reasonable to assume that SKK Migas' authority with regard to the cost recovery regime remains unaffected.

3. Gross Split Calculation

The Gross Split is calculated based on two principal components: (a) the base split component; and (b) the adjustment component.

The base split component is governed by Article 5 of MEMR 8/2017, which allocates the following respective shares to the State and Contractor:

State's Share Contractor's Share
Crude 57% 43%
Natural Gas 52% 48%

In order to ensure flexibility and take account of the economic realities of a field, the Base Split may be adjusted having regard to two sets of additional factors: (1) Variable Components; and (2) Progressive Components. Such adjustment may be made after the Ministry of Energy & Mineral Resources ("MEMR"), or SKK Migas, as the case may be, has approved the Plan of Development ("POD") proposed by the Contractor prior to the development of the field.

The components that may be considered when deciding whether or not to adjust the Base Split are as described in the table below:

Adjustment Factors

Base Split Adjustment

Variable Components

Field Development Stage

Contractor gets an additional 5% share for the first POD of the Working Area. No additional share is available for subsequent PODs.

 

In the case of a PSC extension that is not accompanied by a new POD, the Base Split is reduced by 5% in favour of the State.

Field Location

Contractor's share may be increased based on a sliding scale depending on the location of the field. For example, a deep-water offshore field (1000 meters or more below sea level) is accorded an additional 16% share. No additional share is available for onshore fields.

Depth of Reservoir

Contractor gets additional 1% for a reservoir lying at a depth of more than 2500 meters.

Availability of Supporting Infrastructure

Contractor gets additional 2% if the working area is located in a remote or frontier area that lacks supporting infrastructure.

Reservoir Type

Contractor gets additional 16% for non-conventional hydrocarbon reservoir (i.e., CBM, shale, etc.).

CO2 Content

Contractor gets additional share based on a sliding scale depending on the CO2 content of the reservoir. For example, additional 4% for CO2 content above 60%. No additional share is available of CO2 content below 5%.

H2S Content

Contractor gets additional share based on a sliding scale depending on the H2S content of the reservoir. For example, 1% for H2S above 500 ppm. No additional share is available for H2S below 100 ppm.

Oil Specific Gravity

Contractor gets additional 1% if crude produced has a specific gravity of more than 25 API.?

Domestic Content during Field Development

Contractor gets additional share based on a sliding scale depending on the level of domestic content during development. For example, 4% for domestic content of above 70%. No additional share is available for domestic content of below 30%.

Production Method

Contractor gets additional split of 3% and 5% for production using water injection and enhanced oil recovery, respectively.

Progressive Components

(adjusted monthly by SKK Migas)

Indonesian Crude Price ("ICP")

Additional share for either Contractor or State using a sliding scale based on ICP.

 

Contractor gets additional share if ICP drops below USD 70/barrel while State gets additional share if ICP exceeds USD 85/barrel.

Cumulative Production (in MMBOE)

Contractor gets additional share based on a reversed sliding scale based on Contractor's cumulative production over a defined period. The higher the cumulative production, the lower the additional share for Contractor.

 

For example, Contractor gets additional share of 5% if cumulative production is below 1 MMBOE. No additional share is available if cumulative production exceeds 150 MMBOE.

 

No explanation is provided in MEMR 8/2017 as regards the period or method to be used in calculating cumulative production. However, MEMR has informed us that cumulative production will be calculated on a monthly basis.


The application of the above adjustment factors means that the Contractor's overall take (before tax) will fluctuate based on the following formula:

Base Split (+/ -) Variable Component(s) (+/ -) Progressive Component(s).

The Gross Split that is approved by MEMR for the first POD may subsequently be varied in the event that:
  1. Commercial operation of the field fails to achieve the intended economic return: MEMR may grant an additional share of up to a maximum of 5% in favour of the Contractor;
  2. Commercial operation of the field exceeds the intended economic return: MEMR may grant an additional share of up to a maximum of 5% in favour of the State;
  3. The Variable Component/Progressive Component assumptions set out in the MEMR's approval of the POD turn out to be different from actual conditions in the field following commercial operation.
MEMR 8/2017 does not explain what precisely is meant by "intended economic return" in points 1 and 2 above. However, we have been informed by ministry officials that it refers to the anticipated economic return stated in the POD.

4. Application of Gross Split Mechanism

MEMR 8/2017 does not apply retroactively and all PSCs signed prior to its issuance remain in effect. An existing Contractor may, however, propose to MEMR that its PSC be amended so as to incorporate the Gross Split mechanism. In such circumstances, any unrecovered costs may be taken into account as an additional share in favour of the Contractor.

For expiring PSCs that are to be extended, however, MEMR has the option of applying either (i) the terms of the existing PSC; or (ii) the Gross Split mechanism.

Although MEMR 8/2017 does not specifically state that the Gross Split mechanism will be applied henceforth to all new PSCs, senior MEMR officials have been widely reported in the media as saying that this will be the case.

Indeed, the Deputy Minister of Energy & Mineral Resources. Mr. Arcandra Tahar, is quoted in The Jakarta Post daily on Jan 19 as saying that "no new field can use [cost recovery]. All must use the gross-split scheme."

We have also received independent confirmation to this effect from MEMR officials. Nevertheless, we must stress once again that MEMR 8/2017 does not expressly state that the gross split mechanism will be applied to all new PSCs.

5. AHP Commentary

Although not cast in stone, the Government has applied a set of standard (and rigid) terms under the Cost Recovery Regime, irrespective of the level of difficulty involved in exploiting a field. The Gross Split arrangement under MEMR 8/2017 provides greater flexibility, which is to be welcomed.

Incentives are provided in the form of possible increases in the Base Split in favour of the Contractor depending on the level of difficulty involved in getting the oil or gas out of the ground. There seems to be no cap in place as regards the maximum extent to which a Contractor's take could increase following the application of the Variable and Progressive Components. If the Contractor is eligible to avail of all of these at their maximum levels, then the State's take could even be reduced to zero. This should help encourage Contractors to develop frontier and difficult fields.

However, the corollary of this is that the Contractor will be disincentivised if the crude price or the Contractor's production increases beyond a certain level. The latter eventuality begs the question as to why a Contractor should be penalized for working more efficiently and producing more hydrocarbons?

Against the backdrop of the prevailing low oil-price environment, the incentives provided by MEMR 8/2017 may be appealing in the case of smaller fields, where Contractors would benefit from the Progressive Components and reduced bureaucracy. However, the disincentives that may kick in under the Gross Split mechanism may not be so appealing to Contractors in the case larger fields.

With the issuance of MEMR 8/2017, the status of SKK Migas' existing industry guidelines (Pedoman Tata Kerja/"PTK") has been left somewhat up in the air. As the role of SKK Migas is now limited to approving Contractors' WP&B, this should significantly reduce the level of bureaucracy involved in the procurement of goods & services, hiring and firing of manpower, and other micro-managerial issues on the part of Contractors. The bureaucracy under the Cost Recovery Regime was considered burdensome by many Contractors and hampered efficiency in oil and gas operations. The new mechanism will also eliminate cost recovery disputes and reduce the risk of criminal prosecution.

However, a caveat is in order here. In common with other many other nations, Indonesia has seen a surge in resource nationalism in recent years, including demands that the State be directly involved in resource exploration and exploitation. In light of this, the fact that the authority of SKK Migas has been diminished by MEMR 8/2017 makes it reasonable to assume that the regulation may be subject to challenges in the Supreme Court going ahead.

Thus far, the oil and gas industry's response to the Gross Split mechanism has been sceptical. Characterized by forward-looking and long-term planning that requires stability and continuity, the industry appears to regard the introduction of the new mechanism as being too big and sudden a change to digest easily. It will be a challenging task going ahead for the Government to rebuild the industry's confidence, particularly amid the current low-price environment.

_____________________________________________________________________
  1. Peraturan Menteri Energi dan Sumber Daya Mineral Nomor 08 Tahun 2017 tentang Kontrak Bagi Hasil Gross Split.
  2. Satuan Kerja Khusus Pelaksana Kegiatan Usaha Hulu Minyak dan Gas Bumi, the State body responsible for managing commercial upstream oil and gas operations based on cooperation contracts.


   

*** 

AHP Client Alert is a publication of Assegaf Hamzah & Partners. It brings an overview of selected Indonesian laws and regulations to the attention of clients but is not intended to be viewed or relied upon as legal advice. Clients should seek advice of qualified Indonesian legal practitioners with respect to the precise effect of the laws and regulations referred to in AHP Client Alert. Whilst care has been taken in the preparation of  AHP  Client Alert, no warranty is given as to the accuracy of the information it contains and no liability is accepted for any statement, opinion, error or omission.

Download

AREAS OF PRACTICE

  • Pic Mgmt

    Capital Markets

    As a full-service firm, we do a broad range of transactions covering the entire spectrum. Many are high profile and cement our position as a top-tier firm, including global equity offerings in reliance on Reg. S/Rule 144A, private placements, rights issues and other share-related offerings, such as convertible and exchangeable bonds. We also frequently advise on foreign offerings by issuers having significant interests in Indonesia, bond issuances under global offering rules, mergers, acquisitions, combinations of acquisitions and IPOs, consent solicitations and exchange offers of debt instruments listed on the Indonesia Stock Exchange or offshore. more »

  • Pic Mgmt

    Banking & Finance

    We are a leading force in the Indonesian banking & finance sector, advising on all manner of structured financing transactions, from simple secured or unsecured bilateral lending to multifaceted and complex credit facilities. We handle syndicated, club and bilateral loan documentation; project finance; property finance; acquisition finance; securitization and structured finance; regulatory and compliance issues; banking documentation and legal due diligence reporting. more »

  • Pic Mgmt

    General Corporate/M&A

    Our General Corporate/M&A practice provides advice on corporate governance, compliance, negotiating and drafting agreements, transaction structure, management and succession, legal due diligence reporting, formation of new entities, preparation of internal corporate documents and approvals, and completion of regulatory filings. With a wealth of experience amassed over the years in a wide variety of industries, we are strategically placed to provide you with everything you need to satisfy your corporate or M&A needs. more »

  • Pic Mgmt

    Debt & Corporate Restructuring

    We offer a full range of services in the debt & corporate restructuring arena, including advice on capital reduction, recapitalization and rescue schemes, financial sector takeovers, global asset recovery measures, mergers, creation of new entities, compromise schemes, demergers, buyouts, preparing documents and agreements, and ensuring statutory and regulatory compliance. As an AHP client, you will benefit from the unparalleled expertise gained by many of our senior lawyers as advisors or counsel to the Indonesian Bank Restructuring Agency (IBRA), which restored the country’s banking sector to health in the wake of the Asian financial crisis of 1997/98. more »

  • Pic Mgmt

    Foreign Direct Investment

    As an Indonesian law firm, we are obviously very much at home in our own jurisdiction, and so are able to make you feel at home as well. We know how things work in Indonesia, and have excellent relations with all the relevant government and regulatory agencies. We advise on the establishment of foreign investment companies, permanent business establishments, subsidiaries and joint ventures under the Indonesian FDI regime, merger & acquisition issues, foreign ownership caps, manpower issues, regulatory and environmental compliance, land acquisition, taxation matters -- in fact, everything you will need to get your venture off the ground and to keep it running smoothly throughout the investment lifecycle. more »

  • Pic Mgmt

    Competition Law

    We are widely recognized as being at the forefront of competition law in Indonesia, a rapidly developing field in which we have been instrumental in securing a number of ground-breaking judicial precedents in recent years. We consistently focus on the practicality and commerciality aspects, and combine legal expertise with in-depth experience across a wide range of industries so as to support the achievement of your strategic goals. more »

  • Pic Mgmt

    Dispute Resolution

    AHP has a very strong litigation team made up of one partner and 15 associates, all of whom are licensed advocates. We regularly represent clients in tort, contract, employment, internal corporate fraud, real estate, trademark and intellectual property disputes, to name but a few, with our primary focus being on commercial disputes. In the arbitration field, we have developed a formidable reputation for expertise and successful outcomes with the result that AHP advocates regularly appear before the Indonesian National Arbitration Board (BANI), as well as overseas arbitration bodies, such as the Singapore International Arbitration Centre. more »

  • Pic Mgmt

    Energy, Oil and Gas

    Our Energy, Oil and Gas practice provides top-quality legal advice and transactional support to domestic and international companies operating in the oil and gas, geothermal and renewable energy sectors. As a relatively compact firm, we are able to offer advice across the entire range of practice areas, thereby allowing us to deliver outstanding legal and commercial results for our clients in a practical and cost effective way. more »

  • Pic Mgmt

    Projects & Natural Resources

    As an Indonesian law firm, we know our country, our regulatory environment and our governmental system. Armed with this knowledge, we have garnered a wealth of experience down the years guiding both domestic and international companies through areas that are often fraught with competing interests and controversy. This experience provides us with the expertise and breadth of vision needed to ensure successful outcomes for your business objectives. In doing so, we offer a comprehensive suite of services, all of which dovetail seamlessly one with the other so as to provide holistic solutions to all your legal needs. more »

  • Pic Mgmt

    Telecommunications & Media

    Indonesia has seen exponential growth over the last decade in both the telecommunications and media sectors -- both areas in which AHP is in the vanguard of legal development. Besides having a professional interest in the two sectors, all of our lawyers in the T&M practice share a genuine passion for what they do and are therefore able to offer a combination of solid technical legal knowhow and an excellent understanding of the industries, the technical aspects, the principal factors at work, and the key players in Indonesia. more »

  • Pic Mgmt

    Real Property

    We offer a full range of real property services, including assisting with purchase and sale agreements, leasing agreements, title searches and registrations, conveyancing, and real property dispositions and bequests,.We also provide effective and reliable advice on the complex rules governing property ownership by non-nationals in Indonesia, an area of the law that is set for liberalization in the near future. more »

  • Pic Mgmt

    Intellectual Property

    Our IP practice offers trademark, copyright, patent and design searches and registration, and regularly mounts successful challenges on behalf of clients against decisions of the trademark authorities. Our IP associates are all members of key associations and are frequently engaged to speak at international events as recognized leaders in the field. Combing cutting-edge expertise and a high level of commercial acumen, we take pride in our results and a high level of customer satisfaction, and do our utmost to help ensure the protection of your rights and your peace of mind. more »

  • Pic Mgmt

    Islamic Finance

    At AHP, we understand Islamic finance and have been in the vanguard of the sector’s rapid expansion and development in Indonesia. With an in-depth understanding of the religious and conventional legal principles that underpin the Shariah sector, we believe we are uniquely well-positioned to offer expert and innovative advice on how to conduct any transaction in a Shariah-compliant manner, and to provide the kind of end-to-end solutions that you need. more »

  • Pic Mgmt

    Shipping & Aviation

    As an archipelagic nation, the shipping and aviation industries are of the utmost importance to the Indonesian economy. To accommodate the needs of ship owners, charterers, and marine insurers, we provide advice on all aspects of shipping law, including ship finance & security, sale and purchase, disputes arising out of charter parties, bills of lading, insurance, and collisions, and all other admiralty matters, while in the aviation sector, we assist with aircraft financing, sale and purchase, statutory obligations related to aviation, aviation safety and the aftermath of aviation accidents. more »

  • Pic Mgmt

    Labor Law

    We have a outstanding record in representing both individuals and corporations in employment matters, and in general advisory work on the complex rules governing the employment of expatriates in Indonesia. On the litigation front, we are frequently called upon to advise in cases involving internal fraud and embezzlement, and on the remedies available to employers. We also offer expert advice on employee compensation and incentive schemes (stock options, benefits, allowances), the employment implications of mergers, acquisitions and amalgamations, and the rights and benefits available to employees upon termination. more »

Assegaf Hamzah & Partners