The Indonesian government has recently passed new regulations introducing significant changes to the power and upstream oil and gas sectors. In Part 1, we discussed the power sector. In this briefing note, Sean Prior, Counsel of Mayer Brown JSM and Fadjar Kandar, Managing Partner of Kandar & Partners highlight the latest developments in the upstream oil and gas sector and their likely impact on Indonesian investment.

Introduction of Gross Split Method to Future Upstream Production Sharing Contracts

WHAT NEW REGULATION HAS BEEN PASSED?

a. On 13 January 2017, Indonesia’s Minister of Energy and Mineral Resources of Indonesia (MEMR), which supervises the oil and gas, mining and power sectors, issued Regulation No. 8 of 2017 on Gross Split Production Sharing Contract (Regulation 8).

b. Regulation 8 changes the way in which upstream oil and gas contractors obtain revenue from oil and gas sales under their Production Sharing Contracts (PSCs), and in particular, how they recover their significant upfront development costs.

IN COMPARISON WITH THE EXISTING SYSTEM, WHAT HAS BEEN CHANGED?

a. Existing system: Existing Indonesian PSCs are based on the principle of cost recovery. Under this principle, provided a discovery is developed in accordance with a government approved Plan of Development, the contractor can utilise the proceeds of oil and gas sales to recover the costs it has incurred in exploring, and then developing, the resource. The government usually takes the first tranche of petroleum share (up to 10%), following which the contractor has priority rights to sale proceeds until it has recovered all of its permitted development costs. Following cost recovery, the contractor and the government then split future sale proceeds based on agreed profit shares in the PSC.

b. New system: Regulation 8 replaces this cost recovery mechanism with a system where the contractor receives a gross split of production from the start of operations (Gross Split), on which it pays income tax. Regulation 8 sets out a base production split (Base Split) of 57%/43% in favour of the government for oil, and 52%/48% in favour of the government for gas. The Base Split is then adjusted (following the approval of the contractor’s Plan of Development) by taking into account components such as local content, availability of supporting infrastructure, changes to the indexed oil price and the contractor’s overall production volume (as further detailed in Regulation 8).

WILL IT AFFECT EXISTING PSCs?

a. No. PSCs signed prior to the issuance of Regulation 8 will remain valid until their expiration. A contractor may choose to change an existing PSC to a Gross Split model, but it is not required to.

b. PSCs already approved for extension may continue to use the cost recovery model, or the contractor may choose to convert to the Gross Split model.

c. Regulation 8 does not specifically require contractors to use the Gross Split method for new PSCs, but we understand that the MEMR’s current view is that it will, as a matter of policy, require new PSCs to apply the Gross Split method.

WHAT ARE THE LIKELY PRACTICAL IMPLICATIONS?

a. Whilst Regulation 8 provides broad guidelines, it does not detail how in practice parties will agree the adjustments made to the Base Split. Developers are likely to require clear procedures on this before they undertake significant investment. The rules introduce greater potential for uncertainty by allowing further adjustment to the splits if the field characteristics turn out to be different during development.

b. Since a contractor will no longer have a priority right to use all of the sale proceeds for cost recovery, it will calculate its initial economic base case and sensitivities differently, as it will be “on risk” for recovering the costs of development for a significantly longer time.