Shaping a competitive Indonesia

April 1, 2008
Once a net exporter of petroleum, Asia’s only OPEC member seeks to increase production and to diversify its energy sector by generating power from other energy sources such as biofuels and geothermal.
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Once a net exporter of petroleum, Asia’s only OPEC member seeks to increase production and to diversify its energy sector by generating power from other energy sources such as biofuels and geothermal.

After 100 years of oil and gas activity, Asia’s only member of the Organization of Petroleum Exporting Countries (OPEC) and inventor of the Production Sharing Contract (PSC) finds its oil and gas sector at a crucial turning point. Indonesia, a pioneer and a long-time leading exporter in the LNG market is certainly not a newcomer on the international scene. Yet, after years of internal and external challenges and fundamental transformations, in 2004 the country became a net importer of oil for the first time in its history as increased domestic consumption was met with falling production. But the time has come to set in motion a change in the country’s energy basket, with the objective of re-balancing the share of its oil and gas sectors and to allow for new sources of power from biofuels to geothermal through to possibly nuclear energy to find their place in the country’s future.

“Indonesia is strategically located between two oceans and continents that are of vital importance in today’s energy geopolitics,” says Purnomo Yusgiantoro, Indonesia’s Minister of Energy and Mineral Resources. “Oil from the Middle East must pass through Indonesia before reaching the Far East markets, and the country is also well connected to fast-growing giants China and India and energy-rich Australia. Moreover, Indonesia itself is an important energy producer, with substantial production of oil, gas and coal.”

Minister Purnomo recognizes the challenges Indonesia’s energy sector is facing but believes his country still is in a favorable position.

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Purnomo Yusgiantoro, Indonesia’s Minister of Energy and Mineral Resources

Production of oil and condensate in the period 2001-2004 declined year on year due to a natural maturing of its producing oil fields combined with a slower reserve replacement rate and years of decreased exploration and investments. In 2006, oil production was around 400 million barrels of oil equivalent (boe), while the domestic demand was up to 500 million boe, forcing the country to import 100 million boe to cover the deficit.

This situation has continued into 2007 and is likely to intensify in the years to come, due to booming domestic demand and a lack of significant oil and gas discoveries in the country. Considering soaring oil prices and the Indonesian government’s generous fuel subsidy – despite recent reductions – this could constitute a heavy burden on the state budget.

Nevertheless, Minister Purnomo is quick to point out that investment in E&P activities has picked up over the last several years, and he believes that has a lot to do with the passing of new laws and regulations for the sector.

“Our investment estimate for the total year 2007 is of about US$18 billion in the O&G sector, and there are already US$44 billion committed for projects over the coming years” he adds. As most of Indonesia’s oil and gas production comes from aging brown fields, a good deal of the investments will have to be made in developing enhanced oil recovery (EOR) in order to maintain production levels or to avoid a rapid decline.

Achieving the government’s production objectives for the coming years will also require the exploration and development of new fields in Indonesia’s frontier regions. The President of the Indonesian Geologists Association (IAGI), Achmad Luthfi, echoes other experts’ view that the country is still very prospective geologically for oil and gas discoveries in its many unexplored basins.

“Everyone knows about the oil and gas fields developed in western Indonesia, but geology shows that the future lies in exploring eastern areas, including deepwater basins,” says Mr. Luthfi, who is also Deputy Chairman for Planning of BP Migas, Indonesia’s upstream regulator. Of the estimated 60 oil basins in Indonesia, only 22 have been extensively explored, and this has been carried out mostly in western parts of the country (the bulk of oil reserves are located onshore and offshore central Sumatra and Kalimantan). The government hopes that eastern parts of the country and deep sea areas may contain sizeable oil reserves, which is why it is actively encouraging exploration and development activities in regions like South Sulawesi and Papua.

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Maizar Rahman, Indonesia’s current Governor for OPEC

Indonesia’s place within OPEC may well depend on the country’s capacity to increase oil output in order to at least stop the growing rate of reliance on imports for its domestic energy needs. Indonesia’s current Governor for OPEC, Maizar Rahman, had to go to great lengths in 2005 in order to convince disgruntled sectors of the political landscape that it still made sense for a country that had become net importer of oil to remain a part of OPEC and have to make the annual contributions associated to it.

In the end, the government decided to remain in the oil cartel primarily for political and strategic reasons and because, according to Mr. Rahman, the other OPEC members expressed their support for Indonesia’s continued presence in the organization.” It is important for them to have diversity in its membership,” affirms Mr. Rahman, adding that the traditional role as mediator that Indonesia has played is highly appreciated by its members.

Towards a new energy mix

As the country’s oil production has decreased in recent years and imported fuel has become more expensive, Indonesia has attempted to shift towards using its vast natural gas resources for its own power generation needs. Gas reserves at approximately 187 trillion standard cubic feet (tscf) are equivalent to three times the country’s oil proven and probable reserves of 8.9 billion barrels. Moreover, natural gas is becoming a more competitive source for energy generation as fuel subsidies are gradually phased out. Minister Purnomo and the Indonesian government are confident about Indonesia’s gas potential “because the reserves are there, what is essential is obtaining the massive investments necessary for the infrastructure projects that will make it all possible.”

Important new LNG projects are in development in the country. The BP-led Tangguh LNG project in Papua – Indonesia’s third LNG project after those in Bontang and Arun – is in advanced stages of construction and set to commence production by 2009. Its two trains are expected to produce at least 7.6 million metric tons of LNG per year, enabling Indonesia to service new markets like China and the United States. A fourth, though smaller, LNG project is under construction in Sulawesi and will be operated by state-owned Pertamina and Medco, an emerging Indonesian oil and gas company.

In light of these projects and the country’s long history and expertise in LNG, the government is considering the construction of LNG receiving terminals in Java, by far Indonesia’s most populated and industrialized island, in order to address domestic energy needs.

The government has set the priority for domestic use of natural gas, while at the same time trying to respect the share of gas exported, currently over 50% of the total production, to its main markets of Japan, Korea, and Taiwan. How this policy will have an impact on Indonesia’s leadership on exports of LNG is anybody’s guess, and it is being closely monitored by emerging producers such as Qatar, Australia, Malaysia, and Algeria.

While oil and gas remain the primary source of energy for Indonesia’s growing population and developing economy, with 52% and 29% respectively of the total energy mix, an even more fundamental policy shift is taking place towards other forms of power. The Indonesian government has elaborated a target scenario for the energy basket in 2025 in which oil falls to only 20% of the blend, coal more than doubles its contribution to account for 33%, gas edges up slightly to over 30% (though in absolute terms this means a substantial increase), and geothermal and biofuels each contribute with about 5% of the total amalgam. The remaining 7% would be completed by a combination of biomass, hydro, solar, coal liquefaction, and possibly nuclear energy.

These energy consumption targets were one of the main elements established by the New Energy Law passed by the government in 2007, which constitutes Indonesia’s first effort to provide a general framework for managing the country’s energy resources. The new law also creates a National Energy Council that will be responsible for establishing a concerted energy policy among the main instances within the government.

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William Deertz, leader of international auditor PriceWaterhouseCoopers (PwC) Indonesia’s Energy, Utilities and Mining (EU&M) practice

William Deertz, leader of international auditor PriceWaterhouseCoopers (PwC) Indonesia’s Energy, Utilities and Mining (EU&M) practice, sees this development as a “positive step for the country’s resource sector as it will put into place a structure for ensuring appropriate optimisation of its natural resources.” He adds, “The establishment of concrete energy consumption targets for the economy should provide policy-makers a framework when assessing alternative policies.”

Fine-tuning the regulatory framework

The basic premise underlying the oil and gas industry in Indonesia is established in the Constitution of the Republic of Indonesia promulgated in 1945. Article 33 states that “all the natural wealth on land and in the waters is under the jurisdiction of the State and should be used for the greatest benefit and welfare of the people.”

The Production Sharing Contract (PSC) originated in Indonesia in the 1960s and has been the most common type of oil and gas development contract in the country. The PSC agreement – based on the general concept that the contractor bears all risks and costs of exploration until commencement of commercial production, and is then entitled to cost recovery and a split of production revenues – has been exported to oil and gas producing countries around the world.

In late 2001 a “New Oil and Gas Law No. 22/2001” (Law No. 22) was promulgated which, although it maintained the PSC model as the basis of oil and gas development, mandated the deregulation of the upstream and downstream sectors, including Pertamina’s monopoly over oil distribution and marketing of fuel products. Law No. 22 authorized the establishment of an implementing agency called BP Migas for upstream activities and a regulatory agency called BPH Migas for downstream activities to assume Pertamina’s regulatory roles. BP Migas took over Pertamina’s upstream regulatory functions and management of oil and gas contractors. BPH Migas was charged with assuring sufficient natural gas and domestic fuel supplies and the safe operation of refining, storage, transportation, and distribution of petroleum products.

The impact of this significant restructuring of the institutional framework on the sector’s development has been mixed, notes Deertz: “. . .with the issuance of Law No. 22 expectations were high in the industry for renewed growth, however, this enthusiasm was soon tempered by the fact that it took almost three years for the related implementing regulations to be issued. During the intervening period until the implementing regulations were issued investment levels in the upstream sector dropped significantly, however, over the past several years investment levels have started to rebound.”

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Luluk Sumiarso, Director General MIGAS

Making sure this rebound translates into a sustained recuperation of the oil and gas sector is one of the main tasks of Luluk Sumiarso, head of the Directorate General of Oil & Gas (Migas). Since Minister Purnomo appointed him to this key position in 2006, Luluk has focused on putting things in order and verifying that the recent developments in the oil and gas sector comply with the country’s laws. In this regard, a comprehensive investor guide has recently been edited and a new forum bringing together all of the oil and gas sector’s stakeholders is being created.

“When I arrived to Migas, I found that each group within the oil and gas sector had been going in its own direction, like meteors in the sky or ‘broken pearls’ from the famous Indonesian drama series. It resembles an orchestra made up of good musicians, but each one playing at their own rhythm. They needed a director general to facilitate and help co-ordinate the music,” states Luluk. By opening the doors of Migas to the stakeholders in order to listen to their concerns and suggestions and by encouraging the creation of the Indonesian Oil & Gas Society, he is looking to “put the broken pearls back together.”

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Roberto Lorato, President of IPA

A vital partner in this enterprise is the Indonesian Petroleum Association (IPA) which is preparing its annual convention for May 2008, under the theme “Meeting Energy Challenges through Co-operation.” Roberto Lorato, President of IPA and also Managing Director of Eni Indonesia LTD, the local branch of Italy’s energy giant, points out that this flagship event is not simply an exhibition of the association’s members, but rather “a public forum and debate on the main issues that affect the industry in Indonesia, from the business environment to corporate social responsibility.” Besides having all the main industry players present, the convention also counts on the participation of the highest level of government officials.

Indonesia’s investment climate: the calm after the storm.

Oil and gas sectors are highly sensitive to internal political and economic changes and this has particularly been the case of Indonesia. Over the last 10 years, the country has undergone a transformation from an authoritarian regime into a presidential democracy, has battled related secessionist pressures, endured the full effects of the Asian financial crisis, been at the center of bird flu and severe acute respiratory syndrome (SARS) outbreaks, suffered several radical Islamist terrorist attacks, and faced natural disasters such as the devastating December 2004 tsunami. All of these events created an image of instability and insecurity that put off investors. As a result, the Indonesian economy has lagged behind for several years, particularly when compared with some of its high performing neighbors. Fortunately for Indonesia, the hard times seem to be over.

Recent economic indicators are showing that this huge economy is confidently bouncing back under the current reform government of President Susilo Bambang Yudhoyono, which has focused on improving the fundamentals and creating better conditions for business. Recent economic indicators estimate growth in 2007 and 2008 at well above 6%, and both inflation and interest rates seem under control. Foreign direct investment is increasing, and consumer confidence is on the rise. Major rating agencies such as Moody’s and Standard & Poor’s have been raising the country’s credit ratings over the last several years.

James Castle, founder and director of local advisory firm Castle Asia, is a seasoned businessman and analyst who has experienced Indonesia’s booms and busts first-hand for more than 30 years. In his view, “In 2008, Indonesia has finally moved beyond the 1998 financial crisis, although it remains a watershed and traumatic event in the country’s history. The economy is now looking forward, with only a few residual problems remaining.”

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James Castle, founder of Castle Asia

Regarding the gray clouds over the global economy and its effects on Indonesia, Castle is reassuring: “Despite a potential global economic slowdown, forecasts still call for domestic growth of at least 6%, a good year. Indonesia is in a good situation and is helped by the strong global commodities cycle, as an exporter in many different commodities from agricultural to mineral, not just oil and gas,” he says.

Testament to Indonesia’s commitment to improve the business environment is the active role assumed by BKPM, the government’s investment service agency responsible for foreign investment promotion, which has six international offices around the world. It has recently overseen the writing of a new Investment Law passed in April 2007 that eliminates many of the barriers that previously hindered foreign investment in the country. Muhammad Lutfi, head of BKPM, actively supported the new law, which allows for a reduction in bureaucratic processes, increases anti-corruption measures, guarantees equal treatment for overseas and local investors, and decentralizes investment through regional one-door integrated services.

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Muhammad Lutfi Chairman of BKPM

Responding to such investor concerns as enduring corruption and the added complexity arising from Indonesia’s decentralization, Lutfi affirms, “we have adopted a zero tolerance policy regarding corruption and are also making efforts to create a uniform organization all throughout Indonesia with the local investment agencies. In addition, we strive to make the investment process smoother and more efficient by eliminating bureaucracy, thus turning 30 years of red tape into a red carpet for investors.”

In reference to the oil and gas industry, Mr. Lutfi highlights the major business opportunities in Indonesia’s downstream sector, given the current deregulation process, a population of over 230 million and a growing economy. Moreover, he says, “whereas in the past energy would follow the industries, today the trend is going towards the industry following the energy to their source. In this context, Indonesia is ideally placed to grow substantially its business in the refining and petrochemicals sector.”

In addition, Indonesia needs a variety of land and sea transportation and storage modes to meet future fuel distribution needs. This includes depots and new transit terminals as well as depots for aircraft and gas refuelling stations by private companies. With regard to the upstream sector, there are many investment opportunities such as the development of unexplored oil and gas basins, using secondary recovery technology, applying enhanced oil recovery (EOR), and developing marginal oil fields.

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Dr Subroto, co founder of BIMASENA, former Minister of ESDM and former Sec. Gen. of OPEC

Local eminence Dr. Subroto, a former Minister of Energy and Secretary General of OPEC, considers that things in Indonesia are moving in the right direction but acknowledges that the country has to continue cleaning up its act at home in order to become a preferred place of investment again. In his view, “once the Indonesian government truly overcomes the perception of political and legal uncertainty, there will be no need for road shows to lure investors as they will come running by themselves to take advantage of the numerous opportunities in the energy field. They are already there on the sidelines eagerly observing and waiting for improvements on these critical issues.”

Pertamina: rebuilding Indonesia’s national champion

When Ari Soemarno assumed the position of President and CEO of Pertamina in 2006, his condition was that he would have his hands free to truly transform the company. He was taking the top job in Pertamina, Indonesia’s National Oil Company (NOC), just as its transition period was finalizing, following the fundamental changes introduced by the 2001 Oil & Gas Law. In 2003, Pertamina officially went from being a state oil and gas enterprise governed by its own law to a state-owned limited liability company (Persero). In theory, this meant that Pertamina is to be treated as any other oil and gas company in Indonesia. Pertamina’s monopoly in the downstream market persisted up until early 2006, whereas in the upstream sector the company was already immersed in the competitive Exploration and Production (E&P) market since 2005.

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Ari Soemarno,President and CEO of Pertamina

This statutory transformation was a part of an effort by the government to establish a competitive and efficient NOC for Indonesia. For decades, Pertamina held complete control of the country’s downstream activities and, in upstream, it acted on behalf of the government in the signing of PSC’s for the exploration, development, and exploitation of blocks in the country. It basically became regulator and supervisor of the oil and gas industry for the Indonesian government. The company grew in size but was riddled with corruption and inefficiency, and unable of developing upstream capabilities of its own.

“Our foremost challenge today is to modify the culture, mindset, and management style that are all an inheritance of the past,” says Ari Soemarno. This is a monumental task for a company with more than 18,000 employees and such a long history of its own, but it is seen as a necessary first step in order to get Pertamina moving in the right direction.

control room 055 Pertamina
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In addition to changing the way the company sees itself, Pertamina is making strides to improve its image among ordinary Indonesians. To this end, the company has launched marketing campaigns and is revamping its retail fuel stations where it is facing competition for the first time from major foreign players such as Royal Dutch Shell and Malaysia’s Petronas. For Ari Soemarno, the feedback is encouraging, “The public is already taking notice and gradually changing their perception of Pertamina.”

Of course, becoming a competitive oil and gas company involves much more than polishing your image, and Pertamina’s directors have been concentrating on transforming the business structure according to its new role in both upstream and downstream activities. This includes improving procedures related to transparency and financial reporting, for example, in order to have a company “that is ready and able to operate like a publicly traded company by 2009,” explains Ari Soemarno. In addition, Pertamina is taking other measures in 2008 to become more competitive, such as selling non-core business units and negotiating with the government in order to be able to reinvest a greater proportion of profits.

Exploration and production: shopping for foreign know-how

Although Pertamina is the second-largest producer of oil and gas in Indonesia, after Chevron (in oil) and Total (in gas), its production levels still lag behind those of other comparable NOCs. In order to grow in reserves and production, it is pursuing an aggressive strategy that combines tendering for new blocks, acquisitions, and implementing EOR technology in its numerous but ageing fields. Well aware of both its strong points and limitations, Pertamina points out the advantage that international oil companies looking for a local player could find by partnering with a local firm that has a deep knowledge of the country and can facilitate the often arduous paperwork involved with doing E&P business in Indonesia.

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Sukusen Soemarinda, Corporate Senior VP Upstream Pertamina

A prime example of Pertamina’s upstream cooperation with majors is the ExxonMobil-managed Cepu field in East Java, estimated to have reserves of 600 million barrels and projected to attain a peak production of 160,000 bpd. Other joint ventures in the E&P field include collaborating with companies such as Petronas, Shell, and StatoilHydro. The choice of new partners and blocks reflect Pertamina’s determination to obtain offshore expertise, as stressed by Sukusen Soemarinda, Pertamina’s Corporate Senior VP for Upstream: “Through these alliances, Pertamina is looking to acquire the necessary knowledge, technology, and capital to be successful in deepwater operations. Our goal is to eventually be able to run those kinds of projects by ourselves.”

Pertamina has its hands full in Indonesia with land permits covering an area of about 35 million acres and many new projects, yet the NOC is already quite active in overseas markets where it is developing 20% of its business. With interests mostly in exploration blocks in Malaysia, Libya, and Qatar, Pertamina expects to see substantial growth from its overseas assets within the decade. Partnerships with Lukoil and Petroecuador could also have Pertamina venturing into new markets in Russia and South America in the near future.

Preparing for the cavalry in downstream

Pertamina still largely dominates the domestic market in Indonesia’s downstream business, although it is beginning to face competition at different levels, including storage and retail. It owns and operates the country’s nine oil refineries located throughout the Indonesian archipelago, which have a total installed capacity of just over one million bpd. Even though a large majority of the refined product is allocated to the domestic market, Indonesia still has to import about 300,000 bpd to meet demand.

Kilang Cilacap plant
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With tight refining margins and few incentives to build new refineries, Pertamina is focusing on revamping some of its facilities in order to produce more high-value-added products. The main examples are the Balikpapan refinery, which will be completely transformed to refine sour crude, and the Cilacap refinery, which is being upgraded in partnership with Japan’s Mitsui & Co. In addition, Pertamina has established a US$200 million joint venture with the Korean company SK which will improve and increase the company’s lubricant output, further consolidating its position in the Asian market.

Though not interested in developing greenfield refineries at the present time, Pertamina sees itself as an ideal partner for private investors who have been showing interest in the sector. According to Pertamina’s Corporate Senior VP for Refining, Suroso Atmomartoyo, new players are “likely to turn to Pertamina for cooperation since we are the only company with deep knowledge and experience in Indonesia’s refining sector. In fact, Pertamina is open to establishing synergies with other players interested in new refining projects, and would be able to provide support in terms of operations, administrative tasks, and distribution in the domestic market.”

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Suroso Atmomartoyo, Corporate Senior VP Refining Pertamina

Regarding Pertamina’s de facto monopoly in the distribution of subsidized fuel, with about 3,000 petrol/gasoline stations, Suroso affirms, “in the near future, once the subsidy has been phased out, BPH Migas will assume its full responsibility by tendering the market among all the interested players. For the moment, foreign companies are not able to comply with the strict requirements for subsidised fuel sale, but this is likely to change soon. In 2008 Pertamina remains the sole distributor of subsidized fuel, but we are preparing for the inevitable arrival of competition in this enormous market.”

Despite its strategy to divest non-core business units, Pertamina has decided to keep its geothermal activities and is also involved in the development of coal bed methane (CBM). The government sees CBM as potentially one of the country’s main alternative energy sources of the future. To attract investors, the government is offering a segment that is different from oil and gas contracts, depending on the areas and particular conditions. Pertamina is working on a CBM pilot project in South Sumatra with Shell and the support of the Indonesian Research and Development Center for Oil & Gas Technology (LEMIGAS). Moreover, Australia’s Santos, a major CBM player in its domestic market, is engaged in high-level discussions with the Indonesian government on opportunities for partnership on that front.

A decade of efforts rewarded

Santos entered Indonesia in 1997, but it was not until nearly 10 years later that the company saw its exploratory efforts turn into production and revenues. In late 2006, Santos’ first production in Indonesia began flowing at the Maleo gas field, an event all the more important because it represented the company’s first offshore field operated overseas. In September 2007, Santos hit another milestone in Indonesia when its second producing field, Oyong, was inaugurated by Indonesian President Yudhoyono.

Santos Maleo Field platform
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Eko Lumadyo, President and General Manager of Santos Indonesia, was visibly excited about these new times. “Our Jakarta office has now been turned into a full exploration and production operation. As a result, the organization here is forging a strong identity and the people are motivated to continue working hard for even further achievements,” he said.

Santos Oyong Field
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Santos’ core assets are its oil and gas production in Australia, where it is the country’s largest domestic gas producer and supplier. However, expansion into the Southeast Asia region has been established as one of the five key drivers of growth for the company. Indonesia plays a central role in Santos’ aspirations to become one of the leading energy companies in the region. Santos has been moving fast and is already considered an important player in Indonesia’s petroleum sector, thanks not only to its growing production but also a continued interest in exploration and synergy with other companies.

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Eko Lumadyo, President and General Manager of Santos Indonesia

For Lumadyo, “Santos’ size gives us a competitive advantage, in terms of being more dynamic and able to make quick decisions. This gives us an edge in evaluating and taking opportunities in contrast with bigger companies that have to go through much longer and complex processes. At the same time we don’t have the same capacity as the super majors to take on some of the big risk projects. However Santos is ready and able to embark on frontier-area exploration in Indonesia if we consider it a good opportunity.”

Well aware of the vast potential lying in the deep seas of Indonesia, Santos has established partnerships with companies such as Anadarko Petroleum and Petronas for deepwater exploration and is already operator of the block in the offshore Kutei basin.

LNG is also a significant area of focus for Santos, which is currently exporting LNG from Darwin in northern Australia and progressing on a number of LNG projects abroad. Though there are no concrete plans for LNG development in Indonesia for the time being, the Kutei basin is strategically located near Indonesia’s Bontang LNG facilities and could eventually supply gas to it in the future.

Santos has already become a key partner of the Indonesian government, which strongly favors increasing the role of gas in the country’s overall energy mix. Santos is focusing its production and sales in the densely populated and industrial area of East Java, where it is supplying gas from the Maleo field to state-owned natural gas transporter and distributor PGN and will sell the gas from the second phase of Oyong directly to a local power company.

“Our production has come very timely for the government, because [they are] facing gas shortages and increasing costs due to high oil price,” says Lumadyo. “Through this gas supply, Santos is contributing to cleaner and less expensive energy in Indonesia.”

StatoilHydro, which opened an office in Jakarta in 2007, sees significant ecologically-minded business opportunities in Indonesia. The company is looking to combine the need for reduced carbon emissions with the E&P activities through carbon capture and storage (CCS), including CO2 injection for EOR.

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Tor Fjaeran, President Director of StatoilHydro in Indonesia

“Indonesia has large amounts of gas flaring that could be turned into a means of meeting growing demand for gas in the domestic market,” says Tor Fjaeran, President Director of StatoilHydro in Indonesia. “In addition, LNG and ammonium plants in the country are producing carbon emissions that can be captured, stored, and potentially used for EOR. The question marks are still numerous surrounding this technology, but our company believes that towards the future linking climate change to E&P can be a business opportunity.”

Eyeing deep down

While the viability and scope of these applications will not be clear for years to come, what is more certain is that StatoilHydro’s arrival in Indonesia illustrates how all eyes are on the country’s unexplored deepwater areas. This strategic entry into the competitive Indonesian upstream market came just as the Norwegian oil and gas companies Statoil and Hydro merged, forming the world’s largest offshore operator. Fjaeran explains that, although the country has been on the radar screen for a long time, there was a feeling that the most likely prospects had already been awarded to other companies.

“We considered that the company would have only managed to pick up small pieces, which were onshore or in shallow delta areas,” says Fjaeran. “This all changed when the government announced the opening up of new deep offshore blocks for E&P. This meant that our company could have access to immature basins with potential for large discoveries in deepwater, where our expertise lies.”

Despite the differences between Norway and Indonesia, Fjaeran believes the challenges faced by their respective oil and gas companies are not that different. On a more personal note, he adds that “I like to work on the areas where the industry and business meet society, and there is definitely a lot of that here in Indonesia. I enjoy being here because it is a new place with a completely different setting, yet at the same time it feels familiar because you meet the same companies and people with similar backgrounds as in any other country’s oil and gas industry.”

In his view, Indonesia’s more than 100 years’ experience in oil and gas offers many lessons to be learned for a relatively young industry such as Norway’s oil and gas industry, which, although technologically very advanced, has fewer than 40 years in the business.

For the moment, StatoilHydro is working on the Kuma and Karama PSCs, two exploration blocks in relatively deep water that were awarded in 2007. Winning these exploration licenses has been critical for StatoilHydro because they allowed the company to finally establish itself as a player in Indonesia’s oil and gas sector. Seismic acquisition is set to take place in early 2008, and drilling should begin in 2009.

In Kuma, StatoilHydro is partnering with operator ConocoPhillips with a participating interest of 40%, while in the Karama block StatoilHydro is working with local NOC Pertamina with a 51% interest.

The relationship with Pertamina goes back to the signing of a Memorandum of Understanding (MoU) between the two companies in September 2006, allowing for potential alliances on exploration and production in Indonesia. For Fjaeran, it is a natural fit because “Pertamina has an extensive knowledge of Indonesia’s subsurface, including offshore areas, and also knows the business climate, has experience operating in the country and has close relations with the authorities. All of these aspects are of great benefit to a company like StatoilHydro, which is a new player in Indonesia. In addition, for a partially state-owned company like us it just makes sense to cooperate with other NOCs because we can better understand each others’ issues,” notes Fjaeran.

For Pertamina, the coalition brings benefits in terms of acquiring technology and expertise in offshore operations.

StatoilHydro’s interest in Indonesia does not stop at deepwater exploration and production. Another area of great interest is moving further down the gas value chain, given the company’s long and wide experience being operator, producing, transporting, and selling gas products. Though nothing concrete has been decided in this regard, Fjaeran has high hopes that there will be opportunities to get into the gas business in the country. Similarly, StatoilHydro is intent on further developing its LNG capabilities on a global scale and Indonesia’s expertise in this field makes it a prospective place for partnership. Indeed, StatoilHydro is already benefiting from Indonesian LNG know-how through a group of engineers from PT Barak, which is helping start up LNG facilities in northern Norway.

Elephant hunters on the loose

Though StatoilHydro took its time to make the leap into Indonesia, the super majors have played a defining role in the country’s oil and gas sector since Dutch colonial times. Today, Chevron single-handedly contributes to almost 50% of the country’s oil production. ExxonMobil is working to bring the huge Cepu block onstream and is negotiating the terms for developing the world’s largest gas field in the Natuna Sea, while British Petroleum (BP) is leading the huge Tangguh LNG project in Papua.

Despite these examples, most analysts are quick to point out that overall investment from the oil giants in Indonesia has been declining for many years now. The possible explanations are multiple, but to a large extent this situation is a natural result of the oil and gas cycle in which the majors start looking elsewhere once a country’s “easy” discoveries have been made.

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Richard L. McAdoo, President and CEO of Continental Energy Corporation.

According to Richard L. McAdoo, President and CEO of US-based Continental Energy Corp. and a long-time resident in Indonesia, “in the latter stages of a country’s productivity cycle, the smaller companies eventually take over since the majors have moved on to greener pastures. Considering that this is the point where Indonesia finds itself today, and that there are still vast unexplored areas, I believe that the opportunities are huge for a company like Continental.” Indeed, Indonesia’s prospective geology and open upstream sector make it an attractive setting for small- to medium-sized companies like Continental, which refers to itself as an “elephant hunter.” Record high oil prices and booming energy demand from Asia certainly do not hurt either.

Continental is placing its bets on the Bengara-II block off the coast of oil and gas rich East Kalimantan. “The Bengara-II block contains the last great unexplored delta, the Bulungan Delta, of serious size in East Kalimantan. The block is only 20 to 30 kilometers away from Tarakan Island, which has been producing oil since 1906. The Bulungan Delta is about a third the size of the Mahakam Delta in the adjacent Kutei basin, which has provided company-maker discoveries for several oil companies,” says McAdoo. In 2007, the company carried out an aggressive drilling campaign and submitted a development plan to the Indonesian authorities.

Emboldened by the success of its first major institutional placement with Australia-based Macquarie Bank, Continental is expanding its geographical horizon by looking into the possibility of acquiring blocks outside Indonesia, particularly in the Middle East. Nevertheless, the focus remains on Indonesia, a country which McAdoo is passionate about, and he goes to great lengths to get others to share his excitement.

“There is a misconception in the USA, to a lesser degree in Europe, and surprisingly to me, in the Middle East, that Indonesia is not a safe place to invest,” says McAdoo. “Having been here for a very long time, many other foreigners and I know that this is not the case. There are huge positives which I try to accentuate, like for example the fact that the Indonesian government has never defaulted on a PSC and there has never been an instance of nationalization like in Venezuela or Mexico. Taking all this into account, coupled with a well-trained oil and gas work force, good oil field infrastructure, large unexplored areas and attractive geology, these are compelling arguments in Indonesia’s favor.”

Local players get a foot on the E&P ladder

Foreign players are not the only ones getting in action on Indonesia’s E&P. In fact, over the last decade, the country has witnessed the emergence of important local oil and gas companies such as Medco, Energi Mega Persada, and Star Energy. The combination of low oil prices and the relative decline of the majors’ activities in Indonesia opened windows of opportunity in marginal fields for smaller companies, with leaner cost structures and an extensive knowledge of the country’s petroleum sector.

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ramu Santosa, founder and former CEO of Star Energy

Supramu Santosa, founder and former CEO of Star Energy, states that timing has also been a key factor for new local players entering the E&P business. Only three months after creating the company in 2002, ConocoPhillips decided to sell its interest in the Kakap Natuna PSC to Star Energy since the scale of production was no longer interesting to them and it would start declining fast. Fortunately for Star Energy, oil prices quickly began rising and stable production at Kakap Natuna was maintained.

“We were lucky to have started out at a very low moment of oil prices, just before the boom began,” admits Santosa. “Today the situation is very different because the possibilities of acquiring producing fields at a reasonable price are very low. New companies are having a harder time because they probably have to start out with exploration which is expensive and risky.”

This was not the case for Star Energy, whose first acquisition not only established it as a producer, but also gave the company the financial strength to expand its asset base. Nonetheless, Kakap Natuna’s production has started to decline, so the company is aiming at new discoveries in the three exploration blocks acquired over the last several years. Star Energy’s strategy is to concentrate on proven basins in the western part of Indonesia which, although extensively explored already, still hold potential for small players.

LKF-H-0126 - Star Energy
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“Everyone is now looking to eastern Indonesia as the future of exploration, but these frontier areas imply a great deal of risk and high costs which can only be assumed by the big oil companies,” says Santosa.

Besides oil and gas, Star Energy is active in geothermal development, a sector in which the company made its incursion in 2004 when it acquired the Wayang Windu power generation project. Estimates suggest that Indonesia may have up to 40% of the world’s geothermal reserves, or the potential to produce nearly 28,000 MW, yet the seven plants currently operating only produce a total of 850 MW.

Pertamina is another important player in this field, with rights over 15 geothermal concessions yielding a potential of 8,480 MW (equivalent to 4,390 MMBOE), though current installed capacity is of only 162 MW. Star Energy’s Wayang Windu has a capacity of 110 MW, but is embarking on expansion works in order to get capacity up to 400 MW by 2011.

For Santosa, whether it is regarding E&P of oil, gas, or geothermal, the key for a small company’s success in the industry is the human element. Many of Star Energy’s employees come from big oil companies where the corporate structure can make for a long process in terms of professional growth.

“With us, they felt that they have the chance to realize their full potential, because we give them greater opportunities and responsibilities,” says Santosa. “Thanks to this we have a very motivated team that knows that whenever the company does well they are also going to see the benefits.” Human resources are of crucial importance in Indonesia at the moment, taking into account the constant threat of a “brain drain” of local oil and gas professionals towards better-paying countries.

Central government meets regional players to explore new O&G paths; an innovative model

For this reason, developing local capacities in the oil and gas industry has been a long-time concern for the Indonesian government. Domestic service providers are given preferential treatment under the BP Migas tendering system in order to help them compete with foreign firms and public institutions such as LEMIGAS have been involved with enhancing Indonesia’s R&D level in oil and gas for decades. A new form of government participation at the local level is now taking place directly in upstream development, following the increasingly important role given to regions with regard to the management of their resources.

In 2002, Caltex’s right to develop the Coastal Plains Pekanbaru (CPP) block located in Riau province expired and after much controversy was not renewed by the Indonesian government. Instead, local state-owned company Bumi Siak Pusako and Pertamina formed a new joint venture, BOB CPP, charged with maintaining production and development of the ageing block. This partnership represented an unprecedented model of central and regional government entities coming together to develop oil exploration and production in Indonesia.

According to BOB CPP’s General Manager, Slamet Wibisono, “in this moment BOB CPP is seen as many local governments as an example of what they can achieve in becoming operators of their own O&G resources. As PSC agreements approach their expiry dates, regional players are looking into ways of taking over certain shares of interests owned by foreign companies. Of course, before the local government can take upon the operation of a block, it has to show it is in capacity to handle the responsibility.”

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Slamet Wibisono, BOB CPP’s General Manager

Indeed, this proves to be a challenging task when, as in the case of the CPP block, the fields are mature and new primary oil discoveries are highly unlikely. Although the joint venture was able to maintain Caltex’s production levels initially after taking over operations, production has dropped from approximately 36,000 bpd at that time to 25,000 bpd in 2007.

However, Wibisono believes that over the coming years production level could be doubled if BOB CPP manages to successfully apply EOR techniques to the operations.

“We realize that the techniques our fields require are very advanced, which is why BOB CPP is working together with partners like LEMIGAS and also inviting foreign companies who could provide us with proven technology for enhanced oil recovery.” he says. As there is also exploration taking place in the block, BOB CPP’s production could reach even higher levels if new discoveries are made. Furthermore, the company is preparing itself to be internationally competitive, foreseeing a possible expansion overseas in the future.

The dragon has arrived... and intends to stay

A sign of the times, Chinese companies have been increasingly making their mark on the Indonesian oil and gas sector over the last several years. Upstream giants Petrochina and CNOOC have established their position in the E&P industry and are aggressively expanding their assets and operations in the country. This trend is only likely to intensify towards the future as China’s economy keeps growing at near double-digit rates and domestically-produced resources are insufficient to keep up with the soaring energy demand.

In this context, Indonesia is seen as a strategic partner for the Chinese government with whom relations are going through a positive moment, particularly on energy issues. Moreover, China’s heightened importance in the global economy is prompting Chinese companies to seek growth overseas in order to become internationally competitive, world class firms.

A clear example of this trend is Beijing-based CITIC Group, which is investing for the first time in the oil and gas sector abroad through its energy sector holding company CITIC Resources (based in Hong-Kong). Already involved in the raw materials business in areas such as coal and aluminum, CITIC Resources has recently decided that it was a good moment to expand the company’s portfolio of activities into oil and gas overseas, and Indonesia represents the company’s first international venture.

As Tang Zhongfu, President of the fully owned subsidiary CITIC Seram Energy Limited (CSEL) explains, there are many good reasons why Indonesia was chosen as the first overseas oil and gas destination.

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Tang Zhongfu, President Director CITIC Seram Energy Limited (CSEL)

“First of all, there is the PSC mechanism which is an Indonesian creation and thus very mature in the country. It is a system that makes us feel comfortable to invest in Indonesia because it is very clear and transparent,” says Zhongfu. “The second reason why we have chosen Indonesia is because it serves as a good platform for CITIC Resources to expand its business portfolio, thanks to the large amount of oil companies working in this country as PSCs. Being active here allows us to share experiences with them and be well informed about new business opportunities. Thirdly, Indonesia is one of the main LNG producers in the world, which makes the potential for gas development, especially offshore, very interesting,” he says.

CSEL officially entered the Indonesian upstream petroleum market when it completed acquisition of a 51% majority interest in the Seram Island Non-Bula PSC. A notable aspect of this move is that CSEL also became the operator of the block, which marks a change in the group’s strategy for oil investments from passive holdings to an active involvement. Nonetheless, this is by no means a new task for CSEL’s management, which has gathered much experience over the years operating in companies such as Petrochina.

In 2007, the block’s production was at about 4,200 bpd and the announced objective is to maintain those levels and increase overall production in Indonesia through the development of existing interests in other blocks and possibly through acquisitions. In this regard, CSEL entered into a non-binding MoU with Kuwait Foreign Petroleum Exploration Company (KUFPEC) over closer cooperation in exploring oil and gas business ventures in Indonesia and other countries.

Field Facility Citic Seram
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“Citic Resources sees this first project as a platform, so depending on how good the results are, we will probably go after other business opportunities in the near future,” concludes Zhongfu.

Chinese supporting industry comes along for the ride

Chinese service providers are also taking advantage of their country’s strong economy and high levels of investment in its manufacturing base to target growth in overseas markets. Chinese Oilfield Services Limited (COSL) is one of the main players in this group, with over 30 years’ experience in its domestic market. COSL is also a familiar face in international markets where it has been active for over 10 years, particularly in drilling rigs and different offshore business lines. COSL’s initial strategy for international expansion was based on working exclusively with Chinese E&P players such as CNOOC and Petrochina, which are already established abroad.

This was also the modus operandi for COSL when it first came to Indonesia five years ago, when it began assessing the potential of the country’s large population and rich natural resources. Considering it has passed its first phase of its business development in Indonesia, COSL has taken a significant step forward by working with international majors such as ConocoPhillips, Chevron, and others.

Benefiting from decades of establishing relations with large international oil and gas companies in China’s domestic market, COSL is aiming at becoming a preferred upstream service provider for companies around the world.

In Indonesia, “COSL has developed a strong relationship with Pertamina and prefers to establish partnerships with companies of different sizes and profiles. At this stage in our Indonesian strategy, all companies have the same importance,” says President Director of PT COSL Indo Zi Shilong. So far, COSL’s most important business lines in Indonesia are drilling and well services. But the company intends on bringing its transportation and seismic services to the country by 2009, thereby offering the full range of its capabilities to the Indonesian oil and gas industry. In effect, COSL’s goal is to become involved in Integrated Project Management in Indonesia, servicing the entire project life cycle.

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Zi Shilong, President Director of PT COSL Indo

“We perform this activity in China, extending beyond drilling to transportation, seismic and other services. COSL’s advantage is its ability to perform services over the whole life of the oilfield, from beginning to end,” states Shilong.

Thus far, COSL is satisfied with the business environment in Indonesia and upbeat about future opportunities to continue growing. Stressing the cultural similarities and good relations between China and Indonesia, Mr. Shilong acknowledges the great effort that the Indonesian government has put on increasing its oil production and is confident that this will translate into an even greater demand for oil services.

Although the oil boom has generated a global shortage in oil-related equipment and Indonesian projects must therefore compete with those in other O&G producing regions around the world, COSL has committed to expand its business and increase investment in Indonesia over the coming years.

“COSL has offered the local oil and gas community reasonable cost and comprehensive service. We strongly believe that the existence of COSL in Indonesia will be mutually beneficial to our countries,” says Mr. Shilong.

Investor Insight Into Indonesia’s Oil & Gas Sector

In late 2005 PricewaterhouseCoopers Indonesia (PwC) in cooperation with the Indonesia Petroleum Association (IPA) undertook an industry survey to gauge industry participants’ views on the competitiveness of the Indonesian upstream oil and gas sector (an updated survey is in process and is expected to be published May 2008). The survey found that industry participants were generally very favorable on the geological prospectivity of the country, in particular the Eastern basins, which remain largely unexplored. In addition, survey participants were very positive on the PSC fiscal regime since it was well understood by both regulators and industry players.

Survey participants were also quick to point out many of the challenges confronting the Government of Indonesia (GOI) as it tries to deregulate the oil and gas sector and make it a world-class industry to propel Indonesia’s economic growth into the 21st century. In particular, one area of concern related to inter-ministerial coordination. In the newly deregulated environment created by the New Oil and Gas Law No. 22/2001, there are now more GOI stakeholders that industry players need to deal with. Often at times these stakeholders have different interpretations of the prevailing regulations and their associated scope of responsibility.

Survey participants rated harmonizing conflicting laws and regulations (including timely issuance of implementing regulations after new laws are introduced) and improving teamwork and coordination among the various GOI stakeholders as having the biggest potential impact to improving the investment climate for the energy sector. Since the issuance of this survey there have been many public forums where the GOI stakeholders and industry players have shared views on the issues and ways forward.

In addition, the Coordinating Minister of the Economy has formed a committee to address the lack of coordination and teamwork amongst the different ministries and departments of the government, although the progress to date has been slower than many stakeholders would like. Despite this fact, the GOI stakeholders have been receptive in listening to industry players and taking measurable steps to improve the investment climate in the energy sector. As such, there is reason for optimism.

Is the glass half empty or half full?

While not wanting to downplay the many challenges impeding Indonesia’s economic growth and in particular the competitiveness of its oil and gas sector, one needs to recognize the many difficulties confronting the GOI stakeholders.

Indonesia is a geographically large country spread out over 13,000-plus islands with many diverse cultures and ethnic groups. Because of this diversity there was a real danger early in the post-Suharto era for the country to “Balkanize.” Fortunately this has not happened and in large part can be attributed to the Regional Autonomy Law passed by the government, which shares more powers and economic rewards with the provincial and local governments.

However, this has created new challenges for companies operating in the oil and gas sector such as local government involvement in land acquisition, approvals of plans of development, along with the imposition of new local taxes which are generally prohibited by the contracts issued by the central government. The central government has been reactive in addressing these sorts of issues as they arise and facilitating solutions.

When assessing the competitiveness of the Indonesian upstream oil and gas sector an investor needs to consider many variables. We have highlighted some of the positive and negative trends impacting the sector in the below table:

Positive Trends

  • Increased acreage being tendered, much with improved fiscal incentives
  • Increased political and social stability
  • Direct tendering of acreage now possible
  • Posting of bonds for initial contract commitment now required to encourage active exploration
  • Clear GOI vision and target for oil production of 1.3 million BOPD by 2009
  • Recent renewal of duty and import tax exemptions for exploration activities
  • Development of a national energy policy with concrete energy use targets
  • Significant reduction in fuel subsidies, which has allowed monetization of some stranded gas reserves

Negative Trends

  • Increased cost recovery challenges and continuing uncertainty over upstream taxation
  • Continued lengthy bureaucracy for approving Plans of Development, Work Programs, and AFE’s
  • Operating costs per barrel on upward trend due to maturing fields
  • Continued lack of coordination among the various GOI stakeholders in resolving industry issues
  • Regional governments and local communities have impeded expeditious development of certain projects

Considering Indonesia’s complexity and the recent political and economic transformations, the country has fared fairly well and is heading in the right direction. Industry players tend to agree with this view but mention the speed of progress as their single biggest frustration in Indonesia. Potential investors need to recognize that operating in the Indonesian oil and gas sector presents many challenges but the upside financial opportunities can be significant.

Reason for Optimism

Many economists project Indonesia’s GDP growth to average between 6% and 7% over the next several years. However, with the right leadership and policies, there is no reason not to expect a 9% to 10% growth rate.

PricewaterhouseCoopers Indonesia is cautiously optimistic as to growth opportunities and is projecting a 15% CAGR over the next five years for its own business. For investors that are willing to see through the country’s challenges, the opportunities that await could be a hidden gem.

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William Deertz
PricewaterhouseCoopers Indonesia