Is Indonesia’s move to “gross-split” the future of oil and gas production sharing arrangements?

Over the last decade, the Government of Indonesia has become increasingly concerned that petroleum companies operating the country’s oil and gas fields have been inflating costs through overspending. In 2016, a report by the Supreme Audit Agency (BPK), revealed that several petroleum companies (“contractors”) had inflated the reimbursement of their operating claims by US$300 million.

Production sharing contracts (PSCs) are common in the petroleum sector. Roughly two-thirds of petroleum producing countries have this as the core component of their fiscal regime. Under a PSC, the contractor is entitled to take a share of total production to cover its exploration and development costs (“cost oil”), and what’s left is then split between the contractor and the government (“profit oil”) according to some formula set out in the PSC. This mechanism for apportioning production is called “cost recovery.” While countries may vary the ratio of cost oil to profit oil, cost recovery has, until now, been the defining feature of the PSC.

In January this year, the Government of Indonesia abandoned the cost recovery approach. In its place the Government will apply a “gross-split” method, apportioning production solely based on a percentage, leaving all capital and operating costs to be borne by the contractor. This specific policy is virtually unknown in the world of upstream oil and gas contracts (Peru used it briefly in the 1970s). However, it is not too different from a royalty/ tax regime, whereby the contractor pays a combination of (1) a royalty based on the volume, or value of oil extracted, (2) income tax, and (3) a resource rent tax to capture a larger share of profits of the most profitable projects. Under gross-split, the contractor is effectively ‘paying’ a royalty by handing over a share of production to government before recovering its costs. This is attractive because government can collect revenue as soon as production commences. However, there is still a risk that contractors will inflate cost claims applied to income tax computations.

The Government of Indonesia argues that under cost recovery, contractors are incentivised to inflate costs to increase their share of production, the result being that Government’s share is reduced. By moving to a gross-split, contractors are forced to shoulder the costs themselves, which Government expects will encourage them to operate more efficiently, and protect the State budget. Under cost recovery, all expenses had to be pre-approved by the oil and gas regulator, SKK Migas, which led to significant delays for contractors. By giving contractors more freedom with respect to procurement and technology, the Government hopes to create a more attractive environment for investment.

Indonesia’s move away from cost recovery has been a long time coming. It is an issue that has become increasingly politicized, with the public regarding it as unfair that contractors’ costs reduce the Government’s share of production by hundreds of billions of dollars every year. It’s not hard to see why, when in 2016, the cost of cost recovery reached $13.9 billion, which was more than the sector raised in non-tax revenues. There are also administrative challenges involved in applying cost recovery. According to the Deputy Energy Minister, Arcandra Tahar “the problem with cost recovery is, there have been endless debates between SKK Migas and contractors as to how much exactly the production costs should be. It’s not easy to calculate technology costs, especially in cases where only one company has a particular technology.” SKK Migas has 750 staff; roughly 80% are involved in administering cost recovery.

Gross-split will increase the Government’s take from the sector, and ease administration. However, it may also deter investment, and prevent Government from capturing the upside if oil prices end up rising. Under the proposed gross-split of 57:43 (in favour of Government), contractors’ Internal Rate of Return (IRR) will be reduced by approximately 6% on average across all exploration prospects (i.e. onshore and offshore). The big test will be the bid round currently underway. WoodMackenzie, and company executives, are doubtful there will be much interest under the gross-split model. If they are right, Government may be forced to recalibrate the split to something that more closely resembles contractors current IRR. Given the political significance of the issue, we’re unlikely to see Government do a U-turn on gross-split.

Indonesia is not the only petroleum producing country to struggle with cost recovery risks. Tanzania’s former upstream regulator, the Tanzania Petroleum Development Corporation (TPDC), has expressed concern about companies inflating drilling rig rental fees. According to them, Tanzania’s status as a frontier basin makes it easy for companies to record the maximum rental price, and the TPDC lacks the appropriate benchmarks to challenge these cost claims. The challenge of auditing cost claims does not disappear with the gross-split model, but at least it is contained to calculating income tax, rather than being allowed to erode government’s share of production as well.

There is merit to supporting resource-rich countries to strengthen cost recovery audits. But with finite audit resources, and limited benchmarks to evaluate cost claims, Indonesia’s response to move away from cost recovery as a basis for production sharing may prove a more pragmatic approach. Petroleum producing countries will be watching closely over the next few months to see if Indonesia can get the balance right between maximising economic benefit from oil and gas, whilst continuing to encourage investment. If the Indonesians can achieve this, gross-split may well be the future of production sharing in oil and gas.