Indonesia: The New Indonesian Oil & Gas Law

Mark Newbery, a partner in Herbert Smith’s Singapore office, analyses the new Indonesian oil and gas law which the Parliament finally passed on 23 October 2001. Hiswara Bunjamin & Tandjung, the firm’s associate office in Jakarta, has assisted with this article.

The passing of the new Indonesian Oil and Gas Law (Law No. 22 of 2001) is a hugely significant event. The political significance is even greater than the legal one. The legal regime for the development and exploitation of oil and gas had been largely in place since before the Suharto era (1967-1999), being based on Law 44 of 1960 on oil and gas, Laws 2 and 15 of 1962 on domestic market obligations and Law 8 of 1971 on Pertamina. This provided stability and continuity, but it had long been recognised that the legal regime required modification and a draft new oil and gas law was first submitted to parliament in February 1999. This initial draft was rejected, largely because Pertamina was not consulted on its content and had proposed its own draft. Subsequent attempts to reintroduce and pass a new bill over the next few years failed as the governments of Presidents Habibie and Wahid spent their energies on remaining in power rather than tackling issues like reform of the oil and gas regime.

One of the principal issues which needed to be addressed was reform of the state-owned oil monopoly, Pertamina. It has been a source of concern for the Indonesian authorities for many years that Pertamina was used as a model by Malaysia for its oil and gas company, Petronas but that, while Petronas has become increasing successful, producing around 33% of the country’s output in 2000, Pertamina has not maximised its opportunities, last year producing only approximately 7.2% of the country’s total output. Given the huge patronage wielded by Pertamina, any reform was going to require a huge amount of political will. With Indonesia's democracy in its infancy, it therefore took great courage on the part of President Megawati’s government to tackle this issue, especially early on in the administration's tenure. It has been recognised that reform is required in the sectors of oil and gas, mining and power. Thus to have passed the new oil and gas law is also a sign that the process of reform in all these three sectors is underway.

Under Indonesia’s 1945 Constitution (as amended) all natural resources within the Indonesian Territory are controlled by the State for the greatest prosperity and welfare of the Indonesian people. The State’s authority is exercised by the central government as the holder of general mining authority for the Indonesian people.

Under Indonesia’s regional autonomy laws which came into effect in 2000, oil and gas affairs remain, in principle, within the jurisdiction of the central government. Under Government Regulation No. 25 of 2000, certain matters in the field of mining and energy are stated to be within the authority of the central government.

Although the new Law does provide for the central government to consult with the relevant regional government with respect to certain matters relating to co-operation agreements and for revenue sharing, the precise relationship between central and regional governments will need to be clarified in the implementing regulations for the new Law. The opposition to the new Law from the regions, particularly in relation to its current lack of clarity on key issues such as revenue sharing, has been vocal. This problem is exacerbated by the fact that the government has announced its intention to reform the Regional Autonomy Law with a view to overcoming many of the problems that have been experienced in its implementation.

It is important to recognise that, consistent with Indonesian laws generally, this legislation is a framework and much of the detail will need to be filled in by government regulations. The new Law anticipates this in many areas. To the extent that there are concerns with the existing laws, the programme of new regulations should be able to address these concerns.

We describe below some of the principal features of the new regime, some of the areas where further development of the ideas is required and some of the problems that may arise.

The principles governing the implementation of the oil and gas business regulated under the new Law are set out as the economic benefit of the people, integration, benefit, prosperity and welfare, security, safety and legal certainty as well as concern for the environment. While this is a worthy list, the potential for conflict between the principles is all too apparent. No priority is given to the principles within the list. The Law also sets out the purposes of regulation being to assure effective execution and control of the various businesses in the sector as well as useful, productive, highly competitive and sustainable use of oil and gas resources through an open and transparent mechanism.

Natural oil and gas is to remain a national asset controlled by the state. However, the Law recognises that the regions (consistent with the Regional Autonomy Law and the Law on Financial Equilibrium between the Central and Regional Governments) should share in certain financial benefits and have other controls over the implementation of oil and gas businesses. The degree of control, both legal and financial, retained by the central government has been, and is likely to continue to be, the cause of friction with the regions which are rich in oil and gas resources and have political aspirations.

The government will establish an implementing authority to control and supervise activity in the upstream sector. Its role is dealt with more fully under Development and supervision below.

Upstream business is defined as exploration and exploitation. Downstream business is defined as processing, transportation, storage and trading. Upstream business must be conducted through a co-operation contract, which may be a production sharing contract or other forms of co-operation agreement which are more beneficial to the State and which maximise the people's prosperity. The interpretation of this phase could prove problematic.

Downstream business activities must be conducted under Business Licences. Such activities must be conducted through the mechanism of reasonable, fair and transparent business competition. It is unclear what is intended by this provision. The explanatory notes provide that this competition will still need to take into account the government’s social responsibilities. This is assumed to mean a continuation of subsidies to the poor and other key social groups. While the gradual removal of subsidies is seen as essential for the economy, recent price rises have met with considerable opposition. There are also concerns that introduction of market pricing could mean that those living in remote locations pay substantially higher prices.

The government must give priority to domestic needs in the utilisation of natural gas, must provide a strategic reserve of oil, and must guarantee both the availability and continuous distribution of fuel oil.

It is also provided that commercialisation of natural gas transportation through pipelines which concerns the public interest shall be regulated to ensure that their use is open to all users.

A permanent establishment of a foreign company (that is, a foreign company acting through a branch or similar) can only conduct upstream activities. This means that an Indonesian subsidiary must be established for downstream activities.

There is a prohibition on the same business entity engaging in both upstream and downstream activities. This is a very narrow prohibition applying to the entity only and not on a group basis. The prohibition appears to be driven primarily by financial motives of the central government. Under the revenue provisions, the central government will receive most of its revenue from upstream activities. Accordingly, it wants to ensure that, from an accounting point of view, the revenue streams of upstream and downstream activities are not mixed. It is also concerned to prevent any offsetting of upstream profits against downstream losses and vice versa. Not surprisingly, this approach is one of the reasons for the objections of the regions to the new Law.

Every cooperation contract must be notified in writing to the People’s Representative Assembly (DPR). The implications would appear to be that no part will remain confidential. Whether there is a further implication that the DPR can intervene and/or not approve remains to be determined.

Each entity may only have one operational area. This is consistent with current contract of work and PSC policy which is designed to prevent risk being transferred between projects.

Cooperation contracts can last for a maximum of 30 years, with a provision for an extension of up to 20 years. As further extensions are not prohibited we would assume they are possible. They may have an exploration period of six years, which can be extended once by up to four years. There must be provisions for the gradual relinquishment of the operational area and it must all be relinquished if approval for initial field development has been obtained and the relevant activities have not been conducted within five years after the expiry of the exploration period.

Guidelines, procedures and conditions for the cooperation contracts will be set out in government regulations.

The first development plans for a field must be approved by the Minister based on the considerations of the implementing body and after consultation with the relevant regional government. There are concerns that approval at this level - which is not currently required - may introduce significant delay into the process.

The Domestic Market Obligations, or DMO, which under the old laws applied only to oil production now apply also to gas production. The maximum DMO portion is set at 25% of the private sector's portion of oil and gas. However, it is unclear whether or not the five year DMO-free period that has applied in the past, will still apply under the new Law. Again this may be the subject of further government regulations. The uncertainty about the extent of the obligation and quite how it is to be implemented is a cause for concern: at 5% it may have no significant effect on the economies of a project but at 25% it might change the decision to proceed.

As mentioned above, an Indonesian legal entity is required for downstream business and it must be licensed for processing, transportation, storage or trading. The entity may hold more than one licence provided that it is not inconsistent with the applicable laws and regulations. Under the Anti-monopoly Law, for example, there is a prohibition on vertical integration (that is, control of more than one phase of the production chain) if it causes unfair business competition and/or damage to the public. Thus if an entity held licences for all four phases of a downstream business and used this to gain greater control over the market or set prices at a higher level, it could be in breach of the Anti-monopoly Law.

No licence is required for field processing, transportation, storage and selling activities which are considered part of an entity’s licensed exploration and exploitation activities.

The Minister is to promulgate a master plan for a national network for the transmission and distribution of natural gas. A holder of a licence for transportation of oil and gas through a pipeline network shall only be granted rights for a certain transportation segment and a holder of a licence for gas trading through a pipeline network shall only be granted a licence for a certain trading area. As a gas pipeline network is a natural monopoly, and there are requirements for open access, it is difficult to fathom the justification for this restriction. Equally, a geographic restriction on trading seems inappropriate. It is not clear whether or not the thinking behind these restrictions is related to relationships with the regions or is part of a bigger plan to ensure competition. The concern with traders is the number of players and the size of their market share to ensure there is effective competition rather than a geographic restriction. Indeed such a restriction may encourage the building of significant market share in that area.

Fuel oil and certain processed products sold into the domestic market to meet public needs must meet quality standards to be set by the government. Prices are left to "the mechanism of healthy and fair business competition" although there would appear to be recognition that the government may continue to subsidise certain groups of people as part of the government’s social responsibility.

Business entities and permanent establishments will be obliged to pay state revenues in the form of tax and non-tax state revenues. Taxes consist of taxes, import duties and other levies on import and excise duties as well as regional taxes and regional retributions. This represents a significant expansion of the tax burden for contractors, who until now have only been subject to income tax. Non-tax state revenue shall comprise the state portion of oil under cooperation contracts, exploration and exploitation levies and bonuses under cooperation contracts. Contractors have the option to decide either to pay taxes in accordance with tax laws and regulations prevailing at the time the contract is entered into or under current prevailing tax laws and regulations.

Non-tax revenues will be dealt with under further government regulations and shall comprise revenues of central and regional is to be determined in accordance with prevailing laws and regulations. The current basis for such sharing is set out in Law No.25 of 1999 regarding the Financial Equilibrium between the Central and Regional Governments.

There are detailed provisions on the relationship between oil and gas businesses and land titles and use. These are, however, beyond the scope of this article.

Development of oil and gas activities is a matter for the central government including both policy and implementation.

Supervision will remain with the relevant central government departments while the implementing body will supervise the upstream business through the co-operation contracts and the regulatory body will supervise the downstream business under the various licences.

These matters too will be covered by more detailed government regulations.

There will be further detailed government regulations concerning both the implementing body and the regulatory body and their respective activities.

Certain civil servants are to be granted special authority as investigators under Law 8 of 1981 on Criminal Procedure. There are substantial fines for carrying on a business without the relevant authority and other specific offences. In addition to the criminal sanctions, there are provisions for the revocation of rights or confiscation of assets.

A period of one year from the date the law came into effect (23 November 2001) is allowed for the establishment of the implementing body and the regulatory body and two years to transform Pertamina into a state-owned limited liability company (known as a "Persero"). Until the Persero is established, Pertamina will continue its existing role. Interestingly, the new Law expressly revokes the previous law which established Pertamina and provided for its corporate governance. However, it is provided that Pertamina should continue to perform its functions in relation to exploration and exploitation, including PSCs, until the implementing body is established. Once the Persero has been established it will enter into cooperation contracts with the implementing body in respect of Pertamina's mining authority areas and shall be deemed to have obtained the necessary business licences, for its processing, transporting, storage and trading businesses.

Once the implementing body is established, existing PSCs and related contracts will be transferred to it from Pertamina and will continue in effect notwithstanding the transfer. Other contracts and commitments of Pertamina shall be transferred to the Persero once it is established. With effect from the date the law becomes effective, the responsibility for discussions and negotiations of exploration and exploitation matters shall be transferred from Pertamina to the Minister of Energy and Mineral Resources.

State owned businesses, other than Pertamina, engaged in the oil and gas business, shall be deemed to have obtained the necessary licences and shall continue with those businesses but must, within one year of the effective date of the Law, establish separate business entities in accordance with the Law. This would apply, for example, to PT Perusahaan Gas Negara (Persero), the national gas company.

The previous laws relating to oil and gas are repealed by the Law. However, the implementing regulations enacted under those laws shall continue in effect except to the extent that they are inconsistent with any new regulations under the Law.

While regulations are required in a number of areas, the principal ones are, upstream activities, downstream activities, establishment of the implementing body and the regulatory body. While some work was done on the drafts last year, we understand that recently much more attention has been given to them and drafts for upstream activities and establishing the implementing body are advanced. Some important policy decisions, particularly on the regulatory side, need to be taken before the downstream and regulatory body regulations can be finalised, but we understand these are hoped to be completed within the next few months.

It is premature to draw many conclusions about the new Law. There are, without doubt, some provisions that will help investment while others appear to create problems. The implementing regulations give an opportunity to overcome some of these issues. The manner in which the Law and the regulations are implemented and the degree of cooperation between central and regional government in that implementation will be crucial too. However, the fact that the government has taken steps to unlock the significant oil and gas resources for the nation is a very hopeful sign for Indonesia's future.

"© Herbert Smith 2002

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