Indonesia’s straddle between gross split and cost recovery is positive step forward

Introducing a choice between gross split and cost recovery for new licences is a positive step forward for Indonesia's upstream sector, says Wood Mackenzie.

Indonesia introduced gross split terms to production sharing contracts in 2017 to reduce bureaucracy and improve efficiency in the upstream industry. The aim was to increase investment and boost oil and gas production. Under the gross split terms, 22 blocks were awarded in 2018, with US$1.2 billion of investment commitments, the highest in a decade.

Wood Mackenzie senior petroleum economist Nikita Golubchenko said: “The gross split terms were most effective for expiring contracts. Higher oil prices, significant cost efficiencies, and lesser bureaucratic approvals play in favour of gross split terms for licence extensions. As project risk parameters are lower than in exploration blocks, investors may negotiate additional splits necessary to reach hurdle rates.

“We have seen lead times of project extensions such as Duyung and East Sepinggan improve as a result.”

However, vague criteria for the discretionary ministerial split and the regressive nature of the gross split terms have proven unpopular, particularly in the current low oil price environment. Despite the range of additional variable and progressive revenue splits available, investors do not see sufficient upside under the gross split terms to offset increased project and procurement risks.

Recognising the need for further change, the Indonesian government reintroduced the cost recovery scheme with proposals on the table for additional incentives.

Research analyst Lionel Sumner said: “One benefit of cost recovery is the ability to offer some reward for risks associated with frontier developments. This is important as it could encourage exploration to mitigate Indonesia’s declining production.”

Golubchenko added: “Indonesia offers a range of different opportunities. Maximising these opportunities require a flexible fiscal approach to match investor reward with opportunity risk.”

In addition to attractive fiscal terms, other factors such as a robust gas policy, less bureaucracy and a more flexible and streamlined approval system are considered incentives to Indonesia’s upstream sector. Domestic gas price caps, approvals in several government bodies and carried local government participation in the projects play as deterrents for international investors.  

Under Wood Mackenzie’s Upstream Competitive Index, Indonesia ranks 134 out of 145 regimes for fiscal attractiveness under gross split terms. This improves to 125 under cost recovery, but more work needs to be done.