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The Indonesian Production Sharing Contract
N. Machmud, The Indonesian Production Sharing Contract, an investor's perspective, Klulwer The Hague 2000, ISBN 90-411-1378-8 195 pages, translation of laws, bibliography, index, 53 #
The production-sharing contract has become, over the last 30 years, the probably most dominant form of granting access to oil&gas exploration and development to international petroleum companies in developing countries. Even Russia has adopted a form of production-sharing contract (albeit quite distinct). It has replaced the concessions/licenses as the main form of petroleum-related mining title; its distinct character is that production is shared (reflecting a conceptual root in the sharing of harvest between landowner and tenant) rather than tax/royalties being paid and that the foreign investor (now ""contractor") is in a contractual relationship with a state company which holds the original mining title (this is where the new Russian PSC form differs).
The state company may exercise quite loose control or much more close control over management. Functionally and financially, the PSC may not be that different from a concession plus royalty/tax arrangement; it is is different in terms of management control, depends on the specific management system established and on the way it is implemented. The PSC originated in the 1960s in Indonesia. It has now spread around the world, though there has been a noticeable shift back towards the "developed country" model of concessions/licensing, in particular in Latin America. This model reflects a much cleaner separation between state (politics, bureaucracy) and the investor.
Apart from an early, mainly legal analysis by Robert Fabrikant in the 1970s, there has been very little systematic analysis of the production-sharing contract, and in particular of its "life" and operations in Indonesia. This book - a doctoral thesis at Leiden University - provides an examination of the origin of the Indonesian PSC in the mists of history, its historical, political, institutional, legal (but even personality-based) background; it then surveys the major evolution of the PSC in Indonesia, from 1965 to 1998, provides a brief comparison with the influence of the PSC (and alterations) in the context of Malaysia and later China.
It focuses very much on the PSC's tax and management regime. Most of all, it concentrates on the real operations, the "life" of the PSC in the often tortuous interaction between PERTAMINA, the Indonesian state oil company, the Indonesian ministerial bureaucracy, the influence of the long-term dictatorial President Suharto, politically well connected "crony" service contractors in Indonesia and the foreign oil companies. It identifies a number of "problem areas" in the execution of the Indonesian PSC, relying on several consulting firms' assessment and a questionnaire and interview survey carried out by the author.
The study ends with a discussion of the 1998 reform efforts by then oil minister Kuntoro. It is largely not a typical academic PhD thesis by a junior researcher - with an exhaustive use of literature, descriptive and little originality, but rather the sum of a life-long practical, but theoretically reflected work of the author in negotiating and managing PSCs from the position of General Counsel and later General-Manager/ President of ARCO Indonesia. This provides a much better selected and sharper understanding that a contract is not just "text" in a contract, but unfolds its legal and organisational structuring of a complex relationship only in the context of the institutional, political and commercial tensions and is much influenced by the change in the political and even personnel context of the parties to the contract and with an influence over the contract. It is therefore a proper study on "law in action" which is probably outside the access of normal academic work.
In this respect - law in context and law / contract in action - it sheds much more light on the PSC than the earlier and pathbreaking work by Robert Fabrikant and most other writing by legal practitioners or scholars on PSCs or specific country studies of the interaction between a company and a country in the oil&gas sector. In so far, the study by Nathan Machmud makes a unique contribution. For anybody with an interest in government-company relationships in this industry or the form of the PSC, this is therefore mandatory reading.
The unsung hero of the book is Dr Ibnu Sutowo, the founder and long-term autocratic leader of PERTAMINA. Machmud credits him - and this is novel - with developing the concept of the PSC much earlier than the first well known PSCs in 1965 in two contracts in the 1950s with minor companies. Sutowo adopted the concept from the sharing of the harvest between landowner and tenant. It is only later that under the influence of outside (US tax credit rules) and domestic pressures the PSC became more complicated, included forms of income taxation, much tighter management by PERTAMINA.
Machmud explains the success of the PSC model in making Indonesia a then leading oil exporter to Sutowo's drive, independence and essential commercial sense; he looks back on the Sutowo era as a period when the PS-Contractors could go about their business with full freedom untrammeled by corruption and bureaucratic interference. With the resignation of Sutowo - due to an uncontrolled expansion of PERTAMINA and financial mismanagement (which Machmud lays at the door of presidential intervention), a much more bureaucratic model of PERTAMINA-plus-state interaction with the contractor emerged.
Bureaucrats without comparable expertise or exposure to risk prescribed specific management actions to contractors; corruption entered - Indonesia then acquired the reputation of one of the most corrupt countries around - mainly through the mandatory introduction of Indonesian contractors, suppliers and staff to the PS-Contractors. They got more or less bound to accept politically promoted Indonesian suppliers and contractors; these paid bribes to polticians and PERTAMINA staff which guaranteed them a contract with the foreign oil company.
PERTAMINA never was able to develop its own operational experience; different from Malaysian Petronas, it acted as a supervisor of foreign contractors and a mechanism to impose - what appears largely corrupt - Indonesian procurement, and so never had a chance to become an international oil company with the ability to project its skills beyond Indonesia. Machmud relates that costs in Indonesia - as benchmarked against other areas - were about 30% higher and explains this largely to corruption, without that there is evidence that the local-content preferences have built up any relevant industrial skills - just an ability to bribe and collude with senior bureaucrats, politicians and the President's "cronies". It is not surprising that as a result, Indonesia in spite of a still remaining geological attraction has not experienced growth of development of new reserves as in other competing regions, that PERTAMINA has never attained the competence of PETRONAS and that Indonesia, given an ever declining production-reserves ratio is now likely to become an oil importer in about 5 years.
As Machmud describes it, it is not the production-sharing contract which is to blame, but the way it is implemented. He therefore supports the part of the 1998 (proposed, but not enacted) reforms which would deregulate and de-bureaucratise, but is concerned that some elements of the then proposed reform package would maintain bureaucratic interference, but shift it from the corrupt, but at least more experienced PERTAMINA to a ministry unit. A large comparative survey might have shown how this problem was tackled in Latin American countries - basically by separating the licensing duty (anchored in an autonomous, rather than Ministry agency or state cmpany) from a remaining state operating vehicle.
Machmud's study deals also with issues which are typical for the more mature situation of petroleum producers: With large oilfields largely developed and now with declining production, the chase has to be for more smaller, "marginal" fields, and these need special incentive packages. Similarly, gas development requires market-based payment. Corruption can not be tackled by moral appeals, adhortatory statements, anti-corruption training and the like (something the World Bank engages in at the moment with great zeal), but mainly by disentangling activities following a commercial logic from the state, with minimal contact points and minimal exercise of discretion at such inevitable contact points.
Tendering - always supposed to reduce corruption - is shown in its particular Indonesian shape, to be the principal entry point for imposing on unwilling foreign contractors Indonesian "crony" contracts which in the end make Indonesia uncompetitive and shift income from the state to the crony-politician subculture.
While Machmud focuses on the contractor-government interaction, he notes the inability of Third World petroleum producers to cope with windfall income. Like Venezuela or Nigeria, Indonesia has captured several times huge windfalls from oil; like these OPEC associates, it has never been able to translate such windfall into lasting investment or prosperity. Every upturn in oil prices led to waste, ever downturn to economic crisis. The culture of corruption prevented the use of petroleum windfalls into sensible public infrastructure, anti-cyclical income stabilisation scheme or the development of a competitive and capable oil-related domestic industry.
Machmud in the end remains loyal to the idea of PERTAMINA and the concept of production-sharing. He hopes in the end that better people and better implementation would make these concepts work well. This is perhaps the inherent limit of the study and the author's value as a life-long practitioner in this field in Indonesia - the great asset of the study - is probably also its main handicap. A larger comparative study might have shown that the PSC contract implies by its very nature the existence of a protected state company and opens up ways for the classes dominating a Third World oil producer to appropriate the mineral rent the oil extraction generates - rather than making it a lever for financial stability and economic development.
My reading of the experiences with state companies and PSCs (and related contracts) from 1970s and 2000 is in the end the opposite of Machmud: An oil endowment leads in most cases to the "curse of resource endowment": it makes societies "lazy", makes them give up efforts they would have to expend to survive without the oil endowment; it focuses energies and skills on extracting rent through managing politics and bureaucracy's control over oil extraction under popular flags such as sovereignty and nationalism. The right way is to disentangle the state from the oil business; to introduce as much objectivity and transparency as possible. To expose national businesses as early as possible to competition; to maximise accountability of the inevitable decision-making that must be left with the state (licensing; tax; tax collection; regulation and rule implementation for public interest issues such as safety and environment).
This is in fact the real challenge for policy makers in producing countries, and if these challenges were effectively managed, oil would not be a curse as it is now. In the logic of such analysis, the PSC is now an obsolete instrument and the return to licensing, the creation of separate, focused state licensing agencies with no role in the commercial operations of the industry is the right one. One can still argue about the legitimacy of state-owned enterprises in countries where most of the oil would otherwise be developed by foreign companies.
My solution would not be Machmud's full-fledged support to PERTAMINA in principle (with a severe criticism of its operations in reality), but to suggest that - like Communism - something that can not work in practice is also not good in theory. Perhaps, the existence of state companies exposed to competition, with no monopolistic hold and privilege in a country, and the - time-wise limited - promotion of national private companies would accommodate the problem of complete foreign control, while not generating the rentier- and corruption-tendency of state companies operating in a crony, rather than a competitive culture.
