The Production Sharing Contract

History, highlights, legal and financial aspect and problem areas

Part I

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By T.N. Machmud

Senior Advisor Hakim dan Rekan Law

Firm

LEGAL BASIS Article 33 paragraph (3) of the 1945 Constitution

The land, the waters and the natural resources contained therein shall be controlled by the State and shall be used for the greatest benefit of the people.

Law No. 22 Year 2001 regarding Oil & Gas - Article 1 paragraph 19 Types of Cooperation Contract:

Production Sharing Contract (PSC); or other models of a Cooperation Contract whichever is the most

beneficial to the state and which yield the maximal use for the greatest benefit of the people

- Article 6 Upstream business activities shall be conducted and controlled through the

Cooperation Contracts as referred to in Article 1 paragraph 19.

LEGAL BASIS

- Article 11: Upstream business activities shall be conducted by a Business

Entity (Badan Usaha) or by a Permanent Establishment (Bentuk Usaha Tetap) Cooperation Contracts signed between BPMIGAS and the

Business entity or the Permanent Business Establishment shall be the basis for upstream business activities.44 Government Regulation No. 35 Year 2004

- Article 1 point 4 A PSC is a form of Cooperation Contract in the upstream business

activities based on the principle of sharing the proceeds of production. Note: the current model Cooperation Contract being used in Indonesia is still the PSC

LEGAL BASIS

- Article 1 point 5 A Service Contract (note: sometimes also called “Risk/Service Contract) is a form of Cooperation Contract for the execution of

Exploitation of Oil and Gas based on the principle of granting a cash compensation for services for the production that is produced.

Note: this contractual model is often used in South America

The only other model contract used in the world is the Concession Contract (Tax/Royalty contract) used in Europe /USA and in Thailand

PARTIES IN PSC Government of Indonesia qq BPMIGAS

Contractor• Business Entities are corporations established under Indonesian law:

State Owned Enterprises (Badan Usaha Milik Negara) Regional Government Owned Enterprises (Badan Usaha Milik Daerah) Cooperatives (Koperasi); Small Enterprises Privately Owned Enterprises

• Permanent Establishment – a corporation established outside the territory of the ROI but which conducts upstream business activities within the territory of the ROI and is subject to Indonesian law

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Type of right Mineral right Mining right Economic right

CONCESSIONS yes yes yes

COW no yes yes

PSC no no yes

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Explanation of previous slide:

Mineral rights are rights with regard to the minerals contained in the belly of the earth. As from 1960 mineral rights belong to the State in accordance with Article 33 of the Indonesian 1945 Constitution, the Law nr 44 / 1960 re oil and gas and the Law nr 22 / 2001 re oil and gas

Mining rights are the rights to bring the minerals found in the belly of the earth, to the surface. Such right is in Indonesia referred to as “Kuasa Pertambangan” or “KP”. Concessionnaires under the Old Indies Mining Law of 1899 or Contractors under a COW possess a KP. Under a PSC, a KP is held by the State, formerly entrusted to Pertamina. Pursuant to the Law 22 / 2001 re oil and gas, a KP is now entrusted to the State qq BPMIGAS.

Economic rights are rights to a share of production to which the Contractor is entitled after he enters the commercial production stage. Economic Rights consist of Cost Recovery, Profit split and incentives, if any. Economic rights inure to the Contractor at the “point of export”

PSC STRUCTURECHAPTER TITLE

I SCOPE AND DEFINITIONS

II TERMS AND COMMERCIALITY

III RELINQUISHMENT OF AREA

IV WORK PROGRAM AND EXPENDITURES

V RIGHTS AND OBLIGATIONS OF THE PARTIES

VI RECOVERY OF OPERATING COSTS AND HANDLING OF PRODUCTION

VII VALUATION OF CRUDE OIL

VIII VALUTATION OF NATURAL GAS

IX COMPENSATION ASSISTANCE AND PRODUCTION BONUS

X PAYMENTS

XI TITLE OF EQUIPMENT

PSC STRUCTURECHAPTER TITLE

XII CONSULTATION AND ARBITRATION

XIII EMPLOYMENT AND TRAINING OF INDONESIAN PERSONNEL

XIV TERMINATION

XV BOOKS AND ACCOUNTS AND AUDITS

XVI OTHER PROVISIONS

XVII PARTICIPATION

XVIII EFFECTIVENESS

EXH “A” DESCRIPTION OF CONTRACT AREA

EXH “B” MAP OF CONTRACT AREA

EXH “C” ACCOUNTING PROCEDURES

EXH “D” MEMORANDUM OF PARTICIPATION

TERM 30 Years as of the Effective Date

- covers both exploration and exploitation stage.- 6 years for the initial exploration stage.- 4 years for possible extension of exploration stage.

20 Years Extension to be applied for:

- At the earliest, 10 years before PSC is supposed to end.- At the latest, 2 years before PSC is supposed to end.- earlier if there is a Gas Sales Agreement.

COMMERCIALITYA discovery report on oil or gas reserves, if

followed by a:

Plan of Development or POD within I– 2 years after the discovery report is approved by Minister of Energy & Mineral Resources, leads to

Commerciality, or commercial development i.e. development which can be justified commercially which happens if revenue streams over the life of a field equal the financial targets of each party

RELINQUISHMENT OF AREA Stages of Relinquishment:

- 20% of total area – before the end of the first 3 years- 15% of total area – after 3 years (only if the Firm Commitment has not yet been fulfilled by Contractor)- 20% of total area – between 3 – 6 years.- 20% of total area = total area that may be kept by Contractor for the remainder of the Term

Working Areas not utilized may be offered to other Contractors, called a “farm-out”.

The aim is to accelerate the exploration process.

WORK PROGRAM & BUDGET (WP&B)

3 years “Firm Commitment” or “minimum expenditures”

180 days after Effective Date, Contractor is obliged to commence field activities.

SKKMIGAS focuses on the content of the Work Program as well as on the cost of the Work Program which will be the basis for cost recovery.

Annual WP&B – 3 months before the start of the new year (September).

RIGHTS AND OBLIGATIONS OF THE PARTIES Operational Management in the hands of

SSKMIGAS- POD, WP&B, AFE, Audits

Contractor’s obligation is to carry out the WP&B- Funding, expert manpower, HSE, routine reports- Data confidentiality- Insurance

DMO

RIGHTS AND OBLIGATIONS OF THE PARTIES Transfer of a working interest to an Affiliate or Non-Affiliate must be

approved by SSKMIGAS and by the Minister of Energy & Mineral Resources.

Change of control in Contractor’s Company shall be notified to and obtain the approval from SSKMIGAS and from Minister of Energy & Mineral Resources.

Transfer limitation during the Firm Commitment:During the first three (3) Contract Years, Contractor must retain the majority (greater than 50%) of the working interest in the PSC.

Ring Fencing – Article 13 Law No. 22/2001Every business entity or permanent establishment shall be given only 1 (one) Working Area. In other words a separate legal entity must be set up for each Working Area. There shall be separate accounting for each WK. No consolidation of accounts between PSC’s is allowed.

TITLE to EQUIPMENT Equipment purchased by Contractor

pursuant to the Work Program becomes the property of Government of the Republic of Indonesia (in case of import, when landed at the Indonesian ports of import).

Does not apply for rented equipment.

Local Content rules to be observed.

TERMINATION OF CONTRACT Can not be terminated during the Firm Commitment period.

Contractor may return the Working Area upon expiry of the Firm Commitment period if Contractor feels that the Working Area has no further upside potential

Contractor shall pay cash for the shortfall of funds from the Work Program during the Firm Commitment period.

Performance Deficiency Notice from SKKMIGAS – Contractor shall have 120 days to remedy the deficiencies.

Breach of contract = Arbitration.

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PSC highlights:• All operational funding by Contractor• All risk borne by Contractor• If exploration successful, a POD is submitted to SKKMIGAS

which POD, if approved, becomes the basis for commercial development and thereupon cost recovery may commence.• If exploration is not successful, i.e. no commercial development is established on the block, there will be no cost recovery• There are time limits in the PSC for exploratory success. Upon expiration of these time limits or any extension thereof, without exploratory success, the block is to be returned to the GOI and the PSC ends cont’d

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PSC HIGHLIGHTS (cont’d):• All surface equipment installed by Contractor becomes GOI property once placed in

service• Contractor receives a share of gross production (i.e. 15% of oil and 30% of gas) after

FTP and Cost Recovery, subject to Indonesian income tax. Such percentage shares may vary depending on location• Management of operations is in the hands of SSKMIGAS. Contractor remains responsible for the preparation and execution of the WP&B.• Contractor is allowed to bring in partners to help funding and managing field operations subject to BPMIGAS and GOI approval and is allowed to change partners

subject to SSKMIGAS and GOI approval. • Contractor manages his partnership through a JOA and appoints an Operator from

within the group who will be responsible to the GOI/SSKMIGAS for WP&B execution• Contractor is allowed to operate as a non P.T. business entity or permanent establishment and each partner in the Contractor group pays taxes to the GOI severally and independently

LOCAL PARTICIPATION After a first POD in a WK is approved by Minister of Energy &

Mineral Resources.

Contractor is obliged to offer a 10% “Participating Interest” to a Local Government Owned Company (BUMD) or to a Indonesian National Company (INC).

Business to Business transaction.

BUMD or INC to reimburse Contractor an amount equal to 10% of the sum of Operating Costs (sunk cost) which Contractor has accrued during its past activities in the Working Area prior to declaration of commerciality.

End of Part I

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The Production Sharing Contract

History, highlights, legal and financial aspect and problem areas

Part II 22

By T.N. Machmud

Partner Hakim dan Rekan Law Firm

From previous lectures, we have talked about basis of PSC…

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Following is a discussion on certain terms and expressions in the PSC:

• Risk• Entitlement• Lifting• Participating Interest• POD• FTP• JOA• WP&B• Why production sharing and not profit sharing?• how to determine bonafidity of a migas investor• Derivative forms of the PSC like TAC, JOB, EOR

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FTP:

FTP means First Tranche Petroleum. FTP was not defined in the Law nr 22 of 2001 nor in PP nr 35 tahun 2004 but was raised in the model contract PSC recently introduced by BPMIGAS..

Actually FTP is nothing but a Royalty with another name….a misnomer in our country where we do our utmost to avoid the use of the term “royalty” because it reminds us of a concession or a COW

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Let’s talk about risk………

There is a different concept of risk between oil companies and banks!

Oil industry: Risk is their business. They are risk takers and they understand risk. They are prepared to undertake highly risky operations and fund these operations through equity funding. Normally debt financing is not a choice.

Banks are risk averse and will seek to hedge against any form of risk. The risks in the exploration stage are normally not acceptable to banks. The oil industry regards the development stage as “bankable” because they deem the risk during development to be far less and more “measurable” which view is not necessarily shared by the banks

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Exploration Risk:

The risk that occurs when a PSC is exploring but fails to establish the presence of hydrocarbons on the block which can be developed commercially

Such risk may be present if the PSC fails to discover hydrocarbons completely or when the quantity or quality of hydrocarbons that have been discovered do not meet the PSC expectations

In the event of a discovery the PSC will do reservoir modeling and will try to predict the expected production volume and the price over the expected life of the field until it reaches what is normally referred to as economic limit. Such modeling will yield cash flow predictions which in turn will constitute the basis for the PSC’s decision to propose commercial development

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Development Risk:

The development stage is deemed “bankable” as opposed to the exploration stage risk but there will always remain a residual risk called “development risk”. An example is the producibility of a field.. High viscosity will impact producibility negatively because it will result in a lower level of production than what was predicted. Unusual and unexpected reservoir behavior may also have similar impact. It all results in production levels smaller than forecasted. The result will be reduced cash flows which will negatively impact economics

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Financial risk:

The funding of a PSC operation based on a WP&B is totally the responsibility of the Contractor/PSC. The PSC is deemed financially able and technically competent from the outset and is therefore permitted to sign a PSC on the understanding that he has to prove himself through WP&B performance (a performance guarantee my be required).

Cost of money is not allowed to be included in Cost Recovery.

Important: The GOI accepts no risk in whatever form, different from Malaysia or China where the government may decide to participate financially in the development stage.

Financial Risk in the execution of a WP&B is solely the Contractor’s burden and it is expected that he has the funds available. Therefore the PSC is often referred to as a “performance contract”

Therefore a mechanism was included in the PSC that allows the PSC to bring in partners for the purpose of sharing the burden and spreading the risk).

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Country Risk:

Country Risk is a relatively new concept. In the last two decades certain organizations appeared in Europe and the US which tried to predict the risk an investor is facing if he plans to invest in certain countries, primarily in developing countries.

Criteria used in defining political risk: see notes

Reports on country risk are not always reliable as these depend on the knowledge level and objectivity of the consultant. However, continuous negative reporting to the extent, for example, that Indonesia is a country with high country risk may eventually eventually send a negative signal to prospective investors and cause them to shy away from investing in this country.

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Entitlement:

Entitlement is the right of a party in a PSC to a share of production or to the sharing of production.

Lifting:

Lifting is a physical act of one of the parties in a PSC to physically take its entitlement by making a nomination of a tanker at the point of export (offshore) or by taking its entitlement via pipeline or truck (onshore)

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Local participation:

Local participation is the right to a 10% of production which is made available by the PSC out of the PSC share, to a BUMD, at the occasion of the approval of a first POD in a WK (contract area) , by virtue of article 34 of PP no 35 year 2004 re Upstream Oil and Gas Activities

If a BUMD does not avail himself of such offer within the stated time, then a PI may be offered to a national company. If this offer is not utilized within the stated period then that offer will be deemed closed.

Generally speaking all BUMD’s who receive such an offer declare to accept but will run into funding problems.

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POD (Rencana Pengembangan Lapangan or Plan of Development) :

A POD is a key document in oil and gas practise. It was first officially mentioned in PP 35 of 2004 (art 90 etc). Although it was not mentioned in earlier legislation like Law nr 8 of 1971 which established Pertamina, it was nonetheless accepted in PSC practise as as document which had to be submitted in order to obtain approval for commerciality of a new field. A POD has to be submitted in addition to the WP & B which needs to be submitted once a year whereas a POD is only submitted once.

The POD is now defined in the new model PSC issued by BPMIGAS in their tender documents.

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A question was raised: why is the sharing of production done “in kind”?

Remember: we share production, not revenue. Historically speaking such sharing mechanism is more attractive to the investor because they get an entitlement in kind which they can book as an asset. Conversely, they may get paid in cash, like is done in South America e.g. Ecuador where the contract model is not a PSC but a Revenue Sharing Contract where the Contractor is paid in cash. This form of contract is not popular outside South America.

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Disputes arising from a PSC are settled based on the dispute settlement clause in the PSC which now points to arbitration through BANI. This clause is quoted in our notes. In older PSC’s foreign arbitration agencies were often used which created problems than they solved in that foreign arbitration turned out to be expensive and time consuming whereas BANI has developed in this country as a reputable institution. Also the law nr 30 / 1999 re arbitration was passed as the formal legal basis for BANI. A JOA, however, makes its own rules on arbitration for the settlement of disputes between partners. The parties in a JOA are free to determine their own dispute settlement rules as the JOA is deemed to be an internal affair of the PSC and does not involve SSKMIGAS nor the GOI.

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“Take” is broader than “Share”When we discuss for example production split of 85/15 in favor of the Government, we mean a 85% share to the MOI and a 15% share to Contractor.When we say Government Take it includes:Government Share, FTP, DMO, Bonus payments and TaxWhen we say Contractor Take such term includes:Contractor Share, Cost Recovery, incentives (if any)

Hot issues related to RUU Migas Do we still make room for FDI? If so, how? If GOI policy is to “pile everything” on Pertamina...how? What about rumours there may be an option to adopt a tax royalty

type Cooperation Contract. Pro’s and con’s? Do we need to write a whole new UU Migas or will amending certain

articles related to BMMIGAS as per MK be enough? MK decree madated migas must be controlled by a BUMN. Do we

need to put SKKMIGAS under Pertamina or do we need a “special” BUMN?

If we decide FDI is still wanted then what will GOI do about the long list of grievances accumulated by the PSC to date?

What about regional participation in cooperation contracts? To what extent can GOI afford to accomodate and how so accomodation is acceptable to both the regions and the investor/operator

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End of Part II

Questions, anybody?