Indonesia country focus: Energy risk

Indonesia’s economy relies heavily on extractive industries to generate government revenues and growth. The global collapse in commodity prices has hit the sector hard. But the government also needs to step up reforms to manage the risk more effectively, including an attack on red tape and corruption and a more sustainable relationship with international investors. Indonesia is one of many emerging countries that rely heavily on extractive industries (EI) such as mining, oil and gas to drive its growth and generate tax revenues. But the recent global decline in commodity prices, coupled with a failure to attract investment in the sector because of bureaucracy, taxation and corruption, is hitting revenues and threatening the future overall growth prospects of Indonesia.hidePressure is rising on the Indonesian government to energetically follow through recently promised efforts at reform to revitalise this flagging sector and prevent it dragging the wider economy down. The US Energy Information Administration (EIA), a thinktank funded by the US Congress, summed up the challenge faced by Indonesia in a recent report it published. “Formerly a net oil exporter in the Organization of the Petroleum Exporting Countries (OPEC) for several decades, Indonesia now struggles to attract sufficient investment to meet growing domestic energy consumption because of inadequate infrastructure and a complex regulatory environment. Indonesia encompasses more than 17,000 islands, presenting geographical challenges in matching energy supply in the eastern provinces with demand centers in Java and Sumatra. Also, urbanisation and demand in other areas of the country are rising at a faster pace than energy infrastructure development,” states the EIA report. “After suspending its OPEC membership seven years ago, Indonesia is scheduled to rejoin the cartel by 2016 as the country attempts to secure more crude oil supplies for its swiftly rising demand and greater investment from Middle Eastern members in its downstream infrastructure projects. Despite Indonesia’s energy struggles, it was the world’s largest exporter of coal by weight and the fifth-largest exporter of liquid natural gas in 2014. As Indonesia seeks to meet its energy export obligations and earn revenues through international market sales, the country is also trying to meet energy demand at home,” continues the report. IMF conference A recent report from the International Monetary Fund (IMF) based on a conference in Jakarta last August, entitled Natural Resource Taxation in the Asia-Pacific Region, concludes that there is nothing that any single government can do to solve the problems caused by the global price of commodities. But a sound fiscal regime and improved tax administration can clearly help to reduce the impact of revenue losses. Fiscal transparency and inter-agency cooperation are also key, concluded the politicians and experts at the event. Active risk management at the highest political level is also needed. The conference—co-hosted by the Indonesia Ministry of Finance and the IMF’s Fiscal Affairs Department—brought together 90 senior government officials from resource-rich countries in the region and international experts. The big question discussed at the event was simple: How to structure and administer a fiscal regime for EI that allows governments to retain a reasonable share of revenues and at the same time remain attractive to private investors? As noted by the EIA, resource-rich countries such as Indonesia need to ensure their fiscal regime is attractive enough to private investors or state-owned companies to encourage them to explore, develop and produce, given the big upfront capital investments needed and the inherent uncertainty over future commodity prices and project costs. State-of-the art risk management practices are also critical, concludes the IMF report, as it states: “In addition, an efficient fiscal regime—including clear rules, well-allocated responsibilities, adequate institutional capacity and transparency of the resource revenue management process—is vital.” Historical role Indonesia has historically played an important role in the development of the petroleum industry, and was a pioneer in the use of production-sharing contracts dating back to the 1960s. Combined revenues from the oil, gas, mining, and coal sectors for the Indonesian government reached $28bn in 2014, or 24% of total government revenue. But the trend is not heading in the right direction and action is needed at the highest level to stop the rot. World Bank data shows that Indonesia managed a relatively strong economic performance throughout the global recession, with an average gross domestic product (GDP) growth rate of more than 6% per year between 2007 and 2012, with the exception of 2009 when GDP growth dropped to 4.6%. But GDP began to decline after 2012 and fell to 5% in 2014 as a result of weaker demand from trade partners, lower exports, lower commodity prices and a tighter monetary policy following the government’s decision to raise interest rates sharply between mid-2013 and late 2014. And the energy sector’s contribution to the overall economy is in decline. According to the World Bank, oil and natural gas alone constituted 15% of merchandise exports in 2014, a decline from 23% in 2000. Revenues from the oil and gas sector historically accounted for about 20% of total state revenues. But they fell below 20% after 2008 and were less than 12% in 2014, despite high oil prices during most of the year. The big drop in global crude oil prices, which started in June 2014, is expected to reduce Indonesia’s oil and gas revenues by at least one third in 2015. But, as the EIA points out in its report, the plight of the Indonesian energy sector cannot be totally blamed on falling global prices. “A combination of healthy growth, some market reforms, higher hydrocarbon prices and a stable government encouraged rapid investment, particularly in the commodity sector until around 2010,” states the report. “Factors that have greatly hindered foreign investment in the past few years include more technically challenging oil and natural gas plays, rising domestic energy demand and accompanying limitations on exports, higher taxes on exploration and production, and lengthier processes to procure and renew contracts,” continues the EIA. The thinktank said that, despite the government’s emphasis on more private sector involvement in infrastructure expansion, many infrastructure projects continue to be delayed, because of regulatory challenges and uncertainties that raise the risk exposure for foreign investors. Planned reforms Thankfully for Indonesian citizens and business, the current Indonesian government and petroleum industry itself understand the problem and have publicly committed to reform. Indonesia’s recently elected government, under President Joko Widodo, is attempting several energy sector reforms in an effort to address the regulatory burdens and lack of legal transparency and to attract much-needed foreign investment for its more capital-intensive and technically challenging energy projects. “President Widodo’s new reforms attempt to address corruption and informal markets, streamline the regulatory process for investors, make domestic prices more competitive with international markets and reduce upstream oil and natural gas costs for investors. However, Indonesia’s energy security policy of retaining more of its hydrocarbon production for domestic use and maintaining local content requirements will continue to hamper investment from international companies,” comments the EIA. During the EI conference organised by the Ministry of Finance and IMF, Indonesia’s vice-minister of finance Mardiasmo said: “We fully acknowledge that the oil and gas sector, which has long been a major contributor to the state revenue, is currently under pressure from the sharp decline in crude oil prices in the world market.” “In the area of energy extractives, like many emerging countries Indonesia faces a historic opportunity to enhance the country’s management of its oil and mining industries; these enhancements could include more sustainable economic outcomes to benefit for all, reduction of risks of corruption, and an increase in public trust,” he continued. The government is thankfully not on its own and has the backing of the petroleum industry in its reform efforts. The Indonesian Petroleum Association (IPA) urged the government to fully follow through on its promises of reform during its annual general meeting (AGM) in December in Jakarta. The IPA said the past year has been “traumatic” for the global oil and gas industry because of the collapse in oil and gas prices. This has forced oil and gas companies worldwide to restructure their operations, organisations and investment plans to create sustainable businesses in this new low oil price environment, stated the association. But as noted above, Indonesia’s energy sector is not only suffering from low prices. “Even prior to this situation, the Indonesian oil and gas industry was in urgent need of reform to meet the growing energy needs of the nation. A decade of poor exploration results, increasing bureaucracy, regulatory uncertainty, difficulties in gas commercialisation, long project timelines, criminalisation, land acquisition and local government and community issues all contributed to a decline in the attractiveness of the industry and falling oil and gas reserves and production,” stated the IPA after its AGM. “The new government was elected on a reform platform and has recognised the need to reform the oil and gas industry to meet its goal of making energy Indonesia’s engine of growth,” said Craig Stewart, IPA president. “The government has made significant effort to address some of these issues over the past year and the IPA has endeavoured to work closely with the government to ensure these reforms are effective. The IPA urges the government to continue these efforts and remains committed to working with the government in designing and implementing these reforms,” continued Mr Stewart. Lack of trust One of the biggest problems and risks faced in high-value industries such as EI in emerging nations is lack of trust. Big international companies and leading IPA members like BP, Chevron, ExxonMobil and Total fear that they will be induced to invest heavily in the exploration and development of infrastructure, only to see the local government take an unfair proportion of the rewards through punitive taxes, license fees and the like, or even expropriate as in the case of Venezuela. The governments and local companies fear that the big international companies will persuade officials to grant them licenses at knock-down prices, generate vast revenues and ship all the profits back home without making a meaningful contribution to the local economy. Not surprisingly therefore, the topic of tax was an important subject discussed during the Ministry of Finance and IMF conference last summer. Speakers were asked to work out how to weather the revenue shortfall and, more optimistically, how countries such as Indonesia can best position themselves for a future upswing in commodity prices. “An important focus of the conference was on enhancing tax administration capacity and tackling international taxation issues, including transfer mispricing—that is, manipulating prices for transactions between related parties to shift the tax base away from high tax countries. Conference participants acknowledged the importance of cooperation between finance ministries and line agencies involved in the EI sector, but also recognised the challenges in achieving such cooperation,” concluded the IMF after the event. The Indonesian government clearly needs to find an experienced and capable enterprise-wide risk manager to make sure this all happens and as quickly as possible. The IPA may want to see whether some of the highly paid and experienced risk managers they employ can help out too.

Indonesia country focus: Energy risk

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