- Indonesia will not manage to restore its net oil exporter status, but instead will use OPEC membership to expand its regional influence and transform its economy.
- Jakarta will continue to improve the competency of its domestic oil and natural gas industry to promote higher value-added natural resource industries.
- Indonesia will give state-owned company Pertamina a greater hand in developing energy deposits, eventually moving a substantial amount of its production from international to Indonesian oil companies.
- Jakarta will continue fuel subsidy reforms and policies to increase competition, but in the short-term President Joko "Jokowi" Widodo will hesitate to liberalize prices to protect the manufacturing sector.
In 2009, after 47 years as a member of the oil producers' cartel, Indonesia suspended its OPEC membership, having lost its status as a net oil exporter. On Dec. 4, despite being a net importer, Indonesia will officially rejoin OPEC at the bloc's meeting in Vienna. This time, however, Jakarta is pursuing a new strategy, hoping to barter its status as OPEC's only Asia-Pacific member to become a bridge between Middle Eastern producers and Asian consumers.
Rejoining OPEC is part of President Joko "Jokowi" Widodo's evolving strategy to reassert centralized control over key industries, build up Indonesia's domestic capabilities and cement the country's regional influence. For the upstream sector, which produces oil and natural gas, this means empowering domestic companies — principally state-owned oil company Pertamina — and forcing international investors to establish and use Indonesian companies. For the downstream sector, which refines oil and natural gas, this means not only compulsory natural gas and crude oil sales for products, but also long-term price liberalization to attract foreign investment.
But implementing these reforms will not be easy. One of Jokowi's first moves as president was to cut expensive diesel and gasoline subsidies to bring their prices to market levels. However, the Indonesian economy has slowed, and Jakarta has subsequently hesitated to move the price in tandem with market trends. Jokowi will also need to fight corruption and cut through bureaucratic red tape — both tall orders in Indonesia. Nevertheless, the oil and natural gas industry is due for dramatic long-term change in spite of near-term challenges.
The Rise and Fall of a Petro State
Southeast Asia's status as a vital oil-producing region dates back to Dutch and British colonization, giving rise in Indonesia to Shell Transport and Trading Co. as well as Royal Dutch Petroleum Co. in the 19th century. Indonesia's oil production peaked in 1977 at 1.7 million barrels per day — a level that it managed to more or less maintain until the 1998 fall of Suharto's New Order dictatorship, after which production fell precipitously. Today, Indonesia produces half that amount and consumes nearly two barrels for every one it produces. While it has ceased to be a net oil exporter, the country is still the fifth largest liquefied natural gas exporter.
The causes of the post-Suharto decline are numerous but ultimately rooted in the inefficiency of state-owned energy company Pertamina. Throughout the post-independence period, Indonesia has been plagued by a weak reserve replacement ratio, meaning the amount of new reserves discovered to oil produced has been low. This problem goes back to the period immediately after independence in 1950, when the fledgling government established several underdeveloped companies out of nationalized Dutch assets that still needed to partner with foreign firms to produce. Later, in 1968, these companies were replaced with the newly established Pertamina — a one-stop shop for international oil companies. Pertamina was charged with regulating the energy industry and for operating refineries and supplying refined products to the domestic market. Pertamina was also able to introduce innovative contractual standards now ubiquitous in the oil and natural gas industry, such as ring-fencing, allowable costs for international oil companies and production sharing agreements.
Suharto took power in 1967, however, and under his highly centralized rule Pertamina became a key tool for patronage, leaving it gradually more inefficient and corrupt. Revenues were used to achieve political ends and by the height of the 1973-74 oil embargo, the company was $10 billion in debt ($54 billion in 2015 terms), requiring a bailout from Jakarta. At the same time, Indonesia's once cheap resources were becoming more expensive as low oil prices and plentiful alternatives during the late 1980s and early 1990s enabled many international oil companies to reject onerous domestic partnerships.
When Suharto's New Order government fell in 1998, Pertamina's relevance waned. The 2001 Oil and Gas Law stripped Pertamina of its regulatory functions, granting them instead to the newly established BP Migas and BPH Migas as well as a strengthened Ministry of Mines and Energy. Pertamina was still an important energy refiner but was no longer party to production sharing contracts with international oil companies.
Decentralizing the industry has had mixed results. In 2012, a constitutional court struck down the creation of BP Migas, though not BPH Migas, citing constitutional provisions that the government must control all oil and natural gas production, leaving the country in regulatory limbo with BP Migas replaced temporarily by SKK Migas under the energy ministry. Since then, Jakarta has been working on a new oil and natural gas legislation to replace the 2001 law, but the process will take until the end of 2015 and possibly into 2016. Decentralization has also devolved some aspects of regulatory control to local governments, including land acquisition, increasing the hurdles for foreign businesses trying to enter the country.
Now, nearly two decades after Suharto, Jakarta is trying to once again recentralize Indonesia's political and economic levers. The country needs to undergo structural reform to continue growing. Commodity-export led growth models are dying and Indonesia is hoping to move up the value chain in manufacturing, industrial output and other higher value-added industries. But compared to Suharto's centralized ability to easily remove bureaucratic barriers, the current government will have difficulty fully recentralizing. Regardless, the administration will continue to make progress in the energy sector.
To recentralize control over its energy sector, Jakarta will empower Pertamina to become an energy producer. Even under Suharto, Pertamina was largely limited to being the Indonesian representative in production sharing contracts with international oil companies who led, operated and developed blocks. Indonesia's goal now is to strengthen Pertamina's ability in physical oil and natural gas production.
Pertamina has already sought permission from Jakarta to gain control of important production assets currently administered by international oil companies when the production-sharing contracts expire. The most notable case has been Jakarta's negotiation with French energy company Total SA and Japanese oil company Inpex, which control the Mahakam natural gas block that will produce about 16.5 billion cubic meters of natural gas in 2015. Total SA and Inpex's contract expires at the end of 2017 and Indonesia has already said that it will give Pertamina 50 percent control of the block and make it the operator once the contract expires. There are 26 more blocks that expire between now and 2025. In addition, Pertamina has targeted to increase its production from 520,000 barrels of oil equivalent per day in 2014 to 2.2 million barrels of oil equivalent per day by 2025 — primarily through increased production at existing fields and other domestic blocks, though Pertamina also aims for 600,000 barrels per day to come internationally.
The new draft oil and natural gas law itself gives Pertamina even more preferential access. Under the new law Pertamina would have first right of refusal on any blocks that Indonesia wants to put up for auction. Only if Pertamina chooses not to take control of a block can Indonesia's regulatory agency auction those blocks to private companies. The agency must also give Pertamina the rights to a block after 50 years, allowing Pertamina to regain control of blocks down the road.
And Indonesia is looking to increase domestic content requirements for international oil companies as well. For example, new regulations issued in 2013 pushed for the minimum local content level for drilling to increase from 35 percent to 45 percent for offshore and 70 percent for onshore. More restrictions followed in 2014, which closed off foreign investment into areas such as well operation and maintenance and restricted it in others. By design these policies are meant to force foreign companies wanting to do business in Indonesia to be set up with a large amount of Indonesian capital and significant technology transfer.
But even after empowering Pertamina, corruption is still endemic in Indonesia and Jakarta simply lacks the mechanisms to combat it and root it out. Moreover, by removing Pertamina's competition and giving the company even more room to maneuver domestically, Jakarta may be inadvertently facilitating inefficient and corrupt practices — especially if oil prices rebound and some of Pertamina's inefficiencies can be masked by higher valued output, diminishing the need to minimize cost.
Despite this shortcoming, it is clear Indonesia wants to cultivate a domestic oil and natural gas industry that can provide more jobs, revenue and technology transfer to its domestic industrial base. The country also wants Pertamina to follow in the footsteps of other regional national oil companies like Malaysia's Petronas and Thailand's PTTEP to become a credible, competitive and proficient oil company. The theme of domestic competence in industry also translates to some of the ongoing reforms in Indonesia's downstream sector, where Pertamina is not necessarily seeing some of the same preferential treatment to refine oil and natural gas.
Of course, Indonesia does not want Pertamina to dominate energy production where international oil company holdings are nationalized and their ability to produce taken away. Most international oil companies currently hold the nation's most productive oil and natural gas blocks as well as some of the most attractive resources to be developed. What Indonesia is hoping is that the increased restrictions, domestic supply requirements and other measures are offset by a less restrictive energy processing sector burdened by controlled prices and monopolies in refined products sales. While Indonesia will be somewhat successful at stoking international oil company interest, at least initially, international oil companies will be cash strapped by low oil prices.
Securing Domestic Supply
In contrast with the reforms to oil and natural gas production being designed to empower Pertamina, the main driver for oil and natural gas processing and sales has been ensuring enough domestic energy resources to satisfy domestic needs. Most of its plans are designed to promote the growth of domestic industry and manufacturing — even through protectionism through energy supplies — and ensuring Indonesian ownership.
Though Indonesia's 2001 oil and natural gas law broke down Pertamina's monopoly in retail sales, today the company still commands around 90 percent of the market. Indonesia's broad subsidy scheme and Pertamina's effective monopoly have allowed corruption to also enter this sector and the government is now investigating Pertamina's trading arm, Petral. Jakarta's continued subsidies and price controls have historically deterred foreign firms from committing to this part of the Indonesian market.
One of Jokowi's first moves in office was to significantly reduce subsidies on diesel fuel in November 2014 and eliminate them on the primary gasoline grade used in Indonesia, bringing the price of those fuels to market levels. While removing fuel subsidies does increase the domestic price of energy, at least for those fuels, Indonesia's fuel subsidies had reached 20 percent of the central government's budget and the substantial cuts saved Jakarta about $18 billion. The savings allowed Jakarta to double its capital expenditure budget and increase spending on necessary things such as infrastructure, hopefully in a more efficient way.
While Indonesia brought the price of fuel to market prices, Indonesia's commitment to maintaining that objective in the short term has been questioned. BPH Migas, Indonesia's energy processing regulatory agency, still controls the price of refined products and Pertamina must get approval to change them. When oil prices still fell from November 2014 to January 2015, BPH Migas was quick to react and lower Indonesian prices. However, as oil prices began to recover from the end of January until the middle of May, BPH Migas declined to raise the price of refined product in tandem and despite originally intending on adjusting prices every two weeks. Consequently, BPH Migas has not changed prices since late March and in October announced that it would review prices only every three to six months.
Indonesia, like many countries with fuel subsidies, has historically faced protests when it has tried to dramatically increase prices. For example, demonstrations broke out in 2013 when the preceding government tried to raise prices. Effectively, BPH Migas' price controls have amounted to a subsidy of sorts, just one that Pertamina — the main supplier — had to bear until October when Jakarta announced that it would reimburse the oil company. Nevertheless, if oil prices rise over the next few years, Indonesia's commitment to increase the price of fuel will likely be partly stifled by Jokowi's political needs.
Although the concept is hardly new, Indonesia will place greater emphasis on domestic market obligations for coal, oil and natural gas producers. Oil and natural gas producers will certainly be required to fulfill domestic needs for production. And while what this means in practice is still unclear, it will likely mean greater compulsory sales to the domestic market than what is in practice now. Producers currently must sell 25 percent of their production on the domestic market. One of the biggest problems for Indonesia, particularly its natural gas sector, is the anemic infrastructure system, but there is hope that the domestic obligation requirements and increased spending in infrastructure — either with public spending or private investment — will lead to greater industrial consumption of natural gas.
Pertamina, and Indonesia, is also hoping to continue expanding its energy processing sector and bringing in better technology. Indonesia is a net product importer and about 60 percent of its gasoline is imported as refined product. One critical component of Indonesia's refinery build-out and modernization has been partnering with OPEC members. In June 2015, Iran, China and Indonesia finalized an agreement to build a refinery in East Java to be primarily supplied with Iranian crude oil. Indonesia is in the final stages of reaching an agreement with Saudi Arabia on building a 300,000-barrels per day refinery and Saudi Aramco has also been involved in $10 billion worth of upgrades at existing refineries. Oman has announced that it will begin building a $7 billion refinery in Sumatra in 2016. Indonesia has also restarted talks to build a 200,000-barrels per day refinery with Kuwait.
While not all of these projects will come to fruition, it is a resurrection of Suharto's plan to import Middle Eastern crude oil and refine it on the supply chain between the Middle East and Asia — the world's largest direct energy corridor. Jokowi's renewed attention to Indonesia's maritime position as the conduit between the Indian Ocean and Pacific Ocean (South China Sea) is one reason that Indonesia's interest in maintaining ties with OPEC is not only about concrete economic partnerships but also Jokowi's more assertive foreign policy cementing Indonesia position in Southeast Asia.
Lastly, the fact that OPEC readmitted Indonesia as a member is an interesting development. Indonesia will never be a net exporter of oil again and as such does not fulfill OPEC's membership requirements. However, there are benefits to including Indonesia. First, OPEC's members are trying to protect their market share globally and Indonesia — one of the world's largest growing oil consumers — is an Asian country that OPEC members have clearly singled out as a priority destination. Second, Indonesia's ascension allows the cartel to raise its quota next meeting and eventually, as Indonesian production continues to fall and consumption rises, allows for specific OPEC members to increase exports over the long run while maintaining a stable OPEC export quota in aggregate. Finally, OPEC's members are becoming more focused on natural gas — Qatar, Algeria, Nigeria, UAE, Libya and Angola are all liquefied natural gas exporters and Iran will likely join them — and Indonesia is the fifth largest exporter of liquefied natural gas.