UPDATE – Indonesia’s New Draft Oil & Gas Law

by Reed Smith
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Indonesia has recently made public a full copy of its draft oil and gas law for review and parliamentary discussion. By way of update to our client alert of 21 April 2015, we can now review the further revised and full version of the anticipated draft law that the Indonesian Government is seeking to implement later this year. If passed, this new law will repeal and replace the old law, Law No. 22 of 2001 on Oil and Gas (2001 law).

Background Indonesia has a long history of oil exploration, with the Dutch drilling in the late 1800s. Companies such as Shell have been operating in Indonesia for over 100 years. In the 1960s, under the former President Suharto, Pertamina (the main Indonesian state-owned oil and gas company) was set up to function as both an oil company and as the state’s chief energy regulator. Pertamina both controlled and supervised oil and gas operations under the various production sharing contracts (PSCs). During this time, most of the companies exploring and producing oil in Indonesia were foreign companies, having invested billions of dollars setting up their operations.

In 2001, former President Susilo Bambang Yudhoyono, who at the time was the energy minister, introduced the 2001 law that split Pertamina apart, making Pertamina a state-owned oil company focussing only on oil and gas operations. All of Pertamina’s regulatory functions were moved into an independent oil and gas regulatory agency called BPMIGAS (Badan Pelaksana Minyak dan Gas Bumi, or the Upstream Oil and Gas Regulatory Agency).

Under the 2001 law, BPMIGAS supervised and controlled the exploration blocks that were allocated to third parties. It did this independently, although reporting to the Ministry of Energy.

In 2012, a nationalistic group allied with former Pertamina power-holders challenged the 2001 law at the Constitutional Court, arguing that the supervision of oil and gas should reside with the state, not an independent regulatory agency.

In a controversial decision, this group was ultimately successful, and the Court struck down the 2001 law, disbanding BPMIGAS. However, rather than reverting power to state-owned Pertamina, the Government re-formatted BPMIGAS into SKKMIGAS (Satuan Kerja Khusus Pelaksana Kegiatan Usaha Hulu Minyak dan Gas Bumi, or the Special Unit of the Upstream Oil and Gas Regulatory Agency), which sits directly under the energy minister.

SKKMIGAS was set up as a temporary regulatory entity, pending a new oil and gas law, sections of the first draft of which were leaked to the media in April 2015.

With the latest full release of the draft, it is now entering a new phase in the legislative process. The new draft oil and gas law will now be discussed before the Indonesian House of Representatives.

Although there are no guarantees, it is expected to be passed in some form before the end of this year, or in 2016.

The New Oil and Gas Law The aims of the new draft oil and gas law stem directly from the Court’s strike-down of the 2001 law, and are two-fold:

a. Protecting national control over oil and gas production in Indonesia

b. Increasing oil and gas production to satisfy domestic consumption

In order to implement these aims, the new draft oil and gas law relies on several mechanisms which are likely to have a severe impact on private companies investing and/or operating in Indonesia. In particular:

a. In the upstream sector: the new draft oil and gas law aims to strengthen the market positioning of Pertamina, and limit the involvement of private companies to rights and obligations under a cooperation contract with a new state operator, which holds the relevant upstream business licence.

b. In the downstream sector, the new draft oil and gas law establishes the compulsory sale and purchase of oil and gas, through a new state operator, in quantities which satisfy ‘domestic market needs.’

c. The new draft oil and gas law also rearranges the regulatory and supervisory roles of the various Indonesian agencies involved.

Regulating Upstream Oil and Gas Activities

Cooperation Contracts: The new draft oil and gas law creates a new ‘upstream cooperation organiser’ (Bada Usaha Milik Negara Pelaksana Kerja Sama Hulu or BUMN-K). This state-owned enterprise will take on functions currently assumed by SKKMIGAS.

Under the new draft oil and gas law, the energy ministry issues an upstream business licence in respect of a particular working area to the BUMN-K. The BUMN-K then enters into a cooperation contract with a private oil and gas company for the exploration and exploitation of the working area.

The cooperation contracts may involve product sharing, services or other forms of cooperation. The new draft oil and gas law prescribes the minimum contents of the contracts. Interestingly, the new draft oil and gas law is silent on any particular cost recovery mechanisms.

An important change in the new draft oil and gas law, further to the strike-down of the 2001 law by the Constitutional Court, is the supervision of upstream activities by the energy ministry. Under the 2001 law, SKKMIGAS (to be replaced by the BUMN-K) had both a regulatory and supervisory function.

Allocation of Upstream Business Licences: Under the new draft oil and gas law, not only are upstream business licences no longer awarded to private companies directly, they are also only awarded once Pertamina has exercised a right of first refusal in respect of the particular working area.

Under the new draft oil and gas law, only where Pertamina is uninterested, or unable to utilise a working area, will the energy ministry then auction it to private companies. The energy ministry then issues an upstream business licence to the BUMN-K, which serves as a basis for entering into the cooperation contract with the auction winner.

Further, under the new draft oil and gas law, the BUMN-K must transfer an upstream business licence to Pertamina at the end of its maximum life-span of 50 years. This essentially gives Pertamina the right to reclaim working areas previously explored and exploited by private companies in cooperation with the BUMN-K.

Pertamina may engage with private companies for the provision of technological, financial or other forms of assistance, on the condition that the cooperation does not lessen Pertamina’s total production in the working area.

Pertamina’s new privileges clearly indicate the Indonesian state’s intention to enhance its role in controlling and exploiting the country’s natural resources.

Regulating Downstream Oil & Gas Activities The new draft oil and gas law does not materially change the regulation of downstream oil and gas activities, in so far as businesses engaging in the downstream industry may still operate under a licence.

However, the new draft law establishes a new ‘buffering business entity’ (Badab Usaha Penyangga or BUP) which is responsible for the management of downstream activities. In particular, the BUP centralises the compulsory sale and purchase of oil and gas for domestic needs.

Under a new ‘domestic market obligation,’ both Pertamina and private companies through the BUMN-K must sell substantial parts of their production to the BUP. The proportion of oil or gas production that must be sold to the BUP will depend on what is required to fulfil ‘domestic market needs’. This contrasts with the current requirement for private companies to supply a fixed 25% of their production under a product sharing contract.

Similarly, downstream private companies will have to sell to the BUP and/or buy from BUP (depending on the particular downstream activity) in a similar proportion satisfying ‘domestic market needs.’

The obligation of Pertamina and the BUMN-K to sell their production to the BUP shows the Indonesian Government’s ambition to prioritise national oil and gas consumption.

What does this mean for foreign investors in Indonesia? Under the new draft oil and gas law, upstream oil and gas operations are controlled through the BUMN-K, which owns the upstream business licence. Private investors see their involvement in these activities severely curtailed, since they are limited to providing capital and technology under cooperation contracts. They cannot themselves own the business licence to operate. Further, there is a clear power-shift to Pertamina with a right of first refusal and preferential treatment in all activities. Finally, the new draft oil and gas law introduces uncertainty in the amount of product sharing, which will necessarily fluctuate with ‘domestic market needs.’

It is unclear what transitional provisions are contemplated in respect of the existing foreign investments in Indonesia. The nationalistic spirit of the new draft oil and gas law is, in any event, obviously worrying for foreign investors who have spent considerable sums investing in oil and gas operations in Indonesia. To lose control of operations would be a significant blow to those investments.

Nationalisation and recovering potential losses The new draft oil and gas law has the potential to cause serious financial damage to the value of investments owned or operated by foreign investors in Indonesia and may reduce or eliminate the income these investments generate. One of the biggest consequences of nationalisation will, therefore, be around compensation for loss of the value of an investment and future income potential.

In the latter scenario, foreign investors potentially have four ways of recovering their losses:

i. By a negotiated settlement of compensation claims

ii. Litigating against the state in local courts, where there is no provision for dispute resolution outside Indonesia (an unattractive proposition for many)

iii. Invoking agreed contractual dispute resolution provisions (often international arbitration, but limited to contractual claims, perhaps under a PSC)

iv. Investor-state arbitration, brought pursuant to a bilateral or multilateral investment treaty into which the state has entered

Investor-state arbitration is a powerful weapon in the foreign investor’s armory. It entitles a foreign investor (if it has the benefit of an investment treaty) to initiate an arbitration against a state in a supra-national forum, under the auspices of a treaty-based mechanism for the resolution of disputes over investments made by a foreign investor in a foreign state.

Such treaties confer certain substantive rights and protections to foreign investors under international law that are over and above those conferred by contract or national law. These include the right to fair and equitable treatment, full protection and security, protection against denial of justice and arbitrary and discriminatory measures. Importantly, they also protect against direct or indirect expropriation.
It is the latter that is most relevant in the case of state nationalisation of assets owned, controlled, managed or operated by foreign investors in that state.

Indonesia has signed over 60 bilateral investment treaties (BITs). This will enable foreign investors who are nationals of states which are a party to those BITs to bring claims against Indonesia for breach of its obligations under the terms of the treaties.

Of course, states have a sovereign right to regulate and manage their assets, including, importantly, natural resources.

Most, if not all, BITs permit expropriation by the state in certain situations (nationalisation being one of them), subject to strict conditions to protect the foreign investor. Expropriation must be in the public interest, it must be carried out without discrimination and adequate compensation must be provided promptly.

Expropriation is not always obvious. It can be subtle. It has been found in numerous arbitration cases not to be as blatant as the state simply taking legal title to property owned by the foreign investor. It can be an indirect action whereby the investor is unable to use the asset in a meaningful way as a result of unreasonable interference by the state, or its value is diminished as a result of certain indirect actions taken by the state. Given the nature of the draft new law, it is entirely possible that there will be direct or indirect expropriation of investments.

BITs are negotiated directly between states and, as a consequence, each treaty is different and its terms will vary. However, if one of the requirements of a ‘lawful’ expropriation, or any other, is disputed, the foreign investor may invoke its rights under the relevant BIT to refer the dispute to an arbitration before well-known international forums such as the International Centre for Settlement of Investment Disputes (ICSID), an arm of the World Bank, the International Chamber of Commerce (ICC) or an ad-hoc arbitration under the Arbitral Rules of the United Nations Commission of International Trade Law (UNCITRAL).

The benefit of investor-state arbitration is that awards are directly enforceable in any jurisdiction that is a signatory to the ICSID Convention (for ICSID awards), or the New York Convention (for other awards). If the award is the result of an arbitration carried out under the ICSID Convention, investors can also rely on the support of the World Bank to put pressure on the state to pay up.

A year ago, Indonesia announced its intention to allow its BITs to lapse or to actively terminate them. Of course, that would not protect the state against claims by existing investors but, without the benefit of bilateral investment treaties in the future, it will be interesting to see how quickly foreign investment in Indonesia starts to decline.

There is every likelihood that, if there is direct or indirect expropriation, foreign investors will strongly assert their rights through arbitration. Such proceedings, coupled with increased uncertainty regarding the status of Indonesia's investment treaties, is likely to result in foreign investors proceeding with extreme caution in Indonesia.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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