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Indonesia’s leader must move fast to stave off energy crunch

As falling production and rising energy imports start to take their toll on the wider economy, it is clear Indonesia needs to reshape its oil and gas regime to lure much-needed upstream investment. But is the incoming president up to the challenge?

The recent announcement that US major Chevron will delay its $12 billion deep-water project in Indonesia does not bode well for the former Opec member. Above all, it highlights one of the greatest challenges facing the incoming president, Joko Widodo, when he takes office this month.

The archipelago, home to one of Southeast Asia’s fastest-growing economies, faces a crippling energy crunch. The upstream oil and gas sector has to provide 47% of total primary energy needs in 2025, or 3.7m barrels of oil equivalent per day (boe/d). Analysts estimate a 2.5m boe/d shortfall of supply in 2025.

Muted activity in exploration drilling and disappointing reserves replacement rates  suggests the government desperately needs to spur investment. Failure to do so could entail disastrous consequences for the rest of the economy.

Still, Indonesia’s energy crisis is nothing new. The world’s fourth most-populous nation forfeited its Opec membership in 2008, when it finally accepted its changing role from oil exporter to net importer. More recently, its exports of liquefied natural gas (LNG) have waned too.

Indonesia was once the world’s largest exporter of LNG but is now ranked number four, and will increasingly need to import the fuel to meet expanding demand at home. And as energy imports climb, the country’s domestic fuel subsidy bill, the largest in the region at an absolute cost of almost $32bn in 2013, continues to rise. It will need to be reined in.

Yet without drastic action it’s hard to see how the country will slow the ever-widening energy demand-supply gap, Lukman Mahfoedz, president of the Indonesian Petroleum Association (IPA), wrote in a recent article for the Jakarta Post.

Oil production continues to fall. It hit 788,000 barrels a day (b/d) in July 2014 or half of the 1.65m b/d peak production seen in 1977, while demand stands at 1.5m b/d, almost twice domestic output.

Gas production is forecast to reach 7bn cubic feet a day (cf/d) in 2015, falling to around 6.3bn cf/d by the end of the decade unless new developments are sanctioned, data from energy research consultancy Wood Mackenzie shows.

Demand for gas is 4bn cf/d and expected to rise. But Indonesia’s prospects of narrowing its energy deficit are slim. Chevron’s Indonesia Deepwater Development (IDD) project, as well as several other billion-dollar schemes, remains stalled largely because of the uncertain investment environment and political flux.

Other developments waiting in the wings include Inpex’s Abadi floating LNG project, BP’s Tangguh LNG expansion, Total’s continued investment in its Mahakam Block, and potentially, exploitation of the huge East Natuna (Natuna D-Alpha) field, which together with Chevron’s IDD scheme, could generate over $30bn of new investments. But unless Indonesia starts providing greater incentives for  pure exploration drilling, it will not increase reserves or see sustained incremental production gains, Angus Graham, a strategist at Asean-focused private investor Risco Energy, tells Petroleum Economist.

Indonesia’s reserve replacement ratio – a dismal 47% for oil with gas starting to dip to 90% in 2013 – is telling. Still, there is hope for the oil and gas sector.

Incoming president Widodo, or Jokowi, as he is more commonly known, could be the reform-minded leader Indonesia needs to help its economy, as well as its energy business, take off. Political analysts point to Jokowi’s ability as governor of Jakarta to deliver results, absent of historical hang-ups and constraints.

The son of a timber collector who was raised in a riverbank shack, Jokowi won a clear majority of votes over Prabowo Subianto, a retired army general and former son-in-law of Suharto, the authoritarian president who ruled Indonesia for 32 years. But the incoming president’s ability to implement much-needed reforms remains uncertain.

The old guard that controls the legislative parliament appears determined to obstruct Jokowi’s ambitious plans and avenge defeat in the presidential election. “If pure politics plays out, the same way as the past few months, the political division will generate some difficulty for Jokowi. But of all the sectors, oil and gas is most immune,” Shamim Razavi, an Indonesian-based oil and gas expert at law firm Norton Rose Fulbright, told Petroleum Economist.

Besides juggling factional demands in parliament, the new president will need to ensure that his energy reforms avoid major convulsions. Ravazi adds: “Oil and gas is the most unlikely to be subject to unwelcome experimentation because if they (the new Jokowi government) get it wrong, it would spell economic disaster.”

The incoming president aims to cut the fuel subsidy bill and reduce energy imports by encouraging stronger domestic production. To do this, Jokowi plans to encourage investment in mature fields, streamline the regulatory approvals process, and offer incentives to spur exploration.

Gas is the answer

Figure 1 - Energy demand and supply
Figure 1 - Energy demand and supply

His proposal to accelerate the switch from oil to gas domestically would also help cut Indonesia’s reliance on costly oil imports. But will need major investment in new pipeline and gas distribution networks.

Encouragingly, both sides of the presidential campaign recognise the pressing need to improve the oil and gas regime, as well as arrest declining production - now around 2.2m boe/d.

Jokowi and Prabowo’s support for reform, although their proposed methods differ, is not surprising given the hard economic facts. Indonesia keeps growing and needs fuel. Earnings from hydrocarbon production have bolstered state coffers for decades, but their share is ebbing.

In 2012, the energy sector provided roughly 16% of gross domestic product, while oil and gas alone contributed 16% of state revenues – down from 40% in 1990.

Relatively higher oil prices, coupled with rising demand, mean revenues from energy production end up being spent on fuel subsidies, rather than providing any material benefits, such as healthcare, education or infrastructure for the nation’s 250m people.

As hydrocarbon output falls, so do revenues. In turn, rising energy imports means a fatter subsidy bill, which has dragged down the wider economy and weakened the country’s currency. It’s a circular problem, magnified by the denomination of oil and gas imports in US dollars.

In the past, declining oil production might have been embarrassing, but it was not a real priority for the government. But now the wider public is increasingly aware of the economic effects of declining energy output. And that suggests the government might do something about it, says Risco Energy’s Graham.

Given Jokowi has pledged economic expansion of more than 7% a year by 2017 - the minimum level needed to absorb the 2 million youths entering into the workforce every year - it’s almost certain the government will act, at least on subsidies, which are draining the budget.

Media reports suggest the incoming president is pondering making savings of between 48 trillion to 144 trillion rupiah ($4bn to $11.9 billion) by removing fuel subsidies from petrol and diesel which would see pump pries rise between 1,000 to 3,000 rupiah.

But with the presidential elections over, it is crucial that the government stimulates investment in the upstream sector too.

The IPA estimates that exploration must increase at least threefold to meet half of the demand-supply gap in 2025. But exploration during the first half of 2014 were not encouraging - only 40 exploration wells were drilled out of a planned 130.

Procrastination among local officials, as well as excessive bureaucracy, are largely to blame for the shortfall, according to upstream regulator SKKMigas.

Even so, Indonesia does not only suffer from muted activity in drilling wells. Where exploration does take place, the results are poor by regional and global standards.

Between 2004 to and 2013, Indonesia found 3bn barrels of oil equivalent (boe) of new reserves, compared to between 2 billion and 3bn boe in Malaysia, 7bn boe in Vietnam, and 6bn boe in Brunei.

Figure 2 - Net energy deficit by fuel type
Figure 2 - Net energy deficit by fuel type

Tempting investors

Indonesia needs to attract more exploration dollars – capital which is globally mobile.

But the Asean region is not particularly compelling on an international basis. And regionally, Thailand, Malaysia and the smaller Philippines are relatively more attractive to investors. Indonesia lags near the bottom, Risco Energy’s Bottom of the Barrel report finds.

Malaysia is not necessarily more geologically attractive, but the potential margins from energy investments are a good deal better, says Graham. “Malaysia, for all its other issues, is a stand-out at adjusting its fiscal terms relative to the changing risk-reward proposition offered by the rest of the world. Indonesia is not”, he adds.

Over the past decade, Indonesia has seen a rise in above-ground risk, as its regulatory and operating environments have become increasingly unpredictable, a further deterrent to investors.

The simplest way Indonesia could entice foreign capital is to revise its fiscal regime, but financial incentives for investors can touch a raw nerve, and for many foreign companies, it is not simply a matter of subsidies and tax breaks.

Major underlying risks remain, such as dealing with extra permitting for land and procurement, tax issues, and interference from other ministries. 

Politics too plays a major role. Nationalist elements claim that the provision of better terms to investors, particularly foreigners, would be squandering the country’s wealth. But observers retort that if Indonesia’s incentives were really that generous, then foreign investors would be rushing into the sector. But they aren’t. 

Nonetheless, with parliamentarians carving out more influence as democracy gains traction, there is guarded optimism that improvements will be made in the oil and gas regime, changes that will be needed to encourage the influx of essential foreign expertise. 

A study from Wood Mackenzie shows that 75% of the country’s potential resources lie offshore in the deep and shallow frontier waters of eastern Indonesia. Locating and exploiting these deposits will need both technical expertise, skilled workers and deep pockets.

Indonesia may yet deliver on its strong potential for energy projects, reckons Andrew Harwood, an Asian-based upstream specialist at Wood Mackenzie. But this will only happen if the new president brings greater certainty to the investment climate, improves the regulatory environment, makes swifter decisions and provides greater transparency.

Real incentives to stimulate new exploration activity, will also be essential, Harwood adds.

Indonesia’s upstream sector, despite being mature, could offer big rewards, with nearly half of its discovered resources yet to be produced, Wood Mackenzie said  in a report last year.

Figure 3 - Oil and gas revenues versus subsidies
Figure 3 - Oil and gas revenues versus subsidies

Moreover, the archipelago with its 17,000 islands spanning nearly 2m square km has Southeast Asia’s highest remaining reserves - estimated at around 28bn boe. Of that, 10bn is under development, while a further 2bn boe shows development potential.

Indonesia also has access to the bulk of the region’s deep-water exploration acreage, large tracts of which remain unexplored. Still, explorers burned $1.9bn between 2009-2012 on sub-commercial discoveries in its frontier waters, highlighting the huge risks involved.

Although the government has attempted to compensate with better fiscal terms, some exploration and production companies have already scaled back their activities in Indonesia, or left the country altogether.

This is partly down to greater capital discipline in boardrooms, but also an indication of the perceived attractiveness of Indonesia compared to other opportunities around the globe. 

Maintaining equilibrium

Figure 4 - Oil and gas as percentage of total government revenue
Figure 4 - Oil and gas as percentage of total government revenue

The challenge for Jokowi will be in striking a balance between Indonesia’s need for greater control of its upstream industry and at the same time provide worthwhile opportunities for international investors, Harwood told Petroleum Economist.

One of Jokowi’s key tasks must be a review of the existing oil and gas legislation to provide regulatory clarity, sanctity of contracts and enhanced fiscal terms for investors.

Of major interest to investors will be the extent to which Jokowi’s government has the political will to implement proposed reforms, or whether opposition elements stymie the new president’s policies, observers add.

The incoming president has downplayed the prospect of deadlock, adding that he expects to control a majority in parliament within six months.

Although strong doubts persist about Jokowi’s ability to deliver reform, his direct control of the upstream regulator will give him critical sway over the stalled development projects representing tens of billions of dollars of potential investment and some 10bn boe of possible production.

Although the hold-ups have a political aspect, the delays are largely administrative, and could be resolved without lengthy political manoeuvring, says Norton Rose Fulbright’s Razavi.

“He can take the hard decisions, which have been difficult to deal with over the past year or so, given the political flux”.

Indeed, the industry is hopeful of greater boldness and clarity on decision making for these projects. And Jokowi should be able to deliver, despite a legislative tussle, by stamping his authority on the upstream regulator.

Overall, one thing is for sure, if it’s business as usual, oil companies will not be accelerating their investments. And given it takes an average of over 15 years to develop a discovery in Indonesia, time is of the essence.

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