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il and gas exploration is booming worldwide due to prices increasing to around US$100 a barrel. The revenue generated by this price is helping some, but for Indonesia’s dwindling oil sector and increasing domestic demand, oil subsidies are increasing by 35 percent, or roughly $15 billion.

Although Indonesia has worked hard to expand economic activity in other industries, petroleum still dominates how Indonesia makes money, so we must manage our affairs well in this area by implementing a results-oriented fiscal system. A comparative analysis of oil-exporting countries shows that Indonesia is lagging — production in mature fields is declining and there are increasing costs associated with extracting the oil.

It’s a problem many countries are experiencing. Yet, many of them are attracting sizable investments from major oil companies that have the expertise and finances required to find new fields and reinvigorate old ones. Importantly, these companies are moving forward quickly with new technologies that are changing oil production. As a result, it may be time for Indonesia to reassess its game plan and make adjustments to ensure economic stability.

The foremost consideration should be how Indonesia’s oil fiscal system regulates the set up of exploration and development contracts with oil companies. Indonesia uses a system known as Production Sharing Contract (PSC), allowing oil companies to fully recover exploration and development costs before splitting profits with the government. When costs increase in maturing fields, as a result of exploration in deeper water or in difficult geologic conditions, the final amount of shared oil and gas revenue becomes smaller.

This arrangement divides the oil into two categories: cost oil which comes first and is taken by the oil company as reimbursement for costs and profit oil which follows and is shared with the government. As exploration and development costs go up, more cost oil is required and the oil company ends up with a larger final share of the reserves.

It is a system that depends on government officials reviewing all expense claims and ensuring that they are not unreasonably high. While oil companies bear most exploration risks, these contracts transfer much of the development risk to government; if most of the oil is required to pay for a project, the government is the one left holding an empty bag.

Nevertheless, Indonesia’s PSC system is not performing as intended. Indonesia’s sector is declining while other countries are experiencing success. Applying modern game theory to the situation points to a prime suspect — moral hazard created when downside potential is removed for one of the parties. In this case, contractors behave differently when there are no repercussions to cost overruns. If costs happen to double, they are less concerned because more of the gross production is designated as cost oil.

These escalating costs force government officials to fight back. Indonesia’s upstream oil and gas regulating authority (BP Migas) scrutinizes these expense claims and determines whether control is “too loose” or “too tight,” which constitutes a difficult and contradictory job. Accurately determining exploration and development costs may well be more trouble than it is worth for a government.

A regulatory expense cap was implemented in an attempt to fix the system. The cap added a layer of complication for contractors as they worked within the PSC by not only exposing them to additional bureaucratic process, but also raising the prospect of an almost-finished project stalling due to bumping up against the cap.

Consequently, big industry players were hesitant to do business with Indonesia. In 2009 the government offered 40 oil and gas blocks for development, but only found eight firms as takers —75 percent of the blocks on offers attracted no qualifying bidders. In that year alone, direct investment in oil and gas decreased from $13.57 billion to $12.18 billion. The cap was subsequently lifted to entice more investment, but government was still exposed to unpredictable high costs.

The PSC can easily deteriorate into an adversarial relationship characterized by a tangled web of rules, slow bureaucratic process and lack of trust on both sides. After many years, countries such as Kuwait, Iran and Saudi Arabia have migrated away from PSCs.

An alternative oil fiscal system may be what is needed to bring renewed vigor to Indonesia’s petroleum sector. Using game theory analysis helps determine how various oil fiscal systems affect the behavior of economic players (governments and oil companies), efficiency, overall productivity and ultimately government revenue.

Most developed countries use a royalty oil fiscal system and it has some important distinctions. Primarily, government royalties precede all other financial division and are levied on gross revenues; as soon as oil and gas start to come out of the wellhead, the government starts collecting its contractual share. The remaining oil goes to the oil company, but they pay an income tax on it, cover all the costs, and may have other obligations.

Under a royalty system, game theory solves the problem of higher costs by making the oil company 100 percent responsible for expenses. They are experts at producing oil efficiently and the exposure to a possible loss sharpens their thinking and eliminates nonsense. They cut a deal and get to work.

Everything is accounted for up front when the royalty split (for example, 50/50) is determined with a consequence that increasing costs will diminish contractors’ profits. Efficiency and cost cutting naturally follow. The lack of adversarial government officials slowly checking complex expense reports eliminates much work on both sides and would help Indonesia improve its relationships with energy partners.

Indonesia should build a results-oriented fiscal system that cuts down on bureaucratic red tape, rewards achievement, discourages inefficiency, provides certainty and attracts more investment. In pursuit of this, the government of Indonesia could determine an oil-sharing split under a modified farsighted fiscal framework that guarantees our fair share and still offers oil companies solid profits comparable to Indonesia’s current PSCs, but without bureaucratic headaches. Savvy fiscal policy can turn petro dollars back on!

Darmawan Prasodjo, Ph.D. is an economist focused on energy and the environment at the Nicholas Institute for Environmental Policy Solutions, Duke University, Durham, North Carolina, Arcandra Tahar, Ph.D. is a principal naval architect at Horton Wison Deepwater, Houston, and Erwinsyah Putra, Ph.D. is a staff reservoir engineer at Kinder Morgan Inc., Houston. This article reflects the writers’ own opinions.