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Jakarta Post

Larger cost recovery pool better for government

Jakarta   /   Tue, October 25, 2016   /  09:19 am
Larger cost recovery pool better for government An oil pump seen at sunset in the desert oil fields of Sakhir, Bahrain, Sept. 30, 2015. The Indonesian government is preparing stimuli for the oil and gas industry for the 13th economic policy package to buttress investment in the industry in a sluggish market. (AP/Hasan Jamali)

Cost recovery (CR) is a hot issue and has been a constant topic of debate among all oil and gas stakeholders, including oil and gas companies, the government and now parliament, since cost recovery was put in the state budget. 

What is cost recovery? CR is the term used to recapture a contractor’s capital expenditures and operating expenses out of gross revenues, after first production, under the Production Sharing Contract (PSC). 

The CR scheme allows for oil and gas companies who put up their capital for the project to “at least” get their investment back, provided there is enough resources to do so. It is also important to note that oil and gas company will only capture their past expenditure cost, if they indeed find enough reserves that can be exploited. 

Oil and gas exploration is a risky business and long-term in nature. Data from the Indonesia-Investments website indicated that from 2002 to 2016, nearly US$4 billion was spent in-vain by oil and gas companies in their exploration stage in Indonesia without finding reserves suitable for commercial production. 

What does this mean? It means that the government will never reimburse those costs. The oil and gas companies bear all the risks. 

Let’s look some of the exploration activities that did indeed find oil and gas and how long it took to be developed and commercially produced. 

The first example is West Seno field in East Kalimantan operated by Unocal. It was discovered in 1998 and yielded its first oil on Aug. 5, 2003. 

Using the Net Present Value (NPV) concept, let’s calculate the value of the money spent during the exploration phase using the discount rate of 10 percent. 

For simplicity, assume $1 million spent in 1998, the year of discovery. If we can recover all $1 million in 2003, the year of production, the value of the money would be only $621,000. 

The second example would be the offshore Abadi gas field in the Masela Block, which was discovered by INPEX in 2000 and up to now, INPEX as the operator has yet to start the development project to produce this gas field. 

Let’s assume the first gas would be flowing in 2021, which means 21 years of devastation of time value of money. The $1 million in 2000 would be worth of $135,000 in 2021. 

What would be the cause for such devastation of the time value of money? It is another subject of discussion, but I am pretty sure one of them would be cost recovery issues between the government and the oil and gas companies. 

Every year, oil and gas companies propose and present their exploration work program and budget to the government (represented by SKKMIGAS) and try to justify whether the activities make sense not only technically but also in term of cost. 

The discussions often go on and on with each party firmly standing their ground. It does not only waste a lot of time but also results in losing the essence of activities due to the cost recovery issue.

Oil and gas companies are often puzzled and upset as to why they need to spend so much time justifying their planned exploration activities, and especially the cost part, to the government. 

On the other hand, SKKMIGAS’ argument is that it is doing its job as the government agency responsible for making sure that everything is carried out in accordance with the law. 

So the question now is, should we all forget about cost recovery? Why do we bother? 

If I were wearing the oil and gas companies decision maker’s hat, I would say that insuring an expenditure is cost recoverable in exploration is a business decision. The exploration project as explained above is really a risky business. 

During my last 22 years of experience in the oil and gas industry, most of the exploration projects have had a POS (Possibility of Success) of less than 20 percent, which means that 80 percent of these projects have failed.

If it is successful, it takes many years to recover the costs, while the value of the money has been eroded significantly. 

Hence, as a decision maker, we need to judge whether it costs more to insure an expenditure is cost recoverable than the NPV of that expenditure. If it is, we should forget about cost recovery — a simple business decision. 

However, though cost recovery on a risk-time basis has a low NPV at a 10 percent discount rate, it can be valuable to the overall project economics especially for small or marginal projects or when calculating the project on a point forward basis than on a full cycle basis. 

A point that most people, I believe, do not understand is that in a PSC scheme, the contractor (oil and gas companies) is effectively “loaning” interest free cash to its partner — the Indonesian government — and that the “interest free loan” can only be repaid from production cash flow.  

The bulk of cost recovery is actually the recovery of the government’s share of the expenditure. Companies should never be forced to undertake exploration without benefit of cost recovering the expenditures in a PSC regime — even if NPV of recovery is low.  

What would I do if I were wearing the government’s hat? 

First of all, let’s take a reality check. Indonesia has been a net oil importer since 2004 and it will be a net gas importer in 2019. Meanwhile, our country’s energy demand keeps increasing. According to the National Energy Council (DEN), 47 percent of Indonesia’s energy needs will rely on oil and gas in 2025, and 44 percent in 2050. 

More new oil and gas reserves are required to fulfill the demand, which means more exploration activities are urgently needed. To conduct more exploration activities, more new investments are necessary, which to be honest the Indonesian government will face difficulties to fulfill. 

One way to measure the significance of exploration activities being conducted in the country is by calculating the amount of the cumulative cost recovery pool in the exploration phase. 

The larger the cumulative cost recovery pool, the more significant the exploration activities occurring in Indonesia.  

Moreover, exploration activities will also benefit the country’s economy from their multiplier effects. The Indonesian government, eventually, makes all their profits in the PSCs from production that is the direct result of exploration. 

In conclusion, if I were wearing the government’s hat, I would create a more efficient system that encourages exploration activity in Indonesia.


The writer is an independent oil and gas consultant. He was a country manager and exploration manager for Murphy Indonesia (2010- 2015). Deepwater wild cat exploration is one of his areas of expertise.

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Disclaimer: The opinions expressed in this article are those of the author and do not reflect the official stance of The Jakarta Post.

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