The Analysis of the Marginal Field Incentive - Indonesian Case

(2005)

By: Benny Lubiantara

Abstract

Indonesia oil production has continually declined, the GOI has made extensive effort to find ways to improve the production rate, the marginal fields were considered to provide some contributions and part of the production improvement programs.

The government of Indonesia (GOI) has identified that there are many undeveloped fields in the contractor working areas; the reason for not being developed is simply the economics. Under the existing terms and conditions, the fields are not economics enough to be developed. The GOI conducted some studies to determine the best incentive which would not only improve the economics of the field (the contractor share) but also keep the guarantee that the GOI would still receive significant share. Introduction The government agency for upstream oil and activities (BPMIGAS) and the Directorate General of Oil and Gas – Dirjen Migas (under the Ministry of Energy and Mineral Resources) were responsible to develop and propose the incentive. Before coming up with the sort of proposal, the BPMIGAS and Dirjen Migas invited the contractors (who operate under PSC contract) to have some

coordination meeting regularly, the team from those representatives was formed, the task of this team was to identify and propose some incentive alternatives. Marginal field definition The team first came up with the definition; the marginal field is defined as an oil field located within a producing block that, under the current PSC terms and conditions, is not economics to be developed. This definition was needed because under the production sharing contract, the marginal field had already been defined. The definition of the marginal field under the PSC contract is as follows, “Marginal Field” is the first field of the Contract Area proposed by Contractor for development and approved, capable

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of Crude Oil production not exceeding 10,000 Barrels daily average projected for the initial two (2) production years (24 production months). In order to define which field is entitled to receive this incentive, the field should

fulfill these criteria:

1. Located within a producing block. 2. Its main product is oil. 3. The exploration cost for that field has been fully recovered, i.e. no

more sunk costs considered. 4. If calculated based on the current PSC terms and conditions and

other incentive packages that may be applied for that field in accordance with laws and regulations, the Internal Rate of Return (IRR) is estimated less than 15%.

The first criteria was to ensure that the field have been found and located in the producing area, it means that the cost incurred to find the field was recovered

by other producing fields. The second criteria to make sure that the gas field was out of this program. The forth condition was “the hurdle rate”. In order to find the IRR initially, the oil price assumption is 25 $ per barrel. The same assumption for oil price for economics calculation is very important since difference contractor may have difference oil price assumption.

Fig.1

Figure 1 shows the marginal field candidates within the working area or block. The block has already had two producing fields (Field A and field B); those 4 undeveloped fields fulfill the first criteria.

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Identification of incentive alternatives The team identified some alternatives to improve the economics of the contractors (based on the Indonesian PSC flowchart – see attachment II), the

alternatives include:

- Increasing contractor profit oil - Eliminating the first tranch petroleum (FTP) - DMO holiday - Cost recovery uplift - Increasing the Investment credit

Based on the some exercises using Indonesian PSC economics model, among these alternatives, the increasing contractor profit oil and cost recovery uplift were considered to be the best ways to improve the contractor economics. The team then continued discussion to find which should come to be the first priority. The team was also aware that changing the contractor profit split was

possible, but it might need the approval from the Parliament (it means that the approval for “proposed marginal incentive” would need more time). Given the fact that both could provide the same economics result, the team then put the cost recovery uplift as the first priority. Type of incentive Based on the proposal, the GOI agreed to issue the incentive which was 20% Cost recovery up-lift. The Contractor may also apply other incentive packages (if any) in accordance with the prevailing PSC, laws and regulations (investment credit, etc). Mechanism The feature of this new incentive was that the incentive is not permanently given and will be evaluated on yearly basis (so called ON and OFF). This incentive was issued in order to improve the economics of the field, after receiving the incentive, the IRR of the field is expected at least 15% (the

incentive is “ON”). The Incentive will be removed if the actual cumulative IRR has reached 30% (the Incentive is “OFF”). The Incentive will be re-apllied if the actual cumulative IRR in the following year has dropped below 15%. Before explaining further regarding this mechanism, it is important to understand the concept so- called the IRR cumulative.

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Fig.2 Figure 2 shows the plot of the net cash flow versus year, by having this net cash flow, we then could easily calculate the IRR.

Fig. 3 Figure 3 shows the concept so-called the IRR cumulative (from the same net cash flow on figure 2), basically, the IRR can be calculated at any year using this concept and produce the same number of IRR at the end of the project (18.5%). The purpose of the IRR cumulative method is to know the IRR during the ongoing period. Method of calculation is the same as standard IRR calculation.

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Fig. 4 The incentive would be removed if the IRR cumulative reach 30%, figure 4 shows that in beginning of the year 2011 the incentive will be removed, the IRR of the project (without incentive) would continue increasing (of course) at the slower rate compare to if the incentive still “ON”. Analysis of Incentive Behavior during Project life. Since the incentive will be ON and OFF during the project life depending upon the IRR cumulative, it is important to analyze this behavior.

Fig. 5

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Figure 5 shows the “most likely case”, the incentive will ON from the beginning of the project, after reaching the IRR cumulative 30%, the incentive will be removed (OFF), the IRR contractor would continue increasing at slower rate.

There is also possibility so-called “extreme case” in which the incentive will be ON and OFF during the project life. Figure 6 shows this possibility. At the beginning of the project, the incentive will be ON and IRR cumulative increase until some point that the contractors need to spend another capital expenditure for increasing capacity. Because of this capital investment, the IRR cumulative will decrease, if the IRR drop below 15% then the incentive will be ON again. This will cause the IRR cumulative increase until 30%, and at that point, the incentive will be removed (OFF), but (of course), the IRR will continue increasing at a slower rate. Why does this case happen? Figure 7 explain why this could happen. Initially, the Contractor assumed that the marginal field is “really marginal”, during the project life, after receiving new information - the contractor recalculate the reserves (which is fortunately) much bigger than initial estimation. So that, they need more capital investment to accommodate

more oil production.

Fig. 6

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Fig. 7

Fig. 8

Figure 8 shows the possibility so-called “always ON”, in this case, the Contractor receives the incentive at the beginning of the project and the incentive will continue ON until the end of project.

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Concluding Remark:

- In order to contribute for increasing national oil production, the GOI was issued the marginal field incentive in 2005, the incentive was in the form

of cost recovery uplift amounted 20%, meaning that the contractor could recover their cost 20% higher.

- The unique feature of this incentive was that the incentive is given not on permanent basis but will be on ON and OFF basis - depending upon the IRR cumulative.

- The contractor should report on yearly basis of their IRR cumulative – from the contractor perspective, it is considered as the disadvantage of this incentive since it created another administration burden.

- The Contractor will entitle to receive this incentive if the IRR is less than 15% (using oil price assumption 25 $ per barrel). This oil price assumption may raise the question – it may be too low during the high oil price periods.

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Attachment – I Potential contribution of Marginal Field Development (yellow color)

Attachment – II

Flow Chart of Indonesian PSC

Gross RevenueUnrecovered Cost

Con

tracto

r En

titlem

ent

DMO

25% x CS x TL

Contractor Share

(CS)Government Share

Equity to be Split

Recoverable Cost

FTP

DMO Fee

TAX

Taxable Income

Operating Cost• Previous Year

Unrecovered Cost

• Non Capital Cost

• Depreciation of Capital

Cost

Indonesia IncomeNet Contractor

Income

Bonus(+) (-)

(+)

(-)(+)

(-)