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
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

Unrecovered Cost Gross Revenue

Operating Cost
• Previous Year

Contractor Entitlement
Unrecovered Cost
FTP
• Non Capital Cost
• Depreciation of Capital
Cost
Recoverable Cost

Equity to be Split

Contractor Share
Government Share (CS)
(+) DMO
25% x CS x TL (-)

(-) (+)
DMO Fee
Taxable Income

Bonus
(+) (-)
TAX
Net Contractor
Indonesia Income
Income