UPDATE: I added a new paragraph (in violet) in this posting to re-emphasize the unique (and strange) limitation on DMO for oil.
In this article, I would like to address one basic aspect of the Indonesian PSCs, Domestic Market Obligation (DMO), which is unique and specific. Historically, it is an important part of the PSC concept itself. When the PSC founding fathers initially formulated the concept back in the mid 60’s, they were well aware of the strong link to the constitution whereby it is clearly stipulated that all natural resources belong to the state and shall be utilized for the welfare of the people. Hence, this new concept of PSC should not give the impression that oil resources were given away to foreign parties without considering the implication on domestic need. Taking government share only was not justifiable, even if it was sufficient for domestic requirements. In order to ensure that the foreign contractors were also held responsible to fulfilling domestic needs of the people, DMO was introduced as an inseparable part of the PSC. In the beginning, of course the focus was solely on crude oil as domestic gas use was very limited or even non-existent.
DMO for oil has been in place since the very first PSC ever awarded. Let’s quote the DMO clause in the PSC:
(o) Contractor shall, after commercial production commences, fulfill its obligation towards the supply of the domestic market in Indonesia. CONTRACTOR agrees to sell and deliver to a domestic buyer a portion of the share of the Petroleum to which CONTRACTOR is entitled pursuant to Section VI subsections 1.3 and 3.1 calculated for each Year as follows:
(i) multiply the total quantity of Crude Oil produced from the Contract Area by a fraction the numerator of which is the total quantity of Crude Oil to be supplied, and the denominator is the entire Indonesian production of Crude Oil of all petroleum companies;
(ii) compute twenty-five percent (25%) of total quantity of Crude Oil produced from the Contract Area;
(iii) multiply the lower quantity computed, either under (i) or (ii) by the resultant percentage of CONTRACTOR’s entitlement provided as applicable under subsection 1.3 of Section VI hereof, from the Crude Oil remaining after deducting Operating Costs.
The quantity of Crude Oil computed under (iii) shall be the maximum quantity to be supplied by CONTRACTOR in any Year, pursuant to this Paragraph (o), and deficiencies, if any, shall not be carried forward to any subsequent year; provided that if for any Year the recoverable Operating Cost exceeds the difference of total sales proceeds from Crude Oil produced and saved hereunder minus the First Tranche Petroleum as provided under Section VI hereof, CONTRACTOR shall be relieved from the supply obligation for such year.
The price at which such Crude Oil shall be delivered and sold under this paragraph (o) shall be twenty five percent (25%) of the price (depending on the time the PSC was signed, some PSCs are compensated at 10%, 15%, or 20% of Indonesian Crude Price which is a reflection of market, while older PSCs are compensated for DMO barrels at merely 20 US cents), as determined under subsection 1.2 of Section VI. CONTRACTOR shall not be obligated to transport such Crude Oil beyond the point of export; but, upon request, CONTRACTOR shall assist in arranging transportation, and such assistance shall be without cost or risk to CONTRACTOR.
Notwithstanding the foregoing, for a period of five (5) consecutive years (meaning sixty (60) months) starting the month of the first delivery of Crude Oil produced and saved from each new field in the Contract Area, the fee per Barrel for the pro rata quantity of Crude Oil supplied to the domestic market from each such new field shall be equal to the price determined in accordance with Section VI hereof for Crude Oil from such field taken for the recovery of Operating Costs. The proceeds in excess of the aforesaid twenty five percent (25%) shall preferably be used to assist financing of continued exploration efforts by CONTRACTOR in the Contract Area or in other areas of the Republic of Indonesia, if such opportunity exists. In case no such opportunity can be demonstrated to exist, in accordance with good oil field practice, CONTRACTOR shall be free to use such proceeds at its own discretion.
The interpretation of the above clauses is that the DMO volume shall be applicable to contractor’s entitlement of both the FTP and the profit barrels, being the lesser of (i) and (ii), times the contractor’s entitlement percentage share. If the gross production of the particular PSC is 100,000 bopd, the domestic national consumption is 1,000,000 bopd, while the total national production is also 1,000,000 bopd, then (i) should be 100,000 bopd X 1,000,000 bopd / 1,000,000 bopd = 100,000 bopd. Meanwhile (ii) should simply be 25% of 100,000 bopd produced by the PSC, which gives you 25,000 bopd. In this case then the lesser of the two is (ii), which means that the DMO volume should then be 25,000 bopd X 28.9% (assuming contractor’s entitlement share of profit barrels of 28.9% before tax or 15% after tax) = 7,212 bopd. The basic calculation hence is 25% X 28.9% X 100,000 bopd of gross PSC production.
Things will be completely different if domestic consumption is much lower or gross national production is much higher. If domestic consumption is 1,000,000 bopd while gross national production is 4,000,000 bopd, then (i) essentially will give you the same factor as (ii): 25%. We know that the same factor is true if domestic consumption is 250,000 bopd. Too bad we all know that cutting domestic consumption down to 250,000 bopd is just equally impossible as increasing production to 4,000,000 bopd. Hence, clause (i) definitely will never ever be used in reality (not in our lifetime folks !, unless we have multiple elephant discoveries sometime in the very near future).
Yet, clause (i) is still in place even if it’s practically useless for probably the last 30 years ever since the domestic fuel consumption has exceeded 25% of the domestic oil production level due to increasing domestic consumption as well as declining production. Theoretically, that clause is still important to be fair to the foreign contractors to ensure an extreme situation will not happen where the DMO volumes supplied by all contractors in the country are in excess of the domestic requirement/consumption itself which will lead the government to end up exporting some of the DMO volumes supplied by contractors, hence not consistent with the spirit and idea of DMO itself in the first place.
Note that the essential concept of DMO is such that basically each PSC contractor in the country shall proportionally carry the obligation to supply domestic needs at their profit entitlement share, knowing that the remaining share goes to the government anyway which in theory should then fill the gap. To better illustrate this, let’s take the first example where DMO should be = 7,212 bopd. This means that the difference of the PSC’s gross share of DMO as calculated under (i) 100,000 – 7,212 = 92,788 bopd will have to be closed by the government from their share of FTP and profit barrels which of course is not sufficient given that some portion of the gross production is actually taken by the contractors for cost recovery and their own profit barrels.
Also note that the PSC also regulates that what’s calculated above under point (iii) is the maximum DMO for the contractor, meaning that if contractor’s profit share after FTP and cost recovery is nil due to high cost recovery (in the case of a new field start-up with deferred unrecovered costs), then there’s no DMO obligation at all. Using the same example, if gross production in the PSC is 100,000 bbls and FTP is say 20,000 bbls (20%), then the available barrels for cost recovery is 80,000 bbls. If total cost recovery (including recovery of prior years’ costs) is worth more than 80,000 bbls, then there should be no DMO applicable to the contractor. If cost recovery is equivalent to 79,000 bbls, then DMO is limited to the contractor’s share of FTP and profit barrels rather than 7,212 bbls as calculated under (ii) and (iii), leaving the contractor with no exportable barrels other than those for cost recovery. In the example, DMO then should be limited to (28.8% X FTP 20,000) + (28.8% X profit barrels 1,000) = 6,058 bbls, rather than the maximum of 7,212 bbls.
What’s odd about this is the fact that the contractor has the obligation to supply DMO when they have just a single drop of barrels to be split with the government after cost recovery (equity to be split) which basically means they have to give up their share on FTP, while if you have no barrels left after cost recovery then you are not subject to DMO at all. I suspect that this clause is somehow defective, as in the PSC versions prior to the implementation of FTP (in the 80’s), the limitation on DMO reads exactly the same but hence only applicable to contractor’s profit share (as there was no FTP and hence no FTP share). When the government introduced FTP, they tend to consider that contractor’s share on FTP is similar to its profit share and hence added as being subject to DMO, without changing the limitation. In reality, of course contractor’s share on FTP is not the same as profit share, since FTP share will always be there while the non-existence of profit share is a reflection that there still is deferred unrecovered cost. Deferred unrecovered cost in its turn is somekind of carry-forward losses, so how could a party which still carry cumulative losses be subject to supply DMO ? I guess the true spirit of DMO limitation as originally intended in the earlier PSC versions is probably to have no DMO obligation before there’s profit to be split, but then again a contract is a contract and all parties will have to honor and live with it. This strange limitation in reality can easily be “legally manipulated” by the contractor. Going back to the example in the previous paragraph, the contractor can easily spend legitimate additional cost recovery worth 1,000 bbls to completely avoid supplying DMO of 6,058 bbls.
In theory, this strange limitation should not make a big monetary difference for the contractor as DMO for the first 60 months is fully compensated at ICP market price anyway and the situation where cost recovery is so high hence leaving small fraction of profit barrels should mostly be true only for new project start-ups with lots of deferred unrecovered costs which in most cases should be fully recovered within less than 60 months anyway (unless production level is low, investment cost is excessive, or price is rock-bottom). In the new contracts post 2006, DMO is not limited to contractor’s share of FTP and profit barrels, but also includes its cost recovery barrels.
As for the compensation fee beyond the “full” compensation period of 60 months, I always believe that initially it was a reflection of the production costs per barrel. In the mid sixties, 20 cents was probably the average cost to produce when oil price was less than $2/bbl. When oil price increased to a new level after the first oil crisis in the early 70’s and later in the early 80’s, DMO fee was revised to 10% of weighted average ICP (market) of all crude produced in the PSC within the calendar year. And so on and so forth until the recent PSCs have 25% of ICP as the rate for DMO fee. The idea was that the contractors shall not be penalised for supplying DMO, but they shall not make profits either as it is part of their obligation to supply oil to the “rightful owners” of the resources: the people of the Republic. Today, 25% of a market price of $100/bbl is $25/bbl, not exactly bad for compensating the production costs of the DMO barrels.
What about the 25% factor for (ii) ? My wild guess is that back then probably the domestic consumption was about 25% of the gross national oil production level. Nowadays we consume more than what we produce, but that doesn’t mean that we should revisit the terms and change it to a bigger factor without carefully looking into the consequences on investment climate and the economic implications to the contractors. Again, as I say time and time again, the best way to get a bigger share is not by taking more from the contractors but rather by increasing the production level thru finding more discoveries and developing more reserves.
The investors tend to see DMO as additional government take, especially considering the relatively low compensation fees after 5 years of production. When they calculate economics for investment evaluation, especially for marginal fields, sometimes DMO becomes the hurdle for commercial decision. On the other hand, the fact that the PSC allows contractors to be fully compensated for DMO at weighted average ICP market price for the first 5 years (60 months to be exact) also gives rise to issues of accelerating production well in advance even with the risk of damaging the reservoirs and reducing ultimate recoverable reserves. This is where BPMIGAS plays an important role of monitoring prudent operations while at the same time also makes sure that DMO does not become a disincentive to new field developments.
I did say above that DMO is unique and specific to Indonesian PSCs, but some other countries have similar clauses with completely different terms. For example, in Vietnam they have a clause whereby the government reserves the right to purchase all production in the PSC from the contractor at market price, which probably is important in emergency situation where importing is difficult or for military reason in a state of war (when access to petroleum becomes very strategic). In the Indonesian PSCs, there is also a clause which gives the government the option to “purchase” contractor’s entitlement at ICP “market” price in the case when government’s entitlement share of profit barrels (hence not taking into account its share of FTP and DMO volume) is less than 50% of the gross PSC production to the extent that the “purchase” plus the government’s entitlement share of profit barrels adds to 50% of gross PSC production:
BPMIGAS shall have the option, in any Year in which the quantity of Petroleum to which it is entitled pursuant to subsection 1.3 of Section VI hereof is less than 50% of the total Production by 90 days written notice in advance of that Year, to market for the account of CONTRACTOR, at the price provided for in Section VII hereof for the recovery of Operating Costs, a quantity of Petroleum which together with BPMIGAS’s entitlement under subsection 1.3 of Section VI equals fifty percent of the total Petroleum produced and saved from the Contract Area.
DMO for natural gas is something relatively new, introduced after 2002 post the new oil & gas law. This concept is similar to oil DMO, but not exactly the same and has lots of complications in its implementation.
First of all, gas DMO is applicable to a specific percentage portion of the proved reserves (some parties say that it could be 15%, 25%, or even up to 50%) as negotiated and agreed by both parties (the government and PSC contractor). The DMO volume then is calculated as the agreed percentage of proved reserves multiplied by contractor’s entitlement percentage on volume after cost recovery (profit gas). Applicable price and terms on gas DMO volume should be based on an arms length transaction between the contractor and the domestic gas buyer.
There are some unique complexities around gas DMO relative to that for oil:
First of all it’s applicable to reserves rather than to production volume considering gas sales contract is always done on a mid to long term basis.
Then, the percentage of proved reserves subject to DMO is not definitively stipulated in the PSC as what it is for oil (25%) but rather is subject to be negotiated and agreed by both parties, mostly due to the fact that it depends on so many things such as size of the proved reserves, location relative to closest domestic market, gas prices (both for domestic as well as for international sales), and costs to develop and produce the gas. The last thing we want is having a fixed percentage which is detrimental to the economics of the whole project, making it not commercially viable for the contractor.
There is no dictated price such that for oil DMO, price should be negotiated with the domestic buyer on an arms length basis. The intent of gas DMO is more about supplying some of the gas to domestic buyers when the contractor has the option to export it internationally (by converting into LNG or piping it to a neighbouring country as those are the only ways to export gas at the moment). The fact that domestic gas prices tend to always be lower than international prices is unfavorable enough for the contractor anyway.
Gas has no liquid market, especially for domestic supply. Even if the contractor is obligated and willing to supply to a domestic buyer, it may take an extended time to find one. The time for the buyer to build its infrastructure and plant to take gas for power generation, for example, can also take years. Usually the PSC stipulates that a 2 year limit to reach an agreement with a local buyer is in place, beyond which the contractor then has the option to market the gas internationally instead.
Before the government insists on enforcing gas DMO, I believe there should be a careful evaluation on the overall macroeconomic and social implications, to make sure that the gas DMO implementation gives the utmost benefit to the country. A classic example would be the case when the market price of international gas (LNG) is say $18/mmbtu, while supply to a local fertilizer plant is $3/mmbtu, hence it should be carefully evaluated whether enforcing DMO is better than exporting all the gas on which the government share is much bigger than the $3/mmbtu anyway to the extent that it makes more economic sense to subsidize the fertilizer plant or even importing the final fertilizer products. I’m not saying that we should ignore the social implications, I just mean to say that the overall balance should be closely evaluated.
Gas DMO is in its infancy, there are some unknowns to its enforcement. It is a new concept not to be compared to oil DMO which is as old as the PSC itself (40 years). Considering the fact that it’s only relevant to PSCs producing LNG and piping gas to neighbouring countries, the application is somewhat limited. Nevertheless, the government should be wise with regards to its implications on the overall economics.
In conclusion, DMO is a reflection of foreign contractor’s participation to prioritize on domestic security of supply which is an underlying concept of the PSC itself with regard to honoring the fact that all petroleum minerals belong to the people.
Have a pleasant weekend, folks !