COST RECOVERY DEBATES: WHAT & WHO BENEFITS?

Oil, Gas, Electricity Petromindo
June 2013

COST RECOVERY DEBATES: WHAT & WHO BENEFITS?

By Dr. Madjedi Hasan

Over the past five years, cost recovery has been a hot topic for both the Government

of Indonesia (GOI) and the oil and gas industry. Some even believe that Cost Recovery is

bad for the government, to the extent that different parties propose a complete overhaul of the

system, including a different type of petroleum contract without cost recovery. In the GOI’s

view, oil companies have – in the past – claimed recovery for extraneous expenditures not

related to oil exploration and development, resulting in a decrease of the GOI’s revenue.

This prompted the GOI to issue Law No. 41/2008 and Government Regulation Nr. 79/2010

which regulate the cost recovery where the government’s objective is to limit cost recovery

claims.

Cost recovery is unique term widely used in the Production Sharing Contract (PSC).

It is an ancient concept based on the principle of ‘the one who put up the capital should at

least get their investment back”. Indonesia introduced the concept in early 1960’s for the

petroleum industry, in which the oil and gas company will recoup costs of exploration,

development, and operations out of gross production. The most usual allowable costs

include; unrecovered costs from previous years, operating costs, expensed capital costs,

annual depreciation, depletion and amortization (DD&A), interest on loan (usually

restricted), investment credits and decommissioning fund.

Many countries have adopted PSC system for their petroleum contracts. All have also

adopted Cost Recovery concept including what costs are recoverable, order of priority, and

ceiling cap relative to gross volume. In order to provide guaranteed revenue for the Host

Government, the cost that can be recovered annually is limited. However, not all countries

have cost recovery limits but where it exists it ranges typically between 30%-60%. In the

case of Indonesia, the cost recovery was initially limited to 40%, but the ceiling was later

removed following the GOI’s demand to modify the production split from 65/35 to 85//15

(1975). The cost recovery limit was then reinstated in 1980’s by introducing the concept of

First Tranche Petroleum (FTP), a portion of gross production that cannot be applied to

recover the cost. The FTP is set at 20% for the conventional area and 10% for the frontier

areas, including deep sea and remote areas, which mean cost recovery ceiling of 80% and

90%, respectively, for conventional and frontier areas.

Also, each PSC area in Indonesia is ring fenced. Thus any tax offset is restricted to

cost incurred within the particular PS area. Under the PSC terms, the SKK MIGAS is

responsible for the management of operations while the Company is responsible for the

funding of work program. Expenditure limits have been set in excess of which the Company

must obtain SKK MIGAS’ prior approval. Note that not all Company’s expenditures are

recoverable. For instance bonus payment is not recoverable, but tax deductible in accordance

with the Income Tax Law.

From the GOI’s perspectives, the cost recovery represents the reimbursement by the

GOI to the Company’s costs incurred in exploring, developing, and producing the PSC. This

can be seen by the inclusion of cost recovery as a separate budget item in the State’s Income

and Expenditure Budget since 2009. Such view is based on the concept of ownership of

underground resources as stipulated in the Constitution, i.e. all natural riches are under the

jurisdiction of the State. However, this perception is entirely wrong when we see the fact that

the reimbursement of contractor’s expenditures is considered an income, which is taxable at

44% rate (30% on net income plus 20% on final profit).

Also, from basic taxation logics, claiming that tax deductibility means the government

is “paying” for the costs is in a way misleading. That is similar to claiming that in any other

companies in any other industries, the government also “pays” for 25% of the employees

(and any other) costs simply because the general corporate tax rate is 25% and employee

costs are tax deductible. In reality, it is the companies which are paying the government the

taxes, and not the government.

On the other hand, Company views that cost recovery in reality is just a component of

the contractor’s entitlement share of volumes, along with the so called profit barrels. The fact

that the PSC entitlement share itself is partially based on costs being recovered from volumes

produced or sold is just a mechanism or mathematics of splitting the barrels, not a reflection

of sharing costs. As the name shows, the production sharing contract is in essence not a cost

sharing contract or a revenue sharing contract (such as in Contract of Work). Also, the

present of cost recovery ceiling does not always mean real costs being recovered from

production, while in other cases there are incentives which arguably are not really “incurred”

but yet recovered from production (investment credit). In summary, cost recovery is merely a

component in the overall entitlement calculation, and should not be seen as cost sharing or

reimbursements. A true reimbursement would have kept the contractor fully compensated.

Based on this perspective, the government profit share and the corporate and dividend

taxes are seen as combined taxes at an effective rate of 85%. The rate is increased to 88% if

the loss of revenue associated with domestic oil obligation which is valued at 15% - 25% of

market price is included. This is especially true given the unique position of taxes for the

Indonesian PSCs with the “uniformity principle” where generally what’s cost recoverable is

also tax deductible (refer to the Ministry of Finance’s Letter Nr.S-443/MK012/1982 and

Government Regulation Nr 79/2010).

From the legal perspective, the cost recovery is one of the most important commercial

terms that were negotiated and agreed by the parties in the PSC. Also, when it signed the

PSC, the Government has essentially agreed to be a subject of private law (Book II of

Indonesia Civil Code), with respect to its right and obligation under the contract.

Accordingly, the cost recovery is a private (not public) matter thereby any disagreement

between the contracting parties in the implementation shall be resolved in accordance with

the procedure as agreed in the contract.

Cost recovery method in PSC is indeed specific, because both cost recovery and share

of the profit is given in the form of production (in kind). However, the way a charge is to be

made has been described in sufficient detail in the Accounting Procedures in the PSC contract

document (Exhibit C). In the implementation, various Working Procedure Manuals,

including Annual Work Plan and Budget, Supply Chain Management, Authorization for

Expenditure and Plan of Development have also been issued. The claimed cost is also

subject to audit by the Government’s auditor.

It is true that the parties may have different views from time to time. However, this is

not unique, as similar situation could also happen in other industries between the tax officials

and tax payers. In order to resolve these differences the PSC also contains mechanisms or

process to be used in resolving the differences. Under the agreed procedures, the result of

audit will be submitted to SKK Migas, who will then forward the findings to the Contractor

for comments and explanations on the audit findings. The contractor’s charges may be 

corrected, however if no agreement is reached the dispute may be resolved in the arbitration,

in which its decision is final and binding.

In contrary, certain GOI officials view that the reduced revenue from a PSC as a result

of increasing claimed cost is considered as loss to the State that may be considered as a

criminal act and subject to prosecution. The issue has emerged as there is indeed a conflict in

the present law and regulations with respect to definition of the State’s financial loss. For

instance, the Law Nr. 17/2003 on the Keuangan Negara (State Finance) says that the

Keuangan Negara is that all rights and obligations of the State that can be valued in terms of

money either in the form of cash or goods that may be used in the connection with the

execution of the State’s rights and obligation. This will then place the State Owned

Enterprise (SOE) in the domain of public law.

On the other hand, Article 11 of Law Nr. 19/2003 on SOEs stipulates that the

management of SOEs is conducted under the Law Nr.1/1995 on Limited Liability Company

and its implementing regulations. Furthermore, Article 1 paragraph (1) of SOE’s Law states

that the Government’s share is Kekayaan Negara (State’s wealth) that has been separated.

These mean that if there is a loss in a SOE then the loss is not considered as a financial loss to

the State in the context of public law, but a loss of the corporation or is commonly called

business risks in the context of civil law. This notion was confirmed by the Supreme Court’s

guidance (fatwa) Nr WKMA/Yud/20/VIII/2006 (16 Agustus 2006) on Separation of SOE’s

Assets from the State’s Asset. The fatwa was issued in a response to the Minister of Finance

Letter No. S-324/MK.01/2006 (July 26, 2006), regarding the revised Government Regulation

Nr. 14//2005 on the Procedures for Removal of the State and Regional Government’s Claim.

In conclusion, much of the controversy could have been triggered by a lack of

understanding on the nature of petroleum business and the principles of PSC, how the system

works, and the role of Cost Recovery in the whole PSC mechanism itself. As the PSC’s

founding father (Ibnu Sutowo) said, the PSC system was established to “share oil, not

money”. The Company considers that cost recovery cannot be seen merely as

“reimbursement”, but it is merely tax deductions from the gross revenues while the equity to

be split with the government is in reality comparable to taxable income in a tax and (royalty,

if any) regime. Claiming that the GOI pays for 85% of PSC’s costs (not including DMO) is

indeed misleading and would only create unnecessary misunderstanding and confuse the

general public.

PSC system with its cost recovery concept has been working well and no significant

show stoppers have happened in the past 40 years which will require an overhaul. Indonesia

has in the past been successful in shifting the contractual equilibrium towards greater benefit

for the government. PSC is quite similar with other business contracts however it has unique

characteristics in view of that one of the contracted parties is government. What is Indonesia

presently needs is maintaining conducive investment climate. While its absolute application

may be difficult, good faith and principle of pacta sunt servanda are essential to promote

climate conducive for investment. GOI’s policy in one sector needs to be made in harmony

and be synchronized with that in other sectors in order to obtain optimum results. Both

parties must continue to develop empathy in their respective motive and position, so the PS

sharing system can continue its role for binding different interests of the parties.

.