Newsletter No. 1222
News-Analysis
December 15, 2008

 

The following newsletter has been written by David Adam Stott (Shingetsu Member No. 17). Stott is based at The University of Kitakyushu.

INDONESIA’S LNG DOUBLE GAME IN NORTHEAST ASIA

For those involved with Indonesia’s liquefied natural gas (LNG) industry, 2008 has been a rollercoaster year as new supply contracts were signed with both Japan and South Korea, and attempts to renegotiate a long-term contract with China intensified. Meanwhile, Japan is stepping up its energy investments in the country despite the impending reduction in its supply of LNG from the Bontang plant, and a newly emboldened Indonesia is pushing for further concessions from Japan regarding future LNG supplies. Whilst price gouging customers in Japan and South Korea, the current Indonesian administration must tread carefully with China if it wants to renegotiate a higher price for new LNG exports set to start in 2009.

Japan is the world’s largest importer of LNG, a policy prompted by the first oil shock of 1973. As she reduced her dependence on oil, and moved towards a more diversified energy portfolio, natural gas has risen to account for about 15% of Japan’s energy requirements, up from 2.7% in 1975. This shift turned the country into a major pioneer in the global LNG trade and Japan was the driving force behind the development of the Indonesian LNG industry. Indeed, both of Indonesia’s processing facilities, Arun at Lhokseumawe in Aceh province and Badak at Bontang in East Kalimantan province, were constructed in the mid-1970s under supply contracts to Japan.

Despite this, in March 2008 it was confirmed that annual LNG export contracts to Japan will be slashed from around 12 million tonnes (MT) at present to 3 MT following their expiry in 2010 and 2011. Even though such contracts typically run for 15- to 25-year periods, they will be renewed for only ten years, with 3 MT annually in the first five years and 2 MT per annum thereafter. The affected companies are Japan’s Kansai Electric Power, Chubu Electric, Kyushu Electric, Osaka Gas, Toho Gas, and Nippon Steel Corporation. Their contracts cover gas from East Kalimantan, presently the source of around 90% of Japan’s LNG imports from Indonesia, as the Aceh fields are largely depleted and set to run completely dry in the next half decade. As resource supplies form the bedrock of the bilateral relationship, shorter contracts will invariably provide greater flexibility to Indonesia, but represent a worrying trend for Japan. At the same time, Japanese buyers have been forced to pay record prices to renew these contracts.

For example, in March 2008 it was revealed that Japan has agreed to pay around US$16-18 per MBTU (million British thermal units) to renew the Bontang LNG contracts. This figure, which surprised analysts, set a new record price for Asian LNG beating the previous high of US$11 per MBTU agreed between state-run Korea Gas and Qatar under a twenty-year LNG deal signed in November 2006. Analysts have been concerned that such high prices might be unsustainable, in part due to a raft of new LNG schemes projected to come onstream around 2015. Exacerbated by safety concerns over its nuclear power network, Japan did not appear to have many viable alternatives and Indonesia was able to take advantage of such vulnerability to drive the price up.

Indonesian LNG remains attractive to Japan due to its relative geographic proximity, and thus lower transport costs. Recognising this, Jakarta has factored these lower costs into the higher price it demanded and received for the renewal of the Bontang LNG contracts. Djoko Harsono of the regulator Upstream Oil and Gas Regulatory Agency (BPMigas) reasoned that although Qatar agreed to sell LNG for less, “The cost of transporting LNG from Qatar is higher than from Indonesia to Japan. Now they have agreed to add the difference in these transportation costs to the price of LNG from Bontang. The talks with them now only concern technical transportation problems.” These problems revolve around Jakarta’s request that around 75% of Bontang LNG exports be transported by Indonesian shipping firms. BPMigas head R. Priyono revealed that Japan was asking for 50% of the exports to be carried in Japanese ships, but that Indonesia disagreed, adding that the cost for the transportation to Japan of LNG amounts to US$30,000 per day.

Following the LNG deal with Japan, Indonesia subsequently agreed a price of US$20 per MBTU with Korea Gas in July 2008 for a short-term contract to supply less than 1 MT annually from 2010 to 2012. The gas will come from the new Tangguh LNG plant in Papua province and was originally earmarked for Sempra Energy of San Diego, California. Korea Gas, like its counterparts in Japan, also wants to extend its LNG contracts with Indonesia that expire in 2014 and 2017 and cover around 2 MT per annum, and is hoping that it can be serviced from recently approved new deep-water fields off East Kalimantan, which are expected to start producing by 2014 at the earliest. Energy Minister Purnomo Yusgiantoro has again stressed that domestic needs will take priority, however, and that such deep-lying resources were more difficult to tap and consequently more expensive to develop.

The Tangguh plant will be Indonesia’s third LNG processing plant, and the first opened since the mid-1970s. After receiving final approval from Jakarta in March 2005, deliveries from the plant have been repeatedly delayed but are now scheduled to begin in the second-quarter of 2009. The US$5 billion project will initially run just two trains and should yield 7.6 MT per annum at the first stage. Further enhancements are expected to yield 10 MT by 2011, which would be timely for overseas buyers if the gas is earmarked for export. In recent years, Indonesia has begun to prioritise domestic gas consumption over exports, hence the forthcoming cuts in the Bontang LNG exports to Japan.

In the face of gas supplies delayed by diversions to meet domestic demand and record high prices, Japanese clients have been increasingly unhappy with supply guarantees made to China. Yasuo Ryoki of Osaka Gas, for instance, has been quoted as saying, “Indonesia should offer LNG prices close to the price formula for Fujian.” This refers to the benchmark price agreed in 2002 of US$2.4 MBTU for the Tangguh gas to be supplied to China’s Fujian LNG receiving terminal. Japan’s average import prices rose 9% to US$5.18 MBTU in 2004 from US$4.77 in 2003. Although the Tangguh to Fujian price was subsequently revised to US$3.35 MBTU at the end of 2006, this affair demonstrates that Indonesia had long seemed intent on charging Japan more for LNG than China. At present, the China National Offshore Oil Corporation (CNOOC) is due to receive 2.6 MT a year for 25 years at US$3.35 MBTU, whilst both K Power and POSCO from South Korea each agreed to an annual supply of 1.1 MT for 20 years at US$3.5 and US$3.36 MBTU respectively. The deals with the Koreans were originally sealed in the summer of 2004, whilst CNOOC’s was inked in September 2002. The remainder of the initial production was originally earmarked for Sempra Energy at US$5.94 per MBTU for 20 years, whose deal allows 50% to be diverted to other buyers who offer a higher price (subject to a cancellation fee, of course).

As a result, in June 2007 the Energy and Mineral Resources Ministry and BPMigas were reportedly offering half of Tangguh’s LNG to Japan and South Korea at far higher prices than those agreed with CNOOC, K Power, and POSCO, with the LNG being redirected from the share due to be sold to Sempra. Whilst Japanese utility Tohoku Electric also announced in May 2008 a 15-year commitment to acquire about 120,000 tonnes per annum of Tangguh LNG starting in 2010, negotiations to divert some of Sempra’s allocation to Thailand’s state-owned oil and gas company PTT fell through over price disagreements. At the same time, Indonesia nearly reached a deal with Tokyo Gas for the diverted Sempra cargoes, but again talks collapsed over pricing in October 2008. The two sides were discussing a price of US$20 per MBTU to buy 500,000 tonnes per annum for five years. We can thus assume that Tohoku Electric will be paying considerably more than US$5.94 per MBTU.

On the surface, even the original price of US$2.40 MBTU seemed to compare favourably for Indonesia with a tender Qatar won the same year to supply Taiwan at a price of US$1.8 MBTU. However, the Fujian pricing formula was based on a price of US$25 per barrel, meaning that the gas pricing equivalency would have an upper ceiling of US$25 per barrel and the Tangguh LNG price would not rise if oil prices exceeded this. This effectively locked the LNG selling price, in contrast to a more progressive formula which ensures that gas prices mirror fluctuating global energy prices. Indonesian gas prices are usually linked to oil prices without any price ceiling, and such a progressive formula was applied to the contracts signed with Japan for both the Arun field in Aceh and the Badak field in Bontang, East Kalimantan.

As the price of oil exceeded US$50 per barrel, the Tangguh pricing formula became increasingly controversial, prompting Jakarta in January 2006 to request a revision. In late 2006, both parties eventually agreed the price be increased to US$3.35 MBTU, but once more the pricing formula featured an upper ceiling on the price of oil, now set at a maximum of US$38 per barrel. This new pricing formula was sealed when global oil prices were averaging about US$70 a barrel. It means that for 25 years the price of the Tangguh gas sold to Fujian will never increase much beyond US$3.35 MBTU, even if oil prices always remain above US$100 per barrel or even higher. During the summer of 2008 the price of gas on the international market was approaching US$20 MBTU to reflect oil prices which reached a high of US$147 per barrel in July. Prices agreed with Japan and South Korea mirrored this new reality, and Indonesian energy analyst Kurtubi estimated that such pricing differentials would result in Indonesia losing US$3 billion annually.

As the price of oil continued to climb in 2007 and 2008, domestic political pressures caused a further re-think in Jakarta, and in March 2008 Vice President Jusuf Kalla announced that a further renegotiation of the Fujian contract would be desirable. In the summer of 2008, Jakarta established a Tangguh contract renegotiation team, reporting to Kalla himself and headed by Finance Minister Sri Mulyani Indrawati. In August 2008, Kalla claimed that the Tangguh contract’s present terms would cost Indonesia US$75 billion adding that, “This formula is the worst in the history of the oil industry. The contract is loss-making, especially when the price of oil is high.” Kalla has even pushed the House of Representatives (DPR) to review the deal and the Supreme Audit Agency (BPK) will supposedly investigate the Tangguh contract. With elections on the horizon, part of the reason for such belligerence was to damage the candidacy of Megawati Sukarnoputri who was president when the original Tangguh deal was sealed.

President Susilo Bambang Yudhoyono subsequently met his Chinese counterpart Hu Jintao to renegotiate the Tangguh pricing scheme on October 23, 2008, and this followed a similar meeting after the Beijing Olympics closing ceremony when Kalla also met with Hu and Vice President Xi Jinping. While the two heads of state agreed upon further price negotiations, the concessionary loan programme China has initiated for Indonesia and recent oil price declines might effect Jakarta’s bargaining position. Yudhoyono is pushing for enhanced energy cooperation with China, especially in the construction of power plants, under the concessionary loan scheme. Indeed, energy cooperation has become key to Sino-Indonesia relations. After previously threatening delays, Jakarta has thereby more recently stated that it will not delay Tangguh LNG shipments despite the ongoing price renegotiations.

Nevertheless, some analysts have argued that it would make greater financial sense for Indonesia to cancel the contract, and pay US$300 million in contractual penalties, rather than undersell the gas for 25 years. Such a move would undermine their bilateral memorandum of understanding (MoU) inked in October 2006 to expand cooperation in the energy and mineral resources sectors, but the supply price of US$20 per MBTU agreed with Kogas makes this logic financially compelling. Kalla himself has declined to state what price Indonesia is looking for but US$7 per MBTU seems a fair assumption based on his assessment of a US$75 billion ‘loss’ if the contract is not revised a second time. Meanwhile, an anonymous government official said in September 2008 that Indonesia is seeking a price of US$10 per MBTU for the renegotiated Fujian gas deal.

Indeed, analysts are amazed that Indonesian negotiators ever accepted a pricing formula which placed such a low ceiling on the price of crude. Whilst oil and gas prices were falling in 2002, and China took full advantage with regard to the Tangguh LNG, this was a temporary phenomenon as prices subsequently rose over the following years. To assume that gas prices would not rise for twenty-five years, when accepting such low pricing ceilings of first US$25 then US$38 per barrel, now appears very shortsighted.

According to Purnomo, Energy and Mineral Resources Minister since 2001, the low price was the result of Indonesia’s failed tender for the larger Guangdong supply contract with China. As a consolation prize, China invited Indonesia to become the sole bidder for the Fujian supply contract, but with the US$25 per barrel pricing formula included within that invitation. At the time the price of LNG on the international market was reflecting a supply glut, and Purnomo states that Indonesia had also recently lost tenders in Taiwan and Korea. Having difficulty wooing buyers in Japan too, the original Tangguh pricing formula reeked of desperation. Complicating matters further is the fact that CNOOC now holds a 16.96% stake in the Tangguh scheme, indicating a clear conflict of interest, whilst Japanese firms Nippon Oil Exploration (Berau) Ltd. (12.23%) and LNG Japan Corporation (7.35%) both hold smaller shares. For different reasons, the Tangguh pricing formula is now causing consternation among both Chinese and Japanese buyers, and in hindsight seems to have been handled poorly by the Indonesian government.

Indeed, such erratic management, which characterises the archipelago’s LNG industry, has hit foreign investment hard in recent years. The annual number of gas exploration wells drilled in the country has fallen by around 50% since 1998, and in the government’s 2007-2008 regular tender only nine oil and gas blocks out of twenty-one attracted investors. This is largely due to Jakarta’s insistence on tough production sharing terms, under which the government and operating firms share the output of the block. Such terms deter foreign investment and exploration, which some argue is a holdover from Dutch colonial exploitation. In addition, the lengthening of the investment licensing procedure has deterred investment, and made approvals more complex and time consuming. This reflects a malaise visible in other sectors of the economy, which further dissuades foreign investment. Moreover, a series of contractual production-sharing and long-term-supply disputes pitting Jakarta against multinational energy firms and Japanese LNG importers have also tainted Indonesia’s reputation.

Despite the pitfalls, rising global demand is coaxing Japanese investors back into Indonesia. Whilst in 1996 Japan imported 62% of available world supplies, that proportion had fallen to 41% in 2005 and is under continuing assault as other countries respond to the attractiveness of LNG. In particular, China’s imports of LNG, which began in 2006, are expected to rise rapidly. Although it has two LNG receiving terminals at present, China has plans to build as many as seven LNG terminals in six provinces and municipalities. Indeed, plans were recently announced to build a LNG receiving terminal Qingdao. Responding to this threat, Japan is stepping up its LNG investment in Indonesia.

Then-Japanese Prime Minister Shinzo Abe’s visit to Indonesia in August 2007 coincided with an agreement to accelerate LNG development in Banggai district, Central Sulawesi province, where 51% shareholder Mitsubishi Heavy Industries is constructing an LNG refinery. Land clearance was slated to finish at the US$1.4 billion development by the end of June 2008, and the natural gas will be sourced from the Senoro and Matindok fields owned by Indonesia’s PT Medco Energi International and PT Pertamina. The plant had been scheduled to open in 2011, but progress has been delayed due to difficult pricing negotiations. However, in August 2008, it was finally agreed that Japan will buy 1.7 trillion cubic feet of gas (TCF) over fifteen years from the two fields, with the price based on Japan’s crude oil import costs. This formula, known as the Japan Crude Cocktail, estimates the value of the gas at US$16 billion, based on oil prices of US$100 a barrel. Survey results indicate an annual yield of 2 MT, all of which will be exported to Japan. Mindful of its increasing difficulties in securing a continued supply of Indonesian natural gas, Tokyo had demanded Senoro LNG supply guarantees as part of the Japan-Indonesia Economic Partnership Agreement (JIEPA), whilst the Indonesian side cited a lack of infrastructure to supply it to the domestic market as a reason why the LNG would be exported to Japan.

It is also possible that gas production under exploration in eastern Indonesia’s Timor Sea, a scheme in which the Japanese firm Inpex holds a 100% share, could also be used to meet future export demand. In January 2008, Jakarta was exerting pressure on Inpex to submit a firm proposal by May or risk losing its rights to develop the field, despite Inpex’s original exploration contract of November 1998 expiring in November 2008. Thus, in the final week of May, Inpex duly submitted a project proposal based on estimates of more than 10 TCF of natural gas reserves in the Masela Block’s Abadi field. If confirmed, this will be Indonesia’s second-biggest new gas field after Tangguh which has combined reserves of 14.4 TCF. After deciding not to process the gas in Australia, Inpex has been in negotiations to build Indonesia’s first floating LNG plant instead. The refinery will have just one LNG train but with a capacity of 4.5 MT a year. Shipments are scheduled for a 2016 start, and should provide a huge boost to both countries. Given the ratification of the JIEPA (Japan Indonesia Economic Partnership Agreement) by the Diet on June 1, the timing of Inpex’s proposal could not have been better. The Japanese government holds a 29.35% stake in the firm.

In addition, Inpex has also secured exploration rights for the Semai II block off Papua province. It will carry out exploration with two partners, Consortia Murphy Overseas Ventures Inc. from the United States and Thailand’s PTT, which together will invest US$127.5 million in the first three years of the scheme. The Indonesian government’s share from the projected output from this block is set between 65-85% percent for oil and between 60-70% percent for natural gas. At the same time, Itochu Corporation, Japan’s third largest trading house, is planning to invest around US$4 billion in six energy and infrastructure projects in Indonesia; among them an LNG receiving terminal in West Java, a railway track for coal transport in Central Kalimantan, and a geothermal power plant in North Sumatra, in addition to renewable energy and container projects.

The news from Indonesia indicates the extent to which oil and gas have become seller’s markets recently. However, with Tokyo Gas and Thailand’s PTT both refusing to pay the kind of gas prices that other Japanese and Korean utilities were paying just a few months ago, it remains to be seen for how much longer this situation will continue. In the meantime, Indonesia’s reputation as a reliable supplier has been sullied even further, but Japan continues to push ahead with its efforts to locate and exploit Indonesia’s vast mineral resource base. Whilst the JIEPA has failed to significantly boost bilateral trade, Japanese investment in Indonesia’s energy sector continues apace. China’s emergence as an investor in this sector underlines the importance for Japan to deal carefully and skillfully with the southern archipelago.

References:

Annika Breidthardt, ‘Indonesian Term LNG Deal Sets New Asian Benchmark,’ Reuters, March 31, 2008.

Antara, ‘Japan to Buy LNG from Bontang at Higher-than-Average Price,’ August 20, 2008.

Berita, ‘RI Wants 75 LNG Exports to Japan to be Transported by National Shipping,’ November 4, 2008.

Alfian, ‘Kogas Wants to Extend LNG Supply from RI,’ Jakarta Post, October 16, 2008.

APS Review Gas Market Trends (2005).

Reuters, ‘Japan’s Tohoku Electric Buys Indonesia Tangguh LNG,’ May 20, 2008.

Padjar Iswara, Bunga Manggiasih, Amandra Mustika Megarani, Ninin Damayanti, and Anton Aprianto, ‘Chasing Tangguh All the Way to China’, Tempo, August 2, 2008.

Dow Jones, ‘Indonesia VP: China Understands Need To Seek Gas Price Hike,’ September 5, 2008.

Philip Barnes, Indonesia: The Political Economy of Oil, Oxford University Press, 1995.

Antara, ‘Mitsubishi to Build LNG Refinery in C Sulawesi,’ June 8, 2008.

Jakarta Post, ‘Medco Aims to Halt Oil Output Decline,’ May 6, 2008.

Bloomberg, ‘Medco, Pertamina to Sell $16b of Gas to Japan,’ August 30, 2008.

Ika Krismantari, ‘Japan to Buy More LNG from Indonesia,’ Jakarta Post, August 24, 2007.

Reuters, ‘Japan’s Inpex Due to Unveil Plans on Timor Sea Gas,’ May 14, 2008.

Xinhua, ‘Indonesia Says Inpex Proposes $19.6B LNG Plant,’ June 9, 2008.

BPMigas, ‘Inpex Plans Four-well Masela Program,’ Rigzone.com, May 23, 2007.

Asiapulse, ‘Japan’s Itochu To Invest US$4 Bln In Six Projects In Indonesia,’ August 27, 2008.