Reed Smith Client Alerts

Authors: Chloe J. Carswell David Adelman Patrick A. Beale

Legislators in Indonesia have recently suggested that all petroleum production operations should effectively be state controlled, making many foreign investors in south east Asia’s largest country fear that their assets could in effect be nationalised or ‘expropriated’.

Background Indonesia has a long history of oil exploration, with the Dutch drilling in the late 1800s. Companies such as Shell have been operating in Indonesia for over 100 years. In the 1960s, under the former President Suharto, Pertamina (currently the main Indonesian state-owned oil and gas company) was set up to function as both an oil company and as the state’s chief energy regulator. Pertamina both controlled and supervised oil and gas operations under the various production sharing contracts (PSCs). During this time, most of the companies exploring and producing oil in Indonesia were foreign companies, having invested billions of dollars setting up their operations.

In 2001, former President Susilo Bambang Yudhoyono, who at the time was the energy minister, introduced a new law that split Pertamina apart, making Pertamina a state-owned oil company focussing only on oil and gas operations. All of Pertamina’s regulatory functions were moved into the independent oil and gas regulatory agency called BPMIGAS (Badan Pelaksana Minyak dan Gas Bumi, or the Upstream Oil and Gas Regulatory Agency).

Under the new 2001 oil and gas law, BPMIGAS supervised and controlled the exploration blocks that were allocated to third parties. It did this independently, although reporting to the Ministry of Energy.

In 2012, a nationalistic group allied with former Pertamina power-holders challenged the 2001 oil and gas law at the Constitutional Court, arguing that the supervision of oil and gas should reside with the state, not an independent regulatory agency. In a controversial decision, this group was ultimately successful, and the Court struck down the 2001 law, disbanding BPMIGAS. However, rather than reverting power to state-owned Pertamina, the Government re-formatted BPMIGAS into SKKMIGAS (Satuan Kerja Khusus Pelaksana Kegiatan Usaha Hulu Minyak dan Gas Bumi, or the Special Unit of the Upstream Oil and Gas Regulatory Agency), which sits directly under the energy minister.

New oil and gas law As a result of the 2012 Constitutional Court decision, it has become essential for the Indonesian government to come up with a new oil and gas law. This last week, lawmakers leaked provisions of the new draft law to the media. The provisions of the new draft law suggest that state-owned enterprises should control all production operations, with private investors providing only capital and technology. These provisions of the draft law would boost state-owned oil company Pertamina once more. The new law makes no mention of production sharing or cost recovery, both of which were an essential part of the current exploration system in Indonesia – foreign companies have long been sharing their production with the state, but recovering their costs for doing so.

The lawmakers drafting the new law are looking to finalise it later this year, after which they will submit the new law to Parliament for deliberation and, if successful, passage into law.

What does this mean for foreign investors in Indonesia? The new draft law currently provides that only state-owned oil companies can control oil and gas operations. This suggests that the government may be intending to eliminate the control that private oil and gas companies currently have, by managing their own operations under supervision by SKKMIGAS. Instead, control will shift to Pertamina (or another state-owned entity that may be established), and the private investors can only provide capital and technology. This obviously is worrying for foreign investors who have spent considerable sums investing in oil and gas operations in Indonesia – to lose control of operations would be a significant blow to those investments.

English translations of some of the relevant draft provisions

Article 4

  1. Oil and gas, as a strategic natural resource that is non-renewable and which resides within the legal mining domain of Indonesia, represents a form of national wealth that is controlled by the state.
  2. State control as mentioned in point 1 is carried out by the government as the holder of control over mining.
  3. The government as the holder of control over mining provides business permits for upstream activities to PT Pertamina for every Work Management Region (Pengelolaan Wilayah Kerja).
  4. The government forms a distribution company to ensure the availability and distribution of fuel and natural gas as well as for the development of infrastructure.

Article 6

  1. Upstream oil and gas business activities are conducted based on upstream business permits from the government for special state enterprises or for PT Pertamina for every Work Area.
  2. Upstream business activities as meant in point 1 are carried out with the following considerations:
    A) Upstream business permits are given to PT Pertamina for work regions in which technology, capital and risk can be managed independently by Pertamina.
    B) Upstream business permits are given to special state enterprises for work areas in which technology, capital and risk require partnerships with business entities in cooperation contracts (Kontrak Kerja Sama).
  3. Regarding upstream business activities performed and controlled through upstream oil and gas business permits, these must at least fulfill the following requirements:
    A) The ownership of the natural resource is in the hands of the government
    B) The management control of the operations are under PT Pertamina or a special state enterprise
    C) The entirety of the capital and risk is borne by the company.

Nationalisation and recovering potential losses The new draft oil and gas law has the potential to cause serious financial damage to the value of investments owned or operated by foreign investors in Indonesia and may reduce or eliminate the income these investments generate. One of the biggest consequences of nationalisation will, therefore, be around compensation for loss of the value of an investment and future income potential.

In the latter scenario, foreign investors potentially have four ways of recovering their losses:

i. By a negotiated settlement of compensation claims

ii. Litigating against the state in local courts where there is no provision for dispute resolution outside Indonesia (an unattractive proposition for many)

iii. Invoking agreed contractual dispute resolution provisions (often international arbitration, but limited to contractual claims, perhaps under a PSC)

iv. Investor-state arbitration, brought pursuant to a bilateral or multilateral investment treaty into which the state has entered

Investor-state arbitration is a powerful weapon in the foreign investor’s armory. It entitles a foreign investor (if it has the benefit of an investment treaty) to initiate an arbitration against a state in a supra-national forum, under the auspices of a treaty-based mechanism for the resolution of disputes over investments made by a foreign investor in a foreign state.

Such treaties confer certain substantive rights and protections to foreign investors under international law that are over and above those conferred by contract or national law. These include the right to fair and equitable treatment, full protection and security, protection against denial of justice and arbitrary and discriminatory measures. Importantly, they also protect against direct or indirect expropriation.

It is the latter that is most relevant in the case of state nationalisation of assets owned, controlled, managed or operated by foreign investors in that state.

Indonesia has signed over 60 bilateral investment treaties (BITs). This will enable foreign investors who are nationals of states which are a party to those BITs to bring claims against Indonesia for breach of its obligations under the terms of the treaties.

Of course, states have a sovereign right to regulate and manage their assets, including, importantly, natural resources.

Most, if not all, BITs permit expropriation by the state in certain situations (nationalisation being one of them), subject to strict conditions to protect the foreign investor. Expropriation must be in the public interest, it must be carried out without discrimination and adequate compensation must be provided promptly.

Expropriation is not always obvious. It can be subtle. It has been found in numerous arbitration cases not to be as blatant as the state simply taking legal title to property owned by the foreign investor. It can be an indirect action whereby the investor is unable to use the asset in a meaningful way as a result of unreasonable interference by the state or its value is diminished as a result of certain indirect actions taken by the state. Given the nature of the draft new law, it is entirely possible that there will be direct or indirect expropriation of investments.

BITs are negotiated directly between states and, as a consequence, each treaty is different and its terms will vary. However, if one of the requirements of a ‘lawful’ expropriation, or any other, is disputed, the foreign investor may invoke its rights under the relevant BIT to refer the dispute to an arbitration before well-known international forums such as the International Centre for Settlement of Investment Disputes (ICSID), an arm of the World Bank, the International Chamber of Commerce (ICC) or an ad-hoc arbitration under the Arbitral Rules of the United Nations Commission of International Trade Law (UNCITRAL).

The benefit of investor-state arbitration is that awards are directly enforceable in any jurisdiction that is a signatory to the ICSID Convention (for ICSID Awards), or the New York Convention (for other awards). If the award is the result of an arbitration carried out under the ICSID Convention, investors can also rely on the support of the World Bank to put pressure on the state to pay up.

A year ago, Indonesia announced its intention to allow its BITs to lapse or to actively terminate them. Of course, that would not protect the state against claims by existing investors but, without the benefit of bilateral investment treaties in the future, it will be interesting to see how quickly foreign investment in Indonesia starts to decline.

There is every likelihood that, if there is direct or indirect expropriation, foreign investors will strongly assert their rights through arbitration. Such proceedings, coupled with increased uncertainty regarding the status of Indonesia's investment treaties, is likely to result in foreign investors proceeding with extreme caution in Indonesia.


Client Alert 2015-099