THE INDONESIAN OIL AND GAS COMPETITIVENESS

A PORTER’S DIAMOND BASED ANALYSIS
By Herman Seran

Introduction
As of May 2006, the spot price for crude oil in NYMEX has been around US$70 per barrel or almost twice of that in April 2003. This is a fortune for oil production countries. As an oil and gas producer, Indonesia may benefit from this windfall mirroring its experience before the Asian financial crisis. Prior to crisis, the country’s economic development was strongly supported oil and gas booming during 1970s to 1980s (Gylfason, 2001, Susastro, nd, Temple, 2001). Will Indonesia benefit from the current oil booming? This paper aims to address the question by considering the country’s competitive advantage in the industry employing Porter’s Diamond model.Exploring the Indonesian chance to benefit from this current energy booming implies consideration on the advantages of the country to compete in global energy market. The question is, therefore, what are the competitive advantages of Indonesian oil and gas industry to compete globally or at least play significant role in Asia Pacific oil and gas market. Accordingly, the paper approaches this issue by firstly, briefly discussing the Indonesian macroeconomic position with specific consideration on the role of the oil and gas industry. Secondly, the theory of international competitiveness is touched on briefly to contextualize the Porter’s Diamond model. Thirdly, the current condition of the Indonesian oil and gas industry is assessed employing the Porter’s national competitive advantage determinants.

Economic Indicators and the Role of Oil and Gas Industry
Economic Indicator
The Indonesian economy suffered the most from the 1998 financial crisis. The GDP sharply slumped reaching the lowest level since 1966 at nearly -15% (Temple, 2001). However, as well as political reform, the economic growth has steadily reached the pre-crisis level. Asian Development Bank reported that the GDP growth in 2005 was 5.6%, a significant increase from 3.8% in 2001 (ADB, 2006). Meanwhile, fiscal deficit has encouragingly declined below one percent. The outstanding problems are lowering inflation which experienced a bleak trend during the final quarter, boosting the export which has downed to 13% GDP (17% before crisis), and creating jobs for 2.5 million annual increasing labour forces.
The experts predict a slower economic growth in 2006, due to the current domestic situation, and global issues like spiking oil prices and increasing the US interest rate. Indonesian Central Bank predicts the GDP growth in 2006 will range from 5% to 5.7% (BI, 2006). Meanwhile, the Asian development Bank predicts GDP growth will likely be 5.4% (ADB, 2006).

Indonesian Oil and Gas Industry
Petroleum industry has contributed significantly to the Indonesian economy. As of 2004, the country’s oil and gas reserves were predicted to be 4.7 billion barrels and 2.56 trillion cubic-meters (BP, 2005). It has been argued that natural resource endowment underpinning the Indonesian high economic performance during 1966 to 1998 (Gylfason, 2001, Temple, 2001). Hayashi (2005) reveals that petroleum industry significantly shaped the GDP per capita during 1965 to 2000. For instance, World Energy Council predicts the industry represented 66% of total domestic earnings and 76% of export earnings in 1983 (WEC, 2005).
Nevertheless, soaring domestic demand and continuous decline in oil production since 1994 have made the country a net oil importer in 2004, for the first time ever. Yet, this decline was compensated relatively by growing export in natural gas.
There have been various explanations for the decline in production and increase in domestic consumption. Well exhaustion is the main reason for the down trend of the production (Tse, 2001). Meanwhile, lacking exploration and new discovery are the next contributors (ADB, 2006), in addition to socio-political reasons and OPEC’s strategy to boost oil prices. For example, Exxon-Mobil’s gas production in Aceh was disrupted due to the security problem, while old wells’ production in Cepu, Central Java, has significantly declined. When it comes to consumption, the increase in standard of living may be the explanation. Several analysts, including Asian Development Bank, believe that Indonesian long term oil subsidy was the main trigger for strong domestic consumption (ADB, 2006).
By no means to underestimate the exhaustive and cyclical nature of oil and gas, the country will continue to benefit from the industry, in terms of national export, the source of FDI, and economic multiple effect. Decision to remove most of the oil subsidy is believed to lower the domestic consumption. Thus, the trend of investment in the oil and gas sector indicates an encouraging sign, though the conducive investment condition is still of concern. For example, the recent agreement between the Exxon-Mobil and Pertamina regarding Cepu oil field is a positive precedent to the future investment in the industry (ADB, 2006). This field will contribute approximately 20% of the current daily production (Rigzone News, 2006). Nonetheless, in the next decade the capacity of production is believed to be lower compared to 1999 level (Miriawati, 2004).

International Competitiveness and Porter’s Diamond Model
A country is internationally competitive in a certain industry if it has “the ability to provide internationally a quality product, promptly at a reasonable price” (Gapinski, 2001. p37). To compete in such global environment, a country requires certain advantage over the others which has to be maintained continuously. The term ‘advantage’ is proposed by Adam Smith in 1776 in his book The Wealth of Nations. Smith suggests ‘absolute advantage’ as the explanation for international trade as opposed to mercantilism principle ‘zero sum game’, which has been previously criticized by Hume in 1752 (Gionea, 2004).
The absolute advantage theory is then enhanced by David Ricardo in 1817, by introducing ‘comparative advantage’. Ricardo encourages countries to trade among each other by dedicating their factors of production to the most efficient sectors and obtaining the rest through international trade. Meanwhile, the Hecksher – Ohlin (factor endowment) theory aims to explain the pattern of international trade by revealing that countries are likely to export goods they produce with their abundance factors of production and import what is produced with the factors they scarcely have (Gionea, 2004).
The Porter’s diamond model aims to integrate the previous international trade theories. The model is based on the principle of competition among the nations, by exploiting their competitive advantages and continuously improving them through innovation and technological improvement (Porter, 1990). Porter argues that there are six determinants explaining competitiveness of a country. The determinants form a mutually reinforcing ‘diamond’ system. They are factor endowment, demand condition, related and supporting industries, firm strategy, structure and rivalry, the role of government and chance.
Summarizing his points, factor endowment is divided into basic factors including natural resources, climate, location semiskilled labour, debt capital; and advance factor involving modern infrastructure and skilled human resources and modern technology. These factors are only competitive if they are effectively utilized. Porter stresses the domestic demand as the primary driver for competitiveness. Nevertheless, international demand is likely to the main interest in natural resources sector. Related and supporting industries are very important in helping a firm compete internationally such as suppliers and services industries. Internal condition such as firm structure and strategy in competing domestic rivals is also one of the determinants. Porter believes in the role of the governments is providing supportive environment or the other way around. Finally, chance is factors beyond the control of the industry or government such as economic cycle, war and alike that may influence the competitiveness.

Indonesian Oil and Gas Industry Competitiveness
Factor Endowment
Indonesia has been recognized as one of the oil and gas rich country. Its membership in the OPEC is in support of this argument. In terms of basic factor endowment, the country has significant oil and gas reserves that can compete globally, especially in Asia Pacific region. BP (2005), for example, predicts that Indonesia is one of the largest oil and gas reserves in Asia Pacific as revealed in table 2. Its strategic location near the fast growing economies such as China and Singapore is another advantage. Furthermore, the 240-million population indicates a massive number of potential workforces.
Indonesia is relatively competitive in terms of advance factors. The country is now able to provide skilled workforce to the oil and gas industry. Most of the oil and gas companies employ domestic geologists and engineers. There are hundreds annual graduates from oil and gas related programs from Indonesian universities, though yet to be internationally recognized. There is also large number of operators that have acquired recognizable experiences. These achievements can be seen from increasing number of Indonesian skilled workers employed overseas in natural resources sector, such as Qatar, Malaysia, Laos, Vietnam and Australia. A problem regarding advance factors is high cost communication technology, yet limited coverage. Nevertheless, natural resources companies overcome it by using satellite communication.

Demand condition
Even though strong domestic demand is not the primary concern, nonetheless, it may significantly shape the pattern of the trade. The domestic oil demand is currently getting stronger; gas demand is likewise though in a slower rate. By 2004, the oil consumption has exceeded the production reaching 1.15 million barrels per day, forcing the country to import crude oil. Nevertheless, gas export continues to grow thanks to low domestic demand.
The international consumption has outpaced the global production. The global oil demand has increased reaching 80.76 million barrels per day or nearly 3.4% increase from 2003 consumption level. This number reveals nearly 0.5 million barrels daily deficit in global oil supply as the 2004 production was 80.26 million barrels per day. The global gas consumption, similarly, indicates a faster pace compared to the production pace. For example, in 2004 gas consumption was 3.3% higher than 2003, whereas the production just increased by 2.8%.
The United States, OECD, and Asia Pacific nations were accounted for the majority of share in hydrocarbon consumption. The demand in China and India is expected to grow given their fast growing economies. Accordingly, the global oil deficit will broaden and gas consumption is likely to follow. For example, most of the fast growing Asia Pacific economies experienced roughly two digits annual growth in oil consumption during 2004, with China accounted for nearly 16% (6.68 million barrels daily). Additionally, in Asia Pacific region, the gas demand in Singapore and Hong Kong experienced the most dramatic annual growth in 2004 (45.7% and 44.5% respectively).

Firm Structure, Strategy and Rivalry
The majority of the oil and gas companies operating in Indonesia are overseas affiliation. Their headquarters are mostly in the US, Europe, and several Asia Pacific companies such Petronas and Petrochina International. Despite the state-owned company, Pertamina, there have also been several Indonesian oil companies such as Medco and so on. Given the economies of scale, there has been limited number of companies entering the industry. This results in an oligopolistic environment dominated by companies like Chevron, Exxon Mobil, British Petroleum and Total. This structure, nevertheless, enables the companies to overcome the technology and knowledge capital constrains. For example, the oil and gas companies employ the cutting edge technology from their host countries, such Exxon-Mobil using 4-D seismic technology from the US.
The oil and gas companies, in general, operate their exploration and production fields under joint venture or contract schemes. These strategies help them to spread the risks and distribute the resources among the companies. The schemes also positively contribute to the local partners through the transfer of knowledge and technology. For example, Total Indonesie, one of the biggest gas producers, normally contracts out many of its exploration and maintenance works to local companies, hence local partners should fulfil the required standard. Meanwhile, Medco and Pertamina jointly operate the Tiaka oilfield in offshore Central Sulawesi.

Related and Supporting Industry
As mentioned previously, contractor and service industries play essential role in Indonesian oil and gas industry. Do these related industries deliver an international standard of services? There is large number of world class service industry operating in Indonesia. Particularly, many international financial institutions operate in the country, such like PricewaterhouseCoopers, Ernst and Young, Citibank, and many more. International oil and gas contractors and services are also available; Schlumberger, Geoprolog, and Paradigm just to name a few. Accordingly, there is no real problem regarding world class supporting industries. Nevertheless, investors are still facing the problems regarding research and development and reliable database regarding the industry. Several companies, like Miningindo, have started to provide such information. Yet, research and development still heavily relay on the oil and gas companies.
On the subject of downstream industry, Pertamina still possesses privilege to market the subsidized gasoline and diesel fuels domestically. However, under Government Regulation no. 36/2004, oil and gas operators are eligible to sale their own processed fuel, such as operating unsubsidized fuel stations (Luckey and Gupta, 2004). This new regulation allows oil and gas firms to establish their own processing, transportation, and trade facilities and networks. Furthermore, there have also been established downstream businesses supporting the oil and gas upstream like refineries, gas pipeline to Singapore, and transportation facilities. Frequent domestic fuel supply disruption becomes the main concern as the vast majority of downstream business is still operated by Pertamina plus poor physical infrastructures.

Government Policies and Practices
Government role is the next determinant for the energy businesses after the factor endowment. Tilton (2002) argues that government can boost the competitiveness by creating necessary conditions for innovation and technological improvement. This role materializes in the form of fiscal policies including taxes and royalties, and investment policies.
Governance and law uncertainty are the Indonesia’s main pitfalls (Basri, 2005). Lack of professionalism, unnecessary bureaucracy, and contradiction among regulations are a few that deteriorate Indonesia’s oil and gas investment. To illustrate, investors have experienced difficulties in dealing with conflict between local and central government regulations, and inexperience local government officials since the implementation of regional autonomy in 1998.
In terms of fiscal policy, the main concern is taxes and royalty system. Indonesia is the first country employs contract production sharing (KPS) between the field operator i.e. oil and gas company and the government. Current share ratios are 65:35 for oil and 60:40 for gas in favour to the government or roughly 5 to 14% revenue (Wells, 2006), yet it is subject to negotiation based on individual project (WEC, 2006). This scheme may create uncertainty for companies in calculating the taxes and royalty portions, yet it provides undisputable share between the parties. Hence, the scheme is now widely adopted by most of the Middle Eastern and Asian countries (Wells, 2006).

Chance
The oil and gas industry faces various external forces that can either positively or negatively impact the competitiveness. Firstly, Global oil shortage, fast growing economies such as China and India, political instability in the Middle East are the possible factors for increasing oil and gas prices. Higher oil prices stimulate the companies to increase their exploration budget. Middle Eastern unrests make Indonesia as an alternative choice for oil and gas investment. Meanwhile, under ceteris paribus condition, it will be cheaper for the South East Asian countries to import oil and gas from Indonesia, instead of the Middle East or Russia thanks to Indonesia’s strategic position.
The external factors that may hamper the Indonesian petroleum competitiveness are environmental issues, alternative energy, and pandemic diseases such avian flu and SARS. Uranium and coal are the main substitutes for oil and gas fuels. Furthermore, there has been strong demand for cleaner energy. In conjunction with increasing oil prices, the countries will seek alternatives energy sources like ethanol, wind, tide, and waterfalls. For instance, the trend of global oil and gas demand will change significantly by China’s plan to increase uranium-based power plants. Meanwhile, increasing campaign for utilizing ethanol fuel will decrease the demand for gasoline and diesel fuel. Other issues are regarding pandemic diseases such as avian flue and SARS. These pandemics were firstly encountered in East Asia; thus considerable number of Indonesians died from avian flu. This condition may affect the companies’ decisions to invest in Indonesia including oil and gas industry.

Conclusion
Indonesia’s oil and gas industry is still competitive in the global market, especially in Asia Pacific region, even though not as strong as pre-economic crisis. The macroeconomic indicators and investment climate sound encouraging. Meanwhile, the country has considerable oil and gas reserves, with a strong domestic and regional demand, in addition to its strategic geographical setting. Domestically, Indonesia is able to support the industry with large number of labour forces and adequate number of skilled workforce. There are also reliable supporting industries such as world class financial and technical services companies. Well established world class oil and gas operators and other operational strategies are significant properties to operate competitively. Furthermore, current regulatory reform and the improvement of investment incentive are believed to enhance the domestic investment in oil and gas industry. The competitiveness is also strengthened by increasing fuel prices, deepening global oil deficits, and political instability in hydrocarbon rich countries.
However, there are prices for regaining such competitiveness. The government needs to boost investment in exploration and provide incentive to optimize the existing wells in order to maintain a sustainable competitiveness. Accordingly, the government needs to address governance related issues including improving professionalism and the quality of the service. Resolving the contradiction among regulations, including those relates to the implementation of regional autonomy is a must. Upgrading communication infrastructure is of concern as well as transportation. Increasing the investors’ confidence by implementing strategic approaches in tackling the pandemics in the region is also required.

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