Via Stratfor (subscription required), a detailed analysis of Indonesia’s transition from being a major oil exporter to leaving the Organization of Petroleum Exporting Countries to seeing its natural gas prospects expand.  As the article notes, the question now is whether the government — which received a strong mandate in recent elections — will be able to make reforms to bring in the foreign investment the energy sector needs:

“…Indonesia’s long-awaited Tangguh liquefied natural gas (LNG) facility in the far eastern province of West Papua began operating earlier in July. The facility, which has the capacity to add 10 billion cubic meters (bcm) to Indonesia’s LNG production, is now sending its first shipments of LNG to Gwangyang, South Korea and soon will begin shipments to Fujian, China. Indonesia has been an important energy producer in East Asia since the late 19th century. Energy exports are crucial to the state’s operations, with oil and natural gas together providing 25-45 percent of total government revenues in recent years. Yet the oil sector has been in decline for years, and natural gas offers the best way for Indonesia to pick up the slack — if it can attract the foreign investment.

Suharto and the Energy Sector

Indonesia’s energy sector retains the imprint of Gen. Suharto, who ruled the country from 1967-1998 and used the state-owned energy company Pertamina to manage the country’s oil and natural gas sector, funneling the profits into government coffers in order to fund fiscal policies aimed at consolidating his power and boosting economic development in other sectors across the country. Yet rapid economic growth led to rising energy consumption, while government mismanagement and rampant corruption took their toll on the industry, creating inefficiencies and driving away foreign investment. A non-diversified energy mix further increased demand for oil and oil exports began to decrease in the early 1980s, though they remained strong until the Asian financial crisis of 1997-1998 precipitated the collapse of the Suharto regime and sent shock waves rippling through the country.

In the years after Suharto’s fall, various islands attempted to secede, violence broke out, the military attempted to re-establish control over restive regions, and conflicts erupted in resource-rich areas like Aceh, East Timor and West Papua. The weak economy and chaotic atmosphere — not to mention revelations of financial misconduct and deeply embedded corruption in the offices of Pertamina — threatened oil and gas companies’ operations and deterred foreign investment at a time when oilfields were maturing. As a result, the industry suffered from lack of access to the private capital, technology and expertise necessary to keep the oil sector up to date.

Oil production has thus declined since 1998. Without investment for exploration and development, few new oil fields could replace old mature fields, and reserves fell from 11.6 billion barrels in 1980 to 3.7 billion in 2009 (behind China, India, Malaysia, Vietnam and Australia). Production fell from its peak in 1991 at 1.67 million barrels per day (bpd) to 1 million bpd in 2008 — the same level as in 1972. Domestic consumption ate up a greater share of production as it increased from 410,000 bpd to 1.2 million bpd from 1980 to 2009. Consumption increased even more rapidly in the 2000s as the government adopted fuel subsidies to ease the effects of high fuel prices on citizens, causing overall consumption to increase. Indonesia became a net oil importer in 2004 and finally suspended its membership in the Organization of the Petroleum Exporting Countries at the end of 2008.

The Potential of Natural Gas

At the same time, natural gas has much greater potential as the driver for Indonesia’s energy sector in the future. From 1980 to 2009, while oil reserves fell, natural gas reserves climbed from 820 bcm to 3.18 trillion cubic meters, the largest reserves in the region. Production has risen from 1.2 bcm to 69.7 bcm — 2.3 percent of the world’s total natural gas production — during the same period. And while domestic gas consumption has also risen rapidly, especially as oil became more expensive, nevertheless production remains well ahead of consumption, leaving a surplus of approximately 31.7 bcm in 2008.

LNG technology is crucial because it allows an archipelagic country like Indonesia to export natural gas to a wider range of customers (Indonesia already has the ability to export gas via pipeline to Malaysia and Singapore). Indonesia is currently the world’s third-largest exporter of LNG, with exports consistently topping 25 bcm per year. LNG exports have grown over the years, accounting for approximately 8-10 percent of the country’s total exports by value over the past decade. In 1992, LNG exports generated about $4 billion; that number grew to nearly $10 billion in 2006 and 2007 and to nearly $13 billion after price spikes in 2008. Since 1989, natural gas exports have equaled between 2 and 3 percent of gross domestic product (GDP), while oil fell from nearly 5 percent of GDP to around 2 percent.

Currently Indonesia exports its LNG from the Bontang liquefaction plant in East Kalimantan, which has a capacity of 29 bcm per year, and the Arun plant in Aceh, whose capacity is approximately 15.8 bcm per year. But the country’s LNG operations have encountered difficulties. Arun’s reserves are 90 percent depleted, and production was halted for four months in 2001 due to military clashes with Acehnese separatists; meanwhile, the Bontang facility has fallen short of production and suffered from poor maintenance and operations. The Indonesian government has also diverted production to provide local fertilizer makers with low-priced gas. As a result of these and other problems, LNG production has waxed and waned over the past decade.

The new Tangguh LNG terminal is expected to partially remedy this situation by boosting production and showing that Indonesia’s LNG sector is alive and well. Tangguh has the capacity to supply 10 bcm of new LNG per year. The additional output is expected to bring Indonesia’s total LNG capacity to about 45 bcm per year and total natural gas production to about 80 bcm per year in 2009 — well above domestic consumption, which could exceed 40 bcm.

Tangguh also signifies Indonesia’s widening export markets. LNG from the Bontang and Arun plants go to Japanese consumers, with some LNG going to South Korea and Taiwan. But Tangguh will service not only South Korea (whose Gwangyang terminal received the maiden shipment) and Japan, but also China’s new Fujian regasification terminal, starting in late July. The United States has already contracted half of Tangguh’s output to be received at Baja California, Mexico. Amid the global recession, demand for natural gas is low, but in the long run Indonesia is poised to take advantage of hungry consumers in these countries.

The wide range of potential markets highlights the strategic advantage of LNG. It is particularly important for Indonesia, a massive archipelago that historically has had trouble maintaining control over its outer regions. Java, the core island, traditionally has kept the country unified by sending workers to outlying regions to extract resources, while diluting the power of local populations and reducing the potential for secessionist rebellions or foreign intrusion. Revenues from production go into maintaining the industries, military and bureaucracy needed to strengthen central control. Yet because of inherent geographic difficulties and high costs of production, the Javanese also need to import foreign labor and technology to develop their resource production.

This strategy still applies today. First, Jakarta must focus on maintaining some of the country’s biggest natural gas deposits, which are also the sites of the existing LNG facilities: East Kalimantan, West Papua and the restive Aceh province on the northernmost tip of Sumatra. The next handful of proposed LNG facilities (which are still far from being realized) would be located in the South China Sea (the Natuna plant), Central Sulawesi (Sengkang and Donggi Senoro) and off the coast of East Timor (Masela). These regions are precisely the areas where separatism and conflict erupted in 1998 when the country nearly disintegrated. Furthermore, many are prone to risks related to geography and climate — the Aceh region, for instance, was severely damaged during the 2004 tsunami. Jakarta knows it will require effort on its part to make these areas attractive to potential investors, and that its long-term national security and economic success are at stake.

But in order to concentrate on internal development, Indonesia also must strive for security against external threats. The South China Sea has been a hotbed of territorial disputes so far in 2009, and the desire driving those disputes — energy security — will not fade anytime soon. Indonesia’s biggest natural gas reserves (estimated at 6.3 trillion cubic meters) lie offshore in Natuna, between Malaysia’s peninsular and insular regions. Naval tensions over claims to gas-producing territory have recently flared up again between Malaysia and Indonesia, but in the realm of maritime territorial disputes Indonesia is likely to see China as its greatest potential external threat. Beijing’s economic and political survival depends on maintaining access to energy sources, and with China’s naval capability improving year by year, Indonesia can imagine a future in which a hostile China attempts to grab outlying, resource-rich maritime territories.

Therefore, it is in Indonesia’s interests to make itself indispensable to a diverse group of energy investors and consumers — especially to those who are geographically distant — so that nearby forces that might be tempted to lay claim to Indonesian territory (or foster separatist tendencies within its territory) are reined in by other interests. The United States is the most viable option in this regard due to its demand for natural gas, its historical alliance with Indonesia, and its utility in counterbalancing a China that will inevitably come too close for comfort.

Indonesia’s Political Situation and Investment

Even when order was more or less restored in Indonesia after the post-Suharto madness, investors remained reluctant to return, as the first elected governments were prone to nationalistic interventions in the business sector and ceaseless political struggles between rival interest groups. But since 2004, Indonesia’s reformist President Susilo Bambang Yudhoyono has attempted to spur economic growth by providing the things investors are looking for, including security, transparency and legal predictability. On the energy front, the Yudhoyono government has attempted to bring in foreign investors and to revive Pertamina by reshuffling its top executives, waging anti-corruption campaigns and forcing the company to undertake restructuring with the eventual goal of privatization.

The reforms have had decidedly mixed success, but they have been enough to attract Japanese, Chinese and U.S. investors, among others, to Indonesian LNG projects including Tangguh. Nevertheless, nationalist pressures continue to exert their force, most recently calling for the government to reserve all natural gas from the future Donggi Senoro project for domestic markets, which would reverse agreements with foreign investors to export it and drive away future investment.

However, Yudhoyono’s re-election in July, along with the strong mandate given to his Democratic Party in the House of Representatives in April elections, has given him the most political capital that an elected Indonesian president has yet had, as well as another five-year term to attempt to push forward his preferred reformist policies. Attracting investment for natural resource development, particularly in the energy sector, will be a crucial test of the Yudhoyono administration’s success. Corruption, lack of transparency and the legal and regulatory environment in Indonesia all pose significant challenges even for a president with such broad consensus behind his rule.

Further complications arise in the inherent difficulty of governing and maintaining stability in Indonesia. Though the country has been gradually stabilizing since 2005, the security situation came into focus again with the July 17 bombings in Jakarta, and to a lesser extent the shootings at the Grasberg mine in West Papua in the wake of Yudhoyono’s re-election. The new Tangguh LNG facility, also located in restive West Papua, is another possible target. The possibility of such attacks is ever present, though attacks would have to happen more frequently than they have been to derail the broader trend of stabilization that Indonesia appears to be following. Still, Yudhoyono will have to respond decisively to the July 17 attacks if he is to reassure potential investors, who have now been reminded that Indonesia, with its fragmentary geography, is inherently a risky place.”