Moving into gear: Key changes to the legal framework buoy the sector’s prospects

Buffeted by volatile global commodity prices and legislative uncertainty at home, Indonesia’s mineral output has fluctuated considerably in recent years.

After recovering from a commodity price slump starting in 2008, the sector picked up steam in 2011, in part due to rising demand from emerging economies, resulting in higher levels of both prices and output for Indonesia. These gains proved short lived, however, as prices again receded in 2012 (except gold), resulting in most mining operations in the country taking a financial hit in 2012 compared to the previous year. This was in spite of higher output driven by strong production of nickel in Sulawesi, and declines continued into the first half of 2013. The environment was further complicated by ongoing uncertainty regarding the future of the country’s regulatory framework, particularly foreign divestiture requirements, domestic refining requirements and export restrictions. In contrast the thermal coal segment appears strong, recording production growth owing to regional demand. The performance of coal companies has been less bullish, however, as lower prices in 2012 cut into profits for coal operators. “Top-end mining companies are still performing well, but due to low commodity prices smaller mining companies have been suffering,” Dharma Djojonegoro, president director of Multi Nitrotama Kimia, a local producer of mining explosives, told OBG. “Maybe about 20-30% of the more marginal coal mines had to reduce or stop production because of the price drop in coal.”

Numbers Game

The mining sector has grown substantially over the past decade, increasing in value from Rp205.25trn ($25.52bn), or 8.94% of GDP, in 2004, to Rp1.02qrn ($102bn), or 11.24% in 2013, in current prices. These figures also include oil and gas mining and quarrying, respectively, with the former accounting for Rp401.14trn ($40.11bn), or 4.42% of GDP in 2013, and the latter Rp141.81trn ($14.18bn), equivalent to 1.57%, according to the Indonesian Central Statistics Agency. Notwithstanding, the mining sector’s 2013 contribution to GDP was down on the 11.8% recorded in 2012.

Led by its plentiful coal shipments, the sector plays a substantial role in the country’s export trade, with mining products accounting for around one-fifth of total export value from 2010 to 2012, according to the central bank, Bank Indonesia (BI). Mining exports totalled $33.94bn in 2013, accounting for 20.88% of the country’s total exports, up slightly from $31.23bn, or 20.47% of the total in 2012. Of the 2013 figure, coal represented the lion’s share at $26.64bn, or 16.39% of all exports, followed by copper ore at $3.38bn, nickel ore at $1.88bn and bauxite at $1.39bn.

Investment into the sector, meanwhile, increased by an annual average of 17% from 2010 to 2012, according to data from the Ministry of Energy and Mineral Resources (MEMR). The figure reached $4.23bn in 2012, up 32.6% on $3.41bn recorded in 2011, and was split among contracts of work (CoW), coal CoW (CCoW), state-owned enterprises and mining services.

Hurry Up & Wait

Indonesia’s mining sector is governed primarily by the Law on Mineral and Coal Mining passed in 2009, which replaced previous legislation drawn up in 1967, along with its accompanying secondary regulations enacted thereafter. The government has insisted that the new law is necessary to revamp its contract system in order to create a reliable framework for foreign investment as well as to retain more revenue domestically from the mining value chain.

The new framework includes a number of provisions which mark a departure from its predecessors in terms of displaying more resource nationalism. To this end, there are more restrictions on the export of raw materials, more stringent domestic processing requirements for ore, domestic market obligations (DMOs) and increased divestment requirements of foreign-owned operations. Even the traditional CoW framework governing foreign investment and the separate mining rights, or kuasa pertambangan (KP), licensing system for Indonesian investors has been replaced by the new mining business licence, or izin usaha pertambangan (IUP), system. With discussions ongoing between the government and private sector regarding the merits and feasibility of the new provisions, the former has taken the decision to defend and review certain aspects of the Mining Law. As a result, a series of secondary measures have been adopted altering the timeframe of implementation, exceptions and other changes.

Playing Catch Up

All in all, these actions have done little to enhance the sector’s profile, with Indonesia ranked last (96th out of 96 jurisdictions) behind Kyrgyzstan, the Democratic Republic of Congo, Venezuela and Vietnam on the Policy Potential Index (PPI), according to the Fraser Institute’s “2012/13 Survey of Mining Companies”. The PPI is comprised of survey results gathered through 742 responses covering exploration, development and other mining-related companies, to 15 policy factors that affect investment decisions. Indonesia also ranked second behind only Mongolia in the category of “room for improvement” and second to last, behind only Egypt, in the category of “legal processes that are fair, transparent, non-corrupt, timely and efficiently administered”. By contrast, the country scored fourth on “policy and mineral potential assuming no land use restrictions in place and assuming industry best practices”, behind only Mongolia, the Yukon (Canada) and Papua New Guinea.

Export Ban & Domestic Processing

Under the terms of the new structure, IUP and special mining permits (IUPK) holders are now required to carry out mineral processing domestically or arrange to go through a third party that has a special production operation licence for refining and processing. The implementation deadline was set at January 14, 2014 for firms already in the production phase, with those in the exploration phase given a February 6, 2015 date and for those in the construction phase, February 6, 2016. In addition to the domestic processing requirements, a separate provision, MEMR Regulation 7/2012 was issued in February 2012 which banned outright exports of ore and raw materials. The original implementation date for the ban set for May 2012 was pushed back to January 2014, allowing companies to continue shipping unprocessed minerals abroad albeit with a caveat in the form of a new 20% export duty (Ministry of Finance Regulation No 75/2012) on mineral and stone items, as well as mandatory export approval from the Ministry of Trade (MoT), and registration as an exporter.

Challenges

Given the country’s limited refinery capacity relative to its production, full compliance would require tens of billions of dollars of new investments. The country’s total copper smelting capacity is roughly 2.4m tonnes per annum (tpa), around one-tenth of the capability required to domestically process Indonesia’s total output as per MEMR data. Nickel smelting is more encouraging with a capacity of 19.18m tpa compared to a production of around 33m tonnes, while bauxite capacity is 7.1m tpa, with production of 30m tpa.

One challenge for mining companies is that both the truncated implementation timeline as well as large capital expenditures for relatively small profit margins make compliance with the law all but impossible in the time allotted and in many cases economically unfeasible even in the long term. For minerals that Indonesia does not produce significant quantities of, such as silver, obtaining enough feedstock to justify a smelter would also be difficult. Other factors such as key infrastructure gaps also create additional hurdles to full compliance, particularly for electricity whereby there is already a national supply shortage, something that smelters require a large and consistent supply of. CLEARER HORIZONS?: In response to sector concerns, the Indonesian Chamber of Commerce and Industry (KADIN) announced plans in October 2013 to set up a team to provide the government with input and recommendations particularly related to the raw mineral export ban. According to KADIN, recommendations would be made on several issues, including the criteria companies would need to fulfil to be exempt from the raw material export ban, the applicable transition period for the full implementation of the ban, cooperation among big companies to develop processing facilities and possible supervision for companies claiming the smelting plant projects. As of November 2013, strong indications were given by the government that the law would proceed as planned, but that loopholes and exceptions could also be introduced in practice. Some of the key issues which will need to be addressed by the government include determining which materials lend themselves to be refined domestically and still be profitable, and creating an efficient regulatory process to determine those mining companies capable and motivated to develop their own refining capacity. So far, these new export restrictions do not apply to holders of existing CoW agreements, which include several large-scale operations in the country, including Freeport McMoRan Copper & Gold, Newmont Nusa Tengarra (PTNNT) and Vale. These firms are not immune to the effects of the new framework, however, as contract negotiations for the mandatory transition from the old CoW regimen to newer IUPs are ongoing for the majority of contracts (97 contracts outstanding as of May 2013). These negotiations cover a number of issues surrounding old contracts and new requirements, specifically the size of mining areas, contract extensions, amount of royalties and taxation structure, domestic processing requirements, divestment, and the utilisation of local goods and services. While this law has facilitated a flurry of interest in smelting, with dozens of plans for new smelting operations filed by companies seeking to avoid immediate effects of the ban starting in 2014, the government has so far indicated a stricter interpretation of the law. In spite of filing memoranda of understanding (MoU) in 2013 to construct new smelters for their copper and gold operations, two of the nation’s largest mining companies – Freeport Indonesia and PTNNT – were told by the Coordinating Ministry of Economic Affairs in August 2013 that the MoUs would not exempt them from the domestic refining law. The country’s coal trade has not been immune to regulation either, with the authorities implementing a benchmark pricing scheme for coal and mineral exports, in addition to ongoing discussions on draft regulations prohibiting the export of low energy coal with a caloric value of less than 5700 kCal. This is on top of possible costly upgrading requirements for low rank coal.

Clean & Clear

Another bureaucratic obstacle the Mining Law was intended to address is overlapping usage rights and categorisation of land at the local, regional and federal level. “Land acquisition is problematic primarily due to the complete absence of the rule of law in some regional areas paired with the lack of a current land registry. This means that a landowner can simply point at a piece of land and claim ownership, leaving little available recourse for mining companies,” Freddy Setiawan, chairman of mining specialists Megah Pratama Resources, told OBG.

In a survey published in May 2013 by PwC in conjunction with the Indonesian Mining Association and the Indonesian Coal Mining Association, the single most significant concern about the local mining sector (out of a total of 17 options) was the lack of coordination among the central, provincial and regional governments. This was followed by conflicts between mining operations and forestry regulations, with confusion over the implementation regulations for the new mining law coming in third. Multiple contradictory claims on property along with significant areas of land categorised as off limits for commercial resource extraction purposes has led to a backlog of permit applications and appeals processes causing gridlock in the permit system. As a means of rectifying this backlog, the government has set about mapping the areas where mining is permitted, which includes occasional competing interests of federal, local and regional governments, as well as different types of extractive industries. The process then sets about determining the “clean and clear” status of existing mining licences under the jurisdiction of the 2009 Mining Law, with around half of the roughly 10,000 mining licences sorted through as of May 2013.

New Baseline

Ongoing progress and completion of this programme is key not only in clarifying the parameters of existing operations and weeding out fraudulent, illegal, unworked or abandoned claims, but also because no new mining licences (with the exception of converted KPs) can be issued until the culmination of the process. Although the task has taken longer than anticipated, once completed, registry should provide a reliable baseline for new projects to proceed with a higher assurance of accuracy. Other recent benefits granted to investors include the tax allowance (GR No 52/2011) and tax holiday (ministry regulation 130/2011) passed in 2011, as well as import duty exemption from capital goods. The government has also stated it may relax foreign divestment requirements, if they comply with local processing caveats, though no policy decisions or legislation have yet been made public. Changes to foreign divestment requirements first outlined four years ago were also recently crystallised with the passage of MEMR Regulation 27/2013 and will have repercussions for current and future mining companies with domestic operations (see analysis).

Coal

Indonesia remains one of the world’s leading coal producers, ranking fourth in production in 2012 with 237.4m tonnes of oil equivalent (mtoe), positioning the country behind only China (1825 mtoe), the US (515.9 mtoe) and Australia (241.1 mtoe), according to British Petroleum’s “Statistical Review of World Energy 2013”. Although Indonesia accounts for 6.2% of global production, proven reserves were estimated at just 0.6% of worldwide supplies in 2012, approximately 5.53bn tonnes (4.01bn tonnes of sub-bituminous and lignite and roughly 1.52bn tonnes of anthracite and bituminous). The majority of these deposits are located in South Sumatra, South Kalimantan and East Kalimantan, with various smaller pockets elsewhere on Sumatra, Java, Kalimantan, Sulawesi and Papua. Fuelled mostly by demand within the Asia-Pacific region and the opening of the sector to foreign investment in the 1990s, output has risen substantially over the two past decades, up from 17 mtoe produced in 1992 to 63.5 mtoe in 2002. More recently, growth of 9% was recorded with 2011’s output of 217.3 mtoe (353m tonnes). The majority of mined coal consists of a medium-quality type (between 5100 and 6100 cal/gram) and a low-quality type (below 5100 cal/gram), and is exported primarily to China, India, Japan and Korea. Indonesia exported 304m tonnes of coal in 2012, up from 272m tonnes in 2011, while domestic consumption largely remained static at 80m tonnes in 2011 and 79m tonnes in 2012. However, this ratio is expected to shift towards domestic consumption in the coming years, as a host of new coal-fired power plants are set to be built over the next decade and the government is likely to increase export taxes. Continued growth of overall production, however, is far from guaranteed if market prices stay depressed and the government inflexible in its plans to increase royalties and export duties on coal (as stipulated in the 2009 Mining Law). Coal royalties currently range from 2% to 7% for those companies that work under an IUP, and 13.5% for those that work under joint coal-mining contractors (PKP2B) and earlier generation CCoW agreements. Under the new regulations, which came into force in January 2014, royalties for IUP holders (generally small and medium-sized operations) have increased from 10% to 13.5% depending on the caloric value of their output. Similar to the minerals segment, resistance to the new regulations has been significant, and actual implementation of the law remains in doubt. Still recovering from a drop in commodity prices, smaller mining outfits have already been forced to curtail activity or even shutter their operations, while larger players have ramped up output to lower unit costs in an effort to ride out the downturn.

A benchmark pricing system (MEMR regulations 11 and 17) was established in 2012, along with the DMO (MEMR 34) in 2009, leaving other outstanding issues so far unresolved. This includes the export ban for coal with a calorific value of less than 5700 kCal, an issue which is not expected to be fully addressed until at least after the 2014 presidential elections. Under the DMO arrangement, the MEMR set the DMO requirements at 74.32m tonnes for 2013, spread among 74 coal mining companies, which was equivalent to 20.3% of forecasted coal output for that year. Regarding higher export duties, at the time of publication in early 2014 the government had not announced any specific details.

Contract specifications under the new system for coal companies are similar to those of mineral agreements: coal exploration IUPs and IUPKs are valid for seven years, while production is permitted over a 20-year period, with two optional 10-year extensions. Licensed areas are smaller for coal, ranging in size from 5000 ha to 50,000 ha during the exploratory phase, and reduced to a maximum area of 25,000 ha after three years. Production can cover a maximum of 15,000 ha.

Tin

The world’s second largest producer of tin behind China, Indonesia produced an estimated 40,000 tonnes in 2013 compared to 41,000 tonnes in 2012, according to US Geological Survey (USGS) figures. Recent policy decisions from both the government and by tin mining companies themselves have had significant effects on tin commodity prices, with the industry first propping up slumping tin prices in mid-2012 by collectively curtailing sales, as well as later in 2013 when the government enacted new purity and trading restrictions. The most notable government regulation was a move in August 2013 to require all 47 registered tin ingot exporters to trade tin on the country’s domestic exchange before shipping material, which followed an earlier ruling in July of that year to increase purity standards for exports to 99.9% purity. In response to the new requirements, Indonesia's leading tin exporter, state-owned Timah, halted shipments and declared force majeure in September. Although the regulations have boosted tin commodity prices substantially, Indonesian shipments have fallen off as well, due mostly to the regulatory restrictions. Refined tin shipments, for instance, fell to an 11-month low of 6465 tonnes in July 2013 after exporting 98,817 tonnes in 2012, according to MoT statistics. Decreased tin supply to global markets has pushed up benchmark prices on the London Metal Exchange (LME) by 18% since the end of June 2013 to $23,285 per tonne in late September, whereas tin contracts traded on the Indonesia Commodity and Derivatives Exchange rose from $21,500 at the start of September to $23,285 by the end of the month.

Nickel

Even as global nickel prices continue to contract due to reduced demand from the world’s leading importer China, which uses the metal for stainless steel production in products such as cutlery, production continues to accelerate as mining companies pursue a strategy of increasing economies of scale and reducing unit costs. After remaining soft in 2012, nickel prices declined into 2013 with three-month delivery nickel hitting $13,205 per tonne on the LME on July 9, 2013, its lowest level since May 2009 and down from nearly $19,000 in February. While this has affected the bottom lines of major nickel producers, including those operating in Indonesia such as state majority-owned Antam and Vale Indonesia (formerly Inco Indonesia), production continues to be strong. Sourced mainly from Sulawesi, nickel mine production jumped from 228,000 tonnes in 2012 to 440,000 tonnes in 2013, according to USGS data. Exports have also continued their upward swing, increasing from 10.65m tonnes of nickel ore in 2009 to 19.05m tonnes in 2010, 37.47m tonnes in 2011 and 47.06m in 2012, according to CB&I. In spite of the 25.6% hike in volume from 2011 to 2012, export receipts for nickel shipments increased just 10.01% due to lower commodity prices, which dropped from $1.33bn to $1.47bn. Indonesia’s total nickel content reserves are estimated at 3.9m tonnes by the USGS.

Bauxite

Interest in aluminium ore, which is also used in the production of non-metallurgical products such as abrasives, chemicals and refractories, and in bauxite rock has grown in demand in recent years, spurring a corresponding spike in production and exports. Accompanied by other rare metals such as monazite, the bauxite is found almost exclusively in East Kalimantan, as well as on the Lingga Islands and Bangka-Belitung Islands, which are off the west coast of Java.

Exports of bauxite more than tripled from 11.56m tonnes to 39.64m tonnes between 2007 and 2011, before falling to 29.57m tonnes in 2012, as per CB&I data. The country’s total bauxite reserves were estimated by the USGS to be 1bn tonnes as of February 2014.

Other Metals

Along with the primary production of gold, copper, coal, tin and nickel, several other metals are recovered either as secondary output from other mining operations or through single dedicated mines. Ferro and associated metals, such as iron, cobalt, manganese and chromate, are distributed across the country with the greatest concentrations located along Western Sumatra, Southern Java, East and West Nusa Tenggara, South Kalimantan, Sulawesi and North Maluku, as per data from the Geological Agency of Indonesia. Precious metals such as silver and platinum are concentrated in Western and Southern Sumatra, Eastern Java, Kalimantan and North Sulawesi, while other base metals, namely lead and zinc, often accompany copper and tin finds, which are also dispersed countrywide.

Outlook

In spite of the challenges, the country’s vast potential resources still provide substantial growth opportunities. With mineral prices expected to stabilise as emerging economies increase their demand for the country’s raw materials, both domestic and foreign mining outfits should find further incentives with new exploration and development plans, provided uncertainty around the legislative framework is resolved. In the meantime, the implementation of key components laid out under the Mining Law are unlikely to be resolved until after the 2014 presidential election.