Commentary by Wayne Forrest

I fear a ticking time bomb could soon explode in Indonesia.  Its probably not what you think; its not a natural disaster or mass movement based on religion.  It has to do with natural resources and the origins of the American Indonesian Chamber of Commerce (AICC) and some of its founding members.  It can be avoided, but will take heavy lifting on the part of the Indonesian government.  If it goes off, there could be a diminution of America’s relationship with Indonesia, damage to the environment, harm to the investment climate, and social unrest. AICC members Vale INCO and Freeport McMoRan, first to invest in Indonesia after the 1967 investment law and among the nation’s largest taxpayers, face possible expropriation of their assets.  An instrument for stabilizing Indonesia after the economic and political calamities of the mid 1960’s with billions of dollars in mining investment, the COW (contract of work), invented in part by an AICC member firm, appears to be in tatters. (Members should know that I have written President Jokowi directly to express my concern.)

The story starts in the late 1940’s when a young American lawyer Robert Delson befriended a small group of Indonesians who were sent to NY to drum up support for the 1945 declaration of independence by Soekarno and Hatta (who became Indonesia’s first President and Vice President).  Delson became part of a group of Americans who not only raised money for the young republic, but also lobbied the US government to side with it in its negotiations with the Dutch.  Delson went on to become Indonesia’s first foreign attorney. His firm represented the young nation in many international transactions and helped devise unique devices such as the production sharing contract (PSC) and contracts of work (COW).  He and others formed AICC in 1949.  The PSC (used in oil/gas exploration) and COW (mining) brought a much greater share of production to the host government than similar vehicles in the Middle East and other locations.  Their strength lay in their ability to bring a high degree of legal certainty into a risky industry that is fueled by long term, worldwide investment.

In 2009, in the middle of a commodity boom generated by Chinese demand, Indonesia gave up on the COW, passing a new mining law that created a mining license (IUPK) as well as demands for value added local processing even though both Freeport and INCO had built smelters and tin was mostly processed in-country.   But Indonesia wanted much more, impatient to let natural economic processes work out as they did in rubber, where both the raw material has been exported for decades alongside local production of tires, gloves, fan belts etc.  The government since 2009 has further eroded the sanctity of these contracts through the imposition of conflicting regulations.

The law, and its subsequent regulations, facilitated widespread coal production by local Indonesian companies (often financed by Chinese entities) but caused the exit of over 50 foreign companies who were in the process of exploring for hard rock minerals (copper, nickel, gold, etc.) including several who were AICC members.    The existing COW holders (including AICC members Vale INCO, Freeport McMoRan, and Newmont) stopped exploring for more minerals in their work areas or shelved plans to exploit deposits they had already discovered.  Firms simply cannot risk capital in a project that can take decades to fully develop when the government has set conditions that only give them short term security. As result of the law Indonesia dropped to 99th out of 101 countries in the Fraser Institute rankings of mining investment policy. Indonesia, it seems, no longer courts foreign investment in mining. The law acknowledged the previous COWs but was vague on how they would be changed into an IUPK (License).  Among its other flaws, it treated all mining products alike, ignoring the fact that imposing export bans to generate investment in smelters on some products might make sense but not for others.   For example, the value added by a copper smelter is only 4% over the copper concentrate produced at a typical copper mine.

In 2014, the World Bank issued an important report that demonstrated the weakness of the law, questioning “the assumption that increased smelting and refining will increase the share of value added. In reality, mineral processing is energy intensive so the actual value-addition is far less than the difference in the market prices of ore and processed minerals”.   Nevertheless, regulations issued in 2010 and 2014, imposed export bans that could be released by showing progress on smelter development as well as other provisions.  Naturally, given the huge expense and no money coming in from exports, there was very little smelter development, except in nickel, where Indonesia has market power.  Since 2009, AICC as well as its COW holding members were patient and quietly lobbied for a revision to the law.  Freeport grew increasingly concerned that its timetable to invest over $16 billion to build Indonesia’s first underground mine in Papua would be jeopardized.  Its 1991 30-year contract included the probability of 2 ten year extensions but the government believed it could not begin negotiations until 2019, too short a time frame as the company projected it would need 2 years to unwind its investment.

After the election of President Jokowi in 2014 it was assumed a compromise would be worked out where Freeport and other COW holders could agree to either a modified COW or change to the mining license and receive the right to export that it had under its COW along with extension rights.   Indeed, when I met Indonesia’s Minister of Mining and Energy Sudirman Said in 2016 he understood the flaws of the 2009 law and told me the government would likely submit a revised law to Parliament by the end of the year.  By August, Said was replaced and in January 2017 Indonesia issued a surprising new regulation that  improved the situation for state owned mining enterprises or local companies (who could now export raw minerals again) but worsened the situation for COW holders.   They were in effect told to divest 51% of their shares in 10 years, agree to smelter construction, convert to an insecure mining license, and a pay a host of prevailing taxes and duties.  All these provisions were not in the COW whose legal authority superseded that of new laws and regulations.  More dangerous was the concept that the shares would be valued at “fair market” but not based on known reserves.   After several trips (the latest just last week) to meet senior Ministers and find a solution, Freeport CEO Richard Adkerson finally reluctantly raised the possibly of international arbitration, declaring that Indonesia’s 2009 law and subsequent regulations breached their COW and were a form of forced nationalization and expropriation.

After hearing rumors for years that Indonesia intended to take back the mines run by foreign companies the gloves finally seem to have come off.   Coordinating Minister Luhut Pandjaitan declared that “We can manage [Freeport]. We have PT Inalum. It is up to the state-owned enterprises ministry, but we are ready.” The minister said nothing about the state owned miner’s ability to go underground or raise the $18 billion necessary to develop Grasberg further. Indonesia’s mining industry is already plagued by massive environmental degradation by local firms using unsustainable methods; most workers receive limited training and the nation lacks sufficient engineers. Without the presence of foreign firms subject to strict shareholder and SEC oversight conditions will worsen.  Gaining the foreign mines appears to be less about the national interest other then nationalism and more about allowing local business groups to gain control of a valuable asset on the cheap. Otherwise the policy makes no rational economic sense.

Freeport has invoked a clause in their contract that sets a 120 period for negotiations over contract violations.  It is likely both sides will point out violations.  If issues cannot be resolved both seem ready to go to international arbitration.   Already there is the distinct possibility of social unrest in Papua as thousands of Freeport employees are being furloughed to cut costs since there is no place to store the production.   Down the road, if Indonesia wrests control of the mine as a result of arbitration or other actions, direct investors may see a massive lack of legal clarity to any mining investment.    Continued press attention will no doubt harm the overall business climate for US companies.

Currently President Jokowi still enjoys popular support but it has been shaken by the Jakarta governor’s election. His former deputy, Ahok Purnama,a ethnic Chinese Christian, has been met with a deep challenge by trumped up charges of blasphemy from Islamist groups backed by the President’s opponents looking to the 2019 Presidential elections.  750,000 went into the streets to protest against Ahok’s candidacy on Dec. 12, the most since the upheavals that toppled Suharto in 1998. Jokowi probably did not believe his own populism could be effectively countered by a populism in the name of defending Islam.   Already some of the Islamist groups show signs of preparing a similar anti-Jokowi, social media driven “populism” against Freeport as a symbol of unwanted imperialism.

Can Jokowi find a win-win solution to the mining dilemma in this highly-charged atmosphere?   We will find out in the next 120 days. If he can’t and a series of arbitrations ensue, the new US administration may have to find its way into a scrap that it is –as of yet–unprepared for, with unintended consequences for our business and overall relationship.

(These views are the author’s own and do not necessarily reflect those of the American Indonesian Chamber of Commerce or its members)