Hardly a day goes by when Indonesia's oil and gas industry does not make the headlines in the country's local newspapers. Such extensive coverage is well earned: in the 2001 calendar year the sector, including refining, contributed about 13.7% to GDP and 22.4% to export earnings. Highly important though the oil and gas business is, prospects, particularly in the LNG segment, are imperiled by looming global oversupply.

Nevertheless, the sector is an increasingly important focus for project finance banks, even though there are few deals likely to come to market in the near term. Of those that do come to market, clearly the most important will be to finance the multi-billion-dollar Tangguh LNG venture.

A banker in Tokyo suggests that the timetable for the project is threatened by the Sakhalin project backed by Shell, Mitsui and Mitsubishi. The sponsors are aiming to bring the project to market in the next few months, well before Tangguh is ready.

More importantly, Sakhalin has a lead over Tangguh in securing sales contracts, including in Asia. Tangguh's sponsors (BP, Mitsubishi/Inpex, Nippon oil, Kanematsu and LNG Japan) will want to sell into the Asian market first, before they approach European and North American buyers. Bruce Macfarlane, in ABN Amro's global project finance and advisory team in Singapore, explains this is because supplying European and North America entails higher shipping costs and a longer shipping cycle, and is a less profitable prospect.

So great is the volume of LNG that the Sakhalin and Tangguh ventures will be able to produce, that substantial oversupply (even factoring in economic and therefore demand growth expectations) is a foregone conclusion by 2010, if both projects start production between 2007 and 2008.

Other LNG ventures, including Malaysia LNG Tiga, Bayu-Undan, and Australia's Northwest Shelf also have additional production capacity trying to find customers. It is, in short, a buyer's market, says George Crozer, executive partner of White & Case in Asia. Underlining that fact, Macfarlane notes that Korean buyers, SK and Posco recently invited ten LNG producers to bid for their supply contracts. The Koreans got more - 12 bids, two unsolicited. In two other recent tenders for LNG supply contracts, to supply Japan's Tohoku Electric Power and Taiwan Power the Indonesians lost out to other suppliers. Tohoku is already taking LNG from Indonesia, but says it wants to diversify its sources of supply.

Indonesia now has to square up to the implications of this demand and supply imbalance. Some in Indonesia have even suggested that LNG receiving terminals be built in Indonesia itself so that some of the surplus gas can be used to fire domestic power plants. Crozer is sceptical that such a scheme could be pulled off. "LNG receiving terminals are very expensive, and so are LNG carriers. The financing would be in US Dollars, but, although there is currently no foreign exchange restriction in place, the income stream would be denominated in Indonesian Rupiah and the offtakers would not be credits like Japanese utilities."

What outcome is then likely for Tangguh? Banking sources now suggest that the timetable for the project, delayed many times, will be put back once again. "I think Sakhalin will get there first," says one financier, "and Tangguh may slip as much as three to four years."

When Tangguh does eventually approach the banking market, mainland Chinese institutions will probably feature heavily in the equation, thinks Macfarlane, as the Fujian project, backed by China National Offshore Oil Corp, has agreed to buy 2.5 million tonnes per year of LNG from the Indonesian venture. For international banks this does, however, raise the risk profile of the project. "We've got one emerging market project partly dependent on another," says a banker.

Future Indonesian oil and gas project financings, Tangguh included, are not expected to be radically different from others closed since the Asian crisis. But one transaction that has added a novel element was recently arranged to finance the Blue Sky project.

The project, involving the upgrading of existing Pertamina refineries - Balongan, Cilicap, was financed using a customary trustee borrowing scheme. While there is nothing new in that (all Indonesian LNG projects have employed the same structure in the last 17 years), what is novel, says Bertrand Baot at Credit Lyonnais Hong Kong, is that there is a complete separation between the project being financed and the assets responsible for debt repayment. "Revenues are coming from five other, completely distinct and separate refineries belonging to Pertamina. This is a new concept for the country," says Baot. "Using a similar structure sponsors can finance a lot of projects which otherwise would not be bankable," he adds.

Mitsui is the project's offtaker and, as in other trustee borrowing schemes, the trustee (based offshore) is paid directly by the offtaker. Furthermore, "Debt is paid before capex and opex, dramatically reducing the overall financing risk," says Baot.

The overall project cost for Blue Sky is $280 million, including $200 million of debt. 60% of this amount is being provided by JBIC, 40% by a group of commercial banks, namely: BOTM, UFJ (technical bank), Credit Lyonnais (co-ordinating bank and documentation bank) and ING. The term of the loan is shorter than normal at 4.5 years, related to the relatively short length of the offtake contracts.

The trustee borrowing structure was originally drawn up in response to stringent borrowing restrictions imposed by the IMF on Indonesia, including the stipulation that Indonesian government entities could not directly borrow in US Dollars, says Macfarlane. However, even when these restrictions are removed, the scheme is likely to remain in use, say financiers. "It's tried and tested and works well," suggests Macfarlane.

Two other oil and gas projects being financed on very similar lines are the PT Trans Pacific Petrochemical (TPPI) scheme in Tuban and Unocal's West Seno venture.

TPPI is being arranged by SMBC. ABN Amro is the lead arranger for West Seno, which should be in the market this month.

Apart from the novel nature of Blue Sky, it is remarkable how little project finance has changed or is expected to change in the Indonesian oil and gas sector, given how much else has changed in the country. Yet this is for good reason - Indonesian oil and gas sector financings have proved to be very resilient notes Baot. "None have had to be restructured," he says.

Perhaps with this in mind, appetite for Indonesian oil and gas deals has been increasing, Baot adds. Gavin MacLaren, a partner at Allens Arthur Robinson in Singapore notes that Singapore banks are once again viewing Indonesia as a potential focus area, encouraged by the investment forays that Singapore companies have recently made into the country. Japanese banks remain highly active in the market, "the typical Indonesian deal has a lot of Japanese interest, offtakers, contractors and arrangers, and we don't see that changing much in the short term," says Saadia Khairi, Asia Pacific Head, Citigroup Project & Structured Trade Finance.

That said, the number of banks who are willing to participate in Indonesian financings is still small. "The majority would probably say they are active in Indonesia, but on a selective basis," says Macfarlane.

Nor will the increase in appetite that has occurred have much affect on the pricing of deals. "Project financing in Indonesia is still a difficult proposition and one that demands a pricing premium. And since most financings are now club deals, the consensus needed on pricing will sustain the current pricing levels," Macfarlane suggests.

Like the banks, the ECAs are also increasingly keen on Indonesia. Particularly, this is true of the US agencies - Opic is providing all of the first phase financing for Unocal's West Seno transaction, a $350 million, 6-year corporate loan used to refinance part of Unocal's equity in the project.

Phase 2 will involve another $100 million of debt, $20 million of which will be provided by the Netherlands Development Finance Company (FMO), and about $80 million from commercial banks. ABN Amro is the co-arranger with FMO for this loan.

One other significant change in the Indonesian financing landscape is the rebirth of the country's debt capital markets. "The domestic capital markets are booming with a large volume of issues in the pipeline," says Theodoor Bakker, seconded to Ali Budiardjo, Nugroho, Reksodiputro (ABNR), an Indonesian law firm that has an association with White & Case.

However, project bankers do not believe that the domestic bond market provides great financing opportunities for Indonesian oil and gas projects. "Bond tenors are too short for project finance purposes," notes Macfarlane. PT Medco Energi, Indonesia's third largest oil company, launched a bond in May, but its issues mature in five years, compared to typical project finance terms of 10 to 15 years. Bakker concurs: "Few of the recent issues that I see are project bonds," he says.

Partly for the same reason, Indonesian banks are not likely to be significant providers of project debt. "Only a one or two banks are aggressive in their lending activity, although Indonesian banks will be more visible in the landmark, political projects," says Macfarlane. Indigenous banks are also handicapped by the widespread use of the trustee borrower scheme. Since the borrower in such schemes is off-shore, withholding tax is levied on local banks' loans from Indonesia.

Clearly, oil and gas projects are the most palatable types of project for international banks, but regulatory changes have introduced greater uncertainty into the sector, says Joris Dierckx, in Fortis Bank's Global Export & Project Finance team in Singapore.

Central to these changes is a new oil and gas law, (The Law of the Republic of Indonesia, Concerning Natural Oil and Gas) which was approved by the Indonesian parliament in October 2001. The law is still unfinished. "A number of amendments are still being discussed and not all of the completed legislation has been applied," says Baot. Indeed, only two of the five supporting government decrees have been written up.

The most important change is to Pertamina's status. Ernst Tehuteru, at ABNR, says the law changes Pertamina from a 100% government-owned entity established by a special law to a 'Persero' or a limited liability company, subject to the Indonesian Company Law like other Indonesian corporates.

The oil and gas law also strips Pertamina of its regulatory functions and creates a new regulator to take Pertamina's place, BP MIGAS. Unfortunately, says another legal source based in Singapore, few of the staff at Pertamina who were previously working on regulatory matters have moved to the new regulator. BP Migas is therefore currently swamped with more work than it can process, contributing to a delay in new oil and gas ventures.

The Indonesian government has, at least, decided on how Indonesian LNG will be marketed abroad in the future. In April, it announced plans to set up a special committee to coordinate marketing activities. However, Crozer notes that Japanese corporates have expressed a preference for dealing with Pertamina, based on their long standing relationship. "Pertamina may therefore retain some sort of agent role in the marketing of LNG," he says.

While the regulatory changes and the way in which they are being implemented have their shortcomings, they don't appear to be affecting existing projects. Market sources say that existing production sharing contracts will not be affected by the laws. "Indonesia as a country needs these projects and their revenues and if the regulatory uncertainty does start to affect it, the government has made clear that they will provide some sort of fix to keep the project in question on track," says Macfarlane.

In terms of the pipeline of new projects, on the other hand, the increased uncertainty is causing investors to hold off until the regulatory environment is clearer. Tehuteru says that several implementing regulations still need to be issued, including procedures on the licensing of downstream activities.

And where the changes are clear, not all are being welcomed by investors. Macfarlane notes: "New production sharing contracts (PSCs) will be affected by the laws, including the cost of bidding for PSCs, which will be much higher."

Oil and gas companies are particularly nervous about the new regional autonomy legislation, which hands more power to Indonesia's regions. "The precise situation is still uncertain. Which tier of government will issue operational licenses is still being debated and, in fact, it is not clear whether the existing regulatory framework on regional autonomy will remain in place in their current form, despite only being recently introduced," says a Jakarta-based lawyer.