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How to kill an industry in Indonesia

Asia Times - February 10, 2014

John McBeth, Jakarta Indonesia's exports of mineral ore are now at a standstill, with unprocessed bauxite and nickel the target of an outright ban and mining companies either refusing or unable to pay the draconian new export duty on copper and the other concentrates that were given a 12th-hour three-year extension.

That's only half of the story. Far from clear is whether enforced on-shore processing of mineral ores will actually work when there are serious doubts about the economic viability of building smelters and hydrometallurgical processors in an already over-supplied global market.

The dysfunctional way in which the government has implemented the new value-added policy, with unrealistic deadlines and a clear lack of preparation or understanding of its own contracts of work (COW), has shaken the Indonesian mining industry to its core.

A government regulation extending the January 12 ban for copper giants Freeport Indonesia and Newmont Nusa Tenggara and 66 other, mostly Indonesian, mining companies was undercut the next day by the export tax, which rises from an already daunting 20-25% in the first year to a prohibitive 60% in the second half of 2016.

This year's legislative and presidential elections in April and July make it highly unlikely any relief will be forthcoming, at least to the industry's satisfaction, unless the trade deficit widens alarmingly or until a new administration is installed in October.

In the meantime, already rampant ore smuggling will likely increase dramatically and the central government may face a rising tide of resentment from provincial administrations, angry at losing a valuable source of revenue and worried about social unrest from newly-unemployed mine workers.

Trotting out fanciful figures gobbled up by a nationalist Indonesian media, officials contend the benefits from building the new plants in the next three years will more than make up for the short-term loss of tens of thousands of jobs and billions of dollars in export revenues.

According to one optimistic forecast, the value of copper cathode and aluminum alone will have doubled by 2017, the seemingly magical year when some bureaucrats have talked grandly about finished metal contributing to a five-fold increase in national mining revenues.

But while the government claims there are 25 projects either under construction or at various stages of advanced planning, the available evidence suggests they will fall far short of filling the yawning revenue gap even in the medium term at a time when world mineral prices have taken a dive.

Conflicting reports show the seven projects supposedly nearing completion will refine only modest amounts of zircon, iron sand, iron ore, bauxite, manganese and nickel, with another 10 less than 50% complete.

Indosmelt's long-planned US$1.5 billion copper smelter in South Sulawesi is not among them and, most crucially, is still awaiting financing and the two alumina plants being built will absorb less than 20% of the 15 million tons of bauxite ore Indonesia shipped in 2011.

Alumina processing does make sense. The government recently took full control of Indonesia's sole aluminum smelter from its Japanese partners, but as it has done for the past 30 years the plant continues to use imported alumina, the product from the intermediate stage of the refining process.

Nickel doesn't look any rosier. Bintang Delepan is still in the very early stages of a $1.2 billion, 300,000-ton nickel processor in Central Sulawesi. But apart from two small Chinese-funded nickel pig iron plants, there is little else to point to that would make a dent in previous ore production.

Canada's Sherritt recently abandoned a Sulawesi nickel joint venture with Rio Tinto, and French-owned Eramet's $5 billion Weda Bay nickel project in Halmahera hangs in the balance because of pricing and regulatory uncertainties. Ominously, the company has just laid off 200 of its 700 workers.

Revenues at risk

Minerals and related products have in the past accounted for up to 20% of Indonesia's exports. Copper brought in $7.2 billion in annual receipts in 2011, followed by nickel ($3.1 billion), tin ($2.4 billion) and bauxite ($1.1 billion). So far there have been no requests for export licenses and, even if there were, the Trade Ministry is still waiting for the Mines and Energy Ministry to come up with mineral reference prices on which to base a new export duty it initially knew nothing about.

That's because of the last-minute scramble at President Susilo Bambang Yudhoyono's home on the evening of January 11, when officials working on the regulation, which temporarily exempts semi-processed ore from the export ban, realized the deadline was midnight, not January 12 itself.

According to sources familiar with what transpired at the meeting, Finance Minister Chatib Basri was left to tackle the tax issue and did so the following day, apparently without conferring with Economic Coordinating Minister Hatta Rajasa or Mines and Energy Minister Jero Wacik.

It is doubtful, however, whether anything would have been different if he had. A fortnight later, Freeport executives found themselves in the extraordinary position of having to walk ministers and senior officials through the company's Contract of Work (COW), which rules out any new taxes.

Even then, Industry Minister M S Hidyat, a Golkar appointee who has taken a harder line than anyone in the cabinet on the smelter issue, has since claimed the COW signed in 1991 does not have the same legal standing as legislation and should be amended.

Forget the big boys for a minute. Unable to raise the money to build costly smelters or pay the export tax, scores of small domestic mining companies are shedding jobs and seeking recourse with the Supreme Court to get the ban overturned. It is hardly a good advertisement for a policy that is meant to benefit Indonesians.

Freeport and Newmont, for their part, are now reluctantly threatening international arbitration. Paying even a token duty would undercut their case. It would also allow the government to make further inroads into the sanctity of the contracts, which had previously been regarded as legally rock solid.

In demanding 99% purity for refined copper, compared to only 70% for nickel, the government has clearly made the two US-owned miners the main targets of its value-added policy, first outlined in vague "refining and processing" terms in the 2009 Mining Law.

Important for the feasibility of further processing is the fact that 96% of copper's market value is created at the mining and concentration stage. Only a marginal 4-5% is added during smelting when the metal content of the product is raised from 30% to 100% after the removal of sulfur and iron slag.

Mining officials and other critics claim companies had five years to conform with the onshore processing requirement, but it was not until the belated issuance of Regulation 7/2012 fully three years later that miners had any inkling of what purity was required for each mineral.

Kuntoro Mangkusubroto, the head of the presidential monitoring unit and a former mines and energy minister, told this correspondent last year he had pleaded with mining officials over and over again to expedite the implementing regulations because of the looming deadline.

Blind policy

Beyond appealing to nationalist sentiments and painting itself into a corner the government does not appear to have done any significant research on the global processing industry and how Indonesia, with its inefficiencies and poor infrastructure, will compete on the overseas market.

Some analysts suspect it may be following the template of tin, which has been under similar export restrictions since 2002. But Indonesia controls 60% of the world's tin supply. Its share of the copper, nickel and bauxite markets is substantially less and does not provide the same leverage.

The only known comprehensive studies on the subject have been made by Washington based-consultancy Nathan Associates and Indonesia's Bandung Institute of Technology (ITB), both of which expressed serious reservations about the viability of the new blanket policy.

On top of that, the process of planning and building a smelter is more likely to take five years than three when even state-owned Aneka Tambang struggled for 18 months to get government approvals to build an extension to its existing ferro-nickel smelter in Sulawesi.

Only Aneka Tambang and Brazil's Vale process their own nickel, with the latter relying on its own 350 megawatt hydro-electric plant to supply the power. The export ban will have an impact on Antam's revenues because it was still exporting substantial amounts of ore.

Finance Minister Basri, who called the export ban "a form of punishment" for companies failing to build processors, had this to say about Aneka Tambang's experience with red tape: "That's why this policy should be combined with the ease of doing business. We will do our best to reduce the bureaucratic hurdles."

How many times have international executives in Indonesia heard such empty promises? With national oil production sinking from a million barrels to just 850,000 barrels a day over the past decade, ExxonMobil has been battling licensing and land issues for most of that time to develop its Cepu oilfield in East Java.

The 165,000-a-day field is still not on stream, despite the fact that ExxonMobil's partner in Indonesia's biggest onshore discovery in 30 years is the once all-powerful Pertamina state oil company. A senior mines official explained the delay during a presentation last year: "Too much democracy."

Since the government embarked on its current mining policy, most exploration has dried up because, miners say, increasingly onerous regulatory changes have made it impossible to raise the finance needed to open any sizable mine.

In the mid-1990s, there were 150 junior exploration firms in Indonesia. Today, the number is down to five. For one of them, Kalimantan Gold, the export ban and the subsequent loss of operating capital it was receiving from Freeport may be the last straw.

"I gathered my staff of 100 and told them I had good news and bad news," says Australian vice-president for exploration Mansur Geiger, who has lived in Central Kalimantan for decades. "The good news was they would get a year-end bonus. The bad news was it was their severance pay."

Moreover, not one of the 111 affected mining companies met the December 31, 2013, deadline for re-negotiating adjustments to their COWs to conform with the new licensing regime prescribed under the 2009 Mining Law.

One major reason is that Ministerial Regulation 27/2013 not only increases the pace of divestment laid out in attachments to the 2009 law, but also erodes the principle of "fair market value" if the government wants to take a stake.

Arbitrary decree

Jakarta-based resource lawyer Bill Sullivan calls last September's bombshell decree a "tipping point", noting that it appears to disregard the rights of the COW holders to a degree that may invite additional arbitration.

As things stand, a lack of domestic capital means government divestment targets will be tough to meet more so after Regulation 27 inexplicably ruled out a public listing as one way for a foreign company to meet that obligation.

As the two biggest companies on the block, Freeport and Newmont serve as trip wires for an industry still baffled by a policy that would make a lot more sense if it was applied selectively and in accordance with realistic timetables.

Newmont is in the worst position because its Batu Hijau mine on the island of Sumbawa has much lower ore grades. Executives have said the company will be forced to close and lay off its 9,000 workers if the smelting and tax requirements remain in place.

Freeport's situation may be more urgent. Indonesia's sole Mitsubishi-run smelter in Gresik, East Java, which processes 35% of the company's concentrate, is down for month-long maintenance. With its port-side warehouses likely to reach capacity in mid-February, it will have to curtail mine operations and lay off staff.

Perhaps even more concerning is the fact that the 10,000 artisanal miners panning for gold in Freeport's downstream mine waste will suddenly have their livelihoods disrupted, leaving security forces guarding the Papua mine with an unruly mob it may be unable to control.

The firm's workforce has risen from 19,000 to 30,000 in the three years since it began the $10 billion process of moving from an open pit to a wholly underground operation. Each year, it is spending $550-$600 million building a tunnel and electric rail and conveyor system that will tap into five separate ore bodies and eventually extend to a staggering 950 kilometers.

Yet with only seven years to go, Phoenix-based parent Freeport McMoRan Copper & Gold still doesn't know whether the government will honor an implied pledge in its 1991 COW for two 10-year extensions and what the terms will be if it does.

Chief executive Richard Adkerson told analysts last year the contract had "undisputed firm legal standing", apparently referring to wording which says approval for the two extensions "will not be unreasonably withheld". After what transpired during a recent trip to Jakarta, he must be feeling a lot less confident.

Given the imperatives of maintaining production at the world's most profitable mine, which has already been hit by two prolonged closures in the past two years, the country's largest single taxpayer can not just stop work and wait for that to happen.

When Hatta Rajasa met Freeport executives in 2012, he demanded the company build a smelter and associated fertilizer plant in addition to a power station and a cement factory already on the table as the price for a contract renewal.

Where it gets confusing is that among the minister's expert staff at subsequent sessions has been a prominent businessman with links to one of the two copper smelter projects planned by Indonesian joint ventures.

While Freeport and Newmont have always said up to now they will not invest in such a marginally profitable business, they have agreed to supply their remaining concentrate to any new smelter as long as it is at commercial prices.

Looking at the financial track records of Freeport's own smelter in Spain and the sole Indonesian facility at Gresik, the only way to turn a profit is for the new ventures to acquire the concentrate at a cut rate. The latter facility, for example, has an operating margin of 1%, compared with 35% for the mining operation.

As it has now indicated, Freeport may end up-biting-the bullet, simply because it has too much at stake. But that would be conditional on the government dropping the export ban and entering into a public-private relationship that would carry with it the promise of incentives.

The power requirements alone for what would be a $2.7 billion smelter on the south coast of Papua would add significantly to the additional 130 megawatts it will need for its extended underground operation.

The company is working with the provincial government on a planned "run-of-the river" hydro-plant, 100 kilometers to the northwest, which it hopes will negate the need for another coal-fired station.

While its current contract frees it of any divestment requirement until it runs out in 2021, Freeport will clearly still have to make some significant concessions as the price for retaining control of the fabulously-rich Grasberg deposit it has been mining since the early 1990s.

The company continues to toy with the idea of giving a stake to Papua's provincial government. It should have been done years ago and probably would have, if a politically connected Jakarta lawyer hadn't intervened at the last minute and told the Papuans they would get a free carry if they waited a little longer.

[John McBeth-is a former correspondent with the Far Eastern Economic Review. He is currently a Jakarta-based columnist for the Straits Times of Singapore.]

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