Bill Guerin, Jakarta – Having consistently failed to reach its privatization targets, and battered once again by a bank lending scandal, the Indonesian government is seeking to sell off yet another of its crown jewels – a major chunk of the state-owned gas distribution and marketing company PT Perusahaan Gas Negara (PGN).

The sale is expected to raise 1.5 trillion to 2 trillion rupiah from divestment of 30 percent of the company. The government will keep a minimum 51 percent for the medium term. But just as the government was getting brave enough to restart its sputtering privatization sales, it was rocked by a lending scandal at Bank Negara Indonesia (BNI), which has resulted in the arrest of two senior executives in connection with US$200 million worth of allegedly spurious letters of credit and raised the suspicions of multinational investors, who quite rightly remain dubious of the books of any Indonesian company, governmental or not.

Unloading state-owned companies, including PGN and BNI, is vital to plugging a ballooning state deficit that, coupled with rising expenditures, is expected to widen to an estimated 2 percent of gross domestic product (GDP), or 5.1 trillion rupiah.

The government's failure to divest three state companies – pharmaceutical companies Kimia Farma and Indofarma, and airport operator PT Angkasa Pura II – earlier this year forced government planners to revise downward their privatization target to 6.1 trillion rupiah. However, the government said on Tuesday that it could now bring in around 8 trillion rupiah ($945 million) in privatization proceeds this year.

Although the PGN divestment had been planned for this month, it will now take place in December after several would-be strategic investors were said to have been unhappy with an Arthur Andersen audit of the company's 2001 finances. Ernst and Young crunched the numbers again and filed a report on Monday with the Financial Markets Supervisory Agency (Bapepam).

ABN AMRO Rothschild, Credit Suisse First Boston and Danareksa Sekuritas are expected to kick off the domestic road show on November 10, taking it international on November 12. PGN's dominant market position, established network coverage and customer base, good track record and experienced management are its strong points.

The company sells 91 percent of Indonesia's domestic gas. Its major suppliers have all signed 20-year contracts with take-or-pay clauses. Some 18 percent of PGN's revenue in 2002 came from charges the suppliers pay to run gas through PGN's network.

Long-term transmission contracts, which account for some 95 percent of PGN's total gas supply, generate stable revenue and cash flow. Approximately 50 percent of the projected operating profits over the next three years will come from its 60 percent-owned subsidiary PT Transportasi Gas Indonesia (TGI). PGN has some 2,547 kilometers of gas pipelines serving six separate distribution networks via three transmission pipelines but it badly needs funds to pay for several pipeline projects in the works.

However, the company's revenues and growth prospects are linked to the success of the economy in general. In 2002, for example, 82 percent of its revenue came from end-user sales to industrial companies, whose demand is directly linked to GDP.

Moody's Investors Service, which rated PGN higher than the government itself earlier in the year, explained the apparent anomaly away by the fact that all of PGN's current outstanding debts are soft loans from international credit agencies that were lent to PGN by the government and are not subject to cross-default on the government's other debt obligations.

Demand for gas has outstripped supply for the last two years, and it is imperative to bring more gas fields on line to keep pace. PGN wants the government to up the divestment to 39 percent to ensure sufficient funds for financing new gas pipeline projects in Java and Sumatra. A major expansion program aimed at meeting growing demand will be funded mainly by debt, with the rest from operating cash flow.

PGN expects to develop an East Java-West Java pipeline and a 1000-kilometer East Kalimantan- East Java pipeline in 2005. Its viability has been questioned, given that the gas price in Java is uncompetitive compared with that of LNG (liquefied natural gas). Japan is buying LNG at well above $3 per million BTU (British thermal units), but PLN's ceiling price for buying gas is $3 across the country.

Given the extra costs for transporting their gas from East Kalimantan or Sumatra, producers in East Kalimantan may well prefer to sell their gas for LNG production in Bontang than send it to Java via a pipeline.

PGN has plans for two gas-receiving terminals in Java, expected to be completed by 2007, to receive LNG from Papua and South Sulawesi.

"We might seek loans worth $1.4 billion to finance the two projects. But the numbers will become less and less if a strategic investor comes in," said PGN's president director, Washington Simanjuntak.

A 399-kilometer South Sumatra-West Java transmission pipeline project, linking Grissik to Jakarta via Pagardewa in South Sumatra and Cilegon in West Java, expected to be completed in 2006, will feed gas from South Sumatra to the industrial heartland of West Java. Other planned projects in the offing are a pipeline for the transmission of gas from Sumatra to Malaysia's west coast and a 380-kilometer pipeline from Duri to Belawan, North Sumatra.

Natural gas is already piped into Singapore from gas fields in West Natuna in the South China Sea through a 640-kilometer pipeline, which was launched two years ago. However, Sumatra is projected to become the main source of gas for the Trans-ASEAN (Association of Southeast Asian Nations) Gas Pipeline Project.

PGN's pride and joy, the Interstate Gas Transmission project, a $420 million natural gas pipeline deal between PGN and Singaporean gas utility, Power Gas Ltd, was completed in August.

Stretching 470 kilometers from Grissik in South Sumatra to Singapore's Sakra Island via Sakernan in Jambi and Batam Island, the pipeline has 229 kilometers of pipeline onshore and the is rest underwater.

The pipeline is part of a network linking gas fields in South Sumatra with Singapore, via Batam, and to crude oil fields in Duri, Riau, operated by PT Caltex Pacific Indonesia. It is also an integral part of a master plan to build the Indonesian Integrated Transmission Pipeline (PTGI), aimed at meeting the demand for gas across the country.

The network feeds 150 million standard cubic feet per day of gas from fields operated by ConocoPhillips and PetroChina in Sumatra to Power Gas, with the volume ramped up annually, in a 22-year supply contract. Singapore will buy an estimated $9 billion in natural gas over the contract term, and the project has given jobs to some 2,500 Indonesian workers.

This was the first venture by the private sector into the gas transportation sector following "de- monopolization" through the 2001 Oil and Gas Law, and heralded in similar forays to the sector.

Eighty percent of the expected 100 million cubic feet of gas a day will be sold to the state electricity company PLN, which is to pipe the fuel to power stations in West Java. The field, which has gas reserves of about 300 billion cubic feet, is expected to begin production in 2005.

PGN's solid domestic customer base consists of more than 650 large industrial users. More than 70 percent of these operate in three sectors – chemical and glass and ceramic manufacturers as well as metal producers. However, unlike large scale users in the US, for example, most of these industrial users could easily switch fuel from gas to oil if the balance moved back in the latter's favor.

Clean-air rules, applied rigorously in the West, do not yet exist in Indonesia and thus there is no compelling reason to use natural gas other than a price advantage. Encouraged by the earlier removal of fuel oil subsidies, end users were being persuaded to switch to natural gas, thus fueling the continuing growth in demand for gas.

Notwithstanding the feathers in its cap, PGN's inherent weakness is the mismatch of its short- term take-or-pay end user contracts, which have less than two years to run, against the long-term take-or-pay supply contracts. PGN could be exposed to the risk of non-renewal of sales contracts upon maturity, particularly if the government fails to maintain a stable operating environment and industry structure for the gas industry.

Despite its vast reserves, Indonesia's domestic gas sector remains grossly underdeveloped compared to its neighbors. Gas reserves are estimated at 150 trillion cubic feet, and contracts have been signed for only 30 trillion feet. Gas has been developed as a foreign exchange earner from exports while the domestic market, where investment in pipelines and other enabling infrastructure was minimal, has been largely neglected.

The government has now said that a pillar of its fuel diversification policy would be to price gas competitively, particularly for power generation.

Downstream oil and gas regulator, BPH Migas, established in May this year is mandated to set the eagerly awaited consumer prices and tariffs for network access.

Amid rising demand from industrial plants in Java, the government has said it would keep gas prices low to create a multiplier effect in the overall economy, by creating more employment in the petrochemical industry and providing farmers with cheaper fertilizer to boost agricultural production. But the joker in the pack may be the political considerations.

Fuel subsidies have been progressively reduced and were due to be scrapped next year, but only last week legislators and the government agreed to allocate a bigger slice of the budget pie – Rp14.5 trillion ($1.73 billion) – for subsidies in next year's state budget.

"Fuel subsidies are up because oil prices have changed," Director General of Oil and Natural Gas, Iin Arifin Takhyan said.

However, as Minister of Energy and Mineral Resources Purnomo Yusgiantoro warned, ending subsidies in an election year would be difficult because of the political situation in the country.