ONE of the issues that cropped up in the 13th general election campaigns concerned oil royalty. In the past, many reasons have been presented by political parties from both sides of the divide on who is entitled to what. Perhaps this article will help shed some light on the issue.

When rulers and representatives of the Straits Settlements, the Federated Malay States and the Non-Federated Malay States signed the Federation of Malaya agreement on Jan 31, 1948, nobody imagined the petroleum money conflicts that would ensue in the years to come.

One component made all the difference: jurisdiction over all areas beyond three nautical miles of state shores was handed over to the federal government. Section 4 of the Emergency Ordinance 1969 also defines territorial waters as three nautical miles, subject to some exceptions, including the newer states of Sabah and Sarawak.

This is the case against petroleum-related royalty payments from the federal government to some state governments today. For oil found beyond three nautical miles (beyond state territories), no royalty monies are due because the oil is in federal government territory.

If we believe the story ends here, we could conclude that no royalty is due to the petroleum-producing, opposition-led Kelantan and, rightfully, the Barisan Nasional-controlled Terengganu and Pahang. But the story does not end here.

Petroleum Development Act (PDA) 1974

In 1973, the world witnessed an oil shock caused by a six-month embargo on oil supplies by the Arab members of the Organisation of Petroleum Exporting Countries. Crude oil prices climbed fourfold overnight, causing severe disruptions to many industries. Most developing economies that produced oil, including Malaysia, then realised the strategic and economic importance of having national control over this black gold.

Malaysia responded by setting up Petroliam Nasional Bhd or Petronas on Aug 17, 1974, our homegrown oil giant that we have slowly grown dependent on for revenue — up to 40% of the federal government's budget. It was oil money that financed the multi-billion-ringgit Petronas Twin Towers and Putrajaya. In fact, oil-generated income, thanks to soaring crude oil prices in the past decade, was the only way we could have afforded the whopping RM135 billion increase in government operating expenditure in 2012 compared with 2000.

The incorporation of Petronas paved the way for another defining milestone in the history of Malaysia's petroleum industry — the PDA 1974. The PDA is the "antagonist" of the federal constitution, used by proponents of royalty payments to states when it comes to oil exploration beyond three nautical miles of state shores.

Section 2 of the PDA notes that Petronas is vested with the "entire ownership of petroleum lying onshore or offshore Malaysia" as well as the exclusive rights, power, liberty and privilege of exploring, exploiting, winning and obtaining it. The generic term "offshore Malaysia" is thus the main contention since neither the specific length from state shores nor references to the federal constitution's "three nautical miles" component were stated explicitly.

The PDA was a powerful manifestation of Malaysia's control and sovereignty as it essentially made uniform all previously separate standing agreements between the international oil operators and state governments with regard to the country's hydrocarbon resources.

It entailed three major developments: first, all findings will be under Petronas' custodianship; second, existing concession agreements will be replaced with production-sharing contracts where the government, via Petronas, effectively undertakes expenditure; and third, there will be an additional 5% royalty payment to the federal government (from Petronas) on top of a 5% royalty payment to state governments (also from Petronas). Monies were paid to state governments under the previous concession models, but the amounts are not known.

Supplementing the PDA were 13 identical assignment deeds and vesting grants, which were also separately signed between each of the 13 states and the federal government between 1975 and 1976. All of them vested the rights to "petroleum whether lying onshore or offshore of Malaysia" to Petronas in return for cash payments in the form of a yearly sum equivalent to 5% of the value of petroleum produced. Again, no length from state shores was specified in the generic term "offshore". Thus, the new deeds exacerbated the controversy.

Sabah and Sarawak

Until 2010, Sabah had received a total of RM7.2 billion in oil royalties. Sarawak is estimated to be receiving about RM600 million per annum currently. Having a federal share of the Sabah and Sarawak petroleum industry was actually the overriding aim of the PDA compared with the 1973 oil shock.

By then, the petroleum industry there was close to its centennial with Shell and Esso having fully put crude oil production in place in Sarawak (80,000 barrels per day) and Sabah (5,000 bpd). However, these operations were under legacy British-granted concession agreements with the state governments, generously skewed in favour of the oil operators. Naturally, the latter were unhappy to fork out extra petroleum royalties to the new federal government.

The first chairman and chief executive of Petronas, Tengku Razaleigh Hamzah, took upon himself the arduous task of convincing Sabah and Sarawak to agree to the PDA. His job seemed like a tall order since the pre-conditions were extremely delicate. First, there were contracts in place between the oil majors and Sabah and Sarawak, the sanctity of which needed to be honoured. Second, Malaysia was a federation of previously sovereign states, which entailed dues. Recollection of the process spanning two years unearths an incident in which Razaleigh was apparently barred from entry into Sabah at the airport.

Today, even though Petronas and its contractors are operating and producing more than three nautical miles beyond the coasts of Sabah and Sarawak, both states still receive royalty monies by way of constitution. In addition to royalties, unlike the Peninsular states, these states are constitutionally entitled to export duties on "mineral oils", for which petroleum qualifies. Both royalty and duties total 10%.

Terengganu

Terengganu found petroleum off its shores in 1973. From 1974 to 2000, it received RM7.13 billion in royalties. Not only has the state enjoyed tremendous growth from federal government allocations and royalties, it has also reaped economic benefits from the formation of petroleum townships. Rantau Petronas in Kerteh is one of the most advanced full-fledged petroleum centres, which has a little economy of its own.

However, royalty payments were stopped in 2000 during the PAS government's one-term rule of the state. Under the constitutional clause allowing discretionary payments from the federal to state government, a fraction of the due royalties — known as wang ehsan (goodwill money) — was paid instead through federal government agencies.

Royalty payments were only continued in 2009 when Terengganu was back in the BN fold even though production was from areas located three nautical miles beyond the state. This makes the task of concluding whether or not Terengganu should receive royalties a confusing one, considering payments were stopped the moment the state came under a different government.

Kelantan

Petroleum was found off the shores of Kelantan only in the 1990s when the state was under PAS rule. So the PDA, vesting grant and assignment deed stood unquestioned until then. As it happens, the findings were either 150km (about 81 nautical miles) from Kota Baru or within free economic zones where the federal government had joint development agreements with Thailand and Vietnam.

For production coming from these areas, namely blocks PM2, PM301, Malaysia-Thailand Joint Development Agreement (MTJDA) and PM3 CAA Malaysia-Vietnam, the federal government has received its share of 5% in royalties, totalling RM4.59 billion.

While the same number is theoretically due to Kelantan as well, the state has received nothing in royalties. Worse still, Kelantan enjoys absolutely no spillover economic developments in the form of a supply base, processing or transport activities. Gas extracted off Kelantan's shores through MTJDA bypasses the state and is funnelled directly into Thailand despite it being less economical to do so.

The federal government maintains that the federal constitution dictates that Kelantan not receive any royalties for rights over areas it does not own in the first place. On the other hand, Kelantan bases its claims on the sanctity of the PDA, the Assignment Deed and the Vesting Grant 1975/1976, claiming that it should not be deprived of royalties since these documents use the generic term "onshore and offshore Malaysia" in the case of petroleum instead of three nautical miles in the general case of territorial provisions.

Experts have clarified that the constitution supersedes any other law in place being the supreme law of the land. In August 2010, the Kelantan government filed a lawsuit against Petronas for failing to pay it royalties. The government responded to this with a special study panel, which has yet to come up with a conclusion.

Substance over form

We should be able to conclude by now that this is a complicated battle of legal interpretation. Aside from the litany of agreements and documents signed, one cannot discard the stark reality that both Kelantan and Terengganu were denied royalty payments during PAS' rule. It is hard not to say the issue was politicised and it leaves us, members of the public, with some pertinent questions.

First, the three-nautical-mile component of the federal constitution articulated the maritime borders of the states, but what about the ownership of petroleum assets specifically? Surely, when the relevant preceding documents were enacted, the intention was to designate petroleum as a specially treated issue, given its economic and political importance? Thus, can it be lumped with other maritime border issues in the constitution?

If the signing of the documents were intended to cajole previously sovereign and independent states into handing over custody rights of oil blocks to Petronas, is not depriving them of royalties now a blatant dishonouring of past promises?

Second, why is the application of the three-nautical-mile component inconsistent across the peninsular states? Experts go as far as to label Assignment Deed 1975 as unconstitutional and containing serious defects because it failed to specify that Kelantan can only assign to Petronas areas that belong to it.

Even so, why does it apply to Terengganu and now Pahang, which was without question promised 5% oil royalty for the recent Bertam PM307 discovery 160km (86.3 nautical miles) off Kuantan's shores? Terengganu and Pahang too should not rightfully have any claim over gross oil revenue from areas beyond state borders. This is against Article 8 of the federal constitution that calls for equal treatment of all and non-discrimination.

Third, what was the intention of promising cash payments to the state governments? If it was to convince the sovereign states to agree to share revenue from their natural resources with the rest of the country, is it fair to dishonour them after making them believe their interests were protected prior to the signing? As it is, annual allocations to state governments are only 8.6% of the federal government's annual budget.

At the end of the day, there are two parties that are using two contending documents: the PDA and the federal constitution. But what is the point of the claims bandied about by legal documents when the reality is that the four oil-producing states are among the poorest in the country? Kelantan has the lowest average household income of RM2,536 — far below the national average of RM4,025 — while Sabah's incidence of poverty is 19.2%, which is in stark contrast to the national level of 3.8%.

In conclusion, would the states have willingly signed PDA 1975 and other petroleum-related agreements, vesting Petronas with the rights to their oil, if they had not been misled into believing they would enjoy at least some of their natural endowments?

As Plato said, "We deny that laws are true laws unless they are enacted in the interest of the common wealth of the whole state."

Anas Alam Faizli is an oil and gas professional. He holds a master's degree in project management and is currently pursuing a doctorate.

This story first appeared in The Edge weekly edition of Apr 08-14, 2013.