1. (C) In recent weeks we have picked up a number of hints that the long-running dispute between Brunei and Malaysia over delineation of offshore oil exploration zones may finally be nearing a compromise settlement. There has been no exploration activity in the zones, designated as Blocks "J" and "K" by Brunei, since naval incidents that occurred in 2003.
A senior oil industry executive told Ambassador that the head of Malaysian national oil company Petronas recently commented to the CEO of a major American firm that he expected the dispute to be solved this year. Working level contacts at the Ministry of Foreign Affairs and Trade told us that, even though their government is confident it could win any international arbitration over the dispute with Malaysia, it might be willing to forego such arbitration and reach a compromise in order to avoid causing a fellow Islamic country to lose face.
In our view, these talking points have more to do with avoiding a loss of face by Brunei, which has long maintained that it will accept nothing less than total control over the offshore blocks and that the Malaysian claim has no merit.
2. (C) Local oil industry executives have outlined for us the shape that an eventual resolution could take, at a level of detail not heard previously. They foresee a production sharing arrangement that allocates 65-75 percent of oil and gas output by volume (not revenues) from the disputed offshore blocks to Brunei and the rest to Malaysia.
Companies that have signed competing contracts with Brunei and Malaysia would have their contracts honored based on a pro rata calculation of each country's share; for example, a company which had signed a contract with Brunei for 25 percent of the production rights in the disputed zone might end up receiving 25 percent of 75 percent of total output, or 18.75 percent. Royalties, taxes, and the prices charged to third country customers would depend on the terms dictated by the country with which the original contract was signed, either Brunei or Malaysia.
One sticking point may be a decision on which firm will be named as overall operator for the production sharing area, and how much compensation it will receive. French company Total, which has a contract with Brunei for exploration in the disputed zones, is an obvious candidate because of its long presence in the region and experience in deep-water drilling, but others will also be interested.
3. (C) The sudden flurry of activity on this long-standing dispute is probably attributable to the start of offshore production earlier this year by U.S. firm Murphy Oil under the terms of its contract with Malaysia. Murphy's rig is in a Malaysian offshore zone undisputed by Brunei, but is located very near the disputed area and taps a reservoir that probably extends under the area claimed by Brunei.
The large amount of gas located below the oil in this area produces strong pressure that serves to push the reservoir's hydrocarbons towards Murphy's well. Local oil industry executives who briefed Bruneian government officials on this situation told us that the information was a wake-up call on the need for a resolution sooner rather than later, especially in light of high world-wide demand for exploratory rigs and drilling equipment and resulting long wait times for putting such equipment to use in new locations.
The Bruneians have realized that the longer they wait to reach an agreement that allows them to begin drilling in Blocks J and K, the less oil and gas they may ultimately be able to extract. This serves as powerful motivation to get serious in their negotiations with Malaysia and look for a compromise. That motivation is enhanced by the need for Brunei to identify new gas reserves that will underpin the renegotiation of contracts for the supply of Liquefied Natural Gas to Japan, due to expire in 2013.
4. (C) Comment: As we previously reported, the ultimate decision on whether and when Brunei should reach a compromise agreement with Malaysia over the offshore fields will be made personally by the Sultan, which is another way of saying the decision process will be deliberate and opaque. It is entirely possible the hopeful signs mentioned above will amount to naught.
It is in the U.S. interest, however, for a resolution finally to be reached given the stakes involved with the potentially extensive reserves that could be opened for production. We understand that the industry's upper estimates for potential reserves in the J and K Blocks reach up to 5 billion (sic) barrels. If proved, these reserves could help ease the pressure on East Asian oil and gas markets significantly for a long period after production begins and so lessen the likelihood of potential conflict over access to energy resources.
