An American-based mining company must built a smelter in Indonesia if it wants to extend its copper exploration deal, a senior official has confirmed.

At the same time, Mines and Energy Minister Ginandjar Kartasasmita acknowledged that such a move isn't likely to be a big commercial success.The dispute has rumbled on for several months between Freeport Indonesia Inc., a unit of Freeport-McMoRan Inc. of New Orleans, and the government in Jakarta.

FII, as the Indonesian company is known, announced plans last month to increase copper ore output this year to 32,000 metric tons a day from the current 26,000. It would rise in further stages to 52,000 tons by 1992, local company president Usman Pamuntjak said.

That upgrading is part of a US$500 million expansion program unveiled last year by FII. It is 85 percent owned by its U.S. parent with the balance in the hands of the Indonesian government.

It operates in the remote Irian Jaya district in the far east of the archipelago.

"FII is now challenged to make a hard decision," Mr. Ginandjar said last weekend during a tour of the company's properties. His remarks were carried later by the semi-official Antara news agency.

Mr. Pamuntjak was quoted as saying FII is still studying the wisdom of building a smelter. He estimates it would need annual output of 100,000 tons to be commercially viable.

Domestic consumption of copper is about 40,000 tons a year, according to government statistics. The sole export market, Japan, buys only concentrate.

The government's insistence on a smelter may be linked to its decision last fall that FII must become locally incorporated for all future operations. It was established before a 1967 law stipulating such incorporation, and has resisted the change.

For its part, the company argues that proceeding with its expansion program will also allow FII to triple output of gold to about 15 tons a year by 1993.

The government is keen to produce more gold and has allocated exploration rights on 4.5 million acres to more than 100 foreign joint ventures and domestic operators. It is also moving to clear thousands of unauthorized panners out of areas earmarked for official work.

Indonesian officials are forecasting total gold production of up to 25 tons by 1993. Gold has become a significant revenue earner for the country since a ban on exports of pure gold was lifted in 1986.