ESAI: Japan's petroleum deregulation to be completed by 2001

Deregulation of Japan's petroleum industry is likely to be completed by 2001.

Protectionists measures, such as high tariffs on fuel oil imports, will also be eliminated.

Thereafter, the government's focus will be on energy security, safety, and the environment. But the government will avoid excessive regulation, as it seeks to improve efficiency and competition in the industry.

These are the main conclusions of an analysis of Japanese petroleum deregulation by Energy Security Analysis Inc., Cambridge, Mass., that is incorporated in a larger study, "Refining Profitability After 2000," to be released this month.

Evolution

ESAI's analysis hinges on how Japan's petroleum regulation regime has evolved since the 1960s, starting with the Petroleum Industry Law of 1962, which empowers the Ministry of International Trade and Industry (MITI) to intervene in the most basic areas of Japan's petroleum industry. MITI not only must approve any refining ventures, mergers, or projects, it also oversees a 5-year refined products master plan that authorizes the agency to advise a refiner to alter its production plans. It thus can limit crude runs and gasoline output and even intervene in wholesale products markets by setting "standard selling prices" when the market is perceived to be unbalanced, ESAI said.

MITI's heavy-handed mandate was not intended to protect domestic refiners from competition, ESAI contends, but to channel rapid growth in the new industry to avoid excessive investment, price wars, and inefficient use of capital.

Having since realized that the idea of government intervention in the refining sector is outdated, MITI now is moving to overhaul the regulatory regime in favor of open competition, ESAI said: "It is not certain whether the Petroleum Industry Law will be abolished by 2001. If the law remains after 2001, however, it will become a virtual 'dead letter,' because MITI will not use its power to intervene in the industry."

Energy security

In the 1970s, a new rationale was injected into the government's regulation of Japan's petroleum industry: energy security.

This marked a period of aggressive intervention by MITI-to the point where an unbalanced price structure and imports constraints developed by the agency outlasted the oil shocks of the 1970s. With restricted product imports and exports, Japanese petroleum markets evolved in relative isolation from international markets, ESAI noted.

This unbalanced price structure-involving disproportionate increases for diesel and fuel oil relative to those for gasoline and introduced in 1974-made gasoline a "cash cow" for domestic suppliers and promoted gasoline production and marketing investment, the consultant said: "Over-investment, encouraged by artificially inflated gasoline prices, contributed to the collapse of the Japanese gasoline market when import restrictions were lifted in 1996."

Just as has occurred with price controls, MITI has moved to end requirements for mandatory emergency products stockpiles as an energy security measure.

ESAI contends that MITI "will not return to policies designed to isolate the domestic market from the international market, even though it will retain the power to intervene to stabilize domestic prices in periods of supply crisis."

Protectionism

In 1985, Japan implemented a law to protect Japanese refiners from a wave of imported light products by limiting such imports exclusively to domestic refiners.

It was designed to expire in March 1996, giving domestic refiners plenty of breathing room to prepare for the market opening.

Coupled with tariffs on imported products and rules that protected refiners' margins by transferring costs (plus margins) to dealers, domestic refiners were further isolated from world markets. This encouraged Japan's refiner-marketers to proceed with a service station building spree through the mid-1990s.

Thus the onset of deregulation in 1996 has spawned a massive consolidation in Japan's retail sector that is only now beginning to gather momentum (see related story, p. 25).

Conclusions

The most critical problem in Japan's deregulation of its petroleum industry is not direction, but timing, ESAI pointed out.

"The 10-year moratorium on freeing gasoline imports, in our view, was a lost decade for the Japanese oil industry," it said. "The long lead times, gradual decontrol, and an apparent consensus-building approach have discouraged companies from quick and determined changes in their business strategies.

"The excessive gradualism of MITI deregulation efforts is also creating skepticism over its commitment to the process. MITI says deregulation, but what is MITI's real intention? An effort to read MITI's 'real intention,' however, is less effective than a careful reading of official pronouncements on deregulation. MITI, a branch of the government, cannot but follow the overall goals set by the government. MITI's core mission is to engineer growth, not to help specific companies."

In the contexts of industrial policy, energy security, and protectionism, ESAI said, MITI has formulated a consensus that will move the industry to greater competition in a deregulated environment.

The consultant concludes that the future Japanese petroleum industry will have the following characteristics:

MITI will not continue helping companies by coordinating cuts in Japanese refining capacity. During 1979-87, Japanese refiners cut their capacity by 1.4 million b/d, or 33%. "Orchestrated by MITI, the burden of this downsizing was shared by each company with no major bankruptcies. In the future, however, there will be no such allocated cuts in capacity. Each company will have to independently decide on cuts and closures." For 1998, ESAI noted, the average Japanese crude distillation unit capacity utilization rate was 79%. In order to raise that to 90%, it said, refining capacity must be cut by more than 500,000 b/d.
MITI will not rescue companies from bankruptcy. "It would be no surprise that excess refining and marketing facilities will be reduced by major bankruptcies. Will the Japanese government try to prevent a specific company from going bankrupt? Although MITI will assist in monitoring and other assistance, we think MITI will not 'rescue' a failing refiner."
Gasoline price wars will continue. MITI will not intervene to set "standard prices." As long as excess capacity exists, gasoline margins will remain low and will allow the most inefficient players to continue to operate.
Fuel oil margins will collapse after a tariff reduction in 2002. This may increase demand for fuel oil, predicts ESAI, while a significant part of demand for direct-burned low-sulfur heavy crude will shift to fuel oil. "The availability of fuel oil imports, however, will overwhelm the increase in demand. Lowering fuel oil margins will no doubt be a blow to simple refineries."
Competition in the Japanese petroleum industry and possible bankruptcies will lead to a continuous recapitalization process. "Failed and/or inefficient companies will sell assets. Overvalued assets will be sold at discounted prices, allowing companies who buy those assets to operate them more competitively. This will further encourage high-cost players to give up assets."
A domestic spot petroleum market will emerge. "As the race for survival has become more serious in the retail market, the 'monthly adjusted pricing,' based on suppliers' costs, has been resisted by retailers. In addition, we believe it is only a matter of time before suppliers recognize a lack of wholesale price transparency will harm their business by making hedging impossible." MITI also supports strengthening of the domestic petroleum market. "Growth of the spot market will be encouraged by gasoline and kerosine futures trading at the Tokyo Commodity Exchange beginning in July 1999, and the diesel futures market at the Chubu Commodity Exchange starting in early 2000."

The future

Finally, ESAI said, the deregulation of the Japanese petroleum industry, although delayed by a decade and implemented in a critical economic period, can lead to the rebirth of the industry: "Once companies have restored their courage to compete in the free market, they will creatively participate in the downstream market. The Japanese domestic spot market will have a great potential to send new price signals to the international petroleum market.

"The government could develop a new policy paradigm to integrate security, safety, and environmental policies with maximum reliance on the market mechanism. The darkest time has yet to pass, but it is possible to see the light of dawn."