Nippon-Mitsubishi merger speeds overhaul of Japanese refining-marketing industry

The Negichi, Japan, refinery operated by Nippon Oil Co. Ltd. will be folded into the combined operations of Nippon Oil and Mitsubishi Oil Co. Ltd. when those two companies are merged this April. Photo courtesy of Nippon Oil.

This resid fluid catalytic cracking unit is part of the Hokkaido refinery complex operated by Idemitsu Kosan Co. Ltd., which is struggling under a huge debt load and thus is seen as the most likely target for the next wave of consolidation occurring in Japan's refining-marketing sector. Photo courtesy of Idemitsu Kosan. [72,038 bytes]
Japanese Oil Firms' Rationalization Plans [62,428 bytes]

The restructuring of Japan's refining-marketing industry is gathering speed. The catalyst for this fresh momentum is the imminent merger of Nippon Oil Co. Ltd. and Mitsubishi Oil Co. Ltd., Japan's second and sixth largest oil companies, respectively.

The merger, announced late last year, will take place Apr. 1. It was spurred by shrinking profit margins and intensifying competition-a pro- cess in turn spawned by what had been a sort of long-term "deregulation creep" (OGJ, July 7, 1997, p. 51), which last year accelerated in response to economic tribulations in Japan and much of the rest of Asia.

One local analyst, reacting to the merger announcement last year, said, "It has been endlessly debated ever since the liberalization process of the country's oil industry began over a decade ago, and now it has finally happened: full-blown merger. And it certainly isn't going to be the last."

Coming on the heels of a wave of cost-cutting and a grim year for balance sheets, that presages not only a leaner Japanese oil industry, but one with fewer players.

New giant

The merged Nippon Oil and Mitsubishi Oil will have combined annual sales of ¥36 trillion, a network of about 14,700 service stations, and 4,400 employees, giving it control of about 25% of Japan's fuel market. This will far surpass privately-held Idemitsu Kosan Co. Ltd.'s 16% market share.

Although the total refining capacity of the new firm is not yet clear-as some refineries in the Nippon Oil group are only partly owned by the firm-the new company will probably also become the country's largest refiner. The Nippon Oil group currently has a refining capacity of about 1 million b/d, about 580,000 b/d of which is wholly owned by Nippon Oil. The Mitsubishi Oil group's crude processing capacity totals 475,000 b/d.

In the merger, one Mitsubishi Oil share will be exchanged for 0.525 share in Nippon Oil, and the new firm will be capitalized at ¥137.16 billion ($1.15 billion) and have total assets worth ¥2.6 trillion.

"The merger would save costs of ¥14 billion in production, ¥15 billion in distribution, ¥15 billion in sales, and ¥26 billion in administration," Nippon Oil Pres. Hidejiro Osawa told a recent news conference. Osawa will be president of the new company, while Mitsubishi Oil Pres. Yoshihiko Izumitani will be chairman.

Osawa also stressed the merger should not be considered a rescue of Mitsubishi Oil by Nippon Oil. Last fiscal year, Mitsubishi Oil posted a net loss for the second year in a row, about ¥36 billion. Nippon Oil posted a net profit of ¥11 billion.

Merger fallout

The merger took the market by surprise, given that Mitsubishi Oil had been in talks with Showa Shell Sekiyu KK for some time over the integration of their refining operations.

However, Izumitani told reporters that the negotiations had been abandoned because of "too many restrictions." Analysts say that the real reason is due to the (probably justified) fear that Showa Shell would insist on full management control of the joint venture.

Also surprising analysts is the fact that this is a full-blown merger, rather than a partial tie-up as envisioned between Mitsubishi Oil and Showa Shell. Such an integration would allow the new company to benefit from Nippon Oil's strong retail network and massive cash reserves, from little overlap in terms of refinery sites, and from Mitsubishi Oil's upstream strengths (its holdings include important interests in Viet Nam and Papua New Guinea, as well as involvement in the planned Malaysian LNG Tiga project).

But analysts point out that, although the merger has huge potential, the real key to its success will be the extent to which it can implement radical cost-cutting measures. Indeed, Izumitani warned that the merger would inevitably mean a reduction in work force, although he would not say by how much.

Another vital factor will be the breaking of ties between Mitsubishi Oil and its wholesalers, which, analysts contend, have systematically bled the company dry through their constant demand for financial bail-outs.

"Nippon Oil will have to smash the stranglehold that Mitsubishi Oil's wholesalers have on the company, if the full benefits of the merger are to be realized. Mitsubishi Oil was unable to do this on its own, because its wholesalers were too powerful and essentially irreplaceable. Now, however, they can be replaced with Nippon Oil's (wholesalers)," points out Lalitha Gup- ta, oil industry analyst at Deutsche Securities Japan.

Consolidation trend

Although the merger is certainly the most significant move to come out of the Japanese oil industry in several years, there has been a notable trend towards partial joint ventures in areas such as logistics and transportation.

Last October, for example, seven Japanese oil wholesalers began using half the 300,000-kl storage and shipment facilities of Cosmo Oil Co. in Matsuyama, Ehime Prefecture.

This will be the first time that domestic oil wholesalers will share the distribution base of a single company. The plan, analysts point out, indicates a readiness to extend their current consolidation of product lines to distribution networks.

Nippon Oil, Mitsubishi Oil, Showa Shell, Idemitsu Kosan Co., Japan Energy Corp., and General Sekiyu KK are all joining the plan, which covers gasoline, kerosine, gas oil, and fuel oil. The total volume is estimated at 500,000 kl./year, equal to more than 10% of total demand in Ehime Prefecture.

Japan Energy, General Sekiyu, and Mitsubishi Oil, meanwhile, have closed down their own storage facilities in the region.

Cosmo Oil is expected to earn about ¥100 million/year from leasing the facilities to other wholesalers, which will likely save tens of millions of yen per year each in storage and shipment costs.

In a separate move that the two companies say will save them ¥7 billion ($62 million) in distribution costs over the next 4 years, Japan Energy and Showa Shell say they soon will sign a logistics cooperation pact. This would cover areas such as trucking and depot stations as well as alliances between the two companies' subsidiary distributors.

The link-up will allow both groups to reduce surplus storage capacity. Japan Energy currently operates 32 oil storage stations, and Showa Shell operates 36 depots, including those managed by Japan Oil Network, a subsidiary owned 49% by Showa Shell.

Most of the cost savings will come from the closure of 20-30% of these depots over the next 4 years.

Cost cutting, mergers

In addition to such joint ventures, Japanese refiner-marketers are taking other steps to trim costs.

Japan Energy announced last month that it would cut its staff by 50% through natural attrition and sell assets to reduce its interest-bearing debt levels.

Showa Shell lowered executive salaries, reduced its payroll, and enhanced bartering practices to save ¥60 billion in1998. It expects to lower expenses an additional ¥50 billion by 2000 through similar measures. But analysts caution that such efforts, while undoubtedly helping companies to cut operating costs, only scratch the surface of the problem. They expect that, with warnings of a decline in profits for the fifth

year in a row for many companies, more full-scale mergers are bound to follow.

"The (Mitsubishi Oil-Nippon Oil) merger is the potential trigger we've been waiting for," said Keiko Sasaki, oil industry analyst at ING Barings. Another likely tie-up is between Cosmo Oil and Japan Energy, given that the Bank of Tokyo-Mitsubishi is a major shareholder in both these companies. "But basically, just about all the Japanese companies are ripe for merging," Sasaki pointed out.

This merger, moreover, puts the rest of Japan's oil companies in an increasingly tenuous position. On one hand, the increasing domination of the industry by the top two players means that the smaller companies will find it increasingly difficult to survive on their own.

On the other hand, many of these are already in deep financial trouble and unlikely to find partners as big and cash-rich as Nippon Oil. The result is that future mergers might well create companies larger in size, but with huge fundamental problems in terms of efficiency and financial health.

"Ironically, this might well be the industry's saving grace, because it will force these companies to undertake the reforms that have been needed for so long," argued Gupta.

The merger between Exxon Corp. and Mobil Corp., meanwhile, will provide the opportunity for the two companies to merge and restructure their Japanese operations. "Such a merger would possibly pose even more of a threat to the local players than Nisseki (Nippon)-Mitsubishi, for, although it would control only around 16% of the market, it would be an infinitely more efficient and profitable company," Gupta said.

Meanwhile, Showa Shell and Japan Energy have categorically denied recent reports that they are planning to merge their refining operations. A senior Showa Shell source did acknowledge that "our scale of operations as they stand are too small to satisfy our shareholders, and we are therefore actively looking at ways to increase our size through partnerships with suitable companies. But as yet nothing has come of them, and I can confirm that the recent rumors that we are to tie up with Japan Energy on refining are completely false and unfounded."

Gupta points out that Showa Shell is in a tricky position: "On the one hand, it is understandably desperate to merge, but on the other hand, they are unlikely to lower their standards. This means that potential partners will have to be prepared to make significant cuts in operating costs and refinery output-and whether there are any Japanese companies prepared to accede to such demands is questionable."

Idemitsu Kosan

Analysts point out that there is one option that would go a long way to clearing the problem of excess capacity in the industry, and that would be if Idemitsu Kosan-which has a 16% share of the market-were allowed to go bust and be dissolved.

Idemitsu has been rebuffed by potential foreign investors, having approached Saudi Aramco and others in the past. The company is saddled with debts totaling a staggering ¥1.4 trillion, while its total assets are valued at ¥2 trillion-and at prices that analysts do not believe reflect true current market values. Credit agency Moody's Investors Service recently rated Idemitsu at B2-a speculative level that is five notches below investment-grade.

The greatest beneficiary of Idemitsu's demise would be Showa Shell. It is in the unenviable position of being relatively small in an industry set to become increasingly dominated by two or three very large players, but without a natural partner with which it can tie up to give it the necessary critical mass to compete effectively. While the takeover of one of the smaller players, such as Cosmo Oil or Japan Energy, might seem a fairly unpalatable option, the acquisition of the cream of Idemitsu's assets at bargain-basement prices would not. Moreover, its Japanese rivals are far too debt-laden to buy up any of Idemitsu's assets, however much they would like to.

But the chance that Idemitsu would be allowed to go under is considered remote, for the time being at least, Gupta noted: "Idemitsu might be a family-owned company, but that is in name only. Its debts have reached a proportion where it is in reality owned by its creditor banks. Neither they nor the Ministry of Finance would allow it to be formally declared bankrupt, given the risk that such a declaration might well drag some of its creditors down with it."

The only option left for the company would be some sort of bail-out package along the lines of the ¥100 billion loan arranged for Nissan, the carmaker. However, analysts point out that the sums needed to rescue Idemitsu would have to be far, far larger, and this does not solve the fundamental problem of how it can be restored to long-term financial health in such a fiercely competitive environment.

The chances are, therefore, that the company will be allowed to totter along for a few more years until the rest of the country's financial system is strong enough to cope with the impact of its bankruptcy, and then be killed off.

This is the first of three articles focusing on the consolidation under way in Asia's refining-marketing sector. The first two articles of this series update the outlook for Japan's refiner-marketers.

This week: How the Nippon-Mitsubishi merger is speeding consolidation within Japan's refining-marketing sector.

Next week:

What Japanese refiner-marketers must do to survive.
The final article in this series, to run Mar. 15, will be a Management Perspective by the consultant Sterling Group on the dilemma of Southeast Asia's surplus refining capacity.