Japan's Refiner/Marketers Headed For Major Shakeout

Japanese refiners are facing major changes in the way they do business as a result of deregulation on refined products imports.

Japan's downstream oil industry is in a state of crisis and headed for a major shakeout. The major catalyst for all this was a dramatic deregulation step this past April that allowed refined petroleum product imports by non-refiners (OGJ, May 6, p. 35).

That move, together with with a sharp drop in refining margins, falling retail gasoline prices, and a service station sector on the brink of collapse, are all leading to massive changes in the way the country's refiners and marketers do business.

The trouble began in autumn 1994, when the government of Prime Minister Morihiro Hosokawa disclosed plans to scrap the Provisional Law on the Importation of Specified Petroleum Products (Plispp), which had been introduced 10 years earlier.

The immediate effect of the news was a sharp fall in the retail price of gasoline, which by the end of that fiscal year had dropped to 117 yen/l. from 123 yen/l. the previous April.

For Japanese oil companies this was a disaster, given that-unlike the U.S. or Europe-the vast majority of their business is derived from refining and retail sales. Upstream operations of Japanese petroleum firms are negligible domestically and limited internationally.

Profits collapse

As a result of declining gasoline prices, the aggregate fiscal 1994 profit for the country's top publicly listed seven refiners-Nippon Oil, Showa Shell Sekiyu KK, Mitsubishi Oil Co., Tonen Corp., Cosmo Oil Co., General Sekiyu KK, and Japan Energy Corp.-fell 23%.

But worse was still to come. As retail prices continued to plunge, reaching 107 yen/l. last April, refining and marketing profits also continued to fall. In fiscal 1995, the seven oil giants saw an additional 46% decline in their aggregate pretax profit. Nippon Oil, for example, posted its first operating loss in 9 years. Moreover, the drop in combined profits for the entire refining/marketing sector-including nonlisted companies-was even steeper at about 55%.

Toshinori Ito, senior oil analyst at Daiwa Institute of Research and an advisor on the industry to the Ministry of International Trade and Industry (MITI), said that "in fact, the figures are even worse than this, since a number of oil companies have carried over significant portions of their losses into fiscal 1996."

Analysts point out that for the financial fortunes of Japan's wholesalers and refiners to improve, either the yen must appreciate in value, crude oil prices must fall sharply, or pump prices must increase-all of which are deemed unlikely to occur.

As a result, just about all the country's oil companies have begun implementing radical restructuring programs aimed at streamlining their operations in an attempt to boost profits. These programs, says one senior industry source, "will cost 30-50 billion yen ($270-500 million) per company the next 3-5 years."

But in spite of this, many oil companies are painting a rosy picture for this year. Nippon Oil, which has seen its revenues and pretax profits fall every year for the last 9 years, says that it expects to see a real increase in year-to-year profits this year.

However, most analysts are skeptical about the industry's predictions for fiscal 1996. Estimates among analysts as to when the oil companies will see their profits start rising again range from 1 year to 4 years.

"There is an awful lot to do, and some measures will be extremely painful and expensive," said Keiko Sasaki, oil analyst at ING-Barings, Tokyo. "At the same time, retail gasoline prices are still falling, so I am very pessimistic about the outlook for the next couple of years, in spite of the fact that some oil companies are predicting an increase in profits for 1996."

Thousands of service stations are expected to close in Japan in the next few years as deregulation efforts force consolidation of a marketing sector long deemed inefficient.

New price system

The main reason behind the industry's optimistic outlook is the recent introduction of a new price system under which the wholesale prices of three major petroleum products-gasoline, fuel oil, and kerosine-will be brought in line with each other.

"The basic idea behind the new system is to offset falling gasoline prices by increasing the prices of (diesel) fuel oil and kerosine," explained one senior industry source.

"The previous system set the wholesale price of gasoline (which was considered a luxury item) much higher than those of other petroleum products and had been blamed as a major reason for the country's high retail gasoline prices. At the same time, it made us far too reliant on gasoline for profits, so that once gasoline prices started their inevitable downward trend, companies were harder hit than they might otherwise have been," another industry executive pointed out.

However, the new pricing system, on which many Japanese oil companies have been basing their fiscal 1996 profit predictions, is not working as well as had been hoped. While gasoline retail prices continue to fall, the implementation of price hikes for diesel and kerosine is proving difficult. This is particularly true of diesel prices, with oil majors facing stiff resistance against price hikes from the country's powerful road transportation lobby groups. To date, the oil companies have succeeded in raising the price of diesel by just 2 yen/l. and kerosine by 2.2 yen/l., far short of the projected 5 yen/l. increase for both products. As a result, the profits for fiscal 1996 being predicted by companies based on the 5 yen/l. hikes are extremely unlikely to be realized.

In fact, Keiko Sasaki believes it impossible for the oil companies to ever attain the new price targets. She argues that trading-house Itochu Corp. 's recent import of 7,000 kl. of gas oil from South Korea, which it plans to sell at 27 yen/l.-compared with the current domestic wholesale price of 33 yen/1.-reveals just how vulnerable the domestic marketing sector is to cheap imports.

"Although the volume imported was very small, what it shows is that because the price of imported gasoline is roughly the same as domestic prices, importers will concentrate primarily on diesel and kerosine. This, in turn, will make it very difficult for domestic wholesalers to implement price rises for these two products."

Pressure from imports

Lalita Gupta, oil analyst at UBS Securities in Tokyo, adds that once oil imports really start to pick up, the pressure will seriously build on domestic refiners and marketers, with the survivors being those who have carried out the necessary restructuring to cope with this new competitive environment.

"The price of the marginal barrel is becoming extremely important, arid here imports can play a pivotal role, even if the quantities are small." she pointed out."

Already a number of new potential players are closely eyeing the import market. Sumitomo Corp., while not confirming that it will start to import refined products, does say that it is monitoring the situation "very carefully." Another likely player is Marubeni Corp., which is very keen to move into the sector. It has struck a supply deal with the supermarket chain Daie, which recently opened its first service station, selling gasoline at 165 yen/l. below normal service station prices.

Restructuring under way

The oil companies' strong push for restructuring shows their sense of crisis.

Nippon Oil Co. and its wholly owned subsidiary Nippon Petroleum Refining Co. will cut combined staff levels from 4,286 to about 3,700 by the end of fiscal 1999. Nippon Oil has already frozen hiring of new graduates since last year.

Japan Energy Corp, meanwhile, has started a sweeping restructuring that includes cutting the 860 workers at its headquarters by half during the next 5 years. It also plans not to hire new graduates in spring 1997 for the first time in its history. This year, it hired just 40 new graduates, compared with 440 in 1993.

Other oil majors, such as Showa Shell, Esso, and Mitsubishi Oil are implementing early retirement programs, aimed particularly at middle management.

As a senior executive of one company put it, "These measures are expensive but necessary-they are also proving surprisingly popular among our staff."

The corporate employment policies of all Japanese oil companies are undergoing major changes in the wake of the downturn in the industry's fortunes, and analysts expect other oil companies to also disclose work force cuts.

"Those that do not will live to regret their short-sightedness," said Toshinori Ito. He adds that oil companies should not be too obsessed with the concept of employment for life: "People tend to forget that this is a relatively new phenomenon in Japan that only emerged in the postwar economy."

But although reducing staff levels is considered vital, this is only one part of the overall shakeup the industry is going through.

"With refining margins having fallen by 51% between June 1995 and June 1996, companies are cutting costs wherever they can," Lalita Gupta said. For example, five major Japanese refiner/marketers-Showa Shell Sekiyu KK, Cosmo Oil Co., Japan Energy Corp., General Sekiyu KK, and Mobil Sekiyu KK-will integrate their oil storage complexes in Kochi Prefecture on the southern island of Shikoku by summer 1997 in a bid to trim their distribution costs.

Showa Shell and General Sekiyu will close their tank farms in Kochi, while Japan Energy will halve the capacity of its storage. Cosmo Oil and Mobil Oil will expand their facilities.

The combined storage capacity will total half the current 40,000 kl. when the integration is complete. Operation of the facilities will be consigned to a Japan Freight Railway Co. affiliate specializing in transportation of oil products.

Mitsubishi Oil, Mobil Sekiyu, and General Sekiyu KK, meanwhile, are interconnecting their tank farms at Takamatsu, also on Shikoku Island.

"Everywhere you look, this sort of integration is going on," said the president of one company.

Storage facility integration by Japan's oil companies is likely to increase in years ahead, industry sources and analysts say. However, Keiko Sasaki says that the oil companies' unwillingness to disclose storage tank contents-thus indicating the level of quality and efficiency of their refining operations-means that oil companies are unlikely to merge refineries.

Marketing consolidation

Meanwhile, Japanese oil companies are slowly beginning to learn from the foreign oil companies operating in Japan, such as Mobil and Shell, that it is essential to reduce their vast network of wholesalers.

The fact that foreign oil companies have in the past tended to sell directly to service stations or sell through a single wholesaling division has meant that they were more efficient and profitable than their Japanese counterparts. At the same time, profit has traditionally been far more important than market share for these companies, which has meant that they have been much more selective about where to set up new service stations.

"Generally we are far more accountable to our shareholders than our Japanese counterparts, which means that profit-optimization must be the cornerstone of our strategy," explains a senior executive at one foreign oil company operating a subsidiary in Japan.

For Japanese companies, however, quantity took precedence over quality. The result is that Japan now has about 60,000 service stations, one of the highest ratios of service stations per capita in the world.

But the inability of the market to cope with such a large service station network can be gauged by the fact that, even with rebates from wholesalers, a staggering 40% of the 31,000 companies that own gas stations posted operating losses in fiscal 1994. Moreover, the figure for fiscal 1995 is expected to be considerably higher.

However, as wholesalers see their profits being eaten away as retail prices plummet, they are realizing that such a situation is unsustainable.

"We estimate that up to 20,000 service stations will be closed down within the next few years," an executive said. "The current climate means that we will have to be absolutely ruthless in cutting ties with inefficient service stations, whatever our past practices."

As UBS's Gupta puts it, "A past heavy regulatory environment allowed inefficiency to thrive. But both oil companies and service stations are now realizing that the new order is very much a case of survival of the fittest."

An interesting point is where the MITI, the oil sector's traditional godfather, stands with regards to deregulation. While a MITI official assured OGJ that the ministry "realizes that efficiency is just as important as stability," Toshinori Ito-who acts as an industry advisor to MITI-says there is a split within the ministry between those who believe in the fast track to liberalization and those who would like to see the whole process of deregulation slowed down.

"While everybody is in basic agreement that things need to be changed, the fact that the government has refused to financially support service station closures is causing a division among ministry officials.

"On the one hand, there is a group who basically think: 'Since the money is not forthcoming, let's get this whole painful process over as quickly as possible.' On the other hand, there is another group who are still trying to fight a rear-guard action by saying that loss-making service stations should phased out on a gradual basis."

He adds that if government finance were forthcoming, everybody in MITI (and the oil industry in general) would support the fast route to service station closures, for there is a general consensus that many service stations are unprofitable "largely as result of bad management."

The pressure on the country's service stations is being exacerbated by the emergence of new, large self-serve stations located alongside big supermarkets.

Since such retail chains can operate on much smaller profit margins, their gasoline. prices will be far lower than those at regular service stations. The principal proponent of this new form of service station is supermarket group Daie, which to date has opened two such service stations, with more planned soon. Jusco Co., another major supermarket operator, is expected to follow Daie's lead this fall.

"The impact of these new service stations can be measured by the fact that Daie sold 50 kl. of gasoline in one day at its new service station in the central Japanese city of Matsumoto, where the prefectural average per service station is 70 kl./month," Gupta said.

"While we are publicly putting a brave face on these developments, privately we are extremely worried about such service stations-we are not used to the type of cost-conscious operations that Daie and Jusco are so good at," admitted one senior executive.

He adds that while it might be impossible to install self-serve stations alongside large retail outlets in urban centers, "An increasing number of these stores are being located in the suburbs, where it is quite easy to have a adjoining service station."

Refined products storage terminal operators are consolidating their operations in Japan to produce greater efficiencies, part of an overall trend toward mergers and acquisitions in Japan's downstream industry resulting from deregulation.

Mergers, acquisitions

Meanwhile, with some analysts predicting a drop in profits in fiscal 1996 of as much as 50%, industry officials are privately admitting that talks are under way among a number of companies over possible merger and acquisition activity.

These range from merging distribution and refining operations to capital swaps. A MITI official told OGJ, "We are not against mergers among oil companies, as long as those involved can show that any such course of action will be of benefit to all parties involved. What we want is a strong, efficient oil industry, and if that means fewer companies, so be it."

But, the president of one company said, "The behind-the-scenes posturing by MITI shows that it is still uneasy about the concept of a freely competitive environment. I think it genuinely fears that such competition will lead to the sort of damaging overinvestment in the industry that European oil companies saw a few years ago."

Keiko Sasaki argues that there are serious problems facing companies in the trend toward mergers and acquisitions.

"The smaller, more profitable operators do not want to be swallowed up by their bigger, less efficient peers, while the merger of two big groups has the dangerous possibility of producing one giant white elephant.

"Nevertheless, there are other possibilities, such as partial mergers, especially in the field of distribution. Such minimergers could be of great benefit to both parties, for it would allow them to make serious reductions in their distribution costs."

General Sekiyu and Esso, for example, have already begun joint trucking operations under a common logo.

Downstream dependence

Compounding the problems facing Japanese oi1 companies is their virtually total reliance on the domestic downstream market.

Most major international oil companies conduct horizontally integrated operations from exploration to refining to retail sales, generating profits at all levels. Major Japanese oil companies, however, derive most of their profits from refining and retail sales.

Government policy is to keep the price of industrial fuel oil down, so the only products on which oil companies can actually generate a profit are gasoline, diesel, and kerosine.

Japan's relative lack of experience in drilling and exploration means that most companies simply to not have the technical knowledge or ability to compete with the big multinational players in this field.

At the same time, the country's regulatory framework is not conducive to upstream operations. Gupta argues that one of the main culprits is the Japanese National Oil Corp. (JNOC), which provides funding for overseas upstream operations.

"JNOC insists that each project must be self-supporting," she said. "As a result, funds are given to individual projects, rather than to overall exploration activities. This reveals the serious lack of a coherent global strategy on the part of JNOC."

At the same time, current regulations stipulate that the bulk of crude produced abroad must be brought back to Japan, while exports from Japan cannot total more than 10% of a refiner's capacity.

"Who wants to work under these sorts of restraints?" asked one executive. "It's simply not worth the hassle."

Outlook

While the government is aware of these problems, it has so far failed to seriously address them, analysts and executives say.

Nevertheless, Toshinori Ito says that the general trend towards deregulation means that it is just a question of time before the necessary changes are implemented.

In spite of all the current problems besetting Japan's oil industry, analysts are becoming generally more confident of the outlook as companies start making-perhaps for the first time-really serious efforts to streamline their operations, says Masato Makiama, oil analyst with Salomon Bros., Tokyo.

"Just you wait and see what all these changes will bring," he said. "I'm betting that in the next couple years or so, Japan's oil industry will be totally different from how it is now-much leaner and much fitter," he said.

But the billion dollar question facing Japan's rapidly evolving downstream industry is: at what cost?

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