NEWS Japan's refiner/marketers headed for big shakeout after deregulation

Tohoku Oil Co.'s 83,900 b/d refinery at Sendai, Japan, is one of many in that country braced for a major jolt in the wake of downstream petroleum industry deregulation. Photo courtesy of Tohoku parent Mitsubishi Oil Co.

Japan's petroleum industry is destined for a major shakeout. Focused almost exclusively on refining/marketing in domestic operations, Japanese oil companies must come to grips soon with changing the way they do business in the wake of deregulation.

With deregulation comes increased competition in Japan, especially at an already glutted retail level. Refiners face the choice of cutting ties to unprofitable marketing operations or continuing to book heavy losses.

Analysts have criticized Japan's oil companies for being too slow to recognize this looming shakeout and worry about how much red ink will be spilled before industry rationalization is in full swing.

They contend thousands of retail outlets will be shuttered in years to come as oil companies struggle to maintain profits. In addition, different marketing approaches, common elsewhere, will make their debut soon in Japan, increasing competitive pressures.

All of this means Japan's oil companies must restructure operations and develop new strategies to compete in a more open market. The companies are likely to shift more of their focus upstream outside Japan.

In addition, there will be greater emphasis on diversification. Deregulation in Japan's electrical power industry is spurring some refiners to consider entering the burgeoning independent power business.

Deregulation kicks in

On Apr. 1, the government repealed Japan's Provisional Measures Law on the Importation of Specific Kinds of Petroleum Refined Products, introduced 10 years ago.

Until then petroleum product imports effectively have been restricted to refiners. As of Apr. 1, as long as certain conditions are met, even trading companies or supermarkets will be permitted to import petroleum products-specifically gasoline, gas oil, and kerosine.

With cheaper products entering Japan, domestic competition is heating. What's more, deregulation is expected to squeeze not only refiners and other wholesalers but also distributors and retailers, all of whom have lagged other industries in rationalizing their operations.

The collapse of gasoline prices in an already saturated market at the dealer level in the face of increasing competition from imports has hammered Japan's refiners. Many analysts predict massive losses for oil companies in fiscal 1996 and say there is little room for optimism of an improvement in profit margins the next couple of years.

For this reason, Japan's refiners have been forced to strengthen their domestic sales positions by embracing cost cutting measures such as integrating and reorganizing their entire distribution infrastructure, striking mutual supply agreements, and reducing the size of their work force. At the same time, many money losing service stations will be forced to close in the near to medium term.

With the abolition of the law limiting refined product imports, the Japanese government is seeking to promote greater supply efficiency, which already has spawned lower retail prices and a revamping of the domestic oil industry.

The repeal of the law shows the government is shifting its traditional regulatory stance away from the primary protection of domestic oil companies and toward a greater promotion of the country's consumer interests through increased competition. A director at the powerful Ministry of International Trade and Industry's (MITI) Agency of Natural Resources & Energy (ANRE) explained, "We feel that efficiency is as important as stability."

Deregulation background

Deregulation of the Japanese oil industry started in 1987, culminating with the abolition of quotas for crude oil processing in 1992. The first phase of deregulation involved four basic steps:

Liberalization of capacity expansion for secondary refining, July 1987.
Abolition of production quotas for refiners, March 1989.
Abolition of voluntary guidelines on construction of service stations, March 1990.
Abolition of quotas for crude oil processing, March 1992.

The government of Prime Minister Morihiro Hosokawa believed further deregulation was needed. Its target was the distribution system, in particular abolition of the refined products import law, which had encouraged Japanese refiners to expand capacity.

Repealing this law became a key part of the deregulation push aimed at forcing Japan's oil industry to compete by cutting its high costs. In particular the government sought to narrow the conspicuous gasoline price disparity between domestic and foreign markets-a gap also seen in electricity costs, due partly to appreciation of the yen.

Before the import law was enacted, the Japanese government had effectively banned imports of refined petroleum products, including gasoline, kerosine, and gas oil. But foreign calls for liberalization mounted, especially as Middle East oil producing countries ramped up their refining capacity.

In response to this pressure, the import control law, which took effect in January 1986, allowed some imports. However, it specified that only companies that met three basic conditions could import oil products. Importers had to have:

Facilities to process crude to provide products in times of an oil supply crises-"alternative production capacity."
Crude oil storage capacity so stockpiled oil could be released when oil supply was suspended-"oil stockpiling capacity."
Facilities to adjust product quality-"product quality adjustment capacity"-so imported products of poor quality would not be allowed on the market.

Although the law did not specifically forbid nonrefiners to import petroleum products, those three conditions meant in effect only refiners could import oil products.

Deregulation effects

The primary 5 year deregulation plan at first improved profits for the industry.

The structural change in demand for products, in particular gasoline and kerosine, also helped bolster profits. This also enabled refiners to upgrade their product slate, which in turn resulted in higher capacity utilization.

At the same time, abolition of voluntary guidance on production quotas enabled the country's refiners to trim output more easily. In addition, foreign exchange gains as a result of the yen's appreciation and improvement in balance sheets as a result of lower interest rates further boosted earnings.

However, the operating environment for Japan's refiner/marketers worsened dramatically in 1994 as the gasoline market deteriorated.

Excess capacity resulting from a spurt of capital spending contributed to deteriorating market conditions while an increase in the number of service stations intensified competition.

Effects of the imported refined products law quickly became apparent: By fiscal 1988 imported gasoline accounted for about 11% of total domestic demand, compared with import market shares for kerosine and gas oil of 30% and 20%, respectively.

But these imports eventually dwindled in the wake of a world oil supply squeeze stemming from Iraq's invasion of Kuwait in 1990 and because of growth in domestic refining capacity. By fiscal 1994, imported gasoline had dropped to less than 3% of domestic demand, kerosine less than 8%, and gas oil less than 3%.

Although the refined products imports law often came under fire for widening disparities in the price of gasoline across Japan, a number of analysts argue that, in fact, it benefited consumers as well as the country's oil industry.

They note price increases for refined products on the world market during the Persian Gulf crisis outpaced those of crude. And because production of petroleum products in Japan was regulated, the government was able to rein increases in domestic prices.

At the same time, the law helped strengthen the country's oil industry. This is an important fact to note, analysts point out, in a country without noteworthy hydrocarbon resources.

Efficiency vs. stability

With relative stability restored to the Middle East, the Hosokawa government believed stability had been assured at the cost of efficiency. Hence the reforms.

However, while efficiency has become increasingly important, stability of supply in crude and products can never be ignored by a country so lacking in natural resources. Therefore, analysts explain, the government can never afford to let market forces become the sole determining factor.

Thus, under the current deregulation program, companies that intend to import gasoline are required to stockpile a 70 day supply, calculated every month on the company's previous 12 months of business.

As a senior executive at a major Tokyo oil company told Oil & Gas Journal, "This is the price we have to pay, and it is important to note that it applies not only to new potential importers but also to the oil companies."

New importers also will have to meet strict quality standards such as sulfur and lead content of fuel.

"On this issue, new importers of petroleum products and oil refiners/wholesalers are largely at the mercy of the country's consumers, who demand a very high environmental standard of the products they are buying" said Yasushiro Koide of Japan's Institute of Energy Economics (IEE).

However, it is difficult at this early stage to accurately assess how deregulation will affect the Japanese oil industry in the long term.

As Toshinori Ito, senior analyst at the Daiwa Institute of Research (DIR) and an adviser to MITI, pointed out, "The process has only just begun. So while we can say what the program is intended to achieve, it is much too early to predict what it will achieve."

Gasoline price effects

Nevertheless, effects of the government's move are quickly becoming apparent.

Retail gasoline prices have plummeted since talks on deregulation began in autumn 1994 from about an average 123 yen/l. to 113 yen/l. in July 1995, the lowest level in 16 years.

As of last March, prices have fallen to 108 yen/l. In some areas where competition among service stations is most intense such as Saitama and Kanagawa prefectures, some stations have temporarily posted prices as low as 85 yen/l. Kerosine and diesel prices also have fallen but by a much smaller degree.

The difference in gasoline prices between urban and rural areas has begun to narrow as a result of a new price system recently introduced by oil distributors.

The Oil Information Service Centre, an affiliate of ANRE, reports the spread between the lowest and highest prices narrowed to 24 yen/1. in March from 29 yen/l. in February. The lowest pump prices were 97 yen/l. in Saitama prefecture and the highest 121 yen/l. in western Tottori prefecture.

Keiko Sasaki, oil analyst at ING-Barings, Tokyo, believes domestic prices have not hit bottom. "While they might have reached their lowest possible level in places like Saitama prefecture, there is still room for cuts in other parts of the country, especially in rural areas."

Others, however, are not so sure: As one senior oil executive told OGJ, "Prices in some areas have dropped to a point at which we are losing money."

Toshinori Ito at Daiwa Institute of Research agrees and says some of the lowest retail prices were clearly a case of overreaction combined with an excessively competitive market.

Retail glut, inefficiencies

Sasaki says this is precisely why prices have fallen so sharply: "Simply put, there is a glut of service stations. We currently have almost 60,000 service stations, a number that unlike in France or the U.K. has been steadily rising since deregulation was announced. Moreover, even more service stations are being planned, many of them controlled by refiners."

At the same time, a different retail outlet prototype is starting to emerge in Japan that will only intensify competition. Three discount supermarket chains-Daiei, Jusco Co., and Cowboy-have disclosed plans to build service stations alongside their stores to take advantage of their ability to serve a large number of customers.

Cowboy and Daiei are holding talks with trading house Marubeni over the possible purchase of imported gasoline from South Korea, while Jusco is reported to be considering importing its gasoline directly from South Korea.

Such retailers clearly believe lower priced imported gasoline will enable them to turn a profit by providing minimal but mass service at lower prices. Unlike traditional service stations, where consumer prices are based on marketers' high costs, discount store operators first set the prices for their products, then cut costs to meet the target prices.

At the same time, as an ANRE official points out, "They can greatly reduce the cost of their initial investments by renting storage space from oil companies rather than building their own storage facilities."

However, IEE analyst Yasushiro Koide believes the market effect of such outlets will be limited, given that there is little space available in urban areas for such service stations and not enough demand in rural areas to make such projects viable. "That means such projects can only work in suburban areas."

Others disagree, citing the success of such operations in France and the U.K.

One analyst said, "More and more people are moving to the suburbs, where land prices are cheaper. I do not believe these people, given the opportunity, would not take advantage of the fact that they can do their shopping and fill up their tanks at a lower price, all in one place."

Another type of outlet that would have a drastic effect on Japan's traditional petroleum retail infrastructure is the self-serve station. They are banned under Japan's fire prevention law, but this is likely to be amended next year to allow their introduction.

At the present, five or six persons are usually employed at one service station. Introduction of self-serve stations would imply a substantial saving in labor costs, allowing a marked reduction in the retail price of gasoline. "However," says Keiko Sasaki, "a total of about 400,000 people work in service stations nationwide, and this employment must to some extent be protected. Therefore, self-serve stations are unlikely to be introduced across the board and probably will appear in specific areas only.

"Nevertheless, retail prices must inevitably soften, if and when self-serve stations commence operations."

All of this puts tremendous pressure on today's service stations, many of which are losing money. It is generally accepted that increased competition, combined with the effects of deregulation, will force the closure of thousands of service stations, although estimates on just how many will close down vary enormously. Some analysts believe as many as 20,000 could close during the next few years.

Compounding the problem is the fact that most retail dealers and jobbers are small business operations. Companies with 50 employees or less account for 96% of all such companies, and companies operating only one service station account for 75% of the total.

At the same time, gasoline sales volume per service station in Japan is significantly lower than in the U.S. or Europe. "As a result, too many service stations relative to the volume of demand for gasoline are constantly engaged in cutthroat competition," said Nihon Keizai Shinbum oil writer Yasushiro Goto.

Oil firms' dilemma

For Japanese oil companies, the trends point to a rough and tumble shakeout in the offing.

Unlike their counterparts in the U.S. or Europe, nearly all of Japanese oil companies' revenues comes from refining and marketing. They lag far behind their peers in exploration and development.

Only about 12-13% of crude oil imported by Japanese oil companies comes from oil fields in which they hold interests. Most of this supply comes from the Arabian Oil Co. (AOC) group's Khafji oil field in the Neutral Zone between Kuwait and Saudi Arabia, with the rest purchased mainly on world markets. AOC has no downstream interests.

Because government policy aims to keep the price of heavier ends of the refining barrel low to bolster domestic industrial users, the only products on which oil companies can generate a profit are gasoline and kerosine. Gasoline provides the biggest profit margin, so refiner/marketers in Japan have placed their biggest emphasis on gasoline sales.

But with the gasoline retailing sector apparently teetering on the brink of collapse, oil companies are extremely worried about the situation. All the major wholesalers are is sending teams to affiliated service stations to provide training on boosting efficiency. However, such efforts will affect only a small percentage of service stations. Unique to Japan is the fact that, while refiners own service stations, these are virtually all operated by dealers aligned with the respective oil companies under lease contracts. Refiners thus operate only very small retail divisions. This limits opportunity for reform by oil companies at the dealer level.

Many independent analysts have been sharply critical of the lack of progress on the part of refiners to implement any serious form of restructuring to head off the looming crisis.

Analyst Keiko Sasaki said, "The government announced fully 2 years ago that it was going to deregulate the sector, and even before the scrapping of the import control law dealers were slashing gasoline prices.

"The writing was on the wall for all to see. But what did the oil companies do? Well, for the first year, apparently absolutely nothing. Then last year, they began announcing that they planned to implement internal restructuring programs.

"Better late than never, I suppose. Clearly the last fiscal year's appalling predicted results show restructuring of their operations is necessary. But these restructuring efforts will be negated unless reforms at the dealer level also are implemented."

Why have oil companies been so slow to react to the current situation?

The ANRE official said part of the problem lies in the fact that 1994, the year the reforms were an- nounced, was a very profitable year for Japanese oil companies, and "It is far more difficult for companies to announce cost cutting measures when things are going well than when things are going badly. You have only to look at the fire the U.S.'s AT&T came under when it announced its radical restructuring program."

However, oil company officials say the problem is far more fundamental than that and one they say few outsiders can truly understand. It is, in essence, the way bonds between large and small companies in Japan go beyond the purely economic realm.

As a senior oil executive explained, "Basically, it is incredibly difficult for us in Japan to cut ties with companies with which we have had very close ties for so many years. It is like a mother abandoning her child. These often very small companies are utterly dependent on us, and we have a responsibility toward them, even if it costs us financially."

Therein lies the dilemma facing the Japanese oil industry: How long can oil companies carry the weight of a fast collapsing retail sector, one on which they depend so heavily?

Keiko Sasaki says the sooner oil companies can find the courage to break ties with money losing dealers, the better it will be for all concerned.

"It is better to immediately amputate the foot than to procrastinate and thus be forced to amputate the leg."