Japan's Refiner/Marketers Continue To Grapple With Downstream Deregulation

Idemitsu Kosan Co. Ltd.'s Aichi refinery at Chita, Aichi Prefecture, is one of five the company operates in Japan. Japanese refiner/marketers are struggling to weather the beginnings of deregulation in the country's downstream sector, and further consolidation of capacity is likely. Photo courtesy of Idemitsu.

The government's efforts to deregulate imports of refined products, after a decade of mulling energy deregulation, has resulted in Japan's downstream sector facing company rationalization and closure of capacity while the rest of East Asia's downstream sector is booming.

Accordingly, with the likelihood of still further deregulation steps eating away at their domestic market shares, Japanese refiner/marketers are certain to look abroad and become increasingly important players in the downstream expansion of developing East Asian nations.

"Ostrich" approach?

"So much talking, and so little achieved!"

This reaction by the head of one of the foreign oil majors operating in Japan with regard to the need for companies to restructure in a fast-ailing downstream oil sector is one echoed by many independent analysts.

"The industry is in a state of crisis, and yet most companies continue to act like ostriches-burying their heads in the ground and hoping that the problem will, by some miracle, go away" said Keiko Sasaki, oil analyst at ING-Barings in Tokyo.

"The problem facing the industry is basically a simple one: there continue to be too many service stations supplying too few customers at too low a price," explained Toshinori Ito, senior analyst at the Daiwa Institute of Research and an advisor to Japan's Ministry of International Trade and Industry (MITI) on the sector's deregulation.

Law scrapped

Although Japan's energy deregulation program is more than a decade old, the real crunch for the downstream petroleum industry came in fall 1994, when the government of Morihiro Hosokawa disclosed plans to scrap the Provisional Law on the Importation of Specific Petroleum Products (Plispp)-protectionist legislation introduced 10 years earlier that effectively banned the import of refined products by non-refiners.

The government's refusal to renew Plispp for a further 10 years prompted an immediate collapse in the retail price of gasoline-which fell even further in 1996. The move had a devastating effect on Japanese oil companies.

Unlike their U.S. or European counterparts, the vast majority of Japanese oil companies' business is derived from refining and retail sales. Upstream operations of Japanese oil companies are negligible domestically and limited internationally. Moreover, exports of refined products are effectively banned-although this is about to change.

At the same time, refiners and wholesalers are vulnerable because the ensuing consolidation and liquidation of retail outlets are bound to produce large amounts of bad debt and losses associated with the liquidation of assets.

Excess retail capacity

Japan has about 60,000 service stations, which gives it one of the largest number of outlets of this kind per capita in the world.

"This is a preposterous amount given the level of consumer demand" Sasaki said.

There is virtually no disagreement with this opinion, nor with the estimate that possibly more than 20,000 stations will have to be closed down sooner or later (with the consequent loss of as many as 200,000 jobs in the service station sector).

Compounding the problem is the fact that an estimated 40% of the country's service stations regularly post losses. In fiscal 1995, only 11.3% of them enjoyed a profit ratio of more than 1%, and 39.7% of them posted losses, with these figures expected to be considerably worse for fiscal 1996.

"With average sales of just 79 kl/month and a profit margin of 10-15 yen/l., it's not difficult to figure out why they are losing money hand over fist" pointed out a senior MITI official.

"Moreover, not only are there too many of them, but they are often inefficiently managed and invariably overstaffed" added a senior source at one oil company.

"In the past, when we were making fat profits from over-inflated retail prices, we were happy to dole out literally billions of yen a year in supporting loss-making service stations. But now that prices have collapsed, we are suddenly beginning to realize just how much this is costing us."

The average retail price of gasoline has slumped from 122 yen/l. in January 1994 to 105/l. in May 1997. This marks a drop of about 25% after the gasoline tax is deducted. Moreover, some regions are posting average retail prices as low as 90 yen/l. It is estimated that the reduction in prices in 1996 alone saved consumers more than 1 trillion yen in gasoline costs.

Profits slump

The cost to the country's oil companies is clear: in fiscal 1994, the aggregate profit for the country's top seven publicly listed refiners fell by 23%.

In fiscal 1995, these seven saw an additional 46% decline in their aggregate pre-tax profit. Nippon Oil Co., the country's largest oil major, for example, posted its first operating profit loss in 9 years.

The drop in combined profits for the entire refining/marketing sector was even sharper at about 55%.

Moreover, figures recently released for fiscal 1996 reveal that operating profits for the top seven fell by another 54%, while recurring profits fell by 61% and net profits by 55%. The three worst hit were Mitsubishi Oil Co., which saw operating losses of 8 billion yen as compared with operating profits of 20.6 billion yen the year before; General Sekiyu KK, which saw its operating profits drop by 55% to 8.1 billion yen; and Japan Energy Co., which saw its operating profits slide by 66% to 6.7 billion yen.

In all, total profits for the refinery and wholesale sectors have dropped from 221 billion yen in fiscal 1994 to 68 billion yen in fiscal 1996. This implies a drop in the profit ratio from 1.94% to 0.55%.

Restructuring

As a result, just about all the country's oil companies have begun implementing what at first glance appear to be radical restructuring programs aimed at streamlining their operations in an attempt to boost profits.

One key area being targeted is staff levels, particularly those at company headquarters.

Nippon Oil Co. Ltd. and its wholly owned subsidiary Nippon Petroleum Refining Co. last year disclosed that it would cut combined staff levels from 4,600 to about 3,600 by the end of fiscal 1999. Nippon Oil has already frozen hiring new graduates since 1995.

Japan Energy, meanwhile, has started a sweeping restructuring that includes cutting the 860 workers at its headquarters by half during the next 5 years. It also failed to hire any new graduates this spring for the first time in its history. Last year, it hired just 40 graduates, compared with 440 in 1993.

Many companies are also trying to cut staff levels, particularly at middle management, through the implementation of early retirement programs.

"But these are meeting with little success in a country obsessed with the notion of lifetime employment, and many of those opting for the program are only doing so after a great deal of arm-twisting" admitted one senior executive.

At the same time, there are many who argue that, in real terms, these programs amount to very little. As the president of one foreign oil major pointed out, "Generally, Japanese oil companies are cutting their staff levels by somewhere in the region of 3%/year-but this is little more than the rate of natural attrition.

"Moreover, if you look at the programs being implemented, most of them are 2-3-year plans. There is very little attempt being made to implement longer-term restructuring," another industry source told OGJ.

According to in-house government statistics OGJ was given access to, the top six companies are expected to cut their staff levels by about 20% during the next 4 years. But a senior MITI official agrees that "this is still not enough if companies are to attain maximum levels of efficiency in what will eventually be a fully deregulated environment."

Foreign majors in Japan such as Esso and Mobil, however, have been quicker to cut staff. Last year saw Esso implement a truly radical restructuring program that saw it cut about 12% of its work force. Mobil, meanwhile, cut its own staff levels by 8%, with even sharper reductions expected this fiscal year.

Although most analysts estimate that oil companies operating in Japan are overstaffed on average by about 30% (with overstaffing at head offices reckoned to be as high as 50%), they point out that foreign companies such as Esso and Mobil-which are in many ways already considerably more efficient than their Japanese counterparts-are pulling away from the pack.

"These companies are pointing the way forward, and unless domestic firms act quickly to catch up in terms of boosting their efficiency, they will lose out in the long run" argued Sasaki.

Foreign vs. domestic players

In some ways, foreign companies are having their hands forced by their shareholders: "Generally we are far more accountable to or shareholders than our Japanese counterparts, which means that profit-optimization must be our ultimate concern," explained the foreign company executive.

He further mulled over the possibility that the bigger domestic players are deliberately playing a game of "who blinks first": "I sometimes wonder if these companies-which have massive financial resources at their disposal by any standards-are simply absorbing the losses in an attempt to push us smaller players out of the field, thus allowing them to dominate the market even further."

But foreign refiner/marketers operating in Japan are fighting back hard; not only are they often at the forefront of efforts to boost efficiency, but they are also looking to secure their position by increasing their share of the market. Showa Shell, for example, is expected to establish a joint venture with Mitsubishi Oil. Initially, the two companies are expected to merge their refining operations, with the possibility of this being later extended to cover their retail activities.

"However, this eventuality is unlikely, given the reluctance of the two companies to relinquish the public prestige associated with their brand name. Indeed, this is perhaps the single greatest problem facing future mergers in Japan-nobody is prepared to cede their service stations to another company," Toshinori Ito said. "Nevertheless, I'm convinced that we are going to see, if not full-blown mergers, a number of very close alliances being formed over the next few years and a consequent shift in companies' market shares."

OGJ has learned that Mitsubishi Oil is holding talks not only with Showa Shell over a possible merging of refining operations but also with Mobil.

Mobil, meanwhile, is looking to significantly increase its share of the retail market (currently about 7%) in order to boost its economy of scale: "There are basically three way in which we could do this: first, we could capture further market share through clever and original marketing. Second, we could simply build more service stations. Third, we could look to some sort of tie-up with an existing player," pointed out a senior company source. "However, our objectives will not be easy to reach-all of the options available to us are either very expensive or individually insufficient.

"Nevertheless, even in these troubled times, the Japanese market remains in total volume our second most profitable market in the world, and we intend to keep it that way."

However, he ruled as "unlikely" the possibility of a merger between Mobil and the Exxon group in Japan: "There is too long a history of rivalry between our two companies, and there are many legal complications involved." Many analysts have pointed out that a merger between the two companies makes sense, given that they are both major shareholders in one of Japan's most successful refining companies, Tonen Corp. Their merger, analysts point out, would create a single integrated refining/wholesale/retail company that would pose a very real threat to even their biggest Japanese rivals, given their already high levels of efficiency.

Consolidating facilities

The Exxon Group recently disclosed that it will consolidate a number of facilities belonging to Tonen Corp., General Sekiyu KK, and Esso KK in a move that is expected to save the firms about 4 billion yen/year.

General Sekiyu's plant at Kawasaki, Kanagawa Prefecture, is flanked by the production facilities of Tonen and its subsidiary Kygnus Sekiyu Seisei KK. General Sekiyu's plant currently has to import or receive shipments of unfinished gasoline blendingstock from its Osaka plant. Under the new arrangement, General Sekiyu will gradually contract out this operation to Tonen. Tonen and Kygnus are both short of storage capacity. The consolidation will allow them to use General Sekiyu's storage facilities when their own are shut down for maintenance. Tonen will lay pipelines to ship its kerosine and gas oil to General Sekiyu's tanks and use General Sekiyu's shipping facilities.

Esso Sekiyu and General Sekiyu have agreed to merge their research and production divisions for lubricant oil for industrial and marine use, where profit margins are on the decline. Most of the facilities will be consolidated at Esso, which produces 230,000 kl/year of lubricants, compared with 30,000 kl/year by General Sekiyu. However, the two firms will continue to handle marketing separately.

Nippon Oil and Idemitsu Kosan, meanwhile, are looking to add gasoline to their list of cross-supplied products, which already include residual fuel oil, kerosine, and gas oil. The two companies hope to reduce distribution costs by cross-supplying up to 5 million kl by 2001, or about 6-7% of their annual sales. Together with other cost-cutting measures, each targets savings of more than 5 billion yen in annual distribution costs.

They are also looking to exchange high-octane gasoline, although octane ratings differ between the companies, with Idemitsu's benzene content being less than 1 vol %, and that of Nippon Oil, 2-3 vol %. "Nevertheless, in technical terms, it would not be difficult for Nippon Oil to bring their specifications in line with ours" pointed out an Idemitsu source.

At the same time, the companies are expected to begin sharing eight oil storage facilities in Hokkaido and the Tohoku, Chugoku, and Kyushu regions by yearend, along with some road tanker operations.

"Nevertheless, we should not get too carried away by the announcement of such moves; they are typical of the sort of restructuring that is going on in the industry as a whole and should not be construed as necessarily leading to merger activity" pointed out one industry executive.

Excess service stations

Moreover, analysts argue, these types of tie-ups-while worthwhile-fail to address the far more pressing problems at the retail level facing the industry: "Companies are still being too slow in ruthlessly weeding out those service stations that are unable to be profitable," Ito said.

Part of the problem, he argues, is that many companies are still playing the market share game and are setting up almost as many new service stations as they are closing down unprofitable ones: "This is a suicidal policy-the simple fact is that there are already far too many outlets in Japan. Trying to replace ones situated in bad locations with ones in (presumably) better sites will not help-especially if everybody else is playing the same game."

Much of the dilemma stems from Japan's economic traditions.

The country's postwar mercantile economy was specially designed to gradually pass the cost of economic expansion onto the end consumer. While the economy was booming, this was not a problem because the Japanese consumer was kept happy by a level of personal attendance second to none, analysts contend. It also led oil companies to believe that they could carry on expanding their service stations almost indefinitely.

But now that the financial bubble has burst and deregulation has become a reality, competition has suddenly blossomed and exposed the flaws in the government's strategy.

"But in spite of the new economic environment, the whole structure has been set up in such a way as to make it extremely difficult to pull the plug on that host of mom-and-pop outlets in the middle of nowhere that come running back to us year after year for bail-outs" admitted one executive.

Other ways to profitability

This means that oil companies have had to look at other means to boost the profitability of service stations.

As a result, the last year or so has seen a proliferation of novel ways to achieve these aims through diversification.

These include Nippon Oil's and Showa Shell's respective tie-ups at their retail outlets with fast-food giants McDonalds and Burger King. Mobil and Federal Express, meanwhile, have arranged for the air courier to establish its parcel delivery outlets at Mobil service stations.

"These kinds of tie-ups are all the fad at the moment, but they are also all a shot in the dark that is likely to achieve very little in sorting out the underlying problem," one senior industry source acknowledged.

Weeding out inevitable

Nevertheless, oil companies realize that such a situation is simply not sustainable and admit privately that they are drawing up plans to weed out the hopeless candidates.

The general emphasis is on providing the greatest support in terms of financial assistance, advice, and guidance to those service stations that have the greatest potential for generating profits, with the scale of support diminishing in direct relation to potential profitability.

But the most controversial issue is the rate at which oil companies are implementing truly meaningful restructuring programs. The consensus among not only independent observers, but also at MITI-which drew up the deregulation program-is "far too slowly."

"Companies have to realize that the old way of doing things is gone forever-there will be no turning back the clock. Efficiency above all else is now the new order," said the MITI official.

More competition ahead

And as if the downstream sector didn't already have enough problems to cope with, two further steps aimed at boosting competition even more are on their way.

The first involves the abolition of the system of gasoline purchase certificates by the end of fiscal 1997. Companies will thus be able to operate service stations without a purchase certificate issued by gasoline supplier but will only have to register stations with the authorities.

Since 1977, service station operators have been required to present to MITI's Agency of Natural Resources and Energy a certificate issued by a gasoline supplier before registering stations. But supermarkets and other companies seeking to enter the field have opposed the regulation, because suppliers have refused to issue such certificates, fearing aggressive pricing by newcomers would send retail prices tumbling.

Deregulation measures implemented last April enabled trading firms owning storage facilities to issue purchase certificates. But because many trading firms also purchase from petroleum companies, they have been unable to issue documents without approval from their own suppliers. As a result of the new legislation, this will no longer be a problem.

In a related step, MITI has recently released a report calling for greater transparency in pricing by forcing wholesalers to publish their petroleum product prices-thus allowing service stations to shop around for the cheapest prices.

Second, an inter-ministerial committee is expected to rule in favor of the legalization of self-serve stations before the end of this fiscal year.

"Their imminent appearance is understandably giving the country's service station operators the willies," Sasaki said. "Already under a huge amount of pressure, there is little hope that they will be able to compete with such outlets."

Although refiners are likely to set up self-serve stations, the keenest proponents are bound be the new large-scale commercial distributors, such as retail groups Daiei and Jusco, whose philosophy is based almost solely on price merit. These new entrants, which are backed by plenty of capital as well as considerable managerial and marketing expertise, have already had a big effect on the market in spite of the fact that they only operate a handful of service stations. One clear example of how these new contenders can affect the market is provided by the city of Matsumoto in Nagano Prefecture, where the opening of Daiei's first service station resulted in a price drop of more than 10 yen/l. in the regional market.

What's still needed

But in spite of this constant build-up of pressure for reform, many argue that oil companies are clearly failing to take the necessary steps towards adjustment as envisioned by the designers of the deregulation package. As one industry observer pointed out, "MITI would like to see the downstream sector sorted out over the next 5-10 years. But this year, a mere 1,000 or so service stations were closed down-a figure that is in any case misleading because a large number of new outlets have been inaugurated, many with a far greater capacity than older outlets.

"If one takes a base figure of 40,000 viable service stations and a 10-year adjustment period, that still means that the annual rate of service station closures per year will have to more than double-and that's if they are to start this year, which looks increasingly unlikely."

The MITI source was clearly not kidding when he said that the administration is putting top priority on the promotion of deregulation and competition in order to correct the country's high energy cost structure.

The question now is just how long it will take the industry to change its mindset-and there is little doubt that the longer it takes, the worse the ensuing headache will be.

Copyright 1997 Oil & Gas Journal. All Rights Reserved.