Pressure building to restructure Japan's beleaguered refining-marketing sector

The Hokkaido refinery operated by Idemitsu Kosan Co. Ltd. accounts for part of the 5.3 million b/d of refining capacity in Japan that is underutilized. Analysts say at least 1 million b/d of Japan's refining capacity must be closed to bring utilization up to acceptable levels, a process they contend is moving too slowly. Photo courtesy of Idemitsu Kosan.

Japan's network of service stations, such as this one, owned by Idemitsu Kosan Co. Ltd., faces a massive consolidation in the wake of deregulation of the country's refining-marketing sector. Photo courtesy of Idemitsu Kosan. [34,099 bytes]
Nippon Oil-Mitsubishi Oil Combination [55,220 bytes]
Trends In Japanese Service Station Closures [42,798 bytes]

This is the second of three articles focusing on the consolidation under way in Asia's refining-marketing sector. The first article examined the Nippon-Mitsubishi merger and potential further consolidation in Japan's downstream. This week: a look at what Japan's refiner-marketers must do in order to survive deregulation and dismal profits. Next week: Sterling Group explores the dilemma of Southeast Asia's surplus refining capacity.

The pressure to reform Japan's refining-marketing sector continues to build in the wake of the watershed impending merger of Nippon Oil Co. Ltd. and Mitsubishi Oil Co. Ltd. (OGJ, Mar. 1, 1999, p. 23).

Industry critics charge that the rationalization of capacity in both the refining and marketing sectors is occurring at a glacial pace.

The pressure to reform continues to build; just about all the major Japanese oil firms reported poor first-half year 1998 earnings, largely because a sharp slide in gasoline prices has prevented the industry from enjoying the benefits of a slump in global crude oil prices, analysts say.

Japanese oil firms import almost all of the crude oil they refine, and the decline in crude oil prices to 10-year lows would have boosted their performance under normal conditions. But shriveling profit margins at the pumps have eroded oil companies' profitability.

Shrinking profits

The parent of Nippon Oil Co. Ltd., the soon-to-be industry leader after its merger with Mitsubishi Oil (see table, p. 24), reported a profit of ?593 million in the fiscal half ended Sept. 30, down 88% from the same period a year earlier. This profit is pre-tax and includes losses or gains on investments.

Japan Energy Corp. suffered a loss of ¥6.4 billion in its most recent reporting period, and Mitsubishi Oil Co. Ltd. a loss of ¥2.8 billion. Even General Sekiyu, the Japanese retail group affiliated with Exxon Corp. and one of the country's most profitable operators, is to post its first interim loss in more than 10 years amid deterioration in the country's gasoline market.

General Sekiyu, which is 48.5% owned by Esso Eastern, also cut its second-half forecasts after a worse-than-expected interim performance. In the first half of the current fiscal year, the firm said, it recorded pre-tax losses of ¥3.2 billion ($27 million) before taxes and exceptional items at the parent level, on sales that were down 13% at ¥240 billion. This compares with pre-tax profits of ¥6.94 billion last fiscal year. Net losses were expected to be ¥3.5 billion.

The company last reported an interim loss in 1985. "The decline particularly in gasoline prices is what has (hurt earnings)...The fall has been particularly stiff since April 1998 and shows a steep slide when compared with the first half of fiscal 1997," said Nikko Research Centre analyst Takashi Kawai.

Japan's oil companies lost their virtually exclusive right to import oil products in April 1996, due to market deregulation that triggered a vicious price war at gasoline stations. Last year, analysts said future gasoline prices would be one of the main keys that would determine whether oil companies would see a recovery in earnings for the second half ending Mar. 31, 1999.

Some analysts say the retail gasoline market could stabilize, although it is harder to see whether retail prices will bounce back in the current business climate. The price of gasoline at service stations in Japan during April-September was an average ¥92.5/l., compared with ¥103.3/l. for 1997, says an energy think-tank survey.

Meanwhile, the cost of crude oil imports fell by about only ¥2-3/l., and this caused profit margins to deteriorate by about ¥7/l. in the first-half of the current fiscal year, Kawai said.

Rationalization too slow

Analysts also say Japan's oil industry is moving too slowly to rid itself of excess service stations and refining capacity, both of which are factors weighing on profitability.

Lalith Gupta, oil analyst with Deutsche Securities Japan, contends that Japanese oil companies should step up the pace at which they are trying to close some of their roughly 59,000 service stations nationwide.

"They (Japanese oil refiner-marketers) are shutting down about 3% of their gasoline stations every year. At this rate, it is going to take the industry 17.48 years to achieve a target of closing 40% of the pumps, which is the widely quoted industry figure," she calculated.

Analysts say another burden weighing on the industry is its 5.32 million b/d combined refining capacity, which many say should be reduced by as much as 1 million b/d.

Gupta says oil firms are taking steps to cut costs by staff reductions and streamlining distribution systems, but that they have still not started tackling their excess capacity. "Most companies will have cut their controllable costs by well over a third by 2000," she said, "while Cosmo Oil will have cut its controllable costs by over 80% (see table, OGJ, Mar. 1, 1999, p. 24). Although this sounds impressive, companies are still likely to be posting losses given the level of competition and overcapacity at the refining level. This means that they will eventually have to start looking at making cuts in their assets, and the clear financial candidates are the refineries and service stations."

Indeed, Cosmo Oil recently announced that it plans to institute a lease-back scheme for its 1,500 service stations nationwide, selling them to special-purpose corporations set up by real estate firms, which in turn would then securitize the land and facility assets of the stations, selling them to small-lot investors in the form of stocks or company bonds. The objective for Cosmo is to reduce assets and cut debt in order to improve finances without losing any of its petroleum products sales locations. Cosmo is also reportedly considering securitization of its gasoline, kerosine, and light oil inventory.

Excess refining capacity

Although the industry's consensus is that refining capacity must be cut drastically-its 44 refineries have recently been operating at just 74% of capacity-at present only two refineries are due to be closed. These are a 26,000 b/d Nippon Oil refinery and a 40,000 b/d Showa Shell Sekiyu KK refinery, both in Niigata prefecture on the Japan Sea coast. Mitsubishi Oil says its 75,000 b/d refinery in Kawasaki, near Tokyo, is also a candidate for possible closure, although it has yet to make a decision.

Thomas O'Malley, chairman and CEO of Tosco Corp., had a blunt message for Japanese oil companies during a recent seminar held in Tokyo: "As long as Japan continues to have excess capacity, results will remain poor. Converting or upgrading refineries will not work-there is no solution to the country's 1 million b/d excess refinery capacity bar getting rid of it. At the moment, the weak are destroying the strong, and this must stop.

"My message to companies looking at (mergers and acquisitions) to solve their plight (is that they) must realize that the sole criterion by which their success can be measured is profitability."

Masamoto Yashiro, CEO of Citibank Japan and formerly with Exxon, echoed this view: "Japanese oil companies must concentrate their efforts on recovery by looking at their overall cost structure. They cannot afford to be complacent. Trade-off of supplementary strengths is a mistake; all areas of a company's business should be profitable."

Moreover, although, for over 10 years now, the government has been passing all the major bills covering deregulation of the industry, including the liberalization of oil imports and exports, as well as permission for the establishment of self-serve stations, it has been clear that only recently has the traditional godfather of the industry, MITI, relinquished its hold on the sector (see related story, p. 26).

"For several years, there was clearly a vicious battle going on within MITI between the reformers and the die-hards. MITI's conspicuous absence from the Nippon Oil/Mitsubishi Oil deal shows who has evidently now won the battle-and that will be yet another prop kicked from under the oil companies' feet," pointed out Toshinori Ito, senior analyst at Daiwa Securities.

BP's entry

And yet, in spite of (or perhaps because of) the turmoil, last year saw the surprising announcement by British Petroleum Co. plc that it will move into Jpana's retail sector, marking the first foreign entry into the sector in 50 years.

"Deregulation, combined with the state of paralysis affecting the industry, makes us believe that there exists a good opportunity for us to develop and corner a niche market, namely the self-serve station," explained Gordon Souter, president of BP Japan.

Although the company has as yet only two such stations operating, it will have a further three up and running by midyear, Souter said: "This is the pilot project. If it is successful, then we are looking at building up to 120-150 such service stations over the next 5-7 years."

Souter believes that BP will face little competition from existing retailers, and vice-versa: "We're looking for places that will have big sales volume, such as suburban areas, rather than trying to compete with the typical small urban outlets."

Although much hype has been made over the liberalization of laws covering service stations in April, there has been little investment to date in self-serve stations. Some companies, such as Cosmo Oil, have opened just a couple of such outlets. However, the initial heavy investment needed to remodel existing outlets, along with oil companies' concerns that opening self-serve stations could have a bearish effect on the already weak retail gasoline market by prompting further competition, are clearly holding back widespread expansion.

On the other hand, Souter warns against complacency: "Our competitors are waiting to see just how successful these kinds of outlets are. If they will be as successful as we think they will be, we have no illusions that it will be long before the pack follows hard on our heels."

Service station dilemma

Gupta, however, is less sure: "The problem is that, unlike the foreign players such as Showa Shell, Exxon, and BP, the Japanese companies lack the know-how and expertise in the area, and this means that the development of self-serve stations will be haphazard and likely to be dominated by the foreign oil majors." On the other hand, the basic concept of what a service station is and what services it should provide has remained virtually static since their introduction into Japan. As one foreign executive put it, "They are marked by their singular lack of originality and innovation."

But the level of competition is forcing companies to make more efforts in trying to find a prototype that will attract more customers. The result is that the last couple of years has seen a host of partnerships "ranging from the just about conceivable to the clearly preposterous," said Gupta. Who, for example, is going to want to do their laundry or eat a burger in the smelly environment of a service station?"

Thomas O'Malley, during his speech at the Tokyo seminar, agreed: "With such small margins on the actual gasoline, service stations must be viewed as selling sites, with non-related products on offer for customers to spend their money on. But this does not mean just setting up any old shop-you have to offer products and services that people will want to buy."

However, with most companies far too strapped for cash to afford wide-scale reform of their service stations, Gupta believes that the movement on this front will be limited and consumers will be condemned for several years yet to putting up with the existing retail outlet format.