Japan's energy shake-up
The country's energy industry has been thrown into a state of turmoil by 'Abenomics'
Japan's energy sector faces declining long-term consumption and a reversal of historic government policy that has been preoccupied with security of supply for the best part of half a century. Yet although demand for oil is steadily shrinking, Japan remains an important premium country for oil producers. With limited crude resources of its own—despite decades of exploration, mostly outside the country—Japan imports around 4m barrels a day.
"Accordingly, oil producers that can reliably supply the correct class of API and sulphur content crude compatible with Japanese refinery configurations, can rely on captive customers," notes the Oxford Institute of Energy Studies in a paper published in February.
Unfortunately for non-Middle East producers, it's the Gulf suppliers that have captured those customers. Due mainly to historic reasons, Saudi Arabia and the United Arab Emirates have built up dominant positions and are busily cementing them. Recently, Saudi Aramco and Adnoc struck agreements to store crude in Okinawa and Kagoshima, where it's held for commercial purposes. According to the latest figures, these stores accounted for four days' worth of the two governments' strategic petroleum reserves.
And further deepening their ties with Japan, Middle Eastern NOCs have lately taken mainly small stakes in domestic refiners and distributors such as Showa Shell, Cosmo Oil and Fuji Oil. If a long-planned merger between Idemitsu and Showa Shell gets the green light, Saudi Aramco will put itself in a historically unique position for an offshore NOC. For it will end up holding an equity stake in the merged entity that controls approximately 25% of Japan's crude refining capacity. Even more interestingly, as OIES points out, Saudi Aramco could leverage the stake into downstream operations in other Asian markets, such as Vietnam.
So far though, the saga has been one that typifies the habit of long-standing shareholders to block mergers and acquisitions that could streamline a highly fragmented industry. Idemitsu and Showa Shell, in which Shell sold a 33% stake in late 2016, agreed on a merger exactly a year ago; but it was thwarted by the Idemitsu founding family, which holds a roughly 28% stake.
Fast forward 12 months, and in March 2018, the companies came up with a non-financial arrangement whereby Idemitsu and Showa Shell would swap executives. As the Nikkei Asian Review put it, it's "a further tie-up short of a full-on merger".
Resource diplomacy failures
In the meantime, the upstream and downstream industries are bracing themselves for dwindling demand that's undermining historic government policy. For decades, Japan has been fixated on security of supply, to the extent of making numerous misguided decisions over upstream investments overseas that have fallen well short of targets. Known as "resource diplomacy", the policy has largely driven upstream and downstream strategies.
With an oil import dependency standing at 99.7%, it's not hard to see where Japan's obsession with oil security comes from. For comparison, in absolute terms Japanese oil imports are more than twice the French and Italian levels, and around 60% higher than Germany's.
In much the same way as many countries developed their own steel industries at great cost when ample supply was available from elsewhere, Japan has until now based much of its oil policy on the so-called self-development ratio (SDR). This is the share of oil produced by Japanese upstream companies as a proportion of total imports.
Policy reversal: Prime Minister Shinzo Abe
Unfortunately, the results have proved consistently disappointing. Despite resource diplomacy, Japan's equity oil and gas output growth has stagnated—and from a low base. In the 12 months to March 2017, output inched up by 0.2%, to 1.47m barrels of oil equivalent a day, with Japanese upstream companies' equity stakes accounting for 27.4% of total demand. As the OIES says, that's not much for all those decades of resource diplomacy and heavyweight taxpayer-funded investment. In many of these upstream gambles, it was the government that bore the cost of failures, while the operators banked the profits from the winners.
In part because of the powerful Ministry of Economy, Trade and Industry's (Meti) obsession with the self-development ratio, the oil and gas industry has also remained highly fragmented. Quite unlike the Gulf nations, there's no vertically integrated national oil champion, with the possible exception of Inpex, 18.9%-owned by the government.
And over the years—in fact since the first oil shock—Gulf producers have become such a reliable source of supply that Meti hardly needs to bother about oil security. Between Saudi Arabia, the UAE and other Gulf-based NOCs, Japan relies on the Middle East for 87.2% of its total, annual oil imports.
At this stage it might be time for Meti to get out of the road. As OIES argues: "Japanese oil firms need the freedom to outgrow state support, seek upstream opportunities, compatible with their strategies, and compete on the basis of their competitive advantage and access to the still large Japanese market."
While the oil industry stands at a crossroads, the natural gas sector is in a state of creative turmoil. The flurry of activity reflects the government's plan to establish an international liquefied natural gas hub by the early 2020s.
Gas imports are rapidly becoming more diversified. For example, the Middle East supplies just 23.6% of Japan's needs, with most of the rest coming from Australia, in particular the giant Inpex-operated Ichthys LNG project off Darwin, and from Malaysia and Indonesia.
99.7%—Japan's oil import dependency
In another contrast to its relationship with Gulf crude suppliers, Japan has embarked on a policy of much more flexible LNG supply contracts. In mid-2017, for instance, the domestic competition authorities indirectly forced Malaysia's Petronas to agree to rewrite its delivery arrangements to Japanese LNG customers.
Encouraged by Meti, which has put $10bn worth of investment support on the table, domestic LNG firms are getting out and about. Many are boosting stakes in infrastructure projects in neighbouring countries. At the same time, they're trying to sell off excess LNG availability in the anticipation of weakening domestic demand, mainly because of the imminent prospect of the gradual restart of the nuclear power industry.
After an angst-ridden debate over the future of nuclear, Japan is slowly firing up its reactors. Clearly, this poses questions for the oil and gas industry, and especially for oil imports. The current plan is to generate up to 22% of power output from nuclear reactors in 2030, but there's likely to be several hurdles to clear first. In late 2017, for example, the Hiroshima high court told Shikoku Electric Power to suspend the restart of a reactor. Observers say the decision could significantly influence other legal rulings on a general return to nuclear power.
In this opaque picture, S&P Global Platts has estimated, on the assumption that 16 nuclear reactors will be in operation by late 2022, that gas utilities will end up with a hefty oversupply. By 2019, that could be as high as 21.5m tonnes, albeit declining rapidly thereafter.
When all these factors are thrown into the hat—dwindling oil demand, LNG oversupply, a return to nuclear power and, for good measure, government backing for coal power—Japan's upstream and downstream finds itself in an interesting position.
As the OIES puts it: "There is no denying Japan is a sunset market in the oil sector".