Slick operators: Japan's upstream industry gets a crude awakening: from refining the world's most volatile commodity to refining the way it does business, Japan's upstream industry faces tough times in a deregulated world.

WITH HARDLY ANY 0IL of its own, Japan's relationship with the black stuff has always been a delicate balance. Its upstream industry has always hd to concentrate on research and development in some of the most sensitive spots around the world. Now a landmark decision has tipped that balance, and left government policy on the upstream oil industry in total disarray. The decision to dissolve the Japanese National Oil Corp (JNOC), has turned the industry upside down, and brought a previously closed world into the open.

To make matters worse, the plans laid out by the Japanese government to solve the problem are facing an investor rebellion: The Japan Oil Development Co (JODCO) raised a surprise objection to the rehabilitation schemes. The decision to dissolve the JNOC--slated to be closed down for good in 2005--was largely based on the mountain of debt that the company had amassed over its long and inglorious history. The move is part of a wider plan by the Ministry of Economy, Trade and Industry  (METI) to establish a "core company" to take over the upstream oil business of JNOC. The original idea was that JODCO would then step in to assume the operations, but when the shareholders threw their wrench into the proceedings, METI was forced to reconsider its strategy.

At least METI's upstream business strategy is growing a little clearer: It has been putting an emphasis on gaining more so-called "self development oil fields"--oil fields in which Japanese oil companies are directly involved in the development work from the earliest stages of the business. Projects include geological surveys and the physical digging of trial wells.

This development is largely the result of a disastrous event: In 2001, the Arabian Oil Co. lost its concession in Khafji Island in the Neutral Zone between Kuwait and Saudi Arabia. METI has been struggling ever since to obtain new "self development oil fields." So far, however, the tally is not impressive. JODCO has a meager 12 percent stake in only five oil fields in the oil rich United Arab Emirates (UAE).

The decision to terminate JNOC was also based on intense criticism of the company's management. The enormous debts alone were enough to persuade most observers that the company was poorly run, but management became so reckless that it eventually started to receive blunt attacks from the government's upper echelons. (Former MITI Minister Mitsuo Horiuchi was one of JNOC's more outspoken critics.)

To fill the gap that will be left by JNOC, METI has devised a scheme whereby the three leading upstream companies in Japan--JODCO, Inpex and Sakhalin Oil and Gas Development (SODECO)--will merge to form a core company with total responsibility for all upstream operations. Hiroshi Shiono, the head of the Energy Council's subcommittee on the emerging strategy, explains that the government strive to make the new group a "national flag company." While it will not be big enough to compete with the major players such as ExxonMobil or BP, it will have the size and reach to rival some of the world's second-tier oil companies.

In METI's post-JNOC scenario, JODCO, which imports about 220,000 barrels of crude oil per day, including 110,000 billion barrels per day of equity oil, will now become the central pillar of the new company.

JODCO is one of the largest oil importers in Japan, but it too is saddled with massive debts accrued during its earlier days. Inappropriate capital management policies were the chief culprit: According to its financial statement of December 2002, JODCO has run up a total of [yen] 307.6 billion in debts, including both short-term and long-term borrowings. In a controversial effort to allow the new company a trouble-free takeoff, METI took the unprecedented step of relieving JODCO of its debts under the terms of the then newly enact ed Civil Rehabilitation Law.

By timing this move before the three-way merger officially took place, METI ensured that its grand plans were left seemingly unthreatened on the fiscal front. The Civil Rehabilitation Law, partly modeled on the US bankruptcy law's Chapter 11, has been in place since April 2000, offering failed Companies a lifeline 1hat helps them recover as soon as possible.

Under METI's new vision for upstream oil in Japan, JODCO filed its application for debt protection in the Tokyo District Court on March 19. By June it had compiled its rehabilitation plan, and a creditor's meeting was held on July 9 involving all of JODCO's 25 creditors. At that meeting, the company won support from more than half of the creditors for its rehabilitation plan, and the Tokyo District Court duly granted its approval. The rehabilitation plan was reported on the Kanpo, or Japanese Federal Register, in late July.

The JODCO rehabilitation plan is a relatively straightforward document stating that all of the capital offered by investors will be forfeited, and all creditors except JNOC will write off the interest due on their loans. (principal is to be paid back fully within one month). 51 percent of the loans of JNOC (including the principal and interest) will be written off. Of the remaining 49 percent of JNOC debt, [yen] 10 million will be paid back in cash within one month, and the rest will be converted into newly issued JODCO shares within one year.

At all appeared to be plain sailing at that point--until the shock rebellion took place. Three of JODCO's 10 investors lodged an immediate complaint with the Tokyo High Court over the capital reduction plan. The matter is under appeal, and if the Tokyo High Court approves the investors' complaints, JODCO will be required to scrap its rehabilitation plan and come up with a new one. This prospect has created serious concerns back at METI, where bureaucrats Call sec the fruits of their hard work rotting on the vine. Without a debt-free JODCO, the whole "core company" side of the ministry's plan will effectively collapse.

It does not seem likely that the objections will go away. The investors who lodged their complaints stated flatly that they will not accept JODCO's 100 percent capital reduction plan.

Under the Civil Rehabilitation Law, a failed company can reduce its capital up to 100 percent if the company is in default status. The basis of their objection, say the investors, is that JODCO had notproperly tumbled into default status. Indeed, JODCO's latest financial results showed that the company had not defaulted. JODCO's counter argument to all this was that it foresaw certain default by the end of 2003 if the situation wasn't rectified. JNOC is a 90 percent stakeholder in JODCO (nine non-governmental companies hold the remaining 10 percent). JNOC has been offering a helping hand to JODCO by giving it a grace period for the principal and interest payments until December 2003. Earlier this year, however, JNOC told JODCO that it would terminate that special arrangement between the two companies. With that safety net removed, the firm would therefore fall into default when the payment of a total of [yen] 243.7 billion became due at the end of this year.

But this only explains half of the debt problem looming over JODCO. In February this year, the group's president, Takashi Nonouchi, reached an agreement with the UAE government to revise payment conditions regarding JODCO's five off fields. JODCO has not disclosed the conditions of the new contract. But industry sources believe that the tax payments due in connection with those five oil fields will be increased from the current 67.5 percent to 80 percent in 2004. To make matters worse, starting in 2006 the margin from these oil fields will be pegged at just $1 per barrel of crude. According to Nonouchi, the revision of the contract will deliver an annual [yen] 10 billion hit to JODCO's operating profit.

The Overseas Petroleum Corp, the largest shareholder in JODCO after JNOC, filed a class action lawsuit against President Nonouchi and seven other Board Members of JODCO over their failure to consult the board before changing payment arrangements with the UAE.

Despite all of this, one could easily argue that the very structure and nature of JODCO made it destined for abject-failure from the outset. The rot clearly set in many years ago when the company splashed out $780 million and purchased stakes in the Upper Zakum and other oil fields in the UAE in the early 70s. JODCO did not have much free-flowing cash in those days, so it borrowed heavily to finance its little Middle Eastern spree.

According to industry sources, a group should never use an interest-bearing loan to cover the costs of buying an upstream business, because upstream enterprises always entail high risk. If the business fails to find any oil reserves, it will not be able to make any money. JODCO used a high-interest loan when it went into business, creating a debt that has hollowed-out most of its profits since then.

JODCO and the Overseas Petroleum Corp are sister companies. It was Overseas Petroleum who actually purchased oil field rights in the UAE in 1972. The following year, Overseas Petroleum, with nine other companies, founded JODCO to launch the UAE business.

Hiroki Imazato, the president of Overseas Petroleum and later the president of JODCO, raises an objection to the $780 million stake purchase: "If JODCO purchased these oil fields at such a high price," he notes, "it would fail to run its business." But the Japanese government, which maintained a policy holding that Japan should obtain as many self-production oil fields as it could, urged Overseas Petroleum to close the deal with BP, the former stakeholder in the oil fields. On Dec. 26, 1972, the Japanese Cabinet approved a statement that "the government would provide the necessary financial support to JODCO." In London, Imazato signed the deal with BP over the oil field on the same day.

A spokesman for Overseas Petroleum says that neither the government nor the JNOC gave a helping hand to JODCO, despite the Cabinet decision. "JNOC provided money when JODCO fell short of cash in hand. However, these maneuvers were no more than a symptomatic treatment and did nothing to solve the basic problem," he explains. JODCO's debt continued to swell. According to industry sources, JODCO's interest payments amounted to [yen] 340 billion.

Inpex, one Of the rare profitable upstream businesses in Japan, is said to he reluctant to integrate its business with the debt-ridden JODCO. In the event of a merger between the two, it is obvious that Inpex's financial status will be weakened. Kumihiko Matsuo president of Inpex, reportedly said he would never board a sinking "mud boat." In order to persuade Matsuc, METI allegedly promised him that the government will clean up JODCO's swollen debt before it allows JODCO to integrate with Inpex.

SODECO, the third company in the new triumvirate, has no impact on the cote company right now since its business has not yet been launched. SODECO has a 30 percent stake in the Sakhalin I project. Some industry sources said that SODECO might have financial difficulties for the following reasons: (1) The Sakhalin I project is still a long way from launch production, (2) it has so far failed to find purchasers for its natural gas, and (3) SODECO needs to coordinate its business with ExxonMobil, the operator of the Sakhalin I project, if it integrates its business with two other firms.

There are only one and a half years remaining until the scheduled dissolution of JNOC. The semi-governmental company categorized all of its invested companies into four groups: companies forming the core company--JODCO, Inpex and SODECO; profitable companies; companies which are expected to be profitable; and non profitable companies--in other words companies which should be liquidated. Once evaluation is completed it will start selling the assets via tender.

Overseas Petroleum and Toyo Oil Development, two investors who each lodged a complaint against JODCO's 100 percent capital reduction plan, have another reason for raising an objection.

Nine forming companies of JODCO were granted the lights for selling the crude oil JODCO imported from the UAE. JODCO was founded as a company specializing in production and does not have any distribution networks. Investing companies like Overseas and Toyo were granted rights to market the crude oil to customers. JODCO imports $220,000 billion worth of crude, or about 4 percent of Japan's total crude import. The royalties--a total of [yen] 300 million per year--are the major income for both Overseas Petroleum and Toyo Oil. In the case of Overseas Petroleum,

the royalty income from JODCO accounts for about 20 percent of its total annual income. In the case of Toyo Oil, the income from JODCO accounts for about 50 percent of its total income. A spokesman from Toyo said that if Toyo loses its income from JODCO, Toyo might be forced into bankruptcy.

The crude oil sales scheme was established when JODCO was founded in 1973. Back then there was a consensus that since oil exploration business was so important for resource-scarce Japan, every industry in Japan had to support the business by offering some funds to the upstream industry.

Under the leadership of METI, which was committed to expanding self production oil fields, trading firms and financial institutions have established investing firms and collected funds from a variety of companies. So virtually all major Japanese companies have stakes of varying sizes in these nine investing companies.

Overseas Petroleum has 68 stakeholders while Toyo oil has 33. However, neither company has sound financial results these days. Once the oil sales contract is terminated upon enactment of the Civil Rehabilitation Law scheme, they might face bankruptcy. A spokesman from one of these investing interests said the mission of the companies might be finished, since circumstances surrounding the upstream industry have changed.

An official at the Japan Petroleum Development Association, an upstream business association in Japan, says the confusion has occurred because METI decided the post-JNOC plan without doing establishing the necessary contacts for negotiation. All prior governmental projects in upstream business have failed, he adds.

Kazuhiro Sakuma, an analyst at Daiwa Securities, notes that if JODCO were a regular or nongovernmental company with just 140 employees, it would not need to use the Civil Rehabilitation Law scheme. JNOC and METI decided to let JODCO apply for the Civil Rehabilitation Law in order to win support for METI's post-JNOC plan. He claims the complaints lodged by Overseas Petroleum and Toyo Oil will not have much impact on METI's post JNOC plan.

Hidetoshi Shioda, an analyst from Nomura Securities, argues that since Inpex and JODCO have different business purposes and schemes, it is difficult to integrate them. "Inpex is focused on acquiring stakes in already established oil fields and is carefully considering profitability. On the other hand, JODCO is focused on exploration and does not particularly care about profitability. The government should consider setting up two different core companies--one for profit, and the other one for high risk exploration."

The government is continuing its focus on the expansion of self production oil fields. Circumstances surrounding upstream business have evolved dramatically, and it is now imperative that Japanese oil companies start paying more attention to profitability. It might be time for the government to reconsider upstream strategies and reconfigure its corporate infrastructures. The suggestion from Nomura's Shioda--that the government establish two separate core companies and missions--might be the best solution.