Shares in Japanese refiners surged on Monday after two of the largest said they were discussing a tie-up, as falling demand for fuels spurs the industry to consider consolidation.

Idemitsu Kosan Co., Japan’s third-biggest refiner by capacity, and Showa Shell Sekiyu KK, the fifth-ranked firm, are holding talks, the companies said in separate statements Dec. 20. The announcements followed a Nikkei newspaper report that Idemitsu may bid as much as ¥500 billion ($4.2 billion) for Showa Shell, a 30 percent premium to last week’s closing value.

Domestic demand for fuels has declined amid a shrinking population and a shift to more energy-efficient cars, prompting Japan’s government to encourage consolidation and a reduction in processing capacity. Adding Showa Shell’s operations would give Idemitsu control of about 30 percent of the domestic gasoline market. The two companies have almost 15,000 employees.

In its statement, Idemitsu said it is considering “the realignment of businesses and are discussing a number of possibilities also with Showa Shell.” Showa said it is weighing its options “including tie-ups with other companies and within that context we are holding talks also with Idemitsu Kosan.” Both said nothing has been decided yet.

Nomura Securities Co. called the development positive and views the reorganization of the industry as unavoidable, according to a note by senior analyst Shigeki Matsumoto.

On Nov. 4, Idemitsu cut its forecast for full-year operating profit by 16 percent to ¥67 billion, compared with an average estimate by analysts of ¥82 billion. The company might reduce capacity at its 220,000 barrel-a-day Chiba refinery near Tokyo, it said at the time.

TonenGeneral Sekiyu KK, which has agreed to combine refinery operations in Chiba with another plant operated by Cosmo Oil Co. to increase efficiency, said in a statement Saturday it’s considering alliances with oil companies.

TonenGeneral is Japan’s second-largest refiner by capacity and Cosmo the fourth. The Chiba deal, which starts next year, could pressure other companies to follow suit, according to Nomura’s Matsumoto. TonenGeneral and Cosmo were up 6.2 percent and 17 percent respectively.

Royal Dutch Shell Plc. is the largest shareholder of Showa Shell, with a 33 percent stake, and is inclined to accept an Idemitsu bid, the Nikkei said. Royal Dutch Shell declined to comment.

A unit of Saudi Arabian Oil Co. owns 15 percent of Showa Shell, data show. An official at the company’s office in Tokyo could not immediately comment.

Earnings for Japanese refiners were weaker than expected for the July-September period, Hidetoshi Shioda, an analyst at SMBC Nikko Securities Inc., wrote in a Dec. 15 report.

“We think the oil companies will need to fundamentally overhaul cost and earnings structures, since they can no longer rely on wide spreads for oil products to generate high earnings,” Shioda wrote. “We would like to see these firms implement bold measures, including the scaling back of production facilities, refinery closures and corporate reorganization including alliances with other companies.”

Japanese refiners should seek “restructuring and mergers” to cut processing capacity in a country where oil product demand is forecast to fall by 7.8 percent between fiscal 2013 and 2018, the Economy, Trade and Industry Ministry said in a June report.

JX Holdings and Idemitsu will maintain a refining and distribution partnership regardless of Idemitsu’s talks to acquire Showa Shell, according to the Nikkei.

Idemitsu operates domestic refineries with a combined capacity of 555,000 barrels a day. Showa Shell can process 445,000 barrels a day. Combined, they would rank as Japan’s second largest refiner after JX Holdings, which has a capacity of 1.06 million barrels.

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