* METI pushes for alliance, consolidation as demand declines
* Loose alliances short of merger to be expected by 2017
* Any consolidation may come after 2017
By Osamu Tsukimori
TOKYO, Nov 20 (Reuters) - Japanese refiners are planning to cut crude distillation capacities to meet a new government directive, but analysts say the moves will not forestall the need for them to consolidate at some point over the next several years.
An earlier government directive reduced refining capacity by 20 percent from 2007 levels, putting demand and supply in balance and pushing up gas oil margins to a two-year high. But industry executives say they are still resigned to a long-term bleak outlook as Japan's ageing population shrinks and domestic oil demand falls 2 to 3 percent every year.
The trade ministry's second directive says "reorganisation" of the industry is a goal, with refiners encouraged to merge or cooperate in areas where plants are clustered together to make it easier to comply with requirements to reduce the percentage output of high-value products like diesel and jet fuel.
To further spur reorganisation, industry sources say the Ministry of Economy, Trade and Industry (METI) is likely to impose a third directive after the current one ends in 2017.
"From the trade ministry's point of view, an alliance is regarded as a must," said Okasan Securities senior sector analyst Shinichi Yamazaki, adding that shrinking demand casts a pall over the sector's finances.
"There is a chance that the number of major refiners could be down to four, from five now, by 2020 or 2021 during the third directive. By then consumption should have fallen substantially and made their financial situation dire."
Despite the improvement in fuel margins, Japan's five major refiners posted inventory valuation losses that totalled to 62.3 billion yen ($526 million) in April-September due to oil price declines.
Reiji Ogino, a senior analyst at Mitsubishi UFJ Morgan Stanley Securities, also expects consolidation to occur down the line. "This could occur ... after the current directive ends (in March 2017)," he said.
TonenGeneral Sekiyu, Japan's second biggest refiner by capacity, and Cosmo Oil, the fourth-biggest, are set to form a loose alliance at their Chiba complexes, an example METI hopes other refiners will imitate.
Refiners submitted their initial plans to meet METI's July directive by Oct. 31, many indicating they plan to cut crude capacities while they seek suitable alliances with others.
The second directive will cut refining capacity by 9.5 percent to 3.57 million barrels per day (bpd) by the deadline in March 2017, according to Reuters calculations based on government data.
Even with the cuts, the domestic market could still be oversupplied by about 400,000 bpd, as oil demand in the world's fourth-biggest user is projected to fall to 3.15 million bpd by then.
"At METI they are thinking that in the oil industry two or three (companies) is enough," said a senior executive at one of the smaller refiners.
Japan's biggest refiner JX Holdings, which controls about a third of domestic demand, cannot grow any bigger by absorbing a smaller oil processor due to antitrust concerns.
No.2 TonenGeneral, though, which does not have any upstream business, could play a key part in any future consolidation, Yamazaki said.
Some industry executives are chafing at the latest METI directive and question its effectiveness.
"There is no need to scrap refining units," said an executive with a refiner who declined to be identified. "How does that enhance competitiveness?"
A senior METI official who did not want to be identified said that the refiners misunderstood the intent of the directive.
"The objective is not capacity reduction but enhancing business reorganisation toward improving (efficiency)," the official said.
$1 = 118.51 Japanese yen Additional reporting by Aaron Sheldrick; Editing by Tom Hogue