Japan’s oil refining industry may be forced to cut about 10% of capacity as the government is set to impose new targets to improve efficiency and spur restructuring and mergers.

Refiners will be required to increase the volume of high-value fuels such as gasoline and diesel they produce in relation to the output of low-quality by-products by either renovating their facilities or reducing oil-processing volumes, according to a draft of the Ministry of Economy, Trade and Industry’s rules released on Monday. 

The new targets may force them to cut about 400,000 bpd from the country’s current 3.95 million bpd of capacity, the ministry said.

“The refining industry is very likely to fall into a state of serious oversupply” without measures including cutting excess capacity, Meti said in the report.

Japan’s oil demand has declined due to its shrinking population and a shift to more energy-efficient cars, prompting refiners to lower output. Further reductions would be needed as about 22% of the country’s capacity would be redundant by fiscal year 2018, Meti said in a separate report today citing a study on the industry.

This is the second time in four years that the government has forced the industry to improve efficiency. The ministry in 2010 required an increase in residue cracking-to-distillation ratios by the end of March 2014. Most companies decided to scrap crude units rather than invest in costly cracking facilities.

Refiners will be faced with a similar choice again, said Yuji Nishiyama, a Tokyo-based analyst with JPMorgan Securities Japan.

“The biggest reason is money,” Nishiyama said. “As it is questionable if building such a unit makes sense amid declining demand, nobody would do it.” Cosmo Oil Co., which is partly owned by the government of Abu Dhabi, spent about 100 billion yen ($987 million) to upgrade its Sakai refinery, which started commercial operations in October 2010.

Under the proposed rules, the average ratio of the industry’s capacity to process residues compared to simple crude distillation should be improved by the end of March 2017 to about 50%, from 45%now, according to Meti.

Companies whose upgrading-to-distillation ratio is less than 45% would need to increase the proportion by 13% or more, according to the new rules. Facilities with a ratio between between 45% and 55% would be required to raise the proportion by at least 11%, and those with 55% or more would need to improve the ratio by at least 9%, according to the proposal.

The new rules would allow the refiners to take into consideration three types of units not covered by the 2010 order: fluid catalytic crackers, residue desulfurization units and solvent de-asphalting units. Previously, only residue fluid catalytic crackers, cokers and hydro-crackers were counted.

Refiners will also be allowed to cut crude distillation nameplate capacity, unlike the previous rule, which required them to close units, according to the proposal. Meti would also allow refiners that have merged operations to share reductions in a bid to encourage restructuring. The companies will be required to submit their plans by end of October.