* Japan facing refining sector overhaul
* Idemitsu-Showa talks may spark more mergers
* Falling oil demand pressuring sector
By Osamu Tsukimori
TOKYO, Dec 23 (Reuters) - Japan is facing a refining sectoroverhaul as its population ages and shrinks and the economyshifts from oil to gas, resulting in oil demand falling 2-3percent a year.
Consolidation looks to have kicked off with Japan's No. 2refiner Idemitsu seeking to buy No. 5 Showa Shell in a 500billion yen ($4.2 billion) deal that would bring them close toindustry leader JX Holdings.
"On the background of falling demand, it is better to do it(consolidate) together in terms of distribution cost," saidReiji Ogino of Mitsubishi UFJ Morgan Stanley Securities.
The combined company would have annual sales of about 8trillion yen, making it the second biggest after the leader JXHoldings and control about 30 percent of Japan'sgasoline market. JX has 33 percent of Japan's oil market.
Idemitsu is also considering acquiring No.4-rankedTonenGeneral Sekiyu KK, Sankei newspaper reported,although a company official said that reorganization with ShowaShell was a priority.
The birth of two refining giants could force other playerslike Cosmo Oil Co and TonenGeneral Sekiyu into actionbeyond last week's announcement to set up a venture to integratetheir Chiba complexes from next January, industry sources said.
Consolidation is further supported by the crash in oil,which has seen prices almost halve since June, resulting infalling stock prices for energy firms and reduced asset values,offering opportunities to cash rich investors.
Idemitsu and Showa Shell aim to reach an agreement earlynext year in the first reorganization of oil refining industryin Japan since JX was created in 2010, a source with knowledgeof the matter said on condition of anonymity.
Industry sources said that Royal Dutch Shell, whichhas sold numerous assets this year as part of restructuring andcost saving, is keen to sell its 35 percent stake in Showa Shelland likely to cooperate in the deal.
Saudi Arabia's state-owned oil firm Saudi Aramco also ownsabout a 15 percent stake in Showa Shell. Both Royal Dutch Shelland Saudi Aramco could not be immediately reached for comment.
Shares in Showa Shell closed up 27.7 percent at 1,302 yen onMonday, while Idemitsu ended up 2.5 percent at 2,075 yen. ($1 = 119.4900 yen) (Editing by William Mallard, Henning Gloystein and MichaelPerry)