* Idemitsu to pay $1.4 bln for most of Showa Shell stake
* Merger discussions continuing with Showa Shell
* Sale raises capital for Shell in downturn (Adds comments by Idemitsu president, director)
By Taro Fuse and Osamu Tsukimori
TOKYO, July 30 (Reuters) - Japan's Idemitsu Kosan Co is buying a one-third stake in refiner Showa ShellSekiyu from Royal Dutch Shell, moving itcloser to a potential $4 billion bid for its smaller rival inthe country's cutthroat refining sector.
Idemitsu Kosan, Japan's second-biggest oil refiner, said itwas paying 169 billion yen ($1.4 billion) for the 33.24 percentstake and would continue discussions on a merger.
The combined companies would control about 28 percent ofJapan's refining market, still behind JX Holdings Inc,which has a 35 percent share.
Japan's powerful industry ministry is keen to seeconsolidation in a refining sector where five big operators andthree smaller ones vie for business from a shrinking populationincreasingly opting for more fuel efficient vehicles.
"If the deal goes through, there will be four major players.But that will not likely be the final picture, and I thinkfurther integration is possible," Idemitsu Kosan PresidentTakashi Tsukioka told reporters.
For Royal Dutch Shell, the sale raises funds when it ismaking further cuts to capital investment this year as itexpects a downturn in oil prices to last for several years.
Shell on Thursday reported a 37 percent drop insecond-quarter profits and said it expected $30 billion of assetsales between 2016 and 2018, on top of a total of $20 billion indisposals for 2014 and 2015 combined.
The oil giant said it should complete the Showa Shell salein 2016 subject to regulatory approval and it would retain a 1.8percent holding.
The sale means a sharply reduced presence in a downstreamoil market Shell has operated in for more than 100 years.
INDUSTRY CONTRACTION
A takeover of Showa Shell by Idemitsu would be the secondmerger in the industry since JX was formed in 2010.
Every week, nearly 20 gas stations close on average in Japanafter demand fell by about 22 percent over the last decade andconsumption is set to fall further, according an industryministry forecast in April.
The recent downturn in oil prices has also meant Japaneserefiners have suffered huge inventory losses, with Idemitsureporting its first annual loss since listing in 2006.
A source told Reuters in December that Idemitsu aimed to buyshares in Showa Shell in a tender offer that could be worth asmuch as 500 billion yen ($4 billion).
Saudi Arabia's state-owned oil firm Saudi Aramco also ownsabout a 15 percent stake in Showa Shell.
Idemitsu said it would pay 1,350 yen a share for the Shellshares, almost 23 percent above Showa Shell's close onWednesday. Idemitsu Director Susumu Nibuya said the funds forthe acquisition of the shares would be financed via debt andthat the two firms would seek to integrate fully as soon as theshare acquisition is complete.
Showa Shell shares ended up 6.2 percent on Thursday aftersoaring as much as 13.4 percent on a report on the sale, whileIdemitsu ended down 4 percent.
JPMorgan advised Idemitsu on the Showa Shell purchase, theJapanese refiner said.($1 = 124.2300 yen) (Writing by Aaron Sheldrick, Additional reporting by TaigaUranaka; Editing by Ed Davies and Susan Thomas)
