CZECH ENERGY SECURITY: MODERATE BUT INCREASING

C O N F I D E N T I A L SECTION 01 OF 04 PRAGUE 001402

SIPDIS

SIPDIS

STATE FOR EUR/NCE, EUR/ERA, EB/ESC, E STAFF
DOE FOR TYLER TILLER
NSC FOR DAMON WILSON AND TRACEY MCKIBBEN

E.O. 12958: DECL: 11/09/2016
TAGS: ENRG ECON EFIN ETRD PGOV EZ
SUBJECT: CZECH ENERGY SECURITY: MODERATE BUT INCREASING
RUSSIAN FOOTPRINT

REF: A. PRAGUE 256


B. BRATISLAVA 870

Classified By: Political-Economic Counselor Michael Dodman
for Reasons 1.4 (b) + (d)


1. (C) SUMMARY AND COMMENT: The Czech Republic is moderately
dependent on Russian oil and gas compared to other former
Soviet bloc countries, thanks to its domestic coal production
supplying over 50% of domestic energy needs, its position as
a major electricity exporter in Europe, and diversified oil
and gas supplies. In addition to oil and gas from Russia,
the Czech Republic receives oil from the Middle East and gas
from Norway. Oil and gas each make up 20% of Czech domestic
energy consumption, compared to the EU's combined energy
consumption of 43% oil and 24% natural gas. Nevertheless,
approximately 70% of Czech oil and gas supply comes from
Russia, and Russian footprint in these sectors threatens to
grow. The threat takes several forms: (1) direct pressure
from Russia to have the Czech government sign MOUs to enhance
Russian leverage in the oil and gas sectors (para 9); (2) the
continued debate about reversing the direction of the
Ingolstadt pipeline so that instead of transporting Middle
Eastern oil for domestic consumption, it can become a transit
pipeline carrying Russian oil for German consumption (paras
10-11); (3) rumors that ConocoPhillips may sell its 16.3%
stake in the biggest Czech oil refining company to Russia's
Lukoil (para 12); (4) the majority-government owned
electricity company CEZ's decision to import 100% of its
nuclear fuel from Russia (para 13); (5) the potential impact
of Russia claiming 49% of Slovak oil company Transpetrol
which transports Russian oil to the Czech Republic (ref B).


2. (C) SUMMARY AND COMMENT CONTINUED: Consequently, both
during the former Ambassador's mid-September farewell call
and the current Ambassador's mid-October introductory call on
PM Topolanek, Topolanek raised his concerns about increasing
Russian influence on the Czech energy sector. Despite such
high-level concerns, research for this cable revealed that
the energy sector is highly decentralized, lacking in
transparency, and no one person in the government seems to
have a handle on all the players and the details. Perhaps in
recognition of this reality, the GOCR recently created the
position of Ambassador-at-Large for energy security issues,
who is overseeing the drafting of an energy security strategy
paper, which will be submitted to the State Security Council
by end-November with possible approval by January 2007. The
paper outlines the lack of emergency gas reserves as the key
short-term risk, supply disruptions resulting from pipeline
infrastructure degradation as the key medium-term risk, and
Russia signing more contracts than it can supply as the key
long-term risk. The Czech MFA believes that addressing the
short-term risk is entirely up to the GOCR, while addressing
the medium-term and long-term risks requires coordination
among all EU countries and with the USG. Meanwhile, in the
absence of a national energy security strategy that is
effectively implemented, commercial and bureaucratic
decisions have and may continue to increase Russian influence
in the Czech energy sector and erode Czech energy security.
END SUMMARY AND COMMENT.

-- THE ANATOMY OF CZECH OIL AND GAS SECTORS --


3. (C) In 2005, Czech energy supply consisted of 51% solid
fuels (mainly brown coal),20% natural gas, 20% liquid fuels
(mainly crude oil),and 9% primary electricity and heating
(water and nuclear power plants). 100% of Czech solid fuel
consumption is supplied domestically and the Czech Republic
is one of the major exporters of electricity in Europe,
thanks to its two nuclear power plants (ref A). Therefore,
Czech dependence on Russian energy is based on its oil and
gas consumption, 70% of which relies on Russian imports, as
well as what will soon be 100% nuclear fuel imports from
Russia.


4. (C) GAS INDUSTRY FULLY PRIVATIZED: The Czech government
believes its greatest short-term energy supply vulnerability
is its lack of emergency gas reserves. The Czech gas sector
is 100% privatized and natural gas purchase, transit and
storage is based on long-term contracts between German-owned
RWE Transgas and Russian company Gazexport (expire in 2013)
and six Norwegian producers (expire in 2017). The Norwegian
gas is supplied via Germany through the Verbundsnetz Gas AG
(VNG) pipeline that ends at Hora Svate Kateriny in the Czech

PRAGUE 00001402 002 OF 004


Republic. The Russian gas is supplied via a pipeline that
transits Slovakia and the Czech Republic en route to Germany.
The government does not have any strategic influence on how
Transgas conducts business, nor does it have any influence
over the terms of its long-term contracts. The Czech MFA
believes the current coziness between Germany and Russia
further negates any potential influence the Czech government
could have in the gas industry. However, the fact that the
Czech Republic serves as a transit country for Russian gas
supplies to Germany means it enjoys important protection from
possible supply disruptions as those experienced by countries
with less-advantageous geography. Prague Security Studies
Institute Director Jiri Schneider believes this geographic
protection is limited since the Czech Republic is not the
only gas transit route for Germany, and Russian gas can be
diverted in the medium to long term for better prospects east
(China) or for growing domestic consumption in Russia.


5. (C) TWO OIL PIPELINES EQUALS DIVERSITY: There are two oil
pipelines supplying the Czech Republic with a total capacity
of 19 million Tons (mT),only 9 mT of which the Czech
Republic currently uses, according to state oil company MERO.
The Druzba II pipeline (9 mT capacity vs. 5.2 mT used in
2005) carries Russian oil via Slovakia and ends in the Czech
Republic. The Ingolstadt (IKL) pipeline (10 mT capacity vs.
2.7 mT used in 2005) runs from Bavaria to Bohemia; oil
delivered via the IKL generally originates in the Middle East
and is offloaded at the Port of Trieste. A frequently stated
statistic is that if the Druzba II pipeline were shut off,
the entire amount could be made up via the IKL pipeline given
its existing excess capacity. However, there would be
financial implications since there is a significant price
difference between the cheaper and more sour oil coming via
Druzba and the oil via IKL. Ceska Rafinerska CEO Ivan Soucek
explained that if the Druzba II pipeline were shut down, IKL
can make up 60% of that within 90-days (note: Czech oil
reserves = 90-days per EU requirement).


6. (U) STATE-OWNED OIL COMPANY MERO: MERO owns and operates
the Czech portion of the Druzba II pipeline and the IKL
pipeline. According to Operations Manager Ondrej Smolik, the
Druzba II pipeline underwent a complete upgrade in 2005
(SCADA control system, exchange of 15 line valves, 3 pump
stations and 3 terminals). MERO reports to the former
National Property Fund (FNM),the government body that was in
charge of implementing privatization of state-owned
enterprises but no longer exists as an independent entity and
has been brought under the Ministry of Finance. Smolik said
it was watching developments in Slovakia's Transpetrol case,
and that MERO had expressed interest in buying the 49% Yukos
share because of beneficial synergistic effect and energy
security enhancement for the Czech Republic.


7. (C) THREE OIL REFINERIES: There are three oil refineries
in the Czech Republic with a total refining capacity of 9 mT:
(1) Litvinov (built in 1944 at 5 mT capacity) (2) Kralupy nad
Vltavou (built in 1975 at 3 mT capacity),(3) Pardubice (1 mT
capacity). The first two are operated by Ceska Rafinerska
(CRC),established in 1995 and 51% owned by Unipetrol (a
Czech petrochemical company currently under investigation for
corruption during its privatization and whose majority
shareholder (64%) is the Polish company PKN Orlen) and 49% by
three major foreign investors ConocoPhillips, Agip and Shell
(each with 16.33%). The third refinery in Pardubice is
operated by Paramo, which is 74% owned by Unipetrol, with the
remaining 26% owned by minority shareholders. The four oil
companies that own the two Czech refineries (Unipetrol,
ConocoPhillips, Shell, and Agip) each buy crude oil on the
spot market.


8. (C) OIL STORAGE CAPACITY: As mandated by the EU, the Czech
Republic keeps a 90-day emergency oil supply equal to about 2
mT. MERO, which is responsible for the crude oil reserves,
operates a tank farm in Nelahozeves, where there are 14 tanks
in operation, including the four biggest tanks in continental
Europe with 125 cubic meters each. Two additional tanks are
currently under construction to cope with increasing domestic
consumption and are expected to be completed in 2008. CEPRO,
a state-owned company handling the sale and transport of oil
products, has the contract for reserves of refined oil.
CEPRO has long been a target of corruption allegations, and
some industry observers have suggested that CEPRO has
speculated with its portion of the state reserves. The State
Material Reserves Administration, which reports to the

PRAGUE 00001402 003 OF 004


Ministry of Industry and Trade, is responsible for monitoring
the oil market and the emergency oil reserves, but the
state-owned companies MERO and CEPRO actually hold the
reserves of both crude and refined oil.

-- HOW RUSSIAN INFLUENCE CAN INCREASE --


9. (C) DIRECT PRESSURE FROM RUSSIA: According to MERO, even
though the four private oil companies purchase crude oil
directly on the spot market, there is an ambiguous Memorandum
of Agreement between the Government of the Czech Republic and
the Government of Russia regarding oil supplies dating from

1994. In September, the GOR proposed two new MOUs -- one on
crude oil transit and the other on increased gas deliveries
-- both of which the GOCR rejected in mid-October. The MFA
opposed the MOUs because it would mean the reversal of the
IKL pipeline (see para 10) and because gas transit is already
occurring without any GOCR involvement. When asked about the
significance of these proposed MOUs given existing commercial
contracts for both oil and gas, MFA Security Policy
Department Director Veronika Kuchynova-Smiglova surmised that
Russia is looking for increased leverage in the Czech
Republic, and if anything went wrong with commercial
contracts, the Russian government can try to involve the
Czech government.


10. (C) IKL REVERSAL: One key issue is the role of the
Ingolstadt (IKL) oil pipeline, which the Czech Republic built
in 1995 precisely to enhance the country's energy security.
For some time, the Russians have been proposing reversing the
flow of the IKL pipeline so that instead of transporting oil
for domestic consumption, it can serve as a transit pipeline
transporting Russian oil for German consumption. While
staunch opponents such as the MFA argue this would be
strategically stupid move from the energy security
perspective, those supporting it do so based on commercial
interests (i.e., transit fee prospects) and comfort with
doing business with the Russians (i.e., the Ministry of
Industry and Trade. The MFA argues that if the GOCR wants to
become a transit country, it should build a pipeline parallel
to IKL and not reverse IKL.


11. (C) According to Czech oil company MERO Operations
Manager Smolik, it would take about three years to reverse
the direction of flow of the IKL pipeline. He explained that
necessary technical preparations alone would take 1.5 years,
but there was also time required for Germany and Russia at
the two ends of the pipeline to sign a letter of intent,
followed by one year of "necessary observation." Smolik told
econoff that in anticipation of possible future reversal of
the IKL pipeline, all planned infrastructure upgrades include
reverse technology. For example, the pumping station at
Benesovice to be completed in 2007 will have reverse pumping
capacity and the new pipeline control system to be completed
in March 2008 will have a reverse operation system. Smolik
confirmed that the Ministry of Industry and Trade had
previously asked MERO to look into the possibility of IKL
reversal and that there had been particularly strong interest
in this possibility between 1999-2003 when Czech consumption
was relatively low with significant excess capacity. MERO
was keen on business possibilities then, but Smolik admitted
that these days, IKL reversal was no longer a priority for
MERO, which has several current projects dealing with the
increase in domestic oil consumption.


12. (C) CONOCOPHILLIPS SELLING TO LUKOIL?: On September 27,
the press (including Dow Jones Business News) reported that
Russian company Lukoil was considering a buyout of
ConocoPhillips' 16.3% stake in the Czech refinery Ceska
Rafinerska (CRC),and that Czech petrochemical company
Unipetrol (current majority owner of CRC) is also interested.
(NOTE: ConocoPhillips owns 19.5% of Lukoil. END NOTE)
ConocoPhillips Managing Director for Central and Eastern
Europe Greg Hart (please protect) told econoff October 17
that the information was likely a leak from Lukoil and that
he would know better by end-November what the likely outcome
will be on whether ConocoPhillips will sell its share and to
whom. He also informed that existing CRC shareholders
(Unipetrol, Shell, Agip) have the pre-emptive right to match
or beat whatever offer is made by an outside bidder. When
asked why ConocoPhillips was considering selling its shares
in CRC, Hart pointed to the "lukewarm relationship" with
Unipetrol, whose majority shareholder is Polish company PKN
Orlen, and with whom ConocoPhillips recently settled out of

PRAGUE 00001402 004 OF 004


court for charges that PKN Orlen reneged on its agreement to
include ConocoPhillips in its bid for majority stakes in the
privatization of Unipetrol. In addition to difficulties with
Unipetrol, Hart cited increasing business costs (e.g. real
estate and wages) and inefficiencies in existing refining
infrastructure as reasons for possible departure from the
Czech market.


13. (C) RUSSIAN NUCLEAR FUEL: On March 17, 2006, the Russian
corporation TVEL won the majority-state-owned electricity
company CEZ's international tender for fuel deliveries for
the Czech Republic's nuclear power plant Temelin, effective

2010. Westinghouse Electric (which belongs to British
Nuclear Fuels) is currently supplying Temelin. TVEL already
supplies the other nuclear plant at Dukovany and will,
therefore, have a lock on supplies for all Czech nuclear
production. Another Russian footprint in the nuclear energy
field is the Russian firm OMZ's ownership of Skoda Nuclear
Engineering.

-- CZECH ENERGY SECURITY POLICY ON PAPER --


14. (C) The MFA's Security Policy Department is in the
process of drafting an interagency paper on energy security
for the State Security Council (BRS). Due to the on-going
political stalemate, the BRS met in mid-October for the first
time since May. The energy security paper is due by
end-November and the MFA hopes it will be approved by January

2007. The paper specifically identifies "Russian energy
imperialism" as a key factor threatening Czech energy
security. It outlines measure the GOCR can take to enhance
its energy security, including: (1) diversification of
nuclear fuel sources; (2) finding a way to have emergency gas
reserves; (3) a recommendation against fast privatization of
majority stake in electricity company CEZ; (4) supporting
partial European continental infrastructure projects for
interconnecting oil and gas pipeline networks to increase
their transportation capacities; (5) a recommendation against
reversing the IKL pipeline "under any circumstances." The
paper also recommends the creation of a Foreign Security
Policy Coordination Committee Energy Security Working Group
for the purpose of information gathering, increasing
awareness of the connection between energy and security, and
preventing decisions at lower bureaucratic levels that are
unaware of political and security connections and impacts.


15. (C) The MFA has also created the position of
Ambassador-at-Large for Energy Security, recently filled by
Eastern European expert and former student dissident Vaclav
Bartuska. Bartuska informed econoff October 27 that the
energy security paper will also contain a list of key energy
security risks. The risks are broken down by short, medium
and long-term vulnerabilities. Short-term risks include: (1)
the possibility (but not seen as likely) that Russia will cut
off its gas or oil supplies to the Czech Republic; (2) the
probability that RWE Transgas will sell its gas reserves to
the highest bidder and leave the Czech cold in the event of
an emergency. The primary medium-term risk has to do with
pipeline infrastructure maintenance along the Druzba II and
the possibility of technical failure in Russia or anywhere
along the pipeline. In the long-term, the great concern is
that Russia is over-extending itself in terms of the number
of contracts it has signed versus proven reserves. Given
this outline, the GOCR will have to decide whether and how to
address the short-term issue of emergency gas reserves, and
work with both the EU and the U.S. to approach Russia with
dealing with the medium-term pipeline infrastructure issue
and the long-term contractual commitments issue. Bartuska
remarked that no matter who is in government, the GOCR has
little choice in what it needs to do to address its energy
security vulnerabilities, particularly in the short-term.
GRABER