LITHUANIA'S CHOICE: FIGHT OR SURRENDER ITS

S E C R E T SECTION 01 OF 05 VILNIUS 000727

SIPDIS

SIPDIS

STATE FOR EUR/NB, EUR/NCE, EB/ESC
DOE FOR HARBERT
DOC FOR 4231/IEP/EUR/BOHIGIAN
NSC FOR GRAHAM, MCKIBBEN AND COEN
TREASURY FOR LOWERY, LEE AND COX

E.O. 12958: DECL: 08/03/2031
TAGS: ENRG ECON PREL LH XG VE LY
SUBJECT: LITHUANIA'S CHOICE: FIGHT OR SURRENDER ITS
REFINERY TO THE RUSSIANS

REF: A. VILNIUS 711 AND PREVIOUS

B. VILNIUS 285

C. WARSAW 1336

VILNIUS 00000727 001.2 OF 005


Classified By: Economic Officer Scott Woodard for reasons 1.4 b and d


1. (S) SUMMARY: Lithuania and its Mazeikiu Nafta (MN) oil
refinery need to decide how to proceed, now that an
"accident" has resulted in a complete cutoff in the
refinery's pipeline-delivered supply of Russian crude. State
Department Advisor Steve Hellman framed this issue for the
Lithuanians during his very timely and helpful visit, and
sketched out strategies and tactics that Lithuania can employ
if it chooses to resist this apparent Russian attempt to
squelch the sale of MN to Poland's PKN Orlen and ensure that
the refinery ends up in Rosneft's hands. MN's leadership
says that it can supply the refinery profitably by tanker,
and the GOL seems willing to support this effort. Lithuanian
officials very much appreciated Hellman's visit (and the
USG's willingness to send him),and clearly intend to lean on
his industry expertise as they manage the challenge ahead.
End Summary.

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ASSESSMENT OF CURRENT SITUATION
--------------


2. (S) During his August 2-3 visit to Lithuania, State
Department Advisor Steve Hellman told his interlocutors that
MN should not expect any crude shipments via pipeline in the
foreseeable future. He said that, according to his sources
in Russian industry and government, the Kremlin --
specifically Igor Sechin, Rosneft's chair and Deputy Head of
Russia's Presidential Administration -- had ordered MN's
supply cut off and that the end-of-July pipeline "accident"
near Bryansk, Russia was in fact the execution of this order.
Hellman advised that influential Russians openly spoke of MN
as "Rosneft's refinery" and that members of Russia's "oil
vertical" (nefti vertikal) believed that "their" share of
this bit of Yukos's former empire amounts to USD 3 billion,
which they intended to start collecting by taking over the
refinery. The crude cutoff, Hellman said, was the first step
of the Russians' plan. No amount of negotiation or
diplomatic pressure at any level, Hellman advised, would
result in a re-opening of the pipeline to MN at this time.
(Note: The Lithuanian press, citing Transneft officials,
reports that the damage to the pipeline will take 9-12 months
to repair.)


3. (S) Underlying the Russians' strategy, Hellman said, is
the belief that MN cannot supply itself without the pipeline.
Hellman added that not all members of the Russian oil elite
share this view, specifically citing various Transneft
officials and other technical experts, but emphasized that
those who believe that this strategy will work do.


4. (S) Hellman also explained that Russia's actions towards
MN are only one facet of a much broader Russian energy
strategy. He told his interlocutors that Russia has been
using similar strong-arm tactics in many countries on
Russia's periphery, including Slovakia, Hungary, Italy,
Greece, Serbia, Ukraine, Azerbaijan, Georgia, Turkey,
Uzebkistan, and Turkmenistan. The ultimate goal, he said,
was to achieve Russian domination of the European energy
business. Hellman encouraged the GOL to reach out informally
to these countries and share experiences and strategies for
dealing with Russian pressure on energy.

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LITHUANIA'S CHOICE: FIGHT OR SURRENDER
--------------


5. (S) Hellman said that Lithuania (and MN) therefore faced a
choice. As one option, Lithuania could capitulate and
arrange for a way for Rosneft to take over MN. He admitted
that this choice would probably cost Lithuania less in the
short run. He emphasized, however, that it would turn out to
be far costlier to both Lithuania and Europe over the longer

VILNIUS 00000727 002.2 OF 005


term, because Russia would likely use this foothold inside
the European Union to undercut European refined oil
retailers, beginning with Poland's PKN Orlen. He said that
MN's capacity for exports (only about half of its capacity is
necessary to supply the markets of Lithuania, Latvia, and
Estonia) meant that Russia could supply MN with crude at
rock-bottom prices that would allow the refinery to undercut
retail prices in other markets, starting with Poland. Once
PKN Orlen found itself unable to compete with a Russian-owned
MN, Hellman surmised, PKN Orlen's value would drop, creating
an opportunity for a Russian firm to take it over. With
Poland in the bag, Hellman said, the German market would be
the next target. The end result: customers in Lithuania and
elsewhere would end up subject to the whims of a Russian
energy monopoly that controlled both supply and distribution.


6. (S) Lithuania's other alternative, according to Hellman,
would be to fight by demonstrating that MN can function
perfectly well without the pipeline. This strategy, Hellman
cautioned, could prove expensive in the short run, but had a
very good chance of succeeding, and would likely prove less
expensive over the long run than the capitulation option.
Once MN established itself as a successful economic entity
without the pipeline, Hellman said, the internal debate among
Russia's oil elite would shift in favor of its more
enlightened members, leading eventually to the possibility
for Lithuania and/or PKN to cut some kind of deal to restore
the flow through the pipeline.

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TACTICS FOR THE FIGHT
--------------


7. (S) Hellman suggested several tactics that the GOL and MN
should pursue, should they choose to fight:

-- Take all necessary steps to ensure that MN can be supplied
effectively via its Butinge terminal, including constructing
additional storage facilities (a typical tanker-supplied
refinery would have ten times the storage capacity MN has
now, according to Hellman);

-- Understand that MN may need to supply itself solely via
Butinge for an indefinite period -- at least for the next
6-18 months;

-- Expect that Russia will also move to prevent MN from
obtaining crude via tanker from Primorsk; this means that MN
needs to enhance its trading expertise so that it can more
efficiently obtain the non-Russian crude available in the
Northern European market;

-- Enhance the refinery's ability to operate effectively
using different types and blends of crude (to date, MN has
only operated only on Urals crude);

-- Upgrade physical security and safety procedures at MN --
and especially at Butinge -- to guard against sabotage and
accidental oil spills;

-- Ensure (including through bookkeeping legerdemain) that MN
remains profitable, so that Lithuania will be negotiating
from a position of strength when the time is right to discuss
the issue with the Russians;

-- Follow a public relations strategy that emphasizes a
constructive Lithuanian-Russian joint effort to address the
pipeline supply problem and avoid any suggestion that the
"accident" is anything other than an unfortunate mishap;

-- Emphasize close GOL/MN cooperation to ensure that
bureaucratic bottlenecks do not hamper MN's ability to
function effectively, for example, by expediting the process
of issuing the licenses necessary to build additional storage
capabilities;

-- Recognize that Russia will be losing the capacity to
export approximately 500,000 barrels of crude per day

VILNIUS 00000727 003.2 OF 005


(250,000 to MN and 250,000 to export via Butinge, worth a
total of about USD 15 million) and that this will depress its
own domestic market, causing real pain for many in the oil
business there; and

-- Urge the European Commission's DG-Competition to consider
expeditiously PKN Orlen's application for approval to
purchase MN so that PKN can complete this transaction as soon
as possible.


8. (S) Hellman said that if Lithuania successfully implements
these tactics, the Russians should be willing -- probably in
6-18 months -- to start talking indirectly about how to
reopen supplies to MN via pipeline. At that point, he said,
Lithuania (and MN and perhaps PKN) will need to decide
whether or not they will be willing to pay the price the
Russians will demand, which will likely consist of a few
billion dollars for "repairs" to the pipeline and lucrative
contracts with, or side payments to, various businesses with
close ties to key decision makers.

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PKN NEEDS TO STAY ON THE SIDELINES, FOR NOW
--------------


9. (C) Hellman said that PKN will be unable to provide any
real assistance to Lithuania or MN at present. To do so, he
said, would violate EU anti-competition rules, virtually
guaranteeing that DG-Competition would reject PKN's purchase
of MN.

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GOL RESPONSE: NO SURRENDER
--------------


10. (S) Hellman met with all the key Lithuanian players on
this issue. Their initial reactions suggest that the GOL is
unlikely to hand over MN to the Russians. Saulius Specius,
advisor to the Prime Minister and one of the GOL's
negotiators on the sale of MN to PKN, said that there was no
legal way at this point to hand over the refinery to the
Russians, even if the GOL wanted to. Simonas Satunas and
Nerijus Udrenas, who advise President Adamkus on foreign
policy and economic issues, respectively, also suggested that
the GOL was unlikely to capitulate, especially if there were
a realistic chance for MN to supply itself effectively via
Butinge.


11. (S) Hellman swayed Albinas Januska, an MFA Under
Secretary and one of the country's top foreign policy and

SIPDIS
national security strategists. Januska intimated that the
GOL intended to go public about Russian machinations in order
to bolster the Polish-Lithuanian case for a Common Energy
Policy in the EU. After hearing Hellman's pitch, however, he
said he was "convinced" that the GOL should follow the
approach outlined above. Januska asked, and Hellman agreed,
to stay in touch with Hellman, and asked him to return to
Lithuania in September if necessary.


12. (S) Januska also added some interesting information about
the end-game of MN's sale earlier this year. He said that
Kazakh leader Nazarbayev called then-PM Brazauskas several
times in early 2006 to try to sway him to sell MN to
KazMunayGaz. Last May, four days before a New York
Bankruptcy Court ruling on Yukos assets cleared the way for
the sale, Putin called Nazerbayev and convinced him to pull
KazMunayGaz out of the competition. Januska said that
KazMunayGaz officials pleaded with Brazauskas to call
Nazerbayev to allow them to carry on with the competition,
but he declined, arguing that Nazerbayev would not defy Putin
over an issue of this magnitude. .


13. (S) We detected one exception to the impulse to resist
Russian pressure. The outlier was Under Secretary Anicetas
Ignotas at the Ministry of Economy. Ignotas told Hellman
that he believed that MN would be unable to supply itself via
Butinge and still operate effectively. While he expressed
the hope that PKN would be able to find a way to complete its

VILNIUS 00000727 004.2 OF 005


purchase of MN and be successful. He said that he was
resigned, however, to the fact that Lithuania would always be
vulnerable to Russia on energy issues and that Lithuania
therefore needed to maintain good relations with its large
neighbor. (Note: Ignotas usually does not cover MN issues,
but he is covering the portfolio due to a recent resignation.
We expect Vytautas Nauduzas, currently Ambassador to Turkey
and known to be close to Januska, will take over this
portfolio at the Ministry in early September.)

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MN'S RESPONSES
--------------


14. (C) MN officials, including General Director Nelson
English and Chairman of the Board Nerijus Eidukevicius,
assured Hellman that MN was fully capable of supplying itself
via Butinge. They said that Butinge had a theoretical
capacity to offload about 12 million tons/year, but
considerations of weather and sea conditions in the Baltic
(Butinge cannot offload if waves are 1.5 meters or higher)
meant that 10 million tons/year was a more realistic
estimate. They said that this capacity exceeded MN's
projected annual needs, which they estimated at 8.6 million
tons for 2006.


15. (C) English said that MN had already lined up seven
tankers (carrying approximately 100,000 tons of crude each)
for August and another eight or nine for September, all
delivering Urals crude loaded in Primorsk. Offloading each
ship, he added, took about 28-30 hours. Delivery of these
supplies, he said, would keep the refinery going at full
capacity. He added that MN's calculations indicated that
this method of delivery was approximately USD 2.50/barrel
more expensive than pipeline-delivered oil, but still allowed
the refinery to remain comfortably profitable.


16. (C) Addressing Hellman's concerns about MN's lack of
adequate storage, English said that this was a problem and
that MN and Butinge together had the capacity to store only
about 10-12 days-worth of crude (340,000 tons),if the
refinery was operating at capacity. English added, however,
that Butinge already had a foundation laid for an additional
50,000-ton storage tank and that it would take approximately
six months to construct if MN decided to move ahead with the
project. MN currently has no plans to expand its storage
capacity beyond that.


17. (C) English said he recognized the possibility that the
Russians could also cut off MN from Russian crude loaded at
Primorsk, but that as this is MN's most economic option
(after the pipeline),MN will continue buying from Primorsk
as long as possible. Several Russian producers, he said,
were obviously nervous about doing business with MN,
presumably because of their concern that they would come
under pressure from the Kremlin to cancel their contracts
with the refinery.


18. (C) English said that he was still exploring the options
of obtaining crude from Venezuela, Libya, and elsewhere (ref
B),but had nothing firm yet. He noted that the Venezuelan
deal could result in an arrangement to supply nearly a
quarter of MN's annual needs at a price comparable to what MN
was paying for pipeline-delivered Urals crude, but that he
still considered this a long shot.

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BUTINGE NEEDS TO REPLACE DAMAGED BUOY
--------------


19. (C) English explained that MN plan to replace its damaged
buoy at Butinge in September, a process that he expects to
take 12-14 days, if the weather cooperates. During this
time, he said, the terminal will be unable to offload any
crude. MN plans, however, to stock up as much crude as
possible before the repairs begin and have tankers ready to
offload as soon as the new buoy is in place.


VILNIUS 00000727 005.2 OF 005


--------------
COMMENT
--------------


20. (S) Hellman's visit -- using a top industry expert with a
USG security clearance to help an ally navigate an
economic-commercial crisis with national security
implications -- was transformational diplomacy in action. It
will empower to GOL to react soberly and intelligently to the
cutoff of pipeline-delivered crude. Hellman's interlocutors
were impressed by his depth of understanding of the key
issues, scribbling furiously (along with us) to note his
suggestions and ideas.


21. (S) The GOL and MN will ultimately have to decide for
themselves how to proceed, but there is no doubt that
Hellman's visit demonstrated tangible, credible, and
much-appreciated USG support for Lithuania in a moment of
need. That said, even if the Lithuanians can implement many
of Hellman's suggestions, the GOL will have an increasingly
difficult time avoiding pointed questions about the
"accident." The press is already starting to question this
explanation and the newly-formed, minority government may
come under increasing attack from the conservative,
anti-Russian opposition if it continues to characterize the
cutoff as a mere accident.


22. (S) We do not expect the Lithuanians to capitulate -- at
least not yet. MN will make every attempt to supply itself
via Butinge and operate profitably. If it should fail,
however, we assess that it is not realistic to expect
Lithuania to let its largest economic enterprise simply sit
and rust. Lithuania has allowed the Russians to buy MN
before, when Yukos took over from Williams International.
While it would be the first choice of almost no one here,
there is always the chance that MN could become Russian again.


23. (C) Steve Hellman did not have the opportunity to clear
this cable.

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