UKRAINE: CABINET OF MINISTERS APPROVES VANCO PSA

C O N F I D E N T I A L SECTION 01 OF 02 KYIV 002505

SIPDIS

SIPDIS

DEPT FOR EUR/UMB, EB/ESC/IEC-LWRIGHT
USDOC FOR 4231/ITA/OEENIS/NISD/CLUCYK
DOE FOR LEKIMOFF, CCALIENDO

E.O. 12958: DECL: 10/02/2017
TAGS: EPET ENRG PINR EINV UP
SUBJECT: UKRAINE: CABINET OF MINISTERS APPROVES VANCO PSA
-- SIGNING TO FOLLOW OCT 8

REF: A. KYIV 426


B. KYIV 360

Classified By: AMBASSADOR, REASONS 1.4 (B) AND (D)


1. THIS INFORMATION IS COMMERCIALLY SENSITIVE AND SHOULD NOT
BE SHARED OUTSIDE OF THE USG.


2. (C) Summary. On September 26 the Cabinet of Ministers
approved the production sharing agreement (PSA) for oil and
gas exploration in the Black Sea with Houston-based Vanco.
Vanco told the GOU it would sign the PSA as is. The PSA is
the first of its kind for Ukraine. Vanco won a tender to
negotiate the deal in April 2006, but encountered drawn-out
opposition from senior GOU officials before it finally
reached agreement with the GOU. While Vanco has yet to see
the final text, its management tells us that the company is
confident that the GOU will treat it as a fair and equal
partner. Vanco's backers in the deal include Ukrainian
oligarch Rinat Akhmetov and Russian businessman Yevgeniy
Novitsky. According to Vanco, Akhmetov's engagement will
ultimately help the company achieve its objectives and thwart
any attempts by the deal's opponents to torpedo the deal.
Although the process was anything but smooth, with Vanco
apparently making significant last minute concessions on
issues that it once considered deal-breakers, the agreement
is a signal that modern PSAs are possible in Ukraine, albeit
with much difficulty. End Summary.

Opposition from the Get-Go
--------------


3. (C) In April 2006 Vanco won a tender to negotiate a PSA
for exploration and development of oil and gas in the
Prykerchenska area of the Black Sea. Negotiations dragged on
for months, and Vanco assessed that various GOU officials,
most importantly Fuels and Energy Minister Yuriy Boyko and
Environment Protection Minister Vasyl Dzharty, had tried to
torpedo the deal, using stalling tactics and making
unacceptable demands that would, in Vanco's view, make the
project unviable. Although it has little evidence, Vanco
suspects that the ministers were engaged on behalf of
RosUkrEnergo, so it could gain access to the potential energy
sources of the Black Sea for themselves. After the personal
intervention of Deputy Prime Minister Klyuyev, the original
one-year deadline to finish the deal was extended until
October 21 of this year, after which the tender would expire
in accordance with Ukrainian law. Such a result would have
left Vanco empty-handed.

Navigating Landmines
--------------


4. (C) Major stumbling blocks in the negotiation have
included a GOU demand that Vanco pay $38 million to remove
unexploded military ordinance discovered in the area, and to
compensate the Ukrainian military for moving a military test
range previously located in the area. Vanco has told us it
is now confident that the compensation issue will not torpedo
the deal. Vanco was also concerned that the production
splits percentages demanded by the GOU would make the deal
financially unviable. Gas valuation formulas were another
concern, as was GOU insistence that arbitration be conducted
on Ukrainian soil, although Ukraine was willing to use
internationally acceptable arbitration rules. Vanco feared
that this would allow Ukrainian courts to rule on any future
disputes related to the PSA, and this in turn could deter
potential financial backers.

Vanco Agrees to Production Split, Other Issues
-------------- -


5. (C) Vanco President Gene Van Dyke told Ambassador on
September 26 that ultimately Vanco agreed to a production
sharing split of 70/30 in Vanco's favor before cost recovery,
and 50/50 after cost recovery. Van Dyke said Vanco also
agreed to the GOU's gas valuation formulas and to
international arbitration on Ukrainian soil. He said he was
confident that he had sufficient assurances from the GOU that
Vanco would be treated fairly. More importantly, he said, it
was worth the risk to secure access to the coveted
exploration of the Black Sea. Vanco officials told us they
had not seen the text of the version approved by the Cabinet,
but presumed it was almost identical with a version of the
PSA they were presented on September 24.


KYIV 00002505 002 OF 002


Vanco's Investors
--------------


6. (C) When it contested the tender, Vanco originally had
financial backing from JMR of London, a Rothschild family
investment group. JMR later was replaced by Deutsche Bank,
who subsequently dropped out in favor of other investors.
Vanco has told us that it now has the financial backing of a
powerful group of investors including Rinat Akhmetov's SCM,
the Russian Yevgeniy Novitsky, former CEO and now member of
the board of Sistema, (a Russian conglomerate with assets
that include MTS, the largest Russian cell phone company) and
Integra, an Austrian-based investment fund. Vanco told us
that all of its prospective investors would pass a due
diligence test performed by the law firm Aiken Gump.
Akhmetov played a key role in thwarting opposition from Boyko
and others, Vanco's local representative told us.

Comment
--------------


7. (C) The deal might be a welcome sign to would-be energy
investors that modern PSA agreements are possible in Ukraine.
However, by dragging out these negotiations almost to the
bitter end, the GOU has likely squandered much of the good
will it hoped to attract from international energy companies.
The deal, although still not final, moved forward because
Vanco was ready to make concessions on issues that it once
told us were deal breakers. Vanco may believe that its
access to the lucrative Black Sea reserves (if oil and gas
are discovered) will be so valuable that the residual
concerns it had about the PSA are worth the risk. Still,
Vanco is banking on the goodwill of the GOU, and the ability
of its powerful backers, such as Akhmetov, to prevent the
project from becoming derailed again in the future. End
comment.
Taylor