UKRAINE: RESOURCE NATIONALISM REPORT

C O N F I D E N T I A L SECTION 01 OF 02 KYIV 002820

SIPDIS

SIPDIS

DEPT FOR EUR/UMB,
EEB/EEC/IEC-GALLOGLY/WRIGHT
EEB/ESC/IEC/EPC BGRIFFEN
DOE FOR LEKIMOFF, CCALIENDO

E.O. 12958: DECL: 11/13/2017
TAGS: EPET ENRG ETRD PREL UP
SUBJECT: UKRAINE: RESOURCE NATIONALISM REPORT

REF: STATE 150999

Classified By: Ambassador for reasons 1.4 (b) and (d)


1. (C) Summary: Ukraine has relatively small reserves of oil
and natural gas, but is the world's largest hydrocarbon
transit country, moving 75.8% of Russia's natural gas to
Europe. Ukraine imports 77% of its natural gas and 79% of
its oil needs almost exclusively from Russia. As a legacy of
Soviet practices, some Ukrainian policies in domestic
resource development exhibit some features of resource
nationalism as defined in reftel. If anything, Ukraine's
need to diversify sources of energy supply are weakening this
resource nationalism. End summary.


2. (C) The Ministry of Fuel and Energy of Ukraine exercises
control of the energy sector via state-owned companies, most
under the aegis of the oil and gas company NaftoHaz Ukrainy.
NaftoHaz and related companies have traditionally controlled
upstream production and exploration for hydrocarbons.
Although foreign companies have been allowed into these
activities, they have found the Ukrainians unwilling to allow
large-scale foreign participation in practice, as companies
run into a myriad of licensing, pricing, and other barriers.
In addition, oil and gas pipeline operations remain state
monopolies under NaftoHaz. Ukrainian law forbids any sale of
pipeline assets, which most believe is an effort to prevent
Gazprom or other Russian entities from taking over Ukraine's
gas transit assets. On the other hand, downstream activities
in Ukraine have long been open to foreign investment. There
is significant (mostly Russian) investment in Ukrainian
refineries, oil retailing, and gas distribution. NaftoHaz is
widely regarded as very corrupt, with shady side deals,
kickbacks, and featherbedding that allow a number of its
employees to enrich themselves. This corruption may be a
motivation for keeping foreigners at bay, as those involved
see foreigners eating into their potential take.


3. (C) One particular recent GOU policy that might be defined
as an example of resource nationalism is the January 2007
Cabinet of Ministers Decree #31. Via this decree, the GOU
requires all gas companies that are 50% or more owned by the
state (including joint ventures and subsidiaries) to sell all
domestically produced natural gas, except for gas used for
technical needs, at a low state-regulated price. Recently,
the U.K.-based company Cardinal Resources, which was in a
joint venture with two Ukrainian state-owned companies, sold
its Ukrainian assets to Kuwait Energy Company, claiming that
Decree #31 had virtually bankrupted its Ukrainian venture
because Cardinal Resources was unable to sell at prices above
production costs. However, the underlying motivation for the
decree seems to be to keep domestic gas prices down, thus
keeping the population happy, and does not seem to be driven
by a need to push foreign companies out. Moreover, it should
be noted that under Decree #31, state-owned companies are
also unable to sell their gas at market prices, which has
contributed to financial difficulties for state-owned
companies.


4. (C) At the same time, there has been a trend in the last
few years toward more foreign investment and foreign business
collaboration, and even some foreign ownership of energy
companies over the last few years. The U.S.-based company
AES, for example, since 2005 owns two regional electricity
distribution companies and other distribution companies also
have foreign owners. In October 2007, the Houston-based oil
company Vanco signed Ukraine's first-ever production sharing
agreement for oil and gas exploration in the Black Sea, and
additional U.S. companies are currently engaged in study
agreements for future oil and gas exploration with
state-owned companies. In the nuclear sector, the
Pennsylvania-based company Holtec recently signed a $250
million agreement to complete an Interim Spent Nuclear Fuel
Storage Facility at the Chernobyl Nuclear Power Plant. In
nuclear fuel supply, the nuclear generating monopoly
Energoatom is negotiating with Westinghouse about providing
fuel elements to some nuclear reactors. To date Ukraine has
imported 100% of its nuclear fuel from Russia.


5. (C) What appears to be driving this liberalization is the
imperative to bolster energy security by increasing domestic
production through bringing in international expertise. The
importance of energy security was brought home by Russia's
gas shut-off in January 2006 in a pricing dispute. Since
then, some senior leaders in the GOU recognize Ukraine needs

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to bring in foreign partners with the technology to address
problems such as deep drilling onshore and exploring in the
deep water of the Black Sea. This seems to be forcing
Ukraine to move away from aspects of resource nationalism (or
perhaps more accurately in Ukraine's case - resource
cronyism) towards a more open attitude toward foreign
participation in the energy sector. However, this opening is
likely to move in fits and starts, as those in NaftoHaz who
would like to keep the sector to themselves have not gone
away and are likely to continue to seek to resist and
undermine foreign participation in the sector.
Taylor