UKRAINE: NAFTOHAZ TURNS OFF TAP TO DELINQUENT GAS

UNCLAS SECTION 01 OF 02 KYIV 002221 SENSITIVE SIPDIS DEPT FOR EUR/UMB,EB/ESC/IEC-WRIGHT, GALLOGLY DOE PLEASE PASS TO LEKIMOFF, CCALIENDO E.O. 12958: N/A TAGS: ENRG EPET ECON UP SUBJECT: UKRAINE: NAFTOHAZ TURNS OFF TAP TO DELINQUENT GAS SUBSIDIARIES AS ITS FINANCES WORSEN REF: A) KYIV 2173, B) KYIV 1950 TREAT AS SENSITIVE BUT UNCLASSIFIED NOT FOR INTERNET DISTRIBUTION ¶1. (SBU) Summary. Ukraine's state-owned oil and gas company Naftohaz Ukrainy has refused to supply gas to some of its subsidiary companies until debts to Naftohaz are paid. The socially unpopular decision has resulted in the closing of some schools and public buildings due to a lack of heat. The GOU also announced a 35 percent gas hike for domestic consumers beginning December 1 with increases up to 50 percent scheduled for 2009, in an effort to bring traditionally low domestic gas prices closer to European market prices. As Naftohaz's financial situation continues to deteriorate, it is actively exploring options previously considered socially taboo in order to service its debts to Gazprom. At the same time, it is struggling to keep some creditors from cashing in their Eurobonds later this month because of its inability to provide financial data as required in its bond agreements. End summary. Naftohaz Calls in Debts from Subsidiaries -------------- ¶2. (SBU) The Naftohaz decision to get tough on its subsidiaries comes after an October 2 memorandum of understanding signed by Prime Ministers Putin and Tymoshenko (ref A). According to that document, Naftohaz must settle its outstanding debts (approximately $1.8 billion and 11 billion cubic meters of gas) before Gazprom agrees to the removal of intermediary RosUkrEnergo (RUE) and to the signing of a long-term contract and to prices for gas deliveries in 2009. ¶3. (SBU) According to Naftohaz Chairman Oleh Dubyna, as of October 2, local gas distribution and municipal heating companies owe Naftohaz 1.16 billion UAH ($201 million) for gas supplied last winter. Six of 53 local gas distribution companies have not had their contracts renewed with Naftohaz due to outstanding debts. These include gas suppliers from the western regions of Zakarpatia, Lviv, Ivano-Frankivsk, Chernivtsi, Volyn and Vinnitsya. ¶4. (SBU) Among municipal heating companies, the largest debtors were in the heavily industrialized regions of eastern Ukraine, including Kharkiv, Donetsk, Dnipropetrovsk, and Luhansk. However, Lviv in western Ukraine and the Crimean Autonomous Republic are both indebted to Naftohaz as well. Gas Supply Interruptions Affect the Population -------------- --- ¶5. (SBU) Ukrainian news agencies reported that city officials in the western town of Ivano-Frankivsk temporarily closed 18 secondary schools on October 22 due to low classroom temperatures. The temperature in buildings dropped below 15-16 degrees Celsius (59-61 F). The mayor's office could not say when heat supplies would resume; acknowledging that the municipal gas distribution company owed millions of hryvnya to Naftohaz subsidiary Gaz Ukrainy. Ivano-Frankivsk had temporarily cut short hours in schools, and gave parents of elementary students the option of keeping young children home until schools are heated again. In Kharkiv in eastern Ukraine, heat supplies had not resumed in about 13 percent of the buildings as of November 3, and schools in the city were also affected by gas supply disruptions. GOU Interventions -------------- ¶6. (SBU) President Yushchenko initiated the process by issuing a decree on October 3, ordering the termination of gas supplies until debtors pay off their debts or came forward with bank guarantees. The same decree instructed the Cabinet of Ministers to transfer an additional UAH 9.1 billion ($1.58 million) to Naftohaz and UAH 2.4 billion ($417 million) in subsidies to local budgets in 2008 to compensate utility companies for the gap between their costs and the unrealistically low rates their companies are required to charge to customers. ¶7. (SBU) While the issue of subsidies will have to be approved by the Parliament as part of amendments to the 2008 budget, Prime Minister Tymoshenko urged all regional governors on October 22 to ensure payment of debts to Naftohaz and instructed the Ministry of Fuel and Energy and Naftohaz's Head to supply gas necessary for resumption of centralized heat supply as soon as possible. To date, Naftohaz officials report that outstanding debts have not been paid, and that gas supplies will not be resumed until the debts are paid. KYIV 00002221 002 OF 002 Naftohaz's Financial Situation Worsens -------------- ¶8. (SBU) As Naftohaz struggles to collect debts from its subsidiaries, the company's Eurobond holders plan to meet in London on November 14. Press reports indicate the holders could demand an early redemption of the bonds because the company has failed to deliver a financial report for 2007, an action that is allowed under the terms of the bond issue. Naftohaz faced a similar challenge from bondholders last year over its 2006 reports, but successfully held them off until it finally published the reports in early 2008. Creditors may not be so patient this time around because of the world financial crisis. Naftohaz continues to service its external debt in a timely manner, and the current threat to redeem the bonds simply results from Naftohaz's inability to produce financial reports that most companies could have published months ago. Nonetheless, creditors are worried, and some analysts described the company's situation as "deplorable" and unlikely to improve next year (ref B). Comment -------------- ¶9. (SBU) The gas cutoffs show that the gas sector's debt problems run down the entire value-added chain - starting with Naftohaz's gas purchases from RUE and ending at the level of individual households. The reasons for the debt are well-known: ill-guided regulations force Naftohaz to sell gas below cost, and equally ill-guided tariffs force local distributors and heating companies to supply services to consumers at unrealistically low rates. Domestic gas production is far below its potential because producers are forced to sell at unprofitable low prices. The artificially low prices throughout the system provide no incentive to save energy and deny energy companies the means needed to modernize their aging infrastructure. Moreover, the existence of multiple prices for a homogenous product - gas - throughout the system has created grey markets and solidified corruption. Increased domestic gas prices are a long time coming and should motivate Ukrainians to become more energy efficient, thus decreasing demand. In turn, the government will need to ensure that necessary subsidies are targeted to ensure that they reach those who need them. End comment. TAYLOR