UKRAINE: SPECIAL ENVOY MORNINGSTAR DISCUSSES GAS

C O N F I D E N T I A L SECTION 01 OF 06 KYIV 001092

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E.O. 12958: DECL: 06/30/2019
TAGS: ENRG EPET ECON PINR PREL RU UP
SUBJECT: UKRAINE: SPECIAL ENVOY MORNINGSTAR DISCUSSES GAS
TRANSIT, ENERGY

Classified By: Charge James Pettit for reasons 1.4(b,d).


1. (C) Summary. During a June 19-20 visit to Kyiv, Special
Envoy for Eurasian Energy Ambassador Richard Morningstar
urged senior Ukrainian officials to begin reforms in the
energy sector in order to build confidence with both European
and Russian partners. In meetings with PM Tymoshenko, Energy
Minister Prodan, Presidential Energy Advisor Sokolovsky, and
Naftohaz, Morningstar and DOE PDAS Jonathan Elkind heard that
Naftohaz is in serious financial trouble, in part because of
the January 2009 gas supply and transit contracts and the
company's inability to charge cost recovery rates to
households. Ukrainian officials said they recognized the need
for serious energy sector reforms but argued that reforms
could not be undertaken until after the 2010 presidential
elections. International community representatives linked
any possible financing for Naftohaz to reforms in the gas
sector and increased transparency at Naftohaz. The economic
crisis would play a large role in the presidential elections,
Morningstar was told. End summary.

Naftohaz Financing Needs for Gas Purchases
--------------


2. (C) Prime Minister Tymoshenko, Minister of Fuel and Energy
Prodan, the Naftohaz leadership, and Presidential Advisor
Sokolovsky all claimed that Ukraine needs $5 billion in
financing to purchase adequate volumes of gas in 2009 and
thereby avoid a potential repeat of the winter gas crisis
with Russia. However, they gave various justifications of
what exactly would be funded by the loan. Tymoshenko, Prodan
and Naftohaz stated that Ukraine would use the loan to
purchase 19 bcm of gas. However, Ukraine's gas storage
facilities have a working capacity of 31 billion cubic meters
(bcm). As of June 19, Naftohaz had 19.5 bcm of gas in
storage, meaning that spare capacity was far less that the
additional 19 bcm that both Ukrainian and Russian officials
have repeatedly said was needed to prepare for winter.
Naftohaz and Sokolovsky,s best estimates were that 6 to 8
bcm were needed, which was confirmed by Tymoshenko after the
visit.


3. (C) Tymoshenko argued that Ukraine needed a four month,
$4.2 billion loan from the European Bank for Reconstruction
and Development (EBRD) and European Investment Bank (EIB) to
meet the cost of pumping gas into storage over the summer.
(Note: Morningstar later heard that the $5 billion price tag
included 20 percent VAT, hence the $4.2 billion was net of
VAT payments. End note). Tymoshenko stated that Naftohaz
would need to make the following monthly payments to Gazprom:

July 7: $250 million
August 7: $1.3 billion
September 7: $1.5 billion
October 7: $1.0 billion
November 7: $150 million

To ensure transparency, Tymoshenko said that Ukraine would
accept EU monitors inside Naftohaz to monitor gas storage
facilities' levels and international auditors to monitor
financial flows. Ukraine would offer the gas in storage as
collateral for any financing and would only extract gas as
the loan was paid back.


4. (C) Tymoshenko argued that the current financial crisis
had worsened Naftohaz's position. Naftohaz was unable to
borrow from Ukrainian banks because of their low liquidity,
and international banks were also unable or unwilling to
extend Naftohaz credit. Tymoshenko laid the blame on
President Yushchenko for Russia's decision not to advance
additional transit fees to cover the cost of gas to be pumped
into storage. She said that Yushchenko had called Russian PM
Putin to object to Tymoshenko's proposal. Tymoshenko said
that the situation could have been logically resolved by
Russia advancing transit payments, but now the situation had
turned serious. The Prime Minister also said that in January
she had told German Chancellor Merkel and EC President
Barroso that the economic crisis could create conditions in
which Ukraine would not be able to pay for gas. Tymoshenko
seemed to reject a proposal that the EU had been looking into
that would have European companies purchase gas and place it

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in storage in Ukraine, arguing that Ukraine would not be able
to then ship that gas to Europe as the gas in storage was
intended to meet Ukrainian demand.


5. (C) Deputy Naftohaz Chairman Vadym Chuprun stated that the
company had stored more gas at this point in the year than in
any of the previous five years. He said he understood the
concerns of other European countries, particularly those
without storage facilities, because of last winter's gas
cutoff. However, Chuprun argued that other European
countries' concerns were not solely Ukraine's problem. He
asked why Ukraine, and not the producer (Russia) or the
consumer (Europe),should pay to pump gas into storage.
Chuprun argued that the gas price Naftohaz paid to Gazprom
and the price it received for transit services were highly
imbalanced. He also noted that Naftohaz has transited 20 bcm
less than average to Europe this year. Due in part to low
European purchases, the revenues of Ukrtransgaz, the gas
transit system (GTS) operator, had dropped, and the GTS
worked at 30-50 percent of its normal load. Chuprun said he
could point out several such factors currently shaping
Naftohaz's finances and argued that the situation was not
Naftohaz's fault.


6. (C) Minister of Energy Prodan said that Ukraine needed
$4.2 billion to cover the purchase of 19 bcm of gas. Prodan
stressed that Ukraine's gas storage facilities needed to be
full to ensure the proper operation of the transit system in
the winter. Without being specific, Prodan said some
legislative obstacles prevented the continued use of foreign
currency reserves to finance gas payments. Prodan also noted
that Ukraine would be in the same position next summer --
needing to purchase gas during the summer for storage while
lacking a steady stream of revenues to pay for it -- but
hoped that Naftohaz would get financing in the domestic
market.


7. (C) Presidential Advisor Sokolovsky said that Ukraine
would need only around $1.6 billion to fill its storage
facilities to the needed volume of 25-26 bcm before the
beginning of the heating season in mid-October. Ukraine
planned to use the balance of any $5 billion loan to refill
the storage facilities in the winter, as gas prices were
forecasted to fall in the fourth quarter to $190/thousand
cubic meter (tcm) before rising again in the first quarter of
2010 to $240/tcm. According to Sokolovsky, Naftohaz
currently collected about $150 million monthly, and in June
2009 it would collect $170 million. For June gas deliveries
it would have to pay Gazprom about $290 million. Naftohaz
could cover the June payment, but not thereafter due to a
lack of funds. In July/August, Naftohaz would need $600
million each month to pump gas into storage for the winter.
Sokolovsky said that the IMF conditionality that set floors
on the National Bank's foreign currency reserves would limit
Ukraine's ability to continue financing gas payments through
loans from the National Bank.

Donors: No Loans Without Reforms
--------------


8. (C) Representatives of the European Commission, World
Bank, and the EBRD all agreed that any financing would need
to be predicated on Ukraine undertaking needed reforms in its
gas sector. EBRD country director Andriy Kuusvik confirmed
that EBRD had received a GOU request for a $5 billion working
capital loan for Naftohaz. He pointed out that EBRD was
geared towards long-term project finance loans, and not
well-situated for short-term working capital loans. He also
said the $5 billion price tag was far higher than anything
EBRD could absorb. Nonetheless the bank would be willing to
take the lead in structuring a loan, but would expect
multi-national lenders, individual countries and/or energy
companies to contribute substantially. He also said the bank
would need three months in the best of cases to structure
such a loan, whereas the GOU claimed that it needed the money
soon.


9. (C) Kuusvik also said that EBRD would expect clear,
concrete and upfront reforms in return for its willingness to
consider the loan request. This was seconded by the World
Bank country director Martin Reiser. Although the World Bank

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had not been approached, Reiser offered his personal opinion
that the international community should demand genuine action
on gas sector reforms before lending Naftohaz/Ukraine money.
He said donors should require a significant tariff increase
before disbursing a loan; otherwise any GOU commitment to gas
sector reform would not be credible. He also suggested that
donors require far more transparency into Naftohaz,s
finances. If Naftohaz needed money to 1) cover the deficit
caused by domestic tariffs that were lower than cost, 2) buy
gas from Gazprom, and 3) service its external debt coming due
this year, then donors could demand a segmentation of funding
to meet each of these needs. The subsidy to cover the loss
incurred by selling gas below cost could be a clear and
transparent budget item which would allow anyone to see
exactly how much government subsidies go to this purpose.
Capital for gas purchases and debt servicing, if provided by
donors in return for tariff reform, would come into
Naftohaz's coffers through a direct donor loan. This would
bring transparency, prevent Naftohaz from cross-subsidizing,
introduce truer accountability into the company's finances,
and eliminate some of the rent-seeking that currently
occurred in the company.


10. (C) When asked by Morningstar and Elkind whether Naftohaz
really needed the money, Reiser said that the GOU could
continue to monetize Naftohaz's debt through central bank
lending via the state-owned banks. Foreign exchange
reserves, when coupled with continued IMF disbursements and
IMF flexibility towards foreign reserve conditionalities,
should be sufficient to meet this year,s gas bill. EC
Delegation energy expert Hans Rhein noted that, in principle,
Ukraine did not need 19 bcm in storage for the winter.
Still, sizable reserves would be desirable if there were to
be a harsh winter. He speculated that Tymoshenko needed the
cash and wanted to meet the contract requirements. Ukraine
and Russia had been pushing jointly in Europe for a financing
solution over the last few weeks, but likely could resolve
the payment issue on their own.


11. (C) Morningstar stressed to all interlocutors that the
United States would be willing to facilitate
Ukrainian-Russian-European efforts to deal with Ukraine's
short-term gas issues, but stressed that it was ultimately an
issue for the three stakeholders to solve. Morningstar also
underlined that the proposed financing might help Naftohaz in
the short-term, but that ultimately Ukraine would need to
enact real, long-term reform.

Gas Sector Reforms Needed--Timing and Severity Debated
-------------- --------------


12. (C) Tymoshenko said she acknowledged that serious reforms
were needed in the gas sector, but urged patience from the
international community as Ukraine could not enact stringent
reforms in the current economic and political climate. The
gas sector would be in much better condition if Ukraine could
raise domestic gas prices to cost recovery levels, she said.
She also agreed that Ukraine needed to end cross-subsidizing
the sector and unbundle and modernize the GTS. On gas
prices, Tymoshenko pointed out that industrial consumers had
paid market prices since the beginning of the year, and that
household gas prices had been raised by 35 percent in the
fall of 2008. Tymoshenko claimed that payment collections
from households dropped from 93-95 percent before the price
hike to 78-79 percent after it. Collections could drop to 50
percent, she said, if prices were raised again by 35 percent.
Such stress could undermine the financial situation of
Naftohaz. Tymoshenko also feared that gas price increases,
coupled with the high unemployment and salary cuts that
resulted from the economic crisis, could lead to social
unrest. She said she wanted to raise gas prices, even double
them, but that the current economic and political climate was
too volatile to do so. Before gas prices could be raised, a
substantial system of social protection needed to be
developed. Tymoshenko said the IMF was making a 60 percent
gas price increase for households a key prior action for the
next $3 billion tranche of the Stand-By Agreement. If
Ukraine did not raise prices, it would not get the third
tranche. She asked the USG to intervene with the IMF to
lessen the requirement and accept a detailed roadmap
outlining sector reforms. The roadmap would be implemented

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once political stability was achieved, she said, without
specifying how political stability was to be measured.


13. (C) On the margins of his meeting with Morningstar,
Sokolovsky told us that Tymoshenko was willing to increase
household gas tariffs by 30 percent before the elections, but
not by the 60 percent that the IMF was purportedly demanding.
He also told Morningstar that the GOU would submit to the
Rada during the week of June 21-26 draft gas reform
legislation that would remove criminal liability for gas
companies that turn off gas deliveries to delinquent
household customers, remove multi-tier gas prices, and
address the issue of targeted subsidies for needy households.
In response to Morningstar,s question whether Yushchenko
would support the laws, Sokolovsky said that Yushchenko and
Tymoshenko had a "verbal agreement." Sokolovsky said that
Yushchenko had been urging gas sector reform for four years,
but every government has found it easier to avoid unpopular
decisions, and instead negotiate with Russia agreements that
turned out to be unfavorable to Ukraine. Opposition leader
Viktor Yanukovych was in general open to gas reform,
according to Sokolovsky, and would likely approve big tariff
hikes because he could blame them on the Prime Minister.


14. (C) Leading Ukrainian industrialist and Yanukovych backer
Viktor Pinchuk told Ambassador Morningstar that Tymoshenko
would not enact difficult energy sector reforms ahead of the
elections because they would lower her ratings. Even with
Tymoshenko's political skills, she could not blame a 60
percent gas price increase on the IMF. Pinchuk also
dismissed the possibility of establishing an independent
energy regulator, as no one in Ukraine would believe it was
truly independent. Ukraine's industrialists were not willing
to lobby the government for energy sector reforms, he said,
although they had already begun investing in energy
conservation.


15. (C) Tymoshenko reiterated her support for the joint
declaration signed by the EU, EBRD, World Bank, EIB, and
Ukraine on March 23 in Brussels that seeks to link
international financing for GTS modernization with gas sector
reforms in Ukraine. She said that Ukraine must work to
unbundle the GTS but outlined three issues that complicated
that process. First, Ukrainian law prohibited changes in
Naftohaz property. The law was intended to prevent Russian
takeover of the pipeline. Second, Naftohaz had long term
loans with European banks that allowed the banks to demand
early repayment if pipeline ownership changed. Third, the
contracts between Naftohaz and Gazprom could slow
restructuring of Naftohaz. However, Ukraine was ready,
Tymoshenko said, to develop a plan to implement the Brussels
declaration. Prodan said that Ukraine was working to fulfill
needed requirements in the gas sector to join the European
Energy Community, but that such reforms would take time.
Naftohaz's Chuprun stated that the implementation of the
March 23 agreement was Ukraine's only possibility to
modernize the GTS. Naftohaz had already undertaken many
efforts to implement it, including starting feasibility
studies on separate projects. Chuprun noted that the March
23 agreement was signed without knowledge of future Russian
gas shipments, European consumption, or transit rates.
Naftohaz could not develop a modernization plan without such
parameters, he said. Tymoshenko said Ukraine was already
implementing energy efficiency programs and other ways to
reduce gas consumption. Funds from the sale of carbon
credits under the Kyoto Agreement would modernize municipal
heating boilers and reduce gas consumption by 50 percent, she
claimed.


16. (C) Ambassador Morningstar said the USG could help
Ukraine set up targeted subsidy programs and a roadmap for
the needed reforms. Morningstar stressed that a detailed
roadmap could bring confidence to European doubters. DOE
PDAS Elkind noted that under Tymoshenko's leadership in the
1990s, Ukraine implemented a series of reforms in the
electricity sector that eventually attracted both foreign and
domestic investors. He noted that the gas sector reforms
would be even more complicated, but added that the USG was
looking for constructive ways to assist Ukraine's reform
efforts. He urged Tymoshenko to develop a reform plan now so
that efforts could begin immediately after the elections.

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Deputy Prime Minister Hryhoriy Nemirya suggested that the
upcoming visit of Vice President Biden could be used to
bolster US-Ukrainian cooperation in the energy sector as part
of the bilateral working group on energy.

January 2009 Contracts
--------------


17. (C) Prime Minister Tymoshenko gave a relatively positive
assessment of the January 2009 gas supply and transit
contracts, even claiming that the January crisis had somewhat
of a "purifying effect" because intermediary Rosukrenergo was
removed, and gas prices were now set by a fixed formula,
eliminating the need for end-of-year negotiations.
Tymoshenko noted that the quarterly price adjustments occur
without any difficulty.


18. (C) Naftohaz's Chuprun, however, was openly critical of
the contracts, arguing that both gas prices and transit fees
should have moved towards market levels. He said Naftohaz had
been prepared to accept Gazprom's offers of $238/tcm and
$2.34/tcm/100km for transit. However, when Ukraine failed to
agree to those conditions, gas supplies were cut off, and
Gazprom demanded $450/tcm. Chuprun said the contract
ultimately signed on January 19 gave Ukraine a 20 percent
discount on gas prices in 2009 but kept gas transit fees at
their 2008 levels of $1.70/tcm/100km. Chuprun said the low
fees meant that the needed investment in the GTS was two
times the cost of transit operations. Separately, the World
Bank's Reiser had agreed that Russia had a great deal, as
Ukraine's gas prices were 10 percent higher than Germany's,
whereas Ukraine was getting half of what it should for
transit.

Alternative Corridors
--------------


19. (C) Nemyria said Ukraine wanted to diversify its natural
gas supplies. Tymoshenko said that Ukraine would have
sufficient capacity for Nabucco to feed into the Ukrainian
GTS. Naftohaz strongly rejected Russian proposals for
alternative gas pipeline corridors and noted that discussion
of alternative routes bypassing Ukraine had increased since
the January crisis. Chuprun rejected any notion that the
Ukrainian GTS would not be needed in three to five years,
calling it the only "serious stream" to Europe.

Nuclear Issues
--------------


20. (C) Morningstar urged Tymoshenko and Prodan to expedite
implementation of contracts with Westinghouse and Holtec
International for nuclear fuel supplies and Ukraine's Central
Spent Nuclear Fuel Storage Facility. Timely and successful
implementation of these contracts would help send a positive
signal to Congress, which had allocated hundreds of millions
of dollars to Ukraine's nuclear sector, said Morningstar. He
also urged his interlocutors to take advantage of Holtec's
offer to finance its project despite the severe financial
crisis. At Morningstar,s request, Tymoshenko agreed to meet
with Westinghouse and Holtec executives for a full brief on
each project.

OPIC
--------------


21. (C) In his meeting with Tymoshenko, Ambassador
Morningstar raised the ongoing efforts to solve OPIC's
outstanding claim against Ukraine and urged her to complete
all requirements so that Ukraine could be requalified for
OPIC financing. Tymoshenko assured Morningstar that all
necessary government resolutions had been passed.

Political Climate Ahead of Presidential Elections
-------------- --------------


22. (C) Ambassador Morningstar met with businessman and Party
of Regions MP Andriy Klyuyev to discuss the current political
situation following the failed attempt to establish a broad
coalition between Party of Regions and PM Tymoshenko's party,
BYuT. Klyuyev said the coalition would have been "great" for

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Ukraine, but it failed because Tymoshenko and Party of
Regions' leader Victor Yanukovych could not overcome their
"personal mistrust" of each other. Negotiations to form the
coalition lasted 18 months. Klyuyev said he believed that
Ukrainians were willing to trade direct election of the
president for stability and growth. Separately, Viktor
Pinchuk agreed that the coalition failed due to a lack of
trust in the two camps. Tymoshenko, he said, was power
hungry, while Yanukovych's popularity ratings were high
enough to convince him that he did not need the coalition to
attain higher office. Pinchuk also said that the coalition
attempts were simply a means to divide power between
political forces, and not an attempt to do what was right for
Ukraine.


23. (C) Klyuyev and Pinchuk both thought that Yanukovych,
Tymoshenko, and Arseniy Yatseniuk are the only real
contenders in the 2010 presidential elections. Both said
that the economic crisis made the outcome of the elections
very difficult to predict. Klyuyev pointed to Yanukovych's
2007 premiership to assert that Yanukovych was pro-Ukrainian
and not pro-Russian. According to Pinchuk, Tymoshenko had
two opponents: Yanukovych and the economic crisis. Any
further financial shock would hit Tymoshenko hard. Pinchuk
believed that Yatseniuk would have a good chance of becoming
prime minister if Yanukovych won the election. After noting
that he had recently met with high-level Russian officials,
Pinchuk said that the Russians would not find Yatseniuk
acceptable as president. Yanukovych was the best option for
Moscow, as cooperation between Russia and Ukraine would be
better under a Yanukovych administration. However, Pinchuk
thought that Russia would be "quiet" before the elections and
"bet on both" Tymoshenko and Yanukovych.


24. (U) Ambassador Morningstar's staff has cleared this cable.
PETTIT