UKRAINE: NAFTOHAZ OPTIONS FOR GAS PAYMENTS

C O N F I D E N T I A L SECTION 01 OF 04 KYIV 001981

SIPDIS

DEPT FOR S/EEE, EUR/UMB, EB/ESC/IEC
DOE PLEASE PASS TO JELKIND, LEKIMOFF, CCALIENDO
NSC PLEASE PASS TO KKVIEN

E.O. 12958: DECL: 11/11/2010
TAGS: ECON EFIN ENRG EREL PGOV PREL PINR UA RU
SUBJECT: UKRAINE: NAFTOHAZ OPTIONS FOR GAS PAYMENTS

REF: A. KYIV 1916

B. KYIV 421

C. KYIV 1878

D. KYIV 1943

Classified By: ECON Counselor Edward Kaska for reasons 1.4 (b,d).


1. (C) Summary. Ukraine is expected to need about $1 billion
to cover gas purchased from Russia in November and December.
Prime Minister Tymoshenko has called on President Yushchenko
to allow the National Bank of Ukraine (NBU) to make its
foreign currency reserves available for the gas payments.
However, it is unlikely that the President will allow the NBU
to do so, which will force the Prime Minister to find
alternative sources of funding. GOU officials have said
Ukraine will again use IMF Special Drawing Rights (SDRs) to
cover the payment for November gas purchases, but predict
difficulty making the payment for December gas purchases
without IMF stand-by program "fourth tranche" funds.
Naftohaz is also in talks with Gazprom Bank to secure
alternative financing to cover gas payments. The gas payment
situation is unlikely to improve in 2010, even though rates
for the transit of Gazprom gas through Ukrainian pipelines to
Europe will increase. If Ukraine does miss a gas payment, it
will be forced to make prepayments for gas and could be
threatened with close to $9 billion in "take-or-pay"
penalties from Russia. End summary.

November 7 Payment for October Gas
--------------


2. (C) Per the terms of the January 19, 2009 contract
Naftohaz signed with Gazprom, payments are due by the seventh
of each month following the month of supply. Ukraine on
November 6 paid Gazprom approximately $461 million for 2.2
billion cubic meters (bcm) of gas purchased in October.
According to Naftohaz Spokesman Valentyn Zemlyansky, around
$61 million came from Naftohaz revenues, with the rest coming
from IMF SDRs (Ref A). Naftohaz transferred approximately
UAH 3.25 billion in treasury bills (from the UAH 18.6 billion
that the Cabinet of Ministers allocated to Naftohaz in the
summer) to the Ministry of Finance, which in turn transferred
$400 million to a commercial bank for Naftohaz. Zemlyansky
claimed that the company earned UAH 3.5 billion ($435
million) in revenues in October but that a significant
portion of the revenues are going to pay Naftohaz's tax
burden and service domestic debts. Others estimate that
Naftohaz's monthly revenues are significantly less, at around
$130 million.

Gas Volumes for the Rest of the Year
--------------


3. (C) While Ukraine's gas purchase volumes for the rest of
2009 will depend somewhat on how cold the winter is, Naftohaz
will take far less than it agreed to in the January 19
contract. On October 14 Naftohaz Deputy Director Yaroslav
Marchuk stated in the press that Naftohaz would purchase
between 7-8 bcm of gas from Gazprom in the fourth quarter.
Presidential Envoy for Energy Security Bogdan Sokolovsky told
us on November 9 that Naftohaz had earlier planned to take
3.5 bcm in both November and December, but now would likely
take around 3 bcm or less, if the winter was mild. Others,
however, believe Ukraine could take substantially less gas.
Independent energy expert and former Naftohaz official
Oleksandr Todiichuk estimated that Ukraine would purchase
only 4.5 bcm for the rest of the year. Naftohaz's Zemlyansky
told us that Naftohaz would take up to 5 bcm in the last two
months of 2009, and could take even less. Minister of Fuel
and Energy Yuriy Prodan told the press on November 10 that
Ukraine would take between 2.5-2.7 bcm in November. Assuming
that the working estimate at Naftohaz is still to take
between 7-8 bcm for the fourth quarter, Ukraine will need to
purchase between 4.8-5.8 bcm total in November and December
at a cost of $957 million to $1.17 billion.

Likely Shortfalls
--------------


4. (C) The financial situation at Naftohaz will not improve
in the final months of the year, and the company will again
need some sort of intervention to make its monthly gas
payments. Although Zemlyansky's estimate of Naftohaz's
revenues was much larger than what others have told us, he
also made it clear that the company would not be able to use

KYIV 00001981 002 OF 004


all of its revenues to make the gas payments. Assuming
Naftohaz could contribute $100 million per month from
revenues and Ukraine takes on the low side in both November
and December, Naftohaz will need approximately $340 million
each month to make up the shortfall. If the winter is colder
and Ukraine has to take more gas, the shortfall could grow to
approximately $500 million each month.

Payment Options--National Bank of Ukraine Help Unlikely
--------------


5. (SBU) Ukraine has limited options for coming up with the
payments, but should be able to make each payment if it has
the political will to do so. Yushchenko advisors have
repeatedly stated that the President will block any further
use of NBU reserves for gas payments. His action rules out
the financing scheme Ukraine used for at least three monthly
payments earlier this year wherein the NBU provided financing
to state-owned banks, which in turn lent the funds to
Naftohaz (Ref B). Deputy Presidential Secretariat head
Oleksandr Shlapak said in the press that without the IMF
releasing the fourth tranche ($3.8 billion) of the Stand-By
Arrangement, Ukraine would have difficulty making the
December 7 payment for November gas purchases. Shlapak
stated "What do the President and the National Bank have to
do with this? It is not the President's duty to pay for gas.
It is the duty of the Government."

IMF SDRs Could Be Used
--------------


6. (C) The Prime Minister's office also predicts difficulty
in making gas payments if the IMF does not give Ukraine the
fourth tranche of its Stand-By Arrangement (Ref C),but has
stated that Ukraine will be able to make the December 7
payment. Deputy Prime Minister Hryohriy Nemyria stated on
November 9 that Ukraine would again use a portion of the IMF
SDRs to make the December 7 payment for November gas
purchases. He continued by stating that Ukraine would face
difficulties making the January 7 payment for December gas
purchases if the IMF has not resumed its stand-by program
before then. Assuming Ukraine purchases up to $1.20 billion
worth of gas in November and December, the $2 billion SDR
allocation could cover gas purchases for the rest of the
year.


7. (C) The GOU, however, could choose to use the SDR funds to
cover its own budget gap rather than make the gas payments
(Ref D). Sokolovsky told us on November 6 that the SDRs
would need to be distributed in a way to "keep happy" Russia,
Naftohaz, and the budget. He subsequently told us on
November 9 that the SDRs would not necessarily be used to
make the December 7 and January 7 payments. Zemlyansky also
told us he doubted that the SDRs would be made available to
Naftohaz again.

Naftohaz Could Seek Russian Financing
--------------


8. (C) Another option, which Zemlyansky told us Naftohaz is
actively pursuing, would be to borrow from commercial banks.
Zemlyansky said specifically that Naftohaz is holding talks
with Gazprom Bank to cover gas payments. He said that recent
statements made in the press (some made by Zemlyansky
himself) that Naftohaz was holding negotiations with Gazprom
over changes in the gas contracts were simply cover for the
actual talks--securing financing from Gazprom Bank--that were
ongoing. Zemlyansky did not comment on the loan terms being
discussed or what Naftohaz might offer as collateral.
Naftohaz Deputy Chairman Igor Didenko, reported to be
Tymoshenko's man at Naftohaz, has frequently shuttled between
Kyiv and Moscow over the last month.

Growing Debts Owed to Naftohaz
--------------


9. (SBU) Naftohaz could also seek to collect growing arrears
owed to the company from municipal heating companies and
Oblgas companies (regional gas distributors). Prime Minister
Tymoshenko has stated that municipal heating companies have a
50-60% payment rate to Naftohaz. Heating companies still owe
Naftohaz UAH 2.7 billion ($330 million) from gas purchased in

2008. With the continued economic slump and the lack of
political will at the municipal government level to raise
heating tariffs, it is unlikely that heating company debts

KYIV 00001981 003 OF 004


will be paid off to Naftohaz this year.


10. (SBU) Over the summer the Cabinet of Ministers
established a financing program intended to provide loans
from state-owned banks to cities to repay municipal heating
company gas debts. According to Zemlyansky, the program has
not been very successful as the banks have little liquidity
and are not extending loans to municipalities.


11. (SBU) Zemlyansky also told us that Oblgas companies are
refusing to pay for gas sold to them and have amassed UAH 12
billion ($1.47 billion) in debts. Oblgas companies' refusal
to pay for gas supplies is linked to a decision passed by the
Cabinet of Ministers on June 10 to strip the gas distribution
business from them and give it to a new subsidiary of
Naftohaz, Naftohaz Merezhi, at the beginning of 2010. If
Naftohaz or the government were able to enforce payment
discipline by heating and Oblgas companies, Naftohaz would
have enough resources to make the payments for gas taken in
November and December.

Payment Problems Will Continue
--------------


12. (SBU) Ukraine's ability to pay for Russian gas will
continue to be limited in 2010. The January 19 contract
envisions a marked increase in gas volumes delivered to
Ukraine from 40 bcm in 2009 to 52 bcm in 2010. The
government and Naftohaz reportedly have begun talks with
Gazprom to lower the contracted volume for 2010 to 33 bcm.
On January 1, gas prices will also increase as Ukraine loses
the 20% discount it had in 2009, and as the new quarter
begins. The first quarter price will be at least $260 per
thousand cubic meters (tcm) compared to $208/tcm for the
fourth quarter of 2009. The draft 2010 budget submitted by
the Cabinet of Ministers to the Rada on September 15 uses an
average gas price of $260/tcm for 2010 to calculate subsidies
for Naftohaz. Zemlyansky, however, told us that Naftohaz
estimates that the average price for 2010 will be $295/tcm
(compared to an average price of $235/tcm in 2009). Assuming
Ukraine purchases 33 bcm in 2010, at an average price of
$260/tcm, Ukraine will need to pay Gazprom $8.58 billion.
Assuming an average price of $295/tcm, the bill would jump to
$9.74 billion. Ukraine's total gas bill in 2009 will be
approximately $5.6 billion for around 24 bcm.

Transit to Increase, But Won't Cover Growing Gas Payments
-------------- --


13. (SBU) Per the January 19 transit contract, the pipeline
transit rate should also increase beginning January 1, 2010.
Naftohaz estimates that the rate will increase from the
current rate of $1.70/tcm per 100 kilometers to $2.70/tcm per
100 kilometers. Ukraine could earn around $3-3.5 billion in
transit revenues for 2010, an extra $1-1.5 billion compared
to 2009, depending on volumes shipped to Europe. However, as
Russia advanced Ukraine close to $2 billion for transit at
the beginning of 2009, Naftohaz will not start collecting
transit revenue again until sometime in the spring of 2010,
at the earliest in March.

What Would a Missed Payment Mean?
--------------


14. (SBU) If Ukraine misses a payment, per the terms of the
contract, Naftohaz will be forced to prepay for gas
deliveries before the beginning of each month. Already in
dire financial straits, Naftohaz would probably not be able
to prepay Gazprom. A missed payment could also spark Russia
to threaten Ukraine once again with "take-or-pay" penalties
for the under-purchase of gas in 2009. Gazprom estimates
that total penalties from January-September 2009 total $5.9
billion. According to the Presidential Secretariat, total
penalties in 2009 could reach $8.7 billion. While Putin and
Tymoshenko have agreed in principle that Ukraine would not be
penalized for under-purchase of gas, this agreement has not
been formalized in writing. Most analysts in Kyiv expect
that Russia will not sign a legal agreement ceding Gazprom's
rights to impose penalties. Indeed, many here expect that
Russia would threaten Ukraine with penalties should Ukraine's
new president act against Moscow's interests.


15. (C) Putin also has again warned that Russia would turn
off the gas to Ukraine if Ukraine siphons off transit gas for
its own use. If Russia turned off gas to Ukraine, transit to

KYIV 00001981 004 OF 004


Europe would be threatened. Ukraine has enough gas in its
underground storages to meet domestic needs over the winter,
but it would not be able to meet its own needs and transit
gas to Europe if Russia turns off the gas flows. Hans Rhein,
the EC Delegation's energy expert, told us that a growing
concern for the EU was that Ukraine would siphon gas off the
transit pipeline if the winter is particularly harsh. He
said that while Ukraine has enough gas in storage to replace
whatever gas it might siphon from the transit pipeline, the
transit system might not have the capability to evenly "swap"
the gas in storage with the gas Ukraine would take off the
pipeline. If it seemed that Ukraine might start to siphon
off gas from the pipeline, the EU could consider placing
monitors in Kyiv as it had done in January in an effort to
avoid a shut off, according to Rhein.

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


16. (C) Although Ukraine has significantly reduced the
volumes of gas it plans to purchase from Russia, political
infighting between the President and the Prime Minister and
the dire straits of the government's budget could lead to gas
payment problems over the winter. Yushchenko looks
determined to reject the Prime Minister's request to use NBU
reserves for the gas payment, and by so doing, to create more
problems for Tymoshenko. For Tymoshenko, making the gas
payment with SDRs or other government revenues could mean
increasing the risk that pensions and wages could go into
arrears, just ahead of the presidential election. Tymoshenko
could be willing to deepen Ukraine's dependency on Russia by
forcing Naftohaz to take Russian loans for gas purchases as a
short-term tradeoff to forestall a gas payment crisis and
keep the government's budget afloat. Tymoshenko could also
be playing chicken with the IMF and the EU by threatening
that Ukraine could miss a payment without their fiscal
support. Gazprom meanwhile has again ramped up its public
relations campaign to assign blame to Ukraine for any
possible future gas crisis. Russia, by repeatedly warning
that Ukraine might miss a payment, is reviving its theme that
Ukraine is an unreliable transit partner. Russia also seems
to be setting the stage to blame the EU, at least in part,
for a future gas crisis by criticizing the EU's decision not
to extend financing to cover Ukrainian gas purchases.
PETTIT