UKRAINE: NAFTOHAZ PAYS GAZPROM AND AVOIDS A NEW CONFLICT,

UNCLAS SECTION 01 OF 03 KYIV 000421

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SUBJECT: UKRAINE: NAFTOHAZ PAYS GAZPROM AND AVOIDS A NEW CONFLICT,
FOR NOW

Ref: Kyiv 419

Sensitive But Unclassified. Not For Internet Distribution.

Summary
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1. (SBU) On March 5 Naftohaz paid Gazprom in full for gas delivered
in February. The payment of $360 million averted a possible repeat
of the recent gas crisis after Russia had threatened to cut off
deliveries if Naftohaz failed to pay by the March 7 deadline.
Naftohaz paid despite its worsening financial situation, caused in
part by government regulations forcing it to sell gas below cost,
and in part by a drop in its customers' payment discipline in the
wake of Ukraine's deepening financial crisis. Looking forward,
Naftohaz's financial situation can only get worse, and it may
struggle month-by-month to service its debt to Gazprom in a timely
manner. Ukraine will have sufficient foreign exchange to pay its
gas bills to Russia, however, and the GOU has created a mechanism
that provides Naftohaz with the dollars it needs to pay Gazprom.
The solution only redistributes Naftohaz's problems, however, and
weakens both the central bank and the banking system as a whole.
Ultimately the GOU will need to take painful decisions that will
allow Naftohaz to operate efficiently and service its debts without
resorting to financial alchemy. End summary.

Naftohaz Pays Its Debts on Time
--------------


2. (SBU) The Russia/Ukraine gas agreement stipulates that gas
delivered in a particular month must be paid for by the 7th of the
following month. If Naftohaz fails to pay on time, the agreement
foresees that it will subsequently be required to pay for each
month's deliveries in advance. Pre-payment would pose a notable
economic burden on Naftohaz, which is already facing a tight
liquidity situation on account of the economic crisis.


3. (SBU) Acting Naftohaz Head Ihor Didenko told us on March 5 that
the company had now paid Gazprom for February deliveries. Didenko
said Naftohaz paid $360 million in total. Later on March 5 the
media quoted a Gazprom spokesman as confirming that Gazprom had
received the payment.

Russia Threatens To Cut off Gas
--------------


4. (SBU) In recent weeks, both GOR and Gazprom officials had
publicly stated that Gazprom would cut off deliveries to Ukraine if
Naftohaz failed to pay by March 7. On March 5 PM Putin expressed
concern that the March 4 SBU raid on Naftohaz (reftel) might disrupt
Naftohaz's ability to pay, and cautioned that Russia could in fact
cut off gas to Ukraine, and consequently to the rest of Europe, if
Naftohaz failed to service its debt in a timely manner. It is
unclear whether the gas agreements actually permit Russia to cut off
supplies so swiftly, as the agreements already contained a sanctions
mechanism with the prepayment requirement.

Naftohaz's Financial Woes Deepen
--------------


5. (SBU) The Russian threats arose after Naftohaz reported in
February that it was facing liquidity problems. Commentators in
both Ukraine and Russia assumed that this could imperil Naftohaz's
ability to pay its debts to Gazprom. The concerns were not
unfounded. In recent years, Naftohaz's financial situation has
continuously deteriorated as a result of GOU regulations that force
it to sell gas below cost to large parts of the domestic market. In
recent weeks, its problems have been compounded by a sharp drop in
payment discipline. The company reported that its customers,
primarily regional heating utilities, were only paying for about
sixty percent of gas delivered by Naftohaz, whereas collection rates
were over 90 percent in 2008. Utilities, in turn, had reported that
payments for heating services had dropped because many households
could or would not pay on account of the growing economic crisis in
Ukraine.


6. (SBU) While the threat of another outbreak of the Russia/Ukraine
gas war has been averted for now, Naftohaz's ability to pay Gazprom
will be a recurrent issue in the coming months, as it is expected
that Naftohaz's financial problems will only become worse. Analysts
in Kyiv now expect Ukraine's economy to contract by between 5 and 10
percent this year. This will likely lead to a further deterioration
in payment discipline, and increased liquidity problems at Naftohaz.

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The nearly fifty percent decline in the $/hryvnia exchange rate has
almost doubled Naftohaz's debt burden to Gazprom, because the
company pays in dollars for imported gas but receives hryvnia for
the gas it subsequently sells on the domestic market. Direct
subsidies from the budget have kept Naftohaz afloat in recent years,
and this year the budget foresees subsidies equal to about one
percent of GDP. The GOU's ability to plug Naftohaz's financial hole
will be severely restricted this year, as it is already struggling
to fulfill the IMF's budget conditionalities and is also facing a
budget deficit that probably cannot be financed without significant
external financial support.

Despite Problems, Payments to Gazprom Appear Manageable
-------------- --------------


7. (SBU) Although its financial difficulties will remain, Naftohaz's
ability to service its debt to Gazprom this year nonetheless appears
manageable if the country's IMF program remains on track. From a
pure balance of payments perspective, Ukraine will have sufficient
foreign reserves to pay the debt. Most analysts expect the
country's current account balance, which turned sharply negative in
recent years, to be balanced or even slightly positive this year, as
imports plummet and exports become more competitive on the back of a
weaker hryvnia. This means that export revenues will generate
enough foreign exchange to cover all imports, including gas imports
from Russia, which together with oil imports only account for about
30 percent of Ukraine's imports.


8. (SBU) However, Naftohaz will still need to get access to foreign
exchange, but this appears to be guaranteed as well after the GOU
late last year established a mechanism that allowed Naftohaz to tap
into the central bank's foreign reserves to pay off a $1.5 billion
debt to Gazprom on December 30. It appears that this mechanism was
used, at least partially, to allow Naftohaz to pay the debt for
February gas deliveries as well, since it was reported that the NBU
sold $150 million to Naftohaz last week.


9. (SBU) Under this mechanism, the National Bank of Ukraine (NBU)
loans hryvnia funds to the state-owned banks Ukreximbank and
Oschadbank. These banks in turn loan money to Naftohaz. In
December the CabMin increased the capital of both banks to ensure
that they could continue to meet capital adequacy requirements while
increasing their credit exposure to Naftohaz. Naftohaz, in turn,
uses the liquidity from the two banks to purchase dollars from the
NBU. Normally, only banks can engage in foreign exchange operations
with the NBU, but in December the CabMin passed yet another
resolution allowing Naftohaz to purchase dollars directly from the
NBU in circumvention of the currency market. The NBU confirmed at
the time that it had sold dollars directly to Naftohaz at its
official rate, which at the time was significantly lower than the
true market rate. Naftohaz then used the dollars to pay off its
$1.5 billion debt to Gazprom.


10. (SBU) The mechanism has its risks, but can be employed
repeatedly in coming months under certain conditions. Most
importantly, it can work as long as foreign exchange reserves are
not depleted too quickly. This will most likely be the case if
Ukraine gets its IMF loan program back on track. The program
foresees further disbursements of about $9.4 billion this year, but
a tranche scheduled for disbursement in February has yet to be paid
out because of Ukraine's continued inability to fulfill IMF
conditionalities. The state-owned banks will need sufficient capital
to provide further loans to Naftohaz, but this does not appear to be
an obstacle after the capital increases in December.

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


11. (SBU) Ultimately, Ukraine cannot continue to finance its gas
imports in this manner. The mechanism reshuffles and redistributes
Naftohaz's problems, but does not eliminate them. It forces the NBU
to trade scarce and valuable reserves for hryvnia-based claims
against the state banks, and ultimately against Naftohaz. The loss
of reserves and Naftohaz's perilous financial state weaken both the
central bank and the state banks, and if the scheme is continued for
too long it could drag the state banks deeper into Naftohaz's woes.
In the end, Ukraine will have no choice but to create an environment
where Naftohaz can operate profitably. This will entail painful
reforms that include raising domestic gas prices to cost-recovery
levels, and reforms that will create more efficiency and
transparency in both the gas sector as a whole and at Naftohaz. End
comment.


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