This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 04 BELGRADE 000404 
 
SIPDIS 
 
SENSITIVE 
 
USDOC FOR 4232/ITA/MAC/EUR/OEERIS/SSAVICH 
BRUSSELS PASS TO STABILITY PACT - MIKE MOZUR 
 
E.O. 12958: N/A 
TAGS: ENRG ECON EFIN PGOV EIND SR MW
SUBJECT: NATURAL GAS CRISIS IN SERBIA HIGHLIGHTS PROBLEMS 
 
Summary 
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¶1. (U) The recent gas shortage in Serbia highlights both 
deficiencies in its infrastructure and the perils of relying 
solely on Russian gas delivered through the Ukrainian pipeline. 
Both domestic and foreign companies that rely on natural gas 
supplies were negatively affected, and continued reliability 
problems could deter foreign investors who are major gas 
consumers.  The Government of Serbia (GoS) plans to address the 
gas system's immediate needs with two infrastructure projects: a 
gas storage facility in Banatski Dvor and a new Nis-Dimitrovgrad 
gas pipeline.  These will provide a supply from which to offset 
temporary shortages and alternative access to gas through 
Bulgaria.  Carrying out such projects while both Gazprom and 
Hungary's MOL are seeking to strengthen their position in 
Serbia's energy industry will provide an interesting challenge 
for the Kostunica government.  END SUMMARY 
 
Gas Shortage's Adverse Impact 
----------------------------- 
¶2. (U) On January 19, Russian company Gazprom announced that, due 
to extremely low temperatures in Russia, it would reduce by 25 
percent the amount of gas delivered to a number of countries, 
including Serbia.  However, temporary reductions lasted more than 
two weeks due to the Russia-Ukraine gas conflict and another cold 
wave at the beginning of February.  The shortage left Srbijagas, 
Serbia's monopoly natural gas distributor, able to supply only 
priority customers - health institutions, schools and the food 
industry - while industrial facilities were forced to turn to 
other energy sources, such as coal, mazut, and electricity. 
 
¶3. (U) However, most companies and city heating plants were not 
prepared.  The price of mazut (a heavy oil left from the refining 
of higher value products) jumped from 14 to 20 dinars (approx. 27 
cents) per kilogram, and it was cheaper to import electricity 
than to produce it from mazut.  The electricity network was 
overloaded, although EPS, the state-owned power company, was able 
to avoid restrictions on consumers.  A general lack of mazut 
coupled with the delay necessary to prepare boilers for mazut 
usage caused some cities like Nis and Zrenjanin to face two days 
of freezing weather without central heat.  Meanwhile, both 
domestic and foreign companies suffered losses because of reduced 
gas deliveries. 
 
¶4. (SBU) For instance, from January 19 to 28, US Steel Serbia's 
operations were severely disrupted by reduced deliveries from 
Srbijagas to its plants in Smederevo and Sabac.  Six production 
units failed to meet January output targets due to the cold 
weather and gas reduction.  Steelmaking, in general, is energy 
intensive, and US Steel consumes up to 40,000 cubic meters per 
hour.  During this period, US Steel was receiving between 22,000 
and 27,000 cubic meters per hour.  This business interruption 
adversely impacted U.S. Steel's product shipments and financial 
results, causing millions in losses in January and February. 
 
¶5. (SBU) However, despite pledges from Srbijagas that it would do 
everything possible to avoid more cuts to U.S. Steel, the company 
was notified on February 28 that it would face restrictions 
again. On March 1, the flow to U.S. Steel's Smederovo plant was 
cut from a range of 26,000-30,000 cubic meters to 18,000, and the 
reduction continued on March 2.  Although the initial 
justification was colder weather, government officials revealed 
that Srbjiagas was giving preference (under GOS orders) to a 
state-owned fertilizer plant that consumes 10 percent of Serbia's 
gas on a daily basis.  This plant normally is not permitted to 
operate during the winter, due to its impact on gas supplies. The 
plant also has not been able to pay for its gas on a current 
basis in the past.  (The GOS is in the process of selling this 
plant, Azotera Panchevo, with a decision from the tender 
committee expected this week.) 
 
¶6.  (SBU)Following complaints by U.S. Steel, Ambassador Polt 
called Deputy Prime Minister Labus both on February 28 and on 
March 1, and he followed up with a call to Economy Minister 
Bubalo on March 2.  Labus initially blamed the reductions on cold 
weather, then complained that U.S. Steel was not being 
forthcoming with information about its expected useage.  Bubalo 
agreed that Srbijagas had been a problem this winter, but he said 
that Belgrade's municipal heating plant, not Azotera, was the 
reason for the more recent shortage.  He pointed to the need to 
finish the underground storage by next winter to avoid such 
problems. The Ambassador emphasized to both Ministers that such 
unpredictability seriously damaged not only the bottom line of a 
major U.S. investor, but also the reputation of Serbia among 
other current and future foreign investors. 
 
Unreliable and Insufficient Gas Supplies 
---------------------------------------- 
 
¶7. (U) Serbia's gas pipeline system suffers from its unenviable 
geographic position as the last customer at the end of a single 
pipeline, with the gas supply coming from Russia via Ukraine and 
Hungary.  Serbia takes possession of its Russian gas at the 
Serbia-Hungarian border at Horgos, but pays for it at the 
Ukrainian-Hungarian border in Beregovo.  Transit fees through 
Hungary are paid to Hungary's MOL. 
 
¶8. (U) The agreed deliveries of Russian gas for 2006 are 10 
million cubic meters per day, a level that is sufficient 
(allegedly) at projected temperatures of -15 degrees Celsius. 
But at lower temperatures, an additional 1.5 to 2 million cubic 
meters per day are necessary.  For these additional supplies, 
Srbijagas must issue a tender, in which the price is much higher 
than the contract price. In addition, the transit pipeline has a 
physical limit of 10 million cubic meters per day.  During the 
recent energy crisis, Serbia was receiving only 8.6 million cubic 
meters per day from Russia, allegedly due to unauthorized use of 
gas in Ukraine.  Although Gazprom sought to maintain a steady 
supply or even increase gas deliveries to its European consumers, 
Ukraine was "stealing" some 70 million cubic meters per day, 
according to Gazprom executive Alexandar Medvedev, who cited this 
figure during his meetings in Belgrade on January 27. 
 
¶9. (U) Hungarian MOL delivered to Serbia all of the gas Gazprom 
allocated to Serbia, although MOL received reduced supplies, as 
well. (NOTE: MOL managers told econ chief they were able to 
manage the shortage there without major disruptions.)  Srbijagas 
is paying USD 220-230 per 1,000 cubic meters for the Russian gas, 
and the world price is around USD 270 per 1,000 cubic meters. In 
the contract with Gazprom, the gas price is not based on volume; 
rather, a methodology fixes the gas price at three-month 
intervals, depending on both the dollar and world oil prices. 
Srbijagas pays transit fees of approximately USD 25 per 1,000 
cubic meters, about 10 percent of the gas price, to MOL. 
 
¶10.  (U) Serbia's annual consumption is around 2.7 billion  cubic 
meters,  which pales in comparison to consumption in the  region, 
with  Croatian  consumption at 4.5 billion and  Hungarian  at  10 
billion.  Consumption is expected to increase by some 10  percent 
in  2006, while, at the same time, according to the 2006  Serbian 
Energy  Balance, domestic production of natural gas in 2006  will 
be  lower  by  some  14 percent, at 253.4 million  cubic  meters. 
Imports  are  expected  to  reach  2.568  billion  cubic  meters. 
Consumption  is  rising due to increasing  gasification,  and  US 
Steel's reopening of a second blast furnace in Smederevo in 2005. 
Summer gas consumption is only 2.5 million cubic meters per  day, 
while  during the winter it exceeds 11 million cubic  meters  per 
day, more than 4 times higher. 
 
Infrastructure Projects to Increase Reliability 
--------------------------------------------- -- 
¶11. (U) A gas storage facility in Banatski Dvor and a Nis- 
Dimitrovgrad gas pipeline are two important investments seen as 
necessary for reliable gas supplies to consumers as well as for 
future development of Serbia's gas network.  The Banatski Dvor 
facility requires around USD 65 million for phase one, and a 
total of USD 160 million for the entire project. 
 
¶12. (U) The 167-kilometer gas pipeline, at a cost of around USD 
65 million, will provide Serbia with an alternative route through 
Bulgaria, connected to the Russian gas system. This route also 
could provide a direct connection with the Nabucco project, a 
3,300 kilometer pipeline sponsored by Austria's OMV, Turkey's 
BOTAS and others, that will bring Caspian and Middle Eastern gas 
into Western Europe via Turkey, Bulgaria, Romania and Hungary. 
Completion is projected for 2011.  In addition, construction of 
the Nis-Dimitrovgrad pipeline would improve Serbia's prospects as 
a transit route for gas to some areas in Romania and Pristina. 
 
¶13. (U) The Banatski Dvor gas storage facility will buffer summer- 
winter gaps in consumption and distribution, eliminate penalties 
to MOL because of this seasonal imbalance, and lower gas prices. 
Full capacity is projected at 850 million cubic meters and should 
be reached by 2011.  However, since key equipment has already 
been imported from the U.S., the technical part of the first 
phase could be finished by late summer 2006.  The biggest cost 
will be pumping in the fixed amount of gas - the so called 
"pillow gas" - that would 1) prevent underground water from 
entering the facility and 2) allow pumping of around 250 million 
cubic meters of gas next winter.  Required investment for this 
technical part of the first phase is USD 15 million, and USD 50 
million for the gas supplies.  Once funding is secured, the 
storage facility could be finished by October-November 2006. 
 
Russians and Hungarians Jockeying for Position 
--------------------------------------------- - 
¶14. (U) The Ukrainian gas controversy, Serbia's heavy dependence 
on Russian gas, and Hungary's position as a crucial transit 
corridor, all create the perfect scenario to permit Gazprom and 
MOL to put pressure on the Serbian Government for prime positions 
in the forthcoming multi-million dollar investment projects. 
 
¶15. (SBU) Serbia has a 20-year agreement with Hungary's MOL for 
gas transit from Russia which dates back to 1998.  MOL CEO Zsolt 
Hernadi visited Serbia on January 25, just two days before the 
Gazprom visit.  Knowing that Serbia plans to build an alternative 
gas route to Bulgaria, MOL's sought to strengthen its position in 
Serbia through a new agreement. Hernadi explained that MOL is 
very interested in building underground gas storage together with 
Srbijagas because Serbia's planned investments could affect gas 
prices and transport routes.  A connection to the Bulgarian 
system would end MOL's monopoly on gas transit to Serbia.  MOL 
would like a new agreement with Srbijagas, although the current 
one will not expire until 2018. After difficult negotiations, MOL 
and Srbijagas agreed only on an annex to the current agreement 
that will eliminate penalties for non-delivered gas from Russia. 
However, working groups will be formed to prepare for negotiation 
of a new agreement by the end of April 2006, which the Government 
of Serbia (GoS) wants to have in force starting January 2007. 
 
¶16. (SBU) Negotiations with Gazprom's Alexandar Medvedev were 
held in Belgrade on January 27. The Russians placed the blame for 
the gas shortage on Ukraine's diversion of gas but pledged to try 
to maintain deliveries according to the contract in the future. 
Exploiting the political weakness of the current government and 
Srbijagas's current debt of USD 80 million toward Gazprom, the 
Russians lobbied for a privileged position in the forthcoming 
tenders for concessions to build the gas storage facility and 
pipeline. 
 
¶17. (SBU) Citing two intergovernmental agreements between Russia 
and Serbia from the 1990's, Gazprom asserts that it has exclusive 
rights to build gas infrastructure in Serbia.  These agreements 
established a joint venture company, Jugorosgas, in 1996 to 
manage the distribution of Russian gas and investment in gas 
infrastructure. The ownership structure of Jugorosgas was 50:50 
between Gazprom and various Serbian companies (NIS, Sartid (now 
U.S. Steel Serbia), Progres-Beograd, Progresgas Trading, and 
Beobanka (does not exist anymore)). It was agreed that NIS would 
in time become the majority owner of Jugorosgas via preferential 
purchasing rights.  However, when NIS was reorganized in October 
2005, Srbijagas was left with only 25 percent in Jugorosgas while 
Gazprom bought 25 percent in Progresgas Trading to become the 
majority owner of Jugorosgas. 
 
Public Tenders for Infrastructure Projects 
------------------------------------------ 
¶18. (SBU) Econ officers met with General Director of Srbijagas 
Milos Tomic and Zorana Mihajlovic Milanovic, advisor to the 
Deputy Prime Minister for energy issues, at company headquarters 
in Novi Sad on February 6.  Tomic confirmed that Gazprom is the 
majority owner of Jugorosgas, but denied that it has an exclusive 
right to build such gas infrastructure in Serbia.  Milanovic 
explained that Srbijagas does not have sufficient funds to 
complete the necessary investment projects and said the GoS will 
issue public tenders for a strategic partner for these two 
investments.  A public tender for the Nis-Dimitrovgrad gas 
pipeline concession should be expected sometime in autumn.  The 
gas storage facility in Banatski Dvor will become a subsidiary of 
Srbijagas, and a strategic partner to finalize this facility will 
be sought through public tender no later than May or June 2006. 
In both cases, if Gazprom wins the public tenders, it will manage 
its operations through Jugorosgas. 
 
¶19. (SBU) Tomic explained that borrowing for these projects was 
not feasible, because of Srbijagas's USD 80 million debt toward 
Gazprom.  The current gas price of 16 dinars per cubic meter does 
not even cover production costs.  Srbijagas's proposed price of 
19 dinars per cubic meter would cover only production costs but 
leave nothing for investment.  Srbijagas submitted the price 
increase to the Ministry of Energy and Mining, but, in effect, 
this requires approval not only of the Ministry of Energy, but 
also by the Ministries of Finance and Trade and Tourism. Finance 
Minister Dinkic generally has held up energy price increases to 
restrain inflation. It is possible that the GOS will act on this 
request after the winter. 
 
Poor Management and Insider Deals 
--------------------------------- 
¶20. (SBU) Econoffs met with Assistant Minister for Public 
Enterprises Milutin Prodanovic (protect) at the Ministry of 
Energy on February 3, who laid partial blame for the energy 
crisis on new management at Srbijagas, as well as on unnecessary 
GOS intervention.  Prodanovic said that similar gas problems with 
Russia occurred last year, but without complaints from the 
largest consumers in Serbia.  According to Prodanovic, the new 
management, including General Director Tomic, an agronomist by 
profession, is inexperienced in gas and energy issues.  After NIS 
was restructured into three independent companies (NIS, 
Transnafta and Srbijagas), leadership appointments to Srbijagas 
were awarded to the G17 Plus party, of which Tomic is a member. 
(Comment: Leadership positions as spoils for political parties 
are common in Serbia, often resulting in inexperienced or 
incompetent individuals filling key jobs in state-owned 
companies.)  Prodanovic also blamed Deputy Prime Minister Labus, 
leader of G17 Plus, for intervening in gas issues when it is not 
his responsibility. He also said that Zorana Milanovic 
Mihajlovic, Labus's energy adviser, lacks expertise. 
 
Comment 
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¶21. (SBU) The good news in Serbia's continuing gas squeeze is 
that it could be easily fixed by relatively simple, inexpensive 
projects already on the drawing board.  How skillfully the GOS 
maneuvers around its regional suitors and completes the work on- 
time and on-budget will provide a good test of its commitment to 
transparency and an improved investment climate.  However, its 
handling of these issues so far, particularly with respect to 
U.S. Steel, has not been encouraging.  We are concerned that the 
necessary projects are being structured as separate tenders with 
strategic partners - rather than simply borrowing the money, with 
a sovereign guarantee, if necessary - as a way to create 
opportunity for political payoffs.  Given the high stakes for 
U.S. companies, and for Serbia, we will keep a close eye on these 
projects. END COMMENT. 
 
POLT