VZCZCXRO0887
OO RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #3058/01 3471037
ZNR UUUUU ZZH
O 131037Z DEC 07
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC IMMEDIATE 4557
INFO RHEBAAA/DEPARTMENT OF ENERGY WASHDC
RUCPDOC/DEPT OF COMMERCE WASHDC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 03 KYIV 003058 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/UMB,EB/ESC/IEC - GALLOGLY/WRIGHT 
DOE PLEASE PASS TO LEKIMOFF, CCALIENDO 
 
E.O. 12958: N/A 
TAGS: EPET EFIN ECON ENRG UP
SUBJECT: UKRAINE: NAFTOHAZ'S FINANCIAL UNCERTAINTY A GROWING 
CONCERN 
 
REF: A) KYIV 2611 
 
B) KYIV 2939 
 
Treat as Sensitive but Unclassified.  Not for Internet. 
 
¶1.  (U) Summary.  NaftoHaz Ukraine, the state-owned gas and oil 
company that accounts for 10 percent of GDP, could well be close to 
bankruptcy.  NaftoHaz's losses and debts have mounted as the GOU 
continues to set domestic gas prices that are too low to cover the 
rising cost of gas imports, and because middlemen RosUkrEnergo and 
UkrHazEnergo are siphoning off much of the cash flow in Ukraine's 
gas market, leaving NaftoHaz with the loss-making business of 
selling gas to retail distributors and municipal heating companies 
with poor payment discipline.  International investors could demand 
early repayment of a Eurobond issue, and the respected rating agency 
Fitch may withdraw its ratings for NaftoHaz if the company does not 
publish its already overdue 2006 financial statements by the end of 
the year.  It seems likely that action will be needed to avoid 
bankruptcy.  Such action could involve the GOU providing significant 
subsidies to NaftoHaz, selling off pipeline assets (which Gazprom 
has long expressed interest in purchasing), or privatization of 
other assets.  Due to its strategic role, the GOU is unlikely to 
allow NaftoHaz to go bankrupt, but the cost of avoidance may be 
high. End summary. 
 
The Role of NaftoHaz 
-------------------- 
 
¶2. (U) NaftoHaz (Naftogaz in Russian transliteration) is a 
vertically-integrated oil and gas company.  It (along with its 
majority-owned subsidiary UkrNafta) accounts for over 96 percent of 
domestic oil and gas production and operates Ukraine's gas pipeline 
network, which provides transit to approximately 80 percent of 
Russia's Europe-bound gas.  In addition, it supplies natural gas and 
crude oil to domestic utilities at low tariffs set by regulators. 
Entirely state-owned, it is of considerable strategic importance to 
Ukraine, generating approximately 10 percent of GDP and employing 
approximately 170,000 people. 
 
Recent Changes in Gas Market and Impact on NaftoHaz's Bottom Line 
----------- 
 
¶3. (SBU) Much of the company's operations, and in particular its 
financial health, remain opaque as a result of mismanagement, 
corruption and intentional obfuscation. 
The company has also been on the losing end of various parties' 
efforts to exert control over Ukraine's gas market and to pocket 
some of the significant cash flows associated with the gas trade. 
RosUkrEnergo and its predecessor EuralTransGas have cut off NaftoHaz 
from direct commercial relations with either Gazprom or central 
Asian suppliers.  The creation of UkrHazEnergo, as a result of the 
2005/6 gas crisis, stripped NaftoHaz of the lucrative gas supply to 
industrial customers, leaving NaftoHaz with the unprofitable 
business with distributors and municipal heating providers that is 
marked by poor payment discipline, inefficient and corrupt regional 
distribution companies and politically determined retail prices 
that, despite increases in recent years, are still too low to cover 
costs.  (Note: Although NaftoHaz owns 50 percent of UkrHazEnergo - 
RosUkrEnergo owns the other half - it is widely recognized that 
RosUkrEnergo calls the shots at UkrHazEnergo.  Significantly, 
UkrHazEnergo has not paid its 2006 dividends to NaftoHaz.  End 
note).  At the same time as these structural shifts were hitting at 
NaftoHaz's profitability, prices for imported gas increased from $50 
per thousand cubic meters (tcm) in 2005 to $135/tcm this year, and 
are scheduled to rise to $179.5/tcm in 2008.  Consumer nonpayment 
has increased with the rises in gas prices.  In late 2006 and early 
2007, Yuliya Tymoshenko's BYuT party even politicized the price 
increases, encouraging consumers not to pay. 
 
Financial Situation is Precarious 
--------------------------------- 
 
¶4. (SBU) By all accounts, the financial situation at NaftoHaz is 
precarious.  The company has not yet published its financial figures 
for 2006.  Gas transit still appears to be profitable, but the 
company's domestic gas sales business is accumulating losses, 
liquidity appears to be tight, and its debts are mounting. 
Ukraine's State Tax Administration claims that, as of November 1, 
NaftoHaz owes taxes of UAH 2.3 billion (about $450 million). 
NaftoHaz also received tax deferrals in 2006 and 2007.  One analyst 
report quotes acting Prime Minister Yanukovych as stating that 
NaftoHaz's total losses for 2006 may amount to $1.5 billion. 
According to analysts' reports, NaftoHaz has about $2.5 billion in 
debts.  Of the total, $500 million is in Eurobonds and $1.6 billion 
in loans from foreign banks.  The rest takes the forms of loans from 
 
KYIV 00003058  002 OF 003 
 
 
domestic banks.  The company has reported that it earned $60 million 
after taxes in the first half of 2007, which would indicate a 
significant improvement over the first half of 2006. 
 
¶5. (SBU) A NaftoHaz spokesman blamed the delay in publishing the 
2006 figures on the "machinations" of its previous CEO.  However, 
regional press reports suggest that there may be other reasons. 
According to the press, the audit for 2006, prepared by the auditing 
firm Ernst & Young, will not be signed until parliament provides a 
guarantee to the company.  This is because the auditors reportedly 
refused to certify that NaftoHaz otherwise was a "going concern," 
meaning that it could be expected to continue normal operations for 
the following year.  NaftoHaz management is telling analysts and 
creditors that it expects the Rada to approve a $1 billion subsidy 
for the company to partially offset the losses associated with 
selling gas at below cost to utilities.  The subsidy may be in cash, 
or through tax offsets.  It is unclear, however, whether the new 
parliament will actually be prepared to support the company. 
 
Eurobond Holders May Soon Recall Their Bonds 
-------------------------------------------- 
 
¶6. (SBU) It is particularly doubtful that the Rada will approve of 
financial support by the end of the year. If it doesn't, and if 
NaftoHaz does not publish its 2006 data by December 31, holders of 
its Eurobond issue due for repayment in 2009 could ask for their 
money back.  According to the conditions of the Eurobond, NaftoHaz 
had to publish the 2006 financial figures by August 31.  Failure to 
do so gives the bondholders the right to immediately redeem the 
bonds.  Bondholders usually have the option of waiving this right if 
the borrower pays an additional fee, but NaftoHaz reportedly so far 
has refused.   At a November 14 meeting in London, bondholders 
agreed to give NaftoHaz until December 31 to publish the 2006 
financial figures. 
 
Fitch Threatens to Withdraw Ratings 
----------------------------------- 
 
¶7. (SBU) The international rating agency Fitch has even threatened 
to withdraw its ratings for NaftoHaz because of the delay in 
publishing the 2006 figures.  Withdrawal is merited when Fitch 
believes it no longer has access to adequate information to credibly 
maintain the ratings.  Fitch has yet to actually pull the ratings, 
as it has reportedly received assurances from NaftoHaz that the 
financial figures will be forthcoming.  On October 15, however, 
Fitch placed NaftoHaz's ratings on so-called "rating watch 
negative," indicating that it may soon downgrade the company's 
ratings.  Fitch justified the move because of NaftoHaz's failure to 
publish its 2006 figures in a timely matter, and after NaftoHaz was 
suddenly confronted with an additional debt of $729 million to 
Gazprom shortly after the September 30 parliamentary elections.  The 
debt issue has been solved in the meantime (ref A).  A NaftoHaz 
representative told the press that it does not expect negative 
fallout from a possible downgrade since foreign investors are aware 
of the reason for the delay in submitting the 2006 financial report. 
 
 
¶8. (SBU) NaftoHaz's current ratings are in the non-investment grade 
category (also known as junk bonds).  Fitch last downgraded the 
company's ratings in 2006 as a result of the company's deteriorating 
financial situation in the wake of the gas price hikes of early 
¶2006.  The main ratings now stand in the single B category, one of 
the lower ratings granted by the well-respected rating agency. 
Later in 2006, Fitch indicated it might reduce its ratings of 
NaftoHaz further, yet took no action after NaftoHaz presented plans 
to develop its remaining areas of business (domestic gas production, 
transit, and domestic gas sales).  At that time, the Ministry of 
Fuels and Energy reportedly wrote a letter to NaftoHaz's bank 
lenders stating that it will back the company by supporting any 
actions aimed at improving NaftoHaz's financial position and 
preventing bankruptcy. 
 
Comment: The Future Looks Bleak 
------------------------------- 
 
¶9. (SBU) Looking forward, NaftoHaz's financial prospects remain 
bleak.  With NaftoHaz's limited ability to pass on higher costs to 
consumers, the recently announced price hikes for imported gas in 
2008 will likely increase the losses in the company's domestic 
business.  A failure to publish 2006 financial results by the end of 
this year could cause Eurobond creditors to call their bonds or 
Fitch to withdraw its rating, either of which would negatively 
impact NaftoHaz's ability to borrow in the future, or to refinance 
debts coming due in 2008 and beyond.  Default is a possibility, as 
it is not clear NaftoHaz has the funds to pay if bondholders demand 
 
KYIV 00003058  003 OF 003 
 
 
immediate payment.  These scenarios could even have a negative 
impact on the creditworthiness of Ukraine as a whole because 
NaftoHaz is fully owned by the state. The underlying fundamentals of 
the company are difficult to assess as the company continues its 
policies of financial non-transparency.  It seems likely that GOU 
action will be needed to avoid bankruptcy.  Such action could 
involve the GOU providing significant subsidies or selling off of 
other assets.  Gazprom has long been interested in purchasing or 
taking operational control of Ukraine's transit pipelines.  Current 
Ukrainian law forbids any sale or transfer of control for the 
pipelines, but under the pressure of bankruptcy, it is not 
absolutely certain the GOU will hold to this policy.  Due to its 
strategic role, the GOU is unlikely to allow NaftoHaz to go 
bankrupt, but the cost of avoiding bankruptcy may be high.  End 
comment. 
TAYLOR