VZCZCXRO5004
RR RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #1950/01 2741423
ZNR UUUUU ZZH
R 301423Z SEP 08
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC 6427
INFO RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RHMFISS/DEPT OF ENERGY WASHINGTON DC

UNCLAS SECTION 01 OF 03 KYIV 001950 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/UMB, EEB/EEC/IEC - LWRIGHT 
DOE FOR LEKIMOFF, CCALIENDO 
USDOC FOR 4231/ITA/OEENIS/NISD/CLUCYK 
 
E.O. 12958: N/A 
TAGS: EPET EINV PREL ENRG PINR UP
SUBJECT: UKRAINE: NAFTOHAZ CONTINUES TO FACE MAJOR 
FINANCIAL CHALLENGES 
 
SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION 
 
¶1. (SBU) Summary.  NaftoHaz, Ukraine's state-owned oil and 
gas enterprise, continues to face major financial challenges 
as Russia and Ukraine continue highly-anticipated 2009 gas 
negotiations.  In addition to debt owed to its gas suppliers, 
NaftoHaz faces various other financial difficulties, 
including collecting payments from its customers and 
subsidiaries; Ukrainian government interference in price 
structuring; complications in plans to restructure the 
domestic gas market; and a likely steep gas price increase in 
¶2009.  The GOU proposed several actions intended to improve 
NaftoHaz's financial condition, but the 8 billion hryvnia 
(UAH) or $1.58 billion NaftoHaz had hoped for in the state 
budget was not approved, forcing NaftoHaz to look outside the 
government for loans just to stay afloat.  Despite NaftoHaz's 
troubles, the current government has also made all 
hydrocarbon development the direct responsibility of 
NaftoHaz, severely limiting opportunities for foreign 
investors to provide much-needed capital and technical 
know-how to the state-owned firm.  End Summary. 
 
What Does NaftoHaz Currently Owe for Gas? 
----------------------------------------- 
 
¶2. (SBU) Pinning down the exact amount of debt NaftoHaz owes 
Gazprom and/or its intermediaries is extremely difficult.  In 
July, RosUkrEnergo (RUE), the shadowy gas intermediary that 
purchases gas from Gazprom and sells it to NaftoHaz, accused 
NaftoHaz of owing it more than $2 billion.  According to RUE 
officials, this debt included arrears from previous years, 
the debt on Russian gas consumed in the first quarter of 
2008, the debt for Central Asian gas shipped in the second 
quarter, and payments due for gas shipped in summer 2008. 
NaftoHaz asserted that its debt to RUE did not exceed $897 
million as of July 1, and that $650 million of that amount 
was for gas purchased in June 2008, which was being paid on 
schedule.  In August, NaftoHaz returned the equivalent amount 
of Central Asian gas to RUE as payment for the Russian gas 
previously consumed.  The major outstanding issue appears to 
be whether, and how much, NaftoHaz owes RUE on gas from 
previous years.  In addition to the RUE debt, the Ukrainian 
press reported the Ukrainian-based intermediary UkrHazEnerho 
(UHE) as claiming that NaftoHaz owes them $270 million for 
gas purchases. 
 
Where Does NaftoHaz Stand in Terms of Loans? 
------------------------------------------- 
 
¶3. (SBU) While NaftoHaz tries to clear up its debts to 
Gazprom and the intermediaries, it remains saddled with a 
sizable loan burden. In a July press interview, NaftoHaz 
Chairman Oleh Dubyna reported that payments of $800 million 
had been made so far this year to service loans, decreasing 
NaftoHaz's current liabilities on foreign loans to 10.5 
billion hryvnia (UAH) or $2.3 billion.  While NaftoHaz has 
not, according to Dubyna, increased its corporate debt in 
2008, it is attempting to obtain UAH 8 billion in loans from 
Ukrainian banks for gas purchases as it tries to increase the 
amount of gas in storage to 15 billion cubic meters (bcm) 
from the current 8 bcm prior to the heating season.  If it 
can store gas purchased at a cheaper price, it will delay 
exposure to the higher prices expected in 2009. 
 
Outstanding Debt to NaftoHaz: Dividends, Transportation and 
Storage, and Nonpayment 
--------------------------------------------- ----------- 
 
¶4. (SBU) In addition to its outstanding liabilities, NaftoHaz 
continues to have difficulty in securing its accounts 
receivable, which include the following: 
 
- Dividends:  NaftoHaz claims that RUE obstructionism has 
prevented holding a UHE shareholder's meeting that could 
resolve the matter of more than $180 million in UHE dividends 
owed to NaftoHaz for 2006-2007.  (Note: NaftoHaz oil 
subsidiary Ukrnafta also owes NaftoHaz approximately UAH 2 
billion ($440 million) in dividends for oil revenue.  End 
Note.) 
 
- Transportation and Storage Fees: NaftoHaz claims that RUE 
owes it $141.8 million for gas transit for the period of 
December 2007-July 2008, while UHE owes it about $150 million 
for gas transportation and storage for the same period. 
 
KYIV 00001950  002 OF 003 
 
 
 
- Customer Nonpayment:  Nonpayment by customers continues to 
be a significant problem.  According to Dubyna, gas consumers 
accumulated the following debts to NaftoHaz in January-May 
2008:  municipal heat producing plants--UAH 1.8 billion; 
residential consumers--UAH 153 million; industrial 
consumers--UAH 450 million. 
 
GOU Pricing Policy Detrimental 
------------------------------ 
 
¶5. (SBU) NaftoHaz is mandated by the government to supply gas 
at prices far below the cost of imported gas to residential 
consumers, state-financed entities and public utility 
companies.  NaftoHaz officials complain that GOU pricing 
policies for gas make it difficult for NaftoHaz to improve 
its precarious financial situation.  According to Dubyna, the 
GOU requires that NaftoHaz provide gas to households at 
around $50 per thousand cubic meters (tcm).  In theory, 
cheaper domestically-produced gas is supplied to these 
consumers but, in reality, the amount produced is 
insufficient to meet the demand and must be supplemented with 
imported gas.  (Note: The current price for imported gas is 
currently $179.5 per tcm. End note.) NaftoHaz officials 
assert that either gas prices should be raised or the GOU 
should subsidize the company for losses it incurs by selling 
gas to these sectors below cost.  (Note: While there have 
been increases in rates to these groups, they have thus far 
been insufficient to make up for the shortfall.  End Note.) 
 
¶6. (SBU) In addition to setting prices based on consumer 
categories, the GOU sets the price for domestically produced 
gas at prices ranging from $90-$140 per tcm depending on the 
amount of consumption, which discourages exploration and 
production.  NaftoHaz officials have stated that, for the 
first time, domestic gas production dropped in 2007 because 
it was no longer financially viable. 
 
Intermediary UkrHazEnerho (UHE) Not Gone Yet 
-------------------------------------------- 
 
¶7. (SBU) Following Tymoshenko's gas negotiations with Russia 
earlier this year, it appeared that UHEs days on the domestic 
market were numbered and that NaftoHaz would once again be 
able to profit from sales to industrial customers.  Ukraine 
succeeded in having NaftoHaz replace UHE as the importer of 
natural gas to Ukraine, an important step towards reclaiming 
its former prominence in the domestic market.  However, court 
decisions have breathed new life into the gas intermediary. 
The Kyiv administrative court of appeals this past summer 
ruled against a decision by the National Electricity 
Regulatory Commission that had limited the volume of gas UHE 
could supply to Ukrainian consumers at an unregulated rate. 
Limitations were subsequently lifted and it is uncertain 
whether UHE will undersell NaftoHaz to lure away industrial 
customers.  NaftoHaz, as the sole importer of gas to Ukraine, 
presumably will not sell to UHE; it already is selling 7.5 
bcm to Gazpromsbyt of Ukraine, a Gazprom subsidiary and the 
named replacement for UHE.  If that is the case, UHE would be 
limited to selling only the gas it presently has in storage, 
but could still eat into NaftoHaz's anticipated income this 
year. 
 
Gas Price Negotiations for 2009 Don't Bode Well 
--------------------------------------------- -- 
 
¶8. (SBU) When Tymoshenko returned from talks in Moscow in 
late June, she announced that she had reached an 
understanding with Putin to raise the price of gas sold to 
Ukraine to European levels over a three or four year period 
and expected to sign a long-term gas agreement reflecting 
this by September 15.  Putin reportedly indicated he 
supported the gradual price increase in principle, but stated 
that the prices would be worked out by the companies involved 
and would be affected by the Central Asian gas price for 
¶2009.  Based on a July 25 preliminary agreement between 
Gazprom and Turkmenistan on price formation principles, 
Russian energy analysts calculate that Gazprom would purchase 
Turkmen gas in 2009 at a price ranging from $225 to $295 per 
tcm.  Such a scenario would imply that the price of gas for 
Ukraine will rise sharply from the current $179.5 per tcm, 
edging uncomfortably close to $400 for Ukraine as originally 
put forward by Gazprom as a possibility.  Nevertheless, the 
significant price jump would continue to push NaftoHaz into 
 
KYIV 00001950  003 OF 003 
 
 
further arrears, especially if NaftoHaz is prevented from 
passing on increased costs to its customers. 
 
Recent and Ongoing Audits 
------------------------- 
 
¶9. (SBU) According to NaftoHaz's 2006 Consolidated Financial 
Statements, audited by Ernst and Young, NaftoHaz incurred a 
net loss attributable to equity holders of UAH 2,205 million 
and as of December 31, 2006, its current liabilities exceeded 
its current assets by UAH 12,219 million.  The press has 
reported that Ernst and Young continues to complete its 2007 
audit, and those results are not expected until the summer of 
¶2009.  On a separate track, Chief of the Main Auditing 
Directorate, Mykola Syvulskyy, has sent a preliminary audit 
report on NaftoHaz to the Cabinet of Ministers.  In a press 
interview, Syvulskyy indicated that former senior managers of 
NaftoHaz deliberately tried to bankrupt the company. 
 
GOU Assistance for NaftoHaz 
---------------------------- 
 
¶10. (SBU) The 2008 national budget contains a provision 
compensating NaftoHaz for the losses incurred on selling gas 
to public utility companies in the amount of UAH 4.3 billion. 
 The Cabinet of Ministers (CabMin) has also proposed that 
parliament grant a non-interest-bearing loan of UAH 800 
million to NaftoHaz to buy and pump imported natural gas to 
underground gas storage facilities in 2008, which would be 
transferred to heat supply companies next year.  In addition, 
the Cabinet tabled a draft law in the Parliament obliging 
NaftoHaz-founded companies UHE and Ukrnafta to pay NaftoHaz 
approximately UAH 2.5 billion in dividends from revenue 
received in 2006-2007. 
 
Weak FY07 Results Anticipated 
----------------------------- 
 
¶11. (U) On August 8, Moody's Investors Service downgraded 
NaftoHaz's Ba3 foreign currency corporate family rating to 
B1.  Less than a week later, Fitch Ratings issued a press 
statement indicating that it anticipates weak FY07 results, 
stemming largely from NaftoHaz's inability to fully recover 
gas import prices from its domestic sales.  In Fitch's view, 
a positive resolution of the state budget and gas storage 
financing issues might be sufficient to avoid a negative 
credit impact from the publication of weak FY07 results.  In 
addition, there are growing concerns that NaftoHaz could find 
itself in technical default because it is late in reporting 
its financial results. 
 
¶12. (SBU) COMMENT:  NaftoHaz continues to face severe 
financial challenges.  Even if its debt to RUE is relatively 
minimal, servicing and paying off loans will continue to make 
capital scarce for the company and, with significantly higher 
gas prices seemingly inevitable in 2009, it will become 
increasingly difficult for NaftoHaz to achieve profitability. 
 Moreover, NaftoHaz's financial straits leave NaftoHaz little 
money for the development of much-needed hydrocarbons, which 
the Tymoshenko government believes should be developed solely 
by NaftoHaz without the capital or technical assistance of 
foreign partners.  End comment. 
PETTIT