VZCZCXRO5776
RR RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #2221/01 3121329
ZNR UUUUU ZZH
R 071329Z NOV 08
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC 6701
INFO RHMFISS/DEPT OF ENERGY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 02 KYIV 002221 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/UMB,EB/ESC/IEC-WRIGHT, GALLOGLY 
DOE PLEASE PASS TO LEKIMOFF, CCALIENDO 
 
E.O. 12958: N/A 
TAGS: ENRG EPET ECON UP
 
SUBJECT: UKRAINE: NAFTOHAZ TURNS OFF TAP TO DELINQUENT GAS 
SUBSIDIARIES AS ITS FINANCES WORSEN 
 
REF: A) KYIV 2173, B) KYIV 1950 
 
TREAT AS SENSITIVE BUT UNCLASSIFIED NOT FOR INTERNET DISTRIBUTION 
 
¶1.  (SBU) Summary.  Ukraine's state-owned oil and gas company 
Naftohaz Ukrainy has refused to supply gas to some of its subsidiary 
companies until debts to Naftohaz are paid.  The socially unpopular 
decision has resulted in the closing of some schools and public 
buildings due to a lack of heat. The GOU also announced a 35 percent 
gas hike for domestic consumers beginning December 1 with increases 
up to 50 percent scheduled for 2009, in an effort to bring 
traditionally low domestic gas prices closer to European market 
prices.  As Naftohaz's financial situation continues to deteriorate, 
it is actively exploring options previously considered socially 
taboo in order to service its debts to Gazprom.  At the same time, 
it is struggling to keep some creditors from cashing in their 
Eurobonds later this month because of its inability to provide 
financial data as required in its bond agreements. End summary. 
 
 
Naftohaz Calls in Debts from Subsidiaries 
----------------------------------------- 
 
¶2. (SBU) The Naftohaz decision to get tough on its subsidiaries 
comes after an October 2 memorandum of understanding signed by Prime 
Ministers Putin and Tymoshenko (ref A).  According to that document, 
Naftohaz must settle its outstanding debts (approximately $1.8 
billion and 11 billion cubic meters of gas) before Gazprom agrees to 
the removal of intermediary RosUkrEnergo (RUE) and to the signing of 
a long-term contract and to prices for gas deliveries in 2009. 
 
¶3. (SBU) According to Naftohaz Chairman Oleh Dubyna, as of October 
2, local gas distribution and municipal heating companies owe 
Naftohaz 1.16 billion UAH ($201 million) for gas supplied last 
winter.  Six of 53 local gas distribution companies have not had 
their contracts renewed with Naftohaz due to outstanding debts. 
These include gas suppliers from the western regions of Zakarpatia, 
Lviv, Ivano-Frankivsk, Chernivtsi, Volyn and Vinnitsya. 
 
¶4. (SBU) Among municipal heating companies, the largest debtors were 
in the heavily industrialized regions of eastern Ukraine, including 
Kharkiv, Donetsk, Dnipropetrovsk, and Luhansk.  However, Lviv in 
western Ukraine and the Crimean Autonomous Republic are both 
indebted to Naftohaz as well. 
 
Gas Supply Interruptions Affect the Population 
--------------------------------------------- --- 
 
¶5. (SBU) Ukrainian news agencies reported that city officials in the 
western town of Ivano-Frankivsk temporarily closed 18 secondary 
schools on October 22 due to low classroom temperatures.  The 
temperature in buildings dropped below 15-16 degrees Celsius 
(59-61 F).  The mayor's office could not say when heat supplies 
would resume; acknowledging that the municipal gas distribution 
company owed millions of hryvnya to Naftohaz subsidiary Gaz Ukrainy. 
 Ivano-Frankivsk had temporarily cut short hours in schools, and 
gave parents of elementary students the option of keeping young 
children home until schools are heated again.   In Kharkiv in 
eastern Ukraine, heat supplies had not resumed in about 13 percent 
of the buildings as of November 3, and schools in the city were also 
affected by gas supply disruptions. 
 
GOU Interventions 
----------------- 
 
¶6. (SBU) President Yushchenko initiated the process by issuing a 
decree on October 3, ordering the termination of gas supplies until 
debtors pay off their debts or came forward with bank guarantees. 
The same decree instructed the Cabinet of Ministers to transfer an 
additional UAH 9.1 billion ($1.58 million) to Naftohaz and UAH 2.4 
billion ($417 million) in subsidies to local budgets in 2008 to 
compensate utility companies for the gap between their costs and the 
unrealistically low rates their companies are required to charge to 
customers. 
 
¶7. (SBU) While the issue of subsidies will have to be approved by 
the Parliament as part of amendments to the 2008 budget, Prime 
Minister Tymoshenko urged all regional governors on October 22 to 
ensure payment of debts to Naftohaz and instructed the Ministry of 
Fuel and Energy and Naftohaz's Head to supply gas necessary for 
resumption of centralized heat supply as soon as possible.  To date, 
Naftohaz officials report that outstanding debts have not been paid, 
and that gas supplies will not be resumed until the debts are paid. 
 
 
KYIV 00002221  002 OF 002 
 
 
Naftohaz's Financial Situation Worsens 
-------------------------------------- 
 
¶8. (SBU) As Naftohaz struggles to collect debts from its 
subsidiaries, the company's Eurobond holders plan to meet in London 
on November 14. Press reports indicate the holders could demand an 
early redemption of the bonds because the company has failed to 
deliver a financial report for 2007, an action that is allowed under 
the terms of the bond issue.  Naftohaz faced a similar challenge 
from bondholders last year over its 2006 reports, but successfully 
held them off until it finally published the reports in early 2008. 
Creditors may not be so patient this time around because of the 
world financial crisis.  Naftohaz continues to service its external 
debt in a timely manner, and the current threat to redeem the bonds 
simply results from Naftohaz's inability to produce financial 
reports that most companies could have published months ago. 
Nonetheless, creditors are worried, and some analysts described the 
company's situation as "deplorable" and unlikely to improve next 
year (ref B). 
 
Comment 
------- 
 
¶9. (SBU) The gas cutoffs show that the gas sector's debt problems 
run down the entire value-added chain - starting with Naftohaz's gas 
purchases from RUE and ending at the level of individual households. 
 The reasons for the debt are well-known:  ill-guided regulations 
force Naftohaz to sell gas below cost, and equally ill-guided 
tariffs force local distributors and heating companies to supply 
services to consumers at unrealistically low rates.  Domestic gas 
production is far below its potential because producers are forced 
to sell at unprofitable low prices.  The artificially low prices 
throughout the system provide no incentive to save energy and deny 
energy companies the means needed to modernize their aging 
infrastructure. Moreover, the existence of multiple prices for a 
homogenous product - gas - throughout the system has created grey 
markets and solidified corruption.  Increased domestic gas prices 
are a long time coming and should motivate Ukrainians to become more 
energy efficient, thus decreasing demand.  In turn, the government 
will need to ensure that necessary subsidies are targeted to ensure 
that they reach those who need them. End comment. 
 
TAYLOR