VZCZCXRO2005
PP RUEHDBU RUEHIK RUEHLN RUEHPOD RUEHSK RUEHVK RUEHYG
DE RUEHKV #0421/01 0651108
ZNR UUUUU ZZH
P 061108Z MAR 09
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC PRIORITY 7421
INFO RUCNCIS/CIS COLLECTIVE PRIORITY
RUEHZG/NATO EU COLLECTIVE PRIORITY
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC PRIORITY

UNCLAS SECTION 01 OF 03 KYIV 000421 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/UMB,EEB/ESC/IES FOR SCALLOGLY, LWRIGHT 
NSC FOR KKVIEN 
DOE FOR LEKIMOFF, CCALIENDO, KBOURDREAU 
 
E.O. 12958: N/A 
TAGS: ENRG EFIN EPET PGOV PINR PREL RS UP
 
SUBJECT: UKRAINE: NAFTOHAZ PAYS GAZPROM AND AVOIDS A NEW CONFLICT, 
FOR NOW 
 
Ref: Kyiv 419 
 
Sensitive But Unclassified.  Not For Internet Distribution. 
 
Summary 
------- 
 
¶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. 
 
KYIV 00000421  002 OF 003 
 
 
 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. 
 
 
KYIV 00000421  003 OF 003 
 
 
TAYLOR