VZCZCXRO8475
RR RUEHDBU RUEHIK RUEHLN RUEHPOD RUEHSK RUEHVK RUEHYG
DE RUEHKV #1024/01 1631635
ZNR UUUUU ZZH
R 121635Z JUN 09 ZDK
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC 7944
INFO RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 04 KYIV 001024 
 
SIPDIS 
 
DEPT FOR S/EEE - MORNINGSTAR/NESHEIWAT, EUR/UMB, EB/ESC/IEC 
- GALLOGLY/WRIGHT 
DOE PLEASE PASS TO JELKIND, LEKIMOFF, CCALIENDO 
 
E.O. 12958: N/A 
TAGS: ENRG EPET ECON PINR PREL RU UP
SUBJECT: UKRAINE: SCENESETTER FOR AMBASSADOR MORNINGSTAR'S 
VISIT TO KYIV 
 
¶1. (SBU) Summary. Your June 19-20 visit to Ukraine comes in 
the midst of a severe economic crisis and an increasingly 
tense political environment ahead of presidential elections 
in 2010.  The gas supply and transit contracts signed by 
Naftohaz and Gazprom in January 2009 increased transparency 
somewhat and ended the gas crisis that saw gas shutoffs to EU 
member states.  Naftohaz's precarious financial situation, 
however, has called into question its ability to comply with 
the contracts, which introduced stringent payment 
requirements.  Ukraine's strategically vital gas pipelines 
transit 80 percent of the natural gas Europe purchases from 
Russia but need at least $3 billion in technical upgrades to 
ensure the system's reliability and increase efficiency. 
Ukraine has been slow to adopt reforms that the EU and 
international financial institutions have said are necessary 
before they provide financing for the pipeline modernization. 
 Ukraine also remains heavily dependent on Russia for oil, 
for 100 percent of its nuclear fuel and for 60 percent for 
storage of its spent nuclear fuel. Ukraine's economy is one 
of the most energy intensive in the world, but Ukraine has 
done little to attract foreign investment in its energy 
sector or to encourage increased energy efficiency.  End 
summary. 
 
Ukraine-Russia Gas Relationship 
-------------------------------- 
 
¶2. (SBU) The January 2009 gas supply and transit contracts 
signed by Naftohaz and Gazprom ended the two week standoff 
that saw gas shutoffs to EU member states.  The 10-year 
contracts took limited steps toward transparency by cutting 
out controversial gas intermediary RosUkrEnergo (co-owned by 
Gazprom and Ukrainian oligarch Dymtro Firtash) and 
establishing a fixed formula for determining the price of 
imported gas.  The supply contract includes an annual 80 
percent take or pay provision and allows for stiff penalties 
if Ukraine under or over purchases gas by 6 percent each 
month. The supply contract requires Ukraine to take 40 
billion cubic meters (bcm) of gas in 2009 and 52 bcm per year 
from 2010.  In 2009, Ukraine is receiving a 20 percent 
discount off of "market" prices.  Ukraine is paying $270 per 
thousand cubic meters (tcm) of gas in the second quarter of 
¶2009.  Naftohaz and Gazprom estimated that the average 
purchase price for gas in 2009 would be around $230/tcm.  In 
2010, however, gas prices will reach market levels, which are 
derived from a formula pegged to oil prices.  Ukraine is 
required to pay for each month's gas deliveries by the 
seventh of the following month.  If Ukraine fails to make its 
monthly payment on time and in full, Gazprom can require it 
to make prepayment. 
 
¶3. (SBU) Although the purchase price increased substantially, 
the transit price charged to Russia in 2009 remains below 
market levels at $1.70 per tcm per 100 kilometers. Transit 
prices will increase in 2010 to approximately $2.50 per tcm 
per 100 kilometers.  Depending on amounts shipped to the rest 
of Europe, Ukraine has historically received between $2.0 and 
$2.5 billion yearly from Gazprom for gas transit.  While 
Ukraine is subject to take or pay provisions in the supply 
contract, Russia is not subject to similar provisions in the 
transit contract. Transit volumes to Europe were down 50 
percent in the first quarter, as the financial crisis took 
its toll on European demand. 
 
¶4. (SBU) Ukraine already faces several problems in fulfilling 
its contractual obligations.  First, because of reduced 
demand from industrial consumers and increased reliance on 
gas Ukraine already had in storage, Ukraine has purchased far 
less than the commitments made in the gas agreements. 
Naftohaz officials asked for a revision to 33 bcm, which is 
allowed under the contract's 80 percent take or pay 
provision.  Russian officials had warned that Ukraine could 
face stiff penalties -- $2 billion for the first four months 
of 2009 -- for taking less than the contracted amount. 
However, PM Tymoshenko allegedly secured Russia's agreement 
to waive the fines for 2009.  Second, prior to the January 
2009 supply contract, Ukraine paid for its gas as it was 
consumed, and not as it was delivered.  This allowed Ukraine 
to pump gas into storage during the summer months, and pay 
for it later in the heating season when demand, and hence 
revenues, were high.  The January 2009 contract, however, 
requires full payment for each month's gas deliveries by the 
seventh of the following month.  During the winter season, 
this should not be a serious problem because Naftohaz 
generates revenues from the sale of gas. In the summer, 
however, it pumps up to 20 bcm into underground storage for 
use during the winter heaing season, and has far less 
 
KYIV 00001024  002 OF 004 
 
 
revenue, greatly limiting its ability to pay for this gas. 
In recent weeks, Russian and Gazprom officials repeatedly 
called into question Naftohaz's ability to make the May 
payment and warned of the possibility of another gas crisis. 
To date, however, Naftohaz has made the payments on time by 
borrowing over $650 million from state-owned banks and 
obtaining sufficient foreign exchange in a roundabout route 
from the National Bank of Ukraine. 
 
Gas Sector Reform and Gas Transit System Modernization 
--------------------------------------------- ---------- 
 
¶5. (SBU) The March 23 EU-Ukraine investment conference 
devoted to the modernization of Ukraine's gas transit system 
(GTS) produced a pledge from Ukraine's leadership to 
undertake needed reforms.  International financial 
institutions promised to provide financing for the 
modernization of the GTS once reforms were undertaken.  The 
Brussels declaration calls on Ukraine to ensure the 
independence of the gas transit operator, and to undertake a 
gas sector reform program that would bring Ukraine in line 
with EU directives on the gas market.  Ukraine is to provide 
a detailed timetable for sector reforms, which correspond 
with reforms needed for Ukraine to join the European Energy 
Community, by the end of 2009, and it is required to 
implement the reforms, which include the phasing out of 
domestic price subsidies, by 2011. 
 
¶6. (SBU) Ukraine's gas sector is notoriously opaque and 
inefficient, with structured disincentives for investment and 
modernization, and is burdened with cross subsidies that mask 
the true cost and corruption of the system.  Gas prices are 
largely based on political calculations.  Industrial users 
pay the full cost of imported gas, while household consumers, 
organizations funded by the state budget, and municipal 
heating companies pay a heavily subsidized price, with the 
shortfall made up by allocations from the state budget.  The 
small amount of domestically produced natural gas must be 
sold to domestic household consumers at a rate that barely 
covers the cost to extract and transit the gas.  This cap on 
the sale price has discouraged production and exploration and 
led to a grey market that has furthered corruption. 
Currently, domestic production is around 20 bcm per year, 
although many experts believe that Ukraine could double its 
production within a decade with the right changes to the 
investment and regulatory framework. 
 
¶7. (SBU) The subsidized prices paid by domestic consumers 
leave Naftohaz heavily dependent on transfers from the state 
budget, and will make any attempts to increase the 
independence of Ukrtransgaz, the Naftohaz subsidiary that 
runs the GTS, more difficult.  In their discussions with the 
Europeans, Ukrainian officials make the claim that 
Ukrtransgaz has already been unbundled.  However, the company 
is fully subservient to Naftohaz.  Transit revenues generated 
by Ukrtransgaz are used by Naftohaz to cross-subsidize gas 
purchases from Russia, and limit the amount of resources 
available to Ukrtransgaz to modernize the GTS.  For example, 
Russia has reportedly already advanced all transit fees for 
2009, which Naftohaz has used to cover gas payments. 
 
¶8. (SBU) The European Commission, World Bank, European Bank 
for Reconstruction and Development, and the European 
Investment Bank have pledged to modernize the GTS with a 
$3.02 billion, seven year project that would increase 
capacity from 120 bcm to 150 bcm per year.  The program would 
increase the reliability of the Ukrainian system and reduce 
its environmental impact by upgrading compressor stations, 
installing meters, and reconstructing two of Ukraine's 
underground gas storage facilities.  Ukraine also proposed to 
add an additional 60 bcm of capacity by building new 
pipelines at a cost of $5.55 billion, an idea that has found 
little favor among the Europeans, who want Ukraine to focus 
on upgrading the existing system. 
 
¶9. (SBU) The GTS modernization project has stalled since the 
March 23 Brussels conference.  The EC was initially 
optimistic that Ukraine would quickly form a technical 
coordination unit with the western donors that would 
oversee the implementation of Naftohaz's modernization master 
plan.  This unit, however, has not yet met.  After Russia 
expressed its outrage at being excluded from the March 23 
declaration, Ukraine made overtures to Russia. During 
meetings with Russian PM Putin that took place following the 
conference, PM Tymoshenko said that Russia would be involved 
in the project, although exactly how Russia would participate 
has not yet been outlined. 
 
KYIV 00001024  003 OF 004 
 
 
 
Ukraine's Oil Sector 
--------------------- 
 
¶10. (SBU) Ukraine imports 61 percent of its oil from Russia 
and 70 percent of its gasoline and diesel from Romania, 
Belarus, and Lithuania.  Ukraine's six refineries operate far 
below capacity.  Only one refinery, the Lysychansk refinery 
in eastern Ukraine owned by TNK-BP, has been modernized to 
reach European standards. 
 
¶11. (SBU) When President Yushchenko talks about energy 
security, he invariably makes a pitch for the Odesa-Brody 
pipeline,  Ukraine's most manifest, yet misguided, attempt to 
reduce dependence on Russian crude oil.  The pipeline was 
completed in 2002 under President Kuchma.  Both Kuchma and 
successive governments believed that business would surface 
once the pipeline was built, despite repeated advice by 
foreign experts that the project lacked a sound commercial 
underpinning.  (Comment:  Some observers argue that the 
project was primarily conceived as a cash cow for Interpipe, 
the pipe producer owned by Kuchma son-in-law Victor Pinchuk. 
End comment.)  The pipeline remained empty until 2004 when 
TNK-BP and Transneft concluded a contract with the GOU to 
transport Urals crude in the opposite direction, from Brody 
south to Odesa. In 2007, TNK-BP shipped more than 9 Mt of 
Russian oil through the pipeline. 
 
¶12. (SBU) President Yushchenko has revived efforts to 
re-reverse Odesa-Brody with the hope of off-taking a 
percentage of oil to be refined at the Nadvirna and Drogobych 
refineries in western Ukraine. In order to achieve 
Yushchenko's goal, Ukraine would need to reconfigure an 
existing refinery to refine Caspian crude or invest in the 
construction of a new refinery, which could cost up to $4 
billion.  Yushchenko also aims to transport Caspian crude 
northward via the pipeline to Europe.  Ukraine recently 
commissioned a feasibility study on shipping oil from 
Azerbaijan through the pipeline and lengthening the 
Odesa-Brody route to reach European markets.  The total 
investment needed for the project is estimated to be anywhere 
between $2 billion and $8 billion, depending on the projected 
oil transit volumes.  To date, however, Ukraine has still not 
succeeded in generating commercial interest for the idea. 
 
¶13. (SBU) Ukraine could reduce its dependence on Russian oil 
by further developing onshore resources and by tapping the 
reserves of the Black Sea.  However, as with the case with 
gas, developing the oil resources of the Black Sea will make 
little progress until Ukraine improves its investment 
climate.  Most industry observers agree that Ukraine has 
neither the know-how nor the capital to develop its Black Sea 
resources on its own, yet the country has failed to attract 
investment from abroad.  The most recent and visible example 
of Ukraine's inhospitable climate for foreign investors is 
the dispute with Houston-based Vanco. In October 2007 Vanco 
and the GOU, then headed by PM Victor Yanukovich, signed 
Ukraine's first Production Sharing Agreement (PSA), which 
targeted oil and gas exploration in the Prikercheskaya block 
in the Black Sea.  However, PM Tymoshenko's government 
unilaterally revoked the PSA and Vanco's exploration permit 
in May 2008.  Tymoshenko and 
other Ukrainian officials engaged in a heated public dispute 
with Vanco, charging the company with being the 
marionette of corrupt forces in both Ukraine and abroad. 
Oligarch Rinat Akhmetov, a bitter rival of Tymoshenko, is one 
of Vanco's partners in the project, and some observers in 
Kyiv claim that Tymoshenko is primarily set on derailing his 
participation in the project.  Whatever the merits of 
Tymoshenko's arguments and Vanco's counterarguments, the case 
of a sovereign government unilaterally revoking a deal with a 
foreign investor will make it virtually impossible for 
Ukraine to obtain the type of long-term capital it needs to 
develop the Black Sea as long as the dispute is not settled. 
The case is now under consideration at the Stockholm 
Arbitration Court. 
 
Nuclear Energy 
--------------- 
 
¶14. (SBU) Ukraine's nuclear sector generates approximately 
half of the country's electricity, while Russia provides 100 
percent of Ukraine's nuclear fuel and stores 60 percent of 
its spent fuel.  Department of Energy (DoE) assistance 
totaling $380 million has helped Ukraine boost the 
operational capacity of its reactors by ten percent and 
significantly reduce reportable events.  American firms 
 
KYIV 00001024  004 OF 004 
 
 
Westinghouse and Holtec have proposed projects that would 
diversify Ukraine's nuclear fuel supply and store spent fuel 
domestically.  In March 2008, Westinghouse signed a contract 
with the GOU allowing it to supply nuclear fuel to three 
Ukrainian reactors beginning in 2011.  Westinghouse has 
offered to extend the contract to cover additional reactors 
at a discount.  Westinghouse has also offered to cooperate 
with Ukraine on technology transfer and construction of a 
nuclear fuel assembly plant.  Although PM Tymoshenko and 
other senior GOU officials have publically supported the 
Westinghouse projects, the Prime Minister has also shown 
support for long term contracts with Russia to provide 
nuclear fuel to Ukraine.  New Jersey-based Holtec, meanwhile, 
signed a contract in 2005 to build a $160 million central 
spent nuclear fuel facility in Ukraine.  Currently, Ukraine 
spends approximately $100 million per year to ship its spent 
fuel to Russia for reprocessing.  The project has stalled, 
however, due to a lack of interest by PM Tymoshenko and 
hidden opposition from competing business interests and other 
senior GOU officials. 
 
Municipal Heating Reform 
------------------------- 
 
¶15. (SBU) Nearly 30 percent of Ukraine's natural gas demand 
is used for municipal heating, a sector that is terribly 
inefficient and lacking in resources because of historically 
low prices.  Municipal heating prices, set by local 
governments, reportedly cover 80 percent of costs, and nearly 
60 percent of energy is wasted within the municipal heating 
chain.  Half of this loss is attributable to waste and 
inefficiency by end users.  In May USAID launched a 
three-year, $13.4 million program aimed at transforming 
municipal heating into a financially viable, well-managed, 
and fairly regulated sector that provides reliable services 
at affordable prices.  The project will help 20 
municipalities develop strategic energy plans and attract 
investment to the sector, while encouraging energy efficiency 
upgrades in apartment buildings to decrease overall energy 
needs.  If Ukraine implements relevant reforms in the sector, 
it could potentially save $2 billion per year on energy costs. 
PETTIT