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08KYIV13, UKRAINE: HIGHER GAS PRICE WON’T SLOW ECONOMY, BUT COULD HIT

January 4, 2008

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Reference ID Created Released Classification Origin
08KYIV13 2008-01-04 07:19 2011-08-30 01:44 UNCLASSIFIED//FOR OFFICIAL USE ONLY Embassy Kyiv

VZCZCXRO4568
OO RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #0013/01 0040719
ZNR UUUUU ZZH
O 040719Z JAN 08
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC IMMEDIATE 4654
INFO RHEBAAA/DEPT OF ENERGY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHDC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 02 KYIV 000013 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EUR/UMB, EB/ESC/IEC - GALLOGLY/WRIGHT 
DOE PLEASE PASS TO LEKIMOFF, CCALIENDO 
 
 
E.O. 12958: N/A 
TAGS: ENRG EPET ECON UP
SUBJECT:UKRAINE: HIGHER GAS PRICE WON'T SLOW ECONOMY, BUT COULD HIT 
HOUSEHOLDS 
 
REF:  07 Kyiv 3058 
 
Sensitive But Unclassified. Not for Internet Distribution. 
 
1.  (SBU) Summary:  Russia's 38 percent gas price hike for Ukraine, 
which took effect on January 1st, is unlikely to dampen Ukrainian 
economic growth this year.  The price increase will have a varying 
impact throughout the economy, but in general both industrial reps 
and analysts tell us that Ukrainian industry is adapting well to 
higher energy prices.  The metallurgical and chemical sectors in 
particular, which drive exports and include some of Ukraine's most 
profitable businesses, have invested heavily in modernizing their 
production facilities in recent years and by all accounts are 
positioning themselves to pay world prices for gas.  There are, 
however, divergent views about whether Russia's gas price hike will 
be passed on to Ukrainian households.  Some Embassy interlocutors 
say economics dictates that the GOU raise retail gas prices, which 
are still kept artificially low as a tool of social policy.  The new 
government under Prime Minister Yuliya Tymoshenko has tasked state 
energy company NaftoHaz to come up with an "objective" retail price 
for natural gas.  It is not clear whether she is preparing the 
market for a price hike, or seeking a justification for keeping 
prices low.  If, as many believe, Tymoshenko is positioning herself 
for a presidential bid, she may be reluctant to raise prices much, 
since such an unpopular decision would be felt by nearly every 
household in the country.  End summary. 
 
Higher Gas Prices Shouldn't Hit Economic Growth 
--------------------------------------------- -- 
 
2.  (U) On December 4, Russia and Ukraine agreed on a price of 
$179.50 per thousand cubic meters (tcm) for natural gas supplied to 
Ukraine in 2008, up almost $50 from 2007.  Prices for imported gas 
have risen nearly 360 percent in the last four years, from $50/tcm 
in 2004 to $179.5/tcm in 2008. 
 
3.  (SBU) Representatives from exporting industries have told us 
they are well-prepared to shoulder the higher gas prices.  Jock 
Mendoza-Wilson, Director of International and Investor Relations for 
System Capital Management (SCM), the company owned by Ukrainian 
billionaire and steel tycoon Rinat Akhmetov, told EconOff in early 
December that SCM staff were not concerned about gas price hikes. 
Farooq Siddiqui, Senior Vice President of the Donetsk steel mill 
"ISTIL," echoed Mendoza-Wilson's thoughts, telling EconOff that 
rising gas prices would not be a problem for his company. 
 
4.  (SBU) Analysts agree with industry. In a discussion with 
Econoff, Igor Burakovsky, Director of the Institute for Economic 
Research and Policy Consulting, was generally unconcerned about 
rising gas prices and their affect on Ukraine's economy.  He said 
the metallurgical sector "easily" could pay USD 200 per tcm at the 
border for natural gas.  According to Burakovsky, large metals 
companies, such as SCM and the Industrial Union of Donbass (IUD) are 
particularly well-positioned to handle energy price hikes because 
their real profit margins are as high as 400 percent.  He also 
mentioned that these firms for several years have been proactive in 
responding to rising gas prices.  As early as 2000, according to 
Burakovsky, Ukrainian metals firms began repatriating funds from 
offshore accounts to invest in energy-saving technologies. 
 
5.  (SBU) In addition to large profit margins and more energy 
efficiency, continued high world prices for Ukraine's key commodity 
exports should help offset rising gas prices.  Ildar Gazizullin, 
Senior Economist at the International Centre for Policy Studies 
(ICPS) told Econoff that metals and chemicals companies will be able 
to absorb higher gas prices in 2008 particularly because world 
prices for steel and chemicals products, such as ammonia and urea, 
are expected to remain at high levels or even increase in 2008.  He 
also pointed out that gas comprises only eight to 12 percent of 
metals companies' cost structure, and that metals companies could 
even handle a USD 300/tcm gas price.  Nonetheless, SCM's 
Mendoza-Wilson told us that SCM is preparing itself for a dip in 
steel prices. 
 
Energy Efficiency Improves 
-------------------------- 
 
6.  (U) The energy intensity of the overall Ukrainian economy has 
improved in line with rising gas prices over the past several years, 
although it remains alarmingly high when compared with energy usage 
elsewhere in the industrialized world.  According to an OECD report 
released in 2007, Ukraine in 2004 used almost 2.4 times more energy 
per unit of output than the world average and about three times the 
average for the OECD area.  Nevertheless, every major industrial 
 
KYIV 00000013  002 OF 002 
 
 
sector in Ukraine had become more energy efficient in recent years. 
The OECD report indicates that in 2004 total final consumption of 
energy pe
r real unit of output in industry was 40 percent less than 
in 1999.  When presenting their findings in Kyiv, OECD economists 
argued that improved energy efficiency was a direct response to 
rising energy prices.  In their view, declining energy intensity 
indicated that Ukrainian industry was modernizing quickly and 
developing the ability to react to market signals. 
 
But More Energy Efficiency Measures Still Needed 
--------------------------------------------- --- 
 
7.  (U) Ukraine's private and public sectors still need to implement 
measures that would boost energy efficiency by at least 35 percent 
to bring Ukrainian energy consumption in line with Western European 
norms, according to Burakovsky.  He noted that the first 15 percent 
could be accomplished relatively easy, while the remaining 20 
percent would require significant investment and deep 
restructuring. 
 
Gas Price Hike for Households? 
----------------------------- 
 
8.  (SBU) The GOU regulates the gas prices charged to households. 
The rates are less than those paid by households in Russia for 
natural gas.  (Note:  As most urban consumers receive heat via 
district heating, their direct gas bills only cover gas for cooking, 
while heat is billed separately.  However, district heating rates 
are in the same low range as gas rates.  End note.)  Currently, 
retail tariffs range between USD 63 and USD 96 per thousand cubic 
meters, according to usage, and are still too low to cover costs at 
state-owned energy company NaftoHaz, which may be close to 
bankruptcy (reftel).  NaftoHaz loses money in its dealings with 
municipal utilities and the households that they service.  The GOU 
is effectively using NaftoHaz as an instrument of its social policy, 
forcing it to subsidize gas to households. 
 
9.  (SBU) Prime Minister Yuliya Tymoshenko already has announced 
several actions aimed at shoring up NaftoHaz, including state 
guarantees for the company's debt and the establishment of an 
interagency commission that will investigate its financial 
situation.  She also has commissioned Oleg Dubyna, the new head of 
NaftoHaz, to determine an "objective" retail price for natural gas 
based upon the cost of extracting gas in Ukraine.  Low wellhead gas 
prices have become a disincentive to domestic gas production.  In 
2007, for example, UkrNafta (51 percent owned by the GOU) announced 
it was stopping production at some fields because they were no 
longer profitable.  It is unclear whether Tymoshenko is laying the 
political groundwork for price hikes, or seeking justification for 
maintaining low prices.  Our interlocutors expect Tymoshenko to 
raise prices.  Burakovsky of the Institute for Economic Research and 
Policy Consulting told Econoff he expects household gas prices to 
rise to levels based on cost recovery.  Gazizullin of ICPS had 
similar expectations, arguing that NaftoHaz probably will increase 
gas prices for households by at least 50 percent because household 
gas consumers comprise the largest part of total domestic Ukrainian 
gas consumption.  Earlier, Alexander Shlapak, First Deputy Head of 
the Presidential Secretariat, publicly said that household gas 
prices should be raised. 
 
Comment 
------- 
 
10.  (SBU) Ukrainian industry appears well equipped to move towards 
world prices for gas, yet artificially low prices for households 
provide few incentives to save energy and perpetuate the financial 
malaise at NaftoHaz.  Liberalizing gas prices could help reform 
Ukraine's nontransparent energy sector, but at the same time would 
certainly hit some households hard and contribute to high inflation, 
which already reached 15 percent in 2007.  Higher prices seem 
inevitable, yet it remains to be seen whether Tymoshenko will 
actually allow household gas prices to rise significantly.  Doing so 
would be highly unpopular, as was the last round of utility price 
increases in 2006.  If, as many believe, Tymoshenko is positioning 
herself for a presidential bid, she may be keen to avoid 
implementing economic policies that could potentially undermine her 
chances of becoming Ukraine's next president.  End comment. 
 
PETTIT

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