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July 30, 2008

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Reference ID Created Released Classification Origin
08KYIV1461 2008-07-30 12:25 2011-08-30 01:44 UNCLASSIFIED//FOR OFFICIAL USE ONLY Embassy Kyiv

DE RUEHKV #1461/01 2121225
P 301225Z JUL 08

E.O. 12958: N/A 
Sensitive But Unclassified.  Not for Internet Distribution 
1. (SBU) Deputy Energy Minister Volodymyr Makukha signaled interest 
to DAS Matthew Bryza on July 24 in a possible EU/USG/GOU project to 
boost gas transit capacity through Ukraine in exchange for increased 
transparency in Ukraine's energy sector by constructing the 
Bohorodchany-Uzhgorod bypass pipeline.  The pipeline would cost less 
that $1 billion and boost transit capacity by 20 bcm yearly, 
compared with Gazprom's South Stream with its expected $14 to $20 
billion price tag and 30 bcm capacity.  Makukha said the project 
could build on the work of the Russian/Ukrainian International Gas 
Transit Consortium (IGTC) which planned to build 
Bohorodchany-Uzhgorod but floundered over Gazprom insistence on 
managing Ukraine's entire gas transit network in exchange for 
providing gas to the pipeline.  Getting Gazprom buy-in as a partner 
and a supplier of gas would be a challenge, Makukha said, but it was 
possible if Gazprom viewed the pipeline as a lucrative commercial 
venture that was managed in a professional and transparent manner in 
cooperation with western energy companies.  Makukha said the GOU 
would respond to Bryza's proposal to convene a U.S.-Ukraine-EU 
working group to scope out the project by mid-September, after the 
GOU had discussed Bryza's idea internally.  On a separate issue, 
Makukha said the GOU would convene a donors' meeting in November to 
secure $2.5 billion in loans for the modernization of the existing 
gas transit system.  End summary. 
Bryza: EU Warming to Bohorodchany-Uzhgorod 
2. (SBU) On July 24 DAS Matthew Bryza briefed Deputy Minister of 
Energy Volodymyr Makukha on his discussions earlier that day in 
Brussels on the idea of a EU/USG/Ukraine partnership to support the 
construction of the Bohorodchany-Uzhgorod bypass gas pipeline. 
Bryza recounted his explanation to EU partners that the bypass 
pipeline would boost Ukraine's transit capacity by roughly 20 bcm 
yearly and cost about $800 million, or a fraction of South Stream's 
projected $14 to $20 billion price tag and 30 bcm capacity.  To earn 
U.S. and EU support for the project, Ukraine would have to guarantee 
that the project adhere to EU and U.S. transparency standards. 
3. (SBU) Bryza said he discussed the idea with the EU COEST's 
regional and energy working groups, European Council Secretariat 
Chief Gretschman and the European Council Policy Planning Chief 
Schmidt in Brussels.  In general, EU interlocutors reacted 
positively, albeit focused on Ukraine's unpredictable political 
situation and lack of transparency in the energy sector.  Still, 
there was enough interest in Brussels for the three sides to discuss 
how best to explore the idea further.  One possibility would be a 
trilateral working group to scope out key commercial and financial 
factors and define levels of transparency expected by both the USG 
and EU, Bryza said.  The USG and EU also expected that commercial 
energy companies build and manage the pipeline; governmental support 
could take the form of political backing or, for example, the 
financing of a feasibility study or the sourcing of funding that 
might attract institutional lending from the EIB or EBRD.  He asked 
Makukha whether the GOU would be interested in discussing the 
proposed project in greater detail. 
Makukha:  Project Could Build on Work of Dormant Russian/Ukrainian 
Transit Consortium 
4. (SBU) Makukha confirmed the GOU's interest.  He pledged to 
discuss the idea with all affected parties in the government, and 
hoped to relay a first response to Bryza by mid-September, including 
on the issue of convening a working group.  He suggested that the 
three sides build on the work of the International Gas Transit 
Consortium (IGTC), which had already discussed construction of 
Bohorodchany-Uzhgorod as part of a broader gas transit cooperation 
between Ukraine's NaftoHaz and Russia's Gazprom.  The Kuchma 
government and the GOR established the IGTC in 2002, and it still 
existed as a legal entity, Makukha said, but it never got off the 
ground because the two sides could not agree on IGTC's scope. 
Gazprom hoped to use the IGTC to gain control over Ukraine's gas 
transit system, which went against Ukrainian law and was and 
remained politically unacceptable to Ukraine, he said.  The 
Bohorodchany-Uzhgorod bypass idea floundered along with the general 
lack of movement in the IGTC, he added.  (See paragraphs 11-14 for 
detailed background of the IGTC).  Bryza stressed that a key 
motivation of this U.S. proposal was to rely on market forces and a 
commercial venture to protect Ukraine against Gazprom's push to 
KYIV 00001461  002 OF 003 
acquire control of Ukraine's gas transit and
 storage infrastructure, 
while restoring Ukraine's reliability as a partner of the EU.  Bryza 
noted this project could help advance Ukraine's integration into the 
Euroatlantic community by preventing Ukraine from being bypassed by 
South Stream.  Makukha welcomed the idea of including gas storage in 
the project, and agreed to add metering at both ends of the 
5. (SBU) Makukha gave Bryza an in-depth overview of the previous 
planning for Bohorodchany-Uzhgorod.  The IGTC's feasibility 
assessment confirmed that the pipeline would boost transit capacity 
by about 20 bcm yearly.  Makukha explained that Ukraine's existing 
pipeline system could take in about 178 bcm yearly from Russia, but 
only pass on 120 bcm to countries farther westward.  The IGTC 
planned to build the 240 kilometer pipeline in three stages over two 
years.  The first 50 km could be built within 12 months and increase 
transit capacity by 5 bcm annually.  A second stage would increase 
the length to 130 km and boost capacity to 16 bcm.  The remaining 
110 km would extend capacity to the maximum 20 bcm.  Regional 
government authorities in the oblasts of western Ukraine had already 
procured a right-of-way for the entire route, which Makukha said was 
an added bonus for the new project because obtaining land rights in 
Ukraine was difficult. 
6. (SBU) In all, the IGTC estimated that the pipeline would cost $1 
billion.  The consortium expected to amortize the project fully 
within 13 years with an 18 percent annual return on investment.  The 
amortization period would likely be shorter now because gas prices 
had increased substantially since the partners made their 
projections.  Gazprom and Naftohaz each paid in $20 million in 
capital to a joint venture established for the purpose.  Thirty 
percent of the cost would have been financed by capital injections 
of the two partners, with the rest financed by borrowing, he said. 
Obtaining Gazprom's Buy-In 
7. (SBU) Bryza asked whether the existing company might be expanded 
to include western energy companies alongside NaftoHaz and Gazprom, 
provided Gazprom acted as a commercial partner that did not try to 
take control of the project.  Makukha said he could not predict 
Gazprom's reaction.  During IGTC talks Gazprom made the delivery of 
additional gas for Bohorodchany-Uzhgorod contingent on Ukrainian 
willingness to give it management over the entire transit network, 
which the GOU refused.  But solid EU backing, strong western 
commercial partners and high levels of transparency might make the 
project interesting for Gazprom, Makukha added.  He said German 
companies had been initially interested in the IGTC project but 
later backed out. 
8. (SBU) Bryza noted the U.S. would not be interested in the bypass 
project to enhance Russia's ability to transport Turkmen gas to 
Europe by linking Ukraine's gas transit system to the proposed 
pre-Caspian pipeline in Turkmenistan.  Bryza asked about the 
possibility of procuring gas from independent gas producers in 
Russia.  Makukha said he was skeptical that Russia and Gazprom would 
allow independent producers in the foreseeable future.  Gazprom's 
desire for control was too strong, he said. 
"Insulating" Bohorodchany-Uzhgorod from Ukraine's Transit System 
9. (SBU) Makukha pointed out that Ukrainian law explicitly forbids 
either private or foreign ownership of the existing gas transit 
network.  In his view, however, the law would not apply to a fully 
new pipeline project.  Bryza asked whether the management and 
governance of such a pipeline operation could be "insulated" from 
the main transit network, with all the transparency concerns 
associated with the latter.  The ability to separate a new pipeline 
from the management of the existing network would help secure EU 
backing for the project.  Makukha said that was possible, and cited 
a pipeline delivering Russian gas across Ukraine to Bulgaria and 
Romania.  The stand-alone project had been completed with EBRD 
funding, Gazprom was providing the gas without simultaneously 
pursuing a political agenda, and all involved parties were satisfied 
with the pipeline's operations and management, he said. 
GOU to Hike Gas Prices; Seeks Donor Support for Transit System 
10. (SBU) Makukha said the GOU planed to convene a donors' meeting 
in November to solicit $2.5 billion in loans for the modernization 
of Ukraine's gas transit pipeline system.  The GOU hoped to get 
KYIV 00001461  003 OF 003 
funding from different sources, including EBRD and the EIB.  In 
response to a question by Bryza, Makukha said that donors had 
already indicated that reforming NaftoHaz would be a main condition 
for any loans.  NaftoHaz's financial system remained precarious 
because GOU policies kept gas prices to households and utilities 
lower than cost.  NaftoHaz was bearing the burden and effectively 
subsidizing gas prices on behalf of the GOU.  NaftoHaz had once been 
a prime source of government revenue, but was now a major burden on 
the budget.  Makukha predicted that the GOU would bring retail and 
utility tariffs in line with unregulated industrial prices in the 
foreseeable future. This would cause many Ukrainian enterprises to 
fail, which was a political cost that would have to be borne, as 
Ukraine's two-tiered gas pricing system was no longer sustainable. 
(Comment: Separately, other cabinet-level officials have told us 
that the GOU would announce price hikes for the retail sectors 
before this year's heating season begins.  Previously, however, GOU 
officials were not ready to acquiesce to the failure of enterprises 
as a result of gas price hikes. End comment.) 
Background on the IGTC 
11. (SBU) Many observers view the IGTC as one of several Russian 
attempts to gain more control over Ukraine's gas transit system.  In 
2000 for example, Russia suggested the establishment of a consortium 
that would take control over Ukraine's transit system in exchange 
for canceling gas debts accrued by Ukraine in 1996-1998.  Ukraine 
turned down the suggestion at the time. 
12. (SBU) At a June 2002 summit in St. Petersburg, Presidents Putin 
and Kuchma and German Chancellor Schroeder announced plans to create 
a Ukraine-Russia-German consortium to manage Ukraine's gas transit 
system, ostensibly to increase the reliability and security of gas 
supplies to Europe.  Germany quickly opted out and Ukraine and 
Russia announced the creation of the International Gas Transit 
Consortium (IGTC) in October, 2002.  To explain Germany's absence, 
the parties said they were more prepared to move forward and 
established a consortium that would welcome third parties. In 
January 2003, Gazprom and Naftogaz established a limited liability 
company registered in Kyiv, with each side owning equal equity and 
voting rights.  As of April 2007, IGTC's statutor
y capital was UAH 
186.55 million or roughly $40.5 million. 
13. (SBU) The two sides failed to find a mutually agreeable business 
model.  Gazprom was interested in either a concession or outright 
management of the pipeline, which was unacceptable to Ukraine.  In 
turn, Russia refused to agree to the GOU's desire that the 
consortium jointly manage the entire transit of Turkmen gas on both 
Ukrainian and Russian soil.  In early 2004, the parties agreed to 
build Bohorodchany-Uzhgorod.  It was foreseen that the consortium 
would receive a concession to operate Bohorodchany-Uzhgorod along 
with the existing smaller pipelines Torzhok-Dolyna and 
Ivantsevychi-Dolyna in western Ukraine.  The Orange Revolution 
brought discussions to a halt, and Russia showed little interest 
when President Yuschenko revived the Bohorodchany-Uzhgorod idea in 
early 2005. 
14. (SBU) The IGTC was revived by the GOU in late 2006 after Yuriy 
Boiko (who headed Naftohaz when IGTS was established) became 
Minister of Fuel and Energy.  In February 2007 President Putin 
publicly offered Russian support for IGTC and Ukrainian access to 
Russian gas fields in exchange for allowing the consortium to manage 
Ukraine's gas transit system. 
15.  (SBU) Comment:  Reformulating the IGTC to offer Gazprom a 
commercially viable way to import gas to Europe as a minority 
partner with Naftohaz and European companies and without control 
over the project would set an important precedent.  While Gazprom 
may reject this proposal, compelling it to do so would expose its 
penchant for control and thereby spur greater EU unity in pursuit of 
supply diversification. 
16. (U) DAS Bryza cleared this cable. 


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