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09KYIV1092, UKRAINE: SPECIAL ENVOY MORNINGSTAR DISCUSSES GAS

June 30, 2009

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09KYIV1092 2009-06-30 08:48 2011-08-30 01:44 CONFIDENTIAL Embassy Kyiv

VZCZCXRO2173
PP RUEHDBU RUEHSL
DE RUEHKV #1092/01 1810848
ZNY CCCCC ZZH
P 300848Z JUN 09
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC PRIORITY 8034
INFO RUCNCIS/CIS COLLECTIVE PRIORITY
RUEHZG/NATO EU COLLECTIVE PRIORITY
RHEHAAA/NSC WASHDC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC PRIORITY
RHMFISS/DEPT OF ENERGY WASHINGTON DC PRIORITY
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY

C O N F I D E N T I A L SECTION 01 OF 06 KYIV 001092 
 
SIPDIS 
 
DEPT FOR S/EEE - MORNINGSTAR/NESHEIWAT, EUR/UMB, EB/ESC/IEC 
- GALLOGLY/WRIGHT 
DOE PLEASE PASS TO JELKIND, LEKIMOFF, CCALIENDO 
NSC PLEASE PASS TO KKVIEN 
 
E.O. 12958: DECL: 06/30/2019 
TAGS: ENRG EPET ECON PINR PREL RU UP
SUBJECT: UKRAINE: SPECIAL ENVOY MORNINGSTAR DISCUSSES GAS 
TRANSIT, ENERGY 
 
Classified By: Charge James Pettit for reasons 1.4(b,d). 
 
1. (C) Summary.  During a June 19-20 visit to Kyiv, Special 
Envoy for Eurasian Energy Ambassador Richard Morningstar 
urged senior Ukrainian officials to begin reforms in the 
energy sector in order to build confidence with both European 
and Russian partners.  In meetings with PM Tymoshenko, Energy 
Minister Prodan, Presidential Energy Advisor Sokolovsky, and 
Naftohaz, Morningstar and DOE PDAS Jonathan Elkind heard that 
Naftohaz is in serious financial trouble, in part because of 
the January 2009 gas supply and transit contracts and the 
company's inability to charge cost recovery rates to 
households. Ukrainian officials said they recognized the need 
for serious energy sector reforms but argued that reforms 
could not be undertaken until after the 2010 presidential 
elections.  International community representatives linked 
any possible financing for Naftohaz to reforms in the gas 
sector and increased transparency at Naftohaz.  The economic 
crisis would play a large role in the presidential elections, 
Morningstar was told.  End summary. 
 
Naftohaz Financing Needs for Gas Purchases 
------------------------------------------- 
 
2. (C) Prime Minister Tymoshenko, Minister of Fuel and Energy 
Prodan, the Naftohaz leadership, and Presidential Advisor 
Sokolovsky all claimed that Ukraine needs $5 billion in 
financing to purchase adequate volumes of gas in 2009 and 
thereby avoid a potential repeat of the winter gas crisis 
with Russia.  However, they gave various justifications of 
what exactly would be funded by the loan.  Tymoshenko, Prodan 
and Naftohaz stated that Ukraine would use the loan to 
purchase 19 bcm of gas.  However, Ukraine's gas storage 
facilities have a working capacity of 31 billion cubic meters 
(bcm).  As of June 19, Naftohaz had 19.5 bcm of gas in 
storage, meaning that spare capacity was far less that the 
additional 19 bcm that both Ukrainian and Russian officials 
have repeatedly said was needed to prepare for winter. 
Naftohaz and Sokolovsky,s best estimates were that 6 to 8 
bcm were needed, which was confirmed by Tymoshenko after the 
visit. 
 
3. (C) Tymoshenko argued that Ukraine needed a four month, 
$4.2 billion loan from the European Bank for Reconstruction 
and Development (EBRD) and European Investment Bank (EIB) to 
meet the cost of pumping gas into storage over the summer. 
(Note: Morningstar later heard that the $5 billion price tag 
included 20 percent VAT, hence the $4.2 billion was net of 
VAT payments.  End note).  Tymoshenko stated that Naftohaz 
would need to make the following monthly payments to Gazprom: 
 
July 7:           $250 million 
August 7:   $1.3 billion 
September 7:      $1.5 billion 
October 7:  $1.0 billion 
November 7:       $150 million 
 
To ensure transparency, Tymoshenko said that Ukraine would 
accept EU monitors inside Naftohaz to monitor gas storage 
facilities' levels and international auditors to monitor 
financial flows.  Ukraine would offer the gas in storage as 
collateral for any financing and would only extract gas as 
the loan was paid back. 
 
4. (C) Tymoshenko argued that the current financial crisis 
had worsened Naftohaz's position.  Naftohaz was unable to 
borrow from Ukrainian banks because of their low liquidity, 
and international banks were also unable or unwilling to 
extend Naftohaz credit.  Tymoshenko laid the blame on 
President Yushchenko for Russia's decision not to advance 
additional transit fees to cover the cost of gas to be pumped 
into storage. She said that Yushchenko had called Russian PM 
Putin to object to Tymoshenko's proposal.  Tymoshenko said 
that the situation could have been logically resolved by 
Russia advancing transit payments, but now the situation had 
turned serious.  The Prime Minister also said that in January 
she had told German Chancellor Merkel and EC President 
Barroso that the economic crisis could create conditions in 
which Ukraine would not be able to pay for gas.  Tymoshenko 
seemed to reject a proposal that the EU had been looking into 
that would have European companies purchase gas and place it 
 
KYIV 00001092  002 OF 006 
 
 
in storage in Ukraine, arguing that Ukraine would not be able 
to then ship that gas to Europe as the gas in storage was 
intended to meet Ukrainian demand. 
 
5. (C) Deputy Naftohaz Chairman Vadym Chuprun stated that the 
company had stored more gas at this point in the year than in 
any of the previous five years.  He said he understood the 
concerns of other European countries, particularly those 
wi
thout storage facilities, because of last winter's gas 
cutoff.  However, Chuprun argued that other European 
countries' concerns were not solely Ukraine's problem.  He 
asked why Ukraine, and not the producer (Russia) or the 
consumer (Europe), should pay to pump gas into storage. 
Chuprun argued that the gas price Naftohaz paid to Gazprom 
and the price it received for transit services were highly 
imbalanced.  He also noted that Naftohaz has transited 20 bcm 
less than average to Europe this year.  Due in part to low 
European purchases, the revenues of Ukrtransgaz, the gas 
transit system (GTS) operator, had dropped, and the GTS 
worked at 30-50 percent of its normal load.  Chuprun said he 
could point out several such factors currently shaping 
Naftohaz's finances and argued that the situation was not 
Naftohaz's fault. 
 
6. (C) Minister of Energy Prodan said that Ukraine needed 
$4.2 billion to cover the purchase of 19 bcm of gas.  Prodan 
stressed that Ukraine's gas storage facilities needed to be 
full to ensure the proper operation of the transit system in 
the winter.  Without being specific, Prodan said some 
legislative obstacles prevented the continued use of foreign 
currency reserves to finance gas payments.  Prodan also noted 
that Ukraine would be in the same position next summer -- 
needing to purchase gas during the summer for storage while 
lacking a steady stream of revenues to pay for it -- but 
hoped that Naftohaz would get financing in the domestic 
market. 
 
7. (C) Presidential Advisor Sokolovsky said that Ukraine 
would need only around $1.6 billion to fill its storage 
facilities to the needed volume of 25-26 bcm before the 
beginning of the heating season in mid-October.  Ukraine 
planned to use the balance of any $5 billion loan to refill 
the storage facilities in the winter, as gas prices were 
forecasted to fall in the fourth quarter to $190/thousand 
cubic meter (tcm) before rising again in the first quarter of 
2010 to $240/tcm.  According to Sokolovsky, Naftohaz 
currently collected about $150 million monthly, and in June 
2009 it would collect $170 million.  For June gas deliveries 
it would have to pay Gazprom about $290 million.  Naftohaz 
could cover the June payment, but not thereafter due to a 
lack of funds.  In July/August, Naftohaz would need $600 
million each month to pump gas into storage for the winter. 
Sokolovsky said that the IMF conditionality that set floors 
on the National Bank's foreign currency reserves would limit 
Ukraine's ability to continue financing gas payments through 
loans from the National Bank. 
 
Donors:  No Loans Without Reforms 
--------------------------------- 
 
8. (C) Representatives of the European Commission, World 
Bank, and the EBRD all agreed that any financing would need 
to be predicated on Ukraine undertaking needed reforms in its 
gas sector.  EBRD country director Andriy Kuusvik confirmed 
that EBRD had received a GOU request for a $5 billion working 
capital loan for Naftohaz.  He pointed out that EBRD was 
geared towards long-term project finance loans, and not 
well-situated for short-term working capital loans.  He also 
said the $5 billion price tag was far higher than anything 
EBRD could absorb.  Nonetheless the bank would be willing to 
take the lead in structuring a loan, but would expect 
multi-national lenders, individual countries and/or energy 
companies to contribute substantially.  He also said the bank 
would need three months in the best of cases to structure 
such a loan, whereas the GOU claimed that it needed the money 
soon. 
 
9. (C) Kuusvik also said that EBRD would expect clear, 
concrete and upfront reforms in return for its willingness to 
consider the loan request.  This was seconded by the World 
Bank country director Martin Reiser.  Although the World Bank 
 
KYIV 00001092  003 OF 006 
 
 
had not been approached, Reiser offered his personal opinion 
that the international community should demand genuine action 
on gas sector reforms before lending Naftohaz/Ukraine money. 
 He said donors should require a significant tariff increase 
before disbursing a loan; otherwise any GOU commitment to gas 
sector reform would not be credible.  He also suggested that 
donors require far more transparency into Naftohaz,s 
finances.   If Naftohaz needed money to 1) cover the deficit 
caused by domestic tariffs that were lower than cost, 2) buy 
gas from Gazprom, and 3) service its external debt coming due 
this year, then donors could demand a segmentation of funding 
to meet each of these needs.  The subsidy to cover the loss 
incurred by selling gas below cost could be a clear and 
transparent budget item which would allow anyone to see 
exactly how much government subsidies go to this purpose. 
Capital for gas purchases and debt servicing, if provided by 
donors in return for tariff reform, would come into 
Naftohaz's coffers through a direct donor loan.  This would 
bring transparency, prevent Naftohaz from cross-subsidizing, 
introduce truer accountability into the company's finances, 
and eliminate some of the rent-seeking that currently 
occurred in the company. 
 
10. (C) When asked by Morningstar and Elkind whether Naftohaz 
really needed the money, Reiser said that the GOU could 
continue to monetize Naftohaz's debt through central bank 
lending via the state-owned banks.  Foreign exchange 
reserves, when coupled with continued IMF disbursements and 
IMF flexibility towards foreign reserve conditionalities, 
should be sufficient to meet this year,s gas bill.  EC 
Delegation energy expert Hans Rhein noted that, in principle, 
Ukraine did not need 19 bcm in storage for the winter. 
Still, sizable reserves would be desirable if there were to 
be a harsh winter.  He speculated that Tymoshenko needed the 
cash and wanted to meet the contract requirements.  Ukraine 
and Russia had been pushing jointly in Europe for a financing 
solution over the last few weeks, but likely could resolve 
the payment issue on their own. 
 
11. (C) Morningstar stressed to all interlocutors that the 
United States would be willing to facilitate 
Ukrainian-Russian-European efforts to deal with Ukraine's 
short-term gas issues, but stressed that it was ultimately an 
issue for the three stakeholders to solve.  Morningstar also 
underlined that the proposed financing might help Naftohaz in 
the short-term, but that ultimately Ukraine would need to 
enact real, long-term reform. 
 
Gas Sector Reforms Needed--Timing and Severity Debated 
--------------------------------------------- --------- 
 
12. (C) Tymoshenko said she acknowledged that serious reforms 
were needed in the gas sector, but urged patience from the 
international community as Ukraine could not enact stringent 
reforms in the current economic and political climate.  The 
gas sector would be in much better condition if Ukraine could 
raise domestic gas prices to cost recovery levels, she said. 
She also agreed that Ukra
ine needed to end cross-subsidizing 
the sector and unbundle and modernize the GTS.  On gas 
prices, Tymoshenko pointed out that industrial consumers had 
paid market prices since the beginning of the year, and that 
household gas prices had been raised by 35 percent in the 
fall of 2008.  Tymoshenko claimed that payment collections 
from households dropped from 93-95 percent before the price 
hike to 78-79 percent after it.  Collections could drop to 50 
percent, she said, if prices were raised again by 35 percent. 
 Such stress could undermine the financial situation of 
Naftohaz.  Tymoshenko also feared that gas price increases, 
coupled with the high unemployment and salary cuts that 
resulted from the economic crisis, could lead to social 
unrest.  She said she wanted to raise gas prices, even double 
them, but that the current economic and political climate was 
too volatile to do so.  Before gas prices could be raised, a 
substantial system of social protection needed to be 
developed.  Tymoshenko said the IMF was making a 60 percent 
gas price increase for households a key prior action for the 
next $3 billion tranche of the Stand-By Agreement.  If 
Ukraine did not raise prices, it would not get the third 
tranche.  She asked the USG to intervene with the IMF to 
lessen the requirement and accept a detailed roadmap 
outlining sector reforms.  The roadmap would be implemented 
 
KYIV 00001092  004 OF 006 
 
 
once political stability was achieved, she said, without 
specifying how political stability was to be measured. 
 
13. (C) On the margins of his meeting with Morningstar, 
Sokolovsky told us that Tymoshenko was willing to increase 
household gas tariffs by 30 percent before the elections, but 
not by the 60 percent that the IMF was purportedly demanding. 
 He also told Morningstar that the GOU would submit to the 
Rada during the week of June 21-26 draft gas reform 
legislation that would remove criminal liability for gas 
companies that turn off gas deliveries to delinquent 
household customers, remove multi-tier gas prices, and 
address the issue of targeted subsidies for needy households. 
 In response to Morningstar,s question whether Yushchenko 
would support the laws, Sokolovsky said that Yushchenko and 
Tymoshenko had a "verbal agreement."  Sokolovsky said that 
Yushchenko had been urging gas sector reform for four years, 
but every government has found it easier to avoid unpopular 
decisions, and instead negotiate with Russia agreements that 
turned out to be unfavorable to Ukraine. Opposition leader 
Viktor Yanukovych was in general open to gas reform, 
according to Sokolovsky, and would likely approve big tariff 
hikes because he could blame them on the Prime Minister. 
 
14. (C) Leading Ukrainian industrialist and Yanukovych backer 
Viktor Pinchuk told Ambassador Morningstar that Tymoshenko 
would not enact difficult energy sector reforms ahead of the 
elections because they would lower her ratings.  Even with 
Tymoshenko's political skills, she could not blame a 60 
percent gas price increase on the IMF.  Pinchuk also 
dismissed the possibility of establishing an independent 
energy regulator, as no one in Ukraine would believe it was 
truly independent.  Ukraine's industrialists were not willing 
to lobby the government for energy sector reforms, he said, 
although they had already begun investing in energy 
conservation. 
 
15. (C) Tymoshenko reiterated her support for the joint 
declaration signed by the EU, EBRD, World Bank, EIB, and 
Ukraine on March 23 in Brussels that seeks to link 
international financing for GTS modernization with gas sector 
reforms in Ukraine.  She said that Ukraine must work to 
unbundle the GTS but outlined three issues that complicated 
that process.  First, Ukrainian law prohibited changes in 
Naftohaz property.  The law was intended to prevent Russian 
takeover of the pipeline.  Second, Naftohaz had long term 
loans with European banks that allowed the banks to demand 
early repayment if pipeline ownership changed.  Third, the 
contracts between Naftohaz and Gazprom could slow 
restructuring of Naftohaz.  However, Ukraine was ready, 
Tymoshenko said, to develop a plan to implement the Brussels 
declaration.  Prodan said that Ukraine was working to fulfill 
needed requirements in the gas sector to join the European 
Energy Community, but that such reforms would take time. 
Naftohaz's Chuprun stated that the implementation of the 
March 23 agreement was Ukraine's only possibility to 
modernize the GTS.  Naftohaz had already undertaken many 
efforts to implement it, including starting feasibility 
studies on separate projects.  Chuprun noted that the March 
23 agreement was signed without knowledge of future Russian 
gas shipments, European consumption, or transit rates. 
Naftohaz could not develop a modernization plan without such 
parameters, he said.  Tymoshenko said Ukraine was already 
implementing energy efficiency programs and other ways to 
reduce gas consumption.  Funds from the sale of carbon 
credits under the Kyoto Agreement would modernize municipal 
heating boilers and reduce gas consumption by 50 percent, she 
claimed. 
 
16. (C) Ambassador Morningstar said the USG could help 
Ukraine set up targeted subsidy programs and a roadmap for 
the needed reforms.  Morningstar stressed that a detailed 
roadmap could bring confidence to European doubters.  DOE 
PDAS Elkind noted that under Tymoshenko's leadership in the 
1990s, Ukraine implemented a series of reforms in the 
electricity sector that eventually attracted both foreign and 
domestic investors.  He noted that the gas sector reforms 
would be even more complicated, but added that the USG was 
looking for constructive ways to assist Ukraine's reform 
efforts.  He urged Tymoshenko to develop a reform plan now so 
that efforts could begin immediately after the elections. 
 
KYIV 00001092  005 OF 006 
 
 
Deputy Prime Minister Hryhoriy Nemirya suggested that the 
upcoming visit of Vice President Biden could be used to 
bolster US-Ukrainian cooperation in the energy sector as part 
of the bilateral working group on energy. 
 
January 2009 Contracts 
----------------------- 
 
17. (C) Prime Minister Tymoshenko gave a relatively positive 
assessment of the January 2009 gas supply and transit 
contracts, even claiming that the January crisis had somewhat 
of a "purifying effect" because intermediary Rosukrenergo was 
removed, and gas prices were now set by a fixed formula, 
eliminating the need for end-of-year negotiations. 
Tymoshenko noted that the quarterly price adjustments occur 
without any difficulty. 
 
18. (C) Naftohaz's Chuprun, however, was openly critical of 
the contracts, arguing that both gas prices and transit fees 
should have moved towards market levels. He said Naftohaz had 
been prepared to accept Gazprom's offers of $238/tcm and 
$2.34/tcm/100km for transit.  However, when Ukraine failed to 
agree to those conditions, gas supplies were cut off, and &#x0
00A;Gazprom demanded $450/tcm.  Chuprun said the contract 
ultimately signed on January 19 gave Ukraine a 20 percent 
discount on gas prices in 2009 but kept gas transit fees at 
their 2008 levels of $1.70/tcm/100km.  Chuprun said the low 
fees meant that the needed investment in the GTS was two 
times the cost of transit operations.  Separately, the World 
Bank's Reiser had agreed that Russia had a great deal, as 
Ukraine's gas prices were 10 percent higher than Germany's, 
whereas Ukraine was getting half of what it should for 
transit. 
 
Alternative Corridors 
---------------------- 
 
19. (C) Nemyria said Ukraine wanted to diversify its natural 
gas supplies.  Tymoshenko said that Ukraine would have 
sufficient capacity for Nabucco to feed into the Ukrainian 
GTS.  Naftohaz strongly rejected Russian proposals for 
alternative gas pipeline corridors and noted that discussion 
of alternative routes bypassing Ukraine had increased since 
the January crisis.  Chuprun rejected any notion that the 
Ukrainian GTS would not be needed in three to five years, 
calling it the only "serious stream" to Europe. 
 
Nuclear Issues 
--------------- 
 
20. (C) Morningstar urged Tymoshenko and Prodan to expedite 
implementation of contracts with Westinghouse and Holtec 
International for nuclear fuel supplies and Ukraine's Central 
Spent Nuclear Fuel Storage Facility.  Timely and successful 
implementation of these contracts would help send a positive 
signal to Congress, which had allocated hundreds of millions 
of dollars to Ukraine's nuclear sector, said Morningstar.  He 
also urged his interlocutors to take advantage of Holtec's 
offer to finance its project despite the severe financial 
crisis.  At Morningstar,s request, Tymoshenko agreed to meet 
with Westinghouse and Holtec executives for a full brief on 
each project. 
 
OPIC 
----- 
 
21. (C) In his meeting with Tymoshenko, Ambassador 
Morningstar raised the ongoing efforts to solve OPIC's 
outstanding claim against Ukraine and urged her to complete 
all requirements so that Ukraine could be requalified for 
OPIC financing.  Tymoshenko assured Morningstar that all 
necessary government resolutions had been passed. 
 
Political Climate Ahead of Presidential Elections 
--------------------------------------------- ----- 
 
22. (C) Ambassador Morningstar met with businessman and Party 
of Regions MP Andriy Klyuyev to discuss the current political 
situation following the failed attempt to establish a broad 
coalition between Party of Regions and PM Tymoshenko's party, 
BYuT.  Klyuyev said the coalition would have been "great" for 
 
KYIV 00001092  006 OF 006 
 
 
Ukraine, but it failed because Tymoshenko and Party of 
Regions' leader Victor Yanukovych could not overcome their 
"personal mistrust" of each other.  Negotiations to form the 
coalition lasted 18 months.  Klyuyev said he believed that 
Ukrainians were willing to trade direct election of the 
president for stability and growth.  Separately, Viktor 
Pinchuk agreed that the coalition failed due to a lack of 
trust in the two camps.  Tymoshenko, he said, was power 
hungry, while Yanukovych's popularity ratings were high 
enough to convince him that he did not need the coalition to 
attain higher office.  Pinchuk also said that the coalition 
attempts were simply a means to divide power between 
political forces, and not an attempt to do what was right for 
Ukraine. 
 
23. (C) Klyuyev and Pinchuk both thought that Yanukovych, 
Tymoshenko, and Arseniy Yatseniuk are the only real 
contenders in the 2010 presidential elections.  Both said 
that the economic crisis made the outcome of the elections 
very difficult to predict.  Klyuyev pointed to Yanukovych's 
2007 premiership to assert that Yanukovych was pro-Ukrainian 
and not pro-Russian.  According to Pinchuk, Tymoshenko had 
two opponents: Yanukovych and the economic crisis.  Any 
further financial shock would hit Tymoshenko hard.  Pinchuk 
believed that Yatseniuk would have a good chance of becoming 
prime minister if Yanukovych won the election.  After noting 
that he had recently met with high-level Russian officials, 
Pinchuk said that the Russians would not find Yatseniuk 
acceptable as president.  Yanukovych was the best option for 
Moscow, as cooperation between Russia and Ukraine would be 
better under a Yanukovych administration.  However, Pinchuk 
thought that Russia would be "quiet" before the elections and 
"bet on both" Tymoshenko and Yanukovych. 
 
24. (U) Ambassador Morningstar's staff has cleared this cable. 
PETTIT

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