Cablegate: Embassy Kyiv

DE RUEHKV #0013/01 0040719
O 040719Z JAN 08





E.O. 12958: N/A

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

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sector in Ukraine had become more energy efficient in recent years.
The OECD report indicates that in 2004 total final consumption of
energy per 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

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.


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.


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