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Cablegate: Sri Lanka: Iran Refinery Offer Going Ahead, but in Whose

VZCZCXRO3429
RR RUEHDE RUEHLMC
DE RUEHLM #0503/01 1480416
ZNR UUUUU ZZH
R 270416Z MAY 08
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 8170
INFO RUCPDOC/USDOC WASHDC
RUEHNE/AMEMBASSY NEW DELHI 2056
RUEHKA/AMEMBASSY DHAKA 0911
RUEHIL/AMEMBASSY ISLAMABAD 7900
RUEHKT/AMEMBASSY KATHMANDU 6077
RUEHLO/AMEMBASSY LONDON 4413
RUEHKB/AMEMBASSY BAKU 0014
RUEHKP/AMCONSUL KARACHI 2352
RUEHCG/AMCONSUL CHENNAI 8512
RUEHDE/AMCONSUL DUBAI 0149
RUEHC/DEPT OF LABOR WASHDC
RUEATRS/DEPT OF TREASURY WASHDC
RUEHLMC/MILLENNIUM CHALLENGE CORP WASHINGTON DC

UNCLAS SECTION 01 OF 03 COLOMBO 000503

SENSITIVE

SIPDIS

STATE FOR SCA/INS, EEB/CBA, AND EEB/ESC/IEC
STATE PASS USTR FOR V KADER AND USTDA FOR J NAGY
COMMERCE FOR JONATHAN STONE AND EROL YESIN

E.O 12958: N/A
TAGS: EINV ENRG PREL CE IR CH
SUBJECT: SRI LANKA: IRAN REFINERY OFFER GOING AHEAD, BUT IN WHOSE
INTEREST?

REF: A. 2007 COLOMBO 1707 B. COLOMBO 431 C. 2007 COLOMBO 1050

1. (SBU) Summary and comment: Iran's offer of concessionary
financing for a major expansion of Sri Lanka's sole oil refinery was
firmed up with the late April visit of President Ahmadinejad to Sri
Lanka. Iran has promised to lend Sri Lanka 70% of the estimated
$1.2 billion project cost, at a concessionary interest rate of
roughly 5-6%, with a five year grace period followed by a ten-year
repayment period. Iran will select a contractor for the work, to be
agreed by Sri Lanka. The estimated cost of the refinery has grown
significantly from the $700-800 million that the American firms had
calculated; this large "fudge factor" may be the best explanation
for why Iran is so generously offering financing for the project. A
second reason may be the potential for Sri Lanka to sell to Iran
some of the refined oil it produces, presumably at a friendly rate.
With the head of the state-owned Ceylon Petroleum Corporation now
eager to do the Iran deal, there is now little prospect for U.S.
firms Global Energy and ENGlobal to end up with the work. Yet, like
other big infrastructure project plans in Sri Lanka, there remains a
high probability of this one never actually getting built. The saga
also demonstrates Sri Lanka's continued poor transparency related to
government procurement -- an agenda issue in upcoming U.S.-Sri Lanka
Trade and Investment Framework Agreement (TIFA) talks. End summary
and comment.

IRAN TO LEND GENEROUSLY FOR NEW REFINERY
----------------------------------------

2. (SBU) Ceylon Petroleum Corporation (CPC) Chairman Asantha de Mel
told Econoff that, despite his earlier doubts (ref A), it appears
Iran will actually finance an expansion and upgrade of Sri Lanka's
sole oil refinery at Sapugaskanda outside Colombo. De Mel said
that, during the April 28-29 visit of Iranian President Ahmadinejad
(ref B), Iran delivered a pre-feasibility study for the proposed
refinery work and the two countries agreed to the following general
terms for the deal:

-- Iran to finance 70% of the estimated $1.2 billion project cost.

-- Concessionary interest rate of roughly 5-6%, with a five-year
grace period followed by a ten-year repayment period.

-- National Iranian Oil Refining and Distribution Company (NIORDC)
to select contractor; Sri Lanka to have right to approve Iran's
selection.

-- Construction to take approximately 3.5 years.

-- Expansion to double the output from 50,000 to 100,000 barrels per
day capacity.

-- Refinery to be capable of processing all forms of crude,
including heavy.

-- Refinery output to be roughly 40% heavy fuel oil; the remainder a
mix of diesel, gasoline, and liquid natural gas.

-- The project would qualify under Board of Investment regulations
for a twenty year tax holiday.

-- Sri Lanka's Treasury would give Iran a loan guarantee.

3. (SBU) CPC Chairman De Mel explained that Sri Lanka, which had had
no luck generating financing to expand the refinery on its own,
could hardly turn down Iran's concessionary loan offer. He said
that the new refinery would eliminate Sri Lanka's need to import
refined oil products, saving the country about $750 million dollars
a year. He calculated that Sri Lanka could use these savings to
prepay the loan "in 2 1/2 years." (It was unclear if he meant,
presumably, after the five-year grace period.) He emphasized that
Sri Lanka would not be limited to buying only Iranian light crude as
an input because the improved facility would be capable of refining
all grades up to heavy crude. He noted that its output of heavy

COLOMBO 00000503 002 OF 003


fuel oil could be used in the country's thermal power generating
plants. He expected that total production would exceed domestic
demand, making it possible to export some refined oil products.

4. (SBU) As to why Iran was eager to finance a refinery in Sri Lanka
when its own domestic refining capacity was insufficient, de Mel
said he had asked the Iranians the same question. They had replied
that it made more sense for Iran to invest in expanding domestic oil
production capacity, since its profits on production are higher than
its potential savings from increased domestic refining. For this
reason, Iran would be interested, de Mel expected, in purchasing
refined oil from Sri Lanka.

CPC STILL WILL NEED $360 MILLION OR MORE
----------------------------------------

5. (SBU) The 70/30 funding split means that Sri Lanka will have to
pay approximately $360 million for its share of the refinery
construction cost. De Mel told EconOff that he expects the refinery
could ultimately cost not $1.2 but $1.4 billion due to escalating
construction costs. If so, Sri Lanka's cost would rise to $560
million. De Mel asked if U.S. banks might be interested in lending
that money. EconOff replied that U.S. banks would probably be wary
of, if not outright prohibited from, a deal which so closely
involved Iran.

GOAL: CPC TO NOT LOSE MONEY LIKE IT IS NOW
------------------------------------------

6. (SBU) De Mel reiterated his vision that the Ceylon Petroleum
Corporation would operate at a profit with the expanded refining
capacity. The ability to refine and sell all of Sri Lanka's fuel
demand would make the CPC profitable for the first time, he
anticipated. He explained that, despite the government allowing CPC
to raise retail fuel prices periodically in 2007, the state
enterprise is currently operating at a loss of about 30 Rupees
($0.28) per liter of fuel it sells, due to the increased price it is
paying for crude. He expected to be able to reduce this loss by
raising retail prices again in May or June; however, the government
has been telling local media that it does not intend to permit a
price rise in the near future.

US FIRMS GLOBAL ENERGY AND ENGLOBAL ON SIDELINES...
--------------------------------------------- ------

7. (SBU) CPC's progress with Iran on the proposed deal leaves
would-be U.S. investors Global Energy & Industrial Operations (GEIO)
and ENGlobal farther than ever from securing the right to expand and
upgrade the Sapugaskanda refinery as private investors (refs A and
C). Iran's undertaking the feasibility study for the project --
"for free," according to de Mel -- also means the CPC will not
proceed with the feasibility study contract it had planned to award
to ENGlobal last fall.

...HOLDING THEIR NOSES
----------------------

8. (SBU) The two companies' reactions to the Iran-Sri Lanka plans
were similar: both noted numerous ways in which the deal was likely
to be bad for Sri Lanka. Most significant is that it will probably
waste a lot of public money, by having Sri Lanka overpay for an
inferior product. Noting that the project cost has grown from
around $700 million to $1.2 (or even $1.4) billion, ENGlobal's Sri
Lankan representative told EconOff, "this stinks to high heaven."
Global Energy's principal described CPC Chairman de Mel as "an
operator" with no knowledge of the oil industry. (Note: de Mel is a
marriage relative of President Rajapaksa and was formerly in the
garment industry before the president appointed him to be CPC
chairman.)

9. (SBU) The GEIO and ENGlobal reps also feared the project could
fail to fully utilize the still-valuable asset of the existing
refinery. Worst, they said, would be if the new refinery was built

COLOMBO 00000503 003 OF 003


using technology incompatible with the old refinery. This would
create operating complexities and increase operations and
maintenance costs. They noted that the existing refinery uses
proprietary technology of American firm UOP. Noting that UOP is
blocked by US sanctions from selling its technology to Iran, they
speculated that Iran or its contractor would likely use competing,
incompatible, technology by French firm Axens. They also noted that
a worldwide backlog of orders for new refineries meant that Sri
Lanka's project would probably end up on a waitlist running three to
five years.

ACCOUNTABILITY MISSING AS UNIONS SPLIT,
EXPERIENCED MANAGER SIDELINED
---------------------------------------

10. (SBU) The ENGlobal rep added that the government and CPC
management would normally have a hard time pushing an overpriced,
technically inappropriate project past the enterprise's strong and
influential unions. However, the recent split in the leadership of
the Marxist JVP party had led to a split along the same lines in the
powerful JVP union within the CPC, which resulted in the union being
unable to threaten serious labor action to block the plan. He also
noted that the CPC had recently skipped over appointment of its most
experienced engineer to the position of overall manager of the
Sapugaskanda refinery. He believed that the CPC and the government
were rushing forward on the Iran deal while the unions and refinery
management were weak.

POSSIBLE CHINA LOAN AND CONSTRUCTION ROLE?
-------------------------------------------

11. (SBU) The engineer passed over for refinery manager is suing the
CPC in a "fundamental rights" case to try to gain the post he would
have been entitled to based on normal seniority promotion practices.
The ENGlobal rep repeated to EconOff the engineer's prediction for
how the Iran project might go forward: noting that Sri Lanka will
likely have difficulty coming up with the $360 million or more for
its share of the project, he expects Sri Lanka to turn to China to
lend it that amount, in exchange for the refinery construction
contract going to a Chinese firm.

COMMENT: SHOULD HAVE GONE WITH GLOBAL ENERGY
--------------------------------------------

12. (SBU) The $360-560 million that Sri Lanka will have to borrow
for its share of the Iran-financed project equals half or more of
the entire estimated $700-800 million that Global Energy and
ENGlobal say the project should cost. Given that the Ceylon
Petroleum Corp's perennial losses prevented it from getting bank
financing in the past, it seems unlikely to be able to raise the
money on the open market now. This makes the idea of a
supplementary loan from China look plausible. So too do the
politics of the entire Iran-Sri Lanka aid relationship, with Iran
and China both being vocal about giving Sri Lanka "unconditional"
aid.

13. (SBU) Ultimately, however, we would be surprised if the Iran
refinery project materializes. It will likely falter on the
combination of the long waitlist for refinery construction, the
large amounts of money that Iran and Sri Lanka would have to invest,
and an eventual effort by the unions, the opposition, or the courts
to block it. This has been the case for other high profile
infrastructure projects that have languished for decades amidst
charges of politicization and corruption. We think a time will come
when Sri Lanka will wish it had never abrogated its 2004 MOU with
Global Energy. If that plan had gone forward, Global Energy would
now probably be nearing the end of construction on a state-of-the
art refinery using compatible UOP technology and fully private
financing that would not have cost Sri Lanka a cent. Washington
agencies may wish to keep this case in mind when discussing
government procurement with Sri Lanka in upcoming Trade and
Investment Framework Agreement (TIFA) talks.
MOORE

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