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Cablegate: Ukraine: Gou Signals Interest in Trilateral Bypass Pipeline

VZCZCXRO9360
PP RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #1461/01 2121225
ZNR UUUUU ZZH
P 301225Z JUL 08
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC PRIORITY 6104
INFO RHEBAAA/DEPARTMENT OF ENERGY WASHDC
RUCPDOC/USDOC WASHDC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 03 KYIV 001461

SENSITIVE
SIPDIS

DEPT FOR EUR/UMB,EB/ESC/IEC - WRIGHT
DOE PLEASE PASS TO LEKIMOFF, CCALIENDO
USDOC FOR 4231/IEP/OEENIS/NISD/CLUCYK

E.O. 12958: N/A
TAGS: EPET EFIN ECON ENRG PREL UP
SUBJECT: UKRAINE: GOU SIGNALS INTEREST IN TRILATERAL BYPASS PIPELINE
PROJECT

Sensitive But Unclassified. Not for Internet Distribution

Summary
-------

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

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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
pipeline.

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
Modernization
--------------------

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

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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 statutory 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.

TAYLOR

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