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Cablegate: Ukraine: Naftohaz Continues to Face Major

VZCZCXRO5004
RR RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #1950/01 2741423
ZNR UUUUU ZZH
R 301423Z SEP 08
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC 6427
INFO RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RHMFISS/DEPT OF ENERGY WASHINGTON DC

UNCLAS SECTION 01 OF 03 KYIV 001950

SENSITIVE
SIPDIS

DEPT FOR EUR/UMB, EEB/EEC/IEC - LWRIGHT
DOE FOR LEKIMOFF, CCALIENDO
USDOC FOR 4231/ITA/OEENIS/NISD/CLUCYK

E.O. 12958: N/A
TAGS: EPET EINV PREL ENRG PINR UP
SUBJECT: UKRAINE: NAFTOHAZ CONTINUES TO FACE MAJOR
FINANCIAL CHALLENGES

SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION

1. (SBU) Summary. NaftoHaz, Ukraine's state-owned oil and
gas enterprise, continues to face major financial challenges
as Russia and Ukraine continue highly-anticipated 2009 gas
negotiations. In addition to debt owed to its gas suppliers,
NaftoHaz faces various other financial difficulties,
including collecting payments from its customers and
subsidiaries; Ukrainian government interference in price
structuring; complications in plans to restructure the
domestic gas market; and a likely steep gas price increase in
2009. The GOU proposed several actions intended to improve
NaftoHaz's financial condition, but the 8 billion hryvnia
(UAH) or $1.58 billion NaftoHaz had hoped for in the state
budget was not approved, forcing NaftoHaz to look outside the
government for loans just to stay afloat. Despite NaftoHaz's
troubles, the current government has also made all
hydrocarbon development the direct responsibility of
NaftoHaz, severely limiting opportunities for foreign
investors to provide much-needed capital and technical
know-how to the state-owned firm. End Summary.

What Does NaftoHaz Currently Owe for Gas?
-----------------------------------------

2. (SBU) Pinning down the exact amount of debt NaftoHaz owes
Gazprom and/or its intermediaries is extremely difficult. In
July, RosUkrEnergo (RUE), the shadowy gas intermediary that
purchases gas from Gazprom and sells it to NaftoHaz, accused
NaftoHaz of owing it more than $2 billion. According to RUE
officials, this debt included arrears from previous years,
the debt on Russian gas consumed in the first quarter of
2008, the debt for Central Asian gas shipped in the second
quarter, and payments due for gas shipped in summer 2008.
NaftoHaz asserted that its debt to RUE did not exceed $897
million as of July 1, and that $650 million of that amount
was for gas purchased in June 2008, which was being paid on
schedule. In August, NaftoHaz returned the equivalent amount
of Central Asian gas to RUE as payment for the Russian gas
previously consumed. The major outstanding issue appears to
be whether, and how much, NaftoHaz owes RUE on gas from
previous years. In addition to the RUE debt, the Ukrainian
press reported the Ukrainian-based intermediary UkrHazEnerho
(UHE) as claiming that NaftoHaz owes them $270 million for
gas purchases.

Where Does NaftoHaz Stand in Terms of Loans?
-------------------------------------------

3. (SBU) While NaftoHaz tries to clear up its debts to
Gazprom and the intermediaries, it remains saddled with a
sizable loan burden. In a July press interview, NaftoHaz
Chairman Oleh Dubyna reported that payments of $800 million
had been made so far this year to service loans, decreasing
NaftoHaz's current liabilities on foreign loans to 10.5
billion hryvnia (UAH) or $2.3 billion. While NaftoHaz has
not, according to Dubyna, increased its corporate debt in
2008, it is attempting to obtain UAH 8 billion in loans from
Ukrainian banks for gas purchases as it tries to increase the
amount of gas in storage to 15 billion cubic meters (bcm)
from the current 8 bcm prior to the heating season. If it
can store gas purchased at a cheaper price, it will delay
exposure to the higher prices expected in 2009.

Outstanding Debt to NaftoHaz: Dividends, Transportation and
Storage, and Nonpayment
--------------------------------------------- -----------

4. (SBU) In addition to its outstanding liabilities, NaftoHaz
continues to have difficulty in securing its accounts
receivable, which include the following:

- Dividends: NaftoHaz claims that RUE obstructionism has
prevented holding a UHE shareholder's meeting that could
resolve the matter of more than $180 million in UHE dividends
owed to NaftoHaz for 2006-2007. (Note: NaftoHaz oil
subsidiary Ukrnafta also owes NaftoHaz approximately UAH 2
billion ($440 million) in dividends for oil revenue. End
Note.)

- Transportation and Storage Fees: NaftoHaz claims that RUE
owes it $141.8 million for gas transit for the period of
December 2007-July 2008, while UHE owes it about $150 million
for gas transportation and storage for the same period.

KYIV 00001950 002 OF 003

- Customer Nonpayment: Nonpayment by customers continues to
be a significant problem. According to Dubyna, gas consumers
accumulated the following debts to NaftoHaz in January-May
2008: municipal heat producing plants--UAH 1.8 billion;
residential consumers--UAH 153 million; industrial
consumers--UAH 450 million.

GOU Pricing Policy Detrimental
------------------------------

5. (SBU) NaftoHaz is mandated by the government to supply gas
at prices far below the cost of imported gas to residential
consumers, state-financed entities and public utility
companies. NaftoHaz officials complain that GOU pricing
policies for gas make it difficult for NaftoHaz to improve
its precarious financial situation. According to Dubyna, the
GOU requires that NaftoHaz provide gas to households at
around $50 per thousand cubic meters (tcm). In theory,
cheaper domestically-produced gas is supplied to these
consumers but, in reality, the amount produced is
insufficient to meet the demand and must be supplemented with
imported gas. (Note: The current price for imported gas is
currently $179.5 per tcm. End note.) NaftoHaz officials
assert that either gas prices should be raised or the GOU
should subsidize the company for losses it incurs by selling
gas to these sectors below cost. (Note: While there have
been increases in rates to these groups, they have thus far
been insufficient to make up for the shortfall. End Note.)

6. (SBU) In addition to setting prices based on consumer
categories, the GOU sets the price for domestically produced
gas at prices ranging from $90-$140 per tcm depending on the
amount of consumption, which discourages exploration and
production. NaftoHaz officials have stated that, for the
first time, domestic gas production dropped in 2007 because
it was no longer financially viable.

Intermediary UkrHazEnerho (UHE) Not Gone Yet
--------------------------------------------

7. (SBU) Following Tymoshenko's gas negotiations with Russia
earlier this year, it appeared that UHEs days on the domestic
market were numbered and that NaftoHaz would once again be
able to profit from sales to industrial customers. Ukraine
succeeded in having NaftoHaz replace UHE as the importer of
natural gas to Ukraine, an important step towards reclaiming
its former prominence in the domestic market. However, court
decisions have breathed new life into the gas intermediary.
The Kyiv administrative court of appeals this past summer
ruled against a decision by the National Electricity
Regulatory Commission that had limited the volume of gas UHE
could supply to Ukrainian consumers at an unregulated rate.
Limitations were subsequently lifted and it is uncertain
whether UHE will undersell NaftoHaz to lure away industrial
customers. NaftoHaz, as the sole importer of gas to Ukraine,
presumably will not sell to UHE; it already is selling 7.5
bcm to Gazpromsbyt of Ukraine, a Gazprom subsidiary and the
named replacement for UHE. If that is the case, UHE would be
limited to selling only the gas it presently has in storage,
but could still eat into NaftoHaz's anticipated income this
year.

Gas Price Negotiations for 2009 Don't Bode Well
--------------------------------------------- --

8. (SBU) When Tymoshenko returned from talks in Moscow in
late June, she announced that she had reached an
understanding with Putin to raise the price of gas sold to
Ukraine to European levels over a three or four year period
and expected to sign a long-term gas agreement reflecting
this by September 15. Putin reportedly indicated he
supported the gradual price increase in principle, but stated
that the prices would be worked out by the companies involved
and would be affected by the Central Asian gas price for
2009. Based on a July 25 preliminary agreement between
Gazprom and Turkmenistan on price formation principles,
Russian energy analysts calculate that Gazprom would purchase
Turkmen gas in 2009 at a price ranging from $225 to $295 per
tcm. Such a scenario would imply that the price of gas for
Ukraine will rise sharply from the current $179.5 per tcm,
edging uncomfortably close to $400 for Ukraine as originally
put forward by Gazprom as a possibility. Nevertheless, the
significant price jump would continue to push NaftoHaz into

KYIV 00001950 003 OF 003


further arrears, especially if NaftoHaz is prevented from
passing on increased costs to its customers.

Recent and Ongoing Audits
-------------------------

9. (SBU) According to NaftoHaz's 2006 Consolidated Financial
Statements, audited by Ernst and Young, NaftoHaz incurred a
net loss attributable to equity holders of UAH 2,205 million
and as of December 31, 2006, its current liabilities exceeded
its current assets by UAH 12,219 million. The press has
reported that Ernst and Young continues to complete its 2007
audit, and those results are not expected until the summer of
2009. On a separate track, Chief of the Main Auditing
Directorate, Mykola Syvulskyy, has sent a preliminary audit
report on NaftoHaz to the Cabinet of Ministers. In a press
interview, Syvulskyy indicated that former senior managers of
NaftoHaz deliberately tried to bankrupt the company.

GOU Assistance for NaftoHaz
----------------------------

10. (SBU) The 2008 national budget contains a provision
compensating NaftoHaz for the losses incurred on selling gas
to public utility companies in the amount of UAH 4.3 billion.
The Cabinet of Ministers (CabMin) has also proposed that
parliament grant a non-interest-bearing loan of UAH 800
million to NaftoHaz to buy and pump imported natural gas to
underground gas storage facilities in 2008, which would be
transferred to heat supply companies next year. In addition,
the Cabinet tabled a draft law in the Parliament obliging
NaftoHaz-founded companies UHE and Ukrnafta to pay NaftoHaz
approximately UAH 2.5 billion in dividends from revenue
received in 2006-2007.

Weak FY07 Results Anticipated
-----------------------------

11. (U) On August 8, Moody's Investors Service downgraded
NaftoHaz's Ba3 foreign currency corporate family rating to
B1. Less than a week later, Fitch Ratings issued a press
statement indicating that it anticipates weak FY07 results,
stemming largely from NaftoHaz's inability to fully recover
gas import prices from its domestic sales. In Fitch's view,
a positive resolution of the state budget and gas storage
financing issues might be sufficient to avoid a negative
credit impact from the publication of weak FY07 results. In
addition, there are growing concerns that NaftoHaz could find
itself in technical default because it is late in reporting
its financial results.

12. (SBU) COMMENT: NaftoHaz continues to face severe
financial challenges. Even if its debt to RUE is relatively
minimal, servicing and paying off loans will continue to make
capital scarce for the company and, with significantly higher
gas prices seemingly inevitable in 2009, it will become
increasingly difficult for NaftoHaz to achieve profitability.
Moreover, NaftoHaz's financial straits leave NaftoHaz little
money for the development of much-needed hydrocarbons, which
the Tymoshenko government believes should be developed solely
by NaftoHaz without the capital or technical assistance of
foreign partners. End comment.
PETTIT

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