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Cablegate: Ukraine: Naftohaz Turns Off Tap to Delinquent Gas

VZCZCXRO5776
RR RUEHIK RUEHLN RUEHPOD RUEHVK RUEHYG
DE RUEHKV #2221/01 3121329
ZNR UUUUU ZZH
R 071329Z NOV 08
FM AMEMBASSY KYIV
TO RUEHC/SECSTATE WASHDC 6701
INFO RHMFISS/DEPT OF ENERGY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUCNCIS/CIS COLLECTIVE
RUEHZG/NATO EU COLLECTIVE

UNCLAS SECTION 01 OF 02 KYIV 002221

SENSITIVE
SIPDIS

DEPT FOR EUR/UMB,EB/ESC/IEC-WRIGHT, GALLOGLY
DOE PLEASE PASS TO LEKIMOFF, CCALIENDO

E.O. 12958: N/A
TAGS: ENRG EPET ECON UP

SUBJECT: UKRAINE: NAFTOHAZ TURNS OFF TAP TO DELINQUENT GAS
SUBSIDIARIES AS ITS FINANCES WORSEN

REF: A) KYIV 2173, B) KYIV 1950

TREAT AS SENSITIVE BUT UNCLASSIFIED NOT FOR INTERNET DISTRIBUTION

1. (SBU) Summary. Ukraine's state-owned oil and gas company
Naftohaz Ukrainy has refused to supply gas to some of its subsidiary
companies until debts to Naftohaz are paid. The socially unpopular
decision has resulted in the closing of some schools and public
buildings due to a lack of heat. The GOU also announced a 35 percent
gas hike for domestic consumers beginning December 1 with increases
up to 50 percent scheduled for 2009, in an effort to bring
traditionally low domestic gas prices closer to European market
prices. As Naftohaz's financial situation continues to deteriorate,
it is actively exploring options previously considered socially
taboo in order to service its debts to Gazprom. At the same time,
it is struggling to keep some creditors from cashing in their
Eurobonds later this month because of its inability to provide
financial data as required in its bond agreements. End summary.


Naftohaz Calls in Debts from Subsidiaries
-----------------------------------------

2. (SBU) The Naftohaz decision to get tough on its subsidiaries
comes after an October 2 memorandum of understanding signed by Prime
Ministers Putin and Tymoshenko (ref A). According to that document,
Naftohaz must settle its outstanding debts (approximately $1.8
billion and 11 billion cubic meters of gas) before Gazprom agrees to
the removal of intermediary RosUkrEnergo (RUE) and to the signing of
a long-term contract and to prices for gas deliveries in 2009.

3. (SBU) According to Naftohaz Chairman Oleh Dubyna, as of October
2, local gas distribution and municipal heating companies owe
Naftohaz 1.16 billion UAH ($201 million) for gas supplied last
winter. Six of 53 local gas distribution companies have not had
their contracts renewed with Naftohaz due to outstanding debts.
These include gas suppliers from the western regions of Zakarpatia,
Lviv, Ivano-Frankivsk, Chernivtsi, Volyn and Vinnitsya.

4. (SBU) Among municipal heating companies, the largest debtors were
in the heavily industrialized regions of eastern Ukraine, including
Kharkiv, Donetsk, Dnipropetrovsk, and Luhansk. However, Lviv in
western Ukraine and the Crimean Autonomous Republic are both
indebted to Naftohaz as well.

Gas Supply Interruptions Affect the Population
--------------------------------------------- ---

5. (SBU) Ukrainian news agencies reported that city officials in the
western town of Ivano-Frankivsk temporarily closed 18 secondary
schools on October 22 due to low classroom temperatures. The
temperature in buildings dropped below 15-16 degrees Celsius
(59-61 F). The mayor's office could not say when heat supplies
would resume; acknowledging that the municipal gas distribution
company owed millions of hryvnya to Naftohaz subsidiary Gaz Ukrainy.
Ivano-Frankivsk had temporarily cut short hours in schools, and
gave parents of elementary students the option of keeping young
children home until schools are heated again. In Kharkiv in
eastern Ukraine, heat supplies had not resumed in about 13 percent
of the buildings as of November 3, and schools in the city were also
affected by gas supply disruptions.

GOU Interventions
-----------------

6. (SBU) President Yushchenko initiated the process by issuing a
decree on October 3, ordering the termination of gas supplies until
debtors pay off their debts or came forward with bank guarantees.
The same decree instructed the Cabinet of Ministers to transfer an
additional UAH 9.1 billion ($1.58 million) to Naftohaz and UAH 2.4
billion ($417 million) in subsidies to local budgets in 2008 to
compensate utility companies for the gap between their costs and the
unrealistically low rates their companies are required to charge to
customers.

7. (SBU) While the issue of subsidies will have to be approved by
the Parliament as part of amendments to the 2008 budget, Prime
Minister Tymoshenko urged all regional governors on October 22 to
ensure payment of debts to Naftohaz and instructed the Ministry of
Fuel and Energy and Naftohaz's Head to supply gas necessary for
resumption of centralized heat supply as soon as possible. To date,
Naftohaz officials report that outstanding debts have not been paid,
and that gas supplies will not be resumed until the debts are paid.


KYIV 00002221 002 OF 002


Naftohaz's Financial Situation Worsens
--------------------------------------

8. (SBU) As Naftohaz struggles to collect debts from its
subsidiaries, the company's Eurobond holders plan to meet in London
on November 14. Press reports indicate the holders could demand an
early redemption of the bonds because the company has failed to
deliver a financial report for 2007, an action that is allowed under
the terms of the bond issue. Naftohaz faced a similar challenge
from bondholders last year over its 2006 reports, but successfully
held them off until it finally published the reports in early 2008.
Creditors may not be so patient this time around because of the
world financial crisis. Naftohaz continues to service its external
debt in a timely manner, and the current threat to redeem the bonds
simply results from Naftohaz's inability to produce financial
reports that most companies could have published months ago.
Nonetheless, creditors are worried, and some analysts described the
company's situation as "deplorable" and unlikely to improve next
year (ref B).

Comment
-------

9. (SBU) The gas cutoffs show that the gas sector's debt problems
run down the entire value-added chain - starting with Naftohaz's gas
purchases from RUE and ending at the level of individual households.
The reasons for the debt are well-known: ill-guided regulations
force Naftohaz to sell gas below cost, and equally ill-guided
tariffs force local distributors and heating companies to supply
services to consumers at unrealistically low rates. Domestic gas
production is far below its potential because producers are forced
to sell at unprofitable low prices. The artificially low prices
throughout the system provide no incentive to save energy and deny
energy companies the means needed to modernize their aging
infrastructure. Moreover, the existence of multiple prices for a
homogenous product - gas - throughout the system has created grey
markets and solidified corruption. Increased domestic gas prices
are a long time coming and should motivate Ukrainians to become more
energy efficient, thus decreasing demand. In turn, the government
will need to ensure that necessary subsidies are targeted to ensure
that they reach those who need them. End comment.

TAYLOR

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