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Cablegate: Ukraine: Naftohaz's Financial Uncertainty a Growing

DE RUEHKV #3058/01 3471037
O 131037Z DEC 07





E.O. 12958: N/A

REF: A) KYIV 2611

B) KYIV 2939

Treat as Sensitive but Unclassified. Not for Internet.

1. (U) Summary. NaftoHaz Ukraine, the state-owned gas and oil
company that accounts for 10 percent of GDP, could well be close to
bankruptcy. NaftoHaz's losses and debts have mounted as the GOU
continues to set domestic gas prices that are too low to cover the
rising cost of gas imports, and because middlemen RosUkrEnergo and
UkrHazEnergo are siphoning off much of the cash flow in Ukraine's
gas market, leaving NaftoHaz with the loss-making business of
selling gas to retail distributors and municipal heating companies
with poor payment discipline. International investors could demand
early repayment of a Eurobond issue, and the respected rating agency
Fitch may withdraw its ratings for NaftoHaz if the company does not
publish its already overdue 2006 financial statements by the end of
the year. It seems likely that action will be needed to avoid
bankruptcy. Such action could involve the GOU providing significant
subsidies to NaftoHaz, selling off pipeline assets (which Gazprom
has long expressed interest in purchasing), or privatization of
other assets. Due to its strategic role, the GOU is unlikely to
allow NaftoHaz to go bankrupt, but the cost of avoidance may be
high. End summary.

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The Role of NaftoHaz

2. (U) NaftoHaz (Naftogaz in Russian transliteration) is a
vertically-integrated oil and gas company. It (along with its
majority-owned subsidiary UkrNafta) accounts for over 96 percent of
domestic oil and gas production and operates Ukraine's gas pipeline
network, which provides transit to approximately 80 percent of
Russia's Europe-bound gas. In addition, it supplies natural gas and
crude oil to domestic utilities at low tariffs set by regulators.
Entirely state-owned, it is of considerable strategic importance to
Ukraine, generating approximately 10 percent of GDP and employing
approximately 170,000 people.

Recent Changes in Gas Market and Impact on NaftoHaz's Bottom Line

3. (SBU) Much of the company's operations, and in particular its
financial health, remain opaque as a result of mismanagement,
corruption and intentional obfuscation.
The company has also been on the losing end of various parties'
efforts to exert control over Ukraine's gas market and to pocket
some of the significant cash flows associated with the gas trade.
RosUkrEnergo and its predecessor EuralTransGas have cut off NaftoHaz
from direct commercial relations with either Gazprom or central
Asian suppliers. The creation of UkrHazEnergo, as a result of the
2005/6 gas crisis, stripped NaftoHaz of the lucrative gas supply to
industrial customers, leaving NaftoHaz with the unprofitable
business with distributors and municipal heating providers that is
marked by poor payment discipline, inefficient and corrupt regional
distribution companies and politically determined retail prices
that, despite increases in recent years, are still too low to cover
costs. (Note: Although NaftoHaz owns 50 percent of UkrHazEnergo -
RosUkrEnergo owns the other half - it is widely recognized that
RosUkrEnergo calls the shots at UkrHazEnergo. Significantly,
UkrHazEnergo has not paid its 2006 dividends to NaftoHaz. End
note). At the same time as these structural shifts were hitting at
NaftoHaz's profitability, prices for imported gas increased from $50
per thousand cubic meters (tcm) in 2005 to $135/tcm this year, and
are scheduled to rise to $179.5/tcm in 2008. Consumer nonpayment
has increased with the rises in gas prices. In late 2006 and early
2007, Yuliya Tymoshenko's BYuT party even politicized the price
increases, encouraging consumers not to pay.

Financial Situation is Precarious

4. (SBU) By all accounts, the financial situation at NaftoHaz is
precarious. The company has not yet published its financial figures
for 2006. Gas transit still appears to be profitable, but the
company's domestic gas sales business is accumulating losses,
liquidity appears to be tight, and its debts are mounting.
Ukraine's State Tax Administration claims that, as of November 1,
NaftoHaz owes taxes of UAH 2.3 billion (about $450 million).
NaftoHaz also received tax deferrals in 2006 and 2007. One analyst
report quotes acting Prime Minister Yanukovych as stating that
NaftoHaz's total losses for 2006 may amount to $1.5 billion.
According to analysts' reports, NaftoHaz has about $2.5 billion in
debts. Of the total, $500 million is in Eurobonds and $1.6 billion
in loans from foreign banks. The rest takes the forms of loans from

KYIV 00003058 002 OF 003

domestic banks. The company has reported that it earned $60 million
after taxes in the first half of 2007, which would indicate a
significant improvement over the first half of 2006.

5. (SBU) A NaftoHaz spokesman blamed the delay in publishing the
2006 figures on the "machinations" of its previous CEO. However,
regional press reports suggest that there may be other reasons.
According to the press, the audit for 2006, prepared by the auditing
firm Ernst & Young, will not be signed until parliament provides a
guarantee to the company. This is because the auditors reportedly
refused to certify that NaftoHaz otherwise was a "going concern,"
meaning that it could be expected to continue normal operations for
the following year. NaftoHaz management is telling analysts and
creditors that it expects the Rada to approve a $1 billion subsidy
for the company to partially offset the losses associated with
selling gas at below cost to utilities. The subsidy may be in cash,
or through tax offsets. It is unclear, however, whether the new
parliament will actually be prepared to support the company.

Eurobond Holders May Soon Recall Their Bonds

6. (SBU) It is particularly doubtful that the Rada will approve of
financial support by the end of the year. If it doesn't, and if
NaftoHaz does not publish its 2006 data by December 31, holders of
its Eurobond issue due for repayment in 2009 could ask for their
money back. According to the conditions of the Eurobond, NaftoHaz
had to publish the 2006 financial figures by August 31. Failure to
do so gives the bondholders the right to immediately redeem the
bonds. Bondholders usually have the option of waiving this right if
the borrower pays an additional fee, but NaftoHaz reportedly so far
has refused. At a November 14 meeting in London, bondholders
agreed to give NaftoHaz until December 31 to publish the 2006
financial figures.

Fitch Threatens to Withdraw Ratings

7. (SBU) The international rating agency Fitch has even threatened
to withdraw its ratings for NaftoHaz because of the delay in
publishing the 2006 figures. Withdrawal is merited when Fitch
believes it no longer has access to adequate information to credibly
maintain the ratings. Fitch has yet to actually pull the ratings,
as it has reportedly received assurances from NaftoHaz that the
financial figures will be forthcoming. On October 15, however,
Fitch placed NaftoHaz's ratings on so-called "rating watch
negative," indicating that it may soon downgrade the company's
ratings. Fitch justified the move because of NaftoHaz's failure to
publish its 2006 figures in a timely matter, and after NaftoHaz was
suddenly confronted with an additional debt of $729 million to
Gazprom shortly after the September 30 parliamentary elections. The
debt issue has been solved in the meantime (ref A). A NaftoHaz
representative told the press that it does not expect negative
fallout from a possible downgrade since foreign investors are aware
of the reason for the delay in submitting the 2006 financial report.

8. (SBU) NaftoHaz's current ratings are in the non-investment grade
category (also known as junk bonds). Fitch last downgraded the
company's ratings in 2006 as a result of the company's deteriorating
financial situation in the wake of the gas price hikes of early
2006. The main ratings now stand in the single B category, one of
the lower ratings granted by the well-respected rating agency.
Later in 2006, Fitch indicated it might reduce its ratings of
NaftoHaz further, yet took no action after NaftoHaz presented plans
to develop its remaining areas of business (domestic gas production,
transit, and domestic gas sales). At that time, the Ministry of
Fuels and Energy reportedly wrote a letter to NaftoHaz's bank
lenders stating that it will back the company by supporting any
actions aimed at improving NaftoHaz's financial position and
preventing bankruptcy.

Comment: The Future Looks Bleak

9. (SBU) Looking forward, NaftoHaz's financial prospects remain
bleak. With NaftoHaz's limited ability to pass on higher costs to
consumers, the recently announced price hikes for imported gas in
2008 will likely increase the losses in the company's domestic
business. A failure to publish 2006 financial results by the end of
this year could cause Eurobond creditors to call their bonds or
Fitch to withdraw its rating, either of which would negatively
impact NaftoHaz's ability to borrow in the future, or to refinance
debts coming due in 2008 and beyond. Default is a possibility, as
it is not clear NaftoHaz has the funds to pay if bondholders demand

KYIV 00003058 003 OF 003

immediate payment. These scenarios could even have a negative
impact on the creditworthiness of Ukraine as a whole because
NaftoHaz is fully owned by the state. The underlying fundamentals of
the company are difficult to assess as the company continues its
policies of financial non-transparency. It seems likely that GOU
action will be needed to avoid bankruptcy. Such action could
involve the GOU providing significant subsidies or selling off of
other assets. Gazprom has long been interested in purchasing or
taking operational control of Ukraine's transit pipelines. Current
Ukrainian law forbids any sale or transfer of control for the
pipelines, but under the pressure of bankruptcy, it is not
absolutely certain the GOU will hold to this policy. Due to its
strategic role, the GOU is unlikely to allow NaftoHaz to go
bankrupt, but the cost of avoiding bankruptcy may be high. End

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