UKRAINE/RUSSIA: Debt dominates last-minute gas talks

Analysis

Although Ukraine's energy relationship with Russia has never been easy or straightforward, it has been particularly ridden with conflicts since Ukraine's 'Orange Revolution' leaders came to power in early 2005 (see RUSSIA/UKRAINE: Gas dispute upsets Moscow's G8 image - January 3, 2006). Bilateral ties have cooled, but the economic and commercial fundamentals of the Russian-Ukrainian gas relationship have changed little. Both countries are unavoidably dependent on one another: Ukraine is eager to continue receiving relatively cheap gas from (or through) its northern neighbour, and Russia still needs to channel most of its westward exports through Ukrainian pipelines. As a result, each side is in a position to exert pressure in bilateral negotiations, creating fertile ground for a variety of gas-related conflicts amid growing geopolitical estrangement.

Until recently, such conflicts mainly centred on the contractual terms of gas deliveries and, more specifically, issues of pricing. Public spats between Ukrainian and Russian officials have become a yearly 'tradition', with disputes spiking at the year's end with the imminent expiration of each annual contract. The outgoing year has been no exception to this dubious tradition, and the associated risks seem increasingly ominous as 2008 draws to a close.

However, unlike in previous years, the current negotiation process has been bogged down by disagreements over the debt that Ukraine owes to Russia for gas delivered this year. The problem was sufficiently serious to prompt Moscow to take the matter to an international court of arbitration, and the debt dispute has overshadowed the customary bilateral wrangling over the price Ukraine pays for Russian gas.

Outstanding debt. Ukraine's gas debt first became an issue in mid-November, when Gazprom unexpectedly demanded that its Ukrainian counterpart, Naftohaz, immediately pay arrears in the sum of 2.4 billion dollars. At first, the Ukrainian side attempted to deny the existence of any debt; it then reportedly recognised only around half of the claimed debt (1.27 billion dollars), before eventually agreeing to repay the sum in full, albeit gradually.

However, Naftohaz has proven unable to make even the partial payments that were required according to the agreed deferment schedule:

• By December 1, Naftohaz had repaid only around 270 million dollars out of the 550 million dollars that were to be remitted by that date.
• On December 18, Ukrainian President Viktor Yushchenko personally announced that Naftohaz had repaid a far larger sum -- 800 million dollars -- but this also fell short of Gazprom's expectations.
• According to Gazprom, the most recent payment covered only the debt for October (although Yushchenko claims that the payment covers both October and November), while Naftohaz still has not paid for gas delivered in November and December.
• Gazprom has asserted that November and December debts, along with late payment fees, amount to approximately 2 billion dollars.

Repayment difficulties. Naftohaz officials argue that the company's inability to pay for imported gas on time and in full can be explained by the following factors:

• As a result of the economic crisis, the company reportedly has suffered from a considerable contraction in gas consumption by its most lucrative customers -- large domestic industries. From September to November, Naftohaz apparently fell 300 million dollars short in anticipated revenues.
• Naftohaz is Ukraine's largest state-run enterprise, and as a result, continues to be used by the government as a main source of financing for the state budget. In the first ten months of 2008, Naftohaz had to direct more than 21 billion hryvnia (currently equivalent to 2.75 billion dollars) to the federal budget -- twice as much as it did in the same period of 2007.
• Finally, Naftohaz has cited the hryvnia's sharp depreciation as having an adverse effect on its ability to repay the debt (see UKRAINE: Currency stabilisation remains elusive - December 10, 2008).

While Naftohaz has complained of difficulties in acquiring the required amount of foreign currency, there is another factor that may have complicated the conglomerate's problems: this year, Ukraine pumped a record amount of gas into underground storage. Nearly half of the 28 billion cubic metres being stored still belongs to Gazprom-controlled traders.

Alternative options. Although its lack of financial resources has prompted Naftohaz to search actively for other options to clear its debt, the choices have proven unusually limited:

• Naftohaz is no longer capable of borrowing on international markets -- not so much because of the global financial crisis, as because of its own dire financial straits and mounting problems with creditors.
• It has also refused Gazprom's offer to settle the debt with advance payments for gas transit -- an option to which Naftohaz had resorted in the not-so-distant past.

Naftohaz probably managed to repay some of its debt by tapping into a 4.5 billion dollar tranche that the IMF granted to Ukraine as part of its 16.4 billion dollar standby line of credit. Although this clearly was not the intended purpose of the IMF's facility, it appears that the National Bank of Ukraine (which administers the IMF line of credit) transferred foreign currency to state-owned Oshchadbank, from which a loan could have been granted to Naftohaz. Official information suggests that on December 17, Naftohaz did receive a loan from Oshchadbank in the amount of 6.6 billion hryvnia (then worth slightly less than 900 million dollars).

Outlook. It is almost certain that Naftohaz will enter the new year without remitting the outstanding debt to Gazprom. It is possible, albeit unlikely, that the Ukrainian side could make another partial debt payment in the last days of 2008. The carryover of inevitably massive arrears into 2009 might lead to the suspension or reduction of Russia's supply of gas to Ukraine.

However, the negotiators might still reach a last-minute compromise, and conclude a new supply contract for 2009 (or part of it); bilateral talks will almost certainly continue until late tomorrow evening. Regardless of the talks' exact outcome, the debt issue will probably sideline another point of contention that was supposedly resolved when Prime Ministers Vladimir Putin and Yulia Tymoshenko met in October: whether to remove notorious intermediary RosUkrEnergo from the Russian-Ukrainian gas relationship (see RUSSIA/UKRAINE: Internal rivalry could undo gas deal - February 19, 2008).