The U.S. E&P sector appears poised for a strong showing as the global economy continues rebounding this year, according to KeyBanc Capital Markets analysts’ review that shows the sector up 98% in 2009 relative to 2008’s volatile markets.

Thankfully, technology continues to play a major role by helping domestic and integrated E&P players unlock abandoned natural gas trapped in domestic shale plays and national and international oil companies’ growing interest in acquisitions or joint ventures in Haynesville and Marcellus shale acreage, KeyBanc’s analysts added.

Jack Aydin, E&P analyst at KeyBanc Capital Markets, with research assistance from colleagues Mitchell Wurschmidt, Gabriele Sorbara and Joseph Stewart, reported that ExxonMobil’s announced acquisition of XTO Energy Inc. was tantamount to a US$41-billion wake-up call to a slumbering domestic natural gas market. The Chesapeake Energy Corp. and Total SA Barnett shale joint venture announcement recently also plays a key role in bolstering the sector’s expected better performance going forward.

“We would not be surprised to see additional transactions involving other major integrated oil companies – including foreign internationals – taking over major shale players, or forming joint ventures in the major shale plays,” Aydin said. “Based on our conversations with industry contacts, we are under the impression that some of the larger international oils have an appetite for potentially gaining a nice foothold in the domestic shale plays and, thus, we would not be surprised to see some additional corporate transactions or joint ventures.”

Several E&P companies that are being approached for their Marcellus acreage for potential joint ventures include Atlas Energy Inc. and Exco Resources Inc., he said. Recent transactions in the Haynesville and Marcellus shales have marked up acreage prices in most areas of the plays, including northeastern and central Pennsylvania, to more than $5,000 per acre. Additionally, Aydin and his colleagues believe potential takeover targets include Petrohawk Energy Corp. (which operates in the Haynesville and Eagle Ford shales), Range Resources Corp. (Marcellus and Barnett) and Southwestern Energy Co. (Fayetteville).

“While, on the surface, such potential transactions appear farfetched, bear in mind that in our wildest dreams we could not have come up with the ExxonMobil takeover of XTO scenario. Thus, under no circumstances would we recommend a stock based on a potential takeover; however, we are not (so) naïve (as) to assume that it could not happen. At the present, we are leaning more toward joint ventures.”

Domestic shale-gas players Cabot Oil & Gas Corp. and Exco are poised for breakaway status in the coming year, he adds. In the near term, however, gas prices are facing dark clouds, with domestic storage at 3.276 trillion cubic feet, well above last year’s storage level, and well above the five-year average.

Weather patterns continue to offer challenges as well as a lack of industrial demand. Then there is that sticky supply problem: Domestic, onshore gas production is down only 1 billion cubic feet from its peak although there was a 55% reduction in the gas-rig count, he adds.

There are brighter fundamentals ahead – well, reasonable fundamentals are ahead: “Following our study on prior years’ gas-price corrections, we still come to the conclusion that further reductions in domestic, onshore gas production are more likely, considering the reduction in drilling activity and the delayed response time it takes for lower activity levels to lead to lower U.S. natural gas production.

“Also, early indications are that weather and industrial demand are cooperating. Thus, for the present, we are comfortable with maintaining our gas-pricing assumptions of $5.43 per million Btu and $6.23 per million Btu for 2010 and 2011, respectively.”

Lower drilling levels and improved industrial demand will eventually lead to a more balanced domestic gas supply/demand situation. He believes higher gas prices are in the future, albeit at more reasonable levels than in years immediately preceding 2009. “Nevertheless, given the advent of economically producing natural gas from shales and the ramp-up in activity levels in these plays, we believe gas prices might be capped in the $5.50- to $7-per-million-Btu range over the next three to five years.”

Aydin continues to favor E&Ps with leverage to crude oil since under-investments in oil infrastructure and development during the credit contraction could result in another period of tight supply/demand fundamentals. Moreover, Aydin and his colleagues report that a weaker U.S. dollar should provide a healthy price for oil because oil is primarily priced in U.S. dollars.

“In addition, with the potential global economic recovery, we expect consumption to be up for the first time in three years. We are marginally increasing our oil forecast from $68 per barrel to $70 for 2010 and from $70 to $72 in 2011.”

Aydin’s top oil company picks remain Concho Resources Inc. and Whiting Petroleum Corp. “After the tumultuous declines in commodity and share prices and leveraging up of balance sheets, we believe most E&P companies in one fashion or another have repaired their balance sheets. Our sense after recent marketing trips and conversations with clients is that investors still prefer companies to live within cash flow. We expect companies that are spending above cash flow to be reluctant to increase debt positions meaningfully and thus expect asset sales, joint ventures and equity offerings to be the norm in 2010 and bridge the shortfall,” he said.

Aydin and his colleagues’ data show more than 60% of capital-spending budgets revealed so far by domestic E&Ps are allocated toward shale plays. Also, based on conversations with management teams, Aydin expects budgets to be sensitive to commodity-price movements, especially given management’s desire to hold spending close to internally generated funds.

The significant decline in the gas-rig count took its toll on oil- and gas-well service companies with most severely discounting prices to maintain some activity levels, Aydin reports. However, service-company prices have bottomed for the most part. “Based on our latest check with several E&Ps we follow, we are under the impression that services are getting somewhat tighter, especially in the Marcellus, Haynesville and Bakken plays. One service company mentioned at the present that the services industry prefers pricing power over utilization.” – Bill Brocato, from Hart’s Oil and Gas Investor