Ken Silverstein EnergyBiz Insider Editor-in-Chief

High commodity prices mean that oil companies have excess cash. The thinking is that if they see an opportunity in the exploration sector, they may take it. Those oil conglomerates that already have a foothold in the utility industry are the ones most likely to seek assets that would complement their existing businesses. Many natural gas entities need to strengthen their financial backbone and credit ratings while oil companies want to extend their economies of scale and produce new sources of revenue.

"We think it's very possible the industry will see some large merger and acquisition deals next year, both in the U.S. and globally," said Rick Roberge, with PriceWaterhouseCoopers' Houston-based energy practice. "Many of the larger companies have been content to sit on their cash war chests in 2005. But at some point, commodity prices will settle and companies will begin drilling higher risk projects . That's when consolidation will accelerate because of the need for larger balance sheets to reduce those risks."

The energy practice says that merger and acquisition activity in the broader energy sector could skyrocket in 2006 -- exceeding the $383 billion record set in 1999. In 2005, such activity will amount to $367 billion, adds Thomson Financial.

Oil companies are already active in the utility market: Most deals have been structured so that a utility will buy all of an oil company's natural gas and sell it to an end user in exchange for some percentage of the profits, typically around 50 percent. Others are constructed so that the utility will acquire the rights to all of an oil firm's natural gas supplies, in exchange for cash and stock options.

At the same time, Big Oil is already in the natural gas business, which is currently the electric utilities' number two fuel choice. About 30 percent of those natural gas discoveries are being extracted from the same holes oil companies are finding their petroleum. It wasn't so long ago that oil companies thought their natural gas findings were unprofitable, even going so far as to have them burned off. But they have since seen the light. Gas is now profitable. In this country, the commodity goes at a premium and has been in demand. Overseas, the oil companies already have a foothold.

There's "room for the big oil companies that want to get into natural gas, and even more so if the country commits to the building of liquefied natural gas," says Robert Stratman, vice president for ABB in Wicklife, Ohio.

Excess Cash

To be precise, the top 20 energy companies now have about $75 billion in cash, says Roberge with PriceWaterhouseCoopers. It's a less risky proposition to use some of that money to buy entities that are already in the natural gas production business than to develop those wells themselves. The problem all companies will face is how to bring on additional production to offset capacity declines -- as well as meet possible demand growth at natural gas prices as high as $15 per million BTUs.

Clearly, oil and gas prices alike will remain high over the next few years because there is not enough supply coming on line. But there is little doubt that those prices will eventually fall, albeit at levels much higher than consumers have traditionally known. There are roughly 3,000 trillion cubic feet of stranded natural gas, for example, that has already been discovered around the globe -- some of which could find its way to the U.S. market. Also, alternative fuels are currently being developed and may come onstream.

"In general, it is a very risky time for companies to acquire reserves in the U.S. because of the fear of 'buying high, selling low,'" says Paul Grimmer, president of Eltron Research in Boulder, Co. "That said, the U.S. gas market is interesting and will remain so. U.S. gas consumption is more than 60 billion cubic feet a day, equivalent to more than 12 million barrels/day of crude oil."

Some say that the expected wave of mergers among energy units is part of an ongoing trend to pick up key assets and beef up balance sheets in an effort to off-set some high risk projects. The trading of assets will continue and particularly among oil and gas exploration units, says Jim Halloran, a Wall Street analyst with National City Bank in Cleveland. And, Big Oil may be looking at more than natural gas developers; those companies may be eying oil sands players. Oil sands are a stratum of sand or sandstone containing petroleum.

"The short answer is that this deal -- ConocoPhillips and Burlington Resources -- is just one in a continuum of transactions," says Halloran. "This deal does not push any of the potential buyers to look harder than they already have."

The scenario is playing out. Connacher Oil & Gas just agreed to buy Luke Energy as a way to lock in natural gas costs for its planned oil sands project in the Canadian province of Alberta. In this case, Luke Energy's gas supplies would be used as a hedge against the oil sands supplies -- 10,000 barrels a day -- needed by Connacher. Connacher adds the deal enables it to lock in the gas it will need for production as well as gives it extra gas to sell in the market.

High commodity prices are hurting consumers and giving oil companies ample cash. But such a situation won't lead to an immediate increase in either oil or gas production, given that companies can't bring large amounts of supplies onstream anytime soon. Moreover, they tend to view the economic landscape 10 years out - not in one or two year cycles. Eventually, prices will moderate and the incentive to drill will decline along with it.

The same economic fundamentals, however, do motivate well-heeled energy enterprises to search for valued assets. And right now, natural gas producers are appetizing and may be a logical fit for Big Oil. That's why 2006 is expected to be an active year for those in a position to buy.

For far more extensive news on the energy/power visit:  http://www.energycentral.com .

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