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The integrated oil and natural gas industry had a tough year in 2009. Many companies struggled over the past few months due to higher operating expenses and fluctuating energy prices. Some members of this group ramped up production in 2007 and 2008 in order to take advantage of soaring energy valuations at the time. The glut of supply and lower demand (due to recessionary pressures) over the past year, however, depressed energy prices. These factors caused many members of the industry to take a closer look at their operations and redefine their business plans for long-term growth.

Many integrated energy companies have been shifting their focus from crude oil or coal production when developing their long-term growth strategy. Some have turned to various hydro- or wind-energy sources, while others have concentrated on natural gas production. Recent innovations in natural gas drilling include hydraulic fracturing, the process through which drillers release hydrocarbons trapped in compressed rock formations. And this has led to an upswing in production from shale basins, the most common form of tight-gas deposits. Too, shale-gas drilling may be a key method to tapping domestic energy sources, making it more attractive to legislators mulling cap-and-trade and other energy industry initiatives.

Indeed, natural gas operations took center stage last month when international energy conglomerate Exxon Mobil (XOM) announced plans to acquire XTO Energy. This all stock-deal, roughly valued at $41 billion, is set to be completed by the end of the June quarter. In all, Exxon would be tripling its current domestic natural gas business. XTO has focused on unconventional gas assets in the past few years. It specifically developed shale deposits in the Haynesville, Barnett, Fayetteville, and Woodford basins. We believe that Exxon will continue to expand this segment. Indeed, on its own, Exxon gave the nod to a $15 billion natural gas undertaking in New Guinea last month.

We think that this merger may prompt other big-oil businesses like Royal Dutch Shell (RDSA), BP p.l.c. (BP), or Chevron Corp (CVX) to make similar moves. Natural gas producers, such as Chesapeake Energy (CHK), Devon Energy (DVN), or Andarko (APC) are all potential targets. We think that merger and acquisition activity will pick up in the coming months, thanks to improved credit markets and the  industry trend to diversify energy portfolios. Still, many of these integrated energy producers may rely on organic growth initiatives rather than sweeping other businesses into their conglomerates. 

Acquisition speculation has shined a light on the evolving integrated energy industry landscape. Valuations have gotten richer and there is risk of excessive enthusiasm. After all, access to the remaining large oil deposits may be limited. Current legislation bans much activity in Alaska, and the expense of drilling the deep deposits of the Gulf of Mexico may steer companies away from that region. Further, many of these businesses tend to avoid areas that pose a political risk, and have, therefore, limited ventures in places such as Iraq, Brazil, and Nigeria, among others. In addition, many overseas deposits are aggressively managed by their governments. The present shale-gas boom is more promising, but it should be noted that the oldest wells of this kind are no more than ten years old and so the full-life well production characteristics and cost profiles are not well understood. There is some evidence that shale-gas require frequent refactoring to maintain estimated production rates, thus driving up the per-unit cost of operation. Further, the ecological impact of this method of extraction is also unclear and, therefore, these businesses may soon be subject to legislation from environmental protection agencies.