An uncertain environment exists for North America's oil and gas industry because of "sharp differences" in the economic strength between regions, development opportunities, a changing environmental landscape and the upcoming midterm elections, Ernst & Young LLP said in a report Friday.

The dynamics of oil demand are changing, and while natural gas is full of promise, "key pieces of the puzzle, such as adequate infrastructure and strong demand," are missing, the report noted. The downstream sector faces the challenge of too much capacity and uncertainty about regulation and fuels, and oilfield service companies are in the middle of a geographic shift. On top of that, "transactions are being scrutinized" following the Gulf of Mexico spill.

"The industry, which has been portrayed negatively in the recent past, needs to be an active collaborator and have a clear voice in developing new policies," said Ernst & Young's Marcela Donadio, Americas Oil and Gas Leader. "Clarity around the future of energy policy would go a long way toward helping companies adapt and respond to this period of transformation."

North American natural gas supply is forecast to continue to grow, which will lead to opportunities -- or problems.

"With the North American unconventional gas boom and new liquefied natural gas capacity coming online, natural gas supply remains strong and storage levels remain high. As more of the majors move into the shale space and validate the unconventional gas strategy, Ernst & Young expects growth in supply to accelerate.

"The natural gas resource potential is incredible," said Donadio. "Currently, demand is not keeping up with supply growth. However, a supportive public policy could go a long way toward increasing demand."

According to the consultant, oil demand continues to be driven mostly by emerging economies. Advanced countries' continued low demand is attributable primarily to the economic recession, but the gains in efficiency may be permanent.

"Following years of record high prices and with businesses working to reduce their carbon footprints, less oil-intensive economies are emerging," Ernst & Young stated. "Upstream producers are also facing rising costs as a result of a tighter regulatory environment and are facing the potential loss of key tax advantages. Nevertheless, if the economy continues to improve, oil demand will inevitably increase."

For the downstream market, 3Q2010 refining margins "largely retreated to pre-boom levels as a result of modest utilization in the U.S. and Europe, sluggish demand and relatively high crude prices. In addition, while excess capacity abounds, new capacity is coming from the Middle East and Asia, which will further strain margins.

"There are ongoing questions as to the prospects for sustained transportation fuel growth in advanced economies and possible public policy shifts resulting from the Deepwater Horizon incident to support greater utilization of alternative fuels. All of this creates a very difficult operating environment and uncertainty for refiners."

The oilfield services market also is undergoing a transformation. Global upstream spending declined by 25% in 2009, but it is expected to be up 15-20% in 2010, the report noted.

"While the Gulf of Mexico moratorium has created sharp downward pressures on rig utilization and day rates, new opportunities in South America and offshore Africa are emerging. The boom in unconventional oil and gas drilling has resulted in rising service intensity and has fed the demand for new, high-complexity rigs.

"Enforcement of 'Idle Iron' regulations -- which will require full decommissioning of wells, platforms and pipelines that are no longer producing or providing operational support -- will provide opportunities for some oilfield service companies," the report noted.

With credit markets continuing to loosen up, and with strong oil prices and the evidence of a somewhat mixed financial recovery, there's been "a clear uptick in upstream transactions over the past few quarters," noted the consultant.

Even though confidence in the economic recovery has "waned some" over the past few months, "Ernst & Young believes that, in the oil and gas industry, companies are willing to make investments."

Among other things, international and national oil companies "are beginning to invest heavily in unconventional gas." And with gas prices depressed, investors are buying into gas plays with high liquid content, such as the Eagle Ford, Bakken and Granite Wash. There also is the potential for more oilfield service consolidation, and many companies are "reexamining how they structure deals," the report stated.

"Looking forward, we expect deals that may differ from historic trends, with legacy structures being reevaluated," said Ernst & Young's Jon McCarter, Transaction Advisory Services Leader. And he warned that "the ongoing regulatory and legislative uncertainty has potential to slow the pace of negotiations."

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