Oil prices remain elevated despite signs of a weakening global economy. We think the uncertainties around future oil supply growth are likely to continue to place upward pressure on prices. Fundamentals for gas-focused E&Ps are likely to remain pressured through 2011, but we expect the large-scale shift toward liquids production, a lessening of held-by-production drilling, and fewer dry gas drilling carries to result in higher gas prices in 2012.

We recently raised our mid-cycle oil price assumption to $95 per barrel and lowered our gas price assumption to $6.50 per thousand cubic feet.

The past quarter has seen some of the air come out of oil prices, though more from fears of a weakening global economy than from any real abatement of Middle Eastern unrest. Mixed economic news from the U.S. and ongoing concerns about potential eurozone defaults, plus a slight deceleration in China's growth in recent months cast a shadow on global growth prospects.

Meanwhile, the International Energy Agency (IEA) is urging OPEC to increase production to meet growing demand in the back half of 2011, as currently tight oil markets appear likely to become tighter in the coming months. Saudi Arabia unilaterally declared a willingness to increase production, though whether, when, or how much of this increased production translates into additional oil for the export market remains to be seen.

We think the supply and demand tensions are balanced on a pinhead, and any major development in either direction is likely to strongly affect oil prices. Looking forward over the next several years, we continue to see oil demand growth outpacing new supply, and barring a collapse in demand as a result of economic weakness (potentially caused by high oil prices), marketplace fundamentals will continue to support high oil prices. Reflecting this view, we recently raised our mid-cycle price assumption for West Texas Intermediate crude oil to $95 per barrel from $82/bbl.

In our view, the same supply constraints that support prices also support our thoughts on deepwater drilling. We continue to see deepwater as one of the most attractive plays on oil, as large public companies have a narrow set of exploration opportunities and deepwater is perhaps the most accessible. We think this plays to the strengths of drillers such as Transocean, which has the greatest exposure to deep- and ultra-deepwater drilling as measured by the number of rigs, and rig equipment providers such as National Oilwell Varco, which provide both equipment and services for a growing fleet of rigs.

Natural gas, at least in North America, suffers from the opposite problem. Thanks to held-by-production drilling, an influx of foreign capital in the form of drilling carries and joint ventures, and improved drilling and completion techniques, gas producers have created a glut of shale gas that has kept prices low. However, we are beginning to see evidence of our longstanding thesis playing out as companies aggressively shift capex dollars to liquids-rich plays. Falling gas-directed rig counts are a precursor to flattening, then declining, gas production in the U.S., though a one- to two-quarter drilled-but-uncompleted well backlog will support gas volumes after we've turned the corner. We continue to expect gas-directed drilling to slow considerably in the second half of 2011.

The combination of low gas prices, high service costs, less drill-to-hold acreage pressure, and weak internal cash flow generation at exploration and production companies will sap the desire and ability to perpetuate the presently high active gas rig count. Although this still argues for a weak gas price in 2011, it should set up better fundamentals for gas in 2012 and beyond. However, thanks to shale gas economics, we have moderated our view on gas prices, and lowered our mid-cycle price assumption for Henry Hub natural gas to $6.50 per thousand cubic feet from $8.00/mcf.

Given all of the pain being experienced by gas-oriented E&P companies, it's somewhat unusual to note that U.S.-focused oil- and gas-services companies have experienced a period of incredible pricing power over the past several quarters. Service company consolidation and the shift in drilling from gas to liquids-rich resource plays have contributed to strong services demand from the U.S. E&Ps and put more power in the hands of services providers.

Many E&Ps have thus felt the squeeze from both ends, with lower gas selling prices and higher services costs, and earnings power has suffered. Meanwhile, services companies' profitability has improved. While we think these dynamics are unsustainable longer term, we anticipate that services companies will be able to maintain present pricing power throughout 2011.