After some nail-biting moments in the second half of 2006, Canada’s oil patch is expecting to post solid, if not spectacular, returns in 2007, as analysts forecast both crude oil and natural gas prices to remain comfortably high.

Despite an unprecedented spending boom in Alberta, investors in oil and gas producers had a tough time in 2006, reflecting the year-long slide in natural gas prices, a fall slump in crude oil, and a government-orchestrated crisis in the energy trust sector.

But analysts are expecting a more rewarding 2007, particularly for well-managed companies that can keep unrelenting cost pressures under control.

UBS Canada strategist George Vasic says there should be healthy earnings growth in the country’s oil-and-gas sector, forecasting an average increase of 39 per cent for companies that comprise the TSX energy index.

The index is finishing 2006 virtually flat from where it began the year. It had been up as much as 25 per cent early last spring, but tumbled to a 10-per-cent loss this fall before rallying through November and December.

Mr. Vasic expects crude oil prices to average $69 (U.S.) a barrel next year, up from about $62 currently, while gas prices – which fell as low as $4 (U.S.) per million cubic feet early this fall – should average $7.60.

He recommends buying energy stocks and reducing exposure to financial companies, which have enjoyed a good run in the second half of 2006. “For energy [companies], this year has been their pause year,” he says. “They’ve had a reasonable pause, and investors can at least say they are not getting in at the top or after a frenzied buying period.”

Peter Linder, managing director with Delta One Capital Partners Inc., says investors cooled to energy stocks and trusts this fall, as a result of commodity price weakness and federal rule changes for the trust sector. But that pessimism is already easing.

“Investor sentiment, as much as it has improved already, will significantly improve by the end of this year and especially next year,” Mr. Linder said.

Still, some analysts warn that the energy sector could take some time to shake off the effects of oversupply in both the crude oil and natural gas markets, which resulted in the downward pressure for both commodities this fall.

BMO Nesbitt Burns analyst Randy Ollenberger expects some first-quarter weakness in energy prices, particularly natural gas, given the bulging inventories in storage facilities in North America.

“Q1 will start off a bit weak,” he says. “We are looking to start the year on natural gas weaker than we are today, and on oil, kind of flat.”

But the analyst says the fundamentals are in place for a rally in energy prices throughout the year, particularly if eastern North America doesn’t have a record warm winter, as happened last year.

Mr. Ollenberger expects crude oil prices to drift around $60 (U.S.) a barrel through the winter, then climb to between $65 and $70 in the final three quarters of 2007. And he forecasts natural gas prices to climb to between $8 and $9 (U.S.) per million cubic feet by the end of 2007, from $7 at the beginning of the year.

Although revenue should be buoyant throughout the year, analysts warn that companies are struggling to maintain their margins in the face of rising costs, and some have built worrisome debt loads.

“While we’re looking at strong commodity prices, I think the focus is going to be on cost control in ’07,” says Tom Ebbern, analyst with Calgary-based Tristone Capital Inc. “Companies are going to make a concerted effort to trim their field costs, whether in drilling or services.”

Operating costs climbed an estimated 20 per cent in 2006, as drilling and service companies operated at full capacity and ran into labour shortages. Costs are also being driven higher as companies turn to harder-to-extract, unconventional sources of crude and natural gas to replace conventional reserves.

Mr. Ebbern says companies that have well-regarded management teams should generate attractive returns. He singled out Pro-Ex Energy Ltd., a Calgary-based junior producer, for its savvy management. “In any kind of nervous markets, the market tends to move to quality,” he says. Mr. Linder likes gas-weighted juniors that have clean balance sheets and good drilling prospects. He expects this year’s slide in gas prices to set the stage for a significant rally in 2007.

Analysts say the oil sector should see considerable merger-and-acquisition activity in 2007, as cash-flush companies look to replace reserves through acquisitions.

At the same time, valuations in the trust sector have fallen to more closely resemble the levels of oil company equities, following the federal government’s October announcement that it will phase out special tax treatment for trusts.

“There were too many trusts,” Tristone’s Mr. Ebbern says. “Before the announcement, there was a move afoot to consolidate in an effort to reduce costs and go to higher quality. Obviously this news will help accelerate that, although the trusts will need some clarity for the government on what they are allowed to do.”

Some of the largest trusts, including ARC Energy Trust, EnerPlus Resources Fund and Penn West Energy Trust, have high-quality assets and are expected to add to their portfolios to strengthen their ability to make payout targets.

UBS analysts are also forecasting considerable M&A activity in the oil sands, with international oil companies eager to bolster their positions in the high-cost but politically stable sector.

UBS analyst Andrew Potter noted in a report that pure oil-sands companies had fallen 26 per cent from their 52-week high and their “valuations look quite compelling.” And he said there are plenty of potential buyers for fat oil-sands targets such as UTS Energy Corp. and OPTI Canada Inc.

“With the global majors at near-zero net debt, and expected to generate over $235-billion (U.S.) of free cash flow over the next two years, we expect to see significant consolidation and the oil sands pure plays represent a compelling prize,” Mr. Potter said in a recent report.