Gasoline prices have drifted down from summer peaks as high as $2 a gallon. Natural gas and heating oil hit new highs this winter. But if you want to see real action in the energy business, travel north on I-45 from Houston to Freestone County. There, a number of oil and gas producers are aggressively drilling the Bossier Sand Play, a parched, old natural-gas field that has found new life. With natural-gas prices having tripled over the past year, companies such as Houston's Anadarko Petroleum Corp. (APC) can afford to use the latest technology to find smaller pockets of gas that were missed before. Anadarko now has 27 rigs drilling in the Bossier, up from four at the start of 2000. "It took $2 [per thousand cubic feet] gas to get Bossier off the ground," says Rex Alman, vice-president for domestic drilling at Anadarko. "At $9, we earn back our investment in two weeks."

If 2000 was a year that caught energy producers and consumers by surprise, 2001 will likely be one in which the old law of supply and demand rears its head. After two years of strong prices, energy companies everywhere are increasing their budgets for exploration and production. Such expenditures at the world's largest oil companies should climb 10% this year, to $37 billion, according to Salomon Smith Barney. The number of rigs working worldwide is expected to average 2,080 this year, up more than 40% from the most recent trough in 1998. Worldwide oil production is expected to climb 1.8%, to 78 million bbl. per day. That is about 700,000 bbl. per day greater than projected demand.

Oil prices have already begun to react to the increased activity. In mid-December, the price of oil slid 8% in a matter of days on news of increased worldwide production. At a recent price of $26 a bbl., oil is still up nearly threefold from its low in 1998. Many analysts expect it to hover around $25 this year. As usual, there will be a not-so-delicate ballet performed by OPEC and the world's non-OPEC producers, as everyone tries to maximize their oil production without triggering a collapse in prices. "Non-OPEC supply is increasing," says Deutsche Banc Alex. Brown energy analyst Adam E. Siemanski, "and within OPEC, production capacity is growing, particularly in Kuwait. The net result is that OPEC will have to cut production from 29.5 million bbl. per day now to 27.5 million bbl. during the second quarter of 2001. If they hesitate, inventories will build rapidly and prices should continue to come down." Add to that volatile mix the possibility of a worldwide economic slowdown, crimping demand and knocking prices down even further. "Global economic slowing is the big wild card," says Daniel Yergin, chairman of energy consultancy Cambridge Energy Research Associates.

BOOM COMING? All this spells trouble for oil-company earnings. Lehman Brothers Inc. analyst Paul Y. Cheng expects earnings at the 18 large oil companies he follows to fall about 5% on average this year. Hit hardest will be companies such as Chevron (CHV), Occidental Petroleum (OXY), and Amerada Hess (AHC), which get a higher percentage of their revenues from oil, as opposed to natural gas. "We'll see negative year-over-year earnings comparisons by the third quarter of 2001," Cheng says.

Even if prices fall, some sectors of the energy industry are still poised for a boom. Drilling activity is picking up, and years of underinvestment have left the market for oil rigs, offshore boats, and other oil-field supplies tight. "There is no excess capacity." Salomon Smith Barney expects the earnings of oil field equipment makers such as Schlumberger (SLB), Halliburton (HAL), and Baker Hughes (BHI) to climb smartly this year on the strength of continued demand for their equipment.

Another hot spot will be natural gas. True, companies such as Anadarko, BP, and Unocal (UCL) are greatly increasing their gas output this year. But U.S. production has been flat for six years. Big fields are hard to find and new technology depletes wells at much faster rates than in the past. Cold weather, tightness in supply, and surging demand from new gas-fired power plants caused natural-gas prices to soar to record highs last year. In California, where electricity demand is at near capacity, prices hit $50 per thousand cubic feet in December. That's up from just $2 a couple of years ago. Electric utilities have begun to seriously consider other fuel sources, such as coal, for new power plants. Given the tightness across all petroleum markets, the coal industry could see one of its best years in decades.

New drilling will likely bring natural-gas prices down from their current highs, but analysts believe continued strong demand for clean-burning natural gas will keep a floor on prices. "We'll see gas over $3 [per thousand cubic feet] for some time," says Ron Denhardt of Wefa Inc., based in Eddystone, Pa. "This is the start of a three-year transition period until major new fields open in the Gulf of Mexico, the Rocky Mountains, and Canada."

Gasoline is likely to remain in tight supply as well. While falling oil prices will translate into lower prices at the pump, strong demand for gasoline is bumping up against an industry that has seen capacity shrink in the past 20 years. In 1980, the U.S. refining industry produced 18 million bbl. per day. Today, in spite of increased demand, that number is around 16 million bbl. The reason: Environmental concerns and low margins have forced the closure of almost half of the nation's refineries.

Things may get even tighter. Proposed federal restrictions on the sulfur content in diesel fuel and gasoline could further reduce the amount of gasoline produced, notes Philip K. Verleger Jr., an energy economist in Newport Beach, Calif. Also, the phase-out of controversial gasoline additive MTBE--the choice to reduce emissions until it was found to contaminate groundwater--could erode gasoline supplies, resulting in higher prices. So far, California is the only state to announce such a plan.

Some companies, such as Valero Energy Corp. (VLO) in San Antonio, are busily buying up refineries that larger oil companies such as ExxonMobil Corp. (XOM) have been forced to sell as conditions of their big mergers. As supply shrinks, "we'll make lots of money," says William E. Greehey, Valero's chairman.

Don't expect the big deals to stop, either. After years of cost cutting in the early 1990s, the oil industry began spending again in the mid-1990s. OPEC increased its production to maintain its market share, but did so just before an economic crisis deflated Asia's demand for oil. When prices crashed, oil companies turned to big mergers to help them reduce costs. The mergers had the effect of reducing the supply of oil, because companies focused on cost-cutting rather than production growth. That explains the slow response from non-OPEC producers to the high prices of the past two years.

TIGHTER BELTS. In 2001, deals will be done with an eye toward increasing oil and gas production instead of just cutting costs, contends J. Robinson West, chairman of the oil-industry consulting firm Petroleum Finance Co. He points to Phillips Petroleum Co.'s (P) $7 billion acquisition of Arco's Alaskan operations as an example. Phillips is expected to increase its oil and natural-gas production by 20% this year, to 831,000 bbl. per day.

Oil-company executives tightened their belts during the past two years and played it cool as prices rose. Without losing sight of these cost-saving efforts, in 2001 they will need to steer more toward exploration and production. As Raymond Plank, chairman of Apache Corp. (APA), a major natural-gas producer, puts it: "A tanker doesn't turn on a dime." But when it does turn, it leaves a big wake.

Before it's here, it's on the Bloomberg Terminal.