Chevron Corp , the second-largest U.S. oil company, will increase spending by a fifth to $26 billion in 2011, with 85 percent going to exploration and production as the industry seeks out new sources of growth.

The expanded budget, announced on Thursday, is a big step for Chevron as it enters a period of weak net production growth while it ramps up in natural gas. Massive rival Exxon Mobil Corp budgeted 2010 spending of $30 billion.

Spending by oil companies is expected to rise across the board now that global crude oil demand has recovered and seems likely to grow to meet the needs of huge emerging markets.

Everyone's looking at oil, and it's going to go up -- you got China and India. My guess is these guys are going to be doing a lot of drilling, said Mark Coffelt, chief investment officer at Empiric Advisors in Austin, Texas.

I'm not surprised that capital budgets are going up, and maybe the surprise is that they're not going up even more. said Coffelt, who does not currently hold Chevron shares.

Chevron offers a glimpse of the challenges oil majors face in bringing on new production as existing fields decline. Its annual output growth is expected to be 1 percent through 2014, followed by 4 percent to 5 percent in the three years after that as new liquefied natural gas projects come on line.

We are moving into a period of higher capital spending as we fund new legacy projects, including sizable investment in our LNG mega projects, George Kirkland, Chevron vice chairman and head of global upstream and gas, said in a statement.

These include the Gorgon and Wheatstone projects off Western Australia and LNG processing facilities to serve them. Those alone will eat up well over $50 billion in the next half decade or so, though half the cost of Gorgon will be shared with partners Exxon and Royal Dutch Shell Plc .

SPENDING UP DOWN UNDER

Gorgon, set to cost about $37 billion, is due to start up in 2014, followed by Wheatstone two years later. Their combined peak production, equivalent to 710,000 barrels per day, compares with Chevron's latest worldwide oil and gas output of 2.74 million barrels per day.

With those two in the mix and new crude oil harder to come by, Chevron has estimated natural gas will make up 41 percent of its output by 2017, compared with 31 percent now. And that estimate came before it agreed to buy U.S. natural gas producer Atlas Energy in November.

Chevron's total 2010 budget of $21.6 billion will be eclipsed by its 2011 exploration and production spending, estimated at $22.6 billion, up 31 percent.

That includes capital spending for Atlas, though the acquisition itself is not included in the budget, a Chevron spokesman said. Exxon's $30 billion-plus 2010 budget includes spending for its own big natural gas acquisition, XTO.

Chevron's refining budget is $2.9 billion, down from $3.4 billion budgeted this year. A slump in the sector led the company to slash downstream costs.

Included in the 2011 budget is spending on refineries in Mississippi and California aimed at improving returns.

Shares of San Ramon, California-based Chevron were up 30 cents to $86.44 in afternoon trade on the New York Stock Exchange.

(Reporting by Anna Driver in Houston and Braden Reddall in San Francisco; editing by Gerald E. McCormick, Dave Zimmerman and John Wallace)

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