A sharp drop in U.S. drilling spurred by low oil prices, scarce funding and potential tax hikes may thwart the Obama administration's plans to end U.S. reliance on foreign oil.

U.S. oil output is poised to rise 8 percent this year to 5.4 million barrels per day -- the first increase since 1991 after a six-year rally in prices fed exploration and production projects -- according to the U.S. Department of Energy.

But the drilling spree has collapsed alongside a 65 percent slump in oil prices since last July, putting any increase in domestic output at risk and raising the specter of increased foreign dependence in years to come.

Drillers are like farmers; we only increase activity when the future looks good, said Dewey Bartlett Jr., who chairs the National Stripper Well Association. I'd expect a sharp decline in U.S.-produced oil and gas a year or two from now.

Since September, the number of U.S. rigs drilling for oil and natural gas has dropped almost 50 percent to 1,085 rigs, the quickest decline since 1986, according to data from oil services company Baker Hughes.

The cuts affect many natural gas areas, and oilfields in regions like North Dakota, the Texas plains and the shallow waters of the Gulf of Mexico.

The U.S. rig count may fall by another 22 percent this year to 850, one U.S. government energy expert said, requesting anonymity since his forecast is not official, while oilfield services company Weatherford sees the count bottoming out at about 900.

It can take months or years before a plunge in the rig-count cuts production, but investment in finding new reserves or maintaining marginal fields is falling, dimming the prospects for future output.

The Obama administration supports some new drilling but has focused on alternative fuels and efficiency as keys to cutting imports that have roughly doubled since 1991.

The White House says it aims to eliminate our current imports from the Middle East and Venezuela within 10 years.

LOSING THE WILL TO DRILL

The lull in U.S. drilling comes even as many producing wells remain profitable. Oil prices have averaged $42 a barrel this year and are now over $50 - a far cry from the $10 a barrel that sent oil companies into a panic during 1999.

Rigs have also become cheaper and more abundant due to the slump, but the cost savings are little consolation to many drillers, since a credit crunch has made bank funding scarce. You often hear it said that the U.S. can't increase production, but that's just wrong, said Harold Hamm, the chief executive of oil firm Continental Resources. Problem is, it can't be done with oil at $40.

Hamm is among the biggest producers in North Dakota's Bakken Shale, a rock formation with more than 4 billion recoverable barrels, according to the U.S. Geological Survey.

Shale drilling is costly, and output in North Dakota - the fifth-largest U.S. oil producer - is already falling. Bakken's rig count fell by almost half from a high of 96 in November.

U.S. oil output peaked in 1970 at 9.6 million barrels per day. Now, it falls naturally at around 7 percent a year unless big new finds are tapped to replace maturing fields. Behind this year's growth is the ramping up of BP's 250,000 bpd Thunder Horse field project offshore Louisiana, which took a decade to develop.

But further falls in oil prices could push the U.S. decline rate above 10 percent a year, around double the global average, said Fadel Gheit, an analyst with Oppenheimer in New York.

Small wells, also known as stripper wells, produce 1.4 million barrels a day in the United States, but NSWA's Bartlett expects their output to decline at over 10 percent a year.

Investment bank JP Morgan expects oilfield declines to quicken by 3 to 4 percentage points in costly U.S. fields.

Obama's proposed budget also discourages drillers, since it could end tax breaks - including one that allows companies to write off about 25 percent of drilling costs - and impose excise fees on oil and gas.

Devon Energy, a major driller in the U.S. Gulf, is among companies concerned about the budget and scaling back projects. It plans to spend $3.5 billion to $4 billion this year on field activities, around half what it spent last year.

Majors like ConocoPhillips and Chevron have also announced spending cuts, though others, like Exxon Mobil have raised spending.

(Reporting by Joshua Schneyer; Editing by Marguerita Choy)

Energy