The energy sector has turned upbeat in recent weeks despite still-strong economic headwinds and widespread complaints about political and regulatory uncertainty.

Surviving the financial crisis largely intact has bred a sense of having passed through the worst among the power companies, fuel providers and service firms that keep the energy sector ticking. Although there was widespread acknowledgment this week–at energy industry events in Florida and New York–among bankers, analysts and operators that the business cycle remains stuck at a low, the stress was on fundamental support for new investment and new deals to support continued consolidation.

With the attention of the financial world largely on the sovereign debt crisis in Europe and the week ending with numbers showing a surprise pop in US economic growth, the gloom that sat over much of the domestic energy sector amid stagnant consumer demand and cratered manufacturing demand showed signs of lifting.

The US power sector remains one of the least concentrated in the world, with more than 100 utilities and a multitude of market hubs for trading electricity, fuels and emissions credits. Despite regional regulatory challenges, the sector is almost inevitably set to consolidate as it seeks greater heft and wrings out operational efficiencies. The gains can be enormous, one banker at the Platts Financing US Power conference in New York this week said, pointing to the example of the Midwest Independent System Operator (MISO), which he said had prompted more than $700 million in cost savings by combining transmission systems across a region into a single market.

Further up the supply chain, fuel providers and transport firms are likely to be under pressure to grow in size through merger and acquisition activity as they contemplate the impacts of the $38 billion purchase of El Paso by Kinder Morgan. The deal puts pressure on most other companies in the space and investors expect to see headline-making deals announced in the next year, mergermarket Americas Editor Amanda Levin said at the New York conference as she reviewed the sector’s outlook.

Not Out Of The Woods Yet

Despite the perceptible swing in sentiment, the sector faces an unprecedented variety of challenges as it struggles to remake itself amid aging infrastructure, regulators reticent to allow retirements of inefficient assets and political confusion over federal government commitment to support for renewable fuels.

Environmental regulations are widely cited by operators in the power industry as a hindrance in conducting business, with one utility executive at the CME Global Financial Leadership Conference this week holding his hands more than a foot apart to represent the book of regulations his operations unit has to contend with daily.

While the pace of new environmental regulations has slowed in recent months, and Republican presidential candidate Texas Governor Rick Perry staked out his position as an enemy of “job-destroying” environmental rules promulgated under the Obama Administration, the prospect of rules that require hard decisions on emissions-control investments on aging plants is set to create “localized chaos” in some regional power markets, a private equity energy manager said at the New York event.

Even without the new environmental rules, the “patchwork” of power sector regulations on trading, reliability, fuel requirements and operations are sufficiently confusing and complex to keep power companies region-bound when trying to make deals around individual assets. That hobbles not only deals, but a more economically efficient distribution of generating and transmission assets, despite the efforts of federal regulators at the Federal Energy Regulatory Commission to ease inter-regional planning in electricity.

Finally, the sector faces the hurdle of immensely complex new rules on hedging risk and use of derivatives as regulators release the final rules ordered by the Dodd-Frank bill more than a year ago. Even experts in derivatives admit to not having read the entire bill, and say that the host of exceptions and exemptions will leave companies struggling to comply with or even understand the new rules.

Utility executives say they have had to tie up billions of dollars in assets as trading collateral to reflect conservative accounting by uncertain market players afraid of breaching the new rules unintentionally. That prevents further trading of, or financing based on, most of those assets and slows the process of consolidation, the very process that might allow the power sector to jump ahead even further from the dark days of recession.

Photo Caption: Greece’s central bank the day after a last-hour rescue program for the country’s sovereign debt crisis.