NEW YORK/Philadelphia, United States (Reuters):

United Airlines' parent UAL Corp and Continental Airlines Inc. are in preliminary talks about a merger that would create the largest airline in the world, sources familiar with the situation said on Wednesday.

The talks come amid heightened merger activity in the airline sector, which is emerging from a prolonged slump following the September 11, 2001 attacks on the United States.

US Airways Group Inc. last month made an unsolicited bid for larger, bankrupt rival Delta Air Lines Inc. AirTran Holdings Inc., on Wednesday offered to buy Midwest Air Group Inc.; and bankrupt Northwest Airlines Corp is evaluating strategic alternatives, including a merger.

"Everyone talks to everyone all the time, but (United and Continental) renewed contact after the USAir and Delta situation emerged," said one source, who declined to be identified. "It's far from certain. At the moment, it's just talks."

Despite the potential hurdles, the combined company would have many interesting components.

United brings its strength on the West Coast, coveted gates at London's Heathrow Airport, and its strong presence in the important Chinese market. Continental offers its key Newark, New Jersey hub, Trans-Atlantic access, and a strong presence in Latin America.

"It makes a lot of sense," said Roger King, an analyst with CreditSights. "It would be a good aggressive strategy by United and a good defensive strategy by Continental."

'MORE SMOKE THAN FIRE'

A deal between United and Continental would have to contend with the usual complexity of integrating workforces and combining fleets and route networks.

But the carriers would face an even more difficult road than other potential airline deals. First and foremost may be convincing Continental's management to do a deal, said airline consultant Mike Boyd. "There's probably more smoke than fire at this point," he said.

Continental has repeatedly said it would prefer to remain independent but would consider a deal, if necessary, to remain competitive. The company was not immediately available for comment. United declined to comment.

A deal, which would create an airline with more than 26 per cent market share, would surely face close scrutiny from antitrust authorities.

"The big question is what the regulators will do," said Ray Neidl, an analyst with Calyon Securities.

In the past, U.S. regulators have frowned on big airline mergers, with competition concerns derailing a planned merger between United and the old US Airways in 2001.

But given the industry's troubles over the last five years, airline executives have said they believe the U.S. Department of Justice may be more amenable to big deals now.

A Continental-United deal also faces a unique problem: Northwest Airlines holds a so-called "golden share" in Continental that gives it the right to block mergers involving the Houston-based carrier.

The airlines could offer Northwest assets or other incentives in exchange for its support.

"Anything can be negotiated," said airline consultant Bob Harrell of Harrell Associates.