Why are producers spending ANY money right now?  I’ll tell you why—you can’t shrink yourself to greatness.  But there is one very good reason to stop spending completely—Mergers and Acquisitions.

Now, nobody knows how long sub-$50 oil will last (and always remember that producers get $5-$10 less than WTI).  Morgan Stanley just came out and said it would be a long time.  US boutique brokerage firm Sanford C. Bernstein—considered some of the smartest money on the Street—said oil prices would rebound quickly.

Trust me—the only thing I know for sure in this oil market—is that nobody knows when the turn is coming or how steep or shallow it will be.

Producers are getting the message that this oil price downturn could last.  Virtually every other energy producer in both Canada and the US has announced a scaled back 2015 budget—many of them twice.  Round 1 was 20-30% right after the Saudis said—NO CUTS on Nov. 27.  Round 2 was January—and then the cuts went to 50-80%.

But even at that level–have they scaled back far enough? Because there are two key reasons to preserve capital right now.

1.     It’s going to be tough to add debt over the next few months.  The banks are worried about energy prices.  Reserve evaluations for 2014 year end are yet to come.  That means every dollar available to a company today is worth far more than when it was rolling in the door like a flood when prices were much, much higher.

A producer may be able to generate a positive return on dollars spent today—but  is that in the best interest of the company and its shareholders if that dollar can earn a better return in six months?

2.     The industry already has casualties—and here reserves and production may be able to be bought (a lot) cheaper than drilling.

a.     Southern Pacific (STP-TSX) has declared bankrupty
b.     Privately held Laracina recently defaulted on a portion of its debt
c.      Connacher (CLL-TSX) is desperately exploring alternatives.

The longer the oil price is low, the more opportunities will arise for producers.  They will be able to buy assets at bargain basement prices – if they have capital available.

Another use for cash that could be better than drilling?–buy back their own shares.  If there is a low oil price for a long time, it’s possible that equity prices could get so beaten up that a share buyback provides a better return than drilling wells.

Of course, sometimes it does make sense to keep drilling
1.     The company has to drill a minimum number of wells to hold/earn the land, or perhaps a farm-in agreement.
2.     Their wells still provide a good return on capital even at current prices, (cough cough hack hack)
3.     For larger oilsands producers–if they have already spent most of the capital for a large scale SAGD (Steam Assisted Gravity Drainage) project, then it may make sense to add a few more wells to optimize it.

Otherwise it’s hard to make a case to be spending any of your precious capital right now.

That’s especially true of any tight oil plays, where a third of the oil the well will ever produce comes out in the first 12 months; the decline rates are that high.  That first year makes or breaks the return on that well—even though it may produce for another 10-20 years.

The problem is that stocks get crushed when you stop drilling.  Like I said in the lead of this story—you can’t shrink yourself to greatness.

The penalty for falling production is that the market will punish your stock price making it harder to raise equity and grow.  But perhaps it’s time for a paradigm shift. Given what has happened over the last few months to equity prices, it’s hard to believe there’s a lot more downside for a producer who tries something a little different.

Take Trilogy Energy (TET-TSX) for example, which is managed by the Riddell family—scions of the Canadian industry.  They own 50% of their own publicly traded flagship company, Paramount (POU-TSX) (which owns a big chunk of Trilogy).

Trilogy recently announced that it would reduce its 2015 budget by 75% and that any wells they did drill would be completed but not put on production.  They cited that one third of the reserves are produced in the first year, so why blow down the reserves into a low commodity price.

The Market responded immediately with a 13% drubbing–but the stock has almost recovered to pre-announcement levels.

Now, they were the first to get radical, so maybe it’s understandable that the market will over react.  But what happens to the second, third or fourth company to be so bold?

Almost on queue, Rock Energ (RE-TSE)  announced on Monday that it is virtually eliminating its 2015 capex budget, taking it down to a meagre $25 million.  They will only focus on activities that confirm proof of concept, capture new opportunities and preserve existing inventory (ie: wells to hold or earn land).

Rock is targeting a long term view to value creation and plans no further capital spending on development drilling until commodity prices improve.  The market responded by adding 6.7% to Rock’s share price. Now granted it was an up day for most energy stocks, while the day Trilogy was punished was generally a down day, but it does seem like the market might be starting to see the merits of this kind of strategy.

Going forward there is likely to be a much less negative reaction, especially as investors get their heads around the logic of it.

So maybe it’s time to challenge conventional wisdom.  Maybe it’s time for a new paradigm where management teams get rewarded for preserving liquidity instead of running to stand still on cash flows.