Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) announced last week that it was officially throwing in the towel and dramatically reducing its spending. And, when I say dramatic, I mean it because it’s gutting it budget, slashing it by 90%. That will have an almost immediate impact on production, which is expected to fall sharply in 2016. It’s a clear indication that the company is in survival mode.

Powering down

For 2016, Penn West only plans to spend $50 million on capex, which is not only 90% less than what it spent last year, but an even smaller fraction of the $732 million it spent in 2014. It’s a budget that “reflects the reality of living within our means at current pricing levels,” according to CEO Dave Roberts.

In fact, the current low to mid-$30 a barrel represents only about $40 million in funds flow for the full year if oil stays at this level, so Penn West is spending everything it expects to bring in.

Penn West’s sole focus right now will be on economics. That means only pursuing the handful of new wells that are economic at the current oil price while also shutting down those that are no longer economic. Given where the oil price is right now, some of its fields aren’t producing any cash flow. That’s forcing the company to shut in production in those fields with it estimating that 4,000 BOE/d will be shut in during the first quarter.

Further, Penn West estimates that up to another 2,500 BOE/d of production will be shut in because the repairs to equipment or other replacement projects won’t be economic at the current oil price.

Letting nature take its course

Penn West’s operating plan in 2016 will see the company “focus on the economics of every dollar we spend at the expense of maintaining our production levels,” according to Roberts. As such, its production is expected to head meaningfully lower in 2016. Not only will production be impacted by the aforementioned production shut ins, but the decline in spending will lead to a decline in production because the company won’t drill enough wells to offset its base production decline of 20-22% per year.

In other words, the company is being overcome by the nature of oil wells, which sees production fall as pressure is relieved from the reservoir when oil is produced. By not reinvesting to drill more wells to overcome this decline, the company’s overall production will succumb to the decline rate.

Because of these factors, Penn West estimates that its production will average between 60,000 BOE/d and 64,000 BOE/d in 2016. That’s significantly less than the 77,000 BOE/d the company averaged just last quarter and even further below its full-year average of 103,989 BOW/d in 2014, though some of the difference is due to prior asset sales. Having said that, the company has clearly shifted gears from trying to maintain the status quo to just trying to make it through the downturn.

One thing that’s important to point out is that Penn West’s plan will actually be beneficial to the overall oil market. Because the company’s production is coming down so significantly, it will become part of the solution to the oversupply problems in the oil market because it will be pumping less oil into an oversupplied market.

It’s plans like this that, when taken across the entirety of the industry, could enable the oil market to rebalance quickly in 2016, potentially leading to a sharp rebound in the oil price later in the year.

Investor takeaway

Penn West has hit its breaking point. The oil price is now too low for the company to maintain its production levels because it’s not generating enough cash flow to fund the wells needed to overcome its decline rate. While that means a significant slide in the company’s production, it’s actually exactly what the overall oil market needs right now.