E&P is a capital allocation game, and in a capital intensive industry, driven by a depleting asset base, the capital allocation process is perhaps the single largest driver of future equity value, says Morgan Stanley & Co. Inc research analyst Stephen Richardson. "While lower (and falling) commodity price and tight credit continue to dominate the debate in the industry, the capital budgeting process for 2009 is underway. While capex cuts have been of focus to date, looking forward where capital is allocated (not the absolute level) is likely of more importance. Stock selection matters," he says. A key consideration for the 2009 capital program is likely to be drill it, acquire it, or buy it back, he says. "As we have highlighted previously, much of the group is trading at reserve metrics back to proved reserve levels. With this in mind, and acknowledging that not all assets are equal and future development capital requirements differ across the industry, equity valuations are back to levels where acquiring reserves (either via M&A or repurchasing your own capital) may now be a better decision (on average) than organic drilling projects. We acknowledge that on a project level (versus a corporate level) incremental F&D and project economics are likely to attract additional capital, regardless of the availability of lower cost and or higher risk alternatives in the acquisition market. While operational concerns may dominate near-term decision-making, investing in the lowest cost barrels remains the best decision." A coming consolidation cycle? Not yet, says Richardson. Despite the sound financial logic of acquiring versus drilling, "we are unlikely to see material follow through on this strategy until credit market conditions stabilize. We expect capital preservation to remain the order of the day, particularly as commodity price volatility continues. It is the shrewdest capital allocators with funding capacity that are the likely beneficiaries."