For SmartPlanet this week, I surveyed the production costs of unconventional oil from tight oil shales, tar sands, deepwater, and the Arctic, and suggested that they might make oil unaffordable for the U.S. by 2015. Read it here: The cost of new oil supply

Numerous factors affect oil prices, like supply and demand, geopolitical unrest, natural disasters, monetary policy, and speculation, as I detailed in February.

But there is another factor exerting a continuous upward pressure on prices: the substitution of unconventional resources for conventional crude.

When conventional oil hit its production plateau around 72 – 74 million barrels per day at the end of 2004, but demand kept growing, we turned to various unconventional liquid fuels to make up the difference, such as natural gas liquids, biofuels, and most recently, “tight oil” from shales like the Bakken Formation in the U.S.

Source: Gail Tverberg, Our Finite World

The above chart, from an excellent new post by Gail Tverberg summarizing new international production data from the EIA, shows our increasing reliance on unconventional liquids. The supply of crude (plus condensates) flattened out, while natural gas plant liquids (NGPLs) grew substantially, and “other liquids” (mostly ethanol) became significant contributors to supply. The “processing gain” wedge really should be ignored, as it simply represents an increase in volume that results from refining heavy crude oil into lighter fuels; it’s not actually additional fuel.

The advent of tight oil in the U.S. has been hailed as the beginning of our incipient energy independence, although I have found no basis for such optimism in the data.  In fact, this is the third or fourth time we have been treated to such cornucopian stories. A few years ago it was biofuels that would save us from peak oil, and before that it was natural gas liquids, deepwater oil, heavy oil, tar sands and coal-to-liquids. One need look back no farther than 2005 to find plenty of pollyannish projections in reports from the EIA and IEA, and in op-eds in the Wall Street Journal. None of those projections panned out.

The argument was that high oil prices would make these previously-uneconomic resources viable, and to a limited extent that has been true. What we didn’t know then, however, was the pain tolerance limit of consumers. In 2008 we found that limit as we approached $120 a barrel for oil and $4 a gallon for gasoline. Prices are once again beginning to kill demand in the U.S., but under a slightly lower ceiling, because the economy isn’t nearly as strong as it was in the first half of 2008. Now the ceiling is closer to $100 a barrel.

The new floor

The new floor for oil prices is being set increasingly by the production cost of these unconventional liquids. A few decades ago, we could produce conventional oil profitably in the U.S. for under $15 a barrel. But those days are long gone for the U.S., and for most of the world (except a few old fields in places like Saudi Arabia). As every major oil company has admitted in the past few years, the age of easy and cheap oil has ended.

As the cheap oil from old mature fields is depleted, and we replace it with expensive new oil from unconventional sources, it forces the overall price of oil up. This is because oil prices are set at the margin, as are the prices of most commodities. The most expensive new barrel essentially sets the price for the lot.

Research by veteran petroleum economist Chris Skrebowski, along with analysts Steven Kopits and Robert Hirsch, details the new costs: $40 – $80 a barrel for a new barrel of production capacity in some OPEC countries; $70 – $90 a barrel for the Canadian tar sands and heavy oil from Venezuela’s Orinoco belt; and $70 – $80 a barrel for deepwater oil. Various sources suggest that a price of at least $80 is needed to sustain U.S. tight oil production.

Those are just the production costs, however. In order to pacify its population during the Arab Spring and pay for significant new infrastructure projects, Saudi Arabia has made enormous financial commitments in the past several years. The kingdom really needs $90 – $100 a barrel now to balance its budget. Other major exporters like Venezuela and Russia have similar budget-driven incentives to keep prices high.

Globally, Skrebowki estimates that it costs $80 – $110 to bring a new barrel of production capacity online. Research from IEA and others shows that the more marginal liquids like Arctic oil, gas-to-liquids, coal-to-liquids, and biofuels are toward the top end of that range.

My own research suggests that $85 is really the comfortable global minimum. That’s the price now needed to break even in the Canadian tar sands, and it also seems to be roughly the level at which banks and major exploration companies are willing to commit the billions of dollars it takes to develop new projects.

Production costs soaring

Indeed, production costs have been soaring since we began relying heavily on unconventional fuels. This is the direct result of rising prices for essential inputs like steel and diesel fuel (whose cost inflation is directly tied to the rising cost of the underlying fuels like hard coal and oil), of which ever-greater amounts are needed to drill and complete a new well. Adding another mile of high-specification steel pipe to a deepwater well, or another thousand feet of drilling and well casing for a deeper tight oil well, adds significant costs.

Globally, the cost of drilling a new oil well has gone parabolic:

Source: EIA

The cost of adding a new barrel of reserves — drilling to prove that the oil is there and economically recoverable, before actually producing it — has also jumped sharply:

Source: EIA

(It’s unfortunate that EIA doesn’t have more recent data than 2008 for this analysis, because the sharp downturn at the end of this chart owed mostly to the economic crash in the latter half of that year. Analogous recent data from the oil patch suggests that the curves in the above chart should have resumed their previous, pre-crash trajectory by now.)

As production costs push ever closer to the retail price ceiling, profit margins fall. Consider Canada as an example. Oil production there will likely turn a mere 5 to 8 percent annual return on equity for the next several years, according to analysis by ARC Financial. Under $60 a barrel, they note, “the industry is broadly unprofitable” and would not be able to attract reinvestment. Similarly, University of Alberta energy economist Andrew Leach noted this week that the average operating profit margin of Canadian-owned oil and gas assets is now 7.7 percent, while foreign-owned assets offer only a 5.5 percent margin. A far cry from the heady, ultra-profitable years of 2003 – 2005.

So while the press, ever-anxious to assign blame for high oil prices, highlights the enormous profits that oil companies are making, the fact is that much of those profits owe to producing oil from wells drilled in a much cheaper era and selling it in the new high-priced era.

This will not remain the case for many more years.

The 2014 – 2015 tipping point

Unconventional oil is currently just 3 percent of global supply. The IEA projects that it will make up 6.5 percent of supply by 2020, and 10 percent by 2035. As it gradually replaces cheap oil conventional oil, its real production costs will continue to push oil prices up. Eventually, those costs will cross with the pain tolerance limit of consumers.

Skrebowski sees rising costs outrunning the ability of economies to adapt to higher oil prices by 2014, producing an “economically determined peak” in oil production. After that point, prices will remain economically destructive, and render sustained economic growth impossible. At the same time, it will make new oil production harder to finance.

This matches well with numerous analyses of oil supply that project a major tipping point around 2014 – 2015. At that point, as I have reminded readers repeatedly, we will likely begin down the back of Hubbert’s Curve and see net losses in global oil supply every year.

“Unless and until adaptive responses are large and fast enough to constrain the upward trend of oil prices, the primary adaptive response will be periodic economic crashes of a magnitude that depresses oil consumption and oil prices,” Skrebowski concludes. “These have the effect of shifting consumption from incumbent consumers — the advanced economies — to the new consumers in the developing economies.”

As I detailed last month (“Oil demand shift: Asia takes over“) that is precisely what has been happening since 2005. The world’s emerging markets are buying their first cars and their first trucking fleets, and those vehicles have much better fuel economy than ours. They will be able to pay a price for oil that we cannot tolerate. From 2015 on into the future, fuel will become increasingly unaffordable for U.S. drivers.

So by all means, we should celebrate the ability of high oil prices and truly miraculous technology to bring us oil from under two miles of water and another five miles of rock in the Gulf of Mexico; from previously inaccessible deposits in the Arctic; and from low-grade resources like tar sands and tight oil shales. That technology will mean that we won’t literally run out of oil in the coming decades as depletion takes its toll. But we should not imagine that it will bring us energy independence or bring back the good ol’ days of $2 gasoline. What it will bring, eventually, is oil for Asia as the U.S. and Europe are forced to park their cars for good.

Photo: “Offshore Eiffel,” artwork by Greg Evans.