Tomorrow, the U.S. oil industry turns 150 years old, and we thought the milestone marked a useful moment to reflect about the role of oil in the economy and the challenges the United States will face as the nation seeks to reinvent its energy system. We are going to keep this very general and somewhat brief, so if you want more, today’s FT Energy source links to a handful of more narrow and lengthy retrospectives.

As is well known by most observers, the modern oil industry traces its earliest roots back to Titusville, Pennsylvania. There, Edwin Drake-borrowing technology from salt drillers-bored the first oil well in the U.S. The details from today’s Oil Daily:

Drake designed and assembled a steam-powered drilling rig with the help of a local salt driller he hired, one William “Uncle Billy” Smith, along with Uncle Billy’s two sons. They encountered problem after problem, including a collapsing borehole that required them to redrill and redrill. Installation of what they called a “conductor” pipe, analogous to today’s casing, solved that problem.

The drill became stuck at a depth of 69 feet on Saturday, Aug. 27, 1859, author Daniel Yergin wrote in his Pulitzer Prizewinning history of the industry The Prize: The Epic Quest for Oil, Money & Power. The accident was fortuitous as the drill apparently tapped into an oil-bearing zone. The next day Uncle Billy found the pipe filled with oil when he returned to check on the equipment.

Over the next 40 years, the U.S. oil industry expanded as new discoveries were made in Pennsylvania and Ohio. So-called ‘rock oil’ was refined into kerosene and used for illumination, replacing whale oil and other raw materials used in candles and lamps. It was in this time period that the Standard Oil combine came into being, and global competition erupted with oil production beginning in Azerbaijan, the Far East, and elsewhere.

But it wasn’t really until the early part of the 20^th century that the true oil bonanza began in earnest. On the supply side, a series of substantial discoveries were made, the most famous being the ‘gusher’ at Spindletop in Texas. But the real catalyst was on the demand side. In 1908, Model Ts began rolling off the assembly lines in Michigan, and the way Americans used oil was utterly transformed. From that day forward, Americans have enjoyed one of the most mobile, flexible economies in the world, and a lot of that was built on the back of petroleum. In the United States, vehicle registration rose from 8,000 in 1900 to 944,000 in 1912. By 1929, there were more than 23 million vehicles registered in the United States, and more than 140,000 drive-in gasoline stations provided easy access to gasoline.

There are plenty of excellent histories of the global oil market-the best is probably Dan Yergin’s seminal book “The Prize: the Epic Quest for Oil, Money, and Power.” So we won’t belabor the events of the past many decades. But suffice to say that vast fortunes were made by those willing to take the necessary but not insignificant risks to find oil. Wars were won and lost-both for oil and due to lack of it-and the fates of nations across the globe were practically cast in stone.

Today, the U.S. remains the world’s largest consumer of oil by far. According to the BP Statistical Review of World Energy 2009, over the past five years, our consumption has averaged about 20.5 million barrels per day (mb/d). The next closest consumer is China, which averaged about 7.4 mb/d over the same period. (Of course, with a population about one-fourth the size of China’s, U.S. per capita consumption is especially stark-the average American uses about 24 barrels of oil per year. The average person in China uses 2 barrels per year.)

Oil consumption in the U.S. is still essentially dominated by our transportation sector, which is the second largest end-user of energy in the U.S. economy (The largest sector, industrial activity, accounts for about 25 percent of our oil use). According to the Department of Energy (see Table 11 here), about 70 percent of U.S. oil consumption-or 14.3 mb/d-occurs in transport. Of that, our 250 million cars and SUVs alone account for more than 8 mb/d. In other words, our cars and SUVs use more oil every day than the entire Chinese economy. In total, oil provides about 40 percent of all U.S. energy, about double coal or natural gas.

Bottom line: the U.S. economy is heavily dependent on oil and there are currently no available substitutes.

Of course, if oil were 100 percent benign, none of this would be the least bit interesting. But it has become increasingly clear that consumption is associated with a set of negative externalities whose costs are growing. Oil price volatility (not high prices, but unstable ones) has wreaked havoc on the U.S. economy during oil price spikes and more generally over time.  (Check out this presentation to get a sense of the damage.)

Why is oil so volatile today? Skip over speculators and go straight to the fundamentals: On the supply-side, about 40 percent of current global oil output comes from the OPEC cartel, which regulates output based on politics. And the 60 percent of production that is outside OPEC doesn’t come from the most stable places either (Russia, Mexico, Central Asia, etc.) Over the long-term, conventional reserves are concentrated in the Middle East, and the rest of the reserve base is high-cost and high-carbon (bitumen, sands, CTL, GTL, etc.)

The demand side is no more encouraging today. Even though U.S. oil demand is currently much higher than our emerging competitors, that is about to change. So far in 2009, vehicle sales in China have exceeded U.S. sales-about 7 years ahead of the IEA’s forecast. And IEA now expects 100 percent of the increase in global oil demand to come from emerging markets over the next 20 years.

But prices aren’t the only problem. There are less tangible costs to oil use today based on the state of geopolitics. As Iran (OPEC’s second largest oil producer) gears up its nuclear enrichment program, the U.S. and our allies have to be mindful of the key role Iran plays in the global oil market – not only as a producer, but also as a transit state-almost 20 mb/d of world oil trade passes through the Strait of Hormuz off the coast of Iran every day. Could the world economy afford a shut-down there today as we recover from recession? Could we ever? Take a look at this paper from International Security and asses the threat yourself.

We’re not going to be able drill our way out of the problem this time (though more drilling would help a lot). U.S. production of oil has been in a state of steady decline since the late 1970s. We can argue until we’re blue in the face about peak oil (we don’t buy it), but it’s tough not to see that the challenge of producing oil in the U.S. has been pretty tough recently. Take a look at the two graphs below, both from DOE data. Figure 1 plots the costs of development against the average productivity of individual wells. Basically, it’s getting more and more expensive to develop wells with lower flow rates. It’s been getting much more expensive even to just keep production steady.

Figure two plots the number of successful exploration wells drilled each year against the cumulative producing wells. During the 1970s, a stiff boost in exploration activity led to a pretty substantial boost in producing wells. But over the past several years, a similar boost in exploration has not yet translated into a strong incremental increase in producing wells. In part, this reflects the closure of marginal wells. But regardless, the numbers seems to imply that we are working harder to get a much lower return on investment these days.

As we have been consuming more and producing less, it has been getting costly. In 2007, net U.S. oil imports cost about $295 billion. In 2008, DOE and BEA estimate it cost about $388 billion.

It’s anyone’s guess where the United States and oil are headed over the next 150 years, but the current relationship seems clearly unsustainable. We need revolutionary, transformative change in transportation. If that hasn’t happened by the time oil celebrates its 200^th birthday, the country is going to look a whole lot different, because the only other way we will break our massive dependence on oil will be to relinquish our role as a global economic power and our standard of living along with it.

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