(FORTUNE Magazine) – To appreciate America's energy predicament in the post-Sept. 11 world, you don't have to visit the oil fields of Texas and Alaska or journey to East-of-Suez OPEC strongholds like Kuwait and Saudi Arabia. Instead, just head on down to eastern Kentucky. There, deep in the hollows of Appalachia, rigs no bigger than a giraffe struggle to pump out a barrel or two of crude a day. One is located in a field of kudzu; others are situated in forests where the locals hunt squirrels each fall. These small derricks--"stripper wells" in oilspeak--might seem like a throwback to the days of John D. Rockefeller and the wildcatters. But they're actually a vital part of the nation's energy picture. While rigs in the Middle East can produce 20,000 barrels of black gold a day--without even using a pump--the U.S. still gets nearly a fifth of its domestic oil from strippers and other marginal wells scattered from California to Pennsylvania.

Those production numbers--20,000 barrels a day from a well there, vs. two a day here--vividly illustrate why America is never going to be able to satisfy its hunger for oil through domestic production, whether we drill in the Arctic National Wildlife Refuge, in the Rockies, or anywhere else in the U.S. For all the talk, from President Bush on down, about "energy independence" being a matter of national security, America will always rely on imported oil. Overseas is where the oil is. It's that simple.

Politicians may be loath to admit it, but anyone in the industry will tell you that the percentage of oil we import--roughly 60%--is only going to increase. "Energy independence is out of the question," says veteran petroleum expert Edward Morse. "We consume 25% of the world's oil but only have 3% of its reserves." Exxon Mobil CEO Lee Raymond is even blunter: Finding all the oil we need here at home "was a failed notion under Richard Nixon, and it's certainly a failed notion today," he says. "We're a declining oil province and have been for 25 years." And unless prices rise substantially, it's unlikely Americans will start conserving the way they did in the 1970s and 1980s. The U.S. consumes nearly 20 million barrels of oil a day, up 18% in the past ten years. The bulk of that oil is turned into fuel--for cars, trucks, and planes. Machines that run on alternative fuels are on their way (see "The Coming Hydrogen Economy") but won't be available in large numbers for years.

That's not going to cheer anyone up at a time when U.S. Special Forces are parachuting into Afghanistan and tensions throughout the Middle East are flaring, but things aren't quite as bleak as they seem, at least on the oil front. The good news is that America has many more options today about where to get that overseas oil than it did just a few years ago. Although OPEC still helps set global prices and Saudi Arabia remains the world's leading crude producer, the U.S. gets a smaller percentage of its imported oil from the cartel now than it did 25 years ago. Indeed, in the first half of 2001, America brought in more petroleum from Canada than from Saudi Arabia, and only two of our top ten oil suppliers were Middle Eastern countries.

Even as experts ponder the likelihood of a supply disruption in the Straits of Hormuz, energy giants like Exxon Mobil, ChevronTexaco, BP, and Conoco are spending billions in a race to diversify their sources of oil. That shift away from the Middle East has created some unusual political bedfellows: Russia, our old Cold War enemy, is likely to be one of America's strongest allies in breaking OPEC's grip. And U.S. companies will have to work even more closely with unsavory regimes in countries like Nigeria, Angola, Indonesia, and Vietnam. As Red Cavaney, president of the American Petroleum Institute, notes, "God put oil in some tough places, and we have to go where the oil is."

Obviously, oil security isn't just a theoretical concern for think-tank types anymore. Osama bin Laden and the rising tide of Islamic fundamentalism have forced the U.S. to confront the ultimate nightmare scenario--the overthrow of the Saudi monarchy, which controls 25% of the world's proven oil reserves. In fact, it's about an hour's flight from the Saudi oil fields to where U.S. forces are fighting in Afghanistan right now. Corruption among the Saudi royalty, the country's burgeoning population, and the lack of economic opportunity have already made the kingdom fertile ground for extremism.

Indeed, 15 of the 19 men who hijacked four planes on Sept. 11 were Saudis, and bin Laden--himself a Saudi--and his al Qaeda organization have long sought to topple the House of Saud. In his public fatwas, the world's most wanted terrorist even refers to the crude reserves of the Arabian peninsula as "this Islamic wealth" and calls on followers to resist American influence on petroleum production in the region. "If we were to have a major war in the Middle East, the U.S. and the rest of the world are going to be short of energy," notes Archie Dunham, CEO of Conoco. "There's no alternative to that."

Even a less dramatic development than full-scale war--a U.S. strike against Saddam Hussein, for example--would have far-reaching implications. Incredibly, Iraq was America's sixth-largest source of crude in the first half of 2001, supplying more than 600,000 barrels a day under a U.N.-run program that allows the rogue nation to sell oil to raise money for food and medicine. In late October, though, there was renewed talk in Washington that Saddam could be the next target of the President's anti-terror campaign--especially if any links between Baghdad and the anthrax letters or the Sept. 11 attacks turn up. Just removing that Iraqi production from the market would result in a big spike in prices. "The political situation is coming to a head, and not just in the Middle East," says Larry Goldstein, president of the Petroleum Industry Research Foundation. "The next ten years will be more volatile in terms of prices than the last ten."

The thing to keep in mind about Middle East producers and OPEC members (the two aren't synonymous: Nigeria and Venezuela are both powerful OPEC nations) isn't just that they possess a heck of a lot of oil. What oil they have is also very, very cheap to get out of the ground. While it costs deepwater drillers like Exxon Mobil or Conoco roughly $6 to $8 to produce a barrel in the Gulf of Mexico or the North Sea, the Saudis and Kuwaitis spend a fraction of that--$1 a barrel or less. So OPEC will always have a big price advantage over non-OPEC countries, making money even if oil drops to $10 a barrel, a level that would devastate U.S. producers, especially small strippers like those in Kentucky and West Texas.

Of course, OPEC would like to get more than $10 a barrel. And in recent years it has done just that, boosting oil prices from $12 a barrel in 1998 to over $30 in late 2000 by cutting production by 3.5 million barrels a day in an unusual show of discipline. Although oil prices have since dropped to $21 a barrel on fears of a global recession, the cartel's stated goal is to keep prices in the $22 to $28 range--and it will probably cut production further to accomplish that.

Ironically, OPEC's very success in keeping prices reasonably high has undercut its market share. As simple economics would dictate, those higher prices have stimulated exploration and development around the world, especially in places where oil is more expensive to produce. Russia alone upped its oil output by 600,000 barrels a day last year--helping offset the impact of OPEC's cuts--and is expected to post another sizable increase in 2001. "It's amazing what $30-a-barrel oil will do," says an economist for one of the world's top oil companies.

As new discoveries come onstream, it's likely that OPEC's grip on the market will weaken a bit more. Analysts predict that while global oil consumption will rise by 1.5 million barrels a day annually over the next five years, demand for OPEC oil will be flat. Where will all that non-OPEC oil come from? Huge new discoveries in deepwater fields off Angola and Nigeria, in the Gulf of Mexico, and in the Caspian Sea, for starters. Big finds off Nova Scotia are among the reasons oil imports from Canada have risen from 843,000 barrels a day in 1990 to 1.8 million barrels now, making Canada our No. 1 foreign supplier. At the same time, costlier alternatives like converting oil sands into crude are gaining a foothold--a trend that's likely to continue if oil prices remain high.

As Harry Longwell, executive vice president for upstream operations at Exxon Mobil, sees it, the world is in the midst of the most promising period of new discoveries since the 1970s, when fields like Alaska's Prudhoe Bay and the North Sea entered production. Not that any of it is going to be easy--or cheap. Exxon Mobil plans to spend $50 billion during the next five years to find and develop new fields. "People get upset when we make money, but you have to generate attractive returns in order to do the things we want to do," says Exxon Mobil CEO Lee Raymond. "If you want us to drill in Angola, the Gulf of Mexico, and Kazakhstan, you can't do that on a MasterCard."

Even without the strip mines that stretch to the horizon, the steaming ponds brimming with byproducts, and the absence of any living thing save big black ravens and the occasional bird of prey, the landscape surrounding the giant Syncrude facility in northern Alberta would be forbidding. Carved out of 14 square miles of birch and pine forest some 400 miles north of Calgary, near the town of Fort McMurray, Syncrude is the world's largest producer of oil from tar sands. Getting the oil-bearing, gravel-like material out of the ground and turning it into something resembling conventional petroleum--and making a profit--is a formidable challenge. But thanks to $4 billion in investments from Canadian companies and U.S. giants like Conoco and Exxon Mobil, Syncrude is doing it, producing 250,000 barrels a day of high-quality, low-sulfur crude.

When you figure it takes two tons of oil sand to make just one barrel of oil, you begin to comprehend the vast scale of the operations here. As 30-foot-high Caterpillar trucks haul nearly 400 tons of rock out of the pits every few minutes, mining team leader Pat Crisby notes that at 25 degrees above zero, today's weather is rather mild for his workers--the 3,800 Syncrude employees routinely work at temperatures approaching minus 40 degrees for much of the winter. Since 6 A.M. Crisby's men and women have processed some 41,000 tons of rock, removing not just tar sand but tons of soil and stone as well. The oily grit is heated to 176 degrees and mixed with hot water before being thrown into the equivalent of a giant washing machine that separates the oil from the sand. Then the slurry is upgraded and refined until it reaches its final form--a tan, viscous liquid resembling motor oil.

Very expensive motor oil. While it costs the Saudis about $1 a barrel to get their oil out of the ground and into the hands of customers, Syncrude spends roughly $12 to make a barrel of crude. With oil prices at $21 a barrel, the company's margins are "decent right now," says Syncrude President Jim Carter. But if oil drops back into the mid to low teens, as it did in the late 1990s, Syncrude's profits will get hammered. Nevertheless, says Carter, "we see this as the logical alternative to declining conventional reserves in the U.S. and Canada. Similarly, this can replace imported oil from OPEC."

Several factors make oil sands an important part of the equation if the U.S. is to reduce its dependence on Middle Eastern oil. For starters, they're close to home, with major deposits in Canada and Venezuela. They're also abundant--300 billion barrels of recoverable oil is estimated to be in the tar sands in northern Alberta alone--about 30 times the maximum amount of oil thought to lie in Alaska's Arctic National Wildlife Refuge. Venezuela could possess up to 400 billion barrels in its sands--more than the entire proven reserves of Saudi Arabia.

The problem is that making oil from tar sands isn't just expensive. It's also really messy. Not far from the sprawling pit mines, a 600-foot smokestack spews a white cloud of steam tinged with brown and yellow. "We create our own weather," one worker says proudly. "When it's cold, the steam turns into snow. But I wouldn't make a snow cone out of it." In fact, Syncrude emits roughly 240 tons of sulfur dioxide every day, nearly 25 times what a conventional refinery of similar size in Texas would release. Although Syncrude is spending hundreds of millions to reduce emissions and lessen the facility's environmental impact, one glance at the yellowish cloud over the lunar landscape illustrates the tradeoffs in moving away from cheap Mideast oil.

Just how substantial will the environmental costs be? That's the debate now raging around the proposal to open the Arctic National Wildlife Refuge to drilling, a central goal of President Bush's energy policy and a long-held dream of the U.S. oil industry. While environmentalists warn that drilling would turn the 20-million-acre reserve into something resembling Corpus Christi's Refinery Row, devastating species like the porcupine caribou, industry types insist that new technology would dramatically reduce the "footprint" of infrastructure like wells, pipelines, and storage tanks.

The truth, not surprisingly, lies somewhere in between. Although it's unlikely that developing ANWR could be accomplished with the surgical, minimally invasive approach advocates promise, it's also true that oil drilling has come a long way since Prudhoe Bay and the North Slope were opened in the 1970s. At the same time, the reserve is big enough--about the size of South Carolina--to accommodate both oilmen and caribou. In any case, Congress is expected to open up ANWR eventually but plans to limit permanent facilities to no more than 2,000 acres. Despite talk that ANWR's reserves could yield up to a million barrels a day, it will be years before that oil starts flowing, even under the most optimistic scenarios.

While ANWR dominates the energy debate in Washington, a much more significant domestic exploration program is under way in the Gulf of Mexico, directly south of Texas and Louisiana. All the big boys are there--BP, Exxon Mobil, Shell, and Conoco, as well as independents like Anadarko. The reason is that advances in deepwater-drilling technology have made it possible to tap reservoirs of oil and gas that were off limits just a decade ago. Already rigs reaching down nearly 10,000 feet to the ocean floor are in place. While these projects cost billions to develop, the payoff can be huge: Oil flows out of some of these deepwater wells at a Saudi-like pace, occasionally even faster.

Exxon Mobil, for one, is already producing almost 100,000 barrels of oil and gas a day from its Hoover-Diana platform, 160 miles off the Texas coast in water 4,800 feet deep. And farther east, south of Louisiana, Exxon Mobil geologists have high hopes for the new Crazy Horse field, a world-class discovery believed to hold more than a billion barrels of oil. If it lives up to advance billing, Crazy Horse will be the biggest find ever in the Gulf of Mexico, generating 250,000 barrels a day when it reaches peak production.

Still, the Gulf of Mexico's potential pales in comparison with another deepwater region, off the Atlantic coast of Africa. Exxon Mobil thinks its wells off Angola could yield roughly one million barrels a day--about what Alaska now generates. According to Robert Esser of Cambridge Energy Research Associates, discoveries off Angola, Nigeria, and other African nations could together produce three million barrels a day by 2010.

Finally, there's the Caspian Sea--a vast region that includes Kazakhstan, Turkmenistan, and Azerbaijan. When oilmen anywhere in the world gather, it's this area that stirs talk of a Spindletop-like gusher. Indeed, when word reached Dallas in early 2000 that a test well in the north Caspian's Kashagan field indicated major oil and gas deposits, Exxon Mobil's normally reserved Harry Longwell raised his fists and cheered, "Score!" Outside experts like Esser say Kashagan is the biggest global oil discovery in 30 years, with the potential to deliver a million barrels a day by about 2010.

Toss in other Caspian finds like Tengiz and the Azerbaijan Megastructure, and you're talking another two million barrels a day. Together that's equivalent to 15% of America's daily energy needs. Of course, not all that crude will head for the U.S. But that doesn't matter--what counts is that the worldwide pool of oil will grow, thereby reducing the importance of any one country or region. "You can't replace the Middle East," Esser adds. "You have to chew at different pieces around the world, like the Caspian or Africa, which might add to international sources." Exxon Mobil CEO Raymond agrees: "In the upstream, you have to have as diverse a portfolio as possible. That means we're in every place in the world where there's oil." As a matter of fact, the only continent on planet Earth where Exxon Mobil isn't represented is Antarctica.

Given the sheer size of its highways and the ferocity of its traffic--the 15-mile ride from Conoco's west side headquarters to downtown Houston can take an hour in the morning rush--maybe it's appropriate that Houston is the capital of the U.S. oil industry. From the Petroleum Club on the 43rd floor of the Exxon Mobil Building, you can see the ribbons of concrete and blacktop that surround and bisect the city. And above the clogged 18-lane arteries, new risers are in place for yet another generation of freeways--an additional 245 hundred miles of roadway are on the drawing boards.

Houston's dependence on the automobile, not to mention America's, demonstrates why we're going to need more oil even if mileage standards are tightened and alternative technologies take hold. "The reality is that we're going to be dependent on oil for a while," says Severin Borenstein, a professor at the University of California's Haas School of Business. So forget the old arguments about conservation vs. production. Unless we want to grow even more dependent on OPEC and an increasingly troubled Middle East, we'll need both--and fast.

REPORTER ASSOCIATE: Jessica Sung

FEEDBACK: nschwartz@fortunemail.com