This occurs after constant erosion around a semicircle in a river. The eroded earth is deposited where the water is slowest, and eventually the erosion cuts straight through, while the deposits block the original stream.

ASCII art diagram of how an oxbow lake is formed:

   original river
     / .----. \
    ( (      ) )
     \ \    / /
-----' /    \ '-----
------'      '------
The circle exists as part of a meandering stream, following the lowest land.

 erosion and depostion
    /  .----.  \
    \  \    /  /
     \  \  /  / ,-- deposition at these corners
-----'   )(   '-----
--------'  '--------
           erosion occurring
           on both sides
As a result of the pattern of erosion and deposition, the shape of the stream morphs by expanding at the top and contracting at the bottom.

     separation  .-- oxbow lake
     .--------. /
    /  .----.  \
    \  \    /  /
     \_/    \_/ ,--- cut off (due to deposits)
          straighened stream (due to erosion)
Eventually, a strong storm will come along and force the river over it's edges, where it will find the shorter straight path across the curve easily due to the heavy erosion. The deposits will finally accumulate enough on the sides of the river to cut off the curve to form an oxbow lake.

Oxbow lakes, formed as described in Jafuser's excellent writeup above, are extremely important habitat areas for plants and animals which live in riparian areas. Usually, a river's occasional floods keep it's main channel and adjacent areas clear of debris and plants. The oxbow lakes offer a sheltered area where plants can grow right up to (and in) the water. Often, the areas surrounding oxbow lakes are filled with lush forests - usually dry areas such as the Central Valley of California once had forests in these areas as dense as any Amazon rain forest. (now, most have been leveled to make way for agriculture, as the land in these areas is extremely fertile). Many animals, such as the rare yellow-billed cuckoo, thrive in these dense forests. During flood season, the oxbow lakes are often connected to the main river, allowing fish such as juvenile salmon access to the nutrient-rich lake. Over time, the lake will slowly fill with sediment, going through the stages of ecological succession until it is similar to neigboring areas, and presumably, eventually the river will eat into it again.

In addition to serving as important habitat, oxbow lakes are also very important in dampening flooding along rivers. They offer wide areas of slow-moving water... floodwaters are slowed by these wetlands and allowed to disperse. The excess water is released at a later time - rivers with extensive floodplains will flow longer and fuller during droughts than rivers without them.

Over the last 100 years, organizations such as the Army Corps of Engineers in the US have straigtened out many rivers, bypassing the oxbow lakes completely and denying them water. The Kissimee River in florida is an excellent example. This is done to make boat traffic more efficient, and supposedly to reduce flooding (although it has the opposite effect). People are recently realizing that this is a mistake, and the very organizations which channelized these rivers are charged with repairing the meandering structure of the waterways.

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