After a bit of a prowl on the net i found a good PDF file that shows that the oil in injected into the helical screws to create a seal and lubricate the bearings. The air it generates is a mix of compressed air and oil that sprays into the tank. The air is on the top (naturally) and is taken from the other side, it can then go to a second oil separator (which mine doesn't have) then is ready to use. I found the oil i got spraying out was when i opened the valve fully, so that was blowing all the air out, the gauge read 30psi, so i'm sure the turbulence inside the oil tank was pulling the oil out with it for that reason. The oil and water i got out of the tank was a bit grubby, i need to change the oil and filter, i just need to find what oil i needs.
I managed to hook up the sandblaster today and drilled the tip out to 1/4"... WOW it eats the paint up, but i can go bigger as i was feeding it with 2 standard 1/2" air lines. I don't have the proper ones that you twist like 1/2 a turn to lock in place for high volume. With the 2 lines i was sustaining 70 PSI and the compressor wasn't even working! I think it can easily go 5/16" but my next restriction will be my air feed lines on the blaster, they are only about 1/2" ID, they run from the top of the pot to the bottom where the sand is fed in. Even with 1/4" I'm pretty happy with the results, i just need to try it on better paint like on the chassis of the machine to see how it cuts through the tough stuff.