Mesenchymal stem cells (MSCs) are an attractive cell source for tissue engineering applications due to their multipotentiality and increased expansion potential compared to mature cells. However, the full potential of MSCs for cellular therapies is not realised, due, in part, to premature proliferative senescence and impaired differentiation capacity following expansion under 20% oxygen. Bone marrow MSCs reside under reduced oxygen levels (4%–7% oxygen), thus this study investigates the effects of uninterrupted physiological oxygen tensions (2%, 5%) on MSC expansion and subsequent differentiation. Expansion potential was evaluated from colony formation efficiency, population-doubling rates, and cellular senescence. Colony formation was significantly reduced under 5% oxygen compared to 2% and 20% oxygen. Population-doubling time was initially shorter with 20% oxygen, but subsequently no significant differences in doubling time were detected between the oxygen conditions. MSCs expanded with 20% oxygen contained a greater proportion of senescent cells than those under physiological oxygen levels, indicated by a three to fourfold increase in β-galactosidase staining. This may be related to the approximately twofold enhanced mitochondrial oxygen consumption under this culture condition. Chondrogenic differentiation was achieved following expansion at each oxygen condition. However, osteogenesis was only achieved for cells expanded and differentiated at 20% oxygen, indicated by alkaline phosphatase activity and alizarin red staining. These studies demonstrate that uninterrupted hypoxia may enhance long-term MSC expansion, but results in a population with impaired osteogenic differentiation potential. Thus, novel differentiation conditions are required to enable differentiation to nonchondrogenic lineages using hypoxia-cultured MSCs.