Oil fell more than $2 to below $39 a barrel on Monday, dragged down by widespread evidence that deepening recession was reducing global energy consumption.

The decline came despite news that Saudi Arabia planned to cut output to below its agreed target, as well as gas supply disruptions in Europe as a result of the Russia-Ukraine dispute and tensions in the Middle East.

U.S. light crude for February delivery fell $2.18 to a low of $38.65 by 1020 GMT. London Brent crude fell $1.62 to $42.80.

U.S. jobless data on Friday set the tone for the market.

A U.S. government report showed employers slashed jobs by 524,000 in December, driving the national unemployment rate to its highest level in almost 16 years.

“The U.S. unemployment numbers on Friday started the latest leg downwards. We have had a string of bad news, with companies and economies all reporting negative data. It is almost relentlessly bad,” said Rob Laughlin, senior oil analyst at MF Global in London.

Oil prices fell 54 percent last year and have shed more than $100 from a record peak of above $147 a barrel last July as the global economic downturn hits demand for fuel.

SUPPLY CUTS

The world’s top oil exporter, Saudi Arabia, plans to cut output by up to 300,000 barrels per day (bpd) below its agreed OPEC target, a proactive step to prop up a collapsing market, industry sources said on Sunday.

Riyadh has already lowered supply this month to 8 million bpd, meeting its target under OPEC’s pact to reduce overall supplies by a record amount from Jan. 1.

Saudi Arabia’s cutbacks add to similar moves earlier this month by other OPEC producers including Iran, the United Arab Emirates, Kuwait and Libya to curb supplies, although evidence that oil producers are cutting output has not lent much support to prices so far.

Iran’s representative to OPEC was quoted as saying that the group could decide to reduce oil output again at its meeting in March if crude prices fell further.

The front months on oil futures have been taking the brunt of the falls with the markets is steep contango. March U.S. crude futures have been trading at a premium of more than $5 above February, while April is around $3 above March.

Traders say the wide price spread partly reflects a lack of prompt demand but also a view that OPEC cuts will eventually start to impact the market and support prices.

Also worrying the oil market was the status of a deal to restore Russian gas supplies via Ukraine to Europe.

In the Middle East, Israel leaders trying to find a knockout blow for Hamas militants defying a 17-day-old assault have thrown army reservists into the battle.

Although the Russian-Ukrainian gas price row and Middle East tensions could help push oil prices higher, analysts said any rebound was expected to be short lived.

Goldman Sachs Commodities said in a research note on Friday that a market surplus was expected to continue to drive inventories higher and put pressure on its forecast oil price of $30 a barrel for the first quarter of 2009.

LONDON, Jan 12 (Reuters)

“With the outlook for the global economy deteriorating by the day, commodity investors are no longer confident that demand, even from emerging economies, will be enough to stem a looming surplus of oil in the market,” wrote Simon Wardell, an oil analyst at Global Insight.

OPEC, in its monthly report, said its estimate of world oil demand growth for 2008 has been revised down by 100,000 barrels a day. The cartel cited “an unexpectedly strong decline in oil demand in North America.”

But, “Despite the mixed signals coming from the Saudis after the OPEC meeting, we’re $10 a barrel lower than where we were,” said Mike Wittner, global head of oil research for Société Générale in London. “The Saudis will start cutting sooner or later, probably sooner than later.”

Source: Crude still searching for a bottom -  OPEC cuts demand estimates, may cut production.

Again, it was a measure of how pervasive is the bearish sentiment in the sector that prices declined even as Hurricane Ike appeared set to do massive damage to the Houston area.

At the same time, the Saudis have signaled that they won’t honor the production quota drop agreed to by OPEC in Vienna. “Saudi Arabia will meet the market’s demand,” a senior OPEC delegate told the New York Times, “the policy has not changed.”

The “Saudis are taking the much more intelligent approach,” said Anthony Sabino of St. John’s University. “They realize product is overpriced, downward trend cannot be easily arrested, and cutting production will only spur even more conservation.”

Sabino believes that, “Once [crude] gets below the $100 psychological barrier, you might well see a major sell-off to as low as $80.”

Source: Crude nearly at $100 – Hurricane Ike ignored as Saudis signal they won’t cut production.

The Independent reports that Saudi Arabia’s King Abdullah signaled his commitment to increase Saudi oil production to UN secretary general Ban Ki-moon last weekend, following protests and riots over food and fuel inflation in countries as far apart as Spain and South Korea.

The Independent says the Saudis will begin pumping an extra half-a-million barrels of oil a day compared to last month, bringing Saudi oil production to 9.7 million barrels a day — their highest level ever. Meanwhile, the Saudis are pressuring Western nations to lower fuel taxes to reduce inflation.

For energy investing guru Byron King the recent spike in crude oil prices was due to three separate events…

There were three news stories, although all are quite well understood. Dollar weakness, the unexpectedly large US unemployment report, and the Iranian “story” from Israel all conspired to trigger the upward move. So far, so good. But it’s the same news as we’ve seen many times before. Nothing new, really. (139th story about the impending attack on Iran, for example… Yeah, right. I’ll believe it when I hear the bombs explode.)

But then came the short-covering that drove what would have been a $2 or $3 move into an almost $11 move. Hence the melt-up.

The normal reaction to the excessive advance is a retreat… and this is what we’ve seen early week — when retreated about $3/bbl.

By definition, the “futures” markets are all about the future.

In general, in the future people expect to see a weaker dollar and tighter supplies of oil that cannot meet projected demand.

The way to break this cycle is with a clear signal from the US Federal Reserve that it will defend the dollar. I’d like to see a 1% interest rate increase, with language that if this does not get the dollar on track then there will be more rate increases. This will hurt some parts of the economy (like housing). But it will salvage the rest of the economy. As things now stand, high energy prices are just going to kill off the bulk of the economy and destroy the American middle class.

But this monetary action is only half of the solution.

The other half is that the US govt needs to adopt a strong, production-oriented energy policy. Yes, the new policy must include the usual tributes to conservation & efficiency… as if high energy prices do not enforce and drive home the import of such virtuous behaviors. And the new policy should give wide leeway to windmills, solar, geothermal and 2nd generation biofuels. It’s a true shame to waste good coal or oil on something that you can do with a windmill. But you cannot run an economy on windmills, solar, geothermal and biofuels alone.

U.S. Dependence on Oil…

The US needs to focus on North American energy production, via oil & gas drilling in Alaska and offshore, plus “clean coal” technology, coal-to-liquid, oil shale development, gas hydrates, next-generation nuclear, and anything else that will work in the next 10-20 year time frame.

Just the announcement that the US is adopting this pro-production policy will shape the marketplace and tend to drive long-term prices down. The worst case is that it will sure moderate any future price increases.

There is an astonishing amount of energy technology out there, already invented and workable. The great challenge of the future is systems integration, to bring it all together and apply it to our problems. Integrate it, make it work and scale it up. This just takes a lot of hard work, with direction and incentive to achieve.

The first energy “system” that is broken in the US is the lack of coherent, national energy policy. We have to fix that.

And if we don’t defend the dollar, what’s the use? The dollar will die, and we’ll be calculating our energy transactions with seashells or pretty stones.

Note: Byron King is a frequent contributor to the free e-letter Whiskey & Gunpowder. To receive daily insights into energy, oil, commodities and other natural resources sign up here!