Oil Settles Below $125 on Fed's Inflation Warning

U.S. light, sweet crude oil futures fell sharply Tuesday, pressured by the dollar's strength after Federal Reserve Chairman Ben Bernanke's warnings about the impact of the dollar on inflation and by concerns that oil demand is being curbed by high prices.

On the New York Mercantile Exchange, July crude

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[US@CL.1  Loading...      ()] fell $3.45, or 2.7 percent, to settle at $124.31 per barrel, trading from $123.87 to $127.98.

The move added to a steep sell-off since last month's all-time peak over $135 a barrel that has been propelled by intensifying worries that high prices were denting the outlook for global energy demand.

"In short, the commodity complex's 'all clear to buy' signal has just been flicked off and I am sure traders are on high alert for a rebound in the dollar, a bearish event for commodities," said Chris Jarvis, senior analyst at Caprock Risk Management in New Hampshire.

Dealers said the comments by Bernanke pushed the market lower by feeding a recovery in the U.S. currency and dimming the prospects of a deeper rate cut.

Weakness in the greenback had been one of the factors driving investment in energy, agriculture and metals by encouraging the buying of dollar-denominated commodities as a hedge against inflation.

"Bernanke seems more concerned about inflation than growth and for the first time that I remember, he brings the weak dollar into the macro picture by linking rising import costs— inflationary—to the front page," said Tom Sowanick of Clearbrook Financial.

Correction or Meltdown?

Some analysts say oil's doubling since last year has been propelled by a surge in speculative funds. That was the view of influential hedge fund manager George Soros.

"We are currently experiencing the bursting of a housing bubble and, at the same time, a rise in oil and other commodities which has some of the earmarks of a bubble," Soros said in prepared testimony before the U.S. Senate.

But he said a steep sell-off is not likely soon.

"To be sure, a crash in oil markets is not imminent." Analysts said there was mounting evidence demand for oil was easing and expectations that Asian economies, which have led growth in fuel consumption, will slash subsidies because they have become too costly.

Indonesia, Sri Lanka and Taiwan have already announced cuts to subsidies, while Malaysia said it would scrap fuel price controls in August in a move that could double pump prices.

India was also expected to raise fuel prices.

"The high oil price will clearly be more keenly felt by the end-consumer without these subsidies," said Tom Nelson, an analyst for the Guinness Global Energy Fund, which takes long-only positions in oil and gas firms.

"It's difficult to ascertain the demand destruction this could lead to," he said.

The head of the International Energy Agency (IEA) told Reuters on Monday that world oil demand was shrinking more quickly than first thought and the IEA might cut its demand growth forecasts further.

Most of that decline in demand has so far been in developed economies as sharp price rises bite for consumers and industry.

More evidence on the state of supply and demand will emerge with the release of U.S. weekly stocks data on Wednesday.

A Reuters poll showed analysts expected U.S. crude oil inventories would have risen by 800,000 barrels last week, gasoline stocks up by 400,000 barrels and distillates up 1.4 million barrels.