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Oil Settles at Nearly $127 On Drop in US Gas Supply

Oil prices shot up as much as $5 a barrel, halting a dramatic two-week slide, after the US government reported a surprise drop in gasoline supplies.

Also supporting prices was news that Israeli Prime Minister Ehud Olmert will step down in September, a move that raised doubts about progress for U.S.-backed Middle East peace efforts in the oil-producing region.

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The big advance raised questions whether crude's steep decline was overblown, but also whether the pullback has now brought prices closer in line with flagging U.S. demand.

Still, analysts offered mixed views on whether prices would return to record levels hit earlier this month, with some saying crude could surge higher and others calling Wednesday's rebound a temporary bump.

Light, sweet crude for September delivery soared to settle at $126.77 a barrel in afternoon trading on the New York Mercantile Exchange. Earlier, prices jumped more than $5 a barrel, marking crude's biggest one-day rally since July 10, when prices ended $5.60 higher.

Brent crude also closed higher.

The Energy Information Administration said in its weekly inventory report that U.S. gasoline supplies fell by 3.5 million barrels last week. Analysts surveyed by energy research firm Platts expected gas supplies to increase by 400,000 barrels.

U.S. crude stockpiles also fell by 100,000 barrels last week, less than the 1.3 million barrels analysts had predicted.

The drop in gas supplies suggests record oil prices haven't curbed U.S. fuel demand to the extent that some energy market analysts had anticipated following crude's frenzied run above $147 a barrel earlier this month.

"We came into this report expecting lousy demand and it wasn't as bad as expected. It's stopping the bearish momentum that we've seen over the last few days," said Phil Flynn, analyst at Alaron Trading Corp. in Chicago.

Also boosting prices Wednesday was a report by Goldman Sachs, which affirmed its earlier forecast that crude will hit $149 a barrel by the end of the year.

The investment bank called weakness in U.S. energy demand "transient rather than permanent," saying the fundamentals of falling oil production and rising world energy consumption remain intact.

Past forecasts for higher oil prices have caused jumps in prices as speculative buyers are drawn into the market.

Still, other analysts said oil's recovery doesn't mean prices are about to go higher again, but rather shows that traders saw a short-term buying opportunity after Tuesday's sell-off.

"I still expect to see further air being let out of this balloon," said Stephen Schork, an analyst and trader in Villanova, Pa. He noted that U.S. demand for energy is falling across most sectors.

Inventories of distillates, which include heating oil and diesel, rose by 2.4 million barrels, more than the 1.8 million barrels expected, according to the EIA report.

And Americans continue to cut back on their driving to cope with almost $4-a-gallon pump prices. The average price of a regular gas fell 1.5 cents on Wednesday to $3.926, according to auto club AAA, the Oil Prices Information Service and Wright Express.

"We clearly have demand destruction," Schork said.

Before Wednesday's rebound, crude prices had dropped in seven of the last 10 sessions, and are down about 17 percent from their peak above $147 a barrel earlier this month.

Prices remain about 60 percent higher than at this time last year.

Comments from OPEC President Chakib Khelil indicating he did not see a need for the oil cartel to cut production if prices continued to fall were also pressuring oil prices, according to analysts at JBC Energy in Vienna.

The dollar was stronger Wednesday against the euro, but the oil market seemed to be ignoring a trend that ordinarily would pressure prices.

Investors buy commodities as a hedge against inflation and a weaker dollar but tend to sell when the American currency strengthens.

Oil also gained Tuesday's announcement from Royal Dutch Shell that it may not be able to fulfill some oil export contracts after Nigerian militants sabotaged a pipeline in the Niger Delta.

Militant attacks on Nigerian oil facilities have trimmed nearly one quarter of the country's regular daily output.

The strongest Nigerian militant group, the Movement for the Emancipation of the Niger Delta, said it sabotaged two pipelines early Monday in the southern oil-producing region.

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