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Why Oil Prices Are Lowest They've Been in Months

The free-fall in crude prices is unlikely to reverse course without significant signs that the world economy is improving.

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Oil, like stocks and other risk assets, fell sharply Thursday as fears of slowing global growth gripped markets, which were also beset by speculation about pending bank downgradesand Europe’s sovereign crisis.

But the price of oil has a separate significance in that it is an important lever on the world economy, and its decline could help consumers.

Crude prices have fallen 30 percent from their March highs as oil production globally rose to a record level in May, according to the International Energy Agency.

The world is now pumping 91.1 million barrels per day, the most ever. OPEC production, at more than 31.5 million barrels in May, is also higher than normal.

“I think that we are seeing asset classes moving in response to expectations related to government policy in Europe and the U.S," said Edward Morse, head of commodities research at Citigroup. "I think they are short-term moves that will not be very long in duration. That doesn’t mean there’s not plenty of bearish news in commodity markets, in general, and the oil market, in particular.”

West Texas intermediate plunged 3.5 percent Thursday, following government reports of ample supply and domestic production at a 13-year high. WTI finished $3.05 lower at $78.20 per barrel, the first close below $80 since October.

Brent , the international benchmark, fell to $89.23 per barrel, the lowest level in 18 months.

While Morse doesn’t expect oil to keep falling for long, he doesn’t expect it to get back to its year highs soon either.

“We think there’s no reason for a sustained price recovery for Brent above $100 or WTI above $85 through the second half of the year,” he said.

John Kilduff of Again Capital said after oil sinks through $78, the next level he is watching is $72 per barrel for WTI.

Oil and commodities fell as the dollar rose in its best performance Thursday since November. The fact the Federal Reserve did not announce a new easing program supported the dollar.

Also weak manufacturing data in China and Europe, and a series of disappointments from U.S. jobless claims to the Philadelphia Fed survey, added to the “risk off” temperament of markets Thursday.

In fact, traders say the months-long decline in oil may have been signaling a slowdown in the economy.

Market focus Friday will remain on Europe as finance ministers meet, and the leaders of Germany, France, Italy and Spain meet ahead of next week’s EU summit.

“If the central banks stay put, they may see that oil is helping them out—$68 is not unconceivable,” Kilduff said. “We’re producing about a million barrels a day more than we’re consuming. That’s starting to be a lot.”

IHS CERA Chairman Daniel Yergin, speaking from the St. Petersburg International Economic Forum, said the high production level made sense just several months ago, when speculation around Iran reaction to sanctions sent prices higher.

“It was a quite remarkable period when you go back four months ago. Oil prices got as high as $128 and people were talking about $160, and now it’s at $90,” he said.

“It shows three things: the relentless increase in supply, particularly led by the Saudis, who have been producing very steadily at high volumes since last year and the beginning of this year. Secondly, it reflects the growth of oil from countries as diverse as Iraq and the United states,” said Yergin.

“The supply situation is very different than it was three months ago when Iran was threatening to close the Strait of Hormuz, and the other thing is the bad economic news and weak demand,” he added.

The U.S. has restricted dealings with the Iranian central bank, and Europe has sanctioned Iranian oil starting at end of this month.

Yergin said some of the Iranian oil has already been taken out of the market and the drop in oil prices is also pinching Iran, which has been engaged in talks with a group of six nations on its nuclear program.

So far, Iran refuses to abandon its uranium enrichment program, denying it is seeking to develop nuclear weapons.

The Iran situation remains a wild card for oil prices.

While OPEC affirmed last week that it would hold production at 30 million barrels a day, production of oil elsewhere has increased.

“We’re (the U.S.) probably close to 6.4 million barrels a day, the highest in 13 years,” said Andrew Lipow, president of Lipow Oil Associates. “My unofficial estimate compared to last June, is we’re probably up 800,000 barrels, and that is about a 14 percent increase year over year. It’s huge and it’s being led by North Dakota and Texas. It’s just unbelievable.”

He added: “What we don’t talk about very much is the decline in demand in Europe and that is a good 3 percent year on year, which is a significant amount.”

Lipow also expects gasoline prices to continue dropping to the point where they could be below $3 a gallon nationally by Halloween.

According to AAA, the national average for regular gasoline is $3.472 per gallon. That could be a major factor for the economy.

“To me what really matters is how much of consumer income filling the gas tank eats up," said Ward McCarthy, chief financial economist at Jefferies. "We’ve see it three times now, where gasoline prices get to around $4 a gallon for regular. It takes a bite out of consumer spending. So the further below you get from there the more flexibility it gives consumers. It also gives a boost to consumer confidence.”

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  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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