By Barani Krishnan
NEW YORK (Reuters) - Oil prices fell 1 percent on Friday, ending a two-day rally fueled by short-covering and bargain-hunting, as the dollar surged on robust U.S. jobs data and reasserted its influence over crude futures in an oversupplied market.
The dollar had its biggest daily advance in six weeks, rising 0.7 percent, after U.S. employment growth exceeded expectations in July as higher wages improved chances that the U.S. Federal Reserve would raise interest rates before the year ends.
A stronger dollar makes oil and other commodities denominated in the greenback less affordable to holders of the euro and other currencies, and usually reduces demand for them.
In recent weeks, however, that pattern appeared to have broken down. U.S. crude futures fell to April lows of below $40 per barrel earlier this week despite the dollar's weakening.
"The dollar/oil correlation may be back today to pressure crude but the reality is we just have too much oil supply out there to continue supporting prices at these levels," said Phil Davis, trader at PSW Investments in San Diego, California.
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"We might hold above $40 next week but I doubt we will be trading at $42 when the new WTI front-month comes into play."
The September front-month contract in WTI, or U.S. West Texas Intermediate (WTI) crude, was down 40 cents, or 1 percent, at $41.53 per barrel by 12:31 a.m. EDT (1631 GMT), after a session low at $41.06. The October contract, which will become front-month from Aug 23, traded above $42.
Brent crude was down 43 cents, or 1 percent, at $43.86 per barrel. It earlier fell to $43.51.
For the week though, Brent was on track for a gain of about 3 percent while WTI was marginally lower, helped by technical short-covering and bargain-hunting that pushed oil prices up by nearly 6 percent over the past two sessions.
The mid-week rebound came after WTI broke the key $40-per-barrel support on Monday and settled below that level on Tuesday for the first time since April.
Even so, WTI timespreads weakened earlier this week, with the December contract for 2016 versus 2017 reaching a discount of more than $4 a barrel, its widest in nearly 8 months. That indicated eroding demand for oil slated for nearer-term delivery.
Rebalancing the oil market has proved a long and frustrating process as oil-exporting countries hit hardest by the 2014-15 price slump were themselves some of the fastest-growing oil consumers.
Some traders also worry that net Chinese oil imports will weaken this year despite China surpassing South Korea as the top Asian buyer of North Sea Forties crude.
"A major pillar of oil demand is therefore on course to ease considerably over the coming months," Stephen Brennock, analyst at London-based broker PVM, said.
(Additional reporting by Libby George in LONDON and Henning Gloystein in SINGAPORE; Editing by Marguerita Choy and Richard Chang)