By Devika Krishna Kumar
NEW YORK (Reuters) - Oil prices fell 3 percent on Tuesday, reflecting growing concern that a two-month rally was fading as demand fails to keep up with swelling global supply, including new output from Kuwait and Saudi Arabia.
Remarks by Federal Reserve Chair Janet Yellen, which were seen as generally dovish for the interest rate outlook, sparked a brief rebound before prices slumped again.
Both oil contracts were down more than 3 percent by 1:31 p.m. EST (1731 GMT). Brent futures fell $1.20 to $39.07 a barrel and U.S. crude was down $1.22 to $38.17 per barrel, a 3.1 percent loss.
The decision by Kuwait and Saudi Arabia to resume oil production at the jointly operated 300,000-barrel-per-day Khafji field, at a time when production is supposed to be frozen, triggered the heavy selloff in oil markets, traders said.
"The capacity of that field in the Neutral Zone is more than what Ecuador produces. If they do freeze, it will not be at the January levels but at a lot higher figure," one trader said, referring to the Kuwait-Saudi border area where Khafji is located.
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Earlier, Yellen told the Economic Club of New York that the Fed should proceed "cautiously" as it looks to raise rates again because inflation has not yet proven durable against the backdrop of looming global risks to the U.S economy.
Hawkish comments from several Fed officials last week put investors on guard for the likelihood of two rate hikes this year, triggering a widespread correction in commodities and bolstering the dollar.
"The comments today suggest that it (next rate hike) may be more delayed and the dollar getting whacked is providing support to oil, although oil is still trending to the downside in the short term," Energy Management Institute analyst Dominick Chirichella said.
The dollar index slipped to a one-week low following Yellen's comments, making greenback-denominated commodities cheaper for holders of other currencies.
Oil prices have risen more than 30 percent since mid-February, ahead of an April 17 meeting in Doha where the Organization of Petroleum Exporting Countries (OPEC) and other major suppliers including Russia will discuss an output freeze aimed at bolstering prices.
But with global inventories swelling and signs some OPEC members are losing market share, the meeting is unlikely to do much to prop up prices, analysts and traders said. Rising gasoline demand in the United States is not seen keeping pace with the increased worldwide supplies.
Oil prices sank further after a source familiar with Iranian thinking said Tehran would attend the meeting in Doha, but not necessarily take part in negotiations over production freezes.
Market watchers now believe the rebound in U.S. crude prices from 12-year lows touched in February was more the consequence of a major short covering rally and less to do with improving fundamentals. [O/ICE]
The oil market is also bracing for American Petroleum Institute inventory data due at 1630 EDT (2030 GMT), which is expected to show that U.S. commercial crude stock piles have reached record highs for a seventh straight week, while refined product inventories likely fell.
(Additional reporting by Amanda Cooper in London and Aaron Sheldrick in Tokyo; Editing by Susan Thomas, Fiona Ortiz and Paul Simao)