Oil fell more than $1 a barrel to below $38 on Friday, retreating as the global economic outlook deteriorated, dragging stock markets down across the world.

Oil prices rallied strongly on Thursday, jumping 14 percent after data showing an unexpected draw in U.S. crude stocks. But worries over the health of oil demand have resurfaced, with sentiment dented by sharp falls in equity markets.

European shares <.FTEU3> tumbled to a six-year low on Friday as investors fretted about capital increases and bank nationalizations on the back of a deepening economic downturn. The drop followed falls in New York and Asia.

The broad Topix <.TOPX> index of Japanese shares closed at its lowest level in about 25 years.

U.S. crude futures for March delivery, which expire on Friday, were down $1.68 at $37.80 a barrel by 5:34 a.m. EST, after posting the biggest settlement gain since December 31 in the previous session.

April delivery contracts fell $1.31 to $38.83, while London Brent for April delivery dropped $1.30 to $40.69 a barrel.

The overall driving trend will be the economy as the market remains demand-focused, said Harry Tchilinguirian, commodities analyst at BNP Paribas in London. We expect this to be the case for the entire first half of the year.

BLEAKEST DIAGNOSIS EVER

Most pressure was on the expiring March U.S. crude contract, which has been weighed down by very high crude inventories at Cushing, Oklahoma, the delivery point for NYMEX futures.

Brent and later U.S. crude futures months were more stable.

Brent bounced back above $40 yesterday, said Christopher Bellew, broker at Bache Commodities. In spite of economic gloom and bearish data, Brent is holding its sideways range.

In its monthly report on Friday, the Bank of Japan reiterated that economic conditions were deteriorating rapidly -- its bleakest diagnosis ever -- and would likely continue to worsen for the time being.

Japan has been hit particularly hard by the global slump, triggered by the U.S. housing market meltdown, due to its heavy dependence on exports and chronically weak domestic consumption.

Crude inventories in the United States, the world's top consumer, fell slightly last week on lower imports and higher demand, the U.S. Energy Information Administration said, snapping seven straight weeks of builds against market expectations.

The bullish oil data countered pessimism in the U.S. stock market, where the Dow industrials index <.DJI> closed at its lowest in more than six years on a gloomy jobs report and fears that banks could be nationalized.

Crude prices have fallen more than $100 a barrel from the peaks hit last July as the worsening economic crisis has bitten into oil demand, prompting the Organization of the Petroleum Exporting Countries (OPEC) to agree to deep output cuts.

In the latest indication that OPEC members are complying with the agreed cuts, Kuwait notified at least two buyers in Asia that it will keep curbs of 5 percent below contracted volumes for April-June term crude oil supplies, steady from March, trade sources said.

U.S. economic reports due out later in the day include the consumer price index and real earnings for January, as well as the Economic Cycle Research Institute's (ECRI) weekly index of economic activity.

(Additional reporting by Chua Baizhen in Singapore; Editing by Keiron Henderson)

BNP Paribas OPEC