Oil prices sank to $42 a barrel level on Friday, the lowest level since January 2005, after a larger-than-expected drop in US employment in November which underlined fears that the world's largest economy was heading for a steep recession.

Nymex January West Texas Intermediate fell to a low of $42 a barrel but later recovered to trade $1.17 lower at $42.50.

WTI has not traded below the $40 a barrel level since July 2004 but the options market is pricing in a growing likelyhood of such a move.

ICE January Brent lost 88 cents at $41.40 a barrel after touching alow of $40.72.

Merrill Lynch has warned oil prices could fall as low as $25 a barrel next year if the recession affecting the US, Europe and Japan extended to China, the main driver of demand growth in commodity markets in recent years.

Francisco Blanch, head of commodities research at Merrill Lynch, said his main scenario was for oil prices to average $50 a barrel next year, but warned: "A temporary drop below $25 is possible if the global recession extends to China."

"In the short run, global oil demand growth will likely take a further beating as banks continue to cut credit to consumers and corporations," said Mr Blanch in Merrill's global commodities outlook for 2009.

Merril also said that oil prices were likely to reach a bottom in the first half of next year and start a gradual recovery from June 2009.

On Friday, the International Energy Agency again reduced its global oil demand forecast for next year, due to the global economic slowdown. The energy watchdog of the west cut its 2009 demand forecast by 170,000 barrels a day from its November estimate to 86.37m barrels a day.

Helen Henton, head of commodities research at Standard Chartered bank said demand growth for oil next year was likely to be "minimal", as economic growth outside the OECD would be offset by a sharp contraction in demand from industrialised countries.

However, Standard Charted also said that given structural supply constraints, the crude oil market was likely to recover strongly once demand was rekindled.

"The nature of the industry is that continuous investment is required to (just) keep production constant," said Ms Henton: "Once demand rebounds, the pressure on supplies will once more become evident."

Standard Chartered is forecasting a sharp recovery for oil prices in 2010, averaging $80 a barrel, up from $58 next year.

Gold retreated to its session low of $745 a troy ounce as the US stock market reacted negatively to the latest US employment data which showed the third largest fall on record in non-farm payrolls with a huge decline of 533,000.