Oil fell to near $68 a barrel on Tuesday as investors fled from riskier assets to dollar safety on growing concerns that the European debt crisis could worsen and damage the still fragile global economic recovery.
The U.S. dollar index rose 1.2 percent as investors diverted money away from commodities into the greenback.
A slide in world stocks to their lowest since September 2009 on Tuesday amid growing tension between North and South Korea also weighed on sentiment. Equities are seen as an indicator of future energy demand growth.
U.S. crude fell $2.29 to $67.92 a barrel by 1411 GMT after closing near the key $70 psychological threshold the previous three sessions. The contract earlier fell over $3 during the day but pared losses after the U.S. consumer confidence index hit a two-year high in May.
Brent crude was down $2.56 at $68.61.
"It's risk aversion, falling stock markets and a stronger dollar. People are worried the euro zone crisis will spread and derail the global economic recovery," said Carsten Fritsch, analyst at Commerzbank.
Bank of America Merrill Lynch on Tuesday cut its oil demand growth forecasts for 2010 to 1.5 million barrels per day from 2 mbpd due to anticipated slower global economic growth in the second half of the year.
The U.S. crude benchmark West Texas Intermediate has fallen by more than 20 percent from early May's 2010 high of $87.15 as investors have liquidated long positions and some have bet on further falls.
It touched a low of $64.24 on May 20 — the weakest for a nearby contract since July 2009 but has since recouped some of those losses.
The euro also fell on Tuesday against a basket of currencies, diminishing the buying power for dollar-denominated commodities such as oil.
Spain's central bank took over savings bank CajaSur on Saturday following the failure of its planned merger with another regional lender and this has weighed on the currency this week.
News that euro zone industrial new orders rose in March at their fastest rate in 10 years did little to improve sentiment in the oil market.
SUPPLY COMFORT
Oil markets remain well supplied with the Organization of the Petroleum Exporting Countries pumping about 2 million barrels per day (bpd) above agreed output targets.
While oil is below the $70-$80 range many in OPEC have said they prefer, OPEC officials have stopped short of calling for any steps to prop up prices. The group has not made plans for an emergency meeting, the oil ministers for Kuwait and the United Arab Emirates said on Monday.
A preliminary Reuters survey showed analysts were divided over the direction of U.S. oil inventories last week. The poll of six analysts called for an average drawdown of 100,000 barrels.
Distillate stocks including heating oil and diesel were forecast up 300,000 barrels on average.
Crude stocks at the delivery hub for U.S. futures contracts in Cushing, Oklahoma are at a record high.
But some analysts said the market was unlikely to respond to even a drop in inventories and would instead focus on equities, currently seen as the bellwether for the market.
"If the market is still bearish, I doubt a stock build will lead to a drop in oil prices. What's important is how the stock market develops," said Fritsch.
For some, geopolitical tensions in east Asia could further weigh on oil market sentiment after North Korean leader Kim Jong-il reportedly told his military he might have to go to war if attacked after the sinking of a South Korean ship.
"The impact on oil prices would likely be bearish, since in this area of the world, demand would be impacted far more than supply," said Edward Meir at MF Global.
