Brent crude dropped more than $1 to below $109 a barrel on Monday in its steepest fall in nearly three weeks as the dollar strengthened after an unusual bailout proposal for Cyprus threatened to trigger fresh turmoil in the euro zone.
News that Cyprus would have to tax depositors as part of a bailout plan sparked fears of a run on some banks in the region, driving down the euro and other riskier assets such as Asian shares and base metals. A string of positive numbers from the world's top oil consumer the United States and ongoing supply disruption worries still helped stem further losses in oil.
Brent futures fell $1.28 a barrel to $108.54 a barrel by 0414 GMT, sliding nearly 1.2 percent, the most in one session since Feb. 26.
US oil declined $1.22 at $92.23, slipping 1 percent, the most since March 1.
"Investors are worried that the Cyprus tax plan will set precedence for other EU nations that require bailout," said Victor Shum, senior partner at IHS Purvin & Gertz in Singapore. "But positive economic numbers out of the U.S. and issues with Iran's nuclear programme will support oil."
Oil markets will remain volatile for the next few days as investors watch for any spillover of the developments in Cyprus to other EU nations, with the US benchmark supported at $90 a barrel and Brent at $105, Shum said.
In a radical departure from previous aid packages, euro zone finance ministers want Cyprus savers to forfeit a portion of their deposits in return for a 10 billion euro ($13 billion) bailout for the island, which has been financially crippled by its exposure to neighbouring Greece.
Cyprus's fractious 56-member parliament is to vote on Monday on whether depositors should forfeit part of their savings to fund a bailout, mainly needed to recapitalise banks.
The uncertainty surrounding the proposed bailout drove investors to the safety of gold, which rose above $1,600 an ounce for the first time in more than two weeks. The dollar index rose 0.61 percent on Monday. A stronger greenback can weigh on dollar-denominated commodities such as oil.
"It's a Cyprus shock. The euro fell, and crude followed that lower," said Ken Hasegawa, a commodity sales manager at Newedge in Tokyo. "We don't know what's going to happen, and it's becoming a uncertain factor."
Signals are mixed for Brent as it is not clear that a rebound from the March 13 low has completed, while US oil may drop to $91 as it failed to break a resistance at $93.72 for the second time, Reuters technical analyst Wang Tao said.
Further losses were capped by expectations of a steady revival in demand growth from the United States.
US manufacturing output bounced back in February in the latest signal of strength in an economy that is showing clear momentum. Factory production increased 0.8 percent last month after falling 0.3 percent in January, the Federal Reserve said. The gain was broad based and double what economists had expected.
Lingering worries of an escalation in the continued standoff between the West and Iran over Tehran's disputed nuclear programme will also help ensure prices don't fall much further. Concerns of supply disruption from the Middle East have kept Brent above $100 a barrel through most of 2012 and this year.
As part of its latest effort to choke off Tehran's funding of its nuclear program, the United States has imposed sanctions on Iranian companies it says provide insurance services to the country's main petroleum shipper.