By Jane Merriman
UPDATE 1: Crude prices back below $40 and will see the biggest annual loss on record this year.
Oil fell below $40 a barrel on Tuesday, pressured by gloom about prospects for world economic growth which outweighed heightened tensions in the Middle East due to the Israeli-Hamas conflict.
Prices had jumped as much as 12 percent on Monday after Israel launched its fiercest air offensive in the Hamas-ruled Gaza strip in decades.
US crude was down 77 cents at $39.25 a barrel by 1151 GMT, having earlier touched a session high of $40.39.
London Brent fell 60 cents to $39.95.
"With most global economies struggling and credit markets still in an impaired state, it is hard to get too excited about the upside potential in energy markets attributable solely to geopolitical factors unless, of course, these are directed at the heart of the oil supply system," said Edward Meir of futures broker MF Global.
Oil is heading for a loss of nearly 60 percent this year, its biggest annual fall since futures began trading 25 years ago. It has dropped more than $100 from a record peak above $147 a barrel in July.
"People are still wary of the global economic problems. There is still pessimistic news coming out of the States," said Gerard Rigby, an analyst at Fuel First Consulting in Sydney.
He said he would also be watching the dollar and stock markets moves.
The dollar slipped against the euro and a basket of currencies, depressed partly by the Israeli offensive, which has helped to dampen dollar sentiment.
The Organization of the Petroleum Exporting Countries has agreed its biggest-ever production cut of 2.2 million barrels per day (bpd) to fight the oil market slide.
The group has cut output three times in an effort to remove about 5 percent of world supply.
OPEC oil supply, excluding Iraq and Indonesia, is expected to fall by 400,000 barrels per day in December as members boost compliance with their deal to reduce output, consultant Petrologistics said.
The estimate indicates OPEC has more than delivered on its pledge to lower supply from 11 members to 27.3 million barrels per day from Nov.1 to prop up prices.
A poll of analysts forecast that U.S. crude stocks will have fallen by 1.4 million barrels last week, while distillate inventories will have risen by 1 million barrels and gasoline stocks increased by 1.5 million barrels.
Weekly US fuel inventory data is due on Wednesday. (Reuters)