Crude oil fell below $78 per barrel on Tuesday as shares retreated and on expectations that a slow rise in China's currency would have a more limited impact on global demand than initially anticipated.
China's yuan rose on Tuesday after the central bank set the currency's daily mid-point at its highest against the dollar since a revaluation in July 2005.
The move, which followed an announcement by the Chinese authorities that they would let the currency rise slowly, spurred hopes that China would import more goods, including raw materials such as metals and oil.
But the yuan slipped later on Tuesday and analysts said the impact of the changes would be limited, at least for a while.
The knee-jerk positive reaction and euphoria related to the yuan news were definitely overdone. So, it's logical to see the markets giving up the gains from yesterday, said Eugen Weinberg, head of commodity research at Commerzbank.
The commodity markets again demonstrate that they are under the spell and fate of the financial (equity) markets, which are retreating. Also a weaker euro is contributing to the drop.
Stock markets slipped in Asia and Europe with traders saying optimism over China's move had dissipated and as equity investors took profits from multi-week highs. .EU .T
The July contract for U.S. crude, which expires later on Tuesday, fell to a day's low of $76.53 a barrel, down $1.29, before rallying sharply to trade around $77.50, down 32 cents, by 1317 GMT.
U.S. crude for August, which will become the front month from Wednesday, shed 26 cents to $78.35.
ICE Brent for August lost 32 cents to $78.50.
The oil market largely shrugged off expectations of a drop in U.S. crude inventories in data due later this week.
A Reuters poll of analysts showed an average expectation for a 1.3 million-barrel drawdown in U.S. crude stocks.
The analysts issued their forecasts ahead of inventory reports from industry group American Petroleum Institute, due Tuesday at 4:30 p.m. EDT (2030 GMT), and the federal Energy Information Administration on Wednesday at 10:30 a.m. EDT.
Front-month U.S. crude touched an intraday 6-1/2-week high near $79 a barrel on Monday, but pulled back as charts indicated technical resistance. Although prices have recovered by 20 percent from a trough below $65 on May 20, they are still about $10 lower than an early-May 19-month high above $87.
Crude's failure to breach strong resistance at $78.40 -- the 61.8 percent Fibonacci retracement on the move from $87.15 to $64.24 -- brings a new target of $76.50 into play, according to a Reuters market analyst.
Monday's crude rally came after China's central bank allowed the yuan to surge by nearly 0.5 percent against the dollar in the spot market, the daily limit, following a pledge at the weekend to make the currency more flexible.
That led to a commodities rally on Monday amid prospects for increased buying power from China.
A Reuters poll of analysts showed Chinese authorities will only allow up to a 2.4 percent rise for the yuan against the dollar by the end of 2010, keeping its word that it will keep the currency basically stable.
China is the world's second-biggest oil consumer after the United States, accounting for about 10 percent of global use. But it is also the world's fifth-largest producer and in May it pumped more oil domestically than it bought from abroad.
(Additional reporting by Alejandro Barbajosa; editing by Alison Birrane)