Oil fell as much as 1.1 percent to below $77 on Tuesday on speculation that a gradual appreciation of the yuan would have a limited impact on China's petroleum imports in the short term.
The yuan weakened later on Tuesday after big Chinese state-owned banks aggressively bought dollars. It had earlier strengthened after the central bank set the currency's daily mid-point at the highest level against the dollar since a revaluation in July 2005.
The July contract for U.S. crude, which expires at the end of Tuesday's trading session, fell as much as 85 cents to $76.97 a barrel, erasing Monday's gain, and was down 76 cents at $77.06 at 0617 GMT. It briefly turned positive when the People's Bank of China strengthened Tuesday's yuan mid-point.
Perhaps the market overreacted a bit over the short term, said Yingxi Yu, a Singapore-based commodities analyst with Barclays Capital.
The more active August contract for U.S. crude, which will become the front month from Wednesday, shed 63 cents to $77.98, shrugging off expectations for a drop in U.S. crude inventories and tracking Asian stock markets lower. The Nikkei slipped 1.2 percent on profit-taking on Tuesday after bouncing to a one-month high the day before. .T
It's a positive boost to sentiment following a period of severe risk aversion that has been hitting risky assets including oil, but in terms of the impact on Chinese commodities demand, it's more ambiguous, Yu said.
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.
ICE Brent for August declined 72 cents to $78.10.
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.
The increase in purchasing power for China over the medium term could be a positive thing for prices, but in the short term the actual change in Chinese demand is going to be very modest, Yu at Barclays said.
We do not expect a major single one-off appreciation in the yuan. This strengthening of the band and a more flexible exchange rate is in line with our expectations.
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.
Crude inventories in the U.S. dropped by 1.3 million barrels last week as imports declined, a preliminary Reuters poll of analysts showed on Monday, before Tuesday's weekly industry report from the American Petroleum Institute at 2030 GMT.
The poll also forecast an average 1.3 million barrel increase in distillates and a slim 100,000 barrel decline in gasoline stocks, ahead of U.S. government statistics to follow on Wednesday from the Energy Information Administration.
A tropical wave in the central and eastern Caribbean, spanning from northern Venezuela to Haiti, had a 50 percent chance of becoming a tropical cyclone in the next two days, the U.S. National Hurricane Center said on Tuesday on its website.
Oil services companies went to court on Monday seeking to overturn U.S. President Barack Obama's six-month ban on deepwater drilling in the Gulf of Mexico after the worst oil spill in U.S. history. (Editing by Ed Lane, Himani Sarkar)