Oil fell below $70 on Thursday, pulling back from the more than 5 percent gain a day ago on worries that a rise in U.S. crude and distillate stocks signals weak demand when taken along with the latest economic data.
The price correction was moderated by a weak dollar, which makes crude more affordable for buyers using other currencies, led by gains for the commodities-linked Australian dollar.
U.S. crude futures lost 29 cents to $70.32 a barrel by 0710 GMT (3:10 a.m. EDT), after surging almost $4 on Wednesday to $70.61, the first time in a week that prices have risen above $70 and allowing crude to squeeze out a slight gain for the third quarter.
London Brent crude shed 18 cents to $68.89 a barrel.
Analysts said that despite a surprising drop in gasoline stocks, which might signal nascent recovery in U.S. fuel demand, gasoline and crude supplies maintained their large surplus against the five-year average, and distillates increased their excess to more than 38 million barrels, the biggest seen in years.
Data from the U.S. government Energy Information Agency (EIA) showed a 1.6 million-barrel drop in gasoline stocks for the September 25 week, versus expectations for a 1.0 million-barrel rise.
But crude stocks rose by 2.8 million barrels, against forecasts for a modest 600,000-barrel build. Distillates increased by just 300,000 barrels, but were still at a 26-year high of 171.1 million, coming ahead of winter demand.
The rise in distillate inventories in the latest data is at least strike one and probably strike two for heating oil cracks, in our view, Barclays Capital said in a note.
Another rise in next week's data would be clearly counter-seasonal and from a very high base. The potential sensitivity to that single point makes distillate longs seem overly hazardous to us at this point.
The dollar continued on the defensive on Thursday, having resumed its downtrend in the previous session as investors sold the U.S. currency and went long on growth-linked currencies like the Australian dollar.
The soft dollar helped drive up crude, gold and other commodity prices on Wednesday.
The market performance was also marked by the breakdown between equities and commodities, signaling that asset-specific fundamentals may again be taking center stage.
An unexpected contraction in Midwest business activity and larger private-sector layoffs than had been forecast sounded a downbeat note for the end of a quarter in which stock markets performed strongly.
Traders will be watching talks between Iran's top nuclear negotiator and six world powers in Geneva on Thursday over the Islamic republic's nuclear programme, which U.S. officials said could offer an opportunity for a rare bilateral meeting with the Iranians.
(Editing by Michael Urquhart)