Oil prices dropped sharply on Tuesday with Brent crude falling below $108 a barrel for the first time in nearly three weeks as a deepening nuclear crisis in Japan heightened risk aversion across financial markets.

Japan's nuclear crisis is equivalent to number six on the INES scale of nuclear accidents from one to seven, Kyodo news agency quoted the French Nuclear Agency as saying. The 1986 Chernobyl disaster was a seven and Three Mile Island a five.

There was panic buying in Tokyo shops after explosions at two nuclear reactors sent a low-level radioactive wind toward the capital, although officials said radiation levels at the stricken Fukushima Daiichi nuclear complex had fallen after an earlier spike.

April Brent fell $4.29 to $109.38 a barrel at 1212 GMT after earlier falling by more than $5 to as low as $107.88. U.S. crude for April dropped $3.35 to $97.84 after slipping as much as $4 earlier in the session.

This is a massive risk off day today, said Christin Tuxen, analyst at Danske Bank. The risk averse sentiment is coming through both in the equity market and euro/dollar. It's weighing on oil even though fundamental drivers should suggest an upside.

At one point, Japanese stocks plunged more than 14 percent, heading for their biggest drop since 1987 as concerns grew over the economic impact of the unfolding disaster <.T>

Oil demand from Japan, the world's third-largest user, is likely to decline in the short term as manufacturing and transport stall but could then rise as the country seeks to replace nuclear with oil-fired power during reconstruction.

The International Energy Agency (IEA) said on Tuesday global oil demand was likely to be lower than previously forecast in 2011 as a result of a price shock and trimmed its forecast by 10,000 barrels to 1.44 million barrels per day.

SAUDI TROOPS IN BAHRAIN

Oil markets were also keeping a close eye on developments in the Middle East where Bahrain declared martial law on Tuesday, a day after Saudi forces arrived in the Sunni-ruled kingdom to help restore calm following weeks of protests by the island's Shi'ite Muslim majority.

Opponents of Bahrain's Sunni ruling family called the move a declaration of war, while Iran denounced it as unacceptable and the United States urged its nationals to leave the island, which is home to the U.S. Navy's Fifth Fleet.

The oil market is eyeing both developments in the Middle East and in Japan, said Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas.

While the tensions in the Middle East represent upside risk to oil prices, the disruption to activity in Japan, and regionally through its trading ties with China, is leading oil prices lower for now.

In Libya, Muammar Gaddafi's jets bombed rebels on Monday in a counter-offensive that has pushed them back 100 miles in a week, far outpacing diplomatic efforts to impose a no-fly zone to help the insurgents.

On the data front, markets were looking toward weekly U.S. inventory numbers from industry group American Petroleum Institute. A Reuters poll indicated U.S. crude oil stockpiles probably rose by 1.8 million barrels last week.

(Additional reporting by Alejandro Barbajosa and Ikuko Kurahone; editing by Keiron Henderson)

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