Brent crude oil fell 2 percent to a three-month low under $108 a barrel on Tuesday as uncertainty over a bailout for Cyprus raised concern about the euro zone debt crisis and its impact on energy demand.
Cypriot lawmakers overwhelmingly rejected a deeply unpopular tax on bank deposits on Tuesday, throwing into doubt an international bailout for the troubled euro zone member, needed to avert default and a banking collapse.
The tax proposal, announced over the weekend as a condition of the bailout, has renewed investor concern about the euro zone's ability to tackle its debt crisis, causing stock markets and oil prices to fall this week. Gold and other safe haven assets rose.
"The situation in Cyprus, although small, goes to show that the problems in the EU are far from over and it will exacerbate declining demand," said Natixis analyst Abhishek Deshpande in London.
Brent crude for May delivery touched a three-month low of $107.25 and settled down $2.06, or 1.88 percent, at $107.45 a barrel.
U.S. crude for April delivery settled down $1.58 at $92.16 a barrel.
The spread between the two leading global oil benchmarks, Brent and West Texas Intermediate (U.S. crude) contracted to $14.61 at one point during Tuesday's trading, the narrowest level since mid-January .
The U.S. dollar firmed by 0.3 percent against a basket of foreign currencies. A stronger greenback can help to weaken oil since the dollar-denominated commodity becomes more costly for holders of other currencies.
The result of the vote in Cyprus could also affect oil if it causes a swing in exchange rates, said Tony Machacek, an oil futures broker at Jefferies Bache in London.
"If the euro makes a dramatic move, it will influence oil," he said.
The single currency was down by 0.6 percent against the dollar and traded below $1.29 for the first time since December.
Iran still presents an element of risk that could limit losses in oil markets regardless of the outcome of the vote in Cyprus, said Thorbjoern Bak Jensen of Global Risk Management.
Europe and the United States last year imposed tough new sanctions aimed at Iran's oil trade to force Tehran to the negotiating table over its nuclear programme.
Insurers have refused to cover Indian refineries that process Iranian crude imports, which may halt deliveries.
But China's biggest refiner said on Tuesday it did not expect to have any insurance problems and planned to use more Iranian oil in 2013.
Additionally, oil traders were watching Syria, where the government and rebels accused each other of launching a deadly chemical attack on Tuesday in what would, if confirmed, be the first use of such weapons in the two-year conflict.
Investors looked ahead to the weekly release of U.S. oil inventory data at 4.30 p.m. EDT (2030 GMT) from the American Petroleum Institute (API), followed by government data on Wednesday.
A fall in crude stocks at oil futures delivery hub Cushing, Oklahoma, could strengthen U.S. crude prices against Brent.
Analysts polled by Reuters expected the data to show total U.S. crude inventories rose by 2 million barrels last week on lower refinery utilization, while gasoline stocks were seen falling by 2.1 million barrels. (Additional reporting By Dasha Afanasieva and Jessica Donati in London and Florence Tan in Singapore; Editing by William Hardy, Jason Neely, Bob Burgdorfer, David Gregorio and Nick Zieminski)