Oil fell 2.8 percent in New York on Tuesday, dropping from a one-month high, on signs that an imminent ceasefire would end a week of rocket attacks and air strikes between Palestinians and Israelis.
A Hamas official said Egyptian mediators had clinched a truce with Israel that would go into effect within hours. However, Egypt and Israel said a Gaza ceasefire was still up in the air. One Egyptian official said he was hopeful of an agreement later in the day.
The news helped calm jittery traders, who had feared intensifying violence could eventually draw in regional oil superpowers, who supply a third of the world's crude.
"Yesterday's big rally was all about fears of a wider conflict stemming from Israel and Gaza, so when the truce was announced it's not surprising we've seen prices come right off," said Andy Lebow, vice president at Jefferies Bache in New York.
Concern about Europe's economy also put pressure on prices of oil and other commodities after ratings agency Moody's stripped France of its prized triple-A badge because of an uncertain fiscal and economic outlook.
In New York, U.S. crude oil futures fell $2.53 a barrel to settle at $86.75. U.S. stock markets were little changed, while other commodities dipped.
Brent crude fell $1.87, or 1.7 percent to close at $109.83 a barrel, recoiling from the 200-day moving average at around $111.80 a barrel.
While word of a ceasefire helped pull down prices, Israel pressed on with its strikes in Gaza on the seventh day of its offensive and Palestinian rockets still flashed across the border as U.S. Secretary of State Hillary Clinton headed to the region after attending an Asian summit.
Oil markets have been balancing export problems in the North Sea and the risk of supply disruptions in the Middle East against the struggling economy and its impact on fuel demand.
Efforts by U.S. lawmakers to try to reach a budget deal to avoid a fiscal crisis have also grabbed the attention of traders across equity and commodity markets over the past week, with Federal Reserve Chairman Ben Bernanke adding to anxiety in comments before the Economic Club of New York.
"The ability of the Fed to offset headwinds is not infinite," he said. He predicted a "very good year" for the U.S. economy if politicians can reach a debt deal, but added: "In the worst-case scenario where the economy goes off the broad fiscal cliff ... I don't think the Fed has the tools to offset that."
Traders were also awaiting weekly U.S. oil inventory data for further market signals. An early poll of analysts by Reuters forecast an increase in both crude and gasoline stockpiles for the week to Nov. 16. Distillate inventories were expected to fall before the peak winter heating oil season.
Data from the American Petroleum Institute was due out at 4:30 p.m. (2130 GMT) on Tuesday, with data from the U.S. Energy Information Administration was set to be released on Wednesday morning.
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