Brent crude held above $113 per barrel as heavy fighting in Iraq shut the country's biggest refinery and led to the withdrawal of staff by foreign oil firms, stoking worries about exports from the key oil producer.
Some oil companies are pulling foreign staff from Iraq, fearing Islamic militants from the north could strike at major oilfields concentrated in the south despite moves by the Baghdad government to tighten security.
"Exports haven't been affected yet, so the price gain we've seen so far is only on speculation that things might deteriorate further and instability will spread to the south of Iraq," said Ben Le Brun, a markets analyst at OptionsXpress in Sydney.
"But as soon as we hear about production affected, then we will start to see the price move up more dramatically. But it's very hard to put a figure on this," said Le Brun. "In a worst case scenario, Brent could go above $120 at a minimum."
Brent lost 34 cents to $113.11 a barrel by 0401 GMT, after settling 51 cents higher. U.S. crude gained 9 cents to $106.45 a barrel after it ended 54 cents lower. The U.S. July contract expires on 13 July 2014.
Worries about disruption to Iraq's supply drove up both benchmarks by more than 4 percent last week, the biggest weekly jump since July for Brent and since December for U.S. crude.
Iraqi officials say the southern regions that produce some 90 percent of the country's oil are completely safe from the Islamic State of Iraq and the Levant (ISIL), which has seized much of the north in a week as Baghdad's forces there collapsed.
IRAQ'S OIL OUTPUT TARGET AT RISK
But the International Energy Agency (IEA) said that Iraq's target to hit 4 million barrels per day of oil output by the end of the year looks increasingly at risk, just as demand is picking up due to a stronger global economy.
"Within OPEC, Iraq remains the main source of most of the expected capacity growth, but this expansion looks increasingly at risk," Maria van der Hoeven, IEA's executive director, said.
U.S. crude was supported by data from industry group American Petroleum Institute (API) showing crude stocks fell by 5.7 million barrels last week to 378.2 million, compared with analysts' expectations for a drop of 650,000 barrels.
Crude stocks at the Cushing, Oklahoma, delivery hub rose by 255,000 barrels, API said. The U.S. Department of Energy's Energy Information Administration (EIA) is due to release its closely-watched data at 1430 GMT.
Iran and six world powers re-launched talks on Tuesday to rescue prospects for a deal on Tehran's nuclear activity by a July deadline.
Britain said on Tuesday it would re-open its embassy in Iran "within months," after a hiatus of more than two and a half years, a diplomatic breakthrough that underscores the West's desire to secure Tehran's help in Iraq and elsewhere in the region.
Oil investors will also keep an eye on the outcome of the Federal Reserve's policy meeting later in the day. The Fed is widely expected to shave another $10 billion from its monthly bond purchases, which have supported commodity prices by injecting extra liquidity.