US light, sweet crude fell $2.94 to $41.66 a barrel by 0752 GMT after earlier sliding by as much as $3.52, or almost 8 per cent, reversing a part of Wednesday's $5.57 a barrel gains. Oil tumbled 54 per cent in all last year.

London Brent dropped $3.04 to $42.55 a barrel.

Oil products helped trigger the surge on the last trading day of 2008 after weekly US data showed a fall in refinery activity and an unexpected 500,000-barrel rise in crude stocks, stoking worries that fuel supplies could grow tight.

Inventories of refined products also rose, though less than analysts had expected. Gasoline stockpiles increased by 800,000 barrels, less than forecasts for a 1.5 million-barrel build, while distillates rose by 700,000 barrels, below expectations for a 1.1 million-barrel increase.

But demand remained lower than a year ago, underscoring the dual impact of last year's record-high prices followed by a deepening economic recession, which combined to knock oil prices more than $100 off their $147 a barrel July peak.

Factory activity surveys in the United States and Europe due on Friday are expected to show steeper contractions in December.

Demand is also faltering in emerging Asia, with Chinese commercial fuel stocks rising to another record high in November, while Indian refinery production fell versus a year ago for the first time in three years.

"(Oil demand) data in recent days have been more positive in the cases of the US and the UK, and weaker in the cases of Japan and China," Barclays Capital wrote in a report.

Faced with slumping demand and prices, producer grouping OPEC last month agreed to lower output by 2.2 million barrels per day (bpd), its deepest reduction ever, taking its total cuts since September to the equivalent of 5 per cent of world supply.

Evidence is mounting that OPEC is complying with its goal to reduce production, led by top exporter Saudi Arabia.

GEOPOLITICS SUPPORT

Oil markets have also watched anxiously the dispute between the world's biggest non-OPEC oil exporter, Russia, and its neighbours over natural gas supplies.

Russia shut off the gas to neighbour Ukraine on Thursday, after a contract dispute but increased supplies to other European states to try to reassure customers.

The row could stir new doubts about Moscow's reliability as an energy supplier and fuel suspicions in the West -- already running high since Russia's war with Georgia last August -- that the Kremlin bullies its pro-Western neighbours. However, similar past disputes rarely had an impact on oil flows.