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Oil dropped to $126 a barrel this afternoon, falling for a second straight session, as concern eased that Hurricane Dolly would hit Gulf of Mexico crude supply.

The slowing US economy and lacklustre energy demand in the world's top consumer also weighed on the market, analysts said. Attention later on Wednesday will focus on the latest weekly US inventory report.

“Dolly has not deviated much from its forecasted path," said Olivier Jakob, oil analyst at Petromatrix. "Its price impact potential should now be discounted.”

By 12.04pm, US crude for September fell $2.44 to $125.98. The August contract expired yesterday after falling as far as $125.63, the lowest since June 5th. Brent crude slipped $2.26 to $127.29.

Oil's further drop coincided with a firmer dollar, which may have reduced the appeal of commodities to some investors, analysts said. The dollar hit a one-month high against the yen today.

Analysts who use past price movements to predict future direction said the market could head lower for now, given that the next area of support is around $120 to $122 a barrel for US crude.

"In addition to Dolly's likely fade into oblivion, we suspect that crude's technicals are not helping matters much either," analysts at MF Global said in a report.

Even after its pullback from the July 11th record high of $147.27, oil has rallied almost 30 per cent in 2008 and is up from $20 in early 2002, driven by demand from fast-growing economies like China.

Hurricane Dolly was still expected to come ashore well away from the key offshore platforms, even after it was upgraded to the Atlantic season's second hurricane late yesterday.

Oil companies working in the US Gulf of Mexico shut 5 per cent of oil and natural gas output yesterday but those outages were expected to be short-lived.