Oil plummets $5 a barrel

-- Oil prices fell Tuesday as a perceived decline in U.S. demand took hold again after worries subsided about disruption of production in the Gulf of Mexico.

Light, sweet crude for August delivery fell $5.09 to $125.95 a barrel at 11:35 a.m. ET. Trading of the August contract was set to conclude with the close of the market in New York.

Economy: Analysts said remarks by Treasury Secretary Henry Paulson and a huge loss posted by banking company Wachovia Corp. contributed to the perception that demand for oil will drop in a weakened economy.

"Reduced economic activity translates into reduced energy demand," said John Kilduff, energy analyst with MF Global.

Paulson, speaking in New York, called for Congress to pass a bill to shore up mortgage lenders Fannie Mae and Freddie Mac, saying they were the key to repairing the battered financial markets.

Wachovia (WB, Fortune 500) reported a net loss of $9 billion on losses related to home mortgages and the bank's declining market value.

As financial activity declines, consumers have less money to spend and businesses cut back on transportation, shipping and manufacturing activities, Kilduff said.

Others viewed Paulson's statement, along a speech from Philadelphia Fed governor Charles Plosser supporting a potential rate hike, as a sign that the United States is on the right track to fixing its financial problems, which also would cause investors to pull money out of oil.

"People aren't going to need to buy oil as a hedge against the dollar or systemic risk in the economy," said Phil Flynn, senior market analyst with Alaron Trading in Chicago.

Gasoline: High fuel prices, spurred on by oil's rise, have also done much to reduce demand, causing oil prices to shed more than $16 a barrel last week.

The average price of a gallon of gasoline fell 1.4 cents Tuesday to $4.055 a gallon Tuesday, according to a daily survey from motorist group AAA.

It was the fifth straight decline in the daily average, which has tumbled nearly 6 cents a gallon from the record high of $4.114 set last Wednesday.

Dolly: Oil producers Royal Dutch Shell and Exxon Mobil said Monday that while they were evacuating oil workers from the western part of the Gulf of Mexico, they expected Tropical Storm Dolly to have only a small effect on production.

The National Hurricane Center issued hurricane and tropical storm warnings Tuesday. It said Dolly - with heavy rains and winds up to 60 miles per hour, could touch the Gulf Coast Wednesday somewhere between Texas and northern Mexico.

"By tomorrow [Wednesday], assuming there has been no lasting damage, the attention will focus on the weekly [supply] report," said Peter Beutel, oil analyst at Cameron Hanover.

The Energy Department's weekly supply report was scheduled for release at 10:35 a.m. ET Wednesday.

The threat of Dolly to Gulf production had previously eclipsed concern about decreasing U.S. demand.

Iran: Beutel also said Iran remained a factor in the market, although not nearly as much of one as it has been in recent weeks.

Last weekend, at a meeting in Geneva, Iran rejected calls from the United States and five other world powers to freeze its nuclear program. The United States and its allies gave Iran two weeks to respond or face further United Nations sanctions.

Iran, the second-largest oil-producing member of the Organization of Petroleum Exporting Countries, has been in the process of developing nuclear technology, and said it could respond to military threats by blockading the nearby Strait of Hormuz, which carries about 40% of the world's tanker traffic.