Oil Ends Session Lower

Updated from 11:47 a.m. EDT

Oil staged a sharp reversal Tuesday, moving lower as traders cashed out their long positions after a two-day runup in prices.

After spending most of the morning higher, September crude closed down $1.30 to $73.75 a barrel. Rumors floated among the Nymex pits that two Israeli soldiers held by Hezbollah had been released, CNBC reported, though there were no supporting wire service reports.

Israel has said it would end its conflict with Hezbollah if the soldiers were released, Hezbollah was disarmed and rockets stopped falling on Israeli cities.

Earlier in the session, oil prices rose as Israel stood firm in its refusal to halt its Lebanese offensive, raising concerns that the conflict could become a larger Middle East war. Traders have been anxious that Syria and Iran, which supply Hezbollah with money and arms, could join the conflict and jeopardize global oil supplies.

"Given the current spare capacity situation, recent market sensitivity to any geopolitical chatter and a maturing hurricane season, oil prices could easily surge well above recent highs for a short period if anything else goes wrong on any of these fronts," said Bart Melek, senior economist at BMO Nesbitt Burns in Toronto.

Fighting increased between Israeli forces and Hezbollah militants in southern Lebanon on Tuesday, and air strikes continued around Beirut. Israeli Prime Minister Ehud Olmert vowed to continue the attacks until Hezbollah could no longer threaten Israel.

"We will not hesitate to take severe measures against those who are aiming thousands of rockets and missiles against innocent civilians," said Olmert, Bloomberg reported.

Olmert and U.S. Secretary of State Condoleezza Rice, who flew to the region on Monday, agreed that Hezbollah should be incapacitated before the conflict ended. They also promised to allow aid flights into Lebanon.

However, Saudi Arabia warned that resistance to a cease-fire would erupt into a large-scale war. Thus far, the U.N. and European and Middle Eastern countries have appealed to the U.S. to step in and promote a cease-fire in the region.

"Saudi Arabia warns everybody that if the peace option fails because of Israeli arrogance, there will be no other option but war," said King Abdullah of Saudi Arabia, Reuters reported.

This year, oil prices jumped 21% on higher demand, lower production in Nigeria and the Gulf of Mexico and threats to global supplies in the Middle East. Crude prices have spiked and tumbled over the past two weeks on the crisis in Lebanon.

The benchmark Amex Oil Index of exploration and refining companies and the Philadelphia Oil Service Index were climbing 1% to 3% on robust earnings reports. Energy companies have raked in tremendous profits on higher oil prices over the past two years, and the second quarter was no different.

Drillers and oil-field service companies saw their earnings surge by at least 50% as booming demand and high prices combined to boost income statements. EnCana (ECA Quote), BJ Services (BJS Quote), Rowan Companies (RDC Quote), Smith International(COP Quote), XTO Energy(COP Quote) and Ensco International(ESV Quote) were among the first companies to report stellar earnings today.

Although production fell during the quarter compared with the year-ago period, BP(BP Quote) stilled eked out a 30% rise in profits to $7.3 billion. Output was 4 million barrels of oil equivalent per day vs. 4.1 million barrels in the previous year.

Wide refining margins and high oil prices are expected to result in fat bottom lines at ConocoPhillips, Exxon Mobil(XOM Quote), Royal Dutch Shell(RDS.A Quote) and Chevron(CVX Quote) when they report earnings later this week.

In coming quarters, production may be further dampened because the company's Thunder Horse platform, the largest in the gulf, won't return to operation until early next year. BP had expected the $1 billion platform to begin production in the second half of this year and was expecting it to contribute as much as a fifth of its growth over the next two years.

Falling crude prices erased all of wholesale gasoline's gains, with the August contract fell 2 cents to $2.28 a gallon. Earlier in the session, a spate of refinery outages and fires boosted gasoline prices. A fire at Venezuela's Amuay-Cardon facility -- part of the world's largest refinery complex -- was expected to keep a crude distillation unit offline for at least five months. The facility, which processes 940,000 barrels per day, is one of the largest gasoline suppliers to the U.S.

Repairs are in progress at ConocoPhillips' (COP Quote) Wood River refinery in Illinois and Valero Energy's (VLO Quote) Lake Charles refinery in Louisiana and another in Tennessee. Heating oil shed 2 cents to $1.94 per gallon.

Traders will be keeping an eye on the U.S. Energy Department's weekly update on petroleum supplies on Wednesday. They expect to see increased production and higher imports boost gasoline supplies by 100,000 barrels and distillates by 1.6 million barrels last week, according to a Bloomberg poll of analysts. Inventories of crude, used to produce gasoline and other petroleum products, likely fell by 500,000 barrels while refining capacity inched up 0.50% from 92.9%.

Natural gas lost 19 cents to $6.40 per million British thermal units on concerns of a supply glut and growing expectations that there will be plenty of fuel to last into the early winter. Thanks to mild spring temperatures and low demand for heat, natural gas supplies in storage grew. They are now 18% higher than last year and 26% greater than the five-year average, according to the U.S. Energy Department's weekly update.