The sell-off, which came with the existing futures contract set to expire, was a throwback to last week's sharp declines and dragged crude to its lowest trading level since early June.

Light, sweet crude for August delivery fell $3.80 at $127.24 a barrel on the New York Mercantile Exchange. Earlier, the contract dropped as low as $126.26.

The declines offered further evidence that investors who only a week and a half ago drove prices to a new record above $147 a barrel are now pulling money out of the market. There are also indications that the price of oil is killing demand, especially in the U.S., which consumes far more oil than any other country.

"This is more of the long exit from the market by the hedge funds," said Jim Ritterbusch, president of energy consultancy Ritterbusch and Associates. "A lot of these investors who have been supporting prices are hitting the road"

Prices rose Monday as Tropical Storm Dolly bore down on oil and gas installations in the Gulf of Mexico, but that did little to dent the steep declines left over from last week's sell-off.

Forecasters at the National Hurricane Center in Miami say it is likely Dolly will become a hurricane, but they do not expect it to become a major hurricane.

By morning in the U.S., the storm's center was about 265 miles southeast of Brownsville, Texas. It was moving west-northwest at around 13 mph and winds were expected to strengthen Tuesday to hurricane force, which would mean at least 74 mph.

"The market had a rally yesterday based on concerns about the storm," Ritterbusch said. "Most people I knew were looking for a stronger price rally. When we can't muster up much steam, a lot of these hedge funds are just dumping their long positions."

Other energy commodities were also down sharply. Natural gas is trading below $10 per 1,000 cubic feet for the first time since April.

Retail gas prices continue to fall away, with the cost for a gallon of gas falling more than a penny overnight to $4.055, according to AAA, the Oil Price Information Service and Wright Express.

It is the first time since January that gas has fallen for two consecutive weeks, according to analyst and trader Stephen Schork. Still, a gallon of gas still costs 30% more than it did last year, or more than 80 cents, he said.

In other Nymex trading, natural gas futures dropped 51.4 cents to $9.996 per 1,000 cubic feet. Heating oil sank 7.47 cents to $3.6732 per gallon, while gasoline futures tumbled 9.31 cents to $3.124 per gallon.

In London, September Brent fell $3.74 to $128.89 a barrel on the ICE Futures exchange.