By Laura Sanicola and Muyu Xu
(Reuters) -Oil edged higher on Wednesday as investors grappled with the prospect of supply disruptions due to the Middle East turmoil.
Brent crude rose 25 cents, or 0.3%, to $87.90 a barrel by 0550 GMT. U.S. West Texas Intermediate (WTI) crude rose 24 cents, also 0.3%, to $86.21 a barrel.
Brent and WTI surged more than $3.50 on Monday as the military clashes raised fears that the conflict could spread beyond Gaza, but settled lower in Tuesday's session.
Israel produces very little crude oil, but markets are worried that the conflict could escalate and disrupt Middle East supply, worsening an expected deficit for the rest of the year.
"There is still a risk that this escalates, particularly if there is any Iranian involvement. Under this scenario, stronger enforcement of U.S. sanctions on Iranian oil would tighten up the oil market through 2024," said Warren Patterson and Ewa Manthey, analysts from ING bank, in a note to clients.
U.S. officials have pointed fingers at Iran as being complicit in the Hamas attack on Israel, but credible evidence of the Islamic Republic's role has yet to emerge.
Political risk has kept crude prices from falling further.
Israel says it has razed sections of Gaza in retaliation for the Hamas assaults. Keeping markets on edge, powerful Iraqi and Yemeni armed groups aligned with Iran have threatened to target U.S. interests with missiles and drones if Washington intervenes to support Israel.
Top oil exporter Saudi Arabia said on Tuesday it is working with regional and international partners to prevent the escalation of the situation in Gaza and neighbouring areas, and reaffirmed it supports efforts to stabilise oil markets.
"In the actual geopolitical context, crude oil could further rise toward the $90-$100 per barrel range but a rise beyond the $100 level is unlikely with the morose global economic outlook," said Ipek Ozkardeskaya, senior analyst at Swissquote Bank, in a note.
The U.S. dollar index eased to a two-week-low at 105.78 as the market waited for the U.S. Federal Reserve's September policy meeting minutes due later on Wednesday. A weaker dollar makes crude cheaper for holders of other currencies, which could drive up oil demand.
Several Fed officials in recent days have suggested that the U.S. central bank doesn't need to raise borrowing costs any further.
In a more positive sign for supply, Venezuela and the U.S. have progressed in talks that could provide sanctions relief to Caracas by allowing at least one additional foreign oil firm to take Venezuelan crude oil under some conditions.
(Reporting by Laura Sanicola and Muyu Xu; Editing by Leslie Adler, Shri Navaratnam and Sonali Paul)