Oil sank from 2-1/2-year highs near $120 a barrel on Thursday in strong, late-day profit-taking following an unsubstantiated rumor Muammar Gaddafi had been shot and Saudi Arabia's assurances it can counter Libyan supply disruptions.

A U.S. official said Washington had no reason to believe the Libyan leader was dead after the rumor swept through oil markets and sent prices tumbling more than $2 a barrel just before settlement.

Prices surged in early activity on news the Libyan revolt had caused large disruptions in the OPEC nation's oil supplies -- potentially up to three-quarters of output -- though the scale of the loss could not be confirmed.

Markets had earlier eased on news top OPEC exporter Saudi Arabia was in talks with European refiners affected by the disruption to fill any supply gaps.

After three days of moving to the upside, the market was prone to profit-taking and then we heard the rumor that Gaddafi was dead, said Peter Beutel, president of Cameron Hanover in New Canaan, Connecticut.

It was almost like the fever was breaking anyway, and this was the bucket of water that brought the temperature down quickly.

Traders said an increase in margin requirements for U.S. crude oil futures on the New York Mercantile Exchange and the Intercontinental Exchange in London also added pressure to prices late in the day.

Brent crude hit $119.79 a barrel -- the highest since August 2008 -- in early activity then dropped to $110.51 late, marking the widest trading range for the benchmark since September 2008. Brent settled up 11 cents at $111.36 a barrel, dropping more than $1 in post-settlement activity.

U.S. crude settled down 82 cents at $97.28 a barrel, after touching $103.41, the highest since September 2008.

Brent's performance pushed its premium to U.S. oil, which has been weighed down by large stocks at the Cushing, Oklahoma delivery point for the New York Mercantile Exchange's U.S. oil contract, out more than a dollar to over $14 a barrel.

As concerns mounted about the impact of higher oil prices on economic growth, the International Energy Agency again called on OPEC to draw on excess oil production capacity if required to counter Libyan supply losses.

The IEA estimates the unrest has cut off 500,000 to 750,000 barrels per day (bpd) of Libyan output. Italian oil company ENI, the biggest foreign operator, estimated 1.2 million bpd of the country's 1.6 million bpd had been shut down as international firms pull out workers.

Options trade volumes for the New York Mercantile Exchange's U.S. oil contract hit a record on Wednesday as the unrest sent prices higher, with traders saying bets were being laid for a spike to $120 a barrel by April.

While traders focused on Libya, some support also came after U.S. Energy Information Administration data showed a lower-than-expected build in domestic crude inventories and hefty drawdowns in gasoline and distillate stocks last week.

(Reporting by Matthew Robinson, Gene Ramos, Selam Gebrekidan, David Sheppard, Janet McGurty, Jeffrey Kerr in New York; Christopher Johnson, Nia Williams, Emma Farge, Claire Milhench and Dmitry Zhdannikov in London; Editing by Dale Hudson)