* Libya oil output up near 40 pct of pre-war level
* U.S. Federal Reserve will continue stimulus (New throughout, updates prices and market activity to settlement.)
By Jeanine Prezioso
NEW YORK, Sept 19 (Reuters) - Oil fell sharply on Thursday after a bout of buying to cover short positions ended and traders refocused on increased Libyan production and dwindling geopolitical concerns about Iran.
Early in the session, investors bought contracts to cover short bets. Once that buying dried up, the market was back to focusing on increased Libyan oil production and some progress in diplomatic relations with Iran, said Gene McGillian, an analyst with Tradition Energy in Stamford, Connecticut.
"It's pretty clear the short covering after Fed announcement evaporated early in the morning, then the buying pressure in the market was gone," McGillian said. "The return of Libyan oil and talks between the U.S. and Iran brought some sellers back in.
November Brent crude settled 1.66 percent lower, or $1.84 per barrel lower at $108.76. Losses deepened in a heavy bout of morning trading that sent prices down $1 in 30 minutes.
October U.S. crude, which expires on Friday, slid 1.55 percent and settled $1.68 per barrel lower at $106.39.
In the previous session, Brent and U.S. oil both posted their biggest rise in three weeks as the Federal Reserve's decision to delay the wind-down of its massive monetary stimulus weakened the dollar and stoked demand for risky assets.
But the sentiment did not last as investors realized the Fed was continuing its monetary stimulus because it viewed the U.S. economy as still in recovery mode, translating into weaker oil demand for the world's largest oil consumer, analysts said.
The market turned its attention toward the Middle East, where Iranian President Hassan Rouhani said his country was not seeking war and would never seek to develop a nuclear weapon. He also said he has authority to negotiate a deal with the United States.
Tehran and the West have been at odds over Iran's nuclear ambitions for most of the last decade, leading to sanctions that cut the OPEC members exports and creating concerns that supplies from other producers nearby could be impacted.
Also pressuring oil prices, Libyan crude production surged back following protests that had disrupted the OPEC nation's oil supplies since last month. Libya's crude oil production has recovered to nearly 40 percent of its pre-war capacity.
The premium of November Brent over U.S. crude CL-LCO1=R narrowed to $2.68 per barrel during the session and settled at $2.90, well off levels of over $8 seen when the Libyan disruptions boosted prices for the international benchmark.
RBOB gasoline futures led the oil complex lower, falling 1.8 percent to $2.69 a gallon, after falling to a nine-month low earlier in the week.
"We came out of peak demand season, and we now have the roll over to winter grade," said Stephen Schork, editor of The Schork Report in Villanova, Pennsylvania. "Inventories are at solid levels and we have a comfortable supply of gasoline now that the holiday driving season is over."
Easing fears of a U.S.-led military strike on Syria also helped to dampen prices, with Western powers meeting for a second day of talks on their draft resolution on eradicating Syria's chemical arsenal. (Additional reporting by Anna Sussman in New York and Simon Falush in London; Editing by Matthew Robinson, Leslie Gevirtz, Jim Marshall and David Gregorio)