LONDON (Reuters) - Oil dropped below $127 a barrel on Wednesday, falling for a second straight session, as concern eased that Hurricane Dolly would hit Gulf of Mexico crude supply.

The slowing U.S. economy and lackluster energy demand in the world's top consumer also weighed on the market, analysts said. Attention later on Wednesday will focus on the latest weekly U.S. inventory report.

"Dolly has not deviated much from its forecasted path," said Olivier Jakob, oil analyst at Petromatrix. "Its price impact potential should now be discounted."

By 0828 GMT (4:28 a.m. EDT), U.S. crude for September fell $1.73 to $126.69. The August contract expired on Tuesday after falling as far as $125.63, the lowest since June 5. Brent crude slipped $1.93 to $127.62.

Oil's further drop on Tuesday coincided with a firmer dollar, which may have reduced the appeal of commodities to some investors, analysts said. The dollar was also up on Wednesday.

Even after its pullback from the July 11 record high of $147.27, oil has rallied almost 30 percent in 2008 and is up from $20 in early 2002, driven by demand from fast-growing economies like China.

Hurricane Dolly was still expected to come ashore well away from the key offshore platforms, even after it was upgraded to the Atlantic season's second hurricane late on Tuesday.

Oil companies working in the U.S. Gulf of Mexico shut 5 percent of oil and natural gas output by Tuesday but those outages were expected to be short-lived.

Later on Wednesday, the latest U.S. inventory report is expected to show crude stocks fell by 700,000 barrels and stocks of distillates rose by 2.3 million barrels, according to a Reuters poll.

The U.S. Energy Information Administration will release its inventory data for the week to July 18 at 1435 GMT (10 a.m. EDT).

(Reporting by Annika Breidthardt and Alex Lawler, editing by Anthony Barker)

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