UPDATE 4-Oil drops below $112 as new U.S. budget talks loom

* Eyes on bigger U.S. budget battles

* Upbeat China data lifts demand outlook, limits losses

* US crude stockpiles last week forecast lower -poll

* Coming up: U.S. weekly API oil stocks; 2130 GMT

(Updates prices)

LONDON, Jan 3 (Reuters) - Oil fell below $112 a barrel on Thursday, pressured by fears of looming budget battles in the United States and rising oil supply, although upbeat economic data from China limited losses.

U.S. President Barack Obama and Republicans in Congress face budget wrangling after a hard-fought deal halted a round of fiscal tightening that threatened to tip the world's largest economy into recession.

"Significant longer-term budgetary issues still need to be addressed, and this problem will be returning to the forefront of trader concerns within the next couple of months," analysts from Jefferies Bache said in a research note.

"In the meantime, we are still having much difficulty constructing a case for higher oil values on fundamental merits alone."

Brent crude fell 60 cents to $111.87 a barrel by 1220 GMT after rising more than 1 percent on Wednesday to settle at their highest level since October.

U.S. crude was down 57 cents to $92.55 after closing at its highest since September.

Analysts expect oil prices to drop in 2013 as supply outweighs demand. U.S. crude production has hit a 19-year high, while Russia pumped more oil last year, remaining ahead of Saudi Arabia in production.

Losses in oil prices were checked by data showing that China's services sector expanded in December, fueling hopes that the world's second-largest economy and top energy consumer is recovering.

SPREAD NARROWS

U.S. crude prices are expected to find support as a major pipeline expansion that aims to ease the bottleneck at Cushing, Oklahoma - the delivery point for West Texas Intermediate crude oil futures - should pump at full rates from the end of next week.

The spread between Brent and West Texas Intermediate <CL-LCO1=R> has narrowed to about $19 a barrel from 2012 highs of about $26.

Investors will be scouring weekly data on U.S. jobless claims and oil inventories due later on Thursday for further cues on the economic health of, and fuel demand in, the United States.

U.S. commercial crude oil stockpiles are likely to have fallen last week due to lower imports as refiners drew down inventories for year-end tax purposes, a preliminary Reuters poll of eight analysts showed.

The American Petroleum Institute (API) will release its report on Thursday, delayed due to the New Year day's holiday on Tuesday. The U.S. government's Energy Information Administration (EIA) will issue its data on Friday.

(Additional reporting by Florence Tan in Singapore; Editing by Jane Baird and Jason Neely)