UPDATE 7-U.S. crude rallies on heating oil demand, gains on Brent
* U.S. distillates down 3.21 mln barrels - EIA
* U.S. crude oil build nearly 1 mln barrels - EIA
* China's factory activity contracts, first time in 6 months
(Updates prices, adds quote)
NEW YORK, Jan 23 (Reuters) - U.S. crude oil futures rose more than $1 on Thursday, narrowing the discount to European Brent to the lowest level for two months following a jump in heating fuel to the highest price of 2014 after a big draw down in distillates inventories.
U.S. oil extended its rally from Wednesday earlier in the session after TransCanada announced the start up of its Gulf Coast pipeline that will carry 700,000 barrels of oil per day (bpd) from Cushing, Oklahoma, the pricing point for the New York Mercantile Exchange, to Gulf Coast refineries.
Brutally cold weather this winter, particularly in the densely-populated U.S. Northeast, continued to boost demand for heating fuels, driving natural gas and oil product prices higher.
U.S. ultra low-sulfur diesel futures (ULSD), more commonly known as heating oil, rose to their highest this year after U.S. government data showed distillate stocks fell by 3.21 million barrels last week compared with expectations of a 900,000-barrel draw in a Reuters poll.
The TransCanada news coupled with a large distillate draw narrowed narrowed U.S. oil's discount to Brent by more than $1.50 to hit $9.98 per barrel. The spread broke the 100-day moving average of $10.48 for the first time in three-and-a-half months and contracted to its tightest point since early November.
"It stands to reason that if we see more and more domestically produced oil getting to the Gulf Coast refineries it is bullish for WTI prices," said Gene McGillian, an analyst with Tradition Energy in Stamford, Connecticut.
U.S. crude's rally came in spite of a 990,000 barrel build in stocks, the first increase in eight weeks.
Brent oil fell after data showed China's factory sector contracted in January for the first time in six months. China is the world's second largest oil consumer.
Brent fell 46 cents to $107.81 a barrel by 1:56 p.m. EST (1741 GMT). It settled up $1.54 on Wednesday at $108.27, its highest level this year.
U.S. oil rose $1.06 to $97.79, after settling $1.76 higher at $96.73 in the previous session. The contract was on track for its largest weekly percentage gain in two months.
Heating oil touched a high of $3.0855 per gallon and was last trading 4.42 cents higher at $3.0821, a gain of nearly 1.5 percent.
Analysts are watching to see if a spate of crude-by-rail accidents, which has spurred the debate about tighter rail safety standards, could impact U.S. oil markets by potentially raising transportation costs for refiners, analysts said.
"There's still some serious dislocation in the market; a lot of refiners have been mentioning rail delays, and usually into dislocations you get rallying markets," said Andy Lebow, vice president at Jefferies Bache in New York.
Thursday's moves came against a backdrop of talks to reach a peace agreement in Syria and the partial lifting of sanctions against Iran under a temporary deal with Western Powers trying to get Tehran to halt its most-sensitive nuclear-related activity.
Iran's president and oil minister told oil executives in Davos, Switzerland, on Thursday that Tehran will have a new investment model for oil contracts by September as it is keen to win back Western business.
(Additional reporting by Peg Mackey in London and Manash Goswami in Singapore; Editing by William Hardy, Jason Neely and Sophie Hares)