* U.S. crude reverses earlier losses
* Morgan Stanley ups 2011 Brent forecast to $120
* Strong demand to put a strain on OPEC capacity - analysts
* Coming Up: Weekly U.S. API petroleum stocks; 2030 GMT
By Francis Kan
SINGAPORE, May 24 (Reuters) - Brent crude futures rose on Tuesday, rebounding from the previous day's sharp fall, as the prospect of strong oil demand trimming inventories overrode concerns about Europe's debt crisis.
Brent crude for July
Sovereign debt problems in the euro zone, coupled with data pointing to a slowing Chinese economy, had pushed investors to sell riskier assets like oil and the euro in favour of gold and the dollar.
Spot gold hit an intraday high at $1,517.74 an ounce, its strongest since May 11, while the dollar extended its gains to hit an eight-week high against the pound and edged closer to a 10-week high versus the euro.
"What we're seeing is some short covering or value buying after significant losses yesterday, but in the short term there are still risks from Europe's debt issues and softening economic data," said Ben Le Brun, market analyst with CMC markets in Sydney.
But analysts expect oil prices to head higher after the current correction, as strong demand from emerging economies draws down on global inventories and puts a strain on OPEC's spare capacity.
"While near-term downside risk remains...we believe that the market will continue to tighten to critical levels by 2012, pushing oil prices substantially higher to restrain demand," said U.S. investment bank Goldman Sachs in a research note on Monday.
The influential Wall Street bank, which in April had predicted the major correction in oil prices earlier this month, said on May 7 that oil could surpass its recent highs by 2012.
Echoing this view was Morgan Stanley, who raised their 2011 Brent crude forecast to $120 a barrel, from $100 previously, while it has upped its 2012 target to $130, from $105.
The loss of some 1.5 million barrels per day of Libyan production, and firm demand from emerging economies, will lead to tighter inventories in the second half of the year, the bank's analysts said in a report.
"It is very likely that OPEC will respond to tightening inventories by lifting their production; in response, we see flat prices moving higher as spare capacity continues its fall to untenable levels," the report said. [ID:nL3E7GO054]
The Organization of the Petroleum Exporting Countries are scheduled to meet next on June 8 in Vienna.
An expected fall in U.S. crude stocks last week could also support prices, analysts said. A drop in imports and increased refinery use are forecast to have pushed crude oil inventories lower, according to a Reuters survey of analysts on Monday. [ID:nN23182962]
CHINA TO DRIVE DEMAND
Strong Chinese oil demand is expected to be the key driver of oil prices for the rest of this year, despite data pointing to a slowing economy, analysts said.
A purchasing managers index on Monday showed China's factories expanding at their slowest pace in 10 months in May. [ID:nL3E7GN06N]
However, this news was tempered by data showing no let up in Chinese oil imports last month, which grew 9.6 percent year-on-year, its third-highest level ever.
"The softer manufacturing data is a good sign that tightening measures are starting to take effect and the government may be less inclined to tighten further," said CMC's Le Brun.
The conflict in Libya escalated, with at least 12 heavy explosions heard in Tripoli early on Tuesday and a column of smoke was seen rising from the area of leader Muammar Gaddafi's compound, a Reuters correspondent said. [ID:nLDE74M257]
Uncertainty over pan-Arab protests and Libya's conflict pushed Brent to a 32-month peak last month, before a sharp correction in early May resulted in prices registering their largest ever weekly decline of more than $16 a barrel. (Editing by Michael Urquhart)