"For this market to stop declining, we either need better economic news or a halt in the run-up in the price of oil," said Robert Pavlik, chief investment officer at Oaktree Asset Management.
The benchmark crude contract closed up $5.07, or nearly 4%, at $136.38 a barrel, after inventories data that showed crude supplies fell in the latest week.
"But what makes this environment even more challenging is the inflation concern," Pavlik said. "Any attempt to slow the rise in inflation by rising rates will put downside pressure on a fragile U.S. economy."
The Dow Jones Industrial Average fell 205 points, or 1.7%, to 12,083, with 27 of its 30 components declining, again led by its financial components such as AIG , American Express and J.P. Morgan Chase .
The Dow is now trading at levels unseen since March 20.
"We're getting close to hitting key support levels for the market," said Peter Cardillo, chief market economist at Avalon Partners. "We'll see if the Dow can hold the symbolic 12,000 level."
Among Dow components, shares of Alcoa Inc. fell nearly 8% after the aluminum giant said an explosion at one of it gas suppliers in Australia slowed production, which will likely hit second-quarter earnings by 2 cents to 3 cents a share.
J.P. Morgan also cut its rating on the aluminum producer to "neutral" from "overweight," saying rumors that Alcoa is for sale are incorrect.
The S&P 500 Index fell 22 points, or 1.7%, to 1,335, while the Nasdaq Composite Index fell 54 points, or 1.7%, to 2,394.
Energy shares were the only sector on the rise on the S&P 500, while financials and consumer-related stocks led the declines.
Troubles in the ailing financial sector also came back to the fore, with worries of further write-downs linked to bad home loans lingering ahead of earnings reports next week from Lehman Brothers Holdings Inc. , Morgan Stanley and Goldman Sachs Group.
Speaking at a Deutsche Bank conference, Merrill Lynch Chief Executive John Thain said Merrill remains well-capitalized but that conditions in the second quarter were "still difficult." Merrill shares were recently down 4%.
Technology shares also came under pressure. The Semiconductor Industry Association cut its 2008 growth forecast for semiconductor sales to 4.3% from 7.7%, citing ongoing pricing pressure in memory chips.
The dollar fell, especially against the euro, eroding Tuesday's strong gains tied to remarks by Fed chief Ben Bernanke, who said that the U.S. central bank was focused on holding down inflation expectations.
A weaker U.S. unit boosts the price of dollar-denominated commodities, such as crude oil, as its makes them cheaper for holders of other currencies.
"With oil prices at $140, and other commodities so high, central bankers around the world are scratching their heads and they are worried," said Avalon Partners' Cardillo.
"Currency speculators are forcing central banks to take action," he said, adding that many in the market believe the G8 meeting of financial ministers will either yield strong words to support the dollar, or some sort of concerted intervention.
Economy stays weak, Fed says
The U.S. economy "remained generally weak" in May as higher prices for food and energy were pinching consumers' pocketbooks, the Federal Reserve said Wednesday in its Beige Book report on the economy.
Striking a similarly balanced tone, Fed Vice Chairman Donald Kohn said monetary policy should allow a temporary rise in unemployment and inflation to let an economy find its balance from an oil-price shock.
Among Wednesday's stocks in the spotlight, Yahoo Inc. and activist investr Carl Icahn have sharply different estimates of the cost of a severance plan the Web portal has put in place, The Wall Street Journal reported.
Staples Inc. won the support of Corporate Express NV with its fourth bid for the Dutch office-supplies group, offering $2.6 billion in cash.
Royal Bank of Scotland Group said that its first-half performance was satisfactory, and that write-downs will be roughly in line with the 5.9 billion pounds before tax it estimated back in April.
Amerigroup Corp. shares fell 14% after the health-care provider suspended its earnings outlook while negotiating medical costs with the state of Tennessee.
By Nick Godt