UPDATE 5-Oil Drops Sharply after Bin Laden Death

* Brent futures down more than $4, then recover

* Saudi raised output to 8.5 million bpd in April - sources

* Libya: one of Gaddafi's sons killed by NATO raid

(Updates throughout, previous SINGAPORE)

By Christopher Johnson

LONDON, May 2 (Reuters) - Oil prices fell more than 3 percent on Monday after U.S. forces killed al-Qaeda leader Osama bin Laden after a decade of military operations across central Asia and the Middle East.

ICE Brent crude futures for June fell $4.22 to a low of $121.67 a barrel before recovering some ground to trade around $122.85 by 0942 GMT. Last month Brent hit a 32-month high above $127.

U.S. crude slid $2.40 to $111.53.

Early futures market volume was depressed by a public holiday in Britain and several other countries, which may have added to price volatility, oil brokers said.

The oil market focused on whether the news would help unwind the risk premium attached to prices because of war in Libya and unrest in the Middle East and North Africa.

"There's probably a knee-jerk reaction to the extent that part of the geopolitical risk has been supported by al-Qaeda, so there will be an initial sell-off," said Jeremy Friesen, commodity strategist at Societe Generale.

Economists including David Cohen from Action Economics warned that in the near term Bin Laden's killing might trigger a violent response by al-Qaeda, but analysts said it was unlikely the network would succeed in disrupting oil supplies.

The closest al-Qaeda has been to hitting the oil industry was on Feb. 24, 2006, when Saudi forces repelled a suicide attack on the Abqaiq oil-processing centre, the world's largest.

The U.S. Department of Homeland Security (DHS) and the FBI have not issued any warning of a credible or imminent threat, but Obama warned Americans to remain vigilant.

"TEMPORARY"

Thorbjørn Bak Jensen of Global Risk Management suggested the initial sell-off was unlikely to last.

"We regard the reactions as temporary as nothing fundamentally new is really on the table. If anything it might be a good idea to secure oil costs," he said.

Oil was already down before the Bin Laden news, after NATO air strikes over the weekend killed one of Libyan leader Muammar Gaddafi's sons and industry sources said Saudi Arabia raised output in April.

Gaddafi's youngest son and three grandchildren were killed in a NATO air strike, the Libyan government said on Sunday. Britain said that while it was not targeting the leader, it was homing in on the regime's military machine.

"What's happening in Libya is probably an event that will see Gaddafi moved out of his position, so the risk premium which relates to Middle East concerns will start to erode," said Jonathan Barratt, head of Commodity Broking Services.

Saudi Arabia's crude oil output edged back up in April to around 8.5 million barrels per day (bpd) from roughly 8.3 million bpd in March as demand picked up, Saudi-based industry sources said on Sunday.

The dollar strengthened by around 0.2 percent on Monday following last week's slide, deterring investors from piling into commodities this week and triggering a 10 percent plunge in spot silver prices.

Money managers increased their bets on higher U.S. crude oil prices to a combined record level in New York and London in the week to April 26, data from the CFTC showed on Friday, as U.S. prices rose to their highest level since September 2008.

Volatility and uncertainty due to the pan-Arab protests and Libya's conflict have tempered oil trading. The U.S. 30-day average volume was down by nearly 130,000 lots compared with the 250-day average at the end of last week, Reuters data showed.

(Additional reporting by Alejandro Barbajosa, editing by William Hardy)