* Brent bounces off two-month low
* U.S. crude reverses two weeks of losses
* Libya, Iran supply expectations limit gains in Brent
By Elizabeth Dilts
NEW YORK, Jan 17 (Reuters) - Demand for heating fuels and rising gasoline prices drove oil higher on Friday, but gains were limited by a stronger dollar and expectations for increased supply from Libya and Iran.
U.S. heating oil and gasoline futures both climbed more than 1 percent on higher demand as the U.S. prepares for another cold snap and as traders bought contracts to cover short positions in heating oil.
The spread between the European and U.S. crude oil futures benchmarks contracted to its narrowest point since the start of the new year due to the start-up of a major U.S. pipeline, which is expected to bring more oil to refining markets.
"The Gulf Coast ULSD (heating oil) contract is showing more strength because its underlying fundamentals are tighter than gasoline," said Gene McGillian, an analyst at Tradition Energy in Stamford, Connecticut. "We have forecast for cold weather, and we know we are going to see more export demand in the coming months."
Brent oil for March delivery settled up 73 cents at$106.48 a barrel, rebounding from the two-month low of $105.44 it hit earlier in the day. U.S. crude settled at a two-week high, up 41 cents at $94.37 a barrel, reversing two weeks of losses.
Floor trading will be closed on Monday and there will be no settlement on the New York Mercantile Exchange due to the Martin Luther King, Jr. Day holiday.
Brent prices have fallen almost 10 percent since August on expectations for increased supply from Libya and Iran. The European benchmark's premium to U.S. oil ended the session at $11.89, the narrowest since Dec. 20 when it reached $11.86.
TransCanada's Gulf Coast pipeline is expected to start pumping 300,000 barrels per day of U.S. crude oil from the U.S. storage hub in Cushing, Oklahoma, to the Gulf Coast next week, further narrowing the U.S. discount to Brent.
Front-month RBOB gasoline futures ended the day up 2.53 cents at $2.6204 per gallon, rising from Thursday's more than two-month low of $2.5882.
Ultra low-sulfur diesel futures (ULSD), commonly known as heating oil, settled 3.92 cents higher at $3.0237 per gallon.
Refiners in Asia, Europe and Russia are shipping around half a million tons of heating oil and diesel to the United States this month after bitterly cold weather last week sharply reduced fuel stocks. At least a dozen tankers have been booked so far in January to ship gasoil and diesel to the U.S. East Coast, according to traders and shipping data.
The U.S. dollar index, a measure of the dollar's strength against a basket of currencies, was last trading .41 percent higher at $81.247. A stronger dollar is bearish for commodities priced in the greenback as it makes them more expensive for holders of other currencies.
The restart of crude oil production at the El Sharara field in Libya two weeks ago and a jump in exports from Iraq's southern terminals in the first two weeks of 2014 have weighed on Brent crude prices. However, Iraq's supply could be cut in February because of loading delays caused partly by bad weather, which would support prices.
As well, the market awaited news of increased Iranian oil exports. Sanctions have cut Iran's oil exports by more than half over the past 18 months to about 1 million barrels per day (bpd). But Iran may be able to release more into world markets if a dispute over its nuclear work can be resolved.
A preliminary accord between Iran and a group of world powers is effective starting Jan. 20, while talks on a final settlement will start in February.