* Looming famine, ceasefires fail to end fighting
* Conflict cuts oil production by a third
* Monitoring oil wealth could help heal rifts
* South Sudan holds some of Africa's biggest oil reserves
By Drazen Jorgic and Edmund Blair
NAIROBI, Aug 1 South Sudan's oil fields have become a battleground in the struggle for power in Africa's newest nation, encouraging Western nations and regional mediators to consider international monitoring of crude revenues as a way to remove a major bone of contention from such conflicts.
South Sudan sits on Sub-Saharan Africa's third-biggest crude reserves, and its oil fields were early targets in fighting that erupted in December and has rumbled on despite two ceasefire deals and U.N. warnings that a man-made famine looms.
It marks an alarming slide into dysfunction by a nation whose creation three years ago the United States hailed as a foreign policy success. Instead of lifting the nation out of grinding poverty, oil is blamed for stoking a war.
"If there is a clearer control of oil revenue, that may remove from the table one of the incentives over which people are divided or will fight," said one senior Western diplomat, close to peace talks being held in the Ethiopian capital.
"How do you turn the resource question into a confidence builder as opposed to a conflict creator? That's the challenge in negotiation," he told Reuters.
Monitoring could range from putting oil earnings into an independently managed escrow account, which South Sudan rebel leader Riek Machar called for, to less intrusive mechanisms where allocations of revenues were checked.
Diplomats and regional mediators said monitoring revenues was gaining traction as an idea for discussion, though the mechanics of such a system and how the warring sides would be pushed towards a deal have not been determined.
"Monitoring of oil revenue is being discussed," said another Western diplomat. "But the detail would need to be worked through."
South Sudan's oil output has tumbled by about a third to 160,000 barrels a day since the fighting began in December, but it remains the main source of cash for President Salva Kiir's government both by selling crude and by borrowing against future earnings, digging the nation deeper into debt.
As of June 25, South Sudan owed $256 million to China's National Petroleum Corp, which has 40 percent of a venture developing South Sudan's oil fields, and a further $78 million to oil trader Trafigura.
It plans to borrow about $1 billion from oil firms in fiscal year 2014/15, equal to about a quarter of forecast revenues.
VIOLATION OF SOVEREIGNTY
Rebel leader Machar, who was fired as deputy president last year, said oil sites would be a "legitimate target" unless funds were put into a neutral escrow account pending any deal.
But President Salva Kiir's government says such outside intervention would violate its sovereignty and insists it has not bought arms since fighting began.
"We are not the protectorate of anyone," presidential spokesman Ateny Wek Ateny said. "We have the right to buy arms, but we haven't bought anything since December," he said, despite rebel claims of weapon shipments arriving in recent months.
Kiir and Machar come from rival ethnic groups, and the conflict has re-opened deep ethnic divisions in the country.
Monitoring revenues is on the table for talks sponsored by the regional African grouping IGAD, though diplomats acknowledge it can only be part of a broader deal on how to share wealth and power in the divided nation.
"This is one of the points of the agenda that has been put forward by IGAD negotiators, that is the management of national revenue and national resources," Smail Chergui, the African Union's Commissioner for Peace and Security, said on July 25.
"When the two parties will achieve that level of advancement in the negotiations, this (agreement) might come. It has the support of the international community," he said in the Ethiopian capital, where peace talks are to resume on Monday.
South Sudan has already lost billions of petrodollars in its young life. Kiir wrote to 75 former and serving officials in 2012 seeking the return of $4 billion that disappeared since 2005. No significant amounts were repaid, diplomats said.
Though the country - the size of France - has almost no roads and only a third of its 11 million people can read, South Sudanese now watch more wealth frittered away on fighting than on building roads or paying for schools.
GAMBLING THE FUTURE
"Are we going to buy weapons or are we going to ... put it into development infrastructure," said Henry Odwar, a lawmaker who chaired parliament's energy commission until June.
"As long as we don't have the answers to that, we are just gambling our future now," he said.
Talks in Addis Ababa to end fighting have made glacial progress since January. Two ceasefire deals have crumbled and a deadline of Aug. 10 for a deal on a transitional government is fast approaching with little sign of an agreement.
Fighting has killed at least 10,000 people, displaced 1.5 million and left a third of the population facing the prospect of famine as they have not planted crops.
"Famine is a real possibility," said the second Western diplomat. "The leaders are not putting the needs of the people of South Sudan first. That must change."
The United States and European Union have imposed sanctions on military commanders on both sides.
But Western diplomats say pressure for a deal on oil monitoring needs to come from the region, led by heavyweight neighbours such as Kenya and Ethiopia.
China, with its oil interests, would need to support the move, though diplomats said it had worked with the West during the crisis. Alongside China, other oil investors are India's ONGC Videsh and Malaysia's Petronas.
"If they can get the oil sector right, share the oil revenues in a much more inclusive manner, then that will dictate the country's future," said Luke Patey, author of a book on Sudan and South Sudan's oil industry. (Additional reporting by Aaron Maasho in Addis Ababa; Writing by Edmund Blair; Editing by Will Waterman)