* Indexes down: Dow 1.35%, S&P 500 1.32%, Nasdaq 1.28%

* Oil prices surge, nearing $120/barrel

* Travel and bank stocks hit hard, energy shares rise

* Fed's interest rate outlook complicated by energy costs

(Updates to after markets open)

By Johann M Cherian and Pranav Kashyap

March 9 (Reuters) - Wall Street's main indexes dropped

over 1% on Monday, as oil prices soared, exacerbating inflation

fears as hostilities in the Middle East entered their tenth day.

Geopolitical tensions deepened after Iran named Mojtaba

Khamenei, son of the late Ali Khamenei, as the supreme leader,

signaling firm control of hardliners in Tehran.

Crude prices shot up to just under $120 a barrel but eased

as governments, including those part of the Group of Seven (G7)

and Saudi Arabia, began discussions to limit the jump in energy

costs through increased supply.

The latest developments are likely to fuel stagflation

fears, as data last week showed a weakening U.S. jobs market,

even as broader economic activity accelerated.

"Higher oil prices are playing into fears that inflation

could take off to the upside once again. While the U.S. is

unlikely to suffer supply shortages, unlike the UK, Europe and

Asian-Pacific regions, it will be hit by higher prices, which

are already showing up at the pumps," said David Morrison,

senior market analyst at Trade Nation.

Travel stocks, which were pressured the most last week, were

also the hardest hit on Monday.

An index tracking S&P 500 passenger airlines

dropped over 4%, while cruise stocks such as Carnival Corp ( CCL )

lost 7.3% and Royal Caribbean Cruises ( RCL ) fell 6.3%.

Big banks, the backbone of any economy, also took a hit with

Morgan Stanley ( MS ) down 2.3% and Citigroup ( C ) falling 3%.

A prolonged period of higher oil prices could weigh on

equities this year, Goldman Sachs said, warning that every one

percentage point drop in economic growth could cut S&P 500

earnings by as much as 4%.

Energy was the only sector on the S&P 500 with

marginal gains, aided by the rally in oil and gas prices.

At 09:44 a.m. ET, the Dow Jones Industrial Average

fell 639.86 points, or 1.35%, to 46,861.69, the S&P 500

lost 89.17 points, or 1.32%, to 6,650.85 and the Nasdaq

Composite lost 287.75 points, or 1.28%, to 22,099.93.

The interest-rate-sensitive Russell 2000 index

dropped 1.8% and was just a whisker away from marking a 10% drop

from all-time highs. An index ending 10% lower from its record

closing high is commonly referred to as correction territory.

The CBOE Volatility Index, Wall Street's fear gauge,

was at 31.51, its highest since April.

Prices of traditional safe havens such as precious metals

also came under pressure as investors rushed to the U.S. dollar