The mere mention of oil prices eclipsing $100 per barrel prompts most US consumers to grouse about paying $5 per gallon of gasoline at the pump. It’s easy to focus on the relationship between oil and gasoline prices. But the potential for diesel prices to hit $5 per gallon is of equal concern.

Gasoline accounts for a little over half of every barrel of oil that the US consumes. But despite gasoline’s importance to the oil market–and US consumers’ wallets–rapid growth in consumption of distillate fuel has driven US oil demand over the past few months.

Each year, the US consumes about 63 billion gallons of distillate fuel–second only to gasoline in terms of volume. Diesel fuel and heating oil are the two most common distillate products.

Source: Energy Information Administration

On-highway diesel consumption accounts for about two-thirds of US distillate demand. Diesel-fueled passenger cars are prevalent in Europe, accounting for more than half of all new vehicle registrations in recent years. Despite a brief surge of popularity in the early 1980s, diesel-powered vehicles account for only 1 to 3 percent of new US car sales.  

Long-haul freight trucks and other commercial vehicles account for much of on-highway diesel consumption. Agricultural equipment and marine vessels also run on diesel, and the railroad industry is another major consumer. Distillates also provide residential and commercial heating in parts of the US. Although this use is dwindling, it’s estimated that heating still accounts for roughly 10 percent of demand.

Although heating demand depends on weather patterns, much of US distillate consumption hinges on the health of the domestic economy. For example, volumes of freight transported by truck tend to decline faster during recessions than total miles driven in passenger cars. The graph below illustrates this sensitivity to prevailing economic conditions.

Source: Energy Information Administration, Bloomberg

This graph tracks the year-over-year change in demand for gasoline and distillate fuel over the last decade.

As you can see, US demand for gasoline declined precipitously from late 2007 to mid-2009, largely because of the one-two punch of soaring gasoline prices and the worst US recession in a generation. But this pales in comparison to the demand destruction that occurred in the market for distillates.

By the same token, demand for distillates posted a far more dramatic recovery in 2010. For much of last year, US gasoline consumption was up 1 to 3 percent from year-ago levels, a rebound that reflects solid growth but is well short of pre-recession levels. Demand for distillates, on the other hand, has roared back, up nearly 15 percent on a year-over-year basis–its fastest growth rate since 2004-05.

This rapid recovery in distillate consumption reflects trends in the broader economy. Year-over-year demand comparisons were relatively easy in 2010, as economic weakness continued to weigh on fuel consumption in 2009. But this rebound gibes with a spate of encouraging economic data released in recent months. Railcar loadings, for example, are approaching pre-crisis levels. Meanwhile, robust consumer spending over the holidays also likely increased demand for freight-truck deliveries.

And this isn’t the end of the road for the recovery in distillate consumption. Check out the graph below.

Source: Energy Information Administration, Bloomberg

This graph tracks US distillate inventories in terms of how many days’ worth of demand they can cover. Current supplies are sufficient to cover about 42 days’ worth of demand.

US distillate inventories are still well above 2005-08 levels, but a shift in the pattern of drawdowns is encouraging. In 2010 inventories began to deplete several weeks before normal and rapidly decreased from late summer to mid-November. Over this period demand coverage dropped from well over 50 days to less than 40 days at one point.

This drawdown should continue through early April 2011. If demand remains robust, inventories could recede to the tight coverage levels that prevailed during the bull market of 2005-08.

A similar trend is underway in Europe. Despite all the concerns about the fiscal health of certain peripheral economies, distillate demand remains near all-time seasonal highs and continues to eat into inventories. These drawdowns haven’t occurred at the same pace as in the US, which benefited from a surge in distillate exports to Latin America.

In Asia, Chinese demand for distillates is also on the rise. Chinese authorities reportedly scaled back industrial production and enforced temporary reductions in coal-fired power generation toward the end of 2010. These policies were part of an effort to ensure that the country will meet energy-efficiency targets laid out in its most recent five-year plan.

To fill the gap, some households and businesses have resorted to using small, diesel-powered generators to produce power, pushing up demand for distillates and helping to reduce global inventories. This trend should continue until the Chinese New Year, when Beijing will announce a new five-year plan.

Investors often overlook trends in distillate demand and inventories, focusing instead on gasoline and oil prices. But demand for these refined products is a reliable indicator of economic health and could push oil prices higher in 2011.

Join Me in the Caribbean

In late 2010, the Washington, DC area dodged a bullet, receiving only a dusting of snow, while cities and towns in the Northeast found themselves digging out from more than a foot of precipitation.

Nevertheless, the glancing blow from Old Man Winter makes me look forward to February–mainly because I’ll be sipping mojitos aboard the ms Eurodam as it cruises through the Caribbean. The ship disembarks from sunny Florida on Feb. 12 and won’t return stateside until Feb. 19.

The cruise will feature presentations from me and several other speakers.  I’ll also be available to answer questions and discuss energy markets in the dining room, poolside or over a few drinks at the ship’s bar.

The cruise is a little over a month away, but a few cabins are still available. For more information about this jaunt through the Caribbean, go to http://www.moneyanswerscruise.com/ or call The Cruise Authority at 1-800-707-1634 and ask for details about the Money Answers Cruise.