Diesel demand will surge in India this summer as subsidies make it cheaper than fuel oil for burning in power plants and factories, potentially tightening distillate supplies in Asia if New Delhi does not act soon to raise local tariffs.

The government caps prices of diesel, the most common fuel for transport and its large farm sector, to protect the poor and control inflation. Fuel oil is sold at international rates, which are close to their highest since 2008.

The distortion in the relationship between fuel oil and diesel may result in the nation's diesel imports rising by as much as 30 percent on the year, traders and analysts said, at a time when supplies in Asia are expected to be thin as China clamps down on exports to meet a surge in summer demand.

"In some states a litre of fuel oil is costlier than diesel. Industrial users have already started switching to diesel, which is cheaper and cleaner," said R.K. Singh, chairman of Bharat Petroleum Corp, the nation's third-biggest refiner.

The Paris-based International Energy Agency sees India's diesel demand rising 6.3 percent this year to 1.3 million barrels per day (bpd), while fuel oil demand is seen falling 5.4 percent to 368,000 bpd. But with fuel oil prices rising above diesel, those trends could be exacerbated.

Fuel substitution has already propelled a sharp acceleration in diesel demand growth in May to around 15-18 percent from a year earlier, Singh and other industry sources estimated. That was up from growth in diesel sales of just 1.7 percent in April.

To meet the switch, Indian imports would need to rise despite the startup of two new refineries -- the 120,000 bpd Bina refinery in central India and 180,000 bpd Bathinda plant in the north -- this fiscal year.

"The way demand is going up diesel imports could bounce back to the 2.5 to 2.6 million tonnes... from about 2 million tonnes in 2010/11," an Asian oil trader said.

That would equate to imports of around 53,000 bpd this year, up from around 41,000 bpd. The difference would be about 12,000 bpd over the year. The rise would be concentrated in summer, so the difference would be much higher during those months.

The retail price of diesel in India translates to $84 a barrel in Singapore markets, where benchmark 0.25 percent diesel now costs about $125 a barrel and 180 centistoke fuel oil is about $98 a barrel.

The government has put off a decision to raise diesel and cooking fuel prices, a political hot potato as it juggles double-digit inflation, a soaring deficit and a voter base which has already voiced outrage over gasoline price increases.

It wants to save on subsidy payments and boost revenues at state-run oil companies, despite the impact on already high inflation, which the central bank has failed to cool with nine rate rises since March 2010.

"Diesel is a versatile fuel. It is like a 'go to' fuel for power, small industries and automotive sectors," said Praveen Kumar, senior consultant at FACTS Global Energy in Singapore.

FACTS estimates India's diesel demand could rise by 4.5 percent in 2011, a little slower than the IEA estimate, on top of high growth of about 7 percent seen in 2010, Kumar said. He also estimated that imports would need to rise by as much as 30 percent in 2011.

2008 AGAIN?

In 2008, fuel oil and naphtha prices were way above diesel, leading to a 16.9 percent rise in demand during May that year, triggering heavy imports, said S. Thangapandian, head of marketing at Essar Oil.

"If we don't discourage use of diesel by keeping it close to market-related prices, it will replace the cheaper fuels like light diesel oil and furnace oil," Thangapandian said. "A situation like 2008 could emerge when diesel demand was in double digits and we had to import heavily."

India is a net exporter of refined fuels. This is a result of the split between private and state refiners. Private refiners, which do not get compensation for selling fuel at subsidised rates, prefer to export refined products. State firms meet local demand through their own plants and costly imports, and receive compensation for selling subsidised fuel.

"Our diesel sales have gone up by 7.5 percent in May and demand may rise further, since in the peak summer season, demand from northern India -- particularly Punjab -- goes up for usage in the agriculture sector," a source at India's biggest refiner and fuel retailer Indian Oil Corp said. "So far we are covered for June-July but if need be we will import."

SUPPLIES DWINDLE

Higher imports from India will come as supplies have been hit by China's decision to suspend exports. The IEA estimates China's diesel demand growth rate at 6.5 percent this year, taking total demand to 3.3 million bpd. Power shortages could add as much as 300,000 bpd to the China's diesel demand, the IEA said in its report in May.

China's move to clamp down on exports may help diesel return toward the 30-month-high hit in April after the Japan earthquake. Higher oil product prices could further fuel inflation, already at or near multi-year highs in many countries in the region.

China is bracing for its worst power shortage since 2004, which has led to it clamping down on diesel shipments, while Japan, one of the region's top exporters, struggles to restore shipments to pre-quake levels.

The front-month June gas oil crack spread , a measure of the profitability of refining crude to make fuels such as diesel, was valued at a premium of $17.73 a barrel to Dubai crude on May 23. While this is down from the 30-month peak of $24 seen a month earlier, it is still higher than the 2010 high of $15.14.

Gas oil premiums have been high since the end of last year after China faced a diesel supply squeeze caused by nationwide power restrictions that led companies to switch on diesel-fired generators and refiners to slash diesel exports.

India's power generation capacity in the last fiscal year rose over 9 percent but still lags demand in a country where a growing number of its 1.2 billion population live in new, housing complexes and shop in glitzy, power-guzzling malls that often require diesel-fired generators to ensure uninterrupted supplies.

"We estimate peak power deficit of about 11 percent in May-July but this may decline if the monsoon rains remain normal as predicted," said Gurdial Singh, head of power regulator Central Electricity Authority.

"Capacity addition is constrained by fuel shortages and demand is growing at a rapid pace," he added.