Who'll win the small-car wars?

It took just six months this year for U.S. car buyers to abandon the vehicles that have defined U.S. car culture for more than a decade. Bye-bye, pickup trucks. So long, SUVs. For the first time in decades, bigger is no longer better.

But while dealerships across the nation struggle to unload their stock of gas-devouring trucks -- SUV and pickup sales in the U.S. were down 39% in the second quarter of 2008 -- a new trend has emerged: Small-car sales were up 15%.

Test-driving the tiny Smart car

This suits companies like Honda (HMC, news, msgs) and Toyota (TM, news, msgs) just fine, but it's bad news -- very bad news -- for domestic automakers like General Motors (RGM, news, msgs) and Ford (F, news, msgs). U.S. carmakers are rushing to add more fuel-efficient smaller vehicles and hybrids to their fleets in the immediate future. But the question that keeps Detroit workers and executives up at night is: What do we do next?

Which cars are still selling?

The answer just might change the landscape of the auto industry, which is currently going through an upheaval that is both dramatic and, for the most part, painful. In July, among the top six automakers, only Nissan (NSANY, news, msgs) saw a sales increase -- of 8.5%. The rest of the top car companies saw double-digit drops in sales, with the exception of Honda.

Honda sales were down 1.6% in July. It was the Japanese automaker's first decrease in four months. Overall, U.S. sales for Honda are up 3% so far in 2008, due in part to the best-selling Accord and Civic models.

"Among the big six or seven, Honda is the best positioned to continue to capitalize in this market," says Joseph Phillippi of Auto Trends Consulting, a New Jersey firm, and a former Wall Street analyst. "They're small-car experts."

Although Toyota had a bad July -- its overall sales plummeted 12% -- it has the second-largest U.S. market share, with 17%. (General Motors has the largest slice of the American market, with 20.5%.) And for the time being, Toyota has managed to corner the market on hybrid vehicles. "The Prius is almost synonymous with 'hybrid,'" Phillippi says. According to J.D. Power & Associates, a marketing research firm, half of the hybrids sold in the U.S. are Priuses. In the first half of this year alone, the Japanese automaker sold more than 90,000 Priuses. To keep up with demand, Toyota is opening a new U.S. plant to turn out even more of them.

Chart: How the automakers are doing

Now, however, automakers are looking beyond the hybrid for the next solution.

Talk back: Would you buy a Smart car?

"Everyone recognizes that the era of the gasoline-powered vehicle is coming to a close," Phillippi

says. "It may take 100 years, because there are so many cars out there, but it's an incredible race to see who can come up with the best new technology, whatever that is."

Higher gas prices are here to stay

Whatever, indeed. While that question has no certain answer, there are a few things that automakers and analysts know. First: By U.S. government decree, all fuel economy standards must rise from the current 27.5 miles per gallon for cars and 22.5 mpg for trucks to 35 mpg by 2020. Car manufacturers have no choice but to get innovative.

Analysts are quick to point out a second issue: Historic gasoline prices are here to stay. "Consumers don't believe that higher fuel prices are an anomaly," says Anthony Pratt, senior manager at PriceWaterhouseCoopers' Automotive Institute in Detroit. "We're not going back to the $2 gallon of gas anytime soon."

Today, 90% of all cars in the U.S. are powered by gasoline, according to J.D. Power and Associates. In 10 years, the firm predicts that number may sink to 65% -- or even lower. By then, analysts say, 14% of all cars will have diesel engines and 10% will be hybrids. The rest will be electric cars running on full or partial battery power -- or some new, yet-to-be-perfected technology.

"Gas is here to stay," says Michael Omotoso, an auto analyst for J.D. Power, "but there will be less dependency on it than there is today."

As harsh as that fact is for automakers, they seem to have gotten the message. That's why Toyota, Nissan, Daimler and GM are all developing electric cars that run on next-generation lithium-ion batteries. All plan to make such cars available in 2010.

The lithium-ion battery is seen as the key to the future of cars powered even in part by electricity. It is considered so important to the future of the automobile industry that ExxonMobil (XOM, news, msgs) -- yes, the oil company -- has 14 Ph.D.s in New Jersey, Texas and Japan devoted to improving the battery's energy potential.

Hear from an ExxonMobil scientist

The lithium-ion battery also has the potential to shake up the industry's competitive landscape. "The first manufacturer who realizes the potential of the lithium-ion battery will (provide) an enabling technology that will contribute to the electrification of the car," Pratt says.

See Subaru's electric car

GM taking the electric lead

GM in particular seems to be tying its future to lithium-ion technology. Its Chevy Volt is essentially a hybrid, but while a Prius has two power sources -- electricity and gas -- that run in tandem, the Volt will allow the

driver to run for 40 miles solely on electric power. (GM's market research has shown that 78% of Americans have an average commute of 40 miles or less.) At the 41st mile, the Volt's gas-powered engine will kick in.

If the technology works -- and that's a big if -- the Volt could signal a huge breakthrough for the ailing automaker. "GM is betting the company on this technology in a lot respects," Phillippi says. "Even if the Volt is a total technological success, it'll have to be applied across the board to the rest of their portfolio, and that's 10 years down the line at least."

GM may not have that much time. The company posted an astounding second quarter $15.5 billion loss and already rumors are swirling that the Detroit automaker will file for bankruptcy, even though most analysts note that such a move is unlikely.

"That's definitely a risk," says J.D. Power's Omotoso, who also notes that the market cap for GM has fallen below $10 billion. That means that thanks to the devalued dollar, a foreign carmaker -- say, Volkswagen or one of the Japanese automakers -- could swoop in to bid for the company. "They could come in and buy a 50% stake in the company for a few billion dollars and take control," he says.

Meanwhile, foreign automakers are already seizing the moment, capitalizing on their experience with smaller, more-fuel-efficient vehicles. The U.S. has already become the No. 3 market worldwide for the tiny Smart fortwo car, which Daimler just introduced here in January. By the end of June, the company had sold 10,000 of the vehicles. While no one seriously expects the Smart car -- long a familiar sight on the streets of European cities like London and Paris -- to overtake SUVs in sales anytime soon, its newfound popularity illustrates the willingness of U.S. consumers to explore fuel-saving options.

And later this year, Volkswagen will begin selling diesel-fueled cars in the U.S., something it has done in Europe for years. Volkswagen plans to quadruple the number of cars it sells in the U.S. to 800,000 units a year by 2018, up from the 200,000 units a year it sells now.

Although diesel is still a fossil fuel, and expensive to boot -- the current national average is $4.50, according to the U.S. Energy Department's Energy Administration Agency -- it's 25% to 30% more fuel-efficient than traditional gasoline. "It costs more, but you get more mileage for your dollar," Omotoso says.

Map: World's most expensive fill-ups

Produced by Peggy Collins / Graphics by Joe Farro

Published Aug. 14, 2008