Natgas prices have fallen to levels of $2 per million British thermal units from about $10 in 2008 as surging output from shale fields has flooded the market.
U.S. diesel prices have changed little over the last one year, costing about $3.9 per gallon at the end of May.
"Many of our customers are asking for natural gas-powered equipment in order to reap the financial and environmental benefits," Steve Fisher, a vice president at Caterpillar, said in a statement.
Shares of Westport, which has already tied up with General Motors Co (GM.N) and Cummins Inc (CMI.N) to develop natural gas-powered engines, rose more than 21 percent Tuesday on the Toronto Stock Exchange and on the Nasdaq .
Caterpillar and Westport will also develop technology to use the fuel in Caterpillar's engines employed for applications such as electric power, industrial, machine, marine and petroleum.
Caterpillar, the world's largest maker of earth-moving equipment, will fund the development of the engines, the companies said in a statement. Commercial production is expected to start in about five years.
Many oil and gas producers are also moving away from diesel to power their drilling rigs.
Despite the rising preference for natgas to power engines, Westport's shares have fallen nearly a fourth in the last six months.
Stifel Nicolaus analyst Jeff Osborne said investors feared that companies such as Navistar, Cummins and others will introduce competitive products without relying on Westport's technology over time.
Westport shares rose to a high of C$28.12 on Tuesday. Its U.S.-listed shares jumped to $27.15.
Reporting by Bhaswati Mukhopadhyay and Shounak Dasgupta in Bangalore; Editing by Don Sebastian