How to cash in on Canada's riches

Canada's economy is on a roll and its underlying strength is primarily a commodities story. We look at the best ways to play the main protagonists - uranium and oil.

If you're planning to send Christmas presents to Canadian relatives this year, the Canadian postal service has a warning for you. "Mail your parcels early!" says Paula Shore of the Canada Border Services Agency in Vancouver.

She's not joking. Delays are being reported across the country's postal network, with the three biggest international mail-sorting centres in Montreal, Toronto and Vancouver all at choking point.

Shifts have been added and overtime extended as Canada Post and the Border Services Agency struggle to deal with a 14% surge in volumes in the year to September. "We're caught up dealing with parcels," says Shore.

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Of course, a postal system in chaos and beset with delays is nothing new to those of us on this side of the Atlantic. But Canada's mail-bag problems have nothing to do with strikes, competition, or rural post-office closures. In fact, the country has become a victim of its own economic success.

The Canadian dollar colloquially known as the loonie is trading at a 50-year high of $1.07 against the US dollar, making it cheaper for Canadians to order goods online from the US than to buy them locally. It's led to a surge in US imports and a raft of extra parcels and mail to deal with.

Retailers, who stocked up on goods many months ago when the US dollar was far stronger, are now stuck with shelves of unwanted stock. In some cases, retailers are even trying to attract shoppers by slapping signs promising American Prices' on their shop fronts.

And although it may not feel like it to local retailers, Canada's currency is doing well because its economy is booming. Sure, it's "going up by default against a weakening dollar", says Adam Cole, senior currency strategist at Royal Bank of Canada, like almost every other currency in the world. But its underlying strength "is primarily a commodities story".

The world is growing driven mainly by expanding urban populations in Asia, and China in particular and it needs an unprecedented amount of raw materials to do so. That's great news for Canada. The country is a positive Aladdin's cave of commodities. It is home to the largest oil reserves outside the Middle East and the second-biggest natural gas deposits (see below for more). Its miners are world leaders, conducting 40% of mining operations worldwide, and it is one of the world's largest producers of zinc, lead and copper.

Of course, when you buy your nickel or potash from Canadian mines, or your wheat and beef from the Midwest prairie lands, you have to do so in Canadian dollars. So that means selling your US dollars or sterling or yuan and buying loonies, which in turn pushes up the currency's value.

And with oil, gold and most other commodity prices riding high, the rest of the world has to pay top dollar for the minerals and energy it buys from Canada.

This means that Canada is blessed with something rarely seen in a modern developed world economy a budget surplus. In the first five months of the current fiscal year, Canada's surplus jumped 21% from the same period a year earlier, to C$8.68bn, according to the country's Finance Department.

And the commodities boom has also created a jobs bonanza. In October, the US created twice as many jobs as expected in October, a pleasant surprise for many who'd been expecting a slump. But across the border, the Canadian economy turned out 63,000 jobs, roughly five times the number that had been expected. The jobless rate in Canada has now fallen to a 33-year low of 5.8% from 5.9% in September.

So it looks like Canada could be able to avoid the worst effects of a US recession. Indeed, as Jeff Rubin, chief economist and chief strategist at CIBC World Markets tells Reuters, "I'm not particularly optimistic about the US, but I don't think the Toronto Stock Exchange is really about the US any more".

Although 75% of Canadian exports currently go to the US (though this number is falling), more than half of its exports are commodities. "What we're seeing is strong global growth that no longer seems to be dependent on the US and that's what allows the Canadian market, and indeed the broader Canadian economy, to have the measure of independence from the US that it didn't have in past cycles," Rubin says. "It may be true that Canada sells all of its oil to the United States, but the price at which it does so depends on what's happening in global oil markets."

And regardless of whether or not you buy the idea that Asia can decouple' from America, it does seem unlikely that Canada's oil will become any less popular with its southern neighbour, given that it is the most stable and closest supplier of black gold in geographic terms. We take a closer look at Canada's oil fields below but here are some other Canadian commodities we think you should be popping in your portfolio.

Uranium

The rocketing price of oil, combined with fears about greenhouse gases, has led to a renaissance for nuclear power. In June, the price of uranium the main nuclear fuel hit a peak, at a record $138 an ounce. That was a huge increase on the 2000 average of just $7. But no bull market goes up in a straight line and by September the price had slipped back to around $75. News of further production shortfalls has seen the price rebound to $90 an ounce and it should go further, says Blackmont analyst George Topping. "We believe the uranium price has bottomed, as witnessed by the modest price increases on higher volume reported in October," he told clients in a recent research note.

Speculators such as hedge funds which bailed out in July, are also now making a return. "Renewed buying interest on the part of speculators and hedge funds is contributing to the upward price pressure," says research group TradeTech.

The new rally for uranium is partly down to more bad news from the Cigar Lake mine, the world's second-largest uranium despository. Discovered in 1983, it is located about 400 miles north of Saskatoon, Saskatchewan. It had been expected to supply 18 million tonnes of uranium a year, or 17% of world production by 2008. However, severe flooding in 2006 put those plans on the back burner, affecting other companies with operations at the mine, including French giant Areva.

The mine is operated by Cameco (TSX:CCO). Perhaps understandably, the company's share price has suffered from the delays, and is trading at about 22% below its record high. However, anyone interested in investing in the uranium story should have some exposure to Cameco. Despite the Cigar Lake problems, it remains the world's largest and most liquid uranium miner and is vital to global supply. It already operates the world's largest uranium mine, McArthur River, and third-quarter results showed that the company is still growing healthily, despite the summer drop in the uranium price. It earned C$91m, or 25 Canadian cents per share for the three months ended 30 September, up from C$73m, or 20 Canadian cents per share for the same period in 2006.

And the fundamentals remain strong. According to the International Atomic Energy Agency, China has four reactors, but this is expected to grow fivefold by 2020, while India has similar expansion plans. Meanwhile, Japan wants to increase nuclear power's share of electricity generation from 30% to 40% by 2016. And as Raymond Goldie of Toronto-based Salman Partners told MoneyWeek in August, supply is tight enough as it is. "Between now and 2011 we have to come up with 100 million pounds of uranium inventory, and it's not clear we have 100 million pounds." Cameco CEO Gerald Grandey reckons the price of uranium will hit $100 per pound this month. Topping has a buy rating on the stock and a C$62.50 price target (the stock currently trades at around $46) and expects production in 2015 to hit 32 million pounds, up 46% on this year.

Soft commodities

Canada's not just big on energy and base metals it also has enviable exposure to agriculture. It used to be the case that the price paid for grains such as wheat and corn was reasonably stable. Some years there's a bumper crop, others there's drought. But generally, you can prepare for the worst by storing up excess from the good years.

Unfortunately, that theory has been blown apart by the China factor and the demand for eco-friendly' fuels. Three years ago it cost US$23 a tonne to ship canola, an edible oil, from Vancouver to Shanghai. Today, it's $103. Demand for grains has leapt, in large part because of the Asian middle classes' expanding appetites, and also because of the biofuels craze. Unable to meet demand, commodity prices have soared worldwide. Wheat prices are up 59% in the past year, hitting a record $9.61 a bushel in September. Global stockpiles are expected to fall to 107 million tons their lowest level since 1976 by 31 May 2008, says the USDA. That would be a 13% drop year-on-year.

But Canadians aren't in any danger of going hungry. Canada is the world's second-largest wheat exporter and is expected to harvest 20.64 million tonnes this year, 1.6% more than the 20.32 million tonnes estimated in July, a survey of farmers by Statistics Canada recently showed. That's good news for Viterra Inc. (TSX:VT), the rebranded Saskatchewan Wheat Pool. Viterra is now the biggest grain handler in the Canadian West, with a 42% market share after the purchase of Agricore United in June. Its business stretches across the country, from a livestock business in Manitoba to retail outlets in British Columbia. The valuation has become a bit heady lately, reaching a forward p/e of 19. But if the Canadian Wheat Board monopoly is dismantled, as is currently being discussed in Ottawa, Viterra's grain-handling volumes could jump as a consequence.

Viterra also has an agri-products arm, selling fertiliser, feed and other products to more than 50,000 farmers. With the softs boom leaving farmers flush with cash to invest in their farms, that side of the business is performing well right now, say analysts. And while the ethanol story might only be sustainable for as long as the US government feels like propping it up with subsidies, the changes in Asian eating habits are likely to have some way to run yet.

Railways

It's easy to forget that someone has to move all these commodities from A to B. Two of the main carriers are Canadian National Railway (TSX:CNR) and Canadian Pacific Railway Ltd (TSX:CP). We'd avoid Canadian National Railway because it has a large forestry products business, which exposes it to the ailing US housing market. But Canadian Pacific Railway is less timber exposed than its rivals and earnings per share are expected to rise to $4.70-$4.80 next year, from $4.30 just now.

On Monday the firm reported third-quarter profits of $219m or $1.41 per share, from $164m or $1.04 a share a year ago, as it transported extra grain, coal and industrial products. At C$67 a share, Canadian Pacific Railway trades on a forward p/e of 15. Fadi Chamuon of UBS Canada has a price target of C$80 on the stock.

The three best plays on Canada's oil

Fort McMurray was once a sleepy backwater town. Home to just 1,000 or so residents, there wasn't a road into town until the 1960s just a railway. Yet today, it's home to 70,000 people and the population is expected to hit 100,000 by the end of the decade. Property is more expensive than in the suburbs of Canada's major cities. And it's all down to one thing: oil. It's long been known that Alberta was home to the largest oil deposits outside the Middle East. The oil is mostly found in Alberta, where the Athabasca region is home to approximately 30,000 square miles of the stuff. It's also located in the "Peace River" and "Cold Lake" deposits.

The only problem is extracting it. Trapped in a mixture of sand, water and clay, and black and sticky to the eye, it's popularly called tar sands. When the price of crude oil was cheap as it was throughout the 1990s there wasn't much point in spending the money on getting the oil out of the sands. But with oil becoming much more expensive in recent years and continuing to rise, oil sands have become a more attractive prospect. In fact, back in 2004, Morgan Stanley calculated that oil sands returned an average of 18.0% on capital employed, verses 15.0% for conventional North American oil production. Why? Well, although the oil is harder to refine, it is easy to locate.

So exploration costs are low. The Athabascan sands lie close to the surface, so can be extracted quite easily, moved by enormous trucks to a facility where the sands are converted into synthetic crude oil and then shipped to a refinery. And while the oil price is unlikely to keep rising in a straight line, it's not liable to fall back to a point where tar sands become uneconomical again. Emerging economies now account for just 15% of global oil demand, but at current growth rates that will rise to 40% in the next five years.

This demand has made Albertans very wealthy. Oil sands development returned $1.87bn to the provincial government in the last three fiscal years, from 2003/2004 to 2005/2006. Output reached 966,000 barrels per day (bpd) in 2005, which should grow to three million bpd by 2020 if forecasts are correct. Now the government wants a bigger share of the pie. A recent report recommended a boost in royalties by 20%, or about C$2bn a year. That's led to some short-term weakness in the tar sands stocks. But this is a good buying opportunity, says one Calgary-based analyst, who declined to be named. "I don't think it's going to be that onerous on the companies. What I think we will see is some short-term weakness. All these companies are still attractively valued."

Firms to look at include Suncor Energy (TSX:SU), which was the first company to commercially develop the oil sands back in 1967. In 2006, production at the oil-sands facility averaged 260,000 bpd, but it expects production of 500,000 to 550,000 bpd by 2012. That makes the forward p/e of around 19 look reasonable.

Synacrude oil is the world's biggest producer of crude oil from oil sands. A joint venture between several firms, including Conoco Phillips and Imperial Oil, the largest shareholder is the Canadian Oil Sands Trust (TSX:COS.UN), with a 36.74% stake. Synacrude increased output by 40% in July to about 350,000 bpd. An upgrade will add another 50,000 bpd capacity in five years' time and a final planned expansion will bring production to 500,000 b/d in about ten years, according to Seeking Alpha. The group's bitumen deposits are located close to the surface, meaning they can be mined rather than liquefied and then pumped up from the ground, cutting production costs.

Also interesting is Husky Energy (TSX:HSE), Canada's number-three oil producer, which recently saw third-quarter profit rise 12.8% to C$769m. It has holdings in the Alberta oil sands, but also has operations offshore in Newfoundland on the East Coast, where it expects daily output to rise to 125,000 barrels from 110,000 today. That makes it more diversified than its peers. It trades on a forward p/e of 13.2.

Jody Clarke

Jody studied at the University of Limerick and she has been a senior writer for MoneyWeek for more than 15 years. Jody is experienced in interviewing, for example in her time she has dug into the lives of an ex-M15 agent and quirky business owners who have made millions. Jody’s other areas of expertise include advice on funds, stocks and house prices.