Canada’s gross domestic product (GDP) shrank 0.1% in the first quarter (or 0.3% annualized), marking the country’s first decline since the second quarter of 2003.

Declining exports are chiefly to blame, as spending power in the United States – Canada’s chief trading partner – has significantly contracted since the onset of the credit crunch and subprime mortgage crisis last summer.

Exports – and in turn, the Canadian economy – started losing momentum in the second half of 2007. Cutbacks in manufacturing hurt exports, most notably motor vehicles, Statistics Canada reported today (Friday). 

The slowing economy gives the Bank of Canada more reason to further cut overnight interest rates again at its next meeting June 10. Last month, Bank Governor Mark Carney cut rates by half a point to 3.0% for the second consecutive month.

"Some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada," the Bank said in an April 22 statement announcing its last rate cut.

The Bank projects the Canadian economy to grow by 1.4% in 2008, 2.4% in 2009 and 3.3% in 2010.

Why Canada Shouldn’t Be Too Worried

All this is kind of tragic for Canada, where its domestic demand remains strong because of rising incomes and commodity prices. Yet, all this is more or less offset by weakening exports.

But there’s a happy ending.

In today’s world, where interest rates are low and commodity prices are high, Canada’s in a very strong position for two reasons:

• It has oil reserves – somewhat larger than the Middle East – in the form of the Athabasca tar sands.
• And it’s the world’s largest producer of uranium, with 25% of the world market. For purposes of comparison, Australia is second, with about 23%.

Canada’s wealth of resources protects the country from the rampant inflation spreading around the world. Its core and total consumer price index (CPI) inflation are projected to be slightly below 2% in 2009 and 2% in 2010.

However, as strong as domestic demand is, the health of the U.S. economy is the ultimate indicator of Canada’s economic health.

"The economy here has not only ground to a halt, but is contracting. It’s weaker than the U.S. economy, which I think is probably a surprise to a lot of people," Ted Carmichael, chief economist at JPMorgan (JPM) Canada, told Reuters.

News and Related Story Links:

• Statistics Canada:
  Gross domestic product by income and by expenditure

• Bank of Canada:
  Bank of Canada lowers overnight rate target by 1/2 percentage point to 3 per cent

• Money Morning:
  Canada Inflation Slows Central Bank Expected to Cut Rates Again

• Money Morning:
  With Oil, Uranium and Gold, There’s Nothing Crazy About This Canadian Loonie Tune

• Reuters:
  Canada economy shrinks unexpectedly in 1st quarter

Shares of BCE Inc. (BCE) suffered their biggest downdraft in at least a quarter century yesterday (Thursday), after an unexpected court ruling threatened to derail a $53.9 billion leveraged buyout (LBO).

A collapse would make it the biggest LBO ever to fail.  Indeed, BCE would top the list of 62 LBOs – with a combined value of $174 billion – that were announced last year and then later abandoned as borrowing costs more than tripled, Bloomberg News reported.

BCE had expected to complete the buyout by next month.

The shares of the No. 1 Canadian telephone company plunged as much as 16% yesterday – and closed at $33.10, down $4.73, or 12.5%  – after a Quebec judge had ruled that bondholders can challenge the sale because they weren’t treated fairly. The ruling throws the takeover deal in jeopardy, and could require the buyers to renegotiate the deal’s terms if they opted to proceed.
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The decline was the biggest since 1983, when the company traded in its longstanding "Bell Canada" name for a new listing as "BCE."

One of the suitors, the Canada Pension Plan Investment Board, said it has no interest in making a renewed bid for BCE.

But in a late development yesterday, reports surfaced in the Canadian business press containing speculation that the all-but-certain collapse of the BCE-Teachers deal could prompt another bid by BCE rival Telus Corp. (TU), Canada’s No. 2 phone company. After much groundwork last year – much of it under the glare of close media scrutiny – Telus finally decided not to make a bid for BCE.

The current BCE LBO deal has been the subject of intense speculation over the past several months thanks to a declining capital market and lower trading prices than the offered $42.75 per share.

Back in June, BCE agreed to a $43.44-a-share offer from a group led by the Ontario Teachers’ Pension Plan. The market price of BCE’s U.S. stock is now 24% below the offering price the deal was based upon.

"The probability of the deal closing at [the agreed-upon price] on June 30 is almost zero," Craig MacAdam, a portfolio manager at Aurion Capital in Toronto, told Bloomberg. "But there’s still room to maneuver. The deal is not completely dead yet. All the stakeholders will have to get back to the table and renegotiate."

The bondholders – including CIBC Global Asset Management Inc., a unit of Canadian Imperial Bank of Commerce (CM) – say the LBO would overload the telecom firm with debt, substantially boosting the risk of a default. CIBC is one of Canada’s so-called "Big Four" banks.

According to details of the deal contained in regulatory filings, the teachers would raise about  $34.56 billion in debt (C$34 billion). The equity value of the deal is more than the debt, according to published reports.

Some of the teachers’ partners in the deal include Providence Equity Partners Inc., of Rhode Island and Madison Dearborn Partners LLC of Chicago. The buyout unit of New York-based Merrill Lynch & Co. Inc. (MER) joined the deal later on.

"The decision effectively terminates the proposed transaction," Mark Meland, a Montreal lawyer representing the bondholder group, said in an interview with Bloomberg. "Unless the decision is overruled, the plan of arrangement is now defeated."

News and Related Story Notes:

• Bloomberg News:
  BCE Plunges Most in 25 Years as Buyout in Jeopardy.

• Reuters:
  CPP Investment Board says no plans for new BCE bid.

• Ottawa Business Journal:
  BCE shares pounded following ruling.

• Blackberrycool.com:
  Telus drops out of BCE bid.

Inflation slowed dramatically in Canada, with most of the deceleration credited to falling car prices and less upward pressure from gasoline prices.

Canada’s Consumer Price Index (CPI) increased by 1.8% in the 12-month period from February 2007 to February 2008, the slowest rate of growth in six months, Statistics Canada reported yesterday (Tuesday). It’s also a dramatic turn from the 12-month increase of 2.2% reported in January.

Excluding gasoline prices, CPI rose 1.1%, the smallest increase since March 2004.

Inflation is below the Bank of Canada’s 2% target, meaning the Bank of Canada has room to lower interest rates at its next meeting on April 22.

But even with inflation in check, Canada’s economy is facing a potential slowdown in the face of a possible U.S. recession. Already this month, the bank lowered its benchmark rate 50 points to 3.5%.

“Inflation is under control and that’s good news,” Stefane Marion, an economist with National Bank Financial in Montreal, told Bloomberg. “Inflation is not an impediment to rate cuts in Canada, contrary to other countries where central bankers might be more hesitant.”

Unlike most rate cut scenarios, Canada’s economy is operating above its production capacity and both core and total consumer price index (CPI) inflation are lower than projected in its Monetary Policy Report (MPR) in October.

In this case, the rate cut was primarily a precautionary move – putting up its economic dukes to fend off threats of [and reactions to] a possible U.S. recession.

“Financial market conditions have deteriorated since October, leading to a tightening of credit conditions in industrial countries. Given this, and a deeper, more prolonged decline in the U.S. residential housing sector, the 2008 outlook for the U.S. economy is now significantly weaker than at the time of the October MPR,” the bank said in January.

Domestic demand remains strong because of rising incomes and commodity prices, the bank said. But effects of a weaker U.S. economy will stunt Canada’s exports, and the bank projects that growth in 2008 will be weaker than it projected in October.

Canada’s Economic Challenges

However, consumer prices rose 0.4% between January and February, compared with a 0.2% decline in the previous month. The core index rose by 0.5% between January and February, following growth of 0.1% recorded in the previous period.

“For the Bank of Canada, what this suggests is the free ride of ever declining core inflation may be coming to an end,” Doug Porter, deputy chief economist at BMO Capital Markets, told Reuters. “But I would still say that Canada has got much less of an inflation problem than basically everywhere else in the world.”

In the Bank of Canada’s annual report, issued March 14, departing bank governor David Dodge outlined seven challenges facing the country and bank:

• The need for flexibility in the reallocation of economic resources in response to changing circumstances,
• Building stronger international monetary and financial order,
• Maintaining sustainable levels of public debt,
• Improving the efficiency and stability of the country’s financial system,
• Renewing outdated infrastructure in the most efficient and timely fashion,
• Fostering greater growth in productivity,
• Keeping inflation low.

The Bank of Canada also projected a first-quarter CPI of 1.7% and core inflation of 1.4%.

News and Related Story Links:

• Statistics Canada: Consumer Price Index: February 2008
• Bloomberg: Canada’s Annual Inflation Rate Falls to Six-Month Low
• Reuters: Canada February inflation eases on lower car prices
• Bank of Canada: Annual Report 2007

The Toronto Stock Exchange gained a whopping 477.22 points yesterday (Tuesday), reversing most of Monday’s losses – a 3.93% gain and its best daily performance in five years – after the Bank of Canada cut its main interest rate by a quarter point to 4%.

The Canadian dollar also rose .7% to $1.0282 per U.S. Dollar, a significant gain after hitting a four-month low.

Unlike most rate cut scenarios, Canada’s economy is operating above its production capacity and both core and total consumer price index (CPI) inflation are lower than projected in its Monetary Policy Report (MPR) in October.

In this case, the rate cut was primarily a precautionary move – putting up its economic dukes to fend off threats of [and reactions to] a possible U.S. recession.

"Financial market conditions have deteriorated since October, leading to a tightening of credit conditions in industrial countries. Given this, and a deeper, more prolonged decline in the U.S. residential housing sector, the 2008 outlook for the U.S. economy is now significantly weaker than at the time of the October MPR," the bank said in a statement.

Domestic demand remains strong because of rising incomes and commodity prices, the bank said. But effects of a weaker U.S. economy will stunt Canada’s exports, and the bank projects that growth in 2008 will be weaker than it projected in October.

"In line with this outlook, the Bank has decided to lower the target for the overnight rate and further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term," the bank said. 

The rate cut follows suit with U.S. Federal Reserve Chairman Ben Bernanke’s rate cut of three-quarters of a point before the markets opened yesterday (Tuesday) as a precaution against free-falling stocks around the world. 

"The Bank of Canada’s history is it tends to follow the Fed with a lag," Ted Carmichael, chief Canadian economist at J.P. Morgan Securities in Toronto, told Bloomberg. "That’s going to be the pattern again this time."

The bank will publish an update to its Monetary Policy Report tomorrow (Thursday). Its next scheduled date for announcing the overnight rate target is Mar. 4.

News and Related Story Links:

• Bank of Canada:
  Bank of Canada lowers overnight rate target by 1/4 percentage point to 4 per cent

• Bloomberg:
  Bank of Canada Lowers Main Rate, Signals Further Cuts

Canada’s 25 basis point rate cut on Tuesday had many investors scratching their heads.  After all, the cut goes against conventional thinking for central banks, which often lower rates when a country’s economic growth is threatened by weakening currency valuations, housing markets and/or domestic demand – none of which are currently happening in Canada.  Why cut rates now?

The answer lies with Canada’s largest trading partner and neighbor to the south – the United States.

In 2006, 79% of Canada’s exports went to the United States.  In September of this year, a strong economy and surging commodity prices drove the Canadian dollar to parity with the U.S. dollar for the first time in over three decades. The currency surpassed parity by 10% when it hit an all-time high of 90.58 cents Canadian per U.S. dollar on November 7th.

As the Canadian dollar strengthened against the U.S. dollar, Canada’s exports became increasingly expensive for U.S. consumers.  Weakening export demands due to unfavorable conversion rates and the United States own domestic economic troubles pose a threat to Canada’s economic growth.

"The Canadian economy has been growing broadly in line with the Bank’s expectations, reflecting in large part underlying strength in domestic demand. However, both total CPI inflation and core inflation in October, at 2.4% and 1.8% respectively, were below the Bank’s expectations, reflecting increased competitive pressures related to the level of the Canadian dollar," the bank said in a statement.

As recently as July, the Bank of Canada was concerned with inflation and raised interest rates 25 basis points.  But as the currency continued to rise versus the U.S. dollar and with lower-than-expected inflation, the Bank of Canada had every reason to reverse their position and lower rates.

Like the recent cuts in the United States, Canada’s rate cut weakened its currency.  The Canadian dollar dropped a full cent against the U.S. dollar.

The Bank of Canada also cited concerns of the spreading U.S. subprime mortgage plague that has since touched down in England and Australia.

"Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further," the bank said in a statement.

Will one rate cut do the trick?  It won’t be long before we see the central bank’s next move. The next interest rate decision will come on Jan. 22, 2008 – and given that the Bank of Canada cited U.S. subprime concerns in its statement, surely the Fed’s decision to hold steady or cut interest rates on Dec. 11 will play a part.

News and Related Story Links:

• Bank of Canada:
  Bank of Canada lowers overnight rate target by 1/4 percentage point to 4 1/4 per cent

• Money Morning:
  Canadian Dollar Reaches Par Against the Greenback

• Money Morning:
  Canadian Dollar Dances with Dipping Commodities

• Bloomberg:
  Canada Unexpectedly Cuts Rate as Dollar Gains

• Money Morning:
  Canada’s Unchanged Interest Rate Signals its Concern for U.S. Credit Crunch

• Money Morning:
  How to Profit from Canada’s Commodity Boom

• Money Morning:
  North of the Border: Eight Ways to Profit From the Canadian Dollar and the Commodities Boom (Part 2)

The Canadian dollar had possibly the best year of all world currencies. Its performance against the U.S. dollar is one for the record books – on Nov. 7, almost six weeks after eclipsing parity with the U.S. dollar, the loonie peaked at $1.0837 against the U.S. dollar, a 27% year-to-date appreciation against the greenback.

But that day was also the currency’s jump-the-shark moment, because what propped it up so high is what inevitably brought it back down – record commodity prices, namely gold, oil and uranium.

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And not coincidentally, drops in the price of gold and oil in the past few weeks have pulled the Canadian dollar down to $1.0148, threatening parity once again just as many Canadian Christmas shoppers are planning trips across the border in search of "bargain U.S. prices."

Adding to the buck-related buzzkill, Bank of Canada Governor David Dodge said that an interest rate cut is possible early next year due to "risks" to the country’s economic growth. Those risks were vague, at best, including "growing threats to the global economy" and "volatility in financial markets," Dodge said, according to Bloomberg News – and somewhat directed at the U.S. credit market. Even so, the comments suggest that the Canadian central bank may cut borrowing costs by reducing the current benchmark rate of 4.5%.

And if Dodge & Co. pulls the trigger, Canada can say goodbye to its high-valued currency.

"The central bank has started to take note of the downside risk coming from the trade side," David Watt, a senior currency strategist at RBC Capital Markets in Toronto, told Bloomberg. "The days of easy gains in the Canadian dollar are gone."

But no one can say they are surprised by the talk of a rate cut. In early September, the Bank of Canada held interest rates steady, but noted that credit troubles stemming from the U.S. subprime fallout could lead to a rate cut down the road. And since then, U.S. Federal Reserve Chairman Ben S. Bernanke and fellow central bank policymakers cut interest rates twice.

"Against this background, the Bank judges that the current level of the target for the overnight rate is appropriate. However, there are significant upside and downside risks to the outlook for inflation. On the upside, there is a possibility that household demand in Canada could be stronger than anticipated, while on the downside the ongoing adjustment in the U.S. housing sector could be more severe and spill over to the U.S. economy more broadly," the Bank of Canada’s statement said. 

The Canadian Press suggested a wild card could control the fate of the loonie – China’s massive [and government-controlled] foreign exchange holdings and the country’s lethargy in responding to problems caused by the slumping dollar. 

Even though Canada’s economy is one-tenth the size of the American economy, Ottawa estimates it shouldered a third of the brunt of the dollar’s depreciation. If that estimate is true, it only makes the Canadian dollar’s historic run this year all the more impressive.

‘Border’line returns

If anything, the timing of a devalued Canadian dollar couldn’t be better. As mentioned earlier, a strong loonie gives Canadians more buying power in the U.S. market, where they can scoop up retail deals, not to mention cheaper cars and appliances. Over the summer, a cheap dollar and strong loonie sent more Canadians across the U.S. border for vacation.

But as we head into our unofficial holiday shopping season – from "Black Friday" [the day after Thanksgiving] to Christmas – fewer Canadian shoppers will cross the U.S. border looking for deals because a weaker currency means it’s finally once again more worth their time and money to shop in their home market.

Should the Canadian dollar dip further in the next few weeks, it’ll be a blessing of sorts for the Canadian economy. Retail sales figures are one of the leading indicators of economic health, and a strong retail rally may persuade the Bank of Canada to hold off on cutting rates, which would in turn return buying power to the loonie.

It’s an odd way to full circle back to strength, but it’s very possible.

News and Related Story Links:

• Money Morning:
  Canadian Dollar Reaches Par Against the Greenback

• Money Morning:
  With Oil, Uranium and Gold, There’s Nothing Crazy About This Canadian Loonie Tune

• Bloomberg:
  Canada’s Dollar Falls as Dodge Raises Possibility of Rate Cuts

• The Canadian Press:
  Observers divided over Bank of Canada’s interest rate conundrum
• Money Morning:
  How to Profit from Canada’s Commodity Boom

• Money Morning:
  North of the Border: Eight Ways to Profit From the Canadian Dollar and the Commodities Boom

• Money Morning:
  Tourism to U.S. Climbs as Canadian Dollar Hits 30-year High

[Editors Note: The First of Two Parts. To Read Part One, Please Click Here. It is Free of Charge.]

The slang term for the Canadian dollar is the "Loonie." But there’s nothing crazy about what’s been happening north of the border, where the Canadian dollar is trading at a 50-year high, while Canada’s unemployment rate is at a 33-year low.

The key factor behind both pieces of good news is one and the same: Soaring commodity prices.

In searching for profit opportunities stemming from the strong Canadian dollar and from Canada’s commodities boom, it’s important to understand that it’s not just about oil.

That diversity is part of Canada’s investing allure. Indeed, the country is a veritable Aladdin’s cave of commodities. It is home to the largest oil reserves outside the Middle East, and boasts the second-biggest natural gas deposits. 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 that country’s Midwest prairie region, you have to pay for the purchase in Canadian dollars. That means you must first sell your U.S. dollars, or British pounds Sterling, or Chinese Yuan, and then buy Loonies – an oft-repeated process that pushes up the currency’s relative value. And with oil, gold and most other commodities carrying stratospheric prices, the rest of the world has to pay top dollar for the minerals and energy it buys from Canada.

With all those things considered, it’s no wonder that a currency that was languishing down around $0.62 to the U.S. dollar back in January 2002 finally reached par in mid-September, and right now is trading at about $1.07. That now means it’s cheaper for Canadians to order goods online from the United States and have them shipped over the border than it is to buy them locally.

Needless to say, U.S. imports have soared. And so have job opportunities. The jobless rate in Canada for October was 5.8%, a 33-year low.
Canadians are clearly enjoying an improved lifestyle. And savvy investors have much better profit opportunities. We’ll organize those opportunities by commodity classes.

Uranium

The rocketing price of oil, combined with fears about greenhouse gases, has refueled interest in nuclear power. In June, the price of uranium – the main nuclear fuel – hit an all-time-high of $138 a pound. That’s stunning when you consider that the average price per pound back in 2000 was just $7.

But no bull market goes up unchecked and, by September, the price had slipped back to around $75. News of some production shortfalls has fueled a bit of a rebound, to about $90 a pound, and it should go further, says Blackmont Capital Inc. analyst George Topping.

"We believe the uranium price has bottomed, as witnessed by the modest price increases on higher volume reported in October," Topping told clients in a recent research note.

Speculators such as hedge funds – which bailed out in July – also are 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.

This new uranium rally is partly down to more bad news from the Cigar Lake mine, the world’s second-largest uranium depository. Discovered in 1983, it is located about 400 miles north of Saskatoon, Saskatchewan. It had been expected to supply 18 million tons 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 Corp. (CCJ). Cameco’s share price has understandably suffered from the delays, and is currently trading about 22% below its record high. But anyone buying into the uranium rebound should also buy into Cameco – in modest amounts. Despite its problems at the Cigar Lake site, Cameco remains the world’s largest – and most-liquid – uranium minder, and is vital to the global supply.

Cameco already operates the world’s largest uranium mine, McArthur River, and third-quarter results underscore the company is still growing at a healthy pace. Even with the summer price drop in uranium, Cameco still earned $94.3 million for the three months ended Sept. 30, up 25% from earnings of $75.6 million for the comparable quarter 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. India has similar expansion plans. Japan wants to increase nuclear power’s contribution to its overall electricity supply from 30% now to 40% by 2016.

"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," Raymond Goldie of Toronto-based Salman Partners told MoneyWeek in August. 

Cameco Chief Executive Officer Gerald W. Grandey predicts that that uranium will hit the century mark anew sometime this month. He also believes that uranium production should grow by 80% over the next nine years, noting that if prices don’t firm up, Cameco will make up the shortfall through acquisitions.

In an address to investors in New York earlier this month, Grandey said the company’s mined uranium should reach 36 million pounds of uranium by 2016, just through organic growth.

"That doesn’t count on any new discoveries, potential joint ventures, or any equity investments or acquisitions," Grandey said. "Over time we expect that there will emerge opportunities and then Cameco will … begin to identify better opportunities, the ones that have long term significance, then we’ll become active in the acquisition sphere."

Topping, the Blackmont Capital analyst, expects production in 2015 to hit 32 million pounds, up 46% on this year. He also has a buy rating on the stock and a C$62.50 price target on the Canadian-listed shares [$64.77 in U.S. dollars]. The Canadian shares closed yesterday (Tuesday) at $41.81. The U.S.-listed shares closed at $43.59, down 74 cents each, or 1.73%.

Soft Commodities

Canada’s not just big in the areas of energy and base metals – it also has enviable position in the agricultural sector, a market that will grow significantly as such overseas markets as mainland China continue to make the shift from emerging economy to capitalist powerhouse.

Times were that the prices paid for such grains as wheat and corn were reasonably stable. One year there’d be a bumper crop, and then the next year there would be a ruinous drought.  But farmers try to prepare for the worst by storing the 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 $23 a ton to ship canola, an edible oil, from Vancouver to Shanghai. Now it costs $103. Demand for grains has jumped, in large part because of the expanding appetites of the Asian middle class – with a big assist from the biofuels craze. Unable to keep pace with 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 the end of next May, the United States Department of Agriculture reports. That would be a year-over-year decline of 13%.

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 metric tons this year, 1.6% more than the 20.32 million metric tons estimated in July, a survey of farmers by Statistics Canada recently showed.

That’s good news for the Canadian-listed Saskatchewan Wheat Pool (VT). It’s now the biggest grain handler in the Canadian West, with a 42% market share after the purchase of Agricore United in June.

Saskatchewan Wheat’s business stretches across the country, from a livestock business in Manitoba to retail outlets in British Columbia. The valuation has become a bit frothy of late, with a forward P/E ratio of 19. But if the Canadian Wheat Board monopoly is dismantled, as is currently being discussed in Ottawa, the grain-handling volumes of Saskatchewan Wheat could jump as a consequence.

Saskatchewan Wheat also has an agri-products arm, selling fertilizer, feed and other products to more than 50,000 farmers. With the boom in soft commodities leaving farmers flush with the cash to invest in their farms, that side of the business is performing well right now, analysts say. And while the ethanol story might only be sustainable for as long as the U.S. government feels like propping it up with subsidies, Asian consumers won’t be excusing themselves from the global dining-room table anytime soon, meaning that boom likely has quite a ways to run, yet.

Railways

It’s easy to forget that someone has to move all these commodities from Point A to Destination B. Two of the main carriers are Canadian National Railway (CNI) and Canadian Pacific Railway Ltd. (CP). We’d avoid Canadian National Railway – for now – because it has a large forestry products business, which exposes it to the ailing U.S. housing market.

Timber is big business in Canada. But Canadian Pacific Railway has of a timber-sector exposure than its rivals, meaning it has a smaller entanglement with the U.S. housing malaise. And right now, that’s a huge plus. What’s more, earnings are expected to advance nicely. On Monday, Canadian Pacific Railway reported that third-quarter profits were $219 million, up 34% from the $164 million reported for the comparable quarter in 2006. Earnings per share were $1.41 for this year’s third quarter, up 36% from the $1.04 per share recorded for the third quarter of 2006, as the railway transported extra grain, coal and industrial products.

At yesterday’s closing price of $64.91 a share, Canadian Pacific Railway is trading at a forward P/E of 17.47. Fadi Chamuon of UBS [Canada] AG (UBS), has a price target of $83 on the stock.

From yesterday’s close, that would represent a gain of 28%. The stock has a modest dividend yield of 1.5%.

The Three Best Ways to Play Canada’s Oil Reserves

For McMurray was once a sleepy backwater town. Home to just 1,000 or so residents, there wasn’t even a road into town until the 1960s – just a railway. And 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 it is in the suburbs of Canada’s major cities.

And it’s all because of one thing – oil.

It’s long been known that Alberta was home to the largest oil deposits outside the Middle East. The oil is located in the "Peace River" and "Cold Lake" deposits. But it’s mostly found in Alberta, where the Athabasca Region is home to approximately 30,000 square miles of the stuff – an odd mix of sand, water and clay that’s known as "tar sands."

Black and sticky, it only takes you a moment to realize that extraction is the real problem.

When the price of crude oil was low – 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 with prices expected to continue their upward climb – the tar sands, or oil sands oil sands have become economically relevant.  sands have become a more attractive prospect. In fact, back in 2004, Morgan Stanley (MS) calculated that oil sands returned an average of 18% on capital employed, verses only 15% for conventional North American crude oil. Why is that the case? Well, for one thing, 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, meaning they can be extracted quite easily – moved by enormous trucks to a facility where the sands are converted into synthetic crude oil, which is then shipped to a refinery. And while the price of crude oil is unlikely to keep rising in a straight line, it is expected to keep rising, and it won’t likely 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 share will rise to 40% in the next five years.

This demand has made Albertans very wealthy. Oil sands development returned $1.87 billion to the provincial government in the last three fiscal years, from 2003-04 to 2005-06. Output reached 966,000 barrels per day in 2005, a figure that is expected to grow to 3 million barrels per day 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 $2.08 billion a year. That’s led to some short-term weakness in 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," the analyst said. "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 Inc. (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 barrels per day, but the company expects production of 500,000 to 550,000 barrels per day by 2012. That makes the forward P/E of 19 seem much more reasonable.

Syncrude Canada Ltd. is the world’s biggest producer of crude oil from oil sands. A joint venture between several firms, including ConocoPhillips (COP) and Imperial Oil Ltd. (IMO), the largest shareholder is the Canadian-listed Canada Oil Sands Trust (COS), with a 36.74% stake.

You could invest in any of the three, although we favor the Canada Oil Sands Trust. The stock closed yesterday at $34.50, down 38 cents, or 1.09%.

Syncrude increased output by 40% in July to about 350,000 barrels per day. An upgrade will boost capacity by 50,000 bpd in five years, and a final planned expansion will bring production to 500,000 bpd in about 10 years, according to securities-researcher 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, a reality that slashes production costs.

Also interesting is Canadian-listed Husky Energy Inc. (HSE), Canada’s No. 3 oil producer, which recently saw third-quarter profit rise 12.8% to $800 million. It has holdings in the Alberta oil sands, but also has offshore operations on the East Coast near Newfoundland, where it expects daily output to rise to from the current 110,000 barrels per day to 125,000 barrels per day.

That makes it more diversified than its peers. Husky Energy shares are currently trading at a forward P/E of 13.20.

To summarize, here are the six key profit plays we see, plus the two solid alternatives we identified for you in ConocoPhillips (COP) and Imperial Oil Ltd. (IMO). The six top picks are:

• Cameco Corp. (CCJ).
• Saskatchewan Wheat Pool (VT).
• Canadian Pacific Railway Ltd. (CP).
• Suncor Energy Inc. (SU).
• Canada Oil Sands Trust (COS).
• Husky Energy Inc. (HSE).

[Part One appeared in Money Morning yesterday (Tuesday). To read Part One, please click here. The article is available free of charge.]

News and Related Story Links:

• Money Morning Investment Research Report:
  How to Profit from Canada’s Commodity Boom [Part I].

• Reuters:
  Cameco Sees 80 percent Production Rise by 2016.

• Money Morning Investment Research Report:
  Wheat’s Forecasted Price Drop Highlights Profit Plays in Commodities.

• Money Morning Investment Research Report:
  Four Ways to Profit as China Ignites Global Milk and Dairy Prices.

• Wikipedia:
  Tar Sands.

• Money Morning Investment Research Report:
  Three Ways to Profit From the Mining Sector’s Takeover Boom.

[Editors Note: The First of Two Parts. Part Two Runs Tomorrow.]

If you’re planning to send Christmas presents to Canadian relatives this year, the Canadian postal service has a simple warning for you: "Mail your parcels early!" says Paula Shore, an official with the Canada Border Services Agency in Vancouver, B.C.

She’s not joking. Delays are being reported across the country’s postal network, with the three biggest international mail-sorting centers – Montreal, Toronto and Vancouver – all at a choking point. Shifts have been added, and overtime extended, as Canada Post and the Border Services Agency struggle to deal with a 14% year-over-year surge in volumes through to September.

Canada’s mailbag 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 – known colloquially as the Loonie – is trading at a 50-year high of $1.07 against the U.S. dollar, making it cheaper for Canadians to order goods online from the United States than to buy them locally. That fact has led to a surge in U.S. imports and a raft of extra parcels and mail to deal with. Retailers, who stocked up on goods many months ago when the U.S. 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.

Although it may not feel like it to those local retailers, Canada’s currency is doing well because the nation’s economy is booming. Sure, it’s "going up by default against a weakening dollar," like almost every other currency in the world, says Adam Cole, a senior currency strategist at the Royal Bank of Canada (RY).

But the underlying strength of the Loonie "is primarily a commodities story," Cole noted. The reason: 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, he said.

Commodities Fueling Growth

That’s great news for Canada since, when it comes to commodities, the country is an absolute Aladdin’s cave. Canada is home to the largest oil reserves outside the Middle East, and boasts the second-biggest natural gas deposits. Its miners are world leaders, conducting 40% of the world’s mining operations, making the U.S. neighbor to the north 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 that country’s Midwest prairie region, you have to pay for the purchase in Canadian dollars. That means you must first sell your U.S. dollars, or British pounds Sterling, or Chinese Yuan, and then buy loonies – an oft-repeated process that pushes up the currency’s relative value. And with oil, gold and most other commodities carrying stratospheric prices, the rest of the world has to pay top dollar for the minerals and energy it buys from Canada.

The net effect of these global financial transactions means that Canada is blessed with something rarely seen in a modern-day developed 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 $9 billion (C$8.68 billion), according to the country’s Finance Department.

And the commodities boom has also created a jobs bonanza. The U.S. economy created twice as many jobs as expected in October, a pleasant surprise for many who’d been expecting a slump. North of the border, however, the Canadian economy added 63,000 jobs, roughly five times the number that had been expected. The jobless rate in Canada for October was 5.8%, a 33-year low, and a marked decline from the 5.9% reported for September.

For now, it appears Canada is sound enough to ward off much of the spillover impact of a U.S. recession, should the American economy sputter and stall.

"I’m not particularly optimistic about the U.S., but I don’t think the Toronto Stock Exchange is really about the U.S. anymore," Jeff Rubin, chief economist and chief strategist at CIBC World Markets Inc., told Reuters. 

Although 75% of Canadian exports currently go to the U.S. market, more than half of its exports are commodities. [That ratio is actually in decline, although Canada remains the No. 1 U.S. trading partner, according to the U.S. Census Bureau].

"What we’re seeing is strong global growth that no longer seems to be dependent on the U.S., and that’s what allows the Canadian market and, indeed, the broader Canadian economy, to have the measure of independence from the U.S. that it didn’t have in past cycles," CIBC’s Rubin said. "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."

The bottom line: The fact that Canada’s commodities are in such demand means that Canadian commodity stocks are promising investments, worth closer study by investors looking to capitalize on global growth. Canada may also be something of a safe haven for investors looking to diversify away from the U.S. market and fears that the U.S. economy is recession-bound.

In part two of this series, we’ll outline precisely which commodities are fueling the Canadian economy, and tell you which companies investors will want to consider popping into their portfolios.

[Part Two Will Appear in Tomorrow's Issue of Money Morning.]

News and Related Story Links:

• Money Morning Investment Analysis:
  With Oil, Uranium and Gold, There’s Nothing Crazy About This Canadian Loonie Tune.

• Money Morning Investment Report:
  Two "CanRoy" Investments for the Oil and Gas Boom.

• Money Morning News:
  Canadian Telecom Telus Misses Third-Quarter Estimates, Even With a 28 Percent Gain in Profits.

• U.S. Census Bureau:
  Top 10 Countries With Which the U.S. Trades (September 2007 Statistics).

Surging oil prices have pushed inflation in Canada to its highest rate since May 2006, Bloomberg reported Friday.

And right behind it, not surprisingly, Canada’s dollar hit a 33-year high of $1.0344 (one dollar equals 96.67 Canadian cents) — quelling U.S. hopes the Bank of Canada would cut interests rates.

The Canadian Consumer Price Index (CPI) rose at a 2.5% annual rate in September from a year earlier, compared with a 1.7% rate in August, as gasoline climbed 13%, Statistics Canada reported last week. On a monthly basis, prices rose 0.2% from August to September.

The Bank of Canada said inflation will return to its 2% target sooner than expected. The central bank kept its benchmark rate unchanged at 4.5% on Oct. 16.

Since December, the Canadian dollar has gained 19.8%, reaching parity with the U.S. dollar on Sept. 20, its first time since 1976.

Crude oil hit a record $90 a barrel in New York on Friday morning. Half of Canada’s exports are commodities, and price hikes (or declines) in them affects our northern neighbor’s currency and economy.

The weakening U.S. dollar and volatile credit market have driven many investors to gold, further adding more to Canada’s growth. Inflation was also given major push thanks to the rising costs of mortgage interest, transportation, alcoholic beverages and tobacco.

News and Related Story Links:

• Bloomberg: 
  Canada’s Dollar Rises to 33-Year High as Inflation Accelerates.

• Money Morning:
  Canada’s Unchanged Interest Rate Signals its Concern for U.S. Credit Crunch.

• Money Morning:
  Canadian Dollar Reaches Par Against the Greenback.

• Money Morning:
  With Oil, Uranium and Gold, There’s Nothing Crazy About This Canadian Loonie Tune.

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Alleging that Canada has violated the North American Free Trade Agreement with unlawful restrictions, Exxon Mobil Corp. (XOM) has announced its intention to sue Canada in early November for more than $40 million. Arkansas-based Murphy Oil Corp. (MUR) has also warned Canada of its intent to sue for more than $10 million.

In their August filings, both companies argued that, under NAFTA, Canada agreed not put any "local content" requirements into effect.  Local content consists of rules or regulations that require companies to source a percentage of goods and services from local vendors.

However, Exxon and Murphy Oil both allege that the Canada-Newfoundland Offshore Petroleum Board established several "guidelines and/or obligations" that violate those terms of the agreement.  The regulations require the petroleum companies operating in the region to spend a fixed percentage of revenues in Canada, and to set up a fund for unspent money to be used for research and development in Newfoundland and Labrador.

Exxon and Murphy have filed for redress under Chapter 11 of the NAFTA treaty, which affords companies the right to demand compensation from signatories in violation of the agreement.

News and Related Story Links:

• CNNMoney:
  Exxon Mobil Expected to File $40 million NAFTA Suit Against Canada in November.

• Money Morning Investment Analysis:
  With Oil, Uranium and Gold, There’s Nothing Crazy About This Canadian Loonie Tune.

•  Money Morning News: 
  Soaring Oil Prices, Debt Concerns Send Stocks Skidding Yesterday; Oil Spikes in Asia Today.

• Wikipedia:
  North American Free Trade Agreement (NAFTA).