If We Go Over The Cliff, We're Taking Canada With Us

| About: iShares MSCI (EWC)

Everyone knows that if no "Fiscal Cliff" deal is reached by midnight, we're heading into a recession.

I personally think we'll get a deal later in the week. Republicans will decide that voting for some tax cuts next month makes sense, as opposed to voting for any deal that increases taxes today. There will also be fewer Republicans in the next Congress, and the party's unity is not absolute.

But let's assume there is no deal. Spending goes down and taxes go up. The annual deficit of the country is reduced. Unfortunately, too much of that good thing will also result in a recession. It may be short, but it will be sharp, and we have to be ready for it.

Who gets hurt?


Canada has always had an extractive economy. The joke is that it's a calm socialist paradise, a giant Portlandia, but its economy is more like Texas combined with eastern Oregon. It's economically unbalanced right now, with a lot more wealth coming from its west than its east, thanks to the Athabasca tar sands, which can be dug up with shovels, and from which bitumen can be extracted.

This has also created a political imbalance. The ruling Conservatives of Prime Minister Stephen Harper have been riding high on the back of tar sand prosperity. Expect a bumpier ride if that boom turns to bust. As it may.

Mining.com wrote recently that tar sands producers were getting the equivalent of just $45/barrel for their production, while syncrude, which requires even more expensive refining, is selling on par with U.S. oil. That oil, in turn, sells at a big discount to the Brent price.

The Independent estimates it costs $80-100/barrel to break even on tar sand production, because enormous amounts of water are used in the production process. Deposits near the surface cost less to extract than those underground.

Industry advocates dispute The Independent's figures. Canadian Oil Sands (COS), which sells synthetic crude, or syncrude, at a small discount to West Texas Intermediate, says its operating costs are less than $40/bbl, but these costs include upgrading from bitumen to light SCO. Here's a quarterly report. Deeper deposit, beyond the economic limit of mining, are mostly produced using Steam Assisted Gravity Drainage, or SAGD. A pure SAGD play is MEG Energy (NYSE:MEG). MEG reports operating costs of less than $20/bbl, though they sell bitumen at a substantial discount to WTI. Here's a quarterly report from MEG.

During the financial crisis, a lot of tar sands projects were shelved as global oil prices fell. This is starting to happen again. The profit squeeze is hitting companies like Suncor (NYSE:SU), Cenovus (NYSE:CVE) and Imperial Oil (NYSEMKT:IMO), and that reduction in supply is hurting the big pipeline companies, like TransCanada (NYSE:TRP) and Kinder Morgan (NYSE:KMI), both of which are already facing environmental delays in getting projects approved.

Even if no one cared about the environment at all, tar sand oil faces increasing competition from North Dakota's Bakken, which is actual oil - drilled out of shale - and which is having its own problems getting to market, with most gas associated with it being flared off. I think the Bakken will keep most of the pipeline companies busy, but the competition is going to squeeze the tar sands guys, deal or no deal.

So if you assume there will be no deal, you might consider some selective shorts. Look at EWC (NYSEARCA:EWC), the Canadian ETF run by iShares. I think the Canadian banks will come out OK, because they're not leveraged the way American banks are, but looking at the ETF's holdings you come up with lots of good targets for shorts. About 20% of the holdings in this ETF are in energy stocks, including two pipeline companies tied closely to the sands, TransCanada (which is trying to get the Keystone project built) and Enbridge (which is trying to get over the Rockies and into Vancouver).

If you want to make up for your losses going over the cliff, in other words, consider a general short on Canada. If we go over, we're taking them with us.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.