Why Climate Change Makes XME A Strong Buy (NYSEARCA:XME)

Introduction

It’s time to achieve two things in this article. First, to explain why I am bullish on metals and commodities, in general, that benefit from both secular and cyclical growth fueled by “net-zero”. Second, why that makes the SPDR S&P Metals and Mining ETF (XME) an attractive investment as miners are undervalued and because this ETF offers quality exposure to diversified miners. So, bear with me!

Net-Zero Means Buying “Dirty” Miners

Three things I have covered on a consistent basis in my daily newsletters on Intelligence Quarterly are inflation, supply chain problems, and climate change measures. In the case of this article, all of these issues are connected.

It basically starts with the global push to reach net-zero. In most cases, countries (governments and NGOs) are pushing to get their economies to become climate neutral by 2050. In this case, I laid out the implications in an article written on January 27, which I will use to explain the bull case in this XME-focused article as well.

Becoming net-zero means cutting emissions (obviously). So, where do emissions come from? According to the graph below, it’s mainly from energy. This includes industrial energy sources, transportation, and energy used in buildings. Changing this would mean switching to electric vehicles, wind and solar, heat pumps, and a lot more related applications/technologies.

All of the applications I just mentioned have one thing in common: they need a lot of energy (electricity) and metals.

Data shows how “bad” things could get if we try to achieve net-zero according to the Paris Climate Agreement (the SDS scenario). 90% of demand for lithium would come from “net-zero” initiatives. It would be roughly 70% of cobalt demand, 60% of nickel, 45% of copper, and more than 40% of rare earth metals.

To give you some more details, the table below shows which applications need certain materials. EVs and battery storage require a “high” amount of copper, cobalt, nickel, lithium, rare earths, and aluminium.

To give you an idea of what the change in demand might look like, this is a quote from an article my colleague and commodity expert Tracy Shuchart wrote (paywall may apply):

UBS: forecasts EV penetration of >20% in 2025 and ~50% in 2030. In our view the rapid growth in EV production will be the primary driver of global nickel demand over the next 5-10yrs. In our view developments in battery technology are likely to reduce nickel content (growth in LFP & other potential technologies); but we believe nickel rich NCM cathodes will remain a key part of the battery mix. EV batteries accounted for ~10% of global nickel demand in 2021; we project that demand from EVs could lift to ~800kt by 2025 (~25%) and 2.8mt (~50%) by 2030.

The graph below was used in the article and shows a steep decline in nickel inventories as production cannot keep up with demand.

The same is true for copper. According to the table above, copper demand is high in 3 “sustainable” applications and key in 7 applications.

To give you an example of where copper demand might be headed, a conventional car uses roughly 18 to 50 pounds of copper depending on its size. A plug-in hybrid vehicle uses roughly 130 pounds of copper. An electric vehicle uses more than 180 pounds of copper.

As Tracy wrote in a different article, copper started the year already in a huge deficit (see the graph below), which will only get worse due to accelerating secular demand growth.

And, to make things worse, global mining capital expenditures (“CapEx”) are expected to peak next year at levels that are way below levels seen in 2012. What this means is that despite record commodity demand, producers are unlikely to boost production. The oil industry is seeing something similar for different reasons. Oil & gas companies do not want to be the “bad guys” anymore. They are either pressured to reduce production or decide to focus on free cash flow to boost dividends. In mining, we see similar motives on top of other issues. Mining is risky. New projects are very expensive and come with a lot of risks that are not attractive in a choppy commodity market. Over the past 10-15 years, commodities have been volatile. Miners are finally in a place where they can mine existing mines without additional risks – while making a lot of money. In order to boost production, (local) governments will have to take on some of the risks as miners are unlikely to boost production.

And it gets better. Tracy also included two valuation charts in her copper article I want to share with you before we look at the XME ETF.

Commodities haven’t been this “cheap” versus equities in roughly 50 years. This was caused by a long-term deflationary trend that pushed money into tech and growth stocks, to give you two examples. In an environment where inflation runs hot and the Fed is pressured into hiking while equities trade at lofty valuations, commodities tend to do very well.

The average Stoxx 600 Basic Resources stock is trading at a steep discount versus the Stoxx Europe 600, which shows that investors still haven’t shifted to commodity investments.

Using US-based ETFs, we see that metals and mining stocks have massively underperformed the S&P 500.

So, here’s a way to benefit from this:

Why XME Makes Sense

The SPDR S&P Metals and Mining ETF was used in the graph above when I compared metals and mining companies to the S&P 500 (relative performance).

What makes sense about an ETF is that it gives investors diversified exposure without single-company risk. In this case, XME is the largest mining and metals ETF in the world with roughly $2.2 billion in assets.

XME has 32 holdings with a weighted average market cap of $10.7 billion according to State Street, the owner of this ETF. It pays a quarterly dividend of currently 0.7%. The ETF seeks “to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P® Metals and Mining Select Industry® Index (the “Index”)” according to SPDR.

The table below shows the company’s top holdings. Note that there are no heavyweights in the ETF that can still cause single-company risk. The largest holding is aluminium giant Alcoa (AA) with a 5.9% weighting.

The overview below shows the industry allocation. The ETF is overweight steel but has exposure in aluminium, gold, copper, silver, and companies that engage in rare earths (smaller exposure because the sub-industry is smaller).

The ETF, which was founded in 2006, has an expense ratio of 0.35%. In other words, that’s what it indirectly costs to invest in the ETF. It’s well above the costs of buying an S&P 500 index ETF, which often cost between 0.03-0.10%. However, it is far from expensive. In Europe, a lot of “normal” index funds cost 0.35% and owning a specialised ETF is never “cheap”. If this ETF cost 0.50% or more, I would likely ignore it.

What matters more than anything is that XME follows the price of metals in lockstep. The graph below shows XME (black) and the price of copper (orange). Investors will use XME to bet on higher prices. So, if my bull thesis for metals turns out to be right, XME will continue its uptrend.

The graph below shows the first level I believe XME can hit if my bull case is right. If the ongoing commodity shortage gets additional fuel from secular demand without hurting economic growth too much, I believe that XME can run to $77. If it’s indeed a super-cycle, I think $100 is possible. But for now, I will stick with $77 as my first target.

It also helps that XME is breaking out right now. I think the breakout will be successful – unlike prior attempts.

Takeaway

The world is working its way towards net-zero. If it works needs to be seen. What is sure, however, is that it will come with a lot of additional demand for metals including, but far from limited to, copper, nickel, zinc, and even aluminium and quality steel.

Inventories are low and companies are not boosting production. This will almost make sure the metals bull market continues.

That’s where XME comes in. XME is the largest mining and metals ETF in the world. It has a fair expense ratio and exposure in high-quality companies without being overweight in a few miners.

Given the underperformance and valuation of commodity stocks, I believe that XME has room to run to $77, which gives it a very attractive risk/reward.

(Dis)agree? Let me know in the comments!