Posted by Jon Herring on 1/23/2009

Over the years, I'm sure you have heard a lot about "peak oil" - a condition whereby the remaining reserves of oil become harder to find, harder to extract and of lower quality. This results in declining production, even in the face of rising demand.

But you probably haven't heard much about "peak gold", where a very similar scenario is playing out.

In a free market, increasing demand and rising prices provide a significant incentive for producers to increase the supply of an item. And that's usually how it works. But that's not what is happening in the gold market.

Demand is certainly increasing. According to the United States Geological Survey, the demand for gold reached 1,133 tonnes in 2008, an 18% increase from the previous year. In dollar terms, this represented a 51% increase to an all-time record $31.8 billion.

2008 was also the year when the price of gold hit an all-time high over $1,000 an ounce. In fact, the price of gold has risen every single year since 2001.

These forces should have resulted in the production of gold rising as well, with producers scrambling to capitalize on the favorable conditions. However, despite record demand and record prices, worldwide gold production has been falling since 2001.

South African gold production peaked in the 1970s

Brazilian production peaked in 1982

Canadian production peaked in 1991

Australian production peaked in 1997

U.S. production peaked in 1998

Combined, these countries currently represent 40% of the world's gold production.

This does not suggest that we are "running out of gold", just as we are not running out of oil. However, it does suggest three things:

1. The world's mines are depleting their reserves, particularly their high grade ore

2. The remaining supplies of gold are becoming harder to find

3. On average, new gold discoveries are becoming smaller and of lower quality

According to the Metals Economic Group, despite an estimated $18 billion in exploration expenditure over the past five years, the quality and number of new gold deposits dropped.

As with oil, most of the biggest gold discoveries have already been made. This is quite clear in the graph below, from mining company BHP Billiton. Pay attention to the red bars. These represent "world class discoveries" - a gold deposit of more than five million ounces.

This chart shows that there were only four world-class discoveries in the 1990s, with none since 1993. This chart stops in 2001. There has been one world-class discovery made since then, a discovery made by Aurelian Resources in 2006. In other words, there has only been one world-class gold discovery made in the last 15 years.

Now, compare that to the production numbers. In recent years, the world's top five gold producing companies have each produced between 3.5 and 7 million ounces per year. In other words, just to replace their reserves, the top five companies would each have to find one world-class discovery… every year. In total, we have found only a few of these since 1990.

Gold producers could make up for these numbers by adding numerous smaller discoveries, but as you see in the chart above, those are declining as well. It is no surprise therefore that gold production is falling, and has been for almost a decade.

And even if a big discovery is made, it can take anywhere from three to as many as 10 years to build and permit a mine before production can begin.

The bottom line is that the demand for gold is highly elastic and can increase dramatically, even from today's record levels. At the same time, however, the supply of new gold is highly inelastic. It is heavily constrained, and even with an all-out effort can only be increased very slowly - if at all.

The fundamentals for gold have never been stronger. Countries around the world are debasing their currencies at a rate that is historically unprecedented. Demand for gold should only continue to increase as more and more people shift from paper currencies and financial assets to hard assets and tangible forms of wealth.

So where are the new supplies of gold going to come from?

Mining is a depleting business. If a company does not replace the reserves it sells each year, that company will someday cease to exist. The major producers are voraciously hungry for new gold reserves. But they can't go out and find them by themselves. The best exploration geologists no longer work for the big companies. They work for and own the smaller, more nimble outfits - the junior resource companies. In fact, of all new discoveries, 75 percent are made by the juniors.

If these larger companies want to survive in the long run, they are highly dependent upon the junior resource companies. The majors need new finds desperately. And the juniors are the only ones that can bring them in. That is why over the coming few years, there will be a continuing wave of acquisitions, as the major precious metals companies acquire the juniors with the largest deposits and the greatest prospects.

And since the bull market in gold began nearly a decade ago, these companies have never been cheaper.

In 2008, the exploration industry was decimated due to the worldwide bear market. The quality of these companies didn't matter. Elite management teams didn't matter. World-class projects and proven reserves didn't matter. Financial strength and cash on hand didn't matter. The entire sector was sold with impunity and every company in it was caught in the vicious downward spiral.

Take a look at the following chart, which represents the value of the S&P/CDNX Composite Index (the best proxy for the junior mining and exploration sector) divided by the price of gold.

Many of the companies represented in this index are gold producers and exploration outfits that are discovering and proving up new gold reserves. They should obviously do well when the price of gold is strong and rising. And yet, as you can see in the chart above, these companies have never been more out of favor than they are now.

They are selling at a greater discount to gold than they were even when the gold bull market began, when gold was roughly $600 cheaper than it is today. In fact, many of these companies are trading well below their cash value.

The bull market in gold is fully intact and only shows signs of heating up in the years ahead. The demand for the metal is at record levels and growing. Production has been falling steadily for nearly a decade. And the major mining companies are starved for new reserves and they do not currently have the resources to discover them on their own.

And yet despite it all, the companies that will benefit the most from this scenario are as beaten down and undervalued than they ever have been. I won't try to predict the time frame, but the stage is clearly set for a massive rally in the exploration and junior mining sector. And when these stocks blast off, they really blast off. From the end of 2002 through May of 2007 the CDNX gained nearly 280%. It rose almost 70% from October of 2005 through May of 2006. Numerous smaller companies within the index rose by many multiples of these amounts.

The dislocation in this sector is unsustainable. And we're not just talking about precious metals. The entire commodities supply pipeline begins with junior exploration and mining companies. These are not intangible financial instruments, but real assets that require years of search and development before they can be brought to market.

With all that said, the junior mining and exploration companies are experiencing challenging times. With their stock prices depressed and credit markets in a freeze, these companies are having a difficult time raising money. Undoubtedly many will fail.

But the strongest will survive and lead their investors to rich rewards. Here is what you should look for:

Companies with highly experienced management with a long-term solid track record

Insiders and key people within the company should hold a meaningful equity stake to ensure their interests are aligned with your own

The companies that are exploring for resources (as opposed to those that are already producing) should be hunting for elephants in elephant country. To compensate for the risk, the potential reward must be a large one.

Companies with large existing discoveries and proven reserves should be favored over those that are exclusively in the "exploration" stage

Projects should be located in mining-friendly countries

Projects must be economical at current gold prices

The company must be in a strong financial position with cash reserves and a slow burn rate. Companies that depend on new financing are in a position of weakness in this market