Small-capitalization gold producers in the United States look undervalued. The sell-off in gold producers over the past year was swift and brutal, on par with other resource companies. The crucial difference is that base metals prices are down by more than half, but the price of gold is up.

Fund managers who expected safe-haven buying of gold to benefit the most leveraged companies loaded up on small-cap producers. The strategy was wrong.

The gold price fell only mildly through the credit crisis, but small capitalization exploration companies and producers were devastated. Heavily leveraged gold producers that relied on financing for operations were punished as credit contracted.

Even cash-rich companies like Orvana Minerals Corp. (ORV/TSX) were sold willy-nilly. Orvana's share price was cut down from a high of $1.10 to a low of 35¢ over the year ending November, 2008.

Never mind that Orvana had $91-million in cash and equivalents on its balance sheet at its fiscal year end last October, cash that translates to 80¢ per share. There is also the not-so-small matter of the company's gold production, which added roughly $35-million to its cash holdings over the 2008 fiscal year. It seems the market is valuing Orvana's gold production, based on its current share price of 75¢, at less than nothing.

Orvana may be an extreme example, but you get the point. Assuming the price of gold even holds at existing levels, many small-cap producers appear to be cheap. You need to sort out the wheat from the chaff in the current market of tight credit, so only producing companies with cash flow.

"Near producers," in the words of Investment Strategist Peter Imhof at Sprott Asset Management, are also worth a look because credit is beginning to ease.

Imhof points to a recent $350-million bought deal by Osisko Mining Corp. (OSK/ TSX) that will allow the company to make good on planned production for its Malartic gold property in Quebec.

Imhof agrees that small-cap producers are cheap, apparently a widely held view at Sprott.

"What you have seen recently is that the window has opened up for small cap [gold companies] to do financing" and that has led to a rally in these stocks, although they are still cheap.

Imhof said he expects consolidation and acquisitions by large-cap gold producers who are finding cheaper gold on Bay Street than in the ground.

Margins are also improving because oil prices are down. The cost of oil represents up to a third of production costs for open-pit miners. The sharp divergence in oil prices versus gold prices means that mining is more profitable.

Success breeds success in financial markets (until it doesn't). Gold's weight on the S&P/TSX Composite Index has risen to nearly 12%, almost double its weight on the index only 18 months ago because gold stocks have risen and practically everything else has gone down.

Pension funds will be forced to own gold, said Imhof, because it is getting too big for them to ignore. That may not affect the small-cap companies directly, but the benefits are likely to trickle down.

What is worrying is that it is now received wisdom among (so called) smart money that gold is headed higher on a US dollar debasement trade.

As the story goes, the US Federal Reserve Bank is printing money to save its banking system from collapse and its economy from depression and more supply of dollars in the open market will lead to a U. S. dollar rout and inflation.

Retail investors are catching on. Demand for gold bullion through exchange-traded funds is on the rise: Total gold holdings in ETFs rose above the 40 million-ounce level in January for the first time.

Investors need to understand that inflation is not a near-term concern and that fundamentals have been supportive of the U. S. dollar over the past few months.

Dollar debasement is a long-term issue and is supportive of gold over that time frame. Therefore, it makes good sense to own these stocks for many years to realize their value, but given the rising interest, caution is advised in the near term.