by Daniel Jennings
Worldwide gold production could be entering a permanent decline - a state of affairs that could greatly boost gold-mining stock values. The reason that gold production could start declining is a theory called peak gold, which is similar to the peak oil theory. The peak oil theory states that at some point, world oil production will start falling because most of the world's oil has been pumped out. The peak gold theory states that we will reach a point at which gold production will start declining because all or most of the world's gold mines have been mined out.
The interesting thing is that we may have already reached peak gold - the height of global gold production. Gold production in a number of countries, including South Africa, has been falling for some time. In South Africa, gold production has fallen from a high of 1,000 tons in 1970 to just 250 tons in 2011. Production in South Africa is continuing to decline; it fell by about 2.9% in May 2012 alone.
Other major gold producing nations, including the United States, Australia, Canada, and Peru, have reported declines in production in recent years. Indeed, only two major gold-mining nations, Russia and China, have reported increases in production in recent years.
The benefit this could have for gold mining companies is obvious: higher gold prices. If less gold is being mined, the price should start going up, especially if demand increases because of inflation in India and doubts about the Euro and the U.S. economy. Falling production and increasing prices will naturally increase profits and share value at gold producers.
The miners that would gain most from peak gold would be those with new mines that should come online in the near future. That includes major producers, such as Rio Tinto (RIO), Freeport-McMoRan (FCX), Barrick Gold (ABX), Newmont Mining (NEM), Kinross Gold (KGC), Goldcorp (GG), and BHP Billiton (BHP).
The losers here will be those companies most exposed to South Africa. That includes AngloGold Ashanti (AU) and Anglo American (AAL.L). These companies could lose share value unless they develop resources outside of South Africa where production is falling. If they cannot develop new production, their future growth could be limited, as could earnings per share and dividends.
In contrast, those companies that can bring new production online will see increased profits and stock value because they can increase gold production at a time when prices and demand are increasing. It should be noted here that those companies will have to prove that they can actually increase gold production and avoid peak gold.
Small Miners Could Profit from Peak Gold
Also benefiting from Peak Gold would be smaller and more speculative gold companies, such as Pershing Gold (PGLC) and Bullfrog Gold (BGFC). Pershing, in particular, could benefit because it has purchased the Relief Canyon Mine in Nevada, which could quickly be put back into production.
Instead of purchasing an existing mine, Bullfrog Gold has been buying claims and options in areas with high historic gold production. It is conducting exploration work at the site of the historic Newsboy Mine northwest of Phoenix. The Newsboy project is located in a region that was historically the largest gold producer in Arizona. Bullfrog has also purchased claims near the Barrick Bullfrog and Montgomery-Shoshone open pit mines in Nevada, two historically large producers for Barrick Gold. If that was not enough, it has an option to buy the Klondike Project, which is close to Barrick's prolific Cortez mine in central Nevada.
An established small gold miner that could benefit from peak gold is Thompson Creek Metals (TC). Thompson is developing a large new copper and gold mine at the Mount Milligan project in British Columbia, which could contain up to six million ounces of gold. That would make it the second largest gold reserve in Canada.
These small-cap stocks could benefit from peak gold because those companies could be bringing new mines online at a time when gold prices are increasing from lower supplies. They would benefit from the fact that South African production is declining and showing no signs of improvement.
The profits and cash flow from these companies could be significantly boosted, because they are able to get a higher price for their gold. Even though their production would be smaller, the value of that production would be higher. Peak gold would give such small producers a much higher cash flow than they normally would have.
Peak Gold Could be a Bust Instead of a Boom
There is a major problem with the peak gold theory that investors need to consider. Increased prices lead to increased production and bigger supplies. When gold prices hit major highs, people bring more mines into production, which increases the overall supply.
A major problem is that when gold prices get really high, it gets profitable to bring marginal gold mines into production. Small scale miners, illegal gold miners, and smaller gold mining companies ramp up production. If the new supply from this increased production exceeds demand, the price will begin to fall.
So Peak Gold could actually be bad for gold producers, because increased prices lead to increased production and more supply. Instead of a permanently high gold price, we would get a saturated market with extremely low prices. That would destroy profit and cash flow at gold miners. It would also push gold mining stocks down to new lows.
In such an environment, the value of gold mining stocks, such as Newmont and Barrick, would fall. Smaller miners, such as Pershing and Bullfrog, would also have a harder time making a profit or even getting enough financing to bring their properties into production.
The Long-Term Benefit from Peak Gold
If it does pan out, peak gold would be really good for gold miners because they would be able to make more money with less production. Companies would get a higher price, so they would able to mine less gold and make more money. That means they could cut back on operations and still make a substantial profit.
That could make companies that concentrate on gold, such as Barrick and Randgold Resources (GOLD), a good long-term buy because they could have lower expenses and higher profits with less production. That would mean higher earnings per share and dividends from increased cash flow.
Peak gold could also increase the value of smaller gold miners, including Midway Gold (MDW) and Pershing, because they would become acquisition profits. Larger gold miners in need of more of the metal could spend a premium to buy smaller companies with proven production.
So what this means is that the possibility of peak gold increases the potential long-term value of gold miners. These companies could be in a position to profit from the increasing scarcity of one of the most valuable and sought after resources. They could even find themselves in a position where they could generate more cash flow from lower levels of production. That would make them the ultimate value investment if it comes true.
This means that every value investor should get familiar with the concept of peak gold. If it pans out, it could greatly increase the returns from some really good investments and turn some small-cap stocks into real money makers.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.