Peak Gold and Inflation: A Perfect Storm

The inexorable onset of accelerating inflation, matched with a global decline in gold production, will underpin high-flying gold prices for years to come.

So says John Embry, a world-renowned long-time gold advocate and the chief investment strategist at Toronto-based Sprott Asset Management, which runs the Sprott Gold and Precious Metals Fund.

"As inflation rears its ugly head and future demand for gold promises to overwhelm mine supply, gold's price will launch a parabolic rise from current levels in the near future," he says. "Gold has much, much further to go."

The monetization of various forms of government debt by the printing of large sums of money, disarmingly referred to as 'quantitative easily,' is proving to be the catalyst for accelerated inflation, he says.

Thus, if inflation gathers momentum, long-term interest rates will rise, which in turn should speed up the weakening of the anemic U.S. dollar, Embry reasons. Furthermore, gold is increasingly asserting itself as a powerful inverse proxy to the dollar. This makes the yellow metal the ultimate safe haven alternative to holding U.S. 'fiat' money (a currency that is not backed by anything of tangible value), he adds.

Then there's the fact that most of the world's major deposits are virtually mined-out and new ones are becoming harder to find and more expensive and politically problematic to bring on-stream, Embry says.

So the rally in bullion prices is far from over, contrary to what some market pundits are suggesting. It is merely in a consolidation phase before its next upleg, Embry says. In fact, gold's price still has a long way to go before it even comes close to matching its peak price during its last major bull run, when it hit an intraday high of $875 on January 21, 1980, he adds. To do so it would have to rise to around $2,300 on an inflation-adjusted basis.

Hence, inflation, a debased U.S. dollar and shrinking global output will soon converge to act a springboard for gold's ascendency well above the $1,100 level, Embry says. "At that point, investment demand will explode on a worldwide."

Even the president of the world's largest gold producer is now dropping hints about the implications of a growing below-ground supply squeeze on gold's pricing. Aaron Regent of Barrick Gold (TSX: ABX) (NYSE: ABX) recently told a gold investment conference in London that major gold mining companies are continually struggling to replace mined-out reserves.

"There is a strong case to be made that we are already at peak gold," Regent said. "Production peaked around 2000 and it has been in decline ever since. And we forecast that decline to continue as it is increasingly difficult to find ore."

The facts certainly seem to underscore Regent's argument. Indeed, global gold output has been dwindling by about 5% per annum since it peaked in 2000–2001, even though bullion's spot price has quadrupled since then. In the world's mature gold fields the situation is even worse. For instance, in North America output has dropped over the last decade from 17.06 million ounces in 1998 to 10.59 million ounces in 2008—an extraordinary 60% plunge.

Consider the fact that the world's top trio of producers—Barrick Gold, (Anglogold Ashanti NYSE: AU) (LSE: AGD) and Newmont Mining (NYSE: NEM) (TSX: NMC)—each generate between 5 to 8 million ounces of gold per annum. That means that at least one new multi-million ounce deposit needs to come on-stream every year just to replace this output. That simply is not happening.

Hence, the prospect of a looming below-ground supply/demand imbalance is being enthusiastically regarded by most gold development juniors as a call to action. A good number of them are already relishing the prospect of monetizing their discoveries within the next several years and expect to reap the rewards of a rising tide market for bullion prices for many years to come. Also, a handful of them are already capitalizing on gold's 21st century renaissance as an attractive lifeline investment in the wake of the collapse of the derivatives market.

Arguably the world's first new producer to be able to sell its first gold bar for over $1,000 is Timmins Gold Corp. (TSX.V: TMM). The small Vancouver-based company commissioned its open-pit heap leach (inexpensive to run) San Francisco mine late last year. Just last week it announced the commencement of full-scale production, and is now on-track to generate an output of 80,000–100,000 ounces per year of gold at a cash cost of around $412 per ounce.

Other aspiring gold producers are aiming for even better inaugural profit margins by capitalizing on what they believe will be even higher bullion prices by the time they start doing gold pours against a backdrop of accelerating inflation and even lower global gold production numbers.

In fact, some of them will be salivating over the prospect of profit margins that are almost unheard of in other industries. For instance, one newly-minted publicly traded company, Extorre Gold Mines (TSX: XG) believes that its extremely high grade Cerro Morro deposit in Argentina has the promise to be one of the industry's most lucrative mines.

The company is targeting a gold resource of at least a couple of million ounces—similar to the mines around it. To date, Extorre has outlined a preliminary near-surface resource base of over 600,000 ounces that is amenable to open pit mining (a quarry-like operation). What makes this particularly significant is that the grades are over half an ounce per ton of gold, which translates into the prospect of a very cost-effective mining operation. The company reports 3 drills are turning 24 hours a day and an updated resource estimate is due before the month's end.

Mr. Eric Roth, Extorre's recently appointed CEO, compares Cerro Moro to the rich El Penon Mine in Chile. This world-class gold deposit became a company-maker mine for mid-tier Meridian Gold Inc., which was later taken over by the major mining company, Yamana Gold Inc. (TSX:YRI) (NYSE: AUY).

Such companies have the assurance that major central banks have finally become the catalyst for higher bullion prices. However, until recently, they were the nemesis of the gold sector. In fact, since the 1990s these "arrogant and incompetent Western central banks systematically dumped" up to 1,000 tons of gold per annum in an effort to suppress its spot price, Embry says. But 2010 marks the advent of central banks doing an about-face to become net buyers, he adds.

This is because they have discovered that "their manipulation of the free market has failed," and that gold is the only instrument that will protect them against the debasement of their nations' currencies, as well as their U.S. dollar holdings.

Indeed, central bank officials the world over are waking up to the fact that their predecessors acquired gold reserves in the first place to stave off currency devaluations. And that impetus is once again taking on a heightened importance against a backdrop of "continued economic and currency uncertainty, and inflation concerns." This is the conclusion of a recent report by the London-based World Gold Council.

"In the official sector, we expect to see a continuing trend of central banks diversifying their dollar exposure in favor of the proven store of value represented by gold," the report adds.

Disclaimer: Marc Davis does not directly or indirectly own shares in any of the companies mentioned in this article.