Peak gold?

You may have heard of peak oil, the theory that at some point—ranging from 2005 to 2025–the world will have found all the easy oil there is to find and that after that new finds won’t be able to keep up with the global rate of consumption.

But peak gold? Never even crossed the mind of most investors who, by and large, are still getting used to the idea that they should have some exposure to gold in their portfolios.

Get familiar with the idea.

It is being used by some gold bugs as a marketing ploy to sell more of the yellow metal and to justify today’s high prices. So be careful. Peak gold isn’t nearly as powerful a force on the price of gold as some of this marketing says it is.

But that doesn’t mean peak gold isn’t real. It is. Since oil is consumed and most gold isn’t (aside from that used in industrial processes), peak gold isn’t as important to gold prices as peak oil is for oil prices. But still it is one more factor supporting current high prices.

Let me give you my take on the power and limits of peak gold.

Peak gold proponents argue this way.

Global gold production has been on a downward trend since 2000, proponents point out. The fundamental causes of this are depletion of South African mines where miners have to dig deeper and deeper and a worldwide decline in the grade of ore being mined. South African production has fallen by about half since its peak in 1970. Ore grades have fallen from 12 grams of gold per metric ton in 1950 to about 3 grams in the United States and Canada.

Even soaring gold prices that have made exploration and the development of new mines a priority haven’t been able to reverse this trend. South African gold production fell another 14% in 2008. Global mine production, which had increased slightly in 2006 thanks to increases in supply from China and Indonesia to 2485 metric tons, fell in 2007 to 2478 metric tons and then to 2415 metric tons in 2008, according to the World Gold Council. In the first three quarters of 2009 gold production is up from the same period in 2008, but no source that I have been able to find thinks that marks a reversal of the long-term trend.

Any drop in supply is bullish for gold. It’s especially important with gold trading at historic highs that a price above $1100 an ounce hasn’t brought new supply out of the woodwork. That’s a normal dynamic that caps price increases in most commodities. Traders become reluctant to bid up prices further because they know that current high prices will bring new supply onto the market. That’s exactly what is happening with oil prices right now where prices above $70 are bringing new production onto the market from OPEC members.

But although the drop in gold supply does support the high price of gold, a drop in supply isn’t quite as critical for gold as it is for other commodities since most gold isn’t consumed. Except for gold that is used in industrial processes—and even some of that is recovered—once mined gold just continues to circulate. It may change form, going from jewelry to bullion and then back again, but it doesn’t go up in smoke like the oil burned in a car engine does.

The amount of gold mined annually is, in fact, tiny when compared to the amount of gold circulating through the world. Estimates put total global gold in forms that can circulate relatively easily at about 110,000 metric tons. Total annual gold production was 2,415 metric tons. A fall of 70 tons, the drop in annual production from 2006 to 2008 just isn’t enough to move the price of gold very much.

But the declining global production of gold does work to enhance gold’s status as a stable source of value. In a world where investors worry about the ability of governments to just run the printing presses and create more of their dollars, yen, pounds, Euros or whatever, the inability of gold miners to produce more gold and thus to flood the market with gold is a huge plus.

Because annual gold production is such a small percentage of the world’s total gold and because global gold production is falling, investors who buy gold don’t have to worry about “gold inflation.” And that’s a powerful draw in a world where just about everything else is subject to rising production and falling value.