There are a lot of reasons why investors and institutions buy gold. It has no counterparty risk. It’s the premier hedge against inflation. And it’s a safe haven in a sea of financial turmoil.

But there is really only one reason why the price is going up… because the demand for the metal is significantly outpacing the supply. And every indication points to the situation becoming even more acute in the months and years ahead.

The law of supply and demand would suggest that as demand increases and the price rises, supply should rise as well. After all, there is no greater incentive to producers than rising prices. But the supply of gold from mining operations has been falling.

Despite record high prices and an 8-year bull market, the production of gold has been in a steady downtrend since 2001. If the estimates for this year’s production are on target, mining output will have fallen more than 10% since the bull market began. And several mining research firms believe the trend will continue for years to come.

The reason is simple: the days of cherry-sized nuggets glimmering near the surface of California streams are long gone. The world’s richest deposits are becoming depleted. And in spite of $18 billion spent on exploration in the last five years, new discoveries have been smaller and of a lower quality. The world is not running out of gold. But we are running out of gold that is easy to find and cheap to extract.

And the financial crisis is only making the situation worse. This week, Bloomberg reported that, “Borrowing costs for small gold mining companies have almost tripled in the past year as the credit crunch forces banks to demand a premium for political and security risks.” It has been reported that hundreds of mines have been shuttered in the past year, either because of a lack of funding or because they can not produce at a profit following the commodities crash (gold is often a byproduct of mining for other metals). And this says nothing of the exploration projects that have been mothballed.

From making a new discovery, to proving the deposit, to permitting the mine, to actually producing the metal can easily take six to eight years, in some cases even longer. Clearly, there will be a serious constraint on gold production going forward.

And this is not the only force working to reduce supply…

Besides scrap gold and individuals selling their holdings into the market, the other primary source of supply are sales of bullion from the holdings of central banks. For a number of years, central bank sales and leasing have accounted for about 1,500 metric tons per year. This has bridged a serious supply gap and has helped the banking establishment keep a lid on rising gold prices. I won’t go into the criminal elements of the manipulation and suppression scheme, but there is a light at the end of the tunnel.

The central banks are running out of ammo (gold to sell) and it appears that the tide has turned. The central banks of Brazil, Russia, India and those in the Middle East have all stated a policy of increasing their gold reserves. Not surprisingly, China has also. The Director of China’s Central Bank recently stated:

“Reducing reliance on the dollar and maintaining greater diversification in foreign exchange reserves is the only way to reduce the risk. As a result, an increase in our country’s gold reserves is necessary.”

Russia added 90 metric tons to their reserves in December and January. Ecuador added 28 metric tons in January. And it looks as if European banks could be net buyers this year as well.

Considering that the world’s entire gold production in 2008 amounted to only 2,400 metric tons, the potential impact of central banks going from selling 1,500 metric tons to becoming net buyers can’t be overstated.

In another article, I will address the scorching hot demand for gold and how it could easily rise ten-fold in the coming years. Match that against falling production and you have the equation for an explosive price increase.

If you want to capitalize on these trends, start by holding the physical metal. Then consider the top tier mining companies. These companies are making money hand over fist with gold prices near record highs, and they will leverage any further gains in the metal several times over.

But the real fortunes will be made by investors in the smaller companies. I’m not talking about the extremely small outfits that are out there searching for their first discovery. Owning those shares can be like holding a lottery ticket when they find a deposit. But in today’s financial environment, many of those companies will go broke long before they make a discovery. It’s too big a risk.

A much better risk to reward is to identify the second and third tier miners that are already producing gold and silver at a low cost basis. These companies are targets for the cash-rich majors that are depleting their reserves. The other thing I would look for are companies with a strong cash position and large, rich, proven deposits. Recently, a number of these companies were selling for less than the cash on the books. Can you think of a safer investment than buying cash at a discount and getting gold for free?

If you are not sure how to evaluate mining and exploration companies and pick the best ones, consider my colleague Dr. Russell McDougal’s Resource Windfall Speculator. He has been picking winning resource companies for more than 10 years.