Dollar down, commodities up: That’s the simple mantra many investors practice. The equally trumpeted converse is that a real recovery in the US dollar would sound the death knell for vital resources.

To be sure, the US dollar’s direction is important for commodity prices, particularly in the near term. From oil to copper and grains, most vital resources are still priced globally in US dollars. So when the US dollar rises against other currencies, commodity prices tend to fall. The opposite reaction occurs when the dollar rises.

We’ve commented on this relationship before. (See VRI, 20 March 2008, Day of the Dollar). Since then, we’ve seen it play out in the price action for a range of commodities over the past few months, particularly gold. That’s no surprise, considering gold is a currency alternative to paper money.

In our view, the yellow metal is far from done, and we continue to recommend our three core positions: Goldcorp (NYSE: GG), Lihir Gold (NSDQ: LIHR) and streetTracks Gold Shares ETF (NYSE: GLD). We still look for an ultimate gold price a lot closer to the 1980 highs adjusted for inflation and purchasing power than to current levels.

Gold’s recent journey from more than $1,000 an ounce to less than $900, however, is a fairly clear testament to its volatility. And it’s a crystal clear demonstration of how the metal’s moves can twist and turn depending on how the US dollar performs.

But it would be a real mistake to equate price action in other vital resources with gold’s performance. All commodities are subject to the laws of supply and demand. But unlike every other major commodity, gold is never consumed. Virtually every bit ever mined remains in circulation today.

In contrast, every other commodity winds up consumed. New supplies must constantly uncovered and developed to feed that demand. And when demand is rising globally in earnest—as it has been for the past several years—the task of keeping supplies in step with demand gets harder and harder.

The US dollar’s decline against other major currencies has clearly had some upward impact on commodity prices. Some models put the figure as high as 20 percent, with anti-dollar speculation responsible for much of the moves during recent months.

The main driver of prices, however, is the same as it ever was: Accelerating demand, particularly in the developing world, is putting ever-more pressure on global supplies for everything from base metals to grains. That’s the driving force that’s going to push prices of vital resources—and vital resource stocks—sharply higher in coming years. This is precisely the long-term trend we’re betting on in Vital Resource Investor.

With last week’s addition of DuPont (NYSE: DD), we now hold 18 stocks and two exchange traded funds (ETF) drawn from the four core vital resource areas: base/industrial metals, precious metals, agriculture/water and industrial materials.

That’s as many positions as we’ll hold at one time. Optimally, we’ll only sell when we need to take money off the table following a price spike. This is how we’re going to play the long trend in vital resources and get the most out of the volatility. And it’s what we did two weeks ago when we advised taking money off the table with Syngenta (NYSE: SYT) and the ETF DB Agriculture Fund (AMEX: DBA).

Occasionally, however, it’s necessary to sell a position before we’re ready, either because of a shift in the market or unfavorable developments at a company. And, unfortunately, we may be coming to that point with our agricultural plays.

To be sure, the long-term picture for food is exceedingly bullish. Incomes and tastes are rising globally as never before and demand is surging. But any market that’s enjoyed such parabolic gains is vulnerable to unexpected headwinds, and that appears to be the case here.

For one thing, the last of the bears appear to be throwing in the towel on agriculture. That’s a classic sign that few are left to buy and that expectations have risen to the point where they’re very difficult to exceed. That’s the kind of situation that often adds up to steep declines, even in the middle of historic bull markets.

Second, although we’ve realized some hefty profits in agriculture, we’re now extremely overweight. Again, that’s at a time when prices have exploded to the upside. That’s the time to lighten up a bit, particularly in the more exposed positions.

Third, there’s emerging evidence that prices may be ready for a near-term shift. Again, that’s far from the end of the bull market, but we could see our profits evaporate very quickly, or even turn into near-term losses. And although we’re playing the long trends here, that’s no way to handle the action of a volatile market.

Three of the four commodities in the DB Agriculture ETF have entered a downtrend–whether short lived or not, nobody knows yet. The lone exception is corn, which continues to benefit from federal ethanol mandates. In our view, it’s unlikely Washington will really move to unwind these in an election year, particularly considering how recently they were enacted.

But with an estimated 30 percent of the US corn crop now going to ethanol production, any perceived threat to the mandates could send corn prices into reverse. That, in turn, would mean all four DB Agriculture commodities were in downtrends, and the index would definitely take a major hit.

DB Agriculture has been pushed a bit lower since we recommended taking money off the table two weeks ago, and there may be more downside. Given our big position in the sector, we’d like to lighten it up. Sell DB Agriculture Fund.

Companhia Vale do Rio Doce (NYSE: RIO, CVRD) reported first quarter 2008 results, delivering solid production numbers. Revenues were up 4 percent, but net income fell 9 percent. The latter isn’t too worrisome because the weak US dollar negatively affected its costs for materials and energy.

Brazil-based CVRD is the largest producer of iron ore in the world and a leading producer of nickel following the acquisition of Inco. The group also has presence in the aluminum market and is developing copper deposits in Brazil.

The important theme for long-term oriented investors: CVRD continues to deliver strong operating results led by iron ore production. Iron ore was the greatest contributor to revenue (USD 3.116 billion), followed by nickel (USD 1.891 billion), pellets (USD 655 million), copper (USD 506 million) and aluminum (USD362 million). Emerging markets, particularly in Asia, remain the leading revenue contributor. See the chart below.

Source: Companhia Vale do Rio Doce

CVRD has started experiencing the problems that the rest of the industry has been facing for a long time. Namely, delays in completion of projects, logistical issues, strikes and infrastructure inadequacy–all of which lead to budget overruns.

We’ve flagged these issues, which can be seen all around the world. Strengthening the argument that restricted supply also contributes to the bull market in resources. We expect this trend to continue for the next couple years as the world adjusts and copes with the structurally stronger resource demand. See VRI, 7 February 2008, The Great Game.

That said, CVRD’s management team has been fairly successful in minimizing these problems and should be able to perform relatively better when addressing these issues.

We’re still bullish on iron ore because prices should remain stronger for longer. Chinese iron production seems to have picked up, and steel production continues to increase. Spot iron prices are trading at USD190 per ton, and as steel production remains healthy, iron producers should be able to negotiate even higher prices.

CVRD has been able to negotiate prices 70 percent higher this year and should be able to get at least half that next year. The Australian producers haven’t reached a settlement with steel mills and may demand even higher prices. VRI Portfolio holding Rio Tinto (NYSE: RTP), the second biggest iron ore miner in the world after CVRD, will also benefit from the price hikes. Rio Tinto and Companhia Vale do Rio Doce remain buys at current prices.

Source: Bloomberg