Strong euro, strong gold; weak euro, weak gold: As the graph below illustrates, that’s been a very quantifiable relationship over the past several months. More important, the two markets are likely to keep trading in tandem over the next several months as well.

In the May 15 issue of VRI, Metal Stocks to Buy Now, we noted the role of a declining US dollar–particularly versus the euro–as a major spur to the first-half 2008 run-up in commodity prices and resource stocks in general. In gold’s case, the surge carried the price through the $1,000-an-ounce barrier to new heights, setting off a speculative frenzy.

Our points then were two-fold. First, we stated that sentiment had shifted so radically against the US dollar that a near-term rally was inevitable. We made the same point the week before. (See VRI, May 8, 2008, The Destructive Dollar.) Previous issues are accessible in the “Archives” section on the VRI Web site.

Our second point was that the dollar’s ups and downs are critical drivers for gold prices more than any other commodity. Gold is the only major resource that’s not consumed, so supply is never a major consideration. Rather, people want to own more gold when there’s a perception of growing global economic and political turmoil. Demand falters and prices fall when order appears to return. And the US dollar, for all its recent weakness, is a proxy for order.

For six years, the US dollar was in virtual freefall, collapsing from a high of around 80 cents per euro early in the decade to well above $1.50 per euro this spring. The reasons for this massive, long-term decline are myriad. But the biggest is the long-term call on natural resources from developing Asia and the fact that the US no longer produces more than a fraction of its needs.

Every commodity bull market eventually ends when consumers permanently reduce demand with conservation and switch to alternatives, and the producers ultimately over-expand. This, however, only happens over a period of many years.

To be sure, we’ve seen demand in the US drop for many vital resources, from copper to energy, as the economy has slowed. Demand from developing nations, however, remains entrenched by necessity, as these suddenly more affluent nations struggle to upgrade their vital infrastructure. And although we may see Chinese economic growth slow from its current off-the-chart 10 percent rate, that country will still face critical needs to build out its cities to meet the millions of new migrants that come every year. And that’s a huge call on raw materials.

Russia and energy producers in the Middle East face perhaps an even more pressing need to take advantage of today’s high oil revenues to upgrade lagging infrastructure. That’s the only way it can build healthy domestic economies as China has, thereby avoiding the traditional boom-and-bust cycles that have affected commodity producing nations throughout history.

Gold fits in here as the only form of money that’s held its value throughout the ages. That distinction isn’t so important to Americans, who have thankfully never felt the severe economic and political dislocations faced by the rest of the world. However, it’s critical to billions elsewhere as well as to emerging nations building viable financial systems.

The bottom line is the key long-term drivers of gold’s run this decade are still very much in place. And the metal remains a cornerstone investment. And adjusted for inflation, it’s still far below its 1980 high of $800 an ounce, which equates to something on the order of $3,000 an ounce. As we’ve said before, that’s not our forecast. But, in our view, it points to much higher gold prices over the next few years.

The market is spectacularly volatile, as we’ve seen demonstrated over the past year. Even Barrick Gold (NYSE: ABX), one of the largest and most stable stocks in the sector, is down around 20 percent year-to-date. And our trio of positions highlighted below has also come well off their early-2008 highs.

We wouldn’t be surprised to see a further retreat. For one thing, there are still a number of ill-timed speculative positions likely to be washed out. For another, the US dollar’s rally this year looks like it could take the euro’s value to $1.30 or even lower later this year. That, in turn, could take gold down as far as $700 an ounce, and our trio wouldn’t be spared further downside, either.

This isn’t a market for the feint of heart. But we’re willing to ride out a bit more potential downside for the gains ahead. Moreover, our stock positions already seem to be pricing in considerably more downside in the raw commodity, as the markets focus on the potential for slower global growth for the rest of 2008 and into 2009. That’s also the case with our other vital resource stock positions.

The safest position to take in the gold market is bullion, which is represented in the VRI Portfolio by streetTRACKS Gold Trust (NYSE: GLD). The price of this exchange traded fund is basically one-tenth the price of an ounce of gold, and it moves in tandem. streetTRACKS Gold Trust remains a buy at current prices.

Of the two stocks, Goldcorp (NYSE: GG) is our favorite major gold company. It was the acquisition of Glamis Gold in late 2006 that vaulted Goldcorp to the forefront of global gold producers.

The company now has growing gold production, low cash costs, solid earnings generating ability, large reserves, strong balance sheet and one of the most respected management teams in the industry.

In the second quarter of 2008, the company reported higher output with higher costs versus year-earlier totals. Specifically, output reached 551,600 ounces at a total cash cost of USD308 per ounce, compared to 526,000 ounces at a cash cost of USD133 per ounce a year earlier. The realized selling price was USD897 per ounce for the quarter.

We view the production gains as a positive and the cost increases as temporary. Basically, the company faced some operational problems and lost power at one of its mines for more than a month in midsummer.

Overall, Goldcorp has been doing an excellent job of controlling costs, and we expect that this will continue in coming quarters. Costs will rise in line with the industry’s norm, but we believe the company will keep a lid on them.

Goldcorp has also announced a friendly offer of USDD1.5 billion cash and stock for Gold Eagle Mines. Gold Eagle owns the Bruce Channel discovery zone–now a Cochenour-Willans mine property–which is located adjacent to Goldcorp’s Red Lake mine. According to industry sources, the mine has a solid gold deposit that will fit in well with Goldcorp’s resource base.

Management has calculated a purchase price of less than USD650 per ounce and that the mine has close to 7 million ounces of gold to mine. Development time will be between four and five years.

Elsewhere, the company is on time and on budget with its expansion projects and should increase gold output from 2.4 million ounces this year to 4 million in 2012. Its strong balance sheet will allow for easy project financing, which will add straight to the bottom line. Goldcorp remains a buy at current prices.

For investors in search of a higher stakes in a high-quality play, Lihir Gold (NSDQ: LIHR) offers strong leverage to gold prices. That definitely cuts both ways, as we’ve seen over the past few weeks. But we’re also still very much in the game for a home run.

The company controls one of the world’s most significant gold properties, with reserves of 23 million ounces, Lihir Island. The project is expected to contribute 83 percent of the company’s production for 2008, with an operating upgrade expected to lift output from the current rate of 700,000 ounces per year to 1 million from 2011 through 2030.

The company’s biggest challenge remains reducing costs. In its recent production report, costs averaged USD417 an ounce. That’s a respectable number given the recent environment of increases in diesel and general power costs as well as labor costs. But improvement will be key.

Besides its efforts to improve its Lihir Island operations, management has also been expanding operations globally. For example, the company has been granted 11 exploration licenses in the Ivory Coast, covering an area of 7,936 square kilometers. The Lihir group has the option to acquire a 95 percent interest in an additional 11 licenses covering another 7,062 square kilometers.

In addition, Lihir continues its developmental work in its newly acquired Ballarat mine. Hitting targeted cash flow there will be significant enough to ease the expenditures for further expansion. With the inclusion of the recently merged Equigold projects and development of the recently acquired Ballarat goldfields as well as the expansion at Lihir Island, group production is forecast to grow from 701,000 ounces to 1.4 million ounces in the next couple years.

Lihir will report interim earnings next week and is expected to offer solid guidance for the rest of the year. The stock has been hit since we originally recommended it. The main reasons surround management’s ability to curb costs and handle expansion and the dive in gold because of the US dollar’s summer rally.

The silver lining is Lihir is once again a deep value proposition and offers upside from demonstrated cost cutting and successful expansion as well as higher gold prices. Lihir Gold is a buy at current prices.