How good is an LoR based on a correspondence on one's paper?
From your description, it sounds like this individual has effectively functioned as your research mentor for this project.  A letter he writes for you could certainly be quite valuable as part of your application.  Graduate schools are looking, more than anything else, for the potential to do cutting-edge research as a Ph.D. student and after.

So I would recommend definitely using his letter.  However, keep in mind that this letter will not be able to cover much beyond the quality of your research output.  Your contacts with him have been much more limited than would be typical if you were working with an on-site research supervisor.  Most letters of recommendation submitted through online application management systems require the recommender to give quantitative evaluations of students' skills, relative to some other population of undergraduates.  This professor is saying that he is going to have to select the "don't know" option in multiple categories when he submits his recommendation.

That is not a big deal, but it's not nothing either.  Moreover, this professor is not going to have any way to comment on your classroom performance.  So if you do get a letter about him that points to the high quality of your research, you should make sure that you have at least one other strongly complementary letter that addresses the matters which the first letter cannot.