Understanding why the oil exchange traded fund (ETF) occasionally lags behind jumps in oil prices is a simple matter of knowing how it works.

United States Oil (USO) is the largest ETF that tracks the commodity. It followed the 77% drop of crude prices between July and December. But Kevin Baker for TheStreet explains that although oil prices have risen 45% since the low in 2008, the ETF went down another 4.3%.

What’s happening highlights the challenges that ETFs trading futures encounter. During bullish times, when the price of oil is expected to rise, funds can end up paying contract prices that are higher than spot prices, a situation called “contango.” Each time an oil ETF rolls contracts forward a month during periods of contango its return is eroded.

USO holds long positions on oil futures, rolling them forward each month. Three factors impact the ETF:

1. Changes in the spot price
2. Interest income on uninvested cash
3. The roll yield

USO’s prospectus warns of such a situation: a negative “roll yield” could cause the net asset value of USO to deviate significantly from crude’s spot price.

• United States Oil (USO): down 12.4% year-to-date; up 7.8% for one month

Tags: Commodity ETFs, Energy, ETF 101, Oil, USO