United States Oil Fund (NYSEMKT:USO) purchases light, sweet, crude oil futures on behalf of its investors and passively manages itself according to its prospectus. It's tempting to bet that oil prices will rise while its current price is so low. USO can do that for you, but it's important to understand what risks are involved when investing in an ETF that uses futures to derive its value. 

a miniature oil derrick and a barrel of oil atop a pile of paper money

Source: Getty Images.

How USO works

Crude oil has sunk as low as $19 a barrel in recent weeks. Most people who search for ways to invest in oil often find the USO fund as an option. After all, if you were to purchase a barrel of oil at retail price, where would you store it? And if you were to purchase futures in oil, you'd be putting up much more capital than you may be comfortable with.

USO is an Exchange Traded Fund, meaning it operates like a mutual fund (it takes your money and invests it in products that align with its prospectus) but trades on an exchange. Unlike funds, ETFs aren't limited to just customers of the issuer like mutual funds are, and ETFs trade throughout the trading day, unlike mutual funds, which only trade at the close of the trading day. More time trading throughout the day gives investors a better picture of the market value of an asset -- an advantage called price discovery. 

USO aims to reflect the daily changes, in percentage terms, of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma. Plainly stated, the fund purchases futures contracts that derive value from the price of oil. 

The fund gets the money to invest in futures by issuing shares to a list of predetermined customers in blocks, usually multiples of 100,000. When futures contracts come up for expiration, the fund purchases new futures contracts, or "rolls forward" futures contracts to extend their duration out another month or so. 

It is important to remember that USO isn't an actively managed fund. This means that the fund will abide by what its prospectus says, regardless of whether that is the most lucrative thing to do at the moment. There's nobody behind a trading desk thinking, "Hmmm, these futures contracts have gone up in value a whole lot. We'd better take profits by selling them and reinvest in futures when we can get a better price."

Price vs. NAV

The fund stated on Feb. 29, 2020 that the value of the assets it held were $1.46 billion, while the fund had 156 million shares outstanding, giving the fund a net asset value per share of $9.36 as of the date of the statement. These values represent the value of the futures the fund holds. Crude oil futures have dropped more than $10 in value since that date, adding to the decline of not only the ETF's market price, but also the net asset value of its holdings.

Based on those $1.46 billion in net assets, the ETF reported a $205 million loss at the end of February. The loss owed to a decline in the value of the futures it already held, to the tune of $225 million. The fund also charged its investors expenses of nearly $1 million for the month of February. The good news: When the fund bought new oil futures, those holdings increased in value by about $19.6 million -- hence the difference between how much its holdings shrank, and the overall loss the fund reported. That suggests the futures the fund holds do tend to increase in value, even if its latest statement makes them look like they're decaying. 

In determining whether or not you want to invest in such a fund, it is important to remember that you'll see huge fluctuations in value because of the nature of the futures contracts the ETF holds. These big swings could benefit you if and when the value of oil rises from its current lows, making this a perfect product forinvestors who believe that crude oil prices will rise in the future. 

Investors also need to take into account the management and other fees that USO charges, which add up to around 0.79% of the fund's net asset value per year. Last year, these fees totaled $11.4 million. Fortunately for the fund, it realized $473 million in net income last year. To investors, this means that their shares of the ETF rose more in value than they paid out to it in fees. 

But that won't always remain true. Before going long on oil using this ETF, ask yourself whether the management fees are worth it, and how long we may be in this price environment for oil. Those fees will add up if we keep seeing $20 oil into 2021.