Victoria Bay Asset Management rolled out its third exchange-traded fund (ETF) on the American Stock Exchange (Amex) today, launching the United States 12 Month Oil Fund under the ticker symbol USL. 

The fund is designed to track more closely to the spot price of oil than competing oil futures ETFs. That sounds like a good thing, and to some investors, it might be; but as explained below, it could also cause the fund to underperform its peers.

It's All About Contango

USL will enter an oil ETF market crowded by a number of established funds, including Victoria Bay's own U.S. Oil Fund (USO). Like USO, USL relies on the futures market to gain exposure to oil. 

Oil futures are traded with monthly expirations, meaning you can buy a contract that guarantees oil delivery in January, February, March, etc. USO takes the simple approach of buying the near-month contract and then rolling it over into the next-month as each contract expires. In contrast, USL spreads its investments out across the next 12 months' worth of contracts, buying an equal amount of each contract.

Based on historical evidence, Victoria Bay says this approach will make USL less vulnerable to the forces of contango and backwardation. Contango is the situation when out-month futures contracts are more expensive than near-term contracts, i.e., when February oil costs more than January oil. When the markets are in contango, investors that roll from one contract to the next effectively lose money.

Backwardation is the opposite.

The impact of contango and backwardation on the oil markets is large. During 2006, for instance, investors were regularly losing 2-3% of their money each month—or 24%-36% per year—due to contango. As a result, many oil ETFs stayed flat or trended down even as spot oil prices rose to record highs.

It was during this time that Victoria Bay filed for USL.

Beginning in July 2007, however, the oil markets flipped to backwardation, meaning that investors began earning money with each roll yield—about 4% per year based on yesterday's prices.

Where does that leave USL? Many investors will probably be excited to have the option of investing in the fund and gaining something closer to pure-play exposure to oil prices, without having to worry about contango or backwardation.

More-sophisticated investors may find it worthwhile to hop back and forth from traditional oil ETFs like USO and this new 12-month fund, depending on the status of the oil futures market.

The prospectus is available here.