Hedge Funds Are Plowing Cash Into These Oil Companies, But Should You Follow?

While I don't advocate blindly following the "smart money," I find it is always helpful to keep an eye on what they are buying and selling. One of the sectors that has been popular with hedge funds recently is the oil sector, with funds funneling billions into Valero Energy (NYSE: VLO  ) , Talisman Energy (NYSE: TLM  ) , and Cameron International (NYSE: CAM  ) over the past few quarters.

The question is, should you follow suit?

Making up for past mistakes
Struggling Canadian oil and gas company Talisman Energy is in the midst of a turnaround, and so far things appear to be going well.

Talisman has made some mistakes in the past, namely expanding faster than is realistically sustainable and spending more than it could afford on capital projects. Now, though, the company has put the brakes on expansion and is restructuring, cutting spending, and trying to pull itself back together. Additionally, Talisman's management is concentrating its efforts on developing assets with a short-term payoff, staying out of the large-scale expensive exploration projects other majors are involved in.

Talisman's turnaround plan has only been under way for a year or so, but so far the company has sold down $2 billion worth of assets, increased cash flow by 12% from the first to fourth quarter, and dropped capital spending by 20% year on year.

However, the company's outlook is really exciting. Talisman is expecting to bring online several new projects over the next few quarters to make up for the loss of production from divestments. Production within the Americas and Asia-Pacific regions is expected to expand 4% to 7% during 2014, with liquids volume growing 14% to 19%. What's more, management expects the company's cash margin per barrel of oil extracted to expand 6% to 11% throughout 2014. Operating costs are also expected to fall 10% for the year.

Talisman is also going to divest another $2 billion of assets, which should for the most part cover the company's planned $3.2 billion capital spending for the year. Cash flow was approximately $2 billion during 2013, and Talisman's management expects an operating cash flow of $2.3 billion for 2014. If Talisman sticks to its capex budget, the company's free cash flow for 2014 will be in the region of $800 million, the first time Talisman will have been free cash flow positive since 2008.

With this turnaround well under way, Talisman could be a risk worth taking.

Surging demand
According to data from offshore drilling industry leader Seadrill, since 2005, 314 additional oil rigs have entered service, expanding the size of the existing fleet by approximately 50%. However, over the same period, the volume of offshore oil produced has decreased, from around 24 million barrels of oil equivalent per day, to only 22.5 million barrels per day. All in all, this means that offshore oil exploration and production is now costing significantly more but yielding less than it did nearly ten years ago -- great news for oil service companies like Cameron International.

Cameron is one of the oil service sector leaders, and the company just reported blowout full-year 2013 results and an impressive order backlog. Cameron reported record revenues of $2.9 billion for the fourth quarter of 2013, up an impressive 21% from the same period last year while the company's order backlog for equipment stood at $11.5 billion, up 34% from 2012 and 93% from 2011. Further, Cameron has seen a rise in the demand for high-margin, high-tech equipment as oil and gas exploration is driven to ever more extreme environments. The company reported sequential margin expansion across all of its businesses and divisions during the fourth quarter, and indeed throughout 2013. And it is likely that this growth will continue as, although oil companies are cutting exploration spending, there is an ever increasing need for high-tech equipment and maintenance services, both of which Cameron will happily provide.

Once again Cameron's future appears bright; it could be wise to follow hedge funds on this one.

A poor choice
Lastly, I feel that Valero is a poor choice for hedge funds, at least in the long term. You see, on many metrics, Valero is actually underperforming in comparison to smaller peer, HollyFrontier (NYSE: HFC  ) .

For a quick way of seeing how much more efficient HollyFrontier has been at generating returns in comparison to its larger peer, we can use the return on invested capital, or ROIC, metric.

On average over the past five years, HollyFrontier achieved an average return on invested capital, or ROIC, of 14.7; Valero Energy has only been able to achieve what can be described as an abysmal ROIC of 1% during the past five years.

Further, HollyFrontier has been able to draw wider profit margins from every barrel of oil the company has refined -- 22% higher to be exact. On average, during the past five years, HollyFrontier's average net income per barrel has been $4.57, although Valero Energy has only been able to achieve a five-year average of $0.34.

Having said all of that, Valero has outperformed HollyFrontier by around 10% year to date, although I remain upbeat about the company's long-term prospects.

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