QS Energy Inc (QSEP)

[zerosum]

DRAFT COPY - NOT FOR CIRCULATION. FEBRUARY 20, 2018

Outline of investment thesis in QS Energy (QSEP)
“The simpler it is, the better I like it.” — Peter Lynch

Summary

1. QSEP has developed a disruptive new technology that uses dielectrophoresis
(basically, electric fields) to make crude oil much less viscous, by up to 80%. This
can increase the amount of crude oil midstream companies can transport via
pipeline by up to 20%. With a barrel tariff of $5, moving another 20,000 bbl/d starts
to add up to huge money.
2. The technology has been piloted and shown to work by TransCanada and Kinder
Morgan. There is a lot of peer reviewed science and real-world tests establishing its
efficacy.
3. For years the company was led by ineffectual management that failed to
commercialize the opportunity. That changed in April 2017, when Jason Lane, an oil
industry veteran, took over the company as CEO. He brought on a proactive,
connected board of directors and has been working hard to strike permanent leases
for this product.
4. The company is about to sign some Letters of Intent (Q1-Q2 2018), as well as close
on institutional funding, and ship the tech to South America for installation (Q2-3).
Then, after a period of 30-60 days of testing, a systemwide pipeline installation will
begin (Q4 2018-Q1 2019).
5. As soon as the tech is adopted, the company will have an extremely high-margin,
high revenue business (in the example provided below, an investment of a few
hundred k by QSEP would yield annual revenue of $17m) with an impenetrable
moat, and huge opportunities for reinvesting capital and years of high revenue
growth and compounding returns.
6. The stock is thinly traded. Near-term catalysts for share price increase are the
signing of these LOIs, followed by institutional funding, then the pilot tests, followed
by systemwide installs. It appears that 2-3 LOIs will come out within a several
month period.
Introduction
Oil producers in the U.S. and elsewhere have long faced a problem: the cost and difficulty
of moving crude oil from point A to point B. Crude, especially heavy crude, is highly
viscous and requires massive centrifugal pump power to propel it through pipelines across
the country.
This company (QS Energy) offers a novel way of increasing pipeline capacity and reducing
costs of operating existing infrastructure. The technology, known as the AOT (Advanced
Oil Technology), has the potential to save operators money and move more product more
efficiently than competitor technologies and with a lower environmental impact.
QSE has been developing the technology for over eight years, and right now appears to be
on the cusp of seeing its product adopted by industry.
When the company signs leases for its tech, it will be a business that offers strong returns
on invested capital, a wide moat (it owns the patents to the tech), large opportunity for
reinvesting earnings, double-digit compounding growth for many years, an enormous
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addressable market, and a recurring revenue business model based on the 24/7 flow of the
basic commodity powering modern society: oil.
Background
QS Energy’s product is called Advanced Oil Technology (AOT). It was developed by Temple
University professor Dr. Rongjia Tao, a top scientist in the field of electrorheology. The
company has the exclusive perpetual license to the tech.
AOTs have been tested by TransCanada and Kinder Morgan beginning in 2013 and 2014
respectively. The TransCanada test showed a viscosity reduction of crude from between
8%-30%. The Kinder Morgan test verified that the AOT performed in accordance with
laboratory expectations, and that they demonstrated a pressure drop on the line according
to SCADA data. This is described in a 2017 10K .
But for years this company was run by ineffectual management with a compliant board —
a typical story. The CEO was doing nothing and did not know how to penetrate the oil
industry.
Frustrated with this state of affairs, in early 2017 it appears that shareholders got rid of the
former management and installed a new CEO. Jason Lane, a veteran oil man, assumed
control of the company on April 1, 2017. This breathed new life into the company and
reinvigorated its prospects for commercializing its product. Lane kicked dead wood out of
the board of directors, moved the company to Tomball, Texas, and filled the board of
directors with oil & gas veterans (two current executives at Kinder Morgan, one of them a
high-level executive) who have invested their own money in it.
On January 25, 2018, Lane laid out an ambitious plan for commercial adoption, saying that
he would have systemwide installations of the tech on pipelines in early 2019. The
technology will be extremely profitable when revenue starts coming in.
Some important links:
? Company overview - basic self-introduction
? AOT Technology overview - basic introduction to the tech
? QS Energy CEO Jason Lason Issues Shareholder Update - an overview of the
company’s specific, imminent, commercial developments.
? Application of Electrorheology to Improve Crude Oil Flowing Properties Through
Pipeline - technology paper. Read if you want to geek out.
The technology (AOT)
There are two main ways that oil flows in a pipeline.
Turbulent: Or laminar:

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Obviously, oil companies want flow that is more laminar, since it is far more efficient.
They can move more product.
In short, this is what the technology does:
The crude oil in its original state is on the left — many tiny particles all crashing into one
another.
Once it goes through the device in the middle (the AOT) the particles form chains in the
direction of the flow.
Here are some photographs of the device:
Newly appointed Vice President of Engineering Shannon Rasmussen with AOT installation on a high
volume, high API gravity crude oil pipeline.

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The AOT plugged into the TransCanada pipeline in 2014:
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Here’s what it looks like inside:
Competitor technologies
The other available technologies that do something similar with viscosity reduction are
diluents and drag reducing agents (DRAs). Diluents are refined petroleum products, like
naphtha. They are added to crude to water it down and reduce viscosity so it can be
pumped. They take up space in the line and must be refined out at the destination. These

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are significant additional costs.

DRAs are polymer chains that are added through injector stations after pump stations.
They are added in very, very small amounts, but they’re expensive. They mainly suppress
turbulence.

The AOT does both things - it reduces viscosity and suppresses turbulence. It's solid state.
You plug it in and leave it. It connects with the SCADA system at the pump stations.
Recent changes in management
The tech is only half the story. Management and their ability to execute is also a key part of
the puzzle — and the part that had been missing from the QS Energy story until April 2017.
Jason Lane of JBL Energy Partners quit his job and came onto QSE as CEO in April
2017. Lane has been in the oil business for 20 years and appears to have a thick rolodex.
Lane must have confirmed that it worked through contacts at Kinder Morgan. He also
hired Shannon Rasmussen, formerly a TransCanada pipeline engineer, to be VP of
Engineering. Rasmussen left a cushy job and traveled across the country at short notice
and on half way to take on the new role.
Lane also transformed the board. Proxy here with the new board members — all oil &
gas men:
http://ir.qsenergy.com/all-sec-filings/content/0001683168-17-001185/qsenergy_pre14a.htm .
Note in particular the new board addition of Gary Buchler. COO of NatGas at KM. That
makes the second KM man on the QSEP board.
Interesting to ask: Why does the COO of natural gas at Kinder join the board of a penny
stock that is trading at $0.12?
Insider buying
The total insider buying since October 2016, with most taking place since April/May 2017,
is 5.25 million shares: www.otcmarkets.com/stock/QSEP/insider-transactions . Many board
members have invested tens or hundreds of thousands.
Business model and revenues
This is a pre-revenue company, obviously. No sales.
However, looking forward (if they make sales) the margins are very promising.
QSE will not sell the AOTs, but instead lease them to make recurring revenues.
The January 25, 2018 press release notes that Rasmussen lowered the cost of production of
AOTs by 30-40%. So it may only cost $70,000 to manufacture an AOT, which can generate
that much value in a couple of weeks of operations.
When the first lease contract is signed, valuation of the company will qualitatively change.
It is a high margin business with a huge moat (they own the patents, so they have no
competitors), with recurring revenues and rapid growth for the foreseeable future (this
claim is made based on the imputed significance of one sizable contract: such a contract
would mean industry adoption, which would mean that the AOT offers a substantially
better solution to existing technologies, which would mean continued adoption and,
potentially, eventual ubiquity). This business just ticks off box after box in classic value
investing metrics. And it will also a growth company - moreover, one that no one has
DRAFT COPY - NOT FOR CIRCULATION. FEBRUARY 20, 2018
heard of. Moreover, one that, if all the above plays out, will move from over-the-counter to
NASDAQ in a year or two.
The recent company profile gives some revenue numbers.
Page 4 shows that simply by getting rid of or reducing reliance on diluent, it can increase
crude throughput by ~16% (in the example above).
This means an estimated $17m annual revenue for QSE for a 100,000 bbl/d pipeline. QSE
would have had to pay only a few hundred k to manufacture, deliver, and install that
equipment. This is an extremely high margin business.
In sum
It is impossible to know the future. The best we can do in investing is look at the set-up and
form an educated opinion about what is most probable, and weigh the risk. I would
summarize it like this:
We know from the science that the technology works; we know it works in the lab; we know
it works in prototype; we know it works at a commercial scale. It just hasn't actually been
sold. Now there is a new CEO who is a 20-year oil veteran and who has filled the board with
O&G people. He is about to sign letters of intent with major oil companies, and close on a
round of institutional financing. Insiders are buying shares. When they sign leases, revenue
and margins will be extremely high, and the growth rate of revenue will be extremely high.
The company will go from 0 revenue to millions, then tens of millions of recurring revenue
annually.