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UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

FORM 10-KSB

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 30, 2006

Commission File No.333-72230

TERAX ENERGY, INC.(Name
of small business issuer in its charter)

|Nevada                                                           | 88-0475757         
|---------------------------------------------------------------- | -------------------
|(State or other jurisdiction of                                  | (I.R.S. Employer   
|incorporation or organization)                                   | Identification No.)
|                                                                 |                    
|13355 Noel Road, 1370 One Galleria Tower, Dallas,
      TX 75240 | 78759              
|(Address of principal executive offices)                         | (Zip Code)         

Issuer's telephone number: (972) 503-0900

Securities registered under to Section 12(b) of the Exchange
Act: None

Securities registered under to Section 12 (g) of the Exchange
Act: None

Check whether the issuer (l) has
filed all reports required to be filed by Section 13 or 15(d) of the Exchange
Act during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. [X] Yes   [  
] No

No Check if there is no disclosure of delinquent filers in
response to Item 405 of Regulation S-B is not contained in this form, and no
disclosure will be contained, to the best of registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part
III of this Form 10-KSB or any amendment to this Form 10-KSB. [X]

Revenues for twelve month period ended June 30, 2006 were
$148,636.

The aggregate market value of the voting stock held by
non-affiliates computed by reference to the last reported sale 
  price of such stock as of October 12, 2006 was: $13,208,056.

The number of shares of the issuer's Common Stock outstanding as
of October 12, 2006 was 60,591,529.

Transitional Small Business Disclosure Format (check one): Yes
[   ] No [X]

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TABLE OF CONTENTS

|           |                                                                                                                        | Page
|---------- | ---------------------------------------------------------------------------------------------------------------------- | ----
|           |                                                                                                                        |     
|Part I     |                                                                                                                        | 1   
|           |                                                                                                                        |     
|Item 1.    | Description of Business                                                                                                | 1   
|           |                                                                                                                        |     
|Item 2.    | Description of Property                                                                                                | 15  
|           |                                                                                                                        |     
|Item 3.    | Legal Proceedings                                                                                                      | 17  
|           |                                                                                                                        |     
|Item 4.    | Submission of Matters to a Vote of Securities Holders                                                                  | 17  
|           |                                                                                                                        |     
|Part II    |                                                                                                                        | 17  
|           |                                                                                                                        |     
|Item 5.    | Market for Common Equity and Related Stockholder Matters                                                               | 17  
|           |                                                                                                                        |     
|Item 6.    | Managements Discussion and Analysis or Plan of Operation                                                               | 20  
|           |                                                                                                                        |     
|Item 7.    | Financial Statements                                                                                                   | 21  
|           |                                                                                                                        |     
|Item 8.    | Changes In and Disagreements with Accountants on Accounting
      and Financial Disclosure                             | 22  
|           |                                                                                                                        |     
|Item 8A.   | Controls and Procedures                                                                                                | 22  
|           |                                                                                                                        |     
|Item 8B.   | Other Information                                                                                                      | 22  
|           |                                                                                                                        |     
|Part III   |                                                                                                                        | 23  
|           |                                                                                                                        |     
|Item 9.    | Directors, Executive Officers, Promoters and Control Persons;
      Compliance with Section 16 (a) of the Exchange Act | 23  
|           |                                                                                                                        |     
|Item 10.   | Executive Compensation                                                                                                 | 24  
|           |                                                                                                                        |     
|Item 11.   | Security Ownership of Certain Beneficial Owners and Management
      and Related Stockholder Matters                   | 26  
|           |                                                                                                                        |     
|Item 12.   | Certain Relationships and Related Transactions                                                                         | 27  
|           |                                                                                                                        |     
|Item 13.   | Exhibits                                                                                                               | 28  
|           |                                                                                                                        |     
|Item 14.   | Principal Accountant Fees and Services                                                                                 | 30  
|           |                                                                                                                        |     
|Signatures |                                                                                                                        | 31  

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This form 10-KSB contains forward-looking statements within the
meaning of the federal securities laws. These forward-looking statements are
necessarily based on certain assumptions and are subject to significant risks
and uncertainties. These forward-looking statements are based on management's
expectations as of the date hereof, and we do not undertake any responsibility
to update any of these statements in the future. Actual future performance and
results could differ from that contained in or suggested by these
forward-looking statements as a result of factors set forth in this Form 10-KSB
(including those sections hereof incorporated by reference from other filings
with the Securities and Exchange Commission), in particular as set forth in the
"Plan of Operation" under Item 6. In this filing references to
"Company,we,our", and/or "us, refers to Terax Energy, Inc.



PART I

ITEM 1. DESCRIPTION OF BUSINESS

Introduction

Terax
Energy, Inc. is an independent oil and gas exploration and development company
headquartered in Dallas, Texas. Our principal properties consist of two large
blocks of oil and gas leases, one covering approximately 11,300 gross acres in
the aggregate in close proximity to each other in Erath County, Texas and one
covering a block of approximately 16,200 gross acres in the aggregate in close
proximity located in Comanche County, Texas, both of which permit us to drill
and develop the Barnett Shale formation underlying the lease acreage.

Our
operations are focused on the identification and evaluation of prospective oil
and gas properties and the contribution of capital to projects that we believe
have the potential to produce oil or gas in commercial quantities.

Business Development

We
were incorporated in Nevada as Royal Phoenix in October of 2000. Our initial
plan of business was to sell herbal products via internet sales. However, as a
result of the lack of revenue generation from that business model and the
extremely competitive environment for nutritional supplements, we determined to
re-assess our business plan and alternatively seek out other business
opportunities capable of increasing stockholder value.

Consistent
with this goal, on March 15, 2005, we changed our name from Royal Phoenix to
Terax Energy, Inc.

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Acquisition of Erath Energy Inc.

On
May 31, 2005, we entered into a Share Purchase Agreement with Holywell
Technological Investments Ltd. and First Finance Limited (collectively, the
Sellers) pursuant to which we acquired all of the issued and outstanding
securities of Erath Energy Inc. (EEI) from the Sellers. EEI is a Delaware
corporation, the sole assets of which consist of approximately 30 oil and gas
leasehold interests located in Erath County, Texas comprising approximately
10,600 gross acres and cash of $79,443. Because EEI's assets consisted solely of
leases and cash, and because EEI had not conducted any operations other than
lease acquisitions, we accounted for this transaction as an asset
acquisition.

The
Share Purchase Agreement closed on June 1, 2005. As consideration for the
acquisition, we issued to the Sellers an aggregate of 318,000 pre-split
(1,590,000 post-split) shares of common stock. In addition, we covenanted to
cause our outstanding common stock to be forward split on the basis of five
shares for each one outstanding common share. The forward split was completed on
June 13, 2005. All share figures in the report have been adjusted to reflect
this forward split. Prior to the closing of the Share Purchase Agreement, the
Sellers did not own any shares of our common stock. However, the spouse of one
of the shareholders held 2,250,000 shares or approximately 1.6% of our issued
and outstanding shares prior to the closing. In addition, we were related to EEI
by a common director.

We
accounted for the EEI acquisition based on managements assessment of the fair
value of $1,590,000 of the undeveloped oil and gas leases acquired, taking into
consideration the following: (i) EEIs acquisition cost, since Sellers had
recently acquired the undeveloped oil and gas leases in the period immediately
preceding our acquisition of EEI; and (ii) at the time of the sale there was a
limited trading market and sporadic trading in our common stock. Accordingly,
management concluded that the fair value of the oil and gas leases acquired was
more reliably measurable and representative of the fair value of the shares
issued to the Sellers than the trading price of our common stock at the closing
date of the Share Purchase Agreement. Additionally, the Share Purchase Agreement
provided that, in the event we do not close a financing with minimum gross
proceeds of $5,000,000 at not less than $1.00 per share on or before July 31,
2005, the Sellers would have the right to repurchase EEI. Since we were able to
close on a financing of $5,700,000 on August 8, 2005, as discussed below, this
option was waived by the Sellers.

The
common shares issued as consideration for EEI were offered and sold to the
Sellers in an offshore transaction made in reliance upon the exemption from
registration provided by Regulation S as the Sellers were not US Persons (as
that term is defined in Regulation S).

Management Group Stock Pool

On
June 7, 2005 we entered into a Management Group Stock Pool Agreement with our
management, J. William Rhea, IV and Bill Chester, for the purpose of ensuring
that our management has the proper incentives to enhance our performance.
Messrs. Rhea and Chester placed the 5,500,000 shares of our common stock held by
them in escrow to be returned to treasury or released from escrow pursuant to
the terms of the Management Group Stock Pool Agreement Pursuant to the terms of
the Management Group Stock Pool Agreement, the Companys officers and directors
agreed that the shares will be returned to treasury in the event of resignation
or, in the event of termination for cause and released from escrow upon the
achievement of certain performance milestones.. While in escrow, the shares
remained in the names of Messrs. Rhea and Chester and were treated as part of
our issued and outstanding shares but were not included in the computation of
earnings per share. On October 26, 2005, Mr. Chester resigned his positions of
Director and Vice President of the Company. As provided for in the Management
Group Stock Agreement, Mr. Chesters resignation resulted in forfeiture to earn
500,000 shares under the plan.

On
November 10, 2005, Mr. Rhea was terminated for cause and was removed as officer
and director of the Company. As provided for in the Management Group Stock
Agreement, Mr. Rheas termination resulted in forfeiture to earn 5,000,000
shares under the plan.

There
are currently no shares held in escrow which are subject to the Management Group
Stock Plan.

Return to Treasury

On
June 13, 2005 Bill Chester returned to our treasury for cancellation without
consideration a total of 99,650,000 shares of common stock. These shares were
part of 105,225,000 shares issued from October 2000 through August 2003 which
were acquired by Mr. Chester in March 2005 from one of our former officers. Of
the 105,225,000 shares acquired by Mr. Chester in March 2005, Mr. Chester
subsequently sold 5,000,000 to another officer of Terax. In June 2005, to
facilitate our private placement offering, discussed below, Mr. Chester agreed
to cancel 99,650,000 shares held by him and retained 500,000 shares which he
subsequently deposited into escrow pursuant to the Management Stock Pool
Agreement dated June 7, 2005. There were no additional terms with respect to
such Mr. Chesters agreement to cancel the 99,650,000 shares.

Financing

From
August 8, 2005 through September 14, 2005, the Company issued 739,000 Units at a
price of $10.00 per Unit for gross proceeds to the Company of $7,390,000. Each
Unit consisted of eight shares of our common stock (each a Unit Share) and
four non-transferable share purchase warrants (each a Unit Warrant). Each Unit
Warrant is exercisable into one share of our common stock (each a Warrant
Share) at a

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price of $1.75 until February 8, 2007, subject to acceleration
as follows: in the event that the average closing price of our shares of common
stock on the OTCBB or other, more senior exchange for the twenty previous
trading days exceeds $2.25, and provided that an effective registration
statement registering the resale of the Warrant Shares is then in effect, we
may, by written notice, accelerate the expiry date of the Unit Warrants to
thirty days after the date of such notice.

The
securities were offered and sold to the shareholders in an offshore transaction
made in reliance upon the exemption from registration provided by Regulation S
as the purchasers represented that they were not US Persons (as that term is
defined in Regulation S).

We
agreed to file a registration statement with the Securities and Exchange
Commission to register the possible resale of the Unit Shares and the Warrant
Shares, which registration statement was declared effective by the SEC on August
15, 2006.

On
December 2, 2005 for $2,500,000, December 19, 2005 for $1,600,000, and January
26, 2006 for $900,000, the Company issued promissory notes (the Notes) to an
investor with aggregate principal amounts of $5,000,000. The Notes bear interest
at the rate of 12.5% per annum, and are due on demand after May 31, 2006. The
Notes may be repaid at any time by the Company. The Notes are secured by a
security interest in all of the Companys oil and gas leases and pipeline right
of ways and easements in Erath County, Texas, as well as well and pipeline
equipment and personal property, contracts and agreements, and production from
the Companys wells located on the leases.

On
February 1, 2006, the Company issued an additional promissory note (the
Additional Note) with a principal amount of $2,500,000 to an investor. The
Additional Note has the same terms as the Notes as follows: it bears interest at
the rate of 12.5% per annum, it is due on demand after May 31, 2006, and it may
be repaid at any time by the Company. On April 11, 2006, the Company issued a
total of 215,517 shares of the Companys common stock as further consideration
for the Notes and the Additional Note. The Company has agreed to issue an
additional 84,483 shares of common stock as further compensation for the Notes
and the Additional Note. In the Event of Default, the holder of the Notes and
the Additional Note has the right but not the obligation to seek remedies for
repayment of the notes including but not limited to foreclosure and sale of the
secured assets.

On
February 17, 2006, the Company repaid $7,500,000 principal plus accrued interest
of $117,106. In addition, $375,000 was charged to interest expense for common
stock issued in connection with the notes. As result of the repayment, the
holder of the Notes and the Additional Note released all his security interest
in the properties

On
February 7, 2006, the Company entered into securities purchase agreements to
sell to four institutional investors an aggregate of 12,805,600 shares of the
Companys common stock and warrants to purchase an additional 12,805,600 shares
of common stock, for an aggregate purchase price of $16,007,000. The unit
purchase price of the common stock and corresponding warrant was $1.25. The
warrants are exercisable at an exercise price of $1.50 per share and expire on
February 6, 2011. The Company has the right to require exercise of all of the
warrants in the event that (i) a registration statement registering the resale
of the warrants is then in effect and (ii) the volume weighted average trading
price per share of the Companys common stock for each of the previous thirty
trading days is in excess of $2.50.

The
aggregate commissions paid in connection with the February 7, 2006 private
placement were approximately $862,120. In addition, warrants to purchase 574,120
shares of common stock, identical to those sold to the investors, except with an
exercise price of $1.25 per share, were issued to the placement agent. The
pricing of the securities was agreed to with the lead institutional buyer in
early January 2006 when the Companys stock was trading in the $1.75 range and
represents an approximate 30% discount to the market price at that time. The
fair value of the warrants, as determined using the Black Scholes pricing model,
issued to the placement agent was $1,198,353 and was recorded as an equity
issuance cost and is reflected in the balance sheet as a reduction to paid-in
capital.

On
May 12, 2006, the Company issued a promissory note in the principal amount of
$2,500,000 to an investor. The Note bears interest at the rate of 12.5% per
annum, payable on repayment of the Note. The Note is due on demand after
December 31, 2006. In addition, interest in the amount of $125,000.00 is due and
payable in 71,429 shares of the Companys common stock at closing. The Note is
secured by a security interest in all of the Companys oil and gas leases and
pipeline right of ways and easements in Erath County, Texas, as well as well and
pipeline equipment and personal property, contracts and agreements, and
production from the Companys wells located on the leases. In the event of
default, the holder of the Note has the right, but not the obligation, to seek
remedies for repayment of the notes including but not limited to foreclosure and
sale of the secured assets.

Business Strategy

Our
business strategy is to provide long-term growth in shareholder value by
drilling, developing and exploiting our existing oil and gas properties, as well
as the properties we may acquire in the future. We plan to implement an active
exploration program to maximize the value of our properties, and to use advanced
technologies such as high-resolution aeromagnetics, 3-D seismic and other
technical applications, as appropriate, to manage our exploration and
development risks. We may also work with industry partners to lower our
financial exposure and shorten the time needed to fully develop our properties.
As our business continues to grow, we plan to retain additional executive
management personnel with substantial experience in the oil and gas exploration
and development business.

To
date, we have conducted our lease acquisition activities exclusively in the Fort
Worth Basin of Texas, an area where the Barnett Shale formation is known to be
of sufficient thickness to make exploration for gas reserves feasible.

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Gas Purchase Agreement

On
April 3, 2006, we entered into a Gas Purchase Agreement with Louis Dreyfus Gas
Development L.P. (LDGD) for the sale of gas to LDGD from certain oil and gas
leases in Erath County, Texas which we operate. The Agreement provides for a
term of five years, with automatic renewals of successive additional terms of
one year unless earlier cancelled by either party by written notice 90 days
prior to the end of the term. Each month, for gas received in the preceding
month, upon receipt of the plant allocation, LDGD shall perform applicable
gathering system allocations, after which LDGD shall provide to us a statement
and supporting documentation acceptable in industry practice to support the
amount charged and the various costs incurred. Pursuant to the terms of the
Agreement, payment is due to us upon the earlier of 10 days after LDGDs receipt
of plant allocation or the fifth day of the second month following sales.

Drilling, Exploration and Production Activities

We
have acquired oil and gas leasehold interests in approximately 27,500 aggregate
gross acres located in Erath, Comanche and Hamilton Counties, Texas. See
Description of Properties for a discussion of our significant oil and gas
leasehold interests.

Our
exploration efforts are focused on discovering new reserves by drilling and
completing wells under our existing leases, as well as leases we may acquire in
the future. The investment associated with drilling a well and future
development of our leasehold acreage depends principally upon whether any
problems are encountered in drilling the wells, the depth (including the length
of the horizontal leg) of the wells, whether the wells can be timely connected
to existing infrastructure or will require additional investment in
infrastructure, and, if applicable, the amount of water encountered in the
wells.

Title to Properties

We
believe that the title to our leasehold properties is good and defensible in
accordance with standards generally acceptable in the oil and gas industry,
subject to exceptions that are not so material as to detract substantially from
the use of the properties. Our leasehold properties are subject to royalty,
overriding royalty and other outstanding interests customary in the industry.
The properties may be subject to burdens such as liens incident to operating
agreements and taxes, development obligations under oil and gas leases, and
other encumbrances, easements and restrictions. We do not believe any of these
burdens will materially interfere with our use of these properties.

As
is customary in the oil and gas industry, only a preliminary title examination
is conducted at the time properties believed to be suitable for drilling
operations are acquired by us. We rely upon oil and gas landmen to conduct the
title examination. We intend to perform necessary curative work with respect to
any significant defects in title prior to proceeding with drilling operations.

Competition

The
oil and natural gas business is highly competitive. We compete with private and
public companies in all facets of the oil and gas business, including suppliers
of energy and fuel to industrial, commercial and individual customers. Numerous
independent oil and gas companies, oil and gas syndicates and major oil and gas
companies actively seek out and bid for oil and gas prospects and properties as
well as for the services of third-party providers, such as drilling companies,
upon which we rely. Many of these companies not only explore for, produce and
market oil and gas, but also carry out refining operations and market the
resultant products on a worldwide basis. A substantial number of our competitors
have longer operating histories and substantially greater financial and
personnel resources than we do.

Competitive
conditions may be substantially affected by various forms of energy legislation
and regulation considered from time to time by the government of the United
States and the states in which we have operations, as well as factors that we
cannot control, including international political conditions, overall levels of
supply and demand for oil and gas, and the markets for synthetic fuels and
alternative energy sources. Intense competition occurs with respect to
marketing, particularly of natural gas.

Regulation

General
.. The availability of a ready market for oil and gas production depends upon
numerous factors beyond our control. These factors include local, state, federal
and international regulation of oil and gas production and transportation, as
well as regulations governing environmental quality and pollution control, state
limits on allowable rates of production by a well or proration unit, the amount
of oil and gas available for sale, the availability of adequate pipeline and
other transportation and processing facilities, and the marketing of competitive
fuels. For example, a productive gas well may be "shut-in" because of an
over-supply of gas or lack of an available pipeline in the areas in which we may
conduct operations. State and federal regulations are generally intended to
prevent waste of oil and gas, protect rights to produce oil and gas between
owners in a common reservoir, and control contamination of the environment.
Pipelines and gas plants are also subject to the jurisdiction of various
federal, state and local agencies that may affect the rates at which they are
able to process or transport gas from our properties.

Applicable
legislation is under constant review for amendment or expansion. These efforts
frequently result in an increase in the regulatory burden on companies in our
industry and a consequent increase in the cost of doing business and decrease in
profitability. Numerous federal and state departments and agencies issue rules
and regulations imposing additional burdens on the oil and gas industry that are
often

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costly to comply with and carry substantial penalties for
non-compliance. Our production operations may be affected by changing tax and
other laws relating to the petroleum industry, constantly changing
administrative regulations and possible interruptions or termination by
government authorities.

Sales
of Oil and Natural Gas . Sales of any oil that we produce will be affected
by the availability, terms and costs of transportation. The rates, terms and
conditions applicable to the interstate transportation of oil by pipelines are
regulated by the Federal Energy Regulatory Commission ("FERC") under the
Interstate Commerce Act. FERC has implemented a simplified and generally
applicable ratemaking methodology for interstate oil pipelines to fulfill the
requirements of Title VIII of the Energy Policy Act of 1992 comprised of an
indexing system to establish ceilings on interstate oil pipeline rates. FERC has
announced several important transportation-related policy statements and rule
changes, including a statement of policy and final rule issued February 25,
2000, concerning alternatives to its traditional cost-of-serve rate-making
methodology to establish the rates interstate pipelines may charge for their
services. The final rule revises FERC's pricing policy and current regulatory
framework to improve the efficiency of the market and further enhance
competition in natural gas markets.

Sales
of any natural gas that we produce will be affected by the availability, terms
and costs of transportation. The rates, terms and conditions applicable to the
interstate transportation of gas by pipelines are regulated by FERC under the
Natural Gas Acts, as well as under Section 311 of the Natural Gas Policy Act.
Since 1985, the FERC has implemented regulations intended to increase
competition within the gas industry by making gas transportation more accessible
to gas buyers and sellers on an open-access, non-discriminatory basis.

Pipelines
.. Pipelines that we use to gather and transport our oil and gas will be subject
to regulation by the Department of Transportation ("DOT") under the Hazardous
Liquids Pipeline Safety Act of 1979, as amended ("HLPSA"), relating to the
design, installation, testing, construction, operation, replacement and
management of pipeline facilities. The HLPSA requires pipeline operators to
comply with regulations issued pursuant to HLPSA designed to permit access to
and allowing copying of records and to make certain reports and provide
information as required by the Secretary of Transportation.

State
Restrictions . State regulatory authorities have established rules and
regulations requiring permits for drilling operations, drilling bonds and
reports concerning operations. Many states have statutes and regulations
governing various environmental and conservation matters, including the
unitization or pooling of oil and gas properties and establishment of maximum
rates of production from oil and gas wells, and restricting production to the
market demand for oil and gas. Such statutes and regulations may limit the rate
at which oil and gas could otherwise be produced from our properties.

Most
states impose a production or severance tax with respect to the production and
sale of crude oil, natural gas and natural gas liquids within their respective
jurisdictions. State production taxes are generally applied as a percentage of
production or sales. In addition, in the event we conduct operations on federal
or state oil and gas leases, such operations must comply with numerous
regulatory restrictions, including various nondiscrimination statutes, royalty
and related valuation requirements, and certain of such operations must be
conducted pursuant to certain on-site security regulations and other appropriate
permits issued by the Bureau of Land Management or the Minerals Management
Service or other appropriate federal or state agencies.

Other
.. Oil and gas rights may be held by individuals and corporations, and, in
certain circumstances, by governments having jurisdiction over the area in which
such rights are located. As a general rule, parties holding such rights grant
licenses or leases to third parties, such as us, to facilitate the exploration
and development of these rights. The terms of the licenses and leases are
generally established to require timely development. Notwithstanding the
ownership of oil and gas rights, the government of the jurisdiction in which the
rights are located generally retains authority over the manner of development of
those rights.

Environmental

General
.. Our activities are subject to local, state and federal laws and regulations
governing environmental quality and pollution control in the United States. The
exploration, drilling and production from wells, natural gas facilities,
including the operation and construction of pipelines, plants and other
facilities for transporting, processing, treating or storing natural gas and
other products, are subject to stringent environmental regulation by state and
federal authorities, including the Environmental Protection Agency ("EPA"). Such
regulation can increase our cost of planning, designing, installing and
operating such facilities.

Significant
fines and penalties may be imposed for the failure to comply with environmental
laws and regulations. Some environmental laws provide for joint and several
strict liability for remediation of releases of hazardous substances, rendering
a person liable for environmental damage without regard to negligence or fault
on the part of such person. In addition, we may be subject to claims alleging
personal injury or property damage as a result of alleged exposure to hazardous
substances, such as oil and gas related products.

Waste
Disposal . We may generate wastes, including hazardous wastes, that are
subject to the federal Resource Conservation and Recovery Act ("RCRA") and
comparable state statutes. The EPA has limited the disposal options for certain
wastes that are designated as hazardous under RCRA ("Hazardous Wastes").
Furthermore, it is possible that certain wastes generated by our oil and gas
operations that are currently exempt from treatment as Hazardous Wastes may in
the future be designated as Hazardous Wastes, and therefore be subject to more
rigorous and costly operating and disposal requirements.

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CERCLA
.. The federal Comprehensive Environmental Response, Compensation and Liability
Act ("CERCLA"), also known as the "Superfund" law, generally imposes joint and
several liability for costs of investigation and remediation and for natural
resource damages, without regard to fault or the legality of the original
conduct, on certain classes of persons with respect to the release into the
environment of substances designated under CERCLA as hazardous substances
("Hazardous Substances"). These classes of persons or so-called potentially
responsible parties include the current and certain past owners and operators of
a facility where there is or has been a release or threat of release of a
Hazardous Substance and persons who disposed of or arranged for the disposal of
the Hazardous Substances found at such a facility. CERCLA also authorizes the
EPA and, in some cases, third parties to take action in response to threats to
the public health or the environment and to seek to recover from the potentially
responsible parties the costs of such action. Although CERCLA generally exempts
petroleum from the definition of Hazardous Substances, we may have generated and
may generate wastes that fall within CERCLA's definition of Hazardous
Substances.

Air
Emissions . Our operations may be subject to local, state and federal
regulations for the control of emissions of air pollution. Major sources of air
pollutants are subject to more stringent, federally imposed permitting
requirements, including additional permits. Producing wells may generate
volatile organic compounds and nitrogen oxides. If ozone problems are not
resolved by the deadlines imposed by the federal Clean Air Act, or on schedule
to meet the standards, even more restrictive requirements may be imposed,
including financial penalties based upon the quantity of ozone producing
emissions. If we fail to comply strictly with applicable air pollution
regulations or permits, we may be subject to monetary fines and be required to
correct any identified deficiencies. Alternatively, regulatory agencies could
require us to forego construction, modification or operation of certain air
emission sources.

We
believe that we are in substantial compliance with current applicable
environmental laws and regulations and that, absent the occurrence of an
extraordinary event, compliance with existing local, state, federal and
international laws, rules and regulations governing the release of materials in
the environment or otherwise relating to the protection of the environment will
not have a material effect upon our business, financial condition or results of
operations.

Employees and Consultants

We
currently have 3 employees, including our chief executive officer and chief
financial officer, Lawrence Finn, and Sam M. Governale, our vice-president of
operations. We also utilize the services of several consultants who provide,
among other things, technical support and accounting services to us. Obtaining
additional personnel will depend on the success of the Companys exploration
activities.

Subsidiaries

We
have one wholly-owned subsidiary, Erath Energy Inc., a Delaware corporation,
through which we hold our oil and gas leasehold interests.

Desert Health Products

We
have not totally abandoned our prior business plan. We are party to a "License,
Manufacture and Distribution Agreement, with Desert Health Products dated
October 18, 2000, as subsequently amended. Under this Agreement, Desert Health
Products has agreed to manufacture, package, ship, and handle credit card
processing of Royal Phoenix products. This relationship is intended to allow us
to concentrate on the marketing of herbal products. In addition, we may pursue
and market other vitamin products which will be private labeled specifically for
us by companies other than Desert Health Products.

Our
management is presently reviewing the viability of this business plan in order
to determine what, if any, steps should be taken to further same. Options open
to our management include seeking a joint venture partner willing to assume
operational control of the herbal products business while leaving us with a
residual interest, selling our interest in the herbal products business, or
abandoning the business.

RISK FACTORS

The following risk factors, among others, may affect our
financial condition and results of operations.

Risks Relating to Our Business :

We Have a History of Losses and Limited Revenue to Date,
Which May Continue, Which May Negatively Impact Our Ability to Achieve Our
Business Objectives and Had a Going-Concern Paragraph in our Most Recent Audit
Report.

We
  have experienced net losses in each fiscal quarter since our inception, and
  we expect to continue to incur substantial losses for the foreseeable future.
  As of June 30, 2006 we had an accumulated deficit of $23,107,656. In addition,
  we had a net loss of $23,018,597 for the fiscal year ended June 30, 2006, which
  included a loss on derivative liability of $8,161,075. We have had limited revenues
  to date. There is also a going-concern paragraph in the Companys audit
  report for the fiscal year ended June 30, 2006.

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We
may not be able to generate significant revenues in the future and expect our
operating expenses to increase substantially over the next 12 months as we
continue to pursue our oil and gas exploration activities. As a result, we
expect to continue to experience negative cash flow for the foreseeable future
and cannot predict when, if ever, we might become profitable. We will need to
raise additional funds, and such funds may not be available on commercially
acceptable terms, if at all. If we cannot raise funds on acceptable terms, we
may not be able to execute on our business plan, take advantage of future
opportunities, or respond to competitive pressures or unanticipated
requirements. This may seriously harm our business, financial condition and
results of operations.

We are an Early Stage Company with a Limited Operating History,
  Which May Hinder our Ability to Successfully Meet Our Objectives

We
are an early stage company with only a limited operating history upon which to
base an evaluation of our current business and future prospects. We have only
been actively engaged in the oil and gas exploration and development business
since May 2005 and do not have an established history of locating and developing
properties that have oil and gas reserves. As a result, the revenue and income
potential of our business is unproven. In addition, because of our limited
operating history, we have limited insight into trends that may emerge and
affect our business. We may make errors in predicting and reacting to relevant
business trends and will be subject to the risks, uncertainties and difficulties
frequently encountered by early-stage companies in evolving markets such as
ours. We may not be able to successfully address any or all of these risks and
uncertainties. Failure to adequately do so could cause our business, results of
operations and financial condition to suffer.

Our Proposed Operations Will Require Significant Capital
Expenditures for Which We May Not Have Sufficient Funding and If We Do Obtain
Additional Financing Our Then Existing Shareholders May Suffer Substantial
Dilution.

We
intend to make capital expenditures far in excess of our existing capital
resources to explore our existing oil and gas properties and acquire additional
oil and gas properties. We intend to rely on external sources of financing to
meet our capital requirements to continue acquiring, exploring and developing
oil and gas properties and to otherwise implement our business plan. We plan to
obtain such funding through the debt markets, equity markets, or asset sales but
we cannot assure you that we will be able to obtain additional funding when it
is required or that it will be available to us on commercially acceptable terms,
if at all.

Subject
to capital availability we intends to continue acquiring oil and gas leases in
our development area in the ordinary course of our business. If we are
successful in these acquisitions, our capital needs may increase substantially.
If we fail to obtain the funding that we need when it is required, we may have
to forego or delay potentially valuable opportunities to acquire new oil and gas
properties or default on existing funding commitments to third parties and
forfeit or dilute our rights in existing oil and gas properties. In addition,
any additional equity financing may involve substantial dilution to our then
existing shareholders.

The Successful Implementation of Our Business Plan Is
Subject To Risks Inherent In The Oil And Gas Business, Which if Not Adequately
Managed Could Result in Additional Losses

Our
oil and gas operations are subject to the economic risks typically associated
with exploration and development activities, including the necessity of making
significant expenditures to locate and acquire properties and to drill
exploratory wells. In addition, the availability of drilling rigs and the cost
and timing of drilling, completing and, if warranted, operating wells is often
uncertain. In conducting exploration and development activities, the presence of
unanticipated pressure or irregularities in formations, miscalculations or
accidents may cause our exploration, development and, if warranted, production
activities to be unsuccessful. This could result in a total loss of our
investment in a particular well. If exploration efforts are unsuccessful in
establishing proved reserves and exploration activities cease, the amounts
accumulated as unproved costs will be charged against earnings as impairments.

In
addition, in the event that we commence production, market conditions or the
unavailability of satisfactory oil and gas transportation arrangements may
hinder our access to oil and gas markets and delay our production. The
availability of a ready market for our prospective oil and gas production
depends on a number of factors, including the demand for and supply of oil and
gas and the proximity of reserves to pipelines and other facilities. Our ability
to market such production depends in substantial part on the availability and
capacity of gathering systems, pipelines and processing facilities, in most
cases owned and operated by third parties. Our failure to obtain such services
on acceptable terms could materially harm our business. We may be required to
shut in wells for lack of a market or because of inadequacy or unavailability of
pipelines or gathering system capacity. If that occurs, we would be unable to
realize revenue from those wells until arrangements are made to deliver such
production to market.

Our Future Performance Is Dependent Upon Our Ability To
Identify, Acquire And Develop Oil And Gas Properties, the Failure of Which Could
Result in Under Use of Capital and Losses

Our
future performance depends upon our ability to identify, acquire and develop oil
and gas reserves that are economically recoverable. Our success will depend upon
our ability to acquire working and revenue interests in properties upon which
oil and gas reserves are ultimately discovered in commercial quantities, and our
ability to develop prospects that contain proven oil and gas reserves to the
point of production. Without successful acquisition and exploration activities,
we will not be able to develop oil and gas reserves or generate revenues.

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We cannot provide you with any assurance that we will be able
to identify and acquire oil and gas reserves on acceptable terms, or that oil
and gas deposits will be discovered in sufficient quantities to enable us to
recover our exploration and development costs or sustain our business.

The
successful acquisition and development of oil and gas properties requires an
assessment of recoverable reserves, future oil and gas prices and operating
costs, potential environmental and other liabilities, and other factors. Such
assessments are necessarily inexact and their accuracy inherently uncertain. In
addition, no assurance can be given that our exploitation and development
activities will result in the discovery of any reserves. Our operations may be
curtailed, delayed or canceled as a result of lack of adequate capital and other
factors, such as lack of availability of rigs and other equipment, title
problems, weather, compliance with governmental regulations or price controls,
mechanical difficulties, or unusual or unexpected formations, pressures and or
work interruptions. In addition, the costs of exploitation and development may
materially exceed our initial estimates.

We Have A Very Small Management Team And The Loss Of Any
Member Of This Team May Prevent Us From Implementing Our Business Plan In A
Timely Manner.

We
have two executive officers and a limited number of additional consultants. Our
success depends largely upon the continued services of Lawrence Finn, our Chief
Executive Officer and Chief Financial Officer. We do not maintain key person
life insurance policies on Mr. Finn. The loss of Mr. Finn could seriously harm
our business, financial condition and results of operations. In such an event,
we may not be able to recruit personnel to replace Mr. Finn in a timely manner,
or at all, on acceptable terms.

Future Growth Could Strain Our Personnel And Infrastructure
Resources, and If We Are Unable To Implement Appropriate Controls And Procedures
To Manage Our Growth, We May Not Be Able To Successfully Implement Our Business
Plan.

We
expect to experience rapid growth in our operations, which will place a
significant strain on our management, administrative, operational and financial
infrastructure. Our future success will depend in part upon the ability of our
executive officers to manage growth effectively. This may require us to hire and
train additional personnel to manage our expanding operations. In addition, we
must continue to improve our operational, financial and management controls and
our reporting systems and procedures. If we fail to successfully manage our
growth, we may be unable to execute upon our business plan.

The Geographic Concentration Of All Of Our Properties In The
Fort Worth Basin In Texas, Subjects Us To An Increased Risk Of Loss Of Revenue
Or Curtailment Of Production From Factors Affecting That Area.

The
geographic concentration of all of our leasehold interests in Erath, Comanche
and Hamilton Counties, Texas, means that our properties could be affected by the
same event should the region experience:

- severe weather;
- delays or decreases in production, the availability of equipment,
  facilities or services;
- delays or decreases in the availability of capacity to transport, gather or
  process production; or
- changes in the regulatory environment.

The Oil And Gas Exploration And Production Industry
Historically Is A Cyclical Industry And Market Fluctuations In The Prices Of Oil
And Gas Could Adversely Affect Our Business.

Prices
for oil and gas tend to fluctuate significantly in response to factors beyond
our control. These factors include, but are not limited to:

- weather conditions in the United States and elsewhere;
- economic conditions, including demand for petroleum-based products, in the
  United States and elsewhere;
- actions by OPEC, the Organization of Petroleum Exporting Countries;
- political instability in the Middle East and other major oil and gas
  producing regions;
- governmental regulations, both domestic and foreign;
- domestic and foreign tax policy;

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- the pace adopted by foreign governments for the exploration, development,
  and production of their national reserves;
- the price of foreign imports of oil and gas;
- the cost of exploring for, producing and delivering oil and gas; the
  discovery rate of new oil and gas reserves;
- the rate of decline of existing and new oil and gas reserves;
- available pipeline and other oil and gas transportation capacity;
- the ability of oil and gas companies to raise capital;
- the overall supply and demand for oil and gas; and
- the availability of alternate fuel sources.

Changes
in commodity prices may significantly affect our capital resources, liquidity
and expected operating results. Price changes will directly affect revenues and
can indirectly impact expected production by changing the amount of funds
available to reinvest in exploration and development activities. Reductions in
oil and gas prices not only reduce revenues and profits, but could also reduce
the quantities of reserves that are commercially recoverable. Significant
declines in prices could result in non-cash charges to earnings due to
impairment. We do not currently engage in any hedging program to mitigate our
exposure to fluctuations in oil and gas prices.

Changes
in commodity prices may also significantly affect our ability to estimate the
value of producing properties for acquisition and divestiture and often cause
disruption in the market for oil and gas producing properties, as buyers and
sellers have difficulty agreeing on the value of the properties. Price
volatility also makes it difficult to budget for and project the return on
acquisitions and the development and exploitation of projects. We expect that
commodity prices will continue to fluctuate significantly in the future.

Our Ability To Produce Oil And Gas From Our Properties May
Be Adversely Affected By A Number Of Factors Outside Of Our Control.

The
business of exploring for and producing oil and gas involves a substantial risk
of investment loss. Drilling oil and gas wells involves the risk that the wells
may be unproductive or that, although productive, the wells may not produce oil
or gas in economic quantities. Other hazards, such as unusual or unexpected
geological formations, pressures, fires, blowouts, loss of circulation of
drilling fluids or other conditions may substantially delay or prevent
completion of any well. Adverse weather conditions can also hinder drilling
operations. A productive well may become uneconomic if water or other
deleterious substances are encountered that impair or prevent the production of
oil or gas from the well. In addition, production from any well may be
unmarketable if it is impregnated with water or other deleterious substances.
There can be no assurance that oil and gas will be produced from the properties
in which we have interests. In addition, the marketability of oil and gas that
may be acquired or discovered may be influenced by numerous factors beyond our
control. These factors include the proximity and capacity of oil and gas,
gathering systems, pipelines and processing equipment, market fluctuations in
oil and gas prices, taxes, royalties, land tenure, allowable production and
environmental protection. We cannot predict how these factors may affect our
business.

We Are Dependent Upon The Efforts Of Various Third Parties
That We Do Not Control And, As A Result, We May Not Be Able To Control The
Timing Of Development Efforts, The Associated Costs, Or The Rate Of Production
Of Reserves (If Any).

The
success of our business is dependent upon the efforts of various third parties
that we do not control. At the present, we do serve as the operator for our
projects but may not serve as operator in the future. If we do not serve as
operator, we may have limited ability to exercise influence over the operations
of the properties or their associated costs. Our dependence on the operator and,
where applicable, other working interest owners for these projects and our
limited ability to influence operations and associated costs could prevent the
realization of our targeted returns on capital in drilling or acquisition
activities. The success and timing of development and exploitation activities on
properties operated by others depend upon a number of factors that will be
largely outside of our control, including:

- the timing and amount of capital expenditures;
- the operator's expertise and financial resources;
- approval of other participants in drilling wells;

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- selection of technology;
- the rate of production of the reserves; and
- the availability of suitable drilling rigs, drilling equipment, production
  and transportation infrastructure, and qualified operating personnel.

We
will rely upon various companies to provide us with technical assistance and
services. We will also rely upon the services of geologists, geophysicists,
chemists, engineers and other scientists to explore and analyze oil and gas
prospects to determine a method in which the oil and gas prospects may be
developed in a cost-effective manner. Although we have developed relationships
with a number of third-party service providers, we cannot assure you that we
will be able to continue to rely on such persons. If any of these relationships
with third-party service providers are terminated or are unavailable on
commercially acceptable terms, we may not be able to execute our business plan.

The Unavailability Or High Cost Of Drilling Rigs, Equipment,
Supplies, Personnel And Oil Field Services Could Adversely Affect Our Ability To
Execute Our Exploration And Development Plans On A Timely Basis And Within Our
Budget.

Shortages
or the high cost of drilling rigs, equipment, supplies or personnel could delay
or adversely affect our exploitation and exploration operations, which could
have a material adverse effect on our business, financial condition and results
of operations. Since our operations and properties are concentrated in the Fort
Worth Basin in Texas, we could be materially and adversely affected if drilling
rigs are unavailable or cost of rigs, equipment supplies or personnel increase
significantly over current costs.

We May Be Required To Write-Down The Carrying Values And/Or
Estimates Of Total Reserves Of Our Oil And Gas Properties, Resulting In a
Decreased Asset Base

Accounting
rules applicable to us require that we review periodically the carrying value of
our oil and gas properties for possible impairment. Based on specific market
factors and circumstances at the time of prospective impairment reviews and the
continuing evaluation of development plans, production data, economics and other
factors, we may be required to write down the carrying value of our oil and gas
properties.

We May Be Unable To Retain Our Leases And Working Interests
In Leases, Which Would Result in Significant Financial Losses to the Terax

Our
properties are held under oil and gas leases. If we fail to meet the specific
requirements of each lease, such lease may terminate or expire. We cannot assure
you that any of the obligations required to maintain each lease will be met. The
termination or expiration of our leases may harm our business. Our property
interests will terminate unless we fulfill certain obligations under the terms
of our leases and other agreements related to such properties. If we are unable
to satisfy these conditions on a timely basis, we may lose our rights in these
properties. The termination of our interests in these properties may harm our
business.

In
addition, we will need significant funds to meet capital requirements for the
exploration activities that we intend to conduct on our properties.

Title Deficiencies Could Render Our Leases Worthless

The
existence of a material title deficiency can render a lease worthless and can
result in a large expense to our business. It is our practice in acquiring oil
and gas leases or undivided interests in oil and gas leases to forgo the expense
of retaining lawyers to examine the title to the oil or gas interest to be
placed under lease or already placed under lease. Instead, we rely upon the
judgment of oil and gas landmen who perform the field work in examining records
in the appropriate governmental office before attempting to place under lease a
specific oil or gas interest. This is customary practice in the oil and gas
industry. However, we do not anticipate that we, or the person or company acting
as operator of the wells located on the properties that we currently lease or
may lease in the future, will obtain counsel to examine title to the lease until
the well is about to be drilled. As a result, we may be unaware of deficiencies
in the marketability of the title to the lease. Such deficiencies may render the
lease worthless.

If We Or Our Operators Fail To Maintain Adequate Insurance,
Our Business Could Be Materially And Adversely Affected

Our
operations are subject to risks inherent in the oil and gas industry, such as
blowouts, cratering, explosions, uncontrollable flows of oil, gas or well
fluids, fires, pollution, earthquakes and other environmental risks. These risks
could result in substantial losses due to injury and loss of life, severe damage
to and destruction of property and equipment, pollution and other environmental
damage, and suspension of operations. We could be liable for environmental
damages caused by previous property owners. As a result, substantial liabilities
to third parties or governmental entities may be incurred, the payment of which
could have a material adverse effect on our financial condition and results of
operations.

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Any
prospective drilling contractor or operator which we hire will be required to
maintain insurance of various types to cover our operations with policy limits
and retention liability customary in the industry. Therefore, we do not plan to
acquire our own insurance coverage for such prospects. The occurrence of a
significant adverse event on such prospects that is not fully covered by
insurance could result in the loss of all or part of our investment in a
particular prospect which could have a material adverse effect on our financial
condition and results of operations.

Complying With Environmental And Other Government
Regulations Could Be Costly And Could Negatively Impact Our Production

Our
business is governed by numerous laws and regulations at various levels of
government. These laws and regulations govern the operation and maintenance of
our facilities, the discharge of materials into the environment and other
environmental protection issues. Such laws and regulations may, among other
potential consequences, require that we acquire permits before commencing
drilling and restrict the substances that can be released into the environment
with drilling and production activities.

Under
these laws and regulations, we could be liable for personal injury, clean-up
costs and other environmental and property damages, as well as administrative,
civil and criminal penalties. Prior to commencement of drilling operations, we
may secure limited insurance coverage for sudden and accidental environmental
damages as well as environmental damage that occurs over time. However, we do
not believe that insurance coverage for the full potential liability of
environmental damages is available at a reasonable cost. Accordingly, we could
be liable, or could be required to cease production on properties, if
environmental damage occurs.

The
costs of complying with environmental laws and regulations in the future may
harm our business. Furthermore, future changes in environmental laws and
regulations could occur that result in stricter standards and enforcement,
larger fines and liability, and increased capital expenditures and operating
costs, any of which could have a material adverse effect on our financial
condition or results of operations.

The Oil And Gas Industry Is Highly Competitive, and We May
Not Have Sufficient Resources to Compete Effectively

The
oil and gas industry is highly competitive. We compete with oil and natural gas
companies and other individual producers and operators, many of which have
longer operating histories and substantially greater financial and other
resources than we do, as well as companies in other industries supplying energy,
fuel and other needs to consumers. Our larger competitors, by reason of their
size and relative financial strength, can more easily access capital markets
than we can and may enjoy a competitive advantage in the recruitment of
qualified personnel. They may be able to absorb the burden of any changes in
laws and regulation in the jurisdictions in which we do business and handle
longer periods of reduced prices for oil and gas more easily than we can. Our
competitors may be able to pay more for oil and gas leases and properties and
may be able to define, evaluate, bid for and purchase a greater number of leases
and properties than we can. Further, these companies may enjoy technological
advantages and may be able to implement new technologies more rapidly than we
can. Our ability to acquire additional properties in the future will depend upon
our ability to conduct efficient operations, evaluate and select suitable
properties, implement advanced technologies and consummate transactions in a
highly competitive environment.

Risks Relating to Our Common Stock :

There is no significant market for our common stock

The
trading market for our common stock is limited. Our common stock is not eligible
for trading on any national or regional securities exchange or the NASDAQ Stock
Market. Our common stock is eligible for trading on the OTC Bulletin Board. This
market tends to be substantially less liquid than national and regional
securities exchanges or the NASDAQ Stock Market. We cannot provide you with any
assurance that a more active trading market for our common stock will develop,
or if such a market develops, that it will be sustained.

There is a Large Number of Shares that were Registered for
Resale and the Sale of These Shares May Cause the Price of Our Stock to
Drop.

As
of October 12, 2006, we had 60,591,529 shares of common stock issued and
outstanding. Of those shares, 18,717,600 are registered for resale pursuant to a
Form SB-2 Registration Statement that was declared effective by the SEC on
August 14, 2006, together with up to 16,335,720 additional shares of common
stock issuable upon the exercise of outstanding warrants. As a result, the
registration of these shares may result in substantial sales of our common
stock, which could cause our stock price to drop.

If We Fail to Remain Current in Our Reporting Requirements,
We Could be Removed From the OTC Bulletin Board Which Would Limit the Ability of
Broker-Dealers to Sell Our Securities and the Ability of Stockholders to Sell
Their Securities in the Secondary Market.

Companies
trading on the OTC Bulletin Board, such as us, are required to file reports
under Section 15(d) of the Securities Exchange Act of 1934, as amended, and must
be current in their reports under Section 13, in order to maintain price
quotation privileges on the OTC Bulletin Board. If we fail to remain current on
our reporting requirements, we could be removed from the OTC Bulletin Board. As
a result, the market liquidity for our securities could be severely adversely
affected by limiting the ability of broker-dealers to sell our securities and
the ability of stockholders to sell their securities in the secondary market.

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Our Common Stock is Subject to the "Penny Stock" Rules of
the SEC and the Trading Market in Our Securities is Limited, Which Makes
Transactions in Our Stock Cumbersome and May Reduce the Value of an Investment
in Our Stock.

The
Securities and Exchange Commission has adopted Rule 15g-9 which establishes the
definition of a "penny stock, for the purposes relevant to us, as any equity
security that has a market price of less than $5.00 per share or with an
exercise price of less than $5.00 per share, subject to certain exceptions. For
any transaction involving a penny stock, unless exempt, the rules require:

- that a broker or dealer approve a person's account for transactions in
  penny stocks; and
- the broker or dealer receives from the investor a written agreement to the
  transaction, setting forth the identity and quantity of the penny stock to be
  purchased.

In order to approve a person's account for transactions in
penny stocks, the broker or dealer must:

- obtain financial information and investment experience objectives of the
  person; and
- make a reasonable determination that the transactions in penny stocks are
  suitable for that person and the person has sufficient knowledge and
  experience in financial matters to be capable of evaluating the risks of
  transactions in penny stocks.

The broker or dealer must also deliver, prior to any
transaction in a penny stock, a disclosure schedule prescribed by the Commission
relating to the penny stock market, which, in highlight form:

- sets forth the basis on which the broker or dealer made the suitability
  determination; and
- that the broker or dealer received a signed, written agreement from the
  investor prior to the transaction.

Generally, brokers may be less willing to execute transactions
in securities subject to the "penny stock" rules. This may make it more
difficult for investors to dispose of our common stock and cause a decline in
the market value of our stock.

Disclosure
also has to be made about the risks of investing in penny stocks in both public
offerings and in secondary trading and about the commissions payable to both the
broker-dealer and the registered representative, current quotations for the
securities and the rights and remedies available to an investor in cases of
fraud in penny stock transactions. Finally, monthly statements have to be sent
disclosing recent price information for the penny stock held in the account and
information on the limited market in penny stocks.

ITEM 2. DESCRIPTION OF PROPERTY

The properties in which we have an interest consist of our
principal executive offices and our oil and gas properties in Erath and Comanche
Counties.

Principal Executive Offices

Our
  principal executive offices are located at 13355 Noel Road, 1370 One Galleria
  Tower, Dallas, Texas. We rent this office space for approximately $5,700 per
  month. We also maintain a field office on Stephenville, Texas which we rent
  at $1,300 per month. We believe our current offices will be adequate to support
  our operations for the foreseeable future.

Current Oil and Gas Projects

To
date, our acquisition, exploitation and development activities have been limited
to Texas.

Erath County Property

We
own 100% of the working interest under oil and gas leases covering two blocks of
approximately 11,300 gross acres in the aggregate in close proximity to each
other in Erath County, Texas, which permit us to drill and develop the Barnett
Shale formation underlying that lease acreage. Our interest has been acquired
pursuant to leases from the owners of the minerals covered by the leases.

The
leases are generally for a primary term of three years and most of the leases
contain an option to extend the leases for an additional two years by making a
bonus payment to the mineral owners. In some cases, the leases limit our ability
to drill deeper than the Barnett Shale formation. Almost all of the leases
provide for surface damages to be paid in connection with drilling activities,
and they contain other provisions that are customary for leases in the Fort
Worth Basin.

The company has drilled six
horizontal wells, constructed approximately eight miles of eight inch pipeline,
four miles of gathering line, and two compression and separation facilities on
its Erath County property. Of the six wells drilled, four have been completed
and connected to the gathering and pipeline system and the other two wells are
waiting completion of the gathering lines, fracture stimulation, and completion
activities. The four completed wells are currently considered non commercial.
The Company believes that Mitchell 3-H well could be

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commercial if a workover is successful in substantially
reducing the water production from the well. The Company is also considering the
viability of the refracture stimulation of the Mitchell 1-H well. The completion
of the Mitchell 5-H and 6-H wells, the workover of the Mitchell 3-H well and the
refract of the Mitchell 1-H well until additional financing has been secured.

The Company completed an aeromagnetic survey in November 2005
and a geological update in July 2006 on its Erath acreage. An operator with
acreage offsetting our Erath Acreage is currently conducting a 3-D Seismic
program over both Terax and its acreage. Terax has agreed to allow them conduct
the program over its acreage in exchange for the right to purchase the seismic
covering its acreage at a later date.

Comanche County Property

We
own 100% of the working interest under approximately 17,200 gross acres in the
aggregate in close proximity in Comanche County, Texas, which permit us to drill
and develop the Barnett Shale formation underlying the lease acreage. Our
interest has been acquired pursuant to leases from owners of the minerals
covered by the leases. The leases are generally for a primary term of two years
and most of the leases contain an option to extend the leases for an additional
three years by making a bonus payment to the mineral owners. The leases also
provide for surface damages to be paid in connection with drilling activities,
and they contain other provisions that are customary for leases in the Fort
Worth Basin.

The Company has completed an aeromagnetic survey on its
Comanche acreage and has begun a geological review of the properties.

Erath and Comanche Properties - Geology

Depositionally,
Mississippian-age organic-rich shales are the reservoir for the Barnett Shale
unconventional gas accumulation in the Fort Worth basin. The Barnett hydrocarbon
system is one of the ten richest in the world, due to the massive organic matter
deposited in this setting. This large, geologically continuous gas accumulation
occupies a structurally low position straddling the basin axis. The accumulation
is characterized by the presence of gas downdip from water saturated rocks, no
obvious lithologic or structural barrier that separate the updip water and
downdip gas, very low (microdarcy and nanodarcy level) matrix permeability, the
importance of natural fractures for production, and the absence of truly dry
holes.

The
Barnett Shale in a number of counties lies unconformably on sedimentary rocks of
Ordovician age (Ellenburger Group, Simpson Group, Viola limestone) and is
comformably overlain by the Pennsylvanian Marble Falls formation. Regionally,
the thickness of the Barnett Shale approaches 1,000 feet near the southwest
fault boundary of the Southern Oklahoma aulacogen and thins to the southwest as
it crops out along the flanks of the Llano uplift. Most vertical wells are
completed in the lower part of the Barnett Shale with perforations in vertical
wells typically spanning 200-300 feet. Most horizontal wells are completed with
a horizontal leg of up to 3,000 feet or more using slotted liner technology and
multi-stage fracture stimulation techniques.

The
Barnett Shale, of North Texas, is similar to that of Black Shales in the U.S. of
Devonian-Mississippian age that produce natural gas, such as the Antrim shale of
the Michigan basin, New Albany shale of the Illinois basin, Woodford shale of
the Anadarko basin, and "Devonian" shales of the Appalachian basin. These
organic-rich shales are a storage site for absorbed gas. The organic matter in
the shale contains approximately 60 standard cubic feet of natural gas/ton of
reservoir rock, about 25% of the natural gas stored in the pore space. This gas
is released (desorbed) as formation pressure is lowered and contributes to the
long life of Barnett Shale gas wells.

ITEM 3. LEGAL PROCEEDINGS

From time to time, we may become involved in various lawsuits
and legal proceedings which arise in the ordinary course of business. Except as
disclosed below, we are currently not aware of any such legal proceedings or
claims that we believe will have, individually or in the aggregate, a material
adverse affect on our business, financial condition or operating results.

On
July 20, 2006, an action was commenced in the District Court of Erath County,
Texas, against the Company by Centex Pipeline Construction, Inc. for failure to
pay for services performed, breach of contract and to foreclose on Plaintiffs
mechanic lien. The Complaint alleges that the Company and Centex entered into an
agreement for Centex to install certain components of a gas pipeline gathering
system on the Companys Mitchell Ranch property in Erath County, Texas. The
Complaint further alleges that the Plaintiff completed work on June 5, 2006 and
that the Company has failed to pay certain outstanding invoices. The Plaintiffs
have filed a mechanics lien to create a security interest against the gathering
line and compressor station. The Plaintiffs are seeking damages in the amount
of $510,319.00 plus interest, attorney fees and entry of an Order of Sale
directing the Sheriff to sell the property covered by the Plaintiffs mechanic
lien.

Terax
has filed a general denial and a Counterclaim and third-party claim for
declaratory judgment in response to Centexs petition and has requested
discovery. A motion for summary judgment filed by Centex is pending.

The
Company plans to seek a settlement with Centex and its bank provided that the
Company can be assured that no subcontractors will file liens on Teraxs
property and that Terax has no risk of liability to Centexs bank for not making
all payments directly to the bank. Alternatively, the Company may ask the court
to accept a payment of funds into the registry of the court in order to protect
Terax from further liability and cost.

13

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On August 28, 2006, an action was commenced in the District
Court of Travis County, Texas, against the Company, Andrew Hromyk and Starr
County Energy, Inc. by Sam Warren and Tennessee Eastern Oil & Gas, Inc. for
damages for breach of a personal services contract with the Plaintiffs or in the
alternative, based upon the doctrine of quantum merit, for value of services
which Plaintiffs allegedly rendered to Defendants. The complaint alleges that
in early 2006, Tennessee Eastern and Starr County entered into an agreement to
purchase certain oil and gas properties located in Tennessee, which agreement
was terminated. The complaint alleges that Hromyk continued discussions with
Plaintiff Warren and indicated that a lawsuit filed against the Company by
William Rhea was impeding the potential sale of the Tennessee property, at which
point, Warren offered to assist with settling the William Rhea lawsuit. The
complaint further alleged that Plaintiffs negotiated and mediated a settlement
of the William Rhea lawsuit and that after the lawsuit was settled, the
Defendants breached their agreement to purchase the Tennessee property for $5.7
million. The Plaintiffs are seeking a judgment against the Defendants in the
amount of $5.7 million and attorneys fees and expenses and costs of court.

By agreement with Plaintiffs counsel, a response to the
lawsuit is not due from the Company until November 6, 2006. the Company and the
other Defendants believe that the allegations of the Plaintiffs are without
merit and they are vigorously contesting the allegations made by the Plaintiffs
in this lawsuit.

On September 22, 2006, an action was commenced in the District
Court of Erath County, Texas, by Geosite, Inc. against the Company and Bill
Chester for breach of contract and foreclosure of lien. The Plaintiff alleges
that the Company has failed to pay for certain goods, merchandise or services
sold to the Company. The Complaint is seeking $10,930 allegedly owed to the
Plaintiffs, attorney fees and an order of foreclosure of Plaintiffs lien. The
Company plans to respond to the Geosite lawsuit in a timely manner but plans to
reach a settlement with Geosite in the near future provided funds are available.

On October 5, 2006, an action was commenced in the District
Court of Erath County, Texas, by BJ Services Company, USA against the Company
for breach of contract and foreclosure of lien. The Plaintiff alleges that the
Company has failed to pay for certain goods, merchandise, or services sold to
the Company. The Complaint is seeking $475,844.25 plus interest and allegedly
owed to the Plaintiffs attorney fees and an order of foreclosure of Plaintiffs
lien The Company plans to respond to the BJ Services lawsuit in a timely manner
but plans to reach a settlement with BJ Services in the near future provided
funds are available

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY
HOLDERS

During
the period covered by this report, approval by written consent was obtained from
shareholders owning a majority of the Companys stock for the Companys 2006
Stock Incentive Stock Plan. The 2006 Incentive Stock Plan has initially reserved
3,200,000 shares of common Stock for issuance. Under the 2006 Incentive Stock
Plan, options may be granted which are intended to qualify as Incentive Stock
Options under Section 422 of the Internal Revenue Code of 1986 or which are not
intended to qualify as Incentive Stock Options there under. Under the 2006 Stock
Incentive Plan, options, stock grants, or restricted stock may be granted to key
employees, officers, directors or consultants of the Company, as provided in the
2006 Stock Incentive Plan.

PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

Our
common stock is quoted on the Over-the-Counter Bulletin Board under the symbol
TERX.

As
of October 12, 2006, we had 60,591,529 shares of our common stock outstanding,
which shares were held by approximately 49 shareholders of record.

The
following table sets forth the range of high and low closing bid quotations for
our common stock since our common stock was listed on the Over-the-Counter
Bulletin Board. The quotations represent inter-dealer prices without retail
markup, markdown or commission, and may not necessarily represent actual
transactions.

Period
      Ended
    High
    LowJune 30, 2004
    $0.00 (1)
    $0.00 (1)September 30, 2004
    $0.00 (1)
    $0.00 (1)December 31, 2004
    $0.00 (1)
    $0.00 (1)March 31, 2005
    $0.00 (1)
    $0.00 (1)June 30, 2005
    $1.40
    $0.55September 30, 2005
    $2.89
    $1.30December 31, 2005
    $3.09
    $1.74March 31, 2006
    $2.91
    $1.72June 30, 2006
    $2.56
    $1.43


(1) There were no trades
during these periods.

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The
Securities and Exchange Commission has adopted rules that regulate broker-dealer
practices in connection with transactions in penny stocks. Penny stocks are
generally equity securities with a price of less than $5.00, other than
securities registered on certain national securities exchanges or quoted on the
NASDAQ system, provided that current price and volume information with respect
to transactions in such securities is provided by the exchange or system. The
penny stock rules require a broker-dealer, prior to a transaction in a penny
stock not otherwise exempt from those rules, deliver a standardized risk
disclosure document prepared by the Commission, which: (a) contains a
description of the nature and level of risk in the market for penny stocks in
both public offerings and secondary trading; (b) contains a description of the
broker's or dealer's duties to the customer and of the rights and remedies
available to the customer with respect to a violation to such duties or other
requirements of Securities' laws; (c) contains a brief, clear, narrative
description of a dealer market, including bid and ask prices for penny stocks
and significance of the spread between the bid and ask price; (d) contains a
toll-free telephone number for inquiries on disciplinary actions; (e) defines
significant terms in the disclosure document or in the conduct of trading in
penny stocks; and (f) contains such other information and is in such form as the
Commission shall require by rule or regulation. The broker-dealer also must
provide, prior to effecting any transaction in a penny stock, the customer: (a)
with bid and offer quotations for the penny stock; (b) the compensation of the
broker-dealer and its salesperson in the transaction; (c) the number of shares
to which such bid and ask prices apply, or other comparable information relating
to the depth and liquidity of the market for such stock; and (d) monthly account
statements showing the market value of each penny stock held in the customer's
account. In addition, the penny stock rules require that prior to a transaction
in a penny stock not otherwise exempt from those rules; the broker-dealer must
make a special written determination that the penny stock is a suitable
investment for the purchaser and receive the purchaser's written acknowledgment
of the receipt of a risk disclosure statement, a written agreement to
transactions involving penny stocks, and a signed and dated copy of a written
suitability statement.

These
disclosure requirements may have the effect of reducing the trading activity in
the secondary market for our stock if it becomes subject to these penny stock
rules. Therefore, if our common stock becomes subject to the penny stock rules,
stockholders may have difficulty selling those securities.

Dividends

There
are no restrictions in our articles of incorporation or bylaws that prevent us
from declaring dividends. The Nevada Revised Statutes, however, do prohibit us
from declaring dividends where, after giving effect to the distribution of the
dividend:

- We would not be able to pay our debts as they become due in the usual
  course of business; or
- Our total assets would be less than the sum of our total liabilities plus
  the amount that would be needed to satisfy the rights of shareholders who have
  preferential rights superior to those receiving the distribution.

We
have never declared or paid any cash dividends on our common stock. We currently
intend to retain future earnings, if any, to finance the expansion of our
business. As a result, we do not anticipate paying any cash dividends in the
foreseeable future.

Securities Authorized for Issuance Under Equity Compensation
Plans

The
following table shows information with respect to each equity compensation plan
under which our common stock is authorized for issuance as of the twelve month
period ended June 30, 2006.

Plan category
      
      Number of securities 
        to be issued 
        upon exercise of 
        outstanding 
        options, warrants and 
        stock rights
      
      Weighted average 
        exercise 
        price of 
        outstanding options, 
        warrants and rights
      
      Number of 
        securities 
        remaining available 
        for future issuanceEquity compensation plans approved by security
        holders
      
      3,200,000
      
      N/A
      
      1,350,000Equity compensation plans not approved by
        security holders
      
      Nil
      
      N/A
      
      NilTotal
      
      3,200,000
      
      
      
      1,350,000


See
Executive Compensation for a description of equity compensation plans adopted
after June 30, 2006.

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Recent Sales of Unregistered Securities

During the past three years, we have sold the following
securities which were not registered under the Securities Act of 1933, as
amended.

During
August 2003, the Company issued the then sole officer and director of the
Company 225,000 shares of common stock at $0.0067 per shares for conversion of a
note payable to equity of $1,500.

On
June 1, 2005, we acquired all of the issued and outstanding shares of Erath
Energy Inc., a Delaware corporation pursuant to a Share Purchase Agreement dated
May 31, 2005, between us and Holywell Technological Investments Ltd. and First
Finance Limited. As consideration for the acquisition, we issued to the Sellers
an aggregate of 318,000 shares of common stock. The common shares were offered
and sold to the sellers in an offshore transaction made in reliance upon the
exemption from registration provided by Regulation S as the sellers are not US
Persons (as that term is defined in Regulation S).

In
August and September 2005, we sold an aggregate of 739,000 units for $10.00 per
unit to 13 accredited investors, for aggregate proceeds of $7,390,000. Each Unit
consisted of eight shares of common stock and four non-transferable share
purchase warrants. Each warrant is exercisable into one share of common stock at
a price of $1.75 until March 10, 2007, subject to acceleration as follows: in
the event that the average closing price of our shares of common stock on the
OTC:BB or other, more senior exchange for the 20 previous trading days exceeds
$2.25, and provided that an effective registration statement registering the
resale of the shares underlying the warrants is then in effect, the we may, by
written notice, accelerate the expiration date of the warrants to 30 days after
the date of such notice. Pursuant to the terms of the agreements with the
investors, we are obligated to register the shares sold in the offering,
including the shares underlying the warrants with the Securities and Exchange
Commission. We agreed to file a registration statement with the SEC no later
than March 14, 2006 and use our best efforts to have the registration statement
declared effective as soon thereafter as practicable. The Units were offered and
sold to the investors in offshore transactions made in reliance upon the
exemption from registration provided by Regulation S as the investors are not US
Persons (as that term is defined in Regulation S).

On
September 29, 2005, in connection with his employment by the Company, the
Company agreed to issue options to acquire 500,000 shares of common stock to Sam
M. Governale. On February 26, 2006, we agreed to issue 250,000 shares to Mr.
Governale pursuant to the Companys 2006 Incentive Stock Plan, subject to
certain earn-in provisions, in exchange for the obligation to issue the 500,000
options to him. Such exchange is subject to shareholder approval of the
plan.

On
November 11, 2005, in connection with his employment by the Company, the Company
agreed to issue 500,000 shares of common stock to Lawrence Finn. On February 26,
2006, we agreed to issue 1,500,000 shares to Mr. Finn pursuant to the Companys
2006 Incentive Stock Plan, subject to certain earn-in provisions, in exchange
for the obligation to issue 500,000 shares to him.

On
December 2, 2005, the Company agreed to issue a promissory note to an investor
with a principal amount of $2,500,000, bearing interest at the rate of 12.5% per
annum. The note was due on demand after May 31, 2006 and may be repaid at any
time by the Company. On December 19, 2005, the loan amount was increased to
$4,100,000, on January 26, 2006 it was increased to $5,000,000 and on February
1, 2006 it was increased to $7,500,000. The promissory notes evidencing the
loans were secured by an interest in all of the Companys oil and gas leases and
pipeline right of ways and easements in Erath County, Texas, as well as well and
pipeline equipment and personal property, contracts and agreements, and
production from the Companys wells located on the leases. On February 2, 2006,
the Company issued to a total of 215,517 shares of the Companys common stock as
consideration for the loans and on February 17, 2006 the Company issued an
additional 84,483 shares of common stock as further consideration for the loans,
as required by the terms of the loan documents. The loans were repaid in full on
February 17, 2006. The promissory notes evidencing the loans and the common
shares were offered and sold to the investor in an offshore transaction made in
reliance upon the exemption from registration provided by Regulation S as the
investor was not a US Person (as that term is defined in Regulation S).

On
January 26, 2006, in connection with his employment by the Company, the Company
agreed to issue 200,000 shares of commonstock and options to acquire an
additional 200,000 shares to Richard C. Binz. On February 26, 2006, we agreed to
issue 300,000 shares to Mr. Binz pursuant to the Companys 2006 Incentive Stock
Plan, subject to certain earn-in provisions, in exchange for the obligation to
issue the 200,000 shares and 200,000 options to him.

On
February 7, 2006, we entered into securities purchase agreements to sell to
eight institutional investors an aggregate of 12,805,600 shares of the Companys
common stock and warrants to purchase an additional 12,805,600 shares of common
stock, for an aggregate purchase price of $16,007,000. The sale of the
securities was consummated on February 7, 2006. The unit price of the common
stock and corresponding warrant was $1.25. The warrants are exercisable until
February 6, 2011 at an exercise price of $1.50 per share. We have the right to
require exercise of all of the warrants in the event that (i) a registration
statement registering the resale of the warrants is then in effect and (ii) the
volume weighted average trading price per share of the Companys common stock
for each of the previous thirty trading days is in excess of $2.50.

J.P.
Turner & Company, L.L.C. acted as placement agent in connection with the
offering. The aggregate commissions payable to J.P. Turner in connection with
the private placement were approximately $862,120. In addition, J. P. Turner
received warrants to purchase 574,120 shares of common stock identical to those
sold to the investors.

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On
February 26, 2006, we agreed to issue 100,000 shares to an employee pursuant to
the Companys 2006 Incentive Stock Plan, subject to certain earn-in
provisions.

On
May 12, 2006, we entered into a Purchase Agreement with an investor for the
issuance of a promissory note in the principal amount of $2,500,000 and 71,429
shares of our common stock. The Note was issued pursuant to an exemption from
the registration requirements of the Securities Act of 1933, as amended (the
Act), in compliance with Regulation S, promulgated pursuant to the Act.

*
  Except as noted, all of the above offerings and sales were deemed to be exempt
  under rule 506 of Regulation D and Section 4(2) of the Securities Act of 1933,
  as amended. No advertising or general solicitation was employed in offering
  the securities. The offerings and sales were made to a limited number of persons,
  all of whom were accredited investors, business associates of Terax Energy,
  Inc. or executive officers of Terax Energy, Inc., and transfer was restricted
  by Terax in accordance with the requirements of the Securities Act of 1933.
  In addition to representations by the above-referenced persons, we have made
  independent determinations that all of the above-referenced persons were accredited
  or sophisticated investors, and that they were capable of analyzing the merits
  and risks of their investment, and that they understood the speculative nature
  of their investment. Furthermore, all of the above-referenced persons were provided
  with access to our Securities and Exchange Commission filings. Except as expressly
  set forth above, the individuals and entities to whom we issued securities as
  indicated in this section of the registration statement are unaffiliated with
  us.

ITEM 6. PLAN OF OPERATION

Forward-Looking Statements

This
document contains forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. All statements other than statements
of historical fact are forward-looking statements for purposes of federal and
state securities laws, including, but not limited to, any projections of
earnings, revenue or other financial items; any statements of the plans,
strategies and objections of management for future operations; any statements
concerning proposed new services or developments; any statements regarding
future economic conditions or performance; any statements or belief; and any
statements of assumptions underlying any of the foregoing.

Forward-looking
statements may include the words may, could, estimate, intend,
continue, believe, expect or anticipate or other similar words. These
forward-looking statements present our estimates and assumptions only as of the
date of this report. Except for our ongoing securities laws, we do not intend,
and undertake no obligation, to update any forward-looking statement.

Although
we believe that the expectations reflected in any of our forward-looking
statements are reasonable, actual results could differ materially from those
projected or assumed in any of our forward-looking statements. Our future
financial condition and results of operations, as well as any forward-looking
statements, are subject to change and inherent risks and uncertainties. The
factors impacting these risks and uncertainties include, but are not limited to:

| | o | increased competitive pressures from existing competitors
      and new entrants;                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                               
| | o | increases in interest rates or our cost of borrowing or a
      default under any material debt agreements;                                                                   
| |   |                                                                                                                                                                               
| | o | deterioration in general or regional economic conditions;                                                                                                                     
| |   |                                                                                                                                                                               
| | o | adverse state or federal legislation or regulation that
      increases the costs of compliance, or adverse findings by a regulator with
      respect to existing operations;
| |   |                                                                                                                                                                               
| | o | loss of customers or sales weakness;                                                                                                                                          
| |   |                                                                                                                                                                               
| | o | inability to achieve future sales levels or other
      operating results;                                                                                                    
| |   |                                                                                                                                                                               
| | o | fluctuations of oil and gas prices;                                                                                                                                           
| |   |                                                                                                                                                                               
| | o | the unavailability of funds for capital expenditures; and                                                                                                                     
| |   |                                                                                                                                                                               
| | o | operational inefficiencies in distribution or other
      systems.                                                                                                            

For
a detailed description of these and other factors that could cause actual
results to differ materially from those expressed in any forward-looking
statement, please see Risk Factors above.

17

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Overview and Outlook

We
are an oil and gas exploration, development and production company. Our
properties are located in the Fort Worth Basin. Our corporate strategy is to
continue building value in the Company through the development and acquisition
of gas and oil assets that exhibit consistent, predictable, and long-lived
production. Our current focus is exploring the gas reserves located in the
Barnett Shale formations of the Fort Worth Basin.

We
have consolidated strong mineral lease positions in both Erath and Comanche
counties. Our focus is now on evaluating, developing and producing those leases
so as to realize the value held in them. With approximately 27,500 gross leased
acres, the task of developing the properties with wells commenced in the second
quarter of our fiscal year.

We
intend to continue seeking acquisition opportunities, which compliment our
current focus. We intend to fund our development activity primarily through
proceeds from various private placements sufficient enough to develop a greater
portion of our mineral leases.

Our
revenue, profitability, and future growth rate depend substantially on factors
beyond our control, such as economic, political, and regulatory developments and
competition from other sources of energy. Oil and natural gas prices
historically have been volatile and may fluctuate widely in the future.
Sustained periods of low prices for oil or natural gas could materially and
adversely affect our financial position, our results of operations, the
quantities of oil and natural gas reserves that we can economically produce and
our access to capital

Results of Operations

Our
revenues commenced in the fourth quarter of 2006, and totaled $148,636 for the
full year ended June 30, 2006. We had no revenues during the fiscal year ended
June 30, 2005. We expect that our revenues will remain at modest levels until we
are able to produce additional quantities of oil and gas.

We
  incurred total expenses of $23,167,233 during the fiscal year ended June 30,
  2006. These costs included asset impairment of $9,817,123, and loss on derivative
  liability of $8,161,075. General and administrative expense for the fiscal year
  ended June 30, 2006 were $3,250,689. The deprecation and depletion expense for
  the year ended June 30, 2006 was $1,237,230 and is predominately the depletion
  of the producing property for the year. Lease operating expense of $129,108
  for the year reflects the start up production in our Erath County property.

During
2006, we evaluated the commercial viability of a portion of our property in
Erath County. The four wells completed during the year were deemed
non-commercial which had a negative impact on the value of the wells drilled.
Accordingly, we recognized $7,593,446 in producing impairments and $2,223,677 in
non-producing impairment of property.

A
significant component of our expenses during the year ended June 30, 2006,
constitute non-cash charges related to the impairment of assets of $9,817,123,
derivative liability loss of $8,161,075, depreciation and depletion expense of
$1,237,230 and interest expense of $660,203.

Liquidity and Capital Resources

As
  of June 30, 2006 we had a net working capital deficit balance of $23,200,422
  compared to a positive net working capital of $38,184 at year end June 30, 2005.
  The decrease in our working capital position was primarily attributable to increases
  in accounts payable of $5,144,658, accrued liabilities of $383,347, short term
  note payable of $2,500,000, derivative liability of $16,458,719, which was offset
  by increases in cash of $763,258, and prepaid expenses, deposits and advances
  to operators of $510,330.

Net
  used in operations was $3,031,695 for the year ended June 30, 2006. The primary
  use of cash in operating activities was to fund our net loss. Net cash used
  in investing activities for the year was $21,454,927 and primarily consisted
  of the purchase of oil and gas leases, drilling program, and the installation
  of the pipeline and gathering system, compared to no investing activities for
  the year ended June 30, 2005.

Net
  cash provided by financing activities during the fiscal year ended June 30,
  2006 was $25,249,880 compared to $79,443 of cash provided for the year ended
  June 30, 2005. This cash was provided by both equity and debt financings during
  the year. From August 8, 2005 through September 14, 2005, the Company issued
  739,000 Units at a price of $10.00 per Unit for gross proceeds to the Company
  of $7,390,000. Each Unit consisted of eight shares of our common stock (each
  a Unit Share) and four non-transferable share purchase warrants
  (each a Unit Warrant). Each Unit Warrant is exercisable into one
  share of our common stock (each a Warrant Share) at a price of $1.75.
  On December 2, 2005 for $2,500,000, December 19, 2005 for $1,600,000, and January
  26, 2006 for $900,000, the Company issued promissory notes (the Notes)
  to an investor with aggregate principal amounts of $5,000,000. On February 1,
  2006, the Company issued an additional promissory note (the Additional
  Note) with a principal amount of $2,500,000 to the same investor. On February
  7, 2006, the Company entered into securities purchase agreements to sell to
  four institutional investors an aggregate of 12,805,600 shares of the Companys
  common stock and warrants to purchase an additional 12,805,600 shares of common
  stock, for an aggregate purchase price of $16,007,000. The unit purchase price
  of the common stock and corresponding warrant was $1.25. The warrants are exercisable
  at an exercise price of $1.50 per share

18

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and expire on February 6, 2011. On May 12, 2006, the Company
issued a promissory note in the principal amount of $2,500,000 to another
investor. The Note bears interest at the rate of 12.5% per annum, payable on
repayment of the Note.

Our
  working capital deficit was increased by $23,162,238 during the year ended June
  30, 2006. During the period current assets were increased by $1,273,588 and
  current liabilities increased by $24,512,054. The increase in current assets
  was a result of an increase in cash of $763,258 and an increase in prepaid expenses,
  deposits and advances to operators of $510,330. The increase in current liabilities
  was the result of an increase in accounts payable of $5,144,658, an increase
  in short term note of $2,500,000 which was offset by an increase in accrued
  liabilities of $384,139 and derivative liability of $16,458,719.

Our
liquidity has been adversely affected during three month period and the year
ended June 30, 2006, due to not being able to secure additional financing to
fund the operations of the Company. Since the fiscal year ended June 30, 2006
the Company has continued to seek financing for its operations but has been
unsuccessful.

Satisfaction of our cash obligations for the next 12
months.

Our
current capital resources, together with our expected cash flow from operations,
are not sufficient to continue and maintain our operations over the course of
the next twelve months. If the Company does not secure additional financing in
the near term it will be forced to seek other alternatives including the sale of
assets to repay its current creditors. This includes resources for the payment
of our anticipated overhead expenses and current liabilities. If the Company is
successful in securing sufficient capital to repay its creditors, the Company
will need additional capital to continue its operations and evaluate its
properties. We would, therefore, continue to seek to raise capital over the next
12 months as we attempt to finance the development of our existing projects and
in order to fund our future growth and exploration activities. This may take the
form of either debt-based financing, or sale of equity securities. If we are
unable to obtain additional funds when we need them or if we cannot obtain funds
on terms favorable to us, we may need to delay, scale back, or eliminate plans
for further development efforts.

Our
oil and gas properties have minimal commercial production. We have no history of
earnings or cash flow from our operations. A critical component of our operating
plan impacting our continued existence is to efficiently manage the costs
associated with exploratory drilling efforts, our ability to obtain additional
capital through additional equity and/or debt financing, and JV or WI
partnerships will also be important to our expansion plans. In the event we
experience any significant problems assimilating acquired assets into our
operations or cannot obtain the necessary capital to pursue our strategic plan,
we may have to significantly curtail our operations. This would materially
impact our ability to continue operations.

We
will need additional capital to proceed with the current phase of our operations
and the continued field development of our Erath County properties.

Over
the next twelve months, our existing capital combined with cash flow from
operations will not be sufficient to sustain operations and our planned
expansion.

We
believe we will continue to incur operating losses over the next twelve months.
Our lack of operating history makes predictions of future operating results
difficult to ascertain. Our prospects must be considered in light of the risks,
expenses and difficulties frequently encountered by companies in their early
stage of development and production, particularly companies in the oil and gas
industry. Such risks include, but are not limited to, an evolving and
unpredictable business model and the management of growth. To address these
risks we must, among other things, implement and successfully execute our
business and marketing strategy, continue to develop and upgrade technology and
products, respond to competitive developments, and attract, retain and motivate
qualified personnel. There can be no assurance that we will be successful in
addressing such risks, and the failure to do so can have a material adverse
effect on our business prospects, financial condition and results of operations.

All
of the leases purchased by the Company are paid up oil and gas leases which do
not require future payments. If we begin production of oil or natural gas on a
lease before the end of the primary lease term, we may retain that lease without
additional cost. If production is established, we are required to pay the
leaseholder a portion of the oil or gas production as royalty payments which
range from 16.66% to 21.5% . If production is not established during the primary
term of the lease, in most cases, we have the right but not the obligation to
extend the lease for an additional 2 years in Erath and an additional 3 years in
Comanche by making an addition lump sum payment to the

19

---

leaseholder, as provided for in each lease. If oil and gas
production is not established within the additional period, the lease is
returned to the leaseholder and we have no additional rights to the lease.

The
following table summarizes the maximum additional lease option payments by
quarter that would be required to be made by the Company if it was to choose to
extend the leases by making these additional payments.

Period
    Erath County
    Comanche County
    Total2nd Quarter 2007
    $0.00
    $2,715,075.43
    $2,715,075.433rd Quarter 2007
    $565,068.50
    $141,987.50
    $707,056.004th Quarter 2007
    $75,836.25
    $0.00
    $75,836.251st Quarter 2008
    $0.00
    $0.00
    $0.002nd Quarter 2008
    $0.00
    $0.00
    $0.003rd Quarter 2008
    $167,064.00
    $173,367.22
    $340,431.224th Quarter 2008
    $144,126.35
    $238,018.69
    $382,145.041st Quarter 2009
    $0.00
    $0.00
    $0.002nd Quarter 2009
    $9,300.00
    $0.00
    $9,300.00Grand Total
    $4,229,843.94


As
  of June 30, 2006, we had assets of $17,557,787, and $24,564,362 in liabilities;
  resulting in a stockholders deficit of $7,006,575.

20

---

ITEM 7. FINANCIAL STATEMENTS

|Report
      of Independent Registered Public Accounting Firm                                                     | F-1
|----------------------------------------------------------------------------------------------------------------- | ---
|                                                                                                                  |    
|Consolidated
      Balance Sheet as of June 30, 2006                                                              | F-2
|                                                                                                                  |    
|Consolidated
      Statements of Operations - Twelve Months ended June 30, 2006 and 2005                          | F-3
|                                                                                                                  |    
|Consolidated
      Statements of Stockholders' Equity (Deficit) Twelve Months Ended June 30,
      2006 and 2005 | F-4
|                                                                                                                  |    
|Consolidated
      Statements of Cash Flows - Twelve months ended June 30, 2006 and 2005                          | F-5
|                                                                                                                  |    
|Notes
      to Consolidated Financial Statements                                                                  | F-6

21

---

REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM

To the Stockholders Terax Energy, Inc.

Dallas, Texas

We have audited the accompanying consolidated balance sheet of
  Terax Energy, Inc. (the Company) as of June 30, 2006, and the related
  statements of operations, stockholders equity, and cash flows for the
  two year period then ended. These consolidated financial statements are the
  responsibility of the Companys management. Our responsibility is to express
  an opinion on these financial statements based on our audits.

We conducted our audit in accordance with standards of the Public
  Company Accounting Oversight Board (United States). Those standards require
  that we plan and perform the audits to obtain reasonable assurance about whether
  the financial statements are free of material misstatement. An audit includes
  examining, on a test basis, evidence supporting the amounts and disclosures
  in the financial statements. An audit also includes assessing the accounting
  principles used and significant estimates made by management, as well as evaluating
  the overall financial statement presentation. We believe that our audits provide
  a reasonable basis for our opinion.

In our opinion, based on our audit, the consolidated financial
  statements referred to above present fairly, in all material respects, the consolidated
  financial position of the Company as of June 30, 2006, and the results of its
  operations and its cash flows for the two year period then ended in conformity
  with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been
  prepared assuming that the Company will continue as a going concern. As discussed
  in Note 2 to the consolidated financial statements, the Company has suffered
  recurring losses from operations and has a working capital deficiency, which
  raises substantial doubt about its ability to continue as a going concern. Management's
  plans regarding these matters also are described in Note 2. The financial statements
  do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Malone & Bailey, PC 
  Malone & Bailey, PC 
www.malone-bailey.com
  Houston, Texas

September 28, 2006

F-1

---

TERAX ENERGY, INC. CONSOLIDATED BALANCE SHEETAs of June 30, 2006

|ASSETS                                                                                                       |  
|------------------------------------------------------------------------------------------------------------ | -
|                                                                                                             |  
|Current Assets:                                                                                              |  
|Cash                                                                                                         | $
|Prepaid expenses, and advances to operators                                                                  |  
|                                                                                                             |  
|Total Current Assets                                                                                         |  
|Property, Plant and Equipment:                                                                               |  
|Oil and natural gas properties, successful
      efforts method of accounting:                               |  
|Proved properties, net                                                                                       |  
|Unproved properties not being amortized, net
      of impairment                                             |  
|Pipeline and gathering system, net of accumulated depreciation
      of $195,730                             |  
|Furniture and equipment, net of accumulated
      depreciation of $20,880                                    |  
|                                                                                                             |  
|Total Property, Plant and Equipment, Net                                                                     |  
|Other assets                                                                                                 |  
|                                                                                                             |  
|Total Assets                                                                                                 | $
|                                                                                                             |  
|LIABILITIES AND STOCKHOLDERS' DEFICIT                                                                        |  
|                                                                                                             |  
|Current Liabilities:                                                                                         |  
|Accounts payable and accrued expense                                                                         | $
|Accrued liabilities                                                                                          |  
|Note payable                                                                                                 |  
|Derivative liability                                                                                         |  
|                                                                                                             |  
|Total Current Liabilities                                                                                    |  
|                                                                                                             |  
|Non-Current Liabilities:                                                                                     |  
|                                                                                                             |  
|Asset retirement obligation                                                                                  |  
|                                                                                                             |  
|Commitments and Contingencies                                                                                |  
|                                                                                                             |  
|Stockholders' Deficit:                                                                                       |  
|Preferred stock, $.001 par value, authorized
      5,000,000 shares;                                         |  
|none issued and outstanding                                                                                  |  
|                                                                                                             |  
|Common stock, $.001 par value, authorized 300,000,000 shares;
      60,579,029 shares issued and outstanding |  
|Additional paid-in capital                                                                                   |  
|Accumulated deficit                                                                                          |  
|                                                                                                             |  
|Total Stockholders' Deficit                                                                                  |  
|                                                                                                             |  
|Total Liabilities and Stockholders' Deficit                                                                  | $

See accompanying summary of accounting policies and notes to
consolidated financial statements.

F-2

---

TERAX ENERGY, INC.CONSOLIDATED STATEMENTS OF
OPERATIONS Years Ended June 30, 2006 and 2005

|                                                                   |   | 2006        |   |   | 2005        |  
|------------------------------------------------------------------ | - | ----------- | - | - | ----------- | -
|                                                                   |   |             |   |   |             |  
|Revenues                                                           | $ | 148,636     |   | $ | -           |  
|                                                                   |   |             |   |   |             |  
|Expenses:                                                          |   |             |   |   |             |  
|Lease operating expenses                                           |   | 129,108     |   |   | -           |  
|Depletion, depreciation and amortization                           |   | 1,237,230   |   |   | -           |  
|Impairment of oil & gas properties                                 |   | 9,817,123   |   |   | -           |  
|General and administrative                                         |   | 3,250,689   |   |   | 59,360      |  
|                                                                   |   |             |   |   |             |  
|Total expenses                                                     |   | 14,434,150  |   |   | 59,360      |  
|                                                                   |   |             |   |   |             |  
|Loss from operations                                               |   | (14,285,514 | ) |   | (59,360     | )
|Other income (expenses):                                           |   |             |   |   |             |  
|Interest income and other                                          |   | 88,195      |   |   | -           |  
|Interest expense                                                   |   | (660,203    | ) |   | -           |  
|Loss on derivative liability                                       |   | (8,161,075  | ) |   | -           |  
|                                                                   |   |             |   |   |             |  
|Other income (expenses)                                            |   | (8,733,083  | ) |   | -           |  
|                                                                   |   |             |   |   |             |  
|Net loss to common stockholders                                    | $ | (23,018,597 | ) | $ | (59,360     | )
|                                                                   |   |             |   |   |             |  
|Basic and diluted loss per common share                            | $ | (0.42       | ) | $ | (0.00       | )
|                                                                   |   |             |   |   |             |  
|Basic and diluted weighted average common
      shares outstanding |   | 54,820,513  |   |   | 133,858,094 |  

See accompanying summary of accounting policies and notes to
consolidated financial statements.

F-3

---

TERAX ENERGY, INC.CONSOLIDATED STATEMENT OF
STOCKHOLDERS' DEFICIT

Common StockAdditional
      
      
      
      
      
      TotalPaid-In
      
      
      Accumulated
      
      
      Stockholders'Shares
      
      
      Amount
      
      
      Capital
      
      
      Deficit
      
      
      EquityBalance at June 30, 2004
      
      144,225,000
      
      $
      144,225
      
      $
      (96,425
      )
      $
      (29,699
      )
      $
      18,101Shares Issued for asset
      
      1,508,498
      
      
      1,508
      
      
      1,470,093
      
      
      -
      
      
      1,471,601Shares issued for cash
      
      81,502
      
      
      82
      
      
      79,361
      
      
      -
      
      
      79,443Shares rescinded per agreement
      
      (99,650,000
      )
      
      (99,650
      )
      
      99,650
      
      
      -
      
      
      -Net Loss
      
      -
      
      
      -
      
      
      -
      
      
      (59,360
      )
      
      (59,360
      )Balance at June 30, 2005
      
      46,165,000
      
      
      46,165
      
      
      1,552,679
      
      
      (89,059
      )
      
      1,509,785Shares issued for cash
      
      18,717,600
      
      
      18,718
      
      
      13,939,263
      
      
      -
      
      
      13,957,981Warrants issued
      
      -
      
      
      -
      
      
      1,192,608
      
      
      -
      
      
      1,192,608Shares return to treasury
      
      (4,700,000
      )
      
      (4,700
      )
      
      4,700
      
      
      -
      
      
      -Derivative warrants
        issued to placementagent
      
      -
      
      
      -
      
      
      (1,198,353
      )
      
      -
      
      
      (1,198,353
      )Shares issued
        for interest
      
      371,429
      
      
      371
      
      
      499,629
      
      
      -
      
      
      500,000Shares issued
        for compensation
      
      25,000
      
      
      25
      
      
      49,975
      
      
      -
      
      
      50,000Net Loss
      
      -
      
      
      -
      
      
      -
      
      
      (23,018,597
      )
      
      (23,018,597
      )Balance
        at June 30, 2006
      
      60,579,029
      
      $
      60,579
      
      $
      16,040,501
      
      $
      (23,107,656
      )
      $
      (7,006,576
      )


See accompanying summary of accounting policies and notes to
consolidated financial statements.

F-4

---

TERAX ENERGY, INC.CONSOLIDATED STATEMENTS OF CASH
FLOWS Years Ended June 30, 2006 and 2005

|                                                                                  |   | 2006        |   |   | 2005      |  
|--------------------------------------------------------------------------------- | - | ----------- | - | - | --------- | -
|                                                                                  |   |             |   |   |           |  
|Cash Flows from Operating Activities:                                             |   |             |   |   |           |  
|Net loss                                                                          | $ | (23,018,597 | ) | $ | (59,360   | )
|Adjustments to reconcile net loss to net cash used in operating
      activities: |   |             |   |   |           |  
|Shares issued for compensation                                                    |   | 50,000      |   |   | -         |  
|Asset retirement obligation                                                       |   | 932         |   |   | -         |  
|Deprecation, depletion and
      amortization                                     |   | 1,237,230   |   |   | -         |  
|Impairment of oil and gas
      properties                                        |   | 9,817,123   |   |   | -         |  
|Unrealized loss on derivative
      liability                                     |   | 8,161,075   |   |   | -         |  
|Changes in current assets and liabilities                                         |   |             |   |   |           |  
|Increase in prepaid expenses,
      deposits and advances to operators            |   | (510,330    | ) |   | (49,339   | )
|Increase
      in accounts payable                                                |   | 835,597     |   |   | -         |  
|Increase in accrued liabilities                                                   |   | 383,347     |   |   | 27,769    |  
|Increase
      in asset retirement obligation                                     |   | 24,399      |   |   | -         |  
|Increase in deposits                                                              |   | (12,471     | ) |   | -         |  
|                                                                                  |   |             |   |   |           |  
|Net cash provided by (used in) operating activities                               |   | (3,031,695  | ) |   | (80,930   | )
|Cash Flows from Investing Activities:                                             |   |             |   |   |           |  
|Purchase of oil and gas leases                                                    |   | (5,171,549  | ) |   | -         |  
|Investments
      in drilling and equipment                                       |   | (10,171,277 | ) |   | -         |  
|Investments in pipeline and
      gathering system                                |   | (5,963,138  | ) |   | -         |  
|Investments
      in furniture and fixtures                                       |   | (148,963    | ) |   | -         |  
|                                                                                  |   |             |   |   |           |  
|Net cash used in investing activities                                             |   | (21,454,927 | ) |   | -         |  
|Cash Flows from Financing Activities:                                             |   |             |   |   |           |  
|                                                                                  |   |             |   |   |           |  
|Proceeds from issuance of
      common stock, net of issuance costs               |   | 22,749,880  |   |   | 79,443    |  
|Proceeds
      from issuance of debt                                              |   | 10,325,000  |   |   | -         |  
|Repayment of debt                                                                 |   | (7,825,000  | ) |   | -         |  
|                                                                                  |   |             |   |   |           |  
|Net cash provided by financing activities                                         |   | 25,249,880  |   |   | 79,443    |  
|                                                                                  |   |             |   |   |           |  
|Net Increase (Decrease) in
      Cash                                             |   | 763,258     |   |   | (1,487    | )
|Cash at the
      Beginning of Period                                             |   | 16,614      |   |   | 18,101    |  
|                                                                                  |   |             |   |   |           |  
|Cash at the
      End of Period                                                   | $ | 779,872     |   | $ | 16,614    |  
|                                                                                  |   |             |   |   |           |  
|Supplemental disclosure of cash flow information                                  |   |             |   |   |           |  
|Cash paid during the year
      for:                                              |   |             |   |   |           |  
|Interest                                                                          | $ | 118,251     |   | $ | -         |  
|Taxes                                                                             |   | -           |   |   | -         |  
|Common stock
      for interest                                                   | $ | 500,000     |   | $ | -         |  
|Common stock for oil and
      gas properties                                     | $ | -           |   | $ | 1,471,601 |  

See accompanying summary of accounting policies and notes to
consolidated financial statements.

F-5

---

Terax Energy, Inc.Notes to Consolidated Financial
Statements

NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Terax Energy, Inc. (Terax) or (the Company) is an
independent, oil and gas exploration and development company headquartered in
Dallas, Texas. Terax was organized on October 17, 2000 in Nevada as Royal
Phoenix. Royal Phoenix began activities to license, manufacture, and distribute
vitamin formulations. These activities ceased in 2001. On March 15, 2005, the
Company changed its name to Terax Energy, Inc. . Our principal properties
consist of two large blocks of oil and gas leases, one covering approximately
11,300 gross acres in the aggregate in close proximity to each other in Erath
County, Texas and one covering a block of approximately 16,200 gross acres in
the aggregate in close proximity located in Comanche County, Texas, both of
which permit us to drill and develop the Barnett Shale formation underlying the
lease acreage.

The Company has drilled six and completed four horizontal wells
in Erath County. In addition the Company has installed approximately eight miles
of eight inch pipeline which is connected to the Louis Dreyfus Pipeline, two
compression, and separation facilities, and four miles of six inch gathering
lines connecting the four completed wells. Provided the Company can secure
additional financing, the Company plans to continue completion of its remaining
wells and evaluation of the undeveloped Erath and Comanche County acreage.

Use of Estimates

Our financial statements are prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of our financial statements requires us to make estimates and judgments that
affect the reported amount of assets, liabilities, revenues, and expenses. These
estimates are based on information that is currently available to us and on
various other assumptions that we believe to be reasonable under the
circumstances. Actual results could vary significantly from those estimates
under different assumptions and conditions.

Critical accounting policies are defined as those significant
accounting policies that are most critical to an understanding of a company's
financial condition and results of operation. We consider an accounting estimate
or judgment to be critical if (i) it requires assumptions to be made that were
uncertain at the time the estimate was made, and (ii) changes in the estimate or
different estimates that could have been selected could have a material impact
on our results of operations or financial condition.

Change in fiscal year

On August 4, 2005, Terax changed its fiscal year from December
  31 to June 30.

Risk Factors Related to Concentration of Sales and Products

The Company's future financial condition and results of
operations will depend upon prices received for its oil and natural gas and the
costs of finding, acquiring, developing and producing reserves. Prices for oil
and natural gas are subject to fluctuations in response to changes in supply,
market uncertainty and a variety of other factors beyond the Company's control.
These factors include worldwide political instability (especially in the Middle
East), the foreign supply of oil and natural gas, the price of foreign imports,
the level of consumer product demand and the price and availability of
alternative fuels.

Cash and cash equivalents

For the purpose of the statements of cash flows, all highly
liquid investments with an original maturity of three months or less are
considered to be cash equivalents.

Fair Value of Financial Instruments

The Company measures its financial assets and liabilities in
accordance with accounting principles generally accepted in the United States of
America. For certain of the Company's financial instruments, including prepaid
expenses, deposits and advances to operators, accounts payable and accrued
expenses, the carrying amounts approximate fair value due to their short
maturities. The amounts owed for long-term debt also approximate fair value
because interest rates and terms offered to the Company are at current market
rates.

F-6

---

Principles of Consolidation

The consolidated financial statements include the accounts of
Terax Energy, Inc. and its subsidiaries. All significant intercompany
transactions and balances associated with the consolidated operations have been
eliminated.

Successful Efforts Accounting

Terax follows the successful efforts method to account for its
crude oil and natural gas operations. Under this method of accounting, all costs
associated with oil and gas lease acquisition costs, successful exploratory
wells and all development wells are capitalized and amortized on a
unit-of-production basis over the remaining life of proved developed reserves
and proved reserves on a field basis. Unproved leasehold costs are capitalized
pending the results of exploration efforts. Exploration costs, including
geological and geophysical expenses, exploratory dry holes and delay rentals,
are charged to expense when incurred.

Impairment of Properties

Terax reviews proved properties at the field level when
management determines that events or circumstances indicate that the recorded
carrying value of the properties may not be recoverable. Such events include a
projection of future oil and natural gas reserves that will be produced from a
field, the timing of this future production, future costs to produce the oil and
natural gas, and future inflation levels. If the carrying amount of an asset
exceeds the sum of the undiscounted estimated future net cash flows. The Company
recognizes impairment expense equal to the difference between the carrying value
and the fair value of the asset which is estimated to be the expected present
value of future net cash flows from proved reserves, utilizing a risk-free rate
of return. The Company cannot predict the amount of impairment charges that may
be recorded in the future. Unproved leasehold costs are reviewed periodically
and a loss is recognized to the extent, if any, that the cost of the property
has been impaired.

Valuation of Property and Equipment

The Company follows the provisions of Statement of Financial
Accounting Standards No. 144 Accounting for Impairment or Disposal of Long-Lived
Assets (SFAS 144). SFAS 144 requires that the Company's long-lived assets,
including its oil and gas properties, be assessed for potential impairment in
their carrying values whenever events or changes in circumstances indicate such
impairment may have occurred. Impairment is recognized when the estimated
undiscounted future net cash flows of the asset are less than its carrying
value. Any such impairment is recognized based on the differences in the
carrying value and estimated fair value of the impaired asset.

SFAS 144 provides for future revenue from the Company's oil and
gas production to be estimated based upon prices at which management reasonably
estimates such products will be sold. These estimates of future product prices
may differ from current market prices of oil and gas. Any downward revisions to
management's estimates of future production or product prices could result in an
impairment of the Company's oil and gas properties in subsequent periods.

The long-lived assets of the Company, which are subject to
evaluation, consist primarily of oil and gas properties. During the fiscal year
ended June 30, 2006 the Company recorded an impairment loss of $7,593,446 on
proved oil gas reserves and exploration expenses related to unproved properties
of $2,223,677.

Other Property and Equipment

Other property and equipment of the Company consists primarily
of computer equipment, vehicles and furniture and fixtures, which are
depreciated over estimated useful lives, ranging from three to seven years, on a
straight-line basis. Repairs and maintenance are expensed as incurred while
costs incurred that extend the useful life are capitalized.

Asset Retirement Obligations

The company follows the provisions of Financial Accounting
Standards Board Statement No. 143, Accounting for Asset Retirement

Obligations (SFAS No. 143). This accounting standard requires
entities to record the fair value of a liability for an asset retirement
obligation in the period in which it is incurred. When the liability is
initially recorded, the entity capitalizes a cost by increasing the carrying
amount of the related long-lived asset. Over time, the liability is accreted to
its present value each period, and the capitalized cost is depreciated over the
useful life of the related asset. Upon settlement of the liability, an entity
either settles the obligation for its recorded amount or incurs a gain or loss
upon settlement.

Following is a reconciliation of the asset retirement
obligation liability for the year ended June 30, 2006:

F-7

---

Asset retirement obligation at July 1, 2005
    $
    -Liabilities incurred
    
      23,467Liabilities settled
    
    -Accretion expense
    
    932Asset retirement obligation at June 30,
      2006
    $
    24,399


Revenue Recognition

The Company recognizes oil and natural gas revenue for its
interest in producing wells as oil and natural gas is produced and sold from
those wells. Oil and natural gas sold by the Company is not significantly
different from the Company's share of production.

Income Taxes

The Company uses the asset and liability method of accounting
for income taxes. Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amount of existing assets and liabilities and their
respective tax bases. The Company records a valuation allowance to reduce the
deferred tax assets to the amount that is more likely than not to be realized.

Loss Per Common Share

Basic net loss per common share is computed using the weighted
average number of common shares outstanding.

Diluted net loss per common share is computed by dividing the
net loss, adjusted on an "as if converted" basis, by the weighted average number
of common shares outstanding plus potential dilutive securities. For fiscal 2006
and 2005, potential dilutive securities had an anti-dilutive effect and were not
included in the calculation of diluted net loss per common share.

Recent Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board (FASB)
issued SFAS Statement No. 154 (SFAS 154), Accounting Changes and Error
Corrections. SFAS 154 requires that, when a company changes its accounting
policies, the change must be applied retrospectively to all prior periods
presented instead of a cumulative effect adjustment in the period of the change.
SFAS 154 may also apply when the FASB issues new rules requiring changes in
accounting. If the new rule allows cumulative effect treatment, it will take
precedence over SFAS 154. This statement is effective for fiscal years beginning
after December 15, 2005. The adoption of SFAS 154 is not expected to have a
significant impact on the Companys financial position or its results of
operations.

In June 2006, the Financial Accounting Standards Board (FASB)
issued FASB Interpretation No. 48, Accounting for Uncertainty in Income taxes
(FIN 48). FIN 48, which is an interpretation of SFAS No. 109, Accounting for
Income Taxes, provides guidance on the manner in which tax positions taken or
to be taken on tax returns should be reflected in an entitys financial
statements prior to their resolution with taxing authorities. The Company is
required to adopt FIN 48 during the first quarter of fiscal 2008. The Company is
currently evaluating the requirements of FIN 48 and has not yet determined the
impact, if any; this interpretation may have on its consolidated financial
statements.

NOTE 2  GOING CONCERN

Terax's financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and settlement of
liabilities and commitments in the normal course of business for the foreseeable
future. Since inception, the Company has accumulated losses aggregating to
$23,107,656 and has insufficient working capital to meet operating needs for the
next twelve months as of June 30, 2006, all of which raise substantial doubt
about Terax's ability to continue as a going concern.

Management's plans for Terax's continued existence include
selling additional stock , sale assets or borrowing additional funds to pay
current accounts payables, short-term debt, and overhead expenses. In addition,
the Company will need to rasie additional capital for development of is
properties or enter into joint ventures with other operators in order to execute
its business plan..

Teraxs future success is dependent upon its ability to achieve
profitable operations, generate cash from operating activities and obtain
additional financing. There is no assurance that Terax will be able to generate
sufficient cash from operations, sell additional shares of common stock or
borrow additional funds.

Terax's inability to obtain additional cash could have a
material adverse effect on its financial position, results of operations and its
ability to continue in existence. The consolidated financial statements do not
include any adjustments that might result from the outcome of this uncertainty.

F-8

---

NOTE 3  INCOME TAXES

The Company uses the liability method, where deferred taxes and
liabilities are determined based on the expected future tax consequences of
temporary differences between the carrying amounts of assets and liabilities for
financial and income tax reporting purposes. During fiscal 2005 and 2004, the
company incurred net losses and, therefore, has no tax liability. The net
deferred tax asset generated by the loss carry-forward has been fully reserved.
The valuation allowance increased by approximately $8 million during 2006. The
cumulative net operating loss carry-forward is approximately $23 million at June
30, 2006, and will expire in the years 2025 through 2026.

At June 30, 2006 and 2005, deferred tax assets consisted of the
following:

2006
    
    
    2005Deferred tax assetsNet operating loss carry
      forward
    $
    8,076,441
    
    $
      19,932Valuation
      allowance
    
    (8,076,441
    )
    
    (19,932
    )Net deferred tax asset
    $
    -
    
    $
    -


NOTE 4  STOCKHOLDERS EQUITY (DEFICIT)

Sale of Securities

From August 8, 2005 through September 14, 2005, the Company
issued 739,000 Units at a price of $10.00 per Unit for gross proceeds to the
Company of $7,390,000. Each Unit consists of eight shares of the Companys
common stock and four non-transferable share purchase warrants. Each warrant is
exercisable at a price of $1.75 per share, subject to acceleration upon certain
conditions. The value of the warrants, using the Black Scholes method of
calculation, was $1,192,608. In addition, the Company incurred fees totaling
$285,000 in connection with the offering.

With respect to Units discussed above, the Company agreed to
use its best efforts to file a registration statement with the Securities and
Exchange Commission on or before March 14, 2006 to register the resale of the
shares of common stock sold in the offering and issuable upon exercise of the
warrants. In addition, the Company agreed to use its best efforts to cause the
registration statement to be declared effective by the SEC as soon as
practicable after filing. The Company filed the registration statement with the
Securities and Exchange Commission on March 9, 2006. In the event the
registration statement is not declared effective, the Company is not obligated
to pay any liquidated damages and there are no requirements to settle in cash if
the Company cannot deliver registered shares.

The Company evaluated the application of Statement of Financial
Accounting Standard (SFAS) No. 133, Accounting for Derivative Instruments and
Hedging Activities and Emerging Issues Task Force (EITF) 00-19, Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Companys Own Stock for the units issued. Based on the guidance of SFAS No. 133
and EITF 00-19, the Company concluded that the warrants issued in connection
with the 739,000 Unites were properly classified as equity instruments and were
not required to be accounted for as derivatives.

On February 7, 2006, the Company entered into securities
purchase agreements to sell to four institutional investors an aggregate of
12,805,600 shares of the Companys common stock and warrants to purchase an
additional 12,805,600 shares of common stock, for an aggregate purchase price of
$16,007,000. The unit purchase price of the common stock and corresponding
warrant was $1.25. The warrants are exercisable at an exercise price of $1.50
per share and expire on February 6, 2011. The Company has the right to require
exercise of all of the warrants in the event that (i) a registration statement
registering the resale of the warrants is then in effect and (ii) the volume
weighted average trading price per share of the Companys common stock for each
of the previous thirty trading days is in excess of $2.50.

The aggregate commissions paid in connection with the February
7, 2006 private placement were approximately $862,120. In addition, warrants to
purchase 574,120 shares of common stock, identical to those sold to the
investors, except with an exercise price of $1.25 per share were issued to the
placement agent. The pricing of the securities was agreed to with the lead
institutional buyer in early January 2006 when the Companys stock was trading
in the $1.75 range and represents an approximate 30% discount to the market
price at that time. The fair value of the warrants, as determined using the
Black Scholes pricing model, issued to the placement agent was $1,198,353 and
was recorded as an equity issuance cost and is reflected in the balance sheet as
a reduction to paid-in capital.

With respect to February 7, 2006 private placement, the Company
also entered into registration rights agreements with the investors to register
the resale of the shares of common stock sold in the offering and issuable upon
exercise of the warrants. Subject to the terms of the registration rights
agreement, the Company is required to file the registration statement with the
Securities and Exchange Commission within 30 days of the

F-9

---

closing, to use its best efforts to cause the Registration
Statement to be declared effective under the Securities Act of 1933 (the Act)
within 60 days following the closing date of the offering, or 120 days following
the closing of the offering if the registration statement is reviewed by the
Securities and Exchange Commission. In the event the registration statement is
not filed or declared effective when due, the Company is obligated to pay the
investors liquidated damages in the amount of 1.5% of the purchase price for
each month in which the Company is in default.

The Company is accounting for the warrants associated with the
sale of its common stock in the February 7, 2006 private placement, in
accordance with SFAS 133 Accounting for Derivative instruments and Hedging
Activities and EITF 00-19 Accounting for Derivative Financial Instruments
Indexed to and Potentially Settled in a Companys Own Stock. The accounting
treatment of these derivative financial instruments requires that the Company
record the derivatives at their fair values as of the date of the sale of the
common stock and at fair value as of each subsequent balance sheet date as a
liability. At February 7, 2006 the proceeds were allocated between the common
stock and the warrants. The allocation was based on the value of the common
stock issued utilizing the closing price of the common stock on February 7, 2006
and the fair market value of the warrants as determined using the Black Scholes
pricing model. The proceeds were allocated $7,099,291, to the fair value of the
warrants and recorded as a liability, and the remaining $8,907,709 was allocated
to the common stock. The allocated value of the common stock was recorded as
$8,894,903 in additional paid in capital, and $12,806 in common stock. The
Company is required to record the unrealized changes in fair value in subsequent
periods as an adjustment to the current liability with unrealized changes in the
fair value of the derivative reflected in the statement of operations as
(gain)/loss on derivative liabilities. The Company estimates fair value using
the Black Scholes option pricing model. This model requires the use of estimates
such as the expected holding period, the expected future volatility of the
Companys common stock and the risk-free rate of return over the holding period.
These estimates directly affect the reported amounts of the derivative
instrument liabilities. The fair value of the warrants at February 7, 2006, was
$27,045,484. The excess of the fair value of the warrants over the allocated
purchase price was $19,946,193, of which $1,198,353 representing the fair value
of the warrants issued to the placement agent was recorded as an equity issuance
cost and is reflected in the balance sheet as a reduction to the paid in capital
and the remaining $18,747,840 was recorded in the statement of operations as a
loss on derivative liability. The significant assumptions used in the valuation
were: the exercise price as noted above; Teraxs common stock price on February
7, 2006, which was $2.65; expected volatility of 79.92%; risk free interest rate
of approximately 4.5%, and a term of 5 years. At June 30, 2006 the fair value of
the warrants was again determined utilizing the Black Scholes valuation model.
The fair value of the warrants at June 30, 2006 was $16,458,719. The significant
assumptions used in the valuation were: the exercise price as noted above;
Teraxs common stock price on June 30, 2006, which was $1.80; expected
volatility of 79.22%; risk free interest rate of approximately 5.1%, and a term
of four years and six months. The resulting unrealized change in fair value of
$10,586,765 from February 7, 2006 to June 30, 2006 was recorded in the statement
of operations as a gain on derivative liability resulting in a net loss on
derivative liability for the period of $8,161,075.

On February 2, 2006 the Company and certain current and former
directors, officers and agents of the Company entered into a Master Compromise
and Settlement Agreement with J. William Rhea, IV pursuant to which the parties
resolved all outstanding claims between them. As part of the resolution, 800,000
shares of the Companys common stock were issued to Mr. Rhea. In addition, the
Company paid Mr. Rhea $800,000 on account of compensation due to him under his
employment agreement with the Company.

Stock Return to Treasury

In March 2005, Mr. Chester acquired 105,150,000 shares which
had been previously issued by the Company from October 2000 through August 2003
from one of our former officers. Subsequently, Mr. Chester sold 5,000,000 shares
to Mr. Rhea.

On June 7, 2005, Mr. Rhea and Mr. Chester returned, without
consideration, 5,000,000 and 500,000 shares, respectively, to the treasury
pursuant to a Management Stock Pool Agreement which is discussed below.

On June 13, 2005, to facilitate our private placement offering,
discussed below, Mr. Chester agreed to cancel 99,650,000 shares held by him.
There were no additional terms with respect to such Mr. Chesters agreement to
cancel the 99,650,000 shares.

Management Compensation

Management Group Stock Plan

Pursuant to the terms of the Management Stock Pool Agreement
between the Company and certain of its officers and directors dated June 7,
2005, the officers and directors agreed that in the event of resignation or, in
the event of termination for cause, the officers and directors would forfeit the
opportunity to earn any additional stock under the plan.

On October 26, 2005, Mr. Chester resigned his positions of
Director and Vice President of the Company. As provided for in the Management
Group Stock Agreement, Mr. Chesters resignation resulted in forfeiture to earn
500,000 shares under the plan.

On November 10, 2005, Mr. Rhea was terminated for cause and was
removed as officer and director of the Company. As provided for in the
Management Group Stock Agreement, Mr. Rheas termination resulted in forfeiture
to earn 5,000,000 shares under the plan.

There are currently no shares held in escrow which are subject
to the Management Group Stock Plan.

F-10

---

Management Stock and Options Grants

On October 17, 2005, the Company hired a VP of Operations on an
at will basis. In addition the Company agreed to issue options to acquire
500,000 in common stock at a price of $2.80 per share for a period of 5 years.
The options will vest in equal amounts, over three years from the date of
issue.

On November 15, 2005, the Company hired a Chief Financial
Officer and interim Chief Executive Officer on an at will basis. The Company
has agreed to issue 500,000 shares of common stock as a stock bonus.

On February 8, 2006, the Company retained the services of a
Controller and Chief Accounting Officer on an at will basis. The Company has
agreed to issue 200,000 shares of common stock as a stock bonus to be earned
100,000 at December 31, 2006 and 100,000 at December 31, 2007. In addition the
Company has agreed to issue options to acquire 200,000 shares of common stock at
a price of $2.43 per share for a period of 5 years. The options will vest in
equal amounts, over two years from the date of issue.

The holders of the stock and option grants discussed above have
agreed to waive their rights to the stock and option grants since the 2006
Incentive Stock Plan was approved by the Company's shareholders. Upon the
approval in May 2006 by shareholders owning a majority of the Companys Stock,
the holders waived their rights to the stock and option grants. In exchange for
the waiver of their rights to the stock and option grants, the holders received
stock grants pursuant to the 2006 Incentive Stock Plan, which is discussed
below.

2006 Incentive Stock Plan

The 2006 Incentive Stock Plan has initially reserved 3,200,000
shares of common Stock for issuance. Under the 2006 Incentive Stock Plan,
options may be granted which are intended to qualify as Incentive Stock Options
under Section 422 of the Internal Revenue Code of 1986 or which are not intended
to qualify as Incentive Stock Options there under. Under the 2006 Stock
Incentive Plan, options, stock grants, or restricted stock may be granted to key
employees, officers, directors or consultants of the Company, as provided in the
2006 Stock Incentive Plan.

On February 27, 2006, the Board of Directors approved certain
stock grants to three employees, subject to the approval of shareholders of the
Company. With respect to each of the following grants, 40% of such shares would
be earned on January 1, 2007 and 60% would be earned on January 1, 2008.

|Grantee          | Position      | Shares   
|---------------- | ------------- | ---------
|Lawrence J. Finn | CEO and CFO   | 1,500,000
|Sam M. Governale | VP Operations | 250,000  
|Joyce Moore      | Secretary     | 100,000  

The Companys 2006 Stock Incentive Stock Plan was approved by
shareholders owning a majority of the Companys stock in May 2006.

NOTE 5  RELATED PARTY TRANSACTIONS

For the twelve months ended June 30, 2006, $379,586, of legal
fees and reimbursable expenses, were incurred with a law firm in which a
Director is a partner of the law firm.

For the twelve months ended June, 2006, fees totaling $175,115
were paid by the Company to a Director for services rendered in managing certain
litigation matters.

NOTE 6  NOTES PAYABLE

During the quarter ended September 30, 2005, the Company
borrowed $325,000 bearing interest at 6% per annum. The amount, including $1,110
in interest, was repaid during the first quarter.

On December 2, 2005 for $2,500,000, December 19, 2005 for
$1,600,000, and January 26, 2006 for $900,000, the Company issued promissory
notes (the Notes) to an investor with aggregate principal amounts of
$5,000,000. The Notes bear interest at the rate of 12.5% per annum, and are due
on demand after May 31, 2006. The Notes may be repaid at any time by the
Company. The Notes are secured by a security interest in all of the Companys
oil and gas leases and pipeline right of ways and easements in Erath County,
Texas, as well as well and pipeline equipment and personal property, contracts
and agreements, and production from the Companys wells located on the leases.

On February 1, 2006, the Company issued an additional
promissory note (the Additional Note) with a principal amount of $2,500,000 to
an investor. The Additional Note has the same terms as the Notes as follows: it
bears interest at the rate of 12.5% per annum, it is due on demand after May 31,
2006, and it may be repaid at any time by the Company. On February 2, 2006, the
Company issued a total of 215,517 shares of the Companys common stock as
further consideration for the Notes and the Additional Note. The Company has
agreed to issue an additional

F-11

---

84,483 share of common stock as further compensation for the
Notes and the Additional Note. In the Event of Default, the holder of the Notes
and the Additional Note has the right but not the obligation to seek remedies
for repayment of the notes including but not limited to foreclosure and sale of
the secured assets.

On February 17, 2006, the Company repaid $7,500,000 principal
plus accrued interest of $117,106. In addition, $375,000 was charged to interest
expense for common stock issued in connection with the notes. As result of the
repayment, the holder of the notes released all his security interest in the
properties.

On May 12, 2006, the Company issued a promissory note in the
  principal amount of $2,500,000 to an investor. The Note bears interest at the
  rate of 12.5% per annum, payable on repayment of the Note. The Note is due on
  demand after December 31, 2006. In addition, interest in the amount of $125,000
  is due and payable in 71,429 shares of the Companys common stock at closing.
  The Note is secured by a security interest in all of the Companys oil
  and gas leases and pipeline right of ways and easements in Erath County, Texas,
  as well as well and pipeline equipment and personal property, contracts and
  agreements, and production from the Companys wells located on the leases.
  In the Event of Default, the holder of the note has the right but not the obligation
  to seek remedies for repayment of the notes including but not limited to foreclosure
  and sale of the secured assets.

NOTE 7  CONTINGENCIES AND OBLIGATIONS

Leases

On December 8, 2005 the Company entered into a one (1) year
lease for a field office in Stephenville, Texas, The office space has
approximately 1,188 square feet, and rental is rate is approximately $1,300 per
month. The Company has the right to renew the lease for up to two (2) years. On
January 24, 2006 the Company signed a three (3) year office lease for
approximately 2,893 square feet in Dallas, Texas. The month rental rate is
$5,726 per month. The Stephenville lease expires December 31, 2006 and the
Dallas lease expires January 31, 2009. The total rent expense for the fiscal
year ended June 30, 2006 was $36,430.

Future minimum annual rental payments for these leases are as
follow

Year ending June 302007
    $
    76,5122008
    
    68,7122009
    
    40,082$
    185,306


Registration Obligation

Subject to the terms of the registration rights agreement, the
Company was required to file the registration statement with the Securities and
Exchange Commission within 30 days of the closing, to use its best efforts to
cause the Registration Statement to be declared effective under the Securities
Act of 1933 (the Act) within 60 days following the closing date of the
offering, or 120 days following the closing of the offering if the registration
statement is reviewed by the Securities and Exchange Commission. In the event
the registration statement is not filed or declared effective when due, the
Company is obligated to pay the investors liquidated damages in the amount of
1.5% of the purchase price for each month in which the Company is in
default.

The date the registration needed to become effective with the
Securities and Exchange commission to avoid any registration penalty was June 7,
2006. However, the Company did not get the registration effective with the
Securities and Exchange Commission until August 14, 2006. As a result the
Company has incurred a total registration penalty of $536,783 of which $181,559
has been accrued as of June 30, 2006.

NOTE 8- SUBSEQUNT EVENTS

On July 20, 2006, an action was commenced in the District Court
  of Erath County, Texas, against the Company by Centex Pipeline Construction,
  Inc. for failure to pay for services performed, breach of contract and to foreclose
  on Plaintiffs mechanic lien. The Complaint alleges that the Company and
  Centex entered into an agreement for to install certain components of a gas
  pipeline gathering system on the Companys Mitchell Ranch property in Erath
  County, Texas. The Complaint further alleges that the Plaintiff completed work
  on June 5, 2006 and that the Company has failed to pay certain outstanding invoices.
  The Plaintiffs have filed a mechanics lien to create a security
  interest against the gathering line and compressor station. The Plaintiffs
  are seeking damages in the amount of $510,319 plus interest, attorney fees and
  entry of an Order of Sale directing the Sheriff to sell the property covered
  by the Plaintiffs mechanic lien.

F-12

---

Terax
has filed a general denial and a Counterclaim and third-party claim for
declaratory judgment in response to Centexs petition and has requested
discovery. A motion for summary judgment filed by Centex is pending.

The
Company plans to seek a settlement with Centex and its bank provided that the
Company can be assured that no subcontractors will file liens on Teraxs
property and that Terax has no risk of liability to Centexs bank for not making
all payments directly to the bank. Alternatively, the Company may ask the court
to accept a payment of funds into the registry of the court in order to protect
Terax from further liability and cost.

On
August 28, 2006, an action was commenced in the District Court of Travis County,
Texas, against the Company, Andrew Hromyk and Starr County Energy, Inc. by Sam
Warren and Tennessee Eastern Oil & Gas, Inc. for damages for breach of a
personal services contract with the Plaintiffs or in the alternative, based upon
the doctrine of quantum merit, for value of services which Plaintiffs allegedly
rendered to Defendants. The complaint alleges that in early 2006, Tennessee
Eastern and Starr County entered into an agreement to purchase certain oil and
gas properties located in Tennessee, which agreement was terminated. The
complaint alleges that Hromyk continued discussions with Plaintiff Warren and
indicated that a lawsuit filed against the Company by William Rhea was impeding
the potential sale of the Tennessee property, at which point, Warren offered to
assist with settling the William Rhea lawsuit. The complaint further alleged
that Plaintiffs negotiated and mediated a settlement of the William Rhea lawsuit
and that after the lawsuit was settled, the Defendants breached their agreement
to purchase the Tennessee property for $5.7 million. The Plaintiffs are seeking
a judgment against the Defendants in the amount of $5.7 million and attorneys
fees and expenses and costs of court.

By
agreement with Plaintiffs counsel, a response to the lawsuit is not due from
Company. until November 6, 2006. The Company and the other Defendants believe
that the allegations of the Plaintiffs are without merit and they are vigorously
contesting the allegations made by the Plaintiffs in this lawsuit.

On September 22, 2006, an action was commenced in the District
Court of Erath County, Texas, by Geosite, Inc. against the Company and Bill
Chester for breach of contract and foreclosure of lien. The Plaintiff alleges
that the Company has failed to pay for certain goods, merchandise or services
sold to the Company. The Complaint is seeking $10,930 allegedly owed to the
Plaintiffs, attorney fees and an order of foreclosure of Plaintiffs lien. The
Company plans to respond to the Geosite lawsuit in a timely manner but plans to
reach a settlement with Geosite in the near future provided funds are
available.

On October 5, 2006, an action was commenced in the District
Court of Erath County, Texas, by BJ Services Company, USA against the Company
for breach of contract and foreclosure of lien. The Plaintiff alleges that the
Company has failed to pay for certain goods, merchandise, or services sold to
the Company. The Complaint is seeking $475,844.25 plus interest and allegedly
owed to the Plaintiffs attorney fees and an order of foreclosure of Plaintiffs
lien The Company plans to respond to the BJ Services lawsuit in a timely manner
but plans to reach a settlement with BJ Services in the near future provided
funds are available.

NOTE 9 - SUPPLEMENTARY FINANCIAL INFORMATION FOR OIL AND GAS
PRODUCING ACTIVITIES (UNAUDITED)

All of our operations are directly related to oil and gas
producing activities located in Texas.

Capitalized Costs Relating to Oil and Gas Producing
Activities

|June 30,                                    |  |   | 2006       |   |   | 2005      | 
|------------------------------------------- |  | - | ---------- | - | - | --------- | 
|Proved oil and gas properties               |  | $ | 1,742,658  |   | $ | -         | 
|Unproved oil and gas properties             |  |   | 9,587,310  |   |   | 1,471,601 | 
|Total capitalized costs                     |  |   | 11,329,968 |   |   | 1,471,601 | 
|Less accumulated depreciation and depletion |  |   | (1,023,691 | ) |   | -         | 
|Net Capitalized Costs                       |  | $ | 10,306,277 |   | $ | 1,471,601 | 

Costs Incurred in Oil and Gas Producing Activities

|For the Fiscal
      Years Ended June 30,                         |  |   | 2006       |  |   | 2005      | 
|----------------------------------------------------------------- |  | - | ---------- |  | - | --------- | 
|                                                                  |  |   |            |  |   |           | 
|Acquisition of proved properties                                  |  | $ | -          |  | $ | -         | 
|Acquisition of unproved properties                                |  |   | 5,171,549  |  |   | 1,471,601 | 
|Development costs                                                 |  |   |            |  |   | -         | 
|Exploration costs                                                 |  |   | 20,443,473 |  |   | -         | 
|Asset retirement costs recognized according
      to SFAS No. 143 |  |   | 24,399     |  |   | -         | 
|                                                                  |  |   |            |  |   |           | 
|Total Costs Incurred                                              |  | $ | 25,639,421 |  | $ | 1,471,601 | 

F-13

---

|Results of Operations from Oil and Gas Producing Activities |  |   |            |   |   |      | 
|----------------------------------------------------------- |  | - | ---------- | - | - | ---- | 
|For the Fiscal
      Years Ended June 30,                   |  |   | 2006       |   |   | 2005 | 
|                                                            |  |   |            |   |   |      | 
|Oil and gas revenues                                        |  | $ | 148,636    |   | $ | -    | 
|Production
      costs                                      |  |   | (117,253   | ) |   | -    | 
|Production taxes                                            |  |   | (11,855    | ) |   | -    | 
|Depreciation
      and Depletion                            |  |   | (1,023,691 | ) |   | -    | 
|                                                            |  |   |            |   |   |      | 
|Results
      of operations before income taxes             |  |   | (1,004,163 | ) |   | -    | 
|Provision for income taxes                                  |  |   | -          |   |   | -    | 
|                                                            |  |   |            |   |   |      | 
|Results of Oil and Gas Producing Operations                 |  | $ | (1,004,163 | ) | $ | -    | 

Proved Reserves

Our proved oil and gas reserves have been estimated by
independent petroleum engineers. Proved reserves are the estimated quantities
that geologic and engineering data demonstrate with reasonable certainty to be
recoverable in future years from known reservoirs under existing economic and
operating conditions. Proved developed reserves are the quantities expected to
be recovered through existing wells with existing equipment and operating
methods. Due to the inherent uncertainties and the limited nature of reservoir
data, such estimates are subject to change as additional information becomes
available. The reserves actually recovered and the timing of production of these
reserves may be substantially different from the original estimate. Revisions
result primarily from new information obtained from development drilling and
production history; acquisitions of oil and gas properties; and changes in
economic factors. Our proved reserves are summarized in the table below.

Crude Oil and
    
    
    NaturalNatural Gas
    
    
    GasLiquids
    
    
    McfBbls.Reserves at July 1, 2005
    
    -
    
    
    -Extensions, discoveries and other additions
    
    26,674
    
    
    353,552Revisions of prior estimates
    
    -
    
    
    -Production
    
    (461
    )
    
    (20,407
    )Reserves at June 30, 2006
    
    26,213
    
    
    333,145Proved producing reserves
    
    26,213
    
    
    333,145


Standardized Measure

The standardized measure of discounted future net cash flows
(standardized measure) and changes in such cash flows are prepared using
assumptions required by the Securities and Exchange Commission. Such assumptions
include the use of year-end prices for oil and gas and year-end costs for
estimated future development and production expenditures to produce year-end
estimated proved reserves. Discounted future net cash flows are calculated using
a 10% rate.

As of June 30, 2006, estimated well abandonment costs, net of
salvage, are deducted from the standardized measure using year-end costs. Such
abandonment costs are recorded as a liability on the consolidated balance sheet,
using estimated values of the projected abandonment date and discounted using a
risk-adjusted rate at the time the well is drilled or acquired.

The standardized measure does not represent management's
estimate of our future cash flows or the value of proved oil and gas reserves.
Probable and possible reserves, which may become proved in the future, are
excluded from the calculations. Furthermore, year-end prices used to determine
the standardized measure of discounted cash flows, are influenced by seasonal
demand and other factors, and may not be the most representative in estimating
future revenues or reserve data.

F-14

---

Price and cost revisions are primarily the net result of
changes in year-end prices, based on beginning of year reserve estimates.
Quantity estimate revisions are primarily the result of the extended economic
life of proved reserves and proved undeveloped reserve additions attributable to
increased development activity.

The standardized measure of discounted estimated future net
cash flows related to proved crude oil and natural gas reserves at June 30, 2006
and 2005 is as follows:

Standardized Measure of Discounted Future Cash Flows:

|                                                        |   | 2006       |   |   | 2005 | 
|------------------------------------------------------- | - | ---------- | - | - | ---- | 
|                                                        |   |            |   |   |      | 
|Future cash inflows                                     | $ | 2,791,166  |   | $ | -    | 
|Future production costs                                 |   | (1,950,766 | ) |   | -    | 
|Future development costs                                |   | -          |   |   | -    | 
|Future income taxes                                     |   | -          |   |   | -    | 
|                                                        |   |            |   |   |      | 
|Future net cash flows                                   |   | 840,400    |   |   | -    | 
|10% annual discount                                     |   | (126,328   | ) |   | -    | 
|                                                        |   |            |   |   |      | 
|Standardized measure of discounted net cash
      flows | $ | 714,072    |   | $ | -    | 

The primary changes in the standardized measure of discounted
estimated future net cash flows for the year ended June 30, 2006 and 2005 are as
follows:

Changes in Standardized Measure of Discounted Future Cash
Flows:

2006
    
    
    2005Balance at July 1, 2005
    $
    -
    
    $
    -Net changes in prices and production costs
    
    -
    
    
    -Net changes in future development costs
    
    -
    
    
    -Sales of oil and gas produced, net
    
    (148,636
    )
    
    -Extensions, discoveries and other additions
    
      862,708
    
    
    -Revisions of previous quantity estimates
    
    -
    
    
    -Previously estimated development costs
      incurred
    
    -
    
    
    -Net change in income taxes
    
    -
    
    
    -Accretion of discount
    
    -
    
    
    -Other
    
    -
    
    
    -Balance at June 30, 2006
    $
      714,072
    
    $
    -


F-15

---

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
  AND FINANCIAL DISCLOSURE

None

ITEM 8A. CONTROLS AND PROCEDURES

(a)
Evaluation of Disclosure Controls and Procedures. As of the end of the period
covered by this report, we conducted an evaluation, under the supervision and
with the participation of our chief executive officer and chief financial
officer of our disclosure controls and procedures (as defined in Rule 13a-15(e)
and Rule 15d-15(e) of the Exchange Act). Based upon this evaluation, our chief
executive officer and chief financial officer concluded that our disclosure
controls and procedures were not effective to ensure that the information
required to be disclosed by us in the reports that we file or submit under the
Exchange Act is (i) recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commissions rules and forms,
and (ii) is accumulated and communicated to our management, including our chief
executive officer and chief financial officer, to allow timely decisions
regarding required disclosure.

In
connection with the completion of its audit of, and the issuance of its report
on the financial statements of the Company for the year ended June 30, 2006,
Malone & Bailey, PC identified a deficiency in our internal controls
primarily relating to the accounting for certain derivative financial
instruments. The adjustment relating to this item was detected in the audit
process and has been appropriately recorded and disclosed in this Form 10-KSB.
We are in the process of improving our internal controls in an effort to
remediate this deficiency. Additional effort is needed to fully remedy this
deficiency and we are continuing our efforts to improve and strengthen our
control processes and procedures. Our management and directors will continue to
work with our auditors and other outside advisors to ensure that our controls
and procedures are adequate and effective.

(b)
  Changes in internal controls. There was no change in our internal controls or
  in other factors that could affect these controls during our last fiscal quarter
  that has materially affected, or is reasonably likely to materially affect,
  our internal control over financial reporting.

ITEM 8B. OTHER INFORMATION

Effective
  October 12, 2006, John Legg and Phillip Wylie submitted the resignation as Directors
  of the Company.

22

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PART III

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

MANAGEMENT

|Name              | Age | Position                                                            
|----------------- | --- | --------------------------------------------------------------------
|                  |     |                                                                     
|Lawrence J. Finn  | 61  | President, Chief
      Executive Officer and Chief Financial Officer
|                  |     |                                                                     
|Sam. M. Governale | 55  | Vice-President of
      Operations                                  
|                  |     |                                                                     
|Andrew Hromyk     | 39  | Director                                                            
|                  |     |                                                                     
|Stephen Cochennet | 50  | Director                                                            
|                  |     |                                                                     
|David H. Pratt    | 56  | Director                                                            

Each
of our directors is elected by stockholders to a term of one year and serves
until his or her successor is elected and qualified. Each of our officers is
elected by the board of directors to a term of one year and serves until his or
her successor is duly elected and qualified, or until he is removed from office.
The board of directors has no nominating, compensation or audit committees. We
do not have an "audit committee financial expert" as defined in Item 401(e) of
Regulation S-B. Our Board of Directors believes that attracting and retaining
board members that could be classified as an "audit committee financial expert"
is unlikely due to the high cost of such Director candidates.

Currently,
our Directors are not compensated for their services, although their expenses in
attending meetings are reimbursed. Officers are elected by the Board of
Directors and serve until their successors are appointed by the Board of
Directors.

Lawrence
J. Finn was appointed Chief Financial Officer and Interim Chief Executive
Officer of Terax on November 10, 2005 and on January 26, 2006 he was appointed
Chief Executive Officer on a permanent basis. In addition, on April 19, 2006,
Mr. Finn was appointed as our President. Mr. Finn was most recently vice
president of finance and chief financial officer of Petrol Oil & Gas, a
public natural gas company, from May through November 2005. From 2001 until
2005, Mr. Finn served as vice president of finance, then as project coordinator
for shale projects for CDX Gas, LLC, a private natural gas company. Mr. Finn
served as vice president and chief financial officer of The Wiser Oil Company
from 1993 to 2000. Wiser was a New York Stock Exchange oil exploration and
production company. Mr. Finn served in various other capacities in the oil and
gas industry since 1973. Mr. Finn is a Certified Public Accountant and received
a Bachelor of Business Administration degree from the University of Houston.

Sam
M. Governale was appointed Vice-President of Field Operations on September
29, 2005. From August, 2002 to August 2005 Mr. Governale served as production
superintendent of Swift Energy Co. From March 2001 to August 2002 Mr. Governale
served as quality, health, safety, and environment (QHSE) manager for
Schlumberger Oilfield Services. From January 1990 to May 2000 Mr. Governale was
operations manager for Baker Energy.

Andrew
Hromyk was appointed a member of the Board of Directors on October 31, 2005.
For the past 10 years, Mr. Hromyk has been president of Century Capital
Management Ltd.; an independent venture capital management firm hat makes
strategic investments in the energy, wireless, and telecom sectors. Mr. Hromyk
has been a director of several publicly traded companies, including WPCS
International Inc.

Stephen
Cochennet was appointed a member of the Board of Directors on April 19,
2006. 1985 to 2002, Mr. Cochennet held executive positions with UtiliCorp United
(Aquila) in Kansas City. His responsibilities included finance, administration,
operations, human resources, corporate development, gas/energy marketing, and
managing several new start- up subsidiaries. Prior to his experience at
Aquila/UtiliCorp United, Mr. Cochennet served 6 years with the Federal Reserve
System. Mr. Cochennet formed the CSC Group through which he supports a number of
clients that include Fortune 500 corporations, international companies,
gas/electric utilities, outsource service providers, as well as various start up
organizations. The services provided include strategic planning, capital
formation, corporate development, executive networking, and transaction
structuring. He also serves on several advisory boards. Mr. Cochennet graduated
from the University of Nebraska in Lincoln with a bachelors degree in economics
and finance.

23

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David
Pratt was appointed a member of the Board of Directors on April 19, 2006.
Mr. Pratt has served in different capacities with Harvest Natural Resources,
formerly Benton Oil and Gas Company, and most recently served as its Chief
Financial Officer from 1989 through 1994 and from 2000 through 2001. Mr. Pratt
also held various finance positions with Cincom Systems and Lawson Associates
from 1986 through 1989. He also served in various positions with May Petroleum,
Inc from 1982 through 1986 and with Arthur Andersen from 1974 through 1982. Mr.
Pratt graduated from Texas Christian University with a Bachelor of Science
degree and an MBA. Mr. Pratt is also a certified public accountant.

Effective
  October 12, 2006, John Legg and Phillip Wylie submitted the resignation as Directors
  of the Company. In addition to being a Director John Legg was a member of the
  Compensation Committee.

Conflicts of Interest

We
  believe that director Andrew Hromyk may be subject to conflict of interest.
  Mr. Hromyk’s conflict of interest may arise from the fact that he is a
  founding shareholder of Terax Energy, Inc.

ITEM 10. EXECUTIVE COMPENSATION

The
following table sets forth information with respect to the total compensation
paid or accrued by us for the twelve months period ended June 30, 2006, six
month period ended June 30, 2005 and the three years ended December 31, 2004 on
behalf of each of our named executive officers during such periods.

SUMMARY COMPENSATION TABLE

ANNUAL
      LONG TERM COMPENSATIONCOMPENSATIONAwards
      Payouts
      AllPosition Name and Principal
      Year
      Salary
      Bonus
      Other
      Restricted
      Securities
      
      other($)
      ($)
      annual
      stock
      underlying
      LTIP payouts
      compen -compensation
      award(s)
      options/SARs
      ($)
      sation ($)($)
      ($)
      (#)J. William Rhea IV (1)
      2005 (2)
      $93,454
      Nil
      Nil
      Nil
      Nil
      Nil
      NilChief Executive Officer
      2006
      $48,958Bill Chester (3)
      2005 (2)
      $7,500
      Nil
      Nil
      Nil
      Nil
      Nil
      NilPresident
      2006
      $37,500Joseph Wilson (4)
      2005 (2)
      NilPresident
      2004
      Nil
      Nil
      Nil
      Nil
      Nil
      Nil
      Nil2003
      NilLawrence J. Finn (5)
      2006
      $109,375
      Nil
      Nil
      Nil
      Nil
      Nil
      NilPresident, CEO and CFORichard C. Binz (6)
      2006
      $41,850
      Nil
      Nil
      Nil
      Nil
      Nil
      NilController and CAOSam M. Governale (7)
      2006
      $113,333
      Nil
      Nil
      Nil
      Nil
      Nil
      NilVice President of Operations


| | (1) | Appointed Chief Executive Officer May 27, 2005 and
      terminated on October 31, 2005.                                                                             
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (2) | Six Month Period Ended June 30, 2005.                                                                                                                                
| | (3) | Appointed President March 22, 2005. Resigned as President
      and appointed as Vice President on May 27, 2005. Resigned as Vice
      President on October 1, 2005.
| | (4) | Resigned as President March 22, 2005.                                                                                                                                
| | (5) | Appointed Interim Chief Executive Office and Chief
      Financial Officer on November 10, 2005 and President and Chief executive
      Officer on January 29, 2006. 
| | (6) | Appointed Controller and CAO on January 26, 2006 and
      resigned as Controller and CAO on August 25, 2006.                                                        

24

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| | (7) | Appointed as Vice President of Operations on September
      29, 2005.
| | --- | ----------------------------------------------------------------------

During the years ended December 31, 2004 and 2003, we did not
pay any compensation to our named executive officers.

Director Compensation

Members
of our Board of Director who are not otherwise employed by us will receive an
annual compensation of $10,000 which will be paid in equal quarterly payments.
In addition, each non-employee director will receive 25,000 shares of our common
stock, 12,500 will be issued upon their appointment to the Board of Directors
and 12,500 will be issued upon the first anniversary after joining the Board,
which shares will be issued pursuant to the 2006 Terax Energy, Inc. Incentive
Stock Plan.

The
Chairman of our Audit Committee will be paid an annual compensation of $10,000
which will be paid in equal quarterly payments. Each member of the Audit
Committee will receive an annual compensation of $5,000 which will be paid in
equal quarterly payments.

Each
member of our Board of Directors will be reimbursed for all reasonable out of
pocket expenses incurred for travel to and from board and committee meetings and
in the performance of his duties as a member of our Board of Directors.

Employment Agreements with Executive Officers

On
September 29, 2005, Sam M. Governale was appointed as our Vice President of
Operations. Mr. Governale receives an annual salary of $160,000, subject to
increases based on periodic performance reviews and customary benefits. In
addition, we agreed to award to Mr. Governale options to acquire 500,000 shares
of our common stock. On February 26, 2006, we agreed to issue 250,000 shares to
Mr. Governale pursuant to our 2006 Incentive Stock Plan, subject to certain
earn-in provisions, in exchange for the obligation to issue 500,000 options. We
do not currently have a written agreement with Mr. Governale.

On
November 10, 2005, Lawrence J. Finn was appointed as our chief financial officer
and interim chief executive officer. Mr. Finn receives an initial salary of
$175,000 per year, together with customary benefits. In addition, we agreed to
award to Mr. Finn 500,000 shares of our common stock. On February 26, 2006, we
agreed to issue 1,500,000 shares to Mr. Finn pursuant to our 2006 Incentive
Stock Plan, subject to certain earn-in provisions, in exchange for the
obligation to issue 500,000 shares to him. We do not currently have a written
agreement with Mr. Finn.

Audit Committee

We
have an audit committee comprised of Stephen Cochennet and David Pratt. The
audit committee's responsibilities include: (i) reviewing the independence,
qualifications, services, fees, and performance of the independent auditors,
(ii) appointing, replacing and discharging the independent auditors, (iii)
pre-approving the professional services provided by the independent auditors,
(iv) reviewing the scope of the annual audit and reports and recommendations
submitted by the independent auditors, and (v) reviewing our financial reporting
and accounting policies, including any significant changes, with management and
the independent auditors. The Audit Committee also prepares the Audit Committee
report that is required pursuant to the rules of the SEC.

Compensation Committee

We
  have a compensation committee comprised of Stephen Cochennet and David Pratt.
  The audit committee's responsibilities include: (i) develop guidelines and review
  the compensation and performance of officers of the company, (ii) making recommendations
  to the Board of Directors with respect to incentive compensation plans, (iii)
  develop managerial succession of the Company, (iv) review major organizational
  matters (v) review director compensation, (vi) annually review and reassess
  the adequacy of the charter. The Compensation Committee also prepares the Compensation
  Committee report that is required pursuant to the rules of the SEC

Benefit Plans

We
do not have a defined benefit, pension plan, profit sharing, or other retirement
plan.

On
February 27, 2006, the Board of Directors adopted the 2006 Terax Energy, Inc.
Incentive Stock Plan. In May 2006, we obtained the written consent of
shareholders owning a majority of the Companys stock to the Companys 2006
Stock Incentive Stock Plan.

Description of the 2006 Terax Energy, Inc. Incentive Stock
Plan

The
2006 Incentive Stock Plan has initially reserved 3,200,000 shares of common
Stock for issuance. Under the 2006 Incentive Stock Plan, options may be granted
which are intended to qualify as Incentive Stock Options ("ISOs") under Section
422 of the Internal Revenue Code of 1986 (the "Code") or which are not
("Non-ISOs") intended to qualify as Incentive Stock Options there under. In
addition, direct grants of stock or restricted stock may be awarded.

25

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Purpose.
The primary purpose of the 2006 Incentive Stock Plan is to attract and retain
the best available personnel in order to promote the success of our business and
to facilitate the ownership of our stock by employees and others who provide
services to us.

Administration.
The 2006 Incentive Stock Plan is administered by our Board of Directors, as the
Board of Directors may be composed from time to time. Notwithstanding the
foregoing, the Board of Directors may at any time, or from time to time, appoint
a committee of at least two members of the Board of Directors, and delegate to
the committee the authority of the Board of Directors to administer the 2006
Incentive Stock Plan. Upon such appointment and delegation, the committee shall
have all the powers, privileges and duties of the Board of Directors, and shall
be substituted for the Board of Directors, in the administration of the 2006
Incentive Stock Plan, subject to certain limitations.

Eligibility.
Under the 2006 Stock Incentive Plan, options may be granted to key employees,
officers, directors or consultants of the Company, as provided in the 2006 Stock
Incentive Plan.

Terms
of Options. The term of each option granted under the 2006 Incentive Stock
Plan shall be contained in a stock option agreement between the optionee and
Terax Energy and such terms shall be determined by the Board of Directors
consistent with the provisions of the 2006 Stock Incentive Plan, including the
following:

(a)
Purchase Price. The purchase price of the common stock subject to each incentive
stock option shall not be less than the fair market value (as set forth in the
2006 Incentive Stock Plan), or in the case of the grant of an incentive stock
option to a principal stockholder, not less that 110% of fair market value of
such common stock at the time such option is granted. The purchase price of the
common stock subject to each non-incentive stock option shall be determined at
the time such option is granted, but in no case less than 85% of the fair market
value of such common stock at the time such option is granted;

(b)
Vesting. The dates on which each option (or portion thereof) shall be
exercisable and the conditions precedent to such exercise, if any, shall be
fixed by the Board of Directors, in its discretion, at the time such option is
granted. All options or grants which include a vesting schedule will vest in
their entirety upon a change of control transaction as described in the 2006
Incentive Stock Plan;

(c)
Expiration. The expiration of each option shall be fixed by the Board of
Directors, in its discretion, at the time such option is granted; however,
unless otherwise determined by the Board of Directors at the time such option is
granted, an option shall be exercisable for ten years after the date on which it
was granted, or five years for grants to certain executive officers. Each option
shall be subject to earlier termination or repurchase as expressly provided in
the 2006 Incentive Stock Plan or as determined by the Board of Directors, in its
discretion, at the time such option is granted;

(d)
Transferability. No option shall be transferable, except by will or the laws of
descent and distribution, and any option may be exercised during the lifetime of
the optionee only by such optionee. No option granted under the 2006 Incentive
Stock Plan shall be subject to execution, attachment or other process;

(e)
Option Adjustments. The aggregate number and class of shares as to which options
may be granted under the 2006 Incentive Stock Plan, the number and class shares
covered by each outstanding option and the exercise price per share thereof (but
not the total price), and all such options, shall each be proportionately
adjusted for any increase decrease in the number of issued common stock
resulting from split-up spin-off or consolidation of shares or any like Capital
adjustment or the payment of any stock dividend; and

(f)
Termination, Modification, And Amendment. The 2006 Incentive Stock Plan (but not
options previously granted under the plan) shall terminate ten years from the
date of its adoption by the Board of Directors, and no option or shares shall be
granted after termination of the 2006 Incentive Stock Plan. Subject to certain
restrictions, the 2006 Incentive Stock Plan may at any time be terminated and
from time to time be modified or amended by the affirmative vote of the holders
of a majority of the outstanding shares of the capital stock of the Terax Energy
present, or represented, and entitled to vote at a meeting duly held in
accordance with the applicable laws of the State of Nevada.

On
February 27, 2006, the Board of Directors approved certain stock grants to four
employees, subject to the approval of shareholders of Terax Energy. In May 2006,
we obtained the written consent of shareholders owning a majority of the
Companys stock to the Companys 2006 Stock Incentive Stock Plan. With respect
to each of the following grants, 40% of such shares would be earned on January
1, 2007 and 60% would be earned on January 1, 2008.

Grantee
    Position
    SharesLawrence J. Finn
    CEO and CFO
    1,500,000Sam M. Governale
    VP Operations
    250,000Joyce Moore
    Secretary
    100,000


Indemnification Agreements

On
December 23, 2005, we entered into indemnification agreements with our then
current officers and members of the Board of Directors. The agreements were
unanimously approved by the Board of Directors and were deemed to be effective
as of May 18, 2005.

26

---

Pursuant to the agreements, each indemnitee is indemnified to
the fullest extent permitted by law for all judgments, penalties, fines,
settlement amounts, costs, or expenses which they may incur as a result of or in
connection with their service to Terax Energy.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The
following table sets forth certain information regarding beneficial ownership of
our common stock as of October 12, 2006.

- by each person who is known by us to beneficially own more than 5% of our
  common stock;
- by each of our officers and directors; and
- by all of our officers and directors as a group.

|NAME AND ADDRESS                                         | NUMBER OF SHARES      | PERCENTAGE OF      
|-------------------------------------------------------- | --------------------- | -------------------
|OF OWNER(1)                                              | BENEFICIALLY OWNED(2) | COMMON STOCK       
|                                                         |                       | BENEFICIAL OWNED(3)
|                                                         |                       |                    
|Lawrence J. Finn                                         | 1,500,000 (4)         | 2.48%              
|                                                         |                       |                    
|Sam M. Governale                                         | 250,000 (4)           | 0.41%              
|                                                         |                       |                    
|Andrew Hromyk                                            | 1,864,055 (5)         | 3.08%              
|                                                         |                       |                    
|Stephen Cochennet                                        | 12,500                | 0.02%              
|                                                         |                       |                    
|David Pratt                                              | 12,500                | 0.02%              
|                                                         |                       |                    
|Magnetar Capital Master Fund, Ltd.                       | 7,400,000 (6)         | 9.9%               
|                                                         |                       |                    
|All Officers and Directors As a Group ( 7
      persons) | 3,639,055             | 6.0%               

(1) The address for each named person is c/o Terax
Energy, Inc., 13355 Noel Road, 1370 One Galleria Tower, Dallas, Texas 75240.

(2) Beneficial Ownership is determined in accordance
with the rules of the Securities and Exchange Commission and generally includes
voting or investment power with respect to securities. Shares of common stock
subject to options or warrants currently exercisable or convertible, or
exercisable or convertible within 60 days of October 12, 2006 are deemed
outstanding for computing the percentage of the person holding such option or
warrant but are not deemed outstanding for computing the percentage of any other
person.

(3) Based upon 60,591,529 shares outstanding on
October 12, 2006.

(4) Subject to ratification by the Companys
stockholders and earn-in provisions. See Executive Compensation.

(5) Of which 289,910 shares are owned by a company
owned by Mr. Hromyk and 1,574,145 are owned by Mr. Hromyks wife and for which
Mr. Hromyk disclaims beneficial ownership.

(6) Such holder is contractually restricted to
ownership of no more than 9.9% of the common stock then outstanding.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Except as disclosed below, none
of the following parties has in the last two fiscal years had any material
interest, direct or indirect, in any transaction with us or in any presently
proposed transaction that has or will materially affect us:

- Any of our directors or officers;
- Any person proposed as a nominee for election as a director;
- Any person who beneficially owns, directly or indirectly, shares carrying
  more than 10% of the voting rights attached to our outstanding shares of
  common stock;
- Any of our promoters; or
- Any relative or spouse of any of the foregoing persons who has the same
  house as such person.

27

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On
  June 1, 2005, we acquired all of the issued and outstanding securities of Erath
  Energy Inc. from Holywell Technological Investments Ltd. and First Finance Limited.
  Bill Chester, one of our directors at the time of the acquisition, was also
  a director of Erath Energy Inc. First Finance Limited is controlled by Andrew
  Hromyk, who subsequently was appointed to our board of directors. First Finance
  Limited received 289,910 of the 1,590,000 shares issued.

ITEM 13. EXHIBITS

|Exhibit No. | Document Description                                                                                                                                                                                           
|----------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|            |                                                                                                                                                                                                                
|3.1 (1)     | Articles of
        Incorporation                                                                                                                                                                              
|            |                                                                                                                                                                                                                
|3.1.1 (2)   | Certificate
        of Change                                                                                                                                                                                  
|            |                                                                                                                                                                                                                
|3.1.2 (3)   | Certificate
        of Name Change                                                                                                                                                                             
|            |                                                                                                                                                                                                                
|3.1.3 (4)   | Certificate
        of Change                                                                                                                                                                                  
|            |                                                                                                                                                                                                                
|3.1.4       | Certificate
        of Correction                                                                                                                                                                              
|            |                                                                                                                                                                                                                
|3.2 (1)     | Bylaws                                                                                                                                                                                                         
|            |                                                                                                                                                                                                                
|4.1 (5)     | Specimen Stock
        Certificate                                                                                                                                                                             
|            |                                                                                                                                                                                                                
|4.2 (5)     | Specimen Warrant
        Certificated dated August 8, 2005.                                                                                                                                                    
|            |                                                                                                                                                                                                                
|10.1 (1)    | Separation and
        Distribution Agreement dated October 18, 2001, between Desert Health Products,
        Inc. and Royal Phoenix                                                                           
|            |                                                                                                                                                                                                                
|10.2 (1)    | License, Manufacture
        and Distribution Agreement                                                                                                                                                        
|            |                                                                                                                                                                                                                
|10.3 (1)    | Addendum to
        Separation and Distribution Agreement                                                                                                                                                      
|            |                                                                                                                                                                                                                
|10.4 (6)    | Stock Purchase
        Agreement dated May 31, 2005 between Terax Energy, Inc., Holywell Technological
        Investments Ltd., and First Finance Limited.                                                    
|            |                                                                                                                                                                                                                
|10.5 (5)    | Executive Employment
        Agreement between Terax Energy, Inc. and J. William Rhea, IV dated May
        27, 2005.                                                                                          
|            |                                                                                                                                                                                                                
|10.6 (5)    | Executive Employment
        Agreement between Terax Energy, Inc. and Bill Chester dated June 7, 2005.                                                                                                         
|            |                                                                                                                                                                                                                
|10.7 (6)    | Management Group
        Stock Pool Agreement between Terax Energy, Inc., J. William Rhea, IV,
        and Bill Chester dated for reference June 7, 2005.                                                      
|            |                                                                                                                                                                                                                
|10.8 (5)    | Form of Subscription
        Agreement dated for reference June 13, 2005.                                                                                                                                      
|            |                                                                                                                                                                                                                
|21.1 (5)    | Subsidiaries
        of Terax Energy, Inc.                                                                                                                                                                     
|            |                                                                                                                                                                                                                
|31.1        | Certification
        of Chief Executive Officer and Chief Financial Officer pursuant to Rule
        13a-14 and Rule 15d-14(a), Promulgated under the Securities and Exchange
        Act of 1934, as Amended.
|            |                                                                                                                                                                                                                
|32.1        | Certification
        Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906
        of the Sarbanes-Oxley Act of 2002. (Chief Executive Officer and Chief
        Financial Officer)          
|            |                                                                                                                                                                                                                
|99.1 (5)    | Code of Ethics
        and Business Conduct of Officers, Directors, and Employees.                                                                                                                             

28

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|(1) | Incorporated by reference to same exhibit filed with the
      Companys Form SB-2 filed with the SEC on October 26, 2001, SEC File No,
      333-72230.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Incorporated by reference to same exhibit filed with the
      Companys Form 8-K filed with the SEC on October 22, 2004, SEC File No,
      333-72230. 
|(3) | Incorporated by reference to same exhibit filed with the
      Companys Form 8-K filed with the SEC on March 28, 2005, SEC File No,
      333-72230.   
|(4) | Incorporated by reference to same exhibit filed with the
      Companys Form 8-K filed with the SEC on June 9, 2005, SEC File No, 333-
      72230.    
|(5) | Incorporated by reference to same exhibit filed with the
      Companys Form 10-KSB filed with the SEC on August 19, 2005, SEC File No.
      333-72230
|(6) | Incorporated by reference to same exhibit filed with the
      Companys Form 8-K filed with the SEC on June 2, 2005, SEC File No, 333-
      72230.    

29

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ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The Company's board of directors reviews and approves audit and
permissible non-audit services performed by Malone & Bailey, PC, as well as
the fees charged by Malone & Bailey, PC for such services. In its review of
non-audit service fees and its appointment of Malone & Bailey, PC as the
Company's independent accountants, the board of directors considered whether the
provision of such services is compatible with maintaining Malone & Bailey,
PCs independence. All of the services provided and fees charged by Malone &
Bailey, PC in 2006 and 2005 were pre-approved by the board of directors.

Audit Fees

The aggregate fees billed for professional services rendered by
Malone & Bailey, PC for the audit of our financial statements for the twelve
month period ended June 30, 2006 are $42,131, and the aggregate fees billed by
our predecessor auditors Beckstead and Watts for the twelve months ended June
30, 2006 were $1,450.

Audit-Related, Tax and Other Fees

There were no other fees billed by Malone & Bailey, PC or
Beckstead and Watts for 2006 or 2005.

30

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SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

TERAX ENERGY, INC.

|By: | /s/
      Lawrence J. Finn                                                   | 
|--- | ---------------------------------------------------------------------------- | 
|    | Lawrence J. Finn, President, Chief Executive
      Officer                   | 
|    | (Principal Executive Officer), and Chief
      Financial                     | 
|    | Officer (Principal Financial Officer and
      Principal Accounting Officer) | 

In accordance with the Exchange Act, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.

|SIGNATURE                   |  | TITLE                              | DATE            
|--------------------------- |  | ---------------------------------- | ----------------
|                            |  |                                    |                 
|/s/ Lawrence J.
      Finn  |  | President, Chief Executive Officer | October 13, 2006
|Lawrence J. Finn            |  | and Chief Financial Officer        |                 
|                            |  |                                    |                 
|/s/ Andrew
      Hromyk     |  | Director                           | October 13, 2006
|Andrew Hromyk               |  |                                    |                 
|                            |  |                                    |                 
|                            |  |                                    |                 
|/s/ Stephen
      Cochennet |  | Director                           | October 13, 2006
|Stephen Cochennet           |  |                                    |                 
|                            |  |                                    |                 
|                            |  |                                    |                 
|/s/ David
      Pratt       |  | Director                           | October 13, 2006
|David Pratt                 |  |                                    |                 

31

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