UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-KSB

|ý                                       | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934          
|--------------------------------------- | -------------------------------------------------------------------------------------
|For The Fiscal Year Ended June 30, 2004
|o                                       | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF SECURITIES EXCHANGE ACT OF 1934
|For the transition period            to

Commission File Number

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NATURAL GAS SYSTEMS, INC.(Exact name of registrant as specified in charter)

|Nevada(State of incorporation)                                                                     |  | 41-1781991(I.R.S. employer identification number)
|-------------------------------------------------------------------------------------------------- |  | -------------------------------------------------
|820 Gessner, Suite 1340, Houston, Texas 77024(Address of principal executive offices and zip code)
|Registrant's telephone number, including area code:(713) 935-0122                                 

Securities registered pursuant to Section 12(b) of the Exchange Act:

Securities registered pursuant to Section 12(g) of the Exchange Act:Common Stock, $.001 Par Value

(Title
of class and shares outstanding)

Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B is not contained herein, and will not 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.

Indicate
by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 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.
Yes: ý    No o

Issuer's revenues for its most recent fiscal year: $118,158

As
of August 31, 2004, the aggregate market value of common stock held by non-affiliates of the registrant was approximately $19,530,703, assuming solely for purposes of this
calculation that all directors and executive officers of the registrant and all stockholders beneficially owning more than 10% of the registrant's common stock are "affiliates." This determination of
affiliate status is not necessarily a conclusive determination for other purposes.

The
number of shares of common stock outstanding on August 31, 2004 was 23,145,406 shares.

DOCUMENTS
INCORPORATED BY REFERENCE into Part III hereof Portions of the Proxy Statement to be filed with the Commission in connection with the Company's 2004 Annual Meeting.

Transitional
Small Business Format (Check One): Yes o    No ý



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Glossary of Selected Petroleum Terms

The following abbreviations and definitions are terms commonly used in the oil and natural gas industry and throughout this report on Form 10-KSB:

"BBL"A standard measure of volume for crude oil and liquid petroleum products. One barrel equals 42 U.S. gallons.

"BCF"Billion cubic feet of natural gas.

"BOE"Barrels of oil equivalent. Calculated by converting 6 MCF of natural gas to 1 BBL of oil.

"BTU" or "British Thermal Unit"The standard unit of measure of energy equal to the amount of heat required to raise the temperature of
one pound of water 1 degree Fahrenheit. One BBL of crude is typically 5.8 MMBTU, and one standard MCF is typically 1 MMBTU.

"Field"An area consisting of a single reservoir or multiple reservoirs all grouped on or related to the same individual geologic
structural feature and/or stratigraphic feature.

"gross well"The total number of wells participated in, regardless of the amount of working interest owned. (See net wells).

"MBOE"One thousand barrels of oil equivalent.

"MCF"One thousand cubic feet of natural gas at standard conditions, being approximately sea level pressure and 60 degrees Fahrenheit
temperature. Standard pressure in the state of Louisiana is deemed to be 15.025 psi by regulation but varies in other states.

"MMBTU"One million British thermal units (BTU's).

"MMCF"One million cubic feet of natural gas.

"net wells"The aggregate fractional working interests owned, e.g., a 20% working interest in each of 5 gross wells equals one net well.
(See Gross Well).

"NGL"Natural gas liquids, being the combination of ethane, propane, butane and natural gasolines that can be removed from
natural gas through processing, typically through refrigeration plants that utilize low temperatures, or through J-T plants that utilize compression, temperature reduction and expansion to a lower
pressure.

"NYMEX"New York Mercantile Exchange.

"permeability"The measure of ease with which petroleum can move through a reservoir.

"porosity"(of sand or sandstone) The relative volume of the pore space compared to the total bulk volume of the reservoir.

"royalty or royalty interest"The mineral owner's share of oil or gas production (typically 1/8, 1/6 or
1/4), free of costs, but subject to severance taxes unless the lessor is a government. In certain circumstances, the royalty owner bears a proportionate share of the costs of making the
natural gas saleable, such as processing, compression and gathering.

"psi"pounds per square inch, a measure of pressure.

"shut-in well"A well that is not on production, but has not been plugged and abandoned. Wells may be shut-in in anticipation of future
utility as a producing well, plugging and abandonment or other use.

"Standardized measure"The standardized measure is an estimate of future net reserves from a property, and is calculated in the same exact
same fashion as a PV-10 value, except that the projected

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revenue
stream is adjusted to account for the estimated amount of federal income tax that must be paid.

"working interest"The interest in the oil and gas in place which is burdened with the cost of development and operation of the property.
Also called the operating interest.

"work-over"A remedial operation on a completed well to restore, maintain or improve the well's production.

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PART I.

ITEM 1. BUSINESS

General

Natural
Gas Systems, Inc. ("NGS", the "Company", "we", "us" or "our") is a development stage company formed to acquire established crude oil and natural gas properties and exploit them through
the application of conventional and specialized technology, with the objective of increasing production, ultimate recoveries, or both. At June 30, 2004, NGS conducted operations through its
100% working interest in the Delhi Field. The Company currently operates its properties in the State of Louisiana, with three full time employees and a small number of independent contractors and
service providers administered from its Houston office.

NGS
is a Nevada corporation with its corporate headquarters in Houston, Texas. Its telephone number is 713-935-0122.

Corporate History

Reality
Interactive, Inc. ("Reality"), a Nevada corporation, was incorporated on May 24, 1994 for the purpose of developing technology-based knowledge solutions for the industrial
marketplace. On April 30, 1999, this company ceased business operations, sold substantially all of its assets and terminated all of its employees. Subsequent to ceasing operations, Reality
explored potential business opportunities to acquire or merge with an entity with existing operations, while continuing to file reports with the SEC.

On
May 26, 2004, Natural Gas Systems, Inc., a privately owned Delaware corporation formed in September 2003 ("Old NGS"), was merged into a wholly owned subsidiary of Reality.
Reality was thereafter renamed Natural Gas Systems, Inc. and adopted a June 30 fiscal year end. As part of the merger, the officers and directors of Reality resigned and the officers and
directors of Old NGS became the officers and directors of the Company. Immediately prior to the merger, Reality did not conduct any operations and had minimal assets and liabilities.

The
stock of NGS is quoted on the OTC Bulletin Board under the new symbol of NGSY.OB.

All
regulatory filings and other historical information including stock prices prior to June 30, 2004 that applied to Reality continue to apply to the Company after the merger.

Business Activities

NGS
is a development stage company that seeks to acquire majority working interests of oil and gas resources in established fields and redevelop those fields through the application of capital and
technology to convert the oil and gas resources into producing reserves. We focus on established fields with long-lived production from shallow reservoirs, particularly those reservoirs with low
permeability. We believe this provides us with the following advantages:



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Old
NGS purchased its first property in September 2003 through the acquisition of a 100% working interest in the Delhi Unit in northeastern Louisiana (see Properties section below). The
purchase included six producing wells, one salt water disposal well and 37 shut-in wells with aggregate average production of approximately 18 barrels of oil per day
("BOPD") and no gas sales. The Delhi Unit encompasses approximately 13,636 acres. We own rights to the top of the Massive Anhydride Formation, less and
except the Mengel Reservoir, which is being produced by another operator in a small number of wells.

In
late 2003, we executed an agreement with Verdisys, Inc., the holder of the U.S. license rights to a patented lateral drilling technology. Under the license agreement, Verdisys has agreed to
provide us with lateral drilling services based on our projected needs, subject only to adequate advance notice, at a fixed price not to exceed the lowest price offered to any other customer for
similar services. Although we may find the Verdisys technology useful, our business plan does not rely on it. To date, we have used the Verdisys technology in only two wells, the results of which were
inconclusive.

Markets and Customers

Marketing
of oil and natural gas production is influenced by many factors that are beyond our control, the exact effect of which is difficult to predict. These factors include changes in supply and
demand, market prices, government regulation and actions of major foreign producers.

Over
the past 20 years, crude oil price fluctuations have been extremely volatile, with oil prices varying from $8.50, to in excess of $40 per barrel. Worldwide factors such as geopolitical,
macroeconomic, supply and demand, refining capacity, petrochemical production and derivatives trading, among others, influence prices for crude oil. Localized influences include regulation and
transportation issues unique to certain producing regions.

In
the domestic U.S. market where we operate, crude oil and condensate production are readily transportable and marketable. We sell all of our oil production from the Delhi Field to Genesis Petroleum,
LLC, a crude oil purchaser, at competitive spot field prices. We believe that other crude purchasers are readily available.

Similarly
over the last 20 years, domestic natural gas prices have been volatile, ranging from $1 to $9 per MCF. The spot market for natural gas, changes in supply and demand, derivatives
trading, pipeline availability, BTU content of the gas and weather patterns, among others, cause natural gas prices to be subject to significant fluctuations. Due to the practical difficulties in
transporting natural gas, price influences tend to be more localized for natural gas than for crude oil.

All
of our current natural gas production is located in northeastern Louisiana. There is only one gas pipeline sales point readily available, which reduces our leverage in negotiating a more favorable
transportation charge and sales price. The current gas sales line is also a delivery line to customers, downstream of the pipeline's processing and treating facilities, thus making the pipeline very
sensitive to the quality of gas sold into our point of interconnection.

We
presently sell all of our gas under a short-term contract with a gas marketer. We believe that other gas marketers are readily available. The sales price is typically based on either a daily price
average or a monthly "spot" (Index) price for the applicable production region. Title to the gas passes to the purchaser at the metered interconnection to the transportation pipeline, where the Index
price is reduced by certain pipeline charges. Gas sold from the Delhi Field incurs a $0.25 per MMBTU

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deduction
from the Henry Hub price, the primary pricing market for natural gas futures, less an additional $0.085 per MCF charge for transportation. These costs, along with the costs for gas
processing and transportation prior to delivery to the sales point, are deducted from the gas sales receipts before calculation and distribution of royalties.

Competition and Regulation

The
oil and gas industry is highly competitive. As a small independent, we must compete against companies with substantially larger financial and other resources in all aspects of their businesses.

Oil
and gas drilling and production operations are regulated by various Federal, state and local agencies. These agencies issue binding rules and regulations that carry penalties, often substantial,
for failure to comply. We anticipate the aggregate burden of Federal, state and local regulation will continue to increase, including in the area of rapidly changing environmental laws and
regulations. We also believe that our present operations substantially comply with applicable regulations. To date, such regulations have not had a material effect on our operations, or the costs
thereof. There are no known environmental or other regulatory matters related to our operations that are reasonably expected to result in material liability to us that have not been recognized in our
financial statements or their footnotes. We do not believe that capital expenditures related to environmental control facilities or other regulatory matters will be material in the near term. NGS
cannot predict what subsequent legislation or regulations may be enacted or what affect it will have on our operations or business.

RISK FACTORS

Risks related to the Company

Need for additional financing.



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We have a limited operating history.



We may incur unforeseen costs and we may need to raise capital in addition to that required by our business plan.



We utilize licensed technology from third parties in certain aspects of our operations.



Regulatory and accounting requirements may require substantial reductions in proven reserves and limitations of hedging.



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Maintaining reserves and revenue in the future depends on successful development and acquisitions.



We are subject to substantial operating risks.



The loss of key personnel could adversely affect us.



We depend on skilled technical personnel.



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Our operations have significant capital requirements.



We may have difficulty managing future growth and the related demands on our resources and may have difficulty in achieving future growth.



We face strong competition from larger oil and natural gas companies.



The oil and natural gas reserve data included in or incorporated by reference in this report are only estimates and may prove to be inaccurate.



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Any anticipated credit facility may include substantial operating restrictions and financial covenants and we may have difficulty obtaining such credit facility.



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Our acquisition program may be unsuccessful, particularly in light of our recent formation and limited history of acquisitions.



We cannot market our production without the assistance of third parties.



Risks Relating to the Oil and Gas Industry

Oil and Gas Drilling, re-completions and re-working are speculative activities and involve numerous risks and substantial and uncertain costs.



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Reliance on technological development and possible technological obsolescence.



Oil and natural gas prices are highly volatile in general and low prices negatively affect our financial results.



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Government regulation and liability for environmental matters may adversely affect our business and results of operations.



Risks Associated with Our Stock

Our stock price has been and may continue to be very volatile.



Future sales of our common stock in the public market could adversely affect the price of our common stock.



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Future sales of our common stock in the public market could limit our ability to raise capital.



Present management and directors may control the election of our directors and all other matters submitted to the stockholders for approval.



"Penny stock" regulations may impose certain restrictions on marketability of securities.



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The market for our Company's securities is limited and may not provide adequate liquidity.



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ITEM 2. PROPERTIES

Delhi Field.

In
late September, 2003, Old NGS purchased a 100% working interest in the Delhi Field by paying $995,000 in cash, issuing non-interest bearing notes for $1,500,000 and assuming a plugging and
abandonment reclamation liability in the amount of approximately $302,000, in exchange for the conveyance of all the underlying leasehold interests. The notes are collateralized by a first mortgage on
the leasehold interests and are payable to the sellers in twelve equal monthly installments beginning on January 30, 2004. At June 30, 2004, $750,000 remained payable under the notes. In
addition to the mortgage, the property is burdened by an aggregate 20% royalty interest.

The
Delhi Field was discovered in the 1940's and had been extensively developed over the subsequent decades through the drilling and completion of approximately 450 wells. According to W. D. Von
Gonten & Co., the third party reservoir engineering firm that audits our reserves, the field has produced more than 200 million barrels of oil to date, in addition to substantial amounts of
gas. Much of the gas production was stripped of gas liquids and re-injected for pressure maintenance. Beginning in the late 1950's, the field was unitized to conduct a pressure maintenance water flood
project. Unitization is the process of combining multiple leases into a single ownership entity in order to simplify operations and equitably distribute royalties when common operations are conducted
over multiple leases. Drilling operations were completed on primarily 40-acre spacing across the unit's 13,636 acres. A few wells were drilled below the targeted Tuscaloosa sand stone, and many wells
were not drilled below the first producing reservoir.

At
that time of our acquisition in 2003, production at Delhi averaged approximately 18 BOPD, and no gas was being sold due to a lack of gas processing and transportation facilities. The best producing
well, the 161-36, was immediately lost during a periodic sand wash work-over when water from a lower reservoir broke through along the casing and into the producing reservoir.

Currently,
at September 15, 2004, the gross productive rate of the field was approximately 58 BOPD, 600 MCFD of gas and 7 BLPD. Current gas sales have been approximately 500 MCFD, as a portion
of the produced gas is utilized as compressor, dehydrator and pump engine fuel on site.

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The
Company has performed, or is planning to perform in the near term, the following significant development work.

|Well   |  | BOPD
Before |  | BOPD
After |  | MCFD
After |  | Action                                      
|------ |  | ----------- |  | ---------- |  | ---------- |  | --------------------------------------------
|183-3  |  | 1           |  | 5          |  | 5          |  | Re-completion                               
|178-2  |  | 4           |  | 4          |  | 5          |  | Laterally drilled                           
|184-1  |  | 4           |  | 4          |  | 5          |  | Laterally drilled                           
|197-1  |  | 4           |  | 6          |  | 20         |  | Mechanically repaired                       
|197-2  |  | 0           |  | 65         |  | -65        |  | Restored to production                      
|204-2  |  | 0           |  | 0          |  | 200        |  | Re-completion                               
|198-1  |  | 0           |  | 0          |  | 0          |  | Restore to production  shut-in             
|184-2  |  | 0           |  | 0          |  | 400        |  | Re-completion from water injection status   
|210-2  |  | 0           |  | Pending    |  | Pending    |  | Restore to production                       
|215-17 |  | 0           |  | Pending    |  | Pending    |  | Restore to production                       
|180-1  |  | 0           |  | Pending    |  | Pending    |  | Re-completion from water injection status   
|196-3  |  | 0           |  | Pending    |  | Pending    |  | Re-completion of shut-in producer           
|225-1  |  | 0           |  | Pending    |  | Pending    |  | Restore to production                       
|87-2   |  | 0           |  | Pending    |  | Pending    |  | Restore to production                       
|203-2  |  | 0           |  | Pending    |  | Pending    |  | Restore to production                       
|161-36 |  | 10          |  | 0          |  | 0          |  | Periodic sand wash led to water breakthrough
|204-1  |  | SI          |  | 0          |  | 0          |  | Found collapsed casing                      

We
occupy a leased headquarters containing 2,259 square feet in a modern high-rise office building located in the West Memorial area of Houston, Texas. In April 2003, we extended our lease for
three years, without escalators. Other terms include an option for early termination after 18 months, and the right to use furniture and fixtures without cost.

In
March of 2004, we installed a leased gas treating and compression facility under a one-year operating lease. The facility was necessary to begin sales of natural gas, which began in July of 2004,
thus expanding our revenue base as contemplated by our original plan for the Delhi Field.

NGS
maintains insurance on its properties and operations for risks and in amounts customary in the industry. Such insurance includes general liability, excess liability, control of well, operators
extra expense and casualty coverage. Not all losses are insured, and the Company retains certain risks of loss through deductibles, limits and self-retentions. NGS does not carry lost profits
coverage.

For
more complete information regarding current year activities, including oil and gas production, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations".

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Significant Properties, Estimated Proved Oil and Gas Reserves, and Future Net Revenues

NGS
engaged W. D. Von Gonten & Co. ("Von Gonten") to perform an independent review of our proved reserves located in the Delhi Field as of July 1, 2004. Von Gonten also previously
performed an independent review of our proved reserves at January 1, 2004.

Estimates
of reserve quantities and values must be viewed as being subject to significant change as more data about the properties becomes available. All of our existing wells are generally mature
wells, originally drilled as many as 58 years ago. As such, they contain older down-hole equipment that is more subject to failure than new equipment. The failure of such equipment or other
subsurface failure can result in the complete loss of a well.

At
July 1, 2004, natural gas and associated liquids represented 27% and crude oil represented 73% of total proved reserves, denominated in equivalent barrels using a six MCF of gas to one
barrel of oil conversion ratio.

The
following table sets forth, as of July 1, 2004 and January 1, 2004, information regarding our proved reserves based on the assumptions set forth in Note 10 to the Consolidated
Financial Statements where additional reserve information is provided. The average NYMEX prices used to calculate estimated future net revenues were $37.05 and $32.52 per barrel of oil and $6.16 and
$6.19 per MMBTU of gas as of June 30, 2004 and December 31, 2003, respectively. The average NYMEX prices used were adjusted for transportation, market differentials and BTU content of
gas produced. Amounts do not include estimates of future Federal and State income taxes.

Oil
(bbls)

Gas
(Mcf)

Estimated Future
Net Revenues

Estimated Future
Net Revenues
Discounted at 10%Jul 1, 2004

238,904

508,556
*
$
8,121,711

$
6,320,754Jan 1, 2004

240,362

778,700

$
10,065,493

$
8,119,670


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Proved
Developed reserves total 59% of Total Proved reserves, the balance consisting of Proved Behind Pipe reserves.

The
reduction in proved reserves from January 1, 2004 to July 1, 2004 is primarily a result of the reclassification of proved behind pipe reserves associated with the 208-1 well to an
other-than-proved category, offset by the addition of proved reserves for the 204-2 and 184-2 wells and increase in proved reserves assigned to the 87-2 well. The reclassification of the 208-1
reserves resulted from review of previously unavailable information that lowered the probability of recovery below the threshold required for proved reserves.

Production, Average Sales Prices and Average Production Costs

Our
net production quantities and average price realizations per unit for the fiscal periods set forth below. There were no hedging gains or losses.

6 months ended
June 30, 2004

3 months ended
December 31, 2003Product

Volume

Price

Volume

PriceGas (Mcf)

123


5.28




Oil (bbls)

3,180

$
36.95

857

$
28.27


Average
production costs, including production taxes, per unit of production (using a six to one conversion ratio of MCF's to barrels) were $38.90 and $92.54 per barrel for the six months ended

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June 30,
2004 and the three month period ended December 31, 2003, respectively. The high production costs per barrel are a result of substantial expenses related to general field repair.

Productive Wells and Developed Acreage

Developed
acreage at June 30, 2004 totaled 13,636.55 net and gross acres held by a unitization agreement. At June 30, 2004, we owned working interests in 44 net and gross wells
consisting of 6 oil wells, 1 gas well, 1 water disposal well and 36 shut-in wells. Subsequent to June 30, we converted two shut-in wells to producing status.

Undeveloped Acreage

All
working interest acreage owned by the Company is held by production through a unitization agreement and is previously developed.

Drilling

During
fiscal the fiscal year ended June 30, 2004, the Company drilled no new wells.

Subsequent Events

Since June 30, 2004:



See
Item 8B, Other Information, for a further discussion.

ITEM 3. LEGAL PROCEEDINGS

We
are not a party to any material pending legal proceedings. No such proceedings have been threatened and none are contemplated by NGS.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There
were no matters submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders through the solicitation of proxies or otherwise.

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PART II.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

Our
common stock is traded on the OTC Bulletin Board National Association of Securities Dealers Automated Quotation System under the symbol "NGSY" and its predecessor symbol "RLYI". Market quotations
shown below were reported by Media General Financial Services and represent prices between dealers, excluding retail mark-up or commissions, and adjusted for the 40:1 stock split that occurred on
February 5, 2004.

|             |  | Calendar:
|------------ |  | ---------
|
|
|December 31  |  |          
|September 30 |  |          
|June 30      |  | $        
|March 31     |  | $        

At
August 31, 2004, NGS had 241 shareholders of record. We have never paid a cash dividend and we do not expect to pay any cash dividends in the foreseeable future. Earnings, if any, are
expected to be reinvested in business activities. No stock has been repurchased since the inception of the Company.

Securities authorized for issuance under equity compensation plans

On
August 3, 2004, shareholders approved the adoption of our 2004 Stock Option Plan. No options have been granted under this plan. The purpose of the 2004 Plan is to grant stock options to
purchase our common stock to our employees and key consultants

|Plan category                                              |  | Number of securities to be
issued upon exercise of
outstanding options,
warrants and rights
(a) |   | Weighted-average exercise
price of outstanding
options, warrants and
rights
(b) |        | Number of securities remaining
available for future issuance under
equity compensation plans (excluding
securities reflected in column (a))
(c)
|---------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------- | - | ------------------------------------------------------------------------------- | ------ | -----------------------------------------------------------------------------------------------------------------------------------------------
|Equity compensation plans approved by security holders     |  | 600,000(1                                                                                       | ) | $                                                                               | 0.1048 |                                                                                                                                                
|                                                           |  |                                                                                                 |   |                                                                                 |        |                                                                                                                                                
|Equity compensation plans not approved by security holders |  | 319,932(2                                                                                       | ) | $                                                                               | 1.00   |                                                                                                                                                
|                                                           |  |                                                                                                 |   |                                                                                 |        |                                                                                                                                                
|Total                                                      |  | 931,932                                                                                         |   | $                                                                               | 0.4161 |                                                                                                                                                

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Recent Sales of Unregistered Securities

On
May 26, 2004, we, as Reality Interactive, Inc., executed an Agreement and Plan of Merger with Natural Gas Systems, Inc., a private Delaware corporation ("Old NGS"), whereby the
shareholders of Old NGS received 21,749,478 shares of our common stock in exchange for all of the 21,749,748 shares of Old NGS common stock then outstanding. The operations and management of Old NGS
became our own, and we changed our name to Natural Gas Systems, Inc. The shares of stock that were issued in the transaction we believe to be exempt from registration under Regulation D
promulgated under Section 4(2) of the Securities Act. The issuances were a share for share exchange resulting in a similar investment to that originally contemplated due to the continuation of
management and business plan; the recipients in the exchange were accredited investors as defined in Rule 501 of Regulation D promulgated under Section 4(2) of the Securities Act,
and took their shares for investment purposes
without a view to distribution; they had access to information concerning our Company and our business prospects; there was no general solicitation or advertising for the purchase of our shares; there
were no commissions paid; and the securities are restricted pursuant to Rule 144.

In
June of 2004, we sold 249,667 shares of our common stock at a price of $1.00 per share (net of warrants exercised at $0.01 per share) in a private offering we believe to be exempt from registration
under Regulation D promulgated under Section 4(2) of the Securities Act. These shares were subject to certain registration rights. The sales of stock was to an entity that was an
accredited investor, as that term is defined in Rule 501 of Regulation D promulgated under Section 4(2) of the Securities Act and had adequate access to information pertaining to
our Company. Furthermore, no advertisements were made and the securities are restricted pursuant to Rule 144. Offering costs consisted of 19,973 warrants exercisable at $1.00 per share until
June 2011, and fees of $20,000, both payable to the placement agent.

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

As
used herein, the term "three months ended December 31, 2003" refers to our inception date, September 23, 2003, through December 31, 2003.

Liquidity and Capital Resources

As
of June 30, 2004, we had $367,831 of unrestricted cash and negative working capital of $383,352. We incurred losses for the six months period ended June 30, 2004 and three months
period ended December 31, 2003 of $1,027,682 and $336,905, respectively. Our negative working capital of $383,352 was adversely impacted by $732,806 of short-term mortgage notes we owe on the
Delhi Field, payable in approximately equal monthly installments through December 30, 2004 (the "Delhi Notes" See Note 7 to the financial statements for a further description). Although
our cash flow from operations currently approximates our recurring overhead, our cash flow has been, and continues to be, insufficient to cover the Delhi Note payments. Although we are current in our
payments on the Delhi Notes, we have relied on additional funding sources to meet these payments since the beginning of 2004. At September 24, 2004, we owed four remaining monthly payments of
$125,000 each on the Delhi Notes. At that date, we had cash balances of approximately $256,000 and approximately $176,000 of accounts payable due (excluding deferred fees due CMCP).

Our
negative working capital and cash position, as well as our ongoing operating losses, raise concerns about our ability to meet future obligations and fund future operations. Accordingly, management
has and continues to expend considerable time and effort to deal with this issue as discussed below. Subsequent to June 30, 2004, we have been working to improve our liquidity using three
strategies:



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Because
earnings, if any, are anticipated to be reinvested in operations, cash dividends are not expected to be paid in the foreseeable future. Commitments for future capital expenditures were not
material at year-end. The Company has no defined benefit plans and no obligations for post retirement employee benefits.

Product Prices and Production

Refer
to Item 1, "Markets and Customers", for discussion of oil and gas prices and marketing.

Although
product prices are key to our ability to operate profitably and to budget capital expenditures, they are beyond the Company's control and are difficult to predict. Although we have not
entered into any product price hedges, we may do so. Gas sales are completed on a BTU basis and the gas pipeline measures the BTU content at the delivery point. The gas produced at the Delhi Field is
high BTU, with over 1100 BTU per cubic foot of gas from the dry gas wells, and over 1300 BTU in gas associated with the oil wells. Due to the low initial production volumes, the Company utilizes a J-T
gas processing unit that strips out most of the heavier liquids, in accordance with the sales pipeline criteria. However, the J-T unit is not as efficient as more costly methods such as cryogenic
separation, thus the sales gas heat content of 1117 BTU per cubic foot (actual determination for the month of August, 2004)

22

---



currently
is being delivered to the gas sales pipeline is a higher BTU content than the standard of 1000 BTU per cubic foot. When gas production volume increases to a sufficient level, we may switch
to a more efficient processing unit.

Our
net production for the three month period ended December 31, 2003 was 857 BBLs, and, the average price received was $28.27 per BBL. For the six month period ended June 30, 2004, our
net production was 3,180 BBLs and 123 MCF of natural gas, with average prices received of $36.95 per BBL and $5.28 per MCF. Increases in oil and natural gas volumes for the six months period ended
June 30, 2004 over those for the three months ended December 31, 2003 were a result of more months in the period and the successful work-over and restoration to production of several
wells.

Refer
to Item 2, "Properties", for disclosures regarding reserve values.

Oil and Gas Activities

General

Reserves

Refer
to Item 2, "Properties, General, Estimated Proved Oil and Gas Reserves and Future Net Reserves", for information regarding oil and gas reserves.

Results of Operations

During
the six months period ended June 30, 2004, we generated revenues of $118,158. Revenues for the three months period ended December 31, 2003 were $24,229. Average daily production
increased from 9 BOEPD (857 BOE total) for the three months period ended December 31, 2004, to 21 BOEPD (3,831 BOE total) during the 6 months period ended June 30, 2004. The
increase in production is
primarily a result of adding the 197-2 well to production. Prior to June 30, 2004, the 197-2 well was limited in rate due to restrictions on the amount of associated gas that could be vented,
combined with down time caused by repeated workovers due to sand production. Subsequent to June 30, 2004, the pump was raised 300' and the well has been producing at a more consistent rate
without sand problems.

Also
subsequent to June 30, 2004, we began daily sales of gas through the refurbished gas gathering pipeline and gas treating and processing facility, allowing full production of oil wells and
full production of the 204-2 well, a dry gas producer. Since gas sales began, the 204-2 well has been producing in excess of 150 MCFD. Please see Note 10, Subsequent Events, for wells placed on
production subsequent to June 30, 2004.

Operating
expenses were $79,305 or $92.54 per BOE, for the three months ended December 31, 2003 and $149,001 or $38.90 per BOE, for the six months ended June 30, 2004. Operating expenses
for both periods are high due to the unusual level of workovers needed to control sand production in the 197-2 well (now believed to be corrected) and due to well upsets resulting from frequent
production shut-ins caused by the three month process of getting the gas treating facilities working.

General
and Administrative costs were $239,093 for the three months ended December 31, 2003 and $542,761 for the six months ended June 30, 2004. The costs included the addition of a
second executive officer late in 2003 and the expensing of stock-based compensation in the amount of $50,400 for the three months ended December 31, 2003, and $108,614 for the six months ended
June 30, 2004.

Merger
fees and expenses related to the merger of Old NGS into a subsidiary of Reality were estimated to be $370,000 for the six month period ended June 30, 2004.

23

---



Critical Accounting Policies and Estimates

Accounting
for Oil and Gas Property Costs. As more fully discussed in Note 3 to the consolidated financial statements, the Company (i) follows the full cost method of accounting for the
costs of its oil and gas properties, (ii) amortizes such costs using the units of production method, and (iii) applies a quarterly full cost ceiling test. Adverse changes in conditions
(primarily oil or gas price declines) could
result in permanent write-downs in the carrying value of oil and gas properties as well as non-cash charges to operations, but would not affect cash flows.

Estimates
of Proved Oil and Gas Reserves. An independent petroleum engineer annually estimates 100% of our proved reserves. Reserve engineering is a subjective process that is dependent upon the
quality of available data and the interpretation thereof. In addition, subsequent physical and economic factors such as the results of drilling, testing, production and product prices may justify
revision of such estimates. Therefore, actual quantities, production timing, and the value of reserves may differ substantially from estimates. A reduction in proved reserves would result in an
increase in depreciation, depletion and amortization ("DD&A") expense.

Estimates
of Asset Retirement Obligations. In accordance with SFAS No 143, we make estimates of future costs and the timing thereof in connection with recording our future obligations to plug and
abandon wells. Estimated abandonment dates will be revised in the future based on changes to related economic lives, which vary with product prices and production costs. Estimated plugging costs may
also be adjusted to reflect changing industry experience. Increases in operating costs and decreases in product prices would increase the estimated amount of the obligation and increase DD&A expense.
Cash flows would not be affected until costs to plug and abandon were actually incurred.

This
Form 10-KSB includes certain statements that may be deemed to be "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. All statements included in this Form 10-KSB, other than statements of historical facts, address matters that the Company
reasonably expects, believes or anticipates will or may occur in the future. Such statements are subject to various assumptions, risks and uncertainties, many of which are beyond the control of the
Company. Investors are cautioned that any such statements are not guarantees of future performance and that actual results or developments may differ materially from those described in the
forward-looking statements. The Company bases its forward-looking statements on information currently available and it undertakes no obligation to update them.

ITEM 7. FINANCIAL STATEMENTS

Index to Consolidated Financial Statements

Independent
Auditors' Report

Consolidated
Balance Sheets as of June 30, 2004 and December 31, 2003

Consolidated
Statements of Operations for the Six Months ended June 30, 2004 and the Three Months ended December 31, 2003

Consolidated
Statements of Stockholders' Equity as of June 30, 2004

Consolidated
Statements of Cash Flows for the Six Months ended June 30, 2004 and the Three Months ended December 31, 2003

Notes
to Consolidated Financial Statements

24

---





NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES        Consolidated Balance Sheets

|                                                                |                                                                                                                                                                                          | June 30,
2004                              |                                       | December 31,
2003 |          
|--------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------------------------------------- | ----------------- | ---------
|ASSETS                                                          |                                                                                                                                                                                          |                                            |                                       |                   |          
|Current Assets                                                  |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                | Cash and short-term investments                                                                                                                                                          |                                            | $                                     | 367,831           |          
|                                                                | Receivables                                                                                                                                                                              |                                            |                                       | 24,387            |          
|                                                                | Inventories                                                                                                                                                                              |                                            |                                       | 115,859           |          
|                                                                | Prepaid expenses                                                                                                                                                                         |                                            |                                       | 69,067            |          
|                                                                | Retainers and deposits                                                                                                                                                                   |                                            |                                       | 5,000             |          
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          |                                            | Total current assets                  |                   |          
|Oil and gas properties being amortized (full cost method)       |                                                                                                                                                                                          |                                            | 3,075,438                             |                   |          
|Oil and gas properties not being amortized                      |                                                                                                                                                                                          |                                            | 105,225                               |                   |          
|Less: accumulated amortization                                  |                                                                                                                                                                                          |                                            | (55,509                               | )                 |          
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          |                                            | Net oil and gas properties            |                   |          
|Furniture, fixtures and equipment, at cost                      |                                                                                                                                                                                          |                                            | 3,091                                 |                   |          
|Less: accumulated depreciation                                  |                                                                                                                                                                                          |                                            | (1,159                                | )                 |          
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          |                                            | Net furniture, fixtures and equipment |                   |          
|Other assets (cash balances earmarked for bonding requirements) |                                                                                                                                                                                          |                                            | 301,835                               |                   |          
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          |                                            | Total Assets                          |                   | $        
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|LIABILITIES AND STOCKHOLDERS' EQUITY                            |                                                                                                                                                                                          |                                            |                                       |                   |          
|Current Liabilities:                                            |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                | Accounts payable                                                                                                                                                                         |                                            | $                                     | 139,188           |          
|                                                                | Accrued liabilities                                                                                                                                                                      |                                            |                                       | 50,073            |          
|                                                                | Notes payable                                                                                                                                                                            |                                            |                                       | 776,235           |          
|                                                                | Production taxes payable                                                                                                                                                                 |                                            |                                       |                  |          
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          |                                            | Total current liabilities             |                   |          
|Deferred plugging and abandonment liabilities                   |                                                                                                                                                                                          |                                            | 311,442                               |                   |          
|Stockholders' equity:                                           |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                | Common stock, par value $0.001 per share; 100,000,000 shares authorized, 22,945,406 and 21,772,362 shares issued and outstanding as of June 30, 2004 and December 31, 2003, respectively |                                            |                                       | 22,945            |          
|                                                                | Additional paid-in capital                                                                                                                                                               |                                            |                                       | 4,453,905         |          
|                                                                | Deferred stock based compensation                                                                                                                                                        |                                            |                                       | (378,136          | )        
|                                                                | Accumulated deficit                                                                                                                                                                      |                                            |                                       | (1,364,587        | )        
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          | Total stockholders' equity                 |                                       |                   | 2,734,127
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          
|                                                                |                                                                                                                                                                                          | Total liabilities and stockholders' equity |                                       | $                 | 4,011,065
|                                                                |                                                                                                                                                                                          |                                            |                                       |                   |          

See
accompanying notes to consolidated financial statements.

25

---





NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES        Consolidated Statements of Operations

|                                                            |                                  | Six Months
Ended
June 30, 2004 |                                   | For the
Period From
September 23, 2003
(Inception) to
December 31, 2003 |  
|----------------------------------------------------------- | -------------------------------- | ------------------------------ | --------------------------------- | ----------------------------------------------------------------------- | -
|Revenues:                                                   |                                  |                                |                                   |                                                                         |  
|                                                            | Oil sales                        |                                | $                                 | 117,509                                                                 |  
|                                                            | Gas sales                        |                                |                                   | 649                                                                     |  
|                                                            |                                  |                                |                                   |                                                                         |  
|                                                            |                                  |                                | Total revenues                    |                                                                         |  
|Expenses:                                                   |                                  |                                |                                   |                                                                         |  
|                                                            | Operating costs                  |                                |                                   | 134,420                                                                 |  
|                                                            | Production taxes                 |                                |                                   | 14,581                                                                  |  
|                                                            | Depletion                        |                                |                                   | 41,549                                                                  |  
|                                                            | Reverse-merger fees and expenses |                                |                                   | 370,000                                                                 |  
|                                                            | General and administrative       |                                |                                   | 542,761                                                                 |  
|                                                            |                                  |                                |                                   |                                                                         |  
|                                                            |                                  |                                | Total expenses                    |                                                                         |  
|                                                            |                                  |                                |                                   |                                                                         |  
|Loss from operations                                        |                                  |                                | (985,153                          | )                                                                       |  
|Other revenues and expenses:                                |                                  |                                |                                   |                                                                         |  
|                                                            | Interest income                  |                                |                                   | 4,093                                                                   |  
|                                                            | Interest expense                 |                                |                                   | (46,622                                                                 | )
|                                                            |                                  |                                |                                   |                                                                         |  
|                                                            |                                  |                                | Total other revenues and expenses |                                                                         |  
|                                                            |                                  |                                |                                   |                                                                         |  
|Net loss                                                    |                                  | $                              | (1,027,682                        | )                                                                       | $
|                                                            |                                  |                                |                                   |                                                                         |  
|Income (loss) per common share:                             |                                  |                                |                                   |                                                                         |  
|                                                            | Basic and diluted                |                                | $                                 | (0.05                                                                   | )
|                                                            |                                  |                                |                                   |                                                                         |  
|Weighted average number of common shares, basic and diluted |                                  |                                | 22,057,614                        |                                                                         |  
|                                                            |                                  |                                |                                   |                                                                         |  

See
accompanying notes to consolidated financial statements.

26

---





NATURAL GAS SYSTEMS, INC. AND SUBIDIARIES        Consolidated Statements of Changes in Stockholders' Equity        For the Period From September 23, 2003 (Inception) to June 30, 2004

|                                    |                       | Shares     |   | Dollars |        | Additional
Paid-in
Capital |   | Deferred  |   | Accumulated
Deficit |          | Total
Stockholders'
Equity |  
|----------------------------------- | --------------------- | ---------- | - | ------- | ------ | -------------------------- | - | --------- | - | ------------------- | -------- | -------------------------- | -
|Balances, September 23, 2003        |                       |           |   | $       |       |                            | $ |          |   | $                   |         |                            | $
|Sales of common stock               |                       | 21,772,362 |   |         | 21,772 |                            |   | 2,861,028 |   |                     |         |                            |  
|Stock-based compensation            |                       |           |   |         |       |                            |   | 537,150   |   |                     | (486,750 | )                          |  
|Net loss                            |                       |           |   |         |       |                            |   |          |   |                     |         |                            |  
|                                    |                       |            |   |         |        |                            |   |           |   |                     |          |                            |  
|Balances, December 31, 2003         |                       | 21,772,362 |   |         | 21,772 |                            |   | 3,398,178 |   |                     | (486,750 | )                          |  
|Sales of common stock before merger |                       | 923,377    |   |         | 923    |                            |   | 825,977   |   |                     |         |                            |  
|Sales of common stock after merger  |                       | 249,667    |   |         | 250    |                            |   | 229,750   |   |                     |         |                            |  
|                                    | Deferred compensation |            |  |         |        |                           |   |           |  |                     |          | 108,614                    |  
|Net loss                            |                       |           |   |         |       |                            |   |          |   |                     |         |                            |  
|                                    |                       |            |   |         |        |                            |   |           |   |                     |          |                            |  
|Balances, June 30, 2004             |                       | 22,945,406 |   | $       | 22,945 |                            | $ | 4,453,905 |   | $                   | (378,136 | )                          | $
|                                    |                       |            |   |         |        |                            |   |           |   |                     |          |                            |  

See
accompanying notes to consolidated financial statements.

27

---





NATURAL GAS SYSTEMS, INC. AND SUBIDIARIES        CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                               |                                                                                        | Six Months
ended
June 30, 2004     |                                                | For the Period From
September 23, 2003
(Inception) to
December 31, 2003 |        
|---------------------------------------------- | -------------------------------------------------------------------------------------- | ---------------------------------- | ---------------------------------------------- | ----------------------------------------------------------------------- | -------
|Operating activities:                          |                                                                                        |                                    |                                                |                                                                         |        
|                                               | Net loss                                                                               |                                    | $                                              | (1,027,682                                                              | )      
|                                               | Adjustments to reconcile net loss to net cash provided (used) by operating activities: |                                    |                                                |                                                                         |        
|                                               |                                                                                        | Depletion                          |                                                |                                                                         | 41,549 
|                                               |                                                                                        | Depreciation                       |                                                |                                                                         | 773    
|                                               |                                                                                        | Stock-based compensation expense   |                                                |                                                                         | 108,614
|                                               |                                                                                        | Accretion of debt discount         |                                                |                                                                         |       
|                                               |                                                                                        | Changes in assets and liabilities: |                                                |                                                                         |        
|                                               |                                                                                        |                                    | Accretion of deferred plugging and abandonment |                                                                         |        
|                                               |                                                                                        |                                    |                                                | Liability                                                               |        
|                                               |                                                                                        |                                    | Accounts receivable                            |                                                                         |        
|                                               |                                                                                        |                                    | Inventories                                    |                                                                         |        
|                                               |                                                                                        |                                    | Accounts payable                               |                                                                         |        
|                                               |                                                                                        |                                    | Other current liabilities                      |                                                                         |        
|                                               |                                                                                        |                                    | Prepaid expenses                               |                                                                         |        
|                                               |                                                                                        |                                    | Retainers and deposits                         |                                                                         |        
|                                               |                                                                                        |                                    |                                                |                                                                         |        
|                                               |                                                                                        |                                    |                                                | Net cash used by operating activities                                   |        
|Investing activities:                          |                                                                                        |                                    |                                                |                                                                         |        
|                                               | Capital expenditures for oil and gas properties                                        |                                    |                                                | (209,194                                                                | )      
|                                               | Capital expenditures for furniture, fixtures, and equipment                            |                                    |                                                |                                                                        |        
|                                               | Cash restricted for Delhi bonding requirements                                         |                                    |                                                |                                                                        |        
|                                               |                                                                                        |                                    |                                                |                                                                         |        
|                                               |                                                                                        |                                    |                                                | Net cash used in investing activities                                   |        
|Financing activities:                          |                                                                                        |                                    |                                                |                                                                         |        
|                                               | Payments on notes payable                                                              |                                    |                                                | (710,327                                                                | )      
|                                               | Proceeds from notes payable                                                            |                                    |                                                | 49,490                                                                  |        
|                                               | Proceeds from issuance of common stock                                                 |                                    |                                                | 1,056,900                                                               |        
|                                               |                                                                                        |                                    |                                                |                                                                         |        
|                                               |                                                                                        |                                    |                                                | Net cash provided by financing activities                               |        
|                                               |                                                                                        |                                    |                                                |                                                                         |        
|Net (decrease) increase in cash                |                                                                                        |                                    | (462,481                                       | )                                                                       |        
|Cash and cash equivalents, beginning of period |                                                                                        |                                    | 830,312                                        |                                                                         |        
|                                               |                                                                                        |                                    |                                                |                                                                         |        
|Cash and cash equivalents, end of period       |                                                                                        | $                                  | 367,831                                        |                                                                         | $      
|                                               |                                                                                        |                                    |                                                |                                                                         |        
|Supplemental Cash Flow Information:            |                                                                                        |                                    |                                                |                                                                         |        
|                                               | Interest paid                                                                          |                                    | $                                              | 46,622                                                                  |        
|                                               | Taxes paid                                                                             |                                    |                                                |                                                                        |        
|Non-cash transactions:                         |                                                                                        |                                    |                                                |                                                                         |        
|                                               | Seller note issued to acquire properties, net of discount                              |                                    |                                                |                                                                        |        
|                                               | Assumption of plugging and abandonment liability                                       |                                    |                                                |                                                                        |        

See
accompanying notes to consolidated financial statements.

28

---





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        June 30, 2004

NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES

1.    Company's Business

Reality
Interactive, Inc. ("Reality"), a Nevada corporation that traded on the OTC Bulletin Board under the symbol RLYI.OB, and the predecessor
of Natural Gas Systems, Inc., was incorporated on May 24, 1994 for the purpose of developing technology-based knowledge solutions for the industrial marketplace. On April 30,
1999, Reality ceased business operations, sold substantially all of its assets and terminated all of its employees. Subsequent to ceasing operations, Reality explored other potential business
opportunities to acquire or merge with another entity, while continuing to file reports with the SEC. During the most recent two years, Reality represented that it had not conducted any operations and
had minimal assets and liabilities.

On
May 26, 2004, Natural Gas Systems, Inc., a privately owned Delaware corporation formed in September of 2003 ("Old NGS"), was merged
into a wholly owned subsidiary of Reality and Reality changed its name to Natural Gas Systems, Inc. On the effective date of the merger, Laird Q. Cagan was elected as Chairman of the Board of
Directors of Reality and Robert S. Herlin and Sterling H. McDonald, the CEO and CFO of Old NGS, were elected CEO and CFO of Reality, respectively. The corporation was renamed Natural Gas
Systems, Inc. (the "Company" or "NGS") and adopted a June 30 fiscal year end.

Headquartered
in Houston, Texas, Natural Gas Systems, Inc. is a development stage petroleum company engaged primarily in the acquisition, exploitation and development of properties for the
production of crude oil and natural gas from underground reservoirs. NGS acquires established oil and gas properties and exploits them through the application of conventional and specialized
technology to increase production, ultimate recoveries, or both. At June 30, 2004, NGS conducted operations through its 100% working interest in the Delhi Field in Louisiana.

All
regulatory filings and other historical information including stock prices prior to May 26, 2004 apply to Reality, the predecessor of the Company. NGS trades on the OTC Bulletin Board under
the symbol NGSY.OB. All stock information is adjusted to reflect Reality's 40:1 reverse stock split effected prior to the merger with NGS.

2.    Significant Risks and Uncertainties

Preparation
of the Company's financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and contingencies as of the balance
sheet date, and the reported amount of revenues and expenses during the reporting period. On an ongoing basis, management reviews its estimates, including those related to litigation, environmental
liabilities, income taxes, abandonment costs and the determination of proved reserves. Changes in circumstances may result in revised estimates and actual results may differ from those estimates.

The
Company's business makes it vulnerable to changes in crude oil and natural gas prices. Such prices have been volatile in the past and can be expected to be volatile in the future. This volatility
can dramatically affect cash flows and proved reserves, since price declines reduce the estimated quantity of proved reserves and increase annual amortization expense (which is based on proved
reserves). Other risks related to proved reserves, revenues, and cash flows include the Company's current reliance on the concentration of a few wells. The reserve report dated July 1, 2004,
identified six wells that make

29

---



up
approximately 60% of the Company's future net cash flows, discounted at 10% per annum. At July 31, 2004, approximately 85% of the Company's production was derived from three wells.

3.    Summary of Significant Accounting Policies

Principles of ConsolidationThe consolidated financial statements include the Company and its subsidiaries. All material intercompany
accounts and transactions have been eliminated.

Oil and Gas Properties and Furniture, Fixtures and EquipmentThe Company follows the full cost method of accounting for its investments in
oil and natural gas properties. All costs incurred in the acquisition, exploration and development of oil and natural gas properties, including unproductive wells, are capitalized. Included in
capitalized costs are general and administrative costs that are directly related to acquisition, exploration and development activities. Proceeds from the sale of oil and natural gas properties are
credited to the full cost pool, unless the sale involves a significant quantity of reserves, in which case a gain or loss is recognized. Under the rules of the Securities and Exchange Commission
("SEC") for the full cost method of accounting, the net carrying value of oil and natural gas properties, reduced by the asset retirement obligation, is limited to the sum of the present value (10%
discount rate) of the estimated future net cash flows from proved reserves, based on the current prices, plus the lower of cost or estimated fair market value of unproved properties adjusted for
related income tax effects.

Capitalized
costs of proved oil and natural gas properties are depleted on a unit of production method using proved oil and natural gas reserves. Costs depleted include net capitalized costs subject
to depletion and estimated future dismantlement, restoration and abandonment costs.

Equipment,
which includes computer equipment, hardware and software and furniture and fixtures, is recorded at cost and is generally depreciated on a straight-line basis over the estimated useful
lives of the assets, which range from two to seven years.

Repairs
and maintenance are charged to expense as incurred.

Statement of Cash FlowsFor purposes of the statements of cash flows, cash equivalents include highly liquid financial instruments with
maturities of three months or less as of the date of purchase.

Concentrations of Credit RiskAll of the Company's trade receivables are due from one purchaser. Accounts receivable are not collateralized.

Revenue RecognitionThe Company recognizes oil and natural gas revenue from its interests in producing wells as oil and natural gas is sold.

Accounting for Reverse MergerThe Company accounts for its reverse-merger in accordance with Staff Accounting Bulletin ("SAB") Topic 2A.
Generally, the staff of the Division of Corporate Finance considers reverse-mergers into public shells to be capital transactions in substance, rather than business combinations. That is, the
transaction is equivalent to the issuance of stock by the private company for the net monetary assets of the shell corporation, accompanied by a recapitalization.

Under
this treatment, post reverse-acquisition comparative historical financial statements are those of the "legal acquiree" (i.e., the "accounting
acquirer"), with appropriate disclosure concerning the change in the capital structure effected at the acquisition date. In the Company's case, the historical financial statements are those of the oil
and gas operations of Old NGS, except that the Consolidated Statement

30

---



of
Changes in Stockholder's Equity reflect the activity of Old NGS prior to the merger. All share and per share amounts have been adjusted to reflect the conversion ratio of shares exchanged between
Reality and Old NGS.

Also,
in accordance with SAB Topic 2A, transaction costs incurred for the reverse-merger, such as legal fees, investment banking fees and the like, may be charged directly to equity only to the extent
of the cash received, while all costs in excess of cash received should be charged to expense. Accordingly, since no cash was received, $370,000 in transaction fees were expensed in the Company's
accompanying financial statements.

Stock OptionsAs permitted by SFAS No. 123, "Accounting for Stock Based Compensation," the Company follows the accounting
requirements for stock options and stock-based awards contained in Accounting Principles Board Opinion No. 25, "Accounting for stock Issued to Employees," and related Interpretations and
consensus of the Emerging Issues Task Force in terms of measuring compensation expense.

SFAS 123,
"Accounting for Stock-Based Compensation," as amended by SFAS 148, "Accounting for Stock-Based CompensationTransition and Disclosure," established accounting and
disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. The Company accounts for stock-based compensation using the intrinsic value method
prescribed in Accounting Principles Board Opinion 25, "Accounting for Stock Issued to Employees" ("APB 25").

Fair Value of Financial InstrumentsOur financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable
and seller notes. The carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to the highly liquid nature of these short-term instruments.
The fair values of the seller notes approximates their carrying amounts as of June 30, 2004, based upon interest rates currently available to us for borrowings with similar terms.

New Accounting PronouncementsDuring December 2003, the FASB issued Interpretation No. 46R, "Consolidation of Variable
Interest Entities" ("FIN 46"), which requires the consolidation of certain entities that are determined to be variable interest entities ("VIE's"). An entity is considered to be a VIE when either
(i) the entity lacks sufficient equity to carry on its principal operations, (ii) the equity owners of the entity cannot make decisions about the entity's activities or (iii) the
entity's equity neither absorbs losses or benefits from gains. NGS owns no interest in variable interest entities, and therefore this new interpretation has not affected the Company's consolidated
financial statements.

4.    Acquisitions

In
September 2003, Old NGS completed the acquisition of a 100% working interest in the Delhi Field. The acquisition closed on September 25, 2003, whereby Old NGS paid $995,000 in cash,
issued a purchase money mortgage for $1,500,000 (See Note 7, Notes Payable, for a description of the mortgage) and assumed a plugging and abandonment reclamation liability in the amount of
approximately $302,000 (see Note 5, Asset Retirement Obligations), in exchange for the conveyance of all the underlying leasehold interests. In addition to the mortgage, the property is
burdened by an aggregate 20% royalty interest.

On
May 26, 2004, Reality Interactive, Inc., a publicly traded Nevada corporation ("Reality"), executed an Agreement and Plan of Merger with Natural Gas Systems, Inc., a private
Delaware corporation

31

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("Old
NGS"), whereby the shareholders of Old NGS received 21,749,478 shares of common stock of Reality, in exchange for all of the 21,749,748 shares of Old NGS common stock then outstanding. The
operations and management of Old NGS became our own, and Reality's name was changed to Natural Gas Systems, Inc., a Nevada corporation (the "Company" or "NGS"). Immediately prior to the closing
of the merger, Reality had virtually no operations, assets or liabilities.

5.    Asset Retirement Obligations

When
an oil or gas property ceases economic production, the Company dismantles and removes all surface equipment, plugs the wells and restores the property's surface in accordance with various
regulations and agreements before abandoning the property. The state of Louisiana requires operators of oil and gas properties to secure plugging, abandonment and reclamation liabilities with
financial collateral in favor of the state. In the case of the Delhi Field, the previous owner had established a Site Specific Trust Fund (SSTA Account) that is considered a fully funded liability by
the state of Louisiana. Pursuant to the Company's agreement to purchase the Delhi Field in September of 2003, NGS agreed to replace the seller's collateral on the SSTA Account within 120 days
of closing. During the six months ended June 30, 2004, NGS replaced the seller's collateral by posting a letter of credit in the face amount of $301,835, fully collateralized by a certificate
of deposit issued on Wells Fargo Bank. These restricted cash equivalents are carried as "Other Assets" in the Company's balance sheet.

In
accordance with FAS 143, the Company has recorded an estimated asset retirement obligation ("ARO") for its Delhi Field of approximately $302,000, of which $274,000 relates to the Company's
wells and $28,000 relates to wells operated by the Company for a third party. Accordingly, the Company has recorded an asset retirement obligation in the amount of $302,000, with an offsetting
$274,000 charge to the full cost pool and a $28,000 receivable due from the 3rd party at December 31, 2003. The receivable was collected during the six months ended June 30, 2004.

Also
in accordance with FAS 143, the Company provides accretion expense on all ARO liabilities. For the Delhi Field, NGS uses the 10-year constant maturity Treasury yield of 4.27% available at
September 30, 2003, which equates to 1.05% per quarter.

The
following table describes the change in the Company's asset retirement obligations for the period from September 23, 2003 (inception) to June 30, 2004:

Asset retirement obligation at September 23, 2003

$
301,835Accretion expense for 2003


3,169Asset retirement obligation at December 31, 2003


305,004Accretion expense for 2004


6,438Asset retirement obligation at June 30, 2004

$
311,442


6.    Oil and Gas Properties

Depletion
expense for the period from September 23, 2003 (inception) to December 31, 2003 and for the six months ended June 30, 2004 totaled $13,960 and $41,549, respectively.

32

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During
2003, no costs were excluded from amortization. For the six months ended June 30, 2004, $105,225 of costs were not being amortized, pending the closing or abandonment of property
acquisitions under active consideration.

7.    Notes Payable

In
September 2003, the Company issued $1,500,000 of notes payable in connection with its acquisition of the Delhi Field. The notes were collateralized by a first mortgage on the Company's Delhi
field and are payable to the sellers in twelve equal monthly installments beginning on January 30, 2004. Although the notes bear no interest, the Company has imputed interest at 8% per annum,
thus resulting in an initial recorded principal amount of $1,407,049. At December 31, 2003, the balance of the notes payable was $1,436,973, including $29,924 of imputed interest. At
June 30, 2004, the principal balance outstanding was $732,807.

In
May 2004, the Company borrowed $49,490 to finance 70% of its Director and Officer's liability insurance premiums. The note requires eight level mortgage-amortizing payments in the amount of
$5,350 per month, including 7% interest per annum, with the first payment due on June 25, 2004. At June 30, 2004, the principal outstanding balance of the note was $43,429.

8.    Common Stock and Stock Options

Common Stock

At
December 31, 2003, Reality had issued and outstanding 256,598 shares of its $0.001 par value common stock. From January 1, 2004, up to, but not including, the merger closing on
May 26, 2004, Reality issued 689,663 of its $0.001 par value common shares, net of cancellations and redemptions. At the closing of the merger on May 26, 2004, Reality issued 21,749,478
of its $0.001 par value common shares in exchange for all of the 21,749,478 issued and outstanding $0.001 par value common shares of Old NGS.

During
2003, Old NGS issued 18,000,000 common shares as founder's capital at $0.001 per share, and sold 2,864,600 of its $0.001 par value common shares at $1.00 per share through a private equity
offering to accredited investors. Prior to the merger closing in 2004, Old NGS sold an additional 884,878 of its $0.001 par value common shares to accredited investors for $886,900 gross proceeds,
less $60,000 in commissions equal to 8% of the gross cash proceeds and the issuance of 7 year term warrants equal to 8% of the shares issued, for the account of Chadbourn Securities, Inc. and
Laird Q. Cagan, an affiliate of the Company as described in Footnote 9 on Related Party Transactions.

Since
the merger closing through June 30, 2004, the Company sold 249,667 shares of its $0.001 par value common shares for gross proceeds of $250,000, less $30,000 in commissions and the same
warrant structure described above for the account of Chadbourn Securities, Inc. and Laird Q. Cagan.

At
June 30, 2004, the Company had 22,945,406 issued and outstanding shares of common stock.

See
Note 11, Subsequent Events, for information on additional sales of common stock since June 30, 2004.

33

---



Options

Old
NGS adopted a stock option plan in 2003 (the "2003 Plan"). The purpose of the 2003 Plan was to offer selected individuals an opportunity to acquire a proprietary interest in the success of Old
NGS, or to increase such interest, by purchasing shares of the Old NGS' common stock. The 2003 Plan provided both for the direct award or sale of shares and for the grant of options to purchase shares
in an aggregate amount not to exceed 4,000,000 shares. Options granted under the Plan included nonstatutory options as well as incentive stock options intended to qualify under Section 422 of
the Code. Options granted under the 2003 Plan were assumed by Reality Interactive, Inc., predecessor to the Company. No further shares will be granted under the 2003 Stock Option Plan.

At
June 30, 2004, options totaling 600,000 shares of the Company's stock had were outstanding, having been granted in 2003 by Old NGS and assumed in 2004 by the Company, subject to various
vesting requirements. Options to purchase 250,000, 250,000 and 100,000 shares were granted to Messrs. Herlin, McDonald and Lee (counsel to the Company), respectively. Mr. Herlin's
options are committed for subsequent cancellation and re-issuance as warrants to Tatum Partners, in consideration of its services agreement with the Company. These options were accounted for under APB
25, with respect to Messrs. Herlin and McDonald, and under FASB 123 with respect to Messrs. Lee, and gave rise to $537,150 of Company expense to be recognized over the respective vesting
periods of the options.

On
August 3, 2004, the Company adopted its 2004 Stock Option Plan (the "2004 Plan"). The purpose of the 2004 Plan is to offer selected individuals an opportunity to acquire a proprietary
interest in the success of the Company, or to increase such interest, by purchasing shares of the Company's common stock. The 2004 Plan provides both for the direct award or sale of shares and for the
grant of options to purchase shares in an aggregate amount not to exceed 4,000,000 shares. Options granted under the 2004 Plan may include nonstatutory options as well as incentive stock options
intended to qualify under Section 422 of the Code.

No
options were issued during the six months ended June 30, 2004. However, 200,000 options have been authorized, but not issued, to two members of the Board of Directors of the Company.

A
reconciliation of reported loss as if the Company used the fair value method of accounting for stock-based compensation has not been provided as the fair value of options computed under FASB 123 was
essentially the same as the amount determined in accordance with APB 25.

Fair
value was estimated at the date of grant using the Black-Scholes options pricing model with the following weighted average assumptions: risk-free interest rate of approximately 2.5%; dividend
yield of 0%; volatility factor of 1.31; and a weighted-average expected life of three years. These assumptions resulted in a weighted average grant date fair value of $.99. For purposes of the pro
forma disclosures, the estimated fair value is amortized to expense over the awards' vesting period.

34

---



The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not
necessarily provide a single measure of the fair value of its employee stock options. At June 30, 2004, 3,400,000 shares were available for grant under the plans. A summary of options
transactions for the period from September 23, 2003 (inception) to June 30, 2004 follows:

|                                    |           | Number
of Shares |         | Weighted
Average
Exercise Price
|----------------------------------- | --------- | ---------------- | ------- | -------------------------------
|Outstanding at September 23, 2003   |           |                  |         | $                              
|                                    | Granted   |                  | 600,000 |                                
|                                    |           |                  |         |                                
|                                    | Exercised |                  |        |                                
|                                    | Canceled  |                  |        |                                
|                                    |           |                  |         |                                
|Outstanding at December 2003        |           | 600,000          |         | $                              
|                                    |           |                  |         |                                
|                                    | Granted   |                  |        |                                
|                                    | Exercised |                  |        |                                
|                                    | Canceled  |                  |        |                                
|                                    |           |                  |         |                                
|Outstanding at June 30, 2004        |           | 600,000          |         | $                              
|                                    |           |                  |         |                                
|Shares exercisable at June 30, 2004 |           | 153,122          |         | $                              
|                                    |           |                  |         |                                

|     |  | Options Outstanding |  |     
|---- |  | ------------------- |  | ----
|
|.001 |  | 350,000             |  | .001
|.25  |  | 250,000             |  | .25 

The
weighted average remaining contractual life of options outstanding at June 30, 2004, was approximately 38 months. The weighted average grants date fair value of the options granted
in 2003 was $.89 per share. The options vest as follows: 2004 - 150,000; 2005 - 150,000; 2006 - 150,000; and 2007 - 150,000.

Warrants

At
June 30, 2004, outstanding warrants to purchase the Company's $0.001 par value common shares were as follows:

|                                   |  | Warrants Outstanding |      | 
|---------------------------------- |  | -------------------- | ---- | 
|
|Cagan McAfee Capital Partners, LLC |  | $                    | 1.00 | 
|Laird Q. Cagan                     |  | $                    | 1.00 | 
|Chadbourn Securities, Inc.         |  | $                    | 1.00 | 
|Total                              |  |                      |      | 
|                                   |  |                      |      | 

35

---



The
warrants above were issued for services rendered for the merger and the sale of the Company's common shares. Laird Q. Cagan and Cagan McAfee Capital Partners ("CMCP") are affiliates of the
Company. We issued 240,000 of these warrants to CMCP in connection with arranging the merger. We issued 79,932 to Laird Q. Cagan and Chadbourn Securities, Inc., in connection with capital raising
services.

9.    Related Party Transactions

Laird
Cagan, Chairman of the Board of the Company, is a Managing Director of Cagan McAfee Capital Partners, LLC ("CMCP"). CMCP performs financial advisory services to the Company pursuant to a written
agreement and is paid a monthly retainer of $15,000. In addition, Mr. Cagan is a registered representative of Chadbourn Securities, Inc. ("Chadbourn"), the Company's placement agent in private
equity financings. Pursuant to the Agreement between the Company, Mr. Cagan, and Chadbourn, the Company pays a cash fee equal to 8% of gross equity proceeds and warrants equal to 8% of the
shares purchased. During 2003, the Company expensed and paid CMCP $32,500 for monthly retainers.

In
connection with the founding of the Company, 18,000,000 shares of NGS common stock were directly and indirectly purchased by various parties as founder's shares, including, 1,000,000 shares by
Robert S. Herlin as an incentive to perform as the Company's President and CEO; 1,000,000 shares by Liviakis Financial Communications, Inc., the Company's investor relations firm; 7,500,000 shares by
Laird Q. Cagan, the Company's Chairman and Managing Director of CMCP; and 5,700,000 by Eric M. McAfee, Managing Director of CMCP, and 450,000 by John Pimentel, a member of the Company's Board of
Directors.

During
the six months ended June 30, 2004 the Company has expensed $90,000 in monthly retainers, $60,000 of which remains unpaid at June 30, 2004, and charged $80,000 to stockholder's
equity as a reduction of the proceeds from common stock sales in the amount of $1,000,000. The $80,000 paid to Chadbourn Securities and Laird Q. Cagan was for commissions from the sale of the common
stock. Also during the six months ended June 30. 2004 NGS issued warrants to purchase 319,932 shares of Common Stock to CMCP, Chadbourn Securities and Laird Q. Cagan in connection with
arranging the merger, (240,000 warrants) and placement of 999,145 common shares (79,932 warrants). These warrants have a $1.00 exercise price and a seven year term.

Eric
McAfee, also a Managing Director of Cagan McAfee Capital Partners, has served as Vice Chairman of the Board of Verdisys, Inc., the provider of certain horizontal drilling services to the
Company. Subsequently in 2004, Mr. McAfee resigned from the Board of Directors of Verdisys, but continues to hold shares in both companies. Mr. McAfee has represented to the Company that
he is also a 50% owner of Berg McAfee Companies, LLC, which owns approximately 30% of Verdisys, Inc. NGS paid $130,000 to Verdisys during 2003 and $25,960 during 2004 for horizontal drilling
services.

Subsequent
to June 30, 2004, Laird Cagan, Chairman of the Board of the Company, loaned the Company $475,000 as partial bridge financing for the acquisition of the Tullos Urania Field. See
Footnote 11, Subsequent Events, for a further explanation.

36

---



10.    Supplemental Oil and Gas Disclosures (unaudited)

Costs Incurred in Oil and Gas Producing Activities

|                                 |                       | Six Months
Ended
June 30, 2004 |         | For the Period From
September 23, 2003
(Inception) to
December 31, 2003
|-------------------------------- | --------------------- | ------------------------------ | ------- | -----------------------------------------------------------------------
|Property acquisition costs:      |                       |                                |         |                                                                        
|                                 | Proved                |                                | $       | 6,855                                                                  
|                                 | P&A liability assumed |                                |         |                                                                       
|                                 | Unproved              |                                |         | 105,225                                                                
|Exploration costs                |                       |                                |        |                                                                        
|Development costs                |                       |                                | 97,114  |                                                                        
|                                 |                       |                                |         |                                                                        
|Total Property Acquisition Costs |                       | $                              | 209,194 |                                                                        
|                                 |                       |                                |         |                                                                        

Results of Operations for Oil and Gas Producing Activities

|                                                                                                              |  | Six Months
Ended
June 30, 2004 |          | For the Period From
September 23, 2003
(Inception) to
December 31, 2003 |  
|------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | -------- | ----------------------------------------------------------------------- | -
|Oil and gas sales                                                                                             |  | $                              | 118,158  |                                                                         | $
|Production costs                                                                                              |  |                                | (134,420 | )                                                                       |  
|Production taxes                                                                                              |  |                                | (14,581  | )                                                                       |  
|Depletion                                                                                                     |  |                                | (41,549  | )                                                                       |  
|                                                                                                              |  |                                |          |                                                                         |  
|Results of operations for oil and gas producing activities (excluding corporate overhead and financing costs) |  | $                              | (72,392  | )                                                                       | $
|                                                                                                              |  |                                |          |                                                                         |  

Proved Developed and Undeveloped Reserves
prepared by W.D. Von Gonten & Co. Petroleum Engineers

The
following table sets forth the net proved reserves of the Company as of July 1, 2004, and the changes therein for the period from September 23, 2003 (inception) to July 1,
2004. The reserve

37

---



information
was reviewed by W.D. Von Gonten & Co., independent petroleum engineers. All of the Company's oil and gas producing activities are located in the United States.

|                                      |  | Oil
(bbls) |   | Gas
(mcf) |  
|------------------------------------- |  | ---------- | - | --------- | -
|September 23, 2003                    |  |           |   |          |  
|Purchases of minerals in place        |  | 241,219    |   | 778,700   |  
|Extensions and discoveries            |  |           |   |          |  
|Production                            |  | (857       | ) |          |  
|                                      |  |            |   |           |  
|Sales of minerals in place            |  |           |   |          |  
|December 31, 2003                     |  | 240,362    |   | 778,700   |  
|                                      |  |            |   |           |  
|Purchases of minerals in place        |  |            |   |           |  
|Extensions, discoveries and revisions |  | 2,352      |   | (270,021  | )
|Production                            |  | (3,810     | ) | (123      | )
|                                      |  |            |   |           |  
|Sales of minerals in place            |  |           |   |          |  
|                                      |  |            |   |           |  
|July 1, 2004                          |  | 238,904    |   | 508,556   | *
|Proved developed reserves:            |  |            |   |           |  
|December 31, 2003                     |  | 240,400    |   | 778,700   |  
|July 1, 2004                          |  | 238,900    |   | 508,556   | *

---

38

---





Standardized Measure of Discounted Future Net Cash Flows
at December 31, 2003 and June 30, 2004

The
information that follows has been developed pursuant to SFAS No. 69 and utilizes reserve and production data prepared or reviewed by independent petroleum consultants. Reserve estimates are
inherently imprecise and estimates of new discoveries are less precise than those of producing oil and natural gas properties. Accordingly, these estimates are expected to change as future information
becomes available.

The
estimated discounted future net cash flows from estimated proved reserves are based on prices and costs as of the date of the estimate unless such prices or costs are contractually determined at
such date. Actual future prices and costs may be materially higher or lower. Actual future net revenues also will be affected by factors such as actual production, supply and demand for oil and
natural gas, curtailments or increases in consumption by natural gas purchasers, changes in governmental regulations or taxation and the impact of inflation on costs. Future income tax expense has
been reduced for the effect of available net operating loss carryforwards.

|                         |                       | Six Months
Ended
June 30, 2004 |            | For the Period From
September 23, 2003
(Inception) to
December 31, 2003 |          
|------------------------ | --------------------- | ------------------------------ | ---------- | ----------------------------------------------------------------------- | ---------
|Future cash inflows      |                       | $                              | 11,549,850 |                                                                         | $        
|Future production costs  |                       |                                | (2,978,139 | )                                                                       |          
|Future development costs |                       |                                | (450,000   | )                                                                       |          
|Future income taxes      |                       |                                | (1,465,000 | )                                                                       |          
|                         |                       |                                |            |                                                                         |          
|                         | Future Net Cash Flows |                                |            | 6,656,711                                                               |          
|10% annual discount      |                       |                                | (1,476,100 | )                                                                       |          
|                         |                       |                                |            |                                                                         |          
|                         |                       | Standardized Measure           |            | $                                                                       | 5,180,611
|                         |                       |                                |            |                                                                         |          

Changes in Standardized Measure

The
following table sets forth the changes in standardized measure of discounted future net cash flows for the period from September 23, 2003 (inception) to December 31, 2003 and for the
six months ended June 30, 2004:

|                                |  | Six Months
Ended
June 30, 2004 |            | For the Period From
September 23, 2003
(Inception) to
December 31, 2003 |  
|------------------------------- |  | ------------------------------ | ---------- | ----------------------------------------------------------------------- | -
|Standardized Measure, beginning |  | $                              | 6,173,948  |                                                                         | $
|Net change in income taxes      |  |                                | 737,006    |                                                                         |  
|Oil and gas sales, net of costs |  |                                | 30,843     |                                                                         |  
|Purchase of minerals in place   |  |                                |           |                                                                         |  
|Changes in prices and costs     |  |                                | 82,230     |                                                                         |  
|Change in developments costs    |  |                                | (84,042    | )                                                                       |  
|Accretion of discount           |  |                                | 308,697    |                                                                         |  
|Revisions of estimates          |  |                                | (2,131,318 | )                                                                       |  
|Other                           |  |                                | 64,246     |                                                                         |  
|                                |  |                                |            |                                                                         |  
|Standardized Measure, ending    |  | $                              | 5,180,611  |                                                                         | $
|                                |  |                                |            |                                                                         |  

39

---



11.    Subsequent Events

Subsequent
to June 30, 2004, the Company received $475,000 under a short-term secured promissory note (the "Note") held by Laird Q. Cagan, the Company's Chairman and major stockholder, for the
purpose of bridge financing part of the purchase price of the Tullos Urania Field. Under the terms of the Note, all net revenue derived from the Company's Tullos Urania Field, less operating expenses
and development costs, must be applied toward repayment of the Note. The Note bears interest at 10% per annum, is secured by a pledge of all of the Company's assets and is due in full by
February 10, 2005. Since the origination of the loan, the Company and Mr. Cagan agreed to amend the repayment terms of the loan by delaying the repayment until the earlier of
(a) July 1, 2005, or (b) the date on which the cumulative gross equity funding after August 14, 2004 reaches $1 million. Also amended are the terms of the Note which
delays the mandatory prepayment until all net revenue derived from the Company's Tullos Urania Field, less operating expenses and capital costs accruing after February 5, 2005 and 50% of the
net proceeds of any related third party financings of any kind conducted by the Company after the date of this Note.

From
July 1, 2004 through September 24, 2004, NGS raised gross proceeds from the sale of common stock in the amount of $544,734.

On
September 2, 2004, NGS purchased its second property comprising a 100% working interest in approximately 81 producing oil wells, 8 salt water disposal wells and 54 shut-in wells located in
La Salle and Winn Parishes, Louisiana. Fourteen of the shut-in wells will require a new lease prior to restoration of production. The purchase included leases covering 386.04 gross and net acres, and
fee ownership of 2.33 acres around certain of the wells. NGS intends to initiate a program of restoring the shut-in wells to production, increasing overall production per well by addition of
incremental water disposal capacity and utilizing gas production to replace purchased power for pumps. NGS will file at a later date a Form 8-K to further describe the purchased assets.

12.    Income Taxes

The
tax effect of significant temporary differences representing deferred tax assets and liabilities at December 31, 2003 and June 30, 2004 are as follows:

|                                 |  | June 30, 2004 |          | December 31, 2003 |  
|-------------------------------- |  | ------------- | -------- | ----------------- | -
|Oil and gas properties           |  | $             | (69,389  | )                 | $
|Net operating loss carryforwards |  |               | 366,425  |                   |  
|Valuation Allowance              |  |               | (297,036 | )                 |  
|                                 |  |               |          |                   |  
|Net deferred tax asset           |  | $             |         |                   | $
|                                 |  |               |          |                   |  

The
increase in the valuation allowance during fiscal 2003 and 2004 of $114,485 and $182,551; respectively, is the result of additional net tax losses incurred during the year.

As
of June 30, 2004, the Company has net operating loss carryforwards of approximately $1,078,000 that will expire in 2023 and 2024. Future utilization of the net operating loss carryforwards
and other tax attributes may be limited by changes in the ownership of the Company in May 2004 under section 382 of the Internal Revenue Code.

40

---



The
following is a reconciliation of the Company's expected income tax expense (benefit) based on statutory rates to the actual expense (benefit):

|                                                  |  | Six Months
Ended
June 30, 2004 |          | For the Period From
September 23, 2003
(Inception) to
December 31, 2003 |  
|------------------------------------------------- |  | ------------------------------ | -------- | ----------------------------------------------------------------------- | -
|Income taxes (benefit) at US statutory rate       |  | $                              | (349,412 | )                                                                       | $
|Non-deductible amortization and expenses          |  |                                | 165,141  |                                                                         |  
|Deferred tax asset valuation allowance adjustment |  |                                | 182,551  |                                                                         |  
|Net operating losses                              |  |                                |         |                                                                         |  
|                                                  |  |                                |          |                                                                         |  
|Other                                             |  | $                              | 1.720    |                                                                         |  
|                                                  |  |                                |          |                                                                         |  
|                                                  |  | $                              |         |                                                                         | $

13.    Liquidity

As
of June 30, 2004, we had $367,831 of unrestricted cash and negative working capital of $383,352. We incurred losses for the six months period ended June 30, 2004 and three months
period ended December 31, 2003 of $1,027,682 and $336,905, respectively. Our negative working capital of $383,352 was adversely impacted by $732,806 of short-term mortgage notes we owe on the
Delhi Field, payable in approximately equal monthly installments through December 30, 2004 (the "Delhi Notes" See Note 7 to the financial statements for a further description). Although
our cash flow from operations currently approximates our recurring overhead, our cash flow has been, and continues to be, insufficient to cover the Delhi Note payments. Although we are current in our
payments on the Delhi Notes, we have relied on additional funding sources to meet these payments since the beginning of 2004. At September 24, 2004, we owed four remaining monthly payments of
$125,000 each on the Delhi Notes. At that date, we had cash balances of approximately $256,000 and approximately $176,000 of accounts payable due (excluding deferred fees due CMCP).

Our
negative working capital and cash position, as well as our ongoing operating losses, raise concerns about our ability to meet future obligations and fund future operations. Accordingly, management
has and continues to expend considerable time and effort to deal with this issue as discussed below. Subsequent to June 30, 2004, we have been working to improve our liquidity using three
strategies:



41

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14.    Leases

The
Company is obligated for operating lease payments related to the Company's headquarters in Houston, Texas, and a gas processing plant servicing the Company's Delhi Field. Minimum lease payments
are:

Fiscal 2005:

$
101,772Fiscal 2006:


12,516Total

$
114,288


Lease
expense was $44,770 for the six months ended June 30, 2004 and $8,541 for the three months ended December 31, 2003.

42

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15.    Earnings Per Share

The
following table sets forth the computation of basic and diluted earnings (loss) per share:

|                                                                    |                                                                     | Six Months
Ended
June 30, 2004             |   | For the Period From
September 23, 2003
(Inception) to
December 31, 2003 |    
|------------------------------------------------------------------- | ------------------------------------------------------------------- | ------------------------------------------ | - | ----------------------------------------------------------------------- | ---
|Numerator:                                                          |                                                                     |                                            |   |                                                                         |    
|                                                                    | Net loss applicable to common stockholders                          |                                            | $ | (1,027,682                                                              | )  
|                                                                    | Plus income impact of assumed conversions:                          |                                            |   |                                                                         |    
|                                                                    |                                                                     | Preferred stock dividends                  |   |                                                                         | N/A
|                                                                    |                                                                     | Interest on convertible subordinated notes |   |                                                                         | N/A
|                                                                    |                                                                     |                                            |   |                                                                         |    
|                                                                    | Net loss applicable to common stockholders plus assumed Conversions |                                            |   | (1,027,682                                                              | )  
|Denominator:                                                        |                                                                     |                                            |   |                                                                         |    
|                                                                    |                                                                     |                                            |   | 22,057,614                                                              |    
|Affect of potentially dilutive common shares:                       |                                                                     |                                            |   |                                                                         |    
|                                                                    | Warrants                                                            |                                            |   | N/A                                                                     |    
|                                                                    | Employee and director stock options                                 |                                            |   | N/A                                                                     |    
|                                                                    | Convertible preferred stock                                         |                                            |   | N/A                                                                     |    
|                                                                    | Convertible subordinated notes                                      |                                            |   | N/A                                                                     |    
|                                                                    | Redeemable preferred stock                                          |                                            |   | N/A                                                                     |    
|                                                                    |                                                                     |                                            |   |                                                                         |    
|Denominator for dilutive earnings per shareweighted-average shares |                                                                     |                                            |   |                                                                         |    
|                                                                    | Outstanding and assumed conversions                                 |                                            |   | 22,057,614                                                              |    
|                                                                    |                                                                     |                                            |   |                                                                         |    
|Loss per common share:                                              |                                                                     |                                            |   |                                                                         |    
|                                                                    | Basic and diluted                                                   |                                            | $ | (0.05                                                                   | )  
|                                                                    |                                                                     |                                            |   |                                                                         |    

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INDEPENDENT AUDITORS' REPORT

Report of Independent Registered Public Accounting Firm

The
Board of Directors and Stockholders
Natural Gas Systems, Inc.
Houston, Texas

We
have audited the accompanying consolidated balance sheets of Natural Gas Systems, Inc. as of June 30, 2004 and December 31, 2003 and the related consolidated
statements of operations, stockholders' equity, and cash flows for the six months period ended June 30, 2004 and the period from September 23, 2003 (inception) to December 31,
2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our
audits.

We
conducted our audits in accordance with the 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Natural Gas Systems, Inc. and subsidiaries as
of June 30, 2004 and December 31, 2003, and the results of their operations and their cash flows for each of the periods then ended, in conformity with accounting principles generally
accepted in the United States of America.

HEIN & ASSOCIATES LLP

Houston,
Texas
September 28, 2004

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

None.

ITEM 8A. CONTROLS AND PROCEDURES

Our
management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures, as of the end of the period
covered by this report. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective to ensure that
information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and forms.

There
were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.

ITEM 8B. OTHER INFORMATION

Subsequent
Events

Subsequent
to June 30, 2004, the Company and Laird Cagan, Chairman of the Company, agreed to amend the repayment terms of the outstanding bridge loan provided by Cagan to the Company in the
amount of $475,000. Terms of the original loan and the amendment are discussed in Item 6, Management's Discussion and Analysis and are available herein or incorporated by reference in the exhibits
hereto.

In
September 2004, we placed on production two additional wells that were previously shut-in. The 184-2 well was recompleted into a stray gas sand and initially tested at a rate of 500 mcfd and
1120 psig flowing tubing pressure. Initial shut-in tubing pressure was 1350 psig with a perforated depth of 3,170-78'. The 210-2 well was placed back into production and initially made 5 BOPD while
unloading wash water.

On
September 2, 2004, we purchased our second property comprising a 100% working interest in approximately 81 producing oil wells, 8 salt water disposal wells and 54 shut-in wells located in La
Salle and Winn Parishes, Louisiana. We purchased the property for $725,000, plus post closing adjustments, in cash. Fourteen of the shut-in wells will require a new lease prior to restoration of
production. The production rate aggregates approximately 62 BOPD plus a small amount of associated gas that is not sold currently. The purchase included leases covering 386.04 gross and net acres, and
fee ownership of 2.33 acres around certain of the wells. NGS intends to initiate a program of restoring the shut-in wells to production, increasing overall production per well by addition of
incremental water disposal capacity and utilizing gas production to replace purchased power for pumps. We will file at a later date a Form 8-K to further describe the purchased assets including
audited proved reserves and financial statements.

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PART III.

ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS

Incorporated
by reference to the Company's Proxy Statement to be filed with the Commission pursuant to Regulation 14A within 120 days of the end of the Company's year 2004.

ITEM 10. EXECUTIVE COMPENSATION

Incorporated
by reference to the Company's Proxy Statement to be filed with the Commission pursuant to Regulation 14A within 120 days of the end of the Company's year 2004.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Incorporated
by reference to the Company's Proxy Statement to be filed with the Commission pursuant to Regulation 14A within 120 days of the end of the Company's year 2004.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Incorporated
by reference to the Company's Proxy Statement to be filed with the Commission pursuant to Regulation 14A within 120 days of the end of the Company's year 2004.

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ITEM 13. EXHIBITS AND REPORTS

Index of Exhibits

|2.1   |  | Asset Purchase Agreement for Delhi Field, dated September 24, 2003.                                                                                |  | Included        
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------
|2.2   |  | Asset Purchase Agreement for Tullos Field, dated September 3, 2004.                                                                                |  | Previously Filed
|3(i)  |  | Articles of Incorporation.                                                                                                                         |  | Previously Filed
|3(ii) |  | Bylaws.                                                                                                                                            |  | Previously Filed
|10.1  |  | Employment Agreement  Robert S. Herlin, dated September 23, 2003.                                                                                 |  | Included        
|10.2  |  | Employment Agreement  Sterling McDonald, dated November 10, 2003.                                                                                 |  | Included        
|10.3  |  | Engagement Agreement  Cagan McAfee Capital Partners, LLC, dated September 23, 2003.                                                               |  | Included        
|10.4  |  | Addendum to Engagement Agreement  Cagan McAfee Capital Partners, LLC dated May 5 ,2004.                                                           |  | Included        
|10.5  |  | Lateral Drilling Services Agreement  Verdisys, Inc., January 27, 2004.                                                                            |  | Included        
|10.6  |  | Secured Promissory Note  Laird Q. Cagan, dated August 10, 2004.                                                                                   |  | Previously Filed
|16.1  |  | Letter, dated June 2, 2004, from Chishold, Bierwolf & Nilson, LLC concerning the change in accountants.                                            |  | Previously Filed
|21.1  |  | List of all subsidiaries of the Company.                                                                                                           |  | Included        
|31.1  |  | Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                    |  | Included        
|31.2  |  | Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                    |  | Included        
|32.1  |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |  | Included        
|32.2  |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |  | Included        

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Incorporated
by reference to the Company's Proxy Statement to be filed with the Commission pursuant to Regulation 14A within 120 days of the end of the Company's year 2004.

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SIGNATURES

In
accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

|                          |  | NATURAL GAS SYSTEMS, INC.
|------------------------- |  | -------------------------
|                          |  | By:                      
|                          |  | By:                      
|Date: September    , 2004 |  |                          

In
accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

|Date                |  | Signature                     |  | Title                
|------------------- |  | ----------------------------- |  | ---------------------
|                    |  |                               |  |                      
|September    , 2004 |  | /s/E. J. DIPAOLOE. J. DiPaolo |  | Director             
|September    , 2004 |  | /s/GENE STOEVERGene Stoever   |  | Director             
|September    , 2004 |  | /s/JOHN PIMENTELJohn Pimentel |  | Director             
|September    , 2004 |  | /s/LAIRD CAGANLaird Cagan     |  | Chairman of the Board

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