**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**


(Mark
      One)





x
            QUARTERLY
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934





**For
      the quarterly period ended September 30, 2008**





o
            TRANSITION
                REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE
                ACT





For
      the
      transition period from ____________ to __________




**000-31539**


(Commission
      file number)




**CHINA
      NATURAL GAS, INC.**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            
            **98-0231607**(State
                or other jurisdiction of
            
            (IRS
                Employer ofincorporation
                or organization)
            
            Identification
                No.)




**Tang
      Xing Shu Ma Building, Suite 418**


**Tang
      Xing Road**


**Xian
      High Tech Area**


**Xian,
      Shaanxi Province, China**


(Address
      of principal executive offices)





710075


(zip
      code)




**86-29-88323325**


(registrant’s
      telephone number, including area code)





N/A


(Former
      name, former address and former fiscal year, if changed since last
      report)





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
      (or
      for such shorter period that the registrant was required to file such reports),
      and (2) has been subject to such filing requirements for the past 90
      days.


Yes x  No o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer, or a smaller reporting company.
      See
      the definitions of “large accelerated filer,” “accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large
                accelerated filer ̈
            
            Accelerated
                filer ̈Non-accelerated
                filerx
            
            Smaller
                reporting company ̈(Do not check if a smaller reporting company)





Number
      of
      shares of Common Stock outstanding as of November 11, 2008:
      29,200,304


Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


Yes o No x









**China
      Natural Gas, Inc. and Subsidiaries**


**Index**





PART I.
            FINANCIAL
                INFORMATION
            
            2Item
                1.
            Consolidated
                Financial Statements
            
            2Notes
                to Consolidated Financial Statements (unaudited)
            
            5Item
                2.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            27Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            
            37Item
                4T.
            Controls
                and Procedures
            
            37PART II.
            OTHER
                INFORMATION
            
            39Item 1.
            Legal
                Proceedings
            
            39Item 1A.
            Risk
                Factors
            
            39Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            
            49Item
                3.
            Defaults
                Upon Senior Securities
            
            49Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            
            49Item
                5.
            Other
                Information
            
            49Item
                6.
            Exhibits
            
            49SIGNATURES
            
            51




1





**CHINA
      NATURAL GAS, INC. AND SUBSIDIARIES**





**CONSOLIDATED
      BALANCE SHEETS**


**AS
      OF SEPTEMBER 30, 2008 and DECEMBER 31, 2007**





**September 30, 2008**
            
            **December 31, 2007****(Unaudited)****ASSETS****CURRENT
                ASSETS:**Cash
                & cash equivalents
            
            $
            20,384,702
            
            $
            13,291,729Short-term
                investments
            
            
            -
            
            
            238,554Accounts
                receivable
            
            
            1,622,508
            
            
            306,179Other
                receivable-employee advances
            
            
            865,800
            
            
            549,820Inventories
            
            
            445,420
            
            
            231,339Advances
                to suppliers
            
            
            1,226,341
            
            
            663,041Prepaid
                expense and other current assets
            
            
            891,255
            
            
            109,722Loan
                receivable
            
            
            -
            
            
            274,200**Total
                current assets**
            
            
            25,436,026
            
            
            15,664,584**PROPERTY
                AND EQUIPMENT, net**
            
            
            55,153,057
            
            
            32,291,995**CONSTRUCTION
                IN PROGRESS**
            
            
            19,410,492
            
            
            2,210,367**DEFERRED
                FINANCING COSTS**
            
            
            1,849,288
            
            
            -**OTHER
                ASSETS**
            
            
            10,278,250
            
            
            3,123,052**TOTAL
                ASSETS**
            
            $
            112,127,113
            
            $
            53,289,998**LIABILITIES
                AND STOCKHOLDERS' EQUITY****CURRENT
                LIABILITIES:**Accounts
                payable and accrued liabilities
            
            $
            715,890
            
            $
            487,710Other
                payables
            
            
            98,090
            
            
            55,979Unearned
                revenue
            
            
            384,745
            
            
            327,220Accrued
                interest
            
            
            350,002
            
            
            -Taxes
                payable
            
            
            1,911,550
            
            
            1,211,775**Total
                current liabilities**
            
            
            3,460,277
            
            
            2,082,684**LONG-TERM
                LIABILITIES:**Notes
                payable, net of $16,104,432 discount
            
            
            23,895,568
            
            
            -Derivative
                liabilities - warrants
            
            
            17,500,000
            
            
            -**Total
                long-term liabilities**
            
            
            41,395,568
            
            
            -**COMMITMENTS
                AND CONTINGENCIES**
            
            
            -
            
            
            -**STOCKHOLDERS'
                EQUITY:**Preferred
                stock, $0.0001 per share; authorized 5,000,000 shares; none issued
            
            
            -
            
            
            -Common
                stock, $0.0001 per share; 45,000,000 authorized shares29,200,304
                shares issued and outstanding at September 30, 2008and
                December 31, 2007
            
            
            2,920
            
            
            2,920Additional
                paid-in capital
            
            
            32,098,740
            
            
            32,046,879Accumulative
                other comprehensive gain
            
            
            8,031,065
            
            
            3,477,025Statutory
                reserves
            
            
            3,228,224
            
            
            1,802,735Retained
                earnings
            
            
            23,910,319
            
            
            13,877,755**Total
                stockholders' equity**
            
            
            67,271,268
            
            
            51,207,314**TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY**
            
            $
            112,127,113
            
            $
            53,289,998





The
      accompanying notes are an integral part of these consolidated
      statements.




2


**CHINA
      NATURAL GAS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME**


**FOR
      THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND
      2007**


**(Unaudited)**





**Three months ended**
            
            **Nine months ended****September 30**
            
            **September 30****2008**
            
            **2007**
            
            **2008**
            
            **2007****Revenue**Natural
                gas revenue
            
            $
            15,354,461
            
            $
            7,555,131
            
            $
            40,494,646
            
            $
            19,243,968Installation
                and other
            
            
            3,046,739
            
            
            1,522,958
            
            
            8,822,714
            
            
            4,851,006Total
                revenue
            
            
            18,401,200
            
            
            9,078,089
            
            
            49,317,360
            
            
            24,094,974**Cost
                of revenue**Natural
                gas cost
            
            
            6,973,035
            
            
            4,020,039
            
            
            20,369,778
            
            
            9,975,932Installation
                and other
            
            
            1,935,798
            
            
            738,211
            
            
            5,700,976
            
            
            2,138,734Total
                cost of revenue
            
            
            8,908,833
            
            
            4,758,250
            
            
            26,070,754
            
            
            12,114,666**Gross
                profit**
            
            
            9,492,367
            
            
            4,319,839
            
            
            23,246,606
            
            
            11,980,308**Operating
                expenses**Selling
            
            
            2,098,343
            
            
            939,496
            
            
            5,008,631
            
            
            2,216,048General
                and administrative
            
            
            968,169
            
            
            1,028,197
            
            
            2,947,494
            
            
            1,710,459Total
                operating expenses
            
            
            3,066,512
            
            
            1,967,693
            
            
            7,956,125
            
            
            3,926,507**Income
                from operations**
            
            
            6,425,855
            
            
            2,352,146
            
            
            15,290,481
            
            
            8,053,801**Non-operating
                income (expense):**Interest
                income
            
            
            13,536
            
            
            23,831
            
            
            120,297
            
            
            41,570Interest
                expense
            
            
            (212,774
            )
            
            -
            
            
            (1,249,003
            )
            
            -Other
                income (expense)
            
            
            (55,391
            )
            
            31,148
            
            
            (118,948
            )
            
            39,504Total
                non-operating income (expense)
            
            
            (254,629
            )
            
            54,979
            
            
            (1,247,654
            )
            
            81,074**Income
                before income tax**
            
            
            6,171,226
            
            
            2,407,125
            
            
            14,042,827
            
            
            8,134,875**Provision
                for income tax**
            
            
            1,034,636
            
            
            445,463
            
            
            2,584,774
            
            
            1,317,878**Net
                income**
            
            
            5,136,590
            
            
            1,961,662
            
            
            11,458,053
            
            
            6,816,997**Other
                comprehensive income**Foreign
                currency translation gain
            
            
            756,316
            
            
            455,308
            
            
            4,554,040
            
            
            1,320,878**Comprehensive
                Income**
            
            $
            5,892,906
            
            $
            2,416,970
            
            $
            16,012,093
            
            $
            8,137,875**Weighted
                average shares outstanding**Basic
            
            
            29,200,304
            
            
            27,122,196
            
            
            29,200,304
            
            
            25,191,521Diluted
            
            
            29,279,590
            
            
            27,286,286
            
            
            29,316,837
            
            
            25,223,465**Earnings
                per share**Basic
            
            $
            0.18
            
            $
            0.07
            
            $
            0.39
            
            $
            0.27Diluted
            
            $
            0.18
            
            $
            0.07
            
            $
            0.39
            
            $
            0.27





The
      accompanying notes are an integral part of these consolidated
      statements.




3


**CHINA
      NATURAL GAS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**FOR
      THE NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**


**(Unaudited)**





**Nine months ended****September 30****2008**
            
            **2007****CASH
                FLOWS FROM OPERATING ACTIVITIES:**Net
                income
            
            $
            11,458,053
            
            $
            6,816,997Adjustments
                to reconcile net income to net cashprovided
                by operating activities:Depreciation
            
            
            2,295,534
            
            
            1,146,247Loss
                on disposal of building improvements and equipment
            
            
            12,265
            
            
            -Amortization
                of discount on senior notes
            
            
            555,001
            
            
            -Amortization
                of financing costs
            
            
            147,002
            
            
            -Stock
                based compensation
            
            
            51,861
            
            
            -Change
                in assets and liabilities:Accounts
                receivable
            
            
            (1,269,832
            )
            
            257,002Other
                receivable-employee advances
            
            
            (273,759
            )
            
            400,049Inventories
            
            
            (194,580
            )
            
            222,112Advances
                to suppliers
            
            
            (508,417
            )
            
            (31,464
            )Prepaid
                expense and other current assets
            
            
            (783,706
            )
            
            59,855Accounts
                payable and accrued libilities
            
            
            193,212
            
            
            195,660Other
                payables
            
            
            37,587
            
            
            (204,215
            )Accrued
                interest
            
            
            350,002
            
            
            -Unearned
                revenue
            
            
            34,855
            
            
            187,825Taxes
                payable
            
            
            606,233
            
            
            (1,019,262
            )Net
                cash provided by operating activities
            
            
            12,711,311
            
            
            8,030,806**CASH
                FLOWS FROM INVESTING ACTIVITIES**Proceeds
                from short term investments
            
            
            249,464
            
            
            -Proceeds
                from loan receivable
            
            
            286,740
            
            
            -Purchase
                of property and equipment
            
            
            (21,693,376
            )
            
            (5,871,571
            )Additions
                to construction in progress
            
            
            (16,679,747
            )
            
            -Prepayment
                on long term assets
            
            
            (6,774,616
            )
            
            -Prepayment
                for land use rights
            
            
            -
            
            
            (967,150
            )Net
                cash used in investing activities
            
            
            (44,611,535
            )
            
            (6,838,721
            )**CASH
                FLOWS FROM FINANCING ACTIVITIES:**Stock
                issued for cash
            
            
            -
            
            
            15,000,000Proceeds
                from senior notes
            
            
            40,000,000
            
            
            -Payment
                for offering costs
            
            
            (2,122,509
            )
            
            (1,176,533
            )Net
                cash provided by financing activities
            
            
            37,877,491
            
            
            13,823,467Effect
                of exchange rate changes on cash and cash equivalents
            
            
            1,115,706
            
            
            367,667**NET
                INCREASE IN CASH & CASH EQUIVALENTS**
            
            
            7,092,973
            
            
            15,383,219**CASH
                & CASH EQUIVALENTS, BEGINNING OF PERIOD**
            
            
            13,291,729
            
            
            5,294,213**CASH
                & CASH EQUIVALENTS, END OF PERIOD**
            
            $
            20,384,702
            
            $
            20,677,432**SUPPLEMENTAL
                DISCLOSURE OF CASH FLOW INFORMATION:**Interest
                paid
            
            $
            902,777
            
            $
            -Income
                taxes paid
            
            $
            2,012,652
            
            $
            1,955,424





The
      accompanying notes are an integral part of these consolidated
      statements.


4


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





**Note
      1 - Organization**





Organization
      and Line of Business




China
      Natural Gas, Inc. (the “Company”) was incorporated in the state of Delaware on
      March 31, 1999. The Company through its wholly-owned subsidiaries and variable
      interest entities engages in distribution of natural gas to commercial,
      industrial and residential customers, construction of pipeline networks, and
      installation of natural gas fittings and parts for end-users.




On
      May
      15, 2007, the Company’s variable interest entity, through Xi’an Xilan Natural
      Gas Co, Ltd. (“XXNGC”) established Xi'an Xilan Auto Bodyshop Co., Ltd (“XXABC”)
      with registered capital of $519,200 in Shaanxi province, People’s Republic of
      China (“PRC”). XXABC was established for the purpose of providing modification
      services to different types of automobiles to be able to use natural gas. XXABC
      is 100% owned by Xi’an Xilan Natural Gas Co, Ltd.





On
      March
      18, 2008, Xilan Natural Gas Equipment Co., Ltd (“XNGE”)  increased
      its registered capital from $30,000,000 to $53,929,260. An additional
      $14,429,260 of registered capital was contributed by China Natural Gas, Inc
      on
      April 17, 2008 and $9,500,000 of registered capital was contributed by China
      Natural Gas Inc. as a payment to Chemtex International Inc on January 31, 2008,
      for the purchase of license, know-how, and design of constructing the Liquefied
      Natural Gas (“LNG”) processing plant.





On
      April
      22, 2008, Shaanxi Jingbian Liquefied Natural Gas Co., Ltd. (“SJLNG”) increased
      its registered capital to $2,862,000. SJLNG is 100% owned by Xi’an Xilan Natural
      Gas Co., Ltd.





On
      April
      30, 2008, the Industrial and Commercial Administration Bureau approved XXNGC
      to
      increase registered capital from $8,336,856 to $43,443,640 as an additional
      contribution by the shareholders of XXNGC under PRC Law. $15,513,526 was
      approved by the Industrial and Commercial Administration Bureau to be
      transferred out from the surplus reserve and retained earning as an increase
      of
      registered capital. Another $19,593,258 was contributed by XNGE cumulatively
      prior to April 30, 2008, which was previously classified as intercompany payable
      in XXNGC and was eliminated in the consolidated financial statements. The
      increase in registered capital in XXNGC was in compliance with the Addendum
      to
      Option Agreement entered by the Company through XXGE and XXNGC, Mr. Qinan Ji,
      chairman and shareholder of XXNGC, and each of the shareholders of XXNGC
      (hereafter collectively referred to as the “Transferor”) on August 8, 2008, and
      made retroactive to June 30, 2008. See “Consolidation of Variable Interest
      Entity” section for further detail on the Addendum to Option
      Agreement.





On
      July
      3, 2008, XXNGC formed Henan Xilan Natural Gas Co., Ltd. (“HXNGC”) as a
      wholly-owned limited liability company, with registered capital of $4,383,000
      in
      Henan province PRC. NXNGC was established for the purpose of natural gas city
      gasification engineering design, construction and technical advisory work
      services in Henan, PRC.




5





**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





**Note
      2 – Summary of Significant Accounting Policies**





Principles
      of Consolidation





The
      accompanying consolidated financial statements include the accounts of China
      Natural Gas, Inc. and its wholly owned subsidiary, Xilan Natural Gas Equipment
      Co., Ltd and its 100% variable interest entities (“VIE”), Xi’an Xilan Natural
      Gas Co. Ltd., Shaanxi Jingbian Liquefied Natural Gas Co., Ltd., Xian Xilan
      Auto
      Bodyshop Co., Ltd and Henan Xilan Natural Gas Co., Ltd. All inter-company
      accounts and transactions have been eliminated in the
      consolidation.





In
      accordance with Financial Interpretation No. 46R, Consolidation of Variable
      Interest Entities ("FIN 46R"), VIEs are generally entities that lack sufficient
      equity to finance their activities without additional financial support from
      other parties or whose equity holders lack adequate decision making ability.
      All
      VIEs with which the Company is involved must be evaluated to determine the
      primary beneficiary of the risks and rewards of the VIE. The primary beneficiary
      is required to consolidate the VIE for financial reporting
      purposes.





On
      February 21, 2006, we formed Xilan Natural Gas Equipment Co., Ltd as a
      wholly-owned foreign enterprise (WOFE). We then, through XNGE, entered into
      exclusive arrangements with Xian Xilan Natural Gas and its shareholders that
      give us the ability to substantially influence Xian Xilan Natural Gas’ daily
      operations and financial affairs, appoint its senior executives and approve
      all
      matters requiring shareholder approval. We memorialized these arrangements
      on
      August 17, 2007. As a result, the Company consolidates the financial results
      of
      Xian Xilan Natural Gas as variable interest entity pursuant to Financial
      Interpretation No. 46R, “Consolidation of Variable Interest Entities.” The
      arrangements consist of the following agreements:




a.
            Xian
                Xilan Natural Gas holds the licenses and approvals necessary to operate
                its natural gas business in China.





b.
            XNGE
                provides exclusive technology consulting and other general business
                operation services to Xian Xilan Natural Gas in return for a consulting
                services fee which is equal to Xian Xilan Natural Gas’s
                revenue.





c.
            Xian
                Xilan Natural Gas’s shareholders have pledged their equity interests in
                Xian Xilan Natural Gas to the
                Company.





d.
            Irrevocably
                granted the Company an exclusive option to purchase, to the extent
                permitted under PRC law, all or part of the equity interests in Xian
                Xilan
                Natural Gas and agreed to entrust all the rights to exercise their
                voting
                power to the person appointed by the
                Company.





On
      August
      8, 2008, the Company through XXGE entered into an Addendum to Option Agreement
      with Mr. Qinan Ji, chairman and shareholder of XXNGC, and each of the
      shareholders of XXNGC (hereafter collectively referred to as the “Transferor”),
      and made retroactive to June 30, 2008. According to the agreement, the Chairman
      and the Shareholders of XXNGC irrevocably grants to XNGE an option to purchase
      or cause any person designated by XNGE to purchase, to the extent permitted
      under PRC Law, according to the steps determined by XNGE, at $1.00 for each
      Transferors’ Purchased Equity Interest or the lowest price permissible under the
      applicable laws if the applicable PRC laws stipulate restrictions on the
      purchase price of the Additional Equity Interest at the time that Equipment
      exercises the Option. The Agreement limits the XXNGC and the transferors’ right
      to make certain equity interest related decisions. This Addendum supplements
      that certain Option Agreement entered into as of August 17, 2007 and effective
      as of March 8, 2006 and is in addition to the rights granted in the
      Agreement.


6


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Basis
      of Presentation





The
      accompanying consolidated financial statements have been prepared in conformity
      with accounting principles generally accepted in the United States of America.
      The Company’s functional currency is the Chinese Renminbi (“RMB”); however, the
      Company’s reporting currency is the United States Dollar (“USD”); therefore, the
      accompanying consolidated financial statements have been translated and
      presented in USD.





In
      the
      opinion of management, the unaudited consolidated financial statements furnished
      herein include all adjustments, all of which are of a normal recurring nature,
      necessary for a fair statement of the results for the interim period presented.
      Operating results for the period ended September 30, 2008 are not necessarily
      indicative of the results that may be expected for the year ending December
      31,
      2008 .





Foreign
      Currency Translation





As
      of
      September 30, 2008 and December 31, 2007, the accounts of the Company were
      maintained, and their consolidated financial statements were expressed in RMB.
      Such consolidated financial statements were translated into USD in accordance
      with Statement of Financial Accounts Standards ("SFAS") No. 52, "Foreign
      Currency Translation," with the RMB as the functional currency. According to
      the
      Statement, all assets and liabilities were translated at the exchange rate
      as of
      the balance sheet date, stockholders' equity are translated at the historical
      rates and statements of income and cash flow items are translated at the
      weighted average exchange rate for the year. The resulting translation
      adjustments are reported under other comprehensive income in accordance with
      SFAS No. 130, "Reporting Comprehensive Income."





The
      balance sheet amounts with the exception of equity at September 30, 2008 were
      translated at 6.84 RMB to $1.00 USD as compared to 7.29 RMB at December 31,
      2007. The equity accounts were stated at their historical rate. The average
      translation rates applied to income and cash flow statement amounts for the
      nine
      months ended September 30, 2008 and 2007 were 6.98 RMB and 7.65 RMB to $1.00
      USD, respectively.  Translation adjustments resulting from this process in
      the amount of $8,031,065 and $3,477,025 as of September 30, 2008 and December
      31, 2007, respectively are classified as an item of other comprehensive income
      in the stockholders’ equity section of the consolidated balance sheets. For the
      three months ended September 30, 2008 and 2007, other comprehensive income
      in
      the consolidated statements of income and other comprehensive income included
      translation gains of $756,316 and $455,308, respectively. During the nine months
      ended September 30, 2008 and 2007, other comprehensive income in the
      consolidated statements of income and other comprehensive income included
      translation gains of $4,554,040 and $1,320,878, respectively.


7


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Use
      of
      Estimates





The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities and disclosure of
      contingent assets and liabilities at the date of the financial statements and
      the reported amounts of revenues and expenses during the reporting period.
      Actual results could differ from those estimates.





Cash
      and Cash Equivalents





Cash
      and
      cash equivalents include cash on hand and demand deposits in accounts maintained
      with state-owned banks within the PRC and the United States. The Company
      considers all highly liquid investments with original maturities of three months
      or less at the time of purchase to be cash equivalents.





Certain
      financial instruments, which subject the Company to concentration of credit
      risk, consist of cash. The Company maintains balances at financial institutions
      which, from time to time, may exceed Federal Deposit Insurance Corporation
      insured limits for the banks located in the United States. Balances at financial
      institutions or state-owned banks within the PRC are not covered by insurance.
      As of September 30, 2008 and December 31, 2007, the Company had total deposits
      of $20,078,096 and $13,053,994, without insurance coverage. And as of September
      30, 2008 and December 31, 2007, the Company had deposits in United States of
      $1,395,324 and $126,170 in excess of federally insured limits, respectively.
      The
      Company has not experienced any losses in such accounts and believes it is
      not
      exposed to any significant risks on its cash in bank accounts.





Short
      Term Investments





Short-term
      investments are securities classified as available for sale, held by a private
      investment trust company for investing activities. Gain or loss on securities
      is
      computed using cost basis of first-in, first-out (FIFO) basis. The fair value
      of
      securities at December 31, 2007 totaled $238,554, which equaled the original
      costs, and was returned to the Company in March 2008.





Accounts
      Receivable





Accounts
      and other receivable are recorded at net realizable value consisting of the
      carrying amount less an allowance for uncollectible accounts, as needed. The
      Company maintains reserves for potential credit losses on accounts receivable.
      Management reviews the composition of accounts receivable and analyzes
      historical bad debts, customer concentrations, customer credit worthiness,
      current economic trends and changes in customer payment patterns to evaluate
      the
      adequacy of these reserves. Reserves are recorded primarily on a specific
      identification basis in the period of the related sales. The Company’s
      management has determined that all receivables are collectible and there is
      no
      need for an allowance for uncollectible accounts as of September 30, 2008 and
      December 31, 2007. When amounts are identified as no longer collectible, the
      receivable and the reserve are written off.





Other
      Receivable-employee advances





From
      time
      to time, the Company advances predetermined amounts based upon internal Company
      policy to certain employees and internal units to ensure certain transactions
      to
      be performed in a timely manner. The Company has full oversight and control
      over
      the advanced accounts. Therefore, no allowance for uncollectible accounts is
      needed.


8


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Advances
      to suppliers





The
      Company advances to certain vendors for purchase of its material. The advances
      are interest free and unsecured.





Inventory





Inventory
      is stated at the lower of cost, as determined on a first-in, first-out basis,
      or
      market. Management compares the cost of inventories with the market value,
      and
      allowance is made for writing down the inventories to their market value, if
      lower. Inventory consists of material used in the construction of pipelines
      and
      material used in repairing and modifying of vehicles. Inventory also consists
      of
      natural gas and gasoline.





The
      following are the details of the inventories:





September 30, 2008
            
            December 31, 2007(Unaudited)Materials
                and supplies
            
            $
            266,402
            
            $
            109,333Natural
                gas and gasoline
            
            
            179,018
            
            
            122,006Total
                inventories
            
            $
            445,420
            
            $
            231,339





Property
      and Equipment





Property
      and equipment are stated at cost. Expenditures for maintenance and repairs
      are
      charged to earnings as incurred while additions, renewals and betterments are
      capitalized. When property and equipment are retired or otherwise disposed
      of,
      the related cost and accumulated depreciation are removed from the respective
      accounts, and any gain or loss is included in operations. Depreciation of
      property and equipment is provided using the straight-line method for
      substantially all assets with estimated lives as follows:





Office
                equipment
            
            
            5 yearsOperating
                equipment
            
            
            5-20 yearsVehicles
            
            
            5 yearsBuildings
            
            
            30 years





The
      following are the details of the property and equipment:





September 30, 2008
            
            December 31,2007(Unaudited)Office
                equipment
            
            $
            217,981
            
            $
            163,432Operating
                equipment
            
            
            38,844,394
            
            
            22,413,270Vehicles
            
            
            2,157,667
            
            
            1,484,892Buildings
            
            
            20,192,794
            
            
            11,943,006Total
                property and equipment
            
            
            61,412,836
            
            
            36,004,600Less
                accumulated depreciation
            
            
            (6,259,779
            )
            
            (3,712,605
            )Property
                and equipment, net
            
            $
            55,153,057
            
            $
            32,291,995




9


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Depreciation
      expense for the three months ended September 30, 2008 and 2007 was $937,156
      and
      $419,991, respectively. Depreciation expense for the nine months ended September
      30, 2008 and 2007 was $ 2,295,534 and $1,146,247 respectively.




Long-Lived
      Assets





The
      Company applies the provision of Statement of Financial Accounting Standards
      No.
      144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS
      144") to all long lived assets. SFAS 144 addresses accounting and reporting
      for
      impairment and disposal of long-lived assets. The Company periodically evaluates
      the carrying value of long-lived assets to be held and used in accordance with
      SFAS 144. SFAS 144 requires impairment losses to be recorded on long-lived
      assets used in operations when indicators of impairment are present and the
      undiscounted cash flows estimated to be generated by those assets are less
      than
      the assets' carrying amounts. In that event, a loss is recognized based on
      the
      amount by which the carrying amount exceeds the fair market value of the
      long-lived assets. Loss on long-lived assets to be disposed of is determined
      in
      a similar manner, except that fair market values are reduced for the cost of
      disposal. Based on its review, the Company believes that, as of September 30,
      2008 there were no significant impairments of its long-lived
      assets.





Construction
      in Progress





Construction
      in progress consists of the cost of constructing property and equipment for
      the
      Company’s use. The major cost of construction in progress relates to material,
      labor and overhead.





Interest
      cost capitalized into construction in progress for the three months ended
      September 30, 2008 and 2007 amounted to $990,061 and $0, respectively. Interest
      cost capitalized into construction in progress for the nine months ended
      September 30, 2008 and 2007 amounted to $1,672,565 and $0, respectively.





Fair
      Value of Financial Instruments





On
      January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements.
      SFAS
      No. 157 defines fair value as the price that would be received to sell an asset
      or paid to transfer a liability (i.e., the “exit price”) in an orderly
      transaction between market participants at the measurement date. SFAS No. 157
      establishes a three-level valuation hierarchy for disclosures of fair value
      measurement and enhances disclosures requirements for fair value measures.
      The
      carrying amounts reported in the balance sheets for receivables and current
      liabilities each qualify as financial instruments and are a reasonable estimate
      of fair value because of the short period of time between the origination of
      such instruments and their expected realization and their current market rate
      of
      interest. The three levels are defined as follow:




·
            Level
                1inputs
                to the valuation methodology are quoted prices (unadjusted) for identical
                assets or liabilities in active
                markets.


10


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**




·
            Level
                2inputs
                to the valuation methodology include quoted prices for similar assets
                and
                liabilities in active markets, and inputs that are observable for
                the
                asset or liability, either directly or indirectly, for substantially
                the
                full term of the financial
                instrument.




·
            Level
                3inputs
                to the valuation methodology are unobservable and significant to
                the fair
                value measurement.





The
      Company analyzes all financial instruments with features of both liabilities
      and
      equity under SFAS 150, “Accounting for Certain Financial Instruments with
      Characteristics of Both Liabilities and Equity,” SFAS No 133, “Accounting for
      Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for
      Derivative Financial Instruments Indexed to, and Potentially Settled in, a
      Company’s Own Stock.”




As
      required by SFAS No. 157, financial assets and liabilities are classified
      in their entirety based on the lowest level of input that is significant to
      the
      fair value measurement. Depending on the product and the terms of the
      transaction, the fair value of our notes payable and derivative liabilities
      were
      modeled using a series of techniques, including closed-form analytic formula,
      such as the Black-Scholes option-pricing model, which does not entail material
      subjectivity because the methodology employed do not necessitate significant
      judgment, and the pricing inputs are observed from actively quoted markets.





The
      following table sets forth by level within the fair value hierarchy our
      financial assets and liabilities that were accounted for at fair value on a
      recurring basis as of September 30, 2008.


**Fair Value Measurements at****Carrying Value at**
              
              **September 30, 2008 Using****September 30, 2008**
              
              **Level 1**
              
              **Level 2**
              
              **Level 3**Senior
                  Notes
              
              $
              23,895,568
              
              $
              -
              
              $
              43,306,665
              
              $
              -Derivative
                  Liability - Warrants
              
              
              17,500,000
              
              
              -
              
              
              6,769,351
              
              
              -Total
                  liability measured at fair value
              
              $
              41,395,568
              
              $
              -
              
              $
              50,076,016
              
              $
              -


The
      Company did not identify any other non-recurring assets and liabilities that
      are
      required to be presented on the balance sheet at fair value in accordance with
      SFAS No. 157.




Derivative
      Accounting





The
      financial instruments are accounted for in accordance with Financial Accounting
      Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging
      Activities”, which established accounting and reporting requirements for
      derivative instruments and hedging activities. SFAS No. 133, as amended by
      SFAS
      No. 138 and 149, requires that all derivative instruments subject to the
      requirements of the statement be measured at fair value and recognized as assets
      or liabilities in the balance sheet. The accounting for changes in the fair
      value of a derivative depends on the intended use of the derivative and the
      resulting designation is generally established at the inception of a derivative.
      For derivatives designated as cash flow hedges and meeting the effectiveness
      guidelines of SFAS No. 133, changes in fair value, to the extent effective,
      are
      recognized in other comprehensive income until the hedged item is recognized
      in
      earnings. Hedge effectiveness is measured at least quarterly based on the
      relative changes in fair value between the derivative contract and the hedged
      item over time. Any change in fair value of a derivative resulting from
      ineffectiveness or an excluded component of the gain/loss is recognized
      immediately in the statement of operations.


11


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





The
      Company elected not to apply hedge accounting; therefore the change in fair
      value is recognized in earnings each reporting period. The Company did not
      have
      any derivatives during the period.





Revenue
      Recognition





The
      Company's revenue recognition policies are in accordance with Staff Accounting
      Bulletin (SAB) 104. Revenue is recognized when services are rendered to
      customers, when a formal arrangement exists, the price is fixed or determinable,
      the delivery is completed, no other significant obligations of the Company
      exist
      and collectability is reasonably assured. Payments received before all of the
      relevant criteria for revenue recognition are satisfied are recorded as unearned
      revenue. Revenue from gas and gasoline sales is recognized when gas and gasoline
      is pumped through pipelines to the end users. Revenue from installation of
      pipelines is recorded when the contract is completed and accepted by the
      customers. The construction contracts are usually completed within one to two
      months. Revenue from repairing and modifying vehicles is recorded when service
      are rendered to and accepted by the customers.





Unearned
      Revenue





Unearned
      revenue represents prepayments by customers for gas purchases and advance
      payments on installation of pipeline contracts. The Company records such
      prepayment as unearned revenue when the payments are received.





Advertising
      Costs





The
      Company expenses the cost of advertising as incurred or, as appropriate, the
      first time the advertising takes place. Advertising costs for the three and
      nine
      months ended September 30, 2008 and 2007 were insignificant.





Stock-Based
      Compensation





The
      Company records and reports stock-based compensation pursuant to SFAS 123R
      “Accounting for Stock-Based Compensation”, which
      defines a fair-value-based method of accounting for stock-based employee
      compensation and transactions in which an entity issues its equity instruments
      to acquire goods and services from non-employees. Stock compensation for stock
      granted to non-employees has been determined in accordance with SFAS 123R and
      the Emerging Issues Task Force consensus Issue No. (EITF) 96-18, "Accounting
      for
      Equity Instruments that are issued to Other than Employees for Acquiring, or
      in
      Conjunction with Selling Goods or Services", as the fair value of the
      consideration received or the fair value of equity instruments issued, whichever
      is more reliably measured.


12


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Income
      Taxes





The
      Company utilizes SFAS No. 109, "Accounting for Income Taxes," which requires
      the
      recognition of deferred tax assets and liabilities for the expected future
      tax
      consequences of events that have been included in the financial statements
      or
      tax returns. Under this method, deferred income taxes are recognized for the
      tax
      consequences in future years of temporary differences between the tax bases
      of
      assets and liabilities and their financial reporting amounts at each period
      end
      based on enacted tax laws and statutory tax rates applicable to the periods
      in
      which the differences are expected to affect taxable income. Valuation
      allowances are established, when necessary, to reduce deferred tax assets to
      the
      amount expected to be realized. At September 30, 2008 and December 31, 2007,
      there was no significant book to tax differences. There is no difference between
      book depreciation and tax depreciation as the Company uses the same method
      for
      both book and tax. The Company adopted FASB Interpretation 48, “Accounting for
      Uncertainty in Income Taxes” (“FIN 48”), as of January 1, 2007. A tax position
      is recognized as a benefit only if it is “more likely than not” that the tax
      position would be sustained in a tax examination, with a tax examination being
      presumed to occur. The amount recognized is the largest amount of tax benefit
      that is greater than 50% likely of being realized on examination. For tax
      positions not meeting the “more likely than not” test, no tax benefit is
      recorded. The adoption had no affect on the Company’s financial
      statements.





Local
      PRC Income Tax





The
      Company’s subsidiary or variable interest entities operate in China. Starting
      January 1, 2008, pursuant to the tax laws of China, general enterprises are
      subject to income tax at an effective rate of 25% compare to 33% prior to 2008.
      The Company’s variable interest entity, XXNGC, is in the natural gas industry
      whose development is encouraged by the government. According to the income
      tax
      regulation, any company engaged in the natural gas industry enjoys a favorable
      tax rate. Accordingly, except for income from XNGE, SJLNG, XXABC, HXNGC which
      subjects to 25% PRC income tax rate, XXNGC’s income is subject to a reduced tax
      rate of 15%.





A
      reconciliation of tax at United States federal statutory rate to provision
      for
      income tax recorded in the financial statements is as follows:





For three months ended
            
            For nine months endedSeptember 30,
            
            September 30,(Unaudited)
            
            (Unaudited)2008
            
            2007
            
            2008
            
            2007Tax
                provision (credit) at statutory rate
            
            
            34%
            
            
            34%
            
            
            34%
            
            
            34%Foreign
                tax rate difference
            
            
            (9)%
            
            
            (1)%
            
            
            (9)%
            
            
            (1)%Effect
                of favorable tax rate
            
            
            (8)%
            
            
            (14)%
            
            
            (7)%
            
            
            (17)%Effective
                rate
            
            
            17%
            
            
            19%
            
            
            18%
            
            
            16%




13


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





The
      estimated tax savings for the three months ended September 30, 2008 and 2007
      amounted to approximately $645,717 and $372,960, respectively. The net effect
      on
      earnings per share had the income tax been applied would decrease basic earnings
      per share for the three months ended September 30, 2008 and 2007 from $0.18
      to
      $0.15 and $0.07 to $0.06, respectively, respectively. The estimated tax savings
      for the nine months ended September 30, 2008 and 2007 amounted to approximately
      $1,579,140 and $1,448,000, respectively. The net effect on earnings per share
      had the income tax been applied would decrease basic earnings per share for
      the
      nine months ended September 30, 2008 and 2007 from $0.39 to $0.34 and $0.27
      to
      $0.21, respectively.





China
      Natural Gas, Inc. was incorporated in the United States and has incurred net
      operating loss for income tax purpose for 2008. The net operating loss carry
      forwards for United States income tax purposes amounted to $4,867,724 which
      may
      be available to reduce future years' taxable income. These carry forwards will
      expire, if not utilized, through 2027. Management believes that the realization
      of the benefits arising from this loss appear to be uncertain due to Company's
      limited operating history and continuing losses for United States income tax
      purposes. Accordingly, the Company has provided a 100% valuation allowance
      at
      September 30, 2008. The valuation allowance at September 30, 2008 was
      $1,655,000. Management will review this valuation allowance periodically and
      make adjustments as warranted.





Value
      added tax





Sales
      revenue represents the invoiced value of goods, net of a value-added tax
      (“VAT”). All of the Company’s variable interest entity XXNGC’s products that are
      sold in the PRC are subject to a Chinese value-added tax at a rate of 13% of
      the
      gross sales price. This VAT may be offset by VAT paid by the XXNGC on raw
      materials and other materials included in the cost of producing their finished
      product. XXNGC recorded VAT payable and VAT receivable net of payments in the
      financial statements. The VAT tax return is filed offsetting the payables
      against the receivables.





All
      revenues from XXABC subject to a Chinese value-added tax at a rate of 6%. This
      VAT cannot offset with VAT paid for materials included in the cost of revenues.





Basic
      and Diluted Earning Per Share




Earning
      per share is calculated in accordance with the SFAS 128, “Earnings per share”.
      Basic net earnings per share is based upon the weighted average number of common
      shares outstanding. Diluted net earnings per share is based on the assumption
      that all dilutive convertible shares and stock options were converted or
      exercised. Dilution is computed by applying the treasury stock method. Under
      this method, options and warrants are assumed to be exercised at the beginning
      of the period (or at the time of issuance, if later), and as if funds obtained
      thereby were used to purchase common stock at the average market price during
      the period.





Statement
      of Cash Flows





In
      accordance with Statement of Financial Accounting Standards No. 95, "Statement
      of Cash Flows," cash flows from the Company's operations is calculated based
      upon the local currencies and translated to USD at average translation rates
      for
      the period. As a result, translation adjustment amounts related to assets and
      liabilities reported on the statement of cash flows will not necessarily agree
      with changes in the corresponding balances on the balance sheet.


14


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Reclassifications





Certain
      prior period amounts have been reclassified to conform to current period
      presentation. These reclassifications had no effect on net income or cash flows
      as previously reported.





Recent
      Pronouncements





In
      February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
      Assets and Financial Liabilities—including an amendment of FASB Statement No.
      115 (“FAS 159”). FAS 159 permits companies to choose to measure many financial
      instruments and certain other items at fair value that are not currently
      required to be measured at fair value. The objective of FAS 159 is to provide
      opportunities to mitigate volatility in reported earnings caused by measuring
      related assets and liabilities differently without having to apply hedge
      accounting provisions. FAS 159 also establishes presentation and disclosure
      requirements designed to facilitate comparisons between companies that choose
      different measurement attributes for similar types of assets and liabilities.
      The Company adopted SFAS No. 159 on January 1, 2008. The Company chose not
      to
      elect the option to measure the fair value of eligible financial assets and
      liabilities.





In
      June
      2007, the FASB issued FASB Staff Position No. EITF 07-3, “Accounting for
      Nonrefundable Advance Payments for Goods or Services Received for use in Future
      Research and Development Activities” (“FSP EITF 07-3”), which addresses whether
      nonrefundable advance payments for goods or services that used or rendered
      for
      research and development activities should be expensed when the advance payment
      is made or when the research and development activity has been performed. The
      Company adopted FSP EITF 07-3 and expensed the research and development as
      incurred.





In
      December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
      Consolidated Financial Statements - an amendment of Accounting Research Bulletin
      No. 51” (“SFAS 160”), which establishes accounting and reporting standards for
      ownership interests in subsidiaries held by parties other than the parent,
      the
      amount of consolidated net income attributable to the parent and to the
      noncontrolling interest, changes in a parent’s ownership interest and the
      valuation of retained non-controlling equity investments when a subsidiary
      is
      deconsolidated. The Statement also establishes reporting requirements that
      provide sufficient disclosures that clearly identify and distinguish between
      the
      interests of the parent and the interests of the non-controlling owners. SFAS
      160 is effective for fiscal years beginning after December 15, 2008. The Company
      has not determined the effect that the application of SFAS 160 will have on
      its
      consolidated financial statements.





In
      December 2007, Statement of Financial Accounting Standards No. 141(R), *Business
      Combinations* ,
      was
      issued. SFAS No. 141R replaces SFAS No. 141, *Business
      Combinations.* SFAS
      141R
      retains the fundamental requirements in SFAS 141 that the acquisition method
      of
      accounting (which SFAS 141 called the *purchase
      method* )
      be used
      for all business combinations and for an acquirer to be identified for each
      business combination. SFAS 141R requires an acquirer to recognize the assets
      acquired, the liabilities assumed, and any noncontrolling interest in the
      acquiree at the acquisition date, measured at their fair values as of that
      date,
      with limited exceptions. This replaces SFAS 141’s cost-allocation process, which
      required the cost of an acquisition to be allocated to the individual assets
      acquired and liabilities assumed based on their estimated fair values. SFAS
      141R
      also requires the acquirer in a business combination achieved in stages
      (sometimes referred to as a step acquisition) to recognize the identifiable
      assets and liabilities, as well as the noncontrolling interest in the acquiree,
      at the full amounts of their fair values (or other amounts determined in
      accordance with SFAS 141R). SFAS 141R applies prospectively to business
      combinations for which the acquisition date is on or after the beginning of
      the
      first annual reporting period beginning on or after December 15, 2008. An entity
      may not apply it before that date. The Company is currently evaluating the
      impact that adopting SFAS No. 141R will have on its financial
      statements.


15


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





In
      March
      2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
      Financial Accounting Standards (“SFAS”) No. 161, “Disclosures about
      Derivative Instruments and Hedging Activities – An Amendment of SFAS
      No. 133” (“SFAS 161”). SFAS 161 seeks to improve financial reporting for
      derivative instruments and hedging activities by requiring enhanced disclosures
      regarding the impact on financial position, financial performance, and cash
      flows. To achieve this increased transparency, SFAS 161 requires (1) the
      disclosure of the fair value of derivative instruments and gains and losses
      in a
      tabular format; (2) the disclosure of derivative features that are credit
      risk-related; and (3) cross-referencing within the footnotes. SFAS 161 is
      effective on January 1, 2009. The Company is in the process of evaluating
      the new disclosure requirements under SFAS 161.





In
      May
      2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted
      Accounting Principles" ("FAS 162"). FAS 162 is intended to improve financial
      reporting by identifying a consistent framework, or hierarchy, for selecting
      accounting principles to be used in preparing financial statements that are
      presented in conformity with GAAP for nongovernmental entities. FAS 162 is
      effective 60 days following the SEC's approval of the Public Company Accounting
      Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly
      in
      Conformity with Generally Accepted Accounting Principles." The Company is in
      the
      process of evaluating the impact of adoption of this statement on the results
      of
      operations, financial position or cash flows.





In
      June
      2008, the FASB issued Emerging Issues Task Force Issue 07-5 “Determining whether
      an Instrument (or Embedded Feature) is indexed to an Entity’s Own Stock” (“EITF
      No. 07-5”). This Issue is effective for financial statements issued for fiscal
      years beginning after December 15, 2008, and interim periods within those fiscal
      years. Early application is not permitted. Paragraph 11(a) of Statement of
      Financial Accounting Standard No 133 “Accounting for Derivatives and Hedging
      Activities” (“SFAS 133”) specifies that a contract that would otherwise meet the
      definition of a derivative but is both (a) indexed to the Company’s own
      stock and (b) classified in stockholders’ equity in the statement of
      financial position would not be considered a derivative financial instrument.
      EITF No.07-5 provides a new two-step model to be applied in determining whether
      a financial instrument or an embedded feature is indexed to an issuer’s own
      stock and thus able to qualify for the SFAS 133 paragraph 11(a) scope exception.
      This standard will trigger liability accounting on all options and warrants
      exercisable at strike prices denominated in any currency other than the
      functional currency in China (Renminbi). The Company is currently evaluating
      the
      impact of adoption of EITF No. 07-5 on the Company’s consolidated financial
      statements.


16


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





In
      September 2008, the FASB issued FASB Staff Positions FSP FAS 133-1 and FIN
      45-4,
      Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of
      FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of
      the
      Effective Date of FASB Statement No. 161". This FSP amends FASB Statement No.
      133, Accounting for Derivative Instruments and Hedging Activities, to require
      disclosures by sellers of credit derivatives, including credit derivatives
      embedded in a hybrid instrument. This FSP also amends FASB Interpretation No.
      45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
      Indirect Guarantees of Indebtedness of Others, to require an additional
      disclosure about the current status of the payment/performance risk of a
      guarantee. Further, this FSP clarifies the Board’s intent about the effective
      date of FASB Statement No. 161, Disclosures about Derivative Instruments and
      Hedging Activities. The provisions of this FSP that amend Statement 133 and
      Interpretation 45 shall be effective for reporting periods (annual or interim)
      ending after November 15, 2008. The Company is in the process of evaluating
      the
      new disclosure requirements under this FSP.





**Note
      3 – Other Assets**





Other
      assets consisted of the following,





September 30
            
            December 31,2008
            
            2007(Unaudited)Prepaid
                rent – natural gas stations
            
            $
            265,504
            
            
            225,924Prepayment
                for acquiring land use right
            
            
            1,060,675
            
            
            993,975Advances
                on equipment and construction in progress
            
            
            8,632,303
            
            
            1,501,443Refundable
                security deposits
            
            
            263,340
            
            
            356,460Others
            
            
            56,428
            
            
            45,250Total
            
            $
            10,278,250
            
            $
            3,123,052





All
      land
      in the People’s Republic of China is government owned. However, the government
      grants the user a land use right to use the land. As of September 30, 2008
      and
      December 31, 2007, the Company prepaid $1,060,675 and $993,975, respectively,
      to
      the PRC local government to purchase land use rights. The Company is in the
      process of negotiating the final purchase price with the local government and
      the land use rights have not been granted to the Company. Therefore, the Company
      did not amortize the prepaid land use rights.





Advances
      on the purchase of equipment/construction in progress are monies deposited
      or
      advanced to outside vendors/subcontractors for the purchase of operating
      equipment or for services to be provided for constructions in progress.





Refundable
      security deposits are monies deposited with one of the Company’s major vendors
      and gas station landlord. These amounts will be returned to the Company if
      they
      terminate the business relationship or at the end of the lease.


17


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





**Note
      4 – Senior Notes Payable**





On
      December 30, 2007, the Company entered into a Securities Purchase Agreement
      with
      Abax Lotus Ltd. (the “Investor”). The Purchase Agreement was subsequently
      amended on January 29, 2008, pursuant to which the Company (i) agreed to issue
      5.00% Guaranteed Senior Notes due 2014 (the “Senior Notes”) of approximately
      $20,000,000, (ii) agreed to issue to the Investor Senior Notes in aggregate
      principal amount of approximately $20,000,000 on or before March 3, 2008 subject
      to the Company meeting certain closing conditions, (iii) granted the Investor
      an
      option to purchase up to approximately $10,000,000 in principal amount of its
      Senior Notes and (iv) agreed to issue to the Investor seven-year warrants
      exercisable for up to 2,900,000 shares of the Company’s common stock (the
“Warrants”) at an initial exercise price equal to $7.3652 per share, subject to
      certain adjustments. On January 29, 2008, the Company issued $20,000,000 Senior
      Notes 2,900,000 warrants pursuant to the Purchase Agreement. On March 3, 2008,
      the Investor exercised its first option for an additional $20,000,000 of Senior
      Notes. On March 10, 2008, the Company issued $20,000,000 in additional Senior
      Notes resulting in total Senior Notes of $40,000,000.





At
      the
      closing, the Company entered into:





·
            An
                indenture for the 5.00% Guaranteed Senior Notes due
                2014;


·
            An
                investor rights agreement;


·
            A
                registration rights agreement covering the shares of common stock
                issuable
                upon exercise of the warrants;


·
            An
                information rights agreement that grants to the Investor, subject
                to
                applicable law, the right to receive certain information regarding
                the
                Company, and


·
            A
                share-pledge agreement whereby the Company granted to the Collateral
                Agent
                (on behalf of the holders of the Senior Notes) a pledge on 65% of
                the
                Company’s equity interest in Shaanxi Xilan Natural Gas Equipment Co.,
                Ltd., a PRC corporation and wholly-owned subsidiary of the Company.


·
            An
                account pledge and security agreement whereby the Company granted
                to the
                Collateral Agent a security interest in the account where the proceeds
                from the Senior Notes are
                deposited.





In
      addition, Qinan Ji, Chief Executive Officer and Chairman of the Board of the
      Company, executed a non-compete agreement for the benefit of the
      Investor.





The
      Senior Notes were issued pursuant to an indenture between the Company and DB
      Trustees (Hong Kong) Limited, as trustee, at the closing. The Senior Notes
      will
      mature on January 30, 2014 and will initially bear interest at the stated
      interest rate of 5.00% per annum, subject to increase in the event of certain
      circumstances. The Company is required to make mandatory prepayments on the
      Senior Notes on the following dates and in the following amounts, expressed
      as a
      percentage of the aggregate principal amount of Notes that will be outstanding
      on the first such payment date:




Date
            
            Prepayment PercentageJuly
                30, 2011
            
            
            8.3333
            %January
                30, 2012
            
            
            8.3333
            %July
                30, 2012
            
            
            16.6667
            %January
                30, 2013
            
            
            16.6667
            %July
                30, 2013
            
            
            25.0000
            %




18


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





During
      the twelve month period commencing January 30 of the years set forth below,
      the
      Company may redeem the Senior Notes at the following principal
      amount:




Year
            
            Principal2009
            
            
            43,200,0002010
            
            
            42,400,0002011
            
            
            41,600,0002012
            
            
            40,800,0002013
                and thereafter
            
            
            40,000,000





Upon
      the
      occurrence of certain events defined in the indenture, the Company must offer
      the holders of the Senior Notes the right to require the Company to purchase
      the
      Senior Notes in an amount equal to 105% of the aggregate principal amount
      purchased plus accrued and unpaid interest on the Senior Notes purchased.





The
      indenture requires the Company to pay additional interest at the rate of 3.0%
      per annum of the Senior Notes if the Company has not obtained a listing of
      its
      common stock on the Nasdaq Global Market, the Nasdaq Capital Market or the
      New
      York Stock Exchange by January 29, 2009 and maintained such listing continuously
      thereafter as long as the Senior Notes are outstanding. Pursuant to the
      registration rights agreement (described herein), the Company has agreed to
      pay
      additional interest at the rate of 1.0% per annum of the Senior Notes principal
      amount outstanding for each 90-day period in which the Company has failed to
      comply with the registration obligations under the registration rights
      agreement.





The
      indenture limits the Company's ability to incur debt and liens, make dividend
      payments and stock repurchases, make investments, reinvest proceeds from asset
      sales and enter into transactions with affiliates, among other things. The
      indenture also requires the Company to maintain certain financial
      ratios.





The
      Company also entered into an investor rights agreement, pursuant to which,
      as
      long as an investor holds at least 10% of the aggregate principal amount of
      the
      Senior Notes issued and outstanding or at least 3% of the Company’s issued and
      outstanding common stock pursuant to the warrants on an as-exercised basis
      (“Minimum Holding”), the Company has agreed not to undertake certain corporate
      actions without prior Investor approval. In addition, so long as an Investor
      owns the Minimum Holding, such Investor shall have a right of first refusal
      for
      future debt securities offerings by the Company and the Company is subject
      to
      certain transfer restrictions on its securities and certain other
      properties.




From
      the
      Closing Date and as long as the Investor continues to hold more than 10% of
      the
      outstanding shares of common stock on an as-converted, fully-diluted basis,
      the
      Investor shall be entitled to appoint one of the Company’s board of directors
      (the “Investor Director”). The Investor Director shall be entitled to serve on
      each committee of the board, except that, the Investor Director shall not serve
      on the audit committee unless it is an independent director. Mr. Ji has agreed
      to vote his shares for the election of the Investor Director.


19


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





The
      Company is required to prepare and file a registration statement covering the
      sales of all of the shares of common stock issuable upon exercise of the
      warrants (the “Warrant Shares”). In the event that effectiveness of the
      registration statement is suspended at any time other than pursuant to a
      suspension notice, for each 90-day period during which the registration default
      remains uncured, the Company shall be required to pay additional interest at
      the
      rate of one percent (1%)
      of the Senior Notes.





On
      March
      3, 2008, the Investor exercised its option to purchase an additional $20,000,000
      of Senior Notes. On March 10, 2008, the Company issued the additional
      $20,000,000 in Senior Notes resulting in total Senior Notes of
      $40,000,000.





In
      connection with the issuance of the Securities Purchase Agreement, the Company
      paid $2,122,509 in debt issuance costs which is being amortized over the life
      of
      the Senior Notes. For the three months ended September 30, 2008, the Company
      amortized $24,410 of the aforesaid issuance costs, net of capitalized interest.
      For the nine months ended September 30, 2008, the Company amortized $147,002
      of
      the aforesaid issuance costs, net of capitalized interest.





In
      connection with the Securities Purchase Agreement, the Company agreed to issue
      to the Investor seven-year warrants exercisable for up to 2,900,000 shares
      of
      the Company’s common stock at an initial exercise price equal to $7.3652 per
      share, subject to certain adjustments. The exercise price of the Warrants is
      adjusted on the first anniversary of issuance and thereafter, at every six
      month
      anniversary beginning in the fiscal year 2009 if the volume weighted average
      price, or VWAP, (as defined therein) for the 15 trading days prior to the
      applicable reset date is less than the then applicable exercise price, in which
      case the exercise price shall be adjusted downward to the then current VWAP;
      provided, however, that in no event shall the exercise price be adjusted below
      $3.6826 per share.





If
      the
      Company’s consolidated net profit after tax does not reach the stated level for
      2007 or 2008, the exercise price of the warrants shall be adjusted by
      multiplying the current exercise price by a fraction, the numerator of which
      is
      the sum of (i) the number of shares of the Company’s common stock outstanding
      immediately prior to such adjustment and (ii) 87,000, and the denominator of
      which is the number of shares of the Company’s common stock outstanding
      immediately prior to such adjustment. Pursuant to the terms of the warrant
      agreement, a holder cannot exercise the Warrants to the extent that the number
      of shares of Common Stock beneficially owned by the holder would, following
      such
      exercise, exceed 9.9% of the outstanding shares of common stock at the time
      of
      exercise.





The
      warrants granted to the Investor on January 29, 2008 are considered derivative
      instruments that need to be bifurcated from the original security. If the
      Warrants have not been exercised within the seven year period, then the Investor
      can have the Company purchase the Warrants for $17,500,000. This amount is
      shown
      as a debt discount and is being amortized over the term of the Senior Notes.
      For
      the three months ended September 30, 2008, the Company amortized $95,528 of
      the
      aforesaid discounts, net of capitalized interest. For the nine months ended
      September 30, 2008, the Company amortized $555,001 of the aforesaid discounts,
      net of capitalized interest. As of September 30, 2008, $16,104,432 has not
      been
      amortized.


20


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





**Note
      5 – Stockholders’ Equity**





Common
      stock





On
      August
      2, 2007, the Company entered into a Securities Purchase Agreement with investors
      to sell 4,615,385 shares of the Company’s common stock and attached warrants to
      purchase up to 692,308 shares of Common stock (“Investor warrants”) for $3.25
      per share (or an aggregate purchase price of $15,000,000) and for total net
      proceeds of $13,823,467. Warrants are exercisable for a period of five years
      with exercise price of $7.79 per share.





In
      connection with the above-mentioned offering, the Company entered into a finance
      representation agreement (“Agreement”) with a placement agent (“Agent”).
      Pursuant to the agreement, the Company agreed to pay the Agent $10,000 and
      issued a warrant (“Placement Agent Warrants”) to acquire 75,000 shares of the
      Company’s common stock. In addition, the Company paid a $1,050,000 fee (7% of
      the gross proceeds).





Warrants
      associated with the above-mentioned issuance of common stock were issued in
      October 2007 upon the effective filing of its certificate of Amendment of
      Articles of Incorporation to increase the authorized number of shares of common
      stock from 30,000,000 to 45,000,000.





Both
      Investor Warrants and Placement Agent Warrants meet the conditions for equity
      classification pursuant to FAS 133 “Accounting for Derivatives” and EITF 00-19
“Accounting for Derivative Financial Instruments Indexed to, and Potentially
      Settled in, a Company’s Own Stock.” Therefore, these warrants were classified as
      equity and accounted as common stock issuance cost.





In
      connection with the Securities Purchase Agreement, the Company agreed to issue
      to the Investor seven-year warrants exercisable for up to 2,900,000 shares
      of
      the Company’s common stock at an initial exercise price equal to $7.3652 per
      share, subject to certain adjustments. The warrants have been determined to
      be
      derivative liabilities instruments because there is a required redemption
      requirement if the holder does not exercise the Warrants. However, the warrants
      does not required to be value at mark to market, rather, to be at its
      undiscounted amount of $17.5 million according to FAS 150.





Following
      is a summary of the warrant activity:





Warrants
              Outstanding
            
            Weighted Average
              Exercise Price
            
            Aggregate
              Intrinsic ValueOutstanding,
                December 31, 2006
            
            
            1,140,286
            
            $
            3.60
            
            
            -Granted
            
            
            767,308
            
            $
            7.79
            
            
            -Forfeited
            
            
            -
            
            
            -
            
            
            -Exercised
            
            
            (819,110
            )
            $
            3.60
            
            
            -Outstanding,
                December 31, 2007
            
            
            1,088,484
            
            $
            6.55
            
            $
            376,977Granted
            
            
            2,900,000
            
            $
            7.37
            
            
            -Forfeited
            
            
            -
            
            
            -
            
            
            -Exercised
            
            
            -
            
            
            -
            
            
            -Outstanding,
                September 30, 2008 (Unaudited)
            
            
            3,988,484
            
            $
            7.14
            
            $
            -


21


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





Following
      is a summary of the status of warrants outstanding at September 30, 2008:


Outstanding
                  Warrants
              
              
              
              Exercisable
                  WarrantsExercise
                Price
              
              Number
              
              Average
                Remaining
                Contractual
                Life
              
              Average
                Exercise
                  Price
              
              Number$
              3.60
              
              
              321,176
              
              
              0.28
              
              $
              3.60
              
              
              321,176$
              7.37
              
              
              2,900,000
              
              
              6.33
              
              $
              7.37
              
              
              2,900,000$
              7.79
              
              
              767,308
              
              
              3.84
              
              $
              7.79
              
              
              767,308$
              7.14
              
              
              3,988,484
              
              
              5.36
              
              $
              7.14
              
              
              3,988,484


**Note
      6 – Defined Contribution Plan**





The
      Company is required to participate in a defined contribution plan operated
      by
      the local municipal government in accordance with Chinese law and regulations.
      The Company makes annual contributions of 14% of all employees' salaries to
      the
      plan. Starting from 2008, no minimum contribution is required but the maximum
      contribution cannot be more than 14% of the current salary expense. The total
      contribution for the above plan was $0 and $33,032 for the three months ended
      September 30, 2008 and 2007, respectively. The total contribution for the above
      plan was $0 and $88,024 for the nine months ended September 30, 2008 and 2007,
      respectively.





**Note
      7 – Statutory Reserve**





As
      stipulated by the Company Law of the People’s Republic of China (PRC) as
      applicable to Chinese companies with foreign ownership, net income after
      taxation can only be distributed as dividends after appropriation has been
      made
      for the following:




i.
            Making
                up cumulative prior years’ losses, if
                any;





ii.
            Allocations
                to the “Statutory surplus reserve” of at least 10% of income after tax, as
                determined under PRC accounting rules and regulations, until the
                fund
                amounts to 50% of the Company's registered capital;





iii.
            Allocations
                to the discretionary surplus reserve, if approved in the shareholders’
                general meeting.





The
      Company had appropriated $574,161 and $232,402 as reserve for the statutory
      surplus reserve for three months ended September 30, 2008 and 2007. The Company
      has appropriated $1,425,489 and $726,785 as reserve for the statutory surplus
      reserve for nine months ended September 30, 2008 and 2007.





**Note
      8 – Accounting for stock-based compensation**





On
      September 22, 2007, Mr. Qinan Ji, chairman and shareholder of the Company,
      transferred 100,000 of his personally-owned options to the Company’s attorney to
      cover certain Company legal expenses. 30% of the options vest on September
      22,
      2008, 30% vest on September 22, 2009, and the remaining 40% vest on September
      22, 2010. Upon termination of service to the Company, the attorney is required
      to return all unvested options. These options expire June 1, 2012.


22


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





The
      Company used the Black-Sholes model to value the options at the time they were
      issued, based on the stock price on its grant date, the stated exercise prices
      and expiration dates of the instruments and using a risk-free rate of 4.10%.
      The
      estimated life is based on one half of the sum of the vesting period and the
      contractual life of the option. This is the same as assuming that the options
      are exercised at the mid-point between the vesting date and expiration date.
      $51,861 of compensation expense was recorded during the quarter ended September
      30, 2008.





As
      of September
      30, 2008 ,
      approximately $147,402 of estimated expense with respect to non-vested
      stock-based compensation has yet to be recognized and will be recognized in
      expense over the remaining vesting period of 2 years.




**Note
      9 – Earnings Per Share**





Earnings
      per share for the period ended September 30, 2008 and 2007 is determined by
      dividing net income for the periods by the weighted average number of both
      basic
      and diluted shares of common stock and common stock equivalents outstanding.
      The
      following is an analysis of the differences between basic and diluted earnings
      per common share in accordance with Statement of Financial Accounting Standards
      No. 128, “Earnings Per Share.”





The
      following demonstrates the calculation for earnings per share:





For
                three months ended
            
            For
                nine months endedSeptember
                30,
            
            September
                30,2008
            
            2007
            
            2008
            
            2007**Basic
                earning per share**Net
                income
            
            $
            5,136,590
            
            $
            1,961,662
            
            $
            11,458,053
            
            $
            6,816,997Weighted
                shares outstanding-Basic
            
            
            29,200,304
            
            
            27,122,196
            
            
            29,200,304
            
            
            25,191,521Earnings
                per share-Basic
            
            $
            0.18
            
            $
            0.07
            
            $
            0.39
            
            $
            0.27**Diluted
                earning per share**Net
                income
            
            $
            5,136,590
            
            $
            1,961,662
            
            $
            11,458,053
            
            $
            6,816,997Weighted
                shares outstanding-Basic
            
            
            29,200,304
            
            
            27,122,196
            
            
            29,200,304
            
            
            25,191,521Effect
                of diluted securities-Warrants
            
            
            79,286
            
            
            164,090
            
            
            116,533
            
            
            31,944Weighted
                shares outstanding-Diluted
            
            
            29,279,590
            
            
            27,286,286
            
            
            29,316,837
            
            
            25,223,465Earnings
                per share -Diluted
            
            $
            0.18
            
            $
            0.07
            
            $
            0.39
            
            $
            0.27




23


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





At
      September 30, 2008 and 2007, the Company had outstanding warrants of 3,988,484
      and 1,140,286, respectively. For the three months ended September 30, 2008,
      the
      average stock price was greater than the exercise prices of the 321,176 warrants
      which resulted in additional weighted average common stock equivalents of
      79,286; 3,667,308 outstanding warrants were excluded from the diluted earnings
      per share calculation as they are anti-dilutive. For the nine months ended
      September 30, 2008, the average stock price was greater than the exercise prices
      of the 321,176 warrants which resulted in additional weighted average common
      stock equivalents of 116,533; 3,667,308 outstanding warrants were excluded
      from
      the diluted earnings per share calculation as they are anti-dilutive.





**Note
      10 – Current Vulnerability Due to Certain
      Concentrations**





Concentrations
      of natural gas vendors:




Number
                of
              natural
                gas
              vendors
            
            Percentage
                of
              total
                natural gas
              purchaseThree
                months ended September 30, 2008
            
            
            4
            
            
            97.4
            %Three
                months ended September 30, 2007
            
            
            3
            
            
            99.1
            %Nine
                months ended September 30, 2008
            
            
            4
            
            
            98.4
            %Nine
                months ended September 30, 2007
            
            
            3
            
            
            97.2
            %





Except
      for Shaanxi Natural Gas Co Ltd, no amount was owed to other three vendors as
      of
      September 30, 2008. The other three vendors have long-term agreements with
      the
      Company without minimum purchase requirements. The Company has had annual
      agreements from December 31, 2007 to December 31, 2008 with Shaanxi Natural
      Gas
      Co Ltd to purchase certain amount of natural gas. For the year ending December
      31, 2008, the minimum purchase was 25.58 million cubic meters. Contracts are
      renewed on an annual basis. The Company’s management reports that it does not
      expect any issues or difficulty in continuing to renew the supply contracts
      with
      these vendors going forward. Price points for natural gas are strictly
      controlled by the government and have remained stable over the past 3 years.





Concentrations
      of installation revenue:




Number
                of
              customers
            
            Percentage
                of
              total
                installation
              revenueThree
                months ended September 30, 2008
            
            
            3
            
            
            89.8
            %Three
                months ended September 30, 2007
            
            
            3
            
            
            86.1
            %Nine
                months ended September 30, 2008
            
            
            5
            
            
            75.0
            %Nine
                months ended September 30, 2007
            
            
            5
            
            
            69.2
            %


24


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





The
      Company's operations are carried out in the People’s Republic of China.
      Accordingly, the Company's business, financial condition and results of
      operations may be influenced by the political, economic and legal environments
      in the People’s Republic of China, by the general state of the People’s Republic
      of China‘s economy. The Company's business may be influenced by changes in
      governmental policies with respect to laws and regulations, anti-inflationary
      measures, currency conversion and remittance abroad, and rates and methods
      of
      taxation, among other things.





**Note
      11 – Commitments and Contingencies**





(a)
      Lease
      Commitments





The
      Company recognizes lease expense on a straight line basis over the term of
      the
      lease in accordance to SFAS 13, “Accounting for leases.” The Company entered
      into series of long term lease agreements with outside parties to lease land
      use
      right to the self-built Natural Gas filing stations located in the PRC. The
      agreements have terms ranging from 10 to 30 years. The Company makes annual
      prepayment for most lease agreements. The Company also entered into two office
      leases in Xian, PRC and New York, NY. The minimum future payment for leasing
      land use rights and offices is as follows:




Three
                months ending December 31, 2008
            
            $
            434,356Year
                ending December 31, 2009
            
            
            1,436,956Year
                ending December 31, 2010
            
            
            1,441,547Year
                ending December 31, 2011
            
            
            1,415,124Year
                ending December 31, 2012
            
            
            1,355,864Thereafter
            
            
            14,670,599Total
            
            $
            20,754,446




For
      the
      three months ended September 30, 2008 and 2007, the land use right and office
      lease expenses were $256,876 and $ 68,135, respectively. For the nine months
      ended September 30, 2008 and 2007, the land use right and office lease expenses
      were $630,821 and $ 142,579, respectively.





(b)
      Property and Equipment





In
      January 2008, the Company entered into a contract with Chemtex International
      Inc. to purchase equipment supply for LNG plant and LNG storage tank located
      in
      Jingbian county, Shannxi Province China, in the total amount of $13,700,000.
      On
      May 16, 2008, SJLNG entered into an agreement with Hebei Tongchan Import and
      Export Co. Ltd. (Hebei) and agreed that Hebei will act as the trade agency
      for
      SJLNG. On June 16, 2008, the Company entered into an equipment supply contract
      with Chemtex Internaitonal Inc. to supply imported equipment for a LNG plant
      and
      a storage tank to be built by Jingbian Xilan LNG Co. Ltd. As of September 30,
      2008, the Company advanced $6,290,000 to the trade agency and the future
      commitment for equipment is $7,410,000.


25


**China
      Natural Gas, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements**


**September
      30, 2008**


**(Unaudited)**





(c)
      Legal
      Proceedings





A
      former member
      of
      the board of directors filed a
      lawsuit against the Company in New York State Supreme Court, Nassau
      County ,
      in
      which he has sought, among other things; to recover a portion of his monthly
      compensation plus 20,000 options that he alleges are due to him pursuant to
      a
      written agreement.  After the plaintiff rejected an offer by the Company
      that included the options that plaintiff alleged were due to him, the
      Company moved to dismiss the complaint.  The judge ordered the Company to
      issue the 20,000 options to the plaintiff subject to any restrictions required
      by applicable securities laws, which was essentially what the Company had
      previously offered, and dismissed all of the plaintiff's remaining claims
      against the Company.  The current
      board of directors has
      complied with the court's decision by tendering an options agreement to the
      plaintiff consistent with the court's decision, but the plaintiff has refused
      to
      execute the agreement, and instead has filed an appeal.  Regardless of the
      outcome of the appeal, the Company believes that any liability it would incur
      will not have a materially adverse
      effect on its
      financial condition or its results of operations, and, accordingly, this matter
      has not been reflected on the Company's financial
      statements .


26


**Item
      2.Management's Discussion and Analysis of Financial Condition and
      Results****of****Operations**




**CAUTIONARY
      STATEMENT**





The
      following discussion and analysis should be read in conjunction with the
      Company's Consolidated Financial Statements and the Notes thereto included
      in
      this Report. Unless otherwise noted, all amounts are expressed in U.S. dollars.
      The following discussion regarding the Company and its business and operations
      contains forward-looking statements that consist of any statement other than
      a
      recitation of historical fact and can be identified by the use of
      forward-looking terminology such as "may," "expect," "anticipate," "estimate"
      or
      "continue" or the negative thereof or other variations thereon or comparable
      terminology. In particular, these include statements relating to our expectation
      that we will continue to have adequate liquidity from cash flow from operations
      and the other risks and uncertainties, which are described below under "RISK
      FACTORS." The reader is cautioned that all forward-looking statements are
      necessarily speculative and there are certain risks and uncertainties that
      could
      cause actual events or results to differ materially from those referred to
      in
      such forward-looking statements, including the risk factors discussed in this
      Report. The Company does not have a policy of updating or revising
      forward-looking statements and thus it should not be assumed that silence by
      management of the Company over time means that actual events are bearing out
      as
      estimated in such forward-looking statements.





**Overview**





We
      were
      incorporated in the state of Delaware on March 31, 1999, as Bullet Environmental
      Systems, Inc. On May 25, 2000, we changed our name to Liquidpure Corp. and
      on
      February 14, 2002, we changed our name to Coventure International
      Inc.





On
      December 6, 2005, we issued an aggregate of 4 million shares to all of the
      registered shareholders of Xi’an Xilan Natural Gas Co., Ltd., and entered into
      exclusive arrangements with Xi’an Xilan Natural Gas Co., Ltd. The shareholders
      that give us the ability to substantially influence Xi’an Xilan Natural Gas’
daily operations and financial affairs, appoint our senior executives and
      approve all matters requiring shareholder approval. On December 19, 2005, we
      changed our name to China Natural Gas, Inc.





On
      February 21, 2006, we formed Xilan Natural Gas Equipment Ltd., (“Xilan
      Equipment”) as a wholly owned foreign enterprise (WOFE). We then, through Xilan
      Equipment, entered into exclusive arrangements with Xi’an Xilan Natural Gas Co.,
      Ltd. and these shareholders that give us the ability to substantially influence
      Xi’an Xilan Natural Gas’ daily operations and financial affairs, appoint its
      senior executives and approve all matters requiring shareholder approval. We
      memorialized these arrangements on August 17, 2007, and made retroactive to
      March 8, 2006. As a result, the Company consolidates the financial results
      of
      Xi’an Xilan Natural Gas as variable interest entity pursuant to FASB
      Interpretation No. 46R, “Consolidation of Variable Interest Entities”, effective
      on March 8, 2006.





We
      transport, distribute and sell natural gas to commercial, industrial and
      residential customers in the Xi’an area, including Lantian County and the
      districts of Lintong and Baqiao, in the Shaanxi Province of The People's
      Republic of China ("China" or the "PRC") through a network of 120km high
      pressure pipelines. During the three months ended September 30, 2008, the
      pipeline’s average daily throughput capacity is 28,977 cubic meters; in the
      first nine months of 2008, its average daily throughput capacity is 29,595
      cubic
      meters. We also distribute and sell CNG as vehicular fuel through a network
      of
      approximately 35 CNG fueling stations in Shaanxi and Henan Provinces.  As
      of September 30, 2008, we own and operate 23 CNG fueling stations in Shaanxi
      Province and 12 CNG fueling stations in Henan Province. During the three months
      ended September 30, 2008, we had sold compressed natural gas of 40,547,584
      cubic
      meters through our fueling stations; in the first nine months of 2008, we had
      sold compressed natural gas of 107,226,877 cubic meters.


27





We
      operate three primary business lines:





·
            Distribution
                and sale of compressed natural gas (CNG) through Company-owned CNG
                fueling
                stations for hybrid (natural gas/gasoline) powered vehicles (35 stations
                as of September 30, 2008);





·
            Distribution
                of piped natural gas to residential, commercial and industrial customers
                through Company-owned pipelines as well as installation of natural
                gas
                devices for our pipeline customers. The Company distributes and sells
                natural gas to 92,984 homes and businesses as of September 30, 2008;
                and





·
            Conversion
                of gasoline-fueled vehicles to hybrid (natural gas/gasoline) powered
                vehicles at our Auto Conversion
                Division.




We
      buy
      all of the natural gas that we sell and distribute to our customers. We do
      not
      mine or produce any of our own natural gas and have no plans to do so during
      the
      next 12 months. The natural gas that we buy is available in two forms: (i)
      piped
      natural gas; and (ii) CNG.





On
      October 24, 2006, Xi’an Xilan Natural Gas formed a wholly-owned subsidiary,
      Shaanxi Jingbian Liquified Natural Gas Co., Ltd., for the purpose of
      constructing a liquefied natural gas facility to be located in Jingbian, Shaanxi
      Province. We plan to invest approximately $40 million to construct this
      facility, and we have secured such funding for this project through security
      purchase agreement with Abax Lotus Ltd. The LNG plant is under construction
      and
      is expected to start operation in late 2009. Once completed, the plant has
      LNG
      processing capacity of 500,000 cubic meters per day, or approximately 150
      million cubic meters on an annual basis.





**CONSOLIDATED
      RESULTS OF OPERATIONS**





**Comparing
      Three Months Ended September 30, 2008 and 2007:**





The
      following table presents certain consolidated statement of income information.
      The three months financial information is presented below:.





September 30,
              2008
            
            September 30,
              2007Revenues
            
            $
            18,401,200
            
            $
            9,078,089Cost
                of Revenues
            
            
            8,908,833
            
            
            4,758,250Operating
                Expenses
            
            
            3,066,512
            
            
            1,967,693Income
                from Operations
            
            
            6,425,855
            
            
            2,352,146Net
                Income
            
            $
            5,136,590
            
            $
            1,961,662




28





*Revenues:* We
      generated revenue of $15,354,461, 83.44% of our total revenues, during the
      three
      months ended September 30, 2008 from the sale of natural gas, and revenue of
      $3,046,739, 16.56% of our total revenues from installation fees, conversion
      fees, and other sources. Sales of natural gas at the Company-owned fueling
      stations accounted for 80.20% of our total revenues in the three months ended
      September 30, 2008, or $14,757,762, which was the largest contribution of our
      three business lines. Sales to end-user customers connected to our pipeline
      distribution system accounted for 9.76% of our total revenues during the three
      months ended September 30, 2008, or $1,767,511, including both natural gas
      sales
      and installation fees.





We
      had
      total revenues of $18,401,200 for the three months ended September 30, 2008,
      an
      increase of $9,323,111 or 102.70%, compared to $9,078,089 for the three months
      ended September 30, 2007. The sales of natural gas increased 103.23% and our
      installation and other revenues increased 100.05% over the same period in 2007.
      The increase in revenues was primarily due to the material increase in the
      number of Company-owned fueling stations and pipeline customers. As of September
      30, 2008, the Company had 92,984 pipeline customers, an increase of 8,921
      customers over the same period in 2007, and has constructed and acquired 35
      fueling stations, an increase of 15 stations over the same period in 2007.





During
      the third quarter of 2008, we had sold compressed natural gas of 40,547,584
      cubic meters, compared to 22,462,111 cubic meters in the same period of 2007,
      through Company-owned fueling stations. In terms of average station sales value
      and volume, in the third quarter of 2008, we had sold approximately $423,000
      and
      1,180,000 cubic meters of compressed natural gas per station, compared to
      approximately $380,000 and 1,182,000 cubic meters in the same period of 2007.
      As
      for natural gas pipeline business, during the third quarter of 2008, we had
      sold
      2,665,947 cubic meters, compared to 1,705,668 cubic meters in the same period
      of
      2007, through our pipeline network.





Furthermore,
      during the third quarter of 2008, three major customers contributed 89.83%
      of
      the total installation revenue, compared to 86.1% of the Company’s installation
      revenue from three customers for the same period of 2007. Due to the relatively
      small portion of the installation business and our close relationship with
      other
      potential customers, we believe that the loss of any one of these three
      customers would not have a material adverse effect on our
      operations.





The
      Company expects natural gas revenues to increase on both an actual basis and
      as
      a percentage of revenue in the remaining period of 2008.





*Cost
      of Revenues* :
      Our
      cost of revenues consists of both the cost of natural gas and the cost of
      installation and other. Cost of natural gas consists primarily of the price
      that
      we pay for natural gas purchased from our supplier. Cost of installation and
      other includes certain connection costs related to connecting customers to
      our
      pipeline system that are generally expensed when incurred and vehicle conversion
      cost related to converting gasoline-fueled vehicles into natural gas hybrid
      vehicles.


29


Cost
      of
      revenues during the three months ended September 30, 2008 was $8,908,833, an
      increase of $4,150,583 or 87.23% over the same period in 2007. Cost of natural
      gas increased by 73.46% to $6,973,035 during the three months ended September
      30, 2008, as compared with $4,020,039 for the same period in 2007. The opening
      cost per station during the three months ended September 30, 2008 is
      approximately $1,200,000, compared to approximately $900,000 over the same
      period of 2007. During the three months ended September 30, 2008, the
      transportation cost-per-million cubic meters is approximately $7,700. In
      addition, cost of installation and other increased by 162.23% to $1,935,798
      during the three months ended September 30, 2008, as compared with $738,211
      for
      the same period in 2007. The increase in our cost of revenues was primarily
      related to a material increase in the amount of gas sold. We had sold natural
      gas of 43,213,531 cubic meters during the third quarter of 2008, compared to
      24,167,779 cubic meters over the same period of 2007. The increase of
      installation and other cost is mainly due to the increase in the number of
      pipeline customers, the vehicles the Company had converted and the gasoline
      sales through our existing fueling stations. We converted 713 vehicles to become
      hybrid in the third quarter of 2008, compared to 498 vehicles over the same
      period of 2007.





We
      purchase our natural gas for resale mainly from four vendors: PetroChina
      Changqing Oilfield Company, Jiyuan Yuhai Natural Gas Co Ltd, Shaanxi Natural
      Gas
      Co. Ltd and Jingcheng city Mingshi Coal Bed Methane Exploitage Ltd. We renewed
      the supplying contracts on an annual or semiannual basis and do not think we
      will have difficulty in doing so in the foreseeable future. The four major
      vendors supplied 97.37% of total natural gas we purchased in the third quarter
      of 2008.





As
      the
      government owns all land in China, the government controls and owns all the
      natural resources coming from the ground, thus the government controls the
      price
      and flow of the natural gas. Due to the soaring crude oil price and
      ever-increasing demand for energy consumption, the National Development and
      Reform Commission, which regulates the energy price in China, adjusted the
      upstream natural gas price for industrial users and vehicular CNG distributors
      upward by RMB ¥0.4/CM, or 35% in November, 2007. The retail price for vehicular
      CNG was adjusted upward at a ratio of 0.75:1 to the retail price of #90 gasoline
      in November, 2007. Many large cities see dramatic increase in retail vehicular
      CNG price, for example 66% in Shanghai and 21% (taxi) and 38% (bus) in Tianjin.
      However, the natural gas price for residential customers is not adjusted. As
      China shifts from a centrally-planned economy to a market economy, we believe
      that it is in the government's best interest to keep prices stable, and maintain
      a stable flow of supply. The government has also undertaken programs to promote
      the economic growth of the region in which we are located. Therefore, we expect
      supply and price to continue to be stable in the future.





*Gross
      profit* :
      The
      Company earned a gross profit of $9,492,367 for the three months ended September
      30, 2008, an increase of $5,172,528 or 119.74%, compared to $4,319,839 for
      the
      three months ended September 30, 2007. The increase in gross profit is due
      to a
      material increase in natural gas sales and installation revenue in this quarter,
      partially offset by an increase in cost of revenues.





*Gross
      margin* :
      Gross
      margin, as a percentage of revenues, increased to 51.59% for the three months
      ended September 30, 2008, from 47.59% for the three months ended September
      30,
      2007. The increase in gross margin is primarily due to the higher margin from
      the natural gas sold in fueling stations in Henan province in the third quarter
      of 2008 compared to the same period of 2007. From July 2007, the Company renewed
      its supply contract with a local natural gas vendor in Henan at a much lower
      supply cost of RMB ¥1.0/CM.


30





*Operating
      expenses:* The
      Company incurred operating expenses of $3,066,512 for the three months ended
      September 30, 2008, an increase of $1,098,819, or 55.84%, compared to $1,967,693
      for the three months ended September 30, 2007. Our selling expenses increased
      by
      123.35%, from $939,496 for three months ended September 30, 2007 to $2,098,343
      for the same period of 2008, primarily as a result of expenses related to the
      operation of 15 newly added CNG stations since September 30, 2007, the
      depreciation of more equipment, recruitment of more employees as well as the
      ongoing related selling expenses. However, the general and administrative
      expenses decreased by 5.84% to $968,169 for three months period ended September
      30, 2008 from $1,028,197 for the same period of 2007, which demonstrated the
      Company’s cost control ability and the benefit of economy of scale over
      centralized corporate functions.




Provision
      for income tax was $1,034,636 for the three months ended September 30, 2008,
      as
      compared to $445,463 for the three months ended September 30, 2007. The increase
      in income tax was mainly attributed to the growth of revenues from our fueling
      stations and pipeline business.





*Net
      Income* :
      Net
      income increased to $5,136,590 for the three months ended September 30, 2008,
      an
      increase of $3,174,928 or 161.85% from $1,961,662 during the corresponding
      period in 2007. The increased net income reflects the fueling station business’s
      strong and steady profit-generating ability and the successful outcome of the
      Company’s continuous efforts in sourcing lower natural gas suppliers, which were
      offset by the increase of interest expense and amortization expenses due to
      the
      issuance of $40 million senior note on January 29 th ,
      2008.





**Comparing
      Nine Months Ended September 30, 2008 and 2007:**





The
      following table presents certain consolidated statement of income information.
      Financial information is presented for the nine months ended September 30,
      2008
      and 2007.





September 30,
              2008
            
            September 30,
              2007Revenues
            
            $
            49,317,360
            
            $
            24,094,974Cost
                of Revenues
            
            
            26,070,754
            
            
            12,114,666Operating
                Expenses
            
            
            7,956,125
            
            
            3,926,507Income
                from Operations
            
            
            15,290,481
            
            
            8,053,801Net
                Income
            
            $
            11,458,053
            
            $
            6,816,997





*Revenues:* We
      generated revenue of $40,494,646, 82.11% of our total revenues, during the
      nine
      months ended September 30, 2008 from the sale of natural gas, and revenue of
      $8,822,714, 17.89% of our total revenues from installation, vehicle conversion
      and gasoline sale activity. Sales of natural gas at the Company-owned fueling
      stations accounted for 78.33% of our total revenues in the nine months ended
      September 30, 2008, or $38,632,188, which was the largest contribution of our
      three business lines. Sales of natural gas to end-user customers connected
      to
      our pipeline distribution system accounted for 10.88% of our total revenues
      during the nine months ended September 30, 2008, or $5,365,729, including both
      natural gas sales and installation revenue. The Company expects natural gas
      revenues to increase on both an actual basis and as a percentage of revenue
      in
      2008.





We
      had
      total revenues of $49,317,360 for the nine months ended September 30, 2008,
      an
      increase of $25,222,386 or 104.68%, compared to $24,094,974 for the nine months
      ended September 30, 2007. The sales of natural gas increased 110.43% and our
      installation and other revenues increased 81.87% over the same period in 2007.
      The increase in revenues was primarily due to the material increase in the
      number of Company-owned fueling stations and pipeline customers. As of September
      30, 2008, the Company had 92,984 pipeline customers, an increase of 8,921
      customers over the same period in 2007, and has constructed and acquired 35
      fueling stations, an increase of 15 stations over the same period in 2007.


31





During
      the nine months ended September 30, 2008, we sold compressed natural gas of
      107,226,877 cubic meters, compared to 58,537,895 cubic meters in the same period
      of 2007, through Company-owned fueling stations. In terms of average station
      sales value and volume, during the first nine months ended September 30, 2008,
      we sold approximately $1,292,000 and 3,650,000 cubic meters compressed natural
      gas per station, compared to approximately $1,260,000 and 4,050,000 cubic meters
      in the same period of 2007. As for natural gas pipeline business, during the
      first nine months ended September 30, 2008, we sold 8,079,460 cubic meters,
      compared to 5,346,207 cubic meters in the same period of 2007, through our
      pipeline network.





Furthermore,
      in the nine months ended September 30, 2008, five major customers contributed
      75.02% of the total installation revenue, compared to 69.2% of the Company’s
      installation revenue from five customers for the same period of 2007. Due to
      the
      relatively small portion of the installation business and our close relationship
      with other potential customers, we believe that the loss of any one of these
      five customers would not have a material adverse effect on our
      operations.





The
      Company expects natural gas revenues to increase on both an actual basis and
      as
      a percentage of revenue in the remaining period of 2008.





*Cost
      of Revenues* :
      Our
      cost of revenues consists of both the cost of natural gas and the cost of
      installation and other. Cost of natural gas consists primarily of the price
      that
      we pay for natural gas purchased from our suppliers, Cost of installation
      includes certain connection costs related to connecting customers to our
      pipeline system that are generally expensed when incurred and vehicle conversion
      cost related to converting gasoline-fueled vehicles into natural gas hybrid
      vehicles.





Cost
      of
      revenues during the nine months ended September 30, 2008 was $26,070,754, an
      increase of $13,956,088 or 115.20% over the same period in 2007. Cost of natural
      gas increased by 104.19% to $20,369,778 during the nine months ended September
      30, 2008, as compared with $9,975,932 for the same period in 2007. During the
      nine months ended September 30, 2008, the transportation cost-per-million cubic
      meters is approximately $7,000. In addition, cost of installation and other
      increased by 166.56% to $5,700,976 during the nine months ended September 30,
      2008, as compared with $2,138,734 for the same period in 2007. The increase
      in
      our cost of revenues was primarily related to a material increase in the amount
      of gas sold. We had sold natural gas of 115,306,337 cubic meters in the first
      nine months of 2008, compared to 63,884,102 cubic meters over the same period
      of
      2007. The increase of installation and other cost is mainly due to the increase
      of pipeline customers, the vehicles the Company had converted, and the gasoline
      sales through our existing fueling stations. We converted 1,980 vehicles to
      become hybrid during the nine months ended September 30, 2008, compared to
      548
      vehicles over the same period of 2007.





We
      purchase our natural gas for resale mainly from four vendors: PetroChina
      Changqing Oilfield Company, Jiyuan Yuhai Natural Gas Co Ltd, Jingcheng city
      Mingshi Coal Bed Methane Exploitage Ltd and Shaanxi Natural Gas Co. Ltd. We
      renewed the supplying contracts on an annual or semiannual basis and do not
      think we will have difficulty in doing so in the foreseeable future. The four
      major vendors supplied 98.42% of total natural gas we purchased during the
      first
      nine months period of 2008.


32





As
      the
      government owns all land in China, the government controls and owns all the
      natural resources coming from the ground, thus the government controls the
      price
      and flow of the natural gas. Due to the soaring crude oil price and ever
      increasing demand for energy consumption, the National Development and Reform
      Commission, which regulates the energy price in China, adjusted the upstream
      natural gas price for industrial users and vehicular CNG distributors upward
      by
      RMB ¥0.4/CM, or 35% in November, 2007. The retail price for vehicular CNG was
      adjusted upward at a ratio of 0.75:1 to the retail price of #90 gasoline in
      November, 2007. Many large cities see dramatic increase in retail vehicular
      CNG
      price, for example 66% in Shanghai and 21% (taxi) and 38% (bus) in Tianjin.
      However, natural gas price for residential customers is not adjusted. As China
      shifts from a centrally planned economy to a market economy, we believe that
      it
      is in the government's best interest to keep prices stable, and maintain a
      stable flow of supply. The government has also undertaken programs to promote
      the economic growth of the region in which we are located. Therefore, we expect
      supply and price to continue to be stable in the future.





*Gross
      profit* :
      The
      Company earned a gross profit of $23,246,606 for the nine months ended September
      30, 2008, an increase of $11,266,298 or 94.04%, compared o $11,980,308 for
      the
      nine months ended September 30, 2007. The increase in gross profit is due to
      a
      material increase in natural gas sales and installation (and other) revenues
      in
      this period, partially offset by an increase in cost of sales.





*Gross
      margin* :
      Gross
      margin, as a percentage of revenues, decreased to 47.14% for the nine months
      ended September 30, 2008, from 49.72% for the nine months ended September 30,
      2007. The decrease in gross margin is primarily due to the lower margin of
      natural gas sales in Henan province during the first six months of 2008,
      gasoline sales and vehicle conversion revenue during 2008. Although the gasoline
      sales only represented 7% of our total revenue during the 9 months ended
      September 30, 2008, the low gross margin of gasoline around 7.5% contributed
      to
      a decline in our overall gross margin.




*Operating
      expenses:* The
      Company incurred operating expenses of $7,956,125 for the nine months ended
      September 30, 2008, an increase of $4,029,618 or 102.63%, compared to $3,926,507
      for the nine months ended September 30, 2007. Our selling expenses increased
      by
      126.02% from $2,216,048 for nine months ended September 30, 2007 to $5,008,631
      for the same period of 2008, primarily as a result of expenses related to the
      operation of 15 newly added CNG stations since September 30, 2007, the
      depreciation of more equipment, recruitment of more employees as well as the
      on-going related selling expenses. The general and administrative expenses
      increased by 72.32% to $2,947,494 for nine months period ended September 30,
      2008 from $1,710,459 for the same period of 2007, which is primarily due to
      the
      Company’s engagement of more personnel to manage rapidly expanding business and
      continuous efforts on finding new acquisition opportunities, and also the
      rentals and operating expenses for new offices in Xi’an China and New York.
      Considering the percentage increase from the general and administrative expenses
      is lower than that of revenue, the Company also demonstrated the benefit of
      economy of scale over centralized corporate functions over the nine-month period
      of 2008.





Provision
      for income tax was $2,584,774 for the nine months ended September 30, 2008,
      as
      compared to $1,317,878 for the nine months ended September 30, 2007. The
      increase in income tax was mainly attributed to the growth of revenues from
      our
      fueling stations and pipeline business.





*Net
      Income* :
      Net
      income increased to $11,458,053 for the nine months ended September 30, 2008,
      an
      increase of $4,641,056 or 68.08% from $6,816,997 for the nine months ended
      September 30, 2007. The increased net income reflects the fueling stations
      business’s strong and steady profit-generating ability and the successful
      outcome of the Company’s continuous efforts in sourcing lower natural gas
      suppliers, which were offset by the increase of interest expense and
      amortization expenses due to the issuance of $40 million senior note on January
      29 th ,
      2008.


33





**Liquidity
      and Capital Resources**





As
      of
      September 30, 2008, the Company had $20,384,702 of cash and cash equivalents
      on
      hand compared to $20,677,432 of cash and cash equivalents as of September 30,
      2007.





Cash
      flows provided by operating activities was $12,711,311 for the nine months
      ended
      September 30, 2008 compared to net cash provided by operations of $8,030,806
      in
      the corresponding period last year. The primary reason for the change is
      attributed to the increased cash from net income generated from our CNG fueling
      stations business, which is offset by the higher working capital needs to
      support our operations in the nine months ended September 30, 2008.





Cash
      outflows for investing activities increased from $6,838,721 during the nine
      months ended September 30, 2007 to $44,611,535 for the same period in 2008
      primarily because of the construction and acquisition of additional 15 fueling
      stations, the additions of construction in progress and the prepayment to
      equipment suppliers of our LNG plant, which the Company started to construct
      in
      September 2007.





Cash
      inflow for financing activities was $37,877,491 for the nine months ended
      September 30, 2008, compared to $13,823,467 in the corresponding previous
      period. The increased financing cash inflow comes from the sale of $40 million
      senior notes to Abax Lotus in the first quarter of 2008, partially offset by
      related offering costs. In the August 2007, the Company issued $15 million
      new
      shares at $3.25 per share through private placement.





In
      the
      next three months of 2008, the Company also expects to enter into an acquisition
      project, which is estimated to cost $10 million. The funds for these investing
      activities are expected to come primarily from the existing cash on hand and
      the
      Company's operating cash inflows. If the internally generated cash is not
      sufficient, the Company will consider securing funding from outside capital
      providers.





The
      Company paid $9.5 million for the right to use know-how and basic engineering
      design to construct the LNG plant and storage tank in the first quarter of
      2008.
      The Company also made further investment of approximately $3.4 million and
      $6.9
      million for the LNG plant related fee in the second and third quarter of 2008,
      respectively. The Company expects to continue to invest in LNG project in the
      subsequent quarters with funds already secured and internally generated cash
      flows, and the LNG projects is expected to be completed in October
      2009.





Based
      on
      past performance and current expectations, we believe our existing cash combined
      with cash generated from operations, as well as future possible cash
      investments, will satisfy our working capital needs, capital expenditures (other
      than the possible acquisition of other fueling and compressor stations) and
      other liquidity requirements associated with our operations for at least the
      next 12 months.





The
      majority of the Company's revenues and expenses were denominated primarily
      in
      RMB, the currency of the People's Republic of China. There is no assurance
      that
      exchange rates between the RMB and the USD will remain stable. Inflation has
      not
      had a material impact on the Company's business.


34





**OFF-BALANCE
      SHEET ARRANGEMENTS**





None.





**CRITICAL
      ACCOUNTING POLICIES**





In
      presenting our financial statements in conformity with accounting principles
      generally accepted in the United States of America, we are required to make
      estimates and assumptions that affect the amounts reported therein. Several
      of
      the estimates and assumptions we are required to make relate to matters that
      are
      inherently uncertain as they pertain to future events. However, events that
      are
      outside of our control cannot be predicted and, as such, they cannot be
      contemplated in evaluating such estimates and assumptions. If there is a
      significant unfavorable change to current conditions, it will likely result
      in a
      material adverse impact to our consolidated results of operations, financial
      position and in liquidity. We believe that the estimates and assumptions we
      used
      when preparing our financial statements were the most appropriate at that time.
      Presented below are those accounting policies that we believe require subjective
      and complex judgments that could potentially affect reported
      results.





Use
      of
      Estimates





Our
      discussion and analysis of our financial condition and results of operations
      are
      based upon our consolidated financial statements, which have been prepared
      in
      accordance with accounting principles generally accepted in the United States
      of
      America. The preparation of these consolidated financial statements requires
      us
      to make estimates and judgments that affect the reported amounts of assets,
      liabilities, revenues and expenses, and related disclosures of contingent assets
      and liabilities. On an ongoing basis, we evaluate our estimates, including
      those
      related to impairment of long-lived assets, and allowance for doubtful accounts.
      We base our estimates on historical experience and on various other assumptions
      that we believe to be reasonable under the circumstances, the results of which
      form the basis for making judgments about the carrying value of assets and
      liabilities that are not readily apparent from other sources. Actual results
      may
      differ from these estimates under different assumptions or conditions; however,
      we believe that our estimates, including those for the above-described items,
      are reasonable.




Areas
      that require estimates and assumptions include valuation of accounts receivable
      and determination of useful lives of property and equipment.





Long-Lived
      Assets




We
      periodically assess potential impairments to our long-lived assets in accordance
      with the provisions of SFAS No. 144, “Accounting for the Impairment or
      Disposal of Long-Lived Assets.” SFAS No. 144 requires, among other things,
      that an entity perform an impairment review whenever events or changes in
      circumstances indicate that the carrying value may not be fully recoverable.
      Factors considered by us include, but are not limited to: significant
      underperformance relative to expected historical or projected future operating
      results; significant changes in the manner of use of the acquired assets or
      the
      strategy for our overall business; and significant negative industry or economic
      trends. When we determine that the carrying value of a long-lived asset may
      not
      be recoverable based upon the existence of one or more of the above indicators
      of impairment, we estimate the future undiscounted cash flows expected to result
      from the use of the asset and its eventual disposition. If the sum of the
      expected future undiscounted cash flows and eventual disposition is less than
      the carrying amount of the asset, we recognize an impairment loss. An impairment
      loss is reflected as the amount by which the carrying amount of the asset
      exceeds the fair market value of the asset, based on the fair market value
      if
      available, or discounted cash flows. To date, there has been no impairment
      of
      long-lived assets.


35





Construction
      in Progress





Construction
      in progress consists of the cost of constructing property and equipment for
      the
      Company’s use. The major cost of construction in progress relates to material,
      labor and overhead. Interest cost amounted to $1,672,565 was capitalized into
      construction in progress up to date.





Revenue
      Recognition





Our
      revenue recognition policies are in accordance with Staff Accounting Bulletin
      (SAB) 104. Revenue is recognized when services are rendered to customers, when
      a
      formal arrangement exists, the price is fixed or determinable, the delivery
      is
      completed, no other significant obligations of the Company exist and
      collectability is reasonably assured. Payments received before all of the
      relevant criteria for revenue recognition are satisfied are recorded as unearned
      revenue. Revenue from gas sales is recognized when gas is pumped through
      pipelines to the end users. Revenue from installation of pipelines is recorded
      when the contract is completed and accepted by the customers. The construction
      contracts are usually completed within one to two months. Revenue from repairing
      and modifying vehicles is recorded when service are rendered to and accepted
      by
      the customers.





Unearned
      Revenue





Unearned
      revenue represents prepayments by customers for gas purchases and advance
      payments on installation of pipeline contracts. We record such prepayment as
      unearned revenue when the payments are received.





Recent
      Pronouncements





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities“. This Statement permits entities to
      choose to measure many financial assets and financial liabilities at fair value.
      Unrealized gains and losses on items for which the fair value option has been
      elected are reported in earnings. SFAS No. 159 is effective for fiscal years
      beginning after November 15, 2007. The Company chose not to elect the option
      to
      measure the fair value of eligible financial assets and
      liabilities.





In
      June
      2007, the FASB issued FASB Staff Position No. EITF 07-3, “Accounting for
      Nonrefundable Advance Payments for Goods or Services Received for use in Future
      Research and Development Activities” (“FSP EITF 07-3”), which addresses whether
      nonrefundable advance payments for goods or services that used or rendered
      for
      research and development activities should be expensed when the advance payment
      is made or when the research and development activity has been performed.
      Management is currently evaluating the effect of this pronouncement on financial
      statements.





In
      December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business
      Combinations.” SFAS No. 141 (Revised 2007) changes how a reporting
      enterprise accounts for the acquisition of a business. SFAS No. 141
      (Revised 2007) requires an acquiring entity to recognize all the assets acquired
      and liabilities assumed in a transaction at the acquisition-date fair value,
      with limited exceptions, and applies to a wider range of transactions or events.
      SFAS No. 141 (Revised 2007) is effective for fiscal years beginning on or
      after December 15, 2008 and early adoption and retrospective application is
      prohibited. The Company is currently evaluating the impact that adopting SFAS
      No. 141R will have on its financial statements.


36





In
      December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
      Consolidated Financial Statements”, which is an amendment of Accounting Research
      Bulletin (“ARB”) No. 51.  This statement clarifies that a
      noncontrolling interest in a subsidiary is an ownership interest in the
      consolidated entity that should be reported as equity in the consolidated
      financial statements.  This statement changes the way the consolidated
      income statement is presented, thus requiring consolidated net income to be
      reported at amounts that include the amounts attributable to both parent and
      the
      noncontrolling interest.  This statement is effective for the fiscal
      years, and interim periods within those fiscal years, beginning on or after
      December 15, 2008.  Based on current conditions, the Company does not
      expect the adoption of SFAS 160 to have a significant impact on its results
      of
      operations or financial position.





In
      March
      2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
      Financial Accounting Standards (“SFAS”) No. 161, “Disclosures about
      Derivative Instruments and Hedging Activities – An Amendment of SFAS
      No. 133” (“SFAS 161”). SFAS 161 seeks to improve financial reporting for
      derivative instruments and hedging activities by requiring enhanced disclosures
      regarding the impact on financial position, financial performance, and cash
      flows. To achieve this increased transparency, SFAS 161 requires (1) the
      disclosure of the fair value of derivative instruments and gains and losses
      in a
      tabular format; (2) the disclosure of derivative features that are credit
      risk-related; and (3) cross-referencing within the footnotes. SFAS 161 is
      effective on January 1, 2009. The Company is in the process of evaluating
      the new disclosure requirements under SFAS 161.





In
      May
      2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted
      Accounting Principles" ("FAS 162"). FAS 162 is intended to improve financial
      reporting by identifying a consistent framework, or hierarchy, for selecting
      accounting principles to be used in preparing financial statements that are
      presented in conformity with GAAP for nongovernmental entities. FAS 162 is
      effective 60 days following the SEC's approval of the Public Company Accounting
      Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly
      in
      Conformity with Generally Accepted Accounting Principles." The Company is in
      the
      process of evaluating the impact of adoption of this statement on the results
      of
      operations, financial position or cash flows.





In
      June
      2008, the FASB issued Emerging Issues Task Force Issue 07-5 “Determining whether
      an Instrument (or Embedded Feature) is indexed to an Entity’s Own Stock” (“EITF
      No. 07-5”). This Issue is effective for financial statements issued for fiscal
      years beginning after December 15, 2008, and interim periods within those fiscal
      years. Early application is not permitted. Paragraph 11(a) of Statement of
      Financial Accounting Standard No 133 “Accounting for Derivatives and Hedging
      Activities” (“SFAS 133”) specifies that a contract that would otherwise meet the
      definition of a derivative but is both (a) indexed to the Company’s own
      stock and (b) classified in stockholders’ equity in the statement of
      financial position would not be considered a derivative financial instrument.
      EITF No.07-5 provides a new two-step model to be applied in determining whether
      a financial instrument or an embedded feature is indexed to an issuer’s own
      stock and thus able to qualify for the SFAS 133 paragraph 11(a) scope exception.
      The Company is currently evaluating the impact of adoption of EITF No. 07-5
      on
      the Company’s consolidated financial statements.


37





In
      September 2008, the FASB issued FASB Staff Positions FSP FAS 133-1 and FIN
      45-4,
      Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of
      FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of
      the
      Effective Date of FASB Statement No. 161". This FSP amends FASB Statement No.
      133, Accounting for Derivative Instruments and Hedging Activities, to require
      disclosures by sellers of credit derivatives, including credit derivatives
      embedded in a hybrid instrument. This FSP also amends FASB Interpretation No.
      45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including
      Indirect Guarantees of Indebtedness of Others, to require an additional
      disclosure about the current status of the payment/performance risk of a
      guarantee. Further, this FSP clarifies the Board’s intent about the effective
      date of FASB Statement No. 161, Disclosures about Derivative Instruments and
      Hedging Activities. The provisions of this FSP that amend Statement 133 and
      Interpretation 45 shall be effective for reporting periods (annual or interim)
      ending after November 15, 2008. The Company is in the process of evaluating
      the
      new disclosure requirements under this FSP.





**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk**





Not
      required





**Item
      4.**  **Controls
      and Procedures**





**Evaluation
      of Disclosure Controls and Procedures**




The
      Company's management has evaluated, under the supervision and with the
      participation of the Company's Chief Executive Officer and Chief Financial
      Officer, the effectiveness of the design and operations of the Company's
      disclosure controls and procedures (as defined in Securities Exchange Act Rule
      13a-15(e)), as of the end of the period covered by this quarterly report. Based
      on that evaluation, the Company's Chief Executive Officer and Chief Financial
      Officer have concluded that the evaluation of the effectiveness of our
      disclosure controls and procedures was completed; our disclosure controls and
      procedures were effective subject to the following:




l
            Inadequate
                US GAAP expertise - The current staff in the accounting department
                is
                inexperienced and they were primarily engaged in ensuring compliance
                with
                PRC accounting and reporting requirement for our operating subsidiaries
                and were not required to meet or apply U.S. GAAP requirements.  They
                need substantial training so as to meet with the higher demands of
                being a
                U.S. public company. The accounting skills and understanding necessary
                to
                fulfill the requirements of US GAAP-based reporting, including the
                skills
                of subsidiary financial statements consolidation, are
                inadequate.




We
      have
      engaged a US Certified Public Accountant to serve as our accounting
      consultant. The US CPA is mainly engaged to perform our financial
      statements consolidation and to prepare our financial statements.  In
      particular, we are seeking accountants experienced in several key areas of
      accounting, including persons with experience in Chinese and U.S. GAAP, U.S.
      GAAP consolidation requirements, and SEC financial reporting
      requirements.




In
      addition, we plan to allocate additional resources to train our existing
      accounting staff and continue this effort in the future.


38




**Part
      II.**  **OTHER
      INFORMATION**





**Item
      1.**  **Legal
      Proceedings**




A
      former
      member of the board of directors filed a lawsuit against the Company in New
      York
      State Supreme Court, Nassau County, in which he has sought, among other things
      to recover a portion of his monthly compensation plus 20,000 options that he
      alleges are due to him pursuant to a written agreement.  After the
      plaintiff rejected an offer by the Company that included the options that
      plaintiff alleged were due to him, the Company moved to dismiss the
      complaint.  The judge ordered the Company to issue the 20,000 options to
      the plaintiff subject to any restrictions required by applicable securities
      laws, which was essentially what the Company had previously offered, and
      dismissed all of the plaintiff's remaining claims against the Company.  The
      current board of directors has complied with the court's decision by tendering
      an options agreement to the plaintiff consistent with the court's decision,
      but
      the plaintiff has refused to execute the agreement, and instead has filed an
      appeal.  Regardless of the outcome of the appeal, the Company believes that
      any liability it would incur will not have a materially adverse effect on its
      financial condition or its results of operations.




**Item
      1 A. Risk Factors**





An
      investment in our common stock is speculative and involves a high degree of
      risk
      and uncertainty. You should carefully consider the risks described below,
      together with the other information contained in this report, including the
      consolidated financial statements and notes thereto of our Company, before
      deciding to invest in our common stock. The risks described below are not the
      only ones facing our Company. Additional risks not presently known to us or
      that
      we presently consider immaterial may also adversely affect our Company. If
      any
      of the following risks occur, our business, financial condition and results
      of
      operations and the value of our common stock could be materially and adversely
      affected.





**RISKS
      RELATED TO OUR BUSINESS**





**Prices
      of natural gas can be subject to significant fluctuations, which may affect
      and
      bring uncertainty to our business and financial condition.**





We
      obtain
      most of our natural gas from government owned entities and our supply contracts
      are subject to review every six months. The supply price for natural gas is
      strictly controlled by the PRC government and has remained stable over the
      past
      three years. We do not expect any difficulty in renewing our supply contracts
      during the next 12 months, nor do we expect any significant change to natural
      gas supply price in China during the same period. However, the price level
      of
      natural gas could fluctuate in response to changing national or international
      market forces, to political events, OPEC actions and other factors over the
      short to medium term, and to industry economics over the long term. Accordingly,
      the PRC government may adjust its controlled price limit and our suppliers
      may
      be able to increase or decrease their supply price to us. This would bring
      uncertainty to our business and may affect our financial
      condition.


39





**We
      are dependent on supplies of natural gas to deliver to our
      customers.**





With
      the
      exception of certain compressed and liquid natural gas supplies, we obtain
      our
      supplies of natural gas from one supplier which is a government owned entity.
      The ability to deliver our product is dependent on a sufficient supply of
      natural gas and if we are unable to obtain a sufficient natural gas supply,
      it
      could prevent us making deliveries to our customers. While we have supply
      contracts, we do not control the government owned suppliers or other suppliers,
      nor are we able to control the amount of time and effort they put forth on
      our
      behalf. It is possible that our suppliers will not perform as expected, and
      that
      they may breach or terminate their agreements with us. It is also possible
      that,
      after a regular semi-annual review of our primary supply contract, they choose
      to provide services to a competitor. Any failure to obtain supplies of natural
      gas could prevent us from delivering such to our customers and could have a
      material adverse affect on our business and financial condition.




**Our
      business operations are subject to a high degree of risk and insurance may
      not
      be adequate to cover liabilities resulting from accidents or injuries that
      may
      occur.**





Our
      operations are subject to potential hazards incident to the gathering,
      processing, separation and storage of natural gas, such as explosions, product
      spills, leaks, emissions and fires. These hazards can cause personal injury
      and
      loss of life, severe damage to and destruction of property and equipment, and
      pollution or other environmental damage, and may result in curtailment or
      suspension of our operations.





We
      have
      maintained adequate coverage at reasonable rates and have experienced no
      material uninsured losses. However, the occurrence of an unexpected while
      significant event for which we are not fully insured or indemnified, and/or
      the
      failure of a party to meet its indemnification obligations, may result in our
      incurring substantial costs and materially and adversely affect our operations
      and financial condition. Moreover, no assurance can be given that we will be
      able to maintain adequate insurance in the future at rates considered as
      reasonable.





**Changes
      in the regulatory atmosphere could adversely affect our
      business.**





The
      distribution of natural gas and operations of fueling stations are highly
      regulated requiring registrations for the issuance of licenses required by
      various governing authorities in China. In addition, various standards must
      be
      met for fueling stations including handling and storage of natural gas, tanker
      handling, and compressor operation which are regulated. The costs of complying
      with regulations in the future may harm our business. Furthermore, future
      changes in environmental laws and regulations could result in stricter standards
      and enforcement, larger fines and liability, and increased capital expenditures
      and operating costs, any of which could have a material adverse effect on our
      financial condition or results of operations.




**We
      depend on our senior management's experience and knowledge of the industry
      and
      would be adversely affected by the loss of any of our senior
      managers.**





Our
      future success depends heavily upon the continuing services of the members
      of
      our senior management team, particularly Mr. Ji, who is the founder, Chief
      Executive Officer, Chairman of the Board, and a major shareholder of our
      company. We rely on Mr. Ji’s expertise in our business operations and on his
      personal relationships with the relevant regulatory authorities, customers
      and
      suppliers. We do not currently have employment contracts with our senior
      executives. If, for any reason, our senior executives do not continue to be
      active in management, our business, or the financial condition of our Company,
      our results of operations could be adversely affected. In addition, we do not
      maintain life insurance on our senior executives and other key
      employees.


40





**We
      may need to raise capital to fund our operations, and our failure to obtain
      funding when needed may force us to delay, reduce or eliminate acquisitions
      and
      business development plans.**





If
      in the
      future, we are not capable of generating sufficient revenues from operations
      and
      our capital resources are insufficient to meet future requirements, we may
      have
      to raise funds to continue the development, commercialization and marketing
      of
      our business. The projects we are currently pursuing include the LNG project,
      the Xi'an International Port District project, and Baliu Ecological Park
      project.




We
      cannot
      be certain that funding will be available. To the extent that we raise
      additional funds by issuing equity securities, our stockholders may experience
      significant dilution. Any debt financing, if available, may involve restrictive
      covenants that impact our ability to conduct our business. If we are unable
      to
      raise additional capital when required or on acceptable terms, we may have
      to
      delay, scale back, discontinue our planned acquisitions or business development
      plans or obtain funds by entering into agreements on unattractive
      terms.




**Our
      strategy of geographic expansion and our effort of acquiring additional fueling
      stations may fail.**




As
      part
      of our business strategy, we continue to expand our operations into more regions
      in China as we address growth in our natural gas user base and market
      opportunities. We are constructing new CNG fueling stations and acquiring
      existing stations in those regions. These actions may require a significant
      amount of capital investment, and involve uncertainties and risks. We might
      not
      be as familiar with the local markets as we are in Henan Province and in our
      home market Shaanxi Province. Our effort of geographic expansion may fail
      resulting in loss of investment, competitive edge, and the opportunity to enter
      into those markets in the near future.




**We
      may not be able to manage our expanding operations
      effectively.** ******




To
      manage
      the potential growth of our operations and personnel, as well as geographically
      dispersed CNG fueling stations, we will be required to improve operational
      and
      financial systems, procedures and controls, and expand, train and manage our
      growing employee base, including staff from acquired CNG fueling stations.
      This
      requires significant time and resource commitments from us and our senior
      management, who will also be required to maintain and expand our relationships
      with local governments. We cannot assure you that our current and planned
      personnel, systems, procedures and controls will be adequate to support our
      future operations. Our failure to manage growth and operate efficiently could
      harm our business and adversely affect our financial conditions.





**RISKS
      RELATED TO THE PEOPLE'S REPUBLIC OF CHINA**





**China's
      economic policies could affect our business.**





Substantially
      all of our assets are located in China and substantially all of our revenue
      is
      derived from our operations in China. Accordingly, our results of operations
      and
      prospects are subject, to a significant extent, to the economic, political
      and
      legal developments in China.


41


While
      China's economy has experienced a significant growth in the past twenty years,
      growth has been irregular, both geographically and among various sectors of
      the
      economy. The Chinese government has implemented various measures to encourage
      economic growth and guide the allocation of resources. Some of these measures
      benefit the overall economy of China, but may also have a negative effect on
      us.
      For example, our operating results and financial condition may be adversely
      affected by the government control over capital investments or changes in tax
      regulations.





The
      economy of China has been transitioning from a planned economy to a more
      market-oriented economy. In recent years the Chinese government has implemented
      measures emphasizing the utilization of market forces for economic reform and
      the reduction of state ownership of productive assets and the establishment
      of
      corporate governance in business enterprises; however, a substantial portion
      of
      productive assets in China are still owned by the Chinese government. In
      addition, the Chinese government continues to play a significant role in
      regulating industry development by imposing industrial policies. It also
      exercises significant control over China's economic growth through the
      allocation of resources, controlling payment of foreign currency-denominated
      obligations, setting monetary policy and providing preferential treatment to
      particular industries or companies.





**China’s
      Tax Policies could affect our earnings results.**





The
      PRC
      government currently grants companies in the natural gas industry a reduced
      tax
      rate to encourage the development of the industry. Our variable interest entity,
      XXNGC, enjoys the reduced tax rate of 15%. If there’s any change in this
      favorable policy, though not currently expected, it could adversely affect
      our
      earnings results.





**Capital
      outflow policies in The People's Republic of China may hamper our ability to
      remit income to the United States.**





The
      PRC
      government imposes controls on the convertibility of Renminbi into foreign
      currencies and, in certain cases, on the remittance of currency outside of
      the
      PRC. We receive substantially all of our revenues in Renminbi. Under our current
      structure, our income is primarily derived from payments from Xi’an Xilan
      Natural Gas Co. Shortages in the availability of foreign currency may restrict
      the ability of Xi’an Xilan Natural Gas to remit sufficient foreign currency to
      pay dividends, if any, or other payments to us, or otherwise satisfy its foreign
      currency denominated obligations. Under existing PRC foreign exchange
      regulations, payments of current account items, including profit distributions,
      interest payments and expenditures from trade-related transactions, can be
      made
      in foreign currencies without prior approval from the PRC State Administration
      of Foreign Exchange by complying with certain procedural requirements. However,
      approval from appropriate government authorities is required in those cases
      in
      which Renminbi is to be converted into foreign currency and remitted out of
      the
      PRC to pay capital expenses, such as the repayment of bank loans denominated
      in
      foreign currencies. The PRC government also may at its discretion restrict
      access in the future to foreign currencies for current account transactions.
      If
      the foreign exchange control system prevents us from obtaining sufficient
      foreign currency to satisfy our currency demands, we may not be able to pay
      dividends, if any, in foreign currencies to our shareholders.


42





**Although
      we do not import goods into or export goods out of The People's Republic of
      China, fluctuation of the RMB may indirectly affect our financial condition
      by
      affecting the volume of cross-border money flow.**




The
      value
      of the RMB fluctuates and is subject to changes in the People's Republic of
      China political and economic conditions. Since July 2005, the conversion of
      RMB
      into foreign currencies, including USD, has been based on rates set by the
      People's Bank of China which are set based upon the interbank foreign exchange
      market rates and current exchange rates of a basket of currencies on the world
      financial markets. As of September 30, 2008, the exchange rate between the
      RMB
      and the United States dollar was 6.835 RMB to every one USD (middle
      price).





**We
      may face obstacles from the communist system in The People's Republic of
      China.**





Foreign
      companies conducting operations in The People's Republic of China face
      significant political, economic and legal risks. The Communist regime in The
      People's Republic of China, including a stifling bureaucracy may hinder Western
      investment.





**We
      may have difficulty establishing adequate management, legal and financial
      controls in The People's Republic of China.**





The
      People's Republic of China historically has been deficient in Western style
      management and financial reporting concepts and practices, as well as in modern
      banking, computer and other control systems. We may have difficulty in hiring
      and retaining a sufficient number of qualified employees to work in The People's
      Republic of China. As a result of these factors, we may experience difficulty
      in
      establishing management, legal and financial controls, collecting financial
      data
      and preparing financial statements, books of account and corporate records
      and
      instituting business practices that meet Western standards.





**Because
      our assets and operations are located in China, you may have difficulty
      enforcing any civil liabilities against us under the securities and other laws
      of the United States or any state.**





We
      are a
      holding company, and all of our assets are located in the Republic of China.
      In
      addition, a majority of our directors and officers are non-residents of the
      United States, and all or a substantial portion of the assets of these
      non-residents are located outside the United States. As a result, it may be
      difficult for investors to effect service of process within the United States
      upon these non-residents, or to enforce against them judgments obtained in
      United States courts, including judgments based upon the civil liability
      provisions of the securities laws of the United States or any
      state.





There
      is
      uncertainty as to whether courts of the People’s Republic of China would
      enforce:





·
            Judgments
                of United States courts obtained against us or these non-residents
                based
                on the civil liability provisions of the securities laws of the United
                States or any state; or





·
            In
                original actions brought in the People’s Republic of China, liabilities
                against us or non-residents predicated upon the securities laws of
                the
                United States or any state. Enforcement of a foreign judgment in
                the
                Republic of China also may be limited or otherwise affected by applicable
                bankruptcy, insolvency, liquidation, arrangement, moratorium or similar
                laws relating to or affecting creditors' rights generally and will
                be
                subject to a statutory limitation of time within which proceedings
                may be
                brought.


43





**The
      PRC legal system embodies uncertainties, which could limit law enforcement
      availability.**




The
      PRC
      legal system is a civil law system based on written statutes. Unlike common
      law
      systems, decided legal cases have little precedence. In 1979, the PRC government
      began to promulgate a comprehensive system of laws and regulations governing
      economic matters in general. The overall effect of legislation since 1979 has
      significantly enhanced the protections afforded to various forms of foreign
      investment in China. Each of our PRC operating subsidiaries and affiliates
      is
      subject to PRC laws and regulations. However, these laws and regulations change
      frequently and the interpretation and enforcement involve uncertainties. For
      instance, we may have to resort to administrative and court proceedings to
      enforce the legal protection that we are entitled to by law or contract.
      However, since PRC administrative and court authorities have significant
      discretion in interpreting statutory and contractual terms, it may be difficult
      to evaluate the outcome of administrative court proceedings and the level of
      law
      enforcement that we would receive in more developed legal systems. Such
      uncertainties, including the inability to enforce our contracts, could affect
      our business and operation. In addition, intellectual property rights and
      confidentiality protections in China may not be as effective as in the United
      States or other countries. Accordingly, we cannot predict the effect of future
      developments in the PRC legal system, particularly with regard to the industries
      in which we operate, including the promulgation of new laws. This may include
      changes to existing laws or the interpretation or enforcement thereof, or the
      preemption of local regulations by national laws. These uncertainties could
      limit the availability of law enforcement, including our ability to enforce
      our
      agreements with the government entities and other foreign
      investors.





**The
      admission of China into the World Trade Organization could lead to increased
      foreign competition.**





China
      officially entered the WTO on December 11, 2001. As the country follows its
      timetable in the WTO accession agreements to release restrictions on
      international trade and to improve the investment environment, countries with
      large natural gas reserves including Saudi Arabia may gain more access to
      China’s natural gas market, and foreign investments may be allowed to invest in
      natural gas industry. Such events could lead to increased competition in the
      natural gas industry in China.





**PRC
      laws and regulations governing our businesses and the validity of certain of
      our
      contractual arrangements are uncertain. If we are found to be in violation,
      we
      could be subject to sanctions. In addition, changes in such PRC laws and
      regulations may materially and adversely affect our business.**




There
      are
      substantial uncertainties regarding the interpretation and application of PRC
      laws and regulations, including, but not limited to, the laws and regulations
      governing our business, or the enforcement and performance of our contractual
      arrangements with our VIE, Xi’an Xilan Natural Gas, and its shareholders. We are
      considered a foreign person or foreign invested enterprise under PRC law. As
      a
      result, we are subject to PRC law limitations on foreign ownership of Chinese
      companies. These laws and regulations are relatively new and may be subject
      to
      change, and their official interpretation and enforcement may involve
      substantial uncertainty. The effectiveness of newly enacted laws, regulations
      or
      amendments may be delayed, resulting in detrimental reliance by foreign
      investors. New laws and regulations that affect existing and proposed future
      businesses may also be applied retroactively.


44





The
      PRC
      government has broad discretion in dealing with violations of laws and
      regulations, including levying fines, revoking business and other licenses
      and
      requiring actions necessary for compliance. In particular, licenses and permits
      issued or granted to us by relevant governmental bodies may be revoked at a
      later time by higher regulatory bodies. We cannot predict the effect of the
      interpretation of existing or new PRC laws or regulations on our businesses.
      We
      cannot assure you that our current ownership and operating structure would
      not
      be found in violation of any current or future PRC laws or regulations. As
      a
      result, we may be subject to sanctions, including fines, and could be required
      to restructure our operations or cease to provide certain services. Any of
      these
      or similar actions could significantly disrupt our business operations or
      restrict us from conducting a substantial portion of our business operations,
      which could materially and adversely affect our business, financial condition
      and results of operations.




**We
      may be adversely affected by complexity, uncertainties and changes in PRC
      regulation of natural gas business and companies, including limitations on
      our
      ability to own key assets.**




The
      PRC
      government regulates the natural gas industry including foreign ownership of,
      and the licensing and permit requirements pertaining to, companies in the
      natural gas industry. These laws and regulations are relatively new and
      evolving, and their interpretation and enforcement involve significant
      uncertainty. As a result, in certain circumstances it may be difficult to
      determine what actions or omissions may be deemed to be a violation of
      applicable laws and regulations. Issues, risks and uncertainties relating to
      PRC
      government regulation of the natural gas industry include, but are not limited
      to, the following:





·
            We
                only have contractual control over Xi’an Xilan Natural Gas. We do not own
                it due to the restriction of foreign investment in Chinese businesses;
                and





·
            Uncertainties
                relating to the regulation of the natural gas business in China,
                including
                evolving licensing practices, means that permits, licenses or operations
                at our company may be subject to challenge. This may disrupt our
                business,
                or subject us to sanctions, requirements to increase capital or other
                conditions or enforcement, or compromise enforceability of related
                contractual arrangements, or have other harmful effects on
                us.





The
      interpretation and application of existing PRC laws, regulations and policies
      and possible new laws, regulations or policies have created substantial
      uncertainties regarding the legality of existing and future foreign investments
      in, and the businesses and activities of, natural gas businesses in China,
      including our business.




**In
      order to comply with PRC laws limiting foreign ownership of Chinese companies,
      we conduct our natural gas business through Xi’an Xilan Natural Gas by means of
      contractual arrangements. If the PRC government determines that these
      contractual arrangements do not comply with applicable regulations, our business
      could be adversely affected.**




The
      PRC
      government restricts foreign investment in natural gas businesses in China.
      Accordingly, we operate our business in China through Xi’an Xilan Natural Gas.
      Xi’an Xilan Natural Gas holds the licenses and approvals necessary to operate
      our natural gas business in China. We have contractual arrangements with Xi’an
      Xilan Natural Gas and its shareholders that allow us to substantially control
      Xi’an Xilan Natural Gas. We cannot assure you, however, that we will be able to
      enforce these contracts.


45


Although
      we believe we comply with current PRC regulations, we cannot assure you that
      the
      PRC government would agree that these operating arrangements comply with PRC
      licensing, registration or other regulatory requirements, with existing policies
      or with requirements or policies that may be adopted in the future. If the
      PRC
      government determines that we do not comply with applicable law, it could revoke
      our business and operating licenses, require us to discontinue or restrict
      our
      operations, restrict our right to collect revenues, require us to restructure
      our operations, impose additional conditions or requirements with which we
      may
      not be able to comply, impose restrictions on our business operations or on
      our
      customers, or take other regulatory or enforcement actions against us that
      could
      be harmful to our business.




**Our
      contractual arrangements with Xi’an Xilan Natural Gas and its shareholders may
      not be as effective in providing control over these entities as direct
      ownership.**




Since
      PRC
      law limits foreign equity ownership in natural gas companies in China, we
      operate our business through Xi’an Xilan Natural Gas. We have no equity
      ownership interest in Xi’an Xilan Natural Gas and rely on contractual
      arrangements to control and operate such businesses. These contractual
      arrangements may not be as effective in providing control over Xi’an Xilan
      Natural Gas as direct ownership. For example, Xi’an Xilan Natural Gas could fail
      to take actions required for our business despite its contractual obligation
      to
      do so. If Xi’an Xilan Natural Gas fails to perform under their agreements with
      us, we may have to incur substantial costs and resources to enforce such
      arrangements and may have to rely on legal remedies under PRC law, which may
      not
      be effective. In addition, we cannot assure you that Xi’an Xilan Natural Gas’s
      shareholders would always act in our best interests.





**RISKS
      RELATED TO CORPORATE AND STOCK MATTERS**





**Our
      largest stockholder has significant influence over our management and affairs
      and could exercise this influence against your best interests.**





At
      September 30, 2008, Mr. Qinan Ji, our founder, Chairman of the Board and Chief
      Executive Officer and our largest stockholder, beneficially owned approximately
      20.3% of our outstanding shares of common stock. As a result, pursuant to our
      Bylaws and applicable laws and regulations, our controlling shareholder and
      our
      other executive officers and directors are able to exercise significant
      influence over our Company, including, but not limited to, any stockholder
      approvals for the election of our directors and, indirectly, the selection
      of
      our senior management, the amount of dividend payments, if any, our annual
      budget, increases or decreases in our share capital, new securities issuance,
      mergers and acquisitions and any amendments to our Bylaws. Furthermore, this
      concentration of ownership may delay or prevent a change of control or
      discourage a potential acquirer from making a tender offer or otherwise
      attempting to obtain control of us, which could decrease the market price of
      our
      shares. The limited prior public market and trading market may cause volatility
      in the market price of our common stock.





**We
      have incurred and will continue to incur increased costs as a result of being
      a
      public company.**





As
      a
      public company, we have incurred and will continue to incur significant legal,
      accounting and other expenses that we did not incur as a private company. We
      have incurred and will continue to incur costs associated with our public
      company reporting and compliance requirements, including corporate governance
      requirements under the Sarbanes-Oxley Act of 2002 and rules implemented by
      the
      Securities and Exchange Commission, or the SEC. We expect these rules and
      regulations to increase our legal and financial compliance costs and to make
      certain activities more time-consuming and costly.


46




**We
      may have exposure to greater than anticipated tax
      liabilities.**




We
      are
      subject to income tax, business tax and other taxes in many provinces and cities
      in China and our tax structure is subject to review by various local tax
      authorities. The determination of our provision for income tax and other tax
      liabilities requires significant judgment and in the ordinary course of our
      business, there are many transactions and calculations where the ultimate tax
      determination is uncertain. Although we believe our estimates are reasonable,
      the ultimate decisions by the relevant tax authorities may differ from the
      amounts recorded in our financial statements and may materially affect our
      financial results in the period or periods for which such determination is
      made.





**The
      limited prior public market and trading market may cause volatility in the
      market price of our common stock.**





Our
      common stock is currently traded on a limited basis on the OTCBB under the
      symbol, "CHNG.OB" The quotation of our common stock on the OTCBB does not assure
      that a meaningful, consistent and liquid trading market currently exists, and
      in
      recent years, such market has experienced extreme price and volume fluctuations
      that have particularly affected the market prices of many smaller companies
      like
      us. Our common stock is thus subject to volatility. In the absence of an active
      trading market:





·
            investors
                may have difficulty buying and selling or obtaining market quotations;





·
            market
                visibility for our common stock may be limited;
                and





·
            a
                lack of visibility for our common stock may have a depressive effect
                on
                the market for our common stock.





**Trading
      of our stock may be restricted by the SEC's penny stock regulations which may
      limit a stockholder's ability to buy and sell our stock if our stock trades
      below $5.00 per share.**





The
      SEC
      has adopted Rule 15g-9 which generally defines "penny stock" to be any equity
      security that has a market price (as defined) less than $5.00 per share or
      an
      exercise price of less than $5.00 per share, subject to certain exceptions.
      Our
      securities are covered by the penny stock rules, which impose additional sales
      practice requirements on broker-dealers who sell to persons other than
      established customers and "accredited investors". The term "accredited investor"
      refers generally to institutions with assets in excess of $5,000,000 or
      individuals with a net worth in excess of $1,000,000 or annual income exceeding
      $200,000 or $300,000 jointly with their spouse. The penny stock rules require
      a
      broker-dealer, prior to a transaction in a penny stock not otherwise exempt
      from
      the rules, to deliver a standardized risk disclosure document in a form prepared
      by the SEC which provides information about penny stocks and the nature and
      level of risks in the penny stock market. The broker-dealer also must provide
      the customer with current bid and offer quotations for the penny stock, the
      compensation of the broker-dealer and its salesperson in the transaction and
      monthly account statements showing the market value of each penny stock held
      in
      the customer's account. The bid and offer quotations, and the broker-dealer
      and
      salesperson compensation information, must be given to the customer orally
      or in
      writing prior to effecting the transaction and must be given to the customer
      in
      writing before or with the customer's confirmation. In addition, the penny
      stock
      rules require that prior to a transaction in a penny stock not otherwise exempt
      from these rules, the broker-dealer must make a special written determination
      that the penny stock is a suitable investment for the purchaser and receive
      the
      purchaser's written agreement to the transaction. These disclosure requirements
      may have the effect of reducing the level of trading activity in the secondary
      market for the stock that is subject to these penny stock rules. Consequently,
      these penny stock rules may affect the ability of broker-dealers to trade our
      securities. We believe that the penny stock rules discourage investor interest
      in and limit the marketability of our common stock.


47





**NASD
      sales practice requirements may also limit a stockholder's ability to buy and
      sell our stock.**





Section
      15(g) of the Securities Exchange Act of 1934, as amended, and Rule 15g-2
      promulgated thereunder by the SEC require broker-dealers dealing in penny stocks
      to provide potential investors with a document disclosing the risks of penny
      stocks and to obtain a manually signed and dated written receipt of the document
      before effecting any transaction in a penny stock for the investor's
      account.





Potential
      investors in our common stock are urged to obtain and read such disclosure
      carefully before purchasing any shares that are deemed to be "penny stock."
      Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approve the
      account of any investor for transactions in such stocks before selling any
      penny
      stock to that investor. This procedure requires the broker-dealer to (i) obtain
      from the investor information concerning his or her financial situation,
      investment experience and investment objectives; (ii)reasonably determine,
      based
      on that information, that transactions in penny stocks are suitable for the
      investor and that the investor has sufficient knowledge and experience as to
      be
      reasonably capable of evaluating the risks of penny stock transactions; (iii)
      provide the investor with a written statement setting forth the basis on which
      the broker-dealer made the determination in (ii) above; and (iv) receive a
      signed and dated copy of such statement from the investor, confirming that
      it
      accurately reflects the investor's financial situation, investment experience
      and investment objectives. Compliance with these requirements may make it more
      difficult for holders of our common stock to resell their shares to third
      parties or to otherwise dispose of them in the market or otherwise.





**Shares
      eligible for future sale may adversely affect the market price of our Common
      stock, as the future sale of a substantial amount of our restricted stock in
      the
      public marketplace could reduce the price of our common
      stock.**





From
      time
      to time, certain of our stockholders may be eligible to sell all or some of
      their shares of common stock by means of ordinary brokerage transactions in
      the
      open market pursuant to Rule 144, promulgated under the Securities Act ("Rule
      144"), subject to certain limitations. In general, pursuant to Rule 144, a
      stockholder (or stockholders whose shares are aggregated) who has satisfied
      a
      one-year holding period may, under certain circumstances, sell within any
      three-month period a number of securities which does not exceed the greater
      of
      1% of the then outstanding shares of common stock or the average weekly trading
      -volume of the class during the four calendar weeks prior to such sale. Rule
      144
      also permits, under certain circumstances, the sale of securities, without
      any
      limitations, by a non-affiliate of our company that has satisfied a two-year
      holding period. Any substantial sale of common stock pursuant to Rule 144 or
      pursuant to any resale prospectus may have an adverse effect on the market
      price
      of our securities.




If
      we or
      our independent registered public accountants cannot attest our adequacy in
      the
      internal control measures over our financial reporting, as required by Section
      404 of the U.S. Sarbanes-Oxley Act, we may be adversely
      affected.


48





As
      a
      public company, we are subject to report our internal control structure and
      procedures for financial reporting in our annual reports on Form 10-K, as a
      requirement of Section 404 of the U.S. Sarbanes-Oxley Act of 2002 by the U.S.
      Securities and Exchange Commission (the "SEC"). The report must contain an
      assessment by management about the effectiveness of our internal controls over
      financial reporting. Moreover, the independent registered public accountants
      of
      our Company must attest to and report on management's assessment of the same.
      Even if our management attests to our internal control measures to be effective,
      our independent registered public accountants may not be satisfied with our
      internal control structure and procedures. We cannot guarantee the outcome
      of
      the report and it could result in an adverse impact on us in the financial
      marketplace due to the loss of investor confidence in the reliability of our
      financial statements, which could negative influence to our stock market
      price.





**Stockholders
      should have no expectation of any dividends.**





The
      holders of our common stock are entitled to receive dividends when declared
      by
      the Board of Directors out of funds available. To date, we have not declared
      nor
      paid any cash dividends. The Board of Directors does not intend to declare
      any
      dividends in the near future, but instead intends to retain all earnings, if
      any, for use in our business operations.





**Item
      2.**  **Unregistered
      Sales of Equity Securities and Use of Proceeds**





None.





I **tem
      3.**  **Defaults
      Upon Senior Securities**





None.





**Item
      4.**  **Submission
      of Matters to a Vote of Security Holders**





Not
      applicable





**Item
      5.**  **Other
      Information**





None





**Item
      6.**  **Exhibits**





(a)
            Exhibits


49





**Exhibit
                Number**
            
            **Description
                of Exhibit**31.1
            
            Certification
                of Principal Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a),
                promulgated under the Securities and Exchange Act of 1934, as
                amended31.2
            
            Certification
                of Principal Financial Officer pursuant to Rule 13a-14 and Rule 15d
                14(a),
                promulgated under the Securities and Exchange Act of 1934, as
                amended32.1
            
            Certification
                pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002 (Chief Executive
                Officer)32.2
            
            Certification
                pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002 (Chief Financial
                Officer)




50





**SIGNATURES**





In
      accordance with the requirements of the Exchange Act, the registrant caused
      this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.




China
                Natural Gas, Inc.November
                13, 2008
            By:
            /s/ Qinan
                JiQinan
                Ji
              Chief
                Executive Officer
              (Principal
                Executive Officer)November
                13, 2008
            By:
            /s/ Richard
                P. WuRichard
                P. Wu
              Chief
                Financial Officer
              (Principal
                Financial and Accounting Officer)




51