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 March 31, 2009





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)


_______________________


(zip
code)




86-29-8832-7391


(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 xNo 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 xNon-accelerated
      filer  ̈
            Smaller
      reporting company  ̈


(Do not
check if a smaller reporting company)





Number of
shares of Common Stock outstanding as of May 4, 2009: 14,600,152


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


Yes oNo x














China
Natural Gas, Inc.


Index





PART
      I.
                FINANCIAL
      INFORMATIONItem
      1.
                Financial
      Statements
                
                1Notes
      to Consolidated Financial Statements (unaudited)
                
                4Item
      2.
                Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                29Item
      3.
                Quantitative
      and Qualitative Disclosures About Market Risk
                
                38Item
      4T.
                Controls
      and Procedures
                
                38PART
      II.
                OTHER
      INFORMATIONItem
      1.
                Legal
      Proceedings
                
                39Item
      1A.
                Risk
      Factors
                
                40Item
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                
                40Item
      3.
                Defaults
      Upon Senior Securities
                
                40Item
      4.
                Submission
      of Matters to a Vote of Security Holders
                
                40Item
      5.
                Other
      Information
                
                40Item
      6.
                Exhibits
                
                40SIGNATURES
                
                
                41





PART
I. FINANCIAL INFORMATION


Item
1. Financial Statements


CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


AS
OF MARCH 31, 2009 AND DECEMBER 31, 2008





March
      31,
                                    
                                    
                                    December,
      312009
                                    
                                    
                                    2008(Unaudited)ASSETSCURRENT
      ASSETS:Cash
      & cash equivalents
                                    
                                    $
                                    9,058,361
                                    
                                    
                                    $
                                    5,854,383Accounts
      receivable
                                    
                                    
                                    946,047
                                    
                                    
                                    
                                    906,042Other
      receivable - employee advances
                                    
                                    
                                    180,205
                                    
                                    
                                    
                                    332,263Inventories
                                    
                                    
                                    488,221
                                    
                                    
                                    
                                    519,739Advances
      to suppliers
                                    
                                    
                                    684,632
                                    
                                    
                                    
                                    837,592Prepaid
      expense and other current assets
                                    
                                    
                                    953,578
                                    
                                    
                                    
                                    838,294Loan
      receivable
                                    
                                    
                                    293,000
                                    
                                    
                                    
                                    293,400Total
      current assets
                                    
                                    
                                    12,604,044
                                    
                                    
                                    
                                    9,581,713PROPERTY
      AND EQUIPMENT, NET
                                    
                                    
                                    74,549,788
                                    
                                    
                                    
                                    76,028,272CONSTRUCTION
      IN PROGRESS
                                    
                                    
                                    25,110,473
                                    
                                    
                                    
                                    22,061,414DEFERRED
      FINANCING COSTS
                                    
                                    
                                    1,644,372
                                    
                                    
                                    
                                    1,746,830OTHER
      ASSETS
                                    
                                    
                                    9,278,092
                                    
                                    
                                    
                                    8,844,062TOTAL
      ASSETS
                                    
                                    $
                                    123,186,769
                                    
                                    
                                    $
                                    118,262,291LIABILITIES AND STOCKHOLDERS'
      EQUITYCURRENT
      LIABILITIES:Accounts
      payable and accrued liabilities
                                    
                                    $
                                    1,103,837
                                    
                                    
                                    $
                                    800,013Other
      payables
                                    
                                    
                                    336,936
                                    
                                    
                                    
                                    124,151Unearned
      revenue
                                    
                                    
                                    1,138,536
                                    
                                    
                                    
                                    944,402Accrued
      interest
                                    
                                    
                                    531,111
                                    
                                    
                                    
                                    861,114Taxes
      payable
                                    
                                    
                                    1,904,943
                                    
                                    
                                    
                                    1,862,585Total
      current liabilities
                                    
                                    
                                    5,015,363
                                    
                                    
                                    
                                    4,592,265LONG
      TERM LIABILITIES:Notes
      payable, net of discount $14,844,315 and $15,478,395 as ofMarch
      31, 2009 and December 31, 2008, respectively
                                    
                                    
                                    25,155,685
                                    
                                    
                                    
                                    24,521,605Redeemable
      liabilities - warrants
                                    
                                    
                                    17,500,000
                                    
                                    
                                    
                                    17,500,000Derivative
      liabilities - warrants
                                    
                                    
                                    817,257
                                    
                                    
                                    
                                    -Total
      long term liabilities
                                    
                                    
                                    43,472,942
                                    
                                    
                                    
                                    42,021,605COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITY:Preferred
      stock, $0.0001 per share; 5,000,000 shares authorized; none
      issued
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Common
      stock, $0.0001 per share; 45,000,000 shares authorized, 14,600,152
      sharesissued
      and outstanding at March 31, 2009 and December 31, 2008
                                    
                                    
                                    1,460
                                    
                                    
                                    
                                    1,460Additional
      paid-in capital
                                    
                                    
                                    25,271,339
                                    
                                    
                                    
                                    32,115,043Cumulative
      translation adjustment
                                    
                                    
                                    8,508,945
                                    
                                    
                                    
                                    8,661,060Statutory
      reserves
                                    
                                    
                                    4,284,815
                                    
                                    
                                    
                                    3,730,083Retained
      earnings
                                    
                                    
                                    36,631,905
                                    
                                    
                                    
                                    27,140,775Total
      stockholders' equity
                                    
                                    
                                    74,698,464
                                    
                                    
                                    
                                    71,648,421TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                                    
                                    $
                                    123,186,769
                                    
                                    
                                    $
                                    118,262,291


The
accompanying notes are an integral part of these statements


1





CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME


FOR
THE THREE MONTHS ENDED MARCH 31, 2009 AND 2008


(Unaudited)





Three Months Ended March 31,2009
                                  
                                  
                                  2008RevenueNatural
      gas revenue
                                  
                                  $
                                  14,965,819
                                  
                                  
                                  $
                                  11,345,319Gasoline
      revenue
                                  
                                  
                                  1,174,398
                                  
                                  
                                  
                                  1,130,750Installation
      and other
                                  
                                  
                                  2,387,449
                                  
                                  
                                  
                                  1,549,605Total
      revenue
                                  
                                  
                                  18,527,666
                                  
                                  
                                  
                                  14,025,674Cost
      of revenueNatural
      gas cost
                                  
                                  
                                  6,746,929
                                  
                                  
                                  
                                  6,182,274Gasoline
      cost
                                  
                                  
                                  1,130,057
                                  
                                  
                                  
                                  1,068,037Installation
      and other
                                  
                                  
                                  1,017,028
                                  
                                  
                                  
                                  686,887Total
      cost of revenue
                                  
                                  
                                  8,894,014
                                  
                                  
                                  
                                  7,937,198Gross
      profit
                                  
                                  
                                  9,633,652
                                  
                                  
                                  
                                  6,088,476Operating
      expensesSelling
      expenses
                                  
                                  
                                  2,324,228
                                  
                                  
                                  
                                  1,341,614General
      and administrative expenses
                                  
                                  
                                  1,681,921
                                  
                                  
                                  
                                  939,325Total
      operating expenses
                                  
                                  
                                  4,006,149
                                  
                                  
                                  
                                  2,280,939Income
      from operations
                                  
                                  
                                  5,627,503
                                  
                                  
                                  
                                  3,807,537Non-operating
      income (expense)Interest
      income
                                  
                                  
                                  8,908
                                  
                                  
                                  
                                  55,285Interest
      expense
                                  
                                  
                                  (581,492
                                  )
                                  
                                  
                                  (359,660
                                  )Other
      income (expense), net
                                  
                                  
                                  (2,303
                                  )
                                  
                                  
                                  304Change
      in fair value of warrant
                                  
                                  
                                  197,051
                                  
                                  
                                  
                                  -Foreign
      currency exchange loss
                                  
                                  
                                  (50,788
                                  )
                                  
                                  
                                  (7,430
                                  )Total
      non-operating expense
                                  
                                  
                                  (428,624
                                  )
                                  
                                  
                                  (311,501
                                  )Income
      before income tax
                                  
                                  
                                  5,198,879
                                  
                                  
                                  
                                  3,496,036Provision
      for income tax
                                  
                                  
                                  997,256
                                  
                                  
                                  
                                  687,465Net
      income
                                  
                                  
                                  4,201,623
                                  
                                  
                                  
                                  2,808,571Other
      comprehensive incomeForeign
      currency translation gain (loss)
                                  
                                  
                                  (152,115
                                  )
                                  
                                  
                                  2,303,002Comprehensive
      income
                                  
                                  $
                                  4,049,508
                                  
                                  
                                  $
                                  5,111,573Weighted
      average shares outstandingBasic
                                  
                                  
                                  14,600,152
                                  
                                  
                                  
                                  14,600,152Diluted
                                  
                                  
                                  14,600,152
                                  
                                  
                                  
                                  14,667,042Earnings
      per shareBasic
                                  
                                  $
                                  0.29
                                  
                                  
                                  $
                                  0.19Diluted
                                  
                                  $
                                  0.29
                                  
                                  
                                  $
                                  0.19





The
accompanying notes are an integral part of these statements


2





CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE THREE MONTHS ENDED MARCH 31, 2009 AND 2008


(Unaudited)




Three Months Ended March 31,2009
                                                        
                                                        
                                                        2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                                                        
                                                        $
                                                        4,201,623
                                                        
                                                        
                                                        $
                                                        2,808,571Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
      and amortization
                                                        
                                                        
                                                        1,389,565
                                                        
                                                        
                                                        
                                                        656,587Loss
      on disposal of building improvements and equipment
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        11,957Amortization
      of discount on senior notes
                                                        
                                                        
                                                        170,712
                                                        
                                                        
                                                        
                                                        146,663Amortization
      of financing costs
                                                        
                                                        
                                                        38,578
                                                        
                                                        
                                                        
                                                        56,270Stock
      based compensation
                                                        
                                                        
                                                        14,842
                                                        
                                                        
                                                        
                                                        -Change
      in fair value of warrants
                                                        
                                                        
                                                        (197,051
                                                        )
                                                        
                                                        
                                                        -Change
      in assets and liabilities:Accounts
      receivable
                                                        
                                                        
                                                        (41,244
                                                        )
                                                        
                                                        
                                                        (163,656
                                                        )Other
      receivable - employee advances
                                                        
                                                        
                                                        151,617
                                                        
                                                        
                                                        
                                                        -Inventories
                                                        
                                                        
                                                        30,812
                                                        
                                                        
                                                        
                                                        (782,687
                                                        )Advances
      to suppliers
                                                        
                                                        
                                                        151,828
                                                        
                                                        
                                                        
                                                        63,341Prepaid
      expense and other current assets
                                                        
                                                        
                                                        (100,912
                                                        )
                                                        
                                                        
                                                        (257,016
                                                        )Accounts
      payable and accrued liabilities
                                                        
                                                        
                                                        304,860
                                                        
                                                        
                                                        
                                                        95,847Other
      payables
                                                        
                                                        
                                                        212,961
                                                        
                                                        
                                                        
                                                        1,129Unearned
      revenue
                                                        
                                                        
                                                        195,435
                                                        
                                                        
                                                        
                                                        22,709Accrued
      interest
                                                        
                                                        
                                                        (330,003
                                                        )
                                                        
                                                        
                                                        73,717Taxes
      payable
                                                        
                                                        
                                                        44,898
                                                        
                                                        
                                                        
                                                        768,939Net
      cash provided by operating activities
                                                        
                                                        
                                                        6,238,521
                                                        
                                                        
                                                        
                                                        3,502,371CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
                                                        
                                                        
                                                        (13,484
                                                        )
                                                        
                                                        
                                                        (555,720
                                                        )Proceeds
      from short term investments
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        243,200Additions
      to construction in progress
                                                        
                                                        
                                                        (2,552,098
                                                        )
                                                        
                                                        
                                                        (9,586,215
                                                        )Prepayment
      on long term assets
                                                        
                                                        
                                                        (426,913
                                                        )
                                                        
                                                        
                                                        (4,128,711
                                                        )Payment
      for intangible assets
                                                        
                                                        
                                                        (35,822
                                                        )
                                                        
                                                        
                                                        -Payment
      for land use rights
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (25,091
                                                        )Net
      cash used in investing activities
                                                        
                                                        
                                                        (3,028,317
                                                        )
                                                        
                                                        
                                                        (14,052,537
                                                        )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from senior notes
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        40,000,000Payment
      for offering costs
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (2,122,509
                                                        )Net
      cash provided by financing activities
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        37,877,491Effect
      of exchange rate changes on cash and cash equivalents
                                                        
                                                        
                                                        (6,226
                                                        )
                                                        
                                                        
                                                        635,076NET
      INCREASE IN CASH & CASH EQUIVALENTS
                                                        
                                                        
                                                        3,203,978
                                                        
                                                        
                                                        
                                                        27,962,401CASH
      & CASH EQUIVALENTS, BEGINNING OF PERIOD
                                                        
                                                        
                                                        5,854,383
                                                        
                                                        
                                                        
                                                        13,291,729CASH
      & CASH EQUIVALENTS, END OF PERIOD
                                                        
                                                        $
                                                        9,058,361
                                                        
                                                        
                                                        $
                                                        41,254,130SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Interest
      paid, net of capitalized interest
                                                        
                                                        $
                                                        1,084,130
                                                        
                                                        
                                                        $
                                                        -Income
      taxes paid
                                                        
                                                        $
                                                        997,257
                                                        
                                                        
                                                        $
                                                        57,893


The
accompanying notes are an integral part of these statements
  3


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Note
1 - Organization





Organization and Line of
Business





China
Natural Gas, Inc. (the “Company” or “CHNG”) was incorporated in the state of
Delaware on March 31, 1999. The Company through its wholly-owned subsidiaries
and variable interest entities, located in Shaanxi and Henan Province in the
People’s Republic of China (“PRC”), engages in sales and distribution of natural
gas and gasoline to commercial, industrial and residential customers,
construction of pipeline networks, installation of natural gas fittings and
parts for end-users, and modification of automobiles services for vehicles to be
able to use natural gas.





RecentDevelopments





On March
18, 2008, Shaanxi Xilan Natural Gas Equipment Co., Ltd (“SXNGE”)increased its
registered capital from $30,000,000 to $53,929,260.  The 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, Jingbian Liquefied Natural Gas Co., Ltd. (“JBLNG”) increased its
registered capital by $2,862,000.  JBLNG is 100% owned by Xi’an Xilan
Natural Gas Co., Ltd.





On April
30, 2008, the Industrial and Commercial Administration Bureau approved Xi’an
Xilan Natural Gas Co., (“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 earnings as an increase of registered capital.  Another
$19,593,258 was contributed by SXNGE cumulatively prior to April 30, 2008, which
was previously classified as an 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 SXNGE 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.  HXNGC was established for the purpose of natural gas
city gasification engineering design, construction and technical advisory work
services in Henan, PRC.




4




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





On
October 2, 2008, China Natural Gas, Inc. (the “Company”) through its
wholly-owned subsidiary, XXNGC, entered into an Equity Ownership Transfer
Agreement (the “Acquisition Agreement”) with Lingbao Yuxi Natural Gas Co., Ltd.
(“LBNGC”) and the shareholders of LBNGC (the “Sellers”).  Pursuant to
the term of the Acquisition Agreement, XXNGC acquired for cash consideration of
approximately $19,604,200 (RMB 134 million), 100% of all outstanding registered
equity interest in LBNGC and all assets held by LBNGC, including the land use
right to 0.44 acres and all of LBNGC’s local business’ exclusive operating
right.  LBNGC owns the exclusive rights to operate CNG fueling
stations and pipelines in Lingbao City. In conjunction with this acquisition,
XXNGC has also secured abundant supply of natural gas to support its future
expansion in the Henan province. The Acquisition Agreement was fully executed in
November, 2008.





Note
2 – Summary of Significant Accounting Policies





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 statements of the results for the interim period
presented.  Operating results for the period ended March 31, 2009 are
not necessary indicative of the results that may be expected for the year ended
December 31, 2009. The information included in this Form 10-Q should be
read in conjunction with information included in the 2008 annual report filed on
Form 10-K.





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.





Principles of
Consolidation





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




5




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Consolidation of Variable
Interest Entity





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, the Company formed Shaanxi Xilan Natural Gas Equipment Co.,
Ltd as a wholly-owned foreign enterprise (WOFE). Then through SXNGE, the Company
entered into exclusive arrangements with Xi’an Xilan Natural Gas and its
shareholders that give the Company 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. The Company
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 Financial
Interpretation No. 46R, “Consolidation of Variable Interest Entities.” The
arrangements consist of the following agreements:




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





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





c.
            Xi’an
      Xilan Natural Gas’ shareholders have pledged their equity interests
      in Xi’an 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 Xi’an
      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 SXNGE 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
SXNGE an option to purchase each Transferor’s Purchased Equity Interest at $1.00
or the lowest price permissible under the applicable laws at the time that SXNGE
exercises the Option.  The Agreement limits XXNGC and the transferors’
right to make all equity interest related decisions.




6




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Foreign Currency
Translation





As of
March 31, 2009 and December 31, 2008, 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") 52,
"Foreign Currency Translation," with the RMB as the functional currency.
According to SFAS 52, all assets and liabilities were translated at the exchange
rate as of the balance sheet date, stockholders’ equity were translated at the
historical rates and statement of income and cash flow items were translated at
the weighted average exchange rate for the year. The resulting translation
adjustments are reported under other comprehensive income in accordance with
SFAS 130, "Reporting Comprehensive Income."  In accordance with SFAS
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 adjustments amounts
related to assets and liabilities reported on the consolidated statement of cash
flows will not necessarily agree with changes in the corresponding consolidated
balances on the balance sheet.





The
balance sheet amounts with the exception of equity at March 31, 2009 were
translated 6.83 RMB to $1.00 as compared to 6.82 RMB at December 31, 2008. The
equity accounts were stated at their historical rate. The average translation
rates applied to income and cash flow statement amounts for the three months
ended March 31, 2009 and 2008 were 6.83 RMB and 7.15 RMB to $1.00,
respectively.





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 March 31, 2009 and December 31, 2008, the Company had total deposits of
$8,902,519 and $5,604,383 without insurance coverage.  And as of March
31, 2009 and December 31, 2008, the Company has deposits in United States of $0
and $1,273,639 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.




7




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Accounts
Receivable





Accounts
and other receivable are netted against 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. Delinquent account balances are written-off after management has
determined that the likelihood of collection is not probable, and known bad
debts are written off against allowance for doubtful accounts when identified.
The Company’s management has determined that all receivables are collectible and
there is no need for an allowance for uncollectible accounts of March 31, 2009
and December 31, 2008.





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
are performed in a timely manner. The Company has full oversight and control
over the advanced accounts. As of March 31, 2009 and December 31, 2008, no
allowance for the uncollectible accounts was deemed necessary.





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 an 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:





March 31, 2009
                                (Unaudited)
                              
                              
                              December 31,2008Materials
      and supplies
                              
                              $
                              314,251
                              
                              
                              $
                              318,069Natural
      gas and gasoline
                              
                              
                              173,970
                              
                              
                              
                              201,670$
                              488,221
                              
                              
                              $
                              519,739





Advances to
Suppliers





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




8




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Loan
Receivable





Loan
receivable consists of the following:


March 31, 2009
                      (Unaudited)
                    
                    
                    December 31,
                      2008Shanxi
      Yuojin Mining Company, due on November 26, 2008, extended to November 30,
      2009, annual interest at 6.57%
                    
                    $
                    293,000
                    
                    
                    $
                    293,400





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
      and improvements
                          5-30
      years





The
following are the details of the property and equipment:





March 31, 2009
                            (Unaudited)
                          
                          
                          December 31,2008Office
      equipment
                          
                          $
                          420,275
                          
                          
                          $
                          412,490Operating
      equipment
                          
                          
                          59,396,509
                          
                          
                          
                          59,473,283Vehicles
                          
                          
                          2,412,337
                          
                          
                          
                          2,414,756Buildings
      and improvements
                          
                          
                          21,161,710
                          
                          
                          
                          21,190,599Total
      property and equipment
                          
                          
                          83,390,831
                          
                          
                          
                          83,491,128Less
      accumulated depreciation
                          
                          
                          (8,841,043
                          )
                          
                          
                          (7,462,856
                          )Property
      and equipment, net
                          
                          $
                          74,549,788
                          
                          
                          $
                          76,028,272





Depreciation
expense for the three months ended March 31, 2009 and 2008 was $1,389,565 and
$656,587, respectively.




9




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Construction inProgress





Construction
in progress consists of the cost of constructing property and equipment for the
Company’s gas stations and new project of processing, distribution and sale of
LNG. The major cost of construction in progress relates to technology licensing
fees, equipment purchase, land use rights requisition cost, capitalized interest
and other construction fees.  The facility construction work is
expected to be completed around June 2009, and processing equipment installation
and testing will be finished by October 2009.  No depreciation is
provided for construction in progress until such time as the assets are
completed and placed into service.  Interest incurred during
construction is capitalized into construction in progress. All other interest is
expensed as incurred.





As of
March 31, 2009 and December 31, 2008, the company had construction in progress
in the amount of $25,110,473 and 22,061,414, respectively. Interest cost
capitalized into construction in progress for the three months ended March 31,
2009 and 2008 amounted to $858,379 and $190,648, respectively.





Long-Lived
Assets





The
Company applies the provision of SFAS 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" to all long lived assets. SFAS 144 addresses
accounting and reporting for impairment and disposal of long-lived assets. The
Company evaluates at least annually, more often when circumstances require, 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 March 31, 2009, there were no significant impairments of its
long-lived assets.





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.


10





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Fair Value of Financial
Instruments





FAS 107,
“Disclosure About Fair Value of Financial Instruments” defines financial
instruments and requires fair value disclosure of applicable financial
instruments.  FAS 157, “Fair Value Measurements,” adopted January 1,
2008, defines fair value, establishes a three-level valuation hierarchy for
disclosures of fair value measurement and enhances disclosure requirements for
fair value measures. The carrying amounts reported in the consolidated balance
sheets for current receivables and payables qualify as financial
instruments.  Management concluded the carrying values 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 if
applicable, their stated interest rate approximates current rates
available.  The three levels are defined as follows:





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





·
              Level
      2   inputs 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
      3   inputs 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 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.”





Effective
January 1, 2009, the Company adopted the provisions of EITF 07-5,
"Determining Whether an Instrument (or Embedded Feature) is Indexed to an
Entity’s Own Stock”, which is effective for financial statements for fiscal
years beginning after December 15, 2008 and which replaced the previous guidance
on this topic in EITF 01-6.  Paragraph 11(a) of FAS 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 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 FAS
133 paragraph 11(a) scope exception.





As a
result of adopting EITF 07-5, 383,654 warrants previously treated as equity
pursuant to the derivative treatment exemption are no longer afforded equity
treatment because the strike price of the warrants is denominated in US dollar,
a currency other than the Company’s functional currency, the Chinese
Renminbi.  As a result, the warrants are not considered indexed to the
Company’s own stock, and as such, all future changes in the fair value of these
warrants will be recognized currently in earnings until such time as the
warrants are exercised or expire.


11


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





As such,
effective January 1, 2009, the Company reclassified the fair value of these
warrants from equity to liability, as if these warrants were treated as a
derivative liability since their issuance in October 2007. On January 1,
2009, the Company reclassified from additional paid-in capital, as a cumulative
effect adjustment, $5.8 million to beginning retained earnings and $1.0
million to warrant liabilities to recognize the fair value of such warrants. The
fair value of the warrants was $0.8 million on March 31,
2009.  Therefore, the Company recognized a $0.2 million gain from
the change in fair value of for the three months ended March 31,
2009.





These
common stock purchase warrants do not trade in an active securities market, and
as such, we estimate the fair value of these warrants using the Black-Scholes
Option Pricing Model using the following assumptions:





March31,2009
                  
                  
                  January 1, 2009(Unaudited)Annual
      dividend yield
                  
                  
                  -
                  
                  
                  
                  -Expected
      life (years)
                  
                  
                  3.57
                  
                  
                  
                  3.82Risk-free
      interest rate
                  
                  
                  0.88
                  %
                  
                  
                  1.13
                  %Expected
      volatility
                  
                  
                  90
                  %
                  
                  
                  90
                  %





Expected
volatility is based on historical volatility.  Historical volatility was
computed using daily pricing observations for recent periods that correspond to
the term of the warrants. The Company believes this method produces an estimate
that is representative of our expectations of future volatility over the
expected term of these warrants. The Company has no reason to believe future
volatility over the expected remaining life of these warrants likely to differ
materially from historical volatility. The expected life is based on the
remaining term of the warrants. The risk-free interest rate is based on U.S.
Treasury securities according to the remaining term of the
warrants.





As
required by SFAS 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 the 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 does 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 March 31, 2009.





Carrying Value at
                  March 31, 2009
                
                
                Fair Value Measurement at
                  March 31, 2009Level 1
                
                
                Level 2
                
                
                Level 3Senior
      notes
                
                $
                25,155,685
                
                
                $
                -
                
                
                $
                -
                
                
                $
                35,470,728Redeemable
      liability - warrants
                
                
                17,500,000
                
                
                
                -
                
                
                
                -
                
                
                
                15,587,407Derivative
      liability - warrants
                
                
                817,257
                
                
                
                -
                
                
                
                817,257
                
                
                
                -Total
      liability measured at fair value
                
                $
                43,472,942
                
                
                $
                -
                
                
                $
                817,257
                
                
                $
                51,058135





Other
than the derivative liabilities - warrants carried at fair value, the Company
did not identify any other assets and liabilities that are required to be
presented on the balance sheet at fair value in accordance with SFAS
157.




12


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)




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 services are rendered to and accepted by the
customers.





Enterprise Wide
Disclosure





The
Company’s chief operating decision-makers (i.e. chief executive officer and his
direct reports) review financial information presented on a consolidated basis,
accompanied by disaggregated information about revenues by business lines for
purposes of allocating resources and evaluating financial performance. There are
no segment managers who are held accountable for operations, operating results
and plans for levels or components below the consolidated unit level. Based on
qualitative and quantitative criteria established by SFAS 131, “Disclosures
about Segments of an Enterprise and Related Information”, the Company considers
itself to be operating within one reportable segment.





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 months
ended March 31, 2009 and 2008 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 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.


13


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Income
Taxes





The
Company utilizes SFAS 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 March 31, 2009 and December 31, 2008, 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 consolidated financial
statements.





Local PRC Income
Tax





The
Company’s subsidiary and VIEs 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% compared to 33% prior to 2008. The Company’s VIE,
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 SXNGE, JBLNG, SXABC, HXNGC and LBNGC 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 the United States federal statutory rate to the
provision for income tax recorded in the financial statements is as
follows:





For the three months endedMarch 31,2009
                    
                    
                    2008(Unaudited)
                    
                    
                    (Unaudited)Tax
      provision (credit) at statutory rate
                    
                    
                    34
                    %
                    
                    
                    34
                    %Foreign
      tax rate difference
                    
                    
                    (9
                    )%
                    
                    
                    (9
                    )%Effect
      of favorable tax rate
                    
                    
                    (10
                    )%
                    
                    
                    (11
                    )%Other
      item (1)
                    
                    
                    4
                    %
                    
                    
                    6
                    %Total
      provision for income taxes
                    
                    
                    19
                    %
                    
                    
                    20
                    %




14


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)




(1)  The 4%
represents the $926,195 expenses incurred by CHNG that are not deductible in PRC
for the three months ended March 31, 2009. The 6% represents $1,005,323 expenses
incurred by CHNG that are not deductible in PRC for the three months ended March
31, 2008.




The
estimated tax savings for the three months ended March 31, 2009 and 2008
amounted to approximately $510,331 and $402,051, respectively. The net effect on
earnings per share had the income tax been applied would decrease basic and
diluted earnings per share for the three months ended March 31, 2009 and 2008
from $0.29 to $0.26 and $0.19 to $0.17, respectively.





China
Natural Gas, Inc. was incorporated in the United States and has incurred net
operating loss for income tax purpose for the period ended March 31, 2009. The
estimated net operating loss carry forwards for United States income tax
purposes amounted to $4,262,057 and $3,378,131 at March 31, 2009 and December
31, 2008, respectively, which may be available to reduce future years' taxable
income. These carry forwards will expire, if not utilized, beginning in 2027
through 2029. 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 March 31, 2009. Management
reviews this valuation allowance periodically and makes adjustments as
warranted. The valuation allowances were as follow:





Three months ended
                        
                        
                        Year endedMarch 31, 2009
                        
                        
                        December 31,2008Valuation
      allowance
                        
                        (Unaudited)Balance,
      beginning of period
                        
                        $
                        1,148,565
                        
                        
                        $
                        322,614Increase
                        
                        
                        300,534
                        
                        
                        
                        825,951Balance,
      end of period
                        
                        $
                        1,449,099
                        
                        
                        $
                        1,148,565





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 SXABC subject to a Chinese VAT at a rate of 6%. This VAT cannot
offset with VAT paid for materials included in the cost of
revenues.


15


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





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.





All share
and per share amounts used in the Company's consolidated financial statements
and notes thereto have been retroactively restated to reflect the 1-for-2
reverse stock split, which are effective on April 28, 2009.  Although
this reverse stock split has already occurred under Delaware corporate law, the
Company advises that as of April 28 2009, the Company’s common stock on the OTC
Bulletin Board (“OTCBB”) does not yet reflect this stock split.  The
Company’s common stock trades under the OTCBB ticker symbol, “CHNG” on a pre
1-for-2 reverse stock split basis.





Reclassifications





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





Recently issued accounting
pronouncements and adoptedaccounting





In March
2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and
Hedging Activities – An Amendment of SFAS No. 133.” 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 and the
adoption of SFAS 161 did not impact the Company’s consolidated financial
statements.





In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles." SFAS 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. SFAS 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." Management is currently evaluating SFAS 162 and
do not believe that it will have a significant impact on the determination or
reporting of the financial results.


16


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





In
June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities.” The FSP addresses whether instruments granted in share-based
payment transactions are participating securities prior to vesting and therefore
need to be included in the earnings allocation in calculating earnings per share
under the two-class method described in SFAS 128, “Earnings per Share.” The
FSP requires companies to treat unvested share-based payment awards that have
non-forfeitable rights to dividend or dividend equivalents as a separate class
of securities in calculating earnings per share. The FSP is effective for fiscal
years beginning after December 15, 2008; earlier application is not
permitted. The adoption of EITF 03-6-1 did not have material impact on the
Company’s financial position or results.





In
October 2008, the FASB issued FSP FAS 157-3, “Determining the
Fair Value of a Financial Asset When the Market for That Asset Is Not Active.”
FSP FAS 157-3 clarifies the application of SFAS 157 in an
inactive market, without changing its existing principles. The FSP was effective
immediately upon issuance. The adoption of FSP FAS 157-3 did not have
an effect on the Company’s financial condition, results of operations or cash
flows.





In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment
on Purchased and Retained Beneficial Interests in Securitized Financial Assets.”
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1
achieves this by amending the impairment model in EITF 99-20 to remove its
exclusive reliance on “market participant” estimates of future cash flows used
in determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the “market participant” view to a holder’s
estimate of whether there has been a “probable” adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether an
other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1
did not have a material impact on the Company’s consolidated financial
statements because all of the investments in debt securities are classified as
trading securities.





In April
2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume and
Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly” (FSP FAS 157-4). FSP FAS 157-4
amends SFAS 157 and provides additional guidance for estimating fair value in
accordance with SFAS 157 when the volume and level of activity for the asset or
liability have significantly decreased and also includes guidance on identifying
circumstances that indicate a transaction is not orderly for fair value
measurements. This FSP shall be applied prospectively with retrospective
application not permitted. This FSP shall be effective for interim and annual
periods ending after June 15, 2009, with early adoption permitted for
periods ending after March 15, 2009. An entity early adopting this FSP must
also early adopt FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of
Other-Than-Temporary Impairments” (FSP FAS 115-2 and FAS 124-2). Additionally,
if an entity elects to early adopt either FSP FAS 107-1 and APB 28-1, “Interim
Disclosures about Fair Value of Financial Instruments” (FSP FAS 107-1 and APB
28-1) or FSP FAS 115-2 and FAS 124-2, it must also elect to early adopt this
FSP. Management is currently evaluating this new FSP but do not believe that it
will have a significant impact on the determination or reporting of the
financial results.


17


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





In April
2009, the FASB issued FSP FAS 115-2 and FAS 124-2. This FSP amends SFAS 115,
“Accounting for Certain Investments in Debt and Equity Securities,” SFAS 124,
“Accounting for Certain Investments Held by Not-for-Profit Organizations,” and
EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on
Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held
by a Transferor in Securitized Financial Assets,” to make the
other-than-temporary impairments guidance more operational and to improve the
presentation of other-than-temporary impairments in the financial statements.
This FSP will replace the existing requirement that the entity’s management
assert it has both the intent and ability to hold an impaired debt security
until recovery with a requirement that management assert it does not have the
intent to sell the security, and it is more likely than not it will not have to
sell the security before recovery of its cost basis. This FSP provides increased
disclosure about the credit and noncredit components of impaired debt securities
that are not expected to be sold and also requires increased and more frequent
disclosures regarding expected cash flows, credit losses, and an aging of
securities with unrealized losses. Although this FSP does not result in a change
in the carrying amount of debt securities, it does require that the portion of
an other-than-temporary impairment not related to a credit loss for a
held-to-maturity security be recognized in a new category of other comprehensive
income and be amortized over the remaining life of the debt security as an
increase in the carrying value of the security. This FSP shall be effective for
interim and annual periods ending after June 15, 2009, with early adoption
permitted for periods ending after March 15, 2009. An entity may early
adopt this FSP only if it also elects to early adopt FSP FAS 157-4. Also, if an
entity elects to early adopt either FSP FAS 157-4 or FSP FAS 107-1 and APB 28-1,
the entity also is required to early adopt this FSP.  Management is
currently evaluating this new FSP but do not believe that it will have a
significant impact on the determination or reporting of the financial
results.





In April
2009, the FASB issued FSP FAS 107-1 and APB 28-1. This FSP amends SFAS
No. 107, “Disclosures about Fair Value of Financial Instruments,” to
require disclosures about fair value of financial instruments not measured on
the balance sheet at fair value in interim financial statements as well as in
annual financial statements. Prior to this FSP, fair values for these assets and
liabilities were only disclosed annually. This FSP applies to all financial
instruments within the scope of SFAS 107 and requires all entities to disclose
the method(s) and significant assumptions used to estimate the fair value of
financial instruments. This FSP shall be effective for interim periods ending
after June 15, 2009, with early adoption permitted for periods ending after
March 15, 2009. An entity may early adopt this FSP only if it also elects
to early adopt FSP FAS 157-4 and FSP FAS 115-2 and FAS 124-2. This FSP does not
require disclosures for earlier periods presented for comparative purposes at
initial adoption. In periods after initial adoption, this FSP requires
comparative disclosures only for periods ending after initial adoption.
Management is currently evaluating the disclosure requirements of this new
FSP.


18


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





Note
3 – Other Assets





Other
assets consisted of the following:





March 31,
                
                
                December 31,2009
                
                
                2008UnauditedPrepaid
      rent – natural gas stations
                
                $
                256,746
                
                
                $
                272,635Prepayment
      for acquiring land use right
                
                
                1,406,400
                
                
                
                1,060,675Advances
      on purchasing equipment and construction in progress
                
                
                6,509,123
                
                
                
                6,427,974Refundable
      security deposits
                
                
                969,563
                
                
                
                981,083Others
                
                
                136,260
                
                
                
                101,695Total
                
                $
                9,278,092
                
                
                $
                8,844,062





All land
in the PRC is government owned.  However, the government grants users
land use rights.  As of March 31, 2009 and December 31, 2008, the
Company prepaid $1,406,400 and $1,060,675, 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 and 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.




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 1,450,000 shares of the Company’s common stock (the
“Warrants”) at an initial exercise price equal to $14.7304 per share, subject to
certain adjustments, which adjusted to $7.3652 on January 29,
2009.  On January 29, 2008, the Company issued $20,000,000 Senior
Notes and 1,450,000 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.


19


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





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;


·
            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;
      and


·
            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
                    %





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


20


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





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. As of January 29, 2009,
the Company has not obtained a listing of its common stock on the market stated
in the agreement. However, the Company obtained a three-month waiver from AMAX
for the additional interest payment. The waiver gives the Company three more
months until April 28, 2009 to achieve the uplisting status. By the end of the
extended period, if the Company can’t get its stock uplisted, the Company would
try to get another waiver or the Company will have to pay an additional interest
at the rate of 3.0% starting January 30th, 2009.  As of the reporting
date, the new waiver is still under negotiation but the Company considers the
current progress rendering a new waiver is unlikely. Therefore the Company
accrued the 3% additional interest in the three months ended March 31,
2009.  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.


21


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


March
31, 2009


(Unaudited)





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.




The
Company was 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 or incur additional interest of 1% on the Notes.  The
Company’s registration statement was declared effective on May 6, 2008;
therefore, no penalties were incurred.





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 March 31, 2009 and 2008,
the Company amortized $38,578 and $56,270 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 1,450,000 shares of
the Company’s common stock at an initial exercise price equal to $14.7304 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
$7.3652 per share. The exercise price was adjusted to $7.3652 on January 29,
2009. No further adjustments of the exercise price will be required (as that is
the floor price).





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 March 31, 2009 and 2008, the Company amortized $170,712 and $146,663 of
the aforesaid discounts, net of capitalized interest.





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 are not required to be value at fair
value, rather, to be at its undiscounted redemption amount of $17.5 million
according to FAS 150.


22


China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 March
31, 2009
 (Unaudited)




Note
5 – Warrants





Following
is a summary of the warrant activity:





Warrants
                      Outstanding
                    
                    
                    Weighted
                      Average
                      Exercise Price
                    
                    
                    Aggregate
                      Intrinsic
                      ValueOutstanding,
      December 31, 2007
                    
                    
                    544,242
                    
                    
                    $
                    13.10
                    
                    
                    
                    376,977Granted
                    
                    
                    1,450,000
                    
                    
                    $
                    14.74
                    
                    
                    
                    -Forfeited
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Exercised
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Outstanding,
      December 31, 2008
                    
                    
                    1,994,242
                    
                    
                    $
                    14.28
                    
                    
                    
                    -Granted
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Forfeited
                    
                    
                    (160,588
                    )
                    
                    $
                    7.20
                    
                    
                    
                    -Exercised
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Outstanding,
      March 31, 2009 (Unaudited)
                    
                    
                    1,833,654
                    
                    
                    $
                    8.94
                    
                    
                    
                    -





Following
is a summary of the status of warrants outstanding at March 31, 2009
(Unaudited):





Outstanding WarrantsExercise
                          Price
                        
                        Number
                        
                        
                        Average
                          Remaining
                          Contractual
                          Life$7.36
                        
                        
                        1,450,000
                        
                        
                        
                        5.83$14.86
                        
                        
                        383,654
                        
                        
                        
                        3.34$8.94
                        
                        
                        1,833,654
                        
                        
                        
                        5.31





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 $47,188 and $0 for
the years ended March 31, 2009 and 2008, respectively.




23
  China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 March
31, 2009
 (Unaudited)




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 has appropriated $554,732 and $365,766 as reserve for the statutory
surplus reserve for the three months ended March 31, 2009 and 2008.





Note
8 – Accounting for stock-based compensation





On
September 22, 2007, Mr. Qinan Ji, chairman and shareholder of the Company,
transferred 50,000 of his personally-owned options to the Company’s attorney to
cover certain Company legal expenses. 30% of the options vested 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.





The
Company used the Black-Sholes Option Pricing 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.  $14,842 of compensation expense was recorded during
the three months ended March 31, 2009.





As of
March 31, 2009, approximately $117,717 of estimated expense with respect to
non-vested stock-based compensation has yet to be recognized and will be
recognized in expense over the optionee’s remaining weighted average service
period of approximately 1.50 years.




Note
9 – Earnings per Share





Earnings
per share for the periods ended March 31, 2009 and 2008 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.”




24




China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 March
31, 2009
 (Unaudited)


The
following demonstrates the calculation for earnings per share for the three
months ended March 31, 2009 and 2008:




For the three months endedMarch 31,2009
                        
                        
                        2008(Unaudited)
                        
                        
                        (Unaudited)Basic earning per
      shareNet
      income
                        
                        $
                        4,201,623
                        
                        
                        $
                        2,808,571Weighted
      shares outstanding-Basic
                        
                        
                        14,600,152
                        
                        
                        
                        14,600,152Earnings
      per share-Basic
                        
                        $
                        0.29
                        
                        
                        $
                        0.19Diluted
      earning per shareNet
      income
                        
                        $
                        4,201,623
                        
                        
                        $
                        2,808,571Weighted
      shares outstanding-Basic
                        
                        
                        14,600,152
                        
                        
                        
                        14,600,152Effect
      of diluted securities-Warrants
                        
                        
                        -
                        
                        
                        
                        66,890Weighted
      shares outstanding-Diluted
                        
                        
                        14,600,152
                        
                        
                        
                        14,667,042Earnings
      per share –Diluted
                        
                        $
                        0.29
                        
                        
                        $
                        0.19





At March
31, 2009 and March 31, 2008, the Company had outstanding warrants of 1,833,654
and 1,994,242, respectively.  For the three months ended March 31,
2009, all 1,833,654 outstanding warrants were excluded from the diluted earnings
per share calculation as they are anti-dilutive. For the three months ended
March 31, 2008, the average stock price was greater than the exercise prices of
the 160,588 warrants which resulted in additional weighted average common stock
equivalents of 66,890; 1,833,654 outstanding warrants were excluded from the
diluted earnings per share calculation as they are anti-dilutive.





Note
10 – Current Vulnerability Due to Certain Concentrations





Concentration
of natural gas vendors:





For the three months ended March 31,2009
                      (Unaudited)
                    
                    
                    2008
                      (Unaudited)Numbers
      of natural gas vendors
                    
                    
                    3
                    
                    
                    
                    3Percentage
      of total natural gas purchases
                    
                    
                    80.41
                    %
                    
                    
                    64.18
                    %




25




China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 March
31, 2009
 (Unaudited)


As of
March 31, 2009 and December 31, 2008, the Company has $95,303 and $206,811
payable due to its major suppliers.





The
Company maintains long-term natural gas minimum purchase agreements with one of
its vendors as of March 31, 2009.  There are no minimum purchase
requirements by the Company.  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 three years.





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 FAS 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:





Year
      ending December 31, 2009
                  
                  $
                  910,308Year
      ending December 31, 2010
                  
                  
                  1,208,556Year
      ending December 31, 2011
                  
                  
                  1,204,212Year
      ending December 31, 2012
                  
                  
                  1,131,931Year
      ending December 31, 2013
                  
                  
                  1,052,520Thereafter
                  
                  
                  6,936,959Total
                  
                  $
                  12,444,486





For the
three months ended March 31, 2009 and 2008, the land use right and office lease
expenses were $392,081 and $ 63,247, respectively.




26




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements
 March
31, 2009
 (Unaudited)
  (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, JBLNG entered into an agreement with Hebei Tongchan Import and
Export Co. Ltd. (Hebei) and agreed that Hebei will act as the trade agency for
JBLNG. 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 March 31, 2009,
the Company advanced $6,299,500 to the trade agency and the future commitment
for equipment is $7,400,500.





(c)
Natural Gas Purchase Commitments





The
Company has existing long-term natural gas purchase agreements with its major
suppliers. However, none of those agreements stipulate any specific purchase
amount or quota each year, thus giving the Company enough flexibility to
constantly look for lower-cost sources of supply. Therefore, the Company is not
legally bound in purchase commitments by those agreements.





(d) 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 consolidated financial
statements.





Note
12 – Subsequent Events





(a)
Reverse Split





On
January 15, 2009, the board of directors adopted resolutions by written consent
to effect a 1 for 2 reverse split for the Company’s common stock to potentially
enable the Company to list on the NASDAQ stock market. On January 30 2009,
pursuant section 228 of Delaware General Corporation Law, the majority
shareholders of the Company adopted resolutions by written consent and waiving
all notice of and holding of any stockholder meeting to act upon such
resolutions, to effect a 1 for 2 reverse split of the common stock to
potentially enable the Company to list on the NASDAQ stock market. The Company
has filed a Def14C information statement with SEC on March 26, 2009 and
completed the mailing to stockholders the information statement on April 8,
2009.  Subsequently on April 21, 2009, the Company filed with the
State of Delaware the Certificate of Amendment of its Certificate of
Incorporation, and the effective date for the Amendment is April 28,
2009.




27


China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 March
31, 2009
 (Unaudited)




(b)
Adoption of Stock Option Plan





On March
11, 2009, the board of directors approved by written consent the Company’s stock
option plan for its employees, directors and consultants. Pursuant to the plan,
the total stock option pool will equal to 10% of the Company’s total shares
outstanding as of March 11, 2009. Among the option pool approved, 4% shall be
awarded in 2009 and another 4% shall be awarded in 2010, and 2% reserved for
future awards. For the 2009 stock option award, the CEO and CFO will be granted
total options of 1% and 0.5% of the common shares outstanding respectively, 50%
as Non-qualified Stock Options (NSO) and 50% as Incentive Stock Awards (ISA),
for a vesting period of four years.  As Richard Wu has resigned as
CFO, the Company granted to his successor, Veronica Chen, options to purchase
150,000 shares of the Company’s common stock, representing approximately 0.5% of
the Company’s outstanding shares as of March 11, 2009, with the same terms and
conditions as specified in the stock options plan.  10,000 option
shares per year will be granted to each non-executive board member and 12,000
option shares per year granted to Audit Committee Chairman. Other senior
management and employees will be granted total options of 2.11% of our common
shares. The strike price for the options is $2.45 per share. It is themutual understanding of
the board and the optionee that the 2009 stock option plan shall be effective
April 1, 2009.




28


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





CAUTIONARY
STATEMENT





The
information in this report contains forward-looking statements. All statements
other than statements of historical fact made in this report are forward
looking. In particular, the statements herein regarding industry prospects and
future results of operations or financial position are forward-looking
statements. These forward-looking statements can be identified by the use of
words such as "believes," "estimates," "could," "possibly," "probably,"
anticipates," "projects," "expects," "may," "will," or "should" or other
variations or similar words. No assurances can be given that the future results
anticipated by the forward-looking statements will be achieved. Forward-looking
statements reflect management's current expectations and are inherently
uncertain. Our actual results may differ significantly from management's
expectations.




The
following discussion and analysis should be read in conjunction with our
financial statements, included herewith. This discussion should not be construed
to imply that the results discussed herein will necessarily continue into the
future, or that any conclusion reached herein will necessarily be indicative of
actual operating results in the future. Such discussion represents only the best
present assessment of our management.





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. 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’s 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’s approval. We
memorialized these arrangements on August 17, 2007. 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.”





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 Peoples'
Republic of China ("China" or the "PRC") through our natural gas pipeline
networks. We own approximately 120 km high pressure pipelines in Xi’an, Shaanxi
Province. During the first quarter of 2009, the pipeline’s average daily
throughput capacity is 35,085 cubic meters, comparing to approximately 29,096
cubic meters in the same quarter during 2008. As of March 31, 2009, we own and
operate 23 CNG (Compressed Natural Gas) fueling stations in Shaanxi Province and
12 CNG fueling stations in Henan Province. During the first quarter of 2009, we
had sold compressed natural gas of 37,889,840 cubic meters through our
fueling stations, compared to 30,832,918 cubic meters for the same quarter in
2008.





In 2008,
China consumed 72 billion cubic meters of natural gas, compared with 24.5
billion in year 2000, representing an average annual increase of 14.4%.
Source:http://www.in-en.com/gas/html/gas-1009100965297290.html). According to
the Chinese government’s 11th
Five-Year Plan (2006-2010) natural gas consumption is expected to increase by
2.5% to 5.3% of total energy consumption in China. Based on the government’s
energy policy and the increase in natural gas consumption in China, the demand
for natural gas in China will continue to grow and we expect our sales will
experience corresponding growth.




29





We
operate four primary business lines:





·
            Distribution
      and sale of compressed natural gas (CNG) through Company-owned CNG fueling
      stations for hybrid (natural gas/gasoline) powered vehicles. The company
      totally owned 35 stations as of March 31,
2009;





·
            Installation,
      distribution and sale of piped natural gas to residential, commercial and
      industrial customers through Company-owned pipelines. The Company
      distributes and sells natural gas to approximately 98,754 homes and
      businesses as of March 31, 2009;





·
            Distribution
      and sale of gasoline through Company-owned CNG fueling stations for hybrid
      (natural gas/gasoline) powered vehicles. The Company totally owned 5
      gasoline selling stations by March 31, 2009),
  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. Currently
we do not exploit any of our own natural gas. The natural gas that we buy is
available in two forms: (i) piped natural gas obtained through pipelines in
standard pressures; and (ii) CNG obtained through compressor stations and
transported with tankers.





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. As of March 31, 2009, the Company has invested approximately $25
million in the project.





Both CNG
and LNG are natural gas compressed into canisters for convenient transportation,
usually by tank trucks to locations of distribution or consumption. Typically
CNG is compressed at 200kg per cubic centimeter and can be transported at normal
temperatures to distances of up to 200 kilometers. LNG is compressed at up to
625 times atmospheric pressure and must be transported at sub-zero degree
temperatures. The cost of compressing and processing LNG is higher than those of
CNG, but LNG can be transported over longer distance and per unit transportation
costs are therefore lower. The LNG plant is estimated to have LNG processing
capacity of 500,000 cubic meters per day, or approximately 150 million cubic
meters on an annual basis. We believe that adding LNG to our product offerings
will expand our geographic sales footprint and improve revenues and
profitability.





30


CONSOLIDATED
RESULTS OF OPERATIONS





Comparing
Three Months Ended March 31, 2009 and 2008:





The
following table represents the consolidated operating results for the three
month period ended March 31, 2009 and 2008:





Sales
Revenues:





The
following table sets forth a breakdown of our revenues for the period
indicated:




March 31,
                    2009
                  
                  
                  March 31,
                    2008
                  
                  
                  Increase in dollar
                    amount
                  
                  
                  Increase in
                    percentageNatural
      gas from filling stations
                  
                  $
                  14,257,925
                  
                  
                  $
                  10,759,231
                  
                  
                  $
                  3,498,694
                  
                  
                  
                  32.52
                  %Natural
      gas from pipelines
                  
                  
                  707,895
                  
                  
                  
                  586,088
                  
                  
                  
                  121,807
                  
                  
                  
                  20.78
                  %Gasoline
                  
                  
                  1,174,398
                  
                  
                  
                  1,130,750
                  
                  
                  
                  43,648
                  
                  
                  
                  3.86
                  %Installation
                  
                  
                  1,901,034
                  
                  
                  
                  1,070,170
                  
                  
                  
                  830,864
                  
                  
                  
                  77.64
                  %Auto
      conversion
                  
                  
                  486,414
                  
                  
                  
                  479,435
                  
                  
                  
                  6,979
                  
                  
                  
                  1.46
                  %Total
                  
                  $
                  18,527,666
                  
                  
                  $
                  14,025,674
                  
                  
                  $
                  4,501,992
                  
                  
                  
                  32.10
                  %




Overall: Total revenue for the three
months ended March 31, 2009 increased to $18,527,666 from $14,025,674 in the
same period of 2008, an increase of $4,501,992 or 32.1%. This increase was
mainly due to the addition of 9 new company-owned fueling stations as well as an
increase in the number of residential, commercial and industrial pipeline
customers from 90,269 in the first quarter of 2008 to 98,754 in the first
quarter of 2009. We sold natural gas of 40,878,864 cubic meters in the first
quarter of 2009, compared to 33,562,818 cubic meters in the comparable period of
2008. For the three month period ended March 31, 2009, 87.1% of our total
revenue was generated from the sale of natural gas and gasoline, and the other
12.9% was generated from our installation and conversion services.





Natural Gas From
Filling Stations:Sales revenuesincreased by 32.5%, or $3,498,694, from $10,759,231 in the first quarter
of 2008 to $14,257,925 in the first quarter of 2009, contributed 77.0% to our
total revenues, which was the largest amongst our four major business lines.
During the three months ended March 31, 2009, we had sold compressed natural gas
of 37,889,840 cubic meters, compared to 30,832,918 cubic meters in the same
period of 2008 through Company-owned fueling stations. In terms of average
station sales value and volume, in the three months ended March 31, 2009, we had
sold approximately $405,153 and 1,082,567 cubic meters of compressed
natural gas per station, compared to approximately $413,249 and
1,185,881 cubic meters in the same period of 2008. The reason for the
decline in per station sales was due to the construction of main subway lines in
Xian caused some bus routes to deviate from our stations.  Unit
selling price increased from $0.35 to $0.37 mainly attributable our 4 newly
added stations in Henan Province since the second quarter of 2008 that driven up
our average selling price as our stations in Henan has higher unit selling price
compare to our stations in Shaanxi Province.





Natural Gas FromPipelines: Sales revenue
increased by 20.8%, or $121,807, from $586,088 in the first quarter of 2008 to
$707,895 in the first quarter of 2009, contributed approximately 3.8% to our
total revenue. As of March 31, 2009, the Company had 98,754 pipeline customers,
an increased of 8,485 customers comparing to that as of March 31, 2008, we had
sold 2,989,024 cubic meters in total, compared to 2,729,900 cubic meters in the
same period of 2008.





Gasoline:
Revenue from gasoline sales increased by 3.9%, or $43,648, from $1,130,750 in
the first quarter of 2008 to $1,174,398 in the first quarter of 2009,
contributed 6.3% to our total revenue.




31





Installations:
Revenue from installation services increased by 77.6%, or $830,864, from
$1,070,170 in the first quarter of 2008 to $1,901,034 in the first quarter of
2009, contributed 10.3% to our total revenue. Installation services to the top
four customers contributed approximately 58.1%, 16.8%, 13.9% and 8.6% to the
Company's installation revenue for the three months ended March 31, 2009,
respectively;





Auto
conversion: Revenue from our auto conversion division increased by 1.5%,
or $6,979, from $479,435 in the first quarter of 2008 to $486,414 in the first
quarter of 2009, contributed 2.6% to our total revenue.




Cost of
Revenue:





The
following table sets forth s breakdown of our cost of revenue for the periods
indicated:




March 31, 2009
                  
                  
                  March 31, 2008
                  
                  
                  Increase in dollar
                    amount
                  
                  
                  Increase in
                    percentageNatural
      gas from filling stations
                  
                  $
                  6,244,441
                  
                  
                  $
                  5,756,275
                  
                  
                  $
                  488,166
                  
                  
                  
                  8.48
                  %Natural
      gas from pipelines
                  
                  
                  502,489
                  
                  
                  
                  425,999
                  
                  
                  
                  76,490
                  
                  
                  
                  17.96
                  %Gasoline
                  
                  
                  1,130,057
                  
                  
                  
                  1,068,037
                  
                  
                  
                  62,020
                  
                  
                  
                  5.81
                  %Installation
                  
                  
                  722,862
                  
                  
                  
                  394,231
                  
                  
                  
                  328,631
                  
                  
                  
                  83.36
                  %Auto
      conversion
                  
                  
                  294,165
                  
                  
                  
                  292,656
                  
                  
                  
                  1,509
                  
                  
                  
                  0.52
                  %Total
                  
                  $
                  8,894,014
                  
                  
                  $
                  7,937,198
                  
                  
                  $
                  956,816
                  
                  
                  
                  12.05
                  %





Overall:
Our cost of revenue consists of the cost of natural gas and gasoline sold,
installation and other costs. Cost of natural gas and gasoline sold consists of
the cost for purchase from our suppliers. Cost of installation and other costs
include certain expenditures for the connection of customers to our pipeline
system, and the cost for converting gasoline-fueled vehicles into natural gas
hybrid vehicles.





During
the first quarter of 2009, cost of good sold was $8,894,014, an increase of
$956,816, or 12.1% over the same period in 2008 while our revenue increased by
32.1% during the same period.





Natural Gas From
Filling stations: Cost of revenue increased by 8.5%, or $488,166,
amounted to $6,244,441 during the three months ended March 31, 2009 as compared
to $5,756,275 for the same period in 2008. The low growth rate for cost of
natural gas for our filling stations was primarily due to the decrease of
procurement price of coal bed methane as we obtained better term in 2009 with
one of our major supplier in Henan Province that reduced our unit cost by
approximately 35% in the three months ended March 31, 2009.





Natural Gas From
Pipelines: Cost of natural gas sold through our pipelines increased by
18.0%, or $76,490, amounted to $502,489 during the three months ended March 31,
2009 as compared to $425,999 for the same period in 2008, which was in line with
the sales growth.





Gasoline:
Cost of gasoline increased by 5.8% comparing with the first quarter of 2008 from
$1,068,037 to $1,130,057.





Installations:
Cost of installation increased by 83.4%, or $328,631 during the three months
ended March 2009, amounted to $722,862 as compared to $394,231 in the same
period in 2008 as a result of the increase of pipeline customers.




32





Auto
Conversion: Cost of auto conversion increased by 0.5%, or $1,509, to
$294,165 during the three months ended March 2009, as compared to $292,656 in
the same period in 2008,





Gross
profit:





The
following table sets forth s breakdown of our gross profit for the periods
indicated:




March 31, 2009
                  
                  
                  March 31, 2008
                  
                  
                  Increase in
                    dollar amount
                  
                  
                  Increase in
                    percentageNatural
      gas from filling stations
                  
                  $
                  8,013,484
                  
                  
                  $
                  5,002,956
                  
                  
                  $
                  3,010,528
                  
                  
                  
                  60.17
                  %Natural
      gas from pipelines
                  
                  
                  205,406
                  
                  
                  
                  160,089
                  
                  
                  
                  45,317
                  
                  
                  
                  28.31
                  %Gasoline
                  
                  
                  44,341
                  
                  
                  
                  62,713
                  
                  
                  
                  (18,372
                  )
                  
                  
                  -29.30
                  %Installation
                  
                  
                  1,178,172
                  
                  
                  
                  675,939
                  
                  
                  
                  502,233
                  
                  
                  
                  74.30
                  %Auto
      conversion
                  
                  
                  192,249
                  
                  
                  
                  186,779
                  
                  
                  
                  5,470
                  
                  
                  
                  2.93
                  %Total
                  
                  $
                  9,633,652
                  
                  
                  $
                  6,088,476
                  
                  
                  $
                  3,545,176
                  
                  
                  
                  58.23
                  %





The
Company earned a gross profit of $9,633,652 for the three months ended March 31,
2009, an increase of $3,545,176 or 58.2%, compared to $6,088,476 for the three
months ended March 31, 2008. The increase in gross profit is due to the increase
in natural gas, gasoline sales and installation revenues in the first quarter of
2009, supported by effective cost of sales controls.





Gross
margin:





Gross
margin for natural gas sold through our filling stations increased from 46.6% in
three months ended March 31, 2008 to 56.2% in three months ended March 31, 2009
due to lower coal bed methane procurement cost. Gross margin for natural gas
sold through pipelines was 29.0% in the first quarter of 2009, remained flat as
compared to 27.3% in the same period of 2008. Gross margin for gasoline sales
decreased from 5.6% in the first quarter of 2008 to 3.8% to the first quarter of
2009 due to the decrease of gasoline retail price. Our installation and auto
conversion businesses was 62.0% and 39.5% in the first quarter of 2009,
respectively, remained flat compared to 63.2% and 39.0% in the same period in
2008. Due to the lower natural gas procurement cost, the total gross margin
increased from 43.4% for the first quarter of 2008 to 52.0% for the first
quarter of 2009.





Operating
expenses:





The
Company incurred operating expenses of $4,006,149 for the three months ended
March 31, 2009, an increase of $1,725,210 or 75.6%, compared to $2,280,939 for
the three months ended March 31, 2008. Sales and marketing costs increased 73.2%
from $1,341,614 in the first quarter of 2008 to $2,324,228 in the first quarter
of 2009, primarily as a result of expenses related to the acquisition of Lingbao
Natural Gas, Co., as well as expenses related to nine newly added stations since
the second quarter of 2008. In addition we also increased our efforts to obtain
new residential and commercial customers and attract customers to our fueling
stations. General and administrative expenses increased from $939,325 in the
first quarter in 2008 to $1,681,921 in the first quarter of 2009 due to our
acquisition of Lingbao Natural Gas, Co and we are starting to depreciating its
plant and equipments in 2009, as well as professional service fee for SOX
404 Project. The transportation cost per million cubic meters of natural gas
during the first quarter of 2009 is approximately $3,035.





Income
tax was $997,256 for the three months ended March 31, 2009, as compared to
$687,465 for the three months ended March 31, 2008 which is in line with the
sales growth.




33





Net
Income:





Net
income increased to $4,201,623 for the three months ended March 31, 2009, an
increase of $1,393,052 or 49.6% from $2,808,571 for the three months ended March
31, 2008. Net margin increased from 20.0% in the first quarter of 2008 to 22.7%
in the first quarter of 2009. Increase in net income as well as the improvement
in net margin is attributed to our increased revenues, supported by lower
natural gas procurement prices.





Liquidity
and Capital Resources





As of
March 31, 2009, the Company had $9,058,361 of cash and cash equivalents on hand
compared to $41,254,130 of cash and cash equivalents as of March 31, 2008. The
decrease was primarily attributable to debt financing in the amount of
$40,000,000 incurred in the first quarter of 2008.





Cash
flows provided by operating activities was $6,238,521 for the three months ended
March 31, 2009 compared to net cash provided by operations of $3,502,371 in the
corresponding period last year. The primary reason for the change is attributed
to the increase in net income, adjusted for non-cash expenses items of
$5,618,269 and change in working capital of $620,252





Cash
outflows for investing activities decreased from $14,052,537 during the three
months ended March 31, 2008 to $3,028,317 for the same period in 2009 primarily
because of the prepayment to equipment suppliers of the LNG plant and additions
to the construction in progress.





There is
no cash inflow for financing activities for the three months ended March 31,
2009, compared to $37,877,491 in the corresponding period in 2008, which comes
from the sale of senior notes to Abax Lotus.





The
Company paid $2,979,011 for the LNG processing plant as a prepayment on
equipment as well as addition to construction in progress in the first quarter
of 2009.





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.





OFF-BALANCE
SHEET ARRANGEMENTS





None.





CRITICAL
ACCOUNTING POLICIES





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.





Accounts
Receivables





Accounts
and other receivables are recorded at net realizable value consisting of the
carrying amount less an allowance for uncollectible accounts, as needed. The
Company allowance for uncollectible accounts is not significant.





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. The Company’s management determined that all receivables
are good and there is no need for a bad debt reserve as of March 31,
2009.


34





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 the uncollectible accounts is
needed.





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 installation of pipelines and
material used in repairing and modifying of vehicles. Inventory also consists of
natural gas and gasoline.




Fair
Value of Financial Instruments





FAS 107,
“Disclosure About Fair Value of Financial Instruments” defines financial
instruments and requires fair value disclosure of applicable financial
instruments. FAS 157, “Fair Value Measurements,” adopted January 1, 2008,
defines fair value, establishes a three-level valuation hierarchy for
disclosures of fair value measurement and enhances disclosure requirements for
fair value measures. The carrying amounts reported in the consolidated balance
sheets for current receivables and payables qualify as financial instruments.
Management concluded the carrying values 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 if applicable, their stated interest rate
approximates current rates available. The three levels are defined as
follows:





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





·
            Level 2 inputs 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 3 inputs 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 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 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 does not necessitate significant
judgment, and the pricing inputs are observed from actively quoted
markets.





Effective
January 1, 2009, the Company adopted the provisions of EITF 07-5, "Determining
Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own
Stock”, which is effective for financial statements for fiscal years beginning
after December 15, 2008 and which replaced the previous guidance on this topic
in EITF 01-6. Paragraph 11(a) of FAS 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 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 FAS 133 paragraph 11(a) scope
exception.


35


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.





Segment
Report





The
Company’s chief operating decision-makers (i.e. chief executive officer and his
direct reports) review financial information presented on a consolidated basis,
accompanied by disaggregated information about revenues by business lines for
purposes of allocating resources and evaluating financial performance. There are
no segment managers who are held accountable for operations, operating results
and plans for levels or components below the consolidated unit level. Based on
qualitative and quantitative criteria established by SFAS 131, Disclosures about Segments of
an Enterprise and
Related Information, the Company considers itself to be operating within
one reportable segment.





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.





RECENT
ACCOUNTING PRONOUNCEMENTS





In March
2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and
Hedging Activities – An Amendment of SFAS No. 133”. 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. and the adoption of SFAS
161 did not impact the Company’s consolidated financial statements.





In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles". SFAS 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. SFAS 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 and do not believe that it will have a
significant impact on the determination or reporting of the financial results.





In
October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active.” FSP FAS 157-3
clarifies the application of SFAS 157 in an inactive market, without changing
its existing principles. The FSP was effective immediately upon issuance. The
adoption of FSP No. FAS 157-3 did not have an effect on the Company’s financial
condition, results of operations or cash flows.


36


In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment
on Purchased and Retained Beneficial Interests in Securitized Financial Assets”.
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS 115. FSP EITF 99-20-1 achieves
this by amending the impairment model in EITF 99-20 to remove its exclusive
reliance on “market participant” estimates of future cash flows used in
determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the “market participant” view to a holder’s
estimate of whether there has been a “probable” adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether an
other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1
did not have a material impact on our consolidated financial statements because
all of our investments in debt securities are classified as trading
securities.





In April
2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume and
Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly” (FSP FAS 157-4). FSP FAS 157-4
amends SFAS 157 and provides additional guidance for estimating fair value in
accordance with SFAS 157 when the volume and level of activity for the asset or
liability have significantly decreased and also includes guidance on identifying
circumstances that indicate a transaction is not orderly for fair value
measurements. This FSP shall be applied prospectively with retrospective
application not permitted. This FSP shall be effective for interim and annual
periods ending after June 15, 2009, with early adoption permitted for periods
ending after March 15, 2009. An entity early adopting this FSP must also early
adopt FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of
Other-Than-Temporary Impairments” (FSP FAS 115-2 and FAS 124-2). Additionally,
if an entity elects to early adopt either FSP FAS 107-1 and APB 28-1, “Interim
Disclosures about Fair Value of Financial Instruments” (FSP FAS 107-1 and APB
28-1) or FSP FAS 115-2 and FAS 124-2, it must also elect to early adopt this
FSP. Management is currently evaluating this new FSP but do not believe that it
will have a significant impact on the determination or reporting of the
financial results.





In April
2009, the FASB issued FSP FAS 115-2 and FAS 124-2. This FSP amends SFAS 115,
“Accounting for Certain Investments in Debt and Equity Securities,” SFAS 124,
“Accounting for Certain Investments Held by Not-for-Profit Organizations,” and
EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on
Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held
by a Transferor in Securitized Financial Assets,” to make the
other-than-temporary impairments guidance more operational and to improve the
presentation of other-than-temporary impairments in the financial statements.
This FSP will replace the existing requirement that the entity’s management
assert it has both the intent and ability to hold an impaired debt security
until recovery with a requirement that management assert it does not have the
intent to sell the security, and it is more likely than not it will not have to
sell the security before recovery of its cost basis. This FSP provides increased
disclosure about the credit and noncredit components of impaired debt securities
that are not expected to be sold and also requires increased and more frequent
disclosures regarding expected cash flows, credit losses, and an aging of
securities with unrealized losses. Although this FSP does not result in a change
in the carrying amount of debt securities, it does require that the portion of
an other-than-temporary impairment not related to a credit loss for a
held-to-maturity security be recognized in a new category of other comprehensive
income and be amortized over the remaining life of the debt security as an
increase in the carrying value of the security. This FSP shall be effective for
interim and annual periods ending after June 15, 2009, with early adoption
permitted for periods ending after March 15, 2009. An entity may early adopt
this FSP only if it also elects to early adopt FSP FAS 157-4. Also, if an entity
elects to early adopt either FSP FAS 157-4 or FSP FAS 107-1 and APB 28-1, the
entity also is required to early adopt this FSP. Management is currently
evaluating this new FSP but do not believe that it will have a significant
impact on the determination or reporting of the financial results.





In April
2009, the FASB issued FSP FAS 107-1 and APB 28-1. This FSP amends SFAS No. 107,
“Disclosures about Fair Value of Financial Instruments,” to require disclosures
about fair value of financial instruments not measured on the balance sheet at
fair value in interim financial statements as well as in annual financial
statements. Prior to this FSP, fair values for these assets and liabilities were
only disclosed annually. This FSP applies to all financial instruments within
the scope of SFAS 107 and requires all entities to disclose the method(s) and
significant assumptions used to estimate the fair value of financial
instruments. This FSP shall be effective for interim periods ending after June
15, 2009, with early adoption permitted for periods ending after March 15, 2009.
An entity may early adopt this FSP only if it also elects to early adopt FSP FAS
157-4 and FSP FAS 115-2 and FAS 124-2. This FSP does not require disclosures for
earlier periods presented for comparative purposes at initial adoption. In
periods after initial adoption, this FSP requires comparative disclosures only
for periods ending after initial adoption. Management is currently evaluating
the disclosure requirements of this new FSP.


37


Item
3. Quantitative and Qualitative Disclosures About Market Risk





Natural
Gas Price Risk





Our major
market risk exposure continues to be the pricing applicable to our purchases and
value-added reselling of compressed natural gas (CNG). Our revenues and
profitability depend substantially upon the applicable prices of natural gas,
which in China are regulated and fixed by central and local governments and
doesn’t fluctuate much at all. Such a price involatility situation is expected
to continue for operations in China. We currently don’t have any hedge positions
in place to reduce our exposure to changes in natural gas whole sale and retail
prices.





Interest
Rate Risk





We are
subject to interest rate risk on our long-term fixed-interest rate debt. Fixed
rate debt, where the interest rate is fixed over the life of the instrument,
exposes us to changes in market interest rates reflected in the fair value of
the debt and to the risk that we may need to refinance maturing debt with new
debt at a higher rate. All other things being equal, the fair value of our fixed
rate debt will increase or decrease as interest rates change. We had long-term
debt outstanding of $40 million at March 31, 2009, all of which bears interest
at fixed rates. The $40 million of fixed-rate debt is due on 2014. We currently
have no interest rate hedge positions in place to reduce our exposure to changes
in interest rates.





Foreign Currency Exchange
Rates Risk





We
operate in China local currency and the effects of foreign currency fluctuations
are largely mitigated because local expenses in China are also denominated in
the same currency.




Our
assets and liabilities of which the functional currency is the China local
currency are translated into U.S. dollars using the exchange rates in effect at
the balance sheet date, resulting in translation adjustments that are reflected
as Cumulative Translation Adjustment in the shareholders’ equity section on our
Consolidated Balance Sheets. A portion of our net assets are impacted by changes
in foreign currencies in relation to the U.S. dollar. We recorded a $152,115
adjustment to decrease our equity account for the quarter ended March 31, 2009
to reflect the net impact of the fluctuating of Chinese currency against the
U.S. dollar.





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 not effective.





The
specific material weakness and significant deficiency identified by the
Company’s management as of March 31, 2009 is described as follows:




Material
Weakness





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 was not
required to meet or apply U.S. GAAP requirements. They need substantial training
to meet 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.


38


The
Company did not have sufficient and skilled accounting personnel with an
appropriate level of technical accounting knowledge and experience in the
application of generally accepted accounting principles accepted in the United
States of America commensurate with the Company’s financial reporting
requirements, which resulted in a number of internal control deficiencies that
were identified as being significant. The Company’s management believes that the
number and nature of these significant deficiencies, when aggregated, was
determined to be a material weakness.





Significant
Deficiency





The
Company is lacking qualified resources to perform the internal audit functions
properly. In addition, the scope and effectiveness of the Company's internal
audit function are yet to be developed. We are committed to establishing the
internal audit functions but due to limited qualified resources in the region,
we were not able to hire sufficient internal audit resources before the end of
2008. However, internally we established a central management center to recruit
more senior qualified people in order to improve our internal control
procedures. Externally, we engaged Ernst & Young to assist the Company in
improving the Company's internal control system based on COSO Framework. We also
will increase our efforts to hire the qualified resources.





Remediation
Initiative





We are
focused on enhancing our internal controls, operational risk management and
financial reporting in USGAAP. In particular, we are establishing a central team
who will be responsible for monitoring and independently reviewing the
transactional records at the subsidiaries to detect and rectify any potential
discrepancy and to ensure the accuracy of our accounting information Up to the
reporting date, the Director of Internal Control has been on board, and the
recruitment for the other team members are in progress.





On May 1,
2009, Ms. Veronica Jing Chen was appointed as Chief Financial Officer of the
Company. Ms. Chen has been the CFO of several companies listed on both OTCBB and
NASDAQ and has extensive experience with setting up internal controls and
procedures for publicly listed companies, financial management and US GAAP
reporting.





Changes
in internal control over financial reporting





There was
no change in our internal control over financial reporting that occurred during
the three months ended March 31, 2009 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.





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.


39


Item
1A. Risk Factors




As of the
date of this filing, there have been no material changes from the risk factors
disclosed in the Company’s Annual Report on Form 10-K filed on March 16, 2009.
We operate in a changing environment that involves numerous known and unknown
risks and uncertainties that could materially affect our operations. The risks,
uncertainties and other factors set forth in our Annual Report on Form 10-K
may cause our actual results, performances and achievements to be materially
different from those expressed or implied by our forward-looking statements. If
any of these risks or events occur, our business, financial condition or results
of operations may be adversely affected.





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





None.





Item 3. Defaults Upon Senior
Securities





None.





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





None.





Item 5. Other Information





None





Item 6. Exhibits





(a)
Exhibits




Exhibit Number
              
              Description of Exhibit31.1
              
              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)




40


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.May
      11, 2009
              By:
              /s/ Qinan JiQinan
      JiChief
      Executive Officer(Principal
      Executive Officer)





May
      11, 2009
              By:
              /s/ Veronica ChenVeronica
      ChenChief
      Financial Officer(Principal
      Financial and Accounting
Officer)





41