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 June 30, 2010





 ̈
            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
              incorporation
      ororganization)
            (IRS
      Employer of Identification No.)




19th
Floor, Building B, Van Metropolis


Tang Yan
Road, Hi-Tech Zone


Xi’an,
710065, 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 x No  ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).     Yes  ̈ No x





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 August 6: 21,215,337




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).  Yes  ̈  No x











China
Natural Gas, Inc.


Index





PagePART
      I.
            FINANCIAL
      INFORMATION
            
            2Item
      1.
            Financial
      Statements
            
            2Notes
      to Consolidated Financial Statements (unaudited)
            
            5Item
      2.
            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
            
            34Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            
            51Item
      4.
            Controls
      and Procedures
            
            52PART
      II.
            OTHER
      INFORMATION
            
            54Item
      1.
            Legal
      Proceedings
            
            54Item
      1A.
            Risk
      Factors
            
            54Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            
            54Item
      3.
            Defaults
      Upon Senior Securities
            
            54Item
      4.
            Other
      Information
            
            54Item
      5.
            Exhibits
            
            55SIGNATURES
            
            56




1




PART
I. FINANCIAL INFORMATION




Item
1. Financial Statements




CHINA NATURAL GAS, INC. AND SUBSIDIARIES
  CONSOLIDATED
BALANCE SHEETS
 AS
OF JUNE 30, 2010 AND DECEMBER 31, 2009
  June
      30,
              
              
              December,
      312010
              
              
              2009(Unaudited)ASSETSCURRENT
      ASSETS:Cash
      & cash equivalents
              
              $
              42,606,410
              
              
              $
              48,177,794Accounts
      receivable, net of allowance for doubtful accounts of $206,514
      and $163,280 as of June 30, 2010 and December 31, 2009,
      respectively
              
              
              1,174,673
              
              
              
              1,289,116Other
      receivables
              
              
              36,942
              
              
              
              709,741Other
      receivable - employee advances
              
              
              303,887
              
              
              
              338,689Inventories
              
              
              842,259
              
              
              
              841,837Advances
      to suppliers
              
              
              1,385,058
              
              
              
              596,868Prepaid
      expense and other current assets
              
              
              3,769,977
              
              
              
              1,076,915Loans
      receivable
              
              
              -
              
              
              
              293,400Total
      current assets
              
              
              50,119,206
              
              
              
              53,324,360INVESTMENT
      IN UNCONSOLIDATED JOINT VENTURES
              
              
              1,467,000
              
              
              
              1,467,000PROPERTY
      AND EQUIPMENT, NET
              
              
              80,342,000
              
              
              
              72,713,012CONSTRUCTION
      IN PROGRESS
              
              
              78,363,718
              
              
              
              52,918,236DEFERRED
      FINANCING COSTS
              
              
              1,132,082
              
              
              
              1,336,998OTHER
      ASSETS
              
              
              17,262,417
              
              
              
              15,854,910TOTAL
      ASSETS
              
              $
              228,686,423
              
              
              $
              197,614,516LIABILITIES AND
      STOCKHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts
      payable and accrued liabilities
              
              $
              3,550,860
              
              
              $
              2,081,261Other
      payables
              
              
              96,412
              
              
              
              80,788Unearned
      revenue
              
              
              2,282,024
              
              
              
              1,813,641Accrued
      interest
              
              
              706,065
              
              
              
              786,052Taxes
      payable
              
              
              2,051,374
              
              
              
              1,901,577Notes
      payable, net of discount $11,135,111 and $0 as ofJune 30, 2010 and
      December 31, 2009, respectively
              
              
              28,864,889
              
              
              
              -Redeemable
      liabilities - warrants
              
              
              17,500,000
              
              
              
              -Total
      current liabilities
              
              
              55,051,624
              
              
              
              6,663,319LONG
      TERM LIABILITIES:Notes
      payable, net of discount $0 and $12,707,713 as of June 30,
      2010 and December 31, 2009, respectively
              
              
              -
              
              
              
              27,292,287Derivative
      liabilities - warrants
              
              
              987,455
              
              
              
              19,545,638Long
      term debt
              
              
              17,676,000
              
              
              
              -Total
      long term liabilities
              
              
              18,663,455
              
              
              
              46,837,925Total
      liabilities
              
              
              73,715,079
              
              
              
              53,501,244COMMITMENTS
      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,  21,321,904 shares issued and
      outstanding at June 30, 2010 and December 31, 2009
              
              
              2,132
              
              
              
              2,118Additional
      paid-in capital
              
              
              81,394,533
              
              
              
              79,851,251Cumulative
      other comprehensive gain
              
              
              9,473,023
              
              
              
              8,714,019Statutory
      reserves
              
              
              6,925,689
              
              
              
              5,962,695Retained
      earnings
              
              
              57,175,967
              
              
              
              49,583,189Total
      stockholders' equity
              
              
              154,971,344
              
              
              
              144,113,272TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
              
              $
              228,686,423
              
              
              $
              197,614,516
  The
accompanying notes are an integral part of these consolidated
statements.
  2
  CHINA
NATURAL GAS, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
 FOR
THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2010 AND 2009
 (Unaudited)
  Three
      Months Ended
                June
      30,
              
              
              Six
      Months Ended
                June
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009RevenuesNatural
      gas revenue
              
              $
              16,221,003
              
              
              $
              15,720,679
              
              
              $
              31,704,632
              
              
              $
              30,686,498Gasoline
      revenue
              
              
              2,033,840
              
              
              
              1,633,016
              
              
              
              3,502,656
              
              
              
              2,807,414Installation
      and others
              
              
              2,880,756
              
              
              
              3,388,825
              
              
              
              5,295,134
              
              
              
              5,776,274Total
      revenues
              
              
              21,135,599
              
              
              
              20,742,520
              
              
              
              40,502,422
              
              
              
              39,270,186Cost
      of revenuesNatural
      gas cost
              
              
              8,357,990
              
              
              
              7,490,518
              
              
              
              16,222,644
              
              
              
              14,237,447Gasoline
      cost
              
              
              1,910,294
              
              
              
              1,529,752
              
              
              
              3,277,572
              
              
              
              2,659,809Installation
      and others
              
              
              1,251,783
              
              
              
              1,444,060
              
              
              
              2,291,706
              
              
              
              2,461,088Total cost of
      revenues
              
              
              11,520,067
              
              
              
              10,464,330
              
              
              
              21,791,922
              
              
              
              19,358,344Gross
      profit
              
              
              9,615,532
              
              
              
              10,278,190
              
              
              
              18,710,500
              
              
              
              19,911,842Operating
      expensesSelling
      expenses
              
              
              3,054,992
              
              
              
              2,596,784
              
              
              
              5,946,782
              
              
              
              5,177,609General
      and administrative expenses
              
              
              1,913,866
              
              
              
              917,354
              
              
              
              3,731,522
              
              
              
              2,342,678Total operating
      expenses
              
              
              4,968,858
              
              
              
              3,514,138
              
              
              
              9,678,304
              
              
              
              7,520,287Income
      from operations
              
              
              4,646,674
              
              
              
              6,764,052
              
              
              
              9,032,196
              
              
              
              12,391,555Non-operating
      income (expense):Interest
      income
              
              
              260,021
              
              
              
              7,784
              
              
              
              349,387
              
              
              
              16,692Interest
      expense
              
              
              -
              
              
              
              (388,618
              )
              
              
              -
              
              
              
              (970,110
              )Other
      income (expense), net
              
              
              (3,031
              )
              
              
              (20,926
              )
              
              
              43,538
              
              
              
              (23,229
              )Change
      in fair value of warrants
              
              
              665,115
              
              
              
              (1,312,834
              )
              
              
              1,058,183
              
              
              
              (1,115,783
              )Foreign
      currency exchange loss
              
              
              (34,665
              )
              
              
              (19
              )
              
              
              (42,775
              )
              
              
              (50,807
              )Total non-operating income
      (expense)
              
              
              887,440
              
              
              
              (1,714,613
              )
              
              
              1,408,333
              
              
              
              (2,143,237
              )Income
      before income tax
              
              
              5,534,114
              
              
              
              5,049,439
              
              
              
              10,440,529
              
              
              
              10,248,318Provision
      for income tax
              
              
              973,611
              
              
              
              1,186,683
              
              
              
              1,884,756
              
              
              
              2,183,939Net
      income
              
              
              4,560,503
              
              
              
              3,862,756
              
              
              
              8,555,773
              
              
              
              8,064,379Other
      comprehensive incomeForeign
      currency translation gain (loss)
              
              
              797,858
              
              
              
              (2,997
              )
              
              
              759,004
              
              
              
              (155,112
              )Comprehensive
      income
              
              $
              5,358,361
              
              
              $
              3,859,759
              
              
              $
              9,314,777
              
              
              $
              7,909,267Weighted
      average shares outstandingBasic
              
              
              21,246,771
              
              
              
              14,600,154
              
              
              
              21,215,337
              
              
              
              14,600,154Diluted
              
              
              21,582,662
              
              
              
              14,726,647
              
              
              
              21,619,989
              
              
              
              14,600,154Earnings
      per shareBasic
              
              $
              0.21
              
              
              $
              0.26
              
              
              $
              0.40
              
              
              $
              0.55Diluted
              
              $
              0.21
              
              
              $
              0.26
              
              
              $
              0.40
              
              
              $
              0.55
   
 3
  CHINA NATURAL GAS, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 FOR
THE SIX MONTHS ENDED JUNE 30, 2010 AND 2009
 (Unaudited)
  Six
      Months Ended
                June
      30,2010
              
              
              2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
              
              $
              8,555,773
              
              
              $
              8,064,379Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
      and amortization
              
              
              3,070,705
              
              
              
              2,782,209Loss
      on disposal of equipment
              
              
              -
              
              
              
              21,370Provision
      for bad debt
              
              
              42,390
              
              
              
              -Amortization
      of discount on senior notes
              
              
              -
              
              
              
              217,196Amortization
      of financing costs
              
              
              -
              
              
              
              52,435Stock
      based compensation
              
              
              867,096
              
              
              
              100,758Change
      in fair value of warrants
              
              
              (1,058,183
              )
              
              
              1,115,783Change
      in assets and liabilities:Accounts
      receivable
              
              
              76,830
              
              
              
              (74,409
              )Other
      receivable
              
              
              658,742
              
              
              
              (69,120
              )Other
      receivable - employee advances
              
              
              50,142
              
              
              
              179,083Inventories
              
              
              3,008
              
              
              
              (487,908
              )Advances
      to suppliers
              
              
              (782,495
              )
              
              
              (268,922
              )Prepaid
      expense and other current assets
              
              
              (2,594,001
              )
              
              
              157,372Accounts
      payable and accrued liabilities
              
              
              1,455,262
              
              
              
              822,997Other
      payables
              
              
              15,266
              
              
              
              73,210Unearned
      revenue
              
              
              459,057
              
              
              
              1,026,693Accrued
      interest
              
              
              (79,987
              )
              
              
              376,664Taxes
      payable
              
              
              141,433
              
              
              
              306,975Net
      cash provided by operating activities
              
              
              10,881,038
              
              
              
              14,396,765CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from sales of equipment
              
              
              -
              
              
              
              41,305Loan
      to third parties
              
              
              (14,259,240
              )
              
              
              -Repayment
      from loan to third parties
              
              
              14,552,620
              
              
              
              -Purchase
      of property and equipment
              
              
              (6,260,885
              )
              
              
              (21,033
              )Additions
      to construction in progress
              
              
              (14,317,621
              )
              
              
              (10,372,858
              )Return
      of acquisition deposit
              
              
              1,613,590
              
              
              
              449,910Prepayment
      for long term assets
              
              
              (6,520,371
              )
              
              
              (110,836
              )Payment
      for acquisition deposits
              
              
              (3,637,912
              )
              
              
              -Payment
      for intangible assets
              
              
              (4,869,242
              )
              
              
              (66,971
              )Payment
      for land use rights
              
              
              (1,147,360
              )
              
              
              (463,870
              )Net
      cash used in investing activities
              
              
              (34,846,421
              )
              
              
              (10,544,353
              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from long term loan
              
              
              17,602,800
              
              
              
              -Stock
      issued from exercise of stock options
              
              
              676,201
              
              
              
              -Net
      cash provided by financing activities
              
              
              18,279,001
              
              
              
              -Effect
      of exchange rate changes on cash and cash equivalents
              
              
              114,998
              
              
              
              (5,619
              )NET
      (DECREASE) INCREASE IN CASH & CASH EQUIVALENTS
              
              
              (5,571,384
              )
              
              
              3,846,793CASH
      & CASH EQUIVALENTS, BEGINNING OF PERIOD
              
              
              48,177,794
              
              
              
              5,854,383CASH
      & CASH EQUIVALENTS, END OF PERIOD
              
              $
              42,606,410
              
              
              $
              9,701,176SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Interest
      paid
              
              $
              1,288,328
              
              
              $
              237,641Income
      taxes paid
              
              $
              2,030,575
              
              
              $
              1,934,887Non-cash
      transactions for investing and financing activities:Construction
      in progress transferred to property and equipment
              
              $
              4,107,320
              
              
              $
              -Prepayment
      on long term assets transferred to construction in process
              
              
              1,678,940
              
              
              
              -Capitalized
      interest - amortization of  discount of notes payable and
      issuance cost
              
              $
              1,777,516
              
              
              $
              1,773,594
    4




China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (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 HongKong, Shaanxi, Henan and Hubei
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.
 
 Recent
Developments
 
 On
September 8, 2009, Shaanxi Xilan Natural Gas Equipment Co., Ltd (“SXNGE”)
increased its registered capital by $26,000,000 from $53,929,260 to $79,929,260.
CHNG contributed $10,000,000 and $16,000,000 registered capital to SXNGE on
September 29, 2009 and January 13, 2010, respectively.
 
 On
February 5, 2010 and April 23, 2010, Jingbian Liquefied Natural Gas Co., Ltd.
(“JBLNG”) increased the registered capital by $6,026,343 and $11,668,376,
respectively, which was invested by Xi’an Xilan Natural Gas Co., Ltd. (“XXNGC”)
in the form of equipment and cash.
 
 During
the second quarter of 2010, XXNGC effectively acquired 100% assets and operating
rights of four natural gas stations in Xi’an, PRC, for a total combined cash
consideration of $10,502,490 (RMB 71,300,000), which consists of approximately
$5.6 million plant and equipment and approximately $4.9 million operating
rights.
 
 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 June 30, 2010 are not necessary
indicative of the results that may be expected for the year ended December 31,
2010. The information included in this Form 10-Q should be read in conjunction
with information included in the 2009 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.
  5
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Principles of
Consolidation
 
 The
accompanying consolidated financial statements include the accounts of China
Natural Gas, Inc. and its wholly owned subsidiaries, and its 100% variable
interest entities (“VIE”).  All inter-company accounts and
transactions have been eliminated in the consolidation.
 
 Consolidation of Variable
Interest Entity
 
 In
accordance with Financial Accounting Standards Board’s (“FASB”) accounting
standard regarding consolidation, 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 SXNGE as a wholly-owned foreign enterprise
(WOFE). Then through SXNGE, the Company entered into exclusive arrangements with
XXNGC and its shareholders that give the Company the ability to substantially
influence XXNGC’s 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 XXNGC as
VIE. The arrangements consist of the following agreements:
 
 a.
              XXNGC
      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 XXNGC in return for a consulting services fee which
      is equal to XXNGC’s revenue.
 
 c.
              XXNGC’
      shareholders have pledged their equity interests in XXNGC 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 XXNGC 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
(“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
 JUNE
30, 2010
 (Unaudited)
 Foreign Currency
Translation
 
 The
Company’s reporting currency is the US dollar. The functional currency of PRC
subsidiaries is the Chinese Renminbi (“RMB”). Our results of operations and
financial position of the PRC subsidiaries are translated to United States
dollars using the period end exchange rates as to assets and liabilities and
weighted average exchange rates as to revenues, expenses and cash flows. Capital
accounts are translated at their historical exchange rates when the capital
transaction occurred. The resulting currency translation adjustments are
recorded as a component of accumulated other comprehensive income (loss) within
stockholders’ equity. As a result, translation adjustments amount 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. Transaction gains and losses that arise from exchange rate
fluctuations on transactions denominated in a currency other than the functional
currency are included in the results of operations as incurred.
 
 The
balance sheet amounts with the exception of equity at June 30, 2010 were
translated RMB 6.79 to $1.00 as compared to RMB 6.82 at December 31, 2009. The
equity accounts were stated at their historical rate. The average translation
rates applied to income and cash flow statement amounts for the six months ended
June 30, 2010 and 2009 were RMB 6.82 to $1.00.
 
 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, Hong Kong 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 Hong Kong Deposit Protection Board
(“HKDPB”) insured limits for the banks located in Hong Kong or may exceed
Federal Deposit Insurance Corporation (“FDIC”) 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 June 30, 2010 and
December 31, 2009, the Company had total deposits of $41,832,543 and
$47,459,560, respectively, without insurance coverage or in excess of HKDPB or
FDIC insured limits. 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.
 
 Accounts
Receivable
 
 Accounts
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.
  7
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 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
recorded allowance for bad debts of $206,514 and $163,280 as of June 30, 2010
and December 31, 2009, respectively.
 
 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 June 30, 2010 and December 31, 2009, no
allowance for the uncollectible accounts was deemed necessary.
 
 Inventories
 
 Inventories
are 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. Inventories consist of materials used in the construction of pipelines
and in repairing and modifying vehicles. Inventories also consist of
gasoline.
 
 The
following are the details of the inventories:
 
 June
      30,
                2010
                (Unaudited)
              
              
              December
      31,
                2009Materials
      and supplies
              
              $
              414,639
              
              
              $
              345,611Gasoline
              
              
              427,620
              
              
              
              496,226Total
              
              $
              842,259
              
              
              $
              841,837
 
 Advances to
Suppliers
 
 The
Company advances to certain vendors for purchase of its materials. The advances
are interest-free and unsecured.
 
 Loans
Receivable
 
 Loans
receivable consists of the following:
  June 30,
                  2010
                  (unaudited)
                
                
                December
      31,
                  2009Shanxi
      Yuojin Mining Company, due on November 30, 2009, extended to November 30,
      2010, annual interest at 5.84% (1)
                
                $
                -
                
                
                $
                293,400Shanxi
      JunTai Housing Purchase Ltd., due on January 10, 2011, annual interest at
      5.84%  (2)
                
                
                -
                
                
                
                -Ms.
      Taoxiang Wang, due on February 19, 2011, annual interest at 5.84%
      (3)
                
                
                -
                
                
                
                -$
                -
                
                
                $
                293,400
  (1)
Shanxi Yuojin Mining Company paid off this loan on March 11, 2010.
 
 (2) On
January 11, 2010, the Company extended a loan of $4,401,000 to Shanxi JunTai
Housing Purchase Ltd., a third party with an interest rate of 5.84% and an term
of one year. On May 26, 2010, the Company received the loan repayment of
$4,488,923 from JunTai Housing Purchase Ltd, with whole principle of $4,401,000
and interest income of $87,923. As of May 26, 2010, this loan was paid
off.
 
 (3) On
February 20, 2010, the Company extended a loan of $ 9,858,240 to Ms. TaoXiang
Wang, a third party individual. On April 22 and April 27, 2010, Ms. Wang repaid
$5,868,000 and $4,130,962, respectively, of which $140,722 was the interest
payments. As of April 27, 2010, this loan was paid off.
 
 Investments in
Unconsolidated Joint Ventures
 
 Investee
companies that are not consolidated, but over which the Company exercises
significant influence, are accounted for under the equity method of accounting.
Whether or not the Company exercises significant influence with respect to an
Investee depends on an evaluation of several factors including, among others,
representation on the Investee company’s board of directors and ownership level,
which is generally a 20% to 50% interest in the voting securities of the
Investee company. Under the equity method of accounting, an Investee company’s
accounts are not reflected within the Company’s consolidated balance sheets and
statements of income and other comprehensive income; however, the Company’s
share of the earnings or losses of the Investee company is reflected in the
caption “Earnings (loss) on equity investment” in the consolidated statements of
income and other comprehensive income. The Company’s carrying value in an equity
method Investee company is reflected in the caption “Investments in
Unconsolidated Joint Ventures” in the Company’s consolidated balance
sheets.
 
 When the
Company’s carrying value in an equity method, the investee company is reduced to
zero and no further losses are recorded in the Company’s consolidated financial
statements unless the Company guaranteed obligations of the Investee company or
has committed additional funding. When the Investee company subsequently reports
income, the Company will not record its share of such income until it equals the
amount of its share of losses not previously recognized.
  8
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
Company’s investment in unconsolidated joint ventures that are accounted for on
the equity method of accounting represents the 49% interest in Henan CNPC Kunlun
Xilan Compressed Natural Gas Co., Ltd. (“JV”), which is engaged in building and
operating CNG compressor stations and fueling stations, sell CNG, provide
vehicle conversion services from gasoline-fueled vehicles to hybrid (natural
gas/gasoline) powered vehicles and technical advisory work services in Henan,
PRC. The investment in this company amounted to $1,467,000 at June 30, 2010 and
December 31, 2009. The JV does not have any operations as of June 30,
2010.
 
 The
results of financial position of the JV as of June 30, 2010 are summarized
below:
 
 June
      30,
                2010
                (unaudited)
              
              
              December
      31,
                2009Condensed
      balance sheet information:Current
      assets
              
              $
              2,993,878
              
              
              $
              2,993,878Noncurrent
      assets
              
              
              -
              
              
              
              -Total
      assets
              
              $
              2,993,878
              
              
              $
              2,993,878Current
      liabilities
              
              
              -
              
              
              
              -Noncurrent
      liabilities
              
              
              -
              
              
              
              -Equity
              
              $
              2,993,878
              
              
              $
              2,993,878Total
      liabilities and equity
              
              $
              2,993,878
              
              
              $
              2,993,878
 
 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
 
 9
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
following are the details of the property and equipment:
 
 June
      30,
                2010
                (unaudited)
              
              
              December
      31,
                2009Office
      equipment
              
              $
              496,376
              
              
              $
              439,055Operating
      equipment
              
              
              67,798,379
              
              
              
              61,350,503Vehicles
              
              
              2,899,475
              
              
              
              2,486,614Buildings
      and improvements
              
              
              25,258,288
              
              
              
              21,414,553Total
      property and equipment
              
              
              96,452,518
              
              
              
              85,690,725Less
      accumulated depreciation
              
              
              (16,110,518
              )
              
              
              (12,977,713
              )Property
      and equipment, net
              
              $
              80,342,000
              
              
              $
              72,713,012
 
 Depreciation
expense for the three months ended June 30, 2010 and 2009 was $1,596,146 and
$1,390,017, respectively. Depreciation expense for the six months ended June 30,
2010 and 2009 was $3,066,972 and $2,779,582, respectively.
 
 Construction in
Progress
 
 Construction
in progress (“CIP”) consists of the cost of constructing property and equipment
for the Company’s gas stations and a new project of processing, distribution and
sale of LNG. The major cost of construction in progress relates to technology
licensing fees, equipment purchases, land use rights requisition cost,
capitalized interest and other construction fees. 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
June 30, 2010 and December 31, 2009, the Company had construction in progress in
the amount of $78,363,718 and $52,918,236, respectively. Interest cost
capitalized into construction in progress for the three months ended June 30,
2010 and 2009, amounted to $1,627,034 and $1,172,547, respectively. Interest
cost capitalized into construction in progress for the six months ended June 30,
2010 and 2009, amounted to $2,990,697 and $2,030,926, respectively.
  10
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Construction
in progress at June 30, 2010 consisted of the following:
 
 No.
                
                Project
      Description
                
                Location
                
                June
      30,2010
                  (unaudited)
                
                Commencement
                  Date
                Expected
                  completion
                  date
                
                Estimated
                  additional
                  cost
      to
                  complete1
                
                Jingbian
      LNG (1)
                
                JBLNG
                
                $
                68,708,384
                
                Dec-06
                Oct-10
                
                $
                12,600,0002
                Sa
      Pu mother station
                
                Henan
      Xilan Natural
                  Gas
      Co., Ltd. (HXNGC)
                
                
                873,043
                
                Jul-08
                Jun-11
                
                
                6,300,0003
                
                International
      port
                
                XXNGC
                
                
                5,040,189
                
                May-09
                Dec-11
                
                
                9,730,0004
                
                Other
      CIP projects
                
                XXNGC
                
                
                3,742,102
                
                Various
                Various
                
                
                500,000$
                78,363,718
                
                
                
                
                $
                29,130,000
 
 (1)
              Including
      $60,063,478 construction cost and $7,801,659 capitalized interest for
      phase I of the LNG
                project,
      and additional $13,443,247 in connection with phase II and phase III of
      the LNG plant.
 
 Intangible
Assets
 
 The
Intangible Assets mainly consist of operating rights for four newly acquired
natural gas stations. The operating rights are deemed to have an indefinite
useful life as cash flows are expected to continue indefinitely.
 
 The
operating right will not be amortized until its useful life is deemed to be no
longer indefinite. The Company evaluates intangible assets for impairment, at
least annually and whenever events or changes in circumstances indicate that the
assets might be impaired.
 
 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. 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
June 30, 2010, there were no significant impairments of its long-lived
assets.
  11
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 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 upon the payments are received.
 
 Fair Value of Financial
Instruments
 
 The
accounting standards regarding fair value of financial instruments and related
fair value measurements define fair value, establish a three-level valuation
hierarchy for disclosures of fair value measurement, and enhance 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.
 
 FASB
accounting standard regarding derivatives and hedging 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. This FASB accounting standard also 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 exception.
 
 As a
result of adopting this FASB accounting standard, 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.
 
 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, $5,844,239 to beginning retained earnings and $1,014,308 to warrant
liabilities to recognize the fair value of such warrants. The fair value of the
warrants was $987,455 and $2,045,638 on June 30, 2010 and December 31, 2009,
respectively. The Company recognized a gain of $665,115 and a loss of $1,312,834
for the three months ended June 30, 2010 and 2009, respectively. The Company
recognized a gain of $1,058,183 and a loss of $1,115,783 for the six months
ended June 30, 2010 and 2009, respectively.
  12
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 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:
 
 June
      30,
                2010
                (unaudited)
              
              
              December
      31,
                2009Annual
      dividend yield
              
              
              -
              
              
              
              -Expected
      life (years)
              
              
              2.32
              
              
              
              2.82Risk-free
      interest rate
              
              
              0.74
              %
              
              
              1.49
              %Expected
      volatility
              
              
              80
              %
              
              
              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 is 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.
 
 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 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.
  13
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
following table sets forth by level within the fair value hierarchy of the
Company’s financial assets and liabilities that were accounted for at fair value
on a recurring basis as of June 30, 2010.
 
 Carrying
      Value at
                June
      30,2010
              
              
              Fair
      Value Measurement at
                June
      30, 2010(unaudited)
              
              
              Level
      1
              
              
              Level
      2
              
              
              Level
      3Long-term
      debt
              
              $
              17,676,000
              
              
              
              -
              
              
              $
              -
              
              
              $
              16,720,097Derivative
      liability - warrants
              
              
              987,455
              
              
              
              -
              
              
              
              987,455
              
              
              
              -Total
      liability measured at fair value
              
              $
              18,663,455
              
              
              $
              -
              
              
              $
              987,455
              
              
              $
              16,720,097
 
 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 its fair value on the balance sheet.
 
 Revenue
Recognition
 
 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 establishedby the FASB’s
accounting standard for segment reporting, 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 and six
months ended June 30, 2010 and 2009, were insignificant.
 
 Stock-Based
Compensation
 
 The
Company records and reports stock-based compensation pursuant to FASB’s
accounting standard regarding stock 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 this accounting standard,
as the fair value of the consideration received or the fair value of equity
instruments issued, whichever is more reliably
measured.
  14
 
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Income
Taxes
 
 FASB’s
accounting standard regarding income taxes 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 June 30, 2010 and 2009, 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. 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.
Penalties and interest incurred related to underpayment of income tax are
classified as income tax expense in the year incurred.  No significant
penalties or interest relating to income taxes have been incurred during the
three and six months ended June 30, 2010 and 2009.
 
 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, Shaanxi Xilan Auto Bodyshop(SXABC), HXNGC, LBNGC and Hubei
Xilan Natural Gas Co.,ltd (HBXNGC) 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 ended
                June
      30,
              
              
              For
      the six months endedJune
    30,2010
              
              
              2009
              
              
              2010
              
              
              2009(Unaudited)
              
              
              (Unaudited)
              
              
              (Unaudited)
              
              
              (Unaudited)Tax
      provision (credit) at statutory rate
              
              
              34
              %
              
              
              34
              %
              
              
              34
              %
              
              
              34
              %Foreign
      tax rate difference
              
              
              (9
              )%
              
              
              (9
              )%
              
              
              (9
              )%
              
              
              (9
              )%Effect
      of favorable tax rate
              
              
              (9
              )%
              
              
              (9
              )%
              
              
              (8
              )%
              
              
              (9
              )%Other
      item (1)
              
              
              2
              %
              
              
              8
              %
              
              
              1
              %
              
              
              5
              %Total
      provision for income taxes
              
              
              18
              %
              
              
              24
              %
              
              
              18
              %
              
              
              21
              %
  (1)
                The
      2% represents $366,824 in expenses incurred by CHNG are not deductible in
      PRC for the three months ended June 30, 2010. The 8% represents $2,198,394
      expenses incurred by CHNG that are not deductible in PRC for the three
      months ended June 30, 2009. The 1% represents $655,016 in expenses
      incurred by CHNG that are not deductible in PRC for the six months ended
      June 30, 2010. The 5% represents $3,124,589 expenses incurred by CHNG that
      are not deductible in PRC for the six months ended June 30,
      2009.
  15
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
estimated tax savings for the three months ended June 30, 2010 and 2009,
amounted to approximately $527,818 and $721,445, 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 June 30, 2010 and 2009,
from $0.21 to $0.19 and $0.26 to $0.21, respectively.
 
 The
estimated tax savings for the six months ended June 30, 2010 and 2009, amounted
to approximately $1,026,442 and $1,231,776 respectively. The net effect on
earnings per share, had the income tax been applied, would decrease basic and
diluted earnings per share for the six months ended June 30, 2010 and 2009, from
$0.40 to $0.35 and $0.55 to $0.47, 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 June 30, 2010. The
estimated net operating loss carry forwards for United States income tax
purposes amounted to $3,033,370 and $2,699,276 as of June 30, 2010 and December
31, 2009, respectively, which may be available to reduce future years' taxable
income. These carry forwards will expire, if not utilized, beginning in 2027
through 2030. 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 June 30, 2010. Management
reviews this valuation allowance periodically and makes adjustments as
warranted. The valuation allowances were as follow:
 
 Valuation allowance
              
              For
      the six months end
                June
      30, 2010
                (unaudited)
              
              
              Year
      ended
                December
      31,
                2009Balance,
      beginning of period
              
              $
              917,754
              
              
              $
              563,541Increase
              
              
              113,592
              
              
              
              354,213Balance,
      end of period
              
              $
              1,031,346
              
              
              $
              917,754
  The
Company has cumulative undistributed earnings of foreign subsidiaries of
approximately $38,037,669 as of June 30, 2010, which is included in consolidated
retained earnings and will continue to be indefinitely reinvested in
international operations.  Accordingly, no provision has been made for U.S.
deferred taxes related to future repatriation of these earnings, nor is it
practicable to estimate the amount of income taxes that would have to be
provided if we concluded that such earnings will be remitted in the
future.
 
 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 are 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.
  16
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Taxes
Payable
 
 Taxes
payable at June 30, 2010 and December 31, 2009 consisted of the
following:
 
 June
      30,
                2010
                (unaudited)
              
              
              December31,
                2009Value
      added tax payable
              
              $
              1,028,769
              
              
              $
              740,772Business
      tax payable
              
              
              -
              
              
              
              1,540Income
      tax payable
              
              
              977,411
              
              
              
              1,127,961Urban
      maintenance tax payable
              
              
              41,384
              
              
              
              27,442Income
      tax for individual payable
              
              
              3,810
              
              
              
              3,862Total
      tax payable
              
              $
              2,051,374
              
              
              $
              1,901,577
 
 Basic and Diluted Earnings
Per Share
 
 Earnings
per share is calculated in accordance with the FASB’s accounting standard
regarding 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 were effective on April 28, 2009.
 
 Recently issued accounting
pronouncements
 
 In
January 2010, FASB issued ASU No. 2010-01- Accounting for Distributions to
Shareholders with Components of Stock and Cash. The amendments in this Update
clarify that the stock portion of a distribution to shareholders that allows
them to elect to receive cash or stock with a potential limitation on the total
amount of cash that all shareholders can elect to receive in the aggregate is
considered a share issuance that is reflected in EPS prospectively and is not a
stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings
Per Share). The amendments in this update are effective for interim and annual
periods ending on or after December 15, 2009, and should be applied on a
retrospective basis. The adoption of this ASU did not have a material impact on
its consolidated financial statements.
  17
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 In
January 2010, FASB issued ASU No. 2010-02 – Accounting and Reporting for
Decreases in Ownership of a Subsidiary – a Scope Clarification. The amendments
in this Update affect accounting and reporting by an entity that experiences a
decrease in ownership in a subsidiary that is a business or nonprofit activity.
The amendments also affect accounting and reporting by an entity that exchanges
a group of assets that constitutes a business or nonprofit activity for an
equity interest in another entity. The amendments in this update are effective
beginning in the period that an entity adopts SFAS No. 160, “Non-controlling
Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If
an entity has previously adopted SFAS No. 160 as of the date the amendments in
this update are included in the Accounting Standards Codification, the
amendments in this update are effective beginning in the first interim or annual
reporting period ending on or after December 15, 2009. The amendments in this
update should be applied retrospectively to the first period that an entity
adopted SFAS No. 160. The adoption of this ASU did not have a material impact on
the Company’s consolidated financial statements.
 
 In
January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair
Value Measurements. This update provides amendments to Subtopic 820-10 that
requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A
reporting entity should disclose separately the amounts of significant transfers
in and out of Level 1 and Level 2 fair value measurements and describe the
reasons for the transfers. 2) Activity in Level 3 fair value measurements. In
the reconciliation for fair value measurements using significant unobservable
inputs (Level 3), a reporting entity should present separately information about
purchases, sales, issuances, and settlements (that is, on a gross basis rather
than as one net number). This update provides amendments to Subtopic 820-10 that
clarifies existing disclosures as follows: 1) Level of disaggregation. A
reporting entity should provide fair value measurement disclosures for each
class of assets and liabilities. A class is often a subset of assets or
liabilities within a line item in the statement of financial position. A
reporting entity needs to use judgment in determining the appropriate classes of
assets and liabilities. 2) Disclosures about inputs and valuation techniques. A
reporting entity should provide disclosures about the valuation techniques and
inputs used to measure fair value for both recurring and nonrecurring fair value
measurements. Those disclosures are required for fair value measurements that
fall in either Level 2 or Level 3. The new disclosures and clarifications of
existing disclosures are effective for interim and annual reporting periods
beginning after December 15, 2009, except for the disclosures about purchases,
sales, issuances, and settlements in the roll forward of activity in Level 3
fair value measurements. These disclosures are effective for fiscal years
beginning after December 15, 2010, and for interim periods within those fiscal
years. The Company is currently evaluating the impact of this ASU, however, the
Company does not expect the adoption of this ASU to have a material impact on
its consolidated financial statements.
 
 In
February 2010, FASB issued ASU No. 2010-9 –Amendments to Certain Recognition and
Disclosure Requirements. This update addresses certain implementation issues
related to an entity’s requirement to perform and disclose subsequent-events
procedures, removes the requirement that public companies disclose the date of
their financial statements in both issued and revised financial statements.
According to the FASB, the revised statements include those that have been
changed to correct an error or conform to a retrospective application of U.S.
GAAP. The amendment is effective for interim and annual reporting periods in
fiscal year ending after June 15, 2010. The adoption of this ASU did not have a
material impact on the Company’s consolidated financial statements.
  18
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 In March
2010, FASB issued ASU No. 2010-10 –Amendments for Certain Investment Funds. This
update defers the effective date of the amendments to the consolidation
requirements made by FASB Statement 167 to a reporting entity’s interest in
certain types of entities. The deferral will mainly impact the evaluation of
reporting enterprises’ interests in mutual funds, private equity funds, hedge
funds, real estate investment entities that measure their investment at fair
value, real estate investment trusts, and venture capital funds. The ASU also
clarifies guidance in Statement 167 that addresses whether fee arrangements
represent a variable interest for all service providers and decision makers. The
ASU is effective for interim and annual reporting periods in fiscal year
beginning after November 15, 2009. The adoption of this ASU did not have a
material impact on the Company’s consolidated financial statements.
 
 In March
2010, FASB issued ASU No. 2010-11 –Scope Exception Related to Embedded Credit
Derivatives. Embedded credit-derivative features related only to the transfer of
credit risk in the form of subordination of one financial instrument to another
are not subject to potential bifurcation and separate accounting as clarified by
recently issued FASB guidance. Other embedded credit-derivative features are
required to be analyzed to determine whether they must be accounted for
separately. This update provides guidance on whether embedded credit-derivative
features in financial instruments issued by structures such as collateralized
debt obligations (CDOs) and synthetic CDOs are subject to bifurcation and
separate accounting. The guidance is effective at the beginning of a company’s
first fiscal quarter beginning after June 15, 2010. The Company does not expect
the adoption of this ASU to have a material impact on the Company’s consolidated
financial statements.
 
 In April
2010, the FASB issued Accounting Standards Update 2010-13, “Compensation—Stock
Compensation (Topic 718): Effect of Denominating the Exercise Price of a
Share-Based Payment Award in the Currency of the Market in Which the Underlying
Equity Security Trades,” or ASU 2010-13. ASU 2010-13 provides amendments to
Topic 718 to clarify that an employee share-based payment award with an exercise
price denominated in currency of a market in which a substantial porting of the
entity’s equity securities trades should not be considered to contain a
condition that is not a market, performance, or service condition. Therefore, an
entity would not classify such an award as a liability if it otherwise qualifies
as equity. The amendments in this Update are effective for fiscal years, and
interim periods within those fiscal years, beginning on or after December 15,
2010. The Company does not expect the adoption of this ASU to have a material
impact on the Company’s consolidated financial statements.
 
 In April
2010, the FASB issued Accounting Standard Update 20-10-17, “Revenue
Recognition—Milestone Method (Topic 605): Milestone Method of Revenue
Recognition” orASU 2010-17.This Update
provides guidance on the recognition of revenue under the milestone method,
which allows a vendor to adopt an accounting policy to recognize all of the
arrangement consideration that is contingent on the achievement of a substantive
milestone (milestone consideration) in the period the milestone is achieved. The
pronouncement is effective on a prospective basis for milestones achieved in
fiscal years and interim periods within those years, beginning on or after
June 15, 2010. The adoption of this ASU does not have a material impact on
the Company’s consolidated financial statements.
  19
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Reclassification
 
 Certain
prior period expense amounts have been reclassified to conform to the current
period presentation. These reclassifications have no effect on net income or
cash flows.
 
 Note
3 – Other Assets
 
 Other
assets consisted of the following:
 
 June
      30,
                2010
                (unaudited)
              
              
              December
      31,
                2009Prepaid
      rent – natural gas stations
              
              $
              315,333
              
              
              $
              340,211Prepayment
      for acquiring land use right
              
              
              3,136,017
              
              
              
              1,936,440Prepayment
      for acquisition deposit
              
              
              3,653,040
              
              
              
              -Advances
      on purchasing equipment and construction in progress
              
              
              3,703,622
              
              
              
              12,056,964Refundable
      security deposits
              
              
              1,394,648
              
              
              
              1,264,283Intangible
      assets
              
              
              5,059,757
              
              
              
              257,012Total
              
              $
              17,262,417
              
              
              $
              15,854,910
 
 All land
in the PRC is government owned. However, the government grants users land use
rights. As of June 30, 2010 and December 31, 2009, the Company prepaid
$3,136,017 and 1,936,440 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 yet been
granted to the Company. Therefore, the Company did not amortize the prepaid land
use rights.
 
 Prepayment
for acquisition deposit represents the payment of $3,653,040 (RMB 24,800,000)
made for acquisition of Hanchuan Makou Yuntong Compress Natural Gas Co., Ltd.
(“Makou”) by Hubei Xilan Natural Gas Co., Ltd.  As of June 30, 2010,
the transfer of the assets was under progress and the company has not exercised
full control over its operations. The Company takes full control of the
operations in Makou in July, 2010.
  20
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 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.
 
 Intangible
assets represent operating rights acquired during acquisition of four natural
gas stations, consisting of following:
 
 June
      30,
                  2010
                  (unaudited)
                
                
                December
      31,
                  2009Operating
      rights
                
                $
                4,886,575
                
                
                $
                -Other
      intangible assets
                
                
                173,182
                
                
                
                257,012Total
                
                $
                5,059,757
                
                
                $
                257,012
  Note
4 – Senior Notes Payable
 
 On March
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.
 
 At the
closing, the Company entered into:
 
 ·
              An
      indenture for the 5.00% Guaranteed Senior Notes due
  2014;
 
 ·
              An
      investor rights agreement;
  21
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 ·
              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 SXNGE, 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 an increase in the event of certain
circumstances. The Company is required to make mandatory repayments 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
              
              Repayment
                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
              %January
      30, 2014
              
              
              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
              
              Principal2010
              
              $
              42,400,0002011
              
              
              41,600,0002012
              
              
              40,800,0002013
      and thereafter
              
              
              40,000,000
  22
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (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 had not obtained a listing of its common stock on the market stated
in the agreement. However, the Company obtained a three-month waiver from ABAX
for the additional interest payment. The waiver gave the Company three more
months until April 28, 2009 to achieve the uplisting status. By the end of the
extended period, if the Company was not able to complete the uplisting, the
Company would have to pay additional interest retroactively starting January 30,
2009 in accordance with the terms of the waiver. The Company was approved to be
listed on Nasdaq on June 1, 2009, which passed the wavier period. In August
2009, the Company reached an agreement with ABAX that the Company was to pay
additional interest accrued for the period from April 29, 2009, the expiration
date of previous waiver to June 1, 2009, the date of listing. As such, the
Company paid $113,214 additional interest to ABAX in August 2009.
 
 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. On
February 26, 2010, JBLNG entered into a fixed assets loan contract (see Note 5)
with Pudong Development Bank Xi’an Branch (“SPDB”), pursuant to which the SPDB
agreed to lend $17,676,000 to JBLNG. SPDB transferred $13,257,000 and $4,419,000
to JBLNG on March 17, 2010 and May 31, 2010, respectively. This loan is secured
by Xi’an Xilan Natural Gas Co., ltd (“XXNGC”)’s equipments and vehicles located
within PRC. The lien incurred with this loan is in violation of the Indenture of
the Senior Notes with Abax Lotus Ltd. Under the terms of the Indenture for the
5.00% Guaranteed Senior Notes issued to Abax Lotus Ltd. dated January 20, 2008,
the Company and its subsidiaries including XXNGC, are prohibited from entering
into such pledge of assets and guaranty agreements. As a result, Abax Lotus Ltd.
has the right to declare a default under the Indenture after written notice and
the Company’s 30 days right to cure. Upon an event of default, Abax may
accelerate the outstanding indebtedness together with all accrued interest
thereon and demand immediate repayment. As of the date of this report, the
Company has not received a notice of default from Abax Lotus Ltd. nor does the
Company receive a notice of wavier from Abax Lotus Ltd. As the payment date of
the indenture become dues on demands, the Company reclassified the indenture to
short term liability.
  23
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
Company also entered into an investor rights agreement, pursuant to which, as
long as an investor holds at least 10% of the aggregate principal amount of the
Senior Notes issued and outstanding or at least 3% of the Company’s issued and
outstanding common stock pursuant to the warrants on an as-exercised basis
(“Minimum Holding”), the Company has agreed not to undertake certain corporate
actions without prior Investor approval. In addition, so long as an Investor
owns the Minimum Holding, such Investor shall have a right of first refusal for
future debt securities offerings by the Company and the Company is subject to
certain transfer restrictions on its securities and certain other
properties.
 
 From the
Closing Date and as long as the Investor continues to hold more than 10% of the
outstanding shares of common stock on an as-converted, fully-diluted basis, the
Investor shall be entitled to appoint one of the Company’s board of directors
(the “Investor Director”). The Investor Director shall be entitled to serve on
each committee of the board, except that, the Investor Director shall not serve
on the audit committee unless it is an independent director. Mr. Ji has agreed
to vote his shares for the election of the Investor Director.
 
 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 June 30, 2010 and 2009, the Company
amortized $0 and $13,857 of the aforesaid issuance costs, net of capitalized
interest. For the six months ended June 30, 2010 and 2009, the Company amortized
$0 and $52,435 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 June 30, 2010 and 2009, the Company amortized $811,397
and $676,981 of the aforesaid discounts,of
which $811,397 and $630,497, respectively, were capitalized into construction in
progress. For the six months ended June 30, 2010 and 2009, the Company amortized
$1,572,602 and $1,311,061 of the aforesaid discounts, of which $1,572,602 and
$1,093,865, respectively, were capitalized into construction in
progress.
 
 The
warrants have been determined to be derivative liabilities instruments because
there is a redemption requirement if the holder does not exercise the Warrants.
However, the warrants are not required to be valued at fair value, rather, to be
at its undiscounted redemption amount of $17.5 million in the aggregate. Under
the terms of the Warrant Agreement, in the event of a default under the
indenture for the Senior Notes, the warrants holders are entitled to redeem the
warrants for a price equal to the pro rata portion of the aggregate redemption
price of $17,500,000 applicable to the warrants tendered by such holder. As the
redemption requirement of the warrants become due on demands in connection to
the default under the indenture, the Company reclassified the redemption value
to short term liability.
  24
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Note
5- Long term Loan
 
 The
Company’s long term bank loan as of June 30, 2010 and December 31, 2009 are as
following:
 
 June
      30,
                2010
                (unaudited)
              
              
              December
      31,
                2009Loan
      from Pudong Development Bank Xi’an Branch, due various dates from 2012 to
      2014. Interest at 5.76% for the first year and subject to adjustment after
      the second year, secured by equipment
              
              $
              17,676,000
              
              
              $
              -
 
 
 The above
loan is secured by Xi’an Xilan Natural Gas Co., ltd (“XXNGC”)’s equipments and
vehicles located within PRC. The carrying net value of the asset pledged is
$12,435,247 as of June 30, 2010. Interest expense for the three months and six
months ended in June 30, 2010 were $212,625, of which all expenses were
capitalized into construction in progress. XXNGC also entered into a guaranty
with SPDB to guaranty the repayment of the loans. The Company is required to
make mandatory prepayments on the long term loan in the following date and
amounts:
 
 Date
              
              Repayment
      Percentage
              
              Repayment
      AmountMarch
      5, 2012
              
              
              25
              %
              $
      4,419,000March
      5, 2013
              
              
              25
              %
              4,419,000March
      5, 2014
              
              
              25
              %
              4,419,000December
      5, 2014
              
              
              25
              %
              4,419,000
  25
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
  Note
6 – Warrants
 
 Following
is a summary of the warrant activity:
  Warrants
                Outstanding
              
              
              Weighted
      Average
                Exercise
      Price
              
              
              Aggregate
                Intrinsic
      ValueOutstanding,
      December 31, 2008
              
              
              1,994,242
              
              
              $
              14.28
              
              
              
              -Granted
              
              
              -
              
              
              
              -
              
              
              
              -Forfeited
              
              
              (160,588
              )
              
              
              7.20
              
              
              
              -Exercised
              
              
              -
              
              
              
              -
              
              
              
              -Outstanding,
      December 31, 2009
              
              
              1,833,654
              
              
              $
              8.93
              
              
              $
              4,008,434Granted
              
              
              -
              
              
              
              -
              
              
              
              -Forfeited
              
              
              -
              
              
              
              -
              
              
              
              -Exercised
              
              
              -
              
              
              
              -
              
              
              
              -Outstanding,
      June 30, 2010 (unaudited)
              
              
              1,833,654
              
              
              $
              8.93
              
              
              $
              1,384,750
 
 Following
is a summary of the status of warrants outstanding at June 30,
2010:
 
 Outstanding
      WarrantsExercise
      Price
              
              Number
              
              Average
                Remaining
                Contractual
                Life$
              7.37
              
              1,450,000
              
              
              4.58$
              14.86
              
              383,654
              
              
              2.09$
              8.93
              
              1,833,654
              
              
              4.06
 
 Note
7 – 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 contributes 100RMB per employee per month 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 $58,435 and $33,891 for the three months ended June 30, 2010 and
2009, respectively. The total contribution for the above plan was $248,783 and
$81,079 for the six months ended June 30, 2010 and 2009,
respectively.
  26
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
  Note
8 – Secondary Public Offering
 
 On
September 9, 2009, the Company completed an underwritten public offering for
5,725,000 shares of its common stock at a price of $8.75 per share. China
Natural Gas also granted the underwriters a 30-day option to purchase up to an
additional 858,750 shares to cover over-allotments at the public offering
price.
 
 On
September 21, 2009, the Company closed the sale of an additional 858,750 shares
of common stock at the public offering price of $8.75 per share, pursuant to the
over-allotment option exercised in full by the underwriter in connection with
its public offering that closed on September 9, 2009.
 
 The net
proceeds, after deducting underwriting discounts and commissions and the
relevant expenses, is approximately $54.4 million.
 
 The net
proceeds from the offering was intended to be used for the construction of the
Company's liquefied natural gas facility, the acquisition of CNG fueling
stations, the purchase of CNG trucks and the establishment of a joint venture
company with China National Petroleum Corporation Kunlun Natural Gas Co., Ltd.,
as well as for general working capital purposes.
 
 Note
9 – 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.
 
 As of
June 30, 2010, the remaining reserve needed to fulfill the 50% registered
capital requirement was approximately $75,053,000.
 
 Note
10– Accounting for Stock-based Compensation
 
 1)
Options from CEO to pay for certain Company’s legal expenses
 
 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.
  27
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
Company used the Black-Scholes 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. $22,008 and $14,842 of compensation expense was recorded during
the three months ended June 30, 2010 and 2009, respectively. $44,016 and $29,685
of compensation expense were recorded during the six months ended June 30, 2010
and 2009, respectively.
 
 As of
June 30, 2010, $22,008 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 three months.
 
 2) 2009
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 former CFO were
granted total options of 1% and 0.6% of the common shares outstanding, 50% as
Non-qualified Stock Options (NSO) and 50% as Incentive Stock Awards (ISA), for a
vesting period of four years. The Company granted the former CFO, Veronica Chen,
options to purchase 75,000 shares of the Company’s common stock, representing
approximately 0.5% of the Company’s outstanding shares as of
March 11, 2009, which forfeited as Veronica Chen resigned as CFO. 5,000 option
shares per year will be granted to each non-executive board member and 6,000
option shares per year granted to the Audit Committee Chairman. Other senior
management and employees will be granted total options of 2.11% of the Company’s
common shares. On April 1, 2009, the Company issued 243,850 stock options
pursuant to the Company's 2009 employee stock option and stock award plan.
During the six months ended June 30, 2010, options exercisable 61,700 shares of
the Company's common stock were forfeit. On May 5, 2010, the company issued
380,850 stock options, including 87,600 stock options to the CFO, David She. The
strike price for the options was $4.90 per share.
 
 The
Company used the Black-Scholes 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 risk-free
rates. The volatility of the Company’s common stock was estimated by management
based on the historical volatility of the Company’s common stock, the risk free
interest rate was based on Treasury Constant Maturity Rates published by the
U.S. Federal Reserve for periods applicable to the estimated life of the
options, and the expected dividend yield was based on the current and expected
dividend policy. The Company currently uses the “simplified” method to estimate
the expected term for share option grants as it does not have sufficient
historical experience to provide a reasonable estimate. The Company will
continue to use the “simplified” method until it feels that it has sufficient
historical experience to provide a reasonable estimate of expected terms. 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.
Compensation expense of $770,242 and $823,080 was recorded during the three and
six months ended June 30, 2010, respectively.
  28
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 As of
June 30, 2010, $2,048,326 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 3 years.
 
 Following
is a summary of the stock option activity:
 
 Options
                Outstanding
              
              
              Weighted
      Average
                Exercise
      Price
              
              
              Aggregate
                Intrinsic
      ValueOutstanding,
      December 31, 2008
              
              
              -
              
              
              $
              -
              
              
              $
              -Granted
              
              
              318,850
              
              
              
              4.90
              
              
              
              1,983,247Forfeited
              
              
              (75,000)
              
              
              
              4.90
              
              
              
              466,500Exercised
              
              
              -
              
              
              
              -
              
              
              
              -Outstanding,
      December 31, 2009
              
              
              243,850
              
              
              $
              4.90
              
              
              $
              1,516,747Granted
              
              
              380,850Forfeited
              
              
              (61,700)Exercised
              
              
              (138,000)
              
              
              
              -
              
              
              
              -Outstanding,
      June 30, 2010 (unaudited)
              
              
              425,000
              
              
              $
              4.90
              
              
              $
              1,453,500
  Following
is a summary of the status of stock options outstanding at June 30,
2010:
 
 Outstanding
      Options
              
              
              Exercisable
      OptionsExercise
                Price
              
              Number
              
              
              Average
                Remaining
                Contractual
                Life
              
              
              Exercise
                Price
              
              
              Number
              
              
              Average
                Remaining
                Contractual
                Life$
              4.90
              
              
              425,000
              
              
              
              4.75
              
              
              
              $
              4.90
              
              
              2,750
              
              
              
              4.75
  29
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 Note
11 – Earnings per Share
 
 Earnings
per share for three and six months ended June 30, 2010 and 2009 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 FASB’s accounting standard.
 
 The
following demonstrates the calculation for earnings per share for the periods
ended June 30, 2010 and 2009:
 For
      the three months ended
                    June
      30,
                  
                  
                  For
      the six months ended
                    June
      30,Basic
      earnings per share
                  
                  2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009(Unaudited)
                  
                  
                  (Unaudited)
                  
                  
                  (Unaudited)
                  
                  
                  (Unaudited)Net
      income
                  
                  $
                  4,560,503
                  
                  
                  $
                  3,862,756
                  
                  
                  $
                  8,555,773
                  
                  
                  $
                  8,064,379Weighted
      shares outstanding-Basic
                  
                  
                  21,246,771
                  
                  
                  
                  14,600,154
                  
                  
                  
                  21,215,337
                  
                  
                  
                  14,600,154Earnings
      per share-Basic
                  
                  $
                  0.21
                  
                  
                  $
                  0.26
                  
                  
                  $
                  0.40
                  
                  
                  $
                  0.55Diluted
      earnings per shareNet
      income
                  
                  $
                  4,560,503
                  
                  
                  $
                  3,862,756
                  
                  
                  $
                  8,555,773
                  
                  
                  $
                  8,064,379Weighted
      shares outstanding-Basic
                  
                  
                  21,246,771
                  
                  
                  
                  14,600,154
                  
                  
                  
                  21,215,337
                  
                  
                  
                  14,600,154Effect
      of diluted securities-Warrants
                  
                  
                  137,044
                  
                  
                  
                  126,493
                  
                  
                  
                  287,917Effect
      of diluted securities-Options
                  
                  
                  198,847
                  
                  
                  
                  
                  
                  
                  116,734Weighted
      shares outstanding-Diluted
                  
                  
                  21,582,662
                  
                  
                  
                  14,726,647
                  
                  
                  
                  21,619,988
                  
                  
                  
                  14,600,154Earnings
      per share –Diluted
                  
                  $
                  0.21
                  
                  
                  $
                  0.26
                  
                  
                  $
                  0.40
                  
                  
                  $
                  0.55
  30
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
Company had outstanding warrants of 1,833,654 at June 30, 2010 and
2009.  For the three months ended June 30, 2010 and 2009, the average
stock price was greater than the exercise prices of the 1,450,000 warrants which
resulted in additional weighted average common stock equivalents of 137,044 and
126,493, respectively; 383,654 outstanding warrants were excluded from the
diluted earnings per share calculation as they are anti-dilutive. For the six
months ended June 30, 2010, the average stock price was greater than the
exercise prices of the 1,450,000 warrants which resulted in additional weighted
average common stock equivalents of 287,917; 383,654 outstanding warrants were
excluded from the diluted earnings per share calculation as they are
anti-dilutive. For the six months ended June 30, 2009, all 1,833,654 outstanding
warrants were excluded from the diluted earnings per share calculation as they
are anti dilutive.
 
 The
Company had outstanding employee’s stock options of 425,000 at June 30, 2010.
For the three and six months ended June 30, 2010, the average stock price was
greater than the exercise prices options which resulted in additional weighted
average common stock equivalents of 198,847 and 116,734,
respectively.
 
 Note
12 – Current Vulnerability Due to Certain Concentrations
 
 Concentration
of natural gas vendors:
 Three
      months ended
                  June
      30,
                
                
                Six
      months ended
                  June
      30,2010
                
                
                2009
                
                
                2010
                
                
                2009(unaudited)
                
                
                (unaudited)
                
                
                (unaudited)
                
                
                (unaudited)Numbers
      of natural gas vendors
                
                
                4
                
                
                
                4
                
                
                
                4
                
                
                
                4Percentage
      of total natural gas purchases
                
                
                96
                %
                
                
                97
                %
                
                
                96
                %
                
                
                90
                %
 
 As of
June 30, 2010 and December 31, 2009, the Company has $108,454 and $82,146
payable due to its major suppliers.
 
 The
Company maintains long-term natural gas minimum purchase agreements with one of
its vendors as of June 30, 2010. 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.
  31
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 The
Company's operations are carried out in the People’s Republic of China.
Accordingly, the Company's business, financial condition and results of
operations may be influenced by the political, economic and legal environments
in the People’s Republic of China, by the general state of the People’s Republic
of China‘s economy. The Company's business may be influenced by changes in
governmental policies with respect to laws and regulations, anti-inflationary
measures, currency conversion and remittance abroad, and rates and methods of
taxation, among other things.
 
 Note
13 – 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 FASB’s accounting standard regarding leases. The Company
entered into a series of long-term lease agreements with outside parties to
lease land use rights to the self-built Natural Gas fueling stations located in
the PRC. The agreements have terms ranging from 10 to 30 years. The Company
makes annual prepayments for most lease agreements. The Company also entered
into two office leases in Xi’an, PRC, one office lease in Jingbian, PRC, one
office lease in Wuhan, PRC and one office lease in New York, NY. The minimum
future payment for leasing land use rights and offices is as
follows:
 
 Year
      ending December 31, 2010
              
              $
              1,219,507Year
      ending December 31, 2011
              
              
              2,087,346Year
      ending December 31, 2012
              
              
              1,921,385Year
      ending December 31, 2013
              
              
              1,830,217Year
      ending December 31, 2014
              
              
              2,218,208Thereafter
              
              
              34,447,281Total
              
              $
              43,723,944
 
 For the
three months ended June 30, 2010 and 2009, the land use right and office lease
expenses were $405,785 and $406,016, respectively. For the six months ended June
30, 2010 and 2009, the land use right and office lease expenses were $836,413
and $798,097, respectively.
  32
 China
Natural Gas, Inc. and Subsidiaries
 Notes
to Consolidated Financial Statements
 JUNE
30, 2010
 (Unaudited)
 (b)
Property and Equipment Purchase Commitments
 
 The
Company has purchase commitments for materials, supplies, services and property
and equipment for constructing the LNG plant and other CIP projects. The Company
has future commitments as followings:
 
 Year
      ending December 31, 2010
              
              $
              12,215,777Year
      ending December 31, 2011
              
              
              382,887Thereafter
              
              
              -Total
              
              $
              12,598,664
 
 (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.
 
 Note
14- Subsequent Event
 
 On May
29, 2010, the Company agreed to purchase the 100% ownership in Hanchuan Makou
Yuntong Compress Natural Gas Co., Ltd. (“Makou”) from eight individuals. The
Company prepaid $3,653,040 (RMB 24,800,000) for the acquisition. As of June 30,
2010, the company has not exercised full control over its operating and
financial policies and thus did not consolidate Makou into its consolidated
financial statements dated June 30, 2010.
 
 In July
2010, HBXNGC has obtained full control of the assets, operating and financial
policies of Makou. The Company will consolidate the assets of Makou in its
quarterly financial report for the third quarter of 2010.
 
 The
Company has performed an evaluation of subsequent events through the date these
consolidated financial statements were issued to determine whether the
circumstances warranted recognition and disclosure of those events or
transactions in the consolidated financial statements as of June 30,
2010.




33


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





CAUTIONARY
STATEMENT





FORWARD-LOOKING
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 are an
integrated natural gas operator in The People’s Republic of China (“China” or
the “PRC”), primarily involved in distribution of compressed natural gas (“CNG”)
through our VIE-owned CNG fueling stations. As of June 30, 2010, our VIE
operated 28 CNG fueling stations in Shaanxi province and 12 CNG fueling stations
in Henan province. Our VIE own the CNG fueling stations while we lease the land
upon which our VIE owned CNG fueling stations operate. For the three and six
months ended June 30, 2010, we sold 42,955,867 and 83,548,324 cubic meters of
CNG through our fueling stations, compared to 41,152,513 and 80,446,633 cubic
meters for the three and six months ended June 30, 2009. Our VIE also transport,
distribute and sell piped natural gas to residential and commercial customers in
the city of Xi’an in Shaanxi Province, including Lantian County, and the
districts of Lintong and Baqiao, and in the city of Lingbao in Henan
Province.





We
operate four main business lines:





·
            Distribution
      and sale of compressed natural gas through our VIE owned CNG fueling
      stations for hybrid (natural gas/gasoline) powered vehicles (40 stations
      as of June 30, 2010,);





·
            Installation,
      distribution and sale of piped natural gas to residential and commercial
      customers through our VIE owned pipelines. We distributed and sold piped
      natural gas to 112,343 residential customers as of June 30,
      2010;





·
            Distribution
      and sale of gasoline through our VIE owned CNG fueling stations for
      gasoline and hybrid (natural gas/gasoline) powered vehicles (eight of our
      VIE owned CNG fueling stations sold gasoline as of June 30,
      2010);





·
            Conversion
      of gasoline-fueled vehicles to hybrid (natural gas/gasoline) powered
      vehicles at our auto conversion
sites.





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




34




On
October 24, 2006, our variable interest entity XXNGC, formed a wholly-owned
subsidiary, SJLNG, for the purpose of constructing a LNG facility to be located
in Jingbian, Shaanxi province. We planned to invest approximately
$81 million to construct this facility, with approximately $60 million in
phase I construction and installations, $8 million in capitalized interest and
$13 million associated with phase II and III of the plant. The construction is
funded through the sale of senior notes to Abax and our September 2009 equity
financing, as well as cash flows from operations. The LNG plant is under test
run currently. The test run is expected to be completed by third
quarter 2010. Once test run is completed, the plant is expected to have a
processing capacity of 500,000 cubic meters per day, or approximately 150
million cubic meters on an annual basis.


We had
total revenues of $21,135,599 and $20,742,520 for the three months ended June
30, 2010 and 2009 respectively and revenues of $40,502,422 and $39,270,186 for
the six months ended June 30, 2010 and 2009. We had net income of $4,560,503 and
$3,862,756 for the three months ended June 30, 2010 and 2009 respectively and
net income of $8,555,773 and $8,064,379 for the six months ended June 30, 2010
and 2009 respectively.





Factors
Affecting Our Results of Operations





Significant
factors affecting our results of operations are:





Successful
expansion of our CNG fueling station business in our target markets. Our
revenue increased by 1.9% during the three months ended June 30, 2010 from the
three months ended June 30, 2009 and by 3.1% during the six months ended June
30, 2010 from the six months ended June 30, 2009 largely because of the addition
of 5 new fueling stations added in third quarter of 2009 and first half of 2010,
as well as the increase of pipeline natural gas customers. As of June 30, 2010,
we operated 40 CNG fueling stations in total and, in Shaanxi alone, we operated
28 CNG fueling stations. We believe we are the largest provider of CNG fueling
stations in Xi’an, one of our core target markets for CNG. As of June 30, 2010,
we operated 12 CNG fueling stations in Henan province, another of our core
target markets. The successful expansion of our CNG fueling station business in
Xi’an and Henan province has been a significant factor driving our revenue
growth and results of operations for the period reviewed. While we intend to
expand into different provinces, we anticipate the growth of our CNG fueling
business in Xi’an and Henan province will continue to significantly affect our
results of operations as we intend to continue to increase the number of CNG
fueling stations we operate in these areas.





Regulation of
natural gas prices in the PRC. The prices at which we purchase our
natural gas supplies and sell CNG and pipeline natural gas products are strictly
regulated by the PRC central government, including the National Development and
Reform Commission (“NDRC”), and the local state price bureaus have the
discretion to set natural gas prices within the boundaries set by the PRC
central government. In addition, natural gas procurement and sale prices are not
uniform across China and can vary across provinces. For example, the prices at
which we procure and sell CNG and piped natural gas are lower in Shaanxi than in
Henan. Accordingly, our results of operations and, in particular, our revenue,
cost of revenue and gross profit and gross margin are affected significantly by
factors which are outside of our control. As we expand our natural gas business
into other provinces, we expect our results of operations to continue to be
affected significantly by the regulation of natural gas prices in the
PRC.





Government
policies encouraging the adoption of cleaner burning fuels. Our results
of operations for the periods reviewed have benefited from environmental
regulations and programs in the PRC that promote the use of cleaner burning
fuels, including natural gas for vehicles. As an enterprise engaged in the
natural gas industry, our VIE benefits from a reduced income tax rate of 15%
compared to the standard 25% enterprise income tax rate in the PRC. In addition,
the PRC government has encouraged companies to invest in and build the necessary
transportation, distribution and sale infrastructure for natural gas in various
policy pronouncements such as by officially including CNG/gasoline hybrid
vehicles in the country's "encouraged development" category. These policies have
benefited our results of operations by encouraging the demand for our natural
gas products and also by lowering our expenses. As we plan to expand into the
LNG business, we anticipate that our results of operations will continue to be
affected by government policies encouraging the adoption of cleaner burning
fuels and the increased adoption of CNG and LNG technology.




35




The overall
economic growth of China’s economy.We do not export our products outside
China and our results of operations are thus substantially affected by the
growth of the industrial base, the increase in residential, commercial and
vehicular consumption and the overall economic growth of China. While China's
economy has experienced a slowdown in 2008 and a recovery period in 2009 and
2010, Although the government has initiated extensive domestic stimulus
spending, expanded bank lending, increases in the speed of regulatory approvals
of new construction projects and other economic policies, we are currently
unable to predict the overall direction of PRC economy. Our results of
operations rely on the overall success of China’s economy and may be affected by
the macro economic trends.





Taxation





United
States





We are
incorporated in the State of Delaware and are subject to the tax laws of the
United States. We incurred a net operating loss for income tax purposes for the
period ended June 30, 2010, and the estimated net operating loss carry forwards
for United States income tax purposes amounted to $3,033,370 and $2,699,276 as
of June 30, 2010 and December 31, 2009, respectively, which may be available to
reduce future years' taxable income. These carry forwards will expire, if not
utilized, beginning in 2027 through 2030. Our management believes that the
realization of the benefits arising from this loss appear to be uncertain due to
our Company's limited operating history and continuing losses for United States
income tax purposes. Accordingly, we have provided a 100% valuation allowance at
June 30, 2010.





The
PRC





Our
subsidiary, VIE and its subsidiaries 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. Based on certain
income tax regulations adopted in 2001 to encourage the development of certain
industries, including the natural gas industry, in the western portions of China
such as Shaanxi Province, XXNGC is subject to a reduced tax rate of 15%.
Accordingly, except for income from XXNGC, which is subject to the reduced tax
rate of 15%, income from SXNGE, SJLNG, XXABC, HXNGC, LBNGC, and HBXNGC are
subject to the 25% PRC income tax rate. Our effective income tax rate for the
three months ended June 30, 2010 and 2009 were approximately 17.6% and 23.5%,
respectively. Our effective income tax rate for the six months ended June 30,
2010 and 2009 were approximately 18.1% and 21.3%, respectively.





Value
Added Tax





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





All
revenues from XXABC are subject to a Chinese VAT at a rate of 17%. This VAT also
can be offset with VAT paid for materials included in the cost of
revenues.





36




CONSOLIDATED
RESULTS OF OPERATIONS





Three
Months Ended June 30, 2010 Compared to Three Months Ended June 30,
2009





The
following table represents the consolidated operating results for the three
months period ended June 30, 2010 and 2009:




Sales
Revenues





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





June 30,
              2010
            
            
            June
      30,
              2009
            
            
            Increase
      in
              Dollaramount
            
            
            Increase
      in
              percentageNatural
      gas from fueling stations
            
            $
            15,490,300
            
            
            $
            15,051,319
            
            
            $
            438,981
            
            
            
            2.9%Natural
      gas from pipelines
            
            
            730,703
            
            
            
            669,360
            
            
            
            61,343
            
            
            
            9.2%Gasoline
            
            
            2,033,840
            
            
            
            1,633,016
            
            
            
            400,824
            
            
            
            24.5%Installation
            
            
            2,341,553
            
            
            
            2,690,164
            
            
            
            (348,611)
            
            
            
            (13.0)%Auto
      conversion
            
            
            539,203
            
            
            
            698,661
            
            
            
            (159,458)
            
            
            
            (22.8)%Total
            
            $
            21,135,599
            
            
            $
            20,742,520
            
            
            $
            393,079
            
            
            
            1.9%





Overall.
Total revenue for the three months ended June 30, 2010 increased to $21,135,599
from $20,742,520 for the three months ended June 30, 2009, an increase of
$393,079 or 1.9 %. This increase was mainly due to the addition of 5 new fueling
stations added in third quarter of 2009 and first half of 2010, as well as an
increase in the number of residential and commercial pipeline customers to
112,343 as of June 30, 2010 from 103,343 as of June 30, 2009, We sold natural
gas of 46,033,415 cubic meters during the three months ended June 30, 2010,
compared to 44,090,672 cubic meters during the three months ended June 30, 2009.
We also sold gasoline of 2,584,827 liters during the three months ended June 30,
2010, compared to 2,707,531 liters during the three months ended June 30, 2009.
For the three months ended June 30, 2010, 86.4% of our revenue was generated
from the sale of natural gas and gasoline, and the other 13.6% was generated
from our installation and auto conversion services.





Natural Gas from
Fueling Stations. Natural gas revenue from our fueling stations increased
by 2.9% or $438,981 to $15,490,300 during the three months ended June 30, 2010,
from $15,051,319 during the three months ended June 30, 2009, and contributed to
73.3% of our total revenue, which was the largest among our four major business
lines. During the three months ended June 30, 2010, we sold 42,955,867 cubic
meters of compressed natural gas, compared to 41,152,513 cubic meters during the
three months ended June 30, 2009 through our fueling stations. In terms of
average station sales value and volume, in the three months ended June 30, 2010,
we sold approximately $387,257 and 1,073,897 cubic meters of compressed natural
gas per station, compared to approximately $430,038 and 1,175,786 cubic meters
in the three months ended June 30, 2009. Unit selling price remained stable at
$0.34 (RMB2.34) and $0.42 (RMB2.83) net of VAT in Shaanxi and Henan province,
respectively, or $0.37 (RMB 2.49) on an average basis.




37




Natural Gas from
Pipelines. Natural gas revenue from our pipelines increased by 9.2%, or
$61,343 to $730,703 during the three months ended June 30, 2010, from $669,360
during the three months ended June 30, 2009, and contributed to 3.5% of our
total revenue. As of June 30, 2010, the Company had 112,343 pipeline customers,
an increase of 9,000 customers comparing to as of June 30, 2009. We also sold
3,077,548 cubic meters of natural gas through our pipelines during the three
months ended June 30, 2010, compared to 2,938,159 cubic meters during the three
months ended June 30, 2009.





Gasoline.
Revenue from gasoline sales increased by 24.5 % or $400,824, to $2,033,840
during the three months ended June 30, 2010 from $1,633,016 during the three
months ended June 30, 2009, and contributed 9.6% to our total revenue. The
gasoline revenue increase was due to 31.7% increase of unit sales price from $
0.60 (RMB4.11) per liter in the three months ended June 30, 2009 to $0.79 (RMB
5.36) per liter in the three months ended June 30, 2010, mainly attributable to
the increase of international oil price, partially offset by the sales volume
decrease of 4.5% from 2,707,531 liters to 2,567,364 liters.





Installation
Services. Revenue from installation services decreased by 13.0%, or
$348,611 to $ 2,341,553 during the three months ended June 30, 2010, from
$2,690,164 during the three months ended June 30, 2009, and contributed 11.1% to
our total revenue. Installation services to our top four customers contributed
to 19.4%, 19.4%, 16.6% and 16.6% of our installation revenue for the three
months ended June 30, 2010.





Auto Conversion
Services. Revenue from our auto conversion division decreased by 22.8%,
or $159,458 to $539,203 during the three months ended June 30, 2010, from
$698,661 during the three months ended June 30, 2009, and contributed 2.6% to
our total revenue.





Cost
of Revenue





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





June
      30, 2010
            
            
            June
      30, 2009
            
            
            Increase
      in dollar
              amount
            
            
            Increase
      in
              percentageNatural
      gas from fueling stations
            
            $
            7,847,102
            
            
            $
            7,023,175
            
            
            $
            823,927
            
            
            
            11.7
            %Natural
      gas from pipelines
            
            
            510,888
            
            
            
            467,343
            
            
            
            43,545
            
            
            
            9.3
            %Gasoline
            
            
            1,910,294
            
            
            
            1,529,752
            
            
            
            380,542
            
            
            
            24.9
            %Installation
            
            
            925,145
            
            
            
            1,039,116
            
            
            
            (113,971)
            
            
            
            (11.0)
            %Auto
      conversion
            
            
            326,638
            
            
            
            404,944
            
            
            
            (78,306)
            
            
            
            (19.3)
            %Total
            
            $
            11,520,067
            
            
            $
            10,464,330
            
            
            $
            1,055,737
            
            
            
            10.1
            %




38




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.





Our cost
of revenue for the three months ended June 30, 2010 was $11,520,067, an increase
of $1,055,737, or 10.1%, from $ 10,464,330 for the three months ended June 30,
2009, mainly attributable to increase in procurement cost in Henan Province. Our
revenue increased by 1.9% during the same period.





Natural Gas from
Fueling Stations. Cost of revenue of our natural gas for our fueling
stations increased by 11.7%, or $823,927, to $7,847,102 during the three months
ended June 30, 2010, as compared to $7,023,175 during the three months ended
June 30, 2009. Procurement price for natural gas remained stable at $0.16 (RMB
1.12) in Shaanxi since 2008. In Henan Province, the Company started to use coal
bed methane (‘CBM’) as an alternative to regular natural gas to supply its
fueling station in July 2008. The price for CBM is historically at a discount
compared with natural gas, as a result the average cost of fueling station
revenue in Henan decreased from $0.22 (RMB 1.55) to $0.14 (RMB 1.0) in July
2008. However, due to uncertainty in the production capacity of CBM as a
byproduct of coal mines as well as the increasing demand of both CBM and natural
gas, average cost of fueling station revenue in Henan increased to $0.19 (RMB
1.30) in June 2009 and $0.23 (RMB 1.58) in second quarter of 2010. The cost,
however, is still significantly below the retail price at $0.42 (RMB 2.83) in
Henan Province.





Natural Gas from
Pipelines. Cost of revenue of our natural gas sold through our pipelines
increased by 9.3%, or $43,545 to $510,888 during the three months ended June 30,
2010, as compared to $467,343 during the three months ended June 30, 2009, which
was in line with the sales increase.





Gasoline.
Cost of our gasoline revenue increased by 24.9% or $380,542, to $1,910,294
during the three months ended June 30, 2010, from $1,529,752 for the three
months ended June 30, 2009. The increase of cost of gasoline revenue was due to
the effect of the increase of average unit cost from $0.56 (RMB 3.85) per liter
during the three months ended June 30, 2009 to $0.74 (RMB 5.06) per liter during
the three months ended June 30, 2010 mainly attributable to the increase of
international oil price, partially offset by the decrease in sales
volume.





Installation
Services. Cost of revenue from our installation services decreased by
11.0% or $113,971, to $ 925,145 during the three months ended June 30, 2010, as
compared to $1,039,116 during the three months ended June 30, 2009, which was in
line with the sales decrease.





Auto Conversion
Services. Cost of our auto conversion revenue decreased by 19.3%, or
$78,306, to $326,638 during the three months ended June 30, 2010, as compared to
$404,944 during the three months ended June 30, 2009.




39




Gross
profit





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





June
      30, 2010
            
            
            June
      30, 2009
            
            
            Increase
      in
              dollar
      amount
            
            
            Increase
      in
              percentageNatural
      gas from fueling stations
            
            $
            7,643,198
            
            
            $
            8,028,144
            
            
            $
            (384,946)
            
            
            
            (4.8)%Natural
      gas from pipelines
            
            
            219,815
            
            
            
            202,017
            
            
            
            17,798
            
            
            
            8.8%Gasoline
            
            
            123,546
            
            
            
            103,264
            
            
            
            20,282
            
            
            
            19.6%Installation
            
            
            1,416,408
            
            
            
            1,651,048
            
            
            
            (234,640)
            
            
            
            (14.2)%Auto
      conversion
            
            
            212,565
            
            
            
            293,717
            
            
            
            (81,152)
            
            
            
            (27.6)%Total
            
            $
            9,615,532
            
            
            $
            10,278,190
            
            
            $
            (662,658)
            
            
            
            (6.4)%





We earned
a gross profit of $9,615,532 for the three months ended June 30, 2010, a
decrease of $662,658 or 6.4%, compared to $10,278,190 for the three months ended
June 30, 2009. Gross profit decreased mainly due to increased procurement cost
of natural gas for fueling stations in Henan Province.





Gross
margin





Gross
margin for natural gas sold through our fueling stations decreased from 53.3% in
the three months ended June 30, 2009 to 49.3 % in the three months ended June
30, 2010 due to increased procurement cost of natural gas for fueling stations
in Henan Province.





Gross
margin for natural gas sold through pipelines was 30.1% during the three months
ended June 30, 2010, as compared to 30.2% during the three months ended June 30,
2009.





Gross
margin for gasoline sales was 6.3% during the three months ended June 30, 2009
and 6.1% during the three months ended June 30, 2010, respectively.





Gross
margin for our installation business was 60.5% in the three months ended June
30, 2010 as compare to 61.4% in the three months ended June 30,
2009.





Gross
margin for our auto conversion business decreased from 42.0% in the three months
ended June 30, 2009 to 39.4% in the three months ended June 30, 2010 due to
increase of material costs.





Due to
higher procurement cost of natural gas for fueling stations in Henan Province,
our total gross margin decreased from 49.6% for the three months ended June 30,
2009 to 45.5% for the three months ended June 30, 2010.





Operating
expenses





We
incurred operating expenses of $4,968,858 for the three months ended June 30,
2010, an increase of $1,454,720 or 41.4%, compared to $3,514,138 for the three
months ended June 30, 2009.





Sales and
marketing costs increased $458,208, or 17.6% from $2,596,784 for three months
ended June 30, 2009 to $3,054,992 for the three months ended June 30, 2010,
primarily related to increase in depreciation, transportation expense,
electricity, and salaries associated with existing stations as well as the
addition of 5 new fueling stations in third quarter of 2009 and first half of
2010. The increase also reflects costs related to social security benefit for
our employees commenced in the third quarter of 2009 and our continued efforts
to obtain new residential and commercial, and fueling station customers.
Transportation cost per million cubic meters of natural gas during the three
months ended June 30, 2010 was approximately $4,915.




40




General
and administrative expenses increased $996,512, or 108.6% from $917,354 for the
three months ended June 30, 2009 to $1,913,866 for the three months ended June
30, 2010, primarily reflecting increased $699,169 in stock option expense,
$101,523 in legal fee, $59,339 in consulting fee, $40,271 in training expense
and $35,436 in advertisement. The increase of $699,169 in stock option
compensation was due to 380,850 stock options issued on May 5,
2010.





Income
from Operations and Operating Margin





Largely
impacted by the increase in procurement cost and operating expenses, income from
operations decreased by $2,117,378, or 31.3%, to $4,646,674 for the three months
ended June 30, 2010, from $6,764,052 for the three months ended June 30, 2009.
Our operating margin for the three months ended June 30, 2010 was 22.0%,
compared to 32.6% for the three months ended June 30, 2009.





Non-Operating
Income (Expense)





Non-operating
income was $887,440 for the three months ended June 30, 2010, compared with
$1,714,613 non-operating expense for the three months ended June 30, 2009,
primarily due to the $665,115 gain associated with change in fair value of the
Company’s outstanding warrants. Meanwhile, for the three months ended June 30,
2009, the Company incurred a $1,312,834 loss of change in fair value of
warrants. In addition, the Company capitalized $1,627,034 interest expense for
the three months ended June 30, 2010 while only $1,172,547 was capitalized for
the same period of 2009.





Provision
for Income Tax





Income
tax was $973,611 for the three months ended June 30, 2010, as compared to
$1,186,683 for the three months ended June 30, 2009. Decrease of tax provision
was mainly due to the lower operating income compared to the same period prior
year and non-operating income of change in fair value of warrants was not
subject to income tax as CHNG has incurred net operating loss for income tax
purpose for the three months ended June 30, 2010.





Net
Income





Based on
the foregoing, net income increased to $4,560,503 for the three months ended
June 30, 2010, an increase of $697,747, or 18.1%, from $3,862,756 for the three
months ended June 30, 2009. Net margin increased from 18.6% during the three
months ended June 30, 2009 to 21.6% during the three months ended June 30,
2010.





Six
Months Ended June 30, 2010 Compared to Six Months Ended June 30,
2009





The
following table represents the consolidated operating results for the six month
period ended June 30, 2010 and 2009:





Sales
Revenues





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





June
      30,
              2010
            
            
            June
      30,
              2009
            
            
            Increase
      in dollar
            
            
            Increase
      in
              PercentageNatural
      gas from fueling stations
            
            $
            30,119,910
            
            
            $
            29,309,243
            
            
            $
            810,667
            
            
            
            2.8%Natural
      gas from pipelines
            
            
            1,584,722
            
            
            
            1,377,255
            
            
            
            207,467
            
            
            
            15.1%Gasoline
            
            
            3,502,656
            
            
            
            2,807,414
            
            
            
            695,242
            
            
            
            24.8%Installation
            
            
            4,349,327
            
            
            
            4,604,043
            
            
            
            (254,716)
            
            
            
            (5.5)%Auto
      conversion
            
            
            945,807
            
            
            
            1,172,231
            
            
            
            (226,424
            )
            
            
            (19.3)%Total
            
            $
            40,502,422
            
            
            $
            39,270,186
            
            
            $
            1,232,236
            
            
            
            3.1%




41




Overall.
Total revenue for the six months ended June 30, 2010 increased to $40,502,422
from $39,270,186 for the six months ended June 30, 2009, an increase of
$1,232,236 or 3.1%. This increase was mainly due to the addition of 5 new
fueling stations added in third quarter of 2009 and first half of 2010, and an
increase in the number of residential and commercial pipeline customers to
112,343 as of June 30, 2010 from 103,343 as of June 30, 2009. We sold natural
gas of 86,373,816 cubic meters during the six months ended June 30, 2009,
compared to 90,194,696 cubic meters during the six months ended June 30, 2010.
For the six months ended June 30, 2010, 86.9% of our revenue was generated from
the sale of natural gas and gasoline, and the other 13.1% was generated from our
installation and auto conversion services.





Natural Gas from
Fueling Stations.Natural gas revenue from our fueling stations increased
by 2.8%, or $810,667, to $30,119,910 during the six months ended June 30, 2010,
from $ 29,309,243 during the six months ended June 30, 2009, and contributed to
74.4% of our total revenue, which was the largest among our four major business
lines. The increase of natural gas revenue was mainly due to the increase of
sales volume generated from the newly added fueling stations since the third
quarter of 2009. During the six months ended June 30, 2009, we sold compressed
natural gas of 80,446,633 cubic meters, compared to 83,548,324 cubic meters
during the six months ended June 30, 2010 through our fueling stations. In terms
of average station sales value and volume, in the six months ended June 30,
2009, we sold approximately $837,407 and 2,298,475 cubic meters of compressed
natural gas per station, compared to approximately $792,629 and 2,198,640 cubic
meters in the six months ended June 30, 2010. The reason for the decline in per
station sales was due to the construction of main subway lines in Xi'an, which
caused certain bus routes to deviate from our stations. Unit selling price
remained stable at $0.34 (RMB2.34) and $0.42 (RMB2.83) net of VAT in Shaanxi and
Henan province, respectively, or $0.37 (RMB 2.49) on an average
basis.





Natural Gas
from Pipelines.  Natural
gas revenue from our pipelines increased by 15.1%, or $207,467, to $1,584,722
during the six months ended June 30, 2010, from $1,377,255 during the six months
ended June 30, 2009, and contributed to 3.9% of our total revenue. As of June
30,2010, the Company had 112,343 pipeline customers, an increase of 9,000
customers comparing to as of June 30, 2009.We also sold 6,646,372 cubic meters
of natural gas through our pipelines during the six months ended June 30, 2010,
compared to 5,927,183 cubic meters during the six months ended June 30,
2009.





Gasoline.
Revenue from gasoline sales increased by 24.8%, or $695,242, to $3,502,656
during the six months ended June 30, 2010, from $2,807,414 during the six months
ended June 30, 2009, and contributed 8.6% to our total revenue. The gasoline
revenue increase was due to 36.8% increase of unit sales price from $0.57
(RMB3.93) per liter in the six months ended June 30, 2009 to $0.78 (RMB 5.29)
per liter in the six months ended June 30, 2010, mainly attributable to the
increase of international oil price, partially offset by the sales volume
decrease of 7.5% from 4,878,763 liters to 4,513,861 liters.




42




Installation
Services. Revenue from installation services decreased by 5.5%, or
$254,716, to $4,349,327 during the six months ended June 30, 2010, from
$4,604,043 during the six months ended June 30, 2009, and contributed 10.7% to
our total revenue. Installation services to our top four customers contributed
to 13.0%, 12.2%, 10.4% and 10.4% of our installation revenue for the six months
ended June 30, 2010.





Auto Conversion
Services. Revenue from our auto conversion division decreased by 19.3%,
or $226,424, to $945,807 during the six months ended June 30, 2010, from
$1,172,231 during the six months ended June 30, 2009, and contributed 2.3% to
our total revenue.





Cost of
Revenue:





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





June
      30, 2010
            
            
            June
      30, 2009
            
            
            Increase(Decrease)
      in dollar
              amount
            
            
            Increase
      in
              percentageNatural
      gas from fueling stations
            
            $
            15,119,238
            
            
            $
            13,267,616
            
            
            $
            1,851,622
            
            
            
            14.0
            %Natural
      gas from pipelines
            
            
            1,103,406
            
            
            
            969,831
            
            
            
            133,575
            
            
            
            13.8
            %Gasoline
            
            
            3,277,572
            
            
            
            2,659,809
            
            
            
            617,763
            
            
            
            23.2
            %Installation
            
            
            1,723,199
            
            
            
            1,761,979
            
            
            
            (38,780)
            
            
            
            (2.2)
            %Auto
      conversion
            
            
            568,507
            
            
            
            699,109
            
            
            
            (130,602
            )
            
            
            (18.7)
            %Total
            
            $
            21,791,922
            
            
            $
            19,358,344
            
            
            $
            2,433,578
            
            
            
            12.6
            %





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.





Our cost
of revenue for the six months ended June 30, 2010 was $21,791,922, an increase
of $2,433,578, or 12.6%, from$19,358,344 for the six months ended June 30, 2009;
while our revenue increased by 3.1% during the same period.





Natural Gas from
Fueling Stations.Cost of revenue of our natural gas for our fueling
stations increased by 14.0%, or $1,851,622, to $15,119,238 during the six months
ended June 30, 2010, as compared to $13,267,616 for the six months ended June
30, 2009.The increase for cost of natural gas for our fueling stations was
primarily due to the increase of procurement price in coal bed methane in Henan
province from $0.15(RMB1.00) in first half of 2009 to $0.22(RMB1.53) in first
half of 2010.





Natural Gas from
Pipelines. Cost of revenue of our natural gas sold through our pipelines
increased by 13.8%, or $133,575, to $1,103,406 during the six months ended June
30, 2010, as compared to $969,831 during the six months ended June 30, 2009,
which was in line with the sales growth.




43




Gasoline.
Cost of our gasoline revenue increased by 23.2% or $ 617,763, to $3,277,572
during the six months ended June 30, 2010, from $2,659,809 for the six months
ended June 30, 2009. The increase of cost of gasoline revenue was due to the
increase of average unit cost from $0.55 (RMB 3.72) per liter during the six
months ended June 30, 2009 to per liter $0.73 (RMB4.95) during the six months
ended June 30, 2010 due to the increase price of the international fuel market,
offset by the effect of the decrease in sales volume.





Installation
Services.Cost of revenue from our installation services decreased by
2.2%, or $38,780, to $1,723,199 during the six months ended June 30, 2010, as
compared to$1,761,979 during the six months ended June 30, 2009, as a result of
the increase of pipeline customers.





Auto Conversion
Services. Cost of our auto conversion revenue decreased by 18.7%, or
$130,602, to $568,507 during the six months ended June 30, 2010, as compared to
$699,109 during the six months ended June 30, 2009.





Gross
profit





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





June
      30, 2010
            
            
            June
      30, 2009
            
            
            Increase
      in
              dollar
      amount
            
            
            Increase
      in
              percentageNatural
      gas from fueling stations
            
            $
            15,000,672
            
            
            $
            16,041,627
            
            
            $
            (1,040,955)
            
            
            
            (6.5)
            %Natural
      gas from pipelines
            
            
            481,316
            
            
            
            407,424
            
            
            
            73,892
            
            
            
            18.1
            %Gasoline
            
            
            225,084
            
            
            
            147,605
            
            
            
            77,479
            
            
            
            52.5
            %Installation
            
            
            2,626,128
            
            
            
            2,842,064
            
            
            
            (215,936)
            
            
            
            (7.6)
            %Auto
      conversion
            
            
            377,300
            
            
            
            473,122
            
            
            
            (95,822)
            
            
            
            (20.3)
            %Total
            
            $
            18,710,500
            
            
            $
            19,911,842
            
            
            $
            (1,201,342)
            
            
            
            (6.0
            )%





We earned
a gross profit of $18,710,500 for the six months ended June 30, 2010, a decrease
of $1,201,342 or 6.0%, compared to $19,911,842 for the six months ended June 30,
2009. In summary, gross profit decrease was mainly due to increased cost of
fueling station revenue in Henan Province.





Gross
margin





Gross
margin for natural gas sold through our fueling stations decreased from 54.7% in
the six months ended June 30, 2009 to 49.8% in the six months ended June 30,
2010, due to increased procurement cost of natural gas for fueling stations in
Henan Province.




44




Gross
margin for natural gas sold through pipelines was 30.4% during the six months
ended June 30, 2010, and increased slightly as compared to 29.6% during the six
months ended June 30, 2009.





Gross
margin for gasoline sales increased from 5.3% during the six months ended June
30, 2009 to 6.4% during the six months ended June 30, 2010, due to larger
increase in gasoline retail price compared with procurement price.





Gross
margin for our installation business decreased to 60.4% in the six months ended
June 30, 2010 from 61.7% in the six months ended June 30, 2009 due to increase
of material costs.





Gross
margin for our auto conversion business decreased from 40.4% in the six months
ended June 30, 2009 to 39.9% in the six months ended June 30, 2010 due to
increase of material costs.





Due to
higher procurement cost of natural gas for fueling stations in Henan
Province, our total gross margin decreased from 50.7% for the six months ended
June 30, 2009 to 46.2% for the six months ended June 30, 2010.





Operating
Expenses





We
incurred operating expenses of $9,678,304 for the six months ended June 30,
2010, an increase of $2,158,017 or 28.7%, compared to $7,520,287 for the six
months ended June 30, 2009.





Sales and
marketing costs increased 14.9% or $769,173, from $5,177,609 for the six months
ended June 30, 2009 to $5,946,782 for the six months ended June 30, 2010,
primarily due to $267,231 increase in depreciation expense, $158,716 increase in
transportation expense, and $107,180 increase in utility expense, primarily
related to the addition of 5 new fueling stations since the third quarter of
2009. In addition, we also increased our efforts to obtain new residential and
commercial customers and attract customers to our fueling stations. The increase
also reflect costs related to social security benefit for our employees
commenced in the third quarter of 2009 and our continued efforts to obtain new
residential and commercial, and fueling station customers. Transportation cost
per million cubic meters of natural gas during the six months ended June 30,
2010 was approximately $4,507.





General
and administrative expenses increased $1,388,844, or 59.3% from $2,342,678 for
the six months ended June 30, 2009 to $3,731,522 for the six months ended June
30, 2010 primarily reflecting $752,008 increase in stock option expense for the
Company’s employee stock option plan, increase in costs related to market
development initiatives in Hubei Province and other regions, social security
benefit for our employees commenced in the third quarter of 2009, travel
expenses for investor conferences to Beijing, Shanghai and US, as well as
increased Delaware franchise tax due to the Company’s increased shares
outstanding and asset base.





Income
from Operations and Operating Margin





Largely
impacted by the increase in procurement cost and operating expenses, income from
operations decreased by $3,359,359, or 27.1%, to $9,032,196 for the six months
ended June 30, 2010, from $12,391,555 for the six months ended June 30, 2009.
Our operating margin for the six months ended June 30, 2010 was 22.3%, compared
to 31.6% for the six months ended June 30, 2009.





Non-Operating
Income (Expense)





Our
non-operating income was $1,408,333 for the six months ended June 30, 2010,
compared to non-operating expense of $2,143,237 for the six months ended June
30, 2009. The fluctuation is primarily due to the $1,058,183 gain associated
with change in fair value of the Company’s outstanding warrants. Meanwhile, for
the six months ended June 30, 2009, the Company incurred a $1,115,783 loss of
change in fair value of warrants. In addition, the Company capitalized
$2,990,697 interest expense for the six months ended June 30, 2010 while only
$2,030,926 was capitalized for the same period of 2009.




45




Provision
for Income Tax





Income
tax was $1,884,756 for the six months ended June 30, 2010, as compared to
$2,183,939 for the six months ended June 30, 2009. Decrease of tax provision was
mainly due to the lower operating income, and non-operating income of change in
fair value of warrants was not subject to income tax because CHNG has incurred
net operating loss for income tax purpose for the six months ended June 30,
2010.





Net
Income





Based on
the foregoing, net income increased to $8,555,773 for the six months ended June
30, 2010, an increase of $491,394, or 6.1%, from $8,064,379 for the six months
ended June 30, 2009. Net margin has a slightly increase to 21.1% in the six
months ended June 30, 2010 from 20.5% in the six months ended June 30,
2009.





LIQUIDITY
AND CAPITAL RESOURCES





Historically,
our primary sources of liquidity have consisted of cash generated from our
operations, debt financing and equity offerings. In 2008, we sold senior notes
with a face value of $40 million to Abax Lotus Ltd. In September 2009, the
Company also completed a secondary offering with gross proceeds of approximately
$57 million. Our principal uses of cash have been, and are expected to continue
to be, for operational purposes as well as for constructing our LNG
plant.





As of
June 30, 2010, the Company had $42,606,410 of cash and cash equivalents on hand
compared to $48,177,794 of cash and cash equivalents as of December 31, 2009.
The decrease was primarily attributable to the construction of the LNG plant,
additions of fueling stations, and market development initiatives.





Net cash
provided by operating activities was $10,881,038 for the six months ended June
30, 2010 compared to net cash provided by operations of $14,396,765 for the six
months ended June 30, 2009. The primary reason for the change was due to the
lower operating income, and an increase in change in asset & liability of
$596,743.





Net cash
used in investing activities increased from $10,544,353 during the six months
ended June 30, 2009 to $34,846,421 for the same period in 2010 primarily due to
prepayment to equipment suppliers and construction of the LNG plant, and
addition of fueling stations during the six months ended June 30,
2010.





The
Company paid $17,140,962 to the LNG processing plant as a prepayment on
equipment as well as addition to construction in progress during the six months
ended June 30, 2010.





Net cash
provided by financing activities was $18,279,001 for the six months ended June
30, 2010 compared to net cash provided by financing of $0 for the six months
ended June 30, 2009. The primary reason for the change was due to $17,602,800
domestic loan.





Based on
past performance and current expectations, we believe our cash and cash
equivalents, cash generated from operations, as well as future possible cash
from financing activities; will satisfy our working capital needs, capital
expenditures and other liquidity requirements associated with our
operations.





The
majority of our 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 our business.




46




OFF-BALANCE
SHEET ARRANGEMENTS





We do not
have any off-balance sheet arrangements that have or are reasonably likely to
have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources that are material to our
investors.





CAPITAL
EXPENDITURES





Our
planned capital expenditures as of June 30, 2010 were $39 million, which we
expect to be incurred in connection with the LNG facility, construction or
acquisition of additional fueling stations and compressor stations,
joint-venture cooperation with CNPC Kunlun and to fund the expansion into Hubei
Province.





OUTSTANDING
INDEBTEDNESS





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





We are
required to make mandatory prepayments on the Senior Notes on certain dates and
we are subject to customary covenants for financings of this type, including
restrictions on the incurrence of liens, payment of dividends, and disposition
of properties as well as obligated to maintain certain financial
ratios.





On
February 26, 2010, JBLNG entered into a fixed assets loan contract (see
long-term loan below) with Pudong Development Bank Xi’an Branch (“SPDB”),
pursuant to which the SPDB agreed to lend $17,676,000 to JBLNG. SPDB transferred
$13,257,000 and $4,419,000 to JBLNG on March 17, 2010 and May 31, 2010,
respectively. This loan is secured by Xi’an Xilan Natural Gas Co., ltd
(“XXNGC”)’s equipments and vehicles located within PRC. The lien incurred with
this loan is in violation of the Indenture of the Senior Notes with Abax Lotus
Ltd. Under the terms of the Indenture for the 5.00% Guaranteed Senior Notes
issued to Abax Lotus Ltd. dated January 20, 2008, the Company and its
subsidiaries including XXNGC, are prohibited from entering into such pledge of
assets and guaranty agreements. As a result, Abax Lotus Ltd. has the right to
declare a default under the Indenture after written notice and the Company’s 30
days right to cure. Upon an event of default, Abax may accelerate the
outstanding indebtedness together with all accrued interest thereon and demand
immediate repayment. As of the date of this report, the Company has not received
a notice of default from Abax Lotus Ltd. nor does the Company receive a notice
of wavier from Abax Lotus Ltd. As the payment date of the indenture become dues
on demands, the Company reclassified the indenture to short term
liability.





Long-term
loan





On
February 26, 2010, JBLNG entered into a fixed assets loan contract with Shanghai
Pudong Development Bank Xi’an Branch (“SPDB”), pursuant to which the SPDB agreed
to lend $17,676,000 to JBLNG. SPDB transferred $13,257,000 and $4,419,000 to
JBLNG on March 17 and May 28, 2010, respectively. The applicable interest rate
of this loan is the People’s Bank of China’s standard three to five year rate,
5.76% for the first year and subject to adjustment commencing the second year.
The loan period is 58 months from the date of effectiveness of the contract, and
will be repaid annually, with the last repayment no later than December 5, 2014.
The loan is secured by XXNGC’s equipments and vehicles located within
PRC.




47




CONTRACTUAL
OBLIGATIONS





Our
contractual obligations are as follows:





Payments
      due by periodContractual
      obligations
            
            Total
            
            
            Less
      than
              1
      year
            
            
            1-3
              Years
            
            
            3-5
              years
            
            
            More
      than
              5
      years(in
      thousands)Long-Term
      Debt Obligations
            
            $
            40,000
            
            
            $
            40,000
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Other
      Long-Term Liabilities Reflected on Company's Balance
    Sheet(1)
            
            
            17,500
            
            
            
            17,500
            
            
            
            -
            
            
            
            -
            
            
            
            -Long-term
      loan
            
            
            17,676
            
            
            
            -
            
            
            
            8,838
            
            
            
            8,838
            
            
            
            -Total
            
            $
            75,176
            
            
            $
            57,500
            
            
            $
            8,838
            
            
            $
            8,338
            
            
            $
            -





Note:





(1)
            The
      $17,500,000 reflects derivative liability related to the embedded put
      option in the 1,450,000 warrants we issued to Abax in January 2008. Abax
      is entitled to require the Company purchase back the portion of warrants
      not exercised upon expiration.  Under the terms of the Warrant
      Agreement, in the event of a default under the indenture for the Senior
      Notes, the warrants holders are entitled to redeem the warrants for a
      price equal to the pro rata portion of the aggregate redemption price of
      $17,500,000 applicable to the warrants tendered by such
      holder.  As the redemption requirement of the warrants become
      due on demands in connection to the default under the indenture, the
      Company reclassified the redemption value to short term
      liability.





COMMITMENTS
AND CONTINGENCIES





Lease
Commitments





The
Company recognizes lease expense on a straight-line basis over the term of the
lease in accordance to FASB’s accounting standard regarding leases. The Company
entered into a series of long-term lease agreements with outside parties to
lease land use rights to the self-built Natural Gas fueling stations located in
the PRC. The agreements have terms ranging from 10 to 30 years. The Company
makes annual prepayments for most lease agreements. The Company also entered
into two office leases in Xi’an, PRC, one office lease in Jingbian, PRC, one
office lease in Wuhan, PRC and one office lease in New York, NY. The minimum
future payment for leasing land use rights and offices is as
follows:





Year
      ending December 31, 2010
            
            $
            1,219,507Year
      ending December 31, 2011
            
            
            2,087,346Year
      ending December 31, 2012
            
            
            1,921,385Year
      ending December 31, 2013
            
            
            1,830,217Year
      ending December 31, 2014
            
            
            2,218,208Thereafter
            
            
            34,447,281Total
            
            $
            43,723,944




48




For the
three months ended June 30, 2010 and 2009, the land use right and office lease
expenses were $405,785 and $406,016, respectively. For the six months ended June
30, 2010 and 2009, the land use right and office lease expenses were $836,413
and $798,097, respectively.





Property
and Equipment Purchase Commitments





The
Company has purchase commitments for materials, supplies, services and property
and equipment for constructing the LNG plant and other CIP projects. The Company
has future commitments as followings:





Year
      ending December 31, 2010
            
            $
            12,215,777Year
      ending December 31, 2011
            
            
            382,887Thereafter
            
            
            -Total
            
            $
            12,598,664





Natural
Gas Purchase Commitments





We have
certain effective natural gas purchase agreements with our major suppliers. The
natural gas purchase agreement with Shaanxi Provincial Natural Gas Co., Ltd. has
been renewed annually to date and specifies a maximum amount that can be
purchased but does not specify a minimum amount that must be purchased. Our
natural gas purchase agreements with certain suppliers of coal-bed methane are
of indefinite terms and do not contain either maximum or minimum amounts of
purchase. Without minimum purchase requirements under any of our natural gas
purchase agreements, we have the flexibility to constantly look for lower-cost
sources of supply.





FOREIGN
CURRENCY TRANSLATIONS





As of
June 30, 2010 and December 31, 2009, our accounts were maintained, and our
consolidated financial statements were expressed in RMB. Such consolidated
financial statements were translated into USD with the RMB as the functional
currency. 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. 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 June 30, 2010 were
translated 6.79 RMB to $1.00 as compared to 6.82 RMB at December 31, 2009. The
equity accounts were stated at their historical rate. The average translation
rates applied to income and cash flow statement amounts for the six months ended
June 30, 2010 and 2009 were RMB 6.82 to $1.00.




49




CRITICAL
ACCOUNTING POLICIES





Our
discussion and analysis of our financial position and results of operations
contained in this Quarterly Report on Form 10-Q is based on our condensed
consolidated unaudited financial statements, contained elsewhere herein. The
preparation of these financial statements in conformity with GAAP requires that
we make estimates. There have been no material changes in the development of our
accounting estimates or the assumptions underlying those estimates, or the
accounting policies that we disclosed as our Critical Accounting Policies in our
Annual Report on Form 10-K for the year ended December 31, 2009.





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





Construction
in Progress





Construction
in progress (“CIP”) consists of the cost of constructing property and equipment
for the gas stations and a new project of processing, distribution and sale of
LNG. The major cost of construction in progress relates to technology licensing
fees, equipment purchases, land use rights requisition cost, capitalized
interest and other construction fees. 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.





Revenue
Recognition





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.




50




Fair
Value of Financial Instruments





The
accounting standards regarding fair value of financial instruments and related
fair value measurements 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.





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.





FASB
accounting standard regarding derivatives and hedging 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. This FASB accounting standard also 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
exception.





RECENT
ACCOUNTING PRONOUNCEMENTS





See “Note 2. Summary of Significant
Accounting Policies”in “Item 1. Financial
Statements” herein for a discussion of the new accounting pronouncements
adopted in this Quarterly Report on Form 10-Q.





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 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 $57,676,000 at June 30, 2010, all of which bears interest at
fixed rates. The $40,000,000 fixed-rate debt is due on demand. The $17, 676,000
of flexible-rate debt is due from 2012-2014. We currently have no interest rate
hedge positions in place to reduce our exposure to changes in interest
rates.




51




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 $759,004
adjustment to increase our equity account for the six month ended June 30, 2010
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





We
maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange
Act”)) that are designed to ensure that information required to be disclosed in
the reports we file or submit under the Exchange Act is (a) recorded, processed,
summarized and reported within the time periods specified in the rules and forms
of the Securities and Exchange Commission and (b) accumulated and communicated
to management, including our Chief Executive Officer (“CEO”) and Chief Financial
Officer (“CFO”), as appropriate, to allow timely decisions regarding required
disclosure.





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 ineffective for the reasons discussed below.





In light
of the material weaknesses referred to below, the Company performed additional
analyses and procedures in order to conclude that its consolidated financial
statements for the three and six month periods ended June 30, 2010 are fairly
presented, in all material respects, in accordance with GAAP and has undertaken
remediation initiatives as discussed below.





Management’s
Annual Report on Internal Control over Financial Reporting





The
Company’s management is responsible for establishing and maintaining an adequate
system of internal control over financial reporting.
Internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; (iii) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial statements; and (iv)
provide reasonable assurance as to the detection of fraud.





Because
of its inherent limitations, a system of internal control over financial
reporting can provide only reasonable assurance and may not prevent or detect
misstatements. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation. Further, because of changes in conditions,
effectiveness of internal control over financial reporting may vary over
time.




52




Due to
the following mentioned material weaknesses or significant deficiencies,
we Treadway
Commission (“COSO”).





Based on
the management’s evaluation of the effectiveness of internal control over
financial reporting, we have identified the following material weaknesses or
significant deficiencies as of December 31, 2009 and through the date of this
filing, which require the Company to adopt remedial measures.





Key
executives entered into the following material transactions without pre-approval
from the Company’s board of directors:





·
            Extended
      loans to unrelated third parties in the amount of $14
    million;·
            Entered
      into a bank loan agreement in the amount of $17.7 million in February,
      2010; and·
            Acquired
      4 natural gas fueling stations without
      pre-approval on the final acquisition
  price.




The
failure to obtain board pre-approval of the foregoing transactions constitutes a
significant deficiency or material weakness.





In
addition, as a result of the following, management identified further
deficiencies in our internal controls over financial reporting and disclosure
controls:


·
              The
      Bank loan of $17.7 million was not disclosed in the Company’s Annual
      Report on Form 10-K for the year ended December 31, 2009 as a subsequent
      event on the consolidated financial statements
      footnotes.  Immediately after the filing of the Company’s
      Quarterly Report on Form 10-Q for the period ended June 30, 2010, the
      Company will amend its Annual Report on Form 10-K for the year ended
      December 31, 2009 to disclose the Bank loan of $17.7 million as a material
      subsequent event.·
              The
      Company understated its restricted cash in the amount of $17.7 million and
      did not report the bank loans of $17.7 million in its consolidated balance
      sheet as of March 31, 2010.  Immediately after the filing of the
      Company’s Quarterly Report on Form 10-Q for the period ended June 30,
      2010, the Company will amend its Quarterly Report on Form 10-Q for the
      three months ended March 31, 2010 to include the
      restatement.·
              Improper
      reclassification from short term liabilities to long term liabilities for
      the senior notes payable and fair value of the redeemable warrants in the
      amount of $45.6 million in our consolidated balance sheet as of March 31,
      2010.  Immediately after the filing of the Company’s Quarterly
      Report on Form 10-Q for the period ended June 30, 2010, the Company will
      amend its Quarterly Report on Form 10-Q for the three months ended March
      31, 2010 to include the
restatement.


Based on
its assessment, including consideration of the aforementioned material
weaknesses, and the criteria discussed above, management concludes that our
internal control over financial reporting was not effective at a reasonable
assurance level as of June 30, 2010.





Management’s
Remediation Initiatives





We are in
the process of seeking to hire external qualified internal control consultants
to implementing stronger internal controls surrounding our approval and
authorization policies and procedures and are prepared to establish policies to
remediate such deficiencies and reviewing our financial reporting process to
strengthen controls in terms of preventing omission or improper disclosures of
our consolidated financial statements.




53




The Audit
Committee has directed management to develop and present to the Committee a plan
and timetable for the implementation of the remediation measures described above
(to the extent not already implemented), and the Committee intends to monitor
such implementation. We believe that the actions described above will remediate
the material weakness control deficiencies we have identified and strengthen our
internal control over financial reporting. As we improve our internal control
over financial reporting and implement remediation measures, we may supplement
or modify the remediation measures described above.





In
addition, the Company continues to reassess its internal controls and procedures
in light of these recent events and is in the process of determining additional
appropriate actions to take to remediate these material weaknesses.





Changes
in internal control over financial reporting





Other
than as described above, there have been no changes in our internal control over
financial reporting during the most recently completed fiscal quarter that have
materially affected or are reasonably likely to materially affect, our internal
control over financial reporting.





Part
II. OTHER INFORMATION





Item
1. Legal Proceedings





None.





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 10, 2010.
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.  Other Information





On
February 26, 2010, the Company through its subsidiary, JBLNG entered into a
fixed assets loan contract with Shanghai Pudong Development Bank Xi’an Branch
(“SPDB”), pursuant to which SPDB agreed to lend the Company up to $17,676,000 at
the annual interest rate of 5.76% (the “Loan”). The Company was entitled to
borrow amounts under the loan between March 1, 2010 and June 30,
2010.





In
addition, in connection with the Loan, XXNGC, the variable interest entity of
the Company, entered into a pledge agreement with SPDB, pursuant to which
XXNGC’s equipment and vehicles located within the PRC were pledged to secure the
repayment of the Loan. XXNGC also entered into a guaranty with SPDB to guaranty
the repayment of the Loan.





As of
June 30, 2010, the Company has borrowed the entire amount of the Loan and is
required to make mandatory payments on the Loan on dates and in amounts as
follows:




March
      5, 2012
              
              $
              4,419,000March
      5, 2013
              
              $
              4,419,000March
      5, 2014
              
              $
              4,419,000December
      5, 2014
              
              $
              4,419,000




Under the
terms of the Indenture for the 5.00% Guaranteed Senior Notes issued to Abax
Lotus Ltd. dated January 20, 2008 (the “Senior Notes”), the Company and its
subsidiaries including XXNGC, are prohibited from entering into such pledge and
guaranty agreements.  As a result, Abax Lotus Ltd. has the right to
declare a default under the Indenture after written notice and the Company’s 30
days right to cure.  Upon an event of default, Abax may accelerate the
outstanding indebtedness together with all accrued interest thereon and demand
immediate repayment.





In
addition, in connection with the Senior Notes, the Company also issued certain
warrants to purchase the Company’s common stock pursuant to a Warrant Agreement
and Warrant Certificates. Under the terms of the Warrant Agreement, in the event
of a default under the Indenture for the Senior Notes, the warrants holders are
entitled to redeem the warrants for a price equal to the pro rata portion of the
aggregate redemption price of $17,500,000 applicable to the warrants tendered by
such holder.





As of the
date of this report, the Company has not received a notice of default from Abax
Lotus Ltd.





54


Item
5.  Exhibits





(a)
Exhibits





Exhibit
              Number
            
            Description
      of Exhibit10.1*
            
            Loan
      Contract of Fixed Asset dated February 26, 2010, by the between Jingbian
      Xi’an Xilan Liquefied Natural Gas Co. Ltd. and Xi’an Branch Shanghai
      Pudong Development Bank.10.2*
            
            Mortgage
      Contract of Movables dated February 26, 2010, by and between Xi’an Xilan
      Natural Gas Co. Ltd. and Xi’an Branch Shanghai Pudong Development
      Bank.10.3*
            
            Contract
      of Guarantee dated February 26, 2010, by and between Xi’an Xilan Natural
      Gas Co. Ltd. and Xi’an Branch Shanghai Pudong Development
      Bank.31.1*
            
            Certification
      of Principal Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a),
      promulgated under the Securities and Exchange Act of 1934, as
      amended31.2*
            
            Certification
      of Principal Financial Officer pursuant to Rule 13a-14 and Rule 15d 14(a),
      promulgated under the Securities and Exchange Act of 1934, as
      amended32.1*
            
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Executive
Officer)32.2*
            
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Financial
  Officer)







*  
Filed herewith




55




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.August
      13, 2010
            By:
            /s/
      Qinan JiQinan
      JiChief
      Executive Officer(Principal
      Executive Officer)





August
      13, 2010
            By:
            /s/
      David SheDavid
      SheChief
      Financial Officer(Principal
      Financial and Accounting Officer)




56