SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-K




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


For the
fiscal year ended    December
31, 2008


or


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


For the transition period
from________________________to__________________________


Commission file number:
1-31398





NATURAL GAS SERVICES GROUP,
INC.


(Exact
Name of Registrant as Specified in its Charter)





Colorado
            
            75-2811855(State
      or other jurisdiction of incorporation or
              organization)
            
            (I.R.S.  Employer
      Identification No.)508
      W. Wall St, Suite 550 Midland, Texas
            
            79701(Address
      of principal executive offices)
            
            (Zip
      Code)Registrant’s
      telephone number, including area code:
            
            (432)
      262-2700Securities
      registered pursuant to Section 12(b) of the Act:Title
      of each class
            
            Name
      of each exchange on which registeredCommon
      Stock, $.01 par value
            
            New
      York Stock Exchange


Securities
registered pursuant to section 12(g) of the Act:  None.





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


Yes o                  No
þ





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.


Yes o                  No
þ





Indicate
by check mark whether the registrant:  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.


Yes þ                 No
o





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.[   ]





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


Large
Accelerated Filer  ̈Accelerated Filer þ     Non-Accelerated
Filer  ̈     Smaller
Reporting Company  ̈





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


Yes o                  No
þ





The
aggregate market value of voting and non-voting common equity held by
non-affiliates of the Registrant as of March 2, 2009 was approximately
$83,205,571, based on the closing price of the common stock on the same
date.





At March
2, 2009, there were 12,093,833 shares of common stock outstanding.





Documents
Incorporated by Reference


Certain
information called for in Items 10, 11, 12, 13 and 14 of Part III are
incorporated by reference from the registrant’s definitive proxy statement for
the annual meeting of shareholders to be held on June 16, 2009.







FORM
      10-KNATURAL
      GAS SERVICES GROUP, INC.TABLE OF CONTENTSItem
      No.
            PagePART IItem 1.
            Business
            1Item 1A.
            Risk
      Factors
            7Item 1B.
            Unresolved
      Staff Comments
            13Item 2.
            Properties
            14Item 3.
            Legal
      Proceedings
            14Item 4.
            Submission
      of Matters to a Vote of Security Holders
            14PART IIItem 5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
            15Item 6.
            Selected
      Financial Data
            17Item 7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            19Item 7A.
            Quantitative
      and Qualitative Disclosures About Market Risk
            29Item 8.
            Financial
      Statements and Supplementary Data
            30Item 9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            30Item 9A.
            Controls
      and Procedures
            30Item 9B.
            Other
      Information
            33PART IIIItem 10.
            Directors,
      Executive Officers and Corporate Governance
            33Item 11.
            Executive
      Compensation
            33Item 12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            33Item 13.
            Certain
      Relationships, and Related Transactions, and Director
      Independence
            33Item 14.
            Principal
      Accounting Fees and Services
            33PART IVItem 15.
            Exhibits,
      Financial Statement Schedules
            E-1





Table of Contents





SPECIAL
NOTE REGARDING FORWARD-LOOKING STATEMENTS




This
Annual Report on Form 10-K contains certain forward-looking statements, within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
information pertaining to us, our industry and the oil and natural gas industry
that is based on the beliefs of our management, as well as assumptions made by
and information currently available to our management.  All
statements, other than statements of historical facts contained in this Annual
Report on Form 10-K, including statements regarding our future financial
position, growth strategy, budgets, projected costs, plans and objectives of
management for future operations, are forward-looking statements.  We
use the words “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,”
“continue,” “intend,” “plan,” “budget” and other similar words to identify
forward-looking statements.  You should read statements that contain
these words carefully and should not place undue reliance on these statements
because they discuss future expectations, contain projections of results of
operations or of our financial condition and/or state other “forward-looking”
information.  We do not undertake any obligation to update or revise
publicly any forward-looking statements.  Although we believe our
expectations reflected in these forward-looking statements are based on
reasonable assumptions, no assurance can be given that these expectations or
assumptions will prove to have been correct.  Important factors that
could cause actual results to differ materially from the expectations reflected
in the forward-looking statements include, but are not limited to, the following
factors and the other factors described in this Annual Report on Form 10-K under
the caption “Risk Factors”:




·
            conditions
      in the oil and natural gas industry, including the demand for natural gas
      and wide fluctuations in the prices of oil and natural
  gas;




·
            competition
      among the various providers of compression services and
      products;




·
            changes
      in safety, health and environmental
regulations;




·
            changes
      in economic or political conditions in the markets in which we
      operate;




·
            failure
      of our customers to continue to rent equipment after expiration of the
      primary rental term;




·
            the
      inherent risks associated with our operations, such as equipment defects,
      malfunctions and natural disasters;




·
            our
      inability to comply with covenants in our debt agreements and the
      decreased financial flexibility associated with our substantial
      debt;




·
            future
      capital requirements and availability of
  financing;




·
            fabrication
      and manufacturing costs;




·
            general
      economic conditions;




·
            events
      similar to September 11, 2001; and




·
            fluctuations
      in interest rates.




We
believe that it is important to communicate our expectations of future
performance to our investors.  However, events may occur in the future
that we are unable to accurately predict or that we are unable to
control.  When considering our forward-looking statements, you
should keep in mind the risk factors and other cautionary statements in
this Annual Report on Form 10-K.





Table of Contents




PART I


ITEM 1.      BUSINESS





Unless
the context otherwise requires, references in this Annual Report on Form 10-K to
“Natural Gas Services Group,” the “Company”, “we,” “us,” “our” or “ours” refer
to Natural Gas Services Group, Inc.  Certain specialized terms used in
describing our natural gas compressor business are defined in "Glossary of
Industry Terms" on page 6.





The
Company





We are a
leading provider of small to medium horsepower compression equipment to the
natural gas industry.  We focus primarily on the non-conventional
natural gas production business in the United States (such as coalbed methane,
gas shales and tight gas), which, according to data from the Energy Information
Administration, is the single largest and fastest growing segment of U.S. gas
production.  We manufacture, fabricate and rent natural gas
compressors that enhance the production of natural gas wells and provide
maintenance services for those compressors.  In addition, we sell
custom fabricated natural gas compressors to meet customer specifications
dictated by well pressures, production characteristics and particular
applications.  We also manufacture and sell flare systems for oil and
gas plant and production facilities.





The vast
majority of our rental operations are in non-conventional natural gas regions,
which typically have lower initial reservoir pressures and faster well decline
rates.  These areas usually require compression to be installed sooner
and with greater frequency.





We were
incorporated in Colorado on December 17, 1998





Historically,
the majority of our revenue has been derived from our compressor rental
business.  In January 2005, we acquired Screw Compression Systems,
Inc., or “SCS,” which predominantly focused on the custom fabrication sales
business.  By acquiring SCS, we increased our fabrication facilities
by over 91,000 square feet.  We have primarily used this additional
space for SCS’ core business of custom fabrication but have from time to time
fabricated a minimal number of rental units.  On June 30, 2007, we
merged SCS into Natural Gas Services Group, Inc.





Natural
gas compressors are used in a number of applications for the production and
enhancement of gas wells and in gas transportation lines and processing
plants.  Compression equipment is often required to boost a well’s
production to economically viable levels and enable gas to continue to flow in
the pipeline to its destination.





We
increased our revenue to $85.3 million in 2008 from $10.3 million in 2002, the
year we completed our initial public offering.  During the same
period, income from operations increased to $24.6 million from $1.8
million.  Our compressor rental fleet has grown from 302 compressors
at the end of 2002 to 1,730 compressors at December 31, 2008.





Net
income for the year ended December 31, 2008 increased 27.0% to $15.6 million
($1.28 per diluted share), as compared to $12.3 million ($1.01 per diluted
share) for the year ended December 31, 2007.





At
December 31, 2008, current assets were $47.0 million, which included $1.1
million of cash and $2.3 million in short-term investments.  Current
liabilities were $15.9 million, and long-term debt, net of current portion, was
$6.2 million.  Our stockholders' equity as of December 31,
2008 was $130.5 million.





We
maintain our principal offices at 508 W. Wall St., Suite 550, Midland,
Texas 79701 and our telephone number is (432) 262-2700.  Our
website is located at http://www.ngsgi.com.  The
information on or that can be accessed through our website is not part of this
Annual Report on Form 10-K.





Industry
Trends





Natural
gas prices historically have been volatile, and this volatility is expected to
continue.  Uncertainty continues to exist as to the direction of
future United States and worldwide natural gas and crude oil price
trends.  We believe that natural gas is a more environmentally
friendly source of energy which is likely to result in increases in
demand.  Being primarily a provider of services and equipment to
natural gas producers, we are more significantly impacted by changes in natural
gas prices than by changes in crude oil and condensate prices.  Longer
term natural gas prices will be determined by the supply and demand for natural
gas as well as the prices of competing fuels, such as oil and coal.





We
believe part of the growth of the rental compression capacity in the U.S. market
has been driven by the trend toward outsourcing by energy producers and
processors.  Renting does not require the purchaser to make large
capital expenditures for new equipment or to obtain financing through a lending
institution.  This allows the customer’s capital to be used for
additional exploration and production of natural gas and oil.





1
 Table of Contents





We
believe that there will continue to be a growing demand for natural
gas.  We expect demand for our products and services to continue to
rise as a result of:





·
            the
      increasing demand for and limited supply of energy, both domestically and
      abroad;





·
            continued
      non-conventional gas exploration and
production;





·
            environmental
      considerations which provide strong incentives to use natural gas in place
      of other carbon fuels;





·
            the
      cost savings of using natural gas rather than electricity for heat
      generation;





·
            implementation
      of international environmental and conservation
  laws;





·
            the
      aging of producing natural gas reserves worldwide;
  and





·
            the
      extensive supply of undeveloped natural gas
  reserves.





Our
Operating Units





We
identify our segments based upon major revenue sources as Gas Compressor Rental,
Engineered Equipment Sales, Service and Maintenance and
Corporate.  Please refer to Footnote 11 on page F-16 of the Notes to
Consolidated Financial Statements.





Gas Compressor
Rental.Our rental business is primarily focused on
non-conventional gas production.  We provide rental of small to medium
horsepower compression equipment to customers under contracts typically having
minimum initial terms of six to 24 months.  Historically, in our
experience, most customers retain the equipment beyond the expiration of
the initial term.  By outsourcing their compression needs, we believe
our customers are able to increase their revenues by producing a higher volume
of natural gas due to greater equipment run-time.  Outsourcing also
allows our customers to reduce their compressor downtime, operating and
maintenance costs and capital investments and more efficiently meet their
changing compression needs.  As of December 31, 2008, the utilization
rate of our rental fleet was 84.9%.





The size,
type and geographic diversity of our rental fleet enables us to provide our
customers with a range of compression units that can serve a wide variety of
applications, and to select the correct equipment for the job, rather than the
customer trying to fit the job to its own equipment.  We base our gas
compressor rental rates on several factors, including the cost and size of the
equipment, the type and complexity of service desired by the customer, the
length of contract and the inclusion of any other services desired, such as
rental, installation, transportation and daily operation.





As of
December 31, 2008, we had 1,730 natural gas compressors in our rental fleet
totaling approximately 217,085 horsepower, as compared to 1,353 natural gas
compressors totaling approximately 160,733 horsepower at December 31,
2007.  As of December 31, 2008, we had 1,469 natural gas compressors
totaling approximately 184,831 horsepower rented to 112 third parties, compared
to 1,194 natural gas compressors totaling approximately 140,853 horsepower
rented to 94 third parties at December 31, 2007.





Engineered
Equipment Sales.  This segment includes the following
components:





·
            Compressor
      fabrication.Fabrication involves the assembly of
      compressor components manufactured by us or other third parties into
      compressor units that are ready for rental or sale.  In addition
      to fabricating compressors for our rental fleet, we engineer and fabricate
      natural gas compressors for sale to customers to meet their specifications
      based on well pressure, production characteristics and the particular
      applications for which compression is
sought.





·
            Compressor
      manufacturing.We design and manufacture our own
      proprietary line of reciprocating compressor frames, cylinders and parts
      known as our “CiP”, or Cylinder-in-Plane, product line.  We use
      the finished components to fabricate compressor units for our rental fleet
      or for sale to third parties.  We also sell finished components
      to other fabricators.





·
            Flare
      fabrication.We design, fabricate, sell, install and
      service flare stacks and related ignition and control devices for the
      onshore and offshore incineration of gas compounds such as hydrogen
      sulfide, carbon dioxide, natural gas and liquefied petroleum
      gases.  Applications for this equipment are often
      environmentally and regulatory driven, and we believe we are a leading
      supplier to this market.




2
 Table of Contents




·
            Parts sales
      and compressor rebuilds.To provide customer support for
      our compressor and flare sales businesses, we stock varying levels of
      replacement parts at our Midland, Texas facility and at field service
      locations.  We also provide an exchange and rebuild program for
      screw compressors and maintain an inventory of new and used compressors to
      facilitate this part of our
business.





Service and
Maintenance.We service and maintain compressors owned by our
customers on an “as needed” basis.  Natural gas compressors require
routine maintenance and periodic refurbishing to prolong their useful
life.  Routine maintenance includes physical and visual inspections
and other parametric checks that indicate a change in the condition of the
compressors.  We perform wear-particle analysis on all packages and
perform overhauls on a condition-based interval or a time-based
schedule.  Based on our past experience, these maintenance procedures
maximize component life and unit availability and minimize
downtime.





Business
Strategy





Our
intentions to grow our revenue and profitability are based on the following
business strategies:





·
            Expand
      rental
      fleet.We intend
      to increase the size of our rental fleet by fabricating compressor units
      in numbers that correspond to the growth of the market and in relation to
      market share gains we may experience.  We believe our growth
      will continue to be primarily driven through our placement of small to
      medium horsepower wellhead natural gas compressors for non-conventional
      natural gas production, which is the single largest and fastest growing
      segment of U.S. gas production according to data from the Energy
      Information Administration.





·
            Geographicexpansion.We
      will continue to consolidate our operations in existing areas, as well as
      pursue focused expansion into new geographic regions as opportunities are
      identified.





·
            Expand our‘secondary’product
      lines.In addition to our primary rental and engineered
      product business lines, we will emphasize the growth of our other
      products, e.g., flares, CiP compressor products and general compressor
      maintenance and repair services.




·
            Selectively pursue acquisitions.We will continue to evaluate potential
      acquisitions that would provide us withaccess to new markets or enhance
      our currentmarket
  position.







Competitive
Strengths





We
believe our competitive strengths include:





·
            Superior
      customer service.Our emphasis on the small to medium
      horsepower markets has enabled us to effectively meet the evolving needs
      of our customers.  We believe these markets have been
      under-serviced by our larger competitors which, coupled with our
      personalized services and in-depth knowledge of our customers’
      operating needs and growth plans, have allowed us to enhance our
      relationships with existing customers as well as attract new
      customers.  The size, type and geographic diversity of our
      rental fleet enable us to provide customers with a range of compression
      units that can serve a wide variety of applications.  We are
      able to select the correct equipment for the job, rather than the customer
      trying to fit its application to our
equipment.





·
            Diversified
      product line.Our compressors are available as high and
      low pressure rotary screw and reciprocating packages.  They are
      designed to meet a number of applications, including wellhead production,
      natural gas gathering, natural gas transmission, vapor recovery and gas
      and plunger lift.  In addition, our compressors can be built to
      handle a variety of gas mixtures, including air, nitrogen, carbon dioxide,
      hydrogen sulfide and hydrocarbon gases.  A diversified product
      line helps us compete by being able to satisfy widely varying pressure,
      volume and production conditions that customers
  encounter.





·
            Purpose
      built rental compressors.Our rental compressor packages
      have been designed and built to address the primary requirements of our
      customers in the producing regions in which we operate.  Our
      units are compact in design and are easy, quick and inexpensive to move,
      install and start-up.  Our control systems are technically
      advanced and allow the operator to start and stop our units remotely
      and/or in accordance with well conditions.  We believe our
      rental fleet is also one of the newest with an average age of less than
      four years old.





·
            Experienced
      management team.On average, our executive and operating
      management team has over 30 years of oilfield services industry
      experience.  We believe our management team has successfully
      demonstrated its ability to grow our business both organically and through
      selective acquisitions.





3
 Table of Contents




·
            Broad
      geographic presence.We presently provide our products
      and services to a customer base of oil and natural gas exploration and
      production companies operating in New Mexico, Texas, Michigan, Colorado,
      Wyoming, Utah, Oklahoma, Pennsylvania, West Virginia and
      Kansas.  Our footprint allows us to service many of the natural
      gas producing regions in the United States.  We believe that
      operating in diverse geographic regions allows us better utilization of
      our compressors, minimal incremental expenses, operating synergies,
      volume-based purchasing, leveraged inventories and cross-trained
      personnel.





·
            Long-standing
      customer
      relationships.We have developed long-standing
      relationships providing compression equipment to many major and
      independent oil and natural gas companies.  Our customers
      generally continue to rent our compressors after the expiration of the
      initial terms of our rental agreements, which we believe reflects their
      satisfaction with the reliability and performance of our services and
      products.





Major
Customers





Sales and
rental income to XTO Energy, Inc. and Energen Resources Corporation in the year
ended December 31, 2006 amounted to 39% and 12% of consolidated revenue,
respectively.  Sales and rental income to XTO Energy, Inc. and Devon
Energy, Inc. in the year ended December 31, 2007 amounted to 40% and 12% of
consolidated revenue, respectively.  Sales and rental income to XTO
Energy, Inc. and Devon Energy, Inc. in the year ended December 31, 2008 amounted
to 26% and 14% of consolidated revenue, respectively.  No other single
customer accounted for more than 10% of our revenues in 2006, 2007 or
2008.  XTO Energy, Inc. amounted to 64% and 35% of our consolidated
accounts receivable as of December 31, 2007 and 2008, respectively, and Equipos
y Sistemas Dinamicos amounted to 14% of our consolidated accounts receivable as
of December 31, 2008.  No other customer amounted to more than 10% of
our consolidated accounts receivable as of December 31, 2007 and
2008.  The loss of any one or more of the above customers could have a
material adverse effect on our business, consolidated financial condition,
results of operations and cash flows, depending upon the demand for our
compressors at the time of such loss and our ability to attract new
customers.





Sales
and Marketing





Our sales
force pursues the rental and sales market for compressors and flare equipment
and other services in their respective territories.  Additionally, our
personnel coordinate with each other to develop relationships with customers who
operate in multiple regions.  Our sales and marketing strategy is
focused on communication with current customers and potential customers through
frequent direct contact, technical assistance, print literature, direct mail and
referrals.  Our sales and marketing personnel coordinate with our
operations personnel in order to promptly respond to and address customer
needs.  Our overall sales and marketing efforts concentrate on
demonstrating our commitment to enhancing the customer’s cash flow through
enhanced product design, fabrication, manufacturing, installation, customer
service and support.





Competition





We have a
number of competitors in the natural gas compression segment, some of which have
greater financial resources.  We believe that we compete effectively
on the basis of price, customer service, including the ability to place
personnel in remote locations, flexibility in meeting customer needs, and
quality and reliability of our compressors and related services.





Compressor
industry participants can achieve significant advantages through increased size
and geographic breadth.  As the number of rental compressors in our
rental fleet increases, the number of sales, support, and maintenance personnel
required and the minimum level of inventory do not increase
commensurately.





Backlog





As of
December 31, 2008, we had a sales backlog of approximately $18.0
million.  We expect to fulfill substantially all of the entire backlog
in 2009.  Sales backlog consists of firm customer orders for which a
purchase or work order has been received, satisfactory credit or a financing
arrangement exists, and delivery is scheduled.  Given the recent
dramatic downturn in oil and natural gas prices, there can be no assurance that
a significant number of the orders representing such backlog will not be
cancelled.  In addition, the major components of our compressors are
acquired from suppliers through periodic purchase orders that in many instances
require three or four months of lead time prior to delivery of the
order.  Thus, to the extent that we suffer an unusual number of order
cancellations after we have placed our component purchase orders, we may be left
with an excessive inventory of component parts.





Employees




As of
December 31, 2008, we had 309 total employees.  No employees are
represented by a labor union and we believe we have good relations with our
employees.




4
 Table of Contents





Liability
and Other Insurance Coverage




Our
equipment and services are provided to customers who are subject to hazards
inherent in the oil and gas industry, such as blowouts, explosions, craterings,
fires, and oil spills.  We maintain liability insurance that we
believe is customary in the industry and which includes environment cleanup, but
excludes product warranty insurance because the majority of components on our
compressor unit are covered by the manufacturers.  We also maintain
insurance with respect to our facilities.  Based on our historical
experience, we believe that our insurance coverage is
adequate.  However, there is a risk that our insurance may not be
sufficient to cover any particular loss or that insurance may not cover all
losses.  In addition, insurance rates have in the past been subject to
wide fluctuation, and changes in coverage could result in less coverage,
increases in cost or higher deductibles and retentions.




Government
Regulation




All of
our operations and facilities are subject to numerous federal, state, foreign
and local laws, rules and regulations related to various aspects of our
business, including containment and disposal of hazardous materials, oilfield
waste, other waste materials and acids.




To date,
we have not been required to expend significant resources in order to satisfy
applicable environmental laws and regulations.  We do not anticipate
any material capital expenditures for environmental control facilities or
extraordinary expenditures to comply with environmental rules and
regulations in the foreseeable future.  However, compliance costs
under existing laws or under any new requirements could become material and we
could incur liabilities for noncompliance.




Our
business is generally affected by political developments and by federal, state,
foreign and local laws and regulations, which relate to the oil and natural gas
industry.  The adoption of laws and regulations affecting the oil and
natural gas industry for economic, environmental and other policy reasons could
increase our costs and could have an adverse effect on our
operations.  The state and federal environmental laws and regulations
that currently apply to our operations could become more stringent in the
future.




We have
utilized operating and disposal practices that were or are currently standard in
the industry.  However, materials such as solvents, thinner, waste
paint, waste oil, wash down waters and sandblast material may have been disposed
of or released in or under properties currently or formerly owned or
operated by us or our predecessors.  In addition, some of these
properties have been operated by third parties over whom we have no control
either as to such entities' treatment of materials or the manner in which such
materials may have been disposed of or released.




The
federal Comprehensive Environmental Response Compensation and Liability Act of
1980, commonly known as CERCLA, and comparable state statutes impose strict
liability on:




·
            owners
      and operators of sites,




·
            persons
      who disposed of or arranged for the disposal of "hazardous substances"
      found at sites.




The
federal Resource Conservation and Recovery Act and comparable state statutes
govern the disposal of "hazardous wastes." Although CERCLA currently excludes
certain materials from the definition of "hazardous substances," and the
Resource Conservation and Recovery Act also excludes certain materials from
regulation, such exemptions by Congress under both CERCLA and the Resource
Conservation and Recovery Act may be deleted, limited or modified in the
future.  We could become subject to requirements to remove and
remediate previously disposed of materials (including materials disposed of or
released by prior owners or operators) from properties.




The
federal Water Pollution Control Act and the Oil Pollution Act of 1990 and
implementing regulations govern:




·
            the
      prevention of discharges, including oil and produced water spills,
      and




·
            liability
      for drainage into waters.





Our
operations are also subject to federal, state, and local regulations for the
control of air emissions.  The federal Clean Air Act and various state
and local laws impose on us certain air quality
requirements.  Amendments to the Clean Air Act revised the definition
of "major source" such that emissions from both wellhead and associated
equipment involved in oil and natural gas production may be added to determine
if a source is a "major source." As a consequence, more facilities may become
major sources and thus may require us to make increased compliance
expenditures.




5
 Table of Contents




We
believe that our existing environmental control procedures are adequate and that
we are in substantial compliance with environmental laws and regulations, and
the phasing in of emission controls and other known regulatory requirements
should not have a material adverse affect on our financial condition or
operational results.  However, it is possible that future
developments, such as new or increasingly strict requirements and environmental
laws and enforcement policies thereunder, could lead to material costs of
environmental compliance by us.  While we may be able to pass on the
additional cost of complying with such laws to our customers, there can be no
assurance that attempts to do so will be successful.  Some risk of
environmental liability and other costs are inherent in the nature of our
business, however, and there can be no assurance that environmental costs will
not rise.





Patents,
Trademarks and Other Intellectual Property




We
believe that the success of our business depends more on the technical
competence, creativity and marketing abilities of our employees than on any
individual patent, trademark, or copyright.  Nevertheless, as part of
our ongoing research, development and manufacturing activities, we may seek
patents when appropriate on inventions concerning new products and product
improvements.  We currently own one United States patent covering
certain flare system technologies, which will expire in January
2010.  We do not own any foreign patents.  Although we
continue to use the patented technology and consider it useful in certain
applications, we do not consider this patent to be material to our business as a
whole.




Suppliers
and Raw Materials




Fabrication
of our rental compressors involves the purchase by us of engines, compressors,
coolers and other components, and the assembly of these components on skids for
delivery to customer locations.  These major components of our
compressors are acquired through periodic purchase orders placed with
third-party suppliers on an "as needed" basis, which typically requires a three
to four month lead time with delivery dates scheduled to coincide with our
estimated production schedules.  Although we do not have formal
continuing supply contracts with any major supplier, we believe we have adequate
alternative sources available.  In the past, we have not experienced
any sudden and dramatic increases in the prices of the major components for our
compressors.  However, the occurrence of such an event could have a
material adverse effect on the results of our operations and financial
condition, particularly if we were unable to increase our rental rates and sale
prices proportionate to any such component price increases.





Glossary
of Industry Terms




"coalbed
methane" – A natural gas generated during coal formation and provided from coal
seams or adjacent sandstones.




"gas
shales" – Fine grained rocks where the predominant gas storage mechanism is
sorption and gas is stored in volumes that are potentially
economic.




"reciprocating
compressors" – A reciprocating compressor is a type of compressor which
compresses vapor by using a piston in a cylinder and a back-and-forth
motion.




"screw
compressors" – A type of compressor used in vapor compression where two
intermesh rotors create pockets of continuously decreasing volume, in which the
vapor is compressed and its pressure is increased.




"tight
gas" – A gas bearing sandstone or carbonate matrix (which may or may not contain
natural fractures) which exhibits a low-permeability (tight)
reservoir.




6
 Table of Contents





ITEM
1A.               RISK
FACTORS




You
should carefully consider the following risks associated with owning our common
stock.  If any of the following risks actually occur, our business,
financial condition or results of operations would likely suffer.  If
this occurs, the trading price of our common stock could decline, and you could
lose all or part of your investment in our common stock.  Although the
risks described below are the risks that we believe are material, they are not
the only risks relating to our industry, our business and our common
stock.  Additional risks and uncertainties, including those that are
not yet identified or that we currently believe are immaterial, may also
adversely affect our business, financial condition or results of
operations.





Risks
Associated With Our Industry





Decreased
oil and natural gas prices and oil and gas industry expenditure levels could
adversely affect our revenue.





Our
revenue is derived from expenditures in the oil and natural gas industry, which,
in turn, are based on budgets to explore for, develop and produce oil and
natural gas.  If these expenditures decline, our revenue will
suffer.  The industry’s willingness to explore for, develop and
produce oil and natural gas depends largely upon the prevailing view of future
oil and natural gas prices.  Prices for oil and gas historically have
been, and are likely to continue to be, highly volatile.  Many factors
affect the supply and demand for oil and natural gas and, therefore, influence
oil and natural gas prices, including:





·
            the
      level of oil and natural gas
production;





·
            the
      level of oil and natural gas
inventories;





·
            domestic
      and worldwide demand for oil and natural
gas;





·
            the
      expected cost of developing new
reserves;





·
            the
      cost of producing oil and natural
gas;





·
            the
      level of drilling and completions
activity;





·
            inclement
      weather;





·
            domestic
      and worldwide economic activity;





·
            regulatory
      and other federal and state requirements in the United
    States;





·
            the
      ability of the Organization of Petroleum Exporting Countries and other
      large producers to set and maintain production levels and prices for
      oil;





·
            political
      conditions in or affecting oil and natural gas producing
      countries;





·
            terrorist
      activities in the United States and
elsewhere;





·
            the
      cost of developing alternate energy
sources;





·
            environmental
      regulation; and





·
            tax
      policies.





Depending
on the market prices of oil and natural gas, companies exploring for oil and
natural gas may cancel or curtail their drilling programs, thereby reducing
demand for our equipment and services.  Our rental contracts are
generally short-term, and oil and natural gas companies tend to respond quickly
to upward or downward changes in prices.  Any reduction in drilling
and production activities may materially erode both pricing and utilization
rates for our equipment and services and adversely affects our financial
results.  As a result, we may suffer losses, be unable to make
necessary capital expenditures and be unable to meet our financial
obligations.




7
 Table of Contents





The
intense competition in our industry could result in reduced profitability and
loss of market share for us.





In our
business segments, we compete with the oil and natural gas industry’s largest
equipment and service providers who have greater name recognition than we
do.  These companies also have substantially greater financial
resources, larger operations and greater budgets for marketing, research and
development than we do.  They may be better able to compete because of
their broader geographic dispersion and ability to take advantage of
international opportunities, the greater number of compressors in their fleet or
their product and service diversity.  As a result, we could lose
customers and market share to those competitors.  These companies may
also be better positioned than us to successfully endure downturns in the oil
and natural gas industry.





Our
operations may be adversely affected if our current competitors or new market
entrants introduce new products or services with better prices, features,
performance or other competitive characteristics than our products and
services.  Competitive pressures or other factors also may result in
significant price competition that could harm our revenue and our
business.  Additionally, we may face competition in our efforts to
acquire other businesses.





Our
industry is highly cyclical, and our results of operations may be
volatile.





Our
industry is highly cyclical, with periods of high demand and high pricing
followed by periods of low demand and low pricing.  Periods of low
demand intensify the competition in the industry and often result in rental
equipment being idle for long periods of time.  We may be required to
enter into lower rate rental contracts in response to market conditions, and our
sales may decrease as a result of such conditions.





Due to
the short-term nature of most of our rental contracts, changes in market
conditions can quickly affect our business.  As a result of the
cyclicality of our industry, our results of operations may be volatile in the
future.





We
are subject to extensive environmental laws and regulations that could require
us to take costly compliance actions that could harm our financial
condition.





Our
fabrication and maintenance operations are significantly affected by stringent
and complex federal, state and local laws and regulations governing the
discharge of substances into the environment or otherwise relating to
environmental protection.  In these operations, we generate and manage
hazardous wastes such as solvents, thinner, waste paint, waste oil, wash down
wastes, and sandblast material.  We attempt to use generally accepted
operating and disposal practices and, with respect to acquisitions, will attempt
to identify and assess whether there is any environmental risk before completing
an acquisition.  Based on the nature of the industry, however,
hydrocarbons or other wastes may have been disposed of or released on or under
properties owned or leased by us or on or under other locations where such
wastes have been taken for disposal.  The waste on these properties
may be subject to federal or state environmental laws that could require us to
remove the wastes or remediate sites where they have been
released.  We could be exposed to liability for cleanup costs, natural
resource and other damages as a result of our conduct or the conduct of, or
conditions caused by, prior owners, lessees or other third
parties.  Environmental laws and regulations have changed in the past,
and they are likely to change in the future.  If current existing
regulatory requirements or enforcement policies change, we may be required to
make significant unanticipated capital and operating expenditures.





Any
failure by us to comply with applicable environmental laws and regulations may
result in governmental authorities taking actions against our business that
could harm our operations and financial condition, including the:





·
            issuance
      of administrative, civil and criminal
penalties;





·
            denial
      or revocation of permits or other
  authorizations;





·
            reduction
      or cessation in operations; and





·
            performance
      of site investigatory, remedial or other corrective
    actions.





Risks
Associated With Our Company





We
might be unable to employ qualified technical personnel, which could hamper our
plans for expansion or increase our costs.





Many of
the compressors that we sell or rent are mechanically complex and often must
perform in harsh conditions.  We believe that our success depends upon
our ability to employ and retain a sufficient number of technical personnel who
have the ability to design, utilize, enhance and maintain these
compressors.  Our ability to expand our operations depends in part on
our ability to increase our skilled labor force.  The demand for
skilled workers is high and supply is limited.  A significant increase
in the wages paid by competing employers could result in a reduction of our
skilled labor force or cause an increase in the wage rates that we must pay or
both.  If either of these events were to occur, our cost structure
could increase and our operations and growth potential could be
impaired.





8
 Table of Contents


We
could be subject to substantial liability claims that could harm our financial
condition.





Our
products are used in hazardous drilling and production applications where an
accident or a failure of a product can cause personal injury, loss of life,
damage to property, equipment or the environment, or suspension of
operations.





While we
maintain insurance coverage, we face the following risks under our insurance
coverage:





·
            we
      may not be able to continue to obtain insurance on commercially reasonable
      terms;





·
            we
      may be faced with types of liabilities that will not be covered by our
      insurance, such as damages from significant product liabilities and from
      environmental contamination;





·
            the
      dollar amount of any liabilities may exceed our policy limits;
      and





·
            we
      do not maintain coverage against the risk of interruption of our
      business.





Any
claims made under our policies will likely cause our premiums to
increase.  Any future damages caused by our products or services that
are not covered by insurance, are in excess of policy limits or are subject to
substantial deductibles, would reduce our earnings and our cash available for
operations.





We
will require a substantial amount of capital to expand our compressor rental
fleet and grow our business.





During
2009, capital expenditures related to rental compression equipment will be
determined primarily by the activity of our customers, and we do not anticipate
that demand exceeding what we can fund with internally generated
funds.  The amount and timing of any of these capital expenditures may
vary depending on a variety of factors, including the level of activity in the
oil and natural gas exploration and production industry and the presence of
alternative uses for our capital, including any acquisitions that we may
pursue.





Historically,
we have funded our capital expenditures through internally generated funds,
borrowings under bank credit facilities and the proceeds of equity
financings.  Although we believe that cash flows from our operations
will provide us with sufficient cash to fund our planned capital expenditures
for 2009, we cannot assure you that these sources will be
sufficient.  We may require additional capital to fund any
unanticipated capital expenditures, including any acquisitions, and to fund
our growth beyond 2009, and necessary capital may not be available to us when we
need it or on acceptable terms.  Our ability to raise additional
capital will depend on the results of our operations and the status of various
capital and industry markets at the time we seek such
capital.  Failure to generate sufficient cash flow, together with the
absence of alternative sources of capital, could have a material adverse effect
on our business, consolidated financial condition, results of operations or cash
flows.





Our
current debt level may negatively impact our current and future financial
stability.





As of
December 31, 2008, we had an aggregate of approximately $17.0 million of
outstanding indebtedness, and accounts payable and accrued expenses of
approximately $12.4 million.  As a result of our significant
indebtedness, we might not have the ability to incur any substantial additional
indebtedness.  The level of our indebtedness could have several
important effects on our future operations, including:





·
            our
      ability to obtain additional financing for working capital, acquisitions,
      capital expenditures and other purposes may be
  limited;





·
            a
      significant portion of our cash flow from operations may be dedicated to
      the payment of principal and interest on our debt, thereby reducing funds
      available for other purposes; and





·
            our
      significant leverage could make us more vulnerable to economic
      downturns.





If
we are unable to service our debt, we will likely be forced to take remedial
steps that are contrary to our business plan.





As of
December 31, 2008, our principal payments for our debt service requirements were
approximately $282 thousand on a monthly basis; $845 thousand on a quarterly
basis; and $3.4 million on an annual basis.  It is possible that
our business will not generate sufficient cash flow from operations to meet our
debt service requirements and the payment of principal when due.  If
this were to occur, we may be forced to:





·
            sell
      assets at disadvantageous prices;





·
            obtain
      additional financing; or





·
            refinance
      all or a portion of our indebtedness on terms that may be less favorable
      to us.


9
 Table of Contents





Our
current bank loan agreement contains covenants that limit our operating and
financial flexibility and, if breached, could expose us to severe remedial
provisions.





Under the
terms of our loan agreement, we must:





·
            comply
      with a minimum current ratio;





·
            maintain
      minimum levels of tangible net
worth;





·
            not
      exceed specified levels of debt;





·
            comply
      with a debt service coverage ratio;
and





·
            comply
      with a debt to tangible net worth
ratio.





Our
ability to meet the financial ratios and tests under our bank loan agreement can
be affected by events beyond our control, and we may not be able to satisfy
those ratios and tests.  A breach of any one of these covenants could
permit the bank to accelerate the debt so that it is immediately due and
payable.  If a breach occurred, no further borrowings would be
available under our loan agreement.  If we were unable to repay
the debt, the bank could proceed against and foreclose on our assets,
substantially all of which have been pledged as collateral to secure payment of
our indebtedness.





If
we fail to acquire or successfully integrate additional businesses, our growth
may be limited and our results of operations may suffer.





As part
of our business strategy, we intend to evaluate potential acquisitions of other
businesses or assets.  However, there can be no assurance that we will
be successful in consummating any such acquisitions.  Successful
acquisition of businesses or assets will depend on various factors, including,
but not limited to, our ability to obtain financing and the competitive
environment for acquisitions.  In addition, we may not be able to
successfully integrate any businesses or assets that we acquire in the
future.  The integration of acquired businesses is likely to be
complex and time consuming and place a significant strain on management and may
disrupt our business.  We also may be adversely impacted by any
unknown liabilities of acquired businesses, including environmental
liabilities.  We may encounter substantial difficulties, costs and
delays involved in integrating common accounting, information and communication
systems, operating procedures, internal controls and human resources practices,
including incompatibility of business cultures and the loss of key employees and
customers.  These difficulties may reduce our ability to gain
customers or retain existing customers, and may increase operating expenses,
resulting in reduced revenues and income and a failure to realize the
anticipated benefits of acquisitions.





As
of December 31, 2008, a significant majority of our compressor rentals were for
terms of six months or less which, if terminated or not renewed, would adversely
impact our revenue and our ability to recover our initial equipment
costs.





The
length of our compressor rental agreements with our customers varies based on
customer needs, equipment configurations and geographic area.  In most
cases, under currently prevailing rental rates, the initial rental periods are
not long enough to enable us to fully recoup the average cost of acquiring or
fabricating the equipment.  We cannot be sure that a substantial
number of our customers will continue to renew their rental agreements or that
we will be able to re-rent the equipment to new customers or that any renewals
or re-rentals will be at comparable rental rates.  The inability to
timely renew or re-rent a substantial portion of our compressor rental fleet
would have a material adverse effect upon our business, consolidated financial
condition, results of operations and cash flows.





The
loss of one or more of our current customers could adversely affect our results
of operations.





Our
business is dependent not only on securing new customers but also on maintaining
current customers.  We had two customers that accounted for
approximately 26% and 14% of our consolidated revenue for the year ended
December 31, 2008, and approximately 40% and 12% of our consolidated revenue for
the year ended December 31, 2007.  Unless we are able to retain our
existing customers, or secure new customers if we lose one or more of our
significant customers, our revenue and results of operations would be adversely
affected.




10
 Table of Contents




Excessive
cancellations of backlog orders may have a material adverse effect on our
operations.





As of
December 31, 2008, we had a sales backlog of approximately $18.0
million.  Given the recent dramatic downturn in oil and natural gas
prices, we may experience a significant number of order cancellations by our
customers as they cut back their operations or encounter financial
difficulties.  Cancellations of a significant amount of sales backlog
could have a material negative impact on our results of
operations.  In addition, the major components of our compressors are
acquired from suppliers through periodic purchase orders that in many instances
require three to four months of lead time prior to delivery of the
order.  Thus, to the extent that we suffer an unusual number or order
cancellations after we have placed our component purchase orders, we could be
left with an excessive inventory of components which would negatively impact our
financial condition and results of operations.





Loss
of key members of our management could adversely affect our
business.





We depend
on the continued employment and performance of key members of our executive and
senior management team.  If any of our key managers resign or become
unable to continue in his present role and is not adequately replaced, our
business operations could be materially adversely affected.  We do not
carry any key-man insurance on any of our officers or directors.





Failure
to effectively manage our growth and expansion could adversely affect our
business and operating results and our internal controls.





We have
rapidly and significantly expanded our operations in recent years and anticipate
that our growth will continue if we are able to execute our
strategy.  Our rapid growth has placed significant strain on our
management and other resources which, given our expected future growth rate, is
likely to continue.  To manage our future growth, we must be able to,
among other things:





·
            accurately
      assess the number of additional officers and employees we will require and
      the areas in which they will be
required;





·
            attract,
      hire and retain additional highly skilled and motivated officers and
      employees;





·
            train
      and manage our work force in a timely and effective
  manner;





·
            upgrade
      and expand our office infrastructure so that it is appropriate for our
      level of activity; and





·
            improve
      our financial and management controls, reporting systems and
      procedures.





Liability
to customers under warranties may materially and adversely affect our
earnings.





We
provide warranties as to the proper operation and conformance to specifications
of the equipment we manufacture.  Our equipment is complex and often
deployed in harsh environments.  Failure of this equipment to operate
properly or to meet specifications may increase our costs by requiring
additional engineering resources and services, replacement of parts and
equipment or monetary reimbursement to a customer.  We have in the
past received warranty claims and we expect to continue to receive them in the
future.  To the extent that we incur substantial warranty claims in
any period, our reputation, our ability to obtain future business and our
earnings could be materially and adversely affected.





Failure
to maintain effective internal controls could have a material adverse effect on
our operations.





Section
404 of the Sarbanes-Oxley Act requires annual management assessments of the
effectiveness of our internal control over financial reporting.  If we
fail to maintain effective internal controls, we may not be able to ensure that
we can conclude on an ongoing basis that we have effective internal controls
over financial reporting in accordance with Section 404 of the Sarbanes-Oxley
Act.  Moreover, effective internal controls are necessary for us to
produce reliable financial reports and to help prevent financial
fraud.  If, as a result of deficiencies in our internal controls, we
cannot provide reliable financial reports or prevent fraud, our business
decision process may be adversely affected, our business and operating results
could be harmed, investors could lose confidence in our reported financial
information, and the price of our stock could decrease as a result.





We
must evaluate our intangible assets annually for impairment.





Our
intangible assets are recorded at cost less accumulated amortization and consist
of goodwill and patent costs and other identifiable intangibles.




11
 Table of Contents




We did
not indentify any impairment based on an independent valuation as of June 2006
and internal evaluations in December 2007 and 2008 of our reporting units with
goodwill and other identifiable intangibles.  Future impairment tests
could result in impairments of our intangible assets or goodwill.  We
expect to continue to amortize our intangible assets with finite lives over the
same time periods as previously used, and we will test our intangible assets
with indefinite lives for impairment at least once each year.  In
addition, we are required to assess the consumptive life, or longevity, of our
intangible assets with finite lives and adjust their amortization periods
accordingly.  Our net goodwill and intangible assets were recorded on
our balance sheet at approximately $13.4 million and $13.1 million as of
December 31, 2007 and 2008, respectively.  Our identifiable
intangibles are currently amortized at a rate of $299,000 per
year.  Any impairment in future periods of those assets, or a
reduction in their consumptive lives, could materially and adversely affect our
consolidated statements of income and financial position.





A
reduction in demand
for oil or natural gas or prices for those commodities and
credit marketscould adversely
affect our business.




Our
results of operations depend upon the level of activity in the energy market,
including natural gas development, production, processing and transportation.
Oil and natural gas prices and the level of drilling and exploration activity
can be volatile. For example, oil and natural gas exploration and development
activity and the number of well completions typically decline when there is a
significant reduction in oil and natural gas prices or significant instability
in energy markets. As a result, the demand for our natural gas compression
services could be adversely affected. A reduction in demand could also force us
to reduce our pricing substantially. Additionally, our customers’ production
from unconventional natural gas sources such as tight sands, shales and coalbeds
constitute the majority percentage of our business.  Such unconventional
sources are generally less economically feasible to produce in lower natural gas
price environments. These factors could in turn negatively impact the demand for
our products and services. A decline in demand for oil and natural gas or prices
for those commodities and credit markets could have a material adverse effect on
our business, financial condition, results of operations.





The erosion of
the financial condition of our customers could adversely affect our
business.




Many of
our customers finance their exploration and development activities through cash
flow from operations, the incurrence of debt or the issuance of equity. During
times when the oil or natural gas markets weaken, our customers are more likely
to experience a downturn in their financial condition. Many of our customers’
equity values have substantially declined in recent months, and the capital
markets have been unavailable as a source of financing to these customers. The
combination of a reduction in cash flow resulting from declines in commodity
prices, a reduction in borrowing bases under reserve-based credit facilities and
the lack of availability of debt or equity financing will result in a reduction
in our customers’ spending for our products and services in 2009. For example,
our customers could seek to preserve capital by canceling month-to-month
contracts, canceling or delaying scheduled maintenance of their existing natural
gas compression equipment or determining not to enter into any new natural gas
compression service contracts or purchase new compression
equipment.





Risks
Associated With Our Common Stock





The
price of our common stock may fluctuate which may cause our common stock to
trade at a substantially lower price than the price paid for our common
stock.





The
trading price of our common stock and the price at which we may sell securities
in the future is subject to substantial fluctuations in response to various
factors, including our ability to successfully accomplish our business strategy,
the trading volume of our stock, changes in governmental regulations, actual or
anticipated variations in our quarterly or annual financial results, our
involvement in litigation, general market conditions, the prices of oil and
natural gas, announcements by us and our competitors, our liquidity, our ability
to raise additional funds, and other events.





Future
sales of our common stock could adversely affect our stock price.





Substantial
sales of our common stock in the public market, or the perception by the market
that those sales could occur, may lower our stock price or make it difficult for
us to raise additional equity capital in the future.  These potential
sales could include sales of shares of our common stock by our Directors and
officers, who beneficially owned approximately 7.0% of the outstanding shares of
our common stock as of March 2, 2009.





If
securities analysts downgrade our stock or cease coverage of us, the price of
our stock could decline.





The
trading market for our common stock relies in part on the research and reports
that industry or financial analysts publish about us or our
business.  We do not control these analysts.  Furthermore,
there are many large, well-established, publicly traded companies active in our
industry and market, which may mean that it is less likely that we will receive
widespread analyst coverage.  If one or more of the analysts who do
cover us downgrade our stock, our stock price would likely decline
rapidly.  If one or more of these analysts cease coverage of our
company, we could lose visibility in the market, which in turn could cause our
stock price to decline.





12
 Table of Contents




If
we issue debt or equity securities, you may lose certain rights and be
diluted.





If we
raise funds in the future through the issuance of debt or equity securities, the
securities issued may have rights and preferences and privileges senior to those
of holders of our common stock, and the terms of the securities may impose
restrictions on our operations or dilute your ownership in Natural Gas Services
Group, Inc.





We
do not intend to pay, and have restrictions upon our ability to pay, dividends
on our common stock.





We have
not paid cash dividends in the past and do not intend to pay dividends on our
common stock in the foreseeable future.  Net income from our
operations, if any, will be used for the development of our business, including
capital expenditures, and to retire debt.  In addition, our bank loan
agreement contains restrictions on our ability to pay cash dividends on our
common stock.





We
have a comparatively low number of shares of common stock outstanding and,
therefore, our common stock may suffer from limited liquidity and its prices
will likely be volatile and its value may be adversely affected.





Because
of our relatively low number of outstanding shares of common stock, the trading
price of our common stock will likely be subject to significant price
fluctuations and limited liquidity.  This may adversely affect the
value of your investment.  In addition, our common stock price could
be subject to fluctuations in response to variations in quarterly operating
results, changes in management, future announcements concerning us, general
trends in the industry and other events or factors as well as those described
above.





Provisions
contained in our governing documents could hinder a change in control of
us.





Our
articles of incorporation and bylaws contain provisions that may discourage
acquisition bids and may limit the price investors are willing to pay for our
common stock.  Our articles of incorporation and bylaws provide
that:





·
            directors
      are elected for three-year terms, with approximately one-third of the
      board of directors standing for election each
  year;





·
            cumulative
      voting is not allowed, which limits the ability of minority shareholders
      to elect any directors;





·
            the
      unanimous vote of the board of directors or the affirmative vote of the
      holders of not less than 80% of the votes entitled to be cast by the
      holders of all shares entitled to vote in the election of directors is
      required to change the size of the board of directors;
  and





·
            directors
      may be removed only for cause and only by the holders of not less than 80%
      of the votes entitled to be cast on the
matter.





Our Board
of Directors has the authority to issue up to five million shares of preferred
stock.  The Board of Directors can fix the terms of the preferred
stock without any action on the part of our stockholders.  The
issuance of shares of preferred stock may delay or prevent a change in control
transaction.  In addition, preferred stock could be used in connection
with the Board of Directors’ adoption of a shareholders’ rights plan (also
known as a poison pill), which would make it much more difficult to effect a
change in control of our company through acquiring or controlling blocks of
stock.  Also, our directors and officers as a group will continue to
beneficially own stock and although this is not a majority of our stock, it
confers substantial voting power in the election of directors and management of
our company.  This would make it difficult for other minority
stockholders to effect a change in control or otherwise extend any significant
control over the management of our company.  This may adversely affect
the market price and interfere with the voting and other rights of our common
stock.





ITEM
1B.               UNRESOLVED
STAFF COMMENTS





We have
not received any written comments from the Staff of the Securities and Exchange
Commission that remain unresolved as of the date of this Report.





13
 Table of Contents


ITEM 2. PROPERTIES




The table
below describes the material facilities owned or leased by Natural Gas Services
Group as of December 31, 2008:




Location
            
            Status
            
            Square
              Feet
            
            UsesTulsa,
      Oklahoma
            
            Owned
      and Leased
            
            91,780
            
            Compressor
      fabrication, rental and servicesMidland,
      Texas
            
            Owned
            
            58,000
            
            Compressor
      fabrication, rental and servicesMidland,
      Texas (1)
            
            Owned
            
            24,600
            
            Compressor
      fabrication, rental and servicesLewiston,
      Michigan
            
            Owned
            
            15,360
            
            Compressor
      fabrication, rental and servicesMidland,
      Texas
            
            Leased
            
            13,135
            
            Corporate
      officesBloomfield,
      New Mexico
            
            Lease
            
            4,672
            
            Office
      and parts and servicesBridgeport,
      Texas
            
            Leased
            
            4,500
            
            Office
      and parts and servicesMidland,
      Texas
            
            Owned
            
            4,100
            
            Parts
      and services216,147







(1)           We
currently are not using this facility and have it listed for sale.





We
believe that our properties are generally well maintained and in good condition
and adequate for our purposes.





ITEM
3.                  LEGAL
PROCEEDINGS




From time
to time, we are a party to various legal proceedings in the ordinary course of
our business.  While management is unable to predict the ultimate
outcome of these actions, it believes that any ultimate liability arising from
these actions will not have a material effect on our consolidated financial
position, results of operations or cash flow.  Except as
discussed below, we are not currently a party to any bankruptcy, receivership,
reorganization, adjustment or similar proceeding, and we are not aware of any
other threatened litigation.





On
February 21, 2008, we received notice of a lawsuit filed against us on January
28, 2008 in Montmorency County, Michigan, 26th Circuit Court, Case No.
08-0001901-NZ, styled Dyanna Louise Williams, Plaintiff, v. Natural Gas Services
Group, Inc. and Great Lakes Compression, Defendants.  In this lawsuit,
plaintiff alleges breach of contract, breach of fiduciary duty and negligence.
Plaintiff seeks damages in the amount of $100,000 for lost insurance benefits
and an unspecified amount of exemplary damages. As the basis for her claims,
plaintiff generally alleges that she is the third party beneficiary of a life
insurance policy obtained by her deceased ex-husband through Natural Gas
Services Group's insurance program, and that as a result of Natural Gas Service
Group's negligence and failure to use due care in processing an application
for life insurance prior to her ex-husband's death, she was denied
$100,000 of life insurance proceeds. Plaintiff now seeks to recover
$100,000 from Natural Gas Services Group, plus an unspecified amount of
exemplary damages.  On January 21, 2009, we received the Order and
Judgment from the Court granting our Motion for Summary Judgment and dismissing
the Williams suit with prejudice.  This means that all claims are
dismissed and may not be reasserted.  We have not established a
reserve with respect to plaintiff’s claims.




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




We did
not submit any matters to a vote of our stockholders during the fourth quarter
of 2008.





14
 Table of Contents




PART II




ITEM 5.
            MARKET
      FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES




Our
common stock currently trades on the New York Stock Exchange under the symbol
“NGS”. Prior to October 30, 2008 our common stock traded on the American
Stock Exchange (AMEX). The following table sets forth for the periods
indicated the high and low sales prices for our common stock as reported by
these Exchanges.


2006
            
            Low
            
            
            HighFirst
      Quarter
            
            $
            16.57
            
            
            $
            22.80Second
      Quarter
            
            
            13.77
            
            
            
            18.00Third
      Quarter
            
            
            12.01
            
            
            
            16.69Fourth
      Quarter
            
            
            12.76
            
            
            
            16.432007First
      Quarter
            
            $
            11.68
            
            
            $
            15.00Second
      Quarter
            
            
            13.55
            
            
            
            19.90Third
      Quarter
            
            
            13.55
            
            
            
            18.81Fourth
      Quarter
            
            
            16.45
            
            
            
            19.612008First
      Quarter
            
            $
            16.63
            
            
            $
            23.35Second
      Quarter
            
            
            22.28
            
            
            
            32.56Third
      Quarter
            
            
            15.77
            
            
            
            29.70Fourth
      Quarter
            
            
            6.60
            
            
            
            16.81





As of
December 31, 2008 in accordance with our transfer agent records, we had 20
record holders of our common stock.  This number does not include any
beneficial owners for whom shares of common stock may be held in “nominee” or
“street” name.  On March 2, 2009, the last reported sale price of our
common stock as reported by the New York Stock Exchange was $6.88 per
share.





15
 Table of
Contents


Dividends
 To date,
we have not declared or paid any dividends on our common stock. We currently do
not anticipate paying any cash dividends in the foreseeable future on our common
stock.  Although we intend to retain our earnings, if any, to finance
the growth of our business, our Board of Directors will have the discretion to
declare and pay dividends in the future. Payment of dividends in the future will
depend upon our earnings, capital requirements, and other factors, which our
Board of Directors may deem relevant.  Our loan agreements also contain
restrictions on paying dividends.
  Equity
Compensation Plans
 The
following table summarizes certain information regarding our equity compensation
plans as of December 31, 2008:
 Plan
      Category
              
              (a)
                Number
      of Securities to be Issued Upon Exercise of Outstanding Options, Warrants
      and Rights
              
              
              (b)
                Weighted-average
                Exercise
      Price of
                Outstanding
      Options, Warrants and Rights
              
              
              (c)
                Number
      of Securities Remaining Available for Future Issuance Under Equity
      Compensation Plans
                (Excluding
      Securities Reflected in Column (a))Equity
      compensation plans approved by security holders
              
              
              219,501
              (1)
              
              $
              15.71
              
              
              
              337,500Stock
      options granted during the year ended December 31, 2008
              
              
              ─
              
              
              $
              8.46
              
              
              
              113,000Equity
      compensation plans not approved by security holders
              
              
              45,000
              (2)
              
              $
              9.22
              
              
              
              ─Total
              
              
              264,501
              
              
              $
              14.61
              
              
              
              224,500


Table of Contents






(1)
            Total
      number of shares to be issued upon exercise of options granted to
      employees, officers, and directors under our 1998 stock option
      plan.


(2)
            Total
      number of shares to be issued upon exercise of options granted outside of
      our 1998 stock option plan to Stephen C. Taylor, our Chief
      Executive Officer, under the terms of his employment
      agreement.





Repurchase
of Equity Securities





No
repurchases of our securities were made by us or on our behalf by any
“affiliated purchaser” during the fourth quarter of the fiscal year ended
December 31, 2008.





Sale
of Unregistered Securities





We made
no sales of unregistered securities during the year ended December 31,
2008.





ITEM 6.
            SELECTED
      FINANCIAL DATA





In the
table below, we provide you with selected historical financial
data.  We have derived this information from our audited consolidated
financial statements for each of the years in the five-year period ended
December 31, 2008.  This information is only a summary and it is
important that you read this information along with our audited consolidated
financial statements and related notes, and “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” under Item 7 below,
which discusses factors affecting the comparability of the information
presented.  The selected financial information provided is not
necessarily indicative of our future results of operations or financial
performance.





Year
      Ended December 31,2004
            
            
            2005(1)
            
            
            2006
            
            
            2007
            
            
            2008(in
      thousands, except per share amounts)CONSOLIDATED
      STATEMENTS OF INCOME AND OTHER INFORMATION:Revenues
            
            $
            15,958
            
            
            $
            49,311
            
            
            $
            62,729
            
            
            $
            72,489
            
            
            $
            85,336Costs
      of revenue, exclusive of depreciation shown separately
    below
            
            
            6,951
            
            
            
            31,338
            
            
            
            39,308
            
            
            
            41,106
            
            
            
            44,994Gross
      margin(2)
            
            
            9,007
            
            
            
            17,973
            
            
            
            23,421
            
            
            
            31,383
            
            
            
            40,342Depreciation
      and amortization
            
            
            2,444
            
            
            
            4,224
            
            
            
            6,020
            
            
            
            7,470
            
            
            
            9,925Other
      operating expenses
            
            
            2,652
            
            
            
            4,890
            
            
            
            5,270
            
            
            
            5,324
            
            
            
            5,842Operating
      income
            
            
            3,911
            
            
            
            8,859
            
            
            
            12,131
            
            
            
            18,589
            
            
            
            24,575Total
      other income (expense)(3)
            
            
            603
            
            
            
            (1,798)
            
            
            
            (256
            )
            
            
            144
            
            
            
            355Income
      before income taxes
            
            
            4,514
            
            
            
            7,061
            
            
            
            11,875
            
            
            
            18,733
            
            
            
            24,220Income
      tax expense
            
            
            1,140
            
            
            
            2,615
            
            
            
            4,287
            
            
            
            6,455
            
            
            
            8,627Net
      income
            
            
            3,374
            
            
            
            4,446
            
            
            
            7,588
            
            
            
            12,278
            
            
            
            15,593Preferred
      dividends
            
            
            53
            
            
            
            ─
            
            
            ─
            
            
            ─
            
            
            ─Net
      income available to common stockholders
            
            $
            3,321
            
            
            $
            4,446
            
            
            $
            7,588
            
            
            $
            12,278
            
            
            $
            15,593Net
      income per common share:Basic
            
            $
            0.59
            
            
            $
            0.59
            
            
            $
            0.67
            
            
            $
            1.02
            
            
            $
            1.29Diluted
            
            $
            0.52
            
            
            $
            0.52
            
            
            $
            0.66
            
            
            $
            1.01
            
            
            $
            1.28Weighted
      average shares of common stock outstanding:Basic
            
            
            5,591
            
            
            
            7,564
            
            
            
            11,405
            
            
            
            12,071
            
            
            
            12,090Diluted
            
            
            6,383
            
            
            
            8,481
            
            
            
            11,472
            
            
            
            12,114
            
            
            
            12,143EBITDA(4)
            
            $
            7,796
            
            
            $
            13,282
            
            
            $
            19,541
            
            
            $
            27,358
            
            
            $
            34,887As
      of December 31,2004
            
            
            2005
            
            
            2006
            
            
            2007
            
            
            2008(in
      thousands)BALANCE
      SHEET INFORMATION:Current
      assets
            
            $
            7,295
            
            
            $
            24,642
            
            
            $
            55,170
            
            
            $
            55,222
            
            
            $
            47,032Total
      assets
            
            
            43,255
            
            
            
            86,369
            
            
            
            135,552
            
            
            
            153,233
            
            
            
            181,050Long-term
      debt (including current portion)
            
            
            15,017
            
            
            
            28,205
            
            
            
            18,392
            
            
            
            13,950
            
            
            
            17,013Stockholders’
      equity
            
            
            22,903
            
            
            
            45,690
            
            
            
            101,201
            
            
            
            114,380
            
            
            
            130,450




17
 Table of Contents







(1)
            The
      information for the periods presented may not be comparable because of our
      acquisition of SCS in January 2005.  For additional information
      regarding this acquisition, you should read the information under “Item 7.
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations” in our 2007 10-K and “Item 13. Certain Relationships, and
      Related Transactions, and Director Independence – Acquisition of
      Screw Compression Systems, Inc.” in this Annual Report on Form
      10-K.


(2)
            Gross
      margin is defined, reconciled to net income and discussed further below
      under “-- Non-GAAP Financial
Measures”.


(3)
            Total
      other income (expense) for the year ended December 31, 2004 includes $1.5
      million in life insurance proceeds paid to us upon the death of our former
      Chief Executive Officer.


(4)
            EBITDA
      is defined, reconciled to net income and discussed further below under “--
      Non-GAAP Financial Measures”.





Non-GAAP
      Financial Measures





Our
definition and use of EBITDA





“EBITDA”
is a non-GAAP financial measure of earnings (net income) from continuing
operations before interest, taxes, depreciation, and
amortization.  This term, as used and defined by us, may not be
comparable to similarly titled measures employed by other companies and is not a
measure of performance calculated in accordance with GAAP.  EBITDA
should not be considered in isolation or as a substitute for operating income,
net income or loss, cash flows provided by operating, investing and financing
activities, or other income or cash flow statement data prepared in accordance
with GAAP.  However, management believes EBITDA is useful to an
investor in evaluating our operating performance because:





·
            it
      is widely used by investors in the energy industry to measure a company’s
      operating performance without regard to items excluded from the
      calculation of EBITDA, which can vary substantially from company to
      company depending upon accounting methods and book value of assets,
      capital structure and the method by which assets were acquired, among
      other factors;





·
            it
      helps investors to more meaningfully evaluate and compare the results of
      our operations from period to period by removing the impact of our capital
      structure and asset base from our operating structure;
  and





·
            it
      is used by our management for various purposes, including as a measure of
      operating performance, in presentations to our Board of Directors, as a
      basis for strategic planning and forecasting, and as a component for
      setting incentive compensation.




EBITDA
has limitations as an analytical tool, and you should not consider it in
isolation, or as a substitute for analysis of our results as reported under
generally accepted accounting principles.  Some of these limitations
are:




·          EBITDA
does not reflect our cash expenditures, or future requirements for capital
expenditures or contractualcommitments;




·          EBITDA
does not reflect changes in, or cash requirements for, our working capital
needs;




·          EBITDA
does not reflect the cash requirements necessary to service interest or
principal payments on our debts;and;




·
            although
      depreciation and amortization are non-cash charges, the assets being
      depreciated and amortized willoften have to be replaced in the future, and
      EBITDA does
      not reflect any cash requirements for
    suchreplacements.




There are
other material limitations to using EBITDA as a measure of performance,
including the inability to analyze the impact of certain recurring items that
materially affect our net income or loss, and the lack of comparability of
results of operations of different companies.  Please read the table
below under “Reconciliation” to see how EBITDA reconciles to our net
income, the most directly comparable GAAP financial measure.





18
 Table of Contents




Our
definition and use of gross margin





We define
gross margin as total revenue less cost of sales (excluding depreciation and
amortization expense).  Gross margin is included as a supplemental
disclosure because it is a primary measure used by our management as it
represents the results of revenue and cost of sales (excluding depreciation
and amortization expense), which are key components of our
operations.  Gross margin differs from gross profit, in that gross
profit includes depreciation expense.  We believe gross margin is
important because it focuses on the current operating performance of our
operations and excludes the impact of the prior historical costs of the assets
acquired or constructed that are utilized in those operations, the indirect
costs associated with our selling, general and administrative activities, the
impact of our financing methods and income taxes.  Depreciation
expense may not accurately reflect the costs required to maintain and replenish
the operational usage of our assets and therefore may not portray the costs from
current operating activity.  Rather, depreciation expense reflects the
systematic allocation of historical fixed asset values over the estimated useful
lives.





Gross
margin has certain material limitations associated with its use as compared to
net income.  These limitations are primarily due to the exclusion of
certain expenses.  Each of these excluded expenses is material to our
consolidated results of operations.  Because we use capital assets,
depreciation expense is a necessary element of our costs and our ability to
generate revenue and selling, general and administrative expense is a necessary
cost to support our operations and required corporate activities.  In
order to compensate for these limitations, management uses this non-GAAP measure
as a supplemental measure to other GAAP results to provide a more complete
understanding of our performance.





As an
indicator of our operating performance, gross margin should not be considered an
alternative to, or more meaningful than, net income as determined in accordance
with GAAP.  Our gross margin may not be comparable to a similarly
titled measure of another company because other entities may not calculate gross
margin in the same manner.





Reconciliation





The
following table reconciles EBITDA and gross margin to our net income, the most
directly comparable GAAP financial measure:





Year
      Ending December 31,2004
              
              2005
              
              2006
              
              2007
              
              2008(in
      thousands)Net
      Income
              
              $
              3,374
              
              
              $
              4,446
              
              
              $
              7,588
              
              
              $
              12,278
              
              
              $
              15,593Interest
      expense, net
              
              
              838
              
              
              
              1,997
              
              
              
              1,646
              
              
              
              1,155
              
              
              
              742Income
      taxes
              
              
              1,140
              
              
              
              2,615
              
              
              
              4,287
              
              
              
              6,455
              
              
              
              8,627Depreciation
      and amortization
              
              
              2,444
              
              
              
              4,224
              
              
              
              6,020
              
              
              
              7,470
              
              
              
              9,925EBITA
              
              $
              7,796
              
              
              $
              13,282
              
              
              $
              19,541
              
              
              $
              27,358
              
              
              $
              34,887Other
      operating expenses
              
              
              2,652
              
              
              
              4,890
              
              
              
              5,270
              
              
              
              5,324
              
              
              
              5,842Other
      expenses (income)
              
              
              (1,441
              )
              
              
              (199
              )
              
              
              (1,390
              )
              
              
              (1,299
              )
              
              
              (387
              )Gross
      Margin
              
              $
              9,007
              
              
              $
              17,973
              
              
              $
              23,421
              
              
              $
              31,383
              
              
              $
              40,342


ITEM
      7.
            MANAGEMENT’S DISCUSSION AND ANALYSIS OF
      FINANCIAL CONDITION AND RESULTS OF
  OPERATIONS





The
following discussion is intended to assist you in understanding our financial
position and results of operations for each of the years ended December 31,
2006, 2007, and 2008.  You should read the following discussion and
analysis in conjunction with our audited consolidated financial statements and
the related notes.





The
following discussion contains forward-looking statements.  For a
description of limitations inherent in forward-looking statements, see “Special
Note Regarding Forward-Looking Statements” on page (ii).





Overview





We
fabricate, manufacture, rent and sell natural gas compressors and related
equipment.  Our primary focus is on the rental of natural gas
compressors.  Our rental contracts generally provide for initial terms
of six to 24 months.  After the initial term of our rental contracts,
most of our customers have continued to rent our compressors on a month-to-month
basis.  Rental amounts are paid monthly in advance and include
maintenance of the rented compressors.  As of December 31, 2008, we
had 1,469 natural gas compressors totaling approximately 184,831 horsepower
rented to 112 third parties, compared to 1,194 natural gas compressors totaling
approximately 140,853 horsepower rented to 94 third parties at December 31,
2007.





19
 Table of Contents




We also
fabricate natural gas compressors for sale to our customers, designing
compressors to meet unique specifications dictated by well pressures, production
characteristics and particular applications for which compression is
sought.  Fabrication of compressors involves the purchase by us of
engines, compressors, coolers and other components, and then assembling these
components on skids for delivery to customer locations.  These major
components of our compressors are acquired through periodic purchase orders
placed with third-party suppliers on an “as needed” basis, which presently
requires a three to four month lead time with delivery dates scheduled to
coincide with our estimated production schedules.  Although we do not
have formal continuing supply contracts with any major supplier, we believe we
have adequate alternative sources available.  In the past, we have not
experienced any sudden and dramatic increases in the prices of the major
components for our compressors.  However, the occurrence of such an
event could have a material adverse effect on the results of our operations and
financial condition, particularly if we were unable to increase our rental rates
and sales prices proportionate to any such component price
increases.





We also
manufacture a proprietary line of compressor frames, cylinders and parts, known
as our CiP (Cylinder-in-Plane) product line.  We use finished CiP
component products in the fabrication of compressor units for sale or rental by
us or sell the finished component products to other compressor
fabricators.  We also design, fabricate, sell, install and service
flare stacks and related ignition and control devices for onshore and offshore
incineration of gas compounds such as hydrogen sulfide, carbon dioxide, natural
gas and liquefied petroleum gases.  To provide customer support for
our compressor and flare sales businesses, we stock varying levels of
replacement parts at our Midland, Texas facility and at field service
locations.  We also provide an exchange and rebuild program for screw
compressors and maintain an inventory of new and used compressors to facilitate
this business.





We
provide service and maintenance to our customers under written maintenance
contracts or on an as required basis in the absence of a service
contract.  Maintenance agreements typically have terms of six months
to one year and require payment of a monthly fee.





The
following table sets forth our revenues from each of our three business segments
for the periods presented:




Year
      Ended December 31,2006
            
            
            2007
            
            
            2008(in
      thousands)Sales
            
            $
            38,214
            
            
            $
            41,088
            
            
            $
            41,380Rental
            
            
            23,536
            
            
            
            30,437
            
            
            
            42,864Service
      and maintenance
            
            
            979
            
            
            
            964
            
            
            
            1,092Total
            
            $
            62,729
            
            
            $
            72,489
            
            
            $
            85,336





Our
strategy for growth is focused on our compressor rental business as indicated in
the table above.  Margins for our rental business historically run in the
high 50% to low 60% range, while margins for the compressor sales business tend
to be in the mid 20% range.  As our rental business grows and
contributes a larger percentage of our total revenues, we expect our overall
company-wide margins to improve over time.





The oil
and gas equipment rental and services industry is cyclical in
nature.  The most critical factor in assessing the outlook for the
industry is the worldwide supply and demand for natural gas and the
corresponding changes in commodity prices.  As demand and prices
increase, oil and gas producers increase their capital expenditures for
drilling, development and production activities.  Generally, the
increased capital expenditures ultimately result in greater revenues and profits
for service and equipment companies.





In
general, we expect our overall business activity and revenues to track the level
of activity in the natural gas industry, with changes in domestic natural gas
production and consumption levels and prices more significantly affecting our
business than changes in crude oil and condensate production and consumption
levels and prices.  We also believe that demand for compression
services and products is driven by declining reservoir pressure in maturing
natural gas producing fields and, more recently, by increased focus by producers
on non-conventional natural gas production, such as coalbed methane, gas shales
and tight gas, which typically requires more compression than production from
conventional natural gas reservoirs.





Demand
for our products and services have been strong throughout 2007 and 2008, but in
2009 demand may decline due to lower oil and natural gas prices and decreased
demand for natural gas.  We believe the long-term trend in our markets
is favorable.





20
 Table of Contents




For
fiscal year 2009, our forecasted capital expenditures will be directly dependent
upon our customers’ compression requirements and are not anticipated to exceed
our internally generated cash flows.  Any required capital will be for
additions to our compressor rental fleet and/or addition or replacement of
service vehicles.  We believe that cash flows from operations will be
sufficient to satisfy our capital and liquidity requirements through
2009.  We may require additional capital to fund any unanticipated
expenditures, including any acquisitions of other businesses, although that
capital may not be available to us when we need it or on acceptable
terms.





Our Performance Trends and
Outlook




Given the
current economic environment in North America and anticipated impact of lower
natural gas prices and capital spending by customers, we expect lower overall
activity levels in 2009 than in 2008. Currently, we believe the recent decline
in commodity prices and the impact of uncertain credit and capital market
conditions resulting from the financial crisis will negatively impact the level
of capital spending by our customers in 2009 in comparison to 2008 levels. We
believe that an extended recession would lower capital spending by our
customers and therefore negatively impact demand for our products and
services.  As we anticipate industry capital spending will decline in
2009 from 2008 levels, we believe our fabrication business segment will likely
see order cancellations and requests by our customers to delay delivery on
existing backlog, as well as an overall reduction in demand and profitability.
These conditions are also expected to negatively impact our rental operations
business, although the effects could be less severe on that business because it
is not directly related to capital expenditures and  it has
historically experienced more stable demand than that for certain other energy
service products and services.




Results
of Operations





Year
Ended December 31, 2008 Compared to the Year Ended December 31,
2007





The table
below shows our revenues, percentage of total revenues, gross margin, exclusive
of depreciation, and gross margin percentage of each of our segments for the
years ended December 31, 2008 and December 31, 2007.  Gross margin is
the difference between revenue and cost of sales, exclusive of
depreciation.





Revenue
            
            Gross
      Margin, Exclusive of Depreciation(1)Year
      Ended December 31,
            
            Year
      Ended December 31,2007
            
            2008
            
            2007
            
            2008(dollars
      in thousands)
              (unaudited)Sales
            $41,088
            56.7%
            
            $41,380
            48.5%
            
            $12,964
            31.6%
            
            $13,328
            32.2%Rental
            30,437
            42.0%
            
            42,864
            50.2%
            
            18,055
            59.3%
            
            26,671
            62.2%Service
      and maintenance
            964
            1.3%
            
            1,092
            1.3%
            
            364
            37.8%
            
            343
            31.4%Total
            $72,489
            
            
            $85,336
            
            
            $31,383
            43.3%
            
            $40,342
            47.3%








(1)
            For
      a reconciliation of gross margin to its most directly comparable financial
      measure calculated and presented in accordance with GAAP, please read
      “Item 6. Selected Financial Data – Non-GAAP Financial Measures” in this
      Report.





Total
revenues for the year ended December 31, 2008 increased 17.7% to $85.3 million,
as compared to $72.5 million for the year ended December 31,
2007.  The increase mainly reflects the increase in our rental
revenues.





Sales
revenue increased from $41.1 million to $41.4 million, or less than 1.0%, for
the year ended December 31, 2008, compared to the year ended December 31, 2007.
This increase is mainly represented by a 38.7% increase in part sales which is
only 1.9% of our total sales. The total category includes (1) compressor unit
sales (including used rental equipment), (2) flare sales, (3) parts sales, and
(4) compressor rebuilds.





Rental
revenue increased from $30.4 million to $42.9 million, or 40.8%, for the year
ended December 31, 2008, compared to the year ended December 31,
2007.  The increase is mainly the result of units added to our rental
fleet and rented to third parties.  As of December 31, 2008, we had
1,730 natural gas compressors in our rental fleet totaling approximately 217,085
horsepower, as compared to 1,353 natural gas compressors totaling approximately
160,733 horsepower at December 31, 2007.  As of December 31, 2008, we
had 1,469 natural gas compressors rented compared to 1,194 at December 31,
2007.  The average monthly rental rate per unit increased to $2,900 at
December 31, 2008 compared to $2,300 at December 31, 2007.  This
increase resulted from the addition of larger horsepower units to our rental
fleet and therefore has a higher rental rates.





Service
and maintenance revenue increased from $964,000 to $1.1 million, or 13.3%, for
the year ended December 31, 2008, compared to the year ended December 31,
2007.  This increase is the result of gain in service revenue for all
districts except Midland.





21
 Table of Contents




The
overall gross margin percentage, exclusive of depreciation, increased to 47.3%
for the year ended December 31, 2008, as compared to 43.3% for the year ended
December 31, 2007.  This increase is result of two factors: (1)
rentals which have a higher margin than our other sources of revenue increased
(rental revenue increased to 50.2% from 42.0% of our total revenue for the year
ended December 31, 2008 compared to the same period ended December 31, 2007);
and (2) our rental margin increased to 62.2% from 59.3% for the year ended
December 31, 2008 compared to the same period ended December 31, 2007. This
margin increase is the result of greater efficiencies in our field service
operations and from increasing our rental rates.





Selling,
general and administrative expense increased to $5.8 million or 6.8% of total
revenue from $5.3 million or 7.3% of our total revenue, for the year ended
December 31, 2008 compared to the year ended December 31, 2007.  Our
selling expenses increased 29.4% and our general and administrative expenses
increased 5.5% for year ended December 31, 2008, compared to same period in
2007. Selling expenses mainly increased as result of increased commissions on
larger sales numbers and changes to the commission structure.  General
and administrative expenses increased mainly as a result of additions to the
administrative staff, salary increases and stock option expense.





Depreciation
and amortization expense increased 32.9% from $7.5 million to $9.9 million for
the year ended December 31, 2008, compared to the same period in
2007.  There was a net increase of 377 natural gas compressor units to
our rental fleet between December 31, 2007 and 2008, thus increasing our
depreciable base.





Other income
decreased approximately $911,000 for the year ended December 31, 2008, compared
to the same period in 2007. This decrease was mainly the result of reduced
interest income from our short-term investment account. Our short-term
investments decreased to $2.3 million at December 31, 2008, compared to
$18.7 million at December 31, 2007.  This reduction resulted from the
capital funding of our natural gas compressor rental fleet.





Interest
expense decreased by $412,000, or 35.7%, for the year ended December 31, 2008,
compared to the same period in 2007, mainly due to a decrease in our loan
balances. Our loan balance decreased $4.0 million, and our line increased,
during the later part of the year, from $600,000 to $7 million.





Provision
for income tax increased by $2.2 million, or 33.7%, and is mainly the result of
the increase in taxable income.





Year
Ended December 31, 2007 Compared to the Year Ended December 31,
2006





The table
below shows our revenues, percentage of total revenues, gross margin, exclusive
of depreciation, and gross margin percentage of each of our segments for the
years ended December 31, 2007 and December 31, 2006. Gross margin is the
difference between revenue and cost of sales, exclusive of
depreciation.








Revenue
            
            Gross
      Margin, Exclusive of Depreciation(1)Year
      Ended December 31,
            
            Year
      Ended December 31,2006
            
            2007
            
            2006
            
            2007(dollars
      in thousands)
              (unaudited)Sales
            $38,214
            60.9%
            
            $41,088
            56.7%
            
            $8,585
            22.5%
            
            $12,964
            31.6%Rental
            23,536
            37.5.%
            
            30,437
            42.0%
            
            14,592
            62.0%
            
            18,055
            59.3%Service
      and maintenance
            979
            1.6%
            
            964
            1.3%
            
            244
            24.9%
            
            364
            37.8%Total
            $62,729
            
            
            $72,489
            
            
            $23,421
            37.3%
            
            $31,383
            43.3%






(1)
            For
      a reconciliation of gross margin to its most directly comparable financial
      measure calculated and presented in accordance with GAAP, please read
      “Item 6. Selected Financial Data -- Non-GAAP Financial Measures” in this
      report.





Total
revenues for the year ended December 31, 2007 increased 15.6% to $72.5 million,
as compared to $62.7 million for the year ended December 31, 2006. The increase
in revenue reflects the increase in our rental revenue and unit sales to third
parties.





Sales
revenue increased from $38.2 million to $41.1 million, or 7.5%, for the year
ended December 31, 2007, compared to the year ended December 31, 2006. This
increase was mainly sales of natural gas compressor units from our Tulsa
location, but this category includes (1) compressor unit sales (including used
rental equipment), (2) flare sales, (3) parts sales, and (4) compressor
rebuilds.





Service
and maintenance revenue decreased from $979,000 to $964,000, or 1.5%, for the
year ended December 31, 2007, compared to the year ended December 31, 2006. This
reduction was mainly the result of our strategy implemented in 2006 to move away
from pursuing third party service work.





22
 Table of Contents




Rental
revenue increased from $23.5 million to $30.4 million, or 29.3%, for the year
ended December 31, 2007, compared to the year ended December 31, 2006. The
increase was mainly the result of units added to our rental fleet and rented to
third parties. As of December 31, 2007, we had 1,353 natural gas compressors in
our rental fleet totaling approximately 160,733 horsepower, as compared to 1,111
natural gas compressors totaling approximately 129,158 horsepower at December
31, 2006.  As of December 31, 2007, we had 1,194 natural gas
compressors rented compared to 974 at December 31, 2006. The average monthly
rental rate per unit increased to $2,400 at December 31, 2007 compared to $2,300
at December 31, 2006. This increase resulted from the addition of larger units
to our rental fleet which command higher rental rates.





The
overall gross margin percentage, exclusive of depreciation, increased to 43.3%
for the year ended December 31, 2007, as compared to 37.3% for the year ended
December 31, 2006. This increase was mainly the result of higher margins from
our natural gas compressor unit sales.  Our natural gas compressor
unit sales gross margins increased to 31.6% for the year ended December 31,
2007, as compared to 22.5% for the year ended December 31, 2006, as a result of
our improvement in labor efficiencies.





Selling,
general and administrative expense remained flat at $5.3 million for the years
ended December 31, 2006 and 2007.  Our selling expenses decreased
34.9%, but were offset by an increase of 8.8% in general and administrative
expenses for the year ended December 31, 2007, compared to the same period in
2006.  Selling expenses decreased as a result of changes in the sales
staff, department manager and sales commission structure.  General and
administrative expenses increased mainly as a result of additions to the
administrative staff, salary increases and stock option expense.





Depreciation
and amortization expense increased 24.1% from $6.0 million to $7.5 million for
the year ended December 31, 2007, compared to the year ended December 31, 2006.
There was a net increase of 242 natural gas compressor units to our rental fleet
between December 31, 2006 and 2007, thus increasing our depreciable
base.





Other
income decreased approximately $91,000 for the year ended December 31, 2007,
compared to the same period in 2006. This decrease was mainly the result of
reduced interest income from our short-term investment account.  Our
short-term investments decreased to $18.7 million at December 31, 2007, compared
to $25.1 million at December 31, 2006.  This reduction resulted from
the capital funding of our natural gas compressor rental fleet.





Interest
expense decreased by $491,000, or 29.8%, for the year ended December 31, 2007,
compared to the same period in 2006, mainly due to a decrease in our loan
balance.  Our loan balance decreased $3.8 million during the year
ended December 31, 2007.





Provision
for income tax increased by $2.2 million, or 50.6%, and is the result of the
increase in taxable income, and offset by a lower income tax
rate.  Our effective income tax rate decreased from 36% in 2006 to 34%
in 2007.  This decrease was driven by a higher federal domestic
production activity deduction and a lower state tax assessment.





Critical
Accounting Policies and Practices





We have
identified the policies below as critical to our business operations and the
understanding of our results of operations.  In the ordinary course of
business, we have made a number of estimates and assumptions relating to the
reporting of results of operations and financial condition in the preparation of
our consolidated financial statements in conformity with accounting principles
generally accepted in the United States.  Actual results could
differ significantly from those estimates under different assumptions and
conditions.  We believe that the following discussion addresses our
most critical accounting policies, which are those that are most important to
the portrayal of our financial condition and results of operations and require
our most difficult, subjective, and complex judgments, often as a result of the
need to make estimates about the effect of matters that are inherently
uncertain.





Our
critical accounting policies are as follows:





·
            revenue
      recognition;





·
            estimating
      the allowance for doubtful accounts
receivable;





·
            accounting
      for income taxes;





·
            valuation
      of long-lived and intangible assets and goodwill;
  and





·
            valuation
      of inventory





23
 Table of Contents




Revenue
Recognition





Revenue
from the sales of custom and fabricated compressors and flare systems is
recognized upon shipment of the equipment to customers.  Revenue from
sale of rental units is included in sales revenue when equipment is shipped or
title is transferred to the customer.  Exchange and rebuild compressor
revenue is recognized when both the replacement compressor has been delivered
and the rebuild assessment has been completed.  Revenue from
compressor services is recognized upon providing services to the
customer.  Maintenance agreement revenue is recognized as services are
rendered.  Rental revenue is recognized over the terms of the
respective rental agreements based upon the classification of the rental
agreement.  Deferred income represents payments received before a
product is shipped.





Allowance
for Doubtful Accounts Receivable





We
perform ongoing credit evaluations of our customers and adjust credit limits
based upon payment history and the customer’s current credit worthiness, as
determined by our review of their current credit information.  We
continuously monitor collections and payments from our customers and maintain a
provision for estimated credit losses based upon our historical experience and
any specific customer collection issues that we have
identified.  While such credit losses have historically been within
our expectations and the provisions established, we cannot guarantee that we
will continue to experience the same credit loss rates that we have in the
past.  At December 31, 2008, two customers accounted for approximately
35% and 14%, respectively, of our consolidated accounts receivable, and at
December 31, 2007, one customer accounted for approximately 64% of our
consolidated accounts receivable.  A significant change in the
liquidity or financial position of this customer could have a material adverse
impact on the collectability of our accounts receivables and our future
operating results.





Accounting
for Income Taxes





As part
of the process of preparing our consolidated financial statements, we are
required to estimate our federal income taxes as well as income taxes in each of
the states in which we operate.  This process involves us estimating
our actual current tax exposure together with assessing temporary differences
resulting from differing treatment of items for tax and accounting
purposes.  These differences result in deferred tax assets and
liabilities, which are included in our consolidated balance sheet.  We
must then assess the likelihood that our deferred tax assets will be recovered
from future taxable income and, to the extent we believe that recovery is not
probable, we must establish a valuation allowance.  To the extent we
establish a valuation allowance or increase this allowance in a period, we must
include an expense in the tax provision in the statement of
operations.





Significant
management judgment is required in determining our provision for income taxes,
our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets.





Valuation
of Long-Lived and Intangible Assets and Goodwill





We assess
the impairment of identifiable intangibles, long-lived assets and related
goodwill whenever events or changes in circumstances indicate that the carrying
value may not be recoverable.  Factors we consider important which
could trigger an impairment review include the following:





·
            significant
      underperformance relative to expected historical or projected future
      operating results;





·
            significant
      changes in the manner of our use of the acquired assets or the strategy
      for our overall business; and





·
            significant
      negative industry or economic
trends.





When we
determine that the carrying value of intangibles, long-lived assets and related
goodwill may not be recoverable based upon the existence of one or more of the
above indicators of impairment, we measure any impairment based on a projected
discounted cash flow method using a discount rate determined by our management
to be commensurate with the risk inherent in our current
business model.





We did
not indentify any impairment based on an independent valuation as of June 2006
and internal evaluations in December 2007 and 2008 of our reporting units with
goodwill and other identifiable intangibles.  Future impairment tests
could result in impairments of our intangible assets or goodwill.  We
expect to continue to amortize our intangible assets with finite lives over the
same time periods as previously used, and we will test our intangible assets
with indefinite lives for impairment at least once each year.  In
addition, we are required to assess the consumptive life, or longevity, of our
intangible assets with finite lives and adjust their amortization periods
accordingly.  Our net goodwill and intangible assets were recorded on
our balance sheet at approximately $13.4 million and $13.1 million as of
December 31, 2007 and 2008, respectively.  Our identifiable
intangibles are currently amortized at a rate of $299,000 per
year.  Any impairment in future periods of those assets, or a
reduction in their consumptive lives, could materially and adversely affect our
consolidated statements of income and financial position.





24
 Table of Contents




Inventories





We value
our inventory at the lower of the actual cost to purchase and/or manufacture the
inventory or the current estimated market value of the inventory.  We
regularly review inventory quantities on hand and record a provision for excess
and obsolete inventory based primarily on our estimated forecast of product
demand and production requirements.





Recently
Issued Accounting Pronouncements





In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
157, Fair Value
Measurements, which defines fair value, establishes a framework for
measuring fair value in GAAP, and expands disclosures about fair value
measurements.  This Statement applies under other accounting
pronouncements that require or permit fair value measurements and is effective
for fiscal years beginning after November 15, 2007.  In February 2008,
the FASB issued FASB Staff Position No. FAS 157-2, which defers the effective
date of SFAS 157 for nonfinancial assets and non financial liabilities, except
for items that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually) to fiscal years beginning
after November 15, 2008 and interim periods within those fiscal years.  We
adopted the required provisions of SFAS 157 on January 1, 2008 and the adoption
did not have a significant impact on our financial statements.





In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities-Including an amendment of FASB Statement No.
115(“SFAS 159”).  SFAS 159 permits entities to measure
eligible assets and liabilities at fair value.  Unrealized gains and
losses on items for which the fair value option has been elected are reported in
earnings.  SFAS 159 is effective for fiscal years beginning after
November 15, 2007.  We adopted SFAS 159 on January 1, 2008 and did not
adopt the fair value option, thus, the adoption did not have a significant
impact on our financial statements.





In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations, which
replaces SFAS No. 141, Business Combinations,
requires an acquirer to recognize the assets acquired, the liabilities assumed,
and any non-controlling interest in the acquiree at the acquisition date,
measured at their fair values as of that date, with limited exceptions. This
Statement also requires the acquirer in a business combination achieved in
stages to recognize the identifiable assets and liabilities, as well as the
non-controlling interest in the acquiree, at the full amounts of their fair
values. SFAS No. 141(R) makes various other amendments to authoritative
literature intended to provide additional guidance or to confirm the guidance in
that literature to that provided in this Statement. This Statement applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. We do not expect this SFAS will have a significant
impact on our financial statements.





In
December 2007, FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Financial Statements, which amends Accounting Research
Bulletin No. 51, Consolidated Financial
Statements, to improve the relevance, comparability, and transparency of
the financial information that a reporting entity provides in its consolidated
financial statements. SFAS No. 160 establishes accounting and reporting
standards that require the ownership interests in subsidiaries not held by the
parent to be clearly identified, labeled and presented in the consolidated
statement of financial position within equity, but separate from the parent’s
equity. This statement also requires the amount of consolidated net income
attributable to the parent and to the non-controlling interest to be clearly
identified and presented on the face of the consolidated statement of income.
Changes in a parent’s ownership interest while the parent retains its
controlling financial interest must be accounted for consistently, and when a
subsidiary is deconsolidated, any retained non-controlling equity investment in
the former subsidiary must be initially measured at fair value. The gain or loss
on the deconsolidation of the subsidiary is measured using the fair value of any
non-controlling equity investment. The Statement also requires entities to
provide sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the non-controlling owners. This
Statement applies prospectively to all entities that prepare consolidated
financial statements and applies prospectively for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15, 2008.
We do not expect this SFAS will have a significant impact on our financial
statements.





25
 Table of Contents




Environmental
Regulations




Various
federal, state and local laws and regulations covering the discharge of
materials into the environment, or otherwise relating to protection of human
safety and health and the environment, affect our operations and
costs.  Compliance with these laws and regulations could cause us to
incur remediation or other corrective action costs or result in the assessment
of administrative, civil and criminal penalties and the issuance of injunctions
delaying or prohibiting operations.  In addition, we have acquired
certain properties and plant facilities from third parties whose actions with
respect to the management and disposal or release of hydrocarbons or other
wastes were not under our control.  Under environmental laws and
regulations, we could be required to remove or remediate wastes disposed of or
released by prior owners.  In addition, we could be responsible under
environmental laws and regulations for properties and plant facilities we lease,
but do not own.  Compliance with such laws and regulations increases
our overall cost of business, but has not had a material adverse effect on our
operations or financial condition.  It is not anticipated, based on
current laws and regulations, that we will be required in the near future to
expend amounts that are material in relation to our total expenditure budget in
order to comply with environmental laws and regulations but such laws and
regulations are frequently changed and we are unable to predict the ultimate
cost of compliance.  We also could incur costs related to the clean up
of sites to which we send equipment and for damages to natural resources or
other claims related to releases of regulated substances at such
sites.





Liquidity
and Capital Resources





Our
working capital positions as of December 31, 2007 and 2008 are set forth
below.




2007
              
              2008(in
      thousands)Current
      Assets:Cash
      and cash equivalents
              
              $
              245
              
              $
              1,149Short-term
      investments
              
              
              18,661
              
              
              2,300Trade
      accounts receivable, net
              
              
              11,322
              
              
              11,321Inventory,
      net
              
              
              20,769
              
              
              31,931Prepaid
      income taxes
              
              
              3,584
              
              
              244Prepaid
      expenses and other
              
              
              641
              
              
              87Total
      current assets
              
              
              55,222
              
              
              47,032Current
      Liabilities:Current
      portion of long-term debt and subordinated notes
              
              
              4,378
              
              
              3,378Line
      of credit
              
              
              600
              
              
              ─Accounts
      payable
              
              
              4,072
              
              
              8,410Accrued
      liabilities
              
              
              3,990
              
              
              3,987Current
      portion of tax liability
              
              
              3,525
              
              
              110Deferred
      income
              
              
              81
              
              
              38Total
      current liabilities
              
              
              16,646
              
              
              15,923Total
      working capital
              
              $
              38,576
              
              $
              31,109


Historically,
we have funded our operations through public and private offerings of our equity
securities, subordinated debt, bank borrowings and cash flow from operations.
Proceeds of financings have been primarily used to repay debt, to fund the
manufacture and fabrication of additional units for our rental fleet of natural
gas compressors and for acquisitions.





For the
year ended December 31, 2008, we invested approximately $46.3 million in
equipment for our rental fleet, service vehicles and additions to our
facilities.  We financed this activity with the proceeds from our
March 2006 public offering of common stock and funds from operations and we
borrowed approximately $7.0 million from our bank in 2008.  We also
repaid approximately $5.4 million of our existing debt during 2008.





Cash
flows





At
December 31, 2007, we had cash and cash equivalents of approximately $245,000,
working capital of $38.6 million and total debt of $14.6 million, of which
approximately $5.0 million was classified as current. At that same date, we also
had letters of credit outstanding in the aggregate face amount of $1.0 million.
We had positive net cash flow from operating activities of approximately $18.3
million during 2007. This was primarily from net income of $12.3 million, plus
depreciation and amortization of $7.5 million, an increase in deferred taxes of
$2.9 million, in increase in accounts payable and accrued liabilities including
income taxes of $5.8 million, offset by an increase in trade accounts receivable
of $2.9 million, and increase in inventory of $3.8 million, and an increase in
prepaid expense of $3.9 million.





26
 Table of Contents





At
December 31, 2008, we had cash and cash equivalents of approximately $1.1
million, working capital of $31.1 million and total debt of $17.0 million, of
which approximately $3.4 million was classified as current. We had positive net
cash flow from operating activities of approximately $28.3 million during 2008.
This was primarily from net income of $15.6 million, plus depreciation and
amortization of $9.9 million, an increase in deferred taxes of $8.4 million, and
an increase in prepaid expenses and other of $3.9 million offset by an increase
in inventory of $11.2 million.





Short
term investments decreased to $2.3 million from December 31, 2007 to December
31, 2008.  This amount is the remaining proceeds from our
March 2006 secondary public offering. The initial net proceeds from the offering
were $47.1 million, from which we used $5.0 million to repay bank debt and the
remainder of which has been used for capital expenditures invested in our
natural gas compressor rental fleet.





Trade
accounts receivable remained flat at $11.3 million at December 31, 2008 and
2007.





Inventory
and work in progress increased $11.1 million to $31.9 million as of the end of
2008, as compared to $20.8 million as of the end of 2007. This increase is
mainly a reflection of increased fabrication activity in both of our engineered
products and rental compression equipment lines.




Long-term
debt increased $2.4 million to $17.0 million at December 31, 2008, compared to
$14.6 million at December 31, 2007. The current portion of long-term debt
decreased $1.6 million to $3.4 million at December 31, 2008 compared to
$5.0 million at December 31, 2007, mainly the result of normal amortization of
debt and a payment of $600,000 from our line of credit and additional borrowing
from our line of credit of $7.0 million.





Recession
strategy





For
fiscal year 2009, our overall plan, during the downturn in the economy, is to
reduce expenses in line with the lower anticipated activity, fabricate rental
fleet equipment only in direct response to market requirements, emphasize
marketing of our idle gas compressor units and eliminate bank
borrowing.  Capital expenditures for the year ended December 31, 2009
are not anticipated to exceed our internal cash generating
capacity.  We believe that cash flows from operations will be
sufficient to satisfy our capital and liquidity requirements through
2009.  We may require additional capital to fund any unanticipated
expenditures, including any acquisitions of other businesses.  We currently
have a $40 million dollar bank line of credit with an available balance of $33
million.





Contractual
Obligations and Commitments





We have
contractual obligations and commitments that affect our consolidated results of
operations, financial condition and liquidity.  The following table is
a summary of our significant cash contractual obligations:





Obligation
      Due in Period(in thousands)Cash
      Contractual Obligations
              
              2009
              
              2010
              
              2011
              
              2012
              
              2013
              
              Thereafter
              
              TotalTerm
      loan facility (secured)
              
              $
              3,378
              
              $
              3,378
              
              $
              2,816
              
              $
              
              
              $
              
              
              $
              
              
              $
              9,572Interest
      on term loan facility
              
              
              321
              
              
              186
              
              
              51
              
              
              
              
              
              
              
              
              
              
              
              558Line
      of credit (secured)
              
              
              
              
              
              7,000
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,000Interest
      on line of credit
              
              
              280
              
              
              93
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              373Purchase
      obligations
              
              
              956
              
              
              956
              
              
              956
              
              
              956
              
              
              814
              
              
              
              
              
              4,638Other
      long term debt
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              441
              
              
              441Facilities
      and office leases
              
              
              433
              
              
              357
              
              
              259
              
              
              235
              
              
              168
              
              
              13
              
              
              1,465Total
              
              $
              5,368
              
              $
              11,970
              
              $
              4,082
              
              $
              1,191
              
              $
              982
              
              $
              454
              
              $
              24,047
   Senior
Bank Borrowings





On May
16, 2008, we entered into an Eighth Amended and Restated Loan Agreement with
Western National Bank, Midland, Texas effective April 1, 2008.  This
Loan Agreement (1) decreased the interest rate on existing term loan facilities,
and (2) extended and renewed our revolving line of credit
facility.  Our revolving line of credit and multiple advance term loan
facilities are described below.





27
 Table of Contents




Revolving Line of Credit
Facility.Our revolving line of credit facility allows us to
borrow, repay and re-borrow funds drawn under this facility.  The
total amount that we can borrow and have outstanding at any one time is the
lesser of $40.0 million or the amount available for advances under a “borrowing
base” calculation established by the bank.  As of December 31, 2008,
the amount available for revolving line of credit advances was $33.0
million.  The amount of the borrowing base is based primarily upon our
receivables, equipment and inventory.  The borrowing base is
re-determined by the bank on a monthly basis.  If, as a result of the
re-determination of the borrowing base, the aggregate outstanding principal
amount of the notes payable to the bank under the Loan Agreement exceeds the
borrowing base, we must prepay the principal of the revolving line of credit
note in an amount equal to such excess.  Interest only on borrowings
under our revolving line of credit facility is payable monthly on the first
day of each month.  All outstanding principal and unpaid interest is
due on May 1, 2010.  Since April 1, 2008, our interest rate on the
revolving line of credit is equal to prime rate minus one quarter of one percent
(.25%) but never lower than four percent (4.0%) nor higher than eight and three
quarter percent (8.75%).  We had $7.0 million and $600,000
outstanding as of December 31, 2008 and 2007, respectively, on this
revolving line of credit facility.  The interest rates were 4.00% and
7.5% as of December 31, 2008 and 2007, respectively.





$16.9 Million Multiple Advance Term
Loan Facility.This multiple advance term loan facility
represents the consolidation of our previously existing advancing line of credit
and term loan facilities.  Re-borrowings are not permitted under this
facility.  Principal under this term loan facility is due and payable
in 59 monthly installments of $282,000 each which commenced on November 1, 2006
and continuing through September 1, 2011.  Since April 1, 2008, our
interest rate on the term loan is equal to prime rate minus one half of one
percent (.50%) but never lower than four percent (4%) nor higher than eight and
three quarter percent (8.75%).  Interest on the unpaid principal
balance is due and payable on the same dates as principal
payments.  All outstanding principal and unpaid interest is due on
October 1, 2011.  As of December 31, 2008 and 2007, respectively, this
term loan facility had a principal balance of $9.6 million and $13.0
million.  The interest rates were 4.0% and 7.5% as of December 31,
2008 and 2007, respectively.





Our
obligations under the Loan Agreement are secured by substantially all of our
properties and assets, including our equipment, trade accounts receivable and
other personal property and by the real estate and related plant
facilities.





The
maturity dates of the loan facilities may be accelerated by the bank upon the
occurrence of an event of default under the Loan Agreement.





The Loan
Agreement contains various restrictive covenants and compliance
requirements.  These requirements provide that we must
have:





·
            at
      the end of each month, a consolidated current ratio (as defined in the
      Loan Agreement) of at least 1.6 to
1.0;





·
            at
      the end of each month, consolidated tangible net worth (as defined in the
      Loan Agreement) of at least $85.0
million;





·
            at
      the end of each fiscal quarter, a debt service coverage ratio (as defined
      in the Loan Agreement) of at least 1.50 to 1.00;
  and





·
            at
      the end of each month, a ratio of consolidated debt to consolidated
      tangible net worth (as defined in the Loan Agreement) of less than 2.0 to
      1.0.





The Loan
Agreement also contains restrictions on incurring additional debt and paying
dividends.





As of
December 31, 2008, we were in compliance with all covenants in our Loan
Agreement.  A default under our bank credit facility could trigger the
acceleration of our bank debt so that it is immediately due and
payable.  Such default would have a material adverse effect on our
liquidity, financial position and operations.





As of
December 31, 2008, we had a long-term liability of $150,000 to Midland
Development Corporation.  This amount is to be recognized as income
contingent upon certain staffing requirements in the future.  In
addition, we entered into a purchase agreement with a vendor on July 30, 2008
pursuant to which we agreed to purchase up to $4.8 million of our paint and
coating requirements exclusively from the vendor.  In connection with
the execution of the agreement, the vendor paid us a $300,000 fee which is
considered to be a discount toward future purchases from the
vendor.  Based on our historical paint and coating requirements, we
estimate meeting the $4.8 million purchase obligation within five
years.  The $300,000 payment we received is recorded as a
long-term liability and will decrease as the purchase commitment is
fulfilled.  The long-term liability remaining as of December 31, 2008
was $291,000.





28
 Table of Contents




Subordinated
Debt - Related Parties





We
hadsubordinated
debt which was included in the current portion of long-term debt for the year
ended December 31, 2007.  The $3.0 million principal amount of this
debt was in the form of promissory notes issued to the three stockholders
of Screw Compression Systems who are currently our employees, as part of
the consideration for the acquisition of SCS we completed on January 3,
2005. The principal of each note was payable in three equal annual
installments which commenced on January 3, 2006.  Accrued and unpaid
interest on the unpaid principal balance of each note was payable on the same
dates as, and in addition to, the installments of principal. On
January 3, 2008, we paid the third and last installment of the annual
payments.





Components
of Our Principal Capital Expenditures





The table
below shows the components of our principal capital expenditures for the three
years ended December 31, 2008:





ActualExpenditure
      Category
            
            2006
            
            
            2007
            
            
            2008(in
      thousandsRental
      equipment, vehicles and shop equipment
            
            $
            27,684
            
            
            $
            25,307
            
            
            $
            46,271





The level
of our expenditures will vary in future periods depending on energy market
conditions and other related economic factors.  Based upon existing
economic and market conditions, we believe that our operating cash flow will be
sufficient to fully fund our net investing cash requirements for
2009.  We also believe we have significant flexibility with respect to
our financing alternatives and adjustment of our expenditure plans if
circumstances warrant.  When considered in relation to our total
financial capacity, we do not have any material continuing commitments
associated with expenditure plans related to our current
operations.





Off-Balance
Sheet Arrangements





From
time-to-time, we enter into off-balance sheet arrangements and transactions that
can give rise to off-balance sheet obligations.  As of December 31,
2008, the off-balance sheet arrangements and transactions that we have entered
into include operating lease agreements and purchase agreements.  We
do not believe that these arrangements are reasonably likely to materially
affect our liquidity or availability of, or requirements for, capital
resources.





We
entered into a purchase agreement with a vendor on July 30, 2008 pursuant to
which we agreed to purchase up to $4.8 million of our paint and coating
requirements exclusively from the vendor.  In connection with the
execution of the agreement, the vendor paid us a $300,000 fee which is
considered to be a discount toward future purchases from the
vendor.  Based on our historical paint and coating requirements, we
estimate meeting the $4.8 million purchase obligation within five
years.  The $300,000 payment we received is recorded as a long-term
liability and will decrease as the purchase commitment is
fulfilled.  The long-term liability remaining as of December 31, 2008
was $291,000.





ITEM
7A.              QUANTITATIVE
AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK




Commodity
Risk




Our
commodity risk exposure is the pricing applicable to oil and natural gas
production.  Realized commodity prices received for such production
are primarily driven by the prevailing worldwide price for crude oil and spot
prices applicable to natural gas.  Depending on the market prices of
oil and natural gas, companies exploring for oil and natural gas may cancel or
curtail their drilling programs, thereby reducing demand for our equipment and
services.




Interest
Rate Risk




Our Loan
Agreement provides for Prime Rate less 1/2 % for our term loan facility and
Prime Rate less 1/4 % for our revolving line of credit
facility.  Consequently, our exposure to interest rates relates
primarily to interest earned on short-term investments and paying above market
rates, if such rates are below the fixed rate, on our bank
borrowings.  As of December 31, 2008, we were not using any
derivatives to manage interest rate risk.





29
 Table of Contents




Financial
Instruments and Debt Maturities





Our
financial instruments consist of cash and cash equivalents, short-term
investments, accounts receivable, accounts payable, bank borrowings, and
notes.  The carrying amounts of cash and cash equivalents, accounts
receivable, and accounts payable approximate fair value because of the highly
liquid nature of these short-term instruments.  The fair value of
our bank borrowings approximate the carrying amounts as of December 31, 2008 and
2007, and were determined based upon interest rates currently available to
us.




Customer
Credit Risk




We are
exposed to the risk of financial non-performance by our
customers.  Our ability to collect on sales to our customers is
dependent on the liquidity of our customer base.  To manage customer
credit risk, we monitor credit ratings of our customers.  Unless we
are able to retain our existing customers, or secure new customers if we lose
one or more of our significant customers, our revenue and results of operations
would be adversely affected.  See “Item 7. Management’s Discussion and
Analysis of Financial Condition and Results of Operations – Critical Accounting
Policies and Procedures – Allowance For Doubtful Accounts Receivable” on page
23.




ITEM
8.               FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA




Our
audited consolidated financial statements and supplementary financial data are
included in this Annual Report on Form 10-K beginning on page F-1.





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




None.




ITEM
9A.           CONTROLS
AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





An
evaluation was carried out under the supervision and with the participation of
our management, including our President and Chief Executive Officer and our
Principal Accounting Officer And Treasurer, of the effectiveness of the design
of our “disclosure controls and procedures” (as such term is defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended or, the “Exchange Act”) as of December 31, 2008, pursuant to Exchange
Act Rule 13a-15.  Based upon that evaluation, the President and Chief
Executive Officer and our Principal Accounting Officer And Treasurer have
concluded that our disclosure controls and procedures as of December 31, 2008,
are effective to ensure that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is recorded, processed,
summarized, and reported within the time periods specified in the SEC’s rules
and forms and include controls and procedures designed to ensure that
information required to be disclosed by us in such reports is accumulated and
communicated to our management, including our principal executive and financial
officers as appropriate to allow timely decisions regarding required
disclosures.  Due to the inherent limitations of control systems, not
all misstatements may be detected.  Those inherent limitations include
the realities that judgments in decision-making can be faulty and that
breakdowns can occur because of simple errors or
mistakes.  Additionally, controls could be circumvented by the
individual acts of some persons or by collusion of two or more
people.  Our controls and procedures can only provide reasonable, not
absolute, assurance that the above objectives have been met.





Changes
in Internal Control Over Financial Reporting





There
were no changes in our internal control over financial reporting identified in
connection with the evaluation required by paragraph (d) of Exchange Act Rules
13a-15 or 15d-15 that occurred during our last quarter that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.





Management’s
Report on Internal Control Over Financial Reporting





Our
management, including the President and Chief Executive Officer and our
Principal Accounting Officer and Treasurer, is responsible for establishing and
maintaining adequate internal control over financial reporting, as defined in
Rule 13a-15(f) and 15d-15(f) under the Exchange Act.  Our internal
control system is 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.  Our internal control over financial reporting includes
those policies and procedures that:





30
 Table of Contents




·
            pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of our
      assets;





·
            provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with accounting
      principles generally accepted in the United States of America, and that
      our receipt and expenditures are being made only in accordance with
      authorizations of management and our Board of Directors;
    and





·
            provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of our assets that could have
      a material effect on the financial
statements.




All
internal control systems, no matter how well designed, have inherent
limitations.  A system of internal control may become inadequate over
time because of changes in conditions or deterioration in the degree of
compliance with the policies or procedures.  Therefore, even those
systems determined to be effective can provide only reasonable assurance
with respect to financial statement preparation and presentation.





Our
management assessed the effectiveness of our internal control over financial
reporting as December 31, 2008 using the criteria set forth by the Commission of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated
Framework.  Based on this assessment, our management concluded
that, as of December 31, 2008, our internal control over financial reporting was
effective.








31
 Table
of Contents




Report
of Independent Registered Public Accounting Firm





To the
Board of Directors and Stockholders


Natural
Gas Services Group, Inc.


Midland,
Texas





We have
audited Natural Gas Services Group, Inc.’s (the “Company”) internal control over
financial reporting as of December 31, 2008, based on criteria established in
Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria).  Natural Gas Services Group,
Inc.’s management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting included in the accompanying Management’s
Report on Internal Control over Financial Reporting.  Our
responsibility is to express an opinion on the Company’s internal control over
financial reporting based on our audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  Our audit included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material
weakness exists, and testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk. Our audit also
included performing such other procedures as we considered necessary in the
circumstances.  We believe that our audit provides a reasonable basis
for our opinion.





A
company’s 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 (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) 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; and (3) 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.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or the degree of compliance
with the policies or procedures may deteriorate.





In our
opinion, Natural Gas Services Group, Inc. maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2008,
based on the COSO criteria.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Natural Gas
Services Group, Inc. as of December 31, 2007 and 2008, and the related
consolidated statements of income, stockholders’ equity and cash flows for each
of the three years in the period ended December 31, 2008 of Natural Gas Services
Group, Inc. and our report dated March 2, 2009 expressed an unqualified
opinion.











/s/
HEIN & ASSOCIATES LLP





Dallas,
Texas


March 2,
2009




32
 Table of Contents




ITEM
9B.            OTHER
INFORMATION




None.




PART
III





ITEM
10.             DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE




The information required by this item
is incorporated herein by reference to the sections “Election of
Directors,”  “Executive Officers,” “Corporate Governance” and “The
Board of Directors and its Committees” in our definitive proxy statement which
will be filed with the Securities and Exchange Commission within 120 days after
December 31, 2008.





ITEM
11.               EXECUTIVE
COMPENSATION




The
information required by this item is incorporated herein by reference to the
section “Executive Compensation” in our definitive proxy statement which will be
filed with the Securities and Exchange Commission within 120 days after December
31, 2008.





ITEM 12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS





The
information required by this item is incorporated herein by reference to the
section “Principal Shareholders and Security Ownership of Management” in our
definitive proxy statement which will be filed with the Securities and Exchange
Commission within 120 days after December 31, 2008.





ITEM 13.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE


The information required by this item is incorporated herein by reference to the
sections “Related Person Transactions” and “Corporate Governance” in our
definitive proxy statement which will be filed with the Securities and Exchange
Commission within 120 days after December 31, 2008.





ITEM 14.
            PRINCIPAL
      ACCOUNTANT FEES AND SERVICES





The
information required by this item is incorporated herein by reference to the
section “Principal Accountant Fees and Services” in our definitive proxy
statement which will be filed with the Securities and Exchange Commission within
120 days after December 31, 2008.




33
 Table of Contents




PART IV




ITEM 15.   EXHIBITS, FINANCIAL STATEMENT
SCHEDULES






The
following documents are filed as part of this Annual Report on Form
10-K:




(a)(1)
and (a)(2) Financial Statement and Financial Statement Schedules




For a
list of Consolidated Financial Statements and Schedules, see “Index
to


Financial
Statements” on page F-1, and incorporated herein by reference.





(a)(3)
Exhibits





See Item
15(b) below.





(b)           Exhibits:





A list of
exhibits to this Annual Report on Form 10-K is set forth below:





Exhibit
No.                                                                                     Description





3.1
            Articles
      of Incorporation, as amended (Incorporated by reference to Exhibit 3.1 of
      the 10QSB filed and dated November 10,
2004)





3.2
            Bylaws
      (Incorporated by reference to Exhibit 3.4 of the Registrant's Registration
      Statement on Form SB-2,
  No.  333-88314)





4.1
            Non-Statutory
      Stock Option Agreement (Incorporated by reference to Exhibit 10.2 to Form
      8-K Report filed with the SEC on August 30,
  2005)





10.1
            1998
      Stock Option Plan, as amended (Incorporated by reference to Exhibit 10.1
      of the Registrant’s Form 8-K Report dated September 20, 2006 on file with
      the SEC September 26, 2006)





10.2
            Lease
      Agreement, dated March 1, 2004, between the Registrant and the City of
      Midland, Texas (Incorporated by reference to Exhibit 10.19 of the
      Registrant's Form 10-QSB for the fiscal quarter ended September 30,
      2004)





10.3
            Securities
      Purchase Agreement, dated July 20, 2004, between the Registrant and
      CBarney Investments, Ltd.  (Incorporated by reference to Exhibit
      4.1 of the Registrant's Current Report on Form 8-K dated July 20, 2004 and
      filed with the Securities and Exchange Commission on July 27,
      2004)





10.4
            Employment
      Agreement between Paul D. Hensley and Natural Gas Services Group,
      Inc.  (Incorporated by reference to Exhibit 10.1 of the
      Registrants Form 8-K Report, dated January 3, 2005, as filed with the
      Securities and Exchange Commission on January 7,
  2005)





10.5
            Promissory
      Note, dated January 3, 2005, in the original principal amount of $2.1
      million made by Natural Gas Services Group, Inc.  payable to
      Paul D. Hensley (Incorporated by reference to Exhibit 10.26 of the
      Registrant's Form 10-KSB for the fiscal year ended December 31, 2004, and
      filed with the Securities and Exchange Commission on March 30,
      2005)





10.6
            Guaranty
      Agreement, dated as of January 3, 2005, made by Natural Gas Service Group,
      Inc., for the benefit of Western National Bank (Incorporated by reference
      to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K, dated
      January 3, 2005, and filed with the Securities and Exchange Commission on
      January 7, 2005)





10.7
            Guaranty
      Agreement, dated as of January 3, 2005, made by Screw Compression Systems,
      Inc., for the benefit of Western National Bank (Incorporated by reference
      to Exhibit 10.4 of the Registrant’s Current Report on Form 8-K, dated
      January 3, 2005, and filed with the Securities and Exchange Commission on
      January 7, 2005)





10.8
            Employment
      Agreement between James R. Hazlett and Natural Gas Services Group,
      Inc.  (Incorporated by reference to Exhibit 10.1 of the
      Registrant’s Form 8-K Report, dated September 14, 2005, and filed with the
      Securities and Exchange Commission on November 14,
  2005)




E-1
 Table of Contents




Exhibit
      No.
            Description





10.9
            Promissory
      Note, dated January 3, 2005, in the original principal amount of $300,000
      made by Natural Gas Services Group, Inc.  payable to Jim Hazlett
      (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 8-K
      Report, dated September 14, 2005, and filed with the Securities and
      Exchange Commission on November 14,
2005)





10.10
            Guaranty
      Agreement dated as of January 3, 2006, and made by Screw Compression
      Systems, Inc.  for the benefit of Western National Bank
      (Incorporated by reference to Exhibit 10.4 of the Registrant’s Current
      Report on Form 8-K, dated January 3, 2006, and filed with the Securities
      and Exchange Commission on January 6,
2006)





10.11
            Seventh
      Amended and Restated Loan Agreement (Incorporated by reference to Exhibit
      10.1 of the Registrant’s Form 8-K dated October 26, 2006 and filed with
      the Securities and Exchange Commission on November 1,
  2006





10.12
            Eighth
      Amended and Restated Loan Agreement between Natural Gas Services Group,
      Inc. and Western National Bank.





10.13
            Revolving
      Line of Credit Promissory Note issued to Western National
      Bank.





10.14
            Employment
      Agreement between Natural Gas Services Group, Inc. and Stephen C. Taylor
      dated October 25, 2008 (Incorporated by reference to Exhibit 10.1 of the
      Registrant’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on October 30,
2008)





*10.15
            Lease
      Agreement, dated March 26, 2008, between WNB Tower, LTD (as landlord) and
      Natural Gas Services Group, Inc. (as tenant) in connection with the lease
      of the Company’s principal offices in Midland,
  Texas.





14.0
            Code
      of Ethics (Incorporated by reference to Exhibit 14.0 of the Registrant's
      Form 10-KSB for the fiscal year ended December 31, 2004, and filed with
      the Securities and Exchange Commission on March 30,
  2005)





*23.1
            Consent
      of Hein & Associates LLP





*31.1
            Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002





*31.2
            Certification
      of Principal Accounting Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002





*32.1
            Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002





*32.2
            Certification
      of Principal Accounting Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002








*
      Filed herewith.





E-2
 Table of Contents




SIGNATURES




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




NATURAL
      GAS SERVICES GROUP, INC.Date: 
      March 2, 2009
            By:
            /s/ Stephen
      C. TaylorStephen
      C. TaylorChairman
      of the Board, President and Chief Executive Officer(Principal
      Executive Officer)







Pursuant
to the requirements of the Securities and Exchange Act of 1934, this report has
been signed below by the following persons on behalf of the registrant and in
the capacities and on the dates indicated:







Signature
            Title
            Date/s/
      Stephen C. Taylor
            
            Chairman
      of the Board of Directors, Chief Executive Officer and President
      (Principal Executive Officer)
            March
      2, 2009Stephen
      C. Taylor/s/
      Earl R. Wait
            
            Vice
      President – Accounting (Principal Accounting Officer)
            March
      2, 2009Earl
      R. Wait/s/Charles
      G. Curtis
            
            Director
            March
      2, 2009Charles
      G. Curtis/s/William
      F. Hughes, Jr.
            
            Director
            March
      2, 2009William
      F. Hughes, Jr./s/Richard
      L. Yadon
            
            Director
            March
      2, 2009Richard
      L. Yadon/s/Paul
      D. Hensley
            
            Director
            March
      2, 2009Paul
      D. Hensley/s/Gene
      A. Strasheim
            
            Director
            March
      2, 2009Gene
      A. Strasheim/s/Alan
      A. Baker
            
            Director
            March
      2, 2009Alan
      A. Baker/s/John
      W. Chisholm
            
            Director
            March
      2, 2009John
      W. Chisholm




Table of Contents




INDEX
TO FINANCIAL STATEMENTS






PageReport
      of Independent Registered Public Accounting Firm
            F-1Consolidated
      Balance Sheets as of December 31, 2007 and 2008
            F-2Consolidated
      Statements of Income for the Years Ended December 31, 2006, 2007 and
      2008
            F-3Consolidated
      Statements of Stockholders' Equity for the Years Ended December 31, 2006,
      2007, and 2008
            F-4Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2006, 2007 and
      2008
            F-5Notes
      to Consolidated Financial Statements
            F-6




Table of Contents




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To the
Board of Directors and Stockholders


Natural
Gas Services Group, Inc.


Midland,
Texas








We have
audited the accompanying consolidated balance sheets of Natural Gas Services
Group, Inc. (the “Company”) as of December 31, 2007 and 2008, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the three years in the period ended December 31, 2008. These financial
statements are the responsibility of the Company’s management.  Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.





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





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of December
31, 2007 and 2008, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2008, in conformity
with U.S. generally accepted accounting principles.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Natural Gas Services Group, Inc.’s, internal
control over financial reporting as of December 31, 2008, based oncriteria established in Internal
Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO),
and our report dated March 2, 2009 expressed an unqualified opinion on the
effectiveness of the Company’s internal control over financial
reporting.








/s/ HEIN & ASSOCIATES
LLP





Dallas,
Texas


March 2,
2009




F-1
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.


CONSOLIDATED
BALANCE SHEETS


(in
thousands)





December
      31,2007
            
            
            2008ASSETSCurrent
      Assets:Cash
      and cash equivalents
            
            $
            245
            
            
            $
            1,149Short-term
      investments
            
            
            18,661
            
            
            
            2,300Trade
      accounts receivable, net of doubtful accounts of $110 and $177,
      respectively
            
            
            11,322
            
            
            
            11,321Inventory,
      net of allowance for obsolescence of $273 and $500,
      respectively
            
            
            20,769
            
            
            
            31,931Prepaid
      income taxes
            
            
            3,584
            
            
            
            244Prepaid
      expenses and other
            
            
            641
            
            
            
            87Total
      current assets
            
            
            55,222
            
            
            
            47,032Rental
      equipment,net of
      accumulated depreciation of $16,810 and $24,624,
    respectively
            
            
            76,025
            
            
            
            111,967Property
      and equipment, net
      of accumulated depreciation of $4,792 and $6,065,
    respectively
            
            
            8,580
            
            
            
            8,973Goodwill, net of accumulated
      amortization of $325, both periods
            
            
            10,039
            
            
            
            10,039Intangibles,
      net of accumulated amortization of $1,145 and $1,198,
      respectively
            
            
            3,324
            
            
            
            3,020Other
      assets
            
            
            43
            
            
            
            19Total
      assets
            
            $
            153,233
            
            
            $
            181,050LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      Liabilities:Current
      portion of long-term debt and subordinated notes
            
            $
            4,378
            
            
            $
            3,378Current
      portion of line of credit
            
            
            600
            
            
            
            —Accounts
      payable
            
            
            4,072
            
            
            
            8,410Accrued
      liabilities
            
            
            3,990
            
            
            
            3,987Current
      income tax liability
            
            
            3,525
            
            
            
            110Deferred
      income
            
            
            81
            
            
            
            38Total
      current liabilities
            
            
            16,646
            
            
            
            15,923Long
      term debt, less current portion
            
            
            9,572
            
            
            
            6,194Line
      of credit, less current portion
            
            
            —
            
            
            
            7,000Deferred
      income tax payable
            
            
            12,635
            
            
            
            21,042Other
      long term liabilities
            
            
            —
            
            
            
            441Total
      liabilities
            
            
            38,853
            
            
            
            50,600Commitments
      and contingencies  (Notes 4, 5, 10 and 13)Stockholders’
      equity:Preferred
      stock, 5,000 shares authorized, no shares issued or
      outstanding
            
            
            —
            
            
            
            —Common
      stock, 30,000 shares authorized, par value $0.01; 12,085 and 12,094 shares
      issued and outstanding, respectively
            
            
            121
            
            
            
            121Additional
      paid-in capital
            
            
            83,460
            
            
            
            83,937Retained
      earnings
            
            
            30,799
            
            
            
            46,392Total
      stockholders' equity
            
            
            114,380
            
            
            
            130,450Total
      liabilities and stockholders' equity
            
            $
            153,233
            
            
            $
            181,050





See
accompanying notes to these consolidated financial statements.




F-2
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.


CONSOLIDATED
STATEMENTS OF INCOME


(in
thousands, except earnings  per share)








For
      the Years Ended December 31,2006
            
            
            2007
            
            
            2008Revenue:Sales,
      net
            
            $
            38,214
            
            
            $
            41,088
            
            
            $
            41,380Rental
      income
            
            
            23,536
            
            
            
            30,437
            
            
            
            42,864Service
      and maintenance income
            
            
            979
            
            
            
            964
            
            
            
            1,092Total
      revenue
            
            
            62,729
            
            
            
            72,489
            
            
            
            85,336Operating
      costs and expenses:Cost
      of sales, exclusive of depreciation stated separately
below
            
            
            29,629
            
            
            
            28,124
            
            
            
            28,052Cost
      of rentals, exclusive of depreciation stated separately
    below
            
            
            8,944
            
            
            
            12,382
            
            
            
            16,193Cost
      of service and maintenance, exclusive of depreciation
    statedseparately
      below
            
            
            735
            
            
            
            600
            
            
            
            749Selling,
      general and administrative expense
            
            
            5,270
            
            
            
            5,324
            
            
            
            5,842Depreciation
      and amortization
            
            
            6,020
            
            
            
            7,470
            
            
            
            9,925Total
      operating costs and expenses
            
            
            50,598
            
            
            
            53,900
            
            
            
            60,761Operating
      income
            
            
            12,131
            
            
            
            18,589
            
            
            
            24,575Other
      income (expense):Interest
      expense
            
            
            (1,646
            )
            
            
            (1,155
            )
            
            
            (742
            )Other
      income
            
            
            1,390
            
            
            
            1,299
            
            
            
            387Total
      other income (expense)
            
            
            (256
            )
            
            
            144
            
            
            
            (355)Income
      before provision for income taxes
            
            
            11,875
            
            
            
            18,733
            
            
            
            24,220Provision
      for income taxes:Current
            
            
            1,743
            
            
            
            3,525
            
            
            
            220Deferred
            
            
            2,544
            
            
            
            2,930
            
            
            
            8,407Total
      income tax expense
            
            
            4,287
            
            
            
            6,455
            
            
            
            8,627Net
      income
            
            
            7,588
            
            
            
            12,278
            
            
            
            15,593Earnings
      per common share:Basic
            
            $
            0.67
            
            
            $
            1.02
            
            
            $
            1.29Diluted
            
            $
            0.66
            
            
            $
            1.01
            
            
            $
            1.28Weighted
      average common shares outstanding:Basic
            
            
            11,405
            
            
            
            12,071
            
            
            
            12,090Diluted
            
            
            11,472
            
            
            
            12,114
            
            
            
            12,143





See
accompanying notes to these consolidated financial statements.




F-3
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY


(in
thousands)








Preferred
      Stock
            
            
            Common
      Stock
            
            
            Additional
            
            
            
            
            
            TotalPaid-In
            
            
            Retained
            
            
            Stockholders'Shares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            Earnings
            
            
            EquityBALANCES, January 1,
      2006
            
            
            —
            
            
            $
            —
            
            
            
            9,022
            
            
            $
            90
            
            
            $
            34,667
            
            
            $
            10,933
            
            
            $
            45,690Exercise
      of common stock options
              and
      warrants
            
            
            —
            
            
            
            —
            
            
            
            129
            
            
            
            1
            
            
            
            356
            
            
            
            —
            
            
            
            357Compensation
      expense on
              issuance
      of common stock options
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            376
            
            
            
            —
            
            
            
            376Income
      tax benefit realized from the
              exercise
      of stock options
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            27
            
            
            
            —
            
            
            
            27Issuance
      of common stock, net of
              offering
      costs
            
            
            —
            
            
            
            —
            
            
            
            2,895
            
            
            
            29
            
            
            
            47,134
            
            
            
            —
            
            
            
            47,163Net
      income
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            7,588
            
            
            
            7,588BALANCES,
      December 31, 2006
            
            
            —
            
            
            $
            —
            
            
            
            12,046
            
            
            $
            120
            
            
            $
            82,560
            
            
            $
            18,521
            
            
            $
            101,201Exercise
      of common stock options
              and
      warrants
            
            
            —
            
            
            
            —
            
            
            
            39
            
            
            
            1
            
            
            
            247
            
            
            
            —
            
            
            
            248Compensation
      expense on issuance
              of
      common stock options
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            541
            
            
            
            —
            
            
            
            541Income
      tax benefit realized from the
              exercise
      of stock options
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            112
            
            
            
            —
            
            
            
            112Net
      income
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            12,278
            
            
            
            12,278BALANCES,
      December 31, 2007
            
            
            —
            
            
            $
            —
            
            
            
            12,085
            
            
            $
            121
            
            
            $
            83,460
            
            
            $
            30,799
            
            
            $
            114,380Exercise
      of common stock options
            
            
            —
            
            
            
            —
            
            
            
            9
            
            
            
            —
            
            
            
            54
            
            
            
            —
            
            
            
            54Compensation
      expense on issuance
              of
      common stock options
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            423
            
            
            
            —
            
            
            
            423Net
      income
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            15,593
            
            
            
            15,593BALANCES, December 31,
      2008
            
            
            —
            
            
            $
            —
            
            
            
            12,094
            
            
            $
            121
            
            
            $
            83,937
            
            
            $
            46,392
            
            
            $
            130,450











See
accompanying notes to these consolidated financial statements.




F-4
 Table of Contents




NATURAL
      GAS SERVICES GROUP, INC.
              CONSOLIDATED
      STATEMENTS OF CASH FLOWS(in
      thousands of dollars)





For
      the Years Ended December 31,2006
            
            
            2007
            
            
            2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
            
            $
            7,588
            
            
            $
            12,278
            
            
            $
            15,593Adjustments
      to reconcile net income to net cash provided by
              operating
      activities:Depreciation
      and amortization
            
            
            6,020
            
            
            
            7,470
            
            
            
            9,925Deferred
      taxes
            
            
            2,544
            
            
            
            2,930
            
            
            
            8,407Employee
      stock options expense
            
            
            376
            
            
            
            541
            
            
            
            423Loss
      (gain) on disposal of assets
            
            
            13
            
            
            
            (1)
            
            
            
            7Changes
      in current assets:Trade
      accounts receivables, net
            
            
            (2,271
            )
            
            
            (2,859
            )
            
            
            1Inventory,
      net
            
            
            749
            
            
            
            (3,826
            )
            
            
            (11,162
            )Prepaid
      expenses and other
            
            
            135
            
            
            
            (3,904
            )
            
            
            3,894Changes in current
      liabilities:Accounts
      payable and accrued liabilities
            
            
            (3)
            
            
            
            3,228
            
            
            
            4,335Current
      income tax liability
            
            
            849
            
            
            
            2,581
            
            
            
            (3,415
            )Deferred
      income
            
            
            122
            
            
            
            (144)
            
            
            
            (43
            )Other
            
            
            (46)
            
            
            
            (25)
            
            
            
            285NET
      CASH PROVIDED BY OPERATING ACTIVITIES
            
            
            16,076
            
            
            
            18,269
            
            
            
            28,250CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
            
            
            (27,684)
            
            
            
            (25,307
            )
            
            
            (46,271
            )Purchase
      of short-term investments
            
            
            (38,252)
            
            
            
            (2,609
            )
            
            
            (2,620
            )Redemption
      of short-term investments
            
            
            13,200
            
            
            
            9,000
            
            
            
            18,981Proceeds
      from sale of property and equipment
            
            
            73
            
            
            
            95
            
            
            
            47NET
      CASH USED IN INVESTING ACTIVITIES
            
            
            (52,663
            )
            
            
            (18,821
            )
            
            
            (29,863
            )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from line of credit
            
            
            1,375
            
            
            
            600
            
            
            
            7,500Proceeds
      from long-term debt
            
            
            68
            
            
            
            —
            
            
            
            —Proceeds
      from other long term liabilities, net
            
            
            —
            
            
            
            —
            
            
            
            441Repayments
      of long-term debt
            
            
            (9,581)
            
            
            
            (4,442
            )
            
            
            (4,378
            )Repayment
      of line of credit
            
            
            (1,675)
            
            
            
            —
            
            
            
            (1,100
            )Proceeds
      from exercise of stock options and warrants
            
            
            357
            
            
            
            248
            
            
            
            54Proceeds
      from sale of stock, net of transaction costs
            
            
            47,163
            
            
            
            —
            
            
            
            —NET CASH PROVIDED BY (USED IN)
      FINANCING ACTIVITIES
            
            
            37,707
            
            
            
            (3,594)
            
            
            
            2,517NET
      CHANGE IN CASH
            
            
            1,120
            
            
            
            (4,146)
            
            
            
            904CASH
      AT BEGINNING OF PERIOD
            
            
            3,271
            
            
            
            4,391
            
            
            
            245CASH
      AT END OF PERIOD
            
            $
            4,391
            
            
            $
            245
            
            
            $
            1,149SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW
              INFORMATION:Interest
      paid
            
            $
            1,692
            
            
            $
            1,191
            
            
            $
            802Income
      taxes paid
            
            $
            894
            
            
            $
            4,620
            
            
            $
            294








See
accompanying notes to these consolidated financial statements.




F-5
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





1.  Summary
of Significant Accounting Policies





Organization
and Principles of Consolidation





These
notes apply to the consolidated financial statements of Natural Gas Services
Group, Inc.  (the "Company", “NGSG”, "Natural Gas Services Group",
"we" or "our") (a Colorado corporation).  Natural Gas Services Group,
Inc. was formed on December 17, 1998 for the purposes of combining the
operations of certain manufacturing, service and leasing entities.





On
January 3, 2005, we purchased all of the outstanding shares of capital stock of
Screw Compression System, Inc.  (“SCS”) a manufacturer of natural gas
compressors, with its principal offices located in Tulsa, Oklahoma for the
purpose of expanding the product line, production capacity and customer
base.  SCS operated as a wholly owned subsidiary until June 30, 2007,
when it was merged into Natural Gas Services Group, Inc.





All
significant intercompany accounts and transactions were eliminated in
consolidation.





All
amounts are stated in thousands of dollars except stock options and per share
data.





Nature
of Operations





Natural
Gas Services Group, Inc. is a leading provider of small to medium horsepower
compression equipment to the natural gas industry.  We focus primarily
on the non-conventional natural gas production business in the United States
(such as coalbed methane, gas shales and tight gas).  We manufacture,
fabricate and rent natural gas compressors that enhance the production of
natural gas wells.  NGSG provides maintenance services for its natural
gas compressors.  In addition, we sell custom fabricated natural gas
compressors to meet customer specifications dictated by well pressures,
production characteristics and particular applications.  We also
manufacture and sell flare systems for oil and gas plant and production
facilities.





Use
of Estimates





The
preparation of our consolidated financial statements in conformity with
generally accepted accounting principles requires our management to make
estimates and assumptions that affect the amounts reported in these consolidated
financial statements and accompanying notes.  Actual results could
differ from those estimates.  Significant estimates include the
valuation of identifiable intangible assets and goodwill acquired in
acquisitions, bad debt allowance and the allowance for inventory
obsolescence.  It is at least reasonably possible these estimates
could be revised in the near term and the revisions could be
material.





Cash
Equivalents





For
purposes of reporting cash flows, we consider all short-term investments with an
original maturity of three months or less to be cash equivalents.





Short-term
Investments





We
have short-term investments invested primarily in high grade short term
commercial paper for the maximum return on investments which are held to
maturity that will coincide with our projected cash requirements, and have a
maturity of less than one year.





Accounts
Receivable





Our trade
receivables consist of customer obligations for the sale of compressors and
flare systems due under normal trade terms, and operating leases for the use of
our natural gas compressors.  The receivables are not collateralized
except as provided for under lease agreements.  However, we require
deposits of as much as 50% for large custom contracts.  We extend
credit based on management's assessment of the customer's financial condition,
receivable aging, customer disputes and general business and economic
conditions.  Management believes the allowance for doubtful accounts
for trade receivables of $110,000 and $177,000 at December 31, 2007 and 2008,
respectively, is adequate.





F-6
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





Revenue
Recognition





Revenue
from the sales of custom and fabricated compressors, and flare systems is
recognized upon shipment of the equipment to customers.  Exchange and
rebuilt compressor revenue is recognized when both the replacement compressor
has been delivered and the rebuild assessment has been
completed.  Revenue from compressor service and retrofitting services
is recognized upon providing services to the customer.  Maintenance
agreement revenue is recognized as services are rendered.  Rental
revenue is recognized over the terms of the respective rental
agreements.  Deferred income represents payments received before a
product is shipped.  Revenue from the sale of rental units is included
in sales revenue when equipment is shipped or title is transferred to the
customer.





Description
of Rental Arrangements





Our
rental operations principally consist of the rental of natural gas compressor
packages and flare stacks.  These arrangements are classified as
operating leases.  See Note 2.





Major
Customers and Concentration of Credit Risk





Sales to
two customers in the year ended December 31, 2006 amounted to a total of 39% and
12% of consolidated revenue, respectively.  Sales to two customers in
the year ended December 31, 2007 amounted to a total of 40% and 12% of
consolidated revenue, respectively.  Sales to two customers in the
year ended December 31, 2008 amounted to a total of 26% and 14% of consolidated
revenue, respectively.  No other single customer accounted for more
than 10% of our revenues in 2006, 2007 or 2008.  One customer amounted
to 64% of our consolidated accounts receivable as of December 31, 2007, and two
customers amounted to 35% and 14% of our accounts receivable as of December 31,
2008, respectively.  No other customers amounted to more than 10% of
our consolidated accounts receivable as of December 31, 2007 and
2008.  We generally do not obtain collateral, but require deposits of
as much as 50% on large custom contracts.  We extend credit based on
management's assessment of the customer's financial condition, receivable aging,
customer disputes and general business and economic conditions.





Inventory





Inventory
is valued at the lower of cost or market.  The cost of inventories is
determined by the weighted average method.  A reserve is recorded
against inventory balances for estimated obsolescence.  This reserve
is based on specific identification and historical experience and totaled
$273,000 and $500,000 at December 31, 2007 and 2008,
respectively.  Finished goods at December 31, 2008 consists of 19
completed compressor units which are available for sale or for use in our rental
fleet.  At December 31, 2007 and 2008, respectively, inventory
consisted of the following (in thousands):





2007
            
            
            2008Raw
      materials
            
            $
            17,492
            
            
            $
            26,124Finished
      goods
            
            
            —
            
            
            
            2,417Work
      in process
            
            
            3,277
            
            
            
            3,390$
            20,769
            
            
            $
            31,931





Property
and Equipment





Property
and equipment is recorded at cost less accumulated depreciation and
amortization.  Depreciation and amortization are computed using the
straight-line method over the estimated useful lives of the assets, which range
from three to forty years.  Rental equipment has an estimated useful
life of fifteen years.





Gains and
losses resulting from sales and dispositions of property and equipment are
included in current operations.  Maintenance and repairs are charged
to operations as incurred.





Goodwill





Goodwill
represents the cost in excess of fair value of the identifiable net assets
acquired in three acquisitions.





Goodwill
and intangibles are tested for impairment annually or whenever events indicate
impairment may have occurred.  We completed the most recent test for
goodwill impairment based on management’s evaluation as of December 31, 2008, at
which time no impairment was indicated.




F-7
 Table of Contents


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





Intangibles





At
December 31, 2008, NGSG has intangible assets (excluding patents) with a gross
carrying value of $4.2 million, which relate to developed technology, acquired
customer contracts, distribution agreements and non-compete
agreements.  The carrying amount net of accumulated amortization at
December 31, 2008 was $3.0 million.  Intangible assets (excluding
patents) are amortized on a straight-line basis with useful lives ranging from 5
to 20 years with a weighted average life remaining of approximately fourteen
years as of December 31, 2008.  Amortization expense recognized in
each of the years ending December 31, 2006, 2007, and 2008 was
$299,000.  In addition, NGSG has an intangible asset with a gross
carrying value of $654,000 at December 31, 2008 related to the trade name of
SCS.  This asset is not being amortized as it has been deemed to have
an indefinite life.





The
following table represents estimated future amortization expense for the years
ending December 31, (in thousands).





2009
            
            $
            2992010
            
            
            2602011
            
            
            1792012
            
            
            1252013
            
            
            125Thereafter
            
            
            1,378$
            2,366





Our
policy is to periodically review the net realizable value of intangibles,
through an assessment of the estimated future cash flows related to such
assets.  In the event that assets are found to be carried at amounts
in excess of estimated undiscounted future cash flows, then the assets will be
adjusted for impairment to a level commensurate with a discounted cash flow
analysis of the underlying assets.  Based upon our most recent
analysis, we believe no impairment of intangible assets exists as of December
31, 2008.





Patents





We have
patents for a flare tip ignition device and flare tip burner
pilot.  The costs of the patents were being amortized on a
straight-line basis over nine years, the remaining life of the patents when
acquired.  Amortization expense for patents of $27,000 was recognized
for the years ended December 31, 2006 and 2007, and $4,000 for the year ended
December 31, 2008.  The patents were fully amortized as of
December 31, 2008.





Other
Assets





Included
in other assets are debt issuance costs, net of accumulated amortization, and
deposits totaling approximately $43,000 and $19,000 at December 31, 2007 and
2008, respectively.  Such costs are amortized over the period of the
respective debt agreements on a straight-line method, which approximates the
effective interest method.





Warranty





We accrue
amounts for estimated warranty claims based upon current and historical product
warranty costs and any other related information known.  The warranty
reserve was $165,000 at December 31, 2007 and 2008.





Financial
Instruments and Concentrations of Credit Risk





Management
believes that generally the fair value of the our cash, short-term investments,
trade receivables, payables and notes payable at December 31, 2007 and 2008
approximate their carrying values due to the short-term nature of the
instruments or the use of prevailing market interest rates.  At
certain times during the year, our demand deposits held in banks exceeded
the federally insured limit of $100,000 ($250,000 as of December 31,
2008).  We believe that the credit risk in temporary and short-term
cash investments that we have with financial institutions is
minimal.





Advertising
Costs





Advertising
costs are expensed as incurred.  Total advertising expense was
$41,000, $26,000 and $31,000 in 2006, 2007 and 2008, respectively.





Other
Income





Other
income in 2007 and 2008 primarily consisted of interest income from our
short-term investment account.


F-8
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Per
Share Data





Basic
earnings per common share is computed using the weighted average number of
common shares outstanding during the period.  Diluted earnings per
common share is computed using the weighted average number of common stock and
common stock equivalent shares outstanding during the period.  There
was an anti-dilutive effect of 10,000 and 25,000 common stock options for the
years ended December 31, 2006 and 2007, respectively, and none in
2008.





The
following table sets forth the computation of basic and diluted earnings per
share (in thousands, except per share amounts):





Year
      Ended December 31,2006
            
            
            2007
            
            
            2008Numerator:Net
      income
            
            $
            7,588
            
            
            $
            12,278
            
            
            $
            15,593Denominator
      for basic net income per common share:Weighted
      average common shares outstanding
            
            
            11,405
            
            
            
            12,071
            
            
            
            12,090Denominator
      for diluted net income per share:Weighted
      average common shares outstanding
            
            
            11,405
            
            
            
            12,071
            
            
            
            12,090Dilutive
      effect of stock options and warrants
            
            
            67
            
            
            
            43
            
            
            
            53Diluted
      weighted average shares
            
            
            11,472
            
            
            
            12,114
            
            
            
            12,143Earnings
      per common share:Basic
            
            $
            0.67
            
            
            $
            1.02
            
            
            $
            1.29Diluted
            
            $
            0.66
            
            
            $
            1.01
            
            
            $
            1.28





Income
Taxes





Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to temporary differences between the financial statement carrying
amounts of assets and liabilities and their respective tax bases, and operating
losses and tax credit carry-forwards.  Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled.





Fair
Value Measurement





The
financial assets of the company measured at fair value on a recurring basis are
short-term investments.  Our short-term investments are generally
classified within level 1 or level 2 of the fair value hierarchy because they
are valued using quoted market prices, broker or dealer quotations, or
alternative pricing sources with reasonable levels of
price transparency.





The types
of instruments valued based on quoted market prices in active markets include
most U.S. government and agency securities and most money market
securities.  Such instruments are generally classified within level 1
of the fair value hierarchy.





The type
of instruments valued based on quoted prices in markets that are not active,
broker or dealer quotations, or alternative pricing sources with reasonable
levels of price transparency include most investment-grade corporate bonds, and
state, municipal and provincial obligations.  Such instruments are
generally classified within level 2 of the fair value hierarchy.





As of
December 31, 2008, our short-term investments consisted of certificates of
deposit classified within level 1 of the fair value hierarchy.





Reclassification





Certain
amounts in prior period financial statements have been reclassified to conform
to the 2008 financial statement classification with no impact to operating
income or net income.





F-9
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





Recently
Issued Accounting Pronouncements





In
September 2006, the FASB issued Statement of Financial Accounting Standards
(“SFAS”) No. 157, Fair Value
Measurements(“SFAS No. 157”), which defines fair value, establishes a
framework for measuring fair value in GAAP, and expands disclosures about fair
value measurements.  This Statement applies under other accounting
pronouncements that require or permit fair value measurements and is effective
for fiscal years beginning after November 15, 2007.  In February 2008,
the FASB issued FASB Staff Position No. FAS 157-2, which defers the
effective date of SFAS No. 157 for non-financial liabilities, except for items
that are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually) to fiscal years beginning after November 15,
2008 and interim periods within those years.  We adopted the required
provisions of SFAS No. 157 on January 1, 2008 and the adoption did not have a
significant impact on our financial statements.  See Note 1 for
additional information regarding fair value measurements.





In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities-Including an amendment of FASB Statement No.
115(“SFAS No. 159”).  SFAS No. 159 permits entities to measure
eligible assets and liabilities at fair value.  Unrealized gains and
losses on items for which the fair value option has been elected are reported in
earnings.  SFAS No. 159 is effective for fiscal years beginning after
November 15, 2007.  We adopted SFAS No. 159 on January 1, 2008
and the adoption did not have a significant impact on our financial
statements.




In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations(“SFAS
No. 141(R)”), which replaces SFAS No. 141, BusinessCombinations, and requires
an acquirer to recognize the assets acquired, the liabilities assumed, and any
non-controlling interest in the acquiree at the acquisition date, measured at
their fair values as of that date, with limited exceptions. This Statement also
requires the acquirer in a business combination achieved in stages to recognize
the identifiable assets and liabilities, as well as the non-controlling interest
in the acquiree, at the full amounts of their fair values. SFAS No. 141(R)
makes various other amendments to authoritative literature intended to provide
additional guidance or to confirm the guidance in that literature to that
provided in this Statement. This Statement applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15, 2008. We
do not expect the adoption of SFAS No. 141(R) will have a significant impact on
our financial statements.





In
December 2007, FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Financial Statements(“SFAS No. 160”), which amends
Accounting Research Bulletin No. 51, Consolidated Financial
Statements, to improve the relevance, comparability, and transparency of
the financial information that a reporting entity provides in its consolidated
financial statements. SFAS No. 160 establishes accounting and reporting
standards that require the ownership interests in subsidiaries not held by the
parent to be clearly identified, labeled and presented in the consolidated
statement of financial position within equity, but separate from the parent’s
equity. This statement also requires the amount of consolidated net income
attributable to the parent and to the non-controlling interest to be clearly
identified and presented on the face of the consolidated statement of income.
Changes in a parent’s ownership interest while the parent retains its
controlling financial interest must be accounted for consistently, and when a
subsidiary is deconsolidated, any retained non-controlling equity investment in
the former subsidiary must be initially measured at fair value. The gain or loss
on the deconsolidation of the subsidiary is measured using the fair value of any
non-controlling equity investment. The Statement also requires entities to
provide sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the non-controlling owners. This
Statement applies prospectively to all entities that prepare consolidated
financial statements and applies prospectively for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15,
2008.  We do not expect the adoption of SFAS No. 160 will have a
significant impact on our financial statements.





2.  Rental
Activity





We rent
natural gas compressor packages to entities in the petroleum
industry.  These rental arrangements are classified as operating
leases and generally have original terms of six months to two years and continue
on a month-to-month basis thereafter.  Future minimum rent payments
for arrangements not on a month-to-month basis at December 31, 2008 are as
follows (in thousands):





Years
      Ending December 31,2009
            
            $
            3,8132010
            
            
            264Total
            
            $
            4,077




F-10
 Table of Contents





NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


3.  Property
and Equipment





Property
and equipment consists of the following at December 31, 2007 and 2008 (in
thousands):





2007
            
            
            2008Land
      and building
            
            $
            5,305
            
            
            $
            5,036Leasehold
      improvements
            
            
            431
            
            
            
            662Office
      equipment and furniture
            
            
            1,028
            
            
            
            1,122Software
            
            
            458
            
            
            
            525Machinery
      and equipment
            
            
            1,587
            
            
            
            1,963Vehicles
            
            
            4,563
            
            
            
            5,730Less
      accumulated depreciation
            
            
            (4,792
            )
            
            
            (6,065
            )Total
            
            $
            8,580
            
            
            $
            8,973





Depreciation
expense for property and equipment and the compressors described in Note 2 was
$5.7 million, $7.1 million and $9.6 million for the years ended December 31,
2006, 2007 and 2008, respectively.





4.  Credit
Facility





On May
16, 2008, we entered into an Eighth Amended and Restated Loan Agreement with
Western National Bank, Midland, Texas effective April 1, 2008.  This
Loan Agreement (1) decreased the interest rate on existing term loan facilities,
and (2) extended and renewed our revolving line of credit facility.  Our
revolving line of credit and multiple advance term loan facilities are described
below.





Line
of Credit





Our
revolving line of credit facility allows us to borrow, repay and reborrow funds
drawn under this facility, as amended.  The total amount that we can
borrow and have outstanding at any one time is the lesser of $40.0 million or
the amount available for advances under a “borrowing base” calculation
established by the bank.  As of December 31, 2008, the amount
available for revolving line of credit advances was $33.0
million.  The amount of the borrowing base is based primarily upon our
receivables, equipment and inventory.  The borrowing base is
redetermined by the bank on a monthly basis.  If, as a result of the
redetermination of the borrowing base, the aggregate outstanding principal
amount of the notes payable to the bank under the Loan Agreement exceeds the
borrowing base, we must prepay the principal of the revolving line of credit
note in an amount equal to such excess.  Interest only on borrowings
under our revolving line of credit facility is payable monthly on the first day
of each month.  All outstanding principal and unpaid interest is due
on May 1, 2010.  Since April 1, 2008, our interest rate on the
revolving line of credit is equal to prime rate minus one quarter of one
percent (.25%) but never lower than four percent (4.0%) nor higher than eight
and three quarter percent (8.75%).  We had $7.0 million and $600,000
outstanding as of December 31, 2008 and 2007, respectively, on this revolving
line of credit facility.  The interest rates were 4.0% and 7.5% as of
December 31, 2008 and 2007, respectively.





The line
of credit and note listed below are with the same bank and include certain
covenants, the most restrictive of which require that we maintain certain
working capital, debt to equity and cash flow ratios and certain minimum net
worth.  We were in compliance with covenants at December 31, 2007 and
2008, respectively.





Term
Loan Facility





This
multiple advance term loan facility represents the consolidation of our
previously existing advancing line of credit and term loan
facilities.  Reborrowings are not permitted under this
facility.  Principal under this term loan facility is due and payable
in 59 monthly installments of $282,000 each, which commenced November 1, 2006
and continuing through September 1, 2011.  Since April 1, 2008, our
interest rate on the term loan is equal to prime rate minus one half of one
percent (.50%) but never lower than four percent (4%) nor higher than eight and
three quarter percent (8.75%) and seven and one half percent (7.5%) and four
percent (4.0%) at December 31, 2008 and 2007, respectively.  Interest
on the unpaid principal balance is due and payable on the same dates as
principal payments.  All outstanding principal and unpaid interest is
due on October 1, 2011.  As of December 31, 2008 and 2007,
respectively, this term loan facility had a principal balance of $9.6 million
and $13.0 million.  The interest rates were 4.0% and 7.5% as of
December 31, 2008 and 2007, respectively.





Our obligations under the Loan
Agreement are secured by substantially all of our properties and assets,
including our equipment, trade accounts receivable and other personal property
and by the real estate and related plant facilities.





The
maturity dates of the loan facilities may be accelerated by the bank upon the
occurrence of an event of default under the Loan Agreement.




F-11
 Table of Contents


NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





The Loan
Agreement contains various restrictive covenants and compliance
requirements.  These requirements provide that we must
have:


·
            At
      the end of each month, a consolidated current ratio (as defined in the
      Loan Agreement) of at least 1.6 to
1.0;


·
            At
      the end of each month, a consolidated tangible net worth (as defined in
      the Loan Agreement) of at least $85
million;


·
            At
      the end of each fiscal quarter, a debt service coverage ratio (as defined
      in the Loan Agreement) of at least 1.50 to 1.00;
  and


·
            At
      the end of each month, a ratio of consolidated debt to consolidated
      tangible net worth (as defined in the Loan Agreement) of less than 2.0 to
      1.0.





The Loan
Agreement also contains restrictions on incurring additional debt and paying
dividends.





As of December 31, 2008 and 2007, we
were in compliance with all covenants in our Loan Agreement.  A
default under our bank credit facility could trigger the acceleration of our
bank debt so that it is immediately due and payable.  Such default
would have a material adverse effect on our liquidity, financial position and
operations.





Maturities
of long-term debt based on contractual requirements for the years ending
December 31 are as follows (in thousands):




2009
            
            $
            3,3782010
            
            
            3,3782011
            
            
            2,816Total
            
            $
            9,572





5.  Other
Long-term Liabilities





As of
December 31, 2008, we had a long-term liability of $150,000 to Midland
Development Corporation.  This amount is to be recognized as income
contingent upon certain staffing requirements in the future.  In
addition, we entered into a purchase agreement with a vendor on July 30, 2008
pursuant to which we agreed to purchase up to $4.8 million of our paint and
coating requirements exclusively from the vendor.  In connection with
the execution of the agreement, the vendor paid us a $300,000 fee which is
considered to be a discount toward future purchases from the
vendor.  Based on our historical paint and coating requirements, we
estimate meeting the $4.8 million purchase obligation within five
years.  The $300,000 payment we received is recorded as a long-term
liability and will decrease as the purchase commitment is
fulfilled.  The long-term liability remaining as of December 31, 2008
was $291,000.





6.  Subordinated
Notes – Related Parties





On
January 3, 2005, we issued subordinated promissory notes to Paul D. Hensley,
James R. Hazlett and Tony Vohjesus, the owners of SCS, as part of the
consideration for the acquisition of Screw Compression Systems, Inc. As of
January 3, 2005, Screw Compression Systems, Inc. became a wholly owned
subsidiary of NGSG.  Mr. Hensley is currently the Senior Vice
President of Technical Services and a Director of Natural Gas Services Group,
Inc. Mr. Hazlett is the Vice President of Technical Services. Mr. Vohjesus is a
Manager of Product Services. The aggregate principal amount was $3.0 million
bearing interest at the rate of 4.00% per annum. Beginning January 3, 2006, a
principal payment of $1.0 million is due and payable each year until maturity on
January 3, 2008 plus the current outstanding interest. The subordinated
promissory notes are secured by a letter of credit in the face amount of $2.0
million. As of December 31, 2007, $1.0 million was outstanding on these
notes.  We repaid these notes in full at maturity in January
2008.





7.  Income
Taxes





The
provision for income taxes consists of the following (in
thousands):





2006
            
            
            2007
            
            2008Current
      provision:Federal
            
            $
            1,475
            
            
            $
            3,168
            
            
            $
            —State
            
            
            268
            
            
            
            357
            
            
            
            2201,743
            
            
            
            3,525
            
            
            
            220Deferred
      provision:Federal
            
            
            2,403
            
            
            
            2,775
            
            
            
            8,347State
            
            
            141
            
            
            
            155
            
            
            
            602,544
            
            
            
            2,930
            
            
            
            8,407$
            4,287
            
            
            $
            6,455
            
            
            $
            8,627




F-12
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


The
income tax effects of temporary differences that give rise to significant
portions of deferred income tax assets and (liabilities) are as follows (in
thousands):





2006
            
            
            2007
            
            
            2008Deferred
      income tax assets:Alternative
      minimum tax credit
            
            $
            99
            
            
            $
            —
            
            
            $
            —Net
      operating loss carryover
            
            
            —
            
            
            
            —
            
            
            
            2,331Other
            
            
            242
            
            
            
            362
            
            
            
            650Total
      deferred income tax assets
            
            $
            341
            
            
            $
            362
            
            
            $
            2,981Deferred
      income tax liabilities:Property
      and equipment
            
            
            (8,571
            )
            
            
            (11,623
            )
            
            
            (22,723
            )Goodwill
      and other intangible assets
            
            
            (1,508
            )
            
            
            (1,407
            )
            
            
            (1,299
            )Other
            
            
            (26
            )
            
            
            33
            
            
            
            (1)Total
      deferred income tax liabilities
            
            
            (10,105
            )
            
            
            (12,997
            )
            
            
            (24,023
            )Net
      deferred income tax liabilities
            
            $
            (9,764
            )
            
            $
            (12,635
            )
            
            $
            (21,042
            )





The
effective tax rate differs from the statutory rate as follows:





2006
            
            2007
            
            2008Statutory
      rate
            
            34
            %
            
            34
            %
            
            34
            %State
      and local taxes
            
            3
            %
            
            2
            %
            
            2
            %Other
            
            (1)
            %
            
            (2
            )%
            
            0
            %Effective
      rate
            
            36
            %
            
            34
            %
            
            36
            %





We have a
net operating loss carryover of approximately $2.3 million available to offset
future income for federal income tax reporting purposes, which will expire in
2028, if not previously utilized.  A benefit of approximately $45,000
was generated from the exercise of stock options and will be reclassed to
additional paid in capital when the benefit is realized.





Our
policy regarding income tax interest and penalties is to expense those items as
general and administrative expense but to identify them for tax purposes. During
the twelve months ended December 31, 2008, there were no income tax interest and
penalty items in the income statement or as a liability on the balance
sheet.




We file
income tax returns in the U.S. federal jurisdiction and various state
jurisdictions.  With few exceptions, we are no longer subject to U.S.
federal or state income tax examination by tax authorities for years before
2005.  We are not currently involved in any income tax
examinations.





8.  Stockholders'
Equity





Initial
Public Offering





In
October, 2002, we closed an initial public offering in which we sold 1.5 million
shares of common stock and warrants to purchase 1.5 million shares of common
stock for a total of $7.9 million.  Costs and commissions associated
with the offering totaled $1.3 million.  The warrants
were exercisable anytime through October 21, 2006 at $6.25 per
share.  In connection with this offering, the underwriter received
options to purchase 150,000 shares of common stock at $6.25 per share and
warrants at $0.3125 per share.  The warrants, when purchased by the
underwriter, contained an exercise price of $7.81 per share.  The
underwriter’s warrants were exercised or expired in October 2007.  The
underwriter's options expired in October 2007.  As of December 31,
2008, there were no underwriter options or warrants outstanding.





Secondary
Public Offering





On March
8, 2006, we sold 2.5 million shares of our common stock pursuant to a public
offering at a price of $17.50 per share, resulting in net proceeds to us of
$40.7 million.  We did not receive any proceeds from sales by certain
selling stockholders.  We granted the underwriter an option for a
period of 30 days to purchase up to an additional 428,000 shares to cover
over-allotments, if any.  On March 27, 2006, the underwriter exercised
its over-allotment option and on March 30, 2006, we sold an additional 428,000
shares resulting in proceeds to NGSG of $7.1 million in addition to the net
proceeds of $40.7 million from the sale of the 2.5 million shares of common
stock on March 8, 2006.  The net proceeds after offering costs to
us were $47.1 million and a portion was used to reduce our bank debt by $5.0
million.





F-13
 Table of Contents


NATURAL
GAS SERVICES GROUP, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Preferred
Stock





We have a
total of 5.0 million authorized preferred shares with rights and preferences as
designated by the Board of Directors.  As of December 31, 2007 and
2008, there were no outstanding preferred shares.





9.  Stock-Based
Compensation





Stock
Option Plan





Our 1998
Stock Option Plan (the Plan), which is stockholder approved, permits the grant
of stock options to its employees for up to 550,000 shares of common
stock.  We believe that such awards better align the interests of our
employees with our stockholders.  Option awards are generally granted
with an exercise price equal to the market price of our stock at the date of
grant; those option awards generally vest based on three years of continuous
service and have ten-year contractual terms.  Certain option and share
awards provide for accelerated vesting if there is a change in control of NGSG
(as defined in the Plan).  The last date that grants can be made under
the Plan is March 1, 2016.  As of December 31, 2008, 224,500 shares
were still available for issue under the 1998 Stock Option Plan.





The fair
value of each option award is estimated on the date of grant using the
Black-Scholes option valuation model that uses the assumptions noted in the
following table.  The risk-free rate for periods within the
contractual life of the option is based on the U.S. Treasury yield curve in
effect at the time of grant.  The expected life of options granted is
based on the vesting period and historical exercise and post vesting employment
termination behavior for similar grants.  We use historical stock data
to estimate option exercise and employee termination within the valuation model;
separate groups of employees that have similar historical exercise behavior are
considered separately for valuation purposes.




Weighted
      average Black –Scholes fair value assumption
            
            2006
            
            2007
            
            2008Risk  free
      rate
            
            8.25%
            
            5.83%
            
            3.90%Expected
      life
            
            4
      yrs
            
            5
      yrs
            
            5
      yrsExpected
      volatility
            
            50.3%
            
            47.6%
            
            48.0%Expected
      dividend yield
            
            0.0%
            
            0.0%
            
            0.0%




A summary
of option activity under the Plan as of December 31, 2008 and changes during the
year then ended is presented below:


Number
      of
              Stock
      Options
            
            
            Weighted
      Average
              Exercise
      Price
            
            
            Weighted
              Average
              Remaining
              Contractual
      Life (years)
            
            
            Aggregate
      Intrinsic Value(in
      thousands)Outstanding
      at December 31, 2007
            
            
            167,502
            
            
            $
            11.25
            
            
            
            7.77
            
            
            $
            1,401Granted
            
            
            113,000
            
            
            
            18.81Exercised
            
            
            (8,833)
            
            
            
            6.04Forfeited
      or expired
            
            
            (7,168)
            
            
            
            12.85Outstanding
      at December 31, 2008
            
            
            264,501
            
            
            $
            14.61
            
            
            
            7.94
            
            
            
            *Exercisable
      at December 31, 2008
            
            
            158,333
            
            
            $
            12.15
            
            
            
            7.00
            
            
            
            *






*   Market
price as of December 31, 2008 exceeded the weighted average exercise price, and
as such, resulted in the aggregate intrinsic value being negative or
“out-of-the-money”.





We
granted 40,000 options to an officer on January 15, 2008 at an exercise price of
$20.06 with a three year vesting period.  We granted 15,000 options to
the board of directors on March 18, 2008 at an exercise price of $20.48 vesting
through December 2008.  We granted 30,000 options to officers and
28,000 options to employees on September 10, 2008 at an exercise price of $17.51
with a three year vesting period.





The
weighted average grant date fair value of options granted during the years 2006,
2007 and 2008 was $4.75, $8.49 and $8.46, respectively.  The total
intrinsic value, or the difference between the exercise price and the market
price on the date of exercise, of options exercised during the years ended
December 31, 2006, 2007 and 2008 was approximately $79,000, $213,000 and
$149,000, respectively.  Cash received from stock options exercised
during the years ended December 31, 2006, 2007 and 2008 was $58,000, $152,000
and $53,000, respectively.


F-14
 Table of Contents


NATURAL
GAS SERVICES GROUP, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


The
following table summarizes information about the options outstanding at December
31, 2008:




Options
      Outstanding
            
            
            Options
      ExercisableRange
      of Exercise Prices
            
            
            Shares
            
            
            Weighted
              Average
              Remaining
              Contractual
              Life
      (years)
            
            
            Weighted
              Average
              Exercise
              Price
            
            
            Shares
            
            
            Weighted
              Average
              Exercise
              Price$
            0.00
      – 5.58
            
            
            
            22,000
            
            
            
            3.95
            
            
            $
            4.11
            
            
            
            22,000
            
            
            $
            4.115.59
      – 9.43
            
            
            
            60,000
            
            
            
            6.46
            
            
            
            9.11
            
            
            
            60,000
            
            
            
            9.119.44
      – 15.60
            
            
            
            44,501
            
            
            
            8.03
            
            
            
            14.33
            
            
            
            36,333
            
            
            
            14.1915.61
      – 20.48
            
            
            
            138,000
            
            
            
            9.19
            
            
            
            18.76
            
            
            
            40,000
            
            
            
            19.27$
            0.00
      - 20.48
            
            
            
            264,501
            
            
            
            7.94
            
            
            $
            14.61
            
            
            
            158,333
            
            
            $
            12.15




The
summary of the status of our unvested stock options as of December 31, 2008 and
changes during the year then ended is presented below:





Unvested
              Stock
      Options
            
            
            Weighted
      Average Grant
              Date
      Fair ValueUnvested
      at December 31, 2007
            
            
            41,000
            
            
            $
            9.19Granted
            
            
            113,000
            
            
            
            8.46Vested
            
            
            (43,498)
            
            
            
            10.20Forfeited
            
            
            (4,334)
            
            
            
            5.35Unvested
      at December 31, 2008
            
            
            106,168
            
            
            $
            8.15


We
recognized stock compensation expense from stock options vesting of $376,000,
$541,000 and $423,000, respectively, for the years ended December 31, 2006, 2007
and 2008.  The total income tax benefit recognized in the income
statement for stock based compensation was $135,000, $184,000 and $148,000,
respectively, for the years ended December 31, 2006, 2007 and
2008.  As of December 31, 2008, there was approximately $694,000 of
total unrecognized compensation cost related to unvested stock
options.  We expect to recognize such cost over a weighted-average
period of 1.7 years.  The actual income tax benefit realized for the
tax deductions from stock options exercised was approximately $27,000, $112,000,
respectively, for the years ended December 31, 2006, 2007, and none for the year
ended December 31, 2008.





10.  Commitments





401(k)
Plan





We offer
a 401(k) Plan to all employees that have reached the age of eighteen and have
completed six months of service.  The participants may contribute up
to 100% of their salary subject to IRS limitations.  Employer
contributions are subject to Board discretion and are subject to a vesting
schedule of 20% each year after the first year and 100% after six
years.  We contributed $125,000, $161,000, and $234,000 to the 401(k)
Plan in 2006, 2007 and 2008, respectively.





Rented
Facilities





We lease
certain of our facilities under operating leases with terms generally ranging
from month to month to five years.  Most facility leases contain
renewal options.  Remaining future minimum rental payments due under
these leases for the years ended December 31 are as follows (in
thousands):




2009
            
            $
            4332010
            
            
            3572011
            
            
            2592012
            
            
            2352013
            
            
            168Thereafter
            
            
            13Total
            
            $
            1,465


F-15
 
 Table of Contents





NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


Rent
expense under such leases was $212,000, $244,000, and $363,000 for the years
ended December 31, 2006, 2007, and 2008, respectively.





11.  Segment
Information





SFAS No.
131, Disclosures about
Segments of an Enterprise and Related Information, establishes standards
for public companies relating to the reporting of financial and descriptive
information about their operating segments in financial
statements.  Operating segments are components of an enterprise about
which separate financial information is available that is evaluated regularly by
chief operating decision makers in the allocation of resources and the
assessment of performance.  Our management identifies segments based
upon major revenue sources as shown in the tables below.  However,
management does not track assets by segment.





For
the Year Ended December 31, 2006




Sales
              
              
              Rental
              
              
              Service
      & Maintenance
              
              
              Corporate
              
              
              Total(in
      thousands of dollars)Revenue
              
              $
              38,214
              
              
              $
              23,536
              
              
              $
              979
              
              
              $
              —
              
              
              $
              62,729Operating
      costs and expenses
              
              
              29,629
              
              
              
              8,944
              
              
              
              735
              
              
              
              11,290
              
              
              
              50,598Other
      income/(expense)
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (256
              )
              
              
              (256Income
      before provision for  income taxes
              
              $
              8,585
              
              
              $
              14,592
              
              
              $
              244
              
              
              $
              (11,546
              )
              
              $
              11,875


For
the Year Ended December 31, 2007




Sales
            
            
            Rental
            
            
            Service
      & Maintenance
            
            
            Corporate
            
            
            Total(in
      thousands of dollars)Revenue
            
            $
            41,088
            
            
            $
            30,437
            
            
            $
            964
            
            
            $
            —
            
            
            $
            72,489Operating
      costs and expenses
            
            
            28,124
            
            
            
            12,382
            
            
            
            600
            
            
            
            12,794
            
            
            
            53,900Other
      income/(expense)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            144
            
            
            
            144Income
      before provision for  income taxes
            
            $
            12,964
            
            
            $
            18,055
            
            
            $
            364
            
            
            $
            (12,650
            )
            
            $
            18,733




For
the Year Ended December 31, 2008




Sales
            
            
            Rental
            
            
            Service
      & Maintenance
            
            
            Corporate
            
            
            Total(in
      thousands of dollars)Revenue
            
            $
            41,380
            
            
            $
            42,864
            
            
            $
            1,092
            
            
            $
            —
            
            
            $
            85,336Operating
      costs and expenses
            
            
            28,052
            
            
            
            16,193
            
            
            
            749
            
            
            
            15,767
            
            
            
            60,761Other
      income/(expense)
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            (355)
            
            
            
            (355)Income
      before provision for  income taxes
            
            $
            13,328
            
            
            $
            26,671
            
            
            $
            343
            
            
            $
            (16,122
            )
            
            $
            24,220




12.  Quarterly
Financial Data (in thousands, except per share data) - Unaudited




2006
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4
            
            
            TotalTotal
      revenue
            
            $
            13,578
            
            
            $
            15,458
            
            
            $
            17,130
            
            
            $
            16,563
            
            
            $
            62,729Operating
      income
            
            
            3,053
            
            
            
            1,912
            
            
            
            3,690
            
            
            
            3,476
            
            
            
            12,131Net
      income applicable to common shares
            
            
            1,696
            
            
            
            1,208
            
            
            
            2,364
            
            
            
            2,320
            
            
            
            7,588Net
      income per share - Basic
            
            
            0.18
            
            
            
            0.10
            
            
            
            0.20
            
            
            
            0.19
            
            
            
            0.67Net
      income per share - Diluted
            
            
            0.17
            
            
            
            0.10
            
            
            
            0.20
            
            
            
            0.19
            
            
            
            0.66




2007
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4
            
            
            TotalTotal
      revenue
            
            $
            16,712
            
            
            $
            17,624
            
            
            $
            18,651
            
            
            $
            19,502
            
            
            $
            72,489Operating
      income
            
            
            4,203
            
            
            
            4,134
            
            
            
            5,232
            
            
            
            5,020
            
            
            
            18,589Net
      income applicable to common shares
            
            
            2,681
            
            
            
            2,646
            
            
            
            3,337
            
            
            
            3,614
            
            
            
            12,278Net
      income per share - Basic
            
            
            0.22
            
            
            
            0.22
            
            
            
            0.28
            
            
            
            0.30
            
            
            
            1.02Net
      income per share - Diluted
            
            
            0.22
            
            
            
            0.22
            
            
            
            0.28
            
            
            
            0.30
            
            
            
            1.01




F-16
 Table of Contents




NATURAL
GAS SERVICES GROUP, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





2008
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4
            
            
            TotalTotal
      revenue
            
            $
            18,933
            
            
            $
            19,478
            
            
            $
            24,946
            
            
            $
            21,979
            
            
            $
            85,336Operating
      income
            
            
            5,453
            
            
            
            5,145
            
            
            
            7,448
            
            
            
            6,529
            
            
            
            24,575Net
      income applicable to common shares
            
            
            3,517
            
            
            
            3,333
            
            
            
            4,811
            
            
            
            3,932
            
            
            
            15,593Net
      income per share - Basic
            
            
            0.29
            
            
            
            0.28
            
            
            
            0.40
            
            
            
            0.33
            
            
            
            1.29Net
      income per share - Diluted
            
            
            0.29
            
            
            
            0.27
            
            
            
            0.40
            
            
            
            0.33
            
            
            
            1.28





13.  Legal
      Proceedings





From time
to time, we are a party to various legal proceedings in the ordinary course of
our business.  While management is unable to predict the ultimate
outcome of these actions, it believes that any ultimate liability arising from
these actions will not have a material effect on our consolidated financial
position, results of operations or cash flow.  Except as discussed
below, we are not currently a party to any bankruptcy, receivership,
reorganization, adjustment or similar proceeding, and we are not aware of any
other threatened litigation.




On
February 21, 2008, we received notice of a lawsuit filed against us on January
28, 2008 in Montmorency County, Michigan, 26th Circuit Court, Case No.
08-0001901-NZ, styled Dyanna Louise Williams, Plaintiff, v Natural Gas Services
Group, Inc. and Great Lakes Compression, Defendants.  In this lawsuit,
plaintiff alleges breach of contract, breach of fiduciary duty and negligence.
Plaintiff seeks damages in the amount of $100,000 for lost insurance benefits
and an unspecified amount of exemplary damages. As the basis for her claims,
plaintiff generally alleges that she is the third party beneficiary of a life
insurance policy obtained by her deceased ex-husband through Natural Gas
Services Group's insurance program, and that as a result of Natural Gas Service
Group's negligence and failure to use due care in processing an application for
life insurance prior to her ex-husband's death, she was denied $100,000 of
life insurance proceeds. Plaintiff now seeks to recover $100,000 from
Natural Gas Services Group, plus an unspecified amount of exemplary
damages.  On January 21, 2009, we received the Order and Judgment from
the Court granting our Motion for Summary Judgment and dismissing the
Williams suit with prejudice.  This means that all claims are
dismissed and may not be reasserted.  We have not established a
reserve with respect to plaintiff’s claims.














********




F-17
 Table of Contents





INDEX TO
EXHIBITS





(a)           Exhibits





Exhibit
No.                                                                           Description








3.1
            Articles
      of Incorporation, as amended (Incorporated by reference to Exhibit 3.1 of
      the 10QSB filed and dated November 10,
2004)





3.2
            Bylaws
      (Incorporated by reference to Exhibit 3.4 of the Registrant's Registration
      Statement on Form SB-2,
  No.  333-88314)





4.1
            Non-Statutory
      Stock Option Agreement (Incorporated by reference to Exhibit 10.2 to Form
      8-K Report filed with the SEC on August 30,
  2005)





10.1
            1998
      Stock Option Plan, as amended (Incorporated by reference to Exhibit 10.1
      of the Registrant’s Form 8-K Report dated September 20, 2006 on file with
      the SEC September 26, 2006)





10.2
            Lease
      Agreement, dated March 1, 2004, between the Registrant and the City of
      Midland, Texas (Incorporated by reference to Exhibit 10.19 of the
      Registrant's Form 10-QSB for the fiscal quarter ended September 30,
      2004)





10.3
            Securities
      Purchase Agreement, dated July 20, 2004, between the Registrant and
      CBarney Investments, Ltd.  (Incorporated by reference to Exhibit
      4.1 of the Registrant's Current Report on Form 8-K dated July 20, 2004 and
      filed with the Securities and Exchange Commission on July 27,
      2004)





10.4
            Employment
      Agreement between Paul D. Hensley and Natural Gas Services Group,
      Inc.  (Incorporated by reference to Exhibit 10.1 of the
      Registrants Form 8-K Report, dated January 3, 2005, as filed with the
      Securities and Exchange Commission on January 7,
  2005)





10.5
            Promissory
      Note, dated January 3, 2005, in the original principal amount of $2.1
      million made by Natural Gas Services Group, Inc.  payable to
      Paul D. Hensley (Incorporated by reference to Exhibit 10.26 of the
      Registrant's Form 10-KSB for the fiscal year ended December 31, 2004, and
      filed with the Securities and Exchange Commission on March 30,
      2005)





10.6
            Guaranty
      Agreement, dated as of January 3, 2005, made by Natural Gas Service Group,
      Inc., for the benefit of Western National Bank (Incorporated by reference
      to Exhibit 10.3 of the Registrant’s Current Report on Form 8-K, dated
      January 3, 2005, and filed with the Securities and Exchange Commission on
      January 7, 2005)





10.7
            Guaranty
      Agreement, dated as of January 3, 2005, made by Screw Compression Systems,
      Inc., for the benefit of Western National Bank (Incorporated by reference
      to Exhibit 10.4 of the Registrant’s Current Report on Form 8-K, dated
      January 3, 2005, and filed with the Securities and Exchange Commission on
      January 7, 2005)





10.8
            Employment
      Agreement between James R. Hazlett and Natural Gas Services Group,
      Inc.  (Incorporated by reference to Exhibit 10.1 of the
      Registrant’s Form 8-K Report, dated September 14, 2005, and filed with the
      Securities and Exchange Commission on November 14,
  2005)





10.9
            Promissory
      Note, dated January 3, 2005, in the original principal amount of $300,000
      made by Natural Gas Services Group, Inc.  payable to Jim Hazlett
      (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 8-K
      Report, dated September 14, 2005, and filed with the Securities and
      Exchange Commission on November 14,
2005)





10.10
            Guaranty
      Agreement, dated as of January 3, 2006, and made by Screw Compression
      Systems, Inc.  for the benefit of Western National Bank
      (Incorporated by reference to Exhibit 10.4 of the Registrant’s Current
      Report on Form 8-K, dated January 3, 2006, and filed with the Securities
      and Exchange Commission on January 6,
2006)





10.11
            Seventh
      Amended and Restated Loan Agreement (Incorporated by reference to Exhibit
      10.1 of the Registrant’s Form 8-K dated October 26, 2006 and filed with
      the Securities and Exchange Commission on November 1,
  2006





10.12
            Eighth
      Amended and Restated Loan Agreement between Natural Gas Services Group,
      Inc. and Western National Bank.





10.13
            Revolving
      Line of Credit Promissory Note issued to Western National
      Bank.





F-18
 Table of Contents




Exhibit
      No.
            Description





10.14
            Employment
      Agreement between Natural Gas Services Group, Inc. and Stephen C. Taylor
      dated October 25, 2008 (Incorporated by reference to Exhibit 10.1 of the
      Registrant’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on October 30,
2008)





*10.15
            Lease
      Agreement, dated March 26, 2008, between WNB Tower, LTD (as landlord) and
      Natural Gas Services Group, Inc. (as tenant) in connection with the lease
      of the Company’s principal offices in Midland,
  Texas.





14.0
            Code
      of Ethics (Incorporated by reference to Exhibit 14.0 of the Registrant's
      Form 10-KSB for the fiscal year ended December 31, 2004, and filed with
      the Securities and Exchange Commission on March 30,
  2005)





*23.1
            Consent
      of Hein & Associates LLP





*31.1
            Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002





*31.2
            Certification
      of Principal Accounting Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002





*32.1
            Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002





*32.2
            Certification
      of Principal Accounting Officer pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002






*
      Filed herewith.




F-19