UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K/A


(Amendment
No.2)





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


For the
fiscal year ended December 31, 2008





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


For the
transition period from ________ to _________





Commission
File Number: 000-31539





CHINA NATURAL GAS,
INC.


(Exact
Name of Registrant as specified in its charter)





Delaware
            
            98-0231607(State
      or other jurisdiction of
              Incorporation
      or organization)
            
            (I.R.S.
      Employer
              Identification
      Number)





19th
Floor, Building B, Van Metropolis


Tang Yan
Road, Hi-Tech Zone


Xi’an,
710065, Shaanxi Province, China


(Address
of principal executive office)





Registrant’s
telephone number, including area code: 86-29-88323325





Securities
registered under Section 12(b) of the Exchange Act: None





Securities
registered under Section 12(g) of the Exchange Act:


Common Stock, $.0001 par
value per share


(Title of
Class)





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


Yes 
 ̈ No  x





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 
 ̈ No  x





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  x No   ̈





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (section 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of the 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, a non-accelerated filer or a smaller reporting company. See
the definitions of "large accelerated filer," "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check one):





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





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




The
aggregate market value of the voting and non-voting stock held by non-affiliates
of the registrant, as of June 30, 2008, was approximately $175,201,824. All
executive officers and directors of the registrant have been deemed, solely for
the purpose of the foregoing calculation, to be "affiliates" of the
registrant.





As of
March 10, 2009, there were 29,200,304 shares of the issuer's common stock,
$0.0001 par value per share, issued and outstanding.





FORM
10-K/A


(Amendment
No. 2)




FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2008




INDEX




PagePART
      IITEM
      1.
                BUSINESS
                
                3ITEM
      1A
                RISK
      FACTORS
                
                11ITEM
      1B
                UNRESOLVED
      STAFF COMMENTS
                
                27ITEM
      2.
                PROPERTIES
                
                27ITEM
      3.
                LEGAL
      PROCEEDINGS
                
                28ITEM
      4.
                SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS
                
                28PART
      IIITEM
      5.
                MARKET
      FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITIES
                
                29ITEM
      6.
                SELECTED
      FINANCIAL DATA
                
                29ITEM
      7.
                MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
                
                30ITEM
      7A.
                QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
                
                41ITEM
      8.
                FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA
                
                42ITEM
      9.
                CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE
                
                42ITEM
      9A.
                CONTROLS
      AND PROCEDURES
                
                43ITEM
      9B.
                OTHER
      INFORMATION
                
                45PART
      IIIITEM
      10.
                DIRECTORS,
      EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
                
                45ITEM
      11.
                EXECUTIVE
      COMPENSATION
                
                48ITEM
      12.
                SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS
                
                52ITEM
      13.
                CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE
                
                53ITEM
      14.
                PRINCIPAL
      ACCOUNTING FEES AND SERVICES
                
                54PART
      VITEM
      15.
                EXHIBITS,
      FINANCIAL STATEMENT SCHEDULES
                
                55


2





EXPLANATORY NOTE TO
AMENDMENT NO. 2





We
are filing this Amendment No. 2 on Form 10-K/A, or this Amendment, to amend
certain sections in our Form 10-K for the year ended December 31, 2008,
originally filed on March 16, 2009 and amended on March 23, 2009 (collectively,
the "Previous Filings"). This Amendment amends Item 1. Business, Item 1A. Risk
Factors, Item 3. Legal Proceedings, Item 7. Management's Discussion and Analysis
of Financial Condition, Item 8. Financial Statements and Supplementary Data and
Results of Operations, Item 9A. Controls and Procedures, Item 10. Directors,
Executive Officers and Corporate Governance, Item 11. Executive Compensation,
Item 13. Certain Relationships and Related Transactions and Director
Independence, Item 14. Principal Accounting Fees and Services and Item 15.
Exhibits, Financial Statement Schedules. This Amendment does not otherwise amend
the Previous Filings. We have also corrected certain minor grammatical or
typographical errors throughout this Amendment. As required by Rule 12b-15 under
the Securities Exchange Act of 1934, as amended, new certifications by our Chief
Executive Officer and Chief Financial Officer are being filed as exhibits to
this Amendment under Item 15 of Part IV.




INTRODUCTION





Except
where the context otherwise requires and for purposes of this Amendment
only:





·
            All
      references to "China Natural Gas," "CHNG," "the Company," "we," "us," and
      "our" refer to China Natural Gas, Inc. and its variable interest entity
      and subsidiaries;


·
            "China,"
      "Chinese" and "PRC" refers to the People's Republic of China, excluding,
      for purposes of this Amendment only, Taiwan and the Special Administrative
      Regions of Hong Kong and Macau;


·
            All
      references to "Renminbi" or "RMB" are to the legal currency of China, and
      all references to "U.S. dollars," "dollars," "$" or "US$" are to the legal
      currency of the United States;


·
            "U.S.
      GAAP" refers to generally accepted accounting principles in the United
      States; and


·
            "PRC
      GAAP" refers to generally accepted accounting principles in the
      PRC.





For
purpose of this Amendment, the translation rate used for the fiscal year ended
December 31, 2008 was RMB6.94 to $1.00 as compared to RMB7.59 for the fiscal
year ended December 31, 2007.





STATEMENT
REGARDING FORWARD-LOOKING STATEMENTS




Except
for the historical information contained herein, some of the statements in this
Report contain forward-looking statements that involve risks and uncertainties.
These statements are found in the sections entitled "Business," "Management's
Discussion and Analysis of Financial Condition and Results of Operations," and
"Risk Factors." They include statements concerning: our business strategy;
expectations of market and customer response; liquidity and capital
expenditures; future sources of revenues; expansion of our product lines;
addition of new product lines; and trends in industry activity generally. In
some cases, you can identify forward-looking statements by words such as "may,"
"will," "should," "expect," "plan," "could," "anticipate," "intend," "believe,"
"estimate," "predict," "potential," "goal," or "continue" or similar
terminology. These statements are only predictions and involve known and unknown
risks, uncertainties and other factors, including, but not limited to, the risks
outlined under "Risk Factors," that may cause our or our industry's actual
results, levels of activity, performance or achievements to be materially
different from any future results, levels of activity, performance or
achievements expressed or implied by such forward-looking statements. For
example, assumptions that could cause actual results to vary materially from
future results include, but are not limited to: our ability to successfully
develop and market our products to customers; our ability to generate customer
demand for our products in our target markets; the development of our target
markets and market opportunities; our ability to produce and deliver suitable
products at competitive cost; market pricing for our products and for competing
products; the extent of increasing competition; technological developments in
our target markets and the development of alternate, competing technologies in
them; and sales of shares by existing shareholders. Although we believe that the
expectations reflected in the forward-looking statements are reasonable, we
cannot guarantee future results, levels of activity, performance or
achievements. Unless we are required to do so under U.S. federal securities laws
or other applicable laws, we do not intend to update or revise any
forward-looking statements.





PART
I




ITEM
1. BUSINESS




Overview





We are
a distributor of compressed natural gas ("CNG") in China, which we primarily
distribute through our Company-owned CNG fueling stations. As of December 31,
2008, we operated 23 CNG fueling stations in Shaanxi province and 12 CNG fueling
stations in Henan province. We own our CNG fueling stations while we lease the
land upon which our CNG fueling stations operate. For the year ended December
31, 2008, we sold CNG of 147,666,791 cubic meters through our fueling
stations, compared to 83,739,106 cubic meters for the year ended December 31,
2007. We also transport, distribute and sell piped natural gas to residential
and commercial customers in the Xi’an area, including Lantian County, and the
districts of Lintong and Baqiao, in Shaanxi province through a high pressure
pipeline network of approximately 120 kilometers.


3





We
operate four main business lines:





·
            Distribution and sale of
      compressed natural gas through Company-owned CNG fueling stations for
      hybrid (natural gas/gasoline) powered vehicles (35 stations as of December
      31, 2008);





·
            Installation, distribution and
      sale of piped natural gas to residential and commercial customers through
      Company-owned pipelines. We distributed and sold piped natural gas to
      approximately 96,033 residential customers as of December 31,
      2008;





·
            Distribution and sale of gasoline
      through Company-owned CNG fueling stations for gasoline and hybrid
      (natural gas/gasoline) powered vehicles (eight of our CNG fueling stations
      sold gasoline as of December 31, 2008);
  and





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




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





On
October 24, 2006, our variable interest entity, Xi’an Xilan Natural Gas Co.,
Ltd. ("XXNGC"), formed a wholly-owned subsidiary, Shaanxi Jingbian Liquified
Natural Gas Co., Ltd. ("SJLNG"), for the purpose of constructing a liquefied
natural gas ("LNG") facility to be located in Jingbian, Shaanxi province. We
plan to invest approximately $45 million to construct this facility, a portion
of which was funded through the sale of senior notes to Abax Lotus Ltd.
("Abax"), and the remainder of which will be funded by our cash flows from
operations. The LNG plant is under construction and is expected to be completed
and fully operational by the end of 2009. Once completed, the plant is expected
to have a LNG processing capacity of 500,000 cubic meters per day, or
approximately 150 million cubic meters on an annual basis.





We had
total revenues of $67,720,659, $35,392,053 and $18,828,790 for the three years
ended December 31, 2008, 2007 and 2006, respectively.  We had net
income of $15,190,368, $9,116,070 and $5,451,095 for the three years ended
December 31, 2008, 2007 and 2006, respectively.





Our
Corporate History and Structure





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





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





On
February 22, 2006, we formed Xilan Natural Gas Equipment Co., Ltd., ("Xilan
Equipment") as a wholly foreign owned enterprise (“WFOE”). We then, through
Xilan Equipment, entered into exclusive arrangements with XXNGC and these
shareholders that give us the ability to substantially influence XXNGC's daily
operations and financial affairs, appoint its senior executives and approve all
matters requiring shareholder approval. We memorialized these arrangements on
August 17, 2007. As a result, we consolidate the financial results of XXNGC as a
variable interest entity pursuant to FASB Interpretation No. 46R, "Consolidation
of Variable Interest Entities."





On
October 24, 2006, XXNGC formed a wholly-owned subsidiary, SJLNG, a limited
liability company organized under the laws of the PRC to administer the
production and sales of LNG.





On
December 1, 2006, XXNGC formed a wholly-owned subsidiary, Xi'an Xilan Auto Body
Shop Co., Ltd. ("XXABC"), which converts gasoline-fueled vehicles to hybrid
(natural gas/gasoline) powered vehicles.





On
July 3, 2008, XXNGC formed a wholly owned subsidiary, Henan Xilan Natural Gas
Co., Ltd. ("HXNGC"), for the purpose of improving the efficiency of our natural
gas fueling station operations, pipeline construction, engineering design,
construction and technical advisory work services in Henan province. HXNGC also
operates our CNG fueling stations in Henan province.





On
October 2, 2008, XXNGC acquired a 100% equity interest in Lingbao Yuxi Natural
Gas Co., Ltd. ("LBNGC"), which possesses the right to operate CNG fueling
stations and pipelines in the city of Lingbao, from the shareholders of LBNGC,
Zhihe Zhang, who held a 90% ownership interest in Henan, and Lingjun Hu, who
held a 10% ownership interest in Henan.





The
following diagram illustrates our corporate and share ownership
structure:




4











Our
Variable Interest Entity Agreements





The
following is a summary of the agreements we have with our variable interest
entity, XXNGC:





Consulting Service Agreement, dated
August 17, 2007.Under this agreement entered into between Xilan
Equipment and XXNGC, Xilan Equipment provides XXNGC exclusive consulting
services with respect to XXNGC's general business operation, human resources and
research and development. In return, XXNGC pays a quarterly service fee to Xilan
Equipment, which is equal to XXNGC’s revenue for such quarter. The term of
this agreement is indefinite unless Xilan Equipment notifies XXNGC of its
intention to terminate this agreement. XXNGC may not terminate this agreement
during its term. This agreement is retroactive to March 8,
2006.





Operating Agreement, dated August
17, 2007. Under this agreement entered into between Xilan Equipment,
on the one hand, and XXNGC and certain shareholders of XXNGC, on the other hand,
Xilan Equipment agrees to act as a guarantor for XXNGC in the contracts,
agreements or transactions in connection with XXNGC’s operation between XXNGC
and any other third party, to provide full guarantee for the performance of such
contracts. XXNGC agrees, as a counter-guarantee, to pledge all of its assets,
including accounts receivable to Xilan Equipment. The XXNGC shareholders party
to this operating agreement agree to, among other things, appoint as XXNGC's
director, individuals recommended by XXNGC and appoint Xilan Equipment's senior
officers as XXNGC's general manager, chief financial officer and other senior
officers. The term of this agreement is indefinite unless Xilan Equipment
notifies XXNGC of its intention to terminate this agreementwith 30 days prior
notice. XXNGC may not terminate this agreement during its term. This agreement
is retroactive to March 8, 2006.





Equity Pledge Agreement,datedAugust 17, 2007. Under this agreement
entered into between Xilan Equipment, on the one hand, and XXNGC and certain
shareholders of XXNGC, on the other hand, to secure the payment obligations of
XXNGC under the Consulting Service Agreement described above, the XXNGC
shareholders party to this equity pledge agreement have pledged to Xilan
Equipment their entire equity ownership interests in XXNGC. Upon the occurrence
of certain events of default specified in this agreement, Xilan Equipment may
exercise its rights and foreclose on the pledged equity interest. Under this
agreement, the pledgors may not transfer the pledged equity interest without
Xilan Equipment's prior written consent. This agreement will also be binding
upon successors of the pledgor and transferees of the pledged equity interest.
The term of the pledge is two years after the obligations under the Consulting
Service Agreement have been fulfilled. This agreement is retroactive to March 8,
2006.


5


OptionAgreement, datedAugust 17, 2007.Under this option agreement
entered into between Xilan Equipment, on the one hand, and XXNGC and certain
shareholders of XXNGC, on the other hand, the XXNGC shareholders party to this
option agreement irrevocably granted to Xilan Equipment, or any third party
designated by Xilan Equipment, the right to acquire, in whole or in part,
the respective equity interests in XXNGC of these XXNGC shareholders. The option
agreement can be terminated by Xilan Equipment by notifying XXNGC of its
intention to terminate this agreement with 30 days prior notice. The option
agreement is retroactive to March 8, 2006.





Addendum totheOption Agreement,datedAugust 8, 2008.Underthis addendum to the
option agreement entered into between Xilan Equipment, on the one hand, and
XXNGC and certain shareholders of XXNGC, on the other hand, the XXNGC
shareholders (the "Transferors") irrevocably granted to Xilan Equipment an
option to purchase the XXNGC shareholders' additional equity share in XXNGC (the
"Additional Equity Interest") in connection with an increase in XXNGC's
registered capital since the execution of the option agreement at $1.00 or
the lowest price permissible under the applicable laws at the time that Xilan
Equipment exercises the option to purchase the Additional Equity Interest. The
option agreement can be terminated by Xilan Equipment by notifying XXNGC of its
intention to terminate this agreement with 30 days prior notice. This
addendum is retroactive to June 30, 2008.





Proxy Agreement datedAugust 17, 2007. Under
this agreement entered into between Xilan Equipment, on the one hand, and XXNGC
and certain shareholders of XXNGC, on the other hand, the
XXNGC shareholders irrevocably granted to Xilan Equipment the right to
exercise their shareholder voting rights, including attendance at and voting of
their shares at shareholders meetings in accordance with the applicable laws and
XXNGC’s articles of associations. This agreement is retroactive to March 8,
2006.





Our
Products, Services and Customers





CNG
and Gasoline Fueling Stations





As of
December 31, 2008, we operated 23 CNG fueling stations in the Shaanxi province
and 12 CNG fueling stations in Henan province. Through these Company-owned
fueling stations, CNG is sold to taxis, buses and private cars that operate with
CNG technology. During the year ended December 31, 2008, we purchased natural
gas at an average cost of RMB1.11/cubic meter and sold each cubic meter for
RMB2.34 net of value added taxes in Shannxi province and we purchased natural
gas at an average cost of RMB1.31/cubic meter and sold each cubic meter for
RMB2.83 net of value added taxes in Henan province.





We
continue to expand our CNG fueling station base by constructing new stations as
well as acquiring existing stations. We can obtain approvals and construct a CNG
fueling station in Shaanxi province in approximately 60 days for a cost of
approximately US$1,300,000 to US$1,500,000. We are evaluating additional sites
for CNG fueling stations in Shaanxi, Henan and in other
regions.





We also
own three natural gas compressor stations. Two are located in Xi’an: Hongqing
station, acquired in July 2005, near our pipeline; and Changsheng station,
acquired in September 2008. The third station is located in Xianyang city and
was acquired in January 2008. A compressor station compresses natural gas and
allows trucks to transport CNG to fueling stations. We currently have a daily
processing capacity of 250,000 cubic meters of CNG.





We began
to distribute and sell gasoline during the fourth quarter of 2007 in an effort
to support our sales of CNG by attracting more natural gas/gasoline hybrid car
owners through providing a one-stop refueling option for such customers. Our
gasoline facilities were either installed by us at our existing CNG stations or
acquired through our acquisition of CNG fueling stations that have both CNG and
gasoline fueling capability. As of December 31, 2008, we distributed and sold
gasoline at eight of our Company-owned CNG fueling stations for gasoline and
hybrid (natural gas/gasoline) powered vehicles in Xi'an. During the year ended
December 31, 2008, we purchased gasoline at an average cost of RMB3.95/liter and
sold each liter at an average price of RMB4.65 net of value added taxes in
Xi'an.





Our
Pipeline Distribution System





We own
and operate a high pressure pipeline network of approximately 120 kilometers in
the Xi’an area. The network connects to a high pressure government pipeline
network operated by Shaanxi Natural Gas Company, which supplies natural gas
directly from a gas field in the northern region of the province. Our high
pressure pipeline then feeds into city-gate "let-down" stations at Hongqing and
Lantian County, where the pressure is reduced and natural gas is transported
through a network of low-pressure distribution pipes to supply our residential
and commercial customers in Lantian County and the Lintong and Baqiao Districts.
The supply also feeds our compressor stations at Hongqing and Xianyan where CNG
is collected by tankers to supply our CNG fueling stations.





Each of
our pipeline customers is physically connected to our pipeline network through
Company-installed and maintained piping and natural gas usage gauges. We
generate revenues both from the sale of natural gas to these customers and the
installation and maintenance of this equipment.





We
believe we are currently the sole authorized provider of natural gas to
residential customers in our service areas and the only privately owned company
in Shaanxi province to own and operate this type of high pressure
pipeline.




6


Our
Automobile Conversion Sites





We began
our automobile conversion business during the second quarter of 2007. Our
automobile conversion sites convert gasoline-fueled vehicles to hybrid (natural
gas/gasoline) powered vehicles. As of December 31, 2008, we had four auto
conversion sites, all in the Xi'an area.





Our
CNG Market





As of
December 31, 2008, we estimate that there were approximately 14,285 vehicles
using CNG in the Xi’an area of which 3,639 were buses and 10,646 were taxis.
Each bus uses an average of approximately 100 cubic meters of CNG per day and
each taxi uses an average of approximately 40 cubic meters of CNG per day
(Source: Xi’an Clean Fuel Vehicles Commission 2007 and PRC Ministry of Science
and Technology). The PRC government estimates in its Eleventh Five Year Plan
(2006-2010) that current total demand for CNG as a vehicular fuel in the Xi’an
area will reach approximately 1,070,000 cubic meters per day by 2010. Compared
to gasoline and diesel, we believe natural gas as vehicular fuel is cheaper,
cleaner and safer. The PRC government’s Clean Energy Policy encourages the use
of CNG as a vehicular fuel.





We
estimate that the average CNG station in Xi’an pumped approximately 11,000 cubic
meters of CNG per day in 2008. As of December 31, 2008, there were 71 CNG
fueling stations in Xi’an and we estimate that approximately 781,000 cubic
meters of CNG was pumped per day during 2008, a figure below estimated total
demand. As a result, we believe that there is unmet demand for CNG as vehicular
fuel in the Xi’an area.





As of
December 31, 2008, there were approximately 7,500 vehicles using CNG in Henan
province, of which 3,000 were buses and 4,500 were taxis. (Source: Zhengzhou
Vehicle Administration Bureau). We estimate each bus uses an average of
approximately 100 cubic meters of CNG per day and each taxi uses an average of
approximately 40 cubic meters of CNG per day.





We
estimate that the average CNG station in Henan pumped approximately 11,000 cubic
meters of CNG per day in 2008. As of December 31, 2008, there were 40 CNG
fueling stations in Henan and we estimate that approximately 440,000 cubic
meters of CNG was pumped per day during 2008, a figure below estimated total
demand. As a result, we believe that there is unmet demand for CNG as vehicular
fuel in the Xi’an area.





While
there are many competitors in the distribution and sale of CNG in China, we
believe we are well positioned in the market through our cooperation with local
natural gas suppliers and our experience in Shaanxi and Henan.





Our
Pipeline Network Customers





As of
December 31, 2008, we had 96,033 customers, including residential and commercial
customers. We continue to expand our customer base in Xi’an's newly developed
business and residential areas including Xihan and Chanliu. Our commercial
customers, including the Xiwei Aluminum Company and the Hungtian Company, use
natural gas as a raw material for their production process. We are not dependent
upon any single customer or group of customers for a material portion of our
natural gas sales or revenues.




Our
pipeline customers purchase natural gas by prepaid cards that can be inserted
into the connection equipment to initiate gas flow.





We
entered into agreements with the Xi’an International Port Administrative
Committee (the “Port Committee”) and the town of Tangyu, China, in April 2008
and October 2008, respectively, to provide natural gas to local residents and
businesses. The international port project is estimated to involve the
development of approximately 13.5 square miles of business district and the
investment of up to $30 million over the next several years, based on the Port
Committee’s planning schedule. The Tangyu project involves supplying natural gas
to potentially 50,000 residential and commercial users at a tourist site
undergoing development and expansion. Our agreement with the Port Committee is
currently being challenged by the Xi'an Municipal Administration Commission for
violating an exclusive agreement between the municipal government and Qin Hua
Gas Company, one of our major competitors in our pipeline natural gas business.
We disagree with the Xi'an Municipal Administration Commission's assessment and
are currently in negotiations with it to resolve its assessment.





Our
Liquefied Natural Gas (“LNG”) Project





In
September 2007, we began the construction of an LNG processing and distribution
plant in Jingbian, Shaanxi province (the "LNG Project"). We estimate that the
LNG Project will cost approximately $45 million (RMB309 million), a portion of
which was funded by funds raised through the sale of senior notes to Abax, and
the remainder of which will be funded by our cash flows from operations. We
believe we have obtained all the required permits and approvals to build the LNG
plant and expect to commence production and sale of LNG by the end of
2009.





During
2008, we made significant progress towards completing the LNG Project and spent
approximately $20 million in constructing our LNG facility, acquiring technology
licenses, prepaying for equipment purchases and acquiring land use rights. We
believe that adding LNG to our product offerings will expand our geographic
sales footprint and improve our revenues and profitability as well diversify our
revenue and profit structure. The facility construction work is expected to be
completed in October 2009, and processing equipment installation and testing is
expected to be completed in December 2009.


7





Both CNG
and LNG are natural gas compressed into canisters for convenient transportation,
usually by tank trucks, to locations of distribution or consumption. Typically,
CNG is compressed at 200 kilograms per cubic centimeter and LNG is compressed at
up to 625 times atmospheric pressure per normal cubic meter and must be
transported at sub-zero temperatures. The cost of compressing and processing LNG
is higher than CNG, but LNG can be transported in larger volumes and over longer
distances per tanker and the per unit transportation costs are therefore lower
than CNG.





We
believe we are well positioned in the LNG business because the NDRC has stopped
approving LNG projects based on onshore gas fields that involve the processing
of domestic natural gas supplies since August 2007.





Suppliers





We
purchase our natural gas mainly from four vendors, namely, Shaanxi Natural Gas
Co. Ltd., Petrochina Chang Qing Oil Field Branch, Jiyuan City Yuhai Gas Co.,
Ltd. and Jincheng City Mingshi Coal Bed Methane Utilization Co., Ltd. Our supply
contract with our largest supplier, Shaanxi Natural Gas Co. Ltd., is renewed on
an annual basis. We have supply agreements with Petrochina Chang Qing Oil Field
Branch, Jiyuan City Yuhai Gas Co., Ltd. and Jincheng City Mingshi Coal Bed
Methane Utilization Co., Ltd. with no minimum purchase requirements. The price
of natural gas is strictly controlled by the government and has remained steady
over the past three years.  We do not expect the price to change
materially in 2009.





On
October 19, 2006, we received a letter from PetroChina Company Limited pursuant
to which PetroChina agreed in principle to supply up to 150 million cubic meters
of natural gas annually to our LNG Project subsidiary subject to the negotiation
of a final agreement once our LNG plant is near completion.





We do not
expect any difficulty in continuing to renew our supply contracts during the
next 12 months.





PRC
Natural Gas Industry Overview





We
believe China's rapidly expanding economy is stretching the limits of its energy
resources. The country is the world’s second largest energy consumer after the
United States, with an annual energy consumption growth rate as high as 12.0%
between 2002 and 2007. (Source: BP Statistical Review of World Energy June
2009). During the same period, natural gas consumption grew at 18.2% annually.
(Source: BP Statistical Review of World Energy June 2009). Natural gas currently
accounts for only 3.3% of the PRC's total energy usage, compared to the world
average 23.8% in 2007. (Source: BP Statistical Review of World Energy June
2009).





According
to China’s Ministry of Science & Technology and the World Petroleum Council
China Committee’s 2009 report, for the next 20 years, China’s energy consumption
elasticity index will remain at 0.45-0.50, with coal at 0.30, petroleum at 0.50,
natural gas at 1.4-1.5 and non-renewable electricity at 0.50-0.60. China's
natural gas represents the fastest-growing energy source. (Source: Academy of
Macroeconmic Research, NDRC: www.energy.amr.gov.cn). With
the operation of China’s West-East Natural Gas Pipeline project, NDRC's Research
Centre for Energy Economy and Development Strategy estimated that China’s
natural gas consumption will reach a volume of 100-120 billion cubic meters in
2010, representing an expected CAGR of 15%-17% growth since 2000.





China’s
Eleventh Five-Year Plan (2006-2010) has made the development of natural gas
engines for heavy-load trucks a national key development project, indicating the
Chinese central government’s decision to rely on natural gas as a major
alternate fuel source for high-consumption vehicles.





In order
to meet the demand for natural gas, the PRC government has encouraged private
companies to invest in and build the necessary transportation, distribution and
sale infrastructure for natural gas. On February 24, 2005, China’s State Council
issued an opinion encouraging and supporting private sector businesses to
participate in industries that were previously controlled by state-owned
enterprises. Those industries open to private sectors include oil and natural
gas distribution.  The February 24, 2005 opinion provided a legal
framework for private urban natural gas distribution.





Sources
of Energy





The PRC
has traditionally relied heavily on coal and crude oil as its primary energy
sources. According to the China Statistical Yearbook, in 2006, coal, crude oil,
hydro-electricity and natural gas accounted for 69.4%, 20.4%, 7.2% and 3.0%,
respectively, of the PRC's total energy consumption. During the PRC government’s
Eleventh Five Year Plan (2006-2010), the percentage of coal, crude oil and
hydro-electricity is planned to decline to 66.1%, 20.5% and 6.8%, respectively,
while that of natural gas is planned to increase to 5.1%. Traditionally, a large
portion of natural gas is consumed as raw material for production of fertilizer.
A little over 10% of natural gas is consumed as fuel. (Source: The Institute of
Energy Economics of Japan).




8


The PRC's
heavy reliance on coal exceeds world consumption rates for the same period,
which was 22.2% (Source: Energy Information Administration, U.S. Department of
Energy). The use of coal, however, causes air pollution and other negative
consequences to the environment. In the PRC, the heavy use of unwashed coal has
led to large emissions of sulfur dioxide and particulate matter. An air
pollution study conducted by the World Health Organization in 2006 showed that
seven of the 10 most polluted cities in the world were located in the PRC. As
such, there have been serious environmental concerns in many countries around
the world, resulting in a global trend to reduce coal usage. In consideration of
such trends, in 2006, the PRC presented a plan to raise the share of natural gas
in the country's energy mix (Source: 11th Five-Year Plan (2006-2010)). Before
2006, local municipal governments controlled gas distribution. Since then, the
industry has been opened to private companies, whose investments have fostered
an increase in the use of natural gas in the PRC. The PRC government has deemed
the natural gas industry a suitable industry for public and private
investments.





China's
Natural Gas Reserves and Gas Pipeline Infrastructure





Recognizing the serious problems caused
by the heavy reliance on coal usage, the PRC government has aggressively moved
to reduce coal usage by substituting coal with other, more environmentally
friendly forms of fuel, such as natural gas. The PRC is relatively rich in
natural gas reserves, with major gas fields located inland, in the western and
north-centrals parts of China such as Xinjiang, Sichuan, and Shaanxi provinces,
as well as Inner Mongolia. (Source:International Energy Agency).  According to China’s
Ministry of Science & Technology and World Petroleum Council China
Committee’s 2009 report, by the end of 2007, natural gas reserves in China are
estimated to be 4.7 trillion cubic meters with 3.1 trillion cubic meters
explorable. According to forecast by the PRC Industry of Science of Technology,
from 2009 to 2020, China’s natural gas reserve will increase another 3.0
trillion cubic meters with cumulative reserves exceeding 6.0 trillion cubic
meters (Source: official website of PRC Ministry of Science & Technology:www.most.gov.cn).





Because
China's largest reserves of natural gas are located in western and north-central
China, in 2002, the Chinese government initiated the construction of a 4,000
kilometer long high pressure pipeline project in order to transport natural gas
from Xinjiang and Shaanxi in the northwestern parts of China to Beijing,
Shanghai, and other cities in the southern and eastern regions of China which
are economically stronger and thus account for more energy consumption. The
pipeline network, which runs across nine provinces in China, commenced
operations in December 2004 and has significantly optimized the energy
infrastructure of China.





Demand
for Natural Gas





In 2007, natural gas consumption in the
PRC accounts for about 3.3% of its total energy consumption. (Source: BP
Statistical Review of World Energy June 2009) and China became onethe
world’s top 10 countries in terms of natural gas consumption. (Source:
International Energy Agency). It
is anticipated thatChina will become the top natural gas consuming
country in the Asia-Pacific region, overtaking Japan by 2015. (Source: International Energy
Agency) which we believe is driven by environmental pressures, improvements in
social infrastructure fueled by
economic growth, and a stable energy supply.





According
to China’s National Natural Gas Overall Plan by the State Council, the number of
cities pipelined with natural gas is expected to increase from 140 in 2005 to
270 in 2010 and by the middle of the 21st century, 70% of all cities in China
will be pipelined. Annual natural gas output will increase from 70 billion cubic
meters to 120 billion – 150 billion cubic meters by 2020. According to the
Energy Information Administration ("EIA")’s forecast, worldwide natural gas
consumption is expected to increase by 51.9% from 104 trillion cubic feet in
2005 to 158 trillion cubic feet in 2030 and natural gas is expected to replace
oil wherever possible.





Competition





The three
largest state owned energy companies, CNPC (China National Petroleum
Corporation) Group, SINOPEC (China Petroleum and Chemical Corporation Group),
and CNOOC (China National Offshore Oil Corporation Group) largely dominate the
upstream supply of energy and are significant competitors in the exploration and
transportation of oil and natural gas in China. They build most of the country's
high-pressure pipeline infrastructure. Natural gas is distributed to smaller
regional firms that redistribute the gas to end users, either through lower
pressure pipeline networks, or via tankers in the form of liquid natural gas and
CNG.





As of
December 31, 2008, there were approximately 71 CNG fueling stations in Xi’an
City, among which 15 were state owned enterprises and the remaining 35 stations
were privately owned by other CNG fueling station operators, with the majority
of these being single station operators. We believe that we effectively compete
with the stations based upon our scale, network, stable source of gas supply,
compressing capabilities and brand awareness.





With respect to our pipeline gas
services in Xi’an, we believe we and our competitors each serve a city area
designated by the local government on an exclusive basis; therefore, there is no
direct competition in our pipeline gas services to the extent of the designated
areas. Other pipeline gas service providers in the city of Xi’an include Qin Hua
Natural Gas Limited.





With
respect to our LNG business, our major competitor is expected to be Xinjiang
Guanghui LNG Development Limited, which is located in China’s Xinjiang Uighur
Autonomous Region and has an annual capacity of approximately 300 million cubic
meters. Both our and our competitor’s major target market for the LNG business
is southern China’s economically-developed Guangdong province and its
surrounding regions. However, the distance to the target market from our LNG
facility is only one third of our major competitor, thus giving us a significant
cost advantage in transportation.


9





Intellectual
Property





We have
applied for a service mark on the “Xilan” name, which is used in connection with
all our products and services. XXNGC is currently preparing to apply for the
“CNG” trademark. XXNGC has also applied for the registration of its corporate
name as a trademark under Application No. 5055703. This application has been
published for opposition. If there are no successful oppositions once this
opposition period expires on September 7, 2009, our corporate name will be
registered as a trademark.





Research
and Development





We have
not had and do not anticipate having any material research and development
expenses. The funding for all research and development expenses is expected to
come from operating cash flows.





Governmental
and Environmental Regulation





To date,
we have complied with, or are in the process of renewing, all registrations and
requirements for the issuance and maintenance of all licenses required by the
applicable governing authorities in China. These licenses include:




·
            Xi’an
      Natural Gas Operations License, authorized by the Shaanxi Municipal
      Management Committee, effective from January 2, 2004 to January 2, 2009.
      As we are in the process of renewing such license and expect to receive
      the renewed license by the end of July 2009, we do not expect the lapse of
      such license to have a material impact on our
  business.





·
            License
      to Supply, Install Equipment and Maintain Gas Fuel Lines issued by the
      local Gas Fuels for Heating Bureau, an agency of the Ministry of
      Construction and the Xi’an Natural Gas Management Bureau. (License number:
      XIRAN 136)





·
            Safety
      and Inspection Regulation for Special Equipment Safety Inspection
      Standards for High Pressure Pipeline and Technical Safety Inspection
      Regulations from the Shaanxi Quality and Technology Inspection Bureau for
      compressor stations and pressure storage tank system. (Approval letter
      reference: 2004SHAANGUOCHUHAN033)




·
            Annual
      Safety Inspection of Lightning Conductor Equipment approved by the Shaanxi
      Meteorology Bureau. (Certificate number 0005274) The City-gate and
      Compressor Stations are approved by the local office of the Ministry of
      Construction.





·
            Business
      license to operate Xilan Equipment effective from February 22, 2006 to
      February 21, 2021.





·
            Business
      license to operate Xi’an Xilan Natural Gas Co., Ltd. effective as of
      January 8, 2000.





·
            Business
      license to operate Xi’an Xilan Auto Body Shop Co., Ltd. effective as
      of December 1, 2006.





·
            Business
      license to operate Shaanxi Jingbian Liquified Natural Gas Co. Ltd.
      effective from October 24, 2006 to October 23, 2036.·
            Business
      license to operate Henan Xilan Natural Gas Co. Ltd. effective from July 3,
      2008 to June 25, 2018.





·
            Business
      license to operate Lingbao Yuxi Natural Gas Co., Ltd. effective from June
      13, 2008 to June 12, 2012.




Fuel
service station standards are subject to regulation by the Ministry of
Construction, the General Administration of Quality Supervision and the Bureau
of Inspection and Quarantine of the People's Republic of China. Upon
satisfactory inspection of service stations, certificates will be
issued.





Various
standards must be met for fueling stations, including the handling and storage
of CNG, tanker handling and compressor operation. The Local Ministry of
Construction and the Gas Field Operation Department of the Municipal
Administration Committee regulate these standards. The Municipal Development and
Reform Commission, which issues certificates for the handling of dangerous
chemical agents, carries out inspections.





Standards
for the design and construction of fueling stations must conform to GB50156-2202
and technology standard BJJ84-2000.





Employees




As of
December 31, 2008, we had 1,048 employees, including, 170 in management, 15 in
sales, and 863 in finance, accounting, and operations. We have not experienced
any industrial actions and we believe we have good relationships with our
employees. We are not a party to any collective bargaining
agreements.




10


Available
Information





Our
website is http://www.naturalgaschina.com/.  We
provide free access to various reports that we file with, or furnish to, the
U.S. Securities and Exchange Commission, or the SEC, through our website, as
soon as reasonably practicable after they have been filed or
furnished.  These reports include, but are not limited to, our annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, and any amendments to those reports.  Information on our website
does not constitute part of and is not incorporated by reference into this
Annual Report on Form 10-K or any other report we file or furnish with the
SEC.  You may also read and copy any document that we file at the
public reference facilities of the SEC in Washington, D.C. You may call the SEC
at 1-800-SEC-0330 for further information on the public reference rooms. Our SEC
filings are also available to the public from the SEC’s website at http://www.sec.gov.





ITEM
1A. RISK FACTORS




RISK
FACTORS





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





Risks
Related to Our Business and the PRC Natural Gas Industry





We
may be adversely affected by the slowdown of China’s economy caused in part by
the recent global crisis in the financial services and credit
markets.





We rely
on demand for natural gas in China for our revenue growth, which is
substantially affected by the growth of the industrial base, increase in
residential and vehicle consumption and the overall economic growth of China.
The growth of China’s economy experienced a slowdown in late 2007. We believe a
number of factors contributed to this slowdown, including appreciation of the
Renminbi against the U.S. dollar and the Euro, which has adversely affected
China’s exports, and tightening macroeconomic measures and monetary policies
adopted by the PRC government aimed at preventing overheating of China’s economy
and controlling China’s high level of inflation. The slowdown was further
exacerbated by the recent global crisis in the financial services and credit
markets, which has resulted in extreme volatility and dislocation of the global
capital markets.





It is
uncertain how long the global crisis in the financial services and credit
markets will continue andthe impact
this will have on the global economy in general and the economy of China in
particular. We are currently unable to estimate the impact the slowing of the
PRC economy will have on our business as the impact of the decline in
international trade is being offset in part through domestic stimulus spending,
expanded bank lending, increases in the speed of regulatory approvals of new
construction projects and other economic policies. We do not believe we have
experienced reduced demand for natural gas to date. If the economic downturn
continues, our business may be negatively affected by any decrease in demand for
our natural gas products and services. Reduction in demand for natural gas would
have a material and adverse effect on our financial condition and results of
operations. In particular, if customers of taxis come to rely more on mass
transit rather than taxis, a decline in demand for taxis may result in a decline
of CNG as a vehicle fuel which would adversely affect our revenue and ability to
sustain and grow our operations.





We
have benefited from the natural gas procurement and sale prices set by
government authorities.





Natural
gas sales accounted for 82.3%, 79.9% and 72.8% of our revenue for the three
years ended December 31, 2008, 2007 and 2006, respectively. However, the prices
at which we purchase our natural gas supplies and sell our natural gas products
are strictly regulated by the PRC central government, including the National
Development and Reform Commission (“NDRC”), and the local state price bureaus
who have the discretion to set natural gas prices within the boundaries set by
the PRC central government. Our results of operations for the periods reviewed
have benefited from the natural gas procurement and sale prices set by
government authorities. There is no assurance that the government authorities
will continue to set natural gas procurement and sale prices at levels that will
allow us to improve or even maintain our margins. Increased natural gas prices
affect the cost to us of natural gas and will adversely impact our margins in
cases where we are unable to pass on the increased costs to our customers. In
addition, higher natural gas prices may adversely impact the adoption of CNG and
LNG and have a material and adverse effect on our financial condition and
results of operations.




11


Our
competitors and potential competitors may be larger than us and have greater
financial and other resources than we do and those advantages could make it
difficult for us to compete with them.





We expect
to face intense competition in the natural gas industry, including in both the
CNG and LNG industries. Our current, and potential, competitors include
companies that are part of much larger companies, including state-owned
enterprises. These companies are likely to have greater resources than we do,
including longer operating history, larger customer base, stronger customer
relationships, greater brand or name recognition and greater financial,
technical, marketing, relationship and other resources and may be able to use
these greater resources to enter into the CNG and LNG industries and gain
substantial market share. Competition could result in price reductions, fewer
purchases, reduced gross margins and loss of market share. If we are unable to
remain competitive, we may not be able to establish our LNG business, expand our
CNG business into new provinces or even maintain our current share of the CNG
market in China.





Prices
of natural gas in the PRC are subject to government regulation and can be
subject to significant fluctuations.




Although
regulated by the PRC central government, natural gas prices in China can be
subject to significant fluctuations. Natural gas prices may be increased by the
government for policy or other reasons including in response to changing
national or international market forces, such as changes in domestic and foreign
supplies of natural gas, domestic storage levels, crude oil prices, the price
difference between crude oil and natural gas, price and availability of
alternative fuels, weather conditions, level of consumer demand, economic
conditions, price of foreign natural gas imports, and domestic and foreign
governmental regulations and political conditions. The volatility of natural gas
prices could adversely impact the adoption of CNG vehicle fuel and our
business.




Natural
gas operations entail inherent safety and environmental risks that may result in
substantial liability to us.




Natural
gas operations entail inherent risks, including equipment defects, malfunctions
and failures, human error and natural disasters, which could result in
uncontrollable flows of natural gas, fires, explosions, property damage, injury
and death. For example, a competitor of ours in Xi'an providing natural gas to
residences recently experienced an accident resulting in significant property
damage, injury and death. CNG fuel tanks, if damaged or improperly maintained,
may rupture and the contents of the tank may rapidly decompress and result in
death or injury. Also, operation of LNG pumps requires special training and
protective equipment because of the extreme low temperatures of LNG. LNG tanker
trailers have also in the past been, and may in the future be, involved in
accidents that result in explosions, causing loss of life, injury and property
damage. Improper loading of LNG vehicles can result in venting of methane gas,
leading to explosions.




Inherent
in our natural gas pipeline business are a variety of hazards and operational
risks, such as leaks, ruptures and mechanical problems. The location of
pipelines near populated areas, including residential areas, commercial business
centers, industrial sites and other public gathering places, could increase the
level of damage resulting from these risks, including the loss of human life,
significant damage to property, environmental damage, impairment of our
operations and substantial loss to us. The risks associated with out natural gas
businesses may expose us to liability for personal injury, wrongful death,
property damage, pollution and other environmental damage. We may incur
substantial liability and cost if damages are not covered by insurance or are in
excess of policy limits.




We
are dependent on a limited number of suppliers of natural gas, which may affect
our ability to supply natural gas to our customers.




With
the exception of certain compressed and liquid natural gas supplies, we obtain
our supplies of natural gas primarily from four suppliers. The ability to
deliver our product is dependent on a sufficient supply of natural gas and if we
are unable to obtain a sufficient natural gas supply, we may be prevented from
making deliveries to our customers. While we have supply contracts, we do not
control our suppliers, nor are we able to control the amount of time and effort
suppliers put forth on our behalf. It is possible that our suppliers will not
perform as expected and that they may breach or terminate their agreements with
us. Our supply contract with our largest supplier Petrochina Chang Qing Oil
Field Branch. It is possible that, after a review of our supply contract,
they will choose to provide services to a competitor. Any failure to obtain
supplies of natural gas could prevent us from delivering our product to our
customers and could have a material adverse affect on our business and financial
condition.





Our
growth depends in part on environmental regulations and programs mandating the
use of cleaner burning fuels, and modification or repeal of these regulations
may adversely impact our business.





Our
business depends in part on environmental regulations and programs in China that
promote the use of cleaner burning fuels, including natural gas, for vehicles.
In particular, China’s 11th Five-Year Plan (2006-2010) has made the development
of natural gas engines for heavy-load trucks a national key development project.
In order to meet the demand for natural gas, the PRC government has encouraged
private companies to invest in and build the necessary transportation,
distribution and sale infrastructure for natural gas. On February 24, 2005,
China’s State Council issued an opinion encouraging and supporting private
sector businesses to become involved in industries that were previously
controlled by state-owned enterprises, including oil and natural gas
distribution. In 2007, China's State Development and Reform Commission
officially included CNG/gasoline hybrid vehicles in the country's "encouraged
development" category. In addition, local governments, including those in
Chongqing, Hangzhou, Nanjing, Lanzhou and Dongguan have enacted policies
providing subsidies to taxis and buses which covert their gasoline vehicles to
CNG/gasoline hybrid vehicles. Any delay, repeal or modification of these
regulations or programs that encourage the use of natural gas for vehicles could
have a detrimental effect on the PRC natural gas industry, which, in turn, could
slow our growth and materially adversely affect our business.




12


The
infrastructure to support coal, gasoline and diesel consumption is vastly more
developed than the infrastructure for natural gas vehicle and industrial
fuels.





Coal,
gasoline and diesel fueling stations and service infrastructure are widely
available in China. For natural gas vehicle and industrial fuels to achieve more
widespread use in China, they will require a promotional and educational effort
and the development and supply of more natural gas vehicles and fueling
stations. This will require significant continued effort by us as well as the
government, and we may face resistance from oil companies, coal companies and
gasoline station operators. Also, a prolonged economic recession and continued
disruption in the capital markets may make it difficult or impossible to obtain
financing to expand the natural gas vehicle and industrial fuel infrastructure
and impair our ability to grow our business. There is no assurance natural gas
will ever achieve the level of acceptance as a vehicle and industrial fuel
necessary for us to expand our business significantly.





The
expansion of our business into LNG may not be as successful as our CNG business,
or at all.





Although
a similar business to CNG, our expansion into the LNG business entails different
technology and requires us to expand into new markets where permitting,
environmental issues, lack of materials and lack of human resources, among other
factors, could complicate our ability to operate our LNG processing facility and
successfully compete in the LNG segment. In contrast to CNG, the compression and
production costs of LNG are higher than CNG due to LNG's more complicated and
technical process and we may be unable to complete and operate our LNG expansion
successfully due to the advanced technology involved in its production and sale.
In addition, the construction of the LNG processing facility could also create
increased financial exposure through start-up delays, the need for unforeseen
repairs and failure to ramp up to full capacity. If the new plant has higher
than expected operating costs or is not able to produce the expected amounts of
LNG, we may be forced to sell LNG at a price below processing costs and we may
lose money. While we have received a letter from PetroChina Company Limited
pursuant to which PetroChina agreed in principle to supply up to 150 million
cubic meters of natural gas annually to our LNG Project subsidiary subject to
the negotiation of a final agreement once our LNG plant is near completion, we
have not entered into a final agreement. Additionally, if the quality of LNG
produced at the facility does not meet customer specifications, we may be unable
to compete with other LNG producers, which would harm our business. As our
target market for our LNG expansion is outside Shaanxi and Henan, there is no
assurance that we will be able to establish a strong customer base in our LNG
target markets and we currently have not entered into any contracts with
customers for the supply of LNG. While we currently also benefit from the NDRC's
decision in August 2007 to cease approval of LNG projects based on onshore gas
fields that involve the processing of domestic natural gas supplies, there is no
assurance that the NDRC will continue such a moratorium and should the NDRC
resume such approvals, any expansion of our LNG business may be adversely
affected.





We
are in the process of constructing only one LNG plant and any prolonged
disruption of the construction or operation of the LNG plant may adversely
affect our business development plans.





We are
in the process of constructing only one LNG production facility. If, for any
reason, the LNG production facility should fail to be completed in a timely
fashion or does not operate according to expectation, it may become difficult
for us to obtain substitute LNG to sell and distribute without interruption and
near our current or target markets at competitive prices. We do not have any
performance guarantees, insurance or indemnification from our contractors,
sub-contractors or technology licensors in connection with the construction of
our LNG production facility, and we may be required to make additional
investments to complete the project. In addition, if our LNG production facility
or our natural gas suppliers are damaged by severe weather, earthquake or other
natural disaster, or otherwise experiences prolonged downtime, our LNG
production will be restricted. If we are unable to supply enough of our own LNG
or purchase it from third parties to meet customer demand, our ability to expand
our business into LNG sales may be impeded and may hinder our growth and our
business may be adversely affected.





We
failed to comply with PRC law in our recent contribution of capital to SJLNG and
will be subject to possible fines, penalties and administrative action until the
capital contribution is registered in compliance with PRC law.





In
August 2008, the board of directors of XXNGC passed a resolution to increase the
registered capital of SJLNG to RMB118,305,000 through the form of intangible
asset contributions. In September 2008, SJLNG obtained its updated business
license reflecting the increased registered capital. Pursuant to XXNGC's board
resolution, China Natural Gas, Inc. transferred its right to use the two
licenses it obtained relating to the design of our LNG facility directly to
SJLNG as SJLNG's registered capital. However, China Natural Gas, Inc. is not a
shareholder of SJLNG and is therefore not permitted under PRC law to contribute
capital to SJLNG. In addition, PRC law does not allow the contribution of
capital in the form of an intangible asset, such as these two licenses, where
the assets are not owned by the contributor. We are restructuring the capital
contribution as a cash contribution and revising our LNG licenses so that the
licensee is SJLNG and believe this capital contribution and license structure
will comply with PRC law. However, until we have completed this process, the
relevant regulatory authorities may impose fines or penalties, or require us to
cease the operations of SJLNG, until such time as these defects are remedied.
Any such fines, penalties or stop in operations could have a material and
adverse effect on our LNG business in terms of our future growth, financial
condition and results of operations.





We
rely on suppliers of LNG technology.





Due to
the advanced technology involved in the production, loading and transport of
LNG, we have relied on suppliers of LNG technology for the construction of our
LNG plant, and we anticipate we will rely on such suppliers for technology and
know-how in connection with the operation and maintenance of our LNG plant.
There are a limited number of suppliers of LNG technology and we may be unable
to obtain alternate suppliers at acceptable prices, in a timely manner or at
all. If we should lose the assistance of our LNG technology licensors for any
reason, we may be unable to complete or operate our planned LNG plant, which
could have a material and adverse effect on our future growth, financial
condition and results of operations.




13


If
there are advances in other alternative vehicle and industrial fuels or
technologies, or if there are improvements in gasoline, diesel or hybrid
engines, demand for natural gas vehicle and industrial fuels may decline and our
business may suffer.





Technological
advances in the production, delivery and use of alternative fuels that are, or
are perceived to be, cleaner, more cost-effective or more readily available than
CNG or LNG have the potential to slow adoption of natural gas vehicles and
industrial facilities. In addition, advances in gasoline and diesel engine
technology, especially hybrids, may offer a cleaner, more cost-effective option
and make vehicle customers less likely to convert their vehicles to natural gas.
Technological advances related to ethanol or biodiesel, which are increasingly
used as an additive to, or substitute for, gasoline and diesel fuel, may slow
the need to diversify fuels and affect the growth of the natural gas vehicle
market. In addition, hydrogen and other alternative fuels in experimental or
developmental stages may eventually offer a cleaner, more cost-effective
alternative to gasoline and diesel than natural gas. Advances in technology that
slow the growth of or conversion to natural gas vehicles or industrial
facilities or which otherwise reduce demand for natural gas as a vehicle or
industrial fuel will have an adverse effect on our business.





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





We may
require additional cash resources in order to carry out our business development
plans, including constructing and acquiring CNG and LNG fueling and compression
stations. If the cost of any such construction or acquisition that our
management deems appropriate is higher than our cash resources, we will need to
seek additional cash resources, and may seek to sell additional equity or debt
securities or borrow under credit facilities. The sale or issuance of additional
equity securities could result in dilution to our shareholders. The incurrence
of indebtedness would result in increased debt service obligations and could
result in operating and financing covenants that would restrict our operations.
If we are unable to raise additional capital on terms favorable to us or at all,
we may have to delay, scale back, or discontinue our planned facility
construction or acquisitions, or obtain funds by entering into agreements on
terms not favorable to us.  We may also not be able to secure or repay
debt incurred to fund facility construction or acquisition, especially if
the construction or acquisition does not result in the benefits we anticipated.
As a result, our future growth, financial condition and results of operations
may be materially and adversely affected.





We
have limited insurance coverage and may incur losses due to business
interruptions resulting from natural and man-made disasters, and our insurance
may not be adequate to cover liabilities resulting from accidents or injuries
that may occur.


The
insurance industry in China is still at an early stage of development. Insurance
companies in China offer limited commercial insurance products. We carry auto
insurance on our vehicles and maintain workers compensation insurance for our
fueling station workers. We do not carry any product liability insurance or
property insurance on our office buildings, fueling stations, other industrial
sites or other property. We believe that current facilities are adequate for our
current and immediately foreseeable operating needs. We do not have any policies
regarding investments in real estate, securities or other forms of property. We
have determined that balancing the risks of disruption or liability from our
business, or the loss or damage to our property, including our facilities and
equipment, the cost of insuring for these risks on the one hand, and the
difficulties associated with acquiring such insurance on commercially reasonable
terms on the other hand, makes it impractical for us to have such
insurance.





Should
any natural catastrophes such as earthquakes, floods, or any acts of terrorism
occur in Shaanxi or Henan provinces, where our primary operations are located
and most of our employees are based, or elsewhere, we might suffer not only
significant property damage, but also loss of revenues due to interruptions in
our business operations. In addition, the provision of our services depends on
the continuing operation of our natural gas pipelines and fueling stations,
which are also vulnerable to damage or interruption from natural catastrophes
such as earthquakes and acts of terrorism.





The
occurrence of a significant event for which we are not fully insured or
indemnified, and/or the failure of a party to meet its underwriting or
indemnification obligations, could materially and adversely affect our
operations and financial condition. Moreover, no assurance can be given that we
will be able to maintain adequate insurance in the future at rates we consider
reasonable.





Qinan
Ji, our chairman and chief executive officer, has played an important role in
the growth and development of our business since its inception, and a loss of
his services in the future could severely disrupt our business and negatively
affect investor confidence in us, which may also cause the market price of our
common stock to go down.





Qinan Ji,
our chairman and chief executive officer, has played an important role in the
growth and development of our business since its inception. To date, we have
relied heavily on Mr. Ji’s expertise in, and familiarity with, our business
operations, his relationships within the natural gas industry, including with
our suppliers, and his reputation and experience. In addition, Mr. Ji
continues to be primarily responsible for formulating our overall business
strategies and spearheading the growth of our operations. If Mr. Ji were
unable or unwilling to continue in his present positions, we may not be able to
easily replace him and may incur additional expenses to identify and train his
successor. In addition, if Mr. Ji were to join a competitor or form a
competing business, it could severely disrupt our business and negatively affect
our financial condition and results of operations. Although Mr. Ji is
subject to certain non-competition restrictions during and after termination of
his employment with us, we cannot assure you that such non-competition
restrictions will be effective or enforceable under PRC law. Moreover, even if
the departure of Mr. Ji from our company would not have any actual impact
on our operations and the growth of our business, it could create the perception
among investors or the marketplace that his departure could severely damage our
business and operations and could negatively affect investor confidence in us,
which may cause the market price of our common stock to go down. We do not
maintain key man insurance for Mr. Ji.


14




Failure
to attract and retain qualified personnel and experienced senior management
could disrupt our operations and adversely affect our business and
competitiveness.





Our
continuing success is dependent, to a large extent, on our ability to attract
and retain qualified personnel, including well-trained technicians for the
operation and maintenance of our compressing stations, fueling stations,
pipeline and delivery trucks and experienced senior management. Due to the
intense market competition for highly skilled workers and experienced senior
management and our geographical location, we have faced difficulties locating
experienced and skilled personnel in certain areas, such as engineers, station
and truck operators, administration, marketing, product development, sales,
finance and accounting. We cannot assure you that we will be able to
attract or retain the key personnel that we will need to achieve our business
objectives and if one or more of our key personnel are unable or unwilling to
continue to work for us, we may not be able to replace them within a reasonable
period of time or at all.  Our business may be severely disrupted, our
financial condition and results of operations may be materially and adversely
affected, and we may incur additional expenses in recruiting and training
additional personnel. Although our employees and senior management members are
subject to certain non-competition restrictions during and after termination of
their employment, we cannot assure you that such non-competition restrictions
will be effective or enforceable under PRC law. If any of our key personnel
joins a competitor or forms a competing business, our business may be severely
disrupted. We have no key man insurance with respect to our key personnel that
would provide insurance coverage payable to us for loss of their employment due
to death or otherwise.





The
expansion of our business into new provinces may not be as successful as in
Shaanxi and Henan provinces, or at all.





We plan
to expand our business into additional provinces throughout China. However, our
experience in operating CNG fueling stations in Shaanxi and Henan may not be
applicable in other parts of China. We cannot assure you that we will be able to
leverage such experience to expand into other parts of China. When we enter new
markets, we may face intense competition from natural gas operators with
established experience or presence in the geographical areas in which we plan to
expand and from other natural gas operators with similar expansion targets. In
addition, expansion or acquisition may require a significant amount of capital
investment, divert the resources and time of our management and, if we fail to
integrate the new businesses effectively, affect our operating efficiency.
Demand for natural gas and government regulation may also be different in other
provinces. The distribution of natural gas and operations of fueling stations
are highly regulated industries requiring registration for the issuance of
licenses required by various governing authorities in China. Additionally,
various standards must be met for fueling stations, including handling and
storage of natural gas, tanker handling and compressor operation. While we have
benefited from quicker permitting and licensing processes and stable access to
the supply of natural gas in Shaanxi, there is no assurance that we will have
similar success in other provinces. Our failure to manage any of our planned
expansion or acquisitions may have a material adverse effect on our business,
financial condition and results of operations and we may not have the same
degree of success in other provinces that we have had so far to date, or at
all





Growth
in our CNG business may depend on the increased adoption of CNG technology by
buses and private cars and/or the expansion of taxi fleets.





Our
revenue from CNG comes primarily from the sale of CNG as a fuel for vehicles and
we expect this trend will continue. As many of the taxis in our core CNG markets
have adopted CNG technology, growth in our CNG business may depend on the
increased adoption of CNG technology by buses and private cars. If buses and
private cars do not increasingly adopt CNG technology, growth in our CNG
business may be adversely affected.





To expand
our business, we must develop new customers. Whether we will be able to expand
our customer base will depend on a number of factors, including the level of
acceptance and availability of natural gas vehicles, the level of acceptance of
natural gas as a vehicular and industrial fuel, the growth in our target markets
of natural gas infrastructure that supports CNG and LNG sales and our ability to
supply CNG and LNG at competitive prices. The recent and rapid decline in oil,
diesel and gasoline prices may result in decreased interest in alternative fuels
like CNG and LNG. If our potential customers are unable to access credit to
purchase natural gas vehicles it may make it difficult or impossible for them to
invest in natural gas vehicles and the conversion of industrial facilities to
natural gas, which would impair our ability to grow our business.





If
the prices of CNG do not remain sufficiently below the prices of gasoline and
diesel, potential fleet customers will have less incentive to purchase natural
gas vehicles or convert their fleets to natural gas, which would decrease demand
for CNG and limit our growth, including our expansion into LNG .





Natural
gas vehicles cost more than comparable gasoline or diesel powered vehicles
because converting a vehicle to use natural gas adds to its base cost. If the
prices of CNG do not remain sufficiently below the prices of gasoline or diesel,
fleet operators may be unable to recover the additional costs of acquiring or
converting to natural gas vehicles in a timely manner, and they may choose not
to use natural gas vehicles.  Recent and extreme volatility in oil and
gasoline prices demonstrate that it is difficult to predict future
transportation fuel costs. The decline in the price of oil, diesel fuel and
gasoline has reduced the economic advantages that our existing or potential
customers may realize by using less expensive CNG fuel as an alternative to
gasoline or diesel. The reduced prices for gasoline and diesel fuel and
continuing uncertainty about fuel prices, combined with higher costs for natural
gas vehicles, may cause potential customers to delay or reject converting their
fleets to run on natural gas which may limit our growth and cause our business
to suffer.


15





Our
acquisition and investment in other lines of business may be
unsuccessful.





We intend
to selectively pursue strategic acquisition and investment opportunities which
complement or enhance our current businesses with new product lines or customers
at the appropriate time. However, we may encounter strong competition during the
acquisition or investment process and we may fail to select or value targets
appropriately, which may result in our experiencing difficulty in completing
such acquisitions or investments at reasonable cost or at all. Even if an
acquisition or investment is successful, we may have to allocate additional
capital and human resources to implement the integration of the new line of
business. There is no assurance that such integration will be completed within a
reasonable period of time or at all or that it will generate the expected
economic benefits.





If
we are unable to adequately protect our intellectual property, our business
could be harmed.





We
protect our intellectual property through a combination of trademark laws,
confidentiality procedures and contractual provisions, when appropriate.
Nonetheless, our intellectual property rights may not be successfully asserted
in the future or may be invalidated, circumvented or challenged. Enforcement of
intellectual property rights can lead to costly litigation and counterclaims.
There is a risk that the outcome of such potential litigation will not be in our
favor. Such litigation may be costly and may divert management attention as well
as expend other resources which could otherwise have been devoted to our
business. An adverse determination in any such litigation will impair our
intellectual property rights and may harm our business, prospects and
reputation. In addition, historically, implementation of PRC intellectual
property-related laws has been lacking, primarily because of ambiguities in the
PRC laws and difficulties in enforcement. Accordingly, intellectual property
rights and confidentiality protections in China may not be as effective as in
the United States or other countries, which increases the risk that we may not
be able to adequately protect our intellectual property. Moreover, litigation
may be necessary in the future to enforce our intellectual property rights.
Future litigation could result in substantial costs and diversion of our
management’s attention and resources, and could disrupt our business, as well as
have a material adverse effect on our financial condition and results of
operations. Given the relative unpredictability of China’s legal system and
potential difficulties enforcing a court judgment in China, there is no
guarantee that we would be able to halt the unauthorized use of our intellectual
property through litigation.





We may be subject
to intellectual property infringement claims, which may force us to incur
substantial legal expenses and, if determined adversely against us, may
materially disrupt our business.





We cannot
assure you that our intellectual property does not or will not infringe upon
trademarks, valid copyrights or other intellectual property rights held by third
parties. We may become subject to legal proceedings and claims from time to time
relating to the intellectual property of others in the ordinary course of our
business. If we are found to have violated the intellectual property rights of
others, we may be enjoined from using such intellectual property, and we may
incur licensing fees or be forced to develop alternatives. In addition, we may
incur substantial expenses, and may be forced to divert management and other
resources from our business operations, to defend against these third-party
infringement claims, regardless of their merit. Successful infringement or
licensing claims against us may result in substantial monetary liabilities or
may materially disrupt the conduct of our business by restricting or prohibiting
our use of the intellectual property in question.





In
order to comply with PRC laws limiting foreign ownership of Chinese companies,
we conduct our natural gas business through Xi'an Xilan Natural Gas Co., Ltd. by
means of contractual arrangements which may not be as effective as direct
ownership or may be deemed in violation of PRC restrictions on foreign
investment in our industry.





The
government of the PRC restricts foreign investment in natural gas businesses in
China. Accordingly, we operate our business in China through our variable
interest entity, XXNGC.  XXNGC holds the licenses, approvals and
assets necessary to operate our natural gas business in China. We have no equity
ownership interest in XXNGC and rely on contractual arrangements with XXNGC and
its shareholders that allow us to substantially control and operate XXNGC. These
contractual arrangements may not be as effective in providing control over XXNGC
as direct ownership would be. For example, XXNGC could fail to take actions
required for our business despite its contractual obligation to do so. If XXNGC
fails to perform under its agreements with us, we may have to incur substantial
costs and resources to enforce such arrangements and may have to rely on legal
remedies under the law of the PRC, which may not be effective. In addition, we
cannot assure you that XXNGC’s shareholders would always act in our best
interests.





Although
we believe we comply with current regulations of the PRC, we cannot assure you
that the PRC government would agree that our structure or operating arrangements
comply with the PRC’s licensing, registration or other regulatory requirements
with existing policies or with requirements or policies that may be adopted in
the future. If the PRC government determines that our structure or operating
arrangements do not comply with applicable law, it could revoke our business and
operating licenses, require us to discontinue or restrict our operations,
restrict our right to collect revenues, require us to restructure our
operations, impose additional conditions or requirements with which we may not
be able to comply, impose restrictions on our business operations or on our
customers, or take other regulatory or enforcement actions against us that could
be harmful to our business. In addition, the equity pledge in the Equity Pledge
Agreement between Xilan Equipment and XXNGC and XXNGC's shareholders has not
been registered and may be deemed to be unenforceable under PRC
law.




16


Other
than the proxy agreement between Xilan Equipment and XXNGC and XXNGC's chairman
and shareholders, which does not contain a choice of law or jurisdictional
clause, our contractual arrangements with XXNGC are governed by PRC law and
provide for the resolution of disputes through arbitration in the PRC.
Accordingly, these contracts would be interpreted in accordance with PRC law and
any disputes would be resolved in accordance with PRC legal procedures. If XXNGC
or its shareholders fail to perform their respective obligations under these
contractual arrangements, we may have to (i) incur substantial costs and
resources to enforce such arrangements, and (ii) rely on legal remedies
under PRC law, including seeking specific performance or injunctive relief, and
claiming damages, which we cannot be sure would be effective. However, the legal
environment in the PRC is not as developed as in the United States and
uncertainties in the Chinese legal system could limit our ability to enforce
these contractual arrangements. In the event that we are unable to enforce these
contractual arrangements, our business, financial condition and results of
operations could be materially and adversely affected.




Our contractual arrangements with XXNGC
may be subject to scrutiny by the Chinese tax authorities and create a potential
double layer of taxation for our revenue-generating services conducted by
XXNGC.





We could
face material and adverse tax consequences if the Chinese tax authorities
determine that our contractual arrangements with XXNGC were not priced at arm’s
length for purposes of determining tax liability. If the Chinese tax authorities
determine that these contracts were not entered into on an arm’s-length basis,
they may adjust our income and expenses for Chinese tax purposes in the form of
a transfer pricing adjustment. A transfer pricing adjustment could result in a
reduction, for Chinese tax purposes, of deductions recorded by XXNGC, which
could adversely affect us by increasing the tax liabilities of XXNGC. This
increased tax liability could further result in late payment fees and other
penalties to XXNGC for underpaid taxes. Any payments we make under these
arrangements or adjustments in payments under these arrangements that we may
decide to make in the future will be subject to the same risk. Prices for
such services will be set prospectively and therefore we do not currently have a
basis to believe that any of the payments to be made under the contracts will or
will not be considered arm’s length for purposes of determining tax
liability.





The
shareholders of XXNGC may have potential conflicts of interest with us, which
may materially and adversely affect our business and financial
condition.





The
shareholders of XXNGC are also beneficial holders of our common shares. They are
also directors of both XXNGC and our company. Conflicts of interests between
their dual roles as shareholders and directors of both XXNGC and our Company may
arise. We cannot assure you that when conflicts of interest arise, any or all of
these individuals will act in the best interests of our company or that
conflicts of interests will be resolved in our favor. In addition, these
individuals may breach or cause XXNGC to breach or refuse to renew the existing
contractual arrangements that allow us to receive economic benefits from XXNGC.
Currently, we do not have existing arrangements to address potential conflicts
of interest between these individuals and our company. We rely on these
individuals to abide by the laws of Delaware, which provides that directors owe
a fiduciary duty to the Company, which requires them to act in good faith and in
the best interests of the Company and not to use their positions for personal
gain. If we cannot resolve any conflicts of interest or disputes between us and
the shareholders of XXNGC, we would have to rely on legal proceedings, which
could result in disruption of our business and substantial uncertainty as to the
outcome of any such legal proceedings.





Certain
shares in XXNGC, our variable interest entity, may be subject to adverse
claims.





Six individuals have previously claimed
to own 1,200,000 shares of XXNGC's common stock, our main operating company and
variable interest entity. They have claimed that they acquired these shares from
other shareholders of XXNGC. Based on XXNGC's registered capital of
RMB69,000,000 when it became a joint stock limited company in 2004, we believe
the 1,200,000 shares represented 1.74% of XXNGC's outstanding common stock at
the time the six individuals claim to have acquired the 1,200,000 shares of
XXNGC. While we and XXNGC dispute their claim of ownership over the 1,200,000
shares, there is no assurance that XXNGC will prevail if these six individuals
pursued their claim in legal proceedings. If these six individuals are found to
have ownership over these shares, XXNGC's shareholding structure may change and
our revenues from our contractual arrangements with XXNGC may be
reduced.





We
may lose the ability to use and enjoy assets held by XXNGC that are important to
the operation of our business if XXNGC goes bankrupt or becomes subject to a
dissolution or liquidation proceeding.





As part
of our contractual arrangements with XXNGC, XXNGC holds certain of the assets
that are important to the operation of our natural gas business. If XXNGC were
to file for bankruptcy and all or part of its assets become subject to liens or
rights of third-party creditors, we may be unable to continue some or all of our
natural gas operations, which could materially and adversely affect our
business, financial condition and results of operations. If XXNGC undergoes a
voluntary or involuntary liquidation proceeding, its shareholders or unrelated
third-party creditors may claim rights to some or all of these assets, thereby
hindering our ability to operate our natural gas business, which could
materially and adversely affect our business, financial condition and results of
operations.





The
transfer of state-owned assets in China is subject to approval by authorities in
charge of state-owned assets administration and supervision and any failure by
us or prior owners of our projects to comply with PRC laws and regulations in
respect of the transfer of state-owned assets may result in the imposition of
fines or forfeiture of our projects.





As
part of our business development, we have historically and may continue to
acquire assets which were previously state-owned. In particular, XXNGC, our main
operating company and variable interest entity, was previously a state-owned
enterprise. XXNGC was acquired in 2004 by Xi'an Sunway Technology Industry Co.,
Ltd. ("Sunway"), a company in which our chairman and CEO, Mr. Ji, is a
shareholder, and privatized. Mr. Ji, subsequently acquired XXNGC in October
2005. The acquisition of XXNGC by Sunway was approved by the Xi'an Municipal
Administration Committee. However, the transfer price Sunway paid to acquire
XXNGC was not evaluated by licensed appraisers. Under PRC law, the transfer of
state-owned assets is subject to strict procedures and approvals, including the
requirement that the transfer price be evaluated by licensed appraisers. If a
previous transferor of state-owned assets failed to comply with relevant PRC
law, the transfer of the state-owned assets may be reversed by the government or
fines may be levied. In such circumstances, we will have a legal right to
recover our investment in the assets, but we may not be able to recover from the
relevant parties, which could result in a loss of revenues and a significant
increase in operating costs. In addition, because XXNGC is our main operating
company, any reversal of the transfer of XXNGC would have material adverse
effect on our business, financial condition and result of
operations.




17


Acquisition
of state-owned assets involves a public bidding process and failure to win the
bids for our state-owned target companies or equity interests therein may limit
our future growth and the control of our existing projects.





Under PRC
law, we are required to bid for the acquisition of state-owned assets that we
wish to acquire. We typically negotiate the terms of the sale with the
state-owned seller prior to the bidding process. However, we may not be
successful in the bid and may fail to obtain the project as a result. To the
extent we seek in the future to acquire state-owned assets, we will need to
follow this process, and may not be successful in obtaining the target
business.





We
may be required to vacate some of the land upon which our CNG fueling stations
operate.





We
entered into long term lease agreements with third parties to lease certain land
upon which our CNG fueling stations operate. Some of the entities from which we
leased the land may not possess valid title to their properties. In addition, we
have leased land from individual villagers or villager committees and applicable
PRC law may be interpreted as prohibiting such land to be used for
non-agricultural purposes or from being leased to parties other than local
residents or their collective economic organizations. If there are disputes over
the legal title to any of these leased properties or if the relevant authorities
determine that our use of such properties violate PRC law and our leases are
deemed to be invalid under PRC law, we may be required to vacate such sites and
our business, financial condition and results of operations may be adversely
affected.





We
may be subject to fines in connection with the construction of our CNG fueling
stations due to failure to comply with proper procedural
requirements.





According
to relevant PRC laws and regulations in Shaanxi and Henan provinces, contracts
exceeding certain specified amounts relating to the construction of natural gas
stations, such as construction contracts and equipment purchase agreements, must
be obtained through bidding. We, however, did not comply with such bidding
procedures in connection with the construction of any of our CNG fueling
stations. While we believe this is accepted local practice, it is not in
compliance with national and local legal requirements, and as a result, we may
be subject to administrative fines and other penalties as a result of our
failure to comply with these requirements.





Our
business operations are subject to extensive government regulation.





Our
business activities are extensively regulated by policies and other laws and
regulations enacted by the PRC government. Natural gas operations require
approvals, licenses or permits from the relevant central and local government
authorities, some of which may take longer to obtain than others. In addition,
from time to time, the relevant government authorities may impose new
regulations on these activities. The success of our strategy to increase our
natural gas business is contingent upon, among other things, receipt of all
required licenses, permits and authorizations, including, but not limited to,
construction, safety and environmental permits. While we believe we have, or are
in the process of obtaining, all the required licenses, permits and
authorizations material to our business, there is no assurance that changes or
concessions required by our regulatory authorities could also involve
significant costs and delay or prevent the completion of our growth or could
result in the loss of an existing license, permit or authorization, any of which
could have a material adverse effect on our financial condition and results of
operations. Furthermore, to the extent we have failed to obtain any licenses,
permits and authorizations, the relevant government authorities may subject us
to fines, penalties or require us to cease operations.





Because we may
rely on dividends and other distributions on equity paid by our current and
future Chinese subsidiaries for our cash requirements, restrictions under
Chinese law on their ability to make such payments could materially and
adversely affect our ability to grow, make investments or acquisitions that
could benefit our business, pay dividends to you, and otherwise fund and conduct
our businesses.





We have
adopted a holding company structure, and our holding companies may rely on
dividends and other distributions on equity paid by our current and future
Chinese subsidiaries for their cash requirements, including the funds necessary
to service any debt we may incur or financing we may need for operations other
than through our Chinese subsidiaries. Chinese legal restrictions permit
payments of dividends by our Chinese subsidiaries only out of their accumulated
after-tax profits, if any, determined in accordance with PRC GAAP. Our Chinese
subsidiaries are also required under Chinese laws and regulations to allocate at
least 10% of their after-tax profits determined in accordance with PRC GAAP to
statutory reserves until such reserves reach 50% of the company’s registered
capital. Allocations to these statutory reserves and funds can only be used for
specific purposes and are not transferable to us in the form of loans, advances
or cash dividends. Any limitations on the ability of our Chinese subsidiaries to
transfer funds to us could materially and adversely limit our ability to grow,
make investments or acquisitions that could be beneficial to our business, pay
dividends and otherwise fund and conduct our business.


18




Our
failure to fully comply with PRC labor laws exposes us to potential
liability.





Companies
operating in China must comply with a variety of labor laws, including certain
pension, housing and other welfare-oriented payment obligations. While we intend
to make such payments beginning in July 2009, our failure to make previous
payments may be in violation of applicable PRC labor laws and we cannot assure
you that PRC governmental authorities will not impose penalties on us for
failure to comply. In addition, in the event that any current or former employee
files a complaint with the PRC government, we may be subject to making up the
social insurance payment obligations as well as paying administrative
fines.





Risks
Related to the People’s Republic of China





Adverse
changes in PRC economic and political policies could have a material adverse
effect on the overall economic growth of China, which could reduce the demand
for natural gas and materially and adversely affect our business.





Substantially
all of our assets are located in China and substantially all of our revenue is
derived from our operations in China. Accordingly, our results of operations and
prospects are subject, to a significant extent, to the economic, political and
legal developments in China.The PRC economy differs
from the economies of most developed countries in many aspects,
including:





·
            the
      level of government involvement;


·
            the
      level of development;


·
            the
      growth rate;


·
            the
      level and control of capital
investment;


·
            the
      control of foreign exchange; and


·
            the
      allocation of resources.





While the
Chinese economy has grown significantly in the past two decades, the growth has
been unevengeographically,among
various sectors of the economyand
during different periods. We cannot assure you that the Chinese economy will
continue to growor to do so
at the pace that has prevailed in recent years, or that if there is growth, such
growth will be steady and uniform. In addition, if there is a slowdown, such
slowdown could have a negative effect on our business. Any measures taken by the
PRC government, even if they benefit the overall Chinese economy in the
long-term, may have a negative effect on us. For example, our financial
condition and results of operations may be materially and adversely affected by
government control over capital investments. Although the Chinese economy has
been transitioning from a planned economy to a more market-oriented economy, a
substantial portion of the productive assets in China is still owned by the PRC
government. The continued control of these assets and other aspects of the
national economy by the PRC government could materially and adversely affect our
business. The PRC government also exercises significant control over Chinese
economic growth through allocating resources, controlling payment of foreign
currency denominated obligations, setting monetary policy and providing
preferential treatment to particular industries or companies. Any adverse change
in the economic conditions or government policies in China could have a material
adverse effect on the overall economic growth and the level of investments and
expenditures in China, which in turn could lead to a reduction in demand for
natural gas and consequently have a material adverse effect on our
businesses.





The
PRC legal system embodies uncertainties that could limit the legal protections
available to you and us.





Unlike
common law systems, the PRC legal system is based on written statutes and
decided legal cases have little precedential value. In 1979, the PRC government
began to promulgate a comprehensive system of laws and regulations governing
economic matters in general. The overall effect of legislation since then has
been to significantly enhance the protections afforded to various forms of
foreign investment in China. Our PRC operating subsidiaries are subject to
laws and regulations applicable to foreign investment in China. Our PRC
affiliated entities are subject to laws and regulations governing the
formation and conduct of domestic PRC companies. Relevant PRC laws, regulations
and legal requirements may change frequently, and their interpretation and
enforcement involve uncertainties. For example, we may have to resort to
administrative and court proceedings to enforce the legal protection that we
enjoy either by law or contract. However, since PRC administrative and court
authorities have significant discretion in interpreting and implementing
statutory and contractual terms, it may be more difficult to evaluate the
outcome of administrative and court proceedings and the level of legal
protection we enjoy than under more developed legal systems. Such uncertainties,
including the inability to enforce our contracts and intellectual property
rights, could materially and adversely affect our business and operations.
Accordingly, we cannot predict the effect of future developments in the PRC
legal system, particularly with respect to the natural gas sector, including the
promulgation of new laws, changes to existing laws or the interpretation or
enforcement thereof, or the preemption of local regulations by national laws.
These uncertainties could limit the legal protections available to us and
other foreign investors.




19


The
PRC currency is not a freely convertible currency, which could limit our ability
to obtain sufficient foreign currency to support our business operations in the
future.





The PRC
currency, the “Renminbi” or “RMB,” is not a freely convertible currency. We rely
on the PRC government’s foreign currency conversion policies, which may change
at any time, in regard to our currency exchange needs. We receive substantially
all of our revenues in Renminbi, which is not freely convertible into other
foreign currencies. In China, the government has control over Renminbi reserves
through, among other things, direct regulation of the conversion of Renminbi
into other foreign currencies and restrictions on foreign imports. Although
foreign currencies that are required for current account transactions can be
bought freely at authorized PRC banks, the proper procedural requirements
prescribed by PRC law must be met. At the same time, PRC companies are also
required to sell their foreign exchange earnings to authorized PRC banks and the
purchase of foreign currencies for capital account transactions still requires
prior approval of the PRC government. This substantial regulation by the PRC
government of foreign currency exchange may restrict our business operations and
a change in any of these government policies could negatively impact our
operations, which could result in a loss of profits.





In order
for our PRC subsidiaries to pay dividends to us, a conversion of Renminbi into
U.S. dollars is required. Under current PRC law, the conversion of Renminbi into
foreign currency for capital account transactions generally requires approval
from SAFE and, in some cases, other government agencies. Government
authorities may impose restrictions that could have a negative impact in the
future on the conversion process and upon our ability to meet our cash needs and
to pay dividends to our shareholders. Although, our subsidiaries’ classification
as wholly foreign-owned enterprises, or WFOEs, under PRC law permits them to
declare dividends and repatriate their funds to us in the United States, any
change in this status or the regulations permitting such repatriation could
prevent them from doing so. Any inability to repatriate funds to us would in
turn prevent payments of dividends to our shareholders.





Fluctuations
in exchange rates could result in foreign currency exchange losses.





Because
substantially all of our revenues and expenditures are denominated in Renminbi
and the net proceeds from our capital raising were denominated in U.S. dollars,
fluctuations in the exchange rate between the U.S. dollar and Renminbi affect
the relative purchasing power of these proceeds and our balance sheet and
earnings per share in U.S. dollars. In addition, we report our financial results
in U.S. dollars, and appreciation or depreciation in the value of the Renminbi
relative to the U.S. dollar would affect our financial results reported in U.S.
dollar terms without giving effect to any underlying change in our business or
results of operations. Fluctuations in the exchange rate will also affect the
relative value of any dividend we issue that will be exchanged into U.S. dollars
and earnings from and the value of any U.S. dollar-denominated investments we
make in the future.





Since
July 2005, the Renminbi has no longer been pegged to the U.S. dollar. Although
currently the Renminbi exchange rate versus the U.S. dollar is restricted to a
rise or fall of no more than 0.5% per day and the People’s Bank of China
regularly intervenes in the foreign exchange market to prevent significant
short-term fluctuations in the exchange rate, the Renminbi may appreciate or
depreciate significantly in value against the U.S. dollar in the medium- to
long-term. Moreover, it is possible that in the future, PRC authorities may lift
restrictions on fluctuations in the Renminbi exchange rate and lessen
intervention in the foreign exchange market.





Very
limited hedging transactions are available in China to reduce our exposure to
exchange rate fluctuations. To date, we have not entered into any hedging
transactions in an effort to reduce our exposure to foreign currency exchange
risk. While we may decide to enter into hedging transactions in the future, the
availability and effectiveness of these hedging transactions may be limited and
we may not be able to successfully hedge our exposure at all. In addition, our
currency exchange losses may be magnified by PRC exchange control regulations
that restrict our ability to convert Renminbi into foreign
currency.





SAFE regulations
relating to offshore investment activities by PRC residents may increase our
administrative burden and restrict our overseas and cross-border investment
activity. If our shareholders and beneficial owners who are PRC residents fail
to make any required applications and filings under such regulations, we may be
unable to distribute profits and may become subject to liability under PRC
laws.





The PRC
State Administration of Foreign Exchange, or SAFE, has promulgated several
regulations, including Circular No. 75 issued in November 2005 and
implementation rules issued in May 2007, requiring registrations with, and
approvals from, PRC government authorities in connection with direct or indirect
offshore investment activities by PRC residents. These regulations apply to our
shareholders and beneficial owners who are PRC residents.





The SAFE
regulations require registration of direct or indirect investments made by PRC
residents in offshore companies. In the event that a PRC shareholder with a
direct or indirect stake in an offshore parent company fails to make the
required SAFE registration, the PRC subsidiaries of that offshore parent company
may be prohibited from making distributions of profit to the offshore parent and
from paying the offshore parent proceeds from any reduction in capital, share
transfer or liquidation in respect of the PRC subsidiaries. Further, failure to
comply with the various SAFE registration requirements described above could
result in liability under PRC law for foreign exchange evasion.





We have
requested our shareholders and beneficial owners who are PRC residents to make
the necessary applications and filings as required under these regulations and
under any implementing rules or approval practices that may be established under
these regulations. We believe our PRC resident shareholders, including Mr. Ji,
our chairman and chief executive officer, have already completed the
registration process. However, as a result of the recent enactment of the
regulations, lack of implementing rules and uncertainty concerning the
reconciliation of the new regulations with other approval requirements, it
remains unclear how these regulations, and any future legislation concerning
offshore or cross-border transactions, will be interpreted, amended and
implemented by the relevant government authorities. There is a risk that not all
of our shareholders and beneficial owners who are PRC residents will in the
future comply with our request to make or obtain any applicable registration or
approvals required by these regulations or other related legislation. The
failure or inability of our PRC resident shareholders and beneficial owners to
receive any required approvals or make any required registrations may subject us
to fines and legal sanctions, restrict our overseas or cross-border investment
activities, limit our PRC subsidiaries’ ability to make distributions or pay
dividends or affect our ownership structure, as a result of which our
acquisition strategy and business operations and our ability to distribute
profits to you could be materially and adversely affected.


20





We
may have difficulty establishing adequate management, legal and financial
controls in the People’s Republic of China.





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





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





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





There is
uncertainty as to whether courts of the PRC would enforce:




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


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





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




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




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




21


The
new Antimonopoly Law ("AML") may subject our future acquisitions to increased
scrutiny, which could affect our ability to consummate acquisitions on terms
favorable to us or at all.





On August
8, 2006, six PRC government authorities, including the PRC Ministry of Commerce,
the State Administration for Industry and Commerce, and the China Securities
Regulatory Commission, promulgated a rule entitled “Provisions regarding Mergers
and Acquisitions of Domestic Enterprises by Foreign Investors”, or the New
M&A Rule, which became effective on September 8, 2006. The New M&A Rule,
among other things, requires that certain acquisitions of Chinese domestic
enterprises by foreign investors be subject to anti-trust scrutiny by the
Ministry of Commerce and the State Administration for Industry and Commerce. The
AML was adopted by the Standing Committee of the National People’s Congress on
August 30, 2007 and became effective on August 1, 2008. The AML was enacted in
part to guard against and cease monopolistic activities, and to safeguard and
promote orderly market competition. In accordance with the AML, monopolistic
acts shall include monopolistic agreements among business operators, abuse of
dominant market positions by business operators and concentration of business
operators that eliminates or restricts competition or might be eliminating or
restricting competition. On August 3, 2008, the State Council promulgated the
Regulations on the Thresholds for Reporting of Concentration of Business
Operators, or the Reporting Threshold Regulations, which provide specific
thresholds for reporting of concentration of business operators. Under the AML
and the Reporting Threshold Regulations, the parties to an acquisition must
report to the Ministry of Commerce in advance if in the preceding accounting
year the turnover in the aggregate achieved by all the parties to the
transaction exceeds RMB10.0 billion worldwide or RMB2.0 billion within China,
and the turnover achieved by at least two of them respectively exceeds RMB400.0
million within China. However, the Ministry of Commerce has the right to
initiate investigation of a transaction not reaching the above-mentioned
reporting thresholds if the Ministry of Commerce has evidence that the
transaction has or may have the effect of excluding or restricting competition.
The anti-trust scrutiny procedures and requirements set forth in the AML and the
Reporting Threshold Regulations grant the government extensive authority of
evaluation and control over the terms of acquisitions in China by foreign
investors, and their implementation involves significant uncertainties and
risks. To the extent our future acquisitions meet the threshold requirements set
forth in the AML and the Reporting Threshold Regulations, or are deemed by the
Ministry of Commerce to meet the thresholds, we will be subject to anti-monopoly
review. The consummation of our future acquisitions could therefore be much more
time-consuming and complex, and any required approval processes, including
obtaining approval from the Ministry of Commerce, may delay or prevent the
consummation of such acquisitions, and prevent us from attaining our business
objectives.





We
may be deemed a PRC "resident enterprise" under the EIT Law and be subject to
PRC taxation on our worldwide income.





The EIT
Law also provides that enterprises established outside of China whose “de facto
management bodies” are located in China are considered “resident enterprises”
and are generally subject to the uniform 25% enterprise income tax rate as to
their worldwide income. Under the implementation regulations to the EIT Law
issued by the State Council, “de facto management body” is defined as a body
that has material and overall management and control over the manufacturing and
business operations, personnel and human resources, finances and treasury, and
acquisition and disposition of properties and other assets of an enterprise. It
remains unclear how the PRC tax authorities will interpret this term. A
substantial number of our management personnel are located in the PRC, and all
of our revenues arise from our operations in China. However, we do recognize
some interest income and other gains from our financing activities outside
China. If the PRC tax authorities determine that we are a PRC resident
enterprise, we will be subject to PRC tax on our worldwide income at the 25%
uniform tax rate, which may have a material adverse effect on our financial
condition and results of operations. Notwithstanding the foregoing provision,
the new EIT Law also provides that, if a resident enterprise already invests in
another resident enterprise, the dividends received by the investing resident
enterprise from the invested resident enterprise are exempt from income tax,
subject to certain qualifications. Therefore, if we are classified as a resident
enterprise, the dividends received from our PRC subsidiaries and investee
company may be exempt from income tax. However, due to the short history of the
EIT Law, it is unclear as to (i) the detailed qualification requirements for
such exemption and (ii) whether dividend payments by our PRC subsidiaries and
investee company to us will meet such qualification requirements, even if we are
considered a PRC resident enterprise for tax purposes.




Dividends
we receive from our operating subsidiaries located in the PRC may be subject to
PRC withholding tax.





The EIT
Law provides that a withholding income tax rate of 20% will be applicable to
dividends payable to foreign investors that are “non-resident enterprises” to
the extent such dividends have their source within China unless the jurisdiction
of such foreign investor has a tax treaty with China that provides a different
withholding arrangement. The implementing regulations to the EIT Law
subsequently reduced this withholding income tax rate from 20% to
10%.





We are a
Delaware company and substantially all of our income may be derived from
dividends we receive from our operating subsidiaries located in the PRC. Thus,
dividends paid to us by our subsidiaries in China may be subject to the 10%
withholding income tax if we are considered as a “non-resident enterprise” under
the EIT Law. If we are required under the EIT Law to pay income tax for any
dividends we receive from our subsidiaries, it will materially and adversely
affect the amount of dividends, if any, we may pay to our
shareholders.





PRC
regulation of direct investment and loans by offshore holding companies to PRC
entities may delay or limit our ability to use the proceeds of this offering to
make additional capital contributions or loans to our PRC operating
businesses.





Any
capital contributions or loans that we, as an offshore company, make to our PRC
operating businesses, including from the proceeds of this offering, are subject
to PRC regulations. For example, any of our loans to our PRC operating
businesses cannot exceed the difference between the total amount of investment
our PRC operating businesses are approved to make under relevant PRC laws and
their respective registered capital, and must be registered with the local
branch of the State Administration of Foreign Exchange as a procedural matter.
In addition, our capital contributions to our PRC operating businesses must be
approved by the National Development and Reform Commission and the Ministry of
Commerce or their local counterpart and registered with the State Administration
for Industry and Commerce or its local counterpart. We cannot assure you that we
will be able to obtain these approvals on a timely basis, or at all. If we fail
to obtain such approvals, our ability to make equity contributions or provide
loans to our PRC operating businesses or to fund their operations may be
negatively affected, which could adversely affect their liquidity and their
ability to fund their working capital and expansion projects and meet their
obligations and commitments. Furthermore, the State Administration of Foreign
Exchange promulgated a new circular in August 2008 with respect to the
administration of conversion of foreign exchange capital contribution of foreign
invested enterprises into RMB. Pursuant to this new circular, RMB converted from
foreign exchange capital contribution can only be used for the activities within
the approved business scope of such foreign invested enterprise and cannot be
used for domestic equity investment or acquisition unless otherwise allowed by
PRC laws or regulations. As a result, we may not be able to increase the capital
contribution of our operating subsidiaries or equity investee and subsequently
convert such capital contribution into RMB for equity investment or acquisition
in China.




22


We
may be adversely affected by complexity, uncertainties and changes in PRC
regulation of natural gas businesses and companies, including limitations on our
ability to own key assets.
  The PRC
government regulates the natural gas industry including foreign ownership of,
and the licensing and permit requirements pertaining to, companies in the
natural gas industry. These laws and regulations are relatively new and
evolving, and their interpretation and enforcement involve significant
uncertainty. As a result, in certain circumstances it may be difficult to
determine what actions or omissions may be deemed to be a violation of
applicable laws and regulations. Issues, risks and uncertainties relating to PRC
government regulation of the natural gas industry include the
following:
 
 ·
              we only have contractual control
      over XXNGC. We do not own it due to the restriction of foreign investment
      in Chinese businesses; and
 ·
              uncertainties relating to the
      regulation of the natural gas business in China, including evolving
      licensing practices, means that permits, licenses or operations at our
      company may be subject to challenge. This may disrupt our business, or
      subject us to sanctions, requirements to increase capital or other
      conditions or enforcement, or compromise enforceability of related
      contractual arrangements, or have other harmful effects on
      us.
 
 The
interpretation and application of existing PRC laws, regulations and policies
and possible new laws, regulations or policies have created substantial
uncertainties regarding the legality of existing and future foreign investments
in, and the businesses and activities of, natural gas businesses in China,
including our business.
 
 If
the China Securities Regulatory Commission, or CSRC, or another PRC regulatory
agency determines that its approval was required in connection with this
offering, we may become subject to penalties.
 
 On
August 8, 2006, six PRC regulatory agencies, including the CSRC,
promulgated the Regulation on Mergers and Acquisitions of Domestic Companies by
Foreign Investors, or the M&A Rule, which became effective on
September 8, 2006. The M&A Rule, among other things, has certain
provisions that require offshore special purpose vehicles, or SPVs, formed for
the purpose of acquiring PRC domestic companies and controlled by PRC
individuals, to obtain the approval of the CSRC prior to listing their
securities on an overseas stock exchange. We believe, based on the opinion of
our PRC legal counsel, Shaanxi Jiarui Law Firm, that while the CSRC generally
has jurisdiction over overseas listings of SPVs like us, CSRC’s approval is not
required for our overseas listing and any future offerings given the fact that
our current corporate structure was established before the new regulation became
effective. However, there remains some uncertainty as to how this regulation
will be interpreted or implemented in the context of an overseas offering. If
the CSRC or another PRC regulatory agency subsequently determines that its
approval was required for our overseas listing and any future offerings, we may
face sanctions by the CSRC or another PRC regulatory agency. If this happens,
these regulatory agencies may impose fines and penalties on our operations in
the PRC, limit our operating privileges in the PRC, delay or restrict the
injection of proceeds from an offering into our PRC subsidiaries, restrict or
prohibit payment or remittance of dividends by our PRC subsidiaries to us or
take other actions that could have a material adverse effect on our business,
financial condition, results of operations, reputation and prospects, as well as
the trading price of our common stock.
 
 We
may be subject to fines and legal sanctions imposed by SAFE or other Chinese
government authorities if we or our Chinese employees fail to comply with
Chinese regulations relating to employee share options granted by offshore
listed companies to Chinese citizens.
 
 On
March 28, 2007, SAFE issued the Application Procedure of Foreign Exchange
Administration for Domestic Individuals Participating in Employee Share Holding
Plan or Share Option Plan of Overseas Listed Company, or the Share Option Rule.
Under the Share Option Rule, Chinese citizens who are granted share options
by an offshore listed company are required, through a Chinese agent or Chinese
subsidiary of the offshore listed company, to register with SAFE and complete
certain other procedures, including applications for foreign exchange purchase
quotas and opening special bank accounts. We and our Chinese employees who have
been granted share options are subject to the Share Option Rule. If we or our
Chinese employees fail to comply with these regulations, we or our Chinese
employees may be subject to fines and legal sanctions imposed by SAFE or other
Chinese government authorities and we may be prevented from further granting
options under our share incentive plans to our employees. Such events could
adversely affect our business operations.
 
 Recent
changes in the PRC labor law restrict our ability to reduce our workforce in the
PRC in the event of an economic downturn and may increase our labor
costs.
 
 In June
2007, the National People’s Congress of the PRC enacted the Labor Contract Law,
which became effective on January 1, 2008. To clarify certain details in
connection with the implementation of the Labor Contract Law, the State Council
promulgated the Implementing Rules for the Labor Contract Law, or the
Implementing Rules, on September 18, 2008 which came into effect
immediately. The Labor Contract Law provides various rules regarding employment
contracts that will likely have a substantial impact on employment
practices in China. The Labor Contract Law imposes severe penalties on employers
that fail to timely enter into employment contracts with employees. The employer
is required to pay a double salary to the employee if it does not enter into a
written contract with the employee within one month of the employment, and a
non-fixed-term contract is assumed if a written contract is not executed after
one year of the employment. Additionally, the Labor Contract Law sets a limit of
two fixed-term contracts regardless of the length of each term, after which the
contract must be renewed on a non-fixed-term basis should the parties agree to a
further renewal unless otherwise required by the respective employee. This
requirement curtails the common practice of continuously renewing short-term
employment contracts. The Implementing Rules appear to further tighten this rule
by suggesting that an employee has the right to demand a non-fixed-term contract
upon the completion of the second fixed term regardless of whether the employer
agrees to a contract renewal. A non-fixed-term contract does not have a
termination date and it is generally difficult to terminate such a contract
because termination must be based on limited statutory grounds. The employer can
no longer supplement such statutory grounds through an agreement with the
employee. In addition, the Labor Contract Law requires the payment of statutory
severance upon the termination of an employment contract in most circumstances,
including the expiration of a fixed-term employment contract.
  23
 
 Under the
Labor Contract Law, employers can only impose a post-termination non-competition
provision on employees who have access to their confidential information for a
maximum period of two years. If an employer intends to maintain the
enforceability of a post-termination non-competition provision, the employer has
to pay the employee compensation on a monthly basis post-termination of the
employment. Under the Labor Contract Law, a “mass layoff” is defined as
termination of more than 20 employees or more than 10% of the workforce. The
Labor Contract Law expands the circumstances under which a mass layoff can be
conducted, such as when the company undertakes a restructuring pursuant to the
PRC Enterprise Bankruptcy Law, suffers serious difficulties in business
operations, changes its line of business, performs significant technology
improvements, changes operating methods, or where there has been a material
change in the objective economic circumstances relied upon by the parties at the
time of the conclusion of the employment contract, thereby making the
performance of such employment contract impractical. The employer must follow
specific procedures in conducting a mass layoff. There is little guidance on
what penalties an employer will suffer if it fails to follow the procedural
requirements in conducting the mass layoff. Finally, the Labor Contract Law
requires that the employer discuss the company’s internal rules and regulations
that directly affect the employees’ material interests (such as employees’
salary, work hours, leave, benefits, and training, etc.) with all employees or
employee representative assemblies and consult with the trade union or employee
representatives on such matters before making a final decision.
 
 All of
our employees based exclusively within the PRC are covered by the new laws. As
there has been little guidance and precedents as to how the Labor Contract Law
and its Implementing Rules will be enforced by the relevant PRC authorities,
there remains uncertainty as to their potential impact on our business and
results of operations. The implementation of the Labor Contract Law and its
Implementing Rules may increase our operating expenses, in particular our
personnel expenses and labor service expenses. If we want to maintain the
enforceability of any of our employees’ post-termination non-competition
provisions, the compensation and procedures required under the Labor Contract
Law may add substantial costs and cause logistical burdens to us. Prior to the
new law such compensation was often structured as part of the employee’s salary
during employment, and was not an additional compensation cost. In the event
that we decide to terminate employees or otherwise change our employment or
labor practices, the Labor Contract Law and its Implementing Rules may also
limit our ability to effect these changes in a manner that we believe to be
cost-effective or desirable, which could adversely affect our business and
results of operations. In particular, our ability to adjust the size of our
operations when necessary in periods of recession or less severe economic
downturns such as the recent financial turmoil may be affected. In addition,
during periods of economic decline when mass layoffs become more common, local
regulations may tighten the procedures by, among other things, requiring the
employer to obtain approval from the relevant local authority before conducting
any mass layoff. Such regulations can be expected to exacerbate the adverse
effect of the economic environment on our results of operations and financial
condition.
 
 Risks
Related to Corporate and Stock Matters
 
 Qinan
Ji, our chairman and chief executive officer, beneficially owns a significant
percentage of our outstanding common stock and, as a result, he has
significantly greater influence over us and our corporate actions relative to
our public shareholders and his interests may not be aligned with the interests
of other shareholders.
 
 As of
December 31, 2008, our co-founder and chief executive officer, Mr. Ji,
beneficially owned 5,931,596 shares of common stock or approximately 20.3% of
our outstanding shares of common stock. Mr. Ji is an affiliate as defined
in Rule 144 under the Securities Act of 1933, as amended, or the Securities Act,
due to the large size of his shareholding in us and his positions with us as our
chairman and chief executive officer. Rule 144 defines an affiliate of a company
as a person that, directly or indirectly, through one or more intermediaries,
controls or is controlled by, or is under common control with, our company.
Mr. Ji has, and may continue to have, significant influence in determining
the outcome of any corporate transactions or other matters submitted to our
shareholders for approval, including mergers, consolidations and the sale of all
or substantially all of our assets, election of directors and other significant
corporate actions. He may not act in the best interests of our other
shareholders. In addition, without the consent of Mr. Ji, we could be
prevented from entering into transactions that could be beneficial to us. This
concentration of ownership may also discourage, delay or prevent a change in
control of our company, which could deprive our shareholders of an opportunity
to receive a premium for their shares as part of a sale of our company and might
reduce the price of our common stock. These actions may be taken even if they
are opposed by our other shareholders.
 
 The
limited trading volume in our stock may cause volatility in the market price of
our common stock.
 
 Our
common stock is currently traded on a limited basis on the OTCBB under the
symbol, “CHNG.OB” The quotation of our common stock on the OTCBB does not assure
that a meaningful, consistent and liquid trading market currently exists, and in
recent years, such market has experienced extreme price and volume fluctuations
that have particularly affected the market prices of many smaller companies like
us. Our common stock is thus subject to volatility. In the absence of an active
trading market:
  24
  ·
              investors
      may have difficulty buying and selling or obtaining market
      quotations;
 ·
              market
      visibility for our common stock may be limited;
  and
 ·
              a
      lack of visibility for our common stock may have a depressive effect on
      the market for our common stock.
 
 Trading
of our stock may be restricted by the SEC’s penny stock regulations which may
limit a stockholder’s ability to buy and sell our stock if our stock trades
below $5.00 per share.
 
 The SEC
has adopted Rule 15g-9 which generally defines “penny stock” to be any equity
security that has a market price (as defined) less than $5.00 per share or an
exercise price of less than $5.00 per share, subject to certain exceptions. Our
securities are covered by the penny stock rules, which impose additional sales
practice requirements on broker-dealers who sell to persons other than
established customers and “accredited investors”. The term “accredited investor”
refers generally to institutions with total assets in excess of $5,000,000 or
individuals with a net worth in excess of $1,000,000 or annual income exceeding
$200,000 or $300,000 jointly with their spouse in each of the two most recent
years with a reasonable expectation of reaching the same income level in the
current year. The penny stock rules require a broker-dealer, prior to a
transaction in a penny stock not otherwise exempt from the rules, to deliver a
standardized risk disclosure document in a form prepared by the SEC which
provides information about penny stocks and the nature and level of risks in the
penny stock market. The broker-dealer also must provide the customer with
current bid and offer quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction and monthly account
statements showing the market value of each penny stock held in the customer’s
account. The bid and offer quotations, and the broker-dealer and salesperson
compensation information, must be given to the customer orally or in writing
prior to effecting the transaction and must be given to the customer in writing
before or with the customer’s confirmation. In addition, the penny stock rules
require that prior to a transaction in a penny stock not otherwise exempt from
these rules, the broker-dealer must make a special written determination that
the penny stock is a suitable investment for the purchaser and receive the
purchaser’s written agreement to the transaction. These disclosure requirements
may have the effect of reducing the level of trading activity in the secondary
market for the stock that is subject to these penny stock rules. Consequently,
these penny stock rules may affect the ability of broker-dealers to trade our
securities. We believe that the penny stock rules discourage investor interest
in and limit the marketability of our common stock.
  NASD
sales practice requirements may also limit a stockholder’s ability to buy and
sell our stock.
 
 Section
15(g) of the Securities Exchange Act of 1934, as amended, and Rule 15g-2
promulgated thereunder by the SEC require broker-dealers dealing in penny stocks
to provide potential investors with a document disclosing the risks of penny
stocks and to obtain a manually signed and dated written receipt of the document
before effecting any transaction in a penny stock for the investor’s
account.
 
 Potential
investors in our common stock are urged to obtain and read such disclosure
carefully before purchasing any shares that are deemed to be “penny stock.”
Moreover, Rule 15g-9 requires broker-dealers in penny stocks to approve the
account of any investor for transactions in such stocks before selling any penny
stock to that investor. This procedure requires the broker-dealer to (i) obtain
from the investor information concerning his or her financial situation,
investment experience and investment objectives; (ii)reasonably determine, based
on that information, that transactions in penny stocks are suitable for the
investor and that the investor has sufficient knowledge and experience as to be
reasonably capable of evaluating the risks of penny stock transactions; (iii)
provide the investor with a written statement setting forth the basis on which
the broker-dealer made the determination in (ii) above; and (iv) receive a
signed and dated copy of such statement from the investor, confirming that it
accurately reflects the investor’s financial situation, investment experience
and investment objectives. Compliance with these requirements may make it more
difficult for holders of our common stock to resell their shares to third
parties or to otherwise dispose of them in the market or otherwise.
 
 Shares
eligible for future sale may adversely affect the market price of our common
stock, as the future sale of a substantial amount of our restricted stock in the
public marketplace could reduce the price of our common stock.
 
 From time
to time, certain of our stockholders may be eligible to sell all or some of
their shares of common stock by means of ordinary brokerage transactions in the
open market pursuant to Rule 144, promulgated under the Securities Act (“Rule
144”), subject to certain limitations. In general, pursuant to Rule 144, a
stockholder (or stockholders whose shares are aggregated) who has satisfied a
six-month holding period may, under certain circumstances, sell within any
three-month period a number of securities which does not exceed the greater of
1% of the then outstanding shares of common stock or the average weekly
trading-volume of the class during the four calendar weeks prior to such sale.
Rule 144 also permits, under certain circumstances, the sale of securities,
without any limitations, by a non-affiliate of our company that has satisfied a
one-year holding period. Any substantial sale of common stock pursuant to Rule
144 or pursuant to any resale prospectus may have an adverse effect on the
market price of our securities.
 
 Our
independent registered public accounting firm, in the course of auditing our
consolidated financial statements, noted material weaknesses in our internal
control over financial reporting. If we fail to establish an effective system of
internal control over financial reporting, we may not be able to accurately and
timely report our financial results or detect or prevent fraud. In addition,
investor confidence in us and the market price of our stock may be adversely
impacted if we find that, or our independent registered public accounting firm
reports that, our internal control over financial reporting is ineffective in
light of the requirements of Section 404 of the Sarbanes-Oxley Act of
2002.
  25
 
 We are
subject to reporting obligations under the U.S. securities laws. The
Securities and Exchange Commission, or the SEC, as required by Section 404
of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, adopted rules
requiring every public company to include a management report on such company’s
internal control over financial reporting in its annual report, which contains
management’s assessment of the effectiveness of the company’s internal control
over financial reporting. In addition, an independent registered public
accounting firm must report on our internal control over financial reporting.
Our management may conclude that our internal control over our financial
reporting is not effective. Moreover, even if our management concludes that our
internal control over financial reporting is effective, our independent
registered public accounting firm may report that our internal control over
financial reporting is not effective.
 
 In
connection with the audit of our consolidated financial statements for the years
ended December 31, 2007 and 2008, our independent registered public accounting
firm reported to us that we had material weaknesses in our internal controls
over financial reporting relating to our failure to maintain a sufficient
complement of personnel with an appropriate level of accounting knowledge,
experience and training in the application of generally accepted accounting
principles commensurate with the our financial reporting requirements and did
not implement adequate supervisory review to ensure the financial statements
were prepared in conformity with generally accepted accounting principles in the
United States.  Additionally, they also identified numerous internal
control deficiencies that were identified as being significant, including
inadequate controls within the financial statement closing and reporting
process, which resulted in material adjustments that impacted the assets
accounts of the financial statements, and inadequate controls over the treasury
cycle. The number and nature of these significant deficiencies, when aggregated,
was determined to be a material weakness. In the aggregate, these significant
deficiencies could result in a misstatement of our account balances or
disclosures which could cause a material misstatement in our consolidated
financial statements that would not be prevented or detected.
 
 A
“material weakness” is a deficiency, or a combination of deficiencies, in
internal control over financial reporting such that there is a reasonable
possibility that a material misstatement of the registrant’s annual or interim
financial statements will not be prevented or detected on a timely basis by the
company’s internal controls.  A “significant deficiency” is a
deficiency, or a combination of deficiencies, in internal control over financial
reporting that is less severe than a material weakness, yet important enough to
merit attention by those responsible for oversight of the registrant’s financial
reporting.  A “deficiency” in internal control over financial
reporting exists when the design or operation of a control does not allow
management or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely
basis.
 
 During
our review of our financial statements and results for the years ended December
31, 2007 and 2008, our management also identified deficiencies that were
determined to be a material weakness based on the Internal Control – Evaluation
Framework developed by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”).  The specific material weaknesses and
significant deficiencies identified by our management as of December 31, 2008
are:
  Material
Weakness
 
 ·
              Inadequate US GAAP expertise -
      The current staff in our accounting department is inexperienced and they
      were primarily engaged in ensuring compliance with PRC accounting and
      reporting requirement for our operating subsidiaries and were not required
      to meet or apply U.S. GAAP requirements. They need substantial training to
      meet the higher demands of being a U.S. public company. The accounting
      skills and understanding necessary to fulfill the requirements of US
      GAAP-based reporting, including the skills of subsidiary financial
      statements consolidation, are
inadequate.
 ·
              The Company did not have
      sufficient and skilled accounting personnel with an appropriate level of
      technical accounting knowledge and experience in the application of
      generally accepted accounting principles accepted in the U.S. commensurate
      with our financial reporting requirements, which resulted in a number of
      internal control deficiencies that were identified as being significant.
      Our management believes that the number and nature of these significant
      deficiencies, when aggregated, was determined to be a material
      weakness.
 
 Significant
Deficiency
 
 ·
              The
      Company does not have effective controls to provide reasonable assurance
      that the financial closing and reporting process are properly performed
      over the accounts and disclosure of the financial
    statements.
 
 ·
              The
      Company has inadequate controls over the treasury cycle. For example, the
      Company has not established procedures on collection of cash from the gas
      stations to the headquarter and distribution of cash between operating
      cash flow and deposit into banks. The Company also lacks adequate controls
      over its daily cash transactions and
  recording.
 
 ·
              The
      Company lacks qualified resources to perform the internal audit functions
      properly. In addition, the scope and effectiveness of our internal audit
      function are yet to be developed. We are committed to establishing the
      internal audit functions but due to limited qualified resources in the
      region, we were not able to hire sufficient internal audit resources
      before the end of 2008. However, internally we established a central
      management center to recruit more senior qualified people in order to
      improve our internal control procedures. Externally, we engaged Ernst
      & Young to assist us in improving our internal control system based on
      COSO Framework. We also will increase our efforts to hire the requisite
      qualified personnel.
  26
 
 We are
devoting significant resources to remediating and improving our internal
controls.  Prior to December 31, 2008, we engaged an independent
certified public accountant who is mainly engaged to perform our financial
statements consolidation and to prepare our financial statements. In addition,
we are seeking to internally employ accountants experienced in several key areas
of accounting, including persons with experience in PRC and U.S. GAAP, U.S. GAAP
consolidation requirements and SEC financial reporting requirements. We also
plan to allocate additional resources to train our existing accounting staff and
will continue this effort in the future.  We have also engaged Ernst
& Young to consult on our internal audit function as well as other internal
control practices. Most of the policies, procedures and practices are already in
place and being implemented. To remediate these material weaknesses, we have
undertaken to improve our internal controls, including through the
following:
 
 ·
              identifying
      and hiring additional personnel with U.S. GAAP and SEC reporting
      experience, including our new CFO Veronica Jing
  Chen;
 ·
              providing
      training to our finance personnel to improve their knowledge of U.S. GAAP
      and SEC reporting requirements;
 ·
              holding
      regular meetings of the audit committee and resuming regular communication
      between the committee and our independent registered public accounting
      firm;
 ·
              engaging
      Ernst & Young to consult on our internal audit function as well as
      other internal control practices;
 ·
                establishing
      anonymous whistleblower systems for reporting violations of our governance
      policies, including policies regarding internal
  controls;·
                introducing
      policies and procedures to effectively control daily cash transactions and
      recording;
 ·
              putting
      in place a centralized financial reporting software system in our
      headquarters, management centers and operating sites;
  and
 ·
              engaging
      external professional consultants to assess the entity level internal
      controls over financial reporting using the COSO internal control
      framework.
 
 We have
also begun to formulate policies relating to internal control over financial
reporting, including the preparation of comprehensive accounting policies and
procedures manual, containing, among other things, detailed, expanded closing
checklists, to guide our financial personnel in addressing significant
accounting issues and assist them in preparing financial statements in
compliance with U.S. GAAP and SEC requirements.
 
 These
measures may not ensure the adequacy of our internal controls over our financial
processes and reporting in the future.  If we are unable to remediate
successfully these material weaknesses and significant deficiencies in a timely
manner, investors may lose confidence in our reported financial information,
which could lead to a decline in our stock price, limit our ability to access
the capital markets in the future and require us to incur additional costs to
improve our internal control systems and procedures.
 
 Stockholders
should have no expectation of any dividends.
 
 The
holders of our common stock are entitled to receive dividends when declared by
the Board of Directors out of funds available. To date, we have not declared nor
paid any cash dividends. The Board of Directors does not intend to declare any
dividends in the near future, but instead intends to retain all earnings, if
any, for use in our business operations. Furthermore, if we decide to pay
dividends, foreign exchange and other regulations in China may restrict our
ability to distribute retained earnings from China or convert those payments
from Renminbi into foreign currencies.
 
 Item
1B. Unresolved Staff Comments.
  None
  ITEM
2. PROPERTIES
  Our
principal executive offices are located at 19th Floor, Building B, Van
Metropolis, No. 35 Tangyan Road, Hi-Tech Zone, Xi’an, 710065, Shaanxi province,
People's Republic of China. Our property consists of approximately 818 square
meters, which is rented on an annual basis for $88,225.
  We
have additional properties located in Lantian County, the districts of Baqiao,
Lintong and Gaoxin in the city of Xi’an, and the cities of Jiyuan, Kaifung and
Pindingshan, in Henan province. We own a 120km high-pressure underground
pipeline network and two Citygate stations (terminals) with accompanying
buildings and equipment. We lease the main office building where we are
headquartered and all of our CNG fueling station sites. In order to secure
sufficient CNG supply, we also own three mother stations in Xi’an city to
support our stations. As of December 31, 2008, we own and operate 23 CNG fueling
stations in Shaanxi province and 12 CNG fueling stations in Henan
province.
  In
February, 2006 we formed our 100%-owned subsidiary, Xilan Equipment, which
maintains an office in the No. 3 Xianmen St., Lantian County, Xi’an, Shaanxi
province, China. The office consists of approximately 1001 sq. feet, with annual
rental payment of $1,106.
  27
 
 On
October 24, 2006, we formed our 100% owned subsidiary, Shaanxi Jingbian
Liquified Natural Gas Co., Ltd., which maintains an office in the Tongwang Road,
Zhangjiapan Town, Jingbian County, China. The office consists of approximately
3,921 sq. feet, with annual rental payment of $5,214.
 
 On
February 29, 2008, the Company entered into a 62 month lease agreement in
connection with an office located on the 22nd Floor, 370 Lexington Avenue, New
York, New York. The monthly rent during the first year was
$6432.
 
 In May
27, 2008, the Company purchased a 412.10-square-meter property in Zhengzhou,
Henan province and uses it as office spaces for the local operations in
Henan province.
 
 In
August 2008, the Company purchased a 531.72-square-meter property in Beijing and
uses it as office spaces for local operations in Beijing. Therefore, the Company
does not incur any rent for Henan and Beijing Offices.
 
 In
October 2008, the Company acquired Lingbao Yuxi Natural Gas, Co., Ltd. through
Xi’an Xilan Natural Gas Co., Ltd. Lingbao Yuxi Natural Gas maintains an office
located at Changan Rd. W, Lingbao, Henan province, with annual rent of
approximately $3,314.
 
 As of
December 31, 2008, the Company owned 2 trucks and 33 tankers that the Company
used to transport natural gas.
 
 Insurance
  We carry
auto insurance on our vehicles and maintain workers compensation insurance for
our fueling station workers. We believe this insurance is adequate for our
needs. We do not carry any product liability insurance or property insurance on
our office buildings or other property. We do not carry any third party
liability insurance.
  We
believe that current facilities are adequate for our current and immediately
foreseeable operating needs. We do not have any policies regarding investments
in real estate, securities or other forms of property.
 
 We also
carry directors and officers' liability insurance with XL Insurance Company Ltd.
with aggregate limit of liability of $15 million to cover our management and
directors in the event that any claim may arise against such insured persons due
to employment related acts. The insurance will expire on October 15, 2009 and is
renewed annually.
 
 ITEM
3. LEGAL PROCEEDINGS
  In 2007,
Xiang Ji, one of our shareholders, and son of our CEO, Qinan Ji, filed a
lawsuit against Yangling Bodisen Biotech Development Co. (“Bodisen”) in the
Chinese court system in Shaanxi province contesting the validity of Bodisen’s
ownership of 2,063,768 shares of our common stock. Bodisen obtained these shares
in September 2005 through a share transfer agreement with Xiang Ji and asserted
that it had fully performed its obligations under the agreement and was entitled
to own the shares. On January 15, 2008, Xiang Ji filed another
lawsuit against Bodisen in the State of Utah District Court, Salt Lake County,
seeking to prevent Bodisen from selling the 2,063,768 shares it holds in
the Company. Xiang Ji obtained an order from the Utah court provisionally
preventing Bodisen from selling the shares pending a decision on the merits of
the underlying dispute. In May 2009, Xiang Ji and Bodisen entered into a
settlement agreement through mediation in the Supreme Court of Shaanxi province.
Pursuant to the settlement agreement, Xiang Ji agreed to withdraw the
lawsuit he filed against Bodisen in the State of Utah District Court, Salt
Lake County, and Bodisen agreed to sell back to Xiang Ji the 2,063,768
shares. We believe that the dispute between Xiang Ji and Bodisen will be
resolved in accordance with the settlement agreement and will not have a
material adverse effect on our financial condition or our results of
operations.
 
 A former
member of the board of directors filed a lawsuit on June 16, 2008 against the
Company in New York State Supreme Court, Nassau County, in which he has sought,
among other things, to recover a portion of his monthly compensation plus 20,000
options that he alleges are due to him pursuant to a written agreement. After
the plaintiff rejected an offer by the Company that included the options that
plaintiff alleged were due to him, the Company moved to dismiss the
complaint. The judge ordered the Company to issue the 20,000 options to the
plaintiff subject to any restrictions required by applicable securities laws,
which was essentially what the Company had previously offered, and dismissed all
of the plaintiff's remaining claims against the Company. The current board of
directors has complied with the court's decision by tendering an option
agreement to the plaintiff consistent with the court's decision, but the
plaintiff has refused to execute the agreement, and instead has filed an appeal.
Regardless of the outcome of the appeal, we believe that any liability we would
incur will not have a materially adverse effect on our financial condition or
our results of operations.
  ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  None.
 
 28
  PART
II
 
 ITEM
5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES
  On March
17, 2004, our common stock was approved for listing on the Over-the-Counter
Bulletin Board under the symbol "CVNI" and on December 19, 2005 our symbol was
changed to "CHNG" and our fiscal year end was changed to December 31. The
following table contains information about the range of high and low bid prices
for our common stock for each full quarterly period for 2008 and 2007 based upon
reports of transactions on the OTC Bulletin Board. The source of this
information is the OTC Bulletin Board. The quotations represent inter-dealer
prices without retail markup, markdown or commission, and may not necessarily
represent actual transactions.
 
 COMMON STOCK
                    MARKET PRICEHIGH
                  
                  
                  LOWFISCAL
      YEAR ENDED DECEMBER 31, 2008:Fourth
      Quarter
                  
                  $
                  4.08
                  
                  
                  $
                  2.25Third
      Quarter
                  
                  $
                  6.00
                  
                  
                  $
                  3.50Second
      Quarter
                  
                  $
                  7.33
                  
                  
                  $
                  5.15First
      Quarter
                  
                  $
                  7.25
                  
                  
                  $
                  4.75FISCAL
      YEAR ENDED DECEMBER 31, 2007:Fourth
      Quarter
                  
                  $
                  14.95
                  
                  
                  $
                  6.50Third
      Quarter
                  
                  $
                  8.34
                  
                  
                  $
                  4.39Second
      Quarter
                  
                  $
                  5.06
                  
                  
                  $
                  1.85First
      Quarter
                  
                  $
                  3.16
                  
                  
                  $
                  1.65
  As of
March 10, 2009, there were approximately 31 holders of record of our common
stock.
  Dividends
  There are
no restrictions in our articles of incorporation or bylaws that prevent us from
declaring dividends. The Delaware General Corporation Law, however, does
prohibit us from declaring dividends where, after giving effect to the
distribution of the dividend:
  1. We
would not be able to pay our debts as they become due in the usual course of
business; or
 2. Our
total assets would be less than the sum of our total liabilities plus the amount
that would be needed to satisfy the rights of shareholders who have preferential
rights superior to those receiving the distribution.
  We have
never paid any cash dividends on our common stock. We currently anticipate that
we will retain any future earnings for use in our business. Consequently, we do
not anticipate paying any cash dividends in the foreseeable future.
  The
payment of dividends in the future will depend upon our results of operations,
as well as our short-term and long-term cash availability, working capital,
working capital needs and other factors, as determined by our board of
directors. Currently, except as may be provided by applicable laws, there are no
contractual or other restrictions on our ability to pay dividends if we were to
decide to declare and pay them.
 
 Securities
Authorized for Issuance under Equity Compensation Plan
  There has
been no common stock authorized for issuance with respect to any equity
compensation plan as of the fiscal year ended December 31, 2008.
 
 Recent
Sales of Unregistered Securities
  The
Company did not sell any equity securities that were not registered under the
Securities Act of 1933, as amended, during the quarter ended December 31,
2008.
 
 ITEM 6.   SELECTED FINANCIAL
DATA
 
 For the
past four years, the increase in the number of our CNG fueling stations has not
affected our gross margin or per-station based operating margin since the
natural gas cost and retail price remains unchanged.  Meanwhile, our
SG&A also increases in proportion to our scale of operations. Therefore, the
increase in the number of our CNG fueling stations doesn’t materially affect the
comparability of our financial data.
  29
  Year ended December 312008
                                                    
                                                    
                                                    2007
                                                    
                                                    
                                                    2006
                                                    
                                                    
                                                    2005
                                                    
                                                    
                                                    2004STATEMENT
      OF OPERATIONS:RevenueNatural
      gas revenue
                                                    
                                                    
                                                    55,746,893
                                                    
                                                    
                                                    
                                                    28,278,033
                                                    
                                                    
                                                    
                                                    13,713,145
                                                    
                                                    
                                                    
                                                    1,687,154
                                                    
                                                    
                                                    
                                                    306,306Gasoline
      revenue
                                                    
                                                    
                                                    4,616,052
                                                    
                                                    
                                                    
                                                    38,486
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -Construction
      / installation and other
                                                    
                                                    
                                                    7,357,714
                                                    
                                                    
                                                    
                                                    7,075,534
                                                    
                                                    
                                                    
                                                    5,115,645
                                                    
                                                    
                                                    
                                                    3,163,545
                                                    
                                                    
                                                    
                                                    578,107Total
      revenue
                                                    
                                                    
                                                    67,720,659
                                                    
                                                    
                                                    
                                                    35,392,053
                                                    
                                                    
                                                    
                                                    18,828,790
                                                    
                                                    
                                                    
                                                    4,850,699
                                                    
                                                    
                                                    
                                                    884,413Cost
      of revenueNatural
      gas cost
                                                    
                                                    
                                                    27,234,508
                                                    
                                                    
                                                    
                                                    14,838,997
                                                    
                                                    
                                                    
                                                    7,663,060
                                                    
                                                    
                                                    
                                                    1,293,585
                                                    
                                                    
                                                    
                                                    226,944Gasoline
      cost
                                                    
                                                    
                                                    4,277,458
                                                    
                                                    
                                                    
                                                    34,747
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -Construction
      / installation and other
                                                    
                                                    
                                                    3,469,671
                                                    
                                                    
                                                    
                                                    3,151,331
                                                    
                                                    
                                                    
                                                    2,054,940
                                                    
                                                    
                                                    
                                                    1,110,452
                                                    
                                                    
                                                    
                                                    287,10234,981,637
                                                    
                                                    
                                                    
                                                    18,025,075
                                                    
                                                    
                                                    
                                                    9,718,000
                                                    
                                                    
                                                    
                                                    2,404,037
                                                    
                                                    
                                                    
                                                    514,046Gross
      profit
                                                    
                                                    
                                                    32,739,022
                                                    
                                                    
                                                    
                                                    17,366,978
                                                    
                                                    
                                                    
                                                    9,110,790
                                                    
                                                    
                                                    
                                                    2,446,662
                                                    
                                                    
                                                    
                                                    370,367Operating
      expensesSelling
      expenses
                                                    
                                                    
                                                    7,651,948
                                                    
                                                    
                                                    
                                                    3,451,161
                                                    
                                                    
                                                    
                                                    1,308,464
                                                    
                                                    
                                                    
                                                    474,855
                                                    
                                                    
                                                    
                                                    387,768General
      and administrative expenses
                                                    
                                                    
                                                    4,024,882
                                                    
                                                    
                                                    
                                                    2,837,768
                                                    
                                                    
                                                    
                                                    1,287,735
                                                    
                                                    
                                                    
                                                    500,228
                                                    
                                                    
                                                    
                                                    142,449Total
      operating expenses
                                                    
                                                    
                                                    11,676,830
                                                    
                                                    
                                                    
                                                    6,288,929
                                                    
                                                    
                                                    
                                                    2,596,199
                                                    
                                                    
                                                    
                                                    975,083
                                                    
                                                    
                                                    
                                                    530,217Income
      from operations
                                                    
                                                    
                                                    21,062,192
                                                    
                                                    
                                                    
                                                    11,078,049
                                                    
                                                    
                                                    
                                                    6,514,591
                                                    
                                                    
                                                    
                                                    1,471,579
                                                    
                                                    
                                                    
                                                    (159,850
                                                    )Non-operating
      income (expense):Interest
      income
                                                    
                                                    
                                                    209,502
                                                    
                                                    
                                                    
                                                    70,697
                                                    
                                                    
                                                    
                                                    41,109
                                                    
                                                    
                                                    
                                                    2,131
                                                    
                                                    
                                                    
                                                    1,618Interest
      expense
                                                    
                                                    
                                                    (2,228,244
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -Foreign
      currency exchange loss
                                                    
                                                    
                                                    (397,299
                                                    )
                                                    
                                                    
                                                    31,976
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -Other
      income (expense)
                                                    
                                                    
                                                    111,859
                                                    
                                                    
                                                    
                                                    (150,729
                                                    )
                                                    
                                                    
                                                    (79,021
                                                    )
                                                    
                                                    
                                                    (671
                                                    )
                                                    
                                                    
                                                    (3,536
                                                    )Total
      non-operating income (expense)
                                                    
                                                    
                                                    (2,304,182
                                                    )
                                                    
                                                    
                                                    (48,056
                                                    )
                                                    
                                                    
                                                    (37,912
                                                    )
                                                    
                                                    
                                                    1,460
                                                    
                                                    
                                                    
                                                    (1,918
                                                    )Income
      before income tax
                                                    
                                                    
                                                    18,758,010
                                                    
                                                    
                                                    
                                                    11,029,993
                                                    
                                                    
                                                    
                                                    6,476,679
                                                    
                                                    
                                                    
                                                    1,473,039
                                                    
                                                    
                                                    
                                                    (161,768
                                                    )Income
      tax
                                                    
                                                    
                                                    3,567,642
                                                    
                                                    
                                                    
                                                    1,913,923
                                                    
                                                    
                                                    
                                                    1,025,584
                                                    
                                                    
                                                    
                                                    220,956
                                                    
                                                    
                                                    
                                                    -Net
      income
                                                    
                                                    
                                                    15,190,368
                                                    
                                                    
                                                    
                                                    9,116,070
                                                    
                                                    
                                                    
                                                    5,451,095
                                                    
                                                    
                                                    
                                                    1,252,083
                                                    
                                                    
                                                    
                                                    (161,768
                                                    )Other
      comprehensive incomeForeign
      currency translation gain
                                                    
                                                    
                                                    5,184,034
                                                    
                                                    
                                                    
                                                    2,637,573
                                                    
                                                    
                                                    
                                                    610,705
                                                    
                                                    
                                                    
                                                    228,175
                                                    
                                                    
                                                    
                                                    -Comprehensive
      income
                                                    
                                                    
                                                    20,374,402
                                                    
                                                    
                                                    
                                                    11,753,643
                                                    
                                                    
                                                    
                                                    6,061,800
                                                    
                                                    
                                                    
                                                    1,480,258
                                                    
                                                    
                                                    
                                                    (161,768
                                                    )Weighted
      average shares outstandingBasic
                                                    
                                                    
                                                    29,200,304
                                                    
                                                    
                                                    
                                                    26,200,679
                                                    
                                                    
                                                    
                                                    23,872,936
                                                    
                                                    
                                                    
                                                    16,299,469
                                                    
                                                    
                                                    
                                                    9,275,362Diluted
                                                    
                                                    
                                                    29,290,139
                                                    
                                                    
                                                    
                                                    26,301,802
                                                    
                                                    
                                                    
                                                    23,872,936
                                                    
                                                    
                                                    
                                                    16,299,469
                                                    
                                                    
                                                    
                                                    9,275,362Earnings
      per shareBasic
                                                    
                                                    
                                                    0.52
                                                    
                                                    
                                                    
                                                    0.35
                                                    
                                                    
                                                    
                                                    0.23
                                                    
                                                    
                                                    
                                                    0.08
                                                    
                                                    
                                                    
                                                    (0.02
                                                    )Diluted
                                                    
                                                    
                                                    0.52
                                                    
                                                    
                                                    
                                                    0.35
                                                    
                                                    
                                                    
                                                    0.23
                                                    
                                                    
                                                    
                                                    0.08
                                                    
                                                    
                                                    
                                                    (0.02
                                                    )BALANCE
      SHEET DATA (at end of period):PROPERTY
      AND EQUIPMENT, net
                                                    
                                                    
                                                    76,028,272
                                                    
                                                    
                                                    
                                                    32,291,995
                                                    
                                                    
                                                    
                                                    17,193,728
                                                    
                                                    
                                                    
                                                    8,267,897
                                                    
                                                    
                                                    
                                                    20,935Working
      Capital
                                                    
                                                    
                                                    4,989,448
                                                    
                                                    
                                                    
                                                    13,581,900
                                                    
                                                    
                                                    
                                                    5,289,220
                                                    
                                                    
                                                    
                                                    (320,253
                                                    )
                                                    
                                                    
                                                    (130,368
                                                    )TOTAL
      ASSETS
                                                    
                                                    
                                                    118,262,291
                                                    
                                                    
                                                    
                                                    53,289,998
                                                    
                                                    
                                                    
                                                    28,466,351
                                                    
                                                    
                                                    
                                                    10,911,062
                                                    
                                                    
                                                    
                                                    28,875Long
      Term Debt
                                                    
                                                    
                                                    42,021,605
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    24,078Shareholder
      Equity
                                                    
                                                    
                                                    71,648,421
                                                    
                                                    
                                                    
                                                    51,207,314
                                                    
                                                    
                                                    
                                                    25,630,204
                                                    
                                                    
                                                    
                                                    9,675,550
                                                    
                                                    
                                                    
                                                    (133,511
                                                    )
 
 ITEM
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
  The
information in this report contains forward-looking statements. All statements
other than statements of historical fact made in this report are forward
looking. In particular, the statements herein regarding industry prospects and
future results of operations or financial position are forward-looking
statements. These forward-looking statements can be identified by the use of
words such as "believes," "estimates," "could," "possibly," "probably,"
anticipates," "projects," "expects," "may," "will," or "should" or other
variations or similar words. No assurances can be given that the future results
anticipated by the forward-looking statements will be achieved. Forward-looking
statements reflect management's current expectations and are inherently
uncertain. Our actual results may differ significantly from management's
expectations.
 
 The
following discussion and analysis should be read in conjunction with our
financial statements, included herewith. This discussion should not be construed
to imply that the results discussed herein will necessarily continue into the
future, or that any conclusion reached herein will necessarily be indicative of
actual operating results in the future. Such discussion represents only the best
present assessment of our management.
  30
 
 Overview
 
 We are
a distributor of CNG in China, which we primarily distribute through our
Company-owned CNG fueling stations. As of December 31, 2008, we operated 23 CNG
fueling stations in Shaanxi province and 12 CNG fueling stations in Henan
province. We own our CNG fueling stations while we lease the land upon which our
CNG fueling stations operate. For the year ended December 31, 2008, we sold CNG
of 147,666,791 cubic meters through our fueling stations, compared to
83,739,106 cubic meters for the year ended December 31, 2007. We also transport,
distribute and sell piped natural gas to residential and commercial customers in
the Xi’an area, including Lantian County, and the districts of Lintong and
Baqiao, in Shaanxi province through a high pressure pipeline network of
approximately 120 kilometers.
 
 We
operate four main business lines:
 
 ·
              Distribution and sale of
      compressed natural gas through Company-owned CNG fueling stations for
      hybrid (natural gas/gasoline) powered vehicles (35 stations as of December
      31, 2008);
 
 ·
              Installation, distribution and
      sale of piped natural gas to residential and commercial customers through
      Company-owned pipelines. We distributed and sold piped natural gas to
      approximately 96,033 residential customers as of December 31,
      2008;
 
 ·
              Distribution and sale of gasoline
      through Company-owned CNG fueling stations for gasoline and hybrid
      (natural gas/gasoline) powered vehicles (eight of our CNG fueling stations
      sold gasoline as of December 31, 2008);
  and
 
 ·
              Conversion of gasoline-fueled
      vehicles to hybrid (natural gas/gasoline) powered vehicles at our auto
      conversion sites.
  We buy
all of the natural gas that we sell and distribute to our customers. We do not
mine or produce any of our own natural gas and have no plans to do so during the
next 12 months. We currently sell our natural gas in two forms: (i) CNG and (ii)
piped natural gas.
 
 On
October 24, 2006, our variable interest entity XXNGC, formed a wholly-owned
subsidiary, SJLNG, for the purpose of constructing a LNG facility to be located
in Jingbian, Shaanxi province. We plan to invest approximately $45 million to
construct this facility, a portion of which was funded through the sale of
senior notes to Abax, and the remainder of which will be funded by our cash
flows from operations. The LNG plant is under construction and is expected to be
completed and fully operational by the end of 2009. Once completed, the plant is
expected to have a LNG processing capacity of 500,000 cubic meters per day, or
approximately 150 million cubic meters on an annual basis.
 
 We had
total revenues of $67,720,659, $35,392,053 and $18,828,790 for the three years
ended December 31, 2008, 2007 and 2006, respectively.  We had net
income of $15,190,368, $9,116,070 and $5,451,095 for the three years ended
December 31, 2008, 2007 and 2006, respectively.
  Critical
Accounting Policies
 
 Revenue
Recognition
 
 Our
revenue recognition policies are in accordance with Staff Accounting Bulletin
(SAB) 104. Revenue is recognized when services are rendered to customers when a
formal arrangement exists, the price is fixed or determinable, the delivery is
completed, no other significant obligations of ours exist and collectability is
reasonably assured. Payments received before all of the relevant criteria for
revenue recognition are satisfied are recorded as unearned
revenue.  Revenue from gas and gasoline sales is recognized when gas
and gasoline is pumped through pipelines to the end users. Revenue from
installation of pipelines is recorded when the contract is completed and
accepted by the customers. The construction contracts are usually completed
within one to two months.  Revenue from repairing and modifying
vehicles is recorded when services are rendered to and accepted by the
customers.
 
 Accounts
Receivable
 
 Accounts
and other receivables are netted against an allowance for uncollectible
accounts, as needed. We maintain reserves for potential credit losses on
accounts receivable. Our management reviews the composition of accounts
receivable and analyzes historical bad debts, customer concentrations, customer
credit worthiness, current economic trends and changes in customer payment
patterns to evaluate the adequacy of these reserves. Reserves are recorded
primarily on a specific identification basis in the period of the related sales.
Delinquent account balances are written off after management has determined that
the likelihood of collection is not probable, known bad debts are written off
against allowance for doubtful accounts when identified.  Our
management has determined that all receivables are collectible and there is no
need for an allowance for the uncollectible accounts as of December 31, 2008 and
2007.
 
 31
  Other
Receivable – Employee Advances
 
 From time
to time, we advance predetermined amounts based upon internal Company policy to
certain employees and internal units to ensure certain transactions are
performed in a timely manner. We have full oversight and control over the
advanced accounts. As of December 31, 2008 and 2007, no allowance for the
uncollectible amounts was deemed necessary.
 
 Inventory
 
 Inventory
is stated at the lower of cost, as determined on a first-in, first-out basis, or
market. Our management compares the cost of inventories with the market value,
and allowance is made for writing down the inventories to their market value, if
lower. Inventory consists of material used in the installation of pipelines and
material used in repairing and modifying of vehicles. Inventory also consists of
natural gas and gasoline.
  Fair Value of
Financial Instruments
 
 On
January 1, 2008, we adopted SFAS 157, Fair Value Measurements. SFAS 157 defines
fair value as the price that would be received to sell an asset or paid to
transfer a liability (i.e., the “exit price”) in an orderly transaction between
market participants at the measurement date.  SFAS 157 establishes a
three-level valuation hierarchy for disclosures of fair value measurement and
enhances disclosures requirements for fair value measures. The carrying amounts
reported in the balance sheets for receivables and current liabilities each
qualify as financial instruments and are a reasonable estimate of fair value
because of the short period of time between the origination of such instruments
and their expected realization and their current market rate of
interest.  The three levels are defined as follows:
 
 ·
              Level 1 inputs to the valuation
      methodology are quoted prices (unadjusted) for identical assets or
      liabilities in active
markets.
 
 ·
              Level 2 inputs to the valuation
      methodology include quoted prices for similar assets and liabilities in
      active markets, and inputs that are observable for the asset or liability,
      either directly or indirectly, for substantially the full term of the
      financial instrument.
 
 ·
              Level 3 inputs to the valuation
      methodology are unobservable and significant to the fair value
      measurement.
  We
analyze all financial instruments with features of both liabilities and equity
under SFAS 150, “Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity,” SFAS 133, “Accounting for
Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock.”
 
 As
required by SFAS 57, financial assets and liabilities are classified in their
entirety based on the lowest level of input that is significant to the fair
value measurement. Depending on the product and the terms of the transaction,
the fair value of our notes payable and derivative liabilities were modeled
using a series of techniques, including closed-form analytic formula, such as
the Black-Scholes option-pricing model, which does not entail material
subjectivity because the methodology employed does not necessitate significant
judgment, and the pricing inputs are observed from actively quoted
markets.
 
 Unearned
Revenue
 
 Unearned
revenue represents prepayments by customers for gas purchases and advance
payments on installation of pipeline contracts. The Company records such
prepayment as unearned revenue when the payments are received.
 
 Factors
Affecting Our Results of Operations
 
 Significant
factors affecting our results of operations are:
 
 Successful
expansion of our CNG fueling station business in our target markets. Our
revenue increased by 91.3% during the year ended December 31, 2008, from the
year ended December 31, 2007, largely because of the addition of 11 new CNG
fueling stations during 2008. For the year ended December 31, 2007, our revenue
increased by 88.0%, compared to the year December 31, 2006, primarily because of
the addition of 13 new CNG fueling stations during 2007. As of December 31,
2008, we operated 35 CNG fueling stations in total and, in Shaanxi alone, we
operated 23 CNG fueling stations. We believe we are the largest provider of CNG
fueling stations in Xi’an, one of our core target markets for CNG. As of
December 31, 2008, we operated 12 CNG fueling stations in Henan province,
another of our core target markets. The successful expansion of our CNG fueling
station business in Xi’an and Henan province has been a significant factor
driving our revenue growth and results of operations for the period reviewed.
While we intend to expand into different provinces, we anticipate the growth of
our CNG fueling business in Xi’an and Henan province will continue to
significantly affect our results of operations as we intend to continue to
increase the number of CNG fueling stations we operate in these
areas.
 
 Regulation of
natural gas prices in the PRC.The prices at which we
purchase our natural gas supplies and sell CNG and pipeline natural gas products
are strictly regulated by the PRC central government, including the NDRC, and
the local state price bureaus who have the discretion to set natural gas prices
within the boundaries set by the PRC central government.  In addition,
natural gas procurement and sale prices are not uniform across China and can
vary across provinces. For example, the prices at which we procure and sell CNG
and piped natural gas are lower in Shaanxi than in Henan. Accordingly, our
results of operations and, in particular, our revenue, cost of revenue and gross
profit and gross margin are affected significantly by factors which are outside
of our control. As we expand our natural gas business into other provinces, we
expect our results of operations to continue to be affected significantly by the
regulation of natural gas prices in the PRC.
  32
 
 Government
policies encouraging the adoption of cleaner burning
fuels.  Our results of operations for the periods reviewed have
benefited from environmental regulations and programs in the PRC that promote
the use of cleaner burning fuels, including natural gas for vehicles. As an
enterprise engaged in the natural gas industry in Shaanxi province, our VIE
benefits from a reduced income tax rate of 15% compared to the standard 25%
enterprise income tax rate in the PRC. In addition, the PRC government has
encouraged companies to invest in and build the necessary transportation,
distribution and sale infrastructure for natural gas in various policy
pronouncements such as by officially including CNG/gasoline hybrid vehicles in
the country's "encouraged development" category. These policies have benefited
our results of operations by encouraging the demand for our natural gas products
and also by lowering our expenses. As we expand into the LNG business, we
anticipate that our results of operations will continue to be affected by
government policies encouraging the adoption of cleaner burning fuels and the
increased adoption of CNG and LNG technology.
 
 The overall
economic growth of China’s economy.We do not export our products outside
China and our results of operations are thus substantially affected by the
growth of the industrial base, the increase in residential, commercial and
vehicular consumption and the overall economic growth of China. While's China's
economy has experienced a slowdown after the second quarter of 2007, we are
currently unable to estimate the impact the slowing of the PRC economy will have
on our business as the impact of the decline in international trade is being
offset in part through domestic stimulus spending, expanded bank lending,
increases in the speed of regulatory approvals of new construction projects and
other economic policies. While we do not believe we have experienced reduced
demand for natural gas to date, if the economic downturn continues, our results
of operations may be negatively affected by any decrease in demand for natural
gas in the second half of 2009.
 
 Taxation
 
 United
States
 
 We are
incorporated in the State of Delaware and are subject to the tax laws of the
United States. We incurred a net operating loss for income tax purposes for the
years ended December 31, 2008 and 2007, and the net operating loss carry
forwards for United States income tax purposes amounted to $2,429,266 and
$948,865, respectively, which may be available to reduce future years' taxable
income. These carry forwards will expire, if not utilized, beginning in 2027
through 2028. Our management believes that the realization of the benefits
arising from this loss appear to be uncertain due to our Company's limited
operating history and continuing losses for United States income tax purposes.
Accordingly, we have provided a 100% valuation allowance at December 31,
2008.
 
 The
PRC
 
 Our
subsidiary, VIE and its subsidiaries operate in China. Starting January 1, 2008,
pursuant to the tax laws of China, general enterprises are subject to income tax
at an effective rate of 25% compared to 33% prior to 2008. Based on certain
income tax regulations adopted in 2001 to encourage the development of certain
industries, including the natural gas industry, in the western portions of China
such as Shaanxi province, XXNGC is subject to a reduced tax rate of 15%.
Accordingly, except for income from XXNGC, which is subject to the reduced tax
rate of 15%, income from Xilan Equipment, SJLNG, XXABC, HXNGC and LBNGC are
subject to the 25% PRC income tax rate. Our effective income tax rate for the
years ended December 31, 2008, 2007 and 2006 were approximately 19%, 18% and
19%, respectively.
 
 Value
Added Tax
 
 Sales
revenue represents the invoiced value of goods, net of a value-added tax
("VAT").  All of our variable interest entity XXNGC's products that
are sold in the PRC are subject to a Chinese VAT at a rate of 13% of the gross
sales price. This VAT may be offset by VAT paid by XXNGC on raw materials and
other materials included in the cost of producing their finished products. XXNGC
records VAT payable and VAT receivable net of payments in its financial
statements. VAT tax returns are filed offsetting the payables against the
receivables.
 
 All
revenues from XXABC are subject to a Chinese VAT at a rate of 6%. This VAT
cannot be offset with VAT paid for materials included in the cost of
revenues.
 
 Internal
Control Over Financial Reporting
 
 We are
subject to reporting obligations under the U.S. securities laws. The SEC,
as required by Section 404 of the Sarbanes-Oxley Act, adopted rules
requiring every public company to include a management report on such company’s
internal control over financial reporting in its annual report, which contains
management’s assessment of the effectiveness of the company’s internal control
over financial reporting. In addition, an independent registered public
accounting firm must report on our internal control over financial reporting.
Our management may conclude that our internal control over our financial
reporting is not effective. Moreover, even if our management concludes that our
internal control over financial reporting is effective, our independent
registered public accounting firm may report that our internal control over
financial reporting is not effective.
  33
 
 In
connection with the audit of our consolidated financial statements for the years
ended December 31, 2007 and 2008, our independent registered public accounting
firm reported to us that we had material weaknesses in our internal controls
over financial reporting relating to our failure to maintain a sufficient
complement of personnel with an appropriate level of accounting knowledge,
experience and training in the application of generally accepted accounting
principles commensurate with our financial reporting requirements and did not
implement adequate supervisory review to ensure the financial statements were
prepared in conformity with generally accepted accounting principles in the
United States.  Additionally, they also identified numerous internal
control deficiencies that were identified as being significant, including
inadequate controls within the financial statement closing and reporting
process, which resulted in material adjustments that impacted the assets
accounts of the financial statements, and inadequate controls over the treasury
cycle. The number and nature of these significant deficiencies, when aggregated,
was determined to be a material weakness. In the aggregate, these significant
deficiencies could result in a misstatement of our account balances or
disclosures which could cause a material misstatement in our consolidated
financial statements that would not be prevented or detected.
 
 A
“material weakness” is a deficiency, or a combination of deficiencies, in
internal control over financial reporting such that there is a reasonable
possibility that a material misstatement of the registrant’s annual or interim
financial statements will not be prevented or detected on a timely basis by the
company’s internal controls.  A “significant deficiency” is a
deficiency, or a combination of deficiencies, in internal control over financial
reporting that is less severe than a material weakness, yet important enough to
merit attention by those responsible for oversight of the registrant’s financial
reporting.  A “deficiency” in internal control over financial
reporting exists when the design or operation of a control does not allow
management or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely
basis.
 
 During
our review of our financial statements and results for the years ended December
31, 2007 and 2008, our management also identified deficiencies that were
determined to be a material weakness based on the Internal Control – Evaluation
Framework developed by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”).  The specific material weaknesses and
significant deficiencies identified by our management as of December 31, 2008
are:
  Material
Weakness
 
 ·
                Inadequate US GAAP expertise -
      The current staff in our accounting department is inexperienced and they
      were primarily engaged in ensuring compliance with PRC accounting and
      reporting requirement for our operating subsidiaries and were not required
      to meet or apply U.S. GAAP requirements. They need substantial training to
      meet the higher demands of being a U.S. public company. The accounting
      skills and understanding necessary to fulfill the requirements of US
      GAAP-based reporting, including the skills of subsidiary financial
      statements consolidation, are
  inadequate.
 ·
                The Company did not have
      sufficient and skilled accounting personnel with an appropriate level of
      technical accounting knowledge and experience in the application of
      generally accepted accounting principles accepted in the U.S. commensurate
      with our financial reporting requirements, which resulted in a number of
      internal control deficiencies that were identified as being significant.
      Our management believes that the number and nature of these significant
      deficiencies, when aggregated, was determined to be a material
      weakness.
 
 Significant
Deficiency
 
 ·
                The
      Company does not have effective controls to provide reasonable assurance
      that the financial closing and reporting process are properly performed
      over the accounts and disclosure of the financial
      statements.
 
 ·
                The
      Company has inadequate controls over the treasury cycle. For example, the
      Company has not established procedures on collection of cash from the gas
      stations to the headquarter and distribution of cash between operating
      cash flow and deposit into banks. The Company also lacks adequate controls
      over its daily cash transactions and
  recording.
 
 ·
                The
      Company lacks qualified resources to perform the internal audit functions
      properly. In addition, the scope and effectiveness of our internal audit
      function are yet to be developed. We are committed to establishing the
      internal audit functions but due to limited qualified resources in the
      region, we were not able to hire sufficient internal audit resources
      before the end of 2008. However, internally we established a central
      management center to recruit more senior qualified people in order to
      improve our internal control procedures. Externally, we engaged Ernst
      & Young to assist us in improving our internal control system based on
      COSO Framework. We also will increase our efforts to hire the requisite
      qualified personnel.
  We are
devoting significant resources to remediating and improving our internal
controls.  Prior to December 31, 2008, we engaged an independent
certified public accountant who is mainly engaged to perform our financial
statements consolidation and to prepare our financial statements. In addition,
we are seeking to internally employ accountants experienced in several key areas
of accounting, including persons with experience in PRC and U.S. GAAP, U.S. GAAP
consolidation requirements and SEC financial reporting requirements. We also
plan to allocate additional resources to train our existing accounting staff and
will continue this effort in the future.  We have also engaged Ernst
& Young to consult on our internal audit function as well as other internal
control practices. Most of the policies, procedures and practices are already in
place and being implemented. To remediate these material weaknesses, we have
undertaken to improve our internal controls, including through the
following:
 
 ·
                identifying
      and hiring additional personnel with U.S. GAAP and SEC reporting
      experience, including our new CFO Veronica Jing
  Chen;
 ·
                providing
      training to our finance personnel to improve their knowledge of U.S. GAAP
      and SEC reporting requirements;
 ·
                holding
      regular meetings of the audit committee and resuming regular communication
      between the committee and our independent registered public accounting
      firm;
 ·
                engaging
      Ernst & Young to consult on our internal audit function as well as
      other internal control
practices;
 ·
                  establishing
      anonymous whistleblower systems for reporting violations of our governance
      policies, including policies regarding internal
    controls;·
                  introducing
      policies and procedures to effectively control daily cash transactions and
      recording;
 ·
                putting
      in place a centralized financial reporting software system in our
      headquarters, management centers and operating sites;
    and
 ·
                engaging
      external professional consultants to assess the entity level internal
      controls over financial reporting using the COSO internal control
      framework.
 
 We
have also begun to formulate policies relating to internal control over
financial reporting, including the preparation of comprehensive accounting
policies and procedures manual, containing, among other things, detailed,
expanded closing checklists, to guide our financial personnel in addressing
significant accounting issues and assist them in preparing financial statements
in compliance with U.S. GAAP and SEC requirements.
  Results
of Operations
 
 The
following table sets forth certain information regarding our results of
operations for the three years ended December 31, 2008, 2007 and
2006.
 
 Year Ended December 31,2008
                                              
                                              
                                              2007
                                              
                                              
                                              2006RevenueNatural
      gas revenue
                                              
                                              $
                                              55,746,893
                                              
                                              
                                              $
                                              28,278,033
                                              
                                              
                                              $
                                              13,713,145Gasoline
      revenue
                                              
                                              
                                              4,616,052
                                              
                                              
                                              
                                              38,486
                                              
                                              
                                              
                                              -Installation
      and other
                                              
                                              
                                              7,357,714
                                              
                                              
                                              
                                              7,075,534
                                              
                                              
                                              
                                              5,115,645Total
      revenue
                                              
                                              
                                              67,720,659
                                              
                                              
                                              
                                              35,392,053
                                              
                                              
                                              
                                              18,828,790Cost
      of revenueNatural
      gas cost
                                              
                                              
                                              27,234,508
                                              
                                              
                                              
                                              14,838,997
                                              
                                              
                                              
                                              7,663,060Gasoline
      cost
                                              
                                              
                                              4,277,458
                                              
                                              
                                              
                                              34,747
                                              
                                              
                                              
                                              -Installation
      and other
                                              
                                              
                                              3,469,671
                                              
                                              
                                              
                                              3,151,331
                                              
                                              
                                              
                                              2,054,940Total
      cost of revenue
                                              
                                              
                                              34,981,637
                                              
                                              
                                              
                                              18,025,075
                                              
                                              
                                              
                                              9,718,000Gross
      profit
                                              
                                              
                                              32,739,022
                                              
                                              
                                              
                                              17,366,978
                                              
                                              
                                              
                                              9,110,790Operating
      expensesSelling
      expenses
                                              
                                              
                                              7,651,948
                                              
                                              
                                              
                                              3,451,161
                                              
                                              
                                              
                                              1,308,464General
      and administrative expenses
                                              
                                              
                                              4,024,882
                                              
                                              
                                              
                                              2,837,768
                                              
                                              
                                              
                                              1,287,735Total
      operating expenses
                                              
                                              
                                              11,676,830
                                              
                                              
                                              
                                              6,288,929
                                              
                                              
                                              
                                              2,596,199Income
      from operations
                                              
                                              
                                              21,062,192
                                              
                                              
                                              
                                              11,078,049
                                              
                                              
                                              
                                              6,514,591Non-operating
      income (expense):Interest
      income
                                              
                                              
                                              209,502
                                              
                                              
                                              
                                              70,697
                                              
                                              
                                              
                                              41,109Interest
      expense
                                              
                                              
                                              (2,228,244
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Other
      income, net
                                              
                                              
                                              111,859
                                              
                                              
                                              
                                              31,976
                                              
                                              
                                              
                                              (79,021
                                              )Foreign
      currency exchange loss
                                              
                                              
                                              (397,299
                                              )
                                              
                                              
                                              (150,729
                                              )
                                              
                                              
                                              -Total
      non-operating expense
                                              
                                              
                                              (2,304,182
                                              )
                                              
                                              
                                              (48,056
                                              )
                                              
                                              
                                              (37,912
                                              )Income
      before income tax
                                              
                                              
                                              18,758,010
                                              
                                              
                                              
                                              11,029,993
                                              
                                              
                                              
                                              6,476,679Provision
      for income tax
                                              
                                              
                                              3,567,642
                                              
                                              
                                              
                                              1,913,923
                                              
                                              
                                              
                                              1,025,584Net
      income
                                              
                                              
                                              15,190,368
                                              
                                              
                                              
                                              9,116,070
                                              
                                              
                                              
                                              5,451,095Other
      comprehensive incomeForeign
      currency translation gain
                                              
                                              
                                              5,184,035
                                              
                                              
                                              
                                              2,637,573
                                              
                                              
                                              
                                              610,705Comprehensive
      income
                                              
                                              $
                                              20,374,403
                                              
                                              
                                              $
                                              11,753,643
                                              
                                              
                                              $
                                              6,061,800
  34




Fiscal
Year Ended December 31, 2008 Compared to Fiscal Year Ended December 31,
2007
 
 Revenue.  Revenue
increased by $32,328,606, or 91.3%, to $67,720,659 for the year ended December
31, 2008, from $35,392,053 for year ended December 31, 2007. The increase in
revenue was due primarily to the addition of 11 new CNG fueling stations in 2008
as sales of natural gas at our fueling stations increased by $26,454,604, or
98.8%, and 63,927,685 cubic meters, or 76.3%, to $53,219,853 and 147,666,791
cubic meters for the year ended December 31, 2008 from $26,765,249 and
83,739,106 cubic meters for the year ended December 31, 2007. Revenue from sales
of piped natural gas increased by $1,014,256, or 67.1%, to $2,527,040 for the
year ended December 31, 2008, from $1,512,784 for the year ended December 31,
2007 as our piped natural gas sales volume increased to 11,284,758 cubic meters
for the year ended December 31, 2008, from 7,403,314 cubic meters for the year
ended December 31, 2007. Our residential customers of piped natural gas
increased to 96,033 as of December 31, 2008, from 84,500 as of December 31,
2007.
 
 Revenue
from the sale of gasoline increased by $4,577,566 to $4,616,052 for the year
ended December 31, 2008 from $38,486 for the year ended December 31, 2007
primarily because the fourth quarter of 2007 was when we first began selling
gasoline. We began to sell gasoline at some of our CNG stations in an effort to
support our sales of CNG by attracting more natural gas/gasoline hybrid car
owners through providing a one-stop refueling option for such
customers.
 
 Revenue
from our pipeline installation business decreased by $1,268,015, or 20.7%, to
$4,854,438 for the year ended December 31, 2008, from $6,122,453 for the year
ended December 31, 2007 primarily due to the decline in new housing starts in
the areas we service. Revenue from our automobile conversion business increased
by $1,550,195 to $2,503,276 for the year ended December 31, 2008, from $953,081
for the year ended December 31, 2007 primarily because the second quarter of
2007 was when we first began our automobile conversion business.
 
 We expect
natural gas sales to continue to generate the bulk of our revenue as we intend
to continue to increase the number of CNG fueling stations we operate and the
number of our natural gas pipeline customers as well as begin to process,
distribute and sell LNG once our LNG plant is completed and fully operational,
which we anticipate will occur by the end of 2009. We expect gasoline sales will
continue to comprise a smaller portion of our entire business given that such
sales are primarily designed to support our existing CNG sales to customers with
hybrid fuel vehicles and are not a growth focus for our Company. We also expect
revenue from our pipeline installation and our automobile conversion businesses
to continue to make up a minor portion of our business.
 
 Cost of
revenue.  Cost of revenue increased by $16,956,562, or 94.1%,
to $34,981,637 for the year ended December 31, 2008 from $18,025,075 for the
year ended December 31, 2007, primarily due to the increase in the amount of
natural gas we sold to 158,951,549 cubic meters for the year ended December 31,
2008, compared to 91,142,421 cubic meters for the year ended December 31, 2007.
Our natural gas cost of revenue at our fueling stations increased by
$11,683,458, or 85.1%, to $25,420,764 during the year ended December 31, 2008
from $13,737,306 for the year ended December 31, 2007. Our pipeline natural gas
cost of revenue increased by $712,053, or 64.6%, to $1,813,744 for the year
ended December 31, 2008, from $1,101,691 for the year ended December 31, 2007.
Gasoline cost increased by $4,242,711 to $4,277,458 for the year ended December
31, 2008, from $34,747 for the year ended December 31, 2007 primarily because
the fourth quarter of 2007 was when we first began selling
gasoline.  In addition, installation cost of revenue decreased by
$613,694, or 23.8%, to $1,961,300 for the year ended December 31, 2008, from
$2,574,994 for the year ended December 31, 2007.  Cost of revenue for
our automobile conversion business increased by $932,034 to $1,508,371 for the
year ended December 31, 2008, from $576,337 for the year ended December 31,
2007.  We expect our cost of revenue to continue to increase as we
intend to increase our purchase of natural gas due to the growth of our natural
gas business.
 
 Gross profit and gross
margin.  Our gross profit increased by $15,372,044, or 88.5%,
to $32,739,022 for the year ended December 31, 2008 from $17,366,978 for the
year ended December 31, 2007.  Our gross margin decreased to 48.3% for
the year ended December 31, 2008 from 49.1% for the year ended December 31, 2007
due to the lower profit margin in our gasoline business as gasoline sales
increased to 6.8% of our revenue for the year ended December 31, 2008 from 0.1%
for the year ended December 31, 2007. Gross margins for our gasoline sales
decreased to 7.3% for the year ended December 31, 2008 from 9.7% for the year
ended December 31, 2007 primarily because of a lag between an increase in
gasoline procurement prices and an increase in gasoline retail prices. Because
our gross profit and gross margins are driven primarily by our natural gas
business and because the price of natural gas is regulated in China, changes in
our gross profit and gross margin will largely depend on the regulation of
natural gas prices in China.
  35
 
 Operating
expenses.  Our operating expenses increased by $5,387,901, or
85.7%, to $11,676,830 for year ended December 31, 2008, from $6,288,929 for the
year ended December 31, 2007 primarily as a result of an increase in our labor
and the rent expenses and water and electricity fees as we continued to grow our
business through the construction, acquisition and operation of 11 new fueling
stations in 2008. Selling expenses increased by $4,200,787 to $7,651,948 for the
year ended December 31, 2008 from $3,451,161 for the year ended December 31,
2007 as we increased our efforts to obtain new residential and commercial
customers and attract customers to our fueling stations.  Selling
expenses included depreciation expenses in connection with operating our fueling
stations, pipeline centers and automobile conversion centers.  General
and administrative expenses increased by $1,187,114 to $4,024,882 for the year
ended December 31, 2008 from $2,837,768 for the year ended December 31, 2007 due
to an increase in personnel as a result of our growth. We expect our operating
expenses to increase in connection with the growth of our business.
 
 Income from operations and operating
margin.  Based on the foregoing, income from operations
increased by $9,984,143, or 90.1%, to $21,062,192 for the year ended December
31, 2008 from $11,078,049 for the year ended December 31,
2007.  Operating margin was 31.1% for the year ended December 31,
2008, compared to 31.3% for the year ended December 31, 2007.
 
 Non-operating income
(expense).  Our non-operating expense increased by $2,256,126
to $2,304,182 for the year ended December 31, 2008 from $48,056 during the year
ended December 31, 2007 primarily because of interest expenses in the amount of
$2,228,244 for the year ended December 31, 2008 as a result of the sale of
senior notes with a face value of $20 million on January 29, 2008 and the sale
of additional senior notes with a face value of $20 million on March 3, 2008 to
Abax.
 
 Provision for the income
tax.  Income tax increased by $1,653,719, or 86.4%, to
$3,567,642 for the year ended December 31, 2008, from $1,913,923 for year ended
December 31, 2007 primarily due to the increase in our sale of natural gas and,
consequently, income before income tax.
 
 Net income.  As a
result of the foregoing, net income increased by $6,074,298, or 66.6%, to
$15,190,368 for the year ended December 31, 2008, from $9,116,070 for the year
ended December 31, 2007. Net margin was 22.4% for the year ended December 31,
2008, compared to 25.8% for the year ended December 31, 2007.
 
 Fiscal
Year Ended December 31, 2007 Compared to Fiscal Year Ended December 31,
2006
 
 Revenue.  Revenue
increased by $16,563,263, or 88.0%, to $35,392,053 for the year ended December
31, 2007, from $18,828,790 for the year ended December 31, 2006. The increase in
revenue was due primarily to the addition of 13 new Company-owned fueling
stations during 2007 as sales of natural gas at our fueling stations increased
by $14,313,168 and 44,537,145 cubic meters to $26,765,249 and 83,739,106 cubic
meters for the year ended December 31, 2007 from $12,452,081 and 39,201,961
cubic meters for the year ended December 31, 2006. In terms of average station
sales value and volume, we sold $1,500,000 and 4,760,000 cubic meters of CNG per
station for the year ended December 31, 2007, compared to $1,500,000 and
5,434,000 cubic meters for the year ended December 31, 2006. Sales of natural
gas to our pipeline customers increased by $251,720, or 20.0%, to $1,512,784 for
the year ended December 31, 2007, from $1,261,064 for the year ended December
31, 2006 as our piped natural sales volume increased to 7,403,314 cubic meters
for the year ended December 31, 2007, from 6,497,186 cubic meters for the year
ended December 31, 2006. Our residential customers of piped natural gas
increased to 84,500 as of December 31, 2007, from 72,781 as of December 31,
2006.
 
 Revenue
from the sale of gasoline was $38,486 for the year ended December 31, 2007 as we
began to sell gasoline at our CNG stations for the first time during the fourth
quarter of 2007 in an effort to support our sales of CNG by attracting more
natural gas/gasoline hybrid car owners through providing a one-stop refueling
option for such customers.
 
 Revenue
from our pipeline installation business increased by $1,006,808, or 19.7%, to
$6,122,453 for the year ended December 31, 2007, from $5,115,645 for the year
ended December 31, 2006 primarily because of an increase in customers adopting
natural gas for household use as a result of the growth in new housing starts as
well as an increase in industrial and commercial users. Revenue from our
automobile conversion business was $953,081 for the year ended December 31, 2007
as the second quarter of 2007 was when we first began our automobile conversion
business.
 
 Cost of
revenue.  Cost of revenue increased by $8,307,075, or 85.5%, to
$18,025,075 for the year ended December 31, 2007 from $9,718,000 for the year
ended December 31, 2006, primarily due to the increase in the amount of natural
gas we sold to 91,142,421 cubic meters for the year ended December 31, 2007,
compared to 45,699,147 cubic meters for the year ended December 31,
2006.  Cost of revenue for our natural gas fueling station business
increased by $6,984,814 to $13,737,306 for the year ended December 31, 2007,
from $6,752,492 for the year ended December 31, 2006, primarily due to the
increased sales at our CNG fueling stations.  Pipeline natural gas
cost of revenue increased by $191,123, or 21.0%, to $1,101,691 for the year
ended December 31, 2007, from $910,568 for the year ended December 31,
2007.  Our installation cost of revenue increased by $520,054, or
25.3%, to $2,574,994 for the year ended December 31, 2007, from $2,054,940 for
the year ended December 31, 2006, primarily as a result of the expansion of our
pipelines.  We incurred $576,337 in cost of revenue for our automobile
conversion business as 2007 was the first year we entered into our automobile
conversion business.  Similarly, gasoline costs were $34,747 for the
year ended December 31, 2007 because 2007 was the first year we began selling
gasoline.
  36
 
 Gross profit and gross
margin.  Our gross profit increased by $8,256,188, or 90.6%, to
$17,366,978 for the year ended December 31, 2007 from $9,110,790 for the year
ended December 31, 2006.  Our gross margin increased to 49.1% for the
year ended December 31, 2007 from 48.4% for the year ended December 31,
2006.
  Operating
expenses.   Our operating expenses increased by $3,692,730
to $6,288,929 for year ended December 31, 2007, from $2,596,199 for the year
ended December 31, 2006 primarily as a result of an increase in labor costs and
our depreciation expenses as our business continued to grow with the
construction, acquisition and operation of 13 new fueling stations in 2007, as
well as continuing expenses related to the identification of possible locations
for additional fueling stations and the governmental licensing and approval
process and the evaluation of existing natural gas fueling stations as potential
acquisition targets. Selling expenses increased by $2,142,697 to $3,451,161 for
the year ended December 31, 2007 from $1,308,464 for the year ended December 31,
2006 due to our efforts to obtain new residential and commercial customers and
attract customers to our fueling stations. General and administrative expenses
increased by $1,550,033 to $2,837,768 for the year ended December 31, 2007 from
$1,287,735 for the year ended December 31, 2006 due to an increase in personnel
as a result of our growth.
 
 Income from operations and operating
margin.  Based on the foregoing, income from operations
increased by $4,563,458, or 70.1%, to $11,078,049 for the year ended December
31, 2007 from $6,514,591 for the year ended December 31,
2006.  Operating margin was 31.3% for the year ended December 31,
2007, compared to 34.6% for the year ended December 31, 2006.
 
 Non-operating income
(expense).  Our non-operating expense increased by $10,144, or
26.8%, to $48,056 for the year ended December 31, 2007 from $37,912 for the year
ended December 31, 2006 primarily due to $150,729 in foreign currency exchange
losses.
 
 Provision for income
tax.  Income tax increased by $888,339, or 86.6%, to $1,913,923
for the year ended December 31, 2007, from $1,025,584 for year ended December
31, 2006 primarily due to the increase in our sale of natural gas.
 
 Net income.  As a
result of the foregoing, net income increased by $3,664,975, or 67.2%, to
$9,116,070 for the year ended December 31, 2007, from $5,451,095 for the year
ended December 31, 2006. Net margin was 25.8% for the year ended December 31,
2007, compared to 29.0% for the year ended December 31, 2006.
 
 Liquidity
and Capital Resources
  Historically,
our primary sources of liquidity have consisted of cash generated from our
operations and equity financing. In 2008, we sold senior notes with a face value
of $40 million to Abax. Our principal uses of cash have been, and are expected
to continue to be, for operational purposes as well as for constructing and
acquiring natural gas fueling stations and constructing our LNG
plant.
 
 As of
December 31, 2008, 2007 and 2006, we had $5,854,383, $13,291,729 and $5,294,213
of cash and cash equivalents on hand, respectively.
 
 Net cash
provided by operating activities was $20,916,801 for the year ended December 31,
2008, compared to net cash provided by operating activities of $10,476,441 for
the year ended December 31, 2007, primarily as a result of the increase in our
net income, adjusted for non-cash expense items and changes in working capital.
Net cash provided by operating activities was $10,476,441 for the year ended
December 31, 2007, compared to net cash provided by operating activities of
$4,385,524 for the year ended December 31, 2006, mainly due to the increase in
net income and a decrease in accounts receivable and advances during the year
ended December 31, 2007 offset by a decrease in other payables and tax
payable.
 
 Net cash
used in investing activities was $67,606,724 for the year ended December 31,
2008, compared to net cash used in investing activities of $16,885,340 for year
ended December 31, 2007, primarily due to the equipment purchased
in LBNGC and fueling stations, payments made to equipment suppliers for
investments necessary to construct fueling stations and the LNG facility. Net
cash used in investing activities was $16,885,340 for the year ended December
31, 2007, compared to net cash used in investing activities of $9,738,469 for
the year ended December 31, 2006, as a result of advance payments made to
equipment suppliers for investments necessary to construct and acquire fueling
stations and for construction materials used to build pipelines to individual
households.
 
 Net cash
provided by financing activities was $37,877,491 for the year ended December 31,
2008, compared to net cash provided by financing activities of $13,823,467 for
the year ended December 31, 2007, primarily due to the sale of senior notes with
a face value of $40 million we sold to Abax in 2008. Net cash provided by
financing activities was $13,823,467 for the year ended December 31, 2007,
compared to net cash provided by financing activities of $9,892,854 for the year
ended December 31, 2006 due to the sale and issuance of our common stock and
warrants to purchase our common stock in August 2007.
  Based on
past performance and current expectations, we believe our cash and cash
equivalents, cash generated from operations, as well as future possible cash
from financing activities, will satisfy our working capital needs, capital
expenditures and other liquidity requirements associated with our operations for
at least the next 12 months.
  37
  Off-Balance
Sheet Arrangements
 
 We do not
have any off-balance sheet arrangements that have or are reasonably likely to
have a current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources that are material to our
investors.
 
 Capital
Expenditures
 
 Our
planned capital expenditures for the year ended December 31, 2009 are expected
to be approximately $18,161,437, which we expect to be incurred in connection
with the construction of our LNG facility and the acquisition of additional CNG
fueling stations. To the extent we engage in additional projects in the near
future and to the extent we do not have sufficient internal financial resources
to fund capital expenditures associated with such projects, we will need to
obtain additional financing to fund such capital expenditures from third party
sources, including from the capital markets.
 
 Outstanding
Indebtedness
 
 On
December 30, 2007, we entered into a Securities Purchase Agreement (the
"Purchase Agreement") with Abax. The Purchase Agreement was subsequently amended
on January 29, 2008, pursuant to which we (i) agreed to issue 5.00% Guaranteed
Senior Notes due 2014 (the “Senior Notes”) of approximately $20,000,000, (ii)
agreed to issue to Abax Senior Notes in aggregate principal amount of
approximately $20,000,000 on or before March 3, 2008 subject to our meeting
certain closing conditions, (iii) granted Abax an option to purchase up to
approximately $10,000,000 in principal amount of its Senior Notes and (iv)
agreed to issue to Abax seven-year warrants exercisable for up to 2,900,000
shares of our common stock (the “Warrants”) at an initial exercise price equal
to $7.3652 per share, subject to certain adjustments.  On January 29,
2008, we issued $20,000,000 Senior Notes and 2,900,000 warrants pursuant to the
Purchase Agreement. On March 3, 2008, Abax exercised its first option for an
additional $20,000,000 of Senior Notes. On March 10, 2008, we issued $20,000,000
in additional Senior Notes resulting in total Senior Notes of
$40,000,000.
 
 We are
required to make mandatory prepayments on the Senior Notes on certain dates and
we are subject to customary covenants for financings of this type, including
restrictions on the incurrence of liens, payment of dividends, and disposition
of properties as well as obligated to maintain certain financial
ratios.
 Contractual
Obligations
 
 Our
contractual obligations are as follows:
 
 Payments due by periodContractual obligations
                                    
                                    Total
                                    
                                    
                                    Less than
                                      1 year
                                    
                                    
                                    1-3
                                      years
                                    
                                    
                                    3-5
                                      years
                                    
                                    
                                    More than
                                      5 years(in
      thousands)Long-Term
      Debt Obligations
                                    
                                    
                                    40,000
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    3,333
                                    
                                    
                                    
                                    26,667
                                    
                                    
                                    $
                                    10,000Other
      Long-Term Liabilities Reflected on Company's Balance
    Sheet
                                    
                                    
                                    17,500
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    17,500
                                    (1Total
                                    
                                    
                                    57,500
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    3,333
                                    
                                    
                                    
                                    26,667
                                    
                                    
                                    $
                                    27,500
 
 Note:
  (1)
                The
      $17,500,000 reflects derivative liability related to the embedded put
      option in the 1,450,000 warrants we issued to Abax in January 2008. If
      Abax does not exercise the warrants by January 29, 2015, Abax will be
      entitled to require that we purchase the warrants for $17,500,000 at that
      time.
 Commitments
and Contingencies
 
 Lease
Commitments
 
 We
recognize lease expense on a straight line basis over the term of the lease in
accordance to SFAS 13, “Accounting for leases.” We entered into a series of long
term lease agreements with outside parties to lease land use rights to our
Company-built natural gas fueling stations located in the PRC. The agreements
have terms ranging from 10 to 30 years. We make annual prepayments for most
lease agreements.  We also entered into two office leases in Xi’an,
PRC and New York, NY.  The minimum future payment for leasing land use
rights and offices is as follows:
  Year
      ending December 31, 2009
                      
                      $
                      1,213,744Year
      ending December 31, 2010
                      
                      
                      1,208,556Year
      ending December 31, 2011
                      
                      
                      1,204,212Year
      ending December 31, 2012
                      
                      
                      1,131,931Year
      ending December 31, 2013
                      
                      
                      1,052,520Thereafter
                      
                      
                      6,936,959Total
                      
                      $
                      12,747,922
 
 For the
years ended December 31, 2008, 2007 and 2006, the land use right and office
lease expenses were $1,127,558, $433,755 and $60,289, respectively.
 
 Property
and Equipment
 
 On
January 25, 2008, we entered into a contract with Chemtex International Inc.
("Chemtex") to acquire certain exclusive rights relating to the technical
know-how and designing of our LNG plant and LNG storage tank in Jingbian county,
Shaanxi province, China, in the total amount of $9,500,000.  On April
13, 2008, our subsidiary, XXNGC, entered into a contract with Chemtex to
purchase equipment supply for the LNG plant and LNG storage tank in the total
amount of $13,700,000 (the "Chemtex Purchase Agreement"). The $13,700,000
purchase price was reduced to $13,100,000 under an amendment to the Chemtex
Purchase Agreement with Chemtex in September 2008.  On May 16, 2008,
SJLNG entered into an agreement with Hebei Tongchan Import and Export Co. Ltd.
("Hebei") and agreed that Hebei will act as the trade agency for SJLNG. On June
18, 2008, XXNGC amended the April 13, 2008 agreement with Chemtex and assigned
Hebei to purchase the LNG equipment for the LNG plant and LNG storage tank and
Hebei succeeded the rights and obligations of XXNGC under Chemtex Purchase
Agreement.
  38
 
 As of
December 31, 2008, we advanced $6,106,589 to Hebei and the future commitment for
equipment is $7,593,411.
 
 Natural
Gas Purchase Commitments
 
 We have
certain effective natural gas purchase agreements with our major suppliers. The
natural gas purchase agreement with Shaanxi Provincial Natural Gas Co., Ltd. has
been renewed annually to date and specifies a maximum amount that can be
purchased but does not specify a minimum amount that must be purchased. Our
natural gas purchase agreements with certain suppliers of coal-bed methane are
of indefinite terms and do not contain either maximum or minimum amounts of
purchase. Without minimum purchase requirements under any of our natural gas
purchase agreements, we have the flexibility to constantly look for lower-cost
sources of supply.
 
 Legal
Proceedings
 
 In 2007,
Xiang Ji, one of our shareholders, and son of our CEO, Qinan Ji, filed a
lawsuit against Bodisen in the Chinese court system in Shaanxi province
contesting the validity of Bodisen’s ownership of 2,063,768 shares of our common
stock. Bodisen obtained these shares in September 2005 through a share transfer
agreement with Xiang Ji and asserted that it had fully performed its obligations
under the agreement and was entitled to own the shares. On January 15,
2008, Xiang Ji filed another lawsuit against Bodisen in the State of Utah
District Court, Salt Lake County, seeking to prevent Bodisen from selling the
2,063,768 shares it holds in the Company. Xiang Ji obtained an order from
the Utah court provisionally preventing Bodisen from selling the shares pending
a decision on the merits of the underlying dispute. In May 2009, Xiang Ji and
Bodisen entered into a settlement agreement through mediation in the Supreme
Court of Shaanxi province. Pursuant to the settlement agreement, Xiang Ji
agreed to withdraw the lawsuit he filed against Bodisen in the State of
Utah District Court, Salt Lake County, and Bodisen agreed to sell back to Xiang
Ji the 2,063,768 shares. We believe that the dispute between Xiang Ji and
Bodisen will be resolved in accordance with the settlement agreement and will
not have a material adverse effect on its financial condition or its results of
operations.
 
 A former
member of the board of directors filed a lawsuit on June 16, 2008 against the
Company in New York State Supreme Court, Nassau County, in which he has sought,
among other things; to recover a portion of his monthly compensation plus 20,000
options that he alleges are due to him pursuant to a written agreement. After
the plaintiff rejected an offer by the Company that included the options that
plaintiff alleged were due to him, the Company moved to dismiss the
complaint. The judge ordered the Company to issue the 20,000 options to the
plaintiff subject to any restrictions required by applicable securities laws,
which was essentially what the Company had previously offered, and dismissed all
of the plaintiff's remaining claims against the Company. The current board of
directors has complied with the court's decision by tendering an option
agreement to the plaintiff consistent with the court's decision, but the
plaintiff has refused to execute the agreement, and instead has filed an appeal.
Regardless of the outcome of the appeal, we believe that any liability it would
incur will not have a materially adverse effect on its financial condition or
its results of operations.
 
 Foreign
Currency Translations
  As of
December 31, 2008 and December 31, 2007, our accounts were maintained, and the
consolidated financial statements were expressed in RMB.  Such
consolidated financial statements were translated into USD in accordance with
Statement of Financial Accounts Standards ("SFAS") 52, "Foreign Currency
Translation," with the RMB as the functional currency. According to SFAS 52, all
assets and liabilities were translated at the exchange rate as of the balance
sheet date, stockholder's equity are translated at the historical rates and
statement of income and cash flow items are translated at the weighted average
exchange rate for the year. The resulting translation adjustments are reported
under other comprehensive income in accordance with SFAS 130, "Reporting
Comprehensive Income."  In accordance with SFAS 95, "Statement of Cash
Flows," cash flows from our operations is calculated based upon the local
currencies and translated to USD at average translation rates for the period. As
a result, translation adjustments amounts related to assets and liabilities
reported on the statement of cash flows will not necessarily agree with changes
in the corresponding balances on the balance sheet.
 
 The
balance sheet amounts with the exception of equity as of December 31, 2008 were
translated at RMB6.82 to $1.00 as compared to RMB7.29 as of December 31, 2007.
The equity accounts were stated at their historical rate. The average
translation rates applied to income and cash flow statement amounts for the year
ended December 31, 2008 and 2007 were RMB6.94 and RMB7.59 to $1.00,
respectively.  Translation adjustments resulting from this process in the
amount of $8,661,060 and $3,477,025 as of December 31, 2008 and 2007,
respectively, are classified as an item of other comprehensive income in the
stockholders’ equity section of the consolidated balance sheets. For the year
ended December 31, 2008 and 2007, other comprehensive income in the consolidated
statements of income and other comprehensive income included translation gains
of $5,184,035 and $2,637,573, respectively.
 
 RECENT
ACCOUNTING PRONOUNCEMENTS
 
 In
February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial
Assets and Financial Liabilities—including an amendment of FASB Statement No.
115. SFAS 159 permits companies to choose to measure many financial instruments
and certain other items at fair value that are not currently required to be
measured at fair value. The objective of SFAS 159 is to provide opportunities to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply hedge accounting provisions.
SFAS 159 also establishes presentation and disclosure requirements designed to
facilitate comparisons between companies that choose different measurement
attributes for similar types of assets and liabilities. We adopted SFAS 159 on
January 1, 2008. We chose not to elect the option to measure the fair value of
eligible financial assets and liabilities.
  39
 
 In
December 2007, the FASB issued SFAS 160, “Non-controlling Interests in
Consolidated Financial Statements - an amendment of Accounting Research Bulletin
No. 51,” which establishes accounting and reporting standards for ownership
interests in subsidiaries held by parties other than the parent, the amount of
consolidated net income attributable to the parent and to the non-controlling
interest, changes in a parent’s ownership interest and the valuation of retained
non-controlling equity investments when a subsidiary is deconsolidated. SFAS 160
also establishes reporting requirements that provide sufficient disclosures that
clearly identify and distinguish between the interests of the parent and the
interests of the non-controlling owners. SFAS 160 is effective for fiscal years
beginning after December 15, 2008. We have not determined the effect that the
application of SFAS 160 will have on our consolidated financial
statements.
 
 In
December 2007, SFAS 141(R), “Business Combinations,” was issued. SFAS 141R
replaces SFAS 141. SFAS
141R retains the fundamental requirements in SFAS 141 that the acquisition
method of accounting (which SFAS 141 called the purchase method) be used for all
business combinations and for an acquirer to be identified for each business
combination. SFAS 141R requires an acquirer to recognize the assets acquired,
the liabilities assumed, and any non-controlling interest in the acquiree at the
acquisition date, measured at their fair values as of that date, with limited
exceptions. This replaces SFAS 141’s cost-allocation process, which required the
cost of an acquisition to be allocated to the individual assets acquired and
liabilities assumed based on their estimated fair values. SFAS 141R also
requires the acquirer in a business combination achieved in stages (sometimes
referred to as a step acquisition) to recognize the identifiable assets and
liabilities, as well as the non-controlling interest in the acquiree, at the
full amounts of their fair values (or other amounts determined in accordance
with SFAS 141R). SFAS 141R applies prospectively to business combinations for
which the acquisition date is on or after the beginning of the first annual
reporting period beginning on or after December 15, 2008. An entity may not
apply it before that date. We are currently evaluating the impact that adopting
SFAS No. 141R will have on its financial statements.
 
 In
February 2008, the FASB issued FASB Staff Position (FSP) FAS 140-3,
“Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions.” FSP FAS 140-3 requires an initial transfer of a financial asset
and a repurchase financing that was entered into contemporaneously or in
contemplation of the initial transfer to be evaluated as a linked transaction
under SFAS No. 140 unless certain criteria are met, including that the
transferred asset must be readily obtainable in the marketplace. FSP
FAS 140-3 is effective for fiscal years beginning after
November 15, 2008, and is applicable to new transactions entered into
after the date of adoption. Early adoption is prohibited. We do not expect
adoption of FSP FAS 140-3 to have a material effect on its financial condition
and cash flows.  Adoption of FSP FAS 140-3 will have no effect on our
results of operations.
 
 In March
2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and
Hedging Activities – An Amendment of SFAS No. 133”. SFAS 161 seeks to
improve financial reporting for derivative instruments and hedging activities by
requiring enhanced disclosures regarding the impact on financial position,
financial performance, and cash flows. To achieve this increased transparency,
SFAS 161 requires (1) the disclosure of the fair value of derivative
instruments and gains and losses in a tabular format; (2) the disclosure of
derivative features that are credit risk-related; and (3) cross-referencing
within the footnotes. SFAS 161 is effective on January 1, 2009. We are in
the process of evaluating the new disclosure requirements under SFAS
161.
 
 In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles". SFAS 162 is intended to improve financial reporting by identifying
a consistent framework, or hierarchy, for selecting accounting principles to be
used in preparing financial statements that are presented in conformity with
GAAP for nongovernmental entities. SFAS 162 is effective 60 days following the
SEC's approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, "The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles." We are in the process of evaluating the impact
of adoption of this statement on the results of operations, financial position
or cash flows.
 
 In June
2008, the FASB issued EITF 07-5 “Determining whether an Instrument (or Embedded
Feature) is indexed to an Entity’s Own Stock”. This Issue is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years. Early application is not
permitted. Paragraph 11(a) of SFAS 133 specifies that a contract that would
otherwise meet the definition of a derivative but is both (a) indexed to
the company’s own stock and (b) classified in stockholders’ equity in the
statement of financial position would not be considered a derivative financial
instrument. EITF No.07-5 provides a new two-step model to be applied in
determining whether a financial instrument or an embedded feature is indexed to
an issuer’s own stock and thus able to qualify for the SFAS 133 paragraph 11(a)
scope exception. This standard will trigger liability accounting on all options
and warrants exercisable at strike prices denominated in any currency other than
the functional currency in China (Renminbi). We are currently evaluating the
impact of adoption of EITF 07-5 on our consolidated financial
statements.
 
 In
June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities.” The FSP addresses whether instruments granted in share-based
payment transactions are participating securities prior to vesting and therefore
need to be included in the earnings allocation in calculating earnings per share
under the two-class method described in SFAS 128, “Earnings per Share.” The FSP
requires companies to treat unvested share-based payment awards that have
non-forfeitable rights to dividend or dividend equivalents as a separate class
of securities in calculating earnings per share. The FSP is effective for fiscal
years beginning after December 15, 2008; earlier application is not
permitted. We do not expect adoption of FSP EITF 03-6-1 to have a material
effect on its results of operations or earnings per share.
  40
 
 In
September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, Disclosures about
Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No.
133 and FASB Interpretation No. 45; and Clarification of the Effective Date of
FASB Statement No. 161". This FSP amends SFAS 133 to require disclosures by
sellers of credit derivatives, including credit derivatives embedded in a hybrid
instrument. This FSP also amends FIN 45, “Guarantor’s Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others”, to require an additional disclosure about the current status of the
payment/performance risk of a guarantee. Further, this FSP clarifies the Board’s
intent about the effective date of SFAS 161. The provisions of this FSP that
amend SFAS 133 and FIN 45 shall be effective for reporting periods (annual or
interim) ending after November 15, 2008. We are in the process of evaluating the
new disclosure requirements under this FSP.
 
 In
October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair
Value of a Financial Asset When the Market for That Asset Is Not Active.” FSP
FAS 157-3 clarifies the application of SFAS 157 in an inactive market,
without changing its existing principles. The FSP was effective immediately upon
issuance. The adoption of FSP FAS 157-3 did not have an effect on our
financial condition, results of operations or cash flows.
 
 In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment
on Purchased and Retained Beneficial Interests in Securitized Financial Assets”.
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1
achieves this by amending the impairment model in EITF 99-20 to remove its
exclusive reliance on “market participant” estimates of future cash flows used
in determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the “market participant” view to a holder’s
estimate of whether there has been a “probable” adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether an
other-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1
did not have a material impact on our consolidated financial statements because
all of our investments in debt securities are classified as trading
securities.
 
 ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 Natural
Gas Price Risk
 
 Our major
market risk exposure continues to be the pricing applicable to our purchases and
value-added reselling of CNG.  Our revenues and profitability
depend substantially upon the applicable prices of natural gas, which in China
are regulated and fixed by central and local governments and that have
historically not fluctuated significantly or with great frequency. Such price
involatility is expected to continue for our operations in China. We currently
do not have any hedge positions in place to reduce our exposure to changes in
natural gas wholesale and retail prices.
 
 Interest
Rate Risk
 
 We are
subject to interest rate risk on our long-term fixed-interest rate debt. Fixed
rate debt, where the interest rate is fixed over the life of the instrument,
exposes us to changes in market interest rates reflected in the fair value of
the debt and to the risk that we may need to refinance maturing debt with new
debt at a higher rate. All else being equal, the fair value of our fixed rate
debt will increase or decrease as interest rates change. We had long-term debt
outstanding of $40 million as of  December 31, 2008, all of
which bears interest at fixed rates. The $40 million of fixed-rate debt is
due 2014. We currently have no interest rate hedge positions in place to reduce
our exposure to changes in interest rates.
 
 Foreign Currency
Exchange Rates Risk
 
 Because
substantially all of our revenues and expenditures are denominated in Renminbi
and the net proceeds from this offering were denominated in U.S. dollars,
fluctuations in the exchange rate between the U.S. dollars and Renminbi affect
the relative purchasing power of these proceeds and our balance sheet and
earnings per common stock in U.S. dollars. In addition, we report our financial
results in U.S. dollars, and appreciation or depreciation in the value of the
Renminbi relative to the U.S. dollar would affect our financial results reported
in U.S. dollars terms without giving effect to any underlying change in our
business or results of operations. Fluctuations in the exchange rate will
also affect the relative value of any dividend we issue that will be exchanged
into U.S. dollars and earnings from and the value of any U.S. dollar-denominated
investments we make in the future.
 
 Since
July 2005, the Renminbi has no longer been pegged to the U.S. dollar. Although
currently the Renminbi exchange rate versus the U.S. dollar is restricted to a
rise or fall of no more than 0.5% per day and the People’s Bank of China
regularly intervenes in the foreign exchange market to prevent significant
short-term fluctuations in the exchange rate, the Renminbi may appreciate or
depreciate significantly in value against the U.S. dollar in the medium- to
long-term. Moreover, it is possible that in the future, PRC authorities may lift
restrictions on fluctuations in the Renminbi exchange rate and lessen
intervention in the foreign exchange market.
 
 Very
limited hedging transactions are available in China to reduce our exposure to
exchange rate fluctuations. To date, we have not entered into any hedging
transactions in an effort to reduce our exposure to foreign currency exchange
risk. While we may decide to enter into hedging transactions in the future, the
availability and effectiveness of these hedging transactions may be limited and
we may not be able to successfully hedge our exposure at all. In addition,
our currency exchange losses may be magnified by PRC exchange control
regulations that restrict our ability to convert Renminbi into foreign
currency.
  41
 
 ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
 The
Consolidated Financial Statements of the Company and its subsidiaries as of
December 31, 2008, 2007, and 2006, including the notes thereto, together with
the report of Moore Stephens Wurth Frazer and Torbet, LLP and Kabani &
Company, Inc. are presented beginning on page F-1 of this report.
 
 Year Ended
                                                          December 31
                                                        
                                                        First
                                                          Quarter
                                                        
                                                        
                                                        Second
                                                          Quarter
                                                        
                                                        
                                                        Third
                                                          Quarter
                                                        
                                                        
                                                        Fourth
                                                          Quarter
                                                        
                                                        
                                                        Full Year2008Net
      operating revenues
                                                        
                                                        $
                                                        14,025,674
                                                        
                                                        
                                                        $
                                                        16,890,486
                                                        
                                                        
                                                        $
                                                        18,401,200
                                                        
                                                        
                                                        $
                                                        18,403,299
                                                        
                                                        
                                                        $
                                                        67,720,659Gross
      profit
                                                        
                                                        
                                                        6,088,476
                                                        
                                                        
                                                        
                                                        7,665,763
                                                        
                                                        
                                                        
                                                        9,492,367
                                                        
                                                        
                                                        
                                                        9,492,416
                                                        
                                                        
                                                        
                                                        32,739,022Net
      income
                                                        
                                                        
                                                        2,808,571
                                                        
                                                        
                                                        
                                                        3,512,892
                                                        
                                                        
                                                        
                                                        5,136,590
                                                        
                                                        
                                                        
                                                        3,732,315
                                                        
                                                        
                                                        
                                                        15,190,368Basic
      EPS
                                                        
                                                        
                                                        0.10
                                                        
                                                        
                                                        
                                                        0.12
                                                        
                                                        
                                                        
                                                        0.18
                                                        
                                                        
                                                        
                                                        0.13
                                                        
                                                        
                                                        
                                                        0.52Diluted
      EPS
                                                        
                                                        
                                                        0.10
                                                        
                                                        
                                                        
                                                        0.12
                                                        
                                                        
                                                        
                                                        0.18
                                                        
                                                        
                                                        
                                                        0.13
                                                        
                                                        
                                                        
                                                        0.522007Net
      operating revenues
                                                        
                                                        $
                                                        6,743,576
                                                        
                                                        
                                                        $
                                                        8,273,309
                                                        
                                                        
                                                        $
                                                        9,078,089
                                                        
                                                        
                                                        $
                                                        11,297,079
                                                        
                                                        
                                                        $
                                                        35,392,053Gross
      profit
                                                        
                                                        
                                                        3,517,359
                                                        
                                                        
                                                        
                                                        4,143,110
                                                        
                                                        
                                                        
                                                        4,319,839
                                                        
                                                        
                                                        
                                                        5,386,670
                                                        
                                                        
                                                        
                                                        17,366,978Net
      income
                                                        
                                                        
                                                        2,110,326
                                                        
                                                        
                                                        
                                                        2,745,009
                                                        
                                                        
                                                        
                                                        1,961,662
                                                        
                                                        
                                                        
                                                        2,299,073
                                                        
                                                        
                                                        
                                                        9,116,070Basic
      EPS
                                                        
                                                        $
                                                        0.09
                                                        
                                                        
                                                        $
                                                        0.11
                                                        
                                                        
                                                        $
                                                        0.07
                                                        
                                                        
                                                        $
                                                        0.08
                                                        
                                                        
                                                        $
                                                        0.35Diluted
      EPS
                                                        
                                                        $
                                                        0.09
                                                        
                                                        
                                                        $
                                                        0.11
                                                        
                                                        
                                                        $
                                                        0.07
                                                        
                                                        
                                                        $
                                                        0.08
                                                        
                                                        
                                                        $
                                                        0.352006Net
      operating revenues
                                                        
                                                        $
                                                        1,787,214
                                                        
                                                        
                                                        $
                                                        3,724,183
                                                        
                                                        
                                                        $
                                                        6,514,291
                                                        
                                                        
                                                        $
                                                        6,803,102
                                                        
                                                        
                                                        $
                                                        18,828,790Gross
      profit
                                                        
                                                        
                                                        944,702
                                                        
                                                        
                                                        
                                                        1,614,554
                                                        
                                                        
                                                        
                                                        3,235,405
                                                        
                                                        
                                                        
                                                        3,316,129
                                                        
                                                        
                                                        
                                                        9,110,790Net
      income
                                                        
                                                        
                                                        410,580
                                                        
                                                        
                                                        
                                                        927,269
                                                        
                                                        
                                                        
                                                        2,203,786
                                                        
                                                        
                                                        
                                                        1,909,460
                                                        
                                                        
                                                        
                                                        5,541,095Basic
      EPS
                                                        
                                                        $
                                                        0.02
                                                        
                                                        
                                                        $
                                                        0.04
                                                        
                                                        
                                                        $
                                                        0.09
                                                        
                                                        
                                                        $
                                                        0.08
                                                        
                                                        
                                                        $
                                                        0.23Diluted
      EPS
                                                        
                                                        $
                                                        0.02
                                                        
                                                        
                                                        $
                                                        0.04
                                                        
                                                        
                                                        $
                                                        0.09
                                                        
                                                        
                                                        $
                                                        0.08
                                                        
                                                        
                                                        $
                                                        0.23
 
 The
Company’s fiscal year 2008 operating result was impacted by the following
non-operating items:
 Ÿ
              Interest expense of $2,228,244
      related to the Company’s $40 million senior notes due 2014, net of
      capitalized interest. This charge includes $995,578 in interest expense,
      $1,004,677 in amortization of discount on our senior notes, and $227,989
      in amortization of deferred offering costs. The Company capitalized
      $1,932,931 of interest expense and amortization into construction in
      progress for fiscal year
2008.
 Ÿ
              Foreign currency exchange loss of
      $397,299 due to the decrease in value of the Company’s dollar deposits as
      a result of depreciating US dollar against Chinese
      yuan.
 
 These two
non-operating charges have a combined effect of $2,126,183 on our net income,
assuming effective tax rate of 19.02%. The capitalized interest increases the
cost of our long term assets and is depreciated or amortized over the useful
life of these assets.
 
 ITEM
9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
 
 Effective
as of May 21, 2007, the Company dismissed Kabani & Company, Inc. ("Kabani"),
the Company’s independent registered public accounting firm. The decision to
change accountants was recommended by the Company’s Audit Committee and approved
by the Company's Board of Directors.
 
 Kabani
reported on the Company's consolidated financial statements for the years ending
December 31, 2006 and 2005 and reviewed the Company’s consolidated financial
statements for the period ending March 31, 2007. For these periods and up to May
21, 2007, there were no disagreements with Kabani on any matter of accounting
principle or practices, financial statement disclosure, or auditing scope or
procedure, which disagreement(s), if not resolved to the satisfaction of Kabani,
would have caused it to make reference thereto in its report on the financial
statements for such years.
 
 The
reports of Kabani on the financial statements of the Company for the fiscal
years ended December 31, 2006 and 2005 did not contain any adverse opinion or
disclaimer of opinion and were not qualified or modified as to uncertainty,
audit scope or accounting principles.
  42
  ITEM
9A CONTROLS AND PROCEDURES
 
 (a)
Evaluation of Disclosure Controls and Procedures
 
 The
Company’s management has evaluated, under the supervision and with the
participation of the Company’s Chief Executive Officer and Chief Financial
Officer, the effectiveness of the design and operations of the Company’s
disclosure controls and procedures (as defined in Securities Exchange Act Rule
13a-15(e)), as of the end of the period covered by this annual report. Based on
that evaluation, the Company’s Chief Executive Officer and Chief Financial
Officer have concluded that the evaluation of the effectiveness of our
disclosure controls and procedures was completed; our disclosure controls and
procedures were not effective.
  (b)
Management’s Annual Report on Internal Control over Financial
Reporting
 
 The
Company’s management is responsible for establishing and maintaining an adequate
system of internal control over financial reporting. Internal control over
financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles. A company’s internal control over financial reporting
includes those policies and procedures that (i) pertain to the maintenance of
records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (ii) provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the financial
statements.
 
 Because
of its inherent limitations, a system of internal control over financial
reporting can provide only reasonable assurance and may not prevent or detect
misstatements. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation. Further, because of changes in conditions,
effectiveness of internal control over financial reporting may vary over
time.
 
 A
significant deficiency is a control deficiency, or combination of control
deficiencies, that adversely affects the company’s ability to initiate,
authorize, record, process, or report external financial data reliably in
accordance with generally accepted accounting principles such that there is more
than a remote likelihood that a misstatement of the company’s annual or interim
financial statements that is more than inconsequential will not be prevented or
detected. An internal control material weakness is a significant deficiency, or
combination of significant deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected.
 
 We have
evaluated the effectiveness of our internal control over financial reporting as
of December 31, 2008.  This evaluation was performed using the
Internal Control – Evaluation
Framework   developed by the Committee of Sponsoring
Organizations of the Treadway Commission (“COSO”).  Based on such
evaluation, management identified deficiencies that were determined to be a
material weakness.
 
 A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of the company’s annual or interim financial
statements will not be prevented or detected on a timely
basis.  Because of the material weakness described below, management
concluded that our internal control over financial reporting was not effective
as of December 31, 2008.
 
 The
specific material weakness and significant deficiency identified by the
Company’s management as of December 31, 2008 is described as
follows:
  Material
Weakness
 
 Inadequate
US GAAP expertise - The current staff in the accounting department is
inexperienced and they were primarily engaged in ensuring compliance with PRC
accounting and reporting requirement for our operating subsidiaries and was not
required to meet or apply U.S. GAAP requirements. They need substantial training
to meet the higher demands of being a U.S. public company. The accounting skills
and understanding necessary to fulfill the requirements of US GAAP-based
reporting, including the skills of subsidiary financial statements
consolidation, are inadequate .
 
 The
Company did not have sufficient and skilled accounting personnel with an
appropriate level of technical accounting knowledge and experience in the
application of generally accepted accounting principles accepted in the United
States of America commensurate with the Company’s financial reporting
requirements, which resulted in a number of internal control deficiencies that
were identified as being significant. The Company’s management believes that the
number and nature of these significant deficiencies, when aggregated, was
determined to be a material weakness.
 
 43
  Significant
Deficiency
 
 The
Company does not have effective controls to provide reasonable assurance that
the financial closing and reporting process are properly performed over the
accounts and disclosure of the financial statements.
 
 The
      Company has inadequate controls over the treasury cycle. For example, the
      Company has not established procedures on collection of cash from the gas
      stations to the headquarter and distribution of cash between operating
      cash flow and deposit into banks. The Company also lacks adequate controls
      over its daily cash transactions and
  recording.
 
 The Company
is lacking qualified resources to perform the internal audit functions properly.
In addition, the scope and effectiveness of the Company's internal audit
function are yet to be developed. We are committed to establishing the internal
audit functions but due to limited qualified resources in the region, we were
not able to hire sufficient internal audit resources before the end of 2008.
However, internally we established a central management center to recruit more
senior qualified people in order to improve our internal control procedures.
Externally, we engaged Ernst & Young to assist the Company in improving the
Company's internal control system based on COSO Framework. We also will increase
our efforts to hire the qualified resources.
 
 Remediation
Initiative
  Prior to
December 31, 2008, we engaged an independent CPA consultant in California to
serve as our accountant. She is mainly engaged to perform our financial
statements consolidation and to prepare our financial statements. In addition,
we are seeking accountants experienced in several key areas of accounting,
including persons with experience in Chinese and U.S. GAAP, U.S. GAAP
consolidation requirements, and SEC financial reporting requirements. In
addition, we plan to allocate additional resources to train our existing
accounting staff and continue this effort in the future.
 
 Meanwhile,
the Company has also engaged Earnest & Young to consult on our internal
audit function as well as other internal control practices. Most of the
policies, procedures and practices are already in place for full
implementation.
 
 To
remediate these material weaknesses, we have undertaken to improve our internal
controls, including the following:
 
 •
identifying and hiring additional personnel with U.S. GAAP and SEC reporting
experience, including our new CFO Veronica Jing Chen;
 
 •
providing training to our finance personnel to improve their knowledge of U.S.
GAAP and SEC reporting requirements;
 
 • holding
regular meetings of the audit committee and resuming regular communication
between the committee and our independent registered public accounting
firm;
 
 • engaged
Ernst & Young to consult on our internal audit function as well as other
internal control practices;
 
 •
establishing anonymous whistleblower systems for reporting violations of our
governance policies, including policies regarding internal
controls;
    • putting
in place a centralized financial reporting software system in our headquarters,
management centers and operating plants; and
 
 •
engaging external professional consultants to assess the entity level internal
controls over financial reporting using the COSO internal control framework.
  We
have also begun to formulate policies relating to internal control over
financial reporting, including the preparation of a comprehensive accounting
policies and procedures manual, containing, among other things, detailed,
expanded closing checklists, to guide our financial personnel in addressing
significant accounting issues and assist them in preparing financial statements
in compliance with U.S. GAAP and SEC requirements.
 
 (c)
Changes in Internal Control over Financial Reporting
 
 Except as
described above, there were no changes in its internal controls over financial
reporting in connection with its fourth quarter evaluation that would materially
affected, or are reasonably likely to materially affect, its internal control
over financial reporting.
  (d)
Independent Registered Public Accounting Firm’s Attestation Report
  Our
independent registered public accounting firm has issued the following
attestation report on our internal control over financial
reporting.
 
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  To the
Board of Directors and Stockholders of
  China
Natural Gas, Inc.
  44
 
 We have
audited China Natural Gas, Inc. and subsidiaries’ (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 (COSO).  The Company’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 of internal control over financial reporting 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 the inherent limitations of internal control over financial reporting,
including the possibility of collusion or improper management override of
controls, material misstatements due to error or fraud may not be prevented or
detected on a timely basis. Also, projections of any evaluation of effectiveness
of the internal control over financial reporting to future periods are subject
to the risk that controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may
deteriorate.
  A
material weakness is a control deficiency, or combination of deficiencies, in
internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of the Company’s annual or interim
financial statements will not be prevented or detected on a timely basis. The
following material weakness has been identified and included in management’s
assessment:
  The
Company did not maintain a sufficient complement of personnel with an
appropriate level of accounting knowledge, experience and training in the
application of generally accepted accounting principles commensurate with the
Company’s financial reporting requirements, and did not implement adequate
supervisory review to ensure the financial statements were prepared in
conformity with generally accepted accounting principles in the United States of
America.  Additionally, we identified numerous internal control
deficiencies that were indentified as being significant.  The number
and nature of these significant deficiencies, when aggregated, was determined to
be a material weakness. In the aggregate, these significant deficiencies could
result in a misstatement of the Company’s account balances or disclosures which
could cause a material misstatement of the consolidated financial statements
that would not be prevented or detected.   This material weakness
was considered in determining the nature, timing, and extent of audit tests
applied in our audit of the 2008 financial statements, and this report does not
affect our report dated March 13, 2009 on those financial
statements.
  In our
opinion, because of the effect of the material weakness described above on the
achievement of the objectives of the control criteria, the Company has not
maintained effective 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 (COSO).
  We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets and the related
statements of income and other comprehensive income, stockholders’ equity, and
cash flows of the Company, and our report dated March 13, 2009 expressed an
unqualified opinion.
  /s/ Moore
Stephens Wurth Frazer and Torbet, LLP
 
 Walnut,
California
 March 13,
2009
 
 ITEM
9B. OTHER INFORMATION
  None.
 
 PART
III
  ITEM
10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE.
  45





Below are
the names and certain information regarding our executive officers and directors
as of December 31, 2008:




Name
                          
                          Age
                          
                          Position
                          
                          Held
      Position SinceQinan
      Ji
                          
                          52
                          
                          Chief
      Executive Officer and Chairman of the Board
                          
                          2005Richard
      P. Wu
                          
                          45
                          
                          Chief
      Financial Officer
                          
                          2008Zhiqiang
      Wang
                          
                          69
                          
                          Director
                          
                          2006Donald
      Yang
                          
                          43
                          
                          Director
                          
                          2008Carl
      Yeung
                          
                          30
                          
                          Director
                          
                          2008Lawrence
      Leighton
                          
                          75
                          
                          Director
                          
                          2008




Officers
are elected annually by the Board of Directors, at our annual meeting, to hold
such office until an officer's successor has been duly appointed and qualified,
unless an officer sooner dies, resigns or is removed by the Board.





Background
of Executive Officers and Directors




Qinan
Ji, Chairman of the Board of Directors - Mr. Ji joined Xilan as the Chairman of
the Board of Directors in 2005. In 1996, he founded the Anxian Hotel in Weinan
City in Shaanxi province. In 2001, he formed the Xi’an Sunway Technology and
Industry Co., Ltd. He has more than 20 years experience in the energy and
petroleum industries in operational, administrative, management and government
relation roles. He received a Bachelors of Economic Management from Northwestern
University (Shaanxi).




Richard
P. Wu, Chief Financial Officer – Mr. Wu joined the Company as the Chief
Financial Officer in 2008. Prior joining the Company he served as COO and
Interim CFO of China Operation at Tejari World FZ LLC, one of the largest online
e-procurement service providers and B2B portal operators in the Middle East. In
this capacity, he designed and constructed the China Operation’s financial and
accounting infrastructure and systems to support the company’s growth in China.
Mr. Wu served as CFO and Corporate SVP of The Alliancepharm US LLC from 2003 to
2007, where he assumed full financial and accounting responsibility for the
multi-million-dollar sourcing and contract manufacturing businesses in the area
of active pharmaceutical ingredients. Prior to that, he was CFO and Corporate
EVP of Meetchina.com Inc., a pioneering online cross-border e-commerce portal in
China. Earlier in his financial career, Mr. Wu was Senior Finance Director at
Motorola Inc., and investment banking associate at Lehman Brothers Holdings,
Inc. Mr. Wu received his Master of Business Administration in Finance from The
Wharton School, University of Pennsylvania, and a Master of Justice
Administration from Indiana University. He also holds a Master of Law from China
University of Political Science & Law. He is a licensed lawyer of the
People’s Republic of China and practiced law in Beijing, China for 5
years.




Zhiqiang
Wang, Vice Chairman of the Board of Directors - Mr. Wang was the former head of
energy industry regulations from 1992 to 2002 as well as the Vice Mayor of the
city of Xi'An, China's largest western city with a population of 8 million, in
which position he was in charge of regulating and licensing the city's energy
and natural gas businesses. From 2002 until his retirement in 2004, Mr. Wang was
the Chief Executive Officer of Xi'An Municipal Government Construction Company
where he was in charge of the city's major construction projects. Mr. Wang
graduated from the Northwestern University of Politics and Law in China in
1962.





Donald
Yang, Director - Mr. Yang is a founding partner and president of Abax Global
Capital (“AGC”), a leading Hong Kong based investment firm focused on Pan-Asian
public and private investments especially in Greater China and Southeast Asia.
He was a Managing Director responsible for Merrill Lynch’s Hong Kong and China
Debt Capital Markets division from 2000 to 2007. Mr. Yang also serves as a
director for Sinoenergy Corporation (Ticker “SNEH”), a NASDAQ listed company.
Mr. Yang holds a MBA degree from Wharton School of Business and a BA degree from
Nankai University in China. Abax, an affiliate of AGC, is the sole investor in
the Company’s $40 million note financing which closed in January 2008. Pursuant
to an investor rights agreement, Abax has the right to appoint one member of the
Company’s Board of Directors.





Carl
Yeung, Director - Mr. Yeung is the Chief Financial Officer of ATA Inc, a China
based, leading provider of computer-based testing and education services in
China listed on the NASDAQ Global Market. Prior to that, Mr. Yeung worked as an
associate and analyst at Merrill Lynch (Asia Pacific) Limited from 2002 to 2006.
Mr. Yeung holds a bachelor’s degree in economics with concentrations in finance
and operations management from Wharton School, University of Pennsylvania, and a
bachelor’s degree in applied science with concentration in systems engineering
from School of Engineering and Applied Sciences, University of
Pennsylvania.





Lawrence
Leighton, Director - Mr. Leighton has had an extensive 40-year international
investment banking career. Beginning at what is now Lehman Brothers, he advised
on financing for the Mexican Government and leading Mexican corporations. As
Director of Strategic Planning for the consumer products company, Norton Simon
Inc, he initiated and executed the acquisition of Avis Rent-a-car. Subsequently,
he was a Limited Partner of Bear Stearns & Co., a Managing Director of the
investment bank of Chase Manhattan Bank and then President and Chief Executive
Officer of the U.S. investment bank of Credit Agricole, the major French Bank.
Among his transactions have been advising Pernod Ricard, the major European
beverage company, on its acquisitions in the United States; and advising
Verizon, the major U. S. telecom company, on its dispositions of certain
European operations. Mr. Leighton received his BSE degree in engineering from
Princeton University and an MBA degree from Harvard Business School. He holds a
commercial pilot’s license with instrument rating.




46




Board
of Directors.




Our
Directors are elected by the vote of a plurality in interest of the holders of
our voting stock and hold office for a term of one year or until a successor has
been elected and qualified.




A
majority of the authorized number of directors constitutes a quorum of the Board
for the transaction of business. The directors must be present at the meeting to
constitute a quorum. However, any action required or permitted to be taken by
the Board may be taken without a meeting if all members of the Board
individually or collectively consent in writing to the action.




There are
no family relationships, or other arrangements or understandings between or
among any of the directors, executive officers or other person pursuant to which
such person was selected to serve as a director or officer.




Our
directors, executive officers and control persons have not been involved in any
of the following events during the past five years:




1. any
bankruptcy petition filed by or against any business of which such person was a
general partner or executive officer either at the time of the bankruptcy or
within two years prior to that time;





2. any
conviction in a criminal proceeding or being subject to a pending criminal
proceeding (excluding traffic violations and other minor offenses);




3. being
subject to any order, judgment, or decree, not subsequently reversed, suspended
or vacated, of any court of competent jurisdiction, permanently or temporarily
enjoining, barring, suspending or otherwise limiting his involvement in any type
of business, securities or banking activities; or




4. being
found by a court of competent jurisdiction (in a civil action), the Commission
or the Commodity Futures Trading Commission to have violated a federal or state
securities or commodities law, and the judgment has not been reversed,
suspended, or vacated.




Committees
of the Board of Directors





The Board
of Directors has the following standing committees: Audit, Compensation and
Nominating. The Board of Directors has adopted written charters for each of
these committees, copies of which can be found on our website at www.naturalgaschina.com.
Mr. Wang, Mr. Yeung and Mr. Leighton are independent directors within the
meaning set forth in the rules of NASDAQ, as currently in effect.




Audit
Committee





The Audit
Committee consists of Mr. Leighton and Yeung and Wang with Mr. Yeung serving as
the chair. The board of directors has determined that Mr. Yeung is an “Audit
Committee Financial Expert,” as defined in Item 407(d)(5) of Regulation S-K and
Mr. Yeung is an independent director within the meaning set forth in the rules
of NASDAQ, as currently in effect.  The Audit Committee adopted a
charter which provides that the Committee, (i) oversees our accounting,
financial reporting and audit process; (ii) appoints, determines the
compensation of, and oversees, the independent auditors; (iii) pre-approves
audit and non-audit services provided by the independent auditors; (iv) reviews
of the results and scope of audit and other services provided by the independent
auditors; (v) reviews the accounting principles and practices and procedures
used in preparing our financial statements; and (vi) reviews of internal
controls.





The Audit
Committee works closely with management and our independent auditors. The Audit
Committee also meets with our independent auditors on a quarterly basis,
following our auditors’ quarterly reviews and annual audit and prior to our
earnings announcements, to review the results of their work. The Audit Committee
also meets with our independent auditors to approve the annual scope and fees
for the audit services to be performed.





Compensation
Committee




The
Compensation Committee consists of Mr. Leighton and Yeung and Wang with Mr.
Leighton serving as the chair. The Compensation Committee adopted a charter
which provides that the Committee, (i) review and approves corporate goals and
objectives relevant to the CEO’s compensation, evaluation of the CEO’s
performance relative to goals and objectives and sets the CEO’s compensation
annually and (ii) makes recommendations annually to the Board of Directors with
respect to non-CEO compensation.





Nominating
Committee





The
Nominating Committee consists of Mr. Leighton and Yeung and Wang with Mr. Wang
serving as the chair. The Compensation Committee adopted a charter which
provides that the Committee, (i) identify and review candidates for the Board
and recommend to the full Board candidates for election to the Board and (ii)
review from time to time the appropriate skills and characteristics required of
Board members in the context of current composition of the Board.




47




Code
of Ethics





On
June 14, 2006, we adopted a Code of Ethics that applies to all officers,
directors and employees of our Company. A copy of our Code of Ethics is
available to you at no charge upon written request. The written request should
be addressed to our corporate office at 19th Floor,
Building B, Van Metropolis, No. 35 Tangyan Road, High Tech Zone, Xi’an 710065,
Shaanxi province, the People’s Republic of China.





COMPLIANCE
WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934





Section
16(a) of the Securities Exchange Act of 1934, as amended, requires our executive
officers and directors and persons who own more than 10% of a registered class
of our equity securities to file with the Securities and Exchange Commission
initial statements of beneficial ownership, reports of changes in ownership and
annual reports concerning their ownership of our common stock and other equity
securities, on Forms 3, 4 and 5 respectively. Executive officers, directors and
greater than 10% shareholders are required by the Securities and Exchange
Commission regulations to furnish our Company with copies of all Section 16(a)
reports they file.




To the
Company's knowledge, based solely on a review of the copies of the reports
furnished to the Company, all executive officers, directors and greater than 10%
shareholders filed the required reports in a timely manner, except for Zhiqiang
Wang who did not timely file a Form 3 when he was appointed to the Company’s
Board of Directors.




ITEM
11. EXECUTIVE COMPENSATION




COMPENSATION
DISCUSSION AND ANALYSIS





Our
Compensation Committee assists our board of directors in reviewing and approving
the compensation structure of our directors and executive officers, including
all forms of compensation to be provided to our directors and executive
officers.  Our Compensation Committee, which currently consists of
three members, each of whom is independent of management, seeks to ensure that
senior executives of the Company are compensated effectively in a manner
consistent with the strategy of the Company, competitive practice and the
requirements of the appropriate regulatory bodies. Our Compensation Committee
also oversees, reviews and administers all compensation and employee benefit
plans and programs.





Compensation
Philosophy and Objectives





Our
Compensation Committee’s goals regarding executive compensation are primarily to
recruit, hire, retain, motivate and reward the most talented and dedicated
executives possible. In determining what constitutes fair and competitive
compensation for each executive, our Compensation Committee evaluates individual
executive performance with a goal of setting compensation at levels based on the
executive’s general business and industry knowledge and experience while taking
into account our relative performance and our strategic goals.





We review
annually and approve our compensation strategy to help ensure that executives
are rewarded appropriately for their contributions to company growth and
profitability.  During our review of an individual executive’s
compensation, our Compensation Committee considers primarily individual
performance of that executive and internal review of the executive’s
compensation, both individually and relative to other executive
officers.  Our Compensation Committee also considers factors of
corporate performance including our sales, revenue and the current overall
economic situation.  Adjustments to salary levels are typically made
annually as part of our performance review process, as well as upon a change in
job responsibility.  Merit-based increases to salaries are based on
our Compensation Committee’s assessment of the individual executive’s
performance.





Elements
of Compensation





Our
Compensation Committee has structured our executive compensation to motivate
executives to achieve our business goals.  Our executive compensation
consists of the following elements:





Base
Salary





For base
salary, we determine executive salaries based on job responsibilities and
individual experience and expect to continue to provide competitive salaries to
our executive officers by conducting our annual review and, if appropriate,
recommending adjustments in salaries based on individual performance during the
prior fiscal year and cost of living adjustments. Our Compensation Committee
believes that any increases in base salary should be based upon a favorable
evaluation of individual performance, which is evaluated by assessing factors
such as the functioning of that executive’s team within the corporate structure,
success in furthering the corporate strategy and goals and individual management
skills, responsibilities and anticipated workload.




48




Incentive
and Discretionary Bonus Plans




We
currently have no incentive plans in place. Any incentive plan we adopt will be
aimed at attracting and retaining outstanding executive officers capable of
leading our Company to fulfil its business objectives and establish an
appropriate link between executive compensation and achievement of our Company’s
strategic and financial performance goals. We intend for any incentive plan we
adopt to provide rewards to executive officers who, because of the extent of
their responsibilities, can make significant contributions to the success of our
Company by their ability, loyalty and exceptional services.




The
Compensation Committee may award a discretionary bonus to executive officers to
reward outstanding personal achievement during the year. The actual amount of
discretionary bonus is determined following a review of each executive’s
individual performance and contribution to our strategic goals. In March 2009,
the Compensation Committee recommended, and our board of directors approved, an
annual salary of $120,000 and a discretionary bonus of up to $60,000 for Mr.
Qinan Ji, our CEO, for 2009.





Stock
Options





We did
not have any stock option plans effective during 2008. On March 11, 2009, our
board of directors approved a stock option plan for our employees, directors and
consultants. The total number of our common shares available for grant under the
plan is 1,460,000 shares, taking into account our reverse stock split in April
2009. Among the option pool approved, it is expected that 50% of the pool shall
be awarded in 2009 and another 50% shall be awarded in 2010. For the 2009 stock
option award, the CEO and CFO were granted options of 146,000 and 75,000 of our
common shares, respectively, each with a vesting period of four years. 10,000
option shares per year will be granted to each non-executive board member and
12,000 option shares per year granted to the Audit Committee Chairman. Other
senior management and employees will be granted total options of 307,400 of our
common shares for 2009.





Other
Compensation





Consistent
with our compensation philosophy, we intend to continue to maintain our current
benefits and perquisites for our executive officers; however, the Compensation
Committee in its discretion may revise, amend or add to the officer’s benefits
and perquisites, if it deems it advisable and to the extent permitted by law
and/or the officer's employment agreement. We are required to participate in a
defined contribution plan operated by the local municipal government in
accordance with Chinese laws and regulations. We make annual contributions of
14% of all our employees' salaries to the plan.  Beginning in 2008, no
minimum contribution is required but the maximum contribution cannot exceed 14%
of the current salary expense. In addition, certain employees of our
subsidiaries, including Mr. Ji, our Chairman and Chief Executive Officer, have
pension and healthcare benefits through plans offered by such subsidiaries, as
required by local Chinese laws. In October 2008, we entered into an employment
agreement with our former CFO, Mr. Richard Wu, wherein we agreed to pay Mr. Wu a
$10,000 insurance allowance per year. We do not have any profit sharing plan or
similar plans for the benefit of our officers, directors or employees. However,
we may establish such plans in the future.





We
currently have no plans to change either the employment agreements of our
executive officers as described below (except as required by law or as required
to clarify the benefits to which our executive officers are entitled as set
forth herein) or levels of benefits and perquisites provided
thereunder.





Monitoring
Executive Compensation Program





Our
Compensation Committee monitors our executive compensation program by evaluating
individual performance of that executive and internal review of the executive’s
compensation, both individually and relative to other executive officers. Our
Compensation Committee also considers factors of corporate performance including
our sales, revenue and the current overall economic situation.




Compensation
Committee’s Processes and Procedures for Consideration and Determination of
Executive Compensation




The
Compensation Committee oversees all of our executive compensation policies and
decisions, including the administration and interpretation of our benefit plans.
The Compensation Committee also reviews and approves executive officer
compensation, including, as applicable, salary, bonus, special or supplemental
benefits and other forms of executive officer compensation. The Committee
periodically reviews regional and industry-wide compensation practices and
trends to assess the adequacy and competitiveness of our compensation programs.
The Committee’s membership is determined annually by the full board and includes
only independent directors. The Committee meets as often as it deems
appropriate, but not less frequently than annually.




The board
has delegated authority to the Compensation Committee to review and make
recommendations with respect to compensation matters, but has retained the
authority to approve and take final action on all executive compensation
awards.





Role
of Executive Officers in Compensation Process





The
Compensation Committee also solicits appropriate input from Mr. Ji, our chairman
and CEO, regarding base salary and other forms of executive officer compensation
for our other executive officers and the administration of our benefit
plans.




49




External
Advisors




The
Compensation Committee has not engaged the services of outside advisors to
assist it in fulfilling its duties.





EXECUTIVE
COMPENSATION





The
following table sets forth information regarding compensation awarded or paid
to, or earned by, our principal executive officer and the two individuals who
served as our principal financial officers during the year ended December 31,
2008. No other executive officer of our Company had total compensation exceeding
$100,000 during the year ended December 31, 2008.





Summary
Compensation Table





Summary
Compensation Table


Name and Principal
                                              Position(1)
                                            
                                            Year
                                            
                                            Salary
                                              ($)
                                            
                                            Bonus
                                              ($)
                                            
                                            Option
                                              Awards(2)
                                              ($)
                                            
                                            All Other
                                              Compensation
                                              ($)
                                            
                                            Total
                                              ($)Qinan
      Ji, Chief Executive
                                              Officer
      and Chairman of the Board
                                            
                                            2008
                                            
                                            15,000
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            
                                            -
                                            
                                            15,0002007
                                            
                                            15,000
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            
                                            -
                                            
                                            15,0002006
                                            
                                            15,000
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            
                                            -
                                            
                                            15,000Richard
      P. Wu, Chief Financial Officer(3)
                                            
                                            2008
                                            
                                            47,260
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            
                                            1,890
                                            
                                            49,150Lihong
      Guo, Chief Financial Officer(4)
                                            
                                            2008
                                            
                                            40,000
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            
                                            -
                                            
                                            40,0002007
                                            
                                            4,000
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            
                                            -
                                            
                                            4,000





(1)
            Identifies
      our named executive officers during the specified
  period.


(2)
            Represents
      the dollar amount of expense recognized for financial statement reporting
      purposes with respect to awards of options to acquire common stock, in
      accordance to SFAS 123(R).  See the notes to our financial
      statements contained herein for an explanation of all assumptions made by
      us in determining the SFAS 123(R) values of our option
    awards.


(3)
            Mr.
      Wu was appointed as our CFO on October 23, 2008, and resigned from the
      position on March 25, 2009.


(4)
            Ms. Guo was appointed as our CFO
      on December 10, 2007 and resigned from that position on October 23,
      2008.





Employment
Agreements





The
Company signs employment agreements with all of our employees. Our employment
agreements are intended to comply with the current Labor Contract Law of the
PRC. Our employment agreements are typically valid for one year and are
renewable if both the Company and the employee decide to renew the employment
agreement afterwards. In determining whether to renew an employment agreement,
our Company considers primarily individual performance of that executive and our
corporate performance including our sales, revenue, growth and the current
overall economic situation.





In March
2009, our CEO, Mr. Ji, signed a one-year employment contract with the Company
with the following key terms:





 ̈
            Salary
      for 2009 will be $120,000





 ̈
            Discretionary bonus of up to
      $60,000





 ̈
            Contract can be renewed on a
      yearly basis if both the Company and Mr. Ji decide to renew the employment
      agreement





In May
2005, our CEO, Mr. Ji signed a one-year employment contract with the Company
with the following key terms:





 ̈
            Annual Salary of
      $15,000





 ̈
            Contract was superseded by the
      March 2009 agreement described
above





In
October 2008, our former CFO, Mr. Richard Peidong Wu, signed a one-year
employment contract with the Company with the following key terms:


 ̈
            Salary
      for the 12-month period commencing on October 10, 2008, will be
      $250,000





 ̈
            The Company will provide an
      additional $10,000 insurance allowance per
  year





 ̈
            Eligible for up to 1.5% stock
      option of the Company’s shares outstanding, pending the Company’s employee
      stock option plan




50




 ̈
            Contract can be renewed on a
      yearly basis if both the Company and Mr. Wu decide to renew the employment
      agreement





In
December 2007, our former CFO, Ms. Lihong Guo, signed a one-year employment
contract with the Company with the following key terms:





 ̈
            Salary for 2008 will be
      $40,000





 ̈
            Contract can be renewed on a
      yearly basis if both the Company and Ms. Guo decide to renew the
      employment agreement





Grants
of Plan-Based Awards





We did
not grant any plan-based awards to our executives during 2008.





Outstanding
Equity Awards at the Year Ended December 31, 2008





Our
executives had no outstanding equity awards as of December 31,
2008.





Option
Exercises and Stock Vested





Our
executives did not exercise any stock options or hold any stock awards that
vested during the year ended December 31, 2008.





Pension
Benefits





We have
not adopted any pension benefits plans.




Nonqualified
Deferred Compensation




None of
our executive officers participate in or have account balances in non-qualified
defined contribution plans or other deferred compensation plans maintained by
us.





Severance
and Change of Control Agreements





We do not
have any agreements or arrangements providing for payments to an executive
officer in connection with any termination of the officer's employment or change
of control of our Company.





Director
Compensation





The
Governance and Nominating Committee of the board of directors, which is
comprised of Mr. Lawrence Leighton, Mr. Carl Yeung and Mr. Zhiqiang Wang, are
responsible for evaluating compensation levels and compensation programs for our
board of directors and for making recommendations to the board of directors
regarding appropriate compensation awards for directors. The board of directors'
compensation program is designed to attract, retain and motivate experienced
non-employee (outside) directors, to optimize long-term shareholder value and
reward members of the board of directors based on the extent of their
participation on the board of directors and its committees. Generally, the
Governance and Nominating Committee makes an annual recommendation regarding the
structure of the non-employee director compensation program, considering the
factors described above and considering information regarding director
compensation programs for other comparable companies.




During
the year ended December 31, 2008, Mr. Yueng and Mr. Leighton received a director
fee of $3,000 per month. Mr. Wang received an annual director fee of $5,279.
Each of our directors were reimbursed for reasonable expenses incurred in
attending Board and committee meetings. Our chairman and CEO, Mr. Ji, and Mr.
Yang did not receive any compensation for their services as a director during
the year ended December 31, 2008.





The
following Director Compensation Table summarizes the compensation of our
directors for services rendered to the Company during the year ended December
31, 2008.




51




Name
                    
                    Fees
                      Earned
                      or
      Paid in
                      Cash
                      ($)
                    
                    
                    Stock
                      Awards
                      ($)
                    
                    
                    Option
                      Awards
                      ($)
                    
                    
                    All
      Other
                      Compensation
                      ($)
                    
                    
                    Total
                      ($)James
      Garner (1)
                    
                    
                    21,000
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    21,000Qinan
      Ji (2)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Zhiqiang
      Wang
                    
                    
                    5,187
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    5,187Donald
      Yang(3)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Carl
      Yeung
                    
                    
                    14,400
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    14,400Lawrence
      Leighton
                    
                    
                    14,400
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    14,400




(1)
            Removed from the Board of
      Directors on August 3, 2008.


(2)
            Ji
      Qinan, our Chief Executive Officer, did not receive any compensation for
      his service as a director.


(3)
            Donald
      Yang did not receive any compensation for his service as a
      director.





We did
not pay any other compensation to our directors during the year ended December
31, 2008.





Compensation
Committee Interlocks and Insider Participation





During
our fiscal year ended December 31, 2008, Mr. Lawrence Leighton, Mr. Carl Yeung,
Mr. Zhiqiang Wang and Mr. James Garner served as members of our Compensation
Committee wherein management compensation issues generally were reviewed and
approved. Mr. Garner served as the sole member of our Compensation Committee
from March 27, 2006 to August 3, 2008. Mr. Leighton, Mr. Yeung and Mr. Wang have
serve on the Compensation Committee since their appointment to our board on
August 7, 2008. None of the members who served on our Compensation Committee
during the year ended December 31, 2008 was an officer or employee of our
Company during the fiscal year ended December 31, 2008, was formerly an officer
of our company, was a promoter of the Company or has, or will have, a direct or
indirect interest in a transaction since the beginning of the fiscal year ended
December 31, 2008, or any currently proposed transaction, in which our Company
was or is to be a participant and the amount involved exceeds $120,000. During
our fiscal year ended December 31, 2008, no executive officer of our Company
served on the board of directors, compensation committee or other board
committee performing equivalent functions of a compensation committee of another
entity that had an executive officer serve on our board of directors or
compensation committee.





Compensation
Committee Report





We, the
Compensation Committee of the Board, have reviewed and discussed the
Compensation Discussion and Analysis contained in this Amendment No. 2 on Form
10-K/A with management.  Based on such review and discussion, we have
recommended to the Board that the Compensation Discussion and Analysis be
included in this Amendment No. 2 on Form 10-K/A for the year ended December 31,
2008.





Compensation
      CommitteeLawrence
      LeightonCarl
      YeungZhiqiang
      Wang





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




The
following table sets forth certain information, as of March 10, 2009 with
respect to the beneficial ownership of the outstanding common stock by (i) any
holder of more than five (5%) percent; (ii) each of our executive officers and
directors; and (iii) our directors and executive officers as a group. Except as
otherwise indicated, each of the stockholders listed below has sole voting and
investment power over the shares beneficially owned.




52




Name
      of Beneficial Owner (1)
                      
                      Number
      of
                        Common
                        Stock
                        Beneficially
                        Owned
                      
                      
                      Percentage
                        Of
      Common
                        Stock
                        Outstanding(2)Executive
      Officers and DirectorsQinan
      Ji
                      
                      
                      5,931,596
                      (3)
                      
                      
                      20.3
                      %All
      officers and directors as a group (1 person)
                      
                      
                      5,931,596
                      (3)
                      
                      
                      20.3
                      %5%
      holdersYangling
      Bodisen Biotech Development co, Ltd.
                        c/o
      New York Global Group, Inc.
                        14
      Wall Street, 12 th
      Floor, New York, NY 10005
                      
                      
                      2,063,768
                      (4)
                      
                      
                      7.1
                      %Xiang
      Ji
                      
                      
                      1,456,232
                      
                      
                      
                      5.0
                      %Robert
      Moses
                      
                      
                      2,000,000
                      (5)
                      
                      
                      6.9
                      %Heartland
      Value Fund
                      
                      
                      1,725,000
                      (6)
                      
                      
                      5.9
                      %Xi’an
      Sunway Technology &Industry
      Co., Ltd
                      
                      
                      2,875,364
                      (3)
                      
                      
                      9.8
                      %Abax
      Lotus Ltd.
                      
                      
                      2,900,000
                      (7)
                      
                      
                      9.0
                      %




(1)
Except as otherwise indicated, the address of each beneficial owner is c/o Xi’an
Xilan Natural Gas Co., Ltd., 19th Floor, Building B, Van Metropolis, Tangyan
Road, Hi-Tech Zone, Xi’an, Shaanxi province, China.




(2)
Applicable percentage ownership is based on 29,200,304 shares of common stock
outstanding as of March 10, 2009, together with securities exercisable or
convertible into shares of common stock within 60 days of March 10, 2009 for
each stockholder. Beneficial ownership is determined in accordance with the
rules of the Securities and Exchange Commission and generally includes voting or
investment power with respect to securities. Shares of common stock that are
currently exercisable or exercisable within 60 days of March 10, 2009 are deemed
to be beneficially owned by the person holding such securities for the purpose
of computing the percentage of ownership of such person, but are not treated as
outstanding for the purpose of computing the percentage ownership of any other
person.





(3) Of
which 2,875,364 shares are owned by Xi’an Sunway Technology & Industry Co.,
Ltd. Qinan Ji owns 42.1% of Xi’an Sunway and may be deemed to beneficially own
such shares. None of the shares have been pledged as security for any loan or
indebtedness.




(4) As
set forth in the Schedule 13D filed with the SEC on December 23,
2005.





(5) As
set forth in the Schedule 13G filed with the SEC on September 7,
2007.





(6)
William J. Nasgovitz has shared voting and dispositive power with respect to
such shares as reported in the Schedule 13G filed with the SEC on February 8,
2008 and as amended on February 11, 2009.





(7) As
set forth in Schedule 13D filed with the SEC on February 6, 2008.




No
Director, executive officer, affiliate or any owner of record or beneficial
owner of more than 5% of any class of voting securities of the Company is a
party adverse to the Company or has a material interest adverse to the
Company.




Securities
Authorized for Issuance under Equity Compensation Plans




The
Company had no equity compensation plans as of the fiscal year ended December
31, 2008.




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




Transactions
with Related Persons





None.





Review,
Approval or Ratification of Transaction with Related Persons





Although
we have not adopted formal procedures for the review, approval or ratification
of transactions with related persons, we adhere to a general policy that such
transactions should only be entered into if they are on terms that, on the
whole, are no more favorable, or no less favorable, than those available from
unaffiliated third parties and their approval is in accordance with applicable
law. Such transactions require the approval of our board of
directors.





Director
Independence





The Board
has determined that all Board members, excluding Qinan Ji and Donald Yang, are
independent under the applicable NASDAQ rules. The Board has also determined the
members of each committee of the Board are independent under the listing
standards of the NASDAQ Global Select Market. In making these determinations,
the Board considered, among other things, the types and amounts of the
commercial dealings between the Company and the companies and organizations with
which the directors are affiliated.




53




ITEM
14. PRINCIPAL ACCOUNTANT FEES AND SERVICES




All the
service agreements related with auditors and lawyers need to be approved and
signed by the Company’s Audit Committee. 100% of those services provided were
approved by the Committee.





The
following table shows the fees paid or accrued for the audit and other services
provided by our independent auditors for 2007 and 2008.





Audit
      fees
                
                2007
                
                
                2008Moore
      Stephens Wurth Frazer and Torbet, LLP*
                
                $
                150,000
                
                
                $
                260,000Kabani
      & Company, Inc.
                
                $
                35,000
                
                
                $
                7,500Audit-related
      fees
                
                $
                9,000Tax
      fees**
                
                
                
                
                
                $
                10,000All
      other fees
                
                
                -Total
      fees paid or accrued to our principal accountants
                
                $
                150,000
                
                
                $
                270,000




54




*The fees
billed for professional services rendered for the audit of the Company’s
internal control over financial reporting, audit of the consolidated annual
financial statements and review of the interim consolidated financial statements
included in quarterly reports and services that are normally provided by our
auditors in connection with statutory and regulatory filings or
engagements.





**The fee
billed for professional services rendered for the preparation of the Company’s
corporate and state tax return.





Our Audit
Committee's policy is to pre-approve all audit and permissible non-audit
services provided by our independent registered public accounting firm. These
services may include audit services, audit-related services, tax services and
other services, Pre-approval is generally provided for up to one year and any
pre-approval is detailed as to the particular service or category of services.
The independent registered public accounting firm and management are required to
periodically report to our Audit Committee regarding the extent of services
provided by the independent registered public accounting firm in accordance with
this pre-approval. None of the services related to Audit-Related Fees, Tax Fees
or All Other Fees described above were approved by our Audit Committee pursuant
to a waiver of pre-approval provisions set forth in applicable rules of the
SEC.





ITEM
15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES





Exhibits:





ExhibitNumber
              
              Description
      of Exhibit2.1
              
              Form
      of Equity Ownership Transfer Agreement (incorporated by reference to same
      exhibit filed with the Company’s Form 8-K filed on December 31,
      2008).3.1
              
              Articles
      of Incorporation (incorporated by reference to same exhibit filed with the
      Company's Form 10SB Registration Statement filed September 15, 2000, SEC
      file no. 000-31539).3.2
              
              Registrant's
      Amended and Restated By-Laws (incorporated by reference to exhibit 3.1
      filed with the Registrant's Form 8K filed June 16, 2006, SEC file no.
      000-31539).10.1
              
              Share
      Purchase Agreement made as of December 6, 2005 among Coventure
      International Inc., Xi’an Xilan Natural Gas Co., Ltd. and each of Xilan's
      shareholders. (incorporated by reference to the exhibits to Registrant’s
      Form 8-K filed on December 9, 2005).10.2
              
              Return
      to Treasury Agreement between Coventure International Inc. and John
      Hromyk, dated December 6, 2005. (incorporated by reference to the exhibits
      to Registrant’s Form 8-K filed on December 9, 2005).10.3
              
              Purchase
      Agreement made as of December 19, 2005 between China Natural Gas, Inc. and
      John Hromyk (incorporated by reference to the exhibits to Registrant’s
      Form 8-K filed on December 23, 2005).10.4
              
              Form
      of Securities Purchase Agreement (incorporated by reference to the
      exhibits to Registrant’s Form 8-K filed on January 12,
    2006).10.5
              
              Form
      of Common Stock Purchase Agreement (incorporated by reference to the
      exhibits to Registrant’s Form 8-K filed on January 12,
    2006).10.6
              
              Form
      of Registration Rights Agreement (incorporated by reference to the
      exhibits to Registrant’s Form 8-K filed on January 12,
    2006).10.7
              
              CNG
      Product Purchase and Sale Agreement between Xi’an Xilan Natural Gas Co.,
      Ltd. and Zhengzhou Zhongyou Hengran Petroleum Gas Co., Ltd. made as of
      July 20, 2006, (translated from the original Mandarin) (incorporated by
      reference to the exhibits to Registrant’s Form 10-KSB filed on April 17,
      2007).10.8
              
              Securities
      Purchase Agreement dated, August 2, 2007, between the Company and the
      Investors named therein (incorporated by reference to the exhibits to
      Registrant’s Form 8-K filed on August 8, 2007).10.9
              
              Registration
      Rights Agreement dated, August 2, 2007, between the Company and the
      Investors named therein (incorporated by reference to the exhibits to
      Registrant’s Form 8-K filed on August 8, 2007).10.10
              
              Consulting
      Services Agreement dated, August 17, 2007, between Shaanxi Xilan Natural
      Gas Equipment Co., Ltd. and Xi’an Xilan Natural Gas Co., Ltd.
      (incorporated by reference to the exhibits to Registrant’s Form 10-QSB
      filed on August 20,
2007).




55




10.11
                  
                  Operating
      Agreement, dated August 17, 2007, between Shaanxi Xilan Natural Gas
      Equipment Co., Ltd. and Xi’an Xilan Natural Gas Co., Ltd. (incorporated by
      reference to the exhibits to Registrant’s Form 10-QSB filed on August 20,
      2007).10.12
                  
                  Equity
      Pledge Agreement, dated August 17, 2007, between Shaanxi Xilan Natural Gas
      Equipment Co., Ltd. and Xi’an Xilan Natural Gas Co., Ltd. (incorporated by
      reference to the exhibits to Registrant’s Form 10-QSB filed on August 20,
      2007).10.13
                  
                  Option
      Agreement dated, August 17, 2007, between Shaanxi Xilan Natural Gas
      Equipment Co., Ltd. and Xi’an Xilan Natural Gas Co., Ltd. (incorporated by
      reference to the exhibits to Registrant’s Form 10-QSB filed on August 20,
      2007).10.14
                  
                  Proxy
      Agreement dated, August 17, 2007, between Shaanxi Xilan Natural Gas
      Equipment Co., Ltd. and Xi’an Xilan Natural Gas Co., Ltd. (incorporated by
      reference to the exhibits to Registrant’s Form 10-QSB filed on August 20,
      2007).10.15
                  
                  Securities
      Purchase Agreement, dated December 30, 2007, between the Company and Abax
      Lotus Ltd. (incorporated by reference to the exhibits to Registrant’s Form
      8-K filed on January 31, 2008).10.16
                  
                  Amendment
      to Securities Purchase Agreement, dated January 29, 2008, between the
      Company and Abax Lotus Ltd. (incorporated by reference to the exhibits to
      Registrant’s Form 8-K filed on January 31, 2008).10.17
                  
                  Indenture,
      dated January 29, 2008, by and among the Company and DB Trustees (Hong
      Kong) Limited, as trustee, relating to the 5.00% Guaranteed Senior Notes
      due 2014 (incorporated by reference to the exhibits to Registrant’s Form
      8-K filed on January 31, 2008).10.18
                  
                  Warrant
      Agreement, dated January 29, 2008, by and among the Company, Mr. Qinan Ji,
      Deutsche Bank AG, Hong Kong Branch as Warrant Agent and Deutsche Bank
      Luxembourg S.A. as Warrant Agent (incorporated by reference to the
      exhibits to Registrant’s Form 8-K filed on January 31,
    2008).10.19
                  
                  Equity
      Registration Rights Agreement, dated January 29, 2008, by and between the
      Company and Abax Lotus Ltd. (incorporated by reference to the exhibits to
      Registrant’s Form 8-K filed on January 31, 2008).10.20
                  
                  Investor
      Rights Agreement, dated January 29, 2008, by and among the Company, its
      subsidiaries, Mr. Qinan Ji, and Abax Lotus Ltd. (incorporated by reference
      to the exhibits to Registrant’s Form 8-K filed on January 31,
      2008).10.21
                  
                  Information
      Rights Agreement, dated January 29, 2008, between the Company and Abax
      Lotus Ltd. (incorporated by reference to the exhibits to Registrant’s Form
      8-K filed on January 31, 2008).10.22
                  
                  Onshore
      Share Pledge Agreement, dated January 29, 2008, between the Company and DB
      Trustees (Hong Kong) Limited, as security agent (incorporated by reference
      to the exhibits to Registrant’s Form 8-K filed on January 31,
      2008).10.23
                  
                  Account
      Pledge and Security Agreement, dated January 29, 2008, by and between the
      Company and DB Trustees (Hong Kong) Limited as Security Agent
      (incorporated by reference to the exhibits to Registrant’s Form 8-K filed
      on January 31, 2008).10.24*
                  
                  Natural
      Gas Purchase Agreement entered by and between Xi' An Xilan Natural Gas
      Co., Ltd. and China Petroleum Co., Ltd., Changqing Branch, dated July 30,
      2006.10.25*
                  
                  Natural
      Gas Purchase Agreement entered by and between Ji Nan Yuhai Natural Gas
      Co., Ltd. and Xi' An Xilan Natural Gas Co., Ltd. dated, February 28,
      2008.10.26*
                  
                  Natural
      Gas Supply Agreement between Jincheng Ming Shi Natural Gas Co., Ltd.,
      Jinan Branch, and Xi' An Xilan Natural Gas Co., Ltd. dated, March 20,
      200810.27*
                  
                  Natural
      Gas Purchase Agreement entered by and between Shaanxi Natural Gas Co.,
      Ltd. and Xi' An Xilan Natural Gas Co., Ltd., dated July 17,
      2008.10.28*
                  
                  Independent
      Director Agreement, dated January 1, 2008, by and between China Natural
      Gas., Inc. and Zhiqiang Wang.10.29*
                  
                  Independent
      Director Agreement, dated July 1, 2008, by and between China Natural Gas.,
      Inc. and Carl
Yeung.




56




10.30*
                          
                          Independent
      Director Agreement, dated August 5, 2008, by and between China Natural
      Gas., Inc. and Lawrence W. Leighton.10.31*
                          
                          Employment
      Agreement, dated October 10, 2008, by and between China Natural Gas., Inc.
      and Richard Peidong Wu.10.32*
                          
                          Employment
      Agreement, dated May 10, 2005, by and between China Natural Gas., Inc. and
      Qinan Ji.10.33
                          
                          Equity
      Ownership Transfer Agreement, dated October 2, 2008, by and between Xi'an
      Xilan Natural Gas Co., Ltd., Zhihe Zhang and Lingjun Hu (incorporated by
      reference to the Registrant’s Form 8-K filed on December 31,
      2008).14.1
                          
                          Code
      of Ethics adopted by the Company on June 14, 2006 (incorporated by
      reference to the exhibits to Registrant’s Form 8-K filed on June 16,
      2006).21.1
                          
                          List
      of Subsidiaries. (incorporated by reference to the exhibits to
      Registrant’s Form 10-KSB filed on April 17, 2007).23.1
                          
                          Written
      consent of Moore Stephens Wurth Frazer and Torbet, LLP (incorporated by
      reference to the exhibits to Registrant’s Form S-3/A filed on July 2,
      2009).23.2
                          
                          Written
      consent of Kabani & Company, Inc. (incorporated by reference to the
      exhibits to Registrant’s Form S-3/A filed on July 2,
      2009).31.1*
                          
                          Certification
      of Principal Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a),
      promulgated under the Securities and Exchange Act of 1934, as
      amended31.2*
                          
                          Certification
      of Principal Financial Officer pursuant to Rule 13a-14 and Rule 15d 14(a),
      promulgated under the Securities and Exchange Act of 1934, as
      amended32.1*
                          
                          Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Executive
Officer)32.2*
                          
                          Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Financial
Officer)*
      Filed
herewith





57




SIGNATURES




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




Date:
July 20, 2009




CHINA
      NATURAL GAS, INC./s/
      Qinan Ji
                
                /s/
      Veronica ChenName: 
      Qinan Ji
                
                Name: 
      Veronica ChenTitle:   
      Chief Executive Officer
                  (Principal
      Executive Officer)
                
                Title:   
      Chief Financial Officer
                  (Principal
      Financial and Accounting Officer)




Pursuant
to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf of the
registrant and in the capacities and on the dates indicated.





/s/
      Qinan Ji
                        
                        President
      and Chief
                          Executive
      Officer and
                          Director
      (Principal Executive Officer)
                        
                        July
      20, 2009Qinan
      Ji/s/
      Zhiqiang Wang
                        
                        Director
                        
                        July
      20, 2009Zhiqiang
      Wang/s/
      Donald Yang
                        
                        Director
                        
                        July
      20, 2009Donald
      Yang/s/
      Veronica Chen
                        
                        Chief
      Financial Officer
                          (Principal
      Financial and Accounting Officer)
                        
                        July
      20, 2009Veronica
      Chen/s/
      Carl Yeung
                        
                        Director
                        
                        July
      20, 2009Carl
      Yeung/s/
      Lawrence Leighton
                        
                        Director
                        
                        July
      20, 2009Lawrence
      Leighton


58





CHINA
NATURAL GAS, INC.


AND
SUBSIDIARIES





CONSOLIDATED
FINANCIAL STATEMENTS


AS
OF DECEMBER 31, 2008 AND 2007





CONTENTS





PagesReports
      of Independent Registered Public Accounting Firms
                  
                  F-2Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                  
                  F-3Consolidated
      Statements of Income and Other Comprehensive income for the years ended
      December 31, 2008 and 2007
                  
                  F-4Consolidated
      Statements of Stockholders’ Equity
                  
                  F-5Consolidated
      Statements of Cash Flows for the years ended December 31, 2008 and
      2007
                  
                  F-6Notes
      to Consolidated Financial Statements
                  
                  F-7


F-1





REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Stockholders of


China
Natural Gas, Inc.




We have
audited the accompanying consolidated balance sheets of China Natural Gas, Inc.
and subsidiaries as of December 31, 2008 and 2007, and the related consolidated
statements of income and other comprehensive income, stockholders’ equity, and
cash flows for each of the years in the two-year period ended December 31, 2008.
China Natural Gas, Inc’s management is responsible for these consolidated
financial statements. 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 China Natural Gas, Inc. and
Subsidiaries as of December 31, 2008 and 2007, and the results of its operations
and its cash flows for each of the years in the two-year period ended December
31, 2008 in conformity with accounting principles generally accepted in the
United States of America.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), China Natural Gas, Inc. and subsidiaries’
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 (COSO), and our report dated March 13, 2009 expressed an
adverse opinion.




/s/ Moore
Stephens Wurth Frazer and Torbet, LLP




Walnut,
California


March 13,
2009


F-2





CHINA
NATURAL GAS, INC. AND SUBSIDIARIES





CONSOLIDATED
BALANCE SHEETS


AS
OF DECEMBER 31, 2008 and 2007





2008
                                          
                                          
                                          2007ASSETSCURRENT
      ASSETS:Cash
      & cash equivalents
                                          
                                          $
                                          5,854,383
                                          
                                          
                                          $
                                          13,291,729Short-term
      investments
                                          
                                          
                                          -
                                          
                                          
                                          
                                          238,554Accounts
      receivable
                                          
                                          
                                          906,042
                                          
                                          
                                          
                                          306,179Other
      receivable
                                          
                                          
                                          60,784
                                          
                                          
                                          
                                          292,320Other
      receivable - employee advances
                                          
                                          
                                          332,263
                                          
                                          
                                          
                                          257,500Inventories
                                          
                                          
                                          519,739
                                          
                                          
                                          
                                          231,339Advances
      to suppliers
                                          
                                          
                                          837,592
                                          
                                          
                                          
                                          663,041Prepaid
      expense and other current assets
                                          
                                          
                                          777,510
                                          
                                          
                                          
                                          109,722Loan
      receivable
                                          
                                          
                                          293,400
                                          
                                          
                                          
                                          274,200Total
      current assets
                                          
                                          
                                          9,581,713
                                          
                                          
                                          
                                          15,664,584PROPERTY
      AND EQUIPMENT, net
                                          
                                          
                                          76,028,272
                                          
                                          
                                          
                                          32,291,995CONSTRUCTION
      IN PROGRESS
                                          
                                          
                                          22,061,414
                                          
                                          
                                          
                                          2,210,367DEFERRED
      FINANCING COSTS
                                          
                                          
                                          1,746,830
                                          
                                          
                                          
                                          -OTHER
      ASSETS
                                          
                                          
                                          8,844,062
                                          
                                          
                                          
                                          3,123,052TOTAL
      ASSETS
                                          
                                          $
                                          118,262,291
                                          
                                          
                                          $
                                          53,289,998LIABILITIES AND STOCKHOLDERS'
      EQUITYCURRENT
      LIABILITIES:Accounts
      payable and accrued liabilities
                                          
                                          $
                                          800,013
                                          
                                          
                                          $
                                          487,710Other
      payables
                                          
                                          
                                          124,151
                                          
                                          
                                          
                                          55,979Unearned
      revenue
                                          
                                          
                                          944,402
                                          
                                          
                                          
                                          327,220Accrued
      interest
                                          
                                          
                                          861,114
                                          
                                          
                                          
                                          -Taxes
      payable
                                          
                                          
                                          1,862,585
                                          
                                          
                                          
                                          1,211,775Total
      current liabilities
                                          
                                          
                                          4,592,265
                                          
                                          
                                          
                                          2,082,684LONG
      TERM LIABILITIES:Notes
      payable, net of $15,478,395 discount
                                          
                                          
                                          24,521,605
                                          
                                          
                                          
                                          -Derivative
      liabilities - warrants
                                          
                                          
                                          17,500,000
                                          
                                          
                                          
                                          -Total
      long term liabilities
                                          
                                          
                                          42,021,605
                                          
                                          
                                          
                                          -COMMITMENTS
      AND CONTINGENCIES
                                          
                                          
                                          
                                          
                                          
                                          
                                          -STOCKHOLDERS'
      EQUITY:Preferred
      stock, $0.0001 per share; 5,000,000 shares authorized; none
      issued
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Common
      stock, $0.0001 per share; 45,000,000 shares authorized, 29,200,304
      shares  issued and outstanding at December 31, 2008 and
      2007
                                          
                                          
                                          2,920
                                          
                                          
                                          
                                          2,920Additional
      paid-in capital
                                          
                                          
                                          32,113,583
                                          
                                          
                                          
                                          32,046,879Cumulative
      translation adjustment
                                          
                                          
                                          8,661,060
                                          
                                          
                                          
                                          3,477,025Statutory
      reserves
                                          
                                          
                                          3,730,083
                                          
                                          
                                          
                                          1,802,735Retained
      earnings
                                          
                                          
                                          27,140,775
                                          
                                          
                                          
                                          13,877,755Total
      stockholders' equity
                                          
                                          
                                          71,648,421
                                          
                                          
                                          
                                          51,207,314TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                                          
                                          $
                                          118,262,291
                                          
                                          
                                          $
                                          53,289,998





The
accompanying notes are an integral part of these statements.


See
report of independent registered public accounting firm.


F-3




CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





Years Ended December 31,2008
                                            
                                            
                                            2007RevenueNatural
      gas revenue
                                            
                                            $
                                            55,746,893
                                            
                                            
                                            $
                                            28,278,033Gasoline
      revenue
                                            
                                            
                                            4,616,052
                                            
                                            
                                            
                                            38,486Installation
      and other
                                            
                                            
                                            7,357,714
                                            
                                            
                                            
                                            7,075,534Total
      revenue
                                            
                                            
                                            67,720,659
                                            
                                            
                                            
                                            35,392,053Cost
      of revenueNatural
      gas cost
                                            
                                            
                                            27,234,508
                                            
                                            
                                            
                                            14,838,997Gasoline
      cost
                                            
                                            
                                            4,277,458
                                            
                                            
                                            
                                            34,747Installation
      and other
                                            
                                            
                                            3,469,671
                                            
                                            
                                            
                                            3,151,331Total cost of
      revenue
                                            
                                            
                                            34,981,637
                                            
                                            
                                            
                                            18,025,075Gross
      profit
                                            
                                            
                                            32,739,022
                                            
                                            
                                            
                                            17,366,978Operating
      expensesSelling
      expenses
                                            
                                            
                                            7,651,948
                                            
                                            
                                            
                                            3,451,161General
      and administrative expenses
                                            
                                            
                                            4,024,882
                                            
                                            
                                            
                                            2,837,768Total operating
      expenses
                                            
                                            
                                            11,676,830
                                            
                                            
                                            
                                            6,288,929Income
      from operations
                                            
                                            
                                            21,062,192
                                            
                                            
                                            
                                            11,078,049Non-operating
      income (expense):Interest
      income
                                            
                                            
                                            209,502
                                            
                                            
                                            
                                            70,697Interest
      expense
                                            
                                            
                                            (2,228,244
                                            )
                                            
                                            
                                            -Other
      income, net
                                            
                                            
                                            111,859
                                            
                                            
                                            
                                            31,976Foreign
      currency exchange loss
                                            
                                            
                                            (397,299
                                            )
                                            
                                            
                                            (150,729
                                            )Total non-operating
      expense
                                            
                                            
                                            (2,304,182
                                            )
                                            
                                            
                                            (48,056
                                            )Income
      before income tax
                                            
                                            
                                            18,758,010
                                            
                                            
                                            
                                            11,029,993Provision
      for income tax
                                            
                                            
                                            3,567,642
                                            
                                            
                                            
                                            1,913,923Net
      income
                                            
                                            
                                            15,190,368
                                            
                                            
                                            
                                            9,116,070Other
      comprehensive incomeForeign
      currency translation gain
                                            
                                            
                                            5,184,035
                                            
                                            
                                            
                                            2,637,573Comprehensive
      income
                                            
                                            $
                                            20,374,403
                                            
                                            
                                            $
                                            11,753,643Weighted
      average shares outstandingBasic
                                            
                                            
                                            29,200,304
                                            
                                            
                                            
                                            26,200,679Diluted
                                            
                                            
                                            29,290,139
                                            
                                            
                                            
                                            26,301,802Earnings
      per shareBasic
                                            
                                            $
                                            0.52
                                            
                                            
                                            $
                                            0.35Diluted
                                            
                                            $
                                            0.52
                                            
                                            
                                            $
                                            0.35





The
accompanying notes are an integral part of these statements.


See
report of independent registered public accounting firm.


F-4




CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY





Accumulative
                                                
                                                Retained Earnings
                                                
                                                
                                                TotalCommon Stock
                                                
                                                
                                                Additional
                                                
                                                
                                                Other Comprehensive
                                                
                                                Statutory
                                                
                                                
                                                
                                                
                                                
                                                Stockholders'Shares
                                                
                                                
                                                Amount
                                                
                                                
                                                Paid-in Capital
                                                
                                                
                                                Gain
                                                
                                                Reserve
                                                
                                                
                                                Unrestricted
                                                
                                                
                                                EquityBalance
      January 01, 2007
                                                
                                                
                                                24,210,183
                                                
                                                
                                                $
                                                2,421
                                                
                                                
                                                $
                                                18,223,911
                                                
                                                $
                                                839,452
                                                
                                                $
                                                750,886
                                                
                                                
                                                $
                                                5,813,534
                                                
                                                
                                                $
                                                25,630,204Shares
      issued for cash, at $3.25
                                                
                                                
                                                4,615,385
                                                
                                                
                                                
                                                462
                                                
                                                
                                                
                                                14,999,538
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                15,000,000Offering
      costs
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (1,176,533
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (1,176,533
                                                )Cashless
      exercise of warrants
                                                
                                                
                                                374,736
                                                
                                                
                                                
                                                37
                                                
                                                
                                                
                                                (37
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                -Cumulative
      translation adjustment
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                2,637,573
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                2,637,573Net
      Income
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                9,116,070
                                                
                                                
                                                
                                                9,116,070Transfer
      to statutory reserve
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                1,051,849
                                                
                                                
                                                
                                                (1,051,849
                                                )
                                                
                                                
                                                -Balance
      December 31, 2007
                                                
                                                
                                                29,200,304
                                                
                                                
                                                $
                                                2,920
                                                
                                                
                                                $
                                                32,046,879
                                                
                                                $
                                                3,477,025
                                                
                                                $
                                                1,802,735
                                                
                                                
                                                $
                                                13,877,755
                                                
                                                
                                                $
                                                51,207,314Options
      issued for services
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                66,704
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                66,704Cumulative
      translation adjustment
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                5,184,035
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                5,184,035Net
      Income
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                15,190,368
                                                
                                                
                                                
                                                15,190,368Transfer
      to statutory reserve
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                1,927,348
                                                
                                                
                                                
                                                (1,927,348
                                                )
                                                
                                                
                                                -Balance
      December 31, 2008
                                                
                                                
                                                29,200,304
                                                
                                                
                                                $
                                                2,920
                                                
                                                
                                                $
                                                32,113,583
                                                
                                                $
                                                8,661,060
                                                
                                                $
                                                3,730,083
                                                
                                                
                                                $
                                                27,140,775
                                                
                                                
                                                $
                                                71,648,421





The
accompanying notes are an integral part of these statements.


See
report of independent registered public accounting firm.


F-5




CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 31, 2008 AND 2007





Year Ended December 31,2008
                                  
                                  
                                  2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                                  
                                  $
                                  15,190,368
                                  
                                  
                                  $
                                  9,116,070Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                  
                                  
                                  3,474,905
                                  
                                  
                                  
                                  1,639,685Loss
      on disposal of building improvements and equipment
                                  
                                  
                                  24,806
                                  
                                  
                                  
                                  -Amortization
      of discount on senior notes
                                  
                                  
                                  1,004,677
                                  
                                  
                                  
                                  -Amortization
      of financing costs
                                  
                                  
                                  227,989
                                  
                                  
                                  
                                  -Stock
      based compensation
                                  
                                  
                                  66,704
                                  
                                  
                                  
                                  -Change
      in assets and liabilities:Accounts
      receivable
                                  
                                  
                                  (568,370
                                  )
                                  
                                  
                                  290,660Other
      receivable
                                  
                                  
                                  247,349
                                  
                                  
                                  
                                  36,929Other
      receivable - employee advances
                                  
                                  
                                  (55,747
                                  )
                                  
                                  
                                  -Inventories
                                  
                                  
                                  (267,470
                                  )
                                  
                                  
                                  71,226Advances
      to suppliers
                                  
                                  
                                  (125,896
                                  )
                                  
                                  
                                  245,514Prepaid
      expense and other current assets
                                  
                                  
                                  (642,857
                                  )
                                  
                                  
                                  (11,113
                                  )Accounts
      payable and accrued liabilities
                                  
                                  
                                  275,929
                                  
                                  
                                  
                                  28,531Other
      payables
                                  
                                  
                                  63,239
                                  
                                  
                                  
                                  (208,669
                                  )Unearned
      revenue
                                  
                                  
                                  583,940
                                  
                                  
                                  
                                  22,425Accrued
      interest
                                  
                                  
                                  861,114
                                  
                                  
                                  
                                  -Taxes
      payable
                                  
                                  
                                  556,121
                                  
                                  
                                  
                                  (754,817
                                  )Net
      cash provided by operating activities
                                  
                                  
                                  20,916,801
                                  
                                  
                                  
                                  10,476,441CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
                                  
                                  
                                  (43,225,673
                                  )
                                  
                                  
                                  (14,180,053
                                  )Proceeds
      from sales of equipment
                                  
                                  
                                  194,891
                                  
                                  
                                  
                                  -Proceeds
      from (purchases of) short term investments
                                  
                                  
                                  250,821
                                  
                                  
                                  
                                  (229,106
                                  )Additions
      to construction in progress
                                  
                                  
                                  (19,012,750
                                  )
                                  
                                  
                                  (519,309
                                  )Prepayment
      on long term assets
                                  
                                  
                                  (5,729,833
                                  )
                                  
                                  
                                  (1,914,343
                                  )Payment
      for intangible assets
                                  
                                  
                                  (53,826
                                  )
                                  
                                  
                                  -Payment
      for land use rights
                                  
                                  
                                  (30,354
                                  )
                                  
                                  
                                  (42,529
                                  )Net
      cash used in investing activities
                                  
                                  
                                  (67,606,724
                                  )
                                  
                                  
                                  (16,885,340
                                  )CASH
      FLOWS FROM FINANCING ACTIVITIES:Stock
      issued for cash
                                  
                                  
                                  -
                                  
                                  
                                  
                                  15,000,000Proceeds
      from senior notes
                                  
                                  
                                  40,000,000
                                  
                                  
                                  
                                  -Payment
      for offering costs
                                  
                                  
                                  (2,122,509
                                  )
                                  
                                  
                                  (1,176,533
                                  )Net
      cash provided by financing activities
                                  
                                  
                                  37,877,491
                                  
                                  
                                  
                                  13,823,467Effect
      of exchange rate changes on cash and cash equivalents
                                  
                                  
                                  1,375,086
                                  
                                  
                                  
                                  582,948NET
      (DECREASE) INCREASE IN CASH & CASH EQUIVALENTS
                                  
                                  
                                  (7,437,346
                                  )
                                  
                                  
                                  7,997,516CASH
      & CASH EQUIVALENTS, BEGINNING OF YEAR
                                  
                                  
                                  13,291,729
                                  
                                  
                                  
                                  5,294,213CASH
      & CASH EQUIVALENTS, END OF YEAR
                                  
                                  $
                                  5,854,383
                                  
                                  
                                  $
                                  13,291,729SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Interest
      paid, net of capitalized interest
                                  
                                  $
                                  902,777
                                  
                                  
                                  $
                                  -Income
      taxes paid
                                  
                                  $
                                  2,998,627
                                  
                                  
                                  $
                                  2,387,487Non-cash
      transactions for investing and financing activities:Construction
      in progress transferred to property and equipment
                                  
                                  $
                                  823,464
                                  
                                  
                                  $
                                  -Prepayment
      on long term assets transferred to property and
    equipment
                                  
                                  $
                                  405,630
                                  
                                  
                                  $
                                  -




The
accompanying notes are an integral part of these statements.


See
report of independent registered public accounting firm.


F-6




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Note
1 - Organization





Organization and Line of
Business





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





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





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





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





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





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





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





See
report of independent registered public accounting firm.


F-7




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Note
2 – Summary of Significant Accounting Policies





Principles of
Consolidation





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





Consolidation of Variable
Interest Entity





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





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




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





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





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





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





On August
8, 2008, the Company through XNGE entered into an Addendum to Option Agreement
with Mr. Qinan Ji, chairman and shareholder of XXNGC, and each of the
shareholders of XXNGC (hereafter collectively referred to as the “Transferor”),
and made retroactive to June 30, 2008.  According to the agreement,
the Chairman and the Shareholders of XXNGC irrevocably grants to XNGE an option
to purchase each Transferors’ Purchased Equity Interest at $1.00 or the lowest
price permissible under the applicable laws at the time that XNGE exercise the
Option.  The Agreement limits the XXNGC and the transferors’ right to
make all equity interest related decisions.





Basis of
Presentation





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





See
report of independent registered public accounting firm.


F-8





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Foreign Currency
Translation





As of
December 31, 2008 and December 31, 2007, the accounts of the Company were
maintained, and their consolidated financial statements were expressed in
RMB.  Such consolidated financial statements were translated into USD
in accordance with Statement of Financial Accounts Standards ("SFAS") 52,
"Foreign Currency Translation," with the RMB as the functional currency.
According to SFAS 52, all assets and liabilities were translated at the exchange
rate as of the balance sheet date, stockholder's equity are translated at the
historical rates and statement of income and cash flow items are translated at
the weighted average exchange rate for the year. The resulting translation
adjustments are reported under other comprehensive income in accordance with
SFAS 130, "Reporting Comprehensive Income."  In accordance with SFAS
95, "Statement of Cash Flows," cash flows from the Company's operations is
calculated based upon the local currencies and translated to USD at average
translation rates for the period. As a result, translation adjustments amounts
related to assets and liabilities reported on the statement of cash flows will
not necessarily agree with changes in the corresponding balances on the balance
sheet.





The
balance sheet amounts with the exception of equity at December 31, 2008 were
translated 6.82 RMB to $1.00 as compared to 7.29 RMB at December 31, 2007. The
equity accounts were stated at their historical rate. The average translation
rates applied to income and cash flow statement amounts for the year ended
December 31, 2008 and 2007 were 6.94 RMB and 7.59 RMB to $1.00, respectively.
 Translation adjustments resulting from this process in the amount of
$8,661,060 and $3,477,025 as of December 31, 2008 and 2007, respectively are
classified as an item of other comprehensive income in the stockholders’ equity
section of the consolidated balance sheets. For the year ended December 31, 2008
and 2007, other comprehensive income in the consolidated statements of income
and other comprehensive income included translation gains of $5,184,035 and
$2,637,573, respectively.





Use of
Estimates





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





Cash and Cash
Equivalents





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





Certain
financial instruments, which subject the Company to concentration of credit
risk, consist of cash. The Company maintains balances at financial institutions
which, from time to time, may exceed Federal Deposit Insurance Corporation
insured limits for the banks located in the United States. Balances at financial
institutions or state-owned banks within the PRC are not covered by insurance.
As of December 31, 2008 and 2007, the Company had total deposits of $5,604,383
and $13,053,994, without insurance coverage.  And as of December 31,
2008 and 2007, the Company has deposits in United States of $1,273,639 and
$126,170 in excess of federally insured limits, respectively. The Company has
not experienced any losses in such accounts and believes it is not exposed to
any significant risks on its cash in bank accounts.





See
report of independent registered public accounting firm.




F-9





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Short Term
Investments





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





Accounts
Receivable





Accounts
and other receivable are netted against an allowance for uncollectible accounts,
as needed.  The Company maintains reserves for potential credit losses
on accounts receivable.  Management reviews the composition of
accounts receivable and analyzes historical bad debts, customer concentrations,
customer credit worthiness, current economic trends and changes in customer
payment patterns to evaluate the adequacy of these reserves. Reserves are
recorded primarily on a specific identification basis in the period of the
related sales. Delinquent account balances are written-off after management has
determined that the likelihood of collection is not probable, known bad debts
are written off against allowance for doubtful accounts when identified. The
Company’s management has determined that all receivables are collectible and
there is no need for an allowance for uncollectible accounts as of December 31,
2008 and 2007.





Other Receivable – Employee
Advances





From time
to time, the Company advances predetermined amounts based upon internal Company
policy to certain employees and internal units to ensure certain transactions
are performed in a timely manner. The Company has full oversight and control
over the advanced accounts. As of December 31, 2008 and 2007, no allowance for
the uncollectible accounts was deemed necessary.





Inventory





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





The
following are the details of the inventories:





December
                        31,
      2008
                      
                      
                      December
                        31,
      2007Materials
      and supplies
                      
                      $
                      318,069
                      
                      
                      $
                      109,333Natural
      gas and gasoline
                      
                      
                      201,670
                      
                      
                      
                      122,006$
                      519,739
                      
                      
                      $
                      231,339





Advances to
Suppliers





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





Loan
Receivable





Loan
receivable consists of the following:


December
      31,
                    2008
                  
                  
                  December
      31,
                    2007Shanxi
      Yuojin Mining Company, due on November 26, 2008, extended to November 30,
      2009, annual interest at 6.57%
                  
                  $
                  293,400
                  
                  
                  $
                  274,200





See
report of independent registered public accounting firm.




F-10




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008




Property and
Equipment





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





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





The
following are the details of the property and equipment:





December
      31,
                          2008
                        
                        
                        December
      31,
                          2007Office
      equipment
                        
                        $
                        412,490
                        
                        
                        $
                        163,432Operating
      equipment
                        
                        
                        59,473,283
                        
                        
                        
                        22,413,270Vehicles
                        
                        
                        2,414,756
                        
                        
                        
                        1,484,892Buildings
      and improvements
                        
                        
                        21,190,599
                        
                        
                        
                        11,943,006Total
      property and equipment
                        
                        
                        83,491,128
                        
                        
                        
                        36,004,600Less
      accumulated depreciation
                        
                        
                        (7,462,856
                        )
                        
                        
                        (3,712,605
                        )Property
      and equipment, net
                        
                        $
                        76,028,272
                        
                        
                        $
                        32,291,995





Depreciation
expense for the years ended December 31, 2008 and 2007 was
$3,473,429  and $1,639,685, respectively.





Construction in
Progress





Construction
in progress consists of the cost of constructing property and equipment for the
Company’s gas stations and new project of processing, distribution and sale of
LNG. The major cost of construction in progress relates to technology licensing
fees, equipment purchase, land use rights requisition cost and other
construction fees.  The facility construction work is expected to be
completed around June 2009, and processing equipment installation and testing
will be finished by October 2009. As of December 31, 2008 and 2007, the company
had construction in progress in the amount of $22,061,414 and 2,210,367,
respectively.





Interest
cost capitalized into construction in progress for the years ended December 31,
2008 and 2007 amounted to $1,932,931 and $0, respectively.





Long-Lived
Assets





The
Company applies the provision of SFAS 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" to all long lived assets. SFAS 144 addresses
accounting and reporting for impairment and disposal of long-lived assets. The
Company periodically evaluates the carrying value of long-lived assets to be
held and used in accordance with SFAS 144.  SFAS 144 requires
impairment losses to be recorded on long-lived assets used in operations when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets' carrying
amounts.  In that event, a loss is recognized based on the amount by
which the carrying amount exceeds the fair market value of the long-lived
assets.  Loss on long-lived assets to be disposed of is determined in
a similar manner, except that fair market values are reduced for the cost of
disposal.  Based on its review, the Company believes that, as of
December 31, 2008, there were no significant impairments of its long-lived
assets.





See
report of independent registered public accounting firm.




F-11





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Fair Value of Financial
Instruments





On
January 1, 2008, the Company adopted SFAS 157, Fair Value Measurements. SFAS 157
defines fair value as the price that would be received to sell an asset or paid
to transfer a liability (i.e., the “exit price”) in an orderly transaction
between market participants at the measurement date.  SFAS 157
establishes a three-level valuation hierarchy for disclosure of fair value
measurement and enhances disclosures requirements for fair value measures. The
carrying amounts reported in the balance sheets for receivables and current
liabilities each qualify as financial instruments and are a reasonable estimate
of fair value because of the short period of time between the origination of
such instruments and their expected realization and their current market rate of
interest.  The three levels are defined as follow:





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





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





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





The
Company analyzes all financial instruments with features of both liabilities and
equity under SFAS 150, “Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity,” SFAS 133, “Accounting for
Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock.”





As
required by SFAS 57, financial assets and liabilities are classified in their
entirety based on the lowest level of input that is significant to the fair
value measurement. Depending on the product and the terms of the transaction,
the fair value of our notes payable and derivative libilities were modeled using
a series of techniques, including closed-form analytic formula, such as the
Black-Scholes option-pricing model, which does not entail material subjectivity
because the methodology employed does not necessitate significant judgment, and
the pricing inputs are observed from actively quoted markets.





The
following table sets forth by level within the fair value hierarchy our
financial assets and liabilities that were accounted for at fair value on a
recurring basis as of December 31, 2008.





Carrying
      Value
                          at
                        
                        
                        Fair
      Value Measurement at December
                          31,
      2008December
      31,
                          2008
                        
                        
                        Level
      1
                        
                        
                        Level
      2
                        
                        
                        Level
      3Senior
      notes
                        
                        $
                        24,521,605
                        
                        
                        
                        -
                        
                        
                        $
                        40,047,843
                        
                        
                        
                        -Derivative
      liability - warrants
                        
                        
                        17,500,000
                        
                        
                        
                        -
                        
                        
                        
                        5,282,256
                        
                        
                        
                        -Total
      liability measured at fair value
                        
                        $
                        42,021,605
                        
                        
                        
                        -
                        
                        
                        $
                        45,330,099
                        
                        
                        
                        -





The
Company did not identify any other non-recurring assets and liabilities that are
required to be presented on the balance sheet at fair value in accordance with
SFAS 157.




See
report of independent registered public accounting firm.




F-12




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Revenue
Recognition





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




Enterprise Wide
Disclosure




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





Unearned
Revenue





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





Advertising
Costs





The
Company expenses the cost of advertising as incurred or, as appropriate, the
first time the advertising takes place. Advertising costs for the years ended
December 31, 2008 and 2007 were insignificant.





Stock-Based
Compensation





The
Company records and reports stock-based compensation pursuant to SFAS 123R
“Accounting for Stock-Based Compensation”, which defines a fair-value-based
method of accounting for stock-based employee compensation and transactions in
which an entity issues its equity instruments to acquire goods and services
from non-employees. Stock compensation for stock granted to non-employees has
been determined in accordance with SFAS 123R and the EITF 96-18,
"Accounting for Equity Instruments that are issued to Other than Employees
for Acquiring, or in Conjunction with Selling Goods or Services", as the fair
value of the consideration received or the fair value of equity instruments
issued, whichever is more reliably measured.




Income
Taxes





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





See
report of independent registered public accounting firm.




F-13





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Local PRC Income
Tax





The
Company’s subsidiary and VIE’s operate in China. Starting January 1, 2008,
pursuant to the tax laws of China, general enterprises are subject to income tax
at an effective rate of 25% compared to 33% prior to 2008. The Company’s VIE,
XXNGC, is in the natural gas industry whose development is encouraged by the
government. According to the income tax regulation, any company engaged in the
natural gas industry enjoys a favorable tax rate. Accordingly, except for income
from XNGE, SJLNG, XXABC, HXNGC and LBNGC which subjects to 25% PRC income tax
rate, XXNGC’s income is subject to a reduced tax rate of 15%.  A
reconciliation of tax at the United States federal statutory rate to the
provision for income tax recorded in the financial statements is as
follows:





For
      the years endedDecember
      31,2008
                      
                      
                      2007Tax
      provision (credit) at statutory rate
                      
                      
                      34
                      %
                      
                      
                      34
                      %Foreign
      tax rate difference
                      
                      
                      (9
                      )%
                      
                      
                      (1
                      )%Effect
      of favorable tax rate
                      
                      
                      (6
                      )%
                      
                      
                      (15
                      )%Effective
      rate of income tax
                      
                      
                      19
                      %
                      
                      
                      18
                      %





The
estimated tax savings for the years ended December 31, 2008 and 2007 amounted to
approximately $2,195,871 and $2,174,806, respectively. The net effect on
earnings per share had the income tax been applied would decrease basic earnings
per share for the years ended December 31, 2008 and 2007 from $0.52 to $0.43 and
$0.35 to $0.26, respectively.





China
Natural Gas, Inc. was incorporated in the United States and incurred a net
operating loss for income tax purposes for 2008 and 2007. The net operating loss
carry forwards for United States income tax purposes amounted to $2,429,266 and
$948,865 for the years ended December 31, 2008 and 2007, respectively, which may
be available to reduce future years' taxable income. These carry forwards will
expire, if not utilized, beginning in 2027 through 2028. Management believes
that the realization of the benefits arising from this loss appear to be
uncertain due to Company's limited operating history and continuing losses for
United States income tax purposes. Accordingly, the Company has provided a 100%
valuation allowance at December 31, 2008. Management reviews this valuation
allowance periodically and makes adjustments as warranted The valuation
allowance for the years ended December 31, 2008 and 2007 were as
follow:.





Valuation
      allowance
                    
                    For
      the year ended December 31,2008
                    
                    
                    2007Balance
      of January 01,
                    
                    $
                    322,614
                    
                    
                    $
                    -Increase
                    
                    
                    825,951
                    
                    
                    
                    322,614Balance
      as of December 31,
                    
                    $
                    1,148,565
                    
                    
                    $
                    322,614





See
report of independent registered public accounting firm.




F-14




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Value added
tax





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





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





Basic and Diluted Earning
Per Share




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





Reclassifications





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





Recent
Pronouncements




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





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





See
report of independent registered public accounting firm.




F-15





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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





In
February 2008, the FASB issued FASB Staff Position (FSP) FAS 140-3,
“Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions.” FSP FAS 140-3 requires an initial transfer of a financial asset
and a repurchase financing that was entered into contemporaneously or in
contemplation of the initial transfer to be evaluated as a linked transaction
under SFAS No. 140 unless certain criteria are met, including that the
transferred asset must be readily obtainable in the marketplace. FSP
FAS 140-3 is effective for fiscal years beginning after
November 15, 2008, and is applicable to new transactions entered into
after the date of adoption. Early adoption is prohibited. The Company does not
expect adoption of FSP FAS 140-3 to have a material effect on its financial
condition and cash flows.  Adoption of FSP FAS 140-3 will have no
effect on the Company’s results of operations.





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





In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles". SFAS 162 is intended to improve financial reporting by identifying
a consistent framework, or hierarchy, for selecting accounting principles to be
used in preparing financial statements that are presented in conformity with
GAAP for nongovernmental entities. SFAS 162 is effective 60 days following the
SEC's approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, "The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles." The Company is in the process of evaluating the
impact of adoption of this statement on the results of operations, financial
position or cash flows.





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





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





See
report of independent registered public accounting firm.




F-16





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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





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





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





Note
3 – Other Assets





Other
assets at December 31, 2008 and 2007 consisted of the following,





December
      31,
                    
                    
                    December
      31,2008
                    
                    
                    2007Prepaid
      rent – natural gas stations
                    
                    $
                    272,635
                    
                    
                    $
                    225,924Prepayment
      for acquiring land use right
                    
                    
                    1,060,675
                    
                    
                    
                    993,975Advances
      on purchasing equipment and construction in progress
                    
                    
                    6,427,974
                    
                    
                    
                    1,501,443Refundable
      security deposits
                    
                    
                    981,083
                    
                    
                    
                    356,460Others
                    
                    
                    101,695
                    
                    
                    
                    45,250Total
                    
                    $
                    8,844,062
                    
                    
                    $
                    3,123,052





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





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





See
report of independent registered public accounting firm.




F-17





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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





Note
4 – Senior Notes Payable





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





At the
closing, the Company entered into:





·
            An
      indenture for the 5.00% Guaranteed Senior Notes due
  2014;·
            An
      investor rights agreement;·
            A
      registration rights agreement covering the shares of common stock issuable
      upon exercise of the warrants;·
            An
      information rights agreement that grants to the Investor, subject to
      applicable law, the right to receive certain information regarding the
      Company, and·
            A
      share-pledge agreement whereby the Company granted to the Collateral Agent
      (on behalf of the holders of the Senior Notes) a pledge on 65% of the
      Company’s equity interest in Shaanxi Xilan Natural Gas Equipment Co.,
      Ltd., a PRC corporation and wholly-owned subsidiary of the
      Company.·
            An
      account pledge and security agreement whereby the Company granted to the
      Collateral Agent a security interest in the account where the proceeds
      from the Senior Notes are
deposited.





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





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




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





See
report of independent registered public accounting firm.




F-18




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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




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





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





The
indenture requires the Company to pay additional interest at the rate of 3.0%
per annum of the Senior Notes if the Company has not obtained a listing of its
common stock on the Nasdaq Global Market, the Nasdaq Capital Market or the New
York Stock Exchange by January 29, 2009 and maintained such listing continuously
thereafter as long as the Senior Notes are outstanding. As of January 29, 2009,
the Company has not obtained a listing of its common stock on the market stated
in the agreement. However, the Company does get a three-month waiver from Abax
for the additional interest payment. The waiver gives the Company three more
months untill April 28th to achieve the uplisting status. By the end of the
extended period, if the Company cannot get its stock uplisted, the Company would
try to get another waiver or the Company will have to pay an additional interest
at the rate of 3.0% starting April 28th, 2009.  Pursuant to the
registration rights agreement (described herein), the Company has agreed to pay
additional interest at the rate of 1.0% per annum of the Senior Notes principal
amount outstanding for each 90-day period in which the Company has failed to
comply with the registration obligations under the registration rights
agreement.





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





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




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




The
Company was required to prepare and file a registration statement covering the
sales of all of the shares of common stock issuable upon exercise of the
warrants or incur additional interest of 1% on the Notes.  The
Company’s registration statement was declared effective on May 6, 2008;
therefore, no penalties were incurred.





See
report of independent registered public accounting firm.





F-19




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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





In
connection with the issuance of the Securities Purchase Agreement, the Company
paid $2,122,509 in debt issuance costs which is being amortized over the life of
the Senior Notes.  For the year ended December 31, 2008, the Company
amortized $227,989 of the aforesaid issuance costs, net of capitalized of
interest.





In
connection with the Securities Purchase Agreement, the Company agreed to issue
to the Investor seven-year warrants exercisable for up to 2,900,000 shares of
the Company’s common stock at an initial exercise price equal to $7.3652 per
share, subject to certain adjustments. The exercise price of the Warrants is
adjusted on the first anniversary of issuance and thereafter, at every six month
anniversary beginning in the fiscal year 2009 if the volume weighted average
price, or VWAP, (as defined therein) for the 15 trading days prior to the
applicable reset date is less than the then applicable exercise price, in which
case the exercise price shall be adjusted downward to the then current VWAP;
provided, however, that in no event shall the exercise price be adjusted below
$3.6826 per share. . The latest reset date was January 29, 2009 and the exercise
price for the warrants was adjusted to $3.6826. The Company is in the process of
filing this information with SEC.





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





The
warrants granted to the Investor on January 29, 2008 are considered derivative
instruments that need to be bifurcated from the original security.  If
the Warrants have not been exercised within the seven year period, then the
Investor can have the Company purchase the Warrants for
$17,500,000.  This amount is shown as a debt discount and is being
amortized over the term of the Senior Notes.  For the year ended
December 31, 2008, the Company amortized $1,004,677 of the aforesaid discounts,
net of capitalized of interest.





In
connection with the Securities Purchase Agreement, the Company agreed to issue
to the Investor seven-year warrants exercisable for up to 2,900,000 shares of
the Company’s common stock at an initial exercise price equal to $7.3652 per
share, adjusted to $3.6826 on January 29, 2009.  The warrants have
been determined to be derivative liabilities instruments because there is a
required redemption requirement if the holder does not exercise the
Warrants.  However, the warrants are not required to be value at fair
value, rather, to be at its undiscounted redemption amount of $17.5 million
according to FAS 150.





Note
5 – Stockholders’ Equity





Common
stock





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





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





See
report of independent registered public accounting firm.




F-20




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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





Both
Investor Warrants and Placement Agent Warrants meet the conditions for equity
classification pursuant to FAS 133 and EITF 00-19. Therefore, these warrants
were classified as equity and accounted as common stock issuance
cost.





Following
is a summary of the warrant activity:





Warrants
                            Outstanding
                          
                          
                          Weighted
                            Average
                            Exercise
      Price
                          
                          
                          Aggregate
                            Intrinsic
                            ValueOutstanding,
      January 01, 2007
                          
                          
                          1,140,286
                          
                          
                          $
                          3.60
                          
                          
                          
                          -Granted
                          
                          
                          767,308
                          
                          
                          $
                          7.79
                          
                          
                          
                          -Forfeited
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Exercised
                          
                          
                          (819,110
                          )
                          
                          $
                          3.60
                          
                          
                          
                          -Outstanding,
      December 31, 2007
                          
                          
                          1,088,484
                          
                          
                          $
                          6.55
                          
                          
                          $
                          376,977Granted
                          
                          
                          2,900,000
                          
                          
                          $
                          7.37
                          
                          
                          
                          -Forfeited
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Exercised
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Outstanding,
      December 31, 2008
                          
                          
                          3,988,484
                          
                          
                          $
                          7.14
                          
                          
                          
                          -





Following
is a summary of the status of warrants outstanding at December 31,
2008:





Outstanding
      Warrants
                                      
                                      
                                      
                                      
                                      
                                      Exercisable
      WarrantsExercise
      Price
                                      
                                      Number
                                      
                                      
                                      Average
                                        Remaining
                                        Contractual
                                        Life
                                      
                                      
                                      Average
                                        Exercise
                                        Price
                                      
                                      
                                      Number$
                                      3.60
                                      
                                      
                                      321,176
                                      
                                      
                                      
                                      0.03
                                      
                                      
                                      $
                                      3.60
                                      
                                      
                                      
                                      321,176$
                                      7.37
                                      
                                      
                                      2,900,000
                                      
                                      
                                      
                                      6.08
                                      
                                      
                                      $
                                      7.37
                                      
                                      
                                      
                                      2,900,000$
                                      7.79
                                      
                                      
                                      767,308
                                      
                                      
                                      
                                      3.59
                                      
                                      
                                      $
                                      7.79
                                      
                                      
                                      
                                      767,308$
                                      7.14
                                      
                                      
                                      3,988,484
                                      
                                      
                                      
                                      3.00
                                      
                                      
                                      $
                                      7.14
                                      
                                      
                                      
                                      3,988,484





Note
6 – Defined Contribution Plan





The
Company is required to participate in a defined contribution plan operated by
the local municipal government in accordance with Chinese law and
regulations.  The Company makes annual contributions of 14% of all
employees' salaries to the plan. Starting from 2008, no minimum contribution is
required but the maximum contribution cannot be more than 14 % of the current
salary expense. The total contribution for the above plan was $112,233 and
$122,677 for the years ended December 31, 2008 and 2007,
respectively.





Note
7 – Statutory Reserve





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





See
report of independent registered public accounting firm.




F-21





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





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





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





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





The
Company has appropriated $1,927,348 and $1,051,849 as reserve for the statutory
surplus reserve for the years ended December 31, 2008 and 2007.





Note
8 – Accounting for stock-based compensation





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





The
Company used the Black-Sholes model to value the options at the time they were
issued, based on the stock price on its grant date, the stated exercise prices
and expiration dates of the instruments and using a risk-free rate of 4.10%. The
estimated life is based on one half of the sum of the vesting period and the
contractual life of the option. This is the same as assuming that the options
are exercised at the mid-point between the vesting date and expiration
date.  $66,704 of compensation expense was recorded during the year
ended December 31, 2008.





As of
December 31, 2008, approximately $132,559 of estimated expense with respect to
non-vested stock-based compensation has yet to be recognized and will be
recognized in expense over the optionee’s remaining weighted average service
period of approximately 1.75 years.




Note
9 – Earnings Per Share





Earnings
per share for the periods ended December 31, 2008 and 2007 is determined by
dividing net income for the periods by the weighted average number of both basic
and diluted shares of common stock and common stock equivalents outstanding. The
following is an analysis of the differences between basic and diluted earnings
per common share in accordance with Statement of Financial Accounting Standards
No. 128, “Earnings Per Share.”





The
following demonstrates the calculation for earnings per share for the years
ended December 31, 2008 and 2007:




For
      the years endedDecember
      31,2008
                        
                        
                        2007Basic earning per shareNet
      income
                        
                        $
                        15,190,368
                        
                        
                        $
                        9,116,070Weighted
      shares outstanding-Basic
                        
                        
                        29,200,304
                        
                        
                        
                        26,200,679Earnings
      per share-Basic
                        
                        $
                        0.52
                        
                        
                        $
                        0.35Diluted
      earning per shareNet
      income
                        
                        $
                        15,190,368
                        
                        
                        $
                        9,116,070Weighted
      shares outstanding-Basic
                        
                        
                        29,200,304
                        
                        
                        
                        26,200,679Effect
      of diluted securities-Warrants
                        
                        
                        89,835
                        
                        
                        
                        101,123Weighted
      shares outstanding-Diluted
                        
                        
                        29,290,139
                        
                        
                        
                        26,301,802Earnings
      per share –Diluted
                        
                        $
                        0.52
                        
                        
                        $
                        0.35





See
report of independent registered public accounting firm.




F-22




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





At
December 31, 2008 and 2007, the Company had outstanding warrants of 3,988,484
and 1,088,484, respectively.  For the year ended December 31, 2008,
the average stock price was greater than the exercise prices of the 321,176
warrants which resulted in additional weighted average common stock equivalents
of 89,835; 3,667,308 outstanding warrants were excluded from the diluted
earnings per share calculation as they are anti-dilutive.





Note
10 – Current Vulnerability Due to Certain Concentrations





Concentration
of natural gas vendors:





For
      the years ended December
                            31,2008
                          
                          
                          2007Numbers
      of natural gas vendors
                          
                          
                          4
                          
                          
                          
                          3Percentage
      of total natural gas purchases
                          
                          
                          96.0
                          %
                          
                          
                          88.4
                          %





As of
December 31, 2008 and 2007, the Company has $206,811 and $0 payable due to
Shanxin Natural Gas Company, one of its major natural gas vendors.





The
Company has long-term natural gas minimum purchase agreements with one of its
vendors.  For the years ended December 31, 2008 and 2007, the minimum
purchase requirements were 25.58 million cubic meters and 12.93 million cubic
meters, respectively.  Contracts are renewed on an annual basis. The
Company’s management reports that it does not expect any issues or difficulty in
continuing to renew the supply contracts with these vendors going forward. Price
points for natural gas are strictly controlled by the government and have
remained stable over the past three years.




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





Note
11 – Commitments and Contingencies





(a)  Lease
Commitments





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





Year
      ending December 31, 2009
                        
                        $
                        1,213,744Year
      ending December 31, 2010
                        
                        
                        1,208,556Year
      ending December 31, 2011
                        
                        
                        1,204,212Year
      ending December 31, 2012
                        
                        
                        1,131,931Year
      ending December 31, 2013
                        
                        
                        1,052,520Thereafter
                        
                        
                        6,936,959Total
                        
                        $
                        12,747,922





See
report of independent registered public accounting firm.




F-23





China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





For the
years ended December 31, 2008 and 2007, the land use right and office lease
expenses were $1,127,558 and $ 433,755, respectively.





(b)
Property and Equipment





In
January 2008, the Company entered into a contract with Chemtex International
Inc. to purchase equipment supply for LNG plant and LNG storage tank located in
Jingbian county, Shannxi Province China, in the total amount of $13,700,000. On
May 16, 2008, SJLNG entered into an agreement with Hebei Tongchan Import and
Export Co. Ltd. (Hebei) and agreed that Hebei will act as the trade agency for
SJLNG. On June 16, 2008, the Company entered into an equipment supply contract
with Chemtex Internaitonal Inc. to supply imported equipment for a LNG plant and
a storage tank to be built by Jingbian Xilan LNG Co. Ltd. As of December 31,
2008, the Company advanced $6,106,589 to the trade agency and the future
commitment for equipment is $7,593,411.





(c)
Natural Gas Purchase Commitments





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





(d) Legal
Proceedings





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





See
report of independent registered public accounting firm.




F-24




China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2008





Note
12 – Subsequent Events





(a)
Reverse Split





On
January 15, 2009, our board of directors adopted resolutions by written consent
to effect a 1 for 2 reverse split for our common stock to potentially enable the
Company to list on the NASDAQ stock market.  On January 30 2009,
pursuant section 228 of Delaware General Corporation Law, the majority
shareholders of our Company adopted resolutions by written consent and waiving
all notice of and holding of any stockholder meeting to act upon such
resolutions, to effect a 1for 2 reverse split of our common stock to potentially
enable the Company to list on the NASDAQ stock market.  The Company
has filed a Pre14C information statement with SEC and waiting for comments from
regulatory authorities before the Company can file the Certificate of
Amendment.  Because the stock split is not effect until at least the
Certificate of Amendment is filed and our board of directors can authorize the
Company to suspend or withdraw the filing of Certificate of Amendment before it
is effective, the Company did not consider the stock split is
effective.  The following table disclosed the pro forma information on
EPS to give effect to the 1 for 2 reverse stock split





For
      the years endedDecember
      31,2008
                      
                      
                      2007Basic earning per shareNet
      income
                      
                      $
                      15,190,368
                      
                      
                      $
                      9,116,070Weighted
      shares outstanding-Basic
                      
                      
                      14,600,152
                      
                      
                      
                      13,100,339Earnings
      per share-Basic
                      
                      $
                      1.04
                      
                      
                      $
                      0.70Diluted
      earning per shareWeighted
      shares outstanding-Diluted
                      
                      
                      14,645,069
                      
                      
                      
                      13,150,901Earnings
      per share-Diluted
                      
                      $
                      1.04
                      
                      
                      $
                      0.69




(b)
Adoption of Stock Option Plan





On March
11, 2009, our board of directors approved by written consent the Company’s stock
option plan for its employees, directors and consultants. Pursuant to the plan,
the total stock option pool will equal to 10% of the Company’s total shares
outstanding as of March 11, 2009. Among the option pool approved, 5% shall be
awarded in 2009 and another 5% shall be awarded in 2010. For the 2009 stock
option award, the CEO and CFO will be granted total options of 1% and 0.6% of
our common shares outstanding respectively, 50% as Non-qualified Stock Options
(NSO) and 50% as Incentive Stock Awards (ISA), for a vesting period of four
years. 10,000 option shares per year will be granted to each non-executive board
member and 12,000 option shares per year granted to Audit Committee Chairman.
Other senior management and employees will be granted total options of 2.26% of
our common shares. The strike price for the options is $2.45 per
share.  It is the mutual understanding of the board and the optionee
that the 2009 stock option plan shall be effective January 1, 2009.





See
report of independent registered public accounting firm.




F-25


CHINA
NATURAL GAS, INC.
 AND
SUBSIDIARIES
 
 CONSOLIDATED
FINANCIAL STATEMENTS
 AS OF
DECEMBER 31, 2007 AND 2006
  F-26
 
 CHINA
NATURAL GAS, INC.
 AND
SUBSIDIARIES
 
 CONTENTS
 
 PagesReports
      of Independent Registered Public Accounting Firms
                    
                    F-1Consolidated
      Balance Sheets as of December 31, 2007 and 2006
                    
                    F-3Consolidated
      Statements of Income and Other Comprehensive income for the years ended
      December 31, 2007 and 2006
                    
                    F-4Consolidated
      Statements of Stockholders’ Equity for the years ended December 31, 2007
      and 2006
                    
                    F-5Consolidated
      Statements of Cash Flows for the years ended December 31, 2007 and
      2006
                    
                    F-6Notes
      to Consolidated Financial Statements as of December 31,
    2007
                    
                    F-7 –
      F-22
  
 
 REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 To the
Board of Directors and Stockholders of
 China
Natural Gas, Inc. and Subsidiaries
 
 We have
audited the accompanying consolidated balance sheets of China Natural Gas, Inc.
and Subsidiaries as of December 31, 2007, and the related consolidated
statements of income and other comprehensive income, stockholders’ equity, and
cash flows for year then ended. These consolidated financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audit. The
consolidated financial statements of China Natural Gas, Inc. and Subsidiaries as
of December 31, 2006 were audited by other auditors whose report dated March 12,
2007, expressed an unqualified opinion on those statements.
 
 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 the financial
statements are free of material misstatement. The company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the company’s internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements, assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides 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 China Natural Gas, Inc. and
Subsidiaries as of December 31, 2007, and the results of its operations and its
cash flows for the year ended December 31, 2007, in conformity with accounting
principles generally accepted in the United States of America.
 
 /s/ Moore
Stephens Wurth Frazer and Torbet, LLP
  Walnut,
California
 March 31,
2008
  F-1




Report
of Independent Registered Public Accounting Firm




Board of
Directors and Stockholders of


China
Natural Gas, Inc.





We have
audited the accompanying consolidated balance sheet of China Natural Gas, Inc.
and subsidiaries as of December 31, 2006, and the related consolidated
statements of operations and other comprehensive income, stockholders' equity,
and cash flows for the year ended December 31, 2006. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our 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 the
consolidated 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 consolidated financial statement presentation. We
believe that our audit provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of China Natural
Gas, Inc. and subsidiaries as of December 31, 2006, and the consolidated results
of their operations and their consolidated cash flows for the year ended
December 31, 2006, in conformity with U.S. generally accepted accounting
principles.





/s/
Kabani & Company, Inc.


Certified
Public Accountants





Los
Angeles, California


March 12,
2007


F-2


CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


AS
OF DECEMBER 31, 2007 and 2006





2007
                                          
                                          
                                          2006ASSETSCURRENT
      ASSETS:Cash
      & cash equivalents
                                          
                                          $
                                          13,291,729
                                          
                                          
                                          $
                                          5,294,213Short-term
      investments
                                          
                                          
                                          238,554
                                          
                                          
                                          
                                          -Accounts
      receivable
                                          
                                          
                                          306,179
                                          
                                          
                                          
                                          569,037Other
      receivable
                                          
                                          
                                          824,020
                                          
                                          
                                          
                                          711,279Inventories
                                          
                                          
                                          231,339
                                          
                                          
                                          
                                          285,537Advances
                                          
                                          
                                          663,041
                                          
                                          
                                          
                                          960,681Prepaid
      expense and other current assets
                                          
                                          
                                          109,722
                                          
                                          
                                          
                                          304,620Total
      current assets
                                          
                                          
                                          15,664,584
                                          
                                          
                                          
                                          8,125,367PROPERTY
      AND EQUIPMENT, net
                                          
                                          
                                          32,291,995
                                          
                                          
                                          
                                          17,193,728CONSTRUCTION
      IN PROGRESS
                                          
                                          
                                          2,210,367
                                          
                                          
                                          
                                          2,343,499OTHER
      ASSETS
                                          
                                          
                                          3,123,052
                                          
                                          
                                          
                                          803,757TOTAL ASSETS
                                          
                                          $
                                          53,289,998
                                          
                                          
                                          $
                                          28,466,351LIABILITIES AND STOCKHOLDERS'
      EQUITYCURRENT
      LIABILITIES:Accounts
      payable and accrued liabilities
                                          
                                          $
                                          487,710
                                          
                                          
                                          $
                                          406,212Other
      payables
                                          
                                          
                                          55,979
                                          
                                          
                                          
                                          279,236Unearned
      revenue
                                          
                                          
                                          327,220
                                          
                                          
                                          
                                          284,011Taxes
      Payable
                                          
                                          
                                          1,211,775
                                          
                                          
                                          
                                          1,866,688Total
      current liabilities
                                          
                                          
                                          2,082,684
                                          
                                          
                                          
                                          2,836,147COMMITMENTS
      AND CONTINGENCIES
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -STOCKHOLDERS'
      EQUITY:Preferred
      stock, $0.0001 per share; authorized 5,000,000 shares; none
      issued
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Common
      stock, $0.0001 per share; 45,000,000 authorized shares 29,200,304 and
      24,210,183 shares issued and outstanding at December 31, 2007 and 2006,
      respectively
                                          
                                          
                                          2,920
                                          
                                          
                                          
                                          2,421Additional
      paid-in capital
                                          
                                          
                                          32,046,879
                                          
                                          
                                          
                                          18,223,911Cumulative
      translation adjustment
                                          
                                          
                                          3,477,025
                                          
                                          
                                          
                                          839,452Statutory
      reserves
                                          
                                          
                                          1,802,735
                                          
                                          
                                          
                                          750,886Retained
      earnings
                                          
                                          
                                          13,877,755
                                          
                                          
                                          
                                          5,813,534Total
      stockholders' equity
                                          
                                          
                                          51,207,314
                                          
                                          
                                          
                                          25,630,204TOTAL LIABILITIES AND
      STOCKHOLDERS' EQUITY
                                          
                                          $
                                          53,289,998
                                          
                                          
                                          $
                                          28,466,351




See
report of independent registered public accounting firm.




The
accompanying notes are an integral part of these statements.


F-3


CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME


FOR
THE YEARS ENDED DECEMBER 31, 2007 AND 2006





Years Ended December 31,2007
                        
                        
                        2006RevenueNatural
      gas revenue
                        
                        $
                        28,278,033
                        
                        
                        $
                        13,713,145Installation
      and other
                        
                        
                        7,114,020
                        
                        
                        
                        5,115,645Total
      revenue
                        
                        
                        35,392,053
                        
                        
                        
                        18,828,790Cost
      of revenueNatural
      gas cost
                        
                        
                        14,838,997
                        
                        
                        
                        7,663,060Installation
      and other
                        
                        
                        3,186,078
                        
                        
                        
                        2,054,940Total
      cost of revenue
                        
                        
                        18,025,075
                        
                        
                        
                        9,718,000Gross
      profit
                        
                        
                        17,366,978
                        
                        
                        
                        9,110,790Operating
      expensesSelling
      expenses
                        
                        
                        3,451,161
                        
                        
                        
                        1,308,464General
      and administrative expenses
                        
                        
                        2,837,768
                        
                        
                        
                        1,287,735Total
      operating expenses
                        
                        
                        6,288,929
                        
                        
                        
                        2,596,199Income
      from operations
                        
                        
                        11,078,049
                        
                        
                        
                        6,514,591Non-operating
      income (expense):Interest
      income
                        
                        
                        70,697
                        
                        
                        
                        41,109Other
      income
                        
                        
                        39,076
                        
                        
                        
                        -Other
      expense
                        
                        
                        (7,100
                        )
                        
                        
                        (79,021
                        )Foreign
      exchange loss
                        
                        
                        (150,729
                        )
                        
                        
                        -Total
      non-operating expense
                        
                        
                        (48,056
                        )
                        
                        
                        (37,912
                        )Income
      before income tax
                        
                        
                        11,029,993
                        
                        
                        
                        6,476,679Provision
      for income tax
                        
                        
                        1,913,923
                        
                        
                        
                        1,025,584Net
      income
                        
                        
                        9,116,070
                        
                        
                        
                        5,451,095Other
      comprehensive incomeForeign
      currency translation gain
                        
                        
                        2,637,573
                        
                        
                        
                        610,705Comprehensive
      Income
                        
                        $
                        11,753,643
                        
                        
                        $
                        6,061,800Weighted
      average shares outstandingBasic
                        
                        
                        26,200,679
                        
                        
                        
                        23,872,936Diluted
                        
                        
                        26,301,802
                        
                        
                        
                        23,872,936Earnings
      per shareBasic
                        
                        $
                        0.35
                        
                        
                        $
                        0.23Diluted
                        
                        $
                        0.35
                        
                        
                        $
                        0.23




See
report of independent registered public accounting firm.




The
accompanying notes are an integral part of these statements.


F-4


CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY





Common
      Stock
                            
                            
                            Additional
                            
                            
                            Accumulative
                              Other
                            
                            
                            
                            
                            
                            
                            
                            
                            TotalShares
                            
                            
                            Amount
                            
                            
                            Paid
      in
                              Capital
                            
                            
                            Comprehensive
                              Gain
                            
                            
                            Statutory
                              Reserve
                            
                            
                            Retained
                              Earnings
                            
                            
                            Stockholders'
                              EquityBalance
      December 31, 2005
                            
                            
                            20,204,088
                            
                            
                            $
                            2,020
                            
                            
                            $
                            8,331,458
                            
                            
                            $
                            228,747
                            
                            
                            $
                            169,722
                            
                            
                            $
                            943,603
                            
                            
                            $
                            9,675,550Shares
      issued for cash, at $2.80
                            
                            
                            3,714,428
                            
                            
                            
                            371
                            
                            
                            
                            10,399,629
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            10,400,000Offering
      costs
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,557,147
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,557,147
                            )Cashless
      exercise of warrants
                            
                            
                            291,667
                            
                            
                            
                            30
                            
                            
                            
                            1,049,971
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,050,001Cumulative
      translation adjustment
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            610,705
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            610,705Net
      Income
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            5,451,095
                            
                            
                            
                            5,451,095Transfer
      to statutory reserve
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            581,164
                            
                            
                            
                            (581,164
                            )
                            
                            
                            -Balance
      December 31, 2006
                            
                            
                            24,210,183
                            
                            
                            $
                            2,421
                            
                            
                            $
                            18,223,911
                            
                            
                            $
                            839,452
                            
                            
                            $
                            750,886
                            
                            
                            $
                            5,813,534
                            
                            
                            $
                            25,630,204Shares
      issued for cash, at $3.25
                            
                            
                            4,615,385
                            
                            
                            
                            462
                            
                            
                            
                            14,999,538
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            15,000,000Offering
      costs
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,176,533
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,176,533
                            )Cashless exercise
      of warrants
                            
                            
                            374,736
                            
                            
                            
                            37
                            
                            
                            
                            (37
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            -Cumulative
      translation adjustment
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            2,637,573
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            2,637,573Net
      Income
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            9,116,070
                            
                            
                            
                            9,116,070Transfer
      to statutory reserve
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,051,849
                            
                            
                            
                            (1,051,849
                            )
                            
                            
                            -Balance
      December 31, 2007
                            
                            
                            29,200,304
                            
                            
                            $
                            2,920
                            
                            
                            $
                            32,046,879
                            
                            
                            $
                            3,477,025
                            
                            
                            $
                            1,802,735
                            
                            
                            $
                            13,877,755
                            
                            
                            $
                            51,207,314





See
report of independent registered public accounting firm.




The
accompanying notes are an integral part of these statements.


F-5


CHINA
NATURAL GAS, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE YEARS ENDED DECEMBER 2007 AND 2006





Years
      Ended December 31,2007
                        
                        
                        2006CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                        
                        $
                        9,116,070
                        
                        
                        $
                        5,451,095Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                        
                        
                        1,639,685
                        
                        
                        
                        731,723Change
      in assets and liabilities:Accounts
      receivable
                        
                        
                        290,660
                        
                        
                        
                        (550,831
                        )Other
      receivable
                        
                        
                        36,929
                        
                        
                        
                        (636,262
                        )Inventory
                        
                        
                        71,226
                        
                        
                        
                        (233,582
                        )Advances
                        
                        
                        245,514
                        
                        
                        
                        (1,611,967
                        )Prepaid
      expense and other current assets
                        
                        
                        (11,113
                        )
                        
                        
                        (282,103
                        )Accounts
      payable
                        
                        
                        (130,228
                        )
                        
                        
                        201,661Accrued
      expense
                        
                        
                        158,759
                        
                        
                        
                        -Other
      payables
                        
                        
                        (208,669
                        )
                        
                        
                        1,352,866Unearned
      revenue
                        
                        
                        22,425
                        
                        
                        
                        (28,882
                        )Taxes
      payable
                        
                        
                        (754,817
                        )
                        
                        
                        (8,194
                        )Net
      cash provided by operating activities
                        
                        
                        10,476,441
                        
                        
                        
                        4,385,524CASH
      FLOWS FROM INVESTING ACTIVITIESPurchase
      of property and equipment
                        
                        
                        (14,180,053
                        )
                        
                        
                        (9,192,482
                        )Purchase
      short term investments
                        
                        
                        (229,106
                        )
                        
                        
                        -Additions
      to construction in progress
                        
                        
                        (519,309
                        )
                        
                        
                        (545,987
                        )Prepayment
      on long term assets
                        
                        
                        (1,914,343
                        )
                        
                        
                        -Payment
      for land use rights
                        
                        
                        (42,529
                        )
                        
                        
                        -Net
      cash used in investing activities
                        
                        
                        (16,885,340
                        )
                        
                        
                        (9,738,469
                        )CASH
      FLOWS FROM FINANCING ACTIVITIES:Stock
      issued for cash
                        
                        
                        15,000,000
                        
                        
                        
                        10,400,000Proceeds
      from exercise of warrants
                        
                        
                        -
                        
                        
                        
                        1,050,001Payment
      for offering costs
                        
                        
                        (1,176,533
                        )
                        
                        
                        (1,557,147
                        )Net
      cash provided by financing activities
                        
                        
                        13,823,467
                        
                        
                        
                        9,892,854Effect
      of exchange rate changes on cash and cash equivalents
                        
                        
                        582,948
                        
                        
                        
                        78,680NET
      INCREASE IN CASH & CASH EQUIVALENTS
                        
                        
                        7,997,516
                        
                        
                        
                        4,618,589CASH
      & CASH EQUIVALENTS, BEGINNING OF YEAR
                        
                        
                        5,294,213
                        
                        
                        
                        675,624CASH
      & CASH EQUIVALENTS, END OF YEAR
                        
                        $
                        13,291,729
                        
                        
                        $
                        5,294,213SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Interest
      paid
                        
                        $
                        -
                        
                        
                        $
                        -Income
      taxes paid
                        
                        $
                        2,387,487
                        
                        
                        $
                        -




See
report of independent registered public accounting firm.




The
accompanying notes are an integral part of these statements.


F-6


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007





Note
1 - Organization and Basis of Presentation





Organization and Line of
Business




China
Natural Gas, Inc. (formerly Coverture International Inc.) was incorporated in
the state of Delaware on March 31, 1999 as Bullet Environmental Systems, Inc.
and on May 25, 2000, the Company changed its name to Liquidpure Corp. On
February 14, 2002 the Company changed its name to Coventure International,
Inc.





Xi’an
Xilan Natural Gas Co, Ltd. (“XXNGC”) was incorporated on January 8, 2000 in
Xi’an city in the Shaanxi province, China. The core business of XXNGC is
distribution of natural gas to commercial, industrial and residential customers,
construction of pipeline networks, and installation of natural gas fittings and
parts for end-users. XXNGC has an exclusive permit to provide gas utility
service in Lantian County, Lintong and Baqiao District of Xi’an city,
China.





On
December 6, 2005, XXNGC executed a share purchase agreement with Coventure
International, Inc. (“Coventure”), a public shell in the United States of
America. Pursuant to the purchase agreement, Coventure acquired all of the
issued and outstanding capital stock of XXNGC in exchange for 16,000,000
(post-split) shares of Coventure’s common stock.





Concurrently
with the closing of the purchase agreement and as a condition thereof, Coventure
entered into an agreement with John Hromyk, its President and Chief Financial
Officer, pursuant to which Mr. Hromyk returned 23,884,712 (post-split) shares of
Coventure's common stock for cancellation. Upon completion of the foregoing
transactions, Coventure had an aggregate of 20,204,088 (post-split) shares of
common stock issued and outstanding.





As a
result of the merger, XXNGC’s stockholders own approximately 80% of the combined
company and the directors and executive officers of XXNGC became the directors
and executive officers of the Coventure. Accordingly, the transaction has been
accounted for as a reverse acquisition of Coventure by XXNGC resulting in a
recapitalization of XXNGC rather than as a business combination. XXNGC is deemed
to be the purchaser and surviving company for accounting purposes. Accordingly,
its assets and liabilities are included in the balance sheet at their historical
book values and the results of operations of XXNGC have been presented for the
comparative prior period. The historical cost of the net liabilities of
Coventure that were acquired was $3,378. In addition, Coventure changed it name
to China Natural Gas, Inc. (hereafter referred to as the “Company”) and the
stockholders approved a stock dividend of three shares for each share held,
which has been accounted for as a four to one forward stock split. All shares
and per share data have been restated retrospectively.





However,
this merger acquisition was not able to be approved under the certain laws of
the People’s Republic of China (“PRC”). PRC law currently has limits on foreign
ownership of companies in certain industries. To comply with these foreign
ownership restrictions, the Company established its wholly owned subsidiary,
Xilan Natural Gas Equipment Ltd. (“XNGE”), a limited liability company organized
under the PRC law on February 21, 2006. The Company through XNGE entered into
exclusive arrangements with XXNGC. Through these arrangements, the Company has
the ability to substantially influence XXNGC’s daily operations and financial
affairs, appoint its senior executives and approve all matters requiring
shareholder approval. These arrangements were formalized on August 17, 2007, and
made retroactive to March 8, 2006. As a result, XXNGC became a variable interest
entity effective on March 8, 2006




See
report of independent registered public accounting firm.


F-7


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Shaanxi
Jingbian Liquefied Natural Gas Co., Ltd (“SJLNG”) was incorporated on October
24, 2006 with registered capital of $3,792,000 (RMB 30,000,000) in Jingbian
District, Shaanxi province, People’s Republic of China (“PRC”). SJLNG was
established for the purpose of constructing a liquefied natural gas (“LNG”)
facility to be located in Jingbian, Shaanxi province and to administer the
production and sales of LNG. SJLNG is 100% owned by XXNGC.





Xi'an
Xilan Auto Bodyshop Co., Ltd (“XXABC”) was incorporated on May 15, 2007 with
registered capital of $519,200 (RMB 4,000,000) in Shaanxi province, People’s
Republic of China (“PRC”). XXABC was established for the purpose of providing
modification services to different types of automobiles to be able to use
natural gas. XXABC is 100% owned by XXNGC.





Principles of
Consolidation





The
accompanying consolidated financial statements include the accounts of China
Natural Gas, Inc. and its wholly owned subsidiaries, Shaanxi Natural Gas
Equipment Co., Ltd (incorporated in February 2006) and its 100% variable
interest entities (“VIE”), Xi’an Xilan Natural Gas Co. Ltd., Shaanxi Jingbian
Liquefied Natural Gas Co., Ltd, and Xian Xilan Auto Bodyshop. All inter-company
accounts and transactions have been eliminated in the
consolidation.





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




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





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





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





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





See
report of independent registered public accounting firm.


F-8


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007





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





Basis of
Presentation





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





Foreign Currency
Translation





As of
December 31, 2007 and 2006, the accounts of the Company were maintained, and
their consolidated financial statements were expressed in RMB. Such consolidated
financial statements were translated into USD in accordance with Statement of
Financial Accounts Standards ("SFAS") No. 52, "Foreign Currency Translation,"
with the RMB as the functional currency. According to the Statement, all assets
and liabilities were translated at the exchange rate on the balance sheet date,
stockholder's equity are translated at the historical rates and statement of
income and cash flow items are translated at the weighted average exchange rate
for the year. The resulting translation adjustments are reported under other
comprehensive income in accordance with SFAS No. 130, "Reporting Comprehensive
Income."





Translation
adjustments resulting from this process amounted to $3,477,025 and $839,452 as
of December 31, 2007 and 2006, respectively. The balance sheet amounts with the
exception of equity at December 31, 2007 were translated 7.29 RMB to $1.00 USD
as compared to 7.80 RMB at December 31, 2006. The equity accounts were stated at
their historical rate. The average translation rates applied to income and cash
flow statement amounts for the years ended December 31, 2007 and 2006 were 7.59
RMB and 7.96 RMB to $1.00 USD, respectively.





Note
2 – Summary of Significant Accounting Policies





Use of
Estimates





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





Cash and Cash
Equivalents





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




See
report of independent registered public accounting firm.


F-9


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Certain
financial instruments, which subject the Company to concentration of credit
risk, consist of cash. The Company maintains balances at financial institutions
which, from time to time, may exceed Federal Deposit Insurance Corporation
insured limits for the banks located in the Unites States. Balances at financial
institutions or state owned banks within the PRC are not covered by insurance.
As of December 31, 2007 and 2006, the Company had deposits in excess of
federally insured limits total of $13,053,994 and $5,183,581, respectively. The
Company has not experienced any losses in such accounts and believes it is not
exposed to any significant risks on its cash in bank accounts.





Short Term
Investments





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





Accounts
Receivable





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





The
Company maintains reserves for potential credit losses on accounts receivable.
Management reviews the composition of accounts receivable and analyzes
historical bad debts, customer concentrations, customer credit worthiness,
current economic trends and changes in customer payment patterns to evaluate the
adequacy of these reserves. Reserves are recorded primarily on a specific
identification basis. The Company’s management has determined that all
receivables are collectible and there is no need for a reserve for bad debts as
of December 31, 2007 and 2006.





Other
Receivable





As needed
for normal business purpose, the Company advances predetermined amounts based
upon internal Company policy to certain employees and internal units to ensure
certain transactions to be performed in a timely manner. The Company has full
oversight and control over the advanced accounts. Therefore, the allowance for
the uncollectible accounts is nil.





Advances





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





Inventory





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




See
report of independent registered public accounting firm.


F-10


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




At
December 31, 2007 and 2006, the following are the details of the
inventories:





2007
                            
                            
                            2006Materials
      and supplies
                            
                            $
                            109,333
                            
                            
                            $
                            283,997Natural
      gas and gasoline
                            
                            
                            122,006
                            
                            
                            
                            1,540$
                            231,339
                            
                            
                            $
                            285,537





Property and
Equipment





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





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





At
December 31, 2007 and 2006, the following are the details of the property and
equipment:





2007
                            
                            
                            2006Office
      equipment
                            
                            $
                            163,432
                            
                            
                            $
                            73,636Operating
      equipment
                            
                            
                            22,413,270
                            
                            
                            
                            13,219,979Vehicles
                            
                            
                            1,484,892
                            
                            
                            
                            1,210,552Buildings
                            
                            
                            11,943,006
                            
                            
                            
                            4,559,00336,004,600
                            
                            
                            
                            19,063,170Less
      accumulated depreciation
                            
                            
                            (3,712,605
                            )
                            
                            
                            (1,869,442
                            )$
                            32,291,995
                            
                            
                            $
                            17,193,728





Depreciation
expense for the years ended December 31, 2007 and 2006 was $1,639,685 and
$731,723, respectively.




Long-Lived
Assets





The
Company applies the provision of Statement of Financial Accounting Standards No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS
144") to all long lived assets., SFAS 144 addresses accounting and reporting for
impairment and disposal of long-lived assets. The Company periodically evaluates
the carrying value of long-lived assets to be held and used in accordance with
SFAS 144. SFAS 144 requires impairment losses to be recorded on long-lived
assets used in operations when indicators of impairment are present and the
undiscounted cash flows estimated to be generated by those assets are less than
the assets' carrying amounts. In that event, a loss is recognized based on the
amount by which the carrying amount exceeds the fair market value of the
long-lived assets. Loss on long-lived assets to be disposed of is determined in
a similar manner, except that fair market values are reduced for the cost of
disposal. Based on its review, the Company believes that, as of December 31,
2007 there were no significant impairments of its long-lived
assets.




See
report of independent registered public accounting firm.


F-11


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Construction In
Progress





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





Fair Value of Financial
Instruments





Statement
of Financial Accounting Standard No. 107, Disclosures about fair value of
financial instruments, requires that the Company disclose estimated fair values
of financial instruments. The carrying amounts reported in the statements of
financial position for current assets and current liabilities qualifying as
financial instruments are a reasonable estimate of fair value. The Company
considers the carrying amount of these current assets and current liabilities to
approximate their fair values because of the short period of time between the
origination of such instruments and their expected realization and their current
market rate of interest.





Derivative
Accounting





The
Company entered into a 15 days foreign currency forward contract on December 25,
2007. As of December 31, 2007, the fair value of the contract is $3,055,505 (or
342,030,266 Japanese Yen) and is recorded in cash and cash equivalents in the
accompanying consolidated balance sheets due to the short term nature of the
investment.





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





The
Company elected not to apply hedge accounting. For a derivative instrument that
is not designated, as a hedge, the change in fair value is recognized in
earnings in the period of change. For the year ended December 31, 2007, no gain
or loss was incurred.




See
report of independent registered public accounting firm.


F-12


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Revenue
Recognition





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





Unearned
Revenue





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





Stock-Based
Compensation





The
Company accounts for its stock-based compensation in accordance with Statement
of Financial Accounting Standards (“SFAS”) No. 123R, "Share-Based Payment, an
Amendment of Financial Accounting Standards Board (“FASB”) Statement No. 123."
The Company recognizes in the statement of operations the grant-date fair value
of stock options and other equity-based compensation issued to employees and
non-employees. The Company did not grant any options and no options were
cancelled or exercised during the period ended December 31, 2007 and 2006. As of
December 31, 2007 and 2006, there were no options outstanding.





The
Company accounts for non-employee stock-based compensation expense in accordance
with EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to
Other Than Employee for Acquiring, or in Conjunction with Selling, Goods or
Services (“EITF 96-18”). The Company used the Black-Scholes option-pricing model
as its method of valuation for share-based awards granted. The Company’s
determination of fair value of share-based payment awards on the date of grant
using an option-pricing model is affected by the Company’s stock price as well
as assumptions regarding a number of complex and subjective variables. These
variables include, but are not limited to, the Company’s expected stock price
volatility over the term of the awards and the expected term of the
awards.




See
report of independent registered public accounting firm.


F-13


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Income
Taxes





The
Company utilizes SFAS No. 109, "Accounting for Income Taxes," which requires the
recognition of deferred tax assets and liabilities for the expected future tax
consequences of events that have been included in the financial statements or
tax returns. Under this method, deferred income taxes are recognized for the tax
consequences in future years of differences between the tax bases of assets and
liabilities and their financial reporting amounts at each period end based on
enacted tax laws and statutory tax rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the amount
expected to be realized. At December 31, 2007 and 2006, there was no significant
book to tax differences. There is no difference between book depreciation and
tax depreciation as the Company uses the same method for both book and tax. The
Company adopted FASB Interpretation 48, “Accounting for Uncertainty in Income
Taxes” (“FIN 48”), as of January 1, 2007. A tax position is recognized as a
benefit only if it is “more likely than not” that the tax position would be
sustained in a tax examination, with a tax examination being presumed to occur.
The amount recognized is the largest amount of tax benefit that is greater than
50% likely of being realized on examination. For tax positions not meeting the
“more likely than not” test, no tax benefit is recorded. The adoption had no
affect on the Company’s financial statements.





Local PRC Income
Tax





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





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





For
      the Years
                              Ended
      December 31,2007
                            
                            
                            2006Tax
      provision (credit) at statutory rate
                            
                            
                            34
                            %
                            
                            
                            34
                            %Foreign
      tax rate difference
                            
                            
                            (1
                            )%
                            
                            
                            (1
                            )%Effect
      of favorable tax rate
                            
                            
                            (15
                            )%
                            
                            
                            (14
                            )%18
                            %
                            
                            
                            19
                            %





The
estimated tax savings for the years ended December 31, 2007 and 2006 amounted to
approximately $2,174,806 and $1,232,074, respectively. The net effect on
earnings per share had the income tax been applied would decrease basic earnings
per share for the years ended December 31, 2007 and 2006 from $0.35 to $0.26 and
$0.23 to $0.18, respectively.





Beginning
January 1, 2008, the new Chinese Enterprise Income Tax (“EIT”) law will replace
the existing laws for Domestic Enterprises (“DES”) and Foreign Invested
Enterprises (“FIEs”). The new standard EIT rate of 25% will replace the 33% rate
currently applicable to both DES and FIEs.





Starting
from January 1, 2008, XNGE, SJLNG and XXABC will be subject to 25% income tax
rate according to the newly issued Income Tax Laws of PRC. As XXNGC is in the
natural gas industry, XXNGC is continuing to enjoy the reduced tax rate of 15%
until 2010.




See
report of independent registered public accounting firm.


F-14


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Value added
tax





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





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





Basic and Diluted Earning
Per Share




Earning
per share is calculated in accordance with the Statement of Financial Accounting
Standards No. 128 (“SFAS No. 128”), “Earnings per share”. Basic net earnings per
share is based upon the weighted average number of common shares outstanding.
Diluted net earnings per share is based on the assumption that all dilutive
convertible shares and stock options were converted or exercised. Dilution is
computed by applying the treasury stock method. Under this method, options and
warrants are assumed to be exercised at the beginning of the period (or at the
time of issuance, if later), and as if funds obtained thereby were used to
purchase common stock at the average market price during the
period.





Statement of Cash
Flows





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





Reclassifications





Certain
prior period amounts have been reclassified to conform to current period’s
presentation. This reclassification had no material effect on operations or cash
flows.





Recent
Pronouncements





In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements“. The
objective of SFAS No. 157 is to increase consistency and comparability in fair
value measurements and to expand disclosures about fair value measurements. SFAS
No. 157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles, and expands disclosures about fair
value measurements. SFAS No. 157 applies under other accounting pronouncements
that require or permit fair value measurements and does not require any new fair
value measurements. The provisions of SFAS No. 157 are effective for fair value
measurements made in fiscal years beginning after November 15, 2007. The
adoption of this statement is not expected to have a material effect on the
Company‘s future reported financial position or results of
operations.




See
report of independent registered public accounting firm.


F-15


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities“. This Statement permits entities to
choose to measure many financial assets and financial liabilities at fair value.
Unrealized gains and losses on items for which the fair value option has been
elected are reported in earnings. SFAS No. 159 is effective for fiscal years
beginning after November 15, 2007. The Company is currently assessing the impact
of SFAS No. 159 on its financial position and results of
operations.





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





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





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




See
report of independent registered public accounting firm.


F-16


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Note
3 – Other Assets





Other
assets at December 31, 2007 and 2006 consisted of the following,





2007
                    
                    
                    2006Prepaid
      rent – natural gas stations
                    
                    $
                    225,924
                    
                    
                    $
                    -Prepayment
      for acquiring land use right
                    
                    
                    993,975
                    
                    
                    
                    128,200Advances
      on purchasing equipment/construction in progress
                    
                    
                    1,501,443
                    
                    
                    
                    341,333Refundable
      security deposits
                    
                    
                    356,460
                    
                    
                    
                    333,320Others
                    
                    
                    45,250
                    
                    
                    
                    904Total
                    
                    $
                    3,123,052
                    
                    
                    $
                    803,757





All land
in the People’s Republic of China is government owned. However, the government
grants the user a land use right to use the land. As of December, 2007 and 2006,
the Company prepaid $993,975 and $128,200, respectively, to the PRC local
government to purchase land use rights. The Company is in the process of
negotiating the final purchase price with the local government and the land use
rights have not been granted to the Company. Therefore, the Company did not
amortize the prepaid land use rights.





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





Refundable
security deposit is monies deposited to one of its major vendor and gas station
landlord. These amounts will be returned to the Company if they terminate the
business relationship or at the end of the lease.




Note
4 – Stockholders’ Equity





Common
stock





On
January 6, 2006 and January 9, 2006, the Company entered into securities
purchase agreements with four accredited investors and completed the sale of
$5,380,000 of units. The units contained an aggregate of 1,921,572 shares of
common stock and 523,055 common stock purchase warrants. Each warrant is
exercisable for a period of three years at an exercise price of $3.60 per share.
Pursuant to the terms of the warrant, each investor has contractually agreed to
restrict its ability to exercise the warrants to an amount which would not
exceed the difference between the number of shares of common stock beneficially
owned by the holder or issuable upon exercise of the warrant held by such holder
and 9.9% of the outstanding shares of common stock of the Company.





In
connection with the offering, the Company paid a placement fee of 10% of the
proceeds in cash, together with non-accountable expenses in the amount of 3% of
the proceeds, in cash. In addition, the placement agent was issued warrants to
purchase 298,888 shares of common stock on the same terms and conditions as the
investors. The warrants issued to the placement agent are being treated as a
cost of raising capital.




See
report of independent registered public accounting firm.


F-17


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




On
January 10, 2006 through January 13, 2006, the Company entered into securities
purchase agreements with four accredited investors and completed the sale of
$2,195,198 of units. The units contained an aggregate of 783,999 shares of
common stock and 213,422 common stock purchase warrants. Each warrant is
exercisable for a period of three years at an exercise price of $3.60 per share.
Pursuant to the terms of the warrant, each investor has contractually agreed to
restrict its ability to exercise the warrants to an amount which would not
exceed the difference between the number of shares of common stock beneficially
owned by the holder or issuable upon exercise of the warrant held by such holder
and 9.9% of the outstanding shares of common stock of the Company.





In
connection with the offering, the Company paid a placement fee of 10% of the
proceeds in cash, together with non-accountable expenses in the amount of 3% of
the proceeds, in cash. In addition, the placement agent was issued warrants to
purchase 121,955 shares of common stock on the same terms and conditions as the
investors. The warrants issued to the placement agent are being treated as a
cost of raising capital.





On
January 17, 2006, the Company entered into securities purchase agreements with
an accredited investor and completed the sale of $2,824,802 of units. The units
contained an aggregate of 1,008,857 shares of common stock and 274,633 common
stock purchase warrants. Each common stock purchase warrant is exercisable for a
period of three years at an exercise price of $3.60 per share. Pursuant to the
terms of the warrant, each investor has contractually agreed to restrict its
ability to exercise the warrants to an amount which would not exceed the
difference between the number of shares of common stock beneficially owned by
the holder or issuable upon exercise of the warrant held by such holder and 9.9%
of the outstanding shares of common stock of the Company.





In
September 2006, the Company received $1,050,001 from the exercise of 291,667
warrants.





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





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





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





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




See
report of independent registered public accounting firm.


F-18


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Following
is a summary of the warrant activity:





Warrants
                            Outstanding
                          
                          
                          Weighted
                            Average
                            Exercise
      Price
                          
                          
                          Aggregate
                            Intrinsic
                            ValueOutstanding,
      December 31, 2005
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Granted
                          
                          
                          1,431,953
                          
                          
                          $
                          3.60
                          
                          
                          
                          -Forfeited
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Exercised
                          
                          
                          (291,667
                          )
                          
                          $
                          3.60
                          
                          
                          
                          -Outstanding,
      December 31, 2006
                          
                          
                          1,140,286
                          
                          
                          $
                          3.60
                          
                          
                          
                          -Granted
                          
                          
                          767,308
                          
                          
                          $
                          7.79
                          
                          
                          
                          -Forfeited
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Exercised
                          
                          
                          (819,110
                          )
                          
                          $
                          3.60
                          
                          
                          
                          -Outstanding,
      December 31, 2007
                          
                          
                          1,088,484
                          
                          
                          $
                          6.55
                          
                          
                          $
                          376,977





Following
is a summary of the status of warrants outstanding at December 31,
2007:





Outstanding
      warrants
                                                            
                                                            
                                                            
                                                            
                                                            
                                                            Exercisable
      WarrantsExercise
                                                              Price
                                                            
                                                            Number
                                                            
                                                            Average
                                                              Remaining
                                                              Contractual
                                                              Life
                                                            
                                                            Average
                                                              Exercise
                                                              Price
                                                            
                                                            Number$3.60
                                                            
                                                            
                                                            321,176
                                                            
                                                            1.03
                                                            
                                                            $
                                                            3.60
                                                            
                                                            321,176$7.79
                                                            
                                                            
                                                            767,308
                                                            
                                                            4.59
                                                            
                                                            $
                                                            7.79
                                                            
                                                            767,308$6.55
                                                            
                                                            
                                                            1,088,484
                                                            
                                                            3.54
                                                            
                                                            $
                                                            6.55
                                                            
                                                            1,088,484





Note
5 – Defined Contribution Plan





The
Company is required to participate in a defined contribution plan operated by
the local municipal government in accordance with Chinese law and regulations.
The Company makes annual contributions of 14% of all employees' salaries to the
plan. The total expense for the above plan was $122,677 and $51,765 for the
years ended December 31, 2007 and 2006, respectively.





Note
6 – Statutory Common Welfare Fund





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




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





See
report of independent registered public accounting firm.


F-19


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007





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




iii.
            Allocations of 5-10% of income
      after tax, as determined under PRC accounting rules and regulations, to
      the Company's “Statutory common welfare fund”, which is established for
      the purpose of providing employee facilities and other collective benefits
      to the Company's employees;
and




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




The
Company has appropriated $1,051,849 and $581,164 as reserve for the statutory
surplus reserve and welfare fund for the years ended December 31, 2007 and 2006,
respectively.





Note
7 – Earnings Per Share





Earnings
(loss) per share for the years ended December 31, 2007 and 2006 is determined by
dividing net income (loss) for the periods by the weighted average number of
both basic and diluted shares of common stock and common stock equivalents
outstanding. The following is an analysis of the differences between basic and
diluted earnings per common share in accordance with Statement of Financial
Accounting Standards No. 128, “Earnings Per Share.”





The
following demonstrates the calculation for earnings per share for the years
ended December 31, 2007 and 2006:





Year
      Ended December 31,2007
                              
                              
                              2006Basic earning
      per shareNet
      income
                              
                              $
                              9,116,070
                              
                              
                              $
                              5,451,095Weighted
      shares outstanding-Basic
                              
                              
                              26,200,679
                              
                              
                              
                              23,872,936Earnings
      per share-Basic
                              
                              $
                              0.35
                              
                              
                              $
                              0.23Diluted
      earning per shareNet
      income
                              
                              $
                              9,116,070
                              
                              
                              $
                              5,451,095Weighted
      shares outstanding-Basic
                              
                              
                              26,200,679
                              
                              
                              
                              23,872,936Effect
      of diluted securities-Warrants
                              
                              
                              101,123
                              
                              
                              
                              -Weighted
      shares outstanding-Diluted
                              
                              
                              26,301,802
                              
                              
                              
                              23,872,936Earnings
      per share -Diluted
                              
                              $
                              0.35
                              
                              
                              $
                              0.23




See
report of independent registered public accounting firm.


F-20


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




At
December 31, 2007 and 2006, the Company had outstanding warrants of 1,088,484
and 1,140,286, respectively. For the year ended December 31, 2007, the average
stock price was greater than the exercise prices of the 321,176 warrants which
resulted in additional weighted average common stock equivalents of 101,123;
767,308 outstanding warrants were excluded from the diluted earnings per share
calculation as they are anti-dilutive. The average stock price for the year
ended December 31, 2006 was less than the exercise price of the warrants;
therefore, 1,140,286 outstanding warrants are not factored into the diluted
earning per share calculation as they are anti-dilutive.





Note
8 – Current Vulnerability Due to Certain Concentrations





For the
years ended December 31, 2007 and 2006, the Company purchased all of the natural
gas for resale from three vendors, PetroChina Changqing Oilfield Company,
Shaanxi Natural Gas Co Ltd, and Jingcheng city Mingshi Coal Bed Methane
Exploitage Ltd. No amount was owed to these vendors at December 31, 2007. Except
for Shaanxi Natural Gas Co Ltd, the other two vendors have long-term agreements
with the Company without minimum purchase requirements. The Company has had
annual agreements with Shaanxi Natural Gas Co Ltd to purchase certain amount of
natural gas. For the year ended December 31, 2007, the minimum purchase was
12.93 million cubic meters. Contracts are renewed on an annual basis. The
Company’s management reports that it does not expect any issues or difficulty in
continuing to renew the supply contracts with these vendors going forward. Price
points for natural gas are strictly controlled by the government and have
remained stable over the past 3 years.




For the
year ended December 31, 2007, three suppliers accounted for 88.4% of the total
inventory purchased by the Company and for the year ended December 31, 2006, two
supplier accounts for 72.4% of the total inventory purchased by the
Company





For the
year ended December 31, 2007, two suppliers accounted for 41.02% of the total
equipment purchased by the Company and for the year ended December 31, 2006, two
suppliers accounted for 44.9% of the total equipment purchased by the
Company.





Four
customers accounted for 42.6% of the Company’s installation revenue for the year
ended December 31, 2007 and four customers accounted for 78.4% of the Company’s
installation revenue for the year ended December 31, 2006.





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




See
report of independent registered public accounting firm.


F-21


China
Natural Gas, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements


December
31, 2007




Note
9 – Commitments and Contingencies





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




Year
      ended December 31, 2008
                    
                    $
                    529,921Year
      ended December 31, 2009
                    
                    
                    532,236Year
      ended December 31, 2010
                    
                    
                    534,621Year
      ended December 31, 2011
                    
                    
                    531,874Year
      ended December 31, 2012
                    
                    
                    477,156Thereafter
                    
                    
                    2,665,256Total
                    
                    $
                    5,271,064




For the
year ended December 31, 2007 and 2006, the land use right and office lease
expenses were $433,755 and $60,289, respectively.





Note
10 – Subsequent Event





In
January 2008, the Company purchased an additional Compressor Station in
Xianyang, PRC, approximately 15 miles from Xi’an, PRC.





On
December 30, 2007, as previously reported, China Natural Gas, Inc. (the
“Company”) entered into a Securities Purchase Agreement with Abax Lotus Ltd.
(the “Investor”) which was subsequently amended on January 29, 2008 (as amended,
the “Purchase Agreement”). Pursuant to the Purchase Agreement the Company, among
other things, (i) agreed to issue to the Investor 5.00% Guaranteed Senior Notes
due 2014 (the “Senior Notes”) in aggregate principal amount of RMB 145,000,000
(approximately $20,000,000), (ii) granted the Investor an option to purchase up
to RMB145,000,000 (approximately $20,000,000) in aggregate principal amount of
its Senior Notes (the “First Option Notes”) if such option was exercised on or
before March 3, 2008 and subject to the Company meeting certain closing
conditions, and (iii) granted the Investor an option to purchase up to RMB
73,000,000 (approximately $10,000,000) in principal amount of its Senior Notes
within 30 days following the issuance of the First Option Notes, subject to the
Company meeting certain closing conditions.




On March
3, 2008, the Investor exercised its option to purchase the First Option Notes
for an additional RMB145,000,000 in aggregate principal amount of Senior Notes.
On March 10, 2008, the Company issued Senior Notes for an additional aggregate
principal amount of RMB145,000,000 (approximately $20,000,000) representing the
First Option Notes for total Senior Notes of RMB290,000,000 (approximately
$40,000,000).




See
report of independent registered public accounting firm.




F-22