UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





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


For the
fiscal year ended December 31, 2008





o
            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 oNo 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 oNo 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 xNo o





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. o




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





Large
      accelerated filer  o
              Accelerated
      filer  xNon-accelerated
      filer   o
              Smaller
      reporting company o





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act). Yes o 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 $139,612,648. 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




FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2007




INDEX




PagePART
      IITEM
      1.
                DESCRIPTION
      OF BUSINESS
                
                1ITEM
      1A
                RISK
      FACTORS
                
                9ITEM
      2.
                DESCRIPTION
      OF PROPERTY
                
                17ITEM
      3.
                LEGAL
      PROCEEDINGS
                
                18ITEM
      4.
                SUBMISSION
      OF MATTERS TO A VOTE OF SECURITYHOLDERS
                
                18PART
      IIITEM
      5.
                MARKET
      FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL
      BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES
                
                19ITEM
      6.
                SELECTED
      FINANCIAL DATA
                
                20ITEM
      7.
                MANAGEMENT'S
      DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
                
                21ITEM
      7A.
                QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
                
                30ITEM
      8.
                FINANCIAL
      STATEMENTS
                
                31ITEM
      9.
                CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE
                
                32ITEM
      9A(T).
                CONTROLS
      AND PROCEDURES
                
                32ITEM
      9B.
                OTHER
      INFORMATION
                
                36PART
      IIIITEM
      10.
                DIRECTORS,
      EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION
      16(a) OF THE EXCHANGE ACT
                
                36ITEM
      11.
                EXECUTIVE
      COMPENSATION
                
                39ITEM
      12.
                SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS
                
                41ITEM
      13.
                CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS
                
                42ITEM
      14.
                PRINCIPAL
      ACCOUNTANT FEES AND SERVICES
                
                42ITEM
      15.
                EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES
                
                43







STATEMENT
REGARDING FORWARD-LOOKING STATEMENTS




In this
annual report, references to "China Natural Gas," "CHNG," "the Company," "we,"
"us," and "our" refer to China Natural Gas, Inc.




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 or Plan of Operation," 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 proposed product line; 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 manufacture
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 US federal securities
laws or other applicable laws, we do not intend to update or revise any
forward-looking statements.





PART
I




ITEM
1. DESCRIPTION OF BUSINESS




Organizational
History





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





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





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


1





We
distribute and sell natural gas to commercial, industrial and residential
customers in the Xi’an area, including Lantian County and the Lintong and Baqiao
Districts, of Shaanxi province of The Peoples' Republic of China ("China" or the
"PRC") through a network of approximately 120 km of high pressure
pipelines.  We also distribute and sell CNG as vehicular fuel through a
network of CNG fueling stations in Shaanxi and Henan Provinces.  As of
December 31, 2008, we owned and operated 23 CNG fueling stations in Shaanxi
Province and 12 CNG fueling stations in Henan Province.





We
operate four primary business lines:




·
              Distribution and sale of
      compressed natural gas (CNG) through Company-owned CNG fueling stations
      for hybrid (natural gas/gasoline) powered vehicles (35 stations as of
      December 31, 2008);
  ·
              Installation, distribution and
      sale of piped natural gas to residential, commercial and industrial
      customers through Company-owned pipelines. The Company distributes and
      sells natural gas to approximately 96,033 homes and businesses as of
      December 31, 2008;
  ·
              Distribution and sale of gasoline
      through using Company-owned CNG fueling stations for hybrid(natural
      gas/gasoline) powered vehicles( 5 gasoline selling stations by December
      31, 2008), and
  ·
              Conversion of gasoline-fueled
      vehicles to hybrid (natural gas/gasoline) powered vehicles at our Auto
      Conversion Division.




We buy
all of the natural gas that we sell and distribute to our customers from
government owned enterprises and private sources. We do not mine or produce any
of our own natural gas and have no plans to do so during the next 12 months. The
natural gas that we buy is available in two forms: (i) piped natural gas; and
(ii) CNG. In 2008, the Company entered into multiple agreements to purchase
compressed natural gas of about 160,696,901 cubic meters.





Commitments
and Contingencies





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 flexibility to
constantly look for lower-cost source of natural gas supply. Therefore, the
Company is not legally bound in purchase commitments by those
agreements.





Our
Products, Services and Customers





Our
Pipeline Distribution System





We own
and operate a network of approximately 120 km of high pressure pipeline in the
Xi’an area. The network connects to a high pressure pipeline network of the
government operated 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 feed 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,
commercial and industrial customers in Lantian County and the Lintong and Baqiao
Districts. The spur also feeds our compressor station at Hongqing and Xianyan
where CNG is collected by tankers to supply CNG fueling stations.





Each of
our pipeline customers is physically connected to our pipeline network through
Company installed and maintained connection equipment and natural gas usage
monitoring systems, from which we generate additional revenues.


2





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





CNG
Fueling Stations





As of
December 31, 2008, we own and operate 23 CNG natural gas fueling stations in the
Xi’an metropolitan area and 12 natural gas fueling stations in Henan province.
Through these company-owned fueling stations, CNG is sold to taxis, buses and
private cars that operate on CNG technology. Currently, we purchase natural gas
for 1.22 RMB/cubic meter and sell each cubic meter for 2.35 RMB net of value
added taxes in Shannxi province.





We
continue expanding our CNG fueling station base by constructing new stations as
well as acquiring existing stations. We can construct a CNG fueling station in
approximately 60 days for a cost of approximately US$900,000. We are evaluating
additional sites for CNG fueling stations in Xi’an and in other regions such as
Henan province.





The
Company also owns three compressor stations: two located in Xi’an: Hongqing
station, acquired in July 2005, near our pipeline; Changsheng station, acquired
in September 2008; and the other one in Xianyang city, acquired in January 2008.
A compressor station compresses natural gas and allows trucks to transport CNG
to fueling stations. The Company currently has the daily processing capacity of
250,000 cubic meters of CNG.





Our
Liquefied Natural Gas (LNG) Project





During
2008, we made significant progress to move into the processing, distribution and
sale of LNG. The Company spent about $20 million in the LNG project during 2008,
including technology licensing fees, prepayment of equipment purchases, land
requisition, and other constructions. We plan to raise the remaining $20 million
investment from our cash reverve, internal operating cash flow, prepayments from
our customers, and credit facility from Chinese commercial banks. We believe
that adding LNG to our product offerings will expand our geographic sales
footprint and improve revenues and profitability. The facility construction work
is expected to be completed around June, 2009, and processing equipment
installation and testing will be finished by October, 2009. So far the project
is on schedule for commercial operation towards the end of 2009.





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 times atmospheric pressure and can be transported at
normal temperatures to distances of up to 300 kilometers. LNG is compressed at
up to 625 times atmospheric pressure and must be transported at sub-zero degree
temperatures. The cost of compressing and processing LNG is higher than those of
CNG, but LNG can be transported over longer distance and per unit transportation
costs are therefore lower.





In
September 2007 we have started 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 $40 million (RMB 309
million). As of March 10, 2008, we have secured such financing and we believe
that the plant can be completed by 2009. We have obtained the required permits
and approvals to build the LNG plant from local government
authorities.





The
approval process for LNG plant construction of this type is lengthy and
arduous—a factor which we believe is a significant barrier to entry to potential
competitors and which better positions our company for long-term growth. This
project also allows us to diversify our business and focus on two high-growth
areas: CNG fueling station business and LNG production, distribution, and sale.
We believe that the PRC's clean energy policies will bolster demand for natural
gas in China and we have government support to be a leader in this
area.


3





Our
CNG Market





We
estimate that currently there areapproximately 50,000
vehicles using CNG in the Xi’an area. Currently it is estimated that there are
6,000 buses and 20,000 taxis using CNG in Xi’an. Each bus uses an average of 100
cubic meters of CNG per day and taxis use an average of 40 cubic meters of CNG
per day (Source: Xi’an Clean Fuel Vehicles Commission 2007) 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 is approximately 1,070,000 cubic
meters per day. Compared to gasoline and diesel, 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 pumps approximately 15,000 cubic
meters of CNG per day. In the end of 2008, there were 64 CNG fueling stations in
Xi’an. We estimate that approximately 940,500 cubic meters of CNG is pumped per
day during the year, a figure well below estimated total demand. As a result, we
believe that there is significant unmet demand for CNG as vehicular fuel in the
Xi’an area that provides us great opportunities for profit and
growth.





We
believe that our vertically integrated operations, proprietary pipeline and
secured supply contracts give us greater access to CNG supplies and customers
and a unique competitive position as a major supplier of CNG vehicular fuel in
the Xi’an area.





Our
Pipeline Network Customers





As of
December 31, 2008 we had approximately 96,033 customers, including residential,
industrial and commercial customers. We are continuing to expand our customer
base in Xi’an's newly developed business and residential areas including Xihan
and Chanliu. Our industrial 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.





The
Company entered into agreements with Xi’an International Port Administrative
Committee and the Town of Tangyu in April and October 2008, respectively, to
provide natural gas to local residents and businesses on an exclusive basis. 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 of this well-known tourist
attraction.





Our
Subsidiaries and Variable Interest Entities





On
October 24, 2006, Xi’an Xilan Natural Gas formed a wholly-owned subsidiary,
Shaanxi Jingbian Liquefied Natural Gas Co., Ltd., a limited liability company
organized under the laws of the PRC to administer the production and sales of
LNG.





In 2006,
Xi’an Xilan Natural Gas, through its wholly-owned subsidiary, Shaanxi Jingbian
Liquefied Natural Gas Co., Ltd, received a letter from PetroChina Company
Limited pursuant to which PetroChina agreed in principle, subject to the
negotiation and execution of a final contract, to supply up to 150,000,000 cubic
meters of natural gas annually upon the completion of our LNG
project.


4





In 2006,
we formed a wholly-owned subsidiary, Xi’an Xilan Natural Gas Equipment Ltd., a
limited liability company organized under the laws of the PRC (“Xilan
Equipment”), to provide equipment to our own CNG fueling stations.





Effective
March 8, 2006, we also established a variable interest entity, Xi’an Xilan
Natural Gas by entering into exclusive arrangement with Xi’an Xilan Natural Gas
through our subsidiary Xilan Equipment. Pursuant to the exclusive arrangement,
the Company, through Xilan Equipment, has the ability to substantially influence
Xi’an Xilan Natural Gas’ daily operations and financial affairs, appoint its
senior executives and approve all matters requiring shareholder approval. As a
result, based on FASB Interpretation No. 46R, Consolidation of Variable Interest
Entities, the Company is able to treat Xi’an Xilan Natural Gas as a variable
interest entity of the Company and consolidate its financial
results.




In May
2007, Xi’an Xilan Natural Gas formed a wholly-owned subsidiary, Xi’an Xilan Auto
Body Shop.





In
December 2008, we completed 100% acquisition of Henan Lingbao Yuxi Natural Gas
Limited which owns exclusive operation right to supply natural gas to the city
of Lingbao for residential, industrial, commercial and vehecular uses. According
to the official website of Lingbao Municipal Government (www.lbwbw.com), the
City has a total population of about 800,000 among which 200,000 are urban
residents and 600,000 are countryside residents. There are about 80,000 urban
households, and an estimated annual consumption of natural gas of 20,000,000
cubic meters.




Suppliers





The
Company purchases all of the natural gas for resale mainly from four vendors,
PetroChina Changqing Oilfield Company, Jiyuan Yuhai Natural Company, Shaanxi
Natural Gas Co. Ltd., and Jingcheng City Mingshi Coal Bed Methane Exploitage
Ltd. The Company has long-term supply agreements with PetroChina Changqing
Oilfield Company and Jingcheng City Mingshi Coal Bed Methane Exploitage Ltd.
with no minimum purchase requirements. The price of natural gas is strictly
controlled by the government and has remained stable over the past 3
years.





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 subsidiary subject to the negotiation of a final
agreement once our LNG plant is built.





According
to the general business practices of PetroChina, the above-mentioned approval of
150 million cubic meters’ annual supply quota should ensure our LNG project the
amount of annual supply from PetroChina’s wholly-owned subsidiary Changqing Oil
Field Group Limited which has a 14 billion-cubic-meter natural gas purification
facility next door to our LNG project. The supply agreement for 2009 will be
based on our LNG plant’s expected processing capability for this year and will
be entered between the company and Changqing Oil Field Group Limited around
third quarter of this year because once the supply amount is stipulated in the
agreement, the company would need to pay full fee for the amount no matter we
could use them or not.





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





PRC
Natural Gas Industry Overview





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 12.8% between 2002 and
2006 and slowed down slightly to 10.8% between 2006-2008 due to Chinese
government’s national policy of “saving energy and reducing emission”. During
the same period, natural gas consumption grows at 13.3% annually. Natural gas
currently accounts for only 3% of the country’s total energy usage, compared to
the world average 23%.


5





According
to China’s Ministry of Science & Technology and World Petrolium Council’s
China Committee’s 2009 report, for the next 20 years, China’s energy consumption
elasticity index remains at 0.45-0.50, among which coal is 0.30, petrolium is
0.50, natural gas is 1.4-1.5, and non-renewable electricity is 0.50-0.60.
China’s natural gas represents the fastest-growing energy source. With the
operation of China’s West-East Natural Gas Pipeline” project, it is estimated
that China’s natural gas consumption grows at 15% per year and will reach a
volume of 100 billion cubic meters in 2010, representing 400%-500% growth over
2000.





China’s
11th
Five-Year Plan (2006-2010) has made the development of natural gas engine for
heavy-load trucks as a national key development project, demonstrating Chinese
central government’s decision to reply 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 sectors to get involved
into industries that were previously monopolized by state-owned enterprises
only. Those industries open to private sectors include oil and natural gas
distribution.  The opinion provided a legal framework for private
urban natural gas distribution.





Sources
of Energy





Traditionally,
the PRC has relied heavily on coal and crude oil as its primary energy sources.
According to China Statistical Yearbook, in 2006, coal, crude oil,
hydro-electricity and natural gas accounted for 69.40%, 20.40%, 7.20% and 3.00%,
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 would go down to 66.1%, 20.5% and 6.8% respectively, while
that of natural gas would 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).




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)). In many
locations where natural gas supply is available, local governments often require
all new residential buildings to install piped gas connections as a condition to
the issuance of the construction or occupancy permits. 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
abounds in rich natural gas reserves, which are distributed among Xinjiang,
Sichuan, and Shaanxi Provinces, as well as Inner Mongolia. China’s Ministry of
Science & Technology and World Petrolium Council’s 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 relevant forecast, 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).


6


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 9 provinces on Chinese mainland, started
operation in December 2004, and has significantly optimized the energy
infrastructure of China. The natural gas pipeline presented great business
opportunity for natural gas distributors at the major junctures, such as Shaanxi
province.





Demand
for Natural Gas





Currently,
natural gas consumption in the PRC accounts for less than 3% of its total energy
consumption. However, driven by environmental pressures, improvements in social
infrastructure fueled by economic growth, and a stable energy supply, it is
anticipated that the use of natural gas will grow very rapidly in the PRC over
the next 20 years.





According
to China’s National Natural Gas Overall Plan by the State Council, the number of
cities pipelined with natural gas would increase from 140 in 2005 to 270 in 2010
and by the middle of the 21st
century, 70% of all the cities in China would be pipelined. Annual natural gas
output will crease from currently 70 billion cubic meters to 120 billion – 150
billion cubic meters by 2020. According to IFA’s forecast, natural gas will be
the fastest-growing energy in the 21st
century. Its consumption will exceed petrolium by the middle of the century,
accounting for 51% of the world’s energy consumption and thus becoming the real
“first energy” of the world.





Intellectual
Property





We have
applied for a service mark on the “Xilan” name, which is used in connection with
all our products and services.





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 comply with 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 November 25, 2008 to February 28, 2010.(License number
      XR157)





·
            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)


7





·
            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 Xilan
      Liquified Natural Gas effective from October 24, 2006 to October 23,
      2036.





·
            Business license to operate Xi’an
      Xilan Auto Bodyshop effective as of May 15,
  2007.





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




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.





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) are principally
engaged in the upstream supply of energy and are material competitors in the
exploration and transportation of oil and gas. They build much of the country's
high-pressure pipeline infrastructure. Natural gas is distributed to smaller
regional firms that redistribute the gas to the end user, either through lower
pressure pipeline networks, or via tankers in the form of liquid natural gas
(LNG).





With
respect to our pipeline gas services in Xi’an, the Company and its competitors
each serves a designated city area by local government on a exclusive basis,
therefore there is no direct compeittion in our pipeline gas services. Other
pipeline gas service provider in the city of Xi’an include Qin Hua Natural Gas
Limited





With
respect to our CNG fueling station market, currently, there are approximately 64
CNG fueling stations in Xi’an City. Among those 64, 15 of these stations are
state owned enterprises, and the other 28 stations are privately owned 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 LNG business, our major competitor is Xinjiang Guanghui LNG
Development Limited. It is located in China’s Xinjiang Uygur Autonamous Region
and has an annual capacity around 300 million cubic meters. Both the Company and
the competitor’s major target market for the LNG busness is South China’s
economically-developed Guangdong Province and its surrounding regions. However,
the distance to the target market for our LNG business is only one third of our
competitors’, thus giving us significant cost advantage in
transportation.


8





Employees




Currently,
we have 710 employees, including, 50 in management; 150 in sales, and 510 in
finance, accounting, and operations. We have not experienced any industrial
actions and we have excellent relationships with our employees. We are not a
party to any collective bargaining agreements.








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.





Available
Information





We file
quarterly and annual reports, proxy statements and other information with the
SEC. You may 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 is speculative and involves a high degree of risk
and uncertainty. You should carefully consider the risks described below,
together with the other information contained in this 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





Prices
of natural gas can be subject to significant fluctuations, which may affect our
ability to provide supplies to our customers.





We obtain
most of our supplies of natural gas from a government owned entity and our
supply contracts are subject to review every six months. However, our costs for
natural gas are strictly controlled by the government and have remained stable
over the past 3 years. Management does not expect any difficulty in continuing
to renew the supply contracts during the next 12 months. The price of natural
gas can fluctuate in response to changing national or international market
forces. Accordingly, price levels of natural gas may rise or fall significantly
over the short to medium term due to political events, OPEC actions and other
factors, industry economics over the long term.


9


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





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





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





If in the
future, we are not capable of generating sufficient revenues from operations and
our capital resources are insufficient to meet future requirements, we may have
to raise funds to continue the development, commercialization and marketing of
our business.





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





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





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





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 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 it considers reasonable. To date,
however, we have maintained adequate coverage at reasonable rates and have
experienced no material uninsured losses.





Changes
in the regulatory atmosphere could adversely affect our business.





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




10




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





We are
dependent on the continued efforts of our senior management team. If, for any
reason, our senior executives do not continue to be active in management, our
business, or the financial condition of our Company, our results of operations
could be adversely affected. In addition, we do not maintain life insurance on
our senior executives and other key employees.





Risks
Related to the People’s Republic of China





China’s
economic policies could affect our business.





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





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





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





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





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


11





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





The value
of the RMB fluctuates and is subject to changes in the People's Republic of
China political and economic conditions. Since July 2005, the conversion of RMB
into foreign currencies, including USD, has been based on rates set by the
People's Bank of China which are set based upon the interbank foreign exchange
market rates and current exchange rates of a basket of currencies on the world
financial markets. As of December 31, 2008, the exchange rate between the RMB
and the United States dollar was 6.82 RMB to every one USD.





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





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





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





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





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





We are a
holding company, and all of our assets are located in the Republic of China. In
addition, 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 Republic of China would
enforce:





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





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




12




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




The PRC
legal system is a civil law system based on written statutes. Unlike common law
systems, decided legal cases have little precedence. In 1979, the PRC government
began to promulgate a comprehensive system of laws and regulations governing
economic matters in general. The overall effect of legislation over the past 27
years has significantly enhanced the protections afforded to various forms of
foreign investment in China. Each of our PRC operating subsidiaries and
affiliates is subject to PRC laws and regulations. However, these laws and
regulations change frequently and the interpretation and enforcement involve
uncertainties. For instance, we may have to resort to administrative and court
proceedings to enforce the legal protection that we are entitled to by law or
contract. However, since PRC administrative and court authorities have
significant discretion in interpreting statutory and contractual terms, it may
be difficult to evaluate the outcome of administrative court proceedings and the
level of law enforcement that we would receive in more developed legal systems.
Such uncertainties, including the inability to enforce our contracts, could
affect our business and operation. In addition, intellectual property rights and
confidentiality protections in China may not be as effective as in the United
States or other countries. Accordingly, we cannot predict the effect of future
developments in the PRC legal system, particularly with regard to the industries
in which we operate, including the promulgation of new laws. This may include
changes to existing laws or the interpretation or enforcement thereof, or the
preemption of local regulations by national laws. These uncertainties could
limit the availability of law enforcement, including our ability to enforce our
agreements with the government entities and other foreign
investors.




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





Provincial
and central government authorities regulate the natural gas industry for safety
and ensure that all areas receive natural gas service. However, as a result of
China becoming a member of the World Trade Organization (WTO), restrictions on
foreign investment in the industry may be reduced. With China's need to meet
growth in natural gas demand and the WTO's requirement for a reduction of
restrictions on foreign investment as a condition of membership, such events
could lead to increased competition in the natural gas industry.





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, Xi’an Xilan Natural Gas, and its
shareholders. We are considered a foreign person or foreign invested enterprise
under PRC law. As a result, we are subject to PRC law limitations on foreign
ownership of Chinese companies. These laws and regulations are relatively new
and may be subject to change, and their official interpretation and enforcement
may involve substantial uncertainty. The effectiveness of newly enacted laws,
regulations or amendments may be delayed, resulting in detrimental reliance by
foreign investors. New laws and regulations that affect existing and proposed
future businesses may also be applied retroactively.




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




13




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




The PRC government regulates the
natural gas industry including foreign ownership of, and the licensing and
permit requirements pertaining to, companies in the natural gas industry. These
laws and regulations are relatively new and evolving, and their interpretation
and enforcement involve significant uncertainty. As a result, in certain
circumstances it may be difficult to determine what actions or omissions may be
deemed to be a violation of applicable laws and regulations. Issues, risks and
uncertainties relating to PRC government regulation of the bio-pharmaceutical
industry include the following:





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





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





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




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





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





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





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




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




14




Risks
Related to Corporate and Stock Matters





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





At
December 31, 2008, Mr. Qinan Ji, our founder, Chairman of the Board and Chief
Executive Officer and our largest stockholder, beneficially owned approximately
20.3% of our outstanding shares of common stock. As a result, pursuant to our
Bylaws and applicable laws and regulations, our controlling shareholder and our
other executive officers and directors are able to exercise significant
influence over our Company, including, but not limited to, any stockholder
approvals for the election of our directors and, indirectly, the selection of
our senior management, the amount of dividend payments, if any, our annual
budget, increases or decreases in our share capital, new securities issuance,
mergers and acquisitions and any amendments to our Bylaws. Furthermore, this
concentration of ownership may delay or prevent a change of control or
discourage a potential acquirer from making a tender offer or otherwise
attempting to obtain control of us, which could decrease the market price of our
shares. The limited prior public market and trading market may cause volatility
in the market price of our common stock.





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:




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





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




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





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





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




15




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





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





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





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





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





If
we fail to maintain an effective system of internal controls, we may not be able
to accurately report our financial results. As a result, current and potential
stockholders could lose confidence in our financial reporting, which would harm
our business and the trading price of our stock.





As a
public company, we are subject to report our internal control structure and
procedures for financial reporting in our annual reports on Form 10-K, as a
requirement of Section 404 of the U.S. Sarbanes-Oxley Act of 2002 by the U.S.
Securities and Exchange Commission (the "SEC"). The report must contain an
assessment by management about the effectiveness of our internal controls over
financial reporting. Moreover, the independent registered public accountants of
our Company must attest to and report on management's assessment of the
same.




16




Our
management and our independent registered public accountants concluded that our
internal controls over our financial reporting are not effective, as required by
Section 404 of the U.S. Sarbanes-Oxley Act, for the fiscal year ending December
31, 2008, as such, our independent registered public accountants has issued a
report on our internal control measures that is adverse. The Company’s
management has identified the steps necessary to address the material weakness
and has begun to execute remediation plans, as discussed in “Item 9A(T).
Controls and Procedures” of this Report.





Any
failure to implement and maintain the improvements in the controls over our
financial reporting, or difficulties encountered in the implementation of these
improvements in our controls, could cause us to fail to meet our reporting
obligations. Any failure to improve our internal controls to address these
identified weaknesses could also cause investors to lose confidence in our
reported financial information, which could have a negative impact on the
trading price of our stock.





Stockholders
should have no expectation of any dividends.





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




ITEM
2. DESCRIPTION OF PROPERTY




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.




On
October 24, 2006, we formed our 100% owned subsidiary, Xilan 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.





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 Yuxi Natural Gas Co., Ltd, Changan Rd. W, Lingbao, Henan Province,
with annual rent of approximately $3,314.





In May
27, 2008, the Company purchased a 412.10-square-meter properties in Zhengzhou,
Henan Province  and uses it as office spaces for the local operations
in Henan Province.


17





In
August, 2008, the Company purchased a 531.72-square-meter properties in Beijing
and uses it as office spaces for local operations in Beijing. Therefore, the
Company doesn’t incur any rent for Henan and Beijing Offices.





As of
December 31, 2008, the Company owned 2 trucks and 33 tankers that the Company
used to transport natural gas.





Insurance




The
Company carries auto insurance on its vehicles and maintains workers
compensation insurance for its fueling station workers. The Company believes
this insurance is adequate for its needs. The Company does not carry any product
liability insurance or property insurance on its office buildings 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.





The
Company also carries directors and officers liability insurance with XL
Insurance Company Ltd. with aggregate limit of liability $15 million to cover
its 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 Oct
15th, 2009
and is renewed annually.





ITEM
3. LEGAL PROCEEDINGS




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




ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS




None.




18


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.


19





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 doesn’t
affect 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.





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
                          
                          
                          
                          34,747Construction
      / 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
                          )Other
      income (expense)
                          
                          
                          111,859
                          
                          
                          
                          (118,753
                          )
                          
                          
                          (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
                          
                          
                          
                          5,541,095
                          
                          
                          
                          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
                          
                          
                          4,989,447
                          
                          
                          
                          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
                          
                          
                          71,648,420
                          
                          
                          
                          51,207,314
                          
                          
                          
                          25,630,204
                          
                          
                          
                          9,675,550
                          
                          
                          
                          (133,511
                          )




20





ITEM
7. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION




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.




21


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





Overview





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





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





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





We
transport, distribute and sell natural gas to commercial, industrial and
residential customers in the Xi’an area, including Lantian County and the
districts of Lintong and Baqiao, in the Shaanxi Province of The Peoples'
Republic of China ("China" or the "PRC") through a network of high pressure
pipelines. We also distribute and sell natural gas through a network of
approximately 120 km pipeline in Xi’an, Shaanxi Province. During the year of
2008, the pipeline’s average daily throughput capacity is 31,347 cubic meters,
comparing to approximately 20,565 cubic meters in the year of 2007. As of
December 31, 2008, we own and operate 23 CNG fueling stations in Shaanxi
Province and 12 CNG fueling stations in Henan Province. During the year of 2008,
we had sold compressed natural gas of 149,412,143 cubic meters through our
fueling stations, comparing to 84,744,620 cubic meters in the year of
2007.





We
operate four primary business lines:





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





·
            Installation, distribution and
      sale of piped natural gas to residential, commercial and industrial
      customers through Company-owned pipelines. The Company distributes and
      sells natural gas to approximately 96,033 homes and businesses as of
      December 31, 2008;





·
            Distribution and sale of gasoline
      through using Company-owned CNG fueling stations for hybrid(natural
      gas/gasoline) powered vehicles( 5 gasoline selling stations by December
      31, 2008), and




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




22





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





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




Critical
Accounting Policies





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





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





The
Company maintains reserves for potential credit losses on accounts receivable.
Management reviews the composition of accounts receivable and analyzes
historical bad debts, customer concentrations, customer credit worthiness,
current economic trends and changes in customer payment patterns to evaluate the
adequacy of these reserves. Reserves are recorded primarily on a specific
identification basis. The Company’s management determined that all receivables
are good and there is no need for a bad debt reserve as of December 31,
2008.





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





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




Fair
Value of Financial Instruments





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 disclosures of fair value
measurement and enhances disclosures requirements for fair value measures. The
carrying amounts reported in the balance sheets for receivables and current
liabilities each qualify as financial instruments and are a reasonable estimate
of fair value because of the short period of time between the origination of
such instruments and their expected realization and their current market rate of
interest.  The three levels are defined as follow:


23




·
              Level
      1inputs
      to the valuation methodology are quoted prices (unadjusted) for identical
      assets or liabilities in active
markets.
  ·
              Level
      2inputs
      to the valuation methodology include quoted prices for similar assets and
      liabilities in active markets, and inputs that are observable for the
      asset or liability, either directly or indirectly, for substantially the
      full term of the financial
instrument.
  ·
              Level
      3inputs
      to the valuation methodology are unobservable and significant to the fair
      value measurement.


The
Company analyzes all financial instruments with features of both liabilities and
equity under SFAS 150, “Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity,” SFAS 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.





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





Segment
Report.The Company’s chief operating decision-makers (i.e.
chief executive officer and his direct reports) review financial information
presented on a consolidated basis, accompanied by disaggregated information
about revenues by business lines for purposes of allocating resources and
evaluating financial performance. There are no segment managers who are held
accountable for operations, operating results and plans for levels or components
below the consolidated unit level. Based on qualitative and quantitative
criteria established by SFAS No. 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.





CONSOLIDATED
RESULTS OF OPERATIONS





Comparing
Fiscal Years Ended December 31, 2008 and 2007:





The
following table presents certain consolidated statement of operations
information. Financial information is presented for the 12-month period ending
December 31, 2008 and December 31, 2007.


24




2008
                
                
                2007Revenues
                
                $
                67,720,659
                
                
                $
                35,392,053Cost
      of Revenues
                
                $
                34,981,637
                
                
                $
                18,025,075Operating
      Expenses
                
                $
                11,676,830
                
                
                $
                6,288,929Income
      from Operations
                
                $
                21,062,192
                
                
                $
                11,078,049Net
      Income
                
                $
                15,190,368
                
                
                $
                9,116,070




Revenue.
We generated approximately 89.14% of our revenues in 2008 from the sale of
natural gas and gasoline as well as approximately 10.86% of our revenues from
installation fees charged to connect end-user customers to our natural gas
distribution system. Sales of natural gas at the Company-owned fueling stations
accounted for approximately 78.78% of our total revenues in 2008, or
approximately $53,348,301 which was the largest contribution of our three
business lines. Sales of natural gas to end-user customers connected to our
pipeline distribution system accounted for approximately 3.70% of our total
revenues in 2008, or approximately $2,505,485. Sale of gasoline accounts for
approximately 6.82% of the Company’s total revenue, or approximately $4,616,052.
Installation fees charged to end users accounts approximately 7.10% of the
Company’s total revenue, or approximately $4,810,107.





The
Company started selling gasoline at its CNG filling stations in late 2007 to
better cater the diverse needs of vehicle owners. However, natural gas still
remains the Company’s focus and we expect natural gas revenues continue to
increase on both an actual basis and as a percentage of revenue. In 2009, the
Company expects to add up to 13,000 pipeline customers and construct or acquire
an additional 5 fueling stations, which the Company estimates will increase
sales of natural gas by 5 million cubic meters.




We had
total revenues of $ 67,720,659 for the twelve months ended December 31, 2008, an
increase of $32,328,606 or approximately 91.34%, compared to $ 35,392,053 for
the twelve months ended on December 31, 2007. The increase in revenues was due
primarily to the addition of 11 new company-owned fueling stations during 2008
as well as an increase in the number of residential, commercial and industrial
pipeline customers from approximately 84,500 in 2007 to approximately 96,033 in
2008.




New
pipeline customers pay approximately 60% of the installation costs to connect to
our pipeline system up front and the balance is payable as part of their monthly
natural gas bill. During 2008, our installation revenues increased 3.99% over
the previous year and our sales of natural gas increased approximately 97.14%
over the previous year. Four customers accounted for approximately 13.37%,
12.81%, 10.98% and 9.91% of the Company's installation revenue for the year
ended December 31, 2008.




During
the year of 2008, we had sold compressed natural gas of 149,412,143 cubic
meters, compared to 84,744,620 cubic meters in the same period of 2007, through
Company-owned fueling stations. In terms of average station sales value and
volume, in the year of 2008, we had sold approximately $1,524,237 and 4,268,918
cubic meters of compressed natural gas per station, compared to approximately
$1,500,000 and 4,760,000 cubic meters in the same period of 2007. The
decline in per station sales volume is mainly due to the 11 newly added stations
didn’t contribute full-year in revenue due to construction and tune-ups. As for
our natural gas pipeline business, in the year of 2008, we had sold
11,284,758 cubic meters, compared to 7,403,314 cubic meters in the same
period of 2007 through our pipeline network.




Cost of
Sales. Our cost of sales consists of the cost of natural gas and gasoline sales
as well as the cost of installation. Cost of natural gas and gasoline sales
consists primarily of the cost that we pay for our suppliers, together with
transportation costs and depreciation of equipment. Cost of connection includes
certain installation costs related to connecting customers to our pipeline
system that are generally expensed when incurred.


25


Cost of
sales in 2008 was $34,981,637, an increase of $16,956,562 or approximately
94.07% from 2007. Cost of natural gas sales increased by approximately 83.53% to
$27,234,508 in 2008, as compared with $14,838,997 in 2007. The increase in our
cost of sales was primarily related to a material increase in the amount of gas
sold and the price that we paid to our suppliers in 2008. In addition, our
installation costs increased in 2008 by 10.10% to $3,469,671, as compared with
$3,151,331 in 2007 as a result of the addition of new pipeline customers. The
price that we paid for natural gas in 2008 remained relatively constant compared
to 2007. We had sold natural gas of 160,696,901 cubic meters in 2008, compared
to 92,147,935 cubic meters in 2007.




We purchase all of our natural gas for
resale mainly from four vendors, PetroChina Changqing Oilfield Company, Shaanxi
Natural Gas Co Ltd, Jingcheng city Mingshi Coal Bed Methane Exploitage Ltd and
Jiyuan Yuhai Fuel Gas Company. As the government owns all land in China, the
government controls and owns all the natural resources coming from the ground,
thus the government controls the price and flow of the natural gas. Due to the
soaring crude oil price and ever increasing demand for energy consumption, the
National Development and Reform Commission, which regulates the energy price in
China, adjusted the upstream natural gas price for industrial users and
vehicular CNG distributors upward by ¥0.4/CM, or 35% in November 2007. The
retail price for vehicular CNG was adjusted upward at a ratio of 0.75:1 to the
retail price of #90 gasoline in November 2007. Many large cities see dramatic
increase in retail vehicular CNG price, for example 66% in Shanghai and 21%
(taxi) and 38% (bus) in Tianjin(Sources:www.qq.comnew on November 14, 2007 andwww.tj.gov.cnon December 4, 2007) . However,
natural gas price for residential customers is not adjusted to keep the rate at
an affordable level. As China shifts from a centrally planned economy to a
market economy, we believe it is the government's intention to keep the prices
stable, and maintain an unfluctuaging supply situation. The government has also
undertaken programs to promote the economy growth of the region in which we are
located. Therefore, we expect supply and price to continue to be stable in the
future.





Gross
profit. The Company earned a gross profit of $32,739,022 for the twelve months
ended December 31, 2008, an increase of $15,372,044 or 88.51%, compared to
$17,366,978 for the twelve months ended December 31, 2007. The increase in gross
profit is due to a material increase in natural gas sales and installation
revenues in 2008, partially offset by an increase in cost of sales.




Gross
margin. Gross margin for natural gas sold through our filling stations as well
as our pipeline increased from 47.52% in twelve months ended December 31, 2007
to 51.15% in twelve months ended December 31, 2008 due to lower natural gas
procuring cost in Henan Province. Gross margin for our installation business is
52.84% in 2008 as compared to 55.46% in 2007, and for our auto conversion
business 39.74% in 2008 as compared to 39.53% in 2008, both remained roughly
flat. Due to increasing weight of gasoline revenue during 2008 (6.82% in 2008 as
compared to less than 0.5% in 2007), the total gross margin decreased slightly
from 49.07% for year 2007 to 48.34% for year 2008. We started sell gasoline in
our CNG stations as a supplement of natural gas to attract more natural gas /
gasoline hybrid car owners and natural gas remains the Company’s
focus.





Operating
expenses. The Company incurred operating expenses of $11,676,830 for the twelve
months ended December 31, 2008, an increase of $5,387,901 or 85.67%, compared to
$6,288,929 for the twelve months ended December 31, 2007. Our operating expenses
increased primarily as a result of expenses related to the construction,
acquisition, and operation of 11 new fueling stations in 2008, as well as
continuing expenses related to the identification of possible locations for
additional fueling stations and the governmental licensing and approval process,
as well as the evaluation of existing natural gas fueling stations as potential
acquisition targets. In addition, sales and marketing costs increased in 2008 as
we increased our efforts to obtain new residential and commercial customers and
attract customers to our fueling stations. General and administrative expenses
increased from $2,837,768 in 2007 to $4,024,882 in 2008 due to an increase in
personnel as a result of our growth. The opening cost per station during the
twelve months ended December 31, 2008 is approximately $1,200,000, compared to
approximately $900,000 in the year of 2007. In 2008, the transportation cost per
million cubic meters is approximately $3,137.




For the
year ended December 31, 2008, three suppliers accounted for 46.69%, 21.96% and
20.04% of the total equipment we purchased for construction activities. We
believe that as a result of our relationships within the construction industry
and the construction equipment vendor community, and the availability of other
vendors to supply the construction equipment and materials, the loss of any one
of these three vendors would not have a material adverse effect on our
operations.


26




Net
Income. Net income increased 66.63% to $15,190,368 for the twelve months ended
December 31, 2008, an increase of $6,074,298, from $9,116,070 for the twelve
months ended December 31, 2007. Increase in net income is attributed to our
material increase in revenues, partially offset by a higher cost of sales and
operating expenses, as well as the non cash expense related to the amortization
of offering cost associated with the $40 million senior notes issued to Abax
Lotus, Ltd. in 2008. The company expects revenue from our CNG fueling stations
to increase on both an actual basis and as a percentage of revenue. In 2009, the
Company expects to add up to 13,000 pipeline customers and construct or acquire
an additional 5 fueling stations, which the Company estimates will increase
sales of natural gas by 5 million cubic meters.




Income
tax was $3,567,642 for the twelve months ended December 31, 2008, as compared to
$1,913,923 for the twelve months ended December 31, 2007. The increase in income
tax was attributed to the growth of installation fees and the sale of
natural gas.




Liquidity
and Capital Resources




As of
December 31, 2008 the Company had $5,854,383 of cash and cash equivalents on
hand compared to $13,291,729 of cash and cash equivalents as of December 31,
2007.




The
primary sources of cash in 2008 were income from operations and financing
activities. The Company had net cash flows provided by operations of $20,916,801
for the twelve months ended December 31, 2008 as compared to net cash provided
by operations of $10,476,441 in the corresponding period last year. The increase
in net cash flows from operations in 2008 as compared to 2007 was mainly due to
the increase in net income, adjusted for non-cash expense items and changes in
working capital.




On
January 29, 2007, we completed a private placement offering by issuing senior
notes, which generated net proceeds of $37,877,491, which were used for the
construction of natural gas fueling stations, liquefied natural gas facility as
well as working capital.




Cash
outflows for investing activities increased from $16,885,340 in 2007 to
$67,606,724 in 2008 due to the equipment purchased in LBNGC and
fueling stations, payments made to equipment suppliers for investments necessary
to construct fueling stations, and the liquefied natural gas
facility.




The
Company expects to construct or acquire an additional 5 CNG filing stations in
2009. The Company expects the funds for these investing activities will come
from the Company's operating cash flow.




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




The
majority of the Company's revenues and expenses were denominated primarily in
Renminbi ("RMB"), the currency of the People's Republic of China. There is no
assurance that exchange rates between the RMB and the U.S. Dollar will remain
stable. The Company does not engage in currency hedging. Inflation has not had a
material impact on the Company's business.




27





Off-Balance
Sheet Arrangements and Contractual Obligations




We
entered into series of long term lease agreements with outside parties to lease
land use right to the self-built natural gas fueling stations located in the
PRC, and please refer to footnote "Commitments and Contingencies" to the
financial statements for details. We have purchase agreements with several
natural gas suppliers and please see footnote "Current Vulnerability Due to
Certain Concentrations" for more explanations. We do not have any other
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.





Foreign
Currency Transactions and Comprehensive Income (Loss)




Accounting
principles generally require that recognized revenue, expenses, gains and losses
be included in net income. Certain statements, however, require entities to
report specific changes in assets and liabilities, such as gain or loss on
foreign currency translation, as a separate component of the equity section of
the balance sheet. Such items, along with net income, are components of
comprehensive income. Our transactions occur in Chinese Renminbi. The unit of
Renminbi is in Yuan.




RECENT
ACCOUNTING PRONOUNCEMENTS




In
September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements". The
objective of SFAS In February 2007, the FASB issued SFAS No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities—including an amendment of
FASB Statement No. 115 (“FAS 159”). FAS 159 permits companies to choose to
measure many financial instruments and certain other items at fair value that
are not currently required to be measured at fair value. The objective of FAS
159 is to provide opportunities to mitigate volatility in reported earnings
caused by measuring related assets and liabilities differently without having to
apply hedge accounting provisions. FAS 159 also establishes presentation and
disclosure requirements designed to facilitate comparisons between companies
that choose different measurement attributes for similar types of assets and
liabilities. The Company adopted SFAS No. 159 on January 1, 2008. The Company
chose not to elect the option to measure the fair value of eligible financial
assets and liabilities.





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





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


28





In
February 2008, the FASB issued FASB Staff Position (FSP)
No. FAS 140-3, “Accounting for Transfers of Financial Assets and
Repurchase Financing Transactions.” FSP No. 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 No. 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 firm does not expect adoption of
FSP No. FAS 140-3 to have a material effect on its financial
condition and cash flows. Adoption of FSP No. FAS 140-3 will have
no effect on the Company’s results of operations.





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





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





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





In
June 2008, the FASB issued FSP No. 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 No. 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 No.
EITF 03-6-1 to have a material effect on its results of operations or
earnings per share.


29





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





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





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





Interest Rate
Risk


We
are subject to interest rate risk on our long-term fixed-interest rate debt.
Fixed rate debt, where the interest rate is fixed over the life of the
instrument, exposes us to changes in market interest rates reflected in the fair
value of the debt and to the risk that we may need to refinance maturing debt
with new debt at a higher rate. All other things being equal, the fair value of
our fixed rate debt will increase or decrease as interest rates change. We had
long-term debt outstanding of $40 million at December 31, 2008, all of
which bears interest at fixed rates. The $40 million of fixed-rate debt is
due on 2014. We currently have no interest rate hedge positions in place to
reduce our exposure to changes in interest rates.





30





Foreign Currency
Exchange RatesRisk




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




Our
assets and liabilities of which the functional currency is the China local
currency are translated into U.S. dollars using the exchange rates in
effect at the balance sheet date, resulting in translation adjustments that are
reflected as Cumulative Translation Adjustment in the shareholders’ equity
section on our Consolidated Balance Sheets. A portion of our net assets are
impacted by changes in foreign currencies in relation to the U.S. dollar.
We recorded a $5,184,035 adjustment to increase our equity account for the year
ended December 31, 2008 to reflect the net impact of the strengthening of
Chinese currency against the U.S. dollar.




ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





The
Consolidated Financial Statements of the Company and its subsidiaries including
the notes thereto, together with the report of Moore Stephens Wurth Frazer and
Torbet, LLP is presented beginning on page F-1 of this report.





Year Ended
                                          December 31
                                        
                                        First
                                          Quarter
                                        
                                        
                                        Second
                                          Quarter
                                        
                                        
                                        Third
                                          Quarter
                                        
                                        
                                        Fourth
                                          Quarter
                                        
                                        
                                        FullYear2008Net
      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
                                        
                                        
                                        $
                                        0.35





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.


31





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.




ITEM
9A(T). 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.


32





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 theInternal
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.





Significant
Deficiency





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


33





Remediation
Initiative




Prior to
December 31, 2008, we engaged an independent CPA consultant in CA 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.




Conclusion





Despite
of the material weakness and deficiencies reported above, the Company's
management believes that its consolidated financial statements included in this
report fairly present in all material respects the Company's financial
condition, results of operations and cash flows for the periods presented and
that this report does not contain any untrue statement of a material fact or
omit to state a material fact necessary to make the statements made, in light of
the circumstances under which such statements were made, not misleading with
respect to the period covered by this report.




(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.


34




(d)
Independent Registered Public Accounting Firm’s Attestation Report




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Stockholders of




China
Natural Gas, Inc.




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


35





ITEM
9B. OTHER INFORMATION




None.





PART
III




ITEM
10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE.





Below are
the names and certain information regarding our executive officers and
directors:




Name
              
              Age
              
              Position
              
              Held
      Position SinceQinan
      Ji
              
              51
              
              Chief
      Executive Officer and Chairman of the Board
              
              2005Richard
      P. Wu
              
              44
              
              Chief
      Financial Officer
              
              2008Zhiqiang
      Wang
              
              68
              
              Director
              
              2006Donald
      Yang
              
              42
              
              Director
              
              2008Carl
      Yeung
              
              29
              
              Director
              
              2008Lawrence
      Leighton
              
              74
              
              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. Since 2004,
Mr. Wang has been an independent advisor to the Company. Mr. Wang graduated from
the Northwestern University of Politics and Law in China in
1962.


36





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 Lotus Ltd. (“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.





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;




37





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. Yeung, and 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 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.





Compensation
Committee Interlocks and Insider Participation





No member
of the Compensation Committee served or previously served as an officer of
employee of the Company. In addition, no member of the Compensation Committee
has any relationship with the Company requiring disclosure by the Company under
the Exchange Act of 1934, as currently in effect.





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.


38





Code
of Ethics





On June
14, 2006, the Company adopted a Code of Ethics that applies to all officers,
directors and employees of the Company. A copy of our Code of Ethics is
available to you at no charge upon written request. The written request should
be address 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




EXECUTIVE
COMPENSATION





The
following table sets forth all cash compensation paid by us to our principal
executive officer for fiscal year 2008.





Summary
Compensation Table





In
December 2007, our CEO Mr. Qinan Ji signed a one-year employment contract with
the Company with the following key terms:


 ̈
            Salary
      for 2008 will be $15,000


 ̈
            All
      fringes and benefits were included in the above-mentioned
      salary


 ̈
            Contract
      was renewed in December 2008





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


 ̈
            Salary
      for 2008 will be $48,000


 ̈
            All
      fringes and benefits were included in the above-mentioned
      salary







In
October 2008, our 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 will be
$250,000


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


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


 ̈
            All
      fringes and benefits were included in the above-mentioned
      salary


39





 ̈
            Contract
      will be renewed on a yearly basis





Name and Principal
                                                    Position
                                                  
                                                  Year
                                                  
                                                  Salary
                                                    ($)
                                                  
                                                  Bonus
                                                    ($)
                                                  
                                                  Option
                                                    Awards
                                                    ($)
                                                  
                                                  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(1)
                                                  
                                                  2008
                                                  
                                                  62,499
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  62,499Lihong
      Guo, Chief Financial Officer(2)
                                                  
                                                  2008
                                                  
                                                  40,000
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  40,0002007
                                                  
                                                  4,000
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  4,000
  (1)
            Mr.
      Wu was appointed as our CFO on October 23, 2008.(2)
            Ms.
      Guo was appointed as our CFO on December 10, 2007 and resigned from that
      position on October 23, 2008.





Stock-Based
Compensation




None of
our officers or other employees have been granted stock options or stock
appreciation rights, or paid any other stock-based compensation, by our company
or any of our subsidiaries.




Director
Compensation





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





Name
                        
                        Fees
                          Earned
                          or
      Paid in
                          Cash
                          ($)
                        
                        Stock
                          Awards
                          ($)
                        
                        Option
                          Awards
                          ($)
                        
                        All
      Other
                          Compensation
                          ($)
                        
                        Total
                          ($)James
      Garner(1)
                        
                        
                        36,000
                        
                        -
                        
                        
                        -
                        
                        -
                        
                        
                        36,000Qinan
      Ji(2)
                        
                        
                        -
                        
                        -
                        
                        
                        -
                        
                        -
                        
                        
                        -Zhiqiang
      Wang(3)
                        
                        
                        -
                        
                        -
                        
                        
                        -
                        
                        -
                        
                        
                        -Donald
      Yang
                        
                        
                        36,000
                        
                        -
                        
                        
                        -
                        
                        -
                        
                        
                        36,000Carl
      Yeung
                        
                        
                        36,000
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        36,000Lawrence
      Leighton
                        
                        
                        36,000
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        36,000







(1)
            Removed
      from the Board of Directors on August 3, 2008.(2)
            Ji
      Qinan, our Chief Executive Officer, does not receive any compensation for
      his service as a director.(3)
            Zhiqiang
      Wang was appointed as a director in September 2006; he receives no
      compensation for his service as a
director.





The
Company did not pay any other compensation to these directors in
2008.





Employment
Agreements





The
Company signs employment agreements with all of its employees. Our employment
agreement is in full compliance with the current Labor Contract Law of the
People’s Republic of China. Our employment agreement is typically valid for one
year and is renewable afterwards. All the employment-related matters are either
clearly stipulated in the agreement or in reference to the standard provisions
of China’s Labor Law.


40





Outstanding
Equity Awards at Fiscal Year End





There has
been no outstanding equity awards at fiscal year ended December 31,
2008.




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




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.





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, 12th
      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)
                    
                    
                    9.9
                    %




(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 13, 2008, together with securities exercisable or
convertible into shares of common stock within 60 days of March 13, 2008 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 13, 2008 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.


41





(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.




(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





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.





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




42





*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.





ITEM
15. EXHIBITS





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).




43





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).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).




44





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).




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).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




45


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:
March 13, 2009




CHINA
      NATURAL GAS, INC./s/
      Qinan Ji
              
              
              /s/
      Richard Peidong WuName: 
      Qinan Ji
              
              
              Name: 
      Richard Peidong WuTitle:   
      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)
                                            
                                            March
      13, 2009Qinan
      Ji/s/
      Zhiqiang Wang
                                            
                                            Director
                                            
                                            March
      13, 2009Zhiqiang
      Wang/s/
      Donald
      Yang
                                            
                                            Director
                                            
                                            March
      13, 2009Donald
      Yang/s/
      Richard Peidong Wu
                                            
                                            Chief
      Financial Officer
                                              (Principal
      Accounting Officer)
                                            
                                            March
      13, 2009Richard
      Peidong Wu/s/
      Carl Yeung
                                            
                                            Director
                                            
                                            March
      14, 2009Carl
      Yeung/s/
      Lawrence
      Leighton
                                            
                                            Director
                                            
                                            March
      13, 2009Lawrence
      Leighton




46


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
      1inputs to the valuation methodology are quoted prices
      (unadjusted) for identical assets or liabilities in active
      markets.
 
 ·
              
              Level
      2inputs to the valuation methodology include quoted prices for
      similar assets and liabilities in active markets, and inputs that are
      observable for the asset or liability, either directly or indirectly, for
      substantially the full term of the financial
    instrument.
 
 ·
              
              Level
      3inputs to the valuation methodology are unobservable and
      significant to the fair value
measurement.
 
 The
Company analyzes all financial instruments with features of both liabilities and
equity under SFAS 150, “Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity,” SFAS 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