United
States


Securities
and Exchange Commission


Washington,
D.C. 20549





Form 10-Q




x  Quarterly Report
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934




For the
quarterly period ended September 30,
2010





or





 ̈  Transition Report
Pursuant to Section 13 or 15(d) of the Securities Exchange Act




For the
transition period from ______ to _______





Commission
file number 333-145183





KL ENERGY
CORPORATION


(Name of
registrant as specified in its charter )




Nevada
            
            39-2052941(State
      or other jurisdiction of
              incorporation
      ororganization)
            
            (IRS
      Employer
              Identification
      No.)





306
East Saint Joseph Street, Suite 200


Rapid City, South Dakota
57701


(Address
of principal executive offices)





(605)
718-0372


(Registrant’s
telephone number)





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.


x Yes   
 ̈ No





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).


Yes  ̈
     No  ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.




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





Indicate
by check mark whether the registrant is a shell company


 ̈
Yes      x No





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date: We had 49,893,309 shares of common
stock, $0.001 par value per share, outstanding on November 10,
2010.











KL
Energy Corporation


Form
10-Q


For
the Period Ended September 30, 2010





Table
of Contents





PagePart
      I - Financial Information
            
            
            3Item
      1. Financial Statements
            
            
            3-
      Notes to Consolidated Financial Statements
            
            
            7Item
      2. Management's Discussion and Analysis of Financial Condition and Results
      of Operations
            
            
            26Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            
            
            39Item
      4T. Controls and Procedures
            
            
            39Part
      II - Other Information
            
            
            41Item
      1. Legal Proceedings
            
            
            41Item
      1A.  Risk Factors
            
            
            41Item
      2.  Unregistered Sales of Equity Securities
            
            
            41Item
      3.  Defaults Upon Senior
      Securities
            
            
            41Item
      5. Other Information
            
            
            41Item 6. Exhibits
            
            
            42




CAUTIONARY STATEMENT
REGARDING FORWARD-LOOKING INFORMATION





The
report includes certain forward-looking statements.  Forward-looking
statements are statements that estimate the happening of future events and are
not based on historical fact.  Forward-looking statements may be
identified by the use of forward-looking terminology such as, “may,” “shall,”
“could,” “expect,” “estimate,” “anticipate,” “predict,” “probable,” “possible,”
“should,” “continue,” or similar terms, variations of those terms or the
negative of those terms.  The forward-looking statements specified in
the following information have been compiled by us and are considered by us to
be reasonable.  Our future operating results, however, are impossible
to predict; the reader should infer no representation, guaranty or warranty from
those forward-looking statements.





The
assumptions we used for purposes of the forward-looking statements specified in
the following information represent estimates of future events and are subject
to uncertainty as to possible changes in economic, legislative, industry and
other circumstances.  As a result, our identification and
interpretation of data and other information and their use in developing and
selecting assumptions from and among reasonable alternatives require us to
exercise judgment.  To the extent that the assumed events do not
occur, the outcome may vary substantially from anticipated or projected
results.  We cannot assure that any of the assumptions relating to the
forward-looking statements specified in the following information are accurate,
and we assume no obligation to update any such forward-looking
statements.  You should read the following discussion and analysis in
conjunction with our financial statements and the related notes included
elsewhere in this report.  The following discussion and analysis is
qualified in its entirety by reference to such financial statements and related
notes.





When used
in this report, the terms the "Company," "KL Energy", "we," "us," "ours," and
similar terms refer to KL Energy Corporation, a Nevada corporation, and its
subsidiaries.




-2-





PART
I:  FINANCIAL INFORMATION





Item 1. Financial
Statements




KL
      Energy CorporationConsolidated
      Balance Sheets




September
      30,
              
              
              December
      31,2010
              
              
              2009(unaudited)ASSETSCurrent
      AssetsCash
      and cash equivalents
              
              $
              501,735
              
              
              $
              65,049Restricted
      cash
              
              
              1,413,376
              
              
              
              -Trade
      receivables, net of allowance for doubtful accounts of $393,840 and
      $393,840, respectively
              
              
              18,108
              
              
              
              35,000Accounts
      receivable - related parties
              
              
              61,034
              
              
              
              1,034Inventories
              
              
              55,100
              
              
              
              14,975Prepaid
      expenses and other assets
              
              
              209,491
              
              
              
              138,765Deferred
      issuance costs
              
              
              73,125
              
              
              
              135,000Total
      Current Assets
              
              
              2,331,969
              
              
              
              389,823Non-Current
      AssetsProperty,
      Plant and Equipment, Net
              
              
              2,353,906
              
              
              
              3,501,197Total
      Assets
              
              $
              4,685,875
              
              
              $
              3,891,020LIABILITIES AND
      STOCKHOLDERS' DEFICITCurrent
      LiabilitiesCurrent
      maturities of long-term debt
              
              $
              1,608,163
              
              
              $
              1,851,389Current
      maturities of subordinated debt-related party
              
              
              466,462
              
              
              
              262,500Accounts
      payable
              
              
              1,675,235
              
              
              
              1,672,156Accounts
      payable-related parties
              
              
              3,028
              
              
              
              48,234Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
              
              
              1,640,588
              
              
              
              1,640,588Accrued
      payroll
              
              
              93,131
              
              
              
              203,161Other
      liabilities
              
              
              552,639
              
              
              
              770,052Deferred
      income
              
              
              1,537,900
              
              
              
              -Current
      liabilities of discontinued operations
              
              
              316,431
              
              
              
              356,970Total
      Current Liabilities
              
              
              7,893,577
              
              
              
              6,805,050Long-term
      debt, net of $1,201,295 discount at September 30, 2010
              
              
              298,705
              
              
              
              9,121Subordinated
      debt-related party
              
              
              -
              
              
              
              297,500Total
      Long-Term Debt
              
              
              298,705
              
              
              
              306,621Stockholders'
      DeficitCommon
      stock, $0.001  par value; 150,000,000 shares authorized;
      49,893,309 and 45,029,894 shares issued and outstanding as of September
      30, 2010 and December 31, 2009, respectively
              
              
              49,893
              
              
              
              45,029Additional
      paid-in capital
              
              
              13,241,024
              
              
              
              7,060,161Accumulated
      deficit
              
              
              (14,872,157
              )
              
              
              (9,267,385
              )Deficit
      attributable to KL Energy Corporation
              
              
              (1,581,240
              )
              
              
              (2,162,195
              )Noncontrolling
      interest
              
              
              (1,925,167
              )
              
              
              (1,058,456
              )Total
      Stockholders' Deficit
              
              
              (3,506,407
              )
              
              
              (3,220,651
              )Total
      Liabilities and Stockholders' Deficit
              
              $
              4,685,875
              
              
              $
              3,891,020




See
accompanying notes to consolidated financial statements.





-3-




KL
Energy Corporation


Consolidated
Statements of Operations


(unaudited)





Three
      Months Ended
                          September
      30,
                        
                        
                        Nine
      Months Ended
                          September
      30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009RevenueProject
      development services
                        
                        $
                        698,317
                        
                        
                        $
                        -
                        
                        
                        $
                        818,317
                        
                        
                        $
                        -Total
      Revenue
                        
                        
                        698,317
                        
                        
                        
                        -
                        
                        
                        
                        818,317
                        
                        
                        
                        -Operating
      ExpensesProject
      development services
                        
                        
                        362,607
                        
                        
                        
                        -
                        
                        
                        
                        422,607
                        
                        
                        
                        -General
      and administrative
                        
                        
                        396,155
                        
                        
                        
                        810,692
                        
                        
                        
                        2,033,049
                        
                        
                        
                        3,446,438Research
      and development
                        
                        
                        650,658
                        
                        
                        
                        1,077,873
                        
                        
                        
                        2,316,020
                        
                        
                        
                        2,972,958Acquisition
      of licensing rights
                        
                        
                        2,153,990
                        
                        
                        
                        -
                        
                        
                        
                        2,153,990
                        
                        
                        
                        -Total
      Operating Expenses
                        
                        
                        3,563,410
                        
                        
                        
                        1,888,565
                        
                        
                        
                        6,925,666
                        
                        
                        
                        6,419,396Loss
      from Operations
                        
                        
                        (2,865,093
                        )
                        
                        
                        (1,888,565
                        )
                        
                        
                        (6,107,349
                        )
                        
                        
                        (6,419,396
                        )Other
      Income (Expense):Other
      income
                        
                        
                        3,522
                        
                        
                        
                        25,182
                        
                        
                        
                        20,556
                        
                        
                        
                        36,591Interest
      income
                        
                        
                        427
                        
                        
                        
                        497
                        
                        
                        
                        1,174
                        
                        
                        
                        44,827Interest
      expense
                        
                        
                        (335,562
                        )
                        
                        
                        (63,807
                        )
                        
                        
                        (416,402
                        )
                        
                        
                        (165,551
                        )Total
      Other Expense, Net
                        
                        
                        (331,613
                        )
                        
                        
                        (38,128
                        )
                        
                        
                        (394,672
                        )
                        
                        
                        (84,133
                        )Loss
      from continuing operations, before tax
                        
                        
                        (3,196,706
                        )
                        
                        
                        (1,926,693
                        )
                        
                        
                        (6,502,021
                        )
                        
                        
                        (6,503,529
                        )Income
      taxes
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Loss
      from continuing operations, net of tax
                        
                        
                        (3,196,706
                        )
                        
                        
                        (1,926,693
                        )
                        
                        
                        (6,502,021
                        )
                        
                        
                        (6,503,529
                        )Income
      (loss) from discontinued operations, net of tax
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        30,538
                        
                        
                        
                        (12,000
                        )Net
      Loss
                        
                        
                        (3,196,706
                        )
                        
                        
                        (1,926,693
                        )
                        
                        
                        (6,471,483
                        )
                        
                        
                        (6,515,529
                        )Net
      (income) loss attributable to noncontrolling interests
                        
                        
                        311,792
                        
                        
                        
                        210,414
                        
                        
                        
                        866,711
                        
                        
                        
                        880,711Net
      Loss Attributable to KL Energy Corporation
                        
                        $
                        (2,884,914
                        )
                        
                        $
                        (1,716,279
                        )
                        
                        $
                        (5,604,772
                        )
                        
                        $
                        (5,634,818
                        )Net
      (Loss) Income Per Share, basic and diluted:Loss
      from continuing operations attributable to KL Energy Corporation common
      stockholders
                        
                        $
                        (0.06
                        )
                        
                        $
                        (0.04
                        )
                        
                        $
                        (0.12
                        )
                        
                        $
                        (0.16
                        )Income
      (loss) from discontinued operations attributable to KL Energy Corporation
      common stockholders
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Net
      loss attributable to KL Energy Corporation common
    stockholders
                        
                        $
                        (0.06
                        )
                        
                        $
                        (0.04
                        )
                        
                        $
                        (0.12
                        )
                        
                        $
                        (0.16
                        )Weighted
      Average Common Shares Outstanding
                        
                        
                        48,871,331
                        
                        
                        
                        41,319,327
                        
                        
                        
                        47,549,023
                        
                        
                        
                        34,192,821Amounts
      attributable to KL Energy Corporation common stockholders:Loss
      from continuing operations, net of tax
                        
                        $
                        (2,884,914
                        )
                        
                        $
                        (1,716,279
                        )
                        
                        $
                        (5,635,310
                        )
                        
                        $
                        (5,622,818
                        )Income
      (loss) from discontinued operations, net of tax
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        30,538
                        
                        
                        
                        (12,000
                        )Net
      Loss
                        
                        $
                        (2,884,914
                        )
                        
                        $
                        (1,716,279
                        )
                        
                        $
                        (5,604,772
                        )
                        
                        $
                        (5,634,818
                        )


See
accompanying notes to consolidated financial statements.




-4-




KL Energy Corporation


Consolidated Statement of Stockholders' Deficit




Additional
                
                
                
                
                
                
                
                
                TotalCommon
      Stock
                
                
                Paid-In
                
                
                Accumulated
                
                
                Noncontrolling
                
                
                Stockholders'Shares
                
                
                Amount
                
                
                Capital
                
                
                Deficit
                
                
                Interest
                
                
                DeficitBalance
      - December 31, 2009
                
                
                45,029,894
                
                
                $
                45,029
                
                
                $
                7,060,161
                
                
                $
                (9,267,385
                )
                
                $
                (1,058,456
                )
                
                $
                (3,220,651
                )Issuance
      of shares in private placements at $1.10 per share
                
                
                3,348,484
                
                
                
                3,349
                
                
                
                3,346,651
                
                
                
                -
                
                
                
                -
                
                
                
                3,350,000Legal,
      professional and placement fees
                
                
                -
                
                
                
                -
                
                
                
                (470,000
                )
                
                
                -
                
                
                
                -
                
                
                
                (470,000
                )Debt
      discount on convertible promissory note
                
                
                -
                
                
                
                -
                
                
                
                1,495,000
                
                
                
                -
                
                
                
                -
                
                
                
                1,495,000Stock
      based compensation
                
                
                14,931
                
                
                
                15
                
                
                
                160,712
                
                
                
                -
                
                
                
                -
                
                
                
                160,727Issuance
      of shares for purchase of technology licensing rights
                
                
                1,500,000
                
                
                
                1,500
                
                
                
                1,648,500
                
                
                
                -
                
                
                
                -
                
                
                
                1,650,000Net
      loss attributable fo noncontrolling interests
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (866,711
                )
                
                
                (866,711
                )Net
      loss
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (5,604,772
                )
                
                
                -
                
                
                
                (5,604,772
                )-Balance
      - September 30, 2010
                
                
                49,893,309
                
                
                $
                49,893
                
                
                $
                13,241,024
                
                
                $
                (14,872,157
                )
                
                $
                (1,925,168
                )
                
                $
                (3,506,407
                )




See
accompanying notes to consolidated financial statements.




-5-





KL Energy Corporation


Consolidated
Statements of Cash Flows




Nine
      Months EndedSeptember
      30,2010
                
                
                2009(unaudited)
                
                
                (unaudited)Cash
      Flows From Operating ActivitiesNet
      loss
                
                $
                (6,471,483
                )
                
                $
                (6,515,529
                )Adjustments
      to reconcile net loss by cash used in operating
activities:
                
                
                
                
                
                
                -Depreciation
                
                
                1,381,474
                
                
                
                1,425,717Allowance
      for doubtful accounts
                
                
                -
                
                
                
                437,831Loss
      (gain) an sale of assets
                
                
                (419
                )
                
                
                9,018Stock
      based compensation expense
                
                
                160,727
                
                
                
                -Issuance
      of stock for licensing rights
                
                
                1,650,000
                
                
                
                -Amortization
      of debt discount
                
                
                293,705
                
                
                
                -Amortization
      of debt issuance cost
                
                
                1,875
                
                
                
                -Changes
      in current assets and liabilities:(Increase)
      decrease in:Receivables
                
                
                (43,109
                )
                
                
                28,337Inventories
                
                
                (40,125
                )
                
                
                45,511Prepaid
      expenses and other assets
                
                
                9,274
                
                
                
                422,649Increase
      (decrease) in:Accounts
      payable
                
                
                (82,665
                )
                
                
                (389,422
                )Deferred
      income
                
                
                1,537,900
                
                
                
                -Accrued
      payroll and other liabilities
                
                
                (327,443
                )
                
                
                1,098,613Net
      Cash Provided by (Used In) Operating Activities
                
                
                (1,930,289
                )
                
                
                (3,437,275
                )Cash
      Flows From Investing ActivitiesPurchases
      of property, plant and equipmentProceeds
      from the sale of fixed assets
                
                
                (234,363
                )
                
                
                (143,050
                )Net
      Cash Provided by (Used in) Investing Activities
                
                
                600
                
                
                
                31,291(233,763
                )
                
                
                (111,759
                )Cash
      Flows From Financing ActivitiesProceeds
      (payments) from lines of credit and short-term borrowings
                
                
                (332,348
                )
                
                
                (250,000
                )Payments
      on subordinated debt - related parties, net
                
                
                (93,538
                )
                
                
                -Payments
      on long-term debt principal
                
                
                -
                
                
                
                (839,418
                )Proceeds
      from convertible debt
                
                
                1,500,000
                
                
                
                -Debt
      issuance costs
                
                
                (75,000
                )
                
                
                -Legal,
      professional and placement fees
                
                
                (335,000
                )
                
                
                (840,000
                )Proceeds
      from issuance of common stock
                
                
                3,350,000
                
                
                
                5,000,000Net
      Cash Provided by (Used in)  Financing Activities
                
                
                4,014,114
                
                
                
                3,070,582Net
      Increase (Decrease) in Cash and Cash Equivalents
                
                
                1,850,062
                
                
                
                (478,452
                )Cash
      and cash equivalents at beginning of period
                
                
                65,049
                
                
                
                698,101Cash
      and cash equivalents at end of period
                
                $
                1,915,111
                
                
                $
                219,649Supplemental
      Disclosures of Cash Flow InformationInterest
      paid
                
                $
                85,803
                
                
                
                80,469Conversion
      of accounts payable and accrued liabilities to common
stock
                
                
                -
                
                
                
                1,012,725Conversion
      of deferred issuance costs payable to common stock
                
                
                -
                
                
                
                285,000Settlement
      of accounts payable with debt
                
                
                -
                
                
                
                335,000Insurance
      premium financed with debt
                
                
                80,000
                
                
                
                47,153Debt
      discount
                
                
                1,495,000
                
                
                
                -




See
accompanying notes to consolidated financial statements.




-6-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 1 – Nature of Business and Significant
Accounting Policies





Nature of
Business





KL Energy
Corporation (“KL”, formerly known as Revive-it Corp.) was incorporated on
February 26, 2007, in the State of Nevada, to engage in the development of skin
care and cosmetic products. On September 30, 2008, we entered into an Agreement
and Plan of Merger with KL Process Design Group, LLC (“KLPDG”), which provided
for the merger of KLPDG with and into our Company (the “Merger”).  As
a result of the Merger, our Company acquired all of the assets and liabilities
of KLPDG.





For
accounting purposes, the Merger was treated as a reverse acquisition with KLPDG
as the acquirer and the Company as the acquired party. As a result, the business
and financial information included in this report is the business and financial
information of KLPDG. KLPDG was a South Dakota limited liability company that
was organized in April 2003, and commenced business operations in January
2006.





While we
have historically provided engineering, construction, operating and ethanol
marketing services, for first generation grain based ethanol (“1st Gen” or
“GBE”) our focus is now on owning and operating cellulose based ethanol ("CBE")
second generation (“2nd Gen”) integrated facilities that utilize our proprietary
technology, and designing these facilities for, and licensing our proprietary
process technology to, third-parties seeking to participate in the renewable
energy and advanced biofuel markets.  Initially, we created expansion
and optimization programs for 1st Gen facilities. The experience in the design
and operation of these GBE’s has given our company a significant advantage in
the development and future operations of 2nd Gen facilities. While we are able
to offer design and engineering services to optimize existing GBE facilities,
our emphasis in the future will be on integrated CBE facilities.




The
Company also distributed ethanol blended fuel, through its majority-owned
Patriot Motor Fuels, LLC.  As a result of pricing and competitive
factors, the Patriot business was discontinued in January 2009.  In
June 2009, the Company also discontinued two additional businesses in which it
held a majority interest:  KL Management LLC, which managed ethanol
facilities for third parties, and KLHC LLC (formerly known as KL Energy LLC)
which sold wholesale ethanol.  Both businesses were discontinued as a
result of the severe change in the economics of the first generation ethanol
industry but especially due to the Company’s re-focus on cellulosic second
generation ethanol commercialization.





A key
part of our business model is the design of scalable, custom-designed fully
integrated CBE plants, preferably with integrated Combined Heat and Power
(CHP) and Bio-Lignin production, tailored to a project’s geographic area
and locally available feedstock. Through WBE, we have designed, constructed and
operated what we believe to be one of the first second-generation CBE
demonstration plants in the United States. The WBE plant was built to serve as a
demonstration and research and development facility and has the future
potential, with additional capital investment, to operate commercially with a
capacity of approximately 1.5 million gallons of CBE per
year.  This allows us to continue to research, and refine our
cellulose conversion technology, while also demonstrating the commercial
viability for this type of technology.





-7-





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 1 – Nature of Business and Significant
Accounting Policies (continued)





Nature of Business
(continued)





Significant Accounting
Policies





Use
of Estimates





The
preparation of financial statements 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.  The following estimates are significant to the Company’s
consolidated financial statements: costs to complete long-term contracts, useful
lives of property, plant and equipment, impairment of long-lived
assets, valuation of share based compensation, going concern analysis,
valuation allowance on deferred tax assets and the allowance for doubtful
accounts.





Principles
of Consolidation





The
accompanying consolidated financial statements include the results of operations
and financial position of the Company, KL Energy Services LLC (“KLES”, a
wholly-owned subsidiary, as well as its wholly-owned KLHC LLC (formerly known as
KL Energy LLC, “KLHC”) and majority-owned KL Management, LLC (“KLM”), Patriot
Motor Fuels LLC (“Patriot”) and Western Biomass Energy LLC
(“WBE”).  Until September 30, 2008, KLHC and KLM were 53% owned by
KLPDG and the remaining 47% was owned by three other individuals; Patriot was
50% owned by KLPDG and two other owners held the remaining 50% interest.   At September 30,
2008, the Company ownership interest increased to 75% for KLHC, KLM and Patriot.
WBE is 64% owned by the Company and 36% owned by various unrelated
investors.  All significant intercompany accounts and transactions
have been eliminated in consolidation.




Basis
of Presentation





The
accompanying unaudited consolidated financial statements and related notes have
been prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and the instructions
to Form 10-Q and Rule 10-01 of Regulation S-X. Results for interim
periods should not be considered indicative of results for a full year. These
interim consolidated financial statements should be read in conjunction with the
consolidated financial statements and related notes contained in the Company’s
Annual Report on Form 10-K for the year ended December 31, 2009. In the
opinion of management, all adjustments (consisting of normal recurring
adjustments) considered necessary for a fair statement of the results for
interim periods have been included.





We have
reclassified certain data in the financial statements of the prior period to
conform to the current period presentation.  Specifically, in the
statement of operations, we reclassified approximately $183,000 and $508,000 of
expenses in the three and nine months ended September 30, 2009, respectively,
that were previously included in general and administrative expenses but that
were more appropriately includable in research and development
expenses.





-8-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 1 – Nature of Business and Significant
Accounting Policies (continued)





Significant Accounting
Policies (continued)




Recently
Issued Accounting Pronouncements





In
January 2010, the Financial Accounting Standards Board, or FASB, issued guidance
requiring additional fair value disclosures for significant transfers between
levels of the fair value hierarchy and gross presentation of items within the
Level 3 reconciliation. This guidance also clarifies that entities need to
disclose fair value information for each class of asset and liability measured
at fair value and that valuation techniques need to be provided for all
non-market observable measurements. Our adoption of this guidance on
January 1, 2010, did not impact our consolidated financial statements as we
have no items classified as Level 3.





Restricted
Cash




Restricted
cash includes cash received from Petrobras Americas, Inc. (“Petrobras”) to be
used for the projects included in the Joint Development Agreement between the
Company and Petrobras.




Revenue
and Cost Recognition





Revenue
from  joint development and funded research arrangements are accounted
for using the proportional performance method under which revenue is
recognized in proportion to the services or activities incurred under such
agreements.    If estimated total costs on this contract
indicate a loss, we charge the entire estimated loss to operations in the period
in which the loss becomes known. The cumulative effect of revisions to revenue,
and estimated costs to complete this contract, are recorded in the accounting
period in which the events indicating a loss or change in estimates are known
and the loss can be reasonably estimated.  Amounts billed in excess of
revenue recognized are included in deferred income.




-9-





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 1 – Nature of Business and Significant
Accounting Policies (continued)





Significant Accounting
Policies (continued)




Revenue
and Cost Recognition (continued)





Revenue
from feedstock testing results from agreements with third parties for the
Company to perform extensive tests to determine if the customer’s feedstock is a
viable candidate for use in the production of cellulosic ethanol.  The
standard agreement requires that the customer pay 50% of the testing fee upon
signing the feedstock testing agreement and the remaining 50% when the Company
delivers a final report to the customer explaining the test results and
conclusions.  Feedstock testing revenues, and related expenses, are
only recognized when this report is delivered.





Revenue
from fixed price contracts is recognized on the percentage-of-completion method,
measured by the percentage of costs incurred to date to estimated total costs
for each contract.  This method is used because management considers
expended costs to be the best available measure of progress on these
contracts.  Due to uncertainties inherent in the estimation process,
it is at least reasonably possible that the completion costs for contracts in
progress at June 30, 2010 and December 31, 2009 will be revised
significantly in the near term.  Contract costs include all direct
material, subcontract and labor costs, and those indirect costs related to
contract performance, such as labor, supply, tool, and depreciation
costs.  Operating costs are charged to expense as
incurred.  Revenue is reported net of sales tax
collected.  Provisions for estimated losses on uncompleted contracts
are made in the period in which such losses are determined.  Changes
in job performance, job conditions, and estimated profitability, including those
arising from contract penalty provisions and final contract settlements, may
result in revisions to costs and income and are recognized in the period in
which the revisions are determined.





Pre-contract
costs directly associated with a specific contract are deferred as incurred in
anticipation of that contract if recovery of these costs is determined to be
probable. Conversely, if it appears unlikely that we will obtain the
contract, all previously deferred costs are expensed.  Such costs
include consultant expenses for project development, technology improvements,
facility engineering and feedstock evaluation
expenses.




Based on
our percentage-of-completion revenue recognition policy, revenues and costs
associated with approved change orders are adjusted when Company and customer
approvals of the change order are obtained.  For unpriced or
unapproved change orders, recovery must be deemed probable, if the future event
or events necessary for recovery are likely to occur, at which time revenues and
costs associated with the unpriced or unapproved change orders are adjusted. If
change orders are in dispute or are unapproved in regard to both scope and
price, they are evaluated as claims.




Claims
are amounts in excess of the agreed contract price (or amounts not included in
the original contract price) that a contractor seeks to collect from customers
or others for customer-caused delays, errors in specifications and designs,
contract terminations, change orders in dispute or unapproved as to both scope
and price, or other causes of unanticipated additional costs.




-10-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 1 – Nature of Business and Significant
Accounting Policies (continued)





Significant Accounting
Policies (continued)




Revenue
and Cost Recognition (continued)





Recognition
of amounts of additional contract revenue relating to claims is made only if it
is probable that the claim will result in additional contract revenue and if the
amount can be reliably estimated. Those two requirements are satisfied by the
existence of all of the following conditions:




a.) The
contract or other evidence provides a legal basis for the claim; or a legal
opinion has been obtained, stating that under the circumstances there is a
reasonable basis to support the claim.




b.)
Additional costs are caused by circumstances that were unforeseen at the
contract date and are not the result of deficiencies in the contractor's
performance.




c.) Costs
associated with the claim are identifiable or otherwise determinable and are
reasonable in view of the work performed.




d.) The
evidence supporting the claim is objective and verifiable, not based on
management's feel for the situation or on unsupported
representations.




If the
foregoing requirements are met, revenue from a claim is recorded only to the
extent that contract costs relating to the claim have been incurred. Costs
attributable to claims are treated as costs of contract performance as
incurred.





The
liability, "Billings in excess of costs and estimated earnings on uncompleted
contracts," represents billings in excess of revenue recognized.




Patriot
provided blended fuel on consignment to service stations.  Revenue
related to the sale of blended fuel by Patriot was recorded when the ethanol was
sold by the service station to the end customer.  This operation was
discontinued in January 2009.





Long-Lived
Assets




Property,
plant and equipment is recorded at cost. Depreciation expense is computed using
the straight–line method over the estimated useful lives of the assets,
generally three to five years except for leasehold improvements which are
amortized over the lease term.





Costs
incurred relating to construction-in-progress for plant facilities are
capitalized when those costs are for the active development of the
facility.   Depreciation commences when the construction activity is
completed and the additional assets are available for use.





-11-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




Note
2 - Property, Plant, and Equipment





Property,
plant, and equipment consist of the following as of:





September
      30,
              
              
              December
      31,2010
              
              
              2009Plant
      and Plant Equipment
              
              $
              7,401,564
              
              
              $
              7,402,413Office
      Furnishings and Equipment
              
              
              409,426
              
              
              
              274,103Vehicles
              
              
              51,698
              
              
              
              51,698Construction
      in progress
              
              
              93,448
              
              
              
              -7,956,136
              
              
              
              7,728,214Less
      Accumulated Depreciation
              
              
              (5,602,230
              )
              
              
              (4,227,017
              )Total
      Property, Plant, and Equipment, Net
              
              $
              2,353,906
              
              
              $
              3,501,197




Note
3 - Financing





Debt
Financing





On July
1, 2010, the Company received the final installment of the January 6, 2010
Securities Purchase Agreement with an accredited investor.   Pursuant
to the terms of the Purchase Agreement, the Company received $1.5 million before
expenses on January 6, 2010, representing 50% of this investor’s commitment to
purchase 2,000,000 shares of the Company’s common stock, and the investor will
pay the remaining $1.5 million within 14 days of receiving a written demand from
the Company.  The pricing of these shares may be reduced based on
certain subsequent events.  This Purchase Agreement provides for: (i)
piggyback registration rights allowing the Investor to participate in
registration statements filed by the Company and (ii) participation rights
allowing the Investor to purchase its pro rata share of equity securities issued
by the Company for cash, with certain exceptions including, without limitation,
issuances relating to compensation, commercial credit arrangements, and
strategic transactions involving ongoing business relationships. The shares will
be issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.)  In lieu of issuing stock
pursuant to that Purchase Agreement, the Company agreed to issue a $1.5 million
Convertible Promissory Note on July 1, 2010 for such investment which resulted
in net proceeds to the Company of $1.425 million. This Note is non-interest
bearing and is payable in full on February 11, 2020.  Pursuant to this
Note, if the Company raises at least $15.0 million in equity financing prior to
February 11, 2020, the outstanding Note principal will automatically convert
into the Company’s common stock at a conversion rate of $1.10 per share (or
1,363,636 shares).  The Note holder also has the right to convert this
Note into the Company’s common stock at any time at a conversion rate of $1.10
per share.




-12-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
3 – Financing (continued)





Debt
Financing (continued)





Imputing
interest at the rate of 18%, this Note had a fair value of $286,597 at the
measurement date resulting in a debt discount of $1,213,403.  In
addition, this Note was considered to have a beneficial conversion feature
because the effective conversion price was less than the last quoted market
price at the time of issuance.  However, the intrinsic value of the
beneficial conversion feature exceeded the proceeds allocated to the convertible
debt.  As such, the amount of debt discount assigned to the beneficial
conversion feature was limited to the amount of the proceeds allocable to the
convertible debt of $286,597.  Both discounts are being amortized to
interest expense, using the interest method, over the expected 10-year life of
the Note.  Debt issuance costs of $75,000 were charged to deferred
expense and are being amortized to interest expense over the expected 10-year
life of the Note.





Equity
Financing




On June
4, 2010, the Company received the final installment of an equity financing
pursuant to Securities Purchase Agreement with an accredited
investor.  Pursuant to the terms of the purchase agreement, the
Company issued to this investor 681,818 shares of the Company’s common
stock, at $1.10 per share, for net proceeds to the Company of
$675,000.  The shares were issued in reliance on the exemption
provided by Regulation S of the Securities Act of 1933, as amended.





On May 3,
2010, the Company received the final installment of a Securities Purchase
Agreement with an accredited investor.  Pursuant to the terms of the
Purchase Agreement, the Company issued to this investor 545,455 shares of the
Company’s common stock, at $1.10 per share, for net proceeds to the
Company of $540,000.  The shares will be issued in reliance on the
exemption provided by Regulation S of the Securities Act of 1933, as
amended.





On March
30, 2010, the Company received the final installment of the December 2009
Securities Purchase Agreement with an accredited investor.  Pursuant
to the terms of the Purchase Agreement, the Company issued to the investor
454,545 shares of the Company’s common stock, at $1.10 per share, for net
proceeds to the Company of $450,000.  The shares will be issued
in reliance on the exemption provided by Regulation S of the Securities Act of
1933, as amended.





-13-





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




Note
4 – Net Loss Per Common Share





Basic EPS
includes no dilution and is computed by dividing income or
(loss) applicable to common stock by the weighted average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution
of securities that could share in the earnings of an entity, similar to fully
diluted EPS.   For the three and nine months ended September 30, 2010
and 2009, stock warrants for 3,125 shares were not included in the computation
of diluted loss per share because their effect was anti-dilutive.  For the
three and nine months ended September 30, 2010, stock options for 198,307
shares, and 29,862 unvested restricted shares, of common stock were not included
in the computation of diluted loss per share because their effect was
anti-dilutive.  There were no other stock warrants or options issued
or outstanding as of September 30, 2010.





Note 5 - Operations





Petrobras
Agreement





Effective
August 23, 2010, Petrobras Brasileiro Ltda., through its subsidiary Petrobras
America, Inc. ((“Petrobras”), entered into a Joint Development Agreement (“JDA”)
with the Company to jointly optimize our proprietary cellulosic ethanol process
technology for sugarcane bagasse feedstock (“Bagasse”).  The latest
generation of the Company’s process design provides for substantial enhancements
over the first generation, implemented in 2008 at the Company’s demonstration
plant in Upton, Wyoming using Ponderosa Pine feedstock, including the ability to
be optimized for multiple feedstocks.





As part
of this agreement, Petrobras will provide up to $11.0 million to adapt the
Company’s demonstration facility to the use of Bagasse, validate the optimized
process by producing cellulosic ethanol and bio-lignin from Bagasse in multiple
campaigns and license the technology.  In parallel, Petrobras and KLE
will jointly work on an industrial scale Bagasse based cellulosic ethanol plant
project that shall be fully integrated into a sugarcane mill belonging to the
Petrobras Group in Brazil slated to go on stream in 2013 and capable of
producing 15 million liters per year.  The agreement, which has an
initial term of 18 months and provides for mutual exclusivity in the area of
developing cellulosic ethanol from Bagasse, provides Petrobras with the option
to enter into a technology license for the use of the Company’s technology
within Petrobras Group assets.





For the
three and nine months ended September 30, 2010, approximately $662,000 of
revenue, and approximately $366,000 of expenses, related to the JDA have been
included in the consolidated statements of operations.




-14-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 5 – Operations
(continued)





Continuing
Operations





During
the period from its inception to September 30, 2010, the Company has incurred
significant annual net losses and at September 30, 2010 and December 31, 2009,
the Company had negative working capital (i.e. current assets less current
liabilities) of approximately $5.6 million and $6.4 million,
respectively.  At September 30, 2010, total liabilities exceeded total
assets by approximately $3.6 million.  The first generation ethanol
industry, in which the Company has historically operated, continues to face
significant challenges including increased construction costs, limited
availability of debt and equity financing and a reduction in public and
governmental support.





These
factors, among others, indicate the Company may be unable to meet its current
obligations and may be unable to continue as a going concern unless it raises
additional capital.  Management is continuing its efforts to raise
additional capital through various methods and has refocused its business to
cellulosic ethanol.





Discontinued
Operations





In
January 2009, the Company determined that its majority-owned subsidiary, Patriot
Motor Fuels LLC (“Patriot”), should be discontinued as a result of pricing and
other competitive factors.  Patriot distributed ethanol blended
fuel.  In June 2009, the Company also discontinued two additional
businesses in which it held a majority interest:  KL Management LLC
(“KLM”), which managed ethanol facilities for third parties, and KLHC LLC
(formerly known as KL Energy LLC, “KLHC”), which sold wholesale
ethanol. Both businesses were discontinued as a result of the severe change
in the economics of the first generation ethanol industry but especially due to
the Company’s re-focus on cellulosic second generation ethanol
commercialization.





Operating
results from discontinued operations were income (loss) of approximately $0
and $0 during the three months ended September 30, 2010 and 2009, respectively,
and income (loss) of approximately $31,000 and ($12,000) during the nine months
ended September 30, 2010 and 2009, respectively.   At September
30, 2010 and 2009, these businesses had no assets and the only liabilities were
accounts payable of $316,431 and $356,970, respectively.





Note
6 –Debt





Short-Term
Borrowing Arrangements





The
Company had approximately $38,000 and $44,000 in credit card liability at
September 30, 2010 and December 31, 2009, respectively, which are also
guaranteed by certain shareholders. These credit card liability balances are
included in accounts payable in the accompanying consolidated balance
sheets.  These liabilities are being reduced monthly.




-15-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
6 –Debt (continued)





Subordinated
Debt – Related Parties





The
Company has a subordinated secured note payable to a Company shareholder
totaling $466,462 and $560,000 at September 30, 2010 and December 31, 2009,
respectively.  This note includes interest at a variable rate, which
was 5.0% at September 30, 2010 and December 31, 2009, respectively, with
interest paid quarterly.  Prior to February 2009, this note was
unsecured and did not have a specified due date. In February 2009, the note was
modified to include principal payments of $10,000 per month, beginning in
September 2009, over a 60-month term. The principal payments are scheduled to be
$120,000 in 2010, 2011, 2012, 2013, respectively, and $80,000 in
2014.   As security for our obligations under this note, we granted to
the lender a security interest in our current and future accounts
receivable.  In addition, if the Company receives additional equity
financing, the Company is obligated to pay 5% of the proceeds towards principal
payments on this note.  Since December 31, 2009, an additional
$242,500 has been classified as currently payable. Total current maturities and
the balance on this note as of September 30, 2010 was $466,462.





Long-Term
Debt





Long-term
debt consists of the following as of:




September
      30,
              
              
              December
      31,2010
              
              
              2009Note
      payable to bank with interest at 6.5%. The note is payable in twelve
      monthly installments of $17,560 of principal and interest beginning M
      arch 2010 with any remaining unpaid principal and interest due March
      2011, with additional maturity extensions available. This note is secured
      by substantially all assets of WBE and guaranteed by the Company and
      certain WBE members.
              
              $
              1,302,946
              
              
              $
              1,394,043Payable
      to Hermanson Egge to replace overdue payables for construction services
      with unsecured agreement, interest at 0% with payments of $70,000 in
      July 2009, $15,000 monthly from July 2009 to April 2010, $10,000
      monthly from M ay 2010 to August 2010, $20,000 monthly for September 2010
      to November 2010 and $15,000 in December 2010.
              
              
              35,000
              
              
              
              160,000Note
      payable to Lansing Securities Corp., interest at 10% and the maturity date
      has passed and has been temporarily waived by the note holder until
      further notice.
              
              
              250,000
              
              
              
              250,000Note
      payable to Universal Premium Acceptance Corp. for payment of insurance
      premiums, interest at 9.24%, payable in monthly principal and
      interest installments of $5,239.
              
              
              -
              
              
              
              30,605Note
      payable to Avid Solutions for centrifuge equipment of $195,000, payable in
      monthly principal and interest installments of $10,000, including
      interest at 10% secured by equipment.
              
              
              -
              
              
              
              6,767Note
      payable to Shimadzu for lab equipment of $32,114, payable in monthly
      principal and interest installments of $1,072, including interest at
      13.6% secured by equipment.
              
              
              11,965
              
              
              
              19,095Note
      payable to First Insurance Funding Corporation for payment of director and
      officer insurance premiums, payable in monthly installments of
      $3,692, including interest at 8.4%.
              
              
              8,253
              
              
              
              -Subordinated
      note payable to Randy Kramer and assigned to First National Bank, interest
      at 5.0%, secured by accounts receivable of the Company, payable in
      monthly installments of $10,000 per month plus interest be ginning
      September 2009 and 5% of equity financings after February
      2009.
              
              
              466,462
              
              
              
              560,000Convertible
      promissory note of $1.5 million at 0% interest; payable to an acrredited
      investor and due on February 11, 2020 or, if the Company raises $15
      million in equity financing, automatically converitble into into
      Company common stock at the conversion price of $1.10 per
      share
              
              
              1,500,000
              
              
              
              -Convertible
      promissory note debt discount
              
              
              (1,201,295
              )
              
              
              -Subtotal
              
              $
              2,373,331
              
              
              $
              2,420,510Less
      current maturities of long-term debt
              
              
              (2,074,626
              )
              
              
              (2,113,889
              )Total
      Long-Term Debt
              
              $
              298,705
              
              
              $
              306,621
  -16-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
7 – Common Stock Activity





Effective
April 6, 2010, pursuant to the terms of a Securities Purchase Agreement with an
accredited investor executed on January 6, 2010 and which agreement required
pricing of these shares to be reduced to $1.10 per share based on the absence of
an investment by an additional institutional investor within 90 days after the
date of the agreement, the Company issued to this investor an additional 363,636
shares of the Company’s common stock at $1.10 per share.  The
shares were issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.





Note 8 - Segment
Information





As of
September 30, 2010, the Company manages its business and aggregates its
operational and financial information in accordance with five reportable
segments. The Project
Development Services segment provides economic and technical feasibility
studies, including feedstock testing, to third party customers. The Biofuel Products
segment includes the sale of ethanol, lignin and other CBE
by-products.  The Engineering Services
segment provides basic engineering and design services for CBE
facilities.  The Technology Licensing
segment provides license and royalty revenues from the licensing of our
proprietary technology.  The Biofuel Research and Development segment
provides CBE facility and product research and primarily consists of the WBE
facilities and related expenses.




Management
assesses performance and allocates resources based on specific financial
information for the business segments. For the biofuel segment, performance is
assessed based on total operating expenses and capital expenditures. Operating
expenses for each segment include direct costs of that segment. Expenses and
assets shared by the segments require the use of judgments and estimates in
determining the allocation of expenses to the segments. Different assumptions or
allocation methods could result in materially different results by
segment.




-17-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 8 - Segment Information
(continued)





Financial
information for the Company’s business segments was as follows (in
thousands):




For
      the Three Months Ended
                September
      30,
              
              
              For
      the Nine Months Ended
                September
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009Revenues:Project
      development services
              
              $
              698
              
              
              $
              -
              
              
              $
              818
              
              
              $
              -Biofuel
      products
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Engineering
      services
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Technology
      licensing
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Biofuel
      research and development
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
      Revenues
              
              $
              698
              
              
              $
              -
              
              
              $
              818
              
              
              $
              -Depreciation:Project
      development services
              
              $
              17
              
              
              $
              2
              
              
              $
              46
              
              
              $
              32Biofuel
      products
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Engineering
      services
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Technology
      licensing
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Biofuel
      research and development
              
              
              394
              
              
              
              457
              
              
              
              1,335
              
              
              
              1394Total
      Depreciation
              
              $
              411
              
              
              $
              459
              
              
              $
              1,381
              
              
              $
              1,426Interest
      Expense:Project
      development services
              
              $
              303
              
              
              $
              64
              
              
              $
              347
              
              
              $
              82Biofuel
      products
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Engineering
      services
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Technology
      licensing
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Biofuel
      research and development
              
              
              32
              
              
              
              -
              
              
              
              69
              
              
              
              84Total
      Interest Expense
              
              $
              335
              
              
              $
              64
              
              
              $
              416
              
              
              $
              166Net
      Loss Attributable to KL Energy Corporation:Project
      development services
              
              $
              (2,265
              )
              
              $
              (923
              )
              
              $
              (4,031
              )
              
              $
              (3,640
              )Biofuel
      products
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Engineering
      services
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Technology
      licensing
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Biofuel
      research and development
              
              
              (620
              )
              
              
              (793
              )
              
              
              (1,574
              )
              
              
              (1,995
              )Net
      Loss Attributable to KL Energy Corporation:
              
              $
              (2,885
              )
              
              $
              (1,716
              )
              
              $
              (5,605
              )
              
              $
              (5,635
              )Reconciliations
      to Reported AmountsRevenue
      - Reportable Segments
              
              $
              698
              
              
              $
              -
              
              
              $
              818
              
              
              $
              -Eliminations/Other
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
      Consolidated Revenue
              
              $
              698
              
              
              $
              -
              
              
              $
              818
              
              
              $
              -Net
      Loss - Reportable Segments
              
              $
              (2,885
              )
              
              $
              (1,716
              )
              
              $
              (5,605
              )
              
              $
              (5,635
              )Eliminations/Other
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
      Consolidated Net Loss
              
              $
              (2,885
              )
              
              $
              (1,716
              )
              
              $
              (5,605
              )
              
              $
              (5,635
              )


-18-





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 9
– Noncontrolling Interests





On
January 1, 2009, the Company adopted changes issued by the FASB to
consolidation accounting and reporting. These changes establish accounting and
reporting for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. This guidance defines a noncontrolling
interest, previously called a minority interest, as the portion of equity in a
subsidiary not attributable, directly or indirectly, to a parent. These changes
require, among other items, that (a) noncontrolling interests to be included in
the consolidated statement of financial position within equity separate from the
parent’s equity, (b) consolidated net income to be reported at amounts inclusive
of both the parent’s and noncontrolling interest’s shares and, separately, the
amounts of consolidated net income attributable to the parent and noncontrolling
interest all on the consolidated statement of operations, and (c) if a
subsidiary is deconsolidated, any retained noncontrolling equity investment in
the former subsidiary should be measured at fair value and a gain or loss be
recognized in net income based on such fair value. Other than the change in
presentation of noncontrolling interests, the adoption of these changes had no
impact on the consolidated financial statements. The presentation and disclosure
requirements of these changes were applied retrospectively.





Components
of noncontrolling interests are as follows:





September
      30,
              
              
              December
      31,2010
              
              
              2009(unaudited)Beginning
      of period
              
              $
              (1,058,456
              )
              
              $
              193,399Net
      loss attributable to noncontrolling interests
              
              
              (866,711
              )
              
              
              (1,251,855
              )End
      of period
              
              $
              (1,925,167
              )
              
              $
              (1,058,456
              )


Note 10 -
Contingencies





Litigation





On July
2, 2010, a lawsuit was brought against the Company and certain current directors
and a Company investor in the Seventh Judicial District Court of Pennington
County, South Dakota.  The plaintiff is Randy Kramer, a former CEO of the
Company. The plaintiff alleges, among other things, that the Company
violated the Severance Agreement signed by the Company and the Kramer.  The
plaintiff also alleges that the named individuals engaged in conspiracy to have
him removed as CEO and oppressed him to sign the Severance Agreement.  The
plaintiff has not requested specific damages but seeks awards for all
compensatory, consequential, and pecuniary damages allegedly sustained by him
for breach of contract, fraud, and deceit, breach of fiduciary duty, tortuous
interference, and oppression plus interest and punitive damages.  At
this time, the Company believes these claims are unfounded and any losses that
might be incurred by the Company cannot be reasonably
estimated.  Accordingly, the Company has not recorded an accrual for
such potential loss but plans to vigorously defend its
position.




-19-





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
10 – Contingencies (continued)





Litigation
(continued)




On March
21, 2007 in the District Court of Douglas County, Nebraska, the Company was
named in a personal injury lawsuit as wells as Midwest Renewable Energy, U.S.
Water Services Utility Chemicals (the plaintiffs employer), and a company
employee. The plaintiff claims that the defendants were negligent in not
assuring that the manhole cover to the boiler being serviced by the plaintiff
was depressurized so that the plaintiff could open the manhole cover in a safe
manner.  The Company was performing services at Midwest Renewable
Energy. The plaintiff is seeking $1.2 million for reimbursement of medical bills
plus interest plus punitive damages.  Due to the number of defendants
and the difficulty of imputing liability by the plaintiff to the defendant, any
losses incurred by the Company cannot be reasonably
estimated.  Accordingly, the Company has not recorded an accrual for
such potential loss but plans to vigorously defend its position. The jury trial
is expected to be concluded in the latter half of November
2010.




On
November 12, 2008 in Circuit Court, Second Judicial Circuit, South Dakota,
County of Minnehaha, the Company was named in a pending action, which is
captioned Dakota Supply Group, Inc. (“DSG”) v. KL Process Design Group, LLC
(“KL”), and Midwest Renewable Energy, LLC, (“MRE”).  The action was
commenced in 2008 for the collection of a debt of approximately $524,000 plus
interest for electrical supplies and materials furnished by DSG to MRE. 
DSG alleges that KL and MRE are responsible for the debt because KL executed the
purchase order without clarifying that the debt was the responsibility of MRE
and that credit was extended directly to KL rather than MRE.  A trial is
currently scheduled for March 2011.  At this time, the Company is
unable to predict the outcome of the case, and accordingly has not recorded an
accrual for such potential loss, but plans to vigorously defend its
position.





On June
30, 2009, a lawsuit was brought against the Company, certain subsidiaries, and
certain current and past officers in the District Court of Lincoln County,
Nebraska.  The plaintiff is Midwest Renewable Energy, LLC, a Nebraska
limited liability company ("MRE").  MRE previously engaged the Company to
manage its existing ethanol facility, oversee its expansion construction and
market the ethanol produced at its facilities.  The plaintiff alleged,
among other things, that the named individuals and entities engaged in
breaches of fiduciary duties owed to MRE, breaches of contract, fraud,
interference with contract, conversion and negligence relating to the management
and expansion of its corn-based ethanol facilities in
Nebraska.  In August 2009, Company filed a motion to compel MRE to
arbitrate its claims, and also separately filed three arbitration demands for
claims relating to the three agreements between the Company and its affiliates
and MRE that were at issue in the lawsuit.  In November 2009, the
Court ruled for the Company and issued an order to compel arbitration. The
Company has claimed $2.8 million in these proceedings, and MRE has
counterclaimed $42.1 million, which counterclaim we believe has absolutely no
merit and which we intend to defend vigorously. The arbitration proceedings for
two of the three arbitrations have begun and are expected to conclude in the
first quarter of 2011. No arbitrator has been selected for the arbitration
of claims and counterclaims arising out of or relating to the third
arbitration.  The schedule for this arbitration will be established
when an arbitrator is selected and proceedings will commence
thereafter. Any losses incurred by the Company cannot be reasonably
estimated. Accordingly, the Company has not recorded an accrual for such
potential loss but plans to vigorously defend its position.




The
Company may be subject to various claims and legal actions arising in the
ordinary course of business from time to time. The Company maintains insurance
to cover certain such actions.




-20-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 11
– Related Parties





add
blue Agreements





On September 1, 2010, the Company
entered into a Master Collaboration Agreement (the “Collaboration Agreement”)
with add blue Consultoria Ltda., a foreign company organized under the laws of
Brazil (“Add Blue”) from which we retained the services of our Company President
and CEO who is also an owner of Add Blue.  The Collaboration Agreement
amends and restates and supersedes all prior agreements between the two parties
are replaced.  Pursuant to the Collaboration Agreement, Add Blue
expressly waived any and all rights throughout the world that it may have in
respect to any and all of the Company’s intellectual property, whether obtained
through the prior agreements or otherwise.  In addition, the
Collaboration Agreement provides for the cancellation and termination of an
option previously granted by Add Blue to the Company to purchase 20% of its
equity.  The Collaboration Agreement also provides for payments by the
Company to Add Blue, between September 2010 and August 2011 and based on the
achievements of certain milestones in respect of customer payments to the
Company aggregating up to $2,583,000  for the acquisition of add
blue’s territorial licensing rights to the Company’s proprietary technology.
..  For the three and nine months ended September 30, 2010,
approximately $2.2 million of expense, comprised of approximately $.5 million in
cash and $1.7 million in stock, has been included in the consolidated statement
of operations.





The
Company also agreed to issue to Add Blue 1,500,000 shares of the Company’s
common stock by September 30, 2010, subject to the satisfaction of any and all
applicable securities laws and other regulations in respect of the stock
issuance.  In addition, in the event that the required conditions for
the payment of funds by a customer have been satisfied, the Company agreed to
issue to Add Blue an additional 500,000 shares of the Company’s common
stock.




The
Company and Add Blue also agreed to form a Brazilian subsidiary (“Newco”) by
November 30, 2010, which Newco would be formed to commercialize certain of the
Company’s intellectual property.  Newco shall be owned 60% by the
Company and 40% by Add Blue (the “Add Blue Equity Interest”).  The
Company will have an option to acquire the Add Blue Equity Interest, exercisable
at its sole discretion, by issuing to Add Blue 1,000,000 shares of the Company’s
common stock.




The
Collaboration Agreement will remain in force for a period of 540 days, and upon
the expiration of such term, it will automatically renew for an additional
period of 360 days, unless either party gives no less than 30 days prior written
notice of its intention to terminate the agreement.





In March
2010, the Company entered into a consulting agreement with add blue Consultoria
Ltda., a Brazilian consulting company, for the provision of services by Peter
Gross as CEO and President of the Company and its
subsidiaries.  During the three and nine months ended September 30,
2010, fees paid to add blue Consultoria Ltda. were approximately $40,000
and $128,000, respectively.  On September 1, 2010, the Company signed
a Master Collaboration Agreement with add add blue Consultoria Ltda. which
provided for payments, based on meeting certain criteria during the nine month
period ending approximately June 30, 2011, aggregating approximately $2.6
million in cash




-21-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 11
– Related Parties (continued)





Other
Related Party Agreements





Pursuant
to its agreement with the Company, Pelly Management, Inc. (“Pelly”) provided
financial advisor services and received fees of $75,000 and $410,000 for the
three and nine months ended September 30, 2010, respectively and $0 and $400,000
for the three and nine months ended September 30, 2009,
respectively.





In February
2009 and April 2009, the Company entered into a consulting contract with Thomas
Schueller, for the position of Executive Chairman of the Board, and Thomas
Bolan, for the position of Chief Financial Officer,
respectively.  In July 2009, the Company also entered into
a consulting services contract with Alan Rae, a
Director.  During the three months ended September 30, 2010 and 2009,
fees paid to Messrs. Schueller, Bolan and Rae were approximately $36,000 and
$36,000, $40,000 and $38,000, and $42,000 and $18,000,
respectively.  During the nine months ended September 30, 2010 and
2009, fees paid to Messrs. Schueller, Bolan and Rae were approximately $109,000
and $93,000, $113,000 and $75,000, and $119,000 and $18,000,
respectively.





As
approved by the Board of Directors on March 2, 2010, a Director’s fee of $18,000
per annum will be awarded to all serving non-executive and non-consulting
directors.  However, payment of such fees will be deferred until
approved by the Board. As of the date of this report, Alain Vignon was the only
Non-Executive, Non-Consulting director and $36,000 has been accrued for his
services from his appointment in October 2008 through September
2010.





Note 12 – Share Based
Compensation





Effective
July 1, 2010, and pursuant to the Company’s 2009 Equity Incentive Plan, 119,518
incentive stock options were awarded to employees and 44,794 restricted stock
grants were awarded to consultants.  The grant date and exercise price
of $1.10 per share for each award represents the effective price at which all
private placement sales have been transacted since October 2009.  All
such awards became one-third vested on July 1, 2010 and the remaining two-thirds
vest evenly on July 1, 2011 and July 1, 2012. The fair value of these awards was
approximately $176,000.





On March
2, 2010, the Company issued to a former executive an option to purchase 83,333
shares of the Company’s common stock at an exercise price of $1.10 which became
fully vested on April 2, 2010 and is exercisable for three years.  The
options were issued to Mr. Corcoran pursuant to Regulation D of the Securities
Act of 1933, as amended.  The fair value of this option was $87,500
and this amount is included in general and administrative expense in the
consolidated statements of operations.





Effective
January 1, 2010, we adopted Statement of Financial Accounting Standards
No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)), now codified
in ASC 718, which requires the measurement and recognition of compensation
expense for all share-based payment awards made to employees, directors and
consultants.  Awards granted after that date are valued at fair value
in accordance with the provisions of ASC 718 and recognized on a straight line
basis over the service periods of each award.  We estimated forfeiture
rates for the year based on historical experience.




-22-





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
12 – Share Based Compensation(continued)





Amounts
recognized in the financial statements related to stock-based compensation are
as follows:





Three
      Months Ended
                
                
                Nine
      Months EndedSeptember
      30,
                
                
                September
      30,2010
                
                
                2009
                
                
                2010
                
                
                2009Total
      cost of stock-based compensation charged against income before income
      taxes
                
                $
                73,227
                
                
                $
                -
                
                
                $
                160,727
                
                
                $
                -Amount
      of income tax benefit recognized in earnings
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Amount
      charged against net income
                
                $
                73,227
                
                
                $
                -
                
                
                $
                160,727
                
                
                $
                -Impact
      on net income per common share:Basic
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Diluted
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -


Stock-based
compensation expense of approximately $161,000 for the nine months ended
September 30, 2010 is reflected as general and administrative expense and
research and development  expense of approximately $123,000 and
$38,000, respectively, in the consolidated statement of operations.





The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model (Black-Scholes). We use historical data to
estimate the expected price volatility, the expected option life and expected
forfeiture rate. The risk-free interest rate is based on the U.S. Treasury yield
curve in effect at the time of grant for the estimated life of the option. The
dividend yield is calculated based upon the dividend payments made during the
prior four quarters as a percent of the average stock price for that period. The
following assumptions were used to estimate the fair value of stock options and
restricted shares granted during 2010 using the Black-Scholes
model:





Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009Stock
      options and Restricted Stock:Volatility
              
              
              226.0
              %
              
              
              -
              
              
              
              232.0
              %
              
              
              -Risk-free
      interest rate
              
              
              2.12
              %
              
              
              -
              
              
              
              1.51
              %
              
              
              -Expected
      term (years)
              
              
              6.5
              
              
              
              -
              
              
              
              1.5
      - 6.5
              
              
              
              -Dividend
      yield
              
              
              0
              %
              
              
              0
              %
              
              
              0
              %
              
              
              0
              %


-23-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
12 – Share Based Compensation (continued)





A summary
of the stock option activity for the three and nine months ended September 30,
2010 is as follows:




Number
      of Shares
                
                
                Weighted
      Average Exercise Price Per Share
                
                
                Weighted
      Average Remaining Contractual
                  Term
      (yrs)
                
                
                Aggregate
      Intrinsic ValueOutstanding
      at December 31, 2009
                
                
                -
                
                
                $
                -
                
                
                
                -Options
      granted
                
                
                83,333
                
                
                $
                1.10
                
                
                
                2.9Options
      forfeited
                
                
                
                
                
                $
                -
                
                
                
                -Options
      expired
                
                
                
                
                
                $
                -
                
                
                
                -Options
      exercised
                
                
                
                
                
                $
                -
                
                
                
                -Outstanding
      at March 31, 2010
                
                
                83,333
                
                
                $
                1.10
                
                
                
                2.9Options
      granted
                
                
                -
                
                
                $
                -
                
                
                
                -Options
      forfeited
                
                
                -
                
                
                $
                -
                
                
                
                -Options
      expired
                
                
                -
                
                
                $
                -
                
                
                
                -Options
      exercised
                
                
                -
                
                
                $
                -
                
                
                
                -Outstanding
      at June 30, 2010
                
                
                83,333
                
                
                $
                1.10
                
                
                
                2.7Options
      granted
                
                
                119,518
                
                
                $
                1.10
                
                
                
                9.8Options
      forfeited
                
                
                (4,544
                )
                
                $
                1.10
                
                
                
                -Options
      expired
                
                
                -
                
                
                $
                -
                
                
                
                -Options
      exercised
                
                
                -
                
                
                $
                -
                
                
                
                -Outstanding
      at September 30, 2010
                
                
                198,307
                
                
                $
                1.10
                
                
                
                6.7
                
                
                $
                -Exercisable
      at September 30, 2010
                
                
                121,658
                
                
                $
                1.10
                
                
                
                5.8
                
                
                $
                -





A summary
of the status of our unvested option shares as of September 30, 2010 is as
follows:




Number
      of Shares
                
                
                Weighted
      Average Exercise Price Per ShareUnvested
      at December 31, 2009
                
                
                -
                
                
                $
                -Options
      granted
                
                
                -
                
                
                $
                -Options
      forfeited
                
                
                -
                
                
                $
                -Options
      vested
                
                
                -
                
                
                $
                -Unvested
      at March 31, 2010
                
                
                -
                
                
                $
                -Options
      granted
                
                
                83,333
                
                
                $
                1.10Options
      forfeited
                
                
                -
                
                
                $
                -Options
      vested
                
                
                (83,333
                )
                
                $
                1.10Unvested
      at June 30, 2010
                
                
                -
                
                
                $
                -Options
      granted
                
                
                119,518
                
                
                $
                1.10Options
      forfeited
                
                
                (4,544
                )
                
                $
                1.10Options
      vested
                
                
                (38,325
                )
                
                $
                1.10Unvested
      at September 30, 2010
                
                
                76,649
                
                
                $
                1.10


-24-




KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
12 – Share Based Compensation (continued)





A summary
of the restricted stock activity for the three and nine months ended September
30, 2010 is as follows:




Number
      of Shares
                
                
                Weighted
      Average Exercise Price Per Share
                
                
                Weighted
      Average Remaining Contractual Term (yrs)
                
                
                Aggregate
      Intrinsic ValueOutstanding
      at December 31, 2009
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares granted
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares forfeited
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares expired
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares exercised
                
                
                -
                
                
                $
                -
                
                
                
                -Outstanding
      at March 31, 2010
                
                
                -
                
                
                $
                -
                
                
                
                --Restricted
      shares granted
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares forfeited
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares expired
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares exercised
                
                
                -
                
                
                $
                -
                
                
                
                -Outstanding
      at June 30, 2010
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares granted
                
                
                44,794
                
                
                $
                1.10
                
                
                
                10.0Restricted
      shares forfeited
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares expired
                
                
                -
                
                
                $
                -
                
                
                
                -Restricted
      shares exercised
                
                
                -
                
                
                $
                -
                
                
                
                -Outstanding
      at September 30, 2010
                
                
                44,794
                
                
                $
                1.10
                
                
                
                9.8
                
                
                $
                -Vested
      at September 30, 2010
                
                
                14,931
                
                
                $
                1.10
                
                
                
                9.8
                
                
                $
                -





A summary
of the status of our unvested restricted stock shares as of September 30,
2010 is as follows:




Number
      of Shares
                
                
                Weighted
      Average Exercise Price Per ShareUnvested
      at December 31, 2009
                
                
                -
                
                
                $
                -Options
      granted
                
                
                -
                
                
                $
                -Options
      forfeited
                
                
                -
                
                
                $
                -Options
      vested
                
                
                -
                
                
                $
                -Unvested
      at March 31, 2010
                
                
                -
                
                
                $
                -Options
      granted
                
                
                -
                
                
                $
                -Options
      forfeited
                
                
                -
                
                
                $
                -Options
      vested
                
                
                -
                
                
                $
                -Unvested
      at June 30, 2010
                
                
                -
                
                
                $
                -Options
      granted
                
                
                44,794
                
                
                $
                1.10Options
      forfeited
                
                
                -
                
                
                $
                -Options
      vested
                
                
                (14,931
                )
                
                $
                1.10Unvested
      at September 30, 2010
                
                
                29,863
                
                
                $
                1.10





As of
September 30, 2010, there was approximately $103,000 of total unrecognized
compensation cost related to unvested share-based compensation granted under our
plans. That cost is expected to be recognized over a weighted-average period of
2.2 years.





The
prescribed accounting guidance also requires tax benefits relating to excess
stock-based compensation deductions to be prospectively presented in the
statement of cash flows as financing cash inflows. As of September 30, 2010, the
Company does not have any tax expense (benefits) resulting from stock-based
compensation deductions in excess of amounts reported for financial reporting
purposes.




-25-





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





Business





While we
have historically provided engineering, construction, operating and ethanol
marketing services, for first generation grain based ethanol (“1st Gen” or
“GBE”) our focus is now on owning and operating cellulose based ethanol ("CBE")
second generation (“2nd Gen”) integrated facilities that utilize our proprietary
technology, and designing these facilities for, and licensing our proprietary
process technology to, third-parties seeking to participate in the renewable
energy and advanced biofuel markets.




Initially,
we created expansion and optimization programs for 1st Gen facilities. The
experience in the design and operation of these GBE’s has given our company a
significant advantage in the development and future operations of 2nd Gen
facilities. While we are able to offer design and engineering services to
optimize existing GBE facilities, our emphasis in the future will be on
integrated CBE facilities.





The
majority of 1st Gen ethanol is currently produced from sugar cane or grain-based
feedstocks, predominantly corn in the United States, however it can also be
produced from cellulose. The growth of first generation ethanol is limited due
to the widespread opposition to using land and crops that can be used for
food or feed, for the production of fuels. This is especially relevant now that
technology has provided a solution that uses widely available cellulose as a
feedstock for ethanol production.  Cellulose is the primary component
of plant cell walls and is one of the most abundant organic compounds available.
Advanced biofuels produced from cellulosic materials draws on non-food related
and waste feedstock sources and has been proven to substantially reduce carbon
dioxide emissions and improve engine efficiency.





Our
scientists and engineers continue to optimize our technology both independently
and in cooperation with the South Dakota School of Mines and Technology in
Rapid City, South Dakota. Based on laboratory data, we have shown our
process is capable of producing up to 90 gallons of ethanol from every dry
metric ton of certain biomass feedstock. Using pretreated sugarcane bagasse
and eucalyptus, we currently are achieving up to 75 gallons per dry metric
ton at our bench scale facility.





A key
part of our business model is the design of scalable, custom-designed fully
integrated CBE plants, preferably with integrated Combined Heat and Power
(CHP) and Bio-Lignin production, tailored to a project’s geographic area
and locally available feedstock. Through Western Biomass Energy,
LLC (“WBE”), a majority-owned subsidiary of ours, we have designed,
constructed and operated what we believe to be one of the first
second-generation CBE demonstration plants in the United States. The WBE plant
was built to serve as a demonstration and research and development facility and
has the future potential, with additional capital investment, to operate
commercially with a capacity of approximately 1.5 million gallons of CBE per
year. This allows us to continue to research, and refine our cellulose
conversion technology, while also demonstrating the commercial viability
for this type of technology.





Biomass,
unlike corn, includes all plants and plant-derived materials and is more evenly
distributed among regions of the world.  The quantity of biomass
available for a CBE plant can come from many different sources, including fuel
wood harvesting, wood processing residue, urban wood residue, fuel treatment
operations, municipal solid waste, crop residue, and perennial crops. The
extensive biomass distribution facilitates co-locating CBE plants closer to
plant feedstock, reducing transportation costs relating to feedstock. Locating
CBE facilities near blending facilities and retail fuel outlets will reduce
transportation costs related to the sale of ethanol. This has the potential to
create a truly local and commercially viable energy source.  We
believe that our CBE facilities provide a commercially viable alternative that
may contribute to solving local communities’ energy and economic
needs.




-26-





There is
no assurance that we will operate profitably or will generate positive cash flow
in the future.The
Company has incurred losses since its inception.  There is no
assurance that we will operate profitably or will generate positive cash flow in
the future.Such
losses have resulted from engineering and management contracts and fuel sales,
with favorable gross margins, which were more than offset by research,
development and administrative expenses.  As the engineering and
management contracts expired, and the wholesale fuel business was discontinued,
losses continued while the business focused on cellulosic research and
development.  If we cannot generate positive cash flows in the future,
or raise sufficient financing to continue our normal operations, then we may be
forced to scale down or even close our operations.





Future
Synergistic Projects





Our
design also offers us better access to synergistic opportunities, such as
co-locating  CBE
facilities with combined heat and power plants, pulp & paper industries and
first generation ethanol production plants.





As a
natural consequence of converting the fermentable portion of the biomass
feedstock to ethanol, the solid co-product left behind is rich in lignin, a high
energy solid fuel component which is sulfate-free and can be used as a compound
material in the chemicals industry.  Using a conventional wood pellet
mill, this co-product can be formed into pellets that are more dense and durable
than the typical wood pellet marketed today.  Our process minimizes
chemical biomass pretreatment because the bio-lignin co-product chemistry is
unaltered. This results in a clean-burning, high-energy premium bio-lignin
pellet product.





We have
identified several potential projects and locations for plants using our
technology and are currently conducting multiple pre-feasibility
studies.





Production
Processes





Several
technologies have been developed to produce ethanol from
biomass.  Generally speaking, efforts to convert cellulose into
ethanol follow one of two main processes:




·
            Thermochemical
      conversion of biomass into synthesis gas or “syngas” (a process often
      referred to as “gasification”), followed by catalytic conversion of the
      syngas into mixed alcohols that include ethanol and/or alkaline via
      modified chemistry; or·
            Biomechanical
      conversion, which is the enzymatic or chemical breakdown of biomass into
      component sugars, followed by biological fermentation of the sugars
      into ethanol.





We have
selected the enzymatic breakdown of biomass for producing ethanol from cellulose
alternative because we believe it has distinct advantages over the
thermochemical/gasification methods. Gasification methods present a number of
challenges, including the capital intensity of the process, selectivity of the
syngas conversion to ethanol, and alcohol tolerance of the organisms capable of
converting syngas to ethanol. Furthermore, unlike other cellulosic ethanol
technology, we use insignificant amounts of acid (up to .3%) in our process,
eliminating the environmental hazards that result with acid, and producing
valuable by-products from the resulting lignin. Our process has significantly
reduced process water discharge. Other technologies discharge waste water back
into local streams or municipal waste water systems.





In terms
of reduction of greenhouse gases, cellulosic ethanol represents a significant
advance over grain-based ethanol.  According to a report by Argonne
National Laboratory, grain ethanol reduces greenhouse gas by 18% to 29% per
vehicle mile traveled as compared to gasoline, while cellulosic ethanol reduces
greenhouse gas emissions by approximately 85% per vehicle mile traveled. Other
advantages may include additional revenues through the sale of carbon credits,
federal and state tax incentives and other measures that result from
governmental support of cellulosic ethanol.





-27-




Business
Strategies




During
the current year, we plan to continue to optimize our technology and to design
our first commercial (and possibly second) CBE facility. In addition, we intend
to license our technology and contract our design engineering to third
parties.  We will focus on developing cellulosic ethanol projects
integrated into existing industries like CHP plants, together with partners that
will help us accelerate the commercialization of our cellulosic technology and
expand our global market presence.  These strategic partners and
alliances provide an important advantage in realizing success in commercializing
our process technologies.  Key elements of our business strategy
are:




· Developing and supplying the
technologies for commercial production of cellulosic ethanol from certain
biomass feedstocks like sugarcane bagasse, eucalyptus and other hard woods, soft
woods and agricultural waste





· Owning and operating our own
CBE facilities





· Developing national and international
strategic partnerships and strategic alliances.  We intend to
develop our projects together with partners that will help accelerate the
commercialization of our cellulosic technology and expand our global market
presence.  These strategic partners and alliances will be important in
accelerating the commercialization of our process technologies.





· Improving existing ethanol
production through KL CapacitySM





We
currently do not sell a material amount of ethanol and/or
bio-lignin.  Our WBE facility is currently designed to gather
data for process enhancements, provide input to the design of commercial-scale
projects and validate our technology as part of the feasibility
studies.





Challenges





KL
Energy’s success depends on the ability to develop multiple projects while also
enhancing our process technology. This strategy places increased demand on our
limited human resources and requires us to substantially expand the capabilities
of our operational staff. The ability to attract, train, manage and retain
qualified management, technical, and engineering personnel presents our greatest
challenge.  Other significant challenges are:




●
            A
      significant portion of our business is in the process of scaling-up to
      commercial operations, causing us to rely on outside sources of funding,
      rather than supporting ourselves from our own
  operations.





●
            We
      may be unable to raise debt or equity funding, upon which we will be
      highly dependent, in the near term.





●
            Our
      poor liquidity may deter existing or potential vendors, suppliers or
      customers from engaging in transactions with
us.





●
            We
      depend on enzymes, some of which are in the research and development
      phase, which currently represent a significant and volatile expense in the
      CBE production process. Recent developments have demonstrated that these
      costs should continue to drop rapidly over the next two
    years.





●
            Our
      industry continues to develop both existing and emerging competitors and
      competitive technologies.





-28-





Significant
Developments





Recent
Agreements





add
blue Agreements





On
September 1, 2010, the Company entered into a Master Collaboration Agreement
(the “Collaboration Agreement”) with add blue Consultoria Ltda., a foreign
company organized under the laws of Brazil (“Add Blue”) from which we retained
the services of our Company President and CEO who is also an owner of Add
Blue.  The Collaboration Agreement amends and restates and supersedes
all prior agreements between the two parties are replaced.  Pursuant
to the Collaboration Agreement, Add Blue expressly waived any and all rights
throughout the world that it may have in respect to any and all of the Company’s
intellectual property, whether obtained through the prior agreements or
otherwise.  In addition, the Collaboration Agreement provides for the
cancellation and termination of an option previously granted by Add Blue to the
Company to purchase 20% of its equity.  The Collaboration Agreement
also provides for payments by the Company to Add Blue, between September 2010
and August 2011 and based on the achievements of certain milestones in respect
of customer payments to the Company aggregating up to $2,583,000  for
the acquisition of add blue’s territorial licensing rights to the Company’s
proprietary technology. .  For the three and nine months ended
September 30, 2010, approximately $2.2 million of expense, comprised of
approximately $.5 million in cash and $1.7 million in stock, has been included
in the consolidated statement of operations.





The
Company also agreed to issue to Add Blue 1,500,000 shares of the Company’s
common stock by September 30, 2010, subject to the satisfaction of any and all
applicable securities laws and other regulations in respect of the stock
issuance.  In addition, in the event that the required conditions for
the payment of funds by a customer have been satisfied, the Company agreed to
issue to Add Blue an additional 500,000 shares of the Company’s common
stock.




The
Company and Add Blue also agreed to form a Brazilian subsidiary (“Newco”) by
November 30, 2010, which Newco would be formed to commercialize certain of the
Company’s intellectual property.  Newco shall be owned 60% by the
Company and 40% by Add Blue (the “Add Blue Equity Interest”).  The
Company will have an option to acquire the Add Blue Equity Interest, exercisable
at its sole discretion, by issuing to Add Blue 1,000,000 shares of the Company’s
common stock.




The
Collaboration Agreement will remain in force for a period of 540 days, and upon
the expiration of such term, it will automatically renew for an additional
period of 360 days, unless either party gives no less than 30 days prior written
notice of its intention to terminate the agreement.





Effective
August 23, 2010, Petrobras Brasileiro Ltda., through its subsidiary Petrobras
America, Inc. ((“Petrobras”), entered into a Joint Development Agreement (“JDA”)
with the Company to jointly optimize our proprietary cellulosic ethanol process
technology for sugarcane bagasse feedstock (“Bagasse”).  The latest
generation of the Company’s process design provides for substantial enhancements
over the first generation, implemented in 2008 at the Company’s demonstration
plant in Upton, Wyoming using Ponderosa Pine feedstock, including the ability to
be optimized for multiple feedstocks.  As part of this agreement,
Petrobras will provide up to US$ 11 million to adapt the Company’s demonstration
facility to the use of Bagasse, validate the optimized process by producing
cellulosic ethanol and bio-lignin from Bagasse in multiple campaigns and license
the technology.  In parallel, Petrobras and KLE will jointly work on
an industrial scale Bagasse based cellulosic ethanol plant project that shall be
fully integrated into a sugarcane mill belonging to the Petrobras Group in
Brazil slated to go on stream in 2013 and capable of producing 15 million liters
per year.  The agreement, which has an initial term of 18 months and
provides for mutual exclusivity in the area of developing cellulosic ethanol
from Bagasse, provides Petrobras with the option to enter into a technology
license for the use of the Company’s technology within Petrobras Group
assets.




-29-





On
September 24, 2010, KL Energy Corporation (the “Company”) entered into a
Termination Agreement (the “Termination Agreement”) with Greenext Energy Europe
S.A, a foreign corporation organized under the laws of Luxembourg
(“Greenext”).  The Termination Agreement provides for the termination
of that certain sublicense previously granted to Greenext, and all rights and
licenses thereunder (the “Sublicense”), with respect to the technology subject
to that certain Technology License Agreement dated March 6, 2008 (the “License”)
by and between KL Process Design Group, LLC (the Company’s predecessor company)
and O2Diesel Europe, Plc.  As consideration, the Company agreed to pay
Greenext a termination fee of €40,000 (approximately $54,000). Greenext and its
holding company, Pike S.A., also agreed to be sold and Greenext agreed to change
its name, the occurrence of which will trigger an obligation by the Company to
make a payment of €5,000 (approximately $7,000) the owner of the
companies.





Recent
Financing





Our
recent financings are described in Note 3 of the Notes to Consolidated Financial
Statements included in this Report and incorporated by reference
herein.




Subsequent
Events





Not
applicable.





Critical
Accounting Policies and Estimates:





Restricted
Cash




Restricted
cash includes cash received from Petrobras Americas, Inc. (“Petrobras”) to be
used for the projects included in the Joint Development Agreement between the
Company and Petrobras.





Trade
Receivables





Trade
receivables are carried at original invoice less an estimate made for doubtful
receivables based on a periodic review of all outstanding
amounts.  Management of the Company has established an allowance for
doubtful accounts based on their estimate of uncollectible accounts and is
established based on historical performance that is tracked by the Company on an
ongoing basis.  Trade receivables are written off when deemed
uncollectible. Recoveries of trade receivables previously written off are
recorded when received.




-30-





Long-Lived
Assets





Property,
plant and equipment is recorded at cost. Depreciation expense is computed using
the straight–line method over the estimated useful lives of the assets,
generally three to five years except for leasehold improvements which are
amortized over the lease term.





Costs
incurred relating to construction-in-progress for plant facilities are
capitalized when those costs are for the active development of the
facility.   Depreciation commences when the construction activity is
completed and the additional assets are available for use.




Revenue
and Cost Recognition





Revenue
from joint development and funded research arrangements are accounted for using
the proportional performance method under which revenue is recognized in
proportion to the services or activities incurred under such agreements. If
estimated total costs on this contract indicate a loss, we charge the entire
estimated loss to operations in the period in which the loss becomes known. The
cumulative effect of revisions to revenue, and estimated costs to complete this
contract, are recorded in the accounting period in which the events indicating a
loss or change in estimates are known and the loss can be reasonably
estimated.  Amounts billed in excess of revenue recognized are
included in deferred income.





Revenue
from feedstock testing results from agreements with third parties for the
Company to perform extensive tests to determine if the customer’s feedstock is a
viable candidate for use in the production of cellulosic ethanol.  The
standard agreement requires that the customer pay 50% of the testing fee upon
signing the feedstock testing agreement and the remaining 50% when the Company
delivers a final report to the customer explaining the test results and
conclusions.  Feedstock testing revenues, and related expenses, are
only recognized when this report is delivered.




-31-





Revenue
from fixed price contracts is recognized on the percentage-of-completion method,
measured by the percentage of costs incurred to date to estimated total costs
for each contract.  This method is used because management considers
expended costs to be the best available measure of progress on these
contracts.  Due to uncertainties inherent in the estimation process,
it is at least reasonably possible that the completion costs for contracts in
progress at June 30, 2010 and December 31, 2009 will be revised
significantly in the near term.  Contract costs include all direct
material, subcontract and labor costs, and those indirect costs related to
contract performance, such as labor, supply, tool, and depreciation
costs.  Operating costs are charged to expense as
incurred.  Revenue is reported net of sales tax
collected.  Provisions for estimated losses on uncompleted contracts
are made in the period in which such losses are determined.  Changes
in job performance, job conditions, and estimated profitability, including those
arising from contract penalty provisions and final contract settlements, may
result in revisions to costs and income and are recognized in the period in
which the revisions are determined.





Pre-contract
costs directly associated with a specific contract are deferred as incurred in
anticipation of that contract if recovery of these costs is determined to be
probable.    Conversely, if it appears unlikely that we will
obtain the contract, all previously deferred costs are expensed.  Such
costs include consultant expenses for project development, technology
improvements, facility engineering and feedstock evaluation
expenses.





Based on
our percentage-of-completion revenue recognition policy, revenues and costs
associated with approved change orders are adjusted when Company and customer
approvals of the change order are obtained.  For unpriced or
unapproved change orders, recovery must be deemed probable, if the future event
or events necessary for recovery are likely to occur, at which time revenues and
costs associated with the unpriced or unapproved change orders are adjusted. If
change orders are in dispute or are unapproved in regard to both scope and
price, they are evaluated as claims.





Claims
are amounts in excess of the agreed contract price (or amounts not included in
the original contract price) that a contractor seeks to collect from customers
or others for customer-caused delays, errors in specifications and designs,
contract terminations, change orders in dispute or unapproved as to both scope
and price, or other causes of unanticipated additional costs.





Recognition
of amounts of additional contract revenue relating to claims is made only if it
is probable that the claim will result in additional contract revenue and if the
amount can be reliably estimated. Those two requirements are satisfied by the
existence of all of the following conditions:




a.) The
contract or other evidence provides a legal basis for the claim; or a legal
opinion has been obtained, stating that under the circumstances there is a
reasonable basis to support the claim.




b.)
Additional costs are caused by circumstances that were unforeseen at the
contract date and are not the result of deficiencies in the contractor's
performance.




c.) Costs
associated with the claim are identifiable or otherwise determinable and are
reasonable in view of the work performed.




d.) The
evidence supporting the claim is objective and verifiable, not based on
management's feel for the situation or on unsupported
representations.





If the
foregoing requirements are met, revenue from a claim is recorded only to the
extent that contract costs relating to the claim have been incurred. Costs
attributable to claims are treated as costs of contract performance as
incurred.




The
liability, "Billings in excess of costs and estimated earnings on uncompleted
contracts," represents billings in excess of revenue recognized.




-32-





Patriot
provided blended fuel on consignment to service stations.  Revenue
related to the sale of blended fuel by Patriot was recorded when the ethanol was
sold by the service station to the end customer.  This operation was
discontinued in January 2009.





Income
Taxes





The
Company uses the asset and liability method to account for income
taxes.  Under the asset and liability method, deferred tax assets and
liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax basis.  Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled.  The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date.  The measurement of deferred tax assets
is reduced, if necessary, by a valuation allowance for future tax benefits for
which realization is not considered more likely than not.





Share
Based Compensation





We follow
the guidance in FASB Topic 718 related to share-based payments to recognize all
grants of stock options in our financial statements based upon their respective
grant date fair values.  Under this standard, the fair value of each
employee stock option is estimated on the date of grant using an option pricing
model that meets certain requirements.  We currently use the Black-Scholes
option pricing model to estimate the fair value of our stock options.  The
Black-Scholes model meets the requirements of FASB Topic 718 but the fair values
generated by the model may not be indicative of the actual fair values of our
equity awards as it does not consider certain factors important to those awards
to employees, such as continued employment and periodic vesting
requirements.  The determination of the fair value of share-based payment
awards utilizing the Black-Scholes model is affected by our stock price and a
number of assumptions, including expected volatility, expected life and
risk-free interest rate.  We use a historical volatility rate on our stock
options.  The fair value of our common stock is based on recent private
placement transactions by the Company, as of the date of the grant, which have
been at $1.10 per share.  Because its stock is thinly traded, the
Company does not believe that quotations for our common stock, as reported on
the OTC Bulletin Board prior to the Company being deleted in March 2010,
particularly at December 31, 2009, are indicative of the market value of the
business.  If there are any modifications or cancellations of the
underlying securities, we may be required to accelerate, increase or cancel any
remaining unearned stock-based compensation expense.  To the extent that we
grant additional equity securities to employees, our stock-based compensation
expense will be increased by the additional unearned compensation resulting from
those additional grants.





Liquidity
and Capital Resources





At
September 30, 2010, the Company had approximately $2.3 million of total current
assets which primarily consisted of approximately $1.9 million in cash and cash
equivalents (of which approximately $1.4 million was restricted for use on the
Petrobras project), $79,000 of receivables, $55,000 of
inventories,  approximately $209,000 of prepaid insurance, legal and
project expenses, and $73,000 in debt issuance costs.  In addition, we
had approximately $2.4 million of net property, plant and
equipment.  Our total assets as of September 30, 2010 were
approximately $4.7 million.   With $7.9 million of total current
liabilities, the Company had negative working capital of approximately $5.6
million at September 30, 2010.





We
received additional gross proceeds from private placements of approximately $1.5
million in January 2010, $500,000 in March 2010, $600,000 in May 2010, $750,000
in June 2010 and $1.5 million in July 2010 to fund operating activities and
allow all borrowing commitments to remain current.  These transactions
are described in Note 3 and Note 12 of the Notes to Consolidated Financial
Statements. We expect to rely on funds raised from these recent private
placements, as well as future equity and debt offerings, to implement our growth
plan and meet our liquidity needs going forward. We continue to seek additional
financing but are not certain whether any such financing would be available on
terms acceptable to us, if at all.




-33-




Since Q3
2008, when the business became entirely focused on developing and
commercializing our proprietary technology, we have relied on investors’ funds
to support the business.  We believe that we will continue to do so
until the revenue derived from licenses and engineering services provided to
third parties and the income from proposed projects reaches a level sufficient
to support the Company.




We have
in the past sought, and been successful in attracting, investment from both
traditional sources and from strategic partnerships and it is part of our
strategy that we will continue to do this irrespective of the success of the
offering.  The Company is actively working with professional advisors
that are providing introductions to potential investors in the U.S and
Europe.




Our
ability to generate income from our operations will rely on the ability of
ourselves and our partners to bring existing and future projects to a position
of being fully funded and ready to build.  We believe that, in the
current and projected short term economic climate, our smaller, lower-cost
plants will prove to be considerably more financially viable than the competing
alternatives and will continue to attract the support of strategic industry and
financial partners.




In their
report dated March 8, 2010, the Company’s auditors indicated there was
substantial doubt about the Company’s ability to continue as a going concern.
Accordingly, unless we raise additional working capital, obtain project
financing and/or revenues grow to support our business plan, we may be unable to
remain in business.





Line
of Credit; Loans





The
Company and certain WBE members are guarantors for, and the Company is
funding payments with respect to, a note payable by WBE to Security
National Bank of $1,302,946 at September 30, 2010.  A principal payment of
$500,000 was made in February 2009.  Pursuant to amendments executed
during the first quarter of 2009 and 2010, principal and interest payments of
$17,560 were required to be made from March 2009 until the current maturity date
of March 2011.  This loan’s maturity may be extended on an annual
basis if the Company is in compliance with the note terms. As of the date of
this report, the Company is in compliance with these terms.  This note
bears interest at 6.5% and is secured by substantially all of the assets of
WBE.  The Company has no significant debt covenants for any of its
debt.





We had a
subordinated secured note payable to a current shareholder and former officer of
the Company totaling $600,000 at December 31, 2008.  This note had a
variable interest rate, which was 5.0% at June 30, 2010 and December 31, 2009,
with interest paid quarterly.  Prior to February 2009, this note was
unsecured and did not have a specified due date. In February 2009, the note was
modified to require principal payments of $10,000 per month beginning September
2009 over a 60 month term. The principal payments are scheduled to be $120,000
in each of 2010, 2011, 2012, 2013, and $26,461 in 2014.  As security
for our obligations under this note, we granted to the lender a security
interest in our current and future accounts receivable. In addition, if the
Company receives additional equity financing, the Company is obligated to pay 5%
of the proceeds towards principal payments on this note.  Since
December 31, 2009, an additional $242,500  has been classified as
currently payable. Total current maturities and the balance on this note as of
September 30, 2010 were $466,462.




-34-





The
Company also has a secured promissory note payable to Lansing Securities Corp.
in the amount of $250,000 at 10% interest. The maturity date of this loan has
passed and has been temporarily waived by Lansing Securities until further
notice.





In June
2009, the Company negotiated a repayment of its overdue payables to
Hermanson Egge, a vendor that supplied construction services to
WBE.   The repayment arrangement is unsecured, requires no
interest payments and includes the following schedule of payments:  $70,000
in July 2009, $15,000 monthly from July 2009 to April 2010, $10,000 monthly from
May 2010 to August 2010, $20,000 monthly for September 2010 to November 2010 and
$15,000 in December 2010.  Up to $75,000 of this payable may be
reduced in exchange for the Company engaging Hermanson Egge to provide
future engineering services with scheduled completion and payment dates not
later than December 1, 2010.  The balance of this obligation at
September 30, 2010 was $35,000.





Additional
current liabilities of approximately $5.8 million consist of accounts payable of
approximately $1.7 million (of which approximately $3,000 was to related
parties), billings in excess of costs and estimated earnings on uncompleted
contracts of approximately $1.6 million, and accrued liabilities of $646,000
(primarily consisting of approximately $93,000 of payroll related
expenses, an estimated $119,000 for consulting and engineering services provided
by Niton Capital, an estimated $93,000 for accrued legal and audit fees and
approximately $387,000 for other accrued liabilities), approximately $1.5
million of deferred income for Petrobras projects, and approximately $316,000
representing liabilities of the discontinued operations of KLM, KLHC and
Patriot.





Long-term
debt of approximately $299,000 at September 30, 2010 represents the net of a
$1.5 million convertible promissory note, issued, to the Company on July 1,
2010, and the related debt discount of approximately $1.2.  This
transaction is described in Note 3 of the Notes to Consolidated Financial
Statements.  Our total liabilities were approximately $8.2 million as
of September 30, 2010.




In
October 2008, we issued a $250,000 loan to O2Diesel Corporation (“O2D”), a
business partner, and accounted for this transaction by increasing Note
Receivable and decreasing cash for that amount. In early 2009, when it became
apparent that O2D, as a result of its default on this Note and its deteriorating
financial condition, was not going to be able to repay that loan, we effectively
wrote off this receivable with a $250,000 charge to bad debt
expense.  This bad debt expense was included in the General and
Administrative expense line in the statement of operations for the year ended
December 31, 2008.  In April 2009, the Company sold this Note at face
value to a third party (the "Note Purchaser").  The $250,000 proceeds
from this Note sale was credited to bad debt expense.  This bad debt
expense credit was included in the General and Administrative expense line in
the statement of operations for the three and six months ended June 30,
2009.




Subsequently,
O2D declared bankruptcy and the Note Purchaser acquired O2D out of
bankruptcy.  The Company acquired the Technology License and Services
Agreement (“License Agreement”), executed with O2D in March 2008, from the Note
Purchaser in exchange for a payment of $150,000 in October 2009 and the
Company's agreement to negotiate a new license for limited territories with the
Note Purchaser.  The $150,000 payment was included in the Other
Expense line in the statement of operations for the year ended December 31,
2009.




We have
provided substantial funding for WBE, a 64% owned subsidiary of ours, relating
to the development of our cellulosic technology.  As of September 30,
2010 and December 31, 2009, WBE owed us approximately $9.5 million and $8.8
million, respectively.  There is currently no specific repayment
schedule for these debts owed to the Company by WBE.




-35-





Net
Cash Flow – Operating Activities





As a
result of the Company’s history of losses, our cash flow from operations has
been negative since the inception of the company. We do not anticipate that we
will have a positive cash flow from operations in 2010. Whether we have positive
cash flow in 2011 depends on whether we are able to realize engineering design
and licensing revenue from new CBE projects (expected to start as early as the
last quarter of 2010) and any facility improvement contracts for GBE plants and
other operational revenue.  A significant piece of our business is
still in the research and development phase and we expect to continue to incur
losses until we are able to license our technology for third party projects or
raise financing for our own projects.





We are in
the process of implementing cost control measures that should help us reach our
technology and business goals more efficiently. We have implemented a strict
budgetary and financial control process.  We have also re-focused our
human and financial resources towards the goal of being a technology provider
and eliminated positions that are not critical to this business
mission.





During
the nine months ended September 30, 2010, our operating activities used a net of
approximately $2.0 million of cash. This reflected a loss of approximately $6.5
million from continuing operations, increases in receivables ($43,000),
inventories ($40,000), and decreases in accounts payable ($83,000) and accrued
liabilities ($327,000 of which $300,000 represented the reversal of previous
accruals for estimated services from Niton) which were largely offset by
approximately $5.0 million in cash flows provided by depreciation ($1.4
million), stock based compensation ($161,000), issuance of stock for licensing
rights ($1.6 million), amortization of debt discount and issuance costs
pertaining to the Convertible Promissory Note ($296,000), prepaid expenses and
other current assets ($9,000)  and deferred income related to the
Petrobras project ($1.5 million).





During
the nine months ended September 30, 2009, our operating activities used a net of
approximately $3.4 million of cash. This primarily reflected a net loss of
approximately $6.5 million from continuing operations, decreases in trade
receivables ($28,000), accounts payable ($389,000), inventories ($46,000) and
prepaid expenses and other assets ($423,000) which were largely offset by cash
flows provided by depreciation ($1.4 million), increases in the allowance for
doubtful accounts ($438,000), accrued payroll and other liabilities ($1.1
million – primarily an estimated $510,000 for consulting and engineering
services provided by Niton Capital, current liabilities of discontinued
operations $161,000, and decreases in prepaid expenses and other current assets
($385,000 – primarily the reductions in deferred issuance costs and prepaid
insurance).





Net
Cash Flow - Investing Activities





Net cash
used in investing activities during the nine months ended September 30, 2010 of
approximately $234,000 increased by approximately $122,000 over investing
activities in the nine months ended September 30, 2009.  This increase
was the primarily a result of higher purchases of equipment for the WBE facility
and the Company’s research and development laboratory.





Net
Cash Flow – Financing Activities





Net cash
provided by our financing activities was approximately $4.0 million for the nine
months ended September 30, 2010. During this period, we received approximately
$3.4 million in gross proceeds from the private placement of common stock and
$1.425 million in proceeds, net of $75,000 in debt issuance costs, from
convertible debt offset by approximately $335,000 in legal, professional and
placement fees, and approximately $426,000 of net reductions in short-term
borrowings and subordinated debt – related parties.  Net cash provided
by our financing activities for the nine months ended September 30, 2009 was
approximately $3.1 million. During this period, we received $5.0 million in
gross proceeds from the private placement of common stock offset by $840,000 in
legal, professional and placement fees and approximately $1.1 million of net
reductions in short-term borrowings and long-term debt.




-36-




Results
of Operations for the Three Months Ended September 30, 2010 and
2009





Revenue





In the
three months ended September 30, 2010, the Company recognized approximately
$698,000 of project development services revenue primarily consisting of
approximately $36,000 in biofuel feedstock testing income and approximately
$662,000 of recognized revenue on the Petrobras project.  The Company
did not record any revenue for the three months ended September 30, 2009
which was primarily due to the discontinuance and/or work stoppage on
existing contracts in the grain based ethanol business in the latter half of
2008 and it also reflects our focus on research and the enhancement of our CBE
technology.





Operating
Expenses





Operating
expenses of approximately $3.6 million, in the three months ended September 30,
2010, were approximately $1.7 million higher than the comparable period in the
prior year.  The primary reasons for this increase were project
development services costs of approximately $363,000 and $2.2 million in
technology licensing acquisition costs offset by an approximately $415,000
decrease in general and administrative expenses and an approximately $427,000
decrease in research and development costs.





Project development services
costs, primarily related to the Petrobras project and feedstock testing
activities, were approximately $363,000 for the three months ended September 30,
2010.  These costs were $0 in the comparable period in the prior year
as there were no engineering projects, due to the discontinuance and/or work
stoppage on existing contracts in the grain based ethanol business in the latter
half of 2008 and an absence of new contracts in 2009, or feedstock testing
programs completed in 2009.





General and Administrative
expense of approximately $396,000 for the three months ended September
30, 2010 was approximately $415,000 lower than the comparable 2009
period.  This decrease was primarily attributable to $329,000 of lower
administrative expenses (due to lower staffing, advertising, travel and
insurance costs, the inclusion of approximately $163,000
of  administrative personnel costs in project development services
expenses and the reversal of $300,000 of previous accruals for estimated
services from Niton), $41,000 of lower project expenses , and $59,000
of lower legal costs related to legacy litigation issues offset by
$74,000 of higher audit and legal fees related to being a public
company and $3,000 of higher business development costs.  In addition,
approximately $163,000 of administrative personnel costs were included in
project development services expenses in 2010.





Research and Development
expense of approximately $651,000 for the three months ended September
30, 2010 was approximately $427,000 lower than the comparable 2009 period
primarily due to reduced operations in 2010 and higher WBE plant maintenance
costs in 2009.  In addition, approximately $510,000 of research and
development personnel costs were included in project development services
expenses in 2010.





Licensing rights
expense of approximately $2.2 million represents add blue technology
license rights buy-back ($1.5 million shares of KL stock at $1.10 per share
($1.65 million) plus cash of $450,000) and Greenext technology license rights
buy-back of $54,000.





Other
Income (Expense)





Other income was
approximately $4,000 and $25,000 for the three months ended September 30, 2010
and 2009, respectively, and primarily includes several small government
grants.





Interest income of
approximately $427 for the three months ended September 30, 2010 was
approximately $70 lower than the comparable 2009 period primarily as a result of
lower invested cash balances.





Interest expense of
approximately $336,000 for the three months ended September 30, 2010 was
approximately $272,000 higher than the comparable 2009 period primarily as a
result of the amortization of debt discount and issuance costs of approximately
$294,000, as well as lower interest on the subordinated debt-related party and
financed lab equipment and insurance policies, in 2010.




-37-





Results
of Operations for the Nine Months Ended September 30, 2010 and 2009





Revenue





In the
nine months ended September 30, 2010, the Company recognized approximately
$818,000 project development services revenue primarily consisting of
approximately $156,000 in biofuel income from several feedstock testing programs
and approximately $662,000 of recognized revenue on the Petrobras
project.  The Company did not record any revenue for the nine months
ended September 30, 2009 which was primarily due to the absence of
feedstock testing programs as wells the discontinuance and/or work stoppage on
existing contracts in the grain based ethanol business in the latter half of
2008.  These results also reflect our focus on research and the
enhancement of our CBE technology.





Operating
Expenses





Operating
expenses of approximately $6.9 million in the nine months ended September 30,
2010 were approximately $506,000 higher than the comparable period in the prior
year. The primary reasons for this increase were project development services
costs of approximately $423,000 and $2.2 million in technology licensing
acquisition costs offset by an approximately $1.4 million decrease in general
and administrative expenses and an approximately $657,000 decrease in research
and development costs.





Project development services
costs were approximately $423,000 for the nine months ended September 30,
2010 primarily related to the Petrobras project and feedstock testing
activities.  These costs were $0 in the comparable period in the prior
year as there were no engineering projects, due to the discontinuance and/or
work stoppage on existing contracts in the grain based ethanol business in the
latter half of 2008 and an absence of new contracts in 2009, or feedstock
testing programs completed in 2009.





General and Administrative
expense of $2.0 million for the nine months ended September 30, 2010 was
$1.9 million, or 49%, lower than the $3.4 million for the comparable period in
the prior year.  This significant improvement was primarily
attributable to $1.3 million of lower administrative expenses (due to lower
staffing, advertising, travel,  insurance costs,  and the
inclusion of approximately $163,000 of  administrative personnel costs
in project development services expenses and the reversal of $300,000 of
previous accruals for estimated services from Niton), $128,000 of lower
audit and legal fees related to being a public company and $105,000 in lower
project costs offset by a $99,000 increase in business development costs (due to
an increase in consulting fees and travel expenses) and $50,000 of higher legal
costs related to legacy litigation issues.





Research and Development
expense of $2.3 million for the nine months ended September 30, 2010 was
$657,000, or 7%, lower than the $3.0 million for the comparable period in the
prior year.  This improvement was largely due to reduced operations in
2010 including a significant reduction in personnel and maintenance costs.
Depreciation expense of approximately $1.3 million and $1.4 million for the nine
months ended September 30, 2010 and 2009, respectively, each represents
approximately 57% of research and development expenses in these
periods.





Licensing rights
expense of approximately $2.2 million represents add blue technology
license rights buy-back ($1.5 million shares of KL stock at $1.10 per share
($1.65 million) plus cash of $450,000) and Greenext technology license rights
buy-back of $54,000.




-38-





Other
Income (Expense)





Other income was
approximately $21,000 and $37,000 of income for the nine months ended September
30, 2010 and 2009, respectively, and primarily includes government
grants.





Interest income of
approximately $1,000 for the nine months ended September 30, 2010 was
approximately $44,000 lower than the comparable 2009 period primarily as a
result of higher interest earned on overdue customer balances and higher
invested cash balances in the first half of 2009.





Interest expense of
approximately $416,000 for the nine months ended September 30, 2010 was
approximately $251,000 higher than the comparable 2009 period primarily due to
the amortization of Convertible Promissory Note debt discount and issuance costs
of approximately $294,000, as well as absence of approximately $20,000 in
interest fees on past due vendor balances and $2,000 interest paid on the line
of credit the company held in the first quarter of 2009, offset by minor
interest paid in 2010 on financed lab equipment and D&O
insurance.





Item
3.  Quantitative and Qualitative Disclosures About Market
Risk





As a
“smaller reporting company” defined in Item 10(f)(1) of Regulation S-K, we are
electing scaled disclosure reporting obligations and therefore are not required
to provide the information requested by this item.





Item 4T.  Changes
in Internal Control Over Financial Reporting





(a) Disclosure Controls and
Procedures. We maintain disclosure controls and procedures designed
to provide reasonable assurance that information required to be disclosed in our
reports under the United States Securities and Exchange Act of 1934, as amended,
is recorded, processed, summarized and reported within the time periods
specified in the SEC’s rules and forms, and that such information is accumulated
and communicated to our management, including our Chief Executive Officer and
Chief Financial Officer, to allow timely decisions regarding required
disclosure.





Internal
control over financial reporting 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.




Our
management, with the participation and oversight of our Chief Executive Officer
and our Chief Financial Officer, has reviewed and evaluated the design and
effectiveness of our disclosure controls and procedures as of the end of the
period covered by this quarterly report on Form 10-Q. Based on that evaluation,
our Chief Executive Officer and Chief Financial Officer have concluded that, as
of September 30, 2010, our disclosure controls and procedures were not
effective as a result of the continued existence of material weaknesses in
internal controls as identified more fully in “Item 9A (T) Controls and
Procedures” in our Annual Report on Form 10-K for the year ended December 31,
2009.  Material weaknesses in our disclosure controls and procedures
were first identified by our independent audit firm during its audit procedures
in mid-2008 as the Company prepared for its reverse merger.  These
weaknesses include (a) weak segregation of cash duties (such as expenses did not
have adequate approval, bank reconciliations were not approved, etc.), (b)
journal entries not approved by a non-preparer, (c) documentation, including
signed contracts, (d) inadequately supported various transactions, and (e)
inadequate internal technical expertise related to GAAP and SEC issues and
regulations.  As a result of these weaknesses, and the difficulties
encountered in the preparation of financial statements and footnotes, management
determined that the Company’s internal controls were not effective.  Many
of these material weaknesses were a result of the Company’s lack of sufficient
resources in its accounting department, a challenge that is likely to continue
until the Company is in a financial position that it believes warrants adding
additional resources.  In light of these material weaknesses, we have taken
the actions described below.




-39-





Because
of these material weaknesses, we have added additional controls and performed
procedures and analyses designed to ensure that our unaudited consolidated
financial statements are presented fairly in all material respects in accordance
with accounting principles generally accepted in the United States. We relied on
increased monitoring and review to compensate for the material weaknesses in our
internal controls. Accordingly, management believes that the unaudited
consolidated financial statements included in this quarterly report fairly
present, in all material respects, our financial position, results of operations
and cash flows for the periods presented.





(b) Internal Controls . In order
to remediate the weaknesses in our disclosure controls and procedures and
internal control over financial reporting identified in our Annual Report on
Form 10-K for the period ended December 31, 2009 we have taken and continue to
take the following actions during the period covered by this
report:




·
            mandated
      the segregation of duties regarding cash
  transactions;





·
            increased
      the oversight and review functions over internally developed
      documentation;





·
            maintained a
      Disclosure Committee to review material developments at the Company, as
      well as the effectiveness of the Company’s disclosure controls and
      procedures;





·
            engaged a
      Chief Financial Officer and outside securities counsel, both with SEC
      reporting experience, and





·
            utilized,
      as needed, a third-party financial consulting firm to assist management in
      evaluating complex accounting issues and implement a system to improve
      control and review procedures over all financial statement and account
      balances.





As a
result of the Company’s actions described above, there were changes in our
internal controls over financial reporting (as defined in Rule 13a-15(f) under
the Exchange Act) during the third quarter of 2010 that materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.




Management
does not expect that our disclosure controls or our internal control over
financial reporting will prevent or detect all errors and fraud. A control
system cannot provide absolute assurance due to its inherent limitations as it
is a process that involves human diligence and is subject to lapses in judgment
and breakdowns resulting from human failures. However, these inherent
limitations are known features of the financial reporting process; therefore, it
is possible to design into the process safeguards to reduce, though not
eliminate, this risk.




-40-





PART
II – OTHER INFORMATION





Item 1.  Legal
Proceedings





On July
2, 2010, a lawsuit was brought against the Company and certain current directors
and a Company investor in the Seventh Judicial District Court of Pennington
County, South Dakota.  The plaintiff is Randy Kramer, a former CEO of the
Company. The plaintiff alleges, among other things, that the Company
violated the Severance Agreement signed by the Company and the Kramer.  The
plaintiff also alleges that the named individuals engaged in conspiracy to have
him removed as CEO and oppressed him to sign the Severance Agreement.  The
plaintiff has not requested specific damages but seeks awards for all
compensatory, consequential, and pecuniary damages allegedly sustained by him
for breach of contract, fraud, and deceit, breach of fiduciary duty, tortuous
interference, and oppression plus interest and punitive damages.  At
this time, the Company believes these claims are unfounded and any losses that
might be incurred by the Company cannot be reasonably
estimated.  Accordingly, the Company has not recorded an accrual for
such potential loss but plans to vigorously defend its position.





Item 1A.  Risk
Factors





We are
affected by risks specific to us as well as factors that affect all businesses
operating in a global market.  Certain of the significant factors
known to us that could materially adversely affect our business, financial
condition or operating results are described in our Form 10-K filed with the SEC
on March 9, 2010.  You should consider such risk factors in addition
to the other information set forth below and elsewhere in this
report.  The risks described in our Form 10-K are not the only risks
facing our Company.  Additional risks and uncertainties also may
materially adversely affect our business, financial condition, and/or reporting
results.





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





Not
applicable.





Item 3.  Defaults
Upon Senior Securities





Not
applicable.




Item 5. Other
Information





Effective
November 10, 2010, David Litzen, a Vice President and Chief Technology Officer
for the Company, resigned from his position with KL Energy Corporation in order
to pursue other interests.  Pursuant to a Separation and Release agreement
related to this resignation, Mr. Litzen’s 4,356,336 shares, previously
controlled by an Escrow Agreement, shall remain in escrow until the earlier of
November 1, 2012 or upon attaining nameplate capacity in the first new
commercial cellulosic ethanol plant constructed using the Company’s proprietary
technology.   The Company and Mr. Litzen also signed a Consulting
Agreement whereby Mr. Litzen will provide technical engineering and other
support services as an independent contractor.  This Agreement may be
terminated by either party after four months and with five days’ notice. 
Mr. Litzen will be paid $1,000 per day for specific tasks with a guaranteed
minimum compensation of $60,000 during the first four months of service und upon
compliance with certain conditions.  In addition, if the Agreement is
terminated by the Company after the first four months, Mr. Litzen will be paid a
$26,000 bonus.




-41-





Item 6.
Exhibits





(a)
Exhibits





Exhibit
              Number
            
            Description10.1
            
            Joint
      Development Agreement between KL Energy Corporation and Petrobras America
      Inc., dated August 23, 2010 (incorporated by reference to our Form 8-K
      filed on August 30, 2010) **10.2
            
            Termination
      Agreement between KL Energy Corporation and Greenext Energy Europe S.A.,
      dated September 24, 2010(incorporated by reference to our Form 8-K filed
      on October 5, 2010)10.3
            
            Master
      Collaboration Agreement between KL Energy Corporation and add blue
      Consultoria Ltda., dated September 1, 2010 (incorporated by reference to
      our Form 8-K filed on October 5, 2010)31.1*
            
            Certification
      of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 200231.2*
            
            Certification
      of Acting Chief Financial Officer Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1*
            
            Certification
      of Chief Executive Officer Pursuant to Section 18 U.S.C. Section
      135032.2*
            
            Certification
      of Acting Chief Financial Officer Pursuant to Section 18 U.S.C. Section
      1350








*
            Filed
      herewith.


**
            Certain
      portions of the exhibit have been omitted pursuant to the registrant’s
      confidential treatment request filed with the Commission pursuant to Rule
      24b-2 under the Securities Exchange Act of 1934. The omitted text has been
      filed separately with the
Commission.





-42-




Signature




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.






November
      15, 2010
            By:
            /s/ THOMAS
      J. BOLANThomas
      J. Bolan,
              Chief
      Financial Officer(Principal
      Financial Officer
              and
      duly authorized signatory)




-43-