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 June 30, 2009





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 or organization)
            (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 39,010,340 shares of
common stock, $0.001 par value, outstanding on August 13, 2009.

















Table
of Contents




PagePart
      I - Financial Information
                      4Item
      1. Financial Statements
                      4Item
      2. Management's Discussion and Analysis of Financial Condition and Results
      of Operations
                      27Item
      4T. Controls and Procedures
                      36Part
      II - Other Information
                      37Item
      1. Legal Proceedings
                      37Item
      1A.  Risk Factors
                      38Item
      2.  Unregistered Sales of Equity Securities
                      38Item
      6. Exhibits
                      39







-
2 -











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





-
3 -








PART
1:  FINANCIAL INFORMATION





Item
1. Financial
Statements






KL
      Energy CorporationConsolidated
      Balance SheetsJune
      30,
                                                          
                                                          
                                                          December
      31,2009
                                                          
                                                          
                                                          2008(unaudited)
                                                          
                                                          
                                                          (audited)ASSETSCurrent
      AssetsCash
      and cash equivalents
                                                          
                                                          $
                                                          746,171
                                                          
                                                          
                                                          $
                                                          698,101Trade
      receivables, net of allowance for doubtful accounts of $831,896 and
      $381,681, respectively
                                                          
                                                          
                                                          35,600
                                                          
                                                          
                                                          
                                                          470,322Accounts
      receivable - related parties
                                                          
                                                          
                                                          1,109
                                                          
                                                          
                                                          
                                                          -Inventories
                                                          
                                                          
                                                          45,592
                                                          
                                                          
                                                          
                                                          88,255Prepaid
      expenses and other assets
                                                          
                                                          
                                                          36,513
                                                          
                                                          
                                                          
                                                          101,180Deferred
      issuance costs
                                                          
                                                          
                                                          285,000
                                                          
                                                          
                                                          
                                                          320,000Current
      assets of discontinued operations
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          427Total
      Current Assets
                                                          
                                                          
                                                          1,149,985
                                                          
                                                          
                                                          
                                                          1,678,285Non-Current
      AssetsProperty,
      Plant and Equipment, Net
                                                          
                                                          
                                                          4,437,943
                                                          
                                                          
                                                          
                                                          5,253,916Total
      Assets
                                                          
                                                          $
                                                          5,587,928
                                                          
                                                          
                                                          $
                                                          6,932,201LIABILITIES AND STOCKHOLDERS'
      DEFICITCurrent
      LiabilitiesLines
      of credit & short-term borrowings
                                                          
                                                          $
                                                          -
                                                          
                                                          
                                                          $
                                                          250,000Current
      maturities of long-term debt
                                                          
                                                          
                                                          2,036,040
                                                          
                                                          
                                                          
                                                          1,015,482Current
      maturities of subordinated debt-related party
                                                          
                                                          
                                                          100,000
                                                          
                                                          
                                                          
                                                          40,000Accounts
      payable
                                                          
                                                          
                                                          1,692,128
                                                          
                                                          
                                                          
                                                          2,256,893Accounts
      payable-related parties
                                                          
                                                          
                                                          17,640
                                                          
                                                          
                                                          
                                                          27,312Billings
      in excess of costs and estimated earnings
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          -on
      uncompleted contracts
                                                          
                                                          
                                                          2,039,496
                                                          
                                                          
                                                          
                                                          2,039,496Accrued
      payroll
                                                          
                                                          
                                                          394,160
                                                          
                                                          
                                                          
                                                          222,361Other
      liabilities
                                                          
                                                          
                                                          576,007
                                                          
                                                          
                                                          
                                                          307,314Accrued
      issuance costs
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          320,000Current
      liabilities of discontinued operations
                                                          
                                                          
                                                          367,777
                                                          
                                                          
                                                          
                                                          528,770Total
      Current Liabilities
                                                          
                                                          
                                                          7,223,248
                                                          
                                                          
                                                          
                                                          7,007,628Long-term
      debt, less current maturities
                                                          
                                                          
                                                          95,000
                                                          
                                                          
                                                          
                                                          1,401,283Long-term
      debt-subordinated-related party
                                                          
                                                          
                                                          500,000
                                                          
                                                          
                                                          
                                                          560,000Total
      Long-Term Debt
                                                          
                                                          
                                                          595,000
                                                          
                                                          
                                                          
                                                          1,961,283Stockholders'
      DeficitCommon
      stock, $0.001  par value; 150,000,000 shares authorized,
      39,010,340 and 15,622,953 shares issued and outstanding as of June 30,
      2009 and December 31, 2008, respectively
                                                          
                                                          
                                                          39,011
                                                          
                                                          
                                                          
                                                          15,623Additional
      paid-in capital
                                                          
                                                          
                                                          4,398,679
                                                          
                                                          
                                                          
                                                          26,842Accumulated
      deficit
                                                          
                                                          
                                                          (6,191,112
                                                          )
                                                          
                                                          
                                                          (2,272,574
                                                          )Noncontrolling
      interest
                                                          
                                                          
                                                          (476,898
                                                          )
                                                          
                                                          
                                                          193,399Total
      Stockholders' Deficit
                                                          
                                                          
                                                          (2,230,320
                                                          )
                                                          
                                                          
                                                          (2,036,710
                                                          )Total
      Liabilities and Stockholders' Deficit
                                                          
                                                          $
                                                          5,587,928
                                                          
                                                          
                                                          $
                                                          6,932,201





See
accompanying notes to consolidated financial statements.





-
4 -










KL
      Energy CorporationConsolidated
      Statements of OperationsThree
      Months Ended
                                                              
                                                              
                                                              Six
      Months EndedJune
      30,
                                                              
                                                              
                                                              June
      30,2009
                                                              
                                                              
                                                              
                                                              2008
                                                              
                                                              
                                                              2009
                                                              
                                                              
                                                              
                                                              2008(unaudited)
                                                              
                                                              
                                                              
                                                              (unaudited)
                                                              
                                                              
                                                              (unaudited)
                                                              
                                                              
                                                              
                                                              (unaudited)RevenueEngineering
      and management contract
                                                              
                                                              $
                                                              -
                                                              
                                                              
                                                              
                                                              $
                                                              1,086,011
                                                              
                                                              
                                                              $
                                                              -
                                                              
                                                              
                                                              
                                                              $
                                                              3,003,792Total
      Revenue
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              
                                                              1,086,011
                                                              
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              
                                                              3,003,792Operating
      ExpensesCost
      of engineering and management contract
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              
                                                              1,003,206
                                                              
                                                              
                                                              
                                                              -
                                                              
                                                              
                                                              
                                                              
                                                              1,807,889General
      and administrative
                                                              
                                                              
                                                              745,817
                                                              
                                                              
                                                              
                                                              
                                                              352,084
                                                              
                                                              
                                                              
                                                              2,960,555
                                                              
                                                              
                                                              
                                                              
                                                              1,941,461Research
      and development
                                                              
                                                              
                                                              808,982
                                                              
                                                              
                                                              
                                                              
                                                              747,259
                                                              
                                                              
                                                              
                                                              1,570,276
                                                              
                                                              
                                                              
                                                              
                                                              1,424,634Total
      Operating Expenses
                                                              
                                                              
                                                              1,554,799
                                                              
                                                              
                                                              
                                                              
                                                              2,102,549
                                                              
                                                              
                                                              
                                                              4,530,831
                                                              
                                                              
                                                              
                                                              
                                                              5,173,984Loss
      from Operations
                                                              
                                                              
                                                              (1,554,799
                                                              )
                                                              
                                                              
                                                              
                                                              (1,016,538
                                                              )
                                                              
                                                              
                                                              (4,530,831
                                                              )
                                                              
                                                              
                                                              
                                                              (2,170,192
                                                              )Other
      Income (Expense):Other
      income (expense)
                                                              
                                                              
                                                              28,931
                                                              
                                                              
                                                              
                                                              
                                                              1,900
                                                              
                                                              
                                                              
                                                              11,409
                                                              
                                                              
                                                              
                                                              
                                                              9,921Interest
      income
                                                              
                                                              
                                                              1,744
                                                              
                                                              
                                                              
                                                              
                                                              1
                                                              
                                                              
                                                              
                                                              44,330
                                                              
                                                              
                                                              
                                                              
                                                              9Interest
      expense
                                                              
                                                              
                                                              (26,813
                                                              )
                                                              
                                                              
                                                              
                                                              (99,524
                                                              )
                                                              
                                                              
                                                              (101,743
                                                              )
                                                              
                                                              
                                                              
                                                              (198,177
                                                              )Total
      Other Expense, Net
                                                              
                                                              
                                                              3,862
                                                              
                                                              
                                                              
                                                              
                                                              (97,623
                                                              )
                                                              
                                                              
                                                              (46,004
                                                              )
                                                              
                                                              
                                                              
                                                              (188,247
                                                              )Loss
      From Continuing Operations and BeforeNet
      Loss Attributable to Noncontrolling Interest
                                                              
                                                              
                                                              (1,550,938
                                                              )
                                                              
                                                              
                                                              
                                                              (1,114,161
                                                              )
                                                              
                                                              
                                                              (4,576,835
                                                              )
                                                              
                                                              
                                                              
                                                              (2,358,439
                                                              )Net
      loss attributable to noncontrolling interest
                                                              
                                                              
                                                              670,297
                                                              
                                                              
                                                              
                                                              
                                                              34,282
                                                              
                                                              
                                                              
                                                              670,297
                                                              
                                                              
                                                              
                                                              
                                                              105,062Loss
      From Continuing Operations
                                                              
                                                              
                                                              (880,641
                                                              )
                                                              
                                                              
                                                              
                                                              (1,079,878
                                                              )
                                                              
                                                              
                                                              (3,906,538
                                                              )
                                                              
                                                              
                                                              
                                                              (2,253,377
                                                              )(Loss)
      income from discontinued operations
                                                              
                                                              
                                                              (20
                                                              )
                                                              
                                                              
                                                              
                                                              341,538
                                                              
                                                              
                                                              
                                                              (12,000
                                                              )
                                                              
                                                              
                                                              
                                                              153,663Net
      Loss
                                                              
                                                              $
                                                              (880,661
                                                              )
                                                              
                                                              
                                                              $
                                                              (738,340
                                                              )
                                                              
                                                              $
                                                              (3,918,538
                                                              )
                                                              
                                                              
                                                              $
                                                              (2,099,714
                                                              )Net
      Loss Per Share, basic and diluted:Continuing
      operations
                                                              
                                                              $
                                                              (0.02
                                                              )
                                                              
                                                              
                                                              $
                                                              (0.03
                                                              )
                                                              
                                                              $
                                                              (0.13
                                                              )
                                                              
                                                              
                                                              $
                                                              (0.07
                                                              )Discontinued
      operations
                                                              
                                                              $
                                                              (0.00
                                                              )
                                                              
                                                              
                                                              $
                                                              0.01
                                                              
                                                              
                                                              $
                                                              (0.00
                                                              )
                                                              
                                                              
                                                              $
                                                              0.01Total
                                                              
                                                              $
                                                              (0.02
                                                              )
                                                              
                                                              
                                                              $
                                                              (0.02
                                                              )
                                                              
                                                              $
                                                              (0.13
                                                              )
                                                              
                                                              
                                                              $
                                                              (0.07
                                                              )Weighted
      Average Common Shares Outstanding-Proforma
                                                              
                                                              
                                                              36,436,158
                                                              
                                                              
                                                              
                                                              
                                                              36,436,158
                                                              
                                                              
                                                              
                                                              30,306,036
                                                              
                                                              
                                                              
                                                              
                                                              30,306,036




See
accompanying notes to consolidated financial statements.





-
5 -







KL
      Energy CorporationConsolidated
      Statement of Stockholders' DeficitCommon
      Stock
                                
                                
                                Stockholders'
                                
                                
                                AdditionalPaid-In
                                
                                
                                Accumulated
                                
                                
                                Non-
                                  controlling
                                
                                
                                Total
                                  Stock-
                                  holders'Shares
                                
                                
                                Amount
                                
                                
                                Contributions
                                
                                
                                Capital
                                
                                
                                Deficit
                                
                                
                                Interest
                                
                                
                                DeficitBalance
      - December 31, 2007
                                
                                
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                9,000
                                
                                
                                $
                                -
                                
                                
                                $
                                (1,916,219
                                )
                                
                                $
                                292,990
                                
                                
                                $
                                (1,614,229
                                )KL
      Process Design Group - post merger net loss - September 30,
      2008
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                (5,120,258
                                )
                                
                                
                                
                                
                                
                                
                                (5,120,258
                                )Conversion
      of equity in reverse merger acquisition
                                
                                
                                13,290,266
                                
                                
                                
                                13,291
                                
                                
                                
                                (9,000
                                )
                                
                                
                                (7,040,768
                                )
                                
                                
                                7,036,477
                                
                                
                                
                                
                                
                                
                                
                                -Conversion
      of debt to equity, net of unamortized debt discount
                                
                                
                                2,288,000
                                
                                
                                
                                2,288
                                
                                
                                
                                -
                                
                                
                                
                                4,197,712
                                
                                
                                
                                -
                                
                                
                                
                                
                                
                                
                                
                                4,200,000Equity
      payment to placement agent upon conversion of debt to
      equity
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                (305,000
                                )
                                
                                
                                -
                                
                                
                                
                                
                                
                                
                                
                                (305,000
                                )Conversion
      of derivative liability to equity
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                3,050,000
                                
                                
                                
                                -
                                
                                
                                
                                
                                
                                
                                
                                3,050,000Shares
      issued for accrued interest on convertible debt
                                
                                
                                38,437
                                
                                
                                
                                38
                                
                                
                                
                                -
                                
                                
                                
                                102,462
                                
                                
                                
                                -
                                
                                
                                
                                
                                
                                
                                
                                102,500Issuance
      of shares in private placement (net of issuance costs of
      $2,557)
                                
                                
                                6,250
                                
                                
                                
                                6
                                
                                
                                
                                -
                                
                                
                                
                                22,436
                                
                                
                                
                                -
                                
                                
                                
                                
                                
                                
                                
                                22,442Net
      loss attributed to noncontrolling interests
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                (99,591
                                )
                                
                                
                                (99,591
                                )KL
      Energy Corporation - net loss - 4th quarter 2008
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                (2,272,574
                                )
                                
                                
                                
                                
                                
                                
                                (2,272,574
                                )Balance
      - December 31, 2008
                                
                                
                                15,622,953
                                
                                
                                $
                                15,623
                                
                                
                                $
                                -
                                
                                
                                $
                                26,842
                                
                                
                                $
                                (2,272,574
                                )
                                
                                $
                                193,399
                                
                                
                                $
                                (2,036,710
                                )Issuance
      of shares in private placement (net of issuance costs of
      $750,000)
                                
                                
                                18,181,818
                                
                                
                                
                                18,182
                                
                                
                                
                                -
                                
                                
                                
                                3,231,818
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                3,250,000Issuance
      of shares in settlement of payables
                                
                                
                                5,205,569
                                
                                
                                
                                5,206
                                
                                
                                
                                -
                                
                                
                                
                                1,140,019
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                1,145,225Net
      loss attributed to noncontrolling interests
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                
                                
                                
                                
                                (670,297
                                )
                                
                                
                                (670,297
                                )Net
      loss
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                (3,918,538
                                )
                                
                                
                                -
                                
                                
                                
                                (3,918,538
                                )Balance
      - June 30, 2009
                                
                                
                                39,010,340
                                
                                
                                $
                                39,011
                                
                                
                                $
                                -
                                
                                
                                $
                                4,398,679
                                
                                
                                $
                                (6,191,112
                                )
                                
                                $
                                (476,898
                                )
                                
                                $
                                (2,230,320
                                )





See
accompanying notes to consolidated financial statements.





-
6 -











KL
      Energy CorporationConsolidated
      Statements of Cash FlowsSix
      Months EndedJune
      30,2009
                        
                        
                        2008(unaudited)
                        
                        
                        (unaudited)Cash
      Flows From Operating ActivitiesNet
      loss from continuing operations
                        
                        $
                        (3,906,538
                        )
                        
                        $
                        (2,253,377
                        )Net
      (loss) income from discontinued operations
                        
                        
                        (12,000
                        )
                        
                        
                        153,663Adjustments
      to reconcile net loss by cash used in operating
activities:Depreciation
                        
                        
                        967,118
                        
                        
                        
                        882,764Allowance
      for doubtful accounts
                        
                        
                        450,215
                        
                        
                        
                        110,536Noncontrolling
      interest in net loss of subsidiaries
                        
                        
                        (670,297
                        )
                        
                        
                        (105,062
                        )Gain
      on sale of airplane
                        
                        
                        -
                        
                        
                        
                        3,365Changes
      in current assets and liabilities:(Increase)
      decrease in:Trade
      receivables
                        
                        
                        (16,602
                        )
                        
                        
                        1,087,363Costs
      and estimated earnings in excess of billings on uncompleted
      contracts
                        
                        
                        -
                        
                        
                        
                        168,890Inventories
                        
                        
                        42,663
                        
                        
                        
                        27,250Prepaid
      expenses and other assets
                        
                        
                        384,667
                        
                        
                        
                        85,634Current
      assets of discontinued operations
                        
                        
                        427
                        
                        
                        
                        (76,752
                        )Increase
      (decrease) in:Accounts
      payable
                        
                        
                        (239,437
                        )
                        
                        
                        (22,182
                        )Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
                        
                        
                        -
                        
                        
                        
                        (727,875
                        )Accrued
      payroll and other liabilities
                        
                        
                        980,717
                        
                        
                        
                        261,022Current
      liabilities of discontinued operations
                        
                        
                        (160,993
                        )
                        
                        
                        187,483Net
      Cash Provided by (Used In) Operating Activities
                        
                        
                        (2,180,060
                        )
                        
                        
                        (217,278
                        )Cash
      Flows From Investing ActivitiesPurchases
      of property, plant and equipment
                        
                        
                        (182,436
                        )
                        
                        
                        (119,208
                        )Proceeds
      from the sale of fixed assets
                        
                        
                        31,291
                        
                        
                        
                        48,905Net
      Cash Provided by (Used in) Investing Activities
                        
                        
                        (151,145
                        )
                        
                        
                        (70,303
                        )Cash
      Flows From Financing ActivitiesProceeds
      (payments) from lines of credit and short-term borrowings
                        
                        
                        (250,000
                        )
                        
                        
                        120,000Proceeds
      from subordinated debt – related parties, net
                        
                        
                        -
                        
                        
                        
                        148,148Payments
      on long-term debt principal
                        
                        
                        (620,725
                        )
                        
                        
                        (110,954
                        )Debt
      issuance costs for convertible debt
                        
                        
                        (750,000
                        )
                        
                        
                        -Proceeds
      from issuance of common stock
                        
                        
                        4,000,000
                        
                        
                        
                        -Net
      Cash Provided by (Used in)  Financing Activities
                        
                        
                        2,379,275
                        
                        
                        
                        157,194Net
      Increase (Decrease) in Cash and Cash Equivalents
                        
                        
                        48,070
                        
                        
                        
                        (130,387
                        )Cash
      and cash equivalents at beginning of period
                        
                        
                        698,101
                        
                        
                        
                        130,679Cash
      and cash equivalents at end of period
                        
                        $
                        746,171
                        
                        
                        $
                        292Supplemental
      Disclosures of Cash Flow InformationInterest
      paid
                        
                        $
                        75,237
                        
                        
                        $
                        69,571Conversion
      of accounts payable and accrued liabilities to common
stock
                        
                        
                        860,225
                        
                        
                        
                        -Conversion
      of deferred issuance costs payable to common stock
                        
                        
                        285,000
                        
                        
                        
                        -Settlement
      of accounts payable with debt
                        
                        
                        335,000
                        
                        
                        
                        -




See
accompanying notes to consolidated financial statements.





-
7 -








KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




Note 1 – Nature of Business and Significant
Accounting Policies




Nature of
Business




KL Energy
Corporation (“KLE” or “Company”), a Nevada corporation, was incorporated on
February 26, 2007.  On September 30, 2008, KL Energy Corporation
entered into an Agreement and Plan of Merger (the “Merger”) with KL Process
Design Group, LLC (“KLPDG”), a South Dakota LLC, which provided for the merger
of KLPDG with and into the Company, and accordingly, the Company and KLPDG filed
the Articles of Merger with the State of Nevada effecting the
merger.  All of the outstanding membership interests of KLPDG were
converted into an aggregate of 9,900,765 newly issued shares of common stock of
the Company, which were issued to the former members of KLPDG.




As a
result of the merger, KLPDG merged with and into the Company, with the Company
as the surviving corporation.  The Company succeeded to, acquired all
of, the assets and liabilities of KLPDG, including all of the contractual rights
and interests 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.  In accordance with Staff Accounting Bulletin 1 Topic 4,
KLPDG’s accumulated deficit as of the date of Merger was included in additional
paid in capital.





The
Company is a biofuels technology development, licensing, and engineering firm
with experience rooted in grain-based and cellulose-based ethanol process
design, expansion, operations and profit optimization.  In addition,
the Company, through Western Biomass Energy, LLC (“WBE”), has designed, built,
and operates a cellulose-based ethanol (“CBE”) plant.  Construction on
the plant began during the year ended December 31, 2006 and was substantially
completed in August 2007.  The plant is located in Upton, Wyoming and
is designed to convert wood products and wood waste products into
ethanol.  The WBE plant was built to serve as a demonstration facility
and to operate commercially with a capacity of approximately 1.5 million gallons
of CBE per year.  During 2008, a commercially viable grade of ethanol
was developed; however, the product has not been quality tested and is not yet
marketed to the public.





The
Company also distributed ethanol blended fuel, through Patriot Motor Fuels, LLC
(Patriot) to two service stations located in South Dakota and
Nebraska.  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 to
the severe change in the economics of the ethanol industry as well as the
Company’s re-focus on cellulosic ethanol research and development
efforts.





-
8 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 1 – Nature of Business and Significant
Accounting Policies (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 on long-term contracts,
useful lives of property, plant and equipment, impairment of long-lived assets,
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 KLHC LLC (formerly known as KL Energy LLC,
“KLHC”), 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, 2008. 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.





-
9 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




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





Recently
Issued Accounting Pronouncements





Effective
January 1, 2008 the Company adopted SFAS No. 157, “Fair Value Measurements”
(“SFAS 157”), issued by the Financial Accounting Standards Board (“FASB”), which
defines fair value, establishes guidelines for measuring fair value and expands
disclosures regarding fair value measurements.  SFAS 157 does not
require any new fair value measurements but rather eliminates inconsistencies in
guidance found in various prior accounting pronouncements.  In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2,
“Effective Date of FASB
Statement No. 157 ” (“FSP 157-2”), to partially defer
SFAS 157.  FSP 157-2 defers the effective date of
SFAS 157 for non-financial assets and non-financial liabilities, except
those that are recognized or disclosed at fair value in the financial statements
on a recurring basis (at least annually), to fiscal years, and interim periods
within those fiscal years, beginning after November 15,
2008.  The adoption of SFAS 157 and FSP 157-2 has not had a
material impact on the Company’s consolidated financial statements.





Effective
January 1, 2008 the Company adopted SFAS No. 159 (“SFAS 159”), “The Fair Value Option for Financial
Assets and Financial Liabilities”.  SFAS 159 establishes
presentation and disclosure requirements designed to facilitate comparisons
between companies that choose different measurement attributes for similar types
of assets and liabilities.  Previously, accounting rules required
different measurement attributes for different assets and liabilities that
created artificial volatility in earnings.  SFAS 159 helps to mitigate
this type of accounting-induced volatility by enabling companies to report
related assets and liabilities at fair value, which would likely reduce the need
for companies to comply with detailed rules for hedge
accounting.  SFAS 159 is effective as of the beginning of an entity’s
first fiscal year beginning after November 15, 2007, though early adoption is
permitted.  The adoption of SFAS 159 did not have an impact on the
Company’s consolidated financial statements.





Effective
January 1, 2009 the Company adopted SFAS No. 160 (“SFAS 160”), “Non-Controlling Interests in
Consolidated Financial Statements—an amendment of ARB
No. 51”.  SFAS 160 establishes accounting and
reporting standards for non-controlling interests in subsidiaries. This
statement requires the reporting of all non-controlling interests as a separate
component of stockholders’ equity, the reporting of consolidated net income
(loss) as the amount attributable to both the parent and the non-controlling
interests and the separate disclosure of net income (loss) attributable to the
parent and to the non-controlling interests.  In addition, this
statement provides accounting and reporting guidance related to changes in
non-controlling ownership interests.  The Company adopted SFAS 160 on
January 1, 2009 and has reflected the required disclosures herein..





Effective
January 1, 2009 the Company adopted SFAS No. 161,“Disclosures About Derivative
Instruments and Hedging Activities – an amendment to FASB Statement No.
133”(“SFAS 161”).  SFAS No. 161 is intended to improve
financial standards for derivative instruments and hedging activities by
requiring enhanced disclosures to enable investors to better understand their
effects on an entity's financial position, financial performance, and cash
flows.  Entities are required to provide enhanced disclosures about:
(a) how and why an entity uses derivative instruments; (b) how derivative
instruments and related hedged items are accounted for under Statement 133 and
its related interpretations; and (c) how derivative instruments and related
hedged items affect an entity’s financial position, financial performance, and
cash flows.   The adoption of this statement did not have a material
effect on the Company’s consolidated financial statements.





-
10 -








KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




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





Recently
Issued Accounting Pronouncements (continued)





Effective
January 1, 2009 the Company adopted SFAS No. 141R (“SFAS 141R”),
“Business
Combinations,” which replaces FASB Statement
No. 141.  SFAS 141R establishes principles and requirements for
how an acquirer recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed any non-controlling
interest in the acquiree and the goodwill acquired. The Statement also
establishes disclosure requirements which will enable users to evaluate the
nature and financial effects of the business combination.  The impact
of adopting SFAS 141R will depend on the future business combinations the
Company may pursue after the adoption date.





Effective
January 1, 2009 the Company adopted FASB Staff Position (FSP) FAS 142-3,
“Determination of the Useful
Life of Intangible Assets” (“FSP FAS 142-3”).  FSP
FAS 142-3 amends the factors that should be considered in developing
renewal or extension assumptions used to determine the useful life of a
recognized intangible asset under FASB Statement No. 142, “Goodwill and Other Intangible
Assets.”  The adoption of this statement did not have a
material impact on the Company’s consolidated financial statements.




In April
2009, the FASB issued FSP No. 107-1 and APB No. 28, Interim Disclosures about Fair Value
of Financial Instruments, to require disclosures about fair value of
financial instruments for interim reporting periods of publicly traded companies
as well as in annual financial statements. This FSP also amends Accounting
Principles Board (“APB”) Opinion No. 28, Interim Financial Reporting,
to require those disclosures in summarized financial information at interim
reporting periods. This FSP is effective for interim reporting periods ending
after June 15, 2009. The Company adopted these provisions in the second quarter
ending June 30, 2009 and it did not have a material impact on the Company’s
consolidated financial position, results of operations or cash
flows.




In May
2009, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 165, Subsequent Events(“SFAS No.
165”), which established general standards of accounting for and disclosure of
events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. This Statement introduces the concept
of financial statements being “available to be issued” and requires disclosure
of the date through which an entity has evaluated subsequent events and the
basis for that date. This Statement is effective for interim financial periods
ending after June 15, 2009. The Company adopted these provisions in the second
quarter ending June 30, 2009 and it did not have a material impact on the
Company’s consolidated financial position, results of operations or cash
flows.




In June
2009, the FASB issued SFAS No. 166,Accounting for Transfers of
Financial Assets, an amendment to SFAS No. 140 (“SFAS No. 166”). 
SFAS No. 166 was issued to improve the relevance, representational faithfulness,
and comparability of the information that a reporting entity provides in its
financial reports about a transfer of financial assets; the effects of a
transfer on its financial position, financial performance, and cash flows; and a
transferor’s continuing involvement, if any, in transferred financial assets.
This statement will be effective for fiscal years beginning after
November 15, 2009. We do not expect the adoption of this statement to have
a material effect on our consolidated financial position, results of operations
or cash flows.





-
11 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




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





Recently
Issued Accounting Pronouncements (continued)




In June
2009, the FASB issued SFAS No. 167,Amendments to FASB Interpretation
No. 46(R) (“SFAS No. 167”).  SFAS No. 167 was issued to improve
financial reporting by enterprises involved with variable interest entities and
to provide more relevant and reliable information to users of financial
statements. This statement will be effective for fiscal years beginning after
November 15, 2009. We do not expect the adoption of this statement to have
a material effect on our consolidated financial position, results of operations
or cash flows.


In June
2009, the FASB issued SFAS No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles - a
replacement of FASB Statement No. 162(“SFAS No. 168”).  This
statement replaces SFAS No. 162 and establishes the FASB Accounting Standards
Codification(“Codification”). 
Effective July 1, 2009, the Codification becomes the source of authoritative
U.S. generally accepted accounting principles (GAAP) recognized by the FASB to
be applied by nongovernmental entities. On the effective date of this statement,
the Codification supersedes all then-existing non-SEC accounting and reporting
standards.  This statement will be effective for interim and annual periods
ending after September 15, 2009. We do not expect the adoption of SFAS No.
168 to have any impact to our consolidated financial position, results of
operations or cash flows.  The adoption will require us to prospectively
replace references to previously existing non-SEC accounting and reporting
standards with the respective sections of the Codification.


Cash
and Cash Equivalents





For
financial statement purposes, the Company considers all highly liquid
investments with an original maturity of three months or less to be cash
equivalents.  The Company maintains its cash in bank deposit accounts,
which at times exceed federally insured limits.  The Company has not
experienced any losses in such accounts and believes it is not exposed to any
significant credit risk on cash. The Company held cash in excess of federally
insured limits of approximately $440,000 (unaudited) and $419,000 as of June 30,
2009 and December 31, 2008, respectively.





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 as revenue when received.





Concentration of Credit Risk





The
Company had no revenue in the three or six months ended June 30, 2009 and had
two customers who accounted for approximately 70% and 77% of revenues for the
three and six months ended June 30, 2008, respectively.  At June 30,
2009 and December 31, 2008, one and two customers accounted for approximately
100% and 79% of accounts receivable, respectively.





-
12 -








KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)




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





Inventories





Inventories
are stated at the lower of cost (first-in, first-out method) or
market.




Long-Lived
Assets





The
Company assesses the realizable value of long-lived assets for potential
impairment at least annually or when events and circumstances warrant such a
review.  The carrying value of a long-lived asset is considered impaired
when the anticipated fair value is less than its carrying value.  In
assessing the recoverability of our long-lived assets, we must make assumptions
regarding estimated future cash flows and other factors to determine the fair
value of the respective assets.  In addition, we must make assumptions
regarding the useful lives of these assets.  As of December 31, 2008, we
evaluated our long-lived assets for potential impairment.  Based on our
evaluation, no impairment charge was recognized.





Deferred
Issuance Costs





Deferred
issuance costs at December 31, 2008 represent placement agency fees and other
direct expenses of raising financing.  Upon the successful financing
in February 2009, these costs were netted against the proceeds in
equity.  In May 2009, additional shares of the Company’s common stock
were issued in full payment of financial advisor fees through September 2010 and
the fair value of those shares are reflected in the June 30, 2009 balance of
deferred issuance costs.





Revenue
and Cost Recognition





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, 2009 and December 31, 2008 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.





The
asset, "Costs and estimated earnings in excess of billings on uncompleted
contracts," represents revenue recognized in excess of amounts
billed.  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.





-
13 -








KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





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





Revenue
and Cost Recognition (continued)





The
Company had other long-term contracts whereby it is paid monthly for services
provided. The Company recognized revenue when persuasive evidence of an
arrangement exists and services are provided, the price is fixed and
determinable, and collectability was reasonably assured.





Research
and Development Costs





Research
and development costs consist of direct labor, depreciation, and other direct
expenses incurred in the operations of the CBE plant in Upton, Wyoming and are
expensed as incurred.





Advertising
Costs





The
Company follows the policy of charging the costs of advertising to expense as
incurred.  Included in operating expenses are advertising and
promotion expenses of $9,876 and $18,296 and $6,164 and $12,621 for the three
and six months ended June 30, 2009 and 2008, respectively.





Warranty
Costs





The
Company provides warranties on the engineering and construction management
services it provides.  The Company has not had to provide warranty
services in the past, and management does not anticipate significant warranty
liability for work performed through June 30, 2009.  Therefore, no
allowance for warranty costs has been recorded.





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.




-
14 -








KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Fair
Value of Financial Instruments





The
following methods and assumptions were used to estimate the fair value of each
class of financial instruments for which it is practicable to estimate that
value.  Fair values of receivables, other current assets, accounts
payable, accrued liabilities and other current liabilities are assumed to
approximate carrying values for these financial instruments since they are
short-term in nature and are receivable or payable on demand.




Effective
January 1, 2008, the Company adopted the provisions of SFAS No. 157
for all financial instruments. The valuation techniques required by SFAS
No. 157 are based upon observable and unobservable inputs. Observable
inputs reflect market data obtained from independent resources, while
unobservable inputs reflect the Company’s market assumptions. The standard
established the following fair value hierarchy:




Level
      1 —
            Quoted
      prices for identical assets or liabilities in active
      markets.Level
      2 —
            Quoted
      prices for similar assets or liabilities in active markets; quoted prices
      for identical or similar assets or liabilities in markets that are not
      active; and model-derived valuations whose inputs or significant value
      drivers are observable.Level
      3 —
            Significant
      inputs to the valuation model are
unobservable.





Note
2 - Financing





In July
2008, the Company received financing from Niton Capital (formerly PPM Holdings
LTD) asister
company of Fair Energy S.A. totaling $3,100,000 at 10% per annum interest. In
connection with the Merger, the notes were converted into an aggregate of
1,162,500 shares of our common stock at $4 per share.  At the time of
the Merger these notes had accrued interest of approximately $77,500 which was
converted into approximately 20,667 shares of common stock.  The
Company paid $155,000 to a placement agency for this financing.  This
fee was recorded as debt issuance costs and amortized to interest expense to the
conversion date.  Upon the conversion of the notes the Company
incurred an additional $155,000 of placement fees which were recorded as a
reduction of equity.





On
September 5, 2008, the Company received a financing commitment in the form of
redeemable convertible promissory notes from The GreenFund,a divisionof Pluris Sustainable of
$3,000,000 at 10% per annum interest. In connection with the Merger, the
notes were converted into an aggregate of 1,125,000 shares of our common
stock.  At the time of the   Merger these notes had accrued
interest of approximately $25,000 which was converted into approximately 6,667
shares of common stock.  The Company paid $150,000 to a placement
agent for this financing.  This fee was recorded as debt issuance
costs and amortized to interest expense to the conversion date.  Upon
conversion of the notes the Company incurred an additional $150,000 of placement
fees which were recorded as a reduction to equity.





Contemporaneously
with the closing of the Merger transaction, the Company issued an aggregate of
3,125 units of its securities in a private placement, with each unit comprised
of two shares of common stock and a warrant to purchase one share of common
stock pursuant to the terms of the Securities Purchase Agreement dated September
30, 2008 among the Company and certain investors.  The purchase price
per unit was $8.00 per unit for an aggregate purchase price of
$25,000.  The Company incurred an additional $2,558 of placement fees
which were recorded as a reduction to equity.





-
15 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)








Note
2 – Financing (continued)





On
February 24, 2009, the Company consummated a Securities Purchase Agreement (the
“Purchase Agreement”) with certain investors listed on the signature pages of
the Purchase Agreement (the “Investors”).  Pursuant to the terms of
the Purchase Agreement, the Company issued to the Investors 18,181,818 shares of
the Company’s common stock (the “Shares”), representing approximately 60% of the
total number of issued and outstanding shares of the Company’s common stock, for
a purchase price of $4,000,000. The Company paid $400,000 to a placement
agent for this financing.





Note
3 – Net Loss Per Common Share




SFAS
No. 128, “Earnings Per
Share” provides for the calculation of “Basic” and “Diluted” earnings per
share. Basic earnings per share 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 earnings per share reflect
the potential dilution of securities that could share in the earnings of an
entity, similar to fully diluted earnings per share.





For the
three and six months ended June 30, 2009, stock warrants for 3,125 shares were
not included in the computation of diluted loss per share because their effect
was anti-dilutive.  There were no other stock warrants issued or
outstanding for the three and six months ended June 30, 2008.





Note 4 - Operations




Continuing
Operations




During
the period from its inception to June 30, 2009, the Company has incurred
significant annual net losses and at June 30, 2009 and December 31, 2008, the
Company has negative working capital (i.e. current assets less current
liabilities) of approximately $6.1 million (unaudited) and $5.3 million,
respectively.  At June 30, 2009, total liabilities exceeded total
assets by approximately $2.2 million.  The grain based ethanol
industry, the industry in which the Company has historically operated, has also
begun to face new challenges including the rising cost of raw materials (corn),
increased construction costs, and a reduction in public and governmental
support. Engineering and construction management represents a substantial
amount of the Company’s business and the grain based ethanol industry challenges
may be an impediment to new grain based ethanol
construction.  Furthermore, the Company has used cash flows generated
by management contracts to fund the construction of a demonstration cellulose
based ethanol plant which is considered to be the Company’s future within the
ethanol industry.  Certain contractual payments that have been paid to
the engineering and construction management business may have to be returned to
two customers.  Furthermore, there is a risk that the product produced
at the demonstration cellulose based ethanol plant may not be immediately
commercially viable, or the Company may not be able to produce sufficient
saleable ethanol at this facility to cover the costs of plant operations or to
repay its loans from outside debtors and affiliated
companies.




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.  Management is continuing its efforts to raise additional
capital through various methods and is refocusing its business to cellulose
based ethanol.





-
16 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 4 – Operations
(continued)





Discontinued
Operations





Through
its Patriot subsidiary, the Company distributed ethanol blended fuel to two
service stations located in South Dakota and Nebraska.  As a result of
pricing and other 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:  KLM,
which managed ethanol facilities for third parties, and KLEN, which sold
wholesale ethanol.  Both businesses were discontinued as a result to
the severe change in the economics of the ethanol industry as well as the
Company’s re-focus on cellulosic ethanol research and development efforts. These
businesses had no assets and very slim operating margins and, as such, the
income (loss) from these discontinued operations did not have an impact on
earnings per share (basic or diluted).








Note
5 - Costs and Estimated Earnings on Uncompleted Contracts




Costs and
estimated earnings on uncompleted long-term contracts consist of the
following as of:





June
      30,
                                
                                
                                December
      31,2009
                                
                                
                                2008(unaudited)
                                
                                
                                (audited)Costs
      Incurred on Uncompleted Contracts
                                
                                $
                                5,112,225
                                
                                
                                $
                                5,112,225Estimated
      Earnings
                                
                                
                                2,023,012
                                
                                
                                
                                2,023,0127,135,237
                                
                                
                                
                                7,135,237Less
      Billings to Date
                                
                                
                                (9,174,733
                                )
                                
                                
                                (9,174,733
                                )$
                                (2,039,496
                                )
                                
                                $
                                (2,039,496
                                )Included
      in the Balance Sheet Under the Following Captions:Costs
      and Estimated Earnings in ExcessBillings
      on Uncompleted Contracts
                                
                                $
                                ---
                                
                                
                                $
                                ---Billings
      in Excess of Costs and EstimatedEarnings
      on Uncompleted Contracts
                                
                                
                                (2,039,496
                                )
                                
                                
                                (2,039,496
                                )$
                                (2,039,496
                                )
                                
                                $
                                (2,039,496
                                )




A former
officer of the Company was a member of the board of directors for, and held an
ownership interest in, one customer (Midwest Renewable Energy, LLC, "MRE")
during this period.  The Company was providing construction management
and engineering services for the construction of an addition to MRE’s existing
facility for a total estimated cost to the customer of
$5,600,000.  Due to MRE’s inability to meet contractual obligations,
the Company issued a stop work order on the construction project in March 2008
and has not committed to completing the construction
project. Several
disputes arose in connection with this project that were not able to be resolved
and, as described in Note 13, this resulted in MRE filing a lawsuit on June 30,
2009 against the Company and its affiliates and current and prior officers and
owners.





-
17 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note 5 - Costs and
Estimated Earnings on Uncompleted Contracts (continued)





The
Company provided construction management and engineering services for the
construction of a new biofuels production facility for a total estimated cost to
another customer (Willmark Energy, Inc., “Willmark”) of
$5,980,000.   There was no billing or cost activity on this
project during the first six months of 2009.  Billings on this
contract exceed costs and estimated earnings by approximately $399,000 at June
30, 2009 and December 31, 2008.  The contract was 53.1% complete at June 30, 2009
and December 31, 2008 based on costs incurred to date compared to total
estimated costs.  During 2008, Willmark proposed a change order to
revise the scope of the work to include only engineering services and to reduce
the total contract to $4,660,000.  As of the date of this report, the
change order has not been signed; however, it is likely that the scope of
services will be reduced in the near term.  If the change order were
to take effect, revenue would be increased by approximately $170,000 and
billings in excess of revenue would be reduced by approximately $170,000 at June
30, 2009.  If the project is terminated prior to completion, the
Company may be liable to return excess billings.  Several disputes
arose in connection with this project and, as a result of the parties’ inability
to reach a settlement, Willmark filed a request for arbitration, as provided in
the construction contract, on May 1, 2009.  This arbitration is still
in its initial stages and discovery has not yet commenced.








Note
6 – Property, Plant, and Equipment





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





June
      30,
                    
                    December
      31,2009
                    
                    2008Plant
      and plant equipment
                    
                    $
                    7,408,042
                    
                    
                    $
                    7,348,028Office
      furnishings and equipment
                    
                    
                    264,054
                    
                    
                    
                    187,801Vehicles
      and airplane
                    
                    
                    51,698
                    
                    
                    
                    51,6987,723,794
                    
                    
                    
                    7,587,527Less
      accumulated depreciation
                    
                    
                    (3,285,851)
                    
                    
                    
                    (2,333,611)Total
      property, plant, and equipment, net
                    
                    $
                    4,437,943
                    
                    
                    $
                    5,253,916




Construction
costs associated with CBE 1 are stated at cost (including direct construction
costs, and capitalized interest).  Depreciation expense, excluding
depreciation expenses charged to research and development, was approximately
$14,000 and $30,000 and $16,000 and $49,000 for the three and six months ended
June 30, 2009 and 2008, respectively.  Included in research and
development expense is depreciation expense of approximately $469,000 and
$937,000 and $422,000 and $834,000 for the three and six months ended June 30,
2009 and 2008, respectively.





-
18 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
7 –Debt





Short-Term
Borrowing Arrangements





The
Company had available a $250,000 revolving line of credit with Wells Fargo Bank,
N.A. that was personally guaranteed by certain Company shareholders, and
collateralized by their personal property, with accrued interest payable monthly
at the prime rate plus .5% (3.75% at December 31, 2008). The outstanding
borrowings under this agreement were $250,000 at December 31,
2008.  This line of credit matured and was paid off in March 2009 by a
Company payment of $175,000 plus interest and the proceeds from a management
shareholder line of credit of $75,000.  This shareholder line of
credit was paid in full in June 2009.





In
addition, the Company had approximately $46,000 and $95,000 in credit card
liability at June 30, 2009 and December 31, 2008, respectively, which are also
guaranteed by certain shareholders. These credit card liability balances are
included in accounts payable in the accompanying balance sheets.





Subordinated
Debt – Related Parties





The
Company has a subordinated unsecured note payable to a Company shareholder
totaling $600,000 at June 30, 2009 and December 31, 2008.  This note
includes interest at a variable rate, which was 5.0% at June 30, 2009 and
December 31, 2008, respectively, with interest paid quarterly.  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 $40,000 in 2009, $120,000 in 2010, 2011, 2012, 2013, respectively, and
$80,000 in 2014.  Payments of $100,000 are due on this note in the
next twelve months and therefore have been classified as current at June 30,
2009.  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 financing, the Company is obligated
to pay 5% of the proceeds towards principal payments on this note.




-
19 -








KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
7 –Debt (continued)




Long-Term
Debt





Long-term
debt consists of the following as of:


June
      30,
                        
                        
                        December
      31,2009
                        
                        
                        2008(unaudited)Note
      payable to bank with interest at 6.5%. The note is payable in twelve
      monthly installments of $17,560 of principal and interest beginning March
      2009 with any remaining unpaid principal and interest due March 2010,
      secured by substantially all assets of WBE and guaranteed by the Company
      and certain WBE members.
                        
                        $
                        1,452,256
                        
                        
                        $
                        1,984,949Payable
      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
      May 2010 to August 2010, $20,000 monthly for September 2010 to November
      2010 and $15,000 in December 2010
                        
                        
                        335,000
                        
                        
                        
                        -Note
      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
                        
                        
                        
                        250,000Notes
      to Allegiance Insurance for payment of insurance premiums, interest at
      9.8%, payable in monthly principal and interest installments of
      $4,437.
                        
                        
                        8,766
                        
                        
                        
                        33,816Note
      payable to First Insurance Funding Corporation for payment of director and
      officer insurance premiums, payable in monthly installments of $3,692,
      including interest at 9.1%.
                        
                        
                        10,909
                        
                        
                        
                        32,000Note
      payable to Avid Solutions for centrifuge equipment of $195,000, payable in
      monthly principal and interest installments of $10,000, including interest
      at 20% secured by equipment.
                        
                        
                        74,108
                        
                        
                        
                        116,000Subtotal
                        
                        $
                        2,131,040
                        
                        
                        $
                        2,416,765Less
      current maturities of long-term debt
                        
                        
                        (2,036,040
                        )
                        
                        
                        (1,015,482
                        )Net
      Long-Term Debt
                        
                        $
                        95,000
                        
                        
                        $
                        1,401,283
 -
20 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)








Note
8 – Income Taxes





The
Company has not recorded a provision for federal or state income taxes related
to continuing operations for the periods ended June 30, 2008 and 2007, due to
continuing operating losses.  The Company has recorded a full
valuation allowance against the deferred tax assets due to the uncertainty of
realizing these benefits.  As of December 31, 2008 the Company had net
operating loss carry forwards of approximately $1.1
million.  Significant components related to permanent differences
include losses incurred prior to the Merger and non-deductible registration
statement penalties.




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.





The
Company adopted the provisions of FIN 48 on January 1, 2007. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return.  FIN 48 requires that the Company recognize in its
consolidated financial statements only those tax positions that are
“more-likely-than-not” of being sustained as of the adoption date, based on
technical merits of the position.  As a result of the implementation
of FIN 48, the Company performed a comprehensive review of its material tax
positions in accordance with recognition and measurement standards established
by FIN 48.  No unrecognized tax positions were recorded as of the date
of adoption.  For each of the three and six months ended June 30, 2009
and 2008, the current and deferred provision for income taxes was $0
(unaudited).





Note
9 – Common Stock Activity




On
September 30, 2008, four management stockholders entered into a Performance
Escrow Agreement (“Agreement”) in conjunction with the Reverse Merger and
Securities Purchase Agreement.  The Agreement calls for 9,900,765 of
these stockholders’ common stock to be placed in escrow.  The stock is
maintained in escrow until certain operational benchmarks are met and following
aggregate funding of $23,000,000 (the “Funding”) The operational benchmarks
require certain performance measures within twelve (12) months following the
Funding and twenty-four (24) months following the Funding.  In both of
those measurement periods, 10% of the total escrowed shares shall be cancelled
and will no longer be outstanding if the performance measures are not
met.  As a result of the settlement agreement related to the
resignation of the Company’s President in February 2009, that former officer’s
4,356,337 shares were released from the escrow agreement.  The other
5,544,428 shares remain in escrow.




-
21 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
9 – Common Stock Activity (continued)








On May
13, 2009, the Company approved the issuance of 2,886,364 shares of its common
stock to Pelly Management (“PM”)  in consideration of an aggregate of
$635,000 in fees incurred by the Company for certain financial advisory services
provided by PM since October 2008. Pursuant to the arrangement between the
Company and PM, the Company was obligated to pay cash for the
fees.  However, in light of the Company’s cash flow demands, the
Company and PM agreed that the common shares would be issued in lieu of cash.
The shares were issued in reliance on the exemption provided by Regulation S of
the Securities Act of 1933, as amended.





On May 13, 2009, the Company approved
the issuance of 2,319,205 shares of its common stock to Niton Capital (“NC”) in
consideration of an aggregate of $510,225 in fees incurred by the Company for
certain consulting and engineering services provided by NC from July 2008 to
March 2009.  Pursuant to the arrangement between the Company and NC,
the Company was obligated to pay cash for the fees.  However, in light
of the Company’s cash flow demands, the Company and NC agreed that the
common shares would be issued in lieu of cash. The shares were issued in
reliance on the exemption provided by Regulation S of the Securities Act of
1933, as amended.




On August
14, 2009, the Company approved the issuance of 48,082 and 46,531 shares of its
common stock to Niton Capital and Green Fund, respectively, in consideration of
an aggregate of $76,931 and $74,449, respectively, in interest penalties
incurred by the Company for not filing a timely registration statement within
sixty days after the Merger.  These penalties were accrued as of June
30, 2009 and are included in Other Liabilities in the consolidated financial
statements.  In light of the Company’s cash flow demands, all parties
agreed that common shares would be issued to settle these obligations. The
shares were issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.





Note 10 -Segment
Information




As of
December 31, 2008 the Company consisted of three segments, as defined by SFAS
No. 131, “Disclosures about
Segments of an Enterprise and Related Information,” identified as
engineering and management contract, fuel, and biofuel.  The fuel segment, which
provided ethanol fuel blends to retail users, was discontinued in January 2009
as a result of competition and pricing factors.  As of June 30, 2009,
the Company manages its business and aggregates its operational and financial
information in accordance with two reportable segments. Its engineering and management
contract segment provides contracted engineering and project development
to third party customers.  Despite the lack of activity in this
segment during the first six months of 2009, while the Company focused its
resources on biofuel research and development, management believes this will be
a viable business segment in the near future.  The biofuel segment is
focused on developing unique technical and operational capabilities designed to
enable the production and commercialization of biofuel, in particular ethanol
from cellulosic biomass and is expected to begin operations starting in late
2009.





Management
assesses performance and allocates resources based on discrete 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.





-
22 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)








Note 10 -Segment Information
(continued)





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





For
      the Three Months Ended
                                              
                                              For
      the Six Months EndedEnded
      June 30,
                                              
                                              Ended
      June 30,2009
                                              
                                              
                                              2008
                                              
                                              
                                              2009
                                              
                                              
                                              2008(unaudited)
                                              
                                              
                                              (unaudited)
                                              
                                              
                                              (unaudited)
                                              
                                              
                                              (unaudited)RevenueEngineering
      and Management Contract
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              1,086
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              3,004Total
      Revenue
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              1,086
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              3,004Operating
      ExpensesCost
      of Engineering and Management Contract
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              1,003
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              1,808General
      and Administrative
                                              
                                              
                                              746
                                              
                                              
                                              
                                              352
                                              
                                              
                                              
                                              2,961
                                              
                                              
                                              
                                              1,941Research
      and Development
                                              
                                              
                                              809
                                              
                                              
                                              
                                              747
                                              
                                              
                                              
                                              1,570
                                              
                                              
                                              
                                              1,425Total
      Operating Expenses
                                              
                                              $
                                              1,555
                                              
                                              
                                              $
                                              2,103
                                              
                                              
                                              $
                                              4,531
                                              
                                              
                                              $
                                              5,174(Loss)
      from Operations:
                                              
                                              $
                                              (1,555
                                              )
                                              
                                              $
                                              (1,017
                                              )
                                              
                                              $
                                              (4,531
                                              )
                                              
                                              $
                                              (2,170
                                              )Identifiable
      Fixed Assets:
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              As
      of June 30, 2009
                                              
                                              
                                              As
      of December 31, 2008(unaudited)
                                              
                                              
                                              (unaudited)Engineering
      and management contract
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              316
                                              
                                              
                                              $
                                              240Biofuel
      research and development
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              7,408
                                              
                                              
                                              
                                              7,348Total
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              7,724
                                              
                                              
                                              
                                              7,588Accumulated
      Depreciation
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (3,286
                                              )
                                              
                                              
                                              (2,334
                                              )Total
      Identifiable Fixed Assets
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              4,438
                                              
                                              
                                              $
                                              5,254








Note
11 – Noncontrolling Interests





On
January 1, 2009, we adopted the provisions of SFAS No. 160, “Noncontrolling Interests in
Consolidated Statements – an Amendment of ARB no. 51” (“SFAS 160”) which
requires that amounts attributable to a minority
interest in subsidiaries are now recognized as noncontrolling
interests.  In addition, losses which exceed the minority interest in
the equity capital of the subsidiary must also be recognized.  (During
the three months ended March 31, 2009, the amount of such losses for WBE were
not considered material.  However, based on the continuing losses of
this business, management determined that such losses should be recorded and the
amount recognized as of June 30, 2009 was for the first six months of
2009.)  As such, historically presented financial statements have been
restated to include noncontrolling interests in stockholders’
deficit.





-
23 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
11 – Shareholders’ Deficit (continued)





Components
of noncontrolling interests as of June 30, 2009 (unaudited) and December 31,
2008 (audited) are as follows:





Noncontrolling
      InterestsBalance
      at January 1, 2008
                      
                      $
                      292,990Net
      loss attributable to minority interests
                      
                      
                      (99,591
                      )Balance
      at December 31, 2008
                      
                      $
                      193,399Balance
      at January 1, 2009
                      
                      $
                      193,399Net
      loss attributable to minority interests
                      
                      
                      (670,297
                      )Balance
      at June 30, 2009
                      
                      $
                      (476,898
                      )





Note
12 - Commitments and Contingencies





Leases





The
Company leases its office space. Total rent expense under this lease was
approximately $16,200 and $31,200 and $12,375 and $34,000 for the three and six
months ended June 30, 2009 and 2008, respectively.  The Company has
office lease obligations that expire September 30, 2011, of approximately
$63,000 for 2009, $67,000 for 2010, and $52,000 for 2011.





The
Company leases land in Upton, WY for CBE 1.  In March 2009, the
Company signed a lease for a 2 year term with an option to extend the lease to
2013 at a lease rate of $30,000 per year.  Prior to that, the land was
leased on a month-to-month basis.  Total rent expense under this
agreement was approximately $7,500 and $38,500 and $3,600 and $7,200 for the
three and six months ended June 30, 2009 and 2008,
respectively.





WBE
Ownership





WBE has
an agreement with a wood residue supplier to supply CBE 1 with wood residue raw
materials (“feedstock”) in exchange for an ownership interest in
WBE.  The agreement between the two entities allows the supplier
to receive a 1% ownership interest in WBE for every 625 tons of feedstock
delivered each year, up to a 4% ownership interest and 2,500
tons.   From the agreement’s inception through June 30, 2009,
approximately 835 tons of feedstock were delivered and the supplier was granted
a 1% ownership interest in WBE.  The contribution of feedstock for
ownership was valued at the fair market value of wood feedstock of approximately
$5,000 and $22,000 at June 30, 2009 and December 31, 2008,
respectively.





-
24 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
12 - Commitments and Contingencies (continued)





Licensing
Agreement





The
Company has an agreement with the South Dakota School of Mines and Technology
(“SDSM&T”) whereby SDSM&T granted the Company all intellectual property
rights associated with joint discovery and development of any CBE
technology.  No licenses have been sold to date and no amounts have
been recorded in the consolidated financial statements related to this
agreement.  In August 2009, the Company notified SDSM&T that it
was electing to terminate this agreement.




Litigation





In the normal course of
business, the Company is party to litigation from time to time.
The Company maintains insurance to cover certain actions and believes resolution
of such general litigation matters will not have a material adverse effect on
the Company.  Additional
information regarding litigation may be found in Part II – Item 1 of this
report.





Note
13 – Subsequent Events




The
Company recognizes in the financial statements the effects of all subsequent
events that provide additional evidence about conditions that existed at the
date of the Condensed Consolidated Balance Sheet, including the
estimates inherent in the process of preparing financial statements. Subsequent
events are subcategorized into two types:  recognized and nonrecognized.
For the period ended June 30, 2009, subsequent events have been evaluated
through August 14, 2009, the date the financial statements were issued or were
available to be issued.





On June
30, 2009, a lawsuit was brought in the District Court of Lincoln County,
Nebraska against the Company, KL Management, LLC, KL Energy, LLC, Patriot Motor
Fuels, LLC, Randy Kramer, David Litzen, Dennis Harstad and Steve Corcoran. 
The plaintiff is Midwest Renewable Energy, LLC, a Nebraska limited liability
company ("MRE").  MRE previously engaged the Company and the named
subsidiaries of the Company to manage its existing ethanol facility, oversee its
expansion construction and market the ethanol produced at its facilities. 
The plaintiff alleges, 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.  The Company intends to vigorously defend itself as
well as to pursue claims it believes it has against MRE relating to the same
underlying matters.





The
Defendants, with the exception of Randy Kramer, have filed a motion in the
District Court of Lincoln County to compel MRE to arbitrate its claims against
all defendants and to stay the civil proceedings pending the arbitration. 
The Court will hear oral arguments on that motion on September 28,
2009.




The
Company filed a demand for arbitration with the American Arbitration
Association ("AAA") alleging that MRE breached its contractual obligations
to the Company with respect to the expansion construction, thereby causing
damages to the Company and excusing any non-performance by the
Company.  KL Management, LLC (“KLM”) filed a demand for arbitration
with the AAA alleging that MRE breached its contractual obligations to
KLM with respect to the management of the existing ethanol facility. 
KLHC (formerly known as KL Energy, LLC, “KLHC”) filed a demand for arbitration
with the AAA alleging that MRE breached its contractual obligations to KLHC with
respect to the marketing of ethanol at MRE's facilities.





-
25 -





KL
Energy Corporation


Notes
to Consolidated Financial Statements


(unaudited)





Note
13 – Subsequent Events (continued)





On August
11, 2009, the Company received $1,000,000 from two existing investors,
Pedro de Boeck and Green Fund (“Investors”).  The related Securities
Purchase Agreement calls for each of the Investors to be issued 2,272,727 shares
of the Company’s common stock.  These funds will be used for working
capital purposes and this
stock will be issued in August 2009. The shares will be issued in
reliance on the exemption provided by Regulation S of the Securities Act of
1933, as amended.


On August
14, 2009, the Company approved the issuance of 48,082 and 46,531 shares of its
common stock to Niton Capital and Green Fund, respectively, in consideration of
an aggregate of $76,931 and $74,449, respectively, in interest penalties
incurred by the Company for not filing a timely registration statement within
sixty days after the Merger.  These penalties were accrued as of June
30, 2009 and are included in Other Liabilities in the consolidated financial
statements.  In light of the Company’s cash flow demands, all parties
agreed that common shares would be issued to settle these obligations. The
shares were issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.


-
26 -








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, our current focus is on owning and operating cellulose based
ethanol ("CBE") facilities that utilize our technology, and designing CBE
facilities for, and licensing our proprietary CBE technology to, third-party
participants in the CBE industry.





Initially,
KLPDG created expansion programs for grain-based ethanol (“GBE”)
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 CBE facilities. While we will continue to offer design and
engineering services to optimize existing GBE facilities, our emphasis in the
future will be on CBE facilities.





While the
majority of ethanol is produced from grain-based feedstock, predominantly corn
in the United States, it can also be produced from cellulose. Cellulose is the
primary component of plant cell walls and is one of the most abundant organic
compounds available. Renewable fuel produced from cellulosic materials draws on
non-food related feedstock sources and has been proven to reduce carbon dioxide
emissions and improve motor efficiency.





Our
engineers continue to optimize our technology in cooperation with the South
Dakota School of Mines and Technology, in Rapid City, South Dakota. Based on
modeling from laboratory data, we believe our process is capable of producing 90
gallons/dry ton.  We currently are capable of producing 65 gallons/dry
ton in a laboratory setting and have consistently produced 45 gallons per dry
ton at our pilot facility.




Through
Western Biomass Energy, LLC (“WBE” or “CBE 1”), a majority owned affiliate of
ours, we have designed, constructed and currently operate what we believe to be
the first commercial, modern-era, second generation CBE plant in the United
States.  This plant was designed to both facilitate research and
operate commercially. This flexible design concept allows us to continue to
research and refine our conversion technology while also demonstrating the
commercial potential for this type of facility. A key part of our business model
is the design of scalable, custom-designed CBE plants based on the economics of
the project, including the geographic area and feedstock.





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 allows for 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 relating 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.





Future
Synergistic Projects





Our
design also offers us better access to synergistic opportunities, such as
co-locatingCBE
facilities with wood pellet production plants or biomass utilities.




-
27 -





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.  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 lignin co-product chemistry is
unaltered. This results in a clean-burning premium wood pellet
product.





Our CBE
process also produces a liquid co-product that contains high nutritional value
for poultry, much like the syrup product from a corn ethanol plant, which can be
used as a feed supplement.   This liquid co-product can also be used
as a energy source.




We do not
currently have such synergistic projects planned for
construction.





Production
Processes





Several
technologies are used to convert cellulose to ethanol.  Generally
speaking, these efforts follow one of three 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;•
            thermochemical
      conversion of biomass into syngas, followed by biological conversion of
      the syngas into ethanol; or





•
            enzymatic
      or chemical breakdown of biomass into component sugars, followed by
      biological fermentation of the sugars into
  ethanol.




We have
selected enzymatic breakdown of biomass for producing ethanol from cellulose
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 (less than 0.1 %) in our
process, eliminating the environmental hazards that result with acid, and
producing valuable by-products from the resulting lignin. Our process has
minimal process water discharge. Other technologies discharge waste water back
into local streams or municipal waste water systems.




Our
planned process for producing cellulosic ethanol contains the following steps.
While several steps are generic to other forms of ethanol production, there are
other important steps that we believe are unique to us and are proprietary. The
principal steps are as follows:




1.
            Biomass
      is prepared for processing based on its specific physical and chemical
      characteristics;




2.
            Biomass
      undergoes enzymatic hydrolysis and steam explosion to break down plant
      matter;





3.
            Hemicellulose,
      in the form of syrup containing xylose and other C5 sugars, is drawn off
      for processing;




4.
            Residue,
      in the form of a semi-solid mixture of cellulose and lignin, is sent for
      further processing;




5.
            Cellulose
      is hydrolyzed into C6 sugars using enzyme cocktails.The C6
      fermentation process also yields ethanol referred to as “ethanol
      beer”;









-
28 -








6.
            Ethanol
      beer from steps (4) and (5) is collected prior to
      distillation;




7.
            Ethanol
      beer is distilled into high-grade ethanol through the removal of water and
      residues;




8.
            Lignin-rich
      residue from distillation, or stillage, is burned, yielding steam for the
      process;




9.
            High-grade
      ethanol is ready for shipment to
market.





Business
Strategies





For the
coming year, we plan to continue to optimize our technology and to design
additional CBE facilities.  Key elements of our business strategy
are:





·
            Developing
      and supplying the technologies for commercial application to produce
      cellulosic ethanol from wood waste or other
      feedstocks.  The design and production strategy involves
      developing scalable facilities based on available feedstock supplies
      providing a commercially viable alternative to solving local communities’
      energy and economic needs.





·
            Owning and
      operating our own CBE facilities.  We intend to own and
      operate CBE facilities that utilize our proprietary
      technology.  When feasible, we intend to locate plants near
      other biomass facilities that provide synergistic benefits such as the
      benefits resulting from co-locating with wood pellet
    plants.




·
            Developing
      national and international strategic partnerships and strategic
      alliances.We intend to develop cellulosic ethanol
      projects together with partnersthat
      accelerate the commercialization of our cellulosic technology, and expand
      our global market presence, while gaining a competitive
      advantage.  These strategic partners and alliances are critical
      to our success in commercializing our cellulosic ethanol technology. We
      intend to develop cellulosic ethanol projects in conjunction with partners
      who will enhance our competitiveness and ability to finance our projects.
      Our strategy includes partners who bring key services, and capabilities to
      project development such as engineering, construction, as well as
      feedstock supplies and ethanol off-take
  agreements.





·
            Improving
      existing ethanol production through KL CapacitySM.  KL
      CapacitySM
      is a service that provides existing grain-based ethanol plants with
      specialized engineering enhancements that improve the efficiency of
      ethanol production and potential for increased profitability. KL
      CapacitySM has
      been developed to respond to rapidly changing market conditions in
      grain-based ethanol plants in the US and sugar-based ethanol plants in
      Brazil.







-
29 -








Challenges





KL
Energy’s success depends on the ability to enter into and work on simultaneous
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 scale-up and demonstration
      phase, 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 that are also in the research and development phase and
      represent a significant and volatile expense in the CBE production
      process;





●
            Our
      industry is rapidly developing with many existing and emerging competitors
      and competitive technologies.




Significant
Developments





Recent
Financing





Our
recent financing is described in Note 2 and Note 13 of the Notes to Consolidated
Financial Statements included in this Report and incorporated by reference
herein.




Subsequent
Events
 
 Information
regarding subsequent events may be found in Note 13 of the Notes to Consolidated
Financial Statements included in this Report and incorporated by reference
herein.




Critical
Accounting Policies and Estimates:





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.




Long-Lived
Assets





The
Company assesses the realizable value of long-lived assets for potential
impairment at least annually or when events and circumstances warrant such a
review.  The carrying value of a long-lived asset is considered
impaired when the anticipated fair value is less than its carrying
value.  In assessing the recoverability of our long-lived assets, we
must make assumptions regarding estimated future cash flows and other factors to
determine the fair value of the respective assets.  In addition, we
must make assumptions regarding the useful lives of these assets.  As
of December 31, 2008, we evaluated our long-lived assets for potential
impairment.  Based on our evaluation, no impairment charge was
recognized.








-
30 -








Revenue





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 December 31, 2008 and 2007 will be revised significantly in the near
term.





Income
Taxes





The
Company accounts for income taxes under the liability method, which requires an
entity to recognize deferred tax assets and liabilities.  Temporary
differences are differences between the tax basis of assets and liabilities and
their reported amounts in the financial statements that will result in taxable
or deductible amounts in future years. An income tax valuation allowance has
been established to reduce the Company’s deferred tax asset to the amount that
is expected to be realized in the future. KL Energy Services LLC (“KLES”, a
wholly-owned subsidiary, as well as KLHC LLC (formerly known as KL Energy LLC,
“KLHC”), KL Management, LLC (“KLM”), Patriot Motor Fuels LLC (“Patriot”) and
Western Biomass Energy LLC (“WBE”) are Limited Liability Companies for income
tax purposes. Accordingly, taxable income or losses of these companies are
reported on the income tax returns of the members.





Liquidity
and Capital Resources





At June
30, 2009, the Company had approximately $1.1 million of total current assets
which primarily consisted of $746,000 in cash and cash equivalents and $285,000
of deferred issuance costs.  In addition, we had approximately $4.4
million of net property, plant and equipment.  Our total assets as of
June 30, 2009 were approximately $5.6 million.   With $7.2
million of total current liabilities, the Company had negative working capital
of approximately $6.1 million at June 30, 2009.




In
February 2009, we received additional capital of approximately $4.0 million, or
$3.6 million after placement fees, to fund operating activities and allow
long-term borrowing commitments to remain current. We expect to rely on
funds raised from this recent private placement, 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 have no specific
arrangements for any external financing of debt or equity and are not certain
whether any such financing would be available on terms acceptable to us, if at
all.





In their
report dated March 27, 2009, the Company’s auditors indicated there was
substantial doubt about the Company’s ability to continue as a going concern
without any adequate fund-raising. 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.





-
31 -







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 $1,452,256 at June 30, 2009.  A principal payment of
$500,000 was made in February 2009.  Pursuant to an amendment executed
during the first quarter of 2009, principal and interest payments of $17,560 are
due to be made from March 2009 until the maturity date of March 2010, which
may be extended on an annual basis if the Company is in compliance with the note
terms. This note bears interest at 6.5% and is secured by substantially all of
the assets of WBE including the CBE1 plant.





We had a
line of credit with Wells Fargo for borrowings up to $250,000 and at December
31, 2008 we had borrowed the full amount available.  The interest rate
with respect to borrowed amounts was the prime rate used by Wells Fargo plus
..5%. This line of credit was personally guaranteed by certain persons who
were officers of the Company during 2008. This line of credit has matured and
was paid off in 2009 by a Company payment of $175,000 (plus interest) and by the
proceeds from a line of credit of $75,000 extended to us by a current
shareholder and officer of the Company.  This latter amount (plus
interest) was paid off in June 2009.





We had a
subordinated unsecured note payable to a current shareholder and former officer
of the Company totaling $600,000 at December 31, 2008.  This note has
a variable interest rate, which was 5.0% at June 30, 2009 and December 31, 2008,
with interest paid quarterly.  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 $40,000 in 2009, $120,000 in
each of 2010, 2011, 2012, 2013, 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 we receive future
equity financing, we are obligated to pay 5% of the proceeds towards principal
payments on this note.





The
Company also had 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.





Additional
current liabilities include approximately $504,000 in current maturities of
debt, billings in excess of costs and estimated earnings on uncompleted
contracts of approximately $2.0 million, accounts payable of approximately $1.7
million (of which approximately $18,000 was to related parties), and accrued
liabilities of $1.3 million (of which approximately $394,000 was payroll
related, approximately $140,000 is for consulting and engineering services
provided by Niton Capital, approximately $90,000 for accrued legal and audit
fees, approximately $368,000 represented liabilities of discontinued operations
of KLM, KLEN and Patriot and an accrued $152,000 Securities Purchase Agreement
penalty related to the non-timely filing of a registration statement with the
SEC).





Long-term
liabilities of approximately $605,000 at June 30, 2009 represent long-term
subordinated indebtedness to a related party ($500,000) and the non-current
portion of the note payable to Hermanson Egge ($105,000).  Our total
liabilities were approximately $7.8 million as of June 30, 2009.





-
32 -







On
October 9, 2008, we entered into a term loan agreement (“O2D Loan”) with
O2Diesel Corporation (“O2D”), a publically traded company (OTC: OTOD.PK),
pursuant to which we agreed to provide O2D with up to $1,000,000 for O2D’s
working capital purposes.  O2D is a commercial developer of
cleaner-burning diesel fuel alternatives, including O2DieselTM, an ethanol-diesel
additive.  The O2D Loan provides an initial loan of $250,000 in the
form of a secured promissory note (the “Note”) with an annual interest rate of
10%.  The interest rate increases to 12% in any period in which there
is a continuing default.  O2D was able to make additional draws upon
the delivery of written requests to us specifying the amount and use of the
funds, which requests we may accept or deny in our discretion. The O2D Loan
matured on March 31, 2009 (“Maturity Date”). Interest accruing on the loan was
required to be paid on the Maturity Date. On the Maturity Date, we had the
option of converting the outstanding loan obligation into shares of common stock
of O2Dat a
conversion rate equal to the price of the O2D’s stock on the Maturity Date. If
O2D fails to pay the loan on the Maturity Date, O2D is required to pay us an
indemnification fee equal to 20% of the maximum principal amount outstanding
during the term of the O2D Loan. As security for the loan, O2D provided us with
a security interest in its intellectual property relating to the oxygenating of
diesel fuel, including its proprietary fuel additive,
O2DieselTM.  The O2D Loan and related Note also contain customary
events of default. There are no financial covenants related to this
loan.  As of March 31, 2009, O2D defaulted on this Note and, due to
O2Diesel’s financial condition, the Company determined it would not make any
additional loans to O2D and the Company reserved for the entire amount of
the note receivable.  Our
previously outstanding $250,000 loan to O2DieselTM Corporation was purchased in
April 2009 by Energenics Holdings Pte Ltd, a Singapore
corporation.




We have
provided substantial funding for WBE, a 64% owned subsidiary of ours, relating
to the development of our cellulosic technology.  As of June 30, 2009
and December 31, 2008, WBE owed us approximately $6.8 million and $4.3 million,
respectively.  There is currently no specific repayment schedule for
these debts owed to the Company by WBE.




Net
Cash Flow – Operating Activities





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 2009.
Whether we have positive cash flow in 2010 depends on whether we are able to
realize engineering design and licensing revenue from new CBE projects (expected
to start in the last half of 2009) 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 our technology achieves the CBE yields that allow
us to produce ethanol at a cost that can compete with other alternative
fuels.




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 six months ended June 30, 2009, our operating activities used a net of
approximately $2.2 million of cash. This reflected a loss of approximately $3.9
million from continuing and discontinued operations which was largely offset by
depreciation of approximately $967,000, allowances for doubtful accounts of
approximately $450,000 and an increase of approximately $981,000 in accrued
payroll and other liabilities offset by decreases of approximately $239,000 and
$161,000 in accounts payable and current liabilities of discontinued operations,
respectively.





-
33 -








During
the six months ended June 30, 2008, our operating activities used a net of
approximately $217,000 of cash. This primarily reflected a net loss of
approximately $2.1 million from continuing and discontinued operations and a
decrease of approximately $728,000 in net excess of billings over costs and
estimated earnings on uncompleted contracts offset by an increase of
approximately $1.1 million in net trade receivables, depreciation of
approximately $883,000, increases of approximately $261,000 and $187,000 in
accrued payroll and other liabilities and current liabilities of discontinued
operations, respectively.





Net
Cash Flow - Investing Activities





Net cash
used in investing activities during the six months ended June 30, 2009 of
approximately $151,000 increased by approximately $81,000 over investing
activities in the six months ended June 30, 2008.  This increase was
the result of approximately $63,000 higher purchases of property, plant, and
equipment, primarily for the WBE plant, offset by approximately $18,000 of
higher proceeds from the sale of assets during the six months ended June 30,
2008.





Net
Cash Flow – Financing Activities




Net cash
provided by our financing activities was approximately $2.4 million for the six
months ended June 30, 2009. During this period, we received approximately $3.2
million (net of $750,000 in issuance fees) from the private placement of common
stock.  This amount was offset by approximately $871,000 of payments
on long-term debt principal and short-term borrowings.  Net cash used
in our financing activities was approximately $157,000 for the six months ended
June 30, 2008 primarily due to the restructuring of bank loans.





Results
of Operations for the Three Months Ended June 30, 2009 and 2008





Revenue





The
Company did not record any revenue for the three months ended June 30, 2009
which was approximately $1.1 million lower than the corresponding period in
2008.  This decrease was due to a slowdown and/or work stoppage on
existing contracts in the grain based ethanol business in the latter half of
2008.  This decrease in revenue also reflects our focus on research
and the enhancement of our CBE technology.





Operating
Expenses





Operating
expenses of approximately $1.6 million, in the three months ended June 30, 2009,
were approximately $548,000 (or 26 %) lower than the comparable period in the
prior year.  The primary reason for this decrease was the absence of
engineering and management contract costs in the second quarter of 2009
(compared to approximately $1.0 million of such costs in the second quarter of
2008) due to a slowdown and/or work stoppage on existing contracts in the grain
based ethanol business in the latter half of 2008.  This decrease was
substantially offset by higher general and administrative and research and
development expenses.





General and Administrative
expense of $746,000 increased approximately $394,000 (or 112%) in the
three months ended June 30, 2009 compared to the $352,000 in the three months
ended June 30, 2008.  This increase was primarily attributable to the
$140,000 increase in consulting and engineering services as well as higher audit
and legal costs offset by an absence of expenses at KL Management LLC and KL
Energy LLC, which were unfavorably impacted by the slowdown and/or work stoppage
on existing contracts in the grain based ethanol business, as well as the sale
and elimination of aircraft and its operating costs.





-
34 -








Research and Development
expense of $809,000 increased approximately $62,000 (or 8%) in the three
months ended June 30, 2009 compared to the $747,000 in the three months ended
June 30, 2008.  The increase is primarily related to continued
efforts to enhance the operating performance of the WBE plant and achieve the
yields required by potential licensees of our technology.





Other
Income (Expense)





Other income of
approximately $29,000 for the three months ended June 30, 2009, primarily
consisting of approximately $35,000 in research grants received offset by a loss
on the sale of assets of approximately $6,000, was approximately $29,000
favorable to the $224 of other expense for the three months ended June 30,
2008.




Interest income of
approximately $2,000 for the three months ended June 30, 2009 was approximately
$2,000 higher than the comparable period in 2008 primarily as a result of
interest earned on overdue customer balances and the reclassification of
interest income from discontinued operations.




Interest expense of
$27,000 decreased approximately $73,000 (or 74%) in the three months ended June
30, 2009 compared to approximately $100,000 in the three months ended June 30,
2008. This decrease was primarily due to the repayment of approximately $1.6
million in bank debt and loans from related parties.





Results
of Operations for the Six Months Ended June 30, 2009 and 2008





Revenue





The
Company did not record any revenue for the six months ended June 30, 2009 which
was approximately $3.0 million lower than the corresponding period in
2008.  This decrease was due to a slowdown and/or work stoppage on
existing contracts in the grain based ethanol business in the latter half of
2008.  This decrease in revenue also reflects our focus on research
and the enhancement of our CBE technology.





Operating
Expenses





Operating
expenses of approximately $4.5 million, in the six months ended June 30, 2009,
were approximately $643,000 (or 12%) lower than the $5.2 million reported for
comparable period in the prior year.  The primary reason for this
decrease was the absence of engineering and management contract costs in the
first two quarters of 2009 (compared to approximately $1.8 million of such costs
in the first six months of 2008) due to a slowdown and/or work stoppage on
existing contracts in the grain based ethanol business in the latter half of
2008.  This decrease was substantially offset by higher general and
administrative and research and development expenses.





General and Administrative
expense of $3.0 million increased approximately $1.1 million (or 52%) in
the six months ended June 30, 2009 compared to the $1.9 million in the six
months ended June 30, 2008.  This increase was primarily attributable
to approximately $884,000 of increased professional, consulting, and engineering
services and $178,000 of increased legal costs offset by an absence of expenses
at KL Management LLC and KL Energy LLC, which were unfavorably impacted by the
slowdown and/or work stoppage on existing contracts in the grain based ethanol
business, as well as the sale and elimination of aircraft and its operating
costs.





Research and Development
expense of $1.6 million increased approximately $146,000 (or 10%) in the
six months ended June 30, 2009 compared to the $1.4 million in the six months
ended June 30, 2008.  The increase is primarily related
to continued efforts to enhance the operating performance of the WBE plant
and achieve the yields required by potential licensees of our
technology.





-
35 -








Other
Income (Expense)





Other income of
approximately $11,000 for the six months ended June 30, 2009, primarily
consisting of approximately $35,000 in research grants, $13,000 proceeds from
the sale of Renewable Fuel Standard’s (RFS) renewable identification numbers
(RINS), and $3,000 capital credits from electric cooperative at our CBE1 plant
offset by approximately $6,000 in losses on the sale of assets, $28,000 of
aircraft sales taxes, and $7,000 in property tax expense.  This other
income is approximately $1,000 favorable to the $10,000 of other income for the
six months ended June 30, 2008.




Interest income of
$44,000 for the six months ended June 30, 2009, compared to the $9 of interest
income during the same period in 2008, was higher primarily as a result of
interest earned on overdue customer balances.




Interest expense of
$102,000 decreased approximately $96,000 (or 48%) in the six months ended June
30, 2009 compared to the $198,000 in the six months ended June 30, 2008. This
decrease was primarily due to the repayment of approximately $1.6 million in
bank debt and loans from related parties.





Item 4T.  Controls
and Procedures





(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.
  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 June 30, 2009, 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 2008
Annual Report on Form 10-K.
  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
presents, 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 Quarterly Report on
Form 10-Q for the period ended March 31, 2009, we took 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




·
            had 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




·
            as
      needed, engaged 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






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Other
than described above there were no changes in our internal controls over
financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during
the second quarter of 2009 that materially affected, or is 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; 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.







PART
II – OTHER INFORMATION





Item 1.  Legal
Proceedings





The
Company is named in a personal injury claim relating to an individual working
for a subcontractor who was injured while working on the construction of a
grain-based ethanol plant. The Company was hired for the plant construction. The
individual claims that an employee of the Company gave him direction to open the
boiler when it was not yet cooled and, as a result, he suffered second and third
degree burns. The employer of this individual is seeking to subrogate its
workers compensation claim. At this time, the Company is unable to predict the
outcome of the case. The amount of liability, if any, is not determinable.





The
Company provided construction management and engineering services for the
construction of a new biofuels production facility for Willmark Energy, Inc.
(“Willmark”).  Several disputes arose in connection with this project and,
as a result of the parties’ inability to reach a settlement, Willmark filed a
request for arbitration, as provided in the construction contract, on May 1,
2009.  Willmark alleges that the Company failed to perform its design and
project management duties under the construction contract, as amended, and is
seeking approximately $1.5 million in damages and the release of liens the
Company has placed on Willmark assets.   This arbitration is
still in its initial stages and discovery has not yet commenced.





On June
30, 2009, a lawsuit was brought in the District Court of Lincoln County,
Nebraska against the Company, KL Management, LLC, KL Energy, LLC, Patriot Motor
Fuels, LLC, Randy Kramer, David Litzen, Dennis Harstad and Steve Corcoran. 
The plaintiff is Midwest Renewable Energy, LLC, a Nebraska limited liability
company ("MRE").  MRE previously engaged the Company and the named
subsidiaries of the Company to manage its existing ethanol facility, oversee its
expansion construction and market the ethanol produced at its facilities. 
The plaintiff alleges, 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.  The Company intends to vigorously defend itself as
well as to pursue claims it believes it has against MRE relating to the same
underlying matters.





The
Defendants, with the exception of Randy Kramer, have filed a motion in the
District Court of Lincoln County to compel MRE to arbitrate its claims against
all defendants and to stay the civil proceedings pending the arbitration. 
The Court will hear oral arguments on that motion on September 28,
2009.




The
Company filed a demand for arbitration with the American Arbitration
Association ("AAA") alleging that MRE breached its contractual obligations
to the Company with respect to the expansion construction, thereby causing
damages to the Company and excusing any non-performance by the
Company.  KL Management, LLC (“KLM”) filed a demand for arbitration
with the AAA alleging that MRE breached its contractual obligations to
KLM with respect to the management of the existing ethanol facility. 
KLHC (formerly known as KL Energy, LLC, “KLHC”) filed a demand for arbitration
with the AAA alleging that MRE breached its contractual obligations to KLHC with
respect to the marketing of ethanol at MRE's facilities.





In the normal course of
business, the Company is party to litigation from time to time. The Company
maintains insurance to cover certain actions and believes resolution of such
general litigation matters will not have a material adverse effect on the
Company.





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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 30, 2009.  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 not currently
known to us or that we currently deem to be immaterial also may materially
adversely affect our business, financial condition, and/or reporting
results.




Item
2.  Unregistered Sales of Equity Securities





On
February 24, 2009, the Company consummated a Securities Purchase Agreement (the
“Purchase Agreement”) with certain investors listed on the signature pages of
the Purchase Agreement (the “Investors”).  Pursuant to the terms of
the Purchase Agreement, the Company issued to the Investors 18,181,818 shares of
the Company’s common stock (the “Shares”), representing approximately 60% of the
total number of issued and outstanding shares of the Company’s common stock, for
a purchase price of $4,000,000. We made no general solicitation and we believe
that the issuance of the Shares met the standards for purchases under an
exemption for a non-public offering.





On May
13, 2009, the Company approved the issuance of 2,886,364 shares of its common
stock to Pelly Management (“PM”) in consideration of an aggregate of $635,000 in
fees incurred by the Company for certain financial advisory services provided by
PM since October 2008.  Pursuant to the arrangement between the
Company and PM, the Company was obligated to pay cash for the
fees.  However, in light of the Company’s cash flow demands, the
Company and PM agreed that the common shares would be issued in lieu of cash.
The shares were issued in reliance on the exemption provided by Regulation S of
the Securities Act of 1933, as amended.




On May
13, 2009, the Company approved the issuance of 2,319,205 shares of its common
stock to Niton Capital (“NC”) in consideration of an aggregate of $510,225 in
fees incurred by the Company for certain consulting and engineering services
provided by NC from July 2008 to March 2009.  Pursuant to the
arrangement between the Company and NC, the Company was obligated to pay cash
for the fees.  However, in light of the Company’s cash flow
demands, the Company and NC agreed that the common shares would be issued in
lieu of cash. The shares were issued in reliance on the exemption provided by
Regulation S of the Securities Act of 1933, as amended.




On August
14, 2009, the Company approved the issuance of 48,082 and 46,531 shares of its
common stock to Niton Capital and Green Fund, respectively, in consideration of
an aggregate of $76,931 and $74,449, respectively, in interest penalties
incurred by the Company for not filing a timely registration statement within
sixty days after the Merger.  These penalties were accrued as of June
30, 2009 and are included in Other Liabilities in the consolidated financial
statements.  In light of the Company’s cash flow demands, all parties
agreed that common shares would be issued to settle these obligations. The
shares were issued in reliance on the exemption provided by Regulation S of the
Securities Act of 1933, as amended.


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Item 6.
Exhibits





(a)
Exhibits





Exhibit
                  Number
                Description3.1
                Articles
      of Incorporation, incorporated by reference to our registration statement
      on Form SB-2 (333-145183), filed on August 7, 20073.2
                Bylaws,
      incorporated by reference to our registration statement on Form SB-2
      (333-145183), filed on August 7, 200731.1*
                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.





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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.




August
      14, 2009
              By:
              /s/ THOMAS
      J. BOLANThomas
      J. Bolan
                Acting
      Chief Financial Officer




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