Penn Octane (POCC) 10-Q 2006 Q4 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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, 2006

OR

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

For the transition period from ____________ to _____________

Commission file number: 000-24394

Penn Octane Corporation

(Exact Name of Registrant as Specified in Its Charter)

Delaware	52-1790357
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

77-530 Enfield Lane, Bldg. D, Palm Desert, California	92211
(Address of Principal Executive Offices)	(Zip Code)

Registrant's Telephone Number, Including Area Code: (760) 772-9080

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

Yes x   No o

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

Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer x

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

Yes o   No x

The number of shares of Common Stock, par value $.01 per share, outstanding on August 4, 2006 was 15,386,187.

1

PENN OCTANE CORPORATION

TABLE OF CONTENTS

	ITEM		PAGE NO.
Part I	1.	Financial Statements
		Report of Independent Registered Public Accounting Firm	3
		Consolidated Balance Sheets as of December 31, 2005 andJune 30, 2006 (unaudited)	4-5
		Unaudited Consolidated Statements of Operations for the three months and six months ended June 30, 2005 and 2006	6
		Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and 2006	7
		Notes to Consolidated Financial Statements (Unaudited)	8-32
	2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	33-56
	3.	Quantitative and Qualitative Disclosures About Market Risk	57
	4.	Controls and Procedures	57
Part II	1.	Legal Proceedings	58
	1A.	Risk Factors	58 - 60
	2.	Unregistered Sales of Equity Securities and Use of Proceeds	60
	3.	Defaults Upon Senior Securities	60
	4.	Submission of Matters to a Vote of Security Holders	60
	5.	Other Information	60
	6.	Exhibits	61-62
	Signatures		63

2

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Penn Octane Corporation

We have reviewed the consolidated balance sheet of Penn Octane Corporation and subsidiaries (Company) as of June 30, 2006, the consolidated statements of operations for the three months and six months ended June 30, 2005 and 2006, and the consolidated statement of cash flows for the six months ended June 30, 2005 and 2006. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying interim financial statements for them to be in conformity with United States generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Penn Octane Corporation and Subsidiaries as of December 31, 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated February 13, 2006, we expressed an unqualified opinion on those consolidated financial statements.

Our auditors’ report on the Company’s financial statements as of December 31, 2005 included an explanatory paragraph referring to the matters discussed in Note T of those financial statements which raised substantial doubt about the Company’s ability to continue as a going concern. As indicated in Note L to the accompanying unaudited interim consolidated financial statements, conditions continue to exist which raise substantial doubt about the Company’s ability to continue as a going concern.

/s/  BURTON MCCUMBER & CORTEZ, L.L.P.

Brownsville, Texas

July 31, 2006

3

Part I

Item 1.

Penn Octane Corporation and Subsidiaries

CONSOLIDATED BALANCE SHEETS

ASSETS

	December 31, 2005		June 30, 2006
Current Assets			(Unaudited)
Cash	$	299,597	$	118,982
Restricted cash		5,657,623		4,093,513
Trade accounts receivable (less allowance for doubtful accounts of$0 and $63,958 at December 31, 2005 and June 30, 2006)		12,470,891		9,860,408
Inventories		2,878,268		3,594,060
Prepaid expenses and other current assets		100,272		189,528
Total current assets		21,406,651		17,856,491
Property, plant and equipment - net		14,983,247		14,332,711
Lease rights (net of accumulated amortization of $818,207 and $841,104 at December 31, 2005 and June 30, 2006)		335,832		312,935
Other non-current assets		31,089		29,575
Total assets	$	36,756,819	$	32,531,712

The accompanying notes and accountants’ report are an integral part of these statements.

4

 

Penn Octane Corporation and Subsidiaries

CONSOLIDATED BALANCE SHEETS - CONTINUED

LIABILITIES AND STOCKHOLDERS' EQUITY

	December 31, 2005			June 30, 2006
Current Liabilities				(Unaudited)
Current maturities of debt obligations	$	3,015,054		$	2,405,425
Revolving line of credit		560,283			4,748,087
LPG and Fuel Products trade accounts payable		16,888,320			10,046,769
Other accounts payable		1,770,656			2,190,506
U.S. and foreign taxes payable		21,045			35,385
Accrued liabilities		2,184,168			1,863,189
Total current liabilities		24,439,526			21,289,361
Long-term debt, less current maturities		10,387			7,791
Minority interest in Rio Vista Energy Partners L.P.		11,955,005			11,313,151
Commitments and contingencies		-			-
Stockholders' Equity
Series A - Preferred stock-$.01 par value, 5,000,000 shares authorized; no shares issued and outstanding at December 31, 2005 and June 30, 2006		-			-
Series B - Senior preferred stock-$.01 par value, $10 liquidation value, 5,000,000 shares authorized; no shares issued and outstanding at December 31, 2005 and June 30, 2006		-			-
Common stock - $.01 par value, 25,000,000 shares authorized; 15,522,745 and 15,522,745 shares issued and outstanding at December 31, 2005 and June 30, 2006		155,227			155,227
Additional paid-in capital		28,741,122			28,947,526
Note receivable from a former officer of the Company for exercise of warrants, less reserve of $1,500,000 and $1,578,889 at December 31, 2005 and June 30, 2006		(1,696,693	)		(1,696,693	)
Accumulated deficit		(26,847,755	)		(27,484,651	)
Total stockholders' equity (deficit)		351,901			(78,591	)
Total liabilities and stockholders' equity (deficit)	$	36,756,819		$	32,531,712

The accompanying notes and accountants’ report are an integral part of these statements.

5

Penn Octane Corporation and Subsidiaries

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30, 2005			June 30, 2006			June 30, 2005			June 30, 2006
Revenues	$	52,262,580		$	66,943,426		$	111,989,474		$	136,271,690
Cost of goods sold		52,174,553			65,994,563			109,512,498			134,054,187
Gross profit		88,027			948,863			2,476,976			2,217,503
Selling, general and administrative expenses
Legal and professional fees		565,022			465,941			1,012,448			853,284
Salaries and payroll related expenses		1,574,149			363,048			2,222,599			917,254
Other		452,161			500,475			972,588			998,498
		2,591,332			1,329,464			4,207,635			2,769,036
Operating income (loss)		(2,503,305	)		(380,601	)		(1,730,659	)		(551,533	)
Other income (expense)
Interest and LPG and Fuel Products financing expense		(424,075	)		(397,495	)		(816,017	)		(751,505	)
Interest income		5,290			13,524			9,654			22,985
Minority interest in (earnings) loss of RioVista Energy Partners L.P.		713,232			425,418			544,186			671,746
Income (loss) before taxes		(2,208,858	)		(339,154	)		(1,992,836	)		(608,307	)
Provision for income tax		14,237			14,663			33,847			28,588
Net income (loss)	$	(2,223,095	)	$	(353,817	)	$	(2,026,683	)	$	(636,895	)
Net income (loss) per common share	$	(0.14	)	$	(0.02	)	$	(0.13	)	$	(0.04	)
Net income (loss) per common share assuming dilution	$	(0.14	)	$	(0.02	)	$	(0.13	)	$	(0.04	)
Weighted average common shares outstanding		15,522,745			15,522,745			15,472,710			15,522,745

The accompanying notes and accountants’ report are an integral part of these statements.

6

Penn Octane Corporation and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six months ended
	June 30, 2005			June 30, 2006
Cash flows from operating activities:
Net income (loss)	$	(2,026,683	)	$	(636,895	)
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		511,296			500,955
Amortization of lease rights		22,898			22,898
Amortization of loan discount related to detachable warrants		221,218			22,104
Provision for doubtful accounts		-			63,958
Share-based payment expense		-			214,192
Minority interest in loss of Rio Vista Energy Partners L.P.		(544,186	)		(671,746	)
Discount of note receivable from former officer		1,031,307			-
(Gain) losson sale of assets		(24,000	)		74,520
Changes in current assets and liabilities:
Trade accounts receivable		2,733,067			2,546,525
Inventories		1,499,718			(715,792	)
Prepaid expenses and other current assets		(61,070	)		(89,256	)
LPG and Fuel Products trade accounts payable		(9,065,342	)		(6,841,551	)
Other accounts payable and accrued liabilities		1,162,841			116,940
U.S. and Foreign taxes payable		(24,293	)		14,340
Net cash used in operating activities		(4,563,229	)		(5,378,808	)
Cash flows from investing activities:
Capital expenditures		(61,533	)		(55,715	)
Proceeds from sale of assets		175,000			130,776
Decrease in other non-current assets		5,113			1,514
Net cashprovided by investing activities		118,580			76,575
Cash flows from financing activities:
Decrease in restricted cash		2,682,451			1,564,110
Revolving credit facilities		2,517,741			4,187,804
Issuance of common stock		97,750			-
Distributions paid by Rio VistaEnergy Partners L.P. to limited partners		(955,330	)		-
Reduction in debt		(62,597	)		(630.296	)
Net cash provided byfinancing activities		4,280,015			5,121,618
Net decrease in cash		(164,634	)		(180,615	)
Cash at beginning of period		374,567			299,597
Cash at end of period	$	209,933		$	118,982
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest and LPG and Fuel Products financing expense	$	416,370		$	911,083
Supplemental disclosures of noncash transactions:
Equity-common stock and warrants issued and other	$	108,450		$	-
Note issued for software	$	55,463		$	-

The accompanying notes and accountants’ report are an integral part of these statements.

7

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE A - ORGANIZATION

Penn Octane Corporation, formerly known as International Energy Development Corporation, was incorporated in Delaware in August 1992. Penn Octane Corporation (Penn Octane) and its consolidated subsidiaries, including Rio Vista Energy Partners, L.P. and its subsidiaries, are collectively hereinafter referred to as the Company. The Company has been principally engaged in the purchase, transportation and sale of liquefied petroleum gas (LPG) and the sale of gasoline and diesel fuel (Fuel Products). The Company owns and operates terminal facilities in Brownsville, Texas (Brownsville Terminal Facility) and Matamoros, Tamaulipas, Mexico (Matamoros Terminal Facility) and approximately 23 miles of pipelines (US - Mexico Pipelines) which connect the Brownsville Terminal Facility to the Matamoros Terminal Facility (see note D). The Company has a long-term lease agreement for approximately 132 miles of pipeline (Leased Pipeline) which connects ExxonMobil Corporation’s (Exxon) King Ranch Gas Plant in Kleberg County, Texas and Duke Energy's La Gloria Gas Plant in Jim Wells County, Texas, to the Company's Brownsville Terminal Facility (see note J).

The Company commenced commercial operations for the purchase, transport and sale of LPG in the fiscal year ended July 31, 1995. The primary market for the Company's LPG is the northeastern region of Mexico, which includes the states of Coahuila, Nuevo Leon and Tamaulipas. Since operations commenced, the Company’s primary customer for LPG has been P.M.I. Trading Limited (PMI). PMI is a subsidiary of Petroleos Mexicanos, the state-owned Mexican oil company, which is commonly known by its trade name “PEMEX.” PMI is the exclusive importer of LPG into Mexico. PMI sells the LPG purchased from the Company to PEMEX which distributes the LPG into the northeastern region of Mexico. Sales of LPG to PMI accounted for approximately 31.8% and 44.4% of the Company’s total revenues and 67.5% and 85.5% of the Company’s LPG revenues for the three and six months ended June 30, 2006, respectively. The Company’s gross profit from LPG sales is dependent on sales volume of LPG to PMI, which fluctuates in part based on the seasons. The demand for LPG is strongest during the winter season.

During June 2004, the Company began operations as a reseller of Fuel Products. The Company sells Fuel Products (Fuel Sales Business) through transactional, bulk and/or rack transactions. Typical transactional and bulk sales are made based on a predetermined net spread between the purchase and sales price over posted monthly variable prices and/or daily spot prices. Rack sales transactions are based on variable sale prices charged by the Company which are tied to posted daily spot prices and purchase costs which are based on a monthly average or 3 day average based on posted prices. The Company pays pipeline and terminal fees based on regulated rates.

The Company has the ability to access certain pipeline and terminal systems located in California, Arizona, Nevada and Texas, where it is able to deliver its Fuel Products.

For bulk and transactional sales, the Company enters into individual sales contracts for each sale. Fuel Products sales are subject to credit limitations imposed on each individual buyer by the Company. The Company has several supply contracts for each of the Fuel Products it sells. The supply contracts are for annual periods with flexible volumes but they may be terminated sooner by the supplier if the Company consistently fails to purchase minimum volumes of Fuel Products. Fuel sales approximated 52.8% and 48.0% of total revenues for the three and six months ended June 30, 2006, respectively.

8

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE A - ORGANIZATION - Continued

On September 30, 2004, Penn Octane Corporation (Penn Octane) completed a series of transactions involving (i) the transfer of substantially all of its owned pipeline and terminal assets in Brownsville and Matamoros to its wholly owned subsidiary Rio Vista Operating Partnership L.P. and its subsidiaries (RVOP) (ii) transferred Penn Octane’s 99.9% interest in RVOP to its wholly owned subsidiary Rio Vista Energy Partners L.P. and its subsidiaries (Rio Vista) and (iii) distributed all of its limited partnership interest (Common Units) in Rio Vista to its common stockholders (Spin-Off), resulting in Rio Vista becoming a separate public company. The Common Units represented 98% of Rio Vista’s outstanding partnership interests. The remaining 2% interest represented the general partner interest. The general partner interest is solely owned and controlled by Rio Vista GP LLC (General Partner), a wholly owned subsidiary of Penn Octane at June 30, 2006. On July 1, 2006, options to acquire 50% of the General Partner were exercised, resulting in Penn Octane having a 50% interest in the General Partner. Penn Octane retains control over the General Partner pursuant to a voting agreement. Therefore, Rio Vista is consolidated with the Company and the interests of the General Partner not owned by Penn Octane and the interests of the limited partners are classified as minority interests in the Company’s unaudited consolidated financial statements. The General Partner is responsible for the management of Rio Vista. Subsequent to the Spin-Off, Rio Vista sells LPG directly to PMI and purchases LPG from Penn Octane under a long-term supply agreement. The purchase price of the LPG from Penn Octane is determined based on the cost of LPG under Penn Octane’s LPG supply agreements with its suppliers, other direct costs related to PMI sales and a formula that takes into consideration operating costs of Penn Octane and Rio Vista.

Basis of Presentation

The accompanying unaudited consolidated financial statements include Penn Octane and its U.S. subsidiaries including PennWilson CNG, Inc. (PennWilson) and Penn CNG Holdings, Inc. and Rio Vista and its U.S. and Mexican subsidiaries, including Penn Octane International, L.L.C., Penn Octane de Mexico, S. de R.L. de C.V. (PennMex), Termatsal, S. de R.L. de C.V. (Termatsal) and Tergas, S. de R.L. de C.V. (Tergas), a consolidated affiliate, and Penn Octane’s other inactive Mexican subsidiaries, (collectively the Company). All significant intercompany accounts and transactions are eliminated.

The unaudited consolidated balance sheet as of June 30, 2006, the unaudited consolidated statements of operations for the three months and six months ended June 30, 2005 and 2006 and the unaudited consolidated statements of cash flows for the six months ended June 30, 2005 and 2006, have been prepared by the Company without audit. In the opinion of management, the unaudited consolidated financial statements include all adjustments (which include only normal recurring adjustments) necessary to present fairly the unaudited consolidated financial position of the Company as of June 30, 2006, the unaudited consolidated results of operations for the three months and six months ended June 30, 2005 and 2006 and the unaudited consolidated statements of cash flows for the six months ended June 30, 2005 and 2006.

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to the rules and regulations of the Securities Exchange Commission, although the Company believes that the disclosures made are adequate to make the information not misleading. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 and Rio Vista’s Annual Report on Form 10-K for the year ended December 31, 2005.

Certain reclassifications have been made to prior period balances to conform to the current presentation. All reclassifications have been consistently applied to the periods presented.

9

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE B -INCOME (LOSS)PER COMMON SHARE

Income (loss) per share of common stock is computed on the weighted average number of shares outstanding. During periods in which the Company incurs losses, giving effect to common stock equivalents is not presented as it would be antidilutive.

The following tables present reconciliations from income (loss) per common share to income (loss) per common share assuming dilution (see note H for the warrants):

	For the three months ended June 30, 2005
	Income (Loss) (Numerator)			Shares (Denominator)		Per-Share Amount
Net income (loss)	$	(2,223,095	)
Basic EPS
Net income (loss) available to common stockholders		(2,223,095	)		15,522,745	$	(0.14	)
Effect of Dilutive Securities
Warrants		-			-
Diluted EPS
Net income (loss) available to common stockholders		N/A			N/A		N/A

	For the three months ended June 30, 2006
	Income (Loss) (Numerator)			Shares (Denominator)		Per-Share Amount
Net income (loss)	$	(353,817	)
Basic EPS
Net income (loss) available to common stockholders		(353,817	)		15,522,745	$	(0.02	)
Effect of Dilutive Securities
Warrants		-			-
Diluted EPS
Net income (loss) available to common stockholders		N/A			N/A		N/A

10

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE B -INCOME (LOSS)PER COMMON SHARE - Continued

	For the six months ended June 30, 2005
	Income (Loss) (Numerator)			Shares (Denominator)		Per-Share Amount
Net income (loss)	$	(2,026,683	)
Basic EPS
Net income (loss) available to common stockholders		(2,026,683	)		15,472,710	$	(0.13	)
Effect of Dilutive Securities
Warrants		-			-
Diluted EPS
Net income (loss) available to common stockholders		N/A			N/A		N/A

	For the six months ended June 30, 2006
	Income (Loss) (Numerator)			Shares (Denominator)		Per-Share Amount
Net income (loss)	$	(636,895	)
Basic EPS
Net income (loss) available to common stockholders		(636,895	)		15,522,745	$	(0.04	)
Effect of Dilutive Securities
Warrants		-			-
Diluted EPS
Net income (loss) available to common stockholders		N/A			N/A		N/A

11

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE C - SHARE-BASED PAYMENT

During the quarter ended March 31, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (SFAS 123R) using the modified prospective application transition method. Under this method, previously reported amounts should not be restated to reflect the provisions of SFAS 123R. SFAS 123R requires measurement of all employee share-based payment awards using a fair-value method and recording of such expense in the consolidated financial statements over the requisite service period. Previously, the Company had applied the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and related interpretations and elected to utilize the disclosure option of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). In the three months and six months ended June 30, 2006, the Company recorded share-based payment expense of $81,733 and $214,192, respectively, under the fair-value provisions of SFAS 123R. The Company utilizes share-based awards as a form of compensation for employees, officers and directors.

Had compensation cost related to the warrants granted to employees been determined based on the fair value at the grant dates, consistent with the provisions of SFAS 123, the Company’s pro forma net income, and net income per common share would have been as follows for the three months and six months ended June 30, 2005:

	Three Months Ended			Six Months Ended
	June 30, 2005			June 30, 2005
Net income (loss), as reported	$	(2,223,095	)	$	(2,026,683	)
Add:  Stock-based employee compensation cost expense included in reported net income (loss), net of related tax effects		-			-
Less:  Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(120,023	)		(160,413	)
Net income (loss), pro forma	$	(2,343,118	)	$	(2,187,096	)
Net income (loss) per common share, as reported	$	(0.14	)	$	(0.13	)
Net income (loss) per common share, pro forma	$	(0.15	)	$	(0.14	)
Net income (loss) per common share assuming dilution, as reported	$	(0.14	)	$	(0.13	)
Net income (loss) per common share assuming dilution, pro forma	$	(0.15	)	$	(0.14	)

12

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE D - PURCHASE AND SALE AGREEMENT

On August 15, 2005, Penn Octane and Rio Vista each entered into separate purchase and sale agreements (PSA’s) with TransMontaigne Product Services Inc. (TransMontaigne) which provided for the sale and assignment of all of their respective LPG assets and refined products assets (LPG Asset Sale) including the Brownsville Terminal Facility, the refined products tank farm and associated leases, owned pipelines located in the United States, including land, leases, and rights of ways, LPG inventory, assignment of the lease of the Leased Pipeline, PMI sales agreement and Exxon Supply Contract (see note K) and100% of the outstanding stock of its Mexican subsidiaries. Rio Vista’s Mexican subsidiaries and consolidated affiliate own pipelines in Mexico and the Matamoros Terminal Facility, including land and rights of way. Penn Octane’s agreement with TransMontaigne did not include any assets related to the Fuel Sales Business. The purchase price was $10,100,000 for assets to be sold by Penn Octane and $17,400,000 for assets to be sold by Rio Vista.

In connection with the PSA’s, TransMontaigne loaned Rio Vista $1,300,000 (TransMontaigne Note) which was to be repaid, including interest, as a reduction of the total purchase price at the time of closing or 120 days following demand by TransMontaigne. The TransMontaigne Note is secured by the tank farm and certain LPG storage tanks located at the Brownsville Terminal Facility (Collateral). The TransMontaigne Note began to accrue interest on November 15, 2005 at the prime rate plus 2%. In connection with the TransMontaigne Note, RZB Finance, LLC (RZB) provided a consent and the Brownsville Navigation District issued an estoppel letter. Rio Vista used the proceeds from the TransMontaigne Note to fund certain expenses associated with the PSA’s and for working capital purposes. If the LPG Asset Sale does not occur and Rio Vista does not pay the TransMontaigne Note in accordance with its terms, Rio Vista is required to convey title to the Collateral to TransMontaigne and to lease the Collateral from TransMontaigne for $10,000 per month until such time as Rio Vista pays the $1,300,000, in addition to the lease payments, to TransMontaigne. In the event of a conveyance of the title to the Collateral, no further interest payments would be required under the TransMontaigne Note. If the $1,300,000 is repaid to TransMontaigne, the lease payments will cease and title to the Collateral will be re-conveyed to Rio Vista.

The closing of the LPG Asset Sale was subject to several conditions, including TransMontaigne’s satisfactory completion of its due diligence review, including financial, business, environmental and legal, assignment of LPG related contracts, and the modification of LPG related permits and the related Mexican governmental approvals. Certain of the conditions to closing were not met by October 31, 2005. The PSA’s provided that any party could terminate the agreements if closing did not occur on or before October 31, 2005. None of the parties elected to terminate the agreements and the parties continued to work towards the closing of the LPG Asset Sale.

On August 11, 2006, Penn Octane and TransMontaigne entered into an amended and restated purchase and sale agreement (Penn Octane Restated PSA) with an effective date of August 15, 2006, which provides for the sale and assignment of all of Penn Octane’s LPG assets, including assignment of the lease of the Leased Pipeline and the Exxon Supply Contract, on terms substantially similar to Penn Octane’s PSA. Penn Octane will retain assets related to its Fuel Sales Business, and its interest in the General Partner. The purchase price for assets to be sold under the Penn Octane Restated PSA is $10,100,000, subject to certain adjustments. The Penn Octane Restated PSA provides for a closing date no sooner than August 22, 2006 and is subject to several conditions, including the concurrent closing of the Rio Vista Restated PSA (see below), the assignment of LPG related contracts, the consent of RZB and the modification satisfactory to TranMontaigne of the temporary injunction issued on June 13, 2006 (see note I). The Penn Octane Restated PSA provides that any party can terminate the agreement if closing does not occur on or before October 1, 2006.

13

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE D - PURCHASE AND SALE AGREEMENT - Continued

Also on August 11, 2006, Rio Vista and TransMontaigne entered into an amended and restated purchase and sale agreement (Rio Vista Restated PSA) with an effective date of August 15, 2006, which provides for the sale and assignment of only the LPG assets, including the Brownsville Terminal Facility, the refined products tank farm and associated leases, and LPG inventory, wherever located, (collectively, the Brownsville Terminal Assets) and assignment of the 2006 PMI Agreement (see note K) (Brownsville Terminal Assets and the 2006 PMI Agreement collectively, the Acquired Assets). Rio Vista will retain its owned pipelines located in the United States, including land, leases and rights of way and 100% of the outstanding stock of its Mexican subsidiaries. Rio Vista’s Mexican subsidiaries and consolidated affiliate own pipelines in Mexico and the Matamoros Terminal Facility, including land and rights of way (collectively, the Retained Assets). The purchase price for the Acquired Assets under the Rio Vista Restated PSA is $8,300,000, subject to certain adjustments. In addition, under the Rio Vista Restated PSA, TransMontaigne has agreed to exclusively use the services and Retained Assets of Rio Vista on a fee basis for purposes of transportation of LPG to be delivered into northeastern Mexico and/or LPG sold pursuant to the 2006 PMI Agreement (LPG Transportation Agreement). Rio Vista has agreed not to transport LPG through Rio Vista’s assets in Mexico except on behalf of TransMontaigne, subject to certain conditions. In addition, under the Rio Vista Restated PSA, TransMontaigne agreed to provide routine and non-routine operation and maintenance services for the U.S. portion only of Rio Vista’s pipelines between Brownsville, Texas and Matamoros, Mexico (U.S. Pipeline Services Agreement). TransMontaigne agreed to provide the routine services at its sole cost and expense. For the non-routine services, Rio Vista agreed to reimburse TransMontaigne for all costs actually incurred in performing the services and all materials and supplies provided in connection with such services, plus 15%. Rio Vista has also granted TransMontaigne certain rights of first refusal and first offer with respect to a sale of the Retained Assets by Rio Vista to any third party. The Rio Vista Restated PSA provides for a closing date no sooner than August 22, 2006 and is subject to several conditions, including the concurrent closing of the Penn Octane Restated PSA, assignment of LPG related contracts, the consent of RZB and the modification satisfactory to TranMontaigne of the temporary injunction issued on June 13, 2006 (see note I). The Rio Vista Restated PSA provides that either party may terminate the agreement if closing does not occur on or before October 1, 2006. The transactions contemplated by the Penn Octane Restated PSA and the Rio Vista Restated PSA are hereafter referred to as the Restated LPG Asset Sale. The Penn Octane Restated PSA and the Rio Vista Restated PSA are hereafter referred to as the Restated PSA’s. Under the Restated LPG Asset Sale, the purchase price will be reduced for certain adjustments and amounts reserved totaling $983,350 of which $851,173 relates to Rio Vista.

Under the terms of the Rio Vista Restated PSA, $300,000 of the TransMontaigne Note will be repaid on the closing of the Rio Vista Restated PSA and the remaining balance of $1,000,000 of the TransMontaigne Note will be restructured to provide for the repayment of principal one year from the closing date of the Rio Vista Restated PSA. Rio Vista will be required to prepay a portion of the TransMontaigne Note in an amount equal to the excess of amounts held in reserve for the payment of certain obligations of Rio Vista over actual amounts required as specified in the Rio Vista Restated PSA. Upon the closing of the Restated LPG Asset Sale, the collateral of the TransMontaigne Note will be changed to consist of the US portion of the eight-inch pipeline owned by Rio Vista. The TransMontaigne Note bears interest at the rate of prime (8.25% as of June 30, 2006) plus 2% annually and interest is payable monthly.

In connection with the Restated LPG Asset Sale, Penn Octane intends to use approximately $1,000,000 of its proceeds to pay off the remaining amounts owed under the Restructured Notes and $280,000 Notes including accrued interest. Penn Octane intends to use the balance of the proceeds from the Restated LPG Asset Sale to fund working capital requirements and to pursue activities intended to enhance stockholder value. Penn Octane estimates that it may have a federal tax liability of approximately $1,500,000 in connection with the Restated LPG Asset Sale after utilization of available net operating loss carryforward as of December 31, 2005.

14

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE D - PURCHASE AND SALE AGREEMENT - Continued

Rio Vista intends to use any remaining proceeds to fund working capital requirements and to pursue activities intended to enhance unitholder value.

The following unaudited pro forma consolidated financial information (Pro Forma Statements) for the Company gives effect to the Restated PSA’s. The unaudited pro forma consolidated balance sheet assumes that the Restated PSA’s was consummated on June 30, 2006. The unaudited pro forma consolidated statement of operations for the six months ended June 30, 2006 assumes that the Restated PSA’s was consummated as of January 1, 2006.

The Pro Forma Statements are based on the available information and contain certain assumptions that the Company deems appropriate. The Pro Forma Statements do not purport to be indicative of the financial position of the Company had the transaction referred to above occurred on the dates indicated, nor are the Pro Forma Statements necessarily indicative of the future financial position of the Company. The Pro Forma Statements should be read in conjunction with the unaudited consolidated financial statements and notes thereto included herein.

15

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE D - PURCHASE AND SALE AGREEMENT - Continued

Penn Octane Corporation and Subsidiaries

PRO FORMA CONSOLIDATED BALANCE SHEETAT JUNE 30, 2006

(Unaudited)

	As Reported June 30, 2006			Pro Forma Adjustments					Pro Form June 30, 2006
ASSETS
Current Assets
Cash	$	118,982		$	18,400,000		(1	)	$	16,225,944
					(983,350	)	(1	)
					(1,009,688	)	(3	)
					(300,000	)	(3	)
Restricted cash		4,093,513								4,093,513
Trade accounts receivable, net		9,860,408								9,860,408
Inventories		3,594,060			(1,278,678	)	(1	)		2,315,382
Prepaid expenses and other current assets		189,528								189,528
Total current assets		17,856,491			14,828,284					32,684,775
Property, plant and equipment — net		14,332,711			(3,306,577	)	(1	)		11,026,134
Lease rights — net		312,935			(312,935	)	(1	)		-
Other non-current assets		29,575								29,575
Total assets	$	32,531,712		$	11,208,772				$	43,740,484
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Current maturities of long-term debt	$	2,405,425		$	(940,000	)	(3	)	$	165,425
					(1,000,000	)	(8	)
					(300,000	)	(3	)
Revolving line of credit		4,748,087								4,748,087
LPG and Fuel Products trade accounts payable		10,046,769								10,046,769
U.S. and foreign taxes payable		35,385			1,500,000		(5	)		1,535,385
Other accounts payable		2,190,506								2,190,506
Accrued liabilities		1,863,189			(69,688	)	(3	)		1,843,501
					50,000		(4	)
Total current liabilities		21,289,361			(759,688	)				20,529,673
Long-term debt, less current maturities		7,791			1,000,000		(8	)		1,007,791
Minority interest in Rio Vista Energy Partners L.P.		11,313,151			5,040,430		(6	)		16,353,581
Stockholders’ Equity
Common stock		155,227								155,227
Additional paid in capital		28,947,526								28,947,526
Notes receivable from a former officer of the Company		(1,696,693	)		252,453		(7	)		(1,444,240	)
Accumulated deficit		(27,484,651	)		12,518,460		(1	)		(21,809,074	)
					(1,500,000	)	(5	)
					(5,040,430	)	(6	)
					(252,453	)	(7	)
					(50,000	)	(4	)
Total stockholders’ equity (deficit)		(78,591	)		5,928,030					5,849,439
Total liabilities and stockholders’ equity (deficit)	$	32,531,712		$	11,208,772				$	43,740,484

16

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE D - PURCHASE AND SALE AGREEMENT - Continued

Penn Octane Corporation and Subsidiaries

PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)

	As Reported June 30, 2006			Pro Forma Adjustments					Pro Forma June 30, 2006
Revenues	$	136,271,690		$	(69,410,275	)	(2	)	$	66,861,415
Cost of Goods Sold		134,054,187			(68,778,758	)	(2	)		65,275,429
Gross Profit		2,217,503			(631,517	)				1,585,986
Selling, general and administrative expenses
Legal and professional fees		853,284			(50,976	)	(2	)		802,308
Salaries and payroll related expenses		917,254								917,254
Other		998,498								998,498
		2,769,036			(50,976	)				2,718,060
Operating income (loss)		(551,533	)		(580,541	)				(1,132,074	)
Other income (expense)
Interest and LPG and Fuel Products financing expense		(751,505	)		510,950		(2	)		(240,555	)
Interest income		22,985			(1,369	)	(2	)		21,616
Gain on LPG Asset Sale					12,879,605		(1	)		11,562,331
					(333,924	)	(7	)
					(983,350	)	(1	)
Minority interest in earnings or loss of  Rio Vista Energy Partners L.P.		671,746			(4,921,225	)	(6	)		(4,249,479	)
Income (loss) before taxes		(608,307	)		6,570,146					5,961,839
Provision for income taxes		28,588			1,500,000		(5	)		1,528,588
Net income (loss)	$	(636,895	)	$	5,070,146				$	4,433,251
Net income (loss) per common share	$	(0.04	)						$	0.29
Net income (loss) per common share assuming dilution	$	(0.04	)						$	0.29
Weighted average common shares outstanding		15,522,745								15,522,745

17

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE D - PURCHASE AND SALE AGREEMENT - Continued

Penn Octane Corporation and Subsidiaries

Notes to Pro Forma Unaudited Consolidated Financial Information

June 30, 2006

(Unaudited)

(1)	To reflect the Restated PSA’s, including net proceeds received and the resulting gain. This amount assumes reductions to the purchase price for certain adjustments and reserves of $983,350.
(2)	To eliminate revenues and expenses related to the LPG operations.
(3)	To reflect the payment of outstanding promissory notes including accrued interest which are collateralized by the LPG assets and refined products assets sold and payment of a portion of principal and all accrued interest on the TransMontaigne Note.
(4)	To accrue for estimated expenses associated with the Restated PSA’s.
(5)	To accrue for federal and state taxes estimated to result from the Restated PSA’s.
(6)	To record minority interest in the equity in the earnings of Rio Vista in connection with the Restated PSA’s.
(7)	To accrue fee due to Jerome B. Richter in connection with the Restated PSA’s and offset gainst receivables from Mr. Richter (see note J).
(8)	To reclass the TransMontaigne Note to long-term debt in connection with the Restated PSA’s.

18

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE E - PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consist of the following:

	December 31,			June 30,
	2005			2006
LPG:
Midline pump station (b)	$	2,326,985		$	2,326,985
Brownsville Terminal Facility: (a)
Building		173,500			173,500
Terminal facilities		3,631,207			3,631,207
Tank Farm		373,945			373,945
Leasehold improvements		318,807			318,807
Equipment		226,285			226,285
Truck		25,968			25,968
		7,076,697			7,076,697
US - Mexico Pipelines and Matamoros Terminal Facility: (a)(c)
U.S. Pipelines and Rights of Way		6,914,770			6,919,046
Mexico Pipelines and Rights of Way		993,300			1,038,300
Matamoros Terminal Facility		5,874,781			5,646,822
Land		705,358			705,358
		14,488,209			14,309,526
Total LPG		21,564,906			21,386,223
Other:
Office equipment (b)		108,487			114,926
Software (b)		57,163			57,163
		165,650			172,089
		21,730,556			21,558,312
Less: accumulated depreciation and amortization		(6,747,309	)		(7,225,601	)
	$	14,983,247		$	14,332,711

(a) Rio Vista assets

(b) Penn Octane and Subsidiaries other than Rio Vista

(c) Rio Vista owns, leases, or is in the process of obtaining the land or rights of way used related to the US-Mexico Pipelines

Property, plant and equipment, net of accumulated depreciation, includes $5,327,098 and $4,962,874 of costs located in Mexico at December 31, 2005 and June 30, 2006, respectively.

19

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE F - INVENTORIES

Inventories are valued at the lower of FIFO cost or market (LCM) and consist of the following:

	December 31, 2005				June 30, 2006
	Gallons		LCM		Gallons		LCM
LPG:
Leased Pipeline		1,175,958	$	1,266,040		1,175,958	$	1,277,622
Brownsville Terminal Facility and Matamoros Terminal Facility		349,564		376,342		240,007		260,756
Markham Storage and other		33,535		36,104		-		-
		1,559,057		1,678,486		1,415,965		1,538,378
Fuel Products		687,115		1,199,782		917,513		2,055,682
			$	2,878,268			$	3,594,060

NOTE G - DEBT OBLIGATIONS

Debt obligations are as follows:

	December 31, 2005		June 30, 2006
Noninterest-bearing note payable, discounted at 7%, for legal services; due in February 2001	$	137,500	$	137,500
Restructured Notes and $280,000 Notes		1,550,000		940,000
TransMontaigne Note (see note D)		1,300,000		1,300,000
Other debt		37,941		35,716
Total debt		3,025,441		2,413,216
Less:Current maturities		3,015,054		2,405,425
Long-term debt	$	10,387	$	7,791

At June 30, 2006, the Restructured Notes and the $280,000 Notes (collectively the Notes) have a face value of $940,000, bear interest at an annual rate of 16.5%, and were due December 15, 2005. The Notes are collateralized by substantially all of the Company’s tangible assets, excluding inventories, accounts receivable and sales contracts with respect to which the Company has granted a subordinated security interest. Mr. Jerome B. Richter, former chairman of the board and chief executive officer of the Company, has also pledged 2,000,000 shares of common stock of Penn Octane owned by Mr. Richter including 1,000,000 shares of common stock collateralizing Mr. Richter’s promissory note to the Company. As a result of the Spin-Off, Mr. Richter was also required to provide 250,000 Common Units of Rio Vista owned by him.

On September 30, 2005, the Company and holders of the Notes agreed to an amendment whereby the interest payments required to be paid on June 15, 2005 and September 15, 2005 were extended to December 15, 2005 (Deferred Interest). Under the terms of the amendment, the Company agreed to pay additional interest at an annual rate of 16.5% on the Deferred Interest from the original due date through the date the Deferred Interest is paid. In addition, the Company agreed to pay to the holders of the Notes, an additional amount equal to 5% of the principal amount outstanding of the Notes upon maturity. Mr. Richter agreed that he would deliver 250,000 Common Units of Rio Vista (referred to above) to the collateral agent. The Company also agreed that it would not enter into any additional severance payment obligation in connection with the resignation of Mr. Richter until the Notes are fully paid. In addition, the holders of the Notes agreed to allow Rio Vista to pledge and deliver certain assets in connection with the TransMontaigne Note (see note D). The 250,000 Common Units of Rio Vista referenced above have not yet been delivered.

20

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE G - DEBT OBLIGATIONS - Continued

The Company did not pay the entire balance of principal and interest due under the Notes on December 15, 2005. On December 15, 2005 and January 1, 2006, the Company paid $426,143 and $159,171 to the holders of the Notes of which $267,750 represented payment of principal and related penalties to certain holders of the Notes and $317,564 represented total accrued and unpaid interest on the Notes through December 15, 2005.

During February 2006, the Company repaid $500,021 to certain holders of the Notes representing $488,250 of principal and related penalties and $11,771 of accrued interest.

During March 2006, the Company agreed to extend from December 31, 2006 to December 31, 2008 the expiration date on the Rio Vista warrants corresponding to the Notes then outstanding. The warrants were initially issued in connection with the December 15, 2003 amendment of the Notes. In connection with the extension of the warrants, the Company recorded additional interest expense of approximately $22,000. The Notes have not been renewed or extended since December 15, 2005.

During May 2006, the Company paid $61,418 to the holders of the Notes representing accrued interest and fees through March 15, 2006.

During June 2006, the Company paid $212,474 to the holders of the Notes representing $145,000 of principal and $67,474 of accrued interest and fees through June 15, 2006.

NOTE H - STOCKHOLDERS’ EQUITY

Penn Octane 2001 Warrant Plan

On March 9, 2005, the board of directors of Penn Octane approved the grant of warrants to purchase a total of 1,005,000 shares of Penn Octane common stock under Penn Octane’s 2001 Warrant Plan previously approved by the Penn Octane stockholders. Of the total number of warrants granted, 625,000 were granted to executive officers of Penn Octane, 255,000 were issued to outside directors of Penn Octane and 125,000 were issued to a consultant. The exercise price for the warrants is $1.50 per share, which was the closing price for Penn Octane’s common stock as reported by the NASDAQ Stock Market on March 9, 2005. Warrants granted to executive officers vest in equal monthly installments over a period of 36 months from the date of grant. Warrants granted to outside directors vest in equal monthly installments over a period of 12 months from the date of grant. All warrants become fully exercisable upon a change in control event and expire five years from the date of grant.

Note Receivable from a Former Officer of the Company

The note receivable from Mr. Richter, in the amount of $3,196,693, was due July 29, 2005. On August 3, 2005 in connection with Mr. Richter’s retirement in May 2005 and in consideration of his past services, the Company approved an extension of the note to July 29, 2007 and a discount of the note to $1,696,693 plus accrued interest not waived (see below) on its maturity date, subject to satisfaction of certain conditions. The Company considers it to be probable that the note will be discounted at maturity and accordingly, has recorded a charge to compensation expense as of June 30, 2005 in the amount of $1,031,307 with a corresponding credit to the reserve. The interest rate on the extended note is 6.75%. The Company will waive interest provided that Mr. Richter guarantees debt of the Company to any person in an amount equal to at least $1,800,000 (see Note G). Beginning December 15, 2005, the Company reduced the amount of guaranteed debt below $1,800,000. Accordingly, the Company began accruing interest and reserving the interest on Mr. Richter’s note.

21

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE I - OPTIONS AND WARRANTS OF RIO VISTA

General Partner Options

On July 1, 2006, Penn Octane’s 100% interest in the General Partner was decreased to 50% as a result of the exercise by Shore Capital LLC (Shore Capital), an affiliate of Mr. Richard Shore, Jr., former president of the Company, and by Mr. Richter, of options to each acquire 25% of the General Partner (General Partner Options). The exercise price for each option was approximately $82,000. Mr. Richter’s option was amended to permit payment of the exercise price by surrender of Penn Octane common stock having a fair market value equal to the exercise price. Mr. Richter paid the exercise price for his options by surrender of 136,558 shares of Penn Octane common stock. In connection with the exercise of the General Partner Options, Penn Octane retained voting control of the General Partner pursuant to a voting agreement with each of Shore Capital and Mr. Richter.

Common Unit Warrants

On March 9, 2005, the board of managers of the General Partner of Rio Vista approved the Rio Vista 2005 Equity Incentive Plan (2005 Plan). The 2005 Plan permits the grant of common unit options, common unit appreciation rights, restricted common units and phantom common units to any person who is an employee (including to any executive officer) or consultant of Rio Vista or the General Partner or any affiliate of Rio Vista or the General Partner. The 2005 Plan provides that each outside manager of the General Partner shall be granted a common unit option once each fiscal year for not more than 5,000 common units, in an equal amount as determined by the board of managers. The aggregate number of common units authorized for issuance as awards under the 2005 Plan is 750,000. The 2005 Plan shall remain available for the grant of awards until March 9, 2015 or such earlier date as the board of managers may determine. The 2005 Plan is administered by the compensation committee of the board of managers. Under the terms of the Agreement and applicable rules of the NASDAQ Stock Market, no approval of the 2005 Plan by the common unitholders of Rio Vista was required.

On March 9, 2005, the board of managers of the General Partner of Rio Vista approved the grant of options to purchase a total of 108,750 common units under the 2005 Plan. Of the total number of options granted, 93,750 were granted to certain executive officers of the General Partner and to Mr. Richter and 15,000 were issued to outside managers of the General Partner. The exercise price for the options is $12.51 per common unit, which was the average of the high and low sales prices for Rio Vista common units as reported by the NASDAQ Stock Market on March 9, 2005. The options granted to executive officers (including Mr. Richter) were fully vested on the date of grant. The options granted to outside managers vested in equal monthly installments over a period of 12 months from the date of grant. All options become fully exercisable upon a change in control event and expire three years from the date of grant. The board of managers has not yet determined if Rio Vista will grant any common unit options for the fiscal year 2006.

22

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE J - COMMITMENTS AND CONTINGENCIES

Credit Facility, Letters of Credit and Other

As of June 30, 2006, Penn Octane had a $20,000,000 credit facility with RZB Finance, LLC (RZB) for demand loans and standby letters of credit (RZB Credit Facility) to finance Penn Octane’s purchases of LPG and Fuel Products. The RZB Credit Facility includes a $3,000,000 limit for purchase of Fuel Products inventory for a maximum of 30 days. The RZB Credit facility is an uncommitted facility under which the letters of credit have an expiration date of no more than 90 days and the facility is reviewed annually at March 31. The March 31, 2006 review was deferred on a month to month basis while the Company continued to pursue the LPG Asset Sale. In connection with the RZB Credit Facility, the Company granted RZB a security interest and assignment in any and all of the Company’s accounts, inventory, real property, buildings, pipelines, fixtures and interests therein or relating thereto, including, without limitation, the lease with the Brownsville Navigation District of Cameron County for the land on which the Company’s Brownsville Terminal Facility is located, the Pipeline Lease, and in connection therewith entered into leasehold deeds of trust, security agreements, financing statements and assignments of rent. Under the RZB Credit Facility, the Company may not permit to exist any subsequent lien, security interest, mortgage, charge or other encumbrance of any nature on any of its properties or assets, except in favor of RZB, without the consent of RZB. After the Spin-Off and transfer of assets to Rio Vista, RZB continued to retain a security interest in the transferred assets.

Under the RZB Credit Facility, the Company pays a fee with respect to each letter of credit thereunder in an amount equal to the greater of (i) $500, (ii) 2.5% of the maximum face amount of such letter of credit for LPG and 2% for Fuel Products, or (iii) such higher amount as may be agreed to between the Company and RZB. Any loan amounts outstanding under the RZB Credit Facility accrue interest at a rate equal to the rate announced by the JPMorgan Chase Bank as its prime rate (8.25% at June 30, 2006) plus 2.5%. Pursuant to the RZB Credit Facility, RZB has sole and absolute discretion to limit or terminate its participation in the RZB Credit Facility and to refrain from making any loans or issuing any letters of credit thereunder. RZB also has the right to demand payment of any and all amounts outstanding under the RZB Credit Facility at any time. In addition to the fees described above, the Company is required to pay RZB annual fees of $50,000.

Based on current minimum purchase commitments under the Company’s LPG supply agreement and current LPG prices, the amount available to finance Fuel Products and LPG purchases in excess of current minimum purchase commitments is limited and therefore the ability of the Company to grow the Fuel Sales Business is dependent on future increases in its RZB Credit Facility or other sources of financing, the reduction of LPG supply commitments and/or the reduction in LPG or Fuel Products purchase prices.

Under the terms of the RZB Credit Facility, either Penn Octane or Rio Vista is required to maintain net worth of a minimum of $10,000,000.

In connection with the Company’s purchases of LPG and Fuel Products, letters of credit are issued based on anticipated purchases. Outstanding letters of credit for purchases of LPG and Fuel Products at June 30, 2006 totaled approximately $13,817,000 of which approximately $9,999,000 represents June 2006 purchases and approximately $3,818,000 represents July 2006 purchases.

In connection with the Company’s purchase of LPG and Fuel Products, under the RZB Credit Facility, assets related to product sales (Assets) are required to be in excess of borrowings and commitments (including restricted cash of approximately $3,593,000 at June 30, 2006). At June 30, 2006, the Company’s borrowings and commitments were less than the amount of the Assets.

23

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE J - COMMITMENTS AND CONTINGENCIES - Continued

Credit Facility, Letters of Credit and Other - Continued

In connection with the Company’s Fuel Sales Business, the Company has issued bonds totaling $662,000 to the states of California, Nevada, Arizona and Texas (Bonds) to secure payments of excise and other taxes collected from customers in connection with sales of Fuel Products. The Bonds are partially secured by letters of credit totaling $452,600. At June 30, 2006, such taxes in the amount of approximately $785,000 were due. The letters of credit issued have all been secured by cash in the amount of approximately $474,000 which is included in restricted cash in the Company’s balance sheet at June 30, 2006.

LPG and Fuel Products financing expense associated with the RZB Credit Facility totaled $166,615 and $285,808 for the three months ended June 30, 2005 and 2006, respectively, and $369,925 and $525,576 for the six months ended June 30, 2005 and 2006, respectively.

Amended Leased Pipeline Lease Agreement

On July 21, 2006, the Company and Seadrift entered into an amended and restated lease agreement (Amended Lease) for the Leased Pipeline. The Amended Lease is effective August 1, 2006 and expires on December 31, 2013. Pursuant to the terms of the Amended Lease, the Company will have the exclusive right to transport materials through the Leased Pipeline, and Seadrift will no longer have certain rights to utilize the pipeline for its own purposes as provided in the original lease agreement. In addition, the Company will no longer be required to make minimum payments for propane storage in Markham, Texas and will no longer have access to such storage. The Company will also no longer have access to the Ella-Seadrift pipeline (running approximately 155 miles between Markham and the King Ranch Gas Plant) or to access other propane suppliers via such pipeline. The Company has agreed to indemnify Seadrift for environmental liabilities, including claims relating to the condition of the leased property and any environmental remediation costs, arising after the inception date of the lease, September 1, 1993. Seadrift has agreed to indemnify the Company for similar environmental liabilities arising before that date. The Company’s lease payments, which previously consisted of fixed amounts plus certain variable charges and periodic increases, will now consist of a fixed annual amount of $1,600,000 (total lease expenses for the year ended December 31, 2005 were approximately $1,400,000). The Company may assign the Amended Lease to a third party with Seadrift’s written consent, which consent may not be unreasonably withheld.

Distributions of Available Cash

All Rio Vista unitholders have the right to receive distributions from Rio Vista of “available cash” as defined in the Rio Vista partnership agreement in an amount equal to at least the minimum distribution of $0.25 per quarter per unit, plus any arrearages in the payment of the minimum quarterly distribution on the units from prior quarters subject to any reserves determined by the General Partner. The General Partner has a right to receive a distribution corresponding to its 2% general partnership interest and the incentive distribution rights described below. The distributions are to be paid 45 days after the end of each calendar quarter. However, Rio Vista is prohibited from making any distributions to unitholders if it would cause an event of default, or an event of default exists, underany obligation of Penn Octane which Rio Vista has guaranteed.

In addition to its 2% general partner interest, the General Partner is currently the holder of incentive distribution rights which entitle the holder to an increasing portion of cash distributions as described in the partnership agreement. As a result, cash distributions from Rio Vista are shared by the holders of Rio Vista common units and the General Partner interest based on a formula whereby the General Partner receives disproportionately more distributions per percentage interest than the holders of the common units as annual cash distributions exceed certain milestones.

24

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE J - COMMITMENTS AND CONTINGENCIES - Continued

Distributions of Available Cash - Continued

On both February 14, 2005 and May 13, 2005, Rio Vista made cash distributions of $487,000 for the quarters ended December 31, 2004 and March 31, 2005. Because of insufficient available cash, Rio Vista has not declared any other distributions since May 2005. As a result of the exercise of the General Partner Options, Penn Octane will only be entitled to receive up to 50% of any distributions paid in the future by Rio Vista distributed by the General Partner, including any distributions associated with arrearages prior to the exercise of the General Partner Options.

Partnership Tax Treatment

Rio Vista is not a taxable entity for U.S. tax purposes (see below) and incurs no U.S. federal income tax liability. Rio Vista’s Mexican subsidiaries are taxed on their income directly by the Mexican government. The income/loss of Rio Vista’s Mexican subsidiaries is included in the U.S. partnership income tax return of Rio Vista. The holders of the common units and General Partner interest will be entitled to their proportionate share of any tax credits resulting from any income taxes paid to the Mexican government. Each unitholder of Rio Vista is required to take into account that unitholder’s share of items of income, gain, loss and deduction of Rio Vista in computing that unitholder’s federal income tax liability, even if no cash distributions are made to the unitholder by Rio Vista. Distributions by Rio Vista to a unitholder are generally not taxable unless the amount of cash distributed is in excess of the unitholder’s adjusted tax basis in Rio Vista.

Section 7704 of the Internal Revenue Code (Code) provides that publicly traded partnerships, as a general rule, are taxed as corporations despite the fact that they are not classified as corporations under Section 7701 of the Code. Section 7704 of the Code provides an exception to this general rule for a publicly traded partnership if 90% or more of its gross income for every taxable year consists of “qualifying income” (Qualifying Income Exception). For purposes of this exception, “qualifying income” includes income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines) or marketing of any mineral or natural resource. Other types of “qualifying income” include interest (other than from a financial business or interest based on profits of the borrower), dividends, real property rents, gains from the sale of real property, including real property held by one considered to be a “dealer” in such property, and gains from the sale or other disposition of capital assets held for the production of income that otherwise constitutes “qualifying income”.

No ruling has been or will be sought from the IRS and the IRS has made no determination as to Rio Vista’s classification as a partnership for federal income tax purposes or whether Rio Vista’s operations generate a minimum of 90% of “qualifying income” under Section 7704 of the Code.

If Rio Vista were classified as a corporation in any taxable year, either as a result of a failure to meet the Qualifying Income Exception or otherwise, Rio Vista’s items of income, gain, loss and deduction would be reflected only on Rio Vista’s tax return rather than being passed through to Rio Vista’s unitholders, and Rio Vista’s net income would be taxed at corporate rates.

If Rio Vista were treated as a corporation for federal income tax purposes, Rio Vista would pay tax on income at corporate rates, which is currently a maximum of 35%. Distributions to unitholders would generally be taxed again as corporate distributions, and no income, gains, losses, or deductions would flow through to the unitholders. Because a tax would be imposed upon Rio Vista as a corporation, the cash available for distribution to unitholders would be substantially reduced and Rio Vista’s ability to make minimum quarterly distributions would be impaired. Consequently, treatment of Rio Vista as a corporation would result in a material reduction in the anticipated cash flow and after-tax return to unitholders and therefore would likely result in a substantial reduction in the value of Rio Vista’s common units.

25

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE J - COMMITMENTS AND CONTINGENCIES - Continued

Partnership Tax Treatment - Continued

Current law may change so as to cause Rio Vista to be taxable as a corporation for federal income tax purposes or otherwise subject Rio Vista to entity-level taxation. The Agreement provides that, if a law is enacted or existing law is modified or interpreted in a manner that subject Rio Vista to taxation as a corporation or otherwise subjects Rio Vista to entity-level taxation for federal, state or local income tax purposes, then the minimum quarterly distribution amount and the target distribution amount will be adjusted downward to reflect the impact of that law on Rio Vista.

Litigation

Penn Octane, Rio Vista and/or Rio Vista’s subsidiaries have been named as defendants in two lawsuits filed in connection with an accident in the town of Lucio Blanco, Mexico on August 11, 2005, involving a tanker truck carrying LPG which was struck by a train resulting in an explosion. Neither of Penn Octane, Rio Vista nor any of Rio Vista’s subsidiaries owned or operated the tanker truck or employed or controlled the driver of the tanker truck. Further, neither of the Penn Octane, Rio Vista nor any of Rio Vista’s subsidiaries owned or had custody of the LPG on the tanker truck at the time and location of the accident.

The tanker truck reportedly took delivery of LPG at the Matamoros Terminal Facility operated under agreement with Rio Vista’s Mexican subsidiaries. According to the lawsuits, after leaving the Matamoros Terminal Facility, the tanker truck was involved in a collision with a train in Lucio Blanco, Mexico, resulting in a tragic explosion that killed and injured several persons and caused significant property damage. Published reports indicate that the truck used a road not approved for large trucks and failed to stop at an unprotected rail crossing, resulting in the collision and explosion. The operator of the tanker truck, or its insurance company, is reportedly taking claims in Mexico from victims of the accident.

Even though the accident took place in Mexico, both lawsuits were filed in Texas. The first case is captioned Lesly Camacho by Her Mother Dora Adame as Next Friend, et al. vs. Penn Octane International LLC and was filed in the 404^th District Court for Cameron County, Texas on September 26, 2005. The plaintiffs seek unspecified monetary damages and a temporary injunction in order to preserve evidence relevant to the case. An ex parte temporary restraining order was sought and obtained by the plaintiffs on September 27, 2005, in order to preserve evidence and prevent any sale of assets, including Penn Octane’s and Rio Vista’s LPG Asset Sales. This order was issued without prior notice to, or opportunity to contest by, Penn Octane or Rio Vista. The temporary restraining order expired in accordance with its terms on October 19, 2005. On November 29, 2005, the parties entered into an agreement on the record wherein a subsidiary of Rio Vista assumed the obligation of preserving and delivering relevant evidence, and the plaintiffs dropped their request for a temporary injunction against a sale of assets. On June 13, 2006, the plaintiffs requested, and the court granted, an order for a temporary injunction requiring a subsidiary of Rio Vista to make available for inspection by plaintiffs Rio Vista’s terminal facilities in Brownsville, Texas and Matamoros, Mexico and associated equipment and records. The order also requires Rio Vista to give 30 days advance notice to plaintiffs before conducting any alteration, repair, service, work or changes to the facilities or equipment. In addition, the order requires Rio Vista to make available its employees for deposition by the plaintiffs and to secure and preserve certain physical evidence believed to be located in Mexico. The temporary injunction was issued without prior notice to, or opportunity to contest by, Penn Octane or Rio Vista. The terms of the temporary injunction are broader than the order as agreed by the parties on November 29, 2005. Accordingly, Rio Vista has filed a motion to set aside the temporary injunction and to enter a more limited order consistent with the November 29, 2005 agreement between the parties. A hearing on Rio Vista’s motion has been scheduled for August 24, 2006. Limited discovery has been conducted to date.

26

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE J - COMMITMENTS AND CONTINGENCIES - Continued

Litigation - Continued

The second case is captioned Faustino Izaguirre Gonzalez, et al. vs. Penn Octane Corporation, et al. and was filed in the 107^th District Court for Cameron County, Texas, on November 14, 2005. The plaintiffs seek unspecified monetary damages. On December 28, 2005, Penn Octane, Rio Vista and Rio Vista’s subsidiaries filed a motion for removal of the case in the U.S. District Court for the Southern District of Texas, Brownsville Division. On February 15, 2006, the U.S. District Court denied a motion by the plaintiffs to remand the case to state court and dismissed the case as to defendants other than Penn Octane Corporation. The court found that the plaintiffs failed to provide factual allegations sufficient to establish a possibility of recovery against Rio Vista or its subsidiaries. The plaintiffs filed a motion for reconsideration in which they added a new allegation that Rio Vista and its subsidiaries failed to properly odorize the LPG before the accident. Because of the new allegation by the plaintiffs, the U.S. District Court on May 2, 2006 reinstated Rio Vista and its subsidiaries as defendants and remanded the case to the Cameron County, Texas state court. In its remand order, the U.S. District Court noted that it had not found that the conduct of Rio Vista and its subsidiaries caused the injuries of the plaintiffs, but only that plaintiffs had made sufficient allegations to reinstate the Rio Vista defendants and return the case to state court. Penn Octane and Rio Vista believe that there is no factual basis to support the new allegation by the plaintiffs.

Management believes the above lawsuits against Penn Octane, Rio Vista and/or Rio Vista’s subsidiaries are without merit and, based on the advice of counsel, does not anticipate either liability for damages or the issuance of a temporary injunction against a sale of Penn Octane’s or Rio Vista’s assets. The Company’s insurance carrier is expected to bear the legal fees and expenses in connection with defending these cases. If, however, a court found liability on the part of Penn Octane, Rio Vista or their subsidiaries, a judgment or settlement in excess of insurance coverage could have a material adverse effect on Penn Octane’s and Rio Vista’s business, financial condition and results of operations. If a court enjoined the sale of all or any portion of Penn Octane’s or Rio Vista’s assets to a third party, such an injunction could delay or prevent Penn Octane’s or Rio Vista’s LPG Asset Sale before resolution of the claims underlying the lawsuit. A lengthy delay of, or inability to close, the LPG Asset Sale could have a material adverse effect on Penn Octane’s and Rio Vista’s business, financial condition and results of operations.

On December 14, 2004, a subsidiary of Rio Vista brought a condemnation action against a landowner in order to obtain a right-of-way in connection with Rio Vista’s existing pipelines that run between Brownsville, Texas and Matamoros, Mexico. The case is captioned Rio Vista Operating Partnership L.P. vs. Guajardo, Jr. Farms, Inc., and was filed in the County Court No. 3 of Cameron County, Texas. In October, 2005, special commissioners appointed by the court awarded $100,000 to the landowner in connection with the condemnation action. Pursuant to the award, Rio Vista deposited $100,000 into the Registry of the Court on November 17, 2006. The Company is currently challenging this award in the trial court. Subsequently, the landowner filed an inverse condemnation counterclaim against Rio Vista and Penn Octane seeking damages of $1,800,000. The Company moved for summary judgment against the landowner on its counterclaim. In response to the Company’s motion, the Court granted partial summary judgment in favor of the Company, holding that there are no compensable damages arising from an inverse condemnation. The landowner has subsequently amended his counterclaim seeking damages of $273,000 as rent. The parties are currently conducting discovery and a trial date is set for January 8, 2007.

The Company and its subsidiaries are involved with other proceedings, lawsuits and claims. The Company believes that the liabilities, if any, ultimately resulting from such proceedings, lawsuits and claims should not materially affect its consolidated financial results.

27

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE J - COMMITMENTS AND CONTINGENCIES - Continued

Consulting Agreement

During November 2005, Penn Octane, Rio Vista and Mr. Richter entered into a consulting agreement whereby Mr. Richter shall serve as a special advisor to the board of directors of Penn Octane and the board of managers of Rio Vista and will provide the following services (Services) to both Penn Octane and Rio Vista: assistance with the sale of all or part of their LPG assets, assistance with other transactions (including restructurings) involving the companies as mutually agreed by the parties and such other services that the companies may reasonably request.

In consideration of the Services rendered by Mr. Richter to the companies, Penn Octane and Rio Vista agreed to pay the following fees (Fees) to Mr. Richter: an amount equal to two percent (2%) of (i) the net proceeds, as defined, to the companies resulting from a sale of assets to a third party, and (ii) the net proceeds, as defined, to the companies from sales of LPG to PMI for any calendar month in which such sales exceed the volumes pursuant to the 2005 PMI Agreement (see Note K). Amounts expensed pursuant to (ii) above for the six months ended June 30, 2006 totaled approximately $5,000.

The companies may, in their discretion, offset the amount of any Fees due and payable to Mr. Richter against any amounts owed (whether or not then due or payable) by Mr. Richter to the Company, including without limitation, any amounts owed by Mr. Richter to Penn Octane pursuant to his promissory note payable to Penn Octane.

The term of Mr. Richter’s consulting agreement shall continue until the earlier of November 26, 2006 or termination of the agreement upon 30 days written notice to the other party.

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to credit risk include cash balances at banks which at times exceed the federal deposit insurance limit.

NOTE K - CONTRACTS

LPG Sales to PMI

PMI and the Company operated under a three month contract for the period from January 1, 2005 to March 31, 2005 and monthly contracts for April 2005 and May 2005. Effective June 4, 2005, the Company entered into an agreement with PMI for the period June 4, 2005 through March 31, 2006 for the sale of LPG to PMI (2005 PMI Agreement).

On March 31, 2006, the 2005 PMI Agreement expired. During the month of April 2006, the Company sold LPG to PMI under a monthly contract which provided for volumes of approximately 6,000,000 gallons at prices similar to the 2005 PMI Agreement. During April 2006, PMI purchased approximately 6,000,000 gallons.

On April 28, 2006, the Company received electronic confirmation (PMI Confirmation) from PMI of the terms of a new purchase and sale agreement for LPG for the period May 1, 2006 through March 31, 2007 (Term). The PMI Confirmation was subject to execution of a definitive written agreement between Rio Vista and PMI. The agreement (2006 PMI Agreement) was executed during July 2006 with the terms specified in the PMI Confirmation. The 2006 PMI Agreement provides that PMI does not have a financial obligation with respect to any short falls if volumes actually purchased are less than minimum volumes contained in the 2006 PMI Agreement.

28

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE K - CONTRACTS - Continued

LPG Sales to PMI - Continued

The minimum volumes and applicable margins contained in the 2006 PMI Agreement are expected to provide the Company with gross profit similar to the gross profit the Company would have received if PMI had purchased only the minimum volumes provided under its agreements with Rio Vista during the period from May 1, 2005 to March 31, 2006 as a result of increased margins on lower volume levels contained in the 2006 PMI Agreement.

The following table sets forth the minimum monthly volume of LPG that PMI committed to purchase from the Company pursuant to the 2005 PMI Agreement, the April 2006 monthly contract and the 2006 PMI Agreement and the actual volumes purchased for the months January 2006 through July 2006.

Month	Minimum Contract Volumes	Actual Volumes Sold
	(gallons)	(gallons)
January 2006	11,700,000	14,757,646
February 2006	11,700,000	11,940,257
March 2006	8,100,000	11,606,435
April 2006	6,000,000	6,035,733
May 2006	4,500,000	5,733,193
June 2006	4,500,000	7,130,666
July 2006	4,500,000	4,937,441
August 2006	4,500,000	*
September 2006	4,500,000	*
October 2006	8,100,000	*
November 2006	8,100,000	*
December 2006	9,000,000	*
January 2007	9,000,000	*
February 2007	8,100,000	*
March 2007	8,100,000	*
* Not yet available

PMI has primarily used the Matamoros Terminal Facility to load LPG purchased from the Company for distribution by truck in Mexico. The Company continues to use the Brownsville Terminal Facility in connection with LPG delivered by railcar to other customers, storage and as an alternative terminal in the event the Matamoros Terminal Facility cannot be used.

29

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE K - CONTRACTS - Continued

LPG Sales to PMI - Continued

Revenues from PMI totaled approximately $21,299,000 and $60,537,000 for the three and six months ended June 30, 2006, respectively, representing approximately 31.8% and 44.4% of total revenues for the three and six months ended June 30, 2006, respectively.

LPG Supply Agreements

Effective October 1, 1999, the Company and Exxon entered into a ten year LPG supply contract, as amended (Exxon Supply Contract), whereby Exxon has agreed to supply and the Company has agreed to take, 100% of Exxon’s owned or controlled volume of propane and butane available at Exxon’s King Ranch Gas Plant (Plant) up to 13,900,000 gallons per month blended in accordance with required specifications (Plant Commitment). For the three months ended June 30, 2006, under the Exxon Supply Contract, Exxon has supplied an average of approximately 9,400,000 gallons of LPG per month. The purchase price is indexed to variable posted prices.

Effective March 1, 2006, the Exxon Supply Contract was amended to extend through September 30, 2010.

In addition to the LPG costs charged by its suppliers, the Company also incurs additional costs to deliver LPG to the Company’s facilities. Furthermore, the Company may incur significant additional costs associated with the storage, disposal and/or changes in LPG prices resulting from the excess of LPG purchased under the Exxon Supply Contract over actual sales volumes to PMI. Under the terms of the Exxon Supply Contract, the Company must provide letters of credit in amounts equal to the cost of the product to be purchased. In addition, the cost of the product purchased is tied directly to overall market conditions. As a result, the Company’s existing letter of credit facility may not be adequate to meet the letter of credit requirements if there are increases in quantities of LPG purchased and/or to finance future price increases of LPG.

In order to meet sales volumes in excess of LPG provided under the Exxon Supply Contract, the Company has entered into monthly arrangements with other LPG suppliers. The costs of such LPG supplies vary but are less than amounts received under the PMI Confirmation.

30

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE L - REALIZATION OF ASSETS

The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. The Company has a loss from operations for the three months and six months ended June 30, 2006, has had an accumulated deficit since inception, has a deficit in working capital and a deficit in stockholders’ equity. In addition, substantially all of the Company’s assets are pledged or committed to be pledged as collateral on existing debt in connection with the Notes, the RZB Credit Facility and/or the TransMontaigne Note, and therefore, the Company may be unable to obtain additional financing collateralized by those assets. The Notes were due December 15, 2005 and notes totaling $865,000 were paid in December 2005, February 2006 and June 2006. Notes totaling $940,000 are still outstanding and have not been extended. The TransMontaigne Note may be due on demand by TransMontaigne unless the Restated LPG Asset Sale closes (see note D). The RZB Credit Facility may be insufficient to finance the Company’s LPG purchases and/or Fuel Products purchases, assuming increases in product costs per gallon, or volumetric growth in product sales, and may be terminated by RZB with 90 days notice.

The minimum volumes and applicable margins contained in the 2006 PMI Agreement are expected to provide the Company with gross profit similar to the gross profit the Company would have received if PMI had purchased only the minimum volumes provided under its agreements with Rio Vista during the period from May 1, 2005 to March 31, 2006 as a result of increased margins on lower volume levels contained in the 2006 PMI Agreement. Actual volumes purchased by PMI under those prior agreements, however, exceeded minimum contractual amounts by approximately 35%. There is no assurance that PMI will purchase volumes as indicated in the 2006 PMI Agreement or that PMI will continue to purchase LPG from Rio Vista or in quantities or prices that are profitable upon the expiration of the 2006 PMI Agreement. Assuming that the Restated LPG Asset Sale does not close, the Company projects that its gross profit from operations based on the minimum volumes and applicable margins contained in the 2006 PMI Agreement will not provide sufficient cash flow to pay its normal operating expenses through March 31, 2007, assuming breakeven results from its Fuel Sales Business, unless it can sufficiently reduce its operating expenses. In addition, the Company’s cash flow at the minimum volumes contained in the 2006 PMI Agreement is projected not to be sufficient to pay its other obligations, including its secured debt. The Fuel Sales Business is a relatively new business and, as a result, the Company does not believe it can rely on that portion of its business to provide sufficient additional cash flow.

Penn Octane and Rio Vista project that monthly cash flows from LPG sales during the months of July 2006 through September 2006 will be less than during the months of October 2006 through March 2007 as a result of reduced monthly volumes committed to be purchased during July 2006 through September 2006. In addition, the Company may be unable to make any necessary capital expenditures or to pay arrearages in distributions or to pay future distributions to Rio Vista’s unitholders during the Term of the 2006 PMI Agreement.

In the event Penn Octane does not pay its obligations when due, Rio Vista’s guarantees to Penn Octane and Penn Octane’s creditors may be triggered. Accordingly, Rio Vista may be required to pay such obligations of Penn Octane to avoid foreclosure against Rio Vista’s assets by Penn Octane’s creditors. Assuming that the Restated LPG Asset Sale does not close, Rio Vista projects that its gross profit from operations under the 2006 PMI Agreement, based on the minimum volumes and applicable margins, will not provide sufficient cash flow for Rio Vista to pay its normal operating expenses through March 31, 2007 unless it can sufficiently reduce its operating expenses. If the Company’s revenues and other sources of liquidity are not adequate to pay its obligations, Penn Octane or Rio Vista may be required to raise additional funds to avoid such foreclosure. There can be no assurance that such additional funding will be available on terms attractive to either Penn Octane or Rio Vista or available at all. If additional amounts cannot be raised and the Company is unable to restructure its obligations, the Company would suffer material adverse consequences to its business, financial condition and results of operations, and Penn Octane and/or Rio Vista would likely be required to seek other alternatives, which could include the sale of assets, closure of operations and/or protection under the U.S. bankruptcy laws.

31

Penn Octane Corporation and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE L - REALIZATION OF ASSETS - Continued

In view of the matters described in the preceding paragraphs, recoverability of the recorded asset amounts shown in the accompanying unaudited consolidated balance sheet is dependent upon either (1) closing of the Restated LPG Asset Sale or (2) the ability of the Company to generate sufficient cash flow through operations or additional debt or equity financing to pay its liabilities and obligations when due. If the Restated LPG Asset Sale does not close, the ability for the Company to generate sufficient cash flows from operations is significantly dependent on the sale of LPG to PMI at adequate average monthly sales volumes and margins, the success of the Fuel Sales Business and the adequacy of the RZB Credit Facility to finance such sales. The unaudited consolidated financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

To provide the Company with the ability it believes necessary to continue in existence, management is taking steps to close the Restated LPG Asset Sale. Management is also (i) seeking to expand its Fuel Sales Business and to further diversify its operations to reduce dependency on sales of LPG, (ii) seeking to maintain the amount of financing for its products and operations, and (iii) seeking to reduce supply costs and operating expenses. In the event that the Restated LPG Asset Sale is not closed, management may also continue to attempt to sell its LPG and refined products assets.

32

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

Penn Octane Corporation (“Penn Octane”) and its consolidated subsidiaries which includes Rio Vista Energy Partners L.P. (“Rio Vista”) and its subsidiaries are collectively hereinafter referred to as the “Company”.

The following discussion of the Company's results of operations and liquidity and capital resources should be read in conjunction with the unaudited consolidated financial statements of the Company and related notes thereto appearing elsewhere herein. References to specific years proceeded by “fiscal” (e.g. fiscal 2006) refer to the Company's fiscal year ended December 31.

Forward-Looking Statements

The statements contained in this Quarterly Report that are not historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may be identified by the use of forward-looking terms such as “believes,” “expects,” “may,” “will”, “should”, “estimates”, “projects” or “anticipates” or by discussions of strategy that inherently involve risks and uncertainties. From time to time, the Company has made or may make forward-looking statements, orally or in writing. These forward-looking statements include statements regarding anticipated future revenues, sales, LPG supply, LPG pricing, operations, demand, competition, capital expenditures, future acquisitions, additional financing, the deregulation of the LPG market in Mexico, the operations of the US - Mexico Pipelines, the Matamoros Terminal Facility, other upgrades to facilities, foreign ownership of LPG operations, short-term obligations and credit arrangements, Fuel Sales Business, LPG Asset Sale, Restated LPG Asset Sale, the PMI Confirmation, 2006 PMI Agreement, TransMontaigne Note, cash distributions, “Qualifying Income”, partnership tax treatment, risk factors and other statements regarding matters that are not historical facts, and involve predictions which are based upon a number of future conditions that ultimately may prove to be inaccurate. Actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. Factors that may cause or contribute to such differences include those discussed under “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as those discussed elsewhere in this Report on Form 10-Q. We caution you, however, that the risks contained in this report may not include all material risks facing the Company.

Purchase and Sale Agreements

On August 15, 2005, Penn Octane and Rio Vista each entered into separate purchase and sale agreements (“PSA’s”) with TransMontaigne Product Services Inc. (“TransMontaigne”) which provided for the sale and assignment of all of their respective LPG assets and refined products assets (the “LPG Asset Sale”) including the Brownsville Terminal Facility, the refined products tank farm and associated leases, owned pipelines located in the United States, including land, leases, and rights of ways, LPG inventory, assignment of the lease of the Leased Pipeline, PMI sales agreement and Exxon Supply Contract (see note K to the unaudited consolidated financial statements) and 100% of the outstanding stock of its Mexican subsidiaries. Rio Vista’s Mexican subsidiaries and consolidated affiliate own pipelines in Mexico and the Matamoros Terminal Facility, including land and rights of way. Penn Octane’s agreement with TransMontaigne did not include any assets related to the Fuel Sales Business. The purchase price was $10.1 million for assets to be sold by Penn Octane and $17.4 million for assets to be sold by Rio Vista.

33

In connection with the PSA’s, TransMontaigne loaned Rio Vista $1.3 million (TransMontaigne Note) which was to be repaid, including interest, as a reduction of the total purchase price at the time of closing or 120 days following demand by TransMontaigne. The TransMontaigne Note is secured by the tank farm and certain LPG storage tanks located at the Brownsville Terminal Facility (the “Collateral”). The TransMontaigne Note began to accrue interest on November 15, 2005 at the prime rate plus 2%. In connection with the TransMontaigne Note, RZB Finance, LLC (“RZB”) provided a consent and the Brownsville Navigation District issued an estoppel letter. Rio Vista used the proceeds from the TransMontaigne Note to fund certain expenses associated with the PSA’s and for working capital purposes. If the LPG Asset Sale does not occur and Rio Vista does not pay the TransMontaigne Note in accordance with its terms, Rio Vista is required to convey title to the Collateral to TransMontaigne and to lease the Collateral from TransMontaigne for $10,000 per month until such time as Rio Vista pays the $1.3 million, in addition to the lease payments, to TransMontaigne. In the event of a conveyance of the title to the Collateral, no further interest payments would be required under the TransMontaigne Note. If the $1.3 million is repaid to TransMontaigne, the lease payments will cease and title to the Collateral will be re-conveyed to Rio Vista.

The closing of the LPG Asset Sale was subject to several conditions, including TransMontaigne’s satisfactory completion of its due diligence review, including financial, business, environmental and legal, assignment of LPG related contracts, and the modification of LPG related permits and the related Mexican governmental approvals. Certain of the conditions to closing were not met by October 31, 2005. The PSA’s provided that any party could terminate the agreements if closing did not occur on or before October 31, 2005. None of the parties elected to terminate the agreements and the parties continued to work towards the closing of the LPG Asset Sale.

On August 11, 2006, Penn Octane and TransMontaigne entered into an amended and restated purchase and sale agreement (the “Penn Octane Restated PSA”) with an effective date of August 15, 2006, which provides for the sale and assignment of all of Penn Octane’s LPG assets, including assignment of the lease of the Leased Pipeline and the Exxon Supply Contract, on terms substantially similar to Penn Octane’s PSA. Penn Octane will retain assets related to its Fuel Sales Business, and its interest in the General Partner. The purchase price for assets to be sold under the Penn Octane Restated PSA is $10.1 million, subject to certain adjustments. The Penn Octane Restated PSA provides for a closing date no sooner than August 22, 2006 and is subject to several conditions, including the concurrent closing of the Rio Vista Restated PSA (see below), the assignment of LPG related contracts, the consent of RZB and the modification satisfactory to TransMontaigne of the temporary injunction issued on June 13, 2006 (see note I). The Penn Octane Restated PSA provides that any party can terminate the agreement if closing does not occur on or before October 1, 2006.

Also on August 11, 2006, Rio Vista and TransMontaigne entered into an amended and restated purchase and sale agreement (the “Rio Vista Restated PSA”) with an effective date of August 15, 2006, which provides for the sale and assignment of only the LPG assets, including the Brownsville Terminal Facility, the refined products tank farm and associated leases, and LPG inventory, wherever located, (collectively, the “Brownsville Terminal Assets”) and assignment of the 2006 PMI Agreement (see note K to the unaudited consolidated financial statements) (Brownsville Terminal Assets and the 2006 PMI Agreement collectively, the “Acquired Assets”). Rio Vista will retain its owned pipelines located in the United States, including land, leases and rights of way and 100% of the outstanding stock of its Mexican subsidiaries. Rio Vista’s Mexican subsidiaries and consolidated affiliate own pipelines in Mexico and the Matamoros Terminal Facility, including land and rights of way (collectively, the “Retained Assets”). The purchase price for the Acquired Assets under the Rio Vista Restated PSA is $8.3 million, subject to certain adjustments. In addition, under the Rio Vista Restated PSA, TransMontaigne has agreed to exclusively use the services and Retained Assets of Rio Vista on a fee basis for purposes of transportation of LPG to be delivered into northeastern Mexico and/or LPG sold pursuant to the 2006 PMI Agreement (the “LPG Transportation Agreement”). Rio Vista has agreed not to transport LPG through Rio Vista’s assets in Mexico except on behalf of TransMontaigne, subject to certain conditions. In addition, under the Rio Vista Restated PSA, TransMontaigne agreed to provide routine and non-routine operation and maintenance services for the U.S. portion only of Rio Vista’s pipelines between Brownsville, Texas and Matamoros, Mexico (the “U.S. Pipeline Services Agreement”). TransMontaigne agreed to provide the routine services at its sole cost and expense. For the non-routine services, Rio Vista agreed to reimburse TransMontaigne for all costs actually incurred in performing the services and all materials and supplies provided in connection with such services, plus 15%. Rio Vista has also granted TransMontaigne certain rights of first refusal and first offer with respect to a sale of the Retained Assets by Rio Vista to any third party. The Rio Vista Restated PSA provides for a closing date no sooner than August 22, 2006 and is subject to several conditions, including the concurrent closing of the Penn Octane Restated PSA, assignment of LPG related contracts, the consent of RZB and the modification satisfactory to TransMontaigne of the temporary injunction issued on June 13, 2006 (see note I). The Rio Vista Restated PSA provides that either party may terminate the agreement if closing does not occur on or before October 1, 2006. The transactions contemplated by the Penn Octane Restated PSA and the Rio Vista Restated PSA are hereafter referred to as the Restated LPG Asset Sale. The Penn Octane Restated PSA and the Rio Vista Restated PSA are hereafter referred to as the Restated PSA’s. Under the Restated LPG Asset Sale, the purchase price will be reduced for certain adjustments and amounts reserved totaling $983,350 of which $851,173 relates to Rio Vista.

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Under the terms of the Rio Vista Restated PSA, $300,000 of the TransMontaigne Note will be repaid on the closing date of the Rio Vista Restated PSA and the remaining balance of $1.0 million of the TransMontaigne Note will be restructured to provide for the repayment of principal one year from the closing date of the Rio Vista Restated PSA. Rio Vista will be required to prepay a portion of the TransMontainge Note in an amount equal to the excess of amounts held in reserve for the payment of certain obligations of Rio Vista over actual amounts required as specified in the Rio Vista Restated PSA. Upon the closing of the Restated LPG Asset Sale, the collateral of the TransMontaigne Note will be changed to consist of the US portion of the eight-inch pipeline owned by Rio Vista. The TransMontaigne Note bears interest at the rate of prime (8.25% as of June 30, 2006) plus 2% annually and interest is payable monthly.

In connection with the Restated LPG Asset Sale, Penn Octane intends to use approximately $1.0 million of its proceeds to pay off the remaining amounts owed under the Restructured Notes and $280,000 Notes including accrued interest. Penn Octane intends to use the balance of the proceeds from the Restated LPG Asset Sale to fund working capital requirements and to pursue activities intended to enhance stockholder value. Penn Octane estimates that it may have a federal tax liability of approximately $1.5 million in connection with the Restated LPG Asset Sale after utilization of available net operating loss carryforward as of December 31, 2005.

Rio Vista intends to use any remaining proceeds to fund working capital requirements and to pursue activities intended to enhance unitholder value.

There can be no assurance that the Restated LPG Asset Sale will be completed according to the terms contained in the Restated PSA’s or according to different terms or at all. Even if the Restated LPG Asset Sale is completed, Rio Vista may be unable to resume payment of minimum quarterly distributions or to pay the arrearages of such distributions, in order to maintain cash reserves necessary for the conduct of business. A continued delay of or inability to close the Restated LPG Asset Sale could have a material adverse effect on Penn Octane’s and Rio Vista’s business, financial condition and results of operations.

Immediately following the closing of the Restated LPG Asset Sale, Penn Octane’s sources of cash flows are expected to be derived from net profits from the Fuel Sales Business, income from cash investments and any distributions from its General Partner interest in Rio Vista. Rio Vista’s sources of cash flows are expected to be derived from net profits from the LPG Transportation Agreement and income from cash investments.

Upon the closing of the Restated LPG Asset Sale, the LPG Supply Agreement between Penn Octane and Rio Vista will be terminated. In connection with the Omnibus Agreement, Penn Octane will continue to be entitled to reimbursement of costs incurred by it on behalf of Rio Vista. Neither Penn Octane nor Rio Vista can be certain that future cash flows will be adequate to cover all of their working capital requirements, including minimum distributions of Rio Vista.

The following discussion of the Company's results of operations and liquidity and capital resources should be read in conjunction with the unaudited consolidated financial statements of the Company and related notes thereto appearing elsewhere herein.

Overview

The Company has been principally engaged in the purchase, transportation and sale of LPG for distribution into northeast Mexico and the sale of Fuel Products. To the extent that Penn Octane purchases quantities of LPG under its supply contracts in excess of LPG sold to PMI, the Company sells the excess LPG to U.S. and other customers.

During the three and six months ended June 30, 2006, the Company derived 31.8% and 44.4% of its total revenues and 67.5% and 85.5% of LPG revenues from sales of LPG to PMI, its primary customer.

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The Company provides LPG products and services through a combination of fixed-margin and fixed-price LPG contracts. Costs included in cost of goods sold, other than the purchase price of LPG, may affect actual profits from sales, including costs relating to transportation, storage, leases and maintenance. Mismatches in volumes of LPG purchased from suppliers and volumes sold to PMI or others could result in gains during periods of rising LPG prices or losses during periods of declining LPG prices as a result of holding inventories or disposing of excess inventories.

During June 2004, the Company began the Fuel Sales Business with the ability to access certain pipeline and terminal systems located in California, Arizona, Nevada and Texas. Fuel Sales approximated $35.4 million and $65.5 million in revenues for the three months and six months ended June 30, 2006, respectively, which represents approximately 52.8% and 48.0% of total revenues, respectively.

On September 30, 2004, Penn Octane completed a series of transactions involving (i) the transfer of substantially all of its owned pipeline and terminal assets in Brownsville and Matamoros to RVOP (ii) transferred Penn Octane’s 99.9% interest in RVOP to Rio Vista and (iii) the Spin-Off, resulting in Rio Vista becoming a separate public company. The Common Units represented 98% of Rio Vista’s outstanding partnership interests. The remaining 2% interest represented the general partner interest. The general partner interest is solely owned and controlled by Rio Vista GP LLC (General Partner), a wholly owned subsidiary of Penn Octane at June 30, 2006. On July 1, 2006, options to acquire 50% of the General Partner were exercised, resulting in Penn Octane having a 50% interest in the General Partner. Penn Octane retains control over the General Partner pursuant to a voting agreement. Therefore, Rio Vista is consolidated with the Company and the interests of the General Partner not owned by Penn Octane and the interests of the limited partners are classified as minority interests in the Company’s unaudited consolidated financial statements. The General Partner is responsible for the management of Rio Vista. Subsequent to the Spin-Off, Rio Vista sells LPG directly to PMI and purchases LPG from Penn Octane under a long-term supply agreement. The purchase price of the LPG from Penn Octane is determined based on the cost of LPG under Penn Octane’s LPG supply agreements with its suppliers, other direct costs related to PMI sales and a formula that takes into consideration operating costs of Penn Octane and Rio Vista.

Penn Octane continues to sell LPG to PMI through its supply contract with Rio Vista, and it shifted certain costs of operations related to the Brownsville and Matamoros terminals and pipelines, and certain administrative costs to Rio Vista. In addition, it continues to manage Rio Vista through the General Partner and to explore opportunities to acquire and grow other lines of business such as the Fuel Sales Business described below.

LPG Sales

The following table shows the Company's volume sold in gallons and average sales price for LPG for the three months and six months ended June 30, 2005 and 2006;

	Three months ended June 30, 2005		Three months ended June 30, 2006		Six months ended June 30, 2005		Six months ended June 30, 2006
Volume Sold
LPG (millions of gallons) - PMI		20.4		18.9		52.7		57.2
LPG (millions of gallons) - Other		8.4		10.0		12.0		10.0
		28.8		28.9		64.7		67.2
Average sales price
LPG (per gallon) - PMI	$	0.90	$	1.13	$	0.89	$	1.06
LPG (per gallon) - Other		0.82		1.03		0.78		1.03

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Recent Trends. Since April 2004, PMI has contracted with the Company for volumes which were significantly lower than amounts purchased by PMI in similar periods during previous years, and beginning in April 2005 margins have been significantly lower than historical levels. See Liquidity and Capital Resources - Sales to PMI below. The Company believes that the reduction of volume commitments and margins for April 2004 through March 2006 is based on additional LPG production by PEMEX being generated from the Burgos Basin field in Reynosa, Mexico, an area within the proximity of the Company’s Matamoros Terminal Facility and increased competition from U.S. suppliers (see below). Although the Company is not aware of the total amount of LPG actually being produced by PEMEX from the Burgos Basin, it is aware that PEMEX has constructed and is operating two new cryogenic facilities at the Burgos Basin which it believes may have a capacity of producing up to 12 million gallons of LPG per month. The Company also believes that PEMEX intends to install two additional cryogenic facilities, with similar capacity, to be operational in 2006. The Company is also not aware of the capacity at which the current cryogenic facilities are being operated. Furthermore, the Company is not aware of the actual gas reserves of the Burgos Basin or the gas quality, each of which could significantly impact LPG production amounts.

During June 2004, Valero L.P. (“Valero”) began operation of a newly constructed LPG terminal facility in Nuevo Laredo, Mexico and a newly constructed pipeline connecting the terminal facility in Nuevo Laredo, Mexico to existing pipelines in Juarez, Texas which connect directly to Valero Energy Corporation’s Corpus Christi, Texas and Three Rivers, Texas refineries. Valero originally contracted with PMI under a five year agreement to deliver approximately 6.3 million gallons (of which 3.2 million gallons were previously delivered by truck from Three Rivers, Texas) of LPG per month. During July 2005, Valero announced that it had entered into a new agreement with PMI which provides for double the amount of LPG previously contracted for with PMI.

During 2004, a pipeline operated by El Paso Energy between Corpus Christi, Texas and Hidalgo County, Texas was closed. Historically these facilities had supplied approximately 5.0 million gallons of LPG per month to the Company’s strategic zone. The Company is not aware of any future plans for these facilities.

During 2003, PMI constructed and began operations of a refined products cross border pipeline connecting a pipeline running from PEMEX’s Cadereyta Refinery in Monterrey, Mexico to terminal facilities operated by TransMontaigne, Inc. in Brownsville, Texas. The pipeline crosses the US-Mexico border near the proximity of the Company’s pipelines. In connection with the construction of the pipeline, PMI utilizes an easement from the Company for an approximate 21.67 acre portion of the pipeline. Under the terms of the easement, PMI has agreed that it will not transport LPG through October 15, 2017.

Fuel Sales Business

The following table shows the Company's volume sold and delivered in gallons and average sales price for the Fuel Products for the three months and six months ended June 30, 2005 and 2006, respectively:

	Three months ended June 30, 2005		Three months ended June 30, 2006		Six months ended June 30, 2005		Six months ended June 30, 2006
Volume Sold
Fuel Products (millions of gallons)		15.8		15.0		34.6		30.2
Average sales price
Fuel Products (per gallon)	$	1.71	$	2.36	$	1.61	$	2.17

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Results of Operations

The following summarizes the gross profit among the Company’s LPG and Fuel Sales Business for the three months and six months ended June 30, 2005 and 2006. All amounts are in thousands.

	For the three months ended June 30, 2005
	LPG		Fuel Sales		Total
Revenues	$	25,227	$	27,036	$	52,263
Cost of goods sold		25,217		26,958		52,175
Gross profit	$	10	$	78	$	88

	For the three months ended June 30, 2006
	LPG		Fuel Sales		Total
Revenues	$	31,577	$	35,366	$	66,943
Cost of goods sold		30,944		35,050		65,994
Gross profit	$	633	$	316	$	949

	For the six months ended June 30, 2005
	LPG		Fuel Sales		Total
Revenues	$	56,208	$	55,782	$	111,990
Cost of goods sold		54,598		54,915		109,513
Gross profit	$	1,610	$	867	$	2,477

	For the six months ended June 30, 2006
	LPG		Fuel Sales		Total
Revenues	$	70,812	$	65,460	$	136,272
Cost of goods sold		69,439		64,615		134,054
Gross profit	$	1,373	$	845	$	2,218

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Three Months Ended June 30, 2006 Compared With Three Months Ended June 30, 2005

Revenues. Revenues for the three months ended June 30, 2006, were $66.9 million compared with $52.3 million for the three months ended June 30, 2005, an increase of $14.7 million or 28.1%. Of this increase, $4.7 million was attributable to increases in average sales prices of LPG sold to PMI during the three months ended June 30, 2006, $1.7 million was attributable to increases in average sales prices of LPG sold to customers other than PMI during the three months ended June 30, 2006, $1.6 million was attributable to increased volumes of LPG sold to customers other than PMI during the three months ended June 30, 2006, and $10.3 million was attributable to increases in average sales prices of Fuel Products sold during the three months ended June 30, 2006, partially offset by $1.7 million attributable to decreased volumes of LPG sold to PMI during the three months ended June 30, 2006 and $1.9 million attributable to decreased volumes of Fuel Products sold during the three months ended June 30, 2006.

Cost of goods sold. Cost of goods sold for the three months ended June 30, 2006 was $66.0 million compared with $52.2 million for the three months ended June 30, 2005, an increase of $13.8 million or 26.5%. Of this increase, $4.6 million was attributable to increases in the average costs of LPG sold to PMI during the three months ended June 30, 2006, $1.0 million was attributable to increases in average costs of LPG sold to customers other than PMI during the three months ended June 30, 2006, $1.6 million was attributable to increased volumes of LPG sold to customers other than PMI during the three months ended June 30, 2006, $9.9 million was attributable to increases in average costs of Fuel Products sold during the three months ended June 30, 2006, and $0.1 million was attributable to increases in other direct costs associated with the LPG and Fuel Sales Business during the three months ended June 30, 2006, partially offset by $1.9 million attributable to decreased volumes of Fuel Products sold during the three months ended June 30, 2006 and $1.5 million attributable to decrease volumes of LPG sold to PMI during the three months ended June 30, 2006.

Selling, general and administrative expenses. Selling, general and administrative expenses were $1.3 million for the three months ended June 30, 2006, compared with $2.6 million for the three months ended June 30, 2005, a decrease of $1.3 million or 48.7%. The decrease was principally attributable to reduced professional fees of $0.1 million and reduced payroll related costs of $1.2 million (including $1.0 million associated with the discount of a note receivable from a former officer) during the three months ended June 30, 2006.

Other income (expense). Other income was $0.1 million for the three months ended June 30, 2006, compared with other income of $0.3 million for the three months ended June 30, 2005. The decrease in other income was due primarily to an increase in the minority interest in the losses of Rio Vista of $0.2 million during the three months ended June 30, 2006.

Six Months Ended June 30, 2006 Compared With Six Months Ended June 30, 2005

Revenues. Revenues for the six months ended June 30, 2006, were $136.3 million compared with $112.0 million for the six months ended June 30, 2005, an increase of $24.3 million or 21.7%. Of this increase, $9.1 million was attributable to increases in average sales prices of LPG sold to PMI during the six months ended June 30, 2006, $2.8 million was attributable to increases in average sales prices of LPG sold to customers other than PMI during the six months ended June 30, 2006, $4.8 million was attributable to increased volumes of LPG sold to PMI during the six months ended June 30, 2006, and $19.2 million was attributable to increases in average sales prices of Fuel Products sold during the six months ended June 30, 2006, partially offset by $2.1 million attributable to decreased volumes of LPG sold to customers other than PMI during the six months ended June 30, 2006 and $9.6 million attributable to decreased volumes of Fuel Products sold during the six months ended June 30, 2006.

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Cost of goods sold. Cost of goods sold for the three months ended June 30, 2006 was $134.1 million compared with $109.5 million for the six months ended June 30, 2005, an increase of $24.5 million or 22.4%. Of this increase, $10.0 million was attributable to increases in the average costs of LPG sold to PMI during the six months ended June 30, 2006, $2.2 million was attributable to increases in average costs of LPG sold to customers other than PMI during the six months ended June 30, 2006, $4.5 million was attributable to increased volumes of LPG sold to PMI during the six months ended June 30, 2006, $18.9 million was attributable to increases in average costs of Fuel Products sold during the six months ended June 30, 2006, and $0.4 million was attributable to increases in other direct costs associated with the LPG and Fuel Sales Business during the six months ended June 30, 2006, partially offset by $9.4 million attributable to decreased volumes of Fuel Products sold during the six months ended June 30, 2006 and $2.1 million attributable to decrease volumes of LPG sold to customers other than PMI during the six months ended June 30, 2006.

Selling, general and administrative expenses. Selling, general and administrative expenses were $2.8 million for the six months ended June 30, 2006, compared with $4.2 million for the six months ended June 30, 2005, a decrease of $1.4 million or 34.2%. The decrease was principally attributable to reduced professional fees of $0.2 million and reduced payroll related costs of $1.3 million (including $1.0 million associated with the discount of a note receivable from a former officer) during the six months ended June 30, 2006.

Other income (expense). Other expense was $(0.3) million for the six months ended June 30, 2005. The decrease in other expense was due primarily to an increase in the minority interest in the losses of Rio Vista of $0.3 million during the six months ended June 30, 2006 and decreased amortization of discounts on outstanding debt incurred.

Liquidity and Capital Resources

General. The Company has a loss from operations for the three months and six months ended June 30, 2006, has had an accumulated deficit since its inception, has a deficit in working capital and a deficit in stockholder’s equity. In addition, substantially all of the Company’s assets are pledged or committed to be pledged as collateral on existing debt in connection with the Notes, the RZB Credit Facility and/or the TransMontaigne Note, and therefore, the Company may be unable to obtain additional financing collateralized by those assets. The Notes were due December 15, 2005 and notes totaling $865,000 were paid in December 2005, February 2006 and June 2006. Notes totaling $940,000 are still outstanding and have not been extended. The TransMontaigne Note may be due on demand by TransMontaigne unless the Restated LPG Asset Sale closes (see note D to the unaudited consolidated financial statements). The RZB Credit Facility is an uncommitted facility which is authorized every ninety days and is reviewed annually at March 31. The Company may need to increase its credit facility for increases in quantities of LPG and Fuel Products purchased and/or to finance future price increases of LPG and Fuel Products. The Company depends heavily on sales to one major customer, PMI. The Company's sources of liquidity and capital resources historically have been provided by sales of LPG and Fuel Products, proceeds from the issuance of short-term and long-term debt, revolving credit facilities and credit arrangements, sale or issuance of preferred and common stock of the Company and proceeds from the exercise of warrants to purchase shares of the Company's common stock.

The minimum volumes and applicable margins contained in the 2006 PMI Agreement are expected to provide the Company with gross profit similar to the gross profit the Company would have received if PMI had purchased only the minimum volumes provided under its agreements with Rio Vista during the period from May 1, 2005 to March 31, 2006 as a result of increased margins on lower volume levels contained in the 2006 PMI Agreement. Actual volumes purchased by PMI under those prior agreements, however, exceeded minimum contractual amounts by approximately 35%. There is no assurance that PMI will purchase volumes as indicated in the 2006 PMI Agreement or that PMI will continue to purchase LPG from Rio Vista or in quantities or prices that are profitable upon the expiration of the 2006 PMI Agreement. Assuming that the Restated LPG Asset Sale does not close, the Company projects that its gross profit from operations based on the minimum volumes and applicable margins contained in the 2006 PMI Agreement will not provide sufficient cash flow to pay its normal operating expenses through March 31, 2007, assuming breakeven results from its Fuel Sales Business, unless it can sufficiently reduce its operating expenses. In addition, the Company’s cash flow at the minimum volumes contained in the 2006 PMI Agreement is projected not to be sufficient to pay its other obligations, including its secured debt. The Fuel Sales Business is a relatively new business and, as a result, the Company does not believe it can rely on that portion of its business to provide sufficient additional cash flow.

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Penn Octane and Rio Vista project that monthly cash flows from LPG sales during the months of July 2006 through September 2006 will be less than during the months of October 2006 through March 2007 as a result of reduced monthly volumes committed to be purchased during July 2006 through September 2006. In addition, the Company may be unable to make any necessary capital expenditures or to pay arrearages in distributions or to pay future distributions to Rio Vista’s unitholders during the Term of the 2006 PMI Agreement.

All of Penn Octane’s and Rio Vista's assets are pledged as collateral for existing debt of Penn Octane. In the event Penn Octane does not pay its obligations when due, Rio Vista’s guarantees to Penn Octane and Penn Octane’s creditors may be triggered. Accordingly, Rio Vista may be required to pay such obligations of Penn Octane to avoid foreclosure against Rio Vista’s assets by Penn Octane’s creditors. Assuming that the Restated LPG Asset Sale does not close, Rio Vista projects that its gross profit from operations under the 2006 PMI Agreement, based on the minimum volumes and applicable margins, will not provide sufficient cash flow for Rio Vista to pay its normal operating expenses through March 31, 2007 unless it can sufficiently reduce its operating expenses. If the Company’s revenues and other sources of liquidity are not adequate to pay its obligations, Penn Octane or Rio Vista may be required to raise additional funds to avoid such foreclosure. There can be no assurance that such additional funding will be available on terms attractive to either Penn Octane or Rio Vista or available at all.

Although Rio Vista is not required to do so, if Penn Octane is unable to pay its obligations when they become due, Rio Vista may lend the necessary funds to Penn Octane. Conversely, if Rio Vista does not have the funds necessary to pay its obligations and to make its distributions, to the extent that Penn Octane has sufficient cash to do so, it may (but is not required to) lend such amounts to Rio Vista.

If Penn Octane and/or Rio Vista are required to raise additional funds, management does not believe that either company would be able to obtain such financing from traditional commercial lenders. Rather, they may have to conduct sales of assets or sales of equity and/or debt securities through public or private financings, collaborative relationships or other arrangements. There can be no assurance that such additional funding will be available on terms attractive to either Penn Octane or Rio Vista or that such funding will be available in the required timeframe, if available at all. If additional financing is obtained through the sale of securities of Penn Octane, substantial and immediate dilution to existing Penn Octane common stockholders may occur. If additional amounts cannot be raised and the Company is unable to restructure its obligations, the Company would suffer material adverse consequences to its business, financial condition and results of operations. In such event, Penn Octane and/or Rio Vista would likely be required to seek other alternatives which could include the sale of assets, closure of operations and/or protection under U.S. bankruptcy laws.

On July 19, 2006 pursuant to a written determination received from The NASDAQ Stock Market’s Listing Qualification Department on July 17, 2006, Penn Octane’s common stock was delisted from the NASDAQ Capital Market. As a result of the delisting, Penn Octane’s common stock began trading on the Pink Sheets, a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time. Penn Octane is currently seeking quotation in the OTC Bulletin Board through a market maker. The OTC Bulletin Board is a regulated quotation service that displays real-time quotes, last sale prices and volume information in over-the-counter securities. There is no assurance that Penn Octane will be quoted on the OTC Bulletin Board. Penn Octane will continue to file all required reports with the Securities and Exchange Commission. The delisting by NASDAQ could result in decreased market interest in Penn Octane common stock, investors and stockholders may experience more difficulty in buying and selling Penn Octane common stock and Penn Octane’s common stock price may decline. In addition, Penn Octane may experience greater difficulty in obtaining necessary debt and equity capital for potential acquisitions or the operation of its business.

Further, if Penn Octane is determined to have a federal income tax liability in excess of the amounts which were included in the federal income tax return related to the Spin-Off and if Penn Octane is unable to pay such liabilities or Rio Vista is unable to pay, then the Internal Revenue Service may assert that the Penn Octane stockholders who received Rio Vista’s common units in the Spin-Off are liable for unpaid federal income taxes of Penn Octane, including interest and any penalties, up to the value of the Rio Vista common units received by each stockholder.

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The following summary table reflects comparative cash flows for the six months ended June 30, 2005 and 2006. All information is in thousands.

	Six months ended June 30, 2005			Six months ended June 30, 2006
Net cash (used in) operating activities	$	(4,563	)	$	(5,379	)
Net cash provided by investing activities		118			76
Net cash provided by financing activities		4,280			5,122
Net (decrease) in cash	$	(165	)	$	(181	)

Sales to PMI. PMI and the Company operated under a three month contract for the period from January 1, 2005 to June 30, 2005 and monthly contracts for April 2005 and May of 2005. Effective June 4, 2005, the Company entered into an agreement with PMI for the period June 4, 2005 through March 31, 2006 for the sale of LPG to PMI (the “2005 PMI Agreement”).

On March 31, 2006, the 2005 PMI Agreement expired. During the month of April 2006, the Company sold LPG to PMI under a monthly contract which provided for volumes of approximately 6.0 million gallons at prices similar to the 2005 PMI Agreement. During April 2006, PMI purchased approximately 6.0 million gallons.

On April 28, 2006, the Company received electronic confirmation (the “PMI Confirmation”) from PMI of the terms of a new purchase and sale agreement for LPG for the period May 1, 2006 through March 31, 2007 (the “Term”). The PMI Confirmation was subject to execution of a definitive written agreement between Rio Vista and PMI. The agreement (the “2006 PMI Agreement”) was executed during July 2006 with the terms specified in the PMI Confirmation. The 2006 PMI Agreement provides that PMI does not have a financial obligation with respect to any shortfalls if volumes actually purchased are less than minimum volumes contained in the 2006 PMI Agreement

The minimum volumes and applicable margins contained in the 2006 PMI Agreement are expected to provide the Company with gross profit similar to the gross profit the Company would have received if PMI had purchased only the minimum volumes provided under its agreements with Rio Vista during the period from May 1, 2005 to March 31, 2006 as a result of increased margins on lower volume levels contained in the 2006 PMI Agreement.

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The following table sets forth the minimum monthly volume of LPG PMI committed to purchase from the Company pursuant to the 2005 PMI agreement, the April 2006 monthly contract and the 2006 PMI Agreement and the actual volumes purchased for the months January 2006 through July 2006.

Month	Minimum Contract Volumes	Actual Volumes Sold
	(gallons)	(gallons)
January 2006	11,700,000	14,757,646
February 2006	11,700,000	11,940,257
March 2006	8,100,000	11,606,435
April 2006	6,000,000	6,035,733
May 2006	4,500,000	5,733,193
June 2006	4,500,000	7,130,666
July 2006	4,500,000	4,937,441
August 2006	4,500,000	*
September 2006	4,500,000	*
October 2006	8,100,000	*
November 2006	8,100,000	*
December 2006	9,000,000	*
January 2007	8,100,000	*
February 2007	8,100,000	*
March 2007	8,100,000	*
* Not yet available

PMI has primarily used the Matamoros Terminal Facility to load LPG purchased from the Company for distribution by truck in Mexico. The Company continues to use the Brownsville Terminal Facility in connection with LPG delivered by railcar to other customers, storage and as an alternative terminal in the event the Matamoros Terminal Facility cannot be used.

Revenues from PMI totaled approximately $21.3 and $60.5 million for the three and six months ended June 30, 2006, respectively, representing approximately 31.8% and 44.4% of total revenues for the three and six months ended June 30, 2006, respectively.

LPG Supply Agreements. Effective October 1, 1999, the Company and Exxon entered into a ten year LPG supply contract, as amended (the “Exxon Supply Contract”), whereby Exxon has agreed to supply and the Company has agreed to take, 100% of Exxon’s owned or controlled volume of propane and butane available at Exxon’s King Ranch Gas Plant (the “Plant”) up to 13,900,000 gallons per month blended in accordance with required specifications (the “Plant Commitment”). For the three months ended June 30, 2006, under the Exxon Supply Contract, Exxon has supplied an average of approximately 9.4 million gallons of LPG per month. The purchase price is indexed to variable posted prices.

Effective March 1, 2006, the Exxon Supply Contract was amended to extend through September 30, 2010.

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In addition to the LPG costs charged by its suppliers, the Company also incurs additional costs to deliver LPG to the Company’s facilities. Furthermore, the Company may incur significant additional costs associated with the storage, disposal and/or changes in LPG prices resulting from the excess of LPG purchased under the Exxon Supply Contract over actual sales volumes to PMI. Under the terms of the Exxon Supply Contract, the Company must provide letters of credit in amounts equal to the cost of the product to be purchased. In addition, the cost of the product purchased is tied directly to overall market conditions. As a result, the Company’s existing letter of credit facility may not be adequate to meet the letter of credit requirements if there are increases in quantities of LPG purchased and/or to finance future price increases of LPG.

In order to meet sales volumes in excess of LPG provided under the Exxon Supply Contract, the Company has entered into monthly arrangements with other LPG suppliers. The costs of such LPG supplies vary but are less than amounts received under the 2006 PMI Agreement.

Fuel Sales Business. The Company sells Fuel Products through transactional, bulk and/or rack transactions. Typical transactional and bulk sales are made based on a predetermined net spread between the purchase and sales price over posted monthly variable prices and/or daily spot prices. Rack sales transactions are based on variable sale prices charged by the Company which are tied to posted daily spot prices and purchase costs which are based on a monthly average or 3 day average based on posted prices. The Company pays pipeline and terminal fees based on regulated rates.

The Fuel Products market on the west coast of the United States is characterized by limited pipeline and terminal space to move sufficient Fuel Products to locations where demand for Fuel Products exists. The Company has the ability to access to certain pipeline and terminal systems located in California, Arizona, Nevada and Texas, where it is able to deliver its Fuel Products. The markets where the Company has targeted its products are generally in areas where the Fuel Products are difficult to deliver due to the infrastructure limitations and accordingly, the Company’s access may provide an advantage over other potential competitors who may not have access to these pipelines or terminals. In addition, the Company’s supply contracts provide it with greater flexibility to manage changes in the prices of the Fuel Products. The Company believes it has an advantage over other competitors based on its favorable supply contracts and existing access to certain pipelines and terminals.

For bulk and transactional sales, the Company enters into individual sales contracts for each sale. Fuel Products sales are subject to credit limitations imposed on each individual buyer by the Company. The Company has several supply contracts for each of the Fuel Products it sells. The supply contracts are for annual periods with flexible volumes but they may be terminated sooner by the supplier if the Company consistently fails to purchase minimum volumes of Fuel Products. Fuel sales approximated 52.8% and 48.0% of total revenues for the three months and six months ended June 30, 2006, respectively.

Fuel Sales revenues totaled $35.4 million and $65.5 million and cost of fuel and other direct operating expenses totaled $35.1 million and $64.6 million during the three months and six months ended June 30, 2006, respectively. Future success of the Fuel Sales Business is dependent on the demand for Fuel Products in the Company’s markets and the Company’s ability to manage fluctuations in the price of such products.

The ability of the Company to participate in the Fuel Sales Business is largely dependent on the Company’s ability to finance its supplies. Currently, the Company utilizes the RZB Credit Facility to finance the purchases of Fuel Products. Based on the Company’s commitments under the Exxon Supply Contract, increases in the costs of LPG and/or the increases in the costs of Fuel Products may reduce the amount of financing available for the Fuel Sales Business.

Federal and State agencies require the Company to obtain the necessary regulatory and other approvals for its Fuel Sales Business.

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Credit Arrangements. As of June 30, 2006, Penn Octane had a $20.0 million credit facility with RZB Finance, LLC (“RZB”) for demand loans and standby letters of credit (the “RZB Credit Facility”) to finance Penn Octane’s purchases of LPG and Fuel Products. The RZB Credit Facility includes a $3.0 million limit for purchase of Fuel Products inventory for a maximum of 30 days. The RZB Credit facility is an uncommitted facility under which the letters of credit have an expiration date of no more than 90 days and the facility is reviewed annually at March 31. The March 31, 2006 review was deferred on a month to month basis while the Company continued to pursue the LPG Asset Sale. In connection with the RZB Credit Facility, the Company granted RZB a security interest and assignment in any and all of the Company's accounts, inventory, real property, buildings, pipelines, fixtures and interests therein or relating thereto, including, without limitation, the lease with the Brownsville Navigation District of Cameron County for the land on which the Company’s Brownsville Terminal Facility is located, the Pipeline Lease, and in connection therewith entered into leasehold deeds of trust, security agreements, financing statements and assignments of rent. Under the RZB Credit Facility, the Company may not permit to exist any subsequent lien, security interest, mortgage, charge or other encumbrance of any nature on any of its properties or assets, except in favor of RZB, without the consent of RZB. After the Spin-Off and transfer of assets to Rio Vista, RZB continued to retain a security interest in the transferred assets.

Under the RZB Credit Facility, the Company pays a fee with respect to each letter of credit thereunder in an amount equal to the greater of (i) $500, (ii) 2.5% of the maximum face amount of such letter of credit for LPG and 2% for Fuel Products, or (iii) such higher amount as may be agreed to between the Company and RZB. Any loan amounts outstanding under the RZB Credit Facility accrue interest at a rate equal to the rate announced by the JPMorgan Chase Bank as its prime rate (8.25% at June 30, 2006) plus 2.5%. Pursuant to the RZB Credit Facility, RZB has sole and absolute discretion to limit or terminate its participation in the RZB Credit Facility and to refrain from making any loans or issuing any letters of credit thereunder. RZB also has the right to demand payment of any and all amounts outstanding under the RZB Credit Facility at any time. In addition to the fees described above, the Company is required to pay RZB annual fees of $50,000.

Based on current minimum purchase commitments under the Company’s LPG supply agreement and current LPG prices, the amount available to finance Fuel Products and LPG purchases in excess of current minimum purchase commitments is limited and therefore the ability of the Company to grow the Fuel Sales Business is dependent on future increases in its RZB Credit Facility or other sources of financing, the reduction of LPG supply commitments and/or the reduction in LPG or Fuel Products prices.

Under the terms of the RZB Credit Facility, either Penn Octane or Rio Vista is required to maintain net worth of a minimum of $10.0 million.

In connection with the Company’s purchases of LPG and Fuel Products, letters of credit are issued based on anticipated purchases. Outstanding letters of credit for purchases of LPG and Fuel Products at June 30, 2006 totaled approximately $13.8 million of which approximately $10.0 million represents June 2006 purchases and approximately $3.8 million represents July 2006 purchases.

In connection with the Company’s purchase of LPG and Fuel Products, under the RZB Credit Facility, assets related to product sales (the “Assets”) are required to be in excess of borrowings and commitments (including restricted cash of approximately $3.6 million at June 30, 2006). At June 30, 2006, the Company’s borrowings and commitments were less than the amount of the Assets.

In connection with the Company’s Fuel Sales Business, the Company has issued bonds totaling $662,000 to the states of California, Nevada, Arizona and Texas (the “Bonds”) to secure payments of excise and other taxes collected from customers in connection with sales of Fuel Products. The Bonds are partially secured by letters of credit totaling $452,600. At June 30, 2006, such taxes in the amount of approximately $785,000 were due. The letters of credit issued have all been secured by cash in the amount of approximately $474,000 which is included in restricted cash in the Company’s balance sheet at June 30, 2006.

LPG and Fuel Products financing expense associated with the RZB Credit Facility totaled $166,615 and $285,808 for the three months ended June 30, 2005 and 2006, respectively, and $369,925 and $525,576 for the six months ended June 30, 2005 and 2006, respectively.

If the Restated LPG Asset Sale is completed, the Company expects that the RZB Credit Facility will be restructured and/or reduced.

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The following is a summary of the Company’s estimated minimum contractual obligations and commercial obligations as of June 30, 2006. Where applicable, LPG prices are based on the June 30, 2006 monthly average as published by Oil Price Information Service.

	Payments due by Period (Amounts in Millions)
Contractual Obligations	Total		Less than 1 Year		1 - 3 Years		4 - 5 Years		After 5 Years
Long-Term Debt Obligations and Note Payable	$	2.4	$	2.4	$	-	$	-	$	-
Operating Leases		7.4		1.0		2.0		2.0		2.4
LPG Purchase Obligations		540.6		166.2		332.5		41.9		-
Other Long-Term Obligations		-		-		-		-		-
Total Contractual Cash Obligations	$	550.4	$	169.6	$	334.5	$	43.9	$	2.4

	Amount of Commitment Expiration Per Period (Amounts in Millions)
Commercial Commitments	Total Amounts Committed		Less than 1 Year		1 - 3 Years		4 - 5 Years		Over 5 Years
Lines of Credit	$	4.7	$	4.7	$	-	$	-	$	-
Standby Letters of Credit		13.8		13.8		-		-		-
Guarantees		N/A		N/A		N/A		N/A		N/A
Standby Repurchase Obligations		N/A		N/A		N/A		N/A		N/A
Other Commercial Commitments		N/A		N/A		N/A		N/A		N/A
Total Commercial Commitments	$	18.5	$	18.5	$	-	$	-	$	-

Distributions of Available Cash. All Rio Vista unitholders have the right to receive distributions from Rio Vista of “available cash” as defined in the Rio Vista partnership agreement in an amount equal at least to the minimum distribution of $0.25 per quarter per unit, plus any arrearages in the payment of the minimum quarterly distribution on the units from prior quarters subject to any reserves determined by the General Partner. The General Partner has a right to receive a distribution corresponding to its 2% general partner interest and the incentive distribution rights described below. The distributions are to be paid 45 days after the end of each calendar quarter. However, Rio Vista is prohibited from making any distributions to unitholders if it would cause an event of default, or an event of default exists, underany obligation of Penn Octane which Rio Vista has guaranteed.

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In addition to its 2% general partner interest, the General Partner is currently the holder of incentive distribution rights which entitle the holder to an increasing portion of cash distributions as described in the partnership agreement. As a result, cash distributions from Rio Vista are shared by the holders of Rio Vista common units and the General Partner interest based on a formula whereby the General Partner receives disproportionately more distributions per percentage interest than the holders of the common units as annual cash distributions exceed certain milestones.

On both February 14, 2005 and May 13, 2005, Rio Vista made cash distributions of $487,000 for the quarters ended December 31, 2004 and March 31, 2005. Because of insufficient available cash, Rio Vista has not declared any other distributions since May 2005. As a result of the exercise of the General Partner Options, Penn Octane will only be entitled to receive up to 50% of any distributions paid in the future by Rio Vista and distributed by the General Partner including any distributions associated with arrearages prior to the exercise of the General Partner Options.

Rio Vista’s ability to make distributions will continue to be adversely impacted if sales to PMI are not at sufficient volumes and margins, payments are required on its guarantees, expenses increase, Rio Vista is unable to obtain additional financing on its pledged assets or the Restated LPG Asset Sale does not close. Although Penn Octane is not required to do so, to the extent that Penn Octane has sufficient cash to do so, it may lend amounts to Rio Vista to meet the minimum distributions. If Rio Vista’s revenues and other sources of liquidity after its quarterly distributions are not adequate to satisfy such payment obligations of Penn Octane and/or Penn Octane does not have the necessary cash to loan to Rio Vista, Rio Vista may be unable to resume the quarterly distributions to unitholders or pay any arrearages, and Penn Octane and/or Rio Vista may be required to raise additional funds to avoid foreclosure against their assets. However, there can be no assurance that such additional funding will be available on terms attractive to either Penn Octane or Rio Vista or available at all.

There can be no assurance that the Restated LPG Asset Sale will be completed according to the terms contained in the Restated PSA’s or according to different terms or at all. Even if the Restated LPG Asset Sale is completed, Rio Vista may be unable to resume payment of minimum quarterly distributions or to pay the arrearages of such distributions, in order to maintain cash reserves necessary for the conduct of business. A continued delay of or inability to close the Restated LPG Asset Sale could have a material adverse effect on Penn Octane’s and Rio Vista’s business, financial condition and results of operations.

The following is a reconciliation of Rio Vista’s consolidated net loss to distributable cash flow for the three months ended March 31, 2006 and June 30, 2006.

	Three Months Ended
	March 31, 2006			June 30, 2006
Net loss	$	(251,000	)	$	(434,000	)
Plus interest and LPG financing expense and taxes, net		145,000			137,000
Plus depreciation and amortization		200,000			202,000
Earnings before interest, taxes,depreciation and amortization(“EBITDA”)		94,000			(95,000	)
Plus other non-cash expenses		8,000			-
Less cash interest, LPG financing expense and taxes, net		(122,000	)		(137,000	)
Distributable cash flow (deficit)		(20,000	)		(232,000	)
Distributable cash flow (deficit) applicable to general partner		-			5,000
Distributable cash flow (deficit) applicable to limited partners	$	(20,000	)	$	(227,000	)

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Rio Vista utilizes two financial measures, EBITDA and distributable cash flow, which are not defined in GAAP. Management uses these financial measures because they are widely accepted financial indicators used by investors to compare partnership performance. In addition, management believes that these measures provide investors an enhanced perspective of the operating performance of Rio Vista’s assets and the cash flow the business is generating. Neither EBITDA nor distributable cash flow are intended to represent cash flows for the period, nor are they presented as an alternative to net income. They should not be considered in isolation or as substitutes for a measure of performance prepared in accordance with Generally Accepted Accounting Principles.

Partnership Tax Treatment. See note J to the unaudited consolidated financial statements for discussion of partnership tax treatment.

Litigation. See note J to the unaudited consolidated financial statements for litigation discussion.

Consulting Agreement. See note J to the unaudited consolidated financial statements for discussion of Mr. Richter’s consulting agreement.

Amended Leased Pipeline Lease Agreement. On July 21, 2006, the Company and Seadrift entered into an amended and restated lease agreement (the “Amended Lease”) for the Leased Pipeline. The Amended Lease is effective August 1, 2006 and expires on December 31, 2013. Pursuant to the terms of the Amended Lease, the Company will have the exclusive right to transport materials through the Leased Pipeline, and Seadrift will no longer have certain rights to utilize the pipeline for its own purposes as provided in the original lease agreement. In addition, the Company will no longer be required to make minimum payments for propane storage in Markham, Texas and will no longer have access to such storage. The Company will also no longer have access to the Ella-Seadrift pipeline (running approximately 155 miles between Markham and the King Ranch Gas Plant) or to access other propane suppliers via such pipeline. The Company has agreed to indemnify Seadrift for environmental liabilities, including claims relating to the condition of the leased property and any environmental remediation costs, arising after the inception date of the lease, September 1, 1993. Seadrift has agreed to indemnify the Company for similar environmental liabilities arising before that date. The Company’s lease payments, which previously consisted of fixed amounts plus certain variable charges and periodic increases, will now consist of a fixed annual amount of $1.6 million (total lease expenses for the year ended December 31, 2005 were approximately $1.4 million). The Company may assign the Amended Lease to a third party with Seadrift’s written consent, which consent may not be unreasonably withheld.

Other. The Company intends to upgrade its computer and information systems at a total estimated cost of approximately $350,000 expected to be completed during 2006.

Mexican Operations.Under current Mexican law, foreign ownership of Mexican entities involved in the distribution of LPG or the operation of LPG terminal facilities is prohibited. Foreign ownership is permitted in the transportation and storage of LPG. Mexican law also provides that a single entity is not permitted to participate in more than one of the defined LPG activities (transportation, storage or distribution). PennMex has a transportation permit and Termatsal owns, leases, or is in the process of obtaining the land or rights of way used in the construction of the Mexican portion of the US-Mexico Pipelines, and owns the Mexican portion of the assets comprising the US-Mexico Pipelines. The Company’s consolidated Mexican affiliate, Tergas, owns the Matamoros Terminal Facility and has been granted the permit to operate the Matamoros Terminal Facility. The Company relies on Tergas’ permit to continue its delivery of LPG at the Matamoros Terminal Facility. Tergas is owned 95% by Mr. Vicente Soriano, and the remaining balance is owned by an unrelated party. The Company has an option to purchase Tergas for a nominal price of approximately $5,000.

Through its operations in Mexico and the operations of the Mexican Subsidiaries and Tergas, the Company is subject to the tax laws of Mexico which, among other things, require that the Company comply with transfer pricing rules, the payment of income, asset and ad valorem taxes, and possibly taxes on distributions in excess of earnings. In addition, distributions to foreign corporations, including dividends and interest payments may be subject to Mexican withholding taxes.

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Deregulation of the LPG Industry in Mexico.The Mexican petroleum industry is governed by the Ley Reglarmentaria del Artículo 27 Constitutional en el Ramo del Petróleo (the Regulatory Law to Article 27 of the Constitution of Mexico concerning Petroleum Affairs (the “Regulatory Law”)), Reglamento de Gas Licuado de Petroleo (Regulation of LPG) and Ley Orgánica del Petróleos Mexicanos y Organismos Subsidiarios (the Organic Law of Petróleos Mexicanos and Subsidiary Entities (the “Organic Law”)). Under Mexican law and related regulations, PEMEX is entrusted with the central planning and the strategic management of Mexico's petroleum industry, including importation, sales and transportation of LPG. In carrying out this role, PEMEX controls pricing and distribution of various petrochemical products, including LPG.

Beginning in 1995, as part of a national privatization program, the Regulatory Law was amended to permit private entities to transport, store and distribute natural gas with the approval of the Ministry of Energy. As part of this national privatization program, the Mexican Government is expected to deregulate the LPG market (“Deregulation”). In June 1999, Regulation of LPG was enacted to permit foreign entities to participate without limitation in the defined LPG activities related to transportation and storage. However, foreign entities are prohibited from participating in the distribution of LPG in Mexico. Upon Deregulation, Mexican entities will be able to import LPG into Mexico. Under Mexican law, an entity with a permit to transport LPG is not permitted to obtain permits for the other defined LPG activities (storage and distribution). The Company or its consolidated affiliate expect to sell LPG directly to independent Mexican distributors as well as PMI upon Deregulation. The Company anticipates that the independent Mexican distributors will be required to obtain authorization from the Mexican government for the importation of LPG upon Deregulation prior to entering into contracts with the Company.

During July 2001, the Mexican government announced that it would begin to accept applications from Mexican companies for permits to allow for the importation of LPG pursuant to provisions already provided for under existing Mexican law.

In connection with the above, in August 2001, Tergas received a one year permit from the Mexican government to import LPG. During September 2001, the Mexican government decided to delay the implementation of Deregulation and asked Tergas to defer use of the permit and as a result, the Company did not sell LPG to distributors other than PMI. In March 2002, the Mexican government again announced its intention to issue permits for free importation of LPG into Mexico by distributors and others beginning August 2002, which was again delayed. To date the Mexican government has continued to delay implementation of Deregulation. Tergas’ permit to import LPG expired during August 2002. Tergas intends to obtain a new permit when the Mexican government again begins to accept applications. As a result of the foregoing, it is uncertain as to when, if ever, Deregulation will actually occur and the effect, if any, it will have on the Company. However, should Deregulation occur and should the LPG Asset Sale not close, it is the Company’s intention to sell LPG directly to distributors in Mexico as well as to PMI.

The point of sale for LPG which flows through the US-Mexico Pipelines for delivery to the Matamoros Terminal Facility is the United States-Mexico border. For LPG delivered into Mexico, PMI is the importer of record.

Private Placements and Other Transactions.

Penn Octane 2001 Warrant Plan

On March 9, 2005, the board of directors of Penn Octane approved the grant of warrants to purchase a total of 1.0 million shares of Penn Octane common stock under Penn Octane’s 2001 Warrant Plan previously approved by the Penn Octane stockholders. Of the total number of warrants granted, 625,000 were granted to executive officers of Penn Octane, 255,000 were issued to outside directors of Penn Octane and 125,000 were issued to a consultant. The exercise price for the warrants is $1.50 per share, which was the closing price for Penn Octane’s common stock as reported by the NASDAQ Stock Market on March 9, 2005. Warrants granted to executive officers vest in equal monthly installments over a period of 36 months from the date of grant. Warrants granted to outside directors vest in equal monthly installments over a period of 12 months from the date of grant. All warrants become fully exercisable upon a change in control event and expire five years from the date of grant.

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Note Receivable from a Former Officer of the Company

The note receivable from Mr. Richter, in the amount of $3.2 million, was due July 29, 2005. On August 3, 2005 in connection with Mr. Richter’s retirement in May 2005 and in consideration of his past services, the Company approved an extension of the note to July 29, 2007 and a discount of the note to $1.7 million plus accrued interest not waived (see below) on its maturity date, subject to satisfaction of certain conditions. The Company considers it to be probable that the note will be discounted at maturity and accordingly, has recorded a charge to compensation expense as of June 30, 2005 in the amount of $1.0 million with a corresponding credit to the reserve. The interest rate on the extended note is 6.75%. The Company will waive interest provided that Mr. Richter guarantees debt of the Company to any person in an amount equal to at least $1.8 million (see Note G to the unaudited consolidated financial statements). Beginning December 15, 2005, the Company reduced the amount of guaranteed debt below $1.8 million. Accordingly, the Company began accruing interest and reserving the interest on Mr. Richter’s note.

Restructured Notes and $280,000 Notes.

At June 30, 2006, the Restructured Notes and the $280,000 Notes (collectively the “Notes”) have a face value of $940,000, bear interest at an annual rate of 16.5%, and were due December 15, 2005. The Notes are collateralized by substantially all of the Company’s tangible assets, excluding inventories, accounts receivable and sales contracts with respect to which the Company has granted a subordinated security interest. Mr. Richter has also pledged 2.0 million shares of common stock of Penn Octane owned by Mr. Richter including 1.0 million shares of common stock collateralizing Mr. Richter’s promissory note to the Company. As a result of the Spin-Off, Mr. Richter was also required to provide 250,000 Common Units of Rio Vista owned by him.

On September 30, 2005, the Company and holders of the Notes agreed to an amendment whereby the interest payments required to be paid on June 15, 2005 and September 15, 2005 were extended to December 15, 2005 (the “Deferred Interest”). Under the terms of the amendment, the Company agreed to pay additional interest at an annual rate of 16.5% on the Deferred Interest from the original due date through the date the Deferred Interest is paid. In addition, the Company agreed to pay to the holders of the Notes, an additional amount equal to 5% of the principal amount outstanding of the Notes upon maturity. Mr. Richter agreed that he would deliver 250,000 Common Units of Rio Vista (referred to above) to the collateral agent. The Company also agreed that it would not enter into any additional severance payment obligation in connection with the resignation of Mr. Richter until the Notes are fully paid. In addition, the holders of the Notes agreed to allow Rio Vista to pledge and deliver certain assets in connection with the TransMontaigne Note (see note D to the unaudited consolidated financial statements). The 250,000 Common Units of Rio Vista referenced above have not yet been delivered.

The Company did not pay the entire balance of principal and interest due under the Notes on December 15, 2005. On December 15, 2005 and January 1, 2006, the Company paid $426,143 and $159,171 to the holders of the Notes of which $267,750 represented payment of principal and related penalties to certain holders of the Notes and $317,564 represented total accrued and unpaid interest on the Notes through December 15, 2005.

During February 2006, the Company repaid $500,021 to certain holders of the Notes representing $488,250 of principal and related penalties and $11,771 of accrued interest.

During March 2006, the Company agreed to extend from December 31, 2006 to December 31, 2008 the expiration date on the Rio Vista warrants corresponding to the Notes then outstanding. The warrants were initially issued in connection with the December 15, 2003 amendment of the Notes. The Notes have not been renewed or extended since December 15, 2006. In connection with the extension of the warrants, the Company recorded additional interest expense of approximately $22,000. The Notes have not been renewed or extended since December 31, 2005.

During May 2006, the Company paid $61,418 to the holders of the Notes representing accrued interest and fees through March 15, 2006.

During June 2006, the Company paid $212,474 to the holders of the Notes representing $145,000 of principal and $67,474 of accrued interest and fees through June 15, 2006.

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Options and Warrants of Rio Vista

General Partner Options. On July 1, 2006, Penn Octane’s 100% interest in the General Partner was decreased to 50% as a result of the exercise by Shore Capital LLC (“Shore Capital”), an affiliate of Mr. Shore, and by Mr. Richter, of options to each acquire 25% of the General Partner (the “General Partner Options”). The exercise price for each option was approximately $82,000. Mr. Richter’s option was amended to permit payment of the exercise price by surrender of Penn Octane common stock having a fair market value equal to the exercise price. Mr. Richter paid the exercise price for his options by surrender of 136,558 shares of Penn Octane common stock. In connection with the exercise of the General Partner Options, Penn Octane retained control of the General Partner pursuant to a voting agreement with each of Shore Capital and Mr. Richter.

Common Unit Warrants. On March 9, 2005, the board of managers of the General Partner of Rio Vista approved the Rio Vista 2005 Equity Incentive Plan (the “2005 Plan”). The 2005 Plan permits the grant of common unit options, common unit appreciation rights, restricted common units and phantom common units to any person who is an employee (including to any executive officer) or consultant of Rio Vista or the General Partner or any affiliate of Rio Vista or the General Partner. The 2005 Plan provides that each outside manager of the General Partner shall be granted a common unit option once each fiscal year for not more than 5,000 common units, in an equal amount as determined by the board of managers. The aggregate number of common units authorized for issuance as awards under the 2005 Plan is 750,000. The 2005 Plan shall remain available for the grant of awards until March 9, 2015 or such earlier date as the board of managers may determine. The 2005 Plan is administered by the compensation committee of the board of managers. Under the terms of the Agreement and applicable rules of the NASDAQ Stock Market, no approval of the 2005 Plan by the common unitholders of Rio Vista was required.

On March 9, 2005, the board of managers of the General Partner of Rio Vista approved the grant of options to purchase a total of 108,750 common units under the 2005 Plan. Of the total number of options granted, 93,750 were granted to certain executive officers of the General Partner and to Mr. Richter and 15,000 were issued to outside managers of the General Partner. The exercise price for the options is $12.51 per common unit, which was the average of the high and low sales prices for Rio Vista common units as reported by the NASDAQ Stock Market on March 9, 2005. The options granted to executive officers (including Mr. Richter) were fully vested on the date of grant. The options granted to outside managers vested in equal monthly installments over a period of 12 months from the date of grant. All options become fully exercisable upon a change in control event and expire three years from the date of grant. The board of managers has not yet determined if Rio Vista will grant any common unit options for the fiscal year 2006.

The Spin-Off.

Intercompany Agreements

As a result of the Spin-Off, Rio Vista owns and operates the LPG distribution, transportation and marketing business previously conducted by Penn Octane. Rio Vista sells LPG directly to PMI and purchases LPG from Penn Octane under a long-term supply agreement. Intercompany agreements between Penn Octane and Rio Vista are as follows:

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LPG Supply Agreement with Rio Vista.Penn Octane entered into a long-term supply agreement (the “LPG Supply Agreement”) with Rio Vista pursuant to which Rio Vista has agreed to purchase all of its LPG requirements for sales which utilize the assets transferred to Rio Vista by Penn Octane to the extent Penn Octane is able to supply such LPG requirements. The LPG Supply Agreement further provides that Rio Vista has no obligation to purchase LPG from Penn Octane to the extent the distribution of such LPG to Rio Vista’s customers would not require the use of any of the assets Penn Octane transferred to Rio Vista or Penn Octane ceases to have the right to access the Leased Pipeline. The LPG Supply Agreement terminates on the earlier to occur of:

· Penn Octane ceases to have the right to access the Leased Pipeline that connects to Rio Vista’s Brownsville Terminal Facility; or

· Rio Vista ceases to sell LPG using any of the assets transferred by Penn Octane to Rio Vista pursuant to the Spin-Off.

Omnibus Agreement. In connection with the Spin-Off, Penn Octane entered into an Omnibus Agreement with Rio Vista that governs, among other things, indemnification obligations among the parties to the agreement, related party transactions and the provision of general administration and support services by Penn Octane.

The Omnibus Agreement prohibits Rio Vista from entering into any material agreement with Penn Octane without the prior approval of the conflicts committee of the board of managers of the General Partner. For purposes of the Omnibus Agreement, a material agreement is any agreement between Rio Vista and Penn Octane that requires aggregate annual payments in excess of $100,000.

The Omnibus Agreement may be amended by written agreement of the parties; provided, however that it may not be amended without the approval of the conflicts committee of the General Partner if the amendment would adversely affect the unitholders of Rio Vista. The Omnibus Agreement has an initial term of five years that automatically renews for successive five-year terms and, other than the indemnification provisions, will terminate if Rio Vista is no longer an affiliate of Penn Octane.

Rio Vista’s Guarantees

Debt Guarantee.  Rio Vista is liable as guarantor on the RZB Credit Facility and will continue to pledge all of its assets as collateral in connection with the RZB Credit Facility and other debt of the Company. Rio Vista may also be prohibited from making any distributions to unit holders if it would cause an event of default, or if an event of default exists, under the RZB Credit Facility.

Tax Guarantee. Further, if Penn Octane is determined to have a federal income tax liability in excess of the amounts which were included in the federal income tax return related to the Spin-Off and if Penn Octane is unable to pay such liabilities or Rio Vista is unable to pay, then the Internal Revenue Service may assert that the Penn Octane stockholders who received common units in the Spin-Off are liable for unpaid federal income taxes of Penn Octane, including interest and any penalties, up to the value of the Rio Vista Common Units received by each stockholder.

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Realization of Assets. The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplate continuation of the Company as a going concern. The Company has a loss from operations for the three months and six months ended June 30, 2006, has had an accumulated deficit since inception, has a deficit in working capital and a deficit in stockholders’ equity. In addition, substantially all of the Company’s assets are pledged or committed to be pledged as collateral on existing debt in connection with the Notes, the RZB Credit Facility and/or the TransMontaigne Note, and therefore, the Company may be unable to obtain additional financing collateralized by those assets. The Notes were due December 15, 2005 and notes totaling $865,000 were paid in December 2005, February 2006 and June 2006. Notes totaling $940,000 and still outstanding and have not been extended. The TransMontaigne Note may be due on demand by TransMontaigne unless the Restated LPG Asset Sale closes (see note D to the unaudited consolidated financial statements). The RZB Credit Facility may be insufficient to finance the Company’s LPG purchases and/or Fuel Products purchases, assuming increases in product costs per gallon, or volumetric growth in product sales, and may be terminated by RZB with 90 days notice.

The minimum volumes and applicable margins contained in the 2006 PMI Agreement are expected to provide the Company with gross profit similar to the gross profit the Company would have received if PMI had purchased only the minimum volumes provided under its agreements with Rio Vista during the period from May 1, 2005 to March 31, 2006 as a result of increased margins on lower volume levels contained in the 2006 PMI Agreement. Actual volumes purchased by PMI under those prior agreements, however, exceeded minimum contractual amounts by approximately 35%. There is no assurance that PMI will purchase volumes as indicated in the 2006 PMI Agreement or that PMI will continue to purchase LPG from Rio Vista or in quantities or prices that are profitable upon the expiration of the 2006 PMI Agreement. Assuming that the Restated LPG Asset Sale does not close, the Company projects that its gross profit from operations based on the minimum volumes and applicable margins contained in the 2006 PMI Agreement will not provide sufficient cash flow to pay its normal operating expenses through March 31, 2007, assuming breakeven results from its Fuel Sales Business, unless it can sufficiently reduce its operating expenses. In addition, the Company’s cash flow at the minimum volumes contained in the 2006 PMI Agreement is projected not to be sufficient to pay its other obligations, including its secured debt. The Fuel Sales Business is a relatively new business and, as a result, the Company does not believe it can rely on that portion of its business to provide sufficient additional cash flow.

Penn Octane and Rio Vista project that monthly cash flows from LPG sales during the months of July 2006 through September 2006 will be less than during the months of October 2006 through March 2007 as a result of reduced monthly volumes committed to be purchased during July 2006 through September 2006. In addition, the Company may be unable to make any necessary capital expenditures or to pay arrearages in distributions or to pay future distributions to Rio Vista’s unitholders during the Term of the 2006 PMI Agreement.

In the event Penn Octane does not pay its obligations when due, Rio Vista’s guarantees to Penn Octane and Penn Octane’s creditors may be triggered. Accordingly, Rio Vista may be required to pay such obligations of Penn Octane to avoid foreclosure against Rio Vista’s assets by Penn Octane’s creditors. Assuming that the Restated LPG Asset Sale does not close, Rio Vista projects that its gross profit from operations under the 2006 PMI Agreement, based on the minimum volumes and applicable margins, will not provide sufficient cash flow for Rio Vista to pay its normal operating expenses through March 31, 2007 unless it can sufficiently reduce its operating expenses. If the Company’s revenues and other sources of liquidity are not adequate to pay its obligations, Penn Octane or Rio Vista may be required to raise additional funds to avoid such foreclosure. There can be no assurance that such additional funding will be available on terms attractive to either Penn Octane or Rio Vista or available at all. If additional amounts cannot be raised and the Company is unable to restructure its obligations, the Company would suffer material adverse consequences to its business, financial condition and results of operations, and Penn Octane and/or Rio Vista would likely be required to seek other alternatives, which could include the sale of assets, closure of operations and/or protection under the U.S. bankruptcy laws.

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In view of the matters described in the preceding paragraphs, recoverability of the recorded asset amounts shown in the accompanying unaudited consolidated balance sheet is dependent upon either (1) closing of the Restated LPG Asset Sale or (2) the ability of the Company to generate sufficient cash flow through operations or additional debt or equity financing to pay its liabilities and obligations when due. If the Restated LPG Asset Sale does not close, the ability for the Company to generate sufficient cash flows from operations is significantly dependent on the sale of LPG to PMI at adequate average monthly sales volumes and margins, the success of the Fuel Sales Business and the adequacy of the RZB Credit Facility to finance such sales. The unaudited consolidated financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

To provide the Company with the ability it believes necessary to continue in existence, management is taking steps to close the Restated LPG Asset Sale. Management is also (i) seeking to expand its Fuel Sales Business and to further diversify its operations to reduce dependency on sales of LPG, (ii) seeking to maintain the amount of financing for its products and operations, and (iii) seeking to reduce supply costs and operating expenses. In the event that the Restated LPG Asset Sale is not closed, management may also continue to attempt to sell its LPG and refined products assets.

Impact of Inflation

Inflation in the United States and Mexico has been relatively low in recent years and did not have a material impact on the consolidated financial statements of the Company. However, inflation remains a factor in the United States and the Mexican economies and could increase the Company’s cost to acquire or replace property, plant and equipment as well as our labor and supply costs.

The Company may be adversely impacted as a result of increases in LPG prices and Fuel Products prices, which are related to oil and natural gas prices, because of limits on the RZB Credit Facility.

Environmental Matters

The Company’s operations are subject to environmental laws and regulations adopted by various governmental authorities in the jurisdictions in which these operations are conducted. Under the Omnibus Agreement, Penn Octane will indemnify Rio Vista for five years after the completion of the Spin-Off against certain potential environmental liabilities associated with the assets it contributed to Rio Vista relating to events or conditions that existed before the completion of the Spin-Off.

Pursuant to the Amended Lease, the Company has agreed to indemnify Seadrift for environmental liabilities, including claims relating to the condition of the Leased Pipeline and any environmental remediation costs, arising after the inception date of the lease, September 1, 1993.

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Recently Issued Financial Accounting Standards

In December 2004, the FASB issued Statement of Financial Accounting Standard No. 153, “Exchanges of Nonmonetary Assets-An Amendment of APB Opinion No. 29” (“SFAS 153”). The amendments made by SFAS 153 are based on the principle that exchanges on nonmonetary assets should be measured based on the fair value of the assets exchanged. The provisions in SFAS 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Early application is permitted and companies must apply the standard prospectively. The Company has determined that SFAS 153 will not have a material impact on its consolidated results of operations, financial position or cash flows.

In May 2005, the FASB issued Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”). This new standard replaces APB Opinion No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”. Among other changes, SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Early adoption of this standard is permitted for accounting changes and correction of errors made in fiscal years beginning after June 1, 2005. The Company has determined that SFAS 154 will not have a material impact on its consolidated results of operations, financial position or cash flows.

In March 2005, the Financial Accounting Standards Board issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations. Under the provisions of FIN No. 47, the term conditional asset retirement obligation as used in SFAS No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity while the obligation to perform the asset retirement activity is unconditional. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation is required to be recognized when incurred - generally upon acquisition, construction, or development and/or through the normal operation of the asset. The Company has adopted FIN No. 47 as of December 31, 2005. Adoption of this pronouncement did not have a significant effect on its 2005 consolidated financial statements, and the Company does not expect this pronouncement to have a significant effect on its future reported financial position or earnings.

In February 2006, the FASB issued FASB Statement No. 155, Accounting for Certain Hybrid Instruments. This standard amends the guidance in FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Statement 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. Statement 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006.

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Critical Accounting Policies

The unaudited consolidated financial statements of the Company reflect the selection and application of accounting policies which require management to make significant estimates and judgments. See note B to the Company’s consolidated financial statements included in its Annual Report on Form 10-K for the fiscal year ended December 31, 2005, “Summary of Significant Accounting Policies”. The Company believes that the following reflect the more critical accounting policies that affect the financial position and results of operations.

Revenue recognition - the Company expects in the future to enter into sales agreements to sell LPG and Fuel Products for future delivery. The Company will not record sales until the LPG and Fuel Products are delivered to the customer.

Impairment of long-lived assets - The determination of whether impairment has occurred is based on an estimate of undiscounted cash flows attributable to assets in future periods. If impairment has occurred, the amount of the impairment loss recognized will be determined by estimating the fair value of the assets and recording a loss if the fair value is less than the carrying value. Assessments of impairment are subject to management’s judgments and based on estimates that management is required to make.

Depreciation and amortization expenses - Property, plant and equipment are carried at cost less accumulated depreciation and amortization. Depreciation and amortization rates are based on management’s estimate of the future utilization and useful lives of the assets.

Share-based payment - The Company accounts for share-based payment using the provisions of SFAS 123R (fair value method).

Allowance for doubtful accounts - The carrying value of trade accounts receivable is based on estimated fair value. The determination of fair value is subject to management’s judgments and is based on estimates that management is required to make.

Statement by Management Concerning Review of Interim Information by An Independent Registered Public Accounting Firm.

The unaudited consolidated financial statements included in this filing on Form 10-Q have been reviewed by Burton McCumber & Cortez, L.L.P., an independent registered public accounting firm, in accordance with established professional standards and procedures for such review. The report of Burton McCumber & Cortez, L.L.P. commenting on their review, accompanies the unaudited consolidated financial statements included in Item 1 of Part I.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk.

To the extent that the Company maintains quantities of LPG inventory in excess of commitments for quantities of undelivered LPG and/or has commitments for undelivered LPG in excess of inventory balances, the Company is exposed to market risk related to the volatility of LPG prices. In the event that inventory balances exceed commitments for undelivered LPG, during periods of falling LPG prices, the Company may sell excess inventory to customers to reduce the risk of these price fluctuations.

The Company generally does not maintain quantities of LPG inventory in excess of quantities actually ordered by PMI. Therefore, the Company has not currently entered into and does not currently expect to enter into any arrangements in the future to mitigate the impact of commodity price risk.

To the extent the Company maintains quantities of Fuel Products inventory in excess of commitments for quantities of undelivered Fuel Products; the Company is exposed to market risk related to the volatility of Fuel Product prices. In the event that inventory balances exceed commitments for undelivered Fuel Products, during periods of falling Fuel Products prices, the Company may sell excess inventory to customers to reduce the risk of these price fluctuations.

The Company has existing debt at both fixed and variable interest rates (see note I to the consolidated financial statements). Trade accounts receivable from the Company’s limited number of customers and the Company’s trade and other accounts payable generally do not bear interest. The Company’s credit facility with RZB provides for cash advances at a current variable interest rate. Fees paid to RZB for letters of credit are based on a fixed schedule as provided in the Company’s agreement with RZB. The Company currently has limited, if any, interest rate risk.

The Company routinely converts U.S. dollars into Mexican pesos to pay terminal operating costs and income taxes. Such costs have historically been less than $1 million per year and the Company expects such costs will remain at less than $1 million in any year. The Company does not maintain Mexican peso bank accounts with other than nominal balances. Therefore, the Company has limited, if any, risk related to foreign currency exchange rates.

Item 4. Controls and Procedures.

The Company’s management, including the principal executive officer and principal financial officer, are responsible for establishing and maintaining disclosure controls and procedures and internal controls and therefore have conducted an evaluation of the Company’s disclosure controls and procedures and internal controls, as such term is defined under Rule 13a-15 promulgated under the Securities Exchange Act of 1934, as of June 30, 2006. Based on their evaluation, the Company’s principal executive officer and principal accounting officer concluded that the Company’s disclosure controls and procedures and internal controls are effective.

There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph above.

The Company is not required to complete an annual evaluation pursuant to Section 404 of the Sarbanes Oxley Act of 2002 of its internal controls systems until the year ended December 31, 2007.

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PART II

Item 1. Legal Proceedings

See note J to the Company’s unaudited consolidated financial statements included in this Report.

Item 1A. Risk Factors

Business Factors. Beginning with the expiration of the LPG sales contract with PMI effective March 31, 2004 and continuing through the PMI Confirmation entered into with PMI effective May 1, 2006, the Company has experienced materially lower LPG sales volumes and/or margins that have adversely affected the Company’s results of operations. Penn Octane has one major customer for LPG, Rio Vista, and Rio Vista has only one customer for LPG in Mexico, PMI. The Company commenced its Fuel Sales Business in June 2004. There is no assurance that PMI will purchase volumes as indicated in the PMI Confirmation or that PMI will continue to purchase LPG from Rio Vista or in quantities or prices that are profitable upon the expiration of the PMI Confirmation. There are a limited number of suppliers of LPG that connect to the Company’s pipelines and a limited supply of LPG. The Company may lose its competitive advantage when the Company’s Seadrift pipeline lease expires in 2013. The Company may be unable to successfully develop additional sources of revenue in order to reduce its dependence on PMI. The Company may not have sufficient cash to meet its obligations. All of the Company’s assets are pledged as collateral for existing debt, and the Company therefore may be unable to obtain additional financing collateralized by such assets. The Company is at risk of economic loss due to fixed margin contracts. If the Company cannot develop sufficient capital resources for acquisitions or opportunities for expansion, the Company’s growth will be limited. The Company’s ability to grow the Fuel Sales Business is largely dependent on available financing which may be limited. Future acquisitions and expansions may not be successful, may substantially increase the Company’s indebtedness and contingent liabilities, and may create integration difficulties. The Company’s business would be adversely affected if operations at the Company’s transportation, terminal and distribution facilities were interrupted. The Company’s business would also be adversely affected if the operations of the Company’s customers or suppliers were interrupted.

Restated LPG Asset Sale. There can be no assurance that the Restated LPG Asset Sale will be completed according to the terms contained in the Restated LPG Asset Sale or according to different terms or at all. Even if the Restated LPG Asset Sale is completed, Rio Vista may be unable to resume payment of minimum quarterly distributions or to pay the arrearages of such distributions, in order to maintain cash reserves necessary for the conduct of business. If the Restated LPG Asset Sale is completed, the RZB Credit Facility may be restructured and/or reduced. A continued delay of or inability to close the Restated LPG Asset Sale could have a material adverse effect on Penn Octane’s and Rio Vista’s business, financial condition and results of operations.See the Management’s Discussion and Analysis of Financial Condition and Results of Operations - Purchase and Sale Agreements.

Market Listing. On July 19, 2006 pursuant to a written determination received from The NASDAQ Stock Market’s Listing Qualification Department on July 17, 2006, Penn Octane’s common stock was delisted from the NASDAQ Capital Market. As a result of the delisting, Penn Octane’s common stock began trading on the Pink Sheets, a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time. Penn Octane is currently seeking quotation in the OTC Bulletin Board through a market maker. The OTC Bulletin Board is a regulated quotation service that displays real-time quotes, last sale prices and volume information in over-the-counter securities. There is no assurance that Penn Octane will be quoted on the OTC Bulletin Board. Penn Octane will continue to file all required reports with the Securities and Exchange Commission. The delisting by NASDAQ could result in decreased market interest in Penn Octane common stock, investors and stockholders may experience more difficulty in buying and selling Penn Octane common stock and Penn Octane’s common stock price may decline. In addition, Penn Octane may experience greater difficulty in obtaining necessary debt and equity capital for potential acquisitions or the operation of its business.

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Competitive Factors. The energy industry is highly competitive. There is competition within the industries and also with other industries in supplying the energy and fuel needs of the industrial and individual consumers. The Company competes with other companies in the sale or purchase of LPG and Fuel Products as well as the transportation of these products in the US and Mexican markets and employs all methods of competition which are lawful and appropriate for such purposes. A key component of the Company’s competitive position, particularly given the commodity nature of its products, is its ability to manage its expenses successfully, which requires continuous management focus on reducing unit costs and improving efficiency and its ability to secure unique opportunities for the purchase, sale and/or delivery methods of its products.

International Factors. Mexican economic, political and social conditions may change and adversely affect the Company’s operations. The Company may not be able to continue operations in Mexico if Mexico restricts the existing ownership structure of its Mexican operations, requiring the Company to increase its reliance on Mexican nationals to conduct its business. The LPG market in Mexico has yet to be deregulated. If deregulation occurs, the results may hinder the Company’s ability to negotiate acceptable contracts with distributors. The Company’s contracts and Mexican business operations are subject to volatility in currency exchange rates which could negatively impact its earnings.

Political Factors. The operations and earnings of the Company in the US and Mexico have been, and may in the future be, affected from time to time in varying degree by political instability and by other political developments and laws and regulations, such as forced divestiture of assets; restrictions on production, imports and exports; war or other international conflicts; civil unrest and local security concerns that threaten the safe operation of the Company’s facilities; price controls; tax increases and retroactive tax claims; expropriation of property; cancellation of contract rights; and environmental regulations. Both the likelihood of such occurrences and their overall effect upon the Company vary greatly and are not predictable.

Industry and Economic Factors. The operations and earnings of the Company throughout the US and Mexico are affected by local, regional and global events or conditions that affect supply and demand for the Company’s products. These events or conditions are generally not predictable and include, among other things, general economic growth rates and the occurrence of economic recessions; the development of new supply sources for its products; supply disruptions; weather, including seasonal patterns that affect energy demand and severe weather events that can disrupt operations; technological advances, including advances in exploration, production, refining and advances in technology relating to energy usage; changes in demographics, including population growth rates and consumer preferences; and the competitiveness of alternative hydrocarbon or other energy sources or product substitutes.

Acquisition Factors. In addition to the factors cited above, the advancement, cost and results of particular projects sought by the Company, including projects which do not specifically fall within the areas of the Company’s current lines of businesses will depend on: the outcome of negotiations for such projects; the ability of the Company’s management to manage such businesses; the ability of the Company to obtain financing for such acquisitions; business integration issues; changes in operating conditions or costs; and the occurrence of unforeseen technical difficulties.

Market Risk Factors. See “Notes to Consolidated Financial Statements,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosures About Market Risk” in this report for discussion of the impact of market risks, inflation and other uncertainties.

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Internal Control Factors. Pursuant to Section 404 of the Sarbanes Oxley Act of 2002, beginning with the fiscal year ended December 31, 2007, the Company is required to complete an annual evaluation of its internal control systems. In addition, the Company’s independent auditors are required to provide an opinion regarding such evaluation and the adequacy of the Company’s internal accounting controls. The Company’s internal controls may be found to be inadequate, deficiencies or weaknesses may be discovered, and remediation may not be successful. If the Company acquires an existing business, the internal control systems of the acquired business may be inadequate and may require additional strengthening.

Projections. Projections, estimates and descriptions of the Company’s plans and objectives included or incorporated in Part I. Items 1. and 2. and Part II. Items 1. and 1A. of this report are forward-looking statements. Actual future results could differ materially due to, among other things, the factors discussed above and elsewhere in this report.

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

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

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Item 6. Exhibits

The following exhibits are incorporated by reference to previously filed reports, as noted.

Exhibit No.

10.1 Matamoros LPG Mix Purchase and Sales Agreement made and entered into as of June 4, 2005, by and between Rio Vista Energy Partners L.P. and P.M.I. Trading Limited (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005 filed on August 19, 2005, SEC File No. 000-24394).

10.2 Purchase and Sale Agreement dated as of August 15, 2005 between Penn Octane Corporation and TransMontaigne Product Services Inc. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005 filed on August 19, 2005, SEC File No. 000-24394).

10.3 Form of Amendment of Promissory Note(s) of Penn Octane Corporation due December 15, 2005 and Related Agreements dated September 30, 2005. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 filed on August 14, 2006, SEC File No. 000-24394).

10.4 Form of Escrow Agreement dated as of September 30, 2005 by and between Jerome B. Richter, Penn Octane Corporation and the Noteholders of Promissory Notes of Penn Octane due on December 15, 2005. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 filed on August 14, 2006, SEC File No. 000-24394).

10.5 Fourth Amendment to Purchase, Sale and Service Agreement for Propane/Butane Mix made and extended into effective March 1, 2006 by and between Exxon Mobil Gas and Power Marketing Company and Penn Octane Corporation. (Incorporated by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 filed on April 6, 2006, SEC File No. 000-24394).

10.6 Amendment No. 1 to Purchase and Sale Agreement between Penn Octane Corporation and TransMontaigne Product Services Inc., dated January 26, 2006. (Incorporated by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 filed on April 6, 2006, SEC File No. 000-24394).

10.7 Amended and Restated Consulting Agreement dated November 15, 2005 between Penn Octane Corporation, Rio Vista Energy Partners L.P. and Jerome B. Richter. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 filed on November 21, 2005, SEC File No. 000-24394).

10.8 Amended and Restated Promissory Note by Jerome B. Richter to the Company dated November 15, 2005. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 filed on November 21, 2005, SEC File No. 000-24394).

10.9 Agreement dated as of November 15, 2005 by and between Penn Octane Corporation and Jerome B. Richter. (Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005 filed on November 21, 2005, SEC File No. 000-24394).

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The following Exhibits are filed as part of this report:

2.1 Purchase and Sale Agreement dated August 15, 2006 as amended and restated on August 15, 2006 entered into by and between Penn Octane Corporation and TransMontaigne Product Services Inc.

2.2 Purchase and Sale Agreement dated August 15, 2006 as amended and restated on August 15, 2006 entered into by and between Rio Vista Operating Partnership L.P. and TransMontaigne Product Services Inc.

10.10 Ella-Brownsville Pipeline Lease Agreement effective as of August 1, 2006 between Seadrift Pipeline Corporation and Penn Octane Corporation.

10.11 Matamoros LPG Mix Purchase and Sales Agreement made and entered into as of April 28, 2006, by and between Rio Vista Operating Partnership L.P. and P.M.I. Trading Limited.

15 Accountant’s Acknowledgment.

31.1 Certification Pursuant to Rule 13a - 14(a) / 15d - 14(a) of the Exchange Act.

31.2 Certification Pursuant to Rule 13a - 14(a) / 15d - 14(a) of the Exchange Act.

32 Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes -Oxley Act of 2002.

All of the Exhibits are available from the SEC’s website at www.sec.gov. In addition, Penn Octane will furnish a copy of any Exhibit upon payment of a fee (based on the estimated actual cost which shall be determined at the time of a request) together with a request addressed to Ian T. Bothwell, Penn Octane Corporation, 77-530 Enfield Lane, Bldg. D, Palm Desert, California 92211.

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SIGNATURES

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

	PENN OCTANE CORPORATION
August 14, 2006	By:	/s/Ian T. Bothwell
		Ian T. Bothwell
		Vice President, Chief Financial Officer, Treasurer, and Assistant Secretary

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