**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark  One)**                                             |
|-------------------------------------------------------------|
| ** **                                                  |
| **x**                                                       | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                        |   |   |
| **For  the quarterly period ended September 30, 2009** |
|                                                        |   |   |
| **o**                                                       | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commissionfile number 001-32496**

 

**CANO PETROLEUM, INC.**

(Exact name ofRegistrant as specified in its charter)

 

| **Delaware**                                                                                    | ** ** | **77-0635673**                        |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)                                |       | (IRS Employer  Identification Number) |
|                                                                                            |       |                                  |
| **801  Cherry St., Suite 3200  Fort Worth, Texas**(Address of  principal executive office) | ** ** | **76102**(Zip Code)                   |

 

**(817) 698-0900**(Registrant’stelephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the ExchangeAct:

 

| **Title of each class:**   | ** ** | **Name of each exchange on which registered:** |
|-------------------------------------------|------------|------------------------------------------------------------------------------|
| COMMON STOCK,  PAR VALUE $.0001 PER SHARE |       | NYSE AMEX                                                                    |

 

Securitiesregistered pursuant to Section 12(g) of the Exchange Act: **None**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§ 232.405 of thischapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes o No o

 

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 

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

 

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

 

The number of sharesoutstanding of the registrant’s common stock, par value $.0001 per share, as ofNovember 12, 2009 was 45,570,147 shares.

 

 

 

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**PART I— FINANCIAL INFORMATION**

 

**Item1. Financial Statements.**

 

**CANOPETROLEUM, INC.CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                                                                                                    | ** ** | **September 30,** | ** **        | **June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------------|-------------------|------------|
| **In Thousands, Except Shares and Per Share Amounts**                                                                                                                                                                                                                                                                                      | ** ** | **2009**               | ** **        | **2009**          | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                                                                                                                                  | ** ** | ** **             | ** **        | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                                                                                                                            | ** ** | ** **             | ** **        | ** **        | ** ** |
| Cash  and cash equivalents                                                                                                                                                                                                                                                                                                                                                    |       | $                      |  761         |              | $          |  392 |   |
| Accounts  receivable                                                                                                                                                                                                                                                                                                                                                          |       | 2,474                  |              | 2,999             |       |
| Derivative  assets                                                                                                                                                                                                                                                                                                                                                            |       | 4,385                  |              | 4,955             |       |
| Inventory  and other current assets                                                                                                                                                                                                                                                                                                                                           |       | 1,394                  |              | 810               |       |
| Total  current assets                                                                                                                                                                                                                                                                                                                                                         |       | 9,014                  |              | 9,156             |       |
| **Oil and gas properties**, successful efforts method                                                                                                                                                                                                                                                                                                                         |       | 294,677                |              | 288,857           |       |
| Less  accumulated depletion and depreciation                                                                                                                                                                                                                                                                                                                                  |       | (41,358                | )                 | (40,208           | )          |
| Net  oil and gas properties                                                                                                                                                                                                                                                                                                                                                   |       | 253,319                |              | 248,649           |       |
| Fixed  assets and other, net                                                                                                                                                                                                                                                                                                                                                  |       | 3,071                  |              | 3,240             |       |
| Derivative  assets                                                                                                                                                                                                                                                                                                                                                            |       | 1,840                  |              | 2,882             |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                                      |       | 101                    |              | 101               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                                                                                                              | ** ** | **$**                  | ** 267,345** | ** **        | **$**      | ** 264,028** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                          |       |                   |              |              |       |
| ***LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                                                                                                             |       |                   |              |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                                                                                                                       |       |                   |              |              |       |
| Accounts  payable                                                                                                                                                                                                                                                                                                                                                             |       | $                      |  5,837       |              | $          |  4,434 |   |
| Accrued  liabilities                                                                                                                                                                                                                                                                                                                                                          |       | 2,653                  |              | 2,003             |       |
| Deferred  tax liabilities                                                                                                                                                                                                                                                                                                                                                     |       | 1,432                  |              | 1,431             |       |
| Oil  and gas sales payable                                                                                                                                                                                                                                                                                                                                                    |       | 718                    |              | 702               |       |
| Derivative  liabilities                                                                                                                                                                                                                                                                                                                                                       |       | 199                    |              | 159               |       |
| Current  portion of asset retirement obligations                                                                                                                                                                                                                                                                                                                              |       | 88                     |              | 86                |       |
| Total  current liabilities                                                                                                                                                                                                                                                                                                                                                    |       | 10,927                 |              | 8,815             |       |
| **Long-term liabilities**                                                                                                                                                                                                                                                                                                                                                     |       |                   |              |              |       |
| Long-term  debt                                                                                                                                                                                                                                                                                                                                                               |       | 61,200                 |              | 55,700            |       |
| Asset  retirement obligations                                                                                                                                                                                                                                                                                                                                                 |       | 2,883                  |              | 2,818             |       |
| Derivative  liabilities                                                                                                                                                                                                                                                                                                                                                       |       | 644                    |              | —            |       |
| Deferred  tax liabilities                                                                                                                                                                                                                                                                                                                                                     |       | 21,200                 |              | 22,831            |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                                                                            |       | 96,854                 |              | 90,164            |       |
| **Temporary equity**                                                                                                                                                                                                                                                                                                                                                          |       |                   |              |              |       |
| Series D  convertible preferred stock and cumulative paid-in-kind dividends; par value $.0001  per share, stated value $1,000 per share; 49,116 shares authorized; 23,849  issued at September 30, 2009 and June 30, 2009, respectively;  liquidation preference at September 30, 2009 and  June 30, 2009 of $27,265 and $26,987,  respectively |       | 25,683                 |              | 25,405            |       |
| **Commitments and contingencies (Note 12)**                                                                                                                                                                                                                                                                                                                                   |       |                   |              |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                                                                                                                                 |       |                   |              |              |       |
| Common  stock, par value $.0001 per share; 100,000,000 authorized; 47,273,224 and 45,570,147  shares issued and outstanding, respectively, at September 30, 2009; and 47,297,910  and 45,594,833 shares issued and outstanding, respectively, at June 30,  2009                                                                                                     |       | 5                      |              | 5                 |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                                                   |       | 189,906                |              | 189,526           |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                                          |       | (44,406                | )                 | (40,375           | )          |
| Treasury  stock, at cost; 1,703,077 shares held in escrow at September 30, 2009  and June 30, 2009, respectively                                                                                                                                                                                                                                                    |       | (697                   | )                 | (697              | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                                                              |       | 144,808                |              | 148,459           |       |
| **TOTAL LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                                                        | ** ** | **$**                  | ** 267,345** | ** **        | **$**      | ** 264,028** | ** ** |

 

***See accompanying notes to these unaudited financialstatements.***

 

2

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**CANOPETROLEUM, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** **   |
|-----------------------------------------------------------------------------------|------------|------------------------|--------------|
| ** **                                                                        | ** ** | **September 30,** | ** **   |
| **In Thousands, Except Per Share Data**                  | ** ** | **2009**               | ** **   | **2008** | ** ** |
| **Operating Revenues:**                                                           | ** ** | ** **             | ** **   | ** ** | ** ** |
| Crude  oil sales                                                                  |       | $                      |  4,431  |   | $ |  8,118 |   |
| Natural  gas sales                                                                |       | 833                    |         | 2,734 |   |
| Other  revenue                                                                    |       | —                 |         | 79 |   |
| Total  operating revenues                                                         |       | 5,264                  |         | 10,931 |   |
|                                                                              |       |                   |         |   |   |
| **Operating Expenses:**                                                           |       |                   |         |   |   |
| Lease  operating                                                                  |       | 4,416                  |         | 5,071 |   |
| Production  and ad valorem taxes                                                  |       | 467                    |         | 1,052 |   |
| General  and administrative                                                       |       | 3,573                  |         | 4,860 |   |
| Depletion  and depreciation                                                       |       | 1,263                  |         | 1,211 |   |
| Accretion  of discount on asset retirement obligations                            |       | 67                     |         | 75 |   |
| Total  operating expenses                                                         |       | 9,786                  |         | 12,269 |   |
|                                                                              |       |                   |         |   |   |
| **Loss from operations**                                                          |       | (4,522                 | )            | (1,338 | ) |
|                                                                              |       |                   |         |   |   |
| **Other income (expense):**                                                       |       |                   |         |   |   |
| Interest  expense and other                                                       |       | (158                   | )            | (132 | ) |
| Gain  (loss) on derivatives                                                       |       | (512                   | )            | 23,695 |   |
| Total  other income (expense)                                                     |       | (670                   | )            | 23,563 |   |
|                                                                              |       |                   |         |   |   |
| Income  (loss) from continuing operations before income taxes                     |       | (5,192                 | )            | 22,225 |   |
| Deferred  income tax benefit (expense)                                            |       | 1,631                  |         | (8,619 | ) |
|                                                                              |       |                   |         |   |   |
| Income  (loss) from continuing operations                                         |       | (3,561                 | )            | 13,606 |   |
| Loss  from discontinued operations, net of related taxes of $491 in 2008 (Note 6) |       | —                 |         | (852 | ) |
| **Net income (loss)**                                                             |       | (3,561                 | )            | 12,754 |   |
|                                                                              |       |                   |         |   |   |
| Preferred  stock dividend                                                         |       | (470                   | )            | (936 | ) |
|                                                                              |       |                   |         |   |   |
| **Net income (loss) applicable to common stock**                                  |       | $                      |  (4,031 | ) | $ |  11,818 |   |
|                                                                              |       |                   |         |   |   |
| **Net income (loss) per share - basic**                                           |       |                   |         |   |   |
| Continuing  operations                                                            |       | $                      |  (0.09  | ) | $ |  0.28 |   |
| Discontinued  operations                                                          |       | —                 |         | (0.02 | ) |
| **Net income (loss) per share - basic**                                           |       | $                      |  (0.09  | ) | $ |  0.26 |   |
|                                                                              |       |                   |         |   |   |
| **Net income (loss) per share - diluted**                                         |       |                   |         |   |   |
| Continuing  operations                                                            |       | $                      |  (0.09  | ) | $ |  0.25 |   |
| Discontinued  operations                                                          |       | —                 |         | (0.02 | ) |
| **Net income (loss) per share - diluted**                                         |       | $                      |  (0.09  | ) | $ |  0.23 |   |
|                                                                              |       |                   |         |   |   |
| **Weighted average common shares outstanding**                                    |       |                   |         |   |   |
| Basic                                                                             |       | 45,571                 |         | 46,230 |   |
| Diluted                                                                           |       | 45,571                 |         | 54,739 |   |

 

***See accompanying notes to these unaudited financialstatements.***

 

3

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**CANOPETROLEUM, INC.CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITYJULY 1, 2009 THROUGH SEPTEMBER 30, 2009(Unaudited)**

 
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** **  | **Additional**  | ** ** | ** **              | ** ** | ** **             | ** **        | ** ** | ** **    | **Total**  | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-------------|-------------|-----------------|------------|-------------------------|------------|------------------------|-------------------|------------|---------------|------------|------------|
| ** **                                     | ** ** | **Common Stock** | ** ** | **Paid-in** | ** **  | **Accumulated** | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** **        |
| **Dollar Amounts in Thousands** | ** ** | **Shares**            | ** ** | **Amount**  | ** **  | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares**             | ** **        | **Amount** | ** **    | **Equity** | ** ** |
|                                           |       |                  |       |        |        |            |       |                    |       |                   |              |       |          |       |       |
| **Balance at July 1, 2009**               | ** ** | **47,297,910**        | ** ** | **$**       | ** 5** | ** **      | **$**      | ** 189,526**       | ** ** | **$**                  | ** (40,375** | **)**      | **1,703,077** | ** ** | **$**      | ** (697** | **)** | **$** | ** 148,459** | ** ** |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** **  | ** **      | ** ** | ** **              | ** ** | ** **             | ** **        | ** ** | ** **    | ** ** | ** ** |
| Forfeiture  and surrender of restricted stock  |       | (24,686               | )          | —      |        | (28             | )          | —                  |       | —                 |              | —     |          | (28        | )          |
|                                           |       |                  |       |        |        |            |       |                    |       |                   |              |       |          |       |       |
| Stock-based  compensation expense              |       | —                |       | —      |        | 408             |       | —                  |       | —                 |              | —     |          | 408        |       |
|                                           |       |                  |       |        |        |            |       |                    |       |                   |              |       |          |       |       |
| Preferred  stock dividend                      |       | —                |       | —      |        | —          |       | (470                    | )          | —                 |              | —     |          | (470       | )          |
|                                           |       |                  |       |        |        |            |       |                    |       |                   |              |       |          |       |       |
| Net  loss                                      |       | —                |       | —      |        | —          |       | (3,561                  | )          | —                 |              | —     |          | (3,561     | )          |
|                                           |       |                  |       |        |        |            |       |                    |       |                   |              |       |          |       |       |
| **Balance at September 30, 2009**         | ** ** | **47,273,224**        | ** ** | **$**       | ** 5** | ** **      | **$**      | ** 189,906**       | ** ** | **$**                  | ** (44,406** | **)**      | **1,703,077** | ** ** | **$**      | ** (697** | **)** | **$** | ** 144,808** | ** ** |

 

***See accompanying notes to these unaudited financialstatements.***

 

4

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 **CANO PETROLEUM, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
| ** **                                                                             | ** ** | **Three Months Ended September 30,** | ** **    |
|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------|---------------|
| **In Thousands**                                                                  | ** ** | **2009**                                                 | ** **    | **2008** | ** ** |
| **Cash flow from operating activities:**                                               |       |                                                     |          |   |   |
| Net  income (loss)                                                                     |       | $                                                        |  (3,562  | ) | $ |  12,754 |   |
| Adjustments  needed to reconcile net income (loss) to net cash provided by operations: |       |                                                     |          |   |   |
| Unrealized  loss (gain) on derivatives                                                 |       | 2,307                                                    |          | (24,247 | ) |
| Accretion  of discount on asset retirement obligations                                 |       | 68                                                       |          | 77 |   |
| Depletion  and depreciation                                                            |       | 1,262                                                    |          | 1,219 |   |
| Impairment  of oil and gas properties                                                  |       | —                                                   |          | 3,516 |   |
| Stock-based  compensation expense                                                      |       | 408                                                      |          | 958 |   |
| Deferred  income tax expense (benefit)                                                 |       | (1,631                                                   | )             | 8,128 |   |
| Amortization  of debt issuance costs and prepaid expenses                              |       | 402                                                      |          | 362 |   |
|                                                                                   |       |                                                     |          |   |   |
| Changes  in assets and liabilities relating to operations:                             |       |                                                     |          |   |   |
| Accounts  receivable                                                                   |       | 1,063                                                    |          | 562 |   |
| Derivative  assets                                                                     |       | (549                                                     | )             | — |   |
| Inventory  and other current assets and liabilities                                    |       | (894                                                     | )             | (956 | ) |
| Accounts  payable                                                                      |       | 994                                                      |          | (107 | ) |
| Accrued  liabilities                                                                   |       | 621                                                      |          | 483 |   |
| Oil  and gas sales payable                                                             |       | 16                                                       |          | (234 | ) |
| Derivative  liability                                                                  |       | —                                                   |          | 144 |   |
| **Net cash provided by operations**                                                    | ** ** | **505**                                                  | ** **    | **2,659** | ** ** |
|                                                                                   |       |                                                     |          |   |   |
| **Cash flow from investing activities:**                                               |       |                                                     |          |   |   |
| Additions  to oil and gas properties, fixed assets and other                           |       | (5,445                                                   | )             | (16,510 | ) |
| Proceeds  from sale of equipment used in oil and gas activities                        |       | —                                                   |          | 2,135 |   |
| **Net cash used in investing activities**                                              | ** ** | **(5,445**                                               | **)**         | **(14,375** | **)** |
|                                                                                   |       |                                                     |          |   |   |
| **Cash flow from financing activities:**                                               |       |                                                     |          |   |   |
| Repayments  of long-term debt                                                          |       | —                                                   |          | (54,500 | ) |
| Borrowings  of long-term debt                                                          |       | 5,500                                                    |          | 23,700 |   |
| Payments  for debt issuance costs                                                      |       | —                                                   |          | (305 | ) |
| Proceeds  from issuance of common stock, net                                           |       | —                                                   |          | 53,908 |   |
| Payment  of preferred stock dividend                                                   |       | (191                                                     | )             | (403 | ) |
| **Net cash provided by financing activities**                                          | ** ** | **5,309**                                                | ** **    | **22,400** | ** ** |
|                                                                                   |       |                                                     |          |   |   |
| Net  increase in cash and cash equivalents                                             |       | 369                                                      |          | 10,684 |   |
| Cash  and cash equivalents at beginning of period                                      |       | 392                                                      |          | 771 |   |
| **Cash and cash equivalents at end of period**                                         | ** ** | **$**                                                    | ** 761** | ** ** | **$** | ** 11,455** | ** ** |
|                                                                                   |       |                                                     |          |   |   |
| **Supplemental disclosure of noncash transactions:**                                   |       |                                                     |          |   |   |
| Payments  of preferred stock dividend in kind                                          |       | $                                                        |  278     |   | $ |  533 |   |
|                                                                                   |       |                                                     |          |   |   |
| **Supplemental disclosure of cash transactions:**                                      |       |                                                     |          |   |   |
| Cash  paid during the period for interest                                              |       | $                                                        |  666     |   | $ |  605 |   |

 

***See accompanying notes to these unaudited financialstatements.***

 

5

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**CANOPETROLEUM, INC.**

**NOTESTO FINANCIAL STATEMENTS**

 

**1.   BASIS OF PRESENTATION AND USE OF ESTIMATES**

 

***Consolidation and Use of Estimates***

 

The interim consolidatedfinancial statements are unaudited and contain all adjustments (consistingprimarily of normal recurring accruals) necessary for a fair statement of theresults for the interim periods presented. Results for interim periods are notnecessarily indicative of results to be expected for a full year due in part,but not limited to, the volatility in prices for crude oil and natural gas,future prices for commodity derivatives, interest rates, estimates of reserves,drilling risks, geological risks, transportation restrictions, the timing ofacquisitions, product demand, market competition, interruption in production,our ability to obtain additional capital, and the success of waterflooding andenhanced oil recovery techniques. You should read these consolidated interimfinancial statements in conjunction with the audited consolidated financialstatements and notes thereto included in our Annual Report on Form 10-Kfor the year ended June 30, 2009.

 

The accompanyingfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) andinclude the accounts of Cano and its wholly-owned subsidiaries. Intercompanyaccounts and transactions are eliminated. In preparing the accompanyingfinancial statements, management has made certain estimates and assumptionsthat affect reported amounts in the financial statements and disclosures ofcontingencies. Actual results may differ from those estimates. The computationof stock-based compensation expense requires assumptions such as volatility,expected life and the risk-free interest rate. The computation ofmark-to-market valuation of our commodity derivatives includes the observabilityof quoted market prices and an assessment of potential non-performance of thecounterparties.  It is at leastreasonably possible these estimates could be revised in the near term, andthese revisions could be material.

 

Significant assumptionsare required in the valuation of proved crude oil and natural gas reserves,which may affect the amount at which crude oil and natural gas properties arerecorded. Our estimates of proved reserves materially impact depletion expense.If proved reserves decline, then the rate at which we record depletion expenseincreases. A decline in estimated proved reserves could result from lowerprices, adverse operating results, mechanical problems at our wells andcatastrophic events such as explosions, hurricanes and floods. Lower pricesalso may make it uneconomical to drill wells or produce from fields with highoperating costs. In addition, a decline in proved reserves may impact ourassessment of our oil and natural gas properties for impairment. Our provedreserves estimates are a function of many assumptions, all of which coulddeviate materially from actual results. As such, reserves estimates may varymaterially from the ultimate quantities of crude oil and natural gas actuallyproduced.

 

***New Accounting Pronouncements***

 

In June 2009,the Financial Accounting Standards Board (“FASB”) issued a standard thatestablished the FASB Accounting Standards CodificationTM (“ASC”)and amended the hierarchy of GAAP such that the ASC became the single source ofauthoritative nongovernmental GAAP. The ASC did not change current GAAP, butwas intended to simplify user access to all authoritative GAAP by providing allthe authoritative literature related to a particular topic in one place. Allpreviously existing accounting standard documents were superseded and all otheraccounting literature not included in the ASC is considered non-authoritative.New accounting standards issued subsequent to June 30, 2009 arecommunicated by the FASB through Accounting Standards Updates (ASUs). The ASCbecame effective for us on July 1, 2009. This standard did not have animpact on our financial position, results of operations or cash flows.Throughout the notes to the consolidated financial statements, references thatwere previously made to various former authoritative GAAP pronouncements havebeen conformed to the appropriate section of the ASC.

 

6

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In December 2007, the FASB issued ASC 805 (formerly Statement ofFinancial Accounting Standards (“SFAS”) No. 141 (revised 2007), *Business Combinations*). Among otherthings, ASC 805 establishes principles and requirements for how the acquirer ina business combination (i) recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiredbusiness; (ii) recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase; and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. ASC 805 is effective for fiscal years beginning onor after December 15, 2008, with early adoption prohibited. We adopted ASC805 on July 1, 2009. This standard will change our accounting treatmentfor prospective business combinations.

 

In December 2007,the FASB issued ACS 810 (formerly SFAS No. 160, *Noncontrolling Interests in Consolidated Financial Statements, AnAmendment of ARB No. 51*). ASC 810 establishes accounting andreporting standards for noncontrolling interests in a subsidiary and for thedeconsolidation of a subsidiary. Minority interests will be recharacterized asnoncontrolling interests and classified as a component of equity. It alsoestablishes a single method of accounting for changes in a parent’s ownershipinterest in a subsidiary and requires expanded disclosures. This statement iseffective for fiscal years beginning on or after December 15, 2008, withearly adoption prohibited. We adopted ASC 810 on July 1, 2009. Theadoption of this statement did not have a material impact on our financialposition, results of operations or cash flows.

 

In March 2008, theFASB issued ASC 815 (formerly SFAS No. 161, *Disclosures about Derivative Instruments and Hedging Activities—AnAmendment of FASB Statement 133*). ASC 815 expands the requireddisclosures to discuss the uses of derivative instruments; the accounting forderivative instruments and related hedged items under ASC 815, and howderivative instruments and related hedged items affect the company’s financialposition, financial performance and cash flows. We adopted ASC 815 on July 1,2009. The adoption of this statement did not have a material impact on ourfinancial position, results of operations or cash flows.

 

In June 2008, theFASB issued ASC 260 (formerly EITF 03-6-1*,Determining Whether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities*). ASC 260 addresses whether instrumentsgranted in share-based payment transactions are participating securities priorto vesting and need to be included in the calculation of earnings per shareunder the two-class method*.* UnderASC 260, share-based payment awards that contain nonforfeitable rights todividends are “participating securities”, and therefore should be included incomputing earnings per share using the two-class method. ASC 260 is effectivefor financial statements issued for fiscal years and interim periods beginningafter December 15, 2008. We adopted ASC 260 on July 1, 2009. Theeffect of adopting ASC 260 increased the number of shares used to computeearnings per share; however, the adoption of ASC 260 did not have a materialimpact on our financial position, results of operations or cash flows.

 

In December 2008,the FASB issued ASC 815 (formerly EITF****07-5,*Determining Whether an Instrument (orEmbedded Feature) Is Indexed to an Entity’s Own Stock*).  ASC815 affects companies that have provisions in their securities purchaseagreements (for warrants and convertible instruments) that reset conversionprices based upon new issuances by companies at prices below the currentconversion price of said instrument.  Warrants and convertible instrumentswith such provisions will require the embedded derivative instrument to bebifurcated and separately accounted for as a derivative.  Subject tocertain exceptions, our preferred stock provides for resetting the conversionprice if we issue new common stock below $5.75 per share.  ASC 815 iseffective for financial statements issued for fiscal years and interim periodsbeginning after December 15, 2008. We adopted ASC 815 on July 1,2009. The adoption of this statement did not have a material impact on ourfinancial position, results of operations or cash flows as the reset conversionprovision did not meet the definition of a derivative since it was not readilynet-cash settled.

 

In June 2009, theFASB issued ASC 855 (formerly SFAS 165,*Subsequent Events*)to establish general standards of accounting for and disclosure of events thatoccur after the balance sheet date, but prior to the issuance of financialstatements. Specifically, ASC 855 sets forth: (1) the period after thebalance sheet date during which management of a reporting entity shouldevaluate events or transactions that may occur for potential recognition ordisclosure in the financial statements; (2) the circumstances under whichan entity should recognize events or transactions occurring after the balancesheet date in its financial statements; and (3) the disclosures that anentity should make about events or transactions that occurred after the balancesheet date. ASC 855 is effective for 

 

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financial statementsissued for interim or annual periods ending after June 15, 2009. Weadopted ASC 855 on June 30, 2009 and considered subsequent events through November 13,2009. The adoption of this statement did not have a material impact on ourfinancial position, results of operations or cash flows.

 

**2.    PENDING MERGER WITH RESACA**

 

On September 29,2009, the boards of directors of Cano and Resaca Exploitation, Inc.approved an Agreement and Plan of Merger (the “Merger Agreement”) by and amongCano, Resaca and Resaca Acquisition Sub, Inc., a Delaware corporation andwholly-owned subsidiary of Resaca (“Merger Sub”), pursuant to which Merger Subwill be merged with and into Cano (the “Merger”) and Cano will become awholly-owned subsidiary of Resaca.

 

Underthe terms of the proposed Merger, each share of Cano common stock will beconverted into the right to receive 2.10 shares of common stock of Resaca (or0.42 shares of Resaca common stock if the proposed 1 to 5 reverse stock splitis approved by the Resaca shareholders prior to the Merger) and each share ofCano Series D Convertible Preferred Stock (the “Preferred Stock”) will beconverted into the right to receive one share of Resaca Series AConvertible Preferred Stock.  The Mergeris intended to be a tax-free transaction to the Resaca shareholders and to theCano stockholders to the extent the Cano common stockholders receive Resacacommon stock and the Cano preferred stockholders receive Resaca preferred stockin the Merger.

 

Consummationof the transactions contemplated by the Merger Agreement is conditioned upon,among other things, (1) approval of the holders of the common stock andpreferred stock of Cano, (2) approval of the holders of the common stockof Resaca, (3) the listing of Resaca common stock on the NYSE Amex, (4) therefinancing of existing bank debt of Resaca and Cano, (5) the receipt ofrequired regulatory approvals, (6) Resaca’s application for readmission tothe Alternative Investment Market ofthe London Stock Exchange and (7) the effectiveness of a registration statementrelating to the shares of Resaca common stock to be issued in the Merger. TheMerger Agreement contains certain termination rights for each of Cano andResaca, including the right to terminate the Merger Agreement to enter into aSuperior Proposal (as such term is defined in the Merger Agreement).  Inthe event of a termination of the Merger Agreement under certain specifiedcircumstances described in the Merger Agreement, one party will be required topay the other party a termination fee of $3,500,000.

 

Weentered into stock voting agreements with 75% of the holders of Cano’sPreferred Stock on various dates between September and November 2009.Each stock voting agreement contains the same terms and provides, among otherthings, that each of the preferred holders will vote all its shares of ourstock (a) in favor of an amendment to the Certificate of Designations,Preferences and Rights of Series D Convertible Preferred Stock of Cano(the “Series D Amendment”), (b) in favor of adoption of the MergerAgreement, and (c) in accordance with the recommendation of our Board ofDirectors in connection with any Target Acquisition Proposal (as such term isdefined in the Merger Agreement).  The Series D Amendment generallyprovides that the holders of Preferred Stock shall have no rights arising fromthe proposed Merger with Resaca (including any right to require us to redeemtheir shares of Preferred Stock) other than the right to receive the mergerconsideration specified in the Merger Agreement.  To be effective, the Series DAmendment must be approved by the holders of a majority of the shares ofPreferred Stock, voting as a separate class, and by the holders of a majorityof the shares of our common stock, voting as a separate class, and then filedby us with the Secretary of State of Delaware.

 

On October 20,2009, we entered into a Stock Voting Agreement with S. Jeffrey Johnson, ourChief Executive Officer and Chairman of our board of directors, which provides,among other things, that Mr. Johnson will vote all of his shares of ourstock in favor of the Series D Amendment.   Mr. Johnsonowns approximately 3.7% of the Preferred Stock. During the quarter ended September 30,2009, we paid Mr. Johnson a cash preferred dividend payment ofapproximately $20,000.

 

Forward-lookingstatements in this Quarterly Report on Form 10-Q reflect Cano’s currentplans as a stand-alone entity and do not take into account the impact of theproposed Merger with Resaca, except where such statements specifically relateto the proposed Merger.

 

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Resacais an independent oil and gas exploitation company headquartered in Houston,Texas, with operations focused on properties in the United States, specificallyin the Permian Basin of West Texas and southeast New Mexico.

 

**3.     LIQUIDITY**

 

At September 30,2009, we had cash and cash equivalents of $0.8 million and negative workingcapital of $1.9 million.  For the three-monthperiod ended September 30, 2009, we generated cash flow from operations of$0.5 million.

 

Wedepend on our credit agreements, as described in Note 4, to fund a portion ofour operating and capital needs. Under our amended and restated credit agreement(the “ARCA”), the initial and current borrowing base, based upon our provedreserves, is $60.0 million. At September 30, 2009, our remainingavailable borrowing capacity under the ARCA was $13.8 million. At November 13,2009, our remaining available borrowing capacity was $10.0 million.  Pursuant to the terms of the ARCA, ourborrowing base is to be redetermined based upon our June 30, 2009 reservereport.  We have submitted our reserve report and other financialinformation to our lenders. We have not received formal notification of anychanges to our borrowing base.

 

At September 30,2009, we were in compliance with the debt covenants contained in each of ourcredit agreements. The compliance determination for the twelve-month periodending December 31, 2009 will be the first financial covenant tests whichwill exclude the gain from our sale of the Pantwist Properties (see Note 6).Based upon our nine month operating results through September 30, 2009, itappears likely that we may fall out of compliance with one or more of ourfinancial covenants under our credit agreements as of December 31,2009.  If a combination of increasedproduction, rising commodity prices, changes in our capital structure, theclosing of our pending Merger and other actions do not occur by December 31,2009, we anticipate not being in compliance with the covenants. In that event,we will seek covenant relief from our lenders, though there can be no assurancethat we will be successful in obtaining such relief.

 

Our credit agreements,discussed in Note 4, include change of control provisions which require us torefinance the credit agreements at the close of the Merger. We are working withResaca regarding the credit arrangements for the combined company.

 

**4.   LONG-TERMDEBT**

 

At September 30,2009 and June 30, 2009, the aggregate outstanding amounts under our creditagreements were $61.2 million and $55.7 million, respectively.  The $61.2 million consisted of outstandingborrowings under the ARCA and the subordinated credit agreement of $46.2million and $15.0 million, respectively. At September 30, 2009, the average interest rates under the ARCAand subordinated credit agreements were 2.69% and 6.30%, respectively.

 

Ourlong-term debt consists of the ARCA (current borrowing base of $60.0 million)and our subordinated credit agreement (borrowing availability of $15.0million). As discussed under Note 3, the $60.0 million borrowing base under theARCA is to be redetermined based on our June 30, 2009 reserve report.  Our lenders are Union Bank of North America,N.A. (“UBNA”), acting as administrative agent, and Natixis.

 

**5.   COMMODITY DERIVATIVES**

 

Our derivatives consistof commodity derivatives and an interest rate swap arrangement.

 

***Commodity Derivatives***

 

Pursuant to our ARCA andsubordinated credit agreements, discussed in Note 4, we are required tomaintain our “collar” commodity derivative contracts.  We have commodity derivatives to partiallymitigate the risk associated with extreme fluctuations of prices for crude oiland natural gas sales.  We have noobligation to enter into commodity derivative contracts in the future. Shouldwe choose to enter into commodity derivative contracts to 

 

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mitigate future pricerisk, we cannot enter into contracts for greater than 85% of our crude oil andnatural gas production volumes attributable to proved producing reserves for agiven month. As of September 30, 2009, we maintained the following “collar”commodity derivative contracts with UBNA as our counterparty, which is one ofthe senior lenders under the ARCA:

 
| **Time Period**         | ** ** | **Floor  Oil Price** | ** ** | **Ceiling  Oil Price** | ** ** | **Barrels  Per Day** | ** ** | **Floor  Gas Price** | ** ** | **Ceiling  Gas Price** | ** ** | **Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per Day(a)** | ** ** |
|------------------------------|------------|---------------------------|------------|-----------------------------|------------|---------------------------|------------|---------------------------|------------|-----------------------------|------------|-----------------------|------------|-----------------------------------------------------------|------------|
| 10/1/09 - 12/31/09 |       | $                         | 80.00      |                        | $          | 110.90                    |       | 367                       |       | $                           | 7.75       |                  | $          | 10.60                                                     |       | 1,667 |   | 644 |   |
| 10/1/09 - 12/31/09 |       | $                         | 85.00      |                        | $          | 104.40                    |       | 233                       |       | $                           | 8.00       |                  | $          | 10.15                                                     |       | 1,133 |   | 422 |   |
| 1/1/10 - 12/31/10  |       | $                         | 80.00      |                        | $          | 108.20                    |       | 333                       |       | $                           | 7.75       |                  | $          | 9.85                                                      |       | 1,567 |   | 594 |   |
| 1/1/10 - 12/31/10  |       | $                         | 85.00      |                        | $          | 101.50                    |       | 233                       |       | $                           | 8.00       |                  | $          | 9.40                                                      |       | 1,033 |   | 406 |   |
| 1/1/11 - 3/31/11   |       | $                         | 80.00      |                        | $          | 107.30                    |       | 333                       |       | $                           | 7.75       |                  | $          | 11.60                                                     |       | 1,467 |   | 578 |   |
| 1/1/11 - 3/31/11   |       | $                         | 85.00      |                        | $          | 100.50                    |       | 200                       |       | $                           | 8.00       |                  | $          | 11.05                                                     |       | 967 |   | 361 |   |

 

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(a) This column iscomputed by dividing the “Mcf per Day” by 6 and adding “Barrels per Day.”

 

On September 11,2009, we entered into two fixed price commodity swap contracts with Natixis asour counterparty, which is one of our lenders under the ARCA. The fixed priceswaps are based on West Texas Intermediate NYMEX prices and are summarized inthe table below.

 
| **Time Period**             | ** ** | **Fixed  Oil Price** | ** ** | **Barrels  Per Day** | ** ** |
|-----------------------------|------------|----------------------|------------|----------------------|------------|
| 4/1/11 - 12/31/11 |       | $                    | 75.90      |                 | 700        |   |
| 1/1/12 - 12/31/12 |       | $                    | 77.25      |                 | 700        |   |

 

***Interest Rate Swap Agreement***

 

On January 12,2009, we entered into a three-year LIBOR interest rate basis swap contract withNatixis Financial Products, Inc. (“Natixis FPI”) for $20.0 million innotional exposure. We have the interest rate swap agreement to partiallymitigate the risk associated with interest rate fluctuations on our interestexpense. Under the terms of the transaction, we will pay Natixis FPI, inthree-month intervals, a fixed rate of 1.73% and Natixis FPI will pay Cano theprevailing three-month LIBOR rate.

 

***Financial Statement Impact***

 

During the quarters endedSeptember 30, 2009 and 2008, respectively, the gain (loss) on derivativesreported in our consolidated statements of operations is summarized as follows:

 
| ** **                                             | ** ** | **Location of Gain**      | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                             | ** ** | **(Loss) On Derivatives** | ** ** | **2009**                                                 | ** ** | **2008** | ** ** |
| Settlements  received/accrued on commodity derivatives |       | Other income  (expense)             |       | $                                                        | 1,851      |   | $ | — |   |
| Settlements  paid/accrued on commodity derivatives     |       | Other income  (expense)             |       | —                                                   |       | (552 | ) |
| Settlements  paid/accrued on interest rate swap        |       | Other income  (expense)             |       | (56                                                      | )          | — |   |
| Realized  gain (loss) on derivatives                   |       | Other income  (expense)             |       | 1,795                                                    |       | (552 | ) |
| Unrealized  gain (loss) on commodity derivatives       |       | Other income  (expense)             |       | (2,204                                                   | )          | 24,247 |   |
| Unrealized  loss on interest rate swap                 |       | Other income  (expense)             |       | (103                                                     | )          | — |   |
| Gain  (loss) on derivatives                            |       | Other income  (expense)             |       | $                                                        | (512       | ) | $ | 23,695 |   |

 

The realized gain (loss)on derivatives consists of actual cash settlements under our commodity collarsand interest rate swap derivatives during the respective periods. The cashsettlements received/accrued by us under commodity derivatives were cumulativemonthly payments due to us since the NYMEX natural gas and crude oil priceswere lower than the “floor prices” set for the respective time periods andrealized gains from the sale of uncovered “floor price” contracts as previouslydiscussed. The cash settlements paid/accrued by us under commodity derivativeswere cumulative monthly payments due to our counterparty since the NYMEX crudeoil and natural gas prices were higher than the “ceiling prices” set for therespective time periods. The cash settlementspaid/accrued by us under the interest rate swaprelated to quarterly payments to our counterparty since the actual 

 

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three- month LIBORinterest rate was lower than the fixed 1.73% rate we pay to the counterparty.The cash flows relating to the derivative instrument settlements that are due,but not cash settled are reflected in operating activities on our consolidatedstatements of cash flows as changes to current liabilities. At both September 30,2009 and June 30, 2009, we had recorded a $0.6 million receivablefrom our counterparty included in accounts receivable on our consolidatedbalance sheet at both dates.

 

The unrealized gain(loss) on commodity derivatives represents estimated future settlements underour commodity derivatives and is based on mark-to-market valuation based onassumptions of forward prices, volatility and the time value of money asdiscussed below. We compared our valuation to our counterparties’ independentlyderived valuation to further validate our mark-to-market valuation. During thethree-month period ended September 30, 2009, we recognized an unrealizedloss on commodity derivatives in our consolidated statements of operationsamounting to $2.2 million. During the three-month period ended September 30,2008, we recognized an unrealized gain on commodity derivatives in ourconsolidated statements of operations amounting to $24.2 million.

 

The unrealized loss oninterest rate swap represents estimated future settlements under ouraforementioned interest rate swap agreement and is based on a mark-to-marketvaluation based on assumptions of interest rates, volatility and the time valueof money as discussed below. During the three-month period ended September 30,2009, we recognized realized and unrealized losses on interest rate swaps inour consolidated statements of operations amounting to $0.1 million each.Since we did not implement the interest rate swap until January 2009, wedid not have realized/unrealized gain or loss on the interest rate swap duringthe three-month period ended September 30, 2008.

 

***Fair Value Measurements***

 

Our assets andliabilities recorded at fair value are categorized based upon the level ofjudgment associated with the inputs used to measure their fair value.  Afair value hierarchy has been established that prioritizes the inputs used tomeasure fair value. The hierarchy gives the highest priority to quoted pricesin active markets for identical assets or liabilities (Level 1 measurement) andthe lowest priority to unobservable inputs (Level 3 measurement). We classifyfair value balances based on the observability of those inputs. The threelevels of the fair value hierarchy are as follows:

 

Level 1—Quoted prices inactive markets for identical assets or liabilities that we have the ability toaccess. Active markets are those in which transactions for the asset orliability occur in sufficient frequency and volume to provide pricinginformation on an ongoing basis.

 

Level 2—Inputs are otherthan quoted prices in active markets included in Level 1, which are eitherdirectly or indirectly observable. These inputs are either directly observablein the marketplace or indirectly observable through corroboration with marketdata for substantially the full contractual term of the asset or liabilitybeing measured.

 

Level 3—Inputs reflectmanagement’s best estimate of what market participants would use in pricing theasset or liability at the measurement date. Consideration is given to the riskinherent in the valuation technique and the risk inherent in the inputs to themodel.

 

In valuing certaincontracts, the inputs used to measure fair value may fall into different levelsof the fair value hierarchy. For disclosure purposes, assets and liabilitiesare classified in their entirety in the fair value hierarchy level based on thelowest level of input that is significant to the overall fair valuemeasurement. Our assessment of the significance of a particular input to thefair value measurement requires judgment and may affect the placement withinthe fair value hierarchy levels.

 

The fair value of ourderivative contracts are measured using Level 2 and Level 3 inputs.  TheLevel 3 input pertained to the subjective valuation for the effect of our owncredit risk, which was insignificant to the fair value of the derivativecontracts. The fair value of our commodity derivative contracts and interestrate swap are measured using Level 2 inputs based on the hierarchies previouslydiscussed.

 

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Our asset retirementobligation is measured using primarily Level 3 inputs. The significantunobservable inputs to this fair value measurement include estimates ofplugging, abandonment and remediation costs, inflation rate and well life. Theinputs are calculated based on historical data as well as current estimatedcosts.

 

The estimated fair valueof derivatives included in the consolidated balance sheet at September 30,2009 is summarized below.

 
| **In thousands**                                   | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|
| Derivative  assets (Level 2):                           |       |       |       |
| Crude  oil collars and price floors — current      |       | $          | 2,560      |   |
| Crude  oil collars and price floors — noncurrent   |       | 1,097      |       |
| Natural  gas collars and price floors — current    |       | 1,825      |       |
| Natural  gas collars and price floors — noncurrent |       | 595        |       |
| Interest  rate swap — noncurrent                   |       | 148        |       |
| Derivative  liability (Level 2)                         |       |       |       |
| Interest  rate swap — current                      |       | (199       | )          |
| Crude  oil swap - noncurrent                            |       | (644       | )          |
| Net  derivative assets (Level 2)                        |       | $          | 5,382      |   |
| Asset  retirement obligation (Level 3)                  |       | $          | (2,971     | ) |

 

The following table showsthe reconciliation of changes in the fair value of the net derivative assetsand asset retirement obligation classified as Level 2 and 3, respectively, inthe fair value hierarchy for the three-month period ended September 30,2009.

 
| ** **                          | ** ** | **Total  Net** | ** ** | **Asset**      | ** ** |
|-------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                          | ** ** | **Derivative** | ** ** | **Retirement** | ** ** |
| **In thousands**               | ** ** | **Assets**     | ** ** | **Obligation** | ** ** |
| Balance  at June 30, 2009      |       | $              | 7,678      |           | $          | 2,904 |   |
| Unrealized  loss on derivatives     |       | (2,307         | )          | —         |       |
| Settlements,  net                   |       | 11             |       | —         |       |
| Accretion  of discount              |       | —         |       | 67             |       |
| Balance  at September 30, 2009 |       | $              | 5,382      |           | $          | 2,971 |   |

 

The change from netderivative assets of $7.7 million at June 30, 2009 to net derivativeassets of $5.4 million at September 30, 2009 is attributable to theincreases in crude oil and natural gas futures prices. These amounts are basedon our mark-to-market valuation of these derivatives at September 30, 2009and may not be indicative of actual future cash settlements.

 

The following tablesummarizes the fair value of our derivative contracts as of the dates indicated(in thousands):

 

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| ** **                                                   | ** ** | **Asset Derivatives**       | ** ** | **Liability Derivatives** | ** **  |
|--------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|-------------|
| ** **                                                   | ** ** | **September 30, 2009** | ** ** | **June 30, 2009**    | ** **  | **September 30, 2009** | ** ** | **June 30, 2009** | ** ** |
| ** **                                                   | ** ** | **Balance Sheet**           | ** ** | **Fair**                       | ** **  | **Balance Sheet** | ** ** | **Fair** | ** ** | **Balance Sheet** | ** ** | **Fair** | ** ** | **Balance Sheet** | ** ** | **Fair** | ** ** |
| ** **                                                   | ** ** | **Location**                     | ** ** | **Value**                      | ** **  | **Location** | ** ** | **Value** | ** ** | **Location** | ** ** | **Value** | ** ** | **Location** | ** ** | **Value** | ** ** |
| **Derivatives not  designated as hedging instruments**       |       |                             |       |                           |        |   |   |   |   |   |   |   |   |   |   |   |   |
| Commodity derivative contracts                               |       | Derivatives - current            |       | $                              |  4,385 |   | Derivatives - current |   | $ | 4,955 |   | Derivatives - current |   | $ | — |   | Derivatives - current |   | $ |  — |   |
| Commodity derivative contracts                               |       | Derivatives - noncurrent         |       | 1,692                          |        | Derivatives - noncurrent |   | 2,670 |   | Derivatives - noncurrent |   | (644 | ) | Derivatives - noncurrent |   | — |   |
| Interest rate swaps                                          |       | Derivatives - noncurrent         |       | 148                            |        | Derivatives - noncurrent |   | 212 |   | Derivatives - current |   | (199 | ) | Derivatives - current |   | (159 | ) |
| ** **                                                   |       |                             |       |                           |        |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total derivatives not  designated as hedging instruments** |       |                             |       | $                              | 6,225       |   |   |   | $ | 7,837 |   |   |   | $ | (843 | ) |   |   | $ | (159 | ) |
|                                                         |       |                             |       |                           |        |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total derivatives  designated as hedging instruments**     |       |                             |       | $                              | —      |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |
|                                                         |       |                             |       |                           |        |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total derivatives**                                        |       |                             |       | $                              | 6,225       |   |   |   | $ | 7,837 |   |   |   | $ | (843 | ) |   |   | $ | (159 | ) |

 

**6.   DISCONTINUEDOPERATIONS**

 

On October 1, 2008,we completed the sale of our wholly-owned subsidiary, Pantwist, LLC, for anet purchase price of $40.0 million consisting of a $42.7 millionpurchase price adjusted for $2.1 million of net cash received fromdiscontinued operations during the three months ended September 30, 2008and $0.6 million of advisory fees. The sale had an effective date of July 1,2008.

 

On December 2,2008, we sold our interests in our Corsicana oil and gas properties (the “CorsicanaProperties”) for $0.3 million. In the quarter ended September 30,2008, we recorded a $3.5 million ($2.3 million after-tax) impairmentof the Corsicana Properties, as we determined that we would not be developingits proved undeveloped reserves within the next five years.

 

The operating results ofPantwist, LLC and the Corsicana Properties for the three months ended September 30,2008 have been reclassified as discontinued operations in the consolidatedstatements of operations as detailed in the table below.

 
| **Operating Revenues:**                                |   |   |   |
|--------------------------------------------------------|--------|--------|--------|
| Crude  oil sales                                       |   | $      | 1,311  |   |
| Natural  gas sales                                     |   | 1,696  |   |
| Total  operating revenues                              |   | 3,007  |   |
| **Operating Expenses:**                                |   |   |   |
| Lease  operating                                       |   | 601    |   |
| Production  and ad valorem taxes                       |   | 197    |   |
| Impairment  of long-lived assets                       |   | 3,516  |   |
| Depletion  and depreciation                            |   | 8      |   |
| Accretion  of discount on asset retirement obligations |   | 2      |   |
| Interest  expense, net                                 |   | 26     |   |
| Total  operating expenses                              |   | 4,350  |   |
| **Income before income taxes**                         |   | (1,343 | )      |
| Income  tax provision                                  |   | 491    |   |
| **Income from discontinued operations**                |   | $      | (852   | ) |

 

Interestexpense, net of interest income, was allocated to discontinued operations basedon the percentage of operating revenues applicable to discontinued operationsto the total operating revenues.

 

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**7.   DEFERREDCOMPENSATION**

 

As of September 30,2009, we had non-vested restricted shares totaling 386,667 shares to keyemployees pursuant to our 2005 Long-Term Incentive Plan, as summarized below:

 
| ** **                                               | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date  Fair Value** | ** ** | **Fair Value  $000s** | ** ** |
|----------------------------------------------------------|------------|------------|------------|----------------------------------------------------|------------|----------------------------|------------|
| Non-vested  restricted shares at June 30, 2009      |       | 480,000    |       | $                                                  | 6.97       |                       | $          | 3,344 |   |
| Shares  vested                                           |       | (68,647    | )          | $                                                  | 5.84       |                       | $          | (401 | ) |
| Shares  forfeited                                        |       | (24,686    | )          | $                                                  | 5.84       |                       | (144       | ) |
| Non-vested  restricted shares at September 30, 2009 |       | 386,667    |       | $                                                  | 7.24       |                       | $          | 2,799 |   |

 

Therestricted share grants will vest to the employees based on future years ofservice ranging from one to three years depending on the life of the awardagreement.  Pursuant to the Merger discussed in Note 2, the non-vestedrestricted shares would vest upon the completion of the Merger. The fair valueof the grants is based on our actual stock price on the date of grantmultiplied by the number of restricted shares granted.  As of September 30,2009, the value of non-vested restricted shares amounted to $2.8 million. For the quarters ended September 30, 2009 and 2008, we have expensed $0.3million and $0.8 million, respectively, to stock compensation expense based onamortizing the fair value over the appropriate service period.  Theforfeitures resulted from shares used to satisfy employees’ tax withholdingobligations related to the vesting of their restricted shares.

 

**8.   STOCKOPTIONS**

 

During the three-monthperiod ended September 30, 2009, we did not grant additional stockoptions.  A summary of outstandingoptions as of September 30, 2009 is as follows:

 
| ** **                              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding  at June 30, 2009      |       | 1,400,002  |       | $                                      | 4.42       |   |
| Options  forfeited                      |       | (15,541    | )          | $                                      | 4.87       |   |
| Outstanding  at September 30, 2009 |       | 1,384,461  |       | $                                      | 4.41       |   |

 

Based on our $1.27 stockprice at September 30, 2009, the intrinsic value of both the optionsoutstanding and exercisable was approximately $0.2 million.

 

Total options exercisableat September 30, 2009 amounted to 1,008,705 shares and had a weightedaverage exercise price of $4.41. Upon exercise, we issue the full amountof shares exercisable per the term of the options from new shares. We have noplans to repurchase those shares in the future.

 

For each of the quartersended September 30, 2009 and 2008, we recorded charges to stockcompensation expense of $0.1 million and $0.2 million, respectively, for theestimated fair value of the options granted to our directors andemployees.  As of September 30,2009, total compensation cost related to non-vested option awards not yetrecognized was $0.4 million.  We expect to recognize the remainingunrecognized amount over the related requisite service periods of one to threeyears. Pursuant to the Merger, discussed in Note 2, the outstanding stockoptions would vest upon completion of the Merger.

 

**9.   NETINCOME (LOSS) PER COMMON SHARE**

 

Basic net income (loss)per common share is computed by dividing the net income (loss) attributable tocommon shareholders by the weighted average number of shares of common stockoutstanding.  Diluted net income (loss) per common share is computed inthe same manner, but also considers the effect of common stock shares underlyingstock options, the preferred stock and paid-in-kind (“PIK”) dividends on an “as-converted”basis.

 

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Shares of common stockunderlying the following items summarized below were not included in dilutiveweighted average shares outstanding for the three-month period ended September 30,2009 as their effects would have been anti-dilutive.

 
| Stock  options   |   | 1,384,461 |   |
|------------------|--------|-----------|--------|
| Preferred  stock |   | 4,147,652 |   |
| PIK  dividends   |   | 594,167   |   |

 

The following tablereconciles earnings and shares used in the computation of basic and dilutedearnings per share for the three months ended September 30, 2008:

 
| **In thousands, except per share data** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **Earnings  per Share** | ** ** |
|------------------------------------------------------------------|------------|--------------|------------|------------|------------|------------------------------|------------|
| Basic                                                            |       | $            | 11,818     |       | 46,230     |                         | $          | 0.26 |   |
|                                                             |       |         |       |       |       |                         |       |
| Effect  of dilutive securities:                                  |       |         |       |       |       |                         |       |
| Conversion  of preferred stock and PIK dividends                 |       | 936          |       | 8,502      |       |                         |       |
| Stock  options                                                   |       |         |       | 7          |       |                         |       |
| Diluted                                                          |       | $            | 12,754     |       | 54,739     |                         | $          | 0.23 |   |

 

**10.   INCOME TAXES**

 

Theeffective income tax rate for the quarter ended September 30, 2009 was 31%as compared to 107% for our year ended June 30, 2009.  The income tax rate was higher for ouryear-end June 30, 2009 because of an increase in the state tax rate andother permanent items.

 

**11.   COMMITMENTS AND CONTINGENCIES**

 

***Burnett Case***

 

On March 23, 2006,the following lawsuit was filed in the 100th Judicial District Court inCarson County, Texas: Cause No. 9840, The Tom L. and Anne Burnett Trust,by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, IIIand Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and BurnettRanches, Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. The plaintiffsclaim that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and natural gas operations started a wildfire thatbegan on March 12, 2006 in Carson County, Texas.

 

The plaintiffs (i) allegenegligence and gross negligence and (ii) seek damages, including, but notlimited to, damages for damage to their land and livestock, certain expensesrelated to fighting the fire and certain remedial expenses totalingapproximately $1.7 million to $1.8 million. In addition, theplaintiffs seek (i) termination of certain oil and natural gas leases, (ii) reimbursementfor their attorney’s fees (in the amount of at least $549,000) and (iii) exemplarydamages. The plaintiffs also claim that Cano and its subsidiaries are jointlyand severally liable as a single business enterprise and/or a generalpartnership or de facto partnership. The owner of the remainder of the mineralestate, Texas Christian University, intervened in the suit on August 18,2006, joining Plaintiffs’ request to terminate certain oil and gas leases. On June 21,2007, the judge of the 100th Judicial District Court issued a FinalJudgment (a) granting motions for summary judgment in favor of Cano andcertain of its subsidiaries on plaintiffs’ claims for (i) breach ofcontract/termination of an oil and gas lease; and (ii) negligence; and (b) grantingthe plaintiffs’ no-evidence motion for summary judgment on contributorynegligence, assumption of risk, repudiation and estoppel affirmative defensesasserted by Cano and certain of its subsidiaries.

 

The Final Judgment wasappealed and a decision was reached on March 11, 2009, as the Court ofAppeals for the Tenth District of Texas in Amarillo affirmed in part andreversed in part the ruling of the 100th Judicial District Court. TheCourt of Appeals (a) affirmed the trial court’s granting of summary judgment inCano’s favor for breach of contract/termination of an oil and gas lease and (b)reversed the trial court’s granting of summary judgment in Cano’s favor onplaintiffs’ claims of Cano’s negligence. The Court of Appeals ordered the caseremanded to the 100th Judicial District Court. On March 30, 2009, theplaintiffs filed a motion for rehearing with the Court of 

 

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Appeals and requested arehearing on the trial court’s ruling in favor of the defendants on theplaintiffs’ breach of contract/termination of an oil and gas lease claim. On June 30,2009, the Court of Appeals ruled to deny the plaintiff’s motion for rehearing.On August 17, 2009 we filed an appeal with the Texas Supreme Court torequest the reversal of the Court of Appeals ruling regarding our potentialnegligence.

 

Due to the inherent riskof litigation, the ultimate outcome of this case is uncertain andunpredictable. At this time, Cano management continues to believe that thislawsuit is without merit and will continue to vigorously defend itself and itssubsidiaries, while seeking cost-effective solutions to resolve this lawsuit.Based on our knowledge and judgment of the facts as of November 13, 2009,we believe our financial statements present fairly the effect of actual andanticipated ultimate costs to resolve these matters as of September 30,2009.

 

***Securities Litigation***

 

On October 2, 2008,a lawsuit (08 CV 8462) was filed in the United States District Court for theSouthern District of New York against David W. Wehlmann; Gerald W. Haddock;Randall Boyd; Donald W. Niemiec; Robert L. Gaudin; William O. Powell, IIIand the underwriters of the June 26, 2008 public offering of Cano commonstock (“Secondary Offering”) alleging violations of the federal securitieslaws. Messrs. Wehlmann, Haddock, Boyd, Niemiec, Gaudin and Powell wereCano outside directors on June 26, 2008. At the defendants’ request, thecase was transferred to the United States District Court for the NorthernDistrict of Texas (4:09-CV-308-A).

 

On July 2, 2009, theplaintiffs filed an amended complaint that added as defendants Cano, Cano’sChief Executive Officer and Chairman of the Board, Jeff Johnson, Cano’s formerSenior Vice President and Chief Financial Officer, Morris B. “Sam” Smith, Cano’scurrent Senior Vice President and Chief Financial Officer, Ben Daitch, Cano’sVice President and Principal Accounting Officer, Michael Ricketts and Cano’sSenior Vice President of Engineering and Operations, Patrick McKinney, anddismissed Gerald W. Haddock, a former director of Cano, as a defendant. Theamended complaint alleges that the prospectus for the Secondary Offeringcontained statements regarding Cano’s proved reserve amounts and standards thatwere materially false and overstated Cano’s proved reserves. The plaintiff isseeking to certify the lawsuit as a class action lawsuit and is seeking anunspecified amount of damages. On July 27, 2009, the defendants moved todismiss the lawsuit. Due to the inherent risk of litigation, the outcome ofthis lawsuit is uncertain and unpredictable; however, Cano, its officers andits outside directors intend to vigorously defend the lawsuit. Cano iscooperating with its Directors and Officers Liability insurance carrierregarding the defense of the lawsuit.

 

***Other***

 

Occasionally, we areinvolved in other various claims and lawsuits and certain governmentalproceedings arising in the ordinary course of business. Our management does notbelieve that the ultimate resolution of any current matters that are not setforth above will have a material effect on our financial position or results ofoperations. Management’s position is supported, in part, by the existence ofinsurance coverage, indemnification and escrow accounts. None of our directors,officers or affiliates, owners of record or beneficial owners of more than fivepercent of any class of our voting securities, or security holder is involved ina proceeding adverse to us or our subsidiaries or has a material interestadverse to us or our subsidiaries.

 

**Item 2.Management’s Discussion and Analysis on Financial Condition and Results ofOperations**

 

**Forward-LookingStatements**

 

The information in thisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995. ThisAct provides a “safe harbor” for forward-looking statements to encouragecompanies to provide prospective information about themselves provided theyidentify these statements as forward looking and provide meaningful cautionarystatements identifying important factors that could cause actual results todiffer from the projected results. All statements other than statements ofhistorical fact made in this report are forward looking. In particular, thestatements herein regarding industry prospects and future results of operationsor financial position are forward-looking statements. Forward-looking 

 

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statements reflectmanagement’s current expectations and are inherently uncertain. Our actualresults may differ significantly from management’s expectations as aresult of many factors, including, but not limited to the volatility in pricesfor crude oil and natural gas, future commodity prices for derivative hedgingcontracts, interest rates, estimates of reserves, drilling risks, geologicalrisks, transportation restrictions, the timing of acquisitions, productdemand, market competition, interruptionin production, our ability to obtain additional capital, and the success ofwaterflooding and enhanced oil recovery techniques.

 

Statements in thisQuarterly Report on Form 10-Q regarding Cano’s strategy, risk factors,capital budget, projected expenditures, liquidity and capital resources, anddrilling and development plans reflect Cano’s current plans for the fiscal yearending June 30, 2010 as a stand-alone entity and do not take into accountthe impact of the proposed merger (the “Merger”) with Resaca Exploitation, Inc.(“Resaca”), except where such statements specifically relate to the proposedMerger.

 

You should read thefollowing discussion and analysis in conjunction with the consolidatedfinancial statements of Cano and subsidiaries and notes thereto, includedherewith. This discussion should not be construed to imply that the resultsdiscussed herein will necessarily continue into the future, or that anyconclusion reached herein will necessarily be indicative of actual operatingresults in the future. Such discussion represents only the best presentassessment of management.

 

**Overview**

 

We are an independent oiland natural gas company. Our strategy is to exploit our current undevelopedreserves and acquire, where economically prudent, assets suitable for enhancedoil recovery at a low cost. We intend to convert our proved undeveloped and/orunproved reserves into proved producing reserves by applying water, gas and/orchemical flooding and other EOR techniques. Our assets are located onshore U.S.in Texas, New Mexico and Oklahoma.

 

In September 2009,we entered into a merger agreement with Resaca (the “Merger Agreement”)pursuant to which Cano will be acquired by Resaca through the merger of awholly-owned subsidiary of Resaca with and into Cano. The Merger is subject tocustomary conditions, including the approval of the common and preferredstockholders of Cano and the common shareholders of Resaca. The companies willhold separate meetings of their shareholders to approve the Merger. Assumingshareholder approval is received, the Merger is expected to be completed withina few days following the shareholder meetings. For more information regardingthe proposed Merger, please refer to the Note 2 of the accompanyingConsolidated Financial Statements and the joint proxy statement/prospectus ofResaca and Cano that is included in the registration statement on Form S-4(File No. 333-162652) filed by Resaca with the SEC, and other relevantmaterials that may be filed by Cano or Resaca with the SEC. The followingdiscussion relates to our plans without regard to the potential impact of theproposed Merger.

 

We arefocused on enhancing the infrastructure and waterflood operations in our twolargest properties, Cato and Panhandle. These development activities are moreclearly described below under “Development Capital Expenditures and OperatingActivities Update.” We believe our portfolio of crude oil and natural gasproperties provides opportunities to apply our operational strategy.

 

Our June 30,2009 proved reserves of 49.1 MMBOE, were comprised 7.7 MMBOE of PDP, 2.4 MMBOEof PDNP, and 39.0 MMBOE of PUD. Crude oil reserves accounted for 79% of ourtotal reserves at June 30, 2009.

 

***Development Capital Expenditures and Operating ActivitiesUpdate***

 

For the year ending June 30,2010 (the “2010 Fiscal Year”), our Board of Directors approved a developmentcapital expenditures budget of $13.9 million (which excludes capitalizedgeneral and administrative and interest expenses). Our development capitalbudget is designed to minimize drawing on our available borrowing capacityunder the ARCA until the proposed Merger with Resaca is completed. The budgetis as follows:

 

·                  $5.4 million at the Cato Properties;

·                  $7.8 million at the PanhandleProperties; and

 

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·                  $0.7 million at the remainingProperties.

 

Of the $13.9 millionbudgeted development capital expenditures, we have incurred $5.1 millionthrough September 30, 2009. Our 2010 Fiscal Year development capitalprogram does not include the drilling of new wells. The financing of ourdevelopment capital expenditures is discussed below under “Liquidity andCapital Resources.”  The following reviews our capitaldevelopment activity during the three-month period ended September 30,2009 and planned activity during the balance of the 2010 Fiscal Year.

 

***Cato Properties.***     As a result of increasingproduction response and corresponding high fluid levels from the waterfloodproject at the Cato Properties, we have added ten submersible pumps and plan toinstall additional submersible pumps as fluid levels warrant.  Our 2010 Fiscal Year development capital planincludes the addition of two or three new injection wells and to enlarge thewaterflood footprint from 640 acres to approximately 1,000 acres.  We recently identified a new source of waterlocated in a non-productive formation, that we believe will be able to produce2,000 to 4,000 barrels of water per day per well. This will allow us toincrease our daily water injection rate and expand the waterflood footprint.This formation has been penetrated in a number of existing wellbores in theCato Properties. As we develop this new water source, we will be able toincrease the waterflood footprint without decreasing the injection rate at ourexisting injectors, which should enable us to maintain production from existingproducing wells. Our goal is to add 4,000 to 6,000 barrels of water injectionper day to our waterflood footprint to achieve total injection of 21,000barrels of water per day. Net production at the Cato Properties for September 2009was 302 barrels of equivalent oil per day (“BOEPD”).  Future net production from the CatoProperties is expected to be consistent with the September 2009 productionrate until the total injection of 21,000 barrels of water per day is achieved,which is anticipated in the first calendar quarter of 2010.

 

***Panhandle Properties*** We have retained an independent engineering firm toassist us with reservoir analysis and simulation modeling at the Cockrell Ranchunit. Based on this engineering firm’s recommendations, we established acontrolled water injection pattern to gauge the effects of optimizing waterinjection into the highest remaining crude oil saturation intervals of theBrown Dolomite formation.  We areessentially performing a “Mini-Flood” in the key target interval at theCockrell Ranch unit. The result of this field observation, coupled withrigorous reservoir simulation modeling, is expected to demonstrate an optimalpattern for waterflooding the project with an increasingly predicableproduction profile. Moreover, the field observation and modeling results willimprove the planning of future development programs for the remaining leaseslocated within the Panhandle Properties. The controlled injection projectcaused temporarily shut-in production during most of the quarter ended September 30,2009.  All production that was shut-infor the controlled injection project was restored on September 28, 2009.The results of the controlled injection project and the accompanying reservoirsimulation testing should be completed in the first calendar year of 2010quarter.

 

Net production at the PanhandleProperties for September 2009 was 588 BOEPD. The controlled injectionproject caused temporarily shut-in production during most of the quarter ended September 30,2009 of approximately 25 BOEPD.  Allproduction that was shut-in for the controlled injection project was restoredon September 28, 2009. Production was further reduced by 15 BOEPD as theprimary purchaser, Eagle Rock Field Services, L.P. (“Eagle Rock”), of ournatural gas and natural gas liquids (“NGL”) experienced an unplanned plantoutage from mid-August 2009 through the end of September 2009. TheEagle Rock gas plant was fully operational on October 1, 2009. During thequarter ended September 30, 2009, we constructed gathering lines toredirect natural gas production from Eagle Rock to DCP Midstream, LP (“DCP”).  As of September 30, 2009, we hadredirected approximately 45% of the natural gas production previously deliveredto Eagle Rock, to DCP.

 

***Desdemona Properties.***     During July 2009, weshut-in our Barnett Shale natural gas wells based upon the current andnear-term outlook of natural gas prices and production from the Barnett Shalewells on a per-well basis.  We have beguna project to return to production previously shut-in gas wells from the DukeSand formation.  The proved reservesassociated these gas wells are currently classified as proved developednon-producing reserves.  We plan toreturn 25 of these wells to production by December 2009. Production fromthese gas wells, including 

 

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associated natural gasliquids recovery from our gas plant, is expected to be approximately 10 MCFPDper gas well. Net production at the Desdemona Properties for September 2009was 30 BOEPD.

 

***Nowata Properties.***    We completed injecting ourpolymer flush during June 2009. Preliminary results have shown a two to three fold increase in theproduced oil (as a percentage of total fluids produced) in our pilotobservation wells. While we have seen favorable increases in production resultsfrom the pilot observation wells, we intend to perform several tests on thefluid properties produced from the pilot observation wells to gauge theeffectiveness of thealkaline-surfactant-polymer (“ASP”) chemical formula. We anticipate completingthe ASP Pilot performance analysis within the next three months. There arecurrently no proved reserves associated with the ASP Pilot. Net production atthe Nowata Properties for September 2009 was 216 BOEPD.

 

***Davenport Properties.***    Net production for September 2009was 71 BOEPD.

 

**Liquidityand Capital Resources**

 

***Pending Merger with Resaca***

 

On September 29,2009, the boards of directors of Cano and Resaca Exploitation, Inc.approved an Agreement and Plan of Merger (the “Merger Agreement”) by and amongCano, Resaca and Resaca Acquisition Sub, Inc., a Delaware corporation andwholly-owned subsidiary of Resaca (“Merger Sub”), pursuant to which Merger Subwill be merged with and into Cano (the “Merger”) and Cano will become awholly-owned subsidiary of Resaca.

 

Underthe terms of the proposed Merger, each share of Cano common stock will beconverted into the right to receive 2.10 shares of common stock of Resaca (or0.42 shares of Resaca common stock if the proposed 1 to 5 reverse stock splitis approved by the Resaca shareholders prior to the Merger) and each share ofCano Series D Convertible Preferred Stock (the “Preferred Stock”) will beconverted into the right to receive one share of Resaca Series AConvertible Preferred Stock.  The Mergeris intended to be a tax-free transaction to the Resaca shareholders and to theCano stockholders to the extent the Cano common stockholders receive Resacacommon stock and the Cano preferred stockholders receive Resaca preferred stockin the Merger.

 

Consummationof the transactions contemplated by the Merger Agreement is conditioned upon,among other things, (1) approval of the holders of the common stock andpreferred stock of Cano, (2) approval of the holders of the common stockof Resaca, (3) the listing of Resaca common stock on the NYSE Amex, (4) therefinancing of existing bank debt of Resaca and Cano, (5) the receipt ofrequired regulatory approvals, (6) Resaca’s application for readmission tothe Alternative Investment Market ofthe London Stock Exchange and (7) the effectiveness of a registration statementrelating to the shares of Resaca common stock to be issued in the Merger. TheMerger Agreement contains certain termination rights for each of Cano andResaca, including the right to terminate the Merger Agreement to enter into a SuperiorProposal (as such term is defined in the Merger Agreement).  In the eventof a termination of the Merger Agreement under certain specified circumstancesdescribed in the Merger Agreement, one party will be required to pay the otherparty a termination fee of $3,500,000.

 

Weentered into stock voting agreements with 75% of the holders of Cano’sPreferred Stock on various dates between September and November 2009.Each stock voting agreement contains the same terms and provides, among otherthings, that each of the preferred holders will vote all its shares of ourstock (a) in favor of an amendment to the Certificate of Designations,Preferences and Rights of Series D Convertible Preferred Stock of Cano(the “Series D Amendment”), (b) in favor of adoption of the MergerAgreement, and (c) in accordance with the recommendation of our Board ofDirectors in connection with any Target Acquisition Proposal (as such term isdefined in the Merger Agreement).  The Series D Amendment generallyprovides that the holders of Preferred Stock shall have no rights arising fromthe proposed Merger with Resaca (including any right to require us to redeemtheir shares of Preferred Stock) other than the right to receive the mergerconsideration specified in the Merger Agreement.  To be effective, the Series DAmendment must be approved by the holders of a majority of the shares ofPreferred Stock, voting as a separate class, and by the holders of a majorityof the shares of our common stock, voting as a separate class, and then filedby us with the Secretary of State of Delaware.

 

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On October 20,2009, we entered into a Stock Voting Agreement with S. Jeffrey Johnson, ourChief Executive Officer and Chairman of our board of directors, which provides,among other things, that Mr. Johnson will vote all of his shares of ourstock in favor of the Series D Amendment.   Mr. Johnsonowns approximately 3.7% of the Preferred Stock. During the quarter ended September 30,2009, we paid Mr. Johnson a cash preferred dividend payment ofapproximately $20,000.

 

Forward-lookingstatements in this Quarterly Report on Form 10-Q reflect Cano’s currentplans as a stand-alone entity and do not take into account the impact of theproposed Merger with Resaca, except where such statements specifically relateto the proposed Merger.

 

Resacais an independent oil and gas exploitation company headquartered in Houston,Texas, with operations focused on properties in the United States, specificallyin the Permian Basin of West Texas and southeast New Mexico.

 

***Liquidity***

 

At September 30,2009, we had cash and cash equivalents of $0.8 million and negative workingcapital of $1.9 million.  For thethree-month period ended September 30, 2009, we generated cash flow fromoperations of $0.5 million.

 

Wedepend on our credit agreements, as described in Note 4 to our ConsolidatedFinancial Statements, to fund a portion of our operating and capitalneeds. Under the ARCA, the initial and current borrowing base, based uponour proved reserves, is $60.0 million. At September 30, 2009, ourremaining available borrowing capacity under the ARCA was $13.8 million, and atNovember 13, 2009, our remaining available borrowing capacity was $10.0million.  Pursuant to the terms of theARCA, our borrowing base is to be redetermined based upon our June 30,2009 reserve report.  We have submitted our reserve report and otherfinancial information to our lenders. We have not received formal notificationof any changes to our borrowing base.

 

At September 30,2009, we were in compliance with the debt covenants contained in each of ourcredit agreements. The compliance determination for the twelve-month periodending December 31, 2009 will be the first financial covenant tests whichexclude the gain from our sale of the Pantwist Properties (see Note 6 to ourConsolidated Financial Statements). Based upon our nine month operating resultsthrough September 30, 2009, it appears likely that we may fall out ofcompliance with one or more of our financial covenants under our creditagreements as of December 31, 2009. If a combination of increased production, rising commodity prices,changes in our capital structure, the closing of our pending Merger and otheractions do not occur by December 31, 2009, we anticipate not being incompliance with the covenants. In that event, we will seek covenant relief fromour lenders, though there can be no assurance that we will be successful inobtaining such relief.

 

Our credit agreements,discussed in Note 4 to our Consolidated Financial Statements, include change ofcontrol provisions which require us to refinance the credit agreements at theclose of the Merger. We are working with Resaca regarding the creditarrangements for the combined company.

 

On December 28,2007, our universal shelf registration statement was declared effective by theSEC for the issuance of common stock, preferred stock, warrants, senior debtand subordinated debt up to an aggregate amount of $150.0 million.  Afterthe issuance of common stock on July 1, 2008, we have $96.0 million ofavailability under this registration; however, the amount of securities whichwe may offer pursuant to this shelf registration statement during anytwelve-month period shall be limited to one-third of the aggregate market valueof the common equity of the Company held by our non-affiliates since our publicfloat is not in excess of $75.0 million. We may periodically offer one or moreof these securities in amounts, prices and on terms to be announced when and ifthe securities are offered. At the time any of the securities covered by theregistration statement are offered for sale, a prospectus supplement will beprepared and filed with the SEC containing specific information about the termsof any such offering.

 

Historically, our primarysources of capital and liquidity have been issuance of equity securities,borrowings under our credit agreements, and cash flows from operatingactivities.  Our two credit agreementsare discussed in greater detail as presented below. For the 2010 Fiscal Year,we expect to fund our operations and capital 

 

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expenditures from cashfrom operations, borrowings under our credit agreements and the capitalmarkets. To develop our reserves as reported in our June 30, 2009 reservereport, we will require access to the capital markets in each of the next fouryears, as our projected capital expenditures are greater than projected cashflow from operations through December 2012.

 

***CreditAgreement Covenant Compliance***

 

At September 30,2009, the ARCA and subordinated credit agreements contain three principalfinancial covenants with reconciliations of each to corresponding GAAP amounts(if necessary):

 

·                  For both credit agreements, a current ratio covenant requires us tomaintain a ratio of not less than 1.00 to 1.00 for each fiscal quarter. Thecurrent ratio is calculated by dividing current assets (as defined in bothcredit agreements) by current liabilities (as defined in both creditagreements). Current assets include unused borrowing base under the ARCA andthe aggregate availability under the subordinated credit agreement. Currentliabilities exclude all current portions of long-term debt other than anycurrent debt relating to the Series D Convertible Preferred Stock andliabilities for asset retirement obligations. Current assets and currentliabilities exclude derivative assets and liabilities. At September 30,2009, our ratio of current assets to current liabilities was 1.73 to 1.00,calculated as follows (in thousands):

 
| ** **                                        | ** ** | **September 30, 2009** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|
| Current  assets (GAAP)                            |       | $                           | 9,014      |   |
| Unused  borrowing base at September 30, 2009 |       | 13,800                      | (1)        |
| Less:  derivative assets                          |       | (4,385                      | )          |
| Modified  current assets (non-GAAP)               |       | $                           | 18,429     | (A) |
|                                              |       |                        |       |
| Current  liabilities (GAAP)                       |       | $                           | 10,914     |   |
| Less:  derivative liabilities                     |       | (199                        | )          |
| Less:  asset retirement obligation                |       | (88                         | )          |
| Modified  current liabilities (non-GAAP)          |       | $                           | 10,627     | (B) |
|                                              |       |                        |       |
| Modified  current ratio (A) / (B)            |       | 1.73 to 1.00                |       |

 

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(1)     Represents the $60.0 million borrowing base underthe ARCA at September 30, 2009, less $46.2 million long-term debtoutstanding under the ARCA at September 30, 2009.

 

·                  We are required to maintain a ratio of consolidatedDebt (as defined in both credit agreements) to consolidated EBITDA (as definedin both credit agreements) covenant. Under the ARCA, we are required to maintain a ratio for the four fiscalquarter period then ended of not greater than 4.00 to 1.00.  Under the subordinated credit agreement, theratio is 4.50 to 1.00.  For the purposesof these ratios, Debt does not include amounts relating to our Series DConvertible Preferred Stock. At September 30, 2009, our ratio ofconsolidated Debt to EBITDA was 3.32 to 1.00, calculated as follows (inthousands):

 

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| ** **             | ** ** | **September 30, 2009** | ** ** |
|------------------------|------------|----------------------------------|------------|
| Long-term  debt (GAAP) |       | $                                | 61,200     | (C) |
|                        |            |                                  |            |  |

 
| ** **                                | ** ** | **Four Fiscal Quarter** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **Period Ended**             | ** ** |
| ** **                                | ** ** | **September 30, 2009**  | ** ** |
| Net  loss (GAAP)                          |       | $                                 | (16,547    | )(2) |
| Depletion,  depreciation and amortization |       | 5,771                             |       |
| Interest  expense, net                    |       | 546                               |       |
| Income  tax benefit                       |       | (8,028                            | )(2)       |
| Other  adjustments (non-GAAP)             |       | 36,708                            | (3)        |
| EBITDA  (non-GAAP)                        |       | $                                 | 18,450     | (D) |
|                                      |       |                              |       |
| Debt  to EBITDA (C) / (D)            |       | 3.32 to 1.00                      |       |

 

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(2) Throughthe quarter ending September 30, 2009, EBITDA includes the$19.2 million pre-tax gain on the sale of Pantwist LLC.

 

(3) Asdefined in both credit agreements, other items are considered in thecalculation of EBITDA, including impairment of long-lived assets and goodwill,stock-based compensation, accretion of discount on asset retirementobligations, exploration expense, settlements of fire litigation lawsuits andnon-cash items included in the computation of income from discontinuedoperations.

 

·                  We are required to maintain a ratio of consolidatedEBITDA (as defined in both agreements) to consolidated Interest Expense (asdefined in both agreements) covenant for the four fiscal quarter period thenended. Under the ARCA, we are required to maintain a ratio of not less than3.00 to 1.00.  Under the subordinatedcredit agreement, our ratio is 2.50 to 1.00. At September 30, 2009, our ratio of consolidated EBITDA toconsolidated Interest Expense ratio was 7.25 to 1.00, calculated as follows (inthousands):

 
| ** **                                    | ** ** | **Four Fiscal Quarter** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **Period Ended**             | ** ** |
| ** **                                    | ** ** | **September 30, 2009**  | ** ** |
| EBITDA  (non-GAAP) (see reconciliation above) |       | $                                 | 18,450     | (E) |
|                                          |       |                              |       |
| Interest  expense                             |       | $                                 | 546        |   |
| Capitalized  interest                         |       | 1,425                             |       |
| Cash  payment of preferred stock dividends    |       | 933                               |       |
| Less:  amortization of debt issuance costs    |       | (358                              | )          |
| Interest  expense (non-GAAP)                  |       | $                                 | 2,546      | (F) |
|                                          |       |                              |       |
| EBITDA  to interest expense (E) / (F)    |       | 7.25 to 1.00                      |       |

 

Bothof our credit agreements also contain customary events of default that wouldpermit our lenders to accelerate the debt under both credit agreements if notcured within applicable grace periods, including, among others, failure to makepayments of principal or interest when due, materially incorrectrepresentations and warranties, breach of covenants, failure to make mandatoryprepayments in the event of borrowing base deficiencies, events of bankruptcy,dissolution, the occurrence of one or more unstayed judgments in excess of$1,000,000 and defaults upon other obligations, including obligations under thesubordinated credit agreement. At September 30, 2009, we were incompliance with all of our covenants and had not committed any acts of defaultunder both the ARCA and the subordinated credit agreements.

 

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Basedon our current estimates of income and expenses, it appears likely that we mayfall out of compliance with one or more of our financial covenants under theARCA and/or the Subordinated Credit Agreement as of December 31, 2009. Weare currently in discussions with our lenders regarding this possibility andpotential solutions, including without limitation, obtaining waivers from theapplicable covenants, entering into amendments to our credit agreements orraising additional capital through equity issuances. If we are unable to obtainsuch waivers, to negotiate such amendments or to obtain necessary funding fromoperations or outside capital raising activities, we could default on ourobligations under one or both of our credit agreements, which default, if notcured or waived, could result in the acceleration of all indebtednessoutstanding under our credit agreements.

 

**Resultsof Operations**

 

For the quarter ended September 30,2009 (“current quarter”), we had a loss applicable to common stock of $4.0 million,which was a $15.8 million decrease as compared to the $11.8 million incomeapplicable to common stock incurred for the quarter ended September 30,2008 (“prior year quarter”).  Items contributing to the $15.8 millionearnings decrease were lower gain on derivatives of $24.2 million and loweroperating revenues of $5.7 million. Partially offsetting the earnings decrease were lower operating expensesof $2.5 million, reduced loss on discontinued operations of $0.9 million andlower preferred stock dividends of $0.5 million.

 

These items will beaddressed in the following discussion.

 

***Operating Revenues***

 

The table belowsummarizes our operating revenues for the quarters ended September 30,2009 and 2008.

 
| ** **                                                               | ** ** | **Quarter ended  September 30,** | ** ** | **Increase** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|
| ** **                                                               | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **(Decrease)** | ** ** |
| Operating  Revenues*(in thousands)*                                      |       | $                                          | 5,264      |         | $          | 10,931 |   | $ | (5,667 | ) |
| Sales                                                                    |       |                                       |       |         |       |   |   |
| ·   Crude Oil (MBbls)                                          |       | 72                                         |       | 72           |       | — |   |
| ·   Natural Gas (MMcf)                                         |       | 159                                        |       | 195          |       | (36 | ) |
| ·   Total (MBOE)                                               |       | 99                                         |       | 105          |       | (6 | ) |
| Average  Realized Price                                                  |       |                                       |       |         |       |   |   |
| ·   Crude Oil ($/ Bbl)                                         |       | $                                          | 61.20      |         | $          | 111.88 |   | $ | (50.68 | ) |
| ·   Natural Gas ($/ Mcf)                                       |       | $                                          | 5.24       |         | $          | 14.04 |   | $ | (8.80 | ) |
|                                                                     |       |                                       |       |         |       |   |   |
| Operating  Revenues and Commodity Derivative Settlements*(in thousands)* |       | $                                          | 7,115      |         | $          | 10,379 |   | $ | (3,264 | ) |
|                                                                     |       |                                       |       |         |       |   |   |
| Average  Adjusted Price (includes commodity derivative settlements)      |       |                                       |       |         |       |   |   |
| ·   Crude Oil ($/ Bbl)                                         |       | $                                          | 71.38      |         | $          | 106.25 |   | $ | (34.87 | ) |
| ·   Natural Gas ($/ Mcf)                                       |       | $                                          | 12.24      |         | $          | 13.30 |   | $ | (1.06 | ) |

 

The current quarteroperating revenues of $5.3 million are $5.6 million lower as compared to theprior year quarter of $10.9 million. The $5.6 million reduction is primarilyattributable to lower prices received for crude oil and natural gas sales of$3.7 million and $1.4 million, respectively, and lower natural gas salesvolumes which reduced revenues by $0.5 million.  The lower natural gassales occurred at the Panhandle Field (26 MMcf) and the Desdemona Field (10MMcf).

 

The impact of lowerprices for crude oil and natural gas sales, as discussed above, is partiallymitigated by commodity derivative settlements received during the currentquarter as presented in the preceding table. As discussed in Note 5 to ourConsolidated Financial Statements, if crude oil and natural gas NYMEX pricesare lower than derivative floor prices, we will be reimbursed by our counterpartyfor the difference between the NYMEX price and floor price (i.e. realizedgain). Conversely, if crude oil and natural gas NYMEX prices are higher thanthe 

 

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derivative ceilingprices, we will pay our counterparty for the difference between the NYMEX priceand ceiling price (i.e. realized loss).

 

***Crude Oil Sales.***    Our currentquarter crude oil sales approximated our prior year quarter sales.  Increased production from our Cato Propertiesof 2 MBbls was offset by lower sales from our Panhandle Properties as we hadtemporary shut-in production at the Cockrell Ranch waterflood due to thecontrolled injection project surveillance, as previously discussed under the *“Drilling Capital Development and OperatingActivities Update*.” All Cockrell Ranch production that had beenshut-in for the controlled injection project was restored on September 28,2009.

 

***Natural Gas Sales.***    The lower naturalgas sales during the current quarter occurred at the Panhandle Field (26 MMcf)and the Desdemona Field (10 MMcf).  Atthe Panhandle Field, lower natural gas sales resulted from the controlledproduction project at Cockrell Ranch waterflood, as previously discussed, andone of our gas purchasers experienced an unplanned plant outage from mid-August 2009through the end of September 2009, which resulted in reduced natural gasand NGL sales.  At the Desdemona Field,during July 2009, we shut-in our Barnett Shale natural gas wells basedupon the current and near-term outlook of natural gas prices.

 

***Crude Oil and Natural Gas Prices.***    The average pricewe receive for crude oil sales is generally at market prices received at thewellhead, except for the Cato Properties, for which we receive below marketprices due to the levels of impurities in the oil. The average price we receivefor natural gas sales is approximately the market price received at thewellhead, adjusted for the value of natural gas liquids, less transportationand marketing expenses. As previously discussed, we have commodity derivativesin place that mitigate future price risk.

 

Weexpect to grow sales through our development plans as previously discussedunder “*Overview—Development CapitalExpenditures and Operating Activities Update.”*

 

***Operating Expenses***

 

For thecurrent quarter, our total operating expenses were $9.8 million, which is adecrease of $2.4 million as compared to the prior year quarter of$12.2 million. The $2.4 million improvement resulted from lower generaland administrative of $1.3 million, reduced lease operating expenses of$0.7 million and decreased production and ad valorem taxes of$0.6 million.

 

***Lease Operating Expenses***

 

Ourlease operating expenses (“LOE”) consist of the costs of producing crude oiland natural gas such as labor, supplies, repairs, maintenance, workovers andutilities.

 

Forthe current quarter, our LOE was $4.4 million, which is $0.7 millionlower than the prior year quarter of $5.1 million. The $0.7 milliondecrease resulted primarily from reduced service rates negotiated with vendorsand the shut-in of our Barnett Shale natural gas wells, as previously discussedunder *“Operating Revenues*,” whichreduced LOE by $0.2 million.  Partiallyoffsetting these LOE cost reductions were increased LOE at the Cato Propertiesof $0.3 million to support higher levels of activity, as previously discussedunder *“Operating Revenue.”*

 

Forthe current quarter, our LOE per BOE, based on production, was $38.73, which isan improvement of $6.90 as compared to $45.63 for the prior year quarter. Ingeneral, secondary and tertiary LOE is higher than LOE for companies developingprimary production because our fields are more mature and typically produceless oil and more water. We expect LOE to decrease during the 2010 Fiscal Yearas we realize the continued benefit lower service rates negotiated withvendors, and we expect LOE per BOE to decrease as production increases from thewaterflood and EOR development activities we have implemented and areimplementing as discussed under the “*DrillingCapital Development and Operating Activities Update.*”

 

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***Production and Ad Valorem Taxes***

 

Forthe current quarter, our production and ad valorem taxes were$0.5 million, which is $0.6 million lower than the prior year quarterof $1.1 million. The $0.6 million decrease resulted from lower productiontaxes of $0.4 million due to lower operating revenues and reduced advalorem taxes of $0.2 million due to lower property tax valuations bytaxing authorities for the 2009 calendar year. Our production taxes as apercent of operating revenues for the current quarter were of 6.3% wascomparable to the prior year quarter of 7.0%.

 

***General and Administrative Expenses***

 

Ourgeneral and administrative (“G&A”) expenses consist of support services forour operating activities and investor relations costs.

 

Forthe current quarter, our G&A expenses totaled $3.6 million, which is$1.3 million lower than the prior year quarter of $4.9 million.  The $1.3 million expense reduction resultedfrom lower payroll and benefits costs of $0.3 million, reduced stock-basedcompensation costs of $0.6 million and reduced legal costs of $1.0 million,partially offset by increased costs related to the Merger of $0.8 million, asdiscussed in Note 2 to our Consolidated Financial Statements.

 

Thereduced payroll and benefits costs resulted from workforce reductions weimplemented during the quarter ended March 31, 2009, which eliminated 25%of our home office staff and is estimated to reduce payroll and benefits costsby $0.8 million annually.  The lowerstock-based compensation costs are directly related to reduced issuances ofstock options and restricted stock. Legal cost reduction occurred as we have settled all but one of our firelitigation claims during the fiscal year ended June 30, 2009 as discussedin Note 11 to our Consolidated Financial Statements, we expect significantdecreases in future quarters’ legal expenses.

 

***Depletion and Depreciation***

 

Forthe current quarter, our depletion and depreciation expense was$1.3 million, an increase of $0.1 million as compared to the prioryear quarter expense of $1.2 million. This includes depletion expensepertaining to our oil and natural gas properties, and depreciation expensepertaining to our field operations vehicles and equipment, natural gas plant,office furniture and computers.  Theincrease is due to higher depreciation of non-oil and gas properties assets,partially offset by lower depletion costs due to lower crude oil and naturalgas sales volumes (net) as previously discussed under “*Operating Revenues.”* For the currentquarter, our depletion rate pertaining to our oil and gas properties was $10.60per BOE, as compared to the prior year quarter rate of $10.36 per BOE.

 

***Interest Expense and Other***

 

Forthe current and prior year quarters, we incurred interest expense of$0.2 million and $0.1 million, respectively, as a direct result ofthe credit agreements we entered into, as discussed in Note 4 to ourConsolidated Financial Statements. The interest expense for the current andprior year quarters was reduced by $0.5 million and $0.3 million,respectively, for interest cost that was capitalized to the waterflood and ASPprojects discussed under the “*Overview -**Development Capital Expenditures and OperatingActivities Update.”* We incurred higher interest costs during thecurrent year quarter due to higher outstanding debt balances.

 

***Gain (Loss) on Derivatives***

 

Asdiscussed in Note 5 to our Consolidated Financial Statements, we haveentered into financial derivatives contracts for our commodity sales andinterest expense. For the current quarter, we recorded a loss on derivatives of$0.5 million as compared to a gain of $23.7 million for the prioryear quarter. The current quarter loss of $0.5 million consisted of anunrealized loss of $2.3 million and a realized gain on settlements ofderivative contracts of $1.8 million.

 

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Therealized gain primarily pertains to the realization of commodity settlements,as crude oil and natural gas NYMEX prices were lower than the floor prices.

 

Theunrealized loss for the current quarter reflects the fair value of thecommodity derivatives as of September 30, 2009 as compared to June 30,2009. By their nature, these commodity derivatives can have a highly volatileimpact on our earnings. A five percent change in the prices for our commodityderivative instruments could impact our pre-tax earnings by approximately$0.3 million.

 

***Income Tax Benefit (Expense)***

 

Forthe current quarter, we had an income tax benefit of $1.6 million, ascompared to an income tax expense for the prior year quarter of$8.1 million. The prior year quarter tax amount included taxes related todiscontinued operations as shown in Note 6 to our Consolidated FinancialStatements. The decreased income taxes for the current quarter, as compared tothe prior year quarter, resulted from the decrease in taxable income. Theeffective income tax rates for the current and prior year quarters were 31% and39%, respectively.

 

***Loss from Discontinued Operations***

 

Forthe current quarter, we had no income from discontinued operations, as comparedto a $0.9 million loss for the prior year quarter.  The prior year quarter loss pertains to ourdivestitures of the Pantwist, LLC and Corsicana Properties, as discussedin Note 6 to our Consolidated Financial Statements.

 

***Preferred Stock Dividend***

 

Thepreferred stock dividend for the current quarter of $0.5 million was adecrease of $0.4 million from $0.9 million for the prior yearquarter. The decrease is attributable to our November and December 2008repurchases of preferred stock. Due to the repurchases, our quarterly preferredstock dividends will be approximately $0.5 million per quarter of which59% will be PIK, with the balance paid in cash.

 

***New Accounting Pronouncements***

 

In June 2009,the FASB issued a standard that established the FASB Accounting StandardsCodificationTM (“ASC”) and amended the hierarchy of GAAP suchthat the ASC became the single source of authoritative nongovernmental GAAP.The ASC did not change current GAAP, but was intended to simplify user accessto all authoritative GAAP by providing all the authoritative literature relatedto a particular topic in one place. All previously existing accounting standarddocuments were superseded and all other accounting literature not included inthe ASC is considered non-authoritative. New accounting standards issuedsubsequent to June 30, 2009 are communicated by the FASB throughAccounting Standards Updates (ASUs). The ASC became effective for us on July 1,2009. This standard did not have an impact on our financial position, resultsof operations or cash flows. Throughout the notes to the consolidated financialstatements, references that were previously made to various formerauthoritative GAAP pronouncements have been conformed to the appropriatesection of the ASC.

 

In December 2007,the FASB issued ASC 805 (formerly SFAS No. 141 (revised 2007), *Business Combinations*). Among otherthings, ASC 805 establishes principles and requirements for how the acquirer ina business combination (i) recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquired business, (ii) recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase, and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. ASC 805 is effective for fiscal years beginning onor after December 15, 2008, with early adoption prohibited. We adopted ASC805 on July 1, 2009. This standard will change our accounting treatmentfor prospective business combinations.

 

In December 2007,the FASB issued ASC 810 (formerly SFAS No. 160, *Noncontrolling Interests in Consolidated Financial Statements, anAmendment of ARB No. 51*). ASC 810 establishes accounting andreporting 

 

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standards fornoncontrolling interests in a subsidiary and for the deconsolidation of asubsidiary. Minority interests will be recharacterized as noncontrollinginterests and classified as a component of equity. It also establishes a singlemethod of accounting for changes in a parent’s ownership interest in asubsidiary and requires expanded disclosures. This statement is effective forfiscal years beginning on or after December 15, 2008, with early adoptionprohibited. We adopted SFAS No. 160 on July 1, 2009. The adoption ofthis statement did not have a material impact on our financial position,results of operations or cash flows.

 

In March 2008, theFASB issued ASC 815 (formerly SFAS No. 161, *Disclosures about Derivative Instruments and Hedging Activities—AnAmendment of FASB Statement 13*). ASC 815 expands the requireddisclosures to discuss the uses of derivative instruments; the accounting forderivative instruments and related hedged items, and how derivative instrumentsand related hedged items affect the company’s financial position, financialperformance and cash flows. We adopted ASC 815 on July 1, 2009. Theadoption of this statement did not have a material impact on our financialposition, results of operations or cash flows.

 

In June 2008, the FASBissued ASC 260 (formerly EITF 03-6-1*,Determining Whether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities*). ASC 260 addresses whether instrumentsgranted in share-based payment transactions are participating securities priorto vesting and need to be included in the calculation of earnings per shareunder the two-class method*.* UnderASC 260, share-based payment awards that contain nonforfeitable rights todividends are “participating securities” and, therefore, should be included incomputing earnings per share using the two-class method. ASC 260 is effectivefor financial statements issued for fiscal years and interim periods beginningafter December 15, 2008. We adopted ASC 260 on July 1, 2009. Theeffect of adopting ASC 260 increased the number of shares used to computeearnings per share; however, the adoption of ASC 260 did not have a materialimpact on our financial position, results of operations or cash flows.

 

In December 2008,the FASB issued ASC 815 (formerly EITF****07-5,*Determining Whether an Instrument (orEmbedded Feature) Is Indexed to an Entity’s Own Stock*).  ASC815 affects companies that have provisions in their securities purchaseagreements (for warrants and convertible instruments) that reset conversionprices based upon new issuances by companies at prices below the currentconversion price of said instrument.  Warrants and convertible instrumentswith such provisions will require the embedded derivative instrument to bebifurcated and separately accounted for as a derivative.  Subject tocertain exceptions, our Preferred Stock provides for resetting the conversionprice if we issue new common stock below $5.75 per share.  ASC 815 iseffective for financial statements issued for fiscal years and interim periodsbeginning after December 15, 2008. We adopted ASC 815 on July 1,2009. The adoption of this statement did not have a material impact on ourfinancial position, results of operations or cash flows since the resetconversion provision did not meet the definition of a derivative since it wasnot readily net-cash settled.

 

In June 2009, theFASB issued ASC 855 (formerly SFAS 165,*Subsequent Events*)to establish general standards of accounting for and disclosure of events thatoccur after the balance sheet date, but prior to the issuance of financialstatements. Specifically, ASC 855 sets forth: (1) the period after thebalance sheet date during which management of a reporting entity shouldevaluate events or transactions that may occur for potential recognition ordisclosure in the financial statements; (2) the circumstances under whichan entity should recognize events or transactions occurring after the balancesheet date in its financial statements; and (3) the disclosures that anentity should make about events or transactions that occurred after the balancesheet date. ASC 855 is effective for financial statements issued for interim orannual periods ending after June 15, 2009. We adopted ASC 855 on June 30,2009 and considered subsequent events through November 13 2009. Theadoption of this statement did not have a material impact on our financialposition, results of operations or cash flows.

 

**Item 4T.Controls and Procedures.**

 

As of the end of theperiod covered by this report, our management conducted an evaluation, underthe supervision and with the participation of our chief executive officer andchief financial officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) ofthe Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon thisevaluation, our chief executive officer and chief financial officer concluded,as of September 30, 2009, that our disclosure controls and procedures wereeffective to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is: (1) recorded,processed, summarized and reported, within the time periods specified in theSecurities and 

 

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Exchange Commission’s rules andforms and (2) accumulated and communicated to management, including ourchief executive officer and chief financial officer, to allow timely decisionsregarding required disclosure.

 

During the quarter ended September 30,2009, there was no change in our internal control over financial reporting thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II— OTHER INFORMATION**

 

**Item 1.Legal Proceedings.**

 

See Note 11 to ourConsolidated Financial Statements which is incorporated into this “Item 1.Legal Proceedings” by reference.

 

**Item2.  Unregistered Sales of Equity Securities and Use of Proceeds.**

 

The following shares ofour common stock were delivered to us during the quarter ended September 30,2009 from S. Jeffrey Johnson, Patrick McKinney and Michael Ricketts, pursuantto the terms of the Cano Petroleum, Inc. 2005 Long-Term Incentive Plan, tosatisfy tax withholding obligations relating to the vesting of restricted stockawards:

 
| **Period**                                              | ** ** | **Total  Number  of Shares  (or Units)  Purchased** | ** ** | **Average  Price Paid  per Share  (or Unit)** | ** ** | **Total Number of  Shares  (or Units)  Purchased as  Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum Number  (or Approximate  Dollar Value) of  Shares (or Units)  that May Yet Be  Purchased Under  the Plans or  Programs** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1,  2009 through July 31, 2009           |       | 24,686                                                        |       | $                                                            | 0.85       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |
|                                                    |       |                                                          |       |                                                         |       |                                                                                                                                          |       |                                                                                                                                                                                           |       |
| August 1,  2009 through August 31, 2009       |       | —                                                        |       | —                                                       |       | —                                                                                                                                        |       | —                                                                                                                                                                                         |       |
|                                                    |       |                                                          |       |                                                         |       |                                                                                                                                          |       |                                                                                                                                                                                           |       |
| September 1,  2009 through September 30, 2009 |       | —                                                        |       | $                                                            | —     |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |
|                                                    |       |                                                          |       |                                                         |       |                                                                                                                                          |       |                                                                                                                                                                                           |       |
| Total                                                   |       | 24,686                                                        |       | $                                                            | 0.85       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |

 

**Item 6.Exhibits.**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                 |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | Agreement and Plan of  Merger, dated September 29, 2009 by and among Resaca  Exploitation, Inc., Resaca Acquisition Sub, Inc. and Cano Petroleum, Inc.,  incorporated by reference from Exhibit 2.1 to Current Report on  Form 8-K filed on October 1, 2009. |
| 10.1                |       | Temporary Waiver of  Benefits by and between Cano Petroleum, Inc. and S. Jeffrey Johnson  effective as of October 28, 2008, incorporated by reference from  Exhibit 10.1 to Current Report on Form 8-K filed on July 8,  2009.                                         |
| 10.2*               |       | Gas Purchase Agreement  by and between W.O. Operating Company Ltd. and DCP Midstream, L.P. effective  on July 1, 2009.                                                                                                                                                                     |
| 10.3                |       | Stock Voting Agreement,  dated as of September 29, 2009 by and between Cano Petroleum, Inc.  and D.E. Shaw Laminar Portfolios, L.L.C., incorporated by reference from  Exhibit 10.1 to Current Report on Form 8-K filed on October 1,  2009.                           |
| 10.4                |       | Separation Agreement  and Release, dated as of September 29, 2009 by and among Cano  Petroleum, Inc., Resaca Exploitation, Inc. and S. Jeffrey Johnson,  incorporated by reference from Exhibit 10.2 to Current Report on  Form 8-K filed on October 1, 2009.     |
| 10.5                |       | Separation Agreement  and Release, dated as of September 29, 2009 by and among Cano                                                                                                                                                                                                        |

 

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|   |   | Petroleum, Inc.,  Resaca Exploitation, Inc. and Benjamin L. Daitch, incorporated by  reference from Exhibit 10.3 to Current Report on Form 8-K filed on  October 1, 2009.                                                                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1*  |   | Certification by Chief  Executive Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            |
| 31.2*  |   | Certification by Chief  Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of  the Exchange Act, promulgated pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                            |
| 32.1*  |   | Certification by Chief  Executive Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2*  |   | Certification by Chief  Financial Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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*              Filedherewith

 

**SIGNATURES**

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

**CANOPETROLEUM, INC.**

 
| Date: November 13,  2009 | By:    | /s/ S. Jeffrey  Johnson                            |
|-------------------------------|--------|----------------------------------------------------|
|                          |   | S. Jeffrey  Johnson                                |
|                          |   | Chief Executive  Officer                           |
|                          |   |                                               |
|                          |   |                                               |
| Date:  November 13, 2009 | By:    | /s/ Benjamin  Daitch                               |
|                          |   | Benjamin Daitch                                    |
|                          |   | Senior  Vice-President and Chief Financial Officer |

 

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