**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**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 March 31, 2008** |
|                                                   |                                                                                                    |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                        |                                                                                                         |  |

 

**For the transition periodfrom        to        **

 

**Commission file number 001-32496**

 

**CANOPETROLEUM, INC.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                                                      | ** ** | **77-0635673**                     |
|-------------------------------------------------------------------|------------|------------------------------------|
| (State  or other jurisdiction of incorporation or   organization) |       | (IRS  Employer Identification No.) |

 

**The Burnett Plaza**

**801 Cherry Street, Suite 3200**

**Fort Worth, TX 76102**

(Addressof principal executive offices)

 

**(817) 698-0900**

(Issuer’stelephone number)

 

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

 

Yes  x    No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o    No  x

 

 Indicatethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date:  38,689,015 shares of commonstock, $.0001 par value per share, as of May 7, 2008.

 

 

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**PART I– FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                          | ** ** | **March 31,** | ** **  | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|-------------|-------------------|------------|
| **In Thousands, Except  Shares and Per Share Amounts**                                                                                                                                                                                                              | ** ** | **2008**           | ** **  | **2007**          | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                        |       |               |        |              |       |
| **Current  assets**                                                                                                                                                                                                                                                 |       |               |        |              |       |
| Cash and cash equivalents                                                                                                                                                                                                                                           |       | $                  | 498         |              | $          | 2,119 |   |
| Accounts receivable                                                                                                                                                                                                                                                 |       | 4,140              |        | 4,081             |       |
| Prepaid expenses                                                                                                                                                                                                                                                    |       | 475                |        | 309               |       |
| Derivative assets                                                                                                                                                                                                                                                   |       | —             |        | 810               |       |
| Inventory and other current  assets                                                                                                                                                                                                                                 |       | 395                |        | 293               |       |
| Total current assets                                                                                                                                                                                                                                                |       | 5,508              |        | 7,612             |       |
|                                                                                                                                                                                                                                                                |       |               |        |              |       |
| **Oil  and gas properties****,**successful  efforts method                                                                                                                                                                                                          |       | 258,809            |        | 189,843           |       |
| Less accumulated depletion  and depreciation                                                                                                                                                                                                                        |       | (8,890             | )           | (6,202            | )          |
| Net oil and gas properties                                                                                                                                                                                                                                          |       | 249,919            |        | 183,641           |       |
|                                                                                                                                                                                                                                                                |       |               |        |              |       |
| Fixed assets and other,  net                                                                                                                                                                                                                                        |       | 1,532              |        | 1,548             |       |
| Restricted cash (Notes 2,  10)                                                                                                                                                                                                                                      |       | —             |        | 6,000             |       |
| Derivative assets                                                                                                                                                                                                                                                   |       | 359                |        | 1,882             |       |
| Goodwill                                                                                                                                                                                                                                                            |       | 786                |        | 786               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                    | ** ** | **$**              | **258,104** | ** **        | **$**      | **201,469** | ** ** |
|                                                                                                                                                                                                                                                                |       |               |        |              |       |
| ***LIABILITIES AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                     |       |               |        |              |       |
| **Current  liabilities**                                                                                                                                                                                                                                            |       |               |        |              |       |
| Accounts payable                                                                                                                                                                                                                                                    |       | $                  | 12,836      |              | $          | 7,509 |   |
| Oil and gas sales payable                                                                                                                                                                                                                                           |       | 1,603              |        | 1,346             |       |
| Accrued liabilities                                                                                                                                                                                                                                                 |       | 1,205              |        | 1,421             |       |
| Derivative liability                                                                                                                                                                                                                                                |       | 1,734              |        | —            |       |
| Other current liabilities                                                                                                                                                                                                                                           |       | 564                |        | 714               |       |
| Total current liabilities                                                                                                                                                                                                                                           |       | 17,942             |        | 10,990            |       |
| **Long-term  liabilities**                                                                                                                                                                                                                                          |       |               |        |              |       |
| Long-term debt (Note 2)                                                                                                                                                                                                                                             |       | 55,204             |        | 33,500            |       |
| Asset retirement  obligations                                                                                                                                                                                                                                       |       | 2,233              |        | 2,151             |       |
| Deferred litigation credit  (Note 10)                                                                                                                                                                                                                               |       | 6,000              |        | 6,000             |       |
| Derivative liability                                                                                                                                                                                                                                                |       | 975                |        | —            |       |
| Deferred tax liability                                                                                                                                                                                                                                              |       | 31,235             |        | 32,371            |       |
| Total liabilities                                                                                                                                                                                                                                                   |       | 113,589            |        | 85,012            |       |
|                                                                                                                                                                                                                                                                |       |               |        |              |       |
| **Temporary  equity**                                                                                                                                                                                                                                               |       |               |        |              |       |
| Series D convertible  preferred stock and paid-in-kind dividend; par value $.0001 per share, stated  value $1,000 per share; 49,116 authorized and 44,541 shares issued;  liquidation preference of $47,886,806 and $50,862,925, respectively                  |       | 44,620             |        | 47,596            |       |
|                                                                                                                                                                                                                                                                |       |               |        |              |       |
| **Commitments  and contingencies (Note 10)**                                                                                                                                                                                                                        |       |               |        |              |       |
| **Stockholders’  equity**                                                                                                                                                                                                                                      |       |               |        |              |       |
| Common stock, par value  $.0001 per share; 100,000,000 authorized; 39,957,309 and 38,689,015 shares  issued and outstanding at March 31, 2008, respectively; and 33,956,392  and 32,688,098 shares issued and outstanding at June 30, 2007,  respectively |       | 4                  |        | 3                 |       |
| Additional paid-in capital                                                                                                                                                                                                                                          |       | 121,022            |        | 85,239            |       |
| Accumulated deficit                                                                                                                                                                                                                                                 |       | (20,560            | )           | (15,810           | )          |
| Treasury stock, at cost;  1,268,294 shares held in escrow                                                                                                                                                                                                           |       | (571               | )           | (571              | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                     |       | 99,895             |        | 68,861            |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                | ** ** | **$**              | **258,104** | ** **        | **$**      | **201,469** | ** ** |

 

***See accompanying notes to these unaudited financial statements.***

 

2

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                        | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| **In Thousands, Except Per Share  Data**                          | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Operating  Revenues:**                                          | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil sales                                                   |       | $                                | 7,384      |                            | $          | 3,412 |   | $ | 18,253 |   | $ | 12,006 |   |
| Natural gas sales                                                 |       | 4,192                            |       | 2,471                           |       | 11,905 |   | 7,710 |   |
| Other revenue                                                     |       | 79                               |       | —                          |       | 238 |   | — |   |
| Crude oil and natural gas  sales                                  |       | 11,655                           |       | 5,883                           |       | 30,396 |   | 19,716 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Operating  Expenses:**                                          |       |                             |       |                            |       |   |   |   |   |
| Lease operating                                                   |       | 4,103                            |       | 2,884                           |       | 10,390 |   | 7,940 |   |
| Production and ad valorem  taxes                                  |       | 859                              |       | 560                             |       | 2,313 |   | 1,735 |   |
| General and administrative                                        |       | 3,340                            |       | 2,965                           |       | 10,725 |   | 8,751 |   |
| Depletion and depreciation                                        |       | 1,277                            |       | 1,062                           |       | 3,672 |   | 3,169 |   |
| Total operating expenses                                          |       | 9,579                            |       | 7,471                           |       | 27,100 |   | 21,595 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Income  (loss) from operations**                                |       | 2,076                            |       | (1,588                          | )          | 3,296 |   | (1,879 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Other income  (expenses):**                                     |       |                             |       |                            |       |   |   |   |   |
| Interest expense                                                  |       | (126                             | )          | (286                            | )          | (637 | ) | (2,160 | ) |
| Unrealized loss on  commodity derivatives                         |       | (3,243                           | )          | (1,633                          | )          | (5,605 | ) | (1,790 | ) |
| Realized gain (loss) on  commodity derivatives                    |       | (328                             | )          | 107                             |       | (69 | ) | 858 |   |
| Total other income  (expenses)                                    |       | (3,697                           | )          | (1,812                          | )          | (6,311 | ) | (3,092 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Loss from continuing  operations before income taxes              |       | (1,621                           | )          | (3,400                          | )          | (3,015 | ) | (4,971 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Income tax benefit                                                |       | 571                              |       | 1,149                           |       | 1,046 |   | 1,746 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Loss from  continuing operations**                              |       | (1,050                           | )          | (2,251                          | )          | (1,969 | ) | (3,225 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Income (loss) from  discontinued operations, net of related taxes |       | —                           |       | 60                              |       | (49 | ) | 220 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Net loss**                                                      |       | (1,050                           | )          | (2,191                          | )          | (2,018 | ) | (3,005 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Preferred stock dividend                                          |       | 877                              |       | 967                             |       | 2,732 |   | 2,203 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Net loss  applicable to common stock**                          |       | $                                | (1,927     | )                               | $          | (3,158 | ) | $ | (4,750 | ) | $ | (5,208 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Net income  (loss) per share - basic and diluted**              |       |                             |       |                            |       |   |   |   |   |
| Continuing operations                                             |       | $                                | (0.05      | )                               | $          | (0.10 | ) | $ | (0.14 | ) | $ | (0.18 | ) |
| Discontinued operations                                           |       | —                           |       | —                          |       | — |   | 0.01 |   |
| **Net loss per  share - basic and diluted**                       |       | $                                | (0.05      | )                               | $          | (0.10 | ) | $ | (0.14 | ) | $ | (0.17 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| **Weighted  average common shares outstanding**                   |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted                                                 |       | 37,370                           |       | 32,168                          |       | 35,029 |   | 30,034 |   |

 

***See accompanying notes to these unaudited financial statements.***

 

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENT OF CHANGES**

**IN STOCKHOLDERS’ EQUITY**

**JULY 1, 2007 THROUGH MARCH 31, 2008**

**(Unaudited)**

 
| ** **                                                                    | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** ** | ** **  | ** ** | ** **    | ** ** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------|-------------|------------|---------------|------------|------------|
| ** **                                                                    | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **  |
| **Dollar Amounts in Thousands**                                               | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares** | ** **  | **Amount** | ** **    | **Total**  | ** ** |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| **Balance at  June 30, 2007**                                            | ** ** | **33,956,392**        | ** ** | **$**       | **3**      | ** **      | **$**      | **85,239**              | ** ** | **$**      | **(15,810** | **)**      | **1,268,294** | ** ** | **$**      | **(571** | **)** | **$** | **68,861** | ** ** |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Issuance of restricted  stock                                                 |       | 395,000               |       | —      |       | —          |       | —                  |       | —     |        | —     |          | —     |       |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Stock based compensation  expense                                             |       | —                |       | —      |       | 2,115           |       | —                  |       | —     |        | —     |          | 2,115      |       |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Net proceeds from issuance  of common shares from private placement and other |       | 3,575,000             |       | 1           |       | 23,899          |       | —                  |       | —     |        | —     |          | 23,900     |       |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Net proceeds from issuance  of common shares for warrants exercised           |       | 1,228,851             |       | —      |       | 5,194           |       | —                  |       | —     |        | —     |          | 5,194      |       |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Common stock issued for  preferred stock conversion                           |       | 802,066               |       | —      |       | 4,575           |       | —                  |       | —     |        | —     |          | 4,575      |       |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Preferred stock dividend                                                      |       | —                |       | —      |       | —          |       | (2,732                  | )          | —     |        | —     |          | (2,732     | )          |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Net loss                                                                      |       | —                |       | —      |       | —          |       | (2,018                  | )          | —     |        | —     |          | (2,018     | )          |
|                                                                          |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| **Balance at  March 31, 2008**                                           | ** ** | **39,957,309**        | ** ** | **$**       | **4**      | ** **      | **$**      | **121,022**             | ** ** | **$**      | **(20,560** | **)**      | **1,268,294** | ** ** | **$**      | **(571** | **)** | **$** | **99,895** | ** ** |

 

***See accompanying notes to these unaudited financial statements.***

 

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
| ** **                                                                              | ** ** | **Nine Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **In Thousands**                                                                        | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| **Cash flow from operating activities:**                            |       |                                                |       |   |   |
| Net loss                                                                                |       | $                                                   | (2,018     | ) | $ | (3,004 | ) |
| Adjustments needed to  reconcile net loss to net cash provided by operating activities: |       |                                                |       |   |   |
| Unrealized loss on  commodity derivatives                                               |       | 5,605                                               |       | 1,790 |   |
| Depletion and depreciation                                                              |       | 3,672                                               |       | 3,300 |   |
| Stock based compensation  expense                                                       |       | 2,115                                               |       | 615 |   |
| Deferred income tax  benefit                                                            |       | (1,136                                              | )          | (1,622 | ) |
| Amortization of debt  issuance costs and prepaid expenses                               |       | 970                                                 |       | 1,833 |   |
| Changes in assets and  liabilities relating to operations:                              |       |                                                |       |   |   |
| Restricted cash                                                                         |       | 6,000                                               |       | (6,000 | ) |
| Accounts receivable                                                                     |       | (59                                                 | )          | 210 |   |
| Derivative assets                                                                       |       | (291                                                | )          | (1,218 | ) |
| Prepaid assets                                                                          |       | (923                                                | )          | (1,522 | ) |
| Inventory                                                                               |       | (102                                                | )          | (89 | ) |
| Accounts payable                                                                        |       | (467                                                | )          | 566 |   |
| Oil and gas sales payable                                                               |       | 257                                                 |       | (517 | ) |
| Accrued liabilities                                                                     |       | (216                                                | )          | 413 |   |
| Other current liabilities                                                               |       | (169                                                | )          | (167 | ) |
| Deferred litigation  liability                                                          |       | —                                              |       | 6,000 |   |
| Other current assets                                                                    |       | —                                              |       | 541 |   |
| **Net cash  provided by operating activities**                                          | ** ** | **13,238**                                          | ** ** | **1,129** | ** ** |
| **Cash flow  from investing activities:**                                               |       |                                                |       |   |   |
| Additions to oil and gas  properties                                                    |       | (66,725                                             | )          | (21,878 | ) |
| Acquisition of New Mexico  oil and gas properties                                       |       | —                                              |       | (6,214 | ) |
| Additions to fixed assets  and other                                                    |       | (174                                                | )          | (668 | ) |
| Sale of equipment used in  oil and gas producing activities                             |       | 3,000                                               |       | — |   |
| Acquisition of additional  Davenport revenue interest                                   |       | —                                              |       | (133 | ) |
| **Net cash  used in investing activities**                                              | ** ** | **(63,899**                                         | **)**      | **(28,893** | **)** |
| **Cash flow  from financing activities:**                                               |       |                                                |       |   |   |
| Paydown long-term debt                                                                  |       | —                                              |       | (68,750 | ) |
| Payment of debt issuance  cost                                                          |       | (487                                                | )          | — |   |
| Proceeds from borrowings  of long-term debt                                             |       | 22,000                                              |       | 21,500 |   |
| Payment of preferred stock  dividends                                                   |       | (1,567                                              | )          | (989 | ) |
| Proceeds from issuance of  preferred stock, net                                         |       | —                                              |       | 45,851 |   |
| Proceeds from issuance of  common stock and warrants, net                               |       | 29,094                                              |       | 29,626 |   |
| **Net cash  provided by financing activities**                                          | ** ** | **49,040**                                          | ** ** | **27,238** | ** ** |
| Net decrease in cash and  cash equivalents                                              |       | (1,621                                              | )          | (526 | ) |
| Cash and cash equivalents  at beginning of period                                       |       | 2,119                                               |       | 645 |   |
| **Cash and  cash equivalents at end of period**                                         | ** ** | **$**                                               | **498**    | ** ** | **$** | **119** | ** ** |
| **Supplemental  disclosure of noncash transactions:**                                   |       |                                                |       |   |   |
| Payment of preferred stock  dividends in kind                                           |       | $                                                   | 1,599      |   | $ | 1,214 |   |
| Common stock issued for  preferred stock conversion                                     |       | 4,575                                               |       | — |   |
| Common stock issued for  acquisition of oil and gas properties                          |       | $                                                   | —     |   | $ | 1,854 |   |
| **Supplemental  disclosure of cash transactions:**                                      |       |                                                |       |   |   |
| Cash paid during the  period for interest                                               |       | $                                                   | 2,550      |   | $ | 2,581 |   |

 

***See accompanying notes to these unaudited financial statements.***

 

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** **

**CANO PETROLEUM, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

 

**1.****             ****BASIS OF PRESENTATION ANDUSE OF ESTIMATES**

 

The interim consolidated financial statementsof Cano Petroleum, Inc. are unaudited and contain all adjustments(consisting primarily of normal recurring accruals) necessary for a fairstatement of the results for the interim periods presented. Results for interimperiods are not necessarily indicative of results to be expected for a fullyear or for previously reported periods due in part, but not limited to, thevolatility in prices for crude oil and natural gas, future commodity prices forcommodity derivatives, interest rates, estimates of reserves, drilling risks,geological risks, transportation restrictions, the timing of acquisitions,product demand, market competition, interruption in production, our ability toobtain additional capital, and the success of waterflooding and enhanced oilrecovery techniques. You should read these consolidated interim financialstatements in conjunction with the audited consolidated financial statementsand notes thereto included in Cano’s Form 10-K dated June 30, 2007.

 

The accompanying financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States of America (“GAAP”) and include the accounts of Cano and itswholly-owned subsidiaries. Intercompany accounts and transactions areeliminated. In preparing the accompanying financial statements, management hasmade certain estimates and assumptions that affect reported amounts in thefinancial statements and disclosures of contingencies. Actual results maydiffer from those estimates. Significant assumptions are required in thevaluation of proved oil and natural gas reserves, which may affect the amountat which oil and natural gas properties are recorded. The computation of stockbased compensation expense requires assumptions such as volatility, expectedlife and the risk-free interest rate. It is at least reasonably possible theseestimates could be revised in the near term, and these revisions could bematerial.

 

**NewAccounting Pronouncements**

 

On July 13, 2006, the FinancialAccounting Standards Board (“FASB”) released FIN 48, “Accounting forUncertainty in Income Taxes—an Interpretation of FASB Statement 109” (“FIN 48”).FIN 48 requires a company to evaluate and disclose material uncertain taxpositions it has taken with various taxing jurisdictions. Any interest andpenalties related to uncertain tax positions would be recorded as interestexpense and general and administrative expense, respectively. We adopted FIN 48on July 1, 2007. At the time of adoption and as of March 31, 2008, wedetermined the adoption of FIN 48 does not materially affect our operatingresults, financial position, or cash flows. As of March 31, 2008, we havenot recorded any accruals for uncertain tax positions. We are not involved inany examinations by the Internal Revenue Service. For Texas, Oklahoma, NewMexico and U.S. federal purposes, the review of our tax returns is open for thetax years of 2004 through 2007.

 

Statement of Financial Accounting Standards No. 157,*Fair Value Measurements*, (“SFAS No. 157”)was issued by the FASB in September 2006. SFAS No. 157 defines fairvalue, establishes a framework for measuring fair value under GAAP and expandsdisclosures about fair value measurements. SFAS No. 157 applies to otheraccounting pronouncements that require or permit fair value measurement. No newrequirements are included in SFAS No. 157, but application of the SFAS No. 157will result in additional disclosure requirements. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007. We do not expect adoption of SFAS No. 157 will have a materialimpact on our financial position, results of operations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), *Business Combinations*(“SFASNo. 141R”). SFAS No. 141R, which among other things, establishesprinciples and requirements for how the acquirer in a business combination (i) recognizesand measures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquired business, (ii) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase, and (iii) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. SFAS No. 141R is effective for fiscalyears beginning on or after 

 

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December 15, 2008, with early adoption prohibited. This standardwill change our accounting treatment for business combinations on a prospectivebasis.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements, an Amendment of ARB No. 51* (“SFAS No. 160”).SFAS No. 160 establishes accounting and reporting 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 do not expect the adoption of this statement will have amaterial impact on our financial position, results of operations or cash flows.

 

**2.     LONG-TERM DEBT**

 

At March 31, 2008, the outstandinglong-term debt was $55.5 million, which consisted of $40.5 million underthe senior credit agreement and $15.0 million under the subordinated creditagreement.  Both agreements are discussedin greater detail below.  At March 31,2008, the average interest rate for the two agreements was 5.73%, consisting of4.70% for the senior credit agreement and 8.51% for the subordinated creditagreement.  The interest expense for thecurrent quarter and current nine months was reduced by $0.6 million and $1.7million, respectively, of interest cost that was capitalized to the waterfloodprojects at our Panhandle, Desdemona and Corsicana Properties and to ouralkaline-surfactant-polymer project at the Nowata Properties.

 

At June 30, 2007, the outstanding amountof debt due under the senior credit agreement was $33.5 million and we were incompliance with the debt covenants under the senior credit agreement. At March 31,2008, we were in compliance with the debt covenants of both credit agreements.

 

***Subordinated Credit Agreement***

 

On March 17, 2008, we entered into a$25.0 million subordinated credit agreement with UnionBanCal Equities, Inc.(“UBE”) as the administrative agent.  The initial amount available forborrowing was $15 million which was drawn on March 18, 2008 and used toreduce the outstanding amount under the $100 million senior credit agreementwith Union Bank of California, N.A. as the administrative agent and as issuinglender.  Pursuant to the terms of the subordinated credit agreement, wemay request additional borrowings of up to $10 million with the lendersdetermining in their own discretion whether to permit such additionalborrowings.  Any additional borrowings must be used to reduce theoutstanding amount under the senior credit agreement.

 

At our option, interest is either (i) theprime rate plus the applicable margin of (a) 4.75% if the consolidatedDebt (as defined in the subordinated credit agreement) to consolidated EBITDA(as defined in the subordinated credit agreement) ratio is less than or equalto 4.00 to 1.00 or (b) 5% if the consolidated Debt to consolidated EBITDAratio is greater than 4.00 to 1.00 or (ii) the LIBOR rate plus theapplicable margin of (a) 5.75% if the consolidated Debt to consolidatedEBITDA ratio is less than or equal to 4.00 to 1.00 or (b) 6% if theconsolidated Debt to consolidated EBITDA ratio is greater than 4.00 to1.00.  At March 31, 2008, the interest rate was 8.51% based on LIBORplus 5.75%.  If the interest rate is based on the prime rate, interestpayments are due quarterly, and if the interest rate is based on the LIBORrate, interest payments are due every three months.

 

Unless specific events of default occur, thematurity date is March 17, 2011, subject to our right to request up to twoextensions of one year each with the lenders determining in their owndiscretion whether to permit such extensions.  Specific events of defaultwhich could cause all outstanding principal and accrued interest to beaccelerated, include, but are not limited to, payment defaults, breaches ofrepresentations and warranties and covenants by us, certain cross-defaults,insolvency, a Change in Control or a Material Adverse Change (as both terms aredefined in the subordinated credit agreement).

 

The subordinated credit agreement containscertain negative covenants for us including, but not limited to, covenants,subject to certain exceptions, against the following: (i) incurringadditional liens, (ii) incurring additional debt; (iii) merging orconsolidating or selling, transferring, assigning, farming-out, conveying orotherwise disposing of any property, (iv) making certain payments,including cash dividends to our common 

 

7

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stockholders, (v) making any loans, advances or capitalcontributions to, or making any investment in, or purchasing or committing topurchase any stock or other securities or evidences of indebtedness or interestin any person or oil and gas properties or activities related to oil and gasproperties unless (a) with regard to new oil and gas properties, suchproperties are mortgaged to UBE as administrative agent, or (b) withregard to new subsidiaries, such subsidiaries execute a guaranty, pledge agreement,security agreement or mortgage in favor of UBE, as administrative agent, and (vi) enteringinto affiliate transactions on terms that are not at least as favorable to usas comparable arm’s length transactions.

 

We must also meet certain financialratios.  The ratio of Current Assets to Current Liabilities (as both termsare defined in the subordinated credit agreement) must not be less than 1.00 to1.00 for each fiscal quarter.  The ratio of consolidated Debt toconsolidated EBITDA must not be greater (i) for the quarter ending on March 31,2008, 5.50 to 1.00 and (ii) for all subsequent quarters, 5.00 to1.00.  The ratio of consolidated EBITDA for the previous four fiscalquarters to Interest Expense (as defined in the subordinated credit agreement)for the previous four fiscal quarters must not be less than 1.50 to 1.00. At any time, the ratio of Total Present Value (as defined in the subordinatedcredit agreement) to consolidated Debt must not be less than 1.50 to 1.00.

 

In addition, we are required to maintain thecurrent hedges as summarized in Note 3 until their stated maturity and, unlessotherwise agreed to by the lenders, we are required to maintain hedges coveringat least 50% and no greater than 85% of the production volumes attributable toproved, producing reserves for at least three years and as of the end of eachsix month period ending thereafter at a minimum price floor as set by thelenders.

 

Eight of oursubsidiaries are guarantors under the subordinated credit agreement.  We and eight of our subsidiaries executedmortgages covering all of the oil and gas properties owned by us and the eightsubsidiaries and security agreements covering substantially all assets owned byus and the eight subsidiaries.  Inaddition, we and certain subsidiaries executed pledge agreements covering ourand such subsidiaries’ ownership interests in the eight subsidiaries.

 

***Senior Credit Agreement***

 

At March 31, 2008, the amountoutstanding due under the senior credit agreement is $40.5 million out of a $60million borrowing base.  At March 31, 2008, the average interest ratewas 4.70%.  On September 7, 2007, weentered into Amendment No. 7 to the credit agreement, which provides for (i) anincrease to our borrowing base from $44.0 million to $60.0 million; (ii) permitsus to use $6.0 million of the previously received insurance proceeds forgeneral corporate purposes (as more fully discussed in Note 10); and (iii) providesthat the leverage ratio (a) at the end of each fiscal quarter ending priorto June 30, 2008 shall not be greater than 5.00 to 1.00; (b) at theend of each fiscal quarter ending on or after June 30, 2008 but prior to December 31,2008 shall not be greater than 4.50 to 1.00; and (c) at the end of eachfiscal quarter ending on or after December 31, 2008 shall not be greaterthan 4.00 to 1.00 and for the purposes of calculating the leverage ratio, thedefinition of “consolidated Debt” shall not include “Debt” outstanding underpreferred stock.

 

**3.****             ****COMMODITY DERIVATIVES**

 

Pursuant to our credit agreements discussedin Note 2, we are required to enter into commodity derivative contracts tomitigate price risk on at least 50% and no greater than 85% of our crude oiland natural gas production volumes attributable to proved, producing reservesfor at least three years as of the end of each six month period endingthereafter at a minimum price floor as set by the lenders.  As a directresult of the subordinated credit agreement, we entered into the “costlesscollars” financial contracts with Union Bank of California, N.A. as follows:

 

8

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| ** **           | ** ** | **Floor**          | ** ** | **Ceiling**        | ** ** | **Barrels**      | ** ** | **Floor**          | ** ** | **Ceiling**        | ** ** | **Mcf**          | ** ** | **Barrels of   Equivalent** | ** ** |
|----------------------|------------|--------------------|------------|--------------------|------------|------------------|------------|--------------------|------------|--------------------|------------|------------------|------------|---------------------------------------|------------|
| **Time Period** | ** ** | **Oil Price** | ** ** | **Oil Price** | ** ** | **Per Day** | ** ** | **Gas Price** | ** ** | **Gas Price** | ** ** | **per Day** | ** ** | **Oil per Day**             | ** ** |
| 4/1/08 - 12/31/08    |       | $                  | 80.00      |               | $          | 117.50           |       | 367                |       | $                  | 7.75       |             | $          | 11.40                                 |       | 1,867 |   | 678 |   |
| 1/1/09 - 12/31/09    |       | $                  | 80.00      |               | $          | 110.90           |       | 367                |       | $                  | 7.75       |             | $          | 10.60                                 |       | 1,667 |   | 644 |   |
| 1/1/10 - 12/31/10    |       | $                  | 80.00      |               | $          | 108.20           |       | 333                |       | $                  | 7.75       |             | $          | 9.85                                  |       | 1,567 |   | 594 |   |
| 1/1/11 - 3/31/11     |       | $                  | 80.00      |               | $          | 107.30           |       | 333                |       | $                  | 7.75       |             | $          | 11.60                                 |       | 1,467 |   | 578 |   |
|                 |       |               |       |               |       |             |       |               |       |               |       |             |       |                                  |       |
| 4/1/08 - 12/31/08    |       | $                  | 85.00      |               | $          | 110.60           |       | 267                |       | $                  | 8.00       |             | $          | 10.90                                 |       | 1,233 |   | 472 |   |
| 1/1/09 - 12/31/09    |       | $                  | 85.00      |               | $          | 104.40           |       | 233                |       | $                  | 8.00       |             | $          | 10.15                                 |       | 1,133 |   | 422 |   |
| 1/1/10 - 12/31/10    |       | $                  | 85.00      |               | $          | 101.50           |       | 233                |       | $                  | 8.00       |             | $          | 9.40                                  |       | 1,033 |   | 406 |   |
| 1/1/11 - 3/31/11     |       | $                  | 85.00      |               | $          | 100.50           |       | 200                |       | $                  | 8.00       |             | $          | 11.05                                 |       | 967 |   | 361 |   |

 

Prior to obtaining the subordinated debt, ourfinancial contracts consisted of purchasing price floors. In order to offsetthe costs of the price floors, we had entered into short-term financialcontracts to sell price ceilings. As of March 31, 2008, these financialcontracts are summarized in the table below.

 
| **Time Period**        | ** ** | **Floor   Oil Price** | ** ** | **Barrels   per   Day** | ** ** | **Floor   Gas Price** | ** ** | **Gas Mcf   per Day** | ** ** | **Barrels of   Equivalent   Oil per Day** | ** ** |
|-----------------------------|------------|---------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| 1/1/08 - 12/31/08 |       | $                               | 55         |                              | 479        |                            | $          | 7.50                                 |       | 1,534                                                              |       | 735 |   |
| 1/1/08 - 12/31/08 |       | $                               | 60         |                              | 66         |                            | $          | 7.60                                 |       | 592                                                                |       | 164 |   |
| 1/1/09 - 4/30/09  |       | $                               | 60         |                              | 59         |                            | $          | 7.60                                 |       | 559                                                                |       | 152 |   |
| 1/1/09 - 12/31/09 |       | $                               | 55         |                              | 395        |                            | $          | 7.60                                 |       | 1,644                                                              |       | 668 |   |
| 1/1/10 - 6/30/10  |       | $                               | 55         |                              | 365        |                            | $          | 7.00                                 |       | 1,657                                                              |       | 641 |   |
| 7/1/10 - 12/31/10           |       | $                               | 55         |                              | 395        |                            | $          | 7.50                                 |       | 1,957                                                              |       | 721 |   |

 
| **Time Period**       | ** ** | **Ceiling   Oil Price** | ** ** | **Barrels   per   Day** | ** ** | **Ceiling   Gas Price** | ** ** | **Gas Mcf   per Day** | ** ** | **Barrels of   Equivalent   Oil per Day** | ** ** |
|----------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| 1/1/08 - 6/30/08 |       | $                                 | 86         |                              | 460        |                              | $          | —                               |       | —                                                             |       | 460 |   |
|                            |            |                                   |            |                                   |            |                                   |            |                                      |            |                                                                    |            |  |  |

 

The total volumes covered by the “costlesscollars” and the price floors / price ceilings detailed in the above tables isgreater than 85% of our crude oil and natural gas production volumes attributableto proved, producing reserves for at least three years.  The lenders under our senior and subordinatedcredit agreements have approved all commodity derivative contracts.

 

During the quarters and nine months ended March 31,2008 and 2007, there were settlements under our commodity derivatives due to usand paid by us with our counterparty that are summarized as follows:

 
| ** **                                     | ** ** | **Quarter ended March 31,** | ** ** | **Nine Months ended March 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|
| **Amounts in thousands**             | ** ** | **2008**                                   | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Settlements received                           |       | $                                          | 31         |                                                | $          | 107 |   | $ | 504 |   | $ | 858 |   |
| Settlements paid                               |       | (359                                       | )          | —                                              |       | (573 | ) | — |   |
| Realized gain (loss) on  commodity derivatives |       | $                                          | (328       | )                                                   | $          | 107 |   | $ | (69 | ) | $ | 858 |   |

 

The settlements received by us werecumulative monthly payments due to us since the NYMEX natural gas price waslower than the “floor natural gas prices” ranging between $7.50 and $8.00. Thecash flows relating to the derivative instruments are reflected in operatingactivities on our consolidated statements of cash flows. At March 31,2008, we had no amounts due from our counterparty.

 

The settlements paid by us were cumulativemonthly payments we made to our counterparty since the NYMEX crude oil pricewas higher than the “ceiling crude oil prices” of $83 and $86. The cash flowsrelating to 

 

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the derivative instruments are reflected in operating activities on ourconsolidated statements of cash flows. At March 31, 2008, we had amountspayable to our counterparty of $272,000 included in accounts payable on ourconsolidated balance sheet.

 

We computed our mark-to-market valuationsused for our commodity derivatives based on assumptions regarding forwardprices, volatility and the time value of money. We compared our valuations toour counterparties’ valuations to further validate our mark-to-marketvaluations. During the quarters ended March 31, 2008 and 2007, werecognized unrealized loss on commodity derivatives in our consolidatedstatements of operations amounting to $3.2 million and $1.6 million,respectively.  Of the $3.2 million amountfor the quarter ended March 31, 2008, $2.7 million pertained to thecostless collars, which did not require any initial cash outlay and does notinvolve future cash outlay unless the NYMEX crude oil and natural gas pricesexceed the ceiling prices as specified in the table above.  During the nine months ended March 31,2008 and 2007, we had recognized unrealized loss on commodity derivatives of$5.6 million and $1.8 million, respectively.

 

**4.     DEFERREDCOMPENSATION**

 

A summary of non-vested restricted sharesissued to key employees pursuant to our 2005 Long-Term Incentive Plan for thenine months ended March 31, 2008 is summarized below:

 
| ** **                                         | ** ** | **Shares** | ** ** | **Weighted   Average   Grant-date   Fair Value** | ** ** | **Fair Value   ($000s)** | ** ** |
|----------------------------------------------------|------------|------------|------------|----------------------------------------------------------------------|------------|------------------------------------|------------|
| Outstanding at  June 30, 2007                 |       | 95,000     |       | $                                                                    | 5.59       |                               | $          | 531 |   |
| Shares granted on  July 2, 2007               |       | 395,000    |       | $                                                                    | 5.84       |                               | $          | 2,307 |   |
| Shares vested                                      |       | (25,000    | )          | $                                                                    | 5.50       |                               | (138       | ) |
| Outstanding and Non-Vested  at March 31, 2008 |       | 465,000    |       | $                                                                    | 5.81       |                               | $          | 2,700 |   |

 

On July 2, 2007, we granted our executiveofficers restricted stock totaling 395,000 shares with the restrictions ontransfer lapsing for one-third of the shares on the first, second and thirdanniversaries of July 2, 2007.

 

The other restricted share grants will vestto the individual employees based on future years of service ranging from oneto three years depending on the life of the award agreement. The fair value isbased on our actual stock price on the date of grant multiplied by the numberof restricted shares granted.

 

For the quarters ended March 31, 2008and 2007, we have expensed $0.4 million and $0.1 million, respectively, tostock compensation expense based on amortizing the fair value over therequisite service period. For the nine months ended March 31, 2008 and2007, we have expensed $1.0 million and $0.2 million, respectively, to stockcompensation expense.

 

**5.****             ****STOCK OPTIONS**

 

On September 11, 2007, under the 2005Long-Term Incentive Plan (“LTIP”), we granted 10,000 total options to anemployee. The exercise price is $5.95 per share. The options vest on September 11,2010 if this individual is still an employee on September 11, 2010.

 

On November 30, 2007, under the 2005LTIP, we granted 35,241 total options to certain employees. The exercise priceis $7.47 per share. The options vest on November 30, 2010 if theapplicable individuals are still employed on November 30, 2010.

 

On December 12, 2007, under the 2005LTIP, we granted 150,000 total options to our six non-employee directors(25,000 options to each director). The exercise price is $7.25 per share. Theoptions vested on December 12, 2007.

 

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On February 19, 2008, under the 2005Long-Term Incentive Plan (“LTIP”), we granted 203,700 total options to variousemployees. The exercise price is $5.75 per share. 113,700 options vest on February 19,2011 if the applicable individuals are still employed on February 19,2011.  The remaining 90,000 options vestannually in one-third increments on the first, second and third anniversaries ofFebruary 19, 2008 if the applicable individuals are still employed on suchdates.

 

A summary of options for the nine monthsended March 31, 2008 is as follows:

 
| ** **                         | ** ** | **Shares** | ** ** | **Weighted   Average   Exercise   Price** | ** ** | **Intrinsic   Value($000s)** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------------------------|------------|-----------------------------------|------------|
| Outstanding at June 30, 2007  |       | 801,513    |       | $                                                        | 5.29       |                              |       |   |
| Options granted                    |       | 398,941    |       | 6.46                                                     |       |                              |       |
| Options forfeited or expired       |       | (4,700     | )          | 7.47                                                     |       |                              |       |
| Options exercised                  |       | (75,000    | )          | 5.28                                                     |       |                              |       |
| Outstanding at March 31, 2008 |       | 1,120,754  |       | $                                                        | 5.70       |                              | $          | 62 |   |
| Exercisable at March 31, 2008 |       | 561,803    |       | $                                                        | 5.75       |                              | $          | 62 |   |

 

The fair values of options granted during thenine months ended March 31, 2008, along with the factors used to calculatethe fair values of those options are summarized in the table below:

 
| No. of options                                                                              |   | 398,941                    |   |
|--------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
| Risk free interest rate                                                                          |   | 2.93 - 4.07      | %      |
| Expected life                                                                                    |   | 5 years                    |   |
| Expected volatility                                                                              |   | 49.1 – 49.7 | %      |
| Expected dividend yield                                                                          |   | 0                          | %      |
| Weighted average grant date fair  value—exercise prices equal to market value on grant date |   | $                          | 3.04   |   |
|                                                                                                  |        |                            |        |  |

 

For the nine months ended March 31, 2008,75,000 options were exercised for cash totaling $396,000 and we issued fullamount of shares from new shares.  Uponexercise, we issue the full amount of shares exercisable per the term of theoptions from new shares. We have no plans to repurchase those shares in thefuture.

 

For the quarters ended March 31, 2008and 2007, we had recorded a charge to stock compensation expense of $0.1million and $0.2 million, respectively, for the estimated fair value of theoptions granted to our directors and employees. For the nine months ended March 31, 2008 and 2007, we had recordeda charge to stock compensation expense of $1.1 million and $0.4 million,respectively, for the estimated fair value of the options granted to ourdirectors and employees.

 

**6.     NET LOSS PERCOMMON SHARE**

 

Basic net income (loss) per common share iscomputed by dividing the net income (loss) attributable to common shareholdersby the weighted average number of shares of common stock outstanding during theperiod.

 

Diluted net income (loss) per common share iscomputed in the same manner, but also considers the effect of common stockshares underlying the following:

 
| ** **                   | ** ** | **March 31,** | ** ** |
|------------------------------|------------|--------------------|------------|
| ** **                   | ** ** | **2008**           | ** ** | **2007** | ** ** |
| Stock options                |       | 1,120,754          |       | 819,185 |   |
| Warrants                     |       | —             |       | 1,646,061 |   |
| Preferred stock              |       | 7,746,261          |       | 8,541,913 |   |
| PIK dividends                |       | 581,879            |       | 211,124 |   |
| Non-vested restricted shares |       | 465,000            |       | 115,000 |   |

 

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The shares of common stock underlying thestock options, warrants, the preferred stock, PIK dividends and the restrictedshares, as shown in the preceding table, are not included in weighted averageshares outstanding for the three and nine months ended March 31, 2008 and2007 as their effects would be anti-dilutive.

 

**7.****             ****RELATED PARTY TRANSACTIONS**

 

Pursuant to an agreement dated December 16,2004, as amended, we agreed with R.C. Boyd Enterprises, a Delaware corporation,to become the lead sponsor of a television production called Honey Hole (the “HoneyHole Production”). For the quarters ended March 31, 2008 and 2007, we paidan aggregate of $37,500 to R.C. Boyd Enterprises during both quarters. For the nine month periods ended March 31, 2008 and 2007, we paid anaggregate of $112,500 to R.C. Boyd Enterprises during both periods.

 

Pursuant to a new agreement dated as of December 5,2007, after December 31, 2008, we will no longer be a Honey HoleProduction sponsor.  Our remainingcommitment from April 1, 2008 to December 31, 2008 is $112,500($37,500 per quarter).  We are entitledto receive two thirty second commercials during all broadcasts of the HoneyHole Production and receive opening and closing credits on each episode. Aspart of our sponsorship, we are able to provide fishing and outdooropportunities for children with cancer, children from abusive family situationsand military veterans. Randall Boyd, one of our current directors, is the soleshareholder of R.C. Boyd Enterprises.

 

**8.****             ****PREFERRED STOCK CONVERSION**

 

On October 17, 2007, 2,000 shares of ourSeries D Convertible Preferred Stock (“Preferred Stock”) were convertedinto 349,119 shares of our common stock. The issued common shares consisted of347,826 shares based on the $5.75 conversion price of the Preferred Stock and1,293 shares in lieu of the accrued but unpaid dividends from October 1,2007 to October 17, 2007 pursuant to the terms of the Preferred Stock.

 

On December 4, 2007, 2,000 shares of ourPreferred Stock were converted into 352,772 shares of our common stock. Theissued common shares consisted of 347,826 shares based on the $5.75 conversionprice of the Preferred Stock and 4,946 shares in lieu of the accrued but unpaiddividends from October 1, 2007 to December 4, 2007 pursuant to theterms of the Preferred Stock.

 

On January 8, 2008, 575 shares of ourPreferred Stock were converted into 100,175 shares of our common stock. Theissued common shares consisted of 100,000 shares based on the $5.75 conversionprice of the Preferred Stock and 175 shares in lieu of the accrued but unpaiddividends from January 1, 2008 to January 8, 2008 pursuant to theterms of the Preferred Stock.

 

**9.****             ****COMMON STOCK ISSUANCE**

 

***Private Placement***

 

On November 7, 2007, we sold in aprivate placement 3.5 million shares of our common stock at $7.15 per share forgross proceeds of $25.0 million.  Net proceeds were $23.4 million afterdeducting issuance costs of $1.6 million. The net proceeds were initially usedto pay down our long-term debt due under the credit agreement and have beendrawn down to fund our capital development program and general corporatepurposes.

 

In connection with the private placement, weentered into a registration rights agreement with the purchasers in suchprivate placement. The registration rights agreement provides that at ourexpense we will:

 

·                  Filewith the Securities and Exchange Commission (“SEC”) within 45 days afterthe November 7, 2007 closing date a registration statement on Form S-3covering the resale of the common stock issued in the private placement; and

·                  Keepthe registration statement effective until the date the private placementpurchasers may sell all of the securities registered under the registrationstatement for such purchasers pursuant to 

 

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Rule 144(k) promulgated under the Securities Act of 1933, asamended, or the date on which all the private placement purchasers have soldall of the securities registered under the registration statement for suchpurchasers.

 

Since we were able to file the registrationstatement within 45 days after the November 7, 2007 closing date andhave the registration statement declared effective within 90 days afterthe November 7, 2007 closing date, we did not have to pay any liquidateddamages to the purchasers.  However, if we are not able to maintain theeffectiveness of the registration statement, subject to certain limitations, wewill have to pay 1.0% of the aggregate purchase price of the securitiespurchased in the private placement on the first day of such initial maintenancefailure and on each 30th day after the day of such initialmaintenance failure (pro rated for periods totaling less than 30 days),with the maximum aggregate registration delay payments being 10% of theaggregate purchase price.

 

On December 7, 2007,the registration statement became effective.

 

***Warrants***

 

As discussed in our Form 10-K dated June 30,2007, we had outstanding warrants totaling 1,646,061 common shares at anexercise price of $4.79 per share that were to expire on March 6, 2008.  During the quarter ended March 31, 2008,the warrants were exercised as follows:

 

·                  1,084,345 warrants were cash exercises forwhich we received $5.2 million for the issuance of 1,084,345 common shares.

·                  561,291 warrants were cashless exercises forthe issuance of 144,506 common shares.

·                  425 warrants were not exercised.

 

As of March 31, 2008,we no longer have any outstanding warrants.

 

**10.****      ****COMMITMENTS ANDCONTINGENCIES**

 

***Fire Litigation***

 

*BurnettCase*

 

On March 23, 2006, the following lawsuitwas filed in the 100th Judicial District Court in Carson County, Texas; Cause No. 9840,The Tom L. and Anne Burnett Trust, by Anne Burnett Windfohr, Windi Phillips,Ben Fortson, Jr., George Beggs, III and Ed Hudson, Jr. asCo-Trustees; Anne Burnett Windfohr; and Burnett Ranches, Ltd. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WOEnergy, Inc. The plaintiffs claim that the electrical wiring and equipmentof Cano or certain of its subsidiaries relating to oil and natural gasoperations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas.

 

The plaintiffs (i) allege negligence andgross negligence and (ii) seek damages, including, but not limited to,damages for damage to their land and livestock, certain expenses related tofighting the fire and certain remedial expenses totaling approximately $1.7million to $1.8 million. In addition, the plaintiffs seek (i) terminationof certain oil and natural gas leases, (ii) reimbursement for theirattorney’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 themineral estate, 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 100thJudicial District Court issued a Final Judgment (a) granting motions forsummary judgment in favor of Cano and certain of its subsidiaries on plaintiffs’claims for (i) breach of contract/termination of an oil and gas lease; and(ii) negligence; and (b) granting the plaintiffs’ no-evidence motionfor summary judgment on contributory negligence, assumption of risk,repudiation and estoppel affirmative defenses asserted by Cano and certain ofits subsidiaries. The Final Judgment has been appealed.

 

13

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*OtherCases*

 

On April 28, 2006, the following lawsuitwas filed in the 31st Judicial District Court of Roberts County,Texas, Cause No. 1922, Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WOEnergy, Inc. (“Adcock”). There are 47 plaintiffs and three groups ofintervenors that claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas.  Theplaintiffs and intervenors (i) allege negligence, res ipsa loquitor,trespass and nuisance and (ii) seek damages, including, but not limitedto, damages to their land, buildings and livestock and certain remedialexpenses totaling $11,297,684.  In addition, the plaintiffs andintervenors seek (i) reimbursement for their attorney’s fees and (ii) exemplarydamages.  The plaintiffs also claim that Cano and its subsidiaries arejointly and severally liable as a single business enterprise and/or a generalpartnership or de facto partnership.

 

On April 10, 2006, the following lawsuitwas filed in the 31st Judicial District Court of Roberts County, Texas, Cause No. 1920,Joseph Craig Hutchison and Judy Hutchison v. Cano Petroleum, Inc., W.O.Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc.(“Hutchinson”). The plaintiffs claim that the electrical wiring andequipment of Cano or certain of its subsidiaries relating to oil and gasoperations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas.  The plaintiffs (i) allege negligence and trespass and(ii) seek undisclosed damages, including, but not limited to, damages totheir land and certain remedial expenses.  In addition, the plaintiffsseek exemplary damages.

 

On May 1, 2006, the following lawsuitwas filed in the 31st Judicial District Court of Roberts County, Texas, Cause No. 1923,Chisum Family Partnership, Ltd. v. Cano, W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd, and WO Energy, Inc. (“Chisum”).The plaintiff claims that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas.  Theplaintiff (i) alleges negligence and trespass and (ii) seeksundisclosed damages, including, but not limited to, damages to their land andcertain remedial expenses.  In addition, the plaintiffs seek exemplarydamages.

 

On July 3, 2006, the following lawsuitwas filed in the 31st Judicial District Court of Roberts County,Texas, Cause No. 1928, Rebecca Lee Martinez, et al v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd., andWO Energy, Inc. (“Martinez”).  The plaintiffs claim that theelectrical wiring and equipment of Cano or certain of its subsidiaries relatingto oil and gas operations started a wildfire that began on March 12, 2006in Carson County, Texas.  The plaintiffs (i) allege negligence and (ii) seekundisclosed damages for the wrongful death of two relatives, Gerardo Villarrealand Medardo Garcia, who they claim died as a result of the fire.  On August 6,2006, an additional heir of Medardo Garcia intervened in this case allegingsimilar claims and seeking similar relief.

 

On August 9, 2006, the following lawsuitwas filed in the 233rd Judicial District Court of Gray County, Texas, Cause No. 34,423,Yolanda Villareal, Individually and on behalf of the Estate of GerardoVillareal v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd., and WO Energy, Inc. (“Villareal”). The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) allege negligence and (ii) seek undisclosed damages,including exemplary damages, for the wrongful death of Gerardo Villarreal whothey claim died as a result of the fire.  The plaintiffs also claim thatCano and its subsidiaries are jointly and severally liable under vicariousliability theories.  On August 22, 2006, relatives of Roberto Chaviraintervened in the case alleging similar claims and seeking similar reliefregarding the death of Roberto Chavira.

 

On March 14, 2007, the following lawsuitwas filed in 100th Judicial District Court in Carson County, Texas; Cause No. 9994,Southwestern Public Service Company d/b/a Xcel Energy v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, andWO Energy, Inc. (“SPS”).  The plaintiff claims that the electricalwiring and equipment of Cano or certain of its subsidiaries relating to oil andgas operations started 

 

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a wildfire that began on March 12, 2006 in Carson County,Texas.  The plaintiff (i) alleges negligence and breach of contractand (ii) seeks $1,876,000 in damages for loss and damage to transmissionand distribution equipment, utility poles, lines and other equipment.  Inaddition, the plaintiff seeks reimbursement of its attorney’s fees.

 

On May 2, 2007, the following lawsuitwas filed in the 84th Judicial District Court of Hutchinson County,Texas, Cause No. 37,619, Gary and Genia Burgess, et al. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc.(“Burgess”).  Eleven plaintiffs claim that electrical wiring and equipmentrelating to oil and gas operations of the Company or certain of itssubsidiaries started a wildfire that began on March 12, 2006 in CarsonCounty, Texas.  Five of the plaintiffs are former plaintiffs in the Adcockmatter.  The plaintiffs (i) allege negligence, res ipsa loquitor,nuisance, and trespass and (ii) seek damages, including, but not limitedto, damages to their land, buildings and livestock and certain remedialexpenses totaling approximately $1,152,480.  In addition, the plaintiffsseek (i) reimbursement for their attorney’s fees and (ii) exemplarydamages.  The plaintiffs also claim that Cano and its subsidiaries arejointly and severally liable as a single business enterprise and/or as apartnership or de facto partnership.

 

On May 15, 2007, William L. Arrington,William M. Arrington and Mark and Le’Ann Mitchell intervened in the SPScase.  The intervenors (i) allegenegligence, res ipsa loquitor, nuisance,and trespass and (ii) seekdamages, including, but not limited to, damages to their land, buildings andlivestock and certain remedial expenses totaling approximately $201,280.  In addition, the intervenors seek (i) reimbursementfor their attorney’s fees and (ii) exemplary damages.  The intervenors also claim that Cano and itssubsidiaries are jointly and severally liable as a single business enterpriseand/or a general partnership or de facto partnership.

 

On August 28, 2007, one of theintervenors in the Adcock case, Travelers Lloyds Insurance Company,filed a Notice of Nonsuit requesting the court to sign an order dismissing itsclaims, which seek approximately $367,627 of total damages, withoutprejudice.  The Court granted the Non-suit on September 12, 2007.

 

On September 25, 2007, the TexasJudicial Panel on Multidistrict Litigation granted Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WOEnergy, Inc.’s Motion to Transfer Related Cases to Pretrial Court pursuantto Texas Rule of Judicial Administration 13.  The Panel transferredall pending cases (Adcock, Chisum, Hutchison, Villareal, Martinez, SPS,Burgess, identified above and Valenzuela, Abraham Equine, Pfeffer, Ayers identified below) that assertclaims against the Company and its subsidiaries related to wildfires beginningon March 12, 2006 to a single pretrial court for consideration of pretrialmatters.  The Panel transferred all pending cases to the Honorable PaulDavis, retired judge of the 200th District Court of Travis County, Texas,as Cause No. D-1-GN-07-003353.

 

On October 3, 2007, Firstbank Southwest,as Trustee for the John and Eddalee Haggard Trust (the “Trust”) filed aPetition in intervention as part of the Hutchison case.  The Trustclaims that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and gas operations started a wildfire that beganon March 12, 2006 in Carson County, Texas.  The Trust (i) allegesnegligence and trespass and (ii) seeks undisclosed damages, including, butnot limited to, damages to land and certain remedial expenses.  Inaddition, the Trust seeks exemplary damages.

 

On December 19, 2007, the plaintiffs andintervenor in the Martinezcase nonsuited their claims and refiled inthe 348th Judicial District Court of Tarrant County, Texas as partof the Valenzuela case described below.

 

On December 18, 2007, the followinglawsuit was filed in the 348th Judicial District Court of TarrantCounty, Texas, Cause No. 348-227907-07, Norma Valenzuela, et al. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W.O.Operating, Ltd. and WO Energy, Inc. (“Valenzuela”).  Sixplaintiffs, including the two plaintiffs and intervenor from the nonsuitedMartinez case, claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas.  Theplaintiffs (i) allege negligence and (ii) seek undisclosed damagesfor the wrongful death of four relatives, Manuel Dominguez, Roberto Chavira,Gerardo Villarreal and Medardo Garcia, who they claim died as a result of thefire.  In addition, plaintiffs seek (i) reimbursement for theirattorney’s fees and (ii) exemplary damages.   The plaintiffsalso claim that Cano and its subsidiaries are jointly and severally liable as asingle business enterprise and/or as a partnership or de factopartnership.  Cano and its subsidiaries 

 

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filed a Motion to Dismiss or, in the Alternative, to Transfer Venue anda Notice of Tag Along transferring the case to the MDL Case in the 200thJudicial District Court of Travis County, Texas.

 

On January 10, 2008, Philip L. Fletcherintervened in the consolidated case in the 200th District Court of TravisCounty, Texas as part of the SPS case.  The intervenor (i) allegesnegligence, trespass and nuisance and (ii) seeks damages, including, butnot limited to, damages to his livestock, attorney’s fees and exemplarydamages.  The intervenor also claims that Cano and its subsidiaries arejointly and severally liable as a single business enterprise and/or as apartnership or de facto partnership.

 

On January 15, 2008, the Jones andMcMordie Ranch Partnership intervened in the consolidated case in the 200thDistrict Court of Travis County, Texas as part of the SPS case.  Theintervenor (i) alleges negligence, trespass and nuisance and (ii) seeksexemplary damages.  The intervenor also claims that Cano and its subsidiariesare jointly and severally liable as a single business enterprise and/or as apartnership or de facto partnership.

 

On February 11, 2008, the followinglawsuit was filed in the 48th Judicial District Court of TarrantCounty, Texas, Cause No. 048-228763-08, Abraham Equine, Inc. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd.and WO Energy, Inc. (“Abraham Equine”). The plaintiff claims that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County.  The plaintiff (i) alleges negligence,trespass and nuisance and (ii) seeks damages, including, but not limitedto, damages to its land, livestock and lost profits.  In addition, the plaintiff seeks (i) reimbursementfor its attorney’s fees and (ii) exemplary damages.  The plaintiff also claims that Cano and itssubsidiaries are jointly and severally liable as a single business enterpriseand/or a general partnership or de facto partnership.  Cano and its subsidiaries filed a Motion toDismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Alongtransferring the case to the MDL Case in the 200th Judicial DistrictCourt of Travis County, Texas.

 

On March 10,2008, the following lawsuit was filed in the 352nd Judicial DistrictCourt of Tarrant County, Texas, Cause No. 352-229256-08, Gary Pfeffer v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating,Ltd. and WO Energy, Inc. (“Pfeffer”). The plaintiff claims that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County.  The plaintiff (i) alleges negligence,trespass and nuisance, (ii) seeks undisclosed damages for the wrongfuldeath of his father, Bill W. Pfeffer, who he claims died as a result of thefire and (iii) seeks undisclosed damages, including, but not limited to,damages to his parents’ home and property. In addition, the plaintiff seeks exemplary damages.  The plaintiff also claims that Cano and itssubsidiaries are jointly and severally liable as a general partnership or defacto partnership.  Cano and itssubsidiaries filed a Motion to Transfer Venue and a Notice of Tag Alongtransferring the case to the MDL Case in the 200th Judicial DistrictCourt of Travis County, Texas.

 

On March 11,2008, the following lawsuit was filed in the 141st Judicial DistrictCourt of Tarrant County, Texas, Cause No. 141-229281-08, Pamela Ayers, etal. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O.Operating, Ltd. and WO Energy, Inc. (“Ayers”).  The plaintiffs claim that the electricalwiring and equipment of Cano or certain of its subsidiaries relating to oil andgas operations started a wildfire that began on March 12, 2006 in CarsonCounty.  The plaintiffs (i) allegenegligence and (ii) seek undisclosed damages for the wrongful death oftheir mother, Kathy Ryan, who they claim died as a result of the fire.  In addition, the plaintiffs seek exemplarydamages.  The plaintiffs also claim thatCano and its subsidiaries are jointly and severally liable as a single businessenterprise and/or general partnership or de facto partnership.  Cano and its subsidiaries filed a Motion toTransfer Venue and a Notice of Tag Along transferring the case to the MDL Casein the 200th Judicial District Court of Travis County, Texas.

 

On March 12,2008, the following lawsuit was filed in the 17th Judicial DistrictCourt of Tarrant County, Texas, Cause No. 017-229316-08, The TravelersLloyds Insurance Company and Travelers Lloyds of Texas Insurance Company v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating,Ltd. and WO Energy, Inc. (“Travelers”). The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County.  The plaintiffs (i) allege negligence,res ipsa loquitor, and trespass and (ii) claim they are subrogated to therights 

 

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of their insureds for damages to theirbuildings and building contents totaling $447,764.60.  The plaintiffs also claim that Cano and itssubsidiaries are jointly and severally liable as a single business enterpriseand/or general partnership or de facto partnership.

 

None of the above-mentioned cases arecurrently set for trial.  Due to the inherent risk of litigation, theoutcome of these cases is uncertain and unpredictable; however, at this time,Cano management believes the suits are without merit and is vigorouslydefending itself and its subsidiaries.

 

***Insurance Settlement***

 

As discussed in our Form 10-K dated June 30,2007, during February 2007, we received a $6,699,827 payment fromMid-Continent Casualty Company for policy limits totaling $6,000,000 anddefense costs totaling $699,827. The $6,000,000 payment for policy limits, inaccordance with the senior credit agreement (Note 2), have been placed ina controlled bank account and the use of the proceeds is specified to payattorney’s fees, settlement amounts, other litigation expenses incurred todefend and/or settle the fire litigation, and for general corporate purposes.Specifically, we cannot use the proceeds to fund capital expenditures. Accordingly, our consolidated balance sheets reflect the $6,000,000 as aliability under deferred litigation credit.  As of March 31, 2008, wehad fully expended the restricted cash and we no longer had a balance forrestricted cash.

 

***Other***

 

Occasionally, we are involved in othervarious lawsuits and certain governmental proceedings arising in the ordinarycourse of business. Our management does not believe that the ultimateresolution of any current matters that are not set forth above, will have amaterial effect on our financial position or results of operations. Management’s position is supported, in part, by the existence of insurancecoverage, 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 involvedin a proceeding adverse to our business or has a material interest adverse toour business.

 

***Environmental***

 

To date, our expenditures to comply withenvironmental or safety regulations have not been significant and are notexpected to be significant in the future. However, new regulations, enforcementpolicies, claims for damages or other events could result in significant futurecosts.

 

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

 

**Forward-LookingStatements**

 

The information in thisreport on Form 10-Q contains forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995. This Act providesa “safe harbor” for forward-looking statements to encourage companies toprovide prospective information about themselves provided they identify thesestatements as forward looking and provide meaningful cautionary statementsidentifying important factors that could cause actual results to differ fromthe projected results. All statements other than statements of historical factmade in this report are forward looking. In particular, the statements hereinregarding industry prospects and future results of operations or financialposition are forward-looking statements. Forward-looking 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, product demand,market competition, interruption in production, our ability to obtainadditional capital, and the success of waterflooding and enhanced oil recoverytechniques.

 

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 

 

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the results discussed hereinwill necessarily continue into the future, or that any conclusion reachedherein will necessarily be indicative of actual operating results in thefuture. Such discussion represents only the best present assessment ofmanagement.

 

**GrowthStrategy**

 

We are a growing independentoil and natural gas company that intends to actively pursue enhanced oilrecovery techniques to increase production and reserves at our existingproperties and properties acquired in the future.  Our primary focus iscrude oil and our target acquisitions are onshore U.S. properties.  Ourfocus on domestic, mature oil fields eliminates exploration risks anduncertainties of international sources.  We use waterflooding and enhancedoil recovery methods (“EOR”), such as alkaline/ surfactant/ polymer (“ASP”)technology.

 

During our first two yearsof operations through June 30, 2006, our primary focus was to achievegrowth through acquiring existing, mature oil and natural gas fields. In March 2007,we acquired Permian Basin oil and natural gas properties located in New Mexico.We believe the portfolio of oil and natural gas properties that we haveacquired thus far provides ample opportunities to apply our operationalstrategy. As of June 30, 2007, we had proved reserves of 66,720 MBOE, ofwhich 8,454 MBOE were proved producing, 2,843 MBOE were proved non-producing,and 55,423 MBOE were proved undeveloped.

 

During the fiscal year endedJune 30, 2007 and continuing into our current fiscal year ending June 30,2008 (“2008 Fiscal Year”), our primary emphasis is to achieve growth bydeveloping our existing oil and natural gas properties through developmentactivities such as waterflooding and EOR technology. We will continue toevaluate potential acquisition targets that are consistent with our operationalstrategy. These development activities are more clearly defined in the nextsection titled “Capital Development Update.”

 

***Capital Development Update***

 

For the 2008 Fiscal Year,our capital development budget is $83.3 million.  Of this amount, wehave incurred $72.5 million for the nine months ended March 31,2008.  We have accelerated our capital development in the Panhandlewaterflood and the Cato Fields.  The status and planned activity of ourcapital development for the 2008 Fiscal Year is summarized as follows:

 

***Panhandle Properties.***     The drilling of thefinal contingent of 34 replacement waterflood wells in the Cockrell Ranch Unitwas completed during the six months ended December 31, 2007. In total, wehave drilled 70 replacement wells in the field, which represents the completionof the development patterns of the waterflood project. Water injection wasinitiated at the Cockrell Ranch Unit on July 5, 2007.  We haveincreased our water injection rates steadily since September 2007 andreached our maximum injection rate of 50,500 barrels of water per day (BWPD) onFebruary 11, 2008.  We have injected close to 7.4 million barrels ofwater into the Brown Dolomite formation.  We have completed injectionplant and production facility installation in all three phases of theproject.  This represents 62 injectors and 71 producers.

 

We are seeing preliminaryoil response from 32 producing wells. Through the use of generally acceptedengineering practices and a detailed review of successful analog waterfloods inthe area, we expect meaningful oil response to occur at each Phase of theproject once we inject between .15 and .25 pore volumes (“PV”) of water hasbeen injected.  Therefore, when 15% to25% of the void space has beendisplaced with water, the flood fronts are expected to advance to a point whereproduction response should be seen at the producing wells.

 

We have injectedapproximately 15% of the PV area in the Cockrell Ranch Unit. Current productionis approximately 6,500 barrels of fluid per day, 77 barrels of oil per day and150 Mcf per day of gas.  Total oil cutfor the waterflood is 1.2%.  We expectthe total fluid production rates and associated oil and gas rates will continueto increase as we move towards the 25% PV threshold to further validate theflood response.

 

The total 2008 Fiscal Yearcapital budget for the Panhandle Properties is $27.7 million.

 

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***New Mexico Properties.***    We completed the acquisitionof the New Mexico Properties on March 30, 2007.     We arefocusing on a program of return-to-production and new well/infill drilling todevelop the waterflood in the San Andres formation in these properties.

 

1.               **Return-to-Production (“RTP”)****:** We have returned 45 existing wells toproduction since the acquisition.  We have a workover rig committed to theRTP program and we have seen RTP rates of 2-4 BOEPD from 10 wells recentlyreturned to production at the Tomahawk Field. We have approximately 10 more RTPcandidates in the TomTom Field.

 

2.               **New WellDrilling/20-Acre Infill Wells**: We currently have two drilling rigs committed andtwo workover rigs working in the Cato field. We have drilled and completed 22wells in the Cato Field.  Two wells were 40-acre infill wells and had aninitial production rate of approximately 5-8 BOEPD.  20 of these new welldrills were 20-acre infill wells.  Aspreviously discussed, these infill wells primary purpose is to develop the20-acre waterflood of the P-1 and P-2 production zones in the field. Anassociated benefit of this drilling, is to deepen these wells by approximately500 feet to test undeveloped lower zones of the San Andres reservoir that werenot historically produced by previous operators. To date, incrementalproduction is approximately 210 BOEPD from these wells. These lower zonesexperience high initial decline rates and are expected to level off at about5-7 BOEPD within the first year. Production for the month ending March 2008was 240 BOEPD.

 

The total 2008Fiscal Year Capital Budget for the Cato field is $37.7 million.

 

3.               **20-Acre WaterfloodDevelopment****:** We plan to accelerate the waterflood development in two sections of the CatoField with the drilling the 20-acre infill wells. Our goal is to drill andcomplete all required wells by June 2008 and to commence waterfloodfacility construction and start waterflood operations as soon as regulatorypermits are received.  We have hearingdates set with the New Mexico Oil Conservation Division in May 2008 andexpect to initiate waterflood operations in the third calendar quarter of 2008.

 

***Desdemona Properties—Waterflood.    ***We received the final approval of ourPhase I waterflood permit for the 640 acre G.E. Moore Lease from the TexasRailroad Commission on September 11, 2007.  Water injection commencedshortly thereafter and we have injected approximately 1 million barrels ofwater in total, into the Duke Sandstone reservoir via six injectionwells.   We are seeing oil response at five producers with anincreasing oil cut.  Since this is not a pattern waterflood, but aperipheral flood, the PV fill-up method is not as exact as the Panhandle Fieldfor determining response profiles.  However, we expect meaningful increasesin the number of responding wells and increased oil response in the thirdcalendar quarter of 2008.

 

***Desdemona Properties—Barnett Shale.    ***After we stopped our drilling program inthe Barnett Shale in October 2007, decline rates have been experienced ingas production.  For the month ending March 2008, we had averagedaily gas production rate of approximately 80 BOEPD.  We continue tosupply the Desdemona Field waterflood with over 7,000 BWPD of produced waterfor injection from the Barnett Shale gas production.

 

***Nowata Properties.***    Our tertiary recovery pilotproject at the Nowata Field is operational.  The ASP pilot plant,associated equipment and supplies were installed and tested during August andSeptember 2007.  We began injecting ASP chemicals during December 2007. The plant had extended operational time through March 2008.  Initialresponse is anticipated in the third calendar quarter of 2008.

 

***Corsicana Properties.***    We have drilled and completed16 pattern replacement wells in order to reinstate a prior waterflood in thisfield. We received the required permits to inject water in June 2007. Thewaterflood was successfully re-instated in December 2007.  Weachieved full injection of 4,000 BWPD and are monitoring initial floodresults.  We experienced production rates of between 2-6 BOEPD during thequarter ended March 31, 2008.  As we previously mentioned, we havebeen pleased with the remaining oil saturations in this field and coupled withthe prior successful polymer pilot in this field in the 1980’s we believe thisfield is a prime ASP candidate. Once the waterflood response and laboratoryresults are analyzed, we anticipate evaluating an ASP Pilot in the field duringthe second half of calendar year 2008.

 

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***Davenport Properties.    ***During the nine months ended March 31,2008, we have returned to production five injector wells and four producingwells as we progress toward optimizing the waterflood pattern.  As adirect result of this RTP activity, the production has increased to over 80BOEPD.

 

We have no major development activities planned forthe Pantwist Properties during the 2008 Fiscal Year.

 

**Liquidity and Capital Resources**

 

As discussed in Note 2, our total available borrowingsare $75 million, consisting of $60 million under the senior credit agreementand $15 million under the subordinated credit agreement.  At March 31,2008, we had outstanding long-term debt of $55.5 million and the averageinterest rate of the two credit agreements was 5.73%.

 

At March 31, 2008, our cash balance was $0.5million.  For the nine months ended March 31, 2008, we generated cashfrom operations of $13.2 million, which is a $12.1 million improvement ascompared to the nine months ended March 31, 2007.  The $12.1 millionimprovement is attributed to release of restrictions related to restricted cashand increased income from operations.  As discussed in Note 2, the amendedsenior credit agreement relaxes the restrictions of the $6.0 million of restrictedcash to permit use for general corporate purposes, in addition to attorney’sfees, settlement amounts and other litigation expenses incurred to defend andor settle the fire litigation discussed in Note 10.  Specifically, wecannot use the restricted cash to fund capital expenditures.  As of March 31, 2008, we no longer had abalance for restricted cash.

 

As discussed in Note 9, we completed two primaryissuances of common stock.  On November 7,2007, we received net proceeds of $23.4 million from the private placementissuance of 3.5 million shares of our common stock.  The net proceeds wereinitially used to pay down our long-term debt due under the credit agreementand have been drawn down to fund our capital development program as previouslydiscussed under “*Capital Development Update*”and for general corporate purposes. During the quarter ended March 31, 2008, we received $5.2 millionfrom the exercise of warrants.

 

During January 2008, we received cash proceeds of$3.0 million for the sale of equipment used in oil and gas producingactivities, which included workover rigs and vehicles.

 

We believe the combination of cash on hand, cash flowgenerated from operations, strong commodity prices, expected success of thecapital development projects and available debt is sufficient to finance ouroperations, contractual obligations and capital expenditure program (aspreviously discussed in the section titled “*CapitalDevelopment Update”)* through December 31, 2008.  We expectto seek access to the capital markets for potential debt or equity issuances tofinance the execution and acceleration of our capital development plan.

 

On December 28, 2007, the universal shelfregistration statement was declared effective by the SEC for the issuance ofcommon stock, preferred stock, warrants, senior debt and subordinated debt upto an aggregate amount of $150 million.  We may periodically offer one ormore of these securities in amounts, prices and on terms to be announced whenand if the securities are offered. At the time any of the securities covered bythe registration statement are offered for sale, a prospectus supplement willbe prepared and filed with the SEC containing specific information about theterms of any such offering.  We believe the universal shelf registrationstatement will enhance our financial flexibility and allow us to act morequickly when potential acquisition or other business opportunities mightrequire us to access capital.  We have no immediate plans to utilize theuniversal shelf registration statement.

 

***Commodity Derivatives Activities***

 

As discussed in Note 3, pursuant to our creditagreements, we are required to enter into commodity derivative contracts tomitigate our exposure to commodity price risk associated with expected oil andnatural gas production to cover at least 50% and no greater than 85% of ourcrude oil and natural gas production volumes attributable to proved, producingreserves for at least three years as of the end of each six month period endingthereafter at a minimum price floor as set by the lenders.  The total volumes covered by the “costlesscollars” and the price floors / price ceilings detailed in the  tables set forth in Note 3 are greater than85% of our crude oil and natural gas production volumes attributable to proved,producing reserves for at least three years. The lenders under our senior and subordinated credit agreements haveapproved all commodity derivative contracts.

 

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Prior to obtaining the subordinated debt agreement, wehad purchased crude oil price floors that range from $55 - $60 per barrelthrough December 2010.  We had purchased natural gas price floorsthat range from $7.00 - $8.00 per Mcf through December 2010.  For thenine months ended March 31, 2008, approximately 66% of our sales weresubject to price floors.

 

During the nine months ended March 31, 2008, weentered into financial contracts to sell crude oil price ceilings at $83 perbarrel from August through December 2007, and $86 per barrel from January throughJune 2008.  For the nine months ended March 31, 2008,approximately 30% of our sales were subject to price ceilings.  We entered into these short-term financialcontracts to sell price ceilings in order to offset the costs of price floorswe purchased to comply with our senior credit agreement.

 

As a direct result of the subordinated creditagreement, as discussed in Note 2, we entered into “costless collars” financialcontracts that cover approximately 75% of our crude oil and natural gasproduction volumes attributable to proved, producing reserves for the threeyear period from April 2008 to March 2011.  We did not have any cash outlays for thesefinancial contracts, which created price “collars” consisting of price floorsand ceilings.  For crude oil production,the price floors are $80 and $85 per barrel, and the associated price ceilingsrange from $100.50 to $117.50 per barrel during the three year time period.  For natural gas production, the price floorsare $7.75 and $8.00 per Mcf and the associated price ceilings range from $9.40to $11.40 per Mcf.  The “costless collars”are presented in greater detail in Note 3.

 

If crude oil and natural gas NYMEX prices are lowerthan the price floor, we will be reimbursed for the difference between theNYMEX price and floor price. If crude oil and natural gas NYMEX prices areabove the price ceiling, we have to pay the difference between the ceilingprice and the NYMEX price.

 

**Results of Operations**

 

For the quarter ended March 31, 2008 (“currentquarter”), we had a loss applicable to common stock of $1.9 million, which wasan improvement of $1.3 million as compared to the $3.2 million loss applicableto common stock incurred for the quarter ended March 31, 2007 (“prior yearquarter”).  Increased revenues of $5.8 million were partially offset byhigher operating expenses of $2.1 million, increased unrealized loss oncommodity derivatives of $1.6 million and reduced income from the realized gain(loss) on commodity derivatives of $0.4 million.

 

For the nine months ended March 31, 2008 (“currentnine months”), we had a loss applicable to common stock of $4.8 million, whichwas an improvement of $0.4 million as compared to the $5.2 million lossapplicable to common stock incurred for the nine months ended March 31,2007 (“prior year nine months”).  Positive factors, including increasedrevenues of $10.7 million and lower interest expense of $1.4 million, werepartially offset by higher operating expenses of $5.5 million, increasedunrealized loss on commodity derivatives of $3.8 million, reduced income fromthe realized gain (loss) on commodity derivatives of $0.9 million, higherpreferred stock dividends of $0.5 million and lower income from discontinuedoperations of $0.2 million.

 

These items will be addressed in the followingdiscussion.

 

***Operating Revenues***

 

The table below summarizes our operating revenues forthe quarter and nine months ended March 31, 2008 and 2007.

 
| ** **                         | ** ** | **Quarter ended March 31,** | ** ** | **Increase** | ** ** | **Nine months ended March 31,** | ** ** | **Increase** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-----------------------------------------------------|------------|--------------|------------|
| ** **                         | ** ** | **2008**                                   | ** ** | **2007**     | ** ** | **(Decrease)**                                      | ** ** | **2008**     | ** ** | **2007** | ** ** | **(Decrease)** | ** ** |
| Operating Revenues ($000s)         |       | $                                          | 11,655     |         | $          | 5,883                                               |       | $            | 5,773      |   | $ | 30,396 |   | $ | 19,716 |   | $ | 10,680 |   |
| Sales                              |       |                                       |       |         |       |                                                |       |         |       |   |   |   |   |
| ·  Crude Oil (MBbls)     |       | 79                                         |       | 60           |       | 19                                                  |       | 216          |       | 195 |   | 21 |   |
| ·  Natural Gas (MMcf)    |       | 319                                        |       | 325          |       | (60                                                 | )          | 1,036        |       | 963 |   | 73 |   |
| ·  Total (MBOE)          |       | 133                                        |       | 115          |       | 18                                                  |       | 388          |       | 355 |   | 33 |   |
| Average Price                      |       |                                       |       |         |       |                                                |       |         |       |   |   |   |   |
| ·  Crude Oil ($/ Bbl)    |       | $                                          | 93.16      |         | $          | 56.48                                               |       | $            | 36.69      |   | $ | 84.67 |   | $ | 61.69 |   | $ | 22.98 |   |
| ·  Natural Gas ($/  Mcf) |       | $                                          | 13.13      |         | $          | 7.59                                                |       | $            | 5.54       |   | $ | 11.50 |   | $ | 8.00 |   | $ | 3.50 |   |

 

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The current quarter operating revenues of $11.7million represent an improvement of $5.8 million as compared to the prior yearquarter of $5.9 million. The $5.8 million improvement is primarily attributableto higher prices received for crude oil and natural gas sales of $2.6 millionand $1.9 million, respectively, and increased crude oil sales of $1.3million.  The increased crude oil sales are primarily attributed toproduction from the New Mexico Properties, as the prior year quarter did nothave operating results from the New Mexico Properties since we acquired theseproperties during March 2007.

 

The current nine months operating revenues of $30.4million represent an improvement of $10.7 million as compared to the prior yearnine months of $19.7 million.  The $10.7 million improvement is primarilyattributable to higher prices received for crude oil and natural gas sales of$4.8 million and $4.1 million, respectively, and increased crude oil andnatural gas sales of $1.5 million and $0.3 million, respectively.  Theincreased crude oil sales are attributable to the New Mexico Properties, as previouslydiscussed.  The increased natural gassales are attributed to the Barnett Shale natural gas production from ourDesdemona Properties, partially offset by lower sales from our Panhandle andPantwist Properties.

 

The average price we received for crude oil sales isgenerally at or above market prices received at the wellhead. The average pricewe receive for natural gas sales is approximately the market price received atthe wellhead less transportation and marketing expenses.

 

***Operating Expenses***

 

For the current quarter, our total operating expenseswere $9.6 million, or $2.1 million higher than the prior year quarter of $7.5million. The $2.1 million increase is primarily attributed to increased leaseoperating expenses of $1.2 million, higher general and administrativeexpenses of $0.4 million, higher production and ad valorem taxes of $0.3million, and depletion and depreciation expense of $0.2 million.

 

For the current nine months, our total operatingexpenses were $27.1 million, or $5.5 million higher than the prior year ninemonths of $21.6 million. The $5.5 million increase is primarily attributed toincreased lease operating expenses of $2.5 million, higher general andadministrative expenses of $2.0 million, higher production and ad valorem taxesof $0.6 million, and higher depletion and depreciation expense of $0.5 million.

 

Our lease operating expenses (“LOE”) consist of costsof producing crude oil and natural gas such as labor, supplies, repairs,maintenance, and utilities.  For the current quarter, our LOE was $4.1million, which is $1.2 million higher than the prior year quarter of $2.9million.  We have incurred higher LOE dueto the inclusion of the New Mexico Properties, increased lifting costs at theDesdemona Properties, increased workover rig expenses at the Panhandle andPantwist Properties, increased electricity expense and generally higher costsfor goods and services.   For thecurrent nine months, our LOE was $10.4 million, which is $2.5 million higherthan the prior year nine months of $7.9 million.  The $2.5 million increase is attributable tothe same reasons previously discussed. For the current nine months, the LOE per BOE was $26.53 as compared to$22.10 for the prior year nine months. We generally incur a high amount of LOE because our fields are moremature and typically produce less oil and more water, and they are generally atthe end of the primary or secondary production cycle.  We expect the LOEper BOE to decrease during the 2008 calendar year as production increases fromthe waterflood and EOR development activities we are implementing as discussedunder the *“Capital Development Update*.”

 

Our general and administrative (G&A) expensesconsist of support services for our operating activities and investor relationscosts. For the current quarter, our G&A expenses totaled $3.3 million,which is $0.4 million higher than the prior year quarter of $2.9 million. Theprimary reasons for the $0.4 million increase were increased stock compensationexpense of $0.2 million and higher legal expenses of $0.2 million pertaining tothe fire litigation as discussed in Note 10.  For the current nine months,our G&A expenses totaled $10.7 million, which is $2.0 million higher thanthe prior year nine months of $8.7 million.  The $2.0 million increase isattributed to increased stock compensation expense of $1.5 million and higherlegal fees pertaining to fire litigation. The increased stock compensation expense resulted from the issuance ofrestricted shares as discussed in Note 4 and issuance of stock options asdiscussed in Note 5.

 

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For the current quarter and current nine months, ourdepletion and depreciation expense increased by $0.2 million and $0.5 million,as compared to the respective prior year periods.  This includes depletionexpense pertaining to our oil and natural gas properties, and depreciationexpense pertaining to our field operations vehicles and equipment, natural gasplant, office furniture and computers.  For the current quarter, ourdepletion rate pertaining to our oil and gas properties was $8.06 per barrel ofoil equivalent (“BOE”), as compared to prior year quarter of $7.31 perBOE.  For the current nine months, our depletion rate was $7.61 per BOE ascompared to $6.94 per BOE for the prior year nine months.  Both thecurrent quarter and nine months have higher depletion rates due to lower provedproducing reserves for the Panhandle Properties, the acquisition of the NewMexico Properties and the depletion rate associated with the natural gasproduction from the Barnett Shale.

 

***Productionand Ad Valorem Taxes***

 

For the current quarter, production and ad valoremtaxes were $0.9 million, or $0.3 million higher than the prior year quarter of$0.6 million.  For the current ninemonths, these taxes totaled $2.3 million, which is $0.6 million higher than theprior year nine months.  Both increasesare attributable to higher revenues, as previously discussed.

 

***Interest Expense***

 

The interest expense we incurred in the currentquarter amounted to $0.1 million, as compared to $0.3 million for the prioryear quarter.  For the current nine months, our interest expense totaled$0.6 million, as compared to $2.2 million for the prior year nine months. The interest expense for the current quarter and current nine months wasimpacted by $0.6 million and $1.7 million of interest cost that was capitalizedto the waterflood and ASP projects as discussed under the *“Capital Development Update.”* Therefore, our interest cost (including capitalized interest) for the currentquarter and nine months is $0.7 million and $2.3 million, respectively. The current quarter interest cost of $0.7 million is $0.4 million higher thanthe prior year quarter of $0.3 million due to higher debt balances during thecurrent quarter.  The current nine months interest cost of $2.3 million iscomparable to the prior year nine months of $2.2 million.

 

***Unrealized Loss on Commodity Derivatives***

 

As discussed in Note 3, we have entered into financialcontracts to set price floors and ceilings for crude oil and natural gasproduction.  For the current quarter, we recorded an unrealized loss of$3.2 million to reflect the fair value of the commodity derivatives as of March 31,2008.  Our current quarter loss of $3.2 million is $1.6 million higherthan the prior year quarter of an unrealized loss of $1.6 million.  Forthe current nine months, the unrealized loss is $5.6 million, which is $3.8million higher than the $1.8 unrealized loss recorded for the prior year ninemonths.

 

The unrealized loss is a non-cash charge resultingfrom the mark-to-market valuation of our commodity derivatives that pertains tofuture periods.  Of the $3.2 millionamount for the current quarter, $2.7 million pertained to the costless collarsdiscussed in Note 3, which did not require any initial cash outlay and does notinvolve future cash outlay unless the NYMEX crude oil and natural gas pricesexceed the ceiling prices as specified in the table in Note 3.

 

By their nature, these commodity derivatives can behighly volatile to our earnings.  A ten percent change in these prices forour derivative instruments can impact earnings by approximately $0.2 million.

 

***Realized Gain (Loss) on Commodity Derivatives***

 

During the current quarter, there were net settlementsunder our derivative agreements that required us to pay $0.3 million, ascompared to the prior year quarter for which we received net settlements of$0.1 million.  For the current year ninemonths, the net settlements required us to pay $0.1 million, as compared to the$0.9 million we received in net settlements for the prior year nine months.

 

The settlements received by us were cumulative monthlypayments due to us since the NYMEX natural gas price was lower than the “floornatural gas prices” ranging between $7.50 and $8.00 per Mcf.  The settlements paid by us were cumulativemonthly payments we made to our counterparty since the NYMEX crude oil pricewas higher than 

 

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the “ceiling crude oil prices” of $83 and $86 perbarrel.  Our commodity derivativeagreements are discussed in greater detail in Note 3.

 

***Income Tax Benefit***

 

For the current quarter, we recorded an income taxbenefit of $0.6 million, as compared to the income tax benefit of $1.1 millionduring the prior year quarter.  During the current nine months, werecorded an income tax benefit of $1.0 million, as compared to $1.7 millionduring the prior year nine months.  The changes to the income tax benefitare a direct result of the changes in taxable income.

 

***Preferred Stock Dividend***

 

The preferred stock dividend for the current yearquarter of $0.9 million is $0.1 million less than the prior year quarter of$1.0 million.  The lower preferred dividend is due to the conversion ofpreferred stock to common stock as discussed in Note 8.  The current yearnine months of $2.7 million is higher than the prior year nine months of $2.2million.  The current year nine months amount represents a full ninemonths.  The prior year nine months is a smaller amount since it pertainsto the period beginning September 6, 2006, the date of the preferred stockissuance.

 

***Income (Loss) from Discontinued Operations***

 

As discussed on our Form 10-K dated June 30,2007, we had sold our interest in the Rich Valley Properties during June 2007. The prior year quarter and prior year nine months results of operations forRich Valley have been reclassified as discontinued operations and are presentednet of related income taxes.  During the current year nine months, we hada loss of $0.1 million attributed to discontinued operations due to Oklahomasales taxes.

 

***New AccountingPronouncements***

 

On July 13, 2006, the FASB released FIN 48, whichrequires a company to evaluate and disclose material uncertain tax positions ithas taken with various taxing jurisdictions.  Any interest and penaltiesrelated to uncertain tax positions would be recorded as interest expense andgeneral and administrative expense, respectively.  We adopted FIN 48 on July 1,2007.  At the time of adoption and as of March 31, 2008, wedetermined the adoption of FIN 48 does not materially affect our operatingresults, financial position, or cash flows.  As of March 31, 2008, wehave not recorded any accruals for uncertain tax positions.  We are not involvedin any examinations by the Internal Revenue Service.  For Texas, Oklahoma,New Mexico and U.S. federal purposes, the review of our tax returns is open forthe tax years of 2004 through 2007.

 

SFAS No. 157 was issued by the FASB in September 2006.SFAS No. 157 defines fair value, establishes a framework for measuringfair value under GAAP and expands disclosures about fair value measurements.SFAS No. 157 applies to other accounting pronouncements that require orpermit fair value measurement. No new requirements are included in SFAS No. 157,but application of the SFAS No. 157 will result in additional disclosurerequirements. SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007. We do not expectadoption of SFAS No. 157 will have a material impact on our financialposition, results of operations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141R,which among other things, establishes principles and requirements for how theacquirer in a business combination (i) recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,and any noncontrolling interest in the acquired business, (ii) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase, and (iii) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination.  SFAS No. 141R is effective for fiscalyears beginning on or after December 15, 2008, with early adoptionprohibited.  This standard will change our accounting treatment forbusiness combinations on a prospective basis.

 

In December 2007, the FASB issued SFAS No. 160,which establishes accounting and reporting standards for noncontrollinginterests in a subsidiary and for the deconsolidation of a subsidiary. Minority interests will be recharacterized as noncontrolling interests andclassified as a component of equity.  It also establishes a single 

 

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method of accounting for changes in a parent’sownership interest in a subsidiary and requires expanded disclosures. This statement is effective for fiscal years beginning on or after December 15,2008, with early adoption prohibited.  We do not expect the adoption ofthis statement will have a material impact on our financial position, resultsof operations or cash flows.

 

**Item 3. Quantitative and QualitativeDisclosures About Market Risk.**

 

See Notes 2 and 3 regarding the updates of our marketrisk for the quarter ended March 31, 2008.

 

**Item 4. Controls and Procedures.**

 

As of the end of the period covered by this report, weconducted an evaluation, under the supervision and with the participation ofour chief executive officer and chief financial officer of our disclosurecontrols and procedures 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 concludedthat our disclosure controls and procedures were effective to ensure thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is: (1) accumulated and communicated to ourmanagement, including our chief executive officer and chief financial officer,as appropriate to allow timely decisions regarding required disclosure; and (2) recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

During the quarter ended March 31, 2008, therewas no change in our internal control over financial reporting that hasmaterially affected or is reasonably likely to materially affect our internalcontrol over financial reporting.

 

**PART II— OTHER INFORMATION**

 

**Item 1. Legal Proceedings.**

 

See Note 10 which is incorporated into this “Item 1.Legal Proceedings” by reference.

 

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

 

***Preferred Stock Conversion and Warrants Exercised***

 

On January 8, 2008, 523 shares of Series DConvertible Preferred Stock of Cano were converted by Truk Opportunity Fund,LLC into 91,116 shares of Cano common stock and 52 shares of Series DConvertible Preferred Stock were converted by Truk International Fund, LP into9,059 shares of Cano common stock. Of the shares of Cano common stock issued,an aggregate of 100,000 shares were issued based on the $5.75 conversion priceof the Series D Convertible Preferred Stock and an aggregate of 175 shareswere issued in lieu of the accrued but unpaid dividends from January 1,2008 – January 8, 2008 pursuant to the terms of the Series DConvertible Preferred Stock. The shares of Cano common stock were issued inreliance upon the exemption from registration provided by Section 3(a)(9) ofthe Securities Act of 1933, as amended.

 

Pursuant to a cashless exercise, (i) on January 18,2008, OTA, LLC exercised warrants into 41,741 shares of Cano common stock; (ii) onJanuary 22, 2008, OTA, LLC exercised warrants into 40,660 shares of Canocommon stock; (iii) on February 19, 2008 Dynamis Energy Fund, Ltd.exercised warrants into 2,849 shares ofCano common stock and Dynamis Energy Fund, LP exercised warrants into 12,981shares of Cano common stock; (iv) on February 28, 2008, EuropaInternational, Inc. and Knoll Capital Fund II Master Fund, Ltd. eachexercised warrants into 19,079 shares of Cano common stock for an aggregate of38,158 shares; (v) on February 29, 2008, Ridgecrest Partners, Ltd.exercised warrants into 844 shares of Cano common stock, Ridgecrest PartnersQP, LP exercised warrants into 1,201 shares of Cano common stock and AdvantageAdvisors Catalyst Partners, L.P. exercised warrants into 1,201 shares of Canocommon stock; and (vi) on March 6, 2008, Investor Company, as nomineefor Trapeze Asset Management, Inc.’s managed accounts, exercised warrants into987 shares of Cano common stock, Investor Company, as nominee for TrapezeCapital Corp.’s managed accounts, exercised warrants into 156 shares of Canocommon stock, Investor Company, as nominee for Derek Askey, exercised warrantsinto 428 shares of Cano common stock and Investor Company, as nominee for LoisA. Bauer, exercised warrants into 52 shares of Cano common stock.  The warrant exercise price was $4.79 pershare.  Since 

 

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these were cashless exercises, the shares of Canocommon stock were issued in reliance upon the exemption from registrationprovided by Section 3(a)(9) of the Securities Act of 1933, asamended.

 

On February 28, 2008, Band & Co., asnominee for Trapeze Asset Management, Inc.’s managed accounts, exercisedwarrants into 950 shares of Cano common stock. On March 3, 2008, ING Global Resources Portfolio exercised warrantsinto 283,750 shares of Cano common stock. On March 4, 2008, the William Herbert Hunt Trust Estate exercisedwarrants into 125,000 shares of Cano common stock.  On March 5, 2008, CamCap Energy OffshoreMaster Fund, L.P. exercised warrants into 53,750 shares of Cano common stockand Touradji Global Resources Master Fund and Touradji DeepRock Master Fund,Ltd. each exercised warrants into 62,500 shares of Cano common stock for anaggregate of 125,000 shares of Cano common stock.  On March 6, 2008, Investor Company, asnominee for Trapeze Asset Management, Inc.’s managed accounts, exercisedwarrants into 354,545 shares of Cano common stock and Investor Company, asnominee for Trapeze Capital Corp.’s managed accounts, exercised warrants into141,350 shares of Cano common stock. These exercises were made in cash at an exercise price of $4.79 pershare.  The shares of Cano common stockwere issued in reliance upon the exemption from registration provided by Section 4(2) ofthe Securities Act and/or the exemption from registration provided by Rule 506promulgated by the Securities Act.

 

**Item 5.  Other Information**

 

On a Current Report on Form8-K filed on March 20, 2008, we reported that $34.5 million was outstandingunder our senior credit agreement and $15 million was outstanding under oursubordinated credit agreement. On March 31, 2008, we increased the amountoutstanding under our senior credit agreement to an aggregate of $40.5 million.On April 15, 2008, we increased the amount outstanding under our senior creditagreement to an aggregate of $46.0 million. On May 6, 2008, we increased theamount outstanding under our senior credit agreement to an aggregate of $49.5million. There is still $15 million outstanding under our subordinated creditagreement.

 

 **Item 6.Exhibits.**

 
| **Exhibit   Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*                 |       | Certificate of Amendment to the Certificate of  Limited Partnership of W.O. Production Company, Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 3.2*                 |       | Certificate of Amendment to the Certificate of  Limited Partnership of W.O. Operating Company, Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.1                 |       | Amendment No. 8 and Agreement dated as of  January 16, 2008 by and among Cano Petroleum, Inc., Square One  Energy, Inc., Ladder Companies, Inc., W.O. Energy of  Nevada, Inc., WO Energy, Inc., Pantwist, LLC, Cano Petro of New  Mexico, Inc., W.O. Operating Company, Ltd. and W.O. Production Company,  Ltd., Union Bank of California, N.A., as Administrative Agent, Issuing Lender  and Lender and Natixis, incorporated by reference from Exhibit 10.3 to  the Quarterly Report on Form 10-Q for the quarter-ended  December 31, 2007. |
| 10.2                 |       | Board of Directors Compensation effective  January 1, 2008, incorporated by reference from Exhibit 10.6 to the  Quarterly Report on Form 10-Q for the quarter-ended December 31,  2007.                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.3                 |       | 2008 Annual Incentive Plan, incorporated by  reference from Exhibit 10.1 to the Current Report on Form 8-K filed  on February 21, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.4                 |       | Summary of 2008 Cash Incentive Awards, incorporated  by reference from Exhibit 10.2 to the Current Report on Form 8-K  filed on February 21, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.5*                |       | Summary Sheet of Acceleration of Vesting and  Extension of Exercise Period for Resigning Directors (February 14,  2008).                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.6*                |       | $25,000,000 Subordinated Credit Agreement among Cano  Petroleum, Inc. as Borrower, the Lenders Party Hereto from Time to Time  as Lenders, and UnionBanCal Equities, Inc. as Administrative Agent dated  March 17, 2008.                                                                                                                                                                                                                                                                                                                                                              |
| 10.7*                |       | Subordinated Security Agreement dated as of  March 17, 2008 by and among Cano Petroleum, Inc., Ladder  Companies, Inc., Square One Energy, Inc., WO Energy, Inc.,  W.O. Energy of Nevada, Inc., Cano Petro of New Mexico, Inc.,  Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company, Ltd.,  and UnionBanCal Equities, Inc. as Administrative Agent.                                                                                                                                                                                        |
| 10.8*                |       | Subordinated Pledge Agreement dated as of March 17,  2008 by and among Cano Petroleum, Inc., WO Energy, Inc., W.O.  Energy of Nevada, Inc. and UnionBanCal Equities, Inc. as  Administrative Agent.                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9*                |       | Subordinated Guaranty Agreement dated as of  March 17, 2008 by Ladder Companies, Inc., Square One Energy, Inc.,  WO Energy, Inc., W.O. Energy of Nevada, Inc., Cano Petro of New  Mexico, Inc., Pantwist, LLC, W.O. Operating Company, Ltd., and W.O.  Production Company, Ltd., in favor of UnionBanCal Equities, Inc. as  Administrative Agent.                                                                                                                                                                                                                 |
| 10.10*               |       | Amendment No. 9 and Agreement dated as of  March 17, 2008 by and among Cano Petroleum, Inc., Ladder  Companies, Inc., Square One Energy, Inc., WO Energy, Inc.,  W.O. Energy of Nevada, Inc., Cano Petro of New Mexico, Inc.,  Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company, Ltd.,  Union Bank of California, N.A. and Natixis.                                                                                                                                                                                                      |
| 10.11*               |       | Consent Agreement dated as of February 21, 2008  by and among Cano Petroleum, Inc., Ladder                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

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|   |   | Companies, Inc., Square One Energy, Inc.,  WO Energy, Inc., W.O. Energy of Nevada, Inc., Cano Petro of New  Mexico, Inc., Pantwist, LLC, W.O. Operating Company, Ltd., W.O.  Production Company, Ltd., Union Bank of California, N.A. and Natixis.               |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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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| * |   | Filed herewith |
|---|--------|----------------|

 

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**SIGNATURES**

 

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

 
| **CANO PETROLEUM, INC.** |   |                                               |
|--------------------------|--------|----------------------------------------------------|
|                     |   |                                               |
| Date: May 8, 2008   | By:    | /s/ S. Jeffrey Johnson                             |
|                     |   | S. Jeffrey Johnson                                 |
|                     |   | Chief Executive Officer                            |
|                     |   |                                               |
|                     |   |                                               |
| Date: May 8, 2008   | By:    | /s/ Morris B. Smith                                |
|                     |   | Morris B. Smith                                    |
|                     |   | Senior Vice-President and  Chief Financial Officer |
|                     |   |                                               |
|                     |   |                                               |
| Date: May 8, 2008   | By:    | /s/ Michael J. Ricketts                            |
|                     |   | Michael J. Ricketts                                |
|                     |   | Vice-President and  Principal Accounting Officer   |

 

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