** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

# **FORM 10-QSB**

# ** **

**(MarkOne)**

 
| ý     | ** ** | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005** |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                      |
| o          | ** ** | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                                                                       |

 

**Forthe transition period from               to               **

**Commissionfile number                **

 

**CANOPETROLEUM, INC.**

(Exact name ofsmall business issuer as specified in its charter)

 

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

 

**TheOil & Gas Commerce Building309 West 7th Street, Suite 1600**

**FortWorth, TX 76102**

(Address ofprincipal executive offices)

 

**(817)698-0900**

(Issuer’stelephone number)

 

**NotApplicable**

(Former name,former address and former fiscal year, if changed since last report)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during thepast 12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes ý      No o

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGSDURING THE PRECEDING FIVE YEARS**

 

Check whether the registrant filed all documents andreports required to be filed by Section 12, 13 or 15(d) of the ExchangeAct after the distribution of securities under a plan confirmed by acourt.  Yes o      No o

 

**APPLICABLEONLY TO CORPORATE ISSUERS**

 

State the number of shares outstanding of each of theissuer’s classes of common equity, as of the latest practicable date: 20,352,757 shares of common stock, $.0001 par value per share, as of May 13,2005.

 

Transitional Small Business Disclosure Format (Checkone): Yes o      No ý

 

 

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**PART I - FINANCIAL INFORMATION**

** **

**Item1. Financial Statements.**

** **

**CANO PETROLEUM, INC.**

**CONSOLIDATED BALANCE SHEET**

**(Unaudited)**

 
| ASSETS                                                                                                                                         | ** ** | ** **    | ** **     |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|----------------|
| ** **                                                                                                                                     | ** ** | **March 31,** | ** **     |
| ** **                                                                                                                                     | ** ** | **2005**      | ** **     |
| **Current assets**                                                                                                                             | ** ** | ** **    | ** **     |
| Cash and cash equivalents                                                                                                                      |       | $             | 401,220        |   |
| Accounts receivable                                                                                                                            |       | 622,218       |           |
| Other current assets                                                                                                                           |       | 59,810        |           |
| Total current assets                                                                                                                           |       | 1,083,248     |           |
|                                                                                                                                           |       |          |           |
| **Oil and gas properties****,** successful  efforts method                                                                                     |       | 16,188,080    |           |
| Less accumulated depletion and depreciation                                                                                                    |       | (379,916      | )              |
| Net oil and gas properties                                                                                                                     |       | 15,808,164    |           |
|                                                                                                                                           |       |          |           |
| Fixed assets and other, net                                                                                                                    |       | 271,899       |           |
| Goodwill                                                                                                                                       |       | 101,166       |           |
| **TOTAL ASSETS**                                                                                                                               | ** ** | **$**         | **17,264,477** | ** ** |
| ** **                                                                                                                                     | ** ** | ** **    | ** **     |
| LIABILITIES AND  STOCKHOLDERS' EQUITY                                                                                                          |       |          |           |
| **Current liabilities**                                                                                                                        | ** ** | ** **    | ** **     |
| Accounts payable                                                                                                                               |       | $             | 763,382        |   |
| Oil and gas sales payable                                                                                                                      |       | 54,058        |           |
| Accrued liabilities                                                                                                                            |       | 34,997        |           |
| Current portion of asset retirement obligations                                                                                                |       | 17,183        |           |
| Total current liabilities                                                                                                                      |       | 869,620       |           |
| **Long-term liabilities**                                                                                                                      | ** ** | ** **    | ** **     |
| Asset retirement obligations                                                                                                                   |       | 581,397       |           |
| **Commitments and contingencies (Note 10)**                                                                                                    | ** ** | ** **    | ** **     |
| **Stockholders' equity**                                                                                                                       | ** ** | ** **    | ** **     |
| Preferred stock                                                                                                                                |       | —        |           |
| Common stock, par value $.0001 per share; 50,000,000 authorized;  20,352,757 issued and outstanding, including 5,165,000 shares held in escrow |       | 2,036         |           |
| Additional paid-in capital                                                                                                                     |       | 25,880,305    |           |
| Accumulated deficit                                                                                                                            |       | (9,182,760    | )              |
| Deferred compensation                                                                                                                          |       | (886,121      | )              |
| Total stockholders' equity                                                                                                                     |       | 15,813,460    |           |
| **TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                                 | ** ** | **$**         | **17,264,477** | ** ** |
|                                                                                                                                                |            |               |                |  |  |

*** ***

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

 

 

2

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                         | ** ** | **March 31,**          | ** ** | **March 31,**         | ** ** |
| ** **                                                         | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating Revenues:**                                            | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil and natural gas sales                                    |       | $                      | 1,461,885  |                  | $          | — |   | $ | 3,780,437 |   | $ | — |   |
| ** **                                                         | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Operating Expenses:**                                            | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Lease operating expenses                                           |       | 819,093                |       | —                |       | 1,815,837 |   | — |   |
| Production taxes                                                   |       | 92,711                 |       | —                |       | 241,809 |   | — |   |
| General and adminstrative                                          |       | 729,988                |       | 59,901                |       | 2,121,967 |   | 88,009 |   |
| Deferred compensation expense                                      |       | 431,439                |       | —                |       | 1,341,285 |   | — |   |
| Accretion of asset retirement obligations                          |       | 5,584                  |       | —                |       | 16,444 |   | — |   |
| Depletion and depreciation                                         |       | 159,822                |       | —                |       | 403,538 |   | — |   |
| Total operating expenses                                           |       | 2,238,637              |       | 59,901                |       | 5,940,880 |   | 88,009 |   |
| ** **                                                         | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Loss from operations**                                           |       | (776,752               | )          | (59,901               | )          | (2,160,443 | ) | (88,009 | ) |
|                                                               |       |                   |       |                  |       |   |   |   |   |
| Interest income and deductions, net                                |       | 1,471                  |       | —                |       | 10,536 |   | — |   |
| ** **                                                         | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net loss**                                                       |       | (775,281               | )          | (59,901               | )          | (2,149,907 | ) | (88,009 | ) |
|                                                               |       |                   |       |                  |       |   |   |   |   |
| Preferred stock discount                                           |       | —                 |       | —                |       | 416,534 |   | — |   |
| ** **                                                         | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Loss applicable to common stock**                                |       | $                      | (775,281   | )                     | $          | (59,901 | ) | $ | (2,566,441 | ) | $ | (88,009 | ) |
| ** **                                                         | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net loss per share - basic and diluted**                         |       | $                      | (0.07      | )                     | $          | (0.01 | ) | $ | (0.24 | ) | $ | (0.01 | ) |
| ** **                                                         | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Weighted average common shares outstanding -**basic and  diluted |       | 11,204,155             |       | 6,982,204             |       | 10,722,854 |   | 6,982,204 |   |

 

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

 

 

3

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
| ** **                                                           | ** ** | **Nine Months Ended March 31,** | ** **  |
|----------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                           | ** ** | **2005**                        | ** **  | **2004** | ** ** |
| **Cash flow from operating activities:**                             |       |                            |        |   |   |
| Net loss                                                             |       | $                               | (2,149,907  | ) | $ | (88,009 | ) |
| Adjustments needed to reconcile to net cash flow used in operations: |       |                            |        |   |   |
| Accretion of asset retirement obligations                            |       | 16,444                          |        | — |   |
| Depletion and depreciation                                           |       | 403,538                         |        | — |   |
| Deferred compensation expense                                        |       | 1,341,285                       |        | — |   |
| Stock-based compensation expense                                     |       | 78,666                          |        | — |   |
|                                                                 |       |                            |        |   |   |
| Changes in assets and liabilities relating to operations:            |       |                            |        |   |   |
| Accounts receivable                                                  |       | (605,938                        | )           | — |   |
| Accounts payable                                                     |       | 608,398                         |        | 839 |   |
| Accrued liabilities                                                  |       | (219,696                        | )           | — |   |
| Oil and gas sales payable                                            |       | 14,828                          |        | — |   |
| Other current assets                                                 |       | (46,340                         | )           | — |   |
|                                                                 |       |                            |        |   |   |
| **Net cash used in operations**                                      | ** ** | **(558,722**                    | **)**       | **(87,170** | **)** |
| ** **                                                           | ** ** | ** **                      | ** **  | ** ** | ** ** |
| **Cash flow from investing activities:**                             | ** ** | ** **                      | ** **  | ** ** | ** ** |
| Additions to oil and gas properties                                  |       | (1,936,124                      | )           | — |   |
| Additions to other fixed assets                                      |       | (250,606                        | )           | — |   |
| Cash restricted for development activities                           |       | 866,339                         |        | — |   |
| Acquisition of additional Davenport revenue interest                 |       | (667,000                        | )           | — |   |
| Acquisition of Nowata                                                |       | (2,551,721                      | )           | — |   |
| Acquisition of Square One Energy, Inc.                               |       | (4,020,363                      | )           | — |   |
| Acquisition of Ladder                                                |       | (2,111,517                      | )           | — |   |
| **Net cash used in investing activities**                            | ** ** | **(10,670,992**                 | **)**       | — | ** ** |
| ** **                                                           | ** ** | ** **                      | ** **  | ** ** | ** ** |
| **Cash flow from financing activities:**                             | ** ** | ** **                      | ** **  | ** ** | ** ** |
| Proceeds from issuance of preferred stock, net                       |       | 5,304,872                       |        | — |   |
| Proceeds from issuance of common stock, net                          |       | 4,750,783                       |        | — |   |
| Loan by principal stockholder                                        |       | —                          |        | 70,000 |   |
| **Net cash from financing activities**                               | ** ** | **10,055,655**                  | ** **  | **70,000** | ** ** |
|                                                                 |       |                            |        |   |   |
| Net decrease in cash and cash equivalents                            |       | (1,174,059                      | )           | (17,170 | ) |
|                                                                 |       |                            |        |   |   |
| Cash and cash equivalents at beginning of period                     |       | 1,575,279                       |        | 20,000 |   |
| ** **                                                           | ** ** | ** **                      | ** **  | ** ** | ** ** |
| **Cash and cash equivalents at end of period**                       | ** ** | **$**                           | **401,220** | ** ** | **$** | **2,830** | ** ** |
| ** **                                                           | ** ** | ** **                      | ** **  | ** ** | ** ** |
| **Supplemental disclosure of noncash transactions:**                 | ** ** | ** **                      | ** **  | ** ** | ** ** |
| Common stock issued for acquisition of Square One Energy, Inc.       |       | $                               | 3,519,996   |   | $ | — |   |
| Amortization of preferred stock discount                             |       | $                               | 416,534     |   | $ | — |   |

*** ***

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

 

 

4

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***CANO PETROLEUM, INC.***

 

**NOTESTO FINANCIAL STATEMENTS**

 

**1.****             ****BASIS OF PRESENTATION**

 

The interim consolidated financial statements of CanoPetroleum, Inc. are unaudited and contain all adjustments (consisting primarilyof normal recurring accruals) necessary for a fair statement of the results forthe interim periods presented.  Results for interim periods are notnecessarily indicative of results to be expected for a full year or forpreviously reported periods due in part to the volatility in prices for crudeoil and natural gas, the timing of acquisitions, interruption in production andthe success of drilling activity.  You should read these consolidatedinterim financial statements in conjunction with the audited consolidatedfinancial statements and notes thereto included in Cano’s Form 10-KSB datedJune 30, 2004.

 

**2.****             ****ACQUISITIONS**

 

Ladder Company Oil and Gas Properties - On July 2, 2004, we acquired allof the outstanding common stock of the Ladder Companies, Inc., a Delawarecorporation, for approximately $2.2 million, after purchase priceadjustments.  The Ladder Companies comprise two companies — Ladder EnergyCompany, a Delaware corporation, and Tri-Flow, Inc., an Oklahomacorporation.  The Ladder Companies are engaged in oil and gas explorationand production activities.  The acquisition was effective on May 1, 2004,and net operating income from that date through closing was applied to thepurchase price.

 

Nowata Oil Properties — On September 14, 2004, we acquired oil and gasproducing leases from the Nowata Oil Properties LLC for approximately $2.6million.  The leases are located in Nowata County, Oklahoma.  Theeffective date of the purchase is September 1, 2004.

 

Square One Energy — On March 29, 2005, we completed theacquisition of Square One Energy, Inc. (“Square One”).  The value ofthe consideration we paid for Square One was $7.5 million, consisting of $4million in cash and 888,888 shares of our common stock, which was valued at$3.96 per share.

 

The Ladder, Nowata and Square One acquisitions wererecorded based on the purchase method of accounting.  The purchase priceswere allocated to the acquired assets and assumed liabilities based on theirfair values.  The calculation of each purchase price and allocation toassets is as follows:

 

| ** **                    | ** ** | **Ladder** | ** ** | **Nowata** | ** ** | **Square One** | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|----------------|------------|
| Net Acquisition Price         |       | $          | 2,248,542  |       | $          | 2,551,721      |       | $ | 7,540,359 |   |
| Asset Retirement Obligations  |       | 241,905    |       | 71,027     |       | 212,718        |       |
| Other Liabilities Assumed     |       | 47,975     |       | —     |       | 80,328         |       |
| Total Purchase Price          |       | $          | 2,538,422  |       | $          | 2,622,748      |       | $ | 7,833,405 |   |
|                          |       |       |       |       |       |           |       |
| Allocation of Purchase Price: |       |       |       |       |       |           |       |
| Cash                          |       | $          | 110,075    |       | $          | —         |       | $ | — |   |
| Accounts Receivable           |       | 2,917      |       | —     |       | —         |       |
| Prepaid Assets                |       | 13,470     |       | —     |       | —         |       |
| Fixed Assets                  |       | —     |       | —     |       | 49,448         |       |
| Oil & Gas Properties      |       | 2,411,960  |       | 2,622,748  |       | 7,783,957      |       |
|                          |       | $          | 2,538,422  |       | $          | 2,622,748      |       | $ | 7,833,405 |   |

 

 

5

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The fair value assigned to the oil and gas properties is based on management’s valuation of the properties, which was derived in part by reference to reserve reports prepared by an independent petroleum engineering firm.  Based on the engineer’s reports and Cano’s internal analyses, we believe the value assigned to these properties is reasonably supported.  Regarding the valuation of Square One, the process of determining the fair value of assets and liabilities is underway, and the final results will not be completed until certain information about pre-acquisition contingencies is assessed.

 

Pro Forma Financial Information

The following condensed pro forma information giveseffect to the acquisitions as if they had occurred on July 1, 2004 and2003, respectively.  The pro forma information has been included in theNotes as required by generally accepted accounting principles and is providedfor comparison purposes only.  The pro forma financial information is notnecessarily indicative of the financial results that would have occurred hadthe business combinations been effective on the dates indicated and should notbe viewed as indicative of operations in the future.

 

**CanoPetroleum, Inc.**

**ProForma Information**

 
| ** **                                      | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                      | ** ** | **2005**                               | ** ** | **2004**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating revenues                              |       | $                                      | 1,683,528  |                                  | $          | 1,109,718 |   | $ | 4,725,243 |   | 2,975,083 |   |
| Income (loss) applicable to common stock        |       | $                                      | (734,892   | )                                     | $          | 157,810 |   | $ | (2,514,628 | ) | $ | 259,490 |   |
| Net income (loss) per share - basic and diluted |       | $                                      | (0.08      | )                                     | $          | 0.01 |   | $ | (0.23 | ) | $ | 0.02 |   |

 

**3.****             ****PREFERRED STOCK**

 

                        ***Financings***

 

For the nine months ended March 31, 2005, weissued $5.35 million of Series C Convertible Preferred Stock (5,350 shares at$1,000 per share).  This increased our total issuances of preferred stockto $8.75 million (net proceeds of $8.5 million).

 

The total issuances consisted of $2 million of SeriesB Convertible Preferred Stock and $6.75 million of Series C ConvertiblePreferred Stock.  These were non-voting shares issued at a price of $1,000per share.  The holders of the Series B and Series C Preferred Stock werenot entitled to receive any dividends.

 

***Conversion to Common***

 

DuringMarch 2005, the preferred stockholders elected to convert their preferredshares to common shares.  Each share of Series B and Series CConvertible Preferred Stock was converted by the holder into shares of ourcommon stock at a price of $3.00 and $3.75 per share, respectively.  The conversion is summarized in the followingtable:

 

 

| ** ** | ** ** | **Gross**     | ** ** | **Conversion** | ** ** | **Common** | ** ** |
|------------|------------|---------------|------------|----------------|------------|------------|------------|
| ** ** | ** ** | **Issuances** | ** ** | **Price**      | ** ** | **Shares** | ** ** |
| Series B   |       | $             | 2,000,000  |           | $          | 3.00       |       | 666,665 |   |
| Series C   |       | $             | 6,750,000  |           | 3.75       |       | 1,800,000  |   |
| Total      |       | 8,750,000     |       |           |       | 2,466,665  |       |
|            |            |               |            |                |            |            |            |  |  |

 

 

As of March 31, 2005, there were no outstandingissuances of preferred stock.  Our commonstock is the only class of stock outstanding.

 

6

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***Beneficial Conversion Feature Related to our Series CPreferred Stock***

 

On the dates of certain issuances of our Series CPreferred Stock, the quoted market price of our common stock was higher thanthe conversion price of our Series C Preferred Stock of $3.75 per share,resulting in a beneficial conversion feature.   The value of the beneficial conversionfeature was a discount to preferred stock and a charge to earnings available tocommon stockholders, analogous to a preferred dividend.  As a directresult, we recognized a $416,534 increase in accumulated deficit with acorresponding increase in additional paid-in capital.  Because the SeriesC Preferred Stock was convertible into common stock on the date of issuance,the discount was immediately recognized as a charge to accumulated deficit, andtherefore, there was no impact to Series C Preferred Stock on the balancesheet.

 

**4.****    ****COMMON STOCK FINANCINGS**

 

On March 18, 2005, we entered into agreements to sell1,350,000 shares of common stock to two accredited institutional investors at aprice of $3.75 per share.  The transactions closed on March 24,2005.  We received gross proceeds of $5.1 million from the sale of thesecommon shares (net proceeds of $4.8 million).

 

The amount of common shares issued and outstanding issummarized as follows:

 

 

 

| Issued and outstanding as of June 30, 2004        |   | 15,647,204 |   |
|---------------------------------------------------|--------|------------|--------|
| Shares issued for Square One acquisition (Note 2) |   | 888,888    |   |
| Preferred shares converted to common (Note 3)     |   | 2,466,665  |   |
| Shares issued in private placement (above)        |   | 1,350,000  |   |
|                                              |   | 20,352,757 |   |

 

 

**5.****             ****RELATED PARTYTRANSACTIONS**

 

On August 16, 2004, we agreed to purchase anadditional 10% revenue interest in the Davenport field from Cano EnergyCorporation (“CEC”).  This increased our revenue interest in the Davenportfield to 65%.  In consideration for the additional 10% revenue interest,we agreed to pay $667,000 cash to CEC.  The final payment installment wasmade in October 2004.  Our CEO, S. Jeffrey Johnson, is a principalshareholder of Cano Energy Corporation.

 

As of March 31, 2005, there were no outstandingbalances between Cano and CEC.

 

On December 16, 2004, we issued stock options for50,000 shares of our common stock to Gerald Haddock, who currently serves onour board of directors.  The exercise price is $4 per option share. The options cannot be exercised for a six month period, referred to as theoption period.  After the option period, the options will expire in tenyears.  In accordance with the provisions of Statement of Financial AccountingStandard (“SFAS”) No. 123, *Accounting forStock-Based Compensation*, and SFAS No. 148, *Accounting for Stock-Based Compensation — Transitionand Disclosure*, we have recorded a charge to general andadministrative expenses of $78,666 for the estimated fair value of the options.

 

**6.****             ****RESTRICTED CASH**

 

As discussed in Cano’s Form 10-KSB dated June 30,2004, pursuant to the terms of the Merger Agreement, funds totaling $866,339were placed in escrow and dedicated to improvements and drilling in theDavenport field.   We have conducted drilling activities andimplemented improvements in the Davenport field during the 2005 fiscal year,which were funded by this escrowed amount.  At March 31, 2005, the escrowbalance was used in its entirety, and accordingly, no longer appears in theConsolidated Balance Sheet.

 

7

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**7.****             ****ASSET RETIREMENTOBLIGATION**

 

Our financial statements reflect the provisions ofStatement of Financial Accounting Standards No. 143,*Accounting for Asset Retirement Obligations*.  Ourasset retirement obligation (“ARO”) primarily represents the estimated presentvalue of the amount we will incur to plug, abandon and remediate our producingproperties at the end of their productive lives, in accordance with applicablestate laws.  We determine our ARO by calculating the present value ofestimated cash flows related to the liability.  At March 31, 2005,our liability for ARO was $598,580, of which $581,397 is considered longterm.  Our asset retirement obligations are recorded as current ornon-current liabilities based on the estimated timing of the anticipated cashflows. For the nine months ended March 31, 2005, we have recognizedaccretion expense of $16,444.

 

The following table describes the changes in our assetretirement obligations for the nine months ended March 31, 2005:

 

| Asset retirement obligation at July 1, 2004   |   | $       | 84,272  |   |
|-----------------------------------------------|--------|---------|---------|--------|
|                                          |   |    |    |
| Liabilities incurred:                         |   |    |    |
| Acquisition of Ladder Energy Company          |   | 241,905 |    |
| Acquisition of Nowata Properties              |   | 71,027  |    |
| Acquisition of Square One Energy              |   | 212,718 |    |
| Accretion expense                             |   | 16,444  |    |
| Plugging costs                                |   | (27,786 | )       |
| Asset retirement obligation at March 31, 2005 |   | $       | 598,580 |   |
|                                               |        |         |         |        |  |

 

**8.****             ****DEFERRED COMPENSATION**

 

As discussed in our Form 10-KSB dated June 30,2004, pursuant to the terms of the Merger Agreement, eight individuals (sevenof whom are now employed by us and one who is a member of our board ofdirectors) were issued 5,165,000 shares of common stock.  These shareswere placed in escrow.  The shares will vest to the individuals based on acombination of continued employment (“compensation shares”) and achievingcertain performance goals (“performance shares”) during the period endingJune 30, 2006.  The compensation shares amounted to 2,659,975shares and the performance shares amounted to 2,505,025 shares.  Anyshares that are not released from escrow will be returned to TreasuryStock.  We have accounted for these shares in accordance with theprovisions of SFAS Nos. 123 and 148.  At the merger date, we recognized$2,324,250 of “Deferred Compensation” and “Additional Paid-in Capital” in theConsolidated Balance Sheet.  The shares were recorded based on the quotedmarket price at the time of the transaction and are being amortized to expenseover the periods earned.  At March 31, 2005, the balance of DeferredCompensation was $886,121, net of amortization expense.

 

**9.****             ****NET LOSS PER COMMONSHARE**

 

Basic net income (loss) per common share is computedby dividing the net income attributable to common shareholders by the weightedaverage number of shares of common stock outstanding during the period. Diluted net income (loss) per common share is computed in the same manner, butalso considers the effect of the stock options.  The stock options are notconsidered for the three and nine months ended March 31, 2005 as theireffects would be anti-dilutive.

 

The weighted average shares used in the basic loss percommon share computations for the three months ended March 31, 2005 and2004 were 11,204,155 shares and 6,982,204 shares, respectively.  Theweighted average shares used in the basic loss per common share computationsfor the nine 

 

 

8

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months ended March 31, 2005 and 2004 were 10,722,854and 6,982,204, respectively.  The sharesat March 31, 2005 exclude 5,165,000 contingently issuable shares asdiscussed in Note 8.

 

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

 

***Litigation***

Occasionally, we are involved in various lawsuits andcertain governmental proceedings arising in the ordinary course ofbusiness.  Our management and legal counsel do not believe that theultimate resolution of such matters, will have a material effect on ourfinancial position or results of operations.

 

***Other***

To date, our expenditures to comply with environmentalor safety regulations have not been significant and are not expected to besignificant in the future. However, new regulations, enforcement policies,claims for damages or other events could result in significant future costs.

 

**Item2.  Management’s Discussion and Analysis / Plan of Operation.**

 

                On May 5, 2005, we began trading our common stock onthe American Stock Exchange under the symbol “CFW.”  Previously, we were trading our common stockon the Over-The-Counter Bulletin Board under the symbol “CAOP.”

 

**Forward-LookingStatements**

 

The information in thisreport on Form 10-QSB contains forward-looking statements within the meaning ofthe Private Securities Litigation Reform Act of 1995. This Act provides a “safeharbor” for forward-looking statements to encourage companies to provideprospective 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 a result ofmany factors, including, but not limited to, the volatility in prices for crudeoil and natural gas, the timing of acquisitions, interruption in production andthe success of drilling operations and secondary recovery efforts.

 

The following discussionand analysis should be read in conjunction with the consolidated financialstatements of Cano Petroleum, Inc. and subsidiaries and notes thereto, includedherewith. This discussion should not be construed to imply that the resultsdiscussed herein will necessarily continue into the future, or that anyconclusion reached herein will necessarily be indicative of actual operatingresults in the future. Such discussion represents only the best presentassessment of management.

 

**Plan ofOperation**

 

***Overall Strategy***

 

We are a growingindependent oil and gas company that intends to actively pursue enhanced oilrecovery techniques to increase production and reserves at our existingproperties and future acquisitions.  Ourprimary focus is crude oil and our target acquisitions are onshore U.S.properties.  Our focus on domestic,mature oil fields eliminates exploration risks and uncertainties ofinternational sources.  We usewaterflooding and enhanced oil recovery techniques, such asAlkaline-Surfactant-Polymer (ASP) technology.

 

We believe significantopportunities exist primarily because the major energy companies and largeindependents continue to focus their attention and resources toward thediscovery and development of large fields. In the past several years, the major companies have been divesting themselvesof their mature 

 

 

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oilfields. Also, the recent economics of the oil and gas market have improved asprices have risen substantially.  Theseconditions provide ample opportunities for smaller independent companies toacquire and exploit mature U.S. fields.  We expect that there will beincreased competition for such properties in the future.

 

We will continue totarget potential acquisition candidates in a disciplined manner.  Byadhering to our disciplined approach, we expect to continue to find attractiveeconomic acquisition and development opportunities.

 

Our competitive advantageis our in-house expertise and low internal overhead.  We employindependent engineers and geologists to aid in evaluating the economic meritsof drilling plans and potential acquisitions.  We believe that theincremental cost of hiring independent engineering firms justifies the expensebecause they provide a check and balance on our acquisition and developmentplans.  Further, employing third party experts on a case-by-case basisenables us to maintain low operating expenses and adhere to our commitment tokeep fixed costs low.

 

**Liquidityand Capital Resources**

 

We intend to financefuture acquisitions of oil and gas properties, field development projects andoperating activities with a combination of issuances of equity, access tocapital markets, and cash flow from operations.  We cannot guarantee thatany additional equity financing will be available in sufficient amounts or onacceptable terms when needed.  If such financing is not available insufficient amounts or on acceptable terms, our results of operations andfinancial condition may be adversely affected.  In addition, equityfinancing may result in dilution to existing stockholders and may involve securitiesthat have rights, preferences, or privileges that are senior to our commonstock.

 

***Financing andInvesting Activities***

 

As discussed in Note 3 tothe financial statements, as of March 31, 2005, we have issued preferredstock totaling $8.75 million (net proceeds of $8.5 million), of which $5.35million was issued during the past nine months.   Also, as discussed in Note 4, we received netproceeds of $4.8 million from the issuance of 1,350,000 shares of common stockduring March 2005.

 

During March 2005, the preferred stockholderselected to convert their preferred shares to common shares.  As discussed in Note 3, the Series B and Series C ConvertiblePreferred Stock was converted into shares of our common stock at a price of$3.00 and $3.75 per share, respectively. The total converted shares amounted to 2,466,665 common shares.  As of March 31, 2005, there were nooutstanding issuances of preferred stock. Our common stock is the only class of stock outstanding.

 

The proceeds from ourstock issuances were our primary source to fund the Davenport Merger, asdiscussed in our Form 10-KSB dated June 30, 2004, and the followingacquisitions and development activities during the nine months endedMarch 31, 2005:

 

•               Acquisition of the Nowata Oil Properties LLC for $2.6 million (Note 2).

•                  Acquisition of the Ladder Companies, Inc.for $2.2 million (Note 2).  For operational purposes, we refer to Ladderas the Rich Valley field.

•                  Acquisition of the Square One Energy,Inc. valued at $7.5 million (Note 2), consisting of $4 million of cash andissuing 888,888 common shares.  For operational purposes, we refer toSquare One as the Desdemona field.

•                  Purchase of an additional 10% revenueinterest in the Davenport field for $0.7 million (Note 5).

•                  Capital expenditures of $1.9 million,consisting primarily of drilling two wells in the Davenport field, andimplementation of developmental activities and environmental safeguards.

 

 

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Based on reserve reportsprepared by independent petroleum engineers dated January 1, 2005, ourtotal reserves are summarized as follows:

 

| ** **                                               | ** ** | **Nowata** | ** ** | **Rich Valley** | ** ** | **Davenport** | ** ** | **Desdemona** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------|------------|------------|------------|-----------------|------------|---------------|------------|---------------|------------|------------|------------|
| **Proved**                                               |       |       |       |            |       |          |       |          |       |       |       |
| Oil - Mbbls                                              |       | 1,592      |       | 274             |       | 213           |       | 679           |       | 2,758      |       |
| Gas - Mmcf                                               |       | 234        |       | 2,780           |       | 15            |       | 1,985         |       | 5,014      |       |
|                                                     |       |       |       |            |       |          |       |          |       |       |       |
| **Proved Barrels of Equivalent Oil  ("MBOE")** |       | **1,631**  |       | **738**         |       | **215**       |       | **1,010**     |       | **3,594**  |       |
| ** **                                               | ** ** | ** ** | ** ** | ** **      | ** ** | ** **    | ** ** | ** **    | ** ** | ** ** | ** ** |
| **Proved Producing (MBOE)**                              | ** ** | **1,593**  | ** ** | **583**         | ** ** | **57**        | ** ** | **505**       | ** ** | **2,738**  | ** ** |

 

Energy lenders typicallyloan to oil and gas companies based on the value of the proved producingreserves, defined as reserves that can be reasonably expected to be recoveredfrom existing wells with existing equipment and operating methods from knownreservoirs under existing economic and operating conditions.  We intend toseek a debt facility secured by our proved producing reserves to provide asource of cash to fund our operating activities and acquisitions.  Also, we will continue to consider issuancesof equity as a potential option to provide cash to fund our operatingactivities and acquisitions.

 

***CapitalSpending Plan for 2005***

 

In addition to potentialfuture acquisitions, our capital spending plan for the remainder of 2005 is toimplement developmental projects at our existing fields to increase reserves andproduction.  We project this cost to beapproximately $3.6 million, and to be spent to develop the following fields:

 

*DesdemonaField.*  This was the primary asset of our Square Oneacquisition discussed in Note 2, consisting of 10,300 acres.  This field has not been previouslywaterflooded.  We plan to begin pilotwaterflood operations in mid-2005 and expect an initial response in nine totwelve months.  If the pilot waterfloodsare successful, we intend to begin expanding the waterflood to the entire fieldin 2006.  This field also has mineralrights to the Barnett Shale.  We intendto sell these land rights and focus on our core expertise — secondary andenhanced oil recovery.

 

*NowataField*.  This field is currently beingwaterflooded.  We intend to increaseproduction and reserves by applying a chemical treatment known as such asAlkaline-Surfactant-Polymer (ASP) technology. We are continuing to optimize the ASP chemistry in the labroatory andintend to begin implementing an ASP pilot at Nowata later this year.

 

*DavenportField*.  This field is currently beingwaterflooded.  We intend to evaluate thisfield for ASP technology.  Thisevaluation, coupled with the knowledge gained from the Nowata ASP pilot, isexpected to enhance its value as an ASP candidate.

 

*RichValley Field*.  We intend to drill one development well andconduct an evaluation for waterflood potential.

 

***OperatingActivities***

 

For the nine months endedMarch 31, 2005, net cash used in operating activities was $558,722. We are seeking to improve cash flow from operating activities throughoperational improvements at our existing properties and futureacquisitions.  The increased cash flow from field operations could beoffset, in part, by increased general and administrative costs to support ourexpanding operations.

 

**Resultsof Operations**

 

The table belowsummarizes our results of operations through March 31, 2005.

 

 

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| ** **                      | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|---------------------------------|------------|------------------|------------|-----------------|------------|
| ** **                      | ** ** | **Ended**        | ** ** | **Ended**       | ** ** |
| Net Loss Before Certain         |       |             |       |            |       |
| Accounting Charges              |       | $                | (343,842   | )               | $          | (808,622 | ) |
|                            |       |             |       |            |       |
| Less:                           |       |             |       |            |       |
| Deferred Compensation Expense   |       | 431,439          |       | 1,341,285       |       |
| Preferred Stock Discount        |       | —           |       | 416,534         |       |
| Subtotal                        |       | 431,439          |       | 1,757,819       |       |
| Loss Applicable to Common Stock |       | $                | (775,281   | )               | $          | (2,566,441 | ) |

 

As shown above, we had a net loss before certainaccounting charges of $343,842 and $808,622, respectively, for the three andnine month periods ended March 31, 2005. Since our acquisitions are mature fields, our initial focus is toevaluate the existing operations and make the necessary operationalimprovements to improve operating efficiency. It generally requires six to twelve months to fully analyze the acquiredfield and spend the necessary funds to improve the field operations to meet ouroperational standards.  The net loss thatwe have experienced for the nine months ended March 31, 2005, is a directresult of spending the necessary funds to improve the operational efficiency ofour field facilities and to fund start-up costs we incurred to fund our supportservices.  We expect these expendituresshould lead to increased operational efficiency and reduced operating expensesin future periods.

 

***Operating Revenues***

 

The table belowsummarizes our operating revenues through March 31, 2005.

 

| ** **         | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|--------------------|------------|------------------|------------|-----------------|------------|
| ** **         | ** ** | **Ended**        | ** ** | **Ended**       | ** ** |
| Operating Revenues |       | $                | 1,461,885  |            | $          | 3,780,437 |   |
|               |       |             |       |            |       |
| Sales              |       |             |       |            |       |
| - Oil (MBbls)      |       | 24               |       | 62              |       |
| - Gas (MMcf)       |       | 41               |       | 133             |       |
| - Total (MBOE)     |       | 31               |       | 84              |       |
|               |       |             |       |            |       |
| Average Price      |       |             |       |            |       |
| - Oil ($/ Bbl)     |       | $                | 49.39      |            | $          | 47.78 |   |
| - Gas ($/ Mcf)     |       | $                | 5.60       |            | $          | 5.94 |   |

 

We expect futureincreases to sales through capital expenditures as previously discussed *in “Plan of Operation - Capital Spending Plan for 2005.”*

 

***Operating Expenses***

 

For the three and ninemonth periods ended March 31, 2005, our total operating expenses were$2,238,637 and $5,940,880, respectively.  Our operating expenses consistprimarily of lease operating expenses, general and administrative, depletionand depreciation, and deferred compensation expense, as discussed in Note 8 tothe financial statements.

 

Our lease operatingexpenses (“LOE”) consist of costs of producing crude oil and natural gas suchas labor, supplies, repairs, maintenance, and superintendence.  For the three month and nine month periodsended March 31, 2005, our LOE was $819,093 and $1,815,837, respectively.  For the nine month period ended March 31,2005, the LOE per BOE was $21.55.  We incurred an unusually high amount ofLOE to implement the operational improvements at all fields, as previously discussed. We will continue to evaluate potential operational improvements for all threefields.  We anticipate these expenditureswill lead to improved operational efficiency and reduced operating expenses infuture months.

 

 

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Our general andadministrative expenses consist of support services for our operatingactivities, along with investor relation costs during the current quarter andnine month period of approximately $136,000 and $572,000, respectively.

 

**OffBalance Sheet Arrangements**

 

We do not have any offbalance sheet arrangements as of March 31, 2005 or as of the date of thisreport.

 

**Item3.  Controls and Procedures.**

 

As of the end of theperiod covered by this report, we conducted an evaluation, under thesupervision and with the participation of our chief executive officer and chieffinancial officer of our disclosure controls and procedures (as defined in Rule13a-15(e) and Rule 15d-15(e) of the Exchange Act). Based upon this evaluation,our chief executive officer and chief financial officer concluded that ourdisclosure controls and procedures are effective to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is recorded, processed, summarized and reported, within the timeperiods specified in the Commission’s rules and forms.  There was nochange in our internal controls or in other factors that could affect thesecontrols during our last fiscal quarter that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**PARTII — OTHER INFORMATION**

 

**Item1.  Legal Proceedings.**

 

Occasionally, we areinvolved in various lawsuits and certain governmental proceedings arising in theordinary course of business.  Our management and legal counsel do notbelieve that the ultimate resolution of such matters, will have a materialeffect on our financial position or results of operations.  None of ourdirectors, officers or affiliates is involved in a proceeding adverse to ourbusiness or has a material interest adverse to our business.

 

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

 

On March 18, 2005, weentered into agreements to sell 1,350,000 shares of common stock to twoaccredited institutional investors at a price of $3.75 per share.  Thetransactions closed on March 24, 2005.

 

On March 29, 2005,we completed the acquisition of Square One Energy, Inc. in considerationfor $7.5 million, consisting of $4 million in cash and 888,888 shares of ourcommon stock, which was valued at $3.96 per share.

 

 All of the aboveunregistered issuances of securities were made pursuant to the exemption fromregistration requirements provided by Section 4(2) of the Securities Act of1933, as amended, and/or Rule 506, promulgated thereunder.  Except as expressly set forth above, theindividuals and entities to whom we issued securities are unaffiliated with us.For each of the above sales of unregistered securities, no advertising orgeneral solicitation was employed in offering the securities. The offerings andsales were made to a limited number of persons, all of whom were accreditedinvestors, business associates of ours or our executive officers, and transferwas restricted by us in accordance with the requirements of the Securities Actof 1933, as amended. Each of the above security holders who were not ourexecutive officers represented that the are accredited and sophisticatedinvestors, that they are capable of analyzing the merits and risks of theirinvestment, and that they understand the speculative nature of theirinvestment. Furthermore, all of the above-referenced persons had access to ourSecurities and Exchange Commission filings.

 

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**Item3.  Defaults Upon Senior Securities.**

 

There has been nomaterial default in the payment of principal, interest, a sinking or purchasefund installment, or any other material default not cured within 30 days, withrespect to any indebtedness exceeding five percent of our total assets. There also is no material arrearage in the payment of dividends or any othermaterial delinquency not cured within 30 days, with respect to any class ofpreferred stock which is registered or which ranks prior to any class of ourregistered securities, or with respect to any class of preferred stock of anysignificant subsidiary.

 

**Item4.  Submission of Matters to a Vote of Security Holders.**

 

There were no matterssubmitted to a vote of security holders during the period covered by thisreport.

 

**Item5.  Other Information.**

 

None.

 

**Item6.  Exhibits.**

 

References to “theCompany” in the following exhibit list mean Cano Petroleum, Inc., a Delawarecorporation.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                       |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Purchase and Sale  Agreement dated February 6, 2005 by and between Square One Energy, Inc. and  Cano Petroleum, Inc., incorporated by reference to Form 8-K filed on  March 7, 2005.                                                                             |
| 10.2                |       | Form of Subscription  Agreement entered into March 18, 2005, incorporated by reference to Form 8-K  filed on March 28, 2005.                                                                                                                                          |
| 10.3                |       | Letter agreement dated  March 29, 2005 among the Haddock Enterprises, LLC, the Company and  Kenneth Carlile, incorporated by reference to Form 8-K filed April 1, 2005.                                                                                          |
| 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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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|   |              | **CANO  PETROLEUM, INC.** |
|--------|-------------------|---------------------------|
|   |              |                      |   |   |
| Dated: | May 16, 2005 | By:                       | /s/ S. Jeffrey Johnson |   |
|   |              |                      | S. Jeffrey Johnson |   |
|   |              |                      | Chief Executive Officer |   |
|   |              |                      |   |   |
| Dated: | May 16, 2005 | By:                       | /s/ Michael J. Ricketts |   |
|   |              |                      | Michael J. Ricketts |   |
|   |              |                      | Chief Financial Officer  and 

Principal Accounting  Officer |   |
|   |              |                      |   |   |

 

 

 

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