**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

# **FORM 10-QSB**

** **

** (Mark One)**
| ý     | ** ** | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|------------|------------|---------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                        |
| ** ** | ** ** | **For the quarterly period ended December 31, 2005**                                              |
|       |       |                                                                                              |
| o          | ** ** | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                    |

 

**For the transition period from             to            **

 

**Commission file number 001-32496**

 

**CANOPETROLEUM, INC.**

(Exact name of small business issuer as specified in its charter)

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

 

**The Oil & Gas Commerce Building**

**309 West 7th Street, Suite 1600**

**Fort Worth, TX 76102**

(Address of principal executive offices)

 

**(817) 698-0900**

(Issuer’s telephone number)

 

**Not Applicable**

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

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes ý      No o

 

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

 

**APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGS DURING THE PRECEDING FIVE YEARS**

 

Check whether the registrantfiled all documents and reports required to be filed by Section 12, 13 or15(d) of the Exchange Act after the distribution of securities under aplan confirmed by a court.  Yes o     No o

 

**APPLICABLE ONLY TO CORPORATE ISSUERS**

 

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date:  26,832,158 shares of common stock, $.0001 par value pershare, as of February 2, 2006.

 

Transitional Small BusinessDisclosure Format (Check one): Yes o     No ý

 

 

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**CANO PETROLEUM, INC.CONSOLIDATED BALANCE SHEET**

**December 31, 2005(Unaudited)**

 
| **ASSETS**                                                                                                                                                 |       |        |            |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-----------------|
| **Current  assets**                                                                                                                                        |       |        |            |
| Cash and cash equivalents                                                                                                                                  |       | $           | 1,592,594       |   |
| Accounts receivable                                                                                                                                        |       | 2,134,984   |            |
| Derivative assets                                                                                                                                          |       | 1,020,563   |            |
| Other current assets                                                                                                                                       |       | 509,537     |            |
| Total current assets                                                                                                                                       |       | 5,257,678   |            |
| **Oil and gas properties****,**  successful efforts method                                                                                                 |       | 106,182,149 |            |
| Less  accumulated depletion and depreciation                                                                                                               |       | (828,988    | )               |
| Net oil and  gas properties                                                                                                                                |       | 105,353,161 |            |
| Fixed assets  and other, net                                                                                                                               |       | 4,382,192   |            |
| Derivative  assets                                                                                                                                         |       | 2,661,610   |            |
| Goodwill                                                                                                                                                   |       | 785,796     |            |
| **TOTAL  ASSETS**                                                                                                                                          | ** ** | **$**       | **118,440,437** | ** ** |
|                                                                                                                                                       |       |        |            |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |        |            |
| **Current  liabilities**                                                                                                                                   |       |        |            |
| Accounts payable                                                                                                                                           |       | $           | 486,549         |   |
| Oil and gas payable                                                                                                                                        |       | 672,549     |            |
| Accrued liabilities                                                                                                                                        |       | 469,039     |            |
| Taxes payable                                                                                                                                              |       | 291,620     |            |
| Current portion of asset retirement  obligations                                                                                                           |       | 19,085      |            |
| Total current liabilities                                                                                                                                  |       | 1,938,842   |            |
| **Long-term  liabilities**                                                                                                                                 |       |        |            |
| Long-term debt                                                                                                                                             |       | 40,750,000  |            |
| Asset retirement obligations                                                                                                                               |       | 1,651,165   |            |
| Deferred tax liability                                                                                                                                     |       | 33,675,000  |            |
| Total liabilities                                                                                                                                          |       | 78,015,007  |            |
|                                                                                                                                                       |       |        |            |
| **Commitments  and contingencies (Note 12)**                                                                                                               |       |        |            |
| **Stockholders’  equity**                                                                                                                             |       |        |            |
| Common stock, par value $.0001 per share;  50,000,000 authorized; 26,847,941 issued and 26,832,158 outstanding;  including 2,659,975 shares held in escrow |       | 2,685       |            |
| Additional paid-in capital                                                                                                                                 |       | 52,625,268  |            |
| Accumulated deficit                                                                                                                                        |       | (11,950,488 | )               |
| Treasury stock, at cost; 15,783 shares held  in escrow                                                                                                     |       | (7,102      | )               |
| Deferred compensation                                                                                                                                      |       | (244,933    | )               |
| Total stockholders’ equity                                                                                                                            |       | 40,425,430  |            |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                       | ** ** | **$**       | **118,440,437** | ** ** |

 

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

 

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                      | ** ** | **December 31,**       | ** ** | **December 31,**     | ** ** |
| ** **                                      | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating  Revenues:**                        |       |                   |       |                 |       |   |   |   |   |
| Crude oil and natural gas sales                 |       | $                      | 3,163,282  |                 | $          | 1,454,392 |   | $ | 5,109,241 |   | $ | 2,318,552 |   |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Operating  Expenses:**                        |       |                   |       |                 |       |   |   |   |   |
| Lease operating expenses                        |       | 1,240,129              |       | 581,621              |       | 1,990,302 |   | 996,744 |   |
| Production taxes                                |       | 191,526                |       | 90,177               |       | 301,198 |   | 149,098 |   |
| General and administrative                      |       | 1,686,467              |       | 730,413              |       | 2,913,758 |   | 1,391,979 |   |
| Deferred compensation expense                   |       | 146,961                |       | 619,314              |       | 296,586 |   | 909,846 |   |
| Accretion of asset retirement obligations       |       | 24,780                 |       | 5,810                |       | 45,374 |   | 10,860 |   |
| Depletion and depreciation                      |       | 280,070                |       | 140,262              |       | 426,859 |   | 243,716 |   |
| Total operating expenses                        |       | 3,569,933              |       | 2,167,597            |       | 5,974,077 |   | 3,702,243 |   |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Loss  from operations**                       |       | (406,651               | )          | (713,205             | )          | (864,836 | ) | (1,383,691 | ) |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Other  income (expenses):**                   |       |                   |       |                 |       |   |   |   |   |
| Loss on  hedge contracts                        |       | (1,635,537             | )          | —               |       | (1,635,537 | ) | — |   |
| Interest  expense                               |       | (331,440               | )          | —               |       | (331,440 | ) | — |   |
| Interest  income and deductions, net            |       | 94,092                 |       | 4,252                |       | 94,320 |   | 9,065 |   |
| Total other income (expenses)                   |       | (1,872,885             | )          | 4,252                |       | (1,872,657 | ) | 9,065 |   |
|                                            |       |                   |       |                 |       |   |   |   |   |
| Loss before  income tax benefit                 |       | (2,279,536             | )          | (708,953             | )          | (2,737,493 | ) | (1,374,626 | ) |
|                                            |       |                   |       |                 |       |   |   |   |   |
| Deferred  income tax benefit                    |       | 793,000                |       | —               |       | 793,000 |   | — |   |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Net loss**                                    |       | (1,486,536             | )          | (708,953             | )          | (1,944,493 | ) | (1,374,626 | ) |
|                                            |       |                   |       |                 |       |   |   |   |   |
| Preferred  stock discount                       |       | —                 |       | 80,000               |       | — |   | 416,534 |   |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Loss  applicable to common stock**            |       | $                      | (1,486,536 | )                    | $          | (788,953 | ) | $ | (1,944,493 | ) | $ | (1,791,160 | ) |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Net loss  per share - basic and diluted**     |       | $                      | (0.06      | )                    | $          | (0.08 | ) | $ | (0.09 | ) | $ | (0.17 | ) |
|                                            |       |                   |       |                 |       |   |   |   |   |
| **Weighted  average common shares outstanding** |       |                   |       |                 |       |   |   |   |   |
| Basic and diluted                               |       | 23,019,714             |       | 10,482,204           |       | 20,517,156 |   | 10,482,204 |   |

 

***See accompanying notes to these unauditedfinancial statements.***

 

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Six Months Ended December 31,** | ** **    |
|-----------------------------------------------------------------------|------------|-----------------------------------|---------------|
| ** **                                                            | ** ** | **2005**                          | ** **    | **2004** | ** ** |
| **Cash  flow from operating activities:**                             |       |                              |          |   |   |
| Net loss                                                              |       | $                                 | (1,944,493    | ) | $ | (1,374,626 | ) |
| Adjustments needed to reconcile to net cash  flow used in operations: |       |                              |          |   |   |
| Loss on hedge contracts                                               |       | 1,635,537                         |          | — |   |
| Accretion of asset retirement obligations                             |       | 45,374                            |          | 10,860 |   |
| Depletion and depreciation                                            |       | 426,859                           |          | 243,716 |   |
| Deferred compensation expense                                         |       | 296,586                           |          | 909,847 |   |
| Deferred income tax benefit                                           |       | (793,000                          | )             | — |   |
| Stock based compensation                                              |       | 72,794                            |          | 11,666 |   |
|                                                                  |       |                              |          |   |   |
| Changes in assets and liabilities relating  to operations:            |       |                              |          |   |   |
| Derivative assets                                                     |       | (5,317,710                        | )             | — |   |
| Accounts receivable                                                   |       | 456,950                           |          | (719,976 | ) |
| Inventory                                                             |       | (165,238                          | )             | — |   |
| Accounts payable                                                      |       | (509,871                          | )             | 369,236 |   |
| Accrued liabilities                                                   |       | (398,926                          | )             | (118,276 | ) |
| Other current assets and liabilities                                  |       | 28,494                            |          | 6,326 |   |
|                                                                  |       |                              |          |   |   |
| **Net cash  used in operations**                                      | ** ** | **(6,166,644**                    | **)**         | **(661,227** | **)** |
|                                                                  |       |                              |          |   |   |
| **Cash  flow from investing activities:**                             |       |                              |          |   |   |
| Additions to oil and gas properties                                   |       | (1,941,379                        | )             | (1,391,916 | ) |
| Additions to fixed assets and other                                   |       | (86,623                           | )             | (187,264 | ) |
| Acquisition of W.O. Energy of Nevada, Inc.                            |       | (48,292,607                       | )             | — |   |
| Acquisition of additional Davenport revenue  interest                 |       | (500,250                          | )             | (667,000 | ) |
| Acquisition of Nowata                                                 |       | —                            |          | (2,524,721 | ) |
| Acquisition of Ladder                                                 |       | —                            |          | (2,111,517 | ) |
| Cash restricted for development activities                            |       | —                            |          | 866,339 |   |
| **Net cash  used in investing activities**                            | ** ** | **(50,820,859**                   | **)**         | **(6,016,079** | **)** |
|                                                                  |       |                              |          |   |   |
| **Cash  flow from financing activities:**                             |       |                              |          |   |   |
| Net proceeds from long-term debt                                      |       | 40,750,000                        |          | — |   |
| Payments for debt-issuance costs                                      |       | (684,986                          | )             | — |   |
| Proceeds from issuance of preferred stock,  net                       |       | —                            |          | 5,306,098 |   |
| Proceeds from issuance of common stock, net                           |       | 18,369,594                        |          | — |   |
| **Net cash  from financing activities**                               | ** ** | **58,434,608**                    | ** **    | **5,306,098** | ** ** |
|                                                                  |       |                              |          |   |   |
| Net increase  (decrease) in cash and cash equivalents                 |       | 1,447,105                         |          | (1,371,208 | ) |
|                                                                  |       |                              |          |   |   |
| Cash and  cash equivalents at beginning of period                     |       | 145,489                           |          | 1,575,279 |   |
|                                                                  |       |                              |          |   |   |
| **Cash and  cash equivalents at end of period**                       | ** ** | **$**                             | **1,592,594** | ** ** | **$** | **204,071** | ** ** |
|                                                                  |       |                              |          |   |   |
| **Supplemental  disclosure of noncash transactions:**                 |       |                              |          |   |   |
| Preferred stock discount                                              |       | —                            |          | $ | 416,534 |   |
| Common stock issued for acquisition of W.O.  Energy of Nevada, Inc.   |       | $                                 | 8,240,000     |   | $ | — |   |
| Recognition of deferred tax liability                                 |       | $                                 | 3,124,013     |   | $ | — |   |

 

***See accompanying notes to these unauditedfinancial statements.***

 

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***CANO PETROLEUM, INC.***

 

**NOTES TO FINANCIAL STATEMENTS**

 

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

 

The interim consolidatedfinancial statements of Cano Petroleum, Inc. are unaudited and contain alladjustments (consisting primarily of normal recurring accruals) necessary for afair statement of the results for the interim periods presented.  Resultsfor interim periods are not necessarily indicative of results to be expectedfor a full year or for previously reported periods due in part to the volatilityin prices for crude oil and natural gas, the timing of acquisitions, productdemand, market competition, interruption in production, and the success ofwaterflooding and enhanced oil recovery techniques. You should read theseconsolidated interim financial statements in conjunction with the auditedconsolidated financial statements and notes thereto included in Cano’sForm 10-KSB dated June 30, 2005.

 

In preparing theaccompanying financial statements, management has made certain estimates and assumptionsthat affect reported amounts in the financial statements and disclosures ofcontingencies. Actual results may differ from those estimates. Significant assumptions are required in the valuation of proved oil and gasreserves, which may affect the amount at which oil and gas properties arerecorded.  It is at least reasonably possible these estimates could berevised in the near term, and these revisions could be material.

 

**2.****             ****ACQUISITION OF W.O. ENERGYCOMPANY OF NEVADA, INC.**

 

On November 29, 2005,we acquired all of the outstanding common stock of W.O. Energy ofNevada, Inc. (“WO Energy”) for approximately $57.4 million, after purchaseprice adjustments.  The purchase priceconsisted of approximately $49.2 million in cash and approximately $8.24 millionin restricted shares of our common stock.   $2 million of the cashportion of the purchase price was paid into an escrow account for a minimum oftwo years to cover potential indemnification payments by the sellers.  Theapproximate $8.24 million of common stock resulted in the issuance of 1,791,320shares to the sellers based on the average of the closing price of the commonstock on AMEX for the three trading days immediately prior to November 29,2005, which was $4.60 per share.  We entered into a registration rightsagreement with the sellers pursuant to which we agreed to use commerciallyreasonable efforts to register the resale of the 1,791,320 shares with theSecurities and Exchange Commission by November 29, 2006.  The sellersare prohibited from selling their shares until November 29, 2006 and aftersuch date are limited to selling up to 15% of the shares received in any 90 dayperiod.

 

 

5

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The WO Energy acquisitionwas recorded based on the purchase method of accounting.  The operations of WO Energy are included inour consolidated financial statements beginning December 1, 2005.  The purchase price were allocated to theacquired assets and assumed liabilities based on their fair values.  The calculation of the purchase price andallocation to assets is as follows:

 

| Net Acquisition Price          |   | $          | 57,402,983 |   |
|--------------------------------|--------|------------|------------|--------|
| Asset  Retirement Obligations  |   | 593,800    |       |
| Deferred Tax  Liablity         |   | 31,343,986 |       |
| Other  Liabilities Assumed     |   | 1,512,819  |       |
| Total  Purchase Price          |   | $          | 90,853,588 |   |
|                           |   |       |       |
| Allocation  of Purchase Price: |   |       |       |
| Cash                           |   | $          | 870,376    |   |
| Accounts  Receivable           |   | 2,016,168  |       |
| Other  Current Assets          |   | 158,538    |       |
| Fixed assets  and Other        |   | 3,112,610  |       |
| Oil &  Gas Properties      |   | 84,695,896 |       |
|                           |   | $          | 90,853,588 |   |

 

The fair value assigned tothe oil and gas properties is based on management’s valuation of theproperties, which was derived in part by reference to reserve reports preparedby an independent petroleum engineering firm.  Based on the engineer’sreports and Cano’s internal analyses, we believe the value assigned to theseproperties is reasonably supported.  Weare continuing the process of determining the fair value of assets andliabilities, and the final results will not be completed until we finalize theincome tax implications associated with this acquisition.

 

The acquisition was noteligible for Section 338 treatment.  Asdefined in the Internal Revenue Service tax code, Section 338 treatment wouldhave enabled us to recognize the stepped-up basis in the WO propertiesapproximately equal to the acquisition price, for tax computationpurposes.  Therefore, we recorded a deferredtax liability of approximately $31.3 million (with an offsetting increase inproperty basis) in connection with this purchase.

 

The following condensed proforma information gives effect to the acquisitions as if they had occurred onJuly 1, 2005 and 2004, respectively.  The pro forma information hasbeen included in the Notes as required by generally accepted accountingprinciples and is provided for comparison purposes only.  The pro formafinancial information is not necessarily indicative of the financial resultsthat would have occurred had the business combinations been effective on thedates indicated and should not be viewed as indicative of operations in thefuture.

 

**Cano Petroleum, Inc.**

**Pro Forma Information**

 
| ** **                                       | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating  revenues                              |       | $                                         | 5,382,650  |                                    | $          | 4,408,567 |   | $ | 10,657,661 |   | $ | 8,756,138 |   |
| Income  (loss) applicable to common stock        |       | $                                         | (1,290,133 | )                                       | $          | (385,245 | ) | $ | (1,251,051 | ) | $ | (915,405 | ) |
| Net income  (loss) per share - basic and diluted |       | $                                         | (0.05      | )                                       | $          | (0.02 | ) | $ | (0.05 | ) | $ | (0.04 | ) |

 

**3.****             ****LONG-TERM DEBT**

 

***Senior Credit Agreement***

 

On November 29, 2005,we entered into a $100 million senior credit agreement with the lenders theretofrom time to time and Union Bank of California, N.A., as administrative agentand as issuing lender, due on or before November 29, 2009.  Theinitial borrowing base is $30 million based on our proved reserves.  The$30 million was used, in part, to finance the acquisition of WO Energy. Pursuant to the terms of the senior credit agreement, the borrowing base isbased on our proved

 

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reserves and is redeterminedevery six months with one additional redetermination possible during the sixmonth periods between scheduled redeterminations.

 

At our option, interest isbased either (i) on the prime rate plus the applicable margin ranging upto 0.75% based on the utilization level or (ii) on the LIBOR rateapplicable to the interest period plus the applicable margin ranging from 1.5%to 2.25% based on the utilization level.  At December 31, 2005, theinterest rate was 6.64%.  For loans that are three months or less inmaturity, interest is due on the maturity date of such loan.  For loansthat are in excess of three months, interest is due every three months.

 

At December 31, 2005, theoutstanding amount due under the senior credit agreement was $25.75 million. The outstanding principal is due on or before November 29, 2009 unlesspursuant to the terms of the credit agreement specific events of default occuras a result of which all outstanding principal and all accrued interest may beaccelerated.  Such specific events of default, include, but are notlimited to: payment defaults by us, breaches of representations and warrantiesand covenants by us, our insolvency, a “change of control” of our business asdescribed in the credit agreement and a “material adverse change” as describedin the credit agreement.

 

The credit agreement imposescertain restrictions on us and our subsidiaries including, but not limited to,the following: (i) subject to specific exceptions, incurring additionalliens; (ii) subject to specific exceptions, incurring additional debt;(iii) subject to specific exceptions, merging or consolidating or selling,transferring, assigning, farming-out, conveying or otherwise disposing of anyproperty; (iv) subject to specific exceptions, making certain payments,including cash dividends to our stockholders; (v) subject to specificexceptions, making any loans, advances or capital contributions to, or makingany investment in, or purchasing or committing to purchase any stock or othersecurities or evidences of indebtedness or interests in any person or any oiland gas properties or activities related to oil and gas properties unless withregard to new oil and gas properties, such properties are mortgaged to UnionBank of California, N.A., as administrative agent, or with regard to newsubsidiaries, such subsidiaries execute a guaranty, pledge agreement, securityagreement and mortgage in favor of Union Bank of California, N.A., asadministrative agent; and (vi) subject to specific exceptions, enteringinto affiliate transactions on terms that are not at least as favorable to usas comparable arm’s length transactions.

 

We must also meet certainfinancial requirements based on specified debt coverage ratios, interestcoverage ratios and current assets to current liabilities ratios.  In addition, we are required to enter intofinancial contracts to hedge our exposure to commodity price risk associatedwith expected oil and gas production. Our financial hedge contracts are further discussed in Note 4.

 

As security for ourobligations under the senior credit agreement: (i) each of oursubsidiaries guaranteed all of our obligations; (ii) we, together witheach of our subsidiaries, executed mortgages in favor of Union Bank ofCalifornia, N.A., as collateral trustee, covering oil and gas propertieslocated in Texas and Oklahoma; (iii) we, together with each of oursubsidiaries, granted a security interest in favor of Union Bank of California,N.A., as collateral trustee, in substantially all of our assets; and(iv) we pledged our ownership interests in all of our subsidiaries toUnion Bank of California, N.A., as collateral trustee.

 

***Subordinated Credit Agreement***

 

On November 29, 2005,we entered into a $15 million subordinated credit agreement with the lendersthereto from time to time and Energy Components SPC EEP Energy Exploration andProduction Segregated Portfolio (“EEP”), as administrative agent, due on orbefore November 29, 2010.  The $15 million was used, in part, tofinance the acquisition of WO Energy.

 

Interest pursuant to thesubordinated credit agreement is equal to the LIBOR rate plus 6.5%. AtDecember 31, 2005, the interest rate was 11.24%.  For loans that arethree months or less in maturity,

 

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interest is due on thematurity date of such loan.  For loans that are in excess of three months,interest is due every three months.

 

As of December 31, 2005, theoutstanding amount due under the subordinated credit agreement was $15 million. The outstanding principal is due on November 29, 2010 unless specifiedevents of default occur as a result of which all outstanding principal and allaccrued interest may be accelerated.  Such specific events of default,include, but are not limited to: payment defaults by us, breaches ofrepresentations and warranties and covenants by us, our insolvency, a “changeof control” of our business as described in the subordinated credit agreementand a “material adverse change” as described in the subordinated credit agreement.

 

The subordinated creditagreement imposes certain restrictions on us and our subsidiaries including,but not limited to, the following: (i) subject to specific exceptions,incurring additional liens; (ii) subject to specific exceptions, incurringadditional debt; (iii) subject to specific exceptions, merging orconsolidating or selling, transferring, assigning, farming-out, conveying orotherwise disposing of any property; (iv) subject to specific exceptions,making certain payments, including cash dividends to our stockholders;(v) subject to specific exceptions, 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 interestsin any person or any oil and gas properties or activities related to oil andgas properties unless with regard to new oil and gas properties, suchproperties are mortgaged as requested by EEP, as administrative agent, or withregard to new subsidiaries, such subsidiaries execute a guaranty, pledgeagreement, security agreement and mortgage as requested by of EEP, asadministrative agent; and (vi) subject to specific exceptions, enteringinto affiliate transactions on terms that are not at least as favorable to usas comparable arm’s length transactions.

 

We must also meet certainfinancial requirements based on specified debt coverage ratios, interestcoverage ratios, current assets to current liabilities ratios, and reservevalue coverage.  In addition, we are required to enter into financialcontracts to hedge our exposure to commodity price risk associated withexpected oil and gas production, as further discussed in Note 4.

 

As security for ourobligations under the credit agreement: (i) each of our subsidiariesguaranteed all of our obligations; (ii) we, together with each of oursubsidiaries, executed mortgages in favor of Union Bank of California, N.A., ascollateral trustee, covering oil and gas properties located in Texas andOklahoma; (iii) we, together with each of our subsidiaries, granted asecurity interest in favor of Union Bank of California, N.A., as collateraltrustee, in substantially all of our assets; and (iv) we pledged ourownership interests in all of our subsidiaries to Union Bank of California,N.A., as collateral trustee.

 

 

**4.****             ****DERIVATIVE HEDGING CONTRACTS**

 

As previously mentioned inNote 3, pursuant to our senior and subordinated credit agreements, we arerequired to enter into financial contracts to hedge a portion of our productionat specified prices for oil and natural gas. The objective of the hedging contracts is to reduce our exposure tocommodity price risk associated with expected oil and gas production.  By achieving this objective we intendto protect the outstanding debt amounts and maximize the funds availableunder our existing debt agreements, which should enable us to support ourannual capital budgeting and expenditure plans.

 

During December 2005, wepaid $5.3 million to enter into financial contracts to set price floors, assummarized in the table below.

 

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| ** **   | ** ** | **Floor** | ** ** | ** **  | ** ** | **Floor** | ** ** | ** **  | ** ** | **Barrels of**    | ** ** |
|--------------|------------|-----------|------------|-------------|------------|-----------|------------|-------------|------------|-------------------|------------|
| **Calendar** | ** ** | **Oil**   | ** ** | **Barrels** | ** ** | **Gas**   | ** ** | **Gas Mcf** | ** ** | **Equivlent Oil** | ** ** |
| **Year**     | ** ** | **Price** | ** ** | **per Day** | ** ** | **Price** | ** ** | **per Day** | ** ** | **per Day**       | ** ** |
| 2006         |       | $         | 60         |        | 534        |      | $          | 8.50        |       | 1,784             |       | 832 |   |
| 2007         |       | $         | 55         |        | 507        |      | $          | 8.00        |       | 1,644             |       | 781 |   |
| 2008         |       | $         | 55         |        | 479        |      | $          | 7.50        |       | 1,534             |       | 735 |   |

 

We have no derivativehedging contracts that set a price ceiling.  We do not designate our derivatives as cashflow or fair value hedges.  However, wedo not hold or issue derivative financial instruments for speculative or tradingpurposes.  We are exposed to creditlosses in the event of nonperformance by the counterparties to our financialhedging contracts. We anticipate, however, that such counterparties will beable to fully satisfy its obligations under the contracts. We do not obtaincollateral or other security to support our financial hedging contracts subjectto credit risk but we monitor the credit standing of the counterparties. AtDecember 31, 2005, we had no amounts receivable from our counterparties.

 

Changes in the fair valuesof our derivative instruments are recorded immediately in earnings in otherincome on our statements of operations. Cash flows resulting from the settlement of our derivative instrumentsare recorded as other income or expense in the consolidated statements ofoperations.  During the three- andsix-month periods ended December 31, 2005, there were no settlements under ourderivative agreements. The cash flows relating to the derivative instrumentsare reflected in operating activities on our statements of cash flow.

 

Our mark-to-marketvaluations used for our derivative instruments were based on prices that areactively quoted and provided by external sources.  In accordance with SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities,” as amended, we recorded the$5.3 million payment as Derivative Assets. SFAS 133 also provides that derivative instruments be measured at fairvalue on the balance sheet date.  Accordingly,at December 31, 2005, we recorded a $1.6 million charge to recognize a loss onhedge contracts to our Consolidated Statements of Operations.  At December 31, 2005, our Derivative Assetstotaled $3,682,173, of which $2,661,610 is considered long-term.

 

**5.****             ****COMMON STOCK FINANCINGS**

 

As discussed in Note 2, weissued 1,791,320 shares of our common stock to complete the acquisition of WOEnergy.

 

On September 14, 2005and September 16, 2005, we received written commitments for two privateplacement sales of 2,603,864 shares and 2,100,000 shares, respectively, of ourcommon stock at a per share price equal to $4.14, which was the closing priceon September 13, 2005 on the American Stock Exchange.  The gross andnet proceeds totaled approximately $19.5 million and $18.4 million,respectively.  The transactions closed on or before September 30,2005.

 

The amount of common sharesissued and outstanding is summarized as follows:

 

| Issued shares as of June 30, 2005                 |   | 20,352,757 |   |
|--------------------------------------------------------|--------|------------|--------|
| Shares  issued in private placement (above)            |   | 4,703,864  |   |
| Shares  issued for WO Energy acquisition (Note 2)      |   | 1,791,320  |   |
| Issued  shares as of December 31, 2005                 |   | 26,847,951 |   |
| Management  shares returned to Treasury Stock (Note 7) |   | (15,783    | )      |
| Outstanding  shares as of December 31, 2005            |   | 26,832,168 |   |

 

9

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**6.****             ****ASSET RETIREMENT OBLIGATION**

 

Our financial statementsreflect the provisions of Statement of Financial Accounting StandardsNo. 143,*Accounting for AssetRetirement Obligations*.  Our asset retirement obligation (“ARO”)primarily represents the estimated present value of the amount we will incur toplug, abandon and remediate our producing properties at the end of theirproductive lives, in accordance with applicable state laws.  We determineour ARO by calculating the present value of expected cash flows related to theliability.  At December 31, 2005, our liability for ARO was $1,670,250, ofwhich $1,651,165 is considered long-term.  Our asset retirementobligations are recorded as current or non-current liabilities based on theestimated timing of the anticipated cash flows.

 

The following tabledescribes the changes in our asset retirement obligations for the six monthsended December 31, 2005:

 

| Asset retirement obligation at June 30,  2005     |   | $       | 1,051,453 |   |
|---------------------------------------------------|--------|---------|-----------|--------|
| Acquisition  of WO Energy                         |   | 593,800 |      |
| Accretion  expense                                |   | 45,374  |      |
| Plugging  costs                                   |   | (20,377 | )         |
| Asset  retirement obligation at December 31, 2005 |   | $       | 1,670,250 |   |

 

**7.****             ****DEFERRED COMPENSATION**

 

As discussed in ourForm 10-KSB dated June 30, 2005, pursuant to the terms of the MergerAgreement dated May 28, 2004, eight individuals (six current employees,one former employee and one director) were issued 5,165,000 shares of commonstock.  These shares were placed in escrow and will vest to theindividuals based on a combination of continued employment (“compensationshares”) and achieving certain performance goals during the two years followingthe merger (“performance shares”).  The compensation shares amounted to2,659,975 shares and the performance shares amounted to 2,505,025 shares. Any shares that are not released from escrow will be returned to TreasuryStock.

 

We accounted for theseshares in accordance with the provisions of Statement of Financial AccountingStandard (“SFAS”) No. 123, *Accountingfor Stock-Based Compensation*, and SFAS No. 148, *Accounting for Stock-Based Compensation — Transitionand Disclosure*.  At the merger date, we recognized $2,324,250of “Deferred Compensation” and “Additional Paid-in Capital” in the ConsolidatedBalance Sheet.  The shares were recorded based on the quoted market priceat the time of the transaction and are being amortized to expense over theperiods earned.  At December 31, 2005, the balance of DeferredCompensation was $244,933, net of amortization expense.

 

As of December 31, 2005,shares returned to treasury totaled 15,783 shares and are recorded as TreasuryStock, at cost.  On July 1, 2005, the compensation shares totaling2,505,025 shares were released from escrow to three executive officers. At December 31, 2005, the total escrowed shares were 2,659,975, of which theoutstanding common shares totaled 2,644,192 and treasury shares totaled 15,783.

 

**8.****             ****STOCK OPTIONS**

 

As discussed in ourForm 10-KSB dated June 30, 2005, the 2005 Directors’ Stock OptionPlan (“Plan”) became effective on April 1, 2005.  On April 1,2005, pursuant to the Plan, we granted stock options to our five non-employeedirectors to each purchase 25,000 shares of common stock.  The optionsgranted under the Plan totaled 125,000 shares.  These options have anexercise price of $4.13 per share.  The options vest on April 1,2006, and expire on April 1, 2015.

 

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On September 16, 2005,we granted stock options to James K. Teringo, Jr., our Vice President,General Counsel and Corporate Secretary to purchase 50,000 shares of commonstock.  These options have an exercise price of $3.98 per share.  Theoptions vest on July 11, 2006, and expire on September 16, 2015.

 

On December 7, 2005,our shareholders approved our 2005 Long-Term Incentive Plan (“LTIP”).  The2005 LTIP authorizes the issuance of up to 1,000,000 shares of our common stockto key employees, key consultants and outside directors of our company andsubsidiaries.  The 2005 LTIP permits the grant of incentive stock options,non-qualified stock options, stock appreciation rights, restricted stock,restricted stock units, performance awards, dividend equivalent rights andother awards, whether granted singly, or in combination or in tandem.  Noexecutive officer (as defined in the 2005 LTIP) may receive in any calendaryear (i) stock options or stock appreciation rights relating to more than100,000 shares of common stock or (ii) restricted stock, restricted stockunits, performance awards or other awards that are subject to the attainment ofperformance goals relating to more than 100,000 shares of common stock;provided, however, that all such awards of any executive officer during anycalendar year may not exceed an aggregate of more than 100,000 shares of commonstock.  The 2005 LTIP terminates on December 7, 2015; however, awardsgranted before that date will continue to be effective in accordance with theirterms and conditions.

 

On December 13, 2005,under the 2005 LTIP, 25,000 options were granted to each of our five non-employeeDirectors: Donnie D. Dent, Gerald W. Haddock, Randall Boyd, Dr. JimUnderwood and Morris B. “Sam” Smith.  Eachof these options has an exercise price of $6.30 per share.  These grantedoptions vest on December 13, 2006 if such persons are still directors onDecember 13, 2006.

 

Pursuant to Statement ofFinancial Accounting Standard No. 123 (“SFAS 123”), *Accounting for Stock-Based Compensation*,the fair value of each stock option is estimated on the date of grant using theBlack-Scholes option-pricing model.  The factors used to calculate thefair value of all options are summarized in the table below:

 

 

| ** **               | ** ** | **Reported in Form 10-KSB** | ** ** | **Options to**      | ** ** | **2005** | ** ** |
|--------------------------|------------|-----------------------------|------------|---------------------|------------|----------|------------|
| ** **               | ** ** | **dated June 30, 2005**     | ** ** | **J. Teringo, Jr.** | ** ** | **LTIP** | ** ** |
| No. of  shares           |       | 50,000                      |       | 125,000             |       | 50,000   |       | 125,000 |   |
| Risk free  interest rate |       | 4.27                        | %          | 4.28                | %          | 4.56     | %          | 4.45 | % |
| Expected  life           |       | 4 years                     |       | 4 years             |       | 4 years  |       | 4 years |   |
| Expected  volatility     |       | 51.5                        | %          | 33.7                | %          | 27.4     | %          | 26.5 | % |
| Expected  dividend yield |       | 0                           | %          | 0                   | %          | 0        | %          | 0 | % |

 

The total fair value of theoptions summarized in the above table is approximately $424,000.  In accordance with the provisions of SFAS 123and SFAS No. 148, *Accounting forStock-Based Compensation — Transition and Disclosure*, we haverecorded a charge to general and administrative expenses for the estimated fairvalue of the options granted to our directors of $46,736 and $72,794 for thequarter and six-month period ended December 31, 2005, respectively.  For the quarter and six-month period endedDecember 31, 2004, we charged $11,666.

 

**9.****             ****NET LOSS PER COMMON SHARE**

 

Basic net income (loss) percommon share is computed by dividing the net income attributable to commonshareholders by the weighted average number of shares of common stockoutstanding during the period.

 

Diluted net income (loss)per common share is computed in the same manner, but also considers the effectof the stock options.  The stock options are not considered for the threeand six months ended December 31, 2005 as their effects would be anti-dilutive.

 

11

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The weighted average sharesused in the basic loss per common share computations for the three and six monthsended December 31, 2005 and 2004 were 23,019,714 shares and 20,517,156shares, respectively.   The weightedaverage shares for the three and six months ended December 31, 2004 were10,482,204 shares.  The shares at December 31,2005 and 2004 excluded contingently issuable shares of 2,659,975 and 5,165,000,respectively, as discussed in Note 7.

 

**10.****      ****RELATED PARTY TRANSACTIONS**

 

As discussed in ourForm 10-KSB dated June 30, 2005, on March 29,2005, we enteredinto an agreement with Haddock Enterprises, LLC and Kenneth Q. Carlile(predecessor to Carlile Management, LLC) to explore the possibility ofconverting the Sabine Royalty Trust from a liquidating asset into a vehicle toacquire low risk assets.  Each of the three parties owns a one-thirdinterest in the Sabine Production Operating, LLC.  Gerald W. Haddock isPresident of Haddock Enterprises, LLC and is a member of our Board ofDirectors.  As of December 31, 2005, Cano had incurred approximately $362,000pertaining to the joint venture, of which $322,000 occurred during the sixmonths ended December 31, 2005.  During December 2005, we expensed the$362,000 to general & administrative expense because of the election ofSabine Production Operating LLC to indefinitely suspend the proxy solicitationfrom the unit holders of the Sabine Royalty Trust.

 

Effective December 1,2005, we acquired all overriding royalty interests held by THEprivate EnergyCompany, Inc. (formerly Cano Energy Corporation) on December 27, 2005and we are to acquire all overriding royalty interests acquired in the futureby THEprivate Energy Company, Inc. in and to the oil gas and mineralleaseholder estates and personal property related to leasehold estates locatedon the same property on which the Davenport Field Unit’s properties arelocated.  We paid $66,700 per percentage of net revenue attributableto the interests held by THEprivate Energy Company, Inc. onDecember 27, 2005 for an aggregate of $500,250 based on the acquisition ofa 7.5% overriding royalty interest.  We will pay $66,700 per percentage ofnet revenue attributable to future acquisitions of overriding royalty interestsfrom THEprivate Energy Company, Inc.

 

S. Jeffrey Johnson, ourChairman of the Board and Chief Executive Officer, is a 30% shareholder inTHEprivate Energy Company, Inc.  The terms of the purchase wereagreed to based on arms-length negotiations, supported by a valuationestablished by our independent engineer, and are substantially the same aspreviously paid by us to THEprivate Energy Company, Inc. for a portion ofits interest in September and October of 2004.

 

**11.****      ****INCOME TAXES**

 

Our income tax benefit is asfollows:

 

| ** **                   | ** ** | **Quarter Ended** | ** ** | **6 Months Ended** | ** ** |
|------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                   | ** ** | **December 31,**  | ** ** | **December 31,**   | ** ** |
| ** **                   | ** ** | **2005**          | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current income tax benefit   |       |              |       |               |       |   |   |   |   |
| Federal                      |       | $                 | —     |               | $          | — |   | $ | — |   | $ | — |   |
| State                        |       | —            |       | —             |       | — |   | — |   |
| Total current tax benefit    |       | —            |       | —             |       | — |   | — |   |
| Deferred income tax  benefit |       |              |       |               |       |   |   |   |   |
| Federal                      |       | 710,000           |       | —             |       | 710,000 |   | — |   |
| State                        |       | 83,000            |       | —             |       | 83,000 |   | — |   |
| Total deferred tax benefit   |       | 793,000           |       | —             |       | 793,000 |   | — |   |
| Total income tax benefit     |       | $                 | 793,000    |               | $          | — |   | $ | 793,000 |   | $ | — |   |

 

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The difference between ourbenefit from income taxes recorded on the statements of operations and the taxcomputed using statutory rates primarily comprises state taxes andadjustments to the valuation allowance.

 

Regarding the acquisition ofSquare One Energy, Inc., as discussed in our Form 10-KSB datedJune 30, 2005, this acquisition did not provide for Section 338treatment.  As defined in the InternalRevenue Service tax code, Section 338 treatment would have enabled us torecognize the stepped-up basis in the Square One properties approximately equalto the acquisition price, for tax computation purposes.

 

In accordance with thepurchase method of accounting, we recorded a deferred tax liability ofapproximately $3.1 million with an offsetting increase in property basis of $2.4million and Goodwill of approximately $0.7 million.  Based on a reserve report prepared by anindependent petroleum engineering firm and our internal analysis, we believethe oil and gas properties of Square One have unrealized potential to supportthe recording of “Goodwill” to the Consolidated Balance Sheet.

 

At December 31, 2005, wehave recorded a total deferred tax liability of $33.7 million, which resultedfrom the acquisitions of WO Energy (see Note 2) and Square One, net of deferredincome tax benefit of $0.8 million that we recorded during the quarter endedDecember 31, 2005.  Aschedule showing the significant components of the net deferred taxliability as of December 31, 2005 are as follows:

 

| Deferred compensation expense                                             |   | $           | 787,000     |   |
|---------------------------------------------------------------------------|--------|-------------|-------------|--------|
| Net operating loss carryforwards, net of  valuation allowance of $836,000 |   | 929,000     |        |
| Difference in book and tax bases on  acquired oil and gas properties      |   | (35,867,000 | )           |
| Difference in book and tax bases on  acquired fixed assets                |   | (350,000    | )           |
| Derivative assets                                                         |   | 621,000     |        |
| Other                                                                     |   | 205,000     |        |
| Net deferred  tax liability                                               |   | $           | (33,675,000 | )      |

 

At December 31, 2005, Canohad net operating loss (“NOL”) carryforwards for tax purposes of approximately$4.6 million.  The remaining net operating losses principally expire in2024 and 2025.  Of the $4.6 million, $2.2 million will be unavailable tooffset any future taxable income due to limitations from change in ownership asdefined in Section 382 of the Internal Revenue Service (“IRS”) code.  Accordingly, our valuation allowance reflectsthe unavailable $2.2 million NOL.

 

**12.****      ****COMMITMENTS ANDCONTINGENCIES**

 

***Litigation***

 

Occasionally, we areinvolved in various lawsuits and certain governmental proceedings arising inthe ordinary course of business.  Ourmanagement does not believe that the ultimate resolution of any currentmatters, including due to the existence of insurance coverage, indemnificationand escrow accounts, will have a material effect on our financial position orresults of operations.  None of ourdirectors, officers or affiliates, owners of record or beneficially of morethan five percent of any class of our voting securities, or security holder isinvolved in a proceeding adverse to our business or has a material interestadverse to our business.

 

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***Other***

 

To date, our expenditures tocomply with environmental or safety regulations have not been significant andare not expected to be significant in the future. However, new regulations,enforcement policies, claims for damages or other events could result insignificant future costs.

 

**Item 2.  Management’s Discussion and Analysis or Plan ofOperation**

 

**Forward-Looking Statements**

 

Theinformation in this report on Form 10-QSB contains forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995. This Act provides a “safe harbor” for forward-looking statements toencourage companies to provide prospective information about themselvesprovided they identify these statements as forward looking and providemeaningful cautionary statements identifying important factors that could causeactual results to differ from the projected results. All statements other thanstatements of historical fact made in this report are forward looking. Inparticular, the statements herein regarding industry prospects and futureresults of operations or financial position are forward-looking statements.Forward-looking statements reflect management’s current expectations and areinherently uncertain. Our actual results may differ significantly frommanagement’s expectations as a result of many factors, including, but notlimited to, the volatility in prices for crude oil and natural gas, futurecommodity prices for derivative hedging contracts, the timing of acquisitions, ourability to obtain additional capital, product demand, market competition,interruption in production, and the success of waterflooding and enhanced oilrecovery techniques.

 

Youshould read the following discussion and analysis in conjunction with theconsolidated financial statements of Cano Petroleum, Inc. and subsidiariesand notes thereto, included herewith. This discussion should not be construedto imply that the results discussed herein will necessarily continue into thefuture, or that any conclusion reached herein will necessarily be indicative ofactual operating results in the future. Such discussion represents only thebest present assessment of management.

 

**Overall Strategy**

 

Weare a growing independent oil and gas company that intends to actively utilizesecondary and enhanced oil recovery (“EOR”) methods to increase production andreserves at our existing properties and future acquisitions.  Our primaryfocus is crude oil and our target acquisitions are onshore U.S.properties.  Our focus on domestic, mature oil fields eliminatesexploration risks and logistical uncertainties inherent in internationaloperations.  We use secondary waterflooding and EOR methods, such assurfactant-polymer flooding technology.

 

Webelieve significant growth opportunities exist primarily because the majorenergy companies and large independents continue to focus their attention andresources toward the exploration and production of large fields.  In thepast several years, the major companies have been divesting themselves of theirmature, smaller oil fields.  During recent years, the energy industry haspredominately focused on natural gas exploration and production, and has beensignificantly less focused on crude oil.  The recent economics of the oiland gas market have improved as prices have risen substantially.  Theseconditions provide ample opportunities for smaller independent companies toacquire and exploit mature U.S. oilfields.  Our emphasis on EOR methodspositions us in a unique niche segment in the oil and gas industry.  Ouracquisition targets are proven, mature oil fields that possess significantproved reserves, as well as a high ratio of probable reserves.  We expectto encounter increased competition for such properties in the future.

 

**Liquidity and Capital Resources**

 

Weintend to finance future acquisitions of oil and gas properties, fielddevelopment projects and operating activities with a combination of issuancesof equity, debt financing, and cash flow from operations.  We cannotguarantee that any additional equity or debt financing will be available insufficient amounts or on acceptable terms when needed.  If such financingis not available in sufficient amounts or on acceptable terms, our results ofoperations and financial condition may be adversely affected.  Inaddition, 

 

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equity financing may resultin dilution to existing stockholders and may involve securities that haverights, preferences, or privileges that are senior to our common stock, and anydebt financing obtained must be repaid regardless of whether or not we generateprofits or cash flows from our business activities.

 

***Financing and Investing Activities***

 

During the six months endedDecember 31, 2005, we completed the following capital financings:

 

•                  As discussed in Note 5 to the financialstatements, we received net proceeds of $18.4 million from the issuance of4,703,864 shares of common stock during September 2005.

•                  As discussed Note 3 to the financialstatements, on November 29, 2005, we entered into a $100 million seniorcredit agreement.  The initial borrowing base is $30 million based on ourproved reserves, as identified in the table below.  As of December 30,2005, our borrowings under this agreement totaled $25.75 million and the availableborrowing amount was $4 million.

•                  As discussed in Note 3 to the financialstatements, on November 29, 2005, we entered into a $15 millionsubordinated credit agreement. As of December 31, 2005, our outstanding balancewas $15 million under this agreement.

 

Thenet proceeds from these capital financings were used to finance the acquisitionof WO Energy for approximately $57.4 million, as discussed in Note 2 to thefinancial statements, and the $5.3 million purchase of derivative hedgingcontracts, as discussed in Note 4 to the financial statements.

 

Theprimary asset of WO Energy is the Panhandle Field.  The acquisition of WO Energy was the primaryreason our net oil and gas assets increased from $16.5 million as of September30, 2005 to $105.4 million as of December 31, 2005.  The Panhandle Field represents 34,497 MBOE ofour total 40,131 MBOE proved reserves, as shown in the table in the “*Proved Reserves*” section below.

 

Asdiscussed in Note 4 to the financial statements, pursuant to our senior andsubordinated credit agreements, we are required to enter into financialcontracts to hedge our exposure to commodity price risk associated withexpected oil and gas production.  Forcalendar years 2006, 2007, and 2008, the hedged production amounts, asexpressed in barrels of oil equivalent per day, are 832, 781, and 735,respectively.  We entered into financialcontracts to set the following price floors for calendar years 2006 through2008:

•                  Crude oil production of $60/barrel for 2006,and $55/barrel for 2007 and 2008.

•                  Natural gas production of $8.50/mcf, $8.00/mcf,and $7.50/mcf for 2006, 2007, and 2008, respectively.

 

Wehave no derivative hedging contracts that set a price ceiling.  Therefore, we are entitled to 100% of our revenuereceipts and, if crude oil and natural gas NYMEX prices are lower than theprice floor, we will be reimbursed for the difference between the NYMEX priceand floor price.

 

AtDecember 31, 2005, our cash balance was $1.6 million and our availableborrowing amount was $4 million under the senior credit agreement.  Based on our current cash resources, other current assets, expected cash flow,and available borrowings, we believe this is sufficient liquidity to fundoperations and the capital expenditures (as identified below) for theforeseeable future.

 

Inaddition, as discussed in Note 3, the senior credit agreement currently has atotal commitment of $100 million, of which the current borrowing base is $30million.  The senior agreement providesfor semiannual redeterminations of the borrowing base amount and one additionalredetermination during the six month periods. We believe the combination of unused borrowing commitment of $70 million,issuances of equity, debt financing, and cash flow from operations shouldprovide sufficient capital to finance additional capital development of ourexisting fields and potential acquisitions.

 

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***Proved Reserves***

 

Asset forth in reserve reports dated as of July 1, 2005, except the Panhandle fieldis as of September 1, 2005 and the Putnam field is as of January 1, 2006,prepared by Forrest A. Garb & Associates, Inc., our independent petroleumengineer, our proved reserves are summarized as follows:

 
| ** **                             | ** ** | **Nowata** | ** ** | **Rich Valley** | ** ** | **Davenport** | ** ** | **Desdemona** | ** ** | **Putnam** | ** ** | **Panhandle** | ** ** | **Total**  | ** ** |
|----------------------------------------|------------|------------|------------|-----------------|------------|---------------|------------|---------------|------------|------------|------------|---------------|------------|------------|------------|
| **Proved**                             |       |       |       |            |       |          |       |          |       |       |       |          |       |       |       |
| Oil - Mbbls                            |       | 1,492      |       | 299             |       | 478           |       | 786           |       | 847        |       | 24,128        |       | 28,030     |       |
| Gas - Mmcf                             |       | 268        |       | 2,888           |       | 34            |       | 7,198         |       | —     |       | 62,215        |       | 62,215     |       |
| **Proved  Barrels of**                 |       |       |       |            |       |          |       |          |       |       |       |          |       |       |       |
| **Equivalent  Oil (“MBOE”)** | ** ** | **1,537**  | ** ** | **780**         | ** ** | **484**       | ** ** | **1,986**     | ** ** | **847**    | ** ** | **34,497**    | ** ** | **40,131** | ** ** |
| **Proved  Producing (MBOE)**           | ** ** | **1,537**  | ** ** | **587**         | ** ** | **127**       | ** ** | **348**       | ** ** | **—** | ** ** | **5,097**     | ** ** | **7,696**  | ** ** |

 

Ofour 40,131 MBOE of proved reserves, (19%) or 7,696 MBOE are proved producingreserves, 2,062 MBOE (5%) are proved non-producing reserves and 32,435 MBOE(76%) are comprised of proved undeveloped reserves.  Approximately ninety-seven percent (97%) ofour proved undeveloped reserves or 29,400 MBOE are attributable to a Panhandle Fieldwaterflood implementation and the remaining approximately three percent (3%) or847 MBOE are attributable to a surfactant-polymer application in the PutnamField.  Both the waterflood applicationfor the Panhandle Field and the surfactant-polymer application to the PutnamFiled involve significant capital investment and an extended period of timefrom the first investment until actual production occurs.  Generally, the surfactant-polymer technologyis regarded as more risky as compared to waterflooding; however, the PutnamField has been the subject of a successful polymer pilot and we believeconditions for surfactant polymer-flooding are favorable for this field.  As stated in Risk Factors, our ability torecover and successfully convert proved undeveloped reserves to provedproducing reserves is greatly contingent upon our ability to obtain additionalfinancing and/or raise additional capital, and further, greatly contingent uponinherent uncertainties associated with drilling and producing oil and gas andvolatile oil and gas prices.

 

***Capital Spending Plan for CalendarYear 2006***

 

Ourcapital spending plan for the 2006 calendar year, excluding potentialacquisitions, is projected to be $15.6 million to implement developmentalprojects at our existing fields to increase reserves and production as follows:

 

*Desdemona Field.*  This field has not been previouslywaterflooded.  We began pilot waterflood operations in May 2005 andexpect an initial response by the end of 2006.  If the pilot waterfloodsare successful, we intend to begin expanding the waterflood to the entire fieldin 2007.  This field also has mineral rights to the Barnett Shale. We are currently evaluating our options with regard to our Barnett Shalerights.  The reserve amounts listed in thepreceding table do not give any effect to our Barnett Shale rights.

 

*Panhandle Field.*  These leases were acquired as part ofthe acquisition of WO Energy.  Theseleases have not been previously waterflooded; however, other leases in the samereservoir have been successfully waterflooded.   We intend to implement a waterflood atcertain lease locations and expect to begin the process by the end of 2006.

 

*Nowata Field*.  This field is currently beingwaterflooded.  We intend to increase production and reserves by applyingsurfactant-polymer flooding technology.  We are continuing to optimize thesurfactant-polymer chemistry in the laboratory and intend to begin implementinga surfactant-polymer injection pilot by mid-2006.

 

*Davenport Field*.  This field is currently beingwaterflooded.  We are evaluating this field for surfactant-polymerflooding technology.  Based on this evaluation, we expect to begin asurfactant-polymer pilot toward the end of 2006.

 

*Rich Valley Field*.  We intend to drill a horizontal lateralin the producing zone to evaluate the feasibility of additional horizontalre-entries and/or infill drilling.

 

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*Putnam Field*.  Prior to our acquisition of theselease rights, this field had a successful polymer pilot.  Conditions for surfactant polymer floodingare very favorable.  We intend to conducta laboratory evaluation to determine the optimal mix for a surfactant-polymerinjection, followed by either a pilot or full-lease implementation of surfactant-polymertechnology.

 

***Operating Activities***

 

Forthe six months ended December 31, 2005, we had cash used in our operatingactivities of $6.2 million as compared to the $0.7 million used in operatingactivities for the six months ended December 31, 2004.  This is primarily due to the $5.3 millionpurchase of derivative hedging contracts as discussed in Note 4 to theConsolidated Financial Statements.

 

Weexpect to improve cash flow from operating activities through operationalimprovements at our existing properties, cash flow generated from the recentlyacquired Panhandle Field (i.e. WO Energy), and future acquisitions.  Theincreased cash flow from field operations may be offset, in part, by increasedgeneral and administrative costs to support our expanding operations.

 

**Results of Operations**

 

***Overall***

 

Forthe quarter ended December 31, 2005 (“current quarter”), we had a lossapplicable to common stock of $1.5 million, which is $0.7 million higher ascompared to the $0.8 million loss applicable to common stock incurred for thequarter ended December 31, 2004 (“prior year quarter”).

 

Forthe six months ended December 31, 2005 (“current six months”), we had aloss applicable to common stock of $1.9 million, which is $0.1 million higheras compared to the $1.8 million loss applicable to common stock incurred forthe six months ended December 31, 2004 (“prior year six months”).

 

Thefollowing table summarizes the differences between the quarter and six monthsreporting periods.

 
| ** **                                  | ** ** | **Quarter Ended** | ** ** | ** **   | ** ** | **6 Months Ended** | ** ** | ** **   | ** ** |
|---------------------------------------------|------------|-------------------|------------|--------------|------------|--------------------|------------|--------------|------------|
| ** **                                  | ** ** | **December 31,**  | ** ** | **Increase** | ** ** | **December 31,**   | ** ** | **Increase** | ** ** |
| **Amounts in $millions**                    | ** ** | **2005**          | ** ** | **2004**     | ** ** | **(Decrease)**     | ** ** | **2005**     | ** ** | **2004** | ** ** | **(Decrease)** | ** ** |
| Results of oil and gas producing operations |       | $                 | 1.4        |         | $          | 0.6                |       | $            | 0.8        |   | $ | 2.3 |   | $ | 0.9 |   | $ | 1.4 |   |
| General and administrative expenses         |       | 1.7               |       | 0.7          |       | 1.0                |       | 2.9          |       | 1.4 |   | 1.5 |   |
| Interest expense                            |       | 0.3               |       | —       |       | 0.3                |       | 0.3          |       | — |   | 0.3 |   |
| Deferred compensation expense               |       | 0.1               |       | 0.6          |       | (0.5               | )          | 0.3          |       | 0.9 |   | (0.6 | ) |
| Deferred income tax benefit                 |       | (0.8              | )          | —       |       | (0.8               | )          | (0.8         | )          | — |   | (0.8 | ) |
| Preferred stock discount                    |       | —            |       | 0.1          |       | (0.1               | )          | —       |       | 0.4 |   | (0.4 | ) |
| Loss on effective hedge contracts           |       | 1.6               |       | —       |       | 1.6                |       | 1.6          |       | — |   | 1.6 |   |
| Other                                       |       | —            |       | —       |       | —             |       | 0.1          |       | — |   | 0.1 |   |
| Net loss                                    | ** ** | **$**             | **(1.5**   | **)**        | **$**      | **(0.8**           | **)**      | **$**        | **(0.7**   | **)** | **$** | **(1.9** | **)** | **$** | **(1.8** | **)** | **$** | **(0.1** | **)** |

 

Resultsof oil and gas producing operations consists of operating revenues less leaseoperating expenses, production taxes, accretion of asset retirementobligations, and depletion and depreciation.  The $0.8 million increase inthe current quarter is attributed to:

•                  Includingone month of operating results from the recent acquisition of the PanhandleField (i.e. WO Energy) which contributed $0.5 million to net operating income.

•                  Improvedoperating results from our Davenport, Rich Valley, Desdemona, and Nowata Fields,primarily due to higher oil and gas prices received.

 

The$1.4 million increase in the current six months is attributable to the samefactors, and the current six months includes an additional two months of Nowataoperating results.

 

Theother factors will be addressed in the following discussion.

 

17

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***Operating Revenues***

 

Thetable below summarizes our operating revenues for the quarter and six monthsended December 31, 2005 and 2004.

 
| ** **          | ** ** | **Quarter ended** | ** ** | ** **   | ** ** | **Six months ended** | ** ** | ** **   | ** ** |
|---------------------|------------|-------------------|------------|--------------|------------|----------------------|------------|--------------|------------|
| ** **          | ** ** | **December 31,**  | ** ** | **Increase** | ** ** | **December 31,**     | ** ** | **Increase** | ** ** |
| ** **          | ** ** | **2005**          | ** ** | **2004**     | ** ** | **(Decrease)**       | ** ** | **2005**     | ** ** | **2004** | ** ** | **(Decrease)** | ** ** |
| Operating  Revenues |       | $                 | 3,163,282  |         | $          | 1,454,392            |       | $            | 1,708,890  |   | $ | 5,109,241 |   | $ | 2,318,552 |   | $ | 2,790,689 |   |
| Sales               |       |              |       |         |       |                 |       |         |       |   |   |   |   |
| - Oil (MBbls)       |       | 36                |       | 25           |       | 11                   |       | 64           |       | 38 |   | 26 |   |
| - Gas (MMcf)        |       | 111               |       | 49           |       | 62                   |       | 153          |       | 93 |   | 60 |   |
| - Total (MBOE)      |       | 54                |       | 33           |       | 23                   |       | 89           |       | 53 |   | 37 |   |
| Average  Price      |       |              |       |         |       |                 |       |         |       |   |   |   |   |
| - Oil ($/  Bbl)     |       | $                 | 57.14      |         | $          | 47.37                |       | $            | 9.77       |   | $ | 58.55 |   | $ | 46.31 |   | $ | 12.24 |   |
| - Gas ($/  Mcf)     |       | $                 | 8.97       |         | $          | 5.90                 |       | $            | 3.07       |   | $ | 8.22 |   | $ | 5.88 |   | $ | 2.34 |   |

 

Thecurrent quarter operating revenues of $3.2 million represent an improvement of$1.7 million as compared to the prior year quarter of $1.5 million.  The$1.7 million improvement is primarily attributable to including one month of operatingrevenue from the Panhandle Field ($1.1 million revenue and 21 MBOE of sales)and the higher prices received for oil and gas sales.  The average price we received for crude oilsales is generally at or above market prices received at the wellhead.  Theaverage price we receive for natural gas sales is approximately the marketprice received at the wellhead less transportation and marketing expenses.

 

Thecurrent six months operating revenues of $5.1 million is $2.8 million higherthan the prior year six months of $2.3 million. This is primarily due to the factors previously discussed, and thecurrent six months includes a full six months of operating revenues from Nowataand Desdemona.  The prior year six monthsincludes only four months of Nowata and no operating results from Desdemona.

 

***Operating Expenses***

 

Forthe current quarter, our total operating expenses were $3.6 million, or $1.4million higher than the prior year quarter of $2.2 million.  The $1.4million increase is primarily attributed to including one month Panhandle Fieldoperating expenses of $0.5 million, higher other lease operating expenses (“LOE”)of $0.4 million, and higher general & administrative expenses of $1.0million, partially offset by lower deferred compensation expense of $0.5million.

 

Forthe current six months, our total operating expenses were $6.0 million, or $2.3million higher than the prior year six months of $3.7 million.  The $2.3 million increase is primarilyattributed to including one month of Panhandle Field operating expenses of $0.5million, the inclusion of an additional two months of Nowata operations ($0.5million), higher other LOE of $0.4 million, increased general &administrative expenses of $1.5 million, partially offset by lower deferredcompensation expense of $0.6 million.

 

OurLOE consists of costs of producing crude oil and natural gas such as labor,supplies, repairs, maintenance, and utilities. For the current quarter, the LOE per BOE was $22.77 as compared to $17.98per LOE for the prior year quarter.   For the current six months, the LOE per BOEwas $22.25 as compared to $18.33 for the prior year six months. The current sixmonths’ amount of $22.25 per BOE is an improvement as compared to the LOE perBOE of $22.88 that we incurred for the twelve month period ended June 30,2005.  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.  Since our acquisitionsare mature fields, our initial focus is to evaluate the existing operations andmake the necessary operational improvements to improve operatingefficiency.  Based on

 

18

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management’s pastexperience, it generally requires up to twelve months to fully analyze theacquired field and spend the necessary funds to improve the field operations tomeet our operational standards.   We expect these expenditures shouldlead to increased operational efficiency and reduced operating expenses infuture periods.

 

Ourgeneral and administrative (G&A) expenses consist of support services forour operating activities and investor relations costs.  For the currentquarter, our G&A expenses totaled $1.7, which is $1.0 million higher thanthe prior year quarter.  For the currentsix months, our G&A expenses totaled $2.9 million, which is $1.5 millionhigher than the prior year six months of $1.4 million.  The increases for both periods are primarilyattributed to increased employee staffing, expenses associated with the Sabinejoint venture, higher legal fees to comply with regulatory requirements,incentive payments to certain employees, higher travel costs and increasedinsurance costs.

 

OnJanuary 6, 2006, our Board of Directors approved the followingnon-executive director compensation schedule. Each director shall receive anannual cash retainer of $25,000.  Each director shall be paid $1,000 cashfor each Board meeting and Board committee meeting attended.  The Audit CommitteeChairman shall receive an additional annual cash retainer of $5,000.  TheCompensation Committee Chairman, the Corporate Governance Committee Chairman,the Nominating Committee Chairman and the chairman of any other committee orspecial committee established by the Board shall be paid an additional annualcash retainer of $3,000.

 

DuringJanuary 2006, our executive officers were awarded annual salary increasestotaling approximately $370,000.

 

***Loss on Hedging Contracts***

 

As discussed in Note 4 tothe financial statements, duringDecember 2005, we paid $5.3 million to enter into financial contracts to setprice floors for crude oil and natural gas. In accordance with SFAS 133, we recorded a Loss on Hedging Contracts of$1.6 million to reflect the fair value of the derivative instruments as ofDecember 31, 2005.  By their nature, thesederivative instruments can be highly volatile to our earnings.  A five percent change in these prices for ourderivative instruments can impact earnings by approximately $184,000.  We did not have hedging contracts in 2004.

 

***Interest Expense***

 

The$0.3 million of interest expense we incurred in the current quarter resulteddirectly from senior and subordinated credit agreements we entered into onNovember 29, 2005, as discussed in Note 3 to the financial statements.  We did not have credit agreements in 2004.

 

***Deferred Income TaxBenefit***

 

As the result of therecognition of the deferred tax liabilities assumed in the acquisitions of WOEnergy and Square One, as discussed in Notes 2 and 11, respectively, to thefinancial statements, we now have a net deferred tax liability. This allows usto recognize deferred tax benefits from generation of net operating lossesbecause a valuation allowance against such items is not required. We review ourdeferred tax assets at least quarterly and record a valuation allowance againstthose assets when we conclude that it is more likely than not that those assetswill expire without being utilized.  For thequarter ended December 31, 2005, we recorded a deferred income tax benefit of$793,000.

 

***Preferred Stock Discount***

 

Thereduced preferred stock discount amounting to $0.4 million occurred in 2004 andwas attributable to certain issuances of preferred stock during 2004. Since we did not issue preferred stock during 2005, there is no preferred stockdiscount in 2005.

 

19

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**Off Balance Sheet Arrangements**

 

Wedo not have any off balance sheet arrangements that have or are reasonablylikely to have a current or future effect on our financial condition, changesin our financial condition, revenues or expenses, results of operations,liquidity, capital expenditures or capital resources.

 

**Item 3.  Controls and Procedures.**

 

Asof the end of the period covered by this report, we conducted an evaluation,under the supervision and with the participation of our chief executive officerand chief financial officer of our disclosure controls and procedures asdefined in Rule 13a-15(e) and Rule 15d-15(e) of the SecuritiesExchange Act of 1934 (the “Exchange Act”).  Based upon this evaluation, our chiefexecutive officer and chief financial officer concluded that our disclosurecontrols and procedures are effective to ensure that information required to bedisclosed by us in the reports that we file or submit under the Exchange Actis: (1) accumulated and communicated to our management, including ourchief executive officer and chief financial officer, as appropriate to allowtimely decisions regarding required disclosure; and (2) recorded,processed, summarized and reported, within the time periods specified in the Securitiesand Exchange Commission’s rules and forms.  There was no change inour internal controls over financial reporting or in other factors that couldaffect these controls during our last fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II – OTHER INFORMATION**

 

**Item 1.  LegalProceedings.**

 

Occasionally,we are involved in various lawsuits and certain governmental proceedingsarising in the ordinary course of business. Our management does not believe that the ultimate resolution of anycurrent matters, including due to the existence of insurance coverage, indemnificationand escrow accounts, will have a material effect on our financial position orresults of operations.  None of ourdirectors, officers or affiliates, owners of record or beneficially of morethan five percent of any class of our voting securities, or security holder isinvolved in a proceeding adverse to our business or has a material interestadverse to our business.

 

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds.**

 

Allthe unregistered sales of equity securities during the second quarter werereflected in the Current Report on Form 8-K that was filed with the Securitiesand Exchange Commission on December 5, 2005.

 

 

On November29, 2005, we entered into a $100,000,000 Credit Agreement among Cano Petroleum,Inc., as Borrower, the Lenders Party Thereto from Time to Time, as Lenders, andUnion Bank of California, N.A., as Administrative Agent and as IssuingLender.  This Credit Agreement containscertain negative covenants for us and our subsidiaries, including, subject tocertain exceptions, (i) incurring additional liens, (ii) incurring additionaldebt, (iii) making certain payments, including cash dividends to ourstockholders and (iv) making any loans, advances or capital contributions to,or making any investment in, or purchasing or committing to purchase any stockor other securities or evidence of indebtedness or interests in any person orany oil and gas properties or activities related to oil and gas propertiesunless with regard to new oil and gas properties, such properties are mortgagedto Union Bank, as Administrative Agent, or with regard to new subsidiaries,such subsidiaries execute a guaranty, pledge agreement, security agreement ormortgage in favor of Union Bank, as Administrative Agent.  In addition, we must meet certain financialratios based on debt coverage, interest coverage and current assets to currentliabilities.

 

On November29, 2005, we entered into a $15,000,000 Subordinated Credit Agreement amongCano Petroleum, Inc., as Borrower, the Lenders Party Thereto from Time to Time,as Lenders, and Energy 

 

20

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Components SPC EEP EnergyExploration and Production Segregated Portfolio (“EEP”), as AdministrativeAgent.  This Subordinated CreditAgreement contains certain negative covenants for us and our subsidiaries,including, subject to certain exceptions (i) incurring additional liens, (ii)incurring additional debt, (iii) making certain payments, including cashdividends to our stockholders and (iv) making any loans, advances or capitalcontributions to, or making any investment in, or purchasing or committing topurchase any stock or other securities or evidence of indebtedness or interestsin any person or any oil and gas properties or activities related to oil andgas properties unless with regard to new oil and gas properties, suchproperties as requested by EEP, as Administrative Agent, or with regard to newsubsidiaries, such subsidiaries execute a guaranty, pledge agreement, securityagreement or mortgage in favor of Union Bank, as Administrative Agent.  In addition, we must meet certain financialratios based on debt coverage, interest coverage, current assets to currentliabilities and reserve value coverage.

 

**Item 3.  Defaults UponSenior Securities.**

 

Therehas been no material default in the payment of principal, interest, a sinkingor purchase fund installment, or any other material default not cured within 30days, with respect to any indebtedness exceeding five percent of our totalassets.  There also has been no materialarrearage in the payment of dividends or any other material delinquency notcured within 30 days, with respect to any class of preferred stock which isregistered or which ranks prior to any class of our registered securities, orwith respect to any class of preferred stock of any significant subsidiary.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

 

###### **We submitted a proxy statement to the Company’sstockholders as of the record date, October 25, 2005.  The proxy statement was furnished to theCompany’s stockholders in connection with the Annual Meeting of Stockholdersheld on December 7, 2005.  There were25,040,838 shares entitled to vote at the meeting.  For the election of the Board of Directors,the results were as follows:**

 

| **Nominee**            | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** |
|------------------------|------------|---------------|------------|---------------------|------------|
| S. Jeffrey Johnson (1) |       | 15,610,156    |       | 452,681             | ** ** |
| Donnie D.  Dent (1)    |       | 16,002,621    |       | 60,216              |       |
| Gerald W.  Haddock (1) |       | 15,613,056    |       | 449,781             |       |
| Randall Boyd  (1)      |       | 15,607,356    |       | 455,481             |       |
| Morris B.  Smith (1)   |       | 15,998,371    |       | 64,466              |       |
| Dr. Jim  Underwood (1) |       | 16,000,578    |       | 62,259              |       |

 

----

(1) Incumbent

 

Forthe ratification of Hein & Associates LLP as Cano Petroleum, Inc.’sindependent registered public accounting firm for the year ended June 30, 2006,the results were as follows:

 

| **Votes For** | ** ** | **Votes  Against** | ** ** | **Votes  Abstained** | ** ** |
|---------------|------------|--------------------|------------|----------------------|------------|
| 16,037,882    |       | 14,411             |       | 10,544               |       |

 

Forthe approval of the 2005 Cano Petroleum, Inc. Long-Term Incentive Plan, theresults were as follows:

 

| **Votes For** | ** ** | **Votes  Against** | ** ** | **Votes  Abstained** | ** ** | **Broker  Non-Votes** | ** ** |
|---------------|------------|--------------------|------------|----------------------|------------|-----------------------|------------|
| 9,346,598     |       | 525,648            |       | 70,588               |       | 6,120,003             |       |

 

21

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**Item 5.  Other Information.**

 

None.

 

**Item 6.  Exhibits.**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | Stock Purchase Agreement by and among Cano  Petroleum, Inc., W. O. Energy of Nevada, Inc. Miles O’Loughlin and Scott  White dated November 29, 2005 (the schedule and exhibits have been omitted  from this filing. An exhibit to the schedules and exhibits is contained in  the Stock Purchase Agreement and the schedule and exhibits are available to  the Securities and Exchange Commission upon request) incorporated by  reference from Exhibit 2.1 to Current Report on Form 8-K filed on  December 5, 2005. |
| 4.1                 |       | Registration Rights Agreement by and  between Cano Petroleum, Inc. and Miles O’Loughlin dated November 29,  2005, incorporated by reference from Exhibit 4.1 to Current Report on  Form 8-K filed on December 5, 2005.                                                                                                                                                                                                                                                                                                     |
| 4.2                 |       | Registration Rights Agreement by and  between Cano Petroleum, Inc. and Scott White dated November 29, 2005,  incorporated by reference from Exhibit 4.2 to Current Report on Form 8-K  filed on December 5, 2005.                                                                                                                                                                                                                                                                                                               |
| 10.1                |       | Omnibus Agreement among Cano Petroleum,  Inc., Haddock Enterprises, LLC, Carlile Management, LLC and Sabine Production  Partners, LP dated November 4, 2005, incorporated by reference from Exhibit  10.1 to Current Report on Form 8-K filed on November 9, 2005.                                                                                                                                                                                                                                                                   |
| 10.2                |       | Amended and Restated Regulations of Sabine  Production Operating, LLC among Cano Petroleum, Inc., Haddock Enterprises,  LLC and Carlile Management, LLC dated November 4, 2005, incorporated by  reference from Exhibit 10.2 to Current Report on Form 8-K filed on  November 9, 2005.                                                                                                                                                                                                                                               |
| 10.3                |       | Compensation Reimbursement Agreement  between Cano Petroleum, Inc. and Sabine Production Operating, LLC dated  November 4, 2005, incorporated by reference from Exhibit 10.3 to Current  Report on Form 8-K filed on November 9, 2005.                                                                                                                                                                                                                                                                                                    |
| 10.4                |       | Credit Agreement among Cano Petroleum,  Inc., as Borrower, The Lenders Party Hereto From Time To Time, as Lenders,  and Union Bank of California, N.A., as Administrative Agent and as issuing  Lender, dated November 29, 2005, incorporated by reference from Exhibit 10.1  to Current Report on Form 8-K filed on December 5, 2005.                                                                                                                                                                                                    |
| 10.5                |       | Subordinated Credit Agreement among Cano  Petroleum, Inc., as Borrower, The Lenders Party Hereto From Time To Time, as  Lenders, and Energy Components SPC EEP Energy Exploration and Production  Segregated Portfolio, as Administrative Agent, dated November 29, 2005,  incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K  filed on December 5, 2005.                                                                                                                                                          |
| 10.6                |       | Guaranty Agreement by and among Ladder  Companies, Inc., Square One Energy, Inc., W.O. Energy of Nevada, Inc., W O  Energy, Inc., W. O. Operating Company, Ltd. and W. O. Production  Company, Ltd. in favor of Union Bank of California, N.A., as Administrative  Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.3  to the Current Report on Form 8-K filed on December 5, 2005.                                                                                                                    |
| 10.7                |       | Guaranty Agreement by and among Ladder  Companies, Inc., Square One Energy, Inc., W. O. Energy of Nevada, Inc.,  W O Energy, Inc., W. O. Operating Company, Ltd. and W. O. Production Company,  Ltd. in favor of Energy Components SPC EEP Energy Exploration and Production  Segregated Portfolio, as Administrative Agent, dated November 29, 2005, incorporated  by reference from Exhibit 10.4 to the Current Report on Form 8-K filed on  December 5, 2005.                                                                     |
| 10.8                |       | Escrow Agreement by and among Cano  Petroleum, Inc., Miles O’Loughlin, Scott White and The Bank of New York Trust  Company, N.A., as Escrow Agent, dated November 29, 2005, incorporated by  reference from Exhibit 10.5 to the Current Report on Form 8-K filed on  December 5, 2005.                                                                                                                                                                                                                                               |
| 10.9                |       | Pledge Agreement by and among Cano  Petroleum, Inc., W. O. Energy of Nevada, Inc. and W O Energy, Inc.  in favor of Union Bank of California, N.A., as Administrative Agent, dated                                                                                                                                                                                                                                                                                                                                              |

 

22

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|   |   | November 29, 2005, incorporated by  reference from Exhibit 10.6 to the Current Report on Form 8-K dated on  December 5, 2005.                                                                                                                                                                                                                                                                                                           |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10  |   | Security Agreement by and among Cano  Petroleum, Inc., Ladder Companies Inc., Square One Energy, Inc., W. O.  Energy of Nevada, Inc., W O Energy, Inc., W. O. Operating Company, Ltd.  and W. O. Petroleum, Ltd., in favor of Union Bank of California N.A. as  Administrative Agent, dated November 29, 2005, incorporated by reference from  Exhibit 10.7 to the Current Report on Form 8-K filed on December 5, 2005. |
| +10.11 |   | Cano Petroleum, Inc. 2005 Long-Term  Incentive Plan dated December 7, 2005, incorporated by reference from Exhibit  10.1 to the Current Report on Form 8-K filed on December 9, 2005.                                                                                                                                                                                                                                                   |
| +10.12 |   | Form of Stock Option Agreement,  incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K  filed on December 19, 2005.                                                                                                                                                                                                                                                                                             |
| 10.13  |   | Summary of Terms of Purchase of Overriding  Royalty Interests by Cano Petroleum, Inc. from Theprivate Energy Company,  Inc. dated December 27, 2005, incorporated by reference from Exhibit 10.1 to  the Current Report on Form 8-K filed on January 3, 2006.                                                                                                                                                                           |
| +10.14 |   | Summary Sheet: Director Compensation,  incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K  filed on January 12, 2006.                                                                                                                                                                                                                                                                                        |
| +10.15 |   | Employment Agreement between Cano  Petroleum, Inc. and S. Jeffrey Johnson dated effective January 1, 2006,  incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K  filed on January 19, 2006.                                                                                                                                                                                                                   |
| +10.16 |   | Amendment to Employment Agreement of  Michael J. Ricketts effective January 1, 2006, incorporated by reference from  Exhibit 10.2 to the Current Report on Form 8-K filed on January 19, 2006.                                                                                                                                                                                                                                          |
| +10.17 |   | Amendment to Employment Agreement of Thomas  Cochrane effective January 1, 2006, incorporated by reference from Exhibit  10.3 to the Current Report on Form 8-K filed on January 19, 2006.                                                                                                                                                                                                                                              |
| +10.18 |   | Amendment to Employment Agreement of James  K. Teringo, Jr. effective January 1, 2006, incorporated by reference from  Exhibit 10.4 to the Current Report on Form 8-K filed on January 19, 2006.                                                                                                                                                                                                                                        |
| 10.19* |   | Gas Purchase Contract between W. O.  Operating Company, Ltd. and Duke Field Services L.P. dated November 1, 2003.                                                                                                                                                                                                                                                                                                                  |
| 10.20* |   | Gas Purchase Contract by and between  W. O. Operating Company Limited, as Seller, and One OK Texas Field  Services LP, as Buyer, dated January 1, 2005.                                                                                                                                                                                                                                                                            |
| 23.1*  |   | Consent of Forrest A. Garb & Associates,  Inc., Independent Petroleum Engineering.                                                                                                                                                                                                                                                                                                                                                  |
| 31.1*  |   | Certification by Chief Executive Officer, required by  Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act,  promulgated pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                           |
| 31.2*  |   | Certification by Chief Financial Officer, required by  Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act,  promulgated pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                           |
| 32.1*  |   | Certification by Chief Executive Officer, required by  Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350  of Chapter 63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                |
| 32.2*  |   | Certification by Chief Financial Officer, required by  Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and  Section 1350 of Chapter 63 of Title 18 of the United States Code,  promulgated pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                |

 

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*                 Filedherewith

+                 Management contract or compensatory plan,contract or arrangement

 

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**SIGNATURES**

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|   |                     | **CANO PETROLEUM, INC.** |
|--------|--------------------------|--------------------------|
|   |                     |                     |   |
|   | Dated:February  14, 2006 | By:                      | /s/  S. Jeffrey Johnson |
|   |                     |                     | S.  Jeffrey Johnson |
|   |                     |                     | Chief  Executive Officer |
|   |                     |                     |   |
|   | Dated:February  14, 2006 | By:                      | /s/  Michael J. Ricketts |
|   |                     |                     | Michael  J. Ricketts |
|   |                     |                     | Chief  Financial Officer and |
|   |                     |                     | Principal  Accounting Officer |

 

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