** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

|                                                       | **(Mark  One)** |                                                                                              |
|------------------------------------------------------------|-----------------|---------------------------------------------------------------------------------------------------|
|                                                       |            |                                                                                              |
| **x**                                                      | ** **      | **QUARTERLY REPORT UNDER SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                       |            |                                                                                              |
| **For the quarterly period ended  December 31, 2007** |
|                                                       |            |                                                                                              |
| **o**                                                      | ** **      | **TRANSITION REPORT UNDER SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom         to         **

 

**Commission file number 001-32496**

 

**CANO PETROLEUM, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

| **The Burnett Plaza**                    |
|------------------------------------------|
| **801 Cherry Street, Suite 3200**   |
| **Fort Worth, TX 76102**                 |
| (Address of principal executive offices) |
|                                     |
| **(817) 698-0900**                       |
| (Issuer’s telephone number)         |

 

Indicate by check markwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the past 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.
| Yes | x |   | No | o |
|-----|---|--------|----|---|

 

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company. See definition of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (check one):

 

| Large accelerated filer  o |   | Accelerated filer x |   | Non-accelerated filer o |   | Smaller reporting  company o |
|----------------------------|--------|---------------------|--------|-------------------------|--------|------------------------------|

 

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

 

State the number ofshares outstanding of each of the issuer’s classes of common equity, as of thelatest practicable date:  37,517,565 shares of common stock, $.0001 parvalue per share, as of February 6, 2008.

 

** **

----

 

**PART I– FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

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

 
| ** **                                                                                                                                                                                                                                                             | ** ** | **December 31,** | ** **      | **June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-----------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                             | ** ** | **2007**              | ** **      | **2007**          | ** ** |
| ** **                                                                                                                                                                                                                                                             | ** ** | **(Unaudited)**       | ** **      | ** **        | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                           | ** ** | ** **            | ** **      | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                | ** ** | ** **            | ** **      | ** **        | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                              |       | $                     | 853,797         |              | $          | 2,119,098 |   |
| Restricted cash (Notes 2, 11)                                                                                                                                                                                                                                          |       | 2,818,062             |            | —            |       |
| Accounts receivable                                                                                                                                                                                                                                                    |       | 2,898,998             |            | 4,081,498         |       |
| Prepaid expenses                                                                                                                                                                                                                                                       |       | 568,617               |            | 309,216           |       |
| Derivative assets                                                                                                                                                                                                                                                      |       | —                |            | 810,174           |       |
| Inventory and other current assets                                                                                                                                                                                                                                     |       | 400,419               |            | 292,540           |       |
| Total current assets                                                                                                                                                                                                                                                   |       | 7,539,893             |            | 7,612,526         |       |
|                                                                                                                                                                                                                                                                   |       |                  |            |              |       |
| **Oil and gas properties****,**successful  efforts method                                                                                                                                                                                                              |       | 231,732,830           |            | 189,842,882       |       |
| Less accumulated depletion and depreciation                                                                                                                                                                                                                            |       | (8,375,726            | )               | (6,201,635        | )          |
| Net oil and gas properties                                                                                                                                                                                                                                             |       | 223,357,104           |            | 183,641,247       |       |
|                                                                                                                                                                                                                                                                   |       |                  |            |              |       |
| Fixed assets and other, net                                                                                                                                                                                                                                            |       | 1,485,692             |            | 1,547,875         |       |
| Restricted cash (Notes 2, 11)                                                                                                                                                                                                                                          |       | —                |            | 6,000,000         |       |
| Derivative assets                                                                                                                                                                                                                                                      |       | 1,137,527             |            | 1,881,800         |       |
| Goodwill                                                                                                                                                                                                                                                               |       | 785,796               |            | 785,796           |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                       | ** ** | **$**                 | **234,306,012** | ** **        | **$**      | **201,469,244** | ** ** |
|                                                                                                                                                                                                                                                                   |       |                  |            |              |       |
| ***LIABILITIES  AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                       |       |                  |            |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                |       |                  |            |              |       |
| Accounts payable                                                                                                                                                                                                                                                       |       | $                     | 8,117,023       |              | $          | 7,508,795 |   |
| Oil and gas sales payable                                                                                                                                                                                                                                              |       | 1,451,510             |            | 1,345,537         |       |
| Accrued liabilities                                                                                                                                                                                                                                                    |       | 1,181,887             |            | 1,421,484         |       |
| Taxes payable                                                                                                                                                                                                                                                          |       | 650,899               |            | 450,062           |       |
| Derivative liability                                                                                                                                                                                                                                                   |       | 416,405               |            | —            |       |
| Current portion of asset retirement obligations                                                                                                                                                                                                                        |       | 275,870               |            | 264,140           |       |
| Total current liabilities                                                                                                                                                                                                                                              |       | 12,093,594            |            | 10,990,018        |       |
| **Long-term liabilities**                                                                                                                                                                                                                                              |       |                  |            |              |       |
| Long-term debt                                                                                                                                                                                                                                                         |       | 42,000,000            |            | 33,500,000        |       |
| Asset retirement obligations                                                                                                                                                                                                                                           |       | 2,183,683             |            | 2,150,930         |       |
| Deferred litigation credit (Note 11)                                                                                                                                                                                                                                   |       | 6,000,000             |            | 6,000,000         |       |
| Deferred tax liability                                                                                                                                                                                                                                                 |       | 31,846,000            |            | 32,371,000        |       |
| Total liabilities                                                                                                                                                                                                                                                      |       | 94,123,277            |            | 85,011,948        |       |
|                                                                                                                                                                                                                                                                   |       |                  |            |              |       |
| **Temporary equity**                                                                                                                                                                                                                                                   |       |                  |            |              |       |
| Series D convertible preferred stock and paid-in-kind dividend;  par value $.0001 per share, stated value $1,000 per share; 49,116 authorized  and 45,116 shares issued; liquidation preference of $47,928,846 and  $50,862,925, respectively.                    |       | 44,661,982            |            | 47,596,061        |       |
|                                                                                                                                                                                                                                                                   |       |                  |            |              |       |
| **Commitments and contingencies (Note 11)**                                                                                                                                                                                                                            |       |                  |            |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                          |       |                  |            |              |       |
| Common stock, par value $.0001 per share; 100,000,000 authorized;  38,603,283 and 37,334,989 shares issued and outstanding at December 31,  2007, respectively; and 33,956,392 and 32,688,098 shares issued and  outstanding at June 30, 2007, respectively. |       | 3,861                 |            | 3,396             |       |
| Additional paid-in capital                                                                                                                                                                                                                                             |       | 114,720,969           |            | 85,238,362        |       |
| Accumulated deficit                                                                                                                                                                                                                                                    |       | (18,633,345           | )               | (15,809,791       | )          |
| Treasury stock, at cost; 1,268,294 shares held in escrow                                                                                                                                                                                                               |       | (570,732              | )               | (570,732          | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                        |       | 95,520,753            |            | 68,861,235        |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                    | ** ** | **$**                 | **234,306,012** | ** **        | **$**      | **201,469,244** | ** ** |

 

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

 

2

----

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                       | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| ** **                                                       | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Operating Revenues:**                                          | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil sales                                                  |       | $                                | 5,872,961  |                           | $          | 3,743,117 |   | $ | 10,868,686 |   | $ | 8,594,034 |   |
| Natural gas sales                                                |       | 4,066,646                        |       | 2,362,872                      |       | 7,712,792 |   | 5,129,414 |   |
| Other revenue                                                    |       | 79,272                           |       | 51,943                         |       | 158,566 |   | 109,284 |   |
| Crude oil and natural gas sales                                  |       | 10,018,879                       |       | 6,157,932                      |       | 18,740,044 |   | 13,832,732 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Operating Expenses:**                                          |       |                             |       |                           |       |   |   |   |   |
| Lease operating                                                  |       | 3,183,840                        |       | 2,284,291                      |       | 6,286,838 |   | 5,056,022 |   |
| Production and ad valorem taxes                                  |       | 754,646                          |       | 556,209                        |       | 1,454,004 |   | 1,174,920 |   |
| General and administrative                                       |       | 3,762,524                        |       | 2,640,238                      |       | 7,384,733 |   | 5,785,275 |   |
| Depletion and depreciation                                       |       | 1,152,477                        |       | 1,072,408                      |       | 2,287,146 |   | 2,049,360 |   |
| Accretion of discount on asset retirement obligations            |       | 54,235                           |       | 29,445                         |       | 108,637 |   | 58,336 |   |
| Total operating expenses                                         |       | 8,907,722                        |       | 6,582,591                      |       | 17,521,358 |   | 14,123,913 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Income from operations**                                       |       | 1,111,157                        |       | (424,659                       | )          | 1,218,686 |   | (291,181 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Other income (expenses):**                                     |       |                             |       |                           |       |   |   |   |   |
| Interest expense                                                 |       | (265,275                         | )          | (122,017                       | )          | (664,772 | ) | (1,964,732 | ) |
| Unrealized loss on commodity derivatives                         |       | (1,845,862                       | )          | (693,016                       | )          | (2,361,899 | ) | (156,990 | ) |
| Realized gain (loss) on commodity derivatives                    |       | (37,785                          | )          | 235,128                        |       | 258,695 |   | 751,457 |   |
| Interest income                                                  |       | 51,763                           |       | 74,413                         |       | 154,952 |   | 91,181 |   |
| Total other income (expenses)                                    |       | (2,097,159                       | )          | (505,492                       | )          | (2,613,024 | ) | (1,279,084 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Loss from continuing operations before income taxes              |       | (986,002                         | )          | (930,151                       | )          | (1,394,338 | ) | (1,570,265 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Income tax benefit                                               |       | 344,632                          |       | 399,871                        |       | 474,632 |   | 597,070 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Loss from continuing operations**                              |       | (641,370                         | )          | (530,280                       | )          | (919,706 | ) | (973,195 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Income (loss) from discontinued operations, net of related taxes |       | (48,654                          | )          | 85,109                         |       | (48,654 | ) | 160,131 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Net loss**                                                     |       | (690,024                         | )          | (445,171                       | )          | (968,360 | ) | (813,064 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Preferred stock dividend                                         |       | 888,222                          |       | 966,972                        |       | 1,855,194 |   | 1,235,575 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Net loss applicable to common stock**                          |       | $                                | (1,578,246 | )                              | $          | (1,412,143 | ) | $ | (2,823,554 | ) | $ | (2,048,639 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Net income (loss) per share - basic and diluted**              |       |                             |       |                           |       |   |   |   |   |
| Continuing operations                                            |       | $                                | (0.04      | )                              | $          | (0.04 | ) | $ | (0.08 | ) | $ | (0.07 | ) |
| Discontinued operations                                          |       | —                           |       | —                         |       | — |   | $ | — |   |
| **Net loss per share - basic and diluted**                       |       | $                                | (0.04      | )                              | $          | (0.04 | ) | $ | (0.08 | ) | $ | (0.07 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Weighted average common shares outstanding**                   |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted                                                |       | 35,101,346                       |       | 31,891,608                     |       | 33,858,581 |   | 28,967,429 |   |

 

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

 

3

----

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENT OF CHANGES**

**IN STOCKHOLDERS’ EQUITY**

**JULY 1, 2007 THROUGH DECEMBER 31,2007**

**(Unaudited)**

 
| ** **                                         | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** ** | ** **      | ** ** | ** **    | ** ** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------|-----------------|------------|---------------|------------|------------|
| ** **                                         | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **      |
| ** **                                         | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares** | ** **      | **Amount** | ** **    | **Total**  | ** ** |
| **Balance at June 30, 2007**                  | ** ** | **33,956,932**        | ** ** | **$**       | **3,396**  | ** **      | **$**      | **85,238,362**          | ** ** | **$**      | **(15,809,791** | **)**      | **1,268,294** | ** ** | **$**      | **(570,732** | **)** | **$** | **68,861,235** | ** ** |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| Issuance of restricted stock                       |       | 395,000               |       | 40          |       | (40             | )          | —                  |       | —     |            | —     |          | —     |       |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| Stock based compensation expense                   |       | —                |       | —      |       | 1,660,249       |       | —                  |       | —     |            | —     |          | 1,660,249  |       |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| Net proceeds from issuance of common shares        |       | 3,550,000             |       | 355         |       | 23,822,468      |       | —                  |       | —     |            | —     |          | 23,822,823 |       |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| Common stock issued for preferred stock conversion |       | 701,891               |       | 70          |       | 3,999,930       |       | —                  |       | —     |            | —     |          | 4,000,000  |       |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| Preferred stock dividend                           |       | —                |       | —      |       | —          |       | (1,855,194              | )          | —     |            | —     |          | (1,855,194 | )          |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| Net loss                                           |       | —                |       | —      |       | —          |       | (968,360                | )          | —     |            | —     |          | (968,360   | )          |
|                                               |       |                  |       |        |       |            |       |                    |       |       |            |       |          |       |       |
| **Balance at December 31, 2007**              | ** ** | **38,603,823**        | ** ** | **$**       | **3,861**  | ** **      | **$**      | **114,720,969**         | ** ** | **$**      | **(18,633,345** | **)**      | **1,268,294** | ** ** | **$**      | **(570,732** | **)** | **$** | **95,520,753** | ** ** |

*** ***

***See accompanying notes to theseunaudited financial statements.***

 

4

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **Six Months Ended** | ** **  |
|----------------------------------------------------------------------------------------------|------------|--------------------------------|-------------|
| ** **                                                                                   | ** ** | **December 31,**          | ** **  |
| ** **                                                                                   | ** ** | **2007**                       | ** **  | **2006** | ** ** |
| **Cash flow from operating activities:**                                                     | ** ** | ** **                     | ** **  | ** ** | ** ** |
| Net loss                                                                                     |       | $                              | (968,360    | ) | $ | (813,064 | ) |
| Adjustments needed to reconcile net loss to net cash flow provided by  operating activities: |       |                           |        |   |   |
| Unrealized loss on commodity derivatives                                                     |       | 2,361,899                      |        | 156,990 |   |
| Accretion of discount on asset retirement obligations                                        |       | 108,637                        |        | 67,530 |   |
| Depletion and depreciation                                                                   |       | 2,287,146                      |        | 2,130,036 |   |
| Stock based compensation expense                                                             |       | 1,660,249                      |        | 337,740 |   |
| Deferred income tax benefit                                                                  |       | (502,000                       | )           | (507,000 | ) |
| Amortization of debt issuance costs and prepaid expenses                                     |       | 647,724                        |        | 1,375,388 |   |
|                                                                                         |       |                           |        |   |   |
| Changes in assets and liabilities relating to operations:                                    |       |                           |        |   |   |
| Restricted cash                                                                              |       | 3,181,938                      |        | — |   |
| Accounts receivable                                                                          |       | 1,213,583                      |        | 949,382 |   |
| Derivative assets                                                                            |       | (291,000                       | )           | (1,217,760 | ) |
| Prepaid assets                                                                               |       | (767,609                       | )           | (959,098 | ) |
| Inventory                                                                                    |       | (108,031                       | )           | 91,213 |   |
| Accounts payable                                                                             |       | (1,711,891                     | )           | 1,272,928 |   |
| Oil and gas sales payable                                                                    |       | 105,973                        |        | (630,612 | ) |
| Accrued liabilities                                                                          |       | (239,597                       | )           | (69,028 | ) |
| Taxes payable                                                                                |       | 200,837                        |        | 165,030 |   |
| Other current assets                                                                         |       | 327,286                        |        | 540,404 |   |
| **Net cash provided by operating activities**                                                | ** ** | **7,506,784**                  | ** **  | **2,890,079** | ** ** |
| ** **                                                                                   | ** ** | ** **                     | ** **  | ** ** | ** ** |
| **Cash flow from investing activities:**                                                     |       |                           |        |   |   |
| Additions to oil and gas properties                                                          |       | (39,765,115                    | )           | (10,410,734 | ) |
| Additions to fixed assets and other                                                          |       | (106,510                       | )           | (695,374 | ) |
| Acquisition of additional Davenport revenue interest                                         |       | —                         |        | (133,000 | ) |
| **Net cash used in investing activities**                                                    | ** ** | **(39,871,625**                | **)**       | **(11,239,108** | **)** |
|                                                                                         |       |                           |        |   |   |
| **Cash flow from financing activities:**                                                     |       |                           |        |   |   |
| Paydown long-term debt                                                                       |       | —                         |        | (68,750,000 | ) |
| Payment of debt issuance cost                                                                |       | —                         |        | (189,246 | ) |
| Proceeds from borrowings of long-term debt                                                   |       | 8,500,000                      |        | 2,500,000 |   |
| Payment of preferred stock dividends                                                         |       | (1,223,283                     | )           | (554,570 | ) |
| Proceeds from issuance of preferred stock, net                                               |       | —                         |        | 45,894,807 |   |
| Proceeds from issuance of common stock and warrants, net                                     |       | 23,822,823                     |        | 29,705,396 |   |
| **Net cash provided by financing activities**                                                | ** ** | **31,099,540**                 | ** **  | **8,606,387** | ** ** |
| ** **                                                                                   | ** ** | ** **                     | ** **  | ** ** | ** ** |
| Net increase in cash and cash equivalents                                                    |       | (1,265,301                     | )           | 257,358 |   |
| Cash and cash equivalents at beginning of period                                             |       | 2,119,098                      |        | 644,659 |   |
| **Cash and cash equivalents at end of period**                                               | ** ** | **$**                          | **853,797** | ** ** | **$** | **902,017** | ** ** |
|                                                                                         |       |                           |        |   |   |
| **Supplemental disclosure of noncash transactions:**                                         |       |                           |        |   |   |
| Payment of preferred stock dividends in kind                                                 |       | 1,065,921                      |        | 681,005 |   |
| Common stock issued for preferred stock conversion                                           |       | 4,000,000                      |        | — |   |
|                                                                                         |       |                           |        |   |   |
| **Supplemental disclosure of cash transactions:**                                            |       |                           |        |   |   |
| Cash paid during the period for interest                                                     |       | $                              | 1,778,551   |   | $ | 2,196,081 |   |

 

***See accompanying notes to theseunaudited financial statements.***

 

5

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**CANO PETROLEUM, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

 

**1.****             ****BASIS OF PRESENTATIONAND USE 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. Results forinterim periods are not necessarily indicative of results to be expected for afull year or for previously reported periods due in part, but not limited to,the volatility in prices for crude oil and natural gas, future commodity pricesfor commodity derivatives, interest rates, estimates of reserves, drillingrisks, geological risks, transportation restrictions, the timing ofacquisitions, product demand, market competition, interruption in production,our ability to obtain additional capital, and the success of waterflooding andenhanced oil recovery techniques. You should read these consolidated interimfinancial statements in conjunction with the audited consolidated financialstatements and notes thereto included in Cano’s Form 10-K dated June 30,2007.

 

The accompanyingfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) andinclude the accounts of Cano and its wholly-owned subsidiaries. Intercompanyaccounts and transactions are eliminated. In preparing the accompanyingfinancial statements, management has made certain estimates and assumptionsthat affect reported amounts in the financial statements and disclosures ofcontingencies. Actual results may differ from those estimates. Significantassumptions are required in the valuation of proved oil and natural gasreserves, which may affect the amount at which oil and natural gas propertiesare recorded. The computation of stock based compensation expense requiresassumptions such as volatility, expected life and the risk-free interest rate.It is at least reasonably possible these estimates could be revised in the nearterm, and these revisions could be material.

 

**NewAccounting Pronouncements**

 

On July 13, 2006,the Financial Accounting Standards Board (“FASB”) released FIN 48, “Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB Statement 109” (“FIN48”). FIN 48 requires a company to evaluate and disclose material uncertain taxpositions it has taken with various taxing jurisdictions. Any interest andpenalties related to uncertain tax positions would be recorded as interestexpense and general and administrative expense, respectively. We adopted FIN 48on July 1, 2007. At the time of adoption and as of December 31, 2007,we determined the adoption of FIN 48 does not materially affect our operatingresults, financial position, or cash flows. As of December 31, 2007, wehave not recorded any accruals for uncertain tax positions. We are not involvedin any examinations by the Internal Revenue Service. For Texas, Oklahoma andU.S. federal purposes, the review of our tax returns is open for the tax yearsof 2004, 2005 and 2006. We have not yet filed our tax returns for the 2007 taxyear for Texas, Oklahoma, New Mexico and U.S. federal.

 

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

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS No. 141R”). SFAS No. 141R,which among other things, establishes principles and requirements for how theacquirer in a business combination (i) recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,and any noncontrolling 

 

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interest in the acquired business, (ii) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase, and (iii) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. SFAS No. 141R is effective for fiscalyears beginning on or after December 15, 2008, with early adoptionprohibited. This standard will change our accounting treatment for businesscombinations on a prospective basis.

 

In December 2007,the FASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements, an Amendment of ARB No. 51*(“SFAS No. 160”). SFAS No. 160 establishes accounting and reportingstandards for noncontrolling interests in a subsidiary and for thedeconsolidation of a subsidiary. Minority interests will be recharacterized asnoncontrolling interests and classified as a component of equity. It alsoestablishes a single method of accounting for changes in a parent’s ownershipinterest in a subsidiary and requires expanded disclosures. This statement iseffective for fiscal years beginning on or after December 15, 2008, withearly adoption prohibited. We do not expect the adoption of this statement willhave a material impact on our financial position or results of operations.

 

**2.    LONG-TERM DEBT**

 

At December 31, 2007and June 30, 2007, the outstanding amount due under the credit agreementwas $42.0 million and $33.5 million, respectively. The credit agreement isour only source of debt. At December 31, 2007, the interest rate was 6.90%.The interest expense for the current quarter and current six months wasimpacted by $0.6 million and $1.1 million of interest cost that was capitalizedto the waterflood projects at our Panhandle, Desdemona and Corsicana Propertiesand to our alkaline-surfactant-polymer project at the Nowata Properties.

 

On September 7,2007, we entered into Amendment No. 7 to the credit agreement, whichprovides for (i) an increase to our borrowing base from $44.0 million to$60.0 million; (ii) permits us to use $6.0 million of the previouslyreceived insurance proceeds for general corporate purposes; and (iii) providesthat the leverage ratio (a) at the end of each fiscal quarter ending priorto June 30, 2008 shall not be greater than 5.00 to 1.00; (b) at theend of each fiscal quarter ending on or after June 30, 2008 but prior to December 31,2008 shall not be greater than 4.50 to 1.00; and (c) at the end of eachfiscal quarter ending on or after December 31, 2008 shall not be greaterthan 4.00 to 1.00 and for the purposes of calculating the leverage ratio, thedefinition of “consolidated Debt” shall not include “Debt” outstanding underpreferred stock.

 

Since Amendment No. 7has made the restricted cash less restricted, we have reclassified therestricted cash from a non-current asset to a current asset at December 31,2007. Specifically, we cannot use the restricted cash to fund capitalexpenditures. Restricted cash is more fully discussed in Note 11.

 

At December 31, 2007and June 30, 2007, we were in compliance with the credit agreement debtcovenants.

 

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

 

Pursuant to our creditagreement, we are required to enter into financial contracts to hedge a portionof our production at specified prices for oil and natural gas. Initially, ourfinancial contracts consisted of purchasing price floors. In order to offsetthe costs of the price floors, we also have entered into short-term financialcontracts to sell price ceilings. As of December 31, 2007, these financialcontracts are summarized in the table below.

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

 

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

 

During the quarters andsix months ended December 31, 2007 and 2006, there were settlements underour commodity derivatives due to us and paid by us with our counterparty thatare summarized as follows:

 
| ** **              | ** ** | **Quarter ended December 31,** | ** ** | **Six Months ended December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **              | ** ** | **2007**                                      | ** ** | **2006**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Settlements received    |       | $                                             | 176,550    |                                                  | $          | 235,128 |   | $ | 473,030 |   | $ | 751,457 |   |
| Settlements paid        |       | (214,335                                      | )          | —                                                |       | (214,335 | ) | — |   |
| Realized gain (loss) on |       |                                          |       |                                                  |       |   |   |   |   |
| commodity derivatives   |       | $                                             | (37,785    | )                                                     | $          | 235,128 |   | $ | 258,695 |   | $ | 751,457 |   |

 

The settlements receivedby us were cumulative monthly payments due to us since the NYMEX natural gasprice was lower than the “floor natural gas prices” of $7.60 and $8.00. Thecash flows relating to the derivative instruments are reflected in operatingactivities on our consolidated statements of cash flows. At December 31,2007, we had amounts due from our counterparty of $31,083 included in ouraccounts receivable in our consolidated balance sheet.

 

The settlements paid byus were cumulative monthly payments we made to our counterparty since the NYMEXcrude oil price was higher than the “ceiling crude oil price” of $83. The cashflows relating to the derivative instruments are reflected in operatingactivities on our consolidated statements of cash flows. At December 31,2007, we had amounts payable to our counterparty of $131,130 included inaccounts payable in our consolidated balance sheet.

 

We computed ourmark-to-market valuations used for our commodity derivatives based onassumptions regarding forward prices, volatility and the time value of money. Wecompared our valuations to our counterparties’ valuations to further validateour mark-to-market valuations. During the quarters ended December 31, 2007and 2006, we recognized unrealized loss on commodity derivatives in ourconsolidated statements of operations amounting to $1,845,862 and $693,016,respectively. During the six months ended December 31, 2007 and 2006, wehad recognized unrealized loss on commodity derivatives of $2,361,889 and$156,990, respectively.

 

**4.     ASSET RETIREMENT OBLIGATION**

 

Our asset retirementobligation (“ARO”) primarily represents the estimated present value of theamount we will incur to plug, abandon and remediate our producing properties atthe end of their productive lives, in accordance with applicable state laws. Wedetermine our ARO by calculating the present value of expected cash flowsrelated to the liability. Our asset retirement obligations are recorded ascurrent or non-current liabilities based on the estimated timing of theanticipated cash flows. At December 31, 2007, our liability for ARO was$2,459,553, of which $2,183,683 was considered long term.

 

The following tabledescribes the changes in our asset retirement obligations for the six monthsended December 31, 2007:

 
| Asset retirement obligation at June 30, 2007     |   | $       | 2,415,070 |   |
|-------------------------------------------------------|--------|---------|-----------|--------|
| Accretion of discount                                 |   | 108,637 |      |
| Liabilities settled                                   |   | (64,154 | )         |
| Asset retirement obligation at December 31, 2007 |   | $       | 2,459,553 |   |

 

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**5.     DEFERRED COMPENSATION**

 

As of December 31,2007, we have issued 490,000 restricted shares to key employees pursuant to our2005 Long-Term Incentive Plan, as summarized below:

 
| ** **                            | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date  Fair Value** | ** ** | **Fair Value** | ** ** |
|---------------------------------------|------------|------------|------------|----------------------------------------------------|------------|---------------------|------------|
| Outstanding at June 30, 2007     |       | 95,000     |       | $                                                  | 5.59       |                | $          | 530,950 |   |
| Shares granted on July 2, 2007   |       | 395,000    |       | $                                                  | 5.84       |                | $          | 2,306,800 |   |
| Outstanding at December 31, 2007 |       | 490,000    |       | $                                                  | 5.79       |                | $          | 2,837,750 |   |

 

On July 2, 2007, wegranted our executive officers restricted stock totaling 395,000 shares withthe restrictions on transfer lapsing for one-third of the shares on the first,second and third anniversaries of July 2, 2007.

 

A summary of the statusof our non-vested restricted shares and changes during the six months ended December 31,2007 is presented below:

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date  Fair Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------------------|------------|
| Non-vested at June 30, 2007     |       | 75,000     |       | $                                                  | 5.58       |   |
| Granted                              |       | 395,000    |       | 5.84                                               |       |
| Vested                               |       | (5,000     | )          | 5.03                                               |       |
| Forfeited                            |       | —     |       | —                                             |       |
| Non-vested at December 31, 2007 |       | 465,000    |       | $                                                  | 5.81       |   |

 

The other restrictedshare grants will vest to the individual employees based on future years ofservice ranging from one to three years depending on the life of the awardagreement. The fair value is based our actual stock price on the date of grantmultiplied by the number of restricted shares granted. As of December 31,2007, the value of non-vested restricted shares amounted to $2,700,200, whichis an increase of $2,281,650 as compared to the value for non-vested restrictedshares of $418,550 at June 30, 2007. The increase is primarilyattributable to the 395,000 shares granted on July 2, 2007, as shown inthe table above. For the quarters ended December 31, 2007 and 2006, wehave expensed $350,090 and $53,431, respectively, to stock compensation expensebased on amortizing the fair value over the requisite service period. For the sixmonths ended December 31, 2007 and 2006, we have expensed $700,173 and$146,809, respectively, to stock compensation expense.

 

**6.****             ****STOCK OPTIONS**

 

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

 

On November 30,2007, under the 2005 LTIP, we granted 35,241 total options to certainemployees. The exercise price is $7.47 per share. The options vest on November 30,2010 if the individual is still an employee on November 30, 2010.

 

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

 

A summary of options asof December 31, 2007 is as follows:

 

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| ** **                            | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding at June 30, 2007     |       | 801,513    |       | $                                      | 5.29       |   |
| Shares granted                        |       | 195,241    |       | 7.22                                   |       |
| Shares exercised                      |       | (50,000    | )          | 5.86                                   |       |
| Outstanding at December 31, 2007 |       | 946,754    |       | $                                      | 5.67       |   |

 

Thefair values of options granted during the six months ended December 31, 2007,along with the factors used to calculate the fair values of those options aresummarized in the table below:

 
| No. of shares                                                                               |   | 195,241                    |   |
|--------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
| Risk free interest rate                                                                          |   | 3.41 - 4.07      | %      |
| Expected life                                                                                    |   | 5  years                   |   |
| Expected volatility                                                                              |   | 49.1 – 49.7 | %      |
| Expected dividend yield                                                                          |   | 0                          | %      |
| Weighted average grant date fair value—exercise prices equal to  market value on grant date |   | $                          | 3.38   |   |
|                                                                                                  |        |                            |        |  |

 

Based on our $6.89 stockprice at December 31, 2007, the intrinsic value of the options outstandingwas approximately $1,240,000.

 

Total options exercisableat December 31, 2007 amounted to 586,803 shares and had a weighted averageexercise price of $5.68. At December 31, 2006, total options exercisableamounted to 325,000 shares and had a weighted average exercise price of $4.92. Uponexercise, we issue the full amount of shares exercisable per the term of theoptions from new shares. We have no plans to repurchase those shares in thefuture.

 

For the quarters ended December 31,2007 and 2006, we had recorded a charge to stock compensation expense of$726,785 and $114,699, respectively, for the estimated fair value of theoptions granted to our directors and employees. For the six months ended December 31,2007 and 2006, we had recorded a charge to stock compensation expense of$960,076 and $240,014, respectively, for the estimated fair value of theoptions granted to our directors and employees

 

**7.     NET LOSS PER COMMON SHARE**

 

Basic net income (loss)per common 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 common stock shares underlying the following:

 
| ** **                   | ** ** | **December 31,** | ** ** |
|------------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Stock options                |       | 996,754               |       | 894,185 |   |
| Warrants                     |       | 1,646,061             |       | 1,646,061 |   |
| Preferred stock              |       | 7,846,261             |       | 8,541,913 |   |
| PIK dividends                |       | 489,191               |       | 118,436 |   |
| Non-vested restricted shares |       | 465,000               |       | 115,000 |   |

 

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Theshares of common stock underlying the stock options, warrants, the preferredstock, PIK dividends and the restricted shares, as shown in the precedingtable, are not included in weighted average shares outstanding for the threeand six months ended December 31, 2007 and 2006 as their effects would beanti-dilutive.

 

**8.   RELATED PARTY TRANSACTIONS**

 

Pursuantto an agreement dated December 16, 2004, as amended, we agreed with R.C.Boyd Enterprises, a Delaware corporation, to become the lead sponsor of a televisionproduction called Honey Hole (the “Honey Hole Production”). For the quartersended December 31, 2007 and 2006, we paid an aggregate of $37,500 to R.C.Boyd Enterprises during both quarters.  For the six month periods ended December 31,2007 and 2006, we paid an aggregate of $75,000 to R.C. Boyd Enterprises duringboth periods.  From July 1, 2007 through December 31, 2008, weare to pay an aggregate of $225,000 ($37,500 per quarter). Pursuant to a newagreement dated as of December 5, 2007, after December 31, 2008, wewill no longer be a Honey Hole Production sponsor. We are entitled to receivetwo thirty second commercials during all broadcasts of the Honey HoleProduction and receive opening and closing credits on each episode. As part ofour sponsorship, we are able to provide fishing and outdoor opportunities forchildren with cancer, children from abusive family situations and militaryveterans. Randall Boyd, one of our current directors, is the sole shareholderof R.C. Boyd Enterprises.

 

**9.   PREFERRED STOCK CONVERSION**

 

OnOctober 17, 2007, 2,000 shares of our Series D Convertible PreferredStock (“Preferred Stock”) were converted into 349,119 shares of our commonstock. The issued common shares consisted of 347,826 shares based on the $5.75conversion price of the Preferred Stock and 1,293 shares in lieu of the accruedbut unpaid dividends from October 1, 2007 to October 17, 2007pursuant to the terms of the Preferred Stock.

 

OnDecember 4, 2007, 2,000 shares of our Preferred Stock were converted into352,772 shares of our common stock. The issued common shares consisted of347,826 shares based on the $5.75 conversion price of the Preferred Stock and4,946 shares in lieu of the accrued but unpaid dividends from October 1,2007 to December 4, 2007 pursuant to the terms of the Preferred Stock.

 

OnJanuary 8, 2008, 575 shares of our Preferred Stock were converted into100,175 shares of our common stock. The issued common shares consisted of100,000 shares based on the $5.75 conversion price of the Preferred Stock and175 shares in lieu of the accrued but unpaid dividends from January 1,2008 to January 8, 2008 pursuant to the terms of the Preferred Stock.

 

Asa direct result of this conversion, as of January 8, 2008, our preferredshares issued and outstanding are 44,541 shares and the liquidation preferenceis $47,431,793.

 

**10.  COMMON STOCK ISSUANCE**

 

OnNovember 7, 2007, we sold in a private placement 3.5 million shares of ourcommon stock at $7.15 per share for gross proceeds of $25.0 million.  Netproceeds were $23.4 million after deducting issuance costs of $1.6 million. Thenet proceeds were initially used to pay down our long-term debt due under thecredit agreement and have been and will subsequently be drawn down to fund ourcapital development program and general corporate purposes.

 

Inconnection with the private placement, we entered into a registration rightsagreement with the purchasers in such private placement. The registrationrights agreement provides that at our expense we will:

 

·                  File with the Securities and ExchangeCommission (“SEC”) within 45 days after the November 7, 2007 closingdate a registration statement on Form S-3 covering the resale of thecommon stock issued in the private placement;

 

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·                  Undertake to register such shares on a Form S-3as soon as we are eligible to use Form S-3 for such resale registration;and

·                  Keep the registration statement effectiveuntil the date the private placement purchasers may sell all of the securitiesregistered under the registration statement for such purchasers pursuant to Rule 144(k) promulgatedunder the Securities Act of 1933, as amended, or the date on which all theprivate placement purchasers have sold all of the securities registered underthe registration statement for such purchasers.

 

Sincewe were able to file the registration statement within 45 days after the November 7,2007 closing date and have the registration statement declared effective within90 days after the November 7, 2007 closing date, we did not have topay any liquidated damages to the purchasers. However, if we are not able to maintain the effectiveness of theregistration statement, subject to certain limitations, we will have to pay1.0% of the aggregate purchase price of the securities purchased in the privateplacement on the first day of such initial maintenance failure and on each 30thday after the day of such initial maintenance failure (pro rated for periodstotaling less than 30 days), with the maximum aggregate registration delaypayments being 10% of the aggregate purchase price.

 

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

 

**11.   COMMITMENTS AND CONTINGENCIES**

 

***Fire Litigation***

 

*Burnett Case*

 

OnMarch 23, 2006, the following lawsuit was filed in the 100th JudicialDistrict Court in Carson County, Texas; Cause No. 9840, The Tom L. andAnne Burnett Trust, by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr.,George Beggs, III and Ed Hudson, Jr. as Co-Trustees; Anne BurnettWindfohr; and Burnett Ranches, Ltd. v. Cano Petroleum, Inc., W.O.Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc.The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and natural gas operations starteda wildfire that began on March 12, 2006 in Carson County, Texas.

 

The plaintiffs (i) allege negligence and gross negligence and (ii) seekdamages, including, but not limited to, damages for damage to their land andlivestock, certain expenses related to fighting the fire and certain remedialexpenses totaling approximately $1.7 million to $1.8 million. In addition, theplaintiffs seek (i) termination of certain oil and natural gas leases, (ii) reimbursementfor their attorney’s fees (in the amount of at least $549,000) and (iii) exemplarydamages. The plaintiffs also claim that Cano and its subsidiaries are jointlyand severally liable as a single business enterprise and/or a generalpartnership or de facto partnership.  Theowner of the remainder of the mineral estate, Texas Christian University,intervened in the suit on August 18, 2006, joining Plaintiffs’ request toterminate certain oil and gas leases.

 

OnJune 21, 2007, the Judge of the 100th Judicial District Courtissued a Final Judgment (a) granting motions for summary judgment in favorof Cano and certain of its subsidiaries on plaintiffs’ claims for (i) breachof contract/termination of an oil and gas lease; and (ii) negligence; and (b) grantingthe plaintiffs’ no-evidence motion for summary judgment on contributorynegligence, assumption of risk, repudiation and estoppel affirmative defensesasserted by Cano and certain of its subsidiaries. The Final Judgment has beenappealed.

 

*Other Cases*

 

On April 28, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas,Cause No. 1922, Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WOEnergy, Inc. (“Adcock”). There are 

 

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47plaintiffs and three groups of intervenors that claim that the electricalwiring and equipment of Cano or certain of its subsidiaries relating to oil andgas operations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas.  The plaintiffs andintervenors (i) allege negligence, res ipsa loquitor, trespass andnuisance and (ii) seek damages, including, but not limited to, damages totheir land, buildings and livestock and certain remedial expenses totaling$11,297,684.  In addition, the plaintiffsand intervenors seek (i) reimbursement for their attorney’s fees and (ii) exemplarydamages.  The plaintiffs also claim thatCano and its subsidiaries are jointly and severally liable as a single businessenterprise and/or a general partnership or de facto partnership.

 

On April 10, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas, Cause No. 1920,Joseph Craig Hutchison and Judy Hutchison v. Cano Petroleum, Inc., W.O.Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc.(“Hutchinson”). The plaintiffs claim that the electrical wiring andequipment of Cano or certain of its subsidiaries relating to oil and gas operationsstarted a wildfire that began on March 12, 2006 in Carson County,Texas.  The plaintiffs (i) allegenegligence and trespass and (ii) seek undisclosed damages, including, butnot limited to, damages to their land and certain remedial expenses.  In addition, the plaintiffs seek exemplarydamages.

 

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

 

On July 3, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas,Cause No. 1928, Rebecca Lee Martinez, et al v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd., andWO Energy, Inc. (“Martinez”). The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas.  The plaintiffs (i) allege negligence and(ii) seek undisclosed damages for the wrongful death of two relatives,Gerardo Villarreal and Medardo Garcia, who they claim died as a result of thefire.  On August 6, 2006, anadditional heir of Medardo Garcia has intervened in this case alleging similarclaims and seeking similar relief.

 

On August 9, 2006, the following lawsuit wasfiled in the 233rd Judicial District Court of Gray County, Texas, Cause No. 34,423,Yolanda Villareal, Individually and on behalf of the Estate of GerardoVillareal v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd., and WO Energy, Inc. (“Villareal”).  The plaintiffs claim that the electricalwiring and equipment of Cano or certain of its subsidiaries relating to oil andgas operations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas. The plaintiffs (i) allege negligence and (ii) seekundisclosed damages, including exemplary damages, for the wrongful death ofGerardo Villarreal who they claim died as a result of the fire.  The plaintiffs also claim that Cano and itssubsidiaries are jointly and severally liable under vicarious liabilitytheories.  On August 22, 2006,relatives of Roberto Chavira have intervened in the case alleging similarclaims and seeking similar relief regarding the death of Roberto Chavira.

 

On March 14, 2007, the following lawsuit wasfiled in 100th Judicial District Court in Carson County, Texas; Cause No. 9994,Southwestern Public Service Company d/b/a Xcel Energy v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, andWO Energy, Inc. (“SPS”).  Theplaintiff claims that the electrical wiring and equipment of Cano or certain ofits subsidiaries relating to oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County, Texas.  The plaintiff (i) alleges negligence andbreach of contract and (ii) seeks $1,876,000 in damages for loss anddamage to transmission and distribution equipment, utility poles, lines andother equipment.  In addition, theplaintiff seeks reimbursement of its attorney’s fees.

 

On May 2, 2007, the following lawsuit was filedin the 84th Judicial District Court of Hutchinson County, 

 

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Texas,Cause No. 37,619, Gary and Genia Burgess, et al. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc.(“Burgess”).  Eleven plaintiffs claimthat electrical wiring and equipment relating to oil and gas operations of theCompany or certain of its subsidiaries started a wildfire that began on March 12,2006 in Carson County, Texas.  Five ofthe plaintiffs are former plaintiffs in the Adcock matter.  The plaintiffs (i) allege negligence, res ipsa loquitor, nuisance, andtrespass and (ii) seek damages, including, but not limited to, damages totheir land, buildings and livestock and certain remedial expenses totalingapproximately $1,152,480.  In addition,the plaintiffs seek (i) reimbursement for their attorney’s fees and (ii) exemplarydamages.  The plaintiffs also claim thatCano and its subsidiaries are jointly and severally liable as a single businessenterprise and/or as a partnership or de facto partnership.

 

On May 15, 2007, William L. Arrington, WilliamM. Arrington and Mark and Le’Ann Mitchell intervened in the SPScase.  The intervenors (i) allegenegligence, res ipsa loquitor, trespass and nuisance and (ii) seekexemplary damages and attorney’s fees. The intervenors also claim that Cano and its subsidiaries are jointlyand severally liable as a single business enterprise and/or a generalpartnership or de facto partnership.

 

On August 28, 2007, one of the intervenors inthe Adcock case, Travelers Lloyds Insurance Company, filed a Notice ofNonsuit requesting the court to sign an order dismissing its claims, which seekapproximately $367,627 of total damages, without prejudice.  The Courtgranted the Non-suit on September 12, 2007.

 

On September 25, 2007, the Texas Judicial Panelon Multidistrict Litigation granted Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc.’sMotion to Transfer Related Cases to Pretrial Court pursuant to Texas Rule ofJudicial Administration 13.  The Panel transferred all pending cases(Adcock, Chisum, Hutchison, Villareal, Martinez, SPS, Burgess, identified aboveand Valenzuela, identified below) that assert claims against the Company andits subsidiaries related to wildfires beginning on March 12, 2006 to asingle pretrial court for consideration of pretrial matters.  The Paneltransferred all pending cases to the Honorable Paul Davis, retired judge of the200th District Court of Travis County, Texas, as Cause No. D-1-GN-07-003353. On October 19, 2007, the Court entered a Case Management Order settingdeadlines for completion of discovery in January and February of 2008and a hearing date for summary judgment motions on April 14, 2008.

 

On October 3, 2007, Firstbank Southwest, asTrustee for the John and Eddalee Haggard Trust (the “Trust”) filed a Petitionin intervention as part of the Hutchison case.  The Trust claimsthat the electrical wiring and equipment of Cano or certain of its subsidiariesrelating to oil and gas operations started a wildfire that began on March 12,2006 in Carson County, Texas.  The Trust (i) allegesnegligence and trespass and (ii) seeks undisclosed damages, including, butnot limited to, damages to land and certain remedial expenses.  In addition, the Trust seeks exemplarydamages.

 

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

 

On December 18, 2007, the following lawsuit wasfiled in the 348th Judicial District Court of Tarrant County, Texas,Cause No. 348-227907-07, Norma Valenzuela, et al. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc.(“New Valenzuela”).  Six plaintiffs,including the two plaintiffs and intervenor from the nonsuited Martinez case, claim that the electrical wiring and equipment ofCano or certain of its subsidiaries relating to oil and gas operations starteda wildfire that began on March 12, 2006 in Carson County, Texas.  The plaintiffs (i) allege negligence and(ii) seek undisclosed damages for the wrongful death of four relatives,Manuel Dominguez, Roberto Chavira, Gerardo Villarreal and Medardo Garcia, whothey claim died as a result of the fire. In addition, plaintiffs seek (i) reimbursement for their attorney’sfees and (ii) exemplary damages.  The plaintiffs also claim that Cano and its subsidiaries are jointly andseverally liable as a single business enterprise and/or as a partnership or defacto partnership.  Cano and itssubsidiaries have answered the lawsuit and have transferred the case to the MDLproceeding in the 200th Judicial District Court of Travis County,Texas for pretrial purposes.  Cano and its subsidiaries have further 

 

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requestedthat venue of the underlying case be transferred from Tarrant County, Texas toRoberts, Gray or Carson County, Texas for trial.

 

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

 

On January 15, 2008, the Jones and McMordieRanch Partnership intervened in the consolidated case in the 200th DistrictCourt of Travis County, Texas as part of the SPS case.  The intervenor (i) allegesnegligence, trespass and nuisance and (ii) seeks exemplary damages.  The intervenor also claims that Cano and itssubsidiaries are jointly and severally liable as a single business enterpriseand/or as a partnership or de facto partnership.

 

None of the above-mentioned cases are currently setfor trial.  Due to the inherent risk oflitigation, the outcome of these cases is uncertain and unpredictable; however,at this time, Cano management believes the suits are without merit and isvigorously defending itself and its subsidiaries.

 

***Insurance Settlement***

 

Asdiscussed in our Form 10-K dated June 30, 2007, during February 2007,we received a $6,699,827 payment from Mid-Continent Casualty Company for policylimits totaling $6,000,000 and defense costs totaling $699,827. The $6,000,000payment for policy limits, in accordance with the credit agreement(Note 2), have been placed in a controlled bank account and the use of theproceeds is specified to pay attorney’s fees, settlement amounts, otherlitigation expenses incurred to defend and/or settle the fire litigation, andfor general corporate purposes. Specifically, we cannot use the proceeds tofund capital expenditures.  Accordingly, our consolidated balance sheets reflectthe $6,000,000 as a liability under deferred litigation credit.  The restricted cash of $2.8 million at December 31,2007, is $3.2 million lower than the restricted cash of $6.0 million at June 30,2007 as we have used restricted cash to fund our litigation expenses and forgeneral corporate purposes.

 

***Other***

 

Occasionally,we are involved in other various lawsuits and certain governmental proceedingsarising in the ordinary course of business. Our management does not believethat the ultimate resolution of any current matters that are not set forthabove, will have a material effect on our financial position or results ofoperations.  Management’s position is supported, in part, by the existenceof insurance coverage, indemnification and escrow accounts.  None of ourdirectors, officers or affiliates, owners of record or beneficial owners ofmore than five percent of any class of our voting securities, or securityholder is involved in a proceeding adverse to our business or has a materialinterest adverse to our business.

 

***Environmental***

 

Todate, our expenditures to comply with environmental or safety regulations havenot been significant and are not expected to be significant in the future.However, new regulations, enforcement policies, claims for damages or otherevents could result in significant future costs.

 

**Item 2. Management’s Discussion and Analysis on FinancialCondition and Results of Operations**

 

**Forward-Looking Statements**

 

The information in this report on Form 10-Qcontains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. This Act provides a “safe harbor”for forward-looking statements to encourage companies to provide prospectiveinformation about themselves provided they identify these statements as forwardlooking and provide meaningful cautionary statements identifying importantfactors that could cause actual results to differ from the projected results.All statements other 

 

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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, interest rates, estimates ofreserves, drilling risks, geological risks, transportation restrictions, thetiming of acquisitions, product demand, market competition, interruption inproduction, our ability to obtain additional capital, and the success ofwaterflooding and enhanced oil recovery techniques.

 

You should read the following discussion andanalysis in conjunction with the consolidated financial statements of Cano andsubsidiaries and notes thereto, included herewith. This discussion should notbe construed to imply that the results discussed herein will necessarilycontinue into the future, or that any conclusion reached herein willnecessarily be indicative of actual operating results in the future. Suchdiscussion represents only the best present assessment of management.

 

**Growth Strategy**

 

We are a growing independent oil and natural gascompany that intends to actively pursue enhanced oil recovery techniques toincrease production and reserves at our existing properties and propertiesacquired in the future.  Our primary focus is crude oil and our targetacquisitions are onshore U.S. properties.  Our focus on domestic, matureoil fields eliminates exploration risks and uncertainties of internationalsources.  We use waterflooding and enhanced oil recovery methods (“EOR”),such as alkaline/ surfactant/ polymer (“ASP”) technology.

 

During our first two years of operations through June 30,2006, our primary focus was to achieve growth through acquiring existing,mature oil and natural gas fields. In March 2007, we acquired PermianBasin oil and natural gas properties located in New Mexico. We believe theportfolio of oil and natural gas properties that we have acquired thus farprovides ample opportunities to apply our operational strategy. As of June 30,2007, we had proved reserves of 66,720 MBOE, of which 8,454 MBOE were provedproducing, 2,843 MBOE were proved non-producing, and 55,423 MBOE were provedundeveloped.

 

During the fiscal year ended June 30, 2007 andcontinuing into our current fiscal year ending June 30, 2008 (“2008 FiscalYear”), our primary emphasis is to achieve growth by developing our existingoil and natural gas properties through development activities such aswaterflooding and EOR technology. We will continue to evaluate potentialacquisition targets that are consistent with our operational strategy. Thesedevelopment activities are more clearly defined in the next section titled “CapitalDevelopment Update.”

 

***Capital DevelopmentUpdate***

 

For the 2008 Fiscal Year, our capital developmentbudget is $78.0 million.  Of this amount, we have incurred $41.9million, of which $39.8 million has been spent, for the six months ended December 31,2007.  We have accelerated our capital development in the Panhandlewaterflood and the Cato Field, and have increased our capital spending to drilleight additional wells and to handle the increased gas production from theBarnett Shale in our Desdemona Field during the quarter ended September 30,2007.  The status and planned activity of our capital development for the2008 Fiscal Year is summarized as follows:

 

***        PanhandleProperties.***    The drilling of the final contingent of 34 replacementwaterflood wells was completed during the six months ended December 31,2007. In total, we have drilled 70 replacement wells in the field, whichrepresents the completion of the development patterns of the waterfloodproject. Water injection was initiated at the Cockrell Ranch Unit on July 5,2007.  We have increased our water injection rates steadily since September 2007to a current rate of 48,000 barrels of water per day (BWPD).  We have injected close to 3.0 million barrelsof water into the Brown Dolomite formation.

 

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We have completed injection plant and productionfacility installation in both Phase I and Phase II of the project.  This represents 54 injectors and 50producers. Additionally, we expect to be operational by the end of February 2008with the remaining injectors and producers in the final contingent of Phase IIIdevelopment.

 

We are seeing preliminary response from 26 producingwells as increased water inflow, gas cut and incremental gas rates are beingreported. This is setting the stage for the waterflood response at the CockrellRanch Unit. Engineering calculations indicate that meaningful oil response isexpected to occur after approximately .15 to .25 pore volumes (“PV”) of waterhas been injected.  Therefore, when 15%to 25% of the void space has been displaced with water, the flood fronts areexpected to advance to a point where production response should be seen at theproducing wells.

 

In the Phase I, or south area of the Cockrell Ranch,which has been under injection since July 2007, we have injected between10% PV and 12% PV.  We are currentlyproducing approximately 5,000 barrels of fluid per day with an increasing oilcut. This response is as anticipated and we expect oil cuts to increase overthe near term as the flood front advances. In the NE area, or Phase II, we haveinjected over 1,000,000 barrels of water and have started to see increasingfluid levels and increased gas rates.  Weexpect the response to continue on a path similar to what is being experiencedin the south area, or Phase I.

 

As part of the accelerated waterflood development,an additional 61 total wells are planned to be drilled at the Panhandle Fieldencompassing 36 wells at the waterflood expansion at the Harvey Unit and 25wells to accelerate waterflood development at the Mobil-Fee Unit. The total2008 Fiscal Year capital budget for the Panhandle Properties is $31 million.

 

***       NewMexico Properties.***    Wecompleted the acquisition of the New Mexico Properties on March 30,2007.  As mentioned previously, pursuant to the $25 million privateplacement sale as discussed in Note 10, the capital budget has been increasedto $27.1 million for the New Mexico Properties.   We are focusing ona program of return-to-production and new well/infill drilling to develop theSan Andres formation in these properties. To date, 10 wells have been drilledand completed in the Cato field.

 

1.               **Return-to-Production (“RTP”)****:** We have returned 40 existing wells toproduction since the acquisition.  Wehave increased production from 35 BOEPD to over 80 BOEPD due to the RTPprogram. We have a workover rig committed to the Tomahawk field, as we haveseen RTP rates of 2-4 BOEPD from eight of these wells recently returned toproduction. Cano has approximately 10 more RTP candidates in Tomahawk Field andwill then focus on the TomTom Field.

 

2.               **New Well Drilling**: We currently have two drilling rigs andthree workover rigs working in the Cato field and we have drilled and completedten wells in the Cato Field.  Two wellswere 40-acre infill wells and had an initial production of approximately 5-8BOEPD.  Eight wells were 20-acre infillwells and had an initial production of approximately 10-30 BOEPD. These wellsare relatively shallow at 3,500 – 4,000 feet. Drilling and completion costs areestimated to range from $300,000 to $450,000 per well, depending on the numberof zones completed and fracture stimulations.

 

3.               **20-Acre Waterflood Development:**  Weplan to accelerate the waterflood development in two sections of the Cato Fieldby drilling the 20-acre infill wells. Our goal is to drill and complete allrequired wells by June 2008 and to commence waterflood facilityconstruction and start waterflood operations during our fiscal year ended June 30,2009.

 

***       DesdemonaProperties—Waterflood.    ***We received the final approval of our Phase Iwaterflood permit for the 640 acre G.E. Moore Lease from the Texas RailroadCommission on September 11, 2007.  Water injection commenced shortlythereafter and we have injected 700,000 barrels of water in total, into theDuke Sandstone reservoir via six injection wells.   We are seeing oil response at three producerswith an increasing oil cut.  Since thisis not a pattern waterflood, but a peripheral flood, the PV fill-up method isnot as exact as the Panhandle Field for determining response profiles.  However, we expect meaningful 

 

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increasesin the number of responding wells and increased oil response by the secondcalendar quarter of 2008.

 

***        DesdemonaProperties—Barnett Shale.    ***Severe storms and flooding in the DesdemonaField in late June 2007 and early July 2007 curtailed our BarnettShale production to one-half of the previous levels or roughly 100 BOEPD. Forthe quarter ended September 30, 2007, it is estimated that production wasdown by approximately 120 BOEPD. Equipment repairs and well re-works werecompleted in July and August 2007, and production was not restored toprior levels until late September.

 

In response to currently low natural gas prices,during October 2007, we elected to defer the drilling program in theBarnett Shale. Of the remaining capital amount of roughly $15.0 millioncommitted to this program, roughly $5.0 million will be re-directed to the CatoField and the remaining balance of $10.0 million could be committed to theBarnett Shale program once natural gas prices improve.

 

As anticipated, after westopped our drilling program in the Barnett Shale, decline rates have beenexperienced in gas production.  For December 2007,we had average daily production rate of approximately 100 BOEPD.  We continue to supply the Desdemona Fieldwaterflood with over 7,000 BWPD of produced water for injection from theBarnett Shale gas production.

 

***        NowataProperties.***    Ourtertiary recovery pilot project at the Nowata Field is operational.  TheASP pilot plant, associated equipment and supplies were installed and testedduring August and September 2007.  We began injecting ASPchemicals during December 2007.  Theplant had extended operational time through January 2008.  Response is anticipated in the secondcalendar quarter of 2008.

 

***        CorsicanaProperties.***    Wehave drilled and completed 16 pattern replacement wells in order to reinstate aprior waterflood in this field. We received the required permits to injectwater in June 2007. The waterflood was successfully re-instated in December 2007.  We achieved full injection of 4,000 BWPD andare monitoring initial flood results.  Weexpect to produce between 20-30 BOEPD during the first calendar quarter of2008.  As we previously mentioned, wehave been pleased with the remaining oil saturations in this field and coupledwith the prior successful polymer pilot in this field in the 1980’s we believethis field is a prime ASP candidate. Once the waterflood response andlaboratory results are analyzed, we anticipate evaluating an ASP Pilot in thefield in calendar year 2008.

 

***        DavenportProperties.    ***During the six months ended December 31,2007, we have returned to production five injector wells and four producingwells as we progress toward optimizing the waterflood pattern.  As a direct result of this RTP activity, theproduction has increased to 70-80 BOEPD.

 

We have nomajor development activities planned for the Pantwist Properties duringthe 2008 Fiscal Year.

 

**Liquidity and Capital Resources**

 

As discussed in Note 2, our credit agreement wasamended to increase our borrowing base from $44.0 million to $60.0million.  At December 31, 2007, we had outstanding long-term debt of$42.0 million and the average interest rate was 6.90%.  The creditagreement is our only source of debt.

 

At December 31, 2007, our cash balance was $0.9million.  For the six months ended December 31, 2007, we generatedcash from operations of $7.5 million, which is a $4.6 million improvement ascompared to the six months ended December 31, 2006.  The $4.6 million improvement is attributed torelease of restrictions related to restricted cash and increased income fromoperations.  As discussed in Note 2, the amended credit agreement relaxesthe restrictions of the $6.0 million of restricted cash to permit use forgeneral corporate purposes, in addition to attorney’s fees, settlement amountsand other litigation expenses incurred to defend and or settle the firelitigation discussed in Note 11.  Specifically, we cannot use therestricted cash to fund capital expenditures.

 

As discussed in Note 10, on November 7, 2007,we received net proceeds of $23.4 million from the private placement issuance of3.5 million shares of our common stock.  The net proceeds were initially 

 

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usedto pay down our long-term debt due under the credit agreement and have been andwill subsequently be drawn down to fund our capital development program aspreviously discussed under “*CapitalDevelopment Update*” and for general corporate purposes.

 

We believe the combination of cash on hand,restricted cash, cash flow generated from operations, strong commodity prices,net proceeds from the November 7, 2007 private placement issuance,expected success of the capital development projects and available debt issufficient to finance our operations, contractual obligations and capitalexpenditure program (as previously discussed in the section titled “*Capital Development Update”)* through June 30,2008.  We expect to seek access to the capital markets for potential debtor equity issuances to finance the execution and acceleration of our capitaldevelopment plan.

 

On December 28, 2007,the universal shelf registration statement was declared effective by the SECfor the issuance of common stock, preferred stock, warrants, senior debt andsubordinated debt up to an aggregate amount of $150 million.  We may periodically offer one or more ofthese securities in amounts, prices and on terms to be announced when and ifthe securities are offered. At the time any of the securities covered by theregistration statement are offered for sale, a prospectus supplement will beprepared and filed with the SEC containing specific information about the termsof any such offering.  We believe theuniversal shelf registration statement will enhance our financial flexibilityand allow us to act more quickly when potential acquisition or other businessopportunities might require us to access capital.  We have no immediate plans to utilize theuniversal shelf registration statement.

 

***CommodityDerivatives Activities***

 

As discussed in Note 3, pursuant to our creditagreement, we are required to enter into financial contracts to mitigate ourexposure to commodity price risk associated with expected oil and natural gasproduction. We have purchased crude oil price floors that range from $55 -$60 per barrel through December 2010.  We have purchased natural gas pricefloors that range from $7.00 - $8.00 per Mcf through December 2010. For the six months ended December 31, 2007, approximately 69% of our saleswere subject to price floors.

 

During the six months ended December 31, 2007,we entered into financial contracts to sell crude oil price ceilings at $83 perbarrel from August through December 2007, and $86 per barrel from January throughJune 2008.  For the six months ended December 31, 2007,approximately 35% of our sales were subject to price ceilings.

 

We entered into these short-term financial contractsto sell price ceilings in order to offset the costs of price floors we purchaseto comply with our credit agreement which requires we are to maintain commodityderivatives to cover no less than 50% and no more than 80% of our productionvolumes attributable to proved producing reserves for three years.  Exceptfor the price ceilings, we are entitled to 100% of our revenue receipts and, ifcrude oil and natural gas NYMEX prices are lower than the price floor, we willbe reimbursed for the difference between the NYMEX price and floorprice. If crude oil NYMEX prices are above the price ceiling, we have topay the difference between the ceiling price and the NYMEX price.

 

**Results of Operations**

 

For the quarter ended December 31, 2007 (“currentquarter”), we had a loss applicable to common stock of $1.6 million, which was$0.2 million higher as compared to the $1.4 million loss applicable to commonstock incurred for the quarter ended December 31, 2006 (“prior yearquarter”).  Increased revenues of $3.8 million were more than offset byhigher operating expenses of $2.3 million, reduced valuation of commodityderivatives of $1.2 million, lower income from the realized gain (loss) oncommodity derivatives of $0.3 million and lower income from discontinuedoperations of $0.1 million.

 

For the six months ended December 31, 2007 (“currentsix months”), we had a loss applicable to common stock of $2.8 million, whichwas $0.8 million higher as compared to the $2.0 million loss applicable tocommon stock incurred for the six months ended December 31, 2006 (“prioryear six 

 

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months”).  Positive factors, including increasedrevenues of $4.9 million and lower interest expense of $1.3 million, were morethan offset by higher operating expenses of $3.4 million, reduced valuation ofcommodity derivatives of $2.2 million, lower income from the realized gain(loss) on commodity derivatives of $0.5 million, higher preferred stock dividendsof $0.6 million and lower income from discontinued operations of $0.2 million.

 

These items will be addressed in the followingdiscussion.

 

***Operating Revenues***

 

The table below summarizes our operating revenuesfor the quarter and six months ended December 31, 2007 and 2006.

 
| ** **                         | ** ** | **Quarter ended  December 31,** | ** ** | **Increase** | ** ** | **Six months  ended December 31,** | ** ** | **Increase** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|--------------|------------|---------------------------------------------------|------------|--------------|------------|
| ** **                         | ** ** | **2007**                                  | ** ** | **2006**     | ** ** | **(Decrease)**                                    | ** ** | **2007**     | ** ** | **2006** | ** ** | **(Decrease)** | ** ** |
| Operating Revenues                 |       | $                                         | 10,018,879 |         | $          | 6,157,932                                         |       | $            | 3,860,947  |   | $ | 18,740,044 |   | $ | 13,832,732 |   | $ | 4,907,312 |   |
| Sales                              |       |                                      |       |         |       |                                              |       |         |       |   |   |   |   |
| ·  Crude Oil  (MBbls)    |       | 67                                        |       | 64           |       | 3                                                 |       | 136          |       | 134 |   | 2 |   |
| ·  Natural Gas  (MMcf)   |       | 365                                       |       | 308          |       | 57                                                |       | 716          |       | 638 |   | 78 |   |
| ·  Total (MBOE)          |       | 128                                       |       | 115          |       | 13                                                |       | 256          |       | 241 |   | 15 |   |
| Average Price                      |       |                                      |       |         |       |                                              |       |         |       |   |   |   |   |
| ·  Crude Oil ($/  Bbl)   |       | $                                         | 87.06      |         | $          | 58.40                                             |       | $            | 28.66      |   | $ | 79.73 |   | $ | 64.04 |   | $ | 15.69 |   |
| ·  Natural Gas  ($/ Mcf) |       | $                                         | 11.15      |         | $          | 7.84                                              |       | $            | 3.31       |   | $ | 10.77 |   | $ | 8.21 |   | $ | 2.56 |   |

 

The current quarter operating revenues of $10.0million represent an improvement of $3.8 million as compared to the prior yearquarter of $6.2 million. The $3.8 million improvement is primarily attributableto higher prices received for crude oil and natural gas sales of $1.9 millionand $1.2 million, respectively, and increased natural gas and crude oil salesof $0.5 million and $0.2 million, respectively.  The increased natural gassales are primarily attributed to Barnett Shale natural gas production from ourDesdemona Properties.  The increasedcrude oil sales are primarily attributed to production from the New MexicoProperties, as the prior year quarter did not have operating results from theNew Mexico Properties since we acquired these properties during March 2007.

 

The current six months operating revenues of $18.7million represent an improvement of $4.9 million as compared to the prior yearsix months of $13.8 million.  The $4.9million improvement is primarily attributable to higher prices received forcrude oil and natural gas sales of $2.1 million and $1.8 million, respectively,and increased natural gas and crude oil sales of $0.8 million and $0.2 million,respectively.  The increased natural gas and crude oil sales resulted fromthe same reasons as previously discussed for the current quarter.

 

Freezing weather during December adverselyaffected production and caused the Panhandle and Pantwist Properties totemporarily shut-in production for five days and the Davenport and NowataProperties to temporarily shut-in production for ten days.  Overall, thefreezing weather adversely impacted our total crude oil and natural gas salesvolumes by approximately 190 net BOEPD for December 2007 (approximately 63BOEPD for the current quarter).

 

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

 

***Operating Expenses***

 

For the current quarter, our total operatingexpenses were $8.9 million, or $2.3 million higher than the prior year quarterof $6.6 million. The $2.3 million increase is primarily attributed to highergeneral and

 

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administrative expensesof $1.1 million, increased lease operating expenses of $0.9 million, higherproduction and ad valorem taxes of $0.2 million, and depletion and depreciationexpense of $0.1 million.

 

Forthe current six months, our total operating expenses were $17.5 million, or$3.4 million higher than the prior year six months of $14.1 million. The $3.4million increase is primarily attributed to higher general andadministrative expenses of $1.6 million, increased lease operating expenses of$1.2 million, higher production and ad valorem taxes of $0.3 million, higherdepletion and depreciation expense of $0.2 million, and higher other expensesof $0.1 million.

 

Ourlease operating expenses (“LOE”) consist of costs of producing crude oil andnatural gas such as labor, supplies, repairs, maintenance, and utilities. Forthe current quarter, the LOE per BOE was $24.72 as compared to $19.62 per LOEfor the prior year quarter.  The increase is due to higher LOE incurredprimarily attributed to the weather related outages and non-recurring operatingexpense for the Desdemona Properties.  We generally incur a high amount ofLOE because our fields are more mature and typically produce less oil and morewater, and they are generally at the end of the primary or secondary productioncycle.  We expect the LOE per BOE to decrease during the 2008 calendaryear as production increases from the waterflood and EOR development activitieswe are implementing as discussed under the *“CapitalDevelopment Update*.”

 

Ourgeneral and administrative (G&A) expenses consist of support services forour operating activities and investor relations costs. For the current quarter,our G&A expenses totaled $3.8 million, which is $1.1 million higher thanthe prior year quarter of $2.7 million. The primary reasons for the $1.1million increase were increased stock compensation expense of $0.9 million dueto the issuance of restricted shares as discussed in Note 5 and issuance ofstock options as discussed in Note 6, and higher legal expenses pertaining tothe fire litigation as discussed in Note 11. For the current six months, our G&A expenses totaled $7.4 million,which is $1.6 million higher than the prior year six months of $5.8 million.  The $1.6 million increase is attributed tohigher stock compensation expense of $1.2 million and higher legal fees, aspreviously discussed.

 

Forthe current quarter and current six months, our depletion and depreciationexpense increased by $0.1 million and $0.2 million, as compared to therespective prior year periods.  Thisincludes depletion expense pertaining to our oil and natural gas properties,and depreciation expense pertaining to our field operations vehicles andequipment, natural gas plant, office furniture and computers.  For thecurrent quarter, our depletion rate pertaining to our oil and gas propertieswas $7.43 per barrel of oil equivalent (“BOE”), as compared to prior yearquarter of $6.97 per BOE.  For thecurrent six months, our depletion rate was $7.38 per BOE as compared to $6.76per BOE.  The current quarter and sixmonths have higher depletion rates due to lower proved producing reserves forthe Panhandle Properties, the acquisition of the New Mexico Properties and thedepletion rate associated with the natural gas production from the BarnettShale.

 

***Interest Expense***

 

Theinterest expense we incurred in the current quarter amounted to $0.3 million,as compared to $0.1 million for the prior year quarter.  For the currentsix months, our interest expense totaled $0.7 million, as compared to $2.0million for the prior year six months. The interest expense for the current quarter and current six months wasimpacted by $0.6 million and $1.1 million of interest cost that was capitalizedto the waterflood and ASP projects as discussed under the *“Capital Development Update.”* Therefore, our interest cost (including capitalized interest) for thecurrent quarter and six months is $0.8 million and $1.8 million,respectively.  The current quarter interestcost of $0.9 million is $0.8 million higher than the prior year quarter of $0.1million due to higher debt balances during the current quarter.  The current six months interest cost of $1.8million is $0.2 million lower than the prior year six months of $2.0 milliondue to overall lower debt balances during the current six months as compared toprior year.

 

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***Unrealized Gain (Loss) on CommodityDerivatives***

 

Asdiscussed in Note 3, we have entered into financial contracts to set pricefloors for crude oil and natural gas, and to set price ceilings for crudeoil.  For the current quarter, we recorded an unrealized loss of $1.8million to reflect the fair value of the commodity derivatives as of December 31,2007.  Our current quarter loss of $1.8 million is $1.1 million higherthan the prior year quarter of an unrealized loss of $0.7 million.  For the current six months, the unrealizedloss is $2.4 million, which is $2.2 million higher than the $0.2 unrealizedloss recorded for the prior year six months.  By their nature, thesecommodity derivatives can be highly volatile to our earnings.  A tenpercent change in these prices for our derivative instruments can impactearnings by approximately $0.1 million.

 

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

 

Duringthe current six months and prior year six months, there were net settlementsunder our derivative agreements due to Cano amounting to $0.3 million and $0.8million, respectively. The settlements were cumulative monthly paymentsreceived by Cano when the NYMEX natural gas price was lower than the $8.00 and$7.60 “floor natural gas prices,” as discussed in Note 3.  During the current quarter, Cano madepayments totaling $0.2 million since the NYMEX crude oil price was higher thanthe $83 “ceiling crude oil price,” as discussed in Note 3.

 

***Income Tax Benefit***

 

Forthe current quarter, we recorded an income tax benefit of $0.4 million, whichis comparable to the income tax benefit of $0.4 million during the prior yearquarter.  During the current six months, we recorded an income tax benefitof $0.5 million, as compared to $0.6 million during the prior year sixmonths.  The change is a direct result ofthe change in taxable income.

 

***Preferred Stock Dividend***

 

Thepreferred stock dividend for the current year quarter of $0.9 million is $0.1million less than the prior year quarter of $1.0 million.  The lower preferred dividend is due to theconversion of preferred stock to common stock as discussed in Note 9.  The current year six months of $1.9 million ishigher than the prior year six months of $1.2 million.  The current yearsix months amount represents a full six months.  The prior year six monthsis a smaller amount since it pertains to the period beginning September 6,2006, the date of the preferred stock issuance.

 

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

 

Asdiscussed on our Form 10-K dated June 30, 2007, we had sold ourinterest in the Rich Valley Properties during June 2007.  The prioryear quarter and prior year six months results of operations for Rich Valleyhave been reclassified as discontinued operations and are presented net ofrelated income taxes.  During the currentquarter, we had a loss of $0.1 million attributed to discontinued operationsdue to Oklahoma sales taxes.

 

***New Accounting Pronouncements***

 

On July 13,2006, the FASB released FIN 48, which requires a company to evaluate anddisclose material uncertain tax positions it has taken with various taxingjurisdictions.  Any interest and penalties related to uncertain taxpositions would be recorded as interest expense and general and administrativeexpense, respectively.  We adopted FIN 48 on July 1, 2007.  Atthe time of adoption and as of December 31, 2007, we determined theadoption of FIN 48 does not materially affect our operating results, financialposition, or cash flows.  As of December 31, 2007, we have notrecorded any accruals for uncertain tax positions.  We are not involved inany examinations by the Internal Revenue Service.  For Texas, Oklahoma andU.S. federal purposes, the review of our tax returns is open for the tax yearsof 2004, 2005 and 2006.  We have not yet filed our tax returns for 2007tax year for Texas, Oklahoma, New Mexico and U.S. federal.

 

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

 

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

 

In December 2007,the FASB issued SFAS No. 160, which establishes accounting and reportingstandards for noncontrolling interests in a subsidiary and for thedeconsolidation of a subsidiary.  Minority interests will berecharacterized as noncontrolling interests and classified as a component ofequity.  It also establishes a single method of accounting for changes ina parent’s ownership interest in a subsidiary and requires expandeddisclosures.  This statement is effective for fiscal years beginning on orafter December 15, 2008, with early adoption prohibited.  We do notexpect the adoption of this statement will have a material impact on ourfinancial position or results of operations.

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk.**

 

SeeNotes 2 and 3 regarding the updates of our market risk for the quarter ended December 31,2007.

 

**Item 4.Controls and Procedures.**

 

As ofthe end of the period covered by this report, we conducted an evaluation, underthe supervision and with the participation of our chief executive officer andchief financial officer of our disclosure controls and procedures as defined inRule 13a-15(e) and Rule 15d-15(e) of the SecuritiesExchange Act of 1934 (the “Exchange Act”). Based upon this evaluation, ourchief executive officer and chief financial officer concluded that ourdisclosure controls and procedures were effective to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is: (1) accumulated and communicated to our management,including our chief executive officer and chief financial officer, asappropriate to allow timely decisions regarding required disclosure; and (2) recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

Duringthe quarter ended December 31, 2007, there was no change in our internalcontrol over financial reporting that has materially affected or is reasonablylikely to materially affect our internal control over financial reporting.

 

**PART II — OTHER INFORMATION**

 

**Item 1.Legal Proceedings.**

 

SeeNote 11 which is incorporated into this “Item 1. Legal Proceedings” byreference.

 

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**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**.

 

***November 2007 Common Stock Sale***

 

Asdescribed in Current Reports on Form 8-K filed on November 6, 2007and November 13, 2007, on November 2, 2007, Cano entered into aSecurities Purchase Agreement with 29 institutional investors and on November 7,2007 issued 3,500,000 shares of common stock at a price of $7.15 per share foraggregate gross proceeds of $25,025,000. The exact number of shares of common stock purchased by each investor isset forth in the Schedule of Buyers included in the Securities PurchaseAgreement filed as Exhibit 10.1 with the Current Report on Form 8-Kon November 6, 2007.  The offer andsale of common stock was made pursuant to Rule 506 promulgated pursuant tothe Securities Act of 1933, as amended, since each of the Investors was an “accreditedinvestor” as defined by Rule 501 promulgated pursuant to the SecuritiesAct of 1933, as amended.

 

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

 

Asdescribed in a Current Report on Form 8-K filed on October 22, 2007,on October 17, 2007, 1,878 shares of Series D Convertible PreferredStock (the “Preferred Stock”) of Cano were converted by Fort Mason Master, L.P.into 327,823 shares of Cano common stock and 122 shares of Preferred Stock wereconverted by Fort Mason Partners, L.P. into 21,296 shares of Cano common stock.Of the shares of Cano common stock issued, an aggregate of 347,826 shares wereissued based on the $5.75 conversion price of the Preferred Stock and anaggregate of 1,293 shares were issued in lieu of the accrued but unpaiddividends from October 1, 2007 – October 17, 2007 pursuant to theterms of the Preferred Stock. The shares of Cano common stock were issued inreliance upon the exemption from registration provided by Section 3(a)(9) ofthe Securities Act of 1933, as amended.

 

Asdescribed in a Current Report on Form 8-K filed on December 7, 2007,on December 4, 2007, 1,878 shares of Preferred Stock of Cano wereconverted by Fort Mason Master, L.P. into 331,253 shares of Cano common stockand 122 shares of Preferred Stock were converted by Fort Mason Partners, L.P.into 21,519 shares of Cano common stock . Of the shares of Cano common stockissued, an aggregate of 347,826 shares were issued based on the $5.75conversion price of the Preferred Stock and an aggregate of 4,946 shares wereissued in lieu of the accrued but unpaid dividends from October 1, 2007 – December 4,2007 pursuant to the terms of the Preferred Stock. The shares of Cano commonstock were issued in reliance upon the exemption from registration provided by Section 3(a)(9) ofthe Securities Act of 1933, as amended.

 

On January 8,2008, 523 shares of Preferred Stock of Cano were converted by Truk OpportunityFund, LLC into 91,116 shares of Cano common stock and 52 shares of PreferredStock were converted by Truk International Fund, LP into 9,059 shares of Canocommon stock. Of the shares of Cano common stock issued, an aggregate of100,000 shares were issued based on the $5.75 conversion price of the PreferredStock and an aggregate of 175 shares were issued in lieu of the accrued butunpaid dividends from January 1, 2008 – January 8, 2008 pursuant tothe terms of the Preferred Stock. The shares of Cano common stock were issuedin reliance upon the exemption from registration provided by Section 3(a)(9) ofthe Securities Act of 1933, as amended.

 

Pursuantto a cashless exercise, OTA, LLC (i) on January 18, 2008, exercisedwarrants into 41,741 shares of Cano common stock and (ii) on January 22,2008, exercised warrants into 40,660 shares of Cano common stock.  The warrant exercise price was $4.79 pershare.  Since these were cashlessexercises, the shares of Cano common stock were issued in reliance upon the exemptionfrom registration provided by Section 3(a)(9) of the Securities Act of1933, as amended.

 

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

###### ** **

###### **We submitted a proxy statement to the Company’sstockholders as of the record date, October 29, 2007.  The proxy statement was furnished to theCompany’s stockholders in connection with the Annual Meeting of Stockholdersheld on December 12, 2007.  Therewere 33,482,217 shares of common stock**

###### ** **

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###### ** **

###### **entitled to vote at the meeting and 47,116 shares of our Series DConvertible Preferred Stock entitled to vote at the meeting, on an as convertedbasis into 8,990,395 shares of common stock. For all items there were 42,472,612 shares entitled to vote at themeeting.  For the election of the Boardof Directors, the results were as follows:**

 
| **Nominee**                                 | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** |
|---------------------------------------------|------------|--------------------|------------|---------------------|------------|
|  S. Jeffrey Johnson (1) |       | 22,580,242         |       | 341,041             | ** ** |
|  Gerald W. Haddock (1)                 |       | 22,580,592         |       | 340,691             |       |
|  Randall Boyd (1)                      |       | 22,482,879         |       | 438,404             |       |
|  Robert L. Gaudin (1)                  |       | 22,475,935         |       | 445,348             |       |
|  Donald W. Niemiec (1)                 |       | 22,583,205         |       | 338,078             |       |
|  William O. Powell III (1)             |       | 22,574,632         |       | 346,651             |       |
|  David W. Wehlmann                     |       | 22,580,625         |       | 340,658             |       |

 

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(1) Incumbent

 

For the ratification of Hein & AssociatesLLP as Cano’s independent registered public accounting firm for the year ended June 30,2008, the results were as follows:

 
| **Votes For** | ** ** | **Votes  Against** | ** ** | **Votes  Abstained** | ** ** |
|--------------------|------------|--------------------|------------|----------------------|------------|
| 22,793,571         |       | 70,920             |       | 56,791               | ** ** |

 

 **Item 6. Exhibits.**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                            |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | First Amended and Restated  Bylaws, incorporated by reference from Exhibit 3.1 to the Current Report  on Form 8-K filed on December 7, 2007.                                                                |
| 3.2                 |       | Articles of Incorporation  of Square One Energy, Inc., incorporated by reference from  Exhibit 3.9 to the Registration Statement on Form S-3  (No. 333-148053 filed on December 13, 2007.)        |
| 3.3                 |       | Bylaws of Square One  Energy, Inc., incorporated by reference from Exhibit 3.10 to the  Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                          |
| 3.4                 |       | Certificate of  Incorporation of Ladder Companies, Inc., incorporated by reference from Exhibit 3.11  to the Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)     |
| 3.5                 |       | Bylaws of Ladder  Companies, Inc., incorporated by reference from Exhibit 3.12 to the  Registration Statement on Form S-3 (No. 333-148053 filed on December 13,  2007.)                           |
| 3.6                 |       | Articles of Incorporation  of W.O. Energy of Nevada, Inc., incorporated by reference from  Exhibit 3.13 to the Registration Statement on Form S-3  (No. 333-148053 filed on December 13, 2007.)   |
| 3.7                 |       | Bylaws of W.O. Energy of  Nevada, Inc., incorporated by reference from Exhibit 3.14 to the  Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                      |
| 3.8                 |       | Articles of Incorporation  of WO Energy, Inc., incorporated by reference from Exhibit 3.15 to  the Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)               |
| 3.9                 |       | Bylaws of WO  Energy, Inc., incorporated by reference from Exhibit 3.16 to the  Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                                  |
| 3.10                |       | Certificate of Formation  of Pantwist, LLC, incorporated by reference from Exhibit 3.17 to the  Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                       |
| 3.11                |       | Company Agreement of  Pantwist, LLC, incorporated by reference from Exhibit 3.18 to the  Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                              |
| 3.12                |       | Certificate of Formation  of Cano Petro of New Mexico, Inc., incorporated by reference from  Exhibit 3.19 to the Registration Statement on Form S-3  (No. 333-148053 filed on December 13, 2007.) |
| 3.13                |       | Bylaws of Cano Petro of  New Mexico, Inc., incorporated by reference from Exhibit 3.20 to  the Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                   |
| 3.14                |       | Certificate of Limited  Partnership of W.O. Operating Company, Ltd., incorporated by                                                                                                                                       |

 

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|   |   | reference from  Exhibit 3.21 to the Registration Statement on Form S-3  (No. 333-148053 filed on December 13, 2007.)                                                                                                                                                                                                                                                                                                                  |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.15   |   | Agreement of Limited  Partnership of W.O. Operating Company, Ltd., incorporated by reference from  Exhibit 3.22 to the Registration Statement on Form S-3  (No. 333-148053 filed on December 13, 2007.)                                                                                                                                                                                                                               |
| 3.16   |   | Certificate of Limited  Partnership of W.O. Production Company, Ltd., incorporated by reference from  Exhibit 3.23 to the Registration Statement on Form S-3  (No. 333-148053 filed on December 13, 2007.)                                                                                                                                                                                                                            |
| 3.17   |   | Agreement of Limited  Partnership of W.O. Production Company, Ltd., incorporated by reference from  Exhibit 3.24 to the Registration Statement on Form S-3 (No. 333-148053  filed on December 13, 2007.)                                                                                                                                                                                                                              |
| 4.1    |   | Registration Rights  Agreement dated November 2, 2007 by and among Cano Petroleum, Inc.  and the Buyers listed therein, incorporated by reference from  Exhibit 4.1 to the Current Report on Form 8-K filed on November 6,  2007.                                                                                                                                                                                                |
| 4.2    |   | Form of Common Stock  Certificate, incorporated by reference from Exhibit 4.9 to the  Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                                                                                                                                                                                                                                                           |
| 10.1   |   | Securities Purchase  Agreement dated November 2, 2007 by and among Cano Petroleum, Inc.  and the Buyers listed therein, incorporated by reference from  Exhibit 10.1 to Current Report on Form 8-K filed on  November 6, 2007.                                                                                                                                                                                                   |
| 10.2   |   | Sponsorship Agreement  dated December 5, 2007 by and between Cano Petroleum, Inc. and R.C.  Boyd Enterprises, LLC., incorporated by reference from Exhibit 10.1 to  the Registration Statement on Form S-3 (No. 333-148053 filed on  December 13, 2007.)                                                                                                                                                                    |
| 10.3*  |   | Amendment No. 8 and  Agreement dated as of January 16, 2008 by and among Cano  Petroleum, Inc., Square One Energy, Inc., Ladder  Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc.,  Pantwist, LLC, Cano Petro of New Mexico, Inc., W.O. Operating Company,  Ltd. and W.O. Production Company, Ltd., Union Bank of California, N.A., as  Administrative Agent, Issuing Lender and Lender and Natixis. |
| 10.4*  |   | Amendment dated  January 2, 2008 to Stock Option Agreement of Donnie D. Dent dated  December 13, 2005.                                                                                                                                                                                                                                                                                                                                          |
| 10.5*  |   | Amendment dated  January 2, 2008 to Stock Option Agreement of Donnie D. Dent dated  December 28, 2006.                                                                                                                                                                                                                                                                                                                                          |
| 10.6*  |   | Board of Directors  Compensation effective January 1, 2008.                                                                                                                                                                                                                                                                                                                                                                                          |
| 12.1   |   | Ratio of Earnings to Fixed  Charges, incorporated by reference from Exhibit 12.1 to the Registration  Statement on Form S-3 (No. 333-148053 filed on December 13,  2007.)                                                                                                                                                                                                                                                             |
| 31.1*  |   | Certification by Chief  Executive Officer, required by Rule 13a-14(a or  Rule 15d-14(a of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.)                                                                                                                                                                                                                                             |
| 31.2*  |   | Certification by Chief  Financial Officer, required by Rule 13a-14(a or Rule 15d-14(a of  the Exchange Act, promulgated pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.)                                                                                                                                                                                                                                             |
| 32.1*  |   | Certification by Chief  Executive Officer, required by Rule 13a-14(b or  Rule 15d-14(b of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.)                                                                                                                                                                  |
| 32.2*  |   | Certification by Chief  Financial Officer, required by Rule 13a-14(b or  Rule 15d-14(b of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.)                                                                                                                                                                  |

 

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| * |   | Filed herewith |
|---|--------|----------------|

 

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**SIGNATURES**

 

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

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

 

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