UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

FORM 10-Q

(Mark One)ý

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended December 31, 2009o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


Commission file number 001-32496

CANO PETROLEUM, INC.(Exact name of registrant as specified in its charter)

Delaware(State or other jurisdiction of
incorporation or organization)

77-0635673(I.R.S. Employer
Identification Number)801 Cherry St., Suite 3200
Fort Worth, Texas(Address of principal executive offices)

76102(Zip Code)(817) 698-0900(Registrant's telephone number, including area code)


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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o (Do not check if a smaller reporting company)

Smaller reporting company ý


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

The number of shares outstanding of the registrant's common stock, par value $.0001 per share, as of February 12, 2010 was 45,570,147 shares.



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PART IFINANCIAL INFORMATION

Item 1.    Financial Statements.

CANO PETROLEUM, INC.        CONSOLIDATED BALANCE SHEETS        (Unaudited)

In Thousands, Except Shares and Per Share Amounts

December 31,
2009

June 30,
2009ASSETSCurrent assetsCash and cash equivalents

$
511

$
392Accounts receivable


2,303


2,999Derivative assets


2,976


4,955Inventory and other current assets


1,465


810Total current assets


7,255


9,156Oil and gas properties,successful efforts method


293,124


288,857Less accumulated depletion and depreciation


(42,776
)

(40,208
)Net oil and gas properties


250,348


248,649Fixed assets and other, net


2,838


3,240Derivative assets


654


2,882Goodwill


101


101TOTAL ASSETS

$
261,196

$
264,028LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS' EQUITYCurrent liabilitiesAccounts payable

$
4,427

$
4,434Accrued liabilities


1,888


2,003Deferred tax liabilities


807


1,431Oil and gas sales payable


780


702Derivative liabilities


199


159Current portion of long-term debt (Note 3)


66,700


Current portion of asset retirement obligations


90


86Total current liabilities


74,891


8,815Long-term liabilitiesLong-term debt





55,700Asset retirement obligations


2,950


2,818Derivative liabilities


3,723


Deferred tax liabilities


17,412


22,831Total liabilities


98,976


90,164Temporary equitySeries D convertible preferred stock and cumulative paid-in-kind dividends; no par value, stated value $1,000 per share; 49,116 shares
authorized; 23,849 issued at December 31, 2009 and June 30, 2009, respectively; liquidation preference at December 31, 2009 and June 30, 2009 of $27,544 and $26,987, respectively


25,961


25,405Commitments and contingencies (Note 13)Stockholders' equityCommon stock, par value $.0001 per share; 100,000,000 authorized; 47,273,224 and 45,570,147 shares issued and outstanding, respectively, at
December 31, 2009; and 47,297,910 and 45,594,833 shares issued and outstanding, respectively, at June 30, 2009


5


5Additional paid-in capital


190,211


189,526Accumulated deficit


(53,260
)

(40,375
)Treasury stock, at cost; 1,703,077 shares held in escrow at December 31, 2009 and June 30, 2009, respectively


(697
)

(697
)Total stockholders' equity


136,259


148,459TOTAL LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS' EQUITY

$
261,196

$
264,028


See accompanying notes to these unaudited financial statements.

2

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CANO PETROLEUM, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        (Unaudited)

Three Months Ended
December 31,

Six Months Ended
December 31,In Thousands, Except Per Share Data

2009

2008

2009

2008Operating Revenues:Crude oil sales

$
4,713

$
3,685

$
9,144

$
11,803Natural gas sales


1,430


1,112


2,263


3,846Other revenue





79





159Total operating revenues


6,143


4,876


11,407


15,808Operating Expenses:Lease operating


3,927


4,774


8,343


9,843Production and ad valorem taxes


528


426


995


1,479General and administrative


2,875


9,544


6,448


14,404Exploration expense (Note 11)


5,024





5,024


Impairment of long-lived assets (Note 12)


283


22,398


283


22,398Depletion and depreciation


1,260


1,361


2,522


2,572Accretion of discount on asset retirement obligations


69


76


136


150Total operating expenses


13,966


38,579


23,751


50,846Loss from operations


(7,823
)

(33,703
)

(12,344
)

(35,038
)Other income (expense):Interest expense and other


(297
)

(119
)

(456
)

(254
)Impairment of goodwill





(685
)




(685
)Gain (loss) on derivatives


(4,727
)

21,298


(5,239
)

44,994Total other income (expense)


(5,024
)

20,494


(5,695
)

44,055Income (loss) from continuing operations before income taxes


(12,847
)

(13,209
)

(18,039
)

9,017Deferred income tax benefit (expense)


4,413


4,581


6,044


(4,038
)Income (loss) from continuing operations


(8,434
)

(8,628
)

(11,995
)

4,979Income from discontinued operations, net of related taxes of





12,246





11,393Net income (loss)


(8,434
)

3,618


(11,995
)

16,372Preferred stock dividend


(420
)

(855
)

(890
)

(1,791
)Preferred stock repurchased for less than carrying amount





10,890





10,890Net income (loss) applicable to common stock

$
(8,854
)
$
13,653

$
(12,885
)
$
25,471Net income (loss) per sharebasicContinuing operations

$
(0.19
)
$
0.03

$
(0.28
)
$
0.30Discontinued operations





0.27





0.25Net income (loss) per sharebasic

$
(0.19
)
$
0.30

$
(0.28
)
$
0.55Net income (loss) per sharedilutedContinuing operations

$
(0.19
)
$
0.04

$
(0.28
)
$
0.29Discontinued operations





0.23





0.21Net income (loss) per sharediluted

$
(0.19
)
$
0.27

$
(0.28
)
$
0.50Weighted average common shares outstandingBasic


45,570


46,079


45,570


46,155Diluted


45,570


53,932


45,570


54,518


See accompanying notes to these unaudited financial statements.

3

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CANO PETROLEUM, INC.        CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY        JULY 1, 2009 THROUGH DECEMBER 31, 2009        (Unaudited)

Common Stock





Treasury StockAdditional
Paid-in
Capital

Accumulated
Deficit

Total
Stockholders'
EquityDollar Amounts in Thousands

Shares

Amount

Shares

AmountBalance at July 1, 2009


47,297,910

$
5

$
189,526

$
(40,375
)

1,703,077

$
(697
)
$
148,459Forfeiture and surrender of restricted stock


(24,686
)




(28
)










(28
)Stock-based compensation expense








713











713Preferred stock dividend











(890
)







(890
)Net loss











(11,995
)







(11,995
)Balance at December 31, 2009


47,273,224

$
5

$
190,211

$
(53,260
)

1,703,077

$
(697
)
$
136,259


See accompanying notes to these unaudited financial statements.

4

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

Six Months Ended
December 31,In Thousands

2009

2008Cash flow from operating activities:Net income (loss)

$
(11,995
)
$
16,372Adjustments needed to reconcile net income (loss) to net cash used in operations:Unrealized loss (gain) on derivatives


8,160


(43,180
)Gain on sale of oil and gas properties





(19,309
)Accretion of discount on asset retirement obligations


136


153Depletion and depreciation


2,522


2,587Exploration expense


5,024Impairment of long-lived assets


283


25,914Impairment of goodwill





685Stock-based compensation expense


713


1,761Deferred income tax expense (benefit)


(6,044
)

10,567Amortization of debt issuance costs and prepaid expenses


863


713Changes in assets and liabilities relating to operations:Accounts receivable


782


2,578Derivative assets


(277
)

1,882Inventory and other current assets and liabilities


(1,233
)

(1,216
)Accounts payable


316


(721
)Accrued liabilities


(141
)

(1,554
)Derivative liability





(373
)Net cash used in operations


(891
)

(3,141
)Cash flow from investing activities:Additions to oil and gas properties, fixed assets and other


(9,607
)

(35,982
)Proceeds from sale of oil and gas properties





40,667Net cash provided by (used in) investing activities


(9,607
)

4,685Cash flow from financing activities:Repayments of long-term debt





(73,500
)Borrowings of long-term debt


11,000


30,000Payments for debt issuance costs





(916
)Proceeds from issuance of common stock, net





53,908Repurchases of preferred stock





(10,377
)Payment of preferred stock dividend


(383
)

(762
)Net cash provided by (used in) financing activities


10,617


(1,647
)Net increase in cash and cash equivalents


119


(103
)Cash and cash equivalents at beginning of period


392


771Cash and cash equivalents at end of period

$
511

$
668Supplemental disclosure of noncash transactions:Payments of preferred stock dividend in kind

$
557

$
1,029Preferred stock repurchased for less than carrying amount

$


$
10,890Supplemental disclosure of cash transactions:Cash paid during the period for interest

$
1,445

$
815


See accompanying notes to these unaudited financial statements.

5

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CANO PETROLEUM, INC.        NOTES TO FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND USE OF ESTIMATES

Consolidation and Use of Estimates

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

The
accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") and include the accounts of
Cano Petroleum, Inc. and its wholly-owned subsidiaries ("Cano"). Intercompany accounts and transactions are eliminated. In preparing the accompanying financial statements, management has made certain
estimates and assumptions that affect reported amounts in the financial statements and disclosures of contingencies. Actual results may differ from those estimates. The computation of stock-based
compensation expense requires assumptions such as volatility, expected life and the risk-free interest rate. The computation of mark-to-market valuation of our
commodity derivatives includes the observability of quoted market prices and an assessment of potential non-performance of the counterparties. It is possible these estimates could be
revised in the near term, and these revisions could be material.

Significant
assumptions are required in the valuation of proved crude oil and natural gas reserves, which may affect the amount at which crude oil and natural gas properties are
recorded. Our estimates of proved reserves materially impact depletion expense. If proved reserves decline, then the rate at which we record depletion expense increases. A decline in estimated proved
reserves could result from lower prices, adverse operating results, mechanical problems at our wells and catastrophic events such as fires, hurricanes and floods. Lower prices also may make it
uneconomical to drill wells or produce from fields with high operating costs. In addition, a decline in proved reserves may impact our assessment of our oil and natural gas properties for impairment.
Our proved reserves estimates are based upon many assumptions, all of which could deviate materially from actual results. As such, reserve estimates may vary materially from the ultimate quantities of
crude oil and natural gas actually produced.

New Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board ("FASB") issued a standard that established the FASB Accounting Standards
CodificationTM ("ASC") and amended the hierarchy of GAAP such that the ASC became the single source of authoritative nongovernmental GAAP. The ASC did not change current GAAP, but was
intended to simplify user access to all authoritative GAAP by providing all the authoritative literature related to a particular topic in one place. All previously existing accounting standard
documents were superseded and all other accounting literature not included in the ASC is considered non-authoritative. New accounting standards issued subsequent to June 30, 2009
are communicated by the FASB through Accounting Standards Updates. The ASC

6

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

1. BASIS OF PRESENTATION AND USE OF ESTIMATES (Continued)

became
effective for us on July 1, 2009. This standard did not have an impact on our financial position, results of operations or cash flows. Throughout the notes to the consolidated financial
statements, references that were previously made to various former authoritative GAAP pronouncements have been conformed to the appropriate section of the ASC.

In
December 2007, the FASB issued ASC 805 (formerly Statement of Financial Accounting Standards ("SFAS") No. 141 (revised 2007),Business
Combinations). Among other things, ASC 805 establishes principles and requirements for how the acquirer in a business combination: (i) recognizes and measures in
its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquired business; (ii) recognizes and measures the goodwill acquired
in the business combination or the gain from a bargain purchase; and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and
financial effects of the business combination. ASC 805 is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. We adopted ASC 805 on
July 1, 2009.

In
December 2007, the FASB issued ASC 810 (formerly SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements, An Amendment of ARB
No. 51). ASC 810 establishes accounting and reporting standards for noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. Minority
interests will be recharacterized as noncontrolling interests and classified as a component of equity. It also establishes a single method of accounting for changes in a parent's ownership interest in
a subsidiary and requires expanded disclosures. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. We adopted ASC 810
on July 1, 2009. The adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

In
March 2008, the FASB issued ASC 815 (formerly SFAS No. 161,Disclosures about Derivative Instruments and Hedging ActivitiesAn
Amendment of FASB Statement 133). ASC 815 expands the required disclosures to discuss the uses of derivative instruments; the accounting for derivative
instruments and related hedged items under ASC 815, and how derivative instruments and related hedged items affect the company's financial position, financial performance and cash flows. We
adopted ASC 815 on July 1, 2009. The adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

In
June 2008, the FASB issued ASC 260 (formerly EITF 03-6-1,Determining Whether Instruments Granted in Share-Based Payment
Transactions Are Participating Securities). ASC 260 addresses whether instruments granted in share-based payment transactions are participating securities prior to
vesting and need to be included in the calculation of earnings per share under the two-class method. Under ASC 260, share-based payment awards that contain nonforfeitable rights to
dividends are "participating securities", and therefore should be included in computing earnings per share using the two-class method. ASC 260 is effective for financial statements
issued for fiscal years and interim periods beginning after December 15, 2008. We adopted ASC 260 on July 1, 2009. The effect of adopting ASC 260 increased the number of
shares used to compute our earnings per share; however, the adoption of ASC 260 did not have a material impact on our financial position, results of operations or cash flows.

In
December 2008, the FASB issued ASC 815 (formerly EITF 07-5,Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity's Own Stock). ASC 815 affects companies that have provisions in their securities purchase agreements that provide for the reset of the current

7

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

1. BASIS OF PRESENTATION AND USE OF ESTIMATES (Continued)

conversion
price based upon new issuances by companies at prices below certain thresholds. Securities purchase agreements with such provisions will require the embedded derivative instrument to be
bifurcated and separately accounted for as a derivative. Subject to certain exceptions, our preferred stock provides for resetting the conversion price if we issue new common stock below $5.75 per
share. ASC 815 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. We adopted ASC 815 on July 1, 2009. The
adoption of this statement did not have a material impact on our financial position, results of operations or cash flows as the reset conversion provision did not meet the definition of a derivative
since it was not readily net-cash settled.

In
December 2008, the Securities and Exchange Commission (SEC) issued the final rule,Modernization of Oil and Gas Reporting. The new
disclosure requirements include provisions that permit the use of new technologies to determine proved reserves if those technologies lead to reliable conclusions about reserve quantities. The new
requirements also will allow companies to disclose their probable and possible reserves to investors. In addition, the new disclosure requirements specify for companies to: (a) report the
independence and qualifications of its reserves preparer or auditor; (b) file reports when a third party is relied upon to prepare reserves estimates or conducts a reserves audit; and
(c) report oil and gas reserves using an average price based upon the prior 12-month period rather than year-end prices. The new disclosure requirements are effective
for financial statements for fiscal years ending on or after December 31, 2009. We are not required to conform to these SEC requirements until we file our annual report for our fiscal year
ending June 30, 2010. The effect of adopting the SEC rule has not been determined; however, it is not expected to have a material impact on our financial position, results of operations or cash
flows.

In
June 2009, the FASB issued ASC 855 (formerly SFAS 165,Subsequent Events) to establish general standards of accounting
for and disclosure of events that occur after the balance sheet date, but prior to the issuance of financial statements. Specifically, ASC 855 sets forth: (1) the period after the
balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements;
(2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and (3) the disclosures that an
entity should make about events or transactions that occurred after the balance sheet date. ASC 855 is effective for financial statements issued for interim or annual periods ending after
June 15, 2009. We adopted ASC 855 on June 30, 2009 and considered subsequent events through February 12, 2010. The adoption of this statement did not have a material impact
on our financial position, results of operations or cash flows.

2. PENDING MERGER WITH RESACA

On September 29, 2009, the boards of directors of Cano and Resaca Exploitation, Inc. ("Resaca") approved an Agreement and Plan of Merger (the "Merger Agreement") by and among
Cano, Resaca and Resaca Acquisition Sub, Inc., a Delaware corporation and wholly-owned subsidiary of Resaca ("Merger Sub"), pursuant to which Merger Sub will be merged with and into Cano (the
"Merger") and Cano will become a wholly-owned subsidiary of Resaca. Closing is anticipated before the end of March
2010; however, it is possible that factors outside of either company's control could require us to complete the Merger at a later time or not to complete it at all.

Under
the terms of the proposed Merger, each share of Cano common stock will be converted into the right to receive 2.10 shares of common stock of Resaca (or 0.42 shares of
Resaca common

8

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

2. PENDING MERGER WITH RESACA (Continued)

stock
if the proposed one-for-five reverse stock split is approved by the Resaca shareholders prior to the Merger) and each share of Cano Series D Convertible Preferred
Stock (the "Preferred Stock") will be converted into the right to receive one share of Resaca Series A Convertible Preferred Stock. The Merger is intended to be a tax-free
transaction to the Resaca shareholders and to the Cano stockholders to the extent the Cano common stockholders receive Resaca common stock and the Cano preferred stockholders receive Resaca preferred
stock in the Merger.

Consummation
of the transactions contemplated by the Merger Agreement is conditioned upon, among other things, (1) approval of the holders of the common stock and preferred stock
of Cano, (2) approval of the holders of the common stock of Resaca, (3) the listing of Resaca common stock on the NYSE Amex, (4) the refinancing of existing bank debt of Resaca
and Cano, (5) the receipt of required regulatory approvals, (6) Resaca's application for readmission to the Alternative Investment Market of the London Stock Exchange and (7) the
effectiveness of a registration statement relating to the shares of Resaca common stock to be issued in the Merger. The Merger Agreement contains certain termination rights for each of Cano and
Resaca, including the right to terminate the Merger Agreement to enter into a Superior Proposal (as such term is defined in the Merger Agreement). In the event of a termination of the Merger Agreement
under certain specified circumstances described in the Merger Agreement, one party will be required to pay the other party a termination fee of $3,500,000.

We
entered into stock voting agreements with 75% of the holders of Cano's Preferred Stock on various dates between September and November 2009. Each stock voting agreement contains the
same terms and provides, among other things, that each of the preferred holders will vote all its shares of our stock (a) in favor of an amendment to the Certificate of Designations,
Preferences and Rights of Series D Convertible Preferred Stock of Cano (the "Series D Amendment"), (b) in favor of adoption of the Merger Agreement, and (c) in accordance
with the recommendation of our Board of Directors in connection with any Target Acquisition Proposal (as such term is defined in the Merger Agreement). The Series D Amendment generally provides
that the holders of Preferred Stock shall have no rights arising from the proposed Merger with Resaca (including any right to require us to redeem their shares of Preferred Stock) other than the right
to receive the merger consideration specified in the Merger Agreement. To be effective, the Series D Amendment must be approved by the holders of a majority of the shares of Preferred Stock,
voting as a separate class, and by the holders of a majority of the shares of our common stock, voting as a separate class, and then filed by us with the Secretary of State of Delaware.

On
October 20, 2009, we entered into a Stock Voting Agreement with S. Jeffrey Johnson, our Chief Executive Officer and Chairman of our board of directors, which provides, among
other things, that Mr. Johnson will vote all of his shares of our stock in favor of the Series D Amendment. Mr. Johnson owns approximately 3.7% of the Preferred Stock. During the
three- and six-month periods ended December 31, 2009, we paid preferred dividend payments to Mr. Johnson of approximately $20,000 and $39,000, respectively.

On
January 27, 2010, Resaca filed a registration statement covering a proposed underwritten offering of Resaca common stock, which is expected to close in conjunction with the
closing of the merger.

On
February 3, 2010, Resaca received a firm commitment for a new $200.0 million revolving senior secured credit facility with Union Bank of North America, N.A. ("UBNA") for
the combined company.

9

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

2. PENDING MERGER WITH RESACA (Continued)

UBNA
is the administrative agent and issuing lender of the revolving senior secured credit facility. The facility is expected to mature on July 1, 2012 and is expected to have an initial and
current borrowing base of $90.0 million based upon the combined company's estimated proved reserves.

3. LIQUIDITY

At December 31, 2009, we had cash and cash equivalents of $0.5 million. We had negative working capital of $67.6 million, which includes $66.7 million of
long-term debt that has accelerated to a short-term status. Excluding the current portion of long-term debt totaling $66.7 million, we had negative working
capital of $0.9 million. For the six-month period ended December 31, 2009, we had cash flow used in operations of $0.9 million, which includes $1.5 million of
Merger related expenses.

During
January 2010, pursuant to the terms of a Purchase and Sale Agreement, we sold our interests in certain oil and gas properties located in the Texas Panhandle for net proceeds of
$6.3 million. The agreement had an effective date of January 1, 2010. As of January 1, 2010, the net book value of these sold assets was $1.5 million, which resulted in a
pre-tax gain of $4.8 million. We used a portion of the net proceeds of $6.3 million to pay down our outstanding debt. As of February 12, 2010, we had available
borrowing capacity of $3.0 million and a cash balance of $1.2 million.

As
discussed in Note 4, the lenders under our two credit agreements agreed to waive the covenants relating to our leverage ratio and interest coverage ratio for the quarter ended
December 31, 2009, as we would have been out of compliance with such covenants as of December 31, 2009. Should the merger with Resaca not close by March 31, 2010, based upon our
six-month operating results through December 31, 2009, it is likely that we will not be in compliance with one or more of our financial covenants under our credit agreements as of
March 31, 2010. Accordingly, since we did not receive covenant relief beyond December 31, 2009, we have reclassified our debt from long-term to short-term.

Our
credit agreements, discussed in Note 4, include change of control provisions which require us to refinance the credit agreements at the close of the Merger. As discussed in
Note 2, on February 3, 2010, Resaca received a firm commitment for a new $200.0 million revolving senior secured credit facility with UBNA for the combined company.

We
believe the combination of cash on hand, cash flow generated from operations, and available borrowing capacity, as of February 12, 2010, will be sufficient to fund our
operating and capital activities through the closing of the Merger.

If
the pending Merger and the refinancing of our credit agreements do not occur by March 31, 2010, it is likely that we will not be in compliance with the covenants. In that
event, we will seek covenant relief from our lenders, though there can be no assurance that we will be successful in obtaining such relief.

If
we are unable to obtain relief from our lenders, we will need to raise additional capital through the issuance of equity or the sale of a portion of our assets. There can be no
assurance as to the amount of additional capital we would be able to raise, if any, in connection with any such equity issuances or asset sales. In addition, any such equity issuances could be highly
dilutive to our existing stockholders and any such asset sales would require the consent of our lenders and, potentially, the holders of our outstanding common and preferred stock.

10

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

4. LONG-TERM DEBT

At December 31, 2009 and June 30, 2009, the aggregate outstanding amounts under our credit agreements were $66.7 million and $55.7 million, respectively. The
$66.7 million consisted of outstanding borrowings under the amended and restated credit agreement (the "ARCA") and the subordinated credit agreement of $51.7 million and
$15.0 million, respectively. At December 31, 2009, the average interest rates under the ARCA and the subordinated credit agreement were 2.76% and 6.26%, respectively.

Our
long-term debt consists of the ARCA and our subordinated credit agreement (borrowing availability of $15.0 million). Under the ARCA, our lenders are UBNA, acting
as administrative agent, and Natixis. Under the subordinated credit agreement, our lender is UnionBanCal Equities, Inc. ("UBE").

On
December 30, 2009, we entered into Amendment No. 1 (the "ARCA Amendment No. 1") to the ARCA, which specifies (i) our borrowing base was redetermined to be
$60.0 million, which will remain in effect until it is redetermined in accordance with the ARCA, (ii) advances under the ARCA for any purpose other than to acquire proved, developed,
producing oil and gas properties shall not exceed $52.0 million and (iii) the covenants relating to our leverage ratio and interest coverage ratio were waived for the fiscal quarter
ending December 31, 2009 as we would have been out of compliance with such covenants as of December 31, 2009. We paid an amendment fee of $90,000 pursuant to the ARCA Amendment
No. 1.

As
of February 12, 2010, the ARCA had outstanding borrowings of $49.0 million, and available borrowing capacity of $3.0 million.

On
December 30, 2009, we entered into Amendment No. 1 (the "SCA Amendment") to our Subordinated Credit Agreement, which specifies the covenants relating to our leverage
ratio and interest coverage ratio were waived for the fiscal quarter ending December 31, 2009. We paid an amendment fee of $22,500 pursuant to the SCA Amendment.

5. DERIVATIVES

Our derivatives consist of commodity derivatives and an interest rate swap arrangement.

Commodity Derivatives

Pursuant to our ARCA and the subordinated credit agreement, discussed in Note 4, we are required to maintain our "collar"
commodity derivative contracts. We have commodity derivatives to partially mitigate the risk associated with extreme fluctuations of prices for crude oil and natural gas sales. We have no obligation
to enter into commodity derivative contracts in the future. Should we choose to enter into commodity derivative contracts to mitigate future price risk, we cannot enter into contracts for greater than
85% of our crude oil and natural gas production volumes attributable to proved producing reserves for a given month. As of December 31, 2009, we maintained the following

11

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

5. DERIVATIVES (Continued)

"collar"
commodity derivative contracts with UBNA as our counterparty, which is one of the senior lenders under the ARCA:

Time Period

Floor
Oil Price

Ceiling
Oil Price

Barrels
Per Day

Floor
Gas Price

Ceiling
Gas Price

Mcf
per Day

Barrels of
Equivalent
Oil per Day(a)1/1/10 - 12/31/10

$
80.00

$
108.20


333

$
7.75

$
9.85


1,567


5941/1/10 - 12/31/10

$
85.00

$
101.50


233

$
8.00

$
9.40


1,033


4061/1/11 - 3/31/11

$
80.00

$
107.30


333

$
7.75

$
11.60


1,467


5781/1/11 - 3/31/11

$
85.00

$
100.50


200

$
8.00

$
11.05


967


361


(a)Computed
by dividing the "Mcf per Day" by 6 and adding "Barrels per Day."


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

Time Period

Fixed
Oil Price

Barrels
Per Day4/1/11 - 12/31/11

$
75.90


7001/1/12 - 12/31/12

$
77.25


700


Interest Rate Swap Agreement

On January 12, 2009, we entered into a three-year LIBOR interest rate basis swap contract with Natixis Financial
Products, Inc. ("Natixis FPI") for $20.0 million in notional exposure. We have the interest rate swap agreement to partially mitigate the risk associated with interest rate fluctuations on our
interest expense. Under the terms of the transaction, we will pay Natixis FPI, in three-month intervals, a fixed rate of 1.73% and Natixis FPI will pay Cano the prevailing three-month LIBOR rate.

12

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

5. DERIVATIVES (Continued)

Financial Statement Impact

During the three- and six-month periods ended December 31, 2009 and 2008, respectively, the gain (loss) on
derivatives reported in our consolidated statements of operations is summarized as follows (in thousands):

Three Months Ended
December 31,

Six Months Ended
December 31,Location of
Gain (Loss) on
Derivatives2009

2008

2009

2008Settlements received/accrued on commodity derivatives

Other income (expense)

$
1,196

$
1,712

$
3,047

$
1,712Settlements receivedsale of "floor price" contracts on commodity derivatives

Other income (expense)





653





653Settlements paid/accrued on commodity derivatives

Other income (expense)











(551
)Settlements paid/accrued on interest rate swap

Other income (expense)


(70
)




(126
)

Realized gain on derivatives

Other income (expense)


1,126


2,365


2,921


1,814Unrealized gain (loss) on commodity derivatives

Other income (expense)


(5,783
)

18,933


(7,987
)

43,180Unrealized loss on interest rate swap

Other income (expense)


(70
)




(173
)

Gain (loss) on derivatives

Other income (expense)

$
(4,727
)
$
21,298

$
(5,239
)
$
44,994


The
realized gain (loss) on derivatives consists of actual cash settlements under our commodity collar and interest rate swap derivative agreements during the respective periods. The
cash settlements received/accrued by us under commodity derivatives were cumulative monthly payments due to us since the NYMEX natural gas and crude oil prices were lower than the "floor prices" set
for the respective time periods and realized gains from the sale of uncovered "floor price" contracts as discussed below. The cash settlements paid/accrued by us under commodity derivatives were
cumulative monthly payments due to our counterparty since the NYMEX crude oil and natural gas prices were higher than the "ceiling prices" set for the respective time periods. The cash settlements
paid/accrued by us under the interest rate swap related to quarterly payments to our counterparty since the actual three- month LIBOR interest rate was lower than the fixed 1.73% rate we pay to the
counterparty. The cash flows relating to the derivative instrument settlements that are due, but not cash settled are reflected in operating activities on our consolidated statements of cash flows as
changes to current liabilities. At December 31, 2009 and June 30, 2009, we had recorded a receivable from our counterparty included in accounts receivable on our consolidated balance
sheet of $0.3 million and $0.6 million, respectively.

During
the three-month period ended December 31, 2008, we sold certain uncovered "floor price" commodity derivative contracts to our counterparty for $3.2 million and
realized a gain of $0.7 million.

The
unrealized gain (loss) on commodity derivatives represents estimated future settlements under our commodity derivatives and is based on mark-to-market
valuation based on assumptions of forward prices, volatility and the time value of money as discussed below. We compared our internally derived

13

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

5. DERIVATIVES (Continued)

valuation
to our counterparties' independently derived valuation to further validate our mark-to-market valuation. During the three- and six-month periods ended
December 31, 2009, we recognized an unrealized loss on commodity derivatives in our consolidated statements of operations amounting to $5.8 million and $8.0 million, respectively.
During the three- and six-month periods ended December 31, 2008, we recognized an unrealized gain on commodity derivatives in our consolidated statements of operations amounting to
$18.9 million and $43.2 million, respectively.

The
unrealized loss on interest rate swap represents estimated future settlements under our aforementioned interest rate swap agreement and is based on a
mark-to-market valuation based on assumptions of interest rates, volatility and the time value of money as discussed below. During the three-month period ended
December 31, 2009, we recognized realized and unrealized losses on interest rate swaps in our consolidated statements of operations amounting to $0.1 million each. During the
six-month period ended December 31, 2009, we recognized realized and unrealized losses on interest rate swaps in our consolidated statements of operations amounting to
$0.1 million and $0.2 million, respectively.

Fair Value Measurements

Our assets and liabilities recorded at fair value are categorized based upon the level of judgment associated with the inputs used to
measure their fair value. A fair value hierarchy has been established that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to quoted prices in active
markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). We classify fair value balances based on the
observability of those inputs. The three levels of the fair value hierarchy are as follows:



In
valuing certain contracts, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. For disclosure purposes, assets and liabilities are
classified in their entirety in the fair value hierarchy level based on the lowest level of input that is significant to the overall fair value measurement. Our assessment of the significance of a
particular input to the fair value measurement requires judgment and may affect the placement within the fair value hierarchy levels.

The
fair value of our derivative contracts are measured using Level 2 and Level 3 inputs. The Level 3 input pertained to the subjective valuation for the effect of
our own credit risk, which was significant to the fair value of the crude oil swap derivative contracts. The fair value of our commodity derivative contracts and interest rate swap are measured using
Level 2 inputs based on the hierarchies previously discussed.

14

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

5. DERIVATIVES (Continued)

Our asset retirement obligations are measured using primarily Level 3 inputs. The significant unobservable inputs to this fair value measurement include estimates of plugging,
abandonment and remediation costs, inflation rate and well life. The inputs are calculated based on historical data as well as current estimated costs.

The
estimated fair value of derivatives and asset retirement obligations included in the consolidated balance sheet at December 31, 2009 is summarized below (in thousands).

In thousandsDerivative assets (Level 2):Crude oil collars and price floorscurrent

$
1,097Crude oil collars and price floorsnoncurrent


216Natural gas collars and price floorscurrent


1,879Natural gas collars and price floorsnoncurrent


360Interest rate swapnoncurrent


78Derivative liability (Level 2)Interest rate swapcurrent


(199
)Derivative liability (Level 3)Crude oil swapnoncurrent


(3,723
)Net derivative liabilities

$
(292
)Asset retirement obligation (Level 3)

$
(3,040
)


At
September 30, 2009, our net derivative asset was classified as Level 2 as the subjectivity of our valuation for the effect of our own credit risk was insignificant. At
December 31, 2009, since the subjective valuation of our own credit risk is significant, we have reclassified our derivative liabilities as Level 3 as presented in the table below (in
thousands).

Beginning
Balance

Total
Gains
(Losses) (a)

Purchases,
Sales,
Issuances,
and
Settlements,
net

Transfers
into
Level 3

Ending
balance

Unrealized Gains
(Losses) for Level 3
Assets/Liabilities
Outstanding at
December 31, 2009Derivatives assets (liabilities)

$


$
(3,079
)
$


$
(644
)
$
(3,723
)
$
(3,723
)


(a)Total
realized and unrealized gains are included in gain (loss) on commodity derivatives in the consolidated statements of operations.


15

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

5. DERIVATIVES (Continued)




The
following table shows the reconciliation of changes in the fair value of the net derivative assets and asset retirement obligation classified as Level 2 and 3, respectively,
in the fair value hierarchy for the six-month period ended December 31, 2009 (in thousands).

In thousands

Total Net
Derivative
Assets
(Liabilities)

Asset
Retirement
ObligationBalance at June 30, 2009

$
7,678

$
2,904Unrealized loss on derivatives


(8,160
)

Settlements, net


190


Accretion of discount





136Balance at December 31, 2009

$
(292
)
$
3,040


The
change from net derivative assets of $7.7 million at June 30, 2009 to net derivative liabilities of $0.3 million at December 31, 2009 is attributable to
the increases in crude oil and natural gas futures prices. These amounts are based on our mark-to-market valuation of these derivatives at December 31, 2009 and may not
be indicative of actual future cash settlements.

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

Asset Derivatives

Liability DerivativesDecember 31, 2009

June 30, 2009

December 31, 2009

June 30, 2009Balance Sheet
Location

Fair
Value

Balance Sheet
Location

Fair
Value

Balance Sheet
Location

Fair
Value

Balance Sheet
Location

Fair
ValueDerivatives not designated as hedging instrumentsCommodity derivative contracts

Derivatives 
current

$
2,976

Derivatives 
current

$
4,955

Derivatives 
current

$


Derivatives 
current

$
Commodity derivative contracts

Derivatives 
noncurrent


576

Derivatives 
noncurrent


2,670

Derivatives 
noncurrent


(3,723
)
Derivatives 
noncurrent


Interest rate swaps

Derivatives 
noncurrent


78

Derivatives 
noncurrent


212

Derivatives 
current


(199
)
Derivatives 
current


(159
)Total derivatives not designated as hedging instruments



$
3,630



$
7,837



$
(3,922
)


$
(159
)Total derivatives designated as hedging instruments



$




$




$




$
Total derivatives



$
3,630



$
7,837



$
(3,922
)


$
(159
)


16

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

6. DISCONTINUED OPERATIONS

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

On
December 2, 2008, we sold our interests in our Corsicana oil and gas properties (the "Corsicana Properties") for $0.3 million. In the three-month period ended
September 30, 2008, we recorded a $3.5 million ($2.3 million after-tax) impairment of the Corsicana Properties, as we determined that we would not be developing its
proved undeveloped reserves within the next five years.

The
operating results of Pantwist, LLC and the Corsicana Properties for the three- and six-month periods ended December 31, 2008 have been reclassified as
discontinued operations in the consolidated statements of operations as detailed in the table below (in thousands).

Period Ended
December 31, 2008Three Months

Six MonthsOperating Revenues:Crude oil sales

$
10

$
1,321Natural gas sales





1,696Total operating revenues


10


3,017Operating Expenses:Lease operating


31


633Production and ad valorem taxes





197Impairment of long-lived assets





3,516Depletion and depreciation


8


15Accretion of discount on asset retirement


1


3Interest expense, net





34Total operating expenses


40


4,398Gain (loss) on sale of properties


19,303


19,309Income before income taxes


19,273


17,928Income tax provision


(7,027
)

(6,535
)Income from discontinued operations

$
12,246

$
11,393


Interest
expense, net of interest income, was allocated to discontinued operations based on the percentage of operating revenues applicable to discontinued operations to the total
operating revenues.

17

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

7. DEFERRED COMPENSATION

As of December 31, 2009, we had non-vested restricted shares totaling 386,667 shares to key employees pursuant to our 2005 Long-Term Incentive Plan, as
summarized below:

Shares

Weighted
Average
Grant-date
Fair Value

Fair Value
$000sNon-vested restricted shares at June 30, 2009


480,000

$
6.97

$
3,344Shares vested


(68,647
)
$
5.84

$
(401
)Shares forfeited


(24,686
)
$
5.84


(144
)Non-vested restricted shares at December 31, 2009


386,667

$
7.24

$
2,799


The
restricted share grants will vest to the employees based on future years of service ranging from one to three years depending on the life of the award agreement. Pursuant to the
Merger discussed in Note 2, the non-vested restricted shares would vest upon the completion of the Merger. The fair value of the grants is based on our actual stock price on the
date of grant multiplied by the number of restricted shares granted. As of December 31, 2009, the value of non-vested restricted shares amounted to $2.8 million. For the
three-month periods ended December 31, 2009 and 2008, we have expensed $0.2 million and $0.5 million, respectively, to stock compensation expense based on amortizing the fair
value over the appropriate service period. For the six-month period ended December 31, 2009 and 2008, we have expensed $0.5 million and $1.3 million, respectively, to
stock compensation expense. The forfeitures resulted from shares used to satisfy employees' tax withholding obligations related to the vesting of their restricted shares.

8. STOCK OPTIONS

During the six-month period ended December 31, 2009, we granted 16,032 stock options to two directors under our 2005 Long-Term Incentive Plan. The options
were granted with an exercise price equal to our market price at the date of grant and vest immediately. The factors used to calculate the fair value of these options are summarized in the table
below:

No. of options


16,032Risk free interest rate


2.19
%Expected life


5 yearsExpected volatility


98.9
%Expected dividend yield


0
%Weighted average grant date fair value


$0.77


The
fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model. Expected volatility is based on the historical volatility of our
common stock. We use historical data to estimate option exercise and employee termination within the valuation model. The expected lives of options granted represent the period of time that options
granted are expected to be outstanding. The risk-free interest rate for periods within the contractual life of the option is based on the five-year U.S. Treasury yield curve in
effect at the time of the respective grant. The expected dividend yield reflects our intent not to pay dividends on our common stock during the contractual periods.

18

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

8. STOCK OPTIONS (Continued)

A
summary of outstanding options as of December 31, 2009 is as follows:

Shares

Weighted Average
Exercise PriceOutstanding at June 30, 2009


1,400,002

$
4.42Options granted


16,032

$
1.03Options forfeited


(79,917
)
$
5.29Outstanding at December 31, 2009


1,336,117

$
4.33


Based
on our $0.98 stock price at December 31, 2009, the intrinsic value of both the options outstanding and exercisable was approximately $0.2 million.

Total
options exercisable at December 31, 2009 amounted to 1,106,246 shares and had a weighted average exercise price of $4.09. Upon exercise, we issue the full amount of shares
exercisable per the term of the options from new shares. We have no plans to repurchase those shares in the future.

For
each of the three-month periods ended December 31, 2009 and 2008, we recorded charges to stock compensation expense of $0.1 million and $0.3 million,
respectively, for the estimated fair value of the options granted to our directors and employees. For each of the six-month periods ended December 31, 2009 and 2008, we recorded
charges to stock compensation expense of $0.2 million and $0.5 million, respectively. As of December 31, 2009, total compensation cost related to non-vested option
awards not yet recognized was $0.3 million. We expect to recognize the remaining unrecognized amount over the related requisite service periods of one to three years. Pursuant to the Merger
discussed in Note 2, the outstanding stock options would vest upon completion of the Merger.

9. NET INCOME (LOSS) PER COMMON SHARE

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

Shares
of common stock underlying the following items were not included in dilutive weighted average shares outstanding for the three- and six-month periods ended
December 31, 2009 as their effects would have been anti-dilutive.

Stock options


1,336,177Preferred stock


4,147,652PIK dividends


642,559


19

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

9. NET INCOME (LOSS) PER COMMON SHARE (Continued)

The
following table reconciles earnings and shares used in the computation of basic and diluted earnings per share for the three- and six-month periods ended
December 31, 2008:

Three Months

Six MonthsIn thousands, except per share data

Earnings
($000)

Shares

Earnings
per Share

Earnings
($000)

Shares

Earnings
per ShareBasic

$
13,653


46,079

$
0.30

$
25,471


46,155

$
0.55Effective of dilutive securities:Conversion of preferred stock and PIK dividends


855


7,758





1,791


8,107Stock options





95








256Diluted

$
14,508


53,932

$
0.27

$
27,262


54,518

$
0.50


10. INCOME TAXES

The effective income tax rates for the three- and six-month periods ended December 31, 2009 were 34.4% and 33.5%, respectively. The effective income tax rates for the
three- and six-month periods ended December 31, 2008 were 40.3% and 39.2%, respectively. The prior year tax rates were higher due to an increase in the state tax rate.

11. COSTS INCURRED FOR DRILLING AND EQUIPPING EXPLORATORY WELLS USING SECONDARY AND TERTIARY TECHNOLOGY

At June 30, 2009, we had one tertiary project, the alkaline-surfactant-polymer chemical injection pilot project at our Nowata Properties (the "Nowata ASP Project"), that was
pending the determination of whether proved reserves have been found. During December 2009, we finalized our performance analysis, which indicated the Nowata ASP Project did not result in increased
oil production of significant quantities to be considered economically sufficient to justify the recognition of proved reserves. Accordingly, during December 2009, we recorded a $5.0 million
pre-tax exploration expense.

The
following table reflects the net change in deferred exploratory project costs during the six-month period ended December 31, 2009 for the Nowata ASP Project:

In ThousandsBalance at June 30, 2009

$
4,849Additions pending the determination of proved reserves


175Deferred exploratory well costs charged to expense


(5,024
)Balance at December 31, 2009

$



20

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

12. IMPAIRMENT OF LONG-LIVED ASSETS

During the three-month period ended December 31, 2009, we wrote down $0.3 million of costs associated with the ASP facility used for the Nowata ASP Project. The facility's
water filtering process did not work properly with the oil-water fluid production at our Nowata Properties. We intend to use the ASP facility for future pilot tertiary projects at our Cato
and Panhandle Properties.

During
the three-month period ended December 31, 2008, we recorded a $22.4 million pre-tax impairment to our Barnett Shale Properties and a $0.7 million
pre-tax impairment to the goodwill associated with our subsidiary which holds the equity in our Barnett Shale Properties. We recorded the impairments due to the decline in commodity prices
which created an uncertainty in the likelihood of developing reserves associated with our Barnett Shale natural gas properties (the "Barnett Shale Properties") within the next five years. The fair
value for our Barnett Shale was determined using estimates of future net cash flows, discounted to a present value, which is considered "Level 3" inputs as previously discussed in
Note 5.

13. COMMITMENTS AND CONTINGENCIES

Burnett Case

On March 23, 2006, the following lawsuit was filed in the 100th Judicial District Court in Carson County, Texas: Cause
No. 9840, The Tom L. and Anne Burnett Trust, by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, III and Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr;
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 or certain of its subsidiaries relating to oil and natural gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas.

The
plaintiffs (i) allege negligence and gross negligence and (ii) seek damages, including, but not limited to, damages for damage to their land and livestock, certain
expenses related to fighting the fire and certain remedial expenses totaling approximately $1.7 million to $1.8 million. In addition, the plaintiffs seek (i) termination of
certain oil and natural gas leases, (ii) reimbursement for their attorney's fees (in the amount of at least $549,000) and (iii) exemplary damages. The plaintiffs also claim that Cano and
its subsidiaries are jointly and severally liable as a single business enterprise and/or a general partnership or de facto partnership. The owner of the remainder of the mineral estate, Texas
Christian University, intervened in the suit on August 18, 2006, joining Plaintiffs' request to terminate certain oil and gas leases. On June 21, 2007, the judge of the
100th Judicial District Court issued a Final Judgment (a) granting motions for summary judgment in favor of Cano and certain of its subsidiaries on plaintiffs' claims for
(i) breach of contract/termination of an oil and gas lease; and (ii) negligence; and (b) granting the plaintiffs' no-evidence motion for summary judgment on
contributory negligence, assumption of risk, repudiation and estoppel affirmative defenses asserted by Cano and certain of its subsidiaries.

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

21

---



CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

13. COMMITMENTS AND CONTINGENCIES (Continued)

requested
a rehearing on the trial court's ruling in favor of the defendants on the plaintiffs' breach of contract/termination of an oil and gas lease claim. On June 30, 2009, the Court of
Appeals ruled to deny the plaintiff's motion for rehearing. On August 17, 2009 we filed an appeal with the Texas Supreme Court to request the reversal of the Court of Appeals ruling regarding
our potential negligence. On December 11, 2009, the Texas Supreme Court declined to hear Cano's appeal. Therefore, this case will be remanded to the district court for trial on the negligence
claims.

Due
to the inherent risk of litigation, the ultimate outcome of this case is uncertain and unpredictable. At this time, Cano management continues to believe that this lawsuit is without
merit and will continue to vigorously defend itself and its subsidiaries, while seeking cost-effective solutions to resolve this lawsuit. Cano has not yet determined whether to seek
further review by the Court of Appeals or the Texas Supreme Court. Based on our knowledge and judgment of the facts as of February 12, 2010, we believe our financial statements present fairly
the effect of the actual and the anticipated future costs to resolve this matter as of December 31, 2009.

Securities Litigation

On October 2, 2008, a lawsuit (08 CV 8462) was filed in the United States District Court for the Southern District of New York
against David W. Wehlmann; Gerald W. Haddock; Randall Boyd; Donald W. Niemiec; Robert L. Gaudin; William O. Powell, III and the underwriters of the June 26, 2008 public offering of Cano common
stock ("Secondary Offering") alleging violations of the federal securities laws. Messrs. Wehlmann, Haddock, Boyd, Niemiec, Gaudin and Powell were Cano outside directors on June 26, 2008.
At the defendants' request, the case was transferred to the United States District Court for the Northern District of Texas (4:09-CV-308-A).

On
July 2, 2009, the plaintiffs filed an amended complaint that added as defendants Cano, Cano's Chief Executive Officer and Chairman of the Board, Jeff Johnson, Cano's former
Senior Vice President and Chief Financial Officer, Morris B. "Sam" Smith, Cano's current Senior Vice President and Chief Financial Officer, Ben Daitch, Cano's Vice President and Principal Accounting
Officer, Michael Ricketts and Cano's Senior Vice President of Engineering and Operations, Patrick McKinney, and dismissed Gerald W. Haddock, a former director of Cano, as a defendant. The amended
complaint alleges that the prospectus for the Secondary Offering contained statements regarding Cano's proved reserve amounts and standards that were materially false and overstated Cano's proved
reserves. The plaintiff is seeking to certify the lawsuit as a class action lawsuit and is seeking an unspecified amount of damages. On July 27, 2009, the defendants moved to dismiss the
lawsuit. On December 3, 2009, the U.S. District Court for the Northern District of Texas granted motions to dismiss all claims brought by the plaintiffs. On December 18, 2009, the
plaintiffs filed a notice of appeal with the United States Court of Appeals for the Fifth Circuit. Due to the inherent risk of litigation, the outcome of this lawsuit is uncertain and unpredictable;
however, Cano, its officers and its outside directors intend to continue to vigorously defend the lawsuit.

Cano
is cooperating with its Directors and Officers Liability insurance carrier regarding the defense of the lawsuit. We believe that the potential amount of losses resulting from this
lawsuit in the future, if any, will not exceed the policy limits of Cano's directors' and officers' liability insurance.

22

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS (Continued)

13. COMMITMENTS AND CONTINGENCIES (Continued)

Other

Occasionally, we are involved in other various claims and lawsuits and certain governmental proceedings arising in the ordinary course
of business. Our management does not believe that the ultimate resolution of any current matters that are not set forth above will have a material effect on our financial position or results of
operations. Management's position is supported, in part, by the existence of insurance coverage, indemnification and escrow accounts. None of our directors, officers or affiliates, owners of record or
beneficial owners of more than five percent of any class of our voting securities, or security holder is involved in a proceeding adverse to us or our subsidiaries or has a material interest adverse
to us or our subsidiaries.

23

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Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

The information in this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. This Act provides a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about themselves provided
they identify these statements as forward looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All
statements other than statements of historical fact made in this report are forward looking. In particular, the statements herein regarding industry prospects and future results of operations or
financial position are forward-looking statements. Forward-looking statements reflect management's current expectations and are inherently uncertain. Our actual results may differ significantly from
management's expectations as a result of many factors, including, but not limited to the volatility in prices for crude oil and natural gas, future commodity prices for derivative hedging contracts,
interest rates, estimates of reserves, drilling risks, geological risks, transportation restrictions, the timing of acquisitions, product demand, market competition, interruption in production, our
ability to obtain additional capital, and the success of waterflooding and enhanced oil recovery techniques.

Statements
in this Quarterly Report on Form 10-Q regarding Cano's strategy, risk factors, capital budget, projected expenditures, liquidity and capital resources, and
drilling and development plans reflect Cano's current plans for the fiscal year ending June 30, 2010 as a stand-alone entity and do not take into account the impact of the proposed merger (the
"Merger") with a wholly-owned subsidiary of Resaca, except where such statements specifically relate to the proposed Merger.

You
should read the following discussion and analysis in conjunction with the consolidated financial statements of Cano and subsidiaries and notes thereto, included herewith. This
discussion should not be construed to imply that the results discussed herein will necessarily continue into the future, or that any conclusion reached herein will necessarily be indicative of actual
operating results in the future. Such discussion represents only the best present assessment of management.

Overview

We are an independent oil and natural gas company. Our strategy is to exploit our current undeveloped reserves and acquire, where
economically prudent, assets suitable for enhanced oil recovery at a low cost. We intend to convert our proved undeveloped and/or unproved reserves into proved producing reserves by applying water,
gas and/or chemical flooding and other enhanced oil recovery techniques. Our assets are located onshore in the United States in Texas, New Mexico and Oklahoma.

In
September 2009, we entered into the Merger Agreement with Resaca pursuant to which Cano will be acquired by Resaca through the merger of a wholly-owned subsidiary of Resaca with and
into Cano. The Merger is subject to customary conditions, including the approval of the common and preferred stockholders of Cano and the common shareholders of Resaca. The companies will hold
separate meetings of their shareholders to approve the Merger. Assuming shareholder approval is received, the Merger is expected to be completed within a few days following the shareholder meetings.
For more information regarding the proposed Merger, please refer to the Note 2 of the accompanying Consolidated Financial Statements and the joint proxy statement/prospectus of Resaca and Cano
that is included in the registration statement on Form S-1 (333-164551) and Form S-4 (File No. 333-162652) filed by Resaca with the
SEC, and other relevant materials that may be filed by Cano or Resaca with the SEC. The following discussion relates to our plans without regard to the potential impact of the proposed Merger.

24

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We
are focused on enhancing the infrastructure and waterflood operations in our two largest properties, Cato and Panhandle. These development activities are more fully described below
under "Development Capital Expenditures and Operating Activities Update."We believe our portfolio of crude oil and natural gas properties
provides opportunities to apply our operational strategy.

Our
June 30, 2009 proved reserves of 49.1 million barrels of oil equivalent ("MMBOE"), comprised 7.7 MMBOE of proved developed producing reserves ("PDP"), 2.4 MMBOE of
proved developed non-producing reserves ("PDNP"), and 39.0 MMBOE of proved undeveloped reserves ("PUD") based on crude oil and natural gas prices of $69.89 per barrel and $3.71 per MMBtu,
respectively. Crude oil reserves accounted for 79% of our total reserves at June 30, 2009. Adjusting for the recent sale of wells in the Panhandle, as discussed in Note 3, our adjusted
reserves at June 30, 2009 would be 48.6 MMBOE, which comprised 7.2 MMBOE of PDP, 2.4 MMBOE of PDNP, and 39.0 MMBOE of PUD; and crude oil reserves accounted for 80.2% of total reserves.

Based
on our current estimates of income and expenses, it is likely that we will not be in compliance with one or more of our financial covenants under the ARCA and/or the Subordinated
Credit Agreement as of March 31, 2010. We are currently in discussions with our lenders regarding this possibility and potential solutions, including without limitation, obtaining waivers from
the applicable covenants, entering into amendments to our credit agreements or raising additional capital through equity issuances. If we are unable to obtain such waivers, to negotiate such
amendments or to obtain necessary funding from operations or outside capital raising activities, we could default on our obligations under one or both of our credit agreements, which default, if not
cured or waived, could result in the acceleration of all indebtedness outstanding under our credit agreements. See"Liquidity and Capital
ResourcesLiquidity"and"Liquidity and Capital ResourcesCredit Agreement Covenant
Compliance."



For the quarter ended December 31, 2009 ("current quarter") our production averaged 1,189 net barrels of equivalent oil per day
("BOEPD"). This is 1.2% lower as compared to production of 1,203 net BOEPD for the quarter ended December 31, 2008 ("prior year quarter") and 2.4% lower as compared to production of 1,218 net
BOEPD for the quarter ended September 30, 2009. Production for the six-month period ended December 31, 2009 ("current six months") of 1,204 net BOEPD was 1.1% lower as
compared to the six-month period ended December 31, 2008 ("prior year six months") of 1,218 net BOEPD. For both the current quarter and current six months, the production decrease
was largely attributable to curtailed Barnett Shale production at our Desdemona Properties of 22 BOEPD and 24 BOEPD, respectively. At our other properties, normal field declines of production were
more than offset by consistent and increasing performance at waterfloods from both our Cato and Panhandle Properties.

For
the year ending June 30, 2010 (the "2010 Fiscal Year"), our Board of Directors approved a development capital expenditure budget of $13.9 million (excludes capitalized
general and administrative and interest expenses). Our development capital budget is designed to maintain our current level of production and to minimize drawing on our senior credit facility until
the proposed Merger with Resaca is completed. The development capital budget does not include the drilling of any new wells until the merger closes. The development capital budget is as
follows:



For
the current six months, we have incurred $8.0 million of the $13.9 million budgeted for development capital expenditures. The financing of our development capital
expenditures is discussed below under "Liquidity and Capital Resources."

25

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The
following discusses our field level capital development activity during the current six months and planned activity during the balance of the 2010 Fiscal Year.

Cato Properties.Our 2010 Fiscal Year development capital plan includes expanding the waterflood footprint from 640 acres to
approximately 1,000
acres by adding three new injection wells, which were put into service in the current quarter. We have identified a new source of water in a non-productive formation within our acreage,
and have confirmed that each water well is capable of producing 2,500 to 3,000 barrels of water per day. This new water source formation has
been penetrated in a number of existing wellbores in the Cato Properties and confirms the reservoir continuity necessary for the formation to be validated as a reliable water source for future
expansion of the Cato waterflood. As we develop this new water source, we will be able to increase the waterflood footprint without decreasing the injection rate at our existing injectors. This should
enable us to maintain production from existing producing wells at current levels. We averaged 14,000 barrels of water injection per day ("BWIPD") during the quarter ended September 30, 2009. We
experienced a decrease to 12,000 BWIPD during our current quarter as we measured increasing injection pressures in the northern part of the flood area and we were required, under our existing
waterflood permit, to reduce the injection rate in these wells. When the three new injection wells were activated during the latter portion of the current quarter, we were able to increase water
injection to the southern part of the flood. During January 2010, we increased the injection rate to 14,000 BWIPD. Further development plans for Cato include behind-pipe recompletions,
restoration of production from the Tom Tom and Tomahawk fields and the drilling of a deep Morrow formation test well. These development plans are contemplated to begin after the completion of the
Merger.

Net
production at the Cato Properties for the current quarter was 250 BOEPD, which was 50 BOEPD lower as compared to 300 BOEPD for the quarter ended September 30, 2009. The 50
BOEPD decrease resulted from the reduction of injected water and redistribution of water injection at the waterflood. We have applied for injection pressure increases on 21 wells with the New Mexico
Oil and Gas Conservation Division and expect a decision in the March/April 2010 timeframe. A favorable decision would enable us to achieve increased injection rates up to 21,000 BWIPD (our current
physical plant capacity). Net production at the Cato Properties for the current six months was 275 BOEPD.

Panhandle Properties.In the quarter ended September 30, 2009 we retained an independent engineering firm to assist us with
reservoir analysis
and simulation modeling at the Cockrell Ranch unit. Based on this engineering firm's recommendations, we established a controlled water injection pattern to gauge the effects of optimizing water
injection into the highest remaining crude oil saturation intervals of the Brown Dolomite formation. We are essentially performing a "Mini-Flood" in the key target interval at the Cockrell
Ranch unit. The result of this field observation, coupled with rigorous reservoir simulation modeling, is expected to demonstrate an optimal pattern for waterflooding the balance of the Cockrell Ranch
unit with an increasingly predicable production profile. Moreover, the field observation and modeling results will improve the planning of future development programs for the remaining leases located
within our Panhandle Properties. To isolate the observed wells, we had temporarily shut-in production during most of the quarter ended September 30, 2009, which reduced Panhandle
production by 25 net BOEPD. All production that was shut-in for the controlled injection project was restored on September 28, 2009. The results of the controlled injection project
and the accompanying reservoir simulation testing should be completed in the second calendar quarter of 2010.

Net
production at the Panhandle Properties for the current quarter and current six months was 599 BOEPD and 595 BOEPD, respectively. In addition to the controlled injection project
curtailment, production was lower by 15 BOEPD as Eagle Rock Field Services, L.P. ("Eagle Rock"), a large purchaser of our natural gas and natural gas liquids ("NGL"), experienced
an unplanned plant outage from mid-August 2009 through the end of September 2009. The Eagle Rock gas plant was returned to full operating capacity on October 1, 2009. During the
current six months we constructed gathering lines to redirect natural gas production from Eagle Rock to DCP Midstream, LP ("DCP"). As of

26

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December 31,
2009, we had redirected approximately 75% of the natural gas production previously delivered to Eagle Rock to DCP.

In
November 2009, at the Cockrell Ranch Unit, we performed an injection test of an Alkaline Surfactant Gas ("ASG") recipe designed by the University of Texas, Austin ("UT"). The test
involved injecting the ASG stream at the Cockrell 1R producing well. The five-day test allowed us to monitor surface pressure and rate measurements and analyze flow-back
production data. Results from the test will allow us to evaluate ASG tertiary recovery potential for the Brown Dolomite reservoir in the Panhandle Properties.

Desdemona Properties.During July 2009, we shut-in our Barnett Shale natural gas wells based upon the current and near-term
outlook of natural gas prices and production from the Barnett Shale wells on a per-well basis. We are in the midst of a project to return to production previously shut-in gas
wells from the Duke Sand formation. The proved reserves associated with these gas wells are currently classified as proved developed non-producing reserves on our June 30, 2009
reserve report (1.3 MMBOE). We successfully returned 12 of these wells to production during December 2009 (but did not sell any volumes) and returned an additional 13 wells to production during
January-February 2010. Production from these gas wells, including associated NGL recovery from our gas plant, is expected to be approximately 10-20 Mcfe per day for each gas well returned
to production. We restarted our gas plant in December 2009 and expect to realize the full benefit of these produced volumes by February 2010.

Net
production at the Desdemona Properties for the current quarter and current six months was 46 BOEPD and 42 BOEPD, respectively.

Nowata Properties.Our ASP tertiary recovery pilot project ("ASP Pilot") has been in full operation since December 2007. Through
June 30,
2009, we injected close to .40 PVI of ASP and polymer flush. We drilled and completed four observation wells in December 2008, to enable us to test flood-front results
in the pilot project. We completed injecting our polymer flush during June 2009. Analyses of the ASP Pilot results are complete. While we achieved some positive reaction to the surfactant in the
reservoir, it was determined that the ASP recipe designed by an outside consultant would not achieve viable economics to justify commercial project development. The recipe did not take into
consideration certain factors which lead to significant absorption of the surfactant in the reservoir rock. We have since retained the UT to study the ASP Pilot results at Nowata and develop an
alternate recipe. Using the actual results of the ASP Pilot and performing additional coreflood studies, UT believes they have developed a new and optimal recipe that shows exceptional recoveries can
be achieved at Nowata on a commercial basis. UT's work demonstrates that there is another solution to designing an optimal plan of development going forward. The lessons learned in regard to actual
plant design and operation, fluid handling, injection pressures and rates, and producing fluid properties, will all benefit full field development in the future and similar projects we may undertake
at our other properties.

As
a result of the non-commercial results from the ASP pilot, we recorded a $5.0 million pre-tax exploration expense during December 2009. There were no
proved reserves associated with the ASP pilot project prior to the beginning of this pilot project.

Net
production at the Nowata Properties for the current quarter and current six months was 219 BOEPD and 218 BOEPD, respectively.

Davenport Properties.Net production for both the current quarter and current six months was 73 BOEPD.

27

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Liquidity and Capital Resources



On September 29, 2009, the boards of directors of Cano and Resaca approved the "Merger Agreement" by and among Cano, Resaca and
Resaca Acquisition Sub, Inc., a Delaware corporation and wholly-owned subsidiary of Resaca ("Merger Sub"), pursuant to which Merger Sub will be merged with and into Cano (the "Merger") and Cano will
become a wholly-owned subsidiary of Resaca. Closing is anticipated before the end of March 2010; however, it is possible that factors outside of either company's control could require us to complete
the Merger at a later time or not to complete it at all.

Under
the terms of the proposed Merger, each share of Cano common stock will be converted into the right to receive 2.10 shares of common stock of Resaca (or 0.42 shares of
Resaca common stock if the proposed one-for-five reverse stock split is approved by the Resaca shareholders prior to the Merger) and each share of Cano Series D
Convertible Preferred Stock (the "Preferred Stock") will be converted into the right to receive one share of Resaca Series A Convertible Preferred Stock. The Merger is intended to be a
tax-free transaction to the Resaca shareholders and to the Cano stockholders to the extent the Cano common stockholders receive Resaca common stock and the Cano preferred stockholders
receive Resaca preferred stock in the Merger.

Consummation
of the transactions contemplated by the Merger Agreement is conditioned upon, among other things, (1) approval of the holders of the common stock and preferred stock
of Cano, (2) approval of the holders of the common stock of Resaca, (3) the listing of Resaca common stock on the NYSE Amex, (4) the refinancing of existing bank debt of Resaca
and Cano, (5) the receipt of required regulatory approvals, (6) Resaca's application for readmission to the Alternative Investment Market of the London Stock Exchange and (7) the
effectiveness of a registration statement relating to the shares of Resaca common stock to be issued in the Merger. The Merger Agreement contains certain termination rights for each of Cano and
Resaca, including the right to terminate the Merger Agreement to enter into a Superior Proposal (as such term is defined in the Merger Agreement). In the event of a termination of the Merger Agreement
under certain specified circumstances described in the Merger Agreement, one party will be required to pay the other party a termination fee of $3,500,000.

We
entered into stock voting agreements with 75% of the holders of Cano's Preferred Stock on various dates between September and November 2009. Each stock voting agreement contains the
same terms and provides, among other things, that each of the preferred holders will vote all its shares of our stock (a) in favor of an amendment to the Certificate of Designations,
Preferences and Rights of Series D Convertible Preferred Stock of Cano (the "Series D Amendment"), (b) in favor of adoption of the Merger Agreement, and (c) in accordance
with the recommendation of our Board of Directors in connection with any Target Acquisition Proposal (as such term is defined in the Merger Agreement). The Series D Amendment generally provides
that the holders of Preferred Stock shall have no rights arising from the proposed Merger with Resaca (including any right to require us to redeem their shares of Preferred Stock) other than the right
to receive the merger consideration specified in the Merger Agreement. To be effective, the Series D Amendment must be approved by the holders of a majority of the shares of Preferred Stock,
voting as a separate class, and by the holders of a majority of the shares of our common stock, voting as a separate class, and then filed by us with the Secretary of State of Delaware.

On
October 20, 2009, we entered into a Stock Voting Agreement with S. Jeffrey Johnson, our Chief Executive Officer and Chairman of our board of directors, which provides, among
other things, that Mr. Johnson will vote all of his shares of our stock in favor of the Series D Amendment. Mr. Johnson owns approximately 3.7% of the Preferred Stock. During the
current quarter and current

28

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six
months, we paid preferred dividend payments to Mr. Johnson of approximately $20,000 and $39,000, respectively.

On
January 27, 2010, Resaca filed a registration statement covering a proposed underwritten offering of Resaca common stock, which is expected to close in conjunction with the
closing of the merger.

On
February 3, 2010, Resaca received a firm commitment for a new $200.0 million revolving senior secured credit facility with UBNA for the combined company. UBNA is the
administrative agent and issuing lender of the revolving senior secured credit facility. The facility is expected to mature on July 1,
2012 and is expected to have an initial and current borrowing base of $90.0 million based upon the combined company's estimated proved reserves.



At December 31, 2009, we had cash and cash equivalents of $0.5 million. We had negative working capital of
$67.6 million, which includes $66.7 million of long-term debt that has accelerated to a short-term status. Excluding the current portion of long-term
debt totaling $66.7 million, we had negative working capital of $0.9 million. For the six-month period ended December 31, 2009, we had cash flow used in operations of
$0.9 million, which includes $1.5 million of Merger related expenses.

During
January 2010, pursuant to the terms of a Purchase and Sale Agreement, we sold our interests in certain oil and gas properties located in the Texas Panhandle for net proceeds of
$6.3 million. The agreement had an effective date of January 1, 2010. As of January 1, 2010, the net book value of these sold assets was $1.5 million, which resulted in a
pre-tax gain of $4.8 million. We used a portion of the net proceeds of $6.3 million to pay down our outstanding debt. As of February 12, 2010, we had available
borrowing capacity of $3.0 million and a cash balance of $1.2 million.

As
discussed in Note 4 to our Consolidated Financial Statements, the lenders under our two credit agreements agreed to waive the covenants relating to our leverage ratio and
interest coverage ratio for the quarter ended December 31, 2009. Should the merger with Resaca not close by March 31, 2010, based upon our six-month operating results through
December 31, 2009, it is likely that we will not be in compliance with one or more of our financial covenants under our credit agreements as of March 31, 2010. Accordingly, since we did
not receive covenant relief beyond December 31, 2009, we have reclassified our debt from long-term to short-term.

Our
credit agreements include change of control provisions which require us to refinance the credit agreements at the close of the Merger. As discussed in Note 2 to our
Consolidated Financial Statements, on February 3, 2010, Resaca received a firm commitment for a new $200.0 million revolving senior secured credit facility with UBNA for the combined
company.

We
believe the combination of cash on hand, cash flow generated from operations, and available borrowing capacity, as of February 12, 2010, will be sufficient to fund our
operating and capital activities through the closing of the Merger.

If
the pending Merger and the refinancing of our credit agreements do not occur by March 31, 2010, it is likely that we will not be in compliance with the covenants. In that
event, we will seek covenant relief from our lenders, though there can be no assurance that we will be successful in obtaining such relief.

If
we are unable to obtain relief from our lenders, we will need to raise additional capital through the issuance of equity or the sale of a portion of our assets. There can be no
assurance as to the amount of additional capital we would be able to raise, if any, in connection with any such equity issuances or asset sales. In addition, any such equity issuances could be highly
dilutive to our existing

29

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stockholders
and any such asset sales would require the consent of our lenders and, potentially, the holders of our outstanding common and preferred stock.

On
December 28, 2007, our universal shelf registration statement was declared effective by the SEC for the issuance of common stock, preferred stock, warrants, senior debt and
subordinated debt up to an aggregate amount of $150.0 million. After the issuance of common stock on July 1, 2008, we have $96.0 million of availability under this registration
statement; however, the amount of securities which we may offer pursuant to this registration statement during any twelve-month period is limited to one-third of the aggregate market value
of the common equity of the Company held by our non-affiliates because our public float is not in excess of $75.0 million. We may periodically offer one or more of these securities
in amounts, prices and on terms to be announced when and if the securities are offered. At the time any of the securities covered by the registration statement are offered for sale, a prospectus
supplement will be prepared and filed with the SEC containing specific information about the terms of any such offering.

Historically,
our primary sources of capital and liquidity have been issuance of equity securities, borrowings under our credit agreements, and cash flows from operating activities. To
develop our reserves as reported in our June 30, 2009 reserve report, we will require access to the capital markets in each of the next four years, as our projected capital expenditures are
greater than projected cash flow from operations through December 2012.



As discussed in Note 4 to our Consolidated Financial Statements, the lenders under the ARCA and Subordinated Credit Agreement
agreed to waive the covenants relating to our leverage ratio and interest coverage ratio for the quarter ended December 31, 2009, as we would have been out of compliance with such covenants as
of December 31, 2009. Should the merger with Resaca not close by March 31, 2010, based upon our six-month operating results through December 31, 2009, it is likely
that we will not be in compliance with one or more of our financial
covenants under our credit agreements as of March 31, 2010. Accordingly, since we did not receive covenant relief beyond December 31, 2009, we have reclassified our debt from
long-term to short-term. If a combination of increased production, rising commodity prices, changes in our capital structure, the closing of our pending Merger and other
actions do not occur by March 31, 2010, we anticipate not being in compliance with the covenants. In that event, we will seek covenant relief from our lenders, though there can be no assurance
that we will be successful in obtaining such relief.

Both
the ARCA and Subordinated Credit Agreement, have a current ratio covenant that requires us to maintain a ratio of not less than 1.00 to 1.00 for each fiscal quarter. The current
ratio is calculated by dividing current assets (as defined in both credit agreements) by current liabilities (as defined in both credit agreements). Current assets include unused borrowing base under
the ARCA and the aggregate availability under the subordinated credit agreement. Current liabilities exclude all current portions of long-term debt other than any current debt relating to
the Series D Convertible Preferred Stock and liabilities for asset retirement obligations. Current assets and current liabilities exclude derivative assets and liabilities. At
December 31, 2009, our ratio of current assets to current liabilities was 1.59 to 1.00. The calculation and reconciliation of current assets and current liabilities, as

30

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defined
by GAAP, to current assets and current liabilities, as defined in the credit agreements is as follows (in thousands):

December 31, 2009Current assets (GAAP)

$
7,255Unused borrowing base at December 31, 2009


8,300
(1)Less: derivative assets


(2,976
)Modified current assets (non-GAAP)

$
12,579
(A)Current liabilities (GAAP)

$
74,891Less: current portion of long-term debt


(66,700
)Less: derivative liabilities


(199
)Less: asset retirement obligation


(90
)Modified current liabilities (non-GAAP)

$
7,902
(B)Modified current ratio (A) / (B)


1.59 to 1.00


---

Both
of our credit agreements also contain customary events of default that would permit our lenders to accelerate the debt under both credit agreements if not cured within applicable
grace periods, including, among others, failure to make payments of principal or interest when due, materially incorrect representations and warranties, breach of covenants, failure to make mandatory
prepayments in the event of borrowing base deficiencies, events of bankruptcy, dissolution, the occurrence of one or more unstayed judgments in excess of $1,000,000 and defaults upon other
obligations, including obligations under the subordinated credit agreement. At December 31, 2009, we were not in compliance with the covenants relating to our leverage ratio and interest
coverage ratio for the quarter ended December 31, 2009.

As
discussed in Note 4 to our Consolidated Financial Statements, the lenders under our two credit agreements agreed to waive the covenants relating to our leverage ratio and
interest coverage ratio for the quarter ended December 31, 2009. Should the merger with Resaca not close by March 31, 2010, based upon our six-month operating results through
December 31, 2009, it is likely that we may fall out of compliance with one or more of our financial covenants under our credit agreements as of March 31, 2010. Accordingly, since we did
not receive covenant relief beyond December 31, 2009, we have reclassified our debt from long-term to short-term. If a combination of increased production, rising
commodity prices, changes in our capital structure, the closing of our pending Merger and other actions do not occur by March 31, 2010, we anticipate not being in compliance with the covenants.
In that event, we will seek covenant relief from our lenders, though there can be no assurance that we will be successful in obtaining such relief.

If
the Merger is not completed and we are unable to obtain relief from our lenders, we will need to raise additional capital through the issuance of equity or the sale of a portion of
our assets. There can be no assurance as to the amount of additional capital we would be able to raise, if any, in connection with any such equity issuances or asset sales. In addition, any such
equity issuances could be highly dilutive to our existing stockholders and any such asset sales would require the consent of our lenders and, potentially, the holders of our outstanding common and
preferred stock.

Results of Operations

For the current quarter, we had a loss applicable to common stock of $8.9 million, which was a $22.6 million decrease as
compared to the prior year quarter of $13.7 million income applicable to

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common
stock. Items contributing to the $22.6 million earnings decrease were reduced gain on derivatives of $26.0 million, lower income from discontinued operations of
$12.2 million and decreased income from the preferred stock repurchased for less than the carrying amount of $10.9 million. Partially offsetting the earnings decrease were lower
operating expenses of $24.6 million and higher operating revenues of $1.2 million. The $24.6 million reduction in operating expenses is primarily attributable to a
$22.4 million charge for impairment of long-lived assets in the prior year quarter.

For
the current six months, we had a loss applicable to common stock of $12.9 million, which was a $38.4 million decrease as compared to the $25.5 million income
applicable to common stock incurred for the six-month period ended December 31, 2008 ("prior year six months"). Items contributing to the $38.4 million earnings decrease were
reduced gain on derivatives of $50.2 million, lower income from discontinued operations of $11.4 million, decreased income from the preferred stock repurchased for less than the carrying
amount of $10.9 million and lower operating revenues of $4.4 million. Partially offsetting the earnings decrease were lower operating expenses of $27.0 million, which is primarily
attributable to a $22.4 million charge for impairment of long-lived assets in the prior year quarter.

These
items will be addressed in the following discussion.

Operating Revenues

The table below summarizes our operating revenues for the three- and six-month periods ended
December 31, 2009 and 2008.

Three months ended
December 31,



Six months
ended December 31,Increase
(Decrease)

Increase
(Decrease)2009

2008

2009

2008Operating Revenues(in thousands)

$
6,143

$
4,876

$
1,267

$
11,407

$
15,808

$
(4,401
)SalesCrude Oil (MBbls)


68


70


(2
)

140


143


(3
)Natural Gas (MMcf)


183


195


(12
)

342


390


(48
)Total (MBOE)


99


103


(4
)

197


208


(11
)Average Realized PriceCrude Oil ($/ Bbl)

$
69.29

$
52.55

$
16.74

$
65.12

$
82.72

$
(17.60
)Natural Gas ($/ Mcf)

$
7.83

$
5.70

$
2.13

$
6.62

$
9.87

$
(3.25
)Operating Revenues and Commodity Derivative Settlements(in thousands)

$
7,339

$
6,587

$
752

$
14,454

$
16,968

$
(2,514
)Average Adjusted Price (includes commodity derivative settlements)Crude Oil ($/ Bbl)

$
73.86

$
71.55

$
2.31

$
72.58

$
89.20

$
(16.62
)Natural Gas ($/Mcf)

$
12.66

$
7.65

$
5.01

$
12.46

$
10.47

$
1.99


The
current quarter operating revenues of $6.1 million are $1.2 million higher as compared to the prior year quarter of $4.9 million. The $1.2 million
increase is primarily attributable to higher average prices received for crude oil and natural gas sales of $1.2 million and $0.4 million, respectively, partially offset by lower crude
oil and natural gas sales volumes which combined to reduce revenues by $0.2 million.

The
current six months operating revenues of $11.4 million are $4.4 million lower as compared to the prior year six months of $15.8 million. The $4.4 million
decrease is primarily attributable to lower average prices received for crude oil and natural gas sales of $2.4 million and $1.1 million, respectively, and lower crude oil and natural
gas sales volumes which reduced revenues by $0.2 million and $0.5 million, respectively.

32

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The
impact of lower average prices for crude oil and natural gas sales for the current six months, as discussed above, is partially mitigated by commodity derivative settlements received
during the current quarter as presented in the preceding table. As discussed in Note 5 to our Consolidated Financial Statements, if crude oil and natural gas NYMEX prices are lower than
derivative floor prices, we will be reimbursed by our counterparty for the difference between the NYMEX price and floor price (i.e. realized gain). Conversely, if crude oil and natural gas NYMEX
prices are higher than the derivative ceiling prices, we will pay our counterparty for the difference between the NYMEX price and ceiling price (i.e. realized loss).

Crude Oil Sales.Our current quarter crude oil sales were 2 MBbls lower as compared to the prior year quarter. Increased
production from our
Cato Properties was more than offset by lower sales from our Panhandle Properties due to severe weather during December 2009 which temporarily curtailed production and decreased condensate sales from
our Desdemona Property as the gas plant was temporarily shut-in to equip the plant to handle increased gas production and associated NGL recovery from the return to production of 25
shut-in gas wells as previously discussed under the "OverviewDrilling Capital Development and Operating Activities Update."

Our
current six months crude oil sales were 3 MBbls lower as compared to the prior year six months due to the same reasons previously discussed and lower sales from our Panhandle
Properties as temporary shut-in production at the Cockrell Ranch waterflood due to the controlled injection project surveillance, as previously discussed under the
"OverviewDrilling Capital Development and Operating Activities Update." All Cockrell Ranch production that had been shut-in for
the controlled injection project was restored on September 28, 2009.

Natural Gas Sales.Our current quarter natural gas sales were 12 MMcf lower as compared to the prior year quarter due to lower
production at our
Desdemona Properties since, during July 2009, we shut-in our Barnett Shale natural gas wells based upon the current and near-term outlook of natural gas prices.

Our
current six months natural gas sales were 48 MMcf lower as compared to the prior year six months due to shut-in natural gas production from our Barnett Shale wells, as
previously discussed, and lower natural gas sales at the Panhandle Properties resulting from the controlled production project at Cockrell Ranch waterflood, as previously discussed, and one of our gas
purchasers experienced an unplanned plant outage from mid-August 2009 through the end of September 2009, which resulted in reduced natural gas and NGL sales.

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

We
expect to grow sales through our development plans as previously discussed under "OverviewDevelopment Capital Expenditures and Operating
Activities Update."

Operating Expenses

For the current quarter, our total operating expenses were $14.0 million, which is a decrease of $24.6 million as
compared to the prior year quarter of $38.6 million. The prior year quarter included an impairment of long-lived assets of $22.4 million, which is the primary reason for the
overall decrease. In addition, we had reduced general and administrative of
$6.7 million and lower lease operating expenses of $0.9 million, partially offset by the exploration expense of $5.0 million recorded during the current quarter.

33

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For
the current six months, our total operating expenses were $23.8 million, which is a decrease of $27.0 million as compared to the prior year six months of
$50.8 million. The prior year six months included an impairment of long-lived assets of $22.4 million, which is the primary reason for the overall decrease. In addition, we
had reduced general and administrative of $8.0 million and lower lease operating expenses of $1.5 million, partially offset by the exploration expense of $5.0 million recorded
during the current six months.



Our lease operating expenses ("LOE") consist of the costs of producing crude oil and natural gas such as labor, supplies, repairs,
maintenance, workovers and utilities.

For
the current quarter, our LOE was $3.9 million, which is $0.9 million lower than the prior year quarter of $4.8 million. For the current six months, our LOE was
$8.3 million, which is $1.5 million lower than the prior year six months of $9.8 million. The LOE decreases for the current quarter and current six months of $0.9 million
and $1.5 million, respectively, resulted primarily from reduced service rates negotiated with vendors and the shut-in of our Barnett Shale natural gas wells, as previously discussed
under "Operating Revenues," which reduced LOE for the current quarter and current six months by $0.3 million and $0.4 million,
respectively. Partially offsetting these LOE cost reductions were increased LOE at the Cato Properties for the current quarter and current six months of $0.2 million and $0.4 million,
respectively, to support higher levels of activity, as previously discussed under "Operating Revenues."

For
the current quarter, our LOE per BOE, based on production, was $37.12, which is an improvement of $6.94 as compared to $44.06 for the prior year quarter. For the current six months,
our LOE per BOE, based on production, was $37.93, which is an improvement of $6.92 as compared to $44.86 for the prior year six months. In general, secondary and tertiary LOE is higher than LOE for
companies developing primary production because our fields are more mature and typically produce less oil and more water. We expect LOE to decrease during the 2010 fiscal year as we realize the
continued benefit of lower service rates negotiated with vendors, and we expect LOE per BOE to decrease as production increases from the waterflood and EOR development activities we have implemented
and are
implementing as discussed under the "OverviewDrilling Capital Development and Operating Activities Update."



For the current quarter, our production and ad valorem taxes were $0.5 million, which is $0.1 million higher than the
prior year quarter of $0.4 million. The $0.1 million increase resulted from higher production taxes from increased operating revenue. Our production taxes as a percent of operating
revenues for the current quarter of 6.5% was comparable to the prior year quarter of 5.9%.

For
the current six months, our production and ad valorem taxes were $1.0 million, which is $0.5 million lower than the prior year six months of $1.5 million. The
$0.6 million decrease resulted from lower production taxes of $0.3 million due to lower operating revenues and reduced ad valorem taxes of $0.2 million due to lower property tax
valuations by taxing authorities for the 2009 calendar year. Our production taxes as a percent of operating revenues for the current quarter of 6.4% was comparable to the prior year quarter of 6.7%.



Our general and administrative ("G&A") expenses consist of support services for our operating activities and investor relations costs.

34

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For the current quarter, our G&A expenses totaled $2.9 million, which is $6.7 million lower than the prior year quarter of $9.5 million. The $6.7 million
expense reduction resulted from reduced legal costs of $6.4 million, reduced stock-based compensation costs of $0.5 million, lower payroll and benefits costs of $0.2 million, and
other reductions of $0.2 million, partially offset by increased costs related to the Merger of $0.8 million.

For
the current six months, our G&A expenses totaled $6.5 million, which is $7.9 million lower than the prior year six months of $14.4 million. The
$7.9 million expense reduction resulted from reduced legal costs of $7.5 million, reduced stock-based compensation costs of $1.0 million, lower payroll and benefits costs of
$0.5 million, and other reductions of $0.5 million, partially offset by increased costs related to the Merger of $1.5 million.

The
reduced payroll and benefits costs resulted from workforce reductions we implemented during the quarter ended March 31, 2009, which eliminated 25% of our home office staff and
is estimated to reduce payroll and benefits costs by $0.8 million annually. The lower stock-based compensation costs are directly related to reduced issuances of stock options and restricted
stock. Legal cost reduction occurred as we have settled all but one of our fire litigation claims during the fiscal year ended June 30, 2009. We expect continued decreases in future quarters'
legal expenses.



During the current quarter, we recorded exploration expense of $5.0 million pertaining to the Nowata ASP Project. During
December 2009, we finalized our performance analysis, which indicated the Nowata ASP Project did not result in increased oil production of significant quantities to be considered economically viable
that would justify the
recognition of proved reserves. Accordingly, at December 31, 2009, we recorded a $5.0 million pre-tax exploration expense.



During the quarter ended December 31, 2009, we wrote down $0.3 million of costs associated with the ASP facility used for
the Nowata ASP Project. The facility's water filtering process did not work properly with the oil-water fluid production at our Nowata Properties. We intend to use the ASP facility for
future pilot tertiary projects at our Cato and Panhandle Properties.

During
the quarter ended December 31, 2008, we recorded a $22.4 million pre-tax impairment to our Barnett Shale Properties and a $0.7 million
pre-tax impairment to the goodwill associated with our subsidiary which holds the equity in our Barnett Shale Properties. We recorded the impairments due to the decline in commodity prices
which created an uncertainty in the likelihood of developing reserves associated with our Barnett Shale natural gas properties (the "Barnett Shale Properties") within the next five years.



For the current quarter and current six months, our depletion and depreciation expense was $1.3 million and $2.5 million,
respectively, which is a slight decrease of $0.1 million as compared to each of the corresponding prior year periods. This includes depletion expense pertaining to our oil and natural gas
properties, and depreciation expense pertaining to our field operations vehicles and equipment, natural gas plant, office furniture and computers. The decrease is due to higher depreciation of
non-oil and gas properties assets, partially offset by lower depletion costs due to lower depletion rates and lower crude oil and natural gas sales volumes (net) as previously discussed
under "Operating Revenues."For the current quarter and current six months, our depletion rate pertaining to our oil and gas properties was
$10.49 per BOE and $10.54 per BOE, respectively. For the prior year quarter and prior year six months, our depletion rate pertaining to our oil and gas properties was $11.81 per BOE and $11.07 per
BOE, respectively.

35

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For the current and prior year quarters, we incurred interest expense of $0.3 million and $0.1 million, respectively. For
the current and prior year six months, we incurred interest expense of and $0.5 million and $0.3 million, respectively. Our interest expense is a direct result of the credit agreements
we entered into, as discussed in Note 4 to our Consolidated Financial Statements. The interest expense for the current and prior year quarters was reduced by $0.5 million and
$0.1 million, respectively, for interest cost that was capitalized to the waterflood projects discussed under "OverviewDevelopment Capital Expenditures and
Operating Activities Update."The interest expense for the current and prior year six months was reduced by $1.0 million and $0.6 million, respectively, for the
same reason. We incurred higher interest costs during the current year quarter due to higher outstanding debt balances.



As discussed in Note 5 to our Consolidated Financial Statements, we have entered into financial derivatives contracts for our
commodity sales and interest expense. For the current quarter, we recorded a loss on derivatives of $4.7 million as compared to a gain of $21.2 million for the prior year quarter. The
current quarter loss of $4.7 million consisted of an unrealized loss of $5.8 million and a realized gain on settlements of derivative contracts of $1.1 million.

For
the current six months, we recorded a loss on derivatives of $5.2 million as compared to a gain of $45.0 million for the prior year six months. The current quarter loss
of $5.2 million consisted of an unrealized loss of $8.1 million and a realized gain on settlements of derivative contracts of $2.9 million.

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

The
unrealized loss for the current quarter and six months reflects the fair value of the commodity derivatives as of December 31, 2009 as compared to September 30, 2009
and June 30, 2009, respectively. By their nature, these commodity derivatives can have a highly volatile impact on our earnings. A ten percent change in the prices for our commodity derivative
instruments could impact our pre-tax earnings by approximately $29,000.



For the current quarter, we had an income tax benefit of $4.4 million, as compared to an income tax expense for the prior year
quarter of $2.4 million. For the current six months, we had an income tax benefit of $6.0 million, as compared to an income tax expense for the prior year six months of
$10.5 million. The tax amounts for the prior year quarter and prior year six months included taxes related to discontinued operations as shown in Note 6 to our Consolidated Financial
Statements. The decreased income taxes for the current quarter and current six months, as compared to the corresponding prior year periods, resulted from the decrease in taxable income. The effective
income tax rates for the current quarter and current six months were 34.4% and 33.5%, respectively. The effective income tax rates for the prior year quarter and prior year six months were 40.3% and
39.2%, respectively. The prior year tax rates were higher due to an increase in the state tax rate.



For the current quarter and current six months, we had no income from discontinued operations, as compared to income of
$12.2 million and $11.4 million, respectively, for the prior year quarter and prior year six months. The prior year income pertains to our divestitures of the Pantwist, LLC and
Corsicana Properties, as discussed in Note 6 to our Consolidated Financial Statements.

36

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The preferred stock dividend for the current quarter of $0.4 million was a decrease of $0.5 million from
$0.9 million for the prior year quarter. The preferred stock dividend for the current six months of $0.9 million was a decrease of $0.9 million from $1.8 million for the
prior year six months. The decreases are attributable to our November and December 2008 repurchases of preferred stock. Due to the repurchases, our quarterly preferred stock dividends will be
approximately $0.5 million per quarter of which 59% will be PIK, with the balance paid in cash. Also, the current
quarter decrease includes a one-time adjustment of approximately $50,000 to adjust estimated federal withholding taxes applicable to the preferred stock dividend.



In June 2009, the Financial Accounting Standards Board ("FASB") issued a standard that established the FASB Accounting Standards
CodificationTM ("ASC") and amended the hierarchy of GAAP such that the ASC became the single source of authoritative nongovernmental GAAP. The ASC did not change current GAAP, but was
intended to simplify user access to all authoritative GAAP by providing all the authoritative literature related to a particular topic in one place. All previously existing accounting standard
documents were superseded and all other accounting literature not included in the ASC is considered non-authoritative. New accounting standards issued subsequent to June 30, 2009
are communicated by the FASB through Accounting Standards Updates. The ASC became effective for us on July 1, 2009. This standard did not have an impact on our financial position, results of
operations or cash flows. Throughout the notes to the consolidated financial statements, references that were previously made to various former authoritative GAAP pronouncements have been conformed to
the appropriate section of the ASC.

In
December 2007, the FASB issued ASC 805 (formerly Statement of Financial Accounting Standards ("SFAS") No. 141 (revised 2007),Business
Combinations). Among other things, ASC 805 establishes principles and requirements for how the acquirer in a business combination: (i) recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquired business; (ii) recognizes and measures the goodwill acquired in
the business combination or the gain from a bargain purchase; and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial
effects of the business combination. ASC 805 is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. We adopted ASC 805 on July 1, 2009.

In
December 2007, the FASB issued ACS 810 (formerly SFAS No. 160,Noncontrolling Interests in Consolidated Financial Statements, An Amendment of ARB
No. 51). ASC 810 establishes accounting and reporting standards for noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. Minority
interests will be recharacterized as noncontrolling interests and classified as a component of equity. It also establishes a single method of accounting for changes in a parent's ownership interest in
a subsidiary and requires expanded disclosures. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. We adopted ASC 810 on
July 1, 2009. The adoption of this statement did not have a material impact on our financial position, results of operations or cash flows.

In
March 2008, the FASB issued ASC 815 (formerly SFAS No. 161,Disclosures about Derivative Instruments and Hedging ActivitiesAn Amendment of
FASB Statement 133). ASC 815 expands the required disclosures to discuss the uses of derivative instruments; the accounting for derivative instruments and related hedged items
under ASC 815, and how derivative instruments and
related hedged items affect the company's financial position, financial performance and cash flows. We adopted ASC 815 on July 1, 2009. The adoption of this statement did not have a material
impact on our financial position, results of operations or cash flows.

37

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In
June 2008, the FASB issued ASC 260 (formerly EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment
Transactions Are Participating Securities). ASC 260 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and
need to be included in the calculation of earnings per share under the two-class method. Under ASC 260, share-based payment awards that contain nonforfeitable rights to dividends are
"participating securities", and therefore should be included in computing earnings per share using the two-class method. ASC 260 is effective for financial statements issued for fiscal
years and interim periods beginning after December 15, 2008. We adopted ASC 260 on July 1, 2009. The effect of adopting ASC 260 increased the number of shares used to compute our
earnings per share; however, the adoption of ASC 260 did not have a material impact on our financial position, results of operations or cash flows.

In
December 2008, the FASB issued ASC 815 (formerly EITF 07-5,Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity's Own Stock). ASC 815 affects companies that have provisions in their securities purchase agreements that provide for the reset of the current conversion price based
upon new issuances by companies at prices below certain thresholds. Securities purchase agreements with such provisions will require the embedded derivative instrument to be bifurcated and separately
accounted for as a derivative. Subject to certain exceptions, our preferred stock provides for resetting the conversion price if we issue new common stock below $5.75 per share. ASC 815 is effective
for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. We adopted ASC 815 on July 1, 2009. The adoption of this statement did not have a
material impact on our financial position, results of operations or cash flows as the reset conversion provision did not meet the definition of a derivative since it was not readily
net-cash settled.

In
December 2008, the Securities and Exchange Commission (SEC) issued the final rule,Modernization of Oil and Gas Reporting.The new
disclosure requirements include provisions that permit the use of new technologies to determine proved reserves if those technologies lead to reliable conclusions about reserve quantities. The new
requirements also will allow companies to disclose their probable and possible reserves to investors. In addition, the new disclosure requirements specify for companies to: (a) report the
independence and qualifications of its reserves preparer or auditor; (b) file reports when a third party is relied upon to prepare reserves estimates or conducts a reserves audit; and
(c) report oil and gas reserves using an average price based upon the prior 12-month period rather than year-end prices. The new disclosure requirements are effective
for financial statements for fiscal years ending on or after December 31, 2009. We are not required to conform to these SEC requirements until we file our annual report for our fiscal year
ending June 30, 2010. The
effect of adopting the SEC rule has not been determined; however, is not expected to have a material impact on our financial position, results of operations or cash flows.

In
June 2009, the FASB issued ASC 855 (formerly SFAS 165,Subsequent Events) to establish general standards of accounting for and
disclosure of events that occur after the balance sheet date, but prior to the issuance of financial statements. Specifically, ASC 855 sets forth: (1) the period after the balance sheet date
during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (2) the circumstances
under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and (3) the disclosures that an entity should make about events
or transactions that occurred after the balance sheet date. ASC 855 is effective for financial statements issued for interim or annual periods ending after June 15, 2009. We adopted ASC 855 on
June 30, 2009 and considered subsequent events through February 12, 2010. The adoption of this statement did not have a material impact on our financial position, results of operations
or cash flows.

Item 4T.    Controls and Procedures.

As of the end of the period covered by this report, our management conducted an evaluation, under the supervision and with the
participation of our chief executive officer and chief financial

38

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officer,
of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934
(the "Exchange Act")). Based upon this evaluation, our chief executive officer and chief financial officer concluded, as of December 31, 2009, that our disclosure controls and procedures were
effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is: (1) recorded, processed, summarized and reported, within the
time periods specified in the Securities and Exchange Commission's rules and forms and (2) accumulated and communicated to management, including our chief executive officer and chief financial
officer, to allow timely decisions regarding required disclosure.

During
the quarter ended December 31, 2009, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

39

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PART IIOTHER INFORMATION

Item 1.    Legal Proceedings.

See Note 13 to our Consolidated Financial Statements which is incorporated into this "Item 1. Legal Proceedings" by
reference.

Item 1A.    Risk Factors.

Please refer to the "Risk Factors" section of the joint proxy statement/prospectus of Cano and Resaca that is included in Amendment
No. 2 to the registration statement on Form S-4 filed by Resaca with the SEC on February 3, 2010 for a description of risks applicable to the proposed Merger of Cano
and a wholly-owned subsidiary of Resaca and the combined company following the consummation of such Merger.

Item 6.    Exhibits.

Exhibit
Number

Description2.1

Agreement and Plan of Merger, dated September 29, 2009 by and among Resaca Exploitation, Inc., Resaca Acquisition Sub, Inc. and Cano Petroleum, Inc., incorporated by reference from Exhibit 2.1 to
Current Report on Form 8-K filed on October 1, 2009.3.1

Certificate of Incorporation of Huron Ventures, Inc., incorporated herein by reference to Exhibit 3.1 to Cano's Registration Statement on Form 10 SB (File No. 000-50386) filed with the SEC on
September 4, 2003.3.2

Certificate of Ownership of Huron Ventures, Inc. and Cano Petroleum, Inc., amending Cano's Certificate of Incorporation, incorporated herein by reference to Exhibit 3.2 to Cano's Annual Report on
Form 10-KSB filed with the SEC on September 23, 2004.3.3

Certificate of Amendment to Certificate of Incorporation of Cano Petroleum, Inc., incorporated herein by reference to Exhibit 3.8 to Cano's Post-Effective Amendment No. 2 on Form S-1 filed with the SEC
on January 23, 2007.3.4

First Amended and Restated Bylaws of Cano Petroleum, Inc., incorporated herein by reference to Exhibit 3.1 to Cano's Current Report on Form 8-K filed with the SEC on December 7, 2007.3.5

Amendment to Amended and Restated Bylaws, dated October 20, 2008, incorporated herein by reference to Exhibit 3.1 to Cano's Current Report on Form 8-K filed with the SEC on October 24,
2008.3.6

Second Amended and Restated By-Laws of Cano Petroleum, Inc. dated May 7, 2009, incorporated herein by reference to Exhibit 3.1 to Cano's Current Report on Form 8-K filed with the SEC on May 13,
2009.3.7

Certificate of Designation for Series B Convertible Preferred Stock, incorporated herein by reference to Exhibit 99.2 to Cano's Current Report on Form 8-K filed with the SEC on June 8,
2004.3.8

Certificate of Designation for Series C Convertible Preferred Stock, incorporated herein by reference to Exhibit 99.2 to Cano's Current Report on Form 8-K filed with the SEC on July 15,
2004.3.9

Certificate of Designation for Series D Convertible Preferred Stock incorporated herein by reference to Exhibit 3.1 to Cano's Current Report on Form 8-K filed with the SEC on September 7,
2006.4.1

Registration Rights Agreement dated August 25, 2006 among Cano Petroleum, Inc. and the Buyers listed therein, incorporated herein by reference to Exhibit 4.1 to the Amendment to Cano's Current Report on
Form 8-K/A filed with the SEC on August 31, 2006.


40

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Exhibit
Number

Description4.2

Registration Rights Agreement dated November 2, 2007 among Cano Petroleum, Inc. and the Buyers listed therein, incorporated herein by reference to Exhibit 4.1 to Cano's Current Report on Form 8-K filed
with the SEC on November 6, 2007.4.3

Form of Common Stock certificate, incorporated herein by reference to Exhibit 4.9 to Cano's Registration Statement on Form S-3 (No. 333-148053) filed with the SEC on December 13, 2007.4.4

Designation for Series A Convertible Preferred Stock, included in the Certificate of Incorporation of Huron Ventures, Inc., incorporated herein by reference to Exhibit 3.1 to Cano's registration statement
on Form 10 SB (File No. 000-50386) filed with the SEC on September 4, 2003.4.5

Certificate of Designation for Series B Convertible Preferred Stock, incorporated herein by reference to Exhibit 99.2 to Cano's Current Report on Form 8-K filed with the SEC on June 8,
2004.4.6

Certificate of Designation for Series C Convertible Preferred Stock, incorporated herein by reference to Exhibit 99.2 to Cano's Current Report on Form 8-K filed with the SEC on July 15,
2004.4.7

Certificate of Designation for Series D Convertible Preferred Stock incorporated herein by reference to Exhibit 3.1 to Cano's Current Report on Form 8-K filed with the SEC on September 7,
2006.10.1

Form of Stock Voting Agreement between Cano Petroleum, Inc. and certain holders of Series D Convertible Preferred Stock of Cano Petroleum, Inc., incorporated herein by reference to Exhibit 10.1 to
Cano's Current Report on Form 8-K filed with the SEC on October 21, 2009.10.2

Form of Stock Voting Agreement between Cano Petroleum, Inc. and S. Jeffrey Johnson, incorporated herein by reference to Exhibit 10.2 to Cano's Current Report on Form 8-K filed with the SEC on
October 21, 2009.10.3

Amendment No. 1 and Agreement dated December 30, 2009 among Cano Petroleum, Inc., certain Guarantors, certain Lenders and Union Bank, N.A., incorporated herein by reference to Exhibit 10.1 to Cano's
Current Report on Form 8-K filed with the SEC on January 6, 2010.10.4

Amendment No. 1 and Agreement dated December 30, 2009 among Cano Petroleum, Inc., certain Guarantors, certain Lenders and UnionBanCal Equities, Inc., incorporated herein by reference to
Exhibit 10.2 to Cano's Current Report on Form 8-K filed with the SEC on January 6, 2010.31.1
*
Certification by Chief Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, promulgated pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
*
Certification by Chief Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, promulgated pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
*
Certification by Chief Executive Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, promulgated pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
*
Certification by Chief Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code, promulgated pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.


---

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.

CANO PETROLEUM, INC.



Date: February 12, 2010

By:

/s/ S. JEFFREY JOHNSON S. Jeffrey Johnson Chief Executive OfficerDate: February 12, 2010

By:

/s/ BENJAMIN DAITCH Benjamin Daitch Senior Vice-President and Chief Financial Officer


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