**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(Mark One)**

**x QUARTERLYREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

**For the quarterly period ended March31, 2007**

**o** TRANSITION REPORT UNDER SECTION 13OR 15(d) OF THE EXCHANGE ACT

**For the transition periodfrom                  to                **

**Commission file number 001-32496**

**CANO PETROLEUM, INC.**

(Exact name of registrant as specified in its charter)

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

 

**TheBurnett Plaza****801 Cherry Street, Suite 3200****Fort Worth, TX 76102**

(Address of principal executive offices)

**(817)698-0900**

(Issuer’s telephone number)

Checkwhether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (orfor 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  x    No  o

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of acceleratedfiler and large accelerated filer in rule 12b-2 of the Exchange Act. (checkone):
| Large accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|---------------------------|--------|----------------------|--------|--------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes  o    No  x

State the number of shares outstanding of each of theissuer’s classes of common equity, as of the latest practicable date: 32,683,098 shares of common stock, $.0001 par value per share, as of May 8,2007.

 

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**PART I — FINANCIAL INFORMATION**

**Item 1.Financial Statements.**

**CANOPETROLEUM, INC.CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                                                          | ** ** | **March 31,** | ** **      | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|-----------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                          | ** ** | **2007**           | ** **      | **2006**          | ** ** |
| ** **                                                                                                                                                                                                                                                          | ** ** | **(Unaudited)**    | ** **      | ** **        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                          |       |               |            |              |       |
| **Current assets**                                                                                                                                                                                                                                                  |       |               |            |              |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                          |       | $                  | 119,277         |              | $          | 644,659 |   |
| Accounts  receivable                                                                                                                                                                                                                                                |       | 3,354,055          |            | 3,563,649         |       |
| Derivative  assets                                                                                                                                                                                                                                                  |       | 693,107            |            | 1,176,959         |       |
| Prepaid expenses                                                                                                                                                                                                                                                    |       | 523,489            |            | 205,349           |       |
| Inventory                                                                                                                                                                                                                                                           |       | 484,635            |            | 396,081           |       |
| Other current  assets                                                                                                                                                                                                                                               |       | 101,218            |            | 641,759           |       |
| Total current  assets                                                                                                                                                                                                                                               |       | 5,275,781          |            | 6,628,456         |       |
|                                                                                                                                                                                                                                                                |       |               |            |              |       |
| **Oil  and gas properties**, successful efforts method                                                                                                                                                                                                              | ** ** | 168,923,458        |            | 133,176,618       |       |
| Less accumulated  depletion and depreciation                                                                                                                                                                                                                        | ** ** | (4,701,000         | )               | (2,126,049        | )          |
| Net oil and gas  properties                                                                                                                                                                                                                                         | ** ** | 164,222,458        |            | 131,050,569       |       |
| ** **                                                                                                                                                                                                                                                          | ** ** |               |            |              |       |
| Fixed assets and other,  net                                                                                                                                                                                                                                        | ** ** | 7,343,407          |            | 6,778,055         |       |
| Restricted cash (Note  11)                                                                                                                                                                                                                                          |       | 6,000,000          |            | —            |       |
| Derivative assets                                                                                                                                                                                                                                                   | ** ** | 1,617,431          |            | 1,705,855         |       |
| Goodwill                                                                                                                                                                                                                                                            | ** ** | 785,796            |            | 785,796           |       |
| **TOTAL  ASSETS**                                                                                                                                                                                                                                                   | ** ** | **$**              | **185,244,873** | ** **        | **$**      | **146,948,731** | ** ** |
| ** **                                                                                                                                                                                                                                                          | ** ** | ** **         |            |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                      |       |               |            |              |       |
| **Current liabilities**                                                                                                                                                                                                                                             |       |               |            |              |       |
| Accounts payable                                                                                                                                                                                                                                                    |       | $                  | 6,855,101       |              | $          | 2,304,198 |   |
| Oil and gas  payable                                                                                                                                                                                                                                                |       | 1,060,546          |            | 1,399,047         |       |
| Acquisition  payable                                                                                                                                                                                                                                                |       | 800,000            |            | —            |       |
| Accrued  liabilities                                                                                                                                                                                                                                                |       | 795,447            |            | 321,183           |       |
| Taxes payable                                                                                                                                                                                                                                                       |       | 257,286            |            | 419,692           |       |
| Current portion  of asset retirement obligations                                                                                                                                                                                                                    |       | 143,738            |            | 19,809            |       |
| Total current  liabilities                                                                                                                                                                                                                                          |       | 9,912,118          |            | 4,463,929         |       |
| **Long-term liabilities**                                                                                                                                                                                                                                           |       |               |            |              |       |
| Long-term debt                                                                                                                                                                                                                                                      |       | 21,500,000         |            | 68,750,000        |       |
| Asset retirement  obligations                                                                                                                                                                                                                                       |       | 2,076,470          |            | 1,587,569         |       |
| Deferred tax  liability                                                                                                                                                                                                                                             |       | 31,167,000         |            | 31,511,000        |       |
| Deferred  litigation credit (Note 11)                                                                                                                                                                                                                               |       | 6,000,000          |            | —            |       |
| Total  liabilities                                                                                                                                                                                                                                                  |       | 70,655,588         |            | 106,312,498       |       |
|                                                                                                                                                                                                                                                                |       |               |            |              |       |
| **Temporary Equity**                                                                                                                                                                                                                                                |       |               |            |              |       |
| Series D  convertible preferred stock and paid-in-kind dividend; liquidation preference  of $50,329,965 and $0, respectively                                                                                                                                        |       | 47,064,890         |            | —            |       |
|                                                                                                                                                                                                                                                                |       |               |            |              |       |
| **Commitments and contingencies  (Note 11)**                                                                                                                                                                                                                        | ** ** | ** **         |            |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                       |       |               |            |              |       |
| Common stock,  par value $.0001 per share; 100,000,000 shares authorized; 33,951,392 and  32,683,098 shares issued and outstanding, respectively, at March 31, 2007;  and 26,987,941 and 25,719,647 shares issued and outstanding, respectively, at  June 30, 2006. |       | 3,268              |            | 2,572             |       |
| Additional  paid-in capital                                                                                                                                                                                                                                         |       | 85,149,019         |            | 53,054,812        |       |
| Accumulated  deficit                                                                                                                                                                                                                                                |       | (17,057,160        | )               | (11,850,419       | )          |
| Treasury stock,  at cost; 1,268,294 shares                                                                                                                                                                                                                          |       | (570,732           | )               | (570,732          | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                    |       | 67,524,395         |            | 40,636,233        |       |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                | ** ** | **$**              | **185,244,873** | ** **        | **$**      | **146,948,731** | ** ** |
| * *                                                                                                                                                                                                                                                            |       |               |            |              |       |

 

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

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**CANOPETROLEUM, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| ** **                                      | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Operating  Revenues:**                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil and natural gas sales                 |       | $                                | 6,428,139  |                            | $          | 5,422,987 |   | $ | 21,984,336 |   | $ | 10,532,227 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Operating  Expenses:**                        |       |                             |       |                            |       |   |   |   |   |
| Lease operating expenses                        |       | 3,074,656                        |       | 2,065,739                       |       | 8,487,702 |   | 4,059,837 |   |
| Production and ad valorem taxes                 |       | 590,863                          |       | 379,990                         |       | 1,834,482 |   | 701,482 |   |
| General and administrative                      |       | 3,000,908                        |       | 1,947,525                       |       | 8,890,387 |   | 5,133,779 |   |
| Accretion of asset retirement obligations       |       | 35,606                           |       | 30,282                          |       | 103,136 |   | 75,656 |   |
| Depletion and depreciation                      |       | 1,067,446                        |       | 631,340                         |       | 3,197,482 |   | 1,058,198 |   |
| Total operating expenses                        |       | 7,769,479                        |       | 5,054,876                       |       | 22,513,189 |   | 11,028,952 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Income  (loss) from operations**              |       | (1,341,340                       | )          | 368,111                         |       | (528,853 | ) | (496,725 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Other  income (expenses):**                   |       |                             |       |                            |       |   |   |   |   |
| Interest expense                                |       | (346,929                         | )          | (928,645                        | )          | (2,413,673 | ) | (1,260,690 | ) |
| Unrealized loss  on hedge contracts             |       | (1,633,046                       | )          | (1,274,900                      | )          | (1,790,036 | ) | (2,910,437 | ) |
| Interest income  and other, net                 |       | 15,184                           |       | 27,406                          |       | 106,366 |   | 122,331 |   |
| Total other expenses                            |       | (1,964,791                       | )          | (2,176,139                      | )          | (4,097,343 | ) | (4,048,796 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Loss before  income taxes                       |       | (3,306,131                       | )          | (1,808,028                      | )          | (4,626,196 | ) | (4,545,521 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Income tax  benefit                             |       | 1,115,000                        |       | 677,000                         |       | 1,622,000 |   | 1,470,000 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Net  loss**                                   |       | (2,191,131                       | )          | (1,131,028                      | )          | (3,004,196 | ) | (3,075,521 | ) |
| ** **                                      |       |                             |       |                            |       |   |   |   |   |
| Preferred stock  dividend                       |       | 966,971                          |       | —                          |       | 2,202,545 |   | — |   |
| ** **                                      |       |                             |       |                            |       |   |   |   |   |
| **Net  loss applicable to common stock**        |       | $                                | (3,158,102 | )                               | $          | (1,131,028 | ) | $ | (5,206,741 | ) | $ | (3,075,521 | ) |
| ** **                                      |       |                             |       |                            |       |   |   |   |   |
| **Net loss  per share - basic and diluted**     |       | $                                | (0.10      | )                               | $          | (0.05 | ) | $ | (0.17 | ) | $ | (0.14 | ) |
| ** **                                      |       |                             |       |                            |       |   |   |   |   |
| **Weighted  average common shares outstanding** |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted                               |       | 32,168,385                       |       | 24,187,966                      |       | 30,034,414 |   | 21,740,759 |   |
| ** **                                      |       |                             |       |                            |       |   |   |   |   |

 

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

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**CANOPETROLEUM, INC.CONSOLIDATED STATEMENT OF CHANGESIN STOCKHOLDERS’ EQUITYJULY 1, 2006 THROUGH MARCH 31, 2007(Unaudited)**
| ** **                                                | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------|-------------|------------|------------|------------|------------|
| ** **                                                | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **  |
| ** **                                                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares** | ** **  | **Amount** | ** ** | **Total**  | ** ** |
| Balance at July  1, 2006                                  |       | 25,719,647            |       | $           | 2,572      |            | $          | 53,054,812              |       | $          | (11,850,419 | )          | 1,268,294  |       | $          | (570,732 | ) | $ | 40,636,233 |   |
|                                                      |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Net proceeds  from issuance of common shares and warrants |       | 6,584,247             |       | $           | 659        |            | $          | 29,625,157              |       | —     |        | —     |       | —     |       | $ | 29,625,816 |   |
|                                                      |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Issuance of  common shares for acquisition                |       | 404,204               |       | $           | 40         |            | $          | 1,853,524               |       | —     |        | —     |       | —     |       | 1,853,564 |   |
|                                                      |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Stock based  compensation, net of forfeiture settlements  |       | (25,000               | )          | (3          | )          | 615,526         |       | —                  |       | —     |        | —     |       | 615,523    |       |
|                                                      |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Preferred stock  dividend                                 |       | —                |       | —      |       | —          |       | (2,202,545              | )          | —     |        | —     |       | (2,202,545 | )          |
|                                                      |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Net loss                                                  |       | —                |       | —      |       | —          |       | (3,004,196              | )          | —     |        | —     |       | (3,004,196 | )          |
|                                                      |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Balance at March 31,  2007                                |       | 32,683,098            |       | $           | 3,268      |            | $          | 85,149,019              |       | $          | (17,057,160 | )          | 1,268,294  |       | $          | (570,732 | ) | $ | 67,524,395 |   |

 

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

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**CANOPETROLEUM, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                                   | ** ** | **Nine Months Ended March 31,** | ** **  |
|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|-------------|
| ** **                                                                                   | ** ** | **2007**                                            | ** **  | **2006** | ** ** |
| **Cash  flow from operating activities:**                                                    |       |                                                |        |   |   |
| Net loss                                                                                     |       | $                                                   | (3,004,196  | ) | $ | (3,075,521 | ) |
| Adjustments needed to reconcile net loss to net cash  flow provided by (used in) operations: |       |                                                |        |   |   |
| Unrealized loss on hedge contracts                                                           |       | 1,790,036                                           |        | 2,910,437 |   |
| Accretion of asset retirement obligations                                                    |       | 103,136                                             |        | 75,656 |   |
| Depletion and depreciation                                                                   |       | 3,197,482                                           |        | 1,058,198 |   |
| Deferred compensation expense                                                                |       | —                                              |        | 443,547 |   |
| Stock compensation expense                                                                   |       | 615,523                                             |        | 134,437 |   |
| Deferred income tax benefit                                                                  |       | (1,622,000                                          | )           | (1,470,000 | ) |
| Amortization of debt issuance and prepaid expenses                                           |       | 1,832,697                                           |        | 318,980 |   |
|                                                                                         |       |                                                |        |   |   |
| Changes in operating assets and liabilities:                                                 |       |                                                |        |   |   |
| Restricted cash                                                                              |       | (6,000,000                                          | )           | — |   |
| Accounts receivable                                                                          |       | 209,594                                             |        | 437,499 |   |
| Derivative assets                                                                            |       | (1,217,760                                          | )           | (5,317,710 | ) |
| Prepaid expenses                                                                             |       | (1,522,039                                          | )           | (212,441 | ) |
| Inventory                                                                                    |       | (88,554                                             | )           | (163,586 | ) |
| Accounts payable                                                                             |       | 566,220                                             |        | (119,331 | ) |
| Oil and gas payable                                                                          |       | (517,126                                            | )           | (488,468 | ) |
| Accrued liabilities                                                                          |       | 412,911                                             |        | (593,875 | ) |
| Taxes payable                                                                                |       | (167,053                                            | )           | (194,266 | ) |
| Deferred litigation liability                                                                |       | 6,000,000                                           |        | — |   |
| Other current assets                                                                         |       | 540,544                                             |        | — |   |
|                                                                                         |       |                                                |        |   |   |
| **Net  cash provided by (used in) operations**                                               | ** ** | **1,129,415**                                       | ** **  | **(6,256,444** | **)** |
|                                                                                         |       |                                                |        |   |   |
| **Cash  flow from investing activities:**                                                    |       |                                                |        |   |   |
| Additions to oil and gas properties                                                          |       | (21,877,613                                         | )           | (3,523,340 | ) |
| Acquisition of oil and gas properties                                                        |       | (6,213,895                                          | )           | — |   |
| Additions to fixed assets and other                                                          |       | (668,450                                            | )           | (444,095 | ) |
| Acquisition of W.O. Energy of Nevada, Inc.                                                   |       | —                                              |        | (48,292,605 | ) |
| Acquisition of additional Davenport revenue interest                                         |       | (133,000                                            | )           | (700,350 | ) |
| **Net  cash used in investing activities**                                                   | ** ** | **(28,892,958**                                     | **)**       | **(52,960,390** | **)** |
|                                                                                         |       |                                                |        |   |   |
| **Cash  flow from financing activities:**                                                    |       |                                                |        |   |   |
| Payment for debt-issuance costs                                                              |       | —                                              |        | (707,587 | ) |
| Borrowings under credit agreements                                                           |       | 21,500,000                                          |        | 42,750,000 |   |
| Repayments under credit agreements                                                           |       | (68,750,000                                         | )           | — |   |
| Proceeds from issuance of preferred stock, net                                               |       | 45,850,925                                          |        | — |   |
| Proceeds from issuance of common stock and warrants,  net                                    |       | 29,625,816                                          |        | 18,348,185 |   |
| Payment of preferred stock dividend                                                          |       | (988,580                                            | )           | — |   |
| **Net  cash from financing activities**                                                      | ** ** | **27,238,161**                                      | ** **  | **60,390,598** |   |
|                                                                                         |       |                                                |        |   |   |
| Net (decrease)  increase in cash and cash equivalents                                        |       | (525,382                                            | )           | 1,173,764 |   |
| Cash and cash  equivalents at beginning of period                                            |       | 644,659                                             |        | 145,489 |   |
| **Cash  and cash equivalents at end of period**                                              | ** ** | **$**                                               | **119,277** | ** ** | **$** | **1,319,253** |   |
|                                                                                         |       |                                                |        |   |   |
| **Supplemental  disclosures of non-cash transactions:**                                      |       |                                                |        |   |   |
| Payment of preferred stock dividend in kind                                                  |       | $                                                   | 1,213,965   |   | $ | — |   |
| Common stock issued for acquisition of oil and gas  properties                               |       | $                                                   | 1,853,564   |   | $ | — |   |
| Common stock issued for acquisition of W.O. Energy  of Nevada, Inc.                          |       | $                                                   | —      |   | $ | 8,240,000 |   |
| Recognition of deferred tax liability for Square One  Energy, Inc.                           |       | $                                                   | —      |   | $ | 3,124,013 |   |
|                                                                                         |       |                                                |        |   |   |
| **Supplemental  disclosure of cash transactions:**                                           |       |                                                |        |   |   |
| Cash paid during  the period for interest                                                    |       | $                                                   | 2,580,726   |   | $ | 1,105,432 |   |

 

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

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**CANO PETROLEUM, INC.**

**NOTES TO FINANCIAL STATEMENTS**

**1.   BASIS OFPRESENTATION AND USE OF ESTIMATES**

The interim consolidated financial statements of CanoPetroleum, Inc. are unaudited and contain all adjustments (consistingprimarily of normal recurring accruals) necessary for a fair statement of theresults for the interim periods presented. Results for interim periods are notnecessarily indicative of results to be expected for a full year or forpreviously reported periods due in part, but not limited to, the volatility inprices for crude oil and natural gas, future commodity prices for derivativehedging 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 toobtain additional capital, and the success of waterflooding and enhanced oilrecovery techniques. You should read these consolidated interim financialstatements in conjunction with the audited consolidated financial statementsand notes thereto included in Cano’s Form 10-KSB dated June 30, 2006.

The accompanying financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) and include the accounts of Cano and itswholly-owned subsidiaries. Intercompany accounts and transactions areeliminated. In preparing the accompanying financial statements, management hasmade certain estimates and assumptions that affect reported amounts in thefinancial statements and disclosures of contingencies. Actual results maydiffer from those estimates. Significant assumptions are required in thevaluation of proved oil and natural gas reserves, which may affect the amountat which oil and natural gas properties are recorded. It is at least reasonablypossible these estimates could be revised in the near term, and these revisionscould be material.

**NewAccounting Pronouncements**

On July 13, 2006, theFinancial Accounting Standards Board (“FASB”) released FIN 48, “Accounting forUncertainty in Income Taxes — an Interpretation of FASB Statement 109.” FIN 48 requires companies to evaluate and disclose material uncertain taxpositions it has taken with various taxing jurisdictions.  We are currentlyreviewing FIN 48 and have not yet determined the effect, if any, that FIN 48will have to our operating results, financial position, or future cashflows.  We will be required to adopt FIN 48 for our fiscal year endingJune 30, 2008.

**2.   PREFERRED ANDCOMMON STOCK FINANCINGS**

On September 6, 2006, we sold in a private placement49,116 shares of Series D Convertible Preferred Stock at a price of $1,000.00per share and 6,584,247 shares of common stock at a price of $4.83 per share,the three day average closing price of the stock prior to the execution of thedefinitive agreements, plus a warrant component.  The preferred stock hasa 7.875% dividend and features a paid-in-kind (“PIK”) provision that allows, atthe investor’s option, the investor to receive additional shares of commonstock upon conversion for the dividend in lieu of a cash dividendpayment.  Holders of approximately 55% of the preferred stock chose thePIK dividend option.  The preferred stock is convertible to common stockat a price of $5.75 per share and the common stock was subject to 25% warrantcoverage at an exercise price of $4.79 per share.  If any Series DConvertible Preferred Stock remains outstanding on September 6, 2011, weare required to redeem the Series D Convertible Preferred Stock for aredemption amount in cash equal to the stated value of the Preferred Stock,plus accrued dividends and PIK dividends.  Gross proceeds from thetransactions were $80.9 million, of which $49.1 million was attributable to thepreferred stock, and $31.8 million was attributable to the common stock andwarrants.  Net proceeds were $75.5 million after deducting for issuancecosts of $5.4 million.

The warrant component totals 1,646,061 common sharesand is exercisable at $4.79 per share.  The exercise period commenced onMarch 5, 2007 and expires on March 6, 2008.  We computed the fair value ofthe warrants at September 6, 2006 as approximately $2.3 million based on theBlack-Scholes model assuming the warrants will be exercised prior to the March6, 2008 expiration date, using a 53% expected volatility factor, 

6

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arisk-free rate of 4.92% and assuming no expected dividend yield.  We haveincluded the fair value of the warrants in Additional Paid-In Capital on ourconsolidated balance sheet as of March 31, 2007.

Cash proceeds from the financings were used to repaylong-term debt (see Note 3), for general corporate purposes and to fund ourcapital expenditures.

We were required to file a Registration Statement(Form S-1) with the Securities and Exchange Commission (“SEC”), which was filedon October 13, 2006 and was declared effective on January 4, 2007.  On April 9, 2007, we also filed to registerthese same securities on a Registration Statement Form S-3 which was declaredeffective on April 19, 2007.  We are required to maintain theeffectiveness of the registration statement, subject to certain exceptions, andif the effectiveness is not maintained, then we must pay 1.5% of the grossproceeds and an additional 1.5% for every 30 days it is not maintained. The maximum aggregate of all registration delay payments is 10% of the grossproceeds.

Pursuant to the terms of the preferred stock andsubject to certain exceptions, if we issue or sell common stock at a price lessthan the conversion price (currently $5.75 per share) in effect immediatelyprior to such issuance or sale, the conversion price shall be reduced.  Ifsuch an issuance is made prior to June 6, 2007, the conversion price will belowered to the average of the conversion price and the issue or saleprice.  If such an issuance is made on or after June 6, 2007, theconversion price will be lowered to the issue or sale price.  The abovedescribed adjustments are not triggered by issuances or sales involving thefollowing: (i) shares issued in connection with an employee benefit plan; (ii)shares issued upon conversion of the Series D Convertible Preferred Stock;(iii) shares issued upon exercise of the warrants issued on September 6, 2006;(iv) shares issued in connection with a firm commitment underwritten pubicoffering with gross proceeds in excess of $50,000,000; (v) shares issued inconnection with any strategic acquisition or transaction; (vi) shares issued inconnection with any options or convertible securities that were outstanding onAugust 25, 2006; or (vii) shares issued in connection with any stock split,stock dividend, recapitalization or similar transaction.

Upon a voluntary or involuntary liquidation,dissolution or winding up of Cano or such subsidiaries of Cano the assets ofwhich constitute all or substantially all of the assets of the business of Canoand its subsidiaries taken as a whole, the holders of the Series D ConvertiblePreferred Stock shall be entitled to receive an amount per share equal to$1,000 plus dividends owing on such share prior to any payments being made toany class of capital stock ranking junior on liquidation to the Series DConvertible Preferred Stock.

In accordance with the provisions of Statement ofFinancial Accounting Standards No. 150,*Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity*and EITF D-98*“Classification and Measurement of Redeemable Securities”,* theissuance of preferred stock is accounted for as temporary equity.

For the three months ended March 31, 2007, thepreferred dividend was $966,971, of which $532,960 pertained to holders of thePIK dividend option.  For the nine months ended March 31, 2007, thepreferred dividend was $2,202,545, of which $1,213,965 pertained to holders of thePIK dividend option.

The liquidation preference for the preferred stock is$50,329,965, which comprises the stated value of $49,116,000 and PIK dividendsof $1,213,965 as of March 31, 2007.

On March 30, 2007, as shown in the table below, weissued 404,204 shares as part of the acquisition of oil and gas properties asdiscussed at Note 4.

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

| Issued shares as of June 30,  2006                                |   | 26,987,941 |   |
|-------------------------------------------------------------------|--------|------------|--------|
| Shares issued in  private placement (above)                       |   | 6,584,247  |   |
| Contingently  issued shares (Note 7)                              |   | 5,000      |   |
| Contingently  issued shares — forfeited (Note 7)             |   | (30,000    | )      |
| Shares issued  for acquisition of oil and gas properties (Note 4) |   | 404,204    |   |
| Issued shares as  of March 31, 2007                               |   | 33,951,392 |   |
| Management  shares returned to Treasury Stock (Note 7)            |   | (1,268,294 | )      |
| Outstanding shares as  of March 31, 2007                          |   | 32,683,098 |   |

 

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**3.   LONG-TERM DEBT**

Cash proceeds from the financings discussed in Note 2were used to repay $68.75 million of long-term debt outstanding at June 30,2006, consisting of amounts due under the senior credit agreement andsubordinated credit agreement of $53.75 million and $15 million,respectively.  Due to repaying the $15 million outstanding balance on thesubordinated credit agreement, this debt facility has been permanentlyretired.  The senior credit agreement, with a borrowing base of $48million, is our only remaining source of debt.  At March 31, 2007, we hadoutstanding long-term debt of $21.5 million and we were in compliance with thecovenants stated in our senior credit agreement.  At March 31, 2007, theinterest rate was 7.07%.

On March 6, 2007, we entered into Amendment No. 5senior credit agreement.  Among otheritems, Amendment No. 5 (i) extends the maturity date from November 28, 2008 toNovember 29, 2009; (ii) provides that Cano shall grant the lenders mortgages inCano’s Barnett Shale properties; (iii) clarifies that the development andacquisition of oil and gas properties does not constitute general corporate or workingcapital purposes such that expenditures for the development and acquisition ofoil and gas properties are not subject to the $10 million cap on generalcorporate advances; (iv) provides that Cano’s Barnett Shale properties are nowsubject to the negative covenant of being sold without consent; and(vi) provides that the leverage ratio (a) at the end of each fiscalquarter ending on or after March 31, 2007 shall not be greater than 5.00 to1.00; (b) at the end of each fiscal quarter ending on or after September 30,2007 shall not be greater than 4.50 to 1.00; and (c) at the end of each fiscalquarter ending on or after March 31, 2008 shall not be greater than 4.00 to1.00 and for the purposes of calculating the leverage ratio, the definition of “ConsolidatedDebt” shall not include “Debt” outstanding under preferred stock.  In addition, Amendment No. 5 reduces theinterest rate margin charged on borrowings from the senior credit agreement by0.75%.  Amendment No. 5 also specifies$6,000,000 of insurance proceeds received by Cano shall be placed in acontrolled bank account to be used to pay attorney’s fees, settlement amountsand other litigation expenses incurred to defend and/or settle the firelitigation.  See additional discussion atNote 11.

On March 7, 2007, we entered into an Assignment andAgreement pursuant to which (i) Union Bank of California, N.A. and NatixisBanques Populaires adjusted their proportional lending interests; and (ii) Cano’sborrowing base was reduced from $55 million to $48 million and shall remain $48million until the borrowing base is redetermined in accordance with the termsof the senior credit agreement, as amended.

**4.   ACQUISITION BYCANO PETRO OF NEW MEXICO, INC.**

On March 30, 2007, Cano Petro of New Mexico, Inc. (“CanoPetro”), a wholly-owned subsidiary, acquired certain oil and gas properties inthe Permian Basin effective February 1, 2007 for approximately $8.9 million,after purchase price adjustments.  The purchase price consisted ofapproximately $7 million in cash and 404,204 shares of Cano restricted commonstock, which was valued at $4.59 per share.  Included in the purchaseprice and pursuant to the agreement, $800,000 was withheld from the March 30,2007 cash payment and is to be ratably paid out during the following 120 daysbased on satisfactory completion of certain due diligence procedures.  Accordingly, we have recorded an $800,000acquisition payable to our consolidated balance sheet.

The properties acquired by Cano Petro were recordedbased on the purchase method of accounting. The operations of Cano Petro willbe included in our consolidated financial statements beginning April 1, 2007.The purchase price was allocated to the acquired assets and assumed liabilitiesbased on their estimated fair values. The calculation of the purchase price andallocation to assets is as follows:

| Net Acquisition Price          |   | $         | 8,867,459 |   |
|--------------------------------|--------|-----------|-----------|--------|
| Asset Retirement  Obligations  |   | 451,491   |      |
| Other  Liabilities Assumed     |   | 178,625   |      |
| Total Purchase  Price          |   | $         | 9,497,575 |   |
|                           |   |      |      |
| Allocation of  Purchase Price: |   |      |      |
| Fixed assets and  other        |   | $         | 35,000    |   |
| Oil & Gas  Properties      |   | 9,462,575 |      |
|                           |   | $         | 9,497,575 |   |

 

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The fair value assigned to the oil and natural gasproperties is based on management’s valuation of the properties, which wasderived in part by reference to reserve reports prepared by our internalengineers.  Based on the engineer’sreports and Cano’s internal analyses, we believe the value assigned to theseproperties is reasonably supported. We are continuing the process of determiningour final estimate of fair value of assets and liabilities.

**5.   DERIVATIVEHEDGING CONTRACTS**

Pursuant to our senior credit agreement, we arerequired to enter into financial contracts to hedge a portion of our productionat specified prices for oil and natural gas. The objective of the hedgingcontracts is to reduce our exposure to commodity price risk associated withexpected oil and natural gas production. By achieving this objective we intendto protect the outstanding debt amounts and maximize the funds availableunder our existing senior credit agreement, which should enable us to supportour annual capital budgeting and expenditure plans.

During our fiscal year ended June 30, 2006, we paid$6.1 million to enter into financial contracts to set price floors. During the nine months ended March 31, 2007, we paid $1.2 million to enter intoadditional financial contracts to set price floors for the 2009 calendaryear.  These financial contracts are summarized in the table below. 

| Time  Period            | ** ** | **Floor  Oil  Price** | ** ** | **Barrels  per Day** | ** ** | **Floor  Gas  Price** | ** ** | **Gas Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per Day** | ** ** |
|-------------------------|------------|-----------------------|------------|---------------------------|------------|-----------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| 1/1/06 —  12/31/06 |       | $                     | 60         |                      | 534        |                  | $          | 8.50                           |       | 1,784                                                  |       | 832 |   |
| 6/1/06 —  12/31/06 |       | $                     | 60         |                      | 79         |                  | $          | 7.60                           |       | 690                                                    |       | 194 |   |
| 1/1/07 —  12/31/07 |       | $                     | 55         |                      | 507        |                  | $          | 8.00                           |       | 1,644                                                  |       | 781 |   |
| 1/1/07 —  12/31/07 |       | $                     | 60         |                      | 72         |                  | $          | 7.60                           |       | 658                                                    |       | 182 |   |
| 1/1/08 —  12/31/08 |       | $                     | 55         |                      | 479        |                  | $          | 7.50                           |       | 1,534                                                  |       | 735 |   |
| 1/1/08 —  12/31/08 |       | $                     | 60         |                      | 66         |                  | $          | 7.60                           |       | 592                                                    |       | 164 |   |
| 1/1/09 — 4/30/09   |       | $                     | 60         |                      | 59         |                  | $          | 7.60                           |       | 559                                                    |       | 152 |   |
| 1/1/09 — 12/31/09  |       | $                     | 55         |                      | 395        |                  | $          | 7.60                           |       | 1,644                                                  |       | 668 |   |

 

We have no derivative hedging contracts that set aprice ceiling. We do not designate our derivatives as cash flow or fair valuehedges. We do not hold or issue derivative financial instruments forspeculative or trading purposes. We are exposed to credit losses in the eventof nonperformance by the counterparty to our financial hedging contracts. Weanticipate, however, that our counterparty, Union Bank of California, will beable to fully satisfy their obligations under the contracts. We do not obtaincollateral or other security to support our financial hedging contracts subjectto credit risk but we monitor the credit standing of the counterparty. At March31, 2007, we had a receivable balance due from our counterparty amounting to$26,790.

Changes in the fair values of our derivativeinstruments are recorded immediately in earnings in other income on ourstatements of operations.  Amounts due from or to our counterpartyresulting from the settlement of our derivative instruments are recorded asother income or expense in the consolidated statements of operations. Duringthe three and nine month periods ended March 31, 2007, there were settlementsunder our derivative agreements due to Cano amounting to $106,942 and $858,399,which are included in our Consolidated Statements of Operations under “Crudeoil and natural gas sales.”  The settlements were cumulative monthlypayments due to Cano since the NYMEX natural gas price was lower than the “floornatural gas prices” ranging from $7.60 to $8.50 per mcf and the NYMEX crude oilprice was lower than the “floor crude oil prices” ranging from $55 to $60 perbarrel.  The cash flows relating to the derivative instruments arereflected in operating activities on our statements of cash flow.

We obtained mark-to-market valuations used for ourderivative instruments from an external source and validated such valuationsusing quotes for exchange-traded options with similar terms. In accordance withSFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,”as amended, we recorded the $7.3 million in payments as Derivative Assets. SFAS133 also provides that derivative instruments be measured 

9

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atfair value on the balance sheet date.  During the three and nine monthperiod ended March 31, 2007, we recognized losses on hedge contracts to ourConsolidated Statements of Operations amounting to $1,633,046 and $1,790,036under “Unrealized loss on hedge contracts.”  At March 31, 2007, ourDerivative Assets totaled $2,310,538, of which $1,617,431 is consideredlong-term.

**6.   ASSET RETIREMENT OBLIGATION**

Our financial statements reflect the provisions ofStatement of Financial Accounting Standards No. 143,*Accounting for Asset Retirement Obligations*.Our asset retirement obligation (“ARO”) primarily represents the estimatedpresent value of the amount we will incur to plug, abandon and remediate ourproducing properties at the end of their productive lives, in accordance withapplicable state laws. We determine our ARO by calculating the present value ofexpected cash flows related to the liability. At March 31, 2007, our liabilityfor ARO was $2,220,208, of which $2,076,470 is considered long-term. Our assetretirement obligations are recorded as current or non-current liabilities basedon the estimated timing of the anticipated cash flows.

The following table describes the changes in our assetretirement obligations for the nine months ended March 31, 2007:

| Asset retirement obligation  at June 30, 2006   |   | $       | 1,607,378 |   |
|------------------------------------------------------|--------|---------|-----------|--------|
| Liability  incurred for properties acquired (Note 4) |   | 451,491 |      |
| Accretion of  discount                               |   | 103,136 |      |
| Change in  estimate                                  |   | 76,058  |      |
| Liabilities  settled                                 |   | (17,855 | )         |
| Asset retirement  obligation at March 31, 2007       |   | $       | 2,220,208 |   |

 

**7.   DEFERRED COMPENSATION**

***Management Stock Pool Agreement***

As discussed in our Form 10-KSB datedJune 30, 2006 pursuant to the terms of a Management Stock Pool Agreementdated May 28, 2004, the escrowed performance shares totaled 2,505,025shares.  During October 2006, the Board approved the release of performanceshares totaling 1,252,514 shares to the executive Davenport shareholders andthe remaining 1,252,511 shares have been returned as treasury shares.

As of March 31, 2007, the Treasury Stock totaled1,268,294 shares, consisting of the 1,252,511 performance shares which havebeen returned as treasury stock, as previously discussed, and 15,783compensation shares forfeited by a former employee.

***Contingently Issued Shares from the 2005Long-Term Incentive Plan***

As of March 31, 2007, we have issued 115,000 restrictedshares to key employees pursuant to our 2005 Long-Term Incentive Plan, assummarized below:

|                                        | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Price** | ** ** | **Fair Value** | ** ** |
|----------------------------------------|------------|------------|------------|-----------------------------------------|------------|---------------------|------------|
| Outstanding at  June 30, 2006          |       | 140,000    |       | $                                       | 5.62       |                | $          | 786,800 |   |
| Shares granted  during August 2006     |       | 5,000      |       | $                                       | 5.03       |                | $          | 25,150 |   |
| Shares forfeited  during November 2006 |       | (30,000    | )          | $                                       | 5.62       |                | $          | (168,600 | ) |
| Outstanding at March  31, 2007         |       | 115,000    |       | $                                       | 5.59       |                | $          | 643,350 |   |

 

The restricted shares will vest to the individualemployees based on future years of service ranging from one to three yearsdepending on the life of the award agreement.  The fair value is based ouractual stock price on the date of grant multiplied by the number of restrictedshares granted.  As of March 31, 2007, the value of 

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non-vestedrestricted shares amounted to $442,088.  In accordance with SFAS Nos.123(R), for the three and nine months ended March 31, 2007, we have expensed$74,067 and $220,876, respectively, to stock compensation expense based onamortizing the fair value over the appropriate service period.

**8.   STOCK OPTIONS**

In December 2004, the FASB issued SFASNo. 123(R), “Share-Based Payment.” SFAS No. 123(R) revises SFASNo. 123, “Accounting for Stock-Based Compensation,” and focuses onaccounting for share-based payments for services provided by employee toemployer. The statement requires companies to expense the fair value ofemployee stock options and other equity-based compensation at the grant date.The statement does not require a certain type of valuation model, and either abinomial or Black-Scholes model may be used.  We adopted SFAS 123(R)beginning July 1, 2006.  Since we had expensed stock options granted toemployees in accordance with SFAS 123, the adoption of SFAS No. 123(R) didnot materially impact our operating results, financial position, or our cashflows.

On December 7, 2005, our stockholders approved our2005 Long-Term Incentive Plan (“2005 LTIP”) that authorized the issuance of upto 1,000,000 shares of our common stock to key employees, key consultants andoutside directors of our company and subsidiaries.  On December 28, 2006,our stockholders approved an Amendment to the 2005 LTIP that increases thenumber of shares authorized for issuance under the Plan from 1,000,000 to3,500,000 shares of our common stock.  The Amendment also increases forExecutive Officers (as defined in the Plan) for any calendar year (i) thenumber of stock options or stock appreciation rights that any Executive Officercan receive from 100,000 shares of common stock to 300,000 shares of commonstock, (ii) the number of shares relating to restricted stock, restrictedstock units, performance awards or other awards that are subject to theattainment of performance goals that any Executive Officer can receive from 100,000shares of common stock to 300,000 shares of common stock; and (iii) thenumber of shares relating to all awards that an Executive Officer can receivefrom 100,000 to 300,000.  The 2005 LTIP permits the grant of incentivestock options, non-qualified stock options, stock appreciation rights,restricted stock, restricted stock units, performance awards, dividendequivalent rights and other awards, whether granted singly, or in combinationor in tandem.  The 2005 LTIP terminates on December 7, 2015; however, awardsgranted before that date will continue to be effective in accordance with theirterms and conditions.

On August 11, 2006, under the 2005 LTIP, 15,000options were granted to two non-employee directors. The options granted tothese two directors under the 2005 LTIP totaled 30,000 shares.  Theexercise price is $5.06 per share. These granted options vest on August 11,2007 if such persons are still directors or an employee on this date.  As of March 31, 2007, the 30,000 options wereforfeited.

On December 28, 2006, under the 2005 LTIP, 25,000options were granted to each of our six non-employee directors totaling 150,000shares. The exercise price is $5.42 per share. These granted options vest onDecember 28, 2007 if such persons are still directors or an employee onDecember 28, 2007.  As of March 31, 2007,50,000 of these options were forfeited.

On December 28, 2006, under the 2005 LTIP, we granted265,000 total options to our five executive officers. The exercise price is$5.42 per share. If the executive officer is still employed by us on eachanniversary date of the grant, one-third of the stock options will vest on eachof the following three anniversary dates - December 28, 2007, 2008 and2009.

On February 7, 2007, under the 2005 LTIP, we granted12,000 total options to an employee.  Theexercise price is $4.88 per share.  Theoptions vest on February 7, 2010 if such person is still an employee onFebruary 7, 2010.

A summary of options as of March 31, 2007 is asfollows:

|                                | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|--------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding at  June 30, 2006  |       | 577,185    |       | $                                      | 5.66       |   |
| Shares granted                 |       | 457,000    |       | $                                      | 5.40       |   |
| Shares forfeited  or expired   |       | (215,000   | )          | $                                      | 6.92       |   |
| Outstanding at March  31, 2007 |       | 819,185    |       | $                                      | 5.18       |   |

 

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Total options exercisable at March 31, 2007 amountedto 325,000 shares and had a weighted average exercise price of $4.92. Upon exercise, we issue the full amount of shares exercisable per the term ofthe options from new shares. We have no plans to repurchase those shares in thefuture.

Pursuant to SFAS No. 123(R), *Accounting for Stock-Based Compensation*,the fair value of each stock option is estimated on the date of grant using theBlack-Scholes option-pricing model.  Expected volatilities are based on historicalvolatility of our common stock.  We use historical data to estimate optionexercise and employee termination within the valuation model.  Theexpected lives of options granted represent the period of time that optionsgranted are expected to be outstanding.  The risk-free rate for periodswithin the contractual life of the option is based on the U.S. Treasury yieldcurve in effect at the time of grant.  The expected dividend yieldreflects our intent not to pay dividends on our common stock during thecontractual periods.  The fair values of options granted through March 31,2007 and 2006 along with the factors used to calculate the fair values of thoseoptions are summarized in the table below: 
| ** **                                                                                             | ** ** | **Nine Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| No. of shares                                                                                          |       | 494,185                                             |       | 325,000 |   |
| Risk free interest rate                                                                                |       | 4.69 – 5.15                                    | %          | 4.02 – 4.44 | % |
| Expected life                                                                                          |       | 4 years                                             |       | 4 years |   |
| Expected volatility                                                                                    |       | 51.6 – 53.4                                    | %          | 41.9 – 51.5 | % |
| Expected dividend yield                                                                                |       | 0.0                                                 | %          | 0.0 | % |
| Weighted average grant  date fair value — exercise prices equal to market value on grant date     |       | $                                                   | 2.75       |   | $ | 2.40 |   |
| Weighted average grant  date fair value — exercise prices greater than market value on grant date |       | $                                                   | —     |   | $ | — |   |
| Weighted average grant date fair value — exercise prices less than  market value on grant date    |       | $                                                   | —     |   | $ | 1.75 |   |

 

In accordance with the provisions of SFAS 123(R), forthe three-month periods ended March 31, 2007 and 2006, we had recorded a chargeto stock compensation expense of $154,633 and $61,643, respectively, for theestimated fair value of the options granted to our directors andemployees.  For the nine-month periods ended March 31, 2007 and 2006, wehad recorded a charge to stock compensation expense of $394,647 and $134,437,respectively, for the estimated fair value of the options granted to ourdirectors and employees.

The following is a summary of stock optionsoutstanding at March 31, 2007:

| Exercise  Price | ** ** | **Options  Outstanding** | ** ** | **Remaining Contractual  Lives (Years)** | ** ** | **Options  Exercisable** | ** ** |
|-----------------|------------|--------------------------|------------|----------------------------------------------------|------------|--------------------------|------------|
| $4.00           |       |                     | 50,000     |                                               |       |                     | 8.21       |   |   |   | 50,000 |   |   |
| $4.13           |       |                     | 100,000    |                                               |       |                     | 8.01       |   |   |   | 100,000 |   |   |
| $3.98           |       |                     | 50,000     |                                               |       |                     | 8.47       |   |   |   | 50,000 |   |   |
| $6.30           |       |                     | 125,000    |                                               |       |                     | 8.71       |   |   |   | 125,000 |   |   |
| $4.88           |       |                     | 12,000     |                                               |       |                     | 9.87       |   |   |   | — |   |   |
| $5.15           |       |                     | 117,185    |                                               |       |                     | 9.23       |   |   |   | — |   |   |
| $5.42           |       |                     | 365,000    |                                               |       |                     | 9.75       |   |   |   | — |   |   |
| $5.19           |       |                     | 819,185    |                                               |       |                     | 9.18       |   |   |   | 325,000 |   |   |

 

Based on our $4.52 stock price at March 31, 2007, theintrinsic value of the options outstanding was approximately $92,000.

**9.   NET LOSS PER COMMON SHARE**

Basic net income (loss) per common share is computedby dividing the net income attributable to common shareholders by the weightedaverage number of shares of common stock outstanding during the period.

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Diluted net income (loss) per common share is computedin the same manner, but also considers the effect of common stock sharesunderlying the following:

|                   | ** ** | **March 31, 2007** | ** ** | **March 31, 2006** | ** ** |
|-------------------|------------|------------------------------|------------|------------------------------|------------|
| Stock options     |       | 819,185                      |       | 325,000                      |       |
| Warrants          |       | 1,646,061                    |       | —                       |       |
| Preferred stock   |       | 8,541,913                    |       | —                       |       |
| PIK dividends     |       | 211,124                      |       | —                       |       |
| Restricted shares |       | 115,000                      |       | 2,659,975                    |       |

 

The shares of common stock underlying the stockoptions, warrants, the preferred stock, PIK dividends and the restrictedshares, as shown in the preceding table, are not included in weighted averageshares outstanding for the three and nine months ended March 31, 2007 and 2006as their effects would be anti-dilutive.

**10.   RELATED PARTYTRANSACTIONS**

During August 2006, we acquired an additional 2.0%overriding royalty interests from THEprivate Energy Company, Inc.(formerly Cano Energy Corporation) for $133,400.  We paid $66,700 per percentageof net revenue for these royalty interests, which is consistent with the pricewe paid for prior royalty interests we acquired from THEprivate Energy Company,Inc. during December 2005 and during January 2006.

S. Jeffrey Johnson, our Chairman of the Board andChief Executive Officer, is a 30% shareholder in THEprivate EnergyCompany, Inc. The terms of the purchase were supported by a valuationestablished by our independent engineer.  This purchase was approved byour Board pursuant to a recommendation by our Audit Committee.

We have entered into an agreement to be a lead sponsorof a television production called Honey Hole All Outdoors. As part of thesponsorship, we paid $112,500 during the nine months ended March 31, 2007 toR.C. Boyd Enterprises, the owner of Honey Hole All Outdoors. Randall Boyd isthe sole shareholder of R.C. Boyd Enterprises and is a member of our Board.

**11.   COMMITMENTSAND CONTINGENCIES**

***Litigation***

On March 23, 2006, the following lawsuit wasfiled in the 100th Judicial District Court in Carson County, Texas; CauseNo. 9840, The Tom L. and Anne Burnett Trust, by Anne Burnett Windfohr,Windi Phillips, Ben Fortson, Jr., George Beggs, III and EdHudson, 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 W.O. Energy, Inc. The plaintiffs claim thatthe electrical wiring and equipment of Cano or certain of its subsidiariesrelating to oil and natural gas operations started a wildfire that began onMarch 12, 2006 in Carson County.

The plaintiffs (i) allege negligence and grossnegligence and (ii) seek undisclosed damages, including, but not limitedto, damages for damage to their land and livestock, certain expenses related tofighting the fire and certain remedial expenses. In addition, the plaintiffsseek (i) termination of certain oil and natural gas leases,(ii) reimbursement for their attorney’s fees and (iii) exemplarydamages. The plaintiffs also claim that Cano and its subsidiaries are jointlyand severally liable as a single business enterprise and/or a generalpartnership or defacto partnership. The owner of the remainder of the mineralestate, Texas Christian University, has intervened in the suit joining theplaintiffs’ request to terminate certain oil and natural gas leases.  On January 26, 2007, Southwestern PublicService Company d/b/a XCEL Energy, intervened in the suit as a party adverse toall defendants, claiming that the fire that is the subject of this lawsuit destroyedtransmission and distribution equipment, including utility poles, lines andother equipment with an estimated loss of $1,876,000.  On March 13, 2007, the Court struck this pleain intervention and disallowed XCEL Energy’s intervention.

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On April 9, 2007, the Judge of the 100th JudicialDistrict Court sent a letter to counsel indicating intended rulings on a numberof pending motions that could affect the outcome of this case.  Specifically, the Court indicated in theletter its intention to (a) grant motions for summary judgment in favor of Canoand certain of its subsidiaries on plaintiffs’ claims for (i) breach ofcontract/termination of an oil and gas lease; and (ii) negligence; (b) grantthe plaintiffs’ no-evidence motion for summary judgment on the contributorynegligence, assumption of the risk, repudiation and estoppel affirmativedefenses asserted by Cano and certain of its subsidiaries; (c) deny motions forsummary judgment filed by Cano and certain of its subsidiaries on theories ofdirect and vicarious liability; and (d) deny the motion for summary judgmentfiled by Cano and certain of its subsidiaries on plaintiffs’ claim forexemplary damages.

No final judgment or other orders have been entered bythe Court and the current trial setting has been canceled.  On April 10,2007, plaintiffs filed a Motion to Recuse the Judge and have requested thatanother Judge be appointed to hear the case.  The Motion to Recuse remainspending, and Cano is opposing the Motion to Recuse.  No final judgment maybe entered by the Court while the Motion to Recuse is pending.

Due to the inherent risk of litigation, the outcome ofthis case is uncertain and unpredictable; however, at this time Cano managementbelieves the suit is without merit and is vigorously defending itself and itssubsidiaries.

On April 28, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas, CaseNo. 1922, Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc.; W. O. Operating Company, Ltd, and W.O.Energy, Inc. There are 43 plaintiffs and four groups of interveners thatclaim that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and natural gas operations started a wildfire thatbegan on March 12, 2006 in Carson County.

The plaintiffs (i) allege negligence, grossnegligence, trespass and nuisance and (ii) seek undisclosed damages,including, but not limited to, damages to their land, buildings and livestockand certain remedial expenses. In addition, the plaintiffs seek(i) reimbursement for their attorney’s fees and (ii) exemplarydamages.  This case is set for trial onOctober 29, 2007.

Due to the inherent risk of litigation and the factthat this case is in the early stages of discovery, the outcome of this case isuncertain and unpredictable; however, at this time Cano management believes thesuit is without merit and is vigorously defending itself and its subsidiaries.

On April 10, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas, CaseNo. 1920, Joseph Craig Hutchison and Judy Hutchison v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc.; W. O. OperatingCompany, Ltd, and W.O. Energy, Inc. On May 1, 2006, the followinglawsuit was filed in the 31st Judicial District Court of Roberts County, Texas,Case No. 1923, Chisum Family Partnership, Ltd. v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc.; W. O. Operating Company, Ltd, and W.O.Energy, Inc. The plaintiffs in both cases claim that the electrical wiringand equipment of Cano or certain of its subsidiaries relating to oil andnatural gas operations started a wildfire that began on March 12, 2006 inCarson County.

The plaintiffs in both cases (i) allegenegligence and trespass and (ii) seek undisclosed damages, including, butnot limited to, damages to their land and certain remedial expenses. Inaddition, the plaintiffs in both cases seek (i) reimbursement for theirattorney’s fees and (ii) exemplary damages.

Due to the inherent risks of litigation and the factthat these cases are in the early stages of discovery, the outcome of thesecases is uncertain and unpredictable; however, at this time Cano managementbelieves the suits are without merit and is vigorously defending itself and itssubsidiaries.

On July 3, 2006, the following lawsuit was filedin the 31st Judicial District Court of Roberts County, Texas, CaseNo. 1928, Rebecca Lee Martinez, et al v. Cano Petroleum, Inc., W.O.Energy of Nevada, Inc.; W. O. Operating Company, Ltd., and W.O.Energy, Inc. The plaintiffs claim that the electrical wiring and equipmentof Cano or certain of its subsidiaries relating to oil and natural gasoperations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas. The plaintiffs (i) allege negligence and gross negligenceand (ii) seek undisclosed damages for the wrongful death of twoindividuals who they claim died as a result of the fire. Additional heirs andrelatives of one of the decedents have intervened in this case seeking similarclaims.

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Due to the inherent risk of litigation and the factthat this case is in the early stages of discovery, the outcome of this case isuncertain and unpredictable; however, at this time Cano management believes thesuit is without merit and is vigorously defending itself and its subsidiaries.

On August 9, 2006, the following lawsuit wasfiled in the 233rd Judicial District Court of Gray County, Texas, YolandaVillareal, Individually and on behalf of the Estate of Gerardo Villareal v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd., and W.O. Energy, Inc. The plaintiffs claim that theelectrical wiring and equipment of Cano or certain of its subsidiaries relatingto oil and natural gas operations started a wildfire that began onMarch 12, 2006 in Carson County, Texas. The plaintiffs (i) allegenegligence and gross negligence and (ii) seek undisclosed damages for thewrongful death of Gerardo Villareal who they claim died as a result of thefire. Relatives of Roberto Chavira have intervened in the case alleging similarclaims regarding the death of Roberto Chavira.

Due to the inherent risk of litigation and the factthat this case is in the early stages of discovery, the outcome of this case isuncertain and unpredictable; however, at this time Cano management believes thesuit is without merit and is vigorously defending itself and its subsidiaries.

On June 20, 2006, the following lawsuit was filedin the United States District Court for the Northern District of Texas, FortWorth Division, C.A. No. 4-06cv-434-A, Mid-Continent Casualty Company (“Mid-Con”),vs. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. OperatingCompany, Ltd. and W.O. Energy, Inc. seeking a declaration that Mid-Con isnot responsible for pre-tender defense costs and that the plaintiff has thesole and exclusive right to select defense counsel and to defend, investigate,negotiate and settle the litigation described above and on September 18,2006, the First Amended Complaint for Declaratory Judgment was filed withregard to the cases described above. Cano and its subsidiaries were served withthe lawsuit between September 26-28, 2006.

On February 9, 2007, Cano and its subsidiaries enteredinto a Settlement Agreement and Release with Mid-Con pursuant to which inexchange for mutual releases, in addition to the approximately $923,000 that wehad been reimbursed, Mid-Con agreed to pay to Cano within 20 business days ofFebruary 9, 2007 the amount of $6,699,827 comprised of the following: (a) the$1,000,000 policy limits of the primary policy; (b) the $5,000,000 policylimits of the excess policy; (c) $500,000 for future defense costs; (d)$144,000 as partial payment for certain unpaid invoices for litigation relatedexpenses; (e) all approved reasonable and necessary litigation related expensesthrough December 21, 2006 that are not part of the above-referenced $144,000;and (f) certain specified attorneys fees. During February 2007, we received the $6,699,827 payment fromMid-Con.  Of this $6,699,827 amount, thepayments for policy limits amounting to $6,000,000, in accordance withAmendment No. 5 to the senior credit agreement (Note 3), have been placed in acontrolled bank account and the use of the proceeds is specified to pay attorney’sfees, settlement amounts and other litigation expenses incurred to defendand/or settle the fire litigation. Accordingly, our consolidated balance sheet reflects the $6,000,000 asRestricted Cash and a corresponding liability under Deferred Litigation Credit.  The remaining $699,827 was applied as areduction to General & Administrative Expense for litigation expensesincurred.

On March 14, 2007, the following lawsuit was filed inthe 100th Judicial District Court of Carson County,Texas, Southwestern Public Service Company d/b/a XCEL Energy v. Cano Petroleum,Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd, and W.O. Energy,Inc.  The plaintiff claims thatelectrical wiring and equipment relating to oil and gas operations of theCompany or certain of its subsidiaries started a wildfire that began on March12, 2006 in Carson County, Texas. The plaintiff (i) alleges negligence and (ii)seeks $1,876,000 for damages related to the destruction of its transmission anddistribution equipment, including utility poles, lines and other equipment. Inaddition, the plaintiff seeks reimbursement for its attorney’s fees. Theplaintiff has moved for an expedited trial setting of August 27, 2007, whichCano contests.

Due to the inherent risk of litigation and the factthat this case is in the early stages of discovery, the outcome of this case isuncertain and unpredictable; however, at this time Cano management believes thesuit is without merit and is vigorously defending itself and its subsidiaries.

***Other***

Occasionally, we are involved in other variouslawsuits and certain governmental proceedings arising in the ordinary course ofbusiness. Our management does not believe that the ultimate resolution of anycurrent 

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mattersthat are not set forth above, including due to the existence of insurancecoverage, indemnification and escrow accounts, will have a material effect onour financial position or results of operations. None of our directors,officers or affiliates, owners of record or beneficially of more than fivepercent of any class of our voting securities, or security holder is involvedin a proceeding adverse to our business or has a material interest adverse toour business.

***Environmental***

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

**Item 2. Management’s Discussion andAnalysis on Financial Condition and Results of Operations**

**Forward-Looking Statements**

The information in this report on Form 10-Qcontains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. This Act provides a “safe harbor”for forward-looking statements to encourage companies to provide prospectiveinformation about themselves provided they identify these statements as forwardlooking and provide meaningful cautionary statements identifying important factorsthat could cause actual results to differ from the projected results. Allstatements other than statements of historical fact made in this report areforward looking. In particular, the statements herein regarding industryprospects and future results of operations or financial position areforward-looking statements. Forward-looking statements reflect management’scurrent expectations and are inherently uncertain. Our actual resultsmay differ significantly from management’s expectations as a result ofmany factors, including, but not limited to the volatility in prices for crudeoil and natural gas, future commodity prices for derivative hedging contracts,interest rates, estimates of reserves, drilling risks, geological risks,transportation restrictions, the timing of acquisitions, product demand, marketcompetition, interruption in production, our ability to obtain additionalcapital, and the success of waterflooding and enhanced oil recovery techniques.

You should read the following discussion and analysisin conjunction with the consolidated financial statements of CanoPetroleum, Inc. and subsidiaries and notes thereto, included herewith.This discussion should not be construed to imply that the results discussedherein will necessarily continue into the future, or that any conclusionreached herein will necessarily be indicative of actual operating results inthe future. Such discussion represents only the best present assessment ofmanagement.

**Growth Strategy**

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

During our first two years of operations, our primaryfocus was to achieve growth through acquiring existing, mature oil and naturalgas fields.  We believe the portfolio of oil and natural gas propertiesthat we have acquired thus far provides ample opportunities to apply ouroperational strategy.  The potential of these assets is discussed in ourForm 10-KSB dated June 30, 2006 - “*Management’sDiscussion and Analysis—- Proved Reserves.*”  During the fiscalyear ending June 30, 2007, our primary emphasis has been to achieve growth bydeveloping our existing oil and natural gas properties through developmentactivities such as waterflooding and EOR technology.  We will continue toevaluate potential acquisition targets that are consistent with our operationalstrategy.  These development activitiesare more clearly defined later in this section under “*Capital Spending Plan*.”

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**Liquidity and Capital Resources**

As discussed in Note 2, on September 6, 2006, we soldin a private placement 49,116 shares of Series D Convertible Preferred Stock ata price of $1,000.00 per share and 6,584,247 shares of common stock at a priceof $4.83 per share, the three day average closing price of the stock prior tothe execution of the definitive agreements, plus a warrant component.  Thepreferred stock has a 7.875% dividend and features a paid-in-kind (“PIK”)provision that allows, at the investor’s option, the investor to receiveadditional shares of common stock upon conversion for the dividend in lieu of acash dividend payment.  Holders of approximately 55% of the preferredstock chose the PIK dividend option.  The convertible preferred stock isconvertible to common stock at a price of $5.75 per share and the common stockwas subject to 25% warrant coverage at an exercise price of $4.79 per share. If any Series D Convertible Preferred Stock remains outstanding on September 6,2011, we are required to redeem the Series D Convertible Preferred Stock forthe redemption amount in cash equal to the stated value of the Series DConvertible Preferred Stock, plus accrued dividends and PIK dividends. Gross proceeds from the transactions were $80.9 million, of which $49.1 millionwas attributable to preferred stock, and $31.8 million was attributable to thecommon stock and warrants.  Net proceeds were $75.5 million afterdeducting for issuance costs of $5.4 million.

The warrant component totaled 1,646,061 common sharesand is exercisable at $4.79 per share.  The exercise period commenced 180days after September 6, 2006 and expires on March 6, 2008.  We computedthe fair value of the warrants at September 6, 2006 as approximately $2.3million based on the Black-Scholes model.  We have included the fair valueof the warrants in Additional Paid-In Capital.

Cash proceeds from the financings were used to repay$68.75 million of long-term debt as discussed in Note 3, for general corporatepurposes and to fund our fiscal 2007 capital expenditures.  Thesubordinated debt has been permanently retired.  The senior creditagreement is our only remaining source of debt.  As discussed in Note 3,our senior credit agreement was amended to reduce our borrowing base from $55million to $48 million, and will remain at $48 million until the nextredetermination, which is expected to be for the reporting period ending June30, 2007.  At March 31, 2007, we hadoutstanding long-term debt of $21.5 million.

At March 31, 2007, our cash balance was $0.1million.  For the nine months ended March 31, 2007, we generated cash fromoperations of $1.1 million, which is an improvement of $7.4 million as comparedto the $6.3 million used in operations for the nine months ended March 31,2006.  This is largely due to improved earnings as discussed under “*Results of Operations*,” and the purchaseof derivative hedging contracts.  During the nine months ended March 31,2007 and 2006, we purchased derivative hedging contracts of $1.2 million and$5.3 million, respectively.

We believe the combination of cash on hand, cash flowgenerated from operations, strong commodity prices, and available debt issufficient to finance our contractual obligations and our capital expenditureprogram as further discussed below in the section titled “*Capital Spending Plan.”*

***Hedging Activities***

As discussed in Note 5, pursuant to our senior creditagreement, we are required to enter into derivative hedging contracts to hedgeour exposure to commodity price risk associated with expected oil and naturalgas production.  During December 2006, we paid $1.2 million to enter intoderivative hedging contracts to set price floors for the 2009 calendaryear.  Through the 2009 calendar year, we are hedged at price floors thatrange from $55 - $60 per barrel crude oil prices and $7.50 - $8.50 per mcf fornatural gas prices.  For the nine months ended March 31, 2007, approximately70% of our sales were hedged.

We have no derivative hedging contracts that set aprice ceiling. Therefore, we are entitled to 100% of our revenue receipts and,if crude oil and natural gas NYMEX prices are lower than the price floor, wewill be reimbursed for the difference between the NYMEX price and floor price.

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***Capital SpendingPlan***

Our capital spending plan for the twelve months endedJune 30, 2007 (“Fiscal Year 2007”), excluding potential acquisitions, isprojected to be $41 million to implement developmental projects at our existingfields to increase reserves and production.  Of this amount, we haveincurred $26.3 million, of which $21.9 million has been spent for the ninemonths ended March 31, 2007.  For the second half of the 2007 calendaryear, we anticipate additional capital expenditures of $20 - $30 million tocontinue implementing these development projects.  The status of our capital spending plan issummarized as follows:

*PanhandleProperties*.  We are progressing with the executionof Phase I of our waterflood development plan at the Cockrell Ranch Unit.  We were granted our Phase I WaterfloodInjection Permits from the Texas Railroad Commission on February 21, 2007.  We have two drilling rigs running and havedrilled and completed 24 Waterflood replacement wells. We have completed ourPhase I development pattern. To date, 40 producing wells have been worked overand returned to production.  All of theremaining injection well conversions are expected to be complete by June 30,2007. Our Phase I waterflood facility construction and pipeline installation isin progress. We have secured an option for all of the necessary water rights,easements and pipeline capacity to initiate our water injection at the CockrellRanch. We expect to initiate Phase I water injection by June, 2007 andanticipate initial response from the waterflood by December of 2007.  Full waterflood development over theremaining 11,000+ net acres of the Panhandle Properties is anticipated once theinitial response data is available.

*DesdemonaProperties — Waterflood*. We have drilled and completed 11required replacement wells to initiate the development of the Duke SandWaterflood at Desdemona.  Procurement andinfrastructure development is 75% complete. We expect regulatory approvals toinitiate water injection in the second calendar quarter of 2007, and anticipatean initial waterflood response in the fourth calendar quarter of 2007.

*DesdemonaProperties — Barnett Shale.* We have announced a new fielddiscovery in the Barnett Shale formation in this field, located some 50 mileswest of established Barnett Shale production in the Ft. Worth Basin.  Wehave drilled fifteen vertical wells to delineate the lateral extent of theBarnett Shale formation within the roughly 11,000 acres of our DesdemonaField.  Currently, ten vertical BarnettShale wells are on production, averaging a gross 1.3 MMCFPD of total gasproduction.  The remaining five verticalwells are waiting on gas sales connections and compression installation.  These wells should be on gas sales during thesecond calendar quarter of 2007.  Theresults of the vertical well test program have provided encouraging resultsthat have allowed us to initiate our Horizontal Well Development Program in thefield.  We have drilled and cased threehorizontal wells, drilled with 2,500 foot lateral sections.  We are currently drilling our fourthhorizontal well to test the horizontal capabilities of the field.  Based on our vertical test results andanalogs, it is internally estimated Cano has 80 total horizontal locations onroughly 120 acre spacing. We expect initial production of between 650 MCFPD and1.2 MMCFPD from each horizontal well. The resulting net internally estimated ultimate recovery (“EUR”) rangewould be .8 BCFE to 1.15 BCFE for each horizontal well. Horizontal drilling andcompletion costs are estimated at roughly $838,000 per well, compared to thevertical well drilling and completion cost of $523,000 per well. Based on therecovery ranges mentioned, internal estimates of proved undeveloped reservesare between 63 BCFE (11 MMBOE) to 92 BCFE (15 MMBOE) for the Barnett Shale inthis field. Economics from these recovery ranges indicate return on investment(“ROI”) range of 40% to 75% at a $7/MCF gas price. We anticipate maintaining aone rig horizontal drilling program in this field to develop the play. Aspreviously mentioned, we also have Marble Falls formation re-completionpotential in all of the vertical and horizontal Barnett Shale wells wecomplete.  Based on the three existingMarble Falls re-completions producing in the field, we internally estimate anet recovery of .2 BCFE (.033 MMBOE) per re-completion. Assuming a total of 95Marble Falls re-completions in the field, this could add an additionalinternally generated estimated ultimate recovery of between 15 BCFE (2.5 MMBOE)to 19 BCFE (3.2 MMBOE) of reserves in the field. The economics for thesere-completions (which cost an estimated $100M per well) result in an internallyestimated ROI range of 31% for a $5/MCF gas price to 57% for a $7/MCF price.

*Nowata Properties*. We completed the budgeted workovers to return 15 wells to production in theNowata field to optimize the existing waterflood pattern. Thealkaline-surfactant-polymer (“ASP”) pilot plant construction is on schedulewith delivery and field testing set for June 2007.  The company has sourced surfactants, polymersand equipment for a scheduled July 2007 start-up of the ASP Pilot. Response isanticipated in the first calendar quarter of 2008.

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*Corsicana Properties*. We have drilled and completed 16 pattern replacement wells and plan toreinstate a prior waterflood in this field. We are currently in the permittingphase and expect to receive final approvals to inject water in the thirdcalendar quarter of 2007. As we previously mentioned, we have been pleased withthe remaining oil saturations in this field and coupled with the priorsuccessful polymer pilot in this field in the 1980’s we believe this field is aprime ASP candidate. Once the waterflood response and laboratory results areanalyzed, we anticipate evaluating an ASP Pilot in the field in calendar year2008.

*Davenport Properties*. We completed workovers to return twelve wells to production and are awaitingfinal regulatory approval to activate eleven injection wells to optimize theexisting waterflood pattern at this field. Initial results of the wells returned to production have beenencouraging and production increases have exceeded expectations. Contingent uponsuccessful laboratory studies, we anticipate initiating an ASP Pilot project inthe Fiscal Year 2008 timeframe.

*Rich Valley Field. *We are presently evaluating the Rich Valley Properties for sale.

*New Acquisition — Cato Field*.  In addition to the capital spendingpreviously discussed, we completed an acquisition on March 30, 2007.  As discussed in Note 4, Cano Petro of NewMexico, Inc., our wholly-owned subsidiary, acquired certain oil and gasproperties in the Permian Basin having an effective date of the acquisition ofFebruary 1, 2007 for approximately $8.9 million, after purchase priceadjustments.  The purchase price consisted of approximately $7 million incash and 404,204 shares of Cano restricted common stock, which was valued at$4.59 per share.  We acquired roughly 20,000 acres and three fields inChavez and Roosevelt Counties, New Mexico. The prime asset is the roughly 15,000 acre Cato Field, which producesfrom the historically prolific San Andres formation.  This formation has been successfullywaterflooded in the Permian Basin for over 30 years.  The Cato Field is the largest San Andresfield in the Permian Basin that has never been flooded.  The primary reasons for no flooding to dateincluded multiple major oil company operators that could never agree onunitization and lack of an available water source.  This field was unitized by Kelt Oil in 1990,secondary recovery permits are in place and there now exists a water supplypipeline to an adjacent field 1.5 miles away. Moreover, this field is a very viable CO-2 Tertiary flood candidate witha CO-2 pipeline located four miles from the site.  This field contained roughly 100 MMBOE oforiginal oil in place (“OOIP”), based upon previous third-party engineering andgeologic studies.  Primary production todate is roughly 16 MMBOE or 16%.  Themean recovery estimated in a report by Texas A&M University, when itstudied over 40 San Andres waterflood recoveries in the Permian Basin, is 38%of OOIP.  We expect to initiate wellworkovers and a return to production program in May 2007.  Initiation of Phase I of the waterflood atCato is scheduled for August 2008.

**Results of Operations**

***Overall***

For the quarter ended March 31, 2007 (“current quarter”),we had a loss applicable to common stock of $3.2 million, which was $2.1million higher as compared to the $1.1 million loss applicable to common stockincurred for the quarter ended March 31, 2006 (“prior year quarter”).  Forthe nine months ended March 31, 2007 (“current nine months”), we had a lossapplicable to common stock of $5.2 million, which was $2.1 million higher ascompared to the $3.1 million loss applicable to common stock incurred for thenine months ended March 31, 2006 (“prior year nine months”).

The following table summarizes the differences betweenthe quarters and nine month periods.

|                                                                                | ** ** | **Quarter Ended  March 31,** | ** ** | **Increase** | ** ** | **Nine Months Ended  March 31,** | ** ** | **Increase** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------|------------|-------------------------------------------------|------------|--------------|------------|
| **Amounts in $millions**                                             | ** ** | **2007**                               | ** ** | **2006**     | ** ** | **(Decrease)**                                  | ** ** | **2007**     | ** ** | **2006** | ** ** | **(Decrease)** | ** ** |
| Results of oil and gas  producing operations excluding unrealized hedging loss |       | $                                      | 1.7        |         | $          | 2.3                                             |       | $            | (0.6       | ) | $ | 8.4 |   | $ | 4.6 |   | $ | 3.8 |   |
| Less the following  items:                                                     |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| General and  administrative expenses                                           |       | 3.0                                    |       | 1.9          |       | 1.1                                             |       | 8.9          |       | 5.1 |   | 3.8 |   |
| Interest expense, net                                                          |       | 0.4                                    |       | 0.9          |       | (0.5                                            | )          | 2.3          |       | 1.2 |   | 1.1 |   |
| Deferred income tax  benefit                                                   |       | (1.1                                   | )          | (0.7         | )          | (0.4                                            | )          | (1.6         | )          | (1.5 | ) | (0.1 | ) |
| Preferred stock  dividend                                                      |       | 1.0                                    |       | —       |       | 1.0                                             |       | 2.2          |       | — |   | 2.2 |   |
| Loss on hedge contracts                                                        |       | 1.6                                    |       | 1.3          |       | 0.3                                             |       | 1.8          |       | 2.9 |   | (1.1 | ) |
| Net loss                                                                       | ** ** | **$**                                  | **(3.2**   | **)**        | **$**      | **(1.1**                                        | **)**      | **$**        | **(2.1**   | **)** | **$** | **(5.2** | **)** | **$** | **(3.1** | **)** | **$** | **(2.1** | **)** |

 

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Results of oil and natural gas producing operationsconsist of operating revenues less lease operating expenses, production taxes,accretion of asset retirement obligations, and depletion and depreciation.  The current quarter is $0.6 million lowerthan the prior year quarter.  The currentquarter includes three months of operating results from the Pantwist Propertiestotaling $0.6 million.  The prior year quarter did not include anyoperating results for the Pantwist Properties. The favorable effect of including the operating results of the PantwistProperties in the current quarter was more than offset by $1.2 million ofunfavorable items as compared to the prior year quarter primarily resultingfrom lower revenues and higher operating expenses, which are addressed belowunder “Operating Revenues” and “Operating Expenses.”

The $3.8 million increase from the results of oil andnatural gas producing operations in the current nine months is attributed toincluding nine months of operating results from the Panhandle Properties (i.e.WO Energy) and the Pantwist Properties.  The prior year nine monthsincluded only four months of Panhandle Properties operating results and did notinclude any operating results for the Pantwist Properties.  This contributed$4.8 million to results of oil and gas operations.  The $4.8 million increase is partially offsetby lower revenues and higher operating expenses, which are addressed belowunder “Operating Revenues” and “Operating Expenses.”

The other factors in the table are addressed in thefollowing discussion.

***Operating Revenues***

The table below summarizes our operating revenues forthe quarter and nine months ended March 31, 2007 and 2006.
| ** **                                     | ** ** | **Quarter ended  March 31,** | ** ** | **Increase** | ** ** | **Nine months ended  March 31,** | ** ** | **Increase** | ** ** |
|------------------------------------------------|------------|----------------------------------------|------------|--------------|------------|-------------------------------------------------|------------|--------------|------------|
| ** **                                     | ** ** | **2007**                               | ** ** | **2006**     | ** ** | **(Decrease)**                                  | ** ** | **2007**     | ** ** | **2006** | ** ** | **(Decrease)** | ** ** |
| Operating Revenues  ($millions)                |       | $                                      | 6.4        |         | $          | 5.4                                             |       | $            | 1.0        |   | $ | 22.0 |   | $ | 10.5 |   | $ | 11.5 |   |
| Sales                                          |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| ·  Crude Oil (MBbls)                 |       | 63                                     |       | 58           |       | 5                                               |       | 204          |       | 122 |   | 82 |   |
| ·  Natural Gas (MMcf)                |       | 368                                    |       | 221          |       | 147                                             |       | 1,089        |       | 386 |   | 703 |   |
| ·  Total (MBOE)                      |       | 125                                    |       | 95           |       | 30                                              |       | 386          |       | 186 |   | 200 |   |
| Average Price (includes  hedge reimbursements) |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| ·  Crude Oil ($/ Bbl)                |       | $                                      | 56.84      |         | $          | 60.98                                           |       | $            | (4.14      | ) | $ | 61.88 |   | $ | 60.08 |   | $ | 1.80 |   |
| ·  Natural Gas ($/ Mcf)              |       | $                                      | 7.66       |         | $          | 8.39                                            |       | $            | (0.73      | ) | $ | 8.57 |   | $ | 8.29 |   | $ | 0.28 |   |

 

The current quarter operating revenues of $6.4 millionrepresent an improvement of $1.0 million as compared to the prior year quarterof $5.4 million. The $1.0 million improvement is primarily attributable to:

·                  Increasedoperating results from the Pantwist Properties ($1.6 million of revenue and 31MBOE of sales), as we did not have Pantwist in prior year quarter operatingresults, as previously discussed.

·                  Increasednatural gas sales at the Desdemona Properties ($0.2 million of revenue and 7MBOE of sales) due to our development of the Barnett Shale formation, aspreviously discussed under “Capital Spending Plan.”

·                  Other increases($0.2 million of revenue and 2 MBOE of sales), primarily due to increasedproduction at our Davenport, Rich Valley and Nowata Properties.

Partially offsetting the aforementioned increases aredecreases due to:

·                  Increased crudeoil inventory at the Panhandle Properties due to the extended shutdown of theValero McKee refinery located in the Texas Panhandle (estimated decrease inrevenue and sales of $0.3 million and 6 MBOE, respectively).  This refinery resumed limited operationsduring March 2007 and is expected to be fully on-line during May 2007.

·                  Decreased crudeoil and natural gas sales as production from the Panhandle Properties wastemporarily shut-in due to adverse weather during January and February 2007(estimated decrease in revenue and sales of $0.2 million revenue and 4 MBOE,respectively).

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·                  Lower pricesreceived for crude oil and natural gas sales (revenue effect is approximately$0.5 million).

Also, the Pantwist Properties experienced adverseweather during January and February 2007, which reduced their revenue and salesfor the current quarter by an estimated $0.1 million and 2 MBOE, respectively.

The current nine months operating revenues of $22.0million represent an improvement of $11.5 million as compared to the prior yearquarter of $10.5 million.  The $11.5 million improvement is primarilyattributable to:

·                  Increasedoperating results from the Panhandle Properties and the Pantwist Properties, aspreviously discussed (combined $11.3 million of revenue and 203 MBOE of sales).

·                  Higher pricesreceived for crude oil and natural gas sales (revenue effect is approximately$0.7 million).

·                  Increasednatural gas sales at the Desdemona Properties, as previously discussed above($0.2 million of revenue and 7 MBOE of sales).

Partially offsetting the aforementioned increases aredecreases due to the increased crude oil inventory at the Panhandle Propertiesand adverse weather at the Panhandle and Pantwist properties, as previouslydiscussed.

The average price we received for crude oil sales isgenerally at or above market prices received at the wellhead.  The average price we receive for natural gassales is approximately the market price received at the wellhead lesstransportation and marketing expenses. The average prices received for crude oil and natural gas sales arepositively impacted by settlement payments received under our derivativeagreements as discussed below under “*Loss on Hedging Contracts / Settlement Payments.”*

***Operating Expenses***

For the current quarter, our total operating expenseswere $7.8 million, or $2.7 million higher than the prior year quarter of $5.1million. The $2.7 million increase is primarily attributed to including threemonths of Pantwist Properties operating expenses totaling $1.0 million, highergeneral and administrative expenses of $1.1 million, and higher otheroperating expenses of $0.5 million.

For the current nine months, our total operatingexpenses were $22.5 million, or $11.5 million higher than the prior year ninemonths of $11.0 million. The $11.5 million increase is primarily attributed toincluding nine months of Panhandle Field and Pantwist Properties operatingexpenses totaling $6.4 million, higher general and administrative expensesof $3.8 million, and higher other operating expenses of $1.3 million.

Our lease operating expenses (“LOE”) consists of costsof producing crude oil and natural gas such as labor, supplies, repairs, maintenance,and utilities.  For the current quarter, the LOE per BOE was $24.68, whichis unusually high because it is based on crude oil and natural gas sales whichwere adversely impacted by the increased crude oil inventory at the PanhandleProperties, as previously discussed, and $0.3 million of non-recurringexpenses.  When the LOE per BOE isrecomputed based on production, our LOE per BOE is $21.81, which is slightlyhigher as compared to the prior year quarter of $21.70 per BOE.  For thecurrent nine months, the LOE per BOE was $21.74, which is a slight improvementas compared to the prior year nine months of $21.84 per BOE.  Theimprovement in the current nine months results is due to implementingoperational improvements in prior months, which has led to improved operatingefficiency in current months.  We generally incur a high amount of LOEbecause our fields are more mature and typically produce less oil and morewater, and they are generally at the end of the primary or secondary productioncycle.  We are continuing to implement improvements to field operations toincrease operational efficiency.

Our general and administrative (G&A) expensesconsist of support services for our operating activities and investor relationscosts. For the current quarter, our G&A expenses totaled $3.0 million,which is $1.1 million higher than the prior year quarter amount of $2.0million.  The primary contributors to the $1.1 million increase werehigher legal fees to comply with regulatory requirements and for litigation of$0.8 million; increased labor and staffing costs of $0.3 million; and increasedfees of $0.2 million for accounting services for SEC reporting and to achievefull compliance the Section 404 of the Sarbanes-Oxley Act, partially offset bylower other expenses of $0.2 million.  For the current nine months, ourG&A expenses totaled $8.9 million, which is $3.8 million higher than theprior year nine months’ amount of $5.1 million.  The primary contributorsto the $3.8 million increase were higher 

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legalfees to comply with regulatory requirements and for litigation of $1.6 million;increased labor and staffing costs of $1.4 million; increased fees of $0.6million for accounting services for SEC reporting and to achieve fullcompliance the Section 404 of the Sarbanes-Oxley Act; and higher other expensesof $0.2 million.

Our production and ad valorem taxes (“taxes”) consistof production taxes for crude oil and natural gas sales assessed by Texas andOklahoma, and ad valorem taxes for property taxes assessed by Texas andOklahoma on the value of our oil and gas fields.  For the current andprior year quarters, our taxes totaled $0.6 million and $0.4 million,respectively.  For the current and prior year nine month periods, ourtaxes totaled $1.8 million and $0.7 million, respectively.  The increasein taxes is due to increased sales of crude oil and natural gas as discussedunder “Operating Revenues” and increased ad valorem taxes from the Panhandleand Pantwist properties.  For the current quarter and nine month periods,our ad valorem taxes totaled $0.2 million and $0.5 million, respectively. For the prior year quarter and nine month periods, our ad valorem taxes were$0.1 million.

***Loss on Hedging Contracts / SettlementPayments***

As discussed in Note 5 to the financial statements, weentered into financial contracts to set price floors for crude oil and naturalgas. In accordance with SFAS 133, during the current quarter and current ninemonths, we recorded a Loss on Hedging Contracts of $1.6 million and $1.8 million,respectively, to reflect the fair value of the derivative instruments as ofMarch 31, 2007.  For the prior year quarter and prior year nine months wehad recorded a Loss on Hedging Contracts of $1.3 million and $2.9 million,respectively.  By their nature, these derivative instruments can be highlyvolatile to our earnings. A five percent change in these prices for ourderivative instruments can impact earnings by approximately $100,000.

Also, during the current quarter and current ninemonths, as discussed in Note 5, there were settlements under our derivativeagreements due to Cano.  The settlements were cumulative monthly paymentsto Cano primarily due to the NYMEX natural gas price being lower than the “floornatural gas prices” ranging from $7.60 to $8.50 per mcf.  We also receivedpayments for the NYMEX crude oil price being lower than the “floor crude oilprices” ranging from $55 to $60 per barrel. For the current quarter and current nine months, the settlement paymentsto Cano for natural gas were $88,790 and $813,018, respectively.  For thecurrent quarter and current nine months, the settlement payments to Cano forcrude oil were $18,152 and $45,381, respectively.  For the prior year quarter and nine monthperiods, the settlement payments to Cano for natural gas were $140,996. andthere were no settlement payments for crude oil.

***Interest Expense***

The interest expense we incurred in the currentquarter and current nine months of $0.4 million and $2.4 million, respectively,resulted directly from senior credit agreement and subordinated creditagreement as discussed in Note 3.  The current nine months’ amountincludes $0.5 million for previously deferred financing costs pertaining to oursubordinated credit agreement since we have permanently retired this creditagreement, as discussed in Note 3.  For the prior year quarter and ninemonth periods, our interest expense was $0.9 million and $1.3 million,respectively.  As we continue progress on our “*CapitalSpending Plan,”* as previously discussed, we expect to see increasedinterest expense in future periods.

***Deferred Income TaxBenefit***

As of March 31, 2007, we had a net deferred taxliability of $31.2 million.  This represents deferred tax benefits fromgeneration of net operating losses because a valuation allowance against suchitems is not required. We review our deferred tax assets at least quarterly andrecord a valuation allowance against those assets when we conclude that it ismore likely than not that those assets will expire without being utilized. Forthe current quarter and current nine months, we recorded an income tax benefitof $1.1 million and $1.6 million, respectively.  For the prior yearquarter and prior year nine months, we recorded an income tax benefit of $0.7million and $1.5 million, respectively.

***Preferred Stock Dividend***

The preferred stock dividend during the currentquarter and current nine months of $1.0 million and $2.2 million, respectively,resulted from the preferred stock financing, which was completed on September6, 2006, as discussed in Note 2.  Since we did not issue preferred stockduring the nine months ended March 31, 2006, there were no preferred stockdividends for the periods ended March 31, 2006.

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***New Accounting Pronouncements***

On July 13, 2006, theFASB released FIN 48, “Accounting for Uncertainty in Income Taxes — anInterpretation of FASB Statement 109.”  FIN 48 requires companies toevaluate and disclose material uncertain tax positions it has taken withvarious taxing jurisdictions.  We are currently reviewing FIN 48 and havenot yet determined the effect, if any, that FIN 48 will have to our operatingresults, financial position, or future cash flows.  We will be required toadopt FIN 48 in our June 30, 2008 fiscal period.

***Sabine Joint Venture Withdrawal***

On January 26, 2007 but effective January 8, 2007, weentered into the First Amendment to Amended and Restated Regulations of SabineProduction Operating, LLC (“Sabine Production”) with Carlile Management, LLC, amember, Haddock Enterprises, LLC, a member, Jack I. Tompkins, a manager, Dr.Kenneth Q. Carlile, a manager, Gerald W. Haddock, a manager, and S. JeffreyJohnson, a manager.  Gerald W. Haddock is a member of our board ofdirectors and S. Jeffrey Johnson is our Chairman and CEO.

The amendment provides that the maximum amount to becommitted to Sabine Production by any member is increased from $325,000 to$375,000.  The amendment also provides that after funding the increasedcommitment of $375,000, a member may withdraw as a member of SabineProduction.  Upon a withdrawal, the withdrawing member forfeits itsmembership interests in Sabine Production and is released from all of itsobligations under the Amended and Restated Regulations, as amended, the OmnibusAgreement, the Compensation Reimbursement Agreement and the Non-competitionAgreement.

On January 26, 2007, we made our final contribution of$50,000 to Sabine Production such that our aggregate contribution was $375,000and on February 1, 2007, we delivered our notice of withdrawal from SabineProduction effective on February 1, 2007. As a result of our withdrawal from Sabine Production, pursuant to theterms of the Amended and Restated Regulations, we have terminated our obligationson February 1, 2007 under the Omnibus Agreement by and among us, CarlileManagement, Haddock Enterprises and Sabine Production Partners, LP and theCompensation Reimbursement Agreement by and between us and Sabine Production.

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

See Notes 3 and 5 to the consolidated financialstatements regarding the updates of our market risk from June 30, 2006 throughMarch 31, 2007.

**Item 4. Controls and Procedures.**

As of the end of the period covered by this report, weconducted an evaluation, under the supervision and with the participation ofour chief executive officer, chief financial officer and principal accountingofficer of our disclosure controls and procedures as defined inRule 13a-15(e) and Rule 15d-15(e) of the Securities ExchangeAct of 1934 (the “Exchange Act”). Based upon this evaluation, our chiefexecutive officer, chief financial officer and principal accounting officerconcluded that our disclosure controls and procedures were effective to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is: (1) accumulated and communicated to ourmanagement, including our chief executive officer, chief financial officer andprincipal accounting officer, as appropriate to allow timely decisionsregarding required disclosure; and (2) recorded, processed, summarized andreported, within the time periods specified in the Securities and ExchangeCommission’s rules and forms.

During the quarter ended March 31, 2007, there was nochange in our internal control over financial reporting that has materiallyaffected or is reasonably likely to materially affect our internal control overfinancial reporting.

**PART II— OTHER INFORMATION**

**Item 1. Legal Proceedings.**

See Note 11 which is incorporated into this “Item 1.Legal Proceedings” by reference.

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**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

All the unregistered salesof equity securities during the third quarter were reflected in the CurrentReport on Form 8-K that was filed with the Securities and Exchange Commissionon April 4, 2007.

**Item 6. Exhibits.**
| Exhibit  Number         | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|-------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                     |       | Purchase and Sale Agreement by and among UHC New  Mexico Corporation, as Seller, Cano Petro of New Mexico, Inc., as Buyer, and  Cano Petroleum, Inc., for Certain Limited Purposes, dated March 30, 2007,  incorporated by reference from Exhibit 2.1 to Current Report on Form 8-K  filed on April 4, 2007. (The schedules and exhibits have been omitted from  this filing. An exhibit to the schedules and exhibits is contained in the  Purchase and Sale Agreement and the schedules and exhibits are available to  the Securities and Exchange Commission upon request). |
|  3.1               |       | Certificate of Amendment of Certificate of Incorporation  incorporated by reference from Exhibit 3.8 to Registration Statement on Form  S-1 (No. 333-126167) filed on January 23, 2007.                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1                    |       | First Amendment to Amended and Restated Regulations  of Sabine Production Operating, LLC effective January 8, 2007, incorporated  by reference from Exhibit 10.1 to Current Report on Form 8-K filed on  February 1, 2007.                                                                                                                                                                                                                                                                                                                                                     |
| 10.2                    |       | Amendment No. 5 and Agreement dated as of March 6,  2007 by and among Cano Petroleum, Inc., Square One Energy, Inc., Ladder  Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc., Pantwist, LLC,  Cano Petro of New Mexico, Inc., W.O. Operating Company, Ltd. and W.O.  Production Company, Ltd., Union Bank of California, N.A., as Administrative  Agent, Issuing Lender and Lender, and Natixis, incorporated by reference from  Exhibit 10.1 to Current Report on Form 8-K filed on March 12, 2007.                                                             |
| 10.3                    |       | Supplement No. 2 dated as of March 6, 2007 to the  Guaranty Agreement dated as of November 29, 2005, by Cano Petro of New  Mexico, Inc. in favor of Union Bank of California, as Administrative Agent,  incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K  filed on March 12, 2007.                                                                                                                                                                                                                                                                    |
| 10.4                    |       | Supplement No. 2 dated as of March 6, 2007 to the  Security Agreement dated as of November 29, 2005, by Cano Petro of New  Mexico, Inc. in favor of Union Bank of California, N.A., as Collateral  Trustee, incorporated by reference from Exhibit 10.3 to Current Report on  Form 8-K filed on March 12, 2007.                                                                                                                                                                                                                                                                |
| 10.5                    |       | Supplement No. 2 dated as of March 6, 2007 to the  Pledge Agreement dated as of November 29, 2005, by Cano Petroleum, Inc., W.O.  Energy of Nevada, Inc., and WO Energy, Inc. in favor of Union Bank of  California, N.A., as Collateral Trustee, incorporated by reference from  Exhibit 10.4 to Current Report on Form 8-K filed on March 12, 2007.                                                                                                                                                                                                                          |
| 10.6                    |       | Assignment and Agreement dated as of March 7, 2007  by and among Cano Petroleum, Inc., Square One Energy, Inc., Ladder Companies,  Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc., Pantwist, LLC, Cano Petro  of New Mexico, Inc., W.O. Operating Company, Ltd. and W.O. Production  Company, Ltd., Union Bank of California, N.A., as Administrative Agent,  Issuing Lender and Lender, and Natixis, incorporated by reference from  Exhibit 10.5 to Current Report on Form 8-K filed on March 12, 2007.                                                                  |
| +10.7*                  |       | Stock Option Agreement of William O. Powell, dated  April 4, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| + 10.8*                 |       | Stock Option Agreement of Robert L. Gaudin, dated  April 4, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| + 10.9*                 |       | Stock Option Agreement of Donald W. Niemiec, dated  April 4, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.10                   |       | Settlement Agreement and Release dated February 9,  2007 by and among Mid-Continent Casualty Company, Cano Petroleum, Inc., W.O.  Energy of Nevada, Inc. W.O. Operating Company, Ltd. and W.O. Energy, Inc.,  incorporated by reference from Exhibit 10.1 to Registration Statement on Form  S-3 (SEC No. 333-138003) filed on April 9, 2007.                                                                                                                                                                                                                                  |
|    31.1* |       | Certification by Chief Executive Officer, required  by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, promulgated pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                           |
|    31.2* |       | Certification by Chief Financial Officer, required  by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, promulgated pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                           |

 

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|    31.3* |   | Certification by Principal Accounting 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.      |
|    32.3* |   | Certification by Principal Accounting Officer,  required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section  1350 of Chapter 63 of Title 18 of the United States Code, promulgated  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

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*                    Filedherewith

+                    Managementcontract or compensatory plan, contract or arrangement

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**SIGNATURES**

In accordance with the requirements of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
| **CANO PETROLEUM, INC.** |      |
|--------------------------|-----------|
|                     |      |
| Date: May 9, 2007        | By:  | /s/ S. Jeffrey Johnson |   |
|                     |      | S. Jeffrey Johnson |
|                     |      | Chief Executive Officer |
|                     |      |
|                     |      |
| Date: May 9, 2007        | By:  | /s/ Morris B. Smith |   |
|                     |      | Morris B. Smith |
|                     |      | Senior Vice-President and Chief Financial Officer |
|                     |      |
|                     |      |
| Date: May 9, 2007        | By:  | /s/ Michael J. Ricketts |   |
|                     |      | Michael J. Ricketts |
|                     |      | Vice-President and Principal Accounting Officer |

 

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