**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 
| **x**                                                   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------|
| ** **                                              | ** **                                                                                                        |
| **For  the quarterly period ended March 31, 2010** |
| ** **                                              | ** **                                                                                                        |
| **o**                                                   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number: 001-32496**

 

**CANOPETROLEUM, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                     | ** ** | **77-0635673**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | ** ** | (I.R.S. Employer  Identification No.) |
| ** **                                                       | ** ** | ** **                            |
| **801  Cherry St., Suite 3200  Fort Worth, Texas**          | ** ** | **76102**                             |
| (Address of  principal executive offices)                        | ** ** | (Zip Code)                            |

 

**(817) 698-0900**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x  No o

 

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

 

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

 

| Large  accelerated filer o                    |   | Accelerated  filer o         |
|----------------------------------------------------|--------|-----------------------------------|
|                                               |   |                              |
| Non-accelerated  filer o                      |   | Smaller  reporting company x |
| (Do not check if a smaller reporting company) |   |                              |

 

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

 

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

 

 

 

----

 

**PART I—FINANCIALINFORMATION**

 

**Item 1.    FinancialStatements.**

 

**CANOPETROLEUM, INC. CONSOLIDATED BALANCE SHEETS (Unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                                                                                      | ** ** | **March 31,** | ** **  | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|-------------|-------------------|------------|
| **In Thousands, Except Shares and Per Share Amounts**                                                                                                                                                                                                                                                                        | ** ** | **2010**           | ** **  | **2009**          | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                                                                                                                    | ** ** | ** **         | ** **  | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                                                                                                              | ** ** | ** **         | ** **  | ** **        | ** ** |
| Cash  and cash equivalents                                                                                                                                                                                                                                                                                                                                      |       | $                  | 857         |              | $          | 392 |   |
| Accounts  receivable                                                                                                                                                                                                                                                                                                                                            |       | 2,533              |        | 2,882             |       |
| Derivative  assets                                                                                                                                                                                                                                                                                                                                              |       | 3,486              |        | 4,955             |       |
| Assets  held for sale (Note 6)                                                                                                                                                                                                                                                                                                                                  |       | —             |        | 3,760             |       |
| Inventory  and other current assets                                                                                                                                                                                                                                                                                                                             |       | 1,231              |        | 810               |       |
| Total  current assets                                                                                                                                                                                                                                                                                                                                           |       | 8,107              |        | 12,799            |       |
| **Oil and gas properties**, successful efforts method                                                                                                                                                                                                                                                                                                           |       | 292,942            |        | 285,063           |       |
| Less  accumulated depletion and depreciation                                                                                                                                                                                                                                                                                                                    |       | (43,434            | )           | (40,057           | )          |
| Net  oil and gas properties                                                                                                                                                                                                                                                                                                                                     |       | 249,508            |        | 245,006           |       |
| Fixed  assets and other, net                                                                                                                                                                                                                                                                                                                                    |       | 2,632              |        | 3,240             |       |
| Derivative  assets                                                                                                                                                                                                                                                                                                                                              |       | —             |        | 2,882             |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                        |       | 101                |        | 101               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                                                                                                | ** ** | **$**              | **260,348** | ** **        | **$**      | **264,028** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                            |       |               |        |              |       |
| ***LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                                                                                               |       |               |        |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                                                                                                         |       |               |        |              |       |
| Accounts  payable                                                                                                                                                                                                                                                                                                                                               |       | $                  | 3,830       |              | $          | 4,395 |   |
| Accrued  liabilities                                                                                                                                                                                                                                                                                                                                            |       | 2,364              |        | 1,952             |       |
| Deferred  tax liabilities                                                                                                                                                                                                                                                                                                                                       |       | 898                |        | 1,431             |       |
| Oil  and gas sales payable                                                                                                                                                                                                                                                                                                                                      |       | 730                |        | 702               |       |
| Derivative  liabilities                                                                                                                                                                                                                                                                                                                                         |       | 227                |        | 159               |       |
| Liabilities  associated with discontinued operations (Note 6)                                                                                                                                                                                                                                                                                                   |       | 105                |        | 123               |       |
| Current  portion of long-term debt (Note 3)                                                                                                                                                                                                                                                                                                                     |       | 65,000             |        | —            |       |
| Current  portion of asset retirement obligations                                                                                                                                                                                                                                                                                                                |       | 236                |        | 86                |       |
| Total  current liabilities                                                                                                                                                                                                                                                                                                                                      |       | 73,390             |        | 8,848             |       |
| **Long-term liabilities**                                                                                                                                                                                                                                                                                                                                       |       |               |        |              |       |
| Long-term  debt                                                                                                                                                                                                                                                                                                                                                 |       | —             |        | 55,700            |       |
| Asset  retirement obligations                                                                                                                                                                                                                                                                                                                                   |       | 3,043              |        | 2,785             |       |
| Derivative  liabilities                                                                                                                                                                                                                                                                                                                                         |       | 3,606              |        | —            |       |
| Deferred  tax liabilities and other                                                                                                                                                                                                                                                                                                                             |       | 17,779             |        | 22,831            |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                                                              |       | 97,818             |        | 90,164            |       |
| **Temporary equity**                                                                                                                                                                                                                                                                                                                                            |       |               |        |              |       |
| Series D  convertible preferred stock and cumulative paid-in-kind dividends; par value $.0001  per share, stated value $1,000 per share; 49,116 shares authorized; 23,849  issued at March 31, 2010 and June 30, 2009, respectively;  liquidation preference at March 31, 2010 and June 30, 2009 of  $27,822 and $26,987, respectively |       | 26,240             |        | 25,405            |       |
| **Commitments and contingencies (Note 13)**                                                                                                                                                                                                                                                                                                                     |       |               |        |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                                                                                                                   |       |               |        |              |       |
| Common  stock, par value $.0001 per share; 100,000,000 authorized; 47,273,224 and 45,570,147  shares issued and outstanding, respectively, at March 31, 2010; and 47,297,910  and 45,594,833 shares issued and outstanding, respectively, at June 30,  2009                                                                                           |       | 5                  |        | 5                 |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                                     |       | 190,485            |        | 189,526           |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                            |       | (53,503            | )           | (40,375           | )          |
| Treasury  stock, at cost; 1,703,077 shares held in escrow at March 31, 2010 and June 30,  2009, respectively                                                                                                                                                                                                                                          |       | (697               | )           | (697              | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                                                |       | 136,290            |        | 148,459           |       |
| **TOTAL LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                                          | ** ** | **$**              | **260,348** | ** **        | **$**      | **264,028** | ** ** |

 

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

 

1

----

 

**CANOPETROLEUM, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| **In Thousands, Except Per Share Data** | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Operating Revenues:**                                          |       |                             |       |                            |       |   |   |   |   |
| Crude  oil sales                                                 |       | $                                | 4,924      |                            | $          | 2,761 |   | $ | 14,045 |   | $ | 14,520 |   |
| Natural  gas sales                                               |       | 879                              |       | 692                             |       | 2,323 |   | 3,287 |   |
| Other  revenue                                                   |       | —                           |       | 153                             |       | — |   | 312 |   |
| Total  operating revenues                                        |       | 5,803                            |       | 3,606                           |       | 16,368 |   | 18,119 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Operating Expenses:**                                          |       |                             |       |                            |       |   |   |   |   |
| Lease  operating                                                 |       | 3,598                            |       | 3,992                           |       | 11,785 |   | 13,687 |   |
| Production  and ad valorem taxes                                 |       | 476                              |       | 329                             |       | 1,365 |   | 1,662 |   |
| General  and administrative                                      |       | 2,912                            |       | 2,157                           |       | 9,360 |   | 16,561 |   |
| Exploration  expense (Note 11)                                   |       | —                           |       | —                          |       | 5,024 |   | — |   |
| Impairment  of long-lived assets (Note 12)                       |       | —                           |       | —                          |       | 283 |   | 22,398 |   |
| Depletion  and depreciation                                      |       | 1,132                            |       | 1,572                           |       | 3,627 |   | 4,120 |   |
| Accretion  of discount on asset retirement obligations           |       | 68                               |       | 76                              |       | 203 |   | 225 |   |
| Total  operating expenses                                        |       | 8,186                            |       | 8,126                           |       | 31,647 |   | 58,653 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Loss from operations**                                         |       | (2,383                           | )          | (4,520                          | )          | (15,279 | ) | (40,534 | ) |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Other income (expense):**                                      |       |                             |       |                            |       |   |   |   |   |
| Interest  expense and other                                      |       | (486                             | )          | (149                            | )          | (908 | ) | (357 | ) |
| Impairment  of goodwill                                          |       | —                           |       | —                          |       | — |   | (685 | ) |
| Gain  (loss) on derivatives                                      |       | 788                              |       | 3,486                           |       | (4,451 | ) | 48,480 |   |
| Total  other income (expense)                                    |       | 302                              |       | 3,337                           |       | (5,359 | ) | 47,438 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from continuing operations before income taxes    |       | (2,081                           | )          | (1,183                          | )          | (20,638 | ) | 6,904 |   |
| Deferred  income tax benefit (expense)                           |       | 587                              |       | 360                             |       | 6,803 |   | (3,330 | ) |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Income  (loss) from continuing operations                        |       | (1,494                           | )          | (823                            | )          | (13,835 | ) | 3,574 |   |
| Income  from discontinued operations, net of related taxes       |       | 1,722                            |       | 114                             |       | 2,066 |   | 12,089 |   |
| **Net income (loss)**                                            |       | 228                              |       | (709                            | )          | (11,769 | ) | 15,663 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Preferred  stock dividend                                        |       | (470                             | )          | (470                            | )          | (1,359 | ) | (2,261 | ) |
| Preferred  stock repurchased for less than carrying amount       |       | —                           |       | —                          |       | — |   | 10,890 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Net income (loss) applicable to common stock**                 |       | $                                | (242       | )                               | $          | (1,179 | ) | $ | (13,128 | ) | $ | 24,292 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Net income (loss) per share - basic**                          |       |                             |       |                            |       |   |   |   |   |
| Continuing  operations                                           |       | $                                | (0.04      | )                               | $          | (0.03 | ) | $ | (0.33 | ) | $ | 0.27 |   |
| Discontinued  operations                                         |       | 0.04                             |       | —                          |       | 0.05 |   | 0.26 |   |
| **Net income (loss) per share - basic**                          |       | $                                | —     |                            | $          | (0.03 | ) | $ | (0.28 | ) | $ | 0.53 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Net income (loss) per share - diluted**                        |       |                             |       |                            |       |   |   |   |   |
| Continuing  operations                                           |       | $                                | (0.04      | )                               | $          | (0.03 | ) | $ | (0.33 | ) | $ | 0.27 |   |
| Discontinued  operations                                         |       | 0.04                             |       | —                          |       | 0.05 |   | 0.23 |   |
| **Net income (loss) per share - diluted**                        |       | $                                | —     |                            | $          | (0.03 | ) | $ | (0.28 | ) | $ | 0.50 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| **Weighted average common shares outstanding**                   |       |                             |       |                            |       |   |   |   |   |
| Basic                                                            |       | 45,570                           |       | 45,972                          |       | 45,570 |   | 46,094 |   |
| Diluted                                                          |       | 45,570                           |       | 45,972                          |       | 45,570 |   | 53,254 |   |

 

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

 

2

----

 

**CANOPETROLEUM, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY JULY 1, 2009 THROUGH MARCH 31, 2010 (Unaudited)**

 
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** **             | ** **  | ** ** | ** **    | **Total**  | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------------------|-------------|------------|---------------|------------|------------|
| ** **                                     | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** **  |
| **Dollar Amounts in Thousands** | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares**             | ** **  | **Amount** | ** **    | **Equity** | ** ** |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| **Balance at July 1, 2009**               | ** ** | **47,297,910**        | ** ** | **$**       | **5**      | ** **      | **$**      | **189,526**             | ** ** | **$**                  | **(40,375** | **)**      | **1,703,077** | ** ** | **$**      | **(697** | **)** | **$** | **148,459** | ** ** |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **              | ** ** | ** **             | ** **  | ** ** | ** **    | ** ** | ** ** |
| Forfeiture  and surrender of restricted stock  |       | (24,686               | )          | —      |       | (28             | )          | —                  |       | —                 |        | —     |          | (28        | )          |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Stock-based  compensation expense              |       | —                |       | —      |       | 987             |       | —                  |       | —                 |        | —     |          | 987        |       |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Preferred  stock dividend                      |       | —                |       | —      |       | —          |       | (1,359                  | )          | —                 |        | —     |          | (1,359     | )          |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Net  loss                                      |       | —                |       | —      |       | —          |       | (11,769                 | )          | —                 |        | —     |          | (11,769    | )          |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| **Balance at March 31, 2010**             | ** ** | **47,273,224**        | ** ** | **$**       | **5**      | ** **      | **$**      | **190,485**             | ** ** | **$**                  | **(53,503** | **)**      | **1,703,077** | ** ** | **$**      | **(697** | **)** | **$** | **136,290** | ** ** |

 

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

 

3

----

 

**CANOPETROLEUM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                             | ** ** | **Nine Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **In Thousands**                                                                  | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
| **Cash flow from operating activities:**                                               |       |                                                |       |   |   |
| Net  income (loss)                                                                     |       | $                                                   | (11,769    | ) | $ | 15,663 |   |
| Adjustments  needed to reconcile net income (loss) to net cash provided by operations: |       |                                                |       |   |   |
| Unrealized  loss (gain) on derivatives                                                 |       | 8,051                                               |       | (43,820 | ) |
| Gain  on sale of oil and gas properties                                                |       | (2,488                                              | )          | (19,244 | ) |
| Accretion  of discount on asset retirement obligations                                 |       | 205                                                 |       | 229 |   |
| Settlement  of asset retirement obligations                                            |       | (140                                                | )          | — |   |
| Depletion  and depreciation                                                            |       | 3,654                                               |       | 4,172 |   |
| Exploration  expense                                                                   |       | 5,024                                               |       | — |   |
| Impairment  of oil and gas properties                                                  |       | 283                                                 |       | 25,914 |   |
| Impairment  of goodwill                                                                |       | —                                              |       | 685 |   |
| Stock-based  compensation expense                                                      |       | 987                                                 |       | 2,421 |   |
| Deferred  income tax expense (benefit)                                                 |       | (5,638                                              | )          | 10,257 |   |
| Amortization  of debt issuance costs and prepaid expenses                              |       | 1,300                                               |       | 1,073 |   |
| Treasury  stock                                                                        |       | —                                              |       | (126 | ) |
|                                                                                   |       |                                                |       |   |   |
| Changes  in assets and liabilities relating to operations:                             |       |                                                |       |   |   |
| Accounts  receivable                                                                   |       | 775                                                 |       | 2,480 |   |
| Derivative  assets                                                                     |       | (336                                                | )          | 2,033 |   |
| Inventory  and other current assets and liabilities                                    |       | (1,397                                              | )          | (1,652 | ) |
| Accounts  payable                                                                      |       | 9                                                   |       | (1,541 | ) |
| Accrued  liabilities                                                                   |       | 364                                                 |       | (3,288 | ) |
| Derivative  liability                                                                  |       | —                                              |       | (367 | ) |
| **Net cash provided by operations**                                                    | ** ** | **(1,116**                                          | **)**      | **(5,111** | **)** |
|                                                                                   |       |                                                |       |   |   |
| **Cash flow from investing activities:**                                               |       |                                                |       |   |   |
| Additions  to oil and gas properties, fixed assets and other                           |       | (13,445                                             | )          | (47,439 | ) |
| Proceeds  from sale of oil and gas properties                                          |       | 6,300                                               |       | 40,256 |   |
| **Net cash used in investing activities**                                              | ** ** | **(7,145**                                          | **)**      | **(7,183** | **)** |
|                                                                                   |       |                                                |       |   |   |
| **Cash flow from financing activities:**                                               |       |                                                |       |   |   |
| Repayments  of long-term debt                                                          |       | (3,000                                              | )          | (73,500 | ) |
| Borrowings  of long-term debt                                                          |       | 12,300                                              |       | 43,700 |   |
| Payments  for debt issuance costs                                                      |       | —                                              |       | (927 | ) |
| Proceeds  from issuance of common stock, net                                           |       | —                                              |       | 53,908 |   |
| Repurchases  of preferred stock                                                        |       | —                                              |       | (10,377 | ) |
| Payment  of preferred stock dividend                                                   |       | (574                                                | )          | (954 | ) |
| **Net cash provided by financing activities**                                          | ** ** | **8,726**                                           | ** ** | **11,850** | ** ** |
|                                                                                   |       |                                                |       |   |   |
| Net  increase in cash and cash equivalents                                             |       | 465                                                 |       | (444 | ) |
| Cash  and cash equivalents at beginning of period                                      |       | 392                                                 |       | 771 |   |
| **Cash and cash equivalents at end of period**                                         | ** ** | **$**                                               | **857**    | ** ** | **$** | **327** | ** ** |
|                                                                                   |       |                                                |       |   |   |
| **Supplemental disclosure of noncash transactions:**                                   |       |                                                |       |   |   |
| Payments  of preferred stock dividend in kind                                          |       | $                                                   | 835        |   | $ | 1,307 |   |
| Preferred  stock repurchased for less than carrying amount                             |       | $                                                   | —     |   | $ | 10,890 |   |
|                                                                                   |       |                                                |       |   |   |
| **Supplemental disclosure of cash transactions:**                                      |       |                                                |       |   |   |
| Cash  paid during the period for interest                                              |       | $                                                   | 2,264      |   | $ | 1,273 |   |

 

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

 

4

----

 

**CANOPETROLEUM, INC.**

**NOTESTO FINANCIAL STATEMENTS**

 

**1. BASISOF PRESENTATION AND USE OF ESTIMATES**

 

***Consolidation and Use of Estimates***

 

The interim consolidatedfinancial statements 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 due in part,but not limited to, the volatility in prices for crude oil and natural gas,future prices for commodity derivatives, interest rates, estimates of reserves,drilling risks, geological risks, transportation restrictions, the timing ofevents, product demand, market competition, interruption in production, ourability to obtain additional capital, and the success of waterflooding andenhanced oil recovery techniques. You should read these consolidated interimfinancial statements in conjunction with the audited consolidated financialstatements and notes thereto included in our Annual Report on Form 10-Kfor the year ended June 30, 2009.

 

The accompanyingfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) and includethe accounts of Cano Petroleum, Inc. and its wholly-owned subsidiaries (“Cano”).Intercompany accounts and transactions are eliminated. In preparing theaccompanying financial statements, management has made certain estimates andassumptions that affect reported amounts in the financial statements anddisclosures of contingencies. Actual results may differ from those estimates.The computation of stock-based compensation expense requires assumptions suchas volatility, expected life and the risk-free interest rate. The computationof mark-to-market valuation of our commodity derivatives includes theobservability of quoted market prices and an assessment of potentialnon-performance of the counterparties. It is possible these estimates could berevised in the near term, and these revisions could be material.

 

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

 

***New Accounting Pronouncements***

 

In June 2009, theFinancial Accounting Standards Board (“FASB”) issued a standard thatestablished the FASB Accounting Standards CodificationTM (“ASC”) andamended the hierarchy of GAAP such that the ASC became the single source ofauthoritative nongovernmental GAAP. The ASC did not change current GAAP, butwas intended to simplify user access to all authoritative GAAP by providing allthe authoritative literature related to a particular topic in one place. Allpreviously existing accounting standard documents were superseded and all otheraccounting literature not included in the ASC is considered non-authoritative.New accounting standards issued subsequent to June 30, 2009 arecommunicated by the FASB through Accounting Standards Updates. The ASC becameeffective for us on July 1, 2009. This standard did not have an impact onour financial position, results of operations or cash flows. Throughout thenotes to the consolidated financial statements, references that were previouslymade to various former authoritative GAAP pronouncements have been conformed tothe appropriate section of the ASC.

 

In December 2007,the FASB issued ASC 805 (formerly Statement of Financial AccountingStandards (“SFAS”) No. 141 (revised 2007), *Business Combinations*). Among other things, ASC 805establishes principles and requirements for how the acquirer in a businesscombination: (i) recognizes and measures in its financial 

 

5

----

 

statements theidentifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquired business; (ii) recognizes and measures thegoodwill acquired in the business combination or the gain from a bargainpurchase; and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. ASC 805 is effective for fiscal yearsbeginning on or after December 15, 2008, with early adoption prohibited.We adopted ASC 805 on July 1, 2009 with no impact to our consolidatedfinancial statements.

 

In December 2007,the FASB issued ASC 810 (formerly SFAS No. 160, *Noncontrolling Interests in Consolidated FinancialStatements, An Amendment of ARB No. 51*). ASC 810establishes accounting and reporting standards for noncontrolling interests ina subsidiary and for the deconsolidation of a subsidiary. Minority interestswill be recharacterized as noncontrolling interests and classified as acomponent of equity. It also establishes a single method of accounting forchanges in a parent’s ownership interest in a subsidiary and requires expandeddisclosures. This statement is effective for fiscal years beginning on or afterDecember 15, 2008, with early adoption prohibited. We adopted ASC 810on July 1, 2009. The adoption of this statement did not have a materialimpact on our financial position, results of operations or cash flows.

 

In March 2008, theFASB issued ASC 815 (formerly SFAS No. 161, *Disclosures about Derivative Instruments and HedgingActivities—An Amendment of FASB Statement 133*). ASC 815expands the required disclosures to discuss the uses of derivative instruments,the accounting for derivative instruments and related hedged items underASC 815, and how derivative instruments and related hedged items affectthe company’s financial position, financial performance and cash flows. Weadopted ASC 815 on July 1, 2009. The adoption of this statement didnot have a material impact on our financial position, results of operations orcash flows.

 

In June 2008, theFASB issued ASC 260 (formerly EITF 03-6-1, *Determining Whether Instruments Granted in Share-Based PaymentTransactions Are Participating Securities*). ASC 260 addresseswhether instruments granted in share-based payment transactions areparticipating securities prior to vesting and need to be included in thecalculation of earnings per share under the two-class method. UnderASC 260, share-based payment awards that contain nonforfeitable rights todividends are “participating securities”, and therefore should be included incomputing earnings per share using the two-class method. ASC 260 iseffective for financial statements issued for fiscal years and interim periods beginningafter December 15, 2008. We adopted ASC 260 on July 1, 2009. Theeffect of adopting ASC 260 increased the number of shares used to computeour earnings per share; however, the adoption of ASC 260 did not have amaterial impact on our financial position, results of operations or cash flows.

 

In December 2008,the FASB issued ASC 815 (formerly EITF 07-5, *Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock*). ASC 815 affectscompanies that have provisions in their securities purchase agreements thatprovide for the reset of the current conversion price based upon new issuancesby companies at prices below certain thresholds. Securities purchase agreementswith such provisions will require the embedded derivative instrument to bebifurcated and separately accounted for as a derivative. Subject to certainexceptions, our preferred stock provides for resetting the conversion price ifwe issue new common stock below $5.75 per share. ASC 815 is effective forfinancial statements issued for fiscal years and interim periods beginningafter December 15, 2008. We adopted ASC 815 on July 1, 2009. Theadoption of this statement did not have a material impact on our financialposition, results of operations or cash flows as the reset conversion provisiondid not meet the definition of a derivative since it was not readily net-cashsettled.

 

In December 2008,the Securities and Exchange Commission (the “SEC”) issued the final rule, *Modernization of Oil and Gas Reporting*.The new disclosure requirements include provisions that permit the use of newtechnologies to determine proved reserves if those technologies lead toreliable conclusions about reserve quantities. The new requirements also willallow companies to disclose their probable and possible reserves to investors.In addition, the new disclosure requirements specify for companies to: (a) reportthe independence and qualifications of its reserves preparer or auditor; (b) filereports when a third party is relied upon to prepare reserves estimates orconducts a reserves audit; and (c) report oil and gas reserves using anaverage price based upon the prior 12-month period rather than year-end prices.The new disclosure requirements are effective for financial statements for fiscalyears ending on or after December 31, 2009. On April 20, 2010, theFASB issued Accounting Standards Update No. 2010-14, which became effective on January 1,2010, to reflect changes to fossil fuel exploration and production technologyover the past several decades. We are not required to conform to these SECrequirements until we file our annual report for our 

 

6

----

 

fiscal year ending June 30,2010. The effect of adopting the SEC rule has not been determined;however, it is not expected to have a material impact on our financialposition, results of operations or cash flows.

 

In June 2009, theFASB issued ASC 855 (formerly SFAS 165, *Subsequent Events*) to establish general standards ofaccounting for and disclosure of events that occur after the balance sheetdate, but prior to the issuance of financial statements. Specifically,ASC 855 sets forth: (1) the period after the balance sheet dateduring which management of a reporting entity should evaluate events ortransactions that may occur for potential recognition or disclosure in thefinancial statements; (2) the circumstances under which an entity shouldrecognize events or transactions occurring after the balance sheet date in itsfinancial statements; and (3) the disclosures that an entity should makeabout events or transactions that occurred after the balance sheet date.ASC 855 is effective for financial statements issued for interim or annualperiods ending after June 15, 2009. We adopted ASC 855 on June 30,2009. The adoption of this statement did not have a material impact on ourfinancial position, results of operations or cash flows.

 

**2.PENDING MERGER WITH RESACA**

 

On September 29,2009, the boards of directors of Cano and Resaca Exploitation, Inc. (“Resaca”),a Texas corporation, approved an Agreement and Plan of Merger (the “MergerAgreement”) by and among Cano, Resaca and Resaca Acquisition Sub, Inc., aDelaware corporation and wholly-owned subsidiary of Resaca (“Merger Sub”),pursuant to which Merger Sub will be merged with and into Cano (the “Merger”)and Cano will become a wholly-owned subsidiary of Resaca. Closing isanticipated before the end of June 2010; however, it is possible thatfactors outside of either company’s control could require us to complete theMerger at a later time or not to complete it at all.

 

Under the terms of theproposed Merger, each share of Cano common stock will be converted into theright to receive 2.10 shares of common stock of Resaca (or0.42 shares of Resaca common stock after the proposed one-for-five reversestock split is approved by the Resaca shareholders prior to the Merger) andeach share of Cano Series D Convertible Preferred Stock (the “PreferredStock”) will be converted into the right to receive one share of Resaca Series AConvertible Preferred Stock. The Merger is intended to be a tax-freetransaction to the Cano stockholders to the extent that the Cano commonstockholders receive Resaca common stock and the Cano preferred stockholdersreceive Resaca preferred stock as Merger consideration.

 

Consummation of thetransactions contemplated by the Merger Agreement is conditioned upon, amongother things: (1) approval of the holders of Cano common stock and Canopreferred stock, (2) approval of the holders of Resaca common stock, (3) thelisting of Resaca common stock on the NYSE Amex, (4) the refinancing ofexisting bank debt of Resaca and Cano, (5) the receipt of requiredregulatory approvals, (6) Resaca’s application for readmission to the AIMMarket of the London Stock Exchange, which is anticipated to occur simultaneouswith the closing of the merger and (7) the effectiveness of a registrationstatement relating to the shares of Resaca common stock to be issued inconjunction with the Merger. The Merger Agreement contains certain terminationrights for each of Cano and Resaca, including the right to terminate the MergerAgreement and to enter into a Superior Proposal (as such term is defined in theMerger Agreement). In the event of a termination of the Merger Agreement undercertain specified circumstances described in the Merger Agreement, one partywill be required to pay the other party a termination fee of $3,500,000.

 

On February 3, 2010,Resaca received a commitment for a new $200.0 million revolving seniorsecured credit facility with Union Bank of North America, N.A. (“UBNA”) for thecombined company. UBNA is the administrative agent and issuing lender of therevolving senior secured credit facility. The facility has a maturity of July 1,2012 and is expected to have an initial borrowing base of $90.0 millionbased upon the combined company’s estimated proved reserves.

 

On February 24,2010, Cano and Resaca entered into Amendment No. 1 to the MergerAgreement, which extends the date on which either Cano or Resaca may terminatethe Merger Agreement if the Merger has not become effective from February 28,2010 to April 30, 2010.

 

7

----

 

On March 30, 2010,the shares of Resaca common stock to be issued in the Merger were approved forlisting on the NYSE Amex.

 

On April 1, 2010,Cano and Resaca entered into Amendment No. 2 of the Merger Agreement,which extends the date on which either Cano or Resaca may terminate the MergerAgreement if the Merger has not become effective from April 30, 2010 to May 31,2010, clarifies the rights of holders of Resaca Series A Preferred Stockwith respect to issuances of securities by Resaca, and provides that, for theone year period following closing of the Merger, Resaca’s board committeesshall consist of three or four directors (rather than four directors), with noless than two former Cano directors on each committee.

 

On April 5,2010, Cano and Resaca entered into an investors’ rights agreement with theholders of the Preferred Stock. The investors’ rights agreement grantssuch shareholders substantially similar registration and other rights currentlyassociated with the Cano Preferred Stock with respect to the shares of Resacapreferred stock to be received by them upon consummation of the Merger. Uponthe consummation of the Merger, the Investors Rights Agreement will transferthe rights and obligations of Cano under that certain Securities PurchaseAgreement, dated August 25, 2006, by and among Cano and the holders of theCano Preferred Stock (the “SPA”) and that certain Registration RightsAgreement, dated August 25, 2006, by and among Cano and the holders of theCano Preferred Stock (the “Registration Rights Agreement”) to Resaca and amendsand restates the terms of the SPA and the Registration Rights Agreement. TheInvestors Rights Agreement shall not become effective until the closing of theMerger.

 

S. Jeffrey Johnson, ourChief Executive Officer and Chairman of our board of directors, ownsapproximately 3.7% of the Preferred Stock. During the three- and nine-monthperiods ended March 31, 2010, we paid preferred dividend payments to Mr. Johnsonof approximately $20,000 and $59,000, respectively.

 

On April 28, 2010,Cano and Resaca entered into Amendment No. 3 of the Merger Agreement,which extends the date on which either Cano or Resaca may terminate the MergerAgreement if the Merger has not become effective from May 31, 2010 to June 30,2010.

 

On April 29, 2010,Resaca filed Amendment No. 3 to its registration statement covering aproposed underwritten offering of Resaca common stock, which is expected toclose in conjunction with the closing of the Merger.

 

**3.LIQUIDITY**

 

At March 31, 2010,we had cash and cash equivalents of $0.9 million. We had negative workingcapital of $65.3 million, which includes $65.0 million of long-termdebt that was shown as a current liability. Excluding the current portion oflong-term debt totaling $65.0 million, we had negative working capital of$0.3 million. For the nine-month period ended March 31, 2010, we hadcash flow used in operations of $1.1 million and we incurred$1.7 million of Merger-related expenses.

 

As discussed in Note 6,on January 27, 2010, we sold our interests in certain oil and gasproperties located in the Texas Panhandle for net proceeds of$6.3 million. We used a portion of the net proceeds to pay down ouroutstanding debt. As of May 12, 2010, we had available borrowing capacityof $1.1 million and a cash balance of $0.8 million.

 

As discussed inNote 4, the lenders under our two credit agreements agreed to waive thecovenants relating to our leverage ratio and interest coverage ratio for thequarters ended December 31, 2009 and March 31, 2010, as we would havebeen out of compliance with such covenants as of both dates. Should the mergerwith Resaca not close by June 30, 2010, based upon our nine-monthoperating results through March 31, 2010, it is likely that we will not bein compliance with one or more of our financial covenants under our creditagreements as of June 30, 2010. Accordingly, since we did not receivecovenant relief beyond March 31, 2010, our debt is classified as a currentliability. Further, we will continue to seek covenant relief from our lenders,though there can be no assurance that we will be successful in obtaining suchrelief. If we are unable to obtain relief from our lenders, we will need to 

 

8

----

 

raise additional capitalthrough the issuance of equity or the sale of a portion of our assets. There canbe no assurance as to funding we would be able to raise, if any, in connectionwith any such equity issuances or asset sales. In addition, any such equityissuances could be highly dilutive to our existing stockholders and any suchasset sales would require the consent of our lenders and, potentially, theholders of our outstanding common and Preferred Stock.

 

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

 

We believe thecombination of cash on hand, cash flow generated from operations, and availableborrowing capacity, as of May 12, 2010, will be sufficient to fund ouroperating and capital activities through the closing of the Merger, which isanticipated to occur in June 2010.

 

**4. DEBT**

 

At March 31, 2010and June 30, 2009, the aggregate outstanding amounts under our creditagreements were $65.0 million and $55.7 million, respectively. The$65.0 million consisted of outstanding borrowings under the amended andrestated credit agreement (the “ARCA”) and the subordinated credit agreement(the “SCA”) of $50.0 million and $15.0 million, respectively, all ofwhich is classified as a current liability. At March 31, 2010, the averageinterest rates under the ARCA and the subordinated credit agreement were 2.75%and 6.26%, respectively.

 

Our debt consists of theARCA and our subordinated credit agreement. Under the ARCA, our lenders areUBNA, acting as administrative agent, and Natixis. Under the subordinatedcredit agreement, our lender is UnionBanCal Equities, Inc. (“UBE”).

 

On December 30,2009, we entered into Amendment No. 1 (the “ARCA Amendment No. 1”) tothe ARCA, which specifies (i) our borrowing base was redetermined to be$60.0 million, which will remain in effect until it is redetermined inaccordance with the ARCA, (ii) advances under the ARCA for any purposeother than to acquire proved, developed, producing oil and gas properties shallnot exceed $52.0 million and (iii) the covenants relating to ourleverage ratio and interest coverage ratio were waived for the fiscal quarterending December 31, 2009 as we would have been out of compliance with suchcovenants as of December 31, 2009. We paid an amendment fee of $90,000pursuant to the ARCA Amendment No. 1.

 

On March 30, 2010,Cano entered into Amendment No. 2 to the ARCA, which specifies thecovenants relating to our leverage ratio and interest coverage ratio werewaived for the fiscal quarter ending March 31, 2010. The amendment alsospecifies that if the ARCA has not been replaced, refinanced, or amended andrestated on or before May 31, 2010, then we must pay an amendment feeamount of $90,000 on May 31, 2010.

 

As of May 12, 2010,the ARCA had outstanding borrowings of $50.9 million, and availableborrowing capacity of $1.1 million.

 

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

 

On March 30, 2010,we entered into Amendment No. 2 to the SCA, which specifies the covenantsrelating to our leverage ratio and interest coverage ratio were waived for thefiscal quarter ending March 31, 2010. The amendment also specifies that ifthe SCA has not been terminated on or before May 31, 2010, then we mustpay an amendment fee amount of $22,500 on May 31, 2010.

 

9

----

 

**5.DERIVATIVES**

 

Our derivatives consistof commodity derivatives and an interest rate swap arrangement.

 

***Commodity Derivatives***

 

Pursuant to the ARCA andthe SCA, discussed in Note 4, we are required to maintain our “collar”commodity derivative contracts. We entered into commodity derivative contractsto partially mitigate the risk associated with extreme fluctuations of pricesfor crude oil and natural gas sales. We have no obligation to enter intocommodity derivative contracts in the future. Should we choose to enter intocommodity derivative contracts to mitigate future price risk, we cannot enterinto contracts for greater than 85% of our crude oil and natural gas productionvolumes attributable to proved producing reserves for a given month. As of March 31,2010, we maintained the following “collar” commodity derivative contracts withUBNA as our counterparty, which is one of the senior lenders under the ARCA:

 
| **Time Period**        | ** ** | **Floor  Oil Price** | ** ** | **Ceiling  Oil Price** | ** ** | **Barrels  Per Day** | ** ** | **Floor  Gas Price** | ** ** | **Ceiling  Gas Price** | ** ** | **Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per Day(a)** | ** ** |
|-----------------------------|------------|---------------------------|------------|-----------------------------|------------|---------------------------|------------|---------------------------|------------|-----------------------------|------------|-----------------------|------------|-----------------------------------------------------------|------------|
| 4/1/10 - 12/31/10 |       | $                         | 80.00      |                        | $          | 108.20                    |       | 333                       |       | $                           | 7.75       |                  | $          | 9.85                                                      |       | 1,567 |   | 594 |   |
| 4/1/10 - 12/31/10 |       | $                         | 85.00      |                        | $          | 101.50                    |       | 233                       |       | $                           | 8.00       |                  | $          | 9.40                                                      |       | 1,033 |   | 406 |   |
| 1/1/11 - 3/31/11  |       | $                         | 80.00      |                        | $          | 107.30                    |       | 333                       |       | $                           | 7.75       |                  | $          | 11.60                                                     |       | 1,467 |   | 578 |   |
| 1/1/11 - 3/31/11  |       | $                         | 85.00      |                        | $          | 100.50                    |       | 200                       |       | $                           | 8.00       |                  | $          | 11.05                                                     |       | 967 |   | 361 |   |

 

----

(a) Computed bydividing the “Mcf per Day” by 6 and adding “Barrels per Day.”

 

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

 
| **Time Period**             | ** ** | **Fixed  Oil Price** | ** ** | **Barrels  Per Day** | ** ** |
|-----------------------------|------------|----------------------|------------|----------------------|------------|
| 4/1/11 - 12/31/11 |       | $                    | 75.90      |                 | 700        |   |
| 1/1/12 - 12/31/12 |       | $                    | 77.25      |                 | 700        |   |

 

***Interest Rate Swap Agreement***

 

On January 12, 2009,we entered into a three-year LIBOR interest rate basis swap contract withNatixis Financial Products, Inc. (“Natixis FPI”) for $20.0 million innotional exposure. We entered into the interest rate swap agreement topartially mitigate the risk associated with interest rate fluctuations on ourinterest expense. Under the terms of the transaction, we will pay Natixis FPI,in three-month intervals, a fixed rate of 1.73% and Natixis FPI will pay Canothe prevailing three-month LIBOR rate.

 

During the three- andnine-month periods ended March 31, 2010 and 2009, respectively, the gain(loss) on derivatives reported in our consolidated statements of operations issummarized as follows (in thousands):

 

10

----

 
| ** **                                                                                    | ** ** | **Location of  Gain (Loss) on** | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **Derivatives**                                | ** ** | **2010**                                         | ** ** | **2009**                                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Settlements  received/accrued on commodity derivatives                                        |       | Other income  (expense)                        |       | $                                                | 753        |                                            | $          | 2,846 |   | $ | 3,799 |   | $ | 4,558 |   |
| Settlements  received—sale of “floor price” contracts on commodity derivatives |       | Other income  (expense)                        |       | —                                           |       | —                                          |       | — |   | 653 |   |
| Settlements  paid/accrued on commodity derivatives                                            |       | Other income  (expense)                        |       | —                                           |       | —                                          |       | — |   | (551 | ) |
| Settlements  paid/accrued on interest rate swap                                               |       | Other income  (expense)                        |       | (74                                              | )          | —                                          |       | (199 | ) | — |   |
| Realized  gain on derivatives                                                                 |       | Other income  (expense)                        |       | 679                                              |       | 2,846                                           |       | 3,600 |   | 4,660 |   |
| Unrealized  gain (loss) on commodity derivatives                                              |       | Other income  (expense)                        |       | 233                                              |       | 716                                             |       | (7,754 | ) | 43,896 |   |
| Unrealized  loss on interest rate swap                                                        |       | Other income  (expense)                        |       | (124                                             | )          | (76                                             | )          | (297 | ) | (76 | ) |
| Gain  (loss) on derivatives                                                                   |       | Other income  (expense)                        |       | $                                                | 788        |                                            | $          | 3,486 |   | $ | (4,451 | ) | $ | 48,480 |   |

 

The realized gain (loss)on derivatives consists of actual cash settlements under our commodity collarand interest rate swap derivative agreements during the respective periods. Thecash settlements received/accrued by us under commodity derivatives werecumulative monthly payments due to us since the NYMEX natural gas and crude oilprices were lower than the “floor prices” set for the respective time periodsand realized gains from the sale of uncovered “floor price” contracts asdiscussed below. The cash settlements paid/accrued by us under commodityderivatives were cumulative monthly payments due to our counterparty since theNYMEX crude oil and natural gas prices were higher than the “ceiling prices”set for the respective time periods. The cash settlements paid/accrued by usunder the interest rate swap related to quarterly payments to our counterpartysince the actual three-month LIBOR interest rate was lower than the fixed 1.73%rate we pay to the counterparty. The cash flows relating to the derivativeinstrument settlements that are due, but not cash settled are reflected inoperating activities on our consolidated statements of cash flows as changes tocurrent liabilities. At March 31, 2010 and June 30, 2009, we hadrecorded a receivable from our counterparty included in accounts receivable onour consolidated balance sheet of $0.3 million and $0.6 million,respectively.

 

During October 2008,we sold certain uncovered “floor price” commodity derivative contracts to ourcounterparty for $3.2 million and realized a gain of $0.7 million.

 

The unrealized gain(loss) on commodity derivatives represents estimated future settlements underour commodity derivatives and is based on mark-to-market valuation based onassumptions of forward prices, volatility and the time value of money asdiscussed below. We compared our internally derived valuation to our counterparties’independently derived valuation to further validate our mark-to-marketvaluation. During the three-month period ended March 31, 2010, werecognized an unrealized gain in our consolidated statements of operations amountingto $0.2 million. During the nine-month period ended March 31, 2010, werecognized an unrealized loss on commodity derivatives in our consolidatedstatements of operations amounting to $7.8 million. During the three- andnine-month periods ended March 31, 2009, we recognized an unrealized gainon commodity derivatives in our consolidated statements of operations amountingto $0.7 million and $43.9 million, respectively.

 

The unrealized loss oninterest rate swap represents estimated future settlements under ouraforementioned interest rate swap agreement and is based on a mark-to-marketvaluation based on assumptions of interest rates, volatility and the time valueof money as discussed below. During the three- and nine-month periods ended March 31,2010, we recognized realized losses on interest rate swaps in our consolidatedstatements of operations amounting to $0.1 million and $0.2 million,respectively. During the three- and nine-month periods ended March 31,2010, we recognized unrealized losses on interest rate swaps in ourconsolidated statements of operations amounting to $0.1 million and $0.3million, respectively. During the three- and nine-month period ended March 31,2009, we recognized unrealized losses on interest rate swaps in ourconsolidated statements of operations amounting to $0.1 million for eachperiod.

 

11

----

 

***Fair Value Measurements***

 

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

 

Level 1—Quotedprices in active markets for identical assets or liabilities that we have theability to access. Active markets are those in which transactions for the assetor liability occur in sufficient frequency and volume to provide pricinginformation on an ongoing basis.

 

Level 2—Inputs areother than quoted prices in active markets included in Level 1, which areeither directly or indirectly observable. These inputs are either directlyobservable in the marketplace or indirectly observable through corroborationwith market data for substantially the full contractual term of the asset orliability being measured.

 

Level 3—Inputsreflect management’s best estimate of what market participants would use inpricing the asset or liability at the measurement date. Consideration is givento the risk inherent in the valuation technique and the risk inherent in theinputs to the model.

 

In valuing certaincontracts, the inputs used to measure fair value may fall into different levelsof the fair value hierarchy. For disclosure purposes, assets and liabilitiesare classified in their entirety in the fair value hierarchy level based on thelowest level of input that is significant to the overall fair valuemeasurement. Our assessment of the significance of a particular input to thefair value measurement requires judgment and may affect the placement withinthe fair value hierarchy levels.

 

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

 

Weestimate our asset retirement obligations pursuant to the provisions of FASBASC Topic 410, “Asset Retirement and Environmental Obligations.”  Theincome valuation technique we utilize to determine the fair value of theliability at inception applies a credit-adjusted risk-free rate, which takesinto account the our credit risk, the time value of money, and the currenteconomic state, to the undiscounted expected abandonment cash flows. Given the unobservable nature of the inputs, the initial measurement of theasset retirement obligation liability is deemed to use Level 3 inputs.

 

The estimated fair valueof derivatives included in the consolidated balance sheet at March 31,2010 is summarized below.

 
| **In thousands**                              | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|
| Derivative  assets (Level 2):                 |       |       |       |
| Crude  oil collars and price floors—current   |       | $          | 712        |   |
| Natural  gas collars and price floors—current |       | 2,774      |       |
| Derivative  liability (Level 2)               |       |       |       |
| Interest  rate swap—current                   |       | (227       | )          |
| Interest  rate swap—noncurrent                |       | (18        | )          |
| Derivative  liability (Level 3)               |       |       |       |
| Crude  oil swap—noncurrent                    |       | (3,588     | )          |
| Net  derivative liabilities                        |       | $          | (347       | ) |

 

12

----

 

At September 30,2009, our net derivative asset was classified as Level 2 as thesubjectivity of our valuation for the effect of our own credit risk wasinsignificant. At December 31, 2009, since the subjective valuation of ourown credit risk is significant, we reclassified our derivative liabilities asLevel 3. At March 31, 2010, we continue to classify our derivativeliabilities as Level 3 as presented in the table below.

 
| **In thousands**             | ** ** | **Beginning  Balance** | ** ** | **Total  Gains  (Losses) (a)** | ** ** | **Purchases,  Sales,  Issuances,  and  Settlements,  net** | ** ** | **Transfers  into  Level 3** | ** ** | **Ending  balance** | ** ** | **Unrealized Gains  (Losses) for Level 3  Assets/Liabilities  Outstanding at  March 31, 2010** | ** ** |
|-----------------------------------|------------|------------------------|------------|-------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------|------------|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|
| Derivatives  assets (liabilities) |       | $                      | —     |                                | $          | (2,944                                                     | )          | $                                 | —     |                | $          | (644                                                                                                                              | )          | $ | (3,588 | ) | $ | (3,588 | ) |
|                                   |            |                        |            |                                     |            |                                                            |            |                                   |            |                     |            |                                                                                                                                   |            |  |  |  |  |  |  |

 

----

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

 

The following table showsthe reconciliation of changes in the fair value of the net derivative assetsclassified as Level 2 and 3, respectively, in the fair value hierarchy forthe nine-month period ended March 31, 2010 (in thousands).

 
| **In thousands**               | ** ** | **Total Net  Derivative  Assets  (Liabilities)** | ** ** |
|-------------------------------------|------------|-------------------------------------------------------|------------|
|  Balance at June 30, 2009 |       | $                                                     | 7,678      |   |
| Unrealized  loss on derivatives     |       | (8,051                                                | )          |
| Settlements,  net                   |       | 26                                                    |       |
| Balance  at March 31, 2010     |       | $                                                     | (347       | ) |

 

The change from netderivative assets of $7.7 million at June 30, 2009 to net derivativeliabilities of $0.3 million at March 31, 2010 is attributable to theincreases in crude oil and natural gas futures prices. These amounts are basedon our mark-to-market valuation of these derivatives at March 31, 2010 andmay not be indicative of actual future cash settlements.

 

The following tablesummarizes the fair value of our derivative contracts as of the datesindicated:

 
| ** **                                                  | ** ** | **Asset Derivatives**          | ** ** | **Liability Derivatives** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **March 31, 2010**        | ** ** | **June 30, 2009**    | ** ** | **March 31, 2010** | ** ** | **June 30, 2009** | ** ** |
| **In thousands**                                       | ** ** | **Balance Sheet  Location**    | ** ** | **Fair  Value**                | ** ** | **Balance Sheet  Location** | ** ** | **Fair  Value** | ** ** | **Balance Sheet  Location** | ** ** | **Fair  Value** | ** ** | **Balance Sheet  Location** | ** ** | **Fair  Value** | ** ** |
| **Derivatives not designated as hedging instruments**       |       |                                |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commodity  derivative contracts                             |       | Derivatives –  current    |       | $                              | 3,486      |   | Derivatives –  current |   | $ | 4,955 |   | Derivatives –  current |   | $ | — |   | Derivatives –  current |   | $ | — |   |
| Commodity  derivative contracts                             |       | Derivatives –  noncurrent |       | —                         |       | Derivatives –  noncurrent |   | 2,670 |   | Derivatives –  noncurrent |   | (3,588 | ) | Derivatives –  noncurrent |   | — |   |
| Interest  rate swaps                                        |       | Derivatives –  current    |       | —                         |       | Derivatives –  current |   | — |   | Derivatives –  current |   | (227 | ) | Derivatives –  current |   | (159 | ) |
| Interest  rate swaps                                        |       | Derivatives –  noncurrent |       | —                         |       | Derivatives –  noncurrent |   | 212 |   | Derivatives -  noncurrent |   | (18 | ) | Derivatives -  noncurrent |   | — |   |
| **Total derivatives not designated as hedging instruments** |       |                                |       | $                              | 3,486      |   |   |   | $ | 7,837 |   |   |   | $ | (3,833 | ) |   |   | $ | (159 | ) |
| **Total derivatives designated as hedging instruments**     |       |                                |       | $                              | —     |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |
| **Total derivatives**                                       |       |                                |       | $                              | 3,486      |   |   |   | $ | 7,837 |   |   |   | $ | (3,833 | ) |   |   | $ | (159 | ) |

 

13

----

 

**6. DISCONTINUEDOPERATIONS**

 

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

 

On December 2, 2008,we completed the sale of our Corsicana oil and gas properties (the “CorsicanaProperties”) for $0.3 million. In the three-month period ended September 30,2008, we recorded a $3.5 million ($2.3 million after-tax) impairmentof the Corsicana Properties, as we determined that we would not be developingits proved undeveloped reserves within the next five years.

 

On January 27, 2010,we completed the sale of our interests in certain oil and gas propertieslocated in the Texas Panhandle (“Certain Panhandle Properties”) for netproceeds of $6.3 million, subject to customary post-closing adjustmentswhich resulted in a pre-tax gain of $2.6 million, based on updated reserveinformation as of December 31, 2009. The sale had an effective date of January 1,2010.

 

The operating results ofPantwist, LLC, the Corsicana Properties and the Certain PanhandleProperties for the three- and nine-month periods ended March 31, 2010 and2009 have been reclassified as discontinued operations in the consolidatedstatements of operations as detailed in the table below (in thousands).

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| **In Thousands**                                  | ** ** | **2010**                         | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Operating  Revenues:                                   |       |                             |       |                            |       |   |   |   |   |
| Crude  oil sales                                       |       | $                                | 12         |                            | $          | 13 |   | $ | 35 |   | $ | 1,378 |   |
| Natural  gas sales                                     |       | 153                              |       | 370                             |       | 972 |   | 3,317 |   |
| Total  operating revenues                              |       | 165                              |       | 383                             |       | 1,007 |   | 4,695 |   |
| Operating  Expenses:                                   |       |                             |       |                            |       |   |   |   |   |
| Lease  operating                                       |       | 23                               |       | 79                              |       | 178 |   | 865 |   |
| Production  and ad valorem taxes                       |       | 11                               |       | 46                              |       | 118 |   | 389 |   |
| Impairment  of long-lived assets                       |       | —                           |       | —                          |       | — |   | 3,516 |   |
| Depletion  and depreciation                            |       | —                           |       | 13                              |       | 27 |   | 52 |   |
| Accretion  of discount on asset retirement obligations |       | —                           |       | —                          |       | 2 |   | 4 |   |
| Interest  expense, net                                 |       | 8                                |       | 16                              |       | 43 |   | 96 |   |
| Total  operating expenses                              |       | 42                               |       | 154                             |       | 368 |   | 4,922 |   |
| Gain  (loss) on sale of properties                     |       | 2,591                            |       | (65                             | )          | 2,591 |   | 19,244 |   |
| Income  before income taxes                            |       | 2,714                            |       | 164                             |       | 3,230 |   | 19,017 |   |
| Income  tax provision                                  |       | (992                             | )          | (50                             | )          | (1,164 | ) | (6,928 | ) |
| Income  from discontinued operations                   |       | $                                | 1,722      |                            | $          | 114 |   | $ | 2,066 |   | $ | 12,089 |   |

 

Interest expense, net ofinterest income, was allocated to discontinued operations based on thepercentage of operating revenues applicable to discontinued operations to thetotal operating revenues.

 

At June 30,2009, on our consolidated balance sheet, the assets relating to the CertainPanhandle Properties are classified as assets held for sale and the liabilitiesare classified as liabilities associated with discontinued operations.

 

14

----

 

**7.DEFERRED COMPENSATION**

 

As of March 31,2010, we had non-vested restricted shares totaling 386,668 shares to keyemployees pursuant to our 2005 Long-Term Incentive Plan, as summarized below:

 
| ** **                                           | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date  Fair Value** | ** ** | **Fair Value  $000s** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------------------------|------------|-----------------------|------------|
| Non-vested  restricted shares at June 30, 2009  |       | 480,001    |       | $                                             | 6.97       |                  | $          | 3,344 |   |
| Shares  vested                                       |       | (68,647    | )          | $                                             | 5.84       |                  | $          | (401 | ) |
| Shares  forfeited                                    |       | (24,686    | )          | $                                             | 5.84       |                  | (144       | ) |
| Non-vested  restricted shares at March 31, 2010 |       | 386,668    |       | $                                             | 7.24       |                  | $          | 2,799 |   |

 

The restricted sharegrants will vest to the employees based on future years of service ranging fromone to three years depending on the life of the award agreement. Pursuant tothe Merger discussed in Note 2, any non-vested restricted shares will vestupon the completion of the Merger. The fair value of the grants is based on ouractual stock price on the date of grant multiplied by the number of restrictedshares granted. As of March 31, 2010, the grant date value of non-vestedrestricted shares amounted to $2.8 million. For the three-month periodsended March 31, 2010 and 2009, we have expensed $0.2 million and$0.5 million, respectively, to stock compensation expense based onamortizing the fair value over the appropriate service period. For thenine-month period ended March 31, 2010 and 2009, we have expensed$0.8 million and $1.8 million, respectively, to stock compensationexpense. The shares forfeited represent shares used to satisfy employees’ taxwithholding obligations related to the vesting of their restricted shares.

 

**8. STOCKOPTIONS**

 

During the nine-monthperiod ended March 31, 2010, we granted 16,032 stock options to twodirectors under our 2005 Long-Term Incentive Plan. The options were grantedwith an exercise price equal to our market price at the date of grant and vestimmediately. The factors used to calculate the fair value of these options aresummarized in the table below:

 
| No. of  options                    |   | 16,032       |   |
|-----------------------------------------|--------|--------------|--------|
| Risk  free interest rate                |   | 2.19         | %      |
| Expected  life                          |   | 5 years |   |
| Expected  volatility                    |   | 98.9         | %      |
| Expected  dividend yield                |   | 0            | %      |
| Weighted  average grant date fair value |   | $            | 0.77   |   |
|                                         |        |              |        |  |

 

The fair value of eachstock option is estimated on the date of grant using the Black-Scholesoption-pricing model. Expected volatility is based on the historical volatilityof our common stock. We use historical data to estimate option exercise andemployee termination within the valuation model. The expected lives of optionsgranted represent the period of time that options granted are expected to beoutstanding. The risk-free interest rate for periods within the contractuallife of the option is based on the five-year U.S. Treasury yield curve ineffect at the time of the respective grant. The expected dividend yield reflectsour intent not to pay dividends on our common stock during the contractualperiods.

 

Asummary of outstanding options as of March 31, 2010 is as follows:

 

15

----

 
| ** **                          | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|-------------------------------------|------------|------------|------------|------------------------------------------------|------------|
| Outstanding  at June 30, 2009  |       | 1,400,002  |       | $                                              | 4.42       |   |
| Options  granted                    |       | 16,032     |       | $                                              | 1.03       |   |
| Options  forfeited                  |       | (86,017    | )          | $                                              | 5.24       |   |
| Outstanding  at March 31, 2010 |       | 1,330,017  |       | $                                              | 4.33       |   |

 

Based on our $1.17 stockprice at March 31, 2010, the intrinsic value of both the optionsoutstanding and exercisable was approximately $0.2 million.

 

Total options exercisableat March 31, 2010 amounted to 1,127,845 shares and had a weighted averageexercise price of $4.12. Upon exercise, we issue the full amount of sharesexercisable per the terms of the options from new shares. We have no plans torepurchase those shares in the future.

 

For each of thethree-month periods ended March 31, 2010 and 2009, we recorded charges tostock compensation expense of $0.1 million for the estimated fair value ofthe options granted to our directors and employees. For each of the nine-monthperiods ended March 31, 2010 and 2009, we recorded charges to stockcompensation expense of $0.2 million and $0.6 million, respectively.As of March 31, 2010, total compensation cost related to non-vested optionawards not yet recognized was $0.2 million. We expect to recognize theremaining unrecognized amount over the related requisite service periods of oneto three years. Pursuant to the Merger discussed in Note 2, theoutstanding stock options will vest upon completion of the Merger.

 

**9. NETINCOME (LOSS) PER COMMON SHARE**

 

Basic net income (loss)per common share is computed by dividing the net income (loss) attributable tocommon shareholders by the weighted average number of shares of common stockoutstanding. Diluted net income (loss) per common share is computed in the samemanner, but also considers the effect of common stock shares underlying stockoptions, the preferred stock and paid-in-kind (“PIK”) dividends on an “as-converted”basis.

 

Shares of common stockunderlying the following items were not included in dilutive weighted averageshares outstanding for the three- and nine-month periods ended March 31,2010, and for the three-month period ended March 31, 2009 as their effectswould have been anti-dilutive.

 
| ** **       | ** ** | **March 31,** | ** ** |
|------------------|------------|--------------------|------------|
| ** **       | ** ** | **2010**           | ** ** | **2009** | ** ** |
| Stock  options   |       | 1,330,017          |       | 1,407,512 |   |
| Preferred  stock |       | 4,147,652          |       | 4,147,652 |   |
| PIK  dividends   |       | 690,954            |       | 497,378 |   |

 

The following tablereconciles earnings and shares used in the computation of basic and dilutedearnings per share for the nine-month period ended March 31, 2009:

 
| ** **                                                       | ** ** | **Nine Months Ended March 31, 2009** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **In thousands, except per share data** | ** ** | **Earnings  ($000)**                                          | ** ** | **Shares** | ** ** | **Earnings  per Share** | ** ** |
| Basic                                                            |       | $                                                             | 24,292     |   | 46,094 |   | $ | 0.53 |   |
| Effective  of dilutive securities:                               |       |                                                          |       |   |   |   |   |
| Conversion  of preferred stock and PIK dividends                 |       | 2,261                                                         |       | 6,945 |   |   |   |
| Stock  options                                                   |       | —                                                        |       | 215 |   |   |   |
| Diluted                                                          |       | $                                                             | 26,553     |   | 53,254 |   | $ | 0.50 |   |

 

16

----

 

**10.INCOME TAXES**

 

The effective income taxrates for the three- and nine-month periods ended March 31, 2010 were28.2% and 33.0%, respectively. The effective income tax rates for the three-and nine-month periods ended March 31, 2009 were 30.4% and 48.2%,respectively. The effective tax rate for the nine-month period ended March 31,2009 was higher due to an increase in the state tax rate.

 

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

 

At June 30, 2009, wehad one tertiary project, the alkaline-surfactant-polymer chemical injectionpilot project at our Nowata Properties (the “Nowata ASP Project”), that waspending the determination of whether proved reserves have been found. During December 2009,we finalized our performance analysis, which indicated the Nowata ASP Projectdid not result in increased oil production of significant quantities to beconsidered economically sufficient to justify the recognition of provedreserves. Accordingly, during December 2009, we recorded a$5.0 million pre-tax exploration expense.

 

The following tablereflects the net change in deferred exploratory project costs during thenine-month period ended March 31, 2010 for the Nowata ASP Project:

 
| **In Thousands**                                        | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|
| Balance  at June 30, 2009                          |       | $          | 4,849      |   |
| Additions  pending the determination of proved reserves |       | 175        |       |
| Deferred  exploratory well costs charged to expense     |       | (5,024     | )          |
| Balance  at March 31, 2010                         |       | $          | —     |   |

 

**12.IMPAIRMENT OF LONG-LIVED ASSETS**

 

During the three-monthperiod ended December 31, 2009, we wrote down $0.3 million of costsassociated with the ASP facility used for the Nowata ASP Project. The facility’swater filtering process did not work properly with the oil-water fluidproduction at our Nowata Properties. We intend to use the ASP facility forfuture pilot tertiary projects at our Cato and Panhandle Properties.

 

During the three-monthperiod ended December 31, 2008, we recorded a $22.4 million pre-taximpairment to our Barnett Shale natural gas properties (“Barnett ShaleProperties”) and a $0.7 million pre-tax impairment to the goodwillassociated with our subsidiary which holds the equity in our Barnett ShaleProperties. We recorded the impairments due to the decline in commodity priceswhich created an uncertainty in the likelihood of developing reservesassociated with our Barnett Shale Properties within the next five years. Thefair value for our Barnett Shale Properties was determined using estimates offuture net cash flows, discounted to a present value, which is considered “Level 3”inputs as previously discussed in Note 5.

 

**13.COMMITMENTS AND CONTINGENCIES**

 

***Burnett Case***

 

On March 23, 2006,the following lawsuit was filed in the 100th Judicial District Court inCarson County, Texas: Cause No. 9840, The Tom L. and Anne Burnett Trust,by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, IIIand Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and BurnettRanches, Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. The plaintiffsclaim 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, Texas.

 

The plaintiffs (i) allegenegligence and gross negligence and (ii) seek damages, including, but notlimited to, damages for damage to their land and livestock, certain expensesrelated to fighting the fire and certain remedial expenses totalingapproximately $1.7 million to $1.8 million. In addition, theplaintiffs seek (i) termination of

 

17

----

 

certain oil and naturalgas leases, (ii) reimbursement for their attorney’s fees (in the amount ofat least $549,000) and (iii) exemplary damages. The plaintiffs also claimthat Cano and its subsidiaries are jointly and severally liable as a singlebusiness enterprise and/or a general partnership or de facto partnership. Theowner of the remainder of the mineral estate, Texas Christian University,intervened in the suit on August 18, 2006, joining Plaintiffs’ request toterminate certain oil and gas leases. On June 21, 2007, the judge of the100th Judicial District Court issued a Final Judgment (a) grantingmotions for summary judgment in favor of Cano and certain of its subsidiarieson plaintiffs’ claims for (i) breach of contract/termination of an oil andgas lease; and (ii) negligence; and (b) granting the plaintiffs’no-evidence motion for summary judgment on contributory negligence, assumptionof risk, repudiation and estoppel affirmative defenses asserted by Cano andcertain of its subsidiaries.

 

The Final Judgment wasappealed and a decision was reached on March 11, 2009, as the Court ofAppeals for the Tenth District of Texas in Amarillo affirmed in part andreversed in part the ruling of the 100th Judicial District Court. TheCourt of Appeals (a) affirmed the trial court’s granting of summaryjudgment in Cano’s favor for breach of contract/termination of an oil and gaslease and (b) reversed the trial court’s granting of summary judgment inCano’s favor on plaintiffs’ claims of Cano’s negligence. The Court of Appealsordered the case remanded to the 100th Judicial District Court. On March 30,2009, the plaintiffs filed a motion for rehearing with the Court of Appeals andrequested a rehearing on the trial court’s ruling in favor of the defendants onthe plaintiffs’ breach of contract/termination of an oil and gas lease claim.On June 30, 2009, the Court of Appeals ruled to deny the plaintiffs’motion for rehearing. On August 17, 2009 we filed an appeal with the TexasSupreme Court to request the reversal of the Court of Appeals ruling regardingour potential negligence. On December 11, 2009, the Texas Supreme Courtdeclined to hear Cano’s appeal. Therefore, this case will be remanded to thedistrict court for trial on the negligence claims.

 

Due to the inherent riskof litigation, the ultimate outcome of this case is uncertain andunpredictable. At this time, Cano management continues to believe that thislawsuit is without merit and will continue to vigorously defend itself and itssubsidiaries, while seeking cost-effective solutions to resolve this lawsuit.Based on our knowledge and judgment of the facts as of May 12, 2010, webelieve our financial statements present fairly the effect of the actual andthe anticipated future costs to resolve this matter as of March 31, 2010.

 

There is no remaininginsurance coverage for any claims associated with this fire litigation.

 

***Securities Litigation***

 

On October 2, 2008,a lawsuit (08 CV 8462) was filed in the United States District Court for theSouthern District of New York against David W. Wehlmann; Gerald W. Haddock;Randall Boyd; Donald W. Niemiec; Robert L. Gaudin; William O. Powell, IIIand the underwriters of the June 26, 2008 public offering of Cano commonstock (“Secondary Offering”) alleging violations of the federal securitieslaws. Messrs. Wehlmann, Haddock, Boyd, Niemiec, Gaudin and Powell wereCano outside directors on June 26, 2008. At the defendants’ request, thecase was transferred to the United States District Court for the NorthernDistrict of Texas (4:09-CV-308-A).

 

On July 2, 2009, theplaintiffs filed an amended complaint that added as defendants Cano, Cano’s ChiefExecutive Officer and Chairman of the Board, Jeff Johnson, Cano’s former SeniorVice President and Chief Financial Officer, Morris B. “Sam” Smith, Cano’scurrent Senior Vice President and Chief Financial Officer, Ben Daitch, Cano’sVice President and Principal Accounting Officer, Michael Ricketts and Cano’sSenior Vice President of Engineering and Operations, Patrick McKinney, anddismissed Gerald W. Haddock, a former director of Cano, as a defendant. Theamended complaint alleges that the prospectus for the Secondary Offeringcontained statements regarding Cano’s proved reserve amounts and standards thatwere materially false and overstated Cano’s proved reserves. The plaintiff isseeking to certify the lawsuit as a class action lawsuit and is seeking anunspecified amount of damages. On July 27, 2009, the defendants moved todismiss the lawsuit. On December 3, 2009, the U.S. District Court for theNorthern District of Texas granted motions to dismiss all claims brought by theplaintiffs. On December 18, 2009, the plaintiffs filed a notice of appealwith the United States Court of Appeals for the Fifth Circuit. On April 5,2010, Cano filed its appellate brief to support its position.  On April 19, 2010, the plaintiffs filedtheir response brief. Due to the inherent risk of litigation, the outcome ofthis lawsuit is uncertain and unpredictable; however, Cano, its officers andits outside directors intend to continue to vigorously defend the lawsuit.

 

18

----

 

Cano is cooperating withits directors and officers liability insurance carrier regarding the defense ofthe lawsuit. We believe that the potential amount of losses resulting from thislawsuit in the future, if any, will not exceed the policy limits of Cano’s directors’and officers’ liability insurance.

 

***Other***

 

Occasionally, we areinvolved in other various claims and lawsuits and certain governmentalproceedings arising in the ordinary course of business. Our management does notbelieve that the ultimate resolution of any current matters that are not setforth above will have a material effect on our financial position or results ofoperations. Management’s position is supported, in part, by the existence ofinsurance coverage, indemnification and escrow accounts. None of our directors,officers or affiliates, owners of record or beneficial owners of more than fivepercent of any class of our voting securities, or security holder is involvedin a proceeding adverse to us or our subsidiaries or has a material interestadverse to us or our subsidiaries.

 

19

----

 

**Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

**Forward-LookingStatements**

 

The information in thisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995. This Actprovides a “safe harbor” for forward-looking statements to encourage companiesto provide prospective information about themselves provided they identifythese statements as forward looking and provide meaningful cautionarystatements identifying important factors that could cause actual results todiffer from the projected results. All statements other than statements ofhistorical fact made in this report are forward looking. In particular, thestatements herein regarding industry prospects and future results of operationsor financial position are forward-looking statements. Forward-lookingstatements reflect management’s current expectations and are inherentlyuncertain. Our actual results may differ significantly from management’sexpectations as a result of many factors, including, but not limited to, ourability to complete the Merger, the volatility in prices for crude oil andnatural gas, future commodity prices for derivative hedging contracts, interestrates, estimates of reserves, drilling risks, geological risks, transportationrestrictions, the timing of acquisitions, product demand, market competition,interruption in production, our ability to obtain additional capital, and thesuccess of waterflooding and enhanced oil recovery techniques.

 

Statements in thisQuarterly Report on Form 10-Q regarding Cano’s strategy, risk factors,capital budget, projected expenditures, liquidity and capital resources, anddrilling and development plans reflect Cano’s current plans for the fiscal yearending June 30, 2010 as a stand-alone entity and do not take into accountthe impact of the proposed Merger with a wholly-owned subsidiary of Resaca,except where such statements specifically relate to the proposed Merger.

 

You should read thefollowing discussion and analysis in conjunction with the consolidatedfinancial statements of Cano and subsidiaries and notes thereto, includedherewith. This discussion should not be construed to imply that the resultsdiscussed herein will necessarily continue into the future, or that anyconclusion reached herein will necessarily be indicative of actual operatingresults in the future. Such discussion represents only the best presentassessment of management.

 

**Overview**

 

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

 

In September 2009,we entered into the Merger Agreement with Resaca as discussed under Note 2 ofthe Consolidated Financial Statements. The Merger is subject to customaryconditions, including the approval of the common and preferred stockholders ofCano and the common shareholders of Resaca. The companies will hold separatemeetings of their shareholders to approve the Merger. Assuming shareholderapproval is received, the Merger is expected to be completed within a few daysfollowing the shareholder meetings. For more information regarding the proposedMerger, please refer to the joint proxy statement/prospectus of Resaca and Canothat is included in the registration statement on Form S-4 (File No. 333-162652)filed by Resaca with the SEC, the prospectus filed by Resaca that is includedin the registration statement on Form S-1 (File No. 333-164551) filedby Resaca with the SEC and other relevant materials that may be filed by Canoor Resaca with the SEC.  The followingdiscussion relates to our plans without regard to the potential impact of theproposed Merger.

 

At May 12, 2010, wehad $0.8 million cash on hand and $1.1 million of available borrowingcapacity.  At March 31, 2010, theaggregate outstanding amount under our credit agreements was $65.0 million, allof which is classified as a current liability. 

 

Since December 31,2009, we have been out of compliance with our leverage ratio and interestcoverage ratio under our credit agreements, and based on our current estimatesof income and expenses, it is likely that we will not be in compliance with oneor more of our financial covenants under the ARCA and/or the

 

20

----

 

SCA as of June 30,2010. If the pending Merger and the refinancing of our credit agreements do notoccur by June 30, 2010, we will seek covenant relief from our lenders,though there can be no assurance that we will be successful in obtaining suchrelief. If we are unable to obtain covenant relief from our lenders, tonegotiate amendments to our credit agreements or to obtain necessary fundingfrom operations or outside capital raising activities, we could default on ourobligations under one or both of our credit agreements, which default, if notcured or waived, could result in the acceleration of all indebtednessoutstanding under our credit agreements and requires us to redeem ouroutstanding preferred stock.  At March 31,2010, the redemption price of our preferred stock would have been $27.8million. See *“—Liquidity and CapitalResources—Liquidity”* and *“—Liquidityand Capital Resources—Credit Agreement Covenant Compliance.”*

 

We are primarily focusedon enhancing waterflood operations in our two largest properties, Cato andPanhandle. These development activities are more fully described below under “*—Development Capital Expenditures and OperatingActivities Update.”* We believe our portfolio of crude oil andnatural gas properties provides opportunities to apply our operational strategy.

 

***Proved Reserves***

 

Our June 30, 2009proved reserves of 49.1 million barrels of oil equivalent (“MMBOE”),comprised 7.7 MMBOE of proved developed producing reserves (“PDP”), 2.4 MMBOEof proved developed non-producing reserves (“PDNP”), and 39.0 MMBOE of provedundeveloped reserves (“PUD”) based on crude oil and natural gas prices of$69.89 per barrel and $3.71 per MMBtu, respectively. Crude oil reservesaccounted for 79% of our total reserves at June 30, 2009.

 

On April 5,2010, we announced the results of a mid-year reserves review as of December 31,2009 as estimated by Haas Petroleum Engineering Services, Inc. (“Haas”),our new independent petroleum engineer (Resaca’s independent petroleumengineers). The following table compares our proved reserves by property as of June 30,2009 to December 31, 2009. The amounts are presented in thousands ofbarrels oil equivalent (“MBOE”).

 
| **(in  MBOE)**            | ** ** | **June 30,  2009** | ** ** | **December 31,  2009** | ** ** |
|---------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Properties**            | ** ** | **PDP**                 | ** ** | **PDNP**                    | ** ** | **PUD** | ** ** | **Proved** | ** ** | **PDP** | ** ** | **PDNP** | ** ** | **PUD** | ** ** | **Proved** | ** ** |
| Panhandle                 |       | 3,440                   |       | —                      |       | 25,433 |   | 28,873 |   | 2,462 |   | 383 |   | 20,990 |   | 23,835 |   |
| Cato                      |       | 1,858                   |       | 530                         |       | 13,582 |   | 15,970 |   | 1,095 |   | 724 |   | 13,216 |   | 15,035 |   |
| Nowata                    |       | 1,547                   |       | —                      |       | — |   | 1,547 |   | 1,584 |   | 53 |   | — |   | 1,637 |   |
| Davenport                 |       | 744                     |       | 565                         |       | — |   | 1,309 |   | 685 |   | 507 |   | — |   | 1,192 |   |
| Desdemona                 |       | 147                     |       | 1,251                       |       | — |   | 1,398 |   | 419 |   | 888 |   | 16 |   | 1,323 |   |
| **Total Proved Reserves** | ** ** | **7,736**               | ** ** | **2,346**                   | ** ** | **39,015** | ** ** | **49,097** | ** ** | **6,245** | ** ** | **2,555** | ** ** | **34,222** | ** ** | **43,022** | ** ** |

 

As ofDecember 31, 2009, our proved reserves total 43.0 MMBOE, or 6.1 MMBOElower than our proved reserves of 49.1 MMBOE at June 30, 2009.  The primary contributors to the 6.1 MMBOEdecrease are reduced PUD reserves at the Panhandle Properties of 4.4 MMBOE,reduced PDP reserves at the Cato Properties of 0.8 MMBOE, the sale of certainwells in the Panhandle Properties of 0.5 MMBOE (as discussed in Note 6 to our ConsolidatedFinancial Statements) and production for the six-month period ended December 31,2009 of 0.2 MMBOE.

 

Haas utilized the East Schafer Ranch waterflood as theanalogy for assessing the PUD reserves for each lease of the PanhandleProperties. The East Shafer Ranch waterflood experienced a secondary recoveryof 11% of the original oil in place, or OOIP, which equated to a secondary toprimary ratio of 0.35. Haas, based solely on its professional experience andengineering judgment, determined that for the purpose of reporting thePanhandle Properties’ proved reserves, they would limit each of the PanhandleProperties’ waterflood recovery factors to a 0.35 secondary to primary ratio asa maximum, and not use a percentage of OOIP to determine proved reserves. Insome cases, adjustments were made since the by lease production historyappeared to have allocation issues. Haas’ decision to limit proved reserverecovery based upon a 0.35 secondary to primary ratio resulted in a provedreserve decrease of 3.1 MMBOE. Further, Haas looked at the delayed responsesCano has experienced at its Cockrell Ranch unit, along with reservoirconformance and permeability trends analyzed from core data, and decided tolimit proved reserves to a 0.175 secondary to primary ratio for the CockrellRanch and the adjacent Pond Lease, resulting in a

 

21

----

 

proved reserve decrease of 1.3 MMBOE. Haas determinedthat the reductions to the combined company’s proved reserves would be validly reclassifiedas probable reserves as proved reserves indicate a 90% likelihood thatproduction will meet or exceed the booked value while probable reserves requirea 50% confidence level to be so classified.

 

Thereduction of PDP reserves at Cato Properties is a result of lower fieldproduction rates associated with lower water injection rates at the waterflood.

 

Thereserve estimates as of December 31, 2009 do not include the effects ofthe SEC’s final rule, *Modernization of Oiland Gas Reporting,* issued in December 2008.  This final rule iseffective for annual reports on Form 10-K for years ending on or after December 31,2009.  Since early adoption of the final rule is prohibited, thefinal rule will be fully applied in our annual report on Form 10-Kfor the year ending June 30, 2010.

 

Thebase prices used to compute the crude oil and natural gas proved reservesrepresent the NYMEX crude oil and natural prices at December 31, 2009 of$79.39 per barrel and $5.82 per Mcf, respectively.  Crude oil reserves accountedfor 77% of our total proved reserves at December 31, 2009.

 

The table belowsummarizes the changes in our proved reserves from June 30, 2009 to December 31,2009.

 
| **Summary  of Changes in Proved Reserves**                        | ** ** | **MBOE**   | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|
| Reserves  at June 30, 2009                                   |       | 49,097     |       |
| Extensions  and Discoveries                                       |       | 593        |       |
| Sale  of Producing Properties                                     |       | (511       | )          |
| Forecast  Revisions                                               |       | (5,959     | )          |
| Production  for the six-month period ended December 31, 2009 |       | (198       | )          |
| **Reserves at December 31, 2009**                            | ** ** | **43,022** | ** ** |

 

Extensionsand Discoveries totaling 593 MBOE include newly identified behind-pipeopportunities at our Cato and Panhandle Properties.  Additionally,approximately 311 MBOE of previously categorized PDNP reserves at the DesdemonaProperties were reclassified to PDP reserves as we are in the midst of adevelopment project to return to production previously shut-in gas wells fromthe Duke Sand formation.  Our developmentactivities are more fully described below under “*—Development Capital Expenditures and Operating Activities Update.”*

 

***Development Capital Expenditures and Operating ActivitiesUpdate***

 

For the quarter ending March 31,2010 (“current quarter”) our production averaged 1,085 net barrels of oilequivalent per day (BOEPD). This is 6.6% lower as compared to production of1,162 BOEPD for the quarter ended March 31, 2009 (“prior year quarter”)and 1.4% higher as compared to production of 1,070 net BOEPD for the quarterended December 31, 2009. Production for the nine-month period ended March 31,2010 (“current nine months”) of 1,086 net BOEPD was 3.5% lower as compared tothe nine-month period ended March 31, 2009 (“prior year nine months”) of1,126 net BOEPD.  For both the currentquarter and current nine months, the production decrease was largelyattributable to a reduction at our Cato Properties of 73 BOEPD and 20 BOEPD,respectively, due to mandatory lower waterflood injection volumes. At our otherproperties, normal field declines of production were offset by workoveractivities and an active return-to-production program at the Desdemona Field.

 

For the year ending June 30,2010 (the “2010 Fiscal Year”), our Board of Directors approved a developmentcapital expenditure budget of $13.9 million (excludes capitalized generaland administrative and interest expenses). Our development capital budget isdesigned to maintain our current level of production and to minimize drawing onthe ARCA until the proposed Merger is completed. The development capital budgetis as follows:

 

·                  $5.4 million at the Cato Properties;$4.2 million incurred for the current nine months,

·                  $7.8 million at the PanhandleProperties; $5.8 million incurred for the current nine months, and

·                  $0.7 million at the remainingProperties; $0.6 million incurred for the current nine months.

 

22

----

 

For the current ninemonths, we have incurred $10.6 million of the $13.9 million budgeted fordevelopment capital expenditures. The financing of our development capitalexpenditures is discussed below under *“—Liquidityand Capital Resources*.”

 

The following is adiscussion of our field level activity during the current nine months andplanned activity during the balance of the 2010 Fiscal Year.

 

***Cato Properties.*** Our 2010 Fiscal Year development capital plan included expanding thewaterflood footprint from 640 acres to approximately 1,000 acres by addingthree new injection wells, which were put into service in the second quarter ofour 2010 Fiscal Year. We have identified a new source of water in anon-productive formation within our acreage, and have confirmed that the waterwell is capable of producing 2,500 to 3,000 barrels of water per day. This newwater source formation has been penetrated in a number of existing wellbores inthe Cato Properties and confirms the reservoir continuity necessary to validateit as a reliable water source for future expansion of the Cato waterflood.  As we develop this new water source, we willbe able to increase the waterflood footprint without decreasing the injectionrate at our existing injectors, which should enable us to maintain productionfrom existing producing wells at current levels. We averaged 14,000 barrels ofwater injection per day (“BWIPD”) during the quarter ended September 30,2009.  We experienced a decrease to12,000 BWIPD during our second and third quarters as we measured increasinginjection pressures in the northern part of the flood area and we wererequired, under our existing waterflood permit, to reduce the injection rate inthese wells. On May 6, 2010, we received administrative approval from theNew Mexico Oil and Gas Conservation Division to increase injection pressures atthe 14 active wells to our current physical plant capabilities of approximately21,000 BWIPD.  We expect to seeincreasing fluid production rates and corresponding increasing oil rates asinjection rates increase. Further development plans for the Cato Propertiesinclude behind-pipe recompletions, restoration of production from the Tom-Tomand Tomahawk fields, and the drilling of a Morrow formation test well.  These development plans are contemplated tobegin after the completion of the Merger.

 

Net production at the Cato Properties for the currentquarter was 241 BOEPD, which was 11 BOEPD lower as compared to 252 BOEPD forthe quarter ended December 31, 2009. The 11 BOEPD decrease resulted from the reduction in injected water andredistribution of water injection at the waterflood.  Net production at the Cato Properties for thecurrent nine months was 264 BOEPD.  Netproduction at the Cato Properties for the prior year quarter and prior yearnine months was 313 BOEPD and 284 BOEPD, respectively.

 

***Panhandle Properties.***  In the quarterended September 30, 2009 we retained an independent engineering firm toassist us with reservoir analysis and simulation modeling at the Cockrell Ranchunit. Based on this engineering firm’s recommendations, we established acontrolled water injection pattern to gauge the effects of optimizing waterinjection into the highest remaining crude oil saturation intervals of theBrown Dolomite formation.  We are essentially performing a “Mini-Flood” inthe key target interval at the Cockrell Ranch unit. The result of this fieldobservation, coupled with rigorous reservoir simulation modeling, is expectedto demonstrate an optimal pattern for waterflooding the balance of the CockrellRanch unit with an increasingly predicable production profile. Moreover, thefield observation and modeling results will improve the planning of futuredevelopment programs for the remaining leases located within our PanhandleProperties. To isolate the observed wells, we had temporarily shut-inproduction during most of the quarter ended September 30, 2009, whichreduced Panhandle production by 25 net BOEPD.  All production that wasshut-in for the controlled injection project was restored on September 28,2009. We have experienced positive results from the controlled injectionproject.  Oil production from wells inthe affected area has increased to at or above target levels of 8-12 BOEPD on aper well basis.  These results, coupledwith the accompanying reservoir simulation modeling, should allow acomprehensive analysis of the potential for the Cockrell Ranch Unit.  Results of the studies should be completed inthe third calendar quarter of 2010.

 

Net production at thePanhandle Properties, as adjusted for the sale of Certain Panhandle Propertiesas discussed in Note 6 to the Consolidated Financial Statements, for thecurrent quarter and current nine months was 481 BOEPD and 479 BOEPD,respectively. During the current nine months, we constructed gathering lines toredirect natural gas production from Eagle Rock Field Services L.P. (“EagleRock”) to DCP Midstream, LP (“DCP”).  As of March 31, 2010, we hadredirected approximately 80% of the natural gas production previously deliveredto Eagle Rock to DCP.  Net production atthe Panhandle Properties for the prior year quarter and prior year nine monthswas 498 BOEPD and 485 BOEPD, respectively.

 

23

----

 

***Desdemona Properties.  ***We are in the midst of a project to return toproduction previously shut-in gas wells from the Duke Sand formation.  Weconverted approximately 311 MBOE of previously PDNP reserves to PDP reserveswith the return-to-production (“RTP”) of 12 previously shut-in wells in December 2009.Production increased from 46 BOEPD for the second quarter ending December 31,2009 to 69 BOEPD for the current quarter without the benefit of selling anynatural gas liquids (“NGLs”). We plan to RTP the remaining 13 wells during thequarter ended June 30, 2010. Production from all of the RTP gas wells,including associated NGL recovery from our gas plant, is expected to beapproximately 10-20 Mcfe per day for each gas well returned to production. Werestarted our gas plant in April 2010 and expect to realize the fullbenefit of these produced volumes in May 2010.

 

During the currentquarter, we drilled one new well to a total depth of 3,650 feet to test theMarble Falls, Atoka and Strawn Sand formations. We have completed the new well in the Strawn Sand formation at a depthof 1,750 feet.  The well had initialproduction, on April 16, 2010, of 20 BOPD, 50 MCFPD and 450 BWPD.  We are currently evaluating three offsetlocations for future Strawn Sand development in the Desdemona Properties.

 

Net production at theDesdemona Properties for the current quarter and current nine months was 69BOEPD and 51 BOEPD, respectively.  Netproduction at the Desdemona Properties for the prior year quarter and prior yearnine months was 55 BOEPD and 61 BOEPD, respectively. During July 2009, weshut-in our Barnett Shale natural gas wells based upon the then current and theoutlook for natural gas prices from the Barnett Shale wells.

 

***Nowata Properties.***  Net productionfor the current quarter and current nine months was 222 BOEPD and 219 BOEPD,respectively. Net production for the prior year quarter and prior yearnine months was 227 BOEPD and 222 BOEPD, respectively.

 

***Davenport Properties.***  Net production for the current quarter andcurrent nine months was 78 BOEPD and 75 BOEPD, respectively. Net production forthe prior year quarter and prior year nine months was 70 BOEPD for each timeperiod.

 

**Liquidityand Capital Resources**

 

***Pending Merger with Resaca***

 

Presently, we are pursuinga Merger with Resaca, as discussed in Note 2 to our Consolidated FinancialStatements.  Closing is anticipatedbefore the end of June 2010; however, it is possible that factors outsideof either company’s control could require us to complete the Merger at a latertime or not to complete it at all.

 

***Liquidity***

 

At March 31, 2010,we had cash and cash equivalents of $0.9 million. We had negative workingcapital of $65.3 million, which includes $65.0 million of long-termdebt that was shown as a current liability. Excluding the current portion oflong-term debt totaling $65.0 million, we had negative working capital of$0.3 million. For the nine-month period ended March 31, 2010, we hadcash flow used in operations of $1.1 million and we incurred$1.7 million of Merger related expenses.

 

As discussed in Note 6 toour Consolidated Financial Statements, on January 27, 2010, we sold ourinterests in certain oil and gas properties located in the Texas Panhandle fornet proceeds of $6.3 million. We used a portion of the net proceeds to paydown our outstanding debt. As of May 12, 2010, we had available borrowingcapacity of $1.1 million and a cash balance of $0.8 million.

 

As discussed inNote 4 to our Consolidated Financial Statements, the lenders under our twocredit agreements agreed to waive the covenants relating to our leverage ratioand interest coverage ratio for the quarters ended December 31, 2009 and March 31,2010, as we would have been out of compliance with such covenants as of bothdates. Should the merger with Resaca not close by June 30, 2010, basedupon our nine-month operating results through March 31, 2010, it is likelythat we will not be in compliance with one or more of our financial covenants

 

24

----

 

under our creditagreements as of June 30, 2010. Accordingly, since we did not receivecovenant relief beyond March 31, 2010, our debt is classified as a currentliability. Further, we will seek covenant relief from our lenders, though therecan be no assurance that we will be successful in obtaining such relief. If weare unable to obtain relief from our lenders, we will need to raise additionalcapital through the issuance of equity or the sale of a substantial portion ofour assets. There can be no assurance as to funding we would be able to raise,if any, in connection with any such equity issuances or asset sales. Inaddition, any such equity issuances could be highly dilutive to our existingstockholders and any such asset sales would require the consent of our lendersand, potentially, the holders of our outstanding common and preferred stock.

 

Our credit agreements,discussed in Note 4 to our Consolidated Financial Statements, includechange of control provisions which require us to refinance the creditagreements at the close of the Merger. As discussed in Note 2 to ourConsolidated Financial Statements, on February 3, 2010, Resaca received acommitment for a new $200.0 million revolving senior secured creditfacility with UBNA for the combined company.

 

We believe thecombination of cash on hand, cash flow generated from operations, and availableborrowing capacity, as of May 12, 2010, will be sufficient to fund ouroperating and capital activities through the closing of the Merger.

 

Historically, our primarysources of capital and liquidity have been issuance of equity securities,borrowings under our credit agreements, and cash flows from operatingactivities. To develop our reserves as reported in our December 31, 2009reserve report, we will require access to the capital markets in three of thenext five years, as our projected capital expenditures are greater thanprojected cash flow from operations through December 2014.

 

***Credit Agreement Covenant Compliance***

 

Both the ARCA and the SCAhave a current ratio covenant that requires us to maintain a ratio of not lessthan 1.00 to 1.00 for each fiscal quarter. The current ratio is calculated bydividing current assets (as defined in both credit agreements) by currentliabilities (as defined in both credit agreements). Current assets includeunused borrowing base under the ARCA and the aggregate availability under theSCA. Current liabilities exclude all current portions of long-term debt otherthan any current debt relating to the Preferred Stock and liabilities for assetretirement obligations. Current assets and current liabilities excludederivative assets and liabilities. At March 31, 2010, our ratio of currentassets to current liabilities was 1.84 to 1.00. The calculation andreconciliation of current assets and current liabilities, as defined by GAAP,to current assets and current liabilities, as defined in the credit agreementsis as follows (in thousands):

 
| ** **                                    | ** ** | **March 31, 2010** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|
| Current  assets (GAAP)                        |       | $                       | 8,107      |   |
| Unused  borrowing base at March 31, 2010 |       | 10,000                  | (1)        |
| Less:  derivative assets                      |       | (3,486                  | )          |
| Modified  current assets (non-GAAP)           |       | $                       | 14,621     | (A) |
|                                          |       |                    |       |
| Current  liabilities (GAAP)                   |       | $                       | 73,390     |   |
| Less:  current portion of long-term debt      |       | (65,000                 | )          |
| Less:  derivative liabilities                 |       | (227                    | )          |
| Less:  asset retirement obligation            |       | (236                    | )          |
| Modified  current liabilities (non-GAAP)      |       | $                       | 7,927      | (B) |
|                                          |       |                    |       |
| Modified  current ratio (A) / (B)        |       | 1.84 to 1.00            |       |

 

----

(1)           Represents the $60.0 million borrowing base underthe ARCA at March 31, 2010, less $50.0 million of debt outstanding underthe ARCA at March 31, 2010.

 

We were not in compliancewith the covenants relating to our leverage ratio and interest coverage ratiofor the quarters ended December 31, 2009 and March 31, 2010. Theleverage ratio is the ratio of consolidated Debt (as defined in both creditagreements) to consolidated EBITDA (as defined in both credit agreements) forthe

 

25

----

 

cumulative four fiscalquarter periods.  Under the ARCA and SCA,the leverage ratio cannot be greater than 4.00 to 1.00 and 4.50 to 1.00,respectively.  The interest coverageratio is the ratio of consolidated EBITDA (as defined in both creditagreements) to consolidated Interest Expense (as defined in both agreements)for the cumulative four fiscal quarter periods. Under the ARCA and SCA, the interest coverage ratio cannot be less than3.00 to 1.00 and 2.50 to 1.00, respectively.

 

Both of our creditagreements also contain customary events of default that would permit ourlenders to accelerate the debt under both credit agreements if not cured withinapplicable grace periods, including, among others, failure to make payments ofprincipal or interest when due, materially incorrect representations andwarranties, breach of covenants, failure to make mandatory prepayments in theevent of borrowing base deficiencies, events of bankruptcy, dissolution, theoccurrence of one or more unstayed judgments in excess of $1,000,000 anddefaults upon other obligations, including obligations under the subordinated creditagreement.

 

**Resultsof Operations**

 

For the current quarter,we had a loss applicable to common stock of $0.2 million, which was animprovement of $1.0 million as compared to the prior year quarter of a$1.2 million loss applicable to common stock. The $1.0 million earningsimprovement primarily related to higher operating revenues of $2.2 million andincreased income from discontinued operations of $1.6 million, partiallyoffset by reduced gain on derivatives of $2.7 million.

 

For the current nine months,we had a loss applicable to common stock of $13.1 million, which was a$37.4 million decrease as compared to the $24.3 million incomeapplicable to common stock incurred for the prior year nine months. Itemscontributing to the $37.4 million earnings decrease were reduced gain onderivatives of $52.9 million, lower income from discontinued operations of$10.0 million, decreased income from the preferred stock repurchased forless than the carrying amount of $10.9 million and lower operatingrevenues of $1.7 million. Partially offsetting the earnings decrease werelower operating expenses of $27.0 million, which is primarily attributableto a $22.4 million charge for impairment of long-lived assets during theprior year nine months.

 

These items will be addressedin the following discussion.

 

***Operating Revenues***

 

The table belowsummarizes our operating revenues for the three- and nine-month periods ended March 31,2010 and 2009.

 
| ** **                                                                | ** ** | **Three months ended  March 31,** | ** ** | **Increase** | ** ** | **Nine months  ended March 31,** | ** ** | **Increase** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------|------------|---------------------------------------|------------|--------------|------------|
| ** **                                                                | ** ** | **2010**                               | ** ** | **2009**     | ** ** | **(Decrease)**                        | ** ** | **2010**     | ** ** | **2009** | ** ** | **(Decrease)** | ** ** |
| Operating  Revenues *(in thousands)*                                      |       | $                                      | 5,803      |         | $          | 3,606                                 |       | $            | 2,197      |   | $ | 16,368 |   | $ | 18,119 |   | $ | (1,751 | ) |
| Sales  Volumes                                                            |       |                                   |       |         |       |                                  |       |         |       |   |   |   |   |
| Crude  Oil (MBbls)                                                        |       | 68                                     |       | 78           |       | (10                                   | )          | 208          |       | 220 |   | (12 | ) |
| Natural  Gas (MMcf)                                                       |       | 90                                     |       | 124          |       | (34                                   | )          | 324          |       | 398 |   | (74 | ) |
| Total  (MBOE)                                                             |       | 83                                     |       | 99           |       | (16                                   | )          | 262          |       | 286 |   | (24 | ) |
| Average  Realized Price                                                   |       |                                   |       |         |       |                                  |       |         |       |   |   |   |   |
| Crude  Oil ($/ Bbl)                                                       |       | $                                      | 72.62      |         | $          | 35.40                                 |       | $            | 37.22      |   | $ | 67.56 |   | $ | 65.97 |   | $ | 1.59 |   |
| Natural  Gas ($/ Mcf)                                                     |       | $                                      | 9.70       |         | $          | 5.41                                  |       | $            | 4.29       |   | $ | 7.17 |   | $ | 8.26 |   | $ | (1.09 | ) |
| Operating  Revenues and Commodity Derivative Settlements *(in thousands)* |       | $                                      | 6,556      |         | $          | 6,452                                 |       | $            | 104        |   | $ | 20,167 |   | $ | 22,126 |   | $ | (1,959 | ) |
| Average  Adjusted Price (includes commodity derivative settlements)       |       |                                   |       |         |       |                                  |       |         |       |   |   |   |   |
| Crude  Oil ($/ Bbl)                                                       |       | $                                      | 75.32      |         | $          | 62.32                                 |       | $            | 13.00      |   | $ | 73.48 |   | $ | 79.71 |   | $ | (6.23 | ) |
| Natural  Gas ($/Mcf)                                                      |       | $                                      | 15.99      |         | $          | 11.26                                 |       | $            | 4.73       |   | $ | 15.09 |   | $ | 10.74 |   | $ | 4.35 |   |

 

The current quarteroperating revenues of $5.8 million are $2.2 million higher ascompared to the prior year quarter of $3.6 million. The $2.2 millionincrease is primarily attributable to higher average prices received for

 

26

----

 

crude oil and natural gassales of $2.5 million and $0.4 million, respectively, partiallyoffset by lower crude oil and natural gas sales volumes which combined toreduce revenues by $0.6 million.

 

The current nine monthsoperating revenues of $16.4 million are $1.7 million lower ascompared to the prior year nine months of $18.1 million. The$1.7 million decrease is primarily attributable to lower crude oil andnatural gas sales volumes which reduced revenues by $0.8 million and$0.6 million, respectively, and lower average prices received for naturalgas sales of $0.4 million and lower other revenue of $0.3 million.  Partially offsetting these revenue decreaseswere higher prices received for crude oil sales of $0.3 million.

 

The average prices wereceived for our crude oil and natural gas sales are supplemented by commodityderivative settlements received for the three- and nine month-periods ending March 31,2010 and 2009, as presented in the preceding table. As discussed in Note 5to our Consolidated Financial Statements, if crude oil and natural gas NYMEXprices are lower than derivative floor prices, we will be reimbursed by our counterpartyfor the difference between the NYMEX price and floor price (i.e. realizedgain). Conversely, if crude oil and natural gas NYMEX prices are higher thanthe derivative ceiling prices, we will pay our counterparty for the differencebetween the NYMEX price and ceiling price (i.e. realized loss).

 

***Crude Oil Sales Volumes.***    Our current quarter crude oilsales were 10 MBbls lower as compared to the prior year quarter. Thisresulted from lower sales from our Cato Properties of 6 MBbls and from our PanhandleProperties of 4 MBbls due to severe weather during January and February 2010which temporarily curtailed production. The sales decrease at the Cato Properties resulted from the reduction ofinjected water and redistribution of water injection at the waterflood whichresulted in lower production, as discussed under “*Overview—Drilling Capital Development and Operating Activities Update*.”

 

Our current nine monthscrude oil sales were 12 MBbls lower as compared to the prior year ninemonths due to the reasons previously discussed and lower sales from ourPanhandle Properties due to temporary shut-in production at the Cockrell Ranchwaterflood resulting from the controlled injection project surveillance, aspreviously discussed under the “*Overview—DrillingCapital Development and Operating Activities Update*.”All CockrellRanch production that had been shut-in for the controlled injection project wasrestored on September 28, 2009.

 

***Natural Gas Sales Volumes.***    Our currentquarter natural gas sales were 34 MMcf lower as compared to the prior yearquarter primarily due to reduced sales at our Cato Properties of 21 MMcf, thePanhandle Properties of 8 MMcf and the Desdemona Properties of 7 MMcf.  The sales reduction at the Cato Propertiesoccurred as the natural gas purchaser temporarily declined to take our naturalgas production for most of the current quarter. Gas sales resumed at the Cato Properties in mid-March 2010. Thelower natural gas sales at the Panhandle Properties resulted from the severeweather, as previously discussed.  Lowersales at our Desdemona Properties resulted as the gas plant was temporarilyshut-in to equip the plant to handle increased natural gas production from thereturn to production of 25 shut-in gas wells as previously discussed under the “*Overview—Drilling Capital Development and OperatingActivities Update.”*

 

Our current nine monthsnatural gas sales were 74 MMcf lower as compared to the prior year nine monthsprimarily due to lower sales at the Desdemona Properties of 30 MMcf, PanhandleProperties of 24 MMcf and Cato Properties of 17 MMcf.  Lower natural gas sales at the DesdemonaProperties resulted from the shut-in natural gas production from our BarnettShale wells during July 2009, based upon the current and near-term outlookof natural gas prices and the reactivation of our gas plant, as previouslydiscussed.  Lower natural gas sales atthe Panhandle Properties resulted from severe weather and from the controlledproduction project at Cockrell Ranch waterflood, as previously discussed, andone of our gas purchasers experienced an unplanned plant outage from mid-August 2009through the end of September 2009, which resulted in reduced natural gasand NGL sales. Lower natural gas sales at the Cato Properties resulted from thepurchaser temporarily declining to take natural gas production, as previouslydiscussed.

 

***Crude Oil and Natural Gas Prices.***    The average pricewe receive for crude oil sales is generally at market prices received at thewellhead, except for the Cato Properties, for which we receive below marketprices due to the level of impurities in the oil. The average price we receivefor natural gas sales is approximately the market price

 

27

----

 

received at the wellhead,adjusted for the value of natural gas liquids, less transportation andmarketing expenses. As previously discussed, we have commodity derivatives inplace that mitigate future price risk.

 

We expect to grow salesthrough our development plans as previously discussed under “*Overview—Development Capital Expenditures andOperating Activities Update*.”

 

***Operating Expenses***

 

For the current quarter,our total operating expenses were $8.2 million, which approximated theprior year quarter of $8.1 million. Lower lease operating expenses of $0.4million and lower depletion and depreciation expense of $0.4 million wereoffset by increased general and administrative of $0.8 million andincreased production taxes of $0.1 million.

 

For the current ninemonths, our total operating expenses were $31.6 million, which is adecrease of $27.0 million as compared to the prior year nine months of$58.7 million. The prior year nine months included an impairment oflong-lived assets of $22.4 million, which is the primary reason for theoverall decrease. In addition, we had reduced general and administrative of$7.2 million, lower lease operating expenses of $1.9 million andlower depletion and depreciation expense of $0.5 million, partially offset bythe exploration expense of $5.0 million recorded during the current ninemonths.

 

***Lease Operating Expenses***

 

Our lease operatingexpenses (“LOE”) consist of the costs of producing crude oil and natural gassuch as labor, supplies, repairs, maintenance, workovers and utilities.

 

For the current quarter,our LOE was $3.6 million, which is $0.4 million lower than the prioryear quarter of $4.0 million. The LOE decrease for the current quarter of$0.4 million resulted primarily from reduced service rates negotiated with thevendors of $0.3 million, lower electricity expense of $0.1 million and theshut-in of our Barnett Shale natural gas wells, as previously discussed under “*Operating Revenues*,” which reduced LOE by$0.1 million.  Partially offsettingthese LOE cost reductions were increased LOE at the Cato Properties of$0.1 million to support increased focus on production activities.

 

For the current ninemonths, our LOE was $11.8 million, which is $1.9 million lower thanthe prior year nine months of $13.7 million. The LOE decreases for thecurrent nine months of $1.9 million resulted primarily from reducedservice rates negotiated with vendors of $1.2 million, lower electricityexpense of $0.8 million and the shut-in of our Barnett Shale natural gas wellswhich reduced LOE by $0.5 million. Partially offsetting these LOE costreductions were increased LOE at the Cato Properties $0.6 million tosupport increased focus on production activities.

 

For the current quarter,our LOE per barrels of oil equivalent (“BOE”), based on production, was $36.88,which is an improvement of $1.22 as compared to $38.10 for the prior yearquarter. For the current nine months, our LOE per BOE, based on production, was$39.80, which is an improvement of $5.27 as compared to $45.07 for the prioryear nine months. In general, secondary and tertiary LOE is higher than LOE forcompanies developing primary production because our fields are more mature andtypically produce less oil and more water. We expect LOE to decrease during the2010 fiscal year as we realize the continued benefit of lower service ratesnegotiated with vendors, and we expect LOE per BOE to decrease as productionincreases from the waterflood and EOR development activities we haveimplemented and are implementing as discussed under the “*Overview—Drilling Capital Development and OperatingActivities Update*.”

 

28

----

 

***Production and Ad Valorem Taxes***

 

For the current quarter,our production and ad valorem taxes were $0.5 million, which is$0.2 million higher than the prior year quarter of $0.3 million. The$0.2 million increase resulted from higher production taxes from increasedoperating revenue. Our production taxes as a percent of operating revenues forthe current quarter were 6.4% as compared to the prior year quarter of 5.5%.

 

For the current ninemonths, our production and ad valorem taxes were $1.4 million, which is$0.3 million lower than the prior year nine months of $1.7 million.The $0.3 million decrease resulted from lower production taxes of $0.1 milliondue to lower operating revenues and reduced ad valorem taxes of$0.2 million due to lower property tax valuations by taxing authoritiesfor the 2009 calendar year. Our production taxes as a percent of operatingrevenues for the current nine months of 6.4% was comparable to the prior yearnine months of 6.5%.

 

***General and Administrative Expenses***

 

Our general andadministrative (“G&A”) expenses consist of support services for ouroperating activities and investor relations costs.

 

For the current quarter,our G&A expenses totaled $2.9 million, which is $0.7 millionhigher than the prior year quarter of $2.2 million. The $0.7 millionincrease resulted from higher legal costs of $1.1 million partially offsetby lower stock-based compensation costs of $0.4 million.  The $1.1 million increase in legal expensesis due to the current quarter including $0.3 million of costs pertaining tolitigation and Merger related activities and the prior year quarter included asettlement received from the former owners of the Panhandle Propertiespertaining to the fire litigation.  Thelower stock-based compensation costs are directly related to reduced issuancesof stock options and restricted stock.

 

For the current ninemonths, our G&A expenses totaled $9.4 million, which is $7.2 millionlower than the prior year nine months of $16.6 million. The$7.2 million expense reduction resulted primarily from reduced litigationcosts of $6.4 million, reduced stock-based compensation costs of$1.4 million, and lower payroll and benefits costs of$0.6 million.  Partially offsettingthese expense reductions were increased costs related to the Merger of$1.7 million. The reduced payroll and benefits costs resulted fromworkforce reductions we implemented during the quarter ended March 31, 2009,which eliminated 25% of our home office staff. The lower stock-basedcompensation was previously discussed. The litigation cost reduction occurredas we settled all but one of our fire litigation claims during the fiscal yearended June 30, 2009. We expect continued decreases in future quarters’legal expenses after we close the proposed Merger with Resaca.

 

***Exploration Expense***

 

During the current ninemonths, we recorded exploration expense of $5.0 million pertaining to theNowata ASP Project. During December 2009, we finalized our performanceanalysis, which indicated the Nowata ASP Project did not result in increasedoil production of significant quantities to be considered economically viablethat would justify the recognition of proved reserves. Accordingly, at December 31,2009, we recorded a $5.0 million pre-tax exploration expense.

 

***Impairment of Long-Lived Assets and Goodwill***

 

During the quarter ended December 31,2009, we wrote down $0.3 million of costs associated with the ASP facilityused for the Nowata ASP Project. The facility’s water filtering process did notwork properly with the oil-water fluid production at our Nowata Properties. Weintend to use the ASP facility for future pilot tertiary projects at our Catoand Panhandle Properties.

 

During the quarter ended December 31,2008, we recorded a $22.4 million pre-tax impairment to our Barnett ShaleProperties and a $0.7 million pre-tax impairment to the goodwillassociated with our subsidiary which holds

 

29

----

 

the equity in our BarnettShale Properties. We recorded the impairments due to the decline in commodityprices which created an uncertainty in the likelihood of developing reservesassociated with our Barnett Shale Properties within the next five years.

 

***Depletion and Depreciation***

 

For the current quarter,our depletion and depreciation expense was $1.1 million, which is $0.5million lower as compared to $1.6 million for the prior year quarter.  For the current nine months, our depletion anddepreciation expense was $3.6 million, which is $0.5 million lower ascompared to $4.1 million for the prior year nine months. This includesdepletion expense pertaining to our oil and natural gas properties, anddepreciation expense pertaining to our field operations vehicles and equipment,natural gas plant, office furniture and computers. The decrease is primarilydue to lower crude oil and natural gas sales volumes (net) as previouslydiscussed under “—*Operating Revenues.”*For the current quarter and current nine months, our depletion rate pertainingto our oil and gas properties was $10.60 per BOE and $11.20 per BOE,respectively. For the prior year quarter and prior year nine months, ourdepletion rate pertaining to our oil and gas properties was $13.34 per BOE and$12.57 per BOE, respectively.

 

***Interest Expense and Other***

 

For the current and prioryear quarters, we incurred interest expense of $0.5 million and$0.1 million, respectively. For the current and prior year nine months, weincurred interest expense of $0.9 million and $0.4 million,respectively. Our interest expense is a direct result of the credit agreementswe entered into, as discussed in Note 4 to our Consolidated FinancialStatements. The interest expense for the current and prior year quarters wasreduced by $0.5 million and $0.3 million, respectively, for interestcost that was capitalized to the waterflood projects discussed under “*Overview—Development Capital Expenditures andOperating Activities Update.”* The interest expense for the currentand prior year nine months was reduced by $1.5 million and$0.9 million, respectively, for the same reason. We incurred higherinterest costs during the current year quarter and current year nine months dueto higher outstanding debt balances. The interest rates under our creditagreements for the current quarter and current nine months were comparable tothe interest rates we incurred for the prior year quarter and prior year ninemonths.

 

***Gain (Loss) on Derivatives***

 

As discussed inNote 5 to our Consolidated Financial Statements, we have entered intofinancial derivatives contracts for our commodity sales and interest expense.For the current quarter, we recorded a gain on derivatives of $0.8 millionas compared to a gain of $3.5 million for the prior year quarter. Thecurrent quarter gain of $0.8 million consisted of an unrealized gain of$0.1 million and a realized gain on settlements of derivative contracts of$0.7 million.

 

For the current ninemonths, we recorded a loss on derivatives of $4.5 million as compared to again of $48.5 million for the prior year six months. The current ninemonths loss on derivatives of $4.5 million consisted of an unrealized lossof $8.1 million and a realized gain on settlements of derivative contractsof $3.6 million.

 

The realized gainprimarily pertains to the realization of commodity settlements, as crude oiland natural gas NYMEX prices were lower than the floor prices.

 

The unrealized gain andloss for the current quarter and nine months, respectively, reflects the fairvalue of the commodity derivatives as of March 31, 2010 as compared to December 31,2009 and June 30, 2009, respectively. By their nature, these commodityderivatives can have a highly volatile impact on our earnings. A ten percentchange in the prices for our commodity derivative instruments could impact ourpre-tax earnings by approximately $35,000.

 

30

----

 

***Income Tax Benefit (Expense)***

 

For the current quarter,we had income tax benefit of $0.6 million, as compared to an income taxbenefit for the prior year quarter of $0.4 million. For the current ninemonths, we had an income tax benefit of $6.8 million, as compared toincome tax expense for the prior year nine months of $3.3 million. Theeffective income tax rates for the current quarter and current nine months were28.2% and 33.0%, respectively. The effective income tax rates for the prioryear quarter and prior year nine months were 30.4% and 48.2%, respectively. Theeffective tax rate for the prior year nine months was higher due to an increasein the state tax rate.

 

***Income from Discontinued Operations***

 

For the current quarterand current nine months, we had income from discontinued operations of $1.7million and $2.1 million, respectively. For the prior year quarter and prior year nine months, we had incomefrom discontinued operations of $0.1 million and $12.1 million,respectively. This resulted from our divestitures of the Certain PanhandleProperties, Pantwist, LLC and Corsicana Properties, as discussed inNote 6 to our Consolidated Financial Statements.

 

***Preferred Stock Dividend***

 

The preferred stockdividend for the current quarter and the prior year quarter was$0.5 million for each quarter. The preferred stock dividend for thecurrent nine months of $1.4 million was a decrease of $0.9 millionfrom $2.3 million for the prior year nine months. The decrease of $0.9million is attributable to our November and December 2008 repurchasesof preferred stock. Due to the repurchases, our quarterly preferred stockdividends will be approximately $0.5 million per quarter of which 59% willbe PIK, with the balance paid in cash.

 

***New Accounting Pronouncements***

 

In June 2009, theFASB issued a standard that established the FASB ASC and amended the hierarchyof GAAP such that the ASC became the single source of authoritativenongovernmental GAAP. The ASC did not change current GAAP, but was intended tosimplify user access to all authoritative GAAP by providing all theauthoritative literature related to a particular topic in one place. Allpreviously existing accounting standard documents were superseded and all otheraccounting literature not included in the ASC is considered non-authoritative.New accounting standards issued subsequent to June 30, 2009 arecommunicated by the FASB through Accounting Standards Updates. The ASC becameeffective for us on July 1, 2009. This standard did not have an impact onour financial position, results of operations or cash flows. Throughout thenotes to the consolidated financial statements, references that were previouslymade to various former authoritative GAAP pronouncements have been conformed tothe appropriate section of the ASC.

 

In December 2007,the FASB issued ASC 805 ((formerly SFAS No. 141 (revised 2007), *Business Combinations*). Among otherthings, ASC 805 establishes principles and requirements for how the acquirer ina business combination: (i) recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquired business; (ii) recognizes andmeasures the goodwill acquired in the business combination or the gain from abargain purchase; and (iii) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. ASC 805 is effective for fiscal yearsbeginning on or after December 15, 2008, with early adoption prohibited.We adopted ASC 805 on July 1, 2009 with no impact to our consolidatedfinancial statements.

 

In December 2007,the FASB issued ACS 810 (formerly SFAS No. 160, *Noncontrolling Interests in Consolidated Financial Statements, An Amendmentof ARB No. 51*). ASC 810 establishes accounting and reportingstandards for noncontrolling interests in a subsidiary and for thedeconsolidation of a subsidiary. Minority interests will be recharacterized asnoncontrolling interests and classified as a component of equity. It alsoestablishes a

 

31

----

 

single method ofaccounting for changes in a parent’s ownership interest in a subsidiary andrequires expanded disclosures. This statement is effective for fiscal yearsbeginning on or after December 15, 2008, with early adoption prohibited.We adopted ASC 810 on July 1, 2009. The adoption of this statement did nothave a material impact on our financial position, results of operations or cashflows.

 

In March 2008, theFASB issued ASC 815 (formerly SFAS No. 161, *Disclosures about Derivative Instruments and Hedging Activities—AnAmendment of FASB Statement 133*). ASC 815 expands the requireddisclosures to discuss the uses of derivative instruments, the accounting forderivative instruments and related hedged items under ASC 815, and howderivative instruments and related hedged items affect the company’s financialposition, financial performance and cash flows. We adopted ASC 815 on July 1,2009. The adoption of this statement did not have a material impact on ourfinancial position, results of operations or cash flows.

 

In June 2008, theFASB issued ASC 260 (formerly EITF 03-6-1*,Determining Whether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities*). ASC 260 addresses whether instrumentsgranted in share-based payment transactions are participating securities priorto vesting and need to be included in the calculation of earnings per shareunder the two-class method. Under ASC 260, share-based payment awards thatcontain nonforfeitable rights to dividends are “participating securities”, andtherefore should be included in computing earnings per share using thetwo-class method. ASC 260 is effective for financial statements issued forfiscal years and interim periods beginning after December 15, 2008. Weadopted ASC 260 on July 1, 2009. The effect of adopting ASC 260 increasedthe number of shares used to compute our earnings per share; however, theadoption of ASC 260 did not have a material impact on our financial position,results of operations or cash flows.

 

In December 2008,the FASB issued ASC 815 (formerly EITF 07-5, *Determining Whether an Instrument (or Embedded Feature) Is Indexed toan Entity’s Own Stock*). ASC 815 affects companies that haveprovisions in their securities purchase agreements that provide for the resetof the current conversion price based upon new issuances by companies at pricesbelow certain thresholds. Securities purchase agreements with such provisionswill require the embedded derivative instrument to be bifurcated and separatelyaccounted for as a derivative. Subject to certain exceptions, our preferredstock provides for resetting the conversion price if we issue new common stockbelow $5.75 per share. ASC 815 is effective for financial statements issued forfiscal years and interim periods beginning after December 15, 2008. Weadopted ASC 815 on July 1, 2009. The adoption of this statement did nothave a material impact on our financial position, results of operations or cashflows as the reset conversion provision did not meet the definition of aderivative since it was not readily net-cash settled.

 

In December 2008,the SEC issued the final rule, *Modernizationof Oil and Gas Reporting*. The new disclosure requirements includeprovisions that permit the use of new technologies to determine proved reservesif those technologies lead to reliable conclusions about reserve quantities.The new requirements also will allow companies to disclose their probable andpossible reserves to investors. In addition, the new disclosure requirementsspecify for companies to: (a) report the independence and qualificationsof its reserves preparer or auditor; (b) file reports when a third partyis relied upon to prepare reserves estimates or conducts a reserves audit; and (c) reportoil and gas reserves using an average price based upon the prior 12-monthperiod rather than year-end prices. The new disclosure requirements areeffective for financial statements for fiscal years ending on or after December 31,2009. On April 20, 2010, the FASB issued Accounting Standards Update No.2010-14, which became effective on January 1, 2010, to reflect changes tofossil fuel exploration and production technology over the past severaldecades. We are not required to conform to these SEC requirements until we fileour annual report for our fiscal year ending June 30, 2010. The effect ofadopting the SEC rule has not been determined; however, it is not expectedto have a material impact on our financial position, results of operations orcash flows.

 

In June 2009, theFASB issued ASC 855 (formerly SFAS 165, *SubsequentEvents*) to establish general standards of accounting for anddisclosure of events that occur after the balance sheet date, but prior to theissuance of financial statements. Specifically, ASC 855 sets forth: (1) theperiod after the balance sheet date during which management of a reportingentity should evaluate events or transactions that may occur for potentialrecognition or disclosure in the financial statements; (2) thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements; and (3) thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date. ASC 855 is effective for financialstatements issued for interim or annual periods ending after June 15,2009. We adopted ASC 855 on

 

32

----

 

June 30, 2009. Theadoption of this statement did not have a material impact on our financialposition, results of operations or cash flows.

 

**Item 4.          Controls and Procedures.**

 

Not applicable.

 

**Item 4T.****      ****Controls and Procedures.**

 

As of the end of theperiod covered by this report, our management conducted an evaluation, underthe supervision and with the participation of our chief executive officer andchief financial officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) ofthe Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon thisevaluation, our chief executive officer and chief financial officer concluded,as of March 31, 2010, that our disclosure controls and procedures were effectiveto ensure that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is: (1) recorded, processed,summarized and reported, within the time periods specified in the SEC’s rules andforms and (2) accumulated and communicated to management, including ourchief executive officer and chief financial officer, to allow timely decisionsregarding required disclosure.

 

During the quarter ended March 31,2010, there was no change in our internal control over financial reporting thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II—OTHERINFORMATION**

 

**Item 1.****    ****Legal Proceedings.**

 

See Note 13 to ourConsolidated Financial Statements which is incorporated into this “Item 1.Legal Proceedings” by reference.

 

**Item 1A.       Risk Factors.**

 

In addition to the other information set forth in thisreport, you should carefully consider the risks discussed in our Annual Reporton Form 10-K for the year ended June 30, 2009 under the headings *“Item 1A. “Risk Factors”* and *“Item 7A.Quantitative and Qualitative Disclosures about Market Risk”* filedwith the SEC on September 28, 2009, which risks could materially affectour business, financial condition and results of operations.

 

There have been no material changes to the riskfactors discussed in our Annual Report on Form 10-K for the year ended June 30,2009, filed with the SEC on September 28, 2009, which is accessible on theSEC’s website at *www.sec.gov.*

 

Additionally, please refer to the “Risk Factors”section of the joint proxy statement/prospectus of Cano and Resaca that isincluded in Amendment No. 5 to the registration statement on Form S-4filed by Resaca with the SEC on April 29, 2010 for a description of risksapplicable to the proposed Merger of Cano and a wholly-owned subsidiary ofResaca and the combined company following the consummation of such Merger.

 

**Item 6.     Exhibits.**

 

Alist of the exhibits required by Item 601 of Regulation S-K and filed as partof this report is set forth in the Index to Exhibits immediately following thesignature page to this Quarterly Report on Form 10-Q.

 

33

----

 

**SIGNATURES**

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 

 
|                    |   | **CANO  PETROLEUM, INC.** |
|-------------------------|--------|--------------------------------|
|                    |   |                           |   |
| Date: May 12, 2010 |   | By:                            | /s/ S.  JEFFREY JOHNSON |
|                    |   |                           | S. Jeffrey  Johnson |
|                    |   |                           | *Chief  Executive Officer* |
|                    |   |                           |   |
| Date: May 12, 2010 |   | By:                            | /s/ BENJAMIN  DAITCH |
|                    |   |                           | Benjamin Daitch |
|                    |   |                           | *Senior  Vice-President and Chief Financial Officer* |

 

34

----

 

**Indexto Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                      |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | Agreement and Plan of  Merger, dated September 29, 2009 by and among Resaca  Exploitation, Inc., Resaca Acquisition Sub, Inc. and Cano  Petroleum, Inc., incorporated by reference from Exhibit 2.1 to  Current Report on Form 8-K filed on October 1, 2009.                                                                      |
| 2.2                 |       | Amendment No. 1  dated February 24, 2010 to Agreement and Plan of Merger, dated  September 29, 2009 by and among Resaca Exploitation, Inc., Resaca  Acquisition Sub, Inc. and Cano Petroleum, Inc., incorporated by  reference from Exhibit 10.1 to Cano’s Current Report on Form 8-K filed  on February 25, 2010. |
| 2.3                 |       | Amendment No. 2  dated April 1, 2010 to Agreement and Plan of Merger, dated  September 29, 2009 by and among Resaca Exploitation, Inc., Resaca  Acquisition Sub, Inc. and Cano Petroleum, Inc., incorporated by  reference from Exhibit 10.1 to Cano’s Current Report on Form 8-K  filed on April 6, 2010.         |
| 2.4                 |       | Amendment No. 3  dated April 28, 2010 to Agreement and Plan of Merger, dated  September 29, 2009 by and among Resaca Exploitation, Inc., Resaca  Acquisition Sub, Inc. and Cano Petroleum, Inc., incorporated by  reference from Exhibit 10.1 to Cano’s Current Report on Form 8-K  filed on April 29, 2010.       |
| 3.1                 |       | Certificate of  Incorporation of Huron Ventures, Inc., incorporated herein by reference  to Exhibit 3.1 to Cano’s Registration Statement on Form 10 SB (File  No. 000-50386) filed with the SEC on September 4, 2003.                                                                                                                  |
| 3.2                 |       | Certificate of  Ownership of Huron Ventures, Inc. and Cano Petroleum, Inc.,  amending Cano’s Certificate of Incorporation, incorporated herein by  reference to Exhibit 3.2 to Cano’s Annual Report on Form 10-KSB  filed with the SEC on September 23, 2004.                                                                     |
| 3.3                 |       | Certificate of  Amendment to Certificate of Incorporation of Cano Petroleum, Inc.,  incorporated herein by reference to Exhibit 3.8 to Cano’s Post-Effective  Amendment No. 2 on Form S-1 filed with the SEC on January 23,  2007.                                                                                                     |
| 3.4                 |       | First Amended and  Restated Bylaws of Cano Petroleum, Inc., incorporated herein by  reference to Exhibit 3.1 to Cano’s Current Report on Form 8-K filed  with the SEC on December 7, 2007.                                                                                                                                                  |
| 3.5                 |       | Amendment to Amended  and Restated Bylaws, dated October 20, 2008, incorporated herein by  reference to Exhibit 3.1 to Cano’s Current Report on Form 8-K filed  with the SEC on October 24, 2008.                                                                                                                                           |
| 3.6                 |       | Second Amended and  Restated By-Laws of Cano Petroleum, Inc. dated May 7, 2009,  incorporated herein by reference to Exhibit 3.1 to Cano’s Current Report  on Form 8-K filed with the SEC on May 13, 2009.                                                                                                                             |
| 3.7                 |       | Certificate of  Designation for Series B Convertible Preferred Stock, incorporated  herein by reference to Exhibit 99.2 to Cano’s Current Report on  Form 8-K filed with the SEC on June 8, 2004.                                                                                                                                           |
| 3.8                 |       | Certificate of  Designation for Series C Convertible Preferred Stock, incorporated  herein by reference to Exhibit 99.2 to Cano’s Current Report on  Form 8-K filed with the SEC on July 15, 2004.                                                                                                                                          |
| 3.9                 |       | Certificate of  Designation for Series D Convertible Preferred Stock incorporated herein  by reference to Exhibit 3.1 to Cano’s Current Report on Form 8-K  filed with the SEC on September 7, 2006.                                                                                                                                        |
| 4.1                 |       | Registration Rights  Agreement dated August 25, 2006 among Cano Petroleum, Inc. and the  Buyers listed therein, incorporated herein by reference to Exhibit 4.1  to the Amendment to Cano’s Current Report on Form 8-K/A filed with the  SEC on August 31, 2006.                                                                       |
| 4.2                 |       | Registration Rights  Agreement dated November 2, 2007 among Cano Petroleum, Inc. and the  Buyers listed therein, incorporated herein by reference to Exhibit 4.1  to Cano’s Current Report on Form 8-K filed with the SEC on  November 6, 2007.                                                                                        |
| 4.3                 |       | Form of Common  Stock certificate, incorporated herein by reference to Exhibit 4.9 to  Cano’s Registration Statement on Form S-3 (No. 333-148053) filed  with the SEC on December 13, 2007.                                                                                                                                            |
| 4.4                 |       | Designation for  Series A Convertible Preferred Stock, included in the Certificate of  Incorporation of Huron Ventures, Inc., incorporated herein by reference  to Exhibit 3.1 to Cano’s registration statement on Form 10 SB (File  No. 000-50386) filed with the SEC on September 4, 2003.                                      |
| 4.5                 |       | Certificate of  Designation for Series B Convertible Preferred Stock, incorporated  herein by reference to Exhibit 99.2 to Cano’s Current Report on  Form 8-K filed with the SEC on June 8, 2004.                                                                                                                                           |
| 4.6                 |       | Certificate of  Designation for Series C Convertible Preferred Stock, incorporated  herein by reference to Exhibit 99.2 to Cano’s Current Report on  Form 8-K filed with the SEC on July 15, 2004.                                                                                                                                          |
| 4.7                 |       | Certificate of  Designation for Series D Convertible Preferred Stock incorporated herein  by reference to                                                                                                                                                                                                                                                       |

 

35

----

 
|   |   |   | Exhibit 3.1 to  Cano’s Current Report on Form 8-K filed with the SEC on  September 7, 2006.                                                                                                                                                                                           |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1   |   |   | Amendment No. 1  and Agreement dated December 30, 2009 among Cano, certain Guarantors,  certain Lenders and Union Bank, N.A., incorporated herein by reference to  Exhibit 10.1 to Cano’s Current Report on Form 8-K filed with the  SEC on January 6, 2010.                |
| 10.2   |   |   | Amendment No. 1  and Agreement dated December 30, 2009 among Cano, certain Guarantors,  certain Lenders and UnionBanCal Equities, Inc., incorporated herein by  reference to Exhibit 10.2 to Cano’s Current Report on Form 8-K  filed with the SEC on January 6, 2010. |
| 10.3   |   |   | Amendment No. 2  and Agreement dated March 30, 2010 among Cano, certain Guarantors,  certain Lenders and Union Bank, N.A., incorporated herein by reference to  Exhibit 10.1 to Cano’s Current Report on Form 8-K filed with the  SEC on March 31, 2010.                    |
| 10.4   |   |   | Amendment No. 2  and Agreement dated March 30, 2009 among Cano, certain Guarantors,  certain Lenders and UnionBanCal Equities, Inc., incorporated herein by  reference to Exhibit 10.2 to Cano’s Current Report on Form 8-K  filed with the SEC on March 31, 2010.     |
| 31.1   | *      |   | Certification by Chief  Executive Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                            |
| 31.2   | *      |   | Certification by Chief  Financial Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                            |
| 32.1   | *      |   | Certification by Chief  Executive Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of  Chapter 63 of Title 18 of the United States Code, promulgated pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.            |
| 32.2   | *      |   | Certification by Chief  Financial Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of  Chapter 63 of Title 18 of the United States Code, promulgated pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.            |

 

----

*

Filed herewith

 

36

----