**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

# **FORM 10-Q**

**(Mark One)**

x              **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**For the quarterly period ended September 30, 2006**

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

**For the transition period from                  to                **

**Commission file number 001-32496**

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

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

 

**The Burnett Plaza801 Cherry Street, Suite 3200Fort Worth, TX 76102**(Address of principal executive offices)

**(817) 698-0900**(Issuer’s telephone number)

Checkwhether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.Yes  x    No  o

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of accelerated filer and large acceleratedfiler in rule 12b-2 of the Exchange Act. (check one):

Large acceleratedfiler o      Accelerated filer x      Non-accelerated filer o

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

State the number of shares outstanding of each of theissuer’s classes of common equity, as of the latest practicable date: 32,308,894 shares of common stock, $.0001 par value per share, as of November13, 2006.

 

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**PART I- FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

**CANO PETROLEUM, INC.CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                                                    | ** ** | **September 30,** | ** **      | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-----------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                    | ** ** | **2006**               | ** **      | **2006**          | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** ** | **(Unaudited)**        | ** **      | ** **        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                    | ** ** | ** **             | ** **      | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                            | ** ** | ** **             | ** **      | ** **        | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                                                                    |       | $                      | 6,481,893       |              | $          | 644,659 |   |
| Accounts  receivable                                                                                                                                                                                                                                          |       | 3,047,868              |            | 3,563,649         |       |
| Derivative  assets                                                                                                                                                                                                                                            |       | 1,760,952              |            | 1,176,959         |       |
| Prepaid assets                                                                                                                                                                                                                                                |       | 537,642                |            | 205,349           |       |
| Inventory                                                                                                                                                                                                                                                     |       | 335,966                |            | 396,081           |       |
| Other current  assets                                                                                                                                                                                                                                         |       | 136,123                |            | 641,759           |       |
| Total current  assets                                                                                                                                                                                                                                         |       | 12,300,444             |            | 6,628,456         |       |
|                                                                                                                                                                                                                                                          |       |                   |            |              |       |
| **Oil  and gas properties**, successful efforts method                                                                                                                                                                                                        |       | 135,182,377            |            | 133,176,618       |       |
| Less accumulated  depletion and depreciation                                                                                                                                                                                                                  |       | (2,983,929             | )               | (2,126,049        | )          |
| Net oil and gas  properties                                                                                                                                                                                                                                   |       | 132,198,448            |            | 131,050,569       |       |
|                                                                                                                                                                                                                                                          |       |                   |            |              |       |
| Fixed assets and other,  net                                                                                                                                                                                                                                  |       | 6,578,581              |            | 6,778,055         |       |
| Derivative assets                                                                                                                                                                                                                                             |       | 1,657,888              |            | 1,705,855         |       |
| Goodwill                                                                                                                                                                                                                                                      |       | 785,796                |            | 785,796           |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                              | ** ** | **$**                  | **153,521,157** | ** **        | **$**      | **146,948,731** | ** ** |
|                                                                                                                                                                                                                                                          |       |                   |            |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                |       |                   |            |              |       |
| **Current liabilities**                                                                                                                                                                                                                                       |       |                   |            |              |       |
| Accounts payable  and accrued liabilities                                                                                                                                                                                                                     |       | $                      | 1,928,274       |              | $          | 2,304,198 |   |
| Oil and gas  payable                                                                                                                                                                                                                                          |       | 750,752                |            | 1,399,047         |       |
| Accrued  liabilities                                                                                                                                                                                                                                          |       | 671,679                |            | 321,183           |       |
| Taxes payable                                                                                                                                                                                                                                                 |       | 623,440                |            | 419,692           |       |
| Current portion  of asset retirement obligations                                                                                                                                                                                                              |       | 20,186                 |            | 19,809            |       |
| Total current  liabilities                                                                                                                                                                                                                                    |       | 3,994,331              |            | 4,463,929         |       |
| **Long-term liabilities**                                                                                                                                                                                                                                     |       |                   |            |              |       |
| Long-term debt                                                                                                                                                                                                                                                |       | —                 |            | 68,750,000        |       |
| Asset retirement  obligations                                                                                                                                                                                                                                 |       | 1,597,531              |            | 1,587,569         |       |
| Taxes payable  non-current                                                                                                                                                                                                                                    |       | 33,000                 |            | —            |       |
| Deferred tax  liability                                                                                                                                                                                                                                       |       | 31,323,000             |            | 31,511,000        |       |
| Total  liabilities                                                                                                                                                                                                                                            |       | 36,947,862             |            | 106,312,498       |       |
|                                                                                                                                                                                                                                                          |       |                   |            |              |       |
| **Temporary Equity**                                                                                                                                                                                                                                          |       |                   |            |              |       |
| Series D  convertible preferred stock, liquidation preference of $49,116,000                                                                                                                                                                                  |       | 46,269,287             |            | —            |       |
|                                                                                                                                                                                                                                                          |       |                   |            |              |       |
| **Commitments and contingencies  (Note 11)**                                                                                                                                                                                                                  |       |                   |            |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                 |       |                   |            |              |       |
| Common stock,  par value $.0001 per share; 50,000,000 authorized; 33,577,188 and 32,308,894  shares issued and outstanding at September 30, 2006, respectively; and  26,987,941 and 25,719,647 shares issued and outstanding at June 30, 2006,  respectively. |       | 3,344                  |            | 2,685             |       |
| Additional  paid-in capital                                                                                                                                                                                                                                   |       | 83,358,311             |            | 53,054,699        |       |
| Accumulated  deficit                                                                                                                                                                                                                                          |       | (12,486,915            | )               | (11,850,419       | )          |
| Treasury stock,  at cost; 1,268,294 shares held in escrow                                                                                                                                                                                                     |       | (570,732               | )               | (570,732          | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                              |       | 70,304,008             |            | 40,636,233        |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                           | ** ** | **$**                  | **153,521,157** | ** **        | **$**      | **146,948,731** | ** ** |

 

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

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**CANO PETROLEUM, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**
| ** **                                                                                               | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                               | ** ** | **September 30**            | ** ** |
| ** **                                                                                               | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **Operating  Revenues:**                                                                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Crude oil and natural gas sales                                                                          |       | $                                | 8,653,673  |   | $ | 1,945,959 |   |
|                                                                                                     |       |                             |       |   |   |
| **Operating  Expenses:**                                                                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Lease operating expenses                                                                                 |       | 2,947,594                        |       | 750,173 |   |
| Production and ad valorem taxes                                                                          |       | 651,366                          |       | 109,672 |   |
| General and administrative, including stock  compensation expense of $218,693 and $149,625, respectively |       | 3,190,533                        |       | 1,376,916 |   |
| Accretion of asset retirement obligations                                                                |       | 33,444                           |       | 20,594 |   |
| Depletion and depreciation                                                                               |       | 1,015,164                        |       | 146,789 |   |
| Total operating expenses                                                                                 |       | 7,838,101                        |       | 2,404,144 |   |
|                                                                                                     |       |                             |       |   |   |
| **Income  (loss) from operations**                                                                       |       | 815,572                          | ** ** | (458,185 | ) |
|                                                                                                     | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Other  income (expenses):**                                                                            |       |                             |       |   |   |
| Interest expense                                                                                         |       | (1,891,259                       | )          | — |   |
| Unrealized gain  on hedge contracts                                                                      |       | 536,026                          | ** ** | — |   |
| Interest income  and deductions, net                                                                     |       | 16,769                           |       | 228 |   |
| Total other income (expenses)                                                                            |       | (1,338,464                       | )          | 228 |   |
|                                                                                                     |       |                             |       |   |   |
| Loss before  income taxes                                                                                |       | (522,892                         | )          | (457,957 | ) |
|                                                                                                     |       |                             |       |   |   |
| Income tax  benefit                                                                                      |       | 155,000                          |       | — |   |
|                                                                                                     |       |                             |       |   |   |
| **Net  loss**                                                                                            |       | (367,892                         | )          | (457,957 | ) |
| ** **                                                                                               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Preferred stock  dividend                                                                                |       | 268,604                          | ** ** | — |   |
| ** **                                                                                               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Net  loss applicable to common stock**                                                                 |       | $                                | (636,496   | ) | $ | (457,957 | ) |
| ** **                                                                                               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Net  loss per share - basic and diluted**                                                              |       | $                                | (0.02      | ) | $ | (0.03 | ) |
| ** **                                                                                               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Weighted  average common shares outstanding**                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Basic and  diluted                                                                                       |       | 26,043,250                       | ** ** | 18,014,597 |   |

 

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

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**CANO PETROLEUM, INC.CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY(DEFICIT)****JULY 1, 2006 THROUGHSEPTEMBER 30, 2006(Unaudited)**
| ** **                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------|-------------|------------|------------|------------|------------|
| ** **                                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **  |
| ** **                                        | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares** | ** **  | **Amount** | ** ** | **Total**  | ** ** |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Balance at July  1, 2006                          |       | 25,719,647            |       | $           | 2,685      |            | $          | 53,054,699              |       | $          | (11,850,419 | )          | 1,268,294  |       | $          | (570,732 | ) | $ | 40,636,233 |   |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Net proceeds  from issuance of common shares      |       | 6,584,247             |       | $           | 659        |            | $          | 29,936,874              |       | —     |        | —     |       | —     |       | $ | 29,937,533 |   |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Common stock  issued for preferred stock dividend |       | —                |       | —      |       | 148,045         |       | —                  |       | —     |        | —     |       | 148,045    |       |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Stock based  compensation                         |       | 5,000                 |       | —      |       | 218,693         |       | —                  |       | —     |        | —     |       | 218,693    |       |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Preferred stock  dividend                         |       | —                |       | —      |       | —          |       | (268,604                | )          | —     |        | —     |       | (268,604   | )          |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Net loss                                          |       | —                |       | —      |       | —          |       | (367,892                | )          | —     |        | —     |       | (367,892   | )          |
|                                              |       |                  |       |        |       |            |       |                    |       |       |        |       |       |       |       |
| Balance at September  30, 2006                    |       | 32,308,894            |       | $           | 3,344      |            | $          | 83,358,311              |       | $          | (12,486,915 | )          | 1,268,294  |       | $          | (570,732 | ) | $ | 70,304,008 |   |

 

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

 

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**CANO PETROLEUM, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                          | ** ** | **Three Months Ended September 30,** | ** **    |
|-------------------------------------------------------------------------------------|------------|----------------------------------------------------------|---------------|
| ** **                                                                          | ** ** | **2006**                                                 | ** **    | **2005** | ** ** |
| **Cash  flow from operating activities:**                                           |       |                                                     |          |   |   |
| Net loss                                                                            |       | $                                                        | (367,892      | ) | $ | (457,957 | ) |
| Adjustments needed to reconcile to net cash flow  provided by (used in) operations: |       |                                                     |          |   |   |
| Unrealized gain on hedge contracts                                                  |       | (536,026                                                 | )             | — |   |
| Accretion of asset retirement obligations                                           |       | 33,444                                                   |          | 20,594 |   |
| Depletion and depreciation                                                          |       | 1,015,164                                                |          | 146,789 |   |
| Stock compensation expense                                                          |       | 218,693                                                  |          | 175,683 |   |
| Deferred income tax benefit                                                         |       | (155,000                                                 | )             | — |   |
| Amortization of debt issuance and prepaid assets  costs                             |       | 923,255                                                  |          | — |   |
|                                                                                |       |                                                     |          |   |   |
| Changes in assets and liabilities relating to  operations:                          |       |                                                     |          |   |   |
| Derivative assets                                                                   |       | —                                                   |          | — |   |
| Accounts receivable                                                                 |       | 515,781                                                  |          | (150,877 | ) |
| Inventory                                                                           |       | 60,115                                                   |          | (143,412 | ) |
| Accounts payable                                                                    |       | (1,024,219                                               | )             | (207,221 | ) |
| Accrued liabilities                                                                 |       | 554,244                                                  |          | 126,226 |   |
| Prepaid assets                                                                      |       | (332,323                                                 | )             | — |   |
| Other current assets and liabilities                                                |       | (69,328                                                  | )             | (39,701 | ) |
|                                                                                |       |                                                     |          |   |   |
| **Net  cash provided by (used) in operations**                                      | ** ** | **835,908**                                              | ** **    | **(529,876** | **)** |
|                                                                                |       |                                                     |          |   |   |
| **Cash  flow from investing activities:**                                           |       |                                                     |          |   |   |
| Additions to oil and gas properties                                                 |       | (1,952,219                                               | )             | (454,943 | ) |
| Additions to fixed assets and other                                                 |       | (369,875                                                 | )             | (261,774 | ) |
| Acquisition of additional Davenport revenue interest                                |       | (133,400                                                 | )             | — |   |
| **Net  cash used in investing activities**                                          | ** ** | **(2,455,494**                                           | **)**         | **(716,717** | **)** |
|                                                                                |       |                                                     |          |   |   |
| **Cash  flow from financing activities:**                                           |       |                                                     |          |   |   |
| Paydown long-term debt                                                              |       | (68,750,000                                              | )             | — |   |
| Proceeds from issuance of preferred stock, net                                      |       | 46,269,287                                               |          | — |   |
| Proceeds from issuance of common stock and warrants,  net                           |       | 29,937,533                                               |          | 18,461,453 |   |
| **Net  cash from financing activities**                                             | ** ** | **7,456,820**                                            | ** **    | **18,461,453** | ** ** |
|                                                                                |       |                                                     |          |   |   |
| Net increase in  cash and cash equivalents                                          |       | 5,837,234                                                |          | 17,214,860 |   |
|                                                                                |       |                                                     |          |   |   |
| Cash and cash  equivalents at beginning of period                                   |       | 644,659                                                  |          | 145,489 |   |
|                                                                                |       |                                                     |          |   |   |
| **Cash  and cash equivalents at end of period**                                     | ** ** | **$**                                                    | **6,481,893** | ** ** | **$** | **17,360,349** | ** ** |
|                                                                                |       |                                                     |          |   |   |
| **Supplemental  disclosure of noncash transactions:**                               |       |                                                     |          |   |   |
| Common stock issuable upon conversion for preferred stock  dividend                 |       | $                                                        | 148,045       |   | $ | — |   |
|                                                                                |       |                                                     |          |   |   |
| **Supplemental  disclosure of cash transactions:**                                  |       |                                                     |          |   |   |
| Cash paid during  the period for interest                                           |       | $                                                        | 2,196,081     |   | $ | — |   |

 

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

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**CANOPETROLEUM, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

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

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

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

**NewAccounting Pronouncements**

On July 13, 2006, theFinancial Accounting Standards Board (“FASB”) released FIN 48, “Accounting forUncertainty in Income Taxes – an Interpretation of FASB Statement 109.” FIN 48 requires companies to evaluate and disclose material uncertain taxpositions it has taken with various taxing jurisdictions.  We arecurrently reviewing FIN 48 and are unable to determine the effect, if any, thatFIN 48 will have to our operating results, financial position, or future cashflows.  We will be required to adopt FIN48 for our fiscal year ending June 30, 2008.

**2.****              PREFERREDAND COMMON STOCK FINANCINGS**

On September 6, 2006, we sold in a private placement49,116 shares of Series D Convertible Preferred Stock at a price of $1,000.00per share and 6,584,247 shares of common stock at a price of $4.83 per share,the three day average closing price of the stock prior to the execution of thedefinitive agreements, plus a warrant component.  The preferred stock hasa 7.875% dividend and features a paid-in-kind (“PIK”) provision that allows, atthe investor’s option, the investor to receive additional shares of commonstock upon conversion for the dividend in lieu of a cash dividendpayment.  Holders of approximately 55% of the preferred stock chose thePIK dividend option.  The convertible preferred stock is convertible tocommon stock at a price of $5.75 per share and the common stock was subject to25% warrant coverage at an exercise price of $4.79 per share.  If anySeries D Convertible Preferred Stock remains outstanding onSeptember 6, 2011, we are required to redeem the Series D ConvertiblePreferred Stock for a redemption amount in cash equal to the stated value ofthe Preferred Stock, plus accrued dividends and PIK dividends.  Gross proceeds from the transactions are$80.9 million, of which $49.1 million is preferred stock, and common stock andwarrants are $31.8 million.  Net proceedswere $76.2 million after deducting for issuance costs of $4.7 million.

The warrant component totals 1,646,061 common sharesand is exercisable at $4.79 per share. The exercise period commences on March 5, 2007 and expires on March 6,2008.  We computed the 

6

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fair value of the warrants at September 6, 2006 as approximately $2.3million based on the Black-Scholes model assuming the warrants will beexercised prior to the March 6, 2008 expiration date, using a 53% expectedvolatility factor, a risk-free rate of 4.92% and assuming no expected dividendyield.  We have included the fair valueof the warrants in Additional Paid-In Capital on our consolidated balance sheetas of September 30, 2006.

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

We were required to file a Form S-1 registrationstatement with the Securities and Exchange Commission (“SEC”), which was filedon October 13, 2006 and has not been declared effective yet.  We may be subject to a penalty of 1.5% of thegross proceeds if we do not obtain SEC effectiveness of the Form S-1 within 120days of the September 6, 2006 closing date and an additional 1.5% for every 30days it is not effective.  In addition,subject to certain exceptions, once the registration statement is effective, weare to maintain its effectiveness, and if the effectiveness is not maintained,then we must pay 1.5% of the gross proceeds and an additional 1.5% for every 30days it is not maintained.  The maximumaggregate of all registration delay payments is 10% of the gross proceeds.

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

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

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

For the threemonths ended September 30, 2006, the preferred dividend was $268,604, of which$148,045 pertained to holders of the PIK dividend option.

The amount of common shares issued and outstanding issummarized as follows:
| Issued shares as of June 30,  2006                     |   | 26,987,941 |   |
|--------------------------------------------------------|--------|------------|--------|
| Shares issued in  private placement (above)            |   | 6,584,247  |   |
| Contingently  issued shares (Note 6)                   |   | 5,000      |   |
| Issued shares as  of September 30, 2006                |   | 33,577,188 |   |
| Management  shares returned to Treasury Stock (Note 6) |   | (1,268,294 | )      |
| Outstanding shares as  of September 30, 2006           |   | 32,308,894 |   |

 

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**3.****              LONG-TERMDEBT**

Cash proceeds from the financings discussed in Note 2have been used to repay $68.75 million of long-term debt outstanding at June30, 2006, consisting of amounts due under the Senior and Subordinated DebtAgreements of $53.75 million and $15 million, respectively.  Due to repaying the $15 million outstandingbalance on the Subordinated Debt Agreement, this debt facility has beenpermanently retired.  The Senior Credit Agreement, with an unusedborrowing base of $55 million after the pay down, is our only remaining sourceof debt.  At September 30, 2006, we hadno outstanding long-term debt and we were in compliance with the covenantsstated in our Senior Debt Agreement.

**4.****              DERIVATIVEHEDGING CONTRACTS**

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

During our fiscal year ended June 30, 2006, we paid$6.1 million to enter into financial contracts to set price floors, assummarized in the table below.
|                         | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | ** **       | ** ** | **Barrels of** | ** ** |
|-------------------------|------------|------------|------------|------------------|------------|------------|------------|------------------|------------|---------------------|------------|
| ** **              | ** ** | **Floor**  | ** ** | ** **       | ** ** | **Floor**  | ** ** | ** **       | ** ** | **Equivalent**      | ** ** |
| **Time**                | ** ** | **Oil**    | ** ** | **Barrels**      | ** ** | **Gas**    | ** ** | **Gas Mcf** | ** ** | **Oil**             | ** ** |
| **Period**              | ** ** | **Price**  | ** ** | **per Day** | ** ** | **Price**  | ** ** | **per Day** | ** ** | **per Day**    | ** ** |
| 1/1/06 –  12/31/06 |       | $          | 60         |             | 534        |       | $          | 8.50             |       | 1,784               |       | 832 |   |
| 6/1/06 –  12/31/06 |       | $          | 60         |             | 79         |       | $          | 7.60             |       | 690                 |       | 194 |   |
| 1/1/07 –  12/31/07 |       | $          | 55         |             | 507        |       | $          | 8.00             |       | 1,644               |       | 781 |   |
| 1/1/07 –  12/31/07 |       | $          | 60         |             | 72         |       | $          | 7.60             |       | 658                 |       | 182 |   |
| 1/1/08 –  12/31/08 |       | $          | 55         |             | 479        |       | $          | 7.50             |       | 1,534               |       | 735 |   |
| 1/1/08 –  12/31/08 |       | $          | 60         |             | 66         |       | $          | 7.60             |       | 592                 |       | 164 |   |
| 1/1/09 – 4/30/09   |       | $          | 60         |             | 59         |       | $          | 7.60             |       | 559                 |       | 152 |   |

 

We have no derivative hedging contracts that set aprice ceiling. We do not designate our derivatives as cash flow or fair valuehedges. We do not hold or issue derivative financial instruments forspeculative or trading purposes. We are exposed to credit losses in the eventof nonperformance by the counterparties to our financial hedging contracts. Weanticipate, however, that our counterparty, Union Bank of California, will beable to fully satisfy their obligations under the contracts. We do not obtaincollateral or other security to support our financial hedging contracts subjectto credit risk but we monitor the credit standing of the counterparties. AtSeptember 30, 2006, we had a receivable balance due from our counterpartiesamounting to $280,144.

Changes in the fair values of our derivativeinstruments are recorded immediately in earnings in other income on ourstatements of operations. Cash flows resulting from the settlement of ourderivative instruments are recorded as other income or expense in theconsolidated statements of operations. During the three-month period endedSeptember 30, 2006, there were settlements under our derivative agreements dueto Cano amounting to $516,329, which are included in our ConsolidatedStatements of Operations under “Crude oil and natural gas sales.”  Thesettlements were cumulative monthly payments due to Cano since the NYMEXnatural gas price was lower than the $8.50 and $7.60 “floor natural gas prices.” The cash flows relating to the derivative instruments are reflected inoperating activities on our statements of cash flow.

Our mark-to-market valuations used for our derivativeinstruments were provided by an external source. In accordance with SFAS No.133, “Accounting for Derivative Instruments and Hedging 

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Activities,”as amended, we recorded the $6.1 million payment as Derivative Assets. SFAS 133also provides that derivative instruments be measured at fair value on thebalance sheet date.  During the three month period ended September 30,2006, we recognized a gain on hedge contracts to our Consolidated Statements ofOperations amounting to $536,026 under “Unrealized gain on hedge contracts.” At September 30, 2006, our Derivative Assets totaled $3,418,840, of which$1,657,888 is considered long-term.

**5.****     ASSET RETIREMENT OBLIGATION**

Our financial statements reflect the provisions ofStatement of Financial Accounting Standards No. 143,*Accounting for Asset Retirement Obligations*.Our asset retirement obligation (“ARO”) primarily represents the estimatedpresent value of the amount we will incur to plug, abandon and remediate ourproducing properties at the end of their productive lives, in accordance withapplicable state laws. We determine our ARO by calculating the present value ofexpected cash flows related to the liability. At September 30, 2006, ourliability for ARO was $1,617,717, of which $1,597,531 is considered long-term.Our asset retirement obligations are recorded as current or non-currentliabilities based on the estimated timing of the anticipated cash flows.

The following table describes the changes in our assetretirement obligations for the three months ended September 30, 2006:

| Asset retirement obligation  at June 30, 2006 |   | $       | 1,607,378 |   |
|----------------------------------------------------|--------|---------|-----------|--------|
| Accretion  expense                                 |   | 33,444  |      |
| Plugging costs                                     |   | (23,105 | )         |
| Asset retirement  obligation at September 30, 2006 |   | $       | 1,617,717 |   |

 

**6.****           DEFERREDCOMPENSATION**

***Management StockPool Agreement***

As discussed in our Form 10-KSB datedJune 30, 2006 pursuant to the terms of a Management Stock Pool Agreementdated May 28, 2004, the escrowed compensation and performance shares totaled139,167 and 2,505,025 shares, respectively. During July 2006, compensation shares totaling 139,167 were released tocertain Davenport shareholders (three employees and one director).

Management believed roughly one-half of theperformance shares totaling 2,505,025shares****would be released tothe executive Davenport shareholders and the remaining one-half will bereturned as treasury stock, subject to review, discussion and approval by theBoard.

During October 2006, the Board approved the release ofperformance shares totaling 1,252,514 shares to the executive Davenportshareholders and the remaining 1,252,511 shares have been returned as treasuryshares.

As of September 30, 2006, the Treasury Stock totaled1,268,294 shares, consisting of the 1,252,511 performance shares which havebeen returned as treasury stock, as previously discussed, and 15,783compensation shares forfeited by a former employee.

***Contingently IssuedShares from the 2005 LTIP***

As of September 30, 2006, we have issued 145,000restricted shares to key employees from our 2005 LTIP, as discussed in our Form10-KSB dated June 30, 2006.  Thisincludes 5,000 shares issued to a key employee during August 2006.  A summary of the restricted shares issuedthrough September 30, 2006 is as follows:

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|                                    | ** ** | ** ** | ** ** | **Weighted**         | ** ** | ** **          | ** ** |
|------------------------------------|------------|------------|------------|----------------------|------------|---------------------|------------|
| ** **                         | ** ** | ** ** | ** ** | **Average**          | ** ** | ** **          | ** ** |
| ** **                         | ** ** | **Shares** | ** ** | **Grant Price** | ** ** | **Fair Value** | ** ** |
| Outstanding at  6/30/06            |       | 140,000    |       | $                    | 5.62       |                | $          | 786,800 |   |
| Shares granted  during August 2006 |       | 5,000      |       | $                    | 5.03       |                | $          | 25,150 |   |
| Outstanding at 9/30/06             |       | 145,000    |       | $                    | 5.60       |                | $          | 811,950 |   |

 

The restricted shares will vest to the individualemployees based on future years of service ranging from one to three yearsdepending on the life of the award agreement. The fair value is based our actual stock price on the date of grantmultiplied by the number of restricted shares granted.  As of September 30, 2006, the unrealizedvalue of the restricted shares amounted to $689,268.  In accordance with SFAS Nos. 123(R), we haveexpensed $93,377 to stock compensation expense for the three months endedSeptember 30, 2006 based on amortizing the fair value over the appropriateservice period.

**7.****              STOCKOPTIONS**

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

We have granted stock options and contingentlyissuable shares to key employees and outside directors as discussed below.

On December 16, 2004, we issued stock options for 50,000shares of our common stock to Gerald Haddock, a current member of our board ofdirectors, in exchange for certain financial and management consulting servicesto us.  The exercise price is $4 per share.  The options areexercisable at any time, in whole or in part, during the ten-year option periodwhich commenced six months following the date of grant (June 16, 2005) andexpires on June 15, 2015.

On April 1, 2005, we adopted the 2005 Directors’ StockOption Plan (“Plan”). On April 1, 2005, pursuant to the Plan, we granted stockoptions to our five non-employee directors to each purchase 25,000 shares ofcommon stock. The options granted under the Plan totaled 125,000 shares. Theseoptions have an exercise price of $4.13 per share. The options vested on April1, 2006, and expire on April 1, 2015. During August 2006, options totaling 25,000 shares were forfeited by aformer board member.

On September 16, 2005, we granted stock options toJames K. Teringo, Jr., our Senior Vice President, General Counsel and CorporateSecretary to purchase 50,000 shares of common stock. These options have anexercise price of $3.98 per share. The options had a fair value of $81,428 andvested on July 11, 2006, and expire on September 16, 2015.

On December 7, 2005, our shareholders approved our2005 Long-Term Incentive Plan (“2005 LTIP”). The 2005 LTIP authorizes theissuance of up to 1,000,000 shares of our common stock to key employees, keyconsultants and outside directors of our company and subsidiaries. The 2005LTIP permits the grant of incentive stock options, non-qualified stock options,stock appreciation rights, restricted stock, restricted stock units,performance awards, dividend equivalent rights and other awards, whethergranted singly, or in combination or in tandem. No executive officer (asdefined in the 2005 LTIP) may receive in any calendar year (i) stock options orstock appreciation rights relating to more than 100,000 shares of common stockor (ii) restricted stock, restricted stock units, performance awards or otherawards that are subject to the attainment of performance goals relating to morethan 

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100,000shares of common stock; provided, however, that all such awards of anyexecutive officer during any calendar year may not exceed an aggregate of morethan 100,000 shares of common stock. The 2005 LTIP terminates on December 7,2015; however, awards granted before that date will continue to be effective inaccordance with their terms and conditions.

On December 13, 2005, under the 2005 LTIP, 25,000options were granted to each of our five non-employee directors. The exerciseprice is $6.30 per share. These granted options vest on December 13, 2006 ifsuch persons are still directors or an employee on December 13, 2006.

During April 2006 and June 2006, we granted optionstotaling 227,185 shares to our employees under the 2005 LTIP.  Optionstotaling 90,000 shares were granted and 45,000 vested on April 1, 2006 and theexercise price was $9.55 per share.  The remaining 45,000 shares wereforfeited during July 2006.  On June 21, 2006, options totaling 137,185shares were granted and vest on June 21, 2009, with an exercise price of $5.15per share.  During September 2006, 10,250of these shares were forfeited.

On August 11, 2006, under the 2005 LTIP, 15,000 optionswere granted to two non-employee directors. The options granted to these twodirectors under the 2005 LTIP totaled 30,000 shares.  The exercise priceis $5.06 per share. These granted options vest on August 11, 2007 if suchpersons are still directors or an employee on this date.

A summary of options as of September 30, 2006 is asfollows:
|                              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding at  6/30/06      |       | 577,185    |       | $                                      | 5.66       |   |
| Shares granted               |       | 30,000     |       | $                                      | 5.06       |   |
| Shares forfeited  or expired |       | (80,250    | )          | $                                      | 7.61       |   |
| Outstanding at 9/30/06       |       | 526,935    |       | $                                      | 5.38       |   |

 

Total options exercisable at September 30, 2006amounted to 245,000 shares and had a weighted average exercise price of$5.07.  Upon exercise, we issue the fullamount of shares exercisable per the term of the options from new shares. Wehave no plans to repurchase those shares in the future.

Pursuant to SFAS No. 123(R), *Accounting for Stock-Based Compensation*,the fair value of each stock option is estimated on the date of grant using theBlack-Scholes option-pricing model.  Expected volatilities are based onhistorical volatility of our common stock.  We use historical data toestimate option exercise and employee termination within the valuation model. The expected lives of options granted represents the period of time thatoptions granted are expected to be outstanding.  The risk-free rate forperiods within the contractual life of the option is based on the U.S. Treasuryyield curve in effect at the time of grant.  The expected dividend yieldreflects our intent not to pay dividends on our common stock during thecontractual periods.  The fair values ofoptions granted through September 30, 2006 and 2005 along with the factors usedto calculate the fair values of those options are summarized in the tablebelow:
|                                                                                                         | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| No. of shares                                                                                           |       | 326,935                                                  |       | 200,000 |   |
| Risk free  interest rate                                                                                |       | 4.44 – 5.15                                         | %          | 4.02 - 4.27 | % |
| Expected life                                                                                           |       | 4 years                                                  |       | 4 years |   |
| Expected  volatility                                                                                    |       | 48.8 – 53.8                                         | %          | 41.9 – 51.5 | % |
| Expected  dividend yield                                                                                |       | 0.0                                                      | %          | 0.0 | % |
| Weighted average  grant date fair value – exercise prices equal to market value on grant date      |       | $                                                        | 3.09       |   | $ | — |   |
| Weighted average  grant date fair value – exercise prices greater than market value on grant  date |       | $                                                        | 2.60       |   | $ | 1.63 |   |
| Weighted average grant  date fair value – exercise prices less than market value on grant date     |       | $                                                        | —     |   | $ | 1.75 |   |

 

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In accordance with the provisions of SFAS 123(R), forthe three-month periods ended September 30 2006 and 2005, we have recorded acharge to stock compensation expense of $125,316 and $26,058, respectively, forthe estimated fair value of the options granted to our directors and employees.

The following is a summary of stock options outstandingat September 30, 2006:

| Exercise   Price | ** ** | **Options   Outstanding** | ** ** | **Remaining Contractual  Lives (Years)** | ** ** | **Options   Exercisable** | ** ** |
|-----------------------|------------|--------------------------------|------------|----------------------------------------------------|------------|--------------------------------|------------|
| $                     | 4.00       |                           | 50,000     |                                               | 8.71       |                           | 50,000     |   |
| $                     | 4.13       |                           | 100,000    |                                               | 8.51       |                           | 100,000    |   |
| $                     | 3.98       |                           | 50,000     |                                               | 8.97       |                           | 50,000     |   |
| $                     | 6.30       |                           | 125,000    |                                               | 9.21       |                           | —     |   |
| $                     | 9.55       |                           | 45,000     |                                               | 9.51       |                           | 45,000     |   |
| $                     | 5.15       |                           | 126,935    |                                               | 9.73       |                           | —     |   |
| $                     | 5.06       |                           | 30,000     |                                               | 9.87       |                           | —     |   |
| $                     | 5.38       |                           | 526,935    |                                               | 9.26       |                           | 245,000    |   |

 

Based on our $4.04 stock price at September 30, 2006,the intrinsic value of the options was an insignificant amount.

**8.****              NETLOSS PER COMMON SHARE**

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

Diluted net income (loss) per common share is computedin the same manner, but also considers the effect of common stock sharesunderlying the following:
|                 | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
|-----------------|------------|----------------------------------|------------|----------------------------------|------------|
| Stock options   |       | 526,935                          |       | 200,000                          |       |
| Warrants        |       | 1,646,062                        |       | —                           |       |
| Preferred stock |       | 8,541,913                        |       | —                           |       |

 

The shares of common stock underlying the stockoptions, warrants and the preferred stock, as shown in the preceding table, arenot considered for the three months ended September 30, 2006 and 2005 as theireffects would be anti-dilutive.

The weighted average shares used in the basic loss percommon share computations for the three months ended September 30, 2006 and2005 were 26,043,250 shares and 18,014,597 shares, respectively.   Theshares at September 30, 2006 and 2005 excluded for (i) shares of common stockunderlying stock options (see Note 7), warrants and preferred stock, and (ii)contingently issuable shares were 2,665,808 and 2,659,975, respectively, asdiscussed in Note 6.

**9.****              RELATEDPARTY TRANSACTIONS**

During August 2006, we acquired an additional 2.0%overriding royalty interests from THEprivate Energy Company, Inc.(formerly Cano Energy Corporation) for $133,400.  We paid 

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$66,700per percentage of net revenue for these royalty interests, which is consistentwith the price we paid for prior royalty interests we acquired from THEprivateEnergy Company, Inc. during December 2005 and during January 2006.

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

We have entered into an agreement to be a lead sponsorof a television production called Honey Hole All Outdoors. As part of thesponsorship, we paid $37,500 during the three months ended September 30, 2006to R.C. Boyd Enterprises, the owner of Honey Hole All Outdoors. Randall Boyd isthe sole shareholder of R.C. Boyd Enterprises and is a member of our Board.

**10.****       INCOMETAXES**

Our income tax benefit is as follows:
|                                             | ** ** | **Quarter Ended September 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
| Income tax  payable – non-current      |       |                                           |       |   |   |
| Federal                                     |       | $                                              | —     |   | $ | — |   |
| State                                       |       | (33,000                                        | )          | — |   |
| Total income tax benefit – non-current |       | (33,000                                        | )          | — |   |
| Deferred income  tax benefit                |       |                                           |       |   |   |
| Federal                                     |       | 186,120                                        |       | — |   |
| State                                       |       | 1,880                                          |       | — |   |
| Total deferred tax benefit                  |       | 188,000                                        |       | — |   |
| Total income tax  benefit                   |       | $                                              | 155,000    |   | $ | — |   |

 

The difference between our benefit from income taxesrecorded on the statements of operations and the tax computed usingstatutory rates primarily comprises state taxes and adjustments to thevaluation allowance.

 At September 30, 2006, we have recorded a totaldeferred tax liability of $31.3 million, which resulted primarily from theacquisition of WO Energy, as discussed in our Form 10-KSB datedJune 30, 2006. A schedule showing the significant components of thenet deferred tax liability as of September 30, 2006 is as follows:
|                                   | ** ** | **September 30, 2006** | ** **  | **June 30, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------|-------------|-----------------------------|------------|
| Deferred tax  assets:             | ** ** | ** **                       | ** **  | ** **                  | ** ** |
| Deferred compensation expense     |       | $                                | 913,000     |                        | $          | 834,000 |   |
| Net operating loss carryovers     |       | 5,171,000                        |        | 4,680,000                   |       |
| Other                             |       | 228,000                          |        | 216,000                     |       |
|                              |       | 6,312,000                        |        | 5,730,000                   |       |
| Less: valuation  allowance        |       | (792,000                         | )           | (792,000                    | )          |
| Total deferred tax assets         |       | 5,520,000                        |        | 4,938,000                   |       |
|                              |       |                             |        |                        |       |
| Deferred tax  liabilities:        |       |                             |        |                        |       |
| Difference in book and tax bases: |       |                             |        |                        |       |
| Acquired oil and gas properties   |       | (36,334,000                      | )           | (35,950,000                 | )          |
| Other properties                  |       | (509,000                         | )           | (499,000                    | )          |
| Total deferred tax liabilities    |       | (36,843,000                      | )           | (36,449,000                 | )          |
| Net deferred tax  liability       |       | $                                | (31,323,000 | )                           | $          | (31,511,000 | ) |

 

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At September 30, 2006, Cano had net operating loss (“NOL”)carryforwards for tax purposes of approximately $14.4 million. The remainingnet operating losses principally expire in 2024 and 2025. Of the $14.4 million,$2.2 million will be unavailable to offset any future taxable income due tolimitations from change in ownership as defined in Section 382 of theInternal Revenue Service (“IRS”) code. Accordingly, our valuation allowancereflects the unavailable $2.2 million NOL.

**11.****       COMMITMENTSAND CONTINGENCIES**

***Litigation***

On March 23, 2006, the following lawsuit wasfiled in the 100th JudicialDistrict Court in Carson County, Texas; Cause No. 9840, The Tom L. andAnne Burnett Trust, by Anne Burnett Windfohr, Windi Phillips, BenFortson, Jr., George Beggs, III and Ed Hudson, Jr. asCo-Trustees; Anne Burnett Windfohr; and Burnett Ranches, Ltd. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc.; W. O. OperatingCompany, Ltd, and W.O. Energy, Inc. The plaintiffs claim that theelectrical wiring and equipment of Cano Petroleum, Inc. or certain of itssubsidiaries relating to oil and natural gas operations started a wildfire thatbegan on March 12, 2006 in Carson County.

The plaintiffs (i) allege negligence and grossnegligence and (ii) seek undisclosed damages, including, but not limitedto, damages for damage to their land and livestock, certain expenses related tofighting the fire and certain remedial expenses. In addition, the plaintiffsseek (i) termination of certain oil and natural gas leases, (ii) reimbursementfor their attorney’s fees and (iii) exemplary damages. The plaintiffs alsoclaim that Cano and its subsidiaries are jointly and severally liable as asingle business enterprise and/or a general partnership or de factopartnership. The owner of the remainder of the mineral lease, Texas ChristianUniversity, has intervened in the suit joining the plaintiffs’ request toterminate certain oil and natural gas leases.

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

On April 28, 2006, the following lawsuit wasfiled in the 31st JudicialDistrict Court of Roberts County, Texas, Case No. 1922, Robert and GlendaAdcock, et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.;W. O. Operating Company, Ltd, and W.O. Energy, Inc. There are 43plaintiffs and four groups of interveners that claim that the electrical wiringand equipment of Cano Petroleum, Inc. or certain of its subsidiariesrelating to oil and natural gas operations started a wildfire that began onMarch 12, 2006 in Carson County.

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

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

On April 10, 2006, the following lawsuit wasfiled in the 31st JudicialDistrict Court of Roberts County, Texas, Case No. 1920, Joseph CraigHutchison and Judy Hutchison v. Cano Petroleum, Inc., W.O. Energy ofNevada, Inc.; W. O. Operating Company, Ltd, and W.O. Energy, Inc. OnMay 1, 2006, the following lawsuit was filed in the 31st Judicial District Court ofRoberts County, Texas, Case No. 1923, Chisum Family Partnership, Ltd. v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O. OperatingCompany, Ltd, and W.O. Energy, Inc. The plaintiffs in both cases claimthat the electrical wiring and equipment of Cano Petroleum, Inc. orcertain of its subsidiaries relating to oil and natural gas operations starteda wildfire that began on March 12, 2006 in Carson County.

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

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

On July 3, 2006, the following lawsuit was filedin the 31st JudicialDistrict Court of Roberts County, Texas, Case No. 1928, Rebecca Lee Martinez,et al v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O.Operating Company, Ltd., and W.O. Energy, Inc. The plaintiffs claim thatthe electrical wiring and equipment of Cano Petroleum, Inc. or certain ofits subsidiaries relating to its oil and natural gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) allege negligence and gross negligence and (ii) seekundisclosed damages for the wrongful death of two individuals who they claimdied as a result of the fire. Additional heirs and relatives of one of thedecedents have intervened in this case seeking similar claims.

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

On August 9, 2006, the following lawsuit wasfiled in the 233rd Judicial District Court of Gray County, Texas, CauseNo. 34423 Yolanda Villareal, Individually and on behalf of the Estate ofGerardo Villareal v. Cano Petroleum, Inc., W.O. Energy ofNevada, Inc.; W. O. Operating Company, Ltd., and W.O. Energy, Inc.The plaintiffs claim that the electrical wiring and equipment of CanoPetroleum, Inc. or certain of its subsidiaries relating to its oil andnatural gas operations started a wildfire that began on March 12, 2006 inCarson County, Texas. The plaintiffs (i) allege negligence and gross negligenceand (ii) seek undisclosed damages for the wrongful death of GerardoVillareal who they claim died as a result of the fire. Relatives of RobertoChavira have intervened in the case alleging similar claims regarding the deathof Roberto Chavira.

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

On June 20, 2006, the following lawsuitwas filed in the United States District Court for the NorthernDistrict of Texas, Fort Worth Division, C.A. No.4-06cv-434-A, Mid-ContinentCasualty Company, Plaintiff, vs. Cano Petroleum, Inc., W.O. Energy ofNevada, Inc., W.O. Operating Company, Ltd. and W.O. Energy, Inc.seeking a declaration that the plaintiff is not responsible for pre-tenderdefense costs and that the plaintiff has the sole and exclusive right to selectdefense counsel and to defend, investigate, negotiate and settle the litigationdescribed above and on September 18, 2006, the First Amended Complaint forDeclaratory Judgment was filed with regard to the cases described above.  Cano and its subsidiaries were served withthe lawsuit between September 26-28, 2006. In the First Amended Complaint, the plaintiff seeks a declaratoryjudgment that includes requests for the following declarations: (i) theplaintiff is not obligated to pay for the defendant’s personal counsel from thedate the plaintiff offered an unqualified defense and retained independentcounsel to represent the defendants; (ii) the plaintiff retains the soleand exclusive right to select and retain lead counsel at plaintiff’s expenseand to defend, investigate, negotiate and settle the litigation; (iii) theplaintiff is entitled to reimbursement for all attorney’s fees and expensespaid to Cano, or that the amounts previously paid to Cano are in satisfactionof any obligation owing Cano, or that any obligation to pay Cano’s counsel isonly owed as reasonably and necessarily incurred by Cano; and (iv) theplaintiff is entitled to recovery of its reasonable attorney’s fees and costsincurred in connection with the lawsuit.

As of November 13, 2006, we have received from theplaintiff reimbursements of approximately $726,000. The plaintiff may attemptto recover such reimbursements from us. We do not believe that it is probablethat we will be required to repay such amounts. Cano is vigorously defendingitself and its subsidiaries.

***Other***

We concluded an investigation of an alleged breach offiduciary duties and / or fraud by a senior executive involving fraudulent salesto Cano of equipment and materials.  We quantified economic damage to Canoresulting from these fraudulent transactions as approximately $225,000. OnNovember 9, 2006, the senior executive resigned his employment in connectionwith this investigation.

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On November 9, 2006, Cano entered into a settlementand mutual release agreement with Morris R. Greenhaw, Morris R. Greenhaw Oil& Gas, Inc., Saroco, Inc., KenMor Properties, LLC and Kenneth K. Laughlinregarding various claims and rights of the parties asserted against each otherin connection with Cano's acquisition of Square One Energy, Inc. and SquareOne’s development plans for the Desdemona Field.   As part of the settlement, a lawsuit forindemnification brought by Morris R. Greenhaw, Morris R. Greenhaw Oil &Gas, Inc. and Kenneth K. Laughlin (collectively, the “Litigation Parties”)against Cano, et al., was dismissed with prejudice in exchange for Cano’sagreement to pay reasonable attorneys fees and costs of the Litigation Partiesthrough September 30, 2006 in the approximate amount of $220,000 and futurereasonable attorneys fees and cost incurred by them in connection with alawsuit brought against the Litigation Parties by the Chapter 7 Trustee of theGreenhaw Energy, Inc. estate.  Inaddition, the settlement agreement provided for a $690,000 payment to Morris R.Greenhaw for a three year compressor site lease in the Desdemona Field, awaiver of his right to challenge Square One’s development plans for theDesdemona Field and a waiver of his right to require burial of currentpipelines on the surface of his property in the Desdemona Field.

Occasionally, we are involved in other variouslawsuits and certain governmental proceedings arising in the ordinary course ofbusiness. Our management does not believe that the ultimate resolution of anycurrent matters that are not set forth above, including due to the existence ofinsurance coverage, indemnification and escrow accounts, will have a materialeffect on our financial position or results of operations. Except as set forthabove regarding the breach of fiduciary duties and/or fraud by a seniorexecutive, none of our directors, officers or affiliates, owners of record orbeneficially of more than five percent of any class of our voting securities,or security holder is involved in a proceeding adverse to our business or has amaterial interest adverse to our business.

***Environmental***

 To date, our expenditures to comply withenvironmental or safety regulations have not been significant and are notexpected to be significant in the future. However, new regulations, enforcementpolicies, claims for damages or other events could result in significant futurecosts.

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

**Forward-Looking Statements**

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

You should read the following discussion and analysisin conjunction with the consolidated financial statements of CanoPetroleum, Inc. and subsidiaries and notes thereto, included herewith.This discussion should not be construed to imply that the results discussedherein will necessarily continue into the future, 

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or thatany conclusion reached herein will necessarily be indicative of actualoperating results in the future. Such discussion represents only the bestpresent assessment of management.

**Growth Strategy**

We are a growing independent oil and natural gascompany that intends to actively pursue enhanced oil recovery techniques toincrease production and reserves at our existing properties acquired in thefuture.  Our primary focus is crude oil and our target acquisitions areonshore U.S. properties.  Our focus on domestic, mature oil fieldseliminates exploration risks and uncertainties of international sources. We use waterflooding and enhanced oil recovery (“EOR”) methods, such assurfactant-polymer technology.

During our first two years of operations, our primaryfocus was to achieve growth through acquiring existing, mature oil and naturalgas fields.  We believe the portfolio of oil and natural gas propertiesthat we have acquired thus far provide ample opportunities to applywaterflooding and EOR technology.  The potential of these assets is discussedin our Form 10-KSB dated June 30, 2006 - “*Management’sDiscussion and Analysis—- Proved Reserves.*”  During the nexttwelve months, our emphasis is to achieve growth by developing our existing oiland natural gas properties through development activities such as waterfloodingand EOR technology.  These development activities are more clearly definedlater in this section under “*CapitalSpending Plan for Fiscal Year 2007*.”

**Liquidity and Capital Resources**

As discussed in Note 2, on September 6, 2006, we soldin a private placement 49,116 shares of Series D Convertible Preferred Stock ata price of $1,000.00 per share and 6,584,247 shares of common stock at a priceof $4.83 per share, the three day average closing price of the stock prior tothe execution of the definitive agreements, plus a warrant component.  Thepreferred stock has a 7.875% dividend and features a paid-in-kind (“PIK”)provision that allows, at the investor’s option, the investor to receiveadditional shares of common stock upon conversion for the dividend in lieu of acash dividend payment.  Holders of approximately 55% of the preferredstock chose the PIK dividend option.  The convertible preferred stock isconvertible to common stock at a price of $5.75 per share and the common stockwas subject to 25% warrant coverage at an exercise price of $4.79 pershare.  If any Series D Convertible Preferred Stock remains outstanding onSeptember 6, 2011, we are required to redeem the Series D Convertible PreferredStock for the redemption amount in cash equal to the stated value of the SeriesD Convertible Preferred Stock, plus accrued dividends and PIK dividends.  Gross proceeds from the transactions are$80.9 million, of which $49.1 million is preferred stock, and common stock andwarrants are $31.8 million.  Net proceedswere $76.2 million after deducting for issuance costs of $4.7 million.

The warrantcomponent totals 1,646,061 common shares and is exercisable at $4.79 pershare.  The exercise period commences 180days after September 6, 2006 and expires on March 6, 2008.  We computed the fair value of the warrants atSeptember 6, 2006 as approximately $2.3 million based on the Black-Scholesmodel.  We have included the fair valueof the warrants in Additional Paid-In Capital.

Cash proceeds from the financings were used to repay$68.75 million of long-term debt as discussed in Note 3, general corporatepurposes and to fund our fiscal 2007 capital expenditures.  The subordinated debt has been permanentlyretired.  The Senior Credit Agreement,with an unused borrowing base of $55 million after the pay down, is our onlyremaining source of debt.  At September30, 2006, we had no outstanding long-term debt.

At September 30, 2006, our cash balance was $6.5million.  For the quarter ended September30, 2006, we generated cash from operations of $1.1 million, which is animprovement as compared to the $0.5 million used in operations for the threemonths ended September 30, 2005.  This islargely due to improved earnings as discussed under “*Results ofOperations*.”

We believe the combination of cash on hand, cash flowgenerated from operations, and available senior debt of $55 million issufficient to finance our $41 million capital expenditure program as furtherdiscussed below in the section titled “*Capital Spending Plan for Fiscal Year 2007.”*

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***Hedging Activities***

As discussed in Note 4, pursuant to our senior creditagreement, we are required to enter into financial contracts to hedge ourexposure to commodity price risk associated with expected oil and natural gasproduction. For the remainder of calendar year 2006; and calendar years 2007and 2008, the hedged production amounts, as expressed in barrels of oilequivalent per day, are 1,026; 963, and 899, respectively. We entered intofinancial contracts to set the following price floors for calendar years 2006through 2008:

·                  Crude oilproduction of $60/barrel for 2006, and $55 - $60/barrel for 2007 and 2008.

·                  Naturalgas production of $7.60 - $8.50/mcf, $7.60 - $8.00/mcf, and $7.50 - $7.60/mcffor 2006, 2007, and 2008, respectively.

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

***Capital SpendingPlan for Fiscal Year 2007***

Our capital spending plan for the twelve months endedJune 30, 2007, excluding potential acquisitions, is projected to be $41 millionto implement developmental projects at our existing fields to increase reservesand production.  Of this amount, $2.2million has been spent for the quarter ended September 30, 2006.  Our capital spending plan is summarized asfollows:

*Panhandle Field*. We intend to implement a pilot waterflood injection operation.  This willinvolve drilling eleven new wells, converting 29 existing wells to waterinjection, securing water rights, and designing new facilities.  We expectto see increased production during the quarter ending June 30, 2007.  Ifthe pilot is proved successful, we intend to expand the waterflood injectionoperation to the entire field.

*Desdemona Field.* We intend to implement a waterflood injection operation to the entirefield.  This will involve drilling seven new wells, converting existingwells to water injection, securing water rights, and designing newfacilities. . We expect to see increased production from the waterfloodinjection during the quarter ending June 30, 2007. We also intend to drill tennatural gas wells into the Marble Falls and Barnett Shale formations.  To date, we have recompleted three gaswells.  We expect to see increasedproduction during the quarter ended March 31, 2007.

*Corsicana Field*. This field has had a proven surfactant-polymer chemical injection pilot. We intend to re-implement a prior waterflood injection operation to the entirefield.  This will involve drilling 11 new wells, converting existing wellsto water injection, securing water rights, and designing new facilities. To date, we have drilled 7 new wells.  Weplan to reinstate waterflooding by the end of the quarter ending March 31,2007.  We expect to see increasedproduction during the quarter ending March 31, 2007. We intend to implement asurfactant-polymer chemical injection during the quarter ending June 30, 2007.

*Nowata Field*. This field is currently being waterflooded.  We intend to return up to 15existing wells to production and to optimize the waterflood.  We intend to implement a surfactant-polymerchemical injection pilot project during the quarter ended June 30, 2007. We expect to see a production response during the quarter ending December 31,2007.

*Davenport Field*. This field is currently being waterflooded.  We intend to workover andbring 24 existing non-producing wells to production, and to implement 11 waterinjecting wells to optimize waterflood operations.  We expect to seeincreased production during the quarter ending March 31, 2007.  We are also evaluating this field forsurfactant-polymer injection.  This evaluation, coupled with the knowledgegained from the Corsicana and Nowata fields, is expected to enhance its valueas a surfactant-polymer candidate.

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**Results of Operations**

***Overall***

For the quarter ended September 30, 2006 (“currentquarter”), we had a loss applicable to common stock of $0.6 million, which was$0.1 million lower as compared to the $0.5 million loss applicable to commonstock incurred for the quarter ended September 30, 2005 (“prior year quarter”).

The following table summarizes the differences betweenthe two quarters.
| ** **                                                          | ** ** | **September 30,** | ** ** | **Increase** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|
| **Amounts in $millions**                                  | ** ** | **2006**               | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Results of oil  and gas producing operations excluding hedging loss |       | $                      | 4.0        |         | $          | 0.9 |   | $ | 3.1 |   |
| Gain on hedge  contracts                                            |       | 0.5                    |       | —       |       | 0.5 |   |
| Less the  following items:                                          |       |                   |       |         |       |   |   |
| General and  administrative expenses                                |       | 3.2                    |       | 1.4          |       | 1.8 |   |
| Interest  expense, net                                              |       | 1.9                    |       | —       |       | 1.9 |   |
| Other expense  (income)                                             |       | (0.3                   | )          | —       |       | (0.3 | ) |
| Preferred stock  dividend                                           |       | 0.3                    |       | —       |       | 0.3 |   |
| Net loss applicable to  common stock                                | ** ** | **$**                  | **(0.6**   | **)**        | **$**      | **(0.5** | **)** | **$** | **(0.1** | **)** |

 

Results of oil and natural gas producing operationsconsist of operating revenues less lease operating expenses, production taxes,accretion of asset retirement obligations, and depletion and depreciation. The$3.1 million increase in the current quarter is attributed to:

·                  Including threemonths of operating results from the Panhandle Field (i.e. WO Energy) and thePantwist Properties which contributed $2.6 million to net operating income.  The prior year quarter does not include theoperating results from these two oil and natural gas properties.

·                  Improvedoperating results from our Davenport, Rich Valley, Desdemona, and NowataFields, primarily due to higher oil and natural gas prices received andincreased sales.

The other factors will be addressed in the followingdiscussion.

***Operating Revenues***

The table below summarizes our operating revenues forthe quarter ended September 30, 2006 and 2005.
|                                 | ** ** | **Quarter Ended September 30,** | ** ** | **Increase** | ** ** |
|---------------------------------|------------|------------------------------------------------|------------|--------------|------------|
| ** **                      | ** ** | **2006**                                       | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Operating  Revenues             |       | $                                              | 8,653,673  |         | $          | 1,945,959 |   | $ | 6,707,714 |   |
| Sales                           |       |                                           |       |         |       |   |   |
| ·  Oil  (MBbls)  |       | 73                                             |       | 28           |       | 45 |   |
| ·  Gas  (MMcf)   |       | 376                                            |       | 42           |       | 334 |   |
| ·  Total  (MBOE) |       | 136                                            |       | 35           |       | 101 |   |
| Average Price                   |       |                                           |       |         |       |   |   |
| ·  Oil  ($/ Bbl) |       | $                                              | 68.94      |         | $          | 60.36 |   | $ | 8.58 |   |
| ·  Gas ($/ Mcf)  |       | $                                              | 8.40       |         | $          | 6.22 |   | $ | 2.18 |   |

 

The current quarter operating revenues of $8.6 millionrepresent an improvement of $6.7 million as compared to the prior year quarterof $1.9 million. The $6.7 million improvement is primarily attributable toincluding three months of operating revenue from the Panhandle Field and thePantwist Properties ($5.9 million of revenue and 99 MBOE of sales); the higherprices received for oil and natural gas sales; and 

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

***Operating Expenses***

For the current quarter, our total operating expenseswere $7.8 million, or $5.4 million higher than the prior year quarter of $2.4million. The $5.4 million increase is primarily attributed to including threemonths of Panhandle Field and Pantwist Properties operating expenses totaling$3.2 million, higher general and administrative expenses of $1.8 million,and higher other operating expenses of $0.4 million.

Our lease operating expenses (“LOE”) consists of costsof producing crude oil and natural gas such as labor, supplies, repairs,maintenance, and utilities. For the current quarter, the LOE per BOE was $21.34as compared to $21.56 per LOE for the prior year quarter.  The current quarter LOE per BOE of $21.34 perBOE is an improvement as compared to the LOE per BOE of $22.32 that we incurredfor the twelve month period ended June 30, 2006. We generally incur a highamount of LOE because our fields are more mature and typically produce less oiland more water, and they are generally at the end of the primary or secondaryproduction cycle. Since our acquisitions are mature fields, we will initiallyfocus on implementing the necessary operational improvements to improveoperating efficiency. Based on management’s past experience, it generallyrequires up to twelve months to fully analyze the acquired field and spend thenecessary funds to improve the field operations to meet our operationalstandards.  We expect these expenditures should lead to increased operationalefficiency and reduced operating expenses in future periods.

Our general and administrative (G&A) expensesconsist of support services for our operating activities and investor relationscosts. For the current quarter, our G&A expenses totaled $3.2 million, whichis $1.8 million higher than the prior year quarter. The primary contributors tothe $1.8 million increase was increased labor and staffing costs of $0.5million; higher legal fees to comply with regulatory requirements and forlitigation of $0.6 million; and increased fees of $0.3 million for accountingservices for year-end audit and to achieve full compliance the Section 404 ofthe Sarbanes-Oxley Act.

***Gain on Hedging Contracts***

As discussed in Note 4 to the financial statements,during our fiscal year ended June 30, 2006, we entered into financial contractsto set price floors for crude oil and natural gas. In accordance with SFAS 133,we recorded a Gain on Hedging Contracts of $0.5 million to reflect the fairvalue of the derivative instruments as of September 30, 2006. By their nature,these derivative instruments can be highly volatile to our earnings. A fivepercent change in these prices for our derivative instruments can impactearnings by approximately $170,000.  Wedid not have hedging contracts during the three months ended September 30,2005.

Also, during the current quarter, as discussed in Note4, there were settlements under our derivative agreements due to Cano amountingto $0.5 million. The settlements were cumulative monthly payments due to Canosince the NYMEX gas price was lower than the $8.50 and $7.60 “floor natural gasprices.”

***Interest Expense***

The interest expense we incurred in the currentquarter of $1.9 million resulted directly from senior and subordinated creditagreements as discussed in Note 3.  Ourinterest expense also includes $0.5 million for previously deferred financingcosts pertaining to our subordinated credit agreement since we have permanentlyretired this credit agreement, as discussed in Note 3.  We did not have credit agreements during theprior year quarter.

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***Deferred Income TaxBenefit***

As of September 30, 2006, we had a net deferred taxliability of $31.3 million.  Thisrepresents deferred tax benefits from generation of net operating lossesbecause a valuation allowance against such items is not required. We review ourdeferred tax assets at least quarterly and record a valuation allowance againstthose assets when we conclude that it is more likely than not that those assetswill expire without being utilized. For the current quarter, we recorded anincome tax benefit of $155,000.  We didnot record income taxes for the prior year quarter.

***Preferred Stock Dividend***

The preferred stock dividend of $0.3 million resultedfrom the preferred stock financing, which was completed on September 6, 2006,as discussed in Note 2.  Since we did notissue preferred stock during the three months ended September 30, 2005, therewere no preferred stock dividends during the prior year quarter.

***New Accounting Pronouncements***

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

**Item 3. Quantitative and Qualitative Disclosures About MarketRisk.**

Since on June 30, 2006, we were a “small businessissuer,” we did not have to include in our Form 10-KSB “Quantitative andQualitative Disclosures About Market Risk” as of June 30, 2006.  Now that we are no longer a “small businessissuer,” we have provided “Quantitative and Qualitative Disclosures AboutMarket Risk” as of June 30, 2006 and with material updates through September30, 2006.

***CommodityRisk***

The Company’s revenues are derived from the sale ofits crude oil and natural gas production. The prices for oil and natural gasare extremely volatile and sometimes experience large fluctuations as a resultof relatively small changes in supplies, weather conditions, economicconditions and government actions. Pursuant to our senior credit agreement, weare required to enter into financial contracts to hedge approximatelytwo-thirds of our production at specified floors for oil and natural gasbetween $55 and $60 per barrel and between $7.50 and $8.50 per Mcf.  Therefore, for the hedged production, we willreceive at least the floor prices. Approximately one-third of our production is not subject to the floorsand is subject to the volatility and price fluctuations of oil and natural gas.

Assuming that the prices that we receive for our crudeoil and natural gas production are above the above described floors, based onour actual fiscal year sales volumes for the year ended June 30, 2006, a 10%decline in the prices we receive for our crude oil and natural gas productionwould have had an approximate $1.4 million impact on our revenues.

***InterestRate Risk***

At June 30, 2006, we hadborrowings of $68.75 million outstanding under our credit agreements.  In September 2006 we repaid this indebtednessusing the proceeds from our September 6, 2006 private placement.  If on our borrowings that were outstanding atJune 30, 2006 there had been an increase in the interest rate of 1%, ourinterest expense would have increased by $687,500 annually.

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***Derivative HedgingContracts***

We are required to enter into financial contracts to hedge a portion of ourproduction at specified prices for oil and natural gas. The objective ofthe hedging contracts is to reduce our exposure to commodity price riskassociated with expected oil and natural gas production.  By achieving this objective we intend toprotect the outstanding debt amounts and maximize the funds available under ourexisting debt agreements, which should enable us to support our annual capitalbudgeting and expenditure plans.  We havepurchased hedging contracts that set “price floors” for our crude oil andnatural gas production.

During our fiscal year ended June 30,2006, we paid $6.1 million to enter into financial contracts to set pricefloors, as summarized in Note 4.

We have no derivative hedging contracts that set a price ceiling. We do notdesignate our derivatives as cash flow or fair value hedges. We do not hold orissue derivative financial instruments for speculative or trading purposes. Weare exposed to credit losses in the event of nonperformance by thecounterparties to our financial hedging contracts. We anticipate, however, thatour counterparty, Union Bank of California, will be able to fully satisfy theirobligations under the contracts. We do not obtain collateral or other securityto support our financial hedging contracts subject to credit risk but wemonitor the credit standing of the counterparties. At June 30, 2006, we had areceivable balance due from our counterparties amounting to $161,173, and atSeptember 30, 2006, we had a receivable due from our counterparties amountingto $280,144.

Changes in the fair values of our derivative instruments are recordedimmediately in earnings in other income on our statements of operations. Cashflows resulting from the settlement of our derivative instruments are recordedas other income or expense in the consolidated statements of operations. Duringthe twelve-month period ended June 30, 2006, there were settlements under ourderivative agreements due to Cano amounting to $540,871, and during thethree-month period ended September 30, 2006 there were settlements under ourderivative agreements due to Cano amounting to $516,329 which are included inour Consolidated Statements of Operations under “Crude oil and natural gassales.”  The settlements were cumulativemonthly payments due to Cano since the NYMEX natural gas price was lower thanthe $8.50 and $7.60 “floor natural gas prices.” The cash flows relating to the derivative instruments are reflected inoperating activities on our statements of cash flow.

Our mark-to-market valuations used for our derivative instruments werebased on prices that are actively quoted and provided by external sources. Inaccordance with SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities,” as amended, we recorded the $5.3 million payment asDerivative Assets. SFAS 133 also provides that derivative instruments bemeasured at fair value on the balance sheet date.  During the twelve month period ended June 30,2006, we recognized losses on hedge contracts to our Consolidated Statements ofOperations amounting to $3,245,588 under “Unrealized loss on hedge contracts.”  During the three month period endingSeptember 30, 2006, we recognized a gain on hedge contracts to our ConsolidatedStatements of Operations amounting to $536,026 under “Unrealized gain on hedgecontracts.”  At June 30, 2006, ourDerivative Assets totaled $2,882,814, of which $1,705,855 is consideredlong-term, and at September 30, 2006, our Derivative Assets totaled $3,418,840,of which $1,657,888 is considered long-term.

If crude oil prices fell $1 below our hedged crude oil price floor, wewould save approximately $100,000 due to having the crude oil price floor hedgein place.  If natural gas prices fell $1below our hedged natural gas price floor, we would save approximately $340,000due to having the natural gas price floor hedge in place.

**Item 4. Controls and Procedures.**

As discussed in our Form 10-KSB dated June 30, 2006,we did not maintain effective controls over the preparation and review ofdeferred tax liabilities and the related deferred income tax benefit.Specifically, this pertained to apportioning taxes between states to correctlyaccount for the effect of changes to the state of Texas tax laws in May 2006.Internal controls have been strengthened through increased review andcommunication between Cano and the third-party tax preparer, which began duringthe preparation of the income tax accrual for the quarter ended September 30,2006.

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During the courseof performing our quarter end closing procedures, as discussed in Note 11, ourinternal controls detected that a senior executive was involved in fraudulent salesto Cano of equipment and materials.  Inthe opinion of management, failure to set up adequate controls over payments tovendors represents a material weakness in the Company’s internal control overfinancial reporting as of September 30, 2006.  We have implemented additional procedures tostrengthen our internal controls over accounts payable processing subsequent toSeptember 30, 2006.  The additionalprocedures involve additional procedures to set-up new vendors in our accountspayable system and additional review of vendor invoices prior to payment.

As of the end of the period covered by this report, weconducted an evaluation, under the supervision and with the participation ofour chief executive officer, chief financial officer and principal accountingofficer of our disclosure controls and procedures as defined inRule 13a-15(e) and Rule 15d-15(e) of the SecuritiesExchange Act of 1934 (the “Exchange Act”). Based upon this evaluation, ourchief executive officer, chief financial officer and principal accountingofficer concluded that our disclosure controls and procedures were not effectiveto ensure that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is: (1) accumulated andcommunicated to our management, including our chief executive officer, chieffinancial officer and principal accounting officer, as appropriate to allowtimely decisions regarding required disclosure; and (2) recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.  This specifically pertained to the accountspayable processing, as previously discussed.

There was no change in our internal control overfinancial reporting, except for strengthening internal controls over therecording of deferred income taxes, or in other factors that could affect theinternal control over financial reporting during our last fiscal quarter thathave materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting. As previously stated, we implemented additional procedures to strengthenour internal controls over accounts payable subsequent to September 30, 2006.

**PART II – OTHER INFORMATION**

**Item 1. Legal Proceedings.**

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

**Item 1A.Risk Factors.**

Since on June 30, 2006, we were a “small businessissuer,” we did not have to include in our Form 10-KSB “Risk Factors.”  Now that we are no longer a “small businessissuer,” we have provided risk factors as set forth below.

**Risks Related to Our Industry**

***Oiland natural gas prices are volatile. A decline in prices could adversely affectour financial position, financial results, cash flows, access to capital andability to grow.***

Our revenues, operating results, profitability andfuture rate of growth depend primarily upon the prices we receive for the oiland natural gas we produce and sell. Prices also affect the amount of cash flowavailable for capital expenditures and our ability to borrow money or raise additionalcapital. Historically, the markets for oil and natural gas have been volatileand they are likely to continue to be volatile. Wide fluctuations in oil andnatural gas prices may result from relatively minor changes in the supply ofand demand for oil and natural gas, market and political uncertainty and otherfactors that are beyond our control, including:

·                                          worldwideand domestic demands and supplies of oil and natural gas;

·                                          weatherconditions;

·                                          theprice and availability of alternative fuels;

·                                          theavailability of pipeline capacity;

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·                                          theprice and level of foreign imports;

·                                          domesticand foreign governmental regulations and taxes;

·                                          theability of the members of the Organization of Petroleum Exporting Countries toagree to and maintain oil price and production controls;

·                                          politicalinstability or armed conflict in oil-producing regions; and

·                                          theoverall economic environment.

These factors and the volatility of the energy marketsmake it extremely difficult to predict future oil and natural gas pricemovements with any certainty. Declines in oil and natural gas prices would notonly reduce revenue, but could reduce the amount of oil and natural gas that wecan produce economically and, as a result, could have a material adverse effecton our financial condition, results of operations and reserves.

***Governmentregulation may adversely affect our business and results of operations.***

Oil and natural gas operations are subject to variousand numerous federal, state and local government regulations, which may bechanged from time to time. Matters subject to regulation include dischargepermits for drilling operations, drilling bonds, reports concerning operations,the spacing of wells, injection of substances, unitization and pooling ofproperties and taxation. From time to time, regulatory agencies have imposedprice controls and limitations on production by restricting the rate of flow ofoil and natural gas wells below actual production capacity in order to conservesupplies of oil and natural gas. There are federal, state and local laws andregulations primarily relating to protection of human health and theenvironment applicable to the development, production, handling, storage,transportation and disposal of oil and natural gas, by-products thereof andother substances and materials produced or used in connection with oil andnatural gas operations. The transportation and storage of refined productsinclude the risk that refined products and other hydrocarbons may be suddenlyor gradually released into the environment, potentially causing substantialexpenditures for a response action, significant government penalties, liabilityto government agencies and private parties for natural resources damages,personal injury, or property damages and significant business interruption. Weown or lease a number of properties that have been used to store or distributerefined and unrefined products for many years. Many of these properties havealso been operated by third parties whose handling, disposal, or release ofhydrocarbons and other wastes were not under our control. As a result, we mayincur substantial expenditures and/or liabilities to third parties orgovernmental entities which could have a material adverse effect on us.

***Theoil and natural gas industry is capital intensive, and we may not be able toraise the necessary capital in the future.***

The oil and natural gas industry is capital intensive.We make substantial capital expenditures for the acquisition, exploration forand development of oil and natural gas reserves.

Historically, we have financed capital expendituresprimarily with cash generated by operations, proceeds from bank borrowings andsales of our equity securities. In addition, we may consider selling additionalnon-core assets to raise additional operating capital.

Our cash flow from operations and access to capitalare subject to a number of variables, including:

·                                          ourproved reserves;

·                                          thelevel of oil and natural gas we are able to produce from existing wells;

·                                          theprices at which oil and natural gas are sold; and

·                                          ourability to acquire, locate and produce new reserves.

Any one of these variables can materially affect ourability to borrow under our revolving credit facility.

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If our revenues or the borrowing base under ourrevolving credit facility decreases as a result of lower oil and natural gasprices, operating difficulties, declines in reserves or for any other reason,we may have limited ability to obtain the capital necessary to undertake orcomplete future drilling projects. We may, from time to time, seek additionalfinancing, either in the form of increased bank borrowings, sales of debt orequity securities or other forms of financing, and there can be no assurance asto the availability of any additional financing upon terms acceptable to us.

**Risks Related to Our Business**

***Our limited history makes anevaluation of us and our future difficult and profits are not assured****.*

Prior to theDavenport Merger in May 2004, we were inactive with no significant operations.In connection with the Davenport Merger, we decided to focus our business onthe acquisition of attractive crude oil and natural gas prospects, and theexploration, development and production of oil and natural gas on theseprospects. Since that time, we have acquired rights in oil and natural gasproperties and undertaken certain exploitation and other activities.  However, we do not have a long operatinghistory in our current business and have not initiated any new waterflooding orEOR technologies on our own on any of our properties. In view of our limitedhistory in the oil and natural gas business, you may have difficulty inevaluating us and our business and prospects. You must consider our businessand prospects in light of the risks, expenses and difficulties frequentlyencountered by companies in their early stage of development. For our businessplan to succeed, we must successfully undertake most of the followingactivities:

·                  Find and acquirerights in attractive oil and natural gas properties;

·                  Develop our oiland natural gas properties, including the successful application of EORtechnologies and procedures, to the point at which oil and natural gas arebeing produced in commercially viable quantities;

·                  Contract withthird party service providers regarding services necessary to develop our oiland natural gas wells;

·                  Contract withtransporters and purchasers of our commercial production of oil and naturalgas;

·                  Maintain accessto funds to pursue our capital-intensive business plan;

·                  Comply with allapplicable laws and regulations;

·                  Implement andsuccessfully execute our business strategy;

·                  Respond tocompetitive developments and market changes; and

·                  Attract, retainand motivate qualified personnel.

There can be noassurance that we will be successful in undertaking such activities. Ourfailure to undertake successfully most of the activities described above couldmaterially and adversely affect our business, prospects, financial conditionand results of operations. In addition, there can be no assurance that ourexploitation and production activities will produce oil and natural gas incommercially viable quantities. There can be no assurance that sales of our oiland natural gas production will ever generate sufficient revenues or that wewill be able to sustain profitability in any future period.

***If we cannot obtain sufficientadditional capital when needed, we will not be able to continue with ourbusiness strategy.  In addition, significant infusions of additionalcapital may result in dilution to your ownership and voting rights in oursecurities.***

Our business strategy is to acquire interests inmature oil fields with established reserves that have declined to marginalproduction levels, but possess significant remaining upside exploitationpotential, and implement various secondary and tertiary enhanced oil recoveryoperations.  We are focused on acquiring undervalued properties thatfeature enhanced recovery opportunities.  As we continue to findacquisition candidates, we may require additional capital to finance theacquisitions as well as to conduct our EOR operations. We may not be able toobtain additional financing in sufficient amounts or on acceptable terms whenneeded, which could adversely affect our operating results and prospects. If wecannot raise the additional capital required to implement our businessstrategy, we may be required to curtail operations or 

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develop a different strategy, which could adverselyaffect our financial condition and results of operations. Further, any debtfinancing must be repaid regardless of whether or not we generate profits orcash flows from our business activities. Equity financing may result indilution to existing stockholders and may involve securities that have rights,preferences, or privileges that are senior to our common stock.

***Theactual quantities and present value of our proved reserves may be lower than wehave estimated.***

The process of estimating oil and natural gas reservesis complex. The process involves significant decisions and assumptions in theevaluation of available geological, geophysical, engineering and economic datafor each reservoir. Therefore, these estimates are inherently imprecise. Actualfuture production, oil and natural gas prices, revenues, taxes, developmentexpenditures, operating expenses and quantities of recoverable oil and naturalgas reserves most likely will vary from these estimates and vary over time.Such variations may be significant and could materially affect the estimatedquantities and present value of our proved reserves. In addition, we may adjustestimates of proved reserves to reflect production history, results ofexploration and development drilling, results of secondary and tertiaryrecovery applications, prevailing oil and natural gas prices and other factors,many of which are beyond our control.

***Approximately 79% of our totalproved reserves as of July 1, 2006 consist of undeveloped and developednon-producing reserves, and those reserves may not ultimately be developed orproduced.***

Approximately 76% of our total proved reserves areundeveloped and approximately 3% are developed non-producing.  While we plan to develop and produce all ofour proved reserves, these reserves may not ultimately be developed orproduced.  Furthermore, not all of ourundeveloped or developed non-producing reserves may be ultimately produced atthe time periods we have planned, at the costs we have budgeted, or at all.

***We may not achieve the productiongrowth we anticipate from properties we acquire.***

On May 28, 2004, we acquired Davenport FieldUnit, which owned a 100% working interest in certain oil, natural gas andmineral leasehold estates and personal property related such leasehold estateslocated in Lincoln County, Oklahoma covering approximately 2,178 acres. On July 2, 2004, we acquired all of the outstanding common stock of theLadder Companies, pursuant to which we acquired interests in 61 wells,including 51 that are located primarily in one field of approximately 4,500acres in Grant County, Oklahoma.  On September 14, 2004, we acquiredthe Nowata Properties comprised of more than 220 oil and natural gas producingwells on 2,601 acres of land in Nowata County, Oklahoma.  OnMarch 29, 2005, we acquired Square One, pursuant to which we own a 100%working interest in 10,300 acres of mature oil fields in central Texas. OnNovember 29, 2005, we acquired all of the outstanding common stock of WOEnergy, pursuant to which we own oil and natural gas properties on approximately20,000 acres in Carson, Gray and Hutchinson counties located in the Texaspanhandle with 480 producing wells, 40 water disposal wells and 380 idlewells. On April 28, 2006, our wholly owned subsidiary Pantwist, LLCacquired additional oil and natural gas properties in the Texas panhandle,which properties cover approximately 9,700 acres with 167 wells. Ouroperational strategy is to implement waterflood and EOR techniques.  The performance of waterflood and EORtechniques is often difficult to predict, takes an extended period of time fromfirst investment until actual production and we may not achieve the anticipatedproduction growth from properties we acquire.

***Acquisitionsmay prove to be worth less than we paid because of uncertainties in evaluatingrecoverable reserves and potential liabilities.***

Our recent growth is due in part to acquisitions ofexploration and production companies, producing properties and undevelopedleaseholds. We expect acquisitions will also contribute to our future growth.Successful acquisitions require an assessment of a number of factors, includingestimates of recoverable reserves, exploration potential, recoveryapplicability from waterflood and EOR techniques, future oil and natural gasprices, operating costs and potential environmental and other liabilities. Suchassessments are inexact and their accuracy is inherently uncertain. Inconnection with our assessments, we perform a review 

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of the acquired properties which we believe isgenerally consistent with industry practices. However, such a review will notreveal all existing or potential problems. In addition, our review may notpermit us to become sufficiently familiar with the properties to fully assesstheir deficiencies and capabilities. We do not inspect every well or property.Even when we inspect a well or property, we do not always discover structural,subsurface and environmental problems that may exist or arise. We are generallynot entitled to contractual indemnification for pre-closing liabilities, includingenvironmental liabilities. Normally, we acquire interests in properties on an “asis” basis with limited remedies for breaches of representations and warranties.As a result of these factors, we may not be able to acquire oil and natural gasproperties that contain economically recoverable reserves or be able tocomplete such acquisitions on acceptable terms.

Additionally, significant acquisitions can change thenature of our operations and business depending upon the character of theacquired properties, which may have substantially different operating andgeological characteristics or be in different geographic locations than ourexisting properties. It is our current intention to continue focusing onacquiring properties with development and exploration potential located inonshore United States. To the extent that we acquire properties substantiallydifferent from the properties in our primary operating regions or acquireproperties that require different technical expertise, we may not be able torealize the economic benefits of these acquisitions as efficiently as in ourprior acquisitions.

***Explorationand development drilling and the application of waterflooding and EORtechniques may not result in commercially productive reserves.***

We do not always encounter commercially productivereservoirs through our drilling operations or our application of waterfloodingor EOR techniques. The new wells we drill or participate in may not beproductive and we may not recover all or anyportion of our investment in wells we drill or participate in. The seismic dataand other technologies we use do not allow us to know conclusively prior todrilling a well that oil or natural gas is present or may be producedeconomically. The cost of drilling, completing and operating a well is oftenuncertain, and cost factors can adversely affect the economics of a project.Our efforts will be unprofitable if we drill dry holes or wells that areproductive but do not produce enough reserves to return a profit after drilling,operating and other costs or our application of waterflooding or EOR techniquesis not successful. Further, our drilling and other operations may be curtailed,delayed or canceled as a result of a variety of factors, including:

·                                          unexpecteddrilling conditions;

·                                          titleproblems;

·                                          pressureor irregularities in formations;

·                                          equipmentfailures or accidents;

·                                          adverseweather conditions; and

·                                          increasesin the costs of, or shortages or delays in the availability of, chemicals, drillingrigs and equipment.

***Thedeparture of key personnel could adversely affect our ability to run ourbusiness.***

Our future success is dependent on the personalefforts, performance and abilities of key management, including S. JeffreyJohnson, our Chairman and Chief Executive Officer; Morris B. Smith, Senior VicePresident and Chief Financial Officer; Patrick McKinney, Senior Vice President –Engineering and Operations; James K. Teringo, Jr., Senior Vice President,General Counsel and Secretary; and Michael J. Ricketts, Vice President andPrincipal Accounting Officer.  All of these individuals are integral partsof our daily operations.  We have employment agreements withMessrs. Johnson, Smith, McKinney, Teringo and Ricketts. We do not maintainany key life insurance policies for any of our executive officers or otherpersonnel.  Although, to our knowledge, none of our senior managementcurrently has any plans to retire or leave our company in the near future, theloss of any of them could significantly impact our business until adequatereplacements can be identified and put in place.

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***Weface strong competition from larger oil and natural gas companies, which makesit difficult to conduct profitable operations.***

Our competitors include major integrated oil andnatural gas companies and numerous independent oil and natural gas companies,individuals and drilling and income programs. Many of these competitors arelarge, well-established companies and have substantially larger operatingstaffs and greater capital resources than we do. We may not be able tosuccessfully conduct our operations, evaluate and select suitable propertiesand consummate transactions in this highly competitive environment.Specifically, these larger competitors may be able to pay more for exploratoryprospects and productive oil and natural gas properties and may be able todefine, evaluate, bid for and purchase a greater number of properties andprospects than our financial or human resources permit. In addition, suchcompanies may be able to expend greater resources on the existing and changingtechnologies that we believe are and will be increasingly important toattaining success in the industry.

***Weare subject to many restrictions under our revolving credit facility which mayadversely impact our future operations.***

We may depend on our revolving credit facility forfuture capital needs. As required by our revolving credit facility with ourbank lenders, we have pledged substantially all of our oil and natural gasproperties as collateral to secure the payment of our indebtedness. Therevolving credit facility restricts our ability to obtain additional financing,make investments, sell assets, grant liens, repurchase, redeem or retire oursecurities, enter into specific transactions with our subsidiaries oraffiliates and engage in business combinations. The revolving credit facilityprohibits us from declaring or paying dividends on our common stock. We arealso required to comply with certain financial covenants and ratios.

These financial covenants and ratios could limit ourability to obtain future financing, make needed capital expenditures, withstanda downturn in our business or economy in general or otherwise conduct necessarycorporate activities. We may also be prevented from taking advantage ofbusiness opportunities that arise because of the limitations that therestrictive covenants under the revolving credit facility impose on us.Although we are currently in compliance with these covenants, in the past wehave had to request waivers from or enter into amendments with our lenders toavoid default because of our anticipated non-compliance with certain financialcovenants and ratios. Any future default, if not cured or waived, could resultin the acceleration of all indebtedness outstanding under the revolving creditfacility. If that should occur, we may not be able to pay all such debt or toborrow sufficient funds to refinance it. Even if new financing were available,it may not be on terms that are acceptable to us.

In addition, the revolving credit facility limits theamounts we can borrow to a borrowing base amount, determined by the lenders,based upon projected revenues from the oil and natural gas properties securingour loan. The lenders can independently adjust the borrowing base and theborrowings permitted to be outstanding under the revolving credit facility.

***Derivativeactivities create a risk of financial loss.***

Pursuant to the terms of our senior credit facility,we are parties to oil and natural gas price risk management arrangements withrespect to a portion of our expected production. We purchase floors thatgenerally result in minimum price received by us for a portion of ourproduction over a specified time period. We have the right to receive from thecounterparty, the excess of the fixed price specified in the contract over afloating price based on a market index, multiplied by the quantity identifiedin the derivative contract. These transactions may expose us to the risk offinancial loss if the counterparties to our future contracts fail to performunder the contracts.

***Failureto maintain effective internal controls could have a material adverse effect onour operations.***

Beginning with our fiscal year ending June 30, 2007,we will be subject to Section 404 of the Sarbanes-Oxley Act which requiresannual management assessments of the effectiveness of our internal control overfinancial reporting and a report by our independent auditors addressing ourinternal controls 

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and management’s assessment. Effective internalcontrols are necessary for us to produce reliable financial reports. If, as aresult of deficiencies in our internal controls, we cannot provide reliablefinancial reports, our business decision process may be adversely affected, ourbusiness and operating results could be harmed, we may be in violation of ourlending covenants, investors could lose confidence in our reported financialinformation, and the price of our stock could decrease as a result.

During our evaluation of disclosure controls andprocedures for the year ended June 30, 2006, we concluded that our disclosurecontrols and procedures were not effective to ensure that all informationrequired to be disclosed by us in the reports that we file or submit under theSecurities Exchange Act of 1934, as amended, is: (i) accumulated andcommunicated to our management, including our chief executive officer, chieffinancial officer and principal accounting officer, as appropriate, to allowtimely decisions regarding required disclosure; and (ii) recorded, processed,summarized and reported, with the time periods specified by the Securities andExchange Commission’s rules and forms. This specifically pertained to the preparation and review of deferredtax liabilities and the related deferred income tax benefit.  Our internal controls have been strengthenedthrough increased review and communication between us and the third-party thatassists us with our deferred tax calculations, which began during thepreparation of the income tax accrual for the quarter ended September 30, 2006.

During the courseof performing our quarter end closing procedures as of September 30, 2006, ourinternal controls detected that a senior executive was involved in fraudulentsales to Cano of equipment and materials. In the opinion of management, failure to set up adequate controls overpayments to vendors represents a material weakness in the Company’s internalcontrol over financial reporting as of September 30, 2006.  We have implemented additional procedures tostrengthen our internal controls over accounts payable processing subsequent toSeptember 30, 2006.  The additionalprocedures involve additional procedures to set-up new vendors in our accountspayable system and additional review of vendor invoices prior to payment.

There can be no guarantee that we will not havedeficiencies in our internal controls in the future.

***Ourbusiness involves many operating risks, which may result in substantial losses,and insurance may be unavailable or inadequate to protect us against theserisks.***

Our operations are subject to hazards and risksinherent in drilling for, producing and transporting oil and natural gas, suchas:

·                                          fires;

·                                          naturaldisasters;

·                                          explosions;

·                                          pressureforcing oil or natural gas out of the wellbore at a dangerous velocity coupledwith the potential for fire or explosion;

·                                          weather;

·                                          failureof oilfield drilling and service tools;

·                                          changesin underground pressure in a formation that causes the surface to collapse orcrater;

·                                          pipelineruptures or cement failures;

·                                          environmentalhazards such as natural gas leaks, oil spills and discharges of toxic gases;and

·                                          availabilityof needed equipment at acceptable prices, including steel tubular products.

Any of these risks can cause substantial losses resulting from:

·                                          injuryor loss of life;

·                                          damageto and destruction of property, natural resources and equipment;

·                                          pollutionand other environmental damage;

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·                                          regulatoryinvestigations and penalties;

·                                          suspensionof our operations; and

·                                          repairand remediation costs.

Our liability for environmental hazards includes thosecreated either by the previous owners of properties that we purchase or leaseor by acquired companies prior to the date we acquire them. We maintaininsurance against some, but not all, of the risks described above. Ourinsurance policies currently provide for $1,000,000 general liability coveragefor bodily injury and property damage including pollution, undergroundresources, blow out and cratering. In addition, we have $250,000 coverage forour contractual obligations to our service contractors using their equipmentdownhole. We have a “Hired and Non-Owned” Commercial Automobile liability limitof $1,000,000.  We also have secured $25,000,000 umbrella coverage inexcess of the general liability and automobile liability. Our insurance may notbe adequate to cover casualty losses or liabilities. Also, in the future we maynot be able to obtain insurance at premium levels that justify its purchase.

We do not insure against the loss of oil or naturalgas reserves as a result of operating hazards, insure against businessinterruption or insure our field production equipment against loss. Lossescould occur for uninsurable or uninsured risks, or in amounts in excess ofexisting insurance coverage. The occurrence of an event that is not fullycovered by insurance could harm our financial condition and results ofoperations.

***Thereare risks in acquiring producing properties, including difficulties inintegrating acquired properties into our business, additional liabilities andexpenses associated with acquired properties, diversion of managementattention, increasing the scope, geographic diversity and complexity of ouroperations and incurrence of additional debt.***

Our business strategy includes growing our reservebase through acquisitions. Our failure to integrate acquired businessessuccessfully into our existing business, or the expense incurred inconsummating future acquisitions, could result in unanticipated expenses andlosses. In addition, we may assume cleanup or reclamation obligations or otherunanticipated liabilities in connection with these acquisitions. The scope andcost of these obligations may ultimately be materially greater than estimatedat the time of the acquisition.

We are continually investigating opportunities foracquisitions. In connection with future acquisitions, the process ofintegrating acquired operations into our existing operations may result inunforeseen operating difficulties and may require significant managementattention and financial resources that would otherwise be available for theongoing development or expansion of existing operations. Our ability to makefuture acquisitions may be constrained by our ability to obtain additionalfinancing.

Possible future acquisitions could result in ourincurring additional debt, contingent liabilities and expense, all of whichcould have a material adverse effect on our financial condition and operatingresults.

***Terroristactivities may adversely affect our business.***

Terrorist activities, including events similar tothose of September 11, 2001, or armed conflict involving the United States mayadversely affect our business activities and financial condition. If events ofthis nature occur and persist, the resulting political and social instabilitycould adversely affect prevailing oil and natural gas prices and cause areduction in our revenues. In addition, oil and natural gas productionfacilities, transportation systems and storage facilities could be direct targetsof terrorist attacks, and our operations could be adversely impacted ifinfrastructure integral to our operations is destroyed or damaged. Costsassociated with insurance and other security measures may increase as a resultof these threats, and some insurance coverage may become more difficult toobtain, if available at all.

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***Part of our business is seasonalin nature which may affect the price of our oil and natural gas.***

Weather conditions affect the demand for and price ofoil and natural gas. Demand for oil and natural gas is typically higher duringwinter months than summer months. However, warm winters can also lead todownward price trends. As a result, our results of operations may be adverselyaffected by seasonal conditions.

***Weare subject to potential early repayments as well as restrictions pursuant tothe terms of our Series D Convertible Preferred Stock which may adverselyimpact our operations.***

Pursuant to the terms of our Series D ConvertiblePreferred Stock, if a “triggering event” occurs, the holders of our Series DConvertible Preferred Stock will have the right to require us to redeem theirpreferred stock at a minimum price of at least 125% of the $1,000 per sharestated value plus certain dividends.  “Triggeringevents” include the following:

·                                          ourcommon stock is suspended from trading or fails to be listed on the AMEX, theNew York Stock Exchange, the Nasdaq Global Select Market, the Nasdaq GlobalMarket or the Nasdaq Capital Market;

·                                          wefail to convert and do not cure this failure within 10 business days after theconversion date or give notice of our intention not to comply with a requestfor conversion;

·                                          wefail to pay for at least 5 business days any amount when and as due pursuant tothe terms of the Series D Convertible Preferred Stock or any documents relatedto the sale and registration rights of the Series D Convertible PreferredStock, common stock and warrants;

·                                          certainactions are taken by us or third parties with regard to bankruptcy;

·                                          wedefault on any indebtedness which default is not waived and the applicablegrace period has expired; or

·                                          webreach any representation, warranty, covenant or other term or condition of anydocument relating to the sale and registration rights regarding the Series DConvertible Preferred Stock, the common stock and the warrants, which, to theextent such breach is curable, such breach is not cured within 7 business days.

There is no guarantee that we would be able to repaythe amounts due upon an occurrence of a “triggering event.”

In addition, we cannot issue any preferred stock thatis senior or on par with the Series D Convertible Preferred Stock with regardto dividends or liquidation without the approval of holders of a majority ofthe Series D. Convertible Preferred Stock.

***Weare subject to several lawsuits relating to a fire that allegedly occurred onMarch 12, 2006 in Carson County, Texas which may have an adverse impact on us.***

Cano and certain of itssubsidiaries are defendants in several lawsuits relating to a fire thatallegedly occurred on March 12, 2006 in Carson County, Texas.  The alleged damages include damage to landand livestock, remedial expenses and claims relating to wrongful death.  In addition, our insurance carrier has fileda lawsuit seeking a declaratory judgment regarding whether it is responsiblefor paying the fees of certain of our counsel. In addition to potentially not paying any future fees for certain of ourcounsel, our insurance carrier may attempt to recover the approximately$726,000 that we have been reimbursed through November 13, 2006.  In addition, our insurance coverage may notbe sufficient to cover all of these alleged damages.

**Risks Related to Our Common Stock**

***Our historic stock price has beenvolatile and the future market price for our common stock may continue tobe volatile.  Further, the limited market for our shares will make ourprice more***

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***volatile.  Thismay make it difficult for you to sell our common stock for a positivereturn on your investment.***

The public market for our common stock has historicallybeen very volatile. Since we acquired Davenport Field Unit on May 28, 2004and through the fiscal quarter ended September 30, 2006, the market price forour common stock has ranged from $0.45 to $10.65. On November 13, 2006, ourclosing price on AMEX was $4.75.  Anyfuture market price for our shares may continue to be very volatile.  Thisprice volatility may make it more difficult for you to sell shares when youwant at prices you find attractive.  We do not know of any one particularfactor that has caused volatility in our stock price.  However, the stockmarket in general has experienced extreme price and volume fluctuations thatoften are unrelated or disproportionate to the operating performance ofcompanies. Broad market factors and the investing public’s negative perceptionof our business may reduce our stock price, regardless of our operatingperformance.  Market fluctuations and volatility, as well as generaleconomic, market and political conditions, could reduce our market price. As a result, this may make it difficult or impossible for you to sell ourcommon stock for a positive return on your investment.

***If wefail to meet continued listing standards of AMEX, our common stock may bedelisted which would have a material adverse effect on the price of our commonstock.***

Our common stock was listed on AMEX on May 5,2005 under the symbol “CFW.”  In order for our securities to be eligiblefor continued listing on AMEX, we must remain incompliance with certain listing standards. Among other things, these standardsrequire that we remain current in our filings with the SEC and comply withcertain provisions of the Sarbanes-Oxley Act of 2002. If we were to becomenoncompliant with AMEX’s continued listing requirements, our common stock maybe delisted which would have a material adverse affect on the price of ourcommon stock.

***If weare delisted from AMEX, our common stock may become subject to the “pennystock” rules of the Securities and Exchange Commission, which would maketransactions in our common stock cumbersome and may reduce the value of aninvestment in our stock.***

The Securities and Exchange Commission has adoptedRule 3a51-1 which establishes the definition of a “penny stock,” for thepurposes relevant to us, as any equity security that is not listed on anational securities exchange or registered national securities association’sautomated quotation system and has a market price of less than $5.00 per share,subject to certain exceptions. For any transaction involving a penny stock,unless exempt, Rule 15g-9 require:

·                                          thata broker or dealer approve a person’s account for transactions in penny stocks;and

·                                          thebroker or dealer receive from the investor a written agreement to thetransaction, setting forth the identity and quantity of the penny stock to bepurchased.

In order to approve a person’s account fortransactions in penny stocks, the broker or dealer must:

·                                          obtainfinancial information and investment experience and objectives of the person;and

·                                          makea reasonable determination that the transactions in penny stocks are suitablefor that person and the person has sufficient knowledge and experience infinancial matters to be capable of evaluating the risks of transactions inpenny stocks.

The broker or dealer must also deliver, prior to anytransaction in a penny stock, a disclosure schedule prescribed by theSecurities and Exchange Commission relating to the penny stock market, which,in highlight form:

·                                          setsforth the basis on which the broker or dealer made the suitabilitydetermination; and

·                                          thatthe broker or dealer received a signed, written agreement from the investorprior to the transaction.

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Generally, brokers may be less willing to execute transactionsin securities subject to the “penny stock” rules.  This may make it moredifficult for investors to dispose of our common stock and cause a decline inthe market value of our stock.

***Ifsecurities analysts downgrade our stock or cease coverage of us, the price ofour stock could decline.***

The trading market for our common stock relies in parton the research and reports that industry or financial analysts publish aboutus or our business. We do not control these analysts. Furthermore, there aremany large, well-established, publicly traded companies active in our industryand market, which may mean that it is less likely that we will receivewidespread analyst coverage. If one or more of the analysts who do cover usdowngrade our stock, our stock price would likely decline rapidly. If one ormore of these analysts cease coverage of our company, we could lose visibilityin the market, which in turn could cause our stock price to decline.

***We donot pay dividends on our common stock.***

We have never paid dividends on our common stock, anddo not intend to pay cash dividends on the common stock in the foreseeablefuture. Net income from our operations, if any, will be used for thedevelopment of our business, including capital expenditures and to retire debt.Any decisions to pay dividends on the common stock in the future will dependupon our profitability at the time, the available cash and other factors. Ourability to pay dividends on our common stock is further limited by the terms ofour revolving credit facility and our Series D. Convertible Preferred Stock.

***Provisionsin our corporate governance and loan documents, the terms of our Series DConvertible Preferred Stock and Delaware law may delay or prevent anacquisition of Cano, which could decrease the value of our common stock.***

Our certificate of incorporation, our Series DConvertible Preferred Stock, our bylaws, our loan documents and the DelawareGeneral Corporation Law contain provisions that may discourage other personsfrom initiating a tender offer or takeover attempt that a stockholder mightconsider to be in the best interest of all stockholders, including takeoverattempts that might result in a premium to be paid over the market price of ourstock.

The terms of our Series D Convertible Preferred Stockpermit the holders of such preferred stock the right to have their Series DConvertible Preferred Stock redeemed upon a “change of control.”  In addition, the terms of our Series DConvertible Preferred Stock do not permit us to enter into certain transactionsthat would constitute a “change of control” unless the successor entity assumesall of our obligations relating to the Series D Convertible Preferred Stock andthe holders of a majority of our Series D Convertible Preferred Stock approvesuch assumption and the successor entity is publicly traded on the AMEX, theNew York Stock Exchange, the Nasdaq Global Select Market, the Nasdaq GlobalMarket or the Nasdaq Capital Market.

In addition, subject to the terms of the Series DConvertible Preferred Stock, we are authorized to issue additional shares ofpreferred stock. Subject to the terms of the Series D Convertible PreferredStock and our certificate of incorporation, our board of directors has totaldiscretion in the issuance and the determination of the rights and privilegesof any shares of preferred stock which might be issued in the future, whichrights and privileges may be detrimental to the holders of the common stock. Itis not possible to state the actual effect of the authorization and issuance ofa new series of preferred stock upon the rights of holders of the common stockand other series of preferred stock unless and until the board of directorsdetermines the attributes of any new series of preferred stock and the specificrights of its holders. These effects might include:

·                                          restrictionson dividends on common stock and other series of preferred stock if dividendson any new series of preferred stock have not been paid;

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·                                          dilutionof the voting power of common stock and other series of preferred stock to theextent that a new series of preferred stock has voting rights, or to the extentthat any new series of preferred stock is convertible into common stock;

·                                          dilutionof the equity interest of common stock and other series of preferred stock; and

·                                          limitationon the right of holders of common stock and other series of preferred stock toshare in Cano’s assets upon liquidation until satisfaction of any liquidationpreference attributable to any new series of preferred stock.

The terms of our Series DConvertible Preferred Stock and the provisions in our corporate governancedocuments regarding the granting of additional preferred stock may deter orrender more difficult proposals to acquire control of our company, includingproposals a stockholder might consider to be in his or her best interest,impede or lengthen a change in membership of our Board of Directors and makeremoval of our management more difficult. Furthermore, Delaware law imposessome restrictions on mergers and other business combinations between ourcompany and owners of 15% or more of our common stock. These provisions applyeven if an acquisition proposal is considered beneficial by some stockholdersand therefore could depress the value of our common stock.

***Theconversion price of our Series D Convertible Preferred Stock may be a loweredif we issue shares of our common stock at a price less than the existingconversion price which could cause further dilution to our common stockholders.***

Subject to certain exclusions, if we issue commonstock at a price less than the existing conversion price for our Series DConvertible Preferred Stock, the conversion price shall be adjusted downwardwhich would further dilute our common stock holders upon conversion.

***OurSeries D Convertible Preferred Stock has voting rights both together with andseparate from our common stock which could adversely affect our commonstockholders.***

The holders of our Series D Convertible PreferredStock vote together with the holders of our common stock on an as convertedbasis, subject to a limitation on how many votes the Series D ConvertiblePreferred Stock holders may cast if the conversion price falls below$4.79.  In addition, approval of holdersof a majority of the Series D Convertible Preferred Stock is required for us totake the following actions:

·                                          tomodify the certificate of incorporation or bylaws in a manner adverse to theSeries D Convertible Preferred Stock;

·                                          increaseor decrease the number of authorized shares of Series D Convertible PreferredStock;

·                                          createany class of preferred stock that has a preference over or is in parity withthe Series D Convertible Preferred Stock with respect to dividends orliquidation;

·                                          purchase,repurchase or redeem any share of common stock;

·                                          paydividends or make any other distribution on the common stock; or

·                                          circumventa right of the Series D Convertible Preferred Stock.

These voting rights may have an adverse impact on thecommon stock and the voting power of our common stockholders.

***Sincewe are a United States real property holding corporation, non-U.S. investorsmay be subject to U.S. federal income tax (including withholding tax) on gainsrealized on disposition of our shares, and U.S. investors selling our sharesmay be required to certify as to their status in order to avoid withholding.***

Since we are a United States real property holdingcorporation, a non-U.S. holder of our common stock will generally be subject toU.S. federal income tax on gains realized on a sale or other disposition of ourcommon stock.  Certain non-U.S. holdersof our common stock may be eligible for an exception to the foregoing generalrule if our common stock is regularly traded on an established securitiesmarket during 

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the calendar year in which the sale or dispositionoccurs. However, we cannot offer any assurance that our common stock will be sotraded at any point in time in the future.

If our common stock is not considered to be regularlytraded on an established securities market during the calendar year in which asale or disposition occurs, the buyer or other transferee of our common stockwill generally be required to withhold tax at the rate of 10% on the salesprice or other amount realized, unless the transferor furnishes an affidavitcertifying that it is not a foreign person in the manner and form specified inapplicable Treasury regulations.

**Item 2. Unregistered Sales of Equity Securities and Use ofProceeds.**

During the three-months ended September 30, 2006,there were no unregistered sales of equity securities that were not previouslyreported on a Current Report on Form 8-K.

Inaddition to our Senior Credit Agreement which does not permit us to paydividends on our common stock, the terms of our Series D Convertible PreferredStock do not permit us to pay dividends on our common stock without theapproval of the holders of a majority of the Series D Convertible PreferredStock.

**Item 3. Defaults Upon Senior Securities.**

None.

**Item 4. Submission of Matters to a Vote of Security Holders.**

None.

**Item 5. Other Information.**

None.

**Item 6. Exhibits.**
| Exhibit  Number | ** ** | **Description** |
|-----------------|------------|-----------------|
|            | 3.1        |            | Certificate of Designation for Series D Convertible  Preferred Stock incorporated by reference from Exhibit 3.1 to Current Report  on Form 8-K, filed on September 7, 2006. |
|            | 4.1        |            | Registration Rights Agreement dated August 25, 2006  by and among Cano Petroleum, Inc. and the Buyers listed therein, incorporated  by reference from Exhibit 4.1 to Amendment to Current Report on Form 8-K/A  filed on August 31, 2006. |
| +               | 10.1       |            | Employment Agreement of Michael J. Ricketts  effective July 1, 2006, incorporated by reference from Exhibit 10.1 to  Current Report on Form 8-K filed on August 17, 2006. |
| +               | 10.2       |            | Employee Restricted Stock Award Agreement of Morris  B. Smith dated August 11, 2006, incorporated by reference from Exhibit 10.2  to Current Report on Form 8-K filed on August 17, 2006. |
| +               | 10.3       |            | Stock Option Agreement of Dennis McCuistion dated  August 11, 2006, incorporated by reference from Exhibit 10.4 to Current  Report on Form 8-K filed on August 17, 2006. |
| +               | 10.4       |            | Stock Option Agreement of Patrick W. Tolbert dated  August 11, 2006, incorporated by reference from Exhibit 10.4 to Current  Report on Form 8-K filed on August 17, 2006. |
|            | 10.5       |            | Securities Purchase Agreement dated August 25, 2006  by and among Cano Petroleum, Inc. and the Buyers listed therein, incorporated  by reference from Exhibit 10.1 to Amendment to Current Report on Form 8-K/A  filed on August 31, 2006. |
|            | 10.6       |            | Form of Warrant to Purchase Common Stock dated  September 6, 2006 by Cano Petroleum, Inc., incorporated by reference from  Exhibit 10.1 to Current Report on Form 8-K filed on September 11, 2006. |
|            | 31.1*      |            | Certification by Chief Executive Officer, required  by Rule 13a-14(a) or Rule 15d-14(a) of |

 

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|        |   |   | 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.                                                                            |
|   | 31.3*  |   | Certification by Principal Accounting Officer,  required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act, promulgated  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       |
|   | 32.1*  |   | Certification by Chief Executive Officer, required  by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of  Chapter 63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.      |
|   | 32.2*  |   | Certification by Chief Financial Officer, required  by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of  Chapter 63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.      |
|   | 32.3*  |   | Certification by Principal Accounting Officer,  required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section  1350 of Chapter 63 of Title 18 of the United States Code, promulgated  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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*                 Filedherewith

+                 Managementcontract or compensatory plan, contract or arrangement

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**SIGNATURES**

In accordance with the requirements of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
| **CANO PETROLEUM, INC.** |   |                                                |
|--------------------------|--------|-----------------------------------------------------|
| ** **               |   |                                                |
| Date: November  14, 2006 | By:    | /s/ S. Jeffrey Johnson                              |   |
|                     |   | S. Jeffrey Johnson                                  |
|                     |   | Chief  Executive Officer                            |
|                     |   |                                                |
| Date: November  14, 2006 | By:    | /s/ Morris B. Smith                                 |   |
|                     |   | Morris B. Smith                                     |
|                     |   | Senior  Vice-President and  Chief Financial Officer |
|                     |   |                                                |
| Date: November  14, 2006 | By:    | /s/ Michael J. Ricketts                             |   |
|                     |   | Michael J. Ricketts                                 |
|                     |   | Vice-President  and  Principal Accounting Officer   |

 

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