** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark  One)**                                         |
|---------------------------------------------------------|
| ** **                                              | ** ** |
| **x**                                                   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                              | ** ** |
| **For the quarterly period ended  March 31, 2009** |
| ** **                                              | ** ** |
| **o**                                                   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom            to            **

** **

**Commission file number 001-32496**

 

**CANOPETROLEUM, INC.**

(Exact name of registrant as specified in its charter)

 

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

** **

**The Burnett Plaza**

**801 Cherry Street, Suite 3200**

**Fort Worth, TX 76102**

(Address of principal executive offices, including zip code)

 

**(817) 698-0900**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  x    No  o

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

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

 

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

 

State the number of shares outstanding of each of the issuer’s classesof common stock, as of the latest practicable date:  45,643,735 shares ofcommon stock, $0.0001 par value per share, as of May 8, 2009.

 

 

 

----

 

**PART I— FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                                                                                                        | ** **   | **March 31,** | ** **        | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------------|-------------------|-------------------|------------|
| **In  Thousands, Except Shares and Per Share Amounts**                                                                                                                                                                                                                                                                                                                            | ** **   | **2009**           | ** **        | **2008**          | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                                                                                                                                      | *** *** | *** ***       | ** **        | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                                                                                                                                | ** **   | ** **         | ** **        | ** **        | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                         |         | $                  |  327         |              | $          |  771 |   |
| Accounts receivable                                                                                                                                                                                                                                                                                                                                                               |         | 2,308              |              | 3,916             |       |
| Deferred tax assets                                                                                                                                                                                                                                                                                                                                                               |         | —             |              | 3,592             |       |
| Derivative assets                                                                                                                                                                                                                                                                                                                                                                 |         | 8,776              |              | —            |       |
| Inventory and other current assets                                                                                                                                                                                                                                                                                                                                                |         | 1,510              |              | 642               |       |
| Assets held for sale (Note 2)                                                                                                                                                                                                                                                                                                                                                     |         | —             |              | 25,912            |       |
| Total current assets                                                                                                                                                                                                                                                                                                                                                              |         | 12,921             |              | 34,833            |       |
|                                                                                                                                                                                                                                                                                                                                                                              |         |               |              |              |       |
| **Oil and gas properties****,**successful  efforts method                                                                                                                                                                                                                                                                                                                         |         | 294,695            |              | 247,930           |       |
| Less accumulated depletion and depreciation                                                                                                                                                                                                                                                                                                                                       |         | (34,378            | )                 | (7,962            | )          |
| Net oil and gas properties                                                                                                                                                                                                                                                                                                                                                        |         | 260,317            |              | 239,968           |       |
| Fixed assets and other, net                                                                                                                                                                                                                                                                                                                                                       |         | 3,147              |              | 2,096             |       |
| Derivative assets                                                                                                                                                                                                                                                                                                                                                                 |         | 5,913              |              | 125               |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                                          |         | 101                |              | 786               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                                                                                                                  | ** **   | **$**              | ** 282,399** | ** **        | **$**      | ** 277,808** | ** ** |
|                                                                                                                                                                                                                                                                                                                                                                              |         |               |              |              |       |
| ***LIABILITIES,  TEMPORARY EQUITY AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                                                                                                                |         |               |              |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                                                                                                                           |         |               |              |              |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                  |         | $                  |  7,680       |              | $          |  8,679 |   |
| Accrued liabilities                                                                                                                                                                                                                                                                                                                                                               |         | 5,004              |              | 2,840             |       |
| Deferred tax liabilities                                                                                                                                                                                                                                                                                                                                                          |         | 3,143              |              | —            |       |
| Liabilities associated with discontinued operations (Note 2)                                                                                                                                                                                                                                                                                                                      |         | —             |              | 1,398             |       |
| Oil and gas sales payable                                                                                                                                                                                                                                                                                                                                                         |         | 564                |              | 815               |       |
| Derivative liabilities                                                                                                                                                                                                                                                                                                                                                            |         | 84                 |              | 9,978             |       |
| Current portion of asset retirement obligations                                                                                                                                                                                                                                                                                                                                   |         | 344                |              | 345               |       |
| Total current liabilities                                                                                                                                                                                                                                                                                                                                                         |         | 16,819             |              | 24,055            |       |
| **Long-term liabilities**                                                                                                                                                                                                                                                                                                                                                         |         |               |              |              |       |
| Long-term debt (Note 4)                                                                                                                                                                                                                                                                                                                                                           |         | 43,700             |              | 73,500            |       |
| Asset retirement obligations                                                                                                                                                                                                                                                                                                                                                      |         | 3,068              |              | 2,865             |       |
| Deferred litigation credit (Note 13)                                                                                                                                                                                                                                                                                                                                              |         | —             |              | 6,000             |       |
| Derivative liabilities                                                                                                                                                                                                                                                                                                                                                            |         | —             |              | 16,390            |       |
| Deferred tax liabilities                                                                                                                                                                                                                                                                                                                                                          |         | 29,568             |              | 26,062            |       |
| Total liabilities                                                                                                                                                                                                                                                                                                                                                                 |         | 93,155             |              | 148,872           |       |
| ** **                                                                                                                                                                                                                                                                                                                                                                        |         |               |              |              |       |
| **Temporary equity**                                                                                                                                                                                                                                                                                                                                                              |         |               |              |              |       |
| Series D convertible preferred stock and cumulative paid-in-kind  dividends; par value $.0001 per share, stated value $1,000 per share; 49,116  shares authorized; 23,849 and 44,474 shares issued at March 31, 2009 and  June 30, 2008, respectively; liquidation preference at March 31,  2009 and June 30, 2008 of $26,709 and $48,353, respectively. |         | 25,127             |              | 45,086            |       |
| ** **                                                                                                                                                                                                                                                                                                                                                                        |         |               |              |              |       |
| **Commitments and contingencies (Note 13)**                                                                                                                                                                                                                                                                                                                                       |         |               |              |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                                                                                                                                     |         |               |              |              |       |
| Common stock, par value $.0001 per share; 100,000,000 authorized;  47,346,812 and 45,643,735 shares issued and outstanding, respectively, at  March 31, 2009; and 40,523,168 and 39,254,874 shares issued and  outstanding, respectively, at June 30, 2008.                                                                                                             |         | 5                  |              | 4                 |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                                                        |         | 188,821            |              | 121,831           |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                                               |         | (24,012            | )                 | (37,414           | )          |
| Treasury stock, at cost; 1,703,077 and 1,268,294 shares held in  escrow at March 31, 2009 and June 30, 2008, respectively.                                                                                                                                                                                                                                              |         | (697               | )                 | (571              | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                                                                                   |         | 164,117            |              | 83,850            |       |
| **TOTAL LIABILITIES, TEMPORARY EQUITY AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                            | ** **   | **$**              | ** 282,399** | ** **        | **$**      | ** 277,808** | ** ** |

 

***See accompanyingnotes to these unaudited consolidated financial statements.***

 

2

----

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                       | ** ** | **March 31,**     | ** ** | **March 31,**    | ** ** |
| **In Thousands, Except Per Share Data**                          | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Operating Revenues:**                                          | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil sales                                                  |       | $                      | 2,774      |                  | $          | 6,271 |   | $ | 14,577 |   | $ | 15,182 |   |
| Natural gas sales                                                |       | 1,001                  |       | 2,822                 |       | 4,847 |   | 8,035 |   |
| Other revenue                                                    |       | 153                    |       | 79                    |       | 312 |   | 238 |   |
| Total operating revenues                                         |       | 3,928                  |       | 9,172                 |       | 19,736 |   | 23,455 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| **Operating Expenses:**                                          |       |                   |       |                  |       |   |   |   |   |
| Lease operating                                                  |       | 4,067                  |       | 3,530                 |       | 13,910 |   | 8,760 |   |
| Production and ad valorem taxes                                  |       | 375                    |       | 691                   |       | 1,854 |   | 1,672 |   |
| General and administrative                                       |       | 2,157                  |       | 3,320                 |       | 16,561 |   | 10,700 |   |
| Impairment of long-lived assets (Note 12)                        |       | —                 |       | —                |       | 22,398 |   | — |   |
| Depletion and depreciation                                       |       | 1,585                  |       | 969                   |       | 4,157 |   | 2,721 |   |
| Accretion of discount on asset retirement obligations            |       | 76                     |       | 51                    |       | 226 |   | 152 |   |
| Total operating expenses                                         |       | 8,260                  |       | 8,561                 |       | 59,106 |   | 24,005 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| **Income (loss) from operations**                                |       | (4,332                 | )          | 611                   |       | (39,370 | ) | (550 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| **Other income (expense):**                                      |       |                   |       |                  |       |   |   |   |   |
|  Interest expense and other                                 |       | (165                   | )          | (99                   | )          | (419 | ) | (492 | ) |
|  Impairment of goodwill                                     |       | —                 |       | —                |       | (685 | ) | — |   |
|  Gain (loss) on derivatives (Notes 5 and 11)                |       | 3,486                  |       | (3,571                | )          | 48,480 |   | (5,674 | ) |
| Total other income (expense)                                     |       | 3,321                  |       | (3,670                | )          | 47,376 |   | (6,166 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Income (loss) from continuing operations before income taxes     |       | (1,011                 | )          | (3,059                | )          | 8,006 |   | (6,716 | ) |
| Deferred income tax benefit (expense)                            |       | 308                    |       | 1,089                 |       | (3,731 | ) | 2,378 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Income (loss) from continuing operations                         |       | (703                   | )          | (1,970                | )          | 4,275 |   | (4,338 | ) |
| Income (loss) from discontinued operations, net of related taxes |       | (6                     | )          | 920                   |       | 11,388 |   | 2,320 |   |
| **Net income (loss)**                                            |       | (709                   | )          | (1,050                | )          | 15,663 |   | (2,018 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Preferred stock dividend                                         |       | (470                   | )          | (877                  | )          | (2,261 | ) | (2,732 | ) |
| Preferred stock repurchased for less than carrying amount        |       | —                 |       | —                |       | 10,890 |   | — |   |
| ** **                                                       |       |                   |       |                  |       |   |   |   |   |   |   |   |   |
| **Net income (loss) applicable to common stock**                 |       | $                      | (1,179     | )                     | $          | (1,927 | ) | $ | 24,292 |   | $ | (4,750 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| **Net income (loss) per share - basic**                          |       |                   |       |                  |       |   |   |   |   |
| Continuing operations                                            |       | $                      | (0.03      | )                     | $          | (0.07 | ) | $ | 0.29 |   | $ | (0.20 | ) |
| Discontinued operations                                          |       | —                 |       | 0.02                  |       | 0.25 |   | 0.06 |   |
| **Net income (loss) per share - basic (Note 9)**                 |       | $                      | (0.03      | )                     | $          | (0.05 | ) | $ | 0.54 |   | $ | (0.14 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| **Net income (loss) per share - diluted**                        |       |                   |       |                  |       |   |   |   |   |
| Continuing operations                                            |       | $                      | (0.03      | )                     | $          | (0.07 | ) | $ | 0.29 |   | $ | (0.20 | ) |
| Discontinued operations                                          |       | —                 |       | 0.02                  |       | 0.22 |   | 0.06 |   |
| **Net income (loss) per share - diluted (Note 9)**               |       | $                      | (0.03      | )                     | $          | (0.05 | ) | $ | 0.51 |   | $ | (0.14 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| **Weighted average common shares outstanding (Note  9)**         |       |                   |       |                  |       |   |   |   |   |
| Basic                                                            |       | 45,316                 |       | 37,370                |       | 45,359 |   | 35,029 |   |
| Diluted                                                          |       | 45,316                 |       | 37,370                |       | 52,519 |   | 35,029 |   |

 

***See accompanyingnotes to these unaudited consolidated financial statements.***

 

3

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENT OF CHANGES INSTOCKHOLDERS’ EQUITY**

**JULY 1, 2008 THROUGH MARCH 31,2009(Unaudited)**

 
| ** **                                                                                                          | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **         | ** ** | ** ** | ** **  | ** ** | ** **    | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|--------------------|------------|------------|-------------|------------|---------------|------------|------------|
| ** **                                                                                                          | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **  |
| **Dollar Amounts in Thousands**                                                                                     | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**        | ** ** | **Shares** | ** **  | **Amount** | ** **    | **Total**  | ** ** |
| **Balance at June 30, 2008**                                                                                   | ** ** | **40,523,168**   | ** ** | **$**       | **4**      | ** **      | **$**      | **121,831**        | ** ** | **$**      | **(37,414** | **)**      | **1,268,294** | ** ** | **$**      | **(571** | **)** | **$** | **83,850** | ** ** |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Net proceeds from issuance of common shares on July 1, 2008                                                    |       | 7,000,000        |       | 1           |       | 53,907          |       | —             |       | —     |        | —     |          | 53,908     |       |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Forfeiture and surrender of restricted stock                                                                        |       | (176,356         | )          | —      |       | (228            | )          | —             |       | —     |        | —     |          | (228       | )          |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Stock-based compensation                                                                                            |       | —           |       | —      |       | 2,421           |       | —             |       | —     |        | —     |          | 2,421      |       |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Preferred stock dividend                                                                                            |       | —           |       | —      |       | —          |       | (2,261             | )          | —     |        | —     |          | (2,261     | )          |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Preferred stock repurchased for less than carrying amount                                                           |       | —           |       | —      |       | 10,890          |       | —             |       | —     |        | —     |          | 10,890     |       |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Shares returned to treasury stock from escrow related to acquisition  of W.O. Energy of Nevada, Inc. (Note 13) |       | —           |       | —      |       | —          |       | —             |       | 434,783    |        | (126       | )             | (126       | )          |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| Net income                                                                                                          |       | —           |       | —      |       | —          |       | 15,663             |       | —     |        | —     |          | 15,663     |       |
|                                                                                                                |       |             |       |        |       |            |       |               |       |       |        |       |          |       |       |
| **Balance at March 31, 2009**                                                                                  | ** ** | **47,346,812**   | ** ** | **$**       | **5**      | ** **      | **$**      | **188,821**        | ** ** | **$**      | **(24,012** | **)**      | **1,703,077** | ** ** | **$**      | **(697** | **)** | **$** | **164,117** | ** ** |

 

***See accompanyingnotes to these unaudited consolidated financial statements.***

 

4

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
| ** **                                                                                       | ** ** | **Nine Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| **In Thousands**                                                                                 | ** ** | **2009**                             | ** ** | **2008** | ** ** |
| **Cash flow from operating activities:**                                                         |       |                                 |       |   |   |
| Net income (loss)                                                                                |       | $                                    | 15,663     |   | $ | (2,018 | ) |
| Adjustments needed to reconcile net income (loss) to net cash provided  by (used in) operations: |       |                                 |       |   |   |
| Unrealized loss (gain) on derivatives                                                            |       | (43,820                              | )          | 5,605 |   |
| Gain on sale of oil and gas properties                                                           |       | (19,244                              | )          | — |   |
| Accretion of discount on asset retirement obligations                                            |       | 229                                  |       | 163 |   |
| Depletion and depreciation                                                                       |       | 4,172                                |       | 3,509 |   |
| Impairment of oil and gas properties                                                             |       | 25,914                               |       | — |   |
| Impairment of goodwill                                                                           |       | 685                                  |       | — |   |
| Stock-based compensation expense                                                                 |       | 2,421                                |       | 2,115 |   |
| Deferred income tax expense (benefit)                                                            |       | 10,257                               |       | (1,136 | ) |
| Amortization of debt issuance costs and prepaid expenses                                         |       | 1,073                                |       | 970 |   |
| Treasury stock                                                                                   |       | (126                                 | )          | — |   |
|                                                                                             |       |                                 |       |   |   |
| Changes in assets and liabilities relating to operations:                                        |       |                                 |       |   |   |
| Restricted cash                                                                                  |       | —                               |       | 6,000 |   |
| Accounts receivable                                                                              |       | 2,480                                |       | (59 | ) |
| Derivative assets                                                                                |       | 2,033                                |       | (291 | ) |
| Inventory and other current assets and liabilities                                               |       | (1,652                               | )          | (1,194 | ) |
| Accounts payable                                                                                 |       | (1,541                               | )          | (467 | ) |
| Accrued liabilities                                                                              |       | (3,288                               | )          | (216 | ) |
| Oil and gas sales payable                                                                        |       | (367                                 | )          | 257 |   |
| **Net cash provided by (used in) operations**                                                    | ** ** | **(5,111**                           | **)**      | **13,238** | ** ** |
|                                                                                             |       |                                 |       |   |   |
| **Cash flow from investing activities:**                                                         |       |                                 |       |   |   |
| Additions to oil and gas properties, fixed assets and other                                      |       | (47,439                              | )          | (66,899 | ) |
| Proceeds from sale of equipment used in oil and gas activities                                   |       | —                               |       | 3,000 |   |
| Proceeds from sale of oil and gas properties                                                     |       | 40,256                               |       | — |   |
| **Net cash used in investing activities**                                                        | ** ** | **(7,183**                           | **)**      | **(63,899** | **)** |
|                                                                                             |       |                                 |       |   |   |
| **Cash flow from financing activities:**                                                         |       |                                 |       |   |   |
| Repayments of long-term debt                                                                     |       | (73,500                              | )          | — |   |
| Borrowings of long-term debt                                                                     |       | 43,700                               |       | 22,000 |   |
| Payments for debt issuance costs                                                                 |       | (927                                 | )          | (487 | ) |
| Proceeds from issuance of common stock, net                                                      |       | 53,908                               |       | 29,094 |   |
| Repurchases of preferred stock                                                                   |       | (10,377                              | )          | — |   |
| Payment of preferred stock dividend                                                              |       | (954                                 | )          | (1,567 | ) |
| **Net cash provided by financing activities**                                                    | ** ** | **11,850**                           | ** ** | **49,040** | ** ** |
|                                                                                             |       |                                 |       |   |   |
| Net decrease in cash and cash equivalents                                                        |       | (444                                 | )          | (1,621 | ) |
| Cash and cash equivalents at beginning of period                                                 |       | 771                                  |       | 2,119 |   |
| **Cash and cash equivalents at end of period**                                                   | ** ** | **$**                                | **327**    | ** ** | **$** | **498** | ** ** |
|                                                                                             |       |                                 |       |   |   |
| **Supplemental disclosure of noncash transactions:**                                             |       |                                 |       |   |   |
| Payments of preferred stock dividend in kind                                                     |       | $                                    | 1,307      |   | $ | 1,599 |   |
| Preferred stock repurchased for less than carrying amount                                        |       | $                                    | 10,890     |   | $ | — |   |
| Common stock issued for preferred stock conversion                                               |       | $                                    | —     |   | $ | 4,575 |   |
|                                                                                             |       |                                 |       |   |   |
| **Supplemental disclosure of cash transactions:**                                                |       |                                 |       |   |   |
| Cash paid during the period for interest                                                         |       | $                                    | 1,273      |   | $ | 2,550 |   |
|                                                                                                  |            |                                      |            |  |  |  |  |  |  |

 

***See accompanyingnotes to these unaudited consolidated financial statements.***

 

5

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**CANO PETROLEUM, INC.**

**NOTES TO FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1.****             ****BASIS OF PRESENTATIONAND USE OF ESTIMATES**

 

The interim consolidated financial statements of CanoPetroleum, Inc. are unaudited and contain all adjustments necessary for afair statement of the results for the interim periods presented. Theadjustments consist primarily of normal recurring accruals and items unusual toour normal business activities related to litigation accruals and impairmentcharges. Results for interim periods are not necessarily indicative of resultsto be expected for a full year due in part, but not limited to, the volatilityin prices for crude oil and natural gas, future commodity prices for commodityderivatives, interest rates, estimates of reserves, drilling risks, geologicalrisks, transportation restrictions, the timing of acquisitions, product demand,market competition, interruption in production, our ability to obtainadditional capital, and the success of waterflooding and enhanced oil recoverytechniques. These consolidated interim financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto included in our Form 10-K for the year ended June 30, 2008.

 

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 value atwhich oil and natural gas properties are recorded. The computation ofstock-based compensation expense requires assumptions such as volatility,expected life and the risk-free interest rate.  The computation of themark-to-market valuation of our commodity derivatives includes the observabilityof quoted market prices and an assessment of potential non-performance of thecounterparties. It is at least reasonably possible these estimates could berevised in the near term, and these revisions could be material.

 

***New AccountingPronouncements***

 

In December 2007,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 141 (revised 2007), *Business Combinations* (“SFAS No. 141R”).Among other things, SFAS No. 141R establishes principles and requirementsfor how the acquirer in a business combination (i) recognizes and measuresin its financial statements the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquired business, (ii) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase, and (iii) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. SFAS No. 141R is effective for fiscalyears beginning on or after December 15, 2008, with early adoptionprohibited. We will adopt SFAS No. 141R on July 1, 2009. Thisstandard will change our accounting treatment for prospective businesscombinations.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements, an Amendment of ARB No. 51* (“SFAS No. 160”).SFAS No. 160 establishes accounting and reporting standards fornoncontrolling interests in a subsidiary and for the deconsolidation of asubsidiary. Minority interests will be recharacterized as noncontrollinginterests and classified as a component of equity. It also establishes a singlemethod of accounting for changes in a parent’s ownership interest in a subsidiaryand requires expanded disclosures. This statement is effective for fiscal yearsbeginning on or after December 15, 2008, with early adoption prohibited.We will adopt SFAS No. 160 on July 1, 2009. We do not expect theadoption of this statement will have a material impact on our financialposition, results of operations or cash flows.

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities—An Amendment of FASB Statement 133* (“SFAS No. 161”).SFAS No. 161 amends and expands SFAS No. 133 to expand requireddisclosures to discuss the uses of derivative instruments; the accounting forderivative instruments and related hedged items under SFAS No. 133; andhow derivative instruments and 

 

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related hedged items affect the company’s financialposition, financial performance and cash flows. We will adopt SFAS No. 161on July 1, 2009. We do not expect the adoption of this statement to have amaterial impact on our financial position, results of operations or cash flows.

 

In December 2008, the FASB issued EITF****07-5, *Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock* (“EITF 07-5”). EITF 07-5 affects companies that have provisions in their securities purchaseagreements (for warrants and convertible instruments) that resetissuance/conversion prices based upon new issuances by companies at pricesbelow the exercise price of said instrument.  Warrants and convertibleinstruments with such provisions will require the embedded derivativeinstrument to be bifurcated and separately accounted for as a derivative underSFAS No. 133.  Subject to certain exceptions, our Series Dconvertible preferred stock provides for resetting the conversion price if weissue new common stock below $5.75 per share.  We will adopt EITF 07-5 on July 1,2009.We are evaluating the effect of EITF 07-5 on our financial position andresults of operations; however, there should be no effect on cash flows.

 

In June 2008, the FASB issued EITF 03-6-1*, Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities*(“FSP 03-6-1”). FSP 03-6-1 addresseswhether instruments granted in share-based payment transactions are participatingsecurities prior to vesting and need to be included in the calculation ofearnings per share under the two-class method described in SFAS No. 128, *Earnings per Share.* Under FSP 03-6-1,share-based payment awards that contain nonforfeitable rights to dividends are “participatingsecurities” as defined by EITF 03-6, *Participating Securitiesand the Two-Class Method under FASB Statement No. 128*, andtherefore should be included in computing earnings per share using thetwo-class method. FSP 03-6-1 is effective for financial statements issued forfiscal years and interim periods beginning after December 15, 2008. Wewill adopt FSP 03-6-1 on July 1, 2009. The effect of adopting FSP 03-6-1will increase the number of shares used to compute earnings per share; however,we do not expect the adoption of FSP 03-6-1 to have a material impact on ourfinancial position, results of operations or cash flows.

 

**2.****             ****DISCONTINUED OPERATIONS**

 

On October 1, 2008, we completed the sale of ourwholly-owned subsidiary, Pantwist, LLC, for a net purchase price of $40.0million consisting of a $42.7 million purchase price adjusted for $2.1 millionof net cash received from discontinued operating income during the three monthsended September 30, 2008 and $0.6 million of advisory fees.  The salehad an effective date of July 1, 2008.  At October 1, 2008, werecorded a pre-tax gain associated with the sale, exclusive of discontinuedoperating income, of approximately $19.2 million ($12.2 million after-tax). Allcurrent tax liabilities associated with such gain were offset by existing netoperating losses. We used the entire $42.1 million net cash proceeds receivedfrom the transaction and cash on hand to pay down amounts outstanding under oursenior credit agreement on October 1, 2008.

 

On December 2, 2008, we sold our interests in ourCorsicana oil and gas properties (“Corsicana Properties”) for $0.3million.  In the quarter ended September 30, 2008, we recorded a $3.5million ($2.3 million after-tax) impairment at Corsicana, as we determined thatwe would not be developing its proved undeveloped reserves within the next fiveyears, and reserves that are not going to be developed in the next five yearscannot be included as proved undeveloped reserves.

 

The operating results of Pantwist, LLC and theCorsicana Properties for the three and nine months ended March 31, 2009and 2008 have been reclassified as discontinued operations in the consolidatedstatements of operations as detailed in the table below.

 

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| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| **In Thousands**                                 | ** ** | **2009**                         | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
| Operating Revenues:                                   |       |                             |       |                            |       |   |   |   |   |
| Crude oil sales                                       |       | $                                | —     |                            | $          | 1,113 |   | $ | 1,321 |   | $ | 3,071 |   |
| Natural gas sales                                     |       | 61                               |       | 1,370                           |       | 1,757 |   | 3,870 |   |
| Total operating revenues                              |       | 61                               |       | 2,483                           |       | 3,078 |   | 6,941 |   |
| Operating Expenses:                                   |       |                             |       |                            |       |   |   |   |   |
| Lease operating                                       |       | 4                                |       | 573                             |       | 642 |   | 1,630 |   |
| Production and ad valorem taxes                       |       | —                           |       | 168                             |       | 197 |   | 641 |   |
| General and administrative                            |       | —                           |       | 20                              |       | — |   | 25 |   |
| Impairment of long-lived assets                       |       | —                           |       | —                          |       | 3,516 |   | — |   |
| Depletion and depreciation                            |       | —                           |       | 253                             |       | 15 |   | 788 |   |
| Accretion of discount on asset retirement obligations |       | —                           |       | 4                               |       | 3 |   | 11 |   |
| Interest expense, net                                 |       | —                           |       | 27                              |       | 34 |   | 145 |   |
| Total operating expenses                              |       | 4                                |       | 1,045                           |       | 4,407 |   | 3,240 |   |
| Gain (loss) on sale of properties                     |       | (65                              | )          | —                          |       | 19,244 |   | (76 | ) |
| Income (loss) before income taxes                     |       | (8                               | )          | 1,438                           |       | 17,915 |   | 3,625 |   |
| Income tax provision                                  |       | 2                                |       | (518                            | )          | (6,527 | ) | (1,305 | ) |
| Income (loss) from discontinued operations            |       | $                                | (6         | )                               | $          | 920 |   | $ | 11,388 |   | $ | 2,320 |   |

 

At June 30, 2008, on our consolidated balance sheet,the assets of Pantwist, LLC and assets relating to the Corsicana Properties areclassified as assets held for sale and the liabilities are classified asliabilities associated with discontinued operations.

 

**3.****             ****COMMON STOCK ISSUANCE**

 

On July 1, 2008, we completed the sale of7,000,000 shares of our common stock through an underwritten offering at ashare price of $8.00 per share ($7.75 net to us) resulting in net proceeds ofapproximately $53.9 million after underwriting discounts, commissions andexpenses. We used the net proceeds from the offering to pay down debt which wassubsequently drawn in order to finance (i) development activities and (ii) generalcorporate purposes.

 

**4.****             ****LONG-TERM DEBT**

 

At March 31, 2009 and June 30, 2008, theoutstanding amount due under our credit agreements was $43.7 million and$73.5 million, respectively.  The $43.7 million consisted of outstandingborrowings under the senior and subordinated credit agreements of $28.7 millionand $15.0 million, respectively.  At March 31,2009, the average interest rates under the senior and subordinated creditagreements were 3.20% and 7.32%, respectively.

 

Our long-term debt consists of our senior creditfacility (current borrowing base of $60.0 million) and our subordinated creditagreement ($15.0 million availability), which are discussed in greater detailbelow.

 

*Senior Credit Agreement*

 

On December 17, 2008, we finalized a new $120.0million Amended and Restated Credit Agreement (“ARCA”) with Union Bank of NorthAmerica, N.A. (“UBNA”, f/k/a Union Bank of California, N.A.) and Natixis. UBNAis the Administrative Agent and Issuing Lender of the ARCA.  The initialand current borrowing base, based upon our proved reserves, is $60.0million.  Pursuant to the terms of the ARCA, the borrowing base is to beredetermined based upon our reserves at May 1, 2009 and again at June 30,2009.  Thereafter, there will be a scheduled redetermination every sixmonths with one interim, additional redetermination allowed during any sixmonth period between scheduled redeterminations.

 

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At our option, interest is either (i) the sum of (a) theUBNA reference rate and (b)  the applicable margin of (1) 0.875% ifless than 50% of the borrowing base is borrowed, (2) 1.125% if at least50% but less than 75% of the borrowing base is borrowed, (3) 1.375% if atleast 75% but less than 90% of the borrowing base is borrowed or (4) 1.625%if at least 90% of the borrowing base is borrowed; or (ii) the sum of (a) theone, two, three, six, nine or twelve month LIBOR rate (at our option) and (b) theapplicable margin of (1) 2.0% if less than 50% of the borrowing base isborrowed, (2) 2.25% if at least 50% but less than 75% of the borrowingbase is borrowed, (3) 2.50% if at least 75% but less than 90% of theborrowing base is borrowed or (4) 2.75% if at least 90% of the borrowingbase is borrowed.  We owe a commitment fee on the unborrowed portion ofthe borrowing base of 0.375% per annum if less than 90% of the borrowing base isborrowed and 0.50% per annum if at least 90% of the borrowing base is borrowed.

 

Unless specific events of default occur, the maturitydate of the ARCA is December 17, 2012.  Specific events of defaultwhich could cause all outstanding principal and accrued interest to beaccelerated, include, but are not limited to, payment defaults, materialbreaches of representations and warranties, breaches of covenants, certaincross-defaults, insolvency, a change in control or a material adverse change.

 

The ARCA contains certain negative covenantsincluding, subject to certain exceptions, covenants against the following: (i) incurringadditional liens, (ii) incurring additional debt or issuing additionalequity interests other than common equity interests; (iii) merging orconsolidating or selling, leasing, transferring, assigning, farming-out,conveying or otherwise disposing of any property, (iv) making certainpayments, including cash dividends to our common stockholders, (v) makingany loans, advances or capital contributions to, or making any investment in,or purchasing or committing to purchase any stock or other securities orevidences of indebtedness or interest in any person or oil and gas propertiesor activities related to oil and gas properties unless (a) with regard tonew oil and gas properties, such properties are mortgaged to UBNA, asadministrative agent, or (b) with regard to new subsidiaries, suchsubsidiaries execute a guaranty, pledge agreement, security agreement ormortgage in favor of UBNA, as administrative agent, and (vi) entering intoaffiliate transactions on terms that are not at least as favorable to us ascomparable arm’s length transactions.

 

We must meet certain financial ratios.  The ratioof current assets to current liabilities must not be less than 1.00 to 1.00 foreach fiscal quarter.  Current assets include unused borrowing base underthe ARCA and the availability under the Subordinated Credit Agreement (asdefined below).  Current liabilities exclude current portions of debt otherthan any current debt relating to the Series D Convertible Preferred Stockand liabilities for asset retirement obligations.  Current assets andcurrent liabilities exclude derivative assets and liabilities.  The ratioof consolidated debt to consolidated EBITDA for the trailing four fiscalquarter period then ended must not be greater than 4.00 to 1.00.  For thepurposes of this ratio, debt does not include the amounts of our Series DConvertible Preferred Stock.  The ratio of consolidated EBITDA for theprevious four fiscal quarters to consolidated interest expense for the previousfour fiscal quarters must not be less than 3.00 to 1.00.  Through thequarter ending September 30, 2009, for both ratios, EBITDA includes thenet gain on the sale of Pantwist LLC. At March 31, 2009, we were incompliance with the ARCA debt covenants.

 

*Subordinated Credit Agreement*

 

On September 30, 2008, we paid off the entireoutstanding $15.0 million principal due under the then existing subordinatedcredit agreement, interest expense and a prepayment premium of $0.3million.  In conjunction with the payoff, we terminated that subordinatedcredit agreement.

 

On December 17, 2008, we finalized a new $25.0million Subordinated Credit Agreement among Cano, the lenders and UnionBanCalEquities, Inc (“UBE”) as Administrative Agent (the “Subordinated CreditAgreement”).  On March 17, 2009, we borrowed the maximum availableamount of $15.0 million under this agreement and paid down outstanding seniordebt under the ARCA.  An additional $10.0million could be made available at the lenders’ sole discretion.

 

The interest rate is the sum of (a) the one, two,three, six, nine or twelve month LIBOR rate (at our option) and (b) 6.0%. Through March 17, 2009, we owed a commitment fee of 1.0% on the unborrowedportion of the available borrowing amount.  As of March 17, 2009, weno longer have a commitment fee since we borrowed the full $15.0 millionavailable amount.

 

Unless specific events of default occur, the maturitydate is June 17, 2013.  Specific events of default which could causeall outstanding principal and accrued interest to be accelerated, include, butare not limited to, 

 

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paymentdefaults, material breaches of representations and warranties, breaches ofcovenants, certain cross-defaults, insolvency, a change in control or amaterial adverse change.

 

The Subordinated Credit Agreement contains certainnegative covenants including, subject to certain exceptions, covenants againstthe following: (i) incurring additional liens, (ii) incurringadditional debt or issuing additional equity interests other than common equityinterests of Cano; (iii) merging or consolidating or selling, leasing,transferring, assigning, farming-out, conveying or otherwise disposing of anyproperty, (iv) making certain payments, including cash dividends to ourcommon stockholders, (v) making any loans, advances or capitalcontributions to, or making any investment in, or purchasing or committing topurchase any stock or other securities or evidences of indebtedness or interestin any person or oil and gas properties or activities related to oil and gasproperties unless (a) with regard to new oil and gas properties, suchproperties are mortgaged to UBE, as administrative agent, or (b) withregard to new subsidiaries, such subsidiaries execute a guaranty, pledgeagreement, security agreement or mortgage in favor of UBE, as administrativeagent, and (vi) entering into affiliate transactions on terms that are notat least as favorable to us as comparable arm’s length transactions.

 

We must meet certain financial ratios.  The ratioof current assets to current liabilities must not be less than 1.00 to 1.00 foreach fiscal quarter.  Current assets include the unused borrowing baseunder the ARCA and the availability under the Subordinated CreditAgreement.  Current liabilities exclude current portions of debt otherthan any current debt relating to the Series D Convertible Preferred Stockand liabilities for asset retirement obligations.  Current assets andcurrent liabilities exclude derivative assets and liabilities.  The ratioof consolidated debt to consolidated EBITDA for the trailing four fiscalquarter period then ended must not be greater than 4.50 to 1.00.  For thepurposes of this ratio, debt does not include the amounts of our Series DConvertible Preferred Stock.  The ratio of consolidated EBITDA for theprevious four fiscal quarters to consolidated interest expense for the previousfour fiscal quarters must not be less than 2.50 to 1.00.  Through thequarter ending September 30, 2009, for both ratios, EBITDA includes thenet gain on the sale of Pantwist LLC on October 1, 2008. The ratio oftotal present value to consolidated debt must not be less than 1.50 to1.00.  Total present value is the sum of 100% of the net present value,discounted at 10% per annum, of the future net revenues expected to accrue to (i) PDPreserves, (ii) PDNP reserves and (iii) PUD reserves, with the totalpresent value of PDP reserves being at least 60% of the aggregate total presentvalue.  At March 31, 2009, we werein compliance with the Subordinated Credit Agreement covenants.

 

**5.****             ****DERIVATIVES**

 

Our derivatives consist of commodity derivatives andan interest rate swap arrangement, which are discussed in greater detail below.

 

*Commodity Derivatives*

 

Pursuant to our senior and subordinated creditagreements discussed in Note 4, we are required to maintain our existingcommodity derivative contracts, all of which have UBNA as our counterparty. We have no obligation to enter into commodity derivative contracts in thefuture. Should we choose to enter into commodity derivative contracts tomitigate future price risk, we cannot enter into contracts for greater than 85%of our crude oil and natural gas production volumes attributable to provedproducing reserves.  As of March 31, 2009, we maintain the followingcommodity derivative contracts:

 
| **Time Period**   | ** ** | **Floor  Oil Price** | ** ** | **Ceiling  Oil Price** | ** ** | **Barrels  Per Day** | ** ** | **Floor  Gas Price** | ** ** | **Ceiling  Gas Price** | ** ** | **Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per Day** | ** ** |
|------------------------|------------|---------------------------|------------|-----------------------------|------------|---------------------------|------------|---------------------------|------------|-----------------------------|------------|-----------------------|------------|--------------------------------------------------------|------------|
| 4/1/09 - 12/31/09 |       | $                         | 80.00      |                        | $          | 110.90                    |       | 367                       |       | $                           | 7.75       |                  | $          | 10.60                                                  |       | 1,667 |   | 644 |   |
| 4/1/09 - 12/31/09 |       | $                         | 85.00      |                        | $          | 104.40                    |       | 233                       |       | $                           | 8.00       |                  | $          | 10.15                                                  |       | 1,133 |   | 422 |   |
| 1/1/10 - 12/31/10 |       | $                         | 80.00      |                        | $          | 108.20                    |       | 333                       |       | $                           | 7.75       |                  | $          | 9.85                                                   |       | 1,567 |   | 594 |   |
| 1/1/10 - 12/31/10 |       | $                         | 85.00      |                        | $          | 101.50                    |       | 233                       |       | $                           | 8.00       |                  | $          | 9.40                                                   |       | 1,033 |   | 406 |   |
| 1/1/11 - 3/31/11  |       | $                         | 80.00      |                        | $          | 107.30                    |       | 333                       |       | $                           | 7.75       |                  | $          | 11.60                                                  |       | 1,467 |   | 578 |   |
| 1/1/11 - 3/31/11  |       | $                         | 85.00      |                        | $          | 100.50                    |       | 200                       |       | $                           | 8.00       |                  | $          | 11.05                                                  |       | 967 |   | 361 |   |

 

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During October 2008, we sold certain uncovered “floorprice” commodity derivative contracts for the period July 2010 to December 2010for $0.6 million to our counterparty and realized a gain of $0.1 million. During November 2008, we sold all remaining uncovered “floor price”commodity derivative contracts for the period November 2008 through June 2010for $2.6 million to our counterparty and realized a gain of $0.6 million.

 

*Interest Rate Swap Agreement*

 

On January 12, 2009, we entered into a three-yearLIBOR interest rate basis swap contract with Natixis Financial Products, Inc.(“Natixis FPI”) for $20.0 million in notional exposure.  Under the termsof the transaction, we will pay Natixis FPI, in three-month intervals, a fixedrate of 1.73% and Natixis FPI will pay Cano the prevailing three-month LIBORrate.  We do not designate this interest rate swap contract as either acash flow or fair value hedge.

 

*Financial Statement Impact*

 

 During the three and nine months ended March 31,2009 and 2008, respectively, the gain (loss) on derivatives reported in ourconsolidated statements of operations is summarized as follows:

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| **In Thousands**                                            | ** ** | **2009**                         | ** ** | **2008**                        | ** ** | **2009** | ** ** | **2008** | ** ** |
| Settlements received / accrued                                   |       | $                                | 2,846      |                            | $          | 31 |   | $ | 4,558 |   | $ | 504 |   |
| Settlements received - sale of “floor price” contracts |       | —                           |       | —                          |       | 653 |   | — |   |
| Settlements paid / accrued                                       |       | —                           |       | (359                            | )          | (551 | ) | (573 | ) |
| Realized gain (loss) on commodity derivatives                    |       | 2,846                            |       | (328                            | )          | 4,660 |   | (69 | ) |
| Unrealized gain (loss) on commodity derivatives                  |       | 716                              |       | (3,243                          | )          | 43,896 |   | (5,605 | ) |
| Unrealized loss on interest rate swap                            |       | (76                              | )          | —                          |       | (76 | ) | — |   |
| Gain (loss) on commodity derivatives                             |       | $                                | 3,486      |                            | $          | (3,571 | ) | $ | 48,480 |   | $ | (5,674 | ) |

 

The realized gain (loss) on commodity derivativesconsists of actual cash settlements under our commodity derivatives during therespective periods.  The cash settlementsreceived/accrued by us were cumulative monthly payments due to us since theNYMEX natural gas and crude oil prices were lower than the “floor prices” setfor the respective time periods and realized gains from the sale of uncovered “floorprice” contracts as previously discussed. The cash settlements paid/accrued byus were cumulative monthly payments due to our counterparty since the NYMEXcrude oil and natural gas prices were higher than the “ceiling prices” set forthe respective time periods. The cash flows relating to the derivativeinstrument settlements that are due, but not cash settled are reflected inoperating activities on our consolidated statements of cash flows. At March 31,2009, we had recorded a $0.9 million receivable from our counterparty includedin accounts receivable on our consolidated balance sheet. At June 30,2008, we had recorded a $1.2 million payable to our counterparty included inaccounts payable on our consolidated balance sheet.

 

The unrealized gain (loss) on commodity derivativesrepresents estimated future settlements under our commodity derivatives and isbased on mark-to-market valuation based on assumptions of forward prices,volatility and the time value of money as discussed in Note 11. We compared ourvaluation to our counterparties’ independently derived valuation to furthervalidate our mark-to-market valuation. During the three months ended March 31,2009, we recognized an unrealized gain on commodity derivatives in ourconsolidated statements of operations amounting to $0.7 million ascompared to an unrealized loss on commodity derivatives of $3.2 million for thethree months ended March 31, 2008.  During the nine months ended March 31,2009, we recognized an unrealized gain on commodity derivatives in ourconsolidated statements of operations amounting to $43.9 million ascompared to an unrealized loss on commodity derivatives of $5.6 million for thenine months ended March 31, 2008.

 

The unrealized loss on interest rate swap representsestimated future settlements under our aforementioned interest rate swapagreement and is based on mark-to-market valuation based on assumptions of interestrates, volatility and the time value of money as discussed in Note 11. Wecompared our valuation to our 

 

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counterparties’independently derived valuation to further validate our mark-to-market valuation.During the three and nine months ended March 31, 2009, we recognized anunrealized loss on interest rate swaps in our consolidated statements ofoperations amounting to $0.1 million for each of the three and nine monthperiods.

 

As of March 31, 2009, we had aggregate derivativecommodity assets of $14.7 million and a net derivative liability for theinterest rate swap of $0.1 million.  These amounts are based on ourmark-to-market valuation of these derivatives at March 31, 2009 and maynot be indicative of actual future cash settlements.

 

**6.****             ****PREFERRED STOCKREPURCHASE**

 

During November and December 2008, werepurchased 22,948 shares of Series D Convertible Preferred Stock,including accrued dividends and 2,323 shares from paid-in kind (“PIK”)dividends for approximately $10.4 million.  At March 31, 2009,26,709 shares of Series D Convertible Preferred Stock remain outstanding(including 2,860 shares from PIK dividends).

 

**7.****             ****DEFERRED COMPENSATION**

 

As of March 31, 2009, we have 656,667 non-vestedrestricted shares outstanding to key employees pursuant to our 2005 Long-TermIncentive Plan, as summarized below:

 
| ** **                                          | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** | **Grant-Date  Fair Value** | ** ** |
|-----------------------------------------------------|------------|------------|------------|----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          |       |       |       |                                               |       | **$000s**                       |       |
| Non-vested restricted shares at June 30, 2008  |       | 1,005,000  |       | $                                                  | 6.80       |                            | $          | 6,833 |   |
| Shares vested                                       |       | (217,709   | )          | $                                                  | 6.13       |                            | $          | (1,334 | ) |
| Shares forfeited and surrendered                    |       | (130,624   | )          | $                                                  | 6.57       |                            | (858       | ) |
| Non-vested restricted shares at March 31, 2009 |       | 656,667    |       | $                                                  | 7.07       |                            | $          | 4,641 |   |

 

The restricted share grants vest based on future yearsof service ranging from one to three years depending on the life of theaward.  The grant-date fair value is based on our actual stock price onthe date of grant multiplied by the number of restricted shares granted. As of March 31, 2009, the fair value attributed to non-vested restrictedshares amounted to $4.6 million.  For the quarters ended March 31,2009 and 2008, we have recorded charges of $0.5 million and $0.4 million,respectively, to stock-based compensation expense based on amortizing the fairvalue of prior grants over their requisite service period.  For the ninemonths ended March 31, 2009 and 2008, we have recorded charges of $1.8million and $1.0 million, respectively, to stock-based compensation expense.The forfeitures, noted above, resulted from shares used to satisfy employees’tax withholding obligations related to the vesting of restricted shares, andthe retirement of a key employee, which resulted in the forfeiture ofnon-vested restricted shares.

 

**8.****             ****STOCK OPTIONS**

 

For the nine months ended March 31, 2009, wegranted 449,400 stock options to non-executive employees and 125,000 stockoptions to our directors under our 2005 Long-Term Incentive Plan.  Theoptions were granted with an exercise price equal to our market price at thedate of grant and expire after ten years.  These stock option awards vestanywhere from immediate vesting (for directors) to three years, based uponcontinuous service.  The factors used to calculate the fair value of theseoptions are summarized in the table below.

 
|  No. of options              |   | 574,400                    |   |
|----------------------------------------|--------|----------------------------|--------|
| Risk free interest rate                |   | 2.24 – 3.39 | %      |
| Expected life                          |   | 5 years               |   |
| Expected volatility                    |   | 55.8 – 72.7 | %      |
| Expected dividend yield                |   | 0                          | %      |
| Weighted average grant date fair value |   | $                          | 2.02   |   |
|                                        |        |                            |        |  |

 

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

 

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

 

| ** **                         | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------|------------|------------|------------|------------------------------------------------|------------|
| Outstanding at June 30, 2008  |       | 1,084,051  |       | $                                              | 5.71       |   |
| Options granted                    |       | 574,400    |       | $                                              | 1.88       |   |
| Options forfeited                  |       | (250,949   | )          | $                                              | 4.18       |   |
| Outstanding at March 31, 2009 |       | 1,407,502  |       | $                                              | 4.42       |   |

 

Based on our $0.43 stock price at March 31, 2009,there was no intrinsic value of the options outstanding and exercisable.

 

Total options exercisable at March 31, 2009amounted to 792,510 shares and had a weighted average exercise price of$4.73.  Upon exercise, we issue the full amount of shares exercisable perthe term of the options from new shares.

 

For the quarters ended March 31, 2009 and 2008,we recorded charges to stock-based compensation expense of $0.1 million foreach quarter representing the estimated fair value of the options granted toour directors and employees.  For each of the nine months ended March 31,2009 and 2008, we recorded charges to stock compensation expense of $0.6million and $1.1 million for the estimated fair value of the options granted toour directors and employees.

 

**9.****             ****NET INCOME (LOSS) PERCOMMON SHARE**

 

Basic net income (loss) per common share is computedby dividing the net income (loss) attributable to common stockholders by theweighted average number of shares of common stock outstanding less unvestedrestricted shares during the period.  Diluted net income (loss) per commonshare is computed in the same manner, but also considers the effect of commonstock shares underlying stock options, the Series D Convertible PreferredStock, PIK dividends and unvested restricted stock.

 

For the three months ended March 31, 2009, sharesof common stock underlying the following items summarized below were notincluded in the weighted average shares outstanding as their effects would havebeen anti-dilutive.

 
| Stock options                |   | 1,407,502 |   |
|------------------------------|--------|-----------|--------|
| Preferred stock              |   | 4,147,652 |   |
| PIK dividends                |   | 497,378   |   |
| Non-vested restricted shares |   | 656,667   |   |

 

The following table reconciles earnings and sharesused in the computation of basic and diluted earnings per share for the ninemonths ended March 31, 2009:

 
| ** **                                                       | ** ** | **Nine Months** | ** ** |
|------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                       | ** ** | ** **           | ** ** | ** ** | ** ** | **Earnings** | ** ** |
| **In thousands, except per share data** | ** ** | **Earnings**         | ** ** | **Shares** | ** ** | **per Share** | ** ** |
| Basic                                                            |       | $                    | 24,292     |   | 45,359 |   | $ | 0.54 |   |
|                                                             |       |                 |       |   |   |   |   |
| Effective of dilutive securities:                                |       |                 |       |   |   |   |   |
| Conversion of preferred stock and PIK dividends                  |       | 2,261                |       | 6,945 |   |   |   |
| Stock options                                                    |       | —               |       | 215 |   |   |   |
| Diluted                                                          |       | $                    | 26,553     |   | 52,519 |   | $ | 0.51 |   |

 

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As of March 31, 2009, weighted average non-vestedrestricted shares of 656,667 are not included in the weighted average sharesoutstanding for the nine months ended March 31 2009 as their effects wouldhave been anti-dilutive.  As discussed inNote 1, FSP 03-6-1, which becomes effective for us on July 1, 2009,specifies these non-vested restricted shares should be included in basic anddiluted earnings per share calculations.

 

As of March 31, 2008, shares of common stockunderlying the following items summarized below were not included in theweighted average shares outstanding for the three and nine months ended March 31,2008 as their effects would have been anti-dilutive.

 
| Stock options                |   | 1,120,754 |   |
|------------------------------|--------|-----------|--------|
| Preferred stock              |   | 7,746,261 |   |
| PIK dividends                |   | 581,879   |   |
| Non-vested restricted shares |   | 465,000   |   |

 

**10.****      ****RELATED PARTY TRANSACTIONS**

 

Pursuant to an agreement dated December 16, 2004,as amended, we agreed with R.C. Boyd Enterprises, a Delaware corporation, tobecome the lead sponsor of a television production called Honey Hole (“HoneyHole Production”). As part of our sponsorship, we provided fishing and outdooropportunities for children with cancer, children from abusive family situationsand children of military veterans. We were entitled to receive twothirty-second commercials during all broadcasts of the Honey Hole Productionand received opening and closing credits on each episode.  Randall Boyd is the sole shareholder of R.C.Boyd Enterprises and is a member of our Board of Directors. Pursuant to anagreement dated as of December 5, 2007, as of December 31, 2008, weare no longer a Honey Hole Production sponsor. We paid no money to R.C. Boyd Enterprises for the three months ended March 31,2009 and we paid $37,500 for the three months ended March 31, 2008. For the nine months ended March 31, 2009 we paid $75,000 and for the ninemonths ended March 31, 2008, we paid $102,500.

 

**11.****      ****FAIR VALUE MEASUREMENTS**

 

SFAS No. 157, *FairValue Measurements*, was issued by the FASB in September 2006.SFAS No. 157 defines fair value, establishes a framework for measuringfair value under GAAP and expands disclosures about fair value measurements.SFAS No. 157 applies to other accounting pronouncements that require orpermit fair value measurement. We adopted SFAS No. 157 on July 1,2008.  The initial adoption of SFAS 157 had no material impact to ourfinancial position, results of operations or cash flows.

 

Fair value is the price that would be received to sellan asset or the amount paid to transfer a liability in an orderly transactionbetween market participants (an exit price) at the measurement date. Fair valueis a market based measurement considered from the perspective of a marketparticipant. We use market data or assumptions that market participants woulduse in pricing the asset or liability, including assumptions about risk and therisks inherent in the inputs to the valuation. These inputs can be readilyobservable, market corroborated, or unobservable. If observable prices orinputs are not available, unobservable prices or inputs are used to estimatethe current fair value, often using an internal valuation model. Thesevaluation techniques involve some level of management estimation and judgment,the degree of which is dependent on the item being valued.  We primarilyapply a market approach for recurring fair value measurements using the bestavailable information while utilizing valuation techniques that maximize theuse of observable inputs and minimize the use of unobservable inputs.  Ourvaluation includes the effect of potential non-performance by thecounterparties.

 

Beginning July 1, 2008, assets and liabilitiesrecorded at fair value are categorized based upon the level of judgmentassociated with the inputs used to measure their fair value.  SFAS 157establishes a fair value hierarchy that prioritizes the inputs used to measurefair value. The hierarchy gives the highest priority to quoted prices in activemarkets for identical assets or liabilities (Level 1 measurement) and thelowest priority to unobservable inputs (Level 3 measurement). We classify fairvalue balances based on the observability of those inputs. The three levels ofthe fair value hierarchy are as follows:

 

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Level1—Quoted prices in active markets for identical assets or liabilities that wehave the ability to access. Active markets are those in which transactions forthe asset or liability occur in sufficient frequency and volume to providepricing information on an ongoing basis.

 

Level2—Inputs are other than quoted prices in active markets included in Level 1,which are either directly or indirectly observable. These inputs are eitherdirectly observable in the marketplace or indirectly observable throughcorroboration with market data for substantially the full contractual term ofthe asset or liability being measured.

 

Level3—Inputs reflect management’s best estimate of what market participants woulduse in pricing the asset or liability at the measurement date. Consideration isgiven to the risk inherent in the valuation technique and the risk inherent inthe inputs to the model.

 

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

 

The fair value of our commodity derivative contractsand interest rate swap are measured using Level 2 inputs based on thehierarchies previously discussed.

 

Our asset retirement obligation is measured usingprimarily Level 3 inputs. The significant unobservable inputs to this fairvalue measurement include estimates of plugging, abandonment and remediationcosts, inflation rate and well life. The inputs are calculated based onhistorical data as well as current estimated costs.

 

The estimated fair values of derivatives included inthe consolidated balance sheet at March 31, 2009 are summarized below.

 

| **In thousands**                                  | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|------------|------------|
| Derivative assets (Level 2):                           |       |       |       |
| Crude oil collars and price floors — current      |       | $          | 5,843      |   |
| Crude oil collars and price floors — noncurrent   |       | 4,124      |       |
| Natural gas collars and price floors — current    |       | 2,933      |       |
| Natural gas collars and price floors — noncurrent |       | 1,782      |       |
| Interest rate swap — noncurrent                   |       | 7          |       |
| Derivative liability (Level 2)                         |       |       |       |
| Interest rate swap — current                      |       | (84        | )          |
| Net derivative assets (Level 2)                        |       | $          | 14,605     |   |
| Asset retirement obligation (Level 3)                  |       | $          | (3,412     | ) |

 

At September 30, 2008, our net derivativeliability was classified as Level 3 due to the subjectivity of our valuationfor the effect of our own credit risk.  Since we have derivative assets atMarch 31, 2009, we no longer have a subjective valuation of our own creditrisk.  Therefore, we have reclassified our derivative assets as Level 2 atMarch 31, 2009.  The following is areconciliation of Level 3 measurements for the nine months ended March 31,2009.

 
| ** **  | ** ** | ** **             | ** ** | ** **          | ** ** | **Purchases,**   | ** ** | ** **       | ** ** | ** **  | ** ** | ** **                   | ** ** |
|-------------|------------|------------------------|------------|---------------------|------------|------------------|------------|------------------|------------|-------------|------------|------------------------------|------------|
| ** **  | ** ** | **Unrealized Losses**  | ** ** | ** **          | ** ** | **Sales,**       | ** ** | ** **       | ** ** | ** **  | ** ** | **Unrealized Gains**    | ** ** |
| ** **  | ** ** | **For Level 3**        | ** ** | ** **          | ** ** | **Issuances,**   | ** ** | ** **       | ** ** | ** **  | ** ** | **for Level 3**    | ** ** |
| ** **  | ** ** | **Assets/Liabilities** | ** ** | **Total**           | ** ** | **and**          | ** ** | **Transfers**    | ** ** | ** **  | ** ** | **Assets/Liabilities**       | ** ** |
| ** **  | ** ** | **Outstanding at**     | ** ** | **Gains or**   | ** ** | **Settlements,** | ** ** | **out of**  | ** ** | **Ending**  | ** ** | **Outstanding at**      | ** ** |
| ** **  | ** ** | **June 30, 2008** | ** ** | **Losses (a)** | ** ** | **net**          | ** ** | **Level 3** | ** ** | **balance** | ** ** | **March 31, 2009** | ** ** |
| Derivatives |       | $                      | (2,152     | )                   | $          | 17,565           |       | $                | (1,282     | )           | $          | (14,131                      | )          | $ | — |   | $ | — |   |
|             |            |                        |            |                     |            |                  |            |                  |            |             |            |                              |            |  |  |  |  |  |  |

 

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(a):       Total realized and unrealized gains areincluded in gain (loss) on commodity derivatives in the consolidated statementsof operations.

 

The following table shows the reconciliation ofchanges in the fair value of the net derivative assets and asset retirementobligation classified as Level 2 and 3, respectively, in the fair valuehierarchy for the nine months ended March 31, 2009.

 
| ** **                                | ** ** | **Total Net**  | ** ** | **Asset**      | ** ** |
|-------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                | ** ** | **Derivative** | ** ** | **Retirement** | ** ** |
| **In thousands**                     | ** ** | **Assets**     | ** ** | **Obligation** | ** ** |
| Balance at June 30, 2008             |       | $              | (26,243    | )              | $          | 3,403 |   |
| Unrealized gain on derivatives            |       | 43,819         |       | —         |       |
| Sale of “price floor” contracts |       | (1,169         | )          | —         |       |
| Settlements, net                          |       | (1,802         | )          | —         |       |
| Accretion of discount                     |       | —         |       | 226            |       |
| Sale of Pantwist, LLC (Note 2)            |       | —         |       | (90            | )          |
| Sale of Corsicana Properties (Note 2)     |       | —         |       | (102           | )          |
| Liabilities settled                       |       | —         |       | (25            | )          |
| Balance at March 31, 2009            |       | $              | 14,605     |           | $          | 3,412 |   |

 

The change from net derivative liabilities of $26.2million at June 30, 2008 to net derivative assets of $14.6 million at March 31,2009 is attributable to the steep decline in crude oil and natural gas prices.

 

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

 

In light of current commodity prices, we believe thereis uncertainty in the likelihood of our developing proved undeveloped reservesassociated with our Barnett Shale natural gas properties (“Barnett Shale Properties”)within the next five years.  Accordingly, during the quarter ended December 31,2008, we recorded a $22.4 million pre-tax impairment to our Barnett ShaleProperties and a $0.7 million pre-tax impairment to the Goodwill associatedwith our subsidiary which holds the equity in our Barnett Shale Properties.

 

During the quarter ended September 30, 2008, werecorded a $3.5 million pre-tax impairment on our Corsicana Properties as itbecame unlikely that we would develop this asset within the next five years. During the quarter ended December 31, 2008, this $3.5 million charge wasreclassified as part of income from discontinued operations as shown on ourconsolidated statements of operations.  As discussed in Note 2, on December 2,2008, we sold our interest in the Corsicana Properties for $0.3 million.

 

The fair values for our Barnett Shale and CorsicanaProperties were determined using estimates of future net cash flows, discountedto a present value, which is considered “Level 3” inputs as discussed in Note11.

 

**13.****      ****COMMITMENTS AND CONTINGENCIES**

 

***Burnett Case***

 

On March 23, 2006, the following lawsuit wasfiled in the 100th Judicial District Court in Carson County, Texas; Cause No. 9840,The Tom L. and Anne Burnett Trust, by Anne Burnett Windfohr, Windi Phillips,Ben Fortson, Jr., George Beggs, III and Ed Hudson, Jr. asCo-Trustees; Anne Burnett Windfohr; and Burnett Ranches, Ltd. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd, and WO Energy, Inc. (“Burnett”).The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and natural gas operations starteda wildfire that began on March 12, 2006 in Carson County, Texas.

 

The plaintiffs (i) allege negligence and gross negligenceand (ii) seek damages, including, but not limited to, damages for damageto their land and livestock, certain expenses related to fighting the fire andcertain remedial expenses totaling approximately $1.7 million to$1.8 million. In addition, the plaintiffs seek (i) termination ofcertain oil and natural gas leases, (ii) reimbursement for their attorney’sfees (in the amount of at least $549,000) and (iii) exemplary damages. Theplaintiffs also claim that Cano and its subsidiaries are 

 

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jointlyand severally liable as a single business enterprise and/or a generalpartnership or de facto partnership. The owner of the remainder of the mineralestate, Texas Christian University, intervened in the suit on August 18,2006, joining Plaintiffs’ request to terminate certain oil and gasleases.  On June 21, 2007, the Judge of the 100th Judicial District Court issued aFinal Judgment (a) granting motions for summary judgment in favor of Canoand certain of its subsidiaries on plaintiffs’ claims for (i) breach ofcontract/termination of an oil and gas lease; and (ii) negligence; and (b) grantingthe plaintiffs’ no-evidence motion for summary judgment on contributorynegligence, assumption of risk, repudiation and estoppel affirmative defensesasserted by Cano and certain of its subsidiaries.

 

The Final Judgment was appealed and a decision wasreached on March 11, 2009, as the Court of Appeals for the Tenth Districtof Texas in Amarillo affirmed in part and reversed in part the ruling of the100th Judicial District Court. The Court of Appeals (a) affirmed the trialcourt’s granting of summary judgment in Cano’s favor for breach ofcontract/termination of an oil and gas lease and (b) reversed the trialcourt’s granting of summary judgment in Cano’s favor on plaintiffs’ claims ofCano’s negligence.  The Court of Appealsordered the case remanded to the 100th Judicial District Court.  On March 30, 2009, the plaintiffs fileda motion for rehearing with the Court of Appeals and requested a rehearing onthe affirmance of the trial court’s holding on the plaintiffs’ breach ofcontract/termination of an oil and gas lease claim.  The motion for rehearing remains pending.

 

Due to the inherent risk of litigation, the ultimateoutcome of this case is uncertain and unpredictable.  At this time, Canomanagement continues to believe that this lawsuit is without merit and willcontinue to vigorously defend itself and its subsidiaries, while seekingcost-effective solutions to resolve this lawsuit..  We have not yet determined whether to seekfurther review by the Court of Appeals or the Texas Supreme Court.  Based on our knowledge and judgment of thefacts as of March 31, 2009, we believe our financial statements presentfairly the effect of actual and anticipated ultimate costs to resolve thesematters as of March 31, 2009.

 

***Settled Cases***

 

On April 28, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas: Cause No. 1922,Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W. O. Operating Company, Ltd. andWO Energy, Inc. (“Adcock”). The plaintiffs claimed that theelectrical wiring and equipment of Cano or certain of its subsidiaries relatingto oil and gas operations started a wildfire that began on March 12, 2006in Carson County, Texas. The plaintiffs (i) alleged negligence, res ipsaloquitor, trespass and nuisance and (ii) sought damages, including, butnot limited to, damages to their land, buildings and livestock and certainremedial expenses totaling $5,439,958. In addition, the plaintiffs sought (i) reimbursementfor their attorney’s fees and (ii) exemplary damages. The plaintiffs alsoclaimed that Cano and its subsidiaries were jointly and severally liable as asingle business enterprise and/or a general partnership or de factopartnership. The claims of all plaintiffs in this suit were resolved through aSettlement and Release Agreement effective November 5, 2008 and weredismissed with prejudice.

 

On July 6, 2006, Anna McMordie Henry and JoniMcMordie Middleton intervened in the Adcock case. The intervenors (i) allegednegligence and (ii) sought damages totaling $64,357 as well as exemplarydamages. The claims of these intervenors were resolved through a Settlement andRelease Agreement effective December 9, 2008 and were dismissed withprejudice.

 

On July 20, 2006, Abraham Brothers, LP,Edward C. Abraham, Salem A. and Ruth Ann Abraham and Jason M.Abraham intervened in the Adcock case. The intervenors (i) allegednegligence, nuisance, and trespass and (ii) sought damages, including, butnot limited to, damages to their land, buildings and livestock and certainremedial expenses totaling $3,252,862. In addition, the intervenors sought (i) reimbursementfor their attorney’s fees and (ii) exemplary damages. The intervenors alsoclaimed that Cano and its subsidiaries were jointly and severally liable as asingle business enterprise and/or a general partnership or de factopartnership. The claims of Abraham Brothers, LP, Edward C. Abraham, SalemA. and Ruth Ann Abraham and Jason M. Abraham (along with those asserted byAbraham Equine, Inc. discussed below) were resolved through a SettlementAgreement and Release effective October 12, 2008 and were dismissed withprejudice.

 

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On August 9, 2006, Riley Middleton intervened inthe Adcock case. The intervenor (i) alleged negligence and (ii) soughtdamages totaling $233,386 as well as exemplary damages. The claims of thisintervenor were resolved through a Settlement and Release Agreement effective December 9,2008 and were dismissed with prejudice.

 

On April 10, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas, Cause No. 1920,Joseph Craig Hutchison and Judy Hutchison v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd, and WO Energy, Inc. (“Hutchinson”). The plaintiffsclaimed that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and gas operations started a wildfire that beganon March 12, 2006 in Carson County, Texas. The plaintiffs (i) allegednegligence and trespass and (ii) sought damages of $621,058, including,but not limited to, damages to their land and certain remedial expenses. Inaddition, the plaintiffs sought exemplary damages. The claims of all plaintiffswere resolved through a Settlement and Release Agreement effective December 9,2008 and were dismissed with prejudice.

 

On May 1, 2006, the following lawsuit was filedin the 31st Judicial District Court of Roberts County, Texas: Cause No. 1923,Chisum Family Partnership, Ltd. v. Cano, W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. (“Chisum”).The plaintiff claimed that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiff (i) alleged negligence and trespass and (ii) sought damagesof $53,738.82, including, but not limited to, damages to their land and certainremedial expenses. In addition, the plaintiffs sought exemplary damages. Theclaims of all plaintiffs and intervenor were resolved through a Settlement andRelease Agreement effective December 9, 2008 and were dismissed withprejudice.

 

On August 9, 2006, the following lawsuit wasfiled in the 233rd Judicial District Court of Gray County, Texas, Cause No. 34,423,Yolanda Villarreal, Individually and on behalf of the Estate of GerardoVillarreal v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd., and WO Energy, Inc. (“Villarreal”).The plaintiffs claimed that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) alleged negligence and (ii) sought damages for pastand future financial support in the amount of $586,334, in addition toundisclosed damages for wrongful death and survival damages, as well asexemplary damages, for the wrongful death of Gerardo Villarreal who theyclaimed died as a result of the fire. The plaintiffs also claimed that Cano andits subsidiaries were jointly and severally liable under vicarious liabilitytheories. On August 22, 2006, relatives of Roberto Chavira intervened inthe case alleging similar claims and sought damages for lost economic supportand lost household services in the amount of $894,078, in addition toundisclosed damages for wrongful death and survival damages, as well asexemplary damages regarding the death of Roberto Chavira. The claims of allplaintiffs and intervenors were resolved through Settlement and ReleaseAgreements effective December 8, 2008 and were dismissed with prejudice.

 

On March 14, 2007, the following lawsuit wasfiled in 100th Judicial District Court in Carson County, Texas; Cause No. 9994,Southwestern Public Service Company d/b/a Xcel Energy v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd, and WO Energy, Inc. (“SPS”). The plaintiff claimed thatthe electrical wiring and equipment of Cano or certain of its subsidiariesrelating to oil and gas operations started a wildfire that began on March 12,2006 in Carson County, Texas. The plaintiff (i) alleged negligence andbreach of contract and (ii) sought $1,876,000 in damages for loss anddamage to transmission and distribution equipment, utility poles, lines andother equipment. In addition, the plaintiff sought reimbursement of itsattorney’s fees. The claims of plaintiff were resolved through a Settlement andRelease Agreement effective January 8, 2009 and were dismissed withprejudice.

 

On May 2, 2007, the following lawsuit was filed inthe 84th JudicialDistrict Court of Hutchinson County, Texas, Cause No. 37,619, Gary andGenia Burgess, et al. v. Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc.(“Burgess”). Eleven plaintiffs claimed that electrical wiring and equipmentrelating to oil and gas operations of the Company or certain of itssubsidiaries started a wildfire that began on March 12, 2006 in CarsonCounty, Texas. Five of the plaintiffs were former plaintiffs in the Adcockmatter. The plaintiffs (i) alleged negligence, res ipsa loquitor,nuisance, and trespass and (ii) sought damages, including, but not limitedto, damages to their land, buildings and livestock and certain remedial 

 

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expensestotaling approximately $1,997,217.86. In addition, the plaintiffs sought (i) reimbursementfor their attorney’s fees and (ii) exemplary damages. The plaintiffs alsoclaimed that Cano and its subsidiaries were jointly and severally liable as asingle business enterprise and/or as a partnership or de facto partnership. Theclaims of all plaintiffs were resolved through a Settlement and ReleaseAgreement effective November 5, 2008 and were dismissed with prejudice.

 

On May 15, 2007, William L. Arrington,William M. Arrington and Mark and Le’Ann Mitchell intervened in the SPScase. The intervenors (i) alleged negligence, res ipsa loquitor, nuisance,and trespass and (ii) sought damages, including, but not limited to,damages to their land, buildings and livestock and certain remedial expensestotaling approximately $118,320. In addition, the intervenors sought (i) reimbursementfor their attorney’s fees and (ii) exemplary damages. The intervenors alsoclaimed that Cano and its subsidiaries were jointly and severally liable as asingle business enterprise and/or a general partnership or de factopartnership.  The claims of these intervenors were resolved through aSettlement and Release Agreement effective November 5, 2008 and weredismissed with prejudice.

 

On September 25, 2007, the Texas Judicial Panelon Multidistrict Litigation granted Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W. O. Operating Company, Ltd, and WOEnergy, Inc.’s Motion to Transfer Related Cases to Pretrial Court pursuantto Texas Rule of Judicial Administration 13. The panel transferredall pending cases (Adcock, Chisum, Hutchison, Villarreal, SPS, and Burgess,identified above, and Valenzuela, Abraham Equine, Pfeffer, and Ayers,identified below) that assert claims against the Company and its subsidiariesrelated to wildfires beginning on March 12, 2006 to a single pretrialcourt for consideration of pretrial matters. The panel transferred allthen-pending cases to the Honorable Paul Davis, retired judge of the200th District Court of Travis County, Texas, as Cause No. D-1-GN-07-003353.

 

On October 3, 2007, Firstbank Southwest, asTrustee for the John and Eddalee Haggard Trust (the “Trust”) filed a Petitionin intervention as part of the Hutchison case. The Trust claimed that the electricalwiring and equipment of Cano or certain of its subsidiaries relating to oil andgas operations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas. The Trust (i) alleged negligence and trespass and (ii) soughtdamages of $46,362.50, including, but not limited to, damages to land andcertain remedial expenses. In addition, the Trust sought exemplary damages. Theclaims of this intervenor were resolved through a Settlement and ReleaseAgreement effective December 9, 2008 and were dismissed with prejudice.

 

On January 10, 2008, Philip L. Fletcherintervened in the consolidated case in the 200th District Court of TravisCounty, Texas as part of the SPS case. The intervenor (i) allegednegligence, trespass and nuisance and (ii) sought damages of $120,408,including, but not limited to, damages to his livestock, attorney’s fees andexemplary damages. The intervenor also claimed that Cano and its subsidiarieswere jointly and severally liable as a single business enterprise and/or as a partnershipor de facto partnership. The claims of this intervenor were resolved through aSettlement and Release Agreement effective December 9, 2008 and weredismissed with prejudice.

 

On January 15, 2008, the Jones and McMordie RanchPartnership intervened in the consolidated case in the 200th DistrictCourt of Travis County, Texas as part of the SPS case. The intervenor (i) allegednegligence, trespass and nuisance and (ii) sought damages of $86,250.71,including, but not limited to, damages to his livestock, attorney’s fees andexemplary damages. The intervenor also claimed that Cano and its subsidiarieswere jointly and severally liable as a single business enterprise and/or as apartnership or de facto partnership. The claims of this intervenor were resolvedthrough a Settlement and Release Agreement effective December 9, 2008 andwere dismissed with prejudice.

 

On February 11, 2008, the following lawsuit wasfiled in the 48th Judicial District Court of Tarrant County, Texas: Cause No. 048-228763-08,Abraham Equine, Inc. v. Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“AbrahamEquine”). The plaintiff claimed that the electrical wiring and equipment ofCano or certain of its subsidiaries relating to oil and gas operations starteda wildfire that began on March 12, 2006 in Carson County. The plaintiff (i) allegednegligence, trespass and nuisance and (ii) sought damages of $1,608,000,including, but not limited to, damages to its land, livestock and lost profits.In addition, the plaintiff sought (i) reimbursement for its attorney’sfees and (ii) exemplary damages. The plaintiff also claimed that Cano andits subsidiaries were jointly and severally liable as a single businessenterprise and/or a general partnership or de facto partnership. Cano and itssubsidiaries filed a Motion to Dismiss or, in the Alternative, to TransferVenue and a Notice of Tag Along transferring the case to the 

 

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MultidistrictLitigation Case in the 200th Judicial District Court of Travis County, Texas.On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in theAlternative, to Transfer Venue and took the motion under advisement.  Thissuit (along with the claims of Abraham Brothers, LP, Edward C. Abraham,Salem A. and Ruth Ann Abraham and Jason M. Abraham, discussed above) wasresolved through a Settlement and Release Agreement effective October 12,2008 and were dismissed with prejudice.

 

On March 10, 2008, the following lawsuit wasfiled in the 352nd Judicial District Court of Tarrant County, Texas, Cause No. 352-229256-08,Gary Pfeffer v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Pfeffer”). The plaintiffclaimed that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and gas operations started a wildfire that beganon March 12, 2006 in Carson County. The plaintiff (i) allegednegligence, trespass and nuisance, (ii) sought undisclosed damages for thewrongful death of his father, Bill W. Pfeffer, who he claimed died as aresult of the fire and (iii) sought actual damages of $1,023,572.37 fordamages to his parents’ home and property. In addition, the plaintiff soughtexemplary damages. The plaintiff also claimed that Cano and its subsidiarieswere jointly and severally liable as a general partnership or de factopartnership. Cano and its subsidiaries filed a Motion to Dismiss or, in theAlternative, to Transfer Venue and a Notice of Tag Along transferring the caseto the Multidistrict Litigation Case in the 200th Judicial District Court of Travis County, Texas.On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in theAlternative, to Transfer Venue and took the motion under advisement. The claimsof plaintiff were resolved through a Settlement and Release Agreement effectiveDecember 10, 2008 and were dismissed with prejudice.

 

On March 11, 2008, the following lawsuit wasfiled in the 141st Judicial District Court of Tarrant County, Texas, Cause No. 141-229281-08,Pamela Ayers, et al. v. Cano Petroleum, Inc., W.O. Energy ofNevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Ayers”).The plaintiffs claimed that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County. The plaintiffs (i) allegednegligence and (ii) sought undisclosed damages for the wrongful death oftheir mother, Kathy Ryan, who they claimed died as a result of the fire. Inaddition, the plaintiffs sought exemplary damages. The plaintiffs also claimedthat Cano and its subsidiaries were jointly and severally liable as a singlebusiness enterprise and/or general partnership or de facto partnership. Canoand its subsidiaries filed a Motion to Dismiss or, in the Alternative, toTransfer Venue and a Notice of Tag Along transferring the case to theMultidistrict Litigation Case in the 200th Judicial District Court of Travis County, Texas.On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in theAlternative, to Transfer Venue and took the motion under advisement. The claimsof plaintiffs were resolved through a Settlement and Release Agreementeffective December 10, 2008 and were dismissed with prejudice.

 

On March 12, 2008, the following lawsuit wasfiled in the 17th Judicial District Court of Tarrant County, Texas, Cause No. 017-229316-08,The Travelers Lloyds Insurance Company and Travelers Lloyds of Texas InsuranceCompany v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Travelers”). Theplaintiffs claimed that the electrical wiring and equipment of Cano or certainof its subsidiaries relating to oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County. The plaintiffs (i) allegednegligence, res ipsa loquitor, and trespass and (ii) claimed they aresubrogated to the rights of their insureds for damages to their buildings andbuilding contents totaling $447,764.60. The plaintiffs also claimed that Canoand its subsidiaries were jointly and severally liable as a single businessenterprise and/or general partnership or de facto partnership. The claims ofplaintiffs were resolved through a Settlement and Release Agreement effective November 18,2008 and were dismissed with prejudice.

 

On December 18, 2007, the following lawsuit wasfiled in the 348th Judicial District Court of Tarrant County, Texas, Cause No. 348-227907-07,Norma Valenzuela, et al. v. Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Valenzuela”).Six plaintiffs, including the two plaintiffs and intervenor from the nonsuitedMartinez case, claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) allege negligence and (ii) seek actual damages in theminimal amount of $4,413,707 for the wrongful death of four relatives, ManuelDominguez, Roberto Chavira, Gerardo Villarreal and Medardo Garcia, who theyclaim died as a result of the fire. In addition, plaintiffs seek (i) reimbursementfor their attorney’s fees and (ii) exemplary damages. The plaintiffs alsoclaim that Cano and its subsidiaries are jointly and severally liable as asingle business enterprise and/or as a partnership or de facto partnership.Cano and its subsidiaries filed a Motion to Dismiss or, in the Alternative, toTransfer Venue and a 

 

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Noticeof Tag Along transferring the case to the Multidistrict Litigation Case in the200th JudicialDistrict Court of Travis County, Texas. On May 2, 2008, the Court heardCano’s Motion to Dismiss or, in the Alternative, to Transfer Venue and took themotion under advisement.  The claims ofplaintiffs were resolved through a Settlement and Release Agreement effective April 9,2009 and were dismissed with prejudice. This lawsuit has been listed as the remaining unresolved case in our Form 10-Qunder *“Remaining Case”* for the period ended December 31,2008.

 

***Insurance and OtherSettlements Related to the Fire Litigation***

 

On June 20, 2006, the following lawsuit was filedin the United States District Court for the Northern District of Texas, FortWorth Division, C.A. No. 4-06cv-434-A, Mid-Continent Casualty Company (“MidCon”), Plaintiff, vs. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating Company, Ltd. and W.O. Energy, Inc. seeking adeclaration that the plaintiff is not responsible for pre-tender defense costsand that the plaintiff has the sole and exclusive right to select defensecounsel and to defend, investigate, negotiate and settle the litigationdescribed above. On September 18, 2006, the First Amended Complaint forDeclaratory Judgment was filed with regard to the cases described above.

 

On February 9, 2007, Cano and its subsidiariesentered into a Settlement Agreement and Release with the plaintiff pursuant towhich in exchange for mutual releases, in addition to the approximately$923,000 that we have been reimbursed by plaintiff, the plaintiff agreed to payto Cano within 20 business days of February 9, 2007 the amount of$6,699,827 comprising the following: (a) the $1,000,000 policy limits of theprimary policy; (b) the $5,000,000 policy limits of the excess policy; (c) $500,000for future defense costs; (d) $144,000 as partial payment for certainunpaid invoices for litigation related expenses; (e) all approvedreasonable and necessary litigation related expenses through December 21,2006 that are not part of the above-referenced $144,000; and (f) certainspecified attorneys fees. During February 2007, we received the $6,699,827payment from Mid-Con. Of this $6,699,827 amount, the payments for policy limitsamounting to $6,000,000 were recorded as a liability under deferred litigationcredit as presented on our consolidated balance sheet.

 

On March 11, 2008, one of Cano’s subsidiariesentered into a tolling agreement with an independent electrical contractor thatwas identified as a potentially responsible third party in connection with theclaims related to the pending wildfire litigation against Cano and itssubsidiaries.  In accordance with the terms of a Settlement and ReleaseAgreement effective October 11, 2008, the independent electricalcontractor paid Cano its full insurance policy limits totaling $6.0 million inexchange for a full release of any existing or future claims related towildfires that began on March 12, 2006 in Carson County, Texas.  The$6.0 million was received on October 31, 2008.

 

On March 6, 2009, the Amended and Restated EscrowAgreement (“Escrow Agreement”) terminated in accordance with its terms.  The Escrow Agreement was entered into on June 18,2007 by and among Cano, the Estate of Miles O’Loughlin and Scott White (the “W.O.Sellers”) and The Bank of New York Trust Company, N.A. (the “Trustee”) relatedto the November 2005 purchase of W.O. Energy of Nevada, Inc., and itssubsidiaries, W.O. Operating Company, Ltd., W.O. Production Company, Ltd., andWO Energy, Inc. (collectively “W.O.”), Pursuant to the terms of the EscrowAgreement, the Trustee returned to us 434,783 shares of Cano common stock ownedby the W.O. Sellers which had been held in trust for our benefit.  The shares are held by us as treasurystock.  In addition, the W.O. Sellersprovided additional consideration (collectively, the 434,783 shares and theadditional consideration being the “W.O. Settlement”).The $12.0 million ofinsurance proceeds (from Mid-Con and the independent electrical contractor)have been expended directly or indirectly to pay the settlements describedabove. Accordingly, we no longer have a deferred litigation credit balance.

 

***SecuritiesLitigation against Outside Directors***

 

On October 2, 2008, a lawsuit (08 CV 8462) wasfiled in the United States District Court for the Southern District of NewYork, against David W. Wehlmann; Gerald W. Haddock; Randall Boyd; Donald W.Niemiec; Robert L. Gaudin; William O. Powell, III and the underwriters ofthe July 1, 2008 public offering of Cano common stock (“Secondary Offering”)alleging violations of the federal securities laws.  The plaintiff soughtto 

 

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certifythe lawsuit as a class action.  The lawsuit alleges that the prospectusfor the Secondary Offering contained statements regarding Cano’s proved reserveamounts and standards that were materially false and overstated Cano’s provedreserves.  Messrs. Wehlmann, Haddock, Boyd, Niemiec, Gaudin andPowell were Cano outside directors on June 26, 2008.  The lawsuitseeks an unspecified amount of damages for the class if the lawsuit iscertified as a class action.  Thedefendants have filed a motion to transfer the lawsuit to the United StatesDistrict Court for the Northern District of Texas. Due to the inherent risk oflitigation, the outcome of this lawsuit is uncertain and unpredictable;however, our outside directors named in the lawsuit and management believe thelawsuit is without merit.  Management is cooperating with the Company’sDirectors and Officers insurance provider in the defense of the claims againstthese outside directors.

 

***Other***

 

Occasionally, we are involved in other various claimsand lawsuits and certain governmental proceedings arising in the ordinarycourse of business. Our management does not believe that the ultimateresolution of any current matters that are not set forth above will have amaterial effect on our financial position or results of operations. Management’sposition is supported, in part, by the existence of insurance coverage,indemnification and escrow accounts. None of our directors, officers oraffiliates, owners of record or beneficial owners of more than five percent ofany class of our voting securities, or security holder is involved in aproceeding adverse to us or our subsidiaries or has a material interest adverseto us or our subsidiaries.

 

**Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

**Forward-LookingStatements**

 

Theinformation in this report on Form 10-Q contains forward-lookingstatements within the meaning of the Private Securities LitigationReform Act of 1995. This Act provides a “safe harbor” for forward-lookingstatements to encourage companies to provide prospective information aboutthemselves provided they identify these statements as forward looking andprovide meaningful cautionary statements identifying important factors thatcould cause actual results to differ from the projected results. All statementsother than statements of historical fact made in this report are forwardlooking. In particular, the statements herein regarding industry prospects andfuture results of operations or financial position are forward-lookingstatements. Forward-looking statements reflect management’s currentexpectations and are inherently uncertain. Our actual results may differsignificantly from management’s expectations as a result of many factors,including, but not limited to the volatility in prices for crude oil andnatural gas, future commodity prices for derivative hedging contracts, interestrates, estimates of reserves, drilling risks, geological risks, transportationrestrictions, the timing of acquisitions, product demand, market competition,interruption in production, our ability to obtain additional capital, and thesuccess of waterflooding and enhanced oil recovery techniques.

 

Youshould read the following discussion and analysis in conjunction with theconsolidated financial statements of Cano and subsidiaries and notes thereto,included herewith. This discussion should not be construed to imply that theresults discussed herein will necessarily continue into the future, or that anyconclusion reached herein will necessarily be indicative of actual operatingresults in the future. Such discussion represents only the best presentassessment of management.

 

**OperatingStrategy**

 

We arean independent oil and natural gas company that utilizes enhanced oil recovery(“EOR”) techniques to increase the production and reserves of our existingportfolio of properties.  Our assets are located onshore U.S. in Texas,New Mexico and Oklahoma. Our focus on domestic, mature oil fields eliminatesexploration risk and the uncertainty associated with international development. We primarily use waterflooding and EOR techniques, such as alkaline/surfactant/ polymer (“ASP”), to develop our properties.

 

Ourtotal reserves have changed from June 30, 2008 principally due to thesales of Pantwist, LLC (Note 2) and our Corsicana Properties (Note 2), and the2.3 MMBOE impairment at December 31, 2008 to our Barnett Shale Properties(Note 12) as summarized in the following table.

 

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| **Reserves Category   (MMBOE)** | ** ** | **Reported in   10-K dated   June 30, 2008** | ** ** | **Less: Sale and Impairment of   Properties** | ** ** | **Estimated Reserves   at March 31,   2009(a)** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| PDP                                       |       | 10.6                                                                       |       | (1.9                                                         | )          | 8.7                                                                      |       |
| PDNP                                      |       | 2.5                                                                        |       | —                                                       |       | 2.5                                                                      |       |
| PUD                                       |       | 40.1                                                                       |       | (2.9                                                         | )          | 37.2                                                                     |       |
| **Total Proved**                          | ** ** | **53.2**                                                                   | ** ** | **(4.8**                                                     | **)**      | **48.4**                                                                 | ** ** |

 

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(a)          Table based upon June 30, 2008 pricedeck of $140.00/Bbl and $13.15/Mcf used to calculate our proved reserves at June 30,2008.

 

Whileour next reserve report disclosure will be as of June 30, 2009, assumingcurrent commodity prices, the economic lives of some of our current propertieswould be shortened, causing a decrease from our current properties ofapproximately 2.0 to 3.0 MMBOE of proved reserves.

 

Webelieve our oil and natural gas properties provide ample opportunities to applyour operational strategy.  Our primary focus is to develop our existingoil and natural gas properties through activities such as waterflooding and EORtechnology. These development activities are more clearly outlined in the nextsection titled “Drilling Capital Development and Operating Activities Update.”

 

***Drilling Capital Development and Operating Activities Update***

 

On May 7,2009, our board of directors approved an increase in our drilling capitaldevelopment budget for our fiscal year ending June 30, 2009 (“2009 FiscalYear”) to $49.8 million, which is an increase of $11.3 million, as compared tothe budgeted amount of $38.5 million.  The $11.3 million increase is adirect result of an earlier than expected waterflood response at the CatoProperties,  the opportunity to increasewater injection at the Cockrell Ranch waterflood  and the completion of the Harvey Unitmini-flood at our Panhandle Properties.  At the Cato Properties, ourincremental waterflood response of over 7,000 barrels per day of fluidproduction required adding additional injection wells and facilities to balanceour injection / withdrawal of fluid production. At the Cockrell Ranch, we increased our daily injection capacity by over20,000 barrels per day and increased our fluid production by over 5,000 barrelsper day. We also incurred additional capital charges to support increased fluidproduction for sub-pumps, fluid handling and chemical treatment costs.

 

Theapproved $49.8 million is allocated to our properties as follows:

 

·                  $26.4 million at the CatoProperties;

 

·                  $17.4 million at the PanhandleProperties;

 

·                  $2.1 million at the Nowata Properties;

 

·                  $3.0 million at the Desdemona Properties; and

 

·                  $0.9 million at other projects.

 

Of the$49.8 million budgeted capital expenditures, we have incurred $44.7 million throughMarch 31, 2009.  The financing of our capital expenditures isdiscussed below under “Liquidity and Capital Resources.” The status of ourcapital development activity during the 2009 Fiscal Year, including thedrilling of 18 new wells, is summarized as follows:

 

***Panhandle Properties.***     During thequarter ended March 31, 2009, we increased our average daily waterinjection rate at the Cockrell Ranch Unit from roughly 50,000 barrels per dayto over 70,000 barrels per day.  Thisresulted in increasing our average daily production at the Cockrell Ranch Unitfrom approximately 80-100 net BOEPD between June and December  2008to 100-120 net BOEPD at March 31, 2009, offsetting declines from 

 

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other leases at the Panhandle Properties.  Eight new sub-pumpswere added during the quarter ending March 31, 2009, bringing the total inthe field to 26. During the first quarter of fiscal year 2009, as a result ofour previously announced surveillance program, we identified and correctedinjection issues in 16 of the 62 injector wells.  With the results of thesurveillance and the corrective action taken, coupled with the increase inaverage daily injection, we now estimate the effective pore volume injection (“PVI”)at Cockrell Ranch to be approximately.28 PVI. The surveillance program includeddrilling one observation well which was completed as a producer during January 2009.

 

TheCockrell Ranch waterflood has been at full injection for 13 months withcorrected injection since October 2008.  We are still early in thelife of this waterflood, and the surveillance measures we have taken arenormal. Of note, there are areas of the flood that are responding favorably,with oil saturations between 4% - 10% and others that have not yet seen theflood front. Based upon current observations, we expect to see a more directcorrelation of PVI versus oil saturations and corresponding oil productionthrough calendar year 2009.

 

Ouroriginal 2009 Fiscal Year Panhandle Properties waterflood capital developmentplan included six separate mini-floods on reduced well spacing to enable us toaccelerate field development. Tighter spacing and smaller development patternsshould accelerate permitting and response times, allowing a larger developmentfootprint over a greater acreage position of the field. The current capitaldevelopment plan provides for the development of only one mini-flood phasethrough June 2009. The Harvey Unit had its waterflood permit applicationapproved by the Texas Railroad Commission on October 20, 2008. The HarveyUnit mini-flood consists of six injection wells and 13 producing wells (whichrequired five new wells to be drilled among the existing wells at the field).The drilling of the five replacement injector wells was completed on January 5,2009, thus completing the mini-flood pattern. We initiated injection at theHarvey Unit on March 30, 2009 at a rate of 2,500 barrels per day. We havefiled mini-flood permits at the Pond Lease and at the Olive-Cooper Lease, twoof our planned mini-floods.  The PondLease permit was protested and is set for hearing in June 2009.  The Olive-Cooper permit is underadministrative review.  As a result ofour maintenance capital expenditure program and a focus on our Cato Properties,we slowed the filing of permits for the balance of our mini-floods from what wehad initially intended when we began our 2009 Fiscal Year capital program. Wenow expect to file the appropriate waterflood permits for the remaining threemini-floods by June 2009.  Net production at the Panhandle Propertiesfor March 2009 was approximately 600 BOEPD.

 

***Cato Properties.***     In July 2008,we reinstated our drilling program after a three month pause.  During thequarter ended March 31, 2009, we drilled and completed six waterfloodinfill wells, one injection well and one water source well.  We havecompleted our Cato drilling for the 2009 Fiscal Year. We currently have 19water injection wells on-line and are injecting at a rate of approximately 12,000barrels of water per day. In total, this initial phase of the Cato waterfloodencompasses roughly 640 of the estimated 9,000 floodable acres, and includes 19injection wells and 29 producing wells.  Since the injection permits were received in September 2008,direct waterflood production response has increased from 5 infill producingwells offsetting the prior Amoco pilot injection wells in December 2008,to the current 20 total pattern wells experiencing direct productionresponse.  Our incrementalwaterflood response of over 7,000 barrels per day of fluid production requiredadding additional injection wells and facilities to balance ourinjection/withdrawal of production fluid.  Cato’sJanuary 2009 exit rate of production was over 300 net BOEPD and the March 2009exit rate was approximately 380 net BOEPD, which included an estimatedwaterflood production response of approximately 230 net BOEPD. Moreover, 5additional producing wells are in the first stages of waterflood response andworkovers are being planned to increase production at these wells in thenear-term. We anticipate continued maintenance capital spending for thethrough June 2009, albeit at a lower rate than experienced in the quarterended March 31, 2009, as we continue to manage the responses of ourwaterflood project.  We have a total often sub-pumps running with another seven planned due to increasing patternresponse and corresponding high fluid levels. These actions could increase fluid production by up to 4,000 barrels perday. This would bring the total daily fluid production (and associatedinjection) rates to approximately 16,000 barrels per day.

 

***Desdemona Properties.***    In light ofcurrent commodity prices and our revised drilling capital budget, we believethere is uncertainty in the likelihood of our developing proved undevelopedreserves associated with our Barnett Shale natural gas properties (“BarnettShale Properties”) within the next five years.  Accordingly, during thequarter ended December 31, 2008, we recorded a $22.4 million pre-taximpairment to our Barnett Shale Properties (Note 12).

 

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In January 2009,we shut in four uneconomic horizontal Barnett Shale wells and four uneconomicvertical Barnett Shale/Marble Falls producers.  We expect this action toreduce net production from the Desdemona Properties by 10-14 BOEPD.  Wehave taken actions to reduce our lease operating expenses at Desdemona byapproximately 50% while we continue to waterflood the Duke Sands, though at aslower rate due to a reduction of injected water since our Barnett Shale productionwas curtailed. Even though we do not anticipate seeing a meaningful responsefrom the Duke Sands waterflood during the 2009 calendar year, we believe thisis an attractive project for converting probable reserves to proved reserves.We will continue to manage this property as a marginally profitable field untilsuch time as commodity prices return to levels that provide an appropriatereturn and thus justify consideration for new development capitalspending.  Net production for March 2009 at the Desdemona Propertieswas approximately 40 BOEPD.

 

***Nowata Properties.***    Our ASP tertiaryrecovery pilot project, which has been in full operation since December 2007,has injected close to .20 PVI of ASP. We have now completed the ASP stageof injection and are performing the final injection stage of polymer flush. Wedrilled and completed four observation wells in late 2008. The observationwells should allow us to test flood-front results in our ASP pilot. Netproduction for March 2009 at the Nowata Properties was approximately 240BOEPD.

 

***Davenport Properties.***    Net productionfor March 2009 was approximately 70 BOEPD.

 

**Liquidityand Capital Resources**

 

Forthe nine months ended March 31, 2009, our primary sources of cash werereceipts from the sale of crude oil and natural gas production, issuance ofcommon stock, net borrowings under our credit agreements, sales of oil and gasproperties, payments for in-the-money commodity derivative contracts, andsettlements from third parties and the W.O. Settlement pertaining to thePanhandle fire litigation as discussed in Note 13. Our cash receipts from salesare discussed in greater detail under *“Resultsof Operations — Operating Revenues.” *The other sources of cashare discussed in greater detail below:

 

·                  On July 1, 2008, we received net proceeds of$53.9 million for the issuance of 7.0 million shares of our common stock. The net proceeds were used to pay down long-term debt due under our seniorcredit agreement (Note 3).

 

·                  On October 1, 2008, we sold our wholly-ownedsubsidiary, Pantwist, LLC (“Pantwist”), for $42.7 million ($40.0 million net ofclosing adjustments of $2.1 million of discontinued operating income recordedin the first quarter of the 2009 Fiscal Year and $0.6 million of advisory fees- Note 2).

 

·                  On December 2, 2008, we sold our interests in theCorsicana Properties for $0.3 million (Notes 2 and 12).

 

·                  During October 2008, we sold certain uncovered “floorprice” commodity derivative contracts covering July 2010 to December 2010for $0.6 million to our counterparty, and during November 2008, we soldall remaining uncovered “floor price” commodity derivative contracts covering November 2008through June 2010 for $2.6 million to our counterparty.  We recordeda realized gain of $0.7 million and an unrealized gain of $1.3 million as aresult of these transactions.

 

·                  On October 31, 2008, an independent electricalcontractor paid us $6.0 million (its full insurance policy limits) in exchangefor a full release of any existing or future claims related to wildfires thatbegan on March 12, 2006 in Carson County, Texas.  The $6.0 millionhas been fully expended to cover the settlements discussed in Note 13.

 

Duringthe nine month period ended March 31, 2009, our cash outlays wereprimarily for:

 

·                  Lease operating expense, general andadministrative expenses, and the settlement of fire litigation claims, whichare discussed in greater detail under *“Resultsof Operations — Operating Expenses.”*

 

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·                  Capital expenditures, which are discussedin greater detail under *“Drilling CapitalDevelopment and Operating Activities Update.”*

 

·                  The repurchase of 22,948 shares of Series DConvertible Preferred Stock, including accrued and unpaid PIK dividendsrelating to such shares for approximately $10.5 million, which is discussed ingreater detail in Note 6.

 

Asdiscussed in Note 4, at March 31, 2009, our remaining available borrowingcapacity under the senior credit agreement is $31.3 million.  We intend todraw down from our available borrowing capacity to cover shortfalls in our cashflow from operations to fund our operations, capital development program aspreviously discussed under “*Drilling**Capital Development and Operating ActivitiesUpdate*,” for general corporate purposes and for selectiveacquisitions. Pursuant to the terms of the ARCA, the borrowing base is to beredetermined based upon reserves at May 1, 2009 and again on June 30, 2009. We have begun the process with our bank group and cannot at this time determineif there will be any changes to our borrowing base.

 

At March 31,2009, our cash balance was $0.3 million.  For the nine months ended March 31,2009 and 2008, our cash from operations is summarized in the following table:

 
| **In Thousands**                      | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Cash provided by (used in) operations      |       | $        | (5,111     | )        | $          | 13,238 |   |
| Exclude unusual items:                     |       |     |       |     |       |
| Fire litigation settlements, net           |       | 8,114    |       | —   |       |
| Release of restrictions on Restricted Cash |       | —   |       | (6,000   | )          |
| Adjusted cash provided by operations       |       | $        | 3,003      |     | $          | 7,238 |   |

 

Adjusted cash provided by operations is a NON-GAAP measure;however, we believe that the presentation of “adjusted cash provided by operations” is relevantand useful to users of our financial statements. We believe the net paymentsfor fire litigation settlements and cash from restricted cash are unusual toour normal business activities, and should be excluded for comparison purposesbetween the two nine-month periods.  We believe this is helpfulinformation to our users of our financial statements to understand our currentand future cash flow from operations. For the nine-month period ended March 31, 2009, our adjusted cash provided by operations of $3.0million is $4.2 million lower than the respective nine month period ended March 31,2008 primarily due to lower operating income, as discussed in greater detailunder *“Results of Operations.”*

 

Webelieve the combination of cash on hand, cash flow generated from the expectedsuccess of prior capital development projects and debt available under ourcredit agreements is sufficient to finance our operations, contractualobligations and capital expenditure program (as previously discussed in thesection titled “*Drilling**Capital Development and Operating Activities Update”)*.

 

On December 28,2007, our universal shelf registration statement was declared effective by theSEC for the issuance of common stock, preferred stock, warrants, senior debtand subordinated debt up to an aggregate amount of $150.0 million.  Afterthe issuance of common stock on July 1, 2008, we have $96.0 million ofavailability under this registration. We may periodically offer one or more ofthese securities in amounts, prices and on terms to be announced when and ifthe securities are offered. At the time any of the securities covered by theregistration statement are offered for sale, a prospectus supplement will beprepared and filed with the SEC containing specific information about the termsof any such offering.  We have no immediate plans to utilize theavailability under the universal shelf registration statement.

 

Historically,our primary sources of capital and liquidity have been issuance of equitysecurities, borrowings under our credit agreements, and cash flows fromoperating activities.

 

**Resultsof Operations**

 

Forthe quarter ended March 31, 2009 (“current quarter”), we had a lossapplicable to common stock of $1.2 million, which was a $0.7 millionimprovement as compared to the $1.9 million loss applicable to common stockincurred for the quarter ended March 31, 2008 (“prior year quarter”). Items that led to the improvement were increased gain on commodity derivativesof $7.1 million, reduced preferred stock dividend of $0.4 million and lower 

 

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operating expenses of $0.3 million.  These positive items werepartially offset by lower operating revenues of $5.2 million and lower incomefrom discontinued operations of $0.9 million.

 

Forthe nine months ended March 31, 2009 (“current nine months”), we hadincome applicable to common stock of $24.3 million, which was $29.1 millionhigher as compared to the $4.8 million loss applicable to common stock incurredfor the nine months ended March 31, 2008 (“prior year nine months”).  Items that led to the improvement were increased gains on commodity derivativesof $54.2 million, preferred stock repurchased for less than the carrying amountof $10.9 million, higher income from discontinued operations of $9.1 millionand lower preferred stock dividend of $0.5 million.  These positivefactors were partially offset by higher operating expenses of $35.1 million (includinga $22.4 million impairment charge at our Barnett Shale Properties), loweroperating revenues of $3.7 million and goodwill impairment of $0.7 million.

 

Theseitems will be expanded upon in the following discussion.

 

***Operating Revenues***

 

Thetable below summarizes our operating revenues for the quarter and nine monthsended March 31, 2009 and 2008, respectively.

 
| ** **                                                              | ** ** | **Quarter ended  March 31,** | ** ** | **Increase** | ** ** | **Nine months  ended March 31,** | ** ** | **Increase** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------|------------|-------------------------------------------------|------------|--------------|------------|
| ** **                                                              | ** ** | **2009**                               | ** ** | **2008**     | ** ** | **(Decrease)**                                  | ** ** | **2009**     | ** ** | **2008** | ** ** | **(Decrease)** | ** ** |
| Operating Revenues*(in thousands)*                                      |       | $                                      | 3,928      |         | $          | 9,172                                           |       | $            | (5,244     | ) | $ | 19,736 |   | $ | 23,455 |   | $ | (3,719 | ) |
| Sales                                                                   |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| ·  Crude Oil (MBbls)                                          |       | 78                                     |       | 68           |       | 10                                              |       | 221          |       | 180 |   | 41 |   |
| ·  Natural Gas (MMcf)                                         |       | 181                                    |       | 216          |       | (35                                             | )          | 571          |       | 709 |   | (138 | ) |
| ·  Total (MBOE)                                               |       | 108                                    |       | 104          |       | 4                                               |       | 316          |       | 298 |   | 18 |   |
| Average Realized Price                                                  |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| ·  Crude Oil ($/ Bbl)                                         |       | $                                      | 35.49      |         | $          | 92.64                                           |       | $            | (57.15     | ) | $ | 66.01 |   | $ | 84.51 |   | $ | (18.50 | ) |
| ·  Natural Gas ($/ Mcf)                                       |       | $                                      | 5.52       |         | $          | 13.06                                           |       | $            | (7.54      | ) | $ | 8.49 |   | $ | 11.34 |   | $ | (2.85 | ) |
|                                                                    |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| Operating Revenues and Commodity Derivative Settlements*(in thousands)* |       | $                                      | 6,774      |         | $          | 8,844                                           |       | $            | (2,070     | ) | $ | 23,743 |   | $ | 23,386 |   | $ | 357 |   |
|                                                                    |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| Average Adjusted Price (includes commodity derivative settlements)      |       |                                   |       |         |       |                                            |       |         |       |   |   |   |   |
| ·  Crude Oil ($/ Bbl)                                         |       | $                                      | 62.34      |         | $          | 87.33                                           |       | $            | (24.99     | ) | $ | 79.70 |   | $ | 81.32 |   | $ | (1.62 | ) |
| ·  Natural Gas ($/ Mcf)                                       |       | $                                      | 9.64       |         | $          | 13.21                                           |       | $            | (3.57      | ) | $ | 10.21 |   | $ | 12.15 |   | $ | (1.94 | ) |

 

Thecurrent quarter operating revenues of $3.9 million are $5.2 million lower ascompared to the prior year quarter of $9.2 million. The $5.2 million reductionis primarily attributable to lower prices received for crude oil and naturalgas sales which lowered revenues by $4.3 million and $1.3 million,respectively, and by lower natural gas sales volumes which lowered revenues by$0.5 million. These decreases were partially offset by increased crude oilsales volumes which increased revenues by $0.8 million.

 

Thecurrent nine months operating revenues of $19.7 million are $3.7 million loweras compared to the prior year nine months of $23.4 million. The $3.7 milliondecrease is primarily attributable to lower prices received for crude oil andnatural gas sales which lowered revenues by $3.6 million and $1.5 million,respectively, and by lower natural gas sales volumes which lowered revenues by$1.7 million. These decreases were partially offset by increased crude oilsales volumes which increased revenues by $3.0 million.

 

Theimpact of lower prices for crude oil and natural gas sales, as discussed above,is partially mitigated by commodity derivative settlements received during thecurrent quarter and fully mitigated for the current nine months as presented inthe preceding table.  As discussed inNote 5, if crude oil and natural gas NYMEX prices are lower than the floorprices, we will be reimbursed by our counterparty for the difference betweenthe NYMEX price 

 

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and floor price. Conversely, if crude oil and natural gas NYMEX pricesare higher than the ceiling prices, we will pay our counterparty for thedifference between the NYMEX price and ceiling price (i.e. realized loss).

 

***Crude Oil Sales.***  For the current quarter, approximately93% of the increased crude oil sales of 10 MBbls were attributed to developmentactivity at the Cato Properties, as previously discussed under the “*Drilling**CapitalDevelopment and Operating Activities Update.*” Also, for the currentquarter, we had increased crude oil sales from the Desdemona and PanhandleProperties due to development activity previously discussed under “*Drilling**CapitalDevelopment and Operating Activities Update.*”  For the currentnine month period, approximately 95% of the increased crude oil sales of 41MBbls occurred at the Cato Properties and was attributable to the reasonspreviously discussed for the current quarter.

 

***Natural Gas Sales***. For the current quarter and currentnine months, the overall decrease in natural gas sales of 35 MMcf and 138 MMcf,respectively, pertains primarily to reductions at our Barnett Shale project andat our Desdemona Properties due to the steep decline curves associated withBarnett Shale wells coupled with our reduced development activity. In light ofcurrent commodity prices and our revised drilling capital budget, we havesignificantly curtailed our production activities from the Barnett Shale, asdiscussed below, and we do not expect volumes to return to prior levels duringthe remaining three months of our 2009 Fiscal Year.  Also, higher gasproduction from the Cato Properties due to the aforementioned developmentactivity was offset by lower gas production from our Panhandle Properties dueto normal field decline of approximately 10% annually and temporarycurtailments of gas deliveries by our gas purchasers.

 

During January 2009, wehalted our drilling program in the Desdemona Properties - Barnett Shale. Oncethe drilling activity ceased, we experienced normal Barnett Shale annualproduction declines of approximately 65-90%. During the second half of calendaryear 2008, various workovers and re-fracture stimulations were attempted toincrease production. Through December 2008, these efforts were met withmarginal success. We expect production to follow a normal pattern decline untila new drilling plan is put in place. We will continue to monitor industryresults in the area for new techniques, but due to the current low gas priceenvironment, no further activity is planned.

 

***Crude Oil and Natural Gas Prices***.  The average price we receive forcrude oil sales is generally at or above market prices received at thewellhead, except for the Cato Properties, for which we receive below marketprices due to its “sour” oil content. The average price we receive for naturalgas sales is approximately the market price received at the wellhead, adjustedfor the value of natural gas liquids, less transportation and marketingexpenses.  As discussed in Note 5, we have commodity derivatives in placethat provide for $80 to $85 crude oil “floor prices” and $7.75 to $8.00 naturalgas “floor prices.” If crude oil and natural gas NYMEX prices are lower thanthe “floor prices,” we will be reimbursed by our counterparty for thedifference between the NYMEX price and “floor price.”

 

***Operating Expenses***

 

Forthe current quarter, our total operating expenses were $8.3 million, or $0.3million lower than the prior year quarter of $8.6 million. Lower expenses forgeneral and administrative $1.2 million and production and ad valoremtaxes of $0.3 million were partially offset by increased expenses for leaseoperating of $0.5 million and higher depletion and depreciation expense of $0.6million.

 

Forthe current nine months, our total operating expenses were $59.1 million, or$35.1 million higher than the prior year nine months of $24.0 million. Theprimary contributor to the increase was an impairment of long-lived assets of$22.4 million.  In addition, weexperienced increased expenses for general and administrative of $5.8million, lease operating of $5.2 million, higher depletion and depreciation of$1.4 million and other expenses of $0.3 million.

 

Duringthe quarter ended December 31, 2008, we recorded a pre-tax $22.4 millionimpairment on our Barnett Shale Properties (Note 12).  As previouslydiscussed, in light of current commodity prices and our revised drillingcapital budget, we believe there is uncertainty in the likelihood of ourdeveloping proved undeveloped reserves associated with our Barnett ShaleProperties within the next five years.  The fair value was determinedusing estimates of future production volumes, prices and operating expenses,discounted to a present value.

 

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***Lease Operating Expenses.***** **Our lease operating expenses (“LOE”)consists of costs of producing crude oil and natural gas such as labor,supplies, repairs, maintenance and utilities.

 

·                  For the current quarter, our LOE was $4.1million, which is $0.5 million higher than the prior year quarter.  The$0.5 million increase resulted primarily from increased workover activities andgeneral repairs at the Panhandle Properties of $0.5 million and higheroperating expenses incurred at the Cato Properties of $0.5 million to supportincreased crude oil and natural gas sales, as discussed under *“Operating Revenues,”*partially offset by lower operating expensesof $0.4 million due to lower natural gas sales at the Desdemona Properties, asdiscussed under *“Operating Revenues.”* The workover activities at the Panhandle Properties pertained toreturning wells to production and are expected to result in increasedproduction in future months.  Based upon renegotiated contracts with thekey service provider in the Panhandle Properties, LOE has already decreased asthe current quarter LOE of $4.1 million is $0.7 million lower than the $4.8million LOE amount for the preceding quarter ended December 31, 2008.

 

·                  For the current nine months, our LOE was$13.9 million, which is $5.2 million higher than the prior year ninemonths.  We incurred higher LOE expenses at the Panhandle and CatoProperties of $3.6 million and $1.7 million, respectively, partially offset bylower operating expenses of $0.6 million at the Desdemona Properties, for thereasons previously discussed for the current quarter.  Also, we had higher LOE at the Davenport andNowata Properties of $0.5 million due to increased electricity expenses, generalrepairs and workover expenses.

 

Forthe current quarter, our LOE per BOE, based on production, was $35.70 ascompared to $32.77 for the prior year quarter.  For the current ninemonths, our LOE per BOE, based on production, was $41.78 as compared to $28.77for the prior year nine months.  In general, secondary and tertiary LOE ishigher than the LOE for companies developing primary production because fieldsare more mature and typically produce less oil and more water.  We expectthe LOE to decrease during the fourth quarter of the 2009 Fiscal Year andcontinue into the 2010 Fiscal Year as we have successfully negotiated servicerate decreases with vendors, and we expect LOE per BOE to decrease asproduction increases from the waterflood and EOR development activities we haveimplemented and are implementing as discussed under the “*Drilling**CapitalDevelopment and Operating Activities Update.*”  We have already experienced decreases in ourLOE per BOE as the current quarter LOE per BOE of $35.70 is lower than the$44.06 LOE per BOE amount for the preceding quarter ended December 31,2008.

 

***General and Administrative Expenses.***  Our general and administrative(G&A) expenses consist of support services for our operating activities andlegal costs.

 

·                  For the current quarter, our G&Aexpenses totaled $2.2 million, which is $1.2 million lower than the prior yearquarter.  Reduced legal expensespertaining to the fire litigation and the W.O. Settlement discussed in Note 13of $1.7 million were partially offset by higher payroll and benefits expensesof $0.5.  During the quarter we tooksteps to reduce our payroll, eliminating 25% of our home office staff.  The quarter ended June 30, 2009 will bethe first time we will realize this savings.

 

·                  For the current nine months, our G&Aexpenses totaled $16.6 million, which was $5.8 million higher than the prioryear nine months. The primary reasons for the $5.8 million increase weresettlement costs and higher legal expenses of $4.4 million pertaining to thefire litigation as discussed in Note 13 and increased payroll and benefitsexpenses of $1.4 million.

 

Due tothe settlements and accruals taken at December 31, 2008 for firelitigation claims, as discussed in Note 13, we expect significant decreases infuture quarters’ legal expenses.  Also,the previously discussed workforce reductions are expected to reduce payrolland benefits costs by $0.8 million annually.

 

***Production and Ad Valorem Taxes***.  For the current quarter, ourproduction and ad valorem taxes were $0.4 million, which is $0.3 million lowerthan the prior year quarter.  Our production taxes were lower by $0.4million due to reduced operating revenues, partially offset by increased advalorem taxes of $0.1 million.  For the current nine months, our productionand ad valorem taxes were $1.9 million, which is $0.2 million higher than theprior year nine months.  Our production taxes were lower by $0.3 milliondue to lower operating revenues, offset by 

 

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increased ad valorem taxes of $0.5 million.  For both the currentquarter and current nine months, the increased ad valorem taxes were due tonotification of revisions in tax property valuations by taxing authorities forthe 2008 calendar year.  Therefore, the current nine months includeshigher tax rates for the nine months plus a charge for applying the rates tothe first six months of the 2008 calendar year.

 

***Depletion and Depreciation Expense.***  For the current quarter, ourdepletion and depreciation expense was $1.6 million, or $0.6 million higherthan the prior year quarter.  For the current nine months, our depletionand depreciation expense was $4.2 million, or $1.4 million higher than theprior year nine months.  This includes depletion expense pertaining to ouroil and gas properties, and depreciation expense pertaining to our fieldoperations vehicles and equipment, gas plant, office furniture andcomputers.  For the current quarter and current nine months, our depletionrate per BOE pertaining to our oil and gas properties was $12.35 and $11.51,respectively, as compared to prior year quarter and nine months of $8.03 and$7.52, respectively.  The increased depletion rates resulted from higherdepletion rates for our Cato and Panhandle Properties based on our reserveredetermination at June 30, 2008 and periodic reassessments of depletionrates during the current nine months.

 

***Interest Expense and Other***

 

Theinterest expense and other we incurred in the current quarter and current ninemonths of $0.2 million and $0.4 million, respectively, is comparable to therespective prior year periods.  Our interest expense for the current andprior year quarters is impacted by $0.3 million and $0.7 million, respectively,of interest cost that was capitalized to waterflood and ASP projects asdiscussed under the “*Drilling**Capital Development and Operating Activities Update.*”For the current and prior year nine months, the capitalized interest coststotaled $0.9 million and $1.7 million, respectively.  We incurred higherinterest costs during the prior year quarter and nine months due to higheroutstanding debt balances and higher interest rates.

 

***Impairment of Goodwill***

 

Asdiscussed in Note 12, we recorded a $0.7 million pre-tax impairment of goodwillas a direct result of the $22.4 million pre-tax impairment on our Barnett ShaleProperties during the quarter ended December 31, 2008. The fair value wasdetermined using estimates of future production volumes, prices and operatingexpenses, discounted to a present value.

 

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

 

Asdiscussed in Note 5, we have entered into financial contracts for our commodityderivatives and an interest rate swap arrangement.  For the currentquarter, we recorded a gain on derivatives of $3.5 million as compared to aloss of $3.6 million for the prior year quarter.  The current quarter gain consists of arealized gain on settlements of commodity derivative contracts during thequarter of $2.8 million and an unrealized gain of $0.7 million.

 

Forthe current nine months, we had a gain on derivatives of $48.5 million ascompared to a loss of $5.7 million for the prior year nine months.  The current nine months gain consists of anunrealized gain of $43.8 million, a net realized gain on settlements of thecommodity derivative contracts of $4.0 million and a $0.7 million realized gainon the sale of floor-priced contracts.

 

Forthe realization of settlements, if crude oil and natural gas NYMEX prices arelower than the floor prices, we will be reimbursed by our counterparty for thedifference between the NYMEX price and floor price (i.e. realized gain).Conversely, if crude oil and natural gas NYMEX prices are higher than theceiling prices, we will pay our counterparty for the difference between theNYMEX price and ceiling price (i.e. realized loss).

 

Theunrealized gain for both the current quarter and nine months reflect the fairvalue of the commodity derivatives as of March 31, 2009.  By theirnature, these commodity derivatives can have a highly volatile impact to ourearnings.  A five percent change in the prices for our commodityderivative instruments could impact our pre-tax earnings by approximately $0.7million.

 

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

 

Forthe current and prior year quarters, we recorded an income tax benefit of $0.3million and $0.5 million, respectively.  For the current nine months, werecorded an income tax expense of $10.3 million, which is an increase of $11.2million as compared to an income tax benefit of $1.1 million during the prioryear nine months.  These quarter and nine months tax amounts include taxesrelated to discontinued operations as shown in Note 2.  The $11.2 millionincrease for the current nine months is due to the increase in taxable incomeand an increase in the state tax rate, resulting in an aggregate rate for thecurrent nine months of 39.6%.  The income tax rate for the prior year ninemonths was 34.7%.

 

***Preferred Stock Dividend***

 

Thepreferred stock dividend for the current quarter and nine months of $0.5million and $2.3 million, respectively, are $0.4 million and $0.5 million loweras compared to the respective prior year periods.  This resulted from the November andDecember 2008 repurchases of preferred stock as discussed in Note 6. Thequarterly preferred stock dividends will decrease by approximately 45%,comparatively year-on-year, in the next three quarters due to the repurchases.

 

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

 

Forthe current quarter we had no income from discontinued operations as comparedto $0.9 million for the prior year quarter.  For the current and prioryear nine months, we had income from discontinued operations of $11.4 millionand $2.3 million, respectively.  This represents the income attributable tothe divested Pantwist and Corsicana operations as discussed in Note 2.

 

***New Accounting Pronouncements***

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations* (“SFAS No. 141R”). Among otherthings, SFAS No. 141R establishes principles and requirements for how theacquirer in a business combination (i) recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,and any noncontrolling interest in the acquired business, (ii) recognizesand measures the goodwill acquired in the business combination or a gain from abargain purchase, and (iii) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. SFAS No. 141R is effective for fiscalyears beginning on or after December 15, 2008, with early adoptionprohibited. We will adopt SFAS No. 141R on July 1, 2009. Thisstandard will change our accounting treatment for prospective business combinations.

 

In December 2007,the FASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements, an Amendment of ARB No. 51*(“SFAS No. 160”). SFAS No. 160 establishes accounting and reportingstandards for noncontrolling interests in a subsidiary and for thedeconsolidation of a subsidiary. Minority interests will be recharacterized asnoncontrolling interests and classified as a component of equity. It alsoestablishes a single method of accounting for changes in a parent’s ownershipinterest in a subsidiary and requires expanded disclosures. This statement iseffective for fiscal years beginning on or after December 15, 2008, withearly adoption prohibited. We will adopt SFAS No. 160 on July 1,2009. We do not expect the adoption of this statement will have a materialimpact on our financial position, results of operations or cash flows.

 

In March 2008,the FASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities—An Amendment of FASBStatement 133* (“SFAS No. 161”). SFAS No. 161 amends andexpands SFAS No. 133 to enhance required disclosures regarding derivativesand hedging activities. It requires companies to provide additional disclosureto discuss the uses of derivative instruments; the accounting for derivativeinstruments and related hedged items under SFAS No. 133; and howderivative instruments and related hedged items affect the company’s financialposition, financial performance and cash flows. We will adopt SFAS No. 161on July 1, 2009. We do not expect the adoption of this statement will havea material impact on our financial position, results of operations or cashflows.

 

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In December 2008, the FASB issued EITF****07-5, *Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock* (“EITF 07-5”). EITF 07-5 affects companies that have provisions in their securities purchaseagreements (for warrants and convertible instruments) that reset issuance/conversionprices based upon new issuances by companies at prices below the exercise priceof said instrument.  Warrants and convertible instruments with suchprovisions will require the embedded derivative instrument to be bifurcated andseparately accounted for as a derivative under SFAS No. 133.  Subjectto certain exceptions, our Series D convertible preferred stock providesfor resetting the conversion price if we issue our common stock below $5.75 pershare.  We will adopt EITF 07-5 on July 1, 2009.We are evaluating theeffect of EITF 07-5 on our financial position and results of operations;however, there should be no effects on cash flows.

 

In June 2008, the FASB issued EITF 03-6-1*, Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities*(“FSP 03-6-1”). FSP 03-6-1 addresseswhether instruments granted in share-based payment transactions areparticipating securities prior to vesting and need to be included in thecalculation of earnings per share under the two-class method described in SFAS No. 128,*Earnings per Share.* Under FSP03-6-1, share-based payment awards that contain nonforfeitable rights todividends are “participating securities” as defined by EITF 03-6, *Participating Securities and the Two-Class Method under FASBStatement No. 128,* and therefore should be included incomputing earnings per share using the two-class method. FSP 03-6-1 iseffective for financial statements issued for fiscal years and interim periodsbeginning after December 15, 2008. We will adopt FSP 03-6-1 on July 1,2009. The effect of adopting FSP 03-6-1 will increase the number of shares usedto compute earnings per share; however, we do not expect the adoption of FSP03-06-1 to have a material impact of our financial position, results ofoperations or cash flows.

 

**Item3. Quantitative and Qualitative Disclosures About Market Risk.**

 

SeeNotes 4, 5 and 11 regarding the updates of our market risk for the quarterended March 31, 2009.

 

**Item4. Controls and Procedures.**

 

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

 

Duringthe quarter ended March 31, 2009, there was no change in our internalcontrol over financial reporting that has materially affected or is reasonablylikely to materially affect our internal control over financial reporting.

 

**PART II — OTHER INFORMATION**

 

**Item1. Legal Proceedings.**

 

SeeNote 13 which is incorporated into this “Item 1. Legal Proceedings” byreference.

 

**Item1A.  Risk Factors.**

 

Due tothe recent deterioration in the credit and equity markets, significantly lowercrude oil and natural gas prices and certain settlements regarding the firelitigation, in our Quarterly Report on Form 10-Q for the quarter ended September 30,2008, we updated certain of the risk factors that were included in our AnnualReport on Form 10-K for the year-ended June 30, 2008.  In ourQuarterly Report on Form 10-Q for the quarter ended December 31,2008, we updated two of the risk factors from the Quarterly Report on Form 10-Qfor the quarter ended September 30, 2008 and added an additionalfactor.  In this Quarterly Report on Form 10-Q,we have updated

 

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one risk factor andmodified one risk factor from the Quarterly Report on Form 10-Q for thequarter ended December 31, 2008.

 

**RisksRelated to Our Business**

 

***We are subject to a lawsuit relating to a fire that occurredon March 12, 2006 in Carson County, Texas which may have an adverse impacton us.***

 

Cano and certain of its subsidiaries were defendantsin several lawsuits relating to a fire that occurred on March 12, 2006 inCarson County, Texas and remain defendants in one of the lawsuits.  With regard to the remaining lawsuit, on June 21,2007, the Judge of the 100th Judicial District Court issued a Final Judgment (a) grantingmotions for summary judgment in favor of Cano and certain of its subsidiarieson plaintiffs’ claims for (i) breach of contract/termination of an oil andgas lease; and (ii) negligence; and (b) granting the plaintiffs’no-evidence motion for summary judgment on contributory negligence, assumptionof risk, repudiation and estoppel affirmative defenses asserted by Cano andcertain of its subsidiaries.

 

TheFinal Judgment was appealed and a decision was reached on March 11, 2009,as the Court of Appeals for the Tenth District of Texas in Amarillo affirmed inpart and reversed in part the ruling of the 100th Judicial District Court.  The Court of Appeals (a) affirmed thetrial court’s granting of summary judgment in Cano’s favor for breach ofcontract/termination of an oil and gas lease and (b) reversed the trialcourt’s granting of summary judgment in Cano’s favor on plaintiffs’ claims of Cano’snegligence.  The Court of Appeals orderedthe case remanded to the 100th Judicial District Court.  We have not yet determined whether to seekfurther review by the Court of Appeals or the Texas Supreme Court.

 

Theremaining plaintiffs allege damages include damage to land and livestock,certain expenses related to fighting the fire and remedial expenses totalingapproximately $1.7 million to $1.8 million. In addition the remaining plaintiffs seek termination of certain oil andnatural gas leases, reimbursement of their attorney’s fees and exemplarydamages. Currently, known aggregate actual damage claims are approximately $1.8million.  However, the plaintiffs have not provided actual damage claimsfor all of their claims.  These actual damage claims do not include theadditional claims by the plaintiffs for attorneys’ fees and exemplary damages,the potential amounts of which cannot be reasonably estimated.  In February 2007,we entered into a Settlement Agreement with our insurance carrier pursuant towhich we received $6,699,827 in exchange for releasing the insurance carrierfrom any future claims. $6,000,000 of the amount received related to theinsurance policy limits and the remaining $699,827 related to the reimbursementof defense costs previously incurred by Cano. The $6,000,000 payment for policylimits, in accordance with the senior credit agreement, was placed in acontrolled bank account and the use of the proceeds was specified to payattorneys’ fees, settlement amounts, other litigation expenses incurred todefend and/or settle the fire litigation, and for general corporate purposes.We have fully expended the $6,000,000 payment from fire litigation insuranceproceeds.  On October 11, 2008, an independent electrical contractorcommitted to pay us $6,000,000 in exchange for a full release of any existingor future claims related to wildfires that began on March 12, 2006 inCarson County, Texas.  This $6,000,000 was fully received by October 31,2008 and has been fully expended to cover portions of the settlements enteredinto to date.  There is no remaining insurance coverage for the firelitigation.  In connection with the W.O.Settlement, pursuant to the terms of the Escrow Agreement, the Trustee returnedto us 434,783 shares of Cano common stock owned by the W.O. Sellers which hadbeen held in trust for our benefit, and the W.O. Sellers provided additionalconsideration.  We may not be able tosettle the remaining lawsuit on acceptable terms and may not prevail in courtor on further appeal.  If there is an adverse judgment entered against us,based on the illiquid nature of a significant portion of our assets, we may notbe able to (i) post a sufficient supersedeas bond during the appealprocess of any adverse judgment, which may permit the plaintiffs to attempt toexecute on any judgment pending appeal, and/or (ii) satisfy the amount ofany adverse judgment.

 

***Currently, our lease operating expense per BOE is high incomparison to the oil and natural gas industry as a whole.***

 

Untilsuch time as we achieve production growth from our waterfloods, our leaseoperating expense per BOE should remain higher than standard for our industryas a whole.  With over 1,200 activewells, we are averaging 

 

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approximately 1 BOEPD per active well.  These higher operatingcosts have an adverse effect on our results of operations.

 

**Item2.  Unregistered Sales of Equity Securities and Use of Proceeds.**

 
| **Period**                                            | ** ** | **Total  Number  of Shares  (or Units)  Purchased** | ** ** | **Average  Price Paid  per Share  (or Unit)** | ** ** | **Total Number of  Shares  (or Units)  Purchased as  Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum Number  (or Approximate  Dollar Value) of  Shares (or Units)  that May Yet Be  Purchased Under  the Plans or  Programs** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| January 1, 2009 through  January 31, 2009   |       | —                                              |       | —                                             |       | —                                                                                                          |       | —                                                                                                                                       |       |
|                                                  |       |                                                |       |                                               |       |                                                                                                            |       |                                                                                                                                         |       |
| February 1, 2009 through  February 28, 2009 |       | —                                              |       | —                                             |       | —                                                                                                          |       | —                                                                                                                                       |       |
|                                                  |       |                                                |       |                                               |       |                                                                                                            |       |                                                                                                                                         |       |
| March 1, 2009 through  March 31, 2009       |       | 434,783                                             |       | $                                                  | 0.27       |                                                                                                            | —     |                                                                                                                                         | —     |   |
|                                                  |       |                                                |       |                                               |       |                                                                                                            |       |                                                                                                                                         |       |
| Total                                                 |       | 434,783                                             |       | $                                                  | 0.27       |                                                                                                            | —     |                                                                                                                                         | —     |   |

 

Pursuant to the terms of the Escrow Agreement, on March 6,2009, the Trustee returned to us 434,783 shares of our common stock owned bythe W.O. Sellers in connection with the W.O. Settlement pursuant to which theW.O. Sellers satisfied their indemnification obligations to us.

 

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

 

###### **We submitted a proxy statement to the Company’sstockholders as of the record date, November 26, 2008.  The proxy statement was furnished to theCompany’s stockholders in connection with the Annual Meeting of Stockholdersheld on January 9, 2009.  There were46,078,518 shares of common stock entitled to vote at the meeting and 43,474shares of our Series D Convertible Preferred Stock entitled to vote at themeeting, on an as converted basis into 8,422,225 shares of common stock.  For all items there were 54,500,743 sharesentitled to vote at the meeting.  For theelection of the Board of Directors, the results were as follows:**

 

| **Nominee**               | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** |
|---------------------------|------------|---------------|------------|---------------------|------------|
| S. Jeffrey Johnson (1)    |       | 42,633,570    |       | 1,044,224           |       |
|                      |       |          |       |                |       |
| Randall Boyd (1)          |       | 37,218,827    |       | 6,458,967           |       |
|                      |       |          |       |                |       |
| Robert L. Gaudin (1)      |       | 36,082,570    |       | 7,595,224           |       |
|                      |       |          |       |                |       |
| Donald W. Niemiec (1)     |       | 36,598,133    |       | 7,079,661           |       |
|                      |       |          |       |                |       |
| William O. Powell III (1) |       | 42,663,204    |       | 1,044,590           |       |
|                      |       |          |       |                |       |
| Garrett Smith             |       | 42,678,918    |       | 998,876             |       |
|                      |       |          |       |                |       |
| David W. Wehlmann (1)     |       | 42,201,910    |       | 1,475,884           |       |

 

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(1) Incumbent

 

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For the approval of the Cano Petroleum, Inc.2008 Annual Incentive Plan, the results were as follows:

 

| **Votes For** | ** ** | **Votes  Against** | ** ** | **Votes  Abstained** | ** ** | **Broker  Non-Votes** | ** ** |
|---------------|------------|--------------------|------------|----------------------|------------|-----------------------|------------|
| 25,975,363    |       | 1,609,418          |       | 6,805,172            |       | 9,287,841             |       |

 

For the ratification of Hein & AssociatesLLP as Cano’s independent registered public accounting firm for the year ended June 30,2009, the results were as follows:

 

| **Votes For** | ** ** | **Votes  Against** | ** ** | **Votes  Abstained** | ** ** |
|---------------|------------|--------------------|------------|----------------------|------------|
| 36,577,675    |       | 264,251            |       | 6,835,867            |       |

 

**Item5.  Other Information.**

 

OnMay 7**,** 2009, our Board ofDirectors approved the Second Amended and Restated By-Laws.  The Second Amended and Restated By-Lawsprovide new procedures for stockholders to nominate persons for election to theBoard of Directors.  With regard to anannual meeting of stockholders, to make a timely nomination of a nominee to theBoard of Directors, a stockholder of record must provide a notice to ourSecretary at our principal executive offices not less than 60 or more than 90days prior to the one-year anniversary of the date on which we first mailed ourproxy materials for the prior annual meeting of stockholders.  However, if that annual meeting is convenedmore than 30 days prior to or delayed by more than 30 days after theanniversary of the preceding annual meeting, the record stockholder’s noticemust be received by our secretary no later than the close of business on thelater of the 90th daybefore the annual meeting or the 10th day following the day on which publicannouncement of the date of the annual meeting is first made.  In addition, in the event that the number ofdirectors to be elected to the Board of Directors is increased and there hasbeen no public announcement naming all the nominees for director or indicatingthe increase in the size of the Board of Directors at least 10 days prior tothe last day a record stockholder may deliver a notice as set forth above, withrespect to nominees for any new positions created by such increase, a recordstockholder’s notice shall be considered timely with regard to a nominee forsuch new position created by such increase if it is received by our Secretaryat our principal executive offices not later than the close of business on the10th day following the day on whichsuch public announcement is first made by us. With regard to a special meetingof stockholders at which directors are to be elected, a stockholder of recordmust provide a notice to our Secretary at our principal executive offices nolater than the close of business on the later of the 90th day prior to such special meeting or the 10th day following the date on which publicannouncement is first made of the date of the special meeting and of thenominees proposed by the Board of Directors to be elected at such specialmeeting.

 

It is currently contemplated that our 2009 AnnualMeeting of Stockholders will take place on December 15, 2009. Under the rules ofthe SEC, certain procedures are provided that a stockholder must follow tonominate persons for election to the Board of Directors, or to introduce anitem of business at an Annual Meeting of Stockholders. Any stockholder whointends to present a proposal at the 2009 Annual Meeting of Stockholderspursuant to the process established by Rule 14a-8 promulgated by the SEC, andwho wishes to have a proposal included in our proxy statement for that meeting,must deliver the proposal to the attention of the Company’s Secretary at our principalexecutive offices at 801 Cherry St., Suite 3200, Fort Worth, TX 76102, forreceipt not later than August 10, 2009. A stockholder proposal submittedoutside of the processes established in Rule 14a-8 promulgated by the SEC willbe subject to the timeframes provided in the Second Amended and RestatedBy-Laws described above.  In accordancewith such timeframes, a stockholder of record must provide a notice to ourSecretary at our principal executive offices not earlier than September 9,2009 and not later than October 9, 2009.

 

Arecord stockholder’s notice to nominate a director must set forth the followinginformation regarding the nominee: (i) all information relating to suchnominees as would be required to be disclosed in solicitations for proxiespursuant to Regulation 14A of the Securities Exchange Act of 1934, (ii) anyadditional information that a record stockholder believes would aid in theevaluation of the recommended individual; (iii) written consent of therecommended individual to stand for election if nominated, to serve as adirector if elected and to comply with the expectations and requirements forservice on the Board of Directors set forth in the Code of Ethics and Business 

 

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Conduct and any other applicable rule, regulation, policy or standard ofconduct applicable to the Board of Directors and its individual members; (iv) allrelevant information required to conduct an evaluation of such person; and (v) allother information that may be required by applicable law.

 

A record stockholder’s notice to nominate a directormust also include the following information regarding the record stockholderand the beneficial owner, if any, on whose behalf the nomination is made: (i) thename and address of each of the record stockholder and the beneficial owner; (ii) informationregarding (a) the number of shares owned, directly or indirectly,beneficially and of record, and (b) any derivative securities; (iii) anyarrangements regarding the right to vote any of our securities; (iv) anyshort interest in any of our securities; (v) any additional rights todividends; (vi) any proportionate interest in our shares or derivativesecurities held, directly or indirectly, by a partnership of which the recordstockholder or beneficial owner is a general partner or, directly orindirectly, owns an interest in a general partner; (vii) anyperformance-related fees that the record stockholder or the beneficial owner isdirectly or indirectly entitled to based on any increase or decrease in thevalue of our shares or derivative securities; and (viii) any additionalinformation relating to the record stockholder and the beneficial owner thatwould be required to be disclosed in the proxy statement or other filings inconnection with the solicitation of proxies for the election of directors.

 

**Item6. Exhibits.**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                           |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1*               |       | Certification by  Chief Executive Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            |
| 31.2*               |       | Certification by  Chief Financial Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            |
| 32.1*               |       | Certification by  Chief Executive Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2*               |       | Certification by  Chief Financial Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter  63 of Title 18 of the United States Code, promulgated pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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

 

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**SIGNATURES**

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
| **CANO  PETROLEUM, INC.** |   |                                               |
|---------------------------|--------|----------------------------------------------------|
|                      |   |                                               |
| Date: May 11,  2009  | By:    | /s/ S. Jeffrey  Johnson                            |
|                      |   | S. Jeffrey  Johnson                                |
|                      |   | Chief Executive  Officer                           |
|                      |   |                                               |
|                      |   |                                               |
| Date: May 11,  2009  | By:    | /s/ Benjamin  Daitch                               |
|                      |   | Benjamin Daitch                                    |
|                      |   | Senior  Vice-President and Chief Financial Officer |
|                      |   |                                               |
|                      |   |                                               |
| Date: May 11,  2009  | By:    | /s/ Michael J.  Ricketts                           |
|                      |   | Michael J.  Ricketts                               |
|                      |   | Vice-President  and Principal Accounting Officer   |

 

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