**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended: September 30, 2010**

 

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934**

 

**Commission File Number: 001-32496**

 

**Cano Petroleum, Inc.**

(Exactname of registrant as specified in its charter)

 

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

 

**(817) 698-0900**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

 

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

 

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

 

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

 

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

 

The number of sharesoutstanding of the registrant’s common stock, par value $.0001 per share, as ofNovember 15, 2010 was 45,447,082 shares.

 

 

 

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**PART I — FINANCIAL INFORMATION**

 

**Item 1. Financial Statements.**

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                               | ** ** | **September 30,** | ** **  | **June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|-------------------|------------|
| **In  Thousands, Except Shares and Per Share Amounts**                                                                                                                                                                                                                   | ** ** | **2010**               | ** **  | **2010**          | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                             |       |                   | ** **  | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                       |       |                   | ** **  | ** **        | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                |       | $                      | 1,187       |              | $          | 300 |   |
| Accounts receivable                                                                                                                                                                                                                                                      |       | 2,259                  |        | 2,411             |       |
| Derivative assets                                                                                                                                                                                                                                                        |       | 968                    |        | 2,968             |       |
| Inventory and other current assets                                                                                                                                                                                                                                       |       | 2,285                  |        | 858               |       |
| Total current assets                                                                                                                                                                                                                                                     |       | 6,699                  |        | 6,537             |       |
| **Oil and gas properties**, successful  efforts method                                                                                                                                                                                                                   |       | 295,973                |        | 294,961           |       |
| Less accumulated depletion and depreciation                                                                                                                                                                                                                              |       | (45,729                | )           | (44,615           | )          |
| Net oil and gas properties                                                                                                                                                                                                                                               |       | 250,244                |        | 250,346           |       |
| Fixed assets and other, net                                                                                                                                                                                                                                              |       | 1,598                  |        | 2,404             |       |
| Goodwill                                                                                                                                                                                                                                                                 |       | 101                    |        | 101               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                         | ** ** | **$**                  | **258,642** | ** **        | **$**      | **259,388** | ** ** |
|                                                                                                                                                                                                                                                                     |       |                   |        |              |       |
| ***LIABILITIES, TEMPORARY EQUITY AND  STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                       |       |                   |        |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                  |       |                   |        |              |       |
| Accounts payable                                                                                                                                                                                                                                                         |       | $                      | 3,491       |              | $          | 3,297 |   |
| Accrued liabilities                                                                                                                                                                                                                                                      |       | 4,316                  |        | 2,304             |       |
| Oil and gas sales payable                                                                                                                                                                                                                                                |       | 820                    |        | 804               |       |
| Derivative liabilities                                                                                                                                                                                                                                                   |       | 1,249                  |        | 410               |       |
| Current maturity of debt (Note 3)                                                                                                                                                                                                                                        |       | 66,450                 |        | 66,450            |       |
| Current maturity of Series D convertible  preferred stock, net of discount of $1.6 million (Note 4)                                                                                                                                                                 |       | 26,796                 |        | —            |       |
| Current portion of asset retirement obligations                                                                                                                                                                                                                          |       | 194                    |        | 189               |       |
| Total current liabilities                                                                                                                                                                                                                                                |       | 103,316                |        | 73,454            |       |
| **Long-term liabilities**                                                                                                                                                                                                                                                |       |                   |        |              |       |
| Asset retirement obligations                                                                                                                                                                                                                                             |       | 3,062                  |        | 2,991             |       |
| Derivative liabilities                                                                                                                                                                                                                                                   |       | 2,784                  |        | 1,368             |       |
| Deferred tax liabilities and other                                                                                                                                                                                                                                       |       | 18,428                 |        | 18,992            |       |
| Total liabilities                                                                                                                                                                                                                                                        |       | 127,590                |        | 96,805            |       |
| **Temporary equity**                                                                                                                                                                                                                                                     |       |                   |        |              |       |
| Series D convertible preferred stock and  cumulative paid-in-kind dividends; par value $.0001 per share, stated value  $1,000 per share; 49,116 shares authorized; 23,849 issued at June 30,  2010; liquidation preference at June 30, 2010 of $28,100    |       | —                 |        | 26,518            |       |
| **Commitments and contingencies  (Note 9)**                                                                                                                                                                                                                              |       |                   |        |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                            |       |                   |        |              |       |
| Common stock, par value $.0001 per share;  100,000,000 authorized; 47,150,159 and 45,447,082 shares issued and  outstanding, respectively, at September 30, 2010; and 47,159,706 and  45,456,629 shares issued and outstanding, respectively, at June 30, 2010 |       | 5                      |        | 5                 |       |
| Additional paid-in capital                                                                                                                                                                                                                                               |       | 190,525                |        | 190,500           |       |
| Accumulated deficit                                                                                                                                                                                                                                                      |       | (58,781                | )           | (53,743           | )          |
| Treasury stock, at cost; 1,703,077 shares held in  escrow at September 30, 2010 and June 30, 2010, respectively                                                                                                                                                     |       | (697                   | )           | (697              | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                          |       | 131,052                |        | 136,065           |       |
| **TOTAL LIABILITIES, TEMPORARY  EQUITY AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                   | ** ** | **$**                  | **258,642** | ** **        | **$**      | **259,388** | ** ** |

 

**See accompanying notes to these unaudited financialstatements**

 

1

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                       | ** ** | **September 30,**           | ** ** |
| **In Thousands, Except Per Share Data** | ** ** | **2010**                         | ** ** | **2009** | ** ** |
| **Operating Revenues:**                                          |       |                             |       |   |   |
| Crude oil sales                                                  |       | $                                | 5,361      |   | $ | 4,420 |   |
| Natural gas sales                                                |       | 883                              |       | 511 |   |
| Total operating revenues                                         |       | 6,244                            |       | 4,931 |   |
|                                                             |       |                             |       |   |   |
| **Operating Expenses:**                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Lease operating                                                  |       | 3,307                            |       | 4,347 |   |
| Production and ad valorem taxes                                  |       | 454                              |       | 420 |   |
| General and administrative                                       |       | 2,580                            |       | 3,573 |   |
| Depletion and depreciation                                       |       | 1,343                            |       | 1,250 |   |
| Accretion of discount on asset retirement  obligations           |       | 80                               |       | 66 |   |
| Total operating expenses                                         |       | 7,764                            |       | 9,656 |   |
|                                                             |       |                             |       |   |   |
| **Loss from operations**                                         |       | (1,520                           | )          | (4,725 | ) |
| **Other income (expense):**                                      |       |                             |       |   |   |
| Interest expense and other                                       |       | (2,737                           | )          | (147 | ) |
| Loss on derivatives                                              |       | (2,718                           | )          | (512 | ) |
| Total other expense                                              |       | (5,455                           | )          | (659 | ) |
|                                                             |       |                             |       |   |   |
| Loss from continuing operations before income  taxes             |       | (6,975                           | )          | (5,384 | ) |
| Deferred income tax benefit                                      |       | 2,407                            |       | 1,701 |   |
| Loss from continuing operations                                  |       | (4,568                           | )          | (3,683 | ) |
| Income from discontinued operations, net of  related taxes       |       | —                           |       | 122 |   |
| **Net loss**                                                     |       | (4,568                           | )          | (3,561 | ) |
| Preferred stock dividend                                         |       | (470                             | )          | (470 | ) |
| **Net loss applicable to common  stock**                         |       | $                                | (5,038     | ) | $ | (4,031 | ) |
|                                                             |       |                             |       |   |   |
| **Net loss per share - basic and  diluted**                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Continuing operations                                            |       | $                                | (0.11      | ) | $ | (0.09 | ) |
| Discontinued operations                                          |       | —                           |       | — |   |
| **Net loss per share - basic and  diluted**                      |       | $                                | (0.11      | ) | $ | (0.09 | ) |
|                                                             |       |                             |       |   |   |
| **Weighted average common shares  outstanding**                  |       |                             |       |   |   |
| Basic and Diluted                                                |       | 45,443                           |       | 45,571 |   |

 

**See accompanying notes to these unaudited financialstatements**

 

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENT OF CHANGES IN STOCKHODLERS’EQUITY**

**JULY 1, 2010 THROUGH SEPTEMBER 30, 2010**

**(Unaudited)**

 
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** **             | ** **  | ** ** | ** **    | **Total**  | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------------------|-------------|------------|---------------|------------|------------|
| ** **                                     | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | **Stockholders’** | ** **  |
| **Dollar Amounts in Thousands** | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares**             | ** **  | **Amount** | ** **    | **Equity** | ** ** |
| **Balance at July 1, 2010**               | ** ** | **47,159,706**        | ** ** | **$**       | **5**      | ** **      | **$**      | **190,500**             | ** ** | **$**                  | **(53,743** | **)**      | **1,703,077** | ** ** | **$**      | **(697** | **)** | **$** | **136,065** | ** ** |
| ** **                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **              | ** ** | ** **             | ** **  | ** ** | ** **    | ** ** | ** ** |
| Forfeiture and surrender of stock awards       |       | (14,547               | )          | —      |       | —          |       | —                  |       | —                 |        | —     |          | —     |       |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Stock-based compensation expense               |       | —                |       | —      |       | 23              |       | —                  |       | —                 |        | —     |          | 23         |       |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Net proceeds from issuance of common shares    |       | 5,000                 |       | —      |       | 2               |       | —                  |       | —                 |        | —     |          | 2          |       |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Preferred stock dividend                       |       | —                |       | —      |       | —          |       | (470                    | )          | —                 |        | —     |          | (470       | )          |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| Net loss                                       |       | —                |       | —      |       | —          |       | (4,568                  | )          | —                 |        | —     |          | (4,568     | )          |
|                                           |       |                  |       |        |       |            |       |                    |       |                   |        |       |          |       |       |
| **Balance at September 30,  2010**        | ** ** | **47,150,159**        | ** ** | **$**       | **5**      | ** **      | **$**      | **190,525**             | ** ** | **$**                  | **(58,781** | **)**      | **1,703,077** | ** ** | **$**      | **(697** | **)** | **$** | **131,052** | ** ** |

 

**See accompanying notes to these unaudited financialstatements**

 

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                    | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Dollar Amounts in Thousands**                                               | ** ** | **2010**                                                 | ** ** | **2009** | ** ** |
| **Cash flow from operating activities:**                  |       |                                                     |       |   |   |
| Net loss                                                                      |       | $                                                        | (4,568     | ) | $ | (3,561 | ) |
| Adjustments needed to reconcile net loss to net  cash provided by operations: |       |                                                     |       |   |   |
| Unrealized loss on derivatives                                                |       | 4,359                                                    |       | 2,307 |   |
| Gain on sale of oil and gas properties and other                              |       | 50                                                       |       | — |   |
| Accretion of discount on asset retirement  obligations                        |       | 80                                                       |       | 67 |   |
| Depletion and depreciation                                                    |       | 1,343                                                    |       | 1,262 |   |
| Stock-based compensation expense                                              |       | 23                                                       |       | 408 |   |
| Deferred income tax benefit                                                   |       | (2,407                                                   | )          | (1,631 | ) |
| Amortization of debt issuance costs and prepaid  expenses                     |       | 952                                                      |       | 402 |   |
|                                                                          |       |                                                     |       |   |   |
| Changes in assets and liabilities relating to  operations:                    |       |                                                     |       |   |   |
| Accounts receivable                                                           |       | 289                                                      |       | 1,063 |   |
| Derivative assets                                                             |       | (241                                                     | )          | (549 | ) |
| Inventory and other current assets and liabilities                            |       | (38                                                      | )          | (878 | ) |
| Accounts payable                                                              |       | (214                                                     | )          | 994 |   |
| Accrued liabilities                                                           |       | 2,612                                                    |       | 621 |   |
| **Net cash provided by operations**                                           | ** ** | **2,240**                                                | ** ** | **505** | ** ** |
|                                                                          |       |                                                     |       |   |   |
| **Cash flow from investing  activities:**                                     |       |                                                     |       |   |   |
| Additions to oil and gas properties, fixed assets  and other                  |       | (1,355                                                   | )          | (5,445 | ) |
| **Net cash used in investing  activities**                                    | ** ** | **(1,355**                                               | **)**      | **(5,445** | **)** |
|                                                                          |       |                                                     |       |   |   |
| **Cash flow from financing  activities:**                                     |       |                                                     |       |   |   |
| Repayments of long-term debt                                                  |       | (550                                                     | )          | — |   |
| Borrowings of long-term debt                                                  |       | 550                                                      |       | 5,500 |   |
| Proceeds from issuance of common stock, net                                   |       | 2                                                        |       | — |   |
| Payment of preferred stock dividend                                           |       | —                                                   |       | (191 | ) |
| **Net cash provided by financing  activities**                                | ** ** | **2**                                                    | ** ** | **5,309** | ** ** |
|                                                                          |       |                                                     |       |   |   |
| Net increase in cash and cash equivalents                                     |       | 887                                                      |       | 369 |   |
| Cash and cash equivalents at beginning of period                              |       | 300                                                      |       | 392 |   |
| **Cash and cash equivalents at end  of period**                               | ** ** | **$**                                                    | **1,187**  | ** ** | **$** | **761** | ** ** |
|                                                                          |       |                                                     |       |   |   |
| **Supplemental disclosure of  noncash transactions:**                         |       |                                                     |       |   |   |
| Payments of preferred stock dividend in kind                                  |       | $                                                        | 278        |   | $ | 278 |   |
|                                                                          |       |                                                     |       |   |   |
| **Supplemental disclosure of cash  transactions:**                            |       |                                                     |       |   |   |
| Cash paid during the period for interest                                      |       | $                                                        | 716        |   | $ | 666 |   |

 

**See accompanying notes to these unaudited financialstatements**

 

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**CANO PETROLEUM, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

***Consolidation and Use of Estimates***

 

Theseinterim consolidated financial statements are unaudited and contain alladjustments (consisting primarily of normal recurring accruals) necessary for afair statement of the results for the interim periods presented. Results forinterim periods are not necessarily indicative of results to be expected for afull year due in part, but not limited to, the volatility in prices for crudeoil and natural gas, future prices for commodity derivatives, interest rates,estimates of reserves, drilling risks, geological risks, transportationrestrictions, the timing of events, product demand, market competition, interruptionin production, our ability to obtain additional capital, and the success ofwaterflooding and enhanced oil recovery techniques. You should read theseconsolidated interim financial statements in conjunction with the auditedconsolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the year ended June 30, 2010.

 

Theaccompanying financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”)and include the accounts of Cano Petroleum, Inc. and its wholly-ownedsubsidiaries (collectively, “Cano”). 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. The computation of stock-based compensationexpense requires assumptions such as volatility, expected life and therisk-free interest rate. The computation of mark-to-market valuations of ourcommodity derivatives include the observability of quoted market prices and anassessment of potential non-performance of counterparties. It is possible theseestimates could be revised in the near term, and these revisions could bematerial.

 

Significantassumptions are required in the valuation of proved crude oil and natural gasreserves, which may affect the amounts at which crude oil and natural gasproperties are recorded. Our estimates of proved reserves materially impactdepletion expense. If proved reserves decline, then the rate at which we recorddepletion expense increases. A decline in estimated proved reserves couldresult from lower prices, adverse operating results, mechanical problems at ourwells and catastrophic events such as fires, hurricanes and floods. Lowerprices can make it uneconomical to drill new wells or produce from existingwells with high operating costs. In addition, a decline in proved reserves mayimpact our assessment of our oil and natural gas properties for impairment. Ourproved reserves estimates are based upon many assumptions, all of which coulddeviate materially from actual results. As such, reserve estimates may vary materiallyfrom the ultimate quantities of crude oil and natural gas actually produced.

 

***New Accounting Pronouncements***

 

Accountingstandards-setting organizations frequently issue new or revised accountingrules. We regularly review all new pronouncements to determine their impact, ifany, on our financial statements. No pronouncements materially affecting ourfinancial statements have been issued since the filing of our Form 10-Kfor the year ended June 30, 2010.

 

**2. LIQUIDITY / GOING CONCERN**

 

AtSeptember 30, 2010, we had cash and cash equivalents of $1.2 million.We had negative working capital of $96.6 million, which includes currentliabilities of $66.5 million of long-term debt and $26.8 million of Series Dconvertible preferred stock. For the three-month period endedSeptember 30, 2010, we had cash flow provided by operations of$2.2 million.

 

OnJuly 20, 2010, we terminated our announced merger with ResacaExploitation, Inc. (“Resaca”) that had been initiated pursuant to anAgreement and Plan of Merger dated September 29, 2009.  On July 26, 2010 we announced theengagement of Canaccord Genuity and Global Hunter Securities to assist ourBoard in a review of strategic alternatives, with a goal of maximizing economicvalue for our shareholders.  Thestrategic alternatives we are considering include the sale of the Company, thesale of some or all of our existing oil and gas properties and assets,potential business combinations and recapitalizing the Company. We are alsofocused on cost reduction efforts to improve our profitability and increasecash flow from operations.

 

Wecurrently have limited access to capital. On August 6, 2010, we finalizedConsent and Forbearance Agreements with the lenders under our credit agreementsthat waived potential covenant compliance issues for the periods endingJune 30, 2010 and September 30, 2010, set certain deadlines for theexecution of our strategic alternatives process and allowed us to sell certainnatural gas commodity derivative contracts for cash proceeds of $0.8 million,which was intended to provide Cano sufficient liquidity to complete itsstrategic alternatives process. The Consent and Forbearance Agreements wereterminated as our lenders delivered Reservation of Rights Letters dated September 24,2010, as discussed in Note 3.  Wecontinue to work with our lenders and advisors

 

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aswe consider strategic alternatives.  Asof November 15, 2010, our lenders have taken no actions associated withthe termination of the Consent and Forbearance Agreements.  We currently have no available borrowingcapacity under our senior and subordinated credit agreements.

 

The accompanyingconsolidated financial statements have been prepared on a going concern basiswhich contemplates continuity of operations, realization of assets andliquidation of liabilities in the ordinary course of business. There is noassurance that the carrying amounts of assets will be realized or thatliabilities will be settled for the amounts recorded. The ability of theCompany to continue as a going concern will be dependent upon the outcome ofour strategic alternatives review. Unless we are able to successfully execute one of our strategicalternatives, restructure our existing indebtedness, obtain further waivers orforbearance from our lenders, raise new capital, or restructure the terms ofour Series D Convertible Preferred Stock (“Preferred Stock”), it isunlikely that we will be able to meet our obligations as they become due and tocontinue as a going concern.

 

**3. DEBT**

 

AtSeptember 30, and June 30, 2010, the outstanding amount due under ourcredit agreements was $66.5 million. The $66.5 million consisted ofoutstanding borrowings under the amended and restated credit agreement (the “ARCA”)and the subordinated credit agreement (the “SCA”) of $51.5 million and$15.0 million, respectively. At September 30, 2010, the averageinterest rates charged by the lenders under the ARCA and SCA were 3.03% and6.43%, respectively.

 

OnAugust 5, 2010, we executed a Consent and Forbearance Agreement (the “SeniorForbearance Agreement”) with Union Bank, N.A. (“UBNA”) and Natixis relating toexisting and potential defaults under the ARCA dated December 17, 2008among Cano, UBNA and Natixis and a Consent and Forbearance Agreement (togetherwith the Senior Forbearance Agreement, the “Forbearance Agreements”) withUnionBanCal Equities, Inc. (“UBE”), relating to existing defaults underthe SCA dated December 17, 2008 between Cano and UBE (as amended, the SCAand together with the ARCA, the “Credit Agreements”).

 

OnSeptember 24, 2010, our lenders delivered Reservation of Rights Letters (“Letters”)specifying that we failed to timely comply with the material terms of theForbearance Agreements and therefore terminated the ForbearanceAgreements.  As of November 15, 2010, the lenders have taken noaction with the delivery of these Letters. We have recorded all additional interest and fees due under the terms ofthe Forbearance Agreements in accrued liabilities on our consolidated balancesheet and in interest expense on consolidated statement of operations as of September 30,2010.  We have also recorded additionalinterest expense associated with the accelerated amortization of deferredfinancing costs applicable to the Credit Agreements.

 

**4. PREFERRED STOCK**

 

OnAugust 5, 2010, we entered into Forbearance Agreements with the lendersunder our Credit Agreements that prohibit us from making any indirect or directcash payment, cash dividend or cash distribution in respect of our shares ofPreferred Stock. As discussed under Note 3, the Forbearance Agreements wereterminated.  As of September 30,2010, we have not remitted cash dividend payments for the Preferred Stock of$0.2 million. As of September 30, 2010, the unpaid cash dividend of $0.2million is included in accrued liabilities reported in our consolidated balancesheets. Due to the non-payment of the cash dividends, our Preferred Stock hasbeen reclassified from Temporary Equity to a current liability of $26.8 millionon our consolidated balance sheet, which is the liquidation preference of $28.4million less issuance costs of $1.6 million, which is presented as a discounton the consolidated balance sheet as of September 30, 2010.   The issuance costs of $1.6 million will beamortized in preferred stock dividend beginning October 1, 2010.

 

S.Jeffrey Johnson, our Chief Executive Officer and Chairman of our board ofdirectors, owns approximately 3.5% of our outstanding Preferred Stock. For thethree-month periods ended September 30, 2010 and 2009, we paid preferreddividend payments to Mr. Johnson of approximately $0 and $20,000,respectively.

 

Ifany Preferred Stock remains outstanding on September 6, 2011, we arerequired to redeem the Preferred Stock for a redemption amount in cash equal tothe stated value of the Preferred Stock, plus accrued cash and paid-in-kinddividends.

 

**5. DERIVATIVES**

 

Ourderivatives consist of commodity derivatives and an interest rate swaparrangement, which are discussed in greater detail below.

 

6

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***Commodity Derivatives***

 

Pursuantto the ARCA and SCA discussed in Note 3, we are required to maintain ourexisting commodity derivative contracts. We entered into commodity derivative contracts to partially mitigate therisk associated with extreme fluctuations of prices for our crude oil andnatural gas sales.  We have no obligationto enter into commodity derivative contracts in the future. Should we choose toenter into commodity derivative contracts to mitigate future price risk, wecannot enter into contracts for greater than 85% of our crude oil and naturalgas production volumes attributable to proved producing reserves for a givenmonth. As of September 30, 2010, we maintained the following “collar”commodity derivative contracts with UBNA as our counterparty, which is one ofthe senior lenders under the ARCA:

 
| **Time  Period**             | ** ** | **Floor  Oil Price** | ** ** | **Ceiling  Oil Price** | ** ** | **Barrels  Per Day** | ** ** | **Floor  Gas  Price** | ** ** | **Ceiling  Gas Price** | ** ** | **Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per  Day(a)** | ** ** |
|------------------------------|------------|---------------------------|------------|-----------------------------|------------|---------------------------|------------|-----------------------|------------|-----------------------------|------------|-----------------------|------------|-------------------------------------------------------|------------|
| 10/1/10 - 12/31/10 |       | $                         | 80.00      |                        | $          | 108.20                    |       | 333                   |       | $                           | —     |                  | $          | —                                                |       | — |   | 333 |   |
| 10/1/10 - 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                   |       | $                           | —     |                  | $          | —                                                |       | — |   | 333 |   |
| 1/1/11 - 3/31/11   |       | $                         | 85.00      |                        | $          | 100.50                    |       | 200                   |       | $                           | 8.00       |                  | $          | 11.05                                                 |       | 967 |   | 361 |   |

 

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(a)         This column iscomputed by dividing the “Mcf per Day” by 6 and adding it to “Barrels per Day.”

 

OnSeptember 11, 2009, we entered into two fixed price commodity swapcontracts with Natixis as our counterparty, which is one of our senior lendersunder the ARCA. The fixed price swaps are based on West Texas IntermediateNYMEX prices and are summarized in the table below.

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

 

***Interest Rate Swap Agreement***

 

OnJanuary 12, 2009, we entered into a three-year LIBOR interest rate basisswap contract with Natixis Financial Products, Inc. (“Natixis FPI”) for$20.0 million in notional exposure. We entered into the interest rate swapagreement to partially mitigate the risk associated with rising interestrates.  Under the terms of thetransaction, we will pay Natixis FPI, in three-month intervals, a fixed rate of1.73% and Natixis FPI will pay Cano the prevailing three-month LIBOR rate.

 

***Financial Statement Impact***

 

Duringthe three-month period ended September 30, 2010 and 2009, respectively,the gain (loss) on derivatives reported in our consolidated statements ofoperations is summarized as follows:

 
| ** **                                                  | ** ** | **Location of Gain** | ** ** | **Three-Month Period Ended September 30,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(Loss) Derivative**     | ** ** | **2010**                                                       | ** ** | **2009** | ** ** |
| Settlements  received/accrued on commodity derivatives |       | Other income (expense)         |       | $                                                              | 904        |   | $ | 1,851 |   |
| Settlements  received on sale of commodity derivatives      |       | Other income (expense)         |       | 800                                                            |       | — |   |
| Settlements  paid/accrued on interest rate swap             |       | Other income (expense)         |       | (63                                                            | )          | (56 | ) |
| Realized  gain (loss) on derivatives                        |       | Other income (expense)         |       | 1,641                                                          |       | 1,795 |   |
| Unrealized  gain (loss) on commodity derivatives            |       | Other income (expense)         |       | (4,332                                                         | )          | (2,204 | ) |
| Unrealized  gain (loss) on interest rate swap               |       | Other income (expense)         |       | (27                                                            | )          | (103 | ) |
| Loss  on derivatives                                        |       | Other income (expense)         |       | $                                                              | (2,718     | ) | $ | (512 | ) |

 

On August 10, 2010, wesold certain natural gas commodity derivative contracts realizing net proceedsof $0.8 million pursuant to the Forbearance Agreements. The cash settlementsreceived/accrued by us under commodity derivatives were cumulative monthlypayments due to us since the NYMEX natural gas and crude oil prices were lowerthan the floor prices set for the respective time periods and realized gainsfrom the sale of uncovered “floor price” contracts as previously discussed. Thecash settlements paid/accrued by us under commodity derivatives were cumulativemonthly payments due to our counterparty since the NYMEX crude oil and naturalgas prices were higher than the ceiling prices set for the respective timeperiods. The cash settlements paid/accrued by

 

7

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us under the interest rateswap were quarterly payments to our counterparty since the actual three-monthLIBOR interest rate was lower than the fixed 1.73% rate we pay to thecounterparty. The cash flows relating to the derivative instrument settlementsthat are due, but not cash settled are reflected in operating activities on ourconsolidated statements of cash flows as changes to current assets and currentliabilities. At September 30, 2010 and June 30, 2010, we had recordeda receivable from our counterparty included in accounts receivable on ourconsolidated balance sheet of $0.2 million and $0.3 million, respectively.

 

Theunrealized gain (loss) on commodity derivatives represents estimated futuresettlements under our commodity derivatives and is based on mark-to-marketvaluation based on assumptions of forward prices, volatility and the time valueof money as discussed below. We compared our internally derived valuation toour counterparties’ independently derived valuation to further validate ourmark-to-market valuation.

 

Theunrealized gain (loss) on interest rate swap represents estimated futuresettlements under our interest rate swap agreement and is based on amark-to-market valuation based on assumptions of interest rates, volatility andthe time value of money as discussed below.

 

***Fair Value Measurements***

 

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

 

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

 

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

 

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

 

Invaluing certain contracts, the inputs used to measure fair value may fall intodifferent levels of the fair value hierarchy. For disclosure purposes, assetsand liabilities are classified in their entirety in the fair value hierarchylevel based on the lowest level of input that is significant to the overallfair value measurement. Our assessment of the significance of a particularinput to the fair value measurement requires judgment and may affect theplacement within the fair value hierarchy levels.

 

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

 

Theestimated fair value of derivatives included in the consolidated balance sheetat September 30, 2010 is summarized below.

 
| **In thousands**               | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|
| Derivative assets (Level 2):   |       |       |       |
| Crude oil collars—current      |       | $          | 401        |   |
| Natural gas collars—current    |       | 567        |       |
| Derivative liability (Level 2) |       |       |       |
| Interest rate swap—current     |       | (191       | )          |
| Interest rate swap—noncurrent  |       | (101       | )          |
| Derivative liability (Level 3) |       |       |       |
| Crude oil swap—current         |       | (1,058     | )          |
| Crude oil swap—noncurrent      |       | (2,683     | )          |
| Net derivative liabilities          |       | $          | (3,065     | ) |

 

8

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Thefollowing table shows the reconciliation of changes in the fair value of thenet derivative assets classified as Level 2 and 3, respectively, in thefair value hierarchy for the three months ended September 30, 2010 (inthousands).

 
| **In thousands**              | ** ** | **Total Net  Derivative  Assets  (Liabilities)** | ** ** |
|------------------------------------|------------|-------------------------------------------------------|------------|
| Balance at June 30, 2010      |       | $                                                     | 1,190      |   |
| Unrealized loss on derivatives     |       | (4,359                                                | )          |
| Settlements, net                   |       | 104                                                   |       |
| Balance at September 30, 2010 |       | $                                                     | (3,065     | ) |

 

Thechange from net derivative assets of $1.2 million at June 30, 2010 tonet derivative liabilities of $3.1 million at September 30, 2010 isattributable to the increases in crude oil and natural gas futures prices andsettlements that occurred during the three-month period. These amounts arebased on our mark-to-market valuation of these derivatives at September 30,2010 and may not be indicative of actual future cash settlements.

 

Thefollowing table summarizes the fair value of our derivative contracts as of thedates indicated:

 
| ** **                                                  | ** ** | **Asset Derivatives**          | ** ** | **Liability Derivatives** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **September 30, 2010**    | ** ** | **June 30, 2010**    | ** ** | **September 30, 2010** | ** ** | **June 30, 2010** | ** ** |
| **In thousands**                                       | ** ** | **Balance Sheet  Location**    | ** ** | **Fair  Value**                | ** ** | **Balance Sheet  Location** | ** ** | **Fair  Value** | ** ** | **Balance Sheet  Location** | ** ** | **Fair  Value** | ** ** | **Balance Sheet  Location** | ** ** | **Fair  Value** | ** ** |
| **Derivatives not designated as hedging instruments**  |       |                                |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commodity  derivative contracts                             |       | Derivatives —  current    |       | $                              | 968        |   | Derivatives —  current |   | $ | 2,968 |   | Derivatives —  current |   | $ | (1,058 | ) | Derivatives —  current |   | $ | (206 | ) |
| Commodity  derivative contracts                             |       | Derivatives —  noncurrent |       | —                         |       | Derivatives —  noncurrent |   | — |   | Derivatives —  noncurrent |   | (2,683 | ) | Derivatives —  noncurrent |   | (1,308 | ) |
| Interest  rate swaps                                        |       | Derivatives —  current    |       | —                         |       | Derivatives —  current |   | — |   | Derivatives —  current |   | (191 | ) | Derivatives —  current |   | (204 | ) |
| Interest  rate swaps                                        |       | Derivatives —  noncurrent |       | —                         |       | Derivatives —  noncurrent |   | — |   | Derivatives  - noncurrent |   | (101 | ) | Derivatives  - noncurrent |   | (60 | ) |
| **Total derivatives not designated as hedging instruments** |       |                                |       | $                              | 968        |   |   |   | $ | 2,968 |   |   |   | $ | (4,033 | ) |   |   | $ | (1,778 | ) |
| **Total derivatives designated as hedging instruments**     |       |                                |       | $                              | —     |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |
| **Total derivatives**                                       |       |                                |       | $                              | 968        |   |   |   | $ | 2,968 |   |   |   | $ | (4,033 | ) |   |   | $ | (1,778 | ) |

 

**6. DISCONTINUED OPERATIONS**

 

OnJanuary 27, 2010, we completed the sale of our interests in certain oiland gas properties located in the Texas Panhandle (“Certain Panhandle Properties”)for net proceeds of $6.3 million, subject to customary post-closingadjustments. The sale had an effective date of January 1, 2010. Theoperating results of the Certain Panhandle Properties for the three-monthperiod ended September 30, 2009 have been reclassified as discontinuedoperations in the consolidated statements of operations as detailed in thetable below (in thousands).

 
| Operating  Revenues:                                   |   |   |   |
|--------------------------------------------------------|--------|--------|--------|
| Crude  oil sales                                       |   | $      | 11     |   |
| Natural  gas sales                                     |   | 322    |   |
| Total  operating revenues                              |   | 333    |   |
| Operating  Expenses:                                   |   |   |   |
| Lease  operating                                       |   | 69     |   |
| Production  and ad valorem taxes                       |   | 47     |   |
| Depletion  and depreciation                            |   | 13     |   |
| Accretion  of discount on asset retirement obligations |   | 1      |   |
| Interest  expense, net                                 |   | 11     |   |
| Total  operating expenses                              |   | 141    |   |
| Income  before income taxes                            |   | 192    |   |
| Income  tax provision                                  |   | (70    | )      |
| Income  from discontinued operations                   |   | $      | 122    |   |

 

Interestexpense, net of interest income, was allocated to discontinued operations basedon the percent of operating revenues applicable to discontinued operations tothe total operating revenues.

 

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**7. STOCKOPTIONS**

 

Duringthe three-month period ended September 30, 2010, we did not grantadditional stock options.  A summary of outstanding options as ofSeptember 30, 2010 is as follows:

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding at June 30, 2010      |       | 1,310,710  |       | $                                      | 4.33       |   |
| Options exercised                      |       | (5,000     | )          | 0.43                                   |       |
| Options forfeited                      |       | (120,396   | )          | $                                      | 5.02       |   |
| Outstanding at September 30, 2010 |       | 1,185,314  |       | $                                      | 4.28       |   |

 

Basedon our $0.41 stock price at September 30, 2010, there was no intrinsicvalue of both the options outstanding and exercisable.

 

Totaloptions exercisable at September 30, 2010 amounted to 1,185,314 shares andhad a weighted average exercise price of $4.28. Upon exercise, we issuethe full amount of shares exercisable per the term of the options from newshares. We have no plans to repurchase those shares in the future.

 

Forthe three-month period ended September 30, 2010, we recorded a credit tostock compensation expense of $0.1 million, primarily due to adjusting expensefor the vesting of the estimated fair value of the options granted to ourdirectors and employees. For the three-month period ended September 30,2009, we recorded a charge to stock compensation expense of $0.1 million. As of September 30, 2010, we had fully expensed the total compensationcost related to the outstanding option awards.

 

**8. DEFERREDCOMPENSATION**

 

Asof September 30, 2010, we had non-vested share awards totaling 106,668shares to key employees pursuant to our 2005 Long-Term Incentive Plan, assummarized below:

 
| ** **                                         | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date  Fair Value** | ** ** | **Fair Value  $000s** | ** ** |
|----------------------------------------------------|------------|------------|------------|----------------------------------------------------|------------|----------------------------|------------|
| Non-vested share awards at June 30, 2010      |       | 161,668    |       | $                                                  | 7.18       |                       | $          | 1,160 |   |
| Shares vested                                      |       | (40,453    | )          | $                                                  | 5.84       |                       | $          | (236 | ) |
| Shares forfeited or surrendered                    |       | (14,547    | )          | $                                                  | 5.84       |                       | (85        | ) |
| Non-vested share awards at September 30, 2010 |       | 106,668    |       | $                                                  | 7.87       |                       | $          | 839 |   |

 

The share awards will vest to the employees by July 2,2011. The fair values of the awards are based on our actual stock price on thedate of grant multiplied by the number of shares granted.  As of September 30,2010, the grant date fair value of non-vested shares amounted to $0.8million.  For the quarters ended September 30, 2010 and 2009, we haveexpensed $0.1 million and $0.3 million, respectively, to stock compensationexpense based on amortizing the fair value over the appropriate serviceperiod.  The forfeitures resulted from shares used to satisfy employees’tax withholding obligations related to the vesting of their share awards.

 

**9.COMMITMENTS AND CONTINGENCIES**

 

***Burnett Case***

 

On March 23, 2006, thefollowing lawsuit was filed in the 100th Judicial District Court in CarsonCounty, Texas: Cause No. 9840, The Tom L. and Anne Burnett Trust, by AnneBurnett Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, IIIand Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and BurnettRanches, Ltd. v. Cano Petroleum, Inc., W.O. Energy ofNevada, Inc., W. O. Operating Company, Ltd. and WO Energy, Inc.The plaintiffs claimed 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) alleged negligence and gross negligence and (ii) sought damages,including, but not limited to, damages for damage to their land and livestock,certain expenses related to fighting the fire and certain remedial expensestotaling approximately $1.7 million to $1.8 million. In addition, theplaintiffs sought (i) termination of certain oil and natural gas leases,(ii) reimbursement

 

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for their attorney’s fees(in the amount of at least $549,000) and (iii) exemplary damages. Theplaintiffs also claimed that Cano and its subsidiaries were jointly andseverally liable as a single business enterprise and/or a general partnershipor de facto partnership. The owner of the remainder of the mineral estate,Texas Christian University, intervened in the suit on August 18, 2006,joining Plaintiffs’ request to terminate certain oil and gas leases. OnJune 21, 2007, the judge of the 100th Judicial District Court issueda Final Judgment (a) granting motions for summary judgment in favor ofCano and certain of its subsidiaries on plaintiffs’ claims for (i) breachof contract/termination of an oil and gas lease; and (ii) negligence; and(b) granting the plaintiffs’ no-evidence motion for summary judgment oncontributory negligence, assumption of risk, repudiation and estoppelaffirmative defenses asserted by Cano and certain of its subsidiaries.

 

The Final Judgment wasappealed and a decision was reached on March 11, 2009, as the Court ofAppeals for the Tenth District of Texas in Amarillo affirmed in part andreversed in part the ruling of the 100th Judicial District Court. TheCourt of Appeals (a) affirmed the trial court’s granting of summaryjudgment in Cano’s favor for breach of contract/termination of an oil and gaslease and (b) reversed the trial court’s granting of summary judgment inCano’s favor on plaintiffs’ claims of Cano’s negligence. The Court of Appealsordered the case remanded to the 100th Judicial District Court. OnMarch 30, 2009, the plaintiffs filed a motion for rehearing with the Courtof Appeals and requested a rehearing on the affirmance of the trial court’sholding on the plaintiffs’ breach of contract/termination of an oil and gaslease claim. On June 30, 2009, the Court of Appeals ruled to deny theplaintiff’s motion for rehearing. On August 17, 2009 we filed an appealwith the Texas Supreme Court to request the reversal of the Court of Appealsruling regarding our potential negligence. On December 11, 2009, the TexasSupreme Court declined to hear Cano’s appeal.

 

This lawsuit was resolved through a Settlement andRelease Agreement effective October 19, 2010, pursuant to which thislawsuit has been dismissed without prejudice. The dismissal without prejudicewill automatically convert to a dismissal with prejudice, thus foreclosing theplaintiffs’ ability to re-file this suit, once we have fully satisfied the obligationscontained in the Settlement and Release Agreement.  Based on our knowledgeand judgment of the facts as of November 15, 2010, our financialstatements dated September 30, 2010 present fairly the effect of theactual and the anticipated future costs to resolve this matter.

 

***Securities Litigation against OutsideDirectors***

 

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

 

On July 2, 2009, theplaintiffs filed an amended complaint that added as defendants Cano, Cano’sChief Executive Officer and Chairman of the Board, Jeff Johnson, Cano’s formerSenior Vice President and Chief Financial Officer, Morris B. “Sam” Smith, Cano’scurrent Senior Vice President and Chief Financial Officer, Ben Daitch, Cano’sVice President and Principal Accounting Officer, Michael Ricketts and Cano’sformer Senior Vice President of Engineering and Operations, Patrick McKinney,and dismissed Gerald W. Haddock, a former director of Cano, as a defendant. Theamended complaint alleges that the prospectus for the Secondary Offeringcontained statements regarding Cano’s proved reserve amounts and standards thatwere materially false and overstated Cano’s proved reserves. The plaintiff isseeking to certify the lawsuit as a class action lawsuit and is seeking anunspecified amount of damages. On July 27, 2009, the defendants moved todismiss the lawsuit. On December 3, 2009, the U.S. District Court for theNorthern District of Texas granted motions to dismiss all claims brought by theplaintiffs. On December 18, 2009, the plaintiffs filed a notice of appealwith the U.S. Court of Appeals for the Fifth Circuit. On April 5, 2010,Cano filed its appellate brief to support its position.  On April 19,2010, the plaintiffs filed their response brief. On August 4, 2010, theU.S. Court of Appeals for the Fifth Circuit affirmed the dismissal by the U.S.District Court for the Northern District of Texas of all claims by theplaintiffs.  By affirming the decision of the lower court, the U.S. Courtof Appeals for the Fifth Circuit agreed that the plaintiff’s complaint failedto state a claim upon which relief could be granted, and thus found merit indismissing the lawsuit.

 

***Other***

 

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

 

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Section 7.6of the Merger Agreement with Resaca Exploitation, Inc. (“Resaca”) providedfor the Company and Resaca to share transaction expenses related to theprinting, filing and mailing of the registration statement on Form S-4covering the Resaca shares that would have been issued to Cano stockholders inthe merger, the proxy statements relating to the meetings at which thestockholders of Cano and Resaca voted to approve the merger, and thesolicitation of stockholder approvals.  On September 2, 2010, wefiled an action against Resaca in the Tarrant County District Court seeking adeclaratory judgment to clarify the scope and determine the amount of anyexpenses that are reimbursable under Section 7.6 of the MergerAgreement.  Based on our knowledge and judgment of the facts as of November 15,2010, our financial statements dated September 30, 2010 present fairly theeffect of the actual and the anticipated future costs to resolve this matter.

 

**Item** **2.  Management**’**s Discussion and Analysis of Financial Condition and Results ofOperations.**

 

**CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

 

Theinformation in this Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995. This Act provides a “safe harbor” for forward-looking statements toencourage companies to provide prospective information about themselvesprovided they identify these statements as forward looking and providemeaningful cautionary statements identifying important factors that could causeactual results to differ from the projected results. All statements other thanstatements of historical fact made in this report are forward looking. Inparticular, the statements herein regarding industry prospects and futureresults of operations or financial position are forward-looking statements.Forward-looking statements reflect management’s current expectations and areinherently uncertain. Our actual results may differ significantly frommanagement’s expectations as a result of many factors, including, but notlimited to, our ability to successfully execute one of our strategicalternatives, restructure our existing indebtedness, obtain further waivers orforbearance from our lenders, raise new capital, restructure the terms of ourPreferred Stock, the volatility in prices for crude oil and natural gas, futurecommodity prices for derivative hedging contracts, interest rates, estimates ofreserves, drilling risks, geological risks, transportation restrictions, the timingof acquisitions, product demand, market competition, interruption inproduction, our ability to obtain additional capital, and the success ofwaterflooding and enhanced oil recovery techniques.

 

Statementsin this Quarterly Report on Form 10-Q regarding Cano’s strategy, riskfactors, capital budget, projected expenditures, liquidity and capitalresources, and drilling and development plans reflect Cano’s current plans forthe fiscal year ending June 30, 2011 as a stand-alone entity and do nottake into account the impact of strategic alternatives being considered by Canooperating on a going concern basis.

 

Youshould read the following discussion and analysis in conjunction with theconsolidated financial statements of Cano and its subsidiaries and notesthereto, included herewith. This discussion should not be construed to implythat the results discussed herein will necessarily continue into the future, orthat any conclusion reached herein will necessarily be indicative of actualoperating results in the future. Such discussion represents only the bestpresent assessment of management.

 

**Overview**

 

***Introduction***

 

Weare an independent oil and natural gas company. Our strategy is to exploit ourcurrent undeveloped reserves and acquire, where economically prudent, assetssuitable for enhanced oil recovery at a low cost. We intend to convert ourproved undeveloped and/or unproved reserves into proved producing reserves byapplying water, gas and/or chemical flooding and other EOR techniques. Ourassets are located onshore U.S. in Texas, New Mexico and Oklahoma.

 

Duringour first three years of operations, our primary objective was to achievegrowth through acquiring existing, mature crude oil and natural gas fields.Since then, we have focused on waterflood operations in our two largestproperties, Panhandle and Cato. These development activities are more clearlydescribed below under *“—Drilling Capital Development andOperating Activities Update.”*

 

Asdiscussed under *“—Liquidity / Going Concern,”*on July 20, 2010, weterminated our announced merger with Resaca Exploitation, Inc. (“Resaca”)that had been initiated pursuant to an Agreement and Plan of Merger dated September 29,2009.  On July 26, 2010 we announcedthe engagement of Canaccord Genuity and Global Hunter Securities to assist ourBoard in a review of strategic alternatives. The strategic alternatives we are considering include the sale of theCompany, the sale of some or all of our existing oil and gas properties andassets, potential business combinations and recapitalizing the Company. We arealso focused on cost reduction efforts to improve our profitability andincrease cash flow from operations.

 

12

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***Drilling Capital Development and OperatingActivities Update***

 

Forthe quarter ending September 30, 2010 (“current quarter”) our productionaveraged 1,104 net barrels of oil equivalent per day (BOEPD), which wascomparable to production of 1,102 BOEPD for the quarter ended September 30,2009 (“prior year quarter”). Increased production from the workover activitiesand return-to-production (“RTP”) program at the Desdemona Field were offset bydecreased production at the Cato Properties due to the mandatory lowerwaterflood injection volumes, as discussed below.

 

Forthe current quarter, we incurred development capital expenditures of$0.6 million (excludes capitalized general and administrative and interestexpenses). We held our capital expenditures to a minimum level during thecurrent quarter to maintain our current level of production, while wefinalize  our review of strategicalternatives.

 

Thefollowing is a discussion of our field level activity during the three-monthperiod ended September 30, 2010.

 

**Cato Properties.**

 

Our2011 Fiscal Year development capital plan is to continue the development of theestablished waterflood footprint of approximately 1,000 acres.  On May 6, 2010, we receivedadministrative approval from the New Mexico Oil and Gas Conservation Division (“NMOGCD”)to increase injection pressures at the 14 active wells to our current physicalplant capabilities of approximately 21,000 BWIPD.  As of September 30,2010, we have maintained an injection rate of 12,000 BWIPD, which is less thanthe approved rate from the NMOGCD as we have reduced capital spending pendingthe outcome of our strategic alternatives review.  We have seen increased fluid production ratesand corresponding increasing crude oil rates from this waterflood.  On August 5, 2010, we received anexpansion permit from the NMOGCD to expand the waterflood operations. We arecurrently installing additional equipment to increase water injection and toincrease fluid production and corresponding crude oil production.  Additional development plans for the CatoProperties include possible behind-pipe recompletions and restoration ofproduction from the Tom-Tom and Tomahawk fields.  Net production at theCato Properties for the current quarter was 233 BOEPD, which was 66 BOEPD lowerthan the prior year quarter of 299 BOEPD. The decrease resulted from thereduction in injected water and the redistribution of water injection at thewaterflood.

 

**Panhandle Properties.**

 

Duringthe current quarter, we reduced the rate of waterflood injection at theCockrell Ranch unit to optimize crude oil production from fewer wells since wehave reduced capital spending pending the outcome of our strategic alternativesreview.  Also, during the currentquarter, we completed the project to construct gathering lines to redirectnatural gas production from Eagle Rock Field Services L.P. (“Eagle Rock”) toDCP Midstream, LP (“DCP”), for economically feasible wells.  Netproduction at the Panhandle Properties for the current and prior year quarterswas 489 BOEPD and 475 BOEPD, respectively.

 

**Desdemona Properties.**

 

Duringthe current quarter, we focused on optimizing the activated RTP wells andcompleted upgrades to our gas plant to sell all natural gas and natural gasliquids produced from the Duke Sand formation. Production from all of the RTP’dnatural gas wells, including associated NGL recovery from our gas plant, isexpected to be approximately 10-20 Mcfe per day for each gas well returned toproduction. We have re-equipped our gas plant to handle the increased naturalgas production and the gas plant became functional during August 2010.  Through September 30, 2010, we havecompleted approximately 35% of the RTP project and have increased our dailyproduction from the Desdemona Properties to approximately 90 BOEPD for themonth of September 2010.

 

Netproduction at the Desdemona Properties for the current quarter was 78 BOEPD,which was a 40 BOEPD increase as compared to the prior year quarter of 38 BOEPDresulting from the RTP and workover activity previously discussed.

 

**Nowata Properties.**  Net production for the current and prior yearquarters was 218 BOEPD and 217 BOEPD, respectively.  We are currentlyassessing our operations at the Nowata Properties to increase production,including constructing an additional gas gathering system and optimizingcurrent infrastructure. Our goal is to convert 50 MBOE from PDNP to PDPreserves.

 

**Davenport Properties.**  Net production for the current and prior yearquarters was 86 BOEPD and 73 BOEPD, respectively. We are currently assessingthe economic feasibility of an RTP project to activate non-producing wells,which will convert PDNP to PDP reserves.

 

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**Liquidity and Capital Resources**

 

***Liquidity / Going Concern***

 

AtSeptember 30, 2010, we had cash and cash equivalents of $1.2 million.We had negative working capital of $96.6 million, which includes currentliabilities of $66.5 million of long-term debt and $26.8 million of Series Dconvertible preferred stock. For the three-month period endedSeptember 30, 2010, we had cash flow provided by operations of$2.2 million.

 

OnJuly 20, 2010, we terminated our announced merger with ResacaExploitation, Inc. (“Resaca”) that had been initiated pursuant to anAgreement and Plan of Merger dated September 29, 2009.  On July 26, 2010 we announced theengagement of Canaccord Genuity and Global Hunter Securities to assist ourBoard in a review of strategic alternatives, with a goal of maximizing economicvalue for our shareholders.  Thestrategic alternatives we are considering include the sale of the Company, thesale of some or all of our existing oil and gas properties and assets,potential business combinations and recapitalizing the Company. We are alsofocused on cost reduction efforts to improve our profitability and increasecash flow from operations.

 

Wecurrently have limited access to capital. On August 6, 2010, we finalizedConsent and Forbearance Agreements with the lenders under our credit agreementsthat waived potential covenant compliance issues for the periods endingJune 30, 2010 and September 30, 2010, set certain deadlines for theexecution of our strategic alternatives process and allowed us to sell certainnatural gas commodity derivative contracts for cash proceeds of $0.8 million,which was intended to provide Cano sufficient liquidity to complete itsstrategic alternatives process. The Consent and Forbearance Agreements wereterminated as our lenders delivered Reservation of Rights Letters dated September 24,2010, as discussed in Note 3 to our Consolidated Financial Statements.  We continue to work with our lenders andadvisors as we consider strategic alternatives. As of November 15, 2010, our lenders have taken no actionsassociated with the termination of the Consent and Forbearance Agreements.  We currently have no available borrowingcapacity under our senior and subordinated credit agreements.

 

The accompanyingconsolidated financial statements have been prepared on a going concern basiswhich contemplates continuity of operations, realization of assets andliquidation of liabilities in the ordinary course of business. There is noassurance that the carrying amounts of assets will be realized or thatliabilities will be settled for the amounts recorded. The ability of theCompany to continue as a going concern will be dependent upon the outcome ofour strategic alternatives review. Unless we are able to successfully execute one of our strategicalternatives, restructure our existing indebtedness, obtain further waivers orforbearance from our lenders, raise new capital or restructure the terms of ourPreferred Stock, it is unlikely that we will be able to meet our obligations asthey become due and to continue as a going concern.

 

Under both the ARCA andSCA, we were not in compliance with the covenants relatingto our current ratio, leverage ratio and interest coverage ratio for thequarter ended September 30, 2010. We do not expect to be in compliance with the covenant ratios in theforeseeable future.

 

**Results of Operations**

 

***Overall***

 

Forthe current quarter, we had a net loss applicable to common stock of$5.0 million.  We had a lossapplicable to common stock of $4.0 million for the prior year quarter. Itemsthat positively impacted the current quarter were increased operating revenuesof $1.3 million and lower operating expenses of $1.9 million.  These positive items were partially offset bythe higher unrealized loss on derivatives of $2.2 million and $2.6 million ofexpense accruals and write offs related to our outstanding debt.

 

***Operating Revenues***

 

Thetable below summarizes our operating revenues:

 

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| ** **                                                                    | ** ** | **Three months ended  September 30,** | ** ** | **Increase** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                                                                    | ** ** | **2010**                                             | ** ** | **2009**     | ** ** | **(Decrease)** | ** ** |
| Operating Revenues *(in thousands)*                                           |       | $                                                    | 6,244      |         | $          | 4,931 |   | $ | 1,313 |   |
| Sales Volumes                                                                 |       |                                                 |       |         |       |   |   |
| Crude Oil (MBbls)                                                             |       | 76                                                   |       | 72           |       | 4 |   |
| Natural Gas (MMcf)                                                            |       | 115                                                  |       | 107          |       | 8 |   |
| Total (MBOE)                                                                  |       | 95                                                   |       | 90           |       | 5 |   |
| Average Realized Price                                                        |       |                                                 |       |         |       |   |   |
| Crude Oil ($/ Bbl)                                                            |       | $                                                    | 70.52      |         | $          | 61.19 |   | $ | 9.33 |   |
| Natural Gas ($/ Mcf)                                                          |       | $                                                    | 7.69       |         | $          | 4.78 |   | $ | 2.91 |   |
| Operating Revenues and Commodity Derivative  Settlements *(in thousands)* (a) |       | $                                                    | 7,153      |         | $          | 6,782 |   | $ | 371 |   |
| Average Adjusted Price (includes commodity  derivative settlements) (a)       |       |                                                 |       |         |       |   |   |
| Crude Oil ($/ Bbl)                                                            |       | $                                                    | 74.45      |         | $          | 71.39 |   | $ | 3.06 |   |
| Natural Gas ($/Mcf)                                                           |       | $                                                    | 13.01      |         | $          | 15.21 |   | $ | (2.20 | ) |

 

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(a)          As discussed in Note 5 to our Consolidated FinancialStatements, on August 10, 2010, we sold certain natural gas commodityderivative contracts realizing net proceeds of $0.8 million pursuant to theForbearance Agreement. The $0.8 million is excluded from the commodity derivativesettlements listed above.

 

Thecurrent quarter operating revenues of $6.2 million were $1.3 millionhigher as compared to the prior year quarter operating revenues of$4.9 million. The $1.3 million increase is attributable to increasedprices received for crude oil and natural gas sales volumes of $0.7 million and$0.3 million, respectively, and increased crude oil and natural gas salesvolumes totaling $0.3 million.

 

***Crude Oil Sales.***  Our current quarter crude oil sales were 4MBbls higher as compared to the prior year quarter.  The overall sales increase resulted fromreduced crude oil inventory and improved operational efficiency at ourPanhandle Properties and Davenport Properties, and the RTP program at ourDesdemona properties, which increased crude oil sales by 9 MBbls.  This was partially offset by the salesdecrease of 5 MBbls at our Cato Properties due to the redistribution of waterinjection at the waterflood which resulted in lower production.  The development activities at the DesdemonaProperties and Cato Properties are further discussed under *“Overview-DrillingCapital Development and Operating Activities Update.”*

 

***Natural Gas Sales.***  Our current quarter natural gas sales were 8MMcf higher as compared to the prior year quarter.  The overall sales increase is due to the RTPprogram at our Desdemona Properties, as previously discussed, and  recompletions of natural gas wells from January 2010through April 2010 at our Panhandle Properties which increased natural gassales by 12 MMcf and 5 MMcf, respectively. This was partially offset by the sales decrease of 10 MMcf at our CatoProperties due to the waterflood project, as previously discussed.

 

***Crude Oil and Natural Gas Prices***

 

Theaverage price we receive for crude oil sales is generally at market pricesreceived at the wellhead, except for the Cato Properties, for which we receivebelow market prices due to the level of impurities in the oil. The averageprice we receive for natural gas sales is approximately the market pricereceived at the wellhead, adjusted for the value of natural gas liquids, lesstransportation and marketing expenses.

 

Theaverage prices we received for our crude oil and natural gas sales weresupplemented by commodity derivative settlements received for the current andprior year quarters.  As discussed in Note 5 to our ConsolidatedFinancial Statements, 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” (i.e. realizedgain).  Conversely, if crude oil and natural gas NYMEX prices are higherthan the derivative “ceiling prices,” we will pay our counterparty for thedifference between the NYMEX price and “ceiling price” (i.e. realized loss).

 

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***Operating Expenses***

 

Forthe current quarter, our total operating expenses were $7.8 million, or$1.9 million lower than the prior year quarter of $9.7 million. Wehad lower lease operating expenses of $1.0 million and reduced general andadministrative expenses of $1.0 million, partially offset by higherdepletion and depreciation expense of $0.1 million.  These items are discussed in greater detail below.

 

***Lease Operating Expenses***

 

Ourlease operating expenses (“LOE”) consist of the costs of producing crude oiland natural gas such as labor, supplies, repairs, maintenance, workovers andutilities.

 

Forthe current quarter, our LOE was $3.3 million, which was $1.0 millionlower than prior year quarter of $4.3 million. The $1.0 milliondecrease resulted primarily from reduced service rates negotiated with vendorsand improved operating efficiencies.  The$0.1 million reduction pertained to decreased workover expenses of $0.6million, lower chemical treatments of $0.2 million, reduced payroll of $0.1million and other expense reductions of $0.3 million, which was partiallyoffset by increased electricity expenses of $0.2 million.  We are continuing to evaluate additionalreductions to LOE expenses.

 

Forthe current quarter, our LOE per BOE, based on production, was $31.37, which isa reduction of $10.73 and $4.98, respectively, as compared to $42.10 for theprior year quarter and $36.35 for the quarter ended June 30, 2010.  This is attributed to the reasons previouslydiscussed. In general, secondary and tertiary LOE is higher than the LOE forcompanies developing primary production because our fields are more mature andtypically produce less oil and more water. However, we expect our LOE per BOEto decrease during the 2011 Fiscal Year due to the lower service rates withvendors and improved operational efficiencies. Further, we expect LOE per BOEto decrease as production increases from the waterflood and EOR developmentactivities we have implemented and are implementing as discussed under the “*Drilling Capital Development and Operating ActivitiesUpdate.*”

 

***Production and Ad Valorem Taxes***

 

Forthe 2010 Fiscal Year, our production and ad valorem taxes were$0.5 million, which approximates the prior year quarter as increasedproduction taxes were offset by lower ad valorem taxes due to reductions in taxproperty valuations by taxing authorities. Our production taxes as a percent ofoperating revenues for the current quarter of 6.0% was comparable to the prioryear quarter of 6.3%. We anticipate the 2011 Fiscal Year to be subject tosimilar production tax rates.

 

***General and Administrative Expenses***

 

Ourgeneral and administrative (“G&A”) expenses consist of support services forour operating activities, legal matters and investor relations costs.

 

Forthe current quarter, our G&A expenses totaled $2.6 million, which is$1.0 million lower than the prior year quarter of $3.6 million. The$1.0 million expense reduction resulted primarily from lower costs relatedto the terminated merger of $0.5 million, reduced stock-based compensation of$0.4 million and lower payroll and benefits costs of $0.1 million. Thelower share-based compensation costs are directly related to reduced issuancesof stock options and restricted stock. The reduced payroll and benefits costsresulted from workforce reductions which occurred during the current quarter,which eliminated 46% of our home office staff. On an annualized basis, the workforce reductions are expected to reduceG&A expenses by $1.6 million.

 

Thecurrent quarter includes non-recurring costs totaling $0.6 million related tothe terminated merger, settlement of litigation and advisory fees for priortransactions which are not expected to occur in future periods. On September 28-29,2010, we reduced the size of our Board of Directors from six independentdirectors to two independent directors, which, based on the current quarter, isexpected to reduce G&A expenses by $147,000 per quarter. Beginning January 2011,we expect to reduce the cost of rental expense associated with our Fort Worthcorporate office by $125,000 per quarter. On November 11, 2010, our Senior VicePresident and Chief Financial Officer, Benjamin Daitch, resigned and wassucceeded by our former Chief Accounting Officer, Michael J. Ricketts. Thisemployee reduction is expected to reduce G&A expenses by $0.3 millionannually. We are continuing to evaluate additional reductions to G&Aexpenses.

 

***Depletion and Depreciation***

 

Forthe current quarter, our depletion and depreciation expense was$1.3 million, an increase of $0.1 million as compared to the prioryear quarter depletion and depreciation expense. This includes depletionexpense pertaining to our oil and natural gas properties, and depreciation expensepertaining to our field operations vehicles and equipment, natural gas plant,office furniture and computers. The increase is due to increased crude oil andnatural gas sales volumes (net) as previously discussed under “*Operating Revenues.”*  For the current quarter, our depletion ratepertaining to our oil and gas properties was $11.67 per BOE which is comparableto the prior year quarter.

 

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***Interest Expense and Other***

 

Forthe current quarter, we recorded interest expense of $2.7 million, an increaseof $2.6 million as compared to the prior year quarter of $0.1 million. Aspreviously discussed, the $2.6 million increase consists of additional interestand fees due under the terms of the Forbearance Agreements; acceleratedamortization of deferred financing costs and accounting and legal expenseincurred by our lenders.

 

Theinterest expense for the current and prior year quarters was reduced by$0.6 million and $0.5 million, respectively, for interest cost thatwas capitalized to the waterflood projects discussed under the “*Drilling Capital Development and Operating ActivitiesUpdate.”*

 

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

 

Asdiscussed in Note 5 to our Consolidated Financial Statements, we haveentered into financial contracts for our commodity derivatives and our interestrate swap. For the current quarter, the loss on commodity derivatives of $2.7million consisted of an unrealized loss of $4.3 million and a realized gain of$1.6 million.  For the prior yearquarter, the loss on commodity derivatives of $0.5 million consisted unrealizedloss of $2.3 million and a realized gain of $1.8 million.

 

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). By their nature, thesecommodity derivatives can have a highly volatile impact on our earnings. A tenpercent change in the NYMEX prices for crude oil and natural gas that impactour commodity derivative instruments could affect our pre-tax earnings byapproximately $0.6 million.

 

***Income Tax Benefit***

 

Forthe current quarter and prior year quarters, we had an income tax benefit of$2.4 million and $1.6 million, respectively.  The prior year quarter tax amount includedtaxes related to discontinued operations as shown in Note 6 to ourConsolidated Financial Statements. The higher amount of income tax benefits forthe current quarter, as compared to the prior year quarter, is due to lowertaxable income. The income tax rates for the current and prior year quarterswere 34% and 31%, respectively.

 

***Income from Discontinued Operations***

 

Forthe prior year quarter, we had income from discontinued operations of$0.1 million due to our divestiture of the Certain Panhandle Properties,as discussed in Note 6 to our Consolidated Financial Statements.

 

***Preferred Stock Dividend***

 

Thepreferred stock dividend for the current quarter of $0.5 million wascomparable to the prior year quarter. The paid-in-kind and cash dividends are59% and 41%, respectively.

 

OnAugust 5, 2010, we entered into Consent and Forbearance Agreements withthe lenders under our credit agreements that prohibit us from making anyindirect or direct cash payment, cash dividend or cash distribution in respectof our shares of Series D Convertible Preferred Stock.  As of September 30, 2010, the unpaidcash dividend of $0.2 million is included in accrued liabilities reported inour consolidated balance sheets.

 

**Item3.         Quantitative andQualitative Disclosures About Market Risk.**

 

Not applicable.

 

**Item 4.         Controls and Procedures.**

 

Asof the end of the period covered by this report, our management conducted anevaluation, under the supervision and with the participation of our chiefexecutive officer and chief financial officer, of the effectiveness of ourdisclosure controls and procedures (as defined in Rule 13a-15(e) andRule 15d-15(e) of the Securities Exchange Act of 1934 (the “ExchangeAct”)). Based upon this evaluation, our chief executive officer and chieffinancial officer concluded, as of September 30, 2010, that our disclosurecontrols and procedures were effective to ensure that information required tobe disclosed by us in the reports that we file or submit under the Exchange Actis: (1) recorded, processed, summarized and reported, within the timeperiods specified in the SEC’s rules and

 

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formsand (2) accumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate, to allow timelydecisions regarding required disclosure.

 

Duringthe quarter ended September 30, 2010, 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**

 

**Item 1.     Legal Proceedings.**

 

SeeNote 9 to our Consolidated Financial Statements which is incorporated intothis “Item 1. Legal Proceedings” by reference.

 

**Item 1A.       RiskFactors.**

 

Inaddition to the other information set forth in this report, you shouldcarefully consider the risks discussed in our Annual Report on Form 10-Kfor the year ended June 30, 2010 under the heading *“Item 1A. “Risk Factors”* filed with theSEC on September 22, 2010, which risks could materially affect ourbusiness, financial condition and results of operations.

 

Exceptas shown below, there have been no material changes to the risk factorsdiscussed in our Annual Report on Form 10-K for the year endedJune 30, 2010, filed with the SEC on September 22, 2010, which isaccessible on the SEC’s website at *www.sec.gov*.

 

***Our lenders have terminated each of the Consent andForbearance Agreements with respect to our credit agreements, and we have noguarantee that they will not declare the amounts owed under our creditagreements immediately payable and exercise any other available rights andremedies.***

 

OnSeptember 24, 2010, the lenders under our credit agreements notified us,through the delivery of Reservation of Rights Letters, that we had failed totimely comply with certain covenants in the Consent and Forbearance Agreementsdated August 5, 2010 with such parties, and, as a result thereof, suchConsent and Forbearance Agreements were terminated.  As of November 15, 2010, the lendershave taken no action with the delivery of these letters.  However, if our lenders declare the amountsowed under our credit agreements immediately due and payable, we will be unableto continue as a going concern.  We havenot obtained any further waiver or forbearance from the lenders with respect toour credit agreements, and there is no guarantee that we will be able to obtainany waiver or forbearance in the future.

 

**Item 2.  Unregistered Sales of Equity Securities and Useof Proceeds.**

 

Thefollowing shares of our common stock were delivered to us during the quarterended September 30, 2010 from S. Jeffrey Johnson and Michael Ricketts,pursuant to the terms of the Cano Petroleum, Inc. 2005 Long-Term IncentivePlan, to satisfy tax withholding obligations relating to the vesting ofrestricted stock awards:

 
| **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** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1, 2009 through July 31, 2010            |       | 14,548                                                        |       | $                                                            | 0.61       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |
| August 1, 2009 through August 31, 2010        |       | —                                                        |       | —                                                       |       | —                                                                                                                                        |       | —                                                                                                                                                                                         |       |
| September 1, 2009 through September 30,  2010 |       | —                                                        |       | —                                                       |       | —                                                                                                                                        |       | —                                                                                                                                                                                         |       |
| Total                                                   |       | 14,548                                                        |       | $                                                            | 0.61       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |

 

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**Item3.  Defaults Upon Senior Securities.**

 

OnAugust 5, 2010, we entered into Forbearance Agreements with the lendersunder our credit agreements that prohibited us from making any indirect ordirect cash payment, cash dividend or cash distribution in respect of ourshares of Preferred Stock.  On September 24,2010, our lenders delivered Reservation of Rights Letters specifying that wefailed to timely comply with the material terms of the Forbearance Agreementsand therefore terminated the Forbearance Agreements.  During September 2010, we elected tosuspend the quarterly dividend paid on the Preferred Stock beginning with thequarter ended September 30, 2010. Dividends on the Preferred Stock are cumulative.  As of the date of the filing of this report,unpaid cumulative dividends on the Preferred Stock were $0.3 million.

 

**Item 6.     Exhibits.**

 

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

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                          | **CANO PETROLEUM, INC.** |
|-------------------------------|-------------------------------|
|                          |                          |   |
| Date:  November 15, 2010 | By:                           | /s/ S. JEFFREY JOHNSON |
|                          |                          | S. Jeffrey Johnson |
|                          |                          | *Chief Executive Officer* |
|                          |                          |   |
| Date:  November 15, 2010 | By:                           | /s/ MICHAEL J.  RICKETTS |
|                          |                          | Michael J. Ricketts |
|                          |                          | *Senior Vice-President and Chief Financial Officer* |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                        |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Certificate of  Incorporation of Huron Ventures, Inc., incorporated herein by reference  to Exhibit 3.1 to the Company’s Registration Statement on Form 10  SB (File No. 000-50386) filed with the SEC on September 4, 2003.                                                                             |
| 3.2                 |       | Certificate of Ownership  of Huron Ventures, Inc. and Cano Petroleum, Inc., amending the  Company’s Certificate of Incorporation, incorporated herein by reference to  Exhibit 3.2 to the Company’s Annual Report on Form 10-KSB filed  with the SEC on September 23, 2004.                         |
| 3.3                 |       | Certificate of Amendment  to Certificate of Incorporation of Cano Petroleum, Inc., incorporated  herein by reference to Exhibit 3.8 to the Company’s Post-Effective  Amendment No. 2 on Form S-1 filed with the SEC on January 23,  2007.                                                                |
| 3.4                 |       | Second Amended and  Restated By-Laws of Cano Petroleum, Inc. dated May 7, 2009,  incorporated herein by reference to Exhibit 3.1 to the Company’s Current  Report on Form 8-K filed with the SEC on May 13, 2009.                                                                                        |
| 3.5                 |       | Certificate of Designation  for Series B Convertible Preferred Stock, incorporated herein by  reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K filed with the SEC on June 8, 2004.                                                                                                      |
| 3.6                 |       | Certificate of Designation  for Series C Convertible Preferred Stock, incorporated herein by  reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K filed with the SEC on July 15, 2004.                                                                                                     |
| 3.7                 |       | Certificate of Designation  for Series D Convertible Preferred Stock, incorporated herein by  reference to Exhibit 3.1 to the Company’s Current Report on  Form 8-K filed with the SEC on September 7, 2006.                                                                                                  |
| 3.8                 |       | Certificate of Amendment  to Certificate of Designations, Preferences and Rights of Series D  Convertible Preferred Stock of the Company, incorporated herein by reference  to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed  with the SEC on June 24, 2010.                                  |
| 4.3                 |       | Form of Common Stock  certificate, incorporated herein by reference to Exhibit 4.9 to the  Company’s Registration Statement on Form S-3 (No. 333-148053) filed  with the SEC on December 13, 2007.                                                                                                       |
| 4.4                 |       | Designation for  Series A Convertible Preferred Stock, included in the Certificate of  Incorporation of Huron Ventures, Inc., incorporated herein by reference  to Exhibit 3.1 to the Company’s registration statement on Form 10  SB (File No. 000-50386) filed with the SEC on September 4, 2003. |
| 4.5                 |       | Certificate of Designation  for Series B Convertible Preferred Stock, incorporated herein by  reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K filed with the SEC on June 8, 2004.                                                                                                      |
| 4.6                 |       | Certificate of Designation  for Series C Convertible Preferred Stock, incorporated herein by  reference to Exhibit 99.2 to the Company’s Current Report on  Form 8-K filed with the SEC on July 15, 2004.                                                                                                     |
| 4.7                 |       | Certificate of Designation  for Series D Convertible Preferred Stock incorporated herein by  reference to Exhibit 3.1 to the Company’s Current Report on  Form 8-K filed with the SEC on September 7, 2006.                                                                                                   |
| 4.8                 |       | Certificate of Amendment  to Certificate of Designations, Preferences and Rights of Series D  Convertible Preferred Stock of the Company, incorporated herein by reference  to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed  with the SEC on June 24, 2010.                                  |
| 10.129              |       | Consent and Forbearance  Agreement dated August 5, 2010 among Cano, certain Guarantors, certain  Lenders and Union Bank, N.A., incorporated herein by reference to Cano’s  current report on Form 8-K filed with the SEC on August 10, 2010.                                                                       |
| 10.130              |       | Consent and Forbearance  Agreement dated August 5, 2010 among Cano, certain Guarantors, certain  Lenders and UnionBanCal Equities, Inc., incorporated herein by reference  to Cano’s current report on Form 8-K filed with the SEC on  August 10, 2010.                                                       |
| 31.1*               |       | Certification by Chief  Executive Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                         |
| 31.2*               |       | Certification by Chief  Financial Officer, required by Rule 13a-14(a) or  Rule 15d-14(a) of the Exchange Act, promulgated pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                         |
| 32.1*               |       | Certification by Chief  Executive Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of  Chapter 63 of Title 18 of the United States Code, promulgated pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                         |
| 32.2*               |       | Certification by Chief  Financial Officer, required by Rule 13a-14(b) or  Rule 15d-14(b) of the Exchange Act and Section 1350 of  Chapter 63 of Title 18 of the United States Code, promulgated pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                         |

 

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*                                         Filed herewith.

 

+              Management contract or compensatory plan, contract orarrangement.

 

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