**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

# **FORM 10-QSB**

# ** **

**(Mark One)**

 
| ý |   | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|--------|--------|--------------------------------------------------------------------------------------------------|
|   |   |                                                                                             |
|   |   | **For the  quarterly period ended March 31, 2006**                                          |
|   |   |                                                                                             |
| o      |   | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF  THE EXCHANGE ACT**                   |

 

**For thetransition period from             to            **

 

**Commissionfile number 001-32496**

 

**CANOPETROLEUM, INC.**

(Exact name of smallbusiness issuer as specified in its charter)

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

 

**The Oil &Gas Commerce Building**

**309 West 7thStreet, Suite 1600**

**Fort Worth,TX 76102**

(Address of principalexecutive offices)

 

**(817)698-0900**

(Issuer’s telephone number)

 

**NotApplicable**

(Former name, former addressand former fiscal year, if changed since last report)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Actduring the past 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  ý    No  o

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o     No ý

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGSDURING THE PRECEDING FIVE YEARS**

 

Check whether the registrant filed all documents andreports required to be filed by Section 12, 13 or 15(d) of theExchange Act after the distribution of securities under a plan confirmed by acourt. Yes  o     No  o

 

**APPLICABLEONLY TO CORPORATE ISSUERS**

 

State the number of shares outstanding of each ofthe issuer’s classes of common equity, as of the latest practicable date: 26,832,158 shares of common stock, $.0001 par value per share, as of May 2,2006.

 

Transitional Small Business Disclosure Format (Checkone): Yes  o     No  ý

 

 

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**CANO PETROLEUM, INC.CONSOLIDATED BALANCE SHEET**

**March 31,2006(Unaudited)**

 
| **ASSETS**                                                                                                                                                 | ** ** | ** **  | ** **      |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-----------------|
| **Current  assets**                                                                                                                                        | ** ** | ** **  | ** **      |
| Cash and  cash equivalents                                                                                                                                 |       | $           | 1,319,253       |   |
| Accounts  receivable                                                                                                                                       |       | 2,154,435   |            |
| Derivative  assets                                                                                                                                         |       | 980,589     |            |
| Other  current assets                                                                                                                                      |       | 579,156     |            |
| Total  current assets                                                                                                                                      |       | 5,033,433   |            |
|                                                                                                                                                       |       |        |            |
| **Oil and gas properties****,**successful  efforts method                                                                                                  |       | 107,849,380 |            |
| Less  accumulated depletion and depreciation                                                                                                               |       | (1,361,955  | )               |
| Net oil and  gas properties                                                                                                                                |       | 106,487,425 |            |
|                                                                                                                                                       |       |        |            |
| Fixed assets  and other, net                                                                                                                               |       | 4,610,888   |            |
| Derivative  assets                                                                                                                                         |       | 1,426,684   |            |
| Goodwill                                                                                                                                                   |       | 785,796     |            |
| **TOTAL  ASSETS**                                                                                                                                          | ** ** | **$**       | **118,344,226** | ** ** |
|                                                                                                                                                       |       |        |            |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                             | ** ** | ** **  | ** **      |
| **Current  liabilities**                                                                                                                                   |       |        |            |
| Accounts  payable                                                                                                                                          |       | $           | 877,089         |   |
| Oil and gas  payable                                                                                                                                       |       | 304,482     |            |
| Accrued  liabilities                                                                                                                                       |       | 274,090     |            |
| Taxes  payable                                                                                                                                             |       | 73,265      |            |
| Current  portion of asset retirement obligations                                                                                                           |       | 19,442      |            |
| Total  current liabilities                                                                                                                                 |       | 1,548,368   |            |
| **Long-term  liabilities**                                                                                                                                 |       |        |            |
| Long-term  debt                                                                                                                                            |       | 42,750,000  |            |
| Asset  retirement obligations                                                                                                                              |       | 1,566,261   |            |
| Deferred tax  liability                                                                                                                                    |       | 32,998,000  |            |
| Total  liabilities                                                                                                                                         |       | 78,862,629  |            |
|                                                                                                                                                       |       |        |            |
| **Commitments  and contingencies (Note 12)**                                                                                                               |       |        |            |
| **Stockholders’  equity**                                                                                                                             |       |        |            |
| Common  stock, par value $.0001 per share; 50,000,000 authorized; 26,847,941 issued  and 26,832,158 outstanding; including 2,659,975 shares held in escrow |       | 2,685       |            |
| Additional  paid-in capital                                                                                                                                |       | 52,665,502  |            |
| Accumulated  deficit                                                                                                                                       |       | (13,081,516 | )               |
| Treasury  stock, at cost; 15,783 shares held in escrow                                                                                                     |       | (7,102      | )               |
| Deferred  compensation                                                                                                                                     |       | (97,972     | )               |
| Total  stockholders’ equity                                                                                                                           |       | 39,481,597  |            |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                       | ** ** | **$**       | **118,344,226** | ** ** |

 

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

 

2

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**CANOPETROLEUM, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| ** **                                      | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Operating  Revenues:**                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil  and natural gas sales                |       | $                                | 5,422,987  |                            | $          | 1,461,885 |   | $ | 10,532,227 |   | $ | 3,780,437 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Operating  Expenses:**                        |       |                             |       |                            |       |   |   |   |   |
| Lease  operating expenses                       |       | 2,065,739                        |       | 819,093                         |       | 4,059,837 |   | 1,815,837 |   |
| Production  and ad valorem taxes                |       | 379,990                          |       | 92,710                          |       | 701,482 |   | 241,809 |   |
| General and  administrative                     |       | 1,800,564                        |       | 729,989                         |       | 4,690,232 |   | 2,121,967 |   |
| Deferred  compensation expense                  |       | 146,961                          |       | 431,439                         |       | 443,547 |   | 1,341,285 |   |
| Accretion of  asset retirement obligations      |       | 30,282                           |       | 5,584                           |       | 75,656 |   | 16,444 |   |
| Depletion  and depreciation                     |       | 631,340                          |       | 159,823                         |       | 1,058,198 |   | 403,538 |   |
| Total  operating expenses                       |       | 5,054,876                        |       | 2,238,638                       |       | 11,028,952 |   | 5,940,880 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Income  (loss) from operations**              |       | 368,111                          |       | (776,753                        | )          | (496,725 | ) | (2,160,443 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Other  income (expenses):**                   |       |                             |       |                            |       |   |   |   |   |
| Unrealized  loss on hedge contracts             |       | (1,274,900                       | )          | —                          |       | (2,910,437 | ) | — |   |
| Interest  expense                               |       | (928,645                         | )          | (370                            | )          | (1,260,690 | ) | (752 | ) |
| Interest  income and deductions, net            |       | 27,406                           |       | 1,841                           |       | 122,331 |   | 11,288 |   |
| Total other  income (expenses)                  |       | (2,176,139                       | )          | 1,471                           |       | (4,048,796 | ) | 10,536 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Loss before  income tax benefit                 |       | (1,808,028                       | )          | (775,282                        | )          | (4,545,521 | ) | (2,149,907 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Deferred  income tax benefit                    |       | 677,000                          |       | —                          |       | 1,470,000 |   | — |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Net loss**                                    |       | (1,131,028                       | )          | (775,282                        | )          | (3,075,521 | ) | (2,149,907 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Preferred  stock discount                       |       | —                           |       | —                          |       | — |   | 416,534 |   |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Net loss  applicable to common stock**        |       | $                                | (1,131,028 | )                               | $          | (775,282 | ) | $ | (3,075,521 | ) | $ | (2,566,441 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Net loss  per share - basic and diluted**     |       | $                                | (0.05      | )                               | $          | (0.07 | ) | $ | (0.14 | ) | $ | (0.24 | ) |
|                                            |       |                             |       |                            |       |   |   |   |   |
| **Weighted  average common shares outstanding** |       |                             |       |                            |       |   |   |   |   |
| Basic and  diluted                              |       | 24,187,966                       |       | 11,204,155                      |       | 21,740,759 |   | 10,722,854 |   |

 

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

 

3

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**CANOPETROLEUM, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                               | ** ** | **Nine Months Ended March 31,** | ** **    |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------|---------------|
| ** **                                                               | ** ** | **2006**                                            | ** **    | **2005** | ** ** |
| **Cash flow from operating activities:**             |       |                                                |          |   |   |
| Net loss                                                                 |       | $                                                   | (3,075,521    | ) | $ | (2,149,907 | ) |
| Adjustments  needed to reconcile to net cash flow used in operations:    |       |                                                |          |   |   |
| Loss on  hedge contracts                                                 |       | 2,910,437                                           |          | — |   |
| Accretion of  asset retirement obligations                               |       | 75,656                                              |          | 16,444 |   |
| Depletion  and depreciation                                              |       | 1,058,198                                           |          | 403,538 |   |
| Deferred  compensation expense                                           |       | 443,547                                             |          | 1,341,285 |   |
| Deferred  income tax benefit                                             |       | (1,470,000                                          | )             | — |   |
| Stock based  compensation                                                |       | 134,437                                             |          | 78,666 |   |
| Other  amortization                                                      |       | 318,980                                             |          | — |   |
|                                                                     |       |                                                |          |   |   |
| Changes in  assets and liabilities relating to operations:               |       |                                                |          |   |   |
| Derivative  assets                                                       |       | (5,317,710                                          | )             | — |   |
| Accounts  receivable                                                     |       | 437,499                                             |          | (605,938 | ) |
| Inventory                                                                |       | (163,586                                            | )             | — |   |
| Accounts  payable                                                        |       | (331,772                                            | )             | 608,398 |   |
| Accrued  liabilities                                                     |       | (593,875                                            | )             | (219,696 | ) |
| Other  current assets and liabilities                                    |       | (682,734                                            | )             | (31,512 | ) |
|                                                                     |       |                                                |          |   |   |
| **Net cash  used in operations**                                         | ** ** | **(6,256,444**                                      | **)**         | **(558,722** | **)** |
|                                                                     |       |                                                |          |   |   |
| **Cash  flow from investing activities:**                                |       |                                                |          |   |   |
| Additions to  oil and gas properties                                     |       | (3,523,340                                          | )             | (1,936,124 | ) |
| Additions to  fixed assets and other                                     |       | (444,095                                            | )             | (250,606 | ) |
| Acquisition  of W.O. Energy of Nevada, Inc.                         |       | (48,292,605                                         | )             | — |   |
| Acquisition  of additional Davenport revenue interest                    |       | (700,350                                            | )             | (667,000 | ) |
| Acquisition  of Nowata                                                   |       | —                                              |          | (2,551,721 | ) |
| Acquisition of  Square One Energy, Inc.                             |       | —                                              |          | (4,020,363 | ) |
| Acquisition  of Ladder                                                   |       | —                                              |          | (2,111,517 | ) |
| Cash  restricted for development activities                              |       | —                                              |          | 866,339 |   |
| **Net cash  used in investing activities**                               | ** ** | **(52,960,390**                                     | **)**         | **(10,670,992** | **)** |
|                                                                     |       |                                                |          |   |   |
| **Cash  flow from financing activities:**                                |       |                                                |          |   |   |
| Net proceeds  from long-term debt                                        |       | 42,750,000                                          |          | — |   |
| Payments for  debt-issuance costs                                        |       | (707,587                                            | )             | — |   |
| Proceeds  from issuance of preferred stock, net                          |       | —                                              |          | 5,304,872 |   |
| Proceeds  from issuance of common stock, net                             |       | 18,348,185                                          |          | 4,750,783 |   |
| **Net cash  from financing activities**                                  | ** ** | **60,390,598**                                      | ** **    | **10,055,655** | ** ** |
|                                                                     |       |                                                |          |   |   |
| Net increase  (decrease) in cash and cash equivalents                    |       | 1,173,764                                           |          | (1,174,059 | ) |
|                                                                     |       |                                                |          |   |   |
| Cash and  cash equivalents at beginning of period                        |       | 145,489                                             |          | 1,575,279 |   |
|                                                                     |       |                                                |          |   |   |
| **Cash and  cash equivalents at end of period**                          | ** ** | **$**                                               | **1,319,253** | ** ** | **$** | **401,220** | ** ** |
|                                                                     |       |                                                |          |   |   |
| **Supplemental  disclosure of noncash transactions:**                    |       |                                                |          |   |   |
| Preferred  stock discount                                                |       | —                                              |          | $ | 416,534 |   |
| Common stock  issued for acquisition of Square One Energy, Inc.     |       | —                                              |          | $ | 3,519,996 |   |
| Common stock  issued for acquisition of W.O. Energy of Nevada, Inc. |       | $                                                   | 8,240,000     |   | — |   |
| Recognition  of deferred tax liability                                   |       | $                                                   | 3,124,013     |   | — |   |

 

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

 

4

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**CANO PETROLEUM, INC.**

 

**NOTES TOFINANCIAL STATEMENTS**

 

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

 

The interim consolidated financial statements of Cano Petroleum, Inc.are unaudited and contain all adjustments (consisting primarily of normalrecurring accruals) necessary for a fair statement of the results for theinterim periods presented. Results for interim periods are not necessarilyindicative of results to be expected for a full year or for previously reportedperiods due in part to the volatility in prices for crude oil and naturalgas, the timing of acquisitions, product demand, market competition,interruption in production, and the success of waterflooding and enhanced oilrecovery techniques. You should read these consolidated interim financial statementsin conjunction with the audited consolidated financial statements and notesthereto included in Cano’s Form 10-KSB dated June 30, 2005.

 

In preparing the accompanying financial statements, management has madecertain estimates and assumptions that affect reported amounts in the financialstatements and disclosures of contingencies. Actual results may differfrom those estimates. Significant assumptions are required in the valuation ofproved oil and gas reserves, which may affect the amount at which oil andgas properties are recorded. It is at least reasonably possible these estimatescould be revised in the near term, and these revisions could be material.

 

**2.****             ****ACQUISITION OF W.O. ENERGY COMPANY OF NEVADA, INC.**

 

On November 29, 2005, we acquired all of the outstanding commonstock of W.O. Energy of Nevada, Inc. (“WO Energy”) for approximately $57.4million, after purchase price adjustments. The purchase price consisted ofapproximately $48.3 million in cash (net of cash acquired) and approximately$8.24 million in restricted shares of our common stock.  $2 million of the cash portion of the purchaseprice was paid into an escrow account for a minimum of two years to coverpotential indemnification payments by the sellers. The approximate $8.24million of common stock resulted in the issuance of 1,791,320 shares to thesellers based on the average of the closing price of the common stock on AMEXfor the three trading days immediately prior to November 29, 2005, whichwas $4.60 per share. We entered into a registration rights agreement with thesellers pursuant to which we agreed to use commercially reasonable efforts toregister the resale of the 1,791,320 shares with the Securities and ExchangeCommission by November 29, 2006. The sellers are prohibited from sellingtheir shares until November 29, 2006 and after such date are limited toselling up to 15% of the shares received in any 90 day period.

 

 The WO Energy acquisition was recorded based on the purchasemethod of accounting. The operations of WO Energy are included in ourconsolidated financial statements beginning December 1, 2005. The purchaseprice were allocated to the acquired assets and assumed liabilities based ontheir estimated fair values. The calculation of the purchase price andallocation to assets is as follows:

 

| Net Acquisition Price         |   | $          | 57,402,983 |   |
|-------------------------------|--------|------------|------------|--------|
| Asset Retirement Obligations  |   | 497,906    |       |
| Deferred Tax Liability        |   | 31,343,986 |       |
| Other Liabilities Assumed     |   | 1,512,819  |       |
| Total Purchase Price          |   | $          | 90,757,694 |   |
|                          |   |       |       |
| Allocation of Purchase Price: |   |       |       |
| Cash                          |   | $          | 870,376    |   |
| Accounts Receivable           |   | 2,016,168  |       |
| Other Current Assets          |   | 158,538    |       |
| Fixed Assets and Other        |   | 3,112,610  |       |
| Oil & Gas Properties |   | 84,600,002 |       |
|                          |   | $          | 90,757,694 |   |

 

5

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The fair value assigned to the oil and gas properties is based onmanagement’s valuation of the properties, which was derived in part byreference to reserve reports prepared by an independent petroleumengineering firm. Based on the engineer’s reports and Cano’s internalanalyses, we believe the value assigned to these properties is reasonablysupported. We are continuing the process of determining our final estimate of fairvalue of assets and liabilities.

 

The acquisition was not eligible for Section 338 treatment. Asdefined in the Internal Revenue Service tax code, Section 338 treatmentwould have enabled us to recognize the stepped-up basis in the WO propertiesapproximately equal to the acquisition price, for tax computation purposes. Therefore,we recorded a deferred tax liability of approximately $31.3 million (with anoffsetting increase in property basis) in connection with this purchase.

 

The following condensed pro forma information gives effect to theacquisition as if it had occurred on July 1, 2005 and 2004, respectively. Thepro forma information has been included in the Notes to financial statements asrequired by generally accepted accounting principles and is provided forcomparison purposes only. The pro forma financial information is not necessarilyindicative of the financial results that would have occurred had the businesscombination been effective on the dates indicated and should not be viewed asindicative of operations in the future.

 

**Cano Petroleum, Inc.**

**Pro Forma Information**

 
| ** **                             | ** ** | **Three Months Ended  March 31,** | ** ** | **Nine Months Ended  March 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2006**                               | ** ** | **2005**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Operating revenues                     |       | $                                      | 5,422,987  |                                  | $          | 4,472,761 |   | $ | 16,080,647 |   | $ | 13,092,641 |   |
| Loss applicable to common stock        |       | $                                      | (1,131,028 | )                                     | $          | (317,093 | ) | $ | (2,268,286 | ) | $ | (1,296,260 | ) |
| Net loss per share - basic and diluted |       | $                                      | (0.05      | )                                     | $          | (0.01 | ) | $ | (0.09 | ) | $ | (0.05 | ) |

 

**3.****             ****LONG-TERM DEBT**

 

***Senior Credit Agreement***

 

On November 29, 2005, we entered into a $100 million senior creditagreement with the lenders thereto from time to time and Union Bank ofCalifornia, N.A., as administrative agent and as issuing lender, due on orbefore November 29, 2009. The initial borrowing base is $30 million basedon our proved reserves. The $30 million was used, in part, to finance theacquisition of WO Energy. Pursuant to the terms of the senior credit agreement,the borrowing base is based on our proved reserves and is redetermined everysix months with one additional redetermination possible during the six monthperiods between scheduled redeterminations. During the quarter ended March 31,2006, Natexis Banques Populaires was named as a lender via an amendment to thesenior credit facility.

 

At our option, interest is based either (i) on the prime rate plusthe applicable margin ranging up to 0.75% based on the utilization level or (ii) onthe LIBOR rate applicable to the interest period plus the applicable marginranging from 1.5% to 2.25% based on the utilization level. At March 31,2006, the interest rate was 7.08%. For loans that are three months or less inmaturity, interest is due on the maturity date of such loan. For loans that arein excess of three months, interest is due every three months.

 

At March 31, 2006, the outstanding amount due under the seniorcredit agreement was $27.75 million. The outstanding principal is due on orbefore November 29, 2009 unless pursuant to the terms

 

6

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ofthe credit agreement specific events of default occur as a result of which alloutstanding principal and all accrued interest may be accelerated. Suchspecific events of default, include, but are not limited to: payment defaultsby us, breaches of representations and warranties and covenants by us, ourinsolvency, a “change of control” of our business as described in the creditagreement and a “material adverse change” as described in the credit agreement.

 

The credit agreement imposes certain restrictions on us and oursubsidiaries including, but not limited to, the following: (i) subject tospecific exceptions, incurring additional liens; (ii) subject to specificexceptions, incurring additional debt; (iii) subject to specificexceptions, merging or consolidating or selling, transferring, assigning,farming-out, conveying or otherwise disposing of any property; (iv) subjectto specific exceptions, making certain payments, including cash dividends toour stockholders; (v) subject to specific exceptions, making any loans,advances or capital contributions to, or making any investment in, orpurchasing or committing to purchase any stock or other securities or evidencesof indebtedness or interests in any person or any oil and gas properties oractivities related to oil and gas properties unless with regard to new oil andgas properties, such properties are mortgaged to Union Bank of California,N.A., as administrative agent, or with regard to new subsidiaries, suchsubsidiaries execute a guaranty, pledge agreement, security agreement andmortgage in favor of Union Bank of California, N.A., as administrative agent; and(vi) subject to specific exceptions, entering into affiliate transactionson terms that are not at least as favorable to us as comparable arm’s lengthtransactions.

 

We must also meet certain financial requirements based on specifieddebt coverage ratios, interest coverage ratios and current assets to currentliabilities ratios. In addition, we are required to enter into financialcontracts to hedge our exposure to commodity price risk associated withexpected oil and gas production. Our financial hedge contracts are furtherdiscussed in Note 4.

 

As security for our obligations under the senior credit agreement: (i) eachof our subsidiaries guaranteed all of our obligations; (ii) we, togetherwith each of our subsidiaries, executed mortgages in favor of Union Bank ofCalifornia, N.A., as collateral trustee, covering oil and gas propertieslocated in Texas and Oklahoma; (iii) we, together with each of oursubsidiaries, granted a security interest in favor of Union Bank of California,N.A., as collateral trustee, in substantially all of our assets; and (iv) wepledged our ownership interests in all of our subsidiaries to Union Bank ofCalifornia, N.A., as collateral trustee.

 

Our senior credit agreement has been amended subsequent to March 31,2006 and is further discussed in Note 13.

 

***Subordinated Credit Agreement***

 

On November 29, 2005, we entered into a $15 million subordinatedcredit agreement with the lenders thereto from time to time and EnergyComponents SPC EEP Energy Exploration and Production Segregated Portfolio (“EEP”),as administrative agent, due on or before November 29, 2010. The $15million was used, in part, to finance the acquisition of WO Energy.

 

Interest pursuant to the subordinated credit agreement is equal to theLIBOR rate plus 6.5%. At March 31, 2006, the interest rate was 11.24%.For loans that are three months or less in maturity, interest is due on thematurity date of such loan. For loans that are in excess of three months,interest is due every three months.

 

As of March 31, 2006, the outstanding amount due under thesubordinated credit agreement was $15 million. The outstanding principal is dueon November 29, 2010 unless specified events of default occur as a resultof which all outstanding principal and all accrued interest may beaccelerated. Such specific events of default, include, but are not limited to:payment defaults by us, breaches of representations and warranties andcovenants by us, our insolvency, a “change of control” of our business asdescribed in the subordinated credit agreement and a “material adverse change”as described in the subordinated credit agreement.

 

7

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The subordinated credit agreement imposes certain restrictions on usand our subsidiaries including, but not limited to, the following: (i) subjectto specific exceptions, incurring additional liens; (ii) subject tospecific exceptions, incurring additional debt; (iii) subject to specificexceptions, merging or consolidating or selling, transferring, assigning,farming-out, conveying or otherwise disposing of any property; (iv) subjectto specific exceptions, making certain payments, including cash dividends toour stockholders; (v) subject to specific exceptions, making any loans,advances or capital contributions to, or making any investment in, orpurchasing or committing to purchase any stock or other securities or evidencesof indebtedness or interests in any person or any oil and gas properties oractivities related to oil and gas properties unless with regard to new oil andgas properties, such properties are mortgaged as requested by EEP, asadministrative agent, or with regard to new subsidiaries, such subsidiariesexecute a guaranty, pledge agreement, security agreement and mortgage asrequested by of EEP, as administrative agent; and (vi) subject to specificexceptions, entering into affiliate transactions on terms that are not at leastas favorable to us as comparable arm’s length transactions.

 

We must also meet certain financial requirements based on specifieddebt coverage ratios, interest coverage ratios, current assets to currentliabilities ratios, and reserve value coverage. In addition, we are required toenter into financial contracts to hedge our exposure to commodity price riskassociated with expected oil and gas production, as further discussed in Note4.

 

As security for our obligations under the credit agreement: (i) eachof our subsidiaries guaranteed all of our obligations; (ii) we, togetherwith each of our subsidiaries, executed mortgages in favor of Union Bank ofCalifornia, N.A., as collateral trustee, covering oil and gas propertieslocated in Texas and Oklahoma; (iii) we, together with each of oursubsidiaries, granted a security interest in favor of Union Bank of California,N.A., as collateral trustee, in substantially all of our assets; and (iv) wepledged our ownership interests in all of our subsidiaries to Union Bank ofCalifornia, N.A., as collateral trustee.

 

Our subordinated credit agreement has been amended subsequent to March31, 2006 and is further discussed in Note 13.

 

**4.****             ****DERIVATIVE HEDGING CONTRACTS**

 

As previously mentioned in Note 3, pursuant to our senior andsubordinated credit agreements, we are required to enter into financialcontracts to hedge a portion of our production at specified prices for oil andnatural gas. The objective of the hedging contracts is to reduce our exposureto commodity price risk associated with expected oil and gas production. Byachieving this objective we intend to protect the outstanding debt amountsand maximize the funds available under our existing debt agreements, whichshould enable us to support our annual capital budgeting and expenditure plans.

 

During December 2005, we paid $5.3 million to enter into financialcontracts to set price floors, as summarized in the table below.

 

| ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | ** **       | ** ** | **Barrels of** | ** ** |
|--------------|------------|------------|------------|------------------|------------|------------|------------|------------------|------------|---------------------|------------|
| ** **   | ** ** | **Floor**  | ** ** | ** **       | ** ** | **Floor**  | ** ** | ** **       | ** ** | **Equivalent**      | ** ** |
| **Calendar** | ** ** | **Oil**    | ** ** | **Barrels**      | ** ** | **Gas**    | ** ** | **Gas Mcf** | ** ** | **Oil**             | ** ** |
| **Year**     | ** ** | **Price**  | ** ** | **per Day** | ** ** | **Price**  | ** ** | **per Day** | ** ** | **per Day**    | ** ** |
| 2006         |       | $          | 60         |             | 534        |       | $          | 8.50             |       | 1,784               |       | 832 |   |
| 2007         |       | $          | 55         |             | 507        |       | $          | 8.00             |       | 1,644               |       | 781 |   |
| 2008         |       | $          | 55         |             | 479        |       | $          | 7.50             |       | 1,534               |       | 735 |   |

 

We have no derivative hedging contracts that set a price ceiling. We donot designate our derivatives as cash flow or fair value hedges. However, we donot hold or issue derivative financial instruments for speculative or tradingpurposes. We are exposed to credit losses in the event of nonperformance by thecounterparties to our financial hedging contracts. We anticipate, however, thatsuch counterparties will be able to fully satisfy their obligations under thecontracts. We do not obtain collateral or other security to support ourfinancial hedging contracts subject to credit risk but we monitor the creditstanding of the counterparties. At March 31, 2006, we had a receivable balancedue from our counterparties amounting to $69,766.

 

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Changes in the fair values of our derivative instruments are recordedimmediately in earnings in other income on our statements of operations. Cashflows resulting from the settlement of our derivative instruments are recordedas other income or expense in the consolidated statements of operations. Duringthe three- and nine-month periods ended March 31, 2006, there weresettlements under our derivative agreements due to Cano amounting to $140,996,which is included in our Consolidated Statements of Operations under “Crude oiland natural gas sales.”  The settlementswere cumulative monthly payments due to Cano since the NYMEX gas price waslower than the $8.50 “floor gas price.”  Thecash flows relating to the derivative instruments are reflected in operatingactivities on our statements of cash flow.

 

Our mark-to-market valuations used for our derivative instruments werebased on prices that are actively quoted and provided by external sources. Inaccordance with SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities,” as amended, we recorded the $5.3 million payment asDerivative Assets. SFAS 133 also provides that derivative instruments bemeasured at fair value on the balance sheet date.  During the three- and nine-month periods endedMarch 31, 2006, we recognized losses on hedge contracts to ourConsolidated Statements of Operations amounting to $1.3 million and $2.9million, respectively, under “Unrealized loss on hedge contracts.”  At March 31,2006, our Derivative Assets totaled $2,407,273, of which $1,426,684 isconsidered long-term.

 

**5.****             ********COMMON STOCK FINANCINGS**

 

As discussed in Note 2, we issued 1,791,320 shares of our common stockto complete the acquisition of WO Energy.

 

On September 14, 2005 and September 16, 2005, we receivedwritten commitments for two private placement sales of 2,603,864 shares and2,100,000 shares, respectively, of our common stock at a per share price equalto $4.14, which was the closing price on September 13, 2005 on theAmerican Stock Exchange. The gross and net proceeds totaled approximately $19.5million and $18.3 million, respectively. The transactions closed on or before September 30,2005.

 

The amount of common shares issued and outstanding is summarized asfollows:

 

| Issued  shares as of June 30, 2005                |   | 20,352,757 |   |
|--------------------------------------------------------|--------|------------|--------|
| Shares  issued in private placement (above)            |   | 4,703,864  |   |
| Shares  issued for WO Energy acquisition (Note 2)      |   | 1,791,320  |   |
| Issued  shares as of December 31, 2005            |   | 26,847,941 |   |
| Management  shares returned to Treasury Stock (Note 7) |   | (15,783    | )      |
| Outstanding  shares as of March 31, 2006          |   | 26,832,158 |   |

 

**6.****             ****ASSET RETIREMENT OBLIGATION**

 

Our financial statements reflect the provisions of Statement of FinancialAccounting Standards No. 143,*Accounting for Asset Retirement Obligations*. Our asset retirementobligation (“ARO”) primarily represents the estimated present value of theamount we will incur to plug, abandon and remediate our producing properties atthe end of their productive lives, in accordance with applicable state laws. Wedetermine our ARO by calculating the present value of expected cash flowsrelated to the liability. At March 31, 2006, our liability for ARO was $1,585,703,of which $1,566,261 is considered long-term. Our asset retirement obligationsare recorded as current or non-current liabilities based on the estimatedtiming of the anticipated cash flows.

 

The following table describes the changes in our asset retirementobligations for the nine months ended March 31, 2006:

 

| Asset  retirement obligation at June 30, 2005  |   | $       | 1,051,453 |   |
|-----------------------------------------------------|--------|---------|-----------|--------|
| Acquisition  of WO Energy                           |   | 497,906 |      |
| Accretion  expense                                  |   | 75,656  |      |
| Plugging  costs                                     |   | (39,312 | )         |
| Asset  retirement obligation at March 31, 2006 |   | $       | 1,585,703 |   |

 

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

 

As discussed in our Form 10-KSB dated June 30, 2005, pursuantto the terms of the Merger Agreement dated May 28, 2004, eight individuals(six current employees, one former employee and one director) were issued5,165,000 shares of common stock. These shares were placed in escrow and willvest to the individuals based on a combination of continued employment (“compensationshares”) and achieving certain performance goals during the two years followingthe merger (“performance shares”). The compensation shares amounted to2,659,975 shares and the performance shares amounted to 2,505,025 shares. Anyshares that are not released from escrow will be returned to Treasury Stock.

 

We accounted for these shares in accordance with the provisions ofStatement of Financial Accounting Standard (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*,and SFAS No. 148, *Accounting forStock-Based Compensation — Transition and Disclosure*. At the mergerdate, we recognized $2,324,250 of “Deferred Compensation” and “AdditionalPaid-in Capital” in the Consolidated Balance Sheet. The shares were recordedbased on the quoted market price at the time of the transaction and are beingamortized to expense over the periods earned. At March 31, 2006, thebalance of Deferred Compensation was $97,972, net of amortization expense.

 

As of March 31, 2006, shares returned to treasury totaled 15,783shares and are recorded as Treasury Stock, at cost. On July 1, 2005, thecompensation shares totaling 2,505,025 shares were released from escrow tothree executive officers. At March 31, 2006, the total escrowed shareswere 2,659,975, of which the outstanding common shares totaled 2,644,192 andtreasury shares totaled 15,783.

 

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

 

As discussed in our Form 10-KSB dated June 30, 2005, the 2005Directors’ Stock Option Plan (“Plan”) became effective on April 1, 2005. OnApril 1, 2005, pursuant to the Plan, we granted stock options to our fivenon-employee directors to each purchase 25,000 shares of common stock. Theoptions granted under the Plan totaled 125,000 shares. These options have anexercise price of $4.13 per share. The options vested on April 1, 2006,and expire on April 1, 2015.

 

On September 16, 2005, we granted stock options to James K.Teringo, Jr., our Vice President, General Counsel and Corporate Secretaryto purchase 50,000 shares of common stock. These options have an exercise priceof $3.98 per share. The options vest on July 11, 2006, and expire on September 16,2015.

 

On December 7, 2005, our shareholders approved our 2005 Long-TermIncentive Plan (“LTIP”). The 2005 LTIP authorizes the issuance of up to1,000,000 shares of our common stock to key employees, key consultants andoutside directors of our company and subsidiaries. The 2005 LTIP permits thegrant of incentive stock options, non-qualified stock options, stockappreciation rights, restricted stock, restricted stock units, performanceawards, dividend equivalent rights and other awards, whether granted singly, orin combination or in tandem. No executive officer (as defined in the 2005 LTIP)may receive in any calendar year (i) stock options or stockappreciation rights relating to more than 100,000 shares of common stock or (ii) restrictedstock, restricted stock units, performance awards or other awards that aresubject to the attainment of performance goals relating to more than 100,000shares of common stock; provided, however, that all such awards of anyexecutive officer during any calendar year may not exceed an aggregate ofmore than 100,000 shares of common stock. The 2005 LTIP terminates on December 7,2015; however, awards granted before that date will continue to be effective inaccordance with their terms and conditions.

 

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On December 13, 2005, under the 2005 LTIP, 25,000 options weregranted to each of our five non-employee Directors: Donnie D. Dent, Gerald W.Haddock, Randall Boyd, Dr. Jim Underwood and Morris B. “Sam” Smith. Eachof these options has an exercise price of $6.30 per share. These grantedoptions vest on December 13, 2006 if such persons are still directors on December 13,2006.

 

Pursuant to Statement of Financial Accounting Standard No. 123 (“SFAS123”), *Accounting for Stock-BasedCompensation*, the fair value of each stock option is estimated onthe date of grant using the Black-Scholes option-pricing model. The factorsused to calculate the fair value of all options are summarized in the tablebelow:

 
| ** **               | ** ** | ** **                                                                     | ** ** | **Options to**       | ** ** | ** **     | ** ** |
|--------------------------|------------|--------------------------------------------------------------------------------|------------|---------------------------|------------|----------------|------------|
| ** **               | ** ** | **Reported in Form 10-KSB  dated June 30, 2005** | ** ** | **J. Teringo,  Jr.** | ** ** | **2005  LTIP** | ** ** |
| No. of  shares      |       | 50,000                                                                         |       | 125,000                   |       | 50,000         |       | 125,000 |   |
| Risk free  interest rate |       | 4.27                                                                           | %          | 4.28                      | %          | 4.56           | %          | 4.45 | % |
| Expected  life           |       | 4 years                                                                        |       | 4 years                   |       | 4 years        |       | 4 years |   |
| Expected  volatility     |       | 51.5                                                                           | %          | 33.7                      | %          | 27.4           | %          | 26.5 | % |
| Expected  dividend yield |       | 0                                                                              | %          | 0                         | %          | 0              | %          | 0 | % |

 

The total fair value of the options summarized in the above table isapproximately $424,000. In accordance with the provisions of SFAS 123 and SFAS No. 148,*Accounting for Stock-Based Compensation —Transition and Disclosure*, we have recorded a charge to general andadministrative expenses for the estimated fair value of the options granted toour directors of $61,643 and $134,437 for the three- and nine-month periods endedMarch 31, 2006, respectively. For the three- and nine-month periods ended March 31,2005, we charged $67,000 and $78,666, respectively.

 

**9.****             ****NET LOSS PER COMMON SHARE**

 

Basic net income (loss) per common share is computed by dividing thenet income attributable to common shareholders by the weighted average numberof shares of common stock outstanding during the period.

 

Diluted net income (loss) per common share is computed in the samemanner, but also considers the effect of the stock options. The stock optionsare not considered for the three and nine months ended March 31, 2006 astheir effects would be anti-dilutive.

 

The weighted average shares used in the basic loss per common sharecomputations for the three and nine months ended March 31, 2006 were 24,187,966shares and 21,740,759 shares, respectively.  The weighted average sharesfor the three and nine months ended March 31, 2005 were 11,204,155 sharesand 10,722,854, respectively. The shares at March 31, 2006 and 2005excluded contingently issuable shares of 2,659,975 and 5,165,000, respectively,as discussed in Note 7.

 

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

 

As discussed in our Form 10-KSB dated June 30, 2005, on March 29,2005,we entered into an agreement with Haddock Enterprises, LLC and Kenneth Q. Carlile(predecessor to Carlile Management, LLC) to explore the possibility ofconverting the Sabine Royalty Trust from a liquidating asset into a vehicle toacquire low risk assets. Each of the three parties owns a one-third interest inthe Sabine Production Operating, LLC. Gerald W. Haddock is President of HaddockEnterprises, LLC and is a member of our Board of Directors. As of March 31,2006, Cano had incurred approximately $419,000 pertaining to the joint venture,of which $379,000 occurred during the nine months ended March 31, 2006. Weexpensed the $419,000 to general & administrative expense because ofthe election of Sabine Production Operating, LLC to indefinitely suspend theproxy solicitation from the unit holders of the Sabine Royalty Trust.

 

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Effective December 1, 2005, we acquired all overriding royaltyinterests held by THEprivate Energy Company, Inc. (formerly Cano EnergyCorporation) on December 27, 2005 and we are to acquire all overriding royaltyinterests acquired in the future by THEprivate Energy Company, Inc. in andto the oil gas and mineral leaseholder estates and personal property related toleasehold estates located on the same property on which the Davenport FieldUnit’s properties are located. We paid $66,700 per percentage of net revenueattributable to the interests held by THEprivate Energy Company, Inc. DuringDecember 2005, we paid $500,250 to acquire a 7.5% overriding royaltyinterest and during January 2006, we paid $200,100 to acquire a 3.0%overriding royalty interest.

 

S. Jeffrey Johnson, our Chairman of the Board and Chief ExecutiveOfficer, is a 30% shareholder in THEprivate Energy Company, Inc. The termsof the purchase were agreed to based on arms-length negotiations, supported bya valuation established by our independent engineer, and are substantially thesame as previously paid by us to THEprivate Energy Company, Inc. for aportion of its interest in September and October of 2004. Thispurchase was approved by our Board pursuant to a recommendation by our AuditCommittee.

 

**11.****      ****INCOME TAXES**

 

Our income tax benefit is as follows:

 
| ** **                   | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **March 31,**     | ** ** | **March 31,**              | ** ** |
| ** **                   | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Current  income tax benefit  |       |                   |       |                            |       |   |   |   |   |
| Federal                      |       | $                      | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| State                        |       | —                 |       | —                          |       | — |   | — |   |
| Total  current tax benefit   |       | —                 |       | —                          |       | — |   | — |   |
| Deferred  income tax benefit |       |                   |       |                            |       |   |   |   |   |
| Federal                      |       | 606,000                |       | —                          |       | 1,316,000 |   | — |   |
| State                        |       | 71,000                 |       | —                          |       | 154,000 |   | — |   |
| Total  deferred tax benefit  |       | 677,000                |       | —                          |       | 1,470,000 |   | — |   |
| Total income  tax benefit    |       | $                      | 677,000    |                            | $          | — |   | $ | 1,470,000 |   | $ | — |   |

 

The difference between our benefit from income taxes recorded on thestatements of operations and the tax computed using statutory ratesprimarily comprises state taxes and adjustments to the valuation allowance.

 

Regarding the acquisition of Square One Energy, Inc., as discussedin our Form 10-KSB dated June 30, 2005, this acquisition did notprovide for Section 338 treatment. As defined in the Internal RevenueService tax code, Section 338 treatment would have enabled us to recognizethe stepped-up basis in the Square One properties approximately equal to theacquisition price, for tax computation purposes.

 

In accordance with the purchase method of accounting, we recorded adeferred tax liability of approximately $3.1 million with an offsettingincrease in property basis of $2.4 million and Goodwill of approximately $0.7million. Based on a reserve report prepared by an independent petroleumengineering firm and our internal analysis, we believe the oil and gasproperties of Square One have unrealized potential to support the recording of “Goodwill”to the Consolidated Balance Sheet.

 

 At March 31, 2006, we have recorded a total deferred taxliability of $33 million, which resulted from the acquisitions of WO Energy(see Note 2) and Square One, net of deferred income tax benefit

 

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of$1.4 million that we recorded during the nine months ended March 31, 2006.A schedule showing the significant components of the net deferred taxliability as of March 31, 2006 is as follows:

 
| Deferred  compensation expense                                            |   | $           | 843,000     |   |
|---------------------------------------------------------------------------|--------|-------------|-------------|--------|
| Net  operating loss carryforwards, net of valuation allowance of $836,000 |   | 3,335,000   |        |
| Difference  in book and tax bases on acquired oil and gas properties      |   | (36,930,000 | )           |
| Difference  in book and tax bases on acquired fixed assets                |   | (461,000    | )           |
| Other                                                                     |   | 215,000     |        |
| Net deferred  tax liability                                               |   | $           | (32,998,000 | )      |

 

At March 31, 2006, Cano had net operating loss (“NOL”)carryforwards for tax purposes of approximately $11 million. The remaining netoperating losses principally expire in 2024 and 2025. Of the $11 million, $2.2million will be unavailable to offset any future taxable income due tolimitations from change in ownership as defined in Section 382 of theInternal Revenue Service (“IRS”) code. Accordingly, our valuation allowancereflects the unavailable $2.2 million NOL.

 

**12.****      ****COMMITMENTS AND CONTINGENCIES**

 

***Litigation***

 

On March 23, 2006, the following lawsuitwas filed in the 100th Judicial District Court in Carson County,Texas; Cause No. 9840, The Tom L. and Anne Burnett Trust, by Anne BurnettWindfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, III and EdHudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and Burnett Ranches,Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O.Operating, Ltd, and W.O. Energy, Inc. The plaintiffs claim that theelectrical wiring and equipment of Cano Petroleum, Inc. or certain of itssubsidiaries relating to its oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County.

 

The plaintiffs(i) allege negligence and gross negligence and (ii) seek undiscloseddamages, including, but not limited to, damages for damage to their land andlivestock, certain expenses related to fighting the fire and certain remedialexpenses. In addition, the plaintiffs seek (i) termination of certain oiland gas leases, (ii) reimbursement for their attorney’s fees and (iii) exemplarydamages.

 

Due to theinherent risk of litigation and the fact that this case is in the early stagesof discovery, the outcome of this case is uncertain and unpredictable; however,at this time Cano management believes the suit is without merit and isvigorously defending itself and its subsidiaries.

 

On April 28,2006, the following lawsuit was filed in the 31st Judicial DistrictCourt of Roberts County, Texas, Case No. 1922, Robert and Glenda Adcock,et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O.Operating, Ltd, and W.O. Energy, Inc. There are 43 plaintiffs that claimthat the electrical wiring and equipment of Cano Petroleum, Inc. orcertain of its subsidiaries relating to its oil and gas operations started awildfire that began on March 12, 2006 in Carson County.

 

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

 

Due to theinherent risk of litigation and the fact that this case is in the early stagesof discovery, the outcome of this case is uncertain and unpredictable; however,at this time Cano management believes the suit is without merit and isvigorously defending itself and its subsidiaries.

 

On April 10,2006, the following lawsuit was filed in the 31st Judicial DistrictCourt of Roberts County, Texas, Case No. 1920, Joseph Craig Hutchison andJudy Hutchison v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.;W. O. Operating, Ltd, and W.O. Energy, Inc. On May 1, 2006, the

 

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following lawsuit was filed in the 31stJudicial District Court of Roberts County, Texas, Case No. 1923, ChisumFamily Partnership, Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.;W. O. Operating, Ltd, and W.O. Energy, Inc. Although Cano is aware thatthese two lawsuits were filed, neither it nor any of its subsidiaries that arenamed in the lawsuits have been served with process. The plaintiffs in bothcases claim that the electrical wiring and equipment of Cano Petroleum, Inc.or certain of its subsidiaries relating to its oil and gas operations started awildfire that began on March 12, 2006 in Carson County.

 

The plaintiffsin both cases (i) allege negligence and trespass and (ii) seekundisclosed damages, including, but not limited to, damages to their land andcertain remedial expenses. In addition, the plaintiffs in both cases seek (i) reimbursementfor their attorney’s fees and (ii) exemplary damages.

 

Due to theinherent risks of litigation and the fact that neither Cano nor itssubsidiaries have been served with these suits, the outcome of these cases isuncertain and unpredictable; however, at this time Cano management believes thesuits are without merit and, if and when it is served, will vigorously defenditself and its subsidiaries.

 

***Other***

 

Occasionally, we are involved in other various lawsuits and certaingovernmental proceedings arising in the ordinary course of business. Ourmanagement does not believe that the ultimate resolution of any currentmatters, including due to the existence of insurance coverage, indemnificationand escrow accounts, will have a material effect on our financial position orresults of operations. None of our directors, officers or affiliates, owners ofrecord or beneficially of more than five percent of any class of ourvoting securities, or security holder is involved in a proceeding adverse toour business or has a material interest adverse to our business.

 

***Environmental***

 

To date, our expenditures to comply with environmental or safetyregulations have not been significant and are not expected to be significant inthe future. However, new regulations, enforcement policies, claims for damagesor other events could result in significant future costs.

 

**13.****      ****SUBSEQUENT EVENTS**

 

***New Acquisition***

 

On April 26, 2006, we entered into an Asset Purchase and SaleAgreement regarding the purchase and sale of oil and gas properties in thePanhandle Field located in Texas. The purchase price was $24 million in cash. Theacquisition by our wholly-owned subsidiary, Pantwist, LLC, included twoworkover rigs and other equipment valued at approximately $1.25 million.

 

***Financing***

 

The aforementioned acquisition was funded pursuant to Amendment No. 2to our existing senior credit facility, as described in Note 3. Pursuant to theAmendment, the borrowing base increased from $30 million to $55 million. Canoborrowed an additional $25 million under the senior credit facility to fund theaforementioned acquisition. As of April 28, 2006, this increased Cano’s totaloutstanding borrowings under the senior credit facility to $52.75 million with ablended interest rate of approximately 7.27% at May 4, 2006.

 

The terms of the Amendment (i) require a $5 million reduction ofthe borrowing base by December 31, 2006 and (ii) require that if asof the end of any fiscal quarter end occurring on or after June 30, 2006,the ratio of Cano’s consolidated debt to consolidated earnings before interest,taxes, depreciation and amortization exceeds 3.00 to 1.00, then on or prior tothe following fiscal quarter end, Cano shall prepay advances or, if theadvances have been repaid in full, make deposits as cash collateral to providecash collateral for letter of credit exposure, in an amount equal to thegreater of (a) $20 million and (b) an amount necessary to cause theratio of Cano’s consolidated debt to

 

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consolidatedearnings before interest, taxes, depreciation and amortization to be less than3.00 to 1.00. In addition, we will hedge at least 50% of productionattributable to the new acquisition for three years at “price floors” of $60per barrel and $7.60 per mcf. Cano has implemented these “price floor” hedgesand there is no “price ceiling” on the hedge.

 

Also, the Amendment requires that Cano will hedge or cause to be hedgedbetween 50% and 80% of its existing production. Cano’s existing hedges, asdiscussed in Note 4, comply with this requirement.

 

***Amendment to SeniorCredit Agreement***

 

Based on our financial position and results of operations for thequarter ended March 31, 2006, we were unable to comply with two covenantsof the senior credit facility. As more fully described below, on May 12,2006, but effective as of March 31, 2006, we entered into an amendment tothe Senior Credit Agreement which allowed us, as of March 31, 2006, tocomply with those two covenants, as amended.

 

On May 12, 2006, but effective as of March 31,2006, Cano, its subsidiaries, Union Bank of California, N.A, (“Union Bank”) asAdministrative Agent/Issuing Lender and Natexis Banques Populaires entered intoAmendment No. 3 to the Credit Agreement dated November 29, 2005, aspreviously amended, by and among Cano, the lenders party thereto from time totime and Union Bank, as Administrative Agent and Issuing Lender (“Amendment tothe Credit Agreement”). The Amendment to the Credit Agreement changes as of March 31,2006 the Debt Coverage Ratio and the Interest Coverage Ratio.

 

In the Amendment to the Credit Agreement, theDebt Coverage Ratio changed as follows:  (i) forthe quarter ending March 31, 2006, the ratio of consolidated Debt (asdefined in the Credit Agreement) of Cano for the quarter to the consolidatedEBITDA, an acronym for net earnings plus interest expense, taxes, depreciation,amortization, depletion and other non-cash charges, of Cano for the quartermultiplied by four must not be greater than 7.50 to 1.00 rather than 5.00 to1.00, (ii) for the quarter ending June 30, 2006, the ratio ofconsolidated Debt of Cano for the quarter to the consolidated EBITDA of Canofor the two quarter period multiplied by two must not be greater than 5.25 to1.00 rather than 4.50 to 1.00, (iii)  for the quarter ending September 30,2006, the ratio of consolidated Debt of Cano for the quarter to theconsolidated EBITDA of Cano for the three quarter period multiplied by 4/3 mustnot be greater than 4.50 to 1.00 rather than 4.00 to 1.00, (iv) for thequarter ending December 31, 2006, the ratio of consolidated Debt of Canofor the quarter to the consolidated EBITDA of Cano for the four quarter periodmust not be greater than 4.00 to 1.00 rather than 3.50 to 1.00 and (v) forall quarters ending on or after March 31, 2007, the ratio of consolidatedDebt of Cano for such quarter to the consolidated EBITDA of Cano for the fourquarter period must not be greater than 3.50 to 1.00 which is the same as itwas in the Credit Agreement.

 

In the Amendment to the Credit Agreement, theInterest Coverage Ratio changed as follows: (i) for the quarter ending March 31, 2006, the ratio ofconsolidated EBITDA of Cano for the quarter multiplied by four to theconsolidated Interest Expense (as defined in the Credit Agreement) of Cano forthe quarter multiplied by four must be at least 1.50 to 1.00 rather than 2.00to 1.00, (ii) for the quarter ending June 30, 2006, the ratio ofconsolidated EBITDA of Cano for the two quarter period multiplied by two to theconsolidated Interest Expense of Cano for the two quarter period multiplied bytwo must be at least 1.75 to 1.00 rather than 2.00 to 1.00, (iii) for thequarter ending September 30, 2006, the ratio of consolidated EBITDA ofCano for the three quarter period multiplied by 4/3 to the consolidatedInterest Expense of Cano for the three quarter period multiplied by 4/3 must beat least 2.00 to 1.00 which is the same as it was in the Credit Agreement and (iv) forthe quarter ending December 31, 2006 and all future quarters, the ratio ofconsolidated EBITDA of Cano for the four quarter period to the consolidatedInterest Expense of Cano for the four quarter period must be at least 2.00 to1.00 which is the same as it was in the Credit Agreement.

 

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***Amendment toSubordinated Credit Agreement***

 

Based on our financial position and results of operations for the quarterended March 31, 2006, we were unable to comply with two covenants of ourof the subordinated credit facility. As more fully described below, on May 12,2006, but effective as of March 31, 2006, we entered into an amendment tothe Subordinated Credit Agreement which allowed us, as of March 31, 2006,to comply with those two covenants, as amended.

 

On May 12, 2006, but effective as of March 31,2006, Cano, its subsidiaries, the lenders and Energy Components SPC EEP EnergyExploration and Production Segregated Portfolio, as Administrative Agent (the “AdministrativeAgent”) entered into the Second Amendment to Subordinated Credit Agreementdated November 29, 2005, as previously amended, by and among Cano, thelenders party thereto from time to time and the Administrative Agent (“Amendmentto the Subordinated Credit Agreement”). The Amendment to the SubordinatedCredit Agreement changes as of March 31, 2006 the Debt Coverage Ratio andthe Interest Coverage Ratio.

 

In the Amendment to the Subordinated CreditAgreement, the Debt Coverage Ratio changed as follows:  (i) for the quarter ending March 31,2006, the ratio of consolidated Debt (as defined in the Subordinated CreditAgreement) of Cano for the quarter to the consolidated EBITDA, an acronym fornet earnings plus interest expense, taxes, depreciation, amortization,depletion and other non-cash charges, of Cano for the quarter multiplied byfour must not be greater than 7.50 to 1.00 rather than 5.00 to 1.00, (ii) forthe quarter ending June 30, 2006, the ratio of consolidated Debt of Canofor the quarter to the consolidated EBITDA of Cano for the two quarter periodmultiplied by two must not be greater than 5.25 to 1.00 rather than 4.50 to1.00, (iii)  for the quarter ending September 30, 2006, the ratio ofconsolidated Debt of Cano for the quarter to the consolidated EBITDA of Canofor the three quarter period multiplied by 4/3 must not be greater than 4.50 to1.00 rather than 4.00 to 1.00 and (iv) for the quarter ending on or after December 31,2006, the ratio of consolidated Debt of Cano for the quarter to theconsolidated EBITDA of Cano for the four quarter period must not be greaterthan 4.00 to 1.00 which is the same as it was in the Credit Agreement.

 

Inthe Amendment to the Subordinated Credit Agreement, the Interest Coverage Ratiochanged as follows:  (i) for thequarter ending March 31, 2006, the ratio of consolidated EBITDA of Canofor the quarter multiplied by four to the consolidated Interest Expense (asdefined in the Subordinated Credit Agreement) of Cano for the quartermultiplied by four must be at least 1.50 to 1.00 rather than 2.00 to 1.00, (ii) forthe quarter ending June 30, 2006, the ratio of consolidated EBITDA of Canofor the two quarter period multiplied by two to the consolidated InterestExpense of Cano for the two quarter period multiplied by two must be at least1.75 to 1.00 rather than 2.00 to 1.00, (iii) for the quarter ending September 30,2006, the ratio of consolidated EBITDA of Cano for the three quarter periodmultiplied by 4/3 to the consolidated Interest Expense of Cano for the threequarter period multiplied by 4/3 must be at least 2.00 to 1.00 which is thesame as it was in the Subordinated Credit Agreement and (iv) for thequarters ending December 31, 2006 and all future quarters, the ratio ofconsolidated EBITDA of Cano for the four quarter period to the consolidated InterestExpense of Cano for the four quarter period must be at least 2.00 to 1.00 whichis the same as it was in the Subordinated Credit Agreement.

 

***Amendment toRegistration Rights Agreements***

 

Asdiscussed in Note 2, on November 29, 2005, in connection with theacquisition of W.O. Energy, Cano entered into Registration Rights Agreements(the “Registration Rights Agreements”) with both Miles O’Loughlin (“O’Loughlin”)and Scott White (“White”) regarding shares of Cano common stock that wereissued to O’Loughlin and White in connection with their sale of W.O. Energy toCano (the “Purchase Shares”). The Registration Rights Agreements contained aright that if Cano did not register the Purchase Shares with the Securities andExchange Commission (the “SEC”) by November 29, 2006, O’Loughlin and Whitehad the option to require Cano to purchase the Purchase Shares from them forthe closing price of Cano common stock on November 29, 2005.

 

OnMay 12, 2006, but effective as of November 29, 2005, Cano amended theRegistration Rights Agreements with the Estate of O’Loughlin and with White(the “Registration Rights Amendments”) in order to remove the right of theEstate of O’Loughlin and of White to require Cano to purchase the

 

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Purchase Shares if thePurchase Shares were not registered with the SEC by November 29, 2005. TheRegistration Rights Amendments provide that Cano will include the PurchaseShares on the next registration statement that Cano files that would permit theresale of the Purchase Shares.

 

***Amendment toStock Purchase Agreement***

 

As discussed in Note 2, on November 29, 2005,Cano acquired W.O. Energy from O’Loughlin and White pursuant to a StockPurchase Agreement dated November 29, 2005 (the “Stock Purchase Agreement”).The Stock Purchase Agreement provided that O’Loughlin and White could not sellthe Purchase Shares until November 29, 2006 and with the restriction thaton or after such date, they could sell up to 15% of their Purchase Shares inany 90 day period. On May 12, 2006, Cano and W.O. Energy entered into anamendment to the Stock Purchase Agreement (the “Stock Purchase Amendment”) withthe Estate of O’Loughlin and with White which provides that subject to thelimitation on selling only up to 15% of their Purchase Shares in any 90 dayperiod, the Estate of O’Loughlin and White may sell the Purchase Shares atany time the shares are registered for resale or are exempt from registration.

 

**Item 2. Management’s Discussion andAnalysis or Plan of Operation**

 

**Forward-Looking Statements**

 

The information in thisreport on Form 10-QSB contains forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995. This Actprovides a “safe harbor” for forward-looking statements to encourage companiesto provide prospective information about themselves provided they identifythese statements as forward looking and provide meaningful cautionarystatements identifying important factors that could cause actual results todiffer from the projected results. All statements other than statements ofhistorical fact made in this report are forward looking. In particular, thestatements herein regarding industry prospects and future results of operationsor financial position are forward-looking statements. Forward-lookingstatements reflect management’s current expectations and are inherentlyuncertain. Our actual results may differ significantly from management’sexpectations as a result of many factors, including, but not limited to, the volatilityin prices for crude oil and natural gas, future commodity prices for derivativehedging contracts, the timing of acquisitions, our ability to obtain additionalcapital, product demand, market competition, interruption in production,transportation restrictions, interest rates, valuations of oil and gasreserves, drilling risks and the success of waterflooding and enhanced oilrecovery techniques.

 

You should read thefollowing discussion and analysis in conjunction with the consolidatedfinancial statements of Cano Petroleum, Inc. and 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.

 

**Overall Strategy**

 

We are a growing independentoil and gas company that intends to actively utilize secondary and enhanced oilrecovery (“EOR”) methods to increase production and reserves at our existingproperties and future acquisitions. Our primary focus is crude oil and ourtarget acquisitions are onshore U.S. properties. Our focus on domestic, matureoil fields eliminates exploration risks and logistical uncertainties inherentin international operations. We use secondary waterflooding and EOR methods,such as surfactant-polymer flooding technology.

 

We believe significantgrowth opportunities exist primarily because the major energy companies andlarge independents continue to focus their attention and resources toward theexploration and production of large fields. In the past several years, themajor companies have been divesting themselves of their mature, smaller oilfields. During recent years, the energy industry has predominately focused onnatural gas exploration and production, and has been significantly less focusedon crude oil. The recent

 

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economics of the oil and gas market have improved asprices have risen substantially. These conditions provide ample opportunitiesfor smaller independent companies to acquire and exploit mature U.S. oilfields.Our emphasis on EOR methods positions us in a unique niche segment in the oiland gas industry. Our acquisition targets are proven, mature oil fields thatpossess significant proved reserves, as well as a high ratio of probablereserves. We expect to encounter increased competition for such properties in thefuture.

 

**Liquidity and Capital Resources**

 

At March 31,2006, our cash balance was $1.3 million and our available borrowing amount was$2 million under the senior credit agreement. In addition, as discussed in Note 3, the senior credit agreement currentlyhas a total commitment of $100 million, of which the borrowing base is $30million as of March 31, 2006.  The senioragreement provides for semiannual redeterminations of the borrowing base amountand one additional redetermination during the six month periods. 

 

We intend tofinance future acquisitions of oil and gas properties, field developmentprojects, operating activities and the potential payments under the seniorcredit agreement with a combination of issuances of equity, debt financing, andcash flow from operations.   Thepotential payments under the senior credit agreement pertain to Amendment No.3, as discussed below under “*Amendment to Senior CreditAgreement*” and Amendment No. 2, as discussed below under “*New Acquisition & Financing.*” Pursuant to Amendment No.3, we may be required to make a payment ranging up to $25 million as of June30, 2006.  Pursuant to Amendment No. 2,we may be required to make a minimum $20 million payment by September 30, 2006.  We cannot guarantee that any additionalequity or debt financing will be available in sufficient amounts or onacceptable terms when needed.  If suchfinancing is not available in sufficient amounts or on acceptable terms, ourresults of operations and financial condition may be adversely affected.  In addition, equity financing may result indilution to existing stockholders and may involve securities that have rights,preferences, or privileges that are senior to our common stock, and any debtfinancing obtained must be repaid regardless of whether or not we generateprofits or cash flows from our business activities.

 

***Financing and Investing Activities***

 

Duringthe nine months ended March 31, 2006, we completed the following capitalfinancings:

 

•                  As discussed in Note 5 to the financial statements,we received net proceeds of $18.3 million from the issuance of 4,703,864 sharesof common stock during September 2005.

•                  As discussed Note 3 to the financialstatements, on November 29, 2005, we entered into a $100 million seniorcredit agreement. The initial borrowing base is $30 million based on our provedreserves, as identified in the table below. As of March 31, 2006, ourborrowings under this agreement totaled $27.75 million and the availableborrowing amount was $2 million.

•                  As discussed in Note 3 to the financialstatements, on November 29, 2005, we entered into a $15 millionsubordinated credit agreement. As of March 31, 2006, our outstandingbalance was $15 million under this agreement.

 

The net proceeds from thesecapital financings were used to finance the acquisition of WO Energy forapproximately $57.4 million, as discussed in Note 2 to the financialstatements, and the $5.3 million purchase of derivative hedging contracts, asdiscussed in Note 4 to the financial statements.

 

The primary asset of WOEnergy is the Panhandle Field located in Texas. The acquisition of WO Energywas the primary reason our net oil and gas assets increased from $16.5 millionas of September 30, 2005 to $106.5 million as of March 31, 2006. ThePanhandle Field represents 34,497 MBOE of our total 47,178 MBOE provedreserves, as shown in the table in the “*ProvedReserves*” section below.

 

As discussed in Note 4 tothe financial statements, pursuant to our senior and subordinated creditagreements, we are required to enter into financial contracts to hedge ourexposure to commodity price risk associated with expected oil and gasproduction. For calendar years 2006, 2007, and 2008, the hedged productionamounts, as expressed in barrels of oil equivalent per day, are 832, 781, and735, respectively. We entered into financial contracts to set the followingprice floors for calendar years 2006 through 2008:

 

•                  Crude oil production of $60/barrel for 2006,and $55/barrel for 2007 and 2008.

•                  Natural gas production of $8.50/mcf,$8.00/mcf, and $7.50/mcf for 2006, 2007, and 2008, respectively.

 

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We have no derivativehedging contracts that set a price ceiling. Therefore, we are entitled to 100%of our revenue receipts and, if crude oil and natural gas NYMEX prices arelower than the price floor, we will be reimbursed for the difference betweenthe NYMEX price and floor price.

 

***New Acquisition & Financing***

 

As discussed in Note 13, weacquired additional oil and gas properties in the Panhandle Field located inTexas. On April 28, 2006, Pantwist, LLC (“Pantwist”), a wholly ownedsubsidiary of Cano, acquired these oil and gas properties with an effectivedate of the acquisition of February 1, 2006. The purchase price was $24million in cash, as adjusted. These oil and gas properties cover approximately9,700 acres, currently produce approximately 400 net barrels of oil equivalent(“BOE”) per day and have approximately 7 million BOE of proved reserves, ofwhich approximately 2.1 million BOE are proved producing reserves. Theacquisition included two workover rigs and other equipment valued atapproximately $1.25 million.

 

The acquisition was funded pursuantto Amendment No. 2 to our existing senior credit facility, as discussed inNote 3. Pursuant to the Amendment, the borrowing base increased from $30million to $55 million. Cano borrowed an additional $25 million under thesenior credit facility to fund the aforementioned acquisition. As of April 28,2006, this increased Cano’s total outstanding borrowings under the seniorcredit facility to $52.75 million with a blended interest rate of approximately7.27% at May 4, 2006.

 

The terms of the Amendment (i) requirea $5 million reduction of the borrowing base by December 31, 2006 and (ii) requirethat if as of the end of any fiscal quarter end occurring on or after June 30,2006, the ratio of Cano’s consolidated debt to consolidated earnings beforeinterest, taxes, depreciation and amortization exceeds 3.00 to 1.00, then on orprior to the following fiscal quarter end, Cano shall prepay advances or, ifthe advances have been repaid in full, make deposits as cash collateral toprovide cash collateral for letter of credit exposure, in an amount equal tothe greater of (a) $20 million and (b) an amount necessary to causethe ratio of Cano’s consolidated debt to consolidated earnings before interest,taxes, depreciation and amortization to be less than 3.00 to 1.00. In addition,we will hedge at least 50% of production attributable to the new acquisitionfor three years at “price floors” of $60 per barrel and $7.60 per mcf. Cano hasimplemented these “price floor” hedges and there is no “price ceiling” on thehedge.

 

Also, the Amendment requiresthat Cano will hedge or cause to be hedged between 50% and 80% of its existingproduction. Cano’s existing hedges, as discussed in Note 4, comply with thisrequirement.

 

***Amendment toSenior Credit Agreement***

 

Based on our financialposition and results of operations for the quarter ended March 31, 2006,we were unable to comply with two covenants of the senior credit facility. Asmore fully described below, on May 12, 2006, but effective as of March 31,2006, we entered into an amendment to the Senior Credit Agreement which allowedus, as of March 31, 2006, to comply with those two covenants, as amended.

 

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OnMay 12, 2006, but effective as of March 31, 2006, Cano, itssubsidiaries, Union Bank of California, N.A, (“Union Bank”) as AdministrativeAgent/Issuing Lender and Natexis Banques Populaires entered into Amendment No. 3to the Credit Agreement dated November 29, 2005, as previously amended, byand among Cano, the lenders party thereto from time to time and Union Bank, asAdministrative Agent and Issuing Lender (“Amendment to the Credit Agreement”). TheAmendment to the Credit Agreement changes as of March 31, 2006 the DebtCoverage Ratio and the Interest Coverage Ratio.

 

Inthe Amendment to the Credit Agreement, the Debt Coverage Ratio changed asfollows:  (i) for the quarter endingMarch 31, 2006, the ratio of consolidated Debt (as defined in the CreditAgreement) of Cano for the quarter to the consolidated EBITDA, an acronym fornet earnings plus interest expense, taxes, depreciation, amortization, depletionand other non-cash charges, of Cano for the quarter multiplied by four must notbe greater than 7.50 to 1.00 rather than 5.00 to 1.00, (ii) for thequarter ending June 30, 2006, the ratio of consolidated Debt of Cano forthe quarter to the consolidated EBITDA of Cano for the two quarter periodmultiplied by two must not be greater than 5.25 to 1.00 rather than 4.50 to1.00, (iii)  for the quarter ending September 30, 2006, the ratio ofconsolidated Debt of Cano for the quarter to the consolidated EBITDA of Canofor the three quarter period multiplied by 4/3 must not be greater than 4.50 to1.00 rather than 4.00 to 1.00, (iv) for the quarter ending December 31,2006, the ratio of consolidated Debt of Cano for the quarter to theconsolidated EBITDA of Cano for the four quarter period must not be greaterthan 4.00 to 1.00 rather than 3.50 to 1.00 and (v) for all quarters endingon or after March 31, 2007, the ratio of consolidated Debt of Cano forsuch quarter to the consolidated EBITDA of Cano for the four quarter periodmust not be greater than 3.50 to 1.00 which is the same as it was in the CreditAgreement.

 

Inthe Amendment to the Credit Agreement, the Interest Coverage Ratio changed asfollows:  (i) for the quarter endingMarch 31, 2006, the ratio of consolidated EBITDA of Cano for the quartermultiplied by four to the consolidated Interest Expense (as defined in theCredit Agreement) of Cano for the quarter multiplied by four must be at least1.50 to 1.00 rather than 2.00 to 1.00, (ii) for the quarter ending June 30,2006, the ratio of consolidated EBITDA of Cano for the two quarter periodmultiplied by two to the consolidated Interest Expense of Cano for the twoquarter period multiplied by two must be at least 1.75 to 1.00 rather than 2.00to 1.00, (iii) for the quarter ending September 30, 2006, the ratioof consolidated EBITDA of Cano for the three quarter period multiplied by 4/3to the consolidated Interest Expense of Cano for the three quarter periodmultiplied by 4/3 must be at least 2.00 to 1.00 which is the same as it was inthe Credit Agreement and (iv) for the quarter ending December 31,2006 and all future quarters, the ratio of consolidated EBITDA of Cano for thefour quarter period to the consolidated Interest Expense of Cano for the fourquarter period must be at least 2.00 to 1.00 which is the same as it was in theCredit Agreement.

 

***Amendment toSubordinated Credit Agreement***

 

Based on our financialposition and results of operations for the quarter ended March 31, 2006,we were unable to comply with two covenants of the subordinated credit facility.As more fully described below, on May 12, 2006, but effective as of March 31,2006, we entered into an amendment to the Subordinated Credit Agreement whichallowed us, as of March 31, 2006, to comply with those two covenants, asamended.

 

OnMay 12, 2006, but effective as of March 31, 2006, Cano, itssubsidiaries, the lenders and Energy Components SPC EEP Energy Exploration andProduction Segregated Portfolio, as Administrative Agent (the “AdministrativeAgent”) entered into the Second Amendment to Subordinated Credit Agreementdated November 29, 2005, as previously amended, by and among Cano, thelenders party thereto from time to time and the Administrative Agent (“Amendmentto the Subordinated Credit Agreement”). The Amendment to the SubordinatedCredit Agreement changes as of March 31, 2006 the Debt Coverage Ratio andthe Interest Coverage Ratio.

 

In theAmendment to the Subordinated Credit Agreement, the Debt Coverage Ratio changedas follows:  (i) for the quarterending March 31, 2006, the ratio of consolidated Debt (as defined in theSubordinated Credit Agreement) of Cano for the quarter to the consolidatedEBITDA (as defined in the Credit Agreement) of Cano for the quarter multipliedby four must not be greater than 7.50 to 1.00 rather than 5.00 to 1.00, (ii) forthe quarter ending June 30, 2006, the ratio of consolidated Debt of Canofor the quarter to the consolidated EBITDA of Cano for the two quarter periodmultiplied by two must not be

 

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greater than 5.25 to 1.00rather than 4.50 to 1.00, (iii)  for the quarter ending September 30,2006, the ratio of consolidated Debt of Cano for the quarter to theconsolidated EBITDA of Cano for the three quarter period multiplied by 4/3 mustnot be greater than 4.50 to 1.00 rather than 4.00 to 1.00 and (iv) for thequarter ending on or after December 31, 2006, the ratio of consolidatedDebt of Cano for the quarter to the consolidated EBITDA of Cano for the fourquarter period must not be greater than 4.00 to 1.00 which is the same as itwas in the Credit Agreement.

 

In the Amendment to theSubordinated Credit Agreement, the Interest Coverage Ratio changed asfollows:  (i) for the quarter endingMarch 31, 2006, the ratio of consolidated EBITDA of Cano for the quartermultiplied by four to the consolidated Interest Expense (as defined in theSubordinated Credit Agreement) of Cano for the quarter multiplied by four mustbe at least 1.50 to 1.00 rather than 2.00 to 1.00, (ii) for the quarterending June 30, 2006, the ratio of consolidated EBITDA of Cano for the twoquarter period multiplied by two to the consolidated Interest Expense of Canofor the two quarter period multiplied by two must be at least 1.75 to 1.00rather than 2.00 to 1.00, (iii) for the quarter ending September 30,2006, the ratio of consolidated EBITDA of Cano for the three quarter periodmultiplied by 4/3 to the consolidated Interest Expense of Cano for the threequarter period multiplied by 4/3 must be at least 2.00 to 1.00 which is thesame as it was in the Subordinated Credit Agreement and (iv) for thequarters ending December 31, 2006 and all future quarters, the ratio ofconsolidated EBITDA of Cano for the four quarter period to the consolidatedInterest Expense of Cano for the four quarter period must be at least 2.00 to1.00 which is the same as it was in the Subordinated Credit Agreement.

 

***Proved Reserves***

 

As set forth in reservereports based on oil and gas prices at June 30, 2005, except the Corsicanafield is as of January 1, 2006, prepared by Forrest A. Garb &Associates, Inc., our independent petroleum engineer, our proved reservesare summarized as follows:

 
| ** **                                               |       | **Nowata** | ** ** | **Rich  Valley** | ** ** | **Davenport** | ** ** | **Desdemona** | ** ** | **Corsicana*** | ** ** | **Panhandle  (WO Energy)** | ** ** | **Total @  3/31/06** | ** ** | **New  Acquisition** | ** ** | **Updated  Total** |       |
|----------------------------------------------------------|------------|------------|------------|------------------|------------|---------------|------------|---------------|------------|----------------|------------|---------------------------------|------------|---------------------------|------------|----------------------|------------|--------------------|------------|
| **Proved**                                               |       |       |       |             |       |          |       |          |       |           |       |                            |       |                      |       |                 |       |               |       |
| Oil - Mbbls                                              |       | 1,492      |       | 299              |       | 478           |       | 786           |       | 847            |       | 24,128                          |       | 28,030                    |       | 4,741                |       | 32,771             |       |
| Gas - Mmcf                                               |       | 268        |       | 2,888            |       | 34            |       | 7,198         |       | —         |       | 62,215                          |       | 72,603                    |       | 13,836               |       | 86,439             |       |
| **Proved  Barrels of Equivalent Oil (“MBOE”)** | ** ** | **1,537**  | ** ** | **780**          | ** ** | **484**       | ** ** | **1,986**     | ** ** | **847**        | ** ** | **34,497**                      | ** ** | **40,131**                | ** ** | **7,047**            | ** ** | **47,178**         | ** ** |
| **Proved  Producing**                                    | ** ** | **1,537**  | ** ** | **587**          | ** ** | **127**       | ** ** | **348**       | ** ** | **—**     | ** ** | **5,097**                       | ** ** | **7,696**                 | ** ** | **2,101**            | ** ** | **9,797**          | ** ** |

 

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*   In prior SEC filings, we hadreferred to the Corsicana Field as the Putnam Field.

 

In the preceding table, thereserve amounts are based on reserve reports as of July 1, 2005, exceptthe Panhandle Field is as of September 1, 2005; the Corsicana Field is asof January 1, 2006; and the New Acquisition is as of April 1, 2006.

 

Of our 47,178 MBOE of provedreserves, (21%) or 9,797 MBOE are proved producing reserves, 2,062 MBOE (4%)are proved non-producing reserves and 35,319 MBOE (75%) are comprised of provedundeveloped reserves.

 

Regarding our provednon-producing reserves, approximately eighty-three percent (83%), or 29,400MBOE, are attributable to a Panhandle Field waterflood implementation. Approximatelythree percent (3%), or 847 MBOE, are attributable to a surfactant-polymerapplication in the Corsicana Field and 14%, or 4,946 MBOE, are attributable to waterfloodimplementation for the new acquisition. The waterflood implementations for thePanhandle Field and new acquisition, and the surfactant-polymer application tothe Corsicana Field involve significant capital investment and an extendedperiod of time from the first investment until actual production occurs. Generally,the surfactant-polymer is regarded as more risky as compared to waterflooding;however, the Corsicana Field has been the subject of a successful polymer pilotand we believe conditions for surfactant polymer-flooding are favorable forthis field. Our ability to

 

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recover and successfully convert proved undevelopedreserves to proved producing reserves is greatly contingent upon our ability toobtain additional financing and/or raise additional capital, and further,greatly contingent upon inherent uncertainties associated with drilling andproducing oil and gas and volatile oil and gas prices.

 

***Capital Spending Plan for Calendar Year 2006***

 

Our capital spending planfor the remainder of 2006, excluding potential acquisitions, is projected to be$11.3 million to implement developmental projects at our existing fields toincrease reserves and production as follows:

 

*DesdemonaField.*This fieldhas not been previously waterflooded. We began pilot waterflood operations in May 2005and expect an initial response by the end of 2006. If the pilot waterfloods aresuccessful, we intend to begin expanding the waterflood to the entire field in2007. This field also has mineral rights to the Barnett Shale. We are currentlyevaluating our options with regard to our Barnett Shale rights. The reserveamounts listed in the preceding table do not give any effect to our BarnettShale rights.

 

*PanhandleField.*Theseleases were acquired as part of the acquisition of WO Energy. These leaseshave not been previously waterflooded; however, other leases in the samereservoir have been successfully waterflooded.  We intend to implement a waterflood at certainlease locations and expect to begin the process by the end of 2006.

 

*NowataField*. This fieldis currently being waterflooded. We intend to increase production and reservesby applying surfactant-polymer flooding technology. We are continuing tooptimize the surfactant-polymer chemistry in the laboratory and intend to beginimplementing a surfactant-polymer injection pilot by end of 2006.

 

*DavenportField*. This fieldis currently being waterflooded. We are evaluating this field forsurfactant-polymer flooding technology. Based on this evaluation, we expect tobegin a surfactant-polymer pilot toward the mid-2007.

 

*RichValley Field*. Weintend to drill a horizontal lateral in the producing zone to evaluate thefeasibility of additional horizontal re-entries and/or infill drilling.

 

*CorsicanaField*. Prior toour acquisition of these lease rights, this field had a successful polymerpilot; therefore, conditions for surfactant polymer flooding are veryfavorable. We intend to conduct laboratory evaluation to determine the optimalmix for a polymer injection in mid-2006 and plan to implement a pilot polymer flooddevelopment by the end of 2006.

 

***Operating Activities***

 

For the nine months ended March 31,2006, we had cash used in our operating activities of $6.3 million as comparedto the $0.6 million used in operating activities for the nine months ended March 31,2005. This is primarily due to the $5.3 million purchase of derivative hedgingcontracts as discussed in Note 4.

 

We expect to improve cashflow from operating activities through operational improvements at our existingproperties, cash flow generated from the Panhandle Field (i.e. WO Energy)acquisition as discussed in Note 2, the new acquisition as discussed in Note 13and future acquisitions. The increased cash flow from field operations may beoffset, in part, by increased general and administrative costs to support ourexpanding operations.

 

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**Results of Operations**

 

***Overall***

 

For the quarter ended March 31,2006 (“current quarter”), we had a loss applicable to common stock of $1.1million, which is $0.3 million higher as compared to the $0.8 million lossapplicable to common stock incurred for the quarter ended March 31, 2005 (“prioryear quarter”).

 

For the nine months ended March 31,2006 (“current nine months”), we had a loss applicable to common stock of $3.1million, which is $0.5 million higher as compared to the $2.6 million lossapplicable to common stock incurred for the nine months ended March 31,2005 (“prior year nine months”).

 

The following tablesummarizes the differences between the quarter and nine months reportingperiods.

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | ** **   | ** ** | **9 Months Ended** | ** ** | ** **   | ** ** |
|----------------------------------------------|------------|------------------------|------------|--------------|------------|------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **March 31,**     | ** ** | **Increase** | ** ** | **March 31,**           | ** ** | **Increase** | ** ** |
| **Amounts in $millions**           | ** ** | **2006**               | ** ** | **2005**     | ** ** | **(Decrease)**               | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Results of  oil and gas producing operations |       | $                      | 2.3        |         | $          | 0.4                          |       | $            | 1.9        |   | $ | 4.6 |   | $ | 1.3 |   | $ | 3.3 |   |
| General and  administrative expenses         |       | 1.8                    |       | 0.7          |       | 1.1                          |       | 4.7          |       | 2.1 |   | 2.6 |   |
| Interest  expense, net                       |       | 0.9                    |       | —       |       | 0.9                          |       | 1.1          |       | — |   | 1.1 |   |
| Deferred  compensation expense               |       | 0.1                    |       | 0.4          |       | (0.3                         | )          | 0.4          |       | 1.3 |   | (0.9 | ) |
| Deferred  income tax benefit                 |       | (0.7                   | )          | —       |       | (0.7                         | )          | (1.4         | )          | — |   | (1.4 | ) |
| Preferred  stock discount                    |       | —                 |       | —       |       | —                       |       | —       |       | 0.4 |   | (0.4 | ) |
| Loss on  effective hedge contracts           |       | 1.3                    |       | —       |       | 1.3                          |       | 2.9          |       | — |   | 2.9 |   |
| Other income  (expense)                      |       | —                 |       | (0.1         | )          | (0.1                         | )          | —       |       | (0.1 | ) | 0.1 |   |
| Net loss                                     | ** ** | **$**                  | **(1.1**   | **)**        | **$**      | **(0.8**                     | **)**      | **$**        | **(0.3**   | **)** | **$** | **(3.1** | **)** | **$** | **(2.6** | **)** | **$** | **(0.5** | **)** |

 

Results of oil and gasproducing operations consist of operating revenues less lease operating expenses,production taxes, accretion of asset retirement obligations, and depletion anddepreciation. The $1.9 million increase in the current quarter is attributedto:

 

•                  Including three months of operating resultsfrom the acquisition of the Panhandle Field (i.e. WO Energy) which contributed$1.3 million to net operating income.

•                  Improved operating results from ourDavenport, Rich Valley, Desdemona, and Nowata Fields, primarily due to higheroil and gas prices received and increased sales.

 

The $3.3 million increase inthe current nine months is attributable to:

 

•                  Including four months of operating resultsfrom the acquisition of the Panhandle Field (i.e. WO Energy) which contributed$1.8 million to net operating income.

•                  Including two additional months of operatingresults from the Nowata Field which contributed $0.3 million to net operatingincome.

•                  Improved operating results from ourDavenport, Rich Valley, Desdemona, and Nowata Fields, primarily due to higheroil and gas prices received and increased sales.

 

The other factors will beaddressed in the following discussion.

 

***OperatingRevenues***

 

The table below summarizesour operating revenues for the quarter and nine months ended March 31,2006 and 2005.

 

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| ** **          | ** ** | **Quarter ended**  | ** ** | ** **   | ** ** | **Nine months ended** | ** ** | ** **   | ** ** |
|---------------------|------------|--------------------|------------|--------------|------------|-----------------------|------------|--------------|------------|
| ** **          | ** ** | **March 31,** | ** ** | **Increase** | ** ** | **March 31,**    | ** ** | **Increase** | ** ** |
| ** **          | ** ** | **2006**           | ** ** | **2005**     | ** ** | **(Decrease)**        | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Operating Revenues  |       | $                  | 5,422,987  |         | $          | 1,461,885             |       | $            | 3,961,102  |   | $ | 10,532,227 |   | $ | 3,780,437 |   | $ | 6,751,790 |   |
| Sales               |       |               |       |         |       |                  |       |         |       |   |   |   |   |
| • Oil (MBbls)  |       | 57                 |       | 24           |       | 33                    |       | 120          |       | 62 |   | 58 |   |
| • Gas (MMcf)   |       | 229                |       | 41           |       | 188                   |       | 394          |       | 133 |   | 261 |   |
| • Total (MBOE) |       | 96                 |       | 31           |       | 65                    |       | 186          |       | 84 |   | 103 |   |
| Average Price       |       |               |       |         |       |                  |       |         |       |   |   |   |   |
| • Oil ($/ Bbl) |       | $                  | 61.95      |         | $          | 49.39                 |       | $            | 12.56      |   | $ | 60.69 |   | $ | 47.78 |   | $ | 12.91 |   |
| • Gas ($/ Mcf) |       | $                  | 8.08       |         | $          | 5.60                  |       | $            | 2.48       |   | $ | 8.14 |   | $ | 5.94 |   | $ | 2.20 |   |

 

The current quarteroperating revenues of $5.4 million represent an improvement of $3.9 million ascompared to the prior year quarter of $1.5 million. The $3.9 millionimprovement is primarily attributable to including three months of operatingrevenue from the Panhandle Field ($3.2 million of revenue and 59 MBOE of sales);the higher prices received for oil and gas sales; and increased sales fromother fields. The average price we received for crude oil sales is generally ator above market prices received at the wellhead. The average price we receivefor natural gas sales is approximately the market price received at the wellheadless transportation and marketing expenses.

 

The current nine monthsoperating revenues of $10.5 million is $6.7 million higher than the prior year ninemonths of $3.8 million. The $6.7 million improvement is primarily attributableto including four months of operating revenue from the Panhandle Field ($4.3million of revenue and 80 MBOE of sales); two additional months of Nowata sales($0.8 million of revenue and 13 MBOE of sales); the higher prices received foroil and gas sales; and increased sales from other fields.

 

During March 2006, therewere grass fires in the Texas Panhandle area. These fires temporarily shut-inproduction at the Panhandle Field until flow lines were restored. We estimatethe temporary shut-in resulted in approximately $0.2 million reduction inrevenues for March 2006. By mid-April 2006, the Panhandle Field wasproducing at 95% of normal operations.

 

As discussed in Note 13, on April 28,2006, we acquired additional oil and gas properties in the Panhandle Fieldlocated in Texas. These oil and gas properties currently produce approximately400 net barrels of oil equivalent (“BOE”) per day.

 

***Operating Expenses***

 

For the current quarter, ourtotal operating expenses were $5.1 million, or $2.9 million higher than theprior year quarter of $2.2 million. The $2.9 million increase is primarilyattributed to including three months of Panhandle Field operating expenses totaling$1.9 million, higher general & administrative expenses of $1.1 million,and higher other operating expenses of $0.2 million, partially offset by lowerdeferred compensation expense of $0.3 million.

 

For the current nine months,our total operating expenses were $11.0 million, or $5.1 million higher thanthe prior year nine months of $5.9 million. The $5.1 million increase isprimarily attributed to including four months of Panhandle Field operatingexpenses of $2.6 million, the inclusion of an additional two months of Nowataoperations ($0.5 million), higher other expenses of $0.3 million, increasedgeneral & administrative expenses of $2.6 million, partially offset bylower deferred compensation expense of $0.9 million.

 

Our LOE consists of costs ofproducing crude oil and natural gas such as labor, supplies, repairs,maintenance, and utilities. For the current quarter, the LOE per BOE was $21.61as compared to $26.57 per LOE for the prior year quarter.  For the currentnine months, the LOE per BOE was $21.84, which is comparable to $21.57 for theprior year nine months. The current nine months’ amount of $21.84 per BOE is animprovement as compared to the LOE per BOE of $22.88 that we incurred for thetwelve month period ended June 30, 2005. We generally incur a high amountof LOE because our fields are more mature

 

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and typically produce less oil and more water, andthey are generally at the end of the primary or secondary production cycle. Sinceour acquisitions are mature fields, our initial focus is to evaluate theexisting operations and make the necessary operational improvements to improveoperating efficiency. Based on management’s past experience, it generallyrequires up to twelve months to fully analyze the acquired field and spend thenecessary funds to improve the field operations to meet our operational standards. We expect these expenditures should lead to increased operationalefficiency and reduced operating expenses in future periods.

 

Our general andadministrative (G&A) expenses consist of support services for our operatingactivities and investor relations costs. For the current quarter, our G&Aexpenses totaled $1.8 million, which is $1.1 million higher than the prior yearquarter. The primary contributor to the $1.1 million increase was increased laborand staffing costs of $0.6 million. The remaining increase of $0.5 million isdue to higher legal fees to comply with regulatory requirements, higher travelcosts and increased insurance costs. For the current nine months, our G&Aexpenses totaled $4.7 million, which is $2.6 million higher than the prior yearnine months of $2.1 million. Of the $2.6 million increase, $1.3 million isattributed increased labor and staffing costs, and the same factors previouslymentioned, plus expenses associated with the Sabine joint venture, as discussedin Note 10.

 

On January 6, 2006, ourBoard of Directors approved the following non-executive director compensationschedule. Each director shall receive an annual cash retainer of $25,000. Eachdirector shall be paid $1,000 cash for each Board meeting and Board committeemeeting attended. The Audit Committee Chairman shall receive an additionalannual cash retainer of $5,000. The Compensation Committee Chairman, theCorporate Governance Committee Chairman, the Nominating Committee Chairman andthe chairman of any other committee or special committee established by theBoard shall be paid an additional annual cash retainer of $3,000.

 

During January 2006,our executive officers were awarded annual salary increases totalingapproximately $370,000.

 

***Loss on Hedging Contracts***

 

As discussed in Note 4 tothe financial statements, during December 2005, we paid $5.3 million toenter into financial contracts to set price floors for crude oil and naturalgas. In accordance with SFAS 133, we recorded a Loss on Hedging Contracts of $2.9million, of which $1.3 million occurred during the current quarter, to reflectthe fair value of the derivative instruments as of March 31, 2006. Bytheir nature, these derivative instruments can be highly volatile to ourearnings. A five percent change in these prices for our derivative instrumentscan impact earnings by approximately $184,000. We did not have hedgingcontracts during the nine months ended March 31, 2005.

 

Also, during the currentquarter, as discussed in Note 4, there were settlements under our derivativeagreements due to Cano amounting to $140,996. The settlements were cumulativemonthly payments due to Cano since the NYMEX gas price was lower than the $8.50“floor gas price.”

 

***Interest Expense***

 

The interest expense weincurred in the current quarter and current nine months ended March 31,2006 of $0.9 million and $1.3 million, respectively, resulted directly fromsenior and subordinated credit agreements we entered into on November 29,2005, as discussed in Note 3 to the financial statements. We did not havecredit agreements during the nine month period ended March 31, 2005.

 

***Deferred Income Tax Benefit***

 

As the result of therecognition of the deferred tax liabilities assumed in the acquisitions of WOEnergy and Square One, as discussed in Notes 2 and 11, respectively, to thefinancial statements, we now have a net deferred tax liability. This allows usto recognize deferred tax benefits from generation of net operating lossesbecause a valuation allowance against such items is not required. We review ourdeferred tax assets

 

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at least quarterly and record a valuation allowanceagainst those assets when we conclude that it is more likely than not thatthose assets will expire without being utilized. For the quarter and ninemonths ended March 31, 2006, we recorded a deferred income tax benefit of$677,000 and $1,470,000, respectively.

 

***Preferred Stock Discount***

 

The reduced preferred stockdiscount amounting to $0.4 million occurred during the nine months ended March 31,2005 and was attributable to certain issuances of preferred stock during thatperiod. Since we did not issue preferred stock during the nine months ended March 31,2006, there is no preferred stock discount for the current nine month period.

 

**Off Balance Sheet Arrangements**

 

We do not have any offbalance sheet arrangements that have or are reasonably likely to have a currentor future effect on our financial condition, changes in our financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

 

**Item 3. Controlsand Procedures.**

 

As of the end of the periodcovered by this report, we conducted an evaluation, under the supervision andwith the participation of our chief executive officer and chief financialofficer of our disclosure 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 that our disclosure controls and procedures areeffective to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is: (1) accumulatedand communicated to our management, including our chief executive officer andchief financial officer, as appropriate to allow timely decisions regardingrequired disclosure; and (2) recorded, processed, summarized and reported,within the time periods specified in the Securities and Exchange Commission’s rules andforms. There was no change in our internal control over financial reporting orin other factors that could affect the internal control over financialreporting during our last fiscal quarter that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**PART II – OTHER INFORMATION**

 

**Item 1. LegalProceedings.**

 

***Litigation***

 

On March 23,2006, the following lawsuit was filed in the 100th Judicial DistrictCourt in Carson County, Texas; Cause No. 9840, The Tom L. and Anne BurnettTrust, by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr., GeorgeBeggs, III and Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr;and Burnett Ranches, Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.;W. O. Operating, Ltd, and W.O. Energy, Inc. The plaintiffs claim that theelectrical wiring and equipment of Cano Petroleum, Inc. or certain of itssubsidiaries relating to its oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County.

 

The plaintiffs (i) allege negligence andgross negligence and (ii) seek undisclosed damages, including, but notlimited to, damages for damage to their land and livestock, certain expensesrelated to fighting the fire and certain remedial expenses. In addition, theplaintiffs seek (i) termination of certain oil and gas leases, (ii) reimbursementfor their attorney’s fees and (iii) exemplary damages.

 

Due to the inherent risks of litigation andthe fact that this case is in the early stages of discovery, the outcome ofthis case is uncertain and unpredictable; however, at this time Cano managementbelieves the suit is without merit and is vigorously defending itself and itssubsidiaries.

 

On April 28, 2006, the following lawsuitwas filed in the 31st Judicial District Court of Roberts County,Texas, Case No. 1922, Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc.,W.O. Energy of

 

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Nevada, Inc.; W. O. Operating, Ltd, and W.O. Energy, Inc. Thereare 43 plaintiffs that claim that the electrical wiring and equipment of CanoPetroleum, Inc. or certain of its subsidiaries relating to its oil and gasoperations started a wildfire that began on March 12, 2006 in CarsonCounty.

 

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

 

Due to the inherent risks of litigation andthe fact that this case is in the early stages of discovery, the outcome ofthis case is uncertain and unpredictable; however, at this time Cano managementbelieves the suit is without merit and is vigorously defending itself and itssubsidiaries.

 

On April 10, 2006, the following lawsuitwas filed in the 31st Judicial District Court of Roberts County,Texas, Case No. 1920, Joseph Craig Hutchison and Judy Hutchison v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc.; W. O. Operating, Ltd,and W.O. Energy, Inc. On May 1, 2006, the following lawsuit was filedin the 31st Judicial District Court of Roberts County, Texas, Case No. 1923,Chisum Family Partnership, Ltd. v. Cano Petroleum, Inc., W.O. Energy ofNevada, Inc.; W. O. Operating, Ltd, and W.O. Energy, Inc. AlthoughCano is aware that these two lawsuits were filed, neither it nor any of itssubsidiaries that are named in the lawsuits have been served with process. Theplaintiffs in both cases claim that the electrical wiring and equipment of CanoPetroleum, Inc. or certain of its subsidiaries relating to its oil and gasoperations started a wildfire that began on March 12, 2006 in CarsonCounty.

 

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

 

Due to the inherent risks of litigation andthe fact that neither Cano nor its subsidiaries have been served with thesesuits, the outcome of these case is uncertain and unpredictable; however, atthis time Cano management believes the suits are without merit and, if and whenit is served, will vigorously defend itself and its subsidiaries.

 

***Other***

 

Occasionally, we areinvolved in various lawsuits and certain governmental proceedings arising inthe ordinary course of business. Our management does not believe that theultimate resolution of any current matters, including due to the existence ofinsurance coverage, indemnification and escrow accounts, will have a materialeffect on our financial position or results of operations. None of ourdirectors, officers or affiliates, owners of record or beneficially of morethan five percent of any class of our voting securities, or securityholder is involved in a proceeding adverse to our business or has a materialinterest adverse to our business.

 

**Item 2. UnregisteredSales of Equity Securities and Use of Proceeds.**

 

There were no unregisteredsales of equity securities during the third quarter ended March 31, 2006.

 

**Item 3. DefaultsUpon Senior Securities.**

 

There has been no materialdefault in the payment of principal, interest, a sinking or purchase fundinstallment, or any other material default not cured within 30 days, withrespect to any indebtedness exceeding five percent of our total assets. Therealso has been no material arrearage in the payment of dividends or any othermaterial delinquency not cured within 30 days, with respect to any class ofpreferred stock which is registered or which ranks prior to any class ofour registered securities, or with respect to any class of preferred stockof any significant subsidiary.

 

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

 

None.

 

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**Item 5. Other Information.**

 

None.

 

**Item 6. Exhibits.**

 
| **Exhibit  Number** |   | **Description** |
|---------------------|--------|-----------------|
|                | 2.1*   |            | Asset  Purchase and Sale Agreement among Myriad Resources Corporation, Westland  Energy Company and PAMTEX, a Texas general partnership composed of PAMTEX GP1  Ltd. and PAMTEX GP2 Ltd., as Sellers, and Cano Petroleum, Inc. as Buyer dated  as of April 25, 2006 (The schedules and exhibits have been omitted from this  filling. An exhibit to the schedules and exhibits is contained in the Asset  Purchase and Sale Agreement and the schedules and exhibits are available to  the Securities and Exchange Commission upon request) |
|                | 2.2    |            | Amendment  No. One to Stock Purchase Agreement by and among Cano Petroleum, Inc., W.O.  Energy of Nevada, Inc., Estate of Miles O’Loughlin and Scott White dated May  13, 2006 incorporated by reference from Exhibit 2.1 to Current Report on Form  8-K filed on May 15, 2006. |
|                | 4.1    |            | Amendment  No. One to the Registration Rights Agreement by and between Cano Petroleum,  Inc. and Estate of Miles O’Loughlin dated May 13, 2006 and effective as of  November 29, 2005 incorporated by reference from Exhibit 4.1 to Current  Report on Form 8-K filed on May 15, 2006. |
|                | 4.2    |            | Amendment No.  One to the Registration Rights Agreement by and between Cano Petroleum, Inc.  and Scott White dated May 12, 2006 and effective as of November 29, 2005 incorporated  by reference from Exhibit 4.2 to Current Report on Form 8-K filed on May 15,  2006. |
| +                   | 10.1   |            | Summary  Sheet: Director Compensation, incorporated by reference from Exhibit 10.1 to  Current Report on Form 8-K filed on January 12, 2006. |
| +                   | 10.2   |            | Employment  Agreement between Cano Petroleum, Inc. and S. Jeffrey Johnson effective  January 1, 2006, incorporated by reference from Exhibit 10.1 to Current  Report on Form 8-K filed on January 19, 2006. |
| +                   | 10.3   |            | Amendment to  Employment Agreement of Michael J. Ricketts effective January 1, 2006,  incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K  filed on January 19, 2006. |
| +                   | 10.4   |            | Amendment to  Employment Agreement of Thomas Cochrane effective January 1, 2006,  incorporated by reference from Exhibit 10.3 to Current Report on Form 8-K  filed on January 19, 2006. |
| +                   | 10.5   |            | Amendment to  Employment Agreement of James K. Teringo, Jr. effective January 1, 2006,  incorporated by reference from Exhibit 10.4 to Current Report on Form 8-K  filed on January 19, 2006. |
|                | 10.6   |            | Amendment  No. 1 dated February 24, 2006 to the $100,000,000 Credit Agreement among Cano  Petroleum, Inc., as Borrower, The Lenders Party Hereto From Time to Time as  Lenders and Union Bank of California, N.A., as Administrative Agent and as Issuing  Lender dated November 29, 2005 incorporated by reference from Exhibit 10.1 to  Current Report on Form 8-K filed on March 1, 2006. |
|                | 10.7*  |            | Amendment  No. 2, Assignment and Agreement dated as of April 28, 2006 among Cano  Petroleum, Inc., Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy  of Nevada, Inc., WO Energy, Inc., W.O. Operating Company, Ltd., W.O. Production  Company, Ltd., Pantwist, LLC, the Lenders and Union Bank of California, N.A.,  as Administrative Agent and as Issuing Lender. |
|                | 10.8*  |            | First  Amendment to Subordinated Credit Agreement dated as of April 28, 2006 by and  among Energy Components SPC EEP Energy Exploration and Production Segregated  Portfolio, as Administrative Agent and Lender, UnionBanCal Equities, Inc., Cano  Petroleum, Inc., Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy  of Nevada, Inc., WO Energy, Inc., W.O. Operating Company, Ltd., W.O.  Production Company, Ltd., and Pantwist, LLC. |
|                | 10.9*  |            | Supplement  No. 1 dated as of April 28, 2006 to the Guaranty Agreement dated as of  November 29, 2005, by Pantwist, LLC in favor of Union Bank of California, as  Administrative Agent. |
|                | 10.10* |            | Supplement  No. 1 dated as of April 28, 2006 to the Guaranty Agreement dated as of  November 29, 2005, by Pantwist, LLC in favor of Energy Components SPC EEP  Energy Exploration and Production Segregated Portfolio, as Administrative  Agent. |
|                | 10.11* |            | Supplement  No. 1 dated as of April 28, 2006 to the Pledge Agreement dated as of November  29, 2005, by Cano Petroleum, Inc., W.O. Energy of Nevada, Inc. and WO Energy,  Inc. in favor of Union Bank of California, N.A., as Collateral Trustee. |
|                | 10.12* |            | Supplement  No. 1 dated as of April 28, 2006 to the Security Agreement dated as of  November 29, 2005, by Pantwist, LLC in favor of Union Bank of California, N.A.,  as Collateral Trustee. |
|                | 10.13* |            | Waiver from  Union Bank of California, N.A. dated February 14, 2006 related to Credit  Agreement dated as of November 29, 2005. |
|                | 10.14* |            | Waiver from  Energy Components SPC EEP Energy Exploration and Production Segregated  Portfolio dated February 14, 2006 related to Subordinated Credit Agreement  dated as of November 29, 2005. |
|                | 10.15  |            | Amendment  No. 3 to Credit Agreement among Cano Petroleum, Inc., a Borrower, Square One  Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy,  Inc. Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company,  Ltd., Union Bank of California, N.A. and Natexis Banques Populaires dated May  12, 2006 and effective as of March 31, 2006, incorporated by reference from  Exhibit 10.1 to Current Report on Form 8-K filed on May 15, 2006. |
|                | 10.16  |            | Second  Amendment to Subordinated Credit Agreement among Cano Petroleum, Inc., a  Borrower, Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of  Nevada, Inc., WO Energy, Inc. Pantwist, LLC, W.O. Operating Company, Ltd.,  W.O. Production Company, Ltd., Energy Components SPC EEP Energy Exploration  and Production Segregated Portfolio and UnionBanCal Equities, Inc. dated May  12, 2006 and effective as of March 31, 2006, incorporated by reference from  Exhibit 10.2 to Current Report on Form 8-K filed on May 15, 2006. |
|                | 23.1*  |            | Consent of  Forrest A. Garb & Associates, Inc., Independent Petroleum Engineering. |
|                | 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 or arrangement

 

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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|   |                     | **CANO PETROLEUM, INC.** |
|--------|--------------------------|-------------------------------|
|   |                     |                          |   |
|   | Dated: May 15, 2006 | By:                           | /s/ S. Jeffrey Johnson |   |
|   |                     |                          | S. Jeffrey Johnson |
|   |                     |                          | Chief Executive Officer |
|   |                     |                          |   |
|   | Dated: May 15, 2006 | By:                           | /s/ Michael J. Ricketts |   |
|   |                     |                          | Michael J. Ricketts |
|   |                     |                          | Chief Financial Officer and |
|   |                     |                          | Principal Accounting Officer |

 

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