**UNITED STATESSECURITIES 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 DECEMBER 31, 2004** |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                         |
| **o**      | ** ** | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                                                                          |

 

**For thetransition period from                to               **

**Commissionfile number                          **

 

**CANOPETROLEUM, INC.**

(Exact name of small businessissuer as specified in its charter)

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

 

**The Oil& Gas Commerce Building309 West 7th Street, 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 Act during thepast 12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes ý     No o

 

**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 the ExchangeAct 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:  15,647,204 shares of common stock, $.0001 parvalue per share, as of February 2, 2005.

 

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**

**(Unaudited)**

 
| ** **                                                                                                         | ** ** | **December 31  2004,** | ** **    |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|---------------|
| ASSETS                                                                                                             | ** ** | ** **                  | ** **    |
| **Current  assets**                                                                                                | ** ** | ** **                  | ** **    |
| Cash and cash  equivalents                                                                                         |       | $                           | 204,071       |   |
| Accounts  receivable                                                                                               |       | 736,256                     |          |
| Other  current assets                                                                                              |       | 71,086                      |          |
| Total  current assets                                                                                              |       | 1,011,413                   |          |
|                                                                                                               |       |                        |          |
| **Oil and gas properties****,**  successful efforts method                                                         |       | 8,046,638                   |          |
| Less  accumulated depletion and depreciation                                                                       |       | (230,462                    | )             |
| Net oil and  gas properties                                                                                        |       | 7,816,176                   |          |
|                                                                                                               |       |                        |          |
| Fixed  assets, net                                                                                                 |       | 169,477                     |          |
| Goodwill                                                                                                           |       | 101,166                     |          |
| **TOTAL  ASSETS**                                                                                                  | ** ** | **$**                       | **9,098,232** | ** ** |
|                                                                                                               |       |                        |          |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                         |       |                        |          |
| **Current  liabilities**                                                                                           |       |                        |          |
| Accounts  payable                                                                                                  |       | $                           | 637,498       |   |
| Oil and gas  payable                                                                                               |       | 95,503                      |          |
| Accrued  liabilities                                                                                               |       | 136,417                     |          |
| Current  portion of asset retirement obligations                                                                   |       | 17,183                      |          |
| Total  current liabilities                                                                                         |       | 886,601                     |          |
| **Long-term  liabilities**                                                                                         |       |                        |          |
| Asset  retirement obligations                                                                                      |       | 390,881                     |          |
| **Commitments  and contingencies (Note 9)**                                                                        |       |                        |          |
| **Stockholders’  equity**                                                                                     |       |                        |          |
| Preferred  stock                                                                                                   |       |                        |          |
| Series B;  8,000 shares authorized and 2,000 shares issued and outstanding (liquidation  preference of $2,000,000) |       | 1,861,463                   |          |
| Series C; 8,000  shares authorized and 6,750 shares issued and outstanding (liquidation  preference of $6,750,000) |       | 6,611,423                   |          |
| Common  stock, par value $.0001 per share;                                                                         |       |                        |          |
| 50,000,000  authorized; 15,647,204 issued and outstanding, including 5,165,000 shares  held in escrow              |       | 1,565                       |          |
| Additional  paid-in capital                                                                                        |       | 9,071,337                   |          |
| Accumulated  deficit                                                                                               |       | (8,407,479                  | )             |
| Deferred  compensation                                                                                             |       | (1,317,559                  | )             |
| Total  stockholders’ equity                                                                                   |       | 7,820,750                   |          |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                               | ** ** | **$**                       | **9,098,232** | ** ** |

 

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

 

1

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                      | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **2004**                                  | ** ** | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating Revenues:**                         |       |                                      |       |                                   |       |   |   |   |   |
| Crude oil and natural gas  sales                |       | $                                         | 1,454,392  |                                   | $          | — |   | $ | 2,318,552 |   | $ | — |   |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| **Operating Expenses:**                         |       |                                      |       |                                   |       |   |   |   |   |
| Lease operating expenses                        |       | 581,621                                   |       | —                                 |       | 996,744 |   | — |   |
| Production taxes                                |       | 90,177                                    |       | —                                 |       | 149,098 |   | — |   |
| General and adminstrative                       |       | 730,413                                   |       | 4,814                                  |       | 1,391,979 |   | 28,108 |   |
| Deferred compensation  expense                  |       | 619,314                                   |       | —                                 |       | 909,846 |   | — |   |
| Accretion of asset  retirement obligations      |       | 5,810                                     |       | —                                 |       | 10,860 |   | — |   |
| Depletion and depreciation                      |       | 140,262                                   |       | —                                 |       | 243,716 |   | — |   |
| Total operating expenses                        |       | 2,167,597                                 |       | 4,814                                  |       | 3,702,243 |   | 28,108 |   |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| **Loss from operations**                        |       | (713,205                                  | )          | (4,814                                 | )          | (1,383,691 | ) | (28,108 | ) |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| Interest income and  deductions, net            |       | 4,252                                     |       | —                                 |       | 9,065 |   | — |   |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| **Net loss**                                    |       | (708,953                                  | )          | (4,814                                 | )          | (1,374,626 | ) | (28,108 | ) |
| ** **                                      |       |                                      |       |                                   |       |   |   |   |   |
| Preferred stock discount                        |       | 80,000                                    |       | —                                 |       | 416,534 |   | — |   |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| **Loss applicable to common stock**             |       | $                                         | (788,953   | )                                      | $          | (4,814 | ) | $ | (1,791,160 | ) | $ | (28,108 | ) |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| **Net loss per share - basic and  diluted**     |       | $                                         | (0.08      | )                                      | $          | (0.00 | ) | $ | (0.17 | ) | $ | (0.00 | ) |
|                                            |       |                                      |       |                                   |       |   |   |   |   |
| **Weighted average common shares  outstanding** |       |                                      |       |                                   |       |   |   |   |   |
| Basic and diluted                               |       | 10,482,204                                |       | 6,982,204                              |       | 10,482,204 |   | 6,982,204 |   |

 

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

 

2

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Six Months Ended December 31,** | ** **  |
|-----------------------------------------------------------------------|------------|----------------------------------------|-------------|
| ** **                                                            | ** ** | **2004**                               | ** **  | **2003** | ** ** |
| **Cash flow from operating activities:**                              | ** ** | ** **                             | ** **  | ** ** | ** ** |
| Net loss                                                              |       | $                                      | (1,374,626  | ) | $ | (28,108 | ) |
| Adjustments needed to  reconcile to net cash flow used in operations: |       |                                   |        |   |   |
| Accretion of asset retirement  obligations                            |       | 10,860                                 |        | — |   |
| Depletion and depreciation                                            |       | 243,716                                |        | — |   |
| Deferred compensation  expense                                        |       | 909,847                                |        | — |   |
| Stock-based compensation  expense                                     |       | 11,666                                 |        | — |   |
|                                                                  |       |                                   |        |   |   |
| Changes in assets and  liabilities relating to operations:            |       |                                   |        |   |   |
| Accounts receivable                                                   |       | (719,976                               | )           | — |   |
| Accounts payable                                                      |       | 369,236                                |        | 8,295 |   |
| Accrued liabilities                                                   |       | (118,276                               | )           | — |   |
| Oil and gas sales payable                                             |       | 63,942                                 |        | — |   |
| Other current assets                                                  |       | (57,616                                | )           | — |   |
|                                                                  |       |                                   |        |   |   |
| **Net cash used in operations**                                       | ** ** | **(661,227**                           | **)**       | **(19,813** | **)** |
|                                                                  |       |                                   |        |   |   |
| **Cash flow from investing  activities:**                             |       |                                   |        |   |   |
| Additions to oil and gas  properties                                  |       | (1,391,916                             | )           | — |   |
| Additions to other fixed  assets                                      |       | (187,264                               | )           | — |   |
| Cash restricted for  development activities                           |       | 866,339                                |        | — |   |
| Acquisition of additional  Davenport revenue interest                 |       | (667,000                               | )           | — |   |
| Acquisition of Nowata                                                 |       | (2,524,721                             | )           | — |   |
| Acquisition of Ladder                                                 |       | (2,111,517                             | )           | — |   |
| **Net cash used in investing  activities**                            | ** ** | **(6,016,079**                         | **)**       | — | ** ** |
|                                                                  |       |                                   |        |   |   |
| **Cash flow from financing  activities:**                             |       |                                   |        |   |   |
| Proceeds from issuance of  preferred stock, net                       |       | 5,306,098                              |        | — |   |
| **Net cash from financing  activities**                               | ** ** | **5,306,098**                          | ** **  | — | ** ** |
|                                                                  |       |                                   |        |   |   |
| Net decrease in cash and  cash equivalents                            |       | (1,371,208                             | )           | (19,813 | ) |
|                                                                  |       |                                   |        |   |   |
| Cash and cash equivalents  at beginning of period                     |       | 1,575,279                              |        | 20,000 |   |
|                                                                  |       |                                   |        |   |   |
| **Cash and cash equivalents at  end of period**                       | ** ** | **$**                                  | **204,071** | ** ** | **$** | **187** | ** ** |
|                                                                  | ** ** | ** **                             | ** **  | ** ** | ** ** | ** ** | ** ** |
| Supplemental disclosure of  noncash transactions:                     | ** ** | ** **                             | ** **  | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock discount                                             | ** ** | $                                      | 416,534     | ** ** | $ | **—** | ** ** |

 

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

 

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***CANO PETROLEUM, INC.***

 

**NOTES TOFINANCIAL STATEMENTS**

 

**1.****             ****BASIS OF PRESENTATION**

 

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 forinterim periods are not necessarily indicative of results to be expected for afull year or for previously reported periods due in part to the volatility in pricesfor crude oil and natural gas, the timing of acquisitions, interruption inproduction and the success of drilling activity.  You should read these consolidated interimfinancial statements in conjunction with the audited consolidated financialstatements and notes thereto included in Cano’s Form 10-KSB dated June 30,2004.

 

**2.****             ****PREFERRED STOCK FINANCINGS**

 

For the six months ended December 31, 2004, we received additionalgross proceeds of $5.35 million from the sale of 5,350 shares of Series CConvertible Preferred Stock at a price of $1,000 per share.  Thisincreased our total gross proceeds from the issuances of preferred stock to $8.75million (net proceeds totaled $8.5 million) as of December 31, 2004.

 

The total gross proceeds of $8.75 million consist of $2 million fromthe issuance of Series B Convertible Preferred Stock and $6.75 million ofSeries C Convertible Preferred Stock. These are non-voting shares issued at a price of $1,000 per share. The holders of the Series B and Series C Preferred Stock are not entitled toreceive any dividends.

 

Each share of Series B Convertible Preferred Stock is convertible, atany time, by the holder into shares of our common stock at a price of $3.00 pershare, subject to downward adjustment in the event that:

 

•**                 **Cano issues any common stock or securitiesconvertible into common stock at an effective price of less than $3.00 pershare until May 28, 2006, in which case the effective price shall be that lowerprice; and

 

•**                 **Cano fails to meet the performance goals thatpertain to the issuance of 5,165,000 common shares to our employees asdiscussed in Note 7, in which case the effective price shall be the lesser of(i) $3.00 per share or (ii) the average trailing five day bid price of Cano’scommon stock on the over-the-counter Bulletin Board, less a 25% discount.

 

The terms of the Series C preferred stock are essentially identical tothe Series B stock except the conversion price is $3.75 per share of commonstock.

 

***Restatement for BeneficialConversion Feature Related to our Series C Preferred Stock***

In February 2005, we determined that we hadincorrectly accounted for the beneficial conversion feature related to ourSeries C Preferred Stock as of and for the three month period endedSeptember 30, 2004.  On the dates ofcertain issuances of our Series C Preferred Stock, the quoted market price ofour common stock was higher than the conversion price of our Series C PreferredStock of $3.75 per share, resulting in a beneficial conversion feature.  Previously, we did not recognize the value ofthe beneficial conversion feature as a discount to preferred stock and a chargeto earnings available to common stockholders analogous to a preferreddividend.  Accordingly, we must restate ourbalance sheet and statement of operations for the three month period endedSeptember 30, 2004.

Restatementof the three month period ended September 30, 2004 resulted in a $336,534increase in accumulated deficit with a corresponding increase in additionalpaid-in capital.  Because the Series CPreferred Stock is convertible into common stock on the date of issuance, thediscount is immediately recognized as a charge to accumulated deficit, andtherefore, there was no impact to Series C Preferred Stock on the balance sheetas of September 30, 2004.  Basic loss pershare increased $0.04 per share to $0.10 from $0.06 per share. There was noimpact to the statement of cash flows.

Thetable below outlines the line item adjustments related to the restatement ofthe three month period ended September 30, 2004. 
| ** **                           | ** ** | **Three Months Ended  September 30, 2004** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **As Restated**                            | ** ** | **As Previously  Reported** | ** ** |
| Additional paid-in capital           |       | $                                          | 8,979,671  |   | $ | 8,643,137 |   |
| Accumulated deficit                  |       | (7,618,526                                 | )          | (7,281,992 | ) |
| Net loss applicable to common shares |       | (1,002,207                                 | )          | (665,673 | ) |
| Basic and diluted loss per share     |       | $                                          | (0.10      | ) | $ | (0.06 | ) |

 

For the three and six months ended December 31,2004, the preferred stock discount amounted to $80,000 and $416,534,respectively.

 

**3.****             ****ACQUISITIONS**

 

Ladder Company Oil and Gas Properties - On July 2, 2004, we acquired all ofthe outstanding common stock of the Ladder Companies, Inc., a Delawarecorporation, in consideration for approximately $2.2 million, after purchase priceadjustments.  The Ladder Companies are comprised of two companies – LadderEnergy Company, a Delaware corporation, and Tri-Flow, Inc., an Oklahomacorporation.  The Ladder Companies are engaged in oil and gas explorationand production activities.  The acquisition was effective on May 1, 2004,and net operating income from that date through closing was applied to thepurchase price.

 

Nowata Oil Properties – On September 14, 2004, we acquired oil and gas producing leasesfrom the Nowata Oil Properties LLC for approximately $2.5 million.  Theleases are located in Nowata County, Oklahoma.  The effective date of thepurchase is September 1, 2004.

 

4

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TheLadder and Nowata acquisitions were recorded based on the purchase method ofaccounting.  The purchase price was allocated to the acquired assets andassumed liabilities based on their fair values.  The calculation of thepurchase price and allocation to assets is as follows:

  
| ** **                                  | ** ** | **Ladder** | ** ** | **Nowata** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| • Net Acquisition Price                |       | $          | 2,248,542  |       | $          | 2,524,721 |   |
| • Asset Retirement Obligations         |       | 241,905    |       | 71,027     |       |
| • Assurance of Payment of Indebtedness |       | 47,975     |       | —     |       |
| • Total Purchase Price                 |       | $          | 2,538,422  |       | $          | 2,595,748 |   |
|                                        |       |       |       |       |       |
| Allocation of Purchase  Price:              |       |       |       |       |       |
| • Cash                                 |       | $          | 110,075    |       | $          | — |   |
| • Accounts Receivable                  |       | 2,917      |       | —     |       |
| • Prepaid Assets                       |       | 13,470     |       | —     |       |
| • Oil & Gas Properties             |       | 2,411,960  |       | 2,595,748  |       |
|                                        |       | $          | 2,538,422  |       | $          | 2,595,748 |   |
|                                        |       |       |       |       |       |   |   |   |   |   |

 

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’sinternal analysis, we believe the value assigned to these properties isreasonably supported.

 

Pro Forma FinancialInformation

The following condensed pro forma information gives effect to theacquisitions as if they had occurred on July 1, 2004 and 2003,respectively.  The pro forma information has been included in the Notes asrequired by GAAP and is provided for comparison purposes only.  The actualresults could differ.  The pro forma financial information is notindicative of the financial results that would have occurred had the businesscombinations been effective on and as of the dates indicated and should not beviewed as indicative of operations in the future.

 

**CanoPetroleum, Inc.**

**Pro FormaInformation**

 
| ** **                                       | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **2004**                                  | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Operating revenues                               |       | $                                         | 1,454,392  |                                    | $          | 945,153 |   | $ | 2,847,789 |   | 1,865,365 |   |
| Income (loss) applicable  to common stock        |       | $                                         | (788,953   | )                                       | $          | 175,758 |   | $ | (1,654,406 | ) | $ | 101,680 |   |
| Net income  (loss) per share - basic and diluted |       | $                                         | (0.11      | )                                       | $          | 0.02 |   | $ | (0.16 | ) | $ | 0.01 |   |

 

**4.****             ****RELATED PARTY TRANSACTION**

 

On August 16, 2004, we agreed to purchase an additional 10%revenue interest in the Davenport field from Cano Energy Corporation (“CEC”). This increased our revenue interest in the Davenport field to 65%.  Inconsideration for the additional 10% revenue interest, we agreed to pay$667,000 cash to CEC.  The final paymentinstallment was made in October 2004. Our CEO, S. Jeffrey Johnson, is a principal shareholder of Cano EnergyCorporation.

 

At September 30, 2004, CEC owed Cano approximately $25,000.  Cano collected this amount in full from CEC inOctober 2004.  As of December 31,2004, there are no outstanding balances between Cano and CEC.

 

On December 16, 2004, we issued stock options for 50,000 shares ofour common stock to Gerald Haddock, who currently serves on our board ofdirectors.  The exercise price is $4 peroption share.  The options can not beexercised for a six month period, referred to as the option period.  After the option period, the options willexpire in ten years.  In accordance withthe provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*, and SFAS No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure*,we have recorded a charge to general and administrative expenses of $11,666.

 

**5.****             ****RESTRICTED CASH**

 

As discussed in Cano’s Form 10-KSB dated June 30, 2004, pursuantto the terms of the Merger Agreement, funds totaling $866,339 were placed inescrow and dedicated to improvements and drilling in the Davenportfield.   We have conducted drillingactivities and implemented improvements in the Davenport field during the pastfour months, which were funded by this escrowed amount.  At December 31,2004, the escrow balance was used in its entirety, and accordingly, no longerappears in the Consolidated Balance Sheet.

 

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

 

Our financial statements reflect the provisions of Statement ofFinancial Accounting Standards No. 143,*Accounting for Asset Retirement Obligations*.  Our assetretirement obligation (“ARO”) primarily represents the estimated present valueof the amount we will incur to plug, abandon and remediate our producingproperties at the end of their productive lives, in accordance with applicablestate laws.  We determine our ARO by calculating the present value ofestimated cash flows related to the liability.  At December 31, 2004,our liability for ARO was $408,064, of which $390,881 is considered longterm.  Our asset retirement obligations are recorded as current or non-currentliabilities based on the estimated timing of the anticipated cash flows. Forthe six months ended December 31, 2004, we have recognized accretionexpense of $10,860.

 

The following table describes the changes in our asset retirementobligations for the six months ended December 31:

 
| ** **                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Asset retirement  obligation at July 1,      |       | $        | 84,272     |     | $          | — |   |
| Liabilities incurred:                             |       |     |       |     |       |
| Acquistion of Ladder  Energy Company              |       | 241,905  |       | —   |       |
| Accquistion of Nowata  Properties                 |       | 71,027   |       | —   |       |
| Accretion expense                                 |       | 10,860   |       | —   |       |
|                                              |       |     |       |     |       |
| Asset retirement  obligation at December 31, |       | $        | 408,064    |     | $          | — |   |

 

 

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

 

As discussed in our Form 10-KSB dated June 30, 2004, pursuant tothe terms of the Merger Agreement, eight individuals (seven of whom are nowemployed by us and one who is a member of our board of directors) were issued5,165,000 shares of common stock.  Theseshares were placed in escrow.  The shares will vest to the individualsbased on a combination of continued employment (“compensation shares”) andachieving certain performance goals (“performance shares”) during the periodending June 30, 2006.  The compensation shares amounted to2,659,975 shares and the performance shares amounted to 2,505,025 shares. Any shares that are not released from escrow will be returned to TreasuryStock.  We have accounted for these shares in accordance with theprovisions of SFAS Nos. 123 and 148.  Atthe merger date, we recognized $2,324,250 of “Deferred Compensation” and “AdditionalPaid-in Capital” in the Consolidated Balance Sheet.  The shares wererecorded based on the quoted market price at the time of the transaction andare being amortized to expense over the periods earned.  At December 31,2004, the balance of Deferred Compensation was $1,317,599, net of amortizationexpense.

 

**8.****             ****NETLOSS 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 netincome (loss) per common share is computed in the same manner, but alsoconsiders the effect of the convertible preferred stock and stock options.  The convertible preferred stock and stockoptions are not considered for the three and six months ended December 31,2004 as their effects would be anti-dilutive.

 

The weighted average shares used in the basic loss per common sharecomputations for December 31, 2004 and 2003 were 10,482,204 shares and6,982,204 shares, respectively.  The shares at December 31, 2004exclude 5,165,000 contingently issuable shares as discussed in Note 7.

 

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**9.****             ****COMMITMENTS ANDCONTINGENCIES**

 

***Litigation***

Occasionally, we are involved in various lawsuits and certaingovernmental proceedings arising in the ordinary course of business.  Ourmanagement and legal counsel do not believe that the ultimate resolution ofsuch matters, will have a material effect on our financial position or resultsof operations.

 

***Other***

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.

 

**Item 2.  Management’s Discussion and Analysis or Planof Operation.**

 

**Forward-LookingStatements**

 

Theinformation in this report on Form 10-QSB contains forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of 1995.This Act provides a “safe harbor” for forward-looking statements to encouragecompanies to provide prospective information about themselves provided theyidentify these statements as forward looking and provide meaningful cautionary statementsidentifying important factors that could cause actual results to differ fromthe projected results. All statements other than statements of historical factmade in this report are forward looking. In particular, the statements hereinregarding industry prospects and future results of operations or financialposition are forward-looking statements. Forward-looking statements reflectmanagement’s current expectations and are inherently uncertain. Our actualresults may differ significantly from management’s expectations as a result ofmany factors, including, but not limited to, the volatility in prices for crudeoil and natural gas, the timing of acquisitions, interruption in production andthe success of drilling operations and secondary recovery efforts.

 

Thefollowing discussion and analysis should be read in conjunction with theconsolidated financial statements of Cano Petroleum, Inc. and subsidiaries andnotes thereto, included herewith. This discussion should not be construed toimply that the results discussed herein will necessarily continue into thefuture, or that any conclusion reached herein will necessarily be indicative ofactual operating results in the future. Such discussion represents only thebest present assessment of management.

 

**Plan ofOperation**

 

***Overall Strategy***

 

Weare a growing independent oil and gas company engaged in acquisition anddevelopment of mature fields with established oil and gas reserves that havedeclined to marginal production levels, yet still possess significant remainingupside exploitation potential.  We have increased production and reserveson the properties that we own and intend to continue to increase production andreserves on those properties, as well as new acquisitions, through drilling newwells and implementing other development programs, such as well workovers andsecondary and tertiary recovery operations.  We constantly review existingoperations to determine if actions can be taken to increase efficiency andreduce operating costs.  Our focus on mature fields reduces the risk ofdrilling dry holes.

 

Webelieve significant opportunities exist primarily because the major energycompanies continue to focus their attention and resources toward the discoveryand development of large fields.  Moreover, the major companies have higherinternal overhead costs that prevent them from fully developing production fromexisting, mature fields.  And, the recent economics of the oil and gasmarket have improved as prices have risen substantially. These conditionsprovide ample opportunities for smaller independent companies to purchase andexploit mature U.S. fields.  We expectthat there will be increased competition for such properties in the future.

 

Wewill continue to target potential acquisition candidates in a disciplinedmanner.  By adhering to our

 

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disciplined approach, we expect to prevent overpaying for acquisitionand development opportunities.

 

Ourcompetitive advantage is our in-house expertise and low internaloverhead.  We employ independent engineers and geologists to aid inevaluating the economic merits of drilling plans and potentialacquisitions.  We believe that the incremental cost of hiring independentengineering firms justifies the expense because they provide a check andbalance on our acquisition and development plans.  Further, employingthird party experts on a case-by-case basis enables us to maintain lowoperating expenses and adhere to our commitment to keep fixed costs low.

 

**Liquidity and Capital Resources**

 

We intend to finance futureacquisitions of oil and gas properties, drilling programs, and extensive fielddevelopment activities with a combination of issuances of equity, access tocapital markets, and cash flow from operations. We cannot guarantee that any additional equity financing will beavailable in sufficient amounts or on acceptable terms when needed.  If such financing is not available in sufficientamounts or on acceptable terms, our results of operations and financialcondition may be adversely affected.  Inaddition, equity financing may result in dilution to existing stockholders andmay involve securities that have rights, preferences, or privileges that aresenior to our common stock.

 

***Financing and Investing Activities***

 

As discussed in Note 2 tothe financial statements, as of December 31, 2004, we have received grossproceeds totaling $8.75 million from the issuance of preferred stock, of which$5.35 million was received during the past six months.  These proceeds were our primary source tofund the Davenport Merger, as discussed in our Form 10-KSB dated June 30,2004, and the following acquisitions and development activities during the sixmonths ended December 31, 2004:

 

•                  Acquisition of the Nowata Oil Properties LLCfor $2.5 million (Note 3).

•                  Acquisition of the Ladder Companies, Inc. for$2.2 million (Note 3).  For operationalpurposes, we refer to Ladder as the Rich Valley field.

•                  Purchase of an additional 10% revenueinterest in the Davenport field for $0.7 million (Note 4).

•                  Capital expenditures of $1.4 million,consisting primarily of drilling two wells in the Davenport field.

 

Based on reserve reportsprepared by independent petroleum engineers dated July 1, 2004, our totalreserves are summarized as follows:

 
| ** **                                              | ** ** | **Davenport** | ** ** | **Ladder**  | ** ** | **Nowata**  | ** ** | **Total  Reserves** | ** ** |
|---------------------------------------------------------|------------|---------------|------------|-------------|------------|-------------|------------|---------------------|------------|
|                                                    |       |          |       |        |       |        |       |                |       |
| **Proved:**                                             |       |          |       |        |       |        |       |                |       |
| Oil - barrel  (“bbl”)                         |       | 213,245       |       | 231,807     |       | 995,753     |       | 1,440,805           |       |
| Gas – thousand  cubic feet (“mcf”)       |       | —        |       | 2,341,858   |       | —      |       | 2,341,858           |       |
| **Proved  Barrels of Equivalent (“BOE”) Oil** | ** ** | **213,245**   | ** ** | **622,117** | ** ** | **995,753** | ** ** | **1,831,115**       | ** ** |
|                                                    |       |          |       |        |       |        |       |                |       |
| **Proved  Producing (BOE)**                             | ** ** | **12,608**    | ** ** | **468,556** | ** ** | **995,753** | ** ** | **1,476,917**       | ** ** |

 

Energy lenders typically loanto oil and gas companies based on the value of the proved producing reserves,defined as reserves that can be reasonably expected to be recovered fromexisting wells with existing equipment and operating methods from knownreservoirs under existing economic and operating conditions.  During the firstquarter of 2005, we intend to seek a debt facility secured by our provedproducing reserves to provide a source of cash to fund our operating activitiesand acquisitions.

 

During October 2004, wereceived additional gross proceeds of $750,000 from the sale of 750 shares ofSeries C Convertible Preferred Stock. This increased our total gross proceeds from the issuance of preferredstock to $8.75 million.  For futureconsideration, we will continue to consider issuances of equity as a potentialoption to provide cash to fund our operating activities and acquisitions.

 

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***Operating Activities***

 

For the six months ended December 31,2004, net cash used in operating activities was $661,227.  We are seeking to improve cash flow fromoperating activities through operational improvements at our existingproperties and future acquisitions.  Theincreased cash flow from field operations could be offset, in part, byincreased general and administrative costs to support our expanding operations.

 

**Results of Operations**

 

The table below summarizesour results of operations through December 31, 2004.

 
| ** **                                       | ** ** | **Current Quarter  Dec. 31, 2004** | ** ** | **Prior Quarter  Sept. 30, 2004** | ** ** | **Six Months Ended  Dec. 31, 2004** | ** ** |
|--------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| Net Loss Before Certain Accounting  Transactions | ** ** | $                                  | (89,639    | )                                 | $          | (375,141                            | )          | $ | (464,780 | ) |
|                                             | ** ** |                               |       |                              |       |                                |       |   |   |   |
| Less:                                            | ** ** |                               |       |                              |       |                                |       |
| Deferred Compensation Expense                    | ** ** | 619,314                            |       | 290,532                           |       | 909,846                             |       |
| Preferred Stock Discount                         | ** ** | 80,000                             |       | 336,534                           |       | 416,534                             |       |
| Subtotal                                         | ** ** | 699,314                            |       | 627,066                           |       | 1,326,380                           |       |
| Loss Applicable to Common Stock                  | ** ** | $                                  | (788,953   | )                                 | $          | (1,002,207                          | )          | $ | (1,791,160 | ) |

 

The current quarter net lossbefore certain accounting transactions of $89,639 was an improvement of approximately$286,000 as compared to the prior quarter. This is primarily due to the current quarter including three months of Nowataoperating results, as compared to the prior quarter having one month of Nowataoperating results.

 

As discussed in Note 2 tothe financial statements, we have recorded the beneficial conversion featurerelated to our Series C Preferred Stock.  On the dates of certainissuances of our Series C Preferred Stock, the quoted market price of ourcommon stock was higher than the conversion price of our Series C PreferredStock of $3.75 per share, resulting in a beneficial conversion feature. For the three and six months ended December 31, 2004, the beneficial conversionfeature amounted to $80,000 and $416,534, respectively.  The beneficialconversion feature is analogous to a preferred dividend.  These amountsare presented in our Consolidated Statements of Operations as “Preferred StockDiscount.”  There was no impact to our cash flow.

 

***Operating Revenues***

 

The table below summarizesour operating revenues through December 31, 2004.

 
| ** **         | ** ** | **Current Quarter  Dec. 31, 2004** | ** ** | **Prior Quarter  Sept. 30, 2004** | ** ** | **Six Months Ended  Dec. 31, 2004** | ** ** |
|--------------------|------------|------------------------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| Operating Revenues |       | $                                  | 1,454,392  |                              | $          | 864,160                             |       | $ | 2,318,552 |   |
| Sales              |       |                               |       |                              |       |                                |       |
| - Oil (MBbls)      |       | 25                                 |       | 13                                |       | 38                                  |       |
| - Gas (MMcf)       |       | 49                                 |       | 44                                |       | 92                                  |       |
| - Total (MBOE)     |       | 33                                 |       | 20                                |       | 53                                  |       |
| Average Price      |       |                               |       |                              |       |                                |       |
| - Oil ($/ Bbl)     |       | $                                  | 47.27      |                              | $          | 44.30                               |       | $ | 46.30 |   |
| - Gas ($/  Mcf)    |       | $                                  | 6.25       |                              | $          | 5.69                                |       | $ | 6.00 |   |

 

The current quarteroperating revenues of $1,454,392 were an improvement of approximately $590,000as compared to the prior quarter.  Theincrease is primarily due to the current quarter including three months ofNowata (as previously discussed in “Operating Results”); higher prices receivedfor sales of crude oil and natural gas; and increased gas sales from the RichValley field.

 

***Operating Expenses***

 

For the current quarter, ourtotal operating expenses were $2,167,597, which were approximately $633,000higher as compared to our prior quarter. The increase is primarily due to the current quarter including threemonths

 

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of Nowata (as previously discussed in “Operating Results”) andincreased deferred compensation expense. Our operating expenses consist primarily of lease operating expenses,general and administrative, depletion and depreciation, and deferredcompensation expense, as discussed in Note 7 to the financial statements.

 

The table below summarizesour lease operating expenses through December 31, 2004.

 
| ** **                      | ** ** | **Current Quarter  Dec. 31, 2004** | ** ** | **Prior Quarter  Sept. 30, 2004** | ** ** | **Six Months Ended  Dec. 31, 2004** | ** ** |
|---------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|-------------------------------------|------------|
| Lease Operating Expenses  (LOE) |       | $                                  | 581,621    |                              | $          | 415,123                             |       | $ | 996,744 |   |
|                            |       |                               |       |                              |       |                                |       |
| LOE per BOE                     |       | $                                  | 17.70      |                              | $          | 20.40                               |       | $ | 18.70 |   |
|                                 |            |                                    |            |                                   |            |                                     |            |  |  |  |  |  |

 

As shown above, the currentquarter LOE per BOE of $17.70 is a decrease as compared to the priorquarter.  The prior quarter LOE includedexpenditures for operational improvements made at Davenport and Rich Valleythat contributed toward increased future sales. We will continue to evaluate potential operational improvements for allthree fields.

 

Our general andadministrative expenses consist of support services for our operatingactivities, along with investor relation costs during the current quarter andsix month period of approximately $224,000 and $437,000, respectively.

 

**Off BalanceSheet Arrangements**

 

Wedo not have any off balance sheet arrangements as of December 31, 2004 oras of the date of this report.

 

**Item 3.  Controls and 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 financial officerof our disclosure controls and procedures (as defined in Rule 13a-15(e) andRule 15d-15(e) of the Exchange Act). Based upon this evaluation, our chiefexecutive officer and chief financial officer concluded that our disclosurecontrols and procedures are effective to ensure that information required to bedisclosed by us in the reports that we file or submit under the Exchange Act isrecorded, processed, summarized and reported, within the time periods specifiedin the Commission’s rules and forms.  There was no change in our internalcontrols or in other factors that could affect these controls during our lastfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

**PART II –OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

Occasionally, we areinvolved in various lawsuits and certain governmental proceedings arising inthe ordinary course of business.  Our management and legal counsel do notbelieve that the ultimate resolution of such matters, will have a materialeffect on our financial position or results of operations.  None of ourdirectors, officers or affiliates is involved in a proceeding adverse to ourbusiness or has a material interest adverse to our business.

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

 

During the six months ended December 31,2004, we received gross proceeds of $5.35 million from the sale of 5,350 sharesof Series C Convertible Preferred Stock at a price of $1,000 per share. This sale of preferred stock was exempt from registration requirements pursuantto Section 4(2) of the Securities Act of 1933, as amended (the “SecuritiesAct”), and/or Regulation D, promulgated pursuant to the Securities Act.

 

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**Item 3.  Defaults Upon 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, with respectto any indebtedness exceeding five percent of our total assets.  There also is no material arrearage in thepayment of dividends or any other material delinquency not cured within 30days, with respect to any class of preferred stock which is registered or whichranks prior to any class of our registered securities, or with respect to anyclass of preferred stock of any significant subsidiary.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

 

There were no matterssubmitted to a vote of security holders during the period covered by thisreport.

 

**Item 5.  Other Information.**

 

None.

 

**Item 6.  Exhibits.**

 

References to “the Company” in the following exhibitlist mean Cano Petroleum, Inc., a Delaware corporation.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                       |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Stock Option Agreement dated December 16, 2004 between Cano  Petroleum, Inc. and Gerald W. Haddock, incorporated by reference to Form 8-K  filed on December 16, 2004.                                                                                      |
| 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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**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: | February 16, 2005 |   | By:                                                       | /s/ S. Jeffrey Johnson |   |
|   |                   |   | S. Jeffrey Johnson                                        |
|   |                   |   | Chief Executive Officer                                   |
|   |                   |   |                                                      |
|   |                   |   |                                                      |
| Dated: | February 16, 2005 |   | By:                                                       | /s/ Michael J. Ricketts |   |
|   |                   |   | Michael J. Ricketts                                       |
|   |                   |   | Chief Financial Officer and  Principal Accounting Officer |
|        |                        |        |                                                           |  |  |  |

 

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